Board Oversight of Multi-Manager Funds and Subadvisers Presented by: Diana McCarthy and Joshua Deringer November 29, 2011
Changes in How Funds Use Subadvisers > Open architecture has increased use of subadvisers and led to increased use of multimanager structure. > The use of unaffiliated subadvisers has grown 80% during past decade. 1 Historically: One subadviser per fund As of 2009, 23% of assets of sub-advised funds used a multi-manager structure. 2 > Use of multiple subadvisers and multi-manager structure raises oversight issues for boards. 1 Independent Directors Council, Board Oversight of Subadvisers, Task Force Report, Jan. 2010. 2 Id. 2 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Multi-Manager Structure and Related Exemptive Order Conditions > Exemptive order permits unaffiliated subadvisers to be hired and terminated without shareholder approval as long as, among other things: The adviser develops an investment program (investment objective, strategies, restrictions) and supervises portfolio management and subadvisers, recommends subadvisers for board approval, monitors and evaluates performance, allocates and reallocates assets to subadvisers and oversee subadvisers compliance programs; Bottom line: The Adviser has ultimate responsibility to oversee the subadvisers and to recommend their hiring, termination and replacement. A majority of directors on the board are independent, including independent of all subadvisers, under 2(a)(19) of the 1940 Act; Independent directors retain independent counsel; and The adviser provides at least quarterly a profitability report to the board reflecting the impact of hiring and/or terminating subadvisers. SEC staff concerned with churning. Special rules apply for affiliated subadvisers. > SEC has proposed rules that would codify exemptive relief; final rules not yet adopted. 3 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Independence > Maintaining director independence of the subadvisers can be difficult when many subadvisers are utilized. > Board must monitor its independence from each subadviser and its affiliates; there are significant challenges in maintaining independence of numerous subadvisers. > Best practices for fulfilling this obligation: When retaining a new subadviser, consider whether it raises any director independence issues that need to be resolved prior to approving the investment advisory contract with that particular subadviser. The principal adviser/board counsel should obtain and update the list of subadvisers and affiliates, monitor changes of control that occur with subadvisers and their affiliates, as necessary. 4 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Independence > Best practices (continued): Directors should complete independence questionnaires at least annually that include a list of subadvisers and their affiliates. Questionnaires may be required more frequently if subadvisers are engaged or terminated or upon a change of control. Directors should converse regularly with their financial advisers to monitor their holdings and inform them of newly hired/terminated subadvisers and changes of control of subadvisers. New directors should carefully review their holdings and relationships for independence issues with respect to subadvisers. Where directors on a board are broadly invested, a fund complex might decide to have a different board (or a subset of its existing board) for its multi-manager funds than other funds to facilitate easier monitoring of independence issues. 5 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Initial retention of a subadviser: due diligence and the 15(c) process Due diligence on Subadviser: Adviser should perform due diligence on prospective subadvisers and explain to board both its process for performing due diligence and the results of the due diligence performed. Due diligence can be performed in a number of ways: on site interviews telephonic The board should review and evaluate the adviser s overall due diligence processes and results. 6 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Due diligence (continued): With respect to the due diligence process, the adviser should inform the board: who within the adviser s organization is responsible for the due diligence process, what relevant experience they have and what resources they had to perform the due diligence; what the due diligence process included (e.g., questionnaires, on site interviews, review of third party testing, etc.); and whether and to what extent the fund s CCO reviewed the subadviser s compliance program. 7 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Due diligence (continued): With respect to the due diligence results, the adviser should address for the board such topics as: the subadviser s investment management style and strategy, including its compatibility with the fund s investment program and any other subadvisers; the subadviser s track record managing similar assets in the same style; the risks of the subadviser s investment strategy; the subadviser s research and trading desk capabilities; the subadviser s compensation structure and ability to attract and retain qualified personnel; the subadviser s proposed fee structure compared to those of other subadvisers the adviser considered in its due diligence process; 8 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Due diligence (continued): the reputation of the subadviser in the industry; the subadviser s compliance record and culture, and any pending or threatened litigation or administrative proceedings; any potential real or perceived conflicts of interest between the adviser and subadviser; the subadviser s internal controls with respect to conflicts of interest, such as trade allocation policies; the subadviser s compatibility with the other subadvisers; whether the subadviser is expected to undergo any ownership changes that might change the parties to the sub-advisory agreement; the process that will be followed for communications and reports to the board from or concerning the new subadviser; 9 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Due diligence (continued): extent of subadviser s participation in valuation, proxy voting and similar areas; and whether the subadviser will be permitted to conduct cross transactions, use affiliated brokerage, participate in affiliated underwritings, soft dollar usage and best execution. 10 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > Initial retention of a subadviser: due diligence and the 15(c) process 15(c) process: The board must perform the 15(c) process in determining whether to initially approve, and annually renew, sub-advisory agreements. 15(c) request letters may be delivered to a subadviser by the principal adviser on behalf of the board or by fund or board counsel. In deciding whether to approve a sub-advisory agreement, a board may weigh factors differently depending on the role of a subadviser under a particular sub-advisory agreement. 11 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Initial Retention of Subadviser > 15(c) process (continued): Generally, the Gartenberg factors apply to the process with some modification: Profitability and cost may be less of an issue as adviser often has incentive to negotiation lowest sub-advisory fees; Consideration of fee split between adviser/subadviser; Conflicts of interest with adviser may need evaluation; Past performance may be evaluated in light of subadviser s compatibility with existing subadvisers; If subadviser is a small shop, 1940 Act experience and compliance and operational controls may need to be evaluated closely and monitored on an ongoing basis. 12 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Compliance and Conflicts > Portfolio compliance (i.e. prospectus and 1940 Act rules) When multiple subadvisers are used to manage the assets of one portfolio, the subadvisers investment activities must be coordinated to ensure compliance with the portfolio s prospectus and 1940 Act rules. Under a multi-manager structure, the adviser must monitor each subadviser s compliance with a portfolio s investment objective, policies and restrictions. Boards should ensure that the principal adviser has adequate resources and procedures to monitor subadviser compliance effectively. If the fund has a multi-manager order, such procedures may be required. 13 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Compliance and Conflicts > Soft dollars and best execution > Classic Conflicts Boards must make quarterly determinations that certain transactions involving the fund and the subadvisers or their affiliates, including other funds or accounts they sub-advise, were effected in compliance with Rules 10f-3, 17a-7 and 17e-1. Generally, the principal adviser will monitor affiliated transactions by subadvisers and provide the board with reports confirming that the transactions have met regulatory requirements and applicable fund procedures. 14 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Compliance and Conflicts > Classic Conflicts (continued) Questions a board might consider with respect to affiliated transactions: Do the principal adviser and the subadviser have processes in place to ensure compliance with the fund s policies and procedures relating to affiliated transactions? Has the subadviser provided the fund, and has the adviser provided the subadviser, with a current list of all affiliates so that affiliated transactions may be properly monitored? Rule 17a-10 provides some relief from 17(a) transactions for sub-advised funds. Requires certain provisions in subadvisory agreement. 15 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Compliance and Conflicts > Proxy Voting Many complexes find it easier to administer a more centralized proxy voting system where either the adviser, or in a few cases, the board votes all proxies. If subadviser has discretion to vote all proxies according to its policies, board must adopt these policies which could be problematic with multiple subadvisers in the same complex. If board delegates votes to the subadviser, board will need to exercise oversight, with adviser s assistance, to ensure compatibility with fund policies or to understand the reasons for any differences. > Derivatives Usage Board should understand any derivatives usage by subadvisers as well as their operational abilities to engage in such transactions, including risk management and compliance capabilities. Fund CCO should monitor derivatives usage and report to Board at least quarterly. 16 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Compliance and Conflicts > Codes of Ethics Board must approve each subadviser s code of ethics and any material changes to a code within 6 months of such change. Subadvisers must provide to the board, at least annually, a report of any material violations of the code and sanctions imposed as a result of such violations and must certify that processes are in place to prevent future violations. Board may rely on CCO s evaluation of subadvisers code and whether the code and the subadviser s processes meet applicable legal requirements. 17 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Performance & Board Reporting > Different models of board communication with subadvisers: Some boards meet with representatives of a subadviser at the outset of the relationship and on an annual, or other periodic basis, thereafter. Some boards even visit the offices of the subadviser. Other boards communicate with the subadviser through the principal adviser and/or the fund s CCO and rely on one or all of these entities to visit the subadviser periodically and report findings to the board or a board committee. The model a board uses may depend on how many subadvisers it oversees and the principal adviser s model for overseeing and choosing subadvisers. 18 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Performance & Board Reporting > In evaluating subadviser performance The board may rely on the principal adviser s analysis of the subadviser s performance, which the adviser will generally present to the board quarterly. The board should ask questions about performance data, including, for instance: Can the subadviser and adviser explain particularly poor performance and particularly good performance? Does the adviser appear to understand the subadviser s performance issues? Are benchmarks and peer groupings used to evaluate subadviser performance appropriate? Does action need to be taken in light of consistent poor performance? If a subadviser is consistently outperforming its benchmark, are the sources of the outperformance and the level of risk taken to achieve it understood and appropriate? 19 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Board Oversight Over Shareholder Disclosure > Exemptive order requires certain disclosure in the prospectus regarding the multi-manager structure. Aggregate subadviser fee disclosure > Fund must furnish to shareholders an SEC filing containing information with respect to new subadvisers within 90 days of hiring. > Changes in subadvisers need to be disclosed in the fund s prospectus promptly. > Derivatives usage appropriately disclosed. 20 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Conclusion > A board s legal obligations under the 1940 Act are generally the same with respect to subadvisers as for principal advisers; however, the way a board carries out its oversight role over subadvisers will vary depending on the nature and structure of the relationship. > There is no single correct approach. 21 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011
Diana E. McCarthy Partner Drinker Biddle & Reath LLP Philadelphia (215) 988-1146 Diana.McCarthy@dbr.com Joshua B. Deringer Partner Drinker Biddle & Reath LLP Philadelphia (215) 988-2959 Joshua.Deringer@dbr.com 2011 Drinker Biddle & Reath LLP All rights reserved. A Delaware limited liability partnership 22 Board Oversight of Multi-Manager Funds and Subadvisers November 29, 2011