(Article from Registered Funds Alert, November 2016)
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A key question in the recent AXA excessive fee trial (discussed in our prior Alert) was whether the funds’ board should have hired independent consultants or obtained additional independent information to verify information provided by the funds’ adviser during the contract renewal process under Section 15(c) of the 1940 Act. While the judge’s decision in the AXA case did not find that the board received inaccurate or misleading information, and noted the board had appropriately consulted with consultants and other information providers, some uncertainty remains for boards regarding what boards should do when they think the adviser may have lied to or misled the board. A recent example (albeit an extreme one) may provide some insight.
Burnham Funds
On September 29, 2016, shareholders of what were previously known as the Burnham Funds (the “Funds”) approved a new advisory contract with a new investment adviser, bringing a formal end to the Funds’ separation from their former adviser, Burnham Asset Management (“Burnham”). The separation has been underway since May 11, 2016, when Federal Bureau of Investigation (“FBI”) agents arrested a group of individuals and charged them with orchestrating an audacious and complex fraud scheme. The SEC simultaneously filed civil charges against the same individuals. The alleged fraud involved the individuals obtaining control over multiple registered investment advisers and broker-dealers in order to funnel over $43 million dollars towards the purchase of sham bonds. Though the Funds were not directly the victims of the alleged fraud, four of the seven facing charges were affiliated with Burnham, including one member of the adviser’s board.
Within a week of the FBI and SEC leveling their accusations publicly, the Funds’ board of trustees determined not to renew Burnham’s advisory contract, which was set to expire shortly thereafter, and established an interim advisory agreement with a new investment adviser while the Funds sought shareholder approval of new advisory agreements. Interestingly, it appears that the Funds’ independent trustees suspected a potential link between the adviser and the alleged mastermind of the fraud two years before the accusations came out, which raises questions, particularly in light of the recent AXA case, about when a board should verify information provided by an adviser in connection with annual Section 15(c) process.
The Scam
As the SEC describes events in its civil complaint, the alleged mastermind behind the sham bond scheme was Jason Galanis, son of the infamous John Galanis who received a 27-year prison sentence in 1988 for multiple counts of racketeering, tax fraud, securities fraud, bank fraud and bribery. Jason himself had earned notoriety in his own right in 2007 when he agreed to a five-year ban from serving as an officer or director of a publicly traded company as part of a settlement with the SEC stemming from the agency’s charges that he filed false accounting information for a company in which he owned a significant stake.
The fraud that prompted the Funds’ board to decline renewing Burnham’s advisory contract began in March of 2014 with Jason Galanis allegedly enlisting the help of his father to meet with the Wakpamni Lake Community Corporation (“WLCC”), a corporation affiliated with the Oglala Sioux Nation, at a Native American economic development conference in Las Vegas. The elder Galanis, claiming to be a representative of Burnham Securities (a broker-dealer affiliated with Burnham), convinced WLCC to become the issuer of limited recourse bonds that he claimed Burnham had already developed. In reality, at that time the Galanises were not yet formally affiliated with Burnham.
Soon after they had a willing issuer, the FBI alleges that the Galanises and their co-conspirators moved to seize control over Burnham. Thankfully for the Funds’ investors, it appears it was just Burnham Securities, the broker-dealer affiliate of Burnham, that the conspirators wanted to control to facilitate the fraud. The SEC complaint details how the FBI believes the Galanises enlisted Devon Archer, a respected Yale graduate and former adviser to John Kerry, to be the front man for the Burnham acquisition. Archer and other co-conspirators then directed their newly owned broker-dealer to serve as the placement agent for the sham tribal bonds, as the elder Galanis had already convinced WLCC they would. Concurrently to the takeover of Burnham, the Galanises are said to have used similar methods of disguised ownership to acquire control of two other investment advisers and to install another co-conspirator as CEO. The co-conspirators then used the funds of clients advised by the two advisers to purchase over $43 million of the tribal bonds for which Burnham Securities served as placement agent without disclosing the conflict of interest and despite the fact that the bonds fell outside of the investment parameters of many clients.
The Galanises had allegedly already convinced WLCC that the proceeds from the sale of the bond would be placed with an investment manager that would invest the proceeds to generate annuity payments sufficient to pay the interest on the tribal bonds and provide additional funds to the WLCC to be used for tribal economic development purposes, so the WLCC was not expecting a large payout from the issuance. The FBI alleges that rather than reinvesting the money, the conspirators misappropriated the funds from the first issuance for personal uses such as purchases from Valentino and Yves Saint Laurent, to expand their “corporate empire,” and even to pay John Galanis’ defense attorneys for charges that arose out of a separate scheme.
But things began to fall apart for the alleged schemers shortly thereafter. In September of 2015, fraud charges were brought against Jason and John Galanis and several other co-conspirators in connection with a separate scheme involving the collapse of a formerly NYSE-listed financial institution. In December 2015, the SEC filed suit against one of the advisers controlled by the co-conspirators, alleging that the investment adviser had placed client funds in the illiquid tribal bonds without disclosing the conflict of interest among the adviser’s owners. And then in May 2016, the seven conspirators were charged in the tribal bond scheme. Soon thereafter, Jason Galanis’ bail was revoked after he sent threatening text messages to a former friend he thought was cooperating with the FBI. In July, Jason and John Galanis each pled guilty to securities fraud related to the collapse of the NYSE-listed financial institution. In October, the shares of yet another company collapsed after revelations that the Galanises had seized control of it too.
The Involvement and Response of the Funds’ Board
When the Galanises and their co-conspirators moved to seize control of Burnham Securities in 2014, they also acquired Burnham, the Funds’ adviser, which brought the Funds’ board into play. Under a provision of the Funds’ advisory contract that is required under Section 15 of the 1940 Act, a change of control of Burnham would result in the automatic termination of the existing advisory contract. As with any change of control transaction, the Funds’ board and Burnham had to go through a contract approval process to vet the new owners of the adviser and understand the impact the change of control could have on the Funds.
In their 2014 proxy materials seeking shareholder approval of new advisory agreements in connection with the change of control, the Funds’ board reported to their shareholders that “[t]hroughout the [contract review] process, the Trustees had numerous opportunities to ask questions of and request additional materials from the Adviser and [Archer]. . . . The Independent Trustees also met separately with Devon Archer and with management of the Adviser on three different occasions.” The proxy statement also noted that the board had considered the reputation of the acquiring party (Archer) and representations that the investment and other personnel at Burnham would remain in place after the change of control.
As described above, the SEC alleges that the Galanises purposefully used Archer as a front man to disguise their involvement with the acquisition of Burnham. Interestingly, the recent FBI allegations reveal that the Funds’ independent trustees had their suspicions about a link between Devon Archer and Jason Galanis, even in 2014. According to the SEC complaint, the Funds’ independent trustees “sought ‘iron clad assurance(s)’ from Archer . . . that Jason Galanis would ‘not be involved with any Burnham entities’ or have an ‘interest of any kind, direct or indirect, in any of the Burnham entities or their successors, that he will not source deals to the Burnham entities and that the Burnham entities will not invest with or in, directly or indirectly, any business or enterprise in which Mr. Galanis has any association, affiliation or investment . . . .’” The SEC complaint goes on to state that Archer provided the requested assurances in a letter to the independent trustees in September of 2014. The proxy materials did not discuss any potential link between Archer and Galanis to shareholders, and the SEC complaint does not provide any further detail about what might have prompted the Funds’ independent trustees to ask Archer for such assurances.
Less than two years later, Archer and the Galanises had been arrested and Burnham’s involvement in the alleged tribal bonds scheme was made public. The Funds’ board moved quickly to replace Burnham. They reportedly had delivered a Section 15(c) packet to the replacement adviser within just two days of the tribal bond arrests, and had determined not to renew Burnham as adviser within a week. According to the eventual proxy to approve the new investment adviser, “no assets of the Funds were compromised [in the tribal bond scheme]. However, the allegations raised serious concerns for the Board and raised questions about whether certain representations made by Burnham and its affiliated persons as a condition to the Board’s prior approvals of the Current Advisory Agreement had been complied with.”
Analyzing a Close Call
This case represents a worst-case example of the dangers inherent in relying on assurances from interested parties when performing due diligence as part of the Section 15(c) process. While we do not have full information on what transpired between the parties, the proxy materials and complaint strongly suggest that something in the Funds’ board’s diligence hinted at a connection between Archer and Galanis, given that they reportedly asked Archer to confirm that Galanis would not be involved in anything having to do with Burnham. To the credit of the Funds’ board, it did not simply gloss over whatever hinted at the potential connection; rather it sought assurances from Archer that whatever link they had uncovered was not true. Archer provided those assurances, but the SEC complaint alleges that he was lying to the Funds’ board and that he was working in concert with Galanis the entire time.
Because we are only privy to publicly available information, we do not know what further steps, if any, the Funds’ board took to gain comfort that Galanis was not involved before or after requesting a letter from Archer. If we hypothetically suppose that the board wished to take further action, however, it does provide a potentially instructive thought experiment to ask, what more could they have done?
In the AXA case, the plaintiffs pointedly questioned whether the board received information from any parties unaffiliated with the adviser, or ever hired a third party to verify information provided by the adviser. The decision in that case implies that a board’s diligence does not hinge on whether it fact-checks information provided by the adviser, so long as it has no reason to believe it false or misleading. In our hypothetical here, however, it is not clear, even with the benefit of 20/20 hindsight, that the board could reasonably have done any additional diligence that would have changed the outcome. While the board apparently had enough reason to request clarification about the makeup of Burnham’s new ownership group, it is difficult to argue that this is the type of situation in which an external consultant should be hired to verify the information provided by the adviser because it appears it would have been next to impossible, short of hiring a private investigator, for the board to unearth the alleged fraud in this instance. If the board so distrusted information and representations provided by an adviser that it thought it might need to hire a private investigator, it is unlikely the board would have voted to approve or renew an advisory contract in the first place.
While the Burnham Funds appear to have escaped without significant financial harm, if FBI and SEC allegations are correct, the clients of the two other investment advisers were not so lucky. As boards already know, they should consider utilizing consultants, outside counsel and other resources to the extent they deem necessary to verify information provided by advisers if they have reason to question such information. If a material misrepresentation or fraud does materialize, boards can look to the Burnham situation as an example of how to respond quickly and ensure there is no disruption in the management of the funds overseen by the board.