- Guidance for Mutual Fund Directors
- May 5, 2006 | Authors: Jennifer A. Howell; Gregory J. Nowak; Matthew R. Silver
- Law Firm: Pepper Hamilton LLP - Philadelphia Office
Accepting a position as a director of a mutual fund is a considerable responsibility. New fund directors can expect to be inundated with documents and reports at each board meeting. Among other things, directors must be informed of fund activities and investment processes and performance to protect the shareholders' interests. To navigate these difficult waters, fund directors should be aware of the following issues:
- Advisory Contract Approval and Review: The board is responsible for reviewing and approving investment advisory and sub-advisory contracts for the fund. The board is required to analyze, among other things, the quality and nature of the services performed, and the fees charged and the profits realized by the adviser. Fund counsel usually prepares and distributes a memorandum outlining these and other required considerations for the board in approving an advisory contract.
- Meetings with the Fund CCO: The fund's chief compliance officer (CCO) should meet both in an executive session with the fund's independent directors and with the full board at least annually to discuss: any violations of the adviser's code of ethics; the fund's dividends and distributions since the last quarter; any growth in assets or significant changes in subscriptions or redemptions; brokerage commissions; and any soft dollar arrangements. The board also must review and react to the CCO's written annual report, required under Rule 38a-1.
- Role of Independent Chair: Because the chairman sets the tone and agenda for the board, many fund complexes require that an independent director serve as the chairman of a fund's board. The SEC recently passed Rule 0-1(a)(7)(i) under the Investment Company Act of 1940 (1940 Act), which would require fund boards to have an independent chairman, but the rule has been stayed by a court order.1
- Independent Directors: Currently, the 1940 Act requires that independent directors make up a minimum of 40 percent of the board of every fund, and that a majority of the board be independent if the fund relies on certain exemptive rules (i.e. the fund has a distribution plan paid out of fund assets under Rule 12b-1). If Rule 0-1(a)(7)(i) of the 1940 Act becomes effective, each fund that relies on exemptive rules must have a board that is at least 75 percent independent.
- Independent Director Sessions: Independent directors must generally meet at least quarterly in a session at which no interested director of the fund may be present. The SEC expects that the independent directors will use this forum to discuss their views on the performance of the fund's adviser and other service providers, as well as any other matter of importance. If a fund relies on any exemptive rules, the independent directors must be authorized (but not required) to hire their own staff at the fund's expense.
- Nomination of New Independent Directors: The incumbent independent directors of most funds have the responsibility to select and nominate new independent directors. To this end, a questionnaire concerning a prospective director's outside business activities, affiliations and background should be prepared by each candidate and retained with the records of the fund's nominating committee/board. The SEC has urged independent directors to look beyond the minimum requirements for independent directors set forth in the 1940 Act, and examine whether a candidate's personal or business relationships suggest that the individual will not aggressively represent the interests of the fund's investors.
- Self-Assessments: The board must assess its effectiveness at least annually. The SEC does not require such board self-assessments to be in writing, but has stated that it expects a board's minutes to reflect its discussions. Documentation for self-assessments may range from a discussion outline to detailed questionnaires that include a summary compilation of responses without attribution to any specific director. Generally, the board must evaluate its effectiveness based on a variety of factors including: the number of funds overseen by the board (to determine whether directors have taken on the responsibility of overseeing too many funds); the board's committee structure; and board education and training programs.
1 Enforcement of requirements for 75 percent independent directors and for a chairman who is independent of a Fund's investment adviser is currently stayed due to a court challenge. See Chamber of Commerce of the United States of America v. SEC, No. 05-1240 (D.C. Cir. April 7, 2006, available at http://pacer.cadc.uscourts.gov/docs/common/opinions/200604/05-1240a.pdf. Finding that the SEC failed to adequately consider the cost of compliance with the proposed requirements or give adequate consideration to an alternative proposal endorsed by two dissenting SEC Commissioners that each fund be required prominently to disclose whether it has an inside or an independent chairman and thereby allow investors to make an informed choice, the court technically vacated the challenged requirements on at least a temporary basis and has granted the SEC the opportunity to reopen the record within the next 90 days.