Securities and Exchange Commission disclosure examiners are posing pointed questions to funds that significantly change their investment strategies, asking them to explain directors' deliberations on the matter. At the top of the list is understanding how boards determined the transformation was consistent with their fiduciary duties to shareholders.

Examiners who work at the Disclosure Review and Accounting Office within the Division of Investment Management have requested the same information from at least half a dozen funds this year, filings show. The nearly identical wording of questions suggests to some a coordinated effort that reflects the SEC's uneasiness with wholesale fund strategy changes in this way and a desire to ensure such decisions were made only after carefully considering all options.

"When you look at the SEC comments, they are clear: they express an implied discomfort with this approach," says a '40 Act attorney who spoke on condition of anonymity. "Effectively what the staff is saying is, 'If you come in with this, we're going to make you show your work.'"

That's not to say boards can't approve a strategy overhaul, but lawyers say directors presented with similar proposals should make sure to follow a thorough process.

Most of the funds that received these comments were proposing to radically alter their investment mandate, resulting in repositioning all or nearly all of their portfolio holdings. One fund went from a macro trends strategy to investing in luxury goods companies. An ETF that tracked a proprietary index based on among other things irrational investor behavior planned to switch to an actively managed ETF that used hedging to minimize downside risk.

The SEC began asking about these fund transformations in March, according to letters the funds submitted to the agency in response to the examiners' questions.

With respect to boards' roles, the commission asked for a detailed explanation of the information directors considered and how they weighed that material in making their decision. They also asked why directors concluded a wholesale strategy change might benefit shareholders more than, for example, liquidating the fund and starting a new one.

"Support your explanation of the board's deliberations with data," one letter said. "For example, if cost was a consideration, provide data on the expected cost savings from the proposed changes as compared with starting a new fund."

Examiners also are asking why the adviser believes the changes are consistent with its fiduciary duty to the fund, and they posed several questions regarding shareholders, who, they note, did not vote on the issue. Among the questions addressing shareholders, examiners asked whether the fund notified investors and, if so, how. They also asked about the types of shareholders – affiliated or unaffiliated, institutional or retail, domestic or foreign – invested in the fund; the proportion of the fund retail investors owned; and whether any shareholder contacted the fund or intermediaries about the change. In cases where shareholders did reach out, the SEC asked whether anyone expressed displeasure or threatened legal action.

"It comes from a presumption that is not necessarily supported by law. It comes from the presumption this is not great for shareholders and must have fiduciary duty implications," the attorney says. "But I just don't think that's the case. Switching a fund's focus is not necessarily a fiduciary duty issue."

A board's fiduciary duties relate to loyalty and care, and directors have satisfied those duties if they act in a disinterested, engaged and informed manner, lawyers say, even if someone else might reach a different conclusion on the same issue.

The board of U.S. Global Investors Funds approved changing the name and strategy of the Holmes Macro Trends Fund to the Global Luxury Goods Fund during a March 27 meeting after considering a variety of information, according to an April letter the fund group wrote to the SEC. Management provided directors with a memorandum outlining the proposed changes and its rationale. The board also considered prior conversations with the adviser "concerning the persistent relative underperformance of the fund and the desire to achieve an improved performance experience for the fund's shareholders," the filing said.

"The board believes that it has acted with due care in making its determinations and that approval of the proposal was in the best interests of fund shareholders," the letter said.

The Holmes fund, which represented $35.1 million in assets at the end of 2019, has seen annual outflows for the past 20 years, according to data from Morningstar Direct. Outflows have continued since the July 1 strategy change, the data show. Days after the switch, the fund group asked shareholders of its $12 million All American Equity Fund to approve reorganizing that product into the luxury goods fund. A previously postponed vote is set for the day after Thanksgiving.

Two luxury goods fund shareholders contacted the fund's transfer agent after getting notice of the name and strategy changes. One approved of them and said he trusted the fund's and adviser's decisions; the other said he was skeptical of the new direction and was considering closing his account, the U.S. Global letter said.

SEC disclosure review examiners provided similar comments to Exchange Traded Concepts, a trust that planned to repurpose its FLAG-Forensic Accounting Long-Short ETF into the North Shore Dual Share Class ETF. The board made its decision in the face of the old ETF's index provider telling management it would no longer calculate the index, according to a letter the trust sent the commission.

But the change never went through. Eleven days after responding in March to the SEC's comments, directors approved a plan to liquidate the FLAG ETF, which saw assets drop from $7.5 million on Jan. 31 to $4.8 million as of April 30, according to filings and Morningstar data. The trust launched the dual share class ETF as a new product; it had about $700,000 in assets as of last week.

Other groups that SEC examiners questioned about significant strategy changes include Virtus, MassMutual's MML Series, and ETF Series Solutions. MassMutual's letter noted that "a change of this nature is consistent with actions taken by investment company boards in the ordinary course without shareholder action, and that organization of a new fund in order to accomplish this change would require undue time and expense."

Repurposing funds is not something new, says Ryan Brizek, counsel at Simpson Thacher. Certain funds have designated policies, including some investment policies, as fundamental, and changing those requires shareholder approval. But funds aren't obligated to make their investment policies fundamental, and directors of those that do not can make changes themselves.

He views the SEC questions as more of a fact-finding effort and not an indication commission staff is looking to find fault with boards. "I don't think it's necessarily an indication that something's gone wrong in their view," Brizek says.

More likely, the agency wants to ensure decisions about transforming a fund follow a process, he and the anonymous attorney say.

"You should really be kicking the tires on this and making sure this is in the best interests of the fund," the anonymous attorney says. "[T]his is a useful reminder that good processes and good governance are an ongoing consideration for boards. And for boards that have good governance and good processes, these questions are not going to be an issue."

Contact the reporter on this story at gsaitz@boardiq.com or (212) 542-1240.

Boards Face SEC Scrutiny Over Big Fund Strategy Switches

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