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News February 8, 2010 Issue

How to Oversee Your Subadviser

In the past ten years, the number of mutual funds (including funds underlying variable insurance products) that engage at least one subadviser to manage portfolio assets has almost doubled, rising from 25 percent in 1999 to almost 40 percent as of April 2009. Affiliated subadvisers have consistently dominated the space, both in sheer numbers and assets under management, but it appears that unaffiliated subadvisers have made great strides in the past decade. Funds retaining at least one unaffiliated subadviser grew from 500 a decade ago to 1,130 currently. Thatís just behind the 1,284 funds out there that employ affiliated subadvisers. However, by assets under management (outside the variable fund arena), affiliated subadvisers are still far out in front, managing almost three times as many mutual fund assets as unaffiliated subadvisers.

All this information and more can be found in the latest report from the Independent Directors Council, which addresses independent director considerations in board oversight of subadvisers.

As far as the 1940 Act is concerned, all advisers are alike when it comes to a boardís fiduciary responsibilities, right? Maybe so, says the report, but thatís not how it appears to be playing out. The report found that "a boardís oversight practices in connection with a subadviser may be quite different than with the principal adviser."

The report did not expressly state, but seemed to imply that differing contractual arrangements may influence the boardís actions. For example, the report observed that in some funds, the subadviser manages only a small portion, or "sleeve," of a fundís assets. Or, the terms of the contract with the principal adviser may include express authority to delegate a portion of its duties to a subadviser. At the other end of the spectrum, the report also observes that "[p]articularly in the case of affiliated subadvisers, it is not uncommon for the principal advisory agreement to provide that the principal adviser is responsible for the conduct of the affiliated subadviser o the same extent as if it were its own conduct."

The report offers up the framework of a boardís fiduciary responsibilities with respect to adviser relationships and provides much food for thought on the process. The report is clear that its contents "are not intended to be a model or a set of Ďbest practices,í but are intended to assist directors in considering issues pertinent to the funds they oversee."

So, what are some of the big issues raised by subadvisory arrangements?

Maintaining director independence.

Without a requisite majority of independent directors, much of the board oversight function is impaired. The board cannot approve certain contracts, appoint new directors, or authorize various business relationships. The report observes that independence issues are more complicated in fund complexes that employ subadvisers, as independent directors must maintain independence from both the principal adviser and its affiliates and all sub-advisers and their affiliates.

Independence can be compromised in obvious ways, such as by owning shares of a subadviser or its control persons. The report notes that as little as a single share can trigger interested status, too, because no de minimis exception exists. Under certain circumstances however, the presence of any such securities in an index fund that is owned by a director will not cause the director to lose independent status. No-action relief granted by the SEC in 1995 to the Victory Funds permits such share ownership.

More subtle relationships, such as a director having a home mortgage with an adviser-affiliated bank, can also compromise independence. Other "material business or professional" relationships between a director and the sub-adviser or any of its control persons can also compromise independence. A director can be exposed to these and other independence-threatening situations through the actions or status of immediate family members as well.

The report observes that determinations of independence are "complicated and highly technical," and are not limited to Investment Company Act issues. Director independence requires regular monitoring, which can be carried out by the adviser, fund counsel, and/or counsel for the independent directors. The report notes that directors should be "vigilant of relationships that could jeopardize their independence as a matter of law or perception."

Potential conflicts of interest.

The report describes a number of situations that may arise when a principal adviser seeks to retain one or more subadvisers. A principal adviser may have a potential conflict in selecting a subadviser if an affiliate of that adviser distributes the principal adviserís funds. If a proposed subadviser is an affiliate of the principal adviser Ė more often the case than not Ė boards should confirm that evaluation factors for all subadviser candidates have been evenly applied.

Will the subadviser be managing fund assets side-by-side with other accounts? If so, heightened attention to the subadviserís internal control policies, such as trade allocations, may be required to ensure conflicts are addressed appropriately. The report suggests that boards should also consider any prior relationships among principal advisers and potential subadvisers as well.

Here again, the report urges consideration of any business or financial relationships that "may present the potential for real or perceived" conflicts of interest.

Subadvisory fees.

Once an appropriate subadviser or subadvisers is found, an "integral" component in the contract process is the boardís consideration of the subadviserís fee. The report notes that typically, the fundís principal adviser pays the subadviserís fee from its own fee, although the fund may pay the subadvisory fee directly. Fee issues can be among the toughest considerations in any advisory contract, as the Jones v. Harris Supreme Court case has recently demonstrated. Subadvisory fees can raise complicating factors for consideration, such as the benefits of "branding" a fund with a subadvisory relationship, fee-for-service comparisons, and fee variances among similarly managed portfolios or accounts.

Subadviser profitability is another consideration. The report states that profitabilityís relevance may vary depending on the circumstances, and may be less relevant where the subadviser is unaffiliated. "In the case of affiliated subadvisers, the principal adviser may provide the board with profitability information for the principal adviser and the subadviser on a combined basis to reflect the profitability of a particular fund for the advisory organization as a whole."

Ongoing board oversight considerations.

Once the fundís sub-advisory arrangement is cemented, the board remains responsible to monitor the arrangement and its performance. The report notes the specific oversight responsibilities of fund boards pursuant to ICA Rule 38a-1. These responsibilities include the review and approval of service provider policies and procedures that must be reasonably designed to prevent violation of the securities laws. Service providers include advisers and subadvisers, and the adequacy of any service provider policies and procedures must be revisited at least annually.

Fortunately for the board, it can rely on the services of others to fulfill its obligations. The fundís CCO must report to the board on these matters with respect to each service provider, and the board may rely on the CCO in this capacity. Likewise, the board may invest a subcommittee with specific review responsibilities, or rely on a certification from the subadviser itself. The board may also rely on a summary of the subadviserís compliance program that is prepared by the principal adviser, the fundís CCO, or even the subadviser itself.

And what happens when the board finds a weakness?

First, says the report, the board should look to assistance and oversight from the principal adviser and the fundís CCO. They can increase scrutiny of the subadviser and address issues that could pose a risk for the fund. "If problems persist or are material," suggests the report, "and the subadviser is unresponsive to suggestions from the board or principal adviser for changes, the board may wish to initiate a dialogue with the principal adviser about replacing the subadviser."

The fundís principal adviser has similar oversight responsibilities imposed by Rule 206(4)-7. The SEC has reinforced these responsibilities by affirmatively stating in recent CCOutreach presentations and materials that CCOs are responsible for service provider compliance policies and procedures and may not simply rely on the compliance efforts of the service providers themselves. "Advisers should review each service providerís overall compliance program for compliance with the federal securities laws and should ensure that service providers are complying with the firmís specific policies and procedures" said the SEC guidance.