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Investment Management Update - July 2010

July 13, 2010

Agreement Reached on Financial Reform; Legislation Awaiting Final Approval
On June 25, 2010, a joint House-Senate Conference Committee reached agreement to reconcile the two versions of financial reform legislation. Previously, the Senate had passed the "Restoring American Financial Stability Act of 2010," and the House had approved its own financial reform legislation, the "Wall Street Reform and Consumer Protection Act of 2009."

The compromise financial reform legislation, the "Dodd-Frank Wall Street Reform and Consumer Protection Act," contains the following provisions that may impact the investment management industry:

  • The legislation makes it less likely that mutual funds will be subject to supervision and regulation by the proposed Financial Stability Oversight Council. The Council, made up of representatives from various federal regulators, including the SEC chairperson, will 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. The legislation lists certain factors for the Council to consider before designating a nonbank financial company as "systemically important" and therefore subject to Council oversight. These factors include not only the size of the institution based on consolidated assets, but also the degree of leverage employed by the entity and whether assets are owned or managed, which would weigh against Council oversight of mutual funds.
  • The legislation establishes regulatory and enforcement oversight by the SEC and the CFTC of the over-the-counter derivatives markets. The legislation would require central clearing and exchange trading for many routine derivatives and would require more information to be reported for customized swaps. The SEC previously announced that it was reviewing the use of derivatives by mutual funds, ETFs and other investment companies to determine if additional protections were necessary. This investment company-specific review will likely be influenced by the derivatives provisions included in the final legislation approved by Congress.
  • The legislation also includes provisions that would eliminate the "private investment adviser" exemption under the Investment Advisers Act, thus requiring many previously exempt hedge fund advisers to register as investment advisers. In addition, the legislation raises the asset threshold for federal regulation of investment advisers from $25 million to $100 million.
  • The legislation has implications for broker-dealer regulation, potentially subjecting broker-dealers to the same fiduciary duty standards as investment advisers. Under the terms of the compromise legislation, the SEC will conduct a six-month study analyzing the differences between fiduciary duty and suitability, after which it will have the authority to impose a fiduciary standard on broker-dealers.
  • The legislation also authorizes the SEC to require point-of-sale disclosure regarding investment products and services to customers by broker-dealers.
  • The legislation gives the SEC the authority to review the threshold requirements for natural persons to qualify as "accredited investors" (i.e., income and net worth calculations) for purposes of certain private offerings. The legislation also excludes an investor's primary residence from the net worth calculation.
  • The legislation calls for a GAO study to examine mutual fund advertising.

The House approved the Dodd-Frank legislation on June 30, 2010. The Senate is anticipated to vote on the bill in mid-July. There is some concern that the delay in the Senate vote could upset the balance struck in the Committee's compromise legislation.

Sources: Dodd-Frank Wall Street Reform and Consumer Protection Act (2010); House and Senate in Deal on Financial Overhaul, The New York Times (June 25, 2010); Major Provisions in the Financial Overhaul Bill, The Wall Street Journal (June 25, 2010); SEC Press Release No. 2010-45, SEC Staff Evaluating the Use of Derivatives by Funds (March 25, 2010).

Final Measures Adopted to Curtail "Pay to Play" Practices
The SEC has adopted Rule 206(4)-5 under the Investment Advisers Act, which addresses potential "pay to play" practices by prohibiting advisers from making campaign contributions to officials who are in a position to influence the selection of advisers to provide investment advisory services (e.g., managing public pension plan assets) to state and local government clients.

Investment Advisers and Covered Associates. The rule will apply to (1) all federally registered investment advisers and certain exempt advisers and (2) the adviser's covered associates. "Covered associates" of an adviser include:

  • any general partner, managing member or executive officer of an investment adviser;
  • any employee who solicits a government entity for the investment adviser and any person who directly or indirectly supervises such an employee; and
  • any political action committee (PAC) controlled by the adviser or any of the above persons.

Whether a person is a covered associate will depend on the activities of the individual rather than on title or location on an entity's organizational chart. For example, contributions made by an officer of an investment adviser's parent company could in some instances trigger the prohibitions of the rule.

Official of a Government Entity. The rule does not enumerate the types of government officials who will be covered. Instead, the standard is that an "official" includes an incumbent or candidate for government office who will be able to influence the hiring of an investment adviser or has appointment authority over persons who will be able to influence the award of advisory business for the government entity.

Prohibition on Direct Contributions. An adviser is prohibited from receiving compensation for directly or indirectly providing advisory services to a government entity for a two-year period after the adviser or any of its covered associates makes a political contribution to an official of the government entity.

De Minimis Exceptions. There is a de minimis exception for contributions of up to $350 per candidate, per election, made to an official for whom the covered associate was entitled to vote at the time of the contribution ($150 if the covered associate was not entitled to vote for the candidate).

Bundling Contributions of Others Prohibited. The rule will prohibit an adviser and its covered associates from coordinating or soliciting any person or PAC to make any contribution or payment to an official of a government entity to which the adviser is providing or seeking to provide advisory services; or a political party of a state or locality where the adviser is providing or seeking to provide advisory services to a government entity.

Indirect Contributions Prohibited. Advisers and their covered associates are prohibited from indirectly engaging in pay to play conduct (e.g., by directing contributions through spouses or affiliates).

Third-Party Solicitors Limited. Unlike the proposed rule, which had a flat prohibition on payments by advisers and their covered associates to a third party to solicit a government entity for advisory business on the adviser's behalf, the final rule allows payments for solicitations undertaken by registered investment advisers or broker-dealers subject to similar pay to play restrictions. In a March 15, 2010 letter to the SEC, FINRA agreed to promulgate rules that would prohibit pay to play practices for broker-dealer placement agents.

Covered Investment Pool. An adviser to a covered investment pool in which a government entity invests or is solicited to invest will be treated as though the adviser were providing or seeking to provide advisory services to the government entity, and as a result, will be covered by the rule's prohibitions.

Sources: SEC Proposed Rule, Release No. IA-2910 (August 3, 2009); FINRA Letter to the SEC (March 15, 2010); SEC Final Rule, Release No. IA-3043 (June 30, 2010); SEC Press Release No. 2010-116, SEC Adopts New Measures to Curtail Pay to Play Practices by Investment Advisers (June 30, 2010).
Effective Date: September 13, 2010
Compliance Dates: Generally, advisers will be required to comply with the rule by March 14, 2011, which means that contributions made in connection with the upcoming 2010 elections will not be effected. Compliance with the prohibitions on payments to third-party solicitors and provisions applicable to advisers to registered investment companies that are covered investment pools will be required by September 13, 2011.

Staff Publishes Responses to Questions About Money Market Reform
The SEC's Division of Investment Management has issued staff responses to questions regarding the recently amended money market fund rule, Rule 2a-7 under the Investment Company Act. The following summarizes some of the guidance included in the staff responses.

Compliance with Maturity Requirements. Money market funds may use acquisitions as well as dispositions of securities to bring portfolios in line with the new limits for weighted average maturity (WAM) and weighted average life (WAL).

Amendments to Registration Statements. A fund may include disclosure required by the new money market rules either in a supplement to its registration statement filed under Rule 497 under the Securities Act or as a post-effective amendment to its registration statement filed under Rule 485(b) of the Securities Act.

Maturity Shortening Provisions. Because the maturity shortening provisions of Rule 2a-7 are not always consistent with the requirement that daily and weekly liquid assets include "only cash and securities that can be readily converted to cash," a money market fund may not rely on the maturity shortening provisions in interpreting those definitions.

Agency Notes Acquired at a Premium. A money market fund may treat non-interest bearing agency notes with remaining maturities of 60 days or less that it has acquired at or above their face value as weekly liquid assets as long as the notes were issued at a discount, with principal payable upon maturity.

Timing for Determining Liquidity. A money market fund may choose any reasonable, consistent time for determining the liquidity of its assets.

Proceeds from Sale of Securities. The requirement that a money market fund's daily and weekly liquid assets include securities that can be readily converted to cash is satisfied if a security is sold to a creditworthy buyer, and the proceeds from the sale are due unconditionally within one or five business days, respectively.

Feeder Funds. A taxable feeder money market fund may not look through to the portfolio of its master fund for purposes of meeting the daily liquid asset requirement.

Determination of Relevant Stress Events. A money market fund that invests solely in direct obligations of the U.S. Government is not required to perform a stress test for downgrades or defaults if the fund's board determines that these type of stress events are not relevant for the fund and a record of the determination is retained.

"Upside" Stress Testing. A money market fund is not required to test its portfolio for the risk that it might "break the buck" on the upside.

Stress Testing for Downgrade and Defaults. The newly-required stress tests for downgrades and defaults of portfolio securities should be designed to assist a money market fund's board in assessing the effect of isolated stresses on a fund's shadow NAV. If a downgrade or default is likely to cause the shadow NAV to deviate by more than one-half cent per share, the test should indicate the full extent of the loss a fund might be expected to incur as a result.

Stress Test Reports. A money market fund's board may receive a single report at its regularly scheduled meetings that presents results from each of the monthly stress tests that were conducted since the last regularly scheduled meeting.

"Know Your Customer" Requirements and Stress Testing. A money market fund should include an evaluation of its shareholders' liquidity needs in stress testing procedures.

Designated Credit Rating Agencies Not Always Required. If a money market fund invests only in certain government securities or repurchase agreements collateralized by such government securities, and as a result does not need to rely on ratings from NRSROs, the fund's board is not required to designate NRSROs.

Number of Designated NRSROs. A money market fund does not have to designate four NRSROs for every type of security it holds, or even to designate at least one NRSRO for every type of security held, in light of the fact that a money market fund may hold unrated securities.

Use of Designated NRSROs. A money market fund must incorporate the use of credit ratings from its designated NRSROs in determining whether a security is an eligible security by the time it discloses its selections of designated NRSROs (but no later than December 31, 2010).

Effect of Designation of NRSROs. When a money market fund's board designates its NRSROs, the board must review whether the designation affects the eligibility of portfolio securities held prior to the designation.

Change in Designated NRSROs. If one of the NRSROs designated by a money market fund's board will cease to provide credit ratings or will merge with another NRSRO, the board may designate a new NRSRO at any regularly scheduled meeting held before the event occurs, or the board may postpone the new designation until after the event as reasonably necessary.

Asset Backed Securities. In performing the minimal credit risk evaluation for asset backed securities (ABS), a money market fund's board must consider all relevant elements required to determine the ABS' risk but is not required to consider other elements discussed in the adopting release if not relevant.

Website Posting of Investments. A money market fund is not required to post its schedule of investments on its website for periods prior to September 30, 2010.

Money Market Funds Selling Only to Affiliated Funds. A money market fund that offers and sells shares only to investment companies that are part of the same "group of investment companies" still has to comply with the rule's website disclosure requirements.

Website Links to Form N-MFP. A money market fund must post an actual link to each of its most recent 12 monthly Form N-MFP filings on the SEC's website (Form N-MFP filings will be available starting on January 31, 2011), rather than just providing a link to the SEC's website. On June 25, 2010, the Division of Investment Management staff issued additional responses to questions related to Form N-MFP and related Rule 30b1-7.

Website Disclosure of Master-Feeder Fund's Portfolio. A feeder money market fund must disclose the master fund's portfolio holdings either in its monthly website posting or by providing a link to the master fund's website.

WAM and WAL Disclosure. A money market fund should provide its WAM and WAL on the same web page with the required listing of securities.

Sources: SEC Staff Responses to Questions About Money Market Fund Reform (updated as of May 25, 2010), available at; SEC Staff Responses to Questions About Rule 30b1-7 and Form N-MFP (updated as of June 25, 2010), available at:; SEC Final Rule, Release No. IC-29132 (February 23, 2010).

SEC Updates Responses to Questions on Investment Advisor Custody Rule
The SEC staff released updated 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 updated guidance included in the staff responses.

Custody Based on Authority to Withdraw Client Assets. An adviser will be deemed to have custody if it has authority to withdraw client assets maintained with a qualified custodian upon the adviser's instruction to the custodian. However, this authority to withdraw assets does not include the limited authority to transfer a client's assets between the client's accounts at one or more qualified custodians, if the client has provided written authorization for the adviser to make the transfers and a copy of the authorization is provided to the qualified custodian.

Remittance of Client Funds and Securities. An adviser does not have custody based on having authority to instruct a qualified custodian to remit funds or securities from a client's account to the client's address of record if the client has provided written authorization and a copy has been provided to the qualified custodian, and the adviser does not have authority to open an account on behalf of the client or the authority to designate or change the client's address of record with the qualified custodian.

Password Access and Custody. An adviser that has the ID number and password to a client's pension fund account will be deemed to have custody if the password access enables the adviser to withdraw funds or securities or transfer them to an account that is not in the client's name at a qualified custodian.

Account of a Related Natural Person. Custody will not be imputed to an adviser simply because the adviser has a related natural person who owns an account advised by the adviser, as long as the related person is both the legal and beneficial owner of the account.

Fee Deductions. An adviser will not be deemed to have custody if a client instructs its qualified custodian (that is not a related person of the adviser) to debit the client's account for quarterly advisory fees, and the custodian calculates the fees based on the advisory contract.

Pooled Investment Vehicles. In situations where a pooled investment vehicle does not use the "audit provision" of the custody rule (i.e., the financial statements of the pooled investment vehicle are not audited and distributed to investors), then in order to comply with the rule, the adviser must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends quarterly account statements to each investor in the pool and must obtain an annual surprise examination with respect to the pool's assets. The accountant's confirmation procedures for the surprise examination should include confirmation with the pool's investors.

Source: SEC Staff Responses to Questions About the Custody Rule (updated as of May 20, 2010), available at

New Rules for Fund Transaction Reporting and AML Programs
The Financial Crimes Enforcement Network (FinCEN) has issued final amendments to the Bank Secrecy Act (BSA) regulations that will impact financial transaction reporting and recordkeeping for mutual funds, as well as funds' AML programs. The rules include the following provisions:

Filing Currency Transaction Reports. Instead of filing a Form 8300 report, funds will be required to file a currency transaction report (CTR) for incoming, outgoing or exchange transactions of more than $10,000 in currency in a single business day. Funds must treat multiple transactions as a single transaction if the fund has knowledge that the transactions are being conducted by or on behalf of the same person. The CTR rule has a narrower definition of "currency" (i.e., cash only, not negotiable instruments). CTRs will contain information that is not typically included in a suspicious activity report (SAR) distinguishing them from the Form 8300 reports that often duplicated information in SARs. These amendments will streamline and reduce the compliance burden on funds.

Recordkeeping and Travel Rule. Funds will be required to create and retain records for transmittals of funds of $3,000 or more, and to transmit information on these transactions to other financial institutions in the payment chain. This "recordkeeping and travel" rule requires a transmittor's financial institution to retain the transmittors' name, address and other information about the transaction, as well as requiring the recipient's financial institution to retain identifying information on the recipient. Certain information obtained by the transmittor's financial institution will be required to "travel" with the transmittal order through the payment chain. Mutual funds will be included within an existing exception for transfers or transmittals of funds in which certain categories of financial institutions are the transmittor, originator, recipient or beneficiary. The recordkeeping aspects of the amendments are likely to have a de minimis impact on the information required to be maintained by funds and transfer agents due to existing recordkeeping rules. However, changes to transaction processing and recordkeeping systems may be required to allow information to be retrieved in the manner required under the rule.

Examination Authority Delegated to SEC. The rules also expressly remove investment companies from the list of financial institutions the IRS may examine for compliance with the BSA. Instead, FinCEN delegated authority to the SEC to examine investment companies for BSA compliance.

Sources: Financial Crimes Enforcement Network; Amendment to the Bank Secrecy Act Regulations; Defining Mutual Funds as Financial Institutions, 75 FR 71 (April 14, 2010).
Effective Date: May 14, 2010
Compliance Date for Recordkeeping and Travel Rule: January 10, 2011

Proposed Disclosure for Target Date Funds

The SEC recently proposed rule amendments that are directed at clarifying marketing and advertising materials for target date retirement funds. The SEC's proposal follows an Investor Bulletin that was jointly issued by the SEC and the Department of Labor in May, which provided general information about target date funds to investors, including participants in 401(k) plans. The proposed rules include the following provisions:

"Tag Line" Adjacent to Fund Name. Marketing materials for a fund with a target retirement date in its name would need to include a "tag line" adjacent to the first use of the fund's name, stating the fund's target date asset allocation. For example, a 2020 target date fund tag line could list an allocation breakdown of 40% equity, 50% fixed income and 10% cash in 2020.

Graphic Depiction of Asset Allocation. Target date fund marketing materials would be required to include a prominent table, chart or graph showing the asset allocations of the fund over its entire life (i.e., the fund's "glide path"), together with a statement that, among other things, would highlight the fund's asset allocation at the "landing point" (the date when the fund reaches its final asset allocation).

Disclosure of Risks. The proposed amendments would require target date fund marketing materials to:

  • direct an investor to consider the investor's risk tolerance, personal circumstances and complete financial situation;
  • disclose that an investment in the fund is not guaranteed and that an investor could lose money by investing in the fund, including at and after the target date; and
  • disclose whether the fund may modify its intended allocations without a shareholder vote.

Antifraud Guidance. The SEC also proposed changes to its general antifraud guidance for all funds, not just target date funds. The proposed guidance cautions that statements in fund marketing materials suggesting that fund securities are an appropriate investment could be misleading based on:

  • emphasizing a single factor, such as age or tax bracket, to use to determine whether an investment is appropriate; or
  • representing that investing in a fund is a simple investment plan or requires little or no monitoring by the investor.

Sources: SEC Proposed Rule, Release No. IC-29301 (June 16, 2010); SEC Press Release No. 2010-103, SEC Proposes New Measures to Help Investors in Target Date Funds (June 16, 2010); DOL and SEC Investor Bulletin, Target Date Retirement Funds (May 6, 2010).
Comments Due: August 23, 2010

FASB Proposal Regarding Transaction Cost Reporting

FASB recently issued a proposed accounting standards update that could impact the presentation of fund expense information. The proposal would seek to bring more transparency in the valuation of various financial instruments by incorporating amortized cost and fair value information. The proposal has significant implications for the banking sector based on its recommended expansion of mark-to-market accounting, including the requirement that banks account for most loans at fair value.

FASB's proposal would also impact the investment management industry. The proposal indicates that transaction costs and fees (including brokerage expenses) associated with an investment should not be included in determining the value of the investments and should be broken out and separately reported. This change in treatment could require funds to reflect transaction costs as current period expenses rather than bundling such costs into the underlying value of trades. Commentators have suggested that this in turn could lead to transaction costs being included in funds' overall expense ratios.

Sources: FASB, Proposed Accounting Standards Update (1810-100), Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities-Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815) (May 26, 2010); Ignites Article, Accounting Proposal Could Bump Up Expense Ratios (June 17, 2010).
Comments due: September 30, 2010

Media Contact 

If you have a media request or need an attorney with particular knowledge for comment, please contact Kyle Mondy, Marketing & Communications Manager, at 414.287.9481 or


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