Investment Company Institute
January 8, 2004
Mr. Jonathan G. Katz
Re: Exemption from Shareholder Approval
Dear Mr. Katz:
The Investment Company Institute1 is pleased to provide comments on the Securities and Exchange Commission's proposal to adopt new Rule 15a-5 under the Investment Company Act of 1940, which would, under certain conditions, permit so-called "manager of managers" funds to operate without obtaining shareholder approval when the fund's principal investment adviser hires a new subadviser or replaces an existing subadviser.2 The proposal is designed to reduce burdens on manager of managers funds by eliminating the need for these funds to obtain a Commission exemptive order prior to engaging in these arrangements.
The Institute generally supports the Commission's proposal. The proposal incorporates many of the same shareholder protection measures contained in the Commission's manager of managers exemptive orders, including measures relating to: (1) subadvisory fees;
(2) supervision of the subadviser; (3) conflicts of interest; (4) board oversight; and (5) investor expectations. As set forth below, our comments are largely technical and are intended to help further the goal of maintaining important investor protections, ensure that manager of managers funds fully benefit from the Commission's proposed rule, and minimize unnecessary burdens that might result from some of the rule's conditions.
In summary, the Institute's comments are as follows.
Each of these points is discussed in more detail below.
A. Obligation to Supervise Subadvisers
Proposed Rule 15a-5(a)(4) would require the principal adviser's contract with the fund to include a provision obligating the principal adviser to "supervise and oversee the activities of" the subadviser under the subadvisory contract.3 The Institute generally supports this requirement, to the extent that it would codify a condition contained in the Commission's existing orders, i.e., that a principal adviser should supervise its subadvisers. We have two comments on the proposed condition.
First, we are concerned that requiring a principal adviser to "oversee the activities of" its subadvisers could be interpreted to impose a responsibility on the principal adviser to take an active role in managing the activities of each of its subadvisers. Such an interpretation would go beyond the conditions in the Commission's exemptive orders4 and would impose a difficult and inappropriate burden on principal advisers, particularly those that utilize unaffiliated subadvisers, which represent a substantial segment of the industry. Subadvisers are bound contractually to manage all or a portion of a fund's portfolio securities. The principal adviser exercises general oversight responsibilities to ensure that the subadviser adheres to the terms of the contract with respect to its obligations to the fund. We do not believe that the Commission intended to adopt a rule that would require a principal adviser to micromanage the activities of each of its subadvisers. Accordingly, we recommend that the final rule modify the phrase "supervise and oversee the activities of their subadvisers," by deleting the words "the activities of."
Second, we note that the proposed rule text uses the phrase "supervise and oversee," whereas the conditions contained in the Commission's exemptive orders typically only use the term "oversee." The Proposing Release does not state why both obligations are needed, and what if any distinction exists between them.5 In order to avoid redundancy, we recommend that the final rule should use only one of the two terms, but not both. In any case, we urge the Commission to clarify that the use of either of these terms in an advisory contract would satisfy the proposed condition.
B. Arm's Length Relationship Between Principal Adviser and Subadvisers
The Commission's proposed rule would prohibit (except in the case of wholly-owned subadvisers) a fund's officers or directors, the fund's principal adviser, or any of the principal adviser's officers or directors from owning, directly or indirectly, any material interest in the subadviser, other than through a pooled investment vehicle that is not controlled by such person or entity.6 The Proposing Release explains that this provision is intended to protect against the conflict of interest and potential for self-dealing that are inherent when a principal adviser hires an affiliated subadviser.7 The Institute supports this goal, but has comments on two aspects of the proposal.
First, the proposed rule prohibits the ownership of any material interest in a subadviser, but does not specify what level of ownership would constitute a material interest for this purpose. Consequently, it is unclear what amount of investment ownership would trigger the prohibition. We note that the vast majority of the Commission's orders that contain a condition similar to that proposed have incorporated a materiality threshold of one percent.8 Accordingly, we recommend that the Commission incorporate a one percent threshold in the final rule. If the Commission decides not to incorporate a one percent threshold, then we recommend that, at the very least, it clarify in the adopting release what, in its view, would constitute a material interest under this provision.
Second, the proposed rule would allow a principal adviser to hire a wholly-owned subadviser to replace a terminated wholly-owned subadviser, without shareholder approval. The Proposing Release explains that permitting a principal adviser to replace one of its wholly-owned subadviser with another wholly-owned subadviser is appropriate since it is unlikely to raise any conflict of interest issues.9 We agree, but recommend extending the scope of the provision to also apply to circumstances where a fund's subadviser, and a subadviser that the principal adviser intends to hire to replace that subadviser, both are wholly owned by the principal adviser's parent company. In our view, expanding the scope of the rule in this manner would not provide the principal adviser with any economic incentive to replace one subadviser wholly owned by the principal adviser's parent company with another by virtue of its parent company's interest in both entities.
C. Investor Expectation Requirements
Proposed Rule 15a-5 contains several conditions designed to ensure that investors understand that they are investing in a manager of managers fund, and that they receive information about the identity of the subadvisers and the fact that they can be changed at any time without shareholder approval. The Institute generally supports the intent of these conditions. Our comments and recommendations follow.
a. Information Statement
Consistent with the conditions contained in many of the Commission's manager of manager orders, proposed Rule 15a-5(a)(5) would require that within 90 days of when a principal adviser enters into a subadvisory contract or makes a material change to a wholly-owned subadviser's contract, the fund must furnish its shareholders with (and file with the Commission) an information statement that describes the subadvisory agreement, and contains other information that would have been provided in a proxy statement had a shareholder vote been held.10 The Institute supports providing shareholders information on a new or modified subadvisory arrangement; however, we do not believe that the information statement is the most appropriate document to serve this purpose.
An information statement is used primarily in connection with an annual or other meeting of shareholders to provide information that enables shareholders to make an informed voting decision about matters on which a shareholder vote is solicited.11 Under the Commission's proposal, however, the decision to hire a subadviser, or modify an existing subadviser's contract, will not be subjected to a shareholder vote, as long as the provisions of the final rule are followed. Nevertheless, the proposal would require the same level of information as if a vote were held. Although we recognize that this proposal would codify a condition contained in the Commission's manager of managers orders, we do not believe that requiring this level of information would be appropriate. The breadth of proxy-related information proposed to be provided to fund shareholders is not necessary to achieve the goal of ensuring that investors receive information about and understand the nature of the subadvisory arrangement.12 In fact, providing shareholders with such extensive information may discourage them from reading the material provided.
We recommend that the Commission revise proposed Rule 15a-5 to require that within 90 days of when a principal adviser enters into a subadvisory contract or makes a material change to a wholly-owned subadviser's contract, the fund must furnish a notice in the form of a registration statement supplement (or so-called "prospectus sticker") to its shareholders that describes the subadvisory agreement and contains other relevant information that would enable fund shareholders to understand the subadvisory arrangement.13 In our view, a prospectus sticker would be more appropriate than an information statement simply because it would provide information an investor would need in order to make an informed investment decision, as opposed to a voting decision, as currently proposed. Also, this approach would be consistent with the analogy noted in the Proposing Release that a change in a fund's subadviser is akin to a change in a fund's portfolio manager.14 As the Commission notes, disclosure of any such changes are provided to investors via a prospectus sticker.15
Under this approach, fund shareholders would receive more streamlined, user-friendly disclosure of relevant information on a fund's subadvisory arrangement, which we believe would better serve shareholders. It also would be less costly and burdensome, both for funds and the Commission's staff, than the information statement requirement. For these reasons, we urge the Commission to replace the information statement requirement with a sticker requirement as described above.
b. Fund Name
Proposed Rule 15a-5(a)(6) would require a fund that identifies its subadviser as a part of the fund's name or title to also clearly identify in its name or title the principal adviser with which the subadviser has contracted, before the name of the subadviser. We generally support the intent of this requirement, which is to minimize investor confusion as to the respective roles of the principal adviser and the subadvisers. However, we do not believe that the proposed provision would best achieve that objective.
As drafted, the proposal would require not only that the principal adviser's name be included in the fund's name or title that bears the subadviser's name, but also that such name appear before the subadviser's name. This would impose an unnecessarily restrictive requirement. It is fairly common, for example, for a series trust structured as a manager of managers fund to include in its name or title the name of the principal adviser and for each portfolio to include in its name or title the name of the subadviser that manages the portfolio. The proposed provision, however, would not only require the name of each portfolio to include the principal adviser's name (a rather uncommon situation), but also require that name to appear before the subadviser's name.
The Proposing Release states that the fund name limitation is "designed to prevent confusion about the relative roles of the adviser and subadviser."16 We believe that this concern is unfounded inasmuch as series companies and other manager of managers funds typically include in communications with investors the name of the trust (which reflects the name of the principal adviser) and the name of the portfolio (which reflects the name of the subadviser). It is our understanding that typically both names are prominently disclosed and their respective roles are clearly defined on the cover page of the fund's prospectus, and other forms of shareholder communications (e.g., shareholder reports). In situations where both the principal adviser and subadviser are clearly identified in communications with investors, we believe that there would be little likelihood of investor confusion.17
Accordingly, instead of the proposed requirement, we request that the Commission modify the proposal to require a manager of managers fund that identifies its subadviser as part of the fund's name or title to prominently disclose the names of both the principal adviser and the subadviser, and their respective roles, in the fund's prospectus and other forms of communications with investors.
c. Form N-1A Amendments
The Commission's proposal would make several modifications to Form N-1A. The Institute generally supports these changes, but has one technical comment. As drafted, the proposed amendments would require disclosure regarding manager of managers structures in Item 2(b)(i.e., principal investment strategies), and Item 4(b)(1)(i.e., implementation of investment objectives). We believe the prospectus section providing information on the investment adviser (in response to Item 6(a) of Form N-1A) is the more appropriate location for manager of managers disclosure.
D. Proposed Rescission of Previous Exemptive Orders
The Proposing Release states that once Rule 15a-5 is adopted, the Commission anticipates that it will rescind its existing manager of managers orders.18 The Proposing Release expresses the Commission's concern that because the conditions in some of its existing orders vary slightly from others, permitting funds to continue operating under different sets of conditions could have an adverse effect on competition.19 The Proposing Release solicits comment on the possible effects caused by the rescission of the orders and how competition would be affected if the Commission decided not to rescind the orders.
The Institute opposes the Commission's proposal to rescind its existing manager of managers exemptive orders. We believe that the Commission's concern regarding the potential adverse effect on competition if funds are operating under different sets of conditions is unfounded; that situation exists today and has not, to our knowledge, raised any competitive issues. Ironically, rescinding the existing orders may potentially create an unlevel playing field by disrupting some business relationships that were structured and established in reliance on individually negotiated orders. Funds adversely impacted may be forced to seek additional exemptive relief to maintain their particular business arrangement, a process the Commission recognizes can be costly and lengthy.20
A proposal to rescind existing exemptive orders is highly unusual inasmuch as previous rulemaking initiatives in which the Commission has codified exemptive orders usually have not resulted in the rescission of previously issued exemptive orders.21 To the extent that the Commission's proposal does not encompass all of the different factual circumstances reflected in individually negotiated exemptive orders, funds should be able to rely on their orders if the final rule fails to accommodate their particular arrangement.22 The Proposing Release points out that the Commission's experience in imposing conditions in these orders has evolved over time, albeit only slightly, but that experience does not make the earlier orders any less important or sustainable.23 Moreover, while the operation of certain funds under those orders may involve conditions that vary slightly from those the Commission has proposed, the orders themselves contain most of the same investor protection measures included in the proposal. For the foregoing reasons, we respectfully request that the Commission not rescind its existing manager of managers exemptive orders once it adopts a final rule.
If the Commission nevertheless determines to rescind its manager of managers exemptive orders, then we seek clarification that funds would not be required to seek shareholder approval to operate a manager of managers fund or make any required contract modifications to comply with the conditions in the rule.24 Requiring a fund to conduct a shareholders' meeting for these purposes would be costly, time-consuming and inconsistent with the intent of the proposal.
E. Other Comments
a. Subadvisory Fees
Proposed Rule 15a-5(a)(1) would prohibit a new or modified subadvisory contract from "directly or indirectly" increasing the management fees charged to the fund or its shareholders. The Institute supports this provision, but questions the use of the phrase "directly or indirectly," which in this context seems somewhat ambiguous and superfluous. Given that the intent of the rule is to ensure that fund shareholders are not subject to increased fees without having an opportunity to voice their concerns, and that this standard is met as long as the contract does not result in any increased management fees paid by the fund, we recommend that the Commission modify the provision to eliminate the phrase "directly or indirectly" so that the provision properly focuses on prohibiting any increase in fees charged to the fund or its shareholders.
b. Transition Period
The Proposing Release states that the Commission anticipates providing a sufficiently long compliance period so that any required contract modifications can be made when the fund's board next approves a new advisory contract.25 The Institute agrees that funds will need sufficient time to make appropriate contract modifications and possibly revise the disclosure in their registration statements to convert to the proposed rule's requirements, particularly if the Commission decides to rescind its existing manager of managers orders. Accordingly, we recommend that the final rule provide a reasonable transition period (e.g., one year) to enable the completion of any such modifications.
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The Institute appreciates the opportunity to comment on the Commission's proposal. If you have any questions or would like additional information, please contact the undersigned at (202) 326-5824 or Barry E. Simmons at (202) 326-5923.
cc: Paul F. Roye, Director