SEC Enforcement Action Highlights Profitability Analysis in 15(c) Process

Investment Management Update

Date: May 12, 2015

In a recent administrative proceeding,1 the Securities and Exchange Commission settled an enforcement action against an investment adviser (Adviser) to a family of mutual funds (Funds) relating to inaccurate and incomplete information the Adviser furnished in connection with the annual process under Section 15(c) of the Investment Company Act of 1940, as amended (1940 Act), by which the Adviser renewed its advisory contracts with the Funds. Specifically, the Adviser (and its Chief Financial Officer and Chief Compliance Officer (CCO)) improperly calculated its profitability in materials it furnished to the Funds’ board of trustees (Board), which the Board used to evaluate the appropriateness of the terms of the advisory contracts. The SEC found that, because of this improper profitability calculation, for a three-year period the Adviser failed to furnish information that was reasonably necessary for the Board to evaluate the terms of the advisory contracts with the Funds in violation of Section 15(c) of the 1940 Act, and that the CCO caused these violations.

Section 15(c) of the 1940 Act provides that when a mutual fund and an adviser enter into or renew an advisory contract, it is the mutual fund’s board’s duty to request and evaluate, and the adviser’s duty to furnish, information that may reasonably be necessary to evaluate the advisory contract’s terms. Mutual funds must include in their shareholder reports a discussion 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 fund. As part of this process, the Board annually requested from the Adviser certain information it used to evaluate the advisory contracts, which included an analysis of the Adviser’s profitability with respect to each Fund. This profitability analysis included expenses related to services the Adviser provided to each Fund, with an explanation of the expense allocation methodology used. In the materials it provided to the Board, the Adviser represented that all employee compensation expenses were allocated to the Funds based on estimated labor hours.

However, the SEC found that the Adviser adjusted the allocation of its CEO’s compensation to achieve consistency in its reported profitability in managing each Fund from one year to the next and did not disclose this fact to the Board. It also failed to disclose that the CCO considered other factors beyond estimated labor hours in allocating the CEO’s compensation, which caused the information concerning the Adviser’s reported profitability in managing the Funds to be inaccurate and incomplete.

The Adviser and its CCO were subjected to a cease-and-desist order and required to pay civil monetary penalties of $50,000 and $25,000, respectively. The respondents neither admitted nor denied the findings.

Until now, the SEC has not appeared to focus on the profitability analysis provided by investment advisers in the 15(c) approval process, but this administrative proceeding suggests that it is beginning to consider the analysis an area for scrutiny and enforcement actions. In addition, courts that have considered profitability analyses in fund adviser fee litigation under Section 36(b) of the 1940 Act have acknowledged that there are a number of ways to calculate profitability and that the expense allocations required in such calculations can be made in different ways, resulting in a variety of possible profitability analyses. This enforcement action suggests that the SEC might be starting to see certain allocation decisions as more appropriate.

FOR MORE INFORMATION

For more information, please contact:

Andrew J. Davalla
614.469.3353
Andrew.Davalla@ThompsonHine.com

Tanya L. Goins
202.973.2722
Tanya.Goins@ThompsonHine.com

Michael V. Wible
614.469.3297
Michael.Wible@ThompsonHine.com

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1Release No. IC-31560 (Apr. 21, 2015).