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Pacific Select Fund (Dec. 23, 2004) (Performance Fees)

Pacific Select Fund (Dec. 23, 2004) (Performance Fees)

Thursday, 23 December 2004 08:00

Investment Advisers Act of 1940 – Section 205(a)(1)
Pacific Select Fund, et al.

December 23, 2004

RESPONSE OF THE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTMENT MANAGEMENT
Our Ref. No. 200477947
Pacific Select Fund, et al. File No. 811-05141

Your letter dated December 22, 2004 requests that we concur with your view, as more fully explained below, that Pacific Life Insurance Company would not violate section 205(a)(1) of the Investment Advisers Act of 1940 (the “Advisers Act”) by entering into the proposed advisory fee reduction program with respect to its management of Pacific Select Fund (the “Program”).

BACKGROUND

You represent that Pacific Life Insurance Company (“Pacific Life”) is an investment adviser registered under the Advisers Act and a stock life insurance company ultimately controlled by a mutual holding company. Pacific Life serves as the investment adviser to the Pacific Select Fund (the “Fund”) under an investment advisory agreement between the Fund and Pacific Life (the “Advisory Agreement”).

You represent that the Fund is an open end management investment company of the multi series type and is registered as an investment company under the Investment Company Act of 1940 (the “1940 Act”). The Fund serves as the underlying investment vehicle for variable life insurance and variable annuity contracts issued or administered by Pacific Life and its subsidiary, Pacific Life & Annuity Company (the “Variable Contracts”). Apart from shares sold for initial capital, the Fund offers shares of its series (the “Portfolios”) only to separate accounts of Pacific Life and Pacific Life & Annuity Company to serve as the investment vehicle for the Variable Contracts.

You represent that Pacific Life supervises the management of all of the Portfolios pursuant to the Advisory Agreement and is paid an advisory fee calculated as an annual percentage of each Portfolio’s average daily net assets (the “Advisory Fee”). Pacific Life and the Fund have retained other investment advisory firms as subadvisers to manage certain of the Portfolios. The subadvisers to the Portfolios are compensated by Pacific Life, and not directly by the pertinent Portfolio.

You represent that Pacific Life has proposed, and the Fund’s board of trustees (the “Board”) (including all of the Fund’s trustees who are not interested persons (as defined in section 2(a)(19) of the 1940 Act) (the “Independent Trustees”)) has agreed, to institute the Program, which has the potential to reduce the Advisory Fee paid by each Portfolio. Under the Program, Pacific Life would contractually waive a portion of the Advisory Fee if the Fund’s average annual gross total return over a ten year period (“Return”)1 exceeds a target return rate (the “Target Rate”).2 The amount by which the Advisory Fee would be reduced would depend upon the amount by which the Return exceeds the Target Rate.

You represent that the Fund’s Return would be calculated for the most recently completed ten-year period at the beginning of a calendar year while the Program is in effect. For example, in early 2005, the Fund’s Return would be determined for the ten year period ended December 31, 2004. If that Return exceeds the Target Rate, Pacific Life would waive a portion of its Advisory Fee for the period from May 1, 2005 through April 30, 2006. The amount of the waiver would increase as performance exceeds the Target Rate.3

You represent that any waiver would apply to all of the assets of each Portfolio, as opposed to conventional breakpoints. In addition, the waiver would apply equally to each Portfolio, without regard to the level of the Advisory Fee of the Portfolio and without regard to the size or performance of the individual Portfolio.

Finally, you represent that the intention of the Fund’s Board and Pacific Life in the design of the Program is to permit owners of the Variable Contracts (“contractholders”) to benefit in the form of lower expenses at projected profitability levels expected to be realized by Pacific Life in connection with its management of the Fund as well as its administration of the Variable Contracts. You further represent that savings to the contractholders could be significant under the Program.4

ANALYSIS

Section 205(a)(1) of the Advisers Act provides that, unless exempt from registration under section 203(b), no investment adviser shall use any means or instrumentality of interstate commerce, directly or indirectly, to enter into an advisory contract that provides for “compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client” (a “performance fee”). Section 205(a)(1) is designed, among other things, to eliminate “profit sharing contracts [that] are nothing more than ‘heads I win, tails you lose’ arrangements,”5 and that “encourage advisers to take undue risks with the funds of clients,”6 to speculate, or to overtrade.7

We have taken the position that section 205(a)(1)’s prohibition of investment advisory contracts that contain performance fees extends to investment advisory contracts that provide for “contingent fees.”8 A contingent fee is “an advisory fee [that] will be waived or refunded, in whole or in part, if a client’s account does not meet a specified level of performance” or that is contingent on the investment performance of the funds of advisory clients.9 A contingent fee provides an investment adviser with an incentive to take undue risks, speculate or engage in over-trading because the adviser knows that it will not receive any, or will receive reduced, compensation for its work when the performance of the client’s funds has not reached the agreed upon level.

You believe that Pacific Life would not violate section 205(a)(1) by entering into the Program. As in the case of a contingent fee that implicates section 205(a)(1), the Advisory Fee would be dependent on the Fund’s investment performance because it would increase or decrease depending on the Fund’s performance. In contrast to a contingent fee, however, the Advisory Fee to be paid under the Program would decrease with an increase in the Fund’s performance. Consequently, Pacific Life’s Advisory Fee under the Program is not a contingent fee that implicates section 205(a)(1) because Pacific Life would not be compensated based on a share of the capital gains upon or capital appreciation of a client’s funds.10 In addition, we note your representation that savings to the contractholders could be significant under the Program.11

Based on the foregoing facts and representations, we concur with your view that Pacific Life would not violate section 205(a)(1) by entering into the Program. Our position is based upon the facts and representations made in your letter. Any different facts or representations may require a different conclusion.

John L. Sullivan
Senior Counsel

 

Endnotes

1 Appendix A of your incoming letter describes the methodology proposed to be used for calculating the Return.

2 You represent that, under the Program’s current specifications, the Target Rate would be 8.0%. The Target Rate has been negotiated by Pacific Life and the Independent Trustees based on the following factors, among others: (1) a level of revenues that Pacific Life projects would enable it to meet its obligations under the Advisory Agreement and the Variable Contracts and to maintain financial health at a level appropriate for an insurance company; and (2) the likelihood of the Fund’s performance attaining the Target Rate under different economic scenarios. In considering the Program, the Independent Trustees were assisted by an independent financial consultant.

3 You represent that, under the Program’s current specifications, if the Fund’s Return were 10.0%, the waiver would reduce by 0.005% the investment advisory fee that otherwise would be payable by each Portfolio. If the Fund’s Return were greater than 20%, the waiver would reduce by 0.05% the investment advisory fee that would be payable by each Portfolio. The maximum amount of the waiver would be 0.05% under the Program.

4 You contend that if the Program had been in effect for year 2004, and the Fund’s Return for the ten year period ended December 31, 2003 had been 10%, the amount of Advisory Fees that would be waived would have been approximately $1,219,000 (assuming sustained asset growth at current levels). If the Return had been 14%, the amount waived would have been approximately $4,877,000.

5 S. Rep. No. 1775, 76th Cong., 3d Sess. 22 (1940).

6 H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940). The section was designed to eliminate the possibility of an investment adviser entering into a contract in which he or she “does not participate in the losses, but participates only in the profits.” Investment Trusts and Investment Companies; Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 320 (1940) (statement of David Schenker, Chief Counsel of the Commission’s Investment Trust Study).

7 See Securities and Exchange Commission, Investment Counsel, Investment Management, Investment Supervisor and Investment Advisory Services, H.R. Doc. 477, 76th Cong., 2nd Sess. at 30 (1939).

8 Contingent Advisory Compensation Arrangements, SEC Rel. No. IA-721 (May 16, 1980).

9 Id. A contingent fee arrangement provides for a fee that is “based upon a share of capital gains or capital appreciation,” because the client’s obligation to pay the fee “is dependent on a client’s account achieving a specified level of capital gains or appreciation.” Id.

10 You also address whether Pacific Life would have an incentive to manage the Fund conservatively so that the Fund underperforms the Target Rate, thereby avoiding a waiver of a portion of the Advisory Fee. You argue that the Program would reduce but not eliminate the Advisory Fee so that Pacific Life continues to have an incentive to seek superior performance for the Fund. You further argue that Pacific Life would continue to have an incentive to seek superior investment performance with respect to the Fund because superior performance places Pacific Life in a better position with respect to attracting and retaining additional assets under management upon which to charge a fee.

11 See note 4, supra.

Incoming Letter

December 22, 2004

Douglas J. Scheidt
Associate Director and Chief Counsel
Division of Investment Management
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Pacific Select Fund and Pacific Life Insurance Company — Section 205 of the Investment Advisers Act of 1940

Dear Mr. Scheidt:

On behalf of Pacific Select Fund (the “Fund”), an open-end management investment company, Pacific Life Insurance Company, the investment adviser to the Fund (“Pacific Life”), and the Trustees of the Fund, including the Trustees who are not “interested persons” of the Fund as that term is defined in Section 2(a)(19) of the Investment Company Act of 1940 (the “Independent Trustees”), we hereby request confirmation that the staff of the Division of Investment Management (the “Staff”) will concur with our view, as more fully explained below, that Pacific Life Insurance Company would not violate Section 205(a)(1) of the Investment Advisers Act of 1940 (the “Advisers Act”) by entering into the proposed advisory fee reduction program with respect to its management of the Fund (the “Program”).1

Facts

The Fund

The Fund is an open-end management investment company of the multi-series type registered under the Investment Company Act of 1940 (the “Investment Company Act”) that currently offers 31 separate series (“Portfolios”). The Fund serves as the underlying investment vehicle for variable life insurance and variable annuity contracts issued or administered by Pacific Life Insurance Company and its subsidiary, Pacific Life & Annuity Company (“Variable Contracts”). Owners of the Variable Contracts (“Contract Owners”) do not directly buy, sell, or trade shares of the Fund; rather, a Contract Owner chooses among the investment options offered under the Variable Contracts, and the insurance companies, through their separate accounts, invest in the Portfolios of the Fund according to the investment options selected by the Contract Owners. Apart from shares sold for initial capital, the Fund offers shares of the Portfolios only to separate accounts of Pacific Life and Pacific Life & Annuity Company to serve as the investment vehicle for the Variable Contracts.

The Fund is organized as a Massachusetts business trust and is governed by a Board of Trustees. Currently, the Board of Trustees consists of seven trustees, six of whom are Independent Trustees.

As of December 31, 2003, the Fund’s net assets were $24.3 billion.

Pacific Life

Pacific Life, an investment adviser registered under the Advisers Act, serves as investment adviser to the Fund under an Investment Advisory Agreement between the Fund and Pacific Life (the “Advisory Agreement”). Pursuant to the Advisory Agreement, Pacific Life supervises the management of all of the Fund’s Portfolios, for which it is paid an advisory fee calculated as an annual percentage of each Portfolio’s average daily net assets (the “Advisory Fee”). The Advisory Fee for each Portfolio is prescribed in the Advisory Agreement. The Portfolios’ Advisory Fees range from an annual rate of 0.33% (effective rate) for the Money Market Portfolio to 1.25% for the I Net Tollkeeper Portfolio. Pacific Life manages only two Portfolios directly — the High Yield Bond and the Money Market Portfolios. Pacific Life and the Fund have retained other investment advisory firms as sub-advisers to manage the other 29 Portfolios of the Fund. The sub-advisers to the Portfolios are compensated by Pacific Life, and not directly by the pertinent Portfolio.

Pacific Life, subject to the review of the Fund’s Board of Trustees, has the responsibility to oversee the sub-advisers. Under a “multi-manager” exemptive order from the SEC, Pacific Life and the Fund can enter into, terminate, and materially amend agreements with sub-advisers (other than sub-advisers affiliated with Pacific Life) without shareholder approval.2 Under the multi-manager order, entering into, terminating, or materially amending an agreement with a sub-adviser requires the approval of the Fund’s Board of Trustees and a majority of the Independent Trustees.

Pacific Life was originally organized on January 2, 1868 as a mutual company, under the name “Pacific Mutual Life Insurance Company of California.” It was reincorporated as a mutual life insurance company under the name “Pacific Mutual Life Insurance Company” on July 22, 1936. On September 1, 1997, Pacific Life converted from a mutual life insurance company to a stock life insurance company ultimately controlled by a mutual holding company. Pacific Life is a subsidiary of Pacific LifeCorp, a holding company which, in turn, is a subsidiary of Pacific Mutual Holding Company, a mutual holding company. Pacific Life considers its tradition as a mutual life insurance company as a strong part of its culture.

The Proposed Advisory Fee Reduction Program

From time to time, the Independent Trustees have engaged in discussions with Pacific Life about sharing with Contract Owners potential savings that Pacific Life may realize in connection with its services under the Advisory Agreement. As a result of those discussions, Pacific Life has proposed, and the Fund’s Board of Trustees, including all of the Fund’s Independent Trustees, has agreed, to institute the Program, which has the potential to reduce the Advisory Fee paid by each Portfolio. Initiation of the Program is subject to the Staff granting this no-action request. The Program as approved by the Fund’s Board of Trustees will be in effect through April 30, 2007, after which the structure and operation of the Program will be reviewed by Pacific Life and the Fund’s Board of Trustees. At that time, the Program may be discontinued, renewed, or changed as determined by Pacific Life and the Fund’s Board of Trustees.3 Of course, the Program is also subject to annual renewal of the Advisory Agreement by the Fund’s Board of Trustees, including a majority of the Independent Trustees.

Under the Program, Pacific Life will contractually waive a portion of the Advisory Fee if the Fund’s average annual gross total return over a 10-year period exceeds a target return rate (the “Target Rate”). The amount by which the Advisory Fee will be reduced will depend upon the amount by which the average annual gross total return of the Fund for a 10-year period, calculated as described in Appendix A (“Return”), exceeds the Target Rate.4

In determining the amount of the waiver under the Program, at the beginning of a calendar year while the Program is in effect, the Fund’s Return will be calculated for the most recently completed 10 calendar-year period. For example, in early 2005, the Fund’s Return will be determined for the 10-calendar-years ended December 31, 2004. If that Return exceeds the Target Rate, Pacific Life would waive a portion of its Advisory Fee for the period from May 1, 2005 through April 30, 2006. Then in early 2006, the Fund’s Return will be calculated for the 10-year period ending December 31, 2005. If the Return for that period is greater than the Target Rate, Pacific Life would waive a portion of its Advisory Fee for the period from May 1, 2006 through April 30, 2007. This process will be repeated each year the Program is in effect, subject to renewal of the Advisory Agreement each year. The Return is calculated on a gross basis, without reflecting fees and expenses of the Portfolios, and is asset-weighted.

If the Fund’s Return for a 10-year period does not exceed the Target Rate, no waiver would apply under the Program. If the Fund’s Return for the 10-year period exceeds the Target Rate, a waiver would apply, effective May 1 of the following year as described above. The amount of the waiver would depend on the amount by which the Fund outperformed the Target Rate. Under the Program’s current specifications, as agreed upon by Pacific Life and the Independent Trustees, the Target Rate would be 8.0%. The amount of the waiver increases as performance exceeds the Target Rate. So, for example, if the Fund’s Return were 10.0%, the waiver would reduce by 0.005% the investment advisory fee that otherwise would be payable by each Portfolio. If the Fund’s Return were greater than 20%, the waiver would reduce by 0.05% the investment advisory fee that would be payable by each Portfolio. The maximum amount of the waiver would be 0.05% under the Program.

Accordingly, the greater the amount by which the Fund’s Return exceeds the Target Rate, the greater the waiver of the Advisory Fee. Any waiver would apply to all of the assets of each Portfolio, as opposed to conventional breakpoints, which typically apply a lower fee schedule to a specific Portfolio’s assets above a prescribed asset level. In addition, the waiver will apply equally to each Portfolio, so that a waiver of 0.03% would reduce the Advisory Fee of each Portfolio by that amount, without regard to the level of the Advisory Fee of the Portfolio under the Advisory Agreement, and without regard to the size or performance of the individual Portfolio.

The intention of the Fund’s Board of Trustees and Pacific Life in the design of the Program is to permit shareholders, i.e., Contract Owners, to benefit in the form of lower expenses at targeted projected profitability levels expected to be realized by Pacific Life in connection with its management of the Fund as well as its administration of the Variable Contracts for which the Fund serves as an investment vehicle. The Program is premised on the notion that the actual savings that the Adviser realizes and is able to pass on to Contract Owners, in connection with the management of the Fund and the Administration of the Variable Contracts, is only in part a function of the size of the Fund. Rather, in economic reality, savings are to a more significant degree a function of annual revenues, and these are directly affected by the Fund’s performance. The Target Rate has been negotiated by Pacific Life and the Independent Trustees based on the following factors, among others:

  • a level of revenues that Pacific Life projects will enable it to meet its obligations under the Advisory Agreement and the Variable Contracts and to maintain financial health at a level appropriate for an insurance company; and
  • the likelihood of the Fund’s performance attaining the Target Rate under different economic scenarios.5

In contrast to conventional breakpoints, the Program provides Pacific Life some protection in periods in which revenue projections may not be met because of investment performance, and provides shareholders a discount across all assets in periods in which revenue projections attributable to investment performance are exceeded.

Savings to Contract Owners could be significant under the Program. If the Program had been in effect this year, and the Fund’s Return for the ten year period ended December 31, 2003 had been 10%, the amount of Advisory Fees that would be waived would be approximately $1,219,000 (assuming sustained asset growth at current levels). If the Return had been 14%, the amount waived would be approximately $4,877,000.

Review of Advisory Fee Reduction Program by the Independent Trustees

The Fund’s Independent Trustees considered the Program at several meetings, and approved the Program at a June 2004 Board meeting, subject to the Staff granting this no-action request. The Independent Trustees approved the Program for the following reasons, among others: (i) the Program has the potential to reduce the Advisory Fees paid by each of the Portfolios; (ii) the Program aligns the interests of Contract Owners and Pacific Life, since both benefit when Fund performance exceeds the Target Return; and (iii) the economic effect of the Program is a sharing of profits with Contract Owners that is consistent with Pacific Life’s tradition as a mutual insurance company. The Independent Trustees also considered that many Contract Owners participate in an asset allocation program under which their premiums and contract value are allocated across multiple Portfolios in varying proportions, some of which Portfolios might receive breakpoint benefits and some of which might not; and the Program ensures an even distribution of benefits irrespective of how assets are allocated for particular Contract Owners.

Section 205(a)(1) of the Advisers Act

Section 205(a)(1) of the Advisers Act prohibits an investment adviser from entering into any advisory contract that provides for compensation to the adviser on the basis of a share of capital gains upon or capital appreciation of a client’s funds. The purpose of this prohibition, as indicated in the legislative history of the Advisers Act, was to prevent undue speculation by the adviser in the management of its client’s assets.6

As originally enacted, Section 205(a)(1) did not apply to contracts between registered investment advisers and investment companies registered under the Investment Company Act. However, in 1970 Congress extended the performance fee prohibition to advisory contracts with registered investment companies based, in part, on concerns that many investment companies had performance-based fee arrangements that allowed their advisers to earn a bonus for good performance without imposing a comparable penalty for poor performance.7

In a 1980 interpretive release, while acknowledging that there is a “question” as to whether Section 205(a)(1) directly prohibits contingent compensation arrangements, the Staff expanded the scope of the prohibition in Section 205(a)(1) when it took the view that this provision prohibits “contingent fees,” which generally include any arrangement whereby the adviser’s fee is contingent upon realizing a specified level of capital gains or capital appreciation in the client’s account.8 The Staff stated that such arrangements encourage advisers to take undue risks and engage in undue speculation with the funds of clients, noting that it was these concerns that prompted Congress to adopt Section 205(a)(1).9 The Staff took the position in the Interpretive Release that prohibited contingent advisory compensation arrangements include those in which:

(i) fees are waived or refunded, in whole or in part, by an adviser if a specified level of investment performance in a client’s account is not achieved, . . . (iii) fees are waived if recommended securities do not appreciate in value within a designated period of time, and (iv) fees are contingent upon an account either not decreasing in value or avoiding a specified amount of capital depreciation.10

The Staff seems to have departed from the contingent fee position taken in 1980, at least as applied to investment companies, in a 1986 no-action letter.11 In that letter, the Staff (1) permitted a “fulcrum fee” for a registered investment company that went down for underperformance of a benchmark faster than it went up for outperformance, and (2) permitted a complete waiver of the advisory fee for a year in which the investment company did not have positive performance. In the 1986 letter, however, the Staff did not expressly repudiate the position taken in the Interpretive Release described above.

Analysis

The Advisory Fee Reduction Program is Not a Performance Fee

We do not believe that Pacific Life would violate Section 205(a)(1) by entering into the Program. As in the case of a contingent fee that implicates Section 205(a)(1), the Advisory Fee would be dependent on the Fund’s investment performance because it would increase or decrease depending on the Fund’s performance. However, in contrast to a contingent fee, the Advisory Fee to be paid under the Program would decrease with an increase in the Fund’s performance. Consequently, we do not believe that Pacific Life’s Advisory Fee under the Program is a contingent fee that implicates Section 205(a)(1) because Pacific Life would not be compensated based on a share of the capital gains upon or capital appreciation of a client’s funds.

As described above, the Staff has in the past taken the position that Section 205(a)(1) prohibits advisory fee arrangements that are contingent on an account avoiding a specified amount of depreciation.12 The Staff at times has said that refunds or waivers of advisory fees, if based on the same criteria, are comparable to a more direct incentive fee arrangement, and thus prohibited by Section 205(a)(1).13 However, the reasoning reflected in these Staff positions is that advisory fees that are contingent upon the performance of a client’s account “present the inherent conflicts of interest (i.e., encouraging advisers to take undue risks with clients’ funds in order to protect their contingent fee) that Section 205(a)(1) was designed to prevent.”14 Since, as noted above, the Program would decrease the amount of the Advisory Fee paid by the Fund as the Fund’s rate of return increases, the Program does not create an incentive for Pacific Life to engage in unduly speculative or risky investment techniques. Indeed, Pacific Life’s interests are aligned with shareholder interests in that Pacific Life would waive revenue only under circumstances that indicate its revenues are increasing because of investment returns since it also derives revenue on the amount of gain enjoyed by the Fund, even in excess of the Target Rate.

The Advisory Fee Reduction Program Is Consistent With Staff Pronouncements Regarding Performance Fees

Although, as explained above, we do not believe that the Program is a performance fee within the meaning of Section 205(a)(1), we believe that the Program is consistent with Staff guidance on performance fees. The Staff has consistently said, both in the Interpretive Release and in subsequent no-action letters, that the purpose of Section 205(a)(1) is to avoid the creation of an incentive for the adviser to engage in speculative or risky trading with client assets.15 Because the Program does not compensate Pacific Life on the basis of appreciation in the Fund’s assets, it does not provide an incentive for Pacific Life to engage in unduly speculative or risky trading.

We believe the no-action position taken in Royce Value Trust is consistent with the request in this letter.16 In Royce Value Trust, the Staff granted no-action relief where an adviser entered into a fulcrum fee arrangement with a closed-end fund in which the adviser charged a performance fee to the fund that decreased at a faster rate than it increased, and provided for no compensation if the net asset value per share of the fund decreased, on the basis of a rolling 36-month performance period. The Staff responded that although “the legislative history of Section 205(a)(1) does not indicate whether Congress ever considered this type of arrangement,” it granted the no-action request because “we believe that Congress primarily sought to ensure that performance-based fees would not increase by the amount or rate greater than that by which they decreased.” The Program, like the performance fee arrangement in Royce Value Trust, is an arrangement that provides a benefit to investors while providing no incentive for the adviser to take the kind of undue risk with client assets that Section 205(a)(1) was intended to prevent. In fact, the Program appears to provide an even clearer benefit to investors than the arrangement in Royce Value Trust, since under the Program the Advisory Fee may only be decreased for investment performance and may not be increased. Moreover, in Royce Value Trust the adviser was paid no compensation if the net asset value of the fund decreased.17 Here, the Program would reduce but not eliminate the Advisory Fee so that Pacific Life continues to have incentive to seek superior performance for the Fund.

We also note that some advisers to mutual fund complexes charge as part of their investment advisory fee a “group fee” which is based on the average net assets of all the funds in the complex,18 and that the group fee has breakpoints as the total assets under management increase. The prospectuses of these funds indicate that the group fee is designed to reflect the benefits of the shared resources of the investment advisory complex.19 Similarly, by implementing the Program, Pacific Life and the Fund seek to share with all Contract Owners having interests in all Portfolios the economies of scale that are achieved when the Fund’s 10-year return exceeds the Target Rate.

Pacific Life Has Incentive to Exceed the Target Rate

Because the Advisory Fee will be reduced if the Return exceeds the Target Rate, it could be argued that Pacific Life has an incentive to manage the Fund conservatively so that it underperforms the Target Rate, thereby avoiding a waiver of a portion of the Advisory Fee. We believe that any such concern is, at most, academic, and in reality, nonsensical. Pacific Life will continue to earn increased Advisory Fees even if the Fund’s Return exceeds the Target Rate; exceeding the Target Rate simply means that Pacific Life will begin waiving a portion of its earnings on these “above Target Rate” Advisory Fees. Indeed, the Independent Trustees were mindful of Pacific Life’s need to earn sufficient revenues to meet its obligations under the Advisory Agreement, to meet its obligations under the Variable Contracts, and to maintain its economic health, even after the Target Rate is attained. This was an important part of their consideration in agreeing to the Program and in negotiating the Target Rate. Further, Pacific Life will continue to have an incentive to seek superior investment performance with respect to the Fund. Superior performance places Pacific Life in a better position with respect to attracting and retaining additional assets under management upon which to charge a fee, and increased Fund performance improves Pacific Life’s profitability across its products. Moreover, the Staff has in the past permitted performance fee arrangements where the adviser’s fee could be reduced to zero based upon performance.20

These arguments are particularly compelling given the design of the Program and the structure of the Fund. Pacific Life actively manages only two of the Fund’s 31 Portfolios; all other Portfolios are managed by sub-advisers selected by Pacific Life and the Fund’s Board of Trustees. The Program would not reduce the compensation sub-advisers receive from Pacific Life. Accordingly, with respect to the 29 Portfolios managed by sub-advisers, it defies logic to think that Pacific Life would intentionally intervene in Portfolio management to restrain performance, and would do so on a sustained basis over a 10-year period. To the contrary, as noted above, favorable performance, even in excess of the Target Rate, will be beneficial for Pacific Life, and it is this benefit that provides the rationale for the Program. Favorable performance increases the Fund’s net assets, which will increase advisory fee revenues and revenues earned by Pacific Life under the Variable Contracts. Favorable performance can also aid in the promotion of the Fund and the Variable Contracts, which could result in greater sales and further increase assets under management, thereby increasing Pacific Life’s revenues.

The Advisory Fee Reduction Program Benefits Investors

As noted above, the Program would apply to all Portfolios of the Fund. Thus, the Program provides an opportunity to benefit Contract Owners by reducing the amount of investment advisory fees they indirectly bear. Moreover, the Independent Trustees have determined that the sharing of savings generated by good performance of the Fund is beneficial to shareholders.

Conclusion

For the reasons explained above, we do not believe that the Program is a prohibited performance fee under Section 205(a)(1) of the Advisers Act. Accordingly, we request that the Staff confirm that it concurs with our view that Pacific Life would not violate Section 205(a)(1) of the Advisers Act by entering into the Program.

Sincerely,

Jeffrey S. Puretz
Dechert LLP

cc: Julie Allecta, Paul, Hastings, Janofsky & Walker LLP, counsel to the Independent Trustees

Alan Richards, Chairman of the Policy Committee of the Board of Trustees

Robin S. Yonis, Vice President and Investment Counsel, Pacific Life Insurance Company

APPENDIX A

METHODOLOGY FOR THE CALCULATION OF THE RETURN

The methodology for the calculation of the Return is as follows: the total return of each Portfolio is calculated for each month during the relevant 10-year period using the customary methods as specified in Rule 482 under the Securities Act of 1933 and Item 8 of Form N-1A. To this amount, adjustments are made to add the fees and expenses paid by a Portfolio to the monthly total return, to arrive at a gross return. The gross monthly returns for all of the Portfolios are averaged on an asset-weighted basis, so that the larger Portfolios are weighted proportionately greater, to arrive at a monthly return for the Fund.

For a calendar year, the 12 monthly returns for the Fund are averaged on an asset-weighted basis, so that the monthly returns are weighted on the basis of the size of the Fund during the pertinent month and then annualized, to arrive at a gross annual return for the Fund for a year. Next, the annual returns for a 10-year period are averaged on an asset-weighted basis, so that the annual returns are weighted on the basis of the size of the Fund during the pertinent year, to arrive at an average annual gross total return for the 10-year period.

 

Endnotes

1 The Fund’s Independent Trustees are represented by Paul, Hastings, Janofsky & Walker LLP, which has reviewed and concurs with the views expressed in this letter.

2 See Notice of Application, Pacific Select Fund, et. al.,, Release No. IC-24017 (Sept. 17, 1999) and Order Granting Exemptive Relief, Release No. IC-24081 (Oct. 13, 1999

3 The parties envision that the Program will be effected through a letter from Pacific Life to the Fund’s Board of Trustees that would be similar to another letter from Pacific Life to the Board of Trustees in which Pacific Life commits to certain expense limitations with respect to the Portfolios.

4 Gross returns are used because they are more consistent with the rationale for the Program, as described herein. The use of gross returns is beneficial for shareholders.

5 In considering the Program, the Independent Trustees were assisted by an independent financial consultant.

6 See Division of Investment Management, U.S. Securities and Exchange Commission, Protecting Investors: A Half Century of Investment Company Regulation 238 (1992).

7 Id.

8 Contingent Advisory Compensation Arrangements, SEC Release No. IA-721 (May 16, 1980) (“Interpretive Release”). In the Interpretive Release the Staff took the position that to the extent there is any question as to whether Section 205(a)(1) directly prohibits contingent fees, such fees are prohibited by Section 208(d) of the Advisers Act, which provides that it is unlawful for any person indirectly to do any act or thing that it would be unlawful to do directly.

9 For more recent pronouncements, see also Exemption To Allow Registered Investment Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client’s Account, SEC Release No. IA-996 (Nov. 26, 1995); Service Support Group, Inc. (pub. avail. Feb. 1, 1994).

10 Id.

11 Royce Value Trust, Inc. (pub. avail. Dec. 22, 1986) (“Royce Value Trust“).

12 See Interpretive Release, supra n. 8.

13 See, e.g., V.L. McKenzie (pub. avail. Oct 29, 1975) (no action request denied where advisory fee would be waived if the recommended stock did not advance in price); Robert Reinhart, Jr. (pub. avail. Sept. 21, 1971) (no action request denied where adviser would return its advisory fee if its recommendation of a security was “unsatisfactory” to the client); Leland O’Brien Rubinstein (pub. avail. Jan. 13, 1989) (no action request denied where fee schedule to clients would reduce or refund fees if a particular investment strategy failed to limit losses in a client’s portfolio). But see Royce Value Trust, supra n. 11, where the SEC staff stated it would not object if an advisory agreement contained a performance fee that decreased at a greater rate than it increased and provided for no compensation if the net asset value per share declined.

14 See Leland O’Brien Rubinstein (pub. avail. Jan. 13, 1989).

15 See supra n. 8 and n. 13.

16 See supra n. 13.

17 See supra n. 13.

18 See, e.g., T. Rowe Price New Era Fund, Inc. (SEC File No. 811-1710); Fidelity Investment Trust (SEC File No. 811-4008).

19 Id.

20 See Royce Value Trust, supra n. 11.


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