(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Brief Defends Rule Requiring Independent Fund Chairs

In a brief filed in federal court, the SEC defended its adoption of rules conditioning a mutual fund's reliance on 10 commonly-used exemptions under the Investment Company Act on the fund having at least 75 percent of independent directors on its board and an independent chair. The rules have recently been challenged by the U.S. Chamber of Commerce in an action filed in the U.S. Circuit Court of Appeals for the District of Columbia Circuit.

The Commission said it adopted the rules in the face of mounting evidence that mutual fund managers were misusing their positions of trust by favoring themselves at the expense of fund investors, thereby inflicting huge losses on investors. Because Congress itself relied extensively on independent director oversight under the act, the SEC reasoned that it was entirely rational to construe the authority delegated by Congress to the Commission under the act to include the authority to condition exemptions on independent director oversight.

The new independent chair rule became necessary because of a serious breakdown in the oversight of fund managers plagued by the conflicts of interest inherent in the external management structure of funds, according to the SEC. In light of the recent scandals in the fund industry, the Commission reasonably concluded that independent director oversight of the conflict-of-interest transactions permitted under the exemptive rules had proved ineffective and needed to be strengthened. In the SEC's view, the scandals demonstrated the critical importance of effective independent director oversight of fund advisers and affiliates.

Contrary to the chamber's argument, the Commission said it was not required to conduct an empirical analysis of whether funds with independent chairs performed better than funds with management chairs. The objective of the new rules is to more effectively monitor conflicts of interest and better protect investors. The Commission said that it made a rational policy determination after examining widespread evidence of misconduct harmful to investors and applying its broad regulatory expertise.

The SEC also rejected the argument that it lacked the authority to adopt the challenged conditions because they relate to corporate governance, which the chamber contended is the domain of state law. While acknowledging that funds are created under state law, the SEC noted that a central objective of the Investment Company Act is to impose a regime of governance on mutual funds in order to regulate conflicts of interest that were not being adequately addressed by state law. The SEC stated that, consistent with the act's purposes, it acted to strengthen independent director oversight of conflict-of-interest transactions covered by the exemptive rules that otherwise would be entirely prohibited by the act.

In marked contrast to other federal securities laws that protect investors through mandated disclosures, the SEC noted that the Investment Company Act directly regulates the management and practices, including aspects of the corporate governance, of mutual funds and assigns a specific role to independent directors. The act expressly authorizes the Commission to grant exemptions consistent with the protection of investors and the purposes of the act. Conditioning the use of the exemptions on independent director oversight, as enhanced by the latest rules, is entirely consistent with the purposes and structure of the act, the SEC contended.

The SEC also argued that the statutory requirement in Section 10(a) that at least 40 percent of fund boards be composed of independent directors does not prevent the Commission from requiring a greater percentage of independent directors, or from requiring an independent chair as a condition to using the exemptive rules. Oversight by independent directors may be particularly important in the case of an exemptive rule because, unlike an individual application for an exemption, the SEC staff would no longer individually review the transactions exempted under the rule.