any modification of the framework for measuring fair
value established by Statement of Financial Accounting
Standards No. 157 (SFAS 157) would impact the way funds
fair value securities.
sophisticated instruments, lack of timely information, the
inherent inconsistencies associated with the judgments
and estimates involved in fair valuation, and the fact that
subsequent events can affect measurements of fair value.
According to the SEC, the goal of the roundtable was to
address:
Other topics included trends observed by auditors in recent
meetings with the audit committees of public companies’
boards of directors, when fair value might be the most
relevant attribute of a security, and methods of gauging the
accuracy of a company’s fair value estimates by assessing its
management’s internal controls, business strategy and loss
recovery plan.
•
•
the usefulness of fair value accounting to investors;
•
actual and hypothetical challenges in applying fair value
accounting standards;
•
potential improvements to current fair value accounting
standards; and
•
auditor assurances regarding fair value accounting.
the potential effects on market behavior of fair value
accounting;
Much of the conversation centered on the disclosures that
public companies make in their quarterly reports regarding
the fair valuation of their assets and liabilities, as required by
SFAS 157. Moderators from the SEC’s Division of Corporate
Finance and the FASB asked whether fair valuation
disclosure under SFAS 157 was sufficiently transparent
and otherwise adequate. Suggestions for change
included streamlining disclosures to promote shareholder
understanding of how companies may use fair valuation
techniques to price their shares. A representative from
the Federal Reserve Bank, in particular, advocated far more
disclosure regarding the risks of fair value accounting and the
various types of valuation models used. Continued market
volatility, several panelists commented, could create the need
for further fair valuation disclosure reform.
Referring to the March 2008 “Dear CFO Letter” which the
SEC’s Division of Corporate Finance sent to nearly 30 public
companies to, among other things, evaluate their fair valuation
disclosure, Wayne Carnall, Chief Accountant of the Division of
Corporate Finance, said that none of the companies surveyed
had provided suggested disclosure regarding the sensitivity
of fair value estimates in the context of fair value modeling.
He said that such disclosure could be very informative for
shareholders and would afford greater transparency of
companies’ fair valuation practices. The panelists generally
agreed that education about the objectives of fair value
standards would be useful for shareholders and public
companies alike.
Panelists cited the difficulties associated with determining
fair value under current standards and market conditions,
including the need for costly specialists to value
70 West Madison Street
Chicago, Illinois 60602
t. 312-372-1121
A broadcast of the roundtable is available online through
the SEC’s website at http://www.connectlive.com/events/
secroundtable070908.
Investment Management and
financial MARKETS Group
Cheryl A. Allaire
858-509-7424
callaire@bellboyd.com
Joanne Phillips
202-955-6824
jphillips@bellboyd.com
Cameron S. Avery
312-807-4302
cavery@bellboyd.com
Paulita A. Pike
312-781-6027
ppike@bellboyd.com
Kevin R. Bettsteller
312-807-4442
kbettsteller@bellboyd.com
Eric S. Purple
202-955-7081
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312-781-6029
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202-955-7087
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312-807-4295
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312-807-4303
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Alan Goldberg
312-807-4227
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202-955-7059
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© 2008 Bell, Boyd & Lloyd LLP. All rights reserved.
Investment Management Update is published by Bell, Boyd & Lloyd LLP for clients and friends of the firm and is for information only. It is not a substitute for legal advice or
individual analysis of a particular legal matter. Readers should not act without seeking professional legal counsel. Transmission and receipt of this publication does not create
an attorney-client relationship.
Investment Management Update
A service to our clients.
August 2008
Seventh Circuit Rejects Gartenberg in Favor of Market Forces
Inside This Issue
IDC Releases Task
Force Report on
Board Oversight of
Derivatives - page 3
SEC Proposes to
Remove NRSRO
Ratings References
from Rules Affecting
Mutual Funds page 4
IDC and ICI Weigh in
on ETF Proposal page 5
U.S. Supreme
Court Affirms
Constitutionality of Tax
Exemption Policies
Underlying Municipal
Bond Funds - page 7
SEC Hosts
Roundtable on Fair
Valuation Standards page 7
In Jones v. Harris Associates L.P., the U.S. Court of Appeals for the Seventh Circuit recently
rejected the “reasonableness” standard previously adopted by Gartenberg for determining
whether an advisory fee is excessive. In Jones, shareholders of the Oakmark funds alleged
that the fees paid those funds’ adviser were too high, thus violating Section 36(b). Ruling in
favor of the adviser, Chief Judge Easterbrook stated:
[W]e now disapprove the Gartenberg approach. A fiduciary duty differs from
rate regulation. A fiduciary must make full disclosure and play no tricks but
is not subject to a cap on compensation. The trustees (and in the end
investors, who vote with their feet and dollars), rather than a judge or
jury, determine how much advisory services are worth. Section 36(b)
does not say that fees must be “reasonable” in relation to a judicially
created standard. It says instead that the adviser has a fiduciary duty.
The Court went on to note that, “just as plaintiffs are skeptical of Gartenberg because it
relies too heavily on markets, we are skeptical about Gartenberg because it relies too little
on markets.” Comparing a fund director’s analysis of an advisory contract to the evaluation
by operating company directors of management compensation, the Court observed that “a
committee of independent directors sets the top managers’ compensation. No court has
held that this procedure implies judicial review for ‘reasonableness’ of the resulting salary,
bonus, and stock options.” According to the Court, “[c]ompetitive processes are
imperfect but remain superior to a ‘just price’ system administered by the judiciary.
However weak competition may be at weeding out errors, the judicial process is
worse—for judges can’t be turned out of office or have their salaries cut if they
display poor business judgment.”
Because it focuses on market forces rather than judicial assessments of the reasonableness
of advisory fees, Jones accords greater deference to the business judgment of fund boards
in reviewing those fees. The Jones decision is the law only in the Seventh Circuit (Illinois,
Indiana and Wisconsin). Gartenberg, however, remains the controlling precedent in the
Second Circuit (Connecticut, New York and Vermont), where it was decided, as well as
in many other jurisdictions, including the Fourth Circuit (Maryland, North Carolina, South
Carolina, Virginia and West Virginia). Moreover, rules adopted by the Securities and
Exchange Commission (SEC) require shareholder disclosure of the Gartenberg factors
detailing directors’ consideration of advisory fees.
SEC Proposes Guidance on Fund Directors’ Duties as to Best Execution
and Use of Soft Dollars
The SEC recently proposed guidance regarding the duties of fund directors in overseeing
portfolio trading practices, including the manner in which the adviser seeks best execution
and uses fund brokerage commissions (soft dollars) to obtain products or services. The
SEC notes that its guidance “would not impose any new or additional requirements.”
The SEC stresses that it is “imperative that fund directors both understand and
scrutinize the payment of transaction costs by the fund” and that directors should
Investment Management Update
Proposed Board Oversight of the Adviser’s Use
of Fund Commissions
monitor the fund adviser’s trading practices and
efforts to seek best execution. The proposed
guidance offers detailed examples of questions to
be asked and data to be sought by directors in
performing their oversight role. Comments on the
proposed guidance are due by October 1, 2008.
Fund Directors’ Duties
The SEC reminds fund boards that they need to be
“sufficiently familiar with the adviser’s trading
practices to satisfy itself that the adviser is fulfilling
its fiduciary obligations and is acting in the best
interest of the fund.” Though the proposed guidance
states that “directors are not required or expected
to monitor each trade,” it also states that directors
“should demand, and the fund’s adviser must provide, all
information needed by the fund’s board to complete the
review process.”
Proposed Board Oversight of Best Execution
The proposed guidance describes the factors a fund
adviser should consider related to minimizing the overall
transaction costs incurred by the fund, including explicit
costs—such as commissions and fees, and implicit
costs—such as bid/ask spreads and missed trade
opportunity costs. The SEC suggests that “directors
should also consider the adviser’s decision whether
to use an alternative trading system.” Further, among
the data that the SEC urges fund directors to consider is:
•
the identification of broker-dealers to which the
adviser has allocated fund trading and brokerage;
•
•
the commission rates or spreads paid;
•
In discussing an adviser’s use of soft-dollars, the
proposed guidance lists potential conflicts of interest
that could arise between a fund and the fund’s adviser.
The SEC notes that, “[w]hen evaluating an adviser’s
use of fund brokerage commissions in light of these
conflicts, a fund board may determine that such use
is in the best interests of the fund.” The proposed
guidance goes on to note that while the adviser has the
obligation to satisfy the requirements of Section 28(e)
of the Securities Exchange Act of 1934, it is still
the responsibility of the board to ensure that the
adviser’s actions are in the best interest of the fund.
The SEC states that after receiving and reviewing data
from the adviser that details the adviser’s use of fund
commissions, “if the board believes that the fund’s
brokerage commissions could be used differently so
as to provide greater benefits to the fund, the board
should direct the adviser accordingly (emphasis
added).” The SEC specifies that boards should
consider whether it is appropriate for the adviser (1) to
refrain from using soft dollar trading for certain types of
trades, (2) to alter the mix of trades applying soft dollars,
or (3) to use soft dollar trading only for commission
recapture or expense reimbursement programs. The
SEC’s proposed guidance notes that fund directors
may wish to discuss with the fund CCO the compliance
policies regarding the use of brokerage commissions to
obtain brokerage and research services.
In addition, the ICI, like the IDC, strongly supports
the SEC’s proposal to permit unaffiliated funds to
invest in ETFs beyond statutory limits, subject to
fewer conditions than those contained in exemptive
orders. The ICI offered certain suggestions relating
to investments in ETFs by unaffiliated funds, including
suggestions to allow for greater flexibility for an
acquired ETF to invest in funds and other ETFs, and for
unregistered funds to invest in ETFs beyond statutory
limits as well.
Fund Board Duties in Connection with Annual
Contract Reviews
Tax-Exempt Municipal Bonds and the Public Welfare.
In overruling the Kentucky appeals court’s ruling,
the Supreme Court relied in part on its prior holdings
allowing a state to favor in-state interests when carrying
out typical and traditional local government functions,
especially those designed to benefit the public welfare.
The Court characterized states’ issuance of debt to
pay for public projects as a “quintessentially public
function, with [a] venerable history,” explaining that
proceeds from tax-exempt bonds afford states “a
way to shoulder the cardinal civic responsibilities . .
. [of] protecting citizens’ health, safety, and welfare.”
The Court noted that differential tax policies like
Kentucky’s afford states a competitive tool with which to
attract investors to their bonds, and judged that those
policies do not foster the economic isolationism that the
Court’s “dormant Commerce Clause” analysis might
otherwise prohibit.
The SEC reminds fund boards to incorporate into their
annual 15(c) review of advisory contracts a consideration
of the soft dollar benefits the adviser receives from
fund brokerage. The proposed guidance notes that
fund directors should “require investment advisers,
at a minimum, to provide them with information
regarding the adviser’s brokerage policies, and how
a fund’s brokerage commission, and, in particular,
the adviser’s use of soft dollar commissions, were
allocated, at least on an annual basis.”
the total brokerage commissions and value of
securities executed that are allocated to each
broker-dealer during a particular period; and
the fund’s portfolio turnover rates.
The proposed guidance suggests that directors may
wish to discuss with the adviser additional matters,
including the process for making trading decisions
and selecting execution venues; how the adviser
assesses best execution and execution quality; the
process for negotiating commissions; how the adviser
evaluates “execution-only” trades versus “soft-dollar”
trades; and how the adviser evaluates its traders. The
SEC stresses that, “with the rapid development of
increased options for trading venues, fund boards
need to remain up to date in their familiarity with the
evolving market in this area.”
Request for Comment for Additional Disclosure
The SEC requests comment regarding whether
“(i) further disclosure to fund investors of the information
we suggest fund boards should consider would be
helpful; (ii) any specific disclosure should be mandated
to better assist investors in making informed investment
decisions; and (iii) the public dissemination of particular
2
believing NAV to be a “far more reliable metric of
performance than market price.”
of the effect a rejection of Kentucky’s differential tax
treatment could have on the mutual fund and municipal
bond markets. Because single-state mutual funds
purchase the bonds issued by smaller or lesser known
municipalities that are not attractive in the national
market, the Court said, “many single-state funds
would likely disappear if the current differential tax
schemes were upset.” Moreover, referring to the brief
filed by the National Federation of Municipal Analysts
in support of Kentucky’s defense of its differential tax
policy, the Court explained that the Kentucky appeals
court’s decision could threaten the tax-exempt mutual
fund market, which in 2006 amounted to about $520
billion in long-term municipal bonds and $380 billion in
short-term municipal bonds. A finding that Kentucky’s
differential tax exemption is unconstitutional, the
Court reasoned, would both jeopardize an enormous
amount of public project financing and disrupt the
mutual fund market at large.
The comment period for the proposed rules expired on
May 19.
U.S. Supreme Court Affirms Constitutionality
of Tax Exemption Policies Underlying
Municipal Bond Funds
The Court noted that in a supporting brief, all 49
other states had supported Kentucky’s differential
tax policy, and 41 states maintained substantially
similar policies. Kentucky’s “differential tax scheme
is critical to the operation of an identifiable segment of
the municipal financial market as it currently functions,”
the Court observed, “and this fact alone demonstrates
that the unanimous desire of the States to preserve the
tax feature” is not a campaign toward unconstitutional
economic protectionism.
With its May 2008 decision in Kentucky v. Davis, the
U.S. Supreme Court upheld the ability of a state and
its political subdivisions to issue bonds exempt
from state income tax while imposing income tax
on interest earned on similar bonds issued by other
states. The holding reversed a decision by the court
of appeals of Kentucky that found such differential tax
treatment to be unconstitutionally discriminatory against
out-of-state economic interests, and which stood to alter
the municipal bond market radically.
The Court declined to address the constitutionality of
Kentucky’s differential tax policy for income on certain
private-activity bonds because the argument had not
been sufficiently developed in the lower courts.
SEC Hosts Roundtable on Fair Valuation
Standards
In early July, the SEC hosted a roundtable that was
designed “to facilitate an open discussion of the
benefits and potential challenges associated with
existing fair value accounting and auditing standards.”
The roundtable was divided into two panels, the first
centered on larger financial institutions and concerns
regarding their shareholders, and the second on other
public companies and their shareholders’ needs.
Regulators, including SEC Chairman, Christopher Cox,
participated in the discussion, which was open to the
public, along with representatives from the Financial
Accounting Standards Board (FASB) and the Public
Company Accounting Oversight Board. While the fund
industry was not at the center of the discussion,
Potential Market Impact of Dismantling States’
Differential Tax Exemption Schemes. The Supreme
Court’s decision also was based on an assessment
7
Investment Management Update
•
facilitate investments in ETFs by unaffiliated funds,
and
•
allow ETFs to provide retail investors with
prospectuses similar to those offered by mutual
funds (see the May 2008 Investment Management
Update article entitled “SEC Proposes Rules to
Permit Exchange-Traded Funds”).
•
IDC Comments
The IDC focused on the role of boards, noting that “the
appropriate role of fund boards—and the role in which
they are most effective—is to provide oversight, and not
to engage in day-to-day management.” Specifically, the
IDC made the following observations:
•
•
•
Facilitating the Arbitrage Mechanism: The SEC
requested comments on whether the board of an
ETF should be required to make a finding that “the
ETF is structured in a manner reasonably intended
to facilitate arbitrage,” which functions to minimize
deviations between an ETF’s market price and NAV.
The IDC “strongly objects to imposing this type
of finding on ETF boards,” noting that “[d]irectors
do not have, nor should they be expected to have,
any special knowledge or expertise that would help
them to make this type of determination.”
being overcharged for services provided to the
fund,” the SEC proposed eliminating the condition
requiring additional board findings relating to the
appropriateness of fund fees. The IDC agrees that
such additional findings are “redundant and
unnecessary.”
Reviewing Reports of Transactions Between an
Acquiring Fund and a Broker-Dealer Affiliated
with the ETF: The SEC proposed that transactions
between an acquiring fund that is affiliated with an
ETF by virtue of owning more than 5% of the ETF’s
outstanding shares and a broker-dealer affiliated
with the ETF also by virtue of owning more than
5% of the ETF’s outstanding shares be exempted
from the quarterly board reviews required by Rule
17e-1 under the Investment Company Act of 1940
to determine that those transactions were effected
in accordance with the fund’s procedures regarding
brokerage transactions. The IDC agrees that any
such transaction between second-tier affiliates is
“likely to be at arm’s length.”
Limiting an Acquiring Fund’s Ability to
“Control” an ETF: The SEC proposed permitting
unaffiliated funds to invest in ETFs beyond certain
statutory limits, subject to fewer conditions than
those currently imposed on fund groups that have
received exemptive relief. One of the conditions
that would not be incorporated into the final rules
is that the board of an “acquiring” fund (the fund
investing in an ETF) adopt procedures “reasonably
designed to assure that the acquiring fund’s
investment adviser(s) is conducting the acquiring
fund’s investment program without taking into
account any consideration received by the acquiring
fund or an acquiring fund affiliate from the ETF or
an ETF affiliate in connection with any services or
transactions.” The IDC “strongly supports the
elimination of the conditions requiring specific
board findings.”
•
•
Limiting Duplication of Fees Between ETFs
and Acquiring Funds: Another condition that
would not be part of the final rules is that the
board of an acquiring fund “determine that its
advisory fees are based on services that are in
addition to, rather than duplicative of, the ETF’s
advisory services.” Noting that “an acquiring fund
board is already obligated to protect the fund from
•
•
6
Rather than requiring ETFs either to disclose their
full portfolio holdings daily or, for index-based ETFs,
to track an index for which the full list of component
securities is publicly available, the rule permit ETFs
to disclose either their full portfolio holdings or, for
index-based ETFs, their creation basket, provided
that the basket is an optimized sample of the
portfolio,
the rule not require dissemination of an ETF’s
Intraday Value to occur through a national securities
exchange, but rather permit an ETF to rely on the
rule if its Intraday Value is “widely disseminated by
one or more major market data vendors at regular
trading intervals during the trading day,”
the rule not “require ETFs to identify themselves
as either index-based or actively managed ETFs,”
noting that “the distinction between index-based
and transparent actively managed ETFs is not
necessarily obvious or meaningful,” and
ETF prospectuses not be required to include return
information using market price as well as NAV,
The task force also outlines the potential benefits
of investing in derivatives relative to investing in
comparable cash securities, noting that derivatives
can:
IDC Releases Task Force Report on Board
Oversight of Derivatives
The Independent Directors Council of the ICI has
released a report that offers an overview of financial
derivatives and guidance regarding board oversight.
Summary of Derivatives
The report reviews the purposes of derivatives, which
are “broadly defined as financial instruments whose
value is derived from a separate asset or metric.” It
highlights the potential benefits and risks of investing
in those instruments, noting that derivatives may:
•
•
ICI Comments
The ICI “strongly supports the SEC’s proposal to
permit certain ETFs to begin operating without first
obtaining exemptive orders,” including both indexbased and fully transparent actively managed ETFs.
The ICI also suggested certain changes to the proposed
rules and rule amendments. For example, the ICI
recommends that:
and manage risk (targeting an improved risk-adjusted
return), consistent with the fund’s stated investment
objectives and mandate.”
information regarding a fund adviser’s portfolio trading
practices would have an adverse impact on the fund
adviser’s relationships with the broker-dealers that
execute fund portfolio transactions.”
“offer opportunities to improve a fund’s riskadjusted returns” and
“introduce investment, regulatory, and
operational complexities, particularly for openend funds, which redeem their shares daily at net
asset value.”
The IDC report reminds boards that they are required to
“oversee investments in derivatives as part of their
general oversight of all portfolio investments” and gives
guidance as to that oversight. The report notes that:
•
“gain or reduce exposure to a market, sector,
security, or other target exposure more quickly
and/or with lower transaction costs and portfolio
disruption”
•
•
“precisely target risk exposures”
•
“gain access to markets in which transacting in
cash securities is difficult, costly, or not possible”
and
•
“gain exposure to commodities as an asset
class (subject to certain tax tests).”
“under the ‘business judgment rule,’ board actions
are protected from judicial inquiry so long as the
board acted on an informed basis, in good faith,
and in the honest belief that the action taken
was in the best interests of the fund” and
•
Leverage: “Unlike cash securities, derivatives
enable investors to purchase or sell exposure
without committing cash in an amount equal
to the economic exposure . . . of
. . the position.
This ability could result in leverage . . . of the risk
position”;
•
Illiquidity: “Some derivatives, particularly complex
OTC instruments, may be illiquid and some
previously-liquid derivatives (as well as cash
securities) may become illiquid during periods of
market stress”; and
•
Counterparty Risk: “Because the satisfaction of an
OTC contract depends on the creditworthiness
of the counterparty, OTC derivatives entail
counterparty risk.”
the SEC has stated that such oversight includes:
»
“benefit from price differences between cash
securities and related derivatives”
Along with the benefits of investing in derivatives, the
IDC report highlights some of the risks associated with
investing in those instruments, noting that derivatives
can “raise additional investment risk management
issues,” including:
Responsibilities of the Board
•
•
“the particular responsibility to ask questions
concerning why and how the fund uses
futures and other derivative instruments,”
» “the risks of using such instruments,” and
» “the effectiveness of internal controls
Operational and Regulatory Concerns
designed to monitor risk and assure
compliance with investment guidelines
regarding the use of such instruments.”
The report notes that the board oversight of investments
in derivatives may lead to discussions with the
adviser regarding “operational resources, internal
controls and organizational structures of the adviser
and services providers.” The report offers tools to
assist in these discussions, including:
Fund Use of Derivatives
The report notes that “[d]erivatives offer fund
managers and traders an expanded set of choices,
beyond the cash securities markets, through which
to implement the manager’s investment strategy
•
3
“key derivatives-related operational and
regulatory considerations that are specific to
registered funds” such as:
Investment Management Update
»
»
»
»
»
»
»
»
•
•
fund operations
Advisers Act of 1940) to, among other things, eliminate
references to Nationally Recognized Statistical Rating
Organizations (NRSROs).
custody and collateral
senior security and asset segregation
Background
issuer exposure
In its proposing release, the SEC explains that
underlying the proposed amendments is the “risk
that investors interpret the use of the term in laws
and regulations as an endorsement of the quality of
the credit ratings issued by NRSROs . . . The SEC is
concerned that the inclusion of requirements related
to ratings in its rules and forms has, in effect, placed
an ‘official seal of approval’ on ratings that could
adversely affect the quality of due diligence and
investment analysis.” The SEC notes that its proposal
is “designed to reduce undue reliance on credit ratings
and result in improvements in the analysis that underlies
investment decisions.” The proposal came on the heels
of two other rulemaking initiatives involving NRSROs.
One, under the Securities Exchange Act of 1934, is
“directed at reducing conflicts of interest in the credit
rating process, fostering competition and comparability
among credit agencies and increasing transparency
of the credit rating process;” the other, under the
Securities Act of 1933, is “designed to improve investor
understanding of the risk characteristics of structured
investment products.” Comments on the proposed rule
amendments are due by September 5, 2008.
valuation
accounting and financial reporting
tax issues and
disclosure.
organizational responsibilities and structures
as highlighted in a table regarding functions of
advisers and service providers related to investing
in derivatives; and
policies and procedures related to investing in
derivatives, including both broad policies as well
as those that are narrowly tailored specifically for
investing in derivatives.
Resources and Good Practices for Boards
The report notes that the level of oversight of
derivatives will vary from board to board. One
example would be “the board of an index fund that
uses futures solely to efficiently invest (equitize) cash
may not find it necessary to devote as much time and
attention to the fund’s derivatives investments as might
the board of an actively managed fund with complex
OTC derivatives holdings and strategies.”
Rule 2a-7 (Money Market Funds)
The report recommends that “[a] fund’s derivatives
investments … be captured in compliance and
portfolio performance reports to the board.”
Under the proposed amendments to Rule 2a-7:
•
The report includes an appendix highlighting
educational resources for boards, including papers,
books and conferences available to them. Boards also
can look to the “fund auditor, board and fund counsel,
as well as industry or academic publications and
conferences” for additional information and assistance
with overseeing derivatives.
As the report mentions, the derivatives markets are
evolving rapidly in “volume, type and complexity,”
spurring the evolution of industry practices, as well. The
full task force report can be found on the IDC website at
http://www.idc1.org/idc/doclink.do?file=22729.
SEC Proposes to Remove NRSRO Ratings
References from Rules Affecting Mutual Funds
•
On July 1, 2008 the SEC released a proposal to amend
Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment
Company Act of 1940 (and a rule under the Investment
4
A money market fund’s board of directors
(or its delegates) would be responsible for
determining whether each instrument in the
fund’s portfolio is an “eligible security” (one
presenting minimal credit risks). The Board also
would need to determine whether each security is
a “first tier” security (having the “highest capacity
to meet its short-term financial obligations”) or a
“second tier” security (an “eligible security” that
is not “first tier”). According to the SEC, “money
market fund boards of directors would still be able
to use quality determinations prepared by outside
sources, including NRSRO ratings that they
conclude are credible in making the determinations
. . . [the Commission expects] that the
boards of directors (or their delegates) would
understand the basis for the rating and make an
independent judgment of credit risks.”
The current standards for ensuring the liquidity of
money market fund portfolios would be codified to
expressly limit a money market fund’s investments
in illiquid securities to not more than 10% of its
•
•
total assets. Further, a liquid security would be
statutorily defined as that which “can be sold or
disposed of in the ordinary course of business
within seven days at approximately the value
ascribed to it by the money market fund.”
when the fund invests in the repurchase agreement. The
proposed amendments would eliminate NRSRO ratings
as a factor. Alternatively, the proposed changes would
require that, where collateral is not cash or backed by
the U.S. Government, a mutual fund’s board of directors
(or its delegates) must determine that the securities used
as collateral are:
In the event a money market fund’s adviser
becomes aware of information about a portfolio
security, or its issuer, which suggests that the
security may not continue to present minimal credit
risk, the fund’s board of directors would have to
promptly reassess whether the portfolio security
continued to present minimal credit risk. Under
the current rule, a money market fund board only
must take such action if a portfolio security has
been downgraded by an NRSRO. The SEC notes
that while “the proposed amendments would [not]
require investment advisers to subscribe to every
rating service publication in order to comply with
this proposal . . . [it] would expect an investment
adviser to exercise reasonable diligence in
keeping abreast of new information about a
portfolio security that is reported in the national
press or in publications to which the investment
adviser subscribes.”
•
“sufficiently liquid that they can be sold at or near
their carrying value within a reasonably short period
of time;
•
•
subject to no greater than minimal credit risk; and
issued by a person that has the highest capacity to
meet its financial obligations.”
Rule 10f-3 (Affiliated Underwriters)
As the SEC explains in the proposing release, Rule
10f-3 was adopted “to permit a fund that is affiliated
with members of an underwriting syndicate to purchase
securities from the syndicate if certain conditions are
met.” Municipal securities are included within the
purview of Rule 10f-3 if they “have an investment
grade rating from at least one NRSRO (or, if the issuer
has been in operation for less than three years, the
securities must have one of the three highest ratings
from an NRSRO).” The SEC proposes to eliminate
references to NRSROs and to amend the definition of an
“eligible municipal security” to mean “securities that are
sufficiently liquid that they can be sold at or near their
carrying value within a reasonably short period of time.”
In addition, the securities should carry no greater than
“moderate risk” or, if the issuers have been in operation
for less than three years, the securities must be subject
to “minimal or a low amount of credit risk.”
A money market fund would be required to provide
the SEC with prompt notice when an affiliate (or its
promoter or principal underwriter) purchased from
the fund a distressed security (e.g., one that was
no longer an “eligible security”), in reliance on Rule
17a-9 under the Investment Company Act.
Rule 3a-7
The SEC seeks to eliminate from Rule 3a-7 the
exemption that currently allows a publicly-offered
structured finance vehicle that is rated in one of the four
highest NRSRO categories to avoid registration as an
investment company. In addition, the proposal would
amend the portions of Rule 3a‑7 that address (i) the
acquisition and disposition of securities in the context
of ratings downgrades and (ii) the safekeeping of fund
assets.
With respect to the role of the board, the SEC
would not require any additional responsibilities
because “the board . . . already is required to review
repurchases of municipal securities made in reliance
on the rule . . . . In addition, pursuant to its oversight
role, the board would be required to approve
procedures for ensuring that municipal securities
meet the proposed conditions for credit quality and
liquidity.”
Rule 5b-3 (Repurchase Agreements)
Rule 5b-3 currently allows mutual funds to treat the
acquisition of a repurchase agreement as the acquisition
of securities collateralizing the repurchase agreement
itself (as opposed to an investment in the repurchase
agreement counterparty). The treatment permitted
under Rule 5b-3 is conditioned on a number of factors,
including that the obligation of the counterparty to
repurchase the securities is “collaterized fully.” An
obligation is considered fully collateralized if the
securities used as collateral are, among other things,
rated in the highest category by a “Requisite NRSRO”
IDC and ICI Weigh in on ETF Proposal
The Independent Directors Council (IDC) and the
Investment Company Institute (ICI) recently commented
on the SEC’s proposed rules and rule amendments
relating to Exchange-Traded Funds. Among other
things, the SEC’s proposal would:
•
5
permit ETFs to be offered without obtaining SEC
exemptive relief,
Investment Management Update
»
»
»
»
»
»
»
»
•
•
fund operations
Advisers Act of 1940) to, among other things, eliminate
references to Nationally Recognized Statistical Rating
Organizations (NRSROs).
custody and collateral
senior security and asset segregation
Background
issuer exposure
In its proposing release, the SEC explains that
underlying the proposed amendments is the “risk
that investors interpret the use of the term in laws
and regulations as an endorsement of the quality of
the credit ratings issued by NRSROs … The SEC is
concerned that the inclusion of requirements related
to ratings in its rules and forms has, in effect, placed
an ‘official seal of approval’ on ratings that could
adversely affect the quality of due diligence and
investment analysis.” The SEC notes that its proposal
is “designed to reduce undue reliance on credit ratings
and result in improvements in the analysis that underlies
investment decisions.” The proposal came on the heels
of two other rulemaking initiatives involving NRSROs.
One, under the Securities Exchange Act of 1934, is
“directed at reducing conflicts of interest in the credit
rating process, fostering competition and comparability
among credit agencies and increasing transparency
of the credit rating process;” the other, under the
Securities Act of 1933, is “designed to improve investor
understanding of the risk characteristics of structured
investment products.” Comments on the proposed rule
amendments are due by September 5, 2008.
valuation
accounting and financial reporting
tax issues and
disclosure.
organizational responsibilities and structures
as highlighted in a table regarding functions of
advisers and service providers related to investing
in derivatives; and
policies and procedures related to investing in
derivatives, including both broad policies as well
as those that are narrowly tailored specifically for
investing in derivatives.
Resources and Good Practices for Boards
The report notes that the level of oversight of
derivatives will vary from board to board. One
example would be “the board of an index fund that
uses futures solely to efficiently invest (equitize) cash
may not find it necessary to devote as much time and
attention to the fund’s derivatives investments as might
the board of an actively managed fund with complex
OTC derivatives holdings and strategies.”
Rule 2a-7 (Money Market Funds)
The report recommends that “[a] fund’s derivatives
investments … be captured in compliance and
portfolio performance reports to the board.”
Under the proposed amendments to Rule 2a-7:
•
The report includes an appendix highlighting
educational resources for boards, including papers,
books and conferences available to them. Boards also
can look to the “fund auditor, board and fund counsel,
as well as industry or academic publications and
conferences” for additional information and assistance
with overseeing derivatives.
As the report mentions, the derivatives markets are
evolving rapidly in “volume, type and complexity,”
spurring the evolution of industry practices, as well. The
full task force report can be found on the IDC website at
http://www.idc1.org/idc/doclink.do?file=22729.
SEC Proposes to Remove NRSRO Ratings
References from Rules Affecting Mutual Funds
•
On July 1, 2008 the SEC released a proposal to amend
Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment
Company Act of 1940 (and a rule under the Investment
4
A money market fund’s board of directors
(or its delegates) would be responsible for
determining whether each instrument in the
fund’s portfolio is an “eligible security” (one
presenting minimal credit risks). The Board also
would need to determine whether each security is
a “first tier” security (having the “highest capacity
to meet its short-term financial obligations”) or a
“second tier” security (an “eligible security” that
is not “first tier”). According to the SEC, “money
market fund boards of directors would still be able
to use quality determinations prepared by outside
sources, including NRSRO ratings that they
conclude are credible in making the determinations
. . . [the Commission expects] that the
boards of directors (or their delegates) would
understand the basis for the rating and make an
independent judgment of credit risks.”
The current standards for ensuring the liquidity of
money market fund portfolios would be codified to
expressly limit a money market fund’s investments
in illiquid securities to not more than 10% of its
•
•
total assets. Further, a liquid security would be
statutorily defined as that which “can be sold or
disposed of in the ordinary course of business
within seven days at approximately the value
ascribed to it by the money market fund.”
when the fund invests in the repurchase agreement. The
proposed amendments would eliminate NRSRO ratings
as a factor. Alternatively, the proposed changes would
require that, where collateral is not cash or backed by
the U.S. Government, a mutual fund’s board of directors
(or its delegates) must determine that the securities used
as collateral are:
In the event a money market fund’s adviser
becomes aware of information about a portfolio
security, or its issuer, which suggests that the
security may not continue to present minimal credit
risk, the fund’s board of directors would have to
promptly reassess whether the portfolio security
continued to present minimal credit risk. Under
the current rule, a money market fund board only
must take such action if a portfolio security has
been downgraded by an NRSRO. The SEC notes
that while “the proposed amendments would [not]
require investment advisers to subscribe to every
rating service publication in order to comply with
this proposal . . . [it] would expect an investment
adviser to exercise reasonable diligence in
keeping abreast of new information about a
portfolio security that is reported in the national
press or in publications to which the investment
adviser subscribes.”
•
“sufficiently liquid that they can be sold at or near
their carrying value within a reasonably short period
of time;
•
•
subject to no greater than minimal credit risk; and
issued by a person that has the highest capacity to
meet its financial obligations.”
Rule 10f-3 (Affiliated Underwriters)
As the SEC explains in the proposing release, Rule
10f-3 was adopted “to permit a fund that is affiliated
with members of an underwriting syndicate to purchase
securities from the syndicate if certain conditions are
met.” Municipal securities are included within the
purview of Rule 10f-3 if they “have an investment
grade rating from at least one NRSRO (or, if the issuer
has been in operation for less than three years, the
securities must have one of the three highest ratings
from an NRSRO).” The SEC proposes to eliminate
references to NRSROs and to amend the definition of an
“eligible municipal security” to mean “securities that are
sufficiently liquid that they can be sold at or near their
carrying value within a reasonably short period of time.”
In addition, the securities should carry no greater than
“moderate risk” or, if the issuers have been in operation
for less than three years, the securities must be subject
to “minimal or a low amount of credit risk.”
A money market fund would be required to provide
the SEC with prompt notice when an affiliate (or its
promoter or principal underwriter) purchased from
the fund a distressed security (e.g., one that was
no longer an “eligible security”), in reliance on Rule
17a-9 under the Investment Company Act.
Rule 3a-7
The SEC seeks to eliminate from Rule 3a-7 the
exemption that currently allows a publicly-offered
structured finance vehicle that is rated in one of the four
highest NRSRO categories to avoid registration as an
investment company. In addition, the proposal would
amend the portions of Rule 3a‑7 that address (i) the
acquisition and disposition of securities in the context
of ratings downgrades and (ii) the safekeeping of fund
assets.
With respect to the role of the board, the SEC
would not require any additional responsibilities
because “the board . . . already is required to review
repurchases of municipal securities made in reliance
on the rule . . . . In addition, pursuant to its oversight
role, the board would be required to approve
procedures for ensuring that municipal securities
meet the proposed conditions for credit quality and
liquidity.”
Rule 5b-3 (Repurchase Agreements)
Rule 5b-3 currently allows mutual funds to treat the
acquisition of a repurchase agreement as the acquisition
of securities collateralizing the repurchase agreement
itself (as opposed to an investment in the repurchase
agreement counterparty). The treatment permitted
under Rule 5b-3 is conditioned on a number of factors,
including that the obligation of the counterparty to
repurchase the securities is “collaterized fully.” An
obligation is considered fully collateralized if the
securities used as collateral are, among other things,
rated in the highest category by a “Requisite NRSRO”
IDC and ICI Weigh in on ETF Proposal
The Independent Directors Council (IDC) and the
Investment Company Institute (ICI) recently commented
on the SEC’s proposed rules and rule amendments
relating to Exchange-Traded Funds. Among other
things, the SEC’s proposal would:
•
5
permit ETFs to be offered without obtaining SEC
exemptive relief,
Investment Management Update
•
facilitate investments in ETFs by unaffiliated funds,
and
•
allow ETFs to provide retail investors with
prospectuses similar to those offered by mutual
funds (see the May 2008 Investment Management
Update article entitled “SEC Proposes Rules to
Permit Exchange-Traded Funds”).
•
IDC Comments
The IDC focused on the role of boards, noting that “the
appropriate role of fund boards—and the role in which
they are most effective—is to provide oversight, and not
to engage in day-to-day management.” Specifically, the
IDC made the following observations:
•
•
•
Facilitating the Arbitrage Mechanism: The SEC
requested comments on whether the board of an
ETF should be required to make a finding that “the
ETF is structured in a manner reasonably intended
to facilitate arbitrage,” which functions to minimize
deviations between an ETF’s market price and NAV.
The IDC “strongly objects to imposing this type
of finding on ETF boards,” noting that “[d]irectors
do not have, nor should they be expected to have,
any special knowledge or expertise that would help
them to make this type of determination.”
being overcharged for services provided to the
fund,” the SEC proposed eliminating the condition
requiring additional board findings relating to the
appropriateness of fund fees. The IDC agrees that
such additional findings are “redundant and
unnecessary.”
Reviewing Reports of Transactions Between an
Acquiring Fund and a Broker-Dealer Affiliated
with the ETF: The SEC proposed that transactions
between an acquiring fund that is affiliated with an
ETF by virtue of owning more than 5% of the ETF’s
outstanding shares and a broker-dealer affiliated
with the ETF also by virtue of owning more than
5% of the ETF’s outstanding shares be exempted
from the quarterly board reviews required by Rule
17e-1 under the Investment Company Act of 1940
to determine that those transactions were effected
in accordance with the fund’s procedures regarding
brokerage transactions. The IDC agrees that any
such transaction between second-tier affiliates is
“likely to be at arm’s length.”
Limiting an Acquiring Fund’s Ability to
“Control” an ETF: The SEC proposed permitting
unaffiliated funds to invest in ETFs beyond certain
statutory limits, subject to fewer conditions than
those currently imposed on fund groups that have
received exemptive relief. One of the conditions
that would not be incorporated into the final rules
is that the board of an “acquiring” fund (the fund
investing in an ETF) adopt procedures “reasonably
designed to assure that the acquiring fund’s
investment adviser(s) is conducting the acquiring
fund’s investment program without taking into
account any consideration received by the acquiring
fund or an acquiring fund affiliate from the ETF or
an ETF affiliate in connection with any services or
transactions.” The IDC “strongly supports the
elimination of the conditions requiring specific
board findings.”
•
•
Limiting Duplication of Fees Between ETFs
and Acquiring Funds: Another condition that
would not be part of the final rules is that the
board of an acquiring fund “determine that its
advisory fees are based on services that are in
addition to, rather than duplicative of, the ETF’s
advisory services.” Noting that “an acquiring fund
board is already obligated to protect the fund from
•
•
6
Rather than requiring ETFs either to disclose their
full portfolio holdings daily or, for index-based ETFs,
to track an index for which the full list of component
securities is publicly available, the rule permit ETFs
to disclose either their full portfolio holdings or, for
index-based ETFs, their creation basket, provided
that the basket is an optimized sample of the
portfolio,
the rule not require dissemination of an ETF’s
Intraday Value to occur through a national securities
exchange, but rather permit an ETF to rely on the
rule if its Intraday Value is “widely disseminated by
one or more major market data vendors at regular
trading intervals during the trading day,”
the rule not “require ETFs to identify themselves
as either index-based or actively managed ETFs,”
noting that “the distinction between index-based
and transparent actively managed ETFs is not
necessarily obvious or meaningful,” and
ETF prospectuses not be required to include return
information using market price as well as NAV,
The task force also outlines the potential benefits
of investing in derivatives relative to investing in
comparable cash securities, noting that derivatives
can:
IDC Releases Task Force Report on Board
Oversight of Derivatives
The Independent Directors Council of the ICI has
released a report that offers an overview of financial
derivatives and guidance regarding board oversight.
Summary of Derivatives
The report reviews the purposes of derivatives, which
are “broadly defined as financial instruments whose
value is derived from a separate asset or metric.” It
highlights the potential benefits and risks of investing
in those instruments, noting that derivatives may:
•
•
ICI Comments
The ICI “strongly supports the SEC’s proposal to
permit certain ETFs to begin operating without first
obtaining exemptive orders,” including both indexbased and fully transparent actively managed ETFs.
The ICI also suggested certain changes to the proposed
rules and rule amendments. For example, the ICI
recommends that:
and manage risk (targeting an improved risk-adjusted
return), consistent with the fund’s stated investment
objectives and mandate.”
information regarding a fund adviser’s portfolio trading
practices would have an adverse impact on the fund
adviser’s relationships with the broker-dealers that
execute fund portfolio transactions.”
“offer opportunities to improve a fund’s riskadjusted returns” and
“introduce investment, regulatory, and
operational complexities, particularly for openend funds, which redeem their shares daily at net
asset value.”
The IDC report reminds boards that they are required to
“oversee investments in derivatives as part of their
general oversight of all portfolio investments” and gives
guidance as to that oversight. The report notes that:
•
“gain or reduce exposure to a market, sector,
security, or other target exposure more quickly
and/or with lower transaction costs and portfolio
disruption”
•
•
“precisely target risk exposures”
•
“gain access to markets in which transacting in
cash securities is difficult, costly, or not possible”
and
•
“gain exposure to commodities as an asset
class (subject to certain tax tests).”
“under the ‘business judgment rule,’ board actions
are protected from judicial inquiry so long as the
board acted on an informed basis, in good faith,
and in the honest belief that the action taken
was in the best interests of the fund” and
•
Leverage: “Unlike cash securities, derivatives
enable investors to purchase or sell exposure
without committing cash in an amount equal
to the economic exposure … of the position.
This ability could result in leverage … of the risk
position”;
•
Illiquidity: “Some derivatives, particularly complex
OTC instruments, may be illiquid and some
previously-liquid derivatives (as well as cash
securities) may become illiquid during periods of
market stress”; and
•
Counterparty Risk: “Because the satisfaction of an
OTC contract depends on the creditworthiness
of the counterparty, OTC derivatives entail
counterparty risk.”
the SEC has stated that such oversight includes:
»
“benefit from price differences between cash
securities and related derivatives”
Along with the benefits of investing in derivatives, the
IDC report highlights some of the risks associated with
investing in those instruments, noting that derivatives
can “raise additional investment risk management
issues,” including:
Responsibilities of the Board
•
•
“the particular responsibility to ask questions
concerning why and how the fund uses
futures and other derivative instruments,”
» “the risks of using such instruments,” and
» “the effectiveness of internal controls
Operational and Regulatory Concerns
designed to monitor risk and assure
compliance with investment guidelines
regarding the use of such instruments.”
The report notes that the board oversight of investments
in derivatives may lead to discussions with the
adviser regarding “operational resources, internal
controls and organizational structures of the adviser
and services providers.” The report offers tools to
assist in these discussions, including:
Fund Use of Derivatives
The report notes that “[d]erivatives offer fund
managers and traders an expanded set of choices,
beyond the cash securities markets, through which
to implement the manager’s investment strategy
•
3
“key derivatives-related operational and
regulatory considerations that are specific to
registered funds” such as:
Investment Management Update
Proposed Board Oversight of the Adviser’s Use
of Fund Commissions
monitor the fund adviser’s trading practices and
efforts to seek best execution. The proposed
guidance offers detailed examples of questions to
be asked and data to be sought by directors in
performing their oversight role. Comments on the
proposed guidance are due by October 1, 2008.
Fund Directors’ Duties
The SEC reminds fund boards that they need to be
“sufficiently familiar with the adviser’s trading
practices to satisfy itself that the adviser is fulfilling
its fiduciary obligations and is acting in the best
interest of the fund.” Though the proposed guidance
states that “directors are not required or expected
to monitor each trade,” it also states that directors
“should demand, and the fund’s adviser must provide, all
information needed by the fund’s board to complete the
review process.”
Proposed Board Oversight of Best Execution
The proposed guidance describes the factors a fund
adviser should consider related to minimizing the overall
transaction costs incurred by the fund, including explicit
costs—such as commissions and fees, and implicit
costs—such as bid/ask spreads and missed trade
opportunity costs. The SEC suggests that “directors
should also consider the adviser’s decision whether
to use an alternative trading system.” Further, among
the data that the SEC urges fund directors to consider is:
•
The identification of broker-dealers to which the
adviser has allocated fund trading and brokerage;
•
•
The commission rates or spreads paid;
•
In discussing an adviser’s use of soft-dollars, the
proposed guidance lists potential conflicts of interest
that could arise between a fund and the fund’s adviser.
The SEC notes that, “[w]hen evaluating an adviser’s
use of fund brokerage commissions in light of these
conflicts, a fund board may determine that such use
is in the best interests of the fund.” The proposed
guidance goes on to note that while the adviser has the
obligation to satisfy the requirements of Section 28(e)
of the Securities Exchange Act of 1934, it is still
the responsibility of the board to ensure that the
adviser’s actions are in the best interest of the fund.
The SEC states that after receiving and reviewing data
from the adviser that details the adviser’s use of fund
commissions, “if the board believes that the fund’s
brokerage commissions could be used differently so
as to provide greater benefits to the fund, the board
should direct the adviser accordingly (emphasis
added).” The SEC specifies that boards should
consider whether it is appropriate for the adviser (1) to
refrain from using soft dollar trading for certain types of
trades, (2) to alter the mix of trades applying soft dollars,
or (3) to use soft dollar trading only for commission
recapture or expense reimbursement programs. The
SEC’s proposed guidance notes that fund directors
may wish to discuss with the fund CCO the compliance
policies regarding the use of brokerage commissions to
obtain brokerage and research services.
In addition, the ICI, like the IDC, strongly supports
the SEC’s proposal to permit unaffiliated funds to
invest in ETFs beyond statutory limits, subject to
fewer conditions than those contained in exemptive
orders. The ICI offered certain suggestions relating
to investments in ETFs by unaffiliated funds, including
suggestions to allow for greater flexibility for an
acquired ETF to invest in funds and other ETFs, and for
unregistered funds to invest in ETFs beyond statutory
limits as well.
Fund Board Duties in Connection with Annual
Contract Reviews
Tax-Exempt Municipal Bonds and the Public Welfare.
In overruling the Kentucky appeals court’s ruling,
the Supreme Court relied in part on its prior holdings
allowing a state to favor in-state interests when carrying
out typical and traditional local government functions,
especially those designed to benefit the public welfare.
The Court characterized states’ issuance of debt to
pay for public projects as a “quintessentially public
function, with [a] venerable history,” explaining that
proceeds from tax-exempt bonds afford states “a
way to shoulder the cardinal civic responsibilities . .
. [of] protecting citizens’ health, safety, and welfare.”
The Court noted that differential tax policies like
Kentucky’s afford states a competitive tool with which to
attract investors to their bonds, and judged that those
policies do not foster the economic isolationism that the
Court’s “dormant Commerce Clause” analysis might
otherwise prohibit.
The SEC reminds fund boards to incorporate into their
annual 15(c) review of advisory contracts a consideration
of the soft dollar benefits the adviser receives from
fund brokerage. The proposed guidance notes that
fund directors should “require investment advisers,
at a minimum, to provide them with information
regarding the adviser’s brokerage policies, and how
a fund’s brokerage commission, and, in particular,
the adviser’s use of soft dollar commissions, were
allocated, at least on an annual basis.”
The total brokerage commissions and value of
securities executed that are allocated to each
broker-dealer during a particular period; and
The fund’s portfolio turnover rates.
The proposed guidance suggests that directors may
wish to discuss with the adviser additional matters,
including the process for making trading decisions
and selecting execution venues; how the adviser
assesses best execution and execution quality; the
process for negotiating commissions; how the adviser
evaluates “execution-only” trades versus “soft-dollar”
trades; and how the adviser evaluates its traders. The
SEC stresses that, “with the rapid development of
increased options for trading venues, fund boards
need to remain up to date in their familiarity with the
evolving market in this area.”
Request for Comment for Additional Disclosure
The SEC requests comment regarding whether
“(i) further disclosure to fund investors of the information
we suggest fund boards should consider would be
helpful; (ii) any specific disclosure should be mandated
to better assist investors in making informed investment
decisions; and (iii) the public dissemination of particular
2
believing NAV to be a “far more reliable metric of
performance than market price.”
of the effect a rejection of Kentucky’s differential tax
treatment could have on the mutual fund and municipal
bond markets. Because single-state mutual funds
purchase the bonds issued by smaller or lesser known
municipalities that are not attractive in the national
market, the Court said, “many single-state funds
would likely disappear if the current differential tax
schemes were upset.” Moreover, referring to the brief
filed by the National Federation of Municipal Analysts
in support of Kentucky’s defense of its differential tax
policy, the Court explained that the Kentucky appeals
court’s decision could threaten the tax-exempt mutual
fund market, which in 2006 amounted to about $520
billion in long-term municipal bonds and $380 billion in
short-term municipal bonds. A finding that Kentucky’s
differential tax exemption is unconstitutional, the
Court reasoned, would both jeopardize an enormous
amount of public project financing and disrupt the
mutual fund market at large.
The comment period for the proposed rules expired on
May 19.
U.S. Supreme Court Affirms Constitutionality
of Tax Exemption Policies Underlying
Municipal Bond Funds
The Court noted that in a supporting brief, all 49
other states had supported Kentucky’s differential
tax policy, and 41 states maintained substantially
similar policies. Kentucky’s “differential tax scheme
is critical to the operation of an identifiable segment of
the municipal financial market as it currently functions,”
the Court observed, “and this fact alone demonstrates
that the unanimous desire of the States to preserve the
tax feature” is not a campaign toward unconstitutional
economic protectionism.
With its May 2008 decision in Kentucky v. Davis, the
U.S. Supreme Court upheld the ability of a state and
its political subdivisions to issue bonds exempt
from state income tax while imposing income tax
on interest earned on similar bonds issued by other
states. The holding reversed a decision by the court
of appeals of Kentucky that found such differential tax
treatment to be unconstitutionally discriminatory against
out-of-state economic interests, and which stood to alter
the municipal bond market radically.
The Court declined to address the constitutionality of
Kentucky’s differential tax policy for income on certain
private-activity bonds because the argument had not
been sufficiently developed in the lower courts.
SEC Hosts Roundtable on Fair Valuation
Standards
In early July, the SEC hosted a roundtable that was
designed “to facilitate an open discussion of the
benefits and potential challenges associated with
existing fair value accounting and auditing standards.”
The roundtable was divided into two panels, the first
centered on larger financial institutions and concerns
regarding their shareholders, and the second on other
public companies and their shareholders’ needs.
Regulators, including SEC Chairman, Christopher Cox,
participated in the discussion, which was open to the
public, along with representatives from the Financial
Accounting Standards Board (FASB) and the Public
Company Accounting Oversight Board. While the fund
industry was not at the center of the discussion,
Potential Market Impact of Dismantling States’
Differential Tax Exemption Schemes. The Supreme
Court’s decision also was based on an assessment
7
any modification of the framework for measuring fair
value established by Statement of Financial Accounting
Standards No. 157 (SFAS 157) would impact the way funds
fair value securities.
sophisticated instruments, lack of timely information, the
inherent inconsistencies associated with the judgments
and estimates involved in fair valuation, and the fact that
subsequent events can affect measurements of fair value.
According to the SEC, the goal of the roundtable was to
address:
Other topics included trends observed by auditors in recent
meetings with the audit committees of public companies’
boards of directors, when fair value might be the most
relevant attribute of a security, and methods of gauging the
accuracy of a company’s fair value estimates by assessing its
management’s internal controls, business strategy and loss
recovery plan.
•
•
the usefulness of fair value accounting to investors;
•
actual and hypothetical challenges in applying fair value
accounting standards;
•
potential improvements to current fair value accounting
standards; and
•
auditor assurances regarding fair value accounting.
the potential effects on market behavior of fair value
accounting;
Much of the conversation centered on the disclosures that
public companies make in their quarterly reports regarding
the fair valuation of their assets and liabilities, as required by
SFAS 157. Moderators from the SEC’s Division of Corporate
Finance and the FASB asked whether fair valuation
disclosure under SFAS 157 was sufficiently transparent
and otherwise adequate. Suggestions for change
included streamlining disclosures to promote shareholder
understanding of how companies may use fair valuation
techniques to price their shares. A representative from
the Federal Reserve Bank, in particular, advocated far more
disclosure regarding the risks of fair value accounting and the
various types of valuation models used. Continued market
volatility, several panelists commented, could create the need
for further fair valuation disclosure reform.
Referring to the March 2008 “Dear CFO Letter” which the
SEC’s Division of Corporate Finance sent to nearly 30 public
companies to, among other things, evaluate their fair valuation
disclosure, Wayne Carnall, Chief Accountant of the Division of
Corporate Finance, said that none of the companies surveyed
had provided suggested disclosure regarding the sensitivity
of fair value estimates in the context of fair value modeling.
He said that such disclosure could be very informative for
shareholders and would afford greater transparency of
companies’ fair valuation practices. The panelists generally
agreed that education about the objectives of fair value
standards would be useful for shareholders and public
companies alike.
Panelists cited the difficulties associated with determining
fair value under current standards and market conditions,
including the need for costly specialists to value
70 West Madison Street
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A broadcast of the roundtable is available online through
the SEC’s website at http://www.connectlive.com/events/
secroundtable070908.
Investment Management and
financial MARKETS Group
Cheryl A. Allaire
858-509-7424
callaire@bellboyd.com
Joanne Phillips
202-955-6824
jphillips@bellboyd.com
Cameron S. Avery
312-807-4302
cavery@bellboyd.com
Paulita A. Pike
312-781-6027
ppike@bellboyd.com
Kevin R. Bettsteller
312-807-4442
kbettsteller@bellboyd.com
Eric S. Purple
202-955-7081
epurple@bellboyd.com
Paul H. Dykstra
312-781-6029
pdykstra@bellboyd.com
Bruce A. Rosenblum
202-955-7087
brosenblum@bellboyd.com
David P. Glatz
312-807-4295
dglatz@bellboyd.com
Donald S. Weiss
312-807-4303
dweiss@bellboyd.com
Alan Goldberg
312-807-4227
agoldberg@bellboyd.com
Gwendolyn A. Williamson
202-955-7059
gwilliamson@bellboyd.com
Elizabeth H. Hudson
312-807-4376
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Stacy H. Winick
202-955-7040
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Anna Paglia
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© 2008 Bell, Boyd & Lloyd LLP. All rights reserved.
Investment Management Update is published by Bell, Boyd & Lloyd LLP for clients and friends of the firm and is for information only. It is not a substitute for legal advice or
individual analysis of a particular legal matter. Readers should not act without seeking professional legal counsel. Transmission and receipt of this publication does not create
an attorney-client relationship.
Investment Management Update
A service to our clients.
August 2008
Seventh Circuit Rejects Gartenberg in Favor of Market Forces
Inside This Issue
IDC Releases Task
Force Report on
Board Oversight of
Derivatives - page 3
SEC Proposes to
Remove NRSRO
Ratings References
from Rules Affecting
Mutual Funds page 4
IDC and ICI Weigh in
on ETF Proposal page 5
U.S. Supreme
Court Affirms
Constitutionality of Tax
Exemption Policies
Underlying Municipal
Bond Funds - page 7
SEC Hosts
Roundtable on Fair
Valuation Standards page 7
In Jones v. Harris Associates L.P., the U.S. Court of Appeals for the Seventh Circuit recently
rejected the “reasonableness” standard previously adopted by Gartenberg for determining
whether an advisory fee is excessive. In Jones, shareholders of the Oakmark funds alleged
that the fees paid those funds’ adviser were too high, thus violating Section 36(b). Ruling in
favor of the adviser, Chief Judge Easterbrook stated:
[W]e now disapprove the Gartenberg approach. A fiduciary duty differs from
rate regulation. A fiduciary must make full disclosure and play no tricks but
is not subject to a cap on compensation. The trustees (and in the end
investors, who vote with their feet and dollars), rather than a judge or
jury, determine how much advisory services are worth. Section 36(b)
does not say that fees must be “reasonable” in relation to a judicially
created standard. It says instead that the adviser has a fiduciary duty.
The Court went on to note that, “just as plaintiffs are skeptical of Gartenberg because it
relies too heavily on markets, we are skeptical about Gartenberg because it relies too little
on markets.” Comparing a fund director’s analysis of an advisory contract to the evaluation
by operating company directors of management compensation, the Court observed that “a
committee of independent directors sets the top managers’ compensation. No court has
held that this procedure implies judicial review for ‘reasonableness’ of the resulting salary,
bonus, and stock options.” According to the Court, “[c]ompetitive processes are
imperfect but remain superior to a ‘just price’ system administered by the judiciary.
However weak competition may be at weeding out errors, the judicial process is
worse—for judges can’t be turned out of office or have their salaries cut if they
display poor business judgment.”
Because it focuses on market forces rather than judicial assessments of the reasonableness
of advisory fees, Jones accords greater deference to the business judgment of fund boards
in reviewing those fees. The Jones decision is the law only in the Seventh Circuit (Illinois,
Indiana and Wisconsin). Gartenberg, however, remains the controlling precedent in the
Second Circuit (Connecticut, New York and Vermont), where it was decided, as well as
in many other jurisdictions, including the Fourth Circuit (Maryland, North Carolina, South
Carolina, Virginia and West Virginia). Moreover, rules adopted by the Securities and
Exchange Commission (SEC) require shareholder disclosure of the Gartenberg factors
detailing directors’ consideration of advisory fees.
SEC Proposes Guidance on Fund Directors’ Duties as to Best Execution
and Use of Soft Dollars
The SEC recently proposed guidance regarding the duties of fund directors in overseeing
portfolio trading practices, including the manner in which the adviser seeks best execution
and uses fund brokerage commissions (soft dollars) to obtain products or services. The
SEC notes that its guidance “would not impose any new or additional requirements.”
The SEC stresses that it is “imperative that fund directors both understand and
scrutinize the payment of transaction costs by the fund” and that directors should