Investment Management

Transcription

1 Investment Management JULY 2004 SEC Mandates Enhanced Disclosure Regarding Investment Company Director Approval of Investment Advisory Contracts On June 23, 2004, the Securities and Exchange Commission ( SEC ) adopted amendments 1 that require SEC registered investment companies ( funds ) to disclose to investors the manner in which their boards of directors evaluate, approve, and recommend shareholder approval of investment advisory contracts. 2 As described below, the new amendments require each fund to provide disclosure in its shareholder reports regarding the material factors and subsequent conclusions that formed the basis for the board s approval of advisory contracts during the most recent fiscal half-year. In addition, the new amendments are designed to enhance disclosure in proxy statements regarding the basis for the board s recommendation to shareholders that they approve an advisory contract. The SEC states in its Adopting Release that the new amendments are aimed at increasing transparency with respect to investment advisory contracts, assisting investors in making informed choices among funds, and encouraging fund boards to more thoroughly review advisory contracts. 3 Funds may voluntarily meet the new disclosure requirements regarding fund shareholder reports and proxy statements as of August 5, 2004, the effective date of the amendments. However, the SEC has set the mandatory compliance date as March 31, 2005 for all fund shareholder reports with respects to periods ending on or after that date, and October 31, 2004 for all proxy statements, to give funds sufficient time to determine what additional procedures are needed in order to fulfill the disclosure requirements. The effective date for the amendments that remove the SEC s current Statement of Additional Information ( SAI ) disclosure requirement with respect to the board s approval of any existing investment advisory contract is January 31, DISCLOSURE REQUIREMENTS IN SHAREHOLDER REPORTS The amendments to Forms N-1A, N-2, and N-3 require fund shareholder reports to discuss, in reasonable detail, the material factors and the conclusions that formed the basis for the board of 1 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Securities Act No (June 23, 2004) ( Adopting Release ), available at 2 The amendments pertain to Forms N-1A, N-2, and N-3, which are registration forms used by funds to register under the Investment Company Act of 1940 ( Investment Company Act ) and to offer their securities under the Securities Act of 1933 ( Securities Act ). Form N-1A is used by open-end management investment companies, Form N-2 is used by closed-end management investment companies, and insurance company managed separate accounts that offer variable annuities use Form N-3. In addition to the Form Amendments, the new rules also amend Schedule 14A, the schedule used by registered investment companies for proxy statements, pursuant to Section 14(a) of the Securities Exchange Act of 1934 ( Exchange Act ). 3 Adopting Release, supra note 1, at 4. 4 Prior to January 31, 2006, a fund may omit disclosure in its SAI with respect to board approval of any investment advisory contract if it has previously provided the required disclosure in a shareholder report. For a discussion of the SAI, see infra note 12. Kirkpatrick & Lockhart LLP

2 directors approval of any investment advisory contract. In its Adopting Release, the SEC states that shareholder reports are the location where investors are most likely to read and benefit from this disclosure. Some commentators, in comment letters sent to the SEC relating to the proposed amendments, 5 argued that adding this disclosure could dilute the effectiveness of fund disclosure to shareholders in general. However, the SEC states in its Adopting Release that including disclosure regarding the board s basis for approving an advisory contract in shareholder reports will provide existing fund shareholders with more timely information about the reasons for the board s approval of a contract. As a result, this required disclosure may encourage fund boards to consider investment advisory contracts more carefully and investors to consider more carefully the costs and value of services rendered by the fund s investment adviser. This is especially relevant because the level of fees charged by investment advisers to mutual fund clients, in comparison to those charged by the same advisers to pension plans and other institutional clients, has recently become the subject of much debate. 6 This debate has been spurred by New York Attorney General Eliot Spitzer, who has stated publicly that the advisory fees charged to mutual fund investors are too high, and should be more in line with the advisory fees paid by pension funds or institutional investors. 7 Some fund industry commentators, in objecting to the inclusion of the proposed disclosure in shareholder reports, noted that information in shareholder reports is currently subject to certification by the fund s principal executive and financial officers. 8 As a result, some commentators argued that the amendments would be inappropriate because they would require fund officers to certify disclosure that explains the independent board s basis for approving an advisory contract. However, the SEC states in its Adopting Release that this concern is alleviated by the fact that a certifying officer can rely on information contained in the meeting minutes of the board and other information regarding the board s evaluation that is retained as part of the fund s records. 9 In addition, the SEC suggests that a fund s board, in order to assist the fund s principal executive and financial officers in fulfilling their certification requirement obligations, could approve the discussion that is to be included in shareholder reports regarding its basis for approving an advisory contract. The SEC s disclosure requirement in fund shareholder reports will apply to any new investment advisory contract or contract renewal, including subadvisory contracts, approved by the board during the most recent fiscal half-year. The amendments also eliminate the SEC s proposal that would have excluded from the disclosure 5 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Securities Act No (Feb. 11, 2004) ( Proposed Release ), available at 6 See, e.g., John P. Freeman and Stewart L. Brown, Mutual Fund Advisory Fees: The Costs of Conflicts of Interest, 26 Iowa J. Corp. L. 609 (Spring 2001) ( Freeman Study ) (arguing that advisory fees charged by investment advisers for equity pension funds are substantially lower than advisory fees charged by investment advisers for equity mutual funds because advisory fees for pension funds are negotiated through arm s-length bargaining). But see Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, 930 n.3 (2d Cir. 1982) ( Gartenberg ) (rejecting argument that the lower fees charged by investment advisers to large pension funds should be used as a criterion for determining fair mutual fund advisory fees, and stating, [t]he nature and extent of the services required by each type of fund differ sharply ); Sean Collins, The Expenses of Defined Benefit Pension Plans and Mutual Funds, Investment Company Institute Perspective (Dec. 2003), available at (arguing that Freeman Study fails to take into account significant differences in organizational and expense structures between mutual funds and equity pension funds). 7 Press Release, Office of New York State Attorney General Eliot Spitzer, Investment Company Institute s Mutual Fund Fee Report (Jan. 6, 2004), available at (Spitzer goes on to say that the only way for fees to be fair is to require... that mutual fund directors establish the fairness of the fee contracts they approve ). But see Chairman William H. Donaldson, Speech at the Mutual Fund Directors Forum (Jan. 7, 2004), available at (stating I firmly believe that rules uniformly applicable to the entire [mutual fund] industry are more desirable than [investment advisory] fees set through enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do with fees ). 8 The SEC requires that a fund s principal executive financial officers certify the description of the board s evaluation process based on their knowledge. See Item 11(a)(2) of Form N-CSR, para. 2; see also Rule 30a-2(a) under the Investment Company Act, 17 C.F.R a-2(a) (requiring reports filed on Form N-CSR to require certifications in the form specified in Item 11(a)(2) of Form N-CSR). 9 See Rule 31a-1(b)(4) of the Investment Company Act, 17 C.F.R a-1(b)(4) (2004) (requiring funds to maintain minute books of directors meetings). Kirkpatrick & Lockhart LLP 2

3 requirements contracts that were approved by shareholders, 10 because the SEC has now concluded that the amendment s comprehensive disclosure will better enable shareholders to remain up-to-date on advisory contract approvals, regardless of whether they were involved in the original approval of the contract. The present amendments also modify the SEC s proposed amendments to clarify that a fund is required to provide shareholder report disclosure only regarding board approvals during the fund s most recent fiscal half-year. In addition to amending the disclosure requirement in fund shareholder reports, the SEC also amends the fund recordkeeping rule 11 to require that funds retain copies of the written materials that directors considered in approving the terms or renewal of an advisory contract. In the Adopting Release, the SEC states that the requirement will facilitate their compliance examiners review of whether directors are obtaining the necessary information to make an informed assessment of the advisory contract. DISCLOSURE REQUIREMENTS IN PROXY STATEMENTS, PROSPECTUSES, AND THE SAI The amendments remove the existing requirement for disclosure in the SAI of Forms N-1A, N-2, and N-3 12 with respect to the board s approval of any existing investment advisory contract, because requiring discussion of the board s basis for approving an advisory contract in multiple locations is duplicative. However, because the SEC is concerned that investors should have access to information about advisory contract approvals before investing in a fund, the amendments require that a fund prospectus state that a discussion regarding the board of directors basis for approving any investment advisory contract is available in the fund s shareholder report. The disclosure will be required to appear adjacent to other prospectus disclosure about the fund s investment adviser. Since 1994, the SEC has required fund proxy statements seeking approval of an investment advisory contract to include a discussion of the material factors that form the basis of the fund board s recommendation that shareholders approve the contract. 13 The present amendments, by requiring a similar discussion in shareholder reports, in conjunction with these previous SEC rules, will result in complementary disclosure requirements in fund shareholder reports, prospectuses, and proxy statements. DISCLOSURE ENHANCEMENTS The amendments adopt several enhancements to the existing proxy statement disclosure requirements, and include those same enhancements in the new shareholder reports disclosure requirements. These enhancements are intended to address the SEC s concerns that some funds do not provide adequate specificity regarding the board s basis for recommending that the shareholders approve an advisory contract. Specifically, the enhancements cover discussions by the board regarding: n selection of investment adviser and approval of advisory fee n specific factors n comparison of fees and services provided by adviser n evaluation of factors The amendments specify that the fund s discussion in the shareholder reports and proxy statements must include factors relating to both the board s selection of the investment adviser, and its approval of the advisory fee and any other amounts to be paid under the advisory contract. The amendments also require a fund to include a discussion of the following specific factors: n the nature, extent, and quality of the services to be provided by the investment adviser; n the investment performance of the fund and the investment adviser; n the cost of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; n the extent to which economies of scale would be realized as the fund grows; and n whether fee levels reflect these economies of scale for the benefit of fund investors. 10 Proposed Release, supra note 5, at See Rule 31a-2 of the Investment Company Act, 17 C.F.R a-2 (2004). 12 The SAI is part of a fund s registration statement and contains information about a fund in addition to that contained in the prospectus. The SAI is required to be delivered to investors upon request. 13 Information Required in Proxy Statement, 17 C.F.R a-101 (2004). Kirkpatrick & Lockhart LLP 3

4 These specific factors mirror the factors cited by the Second Circuit in the Gartenberg 14 line of cases, in determining whether investment advisers have met their fiduciary obligations under Section 36(b) of the Investment Company Act. 15 The amendments specify that if any of the enumerated factors is not relevant to the fund board s evaluation of an investment advisory contract, the discussion must note this and explain the reasons why that factor is not relevant. Under the amendments, a fund s discussion is required to state how the board evaluated both the costs of the services provided and the profits realized by the investment adviser and its affiliates from the relationship with the fund. However, the SEC clarifies that disclosure of specific proprietary information about the operating costs and profits of the investment adviser and its affiliates is not necessary to meet this requirement. The amendments also require that the fund s discussion indicate whether the board relied upon comparisons of the services rendered and the amounts to be paid under their contract with those under other investment advisory contracts, such as contracts of the same investment adviser with other funds or other types of clients (e.g., pension funds and other institutional investors). Some commentators objected to this requirement as it relates to comparisons with other types of clients, such as pension funds, because fund boards typically do not use such comparisons as a basis for approving or renewing advisory contracts, but that... fund boards may [as a result of this amendment] feel compelled to consider this factor, notwithstanding the lack of relevance. 16 The amendments, in requiring funds to discuss the comparison of advisory fees under their contract with fees the adviser receives from other contracts, while possibly satisfying some of the SEC s critics, who have accused the SEC of not passing stringent regulation dealing with fund advisory fee levels, 17 will also likely provide future plaintiffs with further points of contention when bringing suit under Section 36(b). The existing proxy statement requirements state that conclusory statements or a list of factors will not be considered sufficient disclosure, and that a fund s discussion must relate the enumerated factors to the specific circumstances of the fund and the investment advisory contract. 18 The amendments clarify these requirements by stating that the fund s discussion must state how the board evaluated each factor, specifically what the board concluded for each factor and how that affected its determination of whether an advisory contract should be approved. 19 The SEC required this discussion despite objections from some comment letters that argued that this information should not be required to be disclosed because, as a factual matter, boards typically determine whether to approve an advisory contract based on the totality of the factors considered. 20 However, the increased disclosure requirements are a result of the SEC s concern that, currently, some funds do not provide adequate specificity regarding the board s basis for its decision on whether to approve an investment advisory contract Gartenberg, supra note Section 36(b) of the Investment Company Act provides that the investment adviser... shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company... to such investment adviser. See Gartenberg, supra note 6 (discussing factors in determining whether a fee is so excessive as to constitute a breach of fiduciary duty, including the adviser-manager s cost in providing the service, the nature and quality of the service, the extent to which the adviser-manager realizes economies of scale as the fund grows larger ); see also Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1228 (S.D.N.Y. 1990) (listing the factors in Gartenberg, but including comparative fee structures ). But see Gartenberg v. Merrill Lynch Asset Management, Inc., 528 F. Supp. 1038, 1046 (S.D.N.Y. 1981) (discussing that the intention of Congress in passing Section 36(b) was not to substitute its business judgment for that of fund directors in approving an investment advisory contract, and not to require a cost-plus type of investment advisory contract). 16 Adopting Release, supra note 1, at See, e.g., Freeman Study, supra note 6, at 656 (arguing that the SEC has not demanded that fund sponsors explain publicly, and in detail, how they profit from their services on both fund-by-fund and complex-wide basis ) a However, the SEC in its Adopting Release does not specify how exactly the board should meet this disclosure requirement, when members of the board will likely undergo a highly individualized process in weighing the enumerated factors. 20 Adopting Release, supra note 1, at Proposed Release, supra note 5, at 5. Kirkpatrick & Lockhart LLP 4

5 CONCLUSION The amendments are one step in a larger series of SEC rulemaking initiatives that have sought to improve disclosure to investors concerning various aspects of fund activities, including fees and charges. The SEC states in its Adopting Release that the increased visibility of this required disclosure resulting from its inclusion in shareholder reports may encourage funds to provide a meaningful explanation of the board s basis for approving an investment advisory contract. In addition, the SEC states that the increased visibility of the disclosure in shareholder reports may encourage fund boards to engage in more vigorous and independent oversight of investment advisory contracts. As a result of the SEC s enhanced disclosure requirements, both funds and management companies need to focus on reviewing and potentially updating their procedures surrounding the advisory contract renewal process, and on determining whether additional procedures are needed for board approval of the required shareholder report disclosure, in order to better enable fund officers to certify this disclosure. PHILIP L. KIRSTEIN pkirstein@kl.com Mr. Kirstein gratefully acknowledges the contributions of Nevin Boparai, a summer associate with the firm. Kirkpatrick & Lockhart LLP 5

6 Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with more than 70 lawyers devoting all or a substantial portion of their practice to this area and its related specialties. We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly represent mutual fund distributors, independent directors of investment companies and service providers to the investment management industry. In addition, we frequently serve as outside counsel to industry associations on a variety of projects, including legislative and policy matters. We work with clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the investment company business. We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also visit our website at for more information, or send general inquiries via to investmentmanagement@kl.com. BOSTON Michael S. Caccese mcaccese@kl.com Philip J. Fina pfina@kl.com Mark P. Goshko mgoshko@kl.com Thomas Hickey III thickey@kl.com Nicholas S. Hodge nhodge@kl.com George Zornada gzornada@kl.com LOS ANGELES William P. Wade wwade@kl.com NEW YORK Ricardo Hollingsworth rhollingsworth@kl.com Philip L. Kirstein pkirstein@kl.com Beth R. Kramer bkramer@kl.com Richard D. Marshall rmarshall@kl.com Robert M. McLaughlin rmclaughlin@kl.com Keith W. Miller kmiller@kl.com SAN FRANCISCO Eilleen M. Clavere eclavere@kl.com Jonathan D. Joseph jjoseph@kl.com David Mishel dmishel@kl.com Timothy B. Parker tparker@kl.com Mark D. Perlow mperlow@kl.com Richard M. Phillips rphillips@kl.com WASHINGTON Clifford J. Alexander calexander@kl.com Diane E. Ambler dambler@kl.com Mark C. Amorosi mamorosi@kl.com Catherine S. Bardsley cbardsley@kl.com Arthur J. Brown abrown@kl.com Arthur C. Delibert adelibert@kl.com Jennifer R. Gonzalez jgonzalez@kl.com Robert C. Hacker rhacker@kl.com Kathy Kresch Ingber kingber@kl.com Michael J. King mking@kl.com Rebecca H. Laird rlaird@kl.com Cary J. Meer cmeer@kl.com R. Charles Miller cmiller@kl.com Dean E. Miller dmiller@kl.com R. Darrell Mounts dmounts@kl.com C. Dirk Peterson dpeterson@kl.com David Pickle dpickle@kl.com Alan C. Porter aporter@kl.com Theodore L. Press tpress@kl.com Francine J. Rosenberger francine.rosenberger@kl.com Robert H. Rosenblum rrosenblum@kl.com William A. Schmidt william.schmidt@kl.com Lori L. Schneider lschneider@kl.com Lynn A. Schweinfurth lschweinfurth@kl.com Donald W. Smith dsmith@kl.com Martin D. Teckler mteckler@kl.com Robert A. Wittie rwittie@kl.com Leslie C. Zimberg lzimberg@kl.com Robert J. Zutz rzutz@kl.com Kirkpatrick & Lockhart LLP BOSTON n DALLAS n HARRISBURG n LOS ANGELES n MIAMI n NEWARK n NEW YORK n PITTSBURGH n SAN FRANCISCO n WASHINGTON... This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED. Challenge us.