The SEC s Recent Focus on the 15(c) Process

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1 The SEC s Recent Focus on the 15(c) Process ICI General Membership Meeting Legal Forum Mary Hansen, Mike Malloy and Diana McCarthy Thursday, May 7, 2015

2 Introduction Section 15(c) of the Investment Company Act It shall be the dutyof the directors of a registered investment company to request and evaluate, and the dutyof an investment adviser to such company to furnish, such information as may reasonably be necessary to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of such company. Recent SEC Scrutiny on 15(c) process - Distribution in Guise - Fees Charged to Similar Clients - Exemptive Orders - Oversight of Sub-Advisers - SEC Enforcement Efforts Advisers and Boards The SEC's Recent Focus on the 15(c) Process 2

3 Distribution In Guise Recent SEC Focus distribution in guise Key Issue: Are advisory fees being used indirectly to fund distribution? When an adviser finances the distribution of fund shares, the directors of the fund, in discharging their responsibilities in connection with the approval of the advisory contract, must satisfy themselves either that the management fee is not a conduit for the indirect use of the fund s assets for distribution, or that the fund has complied with rule 12b-1 [T]here is no indirect use of fund assets for distribution if the adviser makes distribution-related payments out of its own resources. To the extent that such profits are legitimate or not excessive, i.e., not in violation of section 36 of the Act, no indirect payment for distribution occurs If the fund s directors are satisfied that any distribution payments by the adviser are made out of its own resources (including, but not limited to, the profits under the advisory contract), the directors may reasonably conclude that the advisory contract is not a conduit for the payment of distribution expenses. (SEC/ICI 1999 Supermarket Letter) The SEC's Recent Focus on the 15(c) Process 3

4 Distribution In Guise (cont.) Evaluate Gartenberg factors, including profitability SEC will focus on whether Board has robust process Disclosure key to Board s assessment - Revenue sharing payments by provider and amount; purpose of payments - Service fee payments by provider and amount; services provided Rationale for Service/Sub-TA Fees - Robust, well documented process; established methodology - Revisited annually The SEC's Recent Focus on the 15(c) Process 4

5 Fees Charged to Other Similar Clients SEC looking at fee justifications among adviser s clients Higher fees for same advisory services may be questioned - Bundled fees may pose less of an issue Appropriate comparisons should be provided (same strategies) Fee comparisons and explanations for differences clear - Standard industry list of reasons may not apply The SEC's Recent Focus on the 15(c) Process 5

6 Exemptive Orders Many exemptive orders have requirements for 15(c) determinations Examples: - Fund of Funds and duplicative services - Section 15(a) and affiliated sub-adviser changes best interests of fund and no inappropriate advantage to adviser; profitability reports The SEC's Recent Focus on the 15(c) Process 6

7 Oversight of Sub-Advisers Sub-Advisory Agreement Approval per Section 15(c) - Board approval is required initially and upon renewal - Shareholder approval required unless have a manager of managers exemptive order - Gartenberg factors apply The SEC's Recent Focus on the 15(c) Process 7

8 Oversight of Sub-Advisers (cont.) Role of Board and Investment Adviser in Contract Approvals and Ongoing Oversight - Performance - Investment Strategy and Other Compliance - Financial Condition - Resources - Compliance Policies and Procedures per Rule 38a-1 - Code of Ethics - Valuation - Proxy Voting - Soft Dollars The SEC's Recent Focus on the 15(c) Process 8

9 Oversight of Sub-Advisers (cont.) Special Issues - Liquid Alternative Mutual Funds May not be familiar with 1940 Act requirements and burdens Board and adviser monitoring of liquid alt sub-advisers Custody Concentration Liquidity Derivatives - Sub-Advisers of portfolio sleeves - evaluating performance and compliance - Recent litigation alleging excessive compensation to the adviser of sub-advised funds The SEC's Recent Focus on the 15(c) Process 9

10 SEC s Enforcement Efforts 2008 Speech - [O]ver the past 68 years the 15(c) process has evolved to the point where it requires the independent directors to engage, in person, in a detailed analysis of the investment advisory contract with each aspect of the analysis well documented. Asset Management Unit created in 2010 Mutual Fund Fee Initiative OCIE Involvement: Distribution-in-Guise Sweep Focus on Conflicts of Interest The SEC's Recent Focus on the 15(c) Process 10

11 Specific Areas of SEC Enforcement Focus - Advisers Failure to Disclose Conflicts of Interest - Portfolio Manager s interest in fund holdings - Use of brokerage commissions to meet revenue sharing obligations with broker-dealers and sales-recognition directed brokerage - Use of brokerage commissions to pay for shelf-space Failure to Furnish Necessary Information - Financial information/expense Allocation - Ability to execute on trading strategy - Use of sub-advisers The SEC's Recent Focus on the 15(c) Process 11

12 Specific Areas of SEC Enforcement Focus - Boards Boilerplate Board Minutes Delegation of fair value evaluations Policies and Procedures - Rule 38a-1 under the Investment Company Act The SEC's Recent Focus on the 15(c) Process 12

13 Mary P. Hansen Partner (215) Michael P. Malloy Partner (215) Diana E. McCarthy Partner (215) Drinker Biddle & Reath LLP All rights reserved. A Delaware limited liability partnership The SEC's Recent Focus on the 15(c) Process 13