Alert June 02, 2009

SEC Settles Enforcement Action against Mutual Fund Investment Adviser Relating to Disclosure Regarding Fund Guarantee Feature Made to Fund Board during Advisory Contract Approval Process and in SEC Filings

The SEC settled an administrative enforcement proceeding against an investment adviser to a registered investment company relating to the fund’s “Section 15(c) process,” as well as disclosure in various SEC filings.  Section 15(c) of the Investment Company Act of 1940 (the “1940 Act”) generally requires that a majority of a fund’s disinterested directors annually approve the advisory contract between the fund and the fund’s investment adviser, and in connection with that approval, the investment adviser is required to furnish to the fund’s board such information “as may reasonably be necessary [for the board] to evaluate the terms” of that contract.  According to the administrative order issued in connection with the settlement (the “Order”), the adviser, through an affiliate, had offered a guarantee (the “Guarantee”) protecting an investor’s principal invested in the fund, provided that the investor continuously maintained his or her investment in the fund for a ten-year period.  Also according to the Order, the fund’s prospectus had stated that the Guarantee was being provided without any cost to the fund or its shareholders. 

The Order states three principal findings made by the SEC:

  • The adviser violated Section 15(c) by failing to provide to the board adequate information in order that it could evaluate the cost of the Guarantee in the context of the management fee that the adviser was charging.  In particular, the SEC found that for several years during the Section 15(c) process, the adviser had justified its management fees – fees that allegedly were substantially higher than the market average for that type of fund – by pointing to the fact that an affiliate was providing the Guarantee; however, the adviser failed to provide the board with (a) information necessary to evaluate the true cost or value of the Guarantee, (b) the assumptions used to calculate loss reserves related to the Guarantee, or (c) an explanation describing why the reserve should be included in an analysis of the profitability of the fund.
  • The adviser violated Section 206(2) of the Investment Advisers Act of 1940, which generally prohibits an investment adviser from engaging in any transaction, practice or course of business that operates as fraud or deceit on any client or prospective client, for reasons substantially similar to the reasons the SEC gave for the Section 15(c) violations.
  • The adviser violated Section 34(b) of the 1940 Act for stating in the fund’s annual reports to shareholders, registration statements and prospectuses filed with the SEC that the Guarantee was being provided without cost to the fund or its shareholders even thought the adviser was using the cost of the Guarantee to justify its higher fees to the fund’s board.  Section 34(b) generally prohibits any person from making an untrue statement of material fact in registration statements and other documents filed with the SEC, or omitting to state a fact necessary to make the statements made from being materially misleading.

Under the terms of the settlement, the adviser agreed, among other things, to pay disgorgement of approximately $4 million (the amount by which the SEC found the management fees the fund paid the adviser during the relevant period exceeded the “peer median”) and a civil penalty of $800,000.