The SEC recently instituted and settled an enforcement action against an investment adviser to a family of mutual funds for improperly calculating the fund adviser’s profitability in connection with annual renewals of its advisory contract. The SEC found that the adviser violated Section 15(c) of the Investment Company Act of 1940. The adviser and its CFO/CCO were subjected to a cease-and-desist order and required to pay civil money penalties of $50,000 and $25,000, respectively.
Section 15(c) makes it unlawful for registered funds to enter into or renew any advisory contract unless the terms of the contract are approved by a majority of the funds’ independent directors. While Section 15(c) does not define what is “reasonably necessary” to evaluate a contract’s terms, the SEC has promulgated various fund filing disclosure requirements to better inform shareholders about a board’s evaluation process when approving or renewing an advisory contract.
As to the approval or renewal of an advisory contract, funds must include a discussion in their shareholder reports concerning, among other things, 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 funds.
Key Take Away: A key part of the process of renewing funds’ advisory contracts under Section 15(c) is assessing 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 funds. In turn, it is important that fund boards understand the expense allocation methodology that an adviser uses in calculating its profitability, including the methodology for allocating employee compensation expenses to the funds. The board should ensure that it is comfortable with the adviser’s profitability analysis and the methodology for allocating expenses to the fund.
Summary: The funds’ board considered the renewal of the advisory contracts on an annual basis. As part of the process, the board requested certain information from the adviser for the board’s consideration, including an analysis of the profitability of each fund to the adviser over the past two years, including expenses related to services provided to each fund, with an explanation of the expense allocation methodology. In response, the adviser provided the board with a one-page analysis of its profitability in managing the funds for its latest two fiscal years.
The profitability analysis included line items for, among other things: total revenue; total operating expenses; net operating income before income taxes; and net income before income taxes. The bulk of the expenses were employee compensation, of which the compensation of the chief executive officer (CEO) made up a significant portion. The adviser represented that employee compensation was allocated based on estimated labor hours, although it also stated that the CEO’s compensation allocation was an estimate based on his time and his intangible value to the funds.
Contrary to what the adviser had stated in its profitability analyses furnished to the board, the adviser did not allocate the CEO’s compensation to the funds based solely upon the CEO’s estimated labor hours and intangible value to the funds. In actuality, the adviser adjusted the allocation of the CEO’s compensation in a manner designed, in part, to achieve consistency of the reported profitability in managing the fund year over year. From 2010 to 2012 the percentage of the CEO’s compensation allocated to the funds increased from 35% to 49.5%, and the increases kept the adviser’s reported pre-tax net profit margin in a narrow range of 26.8% to 28.1%. In 2013 the CEO's compensation increased by more than 70% and, in part in order to avoid showing a significant reduction in profitability, the adviser allocated just 25% of the CEO’s compensation to managing the funds, resulting in a reported pre-tax net profit margin of approximately 40%.
The SEC concluded, in part, that the adviser’s methodology for allocating employee compensation expenses to the funds was reasonably necessary for the board to evaluate the terms and renewal of the advisory contracts, and failure to accurately provide this information was a violation of Section 15(c) by the adviser.