The Future of Investment Company Governance

In the wake of the market timing and late trading scandals in the investment company industry, the Securities and Exchange Commission (SEC or “Commission”) recently adopted rules and rule amendments designed to enhance the governance practices of registered investment companies (“funds”). In an effort to protect shareholders and reduce conflicts of interest between fund boards and fund investment advisers, the SEC has adopted rules that, among other things, proscribe the composition of and processes for fund boards, increase the required disclosure regarding approval of investment advisory contracts and create the position of fund chief compliance officer (CCO) who reports to the board. This article addresses the responsibilities fund boards will face in the wake of these new rules.

Investment Company Governance

The SEC recently adopted rules, in a rare 3-2 vote, that will require funds to adopt certain governance practices if they intend to rely on a number of important exemptive rules under the Investment Company Act of 1940, as amended (“1940 Act”), including Rule 12b-1 and Rule 18f-3, among others. [As of press time, the SEC had not published the final governance rule release. This article is based on the SEC's press release regarding the adoption of the rules and the proposing release.] In statements at the SEC's open meeting, Commissioners Glassman and Atkins cited, as support for their votes against the proposal, their concern that the SEC lacked sufficient empirical evidence, suggesting that some aspects of the proposal would result in better fund governance or combat recent problems in the fund industry. Additionally, at a conference sponsored by the Securities Industry Association soon after the approval vote, Commissioner Atkins noted that the Commission's approval of governance changes for funds marked “the first time that the federal government has described in such detail a corporate governance model for such a large number of companies.” (Horowitz J: SEC Commissioner Atkins Slams New Fund Governance Rule, The Wall Street Journal Online, June 24, 2004).

The rule amendments require the following changes to the composition of fund boards and the chairman position:

Board Composition ('Supermajority Proposal')

Any fund relying on any of the exemptive rules will be required to have a board whose independent directors comprise at least 75% of its membership. Most fund boards already have an independent director majority and many boards have a two-thirds or 75% supermajority. Under Section 10(a) of the 1940 Act, boards must be composed of at least 40% independent directors. If the fund's principal underwriter is a captive broker-dealer, then under Section 10(b)(2), the board must have a majority of independent directors. In early 2001, as part of then-SEC Chairman Arthur Levitt's independence initiatives, the SEC adopted amendments, similar to the current amendments, which required funds that rely on certain exemptive rules to have boards with a majority of independent directors. (See Role of Independent Directors of Investment Companies, SEC Release No. 33-7932 (Jan. 2, 2001)). Moreover, in 1999, an Advisory Group of the Investment Company Institute issued best practice recommendations for directors that included having an independent director super-majority for fund boards. (See Report of the Advisory Group on Best Practices for Fund Directors (June 1999)).

Independent Chairman of the Board ('Independent Chair Proposal')

The amendments require that the chairman of the fund's board be an independent director. In the release proposing the fund governance amendments (“Fund Governance Proposing Release”), the SEC notes that funds are not required to appoint a chairman under the 1940 Act or, as far as the SEC is aware, under state law. The Fund Governance Proposing Release suggested two rationales for an independent chairman. First, the chairperson controls the board's agenda and, thus, an independent chairperson is more likely to put matters not welcomed by the fund's adviser on the agenda. Second, the chairperson has influence over the boardroom culture. The Fund Governance Proposing Release says, “A boardroom culture conducive to decisions favoring the long-term interest of fund shareholders may be more likely to prevail when the board chairman does not have the conflicts of interest in his role as an executive of the fund's adviser.”

These amendments represent the most controversial aspect of the fund governance rules. Both Commissioners Glassman and Atkins indicated in their remarks at the SEC open meeting that these two proposals presented the stumbling block to their approval of the entire proposal. In her remarks at the open meeting, Commissioner Glassman noted a number of possible alternatives to the independent chairperson that the Commission could have considered, such as 1) requiring prominent disclosure of whether a fund had an independent chairperson; 2) implementing a lead independent director; 3) allowing the board, which under these rule amendments would have an independent director majority, to determine whether an independent chair was appropriate for a fund; and 4) narrowing the definition of “independence.”

Industry members also argued that the SEC's independent chair and supermajority proposals unsuspectingly diminish the fiduciary obligations of non-independent directors. As Eric Roiter, general counsel of Fidelity, explained, “What we are concerned about is a very troubling inference that can be drawn from what the SEC is doing: that the government knows better than independent directors and that, by elevating one type of director, you are necessarily denigrating the fiduciary status of a management director.” (Masters BA, Johnson C: SEC May Alter Mutual Fund Governance, The Washington Post, June 23, 2004, at E1).

In addition to the more controversial supermajority and independent chairman provisions, the rule amendments also will require changes to the board's processes, including:

Annual Self-Assessment

The rule amendments will require fund directors to perform an evaluation, at least annually, of the effectiveness and performance of the board and its committees. The Fund Governance Proposing Release envisions a self-evaluation that focuses both on the substantive and the procedural aspects of a board's operations. While the rule amendments do not mandate the content of the board's annual self-evaluation, the proposed rule amendments would require the directors to: 1) consider the effectiveness of the board's committee structure; and 2) evaluate whether the directors have oversight responsibility for too many funds.

The Fund Governance Proposing Release does not specify the appropriate number of funds a director should oversee, but does acknowledge the conflicting views that exist on the matter. The Fund Governance Proposing Release cites Sen. Susan M. Collins' (R-ME) statements from a Senate Governmental Affairs Committee hearing regarding fund trading practices and abuses:

“There are, in fact, plenty of fund family directors who serve on the boards for 80 or even 90 different funds, which seems too many to me … Now, I realize that many of the funds have similar structures and approaches so there may be some economies of scale, if you will. But it's hard for me to see how anyone, any one director could effectively monitor the activities of so many different entities.

“On the other hand, the Fund Governance Proposing Release also cites an Investment Company Institute Best Practices Report: [S]ervice on multiple boards can provide the independent directors of those boards with an opportunity to obtain better familiarity with the many aspects of fund operations that are complex-wide in nature. It also can give the independent directors greater access to the fund's adviser and greater influence with the adviser than they would have if there were a separate board for each fund in the complex.” Investment Company Institute: Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness (June 24, 1999).

Separate Sessions

The rule amendments will require independent directors to meet at least once quarterly outside the presence of any interested persons of the funds. According to the Fund Governance Proposing Release, the SEC believes these meetings “would afford independent directors the opportunity for a frank and candid discussion among themselves regarding the management of the fund” and to help “strengthen the collegiality and cohesiveness of the independent directors.” The Fund Governance Proposing Release suggests that requiring regular sessions would prevent “any negative inferences from attaching to the calling of such executive sessions.”

Independent Director Staff

While funds will be required explicitly to authorize the independent directors to hire employees and others as necessary to assist the independent directors fulfill their fiduciary duties, the new rules do not require that independent directors hire their own staff.

Disclosure Regarding the Board's Approval of Investment Advisory Contracts

The SEC has adopted rule amendments with respect to disclosure regarding the approval of investment advisory contracts by a fund's board of directors. The SEC intends that these amendments be another step in encouraging fair and reasonable fees through increased transparency of a board's decision making-process related to approving, or recommending that shareholders approve, investment advisory contracts.

The amendments to investment company registration forms require reports to fund shareholders to discuss, in reasonable detail, the material factors and conclusions that formed the basis for the board of directors' approval of any investment advisory contract. The required disclosure would be similar to the disclosure already required in the Statement of Additional Information and proxy statements about the basis for approval of the fund's existing advisory contract and any board recommendation that shareholders approve an advisory contract. The shareholder report disclosure will be required for new investment advisory contracts and any contract renewal, including new or renewed sub-advisory contracts, approved during the semi-annual period covered by the report (other than an advisory contract that was approved by shareholders). Enhanced disclosure requirements for proxy statements have been adopted to conform to the new disclosure that will be required in the shareholder reports.

The amendments will specifically require a fund to include the following in its shareholder report and relevant proxy statements:

• A discussion of the factors relating to both the board's selection of the investment adviser, and its approval of the advisory fee and other amounts to be paid under the advisory contract;
• A discussion, including, but not limited to, the following: 1) the nature, extent, and quality of the services to be provided by the investment adviser; 2) the investment performance of the fund and the investment adviser; 3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; 4) the extent to which economies of scale would be realized as the fund grows; and 5) whether fee levels reflect these economies of scale for the benefit of fund investors;
• A discussion of whether the board relied on comparisons of the services to be rendered and the amounts to be paid under the contract with those under other investment advisory contracts, such as contracts of the same and other investment advisers with other registered investment companies or other types of clients (eg, pension funds and other institutional investors); and
• How the board related the factors to specific circumstances of the fund and the investment advisory contracts and how it evaluated the factors considered in approving the investment advisory contract.

The new disclosure requirements will require fund boards to adjust their current procedures for considering the approval of investment advisory contracts to ensure that their discussion addresses all of the factors included in the rule.

As part of the investment company governance rule discussed above, the SEC also adopted amendments to Rule 31a-2, the fund recordkeeping rule, which requires that funds retain copies of the written materials that directors consider in approving advisory contracts under Section 15 of the 1940 Act. Under Section 15, the directors are required to request, and fund advisers are required to provide, written materials to help the directors in their assessment of whether to approve the advisory contract. Under the amendments, funds are required to maintain the materials on which the board relied in approving the advisory contract for at least 6 years, the first 2 years in an easily accessible place. According to the Fund Governance Proposing Release, the SEC's reason for proposing these amendments to Rule 31a-2 is that staff examiners have found that the nature and quality of these materials varied greatly among funds. Additionally the Fund Governance Proposing Release suggests that examiners have had difficulty determining whether the requirements of Section 15 had been met, because many funds did not retain the materials considered by the board when approving the advisory contract.

In a speech before the Mutual Fund Directors Forum in January 2004 entitled “America's Need for Vigilant Mutual Fund Directors,” SEC Chairman William Donaldson noted that the SEC did not intend to act as “a rate-setter and determine how much mutual fund investors should pay for the services they receive from a particular fund.” Rather, Chairman Donaldson indicated that the SEC would address the issue of fees through its rulemaking process, stating, “I firmly believe that rules uniformly applicable to the entire industry are more desirable than fees set through enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do with fees.” He suggested that the SEC's rulemaking was designed to help directors “focus on the need for breakpoints or reductions in advisory fees, and understand the differences in fees charged to other clients of the adviser.” In discussing the disclosure proposal, Chairman Donaldson went on to say that he hoped “these requirements will help focus directors on the critical task of monitoring fund fees and negotiating appropriate fee rates on behalf of investors.”

Interaction Between Board and the Chief Compliance Officer

The compliance program rule, Rule 38a-1 under the 1940 Act, which the SEC adopted in late 2003, directs each investment company to designate one individual to serve as CCO, who will administer the fund's compliance policies and procedures. Rule 38a-1 contains several provisions that are designed to promote the independence of a fund's CCO from fund management. First, it makes clear that a fund's CCO must report directly to the fund's board of directors, and that the CCO serves at the pleasure of the board. Similarly, the board may prevent the fund's adviser or other service provider from terminating the CCO. In this regard, the designation of the CCO and determination of the CCO's compensation, including bonuses and any changes to the compensation, must be approved by fund's board of directors, including a majority of the non-interested directors. Rule 38a-1 also requires the CCO to meet at least once annually with the fund's non-interested directors without anyone else present (including fund management or the fund's interested directors).

Rule 38a-1 also requires a fund's CCO to annually present the board with a written report on the operations of the fund's policies and procedures, as well as those of the fund's service providers. The report must address: 1) the operation of the fund's and its service providers' policies and procedures since the previous report to the board; 2) any “material” changes to the policies and procedures since the last report; 3) any recommendations for material changes to the policies and procedures as a result of the annual review; and 4) any “material compliance matters” since the date of the last report. A change is material in this context “if it is a change that a fund director would reasonably need to know in order to oversee fund compliance.” In this regard, Rule 38a-1 defines a “material compliance matter” as:

“[A]ny compliance matter about which the fund's board of directors would reasonably need to know to oversee fund compliance, and that involves, without limitation: (i) [a] violation of the [f]ederal [s]ecurities [l]aws by the fund [or its service providers] (or officers, directors, employees and agents thereof, (ii) [a] violation of the policies and procedures of the fund [or its service providers], or (iii) [a] weakness in the design or implementation of the policies and procedures of the fund [or its service providers].”

The Compliance Program Adopting Release makes clear that not every violation of the fund's policies and procedures is a “material compliance matter” and that in determining whether a compliance issue is a “material compliance matter,” the CCO should focus on those matters “about which the fund's board reasonably needs to know in order to oversee fund compliance.”

Conclusion

Fund governance is in the midst of a sea change. Funds directors, in particular independent directors, face increasing regulation, responsibility and scrutiny in light of recent industry scandals. However, only time will tell whether the flurry of new SEC rules and rule amendments will enhance the independence and effectiveness of directors and fund boards.

In the wake of the market timing and late trading scandals in the investment company industry, the Securities and Exchange Commission (SEC or “Commission”) recently adopted rules and rule amendments designed to enhance the governance practices of registered investment companies (“funds”). In an effort to protect shareholders and reduce conflicts of interest between fund boards and fund investment advisers, the SEC has adopted rules that, among other things, proscribe the composition of and processes for fund boards, increase the required disclosure regarding approval of investment advisory contracts and create the position of fund chief compliance officer (CCO) who reports to the board. This article addresses the responsibilities fund boards will face in the wake of these new rules.

Investment Company Governance

The SEC recently adopted rules, in a rare 3-2 vote, that will require funds to adopt certain governance practices if they intend to rely on a number of important exemptive rules under the Investment Company Act of 1940, as amended (“1940 Act”), including Rule 12b-1 and Rule 18f-3, among others. [As of press time, the SEC had not published the final governance rule release. This article is based on the SEC's press release regarding the adoption of the rules and the proposing release.] In statements at the SEC's open meeting, Commissioners Glassman and Atkins cited, as support for their votes against the proposal, their concern that the SEC lacked sufficient empirical evidence, suggesting that some aspects of the proposal would result in better fund governance or combat recent problems in the fund industry. Additionally, at a conference sponsored by the Securities Industry Association soon after the approval vote, Commissioner Atkins noted that the Commission's approval of governance changes for funds marked “the first time that the federal government has described in such detail a corporate governance model for such a large number of companies.” (Horowitz J: SEC Commissioner Atkins Slams New Fund Governance Rule, The Wall Street Journal Online, June 24, 2004).

The rule amendments require the following changes to the composition of fund boards and the chairman position:

Board Composition ('Supermajority Proposal')

Any fund relying on any of the exemptive rules will be required to have a board whose independent directors comprise at least 75% of its membership. Most fund boards already have an independent director majority and many boards have a two-thirds or 75% supermajority. Under Section 10(a) of the 1940 Act, boards must be composed of at least 40% independent directors. If the fund's principal underwriter is a captive broker-dealer, then under Section 10(b)(2), the board must have a majority of independent directors. In early 2001, as part of then-SEC Chairman Arthur Levitt's independence initiatives, the SEC adopted amendments, similar to the current amendments, which required funds that rely on certain exemptive rules to have boards with a majority of independent directors. (See Role of Independent Directors of Investment Companies, SEC Release No. 33-7932 (Jan. 2, 2001)). Moreover, in 1999, an Advisory Group of the Investment Company Institute issued best practice recommendations for directors that included having an independent director super-majority for fund boards. (See Report of the Advisory Group on Best Practices for Fund Directors (June 1999)).

Independent Chairman of the Board ('Independent Chair Proposal')

The amendments require that the chairman of the fund's board be an independent director. In the release proposing the fund governance amendments (“Fund Governance Proposing Release”), the SEC notes that funds are not required to appoint a chairman under the 1940 Act or, as far as the SEC is aware, under state law. The Fund Governance Proposing Release suggested two rationales for an independent chairman. First, the chairperson controls the board's agenda and, thus, an independent chairperson is more likely to put matters not welcomed by the fund's adviser on the agenda. Second, the chairperson has influence over the boardroom culture. The Fund Governance Proposing Release says, “A boardroom culture conducive to decisions favoring the long-term interest of fund shareholders may be more likely to prevail when the board chairman does not have the conflicts of interest in his role as an executive of the fund's adviser.”

These amendments represent the most controversial aspect of the fund governance rules. Both Commissioners Glassman and Atkins indicated in their remarks at the SEC open meeting that these two proposals presented the stumbling block to their approval of the entire proposal. In her remarks at the open meeting, Commissioner Glassman noted a number of possible alternatives to the independent chairperson that the Commission could have considered, such as 1) requiring prominent disclosure of whether a fund had an independent chairperson; 2) implementing a lead independent director; 3) allowing the board, which under these rule amendments would have an independent director majority, to determine whether an independent chair was appropriate for a fund; and 4) narrowing the definition of “independence.”

Industry members also argued that the SEC's independent chair and supermajority proposals unsuspectingly diminish the fiduciary obligations of non-independent directors. As Eric Roiter, general counsel of Fidelity, explained, “What we are concerned about is a very troubling inference that can be drawn from what the SEC is doing: that the government knows better than independent directors and that, by elevating one type of director, you are necessarily denigrating the fiduciary status of a management director.” (Masters BA, Johnson C: SEC May Alter Mutual Fund Governance, The Washington Post, June 23, 2004, at E1).

In addition to the more controversial supermajority and independent chairman provisions, the rule amendments also will require changes to the board's processes, including:

Annual Self-Assessment

The rule amendments will require fund directors to perform an evaluation, at least annually, of the effectiveness and performance of the board and its committees. The Fund Governance Proposing Release envisions a self-evaluation that focuses both on the substantive and the procedural aspects of a board's operations. While the rule amendments do not mandate the content of the board's annual self-evaluation, the proposed rule amendments would require the directors to: 1) consider the effectiveness of the board's committee structure; and 2) evaluate whether the directors have oversight responsibility for too many funds.

The Fund Governance Proposing Release does not specify the appropriate number of funds a director should oversee, but does acknowledge the conflicting views that exist on the matter. The Fund Governance Proposing Release cites Sen. Susan M. Collins' (R-ME) statements from a Senate Governmental Affairs Committee hearing regarding fund trading practices and abuses:

“There are, in fact, plenty of fund family directors who serve on the boards for 80 or even 90 different funds, which seems too many to me … Now, I realize that many of the funds have similar structures and approaches so there may be some economies of scale, if you will. But it's hard for me to see how anyone, any one director could effectively monitor the activities of so many different entities.

“On the other hand, the Fund Governance Proposing Release also cites an Investment Company Institute Best Practices Report: [S]ervice on multiple boards can provide the independent directors of those boards with an opportunity to obtain better familiarity with the many aspects of fund operations that are complex-wide in nature. It also can give the independent directors greater access to the fund's adviser and greater influence with the adviser than they would have if there were a separate board for each fund in the complex.” Investment Company Institute: Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness (June 24, 1999).

Separate Sessions

The rule amendments will require independent directors to meet at least once quarterly outside the presence of any interested persons of the funds. According to the Fund Governance Proposing Release, the SEC believes these meetings “would afford independent directors the opportunity for a frank and candid discussion among themselves regarding the management of the fund” and to help “strengthen the collegiality and cohesiveness of the independent directors.” The Fund Governance Proposing Release suggests that requiring regular sessions would prevent “any negative inferences from attaching to the calling of such executive sessions.”

Independent Director Staff

While funds will be required explicitly to authorize the independent directors to hire employees and others as necessary to assist the independent directors fulfill their fiduciary duties, the new rules do not require that independent directors hire their own staff.

Disclosure Regarding the Board's Approval of Investment Advisory Contracts

The SEC has adopted rule amendments with respect to disclosure regarding the approval of investment advisory contracts by a fund's board of directors. The SEC intends that these amendments be another step in encouraging fair and reasonable fees through increased transparency of a board's decision making-process related to approving, or recommending that shareholders approve, investment advisory contracts.

The amendments to investment company registration forms require reports to fund shareholders to discuss, in reasonable detail, the material factors and conclusions that formed the basis for the board of directors' approval of any investment advisory contract. The required disclosure would be similar to the disclosure already required in the Statement of Additional Information and proxy statements about the basis for approval of the fund's existing advisory contract and any board recommendation that shareholders approve an advisory contract. The shareholder report disclosure will be required for new investment advisory contracts and any contract renewal, including new or renewed sub-advisory contracts, approved during the semi-annual period covered by the report (other than an advisory contract that was approved by shareholders). Enhanced disclosure requirements for proxy statements have been adopted to conform to the new disclosure that will be required in the shareholder reports.

The amendments will specifically require a fund to include the following in its shareholder report and relevant proxy statements:

• A discussion of the factors relating to both the board's selection of the investment adviser, and its approval of the advisory fee and other amounts to be paid under the advisory contract;
• A discussion, including, but not limited to, the following: 1) the nature, extent, and quality of the services to be provided by the investment adviser; 2) the investment performance of the fund and the investment adviser; 3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; 4) the extent to which economies of scale would be realized as the fund grows; and 5) whether fee levels reflect these economies of scale for the benefit of fund investors;
• A discussion of whether the board relied on comparisons of the services to be rendered and the amounts to be paid under the contract with those under other investment advisory contracts, such as contracts of the same and other investment advisers with other registered investment companies or other types of clients (eg, pension funds and other institutional investors); and
• How the board related the factors to specific circumstances of the fund and the investment advisory contracts and how it evaluated the factors considered in approving the investment advisory contract.

The new disclosure requirements will require fund boards to adjust their current procedures for considering the approval of investment advisory contracts to ensure that their discussion addresses all of the factors included in the rule.

As part of the investment company governance rule discussed above, the SEC also adopted amendments to Rule 31a-2, the fund recordkeeping rule, which requires that funds retain copies of the written materials that directors consider in approving advisory contracts under Section 15 of the 1940 Act. Under Section 15, the directors are required to request, and fund advisers are required to provide, written materials to help the directors in their assessment of whether to approve the advisory contract. Under the amendments, funds are required to maintain the materials on which the board relied in approving the advisory contract for at least 6 years, the first 2 years in an easily accessible place. According to the Fund Governance Proposing Release, the SEC's reason for proposing these amendments to Rule 31a-2 is that staff examiners have found that the nature and quality of these materials varied greatly among funds. Additionally the Fund Governance Proposing Release suggests that examiners have had difficulty determining whether the requirements of Section 15 had been met, because many funds did not retain the materials considered by the board when approving the advisory contract.

In a speech before the Mutual Fund Directors Forum in January 2004 entitled “America's Need for Vigilant Mutual Fund Directors,” SEC Chairman William Donaldson noted that the SEC did not intend to act as “a rate-setter and determine how much mutual fund investors should pay for the services they receive from a particular fund.” Rather, Chairman Donaldson indicated that the SEC would address the issue of fees through its rulemaking process, stating, “I firmly believe that rules uniformly applicable to the entire industry are more desirable than fees set through enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do with fees.” He suggested that the SEC's rulemaking was designed to help directors “focus on the need for breakpoints or reductions in advisory fees, and understand the differences in fees charged to other clients of the adviser.” In discussing the disclosure proposal, Chairman Donaldson went on to say that he hoped “these requirements will help focus directors on the critical task of monitoring fund fees and negotiating appropriate fee rates on behalf of investors.”

Interaction Between Board and the Chief Compliance Officer

The compliance program rule, Rule 38a-1 under the 1940 Act, which the SEC adopted in late 2003, directs each investment company to designate one individual to serve as CCO, who will administer the fund's compliance policies and procedures. Rule 38a-1 contains several provisions that are designed to promote the independence of a fund's CCO from fund management. First, it makes clear that a fund's CCO must report directly to the fund's board of directors, and that the CCO serves at the pleasure of the board. Similarly, the board may prevent the fund's adviser or other service provider from terminating the CCO. In this regard, the designation of the CCO and determination of the CCO's compensation, including bonuses and any changes to the compensation, must be approved by fund's board of directors, including a majority of the non-interested directors. Rule 38a-1 also requires the CCO to meet at least once annually with the fund's non-interested directors without anyone else present (including fund management or the fund's interested directors).

Rule 38a-1 also requires a fund's CCO to annually present the board with a written report on the operations of the fund's policies and procedures, as well as those of the fund's service providers. The report must address: 1) the operation of the fund's and its service providers' policies and procedures since the previous report to the board; 2) any “material” changes to the policies and procedures since the last report; 3) any recommendations for material changes to the policies and procedures as a result of the annual review; and 4) any “material compliance matters” since the date of the last report. A change is material in this context “if it is a change that a fund director would reasonably need to know in order to oversee fund compliance.” In this regard, Rule 38a-1 defines a “material compliance matter” as:

“[A]ny compliance matter about which the fund's board of directors would reasonably need to know to oversee fund compliance, and that involves, without limitation: (i) [a] violation of the [f]ederal [s]ecurities [l]aws by the fund [or its service providers] (or officers, directors, employees and agents thereof, (ii) [a] violation of the policies and procedures of the fund [or its service providers], or (iii) [a] weakness in the design or implementation of the policies and procedures of the fund [or its service providers].”

The Compliance Program Adopting Release makes clear that not every violation of the fund's policies and procedures is a “material compliance matter” and that in determining whether a compliance issue is a “material compliance matter,” the CCO should focus on those matters “about which the fund's board reasonably needs to know in order to oversee fund compliance.”

Conclusion

Fund governance is in the midst of a sea change. Funds directors, in particular independent directors, face increasing regulation, responsibility and scrutiny in light of recent industry scandals. However, only time will tell whether the flurry of new SEC rules and rule amendments will enhance the independence and effectiveness of directors and fund boards.