From time to time, AUM Law reports on regulatory developments south of the border, since developments in the United States typically provide an early indication of trends and issues that may be of concern to Canadian securities regulators.
Recent Trends in Expense Allocation
In the United States, Securities and Exchange Commission (SEC) staff have recently highlighted, in a number of enforcement actions, perceived inappropriate expense allocation and disclosure practices by investment fund managers.
For example, in late April 2015, the SEC announced charges against a hedge fund advisory firm and two executives relating to alleged improper allocations of fund assets to pay operating expenses, including office rent, employee salaries and benefits, and similar expenses, without clear authorization from fund investors and without accurate and complete disclosures that fund assets were being used for these purposes. The SEC also charged an accountant who conducted the outside audit of the financial statements that were sent to investors.
To settle the charges, the firm agreed to pay disgorgement amounts, penalties and interest of approximately $700,000. In addition, the two executives agreed to be barred from the securities industry for one year; the executive who acted as general counsel agreed to a one-year suspension from practising as an attorney on behalf of any SEC-regulated entity; and the accountant agreed to pay a penalty of $75,000 and consented to an order suspending him from practising as an accountant on behalf of any SEC-regulated entity for three years. The firm and the three individuals settled the charges without admitting or denying the SEC’s findings. See the SEC release in Re Alpha Titans LLC, Timothy McCormack and Kelly Kaeser dated April 29, 2015.
This case followed an earlier settlement in September 2014 where the SEC announced that it had charged an advisory firm with breach of fiduciary duty to two private equity funds for allegedly improperly allocating expenses between the two funds (e.g., by allocating an expense to one fund even though the expense had primarily benefitted the other fund).
The firm settled the charges without admitting or denying the SEC’s findings by paying disgorgement amounts, penalties and interest of more than $2.3 million. See the SEC release in Re Lincolnshire Management, Inc. dated September 22, 2014.
In Ontario, OSC staff issued two notices in the spring of 2014 that provide extensive guidance on what constitutes (in staff’s view) inappropriate allocation and disclosure practices:
- OSC Staff Notice 81-724 Report on Staff's Continuous Disclosure Review of the Fees and Expenses Disclosure by Investment Funds, dated May 8, 2014
- OSC Staff Notice 33-743 Guidance on sales practices, expense allocation and other relevant areas developed from the results of the targeted review of large investment fund managers, dated June 19, 2014
In light of these developments, it is important that fund managers manage – and are seen to manage – the conflicts of interest that may arise with expense allocation practices, in a manner that is consistent with the fund manager’s duties to act honestly, in good faith and in the best interests of the fund, and to appropriately respond to conflicts.
Similarly, it is important that the fund manager be able to demonstrate that the allocation of expenses as between the manager and the funds, and as across multiple funds, is consistent with the clear terms of the management or trust agreement, the disclosure of such terms in the offering document or investment management agreement provided to investors, and the fund manager’s written policies and procedures in relation to expense allocation.
A failure to effectively manage these potential conflicts or to ensure that the practices are consistent with these documents may result in significant compliance or enforcement consequences and/or potential civil litigation consequences for the fund manager and its principals.