(Article from Registered Funds Alert, September 2015)
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Section 15(c) of the Investment Company Act of 1940, as amended (the “1940 Act”), imposes an affirmative duty on a registered fund’s board members to request and evaluate, and a duty on the fund’s investment adviser to furnish, “such information as may reasonably be necessary to evaluate the terms” of any advisory contract being considered for approval or renewal. A pair of recent SEC enforcement actions highlight the importance of having a sound review and approval process in building a fulsome record upon which trustees can base their approval.
In an action against Commonwealth Capital Management (“Commonwealth”) and several trustees of the Commonwealth mutual funds, including two independent trustees, the SEC alleged deficiencies in the Section 15(c) approval process. According to the SEC, the trustees formally requested the information needed to satisfy their duties under Section 15(c), but Commonwealth failed to provide various requested information and some information provided to the trustees was inaccurate. The SEC also alleged that the trustees failed to follow up with Commonwealth with respect to the information that was not provided.
In another action against Kornitzer Capital Management (“Kornitzer”) and the individual serving as both chief financial officer and chief compliance officer, the SEC alleged that inaccurate and incomplete profitability information was provided to the board of a mutual fund complex advised by Kornitzer in connection with the Section 15(c) process.
The Commonwealth action underscores the importance of a sound review and approval process in discharging the board’s and the adviser’s duties under Section 15(c). The SEC alleged numerous examples of the trustees requesting specific information and receiving no response or an incomplete response. Trustees often rely on their independent counsel to craft and review their requests for information. Trustees, including in consultation with counsel, may conclude that information requested may not be ultimately necessary in order for them to act on the approvals or renewals of advisory contracts they are considering. While the SEC does not speculate as to the reasons why the Commonwealth trustees and/or their counsel did not follow up with Commonwealth for any missing or incomplete information, there are a few factors that generally help to facilitate a sound 15(c) process.
First, a sound process cannot take place overnight. The process should be structured to allow enough time for both (i) an investment adviser to prepare a fulsome response to the trustees’ request for information and (ii) the trustees and their counsel to review the adviser’s response and ask appropriate follow-up questions. Second, it is important for the adviser to explain, and the trustees to understand, the source and methodology behind certain types of information. The Commonwealth and Kornitzer actions both include allegations that the advisers failed to provide adequate context or explanation regarding certain information provided to the trustees. For example, in providing information related to profitability, Kornitzer allegedly intentionally provided an inaccurate explanation of its methodology for allocating expenses, such as employee compensation, among its advisory clients. Commonwealth allegedly provided some comparative fee/expense information pulled from a standard industry database, but failed to explain that certain information might not be an appropriate comparison and did not remove the information. Third, if information is not available with respect to a particular request, trustees should document that the fact that the information was not received was not an impediment to their approval or renewal, in light of all relevant factors. For example, in the Commonwealth matter, the adviser was waiving all advisory fees for the periods covered by the allegedly faulty 15(c) process. If the minutes of meetings or disclosure to shareholders had noted that the waiver influenced the trustees’ decision not to follow up on certain requests, it would seem that an enforcement action could only be brought when the trustees’ determination failed to meet the standards of the business judgment rule. Put another way, the question of what is “reasonably necessary” to make a determination is one where the judgment of trustees should be entitled to deference.
The Commonwealth and Kornitzer actions are the latest enforcement actions indicating that the SEC is pursuing cases related to the Section 15(c) process. Additionally, the Commonwealth action is part of a growing trend of the SEC charging independent trustees in connection with Section 15(c) violations. In light of the foregoing, trustees and advisers should evaluate their own processes and consider whether there is any room for improvement.