SEC Official Reaffirms Mutual Fund Advisory Contract Approval Process

Andrew Donohue, the SEC’s Director of Investment Management has strongly praised the mandated process by which a mutual fund’s independent directors approve the fund’s investment advisory contract. Actually, the SEC official’s remarks represent one of the strongest Commission affirmations of the current process for approving investment advisory contracts in recent memory.

Although the detailed and well-documented analysis of the advisory contract has increased the amount of time independent directors must devote to the approval process, he acknowledged, the ultimate result is beneficial for investors, while also strengthening the business judgment of the directors. His remarks were made at the Mutual Funds Directors Forum.

Section 15(c) of the Investment Company Act requires a fund’s independent directors to approve the investment advisory contract by an in-person vote at a meeting called for that purpose. In addition, section 36(b) of the Act imposes on fund advisers a fiduciary duty with respect to compensation or payments made to them by the fund or the shareholders.
In the director’s view, the section 15(c) approval process is appropriate since mutual funds and their investment advisers have a unique industry structure that does not exist in conventional corporate relationships. The adviser typically creates the fund and then operates it, he noted, and investors buy fund shares relying on the adviser's services.

Given the lack of arms-length bargaining between the adviser and the fund, he reasoned, the investment advisory contract must be approved by independent directors. Because both the adviser and the fund board know that the independent directors are required to engage in a detailed review of the adviser's compensation, this creates an incentive for both sides to work transparently and collaboratively to the benefit of the fund's investors.

As a practical matter, he noted, the primary threat that independent directors who do not approve of an advisory contract can wield is the ``nuclear option,’’ which is a vote not to approve the contract and replace the adviser. However, given the unique structure of the fund and its adviser, combined with the expectation of investors, replacing the adviser would most likely lead to what the SEC official called ``mutually assured destruction’’ because investors will flee the fund, thereby resulting in its closure.

Thus, in his view, an in-depth section 15(c) process is not only beneficial to the fund and its investors, but also directly benefits the adviser and the independent directors. Specifically, a detailed approval process minimizes the likelihood of a successful legal challenge.

This is because the legislative history of Section 36(b) suggests that courts are loathe to substitute their business judgment for that of the independent directors in the area of management fees. Thus, an adviser who provides robust information to the directors to enable them to make an informed decision whether to approve the advisory contract obtains the benefit of the directors' business judgment.

On the other hand, if the directors are not fully informed about all of the facts bearing on the adviser's services and fees, courts may give less credence to their judgment. Therefore, advisers seeking to prove that they have fulfilled their fiduciary duties have a strong incentive to provide the directors with detailed information about their compensation and the services they provide.
Similarly, the independent directors have a strong incentive to fully document their decision to vote to approve the adviser's contract.

The federal courts have indicated that the expertise of the directors, the extent to which they are fully informed, as well as the care with which they perform their duties, are factors to consider when deciding whether a breach of fiduciary duty occurred. Shareholders trying to challenge an adviser's fee must establish that the business judgment of the independent directors who voted to approve the investment advisory contract should not be relied upon by the court.

But by extensively documenting their decision, observed the official, the independent directors will have a record demonstrating that they conscientiously performed their duties and are more likely to have their business judgment relied upon. Moreover, the SEC official pointed out that a carefully documented record undermines a cynic's view that independent directors vote to approve the advisory contract in order to keep their jobs.