Outline of Comments
On Proposed Amendments Requiring Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies

Release Nos. 33-8364; 34-49219; IC-26350
File No. S7-08-04

Prepared by:
Deborah D. Skeens
Division of Investment Management

Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies

List of Commenters

Table of Contents

1. Introduction
2. Discussion
1. Location of Proposed Disclosure
2. Proposed Enhancements to Disclosure
1. Selection of Investment Adviser and Approval of the Advisory Fee
2. Specific Factors
3. Comparison of Fees and Services
4. Evaluation of Each Factor
3. Contracts Covered By Proposal
1. Advisory Contracts Approved by Shareholders
2. Unaffiliated Subadvisers and Non-Sponsor Advisers
4. Compliance Date
5. Cost/Benefit Analysis
6. Paperwork Reduction Act Analysis
7. Consideration of Burden on Competition; Promotion of Efficiency, Competition, and Capital Formation
8. Regulatory Flexibility Analysis
9. Consideration of Impact on the Economy
10. Comments Unrelated to the Disclosure Proposals

Outline of Comments on Proposed Amendments Requiring Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies

I. INTRODUCTION

On February 11, 2004, the Securities and Exchange Commission (the "SEC" or "Commission") issued a release proposing rule and form amendments to improve the disclosure provided by registered management investment companies ("funds") about how their boards of directors evaluate and approve, and recommend shareholder approval of, investment advisory contracts.¹ The comment period closed on April 26, 2004. The Commission received 21 comment letters that used the file number of the proposal (S7-08-04). Thirteen of these comment letters addressed the proposed disclosure requirements in some way; the rest addressed issues related to other rule proposals or recent mutual fund scandals in general. The 13 comment letters included three from participants in the fund industry; three from professional and trade associations; two from other regulatory agencies or associations; two from data providers; one from an investor advocacy group; one from an individual investor; and one from a law student/MBA candidate.²

II. DISCUSSION

The comments that addressed the proposal were generally supportive, although some expressed concerns regarding portions of the disclosure or suggested changes. Commenters noted, for example, that the proposed disclosure requirements will cast much needed light on the process by which fund advisers are selected,³ and that they will help to make fund boards more conscientious in reviewing the advisory contract with an eye toward ensuring that fees are reasonable.⁴ However, one commenter expressed general concern that the proposed disclosure could unexpectedly result in higher fund fees, and argued that the proposed disclosure concerning board oversight of contracts could encourage unethical fund complexes to increase assets by gaining control of boards of smaller funds, then "firing" the existing manager and "hiring" themselves.⁵

A. Location of Proposed Disclosure

Summary: The Commission proposed amendments to Forms N-1A, N-2, and N-3 that would require fund shareholder reports to discuss, in reasonable detail, the material factors and the conclusions with respect thereto that formed the basis for the board of directors' approval of investment advisory contracts. This requirement would apply to shareholder reports of open- and closed-end management investment companies and insurance company managed separate accounts that offer variable annuities. The shareholder reports disclosure would be required for any new investment advisory contract or contract renewal, including subadvisory contracts, approved during the semi-annual period covered by the report, other than a contract that was approved by shareholders.

Eight commenters expressly addressed issues relating to the location of the proposed disclosure.⁶ Five commenters specifically supported adding the proposed disclosure to shareholder reports;⁷ and four of these commenters also supported removing it from the SAI.⁸ One of these commenters argued that inclusion of such disclosure in shareholder reports would cast much needed light on the process by which fund advisers are selected and management contracts evaluated and approved, and that shareholder reports are the one fund document most likely to be read by investors.⁹

One of the commenters who supported requiring the disclosure in shareholder reports urged the Commission to require inclusion of this information in each semiannual and annual report, in a location that is consistent in every report, and clearly marked.¹⁰ However, another of the commenters who supported requiring the disclosure in shareholder reports recommended that this disclosure be included in annual shareholder reports only, because the annual shareholder report is the location where shareholders are most likely to read and benefit from such disclosure.¹¹

Three commenters recommended that, if the Commission removes disclosure regarding directors' approval of the advisory contract from the SAI, funds should be required to include a cross-reference in the SAI and/or prospectus to such disclosure in shareholder reports.¹² Another commenter objected to cross-referencing, and supported requiring the disclosure in the SAI, proxy statements, and shareholder reports, as proposed.¹³

Two commenters opposed the proposal to require disclosure about the board's review of advisory contracts in shareholder reports.¹⁴ Both of these commenters argued that this disclosure may be lengthy, especially if a shareholder report relates to more than one fund or the fund has multiple advisers. Both commenters also noted that information in fund reports must be certified under Form N-CSR, and argued that it was inappropriate to require fund officers to certify disclosures that relate to actions for which the fund's directors, and not the officers, are responsible. One of these commenters recommended placing summary disclosure about the basis for the board's approval of the advisory contract in the prospectus, with a cross-reference to more extensive information in the SAI.¹⁵ The other commenter argued that this disclosure should remain in the SAI and proxy statements.¹⁶

One of the commenters who opposed requiring disclosure in shareholder reports stated that, if the Commission decides to require such disclosure in periodic reports, such disclosure should be made only in the annual reports (arguing that, otherwise, a fund would be required to make the same disclosure twice in one year). The same commenter further recommended that the Commission should not require certification of this information in the annual report, and should not require the disclosure in the SAI.¹⁷

Three commenters recommended that the proposed disclosure be provided in the prospectus as well as in shareholder reports, noting that this would allow prospective investors to evaluate the fund board's effectiveness in negotiating contract terms prior to purchasing a fund.¹⁸ One of these commenters also recommended that the Commission conduct research to determine the best location for the disclosure.¹⁹ Four commenters also recommended that the Commission should require the proposed disclosure on fund company websites.²⁰ One of these commenters recommended that all the materials that the board compiles for contract renewal should be available on the fund's website or by mail for a nominal fee.²¹

B. Proposed Enhancements to Disclosure

Summary: The Commission proposed enhancements to existing disclosure requirements that would require a fund's discussion to include: (1) factors relating to both the board's selection of the investment adviser and its approval of the advisory fee and any other amounts to be paid; (2) several specific factors, including (i) the nature, extent and quality of the services to be provided by the adviser; (ii) the investment performance of the fund and of the adviser; (iii) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from its relationship with the fund; (iv) the extent to which economies of scale would be realized as the fund grows; and (v) whether fee levels reflect these economies of scale for the benefit of fund investors; and (3) whether the board relied on comparisons of the fees and services provided by the fund adviser with those under other advisory contracts. In addition, the proposed enhancements would clarify that the fund's discussion must state how the board evaluated each factor.

Seven commenters specifically addressed the proposed enhancements to the existing SAI and proxy statement disclosure requirements.²² Five commenters specifically noted their support of these proposed enhancements.²³ However, one commenter suggested that added disclosure regarding advisory contract deliberations is unlikely to enhance shareholder understanding of total fund expenses and could, in fact, have a deleterious effect.²⁴

1. Selection of Investment Adviser and Approval of the Advisory Fee

Two commenters objected to language in the proposal that would require a fund to discuss factors relating to the board's selection of the fund's investment adviser.²⁵ Both commenters argued that the fund's investors, and not the board, select the adviser by purchasing fund shares. One of the commenters stated that use of the phrase "selection of the investment adviser" was misleading because it suggested that the board's annual review was an annual opportunity to replace the adviser. ²⁶ This view is unrealistic, this commenter noted, because it is not the role of the board to override the investors' choice except in the most egregious circumstances.

The Commission also requested comment on whether a fund should disclose whether the board separately assessed amounts to be paid under the contract for portfolio management services and amounts to be paid for other services. Three commenters supported this idea as a means of encouraging fund boards to negotiate the best terms possible for each service provided for their funds.²⁷ By contrast, another commenter opposed this idea on the grounds that such disclosure could be misleading because some boards do not or cannot separately assess amounts to be paid for different services.²⁸ Another commenter suggested that the fund should be required to disclose any relationship between the portfolio manager and a third-party service provider.²⁹

2. Specific Factors

Three commenters specifically addressed the proposal to require a fund to include a discussion of the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund.³⁰ One commenter supported this proposed disclosure requirement on the grounds that it should make boards more conscientious in their evaluation and advisory firms more cooperative in providing the necessary information at an appropriate level of detail.³¹ Another commenter recommended that funds not only be required to discuss costs and profits, but disclose all amounts paid or received by the adviser and its affiliates in a tabular form, in order to adequately portray the true cost to the fund of doing business with that adviser.³² A third commenter argued that requiring disclosure of actual cost and profit information could have a harmful competitive effect on investment advisers, and requested that the Commission confirm that a fund would be required to discuss only the process by which the board analyzed such costs and profits, without identifying specific proprietary and confidential operating cost and profit information.³³

Two commenters addressed the proposed requirement that a fund discuss the extent to which economies of scale would be realized as the fund grows, and whether fee levels reflect these economies of scale.³⁴ One commenter supported the proposed disclosure requirement, noting that recent studies show that fee reductions adopted as funds grow may not fully reflect the economies of scale that are realized, and that requiring funds to discuss board review of this issue should help to ensure that shareholders capture a fair share of the benefits of fund growth.³⁵ The other commenter questioned how the term "economies of scale" should be defined for funds of varying sizes, and voiced concern that such disclosure would have a disproportionate negative impact on smaller funds because such funds would not have the resources to employ third-party assistance to help their boards review this issue.³⁶

3. Comparison of Fees and Services

Seven commenters addressed the issue of whether a fund should be required to disclose whether the board relied on comparisons of advisory services and advisory fees under the contract with those under other advisory contracts.³⁷ Of these, four generally supported the proposed disclosure requirement,³⁸ one of whom argued that any responsible board would at least seek to compare the terms of the contract under consideration with relevant terms for similar funds.³⁹ Three other commenters raised concerns relating to certain aspects of the proposed disclosure.⁴⁰

Two of the commenters who supported the proposed requirement also recommended that some type of comparison be mandatory.⁴¹ The remaining two commenters who supported the Commission's current proposal argued that any board choosing not to make such a comparison should be required to disclose the reasons why it made that decision.⁴²

Two commenters addressed the use of peer group data to make comparisons among advisory contracts.⁴³ One commenter recommended that the proposal should require funds to identify the source of any comparative peer group data used in the evaluation of contract terms.⁴⁴ The second suggested that a fund be required to run peer group comparisons and list a minimum of 10 funds closest to it in structure.⁴⁵

Of the commenters who raised concerns about the proposed disclosure requirement, one commenter opposed the Commission mandating that boards rely on fee and service comparisons in connection with the performance of their contract renewal responsibilities.⁴⁶ Another argued that it would be inappropriate to compare fees and services under an advisory contract with those under contracts with other types of clients, such as pension funds, since it would result in an "apples to oranges" comparison. Therefore, this commenter recommended that the proposed disclosure requirement regarding comparisons to pension funds and other institutional investors be eliminated from the final rule.⁴⁷

A third commenter recommended limiting the requirement for boards to disclose whether they relied on comparisons of services to be rendered and amounts to be paid to cases of contracts under which the same adviser provides similar services to another entity, including a pension fund, at a lower cost. This commenter noted that the proposed requirement may lead fund directors to believe that they have satisfied their obligations to ensure that fund costs are reasonable as long as the board ascertains that the contract's costs are roughly in line with those charged by other fund companies, and argued that it would be counter-productive if this disclosure requirement were used to institutionalize this practice.⁴⁸

4. Evaluation of Each Factor

Four commenters addressed the proposed requirement to discuss how the board evaluated each factor that formed the basis for the board's approval of, or recommendation that shareholders approve, an advisory contract,⁴⁹ two of whom generally supported this requirement.⁵⁰ One of these commenters noted that the proposed requirement that the fund's discussion state how the board evaluated each factor would be extremely useful in achieving the goal of requiring boards to discuss these issues in reasonable detail.⁵¹ Another of these commenters urged the Commission to require express disclosure of how the board evaluated each specific factor, and what the board concluded from the evaluation of that factor.⁵²

Another commenter was generally supportive of a requirement for funds to disclose, with adequate specificity, the board's basis for its approval of an advisory contract, but noted concern that the proposals could result in very lengthy disclosures and/or have a chilling effect on discussions among fund directors with respect to advisory contracts.⁵³ This commenter noted that the proposal seems to require that a fund disclose every conclusion reached by the fund board with respect to each specific factor considered in its evaluation of an advisory contract.⁵⁴ The commenter noted that fund boards typically reach conclusions based on a totality of factors and requested clarification that fund directors would not be required to reach conclusions with respect to each specific factor relating to review of advisory contracts.⁵⁵

In response to the Commission's request for comment on whether the proposal's enumeration of specific factors would cause funds to omit discussion of other factors, one commenter suggested that the proposed language be made more forceful to clarify that omission of material factors is not permitted.⁵⁶ Another commenter noted that the more the Commission dictates specific factors, the more likely it is that boards will regress to a "check the box" methodology, rather than use their business judgment and conduct independent analyses.⁵⁷

One commenter also suggested that multiple funds in the same complex should be permitted to provide similar disclosure under this proposal, since the boards of such funds are likely to engage in a review process that is fairly uniform across the funds.⁵⁸

C. Contracts Covered By Proposal

1. Advisory Contracts Approved by Shareholders

Two commenters specifically expressed support for the expanding the proposed requirement for disclosure in shareholder reports to cover all advisory contracts that were approved by the board during the reporting period, including contracts that were also approved by shareholders.⁵⁹ They argued that shareholder reports receive more scrutiny from investors than do proxy statements.

2. Unaffiliated Subadvisers and Non-Sponsor Advisers

One commenter specifically addressed the issue of whether funds should be required to discuss board review and approval of contracts with unaffiliated subadvisers, and another commenter raised the same issue with respect to "non-sponsor advisers" (i.e., investment advisers to funds that are sponsored by third parties that are unaffiliated with the adviser). Both recommended that funds be allowed to make only abbreviated disclosure with respect to such contracts.⁶⁰ Both commenters argued that such contracts differ from contracts with a fund's principal adviser (or sponsor adviser) in that (1) such contracts are negotiated at arm's length; and (2) the board's directors consider different factors when reviewing such contracts.⁶¹

The commenters argued that directors are not likely to consider the costs of the unaffiliated subadviser's or non-sponsor adviser's services and the profits to be realized by the unaffiliated subadviser or non-sponsor adviser, since the most important factors with respect to such contracts involve the adviser's performance, the expertise of its portfolio managers, and the nature of the services to be provided.⁶² One of the commenters noted further that an unaffiliated subadviser or non-sponsor adviser is unlikely to share proprietary information relating to costs and profits with a third party fund sponsor.⁶³ The second commenter added that requiring disclosure of such costs and profits could discourage advisers from offering management services to unaffiliated funds, and could thereby inhibit competition for such contracts.⁶⁴ This commenter further argued that if non-sponsor advisers are required to disclose fees paid under their contracts, they may be reluctant to offer discounts in their standard fee rates.⁶⁵

With respect to unaffiliated subadvisers, one of the commenters added that the Commission's proposal could result in very lengthy disclosure about approval of such contracts, since funds often have several such subadvisers.⁶⁶ Consequently, the commenter recommended that the Commission revise the current proposed disclosure to permit streamlined discussion of unaffiliated subadvisory contracts on an aggregate basis, including the board's consideration of relevant factors for subadvisers as a group. This commenter argued that such abbreviated disclosure would be consistent with the recent Manager of Managers proposal, which permits funds to disclose subadvisory fees on an aggregate rather than an individual basis.⁶⁷

With respect to non-sponsor advisers, the second commenter recommended that the Commission revise the proposal to allow a fund to disclose in the relevant disclosure document that the fund's board has found that the arrangement with the non-sponsor adviser is the result of arm's-length bargaining.⁶⁸ In the alternative, this commenter suggested that the Commission could provide an exception for such non-sponsor advisers, or, at a minimum, restrict the mandatory factors disclosed to those that go into an arm's-length negotiation (i.e., relative performance of core advisory services and the fees of the core advisory services; no discussion of the actual fees charged by the non-sponsor adviser and its competitors, or the profitability to the non-sponsor adviser from the relationship). In support of these recommendations, the commenter also argued that the board's fiduciary duty under Section 36(b) of the Investment Company Act is less acute for non-sponsor advisers than for sponsor advisers, and that lengthy disclosure with respect to board review of such advisory contracts would confuse investors by implying that the board's evaluation of non-sponsor advisers is the same as its review of sponsor advisers. ⁶⁹

D. Compliance Date

Summary: The Commission proposed to require that all fund reports to shareholders, all registration statements, all post-effective amendments that are either annual updates to effective registration statements or that add a new series, and all fund proxy statements filed on or after the effective date of the amendments comply with the proposed amendments.

Three commenters suggested a compliance date for the proposed amendments.⁷⁰ One commenter recommended a 12-month transition period in order to give fund boards sufficient time to refine existing procedures, if necessary.⁷¹ The commenter emphasized that it is important for the requirements to apply prospectively because of the possibility that, for contracts approved before the adoption of the new requirements, not all of the information needed to comply with the requirements necessarily will have been recorded. A second commenter encouraged the Commission to require compliance as soon as possible and stated that there is no reason that disclosure should not be mandatory in all relevant documents filed after December 31, 2004.⁷² The third commenter suggested that funds be required to comply with these amendments by the beginning of the first calendar year following their adoption, provided that adoption occurs at least three months before the end of the year.⁷³

E. Cost/Benefit Analysis

There were no comments specifically related to the Cost/Benefit Analysis.

F. Paperwork Reduction Act Analysis

There were no comments specifically related to the Paperwork Reduction Act analysis.

G. Consideration of Burden on Competition; Promotion of Efficiency, Competition, and Capital Formation

There were no comments specifically related to this section.

H. Regulatory Flexibility Analysis

There were no comments specifically related to the Regulatory Flexibility Analysis.

I. Consideration of Impact on the Economy

There were no comments specifically related to this section.

J. Comments Unrelated to the Disclosure Proposals

Eight comments did not address the disclosure proposals at all.⁷⁴ These included three commenters that expressed support for increased disclosure in general regarding mutual funds and more stringent regulation over the fund industry.⁷⁵ One commenter expressed opposition to excessive fund fees and encouraged the Commission to adopt increased record-keeping and disclosure requirements.⁷⁶ One commenter suggested that the Commission require funds to adopt codes of ethics regarding personal trading by fund employees; to disclose selling and buying of fund shares by "professionals"; and to select independent boards of directors, including independent board chairmen.⁷⁷ Another commenter cited the need for fund and stock investors to have access to as much information as possible, including information relating to the reasons brokerage houses upgrade or downgrade a stock.⁷⁸ One commenter expressed opposition to proposed amendments to rule 12b-1,⁷⁹ and one commenter supported greater transparency in the public trading of stock.⁸⁰

Four commenters that addressed the disclosure proposals also offered other suggestions to deal with fund governance and other fund-related issues.⁸¹ One of these commenters suggested that the proposed disclosure be coupled with other efforts to increase the visibility of fund boards, and recommended that each fund prospectus be required to begin with an explanation of the fund's corporate structure.⁸² Another commenter noted its support for legislation to strengthen the definition of independent director; to extend the fiduciary duty of fund boards to ensure that the totality of fund fees are reasonable; and to allow the Commission to impose its reforms directly without need to apply them as a condition of various exemptive rules.⁸³ The third commenter recommended that the Commission consider requiring that an investment adviser and its affiliates not be affiliated with the fund that is overseen by such adviser, arguing that this requirement would lessen conflicts of interest and reduce financial risk to shareholders.⁸⁴ Another commenter urged the Commission to require that any fund that uses Lipper data for board work not be permitted to use Lipper awards or indexes for other purposes.⁸⁵

Endnotes

¹ Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, Release Nos. 33-8364; 34-49219; IC-26350 (Feb. 11, 2004) [69 FR 7852 (Feb. 19, 2004)] ("Proposing Release").

² Engbrock; Fund Democracy/CFA; ICI; ICI Directors' Committee; ICAA; Lamberton; Massachusetts; Morningstar; NASAA; Rottersman; Spitler; T. Rowe Price; Wellington.

³ Morningstar.

⁴ Fund Democracy/CFA.

⁵ Lamberton.

⁶ Fund Democracy/CFA; ICI; ICI Directors' Committee; Morningstar; NASAA; Rottersman; Spitler; T. Rowe Price.

⁷ Fund Democracy/CFA; ICI Directors' Committee; Morningstar; NASAA; Spitler.

⁸ Fund Democracy/CFA; ICI Directors' Committee; Morningstar; Spitler.

⁹ Morningstar.

¹⁰ Id.

¹¹ ICI Directors' Committee.

¹² ICI Directors' Committee; Morningstar; Spitler.

¹³ NASAA.

¹⁴ ICI; T. Rowe Price.

¹⁵ ICI.

¹⁶ T. Rowe Price.

¹⁷ ICI.

¹⁸ Fund Democracy/CFA; Morningstar; Spitler.

¹⁹ Fund Democracy/CFA.

²⁰ Morningstar; NASAA; Rottersman; Spitler.

²¹ Rottersman.

²² Fund Democracy/CFA; ICI; ICI Directors' Committee; Morningstar; NASAA; Rottersman; Spitler.

²³ Fund Democracy/CFA; Morningstar; NASAA; Rottersman; Spitler.

²⁴ ICI Directors' Committee.

²⁵ ICI; ICI Directors' Committee.

²⁶ ICI Directors' Committee.

²⁷ Fund Democracy/CFA; Morningstar; Spitler.

²⁸ ICI.

²⁹ Rottersman.

³⁰ Fund Democracy/CFA; ICAA; NASAA.

³¹ Fund Democracy/CFA.

³² NASAA.

³³ ICAA.

³⁴ Fund Democracy/CFA; ICI Directors' Committee.

³⁵ Fund Democracy/CFA.

³⁶ ICI Directors' Committee.

³⁷ Fund Democracy/CFA; ICI; ICI Directors' Committee; Morningstar; NASAA; Rottersman; Spitler.

³⁸ Morningstar; NASAA; Rottersman; Spitler.

³⁹ Morningstar.

⁴⁰ Fund Democracy/CFA; ICI; ICI Directors' Committee.

⁴¹ NASAA; Rottersman.

⁴² Morningstar; Spitler.

⁴³ Morningstar; Rottersman.

⁴⁴ Morningstar.

⁴⁵ Rottersman.

⁴⁶ ICI Directors' Committee.

⁴⁷ ICI.

⁴⁸ Fund Democracy/CFA.

⁴⁹ Fund Democracy/CFA; ICI; ICI Directors' Committee; Morningstar.

⁵⁰ Fund Democracy/CFA; Morningstar.

⁵¹ Fund Democracy/CFA.

⁵² Morningstar.

⁵³ ICI.

⁵⁴ ICI.

⁵⁵ Id.

⁵⁶ Morningstar.

⁵⁷ ICI Directors' Committee.

⁵⁸ ICI.

⁵⁹ Morningstar; NASAA.

⁶⁰ ICI; Wellington Management.

⁶¹ Id.

⁶² ICI.

⁶³ Id.

⁶⁴ Wellington Management.

⁶⁵ Id.

⁶⁶ ICI.

⁶⁷ ICI. See Exemption From Shareholder Approval for Certain Subadvisory Contracts, Release No. IC-26230 (Oct. 23, 2003) [68 FR 61720 (Oct. 29, 2003)].

⁶⁸ Wellington Management.

⁶⁹ Id.

⁷⁰ ICI; Morningstar; Spitler.

⁷¹ ICI.

⁷² Morningstar.

⁷³ Spitler.

⁷⁴ Cohen; Donohue; Grant; Hessuey; Johnston; Schall; Smith; Westgard.

⁷⁵ Cohen; Donohue; Johnston.

⁷⁶ Grant.

⁷⁷ Hessuey.

⁷⁸ Schall.

⁷⁹ Smith.

⁸⁰ Westgard.

⁸¹ Fund Democracy/CFA; Morningstar; NASAA.

⁸² Morningstar.

⁸³ Fund Democracy/CFA.

⁸⁴ NASAA.

⁸⁵ Rottersman.

http://www.sec.gov/rules/extra/s70804summary.htm