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