JUNE 2005
Investment Management
Court Remands Investment Company Independent
Director Provisions, SEC to Reconsider Provisions
Prior to Chairman’s Departure
On June 21, 2005, the U.S. Court of Appeals for the
District of Columbia Circuit directed the Securities
and Exchange Commission (the “Commission”) to address technical deficiencies it found with respect to a
controversial rule adopted under the Investment Company Act, as amended (the “1940 Act”) that conditioned reliance by investment companies on certain
exemptive rules upon the satisfaction of certain fund
governance standards.1 The challenged provisions,
which were adopted by a sharply divided 3-2 Commission vote, pertained only to the requirements that a
fund board be comprised of at least 75% independent
directors and be led by an independent chairman.2 Although the Court found that the Commission did not
exceed its statutory authority and had sufficient rationales in adopting the two conditions, the Court
held that the Commission violated the Administrative
Procedure Act3 (the “APA”) by failing to adequately
consider both the potential costs incurred by funds to
comply with the conditions and alternatives to the independent chairman condition. Members of the Commission will vote again on the two conditions on June
29th, just one day prior to Chairman William
Donaldson’s departure from the Commission. At that
meeting the Commission also will consider a disclosure alternative to the independent chairman condition, as originally discussed by the dissenting Commissioners.
The Court rejected the argument that the Commission
lacked the authority under the 1940 Act to adopt the
two conditions, stating that the 1940 Act does not
deny the Commission the authority to establish incentives for funds to enhance the role of independent directors on fund boards. The second contention was
that the Commission violated the APA in its
rulemaking process by failing to: (i) demonstrate a
nexus between the abuses the Commission sought to
rectify and the solutions it promulgated; (ii) consider
whether the two conditions “will promote efficiency,
competition, and capital formulation” as required under Section 2(c) of the 1940 Act; and (iii) consider reasonable alternatives to the condition that the board be
chaired by an independent director. The Court found
that the SEC “reasonably concluded” that the 75% independent director requirement would serve to
“strengthen the hand of the independent directors
when dealing with fund management” and the independent chairman condition would serve “an important role in setting the agenda of the board . . . in providing a check on the adviser, in negotiating the best
deal for shareholders when considering the advisory
contract, and in providing leadership to the board that
focuses on the long-term interest of investors.”4 The
Court refused to second-guess the Commission’s judgment, and stated that the Commission’s solution was
not “arbitrary, capricious, or in any way an abuse of
discretion, in violation of the APA.”5
Although the Court did not find the Commission
lacked authority or justification to adopt the 75% independent director and independent chairman conditions, the Court found that the Commission failed to
consider the costs to the industry and alternatives to
the independent chairman condition. Section 2(c) of
the 1940 Act requires that the Commission consider in
its rulemaking function whether an action “is consistent with the public interest” and “will promote efficiency, competition, and capital formation.”6 The
Court stated that although Chairman Donaldson did
“betray a dismissive attitude toward the value of empirical data,” the Commission’s lack of empirical data
Kirkpatrick & Lockhart Nicholson Graham LLP
did not make its decision unreasoned. However, the
Commission’s stated difficulty in estimating the costs
associated with meeting the 75% independent director
condition was deemed not to “excuse the Commission
from its statutory obligation to determine as best it can
the economic implications of the rule it has proposed”
by setting forth a range in which a fund’s cost of compliance may fall.7 Moreover, although the Commission stated it could not estimate the total cost to the
fund industry to comply with the independent chairman condition, the Court posited that the Commission
“could have estimated the cost to an individual fund,
which estimate would be pertinent to its assessment of
the effect the condition would have upon efficiency
and competition, if not upon capital formation.”8
Finally, the Court agreed with the contention that the
Commission failed adequately to consider alternatives, including an alternative to the independent
chairman condition proposed by dissenting Commissioners Cynthia Glassman and Paul Atkins, each of
whom endorsed considering a disclosure-based approach that would require funds to disclose prominently whether they had an independent chairperson
and allow investors to decide whether that fact was
material to their investment. Although the Court did
not expect the Commission to consider every conceivable alternative, or an alternative “unworthy of con-
sideration,” the Court found the disclosure approach
to be “neither frivolous nor out of bounds” and therefore charged the Commission with the obligation of
considering the approach, even if ultimately rejected.
In light of the Court’s findings that the Commission’s
actions were supported under the 1940 Act, the Court
did not establish any substantive barrier to the
Commission’s reconsideration of the provisions. The
Court’s opinion also does not appear to set high barriers for the Commission’s reconsideration regarding
cost analysis and alternatives. In light of the timing of
Chairman Donaldson’s departure, the outcome of the
Commission’s vote on June 29th as a practical matter
will depend largely on the individual views of the
Commissioners, and the possibility of compromise regarding disclosure alternatives. It should be noted
that the make-up of the Commission has not changed
since the provisions were adopted.
George J. Zornada
gzornada@klng.com
617.261.3231
Christina H. Lim
clim@klng.com
617.261.3243
ENDNOTES
1 See 24 C1Chamber of Commerce of the United States of America v. Securities and Exchange Commission, No. 04-1300,
2005 U.S. App. LEXIS 11805 (D.C. Cir. June 21, 2005). The fund governance standards, which contain the two contested
conditions, are set forth in Rule 0-1(a)(7) under the 1940 Act. See also Investment Company Governance, SEC Release No.
IC-26520 (July 27, 2004). The ten exemptive rules under the 1940 Act include: (1) Rule 10f-3 (permits a fund to purchase
securities in a primary offering when an affiliated broker-dealer is a member of the underwriting syndicate); (2) Rule 12b-1
(permits use of fund assets to pay distribution expenses); (3) Rule 15a-4(b)(2) (permits a fund board to approve an interim
advisory contract without shareholder approval when the adviser or controlling person receives a benefit in connection with
the assignment); (4) Rule 17a-7 (permits securities transactions between a fund and another client of the adviser); (5) Rule
17a-8 (permits mergers between certain affiliated funds); (6) Rule 17-1(d)(7) (permits fund and affiliates to purchase joint
liability insurance policies); (7) Rule 17e-1 (sets forth conditions under which a fund may pay commissions to affiliated
brokers in connection with the sale of securities on an exchange); (8) Rule 17g-1 (permits a fund to maintain joint insured
bonds);
(9) Rule 18f-3 (permits fund to issue multiple classes of voting stock); and (10) Rule 23c-3 (permits operation of an interval
fund by enabling a closed-end fund to repurchase shares from investors).
2 Rule 0-1(a)(7)(i) and (v) under the 1940 Act. The 75% independent board requirement requires that at least 75% of the directors of the fund be disinterested directors or, if the fund has three directors, at least two of the three directors must be disinterested.
3 5 U.S.C. § 551 et seq.
4 Chamber of Commerce, 2005 U.S. App. LEXIS, at *18 (internal citations omitted).
5 Id.
6 Section 2(c) of the 1940 Act.
7 Chamber of Commerce, 2005 U.S. App. LEXIS, at *23-24.
8 Id. at *25-26..
2 JUNE 2005
KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP
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growth and middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE
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Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 950 lawyers and represents entrepreneurs, growth and middle market companies, capital markets
participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally.
K&LNG is a combination of two limited liability partnerships, each named Kirkpatrick & Lockhart Nicholson Graham LLP, one qualified in Delaware, U.S.A. and practicing
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