As the mutual fund industry has evolved, fund boards have been given additional duties. If the Securities and Exchange Commission is looking for ways to reduce those duties without compromising important investor protections, it could consider eliminating fund boards’ Section 15(c) responsibilities over unaffiliated sub-adviser relationships.
How We Got Here
The 1940 Act only imposes three duties on fund directors: to approve advisory contracts, to approve underwriting contracts, and to determine the fair market value of certain securities. However, over the years directors have taken on additional responsibilities, mostly as conditions to exemptive orders, which later were codified into SEC rules. Management companies seeking exemptions often promised that fund boards could properly oversee conflicts permitted by the order.
As a result, directors today oversee a number of fund practices, such as purchases of securities in affiliated underwritings, mergers, foreign custody, the use of amortized cost valuation by money market funds, and payment of 12b-1 fees.
From time to time, the SEC has tweaked its rules, relieving burdens on fund boards it found to be unnecessary. For example, following a comprehensive review of the 1940 Act in 1992, the SEC amended several rules to reduce board micromanagement of fund activities. More recently, the SEC staff issued a no-action letter effectively amending rules permitting cross-trading, purchases of affiliated underwritings, and the use of affiliated broker-dealers to eliminate board-approval requirements.
In other cases, instead of simply eliminating board obligations, the SEC has reconsidered the terms under which it granted exemptive relief to obviate the need for board involvement. In 1997, for example, the SEC amended rule 17f-5 to permit the appointment of a “foreign custody manager” to relieve fund boards from evaluating the risks of foreign custodians. In 2010, the SEC proposed amending rule 12b-1 to eliminate the board’s role in determining whether the 12b-1 fee is reasonable.
But the pendulum swings both ways. In the last several years, the SEC proposed and adopted rules that seem to drag boards back into fund management. Amendments to rule 2a-7 ask boards to decide whether and when to impose redemption fees and gates on money market fund investors. The new liquidity program rule tasks boards with evaluating the liquidity needs of funds. And a 2016 proposal would, if adopted, require boards to deeply enter the impenetrable world of derivatives.
There has been a sense among some observers that if the SEC could not figure out what to do in these difficult areas, it simply gave it to the boards to figure it out. That’s often what Congress does to the SEC when it passes legislation.
Investment Management Division Director Dalia Blass recently indicated that the staff is re-evaluating the extent to which the board is asked to play a role in the management of funds in current and future SEC rules. A recent rule proposed by the SEC seems to reflect a new approach. The December 2018 fund-of-funds proposal would require the fund adviser, rather than the fund board, to evaluate the complexity and fee structure of a multi-tier arrangement.
My experience with fund boards since leaving the SEC staff suggests there is something bolder the SEC should consider to pare back unnecessary board involvement in fund management. The SEC should adopt a rule exempting registered funds from the Section 15(c) process with respect to “independent sub-advisers,” or those that are not otherwise affiliated with either the fund or the principal adviser.
About 40% of funds today employ one or more sub-advisers. Section 15(c) requires boards of such funds to initially approve each sub-advisory contract, and after an initial two-year period, they must review and approve the contract’s renewal. This is so, even if a sub-adviser is compensated by the fund’s principal adviser.
Before initially approving or renewing the contract, directors submit a lengthy list of questions to each sub-adviser and receive back an even lengthier series of responses that focus on their competency, conflicts, and justification of their fee. The board then meets in person to discuss and approve each sub-advisory contract.
The Section 15(c) process and the participation of independent directors is designed to address the imbalance of negotiation power between the fund and its adviser, which has conflicting loyalties to its client (the fund) and its own owners. Meaningful negotiation requires both sides to have the ability to walk away from the table, and most funds are not in that position. Funds rarely fire their own advisers.
In contrast, independent sub-advisers are hired and fired regularly. They provide services to the fund on terms that are closely negotiated by the fund’s principal adviser, which has every interest in striking the best deal for the fund. Poor sub-adviser performance or high fees will reduce the adviser’s own profits either directly or indirectly. Typically, the fund’s principal adviser pays the sub-adviser from its own fee.
The SEC itself has analogized independent sub-advisers to portfolio managers—whose compensation is left entirely to the adviser and set by market forces. Even plaintiffs in the recent spate of Section 36(b) litigation involving sub-advised funds agreed that sub-adviser fees were a product of arms-length bargaining.
There are, perhaps, other changes the SEC also should consider, but this is low-hanging fruit. I am suggesting simply that the SEC waive only the largely choreographed 15(c) process. The board would continue to have ongoing oversight responsibilities of independent sub-advisers, and sub-advisers would remain affiliated persons of the fund. The effect of such an exemption would be to permit the board to oversee independent sub-advisers as it would any other service provider, delegating to the principal adviser the details of the advisory contract, including the sub-advisory fee.
Robert E. Plaze is a partner in the Registered Funds Group at Proskauer Rose LLP in Washington, D.C. He previously spent nearly 30 years in the SEC’s Division of Investment Management, most recently as deputy director.