Investment Management Update - April 2010April 20, 2010
Supreme Court Decides Jones v. Harris
On March 30, 2010, the U.S. Supreme Court resolved the ambiguity caused by the Jones v. Harris excessive advisory fee case by affirming the long-standing "reasonableness" standard established in the seminal Gartenberg case and followed by federal courts and the mutual fund industry for more than 25 years. In a unanimous decision, the Court concluded that the Gartenberg standard correctly provides that to be liable for a breach of fiduciary duty under §36(b) of the Investment Company Act, an adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's length bargaining.
In Jones v. Harris, decided in 2008, the Seventh Circuit had rejected the "reasonableness" standard for determining excessive fees established by the Second Circuit in Gartenberg in favor of a "full disclosure" standard. Under this standard, an adviser would properly discharge its fiduciary duties if it "make[s] full disclosure are play[s] no tricks" in connection with the fees it charges. The Court's decision to grant certiorari in the Jones case was made to resolve the split between the Second Circuit's standard in Gartenberg and the Seventh Circuit's approach in Jones.
When evaluating the reasonableness of advisory fees, the Supreme Court noted that the Investment Company Act requires a court to evaluate all relevant factors, which may include a comparison between the fees that an adviser charges a mutual fund client and an institutional client. However, such comparison may merit little weight if the services provided to each client are sufficiently different. The Court indicated that mutual fund board decisions regarding approval of advisory contracts should be afforded great deference if such decisions were made following a robust §15(c) review process. The Court's opinion states that the "standard for fiduciary breach under §36(b) does not call for judicial second-guessing of informed board decisions."
The Supreme Court's decision reaffirms the legal standard that fund companies and directors have relied on for nearly three decades. Accordingly, advisers should continue to provide boards with all necessary information concerning the advisory contract and boards should consider all relevant factors as part of the §15(c) review process. As the Court noted, mutual fund boards must focus on both "procedure and substance" in their review of advisory fees.
Source: Jones, et al. v. Harris Associates, L.P., No. 08-586, slip op. (U.S. Supreme Court, March 30, 2010).
Senate Financial Reform Bill Introduced
On March 15, 2010, Senator Christopher Dodd (D-Conn.) introduced the "Restoring American Financial Stability Act of 2010." This financial reform bill addresses a wide range of issues designed to promote "accountability and transparency in the financial system." This Senate bill was introduced approximately three months after the U.S. House of Representatives approved its own financial reform legislation in H.R. 4173, the "Wall Street Reform and Consumer Protection Act of 2009." Both the Senate bill and the House legislation are designed to enhance federal regulation of the U.S. financial system in response to the recent financial crisis.
Certain key reforms covered by the Senate bill that impact the investment management industry are highlighted below:
Establishment of Financial Stability Oversight Council.
The Senate bill proposes to establish a nine-member Financial Stability Oversight Council, made up of representatives from various federal regulators, including the chairman of the SEC, whose purpose is to monitor systemic risk by identifying risks to the financial stability of the U.S. that could arise from the financial distress or failure of large interconnected bank holding companies or nonbank financial companies.
Regulation of Hedge Fund Advisers and New Registration Threshold for Federal Advisers.
The proposed "Private Fund Investment Advisers Regulation Act of 2010" would eliminate the private investment adviser exemption under the Investment Advisers Act, thus requiring hedge fund advisers to register as investment advisers. New provisions would also raise the assets under management threshold for federal investment adviser registration to $100 million (up from $25 million).
Regulation of Over-the-Counter Derivatives Markets.
The proposed "Over-the-Counter Derivatives Markets Act of 2010" would establish regulatory oversight of the over-the-counter derivates markets by the SEC and CFTC. More derivatives would be cleared through centralized clearing houses and traded on exchanges.
SEC Management Reform and Improved Investor Protections.
In light of the Madoff scandal, the Senate bill proposes certain management reform initiatives within the SEC, including a mandatory assessment of the SEC's internal supervisory control and a study of the SEC's management structure. The Senate bill proposes to establish an Investor Advisory Committee to consult with the SEC on its regulatory priorities, conduct initiatives to promote investor confidence and make recommendations on proposed legislation. The creation of an Office of Investor Advocate is also proposed, which would identify areas where investors have significant problems dealing with the SEC and provide them with assistance. Additionally, the Senate bill proposes that the SEC be self-funded rather than being subject to the annual Congressional appropriations process.
Establishment of Bureau of Consumer Financial Protection.
The Senate bill proposes the creation of a new Bureau of Consumer Financial Protection within the Federal Reserve, whose sole purpose would be to protect consumers from unfair, deceptive and abusive financial products and practices.
Improvements to Regulation of Credit Rating Agencies.
The Senate bill proposes the creation of a new Office of Credit Ratings housed within the SEC to administer the SEC's rules with respect to the practices of NRSROs in determining credit ratings, to promote accuracy in credit ratings and to ensure that such credit ratings are not unduly influenced by conflicts of interest. In addition, NRSROs would be subject to annual examination by this new office.
A full Senate vote on the bill may take place later this month. Congress will then begin the process of harmonizing the Senate and House legislation.
Sources: Restoring American Financial Stability Act of 2010, S.3217, 111th Cong. (2010); Senate Committee on Banking, Housing, and Urban Affairs, Summary: Restoring American Financial Stability (2010).
Money Market Fund Reform
The SEC has adopted amendments to Rule 2a-7 under the Investment Company Act to tighten risk-limiting conditions of the rule, including imposing more restrictive liquidity requirements, credit quality standards and shorter maturities, in order to make money market funds more resilient to market turmoil. The final rule provides a series of dates by which money market funds must comply with the new amendments. The effective date of the new amendments to Rule 2a-7 and certain related rules is May 5, 2010.
May 5, 2010 Compliance Date.
- Purchases by Affiliates of Portfolio Securities Permitted. Affiliated persons will be permitted to purchase portfolio securities that have defaulted, if the fund is in compliance with certain requirements, including prompt e-mail notice to the SEC.
- Redemptions may be Suspended. Money market funds may suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund.
May 28, 2010 Compliance Date.
Money market funds must comply with new liquidity requirements, higher credit quality standards and certain requirements relating to repurchase agreements. The final rule notes that funds are not required to dispose of portfolio securities owned, or terminate repurchase agreements entered into, as of the time of adoption of the amendments to comply with the new amendments.
New Liquidity Requirements
- General Liquidity Rule. The new amendments require money market funds to hold securities sufficiently liquid to meet reasonably foreseeable redemptions. Additionally, funds and their boards must develop and adopt procedures to identify investors whose redemption requests may pose risks for the fund.
- Illiquid Securities. A money market fund is restricted from investing more than 5% of its assets in illiquid securities (down from the current limit of 10%). The term "illiquid" is defined to include any security that cannot be sold or disposed of within seven days at approximately the market value ascribed to it by the fund.
- Daily Liquidity Requirement. For all taxable money market funds, at least 10% of fund assets must be in cash, U.S. Treasuries or securities that convert or mature within one business day. If the fund falls beneath the daily liquidity requirement, its new purchases must first restore the required liquidity.
- Weekly Liquidity Requirement. For all money market funds, at least 30% of fund assets must be in cash, U.S. Treasuries, certain other government securities with remaining maturities of 60 days or less, or other securities that convert or mature within five business days. If the fund falls beneath the weekly liquidity requirement, its new purchases must first restore the required liquidity.
- Stress Testing. A money market fund's board must adopt written procedures that provide for periodic stress testing of the fund's ability to maintain a stable NAV based on hypothetical events. Hypothetical events include changes in short-term interest rates, increased redemptions, downgrades and defaults and changes in spreads from selected benchmarks. The board will determine the appropriate frequency of testing. The adviser must also assess the fund's ability to withstand events reasonably likely to occur within the following year.
Higher Credit Quality
- Second Tier Securities. A money market fund's second tier securities cannot exceed: 45 days in maturity, 0.5% of the fund's total assets for any individual issuer or conduit obligor, 2.5% for any individual demand feature or guarantee provider or 3% of the fund's total assets (down from the current limit of 5%).
- Designated NRSROs. A money market fund's board must annually designate the NRSROs whose credit ratings will be used to determine whether a security is an eligible security. The board must designate at least four NRSROs and may not delegate this responsibility to another party. A designated NRSRO cannot be an affiliated person of the issuer or an insurer or provider of credit support for the security.
- Diversification and Creditworthiness. For fund diversification purposes, a money market fund can only look through a repurchase agreement that is collateralized by cash items or government securities. The fund's board or its delegate must evaluate the creditworthiness of the counterparty.
June 30, 2010 Compliance Date.
Money market funds must comply with shorter maturity limits. The weighted average maturity, or "WAM," of a fund's portfolio is restricted to a maximum of 60 calendar days (down from the current limit of 90 days). Funds must also comply with a new maturity measurement, weighted average life, or "WAL." The maximum WAL of a fund's portfolio is restricted to 120 calendar days (currently there is no such limit). The WAL is measured without regard to interest rate adjustments.
October 7, 2010 Compliance Date.
Money market funds most disclose their portfolio holdings on their website on a monthly basis.
December 7, 2010 Compliance Date.
A new Form N-MFP is required to be filed with the SEC on a monthly basis. Form N-MFP contains a more detailed report of a money market fund's portfolio securities.
December 31, 2010 Compliance Date.
Money market funds must disclose their designated NRSROs in the statements of additional information.
October 31, 2011 Compliance Date.
Money market funds must have the ability to process transactions at prices other than a stable net asset value.
Sources: SEC Final Rule, Release No. IC-29132 (February 23, 2010); Investment Company Institute and Independent Directors Council Webinar, Money Market Fund Reforms: An Overview (March 5, 2010).
SEC Staff Publishes Responses to Questions on Investment Adviser Custody Rule
The SEC's Division of Investment Management has updated staff responses to questions regarding the investment adviser custody rule, Rule 206(4)-2 under the Investment Advisers Act, and the recent amendments to the rule. The following summarizes some of the guidance included in the staff responses.
Inadvertent Receipt of Client Assets.
Under the rule, adviser that inadvertently receives securities from a client and does not return the securities to the client within three business days will be deemed to have custody of the securities and also be in violation of the requirement that client securities be maintained with a qualified custodian. The guidance notes that exceptions would apply in certain situations, for example, where the adviser receives tax refunds from tax authorities or client settlement proceeds in connection with class action lawsuits, and forwards these assets within five business days.
Advisory Firm Employee Serving as a Trustee.
An adviser will be deemed to have custody of client assets if one of its employees serves as trustee to a firm client, unless the employee has been appointed as trustee as a result of a family or personal relationship with the grantor or beneficiary and not as a result of employment with the adviser.
Authority to Transfer Assets Between Client Accounts.
An adviser does not have custody of client assets if the adviser has the limited authority to transfer assets between client accounts managed at a qualified custodian.
Non-Compensated Investment Advisers.
Even if an adviser does not receive compensation from a client for providing investment advisory services, the adviser remains subject to the custody rule.
Electronic Delivery of Account Statements.
Account statements may be delivered electronically if the client has given informed consent to receiving the information electronically, the client can effectively access the information and there is evidence that the client received the information. Advisers must still have a reasonable belief after due inquiry that their clients have received the information.
Voluntary Delivery of Account Statements.
An adviser may send its own account statements to clients in addition to the statements that the clients receive directly from qualified custodians. The adviser must include a legend on its statements urging clients to compare the adviser's statements to those from the qualified custodian.
Pooled Investment Vehicle Audits.
Financial statements for pooled investment vehicles must be prepared in accordance with U.S. GAAP, unless the vehicle is organized outside the U.S. or has a general partner or other manager with a principal place of business outside the U.S., in which case certain reconciliations with U.S. GAAP may be required.
Offshore advisers registered with the SEC are not subject to the custody rule with respect to offshore funds.
Fund of Funds Financial Statements Deadline.
An adviser to a fund of funds relying on the audit provision of the custody rule may rely on an extended 180-day deadline from the end of the fund of funds' fiscal year to distribute audited financial statements to investors.
Unregistered Money Market Funds.
For unregistered money market funds that have been organized by fund families for investment exclusively by their registered investment companies, audited financial statements of the money market funds do not need to be delivered to fund shareholders. However, the financial statements must be delivered to each registered investment company's chief compliance officer, audit committee members and members of the board who are not interested persons of the adviser.
Defined Contribution Plan for Adviser Employees.
An adviser does not have to treat the assets of a defined contribution plan established for the benefit of the adviser's employees as client assets of which it has custody, provided specified conditions are met.
For trusts with co-trustees, where no co-trustee can withdraw assets without the prior written consent of the other co-trustees, such co-trustees would not be deemed to have custody of client assets, provided specified conditions are met.
Operationally Independent Qualified Custodian.
An adviser must receive an internal control report from a related person who acts as a qualified custodian for the adviser's clients, even if that related person is operationally independent as defined in the rule. In this case, however, the adviser is exempt from the surprise examination requirement.
In addition to the staff responses, the SEC has also published a small business compliance guide relating to the custody rule.
Sources: SEC Staff Responses to Questions About the Custody Rule (updated as of March 15, 2010), available at http://www.sec.gov/divisions/investment/custody_faq_030510.htm; SEC Final Rule, Release No. IA-2968 (December 30, 2009); SEC, Custody of Funds or Securities of Clients by Investment Advisers: A Small Entity Compliance Guide, available at
SEC Staff to Evaluate Use of Derivatives by Funds
The SEC staff is reviewing the use of derivatives by mutual funds, ETFs and other investment companies in order to determine if additional protections are necessary under the Investment Company Act. Given the growing complexity of derivatives and their associated risks, the SEC believes further review of derivatives is warranted. In particular, the SEC staff will explore issues relating to whether practices involving derivatives are consistent with the leverage, concentration and diversification provisions of the Investment Company Act, whether funds have adequate risk management procedures, whether there is appropriate board oversight, the sufficiency of derivative-related risk disclosures in fund prospectuses and whether any special reporting should be imposed with respect to derivatives. In connection with this review, the SEC staff has determined to defer its consideration of exemptive applications involving certain actively managed ETFs that could make significant investments in derivatives. Additionally, the SEC will carry out a sweep of the industry, which will include both big and small managers, as part of its review.
Source: SEC Press Release No. 2010-45, SEC Staff Evaluating the Use of Derivatives by Funds (March 25, 2010); Fund Derivatives Sweep Under Way, Ingnites (April 21, 2010).
Board Oversight of Subadvisers
The Independent Directors Council (IDC) recently published a comprehensive task force report addressing board oversight of subadvisers. The report provides an overview of the business reasons for an adviser-subadviser structure, describes typical subadviser structures used in the mutual fund industry and provides guidance to boards regarding their responsibilities in retaining a subadviser and overseeing the subadvisory relationship.
Retaining a New Subadviser. In selecting a subadviser, a board should expect that the principal adviser has conducted necessary due diligence on the subadviser and can explain its reasons for choosing the subadviser from among other candidates. The report discusses several issues a board should consider when evaluating a new subadviser relationship, including:
- identifying the person(s) at the principal adviser who were responsible for selecting the subadviser and reviewing their due diligence process;
- confirming that the fund's CCO has reviewed the subadviser's compliance program, including the underlying policies and procedures required under the Investment Company Act
- assessing the financial stability of and any legal or regulatory matters involving the subadviser; and
- determining whether any potential conflicts of interest exist with the subadviser, including any business or financial relationships between the principal adviser and subadviser and any similar investment strategies the subadviser uses in managing other types of accounts.
Determining whether director independence requirements under the Investment Company Act are satisfied is more difficult in a fund complex with multiple subadvisers. The report emphasizes that the Investment Company Act does not have a de minimus standard when it comes to share ownership. A single equity interest owned by a director in the subadviser or any of its control persons could negate the director's "independence."
Approving Subadvisory Agreements.
Like investment advisory agreements, boards must approve subadvisory agreements in accordance with §15(c) of the Investment Company Act. The factors considered by a board in approving a subadvisory agreement must be disclosed in the fund's shareholder reports. A board should consider factors such as the services to be provided under the agreement, subadviser compensation and subadviser performance.
A board should also determine how the subadviser will fit within the fund complex as a whole. For example, a board should consider how the subadviser will coordinate its operations with the principal adviser and fund CCO. A board should also review how a subadviser's policies and procedures, including, among other issues, portfolio management, valuation, proxy voting and soft dollars, will integrate with the adviser's and fund's policies and procedures.
A board should review the same types of information regarding a subadviser's performance that the board considers in reviewing the principal adviser's performance. The principal adviser may also provide its own analysis of the subadviser's performance. The board should review, among other things, portfolio construction and turn-over, explanations for unexpected positive or negative results, fund performance in comparison to appropriate benchmarks, the evaluation by the principal adviser and any material changes in the subadviser's investment process.
Finally, the report emphasizes a board's continuing obligation to review the adequacy of the subadviser's policies and procedures. A board may rely on the fund's CCO or others (including certifications by the subadviser itself) to assist in its evaluation of the sufficiency of the subadviser's compliance program.
Source: IDC, Task Force Report: Board Oversight of Subadvisers (January 2010). The task force report is available through the IDC's website at
Privacy Law Developments
Regulatory Agencies Issue Model Privacy Form
The SEC and seven other federal regulatory agencies have adopted a model privacy form that financial institutions, including SEC registrants, may rely on as a safe harbor to provide disclosures under the Gramm-Leach-Bliley Act and Regulation S-P (collectively, the "privacy rule"). SEC registrants may use other types of notices that vary from the model as long as they comply with the privacy rule, but would not be able to rely on these notices as a safe harbor. The purpose of the model privacy form is to provide consumers with a standardized and easily comprehensible notice that describes how financial institutions will use consumers' personal information, and enables consumers to compare how different financial institutions use their information. The model privacy form was proposed after the agencies found that privacy notices had become too long and difficult for consumers to understand, and is the result of several years of research and industry input.
The model privacy form is comprised of two pages, and covers various standard information. The model form may be incorporated into other documents. Corporate logos and color may be incorporated into the model form.
The new amendments will eliminate the sample clauses used by financial institutions to comply with privacy requirements, which were provided by the SEC in Regulation S-P as guidance, and by other federal agencies as a safe harbor. Financial institutions will not be able to rely on these sample clauses in privacy notices delivered or posted on or after January 1, 2011.
Sources: SEC Final Rule, Release No. 34-61003 (November 16, 2009); SEC Model Privacy Form, available at
SEC Small Entity Compliance Guide, available at
Effective Date: December 31, 2009
Compliance Date: December 31, 2010 (date after which financial institutions may no longer rely on sample clauses in privacy notices)
SEC Adopts Rules Regarding Internet Availability of Proxy Materials
The SEC has issued amendments to Rule 14a-16 under the Securities Exchange Act to provide greater flexibility to issuers who choose to use the notice-only method of delivering proxy materials. According to the SEC, statistics reveal lower shareholder response rates to proxy solicitations using the notice-only option. The new amendments eliminate certain legal requirements on the notice to be sent to shareholders regarding the internet availability of proxy materials, giving issuers the flexibility to include tailored explanatory language regarding why the shareholder is receiving the notice and describing the voting process.
The new amendments also extend the timeframe by which a soliciting person other than the issuer choosing to use the notice-only option must first send its proxy materials to shareholders. The current rules require that a soliciting person other than the issuer send its notice to shareholders 10 calendar days after the date the issuer first sends its proxy materials to shareholders, which can create potential compliance issues for the soliciting person (e.g., if the SEC staff's review process of the preliminary proxy statement extends beyond 10 calendar days). To alleviate this problem, the new amendments require a soliciting person other than the issuer to file a preliminary proxy statement within 10 calendar days after the issuer files its definitive proxy statement and to send its notice to shareholders no later than the date on which it files its definitive proxy statement with the SEC.
Additionally, for investment companies, the new amendments permit a summary prospectus, rather than the statutory prospectus, to accompany the notice of internet availability of proxy materials sent to shareholders.
Source: SEC Final Rule, Release No. 33-9108 (February 22, 2010).
Effective Date: March 29, 2010
SEC Adopts Amendments to Regulation SHO
The SEC has adopted new Rule 201 under Regulation SHO to place certain restrictions on short selling when a stock is experiencing downward price pressure. Generally referred to as the "alternative uptick rule," Rule 201 restricts short selling when a publicly-traded stock has declined in price by at least 10% in one day, thus triggering a "circuit breaker." Once the circuit breaker is triggered, short sellers cannot sell at or below the current national best bid. This restriction will remain in place for the remainder of the day and the following day. Rule 201 will require trading centers to establish, maintain and enforce written policies and procedures that are reasonably designed to prevent the execution of a prohibited short sale. The ICI has previously voiced opposition to any new restrictions on short selling.
Sources: SEC Final Rule, Release No. 34-61595 (February 26, 2010); SEC Press Release No. 2010-26, SEC Approves Short Selling Restrictions (February 24, 2010).
Effective Date: May 10, 2010
Compliance Date: November 10, 2010