Fund Fee Settlement May Be Harbinger of More to Come
Alex Kreonidis | Bloomberg Law
The Securities and Exchange Commission (SEC) settled charges against Morgan Stanley Investment Management Inc. (MSIM), the primary investment adviser to The Malaysia Fund, Inc. (Fund), a registered closed-end fund. The SEC enforcement proceeding stemmed from an allegedly improper fee arrangement involving the Fund and AMMB Consultant Sendirian Berhad (AMMB), a former sub-adviser to the Fund. The SEC found that MSIM violated the securities laws when it allowed AMMB to be paid about $1.8 million over an 11-year period despite providing no advisory services for the Fund’s benefit. Without admitting or denying the allegations, MSIM agreed to improve its compliance procedures and pay approximately $3.3 million to settle the charges.
MSIM has acted as the Fund’s primary investment adviser and AMMB, an unaffiliated Malaysian investment adviser, acted as the Fund’s sub-adviser from 1996 to 2007, when its services were terminated. Pursuant to an investment advisory contract among AMMB, MSIM, and the Fund, AMMB agreed to provide advice, research, and assistance to MSIM for the benefit of the Fund.
The SEC found that MSIM willfully violated Section 34(b) of the Investment Company Act of 1940 (Investment Company Act), which makes it unlawful for any person to make a material misstatement or omission in a document filed or transmitted pursuant to the act. The SEC alleged that MSIM prepared and distributed on behalf of the Fund “materially false and misleading annual and semi-annual reports stating that AMMB provided ‘investment advice, research and assistance on behalf of the Fund to [MSIM] under terms of a contract.’” According to the SEC, AMMB did not, in fact, provide any advisory services to MSIM.
— Significance of Janus
In its order approving the settlement, the SEC did not address the impact of Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) on Section 34(b) liability. In Janus, the Supreme Court held that an investment adviser did not “make” allegedly misleading statements in mutual fund prospectuses, and therefore could not be held liable in a private action pursuant to Rule 10b-5 under the Securities Exchange Act of 1934. The Supreme Court concluded that the mutual fund “made” the statements in the prospectuses. It also noted that “none of the statements in the prospectuses were attributed, explicitly or implicitly,” to the adviser.
Although the Janus holding applied to Rule 10b-5 liability in a private action, similar issues regarding the “maker” of allegedly misleading statements could arise in an SEC Section 34(b) enforcement action as well. For example, query whether MSIM was the maker of the allegedly misleading statements that appeared in the annual and semi-annual reports or whether the Fund was the maker given that the statements appeared in the Fund’s reports?
An argument could be made that even though the statements appeared in the Fund’s reports, the statements should be viewed as being implicitly attributed to MSIM because MSIM prepared the statements and they involved a description of services that were purportedly provided to MSIM. Moreover, even if MSIM were not the maker of such statements, Section 34(b) could provide additional bases for liability beyond the making of misleading statement. For example, Section 34(b) prohibits any person that files, transmits, or keeps a document required under the Investment Company Act, from omitting a material fact in such document. As a result, arguments could further be made that MSIM was the filer, transmitter, and/or keeper of such reports, if not the maker of statements contained in the reports.
For discussion of a recent district court opinion addressing Janus in an SEC Rule 10b-5 action, see Bloomberg Law Reports®—Securities Law, Janus, Dodd-Frank, and the SEC; S.D.N.Y. Denies CFO’s Motion to Dismiss (Oct. 28, 2011).
Misleading Section 15(c) Process
Under Investment Company Act Section 15(c), an investment adviser to a registered fund is required to furnish such information as may reasonably be necessary for the fund’s board to evaluate the terms of an advisory contract. According to the SEC, MSIM did not provide the Fund’s board with information reasonably necessary to evaluate the nature, quality, and cost of AMMB’s services.
As the SEC explained, each year that AMMB served as sub-adviser, it submitted a report to MSIM in connection with the Fund’s annual advisory contract approval process. MSIM allegedly included each AMMB report in materials used by the Fund’s board of directors to renew the advisory contracts with MSIM and AMMB. According to the SEC, the AMMB reports falsely claimed AMMB was providing specific research, intelligence, and advice to MSIM. In reality, the SEC claimed that “AMMB’s advisory services were limited to preparing two minor monthly reports for MSIM, which MSIM’s portfolio management team neither requested nor used in its management of the Fund.”
— Recent SEC Actions
In recent years, the SEC reached settlements with other advisers that allegedly violated Section 15(c). For example, in 2010, the SEC settled charges that investment adviser Value Line, Inc., broker-dealer Value Line Securities, Inc. (VLS), and two officers misled the independent directors of the Value Line Family of Mutual Funds regarding a commission recapture program. In 2009, the SEC also settled charges against investment adviser New York Life Investment Management LLC (NYLIM), alleging that NYLIM failed to provide a fund’s board of trustees information reasonably necessary to evaluate the true cost or value of a guarantee. NYLIM allegedly used the guarantee to help justify its management fees, which were among the highest in the fund’s peer group.
Moreover, Robert Khuzami, Director of the SEC’s Division of Enforcement (Enforcement), has highlighted a renewed focus on adviser fee arrangements. In 2010, he testified that Enforcement’s newly created Asset Management Unit had “established a Mutual Fund Fee Initiative to develop analytics, along with other SEC Divisions, for inquiries into the extent to which mutual fund advisers charge retail investors excessive fees.” The SEC referenced this initiative in its press release announcing the MSIM settlement. Khuzami also was quoted as saying, “We want to take the advisory fee setting process out of the shadows by scrutinizing the role of investment advisers and fund board members in vetting fee arrangements with registered funds.” Accordingly, it appears that mutual fund advisory fees and the Section 15(c) approval process will be a focus area for SEC staff going forward.
Breach of Fiduciary Duty
Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act) prohibits investment advisers from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client.” Section 206 has been interpreted as imposing a fiduciary duty on investment advisers to fully and fairly disclose all material facts and use reasonable care to avoid misleading clients. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). According to the SEC, MSIM willfully violated Section 206(2) by representing and providing information to the Fund’s board that AMMB was providing advisory services to MSIM when, in fact, AMMB was not providing such services.
Lastly, the SEC found that MSIM willfully violated Advisers Act Section 206(4) and Rule 206(4)-7 thereunder, which require registered advisers to adopt and implement written compliance procedures reasonably designed to prevent Advisers Act violations. MSIM allegedly failed to adopt and implement procedures governing its oversight of AMMB’s services and its representations and provision of information to the Fund board’s regarding those services. As part of the settlement, MSIM agreed to “implement and maintain policies and procedures specifically governing the Section 15(c) process and its oversight of advisers and sub-advisers, principal underwriters, administrators, and transfer agents.”
This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
©2011 Bloomberg Finance L.P. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of Bloomberg Finance L.P.