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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.