Ropes & Gray's Investment Management Update – June-July 2019

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry:

SEC No-Action Letter Provides More Flexibility Under Manager-of-Managers Orders On July 9, 2019, the SEC staff issued a no-action letter to the BNY Mellon Family of Funds ("BNY Mellon") in which the staff provided its assurance that an adviser with an existing manager-of-managers order could rely on the relief provided under the Carillon Order (described below) with respect to subadvisory agreements with affiliated advisers (in addition to wholly-owned subadvisers and unaffiliated subadvisers), without having to amend its existing manager-of-managers order. The no-action position was conditioned on BNY Mellon's compliance with the conditions in the Carillon Order (the "Carillon Conditions").

Background. On May 29, 2019, the SEC issued an order to Carillon Series Trust (the "Carillon Order") that expanded the scope of exemptive relief available under a pre-existing manager-of-managers exemptive order. The Carillon Order allows (i) the Carillon Series Trust and its investment adviser, without the approval of fund shareholders, to enter into or amend a subadvisory agreement with a subadviser ("Subadviser Voting Relief"), including any subadviser that is an affiliated person of the investment adviser (an "Affiliated Subadviser"),1 and (ii) the Carillon funds to disclose the advisory fees paid to subadvisers on an aggregate, rather than individual, basis.

In prior manager-of-managers orders (each a "Prior Multi-Manager Order"), including the order amended by the Carillon Order, the SEC exemptive relief applied solely with respect to subadvisers that were either wholly-owned by the principal adviser or its parent or unaffiliated with the principal adviser.

The Carillon Order modified certain conditions that frequently have been included in Prior Multi-Manager Orders:

Eliminating the condition that the principal adviser provide the fund board, no less frequently than quarterly, with information about the profitability of the adviser with respect to each subadvised fund; Eliminating a prohibition on trustee and officer ownership of an interest in a subadviser (although any such ownership would still make a trustee an interested person of the fund); Expanding the findings that must be made by the fund board to cover potential material conflicts of interest when considering a proposed subadviser change or reviewing an existing subadvisory agreement as part of the annual contract renewal process; and Requiring the adviser to provide the fund board with information related to material conflicts of interest each year during the annual contract renewal process, including (i) any material interest the adviser has in the subadviser and any material impact the subadvisory agreement may have on that interest, (ii) any arrangement or understanding in which the adviser is a participant that may materially affect, or be materially affected by, the subadvisory agreement, (iii) any material interest in a subadviser by an officer or trustee of the fund or officer or board member of the adviser, and (iv) any other information that may be relevant to the board in evaluating potential material conflicts of interest with respect to the subadvisory agreement. The BNY Mellon No-Action Letter. In the BNY Mellon no-action letter, the SEC staff stated that it would not recommend enforcement action under Section 15(a) of the 1940 Act if the BNY Mellon applicants, without amending their Prior Multi-Manager Order, deemed their Prior Multi-Manager Order amended in the same manner as the Carillion Order and subject to the Carillon Conditions ("Multi-Manager Relief"). In this regard, the SEC staff stated:

We would not expect a fund or investment adviser that relies on this position to comply with the conditions of their Prior Multi-Manager Order. A fund that wishes to rely on its Prior Multi-Manager Order with respect to an Affiliated Subadviser not covered by the Prior Multi-Manager Order, must comply with the [Carillion] Conditions, including obtaining shareholder approval to operate as a fund using Multi-Manager Relief for Affiliated Subadvisers, with respect to any existing or future subadviser going forward. (Emphasis added).

The SEC staff also stated that a fund that wishes to rely on its Prior Multi-Manager Order solely with respect to the type(s) of subadvisers covered by the Prior Multi-Manager Order (which would exclude Affiliated Subadvisers), "may choose to comply with the [Carillon] Conditions, in their entirety, instead of the conditions in its Prior Multi-Manager Order, provided the fund does so with respect to all existing and future subadvisers going forward. If a fund's Prior Multi-Manager Order provides only Subadviser Voting Relief, our no-enforcement position extends only to that relief."

In sum, the BNY Mellon no-action letter provides greater flexibility to funds operating under a Prior Multi-Manager Order in that it permits funds (i) to expand the scope of existing manager-of-managers relief to include Affiliated Subadvisers without amending the Prior Multi-Manager Order, provided the Carillion Conditions are observed and, (ii) even without expanding the relief to include Affiliated Subadvisers, to choose to operate under the Prior Multi-Manager Order's conditions or the Carillon Conditions, whichever are less burdensome.

Adviser Prevails in "Subadviser" Excessive Fee Suit In a recent decision by the U.S. District Court for the Southern District of New York, In re Davis N.Y. Venture Fund Fee Litigation, the court granted the defendants' motion for summary judgement in a case in which the plaintiffs alleged that the fees charged by a registered mutual fund's adviser were excessive and, therefore, constituted a violation of Section 36(b) of the 1940 Act.

The decision is among a group of Section 36(b) suits in which plaintiffs assert a theory that the plaintiffs' bar has developed. Specifically, in these "subadviser" suits, plaintiffs try to establish that the fees charged a mutual fund by its adviser are excessive because the fees that the adviser charged third-party funds in its capacity as subadviser were substantially less than the fees the adviser charges its own fund despite allegedly providing similar services. In granting summary judgment, the Davis court rejected the notion that such fee comparisons on their own are adequate to bring a case to trial.

The plaintiffs, shareholders of the Davis New York Venture Fund, alleged that Davis Advisers charged the Fund excessive fees, as evidenced by the lower fees it charged to third-party subadvised funds with similar investment strategies, the allegedly poor performance experienced by the Fund during the relevant time period, the allegedly high profit margins that Davis Advisers experienced during the same period (73-81%) and the Fund board's allegedly deficient process.

Board's Process. The plaintiffs criticized the Fund board's process in light of the board members' allegedly "deep ties to the financial industry," alleged failure to negotiate a lower advisory fee during the relevant time period and alleged lack of interest with respect to issues plaintiffs contended were important, as well as the adviser's alleged withholding of information from the board, including (i) an accurate description of the services Davis Advisers provided to the subadvised funds; (ii) an explanation of the services provided under the advisory agreement with the Fund compared to those provided under the subadvisory contracts; and (iii) an estimate of the profits the adviser would have earned if it had charged the Fund at the same rates it charged the subadvised funds. The court found none of these complaints raised a genuine issue of material fact and found that the board's decision to approve the Fund's contract with Davis Advisers was entitled to substantial deference. The court based this conclusion on various factors, including:

It was undisputed that six of eight board members were "disinterested" as defined under the 1940 Act, and that the requisite majority voted to approve the Fund's advisory agreement annually. It was undisputed that matters relevant to the approval were considered at board meetings, including comparisons of advisory fee rates and expense ratios of the Fund and other "peer" funds selected by Lipper and Morningstar, as well as fees paid to Davis Advisers by other third-party funds for which Davis Advisers was the primary adviser. The board retained independent counsel with whom the board members met frequently and separately. Evidence that board members were informed that Davis Advisers provided shareholder services and administrative services under agreements separate from the advisory agreement, and that the fees paid by the Fund under those separate agreements did not cover all of Davis Advisers' expenses in performing those services. "Gartenberg" Analysis. After finding that the board's decision to approve the Fund's contract with the adviser was entitled to substantial deference, the court concluded that the U.S. Supreme Court's Jones decision required the court to "apply" the Gartenberg factors.

Comparative Fees. Years before the relevant litigation period, Davis Advisers had entered into advisory agreements with unaffiliated third-party sponsored funds. Finding that these funds, which were governed by an entirely separate board of trustees, had engaged in fee negotiations at arm's-length with Davis Advisers, the court held that the plaintiffs did not provide evidence showing that a comparison of the Fund's total advisory fee with the total advisory fee of the unaffiliated third-party sponsored funds - whose fee structures were nearly identical to that of the Fund - was inappropriate. Therefore, because there was actual evidence of a similar advisory fee resulting from a demonstrably arm's length negotiation with a third-party sponsor...