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Godfrey & Kahn Updates

Investment Management Legal and Regulatory Update - October 2014

October 21, 2014

Recent SEC guidance and releases

SEC adopts long-awaited money market fund reform rules
On July 23, 2014, the U.S. Securities and Exchange Commission (SEC) adopted long-awaited rules that implement two principal reforms for heightened regulation of money market funds. The first principal reform requires that institutional prime money market funds float their net asset values (NAVs). The second principal reform applies to retail money market funds and institutional prime money market funds and allows such funds to impose liquidity fees and redemption gates if a money market fund’s weekly liquid assets fall below certain thresholds. The amendments exempt government money market funds from both the floating NAV and the liquidity fee and redemption gate requirements, but such funds may opt into the fees and gates requirements. The new money market reform rules also impose heightened disclosure requirements.

Floating NAV. The floating NAV requirement for institutional prime money market funds requires such funds to value their portfolio securities by using market-based factors and to sell and redeem shares based on the floating NAV. “Institutional prime money market funds” do not include retail, prime and municipal money market funds (where shareholders are limited to “natural” persons) and government funds, where 99.5% of assets are invested in cash, government securities or repurchase agreements collateralized fully by government securities. The amendments eliminate the use of amortized cost by institutional prime money market funds and require those funds to provide an NAV to the fourth decimal (i.e., $1.0000).

Retail and government funds, on the other hand, are required to market price their shares daily, but they are permitted to use amortized cost and penny rounding to maintain a stable net asset value. Institutional prime money market funds must comply with the floating NAV requirement by October 5, 2016. If a money market fund wishes to avoid the floating NAV requirement, it will need to either be a retail money market fund or a government money market fund.

According to an article in The Wall Street Journal, investment advisers are predicting and reassuring their retail clients invested in retail money market funds that the new money market fund reforms rules will not adversely affect them. On the other hand, advisers to institutional investors invested in institutional money market funds (or mixed retail and institutional funds) are considering moving their investments into other types of money funds or fixed-income products given the ramifications of the floating NAV requirements as well as the fees and gates requirements, which are currently unknown.

Liquidity fee and redemption gate requirements. The fees and gates requirements apply to both institutional prime money market funds and retail money market funds. The new amendments allow/require such funds to impose either liquidity fees, redemption gates, or both if a money market fund’s weekly liquid assets fall below certain thresholds (subject to action by a fund’s board of directors).

  • Liquidity fee. If the weekly liquid assets fall below 30% of a fund’s total assets, the board of directors of such fund, at its discretion, may impose a liquidity fee up to 2%. If the weekly liquid assets fall below 10% of a fund’s total assets, a 1% liquidity fee must be imposed unless the board (including a majority of its independent directors) determines that: (1) imposing a 1% liquidity fee would not be in the best interests of shareholders, and (2) imposing a lesser or greater liquidity fee (not greater than 2%) would be in the best interests of shareholders. A liquidity fee is meant to cover the cost of providing liquidity to shareholders and/or repairing NAV.
  • Redemption gate. If a money market fund’s weekly liquid assets fall below one of the two liquidity fee thresholds (as described above), the fund’s board of directors (including a majority of its independent directors) may impose a temporary suspension of redemptions by investors, or a redemption gate, if the board determines that doing so would be in the best interests of shareholders. In this scenario, the redemption gate is optional and may be used, sequentially, in addition to a liquidity fee or in lieu of a liquidity fee. Redemption gates provide money market funds the necessary time and space to consider their options, and also allow funds to restore liquidity through maturing securities while also allowing investor panic to subside.

As for the timing of the fees and gates requirements, a liquidity fee may be imposed on the same business day the triggering threshold (either 30% or 10% of a fund’s total assets) is breached. A redemption gate may not be imposed for more than ten business days in any 90-day period. Fees or gates may be lifted or modified by board action (including a majority of independent directors). Liquidity fees and redemption gates are automatically lifted if a fund’s weekly liquid assets rise to or above the 30% threshold. Retail and institutional prime money market funds must comply with the liquidity fee and redemption gate requirements by October 5, 2016.

Disclosure and reporting obligations. The money market reform rules also heighten the disclosure and reporting requirements for these funds. For example, money market funds will need to include a disclosure statement in their advertisements and summary prospectus that: (1) investors could lose money, (2) the NAV could fluctuate (institutional money market funds only), (3) a fee on redemptions may be imposed in certain circumstances, (4) redemptions may be suspended temporarily, (5) there is no FDIC guarantee, and (6) a fund’s sponsor has no legal obligation to provide financial support.

The new rules also implement certain disclosures that must be included in a fund’s registration statement, including disclosure in the statutory prospectus that, as a restriction on redemptions, a fund may impose a liquidity fee, a redemption gate or both. Institutional money market funds will also need to disclose the tax implications of a floating NAV and the transition to the floating NAV in its statutory prospectus. Money market funds will be subject to a ten-year look back (beginning October 5, 2016), where disclosure in a fund’s statement of additional information (SAI) must include: (1) historical occasions where the weekly liquid assets have fallen below the 10% threshold and whether the board of directors imposed a liquidity fee or redemption gate, and (2) historical occasions where the weekly liquid assets have fallen below 30% and whether the board of directors imposed a liquidity fee or redemption gate. With respect to each occasion, a money market fund must state the length of time the fund’s weekly liquid assets remained below either the 10% or the 30% threshold, the dates the liquidity fee and/or redemption gate was imposed, and the size of the liquidity fee. Lastly, a money market fund must state in its SAI the historical occasions where an affiliated person, promoter or principal underwriter (or any of its affiliates) provided any form of financial support to a money market fund to help such fund avoid an NAV break or a breach of either the 10% or the 30% weekly liquid assets thresholds.

Money market funds must also disclose on new Form N-CR certain significant events, such as a default in a portfolio security or the bankruptcy of an issuer. Form N-CR must be filed generally within one business day of the occurrence of such event. There were also conforming amendments to Form N-MFP arising from the adoption of the floating NAV and liquidity fees and redemption gates requirements. Lastly, Form PF was also amended to require private liquidity funds to report the same information required of registered funds in Form N-MFP.

Sources: Money Market Funds Reform; Amendments to Form PF, Release No. 33-9616, IA-3879, IC-3116, FR-84 (July 23, 2014), available at: SEC Adopts Money Market Fund Reform Rules, Press Release (July 23, 2014), available at: Advisers Weigh Impact of New Money-Fund Rules, Daisey Maxey, Wall St. J. (August 1, 2014), available at:

SEC announces charges against corporate insiders for violations of Section 16(a), Section 13(d) and Regulation S-K Item 405
The SEC announced a major enforcement initiative where it sought enforcement actions against twenty-eight officers, directors or major shareholders for violating laws requiring prompt reporting of transactions and holdings in the stock of public companies. Twenty-seven of the insiders agreed to settle the charges and pay financial penalties that totaled $2.6 million. Specifically, the SEC brought charges against these insiders for failing to file timely Schedule 13D, 13G and Section 16(a) reports. Beneficial owners of more than five percent of a class of a company’s stock use Schedules 13D and 13G to report their holdings or intentions with respect to such company. Under Section 16(a), officers, directors and holders of ten percent of more of an issuer’s outstanding shares must report transactions in the issuer’s shares within two business days on Form 4.

The SEC’s charges stem from its enforcement initiative focusing on Schedules 13D and 13G and Section 16(a) reports. An insider’s failure to file timely reports, even if inadvertent, is a violation of these rules. The SEC’s order named ten investment firms in connection with their beneficial ownership of certain public companies. During a news conference on September 10, 2014, Enforcement Director Andrew Ceresney said the SEC used quantitative analytics to identify individuals and entities with high levels of filing deficiencies.

Sources: SEC Announces Charges Against Corporate Insiders for Violating Laws Requiring Prompt Reporting of Transactions and Holdings, Press Release 2014-190 (September 10, 2014), available at VDA4-k10wiR. Federal Securities Law Reporter, Report Letter 2647 (September 25, 2014).

SEC initiating sweep of bond funds
The SEC is initiating a sweep of bond funds, where it is targeting more than two dozen complexes to: (1) determine how prepared such firms are for rising interest rates, (2) evaluate their disclosures concerning rising rates, and (3) evaluate their communications with the funds’ board of directors. This bond fund sweep stems from the SEC’s Division of Investment Management (IM Division) guidance update in January 2014 which provided guidance that fixed-income funds should follow to ensure that they are prepared for increases in interest rates. Additionally, the SEC included fixed-income funds on its list of 2014 exam priorities, where the Commission indicated it would monitor the risks associated with interest rate increases as well as the types of disclosures to investors in fixed-income funds and the board communications related to such risks. See “SEC Guidance on Risk Management in Changing Fixed Income Market” in our April 2014 Update and “SEC Announces 2014 Examination Priorities” in our January 2014 Update.

The guidance the IM Division issued suggested that bond funds should communicate with their independent directors with respect to risk exposures and liquidity. With respect to liquidity, the guidance also suggested that bond funds should conduct stress tests in order to evaluate their capacity to meet liquidity needs in unpredictable markets. Additionally, the guidance recommended that investment advisers to bond funds should assess whether their risk management strategies will be able to respond appropriately to changes in the fixed-income market, and if not, recommend that such advisers should consider actions that would be more appropriate.

Source: Saitz, Greg, SEC Starting Sweep of Bond Funds Following Guidance, Board IQ (October 7, 2014).

SEC announces Municipal Adviser Exam Initiative
On August 19, 2014, the SEC announced that the Office of Compliance Inspections and Examinations (OCIE) is launching a two-year examination initiative for newly registered municipal investment advisers that registered with the SEC in accordance with the final municipal adviser rules that were effective as of July 1, 2014. The OCIE’s National Examination Program (NEP) launched this initiative to lead “focused, risk-based” examinations of municipal advisers that are registered with the SEC but not with Financial Industry Regulatory Authority (FINRA).

The SEC is working with the Municipal Securities Rulemaking Board (MSRB) and FINRA to coordinate their efforts with respect to municipal adviser oversight. The NEP will examine municipal advisers for compliance with applicable SEC and MSRB rules (once the MSRB rules are approved by the SEC and become effective). This initiative will proceed in the following three phases:

  • Engagement phase. The OCIE is planning to reach out to municipal advisers to inform them about their obligations under the Dodd-Frank Act and related rules, the Municipal Adviser Examination Initiative and the OCIE’s practice of engaging directly with an adviser’s senior management. The SEC is also planning a Compliance Outreach Program designed for municipal advisers, which will be held in Chicago on November 3, 2014.
  • Examination phase. During the examination phase, the OCIE will review one or more of the following risk areas of the businesses and operations of municipal advisers being examined: compliance with SEC and MSRB registration rules; compliance with a municipal adviser’s fiduciary duty to its municipal entity clients; disclosure, fair dealing, supervision, books and recordkeeping requirements; and employee qualifications and training.
  • Informing policy phase. After the examination phase, the NEP will report its findings to the SEC, which may include common practices of municipal advisers identified in high-risk focus areas, industry trends and significant issues.

Sources: SEC Announces Municipal Advisor Exam Initiative, Press Release 2014-170 (August 19, 2014), available at: SEC Letter to Municipal Advisors (August 19, 2014), available at:; SEC, FINRA and the MSRB to Hold Compliance Outreach Program for Municipal Advisors, Press Release 2014-224 (October 1, 2014).

SEC proposes extending temporary rule regarding adviser principal trades
On August 12, 2014, the SEC proposed an amendment to Rule 206(3)-3T. Rule 206(3)-3T establishes an alternative for dually registered investment advisers and broker-dealers to meet the requirements of Section 206(3) under the Advisers Act. Section 206(3) requires an investment adviser to obtain client consent prior to engaging in principal transactions with such client.

Rule 206(3)-3T applies only to non-discretionary accounts of dually registered investment advisers and broker dealers. Under Rule 206(3)-3T, if an investment adviser enters into a principal trade with its client, it is compliant with Section 206(3) if the adviser, among other things: (1) provides written prospective disclosure regarding the potential conflicts arising from principal trades; (2) obtains written, revocable consent from the client that allows the adviser to enter into principal transactions; (3) makes certain disclosures (oral or written) and obtains the client’s consent prior to each principal transaction; (4) sends the client confirmation statements disclosing the capacity in which the adviser had acted and discloses that the adviser had informed the client it may act in such capacity and the client authorized the transaction; and (5) delivers to the client an annual report listing the principal transactions.

The proposed amendment seeks to extend Rule 206(3)-3T’s expiration date by two years (until December 31, 2016). Comments on this proposal were due to the SEC by September 17, 2014. The SEC believes the extension of Rule 206(3)-3T’s expiration date will provide adequate protection to advisory clients, as the SEC contemplates the amendments to rules currently in place for dually registered investment advisers and broker dealers.

Source: Temporary Rule Regarding Principal Trades with Certain Advisory Clients, Release No. IA-3893 (August 12, 2014), available at

SEC’s director of the Division of Investment Management reports on SEC activity at the Hedge Fund Management Seminar
The director of the SEC’s IM Division, Norm Champ, recently spoke before the 2014 Hedge Fund Management Seminar hosted by the Practising Law Institute, where he discussed the changes in the regulatory landscape over the past four years following the implementation of the Dodd-Frank Act. During his speech, Director Champ covered various topics, including risk monitoring and compliance, examinations and enforcement.

Director Champ first discussed the SEC’s efforts to implement provisions pursuant to the Dodd-Frank Act that are designed to enhance the oversight of private advisers, including the registration of private fund advisers that were previously exempt from registering with the SEC. He stated that as a result of the Dodd-Frank Act and the SEC’s new registration rules, the number of SEC-registered private advisers increased by more than 50%.

Director Champ identified the SEC’s Risk and Examinations Office (REO), which was created in 2012, as an important tool because it maintains an industry monitoring program, which provides continuous qualitative and quantitative financial analysis of the investment management industry. REO’s program includes analyses of information provided through various regulatory filings, such as the Form ADV and Form PF.

Additionally, Director Champ said the SEC has been reviewing the Advisers Act and recent IM Division guidance regarding their application to private fund investment advisers, which is important given that approximately 40% of investment advisers registered with the SEC provide advisory services to private funds.

At the beginning of 2014, the OCIE launched an initiative to examine a significant percentage of investment advisers registered with the SEC since the effective date of the Dodd-Frank Act (specifically, those who have never been examined by the SEC). A vast majority of these new registrants are private fund advisers. See “OCIE Initiative for Never-Before Examined Advisers” in our April 2014 Update. Director Champ stated that a private fund adviser’s compliance policies and procedures must be specifically tailored to a firm’s business, and in turn, such advisers must be diligent in identifying, disclosing and monitoring conflicts of interests. Director Champ warned advisers about alternative mutual funds, saying that alternative funds present special regulatory concerns with respect to compliance programs, conflicts of interest, valuation, portfolio management and marketing.

Source: Remarks to the Practising Law Institute, Hedge Fund Management Seminar 2014 (September 11, 2014), available at:

SEC to pay its largest-ever whistleblower award of $30 million
The SEC announced an expected award of over $30 million to a non-U.S. whistleblower. To date, this award is the largest award made under the SEC’s whistleblower program and is the fourth award made to a non-U.S. resident. The SEC’s whistleblower program provides awards for original information that results in an enforcement action with sanctions over $1 million. In determining the award amount, the SEC considered the significance of the information provided, the assistance the whistleblower provided, and the law enforcement interests at issue. In the order, the SEC indicated the $30-35 million award could have been larger had the tipster acted faster. The SEC’s press release highlighted the international breadth of this award, explaining that whistleblowers from all over the world should be incentivized to come forward with original information about potential federal securities law violations.

Sources: In the Matter of Claim for Award, SEC Release No. 73174 (September 22, 2014), available at: SEC Announces Largest-Ever Whistleblower Award, Press Release 2014-206 (September 22, 2014), available at:, Ensign, Rachel Louise, SEC to Pay $30 Million Whistleblower Award, Its Largest Yet, Rachel Louise Ensign, The Wall St. J. (September 22, 2014), available at

Registered investment adviser may offer rebate of advisory fees for underperforming portfolios
The staff of the SEC’s IM Division recently assured Amerivest Investment Management, LLC, a registered investment adviser and affiliate of TD Ameritrade, Inc., that it would not recommend enforcement action to the SEC if Amerivest offers to rebate its advisory fees for eligible clients who are invested in a model portfolio that experiences two consecutive quarters of poor performance, before advisory fees, for a 12-month period.

Amerivest sought no-action relief because Section 205(a) of the Advisers Act generally prohibits registered investment advisers from entering into, extending, renewing or performing any investment advisory contract that provides for compensation to the investment adviser on the basis of a share of capital gains or capital appreciation in a client’s account or any portion thereof.

Through a discretionary advisory service, Amerivest serves as the adviser to retail clients and is responsible for implementing the asset allocations models and corresponding mutual fund and exchange-traded fund investment recommendations that Morningstar Associates, LLC provides to Amerivest. With respect to this service, Morningstar acts as an investment adviser and independent consultant to Amerivest. Amerivest compensates Morningstar based on a fee schedule that includes an asset-based fee component and a licensing fee component.

Amerivest proposed to continue to charge a quarterly asset-based advisory fee in advance. However, it would rebate investment advisory fees for eligible clients that invested in a model portfolio that experienced two consecutive discrete calendar quarters of negative performance during a 12-month period.

The SEC staff noted that Section 205(a)(1) does not, on its face, extend to fee waivers or rebates that are contingent on negative performance. The SEC staff said that certain aspects of Amerivest’s proposed fee arrangement help to alleviate concerns that Section 205(a)(1) is meant to deter, such as the role of Morningstar in selecting securities and making asset allocation recommendations and the limited discretion Amerivest has in deviating from these recommendations. Additionally, the SEC staff stated it would not recommend enforcement action to the SEC because the terms of the rebate will be fully and clearly disclosed to all Amerivest clients, in addition to other conditions set forth in the letter.

Source: No Action Letter, Amerivest Investment Management, LLC, IM Ref. No 20144101037 (August 19, 2014), available at:

SEC enforcement actions and litigation

Advisory firm agrees to pay $300,000 penalty for inadequate trade allocations policy
On August 28, 2014, Structured Portfolio Management, L.L.C., a Connecticut-based hedge fund adviser, and its affiliated advisers, SPM Jr., L.L.C. and SPM IV, L.L.C. (collectively, SPM), agreed to pay a $300,000 penalty to settle an SEC enforcement action. The SEC claimed that SPM failed to adopt and implement written compliance procedures and policies that were reasonably designed to prevent conflicts of interests. Specifically, the compliance failures were allegedly the result of a disclosed, but inadequately addressed, conflict of interest where SPM purportedly allowed one of its traders to trade the same securities across three SPM-advised hedge funds, which may have led to improper trade allocations.

The SEC found that, after reviewing the funds’ trading data, one of the funds consistently bought the same securities at a lower price and sold at a higher price than the other two funds. Despite SPM’s disclosure of this conflict of interest, it failed to adopt and implement adequate policies and procedures designed to detect and prevent improper trade allocations. Additionally, SPM failed to adopt and implement policies and procedures that were designed to prevent inaccurate disclosures regarding its funds and their respective investment strategies.

Source: In the Matter of Structured Portfolio Management, L.L.C. et al, IA Release No. 3906 (August 28, 2014), available at:

Advisory firm charged with failure to disclose conflicts of interests
The SEC brought fraud charges against an investment advisory firm and its owners for failure to advise clients that the adviser was receiving compensation from a broker that was offering mutual funds that the adviser recommended to its clients. The SEC alleged that Robare Group Ltd., the adviser, received a percentage of every dollar that its clients invested in certain mutual funds through an undisclosed compensation arrangement with the brokerage firm. The SEC alleged that the adviser (and its owners) had an incentive to recommend these mutual funds to its clients over other investment opportunities which resulted in the generation of additional revenue for Robare Group without their clients’ knowledge.

According to the SEC’s order, the Robare Group revised its Form ADV in 2011 to disclose the compensation agreement with the brokerage firm, but that disclosure and subsequent disclosure incorrectly stated that the Robare Group did not receive any economic benefit from a non-client for providing investment advice. The SEC found this disclosure to be inadequate because such disclosures stated that the Robare Group “may” receive compensation from the broker, when the firm was consistently receiving payments. Additionally, the SEC’s allegations stated the Robare Group and the broker entered into a new arrangement in 2012, which provided for similar payments, and the Robare Group failed to disclose its incentive to recommend buying and holding particular mutual funds through the broker’s platform or the scale of the conflict. Over an eight-year period, the Robare Group purportedly received over $440,000 from its arrangement with the broker.

Sources: In the Matter of the Robare Group, Ltd., et al, IA Release No. 3907, IC Release No. 31237 (September 2, 2014), available at: Houston-Based Investment Advisory Firm and Co-Owners Charged with Failing to Disclose Conflict of Interest to Clients, Press Release 2014-183 (September 2, 2014), available at:

Misappropriation theory does not apply to former mutual fund compliance officer
The U.S. District Court for the Eastern District of Wisconsin dismissed an insider trading action brought in 2003 by the SEC against a mutual fund’s former chief compliance officer and general counsel, Jilaine H. Bauer, because the court concluded the misappropriation theory did not apply.

Ms. Bauer was the former chief compliance officer and general counsel of Heartland Advisors, Inc. (the Adviser), which serves as investment adviser to several mutual funds. Ms. Bauer had allegedly redeemed her shares in one of the mutual funds in October 2000 based on certain insider information she possessed about that fund. Ms. Bauer appealed the lower court’s grant of summary judgment, which was in favor of the SEC, where the SEC argued to the Seventh Circuit Court of Appeals that Ms. Bauer violated insider trading laws based on the misappropriation theory of insider trading. Previously, the SEC had argued the “classical” theory of insider trading but switched its argument upon appeal. Accordingly, the Seventh Circuit remanded the case back to the U.S. District Court for the Eastern District of Wisconsin.

The district court granted summary judgment and dismissed the SEC’s case, concluding that it was unwilling to extend the misappropriation theory to this insider trading claim because the SEC had never raised the misappropriation theory with the district court. Accordingly, the misappropriation theory argument was not properly before the court and no precedent supports the extension of this theory to Ms. Bauer. Moreover, the SEC failed to properly argue the misappropriation theory because her former position with the adviser qualified her as a corporate insider, and the misappropriation theory applies only to outsiders.

Source: SEC v. Bauer, Case No. 03-C-1427 (E.D. Wis., Aug. 29, 2014).

Excessive subadvisory fee suits
A second excessive subadvisory fee lawsuit was filed against Davis Selected Advisers and was combined with a prior suit involving the New York Venture Fund in September 2014. In the now-combined lawsuit, the plaintiffs alleged that: (1) Davis overcharged investors in its $20 billion New York Venture Fund, and (2) Davis collected lower management fees for an almost identical investment strategy used in other funds subadvised by Davis. Davis similarly faced another excessive-fee lawsuit involving the New York Venture Fund, but that case was dismissed in 2011 and is now before the Second Circuit Court of Appeals. In this lawsuit, the plaintiffs alleged that the New York Venture Fund had management fees that were almost twice as high as certain subadvisory fees on outside funds that Davis subadvised, which charged 0.25% at the $1 billion breakpoint.

Recently, a U.S. district court judge dismissed an excessive fee lawsuit against SEI Investment Management without prejudice. The plaintiffs alleged that SEI charged excessive fees for services performed by sub-advisers, thus violating Section 36(b) of the 1940 Act. The SEI case was dismissed because the court found that the plaintiffs failed to meet the one-year statute of limitations. However, the court is allowing the plaintiffs to amend and refile their complaint. In an important footnote, the court noted that regardless of their timeliness, it had serious doubts about the sufficiency of the allegations in the complaint as compared to the standard for violation of Section 36(b) articulated in Gartenberg v. Merrill Lynch Asset Management and adopted by the U.S. Supreme Court in Jones v. Harris Associates.

Sources: Davis Targeted Again for Management Fees, Ignites Emily Hallez (September 23, 2014), available at: Judge Throws Out 36(b) Suit Against SEI, Fund Director Intelligence, Vol. XXIII, No. 10 (October 2014).

The information contained herein is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation.




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