The SEC and media are driving scrutiny on the topic of advisory contracts: looking ahead, this could be the next big issue, with implications for investors, funds and fund managers. Two recent developments are worth noting:
The New York Times just reported that Calpers has failed to track carried interest and certain other fees paid to private equity firms. (Carried interest is a reduction in what would otherwise be a distribution to investors from an investing vehicle and, therefore, may not be viewed as an expense by investors as they prepare financial statements.) The Times quotes one board member as saying he is “appalled.” A “pension fraud investigator” states, “They are intentionally not asking because if the fees were publicly disclosed, the public would scream.” The investigator also plans to scrutinize relationships Calpers executives and placement agents have with managers for any conflicts of interest that may exist. Expect more inquiries of this sort.
Secondly, the SEC has highlighted the topic by charging a mutual fund adviser, its principal, and three mutual fund board members for failing to consider sufficient information before approving the mutual fund’s advisory contract. The case was based on Section 15(c) of the Investment Company Act, but may have implications concerning diligence for advisory contracts in wider situations. Here the trustees approved advisory contracts without obtaining fee information paid by comparable mutual funds which was needed to determine that fees paid by the approving mutual fund were reasonable, with inadequate descriptions of the services to be provided by the adviser and sub-advisers, and without sufficient information about the adviser’s profitability and cost-allocation. Moreover, the trustees did not seek to obtain information requested after consulting with counsel.
The basic questions in these cases are (i) what standard of care applies when a relationship with an advisory firm is approved and (ii) have those approving the contract met that standard? For any board or committee approving advisory contracts, it is important to have a reasonable process and to carefully consider any deviations. Now may be an opportune time to make sure the process covers all expenses and considers conflicts as well.