Boards troubled about SEC goals for 15(c) sweep on profitability

Exam letters that focus on the “least instructive” factor in fee reviews follow hints that SEC will dig further into question about fund fees

Exam letters the Securities and Exchange Commission sent recently to fund advisers included questions about the fee-review process and the role profitability plays in fund board decisions about fees.

The sweep raised a few questions within the industry about what the SEC plans to do with the information it has collected.

“What we’ve heard about that letter is that one of the things it asks about specifically is profitability, which is one of the hardest factors to really look into and look at and quantify,” said Kelley Howes, a partner at Morrison Foerster. “And so I think there’s going to be a lot more discussion about that in particular.”

Under prior administrations, the fund industry generally understood that the SEC wanted fund boards to follow the so-called Gartenberg standard, lawyers said. The words and actions of the current SEC staff, however, suggest something has changed, even if observers have no idea what.

A provocative speech by Division of Investment Management (DIM) head William Birdthistle in March signaled to many in the industry that the top fund regulator was looking to shake things up regarding fund fee-setting.

Birdthistle had written extensively on fund fees before joining the SEC in December 2021—even going so far as to argue in his book Empire of the Fund that SEC lawsuits “could and should be brought against outlier advisers that charge the most outrageous fees”—but almost a year into his tenure and on the heels of an unusual sweep, trustees and board counsel are still hoping to figure out what he intends to do, according to Devin McCune, a vice president of regulatory and compliance at Broadridge Financial Solutions who consults with fund boards on 15(c) reviews.

“They’re trying to understand how this all works together and what the commission is really trying to understand with this,” McCune said.

“I’m interested to see how the SEC thinks things might be done differently, or if they’re satisfied with the processes,” said Molly Moynihan, a partner at Perkins Coie. “Certainly, I’m very interested to see if they have a view that could be helpful to boards, but I don’t know what it is.”

Profitability is “least instructive” Gartenberg factor

Among the list of issues fund boards are responsible for considering during a fee review, profitability is one of the most difficult to consider.

A fund’s profitability is one of the six Gartenberg factors that courts use to determine the reasonableness of fund fees. That means, in effect, that boards always have to discuss it when approving a fee.

“We’re constantly looking at [profitability] in the context of the benefits that accrue to shareholders as funds get scale,” said Hassell McClellan, chair of the John Hancock Funds. “It’s something that funds grapple with a great deal.”

On the other hand, it can be difficult for trustees to compare the profitability of different funds as they would do with other metrics, because individual funds don’t publicly disclose profit numbers, which would be difficult to compare even if they were public due to variations in accounting methods used by different fund complexes.

The Gartenberg Factors, as endorsed by the Supreme Court
  • The extent to which the adviser realizes economies of scale as the fund grows larger
  • The nature and quality of the services provided to the fund and shareholders
  • The profitability of the fund to the adviser
  • Any “fall-out financial benefits,” those collateral benefits that accrue to the adviser because of its relationship with the mutual fund
  • Comparative fee structure (meaning a comparison of the fees with those paid by similar funds)
  • The independence, expertise, care, and conscientiousness of the board in evaluating adviser compensation

“There’s … no way to benchmark your profitability versus someone else’s. So fund company A may have profitability of a fund of 40%, but they don’t know what fund company B has for a similar product in that space,” McCune said. “It’s proprietary information that just doesn’t get shared, so the board’s kind of working in a vacuum.”

Some analytics providers like Broadridge do try to fill this data gap by helping boards analyze what public profitability data exists, including by using trend data over three- or five-year periods from publicly traded asset management companies as a proxy for fund-level profitability.

Nonetheless, Moynihan called profitability the “least instructive” of the Gartenberg factors due to the difficulty of comparing it across fund complexes.

“I can look [at industry fee data] and say, ‘My fund is in the 90th percentile in fees,’” Moynihan said. “But I can’t do that with profitability, because the data just isn’t there.”

Can an asset manager make too much money?

When discussing profits, fund trustees usually focus on whether the adviser is making excessive margins at the expense of shareholder competitiveness. That comparison can be tricky, given that different types of fund products have different financial profiles. Even similar funds can generate dramatically different profits depending on the size, structure, and locations of their parent companies.

As a result, boards can’t rely on a rule of thumb as to how much profit an asset manager is allowed to earn from a fund.

“There is no bright line,” said one ’40 Act lawyer who asked not to be named. “There is no case that really tells you, ‘This is how much you’re entitled to get.’”

“Determining what’s a reasonable profitability, that’s a little bit of art and a little bit of science,” McClellan said. He added that his board uses Broadridge to gather as much data on fund profitability as possible.

Often, the best boards can do is use what data they have to look at whether one fund is producing drastically higher profits than its peers.

“As I’ve sat in boardrooms and heard boards talk about it, I’ve never heard an explicit, ‘We think the margins are too high.’ It’s, ‘These margins differ from the rest of our funds. Can you explain to us what’s going on here?’” McCune said. “Then it’s incumbent on the finance team at the fund company to explain what’s happening there and have that dialogue.”

In cases where the board deems a fund to have excess profitability, trustees may ask or demand that the adviser lower fees or introduce a breakpoint.

“When you have very, very high levels of profitability that are recurring, there’s going to be a discussion about sharing those profits, and it can result in reduced advisory fees. I’ve seen countless examples through the years,” said the ’40 Act lawyer.

Boards should also keep in mind, however, that shareholders tend not to care about asset manager profits and mainly care about how much they’re paying for performance, according to the lawyer.

“It’s really a commercial relationship in the end, and you have fiduciary considerations, but remember quality of services and performance of the funds are also key,” the lawyer said. “The financial dimensions have got to be looked at in light of the other factors.”

If shareholders aren’t being disadvantaged, fund trustees have little interest in limiting adviser profitability for their own sake. Boards generally want their fund advisers to perform well so that they can provide shareholders with high-quality service.

If the fund is providing shareholders with good performance for a fair price—and trustees don’t detect exorbitant profits at the expense of shareholders—the board doesn’t necessarily care how much profit the adviser makes.

“If they push too hard on some of these items and reduce profitability too much for an asset manager, the asset manager may not be able to sustain itself,” McCune said. “That’s also not good for the investor, so it really is a tough position that the independents are in as they’re looking at all these factors.”

Have thoughts about this or other Fund Directions stories? Write to us at