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News May 18, 2015 Issue

Misallocation of CEO Compensation Adds Penalty to Adviser’s Ledger

One dollar here, one dollar there; one dollar here, one dollar there; one dollar here, 75 cents ther – oops.

The name of the game is allocation. If the charges in an SEC settlement are to be believed, an adviser and its chief financial officer/chief compliance officer attempted to deceive the board of directors of a fund series by misallocating the adviser CEO’s salary in an attempt to make profits look consistent. Now it is paying the costs of a settlement instead.

Kornitzer Capital Management, a Kansas-based advisory firm with approximately $11.3 billion in assets under management, on April 21 settled an administrative action brought against it by the SEC and paid a civil money penalty of $50,000. Barry Koster, the firm’s chief financial officer and chief compliance officer, also settled and paid a civil money penalty of $25,000.

According to the administrative order instituting the settlement, Koster each year "adjusted the allocation of the compensation of [the firm’s] chief executive officer to the funds in a manner designed, in part, to achieve consistency of [the fund’s] reported profitability in managing the funds year over year. Koster did not disclose this information to the board."

Kornitzer Capital was charged with violating Section 15(c) of the Investment Company Act, which makes it unlawful for a registered fund to enter into or renew any advisory contract unless the terms of the contract are approved by a majority of the fund’s independent directors. The SEC makes it the duty of a fund adviser, in this regard, to furnish the directors with the information necessary for them to evaluate the terms of the advisory contract. By providing incorrect information about the CEO’s compensation, the adviser failed in this duty, according to the administrative order. Koster was charged with having caused the firm’s violation. The attorney representing both Kornitzer Capital and Koster, when reached by phone, chose not to comment.

The settlement "appears to be the latest episode in a broader effort by the SEC to scrutinize the advisory contract approval and renewal process for registered funds," said Mayer Brown partner Matthew Rossi. "From the SEC’s perspective, there is little point in
requiring directors to evaluate information provided by an adviser if the adviser’s information is inaccurate or incomplete. In fact, the SEC likely views the provision of inaccurate information by investment advisers under these circumstances as threatening to undermine the entire contract approval and renewal process required by Section 15(c)."

"This case demonstrates the SEC’s continued focus on transparency in an adviser’s allocation of expenses to the funds it manages," said Zaccaro Morgan partner Nicolas Morgan. "While other cases involving expense allocation have criticized private equity or hedge fund managers for misrepresenting expense allocation in representations to investors or potential investors, this case extends that same principal to communications between an investment company fund adviser and its board."

"The enforcement action makes clear that the SEC is focused not only on ensuring accurate disclosures to fund investors but also to those charged with statutory obligations (here, under 15(c)) to protect investors by overseeing funds, such as the board in this case," said Foley Hoag partner Daniel Marx.

"The takeaway for fund advisers," Morgan said, "is the same in both contexts: the SEC will scrutinize representations regarding the allocation of an adviser’s expenses and pursue charges when there’s a discrepancy between the representations and actual practice."

Revenue and expense allocation reporting

Kornitzer Capital, which has been an SEC-registered adviser since 1989, has been the adviser to the Buffalo Funds, an open-end investment company, since 1994. From fiscal years 2010 through 2013, the period during which the agency’s allegations apply, the funds operated as a series trust with 10 different series.

In each of those years, the board requested an analysis of Kornitzer Capital’s profitability in managing the funds, the SEC said. This included an explanation of the methodology for expense allocation among the funds and its clients. Such an analysis "was reasonably necessary for the board’s consideration of [Kornitzer Capital’s] advisory contracts under Section 15(c) of the Investment Company Act," the agency said.

While Kornitzer Capital’s only revenue from the funds was the investment advisory fees it earned, only a portion of its total operating expenses were attributable to services provided the funds, the SEC said. That’s because Kornitzer Capital had other advisory clients. The board requested that the profitability analysis explain how expenses were allocated, the agency said.

For the years 2010 through 2012, Kornitzer Capital allegedly said that salaries and benefits were "allocated based on estimated labor hours." For 2013, it made the same representation, but added that the CEO’s compensation allocation was based on an estimated percentage of time working on the Buffalo Funds, as well as "intangible value to the Buffalo Funds based on leadership, decision making and management responsibilities."

Allocation adjustments

"Contrary to what [Kornitzer Capital] had stated in its profitability analyses furnished to the board, each year during the relevant period Koster did not allocate the CEO’s compensation to the funds based solely on the CEO’s estimated labor hours, but also took into account other factors," the SEC said. Those alleged "other factors" included consideration of the profit margin that would result from the proposed allocation of the CEO’s compensation.

As a result of that analysis, Koster then allegedly "allocated a percentage of the CEO’s compensation to the funds in a manner in part designed to achieve consistency of [Kornitzer Capital’s] reported profitability in managing the funds."

This included efforts to show that the advisory firm maintained consistent pre-tax net profit margins from year to year, the SEC said. As Kornitzer Capital’s revenue from managing the funds increased from approximately $22.6 million to $34.1 million from fiscal years 2010 to 2012, so allegedly did the percentage of the CEO’s compensation allocated to the funds, rising from 35 percent in 2010 to 49.5 percent in 2012.

Fiscal year 2013 was somewhat different, according to the administrative order. Revenue for managing the funds increased to $38 million, while the CEO’s compensation increase by more than 70 percent from the prior year, the agency said. "In part, in order to avoid showing a significant reduction in KCM’s profitability, Koster allocated just 25 percent of the CEO’s compensation to managing the funds."

Disclosure … or lack thereof

Kornitzer Capital "did not disclose to the board that Koster considered other factors beyond estimated labor hours in allocating CEO compensation expense or that Koster adjusted the percentage of the CEO’s compensation allocated to the funds in part in order to maintain the consistency of [Kornitzer Capital’s] reported profitability," the SEC charged. This meant, it said, that for the years when this conduct allegedly occurred, the information given to the board in regard to the advisory firm’s profitability in managing the funds was "in accurate and incomplete."

"In particular, this information was reasonably necessary for the board’s determination that [Kornitzer Capital’s] profitability in managing the funds had not been and would not be excessive and would enable [Kornitzer Capital] to maintain adequate profit levels to support its provision of advisory services to the funds," the SEC said.