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SEC Settles Enforcement Action with Trustees Regarding Investment Advisory Contract Approvals and Renewals

The Investment Company Act requires mutual fund directors to evaluate and approve a fund's contract with its investment adviser, and the fund must report to shareholders about the material factors considered by the directors in approving the contract. The SEC Enforcement Division's Asset Management Unit has been taking a widespread look into the investment advisory contract renewal process and fee arrangements in the fund industry. "Determining the terms of the investment advisory contract, especially compensation of the adviser, is one of the most critical duties of a mutual fund board," said George S. Canellos, Co-Director of the SEC's Division of Enforcement. "We will aggressively enforce investors' rights to accurate and complete information about the board's process and decision-making."

An SEC investigation that arose from an examination of the Northern Lights Fund Trust and the Northern Lights Variable Trust found that some of the trusts' shareholder reports either misrepresented material information considered by the trustees or omitted material information about how they evaluated certain factors in reaching their decisions on behalf of the funds and their shareholders. The trusts are series trusts that included up to 71 mutual funds, most of which were managed by different unaffiliated advisers and overseen by a single board of trustees. From January 2009 to December 2010, the trustees conducted 15 board meetings and made decisions about 113 advisory and 32 sub-advisory contracts pursuant to Section 15(c) of the Investment Company Act.

In the enforcement order, the SEC alleged that: the trustees caused violations of Section 34(b) of the Investment Company Act; the chief compliance officer, Northern Lights Compliance Services (NLCS), and the trustees caused violations of Rule 38a-1 under the Investment Company Act; and the trusts' administrator, Gemini Fund Services, LLC (GFS), caused violations of Sections 30(e) and 31(a) of the Investment Company Act.

Without admitting or denying the SEC's allegations, the five trustees, including four independent trustees, consented to a cease and desist order against them. NLCS and GFS also consented to a cease and desist order and each agreed to pay a $50,000 civil money penalty. NLCS, GFS and the trustees also agreed to hire an independent compliance consultant to address the violations in the SEC's order.

"These violations make clear that turnkey mutual fund arrangements can pose significant governance concerns, and trustees must be vigilant in ensuring that the funds they oversee meet their disclosure, compliance, reporting, and recordkeeping obligations," said Marshall S. Sprung, Deputy Chief of the SEC Enforcement Division's Asset Management Unit.

Board Minutes. Prior to each board meeting, the trustees requested information from the applicable advisers and sub-advisers to evaluate the proposed agreements and such information was then reviewed by the trusts' outside counsel. After each board meeting, GFS paralegals prepared a skeleton draft of the meeting minutes based on a minutes template. The draft minutes were then supplemented by the trusts' secretary, reviewed and revised by outside counsel, and then reviewed and approved by the trustees. The discussion of the trustees' approval process included in the meeting minutes was then used to draft the disclosure in the trusts' shareholder reports.

Shareholder Reports. Section 34(b) of the Investment Company Act makes it unlawful for any person to make any untrue statement of a material fact or omit a material fact in any shareholder report. The SEC found that the trustees were a cause of the Section 34(b) violation that resulted from the inclusion of untrue statements of material fact and omissions necessary to prevent statements from being materially misleading in the portion of shareholder reports that covered the discussion of the board's advisory contract approval process.

The SEC cited examples of disclosures it considered untrue or misleading. In one example, the SEC noted that a shareholder report disclosed that the trustees "discussed the comparison of management fees and total operating expense data and reviewed the Fund's advisory fees and overall expenses compared to a peer group of similarly managed funds. . . . The trustees concluded that the Fund's advisory fees and expense ratio were acceptable in light of the quality of the services the Fund currently receives from the Adviser, and the level of fees paid by a peer group of other similarly managed mutual funds of comparable size." However, the SEC found that these statements were materially misleading since they implied that the fund was paying fees that were not materially higher than the middle of its peer group range when, in fact, the adviser's approved fee was materially higher than all of the fees of the adviser's selected peer group of 74 funds and nearly double the peer group's mean fee.

Approval of Adviser's Compliance Policies. The SEC also determined that the trustees and NLCS each caused violations of Rule 38a-1 under the Investment Company Act, which requires fund boards to approve the policies and procedures of fund service providers, including the policies and procedures of the fund's adviser. The approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violations of the federal securities laws. Consistent with Rule 38a-1, the trusts' compliance policies and procedures required NLCS to provide the trustees with either the policies and procedures of each adviser or a summary of each adviser's compliance program. In practice, however, NLCS provided the trustees with a written statement that NLCS had reviewed the adviser's compliance programs and that they were "sufficient and in use" and that NLCS had reviewed the adviser's code of ethics and proxy voting policies and that they were "compliant." This written statement was accompanied by a verbal representation by an NLCS representative at the relevant board meeting that the adviser's policies and procedures were adequate. The SEC found that the written statement and oral representation by NLCS did not constitute an adequate summary that familiarized the trustees with the salient features of each adviser's compliance programs and that provided the trustees sufficient understanding of how the programs addressed particularly significant risks. As a result of this deviation from the trusts' written policies and procedures, the SEC alleged that each of the trustees and NLCS caused the trusts' violations of Rule 38a-1.

Records. In addition, the SEC's order stated that GFS, in its role as fund administrator, caused the trusts' failure to comply with requirements set forth in Section 31(a) of the Investment Company Act and Rule 31a-2 by failing to maintain all board materials considered in approving a fund's advisory contract. These materials included documents containing fee comparisons for peer groups and summaries that were prepared by the trusts' outside counsel as part of the trustees' approval process. The SEC stated that, in some instances, GFS discarded such information after the meetings or returned it to an adviser due to the adviser's concerns with confidentiality.

Takeaway from Morgan Keegan and Northern Lights Enforcement Actions

Taken together, the Morgan Keegan and Northern Lights settled enforcement actions suggest a broader trend of SEC inquiry into fund governance procedures, a closer look at the actions of fund boards, and a potentially increased willingness by the SEC to bring enforcement actions against fund boards and, in certain circumstances, against individual directors and trustees.

Sources: SEC Charges Gatekeepers of Two Mutual Fund Trusts for Inaccurate Disclosures About Decisions On Behalf of Shareholders, SEC Press Release 2013-78 (May 2, 2013); In the Matter of Northern Lights Compliance Services, LLC, Gemini Fund Services, LLC, Michael Miola, Lester M. Bryan, Anthony J. Hertl, Gary W. Lanzen and Mark H. Taylor, Investment Company Release No. 30502 (May 2, 2013).

Copyright © 2020 Godfrey & Kahn S.C.National Law Review, Volume III, Number 197


About this Author

Chris Cahlamer Investment Management Attorney

Chris Cahlamer is the team leader of the firm’s Investment Management Practice Group, where he practices in investment management and securities law, focusing on investment companies, investment advisers, regulatory examinations, new product development, SEC compliance and reporting obligations, CCO support, private fund formation and operation, investment company reorganizations, investment advisor mergers and acquisitions, and general corporate and board fiduciary issues.

Chris earned his law degree, summa cum laude, at Marquette University Law School. While there, he...

Carol A. Gehl, Securities Law Attorney, Godfrey and Kahn law firm

Carol Gehl is a shareholder and the team leader of the Securities Practice Group in the Milwaukee office.

Carol’s practice is focused on investment management entities, including mutual funds, hedge funds, investment advisers and broker-dealers throughout the nation. During the last number of years, Carol has facilitated the organization of numerous mutual funds, hedge funds and investment advisers; assisted in SEC and FINRA examinations of regulated entities; provided ongoing advice to mutual fund Boards of Directors; and assisted with several mergers of investment advisers and reorganizations of mutual funds.

Susan Hoaglund, Investment Management Attorney, Godfrey Kahn law firm

Susan Hoaglund is a member of the Investment Management Practice Group. Susan provides advice to investment advisers, investment companies, broker-dealers and banks regarding legal, regulatory and compliance matters.