Client Alerts

SEC Charges Investment Adviser and Mutual Fund Board Members with Failures in 15(C) Advisory Contract Approval Process

June 29, 2015

By The Investment Management Practice

Overview

On June 17, 2015, the Securities and Exchange Commission (the “Commission”) charged a mutual fund adviser, its principal, John Pasco III, and three mutual fund board members with failing to satisfy specific duties imposed upon them by Section 15(c) of the Investment Company Act of 1940 (the “Act”) in relation to the evaluation and approval of mutual fund advisory contracts.

Commonwealth Capital Management (“CCM”), part of a mutual fund platform that provided various services to small to mid-size mutual funds, acted as the investment adviser to various mutual funds within World Funds Trust (“WFT”) and World Funds Inc. (“WFI”). In connection with one meeting of the board of trustees of WFT, and two meetings with the independent directors of WFI, the board, with the assistance of independent counsel, requested certain materials and information from CCM and related sub-advisers as part of the 15(c) process. These materials included the most recent Form ADV Parts I and II, compliance manuals, code of ethics and current financial statements.

In addition, a questionnaire prepared by independent counsel requested information related to adviser operations, compensation, and compliance procedures, as well as requests for comparative performance information.

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For each meeting, responses to the questionnaire were compiled into a “board book” by Commonwealth Shareholder Services (“CSS”), a fund administrator owned and operated by Pasco, which was reviewed and certified by Pasco, and distributed to board members along with a detailed memorandum, commonly known as a Gartenberg memorandum, describing the board members Section 15(c) duties.

15(c) Process Deficiencies

The Commission determined that “[i]n certain instances, CCM’s and Pasco’s written responses did not provide all of the requested information; in certain other instances (pertaining to WFI), the information provided was inaccurate.”

In response to requests for comparative fee information, the Commission found “no documentary evidence that CCM furnished information regarding the fees paid by comparable funds”

to the board of WFT. Notwithstanding this lack of information, and without requesting that it be provided, the WFT trustees “approved the advisory contracts because they considered the proposed advisory fees to be within an appropriate range.”

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In response to requests for information related to the evaluation of the nature and quality of services provided by CCM, the Commission determined that the materials CCM produced “did not permit a sufficient evaluation of the nature and quality of such services.”

In particular, CCM failed to sufficiently disclose what services it would provide versus those to be provided by sub-advisers and the administrator. The advisory and sub-advisory contracts used near identical language to describe the adviser’s and sub-adviser’s proposed duties, and CCM’s response to the questionnaire’s query on services provided referred the WFT trustees to the sub-adviser’s questionnaire, which did not elaborate on CCM’s services.

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The 15(c) questionnaire also requested information as to what services of a material nature CCM would provide to WFT. CCM stated that it would oversee the sub-adviser and that CSS would ensure compliance with investment limitations. CCM did not articulate what portfolio management compliance services it would perform itself, and the WFT trustees did not seek additional information on the issue. The Commission determined that “[a]lthough during the relevant period the WFT Funds did not pay any advisory fees and CCM reimbursed the majority of the operating expenses incurred pursuant to the [expense limitation agreement], the [WFT trustees] were obligated to evaluate CCM’s services as compared to the fees provided for in the advisory contracts.”

As a result of these incomplete responses, and the failure to request additional information or clarifications, the WFT trustees “approved the WFT Funds’ advisory contracts without having all the information they requested as reasonably necessary to evaluate the advisory contracts.”

The Commission found similarly lacking responses, and a failure to request that deficiencies be corrected, in regards to the WFI 15(c) approval process.

In providing information on comparable fund fees to the board of WFI, CCM utilized a standard industry database; but in order to avoid “cherry-picking,” CCM chose not to edit the tables to just those share classes which were comparable to the WFI Fund, instead including different types of funds (including ETF’s and index funds) funds with different fee structures, displaying assets at a share class level instead of at a total fund level, as well as providing only partial information for some entries.

This resulted in a chart with numerous inappropriate comparisons.

Additional charts provided by CCM intended to aid comparison of the WFI Fund’s expense ratio and advisory fee provided only limited information to assist in this evaluation. One chart compared the total expense ratio of the WFI Fund to four CCM selected funds with different share classes, two of which had a 12b-1 fee of 1.00% compared to the WFI Fund’s 0.25% 12b-1 fee.

The chart also misstated one comparison fund’s 12b-1 fee in place of its expense ratio. A second chart evaluated the WFI Fund’s advisory fee utilizing the same four comparison funds, two of which had a combined advisory/administration fee.

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As the WFI Fund had a separate administration fee, an accurate comparison required that CCM add that fee to the WFI Fund advisory fee.

In response to a request for reasonably available financial information, including two years of financial statements, in order to assist the board in assessing the adviser’s profitability, CCM provided only an income statement for one year and a profitability chart containing estimated overhead and expense figures.

CCM also provided no response to the questionnaire’s request for a description of the basis and methodology CCM used for allocating indirect costs, overhead, and other costs to the fund.

CCM also made factual misstatements in its responses to the questionnaire, stating that no fees had been waived pursuant to the WFI Fund’s expense limitation agreement since the last renewal of the advisory contract, when in fact CCM had waived a portion of its advisory fee during the relevant period.

CCM also informed the WFI directors that the WFI Fund had instituted breakpoints, and that such breakpoints were appropriate. However, despite the belief of all parties that the breakpoints were in place, they had in fact been omitted from the CCM contract presented for renewal.

In addition to the failures of the 15(c) process, the Commission found that CSS, as the fund administrator, inadvertently failed to include a discussion of the material factors and conclusions that formed the basis of WFI directors’ approval of the advisory contracts in the subsequent WFI Fund annual report to shareholders. This omission caused WFI to file an incomplete report.

Violations

The Commission determined that “CCM did not provide all the necessary information requested by the boards” and that the directors did not follow up to obtain such information.” As a result of these failures, the trustees and independent directors “did not have, and consequently did not evaluate, all the information they requested as reasonably necessary before approving the advisory contracts.”

Accordingly, the Commission determined that both CCM and the trustees had willfully

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violated Section 15(c) of the Act, and that Pasco had caused its violations. Additionally, the failure of CSS to include a discussion of the 15(c) process in the WFI Fund’s subsequent annual report to shareholders resulted in WFI’s violation of Section 30(e) of the Act and Rule 30e-1 thereunder.

Without admitting or denying the findings, each board member, CCM, and Pasco consented to the order and agreed to cease and desist from committing any further violations of Section 15(c) and CCS agreed to cease and desist from committing any further violations of Section 30(e) or Rule 30e-1. Each of the board members agreed to pay $3,250 in penalties, while Pasco, CCM, and CCS agreed to jointly and severally pay a $50,000 penalty.

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  Commonwealth Capital Management, Investment Company Act Release No. 31678 (June 17, 2015), at n.28.

  Id.

  Id. at 2.

 Id. at n.32.

  Id. at n.33.

  Id. at n.34.

Id.

Id. at n.35.

  Id. at n.36.

  Id. at n.43.

  Id. at n.44.

Id. at n.45.

Id. at n.47.

Id. at n.49.

Id. at n.50.

Id. at n.52.

 Id. at 2.

 The Commission pointed out that a willful violation of the securities laws means merely “‘that the person charged with the duty knows what he is doing.’” Wonsover v. SEC, 205 F.3d 408, 414 (D.C. Cir. 2000) (quoting Hughes v. SEC, 174 F.2d 969, 977 (D.C. Cir. 1949)). There is no requirement that the actor “‘also be aware that he is violating one of the Rules or Acts.’” Id. (quoting Gearhart & Otis, Inc. v. SEC, 348 F.2d 798, 803 (D.C. Cir. 1965)).