Tuesday, 12 February 2002 08:00

No-Action Letter under: Investment Company Act of 1940 – Rule 0-1(a)(6); 2a-19

Investment Company Institute

February 12, 2002 Craig S. Tyle, Esq. General Counsel Investment Company Institute 1401 H Street, NW Suite 1200 Washington, DC 20005 Dear Mr. Tyle: As you are aware, in January 2001, the Commission adopted new fund governance provisions that were designed to enhance the independence and effectiveness of independent directors of investment companies.1 The rule amendments add new conditions to a set of ten rules under the Investment Company Act of 1940 (the “1940 Act”) that exempt funds and their affiliates from certain prohibitions of the 1940 Act (the “Exemptive Rules”). These rules were selected because they require the independent judgment and scrutiny of independent directors in overseeing activities that are beneficial to funds and their investors, but involve potential conflicts of interest between the funds and their management and management affiliates. The three new conditions added to each of the rules require that independent directors of a fund seeking to rely on any of the Exemptive Rules: (1) constitute at least a majority of the fund’s board of directors; (2) select and nominate other independent directors to fill vacancies on the Board; and (3) determine that any legal counsel retained to represent the independent directors be an “independent legal counsel” within the meaning of Rule 0-1(a)(6) under the 1940 Act. It is the staff’s understanding that some of your members have raised questions regarding the independent legal counsel provision, noting that: (1) the inherently subjective nature of the directors’ determination that counsel is independent could lead to the retroactive loss of exemptive relief if the directors’ determination is overturned; (2) funds may be adversely affected if reliance on the Exemptive Rules is lost as a result of discovery that counsel has performed work for an entity that could affect its status as “independent legal counsel” despite good faith reliance on counsel’s representations; and (3) the rule restricts the ability of the independent directors to retain legal counsel in matters not involving significant conflicts of interest between funds and fund management (for purposes of this letter, “Special Counsel”). Given that the independent counsel provision must be complied with no later than July 1, 2002 we would like to clarify certain aspects of this rule provision in an effort to address your members’ questions as outlined above. Background: In adopting the independent counsel requirement in its final form, the Commission responded to the comments of independent directors and others that the selection of counsel for directors should be a matter within the discretion of the independent directors. Accordingly, under Rule 0-1(a)(6), a person is considered an independent legal counsel if: (1) the independent directors determine that any representation of the fund’s adviser, principal underwriter, administrator (collectively “management organizations”) or their control persons during the past two fiscal years is or was sufficiently limited that it is unlikely to adversely affect the professional judgment of the person in providing legal representation; and (2) the independent directors have obtained an undertaking from counsel to provide them information necessary for their determination, and to update promptly that information if the counsel begins, or materially increases, the representation of a management organization or control person. The independent directors must make their determination no less frequently than annually, and the basis for the determination must be recorded in meeting minutes. Potential for Retroactive Loss of Exemptive Relief: Rule 0-1(a)(6) relies on the independent directors to determine whether a person is an independent counsel. Accordingly, independent directors’ selection of their counsel is a matter of their business judgment. As such, their selection of counsel is entitled to considerable deference. As you are aware, independent directors are called upon to exercise their business judgment under the 1940 Act in a number of areas, including the reasonableness of advisory fees, and courts generally have been reluctant to second-guess directors’ business judgments when they have been fully informed, made in good faith and with due care. In the absence of facts showing that the independent directors have not acted in good faith or exercised care and diligence in scrutinizing conflicting representations that counsel may have, the staff would not seek to retroactively question their judgments regarding the selection of counsel. In addition, the staff believes that these determinations by independent directors will and should be given the same deference by courts as other business judgment by directors. Subsequent Discovery of Representations of Management Organizations: The answer to the question regarding the inadvertent loss of reliance on the Exemptive Rules as a result of the discovery that counsel for the independent directors performed work for a management organization or its affiliates is addressed in the rule itself. Rule 0-1(a)(6) requires an undertaking of counsel to provide the directors with information necessary to make their “independence” determination. Further, the rule makes it clear that in making their determination, the directors are entitled to rely on the information obtained from counsel unless they know or have reason to believe that the information is false or misleading. Footnote 56 in the adopting release states that if counsel begins, or materially increases, the representation of a fund management organization, but does not inform the independent directors, the independent directors can rely on the previous representation they received so that counsel’s change in representation will not trigger the requirement that the independent directors make a new determination. Accordingly, if counsel fails to fully inform the directors about the existence or extent of a conflicting representation, the rule would not invalidate the director’s determination or compromise reliance on the Exemptive Rules. Special Counsel: With respect to your members’ question whether the current independent counsel provision restricts directors from accessing a variety of special counsel relationships, we would note that the rule, in our view, clearly contemplates the possibility of the directors, hiring special counsel in a variety of circumstances. Directors are urged to consider a variety of factors in assessing their counsel’s potential conflicts, including (1) whether the representation involves a minor or substantial matter; (2) whether it involves the fund, an adviser or an affiliate; (3) the duration of the conflicting representation; and (4) whether the individual who will serve as legal counsel was or is involved in the representation. Applying this standard, independent directors could retain as special counsel, in appropriate circumstances, a person who has or is representing a management organization. We further note that counsel for a management organization is not restricted in its ability to represent the fund under the rule. A fund is not a “management organization” under the rule. Accordingly, the new rule imposes no limits on directors’ ability to engage a lawyer to act as a special counsel to advise, for example, on a director’s retirement plan. In such a matter the lawyer would be acting as special counsel to the fund. We appreciate hearing your members’ thoughts on this matter. As your members continue to prepare for compliance with the independent counsel provision, please let us know if you have additional concerns so that we can offer further clarification. You can also expect that we will monitor implementation of the independent counsel provision and that the fund governance rules will be considered in the context of the planned comprehensive review of all Commission regulations. If you have further comments, please contact me at 202/942-0720. Sincerely, Paul F. Roye Cc: Chairman Harvey L. Pitt Commissioner Isaac C. Hunt, Jr. Commissioner Cynthia A. Glassman


1 See Role of Independent Directors of Investment Companies, Investment Company Act Release No. 25816 (January 2, 2001). The new fund governance provisions include new rules and amendments to existing rules and forms under the 1940 Act and the Securities Exchange Act of 1934 and were effective February 15, 2001. Compliance with the form amendments was required by January 31, 2002 and compliance with the rules and rule amendments is required by July 1, 2002.