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News June 29, 2015 Issue

Advisory Contracts: Don’t Cut Corners on the Approval Process

The advisory contract process for mutual funds is meant to be followed. Advisers and board members cannot ignore parts they don’t like.

That’s one takeaway from the June 17 settlement between the SEC and an investment adviser, the adviser’s principal, and three board members of two mutual funds. All were charged with violating what is known as the 15(c) process, referring to the section of the Investment Company Act that covers evaluation and approval of mutual fund advisory contracts.

The adviser, Commonwealth Capital Management, allegedly provided incomplete or inaccurate information to the two mutual fund boards, and the adviser’s majority owner, John Pasco III, allegedly caused those violations. The three board members were charged with moving forward on advisory contracts without having all the information they had requested. An attorney representing Commonwealth Capital Management and Pasco did not respond to a voice mail and email seeking comment.

Under Section 15(c), it is illegal for a registered investment company to enter into or renew an advisory contract unless the terms of the contract are approved by a majority of the fund’s independent directors. "As part of the approval process, Section 15(c) imposes a duty on the directors to request and evaluate, and a duty on the adviser to furnish, such information as may reasonably be necessary for the directors to evaluate the terms of the adviser’s contract," the SEC said.

Commonwealth Capital Management was part of a turnkey mutual fund platform providing services to small to mid-sized mutual funds, according to the SEC’s administrative order instituting the settlement, and advised various fund series within two larger fund entities, World Funds Trust (WFT), set up as a trust, and World Funds Inc. (WFI), set up as a corporation. The three board members charged served as trustees for WFT and as independent directors for WFI.

While the Commission collectively fined the adviser, Pasco and a subsidiary mutual fund administrator $50,000, each of the board members was fined only $3,250. Yet the words of SEC officials in the agency’s litigation release focused on the role of the board
members, particularly in terms of their roles as trustees at WFT.

"As the first line of defense in protecting mutual fund shareholders, board members must be vigilant," said SEC Division of Enforcement director Andrew Ceresney. "These trustees failed to full discharge their fund governance responsibilities on behalf of fund shareholders."

"The advisory fee typically is the largest expense reducing investor returns," said the Enforcement Division’s Asset Management Unit co-chief Julie Riewe. "The [parent fund of some of the funds’] trustees fell short as the shareholders’ watchdog by essentially rubber-stamping the adviser’s contract and related fee."

"The case is a reminder to fund advisers that the contract renewal process is a vital exercise, and advisers are obligated to provide boards with the information boards need to carry out their responsibilities," said Mutual Fund Directors Forum president and CEO Susan Wyderko. "The SEC is clearly focusing on this issue, and here took action when the adviser provided incomplete and inaccurate information to the fund boards."

"Asking the correct questions and requesting the correct documentation is only half of what’s required of mutual fund boards," noted Zaccaro Morgan partner Nicolas Morgan. "The board must also receive and evaluate the information before approving an adviser’s contract."

"The obligations of investment advisers and investment company boards under Section 15(c) of the Investment Company Act are a priority for the SEC Enforcement Division’s Asset Management Unit," said Mayer Brown partner Matthew Rossi. "I would not be at all surprised to see the SEC bring additional enforcement actions like the Commonwealth case in the future."

Requests and responses

The WFT board of trustees evaluated and approved advisory contracts for its funds with Commonwealth Capital Management and a sub-adviser on October 1, 2008. The WFI board of directors evaluated and approved advisory and sub-advisory contract renewals with Commonwealth Capital Management on August 27, 2009.

Prior to the WFT approval, according to the SEC, WFT trustees requested certain materials and information from Commonwealth Capital Management and its sub-adviser as part of the 15(c) process. These included a copy of the adviser’s and sub-adviser’s most current Form ADV, compliance manuals, code of ethics, and current financial statements. WFT also requested that the adviser and sub-adviser complete a questionnaire prepared by an independent counsel regarding their operations, compensation and compliance procedures.

The adviser compiled information into a "board book" and, following a review and certification of the questionnaire responses by Pasco, delivered it to WFT in advance of the October 1 meeting, at which the board reviewed it, the SEC said.

But Commonwealth Capital Management did not, in fact, provide the board with all the information requested, the agency charged. Specifically, the trustees had requested that the adviser and Pasco submit comparative fee information – fees paid by comparable funds – along with the completed questionnaire. "There is no documentary evidence [Commonwealth Capital Management] furnished information regarding the fees paid by comparable funds," the agency said. In addition, the adviser provided incomplete responses about the nature and quality of the services the adviser provided versus services provided by the sub-adviser and administrator.

"Notwithstanding the fact that [Commonwealth Capital Management] failed to provide the requested comparative fee information, the trustees approved the advisory contracts because they considered the proposed advisory fees to be within an appropriate range," the SEC said.

Wyderko noted that the SEC said it found no documentary evidence that fee information was provided to the board. "It’s a reminder to fund boards of the importance of memorializing important aspects of the board’s deliberations in the minutes," she said.

The agency, in its order instituting the settlement, described a similar set of circumstances involving the approval of the advisory contract with WFI, with Commonwealth Capital Management providing WFI’s board with a book of information. As with WFT, the book provided to WFI allegedly did not provide all the requested information.

"Commonwealth Capital Management supplied a fee chart containing inapt comparisons and erroneous information while omitting other details," the SEC charged. "The firm additionally failed to provide certain information about profitability and an expense limitation agreement that had been in place to limit the relevant fund’s expenses. Commonwealth Capital Management also informed the WFI independent directors that the fund had appropriate breakpoints when, in fact, breakpoints were omitted from the advisory contract."

"In this environment, advisers must be particularly careful to ensure that the information they provide to fund boards during the Section 15(c) process is complete and accurate, particularly when that information includes the nature and quality of the adviser’s services and the fee structures for comparable funds," Rossi said. "Moreover, when providing the information on fee structures for comparable funds, an adviser must make sure that those funds are in fact comparable. Obviously, fund boards must also request and carefully consider this information and all other necessary information when approving investment advisory contracts for registered investment companies."

The WFI board, after approving the advisory contract renewals in 2009, held its next annual 15(c) review on August 25, 2010, when it again approved the advisory contracts, according to the administrative order. But also again, the information provided was incomplete, the SEC said. "The performance and fee comparison charts provided by [Commonwealth Capital Management] had the same comparisons and deficiencies as the 2009 charts. [Commonwealth Capital Management] provided a table of fees and expenses so that the board could evaluate the adviser’s profitability, but [Commonwealth Capital Management] again did not fully explain its entries or its methodology for allocating expenses and provided only a single year’s financial statements."