The New Board Approval Process: What Should Subadvisers Expect?
With all the hullabaloo surrounding the SECís independent chairman proposal, you may not have paid much attention to another rulemaking quietly making its way through the SECís pipeline: a new requirement that a fund describe, "in reasonable detail," the material factors its board considered, and the conclusions the board reached, when approving the fundís adviser(s) and fees.
If your firm advises or subadvises a fund, itís time to sit up and pay attention. The rule amendments, which were adopted late last month, will have a direct affect on how your firm presents itself for board approval or reapproval beginning this fall.
Hereís why: As you may know, funds have long been required to disclose in their SAIs and proxy reports how their boards selected their advisers. The recent amendments kicked that disclosure up several notches by:
putting it in the annual and semi-annual shareholder reports, with a cross-reference in the prospectus (the disclosure will stay in proxies, but will be phased out of the SAI);
requiring the fundís principal executive and financial officers to certify, based on their knowledge, that the disclosure is accurate; and, most significantly,
effectively requiring the board to trot down a specific list of factors and spell out their conclusions for each, or to discuss why they didnít think a specific factor was relevant.
"When people have to explain a decision publicly they are forced to think about it more," said Bingham McCutchen partner Roger Joseph. "I think in the end it will be a much more powerful influence on board members to know that they have to publicly justify their positions than the independent chairmanship [requirement]."
Subadvisers may feel the change the most. In the past, many subadvisers viewed the fundís adviser as "the client" that made the hire/fire decision. Even though subadvisers ó including those for funds operating with a manager-of-managers order ó were technically subject to a full 15(c) board review and approval, the process may have been viewed as more of a formality than a presentation before a true decision-maker. "The old concept was, ĎThe adviser chose you because of performance and fees, and all you have to do is show the board that you are a real firm, end of inquiry,í" said one fund industry insider. "Now, the board has to make inquiries and findings about performance and fees independent of the adviserís findings."
But wait a minute. Just nine months ago, didnít the SEC say that its proposed manager-of-manager amendments "would largely rely on the principal adviser, negotiating with each subadviser on an armís length basis and subject to the approval of the fundís board, to determine the terms of the subadvisory contract, including the amount of the subadviserís fee?"
Apparently, that reliance didnít carry much weight in the board approval disclosure context. The SEC made clear that there will be no "disclosure-lite" for the boardís approval of unaffiliated subadvisers, declining requests by the Investment Company Institute and Wellington Management Company to tailor the disclosure requirements for unaffiliated subadvisers. The agency did, however, add an instruction that permits all funds to tailor the disclosure to their particular circumstances, by substantively addressing each of the listed factors or by explaining why the factor is not relevant. The SEC warned that unaffiliated subadvisers may have other material business arrangements with the fundís adviser or principal underwriter, and that the board should consider those arrangements when evaluating a subadviserís contract (to be fair to the SEC, the manager-of-managerís release contained a similar warning, although it was buried in a footnote and was not specifically geared towards those dangerous unaffiliated subadvisers).
What, exactly, do funds and boards have to do? The new rule amendments require funds to describe the boardís "selection" process for all advisers and subadvisers that came up for approval during the six-month period covered by the report. (As an aside: The SEC, in the adopting release, said that the directorsí decision to renew an advisory contract effectively constitutes the "selection" of the adviser, despite being asked by the ICI not to use that particular term. To temper the s-word a bit, the SEC made a point of stating that it would not expect that boards routinely replace advisers.)
The funds must discuss, "in reasonable detail," a list of material factors that the board considered when approving the fundís adviser and subadviser, and their advisory fees and other compensation paid by the fund. The fund must discuss the conclusions the board reached with respect to each factor.
Lest folks wonder what material factors should be considered, the SEC provided a non-exclusive list:
the nature, extent, and quality of the adviserís services;
the fundís investment performance;
the adviserís investment performance;
the costs of the services to be provided and profits to be realized by the adviser and its affiliates from their relationship with the fund; and
the extent to which economies of scale would be realized as the fund grows and whether the fundís fee levels reflect these economies of scale.
The SEC also said that the disclosure must discuss whether the board relied on comparisons of the services and fees under the fundís contract, on one hand, with 1) the services and fees provided by the fundís adviser to a) other registered funds and b) other clients, such as pension funds, as well as comparisons against 2) the services and fees provided by other advisers to a) other registered funds b) other advisory clients. In case you lost count, thatís a total of four different types of comparisons. The fund is required to describe the comparisons and how they assisted the board in concluding that the contract should be approved.
The fund also must disclose whether the board discussed the benefits that will flow to the adviser from its relationship with the fund, such as soft dollar arrangements by which brokers provide research to the fund or its adviser in return for fund brokerage.
The SEC said that funds are not required to disclose the fee paid to an unaffiliated subadviser if that information is not otherwise be required to be disclosed.
The SEC clarified that a fund need not disclose specific proprietary information about the adviserís, or its affiliates, operating costs and profits. However, boards are likely continue to ask for it. Joseph pointed out that the practice of advisers providing profit and loss information to a board is not new, noting that the practice was cited with approval in the 1980s Gartenberg case. "Boards typically get it with a varying level of kicking and screaming," explained Joseph, adding that "people established in the businesses donít kick and scream" about providing P&L information.
The new challenge, said Joseph, is for boards to explain why their conclusion with respect to the adviserís P&L was reasonable, without actually disclosing the number. "The tightrope they now have to walk is to explain their consideration of that factor without actually disclosing the profit and loss," he said. "Iím sure itís doable but it takes some art because you donít want to get into a situation where a board or a fund gets sued where someone alleges ĎYou said it was reasonableí and it turns out [the adviser was making] an 85 percent profit."
Will boards request different, or more, information? Joseph said it was unlikely that the new disclosure standards would prompt boards to request significantly greater volumes of information from subadvisers, since boards already typically receive very good information from their advisers. "The material provided to the boards will not look a lot different from what it always has," Joseph said, noting that "people out there are doing a generally pretty good job" in providing boards with information.
Constellation Funds CEO John Grady agreed. He pointed out that the amount of information that provided by subadvisers has increased in recent years. For example, instead of just discussing the subadviserís policies and procedures during the meeting, the board, and presumably the fundís adviser, is more likely to request the subadviserís policies and procedures in written form and review them (or have independent board counsel review them) prior to the meeting. He also said that subadvisers are being asked to supply written records farther in advance of the meetings.
Will the dynamics of the board presentation change? Yes. It seems safe to say that subadvisers should expect more questions from the board, and may have to spend a longer time cooling their heels outside the meeting before being brought in for the vote.
The amendments "are going to require more time spent in the board meeting actually articulating what the board is thinking on each of these factors, so they can be reflected in the minutes and in turn be reflected in the public disclosure," said Joseph. "What may not exist today is something in the minutes that really explains what the board was thinking in approving the contracts." He predicted that the board will spend more time not only discussing the facts, but additionally discussing how they want to explain their position. In the past, he said, those discussions typically have been focused on "okay, where are the problems, where are the issues?" When the adviser comes back into the room, "that could be the point when the board articulates its thinking process."
In contrast, Grady said that board discussion of a subadviser may not take longer than before. Because of the more complete board materials being provided to subadvisers, "it may be the case that there are fewer surprises or open issues" to discuss, he said.
And how long will this take, exactly? Then thereís the logistical issue of how a fund board faced with approval of numerous subadvisers is going to find the time to consider, for each subadviser, all of the ruleís factors and reach conclusions for each factor.
"This is really crystal ball gazing," said Morgan Lewis & Bockius partner John McGuire, "but I think youíre going to end up with a matrix." The matrix, he said, could list each of the factors that the board is supposed to consider under the rule. The subadviser could be asked to explain, in plain English, why it thinks the board should approve it, given each factor.
The subadviser could provide language that could be used to craft the minutes and the shareholder reports. "Not necessarily verbatim," added McGuire, explaining that the board would be looking for a rationale with which it can agree or disagree. Then, the board and fund counsel can edit the rationale, rather than "making it up from whole cloth."