Investment Management
JULY 2004
SEC Mandates Enhanced Disclosure Regarding
Investment Company Director Approval
of Investment Advisory Contracts
On June 23, 2004, the Securities and Exchange
Commission (“SEC”) adopted amendments1 that
require SEC registered investment companies
(“funds”) to disclose to investors the manner in
which their boards of directors evaluate, approve,
and recommend shareholder approval of investment
advisory contracts.2 As described below, the new
amendments require each fund to provide disclosure
in its shareholder reports regarding the material
factors and subsequent conclusions that formed the
basis for the board’s approval of advisory contracts
during the most recent fiscal half-year. In addition,
the new amendments are designed to enhance
disclosure in proxy statements regarding the basis for
the board’s recommendation to shareholders that
they approve an advisory contract. The SEC states
in its Adopting Release that the new amendments are
aimed at increasing transparency with respect to
investment advisory contracts, assisting investors in
making informed choices among funds, and
encouraging fund boards to more thoroughly review
advisory contracts.3
Funds may voluntarily meet the new disclosure
requirements regarding fund shareholder reports and
proxy statements as of August 5, 2004, the effective
date of the amendments. However, the SEC has set
the mandatory compliance date as March 31, 2005 for
all fund shareholder reports with respects to periods
ending on or after that date, and October 31, 2004 for
all proxy statements, to give funds sufficient time to
determine what additional procedures are needed in
order to fulfill the disclosure requirements. The
effective date for the amendments that remove the
SEC’s current Statement of Additional Information
(“SAI”) disclosure requirement with respect to the
board’s approval of any existing investment advisory
contract is January 31, 2006.4
DISCLOSURE REQUIREMENTS IN
SHAREHOLDER REPORTS
The amendments to Forms N-1A, N-2, and N-3
require fund shareholder reports to discuss, in
reasonable detail, the material factors and the
conclusions that formed the basis for the board of
1 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Securities Act
No. 33-8433 (June 23, 2004) (“Adopting Release”), available at http://www.sec.gov/rules/final/33-8433.htm.
2 The amendments pertain to Forms N-1A, N-2, and N-3, which are registration forms used by funds to register under the
Investment Company Act of 1940 (“Investment Company Act”) and to offer their securities under the Securities Act of
1933 (“Securities Act”). Form N-1A is used by open-end management investment companies, Form N-2 is used by
closed-end management investment companies, and insurance company managed separate accounts that offer variable
annuities use Form N-3. In addition to the Form Amendments, the new rules also amend Schedule 14A, the schedule used
by registered investment companies for proxy statements, pursuant to Section 14(a) of the Securities Exchange Act of
1934 (“Exchange Act”).
3 Adopting Release, supra note 1, at 4.
4 Prior to January 31, 2006, a fund may omit disclosure in its SAI with respect to board approval of any investment
advisory contract if it has previously provided the required disclosure in a shareholder report. For a discussion of the SAI,
see infra note 12.
Kirkpatrick & Lockhart LLP
directors’ approval of any investment advisory
contract. In its Adopting Release, the SEC states
that shareholder reports are the location where
investors are most likely to read and benefit from this
disclosure. Some commentators, in comment letters
sent to the SEC relating to the proposed
amendments,5 argued that adding this disclosure
could dilute the effectiveness of fund disclosure to
shareholders in general. However, the SEC states in
its Adopting Release that including disclosure
regarding the board’s basis for approving an
advisory contract in shareholder reports will provide
existing fund shareholders with more timely
information about the reasons for the board’s
approval of a contract. As a result, this required
disclosure may encourage fund boards to consider
investment advisory contracts more carefully and
investors to consider more carefully the costs and
value of services rendered by the fund’s investment
adviser. This is especially relevant because the level
of fees charged by investment advisers to mutual
fund clients, in comparison to those charged by the
same advisers to pension plans and other
institutional clients, has recently become the subject
of much debate.6 This debate has been spurred by
New York Attorney General Eliot Spitzer, who has
stated publicly that “the advisory fees charged to
mutual fund investors are too high,” and should be
more in line with the advisory fees paid by pension
funds or institutional investors.7
Some fund industry commentators, in objecting to
the inclusion of the proposed disclosure in
shareholder reports, noted that information in
shareholder reports is currently subject to
certification by the fund’s principal executive and
financial officers.8 As a result, some commentators
argued that the amendments would be inappropriate
because they would require fund officers to certify
disclosure that explains the independent board’s
basis for approving an advisory contract. However,
the SEC states in its Adopting Release that this
concern is alleviated by the fact that a certifying
officer can rely on information contained in the
meeting minutes of the board and other information
regarding the board’s evaluation that is retained as
part of the fund’s records.9 In addition, the SEC
suggests that a fund’s board, in order to assist the
fund’s principal executive and financial officers in
fulfilling their certification requirement obligations,
could approve the discussion that is to be included
in shareholder reports regarding its basis for
approving an advisory contract.
The SEC’s disclosure requirement in fund
shareholder reports will apply to any new investment
advisory contract or contract renewal, including
subadvisory contracts, approved by the board
during the most recent fiscal half-year. The
amendments also eliminate the SEC’s proposal that
would have excluded from the disclosure
5 Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Securities Act
No. 33-8364 (Feb. 11, 2004) (“Proposed Release”), available at http://www.sec.gov/rules/proposed/33-8364.htm.
6 See, e.g., John P. Freeman and Stewart L. Brown, Mutual Fund Advisory Fees: The Costs of Conflicts of Interest, 26 Iowa
J. Corp. L. 609 (Spring 2001) (“Freeman Study”) (arguing that advisory fees charged by investment advisers for equity
pension funds are substantially lower than advisory fees charged by investment advisers for equity mutual funds because
advisory fees for pension funds are negotiated through arm’s-length bargaining). But see Gartenberg v. Merrill Lynch
Asset Management, Inc., 694 F.2d 923, 930 n.3 (2d Cir. 1982) (“Gartenberg”) (rejecting argument that the lower fees
charged by investment advisers to large pension funds should be used as a criterion for determining fair mutual fund
advisory fees, and stating, “[t]he nature and extent of the services required by each type of fund differ sharply”); Sean
Collins, The Expenses of Defined Benefit Pension Plans and Mutual Funds, Investment Company Institute Perspective
(Dec. 2003), available at http://www.ici.org/statements/res/1per09-06.pdf (arguing that Freeman Study fails to take into
account significant differences in organizational and expense structures between mutual funds and equity pension funds).
7 Press Release, Office of New York State Attorney General Eliot Spitzer, Investment Company Institute’s Mutual Fund Fee
Report (Jan. 6, 2004), available at http://www.oag.state.ny.us/press/2004/jan/jan06b_04.html (Spitzer goes on to say that
“the only way for fees to be fair is to require . . . that mutual fund directors establish the fairness of the fee contracts they
approve”). But see Chairman William H. Donaldson, Speech at the Mutual Fund Directors Forum (Jan. 7, 2004),
available at http://www.sec.gov/news/speech/spch010704whd.htm (stating “I firmly believe that rules uniformly
applicable to the entire [mutual fund] industry are more desirable than [investment advisory] fees set through
enforcement actions that can fragment the marketplace, particularly in enforcement matters that have nothing to do
with fees”).
8 The SEC requires that a fund’s principal executive financial officers certify the description of the board’s evaluation
process based on their knowledge. See Item 11(a)(2) of Form N-CSR, para. 2; see also Rule 30a-2(a) under the
Investment Company Act, 17 C.F.R. § 270.30a-2(a) (requiring reports filed on Form N-CSR to require certifications in
the form specified in Item 11(a)(2) of Form N-CSR).
9 See Rule 31a-1(b)(4) of the Investment Company Act, 17 C.F.R. § 270.31a-1(b)(4) (2004) (requiring funds to maintain
minute books of directors’ meetings).
Kirkpatrick & Lockhart LLP
2
requirements contracts that were approved by
shareholders,10 because the SEC has now concluded
that the amendment’s comprehensive disclosure will
better enable shareholders to remain up-to-date on
advisory contract approvals, regardless of whether
they were involved in the original approval of the
contract. The present amendments also modify the
SEC’s proposed amendments to clarify that a fund is
required to provide shareholder report disclosure
only regarding board approvals during the fund’s
most recent fiscal half-year.
In addition to amending the disclosure requirement in
fund shareholder reports, the SEC also amends the
fund recordkeeping rule11 to require that funds retain
copies of the written materials that directors
considered in approving the terms or renewal of an
advisory contract. In the Adopting Release, the SEC
states that the requirement will facilitate their
compliance examiners’ review of whether directors are
obtaining the necessary information to make an
informed assessment of the advisory contract.
DISCLOSURE REQUIREMENTS IN PROXY
STATEMENTS, PROSPECTUSES, AND THE SAI
The amendments remove the existing requirement for
disclosure in the SAI of Forms N-1A, N-2, and N-312
with respect to the board’s approval of any existing
investment advisory contract, because requiring
discussion of the board’s basis for approving an
advisory contract in multiple locations is duplicative.
However, because the SEC is concerned that
investors should have access to information about
advisory contract approvals before investing in a
fund, the amendments require that a fund prospectus
state that a discussion regarding the board of
directors’ basis for approving any investment
advisory contract is available in the fund’s
shareholder report. The disclosure will be required to
appear adjacent to other prospectus disclosure about
the fund’s investment adviser.
Since 1994, the SEC has required fund proxy
statements seeking approval of an investment
advisory contract to include a discussion of the
material factors that form the basis of the fund
board’s recommendation that shareholders approve
the contract.13 The present amendments, by
requiring a similar discussion in shareholder reports,
in conjunction with these previous SEC rules, will
result in complementary disclosure requirements in
fund shareholder reports, prospectuses, and proxy
statements.
DISCLOSURE ENHANCEMENTS
The amendments adopt several enhancements to the
existing proxy statement disclosure requirements,
and include those same enhancements in the new
shareholder reports disclosure requirements. These
enhancements are intended to address the SEC’s
concerns that some funds do not provide adequate
specificity regarding the board’s basis for
recommending that the shareholders approve an
advisory contract. Specifically, the enhancements
cover discussions by the board regarding:
n
selection of investment adviser and approval
of advisory fee
n
specific factors
n
comparison of fees and services provided by
adviser
n
evaluation of factors
The amendments specify that the fund’s discussion
in the shareholder reports and proxy statements
must include factors relating to both the board’s
selection of the investment adviser, and its approval
of the advisory fee and any other amounts to be
paid under the advisory contract. The amendments
also require a fund to include a discussion of the
following specific factors:
n
the nature, extent, and quality of the services
to be provided by the investment adviser;
n
the investment performance of the fund and
the investment adviser;
n
the cost of the services to be provided and
profits to be realized by the investment adviser
and its affiliates from the relationship with the
fund;
n
the extent to which economies of scale would
be realized as the fund grows; and
n
whether fee levels reflect these economies of
scale for the benefit of fund investors.
1 0 Proposed Release, supra note 5, at 5.
1 1 See Rule 31a-2 of the Investment Company Act, 17 C.F.R. § 270.31a-2 (2004).
1 2 The SAI is part of a fund’s registration statement and contains information about a fund in addition to that contained in
the prospectus. The SAI is required to be delivered to investors upon request.
1 3 Information Required in Proxy Statement, 17 C.F.R. § 240.14a-101 (2004).
Kirkpatrick & Lockhart LLP
3
These specific factors mirror the factors cited by the
Second Circuit in the Gartenberg14 line of cases, in
determining whether investment advisers have met
their fiduciary obligations under Section 36(b) of the
Investment Company Act.15 The amendments
specify that if any of the enumerated factors is not
relevant to the fund board’s evaluation of an
investment advisory contract, the discussion must
note this and explain the reasons why that factor is
not relevant. Under the amendments, a fund’s
discussion is required to state how the board
evaluated both the costs of the services provided
and the profits realized by the investment adviser and
its affiliates from the relationship with the fund.
However, the SEC clarifies that disclosure of specific
proprietary information about the operating costs
and profits of the investment adviser and its affiliates
is not necessary to meet this requirement.
The amendments also require that the fund’s
discussion indicate whether the board relied upon
comparisons of the services rendered and the
amounts to be paid under their contract with those
under other investment advisory contracts, such as
contracts of the same investment adviser with other
funds or other types of clients (e.g., pension funds
and other institutional investors). Some
commentators objected to this requirement as it
relates to comparisons with other types of clients,
such as pension funds, because “fund boards
typically do not use such comparisons as a basis for
approving or renewing advisory contracts, but that . .
. fund boards may [as a result of this amendment] feel
compelled to consider this factor, notwithstanding
the lack of relevance.”16 The amendments, in
requiring funds to discuss the comparison of
advisory fees under their contract with fees the
adviser receives from other contracts, while possibly
satisfying some of the SEC’s critics, who have
accused the SEC of not passing “stringent”
regulation dealing with fund advisory fee levels,17
will also likely provide future plaintiffs with further
points of contention when bringing suit under
Section 36(b).
The existing proxy statement requirements state that
conclusory statements or a list of factors will not be
considered sufficient disclosure, and that a fund’s
discussion must relate the enumerated factors to the
specific circumstances of the fund and the
investment advisory contract.18 The amendments
clarify these requirements by stating that the fund’s
discussion must state how the board evaluated each
factor, specifically what the board concluded for each
factor and how that affected its determination of
whether an advisory contract should be approved.19
The SEC required this discussion despite objections
from some comment letters that argued that this
information should not be required to be disclosed
because, as a factual matter, boards typically
determine whether to approve an advisory contract
based on the totality of the factors considered.20
However, the increased disclosure requirements are a
result of the SEC’s concern that, currently, some
funds do not provide adequate specificity regarding
the board’s basis for its decision on whether to
approve an investment advisory contract.21
1 4 Gartenberg, supra note 6.
1 5 Section 36(b) of the Investment Company Act provides that “the investment adviser . . . shall be deemed to have a
fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such
registered investment company . . . to such investment adviser.” See Gartenberg, supra note 6 (discussing factors in
determining whether a fee is so excessive as to constitute a breach of fiduciary duty, including “the adviser-manager’s cost
in providing the service, the nature and quality of the service, the extent to which the adviser-manager realizes economies
of scale as the fund grows larger”); see also Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222, 1228 (S.D.N.Y. 1990)
(listing the factors in Gartenberg, but including “comparative fee structures”). But see Gartenberg v. Merrill Lynch Asset
Management, Inc., 528 F. Supp. 1038, 1046 (S.D.N.Y. 1981) (discussing that the intention of Congress in passing Section
36(b) was not to substitute its business judgment for that of fund directors in approving an investment advisory contract,
and not to require a cost-plus type of investment advisory contract).
1 6 Adopting Release, supra note 1, at 7-8.
1 7 See, e.g., Freeman Study, supra note 6, at 656 (arguing that the SEC has not “demanded that fund sponsors explain
publicly, and in detail, how they profit from their services on both fund-by-fund and complex-wide basis”).
1 8 § 240.14a-101.
1 9 However, the SEC in its Adopting Release does not specify how exactly the board should meet this disclosure requirement,
when members of the board will likely undergo a highly individualized process in weighing the enumerated factors.
2 0 Adopting Release, supra note 1, at 8.
2 1 Proposed Release, supra note 5, at 5.
Kirkpatrick & Lockhart LLP
4
CONCLUSION
The amendments are one step in a larger series of
SEC rulemaking initiatives that have sought to
improve disclosure to investors concerning various
aspects of fund activities, including fees and
charges. The SEC states in its Adopting Release that
the increased visibility of this required disclosure
resulting from its inclusion in shareholder reports
may encourage funds to provide a meaningful
explanation of the board’s basis for approving an
investment advisory contract. In addition, the SEC
states that the increased visibility of the disclosure in
shareholder reports may encourage fund boards to
engage in more vigorous and independent oversight
of investment advisory contracts. As a result of the
SEC’s enhanced disclosure requirements, both funds
and management companies need to focus on
reviewing and potentially updating their procedures
surrounding the advisory contract renewal process,
and on determining whether additional procedures
are needed for board approval of the required
shareholder report disclosure, in order to better
enable fund officers to certify this disclosure.
PHILIP L. KIRSTEIN
212.536.4831
pkirstein@kl.com
Mr. Kirstein gratefully acknowledges the contributions of
Nevin Boparai, a summer associate with the firm.
Kirkpatrick & Lockhart LLP
5
Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 70 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties.
We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly
represent mutual fund distributors, independent directors of investment companies and service providers to the
investment management industry. In addition, we frequently serve as outside counsel to industry associations on a
variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of
the investment company business.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.kl.com for more information, or send general inquiries via email to
investmentmanagement@kl.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas S. Hodge
George Zornada
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
617.261.3231
LOS ANGELES
William P. Wade
310.552.5071 wwade@kl.com
NEW YORK
Ricardo Hollingsworth
Philip L. Kirstein
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Keith W. Miller
212.536.4859
212.536.4831
212.536.4024
212.536.3941
212.536.3924
212.536.4045
rhollingsworth@kl.com
pkirstein@kl.com
bkramer@kl.com
rmarshall@kl.com
rmclaughlin@kl.com
kmiller@kl.com
SAN FRANCISCO
Eilleen M. Clavere
Jonathan D. Joseph
David Mishel
Timothy B. Parker
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1012
415.249.1015
415.249.1042
415.249.1070
415.249.1010
eclavere@kl.com
jjoseph@kl.com
dmishel@kl.com
tparker@kl.com
mperlow@kl.com
rphillips@kl.com
WASHINGTON
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
thickey@kl.com
nhodge@kl.com
gzornada@kl.com
Clifford J. Alexander
Diane E. Ambler
Mark C. Amorosi
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Jennifer R. Gonzalez
Robert C. Hacker
Kathy Kresch Ingber
Michael J. King
Rebecca H. Laird
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
C. Dirk Peterson
David Pickle
Alan C. Porter
Theodore L. Press
202.778.9068
202.778.9886
202.778.9351
202.778.9289
202.778.9046
202.778.9042
202.778.9286
202.778.9016
202.778.9015
202.778.9214
202.778.9038
202.778.9107
202.778.9372
202.778.9371
202.778.9298
202.778.9324
202.778.9887
202.778.9186
202.778.9025
calexander@kl.com
dambler@kl.com
mamorosi@kl.com
cbardsley@kl.com
abrown@kl.com
adelibert@kl.com
jgonzalez@kl.com
rhacker@kl.com
kingber@kl.com
mking@kl.com
rlaird@kl.com
cmeer@kl.com
cmiller@kl.com
dmiller@kl.com
dmounts@kl.com
dpeterson@kl.com
dpickle@kl.com
aporter@kl.com
tpress@kl.com
Robert H. Rosenblum
William A. Schmidt
Lori L. Schneider
Lynn A. Schweinfurth
Donald W. Smith
Martin D. Teckler
Robert A. Wittie
Leslie C. Zimberg
Robert J. Zutz
202.778.9464
202.778.9373
202.778.9305
202.778.9876
202.778.9079
202.778.9890
202.778.9066
202.778.9215
202.778.9059
rrosenblum@kl.com
william.schmidt@kl.com
lschneider@kl.com
lschweinfurth@kl.com
dsmith@kl.com
mteckler@kl.com
rwittie@kl.com
lzimberg@kl.com
rzutz@kl.com
Francine J. Rosenberger 202.778.9187 francine.rosenberger@kl.com
®
Kirkpatrick & Lockhart LLP
Challenge us.
®
www.kl.com
BOSTON
n
DALLAS
n
HARRISBURG
n
LOS ANGELES
n
MIAMI
n
NEWARK
n
NEW YORK
n
PITTSBURGH
n
SAN FRANCISCO
n
WASHINGTON
............................................................................................................................................................
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2004 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.