SEC Analysis of Independent Directors Who Have Conflicts of Interest

" The legislative history [of the federal definition of independent director] indicates that a business or professional relationship would be material if it 'might tend to impair the independence of [a] director.'"

Full Text of the SEC Release

Return to Discussion of Protection of
Self-Dealing Directors Bill

In October 1999, the Securities and Exchange Commission issued a staff release that discussed various issues under the Investment Company Act, which is the federal law under which mutual funds are regulated.

Under the Act, 40% of a fund's board must be independent as defined under Section 2(a)(19) of the Act. In addition, the SEC can issue an order declaring that a person is nonindependent under the Act.

The release provides a laundry list of situations in which the SEC would consider a fund director who was independent under the Act's definition of independent director to be nonindependent. If a fund counted such a director toward meeting the 40% requirement, the staff would recommend that the SEC issue an order declaring the director to be nonindependent.

In practice, however, the mere threat that the SEC would issue a nonindependence order has always been enough to deter funds from trying to count legally independent -- but factually nonindependent --directors toward the 40% minimum.

The Maryland Protection for Self-Dealing Fund Directors bill directly conflicts with the SEC's analysis. The bill would require courts to treat factually nonindependent directors as independent under Maryland law, no matter how blatant the directors' conflicts of interest.

The bill also conflicts with the fund industry's position that persons formerly associated with a fund's manager or underwriter, or affiliates of the manager or underwriter, not serve as independent directors notwithstanding that they are legally independent under federal law.

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The relevant section of the SEC release is provided below:

II. Interpretive Guidance

A. Commission Orders Under Section 2(a)(19) of the Act

Sections 2(a)(19)(A)(vi) and (B)(vi) of the Act authorize the Commission to issue an order finding that a person is "interested" by reason of a material business or professional relationship with certain persons and entities./28/ The Commission and the staff have not publicly provided guidance concerning these sections for a significant period of time./29/ The staff believes that it would be useful to provide additional guidance about the types of professional and business relationships that may be considered to be material for purposes of sections 2(a)(19)(A)(vi) and (B)(vi)./30/ This guidance should be particularly useful because the staff understands that many fund groups will not nominate an individual as an independent director if they identify a material business or professional relationship that the individual has with a Specified Entity (as defined below) due to concerns that the Commission may commence proceedings under section 2(a)(19)./31/

The Commission has the authority to issue an order under section 2(a)(19) of the Act when it finds that a person has or had a "material business or professional relationship" with certain specified persons and entities, including some fund affiliates ("Specified Entities")./32/ Section 2(a)(19) does not define a "material business or professional relationship." The legislative history, however, indicates that a business or professional relationship would be material if it "might tend to impair the independence of [a] director."/33/ The legislative history also states that "[o]rdinarily, a business or professional relationship would not be deemed to impair independence where the benefits flow from the director of an investment company to the other party to the relationship. In such instances the relationship is not likely to make the director beholden to that party."/34/

The staff believes that issues arising under sections 2(a)(19)(A)(vi) and (B)(vi) must be analyzed based on the particular facts of each case to determine whether a director's interests and relationships might tend to impair his or her independence./35/ The staff also believes, however, that it would be useful to provide guidance about the types of professional and business relationships between a director and a Specified Entity that may be considered to be material. In particular, this section of the release describes how the staff will analyze whether a person should be treated as "interested" by virtue of (1) holding or having held certain positions with a Specified Entity, and (2) engaging or having engaged in certain material transactions with a Specified Entity./36/

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Positions as Material Business or Professional Relationships

The staff believes that a fund director may be treated as "interested" if he or she currently holds or held, at any time since the beginning of the last two completed fiscal years of the fund (the "two-year period"), certain positions with a Specified Entity. The staff would consider a position that a director holds with a Specified Entity as a "material business or professional relationship" if it would tend to impair a director's independence by providing incentives for the director to place his or her own interests over the interests of fund shareholders. The key factors in evaluating whether a director's position with a Specified Entity would tend to impair his or her independence include the level of the director's responsibility in the position and the level of compensation or other benefits that the director receives or received from the position.

For instance, the staff would consider an individual who served as the fund's portfolio manager during the two-year period to have had a material business or professional relationship with the fund and its investment adviser. The staff previously has informally advised certain funds of this position on several occasions. The staff believes that a fund's former portfolio manager must be viewed as having had a material business or professional relationship with the fund and its adviser because he or she would have had significant responsibilities with the fund and the adviser, and likely would have received substantial compensation and other benefits from the adviser and/or the fund./37/ Indeed, the staff would view the former portfolio manager's position as material due to the manager's responsibility in the position even if the manager had not received substantial compensation from adviser or the fund. Similarly, the staff believes that former directors, officers, and employees of the fund's investment adviser or principal underwriter could be viewed as having had a material business or professional relationship with a Specified Entity, depending on the facts and circumstances./38/

In addition, a fund director who at any time during the two-year period also was a director, officer or employee of a current or former holding company of the fund's investment adviser may be treated as interested by reason of a material business or professional relationship with the controlling person of the fund's adviser (a Specified Entity)./39/ As described above, the staff's analysis of the materiality of the relationship would focus on, among other things, the level of the director's responsibility with the holding company and the level of compensation or other benefits that the director received from the position.

The staff believes that not every position that a director holds or held with a Specified Entity would be deemed to impair his or her independence. For example, a director of a fund who also is a director of another fund managed by the same adviser generally would not be viewed as an interested person of the fund under section 2(a)(19) solely as a result of this relationship./40/

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Material Transactions as Material Business or Professional Relationships

The staff believes that a fund director may be treated as "interested" if he or she has, at any time during the two-year period, directly or indirectly engaged (or proposed to engage) in any material transactions (or proposed material transactions) with a Specified Entity. Such a relationship could result from a single transaction or from multiple transactions. These transactions may be structured as service arrangements, including legal, investment banking, and consulting services, or other business transactions, such as business and personal loans, and real estate purchases./41/ In addition, a material business or professional relationship with a Specified Entity may result from a fund director's position with, or ownership interest in, an entity that engages in material transactions with a Specified Entity.

For example, the staff believes that a fund director may be treated as "interested" if the fund's investment adviser manages or managed for the director, at any time during the two-year period, an advisory or brokerage account, and the adviser favors, or creates the expectation that it will favor, the account over the other accounts that it manages./42/ In the staff's view, a director would receive favored treatment, for instance, if the adviser charged the director no fees or fees that were lower than the fees that it charged for similar types of accounts, or accorded the director's account special treatment regarding portfolio management decisions or securities allocations. By favoring the director's account over other accounts that it manages, the adviser may create an incentive for the director to act in a manner that will preserve or increase the favorable treatment./43/ In this instance, significant economic benefits from the relationship between the director and the adviser would flow to the director, or the director may have the expectation that significant economic benefits would flow in the future to the director./44/

The staff believes that a fund director who serves as a chief executive officer of any company for which the chief executive officer of the fund's adviser serves as a director also may be treated as "interested." The relationship between the fund director and the adviser's chief executive officer may tend to impair the director's independence because the adviser's chief executive officer has the power to vote on matters that affect the director's compensation and status as chief executive officer of the company. In this instance, the fund director may act with respect to fund matters in a manner to preserve his or her relationship with the company and with the adviser's chief executive officer, rather than in the interest of the fund's shareholders./45/

A fund director may be deemed to have indirectly engaged in a material transaction with a Specified Entity through his or her interest in a company that conducted business with the Specified Entity./46/ In determining whether the director would have a material business or professional relationship with a Specified Entity due to his or her interest in the company and the company's transaction with the Specified Entity, the staff would look to the nature and significance of the director's interest in the company and the company's interest in the transaction. In particular, the staff would focus on the significance of any economic or other benefit that would flow to the director. For example, a fund director who had a controlling interest in a company that conducted material business with a fund would likely receive significant economic benefits, either directly or indirectly, as a result./47/ Such a director may be treated as interested because the director may have a material business or professional relationship with the fund as a result of having indirectly engaged in a material transaction with the fund.

A material relationship resulting from a proposed material transaction with a Specified Entity might include the negotiation of a service contract between a company controlled by the director and the Specified Entity. During the negotiation of such a contract (and even if such contract is never finalized), the director may be concerned about interests other than those of the fund and its shareholders. As a result, the process of negotiating a material transaction may tend to impair the director's independence, and thus may itself create a material business or professional relationship with a Specified Entity for purposes of section 2(a)(19).

Other Related Matters

In the Companion Release, the Commission is proposing amendments to various disclosure requirements. The purpose of the proposed disclosure amendments is, in part, to assist the Commission and the staff in determining whether it would be appropriate to make further inquiry into a particular director's independence. If the proposed rules are adopted, the staff will review and monitor the new disclosure. Based on its review of the disclosure, the staff will consider whether to issue additional guidance regarding other types of relationships that may be considered to be material under section 2(a)(19).

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Footnotes:

-[28]- Section (a)(19)(A)(vi) of the Act defines "interested person," when used with respect to an investment company, in part, as: any natural person whom the Commission by order shall have determined to be an interested person by reason of having had, at any time since the beginning of the last two completed fiscal years of such company, a material business or professional relationship with such company or with the principal executive officer of such company or with any other investment company having the same investment adviser or principal underwriter or with the principal executive officer of such other investment company. 15 U.S.C. § 80a-2(a)(19)(A)(vi). Section 2(a)(19)(B)(vi) of the Act defines "interested person," when used with respect to an investment adviser of or principal underwriter for, any investment company, in part, as: any natural person whom the Commission by order shall have determined to be an interested person by reason of having had at any time since the beginning of the last two completed fiscal years of such investment company a material business or professional relationship with such investment adviser or principal underwriter or with the principal executive officer or any controlling person of such investment adviser or principal underwriter. 15 U.S.C. § 80a-2(a)(19)(B)(vi).

-[29]- For a number of years, the staff provided some informal guidance by issuing no-action letters, but has not done so since 1984 as a matter of policy. See Daniel Calabria, SEC No-Action Letter (Sept. 12, 1984); Capital Supervisors Helios Fund, Inc., SEC No-Action Letter (June 13, 1984).

-[30]- In the Companion Release, the Commission has proposed rules that would require additional disclosure about fund directors to, among other things, assist the Commission and its staff in evaluating directors' independence. Companion Release, supra note 2.

-[31]- See ICI Advisory Group Report, supra note 27, at 6; Roundtable Transcript of Feb. 24, 1999, at 253 (statement by Thomas R. Smith, Jr.). The staff believes that the guidance provided in this portion of the release may assist funds in the independent director nominating process.

-[32]- Those entities include the fund, its principal executive officer, the investment adviser and principal underwriter of the fund, the principal executive officer of the investment adviser or principal underwriter, or any controlling person of the investment adviser or principal underwriter, any other fund with the same investment adviser or principal underwriter, and the principal executive officer of such other fund. See Sections 2(a)(19)(A)(iv) and (B)(vi) [15 U.S.C. §§ 80a-2(a)(19)(A)(vi), (B)(vi)].

-[33]- H.R. Rep. No. 1382, 91st Cong., 2d Sess. 14 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 33 (1969).

-[34]- Id.

-[35]- The legislative history indicates that Congress intended for the Commission to determine whether a material business and professional relationship exists on a case-by-case basis. H.R. Rep. No. 1382, 91st Cong. 2d Sess. 15 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 33 (1969).

-[36]- The examples discussed in this release are not exhaustive and are provided for illustrative purposes only. There may be other relationships that would be viewed by the staff as material under section 2(a)(19).

-[37]- Similarly, the ICI Advisory Group recommends that former employees of a fund's investment adviser who had significant responsibilities in their positions with the adviser not serve as independent directors of the fund. See ICI Advisory Group Report, supra note 27, at 13.

-[38]- In addition, the staff notes that many former officers and employees of a fund's investment adviser or principal underwriter may own securities issued by the adviser or underwriter. Such persons are interested persons of the fund by virtue of sections 2(a)(19)(A)(iii) and (B)(iii) [15 U.S.C. §§ 80a-2(a)(19)(A)(iii), (B)(iii)].

-[39]- See also Western Separate Account A, SEC No-Action Letter (Mar. 8, 1976) (directors who are employees or executives of a fund adviser, principal underwriter or controlling person may not be disinterested); NEA Mutual Fund, SEC No-Action Letter (June 3, 1971) (directors who are employees or executives of an entity that controls the fund's adviser or principal underwriter may not be disinterested).

-[40]- See H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 34 (1969) (stating that "a director of one investment company would not ordinarily be deemed an interested person of that company by reason of being a director of another investment company with the same adviser").

-[41]- See, e.g., Alpha Investors Fund, SEC No-Action Letter (Jan. 9, 1972) (director who is a partner at a law firm that provides legal services to an entity that controls the fund's adviser may be interested under section 2(a)(19)(B)(vi) because the director has a material business or professional relationship with that entity).

-[42]- Cf. H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 34 (1969) (stating that "a director ordinarily would not be considered to have a material business relationship with the investment adviser simply because he is a brokerage customer who is not accorded special treatment").

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-[43]- Such favoritism would raise additional issues under the federal securities laws. See, e.g., In the Matter of Monetta Financial Services, Inc., supra note 24.

-[44]- For an example of a relationship in which the staff believed that significant economic benefits did not flow to the director, see Securities Groups, SEC No-Action Letter (Apr. 20, 1981) (staff stated that a nominated director's participation in a symposium sponsored by the parent of the fund's adviser did not constitute a material relationship because "the $2,000 paid to him for taking part in that seminar is not so significant as to tend to impair his independence were he to serve as a disinterested director of the fund").

-[45]- See Southwestern Investors, Inc., SEC No-Action Letter (June 13, 1971) (fund director who is an officer and director of company A may not be disinterested if the president of a company that indirectly controls the fund's investment adviser and principal underwriter also serves as a director of company A). Cf. H.R. Rep. No. 1382, 91st Cong., 2d Sess. 15 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 34 (1969) (fund director that serves with the chief executive officer of the fund's adviser on the board of another company generally would not be deemed to have a material business or professional relationship with the chief executive officer). Unlike the facts in Southwestern Investors, Inc., the fund director described in the House and Senate Reports was not an officer or employee of the other company, such that the chief executive officer of the fund's adviser did not appear to have the power to vote on matters affecting the fund director's status with the other company.

-[46]- See also The MONY Fund, Inc., SEC No-Action Letter (Jan. 29, 1972) (director who is a senior officer of a company that contracted with company A, which wholly owns the fund's investment adviser, to find a vice president for company A, may have a material relationship with a controlling person of the fund's adviser).

-[47]- Cf. Travelers Equities Fund, Inc., SEC No-Action Letter (Jan. 11, 1982) (director who is a limited partner of a partnership that obtained a loan from the principal underwriter of the fund is not an interested person of the underwriter).

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