The SEC settled administrative proceedings against the investment adviser (the “Adviser”) to a registered closed-end fund (the “Fund”) related to the Adviser’s oversight of a subadviser engaged by the Fund (the “Subadviser”) and representations regarding the subadviser’s services made to the Fund’s board in connection with contract renewals and to Fund investors in shareholder reports. This article summarizes the SEC’s findings in the settlement order, which the Adviser neither admitted nor denied.
Background. At the time it engaged the Adviser, the Fund also entered into an agreement with the Subadviser (the “Subadvisory Agreement”) under which the Subadviser would provide “such investment advice, research and assistance, as [the Adviser] shall from time to time reasonably request.” The Subadvisory Agreement did not grant the Subadviser investment discretion or authority over Fund assets. The Subadviser’s performance of the Subadvisory Agreement during the period from 1996 to 2007 (the “relevant period”) consisted of providing the Adviser with the following two reports on a monthly basis: (a) a two‑page list of the market capitalization of the composite stock market index for the Fund’s target country and (b) a two-page comparison of the Fund’s monthly performance versus that of local market competitors. The Adviser did not request, or have any other contact with the Subadviser, regarding the reports, and did not use them in managing the Fund. During the relevant period, the Fund paid the Subadviser approximately $1.8 million in accordance with a fee rate calculated as a percentage of Fund net assets.
The Adviser was also a party to the Subadvisory Agreement, under which the Adviser was responsible for overseeing the Subadviser. Separately, the Adviser agreed with the Fund to serve as its primary investment adviser and its administrator; in the latter capacity, the Adviser was responsible for overall management and administration of the Fund, including the preparation of the Fund’s annual and semi-annual reports, preparation of materials for meetings of the Fund’s Board of Directors and compliance monitoring.
Contract Renewal Materials. Beginning in 1994, the Subadviser submitted annual reports (the “Subadviser Reports”) to the Fund’s Board of Directors for consideration in connection with the Board’s annual review and renewal of the Fund’s advisory arrangements. These reports represented that the Subadviser provided the following services to the Adviser: (a) research on companies in the Fund’s target market; (b) statistical reports to assist investment decision-making; (c) intelligence on local corporate developments; and (d) advice on changes in economic and political conditions in the Fund’s target market. The Subadviser Reports also identified key Subadviser personnel and included the Subadviser’s unaudited financial statements. The Adviser included the Subadviser Reports in the materials provided to the Board as part of the annual review and renewal process for the Fund’s various advisory arrangements. In each of 2006 and 2007, the Adviser’s submissions to the Fund’s Board also included an annual compliance program review prepared pursuant to Rule 38a-1 under the Investment Company Act of 1940 (the “1940 Act”) which stated that the Subadviser provided research and investment advisory services to the Adviser.
Shareholder Report Disclosure. The notes to the financial statements in the Fund’s shareholder reports during the relevant period, which were prepared by the Adviser, stated that for an advisory fee the Subadviser provided the Adviser with investment advice, research and assistance under the terms of a contract.
Termination of the Subadvisory Contract. In late 2007, in response to inquiries by SEC staff regarding the Fund’s relationship with the Subadviser, the Adviser conducted an investigation, ultimately acknowledging to the Fund’s Board that (i) the reports provided by the Subadviser fell short of what was described in the reports provided in connection with the contract renewals and (ii) certain internal controls needed improvement. The Board terminated the Subadviser in February 2008.
Violations. The SEC found the following violations of law:
Section 15(c) – By misrepresenting to the Fund’s Board the services provided by the Subadviser, the Adviser violated its duty under Section 15(c) of the 1940 Act to provide the Fund’s Board with information necessary for the Board to evaluate the nature, quality and cost of the Subadviser’s services in connection with the Board’s annual review of the Fund’s advisory arrangements.
Section 206(2) – By misrepresenting to the Fund’s Board the services provided by the Subadviser, the Adviser failed to fulfill its fiduciary duty under Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) to fully and fairly disclose all material facts to clients and to use reasonable care to avoid misleading clients.
Section 206(4) and Rule 206(4)-7 – The Adviser violated the Advisers Act’s compliance program requirements by failing to implement appropriate procedures to oversee (i) the services provided by the Subadviser and (ii) the information provided to the Board regarding those services as part of the advisory contract renewal process.
Section 34(b) – By preparing and distributing on the Fund’s behalf shareholder reports with misleading descriptions of the services provided by the Subadviser, the Adviser violated requirements regarding the accuracy and completeness of documents transmitted pursuant to the 1940 Act.
Sanctions and Remedial Undertakings. The Adviser agreed to reimburse the Fund for fees paid to the Subadviser during the relevant period less a credit for amounts already reimbursed by the Adviser. The Adviser also agreed to a civil penalty of $1.5 million.
The settlement order includes remedial undertakings related to the advisory contract renewal process and the Adviser’s oversight not only of advisers and sub-advisers, but also principal underwriters, administrators, and transfer agents (collectively with advisers and subadvisers, “service providers”). The order prescribes the following specific procedures:
- Adviser personnel with direct knowledge of the particular service provider’s agreement and services must review and verify any information or representations provided by an adviser, sub‑adviser or principal underwriter as part of the Section 15(c) contract renewal process;
- each unaffiliated service provider that is not a subadviser must provide an annual certification that it has performed the services contracted for;
- each unaffiliated subadviser not exercising investment discretion must provide a quarterly certification regarding the performance of its contractual obligations;
- certain senior personnel of the Adviser must provide a quarterly certification regarding each unaffiliated subadviser’s performance of services contracted for, and those certifications must be reviewed by Adviser administrative personnel prior to the payment of an unaffiliated subadviser’s fees; and
- with respect to any registered investment company sponsored by the Adviser for which it acts as investment adviser, Adviser personnel with sufficient knowledge of a service provider’s agreements and services must review any description of the service provider contained in a registration statement, application, report, account, record, or other document filed or transmitted pursuant to the 1940 Act, including financial statements and marketing materials.