Increased Transparency Proposed for the Investment Advisory Contract Approval Process

From the Investment Management Practice Group

This has been (and continues to be) a period of extraordinary change in the investment management industry. During the past three months, the Securities and Exchange Commission ("SEC") has issued numerous proposed and final rulemakings affecting mutual funds and investment advisers. (At right is our survey of recent SEC regulatory activity.) This article briefly discusses one of these proposals: the SEC ’s recent initiative to increase the transparency of a fund ’s investment advisory contract approval process undertaken by its board of directors.¹ The SEC hopes that the increased transparency will be another important step in its various efforts to assure fair and reasonable fund fees.

As proposed, a fund would now be required to disclose, in reasonable detail, the material factors and conclusions that formed the basis for the board ’s approval of any investment advisory contract with the fund. The focus of the additional disclosure would be a fund ’s semiannual and annual shareholder reports. The SEC believes that the periodic nature of these reports would provide shareholders with more timely disclosure of the reasons for the board ’s approval of any advisory contracts during the reporting period, particularly contracts that were not approved by shareholders (for example, under existing orders of the SEC granting relief from Section 15(a) of the Investment Company Act to permit a fund to enter into or materially amend advisory contracts with certain unaffiliated subadvisers without obtaining shareholder approval).

The SEC also proposes to require similar enhanced disclosure of the advisory contract approval process in a fund ’s proxy statement and statement of additional information ("SAI"). The disclosure in proxy statements would cover the board ’s basis for recommending that shareholders approve an investment advisory contract, while the disclosure included in a fund ’s SAI would cover board deliberations of existing advisory contracts with the fund. Although some disclosure is already required in a fund ’s proxy statement and SAI, the SEC believes there is a need to reinforce the existing disclosure obligations and improve this disclosure in a manner that would parallel the disclosure proposed for inclusion in fund shareholder reports.

The proposals would augment current disclosure by requiring funds to discuss the factors relating to the board ’s selection of the investment adviser (including subadvisers) and approval of the advisory fee, as well as any other amounts to be paid under the advisory contract. In addition, funds would be required to discuss certain specific factors the board has considered, including: (1) the nature, extent, and quality of the services to be provided by the adviser; (2) the investment performance of the fund and the adviser;(3) the costs of the services to be provided and the profits to be realized by the adviser and its affiliates from the relationship with the fund;(4) the extent to which economies of scale would be realized as the fund grows; and (5) whether fee levels reflect these economies of scale for the benefit of fund investors.

The fund would also be required to discuss whether the board compared the adviser’s services and fees with those provided under other investment advisory contracts, including the contracts of the same or other advisers with other funds and other types of clients, such as pension funds or separate accounts. To the extent that the board uses such comparisons, the board would be required to describe them and how they assisted the board in deciding whether to approve the contract.

The SEC reiterated that conclusory statements or a list of factors are not considered sufficient disclosure under the current or proposed requirements, and that a fund ’s discussion should relate the factors to the specific circumstances of the fund and the investment advisory contract. The rule proposals would clarify this further by requiring that a fund ’s discussion state how the board evaluated each factor .The SEC noted that the rule proposals "are designed to reinforce the existing obligation of a fund to provide meaningful disclosure in the SAI and proxy statements about the basis for the board ’s approval of the fund ’s existing advisory contract and any board recommendation that shareholders approve an advisory contract."²

Some critics of the fund industry have cited anecdotal evidence that the advisory contract review process lacks teeth. In the rule release, the SEC stated that some have "argued that the process by which fund boards determine to renew advisory contracts is often cursory, at best."³ Some critics have also argued that fund fees are unjustifiably higher than those charged to other advisory clients.⁴ Whether or not these arguments have merit, the SEC believes that the rule proposals, if adopted, would increase transparency of the advisory contract review process and provide an added spotlight on the level of advisory fees. Consequently, in the SEC’s view, the proposals would have the salutary effect of encouraging fund boards to engage in vigorous and independent oversight of these contracts and assisting investors in making informed choices among funds.

Although the rule proposals have not yet been adopted, the SEC ’s discussion in the rule release provides insight into the SEC ’s current thinking on the contract review process. While the essence of a director ’s fiduciary duties has not changed, the standard of what the SEC considers to be reasonable conduct in fulfilling these duties does appear to be changing⁵ The rule release suggests that the SEC now requires directors to be more rigorous and diligent in their review and oversight of investment advisory contracts, and to pay particular attention to each factor typically considered in evaluating these contracts.

The period for comments on the rule proposals ends April 26, 2004.