It might sound scary to independent directors of mutual funds, but the ordinary operation of funds is rife with conflicts of interest between the funds (and their shareholders) on the one hand and the funds’ investment adviser on the other. You might say that a conflict is inherent in the very structure of a fund since the adviser typically sponsors the fund to sell its investment management services and charges a fee based on the fund’s asset size. The conflicts presented in the fund arena, however, are not dissimilar from those in any adviser/client relationship. The contexts in which they arise can be different, however, and as fund boards are presented with myriad decisions about fund mergers, new distribution models, asset manager acquisitions, and much more, the fact that advisers may be conflicted in making recommendations should be borne in mind.
The starting point of any discussion of conflicts of interest is a recognition that the adviser to a fund owes a fiduciary duty to that fund. This fiduciary duty includes a responsibility to identify conflicts, mitigate those conflicts, and disclose those conflicts to the board of the funds. In the first instance, then, the burden is on a fund adviser to fully inform the board of any conflicts and efforts to eliminate or mitigate them. Said differently, the board’s duty is not to act as a sleuth detecting hidden conflicts. Nevertheless, sensitivity to actual and potential conflicts is important in fulfilling board members’ duty of care.
Independent Trustees: A Check on Conflicts
An independent director once told me that in his view, there are no situations he could think of where the interests of the adviser and fund shareholders are aligned. As he saw it, in every interaction and transaction relating to a fund, the adviser’s economic self-interest creates an actual or potential conflict. I thought then—and I still think—that this is an extreme view. Having said that, conflicts are prevalent and inherent in the adviser’s relationship with funds. Perhaps the two areas where this is clearest are: (1) the initial approval and annual consideration of a fund’s investment advisory agreement and (2) the initial and ongoing approval of fund distribution arrangements. In the first, the adviser sits “across the table” from the funds as it negotiates its fee. The second involves a decision as to whether an adviser’s or the funds’ assets are used to pay intermediaries whose clients/customers invest in the fund and how those costs are shared. In these two situations, the independent directors have a clear statutory role, specifically because of the conflicts presented.
Other situations raising potential conflicts between an adviser and its fund clients abound, including valuation, resolution of trade errors, side-by-side management of hedge funds and registered funds, allocation of investment opportunities, proxy voting, and use of soft dollars, to name a few. Funds’ Rule 38a-1 compliance programs and an adviser’s Rule 206(4)-7 compliance program can be expected to cover these types of conflicts, and the annual chief compliance officer report to the fund board mandated by Rule 38a-1 would address the efficacy of the policies and procedures addressing these (and other) conflicts.
There are yet other situations where the involvement of the independent directors is mandated by SEC rule in recognition of the conflict presented. Examples are Rule 17e-1 (relating to use of an affiliated broker), Rule 17a-7 (relating to cross-trades between a registered fund and other adviser clients), and Rule 10f-3 (relating to use of an affiliated underwriter). Here, quarterly oversight by independent directors is mandated given the potential for an adviser to prefer one client over another or to generate compensation for an affiliate at the expense of a fund client. Oversight by independent directors as an independent check in situations presenting a conflict is often a condition to granting an SEC order for exemptive relief as well. An example is the exemption to permit interfund lending.
Potential Conflict Scenarios
You might say that a requirement for independent director approval or oversight is a tip-off that the situation is one where the adviser is wearing two hats, where the economic interests of the adviser and the funds diverge, or otherwise where a conflict of interest is presented. Nevertheless, there are frequent situations that do not have a mandatory role for the independent trustees but where an adviser could be conflicted in making its recommendation to the board. Three of these, which arise more and more as the fund landscape changes, are: repurposing funds, merging funds, and changing service providers.
- Repurposing: Simply put, a fund is “repurposed” where its strategy or investment policies are changed. Typically this occurs when a fund has not been able to reach an economic size and rather than liquidate the fund, the adviser recommends that the board approve a restructuring of the fund in a way designed to be more attractive to investors. Depending on the nature of the changes, shareholder approval of the repurposing may not be required.
Repurposing allows the assets on which the adviser’s fee is based to be retained and may allow the adviser to launch a new strategy without the need to provide seed capital. If the failing fund had been liquidated, these potential benefits to the adviser would be forfeited. Thus, the adviser is conflicted in recommending a repurposing to the board.
- Merging: In addition to repurposing, one alternative for addressing an underperforming or uneconomic fund is to merge it into another fund. The acquiring fund may be similar to the target fund in terms of strategies and policies or it may markedly differ. For example, an adviser can recommend the merger of two international equity funds in a complex to create a single, larger fund, or it might recommend the merger of a high-yield fund into an investment-grade bond fund. In the latter case, the investor’s risk/return potential may be radically altered. If the requirements of Rule 17a-8 are met, shareholders in the high-yield fund will not vote on the merger even though it results in a major change to the investment they had made when they invested in a high-yield fund.
Like repurposing and in contrast to liquidating the underperforming or uneconomic fund, a merger enables an adviser to retain the assets in the target fund. The adviser could benefit from avoiding expense reimbursements or waivers for a small target fund. The adviser also could benefit if it could reduce the fee waivers or expense reimbursements on the combined fund resulting from its increased size. If the acquiring fund has a third-party sub-adviser, the increased asset size could reduce a payment obligation of the adviser to the sub-adviser under a fund arrangement. If revenue-sharing payments by an adviser are based on a fund’s assets, the merger may enable the adviser to avoid a minimum payment for the target fund and/or take advantage of a volume discount for the combined fund. Because of these or other economic benefits inuring to the adviser from the merger, the adviser’s recommendation of the merger to the board raises a conflict of interest concern.
- Changing Providers: From time to time, an adviser may recommend to a fund board a change in a service provider to a fund (e.g., administrator, securities lending agent, custodian). The proposed provider may be an affiliate of the adviser, in which case the potential conflict is apparent. The affiliate may not be the best person for the job, and the adviser’s recommendation could be influenced by its desire to generate revenues for its firm. Conflicts also can exist where a proposed provider is not affiliated with the adviser. The provider could be a current or prospective client of the adviser that the adviser desires to solidify or generate a better financial relationship with. The provider and the adviser could tie the new service provider role to the adviser’s other business—e.g., by requiring the new provider to reduce fees or provide improved contract terms in adviser-managed hedge funds or other products or proprietary accounts of the adviser. If these were part of an understanding between the adviser and the new provider, the adviser’s recommendation could be influenced by its economic self-interest.
To restate the obvious, conflicts of interest are not new in the investment company context. And boards dealing with them effectively is not new either. First and foremost, the duty to disclose and mitigate conflicts is the adviser’s duty as a fiduciary. The independent directors nonetheless should be sensitive to the potential for conflicts and ask questions of the adviser to satisfy themselves that full disclosure has been made. Once conflicts are “on the table,” the independent directors (or full board) must evaluate the proposal taking the conflicts into account.
It is often said that to identify a conflict of interest, “follow the money.” In the case of funds, when a separate vote or separate findings by independent trustees is required—either by statute, rule or exemption—the independent directors should attend to the conflict presented. In other cases, such as the three situations above, independent directors can ask a few basic questions:
- Does the adviser (or an affiliate) benefit, directly or indirectly, as a result of the recommended action? If so, how?
- What alternatives to the one recommended were considered, and why were they rejected?
- Did they result in a lower benefit to the adviser (or its affiliates)?
- What steps were taken to eliminate or minimize any conflict presented? For example, if the adviser will benefit financially, was consideration given to that benefit being shared with the funds involved? Was consideration given to a portion of any financial benefits being used to offset costs to be incurred by the funds in taking the course of action?
- What business relationship, if any, is there between the adviser (and its affiliates) and any new service provider?
The presence of a conflict or a benefit to the adviser (or its affiliates) does not mean that the recommended action should be rejected or must be altered in some way. The board may act, consistent with its duty of care, to pursue an action with the sole purpose of benefitting the fund and its shareholders, notwithstanding that the adviser derives a benefit at the same time. The important thing is for the board to recognize the conflicts, to understand any benefit to the adviser, and then, with informed judgment, to make a decision in the best interest of the fund and its shareholders.
Rose DiMartino is a senior counsel in the Asset Management Department at Willkie Farr & Gallagher LLP, where she focuses on open- and closed-end funds, advising them, their boards and advisers on a full range of matters, including regulatory and compliance, contract approvals, disclosure issues, restructuring and financing, and acquisitions.