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Investment Management Legal and Regulatory Update - August 2011

August 05, 2011

Proxy Access Rule Vacated

On July 22, 2011, the U.S. Court of Appeals for the District of Columbia Circuit unanimously vacated Rule 14a-11 under the Securities Exchange Act of 1934, which would have required public companies, including investment companies, to provide information about shareholder-nominated candidates for the board of directors in their proxy statements, except in limited circumstances. The rule was scheduled to be effective on November 15, 2010, but was stayed pending a challenge by the U.S. Business Roundtable and Chamber of Commerce.

The court found that the SEC was "arbitrary and capricious" in adopting Rule 14a-11. The court stated that the SEC failed to adequately assess the economic effects of the rule or to quantify its costs. For example, the SEC did not sufficiently evaluate the extent to which companies would oppose shareholder nominees, the impact of union and state pension funds who might use the rule to further narrow interests at the expense of other shareholders, or the frequency of election contests. With respect to investment companies, the SEC failed to justify the rule in light of the already heightened regulatory requirements of the Investment Company Act of 1940 or the potential disruption to board structures in the investment company setting.

Source: Business Roundtable and Chamber of Commerce of the U.S. vs. SEC, No. 10-1305 (D.C. 2011).

SEC Adopts Final Registration and Exemption Rules Under the Advisers Act

The SEC issued final rules under the Investment Advisers Act of 1940 that will result in "mid-sized" advisers (i.e., advisers with $25 million to $100 million in assets under management) being regulated by the states instead of the SEC. The rules also provide for new exemptions from SEC registration for venture capital fund advisers, private fund advisers with assets under management of $150 million or less, foreign private advisers and family offices. The SEC also adopted various amendments to Form ADV. The rules give effect to requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted on July 21, 2010 (the "Dodd-Frank Act").

State Oversight of Mid-Sized Advisers
State vs. SEC Registration Eligibility. Under the new rules, the states generally will have jurisdiction over small and mid-sized advisers and the SEC will have jurisdiction over large investment advisers (i.e., advisers with at least $100 million in assets under management). However, a mid-sized adviser is required to register with the SEC if the adviser: (1) is not required to register with the state securities commissioner of the state in which it maintains its principal office and place of business; (2) is registered with the state but is not subject to examination (e.g., advisers in Minnesota, New York and Wyoming); or (3) advises a registered investment company or business development company.

Filing Deadlines. By March 31, 2012, each SEC-registered investment adviser must file an amendment to its Form ADV to disclose its eligibility to register with a state securities commissioner or the SEC. An SEC-registered adviser no longer eligible to be registered with the SEC must file a Form ADV-W to withdraw from SEC registration no later than June 28, 2012.

Repeal of Private Adviser Exemption
Many advisers to private funds and family offices relied on former Section 203(b)(3) of the Advisers Act, the private adviser exemption, to avoid registration with the SEC as an investment adviser. The exemption was available to advisers with fewer than 15 clients (each fund counted as a client and certain related accounts were combined for purposes of this test).

The Dodd-Frank Act eliminated the private adviser exemption effective July 21, 2011 and created, in its place, new exemptions, including exemptions for advisers to venture capital funds, advisers to private funds with less than $150 million in assets under management, foreign private advisers and family offices. Advisers currently relying on the private adviser exemption have until March 30, 2012 to register with the SEC unless they can rely on one of the new exemptions.

Exempt Reporting Advisers
Venture Capital Fund Advisers. Advisers to qualifying venture capital funds may rely on an exemption from SEC registration. The new exemption was designed to distinguish venture capital funds from private equity funds, which may have a greater potential for systemic risk due to investment strategies involving debt or leverage. Rule 203(l)-1 defines a "venture capital fund" as a private fund that satisfies the following conditions:

  • Venture Capital Strategy. The fund must represent to potential investors that it pursues a "venture capital" strategy.
  • Qualifying Investments Test. The fund must have at least 80% of its assets invested in qualifying investments of portfolio companies. Up to 20% of the fund's aggregate capital contributions and uncalled committed capital may be invested in other assets (other than short-term holdings), such as debt or publicly offered securities.
  • Limitation on Leverage. The fund's borrowings, debt obligations, guarantees or other leverage must be less than 15% of the fund's aggregate capital contributions and uncalled committed capital. An obligation must have a non-renewable term of no more than 120 calendar days except in limited circumstances.
  • Limitation on Redemption Rights. The fund must not issue securities that provide holders with any rights to withdraw, redeem or require the repurchase of securities except in extraordinary circumstances.
  • Unregistered. The Fund must not be registered as an investment company, or have elected to be treated as a business development company, under the Investment Company Act of 1940.

Qualifying investments are generally equity securities (such as common stock, preferred stock, warrants, securities convertible into common stock and limited partnership interests) acquired in one of three ways that suggest the fund's capital is being used to finance the operations or expansion of businesses rather than for trading in secondary markets. Under the new rule, a qualifying investment is generally an equity security issued by a "qualifying portfolio company" ("QPC") and directly acquired by a private fund, or exchanged for equity that has been issued by the same QPC and directly acquired by a private fund. In order to be deemed a QPC, a company may not:

  • be a reporting or foreign-traded company (or have a control relationship with a reporting or foreign-traded company);
  • borrow or issue debt in connection with the private fund's investment in the QPC, where the proceeds of the borrowings are distributed to the private fund; or
  • be an investment company (or a company that would be an investment company but for an exemption), private fund or a commodity pool.

Private Fund Advisers. Advisers that solely advise one or more "qualifying private funds" are exempt from registration provided that the aggregate value of the assets of the private funds is less than $150 million. A qualifying private fund means any private fund that is not registered, and that has not elected to be treated as a business development company, under the Investment Company Act.

An adviser relying on this exemption must report private fund assets as part of its "regulatory assets under management" calculation annually on Schedule D of revised Form ADV. Regulatory assets under management must be calculated in accordance with new methods described in Form ADV. Among other requirements, the new calculation methods require that proprietary assets and assets managed without compensation be included in the calculation for purposes of this exemption. A U.S. adviser must consider the assets of all private funds advised by the adviser for purposes of the assets calculation, even if day-to-day management of the funds takes place in non-U.S. offices. In contrast, for a non-U.S. adviser, only those private fund assets it manages at a place of business in the U.S. are considered in the calculation.

Form ADV Reporting Requirements. Form ADV has been revised to elicit information specific to venture capital fund advisers and private fund advisers (collectively referred to as "exempt reporting advisers"). Part 1A of Form ADV requests disclosure regarding the above exemptions, information on affiliates, private funds, calculation of regulatory assets under management, disciplinary information and other information about the adviser's business. When reporting to the SEC, exempt reporting advisers will be required to complete only certain items of Part 1A and will not be required to complete Part 2A (the "brochure").

Deadlines. Exempt reporting advisers must file their initial reports on Form ADV with the SEC no later than March 30, 2012. Thereafter, annual updating amendments must be filed within 90 days of fiscal year end. An amendment to Form ADV must be filed promptly if specified information becomes inaccurate.

Other Exemptions from SEC Registration
Family offices are excluded from the definition of investment adviser and foreign private advisers are exempt from registration and under new SEC rules.

Family Offices. Section 202(a)(11)(G) of the Advisers Act excludes a qualifying family office from the definition of investment adviser. Family offices are generally entities established by families to manage their assets and provide related trust and estate planning services to family members. Rule 202(a)(11)(G)-1 contains three general conditions:

  • the exclusion is limited to family offices that provide advice about securities only to certain "family clients;"
  • the family office must be wholly owned by family clients and controlled by family members and/or family entities; and
  • a family office may not hold itself out to the public as an investment adviser.

Family clients include current and former family members, key employees (and, under certain circumstances, former key employees), charities funded exclusively by family clients, estates of current and former family members or key employees, trusts existing for the sole current benefit of family clients or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients, revocable trusts funded solely by family clients, certain key employee trusts and companies wholly owned exclusively by, and operated for the sole benefit of, family clients. Family members include all lineal descendants of a common ancestor (who may be living or deceased) as well as current and former spouses or spousal equivalents of those descendants, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members.

Foreign Private Advisers. A foreign private adviser is an adviser that:

  • has no place of business in the U.S.;
  • has, in total, fewer than 15 clients in the U.S. and investors in the U.S. in private funds advised by the adviser;
  • has less than $25 million in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds advised by the adviser; and
  • does not hold itself out to the U.S. public as an investment adviser.

Sources: SEC Final Rule, Rules Implementing Amendments to the Investment Advisers Act of 1940, Rel. No. IA-3221, June 22, 2011; SEC Final Rule, Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Rel. No. IA-3222, June 22, 2011; SEC Final Rule, Family Offices, Rel. No. IA-3220, June 22, 2011.

Material Misstatements in Prospectuses

The U.S. Supreme Court held that an investment adviser could not be held liable in a private right of action pursuant to Rule 10b-5 under the Securities Exchange Act of 1934 for making untrue statements of material fact in mutual fund prospectuses because the investment adviser did not "make" the statements in the fund prospectuses.

Janus Capital Management LLC ("JCM") is the investment adviser to the Janus Investment Fund, a registered investment company. JCM is a wholly-owned subsidiary of Janus Capital Group, Inc. ("JCG"), a publicly-traded company. A class of JCG investors alleged that JCM and JCG created a misleading impression in prospectuses for the Janus Investment Fund mutual funds that JCM and JCG would implement measures to curb market timing in the funds. JCM did not contest that the prospectuses were misleading.

The Supreme Court held that JCM did not "make" the material misstatements in the prospectuses and therefore could not be liable for a private right of action under Rule 10b-5. Rule 10b-5 makes it unlawful for any person to make any untrue statement of a material fact in connection with the purchase or sale of securities. Despite the significant influence an investment adviser has over the mutual funds it advises, the Court explained that the separate legal existence of an investment adviser from a mutual fund could not be ignored. The Court reasoned that the maker of a statement is the entity with ultimate authority over the statement. Accordingly, because JCM did not have ultimate control over the Janus Investment Fund, JCM did not "make" the statements in the prospectuses and therefore could not be held primarily liable under Rule 10b-5.

Sources: Janus Capital Group, Inc., et al., v. First Derivative Traders, Slip Op. No. 09-525, 564 U.S. ___ (2011); Beagan Wilcox Volz, Janus, Industry Dodge Bullet in 5-4 High Court Decision, Ignites, June 14, 2011.

SEC Adopts Final Whistleblower Rules

Pursuant to the Dodd-Frank Act, the SEC established a whistleblower award program pursuant to which the SEC will pay monetary awards to whistleblowers. The SEC expects to receive approximately 30,000 tips per year and plaintiffs' law firms have set up websites to attract whistleblower leads. Although the program provides incentives for employees to use internal compliance programs to report potential violations, industry concerns remain that the program will encourage employees to bypass these compliance procedures. The key aspects of the program are described below.

Definition of Whistleblower. A whistleblower is an individual who, alone or jointly with others, provides the SEC with "original information" relating to a possible violation of the federal securities laws. To qualify as original information, the information must: (1) be based on the whistleblower's independent knowledge or independent analysis, (2) not already be known to the SEC, (3) not be derived from an allegation made in a judicial or administrative hearing, in a government report, hearing, audit or investigation, or from the news media, unless the whistleblower is a source of the information and (4) be provided to the SEC for the first time after July 21, 2010 (the date of enactment of the Dodd-Frank Act).

Qualification for Award. The SEC will pay a monetary award to a whistleblower only if the following conditions are met: (1) the whistleblower voluntarily provides information to the SEC, (2) the information is original information, (3) the information leads to a successful enforcement action by the SEC or a federal court or administrative action and (4) the SEC obtains monetary sanctions totaling more than $1 million.

Amount of Award. The amount of the award paid to a whistleblower will be at least 10%, and no more than 30%, of the monetary sanctions collected by the SEC and other authorities. The SEC will determine the amount of the award based on various factors, including the significance of the information, the degree of assistance provided by the whistleblower and whether the whistleblower participated in internal compliance systems and reported any violation internally, or assisted in any internal investigation.

Anti-Retaliation Provisions. The rules provide whistleblowers with a right of action against employers who take retaliatory actions against them, such as a demotion or harassment. To qualify for anti-retaliation protection, the whistleblower must have a reasonable belief that the information provided to the SEC relates to a possible securities law violation. The anti-retaliation provisions apply even if the case does not ultimately lead to an award.

Exclusions. The rules prohibit persons from receiving awards if they are "core" persons related to the internal compliance mechanisms of a company. For example, officers, directors, trustees or partners of any entity who learned of misconduct in connection with the entity's internal compliance processes would not be eligible for awards. Also, accountants who obtained information through the performance of work required by the federal securities laws would also not be eligible.

Sources: SEC Final Rule, Implementation of the Whistleblower Provisions of Section 21F of the Securities Exchange Act of 1934, Rel. No. 34-64545, May 25, 2011; Amy Goodman et al., U.S. SEC Adopts Final Rules Implementing Whistleblower Provisions of Dodd-Frank, BNA Insights, June 13, 2011.

Changes to Rules Regarding Performance-Based Compensation

The SEC issued an order, effective September 19, 2011, to adjust for inflation the dollar amount thresholds used to determine whether SEC-registered investment advisers may charge performance-based compensation. The SEC also proposed revisions to the performance fee rule, Rule 205-3 under the Advisers Act, that are still under consideration.

Section 205(a)(1) of the Advisers Act prohibits investment advisers from entering into, extending, renewing or performing investment advisory contracts pursuant to which an investment adviser receives compensation based on a share of capital gains on, or capital appreciation of, the funds of a client (i.e., performance-based compensation). The purpose of the prohibition is to deter advisers from taking undue risks with client assets. Rule 205-3 exempts an adviser from the prohibition against charging a client performance-based compensation, provided the client meets certain criteria, including an assets under management test or a net worth test. The order raises the dollar amounts of the assets under management test to $1 million (from $750,000) and the net worth test to $2 million (from $1.5 million).

The SEC is still considering its proposed amendments to Rule 205-3, which include an amendment to require the SEC to issue an order every five years adjusting for inflation the dollar amount tests. The SEC also proposed rules for investment advisers to grandfather certain investment advisory contracts that were entered into before the new dollar amount tests go into effect.

Finally, the SEC proposed revisions to the calculation of a natural person's net worth. The SEC proposed that the value of a person's primary residence and the amount of debt secured by the property be excluded from the calculation. However, if the outstanding debt exceeds the market value of the residence, the amount of the excess would be considered a liability in calculating the person's net worth.

Sources: SEC Proposed Rule, Investment Adviser Performance Compensation, Release No. IA-3198, May 10, 2011; Order Approving Adjustment for Inflation of the Dollar Amount Tests in Rule 205-3 under the Investment Advisers Act of 1940, Release No. IA-3236, July 12, 2011.

Late Prospectus Delivery, Unethical Behavior and Excessive Fees

FINRA Fines Wells Fargo for Failure to Deliver Prospectuses on a Timely Basis
FINRA fined Wells Fargo Advisors, LLC $1 million for its failure to deliver prospectuses in a timely manner to customers who purchased mutual funds in 2009. FINRA found that 934,000 customers did not receive prospectuses within three business days in violation of federal securities laws and FINRA rules. The customers received their prospectuses from one to 153 days late. Wells Fargo contracted with a service provider to send prospectuses to customers for mutual fund transactions. The service provider provided Wells Fargo with regular reports indicating that a number of customers had not received the prospectuses on time. The primary cause of the late deliveries was the failure of mutual fund companies to maintain adequate supplies of paper copies of prospectuses. FINRA found that Wells Fargo did not take steps to change the practices of those fund companies that did not keep adequate stocks of prospectuses. Also, Wells Fargo did not take advantage of the service provider's print-on-demand service, whereby the service provider could print electronically available prospectuses and send them to customers.

Source: FINRA, Letter of Acceptance, Waiver and Consent No. 2010029218 to Wells Fargo Advisors, LLC, March 4, 2011.

Goldman Sachs Fined in Massachusetts for Unethical Behavior
The Massachusetts Securities Division fined Goldman, Sachs & Co. $10 million for engaging in unethical and dishonest conduct in violation of Massachusetts securities laws. Massachusetts also required Goldman Sachs to permanently discontinue certain sales practices and to develop written supervisory procedures to ensure all clients fairly receive information.

The Global Investment Research Division of Goldman Sachs developed a client prioritization system called the "Asymmetric Service Initiative." Under the system, priority clients received telephone calls directly from Goldman Sachs research analysts regarding topics discussed at internal Goldman Sachs meetings, including short-term trading ideas.

Under the system, priority clients were identified based on their business level with the firm and their potential for generating additional sales and trading revenues. Priority clients were grouped into tiers. Tier 1 clients, which included several hedge funds that conducted a large volume of trading, received calls from senior analysts. Tier 2 clients received calls from junior analysts. Tier 3 and Tier 4 clients were not eligible to receive calls from analysts; however, their status, based in part on their revenue level with Goldman Sachs, would be monitored by Goldman Sachs for possible upgrades to Tiers 1 and 2.

Massachusetts found that the dissemination of information through the Asymmetric Service Initiative was a dishonest and unethical violation of Massachusetts laws because it gave some clients advantages over others. Massachusetts also found that Goldman Sachs had inadequate procedures to address conflicts of interest and to supervise its personnel.

Sources: In the matter of Goldman, Sachs & Co., Consent Order, Commonwealth of Massachusetts, Offices of the Secretary of the Commonwealth, Securities Division, June 9, 2011.

Oppenheimer Wins Case on Rule 12b-1 Fees
A federal district court dismissed a case against Oppenheimer Funds Distributor, Inc. (the "Distributor") and individual trustees of certain Oppenheimer funds that alleged improper payment of Rule 12b-1 fees. The funds paid Rule 12b-1 fees to the Distributor for distribution of fund shares, which fees were then forwarded to retail brokers. The plaintiffs asserted that payment of Rule 12b-1 fees to brokers violated the Advisers Act.

Under the Advisers Act, a broker is exempt from registering as an investment adviser if the investment advice provided by the broker is only incidental to its conduct as a broker and the broker does not receive "special" compensation for the advice. The plaintiffs interpreted "special" compensation to include compensation other than transaction commissions. In 2005, the SEC issued a regulation allowing brokers that provide incidental investment advice to receive non-transactional compensation as long as they did not contract to provide that advice or charge a separate fee. This regulation, however, was invalidated in 2007 by the U.S. Court of Appeals for the District of Columbia Circuit. The plaintiffs viewed this holding as a prohibition on brokers that provide incidental investment advice from receiving non-transactional compensation, such as asset-based Rule 12b-1 fees.

However, because the Advisers Act has no private right of action against funds, trustees or distributors, the plaintiffs claimed a private right of action under Section 47(b) of the Investment Company Act, which provides that contracts that violate provisions of the Investment Company Act (or whose performance involves a violation of the Investment Company Act) are unenforceable. The plaintiffs alleged that the defendants violated their fiduciary duty of care to the funds under Section 36(a) of the Investment Company Act. The plaintiffs also claimed that the defendants violated Rule 38a-1 under the Investment Company Act by failing to oversee compliance by the funds with federal securities laws and failing to ensure that shareholders were not harmed.

The court held that Section 47(b) did not provide plaintiffs
with a private right of action because the underlying sections of the Investment Company Act did not themselves provide for private rights of action. Although Section 36(a) imposes a fiduciary duty on a fund's officers, directors and principal underwriter, it gives the SEC, not individuals, the authority to bring an action. With respect to Rule 38a-1, which requires funds to institute a compliance program, the court held that it did not contain any language that would explicitly create a private right of action. Accordingly, the court dismissed the case for failure to state a claim.

Source: Smith v. Oppenheimer Funds Distributor, Inc., et al., 10 Civ. 7387 (S.D.N.Y. 2011).

Second Circuit Rules Against Salomon Funds in Excessive Transfer Agent Fee Case
The U.S. Court of Appeals for the Second Circuit issued a summary order against various funds organized by Salomon Smith Barney (n/k/a Citigroup Global Markets Inc.) (the "SSB Funds"), stating that the savings realized by the SSB Funds resulting from renegotiated transfer agent contracts should have been passed on to fund shareholders. Although the order does not have precedential effect, it is indicative of how the Second Circuit may consider similar cases in the future.

The case relates to a 2005 SEC Order where subsidiaries of Citgroup, Inc., including Smith Barney Fund Management LLC ("Smith Barney"), paid a $208 million settlement relating to an affiliated transfer agent arrangement. Nearing the expiration date of an existing transfer agent agreement, Smith Barney, the investment adviser to the SSB Funds, recommended to the funds' board of directors that the funds contract with a Smith Barney affiliate for transfer agent services and then also sub-contract with the funds' existing transfer agent for related services. However, Smith Barney did not disclose that, under the arrangement, the existing transfer agent would be performing nearly all of the same transfer agent services as it had performed previously at a deeply discounted fee rate. This allowed the Smith Barney affiliate to benefit from the discount by making a high profit for performing limited work. The arrangement led to a profit for the affiliated transfer agent of $100 million over five years. The order states that Smith Barney misled the funds' board of directors by representing that the arrangement was in the best interests of the funds.

The court considered the allegations regarding excessive transfer agent fees, describing the arrangement as "a garden variety breach of fiduciary duty." The court stated that the arrangement could not have been a product of arm's length bargaining and could not have been upheld under the Gartenberg factors. For example, with respect to the nature and quality of services provided, the arrangement suggests that the investors overpaid for transfer agent services and the defendants knowingly inflated the price for transfer agent services in order to keep the profits for themselves. The Second Circuit remanded the case back to the district court to reconsider the transfer agent fee arrangements.

Sources: Winter, et al. vs. Smith Barney Adjustable Rate Government Income Fund, et al., Summary Order 08-0338-cv (2nd Cir., June 9, 2011); In the matter of Smith Barney Fund Management LLC and Citigroup Global Markets, Inc., SEC Rel. No. 51761, May 31, 2005.

Federal Court Dismisses Excessive Fee Allegations Against Davis Select Advisers
The U.S. District Court for the District of Arizona dismissed a case, with prejudice, against Davis Select Advisers LP and Davis Distributors LLC for allegedly charging excessive advisory and Rule 12b-1 fees. The decision supports the use of the Gartenberg factors, which were confirmed by the U.S. Supreme Court in Jones v. Harris Assocs., L.P., 130 S.Ct. 1418 (2010). In particular, the court held that the plaintiff failed to state a claim under Section 36(b) of the Investment Company Act because the plaintiff did not show how the advisory and Rule 12b-1 fees were so disproportionately large that they bore no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining.

The court dismissed all of the plaintiff's claims under the Gartenberg factors. For example, in reviewing the profitability of the mutual fund to the adviser, the court stated that the large total fees charged by the adviser do not necessarily equal excessive fees. Also, the court rejected the plaintiff's attempts to compare the fees charged by the defendants to the fees charged by index funds and actively managed Vanguard funds, stating that the comparisons had little probative value because they were index funds (the Davis fund is actively managed) or because they were managed by Vanguard, which is known in the industry for its low fees.

Source: Donald Turner vs. Davis Select Advisers LP and Davis Distributors LLC, No. 08-CV-421-TUC-AWT (Ariz. May 31, 2011).


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