4.05 Federal Obligations Federal law imposes the same duties and obligations on both directors and trustees. 1

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1 4-17 BOARD OBLIGATIONS 4.05[1] 4.05 Federal Obligations Federal law imposes the same duties and obligations on both directors and trustees. 1 [1] Federal Obligations of Independent Directors or Trustees The directors of a mutual fund must approve five principal categories of things, by federal statute or regulation: (1) all contracts, including fees, with investment advisers 2 (2) all contracts with distributors 3 (3) all transactions with affiliates 4 (4) the selection of an independent auditor 5 (5) registration and related SEC filings 6 In addition, there are obligations imposed by the SEC in order for a mutual fund to avail itself of certain exemptive rules. 7 An exemptive order from the SEC, effectively allows for the exemption of persons, securities or transactions from the ICA (or rules or regulations issued thereunder) as necessary and appropriate in the public interest. 8 Such an order may be issued by rules and regulations, or by order upon application, and may be conditional or unconditional. 9 This is perhaps one of the most powerful tools at the disposal of the SEC. It is the regulatory analog to prosecutorial discretion. [a] Investment Advisory and Sub-Advisory Agreements An investment adviser, including a sub-adviser, to a mutual fund can only serve pursuant to a written contract, which has been approved initially by the board of directors including a majority of 1 The ICA generally uses the term director. Section 2(a)(12) of the ICA provides that the term means any director of a corporation or any person performing similar functions with respect to any organization, whether incorporated or unincorporated, including any natural person who is a member of the board of trustees of a management company created as a common-law trust. See 15 USC 80a-2(a)(12). 2 See 15 U.S.C. 80a-15(c). 3 4 See 15 U.S.C. 80a See 15 U.S.C (a). 6 See 15 U.S.C. 77f(a). 7 See 15 U.S.C. 80a-6c. 8 9

2 4.05[1] MUTUAL FUNDS 4-18 the disinterested directors and the shareholders. 10 Once approved, this contract may continue in effect for periods up to two years provided its continuance is specifically approved at least annually by the board of directors, including a majority of the disinterested directors. 11 The board s approval must occur at an in-person meeting called for such a purpose. 12 This makes it imperative, in order to be in technical compliance with the law, that a meeting notice sent to the board contain wording or an agenda item to the effect that the meeting will consider the approval of an advisory or sub-advisory contract. [i] Factors that Must be Considered by a Board for Advisory Contracts The contract for each fund in a fund complex must be considered separately. 13 Fortunately, boards have some guidance as to what factors must be considered in their evaluation and approval of an advisory or sub-advisory contract. This guidance exists in the ICA, SEC Rules and court decisions. Under Section 15(c) of the ICA, the board must request and evaluate... such information as may be reasonably necessary to evaluate the terms of any contract This review by a board has come to be known as a 15(c) review. This statutory section also makes it unlawful for a board to take into account certain benefits received from the sale of securities as a result of the assignment of an advisory contract. In other words, when an advisory contract has been assigned, special care must be taken not to consider certain benefits when approving such contract. 15 There is little beyond the reasonably necessary guidance contained in the 40 Act, perhaps because Section 15 does not specifically grant rule making authority to the SEC. 16 Boards were intended to be given broad discretion in determining what factors to consider when approving an advisory or sub-advisory contract. However, there 10 See 15 U.S.C. 80a-15(c) See American Bar Association, Committee on Federal Regulation of Securities, Fund Director s Guidebook, p. 31. (3d ed. 2006). 14 There is also a corollary duty imposed by the ICA Section 15(c) for an adviser to furnish such information. See 15 U.S.C. 80a-15(c). 15 These benefits are described fully, though inartfully, in paragraph (1), (3), or (4) of subsection (f) of Section 15 of the ICA. See 15 U.S.C. 80a-15(f)(1)-(4). 16 See 15 U.S.C. 80a-15.

3 4-19 BOARD OBLIGATIONS 4.05[1] is a good roadmap in the instructions to the SEC s mutual fund registration statement. 17 This form requires a fund to disclose its board s consideration of seven factors during the advisory contract approval process and the board s conclusions regarding those factors. Boards that fail to consider these seven factors do so at their own peril. These factors are: The nature, extent and quality of services to be provided by the investment adviser and sub-advisers. In order to make this evaluation boards typically request: (i) a comprehensive description of the investment advisory and other services provided to the mutual funds, both directly and indirectly by the advisers, sub-advisers and their affiliates; (ii) a list of all personnel furnishing advisory services along with description of their duties and qualifications; and, (iii) current financial statements for the adviser and sub-adviser. This is a challenging area of inquiry because advisers are typically advisers to multiple funds and/or operate within a holding company. A director is thus confronted with one of two issues: a) an allocation of costs and profits; and b) no fund-specific or entity-specific financial statements. As anyone who has taken a class in cost accounting can attest to, allocations can be the difference between profit or loss. Thus, directors should carefully consider the method of allocating expenses among various investment product lines and business units. A method of allocating expenses should have a reasonable, objective basis and be applied consistently both during the current year and from year to year. Where an adviser indicates that there are no financial statements prepared for the entity that employs the adviser and instead provides financial statements for a holding company, directors must decide whether the financial statements of the holding company can serve as a proxy for the entity providing the service and whether the holding company is expected to support such entity if it experiences financial distress. 2. The investment performance of the mutual fund. Performance is contextual and should be made in view of a mutual fund s 17 SEC Form N1-A, Item 27. See 17 C.F.R A. 18

4 4.05[1] MUTUAL FUNDS 4-20 stated investment objective and policies; the performance of appropriate, recognized indices and the performance of comparable investment companies. Consideration of similarly managed funds or investment strategies is sufficient where an adviser is being proposed to manage a fund. 3. The cost of services to be provided and the profits to be realized by the investment adviser, sub-advisers and their affiliates from their relationship with the investment company. The profitability of the adviser is properly analyzed as a percentage of revenues rather than as a return on assets or invested capital. 19 Courts have generally not attempted to contain the profitability of an adviser. For example, pre-tax profit margins that ranged from 85% to 90% over a three-year period have been upheld. 20 Profitability is also contextual with performance. Superior performance may operate to justify a relatively high fee, which in turn increases profitability The possible economies of scale that would be realized due to mutual fund growth. This factor is closely related to and best considered with the factor below. 5. Whether fee levels reflect such economies of scale for the benefit of investors. Directors should evaluate whether the fees contain breakpoints (i.e., the level of assets at which discounted fees are available) and whether these breakpoints are appropriate. A comparison of fee structures for similar funds is appropriate. 6. Whether and how the board relied on comparisons of services to be rendered to and fees to be paid by the mutual fund with the services provided by and the fees paid to other investment advisers 19 See Meyer v. Oppenheimer Management Corp., 715 F. Supp. 574, 576 (S.D.N.Y. 1989). 20 See Meyer v. Oppenheimer Management Corp., 707 F. Supp 1394, 1405 (S.D.N.Y. 1988), aff d, 895 F.2d 861 (2d Cir.1990). See also: Schuyt v. T. Rowe Price Prime Reserve Fund, Inc., 663 F. Supp. 962, 989 (S.D.N.Y.), aff d, 835 F.2d 45 (2d Cir. 1987), cert. denied, 485 U.S (1988); Krinsk v. Fund Asset Management, Inc., 715 F. Supp. 472, 502 (S.D.N.Y. 1988), aff d, 875 F.2d 404 (2d Cir.), cert. denied, 493 U.S. 919 (1989); and Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1250 (S.D.N.Y. 1990), aff d, 928 F.2d 590 (2d Cir.), cert. denied, 502 U.S. 818 (1991). 21 See Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1250 (S.D.N.Y. 1990), aff d, 928 F.2d 590 (2d Cir.), cert. denied, 502 U.S. 818 (1991).

5 4-21 BOARD OBLIGATIONS 4.05[1] and sub-advisers or the services provided to and the fees paid by other clients of the mutual fund s investment adviser and sub-adviser. 22 It is particularly important for directors to compare products that are truly comparable. For example, accounts of investors in annuity contracts are generally thought to be more stable than those of investors in a vehicle that has no tax penalties associated with withdrawals and thus, may require less effort from the adviser. 7. Any benefits derived by the investment adviser from its relationship to the mutual fund. These are typically known as fallout benefits. These may include reputational value, soft dollar arrangements where broker research is provided in return for the allocation of trades, and certain tax benefits enjoyed by annuity funds. According to the SEC this list is not intended to be exclusive, thus industry best practices have a role in what a board should consider when approving an advisory contract. 23 Significantly, the SEC does not allow a listing of conclusory statements to constitute sufficient disclosure. A fund s disclosure must relate each factor to the specific circumstances of the fund and the advisory contract and state how the board evaluated each factor. Moreover, a fund must disclose each factor that was not relevant to the board s evaluation of an investment advisory contract and explain why it was not relevant. 24 Not only must these factors and indeed all factors considered by directors be disclosed in a mutual fund s annual and semi-annual reports, but they must also be disclosed in certain information statements and proxy statements. [ii] Factors that Must be Considered by a Board for Sub-Advisory Contracts Significantly, there is no distinction in the ICA between a principal advisor and a sub-advisor. 25 Note that sub-advisory contracts must 22 See, for example, Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp (S.D.N.Y. 1983), aff d, 740 F.2d 190 (2d Cir. 1984), suggests that fees charged by other advisers should be merely one factor directors consider in evaluating the fairness of an adviser s fee and noted that management fees are not really a competitive factor in an investor s choice of investment companies because their impact on individual shareholders is slight. 23 SEC Form N1-A, Item 27. See 17 C.F.R A See 15 U.S.C. 80a-2(a)(20).

6 4.05[1] MUTUAL FUNDS 4-22 also be approved by a majority of independent directors. 26 The level of review for a sub-advisory contract with a sub-adviser that is affiliated with the mutual fund s adviser is the same because the arm slength element is missing from the negotiation. However, in the case on an unaffiliated sub-adviser, different weight may be in order for each factor because the fee is paid by the adviser and, absent collusion, one may assume that a contract is negotiated at arm s length. Nevertheless, a board should inquire and become comfortable with the amount of investment management and other responsibilities that are being delegated by the advisor to the sub-advisor and whether the sub-advisor is able to perform the delegated duties. 27 [iii] The Advisory Fee The most important element of an advisory contract is the fee. Not surprisingly advisory fees generate the largest number of disputes. The U.S. Supreme Court has noted, a measure of deference to a board s judgment may be appropriate in some instances... [however,] the appropriate measure of deference varies depending on the circumstances. 28 While there is no federal statutory standard for what constitutes a reasonable advisory fee, there is a federal statutory remedy for excessive compensation paid under an advisory or sub-advisory contract that results in a breach of fiduciary duty to a fund by its adviser or sub-adviser. 29 This is a check on compensation that is independent of the requirement that adviser contracts be approved by the mutual funds directors. 30 This remedy allows the SEC or shareholders to file suit against advisers and sub-advisers: not against directors. 31 Under the ICA an investment adviser to a mutual fund shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services. 32 This has not, however, stopped plaintiffs from alleging misstatements or omissions in the proxy materials describing an advisory agreement. The ICA provides that in any action against an investment adviser dealing with excessive fees approval by the board of directors See 15 U.S.C. 80a-15(c). 27 See Board Oversight of Subadvisers, Independent Directors Council, Task Force Report, (Jan. 2010). 28 See Jones v. Harris Associates L.P., 559 U.S., 130 S.Ct (2010). 29 See 15 U.S.C. 80a-35(b). 30 See Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 541, 104 S.Ct. 831, 78 L.Ed.2d 645 (1984) See 15 U.S.C. 80a-35(b).

7 4-23 BOARD OBLIGATIONS 4.05[1] of such compensation or payments... shall be given such consideration by the court as is deemed appropriate under all the circumstances. 33 Thus, a board is effectively required to evaluate the compensation of an adviser and sub-adviser because of the potential for litigation. 34 The standard for an appropriate fee that has been consistently articulated by the courts since 1983 is that a fee schedule should represent a charge within the range of what would have been negotiated at arm s length in light of all of the surrounding circumstances. 35 To face liability, a fee must be 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. 36 Furthermore, the burden of proof is on the party claiming breach. 37 Boards should compare advisory fees charged by the investment advisor to other funds, and to the extent appropriate, to institutional clients. However, there may be significant differences in the economies of scale available depending on the size of the fund. Additionally, other factors, such as greater frequency of shareholder redemptions or more restrictive regulatory requirements, may increase the costs to the investment adviser of administering a fund. The Supreme Court has noted that the ICA does not necessarily ensure fee parity between mutual funds and institutional clients. 38 [b] Distribution Agreements A written agreement is required between a mutual fund and its principal underwriter, which must be initially approved by the board See, e.g.: Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp (S.D.N.Y. 1983), aff d, 740 F.2d 190 (2d Cir. 1984); Schuyt v. Rowe Price Prime Reserve Fund, Inc., 663 F. Supp. 962 (S.D.N.Y.), aff d, 835 F.2d 45 (2d Cir. 1987), cert. denied, 485 U.S (1988); Krinsk v. Fund Asset Management, Inc., 715 F. Supp. 472 (S.D.N.Y. 1988), aff d, 875 F.2d 404 (2d Cir.), cert. denied, 493 U.S. 919 (1989); Meyer v. Oppenheimer Management Corp., 895 F.2d 861 (2d Cir. 1990); Kalish v. Franklin Advisers, Inc., 742 F. Supp (S.D.N.Y. 1990), aff d, 928 F.2d 590 (2d Cir.), cert. denied, 502 U.S. 818 (1991); Wexler v. Equitable Capital Management Corporation, 1994 WL 48807, Fed. Sec. L. Rep. (CCH) 98,118 (S.D.N.Y. Feb. 16, 1994). 36 See Jones v. Harris Associates L.P., 559 U.S., 130 S.Ct (2010). See also, Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F. Supp (S.D.N.Y. 1983), aff d, 740 F.2d 190 (2d Cir. 1984) See Jones v. Harris Associates L.P., 559 U.S., 130 S.Ct. 1418, 176 L.Ed.2d 265 (2010).

8 4.05[1] MUTUAL FUNDS 4-24 of directors (including a majority of the independent directors). 39 In similar fashion to an advisory agreement, this agreement may continue in effect for a period of more than two years provided such continuance is specifically approved at least annually by the board of directors (including a majority of the independent directors). The approval must occur in person at a meeting called for the purpose of voting on such matter. The standard for such review has not been elaborated in case law but it is safe to say that reasonable business judgment should be exercised in such review. Each review must be mutual fund specific and a decision that is in the best interests of each mutual fund should be reached. One federal district court has rejected the contention that advisory fees and distribution fees and their profitability should be considered in the aggregate. 40 [c] Rule 12b-1 Distribution Plans A Rule 12b-1 plan is named after Rule 12b-1 promulgated by the SEC under the ICA. 41 It is a plan where a distribution fee is paid by the investor as an on-going expense and not front-loaded as a brokerage or similar fee. There are three principal requirements for directors when approving or continuing a Rule 12b-1 plan: (i) the directors must conclude, in the exercise of reasonable business judgment and in light of their fiduciary duties under state law and the ICA, 42 that there is a reasonable likelihood that the plan will benefit the mutual fund and its shareholders; 43 (ii) the directors have a duty to request and evaluate such information as may reasonably be necessary to reach an informed determination and give appropriate weight to all pertinent factors; 44 and (iii) minutes describing the factors considered and the basis for the decision to use mutual fund assets for distribution must be made and preserved. 45 Once a 12b-1 plan is approved, directors must review its expenditures quarterly. 46 Additionally, when Rule 12b-1 was first proposed by the SEC in 1980, the Rule, including the accompanying release, enumerated fac- 39 See 15 U.S.C. 80a-15(c). 40 See Meyer v. Oppenheimer Management Corp., 715 F. Supp. 574, 576 (S.D.N.Y. 1989). 41 See 17 C.F.R b See 15 U.S.C. 80a-36(a)-(b). 43 See 17 C.F.R b-1(e). 44 See 17 C.F.R b-1(d) See 17 C.F.R b-1(b)(3)(ii).

9 4-25 BOARD OBLIGATIONS 4.05[1] tors that a mutual fund board would have to consider in approving a Rule 12b-1 plan. 47 The SEC proposed the factors in order to ensure an orderly process of decisionmaking by directors. The factors cover broad categories rather than technical points. When the SEC released the final 12b-1 Rule it deleted the list of factors from the Rule believing the list might unduly restrict director s decisionmaking by creating a mechanical checklist. However, the SEC did note that the factors it originally enumerated would normally be relevant considerations. 48 These factors are: 49 (1) the need for independent counsel or experts to assist the directors in reaching a determination; (2) the nature of the problems or circumstances which purportedly make implementation or continuation of such a plan necessary or appropriate; (3) the causes of such problems or circumstances; (4) the way in which the plan would address these problems or circumstances and how it would be expected to resolve or alleviate them, including the nature and approximate amount of the expenditures; the relationship of such expenditures to the overall cost structure of the fund, the nature of the anticipated benefits, and the time it would take for those benefits to be achieved; (5) the merits of possible alternative plans; (6) the interrelationship between the plan and the activities of any other person who finances or has financed distribution of the fund s shares, including whether any payments by the fund to such other person are made in such a manner as to constitute the indirect financing of distribution by the fund; (7) the possible benefits of the plan to any other person relative to those expected to inure to the fund; 47 See SEC Inv. Co. Act Rel. No. IC (Sept. 7, 1979). See also, Mutual Fund Director s Forum, Best Practices and Practical Guidance for Directors Under Rule 12b-1, (May, 2007), available at resource/practical_guidance_for_directors_under_rule_12b-1/ (last visited on May 19, 2010) has called the standard of review for the implementation of 12b-1 plans announced by the SEC in 1980 largely irrelevant. This is based on the Report s view that that when adopted by the SEC, 12b-1 plans were meant to be short lived and largely limited to situations where a fund was facing net redemptions. p See Inv. Co. Act Rels. Nos. IC (Sept. 7, 1979) and IC (Oct. 28, 1980). 49 See Bearing of Distribution Expenses by Mutual Funds, Inv. Co. Act Rel. No. IC (Oct. 28, 1980).

10 4.05[2] MUTUAL FUNDS 4-26 (8) the effect of the plan on existing shareholders; and (9) in the case or plan renewals, whether the plan has in fact produced the anticipated benefits for the funds and its shareholders. [2] Contractual Agreements With Affiliated Persons Contractual agreements with affiliated persons for non-advisory services are generally entered into and continued according to the same procedural requirements applicable to investment advisory agreements under the ICA. The SEC has indicated that initial approval and continuation of such agreements should be based upon findings by a majority of the independent directors of the mutual fund, made in the course of a review such as would have been made with respect to an investment advisory agreement, that: (1) the agreement for non-advisory services is in the best interest of the mutual fund and its shareholders; (2) the services to be performed pursuant to the agreement are services required for the operation of the mutual fund; (3) the affiliated person can provide services the nature and quality of which are at least equal to those provided by others offering the same or similar services; and, (4) the fees for such services are fair and reasonable in light of the usual and customary charges made by others for services of the same nature and quality.