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Adviser Ignored Board, Resulting in Huge Fund Losses


The adviser to four collective investment trusts (CITs) and its principal/PM/CEO agreed to pay over $7.6 Million in disgorgement and penalties for ignoring the CITs’ board and incurring losses due to over-concentration in a single security.  The board recognized that the CITs were overconcentrated in a single security that comprised 30% to 89% of their assets.   The board instructed the adviser to reduce the concentrations to 10%, and the adviser undertook to put a plan together.  According to the SEC, the adviser ignored the board, the CITs continued to be over-concentrated, and the CITs ultimately experienced significant losses as a result.  The board fired the adviser soon thereafter.  The CITs were sponsored by a trust company affiliated with the adviser.

A fund board, even if completely independent, has few remedies available when confronted with a fund sponsor that misleads or ignores the board.  The board can threaten to terminate the adviser (or constructively terminate by reducing fees), but that only leads to the untenable situation of a board having to find a new manager or closing the fund.  Perhaps, the U.S. fund industry should consider a European-style governance structure that includes a third party trustee that can monitor and step in if necessary. 

Fund Boards Allowed to Continue Main Agreements without In-Person Meetings

The staff of the SEC’s Division of Investment Management will allow registered fund boards to meet telephonically, rather than in-person, to approve the continuation of advisory and distribution agreements.  The no-action letter allows Boards to meet by telephone or video conference (or by other simultaneous meeting venue) to continue a previously-approved agreement so long as the in-person meeting is impossible due to “unforeseen or emergency circumstances” (e.g. illness, death, weather, or other force majeure), the approval does not request material changes, and the Board ratifies the approval at the next in-person Board meeting.  Also, a Board could use a telephonic approval if the Board discusses and considers all material information concerning approval but delays a final vote until the directors receive additional information or a contingent event occurs.  The no-action relief also applies to approvals of auditor engagements and 12b-1 distribution plans. 

The in-person meeting requirement is so archaic that it feels like it was adopted in 1940, although it was actually adopted in 1970.  As a statutory requirement, the SEC cannot completely strike the in-person requirement without an act of Congress (which is not a bad idea).  The SEC deserves some credit for adapting the rules to modern realities, and we would urge them to further liberalize the rules to the extent legally permissible. 

SEC Allows Fund Boards to Rely on CCO for Exemptive Rule Compliance

 The staff of the SEC’s Division of Investment Management has issued no-action relief allowing fund boards to rely on the representations of the Chief Compliance Officer for Rule 10f-3, 17a-7 and 17e-1 transactions.  Rather than duplicate the due diligence performed by the CCO, the no-action letter allows fund boards to rely on quarterly CCO representations that transactions effected under exemptive Rules 10f-3 (affiliated underwriting), 17a-7 (cross-trades) and 17e-1 (affiliated brokerage) complied with the applicable fund procedures.  The SEC opines that this reliance will allow fund boards to more efficiently exercise its oversight role with respect to conflicts of interest.  The no action letter reverses a 2010 staff position.

OUR TAKE: The no-action position reflects the reality of how most funds operate.  The Board has very little ability to perform due diligence independent of the work performed by the Chief Compliance Officer, so it makes sense to rely on the representations.  The big open question is whether this position increases CCO liability, thereby creating additional due diligence requirements.

Large Asset Manager Pays $97 Million for Over-Relying on Faulty Quant Models

 A large asset manager agreed to pay over $97 Million in disgorgement, fines and interest for over-relying and marketing faulty quantitative models and other portfolio management missteps.  The SEC maintains that the respondents rolled out registered funds and separate accounts based on un-tested quantitative models created by an inexperienced research analysist.  When the models failed to work as described to the Board and investors, the respondents discontinued their use without explanation or disclosure.  The SEC also accuses the firm of declaring dividends without proper disclosure of the percentage attributable to return of capital and for using third party performance data without verification.  The SEC charges violations of the anti-fraud rules, the compliance rule, and Section 15(c) of the Investment Company Act for lying to the funds’ Board.

OUR TAKE: This case reads like a cautionary tale for large firms trying to quickly roll out a product.  It appears that the portfolio management, marketing, legal, operations, and legal functions worked in silos, and, as a result, failed to properly vet or describe the products.  We recommend that firms create a cross-functional product assessment team that can ask the hard questions before launching a product.

SEC Fines and Bars Fund Manager in Series Trust

The SEC fined and barred the portfolio manager of a registered mutual fund for failing to disclose to the Board and shareholders significant changes in investment strategy.  The fund operated as part of a platform series trust sponsored by a third party fund administrator that was responsible, along with the Board, for compliance oversight, although each adviser was responsible its own tailored compliance program.  As the SEC alleged, the PM altered the fund’s strategy and began investing the vast majority of assets in derivatives, which ultimately led to the fund’s demise.  Although the PM did ask for permission to invest in derivatives, he did not disclose that engaging in derivatives and short selling would become the principal investment strategy.    The SEC also accuses the respondent with failing to properly disclose the changes in investment strategy in the prospectus and shareholder reports and for causing the series trust’s Investment Company Act violations.

OUR TAKE: The SEC has wrestled with the allocation of compliance responsibility between series trust sponsors and boards and the underlying managers.  In this case, the SEC targets the manager for failing to ensure proper disclosure.  It is unclear at this writing whether the SEC will also charge the series trust or its board.