Failure to Adequately Oversee Service Providers

Citing what it called “wholly inadequate” oversight of a faraway subadviser, the Securities and Exchange Commission fined and ordered repayment of advisory fees by Morgan Stanley Investment Management. According to the settlement, Morgan Stanley will repay its client, the Malaysia Fund, $1.8 million for fees it paid from 1996-2007 for “research, intelligence, and advice” that  AMMB Consultant Sendirian Berhad of Malaysia, was to provide as subadviser.

AMMB served as a sub-adviser to the Fund from inception until it was terminated at the end of 2007. The Research and Advisory Agreement specified that AMMB would register with the SEC as an investment adviser under the Investment Advisers Act and furnish Morgan Stanley “such investment advice, research and assistance, as [Morgan Stanley] shall from time to time reasonably request.” AMMB did not exercise investment discretion or authority over any of the assets in the Fund. Morgan Stanley took responsibility for monitoring AMMB’s performance of services. The Fund would pay AMMB an escalating fee based on the fund’s assets. During the relevant time period, the Fund paid AMMB advisory fees totaling $1,845,000. As the fund administrator, Morgan Stanley facilitated the Fund’s payment of AMMB’s advisory fees.

Section 15(c) of the Investment Company Act requires an investment adviser of a registered investment company to furnish such information as may reasonably be necessary for such company’s directors to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of the company.

It was an OCIE exam in 2008 that first questioned the arrangement between AMMB and Morgan Stanley. AMMB did not provide any of the services it and Morgan Stanley represented to the Fund’s Board. Instead, AMMB provided two monthly reports that Morgan Stanley neither requested nor used in its management of the Fund. The first was a two-page list of the market capitalization of the Kuala Lumpur Composite Index. The second was a two-page comparison of the monthly performance of the Fund against other Malaysian equity trusts. For twelve years, the fund’s Board relied on Morgan Stanley’s representations and submissions of information regarding AMMB’s services when it unanimously approved the continuation of AMMB’s advisory contracts. The SEC stated that even though Morgan Stanley took responsibility for monitoring AMMB’s services, its oversight and involvement with AMMB during the relevant time period were wholly inadequate.

The settlement calls on the RIA to devise written procedures, reimburse the fund and pay a fine of $1.5 million.

If you are charging a fund for services provided by a third, then there is an obligation to make sure the third party is providing those services.  The SEC stated a violation of Section 206(2) of the Investment Advisers Act that prohibits an investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client”. It also imposes on investment advisers a fiduciary duty to act in “utmost good faith,” to fully and fairly disclose all material facts, and to use reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963). Morgan Stanley willfully violated Section 206(2) of the Investment Advisers Act by representing and providing information to the Fund’s Board that AMMB was providing advisory services for the benefit of the Fund, which it was not.