Board Responsibilities with Respect to Investment Advisory Arrangements

Transcription

1 SECTION 6 Board Responsibilities with Respect to Investment Advisory Arrangements A. Statutory Responsibilities The 1940 Act contains important provisions governing the relationship between the adviser and the fund s board of directors in negotiating an advisory contract. Congress viewed these provisions as particularly important given the significant nature of this relationship and the inherent conflicts of interest between advisers and funds. Section 15 of the 1940 Act governs the terms of an advisory contract and the process of entering into, continuing, amending and terminating the contract. After the initial two-year term, the contract may be continued annually if it is approved either by the full board of directors of the fund or by the shareholders of the fund. Typically, the contract is renewed by the directors, not the shareholders (which is a costly and cumbersome alternative). In addition, any renewal of the advisory contract must separately be approved by the independent directors at an in-person meeting called for the purpose of voting on the contract. In entering into or renewing an advisory contract, Section 15(c) provides that it is the duty of the directors to request and evaluate, and the duty of the adviser to furnish, such information as may reasonably be necessary to evaluate the terms of the contract. The advisory agreement for each fund must be considered separately rather than on a complexwide basis. The annual review of the investment advisory arrangements is commonly called the 15(c) process. To provide a remedy for excessive compensation, Section 36(b) of the 1940 Act imposes a fiduciary duty upon the adviser with respect to the receipt of compensation for services, or of payments of a material

2 30 Fund Director s Guidebook nature, paid by the fund to the adviser or its affiliates. Section 36(b) authorizes actions by shareholders and by the SEC against an adviser (not against fund directors) for breach of this duty. In Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923, (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983) (citations omitted), the court articulated the applicable standard for determining whether an adviser has received excessive compensation in breach of its fiduciary duty under Section 36(b) as follows: [T]he test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm s length in the light of all the surrounding circumstances.... To be guilty of a violation of 36(b), therefore, the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm s-length bargaining. To make this determination, all pertinent facts must be weighed. The Senate Report accompanying the enactment of Section 36(b) in 1970 states that: Nothing in the bill is intended to... suggest that a cost-plus type of contract would be required. It is not intended to introduce general concepts of rate regulation as applied to public utilities. B. Factors to Consider in Carrying Out Responsibilities Section 36(b) directs courts to give approval of the advisory arrangements by the board of directors such consideration as it deems appropriate. The excessive-fee cases demonstrate that a valid Section 15(c) approval process is an important factor that increases the likelihood that the fee determination will be upheld. The excessive-fee cases suggest that all of the facts and circumstances surrounding the adviser s relationship with a fund are appropriate for independent director consideration. In determining whether there has been a valid approval process, courts often look to the expertise of the directors, the extent to which

3 Section 6: Board Responsibilities Investment Advisory Arrangements 31 they are fully informed, the care and conscientiousness with which they perform their duties and whether they are represented by counsel independent of the investment adviser. Other factors the directors may consider include (i) the nature, extent and quality of the services provided by the investment adviser; (ii) the investment performance of the fund; (iii) the costs of the services provided and the resulting profits realized by the adviser and its affiliates from its relationship with the fund, including the extent to which the adviser has realized economies of scale as a fund grows; (iv) other sources of revenue to the investment adviser and its affiliates from their relationship to the fund and intangible or fall-out benefits that accrue to the adviser and its affiliates; (v) the control of the operating expenses of the fund; (vi) the manner in which the portfolio transactions of the fund are conducted, including any use of soft dollars; (vii) a comparative analysis of expense ratios of, and advisory fees paid by, similar funds; and (viii) the entrepreneurial risk and financial exposure assumed in organizing and managing the fund. Data, including profitability, should be provided on a fund-by-fund basis. Counsel can help guide the independent directors through the approval process. In considering various factors, the court in Gartenberg notes that evaluating comparable fees and expenses alone will not satisfy Section 36(b) because a fund cannot move easily from one adviser to another. The court observed that advisers seldom, if ever, compete with each other for advisory contracts with funds, which weakens the weight to be given to rates charged by advisers of similar funds. As a result, the court focused its attention on (i) the nature and quality of services, (ii) the adviser s cost in providing the service (i.e., profitability), and (iii) the extent to which the adviser realizes economies of scale as the fund grows larger. Courts generally have not second-guessed a board s determination as to the fairness of a fee structure if the board has employed appropriate evaluatory procedures and has given due consideration to all appropriate factors, including the profitability of the adviser. Thus, the courts have effectively applied a business judgment rule in the 1940 Act context. Court opinions in the excessive-fee cases (which are cited in the Bibliography) provide informative and interesting reading for independent directors and illustrate in detail the nature of appropriate board deliberations and the scrutiny applied to those deliberations if litigation arises.

4 32 Fund Director s Guidebook 1. Nature and Quality of the Services The courts generally have identified the nature and quality of the services rendered to a fund by the adviser as among the most significant factors that a board ought to consider. Although many different services are typically provided by an adviser under the advisory contract with a fund, the primary service generally is portfolio management, except in cases where sub-advisers are employed for that purpose. See Section 6.C. 2. Profitability Profitability is one of the most difficult factors to analyze in reviewing an advisory contract. Courts have closely scrutinized costs and profitability data and methodologies. In so doing, the courts have acknowledged that there are many acceptable ways to allocate common costs, each of which could lead to a significantly different result. A difficult issue in determining profitability is arriving at an equitable allocation of the adviser s overall costs and expenses among the various funds and any other clients for whom it provides services. In general, a court should not invalidate a cost allocation methodology reviewed by independent directors if the methodology has a reasonable basis. Information about distribution costs is relevant, but it is important to identify and distinguish the marketing and promotional costs incurred by the adviser and its affiliates. If the adviser prepares the profitability information (as is usually the case), the information should be consistent with the information used by the adviser for internal management purposes. Retaining an independent expert to assist in preparing a profitability study may prove helpful, especially to the extent the expert establishes or reviews the allocation methodology. 3. Economies of Scale With respect to economies of scale, the courts have concluded that the basic test is whether the directors can satisfy themselves that the information that is available provides a reasonable basis for judgment that the benefits of any economies of scale are equitably shared by the adviser

5 Section 6: Board Responsibilities Investment Advisory Arrangements 33 with the fund (e.g., through appropriately fixed break-points or, alternatively, by means of a fee structure that in effect incorporates economies of scale by virtue of a relatively low starting point which subsumes economies of scale throughout). The importance of economies of scale was reiterated in the SEC staff s 2001 mutual fund fee study, which stated that, if a fund or fund family is experiencing economies of scale, fund directors have an obligation to ensure that fund shareholders share in the benefits of the reduced costs by, for example, requiring that the adviser s fees be lowered, breakpoints be included in the adviser s fees, or that the adviser provide additional services under the advisory contract. If the fund or fund family is not experiencing economies of scale, the SEC staff suggests that directors seek to determine from the adviser how the adviser might operate more efficiently in order to produce economies of scale as fund assets grow. C. Sub-Advisory Contracts With increasing frequency, advisers are delegating some or all of their functions to one or more sub-advisers. Under the 1940 Act, subadvisory contracts are regulated in the same manner as advisory contracts. This means that they must meet the Section 15 requirements described above (including shareholder approval). A number of funds have been formed with a manager-of-managers structure. Under this structure, the primary adviser maintains overall responsibility for the management of the fund (as well as certain administrative responsibilities) but allocates management of some or all of the assets to one or more sub-advisers. The SEC has granted exemptive relief to funds to permit this flexible approach without the fund having to seek further shareholder approval. D. Other Contracts with Affiliates When a fund engages the adviser or its affiliates to perform services such as transfer agency, custodial, valuation or bookkeeping services, special consideration by the fund board is required. These other service arrangements are generally permissible. Based upon positions taken by

6 34 Fund Director s Guidebook the SEC staff, it is prudent for the independent directors to determine that (i) the service contract is in the best interests of the fund and its shareholders, (ii) the services are required for the operation of the fund, (iii) the services are of a nature and quality at least equal to the same or similar services provided by independent third parties and (iv) the fees for those services are fair and reasonable in light of the usual and customary fees charged by service providers for services of the same nature and quality. Payments to the adviser or its affiliates for other services may be subject to the fiduciary standards of Section 36(b). E. Change of Control of the Investment Adviser or Distributor In the event of a change of control of the adviser or distributor, the fund s investment advisory or distribution agreement is terminated by operation of law. In these events, the 1940 Act requires that the board of directors consider the approval of new investment advisory and distribution arrangements, considering the relevant factors discussed in this Section 6 for advisers and in Section 7 for distributors. Any new management arrangement must then be approved by shareholders. In considering the proposal of the existing adviser or distributor to continue under new agreements, emphasis should be placed upon any changes in the surviving entity s plans generally with respect to the fund, including the manner in which the portfolio management, administrative, distribution and other services will be provided and the extent to which new personnel, methods and systems will be used. Many corporate transactions, including the sale of an adviser or a parent of the adviser, are deemed to be a change of control, which triggers this provision. Typically, the parties to the transaction seek to obtain shareholder approval of a new advisory agreement before the transaction actually takes place. Often, the nature of the transaction makes it difficult to secure shareholder approval of a new advisory agreement in advance of the transaction. In this circumstance, an adviser can continue to provide advisory services to a fund after a change of control under an interim contract for up to 150 days, subject to certain conditions and determinations by the directors. A change of control of an investment adviser often implicates Section 15(f) of the 1940 Act. This section provides a safe harbor for an

7 Section 6: Board Responsibilities Investment Advisory Arrangements 35 adviser that sells or assigns its fund advisory business for profit, provided the transaction satisfies two requirements: (i) for three years thereafter, at least 75 percent of the fund s board of directors must not be interested persons of either the adviser or the predecessor adviser, and (ii) no unfair burden may be imposed upon the fund as a result of the transaction. Most acquisitions of advisers are structured to comply with the terms of Section 15(f). The predecessor adviser and the successor adviser each represent and warrant that the transaction will not impose an unfair burden upon the funds. In addition, typically, the predecessor adviser or the successor adviser undertakes to pay all the fund s costs associated with approving the new advisory agreement.

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