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News September 20, 2004 Issue

Bridgeway Performance Fee Case Holds Lessons For All Advisers

Last week, the SEC settled an enforcement proceeding against Bridgeway Capital Management and its founder and president John Montgomery for allegedly charging "illegal performance fees" on Bridgeway funds. If those names ring a bell, itís because Montgomery has testified several times in the past two years before Congress in support of various mutual fund reform efforts. He and his firm had a strong reputation for integrity.

Lesson #1: If it can happen to John Montgomery, it can happen to you. Or, put another way: Simply trying to do the right thing for your clients is no substitute for a good legal and compliance scrub.

Hereís what went wrong: The Bridgeway fundsí advisory contracts stated that the adviser would assess its performance fee based on the fundís average daily net assets for the month, using the performance of an external index during a rolling five-year period as the benchmark. However, under the Advisers Act, advisers may charge funds performance fees only if the fees are based on the fundís asset value averaged over the same period of time that the benchmark indexís investment performance is computed.

As a result, the Bridgeway fundsí performance fees should have been based on the average asset value of the fund over the rolling five-year period, not over the month. The calculation method, albeit wrong, was disclosed in the fund prospectuses since the fundsí inception.

Lesson #2: Go back and read the rule (or statute).

The SEC found that Bridgeway overcharged its funds by a total of $4.4 million. To settle the proceeding, Bridgeway and Montgomery agreed to be censured, to cease and desist from future violations, to reimburse the $4.4 million to the fund shareholders, and to pay civil penalties of $200,000 and $50,000, respectively. Bridgeway also agreed to retain "experienced counsel" to review the performance fee provisions in its advisory contracts, to pay the costs of soliciting shareholder approval of new advisory contracts for seven of its funds, and to hire or designate experienced compliance personnel to ensure that the new performance-based fees are correctly applied going forward.

The same day that the SEC announced the settlement, Montgomery issued a letter of apology to his fundsí shareholders He admitted that he may not have had a "firm grasp on the full legal requirements that surround" performance fees. He and his firm "should have sought specialized legal counsel on this issue long ago," he said.

Lesson #3: For some of this stuff, thereís no substitute for experienced investment management lawyers.

To his credit, Montgomery took full responsibility for the error. "As founder of Bridgeway Capital Management and President of Bridgeway Funds, this calculation was absolutely my responsibility, and I am the one at fault," he told shareholders. His funds already have waived future management fees in an amount that will cover the estimated increase in legal, audit, and communications expenses stemming from the SECís action. Moreover, he announced that Bridgewater hired a compliance officer with 20 years experience in the mutual fund industry and "significantly increased" the amount of staff time to be spent on compliance. Bridgewater also outsourced its accounting and administration services.

Morningstar seemed sympathetic. While it said that Montgomery and his staff "simply failed" in their obligations to be intimately familiar with the laws governing mutual funds, it went on to note that the case "highlights the operational risk that smaller shops like Bridgeway face in trying to comply with an increasingly daunting regulatory climate." Pointing to the "abundance of evidence" that Bridgeway consistently acts in shareholdersí best interests, Morningstar said it couldnít "fathom that there was any intentional or malicious wrongdoing in this case."

The upshot: while Morningstar said it was disappointed in the infraction, it said it still supported fundsí use of performance fees and continued to believe that Bridgeway "is a good steward of investor capital and that its fiduciary performance is strong."