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SEC Fines Adviser for Skewed Profitability Reporting

The SEC settled a case last week against Kornitzer Capital Management (“KCM”), adviser to the Buffalo Funds, and Barry Koster, KCM’s CFO and CCO, for alleged violations of Section 15(c). According to the SEC, KCM adjusted the portion of its CEO’s compensation allocated to the funds to achieve year-over-year consistency in the 15(c) profitability analysis rather than basing the allocations on “estimated labor hours” as disclosed to the board.  As reported by John Baker in his FundLaw news group, the case represents “the first enforcement action involving a profitability analysis.”

From 2011 to 2012, Koster increased the allocation of the CEO’s compensation to the funds from 35% to 49.5% so that the reported profitability remained relatively stable, ranging from 26.8% to 28.1%. In 2013, when the CEO’s overall pay increased by more than 70%, the allocation of the CEO’s compensation to the funds was lowered to 25% resulting in a profit margin of 40%.  The SEC alleged that the adviser “failed to furnish information that was reasonably necessary for the Board to evaluate the terms of [the] advisory contracts in violation of Section 15(c) of the Investment Company Act.” The settlement resulted in fines of $50,000 from the adviser and $25,000 from Koster.

While Section 15(c) does not define what information boards should consider when reviewing an advisory contract, the case law (most recently affirmed by the Supreme Court in Jones v. Harris) has identified profitability as a potentially relevant factor.  However, those cases do not prescribe a particular allocation methodology.  In fact, according to Baker, fund fee litigation has recognized the difficulty in these allocations and that the calculations can result “in a variety of possible profitability analyses.” Further, while disclosure rules require a discussion of the factors considered by the board in renewing an advisory contract, including profitability, the SEC has not focused on the adviser’s analysis.  According to Baker, this case may represent “a new SEC focus on the adviser's justification of its profitability analysis.”

The order in the case can be found here