August 2011
Inside this issue:
The Supreme Court’s Janus
Decision: No Secondary
Liability, but Many Secondary
Questions .................................. 1
D.C. Circuit Strikes Down
SEC Proxy Access Rule ............ 5
Congressional Panel
Considers Systemic Risk of
Mutual Funds ............................. 6
Floating NAV Proposal
Dominates SEC Systemic
Risk Roundtable ........................ 8
Custodians Alleged to
Overcharge in Foreign
Exchange Transactions ............. 9
SEC Issues Report on
Review of Reliance on
Credit Ratings ............................ 9
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The Supreme Court’s Janus Decision: No
Secondary Liability, but Many Secondary
Questions
The U.S. Supreme Court’s recent decision in Janus Capital Group, Inc. v. First
Derivative Traders raises questions for fund directors about the allocation of
liability for prospectus errors and whether directors should take additional
measures either to protect their funds and themselves from liability for
prospectus errors or to provide their funds’ investment adviser with
additional incentive to ensure the accuracy and completeness of fund
prospectuses.
The Janus Decision. The Janus case is unusual in that the plaintiffs, who
alleged that the prospectuses of certain Janus funds contained material
misstatements, were suing as shareholders of the investment adviser’s parent
company, Janus Capital Group, Inc. (“Janus Capital”), not as fund shareholders.
Plaintiffs claimed that shares of Janus Capital lost value when its assets under
management declined because of regulatory action against company affiliates in
the 2003 market-timing scandal.
Plaintiffs brought an action against Janus Capital for alleged misstatements about
market timing in the funds’ prospectuses, under the Securities Exchange Act of
1934 (“1934 Act”) Rule 10b-5, which declares it unlawful “to make any untrue
statement of a material fact” in a prospectus. The Court, in a 5-4 decision, ruled
in favor of Janus Capital, finding, in effect, that the only person who can be
liable under Rule 10b-5 is the person “making” the statement, in this case the
funds that issued the prospectuses. The Court held that the Janus funds
ultimately controlled the content of their own prospectuses; therefore, the funds,
and not the other persons or entities who contributed information to the
document, were the makers of the statements in question.
The Court observed that the Securities and Exchange Commission (“SEC”)
has authority to bring a case for aiding and abetting violations of Rule
10b-5, under which the various contributors to the prospectus might have
been liable, but that there is no private right of action for aiding and
abetting such a violation. The Janus decision represents a determined effort by
the Court not to allow such secondary liability to slip in through a back door.
The decision is noteworthy for the complete absence of language found in many
earlier decisions stating that the federal securities laws are “remedial statutes”
and should be interpreted broadly in accordance with their remedial intent.
Allocation of Liability After Janus. The Janus decision did not significantly
change registration statement liability for funds, their directors or their advisers.
However, given the structure of the typical investment company complex, in
which the funds have no employees of their own and employees of the adviser
and the administrator provide all of the funds’ officers and all services necessary
to the funds’ day-to-day operation, the decision has left many in the industry
scratching their heads. If the adviser is not
responsible for the prospectus content, who is?
Some have expressed concern that under the Janus
ruling, fund directors may face increased liability
for prospectus errors. They question whether, if
the adviser is not the maker of the statements in
the fund’s prospectus, that leaves fund directors in
the position of being the only responsible party.
But is that right? The role of a board of
directors is generally oversight, not execution.
Rather, it is the officers of a corporation who are
responsible for its executive function. It is
arguable whether even they would be deemed to
have made the statements contained in a fund’s
prospectus under the Supreme Court’s new
interpretation of Rule 10b-5, but one would think
the light would shine on them before it falls on
independent directors.
Perhaps more to the point, very few prospectus
liability cases are brought under Rule 10b-5. The
rule imposes on the plaintiff the burden of proving
that the defendant acted with scienter (or at least
with recklessness), and that the plaintiff (or the
market) relied on the false statement. Plaintiffs’
counsel typically find it much more appealing
to bring prospectus cases under Section 11 of
the Securities Act of 1933 (“1933 Act”), which
imposes liability for losses stemming from a
registration statement that was materially false or
misleading at the time it went effective.
Section 11 liability falls on the fund, its
directors, certain officers and anyone who has
“expertised” the allegedly false portion of the
prospectus (e.g., the auditors). The plaintiff is
not required to prove scienter or even
recklessness. Defendants in such cases may have
defenses available, but they are just that –
defenses. The burden falls on the defendants to
establish those defenses once the plaintiff has
asserted a prima facie case.
Clearly, the Janus case did nothing to change
liability under Section 11, since that question
was not before the Court. And although the
adviser itself may not be a defendant in a
Section 11 case, the fund’s inside directors and
certain officers, who typically are significant
players in the advisory organization, likely would
be defendants. Fund officers and directors do
have available under Section 11 a “due diligence”
defense; however, the officers and inside
2
August 2011
directors, precisely because they are insiders, may
have a more difficult time than would the
independent directors in establishing that they did
not know the truth of the matter at the heart of the
plaintiff’s claim.
Advisers and their affiliates are potentially
liable under other provisions of the federal
securities laws as well. For example, plaintiffs
may sue a fund’s distributor – often an affiliate of
the adviser – under Section 12 of the 1933 Act for
selling shares by means of a materially false
prospectus. Additional provisions of the federal
securities laws, enforceable only by the
government, also might be used to impose
monetary liability and other penalties on an
adviser for misstatements in the fund’s
prospectus. Thus, the Janus case did very little
to alter the potential liability of advisers,
funds, or fund officers and directors in cases
where a fund’s prospectus is arguably false.
That said, however, the discussion generated by
the case would seem to present directors with
the opportunity to consider several matters
that could be important in allocating liability
in a case alleging a false prospectus. These
matters are (1) the best way for fund directors
to carry out their “due diligence” regarding
the content of fund registration statements; (2)
the provisions of advisory, administrative and
distribution contracts that allocate liability
between those entities and the fund for prospectus
misstatements and omissions; and (3) various
avenues for indemnification and shared
liability, including D&O/E&O coverage and an
indemnification agreement with the adviser.
Due Diligence. As noted, Section 11 of the 1933
Act provides fund directors, among others, with a
defense against liability based on their having
performed due diligence to assure themselves of
the accuracy and completeness of the registration
statement. In the wake of Janus, some boards of
directors are reviewing carefully the manner in
which such a defense might be established. The
investment process is largely intangible, and
director due diligence might therefore be
enhanced by a focus on process and
safeguards.
•
Certainly, it may be important to show that
a director or his/her delegate (e.g., a board
Investment Management Update
(who may also be fund officers) and fund
counsel, could one ever reconstruct in
retrospect which information had been
“provided by” an officer of the adviser, acting
as such?
committee or counsel) reviewed the
prospectus carefully.
•
In this day of complex securities and
investment strategies, directors may be well
advised to consider additional measures
consistent with their traditional oversight role.
Some boards are asking how the
prospectus is prepared and vetted, and by
whom. Who signs off on each section of the
prospectus, and what records are kept of the
sign-off? Does a person familiar with the
risks of the investment program, other than
the portfolio manager, review and sign off on
the risk disclosure? Does the Chief
Compliance Officer or someone else regularly
review the portfolio to make sure it remains
within the limits stated in the prospectus and
statement of additional information? What
comments were received from the SEC staff
during the initial or annual update filing of the
registration statement, and how were they
addressed? Does independent board counsel
or outside fund counsel play a meaningful role
in preparing and vetting the document? Do
his or her comments and concerns carry
weight with the adviser?
Contractual Provisions. Fund directors also may
want to review provisions in the advisory or
distribution contracts allocating liability for false
statements in or omissions from the prospectus.
The contracts may say nothing at all about the
subject, or the fund may undertake to
indemnify the adviser or distributor for such
liability, unless it stems from information in the
prospectus that was provided to the fund by the
adviser or distributor in writing.
•
•
Directors may want to consider whether
such provisions are appropriate in the
investment company context, where the
adviser typically provides all operating staff
for the fund and has the primary knowledge
about the fund’s activities and processes
described in the prospectus.
Directors also may want to consider how
such provisions will operate in practice.
Given the process by which prospectuses
typically are drafted, involving a lengthy
exchange of information and comments
among employees of the adviser or distributor
Insurance, Indemnification and Shared
Liability. Fund directors also may want to
consider whether they and their funds can
improve the benefits they might expect to
receive under liability insurance,
indemnification provisions or other
approaches.
D&O/E&O Insurance. While fund directors
generally assume that they have insurance
coverage for prospectus liability, some insurers
have argued that Section 11 claims are not
covered.
•
Certain insurers have focused on the
definition of “Loss,” which in certain policies
contains a carve-out excluding from coverage
amounts paid that are “uninsurable” as a
matter of public policy.
•
Certain insurers have argued that public
policy should preclude coverage for Section
11 claims on the basis that such claims
arguably seek disgorgement or restitution of
an ill-gotten gain.
Policyholders have vigorously contested such
arguments, and courts have reached mixed
results based on the policy language at issue and
controlling law.
•
In certain cases, policyholders have argued
that when an insurer has expressly afforded
broad coverage for “Securities Claims”
(which is often defined to include claims
under the 1933 Act and the 1934 Act), an
insurer should not be able to rely on a vague
“public policy” exception to deny coverage
for Section 11 claims.
•
Policyholders also have contested whether
Section 11 claims in fact seek disgorgement
of an ill-gotten gain.
•
Further, policyholders have argued that
“public policy” should not preclude coverage
for the settlement of a disputed claim when
there has been no judgment establishing that
some illegal conduct occurred. These
3
negligence or reckless disregard of the duties
involved in the conduct of his office.” It
implies only that the plaintiff made a prima
facie case that the registration statement was
false when it became effective, and that the
director failed to establish the defense of
having made a “reasonable investigation” of
the facts underlying the statements in
question. Difficult questions of fiduciary duty
could arise if such an indemnification
agreement might involve a higher advisory
fee to compensate the adviser for added risk.
arguments might have particular force with
respect to directors (as opposed to the fund or
adviser), given that directors receive only a
set fee from the fund for their services and do
not share in amounts obtained through an
allegedly false prospectus.
In any event, it should be noted that many
insurers are now offering new policy language
or endorsements that expressly confirm the
intent to provide coverage for Section 11
claims. Policyholders may wish to ensure that
their policies contain the broadest language
available.
Indemnification. In the wake of Janus, some
have raised the prospect of fund directors
seeking an agreement that the adviser will
indemnify the fund and the directors for
liability resulting from a prospectus
misstatement. Such indemnification
presumably would be available only when the
parties could not obtain payment under the
insurance policy or when the directors could
not obtain indemnification from the fund
under its charter and bylaws.
Some have questioned whether an agreement for
such director indemnification would be legally
enforceable.
•
•
4
Section 17(h) of the Investment Company Act
of 1940 (“1940 Act”) does provide a limit on
director indemnification, in that it prohibits
“any . . . instrument pursuant to which [a
registered investment company] is organized
or administered” from containing any
provision to protect a director or officer of
such company against liability to the company
or its shareholders “to which he would
otherwise be subject by reason of willful
misfeasance, bad faith, gross negligence or
reckless disregard of the duties involved in the
conduct of his office.”
However, an agreement between an
investment adviser and each director of a fund
would not seem to be “an instrument pursuant
to which [a registered investment company] is
organized or administered.” And, the fact that
an investment company director has been
found liable under Section 11 does not mean
that the director necessarily has engaged in
“willful misfeasance, bad faith, gross
August 2011
The SEC also asserts that it may be “against
public policy” for directors to receive
indemnification for Section 11 liability.
•
The SEC argues that such indemnification
tends to undermine the purpose of such
liability, which is to strongly encourage
directors to do their jobs in probing the
accuracy of prospectus disclosure. Be that as
it may, such a position would seem to stand
public policy on its head where it is used to
prevent indemnification by the party that is in
the best position to assure the accuracy of the
registration statement.
None of these questions would seem to affect an
agreement whereby the adviser undertakes to
indemnify the fund for prospectus liability costs.
Shared Liability. Directors might avoid all of
these questions with another approach – asking
the advisory organization to sign the fund’s
registration statement. Section 11, besides
imposing liability on the issuer and its officers
and directors, also imposes liability on “every
person who signed the registration statement.”
All parties except the fund, but including the
adviser, would have access to Section 11’s due
diligence defense. As between the adviser and
the outside fund directors, however, the adviser
would seem to be in the weaker position to
establish such a defense. Accordingly, such a
practice would seem to rectify any imbalance that
fund directors believe may have been created by
the Janus decision.
Such an arrangement would certainly provide
additional assurance – if any is needed – that the
adviser has a strong financial interest in the
accuracy of the fund’s prospectus. It may,
however, raise other concerns, such as whether
Investment Management Update
the “deep pockets” of the adviser would attract
more strike suits. These questions must be
considered carefully before proceeding.
D.C. Circuit Strikes Down
SEC Proxy Access Rule
The U.S. Court of Appeals for the D.C. Circuit
dealt the beleaguered SEC another blow on July
22, 2011, when, at the behest of the Business
Roundtable and the Chamber of Commerce of the
United States, it struck down the SEC’s recently
adopted proxy access rule that required public
companies, including mutual funds, to provide
proxy disclosure and require a shareholder vote
related to shareholder-nominated candidates for
the company’s board of directors.
The SEC adopted Rule 14a-11 under the 1934 Act
to allow corporate shareholders to nominate a
candidate for election to their corporation’s board
of directors through procedures less onerous than
the normal proxy contest rules. Adopted by a
divided SEC vote of three to two, the rule
generally permitted shareholders – who
continuously have held at least 3% of the voting
power of the corporation for the prior three years
– to require the corporation (subject to certain
exceptions) to include in its proxy statement
information about the shareholder nominee.
The effective date of the rule had been stayed
pending the outcome of this case.
The case was the third instance in recent memory
that the Court criticized the SEC for “fail[ing]
adequately to consider [a] rule’s effect upon
efficiency, competition, and capital formation.”
The Court, in a unanimous opinion, harshly
chastised the SEC for having “inconsistently and
opportunistically framed the costs and benefits of
the rule; failed adequately to quantify the certain
[sic] costs or to explain why those costs could not
be quantified; neglected to support its predictive
judgments; contradicted itself; and failed to
respond to substantial problems raised by
commenters.” The Court also noted that the
SEC’s “decision to apply the rule to investment
companies was also arbitrary.”
The Court agreed with the allegations that the
SEC had inadequately considered various
economic consequences of the rule by not
quantifying the costs companies would incur
opposing shareholder nominees or substantiating
the rule’s predicted benefits, particularly in the
context of union and state pension fund
shareholders and mutual fund issuers. The view
of the petitioners, with which the Court agreed,
was that issuers would oppose shareholder
nominees with greater intensity, at a greater cost,
than presumed in the SEC’s analyses. For
example, the Court quoted a Chamber of
Commerce submission to the SEC commenting
that boards would expend significant time and
money opposing shareholder nominees through
“significant media and public relations efforts,
advertising . . . , mass mailings, and other
communication efforts, as well as the hiring of
outside advisors and the expenditure of
significant time and effort by the company’s
employees.” With regard to those allegations, the
Court concluded that the SEC did not
sufficiently provide reasonable explanations
for its determination that the eventual costs
may be less than commenters’ estimates.
Moreover, where the SEC relied on published
reports as an empirical basis for determining that
the rule would improve board performance and
increase shareholder value by facilitating the
election of dissident shareholder nominees, the
Court concluded that the studies relied on by
the SEC were “relatively unpersuasive.” The
Court was also not impressed by the SEC’s
determination that the ownership and holding
period requirements for shareholders entitled to
propose nominees limited the number of
opportunities for reliance on the rule. There the
Court agreed with the allegations that union and
state pension funds might use the rule “as
leverage to gain concessions, such as additional
benefits for unionized employees, unrelated to
shareholder value,” and criticized the SEC for
“ducking a serious evaluation of the costs” that
companies might incur in fighting these special
interests. In keeping with its lack of deference to
the SEC’s process, the Court also called the
SEC’s reasoning “inconsistent and therefore
arbitrary” because it “anticipated frequent use of
[the rule] when estimating benefits, but assumed
infrequent use when estimating costs.”
5
A separate portion of the Court’s opinion dealt
with the unique issues presented by mutual
funds, particularly those with unitary boards –
where one group of directors sit as the board of all
funds in a complex – or cluster boards – where
each of two or more groups of directors oversees a
distinct set of funds in a complex. For one thing,
the Court stated that the SEC “did almost
nothing to explain” what benefits the rule
could add for fund shareholders, given the
significant regulatory protection already
provided by the Investment Company Act of
1940.
The Court also stated that the SEC “failed to
deal with” the concerns about increased costs
imposed by the rule on unitary or cluster
boards “with the introduction of shareholdernominated directors who sit on the board of a
single fund, thereby requiring multiple,
separate board meetings and making
governance less efficient.” In addressing the
SEC’s explanations justifying application of the
rule in this context, the Court was its harshest.
First, responding to the SEC’s views that costs
would be lower for funds because, among other
things, their shareholders were primarily retail
investors who would not meet the ownership and
holding requirements, the Court criticized the
SEC for not taking into account that less
frequent use of the rule also reduces the rule’s
expected benefits.
Second, the Court characterized the SEC’s
assertion that unitary and cluster boards could
mitigate disruptions through use of confidentiality
agreements as “without any evidentiary support.”
Moreover, continuing its theme that the SEC had
not adequately addressed concerns raised
during the comment process, the Court
continued that the SEC’s position was
“unresponsive to the contrary claim of [funds] that
confidentiality agreements would be no solution
because the shareholder-nominated director would
have no fiduciary duty to other funds in the
complex and, in any event, could not be ‘legally
obliged’ to enter into a confidentiality
agreement.”
Finally, the Court quoted the SEC’s adopting
release to the effect that increased costs and
decreased efficiency of a unitary or cluster board
would only occur if in fact the shareholder6
August 2011
nominated director was elected, and that the
proxy materials could lay out the costs and
benefits of that board structure and the impact of
electing a shareholder-nominated director. That
rationale the Court characterized as “tantamount
to saying the saving grace of the rule is that it
will not entail costs if it is not used, or at least
not used successfully to elect a director.” That,
said the Court, is an “utterly mindless reason”
for applying the rule to funds.
Congressional Panel
Considers Systemic Risk of
Mutual Funds
On June 24, 2011, a Subcommittee of the House
Financial Services Committee held a hearing to
discuss oversight of the mutual fund industry.
The hearing was well attended by members of
both parties and, in contrast to some recent
oversight hearings, was non-partisan. The
hearing separately focused on (i) money market
fund (“MMF”) reform options and (ii) the
possibility of any type of mutual funds being
considered systemically important financial
institutions (“SIFIs”), subject to heightened
supervision and regulation by the Board of
Governors of the Federal Reserve System
(“Federal Reserve”).
Suggested MMF Reform Options
Floating Net Asset Value (“NAV”). The hearing
appears to have been organized in part as a
counter to the May 10, 2011 roundtable
(“Roundtable”) hosted by the SEC, at which
banking regulators and others advocated for the
adoption of a floating NAV to mitigate the
systemic risk of MMFs, particularly the risk of
runs on the MMF industry.
In October 2010, the President’s Working Group
on Financial Markets (“Working Group”) had
issued a report finding that the SEC’s 2010 MMF
reforms were inadequate to mitigate MMF
susceptibility to runs and the related instability
such a run might cause. In response, the SEC is
considering various additional reforms proposed
by the Working Group. Of these reforms, the
Investment Management Update
floating NAV continues to be the dominant
proposal.
Echoing views expressed by bank regulators at the
Roundtable, Subcommittee Chairman Garrett (RNJ) and Congressmen Royce (R-CA) and
Neugebauer (R-TX) expressed concerns that the
stable NAV creates a perception that MMFs
are government-guaranteed. Advocates of the
floating NAV proposal argue that a floating NAV
would clarify that MMFs are investments subject
to losing value.
Mr. Paul Schott Stevens of the Investment
Company Institute (“ICI”); Mr. Scott Goebel
of Fidelity Management & Research Company
(“Fidelity”); and Mr. Mercer Bullard of the
University of Mississippi School of Law,
testified that moving to a floating NAV would
end investors’ use of MMFs – because of various
obligations to seek, as well as conveniences of
investing in, a stable value instrument – and do
nothing to reduce any possible systemic risks.
Mr. Stevens argued that the resulting decline of
the MMF industry would, in turn, negatively
impact access to short-term funding by
corporations and state and local governments.
During his opening statements, Chairman Garrett
made similar comments, pointing out that any
reform that led to the demise of the MMF industry
would create a significant risk that the money
invested in MMFs would migrate to
unregulated sectors of the economy.
Mr. Andrew “Buddy” Donohue, former Director
of the SEC’s Division of Investment
Management, also made similar comments, noting
that if MMFs were no longer attractive investment
options, institutional investors may access the
commercial paper market through unregulated
pools.
Mr. René Stulz, a professor at The Ohio State
University, was the only witness who believed
that moving to a floating NAV was an option that
should be studied. While acknowledging that
some operational difficulties would need to be
considered, Mr. Stulz argued that a floating
NAV has the advantage of full transparency
over other reform options.
Capital Buffers and Other Reform Proposals.
The witnesses also discussed other options for
reducing any systemic risk associated with
MMFs. Mr. Goebel and Mr. Stulz both favored a
capital buffer requirement, but each had a
somewhat different approach to this option. As
advocated by Mr. Goebel on behalf of Fidelity,
MMFs would hold back a portion of the yield
shareholders would otherwise receive to
gradually build a capital buffer. As advocated
by Mr. Stulz, MMF sponsors would contribute
a capital buffer all at once. During times of
financial distress, the capital buffer would
provide the MMF with liquidity and help to
absorb losses.
Mr. Stevens spoke favorably of the capital buffer
option, but also advocated the ICI’s
recommendation to create a liquidity bank.
Under this approach, MMFs would contribute
capital to a liquidity bank, which would serve
as a source of liquidity and as a market maker
for commercial paper during times of crisis. In
rare circumstances, this bank would also have
access to the Federal Reserve’s Discount
Window.
Mutual Funds as SIFIs
Under the financial regulatory reforms mandated
by the Dodd-Frank Wall Street Reform and
Consumer Protection Act (“Dodd-Frank Act”),
the Financial Stability Oversight Council
(“FSOC”) is currently developing criteria for
identifying SIFIs. Chairman Garrett,
Congressman Dold (R-IL), and Congressman
Perlmutter (D-CO) expressed concern over the
ongoing lack of clarity regarding the FSOC’s
criteria for designating SIFIs.
Mr. Stulz asserted that the final SIFI criteria
should be objective and quantifiable, adding that
he expected there to be no more than 50 SIFIs.
Chairman Garrett then asked Mr. Stulz to aid in
setting forth designation criteria, and Mr. Stulz
agreed to follow up with a list of criteria for the
hearing record. Congressman Perlmutter added
his belief that although the criteria should be
objective, it was difficult for regulators to predict
in advance where systemic risk would develop
and, therefore, regulators should consider a broad
array of factors.
Later in the hearing, Congresswoman Maloney
(D-NY) expressed her concern that the FSOC was
not giving enough weight to the statutory criteria
that SIFIs be highly leveraged. She noted that
7
one of the main problems of failing firms during
the crisis was their use of excessive leverage,
which mutual funds are prohibited from having
under the 1940 Act.
of both worlds”—the ability to offer a higher
yield and an implicit government guarantee, all
without bank-like regulation and capital
requirements.
All of the witnesses agreed that mutual funds,
with the exception of MMFs, did not pose risks
to the broader financial markets. No member
of the Committee challenged this assertion.
Although generally conceding that runs on MMFs
pose a systemic risk, investors, money
managers, and representatives of the mutual
fund industry defended the status quo.
According to Robert Brown, president of the
money market group at Fidelity, a lack of
portfolio transparency – not the stable NAV –
caused the flight from MMFs in September 2008,
when the Reserve Primary Fund broke the buck.
Mr. Brown asserted that new requirements to
disclose a MMF’s portfolio composition will
prevent sophisticated investors from pulling their
money out of MMFs in periods of illiquidity.
Although industry participants avoided conceding
that MMFs do pose a risk to the financial system,
the two academics on the panel, Mr. Stulz and
Mr. Bullard, testified that MMFs could
contribute to systemic risk, and therefore could
be SIFIs, citing events when the Reserve Primary
Fund broke the buck. The European debt crisis
was discussed as well, but the panelists generally
downplayed any potential negative impact it could
have on MMFs and the larger U.S. financial
system.
Floating NAV Proposal
Dominates SEC Systemic
Risk Roundtable
At a May 10, 2011 roundtable, the SEC assembled
a panel of regulators and industry representatives
to discuss various options for reducing the
systemic risk associated with MMFs, namely the
possibility of a run on the fund. Although various
proposals were on the agenda, a proposal to
convert the MMF’s stable NAV to a floating
NAV dominated the conversation.
The strongest push to eliminate the stable NAV
came from Paul Volcker, former Chairman of
the Federal Reserve Board. He said that MMFs
were created as “pure regulatory arbitrage” in
order to pay interest on demand deposits and are
“incontestably” prone to runs. He asserted that
the simplest solution is to adopt a floating NAV,
which would eliminate what some view as an
implicit $1-per-share guarantee associated with
MMFs.
Similarly, Sheila Bair, Chairman of the Federal
Deposit Insurance Corporation, argued that the
stable NAV model is “broken” because, in her
view, its implied government guarantee creates a
moral hazard. To her, this gives MMFs the “best
8
August 2011
Seth Bernstein, head of fixed income at J.P.
Morgan Asset Management, argued that
mechanisms to enable MMF boards of
directors to suspend redemptions and liquidate
will mitigate the possibility of a run threatening
the entire system.
Travis Barker, Chair of the Institutional
Money Market Funds Association, questioned
whether a floating NAV would reduce systemic
risk at all. He pointed out that MMFs in other
countries have floating NAVs and they are as
susceptible to a run as are MMFs with stable
NAVs.
The strongest advocate for the MMF industry was
John “Jerry” Hawke, former Comptroller of
the Currency. After Mr. Volcker openly
questioned whether MMFs serve any public good
meriting a government backstop, Mr. Hawke
defended them as providing a mechanism for
investors to manage their cash and maintain
liquidity and diversification. Mr. Hawke insisted
that MMFs need a mechanism for managing
liquidity crises; they do not need bank-like
regulation. Like Mr. Barker, he pointed out that
a floating NAV would not prevent future runs.
In the middle of the discussion, Mary Schapiro,
SEC Chairman, redirected the conversation to the
institutional investors on the panel, explicitly
asking them how important the stable NAV is to
them. Kathryn Hewitt, representing the
Government Finance Officers Association, and
Carol DeNale, Senior Vice President and
Investment Management Update
Treasurer at CVS Caremark, stated firmly that
they would not invest in any MMF with a
floating NAV. It is not clear, however, where
else they would invest because they also said they
would not invest in bank deposits. They reasoned
that bank deposits cannot match the
diversification benefits of an MMF.
At the end of the meeting, the panel discussed
other possible reform options as alternatives to
the floating NAV. These options include
imposing bank-like capital reserve
requirements or creating a liquidity bank with
access to the Federal Reserve’s Discount
Window. Several members of the panel,
including Mr. Volcker, cautioned the industry
against embracing the liquidity bank as it would
only invite the Federal Reserve Board to
indirectly regulate the MMF industry. Ms. Bair
argued that any system that left in place what she
views as an implicit government guarantee would
serve only to institutionalize, not reduce, systemic
risk.
Custodians Alleged to
Overcharge in Foreign
Exchange Transactions
With a number of pending legal actions alleging
that custodian banks are systematically
overcharging for foreign exchange (“Forex”)
transactions, investment firms are looking
closely at the Forex pricing practices of their
custodians. These pressures could ultimately
increase custodian transparency in the Forex
market.
The cost of converting U.S. dollars to a foreign
currency has historically been viewed as a minor
administrative expense. These Forex costs are
often bundled with other custodial services and
reported on periodic statements. Individual Forex
trades are generally not time-stamped on such
statements. The lack of detailed information,
for example, could enable a custodian to charge
the highest price of the day when the actual
price at the time of the transaction is much
lower.
An academic report prepared by researchers at the
Brandeis International Business School and
Williams College illustrates the disparity in Forex
pricing when investment firms do not scrutinize a
custodian’s pricing. In the report, a custodian’s
average margin on all trades against the U.S.
dollar was 20.8 basis points. When clients
called the custodian’s traders directly to
negotiate the price, that average margin
shrank to 3.4 basis points.
Various lawsuits and reports by whistleblowers
allege that several of the major custodians in the
Forex market deliberately hide or manipulate the
spread between what clients are charged for
Forex transactions and the actual costs. The SEC
and the Massachusetts Securities Division, among
others, are investigating such claims.
This attention has led many investment firms to
more closely scrutinize the Forex pricing
practices of their custodians. As custodial
contracts are renewed, investment firms are
expected to push for increased transparency in
Forex pricing. These negotiations may also
lead to changes in how bundled custodial
services are priced.
SEC Issues Report on
Review of Reliance on
Credit Ratings
As required by the Dodd-Frank Act, the SEC
issued a report in July 2011 that reviewed SEC
action taken to modify any rules requiring the
use of an assessment of the credit-worthiness
of a security or money market instrument or
referring to credit ratings.
The Act required every federal agency, by
July 21, 2011, (i) to review its regulations
requiring “the use of an assessment of the creditworthiness of a security or money market
instrument” and “any references to or
requirements in such regulations regarding credit
ratings” and (ii) to “modify any such
regulations . . . to remove any reference to or
requirement of reliance on credit ratings and to
substitute . . . such standard of credit-worthiness
[that the agency] shall determine as appropriate”
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demand feature is of high quality and
subject to very low credit risk;
and to “seek to establish . . . uniform standards of
credit-worthiness” within the context of the
entities regulated. The Act also required each
agency to transmit a report to Congress containing
a description of any modifications made.
o
Requirements for monitoring
securities for ratings downgrades
and other credit events – the
proposed amendments require the
fund board (or its delegate) to
promptly reassess whether a security
that has been downgraded continues
to present minimal credit risks and
take appropriate action; and
o
Stress testing – the proposed
amendments require that a money
market fund’s stress testing
procedures include as a hypothetical
event an adverse change in the ability
of a portfolio security issuer to meet
its short-term financial obligations.
In its report, the SEC described its proposed rule
revisions issued pursuant to these requirements,
including:
•
•
Proposed amendments to six sets of rules and
forms under the 1933 Act and 1934 Act that
rely on, or make special accommodations for,
securities ratings. These amendments
generally relate to qualifications of operating
companies to use short-form registration
statements for capital-raising filings.
Proposed amendments to Rule 2a-7 under
the 1940 Act that requires money market
funds to invest in highly liquid, short-term
instruments of the highest quality. These
proposals, which we have described in detail
in earlier articles, are designed to
appropriately achieve the same purpose as the
ratings requirement, according to the SEC,
and would remove references to credit ratings
affecting the following five elements of
Rule 2a-7:
o
Determination of whether a security is
an eligible security – under the
proposed amendments, the fund board
(or its delegate) would be responsible
for determining whether securities
present minimal credit risks;
o
Determination of whether a security is
a first tier security – under the
proposed amendments, the fund board
(or its delegate) would similarly be
responsible for determining whether
each portfolio security is a “first tier”
or a “second tier” security, subject to
standards intended to replicate the
credit quality standards articulated by
the credit rating agencies;
o
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Credit quality standards for securities
with a conditional demand feature
– under the proposed amendments,
the fund board (or its delegate) would
be required to determine that the
security subject to a conditional
August 2011
•
Proposed amendments to Form N-MFP, for
monthly electronic filings of portfolio
holdings by money market funds, which
would eliminate items requiring disclosure of
ratings information.
•
Proposed amendments to Rule 5b-3 under the
1940 Act, providing mutual funds technical
relief related to the acquisition of
repurchase agreements, which would
require a fund board (or its delegate) to
determine whether the collateral supporting
the obligation of the seller to repurchase the
securities is: (i) issued by an issuer that has
the highest capacity to meet its financial
obligations; and (ii) sufficiently liquid that it
can be sold at approximately its carrying
value in the ordinary course of business
within seven calendar days.
•
Proposed amendments to investment
company registration forms – Forms N-1A,
N-2 and N-3 – which would revise the
reference to credit ratings in the table,
chart or graph depicting portfolio
holdings.
•
Proposed amendments to seven technical
rules under the Exchange Act related to
broker-dealer financial responsibility,
distributions of securities and confirmations
of transactions.
Investment Management Update
o
•
The confirmation rule, Rule 10b-10
under the Exchange Act, requires a
broker-dealer to inform the customer
if the confirmation is unrated, which
the SEC proposed be deleted.
Proposed amendments to technical
requirements related to asset-backed
securities.
11