The SEC issued orders settling administrative proceedings against the former president of a third party mutual fund administrator (the “Administrator”) and the former general counsel of the Administrator over an undisclosed marketing arrangement between the Administrator and the investment adviser (the “Adviser”) of a family of mutual funds (the “Funds”). The former president also served as chairman of the board of trustees of the Funds. This article describes the SEC’s findings as presented in the orders with respect to the former president and former general counsel and in a prior order with respect to the Administrator relating to the same subject matter; in each case, the party to the order consented to the order without admitting or denying its findings.
Prior Proceedings Against the Administrator. In 2006, the SEC issued an order (the “2006 Order”) settling administrative proceedings against the Administrator based on findings that, between June 1999 and July 2004, rebates of mutual fund administrative fees paid by the Administrator to the advisers of funds that the Administrator serviced resulted in violations of the Advisers Act of 1940, as amended (the “Advisers Act”), and the Investment Company Act of 1940, as amended (the “1940 Act”). As found in the 2006 order, the Administrator entered into oral and written side agreements (“Side Agreements”) with 27 mutual fund advisers under which the advisers recommended to mutual fund boards that the Administrator be retained as fund administrator. The Administrator paid rebates to the fund advisers under the Side Agreements with amounts set aside by the Administrator from the fees it received under the fund administration agreements. The rebated amounts were designated as a marketing budget for the advisers to use in promoting fund sales; in some cases, an adviser also used its marketing budget to pay expenses entirely unrelated to fund marketing, including check fraud losses, seed capital for new mutual funds, and expenses for settlement of adviser disputes with third parties.
The existence and terms of the Side Agreements were not disclosed to the mutual funds’ boards or shareholders although fund boards were generally informed that the Administrator spent a portion of its administration fee on marketing the mutual funds. Fund boards were not informed that the Administrator and the respective advisers had entered into Side Agreements before the advisers recommended to the fund directors that the Administrator be awarded the administration agreements to which the Side Agreements related. The marketing arrangements contemplated by the Side Agreements were not included in any of the funds’ Rule 12b-1 plans. There was no disclosure to shareholders of the marketing arrangements until the fall of 2003, and the SEC found that those disclosures were incomplete and misleading. From July 1999 to June 2004, the Administrator provided over $230 million from its administration fees for the benefit of the funds’ advisers or third parties pursuant to the Side Agreements.
The Administrator was found to have willfully aided and abetted and caused (a) the advisers’ violations of Sections 206(1) and 206(2) of the Advisers Act, which prohibit fraudulent conduct by an investment adviser, and Section 34(b) of the 1940 Act, which prohibits the making of any untrue statement of a material fact in a mutual fund registration statement, and (b) the mutual funds’ violations of Section 12(b) of the 1940 Act and Rule 12b‑1(d) thereunder, which provides that any person who is a party to any agreement with a mutual fund relating to the fund’s Rule 12b-1 plan has a duty to furnish such information as may reasonably be necessary for the fund’s directors to make an informed decision regarding whether the Rule 12b-1 should be implemented or continued.
Prior Proceedings against the Adviser. In 2008, the SEC settled administrative proceedings against the Adviser regarding Side Agreements between it and the Administrator relating to the Funds and similar rebate arrangements relating to securities lending services provided by the Administrator to the Funds. Consistent with the 2006 Order, the SEC found that the Adviser had willfully violated Sections 206(1) and 206(2) of the Advisers Act, willfully violated Section 34(b) of the 1940 Act and willfully aided and abetted and caused violations of Section 12(b) of the 1940 Act and Rule 12b-1 thereunder by the Adviser’s funds. The SEC has not announced any action taken against any of the other unnamed advisers referenced in the 2006 Order.
Findings – Former General Counsel. Prior to the first of the two Side Agreements between the Administrator and the Adviser, the former general counsel retained outside counsel to provide legal advice regarding marketing arrangements. Outside counsel provided a written memorandum that analyzed, among other distribution-related issues, marketing arrangements in which the Administrator would agree to pay a fixed amount of its fee to market mutual funds it serviced. The memorandum stated that when the Administrator agrees to pay a fixed amount of its fee to market a mutual fund it has a duty to disclose the existence of the arrangement to a fund’s trustee, and the fund’s statement of additional information should include disclosure regarding the arrangement. The former general counsel did not disclose the Side Agreements’ marketing arrangement to the Funds’ board of trustees or to their shareholders even though she received, reviewed, and commented on drafts of the Side Agreements. The SEC noted that the former general counsel had indicated on drafts of the Side Agreements that there were issues with the arrangement under Rule 12b-1.
Subsequent to entering into Side Agreements, the former general counsel reviewed and commented on a disclosure template for the Funds’ trustees addressing the marketing assistance provided by the Administrator. The template described the arrangement as an “informal arrangement under which [the Administrator] voluntarily expends its own assets in marketing the Funds.” The SEC found this disclosure to be misleading because it failed to describe the exchange of a portion of the administration fee for a recommendation to the Funds’ board or disclose the fact that the Administrator’s expenditures were not voluntary, but had been negotiated and agreed upon by the parties. Subsequently, the former general counsel drafted a disclosure template for inclusion in the Funds’ statements of additional information (“SAIs”) concerning the marketing arrangements that indicated that the Funds’ distributor, an affiliate of the Administrator, could finance from its own resources certain activities intended to result in the distribution of the Funds’ shares. The SEC found that the template, which served as the basis for the disclosure eventually included in the Funds’ SAIs, was misleading because it, among other things, failed to describe the nature of the arrangement in which the Administrator contractually agreed to set aside a certain portion of its administration fee to be used at the Adviser’s direction in exchange for the Adviser’s recommending the Administrator as administrator to the Funds’ board.
Findings – the Former President. Prior to the entering into a Side Agreement with the Adviser, the former president, who also served as chairman of the Funds’ board of trustees, received a legal memorandum from outside counsel recommending that the Administrator disclose marketing arrangements of the type embodied in the Side Agreement to Fund shareholders and trustees. Subsequent to executing the Side Agreement, the former president executed administration and sub-administration agreements between the Administrator and Funds without disclosing either the existence of the Side Agreement or its terms to the Funds’ boards of trustees or shareholders. Prior to the execution of the second Side Agreement, the former president was copied on an e-mail from one of the Funds’ independent trustees requesting a breakdown of the fees for administration and other contract proposals relating to the Administrator being considered for approval by the Funds’ board at the time. The former president did not apprise the independent trustee of the rebate arrangements under the proposed Side Agreement. Subsequently while presiding over a meeting at which the renewal of the Funds’ agreements with the Administrator was discussed, the former president failed to disclose terms of the Side Agreement then in process.
Violations. The SEC found that the former general counsel and former president each had willfully aided and abetted and caused the Adviser’s violations of Sections 206(1) and 206(2) of the Advisers Act.
Sanctions. As part of her settlement, the former general counsel agreed to pay a total of approximately $21,000 in disgorgement and prejudgment interest and a civil money penalty of $15,000. As part of his settlement, the former president agreed to pay a total of $18,000 in disgorgement and prejudgment interest.