Investment Management
JULY 2003
New Mutual Fund Legislative and Regulatory
Developments
The month of June witnessed an extraordinary
amount of fast-breaking activity in the world of
mutual fund regulation. First, on June 9, the SEC
responded to the request of Richard H. Baker,
Chairman of the House Subcommittee on Capital
Markets, on a large number of issues raised in
Subcommittee hearings held in March of this year.
The SEC’s response took the form of a memorandum
from Paul Roye, Director of the Division of
Investment Management (“SEC Response”).
Although such a memorandum would be expected to
receive intensive review by the members of the
Commission, its publication as a staff document, as a
matter of practice, provides the Commission with
considerable “wiggle” room on the positions taken in
the SEC Response.
Second, on June 11, within two days of receiving the
SEC Response, Chairman Baker introduced the
Mutual Funds Integrity and Fee Transparency Act of
2003 (“Bill”) designed to enhance independent
director governance of fund affairs, as well as
shareholder disclosure of fund operating expenses,
distribution payments and soft dollar arrangements.
The Bill’s disclosure requirements, in particular,
differ in substantial respects from the positions taken
in the SEC Response.
Also on June 11, the SEC responded to the request of
Congressmen Paul E. Kanjorski and Robert W. Ney,
members of the House Subcommittee, on several of
the same issues raised by Congressman Baker. On
those issues, the SEC’s response was substantially
similar to its earlier response.
Finally, the House Subcommittee held a hearing on
the Bill on June 18 at which it heard testimony from
the SEC, the General Accounting Office (“GAO”),
the Investment Company Institute (“ICI”) and
industry representatives.
Chairman Baker seems determined to mark up the
Bill quickly and seek House passage prior to the end
of this session. The Senate leadership, on the other
hand, has indicated that it will not actively consider
this legislation, but its position could change if the
House passes a Bill that the SEC supports.
Significantly, a substantial portion of the Bill could
be implemented by the SEC under its existing
rulemaking authority. Accordingly, there is little
doubt that the issues raised by the Bill and by the
SEC Response represent what will become the SEC’s
mutual fund regulatory agenda during the Donaldson
administration.
Our analysis of the issues raised in the Subcommittee
hearing, the Bill and the SEC Response is set forth
below.
MUTUAL FUND GOVERNANCE
Independent Supermajority, Independent
Chairman, and Definition of “Interested
Person”
The Bill would amend provisions of the Investment
Company Act of 1940 (“1940 Act”) that address
mutual fund governance by requiring a
“supermajority”—at least two-thirds—of a fund’s
board to be independent (that is, not “interested
persons” of the fund, as defined in the 1940 Act) and
by requiring the chairman of the board to be
independent as well.
Kirkpatrick & Lockhart LLP
At the Subcommittee hearing, the SEC, represented
by Paul Roye rather than Chairman Donaldson, was
supportive of the independent “supermajority
requirement,” even though it was not mentioned in
the SEC Response. The ICI, represented by its
Chairman, Paul G. Haaga, Jr., also supported the
supermajority requirement, noting that it had
previously recommended a supermajority as a best
practice.
The ICI, however, strongly opposed the requirement
that the chairman of each fund board be an
independent director on the grounds that (1) having a
chairman who is acquainted with fund operations
affirmatively benefits the board; and (2) having an
independent chairman is unnecessary with a twothirds supermajority of independent directors. The
SEC Response had favored a lead independent
director mechanism over an independent chairman,
and at the hearing the SEC seemed to agree with the
ICI that an independent chairman would not be
necessary with a two-thirds supermajority.
The Bill would also provide the SEC with expanded
rulemaking authority to determine who is an
“interested person” of a fund by including in the
definition of “interested person” any natural person
who may be deemed unlikely to exercise an
appropriate degree of independence because of (1) a
material business or professional relationship with
the fund or a fund affiliate; or (2) a close familial
relationship with any natural person who is affiliated
with the fund. Both the SEC and the ICI supported
this provision.
Audit Committee Requirements for
Mutual Funds
The Bill would extend to mutual funds the audit
committee requirements of Section 301 of the
Sarbanes-Oxley Act of 2002, which currently apply
only to exchange-listed companies, including closedend investment companies. These provisions require
that audit committees: (1) be directly responsible for
the appointment, compensation and oversight of the
work performed by the auditors (including resolution
of disagreements between management and the
auditors regarding financial reporting); (2) be
comprised only of independent directors;
(3) establish “whistleblowing” procedures for
complaints received regarding accounting matters;
(4) have authority to engage independent counsel and
other advisers as the audit committee determines
necessary to carry out its duties; and (5) have
authority to obtain funding to compensate the
independent auditors and any advisers employed by
the audit committee.
Many fund boards have amended their audit
committee charters, or are in the process of
amending their charters, to comply substantially with
all these requirements. Accordingly, this proposal
should have limited impact on the mutual fund
industry.
Revenue Sharing, Directed Brokerage and Soft
Dollars: Affirmative Fiduciary Duty for Fund
Directors
The Bill would amend Section 15 of the 1940 Act to
require fund advisers to report annually to a fund’s
board of directors on revenue sharing, directed
brokerage and soft dollar arrangements with respect
to the fund. The Bill also would amend Section 15 to
state that a fund’s board has an express fiduciary
duty to: (1) supervise the investment adviser’s
direction of fund brokerage, including directed
brokerage and soft dollar arrangements; and
(2) determine that the adviser’s direction of fund
brokerage is in the best interests of fund
shareholders. The Bill would further require the
board to review any arrangements involving
payments by fund affiliates (typically the adviser) for
the sale and distribution of the fund’s shares—a
practice commonly known as “revenue sharing”—to
ensure compliance with the 1940 Act and to
determine that any revenue sharing arrangements are
in the best interests of fund shareholders.
Paul Roye stated that the SEC supports these
proposals. As outlined in the SEC Response, he
noted that mutual fund boards of directors currently
consider the transaction costs incurred by a mutual
fund in connection with a mutual fund board’s review
of investment advisory contracts under Section 15(c),
as well as the standards set forth in court decisions,
such as Gartenberg.
Paul Haaga, on behalf of the ICI, also voiced no
objection to making explicit the fiduciary duty of
directors with respect to soft dollars and directed
brokerage. He noted, however, that directors already
review these issues and that the SEC has adequate
authority under existing law to deal with them. With
regard to revenue sharing payments for sales of fund
shares, in contrast, the ICI noted that fund board
oversight would be misplaced because those
payments are made from revenues of the adviser or
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its affiliates and do not involve a cost to the fund.
The ICI also reaffirmed its long-standing support of
point-of-sale disclosure of revenue sharing payments
by broker-dealer recipients of such payments as a
more direct and appropriate regulatory response to
the issues raised by revenue sharing.
ENHANCED DISCLOSURE OF FEES AND
EXPENSES
The Bill would require the SEC to amend federal
securities regulations to require mutual funds to
disclose, in a document other than the prospectus or
statement of additional information (“SAI”) (such as
quarterly account statements or shareholder reports),
the following:
n
The estimated dollar amount of fund operating
expenses that is borne by each shareholder;
n
The structure of, or method used to determine,
portfolio manager compensation;
n
The fund’s portfolio transaction costs,
including brokerage commissions, set forth in a
manner that facilitates comparison among
funds;
n
Information about the fund’s policies and
practices concerning “soft dollar” payments for
research;
n
Information about the fund’s use of “directed
brokerage” to dealers that distribute the fund’s
shares in addition to providing brokerage
services;
n
Information about “revenue sharing” payments;
and
n
Information about investor eligibility for
discounts on front-end sales loads, including
any required minimum purchase amounts.
At the Subcommittee hearing, those testifying
generally expressed support for the goals of the Bill’s
disclosure initiatives. There was, however,
significant disagreement regarding the details: when,
where and how the disclosures should be made. In
particular, both the SEC and the ICI opposed
provisions of the Bill that (1) mandate disclosure of
the above matters in a mutual fund quarterly
statement, periodic report or other appropriate
document, and (2) explicitly state that disclosure
“exclusively in a prospectus or SAI or both” is not
considered appropriate. Both the SEC and the ICI
urged that the Bill preserve the SEC’s flexibility to
determine the appropriate location for each of the
mandated disclosures.
Disclosure of Fund Operating Expenses
The Bill would require disclosure of the estimated
amount in dollars of a fund’s operating expenses that
is borne by each shareholder. Both the SEC and the
ICI expressed clear support for the requirement of
disclosure of the dollar amount of fund expenses that
each investor indirectly bears. However, both
opposed the disclosure in quarterly account
statements individualized for each shareholder.
Paul Roye pointed out that the SEC had an existing
rule proposal to require annual and semiannual report
disclosure of fund expenses in dollars associated
with a hypothetical $10,000 investment. Roye
argued that this approach was far less costly and
would provide investors with many advantages,
especially a basis for expense comparisons among
various funds. The ICI, as expected, strongly
supported the SEC’s disclosure proposal over the
provisions in the Bill. The GAO, on the other hand,
argued for disclosure in quarterly account statements
on the theory that investors are more likely to read
those statements than fund shareholder reports.
Portfolio Transaction Costs
The Bill also would call for disclosure of mutual
fund transaction costs, including not only
commissions, but also spreads and market impact
and opportunity costs. Roye agreed with Chairman
Baker that mutual fund shareholders need to better
understand a fund’s trading costs to evaluate the
costs of operating a fund. He cautioned, however,
that quantitative disclosure of trading costs is
extremely problematic. He noted that some trading
cost components, such as brokerage commissions,
can be quantified easily and precisely, while others,
such as spreads, market impact cost and opportunity
cost can be quantified only with great difficulty,
using one of a variety of estimation methods based
on easily manipulable assumptions. Accordingly, the
SEC concluded that proposals to quantify transaction
costs are not feasible and, if adopted, would result in
estimates that would not be uniform, reliable or
verifiable. Nonetheless, Roye indicated that the staff
would consider whether to recommend that the SEC
issue a concept release to elicit views on how to
quantify transaction costs. He also indicated that the
staff would examine various approaches for
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improving current disclosure of transaction costs to
make the information more understandable to the
average investor.
The ICI strongly opposed the proposal to require
quantified disclosure of transaction costs. Such a
disclosure requirement would be the most
problematic of all the Bill’s provisions for mutual
funds to implement because of the unavoidable lack
of clear standards.
Portfolio Management Compensation
The Bill would require disclosure of the structure of,
or methods used to determine, the compensation of
fund portfolio managers, e.g., how any performance
bonuses are determined. Both the SEC and the ICI
supported this disclosure as a supplement to the
existing disclosure of advisory fees.
Soft Dollars
The Bill would require disclosure of soft dollars to
acquire research. The SEC supported the legislation
in principle, as did the ICI. The SEC Response
expressed the belief that independent directors are in
the best position to monitor the use of fund
brokerage but agreed that the time may have come to
consider improved disclosure in shareholder
disclosure documents suggested by the Bill.
Significantly, the SEC Response also had suggested
that legislation may be appropriate to eliminate or
modify the safe harbor for the use of brokerage to
acquire research provided by Section 28(e) of the
Securities Exchange Act of 1934. The Bill does not
contain such a provision. It does, however, provide
for an SEC study of Section 28(e) to be submitted to
Congress within 18 months of the Bill’s enactment.
The study would address trends in soft dollar
commissions, potential impairment created by soft
dollar arrangements on the ability of fund investors
to evaluate mutual fund expenses, conflicts of
interest created by soft dollar arrangements, and,
significantly, whether Section 28(e) should be
repealed or modified. The SEC and the ICI both
supported a soft dollar study.
Brokerage for Sales of Fund Shares
The Bill also provided for improved information
concerning fund policies and practices regarding
directed brokerage to sellers of fund shares. The
SEC supported in principle the provisions of the Bill
with respect to such disclosure, as did the ICI.
More significantly, the SEC Response indicated that
the staff was considering proposals to require that a
portion of brokerage commissions allocated for the
purpose of compensating selling broker-dealers be
recognized as a use of fund assets to finance
distribution. In that event, some portion of the
brokerage commissions would be treated as a
payment that must be made under a Rule 12b-1 plan
and, thus, would be subject to board oversight and
limitations imposed by NASD sales charge rules.
This proposal, if adopted, could significantly impact
the ability of broker-dealer distributed funds to use
brokerage as extra compensation for sales of fund
shares.
Revenue Sharing Payments
The Bill also would require disclosure to investors of
information concerning revenue sharing payments by
fund advisers and distributors to sellers of fund
shares. The SEC supported this legislation, noting
that there are increased demands from broker-dealers
for revenue sharing payments in addition to sales
loads and 12b-1 fees. The SEC stated that it has
directed its staff to make recommendations for
requiring disclosure of revenue sharing payments by
broker-dealers. The SEC staff has indicated that it is
likely that the SEC will require such disclosure,
either in confirmations or in quarterly account
statements of broker-dealers, regardless of whether
the Bill is enacted. The ICI is on record as favoring
this kind of disclosure.
Sales Load Breakpoints
The SEC Response also supported provisions of the
Bill requiring improved disclosure concerning
available discounts on front-end sales loads, and it is
likely that such disclosure requirements will be
imposed either by the SEC or the NASD. There has
been widespread recent publicity concerning the
failure of broker-dealers to provide fund investors
with the benefit of available breakpoint discounts on
front-end sales loads. There are currently extensive
inquiries being conducted by the NASD, the NYSE
and the SEC in this area.
The SEC Response also outlined the role of fund
directors with respect to breakpoint discounts in
connection with purchases of fund shares. The SEC
Response acknowledged that the 1940 Act does not
impose any specific obligation on fund boards with
respect to the application of front-end sales loads.
Nevertheless, it argued that the directors’ general
Kirkpatrick & Lockhart LLP
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fiduciary duty to act in the best interests of their
funds requires them to oversee the administration of
breakpoint discounts, especially in light of the
problems that have been identified in the recent
regulatory inquiries. In particular, the SEC
Response stated that fund boards should review the
adequacy of their funds’ policies and procedures
relating to front-end sales loads and that fund boards
should further obtain assurances, through the funds’
principal underwriters, that broker-dealers selling
their shares have adequate policies and procedures
to ensure that investors receive the breakpoint
discounts to which they are entitled.
OTHER ISSUES COVERED BY THE SEC
RESPONSE
The SEC Response also covered other important
issues raised by Chairman Baker that were not
addressed in the Bill. These include the following:
Role of Fund Directors in Approving
Rule 12b-1 Plans
The SEC Response outlined fund directors’
obligations under 1940 Act Rule 12b-1, including
specific obligations set forth in the rule and the
enumerated factors from the rule’s 1980 adopting
release. The SEC Response noted that the staff
recommended that the SEC consider reviewing and
amending the requirements of Rule 12b-1. The SEC
Response acknowledged that Rule 12b-1 is outdated
because it essentially requires fund directors to view
a fund’s Rule 12b-1 plan as a temporary measure
even though payments under the plan often are used
on a continuing basis as a substitute for a front-end
sales load. The SEC Response stated that it will
continue to assess the issues raised by Rule 12b-1.
Board Rationale for Approving Advisory
Contracts
In dealing with a question from Chairman Baker on
the effectiveness of disclosures relating to a board’s
rationale for approving advisory contracts, the SEC
Response noted that much of the disclosure the staff
has reviewed on the subject has been satisfactory.
The SEC Response detailed what the staff considers
both poor disclosure and better disclosure:
n
Poor disclosure primarily recites boilerplate or
conclusory statements and fails to relate the
board’s considerations to the specific
circumstances of the fund, the adviser, and the
contract.
n
Better disclosure addresses or provides:
o
specific factors that were significant in the
board’s consideration and factors that were
not considered or deemed less significant;
o
the quality of specific services provided to
the fund;
o
the particular experience and performance
of the adviser with the particular fund and/
or the investment objectives and strategies
used by the fund; and
o
a non-cursory comparison of the fund’s
advisory fees to those of similarly situated
funds.
The SEC Response noted that the better disclosure
can be lengthy and, thus, is better suited for the SAI
than the prospectus.
Rejection of Management Contracts
The SEC Response also outlined fund directors’ and
investment advisers’ obligations in considering
investment advisory contracts. The SEC Response
acknowledged that fund directors have infrequently
terminated or rejected management or investment
advisory contracts during the period covered in
Congressman Baker’s request letter. Significantly,
the SEC Response argued that the infrequency of
contract terminations does not necessarily indicate
that the legal standards are inadequate or that
independent directors have not been forceful enough
in representing shareholder interests. The SEC
Response noted that directors have other options
available, such as renegotiating the terms of a
contract by adjusting the fee structure, or requiring
the adviser to take remedial steps, such as retaining a
subadviser, merging or liquidating the fund or
closing a fund to new investors.
Adequacy of Management Discussions in
Shareholder Reports
The SEC Response stated that, overall, discussions
of fund performance in shareholder reports were
either of good or average quality. The SEC
Response stated that a “better” discussion should
contain the following elements:
n
relatively detailed explanations of general
economic and market conditions, and specific
linkage of those explanations to fund
performance;
Kirkpatrick & Lockhart LLP
5
n
specific disclosure regarding particular fund
strategies and major portfolio holdings together
with a discussion of their impact on fund
performance;
n
for equity funds, discussion of exposures to
particular market sectors or industries; and
n
for debt funds, discussion of maturity and
duration issues.
With respect to multi-series funds, the SEC Response
noted that the “better” discussions usually set forth a
general discussion of the markets and world events,
instruct the reader to read on for discussions for each
fund, and provide specific analysis of why each fund
performed the way it did (repeating as necessary the
discussion of general factors and events where they
were relevant to a particular fund).
The SEC Response stated that “poorer” quality
discussions:
n
fail to address specifically how the funds’
specific investment choices and strategies
affect performance;
n
provide general “laundry lists” of world events
to explain their performance;
n
have general discussions that are too lengthy
and/or tied to specific funds; and
n
group the general and specific discussions in
such a way that it is difficult to determine
which fund is being discussed at any one point.
The SEC Response also noted, in particular, that any
significant impact of a fee waiver on the performance
of a fund should be discussed in shareholder reports.
Fund Performance Advertising
The SEC Response expressed concern that some
funds may use techniques in performance advertising
that “create unrealistic investor expectations or may
mislead potential investors.” These techniques
include failing to disclose that unusual circumstances
contributed to a fund’s advertised performance,
failing to provide performance data as of the most
recent practicable date, and using a fund’s
performance for a certain time period without
providing sufficient information to permit an investor
to evaluate the significance of performance data.
The SEC Response also suggested that fund families
be required to disclose in fund performance
advertising the average performance of all their
funds, including the performance of funds no longer
in existence. However, the SEC Response noted that
the NASD does not permit the use of aggregated
fund family performance in advertising and sales
material.
RICHARD M. PHILLIPS
202.778.9040
rphillips@kl.com
DIANE E. AMBLER
202.778.9886
dambler@kl.com
FRANCINE J. ROSENBERGER
202.778.9187
francine.rosenberger@kl.com
FATIMA SULAIMAN
202.778.9223
fsulaiman@kl.com
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Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related
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We work with clients in connection with the full range of investment company industry products and activities,
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WASHINGTON
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should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
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ALL RIGHTS RESERVED.