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Investment Management Legal and Regulatory Update - October 2011

October 20, 2011

Volcker Rule Proposed by the SEC
On October 12, the OCC, the Board of Governors of the Federal Reserve System, the FDIC and the SEC issued a release requesting comment on a proposed rule that would implement Section 619 of the Dodd-Frank Act, commonly known as the "Volcker Rule." This provision restricts commercial banks and their affiliates ("banking entities") from engaging in short-term proprietary trading of securities, derivatives and certain other financial instruments for a banking entity's own account.

Section 619 of the Dodd-Frank Act added a new section 13 to the Bank Holding Company Act of 1956 (the "BHC Act") that generally prohibits any banking entity from engaging in proprietary trading or from acquiring or retaining an ownership interest in, sponsoring or having certain relationships with a hedge fund or private equity fund. In formulating the proposed rule, the agencies attempted to reflect the intent of the BHC Act while permitting banking entities to continue to provide client-oriented financial services. However, the release notes that the delineation of what constitutes a prohibited or permitted activity often involves subtle distinctions that are difficult to describe in a rule. In addition, banking entities should be permitted to continue to effectively deliver client-oriented financial services such as underwriting, market making and traditional asset management services. Given these complexities, the release requests comment on the potential impacts the proposed approach may have on banking entities and the businesses in which they engage.

The proposed rule describes the key characteristics of both prohibited and permitted activities; requires banking entities to establish a comprehensive compliance regime reflecting the unique nature of a banking entity's businesses; and with respect to proprietary trading, requires certain banking entities to calculate and report quantitative data that will assist both banking entities and the regulatory agencies in distinguishing prohibited proprietary trading from otherwise permissible activities.

Comments should be received on or before January 13, 2012.

Source: SEC Proposed Rule, Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds, Release No. 34-65545, October 12, 2011.


SEC Provides No-Action Relief on Pay-to-Play Rule
In response to a request from the Investment Company Institute ("ICI"), the SEC issued a no-action letter on September 12, 2011, agreeing not to seek enforcement against investment advisers that do not adhere to certain recordkeeping requirements of the "pay-to-play" rule under the Investment Advisers Act. Rule 204-2(a)(18)(i)(B) requires all investment advisers to maintain a list of all government entities that are or were investors in any covered investment pool (including mutual funds and other investment companies) to which the investment adviser provides or has provided advisory services. The ICI requested relief for advisers from maintaining information on government entities they could not reasonably identify.

In its request, the ICI noted that a government entity may hold shares in an investment pool such as an investment company through one or more omnibus accounts so that the government entity is wholly unknown to the adviser or investment company. While larger government entities that invest directly in a mutual fund or that sponsor a qualified 529 plan may be transparent to the adviser, government entities that invest through intermediaries may not be known to the adviser.

As an alternative to the recordkeeping requirements specified in Rule 204-2(a)(18), the ICI proposed that investment advisers should keep records of the following:

  • each government entity that invests in a covered investment pool whose account can reasonably be identified as being held in the name of or for the benefit of such government entity on the records of the investment company or its transfer agent;
  • each government entity whose account was identified as that of a government entity - at or around the time of the initial investment - to the adviser or one of its client servicing employees, regulated persons or covered associates;
  • each government entity that sponsors or establishes a 529 plan and has selected a covered investment pool as an option to be offered by such 529 plan; and
  • each government entity that has been solicited to invest in a covered investment pool either (i) by a covered associate or regulated person of the adviser; or (ii) by an intermediary or affiliate of the investment company if a covered associate was involved in the solicitation.

The SEC conditioned its no-action relief on maintaining the alternative records specified by the ICI. Accordingly, an adviser relying on the no-action letter must create a system to track the solicitation of its covered associates or regulated persons involving a government entity, as well as a system to ensure that its covered associates and client service personnel notify the adviser when they become aware of a government entity account. The SEC staff has assured the ICI that advisers will have a "reasonable period of time" to develop and implement these systems.

The SEC adopted the recordkeeping requirement to accompany the "pay-to-play" provisions under the Investment Advisers Act. The "pay-to-play" rule prohibits an investment adviser from providing advisory services for compensation to a government client for two years after making a contribution to certain candidates or elected officials. Rule 204-2(a)(18) as written requires advisers to maintain a list of all government entities that have invested in an investment pool to which the adviser provides advisory services during the five prior years, whether or not they can be reasonably identified. In some cases, advisers would not be able to identify government entities without seeking information from intermediaries through which government entities invest. Intermediaries are under no obligation to provide such information. The no-action letter relieves advisers of the burden of attempting to comply with a recordkeeping requirement under circumstances in which they do not have access to the information necessary to create the record, provided they maintain the alternate records described above.

Sources: Investment Company Institute Request for No-Action Relief for Advisers to Mutual Funds under the Recordkeeping Requirements of SEC Rule 204-2(a)(18)(i)(B), September 12, 2011; SEC Response of the Office of Chief Counsel, Division of Investment Management, Ref. No. 2011510416, September 12, 2011; ICI Memo Re: SEC Provides No-Action Relief on Pay-to-Play Rule, September 14, 2011.

SEC Issues Concept Release on Use of Derivatives by Mutual Funds
The SEC issued a concept release on August 31, 2011 asking mutual fund firms for information on their compliance policies for derivative instruments. Industry participants hope that the information developed in response to the concept release will lead to a more comprehensive and systematic approach to derivatives regulation by the SEC, which previously has addressed various derivatives issues on a case- by-case basis. The concept release requested feedback from participants to help determine whether regulatory initiatives or guidance are needed.

The SEC requested comment on various topics, including the following:

  • the costs, benefits and risks to funds of investing in derivatives;
  • how to measure the amount of leverage that a fund incurs when it invests in a derivative;
  • alternatives to the current asset segregation approach to assure adequate coverage of a fund's exposure under a derivative investment;
  • how a fund should value a derivative to determine the percentage of the fund's assets that are invested in a particular company for diversification purposes (e.g., market value or notional value);
  • with respect to the Investment Company Act's restrictions on investments in securities-related issuers, how investing in a derivative issued by a broker-dealer may be different from investing in a broker-dealer's
  • common stock or debt securities;
  • how funds determine the industry of a derivative instrument for purposes of compliance with the concentration requirements of the Investment Company Act; and
  • whether the SEC should issue guidance on the fair valuation of derivatives.

Comments should be received on or before November 7, 2011.

Source: SEC Concept Release, Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776, August 31, 2011.


Ninth Circuit Decides Excessive Fees Case in Favor of Adviser
In Rodney Jelinek v. Capital Research Management Co., the Ninth Circuit Court of Appeals upheld a lower court decision in favor of Capital Research Management Company ("CRMC") by holding that the mutual fund investors failed to prove that CRMC, adviser to the American Funds, and American Funds Distributors, distributor to the American Funds, breached the fiduciary duty imposed by §36(b) of the Investment Company Act. The lower court had held that plaintiffs failed to show that the adviser and distributor misused the fees or that the mutual funds did not benefit from the services provided by those fees.

On appeal, the Court of Appeals held that the lower court applied the correct standard when it ruled for CRMC (i.e., the traditional Gartenberg standard endorsed in the recent Jones v. Harris Supreme Court decision). The district court properly evaluated the relevant factors to determine that CRMC's fees were not so "disproportionately large" that they "bore no reasonable relationship to the services rendered."

The Court of Appeals also found that the district court correctly concluded that, despite criticizing the independent directors for their lack of conscientiousness, overall their conduct met the Gartenberg standard because they carefully and diligently exercised their responsibility in approving the fees at issue.

Source: Rodney T. Jelinek v. Capital Research and Management Co., United States Court of Appeals for the Ninth Circuit, No. 10-55221 (Filed August 24, 2011).


Department of Labor Backs Off Fiduciary Rule
On September 19, 2011, the Department of Labor ("DOL") withdrew a proposed rule to expand the scope of the definition of a "fiduciary." Under the rule as proposed, the DOL would have imposed fiduciary duties on any person who made investment recommendations, whether or not those recommendations were individualized or there was mutual agreement that the recommendations were intended as investment advice.

The DOL anticipates revising provisions of the rule to clarify that fiduciary advice is limited to individualized advice directed to specific parties. The DOL will also address concerns about the application of the rule to routine appraisals and arm's length commercial transactions such as swaps. The DOL anticipates re-proposing the rule in early 2012.

Source: US Labor Department's Employee Benefits Security Administration to Re-Propose Rule on Definition of a Fiduciary, Release No. 11-1382-NAT, September 19, 2011.


SEC Announces Effective Date of Rule on Shareholder Director Nominations
The SEC issued a notice that an amendment to the shareholder proposal rule, Rule 14a-8 under the Securities Exchange Act, became effective on September 20, 2011. The amended rule will require companies to include in their proxy materials, under certain circumstances, shareholder proposals that seek to establish a procedure in the company's governing documents for the inclusion of one or more shareholder director nominees in the company's proxy materials.

The SEC originally adopted the amendment to Rule 14a-8 in August 2010, but stayed its effectiveness when an accompanying rule, Rule 14a-11, was challenged in federal court. Rule 14a-11 required companies to include shareholder nominees for directors in the company proxy materials. In 2011, the U.S. Court of Appeals for the District of Columbia Circuit struck down Rule 14a-11 in Business Roundtable and Chamber of Commerce of the U.S. v. Securities and Exchange Commission. The SEC decided not to seek a rehearing on Rule 14a-11 and lifted the stay on the amendment to Rule 14a-8, which had not been challenged.

The amendment to Rule 14a-8 prohibits companies, including investment companies, from relying on Rule 14a-8(i)(8) to exclude certain shareholder proposals from proxy statements. Rule 14a-8(i)(8) had allowed a company to exclude from its proxy statement a shareholder proposal relating to the nomination or election of a candidate to the company's board of directors or a procedure for such nomination or election. Under the amendment, shareholders will be permitted, under certain circumstances, to require companies to include in their proxy materials shareholder proposals that amend the companies' governing documents regarding nomination procedures.

Companies may still exclude certain shareholder proposals relating to board nominations. For example, companies can exclude proposals that disqualify nominees standing for election; remove a director from office before his or her term has expired; question the competence, business judgment or character of one or more nominees or directors; seek to include a specific individual in a company's proxy materials for election to its board; or otherwise could affect the outcome of the upcoming election of directors.

Source: SEC Final Rule, Facilitating Shareholder Director Nominations, Release No. IC-29788, September 15, 2011.


SEC Proposes Rule Disqualifying Bad Actors From Rule 506 Offerings
The SEC has proposed amendments to Rule 506 under Regulation D of the Securities Act to set forth the "bad actor" (commonly known as "bad boy") provisions that could disqualify companies from relying on the rule, which is commonly relied on by companies offering securities to qualified investors in a private placement. The Dodd-Frank Act directed the SEC to adopt the amendments in order to prevent issuers from relying on the Rule 506 safe harbor if certain disqualified persons were involved in the offering.

As required by the Dodd-Frank Act, the SEC proposed disqualifications under Rule 506 that are substantially similar to the disqualifications found in other securities regulations. Persons covered by the bad boy provisions would include: issuers; directors, officers, general partners or managing members of issuers; beneficial owners of 10% or more of any class of the issuer's equity securities; promoters connected with the issuer; persons compensated for solicitation of purchasers in connection with sales of securities in the offering; and directors, officers, general partners or managing members of any such compensated solicitor. The disqualifying events proposed by the SEC in the rule amendment include:

  • securities-related criminal convictions;
  • securities-related court injunctions and restraining orders;
  • final orders of a state securities commission, state insurance commission or state or federal bank, savings association or credit union regulator barring an individual from association with regulated entities or from engaging in securities, insurance or banking business or finding a violation of any law pertaining to fraudulent, manipulative or deceptive conduct;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization; and
  • SEC stop orders pertaining to the filing of a registration statement or the suspension of an exemption.

The proposal includes a "reasonable care" exception. Under this exception, even if a disqualifying event exists, a company would not lose the benefit of the Rule 506 safe harbor if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. The SEC also requested comment on whether the "bad actor" disqualifications should be applied uniformly to other exempt offerings under Regulation D, such as to Rule 504, and whether a uniform look-back period should be imposed for disqualifying events. For example, the SEC is considering whether a ten-year look back period should be imposed for all disqualifying events rather than five-year or ten-year look-back periods depending on the nature of the disqualifying event.

Source: SEC Proposed Rule, Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings, Release No. 33-9211,
May 25, 2011.

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