On July 30, 2008, the Securities and Exchange Commission issued proposed guidance regarding the duties and responsibilities of investment company boards of directors with respect to the oversight of investment adviser portfolio trading practices (the “Proposed Guidance”). This Client Alert summarizes the Proposed Guidance, which is quite broad in scope and, if adopted as proposed, could significantly impact relationships among fund boards, advisers, and broker-dealers. Accordingly, we believe that the Proposed Guidance should be given diligent focus and attention by all mutual fund industry participants and stakeholders. Public comments on the Proposed Guidance are due back to the SEC by Oct. 1, 2008.
On July 30, 2008, the Securities and Exchange Commission (the “SEC”) issued proposed guidance regarding the duties and responsibilities of investment company boards of directors with respect to the oversight of investment adviser portfolio trading practices (the “Proposed Guidance”).1 In summary, the SEC proposed that a board has a duty to:
- Oversee the adviser’s best execution practices and portfolio transaction costs
- Oversee the adviser’s use of fund brokerage commissions
- Monitor and approve the adviser’s compliance and procedures relating to the Section 28(e) safe harbor policies
- Monitor and approve the adviser’s compliance policies and procedures regarding the use of fund brokerage commissions and related conflicts of interest
- Take into consideration, as part of the annual adviser contract and compensation review process, benefits to the adviser from its use of fund brokerage commissions
Throughout the Proposed Guidance, the SEC reiterated that fund directors must ask for and be provided with information from the adviser in sufficient detail to enable the board to satisfy these supervisory obligations. As a related matter, the SEC discussed whether it should mandate additional Form ADV disclosure regarding an adviser’s trading practices and use of soft dollars. In connection with the issuance of the Proposed Guidance, the SEC has requested public comments, which are due back to the SEC by Oct. 1, 2008.
Board Duties Related to Oversight of Adviser Trading Practices
The following are the highlights of the duties as described by the SEC in the Proposed Guidance:
(1) Adviser’s Best Execution Practices and Portfolio Transaction Costs – As part of its oversight of the adviser’s duty to seek best execution, a mutual fund board should monitor the overall transaction costs incurred by a fund when it buys or sells portfolio securities. Significantly, for purposes of the Proposed Guidance, the use of the term “securities” includes all instruments that an investment company may invest in under the Investment Company Act of 1940 (the “1940 Act”). Presumably, this would include fixed-income securities and derivative contracts, in addition to equity securities. As a related matter, the SEC highlighted several factors for consideration by a fund’s board and adviser with respect to portfolio transaction costs and the board’s evaluation of an adviser’s procedures regarding its best execution obligations. Attachment 1 to this Client Alert lists these factors. The SEC indicated that a board should give direction to the adviser if the consideration of these and other relevant factors suggests that the adviser’s trading practices could be altered in order to provide greater benefits to the fund.
(2) Adviser’s Use of Fund Brokerage Commissions – A mutual fund board should monitor the adviser’s use of fund brokerage commissions to buy research and/or brokerage to ensure that any such use is in the fund’s best interest. To this end, the Proposed Guidance emphasizes that fund boards and advisers must be mindful of potential conflicts of interest present when an adviser benefits from the use of fund brokerage commissions. Attachment 2 to this Client Alert lists the potential conflicts of interest included in the Proposed Guidance.
(3) Adviser’s Section 28(e) Safe Harbor Monitoring – The fund’s adviser bears the burden of demonstrating— and the mutual fund’s board should determine—that the adviser’s use of fund brokerage commissions to obtain research and brokerage falls within the safe harbor available under Section 28(e) of the Exchange Act of 1934. According to the Proposed Guidance, as part of the annual approval of the adviser’s compliance policies and procedures, a fund’s board should give specific attention to the Section 28(e) safe harbor analysis, as well as the related issue of monitoring and preventing excessive portfolio trading.
(4) Adviser’s General Fiduciary Obligations – A mutual fund board should critically analyze, and must approve, the adviser’s brokerage-related compliance policies and procedures, including procedures that the adviser employs to address any potential conflicts of interest. A board must also ensure that the adviser uses fund commissions appropriately and for the benefit of the fund. Attachment 3 to this Client Alert lists questions that, according to the SEC, a fund board should raise as part of its analysis of the adviser’s brokerage-related compliance policies and procedures. If the board’s analysis suggests that fund brokerage commissions could be used in a manner that provides greater benefit to the fund, then the board should direct the adviser accordingly. Attachment 4 to this Client Alert lists factors to be considered by a board in directing an adviser to use fund brokerage commission in a manner that provides greater benefits to the fund.
(5) Annual Review of Adviser’s Compensation – As part of the annual investment advisory contract/ compensation approval process required by Section 15(c) of the 1940 Act, a mutual fund board should give consideration to any adviser benefits resulting from the use of fund brokerage by the adviser. Attachment 5 to this Client Alert contains a list of information that the SEC believes is appropriate for fund boards to request from an adviser in connection with the board’s discharge of its Section 15(c) obligations.
Additional Form ADV Disclosure
As a final and related matter, the SEC solicited comments on whether it should mandate additional Form ADV disclosure regarding an adviser’s trading practices and use of soft dollars. Any such disclosure items would be in addition to the currently proposed amendments to Part 2 of Form ADV, which would require an adviser that receives soft dollar products and services to disclose its soft dollar practices, and to discuss the inherent conflicts of interest related to such practices.2
Request for Public Comments
The SEC has requested public comments on the topics highlighted in this Client Alert, as well as any other any other issues relating to mutual fund board oversight of advisers’ portfolio trading practices. Comments are due to the SEC by Oct. 1, 2008. Please do not hesitate to contact us if we may be of further assistance to your further consideration of the Proposed Guidance or with your preparation of any related comments.