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News January 3, 2005 Issue

Performance-Related Fee Reduction Agreement Not Prohibited Contingent Fee, Says SEC Staff

If you want to reduce your management fee when your performance exceeds a certain target, the SECís Division of Investment Management isnít going to stop you.

In a December 23 no-action letter issued to Pacific Select Fund, the SEC staff took the position that a fee reduction arrangement under which an adviser contractually agrees to waive a portion of a mutual fundís management fee if the fundís total return over a ten-year period exceeds a target rate is not a contingent fee prohibited by the Advisers Act.

In the past, the SEC has taken the position that contingent fee arrangements under which a clientís advisory fee is decreased if the clientís account does not meet a specified level of performance are prohibited under Adviser Act Section 205(a)(1), which generally prohibits performance fee arrangements. Contingent fee arrangements, explained the staff, incentivize the adviser to "take undue risks, speculate, or engage in over-trading, because the adviser knows that it will not receive any, or will receive reduced, compensation for its work when the performance of the clientís funds has not reached the agreed upon level."

In contrast, the arrangement proposed by Pacific Life Insurance Company, the adviser to the Pacific Select Fund, put a 180 degree spin on the traditional notion of contingent fees: instead of dropping the fee if performance is bad, the arrangement would drop the fee if the performance is good. Specifically, Pacific Lifeís proposed fee arrangement would involve a waiver of a portion of the fundís management fee if the fundís average annual gross return over a ten-year period exceeded a 8 percent target return rate. The better the return, the lower the fee rate. For example, if the fundís return was 10 percent, the management fee would be reduced by half a basis point. If the fundís return was 20 percent, the management fee would be reduced by 5 basis points (the maximum amount of the waiver). If the fundís return for the ten-year period did not exceed the target rate, the fee would not be reduced. The letter set out the specific methodology by which the fundís total return would be calculated.

Interestingly, although the Pacific Select Fund consists of 31 series, the fundís overall performance would be used to determine whether the target rate was exceeded, and any applicable fee reduction would be applied across all series, regardless of the particular seriesí historical performance. And, unlike breakpoint arrangements, all asset levels of the series would receive the fee reduction.

Whyíd Pacific Life want to do it?

Fund shareholders would benefit in the form of lower expenses, explained the adviser. The program was premised on the notion that while the adviserís profits were partly a function of the size of the fund, there were "to a more significant degree a function of annual revenues, and these are directly affected by the fundís performance." Pacific Life emphasized that the shareholdersí savings under the arrangement could be significant.

But wouldnít such an arrangement take away Pacific Lifeís profit motive? In other words, if an adviser knows that the better its performance, the lower its fee rate, wouldnít that take away the adviserís incentive to outperform?

No, said Pacific Life, calling such an argument "at most, academic, and in reality, nonsensical." Among other things, it noted that 29 of the series were subadvised. "It defies logic to think that Pacific Life would intentionally intervene in portfolio management to restrain performance, and would do so on a sustained basis over a ten-year period," said Dechert LLP partner Jeffrey Puretz, who represented Pacific Life before the staff.