The Illusory Protection By “Most Favored Nation's"
July 1, 2003
The Illusory Protection Provided By “Most Favored Nation’s Clauses”
Pensions seeking to ensure they are paying the lowest investment advisory fees managers offer often require the managers they hire to agree to a “most favored nation’s” provision or “mfn.” Frequently the mfn provision will be included in the investment advisory contract between the pension and the investment manager. In other cases the advisory contract will be silent on the issue but the manager will be required to certify quarterly or annually that the client is receiving the lowest fee. In brief, an mfn provision states that the manager represents the fee the client is paying is the lowest fee the manager offers to “similarly situated” clients. At the outset it is important to note that the mfn does not require the manager to represent the pension is paying the lowest effective fee the manager offers to anyone—only the lowest fee offered to “similarly situated” pensions. More on the meaning of “similarly situated” later.
While mfns are common among pensions, they vary considerably in their wording and complexity. For example, one fund we advised required its managers to complete a quarterly questionnaire containing the following simply worded question which served as the fund’s mfn clause: “Do any accounts of similar size and with similar assets under management pay lower fees than this plan? If yes, please explain.” Below is the substantially lengthier mfn of another pension fund of comparable size. (As you can see, the size of the fund does not dictate the specificity of the mfn.)
“If, at any time from and after the execution date of this Agreement, the Investment Manager enters into an agreement with any other client to provide investment management services comparable to those provided under this Agreement, and if such agreement requires the payment of fees that are in any respect lower than the fee established in this Agreement, the Investment Manager agrees that the fee required under this Agreement shall be reduced to the level specified in the agreement with such other client.
Principal variables which shall be utilized to determine whether the services are comparable include, but are not limited to, size of account, restrictions on the account, aggressiveness of investment objectives and discretionary character of the account. Such reduction in fees shall be effective as of the effective date of the agreement with such other client. The Investment Manager agrees to provide the Board with timely written notice of any event or occurrence that would require a reduction in fees provided under this Agreement. Further, the Investment Manager represents and warrants that the fees provided under this Agreement do not exceed those currently charged to other clients receiving comparable services.”
Due to the variation in the wording and complexity of mfn provisions, the issue of compliance with these clauses is a subject of intense concern among money managers. Firms differ in their understandings as to the meaning of such clauses in their clients’ contracts. A single large investment advisory firm may be subject to hundreds of mfns in their contracts with pensions. Larger firms may have internal compliance professionals to review contracts for mfn compliance, however, the size of the firm does not guarantee compliance. Smaller firms, on the other hand, may lack the resources to monitor compliance. According to a recent survey, one of the four biggest issues of concern to pensions and money managers alike was mfn clauses.
Unfortunately the language in most mfn clauses is open to tremendous interpretation. Managers may contend a client paying a lower fee is receiving a different asset management service and therefore the mfn clause has not been violated.
Accounts paying “performance fees” are routinely considered exempt from mfn compliance by managers since performance fees typically involve low or no minimum fees and higher than usual maximum fees if the manager performs well.
Managers may believe “similar accounts” only includes other public pension funds and not corporate pensions or endowments and foundations. For example, one manager we recently interviewed candidly indicated that while he “might have a church account paying a lower fee,” he was still in compliance with our client’s mfn. “Wrap fee” accounts are also generally not considered “similar” by managers for mfn compliance purposes.
In summary, managers have become very skilled at distinguishing between clients and accounts in order to justify different fees for “similar accounts,” yet maintain they are in compliance with mfn clauses. On the other hand, few pensions even attempt to monitor compliance with their mfn clauses. Thus, managers who fail to comply have little to fear. Managers who are questioned by clients need only develop a plausible explanation for fee differentials.
Another problem with “most favored nation’s” clauses is they rely upon managers coming forward in good faith to notify the client it is entitled to a fee reduction, perhaps years after the initial fee negotiation. Many managers cannot be relied upon to volunteer such information against their financial interests. Therefore, where possible funds should contact other pension clients of their managers to determine whether the fee they pay is the same or lower. Pensions should also review managers’ Forms ADV on the SEC’s WebIARD system for information regarding their advisory businesses, such as percentages of institutional and retail clients and participation in “wrap fee” programs.
In the investigations we have undertaken involving blatantly excessive investment advisory fees, managers generally respond that the account managed for our pension client was unique and therefore any comparisons with other accounts of the manager, with lower fees, is inappropriate. In other words, the explanation for unusually high fees is that there is something unique about the investment mandate or account. Such manager explanations are hollow to those experienced in investment management matters. Fortunately for managers, many pensions are not sophisticated, or even informed, regarding the investment advisory fees funds actually pay. (See, Why Pension Investment Advisory Fees Are So High, January 2003, regarding the lack of “actual fee” databases.)
Managers charge certain funds unusually high fees because they can. In other words, either the pension’s investment consultant or the fund’s board itself has not effectively negotiated fees. Pensions that rely upon “most favored nation’s” provisions to ensure they are paying the lowest possible investment advisory fees are missing the boat. A “most favored nation’s” provision is no substitute for informed, vigorous fee negotiation. Finally, funds that fail to continuously monitor “most favored nation’s” compliance are likely to be unaware of fee reductions to which they may be entitled.
Setting Standards For The Investment Management Industry
