Enhancing The Investment Advisory Contract Review Process For U.S. Sub-Advised Funds

In light of recent SEC enforcement and private class action litigation developments regarding sub-advised mutual fund fees, mutual fund boards and management companies should review and consider ways to enhance their investment advisory contract approval process pursuant to Section 15(c) of the Investment Company Act of 1940, as amended (the "Act"). This article will discuss a number of strategies that can enhance the Section 15(c) process.1

Both the SEC and private plaintiffs' bar have focused recently on sub-advised fund fees. The SEC brought an enforcement action last year against an investment adviser that hired a sub-adviser to help it manage a Malaysian sector fund.2 The SEC alleged that the adviser represented to the board that the sub-adviser was providing services to the fund and recommended that the board approve the sub-advisory contract, even though the sub-adviser provided no real services to the fund. The SEC's enforcement action alleged violations of Section 15(c) and other securities laws. At the same time, the plaintiffs' class action bar is pursuing a new theory of liability against sponsors of sub-advised funds, alleging that they receive a disproportionately large portion of the investment advisory fee while the sub-adviser purportedly does most of the work.3

Advisers should structure their Section 15(c) presentations to disprove the primary factual premise in the recent class action lawsuits against managers of sub-advised funds: that the investment adviser performs little or no services in connection with the fee that it receives. Investment advisers in fact perform a variety of functions in the course of overseeing sub-advisers, including: researching and selecting the sub-advisers; performing due diligence on the sub-advisers from an investment process, operational and compliance perspective; portfolio construction (that is, combining multiple sub-advisers, and allocating fund assets among them, in a manner designed to serve fund investment objectives); monitoring their ongoing performance; ensuring compliance with the investment objectives of the fund and consistency with the fund's disclosures; oversight of third-party service providers; and reporting to the fund board, to name a few.

If the investment advisory contract does not clearly delineate the responsibilities of the investment adviser, however, the adviser should consider ways it can clarify for the board and the record the work it performs pursuant to its advisory contract. One way would be for management to clearly specify (for example, in the Section 15(c) meeting board materials) the various services it actually performs for the funds, and differentiate these services from those performed by the sub-adviser. Another approach would be to

amend the investment advisory agreement to specify the responsibilities of the investment adviser. Before undertaking such an amendment, however, it would be necessary to determine whether the amendment would be material and require a shareholder vote under Section 15(a).

Enhancing the Contract Approval Process

Management and boards should consider ways that they can improve upon their process and address some of the concerns raised by the SEC and plaintiffs' bar about mutual fund fees in general and sub-advised fund fees in particular. The case law under Section 36(b) and SEC disclosure rules in this area provide a framework for considering how to improve the Section 15(c) process.

Care and Conscientiousness of the Board

In both Gartenberg4 and Jones v. Harris, the courts focused on the role of the board, the care and conscientiousness with which the directors approached the contract review process, and their independence.5 Courts and the SEC are most likely to defer to the business judgment of boards where the record demonstrates that a thorough review process took place, the board reviewed all of the information necessary to evaluate the investment advisory contract, and the board asked relevant questions and received meaningful responses...