(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 Adopts Independent Chair Requirement for Mutual Funds

Over the dissent of two commissioners, the SEC adopted new governance provisions for mutual funds that rely on certain exemptive rules, including a requirement for an independent board chairman. Commissioners Cynthia Glassman and Paul Atkins argued strongly against such governmental intervention in the absence of empirical evidence to support the move. Chairman William Donaldson and Commissioners Harvey Goldschmid and Roel Campos and supported the action as a necessary step to address the conflicts of interest that are inherent between fund managers and the funds they advise. Commissioners Glassman and Atkins plan to include written dissents in the final rule.

In a separate action, the SEC unanimously voted to adopt Regulation SHO, with modifications, to govern the short selling of securities. The Commission also approved amendments to require management investment companies to provide enhanced disclosure in shareholder reports about the basis for the board of directors' approval of advisory contracts.

The SEC proposed the amendments to the exemptive rules in January 2004 (2003-04 CCH Dec. ¶87,132) and received over 180 comment letters. In addition to an independent chairman, the provisions will require that at least 75 percent of funds' boards be made up of independent directors and that the independent directors meet at least quarterly in separate sessions from the full board. Funds will be required to authorize independent directors to hire staff as needed. The full board must conduct an annual self-review to consider its effectiveness, including the committee structures and the number of funds on whose boards the directors serve. The independent chair provision will affect a wide range of funds, as approximately 80 percent of funds are currently chaired by insiders.

Paul Roye, director of the Division of Investment Management, noted that the fund chairman typically is the CEO of the adviser and can dominate the board. The staff concluded that fund boards would be in a better position to protect the interests of the fund if the chairman does not have the conflicts of interest that come with the dual role as an executive of the adviser.

Ms. Glassman noted that when the proposal was approved for comment, she asked for evidence of high performance or low costs associated with having an independent chair. She charged that the SEC did not commit resources to study the question. Further, she said there were alternatives that could have been considered, including leaving the decision to the independent directors or endorsing the concept of a lead independent director.

Mr. Goldschmid said that for him the decision was not difficult. It is simply good sense to separate the chair from management, in his view. He characterized the vote as a truly historic occasion. Commissioner Atkins, on the other hand, said he too wished the SEC would have considered the alternatives before adopting such a profound and costly change. He said the SEC has entered an age of atmospherics in which it has adopted the contagious view that it must do something lest it be accused of doing nothing. Regulation by " gut feelings" and " anecdote" and is not a sufficient basis for reorganizing the boardrooms of most of the funds in this country, he said. Commissioner Atkins believes the rule adoption represents the use of the coercive power of the government rather than market forces to bring about change.

Mr. Campos said it was important to remember what is at stake, as individual investors in the United States have invested approximately $7.5 trillion in mutual funds. He added that the figure recently dropped two percent in light of the numerous mutual fund scandals. "It is hard to be wrong when choosing additional investor protection measures," in his view.

Chairman Donaldson noted that the lack of economic studies was a constant refrain against adopting the provisions, but said that the absence of such studies was not determinative to his decision. Congress prohibited numerous transactions between mutual funds and their advisers unless the SEC exempted funds from those prohibitions, he noted. The time has come to strengthen the conditions under which those exemptions are granted, in his view. An interested chairman of a mutual fund necessarily finds himself in an untenable conflict of interest, according to Mr. Donaldson, in that he has to serve two masters.

As for the split vote on the final rule, Mr. Donaldson said that since he has been chairman, the Commission has voted 1,606 times and only 16 of those votes were cast against a recommendation. He said that he respects the opinions that have been expressed and those who expressed them.

Regulation SHO, which was adopted with modifications from the original proposal, will provide a new regulatory framework for the short selling of securities. Through a separate order, the SEC will suspend for a one-year pilot period the tick test provisions of Rule 10a-1 and any short sale price test of the exchanges for approximately one-third of the shares in the Russell 3000 index. The pilot is expected to commence January 3, 2005. The SEC deferred action on its proposal to replace the current tick test with a new uniform bid test and will reconsider the proposal upon the completion of the pilot.

The SEC will require broker-dealers to locate securities available for borrowing prior to effecting short sales, with limited exceptions for market makers. The SEC also adopted additional requirements for threshold securities with a fail to deliver position for five settlement days of 10,000 or more shares. Rule 105 of Regulation M was also amended to remove the current shelf offering exception.

The enhanced disclosure about the basis for awarding advisory contracts must include a discussion of the material factors and conclusions that led to the board's decision, including the selection of the adviser and the approved advisory fee. The disclosure must also include a discussion of the services to be provided by the adviser, the performance of the fund and the adviser, the costs of the services and any economies of scale that may be realized as the fund grows. Ms. Glassman, while supporting the adoption, expressed concern about the potential for "information overload." She urged the staff to consider ways to streamline and prioritize the information that is required in SEC filings. Mr. Roye assured her that the staff will focus on that issue.

The rules are effective August 5, 2004, except that the amendments to Item 12 of Form N-1A, Item 18 of Form N-2 and Item 20 of Form N-3 are effective January 31, 2006. All fund reports to shareholders for periods ending on or after March 31, 2005, and all fund proxy statements filed on or after October 31, 2004, are required to comply with these amendments.

¨ The adopting releases will be published in a forthcoming REPORT