The SEC recently announced an administrative settlement against Commonwealth Capital Management, LLC (CCM), a mutual fund adviser, and the members of the boards of two mutual funds for their failure to properly evaluate fund advisory contracts.  Although board approval of advisory contracts is only required once per year, this case reaffirms that approval is not just a casual decision during an annual review meeting.  Rather, approval of the advisory contract should reflect a thorough and thoughtful process that requires time and diligence from both the investment adviser and the company.  In addition, board members should understand that the failure of an adviser to provide the requested information does not excuse the board members from properly evaluating the advisory contract before approval, and, in fact, can lead to liability. 

The fairly extraordinary facts that are alleged by the SEC in this case do not suggest that the well-established standards for approval of advisory contracts have changed or that members of boards will be punished for honest mistakes made in good faith and reasonable judgment.  However, this is a reminder that advisers and members of boards must be diligent when evaluating information regarding the contracts to ensure their fairness with respect to the fees being charged and services being provided and to follow up when information is lacking or not provided.

Background of CCM Case

Section 15(c) of the Investment Company Act (the Act) requires the members of a board  of an investment company to request and evaluate the terms of contracts with investment advisers to the fund.  Likewise, the Act requires investment advisers to provide information that “may reasonably be necessary” for the board members of a fund to evaluate the contract.  Even if an advisory contract is in effect for more than two years, continuance of the contract must be approved by the members of the board at least annually.  Pursuant to Section 30(e) of the Act, Form N-CSR requires investment companies to provide reports containing certain information at least semiannually to its stockholders.  These semiannual reports must discuss the factors the board considered when approving investment advisory contracts, and they must, among other things, include a balance sheet for a fund and a statement of the aggregate value of the investments of the fund, as of the date of the balance sheet. 

In this instance, CCM served as the investment adviser to various mutual funds, including World Funds, Inc. (WFI) and World Funds Trust (WFT).  Members of the boards of WFI and WFT supposedly requested but failed to receive “reasonably necessary” information from CCM before approving the advisory contracts in accordance with Section 15(c).  CCM’s responses were allegedly insufficient and at times even inaccurate; yet the board members apparently did not follow up with questions or demands for the requested documents.  For example, according to the Order Instituting Administrative and Cease-and-Desist Proceedings (the Order), the board members of WFI sent CCM a questionnaire that asked for two years of financial statements to assist the board in assessing the adviser’s profitability.  Instead, CCM provided an income statement (with no balance sheet) for one year and a profitability chart that estimated overhead and other expenses for that year.  The board members of WFT also requested comparative fee information, and CCM provided nothing in response. 

Notwithstanding its failure to respond to WFT’s request, the Order alleged that CCM did prepare a “comparable fund analysis chart” for WFI.  The chart purported to use a standard industry database to provide fee information for share classes that were comparable in size to the WFI Fund’s class A shares and that had an investment strategy that was comparable to the strategy of the WFI Fund.  The chart, however, allegedly contained numerous flaws.  For example, the Order alleged that CCM did not edit the tables to delete share classes of funds that were not directly comparable to the WFI Fund, which resulted in numerous inapt comparisons of fees.  In addition, certain information in the chart was allegedly missing or incomplete.  Another chart prepared by CCM compared WFI Fund’s advisory fees to four other funds that had a combined advisory/administration fee, even though the WFI Fund had a separate administration fee.  An accurate comparison chart would have added the WFI Fund’s separate administration fee.  Even so, the inaccurate chart demonstrated that the WFI Fund’s advisory fee was the highest in comparison to the four other funds. 

The Order also alleged that the board members of WFT and WFI did not follow up with reasonable questions about the information provided nor demand that CCM provide the requested information that was missing at the time the advisory contracts were approved.  Consequently, the report to shareholders allegedly reflected the inaccurate and insufficient information provided by CCM.  

As a result of these significant deficiencies, the SEC determined that Section 15(c) and Section 30(e) of the Act were violated, and it imposed sanctions and cease and desist orders against CCM as well as members of the boards of the funds.

Sufficient Evaluations of Advisory Contracts

Although Section 15(c) does not define what may be “reasonably necessary” to evaluate a contract’s terms, board members are well-advised to make good faith judgments about what information they need and the weight that information should be given.  Specifically, board members are expected to consider the “Gartenberg factors,” which are named after the court decision that first developed them.[1]  These factors were subsequently incorporated into an SEC Disclosure Rule that requires funds to disclose and discuss the basis for the board’s approval of advisory contracts.  The Gartenberg factors can be summarized as:

• The adviser’s cost in providing the services.
• The nature and quality of the adviser’s services.
• The extent to which the adviser realizes economies of scale as the fund grows larger.
• The profitability of the fund to the adviser.
• Fee structures for comparable funds.
• Fall-out benefits accruing to the adviser or its affiliates.
• The independence, expertise, care and conscientiousness of the board can also be considered by courts.

Boards also commonly consider comparative fees and services in contracts between the same adviser and other types of clients (i.e., pension funds and other institutional clients).  The SEC recognizes that some of these factors and considerations might not be relevant to the approval of a contract, however, in those cases, the adviser must explain in the fund’s Form N-CSR disclosure the reasons why that factor is irrelevant to the evaluation.  The shareholder reports must include not only a discussion of the material factors considered by the members of the board when approving or renewing an advisory contract but also the board’s conclusions.

Intersection of Section 15(c) with Section 36(b)

The CCM case does not appear to change the long-established standards for evaluating advisory contracts.  In Jones v. Harris Associates,[2] the U.S. Supreme Court recently reaffirmed that the Gartenberg factors are the correct framework to use when evaluating advisory contracts.  Notably, the Supreme Court’s decision did not interpret Section 15(c) of the Act.  Instead, the decision interpreted Section 36(b) of the Act, which creates a fiduciary duty for investment advisers with respect to the fees charged for their services.  This section of the statute allows the SEC or a shareholder to sue a fund advisor for breach of fiduciary duty with respect to their compensation. 

Federal courts and practitioners often refer to these “excessive fee” cases as Section 36(b) cases, in reference to this section of the Act.  However, Section 36(b) imposes the burden on the plaintiff—either the SEC or shareholders—to prove that an investment adviser breached its fiduciary duty by charging excessive fees under the Gartenberg standard, which is a high threshold.  As a result, plaintiffs filing Section 36(b) cases have faced uphill battles. 

Recognizing this heavy burden, it appears the SEC is now using Section 15(c) to emphasize the importance of creating a thorough record regarding the reasonableness of the fees being charged in exchange for the services provided, without having to prove that the adviser breached its fiduciary duty.  Simply put, board members and advisers are expected to follow a thoughtful process in which they thoroughly analyze the fees and other terms of advisory contracts, and the SEC appears to be willing to use Section 15(c) to enforce this expectation.

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