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News July 26, 2004 Issue

SEC Enforcement Attorneys Honing In on Fund Advisory Contracts

The SECís Division of Enforcement is conducting at least four investigations of fund advisers and directors relating to the directorsí approval of fund advisory contracts. The investigations are focusing on a perceived failure of the directors to comply with the procedural requirements of Section 15(c) of the Investment Company Act. Under 15(c), directors are obligated to request and evaluate any information that is reasonably necessary to evaluate the terms of the fundís advisory contract.

The enforcement staff, said one industry attorney familiar with the investigations, "is attempting to put some teeth in Section 15(c)." Another industry participant described the investigations as an attempt to put a "gloss" on the Gartenberg standard. It is rare for the SEC to sue fund directors (a notable recent exception being the SECís case late last year against the Heartland Fund directors relating to municipal bond pricing issues).

Although the SEC has publicly proclaimed that it is not interested in "rate-setting," one adviser already has lowered its management fee (on an index fund) in the face of the inquiries. However, advisers donít appear to be the primary focus of the investigations. In one instance, the investigation began as an inquiry about the adviser, but then sharply shifted to the directors.

Already, the staff has issued at least one Wells notice in connection with the investigations, although based on a review of recent SEC filings the recipient of the notice apparently has not chosen to specifically disclose it. Before recommending that the Commission approve a formal enforcement proceeding, the enforcement staff may issue a Wells notice to inform a firm of the pending charges. Firms may make a Wells submission back to the staff in an effort to persuade them that a formal action is unwarranted.

Last week, the staff was considering whether to issue Wells notices in the other cases.

Earlier this month, Morgan Stanley disclosed that the SEC is conducting an investigation regarding the amount of fees charged by certain of its index funds "as well as the process by which those fees were determined." Morgan Stanley did not mention a Wells notice.

In focusing on whether directors have met their obligations under Section 15(c), SEC enforcement attorneys are applying some rather creative tests.

Hereís what IM Insight is hearing:

  • Using Vanguard as a benchmark. Enforcement attorneys asked the directors of one money market fund why they did not compare the expenses of their fund to lower-cost money market funds, such as those managed by Vanguard, said one attorney. According to another source, "Vanguard was used as the standard."
  • Focusing on outsourcing. The staff asked one adviser why it did not outsource the management of its index fund to another firm that would have charged "two or three basis points" less, said one attorney. Another lawyer described outsourcing as a "buzzword" that the enforcement staff has picked up on.
  • Assuming that a primate can run an index fund. An SEC enforcement attorney recently referred to running an index fund as "monkey work," according to one attorney. "Thatís not only flip," he said. "Itís wrong." Another lawyer said that "the staff is only now beginning to understand that it takes some brains to run an index fund." He pointed out that portfolio managers of index funds have to deal with cash flow and redemptions and may have to rebalance the portfolio on a daily or weekly basis. If the index is tax managed, he added, the manager must take gains and losses into consideration. Moreover, some index fund managers use derivatives to track the index, or engage in securities lending to boost the fundís return. "There are all sorts of management choices," said the lawyer. "Itís not as simple as ĎBuy everything in the S&P 500 and hold it foreverí, although thatís what the kids seem to think," he said, referring to the youthful SEC enforcement staff.
  • Taking X minutes and Y funds and doing the math. In perhaps the most novel approach to looking at 15(c), SEC enforcement attorneys seem to have concluded that the directors of one index fund breached 15(c) because they spent only six minutes considering the fundís advisory contract. The staff came to that six minute number by taking the amount of board time spent on the 15(c) approvals and dividing that by the number of funds the board was responsible for overseeing. Spending roughly six minutes per fund, they seem to have concluded, represents a per se violation of Section 15(c).

"Thatís ridiculous!" exclaimed more than one investment management attorney when asked about that methodology. Several pointed out that boards spend a significant amount of time before the board meeting reviewing board books and that board meeting time is spent focusing on "problem children."

Said one: "If this is flunking behavior, then everybody flunks."

Even fund industry critic Mercer Bullard agreed. While he called the amount of time spent in a meeting "relevant," he emphasized that should not, by itself, be used to determine whether a board met its Section 15(c) obligations. "The amount of time spent in the actual meeting evaluating the contract is not by itself dispositive as to whether the independent directors have fulfilled their duty under Section 15(c)," said Bullard, founder of fund shareholder advocacy group Fund Democracy.

Of course, the enforcement staff ultimately may decide not to recommend that the Commission authorize formal enforcement proceedings against the advisers and directors under investigation. And if they do, "whether the Commission will agree is another matter," as an industry attorney put it. "This is being driven by the enforcement people," he added. "Iíd like to know where the Ď40 Act people are."