Mutual fund firms and boards, it may be time to make sure that you can verify that anyone paid by your mutual funds is actually putting in the work. Yesterday the Securities and Exchange Commission (SEC) officially reanimated its enforcement actions over mutual fund fees by landing a settlement of more than $3.3-million settlement from Morgan Stanley Investment Management.

James Cavoli of Milbank Tweed Hadley & McCloy told the WSJ that this is SEC's first mutual fund fee fight in more than two decades. The WSJ also noted that last year the SEC launched a "mutual-fund fee initiative," and this is their first attack under that initiative. The regulators are focusing for now on the low-hanging fruit: namely, fees for un-provided or inadequately-vetted services.

The case revolves around a fund sub-advisor, AMMB Consultant Sendirian Berhad, who received $1.845 million from the fund over more than decade without, according to SEC, ever actually providing the "advice, research and assistance" the sub-advisor promised.

AdvisorOne, Associated Press, Banking Business Review, Bloomberg, Courthouse News Services, Economic Times, FierceFinance, Financial News, the Financial Times, the Miami Herald, Pensions & Investments, Reuters, the Wall Street Journal and News.Xinhuanet.com all covered the news. The Yale Alumni Magazine's blog even mentioned the settlement in a post about an apparently unrelated "Occupy Morgan Stanley" protest on Tuesday.

"MSIM failed in its duty to provide the fund's board members with the information they needed to fulfill their significant responsibility of reviewing and approving the sub-adviser's contract," stated Bruce Karpati, co-chief of the asset management unit of the SEC's enforcement division. MSIM's failure undermined the integrity of the board's oversight process."

The case involves a closed-end fund, the Malaysia Fund, but the laws, regulations and logic that the SEC applied here could be applied to open-end funds, too. According to the SEC, from 1996 through 2007 a subsidiary of AM Bank Group of Malaysia, AMMB, "did not provide those purported advisory services" that it agreed to do. Morgan Stanley fired AMMB in 2008 once the SEC started looking in to things.

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Company Press Release

Washington, D.C., Nov. 16, 2011 – The Securities and Exchange Commission today charged Morgan Stanley Investment Management (MSIM) with violating securities laws in a fee arrangement that repeatedly charged a fund and its investors for advisory services they weren’t actually receiving from a third party.

The SEC’s Enforcement Division Asset Management Unit has been focused on fee arrangements with registered funds. The SEC’s investigation found that MSIM – the primary investment adviser to The Malaysia Fund – represented to investors and the fund’s board of directors that it contracted a Malaysian-based sub-adviser to provide advice, research and assistance to MSIM for the benefit of the fund, which invests in equity securities of Malaysian companies. The sub-adviser did not provide these purported advisory services, yet the fund’s board annually renewed the contract based on MSIM’s representations for more than a decade at a total cost of $1.845 million to investors.

MSIM agreed to pay more than $3.3 million to settle the SEC’s charges.

The SEC’s Asset Management Unit has an initiative inquiring into the investment advisory contract renewal process and fee arrangements in the fund industry.

“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,” said Robert Khuzami, Director of the SEC’s Division of Enforcement.

According to the SEC’s order instituting the settled administrative proceedings, The Malaysia Fund’s board of directors evaluated and approved the sub-adviser fees each year from 1996 to 2007 based on MSIM’s representations during what’s known as the “15(c) process.” Section 15(c) of the Investment Company Act requires an investment adviser to provide a fund’s board with information that is reasonably necessary to evaluate the terms of any contract whereby a person undertakes regularly to serve as an investment adviser of a registered investment company.

“MSIM failed in its duty to provide the fund’s board members with the information they needed to fulfill their significant responsibility of reviewing and approving the sub-adviser’s contract,” said Bruce Karpati, Co-Chief of the SEC Enforcement Division’s Asset Management Unit. “MSIM’s failure undermined the integrity of the board’s oversight process.”

According to the SEC’s order, MSIM arranged The Malaysia Fund’s sub-advisory agreement with a subsidiary of AM Bank Group, one of the largest banking groups in Malaysia. Despite the research and advisory agreement stating that the AM Bank Group subsidiary (AMMB) would provide MSIM with “investment advice, research and assistance, as [MSIM] shall from time to time reasonably request,” the SEC found that AMMB merely provided two monthly reports based on publicly available information that MSIM neither requested nor used in its management of the fund. Furthermore, MSIM’s oversight and involvement with AMMB during the relevant time period were wholly inadequate. MSIM had no written procedures specifically governing its oversight of sub-advisers, and did not have a procedure in place for reviewing work done by AMMB.

According to the SEC’s order, MSIM also was responsible for preparing and filing the fund’s annual and semi-annual reports to shareholders. The fund’s filings stated that for an advisory fee, AMMB provided MSIM with “investment advice, research and assistance.” Since AMMB was not providing any advisory services, MSIM prepared and filed false information in the annual and semi-annual reports.

“Not only did MSIM’s internal controls fail in allowing this purported services arrangement to go on, but the firm repeatedly issued reports to investors that inaccurately represented those services,” said Eric I. Bustillo, Director of the SEC’s Miami Regional Office. “MSIM clearly lost sight of this sub-adviser.”

According to the SEC’s order, the fund’s sub-adviser contract with AMMB was terminated in early 2008 after the SEC’s examination staff inquired into the fund’s relationship with the sub-adviser.

The SEC’s order finds that MSIM willfully violated Sections 15(c) and 34(b) of the Investment Company Act and Sections 206(2) and (4) of the Investment Advisers Act of 1940, and Rule 206(4)-7 thereunder. Without admitting or denying the SEC’s findings, MSIM agreed to a censure and to cease and desist from committing or causing any violations and any future violations of those provisions. MSIM agreed to repay the fund $1.845 million for the sub-adviser’s fees and pay a $1.5 million penalty. MSIM also agreed to implement policies and procedures specifically governing the Section 15(c) process and its oversight of service providers.

The SEC’s case was handled by Chad Alan Earnst, Christine Lynch, and Jessica Weiner, members of the Asset Management Unit in the Miami Regional Office, and Tonya Tullis, staff accountant. Karen Stevenson, Susan Schneider, and Dennis Delaney from the SEC’s Washington D.C. office conducted the related examinations. The SEC acknowledges the assistance of the Securities Commission of Malaysia and the Monetary Authority of Singapore.

The SEC’s investigation is continuing. 

Edited by: Neil Anderson, Managing Editor


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