What a difference a single word makes! A one-word error in the investment advisory contract between the $1 billion Highland Floating Rate Advantage Fund and Highland Capital Management of Dallas is causing a major headache for the niche registered investment advisor, which as of Sept. 30 managed a total of $18 billion in assets.
That seemingly minor but impactful error has prompted the fund's investment advisor to call a special meeting to ask shareholders of the interval fund to approve a corrective amendment to the contract. It is also seeking to allow the advisor to keep more than $944,000 it had improperly been earning since April 2004.
An interval fund is a closed-end fund that is continuously sold but only permits shareholders to redeem some of their shares at various intervals, typically quarterly tender offers. Floating-rate funds invest in adjustable-rate, non-investment-grade loans made by banks.
In early April 2004, Highland Capital struck a deal with Columbia Management Advisors, the asset management arm of Bank of America, under which Highland would purchase three floating-rate funds that Columbia had decided were no longer necessary to its investment management competency. The three funds had originated as Stein Roe & Farnham funds, but through successive mergers, came under the Liberty Funds banner and were eventually folded into the Columbia Funds group.
The ink on the acquisition deal dry, Highland signed on as the interim investment advisor to all three funds, effective April 15, 2004, and shareholders formally approved the appointment of Highland as the funds' permanent advisor on July 30, 2004.
Net' vs. Managed'
However, through a technical error in both a June 2004 proxy statement to investors that described the new advisory arrangements and fee, as well as the actual management contract agreement between the fund and Highland, the agreement's wording called for the new advisor to annually earn 45 basis points of the fund's "average daily net assets" on the fund's first $1 billion. The actual wording should have noted that Highland would earn 45 basis points on the fund's "average daily managed assets."
That difference lies in the fact that the fund advisor, by design, is allowed to use leverage and borrow an amount equal to no more than one-third of the fund's total assets. Those borrowings then get added to the fund's net assets, and after subtracting all current liabilities and expenses of the fund, the advisor's management fee should be charged based on that larger asset base.
The ability to leverage existed when Columbia managed the fund's assets and did not change when Columbia handed off the fund to Highland.
In fact, according to fund industry experts, leverage can be a very common tool among some closed-end funds, especially floating-rate bank funds.
"Leverage is awesome," said Jeff Malliet, a principal with Nobel Asset Management in Chicago. Malliet is credited as being the father of the bank loan fund product. Leverage, when applied by a talented manager, allows the investor outsized opportunities to earn a greater return.
"The gain you get off the return can be substantial," Malliet noted. "Leverage is absolutely and completely beneficial" but could increase the fund's volatility and its risk, should certain leveraged securities default, he added.
Although it isn't clear exactly how Highland's one-word management contract error originally occurred, in a filing with the SEC earlier this month, the fund's board of directors revealed that the wording error first came to light during an Oct. 28 board conference call. The board subsequently met in person and decided to issue a shareholder proxy to approve a corrected contract. A call to Highland Capital for comment was not returned.
But a review of the SEC filings on all three of the floating-rate funds that Highland acquired last year reveals that the Highland Floating Rate Advantage Fund is definitely the odd man out of the bank fund trio. This fund is the only one of the three with the "advantage" of being allowed to use leverage via borrowings. The two other former Stein Roe-turned-Columbia bank loan funds are both feeder funds that invest in the same master fund, namely the Highland Floating Rate Limited Liability Co., and neither allows for leveraging. It appears that the fund's unique structure may have led to the wording discrepancy.
Since Highland was legally only entitled to the management fee on the fund's net assets as per the contract, shareholders are now being asked to vote to allow the advisor to keep the $944,696 management fee differential that the advisor took but technically hadn't earned between April 15, 2004 and Sept. 30, 2005. The advisor received $4,358,222 but was only entitled to $3,623,591, according to the erroneous contract.
According to the new Highland proxy, that works out to a fee differential of 90 cents per $1,000 in fund net assets, or just shy of 1.6 cents per share.
While a fund's board of directors is legally charged with periodically reviewing and approving the investment management contract with a fund, that drafting error is not something that even savvy board members would have ordinarily caught.
"Boards generally rely on their support people to focus on the nitty grittty of the advisory contract," said Allan Mostoff, president of the Mutual Fund Directors Forum of Washington and a retired investment company industry attorney. "But they are responsible for reviewing the contract that the fund enters into." Presumably, someone must have looked back at the terms of the original Columbia Funds' management contract, he added. "It's strange that the advisor wouldn't have caught the error in 2004 and all through 2005," Mostoff said, further noting that there is nothing wrong with a board determining to pay a management fee based on gross assets.
"Virtually all of the [closed-end] funds that have the ability to leverage do leverage and charge a management fee on total assets, inclusive of any leveraged assets," echoed Jeff Keil, principal of Keil Fiduciary Strategies of Littleton, Colo. Most advisors leverage between 75% and 100% of whatever they are allowed, he added. While the Highland Floating Rate Advantage Fund was allowed to leverage up to one-third of the fund's assets, the average leverage was about 26%, the latest fund filing revealed.
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