The SEC settled public administrative and cease and desist proceedings against the trustees (the “Trustees”) of certain registered open-end investment companies (the “Funds”) and the Funds’ compliance and administrative services providers (collectively with the Trustees, the “Respondents”), relating to (1) the requirement under the Investment Company Act of 1940 (the “1940 Act”) to provide disclosure in the Funds’ shareholder reports describing advisory contract approvals during the period January 2009 through December 2010 (the “Relevant Period”), (2) recordkeeping required by the 1940 Act related to advisory contract approvals and (3) the Trustees’ approval of certain Fund advisers’ compliance programs. This article summarizes the SEC’s findings, which the Respondents neither admitted nor denied.
Background. The order describing the settlement characterizes the Funds as being part of a “turn-key” operation in which the Trustees as a single board oversaw as many as 71 Funds, most of them managed by different, unaffiliated advisers and sub-advisers. The company that provided chief compliance officer services to the Funds (the “CCO Services Provider”) and the company that provided administrative/transfer agency services to the Funds (the “Administrator”) were affiliates. The only Trustee who was an interested person of the Funds within the meaning of the 1940 Act is an indirect owner of each of the service providers.
The settlement focuses in large part on disclosure that each Fund is required to provide in its shareholder reports regarding its Trustees’ initial approval and subsequent annual renewal of the Fund’s advisory and any sub-advisory contracts. The order notes the number of advisory and sub-advisory contract approvals and renewals for the Funds during the Relevant Period, stating that the Trustees “conducted fifteen board meetings during which they considered whether to approve or renew a total of 113 advisory and 32 sub-advisory contracts in accordance with their duties under Section 15(c) of the 1940 Act. The board meetings also covered other official business of the [Funds], and typically lasted at least a full day. The number of advisory contracts that the Trustees considered varied with respect to each meeting as did the time for which the Trustees discussed each contract, with more time typically spent on new contracts and less on renewals. Because of the large number of [Funds], the Trustees often had to consider several new contracts and renewals at each board meeting, and at two separate board meetings, the Trustees considered over twenty contracts.”
Advisory Contract Approval Disclosure Requirement. The specific disclosure obligation cited by the SEC in the settlement requires shareholder report disclosure regarding advisory contract approval to address specific factors the SEC deems material to the ultimate decision to approve or renew a particular advisory contract, as follows (the “Specified Factors”): “[A]s to the approval or renewal of an advisory contract, Funds must include a discussion in their shareholder reports concerning, at a minimum: (1) the nature, extent, and quality of the services to be provided by the investment adviser; (2) the investment performance of the fund and the investment adviser; (3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; (4) the extent to which economies of scale would be realized as the fund grows; and (5) whether fee levels reflect these economies of scale for the benefit of fund investors. See Form N-1A, Item 27(d)(6)(i). Furthermore, Form N-1A requires that the shareholder report indicate whether the board relied upon fee comparisons with other funds or types of clients in approving the contract and, if so, describe the comparisons that were relied upon and how they assisted the board in concluding that the contract should be approved.” Form N-1A directs that this disclosure discuss how the board evaluated each factor and cautions that conclusory statements or a list of factors will not be considered sufficient. In enacting these disclosure requirements, the SEC stated that “boilerplate” disclosure would not be appropriate.
Advisory Contract Approval and Related Minutes and Shareholder Report Disclosures. The order describes the process followed by the Trustees, the Administrator, outside counsel and others that ultimately resulted in the Funds’ shareholder report disclosure regarding advisory contract approvals. For each contract, the Trustees requested that each adviser provide information related to the Specified Factors. Outside counsel reviewed the information received for completeness in advance of the board meeting at which the Trustees, with counsel’s guidance, used the information in making their decision to approve or renew the advisory contract. The SEC found that the process of creating minutes began with draft minutes created by paralegals at the Administrator using “a minutes template, which included boilerplate language concerning the material factors and conclusions which formed the basis for the Trustees’ Section 15(c) approval or renewal of the advisory contracts.” The initial draft was reviewed and revised successively by the secretary of the particular board meeting, the Funds’ secretary and the Funds’ outside counsel before the minutes were reviewed and approved by the Trustees. The Administrator used the Trustee-approved minutes to draft the advisory contract approval disclosures that appeared in the Funds’ shareholder reports.
Boilerplate Disclosures. A principal finding of the order is that in certain instances the Funds provided “boilerplate disclosure” regarding certain of the Specified Factors that was materially untrue or misleading. The order gives only three examples of “boilerplate disclosure” that the SEC found materially untrue or misleading, all of which are variations on the following conclusion: “the Fund’s advisory fees and expense ratio were acceptable in light of the quality of the services the Fund currently receives from the Adviser, and the level of fees paid by a peer group of other similarly managed mutual funds of comparable size.” As to the Fund in one example, the SEC found that the Trustees had not received any peer group information. In the other two examples, the SEC found that “these boilerplate statements were materially misleading since they implied that the fund was paying fees that were not materially higher than the middle of its peer group range when, in fact, the adviser’s approved fee was materially higher than all of the fees of the adviser’s selected peer group and nearly double the peer group’s mean fee.” As noted above, the SEC also found that the paralegals at the Administrator who produced the initial draft of minutes used “boilerplate language concerning the material factors and conclusions which formed the basis for the Trustees’ Section 15(c) approval or renewal of the advisory contracts.” The SEC also determined that the minutes of board meetings at which the Trustees approved advisory contracts “sometimes contained boilerplate language that was materially untrue or misleading.”
On the basis of the foregoing, the SEC found that the Trustees caused certain Funds to violate Section 34(b) of the 1940 Act, which prohibits any person from making any untrue statement of a material fact in any document filed with the SEC or required to be maintained by Section 31(a) of the 1940 Act, which specifies the records required to be kept by registered funds. Specifically, the SEC found that “certain board minutes reviewed and approved by the Trustees contained boilerplate language and materially untrue or misleading statements concerning the material factors and conclusions that formed, at least in part, the basis for the Trustees’ renewal or approval of certain advisory contracts. These minutes were then used by [the Administrator] to draft the required disclosures within the applicable series’ shareholder reports, which also included the materially untrue or misleading disclosures concerning the Trustees’ Section 15(c) evaluation process.”
The SEC also cited Rule 31a-1(b)(4) which requires a registered fund to maintain minute books of its trustees’ meetings, and in that regard, found that “in connection with each meeting, the Trustees understood that their meeting minutes should document their consideration of the material factors considered, and conclusions reached, in deciding to approve or renew a fund’s advisory contract. Accordingly, the Trustees also caused violations of Section 34(b) of the Investment Company Act by approving certain board minutes that were materially untrue or misleading.”
Missing Contract Approval Disclosures. The SEC found that the Administrator, which had contractually agreed to prepare the Funds’ shareholder reports, caused certain Funds to violate 1940 Act’s disclosure requirements for shareholder reports under Section 30(e) and Rule 30e‑1 by failing in ten instances during the Relevant Period to include the required disclosures regarding advisory contract approval in the relevant Funds’ shareholder reports.
Recordkeeping Omissions. The SEC found that the Administrator caused certain Funds to violate Section 31(a) of the 1940 Act and Rule 31a-2(a)(6) thereunder which require a fund to maintain documents considered by fund trustees during the advisory contract approval process, an obligation that the Funds had delegated to the Administrator. In three instances, in response to requests from advisers prompted by concerns about confidentiality, the Administrator discarded or returned written financial information the adviser had submitted as part of the contract approval process. In four other instances, the Administrator failed to keep peer group fee comparisons submitted by advisers. The Administrator also failed to maintain some of the written summaries prepared by outside counsel to assist the Trustees in the contract approval process.
Inadequate Basis for Adviser Compliance Program Approvals. The SEC found fault with the fact that the Trustees approved the compliance programs for certain Fund advisers based on summaries provided by the CCO Services Provider that were inadequate under the Funds’ compliance program and Rule 38a-1 under the 1940 Act relating to the approval of Fund compliance programs, which required the Trustees to receive “either: (1) copies of the advisers’ policies and procedures for the Trustees’ review; or (2) a summary of the advisers’ compliance programs prepared by [the CCO Services Provider] that familiarized the Trustees with the salient features of the compliance programs and that provided the Trustees with a good understanding of how the advisers’ compliance programs addressed particularly significant risks.” (Consistent with the SEC’s statements regarding the basis on which a fund board could approve the compliance program of a fund service provider, the Funds’ compliance program also allowed the Trustees to rely on summaries produced by legal counsel or other persons familiar with the compliance program.) The SEC found that in certain instances the Trustees’ approval was instead based on “a brief written statement prepared by [the CCO Services Provider] at the conclusion of its compliance review, indicating that the advisers’ compliance manuals were ‘sufficient and in use’ and also indicating that the code of ethics and proxy voting policies were ‘compliant.’ This written statement was accompanied by a verbal representation by [a representative of the CCO Services Provider] at the relevant board meeting that the adviser’s policies and procedures were adequate.”
On the basis of the foregoing, the SEC found that the CCO Services Provider and the Trustees caused certain Funds to violate Rule 38a-1 under the 1940 Act.
Sanctions. Both the Trustees and the service providers agreed to a cease and desist order. Each of the service providers will pay a civil money penalty of $50,000. The Respondents undertook to engage a compliance consultant to address the problems with advisory contract and compliance program approval found by the SEC in the order.
In the Matter of Northern Lights Compliance Services, LLC, Gemini Fund Services, LLC, Michael Miola, Lester M. Bryan, Anthony J. Hertl, Gary W. Lanzen, and Mark H. Taylor, SEC Release No. ICA-30502 (May 2, 2013).