Board Oversight of Sub-Advisers and What to Expect from the CCO Kevin M. Gleason Senior Vice President Voya Investment Management, LLC Chief Compliance Officer Voya Funds Philip S. Wellman Vice President & Chief Compliance Officer MML Investment Advisers, LLC Vice President, Associate General Counsel & Chief Compliance Officer Mutual Funds Massachusetts Mutual Life Insurance Company Frank Knox Vice President U.S. Investment Management, Corporate Compliance Office Chief Compliance Officer John Hancock Mutual Funds 1
Agenda 1) Legal Responsibilities of Fund Boards 2) Initial Board Approval and Ongoing Oversight 3) Due Diligence and Oversight Of Sub-Advisers 4) What Should Compliance Reviews Cover 5) How Are Compliance Reviews Conducted 6) Conflicts of Interest 7) Multi-Manager Structures 8) Current SEC Rule Proposals: Enhanced Reporting, Liquidity and Derivatives 9) Summary Of Select SEC Enforcement Actions 10) Conclusion 2
1. Legal Responsibilities of Fund Boards Section 15(c) of the Investment Company Act of 1940 ( ICA ) imposes on trustees a legal responsibility and duty to evaluate the performance of fund managers, the power to hire and fire them and the authority to set fund fees. While neither the ICA nor the rules thereunder set forth specific factors trustees must consider in approving an advisory agreement, over the years, the federal courts have developed a framework by which trustees should consider the terms of the advisory agreement. Much of this framework has developed as a result of private litigation and SEC enforcement related actions under Section 36(b) of the ICA which imposes upon investment advisers a fiduciary duty with respect to compensation received from a mutual fund. In particular, the framework for evaluating and approving investment advisory agreements and thus the hiring of an adviser has come to be known as the Gartenberg Standards. 3
Gartenberg Standards The primary criteria which trustees examine are: (i) the nature and quality of the adviser s services; (ii) adviser s and/or sub-adviser s cost of and profits realized in providing services; and (iii) economies of scale and fall-out benefits. These inquiries and the information obtained are typically acquired through questionnaires provided to the adviser and/or sub-adviser. The responses and documents produced are reviewed by independent counsel, independent trustees and certain internal stakeholders. The test for determining whether an investment adviser has breached its fiduciary duty has been stated as: essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arms length in light of all the surrounding circumstances... To be guilty of a violation of Section 36(b)... the adviser-manager must charge a fee that it 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. 4
2. Initial Board Approval and Ongoing Board Oversight New sub-advisers typically provide the following for Board review: o Form ADV Parts I and II o Corporate structure, list and description of affiliates o Bios of key personnel, including proposed portfolio managers of fund o Description of key operations and staffing levels o Financial information o Description of investment process and philosophy 5
Materials for Board Review Key compliance policies and procedures, including code of ethics, soft dollars, trade allocation, best execution, proxy voting, and business continuation. o Board must approve the Sub-Adviser s compliance program. o Board may rely on summaries provided by Fund s CCO. Summary of material regulatory matters. Summary of material legal proceedings. 6
Ongoing Board Oversight Annually o Rule 38a-1 report of the adequacy of the Sub-Adviser s compliance program. o Rule 17j-1 report of the Sub-Adviser s code of ethics administration. Quarterly o Compliance Reports of any violations of fund policies or 1940 Act provisions; corrective measures taken New policies and changes to policies requiring Board approval (e.g., Code of Ethics) Report and certification on Code of Ethics compliance o Brokerage (usually combined with adviser s reports) Commission and soft dollar reports Top ten brokers Brokerage trades with affiliates Periodically o On a rotating basis, sub-advisers will present to the board. 7
3. Due Diligence and Oversight Of Sub- Advisers The SEC rarely gives affirmative advice about what you should do, usually it focuses on what you should not. Sub-advisers are a rare exception. After the SEC issued the supervision case against Western Asset Management, the then Director of the Division of Enforcement Steven Cutler -- gave a speech outlining his expectations in December of 2001 to the ICI s Securities Law Developments Conference. Have sub-adviser s provide annual certifications of compliance with the substantive policies and procedures governing its responsibilities and with the federal securities laws. Periodically meet with the sub-adviser s compliance staff which could include conference calls as well as on-site inspections. 8
Effective Controls Require the sub-adviser to provide notice of exams; provide copies of annual reports; and implement procedures to followup on any troubling findings. Periodically reassess supervisory procedures in light of: o Changes in a fund's investment strategy or portfolio manager, o Significant changes in the sub-adviser's business, o Dramatic changes in market conditions, or o Any other event likely to have a significant impact on the sub-adviser's operations. 9
Sources of Duty The source of the legal obligation to perform adequate due diligence with regard to the use of sub-advisers by principal advisers stems primarily from three sources: A. Common Law: The United States Supreme Court in Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., stated that investment advisers owe fiduciary duties of care and loyalty to their advisory clients. Boards owe similar fiduciary duties of care and loyalty to shareholders. B. Statute: Section 206 of the Investment Advisers Act of 1940 has been interpreted to require an investment adviser to make an appropriate inspection and evaluation of sub-advisers (See also Section 203 and Rule 38a-1). C. Agreements and Disclosures: What, if any due diligence has the adviser committed to performing. What does the investment management agreement between the parties say? What does the prospectus or SAI state? 10
Due Diligence Oversight Process Risk Evaluation Process Due Diligence Questionnaire Document Request 206(4-7) Annual Reports Pre On-Site Review On-Site Visit Regular Interaction/Reports Industry News Review Compliance Certifications 11
4. What Should Compliance Reviews Cover? Compliance reviews of sub-advisers should cover a number of topics. It is important to understand the sub-advisers corporate structure including the compliance department, to whom the CCO reports, and what committees the CCO is a member. A subadviser s code of ethics provides an understanding of the compliance culture of the firm. Other areas of review include: o Compliance personnel and practices Biographies and experience of compliance personnel Reporting structure Committee membership Management engagement Monitoring systems and reporting Code of ethics: personal trading, outside business activities, gifts and entertainment, and political contributions 12
Compliance Reviews o Portfolio and trading compliance New account set up and guideline compliance PM-Trading desk communications Best execution Trade aggregation/allocation policies Trading systems and error reporting Leakage Soft dollar arrangements Participation in fund s commission recapture program Broker and counterparty review and approval process Participation in expert networks Controls with regard to material nonpublic information Use of derivatives 13
Compliance Reviews o Proxy voting o Valuation o E-mail review o Books and records o Risk and conflicts assessments o Legal and regulatory issues o SEC and FINRA audits and inquiries o Litigation o Business continuity, disaster recovery, and cybersecurity 14
5. How Are Compliance Reviews Conducted? In-person meeting at Sub-Adviser s offices with key personnel CCO and staff Legal staff Head trader Portfolio manager Operations personnel Business continuity head Review written responses to Sub-Adviser questionnaire Review annual reports, SSAE 16s, and limited scope attestations Review compliance certifications and exemption reports Prepare compliance inspection report 15
6. Conflicts of Interest Boards and CCOs must be aware of conflicts of interest in hiring sub-advisers and seek to understand how those conflicts are managed, disclosed, mitigated and resolved. One of the most significant conflicts know as side-by-side management -- describes how a sub-adviser manages other accounts in the same strategy: separate accounts, public funds, and private funds, has accounts in the same strategy that pay performance fees, or has accounts in the same strategy that can take short positions. A key issue here being how a sub-adviser allocates limited trading opportunities across all of its client accounts. Additionally, it will be important to understand the sub-adviser s trade rotation practices to make sure all client accounts are being treated fairly. Other conflicts of importance include whether and how sub-advisers engage in affiliated transactions such as cross trades (Rule 17a-7) or principal trades (Rule 10f-3). 16
7. Multi-Manager Structures Funds managed by two or more sub-advisers selected to complement each other. o Prospectus/1940 Act limits simplest approach: each subadviser manages its portion of the fund s assets as if the fund s limits applied to the portion: If the fund is limited to 15% illiquid investment, each subadviser should observe this limit for its sleeve of the fund; Giving one manager greater leeway (i.e., borrowing from another sub-adviser s allowable basket) requires greater vigilance and oversight by top-tier adviser; and Board should be notified of this arrangement and should receive periodic reports of its operations and any issues. o Establish standard protocols and procedures across subadvisers: affiliated transactions, industry classifications, board reporting, pricing and valuation, and portfolio trade processing. 17
8. Current SEC Rule Proposals Enhanced Reporting: development of new monthly portfolio reporting (Form N-PORT), a replacement form (Form N-CEN) for Form N-SAR, and additional disclosures in fund financial statements and shareholder reports Liquidity Risk Management: approve a written liquidity risk management program and any material changes to the program designate the fund s adviser or officers responsible for administering the program review annual reports on the effectiveness of the program Use of Derivatives: approve one of two alternative portfolio limitations on a fund s use of derivatives approve policies and procedures for managing risks associated with a fund s derivatives transactions 18
9. Summary of Select SEC Enforcement Actions There have been several SEC enforcement actions involving subadviser due diligence screening, management, and oversight. The cases identified below highlight some of the enforcement issues one can expect in this area: In the Matter of Western Asset Management Co. and Legg Mason Fund Adviser, Inc. (Sept. 28, 2001) In the Matter of Hennessee Group LLC and Charles J. Gradante (April 22, 2009) In the Matter of Morgan Stanley Investment, Inc. (Nov. 16, 2011) In the Matter of Northern Lights Compliance Services, LLC et al (May 2, 2013) In the Matter of Virtus Investment Advisers, Inc. (Nov. 16, 2015) 19
Western Asset Management Legg Mason ( LM ) hired Western Asset Management ( WAM ) as a sub-adviser for a fixed income fund for which LM was the adviser/sponsor. The portfolio manager responsible for managing the fixed income fund at WAM inflated the value of investments overstating the fund s NAV. WAM failed to supervise the portfolio manager, failed to oversee the portfolio manager s investment activities, and failed to follow its own procedures. LM failed to supervise the activities of the WAM and failed to respond to red flags regarding prices that were stale and assets that were troubled. LM and WAM settled an administrative action agreeing to pay fines of $50,000 each. 20
Hennessee Group LLC Hennessee Group is a hedge fund consultant and investment adviser; Charles Gradante, as its principal, made numerous representations concerning the quality and rigor of its due process procedures for vetting hedge funds. Approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 and August 2005 based on the Hennessee Group recommendations. Most of the money was lost through trading or misappropriated by Bayou s principals who defrauded their investors by fabricating Bayou s performance. Hennessee Group and Mr. Gradante failed to conduct the portfolio and trading analysis advertised to clients. When Bayou refused to produce its trading data, Hennessee did not investigate further but instead relied entirely on Bayou s uncorroborated representations. Hennessee Group and Mr. Gradante failed to verify the relationship of Bayou s independent auditor despite red flags and contradictory responses to inquiries concerning the identity of the auditor. Hennessee Group and Mr. Gradante were fined $814,000. 21
Morgan Stanley Investment Management MSIM contracted with a Malaysian sub-adviser to provide it with research reports. At the time the business relationship was created, MSIM was obligated to hire the sub-adviser under Malaysian law. The Malaysian sub-adviser provided MSIM with two monthly reports based on public information that MSIM neither specifically requested nor did it use. In the course of 15(c) contract reviews for sub-advisers, MSIM failed to tell the board of the true value of the Malaysian sub-adviser s services and claimed in periodic disclosures that sub-adviser provided it with advice, research, and assistance. The case demonstrated a failure by MSIM to provide appropriate oversight of sub-advisers. MSIM settled administrative proceeding agreeing to pay a fine of $3.3 million. 22
Northern Lights The SEC charged five trustees, the funds administrator, and the funds CCO service provider for violations of the Investment Company Act. Northern Lights and its affiliates operated a turnkey mutual fund platform compromised of seventy-one funds, most of which were managed by different advisers and sub-advisers. Those violations included: (1) misleading disclosures regarding the 15(c) process both in the funds financials and board minutes and (2) failure to adequately review and thus approve the compliance manuals of sub-advisers in contravention of the funds compliance procedures. The trustees settled the matter without an imposition of a monetary fine consenting to a cease-and-desist order. The administrator and the CCO service provider settled the matter agreeing to pay a penalty of $50,000. 23
Virtus Investment Advisers Virtus was charged with misleading mutual fund investors and others with advertisements containing false historical performance data. The SEC determined that Virtus overstated the performance track record of one of its sub-advisers. Virtus falsely stated in client presentations, marketing materials, SEC filings, and other communications that the sub-advised strategy had a performance history dating back to April 2001 and outperformed the S&P 500 Index for several years. Virtus failed to adequately examine and investigate the sub-adviser s claims regarding its historical performance. Virtus neither had nor did it request documentation or records supporting the sub-adviser s historical performance. Virtus accepted the sub-adviser s representations at face value and ignored red flags. Virtus agreed to settle this matter with the SEC for $16.5 million. 24
Enforcement Statistics 25
The following are some take ways: 10. Conclusion 1. Ensure that there is a robust 15(c) review process and that the appropriate stakeholders are included. 2. An in-depth due diligence review should be performed of any subadviser before hiring the firm. 3. There should be an appropriate oversight system to perform ongoing supervision of the sub-adviser. 4. Be alert to any red flags for possible problems, and make sure to respond as quickly as possible. 5. Thoroughly investigate, document and remediate errors, violations, breaches and other issues with sub-advisers. 6. Have an escalation process tailored to the business. 7. Be sure there are good lines of communication between the primary adviser and the sub-adviser. 8. Delegation of authority does not mean abdication of responsibility. 26