ICI Comments on SEC Studies Concerning Board Independence, March 2007

Ms. Nancy M. Morris
Secretary
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-0609

The Investment Company Institute¹appreciates the opportunity to comment on the studies prepared by the Commission's Office of Economic Analysis (OEA) relating to mutual fund board independence.²While the studies provide useful background on the staff's economic analysis, ultimately they do not justify a regulatory mandate that fund boards have an independent chair. Similarly, the studies do not provide any compelling evidence that a requirement that 75 percent of a fund's board be independent would further the SEC's objectives more than the two-thirds requirement supported by the Institute.³ Our detailed analysis of and comments on the studies are attached and key observations and conclusions are summarized below.

The publication of the studies for comment is the latest step in a rulemaking proceeding with an unusually long and tumultuous history. Over three years ago, the Commission first proposed rule amendments under the Investment Company Act of 1940 that would require virtually all fund boards to be comprised of at least 75 percent independent directors and to have an independent director as chair.⁴ The amendments have never taken effect. In response to legal challenges, a federal appeals court has twice found deficiencies in the Commission's rulemaking process.⁵

Following the most recent court decision, the Commission announced plans to undertake a "top-to-bottom review" of its process for complying with legal obligations to analyze the economic impact of proposed rules.⁶ We are hopeful that the Commission's initiative will lead to improvements to the rulemaking process, in particular by highlighting the need for timely and thorough consideration of the economic consequences of proposed rules.⁷At a minimum, the OEA staff should regularly perform economic analysis of significant rule proposals and should do so early in the rulemaking process.

In addition, we strongly encourage the Commission to make the public release of the staff's economic analysis a routine practice in future rulemaking proceedings. We also urge the Commission to release this type of information much earlier in the process. As the Court of Appeals for the District of Columbia Circuit observed, in light of Section 2(c) of the Investment Company Act, the Commission has a "statutory obligation to do what it can to apprise itself - and hence the public and the Congress - of the economic consequences of a proposed regulation before it decides whether to adopt the measure." (Emphasis added.) It would be far more productive, and more consistent with the court's interpretation of this statutory mandate, to make the staff's economic analysis available at the time new rules are first proposed.

In this regard, we are troubled by reports that proponents of the independent chair and 75 percent board independence requirements may have limited the dissemination of these studies within the Commission and prevented their release to the public at an earlier stage because of concerns that the studies cast doubt on the need for or efficacy of the requirements.⁸ We commend the Commission for making these studies available now, and we hope that the Commission's "top-to-bottom" review will address how to avoid the possibility that this situation could re-occur.

Summary of Observations and Conclusions
The analysis of the OEA studies conducted by the Institute's economists, as set forth in the attached paper, includes the following observations and conclusions:

The Literature Review discusses several potential "market imperfections" that could motivate regulatory intervention, but it does not conclude that the independent chair and 75 percent board independence requirements (collectively, "board independence requirements") would enhance current regulations that seek to address those same market imperfections.
The Literature Review discusses market forces that help to align the interests of advisers and fund investors. For reasons set forth in the attached paper, such market forces are much stronger than suggested by the Literature Review.
The OEA studies indicate that the arguments and evidence that greater board independence is associated with better governance are mixed. Indeed, the Literature Review suggests that the optimal board structure may vary from firm to firm.
Neither OEA study finds any compelling evidence that independent chairs enhance shareholder protections.
The Literature Review finds that there is no consensus as to the optimal percentage of independent directors on a fund board.
The Power Study suggests that weak statistical tests and insufficient data could have prevented researchers from uncovering evidence of the benefits of an independent chair. Our review of the empirical research indicates that the tests were much stronger than the Power Study implies.
Based upon the Institute's research, the costs of the board independence requirements will disproportionately affect small fund organizations, potentially increasing barriers to entry to the mutual fund industry.

Based on our analysis of the SEC's own studies, the Institute does not believe they provide any basis for mandating that virtually all fund boards have an independent chair or for raising the required percentage of independent directors to 75 percent. To the contrary, they call the imposition of these requirements into serious question. On the basis of the entire record before it, the SEC should conclude this rulemaking without further action.

If you have any questions about our comments, please contact me at 202/326-5901, Elizabeth Krentzman at 202/326-5815, or Brian Reid at 202/326-5917.

cc: The Honorable Christopher Cox, Chairman
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
The Honorable Annette L. Nazareth
The Honorable Kathleen L. Casey

Andrew J. Donohue, Director
Robert E. Plaze, Associate Director
Division of Investment Management

Chester S. Spatt, Chief Economist
Jonathan Sokobin, Deputy Chief Economist
Office of Economic Analysis

1 The Investment Company Institute is the national association of the American investment company industry. The Investment Company Institute's membership include 8,839 open-end investment companies (mutual funds), 658 closed-end investment companies, 363 exchange-traded funds, and four sponsors of unit investment trusts. Mutual fund members of ICI have total assets of approximately $10.445 trillion (representing 98 percent of all assets of U.S. mutual funds); these funds serve approximately 93.9 million shareholders in more than 53.8 million households.

2 See SEC Release No. IC-27600 (December 15, 2006), 71 Fed. Reg. 76618 (December 21, 2006). One study (the "Literature Review") provides a summary of recent academic research related to mutual fund governance. The other study (the "Power Study") discusses the strength of the statistical tests used in many of the academic papers cited in the Literature Review.

3 See, e.g., Letter from Elizabeth R. Krentzman, General Counsel, Investment Company Institute, to Ms. Nancy M. Morris, Secretary, Securities and Exchange Commission, dated August 21, 2006.

4 SEC Release No. IC-26323 (January 15, 2004), 69 Fed. Reg. 3472 (January 23, 2004). The Commission adopted the rule amendments several months later. SEC Release No. IC-26520 (July 27, 2004), 69 Fed. Reg. 46378 (Aug. 2, 2004).

5 Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005); Chamber of Commerce v. SEC, 443 F.3d 890 (D.C. Cir. 2006).

6 SEC Complies with Court Order on Mutual Fund Rules, SEC Press Release 2006-95 (June 13, 2006).

7 The attached paper discusses a framework for economic analysis of proposed rules at p. 1 and in Appendix A.