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February 15, 2007, marks the sixth anniversary of the effectiveness of Securities and Exchange Commission (SEC) requirements (1) that a mutual fund (fund) disclose the basis of director approval (approval disclosure) of an investment advisory contract (contract). So, the mutual fund industry has had six years of experience with these disclosure requirements. (2)
The SEC's stated goal of the disclosure requirements has been "specificity" and "uniformity" of disclosure. (3) The SEC, at least at the outset, seemed to disavow any intent to substantively change the traditional approval process, and the SEC determined that the best location for the approval disclosure was in a fund's statement of additional information (SAI). But things have not turned out quite as the SEC originally envisioned.
Approval disclosure varies widely in terms of substance and form. (4) The disclosure requirements have had the effect of altering the traditional approval process in subtle, if not dramatic, ways. And the SEC has found it advisable to shift the location of the approval disclosure from the SAI to the report to shareholders (shareholder report).
These developments, in turn, have created new tensions or pressures for fund directors and officers and shifted applicable liabilities under the federal securities laws.
The SEC has recognized that it has not achieved specificity and uniformity in approval disclosure. (5) In 2004, the SEC amended its requirements to make them stricter. So, the industry has actually had less than six years' experience with the SEC's requirements in their current form.
Lack of Specificity and Uniformity
The SEC disclosure requirements currently call for disclosure of a fund board's consideration of at least five specified factors relating to: (1) services; (2) investment performance; (3) adviser costs and profits; (4) possible economies of scale; and (5) whether fee levels reflect economies of scale.
From the outset, funds have taken widely, and some might say wildly, varying approaches to approval disclosure. They have followed different concepts, styles, lengths, and degrees of detail. A few funds have made no disclosure.
There are several reasons for the lack of specificity and uniformity in approval disclosure. The fundamental reason is that the SEC drafted its disclosure requirements in a manner that does not promote specificity and uniformity. For example, certain requirements are open-ended or ambiguous and are not tailored to particular types of funds. Consequently, funds have had to draft their approval disclosure on the basis of interpretation, and interpretation has varied from fund to fund.
Perhaps the crucial reason is the concern of funds and their investment advisers (advisers) that detailed approval disclosure could enable private litigation against funds, directors and advisers under Section 36 of the Investment Company Act of 1940 (1940 Act). For example, detailed disclosure of director consideration could be the subject of probing questioning of directors by hostile parties. So, funds have refrained from making approval disclosure to the extent that it would enable private lawsuits.
A possible third reason is that the SEC adopted other disclosure requirements in response to the so-called mutual fund scandals that came to light in late 2003. For example, the SEC required disclosure regarding policies on market timing and late trading. Funds have had to struggle to develop these disclosures over part of the same period that the funds were refining their approval disclosure.
Despite these reasons, the SEC has pursued its goal of specificity and uniformity in approval disclosure. In the beginning, the Staff jawboned through appearances at legal conferences and gave comments to funds through the filing review process. These efforts were not entirely successful. So, in 2004, the SEC amended its disclosure requirements to require more detail.
However, the amendments did not answer all of the questions, resolve all of the ambiguities or tailor the requirements to particular kinds of funds. Moreover, if the SEC perceived the industry's concern with litigation, the SEC did not expressly acknowledge it. Conceivably, the SEC recognized the industry's concern and purposely left the disclosure requirements open-ended because of it. Some support for this conclusion can be found in the statement in the SEC's adopting release that proprietary information need not be disclosed. (6) But for whatever reason, the amendments have not achieved specificity and uniformity in approval disclosure.
Convergence Toward Overarching Approach
A number of funds with knowledgeable inside and outside 1940 Act legal counsel appear to be moving toward at least a somewhat consistent, if not uniform, overarching approach to disclosing director consideration of the SEC's five specified factors listed above.
Conceptually, this approach sets out more specific discussion regarding quantitative factors that lend themselves to comparisons, …