What is being described as an "administrative oversight" has tripped up the Lighthouse Capital Opportunity Fund and caused the Securities and Exchange Commission to scrutinize an October proxy that the fund filed and to retain its advisory fees.
In the proxy, the fund's advisor, Lighthouse Capital Management of Houston, asked shareholders to reapprove the fund's advisory contract and allow it to keep the $232,000 in management fees it believed it had been properly earning over the past six years, despite an oversight that caused its investment contract to inadvertently terminate in mid-1999 because of a change in ownership. Until the matter is resolved, the SEC is currently holding the advisor's fees.
Since filing that proxy, a subsequent Nov. 17 proxy filing revealed that SEC staff contacted the fund's advisor three times in November, asking for clarification on several important points about the advisory contract and ordering it to include additional shareholder disclosure in the final proxy statement to investors.
The $10 million Lighthouse Capital Opportunity Fund is a small-growth fund that launched in September 1995. The fund, the advisor's only offering, was originally named the Lighthouse Contrarian Fund, but dropped its "contrarian" moniker four years ago in favor of the "opportunity" name because the contrarian concept was often misunderstood.
The predicament came to light a month ago, when the fund's portfolio manager was making a presentation to the fund's board and the question arose as to who owned the advisory company and when.
In July 1999, Paul Horton, then partner and 51% owner of Lighthouse Capital, bought out the 49% ownership stake of the only other partner, Kevin Duffy, who served as the firm's director of research. In March 2003, Horton, then the president and sole owner of the advisory firm, sold some shares to two individuals: William Choice, Lighthouse Capital's vice president, and Chris Matlock, chief investment officer, who, three months later, would formally become the fund's portfolio manager.
The sale was executed under a "plan [that] ultimately intended to allow other key employees to become additional owners of the advisor," according to the proxy. In June 2003, a third transaction took place, making Horton, Choice and Matlock equal partners, each owning a 33.3% stake.
But the advisory contract had effectively been terminated with the first change of control in what is known as an "assignment." The 40 Act requires an advisor to ask for fund shareholders' approval anytime there is a change in ownership because that warrants a new investment advisory contract.
"At the time of the transactions, no legal analysis or consideration was undertaken on behalf of the advisor or the fund concerning each transaction's impact on the original advisory agreement because the personnel of the advisor believed in good faith that there was no change in actual control or management of the advisor," according to the proxy.
The SEC asked the fund to explain how the board of trustees discovered the changes in the advisor's control, why the board was not aware of the changes and what internal rules the board has put in place to prevent such an oversight from occurring again. The advisor explained that although it provided ownership information to the board each year, only the current year's ownership was provided, not ownership information from previous years for comparison. To prevent future errors of this sort, the investment advisor will now make any changes in the ownership of voting securities of the adviser known to the board.
Horton referred calls to an executive with the fund's administrator U.S. Bancorp of Milwaukee, but executives of U.S. Bancorp were not available by press time.
Shareholders will vote on the new advisory contract at a Dec. 15 shareholder meeting as well as whether to allow Lighthouse Capital to keep its fees since 1999.
While administrative glitches of this sort are uncommon, they do sometimes occur. In 2003, Credit Suisse Asset Management of New York neglected to have the advisory contract on seven of its funds extended via renewal by its funds' board of directors, imperiling $9.9 million in past investment advisory fees paid over a 2-1/2 year period. (see MME 2/10/03).
In 2002, FBR Fund Advisers, a unit of Friedman, Billings , Ramsey Group of Arlington, Va., and adviser to the FBR Family of Funds, failed to renew its funds' advisory contract, sub-advisory agreement and 12b-1 distribution agreement.
The difference now is that with all of the increased compliance and disclosure burden on mutual funds, the SEC is certainly taking a harder look at fund filings, said Carl Frischling, a partner with the New York law firm of Kramer Levin Naftalis & Frankel. "The SEC is saying, We want full disclosure,' and it is not just accepting the situation. It's saying, Explain who screwed up and why.'" In this case, the SEC wants to be sure shareholders know who was watching the store and how this happened, Frischling said.
While the SEC is examining a percentage of the larger fund firms, it is also focusing on small complexes that may face risks because of thinner staffs, and fewer resources, Frischling added.
"Even routine prospectuses are generating comment from the SEC," confirmed Tom Westle, a partner with the New York law firm of Blank Rome. The SEC has long contemplated whether small firms really understand all of the rules. With the heightened issues of compliance, the SEC staff was probably very surprised that such an oversight could have occurred, and for so long, he added.
This may not be the end of the bad news for Lighthouse Capital, Westle predicted. If an investment advisor even inadvertently shows a disregard for the rules, it's a red flag for the SEC. The firm may find it is suddenly penciled into the schedule for an upcoming examination by the SEC, he noted.
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