Vol. 41 No. 5
March 5, 2008
INVESTMENT COMPANY BOARD OVERSIGHT
OF SUBADVISED RELATIONSHIPS
The Investment Company Act requires fund boards to review and approve subadvisory
agreements, and to disclose to shareholders the factors considered in approving such
agreements. Boards must also approve subadviser compliance programs and monitor
for compliance with rules regarding such matters as affiliated transactions, trade
execution, and soft-dollar practices.
By George P. Attisano *
An open-end or closed-end fund is customarily governed
by a board of directors or trustees, which oversees the
fund’s operations and engages professional investment
advisers to manage the fund’s assets. Often, an
investment adviser, with the consent of the board and the
fund’s shareholders, will subcontract some or all of its
duties to an investment subadviser. This article
discusses the duties of boards in approving subadvisers 1
and monitoring their services to funds.
prepared by Financial Research Corp. 2 found that
subadvised fund assets grew at a compound annual rate
of 27 percent from 2003 to 2006, compared with a
growth rate of 17 percent for internally managed funds.
The study also found that the market share of subadvised
funds grew from 10 percent to 14 percent over the same
period. According to fund research firm Morningstar
Inc., more than 2,290 funds, with $2.3 trillion in assets
under management, listed a subadviser as of August
2007. 3
Subadvised funds represent a growing segment of the
investment management marketplace. A 2007 study
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1
In this article, the term “adviser” refers to the investment adviser
ultimately responsible for the management of the fund’s assets
and the term “subadviser” refers to any person to whom the
adviser delegates investment authority over some or all of the
fund’s assets.
∗ GEORGE P. ATTISANO is a Counsel in the Boston office of
Kirkpatrick & Lockhart Preston Gates Ellis LLP. His e-mail
address is george.attisano@klgates.com. This article is for
informational purposes and does not contain or convey legal
advice. The information in this article should not be used or relied
upon in regard to any particular facts or circumstances without
first consulting a lawyer.
March 5, 2008
————————————————————
2
3
S. Asci, Subadvisers are grabbing larger piece of the market,
InvestmentNews.com, Nov. 12, 2007.
Id.
IN THIS ISSUE
● INVESTMENT COMPANY BOARD OVERSIGHT OF
SUBADVISED RELATIONSHIPS
Page 1
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THE SUBADVISORY RELATIONSHIP
Overview
Subadvised funds operate in several contexts.
Sometimes, an adviser may retain the services of a
subadviser to manage fund assets that are outside the
adviser’s expertise. For example, in managing a
balanced fund, which invests in both equity and debt
securities, an adviser that specializes in equity investing
may retain a subadviser that specializes in debt
investments to manage that portion of the fund’s assets
(often referred to as a “sleeve”). Even funds that invest
in one asset class may have a subadvisory structure. The
adviser to a broad-based equity fund, for example, may
invest a sleeve in large-capitalization companies while a
subadviser invests the remaining portion of the fund’s
assets in smaller-capitalization companies.
Subadvisory relationships are often prevalent in
“multi-manager” structures where a fund’s assets are
managed by a number of subadvisers under the
supervision of an adviser that does not directly manage
the fund’s assets. This structure is frequently employed
by broad-based financial institutions, such as insurance
companies, which often obtain “manager of managers”
exemptive relief from the requirement in Section 15 of
the Investment Company Act of 1940 for shareholder
approval of new subadvisers. Pursuant to such relief, an
adviser may hire and fire subadvisers with board
approval, without having to submit new subadvisers for
shareholder approval. 4
————————————————————
4
Among other things, §15(a) of the 1940 Act requires funds to
have written agreements with their investment advisers and
further requires those agreements to have been approved by a
majority of the fund’s shareholders. Prior to the public offering
of a fund’s shares, the fund customarily sells shares to the fund’s
adviser. The adviser, as the fund’s initial sole shareholder,
approves the fund’s advisory agreements, thereby satisfying
§15(a). Once a fund is operational, however, in the absence of
an SEC “manager of managers” order or other form of
regulatory relief, it must call a shareholder meeting for the
purpose of approving any new investment advisory agreements.
In 2003, the SEC proposed Rule 15a-5 under the 1940 Act,
March 5, 2008
P
P
Subadvisory relationships can also be found in
arrangements where an adviser acts primarily as a fund
sponsor and retains a subadviser to manage all of the
fund’s assets. The adviser in this structure primarily
markets the fund and provides other administrative
services, although it is also responsible for supervising
the subadviser’s activities.
In addition, the adviser may retain the services of a
subadviser in the case of a fund with poor investment
performance. Although uncommon, this arrangement is
sometimes considered during the board’s annual review
of the fund’s contract with the adviser (discussed further
below).
Generally, fund advisers compensate subadvisers
directly and no additional fees are charged to the fund.
A subadviser can be an affiliate of the adviser or it can
be independent.
Advantages and Issues
Fund subadvisory arrangements offer particular
benefits to both advisers and subadvisers, as well as pose
particular issues. By retaining subadvisers, an adviser
with a broad client base can attract and retain more
assets by “filling in the gaps” in its money management
services. Rather than “growing its own” expertise in a
particular asset class, an adviser can more efficiently
delegate its duties with respect to the asset class to a
subadviser with expertise in that area. Also, advisers
facing capacity constraints and unable to effectively
invest increased assets under management may retain a
subadviser to handle the additional assets.
Retaining subadvisers permits fund sponsors to offer
“best of breed” funds employing subadvisers with
demonstrated expertise in particular asset classes. This
is especially attractive for a financial services firm with
an extensive client base and an established brand name.
footnote continued from previous column…
which would codify a number of conditions under which
“manager of managers” relief is granted. Inv. Co. Act Rel. No.
IC-26230 (2003). The SEC has not yet adopted this rule.
Page 2
These advantages come at a price, however, since the
adviser cedes considerable control over the management
of the fund assets allocated to the subadviser. Portfolio
managers (those individuals principally responsible for
the day-to-day investment of a fund’s assets) employed
by the subadviser are only indirectly accountable to the
adviser; the adviser’s main point of contact with the
subadviser may be someone other than a portfolio
manager in charge of investing the fund’s assets. In
addition, the adviser’s familiarity and comfort with a
subadviser’s financial condition is limited to whatever
financial statements are publicly available or that the
subadviser otherwise agrees to provide to the adviser.
As a result, if the subadviser is experiencing financial
difficulty, the adviser (and, ultimately, the fund’s board)
may not learn of it until it is too late.
Subadvisers benefit from these arrangements by
increasing assets under management with little or no
marketing expense, which can lead, in addition to
increased fee revenue, to more efficient utilization of
resources and more favorable trading costs. In addition,
the subadviser’s role is generally “pure” investment
management and does not include many of the
marketing, administrative, and compliance expenses
often borne by the adviser. On the other hand, a
subadviser is subject to the supervision of the adviser
and often deals with the fund board indirectly through
the adviser, a decided disadvantage during periods when
the subadviser’s sleeve underperforms the fund’s
benchmark index or other performance measures.
Subadvisers are especially vulnerable in a “manager of
managers” context, as a fund board, at the urging of the
adviser, can replace a subadviser without the delay, cost,
and uncertainty involved in obtaining shareholder
approval of a replacement. In addition, the fees for
subadvising a pool of assets are lower than the overall
advisory fees charged on those assets and, depending on
the relative bargaining strength of the adviser and the
subadviser, can be considerably lower than the fees that
the subadviser customarily receives when it manages
such assets directly.
adviser and any subadvisers must be approved by the
fund’s shareholders (discussed above) and by the fund’s
board, including a majority of the board members who
are not “interested persons” (as defined by the 1940 Act)
of the fund, the adviser, or the subadviser (“independent
board members”), 6 even though the fund often is not a
party to the subadvisory agreement. As is the case with
agreements between a fund and its adviser, subadvisory
agreements can have an initial term of two years and are
renewable thereafter for one-year terms, subject to the
approval of the fund’s board, including a majority of the
independent board members.
Section 15(c) of the 1940 Act requires fund boards to
request and evaluate (and the adviser to furnish) “such
information as may reasonably be necessary to evaluate
the terms of any contract whereby a person undertakes
regularly to serve or act as investment adviser” of the
fund. 7 The factors that boards should consider in
approving or renewing advisory agreements were first
set forth in the Second Circuit case, Gartenberg v.
Merrill Lynch Asset Management, Inc. 8 For 20 years,
the factors detailed in Gartenberg and other cases that
expanded upon these factors 9 served as the primary
footnote continued from previous column…
regularly furnishes advice to such
company with respect to the desirability
of investing in, purchasing or selling
securities or other property, or is
empowered to determine what securities
or other property shall be purchased or
sold by such company, and (B) any
other person who pursuant to contract
with a person described in clause (A)
regularly performs substantially all of
the duties undertaken by such person
described in clause (A) . . . . (emphasis
added).
6
Section 2(a)(19) defines the types of individuals who would be
considered “interested persons” of a fund, any of its investment
advisers, or the fund’s principal underwriter.
APPROVAL OF SUBADVISORY AGREEMENTS
7
The provisions of Section 15 of the 1940 Act, as well
as other provisions of the 1940 Act and the rules
thereunder, apply to subadvisers as well as investment
advisers. 5 As a result, contracts between a fund’s
Although §15(c) does not specify the information that boards
must consider and advisers provide, a board must review this
information in light of the adviser’s fiduciary duty under §36(b)
of the 1940 Act regarding the receipt of compensation from the
fund.
8
528 F. Supp. 1038 (S.D.N.Y. 1981), aff’d, 694 F.2d 923 (2d Cir.
1982), cert. denied, 461 U.S. 906 (1983).
9
Gartenberg v. Merrill Lynch Asset Management, Inc., 573 F.
Supp. 1293 (S.D.N.Y. 1983), aff’d, 740 F.2d 190 (2d Cir. 1984);
Schuyt v. T. Rowe Price Prime Reserve Fund, Inc., 663 F. Supp.
962 (S.D.N.Y.), aff’d, 835 F.2d 45 (2d Cir. 1987), cert. denied,
————————————————————
5
Section 2(a)(20) of the 1940 Act reads, in pertinent part:
“Investment adviser” of an investment
company means (A) any person . . . who
pursuant to contract with such company
March 5, 2008
Page 3
roadmap by which boards considered whether to
approve or continue advisory agreements. While these
cases continue to be relevant and the factors included in
the cases continue to be seriously considered (and are
discussed in annual memoranda from legal counsel to
fund boards in connection with the approval of advisory
agreements), in 2004, the SEC, in amending shareholder
report disclosure rules for funds, promulgated a list of
required factors for board consideration. 10 Boards must
consider the following five factors: “(1) the nature,
extent, and quality of the services to be provided by the
investment adviser; (2) the investment performance of
the fund and the investment adviser; (3) the costs of the
services to be provided and profits to be realized by the
investment 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.” 11 If any of these factors is not
considered relevant to the board’s consideration of the
advisory agreement, the fund must note this and explain
why the factor is not relevant. Funds also must disclose
whether the board relied on comparisons of the services
to be rendered and the fees to be paid with those under
other advisory agreements (e.g., comparisons to
agreements for other funds, or for other types of
investors, such as pension funds and other institutional
investors).
In addition to these factors, a fund should disclose, if
applicable, any benefits that the adviser may derive from
its relationship with the fund, such as soft-dollar
arrangements in which the adviser receives research
from broker-dealers in return for allocating fund
brokerage.
The following sections discuss how these factors
apply to board considerations of subadvisory
agreements.
footnote continued from previous page…
485 U.S. 1034 (1988); Krinsk v. Fund Asset Management, Inc.,
715 F. Supp. 472 (S.D.N.Y. 1988), aff’d, 875 F.2d 404 (2d Cir.),
cert. denied, 493 U.S. 919 (1989); and Kalish v. Franklin
Advisers, Inc., 742 F. Supp. 1222 (S.D.N.Y. 1990), aff’d, 928
F.2d 590 (2d Cir.), cert. denied, 112 S. Ct. 75 (1991).
10
11
Inv. Co. Act Rel. No. IC-26486 (2004). Funds must disclose
these board considerations in the shareholder report for the six
months during which the contract approval took place.
Id. See also n. 31, in which the staff of the SEC, citing
Gartenberg, comments that “Courts have used similar factors in
determining whether investment advisers have met their
fiduciary obligations” under §36(b) of the 1940 Act.
March 5, 2008
Nature, Extent, and Quality of Services
Boards often review the same type of information
about subadvisers that they would review concerning
advisers. In connection with the initial approval of a
subadvisory agreement, a board typically will receive
various documents from the subadviser, including:
•
the subadviser’s complete SEC registration on Form
ADV;
•
the subadviser’s latest independently audited
financial statements (whether or not the subadviser
or its parent is publicly held);
•
a summary description of the subadviser’s business
operations, including a brief history of the
subadviser, the nature of its client base, the types of
services it provides, and a recent statement of assets
under management; and
•
an organizational chart showing the subadviser’s
key management personnel.
Subadvisers also frequently provide copies of
marketing materials used in soliciting business from
clients.
To satisfy particular 1940 Act rules, a subadviser
must submit for fund board approval the subadviser’s
code of ethics 12 and written compliance program. 13 The
subadviser should discuss with the board any
examinations of the subadviser’s operations by state or
federal regulatory authorities, including findings by such
regulators and remedial actions taken in response to
those findings. The subadviser also should disclose to
the board any material litigation in which the subadviser
is involved.
The board also should meet in person with
representatives of the subadviser’s management and with
the portfolio managers who will be investing the fund’s
assets.
————————————————————
12
Rule 17j-1 under the 1940 Act requires a fund board, including
a majority of the independent board members, to approve the
code of ethics of any adviser to the fund and receive periodic
certifications under the code.
13
Rule 38a-1 under the 1940 Act requires a fund board, including
a majority of the independent board members, to approve the
written compliance program of any adviser to the fund. The
board’s role in overseeing compliance by the subadviser is
discussed in this article under “Subadviser Compliance.”
Page 4
In connection with annual reviews, a fund board often
will review updated versions of the same type of
information that is presented in the initial approval
process. It is also common for the board to meet in
person with the subadviser’s portfolio manager during
the contract renewal meeting. The board, including a
majority of the independent board members, must
approve any material change to the code of ethics within
six months of the change, and the board must annually
review the adequacy and effectiveness of the
subadviser’s compliance program. While annual board
approval of a subadviser’s codes of ethics and
compliance programs is not required, the board should
be mindful of any written board policies (including
board committee charters) that require such approval.
Investment Performance of the Fund and the
Subadviser
In considering whether to hire a new subadviser, past
fund performance is customarily not a factor (although a
fund board may seek to hire a new subadviser to remedy
poor fund performance). Also, for new funds with no
track record, fund performance is clearly not a factor.
Even in these contexts, a fund board should nevertheless
compare to relevant benchmarks the subadviser’s track
record in managing other funds and client accounts with
similar investment policies. The board should consider
whether the portfolio manager or managers who are
proposed to manage the fund’s assets were primarily
responsible for managing those other funds and accounts
during the period in question. If the proposed managers
were not primarily responsible, the board should be able
to reasonably conclude from information supplied by the
subadviser that the subadviser’s track record is
attributable to a consistently applied investment process.
This could be the case with either “team-managed”
accounts, where no one individual is solely responsible
for making investment decisions, or “black-box”
quantitative investment processes, in which computer
models generate investment decisions that, while subject
to portfolio manager review and approval, largely guide
the portfolio’s management.
Subadvisers that propose a recently hired portfolio
manager may present that manager’s track record from a
previous employer. In this case, the board should be
reasonably satisfied that the pool of assets managed at
the prior firm was comparable to the fund assets to be
managed and that the portfolio manager was primarily
responsible for managing those assets during the period
of the track record.
With respect to annual reviews, the performance of
the fund assets under the subadviser’s management
March 5, 2008
becomes a very important factor in determining whether
to continue the agreement with the subadviser. With
multi-manager funds, when considering a particular
subadvisory agreement, the board should consider only
the performance of the sleeve managed by that
subadviser. The board should also consider whether any
underperformance is due to rapid investor flows into or
out of the fund. Such flows would be more problematic
for a subadviser managing a less-liquid asset class, as the
subadviser might find few opportunities to invest new
cash or, in order to meet shareholder redemptions, might
be compelled to liquidate fund assets on unfavorable
terms. The board should also take into account the
amount of assets managed by the subadviser, since a
small asset base would tend to result in higher
transaction costs due to less favorable trade execution
and less access to attractive investment opportunities.
Benchmarking is also very important. Especially in
the case of a new subadviser, the subadviser may
“inherit” a fund benchmark that the subadviser typically
doesn’t use to measure its own performance. Although
all open-end funds, other than money market funds, must
compare their performance to a broad-based securities
market index, 14 the selection of the index often
combines an attempt to choose a benchmark that is
representative of the fund’s holdings, with choosing a
benchmark frequently used by sales intermediaries
(banks, broker-dealers, financial advisers) and fund
rating services (such as Lipper or Morningstar) in
connection with marketing or evaluating the fund.
Although a subadviser may present the performance of
its allocated sleeve in comparison to benchmarks other
than those used by the fund in its prospectus and
shareholder reports, the board should primarily review
the subadviser’s performance against the fund’s
benchmarks and may also consider these other
subadviser-recommended benchmarks. In certain
contexts, the subadviser’s benchmark, if consistently
applied, may be useful, especially for funds with
multiple asset classes but only one benchmark index.
For example, a subadviser managing a small-cap sleeve
of a multi-cap fund that uses the S&P 500 Index as a
fund benchmark might also show the performance of its
sleeve against the Russell 2000 Index.
In addition to broad-based securities market indices, a
board also should compare the fund’s performance to
other similarly managed funds. Reports containing this
information may be prepared and provided by the
————————————————————
14
See Item 2(b)(2)(iii) of Form N-1A, the form for registering
shares of open-end funds under the Securities Act of 1933.
Page 5
adviser, or they may be prepared by outside services
such as Morningstar or Strategic Insight.
be involved in other business relationships with the
adviser.
A fund board also should carefully evaluate the
subadviser’s explanation of the performance of its
sleeve, which is likely to include discussion of particular
transactions or industry sector allocations (both
profitable and not). The annual evaluation should take
into account discussions the subadviser may have had
with the board during quarterly reviews of the fund’s
investment performance.
If a fund board concludes that cost to the fund and
profitability to the subadviser is not a relevant factor, the
fund must disclose this and discuss the reasons for its
conclusion in the relevant shareholder report.
Costs of the Services Provided and Profits to the
Subadviser
Fund boards are required by statute to approve the
fees to be charged under subadvisory agreements 15 and
subadvisers have a fiduciary duty with respect to the
receipt of subadvisory fees. 16 Nevertheless, while it is
generally accepted that this factor is important to
considering whether to approve an agreement with the
adviser, many market participants consider it less
important in the context of reviewing subadvisory
arrangements. At one level, a fund should be
economically indifferent to the cost of subadvisory
services since the adviser, not the fund, is bearing those
costs. Also, in cases where the subadviser is not an
affiliate of the adviser, it can be presumed that the
parties engaged in arms-length bargaining to arrive at a
mutually acceptable subadvisory fee. A fund board
nonetheless should compare the subadvisory fee to
subadvisory fees charged with respect to similar funds to
determine whether the subadvisory fee comes within the
range of fees generally charged with respect to a
particular type of fund or asset class.
Whether to consider the subadviser’s profitability in
managing the fund is another contentious area. While
many subadvisers, especially those that are publicly held
or are affiliates of public companies, readily share their
financial information with their fund clients (including
information about the profitability of their relationship
with a fund), other subadvisers, especially private firms,
are reluctant to do so. A fund board should, in any case,
be aware of a subadviser’s complete business
relationship with an adviser. In many cases, a
subadviser will not only subadvise a particular fund, but
may also subadvise other funds or accounts managed by
the adviser. In addition, the subadviser’s affiliates, such
as banks, broker-dealers, or insurance companies, may
Economies of Scale
Industry observers disagree whether factors
concerning economies of scale are relevant to board
consideration of subadvisory agreements. While some
may argue that the subadviser, as well as the adviser,
should share with the fund any cost savings resulting
from growth in the fund’s asset base, others note that a
reduction of fees paid to the subadviser accrues to the
benefit of the adviser, rather than the fund. Although
many advisory contracts have fee “breakpoints” (that is,
fee reductions when certain asset thresholds are
achieved), the corresponding subadvisory arrangements
may not have corresponding breakpoint schedules.
Depending again on the relative bargaining power of the
adviser and the subadviser, a subadviser that receives a
small portion of the overall advisory fee may be
reluctant to reduce its fee at any asset levels.
After evaluating the fund’s subadvisory fee structure,
a fund board may conclude that the “economies of scale”
factors are not relevant to approval of subadvisory
agreements, particularly if the fund stands to realize
benefits from asset growth in the form of overall
advisory fee reductions resulting from advisory fee
breakpoints. Again, if the board reaches this conclusion,
appropriate disclosure of the conclusion and the reasons
for it are required in the relevant shareholder report.
Other Factors
Funds also must disclose whether the board relied on
comparisons of the services to be rendered and the fees
to be paid with those under other advisory agreements
(e.g., comparisons to agreements for other funds, or for
other types of investors, such as pension funds and other
institutional investors). This is yet another contentious
area, as some industry observers 17 have claimed that
mutual funds generally pay higher fees than are paid by
pension funds for similar services, while others 18 have
argued that the fees paid by mutual funds are not
————————————————————
17
Notably, in 2003 and 2004, then-New York State Attorney
General Elliot Spitzer.
18
Notably, the Investment Company Institute, the fund trade
group.
————————————————————
15
Section 15(a) of the 1940 Act.
16
Section 36(b) of the 1940 Act.
March 5, 2008
Page 6
comparable to those paid by pension funds due to the
differing cost structure of funds (with its numerous
shareholders, as opposed to a single pension fund or
large institution), as well as a broader array of investor
services available to fund investors.
In contrast to the previously discussed factors,
however, if a board does not consider comparisons to
other types of products, no disclosure of that fact is
necessary. 19
While approval of a fund’s subadvisory arrangements
is a crucial (and statutory) board responsibility, the
board has other duties with respect to oversight of
subadvisory relationships, particularly in the area of fund
compliance with the federal securities laws.
SUBADVISER COMPLIANCE
Fund boards have a duty to oversee the subadviser’s
activities on behalf of the fund to be reasonably certain
that the fund is not violating the federal securities
laws. 20 Fund boards, including a majority of the
independent board members, must approve the
compliance programs of the fund, each adviser to the
fund (including any subadviser, as mentioned above),
and the fund’s principal underwriter, administrator, and
transfer agent. In approving a subadviser’s compliance
program, a board may generally rely on the evaluation of
the program by the fund’s chief compliance officer
(“CCO”). Also, the fund’s CCO is expected to monitor
the implementation of the subadviser’s compliance
program, address any compliance issues arising from the
subadviser’s activities with respect to the fund, and
report annually to the board, in writing, concerning the
continued adequacy of the subadviser’s program.
————————————————————
19
20
Inv. Co. Act Rel. No. IC-26486 (2004). “As adopted, the
amendment requires a description of the comparisons upon
which the board relied and how they assisted the board in
concluding that the contract should be approved, and does not
require an enumeration of the types of comparisons that the
board did not use.”
Rule 38a-1 under the 1940 Act requires funds to adopt and
implement written policies and procedures “reasonably
designed to prevent violation of the Federal Securities Laws”
by the fund, and to appoint a chief compliance officer. For
purposes of Rule 38a-1, “Federal Securities Laws” means the
Securities Act, the Securities Exchange Act, the SarbanesOxley Act, the 1940 Act, the Advisers Act, Title V of the
Gramm-Leach-Bliley Act (relating to the privacy of customer
information), and the Bank Secrecy Act (relating to money
laundering), and any rules adopted thereunder by the relevant
federal agencies.
March 5, 2008
Other provisions of the federal securities laws and the
rules thereunder require fund boards to review and
approve a number of matters concerning subadvisers,
often on a quarterly basis.
Affiliated Transactions
Since subadvisers are considered “affiliated persons”
of funds under the 1940 Act, 21 various provisions of the
1940 Act and the rules thereunder apply to fund
transactions involving subadvisers (and their affiliates).
At the outset of the relationship with a fund, a
subadviser should provide a list of its affiliates
(particularly affiliated broker-dealers) to the adviser to
permit the adviser to monitor for transactions that are
governed by the 1940 Act and the related rules, and the
subadviser should update this list on a timely basis.
Several of the 1940 Act rules discussed in this section
(Rule 10f-3, Rule 17a-7, and Rule 17e-1), require the
fund board, including a majority of the independent
board members, to adopt written procedures reasonably
designed to ensure compliance with the rule, and, on a
quarterly basis, to determine that all transactions effected
in reliance on the rule during the preceding quarter
complied with the procedures. As is the case with other
“exemptive rules” under the 1940 Act, the board of a
fund relying on these rules must meet the fund
governance standards set out in Rule 0-1(a)(7) under the
1940 Act.
Another 1940 Act rule, Rule 17a-10, discussed further
below, permits funds with multiple subadvisers to
engage in certain principal transactions that would
otherwise be prohibited under Section 17(a). Although
this rule does not impose any specific duties on the fund
board, the board should nonetheless be satisfied that
trades effected in reliance on the rule meet the rule’s
conditions.
Section 10(f) of the 1940 Act and Rule 10f-3.
Included in the 1940 Act under the heading “Affiliations
of Directors,” Section 10(f) in pertinent part prohibits
funds from acquiring securities during the existence of
an underwriting in which the subadviser or its affiliate
serves as a syndicate member. Rule 10f-3 nonetheless
permits such transactions under certain conditions.
Section 17(a) of the 1940 Act. Under Section 17(a),
an affiliated person of a fund (a “first-tier affiliate”), or
————————————————————
21
Under §2(a)(3) of the 1940 Act, an “affiliated person” of an
investment company includes “any investment adviser . . .
thereof.”
Page 7
an affiliated person of the affiliated person (a “secondtier affiliate”) may not, acting as “principal,” engage in
various transactions with the fund (buying or selling
securities or other property, or borrowing or lending
money). “Principal transactions” involve parties buying
property into, or selling it from, their own accounts. In
contrast, a person acting in an “agency” capacity
arranges transactions between others but does not act for
its own account. 22 While Section 17(a) does not apply
to agency transactions, Section 17(e) of the 1940 Act,
discussed below, applies to agency transactions where a
first- or second-tier affiliate of the fund acts as a broker.
Section 17(e) of the 1940 Act and Rule 17e-1. Section
17(e) prohibits first- and second-tier affiliates of funds,
acting as brokers, from receiving compensation in
connection with securities trades that exceeds the usual
and customary broker’s commission. Rule 17e-1 under
the 1940 Act sets out guidelines for such
compensation. 26 Accordingly, a subadviser may effect
agency trades on the fund’s behalf with the subadviser’s
affiliated broker-dealer on terms that satisfy Rule 17e1(a).
Certain typical fund transactions, primarily trades in
debt securities and over-the-counter equity trades
(including trades on Nasdaq), are considered principal
transactions. Since a subadviser may be affiliated with a
broker-dealer, 23 a fund board should be aware of any
such affiliations and review the fund’s principal trades to
ensure that the fund has not entered into any transactions
in violation of Section 17(a).
As part of its oversight role, a fund board should
periodically review information concerning the
execution of the fund’s portfolio transactions (many
boards do so quarterly). Many boards, particularly those
overseeing larger funds with substantial trading activity,
will at least annually review an independent third-party
report on the quality of the funds’ trade execution.
The following points discuss two 1940 Act rules that
exempt certain transactions from the provisions of
Section 17(a).
•
Rule 17a-7. This rule exempts from Section 17(a)
of the 1940 Act those transactions between the fund
and other funds or accounts managed by the
subadviser under certain conditions. 24
•
Rule 17a-10. In the context of a fund with multiple
subadvisers, the subadvisers could be considered
affiliates of each other with respect to the fund’s
operations. This rule permits, under certain
conditions, principal transactions between an
affiliate of the subadviser of one sleeve and an
affiliate of the subadviser of another sleeve. 25
Trade Execution and Soft Dollars
Subadvisers have an obligation to obtain “best
execution” of their clients’ transactions. 27 While a fund
board has no specified duties with respect to reviewing
the quality of a subadviser’s trade execution, the board
should be satisfied that the subadviser is meeting its
obligation to obtain best execution of the fund’s
transactions. In evaluating the quality of a trade’s
execution, a fund board should not only consider
whether the fund paid the lowest commission rate, but
also take other factors into account, such as the size of
the trade, the nature and liquidity of the securities traded,
and whether the counterparty committed its capital to
executing or settling the trade.
Many subadvisers use a portion of their clients’
brokerage commissions to pay for brokerage and
research services. These payments are commonly
referred to as “soft dollars.” Section 28(e) of the
————————————————————
22
23
24
25
For a discussion of the distinction between principal and agency
transactions in the advisory context, see Inv. Adv. Act Rel. No.
IA-1732 (1998) (concerning transactions between registered
investment advisers and their clients).
A broker-dealer affiliated with a fund’s subadviser is
considered a second-tier affiliate of the fund.
Generally, trades relying on Rule 17a-7 must be: (a) effected
solely for cash against delivery of the securities; (b) effected at
an independent current market price; (c) consistent with each
fund’s investment policies; (d) transacted without any
brokerage commission or other fee.
Generally, the fund’s counterparty must not be affiliated with
the subadviser managing the sleeve for which the trade is
March 5, 2008
footnote continued from previous column…
executed; and both subadvisers’ agreements with respect to the
fund must prohibit consultation between the subadvisers
concerning the transaction.
26
See Rule 17e-1(a): “The commission, fee, or other remuneration
received or to be received is reasonable and fair compared to
the commission, fee, or other remuneration received by other
brokers in connection with comparable transactions involving
similar securities being purchased or sold on a securities
exchange during a comparable period of time.”
27
See Exch. Act Rel. No. 34-54165 (2006), at n. 1, citing Exch.
Act Rel. No. 34-23170 (1986) and Delaware Management Co.,
43 SEC 392, 396 (1967).
Page 8
Exchange Act permits subadvisers to use fund brokerage
commissions to purchase these services under certain
circumstances without breaching their fiduciary duties to
clients. 28 A fund’s use of soft dollars is a frequent topic
of discussion in public statements from the SEC staff,
which is currently in the process of preparing guidance
for fund boards in evaluating whether such payments are
used properly. 29 Currently, many fund boards review
reports showing the amount of soft-dollar commissions
paid by the fund, both on a dollar basis and expressed as
a portion of the commission rate, as well as a description
of the services received in exchange for the soft-dollar
payments, usually accompanied by a representation from
the subadviser that the services qualify for the Exchange
Act Section 28(e) safe harbor.
A fund board should be satisfied that the subadviser’s
soft-dollar payments in connection with the fund’s
portfolio transactions are not disproportionate to those
paid in connection with transactions for the subadviser’s
other clients. To this end, a subadviser could provide
information showing the soft dollars paid by the fund as
a percentage of the soft dollars paid by all of the
subadviser’s clients, compared to the percentage of the
subadviser’s assets under management represented by
the fund. If the fund’s soft-dollar payments appear to be
disproportionate, the board should consider whether the
higher soft-dollar payments by the fund are attributable
to factors such as: differing investment policies that
would make order aggregation difficult; more frequent
trading activity for the fund (e.g., to meet fund inflows
or redemptions); or directed brokerage arrangements for
the subadviser’s other clients that preclude or otherwise
qualify the payment of soft dollars by those clients.
CONCLUSION
The duties of a fund board with respect to its
oversight of the fund’s subadvisers is virtually the same
as its duties in overseeing the fund’s adviser. While
nuances flowing from the nature of the advisersubadviser relationship modify certain considerations,
the board is nonetheless responsible for satisfying the
federal securities laws applicable to subadvisers to the
same extent that such laws apply to advisers. Formal
compliance oversight rules (Rule 38a-1 under the 1940
Act and Rule 206 (4)-7 under the Advisers Act), adopted
in 2003, have had a relatively short history and best
practices in this area are continuing to develop. Other
areas, such as fund board review of soft-dollar payments,
are under scrutiny at the SEC and any SEC guidance is
almost certain to elicit vigorous comment from the
adviser, broker-dealer, and fund board community.■
————————————————————
28
The SEC’s current guidance on the permissible uses of soft
dollars is set out in Exch. Act Rel. No. 34-54165 (2006).
29
See Keynote Address at the Investment Company Directors
Conference, by Andrew J. Donohue, Director, Division of
Investment Management of the SEC: “As fund directors, one of
your duties is to appropriately monitor the conflicts of interest
that are inherent in soft-dollar arrangements. This is because
brokerage commissions are paid with assets of the client fund,
not the assets of the adviser. As such, fund directors must
carefully monitor the way these assets are used and how the
adviser's trading practices are described to investors in order to
be satisfied that the use of soft dollars is appropriate and that
the potential conflicts of interest have been adequately
addressed.”
March 5, 2008
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