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Investment Management Legal and Regulatory Update - January 2010

January 14, 2010

SEC Adopts Amendments to Investment Adviser Custody Rule

The SEC has adopted amendments to the investment adviser custody rule, Rule 206(4)-2 under the Investment Advisers Act, to provide additional safeguards when a registered adviser has custody of client assets and to encourage the use of independent custodians. The amended rule requires that an adviser with custody of client assets have a reasonable belief, after "due inquiry," that the qualified custodian maintaining the client assets sends an account statement, at least quarterly, directly to each of the adviser's clients. The amended rule eliminates the alternative under which an adviser could previously send quarterly account statements to clients if it undergoes a surprise examination by an independent public accountant. When an adviser notifies a client that it has opened a custodial account on the client's behalf, and if an adviser elects to send its own account statements to clients, such notices and account statements must contain a cautionary legend urging clients to compare the account statement they receive from the custodian with those they receive from the adviser.

The amended rule requires an adviser with custody of client assets to undergo an annual surprise examination by an independent public accountant to verify client assets, even if the client assets are maintained by an independent qualified custodian. The surprise audit examination requirement will not apply to:

  • advisers that have custody of client assets solely because of their authority to deduct advisory fees; or
  • advisers to pooled investment vehicles that (i) are subject to an annual audit by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB), and (ii) distribute audited financial statements prepared in accordance with GAAP to fund investors.

In addition, privately offered securities will now be subject to the surprise audit examination requirement when an adviser maintains custody of these securities.

Advisers subject to the surprise audit examination requirement will be required to enter into a written agreement with an independent public accountant to ensure certain reporting requirements are fulfilled. The independent public accountant must notify the SEC within one business day of finding any material discrepancy during the course of the examination, and must submit a Form ADV-E, accompanied by a certificate from the accountant, to the SEC within 120 days of the time chosen for the surprise examination stating the nature and extent of the examination. In addition, upon resignation or dismissal, the accountant must file with the SEC a statement regarding the termination along with Form ADV-E within four business days.

The definition of "custody" has been expanded to provide that an adviser has custody of client assets that are directly or indirectly held by a "related person" in connection with advisory services provided to its clients. A "related person" is any person controlling or controlled by the adviser or under common control with the adviser. The amendments provide for a limited exemption from the surprise audit examination requirement for an adviser that is: (1) deemed to have custody solely as a result of certain of its related persons holding client assets; and (2) "operationally independent" of the custodian.

When advisory client assets are maintained by the adviser itself or a related person rather than with an independent qualified custodian, the adviser must:

  • obtain an internal control report (Type II SAS 70 report) from an independent public accountant registered with the PCAOB at least once a year that demonstrates that the adviser, or the adviser's related person, has established appropriate custodial controls; an
  • have their surprise examination conducted by an independent public accountant registered with the PCAOB.

In the release, the SEC also:

  • offered guidance to advisers with custody of client assets regarding the types of policies and procedures relating to safekeeping of client assets that advisers should consider including in their written compliance programs under Rule 206(4)-7;
  • adopted amendments to Part 1A and Schedule D of Form ADV, which, among other things, require registered advisers to report more detailed information about their custody practices;
  • adopted amendments to the books and records rule to require an adviser to maintain for five years a copy of (i) the internal control report required when client assets are not maintained by an independent custodian, and (ii) a memorandum describing the basis upon which the adviser determined that it is "operationally independent" of a custodian that is a "related person"; and
  • referenced a companion release that provides guidance for accountants with respect to the surprise examination and internal control report.

Source: SEC Final Rule, Release No. IA-2968 (available December 30, 2009)
Effective Date: March 12, 2010
Compliance Dates:

  • March 12, 2010 for account statement delivery, notification of account opening and client legend requirements.
  • Advisers subject to the surprise audit examination requirements must enter into a written agreement with an independent public accountant that provides that the first examination will take place by December 31, 2010 or, for advisers that maintain client assets themselves, no later than six months after obtaining the internal control report.
  • Advisers required to obtain or receive an internal control report must do so within six months of becoming subject to the requirement.
  • Advisers to a pooled investment vehicle may rely on the annual audit provision if the adviser becomes contractually obligated to obtain an audit for fiscal years beginning on or after January 1, 2010.
  • Advisers must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.

U.S. House of Representatives Passes Financial Services Reform Legislation

On December 11, 2009, the U.S. House of Representatives approved H.R. 4173, the "Wall Street Reform and Consumer Protection Act of 2009." The legislation is designed to enhance federal regulation of the U.S. financial system in response to the recent financial crisis. The legislation would create the Financial Services Oversight Council (Oversight Council), chaired by the Secretary of the Treasury, to advise Congress on financial, domestic and international regulatory developments, and to identify, monitor and address potential threats to the stability of the U.S. financial system.

The Oversight Council and the Federal Reserve Board would jointly have the authority to impose "stricter prudential standards" on large financial companies, which could include investment companies, that pose a "systemic risk". If the Oversight Council determines that, despite the imposition of stricter prudential standards, a large financial company continues to pose a "grave threat" to the U.S. financial system or economy, the Oversight Council would have the authority to, among other things, break apart the financial company to mitigate the risk of harm that the financial company's failure would cause to the U.S. financial system. The legislation would also create a "systemic dissolution fund" administered by the FDIC to facilitate the dissolution of any failed financial company that poses a systemic risk. The dissolution fund would be funded by assessments levied against financial companies that have at least $50 billion in assets ($10 billion for hedge funds).

In a letter sent to House leadership, the Investment Company Institute (ICI) argued that giving the Federal Reserve Board authority to impose the stricter prudential standards described above is inappropriate in the mutual fund context. In addition, the ICI criticized the fact that mutual funds would be subject to assessments used to fund the systemic dissolution fund. Because mutual funds cannot "fail" in a manner requiring systemic resolution, the ICI believes that fund shareholders should not be subject to such assessments.

The legislation would also:

  • create the Consumer Financial Protection Agency to regulate the provision of consumer financial products and services, including lending practices identified as contributing to the recent economic crisis;
  • require the SEC to promulgate rules that impose a fiduciary standard on broker-dealers when providing personalized investment advice to customers that parallels the fiduciary duties already imposed on investment advisers;
  • allow the SEC to adopt rules governing distribution practices and compensation for financial intermediaries;
  • eliminate the private adviser exemption under Section 203(b)(3) of the Investment Advisers Act. Instead, an adviser to any private fund must register with the SEC unless all of the adviser's clients are private funds and the adviser has less than $150 million in total assets under management in the U.S.;
  • impose record keeping and filing requirements authorized by the SEC, which would be used by the Oversight Council and the Federal Reserve Board to assess systemic risk;
  • provide shareholders with a non-binding, advisory vote on executive compensation;
  • require each large institutional investment manager to disclose how it voted on executive compensation matters; and
  • regulate a portion of the over-the-counter market for derivatives and ratings agencies.

The Senate is expected to address the legislation this year.

Sources: The Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong. (2009); Beagan Wilcox Volz, ICI to Congress: Beware of Reform Bill's 'Adverse Consequences,' Ignites, December 16, 2009; ICI Memorandum No. 24036 (December 21, 2009) (available at

SEC Adopts Rules to Enhance Compensation and Corporate Governance Disclosure

The SEC has adopted rules to enhance the compensation and corporate governance disclosures of public companies, including investment companies, in proxy statements and registration statements. The new rules include two categories of amendments specifically relating to investment company disclosures: (1) enhanced director and nominee disclosures; and (2) new disclosures concerning board leadership structure and the board's role in risk oversight. The new rules amend disclosures in fund proxy statements and information statements where action is to be taken with respect to the election of directors. Funds are also required to include expanded disclosures in their SAI.

Enhanced Director Disclosures
The new rules require funds to disclose for each director and nominee the particular experience, qualifications, attributes or skills that led the board to conclude that the person should serve as a director of the fund. The new rules also require disclosure of any directorships held by each director and nominee at any time during the past five years at public companies and registered investment companies (rather than only requiring disclosure of directorships currently held). In addition, the new rules lengthen the time during which disclosure of relevant legal proceedings involving a fund's executive officers, directors and nominees is required from five to ten years, and expand the list of legal proceedings that trigger disclosure.

The new rules also require additional disclosure regarding whether, and if so how, a nominating committee considers diversity in identifying nominees for director. In the release, the SEC stated that companies may define diversity in various ways as they consider appropriate.

Board Leadership Structure
The new rules require disclosure regarding whether the board chair is an "interested person" of the fund, as that term is defined under the Investment Company Act, and if the board chair is an interested person, disclosing whether the fund has a lead independent director and what specific role the lead independent director plays in the leadership of the fund. In addition, the new rules require disclosure about the board's role in the fund's risk oversight. This disclosure should discuss the role of the board and the relationship between the board and the fund's adviser in managing material risks facing the fund.

Source: SEC Final Rule, Release Nos. 33-9089, 34-61175 and IC-29092 (available December 16, 2009)
Compliance Date: Generally, February 28, 2010. The compliance date varies for new and existing funds.
See Frequently Asked Questions About Proxy Disclosure Enhancements Transition for Registered Investment Companies

Update to Proposed Proxy Rule Amendments to Facilitate Shareholder Director Nominations: Comment Period Re-Opened

The SEC has re-opened the comment period for its proposed changes to the proxy rules that would facilitate shareholders' ability to nominate and elect directors. In response to numerous comments received on the proposal, the comment period was extended to January 19, 2010. The comment period relates to SEC proposed Rule 14a-11 under the Securities Exchange Act of 1934 that would require companies, including investment companies, to include disclosures about shareholder nominees for directors in a company's proxy materials, under certain circumstances, so long as the shareholders meet certain eligibility requirements.

Sources: SEC Proposed Rule, Release Nos. 33-9046, 34-60089 and IC-28765 (available June 10, 2009); SEC Release Nos. 33-9086, 34-61161 and IC-29069 (available December 14, 2009)
Compliance Date: TBD

Proposed Amendments to Rules Requiring Internet Availability of Proxy Materials

The SEC has proposed changes to the proxy rules relating to the notice and access model for furnishing proxy materials to shareholders and the Notice of Internet Availability of Proxy Materials (the "Notice") that is sent to shareholders. The SEC is concerned that the notice and access model has caused confusion among shareholders, resulting in a lower response rate to proxy solicitations by shareholders receiving the Notice versus shareholders receiving delivery of the full set of proxy materials.

First, the proposal would eliminate the explanatory legend currently required in the Notice. The proposal would permit issuers and other soliciting persons to include an explanation in their own words of the importance and effect of the Notice.

Second, the proposal clarifies that the rules do not require the Notice to directly mirror the proxy card.

Third, a proposed rule would permit issuers and other soliciting persons to provide an explanation of the notice and access model with the Notice to better educate shareholders. The proposal would also permit registered investment companies to include a summary prospectus with the Notice.

In addition, the SEC has proposed to revise the timeframe for delivering the Notice when a soliciting person other than the issuer relies on the notice and access model.

The ICI has submitted a comment letter to the SEC recommending that issuers be permitted to include a proxy card with the Notice, which the ICI believes would substantially improve shareholder participation in proxy voting and reduce the costs associated with the notice and access model. The ICI supported the proposal to permit an explanation of the notice and access model to accompany the Notice. The ICI also expressed its support for the amendment to permit registered investment companies to include a summary prospectus with the Notice.

Sources: SEC Proposed Rule, Release Nos. 33-9073, 34-60825 and IC-28946 (available October 14, 2009); Comment Letter Submitted by Robert C. Grohowski, Investment Company Institute (November 20, 2009)
Compliance Date: TBD
Comment period ended November 20, 2009

Regulated Investment Company Modernization Act of 2009

On December 16, 2009, the "Regulated Investment Company Modernization Act of 2009" was introduced in the U.S. House of Representatives. The proposed legislation would streamline and modernize various tax rules applicable to regulated investment companies (RICs). The proposed legislation would, among other things:

  • allow RICs unlimited carryforwards of net capital losses, similar to loss carryforwards for individuals;
  • allow gains from the sale or other disposition of commodities, including income derived with respect to the RIC's investments in commodities (such as income earned by a RIC from derivative contracts with respect to commodity indices), to be included in the type of "good income" from which a RIC must derive at least 90% of its income;
  • allow a RIC to cure inadvertent failures to comply with the 90% gross income test by paying a tax equal to the amount by which the RIC failed the gross income test, rather than being taxed as a corporation at the corporate income tax rates (currently up to 35%);
  • eliminate the requirement that RICs send a written designation notice to shareholders regarding the taxation of fund distributions within 60 days of the end of the RIC's tax year;
  • permit qualifying RICs using a "fund of funds" structure to pass through exempt-interest dividends without regard to the requirement that at least 50% of the value of the RIC's total assets consist of tax-exempt state and local bonds;
  • permit qualifying RICs using a "fund of funds" structure to pass through the foreign tax credit without regard to the requirement that more than 50% of the value of their total assets consist of stock or securities in foreign corporations;
  • permit RICs to compute current earnings and profits using deductions that are otherwise disallowed in computing investment company taxable income;
  • expand the excise tax rule allowing a RIC to elect to treat certain ordinary income derived after October 31 as being derived on the first day of the following calendar year to cover all ordinary gains or losses from the sale, exchange or other disposition of property, including foreign currency gains and losses; and
  • repeal the additional penalty that applies to RICs making a "deficiency dividend" in the case that the RIC has a tax deficiency with respect to a previous tax year for failing to distribute all of its investment company taxable income.

Sources: The Regulated Investment Company Modernization Act of 2009, H.R. 4337, 111th Cong. (2009); Technical Explanation of H.R. 4337

Amendments and Proposed Amendments to Rules Governing Nationally Recognized Statistical Rating Organizations (NRSROs) and Credit Ratings Disclosure

The SEC has amended and proposed additional amendments to its rules governing NRSROs. The adopted amendments impose additional disclosure and conflict of interest requirements on NRSROs in order to address concerns about the integrity of their credit ratings procedures and methodologies. The proposed amendments would require an NRSRO to: (i) furnish a new annual report with respect to compliance matters; (ii) disclose additional information about sources of revenues on Form NRSRO; and (iii) make publicly available a report containing information about revenues of the NRSRO attributable to persons paying for credit ratings.

The SEC has also proposed amendments to rules governing the disclosure of information regarding credit ratings used by registrants, including closed-end (but not open-end) management investment companies. In the proposing release, the SEC noted that the proposed amendments are intended to enhance credit rating disclosures to help investors better understand credit ratings (and their limitations). Specifically, the SEC has proposed to amend Regulation S-K and Forms 20-F and N-2 to require detailed disclosure regarding credit ratings if the registrant, any selling security holder, any underwriter or any member of a selling group, uses a credit rating in connection with a registered offering. The disclosure must include the following information:

  • general information regarding credit ratings, including the scope of the rating and any limitations on the scope of the rating;
  • the identity of the party who is compensating the credit rating agency for providing the credit rating in order to alert investors to potential conflicts of interest; and
  • any credit rating obtained, but not used, and all preliminary ratings of the same class of securities obtained from a credit rating agency other than the credit rating agency providing the final rating to alert investors to possible "ratings shopping" by the registrant.

The SEC has also proposed rules requiring registrants, including closed-end funds, to update disclosures on Form 8-K regarding changes to a previously disclosed credit rating.

Adopted Amendments Governing NRSROs: SEC Final Rule, Release No. 34-61050 (available November 23, 2009)
Effective Date: February 2, 2010

Proposed Amendments Governing NRSROs: SEC Proposed Rule, Release No. 34-61051 (available November 23, 2009)
Compliance Date: TBD
Comments due by February 2, 2010

Proposed Amendments Relating to Credit Rating Disclosure: SEC Proposed Rule, Release Nos. 33-9070, 34-60797 and IC-28942 (available October 7, 2009)
Compliance Date: TBD
Comment period ended December 14, 2009

Update on Excessive Fee Legal Developments

Jones v. Harris

On November 2, 2009, the U.S. Supreme Court heard oral arguments in the Jones v. Harris excessive advisory fee case. In Jones, shareholders of three Oakmark funds filed suit against Harris Associates L.P. (Harris), the funds' investment adviser, alleging that Harris charged excessive advisory fees. In its 2008 ruling, the Seventh Circuit rejected the long-standing "reasonableness" standard for determining excessive fees under Section 36(b) of the Investment Company Act. This "reasonableness" standard was established by the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc. (1982).

At the center of the argument is whether it is appropriate under Gartenberg for a fund's board to compare fees charged to institutional investors with those charged to retail investors when determining whether advisory fees are reasonable in relation to the services provided to the fund. Harris argued that higher fees charged to retail investors are justified because these investors require significantly different services than institutional investors, and that the courts have correctly applied Gartenberg by recognizing that fund boards are not obligated to compare retail and institutional fees. While it may be appropriate in some cases to compare such fees, Harris argued that the decision to do so should be left to the board's discretion. Jones argued that the original intent of Gartenberg was that a board should compare institutional and retail fees and that retail fund investors do not have the same bargaining power as institutional investors to negotiate lower fees. In addition, Jones noted that there was evidence that the services provided by Harris to institutional and retail investors were similar.

The Supreme Court justices seemed divided on the role of courts in reviewing the reasonableness of advisory fees. Justices Sotomayor, Breyer and Ginsberg challenged Harris' resistance to comparing retail and institutional fees, while Justices Roberts and Scalia highlighted competition in the market that has put downward pressure on advisory fees and the increased ability of fund shareholders to make changes relatively quickly and easily if they are dissatisfied with the fees charged by an adviser. Commentators have predicted that the Supreme Court's decision will likely not depart significantly from the Gartenberg standard. However, some predict that the Court may create a "Gartenberg-plus" standard that will recognize that institutional fees may be relevant and should be considered in the advisory contract renewal process.

The Supreme Court's decision is expected to be published in the summer of 2010. Until the decision is published, we recommend that boards continue to review advisory contracts using a robust Section 15(c) process that evaluates, among other items, the factors set forth in Gartenberg and to document this process in the required shareholder report disclosures.

Sources: Jones, et. al. v. Harris Associates L.P., 537 F. 3d 788 (7th Cir. 2008), cert. granted (U.S. March 9, 2009) (No. 08-586); Peter Ortiz, Justices Debate Fee Case, Question Attorneys, Ignites (November 3, 2009); Peter Ortiz, Lawyers Predict Supreme Court's Decision on Fees, Ignites (November 9, 2009)

Court Rules in American Funds Trial
In a decision published on December 28, 2009, the court in the American Funds excessive-fees case ruled that the fees charged to the funds by their adviser, Capital Research and Management Company (CRMC), and their principal underwriter, American Funds Distributors, Inc. (AFD), were not excessive under the controlling Gartenberg standard, which it characterized as establishing "a very low threshold for mutual fund companies and a very high hurdle for a plaintiff." Notwithstanding its ruling, the court stated that there were shortcomings in the board's consideration of the fees. The court's criticism of the board's performance is a departure from other excessive-fees cases in which courts have approved of the board's performance, which may prompt a more thorough diligence process in the future.

This shareholder against CRMC and AFD suit went to trial in July 2009. The suit alleged that the defendants breached their fiduciary duties under Section 36(b) of the Investment Company Act in connection with excessive advisory fees, Rule 12b-1 fees and servicing fees charged to eight funds from 2004 to 2007. The plaintiffs argued that these excessive fees violated the "reasonableness" standard established in Gartenberg.

Sources: In re American Funds Fee Litigation, CV 04-05593, U.S. District Court, Central District of California (December 28, 2009); Peter Ortiz, Court Rules for American Funds in Fee Case, Ignites (January 4, 2010)

Update on Identity Theft Prevention Programs: Compliance Date Extended

The Federal Trade Commission (FTC) has extended the date by which certain financial institutions must comply with its new regulations known as the "red flags rule" to June 1, 2010. The FTC said that the compliance date extension is designed to provide Congress with more time to finalize legislation that would reduce the number of entities that are required to comply with the red flags rule.

The FTC and other regulatory agencies adopted the red flags rule as part of the Fair and Accurate Credit Transactions Act of 2003. The red flags rule is applicable to financial institutions, including investment companies, that offer "transaction accounts," which are accounts that permit the account holder to make payments or transfers to third parties through check writing, wire transfers or other similar means. The red flags rule requires financial institutions to establish an identity theft prevention program designed to detect, prevent and mitigate identity theft in connection with the opening of a covered account or an existing covered account.

Identity Theft Red Flags and Address Discrepancies under the Fair and Accurate Credit Transactions Act of 2003, Final Rule, 72 Fed. Reg. 63718 (November 9, 2007); Press Release, Federal Trade Commission, FTC Extends Enforcement Deadline for Identity Theft Red Flags Rule (October 30, 2009)
Compliance Date: June 1, 2010.

Privacy Law Developments

Update on Regulation S-AM: Compliance Date Extended
The SEC has extended the compliance date for Regulation S-AM to June 1, 2010 in order to permit a more orderly implementation of the regulation. The SEC adopted Regulation S-AM under the Fair Credit Reporting Act and the Fair and Accurate Credit Transactions Act of 2003, which required the SEC and other federal agencies to adopt rules implementing limitations on a person's use of certain information received from an affiliate to solicit a consumer for marketing purposes, unless the consumer has been given notice and a reasonable opportunity and a reasonable and simple method to opt out of such solicitations.

Regulation S-AM allows a consumer, in certain situations, to block affiliates of a covered firm from soliciting the consumer based on certain eligibility information (e.g., financial information) received from the person. Persons subject to Regulation S-AM include brokers, dealers, investment companies, investment advisers, transfer agents and municipal securities dealers registered with the SEC. Regulation S-AM does not prohibit the sharing of information with another entity. However, Regulation S-AM does prohibit a person from using eligibility information received from an affiliate to make marketing solicitations to consumers unless certain criteria are met.

Notice and opt out provisions can be combined with other required disclosures, such as initial or annual privacy notices required by Regulation S-P. In addition, Regulation S-AM has a number of exceptions to the notice and opt out requirements (e.g., when an affiliate making a marketing solicitation has a previous business relationship with the consumer or provides marketing materials in response to a communication initiated by the consumer).

Sources: SEC Final Rule, Release Nos. 34-60423, IC-28842 and IA-2911 (available August 4, 2009); SEC Final Rule, Release Nos. 34-60946, IC-28990 and IA-2946 (available November 5, 2009)
Effective Date: September 10, 2009
Compliance Date: June 1, 2010

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