The Securities and Exchange Commission has announced the settlement of an enforcement action against the primary investment adviser to a closed-end fund for its role in allowing excessive fees to be paid to a second fund adviser. Release Nos. IA-3315, IC-29862 (Nov. 16, 2011). The SEC order describes the second adviser as a sub-adviser, although the arrangement was different from what is usually understood by a sub-advisory arrangement, in which the primary adviser delegates advisory responsibilities to another adviser and is responsible for the sub-adviser's compensation (subject, however, to the oversight of the fund's board of directors). Instead, the closed-end fund, which specialized in Malaysian equity securities, entered into an agreement with a Malaysian investment adviser, under which the Malaysian adviser was to provide the primary adviser with investment advice, research, and assistance for the benefit of the fund. The fund paid the Malaysian adviser directly, and over a 20-year period its compensation aggregated $1.845 million, or almost 2% of the fund's net assets as of 2011.
In reality, according to the SEC order, the Malaysian adviser did not provide any valuable investment advice, research, or assistance. Instead, it provided only two minor monthly reports, based on readily available public information and neither requested nor used by the primary adviser. After questions were raised by the SEC staff in an examination in late 2007, the fund board terminated the relationship with the Malaysian adviser in early 2008. The SEC found several regulatory violations by the primary adviser:
* The primary adviser violated Section 15(c) of the Investment Company Act of 1940, which requires annual approvals of advisory contracts and also provides that it is the duty of a fund adviser 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. (Note that the fund adviser's duty to furnish information is not limited to information about its own advisory contract.) The Malaysian adviser prepared exaggerated descriptions of its advisory services, and the primary adviser always passed these on to the fund board, even representing that services were as described in the relevant agreements and disclosure documents. According to the order, the primary adviser willfully violated Section 15(c) by failing to provide the fund board with information necessary for the board to evaluate the nature, quality, and cost of the sub-adviser's services, resulting in the fund paying for advisory services it did not receive. In addition, the primary adviser violated the disclosure requirements of Section 206(2) of the Investment Advisers Act of 1940.
* The primary adviser violated Rule 206(4)-7 under the Advisers Act by failing to adopt and implement procedures governing its oversight of the Malaysian adviser's services and its representations and provision of information to the board regarding those services in connection with the investment advisory contract renewal process. Although the primary adviser took responsibility for monitoring the Malaysian adviser's services, it had no written procedures specifically governing its oversight of sub-advisers, and it did not have a procedure in place for reviewing work done by the Malaysian adviser. It did not conduct due diligence visits of the Malaysian adviser and performed no other routine supervision of it, nor did it work with the Malaysian adviser in developing the research contemplated by the advisory agreement.
* The primary adviser violated Section 34(b) of the 1940 Act, which makes it unlawful to make any untrue statement of a material fact in a document filed or transmitted pursuant to the 1940 Act. The fund's shareholder reports, which the primary adviser prepared, stated in the notes to the financial statements that the Malaysian adviser provided the investment advice, research, and assistance contemplated by its advisory agreement.
The primary adviser agreed to reimburse the fund the $1.845 million paid to the Malaysian adviser, to pay a civil money penalty of $1.5 million, and to adopt policies and procedures to verify the services provided by sub-advisers and other service providers.
The SEC order is an important statement on the responsibility of primary fund advisers in overseeing services performed by sub-advisers and the role of primary advisers in the 15(c) approval process. The proceeding also represents the first advisory fee enforcement action under the auspices of the SEC's Enforcement Division Asset Management Unit. The SEC's press release emphasizes the role of the Asset Management Unit and its initiative inquiring into the investment advisory contract renewal process and fee arrangements in the fund industry, although the matter actually came to the staff's attention prior to the establishment of the Asset Management Unit.
The SEC press release, with a link to the order, is available at
John M. Baker <JMB@...
Stradley Ronon Stevens & Young, LLP http://www.stradley.com
1250 Connecticut Avenue, NW, Suite 500
Washington, DC 20036
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