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News August 28, 2006 Issue

Industry Commenters Urge SEC to Drop Fund Governance Rulemaking

The comment period closed last week on the costs and benefits of the SECís controversial fund governance rule. Not surprisingly, the groups that supported the independent chair and 75 percent independent requirements in the past continued to support it. And those that opposed it continued to oppose it.

One notable change in position, however, came from the Independent Directors Council, an offshoot of the Investment Company Institute. In the past, the IDC said they would not oppose the 75 percent independent requirement. This time, however, they affirmatively supported it.

(Technically, the IDC did not exist back when the fund governance rules were proposed in January 2004. At the time, though, the ICIís Directors Committee, the predecessor to the IDC, commented that it would "not oppose the increase in independent board members to 75 percent.")

In its recent comment letter, the IDC noted that according to an ICI/IDC study, 80 percent of fund boards already met the 75 percent requirement as of year-end 2005.

In contrast, the ICI itself strongly opposed the 75 percent requirement and asked the Commission to instead require a two-thirds majority of independent directors. Noting that the most fund boards consist of eight members, the group pointed out that under a 75 percent standard, an eight-person board "would be in violation of the requirement after a single independent director resigned." A board with two interested directors would need to have nine members "before it could withstand a single independent director resignation without needing a replacement," said the group. In contrast, a seven-person board with two interested directors could withstand a resignation without needing to elect or appoint another director, under a two-thirds independent standard.

The IDC and the ICI were united in their opposition to a mandatory independent chair requirement. They noted that because the chair is selected by the fundsí independent directors, those independent directors already are in a position to select an independent chair if they so choose. The ICI noted that the SEC could alternatively require fund boards that do not have an independent chair to appoint a "lead independent director." The group also noted that the "disclosure approach" first suggested by Commissioner Paul Atkins and former Commissioner Cynthia Glassman "would allow investors to choose among funds on this basis if the status of the board chair is important to them."

The most compelling arguments came from the ICIís Small Funds Committee. In a letter submitted separately from the general ICI letter, the Committee noted that the median annual expense paid by a small fund complex is $1.7 million. In contrast, the average industry-wide fund complex expense is $91 million. The Committee, therefore, took exception to the Commissionís statement (in its response to the courtís first opinion) that the costs of the proposed requirements "are extremely small relative to the fund assets for which fund boards are responsible" and that the SEC expected "that the minimal added expense of compliance with these conditions will have little, if any, adverse effect on efficiency, competition, and capital formation."

Not so, sayeth the small funds. "While the costs to a fund complex with expenses equal to the industry average of $91 million may not be significant, we can assure the SEC that the costs of implementing these rules will impact those of us with expenses closer to $1.7 million," they asserted.

The Mutual Fund Directors Forum did not affirmatively support the SECís adoption of a rule requiring fund boards to have an independent chair and consist of 75 percent independent directors. Instead, said the group, mutual funds "should be encouraged, as a best practice," to have an independent chair and a 75 percent independent board.

A recommended best practice and a mandatory rule are, of course, two different things.

"In recommending best practices," said the group, "the Forum recognizes that each fund and fund family is unique, that fund directors need to assess whether a particular practice makes sense for a particular fund, and that in some circumstances the independent directors of a fund may reasonably conclude that the recommended governance structure may not be in the best interests of their fundís shareholders."

Not surprisingly, the Consumer Federation of America and Fund Democracy wrote in support of both the independent chair and the 75 percent independent requirements, urging the SEC to quickly reaffirm the rule. Putting a positive spin on the two court decisions striking down the SECís rule, the groups noted that the court "has repeatedly rejected the substance of industry challenges to the rules and instead has upheld both the authority of the Commission to adopt these rules and the basis for its action." In fact, said the group, "[t]he last ruling from the court essentially left only the collection of cost data on the rules and a weighing of their costs and benefits to be completed before the rules could become law."

Now that the mandate is issued, however, it seems that the SEC would have to begin a new formal proposal-comment-adoption cycle before the fund governance rules could be finalized.

Lastly . . . the Chamber of Commerceís 19-page, densely-written, legalistic comment letter was a far cry from its short, mild-mannered letter submitted in March 2004. Reading like a brief, the Chamber urged the SEC to close the rulemaking record, or, if anything, adopt the disclosure approach urged by Commissioner Atkins and former Commissioner Glassman.