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Director Independence

The 1940 Act requires that at least 40 percent of directors be “independent” and strictly defines independence. An independent director cannot own any stock of the investment adviser (or any subadviser) or certain related entities, such as parent companies or subsidiaries of the investment adviser (or any subadviser). In general, under the 1940 Act, an independent director also cannot have, or at any time during the previous two years have had, a significant business relationship with the fund’s adviser (including any subadvisers), principal underwriter (distributor), or their affiliates. The 1940 Act also sets standards for when a person will be disqualified from being an independent director. A director who is not independent is considered an “interested person” under the 1940 Act. It is important that all directors consult periodically with fund or independent counsel to be sure they understand the thresholds that may lead an otherwise independent director to become “interested.”


According to the 2018 IDC/ICI Directors Practices Study, eighty-seven percent of fund boards are composed of at least three-quarters independent directors.

The issues related to director independence are not limited to those under the 1940 Act. Directors should be mindful of any relationships or situations that might call into question the director’s ability to independently discharge his or her fiduciary duties to the fund and its shareholders. Every independent director should carefully review business or financial relationships that he or she (or any immediate family member) has with the fund’s adviser (including any subadvisers), principal underwriter (distributor), or their affiliates. To help facilitate this review, fund counsel typically provides directors with a detailed questionnaire annually.

Because a number of the actions taken by a fund board, such as approval of the investment advisory contract, must be taken by a majority of independent directors, the potential ramifications in the event that an independent director is deemed to not be independent can be significant. Independent directors, therefore, should be vigilant of relationships that could jeopardize their independence as a matter of law or perception and inform the fund’s adviser and counsel of any contemplated changes in occupation or employment.

Whether independent or interested, all fund directors are subject to the same fiduciary standards. While the number of interested directors on a board is limited by law, and some boards do not have any interested directors, most boards have at least one interested director who is employed by or otherwise affiliated with the fund’s adviser. One or more interested directors on a board may enhance a board’s effectiveness if they have specific knowledge about the adviser’s operations. They also may help to maintain open communication with the adviser and more direct accountability on the adviser’s part.