The 15(c) Process Continues to Be a Focus of the SEC Enforcement Staff
August 13, 2015
Two recent SEC Enforcement Division administrative settlements reinforce the importance for fund boards of directors and fund advisers to maintain a robust annual advisory contract renewal process.
In both In the Matter of Commonwealth Capital Management, et al., SEC Rel. No. IC-31678 (June 17, 2015) (Commonwealth) and In the Matter of Kornitzer Capital Management, et al., SEC Rel. No IC-31560 (Apr. 21, 2015) (Kornitzer) (collectively, Orders), the Securities and Exchange Commission’s (SEC or Commission) Enforcement Division staff (Staff or Enforcement Division) alleged deficiencies in the process that certain mutual funds used to renew the annual advisory contract with their investment advisers, as required by Section 15(c) of the Investment Company Act of 1940 (1940 Act).1 The Orders serve as the most recent examples of the Enforcement Division’s pursuit of penalties when it observes deficiencies in the annual advisory contract approval process (15(c) Process). In addition, Commonwealth highlights a growing trend of the Enforcement Division to name personally individual board members of registered investment companies, even where the underlying conduct does not warrant the imposition of a significant penalty.2
The Section 15(c) Process
Section 15(c) of the 1940 Act provides, in part, that “it shall be unlawful for any registered investment company ... to ... renew ... any [investment advisory or principal underwriting] contract or agreement ... unless the terms of such ... agreement and any renewal thereof have been approved by ... a majority of [the independent] directors, cast in person at a meeting called for the purpose of voting on such approval.” In anticipation of that vote, Section 15(c) instructs that “[i]t shall be the duty of the directors of a registered investment company to request and evaluate ... such information as may reasonably be necessary to evaluate the terms of any [investment advisory contract].” (Emphasis added.) Concomitantly, Section 15(c) requires the fund’s investment adviser to furnish this information.
Section 15(c) does not specify what information may be “reasonably necessary” for the directors to evaluate an advisory contract. Instead, the well-established “Gartenberg Factors” inform this analysis.3 These include an analysis of: (i) the adviser’s cost in providing the services; (ii) the nature and quality of the adviser’s services; (iii) the extent to which the adviser realizes economies of scale as the fund grows larger; (iv) the profitability of the fund to the adviser; (v) fee structures for comparable funds; (vi) fall-out benefits accruing to the adviser or its affiliates; and (vii) the independence, expertise, care, and conscientiousness of the board.
Importantly, as demonstrated by recent Enforcement Division activity in this area, if a fund’s directors make a request for information during the 15(c) process, the Staff may well view the request itself as dispositive of whether the requested information was “reasonably necessary” for the directors to evaluate the advisory contract. Accordingly, once a fund board makes such a request, the Staff likely will view it as incumbent on the adviser to provide – and the board both to receive and consider – that information before the board properly may approve the annual advisory contract. To the extent that requested information is unavailable, the enforcement activity here indicates that this unavailability should be well justified, well documented, and communicated clearly to the board. Of course, it remains incumbent on the adviser to ensure that the information it provides the board is complete and accurate.
The Commonwealth Order
On June 17, 2015, the Enforcement Division charged SEC-registered mutual fund adviser Commonwealth Capital Management (CCM), the individual who served as CCM’s owner and president as well as an “interested” trustee of the Commonwealth funds (President), and other trustees (including two independent trustees) with violating Section 15(c) in connection with the evaluation of the fund’s advisory contract.4
The SEC alleged that, although the fund boards formally requested information described as “reasonably necessary” for the boards to fulfill their duties in evaluating the funds’ advisory and third-party sub-advisory agreements, CCM failed to supply certain information that the directors had requested and it provided certain information that was factually inaccurate.
The Commonwealth order specifically notes that, prior to the meeting during which trustees would vote on the advisory contract’s renewal, the fund’s trustees had requested certain materials and information from the adviser and sub-adviser, including “various information to evaluate the nature and quality of [the adviser’s] services” and “a request for comparative fee information.” The SEC found, however, among other deficiencies, “[the adviser] provided only limited disclosures that left unclear what services it intended to provide versus those that would be provided by others.” Furthermore, “[t]here [wa]s no documentary evidence that [the adviser] furnished information regarding the fees paid by comparable funds.” The SEC also found that, “[a]fter reviewing the materials, the [t]rustees did not ask for, and [the adviser] did not provide, additional materials to clarify what services [the adviser] would perform in exchange for its proposed fee.” The SEC found that, “[n]otwithstanding the fact that [the adviser] failed to provide the requested comparative fee information, the [t]rustees approved the advisory contracts because they considered the proposed advisory fees to be within an appropriate range.”
With respect to the board of another fund advised by CCM, the adviser similarly did not furnish all the information the board requested as reasonably necessary to evaluate the advisory contract. For example, CCM provided to the board a table containing numerous “inapt” comparisons involving industry fee data that included: (i) share classes not comparable to the relevant funds’ offerings; (ii) share-class-level asset information rather than fund-level asset information; (iii) products of types different from the relevant funds; and (iv) funds with fee structures different from the relevant funds. In addition, the order notes that CCM failed to provide certain financial information requested by the board to assist in assessing the adviser’s profitability. The order also notes that the adviser inaccurately reported to the board that the fund had appropriate breakpoints, when breakpoints had actually been omitted from the adviser’s contract.
The Commonwealth order indicates that: the respondents agreed to cease and desist from committing or causing future violations of Section 15(c),5 the adviser and its President agreed to a $50,000 penalty, and each of the independent trustee respondents agreed to pay a $3,250 fine.6
The Kornitzer Order
On April 21, 2015, the Enforcement Division charged SEC-registered investment adviser Kornitzer Capital Management, Inc. (KCM) and the individual who served as KCM’s chief financial officer and chief compliance officer (CFO/CCO) with violations of Section 15(c). KCM serves as adviser to 10 separate series of mutual funds, which all share a common board of trustees (Trustees).
According to the SEC, from 2010 through 2013, the Trustees annually requested an analysis of KCM’s profitability in managing the relevant funds, including an explanation of KCM’s methodology for allocating its expenses among the funds and KCM’s other clients. The order indicates that the CFO/CCO prepared and provided the analysis to the board on KCM’s behalf, including an explanation of KCM’s expense allocation methodology. As the order notes, the expense allocation methodology documented KCM’s allocation of all employee-compensation expenses to the funds based on “estimated labor hours.” Each year, however, CFO/CCO allegedly allocated an increasingly larger portion of KCM’s CEO’s compensation to the funds in order to maintain consistent profitability levels. The SEC found that KCM did not disclose to the Trustees that the analysis considered other factors beyond “estimated labor hours” in allocating the CEO compensation expense. According to the Kornitzer order, the adjustment to the compensation expense allocation process resulted in “KCM report[ing] almost identical pretax net profit margins year over year.” This conduct “caused information concerning KCM’s reported profitability in managing the [f]unds to be inaccurate and incomplete.”
Based on the above conduct, the SEC found that KCM violated Section 15(c), and that the CFO/CCO was a cause of the violations. The Kornitzer respondents agreed to cease and desist from committing or causing any future violations of Section 15(c), and KCM and the CFO/CCO agreed to pay penalties of $50,000 and $25,000, respectively.
A Continuing Priority of the Enforcement Division’s Asset Management Unit
Since the Enforcement Division launched its Asset Management Unit (AMU)7 five years ago, the Staff has been pursuing more cases involving alleged failures in the 15(c) process.8 All signs seem to indicate that this focus of the AMU will continue. Indeed, both of these recent Section 15(c)-related administrative actions are an outgrowth of the AMU’s years-long “Fund Fee Initiative.”
As the AMU’s co-chief explained in a speech earlier this year, “the Fund Fee Initiative … is a coordinated effort by AMU, the Division of Investment Management, and OCIE [the Office of Compliance Inspections and Examinations] to examine fee arrangements involving … funds, their advisers, and boards of directors.”9 In 2010, the then-Director of the Enforcement Division reported to Congress that the new AMU had “established a Mutual Fund Fee Initiative to develop analytics ... for inquiries into the extent to which mutual fund advisers charge retail investors excessive fees.” He explained that “[t]hese analytics [we]re expected to result in examinations and investigations of investment advisers and their boards of directors concerning duties under the Investment Company Act.”10 Then, in announcing an August 2013 enforcement action, the AMU Staff noted a particular focus on the 15(c) process.11 When announcing the settlement of another 15(c)-related enforcement action in May 2013, the then-Co-Director of the Enforcement Division acknowledged a “widespread look into the investment advisory contract renewal process and fee arrangements in the fund industry.” He explained the Staff’s view that “[d]etermining the terms of the investment advisory contract ... is one of the most critical duties of a mutual fund board.” He further emphasized that the Staff will “aggressively enforce investors' rights to accurate and complete information about the board's process and decision-making.”12
The Fund Fee Initiative dovetails with a more recently publicized Enforcement Division emphasis on “gatekeepers.” As Chair Mary Jo White explained in a 2014 speech discussing the SEC’s enforcement program, “[the Commission] use[s] th[e] term [“gatekeepers”] to describe the attorneys, accountants, auditors, fund directors and other board members and professionals who play a critical role in the securities industry and share the responsibility with regulators to protect investors.”13 She went on to warn that the Commission will “continue [to] focus on pursuing these cases to ensure that gatekeepers understand their special duties and responsibilities, and that they will be held accountable if they do not safeguard the interests of investors as they are obligated by law to do.” Earlier this year, the Director of the Enforcement Division stressed the Staff’s view that gatekeepers – including fund directors – were “integral to protecting investors ... because they are best positioned to detect and prevent the compliance breakdowns and fraudulent schemes that cause investor harm.” He went on to warn that “[w]hen gatekeepers fail to live up to their responsibilities, the Division has held – and will continue to hold – them accountable.”14
Gatekeepers Should Remain Diligent in the 15(c) Process
Fund managers and directors/trustees should view this recent and continuing activity by the Enforcement Division as a reminder to remain diligent in carrying out all of their duties and, particularly, to take an objective look at their current 15(c) process and determine whether anything should be improved. The annual advisory contract renewal process is generally regarded as among the most significant fund board responsibilities, given the inherent potential conflicts of interests between advisers and funds. The process should be robust and one that is periodically updated to keep pace with the changing marketplace and ever increasing regulatory demands. In light of the Enforcement Division’s recent and continuing focus on the 15(c) process, fund managers and directors/trustees should consider working with counsel to reassess their current 15(c) process and related practices.
Footnotes
1) The Orders represent administrative settlements, rather than the results of an adjudicated proceeding. The respondents settled without admitting or denying the Commission’s findings.
2) For example, see Dechert OnPoint, SEC Targets Another Fund Board in Recent Enforcement Case, pertaining to In the Matter of Northern Lights Compliance Services, et al., SEC Rel. No. IC-30502 (May 2, 2013) (Northern Lights), where the SEC similarly named individual board members as respondents in an enforcement action involving alleged violations of Section 15(c). See also In the Matter of J. Kenneth Alderman, et al., SEC Rel. No. IC-30557 (June 13, 2013) (personally naming former directors of five Regions Morgan Keegan registered funds in an enforcement action outside of the Section 15(c) context).
3) Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d. Cir. 1982) (Gartenberg). See also Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies, SEC Rel. No. IC-26486 (June 23, 2004); Jones v. Harris Assoc., 559 U.S. 335 (2010) (holding that the appropriate standard for determining whether a fund’s adviser violated its fiduciary duty under 1940 Act Section 36(b) is the standard set forth in Gartenberg).
4) The Section 15(c) approval processes described in Commonwealth occurred in 2008, 2009, and 2010, and involved two different registrants with different board members. The registrants were combined in 2014.
5) The SEC also found that the fund administrator, a CCM affiliate responsible for preparing shareholder reports, on one occasion inadvertently omitted the discussion of the independent directors’ Section 15(c) evaluation process. The SEC found that, in doing so, the administrator caused the fund to violate Section 30(e) of the 1940 Act and Rule 30e-1 thereunder (requiring registered investment companies to send shareholders semi-annual and annual reports containing information as required by the Commission; in Item 27(d)(6) of Form N-1A, the Commission requires that such shareholder reports contain a detailed discussion concerning “the material factors and the conclusions with respect thereto that formed the basis for the board’s approval” of the fund’s advisory contract). The administrator agreed to cease and desist from committing or causing future violations these provisions, and the administrator, CCM, and its President, jointly and severally, agreed to pay a civil money penalty.
6) The imposition of such an arguably nominal monetary penalty in this matter may well be significant, signaling the SEC’s willingness to impose fines on individual directors or trustees even in cases where there is no allegation of self-dealing or investor harm.
7) The AMU is a specialized unit within the Enforcement Division that focuses on investigating potential misconduct involving registered investment companies, private funds (both hedge funds and private equity funds), and separately managed accounts and retail accounts. Currently, there are approximately 75 professionals in the unit, and there is a representative of the unit in all 12 SEC offices. Julie Riewe, Co-Chief, Asset Management Unit, Division of Enforcement, Conflicts, Conflicts Everywhere – Remarks to the IA Watch 17th Annual IA Compliance Conference: The Full 360 View (Feb. 26, 2015) (Riewe Speech).
8) See, e.g., In the Matter of Chariot Advisors, LLC, et al., SEC Rel. No. IC-31149 (July 3, 2014); Northern Lights, SEC Rel. No. IC-30502; In the Matter of Focus Point Solutions, Inc., et al., SEC Rel. No. IC-30196 (Sept. 6, 2012); In the Matter of Peak Wealth Opportunities, LLC, et al., SEC Rel. No. IC-30165 (Aug. 10, 2012), Order Making Findings and Imposing Sanctions by Default, SEC Rel. No. IC-30414 (Mar. 5, 2013); In the Matter of Morgan Stanley Investment Management Inc., SEC Rel. No. IC-29862 (Nov. 16, 2011).
9) Riewe Speech.
10) Robert Khuzami, Director, Division of Enforcement, Testimony Concerning Investigating and Prosecuting Fraud after the Fraud Enforcement and Recovery Act Before the Before the United States Senate Committee on the Judiciary (Sept. 22, 2010).
11) SEC Press Release, SEC Charges North Carolina-Based Investment Adviser for Misleading Fund Board About Algorithmic Trading Ability (Aug. 21, 2013).
12) SEC Press Release, SEC Charges Gatekeepers of Two Mutual Fund Trusts for Inaccurate Disclosures About Decisions On Behalf of Shareholders (May 2, 2013).
13) Mary Jo White, Chair of the Securities and Exchange Commission, Perspectives on Strengthening Enforcement (Mar. 24, 2014); see also Norm Champ, Director, Division of Investment Management, Remarks to the 2013 Mutual Funds and Investment Management Conference (Mar. 18, 2013) (describing fund directors as “gatekeepers” and the “eyes and ears of fund investors”).
14) Andrew Ceresney, Director, Division of Enforcement, Testimony on “Oversight of the SEC’s Division of Enforcement” Before the United States House of Representatives Committee on Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises (Mar. 19, 2015).
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