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In today's legal landscape, an investment adviser (1) must supervise its sub-advisers or risk liability if errors, violations, or wrongdoing are committed by a sub-adviser or a sub-adviser's personnel. In last month's issue, Part I of this article discussed the legal framework and current developments that underpin an adviser's duty to supervise. Here, Part II provides some practical tips on how an adviser can manage its supervisory risk.
An adviser's supervisory responsibilities do not stop at its organizational boundaries. (2) An adviser risks liability for failure to supervise any person--including a sub-adviser--that is subject to the adviser's supervision, whether the adviser's duty to supervise emanates from Section 203(e)(6) of the Investment Advisers Act of 1940 (Advisers Act), an exemptive order issued by the Securities and Exchange Commission (SEC), relevant disclosures, an advisory agreement, fiduciary duties, or elsewhere. (3) Accordingly, advisers considering a sub-advisory relationship should think through the arrangement carefully and structure the relationship so they assume only the risk necessary to achieve their business goals. Questions such as the following should be analyzed:
1. Is the relationship best structured as a sub-advisory relationship? As simplistic as it may seem, an adviser in a sub-advisory relationship with another adviser may be viewed as having some level of supervisory responsibility for the sub-adviser simply because the sub-adviser is aligned under or sub to the adviser. A key question, then, is does the other adviser need to be--or will it in fact be--under the adviser's supervision in any respect? If not, perhaps the relationship should be structured as something other than a sub-advisory relationship, which would better reflect the underlying reality and help to mitigate the adviser's supervisory risk. Another relevant question is, does the adviser expect to have an ongoing intermediating role between the client and the other adviser? If not, something other than a sub-advisory relationship might again be more appropriate.
Typically, a sub-advisory relationship would be well-suited to a scenario in which the sub-adviser is delegated some of the adviser's duties and the adviser has an ongoing role with the client. An example is the subadvised fund scenario where an adviser engages a sub-adviser to handle the portfolio of one of the adviser's funds. Here, the adviser and sub-adviser enter into a sub-advisory agreement in which the sub-adviser is delegated portfolio management duties to be performed subject to the adviser's supervision. These duties are among those the adviser is contractually obligated to perform as part of its broad managerial responsibilities under the advisory agreement with the fund. Note that as a matter of contract law, the adviser remains liable to the fund for failure to perform the delegated duties, even if the failure is caused by the sub-adviser. (4) The adviser plays an overarching role in managing the fund and is the key interface with the fund's board of directors. The sub-adviser handles day-to-day portfolio management. This is a classic sub-adviser scenario.
In contrast, some relationships might be better structured as co-advisory relationships or some other type of alliance or side-by-side arrangement if neither adviser is expected to be under the other's supervision or they are expecting to coordinate more like equals. Still other relationships might be better structured as separate, direct relationships between the client and each of the advisers involved. These different alignments could help to mitigate or eliminate the adviser's duty to supervise the other adviser. An example of this might be where a client engages one adviser to manage only the equity portion of its portfolio and another to manage only the fixed income portion, or where one adviser is engaged only to set asset allocation guidelines, while another is engaged only to select specific securities within those guidelines.
2. What are the client's expectations? The client's expectations could influence the interpretation of whether a sub-adviser is under an adviser's supervision in any given case. On a more practical level, advisers should be concerned about meeting the client's expectations since this will help to avoid misunderstandings or disputes with the client and generally keep the client happy, presumably one of the adviser's key business goals.
Therefore advisers should ask such questions as: Did the client engage the adviser with a narrow mandate to manage just one area or to perform a single function without further involvement? Or, in contrast, did the client engage the adviser to manage a portfolio and all its affairs, even though the adviser may be permitted to engage another adviser for assistance? Is the client sophisticated enough or does the client have the internal resources or expertise to do any monitoring or supervision itself, or is the client likely to be counting on the adviser to fill that role?
A broad engagement in which the adviser is obligated to manage all the affairs of a portfolio suggests that the client may expect the adviser to stand behind virtually any problem that comes up, particularly if the problem was caused by another party selected by the adviser. In that case, a sub-advisory relationship might be suitable in light of the client's likely expectation that the adviser is in some respect supervising the sub-adviser. On the other hand, a narrow engagement suggests that the client may expect the adviser to stand behind only …