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Donohue Addresses Challenges Facing Directors

On November 12, Andrew Donohue, Director of the SEC’s Division of Investment Management, gave a keynote address at the Independent Directors Council Investment Company Directors Conference where he discussed challenges facing fund directors.  Rather than focusing on issues that arise with tasks regularly performed by directors such as review of a fund’s investment advisory contract, Mr. Donohue focused on less obvious, though no less important challenges.  Specifically, he urged directors to think carefully about the following five issues:


    • Expense Recapture. Mr. Donohue discussed the common practice of fee waivers by advisers for new funds designed to help these funds as they gain assets.  These waivers are often subject to recapture once a fund’s total expenses fall below the cap.  Mr. Donohue asked independent directors to be cautious in circumstances where an adviser asks the fund to increase the expense cap to allow recapture of fees waived under the new, higher cap because “absent some extraordinary circumstance which I cannot now imagine, it is difficult to articulate how a board would find such a transaction to be in the best interests of fund investors.”


    • Management Entrenchment.  Mr. Donohue also discussed the adoption of shareholder rights plans (poison pills) and other measures designed to protect existing fund management from “dissident” shareholders in closed-end funds.  He encouraged directors to consider the adoption of any strategies that would have the effect of entrenching existing management because even if permissible under state law, such measures may be inconsistent with federal law and not in the best interests of a fund and its shareholders.


    • Mergers.  Mr. Donohue noted the recent increase in fund merger activity, adding that in many cases mergers may be beneficial to fund shareholders by reducing expenses and providing better performance.  However, he mentioned that in some cases advisers pursue mergers solely to merge away funds with poor performance.   Mr. Donohue asked independent directors to thoroughly question advisers on proposed mergers to gain confidence that the transaction is in the best interest of the fund and its shareholders.


    • Fulcrum Fees.  Mr. Donohue described fulcrum fees where an adviser receives a base fee plus an incentive adjustment.  If the fund outperforms a benchmark, the adviser collects the base fee plus the incentive adjustment.  If the fund underperforms the benchmark, however, the incentive adjustment is subtracted from the base fee.  He urged that directors gain a thorough understanding of the calculation and ramifications of a fulcrum fee before entering these fee arrangements.


    • Yield and Managed Distribution Plans.  Mr. Donohue also discussed disclosures with respect to a fund’s yield or its managed distribution plan.  He explained that a managed distribution may represent a return of capital, not a distribution of a fund’s earnings.  He encouraged directors to make sure that the fund’s disclosures explain what a dividend does and does not represent and to make sure a dividend is not confused with a fund’s performance.  Additionally, he asked that directors consider whether managed distribution plans continue to be in the best interests of a fund and its shareholders.


The full text of Mr. Donohue’s speech is available at: