UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
DATE OF REPORT (DATE OF EARLIEST EVENT REPORTED): JUNE 18, 2004
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COMMISSION FILE NO. 33-75758
RENAISSANCE CAPITAL GROWTH & INCOME FUND III, INC.
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(Exact Name of Registrant as Specified in Its Charter)
TEXAS 75-2533518
(State of incorporation or organization) (I.R.S. Employer Identification No.)
SUITE 210, LB 59, 8080 NORTH CENTRAL EXPRESSWAY, DALLAS, TEXAS 75206
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (214) 891-8294
Item 5. Other
INTRODUCTION AND SUMMARY
Renaissance Capital Growth & Income Fund III (the "Fund") is filing this
report on Form 8-K to announce that the Fund's auditor, Ernst & Young LLP
("E&Y"), has declined to issue an audit report on the Fund's financial
statements for the fiscal year ending December 31, 2003 that would permit the
Fund to file its Form 10-K with the Securities and Exchange Commission (the
"SEC").(1)
As discussed more fully below, E&Y's reasons for declining to issue the
audit report relate to an oral comment from the staff of the SEC (the "Staff")
suggesting that the Fund's investment advisory agreement (the "Investment
Advisory Agreement") with the Fund's investment adviser, Renaissance Capital
Group, Inc. (the "Investment Adviser"), might be invalid. The Fund and the
Investment Adviser strongly believe that the Investment Advisory Agreement is
valid, and have taken steps to minimize or eliminate any financial effects to
the Fund and the Adviser even if the Investment Advisory Agreement were deemed
to be invalid. Moreover, the Fund and the Investment Adviser are not aware of
any litigation or contemplated litigation by the SEC or any other party relating
to the validity of the Investment Advisory Agreement.
E&Y has not identified or suggested any changes to the information
presented in the Fund's financial statements. Nonetheless, E&Y has expressed the
concern that, if the Investment Advisory Agreement is deemed to be invalid, and
if the Investment Adviser is required to pay money to the Fund as a result of
that invalidation, the Fund's prior financial statements might have to be
restated to reflect that payment (that is, to reflect the fact that the Fund
would receive money from the Investment Adviser).
E&Y has advised the Fund and the Investment Adviser that it would not issue
an audit opinion unless Fund counsel provides E&Y with an opinion to the effect
that the possibility of a material adverse effect to the Fund as a result of
this issue is "remote," as defined in an accounting pronouncement that all
parties -- including E&Y -- appear to agree is not applicable in this instance.
In addition, such an opinion is not required, or even recognized, by any
auditing or accounting standards of which the Fund or the Investment Adviser is
aware.
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(1) E&Y has advised the Fund that it would be willing to issue what it terms a
"qualified opinion" that would provide, in relevant part: "Because of the
possible material effects on the financial statements [relating to any potential
restatement of financial statements to reflect a payment from the Investment
Adviser to the Fund in connection with the issues concerning the calculation of
the incentive fee and the validity of the Investment Advisory Agreement], we are
unable to, and do not, express an opinion on the Fund's financial statements."
The Fund and the Investment Adviser view this as a disclaimer of an opinion,
rather than a qualified opinion. In any event, the Fund and the Investment
Adviser believe that this "opinion" would not permit the Fund to, among other
things, successfully file its Form 10-K, retain its listing on Nasdaq, and
access the public markets. E&Y has not offered to provide the Fund with any
other audit opinion.
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The Fund's counsel offered to opine to E&Y, among other things, that it is
unlikely that a court would invalidate the Investment Advisory Agreement, and
that even if a court did invalidate that Agreement, the invalidation ought not
to have a material effect on the financial condition or results of operations of
the Fund. In the absence of court cases or other authority directly on point
(among other reasons), the Fund's counsel was unable to use the "remote"
standard.
Despite the fact that the Fund and the Investment Adviser have worked
diligently to attempt to provide E&Y with information, documents and other
materials that would permit E&Y to issue an audit report, E&Y has declined to do
so.
E&Y has not resigned, and the Fund has not dismissed E&Y as its independent
auditor. Nonetheless, the Fund is in the process of interviewing other audit
firms, and hopes to select a new independent auditor shortly. E&Y has advised
the Fund and the Investment Adviser that it will work with the new audit firm
and that it is not currently withdrawing, qualifying or modifying its audit
reports for any of the Fund's prior financial statements.
BACKGROUND
In October 2003, the Fund filed with the SEC a registration statement for a
proposed rights offering (that registration statement was subsequently
withdrawn). In connection with its review of that registration statement, the
Staff of the SEC orally informed the Fund's counsel of two significant potential
regulatory issues relating to the Investment Advisory Agreement. These issues
are that: (1) the formula that has been used to calculate the incentive fee
payable by the Fund to the Investment Adviser, and which has been in the
Investment Advisory Agreement since 1998, is, in the Staff's view, inconsistent
with the requirements of the Investment Advisers Act of 1940, as amended (the
"Advisers Act"); and (2) the current Investment Advisory Agreement, which has
been in effect since 1998, may, in the Staff's view, not be valid because of (i)
the inclusion of the incorrect formula for calculating the incentive fee (which
the Staff suggests may invalidate the entire Agreement because Section 215 of
the Advisers Act provides that any contract is void if its performance would
violate a provision of the Advisers Act), and (ii) the failure to file a
preliminary proxy statement with the SEC prior to sending to the Fund's
shareholders a final proxy statement seeking shareholder approval for certain
amendments to that Agreement.
The Fund and the Investment Adviser, with the advice of counsel, disagree
with the Staff on each of these issues. Nonetheless, the Fund and the Investment
Adviser have taken steps to address the issues raised by the Staff, including
steps which they believe have largely resolved any financial impact to the Fund.
In addition, the independent directors of the Fund have engaged independent
counsel to advise them on these matters.
INCENTIVE FEE ISSUE. With respect to the formula to calculate incentive
fees, the Staff contends that the formula contained in the Investment Advisory
Agreement is inconsistent with Section 205(b)(3) of the Advisers Act, which
provides that a BDC may charge an incentive fee that does not exceed 20 % of the
"realized capital gains upon the [assets] of the [BDC]...computed net of all
realized capital losses and unrealized capital depreciation." The formula
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contained in the Investment Advisory Agreement follows this formulation, but
specifies that unrealized capital depreciation is to be computed as "unrealized
capital losses" net of "unrealized capital gains." Other than the Staff's oral
comments, the Fund and the Investment Adviser are not aware of any prior SEC
interpretations, statutes, court cases or other authority suggesting that the
Fund's formula is improper.
The Fund and the Investment Adviser, with the advice of counsel, believe
that the formula contained in the Investment Advisory Agreement is consistent
with Section 205(b)(3). Nonetheless, the Fund has provided to the Staff a
recalculation of the amount of incentive compensation it would have paid since
inception, had the formula in the Investment Advisory Agreement been consistent
with what the Fund believes to be the Staff's interpretation of Section
205(b)(3). Under that recalculation, the Fund has paid incentive allocations to
the Investment Adviser of $149,555.51 more than it believes the Staff
interpretation would permit. The Investment Adviser has reimbursed the Fund for
this amount, plus interest, for a total reimbursement of $254,244.37. The Staff
has not addressed whether it agrees or disagrees with this recalculation. The
Fund's board of directors, which for this purpose is comprised only of the
independent directors, has unanimously determined to accept this amount as an
appropriate recalculation of the incentive fee.
The Fund also intends to seek shareholder approval to amend the Investment
Advisory Agreement to conform the incentive fee formula in that Agreement to the
relevant language of the Advisers Act, and the Fund will in the future use the
Staff's interpretation, as the Fund understands that interpretation, for the
calculation of the incentive fee.
VALIDITY OF INVESTMENT ADVISORY AGREEMENT. With respect to the validity of
the Investment Advisory Agreement, the Staff has informed the Fund and the
Investment Adviser that the Agreement may be deemed not valid as a result of the
inclusion of the purportedly incorrect incentive fee formula (which the Staff
suggests may invalidate the entire Agreement because Section 215 of the Advisers
Act provides that any contract is void if its performance would violate a
provision of the Advisers Act), and as a result of the failure in 1998 to file
with the SEC a preliminary proxy statement in connection with a shareholder vote
principally relating to an amendment to the Investment Advisory Agreement. The
amendment was intended to reflect more accurately the manner in which the Fund
was calculating the fee and to change the period used to calculate that fee from
an annual to a quarterly basis in an effort to more clearly account for the
liability, and to facilitate more timely distributions to shareholders.
The Fund, with the advice of counsel, does not believe that either of these
purported reasons serves as a basis for invalidating the Investment Advisory
Agreement. As discussed above, the Fund believes that the formula in the
Investment Advisory Agreement for calculating the incentive fee is consistent
with the Advisers Act, and in any case the Investment Adviser has reimbursed the
Fund for the amount by which the incentive payments it actually received exceed
the amount that would have been paid under what it believes to be the Staff's
formula, plus interest. The Fund, with the advice of counsel, also believes that
the Investment Advisory Agreement should not be invalidated even if the formula
for calculating the incentive fee is inconsistent with the Advisers Act.
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The Fund, with the advice of counsel, also disagrees with the Staff that
the failure to file a preliminary proxy statement should result in the
Investment Advisory Agreement being deemed invalid, particularly where, as here,
a final proxy statement describing the proposed amendment was sent to
shareholders, the shareholders and the Fund's independent directors approved the
amendments to the Investment Advisory Agreement in 1998, the independent
directors have approved the amended Agreement every year since 1998, and the
Fund has performed well since 1998. Fund counsel also has advised the Fund that
courts have held that, by itself, the failure to file a preliminary proxy
statement is a technical violation for which no sanction generally should be
applied.
The Staff has advised the Fund that it believes that, if the Investment
Advisory Agreement is not valid, then under the Advisers Act the Investment
Adviser is entitled only to the lesser of: (a) the amount it actually received
from the Fund under that Agreement, and (b) its actual expenses incurred in
performing the services under that Agreement.
Nonetheless, the Fund and the Investment Adviser, with the advice of
counsel, believe that even if the Investment Advisory Agreement were considered
to be not valid, under state law and other legal principles the Investment
Adviser would be entitled to reasonable compensation for the services it has
performed for the Fund. The Fund's board of directors, which for this purpose is
comprised only of the independent directors, has determined that, under the
circumstances, a reasonable level of compensation is the amount of compensation
that was provided for in the Investment Advisory Agreement, less the
reimbursement from the Investment Adviser of $254,244.37 to resolve the issue
identified by the Staff concerning the appropriate formula for calculating the
incentive fee.
The independent directors' determination was based on, among other things,
the shareholders' approval of the Investment Advisory Agreement in 1998; the
independent directors' approval of that Agreement in every year since and
including 1998; the fact that the Investment Adviser has in fact performed under
the Investment Advisory Agreement in the manner expected by the board, and has
achieved strong results for Fund shareholders; the technical nature of the
issues asserted by the Staff, which do not affect the fundamental nature of the
relationship between the Fund and the Investment Adviser; the board's desire to
avoid the substantial costs and difficulties of litigating with the Investment
Adviser in order to determine a reasonable level of compensation; and the
possibility that, if the Investment Adviser was forced to repay a substantial
portion of the fees that it had received from the Fund since 1998, the
relationship between the Investment Adviser and the Fund might be discontinued,
creating a significant issue for the Fund in trying to find an acceptable
replacement investment adviser that could successfully manage the existing and
future portfolio of the Fund.
E&Y'S REFUSAL TO ISSUE AN AUDIT OPINION
The Fund does not believe that E&Y has identified any issues with the
Fund's financial statements, other than the calculation of the incentive fee and
the potential invalidity of the Investment Advisory Agreement, which would have
prevented E&Y from issuing an unqualified audit opinion on those financial
statements.
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From the time that the SEC Staff advised the Fund of the potential
invalidity of the Investment Advisory Agreement, the Fund and the Investment
Adviser worked closely with E&Y to try to provide information, documents and
other materials that would permit E&Y to issue an audit opinion. Among other
things, the Fund: prepared draft language to insert into its Form 10-K to
disclose this issue; prepared a draft footnote to its financial statements
disclosing this issue; and offered to E&Y an opinion of the Fund's outside
counsel to the effect that, among other things, it is unlikely that a court
would invalidate the Investment Advisory Agreement, and that even if a court did
invalidate that Agreement, the invalidation ought not to have a material effect
on the financial condition or results of operations of the Fund.
On several occasions the Fund and the Investment Advisor believed that E&Y
had decided to issue an audit opinion, but ultimately E&Y declined to do so. E&Y
eventually requested that the Fund's outside counsel issue an opinion to the
effect that the likelihood of any material, adverse effect to the Fund from this
issue would be "remote," as defined in an accounting pronouncement that all
parties -- including E&Y -- appear to agree is not applicable in this instance.
In addition, such an opinion is not required, or even recognized, by any
auditing or accounting standards of which the Fund or the Investment Adviser is
aware.
Fund counsel remained willing to issue the opinion described above.
However, in the absence of court cases or other authority directly on point
(among other reasons), the Fund's counsel was unable to use the "remote"
standard.
EFFECT OF NO AUDIT OPINION
As a result of the Fund's inability to obtain an audit opinion on its
financial statements for the fiscal year ending December 31, 2003, the Fund has
been unable to file with the SEC its annual report on Form 10-K for that year,
and was unable to send its annual report to shareholders. The Fund also has been
unable to file its quarterly report for the quarter ending March 31, 2004.
The Fund's failure to file with the SEC the Form 10-K and 10-Q, and to send
its annual report to shareholders, has caused it to fail to meet its reporting
obligations under the federal securities laws and the rules and regulations
thereunder. In addition, until the Fund is able to send its annual report to
shareholders, the Fund cannot conduct a proxy solicitation to elect directors.
The Fund intends to engage a new independent audit firm as promptly as
possible and, assuming that firm provides an audit opinion on the Fund's
financial statements, the Fund will file its Form 10-K and Form 10-Q with the
SEC promptly thereafter, will promptly send its annual report to shareholders,
and will conduct a proxy solicitation to elect directors. The Fund is attaching
as an exhibit to this report on Form 8-K a draft of its annual report on Form
10-K for the fiscal year ending December 31, 2003, containing unaudited
financial statements.
The Fund's failure to file the Form 10-K has also caused it to fail to meet
the requirements for continued listing on Nasdaq, and the Fund's shares may be
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removed from trading on Nasdaq. In such a case, the Fund's shares would trade in
the "pink sheets," and the Fund would, upon receiving an audit report on its
financial statements, seek relisting on Nasdaq as promptly as possible under the
rules of Nasdaq. There is no assurance, however, that if the Fund's shares are
removed from trading on Nasdaq, the Fund's shares subsequently will be
readmitted for trading on Nasdaq.
The Fund's inability to obtain an audit report on its financial statements
has also caused it to be unable to pursue a registration statement to effect a
rights offer or other public offer to raise additional money. This has prevented
the Fund from raising money that it had intended to use to make additional Fund
investments, so as to further diversify the Fund's portfolio.
In addition, if the Fund's inability to obtain an audit report interferes
with its ability to raise capital by borrowing and making an offering of its
securities, it will need to find other means to make sufficient distributions to
shareholders by the end of 2004 in order to preserve its advantageous tax status
as a regulated investment company under Subchapter M of the Internal Revenue
Code.
OTHER MATTERS RELATING TO E&Y
E&Y has been the Fund's auditor since 1999, and has never issued an adverse
opinion, disclaimer of opinion, or a qualified opinion with respect to the
Fund's financial statements. E&Y also has not withdrawn, qualified or modified
its audit report for any of the Fund's prior financial statements.
Prior to the issues relating to the calculation of the incentive fee and
the potential invalidity of the Investment Advisory Agreement, the Fund has not
had any disagreements with E&Y on any matter of accounting principles or
practices, financial statement disclosure, or auditing scope or procedure which,
if not resolved to the satisfaction of E&Y, would have caused E&Y to make
reference to the subject matter of the disagreement in connection with its audit
report.
In addition, prior to the issues relating to the calculation of the
incentive fee and the potential invalidity of the Investment Advisory Agreement:
1. E&Y has never advised the Fund that the Fund's internal controls necessary
for the Fund to develop reliable financial statements do not exist;
2. E&Y has never advised the Fund that information had come to E&Y's attention
that led it to no longer be able to rely on management's representations, or
that had made E&Y unwilling to be associated with the financial statements
prepared by the Fund's management;
3. E&Y has never advised the Fund that E&Y needed to expand significantly the
scope of its audit or that information had come to E&Y's attention that, if
further investigated, might have: (a) materially impacted the fairness or
reliability of any prior audit reports or underlying financial statements or the
financial statements for the fiscal year ending December 31, 2003, or (b) caused
7
E&Y to be unwilling to rely on management's representations or be associated
with the Fund's financial statements; or
4. E&Y has never advised the Fund that information had come to E&Y's attention
that it concluded materially impacted the fairness or reliability of either a
previously issued audit report or the underlying financial statements of the
Fund, or the financial statements of the Fund for the fiscal year ending
December 31, 2003 (including information that, unless resolved to the
accountant's satisfaction, would have prevented E&Y from rendering an
unqualified audit report on those financial statements).
Concurrently with filing with the SEC this report on Form 8-K, the Fund
also is providing a copy of the report to E&Y, and has requested that E&Y
furnish the Fund with a letter addressed to the SEC stating whether E&Y agrees
with the statements made by the Fund in this Form 8-K and, if not, stating the
respects in which E&Y does not agree. The Fund intends to file E&Y's letter with
the SEC, as an exhibit to this report, within ten business days from the date of
this report, and in any event within two business days of receiving the letter
from E&Y. In this regard, the Fund has requested E&Y to provide the letter as
promptly as possible so that the Fund can file the letter with the SEC within
ten business days from the date of this report.
E&Y was provided with, reviewed, and commented upon a draft of this report
on Form 8-K, and E&Y's comments are reflected in this report to the extent the
Fund determined them to be appropriate.
Item 7. Financial Statements and Exhibits
(c) Exhibits.
99.1 Unaudited Draft Annual Report of Form 10-K for Renaissance
Capital Growth & Income Fund III, Inc. for the year ended
December 31, 2003.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Date: June 18, 2004 Renaissance Capital Growth & Income Fund III, Inc.
(Registrant)
By: /s/ Russell Cleveland
_______________________________________________
Russell Cleveland, President
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INDEX TO EXHIBITS
Exhibit
NUMBER DESCRIPTION
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99.1 Unaudited Draft Annual Report of Form 10-K for
Renaissance Capital Growth & Income Fund III, Inc. for
the year ended December 31, 2003.