2006 MUTUAL FUNDS AND INVESTMENT MANAGEMENT CONFERENCE. Sub-Advised Funds: The Legal Framework

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1 2006 MUTUAL FUNDS AND INVESTMENT MANAGEMENT CONFERENCE I. Introduction Sub-Advised Funds: The Legal Framework Arthur J. Brown * Partner Kirkpatrick & Lockhart Nicholson Graham LLP A fund can internally manage its assets or can employ an investment adviser to manage its assets. The overwhelming majority of funds use the latter method. Increasingly, those advisers, in turn (i) select other advisers to manage a portion of the assets of the fund; (ii) select other advisers to manage all of the assets of the fund; or (iii) select two or more advisers to manage all of the assets of the fund (each of these arrangements, so-called sub-advised funds ). This outline provides background regarding sub-advised funds and an overview of the legal framework surrounding these funds. II. Sub-advisers are treated as Investment Advisers under the Investment Company Act of 1940, as amended ( 1940 Act ) A. Section 2(a)(20) of the 1940 Act Section 2(a)(20) of the 1940 Act defines an investment adviser of an investment company as: (A) any person who pursuant to contract with such company regularly furnishes advice to such company with respect to the desirability of investing in, purchasing or selling securities or other property, or is empowered to determine what securities or other property shall be purchased or sold by such company, and (B) any other person who pursuant to contract with a person described in clause (A) regularly performs substantially all of the duties undertaken by such person described in clause (A) (emphasis added). B. Interpretation of Section 2(a)(20) * The author would like to acknowledge the assistance of Andrea J. Ottomanelli, Associate, Kirkpatrick & Lockhart Nicholson Graham LLP, in preparing this outline. M:\Cross Marketing\April 2006\Files\Arthur Brown Presentation.DOC

2 1. Clause (A) investment advisers: Some Sub-advisers contract directly with a fund to provide to it investment advice regarding the investment of some or all of its assets or enter into a tri-party contract with the fund and the socalled investment manager of the fund. 2. Clause (B) investment advisers: Some Sub-advisers contract with the investment manager ( Manager ) of the fund who, in turn, has an advisory contract with the fund. 1 a. In some cases, the Sub-adviser undertakes to provide substantially all of the advisory services needed by the fund, other than selection and monitoring of the Sub-advisers. b. In some cases, the Sub-adviser undertakes to provide substantially all of the portfolio management services needed by the fund, but only as to a portion of the fund s assets, such as where three or four Sub-advisers each manage discrete portions of the fund (socalled multi-manager funds ). In each of these circumstances, the Securities and Exchange Commission ( SEC ) asserts that Section 2(a)(20) covers such persons. 2 1 See In the Matter of Managed Funds Incorporated, 36 S.E.C. 313 (1959) (holding that a registered representative who was responsible for determining the particular securities purchased and sold for a portfolio pursuant to a contract with the Manager of a fund was an investment adviser under what is now Section 2(a)(20)(B) of the 1940 Act). 2 Although the definition of investment adviser in Section 2(a)(20)(B) of the 1940 Act as it pertains to multi-managed funds has not been specifically adjudicated, applications for Multi- Manager Orders, SEC rule releases, no-action letters issued by the SEC staff and industry guidance suggest that the definition applies to Sub-advisers that manage only a portion of a fund s assets. See, e.g., SunAmerica Series Trust, et al., 1940 Act Release Nos (Nov. 6, 1996) (notice) and (Dec. 3, 1996) (order); see, e.g., The Charles Schwab Family of Funds, et al., 1940 Act Release Nos (Oct. 3, 2002) (notice) and (Oct. 29, 2002) (order); see Exemption from Shareholder Approval for Certain Subadvisory Contracts, 1940 Act Release No (Oct. 23, 2003) available at [hereinafter, Rule 15a-5 Release ] (citing the definition of investment adviser in Section 2(a)(20)(B) to define the term sub-adviser to mean a party that contracts with a fund s [Manager] to provide investment advisory services to the fund and stating that Sub-advisers (as defined therein) are responsible for all or a portion of the portfolio of a fund) (emphasis added); see Transactions of Investment Companies with Portfolio and Subadviser Affiliates, 1940 Act Release No (January 14, 2003), available at htm [hereinafter, 17a-10 Adopting Release ] (noting that a Sub-adviser may only manage a discrete portion of a fund s assets and defining a Sub-adviser, in such context, as an investment adviser under the 1940 Act pursuant to Section 2(a)(20)(B)). In both the Rule 15a-5 Release and the 17a-10 Adopting Release, the SEC describes Sub-advisers as advising all or a portion of a fund s assets and defines Sub-advisers in the context of the rules as investment - 2 -

3 C. Implications of treating Sub-advisers as Investment Advisers under the 1940 Act 1. Section 15 of the 1940 Act applies to management and subadvisory agreements, including agreements entered into by a Manager on behalf of an investment company or a series of an investment company ( Fund ) with a Sub-adviser. Section 15 provides, in pertinent part, that: (a) It shall be unlawful for any person to serve or act as investment adviser of a registered investment company, except pursuant to a written contract, which contract, whether with such registered company or with an investment adviser of such registered company, has been approved by the vote of a majority of the outstanding voting securities of such registered company, and (c) [has] been approved by the vote of a majority of directors, who are not parties to such contract or agreement or interested persons [as that term is defined in Section 2(a)(19) of the 1940 Act] of any such party, cast in person at a meeting called for the purpose of voting on such approval. 2. The Sub-adviser is an affiliated person of the Fund; 3 it and its affiliates are subject to Section 17 of the 1940 Act and related provisions Section 38(a) and Rule 38a-1 cover Sub-advisers, as do code of ethics and related compliance requirements. 5 advisers under Section 2(a)(20)(B). See also Proposed New Disclosure Option for Open-End Management Investment Companies, 1940 Act Release No (Feb. 27, 1997), available at (stating that Section 2(a)(20) of the 1940 Act defines investment adviser to include Sub-advisers and noting that a Sub-adviser may manage only a portion of a fund s portfolio); see also Savoy Capital Management, Inc., 1989 SEC No- Act. LEXIS 1162 at n.3 (Nov. 15, 1989) (stating, in the context of a Sub-adviser managing a distinct portion of a fund, that a Sub-adviser is an investment adviser under the 1940 Act); see also Benjamin Haskin, Hiring and Oversight of Sub-Advisers, 5 THE INVESTMENT LAWYER 8 (Jan. 1998) (noting that Managers contract with Sub-advisers to manage all or a portion of a fund s assets and that, pursuant to Section 2(a)(20) and Section 15(a), almost all entities providing sub-advisory services will be subject to investment adviser regulation under the 1940 Act) (emphasis added). 3 Section 2(a)(3) of the 1940 Act states that a Fund s investment adviser is an affiliated person of that Fund. 4 See Section IV herein. 5 See Section V.B. herein

4 4. Disclosure regarding Sub-advisers and their subadvisory agreements with the Manager and/or Fund must be included in certain Fund documents. 6 III. Exemptive Relief has been provided to Sub-advised Funds relating to Shareholder Approval of Sub-advisers A. Multi-Manager Orders 6 See Section VII herein. 1. Since 1981, the SEC has issued exemptive orders ( Multi-Manager Orders ) to those Companies and Managers that utilize subadvisory arrangements. 7 The Multi-Manager Orders differ slightly, but basically (a) exempt subadvisory agreements from the shareholder approval requirement of Section 15(a) so that Funds, Managers and Sub-advisers can (i) enter into and (ii) materially amend subadvisory agreements without shareholder approval; and (b) in some cases, allow Funds to avoid disclosures relating to the fees paid to those Sub-advisers by Managers, including, among other things, the rate at which such fees are paid and the amount of each Sub-adviser s fee A Manager may not enter into a subadvisory agreement, however, with an affiliated Sub-adviser, unless such agreement, and the compensation to be paid thereunder, is approved by the shareholders of the applicable Fund. Additionally, when a Sub-adviser change is proposed for a Fund with an affiliated Sub-adviser, the directors of the Fund, including a majority of Independent Directors, must make a separate finding, reflected in the minutes, that such change is in the best interests of the Fund and its shareholders and that such change does not involve a conflict of interest. 3. A Manager may not enter into a subadvisory agreement without shareholder approval, unless no director or officer of the Fund and no director or officer of the Manager owns directly or indirectly (other than through a pooled vehicle that is not controlled by such person) any interest in a Sub-adviser, except that such director or officer may own less than 7 See Frank Russell Investment Company, et al., 1940 Act Release Nos (Sept. 21, 1981) (notice) and (Oct. 14, 1981) (order). 8 See, e.g., American AAdvantage Funds, et al., 1940 Act Release Nos (May 30, 1996) (notice) and (June 25, 1996) (order); SunAmerica Series Trust, et al., 1940 Act Release Nos (Nov. 6, 1996) (notice) and (Dec. 3, 1996) (order); The Chapman Funds, Inc., 1940 Act Release Nos (Aug. 10, 1999) (notice) and (Sept. 8, 1999) (order); Hillview Investment Trust II and Hillview Capital Advisors, LLC, 1940 Act Release Nos (Feb. 6, 2001) (notice) and (June 29, 2001) (order) (issued after hearing request); AB Funds Trust and SBC Financial Services, Inc., 1940 Act Release Nos (Nov. 19, 2002) (notice) and (Dec. 17, 2002) (order)

5 1% of a publicly traded Sub-adviser or an entity that controls, is controlled by, or is under common control with the Sub-adviser The Multi-Manager Orders issued by the SEC are subject to a number of conditions. Although these conditions differ slightly from Fund to Fund, below are the basic representations and conditions most often found in Multi-Manager Orders: a. Manager Responsibility The Manager will provide general management services to each Fund and subject to Board review and approval will (i) set each Fund s general investment strategy; (ii) select Sub-advisers; (iii) recommend allocation of a Fund s assets among multiple Subadvisers; (iv) monitor and evaluate Sub-adviser performance; and (v) implement procedures designed to ensure Sub-adviser compliance with Fund objectives, policies and restrictions; b. Shareholder Approval of Arrangement The arrangement for Sub-adviser selection and replacement, and advisory contract amendments, without shareholder approval, must first be approved by a majority of outstanding voting securities of the Fund relying on the Multi-Manager Order, and, in the case of a new Fund, by the sole initial shareholder before offering shares of such Fund to the public; c. Disclosure of Arrangement The Fund will disclose in its prospectus the existence, substance and effect of the Multi-Manager Order and hold itself out as employing a multi-manager system, as well as disclose that the Manager has ultimate responsibility (subject to Board oversight) to oversee the Sub-advisers and to recommend their hiring, termination and replacement; d. Independent Director Control of Sub-Adviser Agreements A majority of a Fund s Independent Directors must approve the selection of any new Sub-adviser and any material advisory agreement amendment, and must have the discretion to nominate new and additional Independent Directors; and 9 Proposed Rule 15a-5 does not contain such an exception. See Rule 15a-5 Release, supra note

6 e. Disclosure of New Sub-advisers Within ninety days of hiring any new Sub-adviser, the Fund must furnish to shareholders all information about a new Sub-adviser or subadvisory agreement, by providing shareholders with an information statement on Schedule 14C under the Securities Exchange Act of 1934, as amended. This is in addition to any prospectus supplement that may be furnished to investors. 5. In addition, those Multi-Manager Orders that allow Funds to avoid disclosures relating to the fees paid to Sub-advisers, are also subject to the following conditions: a. Fee Disclosure The Fund will include in its registration statement the aggregate fees paid to (i) the Manager and any affiliated Sub-advisers and (ii) the Sub-advisers, other than the affiliated Sub-advisers; b. Independent Counsel The Independent Directors shall retain and be represented by independent counsel and the selection of such counsel shall be within the discretion of the Independent Directors 10 ; and c. Manager Profitability The Manager will provide the board of directors ( Board ), no less frequently than quarterly, information about the Manager s profitability on a per-fund basis. Such information will reflect the impact on profitability of hiring or terminating any Sub-adviser during the applicable period. In addition, whenever a Sub-adviser is hired or terminated, the Manager will provide the board of directors information showing the expected impact on the Manager s profitability Rule 15a-5 Release, supra note 2 at n.39 (noting that those Multi-Manager Orders that provide exemption from certain disclosure requirements are subject to this condition). 11 This condition is not included in proposed Rule 15a-5. See Rule 15a-5 Release, supra note

7 B. Proposed Rule 15a-5 under the 1940 Act 1. In the fall of 2003, the SEC proposed for comment Rule 15a-5 under the 1940 Act. 12 Rule 15a-5 would generally codify the Multi-Manager Orders. 2. Proposed Rule 15a-5 would also require, among other things, that: a. The subadvisory agreement does not directly or indirectly increase the management and subadvisory fees charged to the Fund or its shareholders; b. The management agreement between the Fund and the Manager provides that the Manager must supervise and oversee the activities of the Sub-adviser; 13 and c. If a Fund identifies the Sub-adviser as part of its name, it also must identify the name of the Manager in its name before the name of the Sub-adviser. 3. There were only nine comment letters submitted in response to proposed Rule 15a-5, all but one of which supported the basic concept of the rule. 14 Some letters, however, took issue with certain provisions of the proposed rule, including each of the conditions listed above. a. Three letters request clarification of the condition that would require that the subadvisory agreement not directly or indirectly increase the management or subadvisory fees charged to the Fund or its shareholders, to underscore that the condition would not prohibit Funds from entering into subadvisory agreements that would increase subadvisory fees paid by a Manager, not the Fund. b. Two letters opposed the condition that would require a contractual provision requiring the Manager to supervise and oversee the Subadviser. These commenters suggested that a contractual provision requiring oversight of a Sub-adviser by a Manager is unnecessary and should not be the focus of the condition. They noted that the 12 Rule 15a-5 Release, supra note See infra note Comments on Proposed Rule: Exemption from Shareholder Approval for Certain Subadvisory Contracts (January 8, 2004) available at

8 condition should focus on Manager oversight rather than a contractual provision requiring such oversight. 15 c. One letter opposed the condition requiring that a sub-advised Fund that identifies its Sub-adviser in its name also identify the Manager in its name before the name of Sub-adviser. The commenter suggests that this condition is too restrictive and should be revised to require prominent prospectus disclosure of the names of both the Manager and the Sub-adviser. d. Five letters opposed the SEC s proposal to rescind the Multi- Manager Orders previously issued by the SEC. These commenters noted that this would be an unusual step for the SEC and that such a revision could unduly burden Funds and Managers by requiring them to make changes to the current system in which they operate. 4. As of the date of this outline, proposed Rule 15a-5 has not been adopted or re-proposed by the SEC and no date has been set publicly for action on the rule. IV. Exemptive Relief has been provided to Sub-advised Funds relating to Affiliated Transaction Prohibitions of the 1940 Act A. Sub-advisers as Affiliates Because a Sub-adviser to a Fund is an affiliated person of that Fund, it may be a second tier affiliate of other Funds affiliated with that Fund (such as other Funds managed by the same Manager and having the same board of directors). Whether one Fund managed by the same adviser as another and subject to the same board of directors is commonly controlled with that second Fund depends on the 16 particular facts of a case, but often is assumed to create common control. As a result, a Sub-adviser to a Fund may be treated as a second tier affiliate of another Fund in the complex with which the Sub-adviser has no relationship. The Sub-adviser, therefore, may be prohibited by the 1940 Act and the rules 15 For more information regarding the supervisory role of the Manager, see Section V.A Section 2(a)(3) of 1940 Act defines affiliated person to include, among other things, any person directly or indirectly under common control with such other person. In this connection, a Fund may be deemed an affiliated person of the other Funds in a complex. See Investment Company Mergers, 1940 Act Release No (Nov. 8, 2004), available at Funds with the same investment advisers, officers and/or directors do not fit specifically within one of the categories of affiliated persons set forth in Section 2(a)(3) of the 1940 Act, however, they would be deemed affiliates if they are under common control. The determination of whether these funds are under common control turns on whether the adviser, officers, or directors control the funds, which depends on the relevant facts and circumstances. Id. at n

9 thereunder from entering into certain transactions with each other Fund because they would be prohibited by Sections 17(a) and/or 17(e), among others. 17 Moreover, affiliates of the Sub-adviser, such as a control person which is a broker-dealer, may also be prohibited from transactions not just with the Fund the Sub-adviser advises (whether or not the Sub-adviser manages all of the assets of the Fund), but with other Funds in the complex. B. Exemptive Rules for Certain Affiliated Transactions 1. Rules have been Adopted to Permit Certain Transactions: Rule 17a-10 and Amendments to Rules 10f-3, 12d3-1 and 17e-1 a. Following the issuance of a number of individual exemptive orders to multi-managed Funds, 18 in April 2002, the SEC proposed and in January 2003, the SEC adopted, Rule 17a-10 and amendments to Rules 10f-3, 12d3-1 and 17e b. Rule 17a-10 permits: (i) a Sub-adviser of a Fund (and affiliated persons of the Sub-adviser, e.g. broker-dealers that are affiliates of the Sub-adviser) to enter into transactions with Funds that the Sub-Adviser does not advise, but which are affiliated persons of a Fund that it does advise (e.g. other Funds in an investment company complex) and (ii) a Sub-adviser of a portion of the assets of a Fund (and affiliated persons of the Sub-adviser, e.g. broker-dealers that are affiliates of the Sub-adviser) to enter into transactions and arrangements with Funds the Sub-adviser does advise, but only with respect to discrete portions of 17 Certain sections and rules under the 1940 Act prohibit affiliated transactions among first tier affiliates and often, second tier affiliates. A first tier affiliate is an affiliated person under Section 2(a)(3), while a second tier affiliate is an affiliated person of an affiliated person. Among the sections and rules that prohibit certain transactions involving parties who are affiliated persons are Section 17(a), Section 17(e), Section 10(f) and Rule 12d a-10 Adopting Release, supra note 2 (adopting Rule 17a-10 and amendments to Rules 17e- 1, 12d3-1 and 10f-3 and citing to orders that have been issued by the SEC to allow certain affiliated transactions); see, e.g., State Street Bank and Trust Co., 1940 Act Release Nos (Oct. 13, 1993) (notice) and (Nov. 9, 1993) (order); SEI Investments Management Corporation, 1940 Act Release Nos (Apr. 28, 2000) (notice) and (May 23, 2000) (order); Frank Russell Investment Co., 1940 Act Release Nos (Jan. 3, 2001) (notice) and (Jan. 30, 2001) (order) a-10 Adopting Release, supra note

10 the sub-advised Fund for which the Sub-adviser does not provide investment advice. c. The amendments to Rule 10f-3 apply to purchases during a primary offering underwritten by a Sub-adviser. Section 10(f) of the 1940 Act prohibits a Fund from purchasing any security during an underwriting or selling syndicate if the Fund has certain affiliated relationships with a principal underwriter for the security. Rule 10f-3 provides an exemption from Section 10(f) provided certain conditions are met. The amendments to Rule 10f-3 deem each series of an investment company, and each separately managed portion of a series, to be separate registered investment companies for purposes of Section 10(f) and Rule 10f-3. d. Rule 12d3-1 permits a Fund to invest up to 5% of its assets in securities of a so-called securities-related issuer (deriving more than 15% of its gross revenues from securities-related businesses), but not securities of its own Sub-adviser or any affiliated person thereof, unless the circumstances are identical to those in which a Sub-adviser (or affiliated person of the Sub-adviser) would be permitted by Rule 17a-10 to enter into a principal transaction with the Fund. 20 e. The amendments to Rule 17e-1 permit a Fund s Sub-adviser (or other affiliated person of the Sub-adviser) to receive brokerage commissions without complying with the recordkeeping and review requirements of Rule 17e-1 if the person acting as broker is a person permitted to enter into a transaction with an investment company under Rule 17a-10. V. Manager and Board Oversight of Sub-advisers A. Manager Role relative to Sub-advisers 1. Pursuant to the Multi-Manager Orders issued by the SEC, the Fund must disclose the existence, substance and effect of the order in its prospectus. This is in addition to the requirement that the role of management of a Fund be identified and disclosed. Fund prospectuses usually disclose that the Fund Manager monitors and evaluates Sub-adviser performance and that a Manager may hire or terminate a Sub-adviser based on its evaluation 20 See Section IV.B.1.b herein. Rule 12d3-1(c)(3) under the 1940 Act permits a Fund to acquire a security issued by a Sub-adviser or an affiliated person of a Sub-adviser of the acquiring company provided that the Sub-adviser that is (or whose affiliated person is) the issuer is not, and is not an affiliated person of, an investment adviser responsible for providing advice with respect to the portion of the acquiring company that is acquiring the securities

11 of the Sub-adviser. For more information on the oversight role of a Manager relative to Sub-advisers, see Section III.B discussing proposed Rule 15a-5 and Section VI.B discussing contractual provisions of subadvisory agreements. 2. Supervisory Role of Manager a. Section 203(e)(6) of the Investment Advisers Act of 1940, as amended ( Advisers Act ), authorizes the SEC to sanction an investment adviser that has failed reasonably to supervise, with a view towards preventing violations of [the federal securities laws], another person who commits such a violation, if such other person is subject to his supervision. Section 203(e)(6) provides an affirmative defense to a failure to supervise charge if an investment adviser can demonstrate that it established and complied with procedures reasonably designed to prevent and detect the violations at issue. b. In September 2001, the SEC and Legg Mason Fund Adviser, Inc. (the Manager) and Western Asset Management Co. (the Sub-adviser), affiliated investment advisers, agreed to an administrative order based on, among other things, the alleged failure by the Manager to supervise a portfolio manager employed by the Subadviser. 21 The SEC found that the Manager failed to reasonably supervise the portfolio manager of the Subadviser with a view toward preventing and detecting her violations of federal securities laws and that the Manager had not established or implemented adequate procedures to follow up and/or review potential violations. The Subadviser was also cited for supervisory violations related to its employee. c. In the Rule 15a-5 Release, the SEC proposed a provision that would require any management agreement under the rule to obligate the Manager to supervise and oversee the activities of the Sub-adviser under the subadvisory agreement. In so proposing, the SEC notes Release No and also suggests that the Multi-Manager Orders that have been issued by the SEC require Managers to supervise 21 In the Matter of Western Asset Management Co. and Legg Mason Fund Adviser, Inc., Advisers Act Release No. 1980, 2001 SEC LEXIS 2042 (Sept. 28, 2001) [hereinafter, Release No ]

12 B. Board Oversight of Sub-advisers Fund Sub-advisers. 22 To protect against charges under Section 203(e)(6), a Manager should have adequate systems in place to prevent and detect violations of federal securities laws by Sub-advisers and their employees and should discharge its obligations and duties under its procedures. For more information regarding compliance policies and procedures, see Section V.B.3 below. 1. Subadvisory Agreements - Section 15 a. Section 15(c) of the 1940 Act requires that the Independent Directors, who are not a party to the agreement or interested persons of a party to the agreement, review and, if the agreement is to be entered into and/or continued, approve it, in person at a meeting called for such purpose. b. Section 15(a) of the 1940 Act also requires that in order for an advisory agreement to be retained for longer than an initial two year term, the full board of directors (or a majority of the outstanding voting securities of the Fund) approve the advisory agreement annually. 2. Codes of Ethics a. Rule 17j-1(c)(1)(i) under the 1940 Act requires every Fund and each investment adviser of a Fund to adopt a written code of ethics containing provisions reasonably necessary to prevent its access persons from engaging in any conduct prohibited by paragraph (b) thereof (i.e. any conduct that is fraudulent, misleading or deceptive). b. Rule 17j-1(c)(1)(ii) requires that every board of directors, including a majority of Independent Directors, approve the code of ethics of the Fund and the code of ethics of each investment adviser, prior to the initial retention of that adviser, as well as any material changes to that code. 22 See Rule 15a-5 Release, supra note 2, at n.27. In its proposing release for Rule 17a-10 and the amendments to Rules 17e-1, 12d3-1 and 10f-3, the SEC similarly notes that a Manager has a duty to supervise the performance of a Sub-adviser and cites Release No See Transactions of Investment Companies with Portfolio and Subadviser Affiliates, 1940 Act Release No (April 30, 2002), available at htm

13 3. Compliance Policies and Procedures a. Rule 38a-1(a)(1) under the 1940 Act provides that each investment company must adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, including policies and procedures that provide for the oversight of compliance by each investment adviser of a Fund. b. Rule 38a-1(a)(2) and (a)(3) require that the board of directors, including a majority of Independent Directors, approve the Fund s policies and procedures and those of each investment adviser and review these policies and procedures at least annually. 23 c. Pursuant to Rule 38a-1, the board of directors of a sub-advised Fund must approve initially and review annually not only the Fund s compliance policies and procedures, but also each Subadviser s compliance policies and procedures. d. Rule 38a-1(a)(4) also requires each Fund designate a Chief Compliance Officer ( CCO ) responsible for administering the Fund s compliance policies and procedures, including oversight of the compliance policies and procedures of its Sub-advisers. 24 VI. Subadvisory Agreements A. Section 15(a) requires Certain Provisions in all Investment Company Advisory Contracts 1. Section 15(a)(1) requires that an advisory contract precisely describes all compensation to be paid thereunder. 2. Section 15(a)(3) requires an advisory contract to provide that it may be terminated at any time, without the payment of any penalty on not more than sixty days written notice to the investment adviser. 23 In its proposing release for Rule 38a-1, the SEC noted that compliance programs are necessary to protect against violations of federal securities laws. Citing Release No. 1980, the SEC also noted that the consequences of inadequate compliance programs have been well documented through its enforcement actions. See Compliance Programs of Investment Companies and Investment Advisers, 1940 Act Release No (February 5, 2003), available at 24 See Compliance Programs of Investment Companies and Investment Advisers, 1940 Act Release No (December 17, 2003), available at htm (stating that the role of the Fund s CCO [would include] oversight of the service providers compliance policies and providing advice to the board on their operation )

14 3. Section 15(a)(4) requires an advisory contract to provide that it will automatically terminate in the event of an assignment. B. Additional Provisions of Subadvisory Agreements In addition to those provisions required by Section 15 of the 1940 Act, subadvisory agreements contain other provisions defining the relationship of the parties, including those listed below. 1. Services to be rendered by Sub-adviser Subadvisory agreements usually contain provisions noting that the Subadviser is subject to Board and Manager direction and oversight. Additionally, the subadvisory agreements contain provisions regarding the services to be rendered by a Sub-adviser, typically including portfolio management, placing trade orders with brokers and dealers consistent with best execution, furnishing the Board and/or Manager with information/reports regarding the Fund, assisting the relevant persons in determining the value of portfolio securities and adhering to the Fund s organizational documents, policies and procedures and prospectus and statement of additional information ( SAI ) as well as applicable law and regulations. 2. Limitations of Liability and Indemnification a. Subadvisory agreements often include a provision relating to the liability of a Sub-adviser under the subadvisory agreement. One provision usually provides that the Sub-adviser will not be held liable, except by reason of the Sub-adviser s willful misfeasance, bad faith, or (gross) negligence in the performance of its duties, or by reason of its reckless disregard of its obligations under the agreement. b. Subadvisory agreements may also include provisions regarding the indemnification of the Sub-adviser by the Manager for any losses, liabilities or litigation arising out of (1) the willful misfeasance, bad faith, or (gross) negligence in the performance of the Manager s duties, or by reason of the Manager s reckless disregard of its obligations or (2) any untrue statement of material fact included in a Fund s prospectus, SAI and certain other publicly disclosed materials, or any omission of material fact therein other than if provided by the Sub-adviser. 3. Miscellaneous Subadvisory agreements often contain other provisions, including ones relating to (a) the exclusivity/non-exclusivity of the services provided by the Sub-adviser under the agreement; (b) delivery of notices to the parties

15 to the agreement; (c) amendments to the agreement; (d) the state law governing the agreement; and (e) the maintenance of records for the Fund by the Sub-adviser and the acknowledgment that such records are the property of the Fund. VII. Disclosure Regarding Sub-advisers A. General Disclosure in Form N-1A Form N-1A requires each Fund to disclose certain information regarding its Manager and each Sub-adviser in its registration statement. 1. General Information regarding a Sub-adviser Item 5(a)(1) of Form N-1A requires, among other things, information in the prospectus regarding each Fund s Sub-adviser, including its address and investment experience. Item 5(a)(2) of Form N-1A also requires information in the prospectus regarding the portfolio managers employed by a Sub-adviser to manage the assets of the Fund, including title, length of service and business experience for the past five years. Item 14(a) requires information with respect to each Fund s Sub-adviser in the SAI regarding each Sub-adviser s control persons. Item 15 of Form N-1A requires information in the SAI regarding portfolio managers, including other accounts managed by the portfolio manager, compensation paid to the portfolio manager, and the portfolio manager s ownership of Fund securities. 2. Legal Proceedings Item 5(a)(3) of Form N-1A also requires that a Fund s prospectus disclose any material legal proceedings, other than ordinary routine litigation incidental to the business, to which the Fund, principal underwriter or investment adviser, including a Sub-adviser, is a party. B. Advisory Contract Approval Disclosure in Shareholder Reports 1. Pursuant to amendments to Form N-1A adopted in 2004, 25 shareholder reports are required to contain disclosure regarding advisory contract (including subadvisory contracts) approvals and renewals by the board of directors during the most recent fiscal half-year Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, 1940 Act Release No (June 23, 2004) available at 26 See Item 22(d)(6) of Form N-1A

16 2. Item 22(d)(6)(i) of Form N-1A requires a description of the Board s approval of advisory contracts to include the factors it considered in selecting an investment adviser and approving the advisory fee. The factors include (1) the nature, quality and extent of the services to be provided by the Sub-adviser; (2) the investment performance of the Fund and the Sub-adviser; (3) the costs of services to be provided and profits to be realized by the Sub-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 whether fee levels reflect these economies of scale for the benefit of Fund investors; and (5) if applicable, the benefits derived or to be derived by the Sub-adviser from the relationship with the Fund, such as soft dollar arrangements by which brokers provide research to the Fund or its Sub-adviser in return for allocation of brokerage. If a factor was not considered, an explanation of why it was irrelevant should be disclosed. C. Special Arrangements on Fee Disclosure in Form N-1A 1. Item 5(a)(1)(ii)(A) of Form N-1A requires prospectus disclosure of the aggregate fee paid to an adviser for the most recent fiscal year as a percentage of average net assets. Instruction 3 to Item 5(a)(1) provides that if a Fund has more than one investment adviser, the aggregate fee paid to all of the advisers, rather than each separate adviser, must be disclosed. Therefore, the fees paid to an individual Sub-adviser need not be disclosed in a Fund s prospectus Item 14(a)(3) of Form N-1A requires a Fund disclose in its SAI [t]he method of calculating the advisory fee payable by the Fund including: (i) The total dollar amounts that the Fund paid to the adviser (aggregated with amounts paid to affiliated advisers, if any), and any advisers who are not affiliated persons of the adviser, under the investment advisory contract for the last three fiscal years 27 See Registration Form Used by Open-End Management Investment Companies, 1940 Act Release No (Mar. 13, 1998) available at (adopting amendments to Form N-1A). In the release, the SEC noted that it is persuaded that information about sub-advisory fees is not necessary for a typical fund investor, but may be of interest to some investors. Therefore, Form N-1A, as amended, requires prospectus disclosure of the aggregate advisory fees paid by a fund and disclosure in the SAI of the amount of subadvisory fees paid by the fund. Id

17 In an arrangement where the Manager pays the subadvisory fees to the Sub-adviser out of its management fee, Item 14 does not require that such subadvisory fees be disclosed. D. Use of Sub-adviser Names in Fund Names 1. As noted above, some Funds use the name of the Sub-adviser managing its assets in its name. The SEC has suggested that use of a Sub-adviser s name in a Fund name could be confusing to investors. More specifically, the SEC has suggested that a fund name that includes the name of a subadviser might serve to invite investors to invest in the fund to obtain advisory services of the subadviser rather than the adviser, which is arguably inconsistent with the basis upon which we have granted relief under Multi-Manager Orders Funds normally disclose that the Manager monitors and evaluates Subadviser performance and that a Manager may hire or terminate a Subadviser based on its evaluation of the Sub-adviser. This is in addition to disclosure for all sub-advised Funds of the Board s duty to review these contracts and its ability to terminate any contract, without penalty, with not more than 60 days notice. The combination of such disclosures amplifies that a Sub-adviser for a Fund may be changed from time to time regardless of whether its name appears in the name of the Fund. Mr. Brown is a Partner in the Washington office of Kirkpatrick & Lockhart Nicholson Graham LLP, where his practice involves all aspects of corporate and federal securities laws. He serves as lead partner on significant investment company, investment adviser and broker-dealer representations in which he regularly provides counsel to sponsors of registered investment companies and to the independent directors of such companies on regulatory, compliance and operational matters. Mr. Brown speaks frequently at a number of investment company industry seminars, including those sponsored by the Investment Company Institute, Practicing Law Institute, Securities Industry Association Legal and Compliance Division, American Bar Association, and FBA/ICI Mutual Fund Conference. Prior to entering private practice, Mr. Brown served from 1974 to 1982 as Chief of the Office of Investment Company Act Study Group; Special Counsel in Office of Investment Company Regulation; and Attorney in Office of Chief Counsel, Division of Investment Management at the U.S. Securities and Exchange Commission. He holds a J.D. from New York University School of Law (1973) and a B.S. from the City College of New York (1970). 28 See Rule 15a-5 Release, supra note