Investment Management Update
May 2009
Inside this issue:
Eighth Circuit Upholds
Gartenberg, Requires
Comparison with Institutional
Account Fees............................. 1
Money Market Update
ICI Releases Money Market
Working Group Report .............. 2
Independent Directors Oppose
Bank-Style Regulation of Money
Market Funds ........................... 3
Treasury Department Extends
Guarantee Program .................... 4
Donohue on:
Key Concerns and Money
Market Fund Reform ................. 5
Challenges Facing the
Mutual Fund Industry and
the SEC’s Response ................. 6
Chairman Describes Role of
SEC in Financial Markets
Regulatory Structure ................. 8
FASB Issues New Guidance
for Fair Value Accounting ........ 10
Division of Investment
Management Releases
Fair Valuation Bibliography ..... 12
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Eighth Circuit Upholds Gartenberg, Requires
Comparison with Institutional Account Fees
Close on the heels of the Supreme Court’s decision to grant review of Jones
v. Harris Associates L.P., which has been discussed in previous editions of
this newsletter, the Eighth Circuit Court of Appeals has weighed in with its
view of Section 36(b) of the Investment Company Act in Gallus v. Ameriprise
Financial, Inc.
In Ameriprise, the district court granted summary judgment in favor of the
investment adviser, holding that no violation had occurred because the adviser’s
fee “passed muster” under the Gartenberg v. Merrill Lynch Asset Management,
Inc. standard for evaluating whether an advisory fee is so high as to violate
the statute. Nonetheless, the Eighth Circuit reversed summary judgment and
remanded the case to the district court for further proceedings. The Eighth
Circuit concluded that the lower court had erred in rejecting a comparison
between fees charged to the investment adviser’s institutional clients and those
charged to its investment company clients.
On the Gartenberg Framework. The Eighth Circuit acknowledged that, under
Gartenberg, “the relevant test for a fee is whether it ‘represents a charge
within the range of what would have been negotiated at arm’s-length in light
of all the surrounding circumstances’” and concluded that the Gartenberg
factors provide a “useful framework for resolving claims of excessive fees....”
Ameriprise accordingly disagreed with the Seventh Circuit’s decision in the
Jones case, where the Seventh Circuit disapproved of Gartenberg and held
that, if an adviser “make[s] full disclosure and plays no tricks,” a court should
refrain from engaging in an evaluation of the reasonableness of an advisory fee
approved by investment company directors.
On Comparison with Institutional Account Fees. The Eighth Circuit diverged
from other decisions interpreting Gartenberg on the question of whether
courts evaluating an excessive fee claim should consider a comparison of
investment advisory fees charged to investment companies and those charged to
institutional investors. The Court noted that the plaintiffs in the Ameriprise case
had challenged the veracity and completeness of the adviser’s comparative fee
information and the extent to which the fund’s directors were able to properly
evaluate that information. It concluded that “[a]lthough the district court
properly applied the Gartenberg factors” in determining whether the advisory
fee “itself constituted a breach of fiduciary duty,” the district court had erred
“in rejecting a comparison between the fees charged to Ameriprise’s
institutional clients and its mutual fund clients.” The Eighth Circuit opined
that such comparisons are particularly appropriate where “the investment
advice may have been essentially the same for both accounts.” In this respect,
Ameriprise comports with the view expressed in Jones by Seventh Circuit
Judge Posner, dissenting from the denial of rehearing en banc, but is contrary
to a number of district court holdings and is in
tension with language in Gartenberg that the
Eighth Circuit characterized as dicta.
require funds choosing not to implement these
recommendations to disclose that fact to
their investors.”
On Process and Result. The Court in Ameriprise
also concluded that the proper approach to an
excessive fee claim is one that looks at both
process and result; that is, at both the adviser’s
conduct during fee negotiations and to the
resulting fees. According to the Eighth Circuit,
“[u]nscrupulous behavior with respect to either
can constitute a breach of fiduciary duty.” In
this respect, Ameriprise borrows both from
Gartenberg (with its focus on the amount of an
advisory fee) and Jones (with its allusions to
candor in negotiations and instances in which a
board “abdicate[s]” its responsibility).
The recommendations “are designed to
strengthen and preserve the unique attributes
of money market funds: safety, liquidity, and
the convenience of a stable $1.00 net asset
value,” and, according to the ICI, “will ensure
that money market funds are better positioned
to sustain prolonged and extreme redemption
pressures and that mechanisms are in place to
ensure that all shareholders are treated fairly
if a fund sees its NAV fall below $1.00.” The
recommendations include:
Money Market Update
ICI Releases Money Market
Working Group Report
The ICI Money Market Working Group recently
released its recommendations for new regulatory
and oversight standards for money market
funds, intended to counter the recommendations
made by the Group of Thirty. According to John
J. Brennan, Chairman of the Working Group and
The Vanguard Group, “the recommendations
respond directly to weaknesses in current money
market fund regulation, identify additional
reforms that will improve the safety and
oversight of money market funds, and will
position responsible government agencies to
oversee the orderly functioning of the money
market more effectively.”
The Working Group proposes both regulatory
changes as well as recommendations to be
voluntarily implemented by money market
fund managers. The ICI “has called for prompt
implementation of these improved practices
across the industry, pending regulatory
action” and “will encourage the SEC to
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May 2009
• Daily and weekly minimum liquidity
requirements and regular “stress testing” of
the fund’s individual portfolio holdings and
shareholder base.
• Tightened portfolio maturity limits, including
a reduction in the maximum weighted
average maturity from 90 days to 75 days.
• Increased credit quality standards, which
would be accomplished by:
• requiring advisers to establish a “new
products” or similar committee to review
and approve new structures prior to a
fund’s investing in those structures,
•encouraging advisers to follow “best
practices” in connection with minimal
credit risk determination, as set forth in
the report,
• requiring advisers to designate and
publicly disclose, pursuant to procedures
approved by the fund’s board, a minimum
of three credit rating agencies that the
adviser will monitor for purposes of
determining the eligibility of portfolio
securities, and
• eliminating a fund’s ability to invest up to
5% of its assets in “second tier securities.”
• Encouraging advisers to adopt “know your
client” procedures and requiring them to
Investment Management Update
post monthly website disclosures of client
concentration levels and the risks that such
concentration, if any, may pose to the fund.
banking regulations. If implemented, the Group
of Thirty’s recommendation would mark the end
of money market funds as we know them.
• Requiring funds to reassess and, if
appropriate, revise the risk disclosures they
provide to investors and to provide monthly
website disclosure of portfolio holdings.
In response to the Group of Thirty’s
recommendations, the four authors – IDC
Chairman Michael S. Scofield, past IDC
Chairman Robert W. Uek, past IDC and Director
Services Committee Chairman James H.
Bodurtha, and past Director Services Committee
Chairman Dawn-Marie Driscoll – noted that
“money market funds provide incomparable
benefits to U.S. investors and this country’s
capital markets, [and that] [f]or more than 25
years, these funds have provided shareholders
with a safe, liquid cash-management vehicle
and the capital markets with a vital source
of funding.”
• Addressing the possibility of a “run on the
fund” by authorizing a fund’s board to:
• suspend redemptions and purchases of
fund shares for a period of five business
days in order to seek a “cure” for a fund
that has either broken or reasonably
believes it may be about to “break the
buck,” and
• permanently suspend redemptions for
a fund preparing to liquidate “in order
to ensure that all shareholders are
treated fairly.”
• Developing a non-public reporting regime for
all institutional investors in the money market
and encouraging the SEC staff to monitor
funds with clearly higher-than-peer
performance during any month.
• Addressing market confusion about funds
that appear to be similar to money market
funds, but do not comply with the risklimiting provisions applicable to money
market funds.
With the report now complete, Paul Schott
Stevens, ICI’s President, has stated that “we
look forward to working with regulators and
other policymakers in the months ahead as they
consider how to best address these issues.”
Independent Directors Oppose
Bank-Style Regulation of Money
Market Funds
Four leaders of the independent fund director
community recently published an open letter
on Board IQ opposing the Group of Thirty’s
recommendation that money market funds, as
currently structured, be required to reorganize
as special purpose banking entities subject to
Citing the fundamental differences between
how banks and money market funds operate,
the authors note that “subjecting money
market funds to bank-style regulation would
likely deprive investors of daily liquidity, high
standards of safety, and competitive yields.”
As such, the authors “are concerned about any
proposal that would significantly diminish the
benefits provided by money market funds as
they are currently structured and regulated.” The
benefits identified by the four directors include:
• Safety. “Even though two money market
funds ‘broke the buck,’ more than $300
trillion has moved in and out of all other
money market funds for almost three decades
with no loss of principal,” they wrote. “No
other financial product or service comes
remotely close to meeting this impressive
record of safety.”
• Liquidity. “Money market funds are also a
critical source of liquidity in America’s
capital markets… This nearly $4 trillion
industry of some 800 funds buys the
commercial paper, municipal securities and
other financial products that U.S. companies,
financial institutions, and state and local
governments rely upon to finance
their operations.”
3
• Convenience. “[M]ost money market funds
offer check-writing features,” they wrote.
“These attributes provide a variety of
benefits to fund shareholders. Many retail
investors use them as a place to ‘park cash’
between investments.”
• Aid to infrastructure. At the end of 2008,
“tax-exempt money market funds had close
to $500 billion under management, nearly
all of which is invested in short-term state
and local government debt. Without a
doubt they are playing an indispensable
role in public infrastructure and municipal
service initiatives.”
• Regulation. “Money market funds already are
among the most regulated financial products
available today. They operate under strict SEC
requirements regarding the investments they
are permitted to make and how much they
may invest in any one issuer.”
Noting the “unprecedented” lack of liquidity
in the commercial paper market, the authors
“strongly support a top-to-bottom review by
the industry and the SEC of the regulatory
requirements that govern money market funds
to determine whether changes are warranted.”
However, the directors maintain that the Group
of Thirty’s recommendations would not be
effective. “With almost $4 trillion invested in
money market funds, investors have spoken,”
they stated. “They prefer this product over
bank certificates of deposit, passbook savings
accounts and other comparable products. …
We think the Group of Thirty’s proposals, if
enacted, would do far more harm than good.”
Treasury Department Extends
Guarantee Program
The U.S. Treasury Department has extended
its temporary Money Market Fund Guarantee
Program through September 18, 2009 to cover
participating money market funds that “break
the buck.” The Program had been scheduled to
end on April 30, 2009.
4
May 2009
The Program will continue to protect investors
of record as of September 19, 2008 from losses
on the value of their shares if their money
market fund’s net asset value (NAV) drops
below $0.995. Should this occur, the Treasury
will pay to the fund the difference between its
actual NAV and an NAV of $1.00 per share
for the amount of outstanding shares held on
September 19, 2008. The Treasury’s Exchange
Stabilization Fund, which is funded with
$50 billion, will cover any losses under the
insurance program.
Only funds that previously participated in the
program may participate in this extension.
Funds had to enroll in the extension by April 13,
2009 and were eligible only if their NAV per
share remained at least $0.995.
To participate in the extension period,
eligible money market funds must pay the
Treasury Department a fee according to the
following scale, based on the fund’s number of
outstanding shares as of September 19, 2008:
• Funds with an NAV per share of $0.9975 or
more pay 1.5 basis points.
• Funds with an NAV per share equal to or
greater than $0.995 but less than $0.9975 pay
2.3 basis points.
These costs are in addition to prior payments for
participation in the Program. Aggregated over
the entire extended Program term, the fees equal
4 or 6 basis points, on an annualized basis, of
the fund’s asset base on September 19, 2008.
This is the second (and final) extension of the
program, which will terminate on September
18, 2009. Launched in September 2008, the
Program initially ran through December 18,
2008 before the Treasury Department extended
it through April 30. Currently the Program
covers more than $3 trillion in combined
fund assets.
Investment Management Update
Donohue on Key Concerns and
Money Market Fund Reform
Andrew “Buddy” Donohue, Director of the
SEC’s Division of Investment Management,
recently spoke at the Practicing Law Institute’s
Investment Management Institute about the
importance of “re-evaluating the current
regulatory framework governing investment
companies and investment advisers.”
Mr. Donohue first addressed the “surprising”
investment results that “investors have
experienced with respect to certain, [similar]
investment products.” He then focused on
the appropriateness of certain “trendy” fund
products and on possible money market
fund reform.
Disparate Returns Among Similar Types
of Funds
Noting that the last year was a “particularly
difficult year for America’s investors,” Mr.
Donohue explained that “it is to be expected”
that performance of individual funds will differ.
According to Mr. Donohue, however, “what
has been surprising . . . has been how wide the
difference has been. For example, in the bond
fund area, while the average high yield bond
fund lost 26 percent on average, the range of
performance was plus 7 percent to minus 78
percent. Similarly, with national tax-exempt
bond funds, while the average fund lost
almost 7 percent, the range in performance was
from plus 6 percent to minus 49 percent.”
Mr. Donohue indicated that these types of varied
investment results among purportedly similar
funds pose a “real challenge to the industry
and American investors. At a time when
some 70 percent of actively managed funds
underperform their benchmarks, if an investor
or an investment adviser can not accurately
identify who might outperform, what is the
value proposition in taking on the risk for this
variance in performance?”
Concerns Over Trendy Investment Products
Mr. Donohue explained that “[i]nvestment
companies have become the investment vehicle
of choice for America’s investors over the years
because of their value added. The development
of new products that are marketed to investors
should not be about what you can sell but rather
about what you should sell to investors.” Mr.
Donohue cited as “trends” he “finds worrisome”
the increased use of leverage by funds as well as
funds “tied to high-risk investments in subprime
mortgage securities and credit-default swaps.”
Mr. Donohue noted that, even assuming a
fund’s disclosures are accurate, he believes that
“sophisticated investors might have the ability
to properly evaluate the impact of employing
leverage in funds” but “question[ed] whether
many retail investors can.” According to Mr.
Donohue, “funds should be built on sound
principles and designed for investing for the
long term, not to capture assets based on short
term trends.”
Mr. Donohue concluded by clarifying that he
does not believe the SEC should be a “merit
regulator [and that] . . . the Division can[not]
necessarily discern a good or bad investment
product any better than the firms can.” Mr.
Donohue explained that he is, “however,
challenging the investment company industry to
take this issue seriously. Not all innovation or
ingenuity is positive.”
Money Market Fund Reform
Mr. Donohue observed that the “twin goals
of providing liquidity, typically on a sameday basis, and preserving capital at times can
conflict,” especially during times of “severe
market turmoil.” For example, Mr. Donohue
stated that “when liquidity is at a premium
spreads may widen considerably, thus making
it more difficult to sell even the highest quality
instruments at or near ‘amortized cost.’ On the
other hand, a desire to maintain a $1.00 NAV
can cause a fund to seek to delay redemptions
or the payment of redemptions and thus fail
to meet fund shareholders’ expectations of
5
liquidity.” Mr. Donohue also explored other
challenges posed by the existing money market
fund model. According to Mr. Donohue, these
include the following:
• “First, the choice of $1.00 instead of $10.00
per share NAV has made the NAV quite
insensitive to losses and gains in the funds’
portfolios until, once they reach 0.5%, the
share price rises or falls a full 1.0%. That
means that while price changes can be
expected to be infrequent, when they do
occur, they will be fairly dramatic.”
• “Second, this lack of sensitivity to volatility
affords investors, particularly large investors,
the opportunity to take advantage of the fund
and its other shareholders . . .. Sophisticated
investors know this dynamic and will redeem
their shares in the fund quickly, leaving the
loss for the remaining shareholders.”
• “Third, the $1.00 price may not provide
investors with adequate information
regarding their investment.” “[A]n investor
purchasing at $1.00 when the NAV [is]
$0.996 ha[s] no way to know that he (she)
[is] at risk of losing 1% in one day merely
because of redemptions by others or other
minor valuation moves.”
Mr. Donohue stated that the review of “the
money market fund model and its regulatory
regime” is a “top priority” and will be “guided
by the fundamental principle that the money
market fund model and its regulation should be
tailored to best meet the liquidity and capital
preservation needs of fund investors.”
Donohue Addresses Challenges
Facing the Mutual Fund Industry
and the SEC’s Response
Andrew “Buddy” Donohue, Director of the
SEC’s Division of Investment Management,
recently spoke at the Investment Company
Institute’s Mutual Funds and Investment
6
May 2009
Management Conference about the “incredible
challenges, many unprecedented”
that face the mutual fund industry and certain
rulemaking initiatives.
Industry Challenges in a “[P]rofoundly
[D]ifferent” Environment
Reflecting on the last two years, Mr. Donohue
expressed his “amazement at the turn of
events that has occurred over the course of this
two-year period” and listed several notable
developments, including:
• the turmoil of the last two years that has
“shaken core understandings and left the
financial world questioning basic tenets
that we have always considered to be
true.” For example, he cited the concept
of diversification, noting that “as we see
‘a flight to quality’ and a movement to
hold cash and treasury bills… normally
uncorrelated or negatively correlated
assets become correlated, and investment
strategies developed around more traditional
correlations inevitably fail.”
• “reports showing that actively managed
funds don’t outperform major market indices
over long periods of time. In fact, one report
shows the index benchmarks outperformed
fund managers in at least 70 percent of cases
in almost all categories, and that is before
considering the higher fees associated with
active management.”
• the “increased operational pressures” facing
funds and fund boards arising “from a variety
of factors, including a lack of liquidity in the
marketplace and the resulting difficulties in
valuation of many portfolio securities.”
• climbing expense ratios resulting from a
decline in fund assets while “transfer agent
and other fixed dollar fees” remain fixed and
from advisory fee breakpoints “working in
reverse” as funds experience net outflows.
• decreasing fund assets that make the 15(c)
review process more complicated and
unreliable: “Funds are typically compared
Investment Management Update
to peer funds that have similar investment
objectives and asset sizes. Asset size is
usually calculated as a fund’s average assets
during its most recent fiscal year. However,
the current asset size of many funds may be
only half the average asset size during the
most recent fiscal year. This phenomenon
may cause fund advisers and boards to
reconsider the time period and other
aspects of the methodology normally used
to compare fund expense ratios for 15(c)
reviews and determine comparable funds.”
•the “increasing use by funds of derivatives
and sophisticated financial instruments.”
Mr. Donohue noted that “it is imperative
that all relevant parts of a fund’s operations
team understand a portfolio instrument
and appreciate its use, characteristics and
implications,” including “legal, compliance
and accounting groups.”
Mr. Donohue asked the industry “not [to]
ignore the issues that worry us, but rather, [to]
confront our fears.” He encouraged the industry
to “remain vigilant and aware, to the extent
possible, of potential risks. For example, funds
should be attentive to counterparty exposure
and ask the ‘tougher questions’ to evaluate
potential credit and other risks, particularly
with respect to derivative transactions. Also,
observe how well your risk systems worked
during the past 18 months. Go back and review
whether derivative instruments performed as
expected, and review whether basic strategies
have delivered expected results. These reviews,
among many others, are undoubtedly going on
now at many firms.”
Rulemaking Initiatives
Mr. Donohue summarized certain “key initiatives
in the Division of Investment Management”
pursued in the last two years, many in response
to the recent market crisis. Among the examples
cited by Mr. Donohue were (i) the quickness
with which his staff responded to inquries and
requests for no-action assurances by money
market funds (or their sponsors) in connection
with actions necessary to help assure that money
market funds would not “break the buck;” (ii) the
staff’s involvement and actions to help alleviate
the problems posed to closed-end funds by
virtue of the failure of the auction rate preferred
market; and (iii) improvements related to the
SEC’s issuance of exemptive order relief.
Mr. Donohue also outlined several initiatives
“coming down the pike” from the Division of
Investment Management, including:
• Soft Dollar Guidance. According to
Mr. Donohue, guidance to independent
directors on soft dollars is on the horizon.
(It was originally promised for last year.)
“The guidance would not impose any new
requirements on fund directors or advisers,
but instead proposes to provide a flexible
framework to assist directors in fulfilling
existing oversight obligations. In this regard,
the proposed guidance suggests information
directors may request from advisers to
monitor the conflicts of interest advisers
face in their trading activities and reminds
directors that they have the authority to direct
how an adviser uses fund brokerage.”
• Rule 12b-1 Reform. Mr. Donohue explained
that while, in 2007, he had announced that
Rule 12b-1 reform was a priority for his
Division, he believed that the current market
environment demanded that other regulatory
areas be addressed first. As a result, he noted
that “[i]t would be wise . . . for us to defer
consideration of Rule 12b-1 reform for this
year.” Mr. Donohue also noted, however,
that “[I]t may be useful to consider exploring
other potential means of addressing issues
associated with the rule, separate from, and
in advance of, meaningful 12b-1 reform,
such as the possibility of providing guidance
to fund directors to better assist them in
this area.”
• Valuation. Stating that “[d]uring this
period of market pressures, fund directors’
role in overseeing conflicts faced by the
fund and protecting the interests of fund
7
shareholders is even more vital,” Mr.
Donohue emphasized the SEC’s intent “to
move forward on providing guidance to
fund directors in the valuation of portfolio
securities. This is a difficult, and very
important initiative . . .. [T]here have been
many significant developments impacting
valuation. For example, funds are now
investing in many complex and difficult-tovalue securities that did not exist a decade
ago. Also, much more valuation-related
information is now available to funds, and
there are more companies that provide a wide
array of pricing services to funds. As a result
of these developments, there is a need for the
Commission to provide guidance to assist
funds and their directors to ensure that fund
investors are treated fairly.”
• Director Outreach Initiative. Mr. Donohue
described the many board meetings he
has attended over the last two years as
part of his Director Outreach Initiative.
He indicated that “[b]ased on director
feedback and the Division’s own analysis,
my staff is preparing recommendations for
the Commission’s consideration that will
suggest possible rule modifications and
other guidance that may enable directors to
focus their time more efficiently overseeing
conflicts of interest rather than engaging in
day-to-day management of the fund.”
• Rule 2a-7 and the Money Market Fund
Model. “With almost $4 trillion in assets,
money market funds are of fundamental
importance to the financial system,”
Mr. Donohue said. He commended the
Investment Company Institute’s work “in
this area through its Money Market Working
Group” and noted his belief that “the
recommendations contained in the Group’s
Report issued last week are a good first step
in developing changes to Rule 2a-7.” Mr.
Donohue recognized “that the stable net
asset value of $1.00 has been an integral
part of the money market fund model,” but
8
May 2009
admitted that it presents “certain challenges.”
He stated that reviewing Rule 2a-7 is a “very
high” priority for the Division.
Chairman Describes Role of
SEC in Financial Markets
Regulatory Structure
Testifying before the United States Senate
Committee on Banking, Housing and Urban
Affairs (the “Senate Banking Committee”),
Mary L. Schapiro, Chairman of the SEC, said
she supported the view that a “reconsideration
of the financial regulatory regime,” including
a reassessment of the systemic risks to
the financial system and “the creation of
mechanisms to reduce and avert them,” was
both “timely and critically important.” She
commended the Senate Banking Committee
for focusing on investor protection and
securities regulation, and explained why the
SEC as a “capital markets regulator devoted to
investor protection” is “indispensable” to the
Committee’s goal of improving the nation’s
financial regulatory scheme.
The SEC, Chairman Schapiro said, is a “strong,
focused, vibrant, and nimble market regulator…
critical to getting investors back into the market
and to maintaining their trust and confidence
in the future…[and] fundamental to the future
growth of our economy.” Chairman Schapiro
reviewed what she characterized as the core
functions of the SEC: regulation of mutual
funds; regulation of the integrity of the markets,
market information and financial intermediaries
and other market professionals; and enforcement
of the federal securities laws.
Mutual Funds and Other Money Pools.
Citing the over $9 trillion in assets held by
92 million American shareholders in mutual
funds, Chairman Schapiro said that the SEC
places special emphasis on mutual funds and
similar pooled investment vehicles. She said
Investment Management Update
that “a particular focus of the Commission in
coming weeks will be proposals to enhance the
standards applicable to money market mutual
funds, which are widely used by both retail and
institutional investors as a cash management
vehicle.” Chairman Schapiro noted that the
SEC staff expects to “act quickly this spring
to strengthen the regulation of money market
funds by considering ways to improve the
credit quality, maturity, and liquidity standards
applicable to these funds,” so that the risk of
“breaking the buck” is mitigated.
Integrity of the Markets. “The securities laws
and our rules, and the rules of the exchanges
and the national securities association we
supervise,” Chairman Schapiro said, “prohibit
fraudulent trading practices, manipulation
of securities prices, insider trading and other
abuses. These laws and rules require trades
to be executed at fair prices, require market
participants to keep records of their activities,
and require prompt dissemination of pricing
information.” She added that the SEC works to
“keep up with the breakneck pace of change in
our ever-evolving markets,” and has taken many
“pro-investor” actions across the past decade,
such as the decimalization of stock quotes,
which greatly reduced investor trading costs and
helped maintain integrity in the markets.
Integrity of Market Information. “Accurate
information is the lifeblood of the securities
market…[and] a big part of the SEC’s mission
is to safeguard the markets’ blood supply,”
Chairman Schapiro told the Senate Banking
Committee. She also spoke specifically to the
integrity of market information in the context of
financial data and shareholder voting.
• The SEC works to protect the integrity of
“both words and numbers” disclosed to
investors, Chairman Schapiro explained. “We
oversee the process by which [accounting
standards] are set to ensure that professional,
independent standard-setters include those
whose primary concern is the welfare of
investors, that the deck is not stacked against
investors, and that the outputs of the process
are fair and appropriate.”
• Investors need “accurate and comprehensive
information” when they make their
investment decisions and when they vote,
Chairman Schapiro urged, “whether it is to
elect directors, adopt compensation plans,
approve transactions, or consider shareholder
proposals.” She said that SEC rules require
complete and accurate disclosure of
information that investors need to make
informed voting decisions but suggested that
further measures were needed “to promote
fair corporate voting.” Indeed, Chairman
Schapiro said that she intended “to make
proxy access — meaningful opportunities for
a company’s owners to nominate its directors
— a critical part of the Commission’s agenda
in the coming months.”
Financial Intermediaries and Market
Professionals. Chairman Schapiro reported
that the SEC regulates and oversees financial
intermediaries and other market professionals
who must be “competent, financially capable,
and honest.” According to Chairman Schapiro,
the SEC is considering the following vis-à-vis
those intermediaries and market professionals:
•O
utstanding rule proposals related to credit
rating agencies. According to Chairman
Schapiro it is essential that the SEC “stay
active in this area” given the central role of
ratings in our capital markets.
•L
egislation that would require hedge funds
and their advisers to register with the SEC.
• A recommendation “to break down the
statutory barriers that require a different
regulatory regime for investment advisers
and broker-dealers, even though the services
they provide often are virtually identical
from the investor’s perspective.”
•“Whether legislation is needed to fill other
gaps in regulatory oversight, including
those related to credit default swaps and
municipal securities.”
9
• “A series of reforms… that would require
investment advisers with custody of client
assets to undergo an annual third-party
audit, on an unannounced basis, to confirm
the safekeeping of those assets.” Chairman
Schapiro said that she also expected that
a senior officer from each firm would be
required “to attest to the sufficiency of the
controls they have in place to protect
client assets.”
Securities Law Enforcement. Chairman
Schapiro discussed recent noteworthy
enforcement action taken by the SEC, including
a large foreign bribery case and others “related
to sub-prime abuses, market manipulation
through the circulation of false rumors, insider
trading by hedge funds and other institutional
investors, Ponzi schemes, false corporate
disclosures, and penny stock frauds.” As
part of these enforcement efforts, Chairman
Schapiro said she expected to return to the
Senate Banking Committee “in the near term
with a request for authority to compensate
whistleblowers who bring us well-documented
evidence of fraudulent activity.” She reminded
the Senate Banking Committee that “the vision
of Congress when it created an independent
SEC was to make sure that there was an agency
of government focused single-mindedly and
without dilution on the well-being of
America’s investors.”
FASB Issues New Guidance for
Fair Value Accounting
On April 9, 2009, the Financial Accounting
Standards Board (FASB) issued a new staff
position (FSP) designed to provide additional
guidance and enhance disclosures about fair
value measurements. The new guidance clarifies
how to estimate fair value when the volume
and level of activity for an asset or liability
have significantly decreased and identifies
circumstances that could indicate when a
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May 2009
transaction is not orderly under FASB Statement
No. 157, Fair Value Measurement (FAS 157). At
the same time, the FASB is requiring publicly
traded companies to provide certain fair value
disclosures in their interim reports.
The FASB’s staff position comes at a time
when the fund industry continues to await
long-promised guidance on fair valuations from
the SEC. While mutual fund auditing firms rely
on applicable FASB guidance in conducting
audits, the SEC’s guidance (both that which
is anticipated and that which already exists)
governs the legal responsibilities of independent
fund directors in reaching or reviewing fair
value determinations.
Overview and Prior Clarifications of FAS 157
FAS 157 requires companies (including
investment companies) to value assets and
liabilities at “the prices that would be received
to sell an asset or paid to transfer a liability
in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market
participants at the measurement date under
current market conditions.” It establishes
a fair value hierarchy that distinguishes
between (1) market participant assumptions
developed based on market data obtained from
sources independent of the reporting entity
(observable inputs) and (2) the reporting entity’s
own assumptions about market participant
assumptions developed based on the best
information available in the circumstances
(unobservable inputs).
In an attempt to address uncertainties related,
in part, to fair value determinations based on
“unobservable” inputs, the FASB provided
further clarifications in the fall of 2008: First, in
a joint release with the SEC and subsequently
with the issuance of FSP FAS 157-3. The latter
sought to clarify the application of FAS 157 in
an inactive market and provide an example of
how to determine fair value of a financial asset
when the market for the asset is not active.
Some constituents felt, however, that FSP FAS
Investment Management Update
recent indications of fair values for that asset
or liability;
157-3 did not “provide sufficient guidance
on how to determine whether a market for a
financial asset that historically was active is no
longer active (including guidance on when to
make a significant adjustment to a transaction
or quoted price) and whether a transaction is
not orderly.” On April 9, 2009, the FASB issued
FSP FAS 157-4, Determining Fair Value When
the Volume and Level of Activity for the Asset
or Liability Have Significantly Decreased and
Identifying Transactions That Are Not Orderly.
• significant increase in implied liquidity risk
premiums, yields, or performance indicators
(such as delinquency rates or loss severities)
for observed transactions or quoted prices
when compared with the reporting entity’s
estimate of expected cash flows, considering
all available market data about credit and
other nonperformance risk for the asset
or liability;
Key Elements of the New Fair Value
Accounting Guidance
•w
ide bid-ask spread or significant increase in
the bid-ask spread;
The new guidance under FSP FAS 157-4
“emphasizes that even if there has been a
significant decrease in the volume and level of
activity for the asset or liability and regardless
of the valuation technique(s) used, the objective
of a fair value measurement remains the same”
- to reflect how much an asset would be sold
for in an orderly transaction at the date of
the financial statements under current market
conditions. It also reaffirms the need to use
judgment to ascertain if a market has become
inactive and to determine fair values in
inactive markets.
• s ignificant decline or absence of a market for
new issuances (that is, a primary market) for
the asset or liability or similar assets
or liabilities; and
The recently issued FSP establishes a twostep process. First, an entity should determine
whether there are factors present indicating,
based on the weight of the evidence, that there
has been a significant decrease in the volume
and level of activity for the asset or liability.
Factors to consider include the following:
• few recent transactions;
• price quotations not based on
current information;
• price quotations vary substantially either
over time or among market makers (for
example, some brokered markets);
• indexes that previously were highly
correlated with the fair values of the asset or
liability are demonstrably uncorrelated with
• little information released publicly (for
example, a principal-to-principal market).
A determination that there has been a significant
decrease in volume and activity under step one,
however, does not result in a presumption that a
transaction is not orderly. As a result, the entity
should move to step two to determine whether
a transaction or quoted price is associated with
other than an orderly transaction. Circumstances
that may indicate that a transaction is not
orderly include, but are not limited to:
• lack of adequate exposure to the market for
a period before the measurement date to
allow for marketing activities that are usual
and customary for transactions involving
such assets or liabilities under current market
conditions;
• a usual and customary marketing period, but
the seller marketed the asset or liability to a
single market participant;
• seller is in or near bankruptcy or receivership
(that is, distressed), or the seller was
required to sell to meet regulatory or legal
requirements (that is, forced); and
• the transaction price is an outlier when
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compared with other recent transactions for
the same or similar asset or liability.
A reporting entity should evaluate the
circumstances to determine whether the
transaction is orderly based on the weight of
the evidence. In addition, in its determinations
a reporting entity may not “ignore information
that is available without undue cost and effort”
and is expected “to have sufficient information
to conclude whether a transaction is orderly
when it is a party to the transaction.”
Compliance Dates
The FSP is effective for interim and annual
periods ending after June 15, 2009, but entities
may voluntarily adopt the FSP for interim and
annual periods ending after March 15, 2009.
The full text of the staff position issued by the
FASB can be found on the FASB’s website at
http://www.fasb.org/pdf/fsp_fas157-4.pdf.
Division of Investment
Management Releases
Fair Valuation Bibliography
The SEC’s Division of Investment Management
recently released a bibliography that lists
“relevant provisions of the Investment
Company Act and related rules and Commission
guidance, which is intended to assist funds
and their counsel in understanding and
applying the valuation requirements under
the Investment Company Act.” Also included
in the bibliography are proposing releases,
staff guidance (including no-action letters)
and enforcement actions involving fair value
determinations. The Division reiterated that,
“[w]hen market quotations are not readily
available, funds must value portfolio securities
and all other assets by using fair value as
determined in good faith by the board of
directors of the funds.”
In a speech delivered at the end of March,
Andrew “Buddy” Donohue, Director of the
Division of Investment Management, called the
bibliography a “first step” in providing guidance
“to funds and their directors concerning their
valuation responsibilities.” He also noted his
hope “that fund directors and fund personnel
will find the bibliography a useful tool when
approaching valuation in this uncertain market.”
Presumably, the next step for the Commission is
to publish its long-awaited guidance on
fair valuation.
For a full copy of the bibliography,
visit http://sec.gov/divisions/investment/
icvaluation.htm.
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12
May 2009