The SEC charged a registered investment adviser and its principal with misleading a mutual fund’s board about the adviser’s portfolio management trading capabilities.  The SEC said the adviser misled the board at two meetings when the board considered and approved the investment advisory contract between the fund and the adviser.  In addition, the SEC claimed that, based on these misrepresentations, the fund misrepresented its investment strategy in its registration statement.

The case represents at least the third action arising out of the SEC Enforcement Division Asset Management Unit’s initiative focusing on the annual investment company contract approval process.

Section 15(c) of the Investment Company Act of 1940 (the “1940 Act”) requires the board of directors of a registered investment company annually to evaluate and approve the fund’s advisory agreement.  Section 15(c) also requires an investment adviser to provide the board with information as may reasonably be necessary to evaluate the contract.

Here, the adviser claimed it employed an algorithmic high speed currency trading to help the fund achieve its investment objective.  The SEC claimed that in truth the adviser did not possess any algorithms or computer models capable of the currency trading described to the board.  Rather, the SEC said, at the time the fund commenced operations, an individual trader controlled currency trading using a technical, rules-based analysis and “her own intuition.”

The adviser responded to a request from the board’s legal counsel in writing and prepared a PowerPoint presentation describing “a currency arbitrage overlay” involving an algorithmic trading program.  Based on this representation and an in-person presentation, the SEC said, the board approved the fund’s contract with the adviser and the proposed fee structure for the adviser’s services.

Pending a change of control of the adviser, the adviser made a second submission to the board, containing essentially the same claims about its trading capacities, the SEC said.  The adviser also justified a fee increase as necessary because the fund’s investment strategy “required more work to implement” than originally anticipated, according to the SEC.   The board approved a new contract between the fund and the adviser with the proposed higher fees.

Based on information provided by the adviser, the board also approved the fund’s prospectus.  The prospectus disclosure that the adviser’s principal reviewed claimed that “[u]sing high frequency market data, the adviser has created models of the [foreign exchange] market that it believes are able to analyze the price formation process of exchange rates in real-time.”  The SEC charged that this disclosure was inaccurate.

The SEC charged that the adviser and its principal violated Section 15(c) of the 1940 Act and Section 34(b) of the 1940 Act, which makes it unlawful for any person to make an untrue statement of a material fact in a fund’s registration statement or to omit to state in the prospectus a fact necessary in order to prevent the statements, in light of the circumstances, from being materially misleading.  The SEC also charged that the respondents violated the anti-fraud provisions of the Investment Advisers Act.

The SEC staff said “it is critical that investment advisers provide truthful information to the directors of the registered funds they advise.”  The staff pointed out that “[b]oth boards and advisers have fiduciary duties that must be fulfilled to ensure that a fund’s investors are not harmed.”

The obligation of a fund’s board to review and approve the fund’s investment advisory contract each year is one of its most significant roles.  The SEC staff and commissioners have characterized fund boards as “watchdogs” charged with safeguarding the interests of fund shareholders in the negotiation of an advisory contract between a fund and its adviser.  Over the past two years, the SEC’s Enforcement Division has increased its focus on the board’s role in this process.

But investment advisers cannot lose sight of their statutory responsibilities under Section 15(c) of the 1940 Act, as well as under the Investment Advisers Act.  Here, the staff is again stepping into a fund boardroom to review the contract review process, this time to ensure that fund investment advisers carry out their fiduciary responsibilities.