Mutual Fund Pricing
and Fair Valuation
Franklin H. Na
DC 9567487 v4
Overview—
 Valuation procedures are important for
individual accounts, hedge funds, bank
funds or registered investment companies
 Improper valuation can impact fee and
performance calculations
 Focus on mutual fund valuations because
relatively well developed
2
Overview—
The Importance and the Complexity
of Valuation Determinations
 Rule 22c-1 (the “forward pricing rule”) effectively requires
that open-end investment companies accurately value their portfolio
securities on a daily basis.
 Accuracy in the daily pricing of portfolio securities is essential.
 Valuation must be accomplished quickly, usually in the roughly
2-hour period between the NYSE close and the
NASD reporting deadline.
 Nevertheless, for a long time–probably for about half
of the current life span of the 1940 Act–this did not appear
to be a particularly difficult or challenging endeavor.
 This is no longer true for most funds.
3
Regulatory Framework
Section 2(a)(41) and Rule 2a-4 view valuation issues in
terms of a simple dichotomy between Market Value and
Fair Value.
 Securities “for which market quotations are readily available” are to
be valued at “market value.”
 All other securities are to be valued at “fair value as determined in
good faith by the board of directors.”
 The special responsibilities placed on fund boards for fair value
determinations, appear to arise out of a kind of objective vs.
subjective distinction:

The implicit notion is that market valuations are essentially objective, while fair
valuations require more judgment (i.e., are more subjective) and thus require
more direct board involvement.
4
Regulatory Framework (continued)
When should securities be fair valued?
 When market quotations are not readily available.
 When market quotations are not reliable.
 This may (but will not necessarily) occur if:
 sales have been infrequent;
 there is a thin market for the security; or
 the validity of the market quotations appears questionable
due to (among other things):
 an unreliable source;
 staleness;
 significant post-quotation events.
5
Regulatory Framework (continued)
The Effect of Significant Events
 The question of how significant events should affect
fund valuations dates back at least to a 1981 noaction letter issued to Putnam.
 This letter established the principle that it is
appropriate to use
fair value methodologies to reflect material events
that occur after the closing of the relevant foreign
markets but before the fund’s normal pricing time.
6
Regulatory Framework (continued)
The Effect of Significant Events (continued)
 In 2001, the Staff effectively mandated fair
valuation when a “significant event” occurs.
 But questions remain:
 When is an event “significant?”
 What should be the basis for a fair valuation
when a significant event occurs?
7
Regulatory Framework (continued)
Bases for Making Fair Value Determinations
 No single correct way.
 Methodologies and factors that may be used
include:
 multiples of earnings;
 discount from market of similar, freely traded securities;
 for debt instruments, yield to maturity;
 fundamental analytical data; and
 combinations of the foregoing.
8
Delegation and Controls




Despite the emphasis on board responsibility, delegation
of day-to-day responsibility for fair valuation
determinations
is both necessary and contemplated by SEC guidelines.
For most funds, direct board determinations of valuations
and “continuous” board review of day-to-day decisions is
impractical.
The appropriate role for the board is to act as the highest
level of oversight in a multi-tiered system of supervision
and controls.
Effective controls are central to the discharge of the
board’s responsibilities.
9
Delegation and Controls (continued)
 The key elements of an effective control system include:
 Identification of acceptable sources of regular pricing information,
preferably from third parties, and verifying that those sources
have internal controls for verifying the validity of the information
they provide.
 Review and supervision by the primary pricing group–
generally fund accounting or administrators or the fund's
custodian.
 Oversight of the primary pricing group by a special valuation
committee or other supervisory personnel within fund
management.
10
ASC 820 (formerly, FAS 157)
Eliminating the Market Value/Fair Value Dichotomy
 FASB’s ASC 820 does not reflect the same market value/fair
value dichotomy that is reflected in the 1940 Act.
 Instead, ASC 820 makes clear that market quotations–
whether obtained from an exchange closing price or from
dealer quotes–are merely means (“inputs”) for determining the
fair value of an asset.
 ASC 820 establishes a somewhat different dichotomy–
between “observable” and “unobservable” inputs.
 ASC 820 presents a hierarchy of these inputs that
is substantially similar to what is called for under existing
SEC guidance.
11
ASC 820 (formerly, FAS 157)
(continued)
Techniques, Approaches and Inputs (continued)
 The heart of ASC 820 is a hierarchy of valuation “inputs”
that are to be used to apply the chosen valuation
approach and technique.
 Inputs are divided into two categories:
observable and unobservable.
 “Observable” inputs are based on market data obtained
from sources independent of the reporting entity.
 “Unobservable” inputs reflect the reporting entity’s
own assumptions as to how market participants would
approach pricing.
12
ASC 820 (formerly, FAS 157)
(continued)
The Fair Value Hierarchy
 Level 1–the highest level of inputs–comprises
unadjusted quoted prices in active markets for
identical assets.
 Level 2 inputs are inputs other than quoted prices
that are “observable” either directly or indirectly.
 Level 3 inputs are those that are unobservable.
13
ASC 820 (formerly, FAS 157)
(continued)
Disclosure
 ASC 820 requires that entities (including mutual funds)
disclose the following information at the end of each
reporting period:
 The fair values of their assets;
 The “level” within the fair value hierarchy in which the assets fell;
 For the assets valued using Level 3 (unobservable) inputs,
a reconciliation showing beginning and ending balances
broken down to show gains and losses, purchases and sales
and transfers in and out of the Level 3 input category.
14
Correction of Pricing Errors
 Errors of less than 1¢ per share are immaterial
and do not require corrective action.
 Errors of 1¢ or more per share require financial
adjustments in favor of the fund, but no
payments to affected shareholders
or reprocessing of shareholder accounts is
required unless the errors amount to at least ½
of 1% of per share NAV.
15
Investment Objectives
and Policies
Mark C. Amorosi
DC 767627 v4
Investment Objectives
 An investment objective is a short statement that
describes what the fund seeks to achieve for its
shareholders.
 A fund may (but is not required to) designate its
investment objective as a fundamental policy
(i.e., changeable only with shareholder
approval).
 If the investment objective is not fundamental,
the fund must disclose this fact in its prospectus.
1
Fundamental Policies
 Section 8(b) of the 1940 Act requires a
registered fund to recite in its registration
statement its policies with respect to certain
types of investments and investment practices.
 Section 13 makes it unlawful for a registered
fund to deviate from any policies set forth in
response to Section 8(b) without a vote of a
“majority of the outstanding voting securities” of
the fund.
2
Fundamental Policies




Concentration
Senior Securities
Borrowing Money
Underwriting
 Commodities
 Loans
 Real Estate
3
Fundamental Policies –
Concentration
 Section 8(b)(1)(E) requires a registered fund to
disclose in its registration statement its policy
with respect to concentrating its investments in a
particular industry or group of industries.
 The SEC staff takes the position that investment
(including holdings of debt securities) of more
than 25% of the value of a fund’s assets in any
one industry represents concentration.
4
Fundamental Policies –
Concentration (continued)
 If the fund intends to concentrate its investments in an industry or
group of industries, the fund is required to disclose in its prospectus
the industry or group of industries in which it will concentrate.
 If the fund does not intend to concentrate its investments, it may not
invest in any given industry, if upon making the investment, more
than 25% of the value of the fund’s assets would be invested in such
industry.
 If securities of a given industry come to constitute more than 25% of
the value of the fund’s assets due to market movements (as
opposed to portfolio transactions), the fund generally is not required
to sell the excess and it is not treated as a violation of its policy on
concentrating investments.
5
Fundamental Policies – Senior
Securities and Borrowing Money
 Sections 8(b)(1)(B) and (C) require a registered fund to
disclose in its registration statement its policy with respect
to the issuance of senior securities and borrowing money.
 Section 18(f) prohibits a registered open-end fund from
issuing any senior security.
 Section 18(g) defines a senior security as “any bond,
debenture, note, or similar obligation or instrument
constituting a security and evidencing indebtedness, and
any stock of a class having priority over any other class as
to distribution of assets or payment of dividends ....”
6
Fundamental Policies – Senior
Securities and Borrowing Money
(continued)
 Exceptions for borrowing money:
 Section 18(g) states that a senior security does not include a borrowing
from a bank which is “for temporary purposes only” and does not exceed
5% of the fund’s assets at the time the loan was made.
 Section 18(f) provides that a registered open-end fund may borrow
money, provided that (1) the borrowing is from a bank and (2) the fund
has “asset coverage” (as defined in Section 18(h)) at least equal to 300%
of such borrowings.
7
Fundamental Policies – Senior
Securities and Borrowing Money
(continued)
 The definition of “senior security” has been construed broadly by the
SEC and its staff to apply to a wide variety of portfolio transactions,
including futures contracts and options on futures contracts; forward
commitment contracts, future commitments; and when-issued
securities.
 The SEC has taken the position that Section 18 restrictions do not
apply to the above types of portfolio transactions if a fund “covers”
such transactions (e.g., enters into an offsetting portfolio transaction)
or if it “segregates” assets (e.g., places liquid assets in a separate
account, or marks such assets on the fund’s books, at least equal in
value to the obligation undertaken by the fund).
8
Fundamental Policies –
Underwriting
 Section 8(b)(1)(D) requires a registered fund to disclose in its
registration statement its policy with respect to underwriting
securities of other issuers.
 “Underwriter” is defined in Section 2(a)(40) of the 1940 Act
generally to mean “any person who has purchased from an
issuer with a view to, or sells for an issuer in connection with,
the distribution of any security, or participates or has a direct or
indirect participation in any such undertaking, or participates or
has a participation in the direct or indirect underwriting of any
such undertaking…”
 Funds commonly seek to provide flexibility for circumstances
where a fund may be deemed to be an underwriter in
connection with its regular investment program.
9
Fundamental Policies –
Commodities
 Section 8(b)(1)(F) requires a registered fund to disclose in its
registration statement its policy with respect to purchase or sale of
commodities or commodities contracts.
 The Internal Revenue Code generally limits the ability of registered
funds to invest directly in commodities.
 Funds commonly seek to preserve the ability to make commoditiesrelated investments to the extent permissible, such as through the
acquisition of securities or other instruments backed by commodities
or securities of companies engaged in commodities businesses and
through the acquisition of commodities due to ownership of
securities or other instruments.
10
Fundamental Policies –
Making Loans
 Section 8(b)(1)(G) requires a registered fund to disclose in its
registration statement its policy with respect to making loans.
 The SEC staff has taken the position that the making of a loan
does not include the purchase of a portion of an issue of debt
securities, whether or not the purchase was made upon the
original issuance of the securities.
 Funds commonly seek to (1) provide flexibility to invest in a
wide range of debt instruments and (2) reserve the right to
make loans of portfolio securities in connection with securities
lending programs.
11
Fundamental Policies –
Real Estate

Section 8(b)(1)(F) requires a registered fund to disclose in its registration
statement its policy with respect to the purchase or sale of real estate and
real estate mortgage loans.

The SEC staff generally takes the position that an interest in real estate
includes securities of companies whose assets consist substantially of real
property and interests therein, but does not include securities of companies
whose investments in real estate are incidental to another business which is
primary (e.g., banks).

The Internal Revenue Code generally limits the ability of registered funds to
invest directly in real estate.

Funds commonly seek to preserve the ability to make real estate-related
investments, such as through the acquisition of securities or other
instruments backed by real estate or securities of companies engaged in real
estate businesses and through the acquisition of real estate due to
ownership of securities or other instruments.
12
Fund Diversification
 Section 5(b) of the 1940 Act classifies management companies as
“diversified” or “non-diversified” investment companies. A
“diversified” investment company must satisfy certain requirements.
 At least 75% of the fund’s total assets must be represented by (i) cash and cash
items (including receivables), (ii) Government securities (as defined in the 1940
Act), (iii) securities of other investment companies, and (iv) securities of other
issuers, provided that the investment represented by securities of other issuers
does not exceed 5% of the total assets of a fund or 10% of the voting stock of
the issuer.
 If an investment company does not satisfy these requirements, it is a
“non-diversified” company and must describe itself as such. Its
disclosures, if it is offering its securities to the public, must note that
status and the risks thereof.
 There are separate diversification standards for registered
investment companies under the Internal Revenue Code.
13
Fund Names
 Section 35(d)
 Prohibits a fund from using as its name any
words which the SEC finds by rule or order to
be “materially deceptive or misleading.”
 Rule 35d-1
 Defines certain “materially deceptive or
misleading” names for purposes of Section
35(d).
14
Rule 35d-1: Scope
 Rule 35d-1 addresses four categories of fund
names:
 Names suggesting guarantee or approval by the U.S.
government;
 Names suggesting investment in certain investments
or industries;
 Names suggesting investment in certain countries or
geographic regions; and
 Names suggesting that a fund’s distributions will be
exempt from federal and/or state income tax.
15
Rule 35d-1: U.S. Government
 Rule 35d-1 prohibits the use of any name
suggesting that the fund or its shares are
“guaranteed” or “approved” by the U.S.
Government.
 This prohibition includes use of any name that
uses the terms “guaranteed” or “insured” or
similar terms in connection with “U.S.
Government.”
16
Rule 35d-1:
Investments/Industries
 Rule 35d-1 prohibits the use of any name
suggesting that the fund focuses its investments
in a particular type of investment, or in
investments in a particular industry, unless:
 The fund has a policy of investing at least 80% of the
value of its assets in the particular type of investment,
or in investments in the particular industry, suggested
by its name; and
 This policy is either fundamental or changeable only
with at least 60 days prior notice to shareholders.
17
Rule 35d-1: Countries/Regions
 Rule 35d-1 prohibits the use of any name suggesting
that the fund focuses its investments in a particular
country or geographic region, unless:
 The fund has a policy to invest at least 80% of the value of its
assets in investments that are tied economically to the particular
country or region suggested by its name;
 The fund discloses in its prospectus the criteria used to select
these investments; and
 This policy is either fundamental or changeable only with at least
60 days prior notice to shareholders.
18
Rule 35d-1: Tax-Exempt Funds
 Rule 35d-1 prohibits the use of any name suggesting
that the fund’s distributions are exempt from federal
and/or state income tax, unless the fund has adopted a
fundamental policy:
 To invest at least 80% of the value of its assets in investments
the income from which is exempt from federal and/or state
income tax (as applicable); or
 To invest its assets so that at least 80% of the income that it
distributes is exempt from federal and/or state income tax (as
applicable).
19
Rule 35d-1: Compliance
Considerations
 The 80% tests apply at the time of investment.
 The 80% tests apply “under normal
circumstances.”
 “Assets” is defined in the rule to mean “net
assets, plus the amount of any borrowings for
investment purposes.”
 Strict prior notice requirements apply to changes
to the 80% investment policies.
20
Transactions With Affiliates
Alan C. Porter
DC 1370939 v5
Legislative Policy
“In the exhaustive study of the industry which
preceded passage of the [1940] Act it was
found that, in many instances, investment
companies had been operated in the interests
of their managers rather than in the interests of
their shareholders.”
“Congress determined that the [1933 and 1934
Acts] were inadequate to meet the problems
which had been revealed . . . and passed a
special regulatory statute – the Investment
Company Act.”
SEC Report on the Public Policy Implications
of Investment Company Growth (1966)
1
Is There a Prohibited Transaction?
Parent
Adviser
I
Issuer
−???
Fund A
Adviser
II
SMAs
≥ 5%
Fund B
2
“Affiliated Person” – Section 2(a)(3)
One-Way Affiliations
 Director
 Officer
 Partner
 Employee
 Investment Adviser
A director, officer, or investment adviser is an “affiliated person” of the
fund; but
The fund is not an “affiliated person” of its directors, officers, or
investment adviser.
3
Two-Way Affiliations
 A person directly or indirectly controlling, controlled by, or under
common control with, another person;
 A person directly or indirectly owning, controlling, or holding with
power to vote, 5% or more of the outstanding voting securities of
another person; and
 A person 5% or more of whose outstanding voting securities are
directly or indirectly owned, controlled, or held with power to
vote, by such other person.
A 5% shareholder is an “affiliated person” of a fund; and the fund is an
“affiliated person” of its 5% shareholder.
4
Ownership
Ownership is not defined in the 1940 Act. It can include both legal
and beneficial ownership.
 1934 Act Rule 13d-3 defines beneficial ownership based on
 Voting power
 Investment power
 1934 Act Rule 16a-1 defines beneficial ownership based on
 Direct or indirect pecuniary interest
5
“Control” – Section 2(a)(9)
“[T]he power to exercise a controlling influence over the management
or policies of a company, unless such power is solely the result of an
official position with such company.”
 Control is presumed when a person directly or indirectly owns
beneficially more than 25% of the outstanding voting securities
of a company.
 “Voting security” is defined in Section 2(a)(42).
 The statutory presumption of control is rebuttable.
 Natural persons are presumed not to be controlled.
6
Fund Family Affiliations
“The nature of the advisory relationship has been considered to carry
with it a strong indication of control. [However,] investment
companies with a common investment adviser are not necessarily
under common control.” Fundtrust, 1987 SEC No-Act. LEXIS 2085
(pub. avail. May 26, 1987).
 Funds under common control are first-tier affiliates of each
other.
7
Fund Family Affiliations
Neither Fund A nor Fund B is an affiliated person of Adviser. Thus,
Fund A and Fund B are not second-tier affiliates (an affiliated person of
an “affiliated person”) of one another.
Adviser
One Way –
Fund A
– One Way
Two Way
Fund B
But if Fund A and Fund B are under common control, then they are
first-tier affiliates and the affiliation is two-way ─ Fund A is an affiliated
person of Fund B and vice versa.
8
Categories of Prohibited Transactions
 Principal Transactions
 Section 17(a)
 Section 17(d) / Rule 17d-1
 Agency Transaction
 Section 17(e)
 Underwritings
 Section 10(f)
9
Section 17(a)
Section 17(a) prohibits first-tier and second-tier affiliates of a fund,
acting as principal, from:
1) Knowingly selling any securities or other property (except fund
shares) to the fund;
2) Knowingly purchasing any securities or other property (except fund
shares) from the fund;
3) Borrowing money or other property from the fund; or
4) Loaning money or other property to the fund in contravention of
SEC regulations.
10
Section 17(d) and Rule 17d-1
Section 17(d) and Rule 17d-1 prohibit first-tier and second-tier affiliates
of a fund, acting as principal, from engaging in a joint arrangement with
the fund.
 Rule 17d-1(c) defines a joint arrangement as:
“a written or oral plan, contract, authorization or arrangement,
or any practice or understanding concerning an enterprise or
undertaking whereby a [fund] and [a first-tier or second-tier
affiliate] have a joint or a joint and several participation, or
share in the profits . . . .”
11
Section 17(e)
Section 17(e) prohibits first-tier and second-tier affiliates of a fund:
1) Acting as agent, from accepting any compensation for the
purchase or sale of any property to or from the fund (except in
the course of its business as an underwriter or broker); or
2) Acting as broker, from receiving a commission, fee, or other
remuneration for effecting a securities transaction for the fund
which exceeds:
A. the “usual and customary broker’s commission” if the sale
is effected on an exchange; or
B. 2% of the sales price in a secondary distribution; or
C. 1% of the purchase or sale price for other sales.
12
Section 10(f)
Section 10(f) prohibits a registered investment company from
knowingly purchasing securities underwritten by a fund
 Officer
 Director
 Advisory Board Member
 Investment Adviser
 Employee, or
 Affiliated person of any such person
13
Statutory Exemptions
Section 17(b)
The SEC may, upon application by any person, issue an order
permitting a prohibited principal transaction. The SEC must find
that the transaction is:
 Reasonable and fair and does not involve overreaching on
the part of any person concerned; and
 Consistent with the policy of each fund concerned and with
the general purposes of the Investment Company Act.
14
Section 6(c)
The SEC may, upon application, conditionally or unconditionally
exempt any person, security or transaction, or any class of persons,
securities or transactions, from any provision of or rule under the
Investment Company Act. The SEC must find that the requested
exemption is:
 Necessary or appropriate in the public interest; and
 Consistent with the protection of investors and the purposes
fairly intended by the policy and provisions of the Investment
Company Act.
15
Selected Exemptive Rules
Rule 17a-7
–
Portfolio Cross Transactions
Rule 17a-8
–
Fund Reorganizations
Rule 17a-9
–
Purchase of MMF Portfolio Securities
Rule 17d-1(c)
–
Certain Joint Arrangements
Rule 17e-1
–
Transactions with Affiliated Brokers
16
Portfolio Cross Transactions
Rule 17a-7 permits purchase or sale transactions between:
 Affiliated funds; and
 Fund and non-fund accounts affiliated solely by reason of
having a common adviser.
17
Conditions
 The transaction must be a purchase or sale, for no consideration
other than cash payment against prompt delivery of a security for
which market quotations are readily available.
 The transaction must be effected at the independent “current
market price” of the security.
 The transaction must be consistent with the policies of each
participating fund.
 No brokerage commission, fee (except customary transfer fees) or
other remuneration may be paid in connection with the
transaction.
18
The “current market price” of a security is:
 For securities whose principal market is an exchange:
 the last sale price on the exchange or,
 if there are no reported transactions that day, the average
of the highest current independent bid and lowest current
independent offer on the exchange.
 For other securities:
 the average of the highest current independent bid and
lowest current independent offer determined on the basis
of reasonable inquiry.
19
Additional Conditions
 The fund board (including a majority of the independent directors)
must:
 Adopt procedures which are reasonably designed to provide
that all conditions of the rule will be met; and
 Determine at least quarterly that all transactions during the
preceding quarter were in compliance.
 The fund board must also satisfy the governance standards
defined in Rule 0-1(a)(7).
20
Fund Reorganizations
Rule 17a-8 permits reorganization transactions between:
 Affiliated funds;
 A fund and an affiliated common or collective trust; and
 A fund and an affiliated insurance company separate account.
21
Conditions
 The fund board (including a majority of the independent directors)
must determine that:
 Participation in the transaction is in the best interests of the
fund; and
 The interests of the fund’s existing shareholders will not be
diluted as a result of the transaction.
 The board must request and evaluate information necessary to
make these determinations and give appropriate weight to all
pertinent factors.
 The board’s determinations and the bases for them must be fully
recorded in the fund’s minute book.
22
Additional Condition
 Approval by an acquired fund’s shareholders is required, unless:
 The fundamental policies of the surviving fund are not
materially different;
 The advisory contact of the surviving fund is not materially
different;
 The independent directors elected by acquired fund
shareholders will comprise a majority of the independent
directors of the surviving fund; and
 The 12b-1 fees paid by the surviving fund are not greater than
those authorized by the acquired fund.
23
Purchase of MMF Portfolio Securities
Rule 17a-9 permits a first-tier or second-tier affiliate to purchase a
portfolio security from a money market fund if:
 The purchase price is paid in cash;
 The purchase price is equal to the greater of the amortized
cost value of the security or its market price; and
 Any profit on a subsequent sale is paid to the fund.
24
Certain Joint Arrangements
Rule 17d-1(d)(c) provides an exemption for certain joint
arrangements, including:
 Joint liability insurance policies, provided:
 Premiums are allocated in a fair and reasonable manner;
and
 The policy does not exclude coverage for bona fide
claims made against an independent director by another
insured.
 Assumption by an adviser of expenses incurred in connection
with a fund reorganization.
25
Affiliated Brokerage
Rule 17e-1 provides a safe harbor from Section 17(e)(2)’s restriction
that a fund not pay an affiliated broker in excess of the usual and
customary broker's commission.
26
Conditions
 Commissions paid by the fund must be reasonable and fair in
comparison to what others charge for comparable transactions.
 The fund board (including a majority of the independent directors)
must:
 Adopt procedures which are reasonably designed to provide
that the commissions paid by the fund meet this standard; and
 Determine at least quarterly that transactions during the
preceding quarter were in compliance.
 The fund board must also satisfy the governance standards
defined in Rule 0-1(a)(7).
27
Portfolio Cross Transaction
Fund’s portfolio manager has decided to sell Apple stock; the portfolio
manager of Adviser’s separately managed account (SMA) has
decided to purchase Apple stock.
Adviser
FundA
Fund
???
SMA
Apple
Stock
Does Section 17(a) prohibit a cross transaction between Fund and SMA?
28
Yes, but . . .
Rule 17a-7 provides an exemption for this transaction if Fund
and SMA are first-tier or second-tier affiliates solely by reason of
having a common adviser or advisers that are affiliated persons
of each other.
29
What if the portfolios of the SMAs managed by Adviser hold in the
aggregate 5% or more of Fund’s shares?
Adviser
Fund
≥ 5%
SMAs
In such case, Rule 17a-7 would not be available because Fund and
SMA would not be affiliated solely by reason of having a common
adviser.
30
Transaction With Upstream Affiliate
Fund A’s portfolio manager wants to buy securities issued by a subsidiary of
Parent (Issuer). SMAs over which another subsidiary of Parent (Adviser I)
has investment discretion hold in the aggregate 5% or more of Fund B (another
fund in Fund A’s fund family).
Parent
Adviser
I
Issuer
SMAs
Fund A
Adviser
II
≥ 5%
Fund B
31
Is the purchase prohibited?
Parent
Adviser
I
Issuer
SMAs
−???
Adviser
II
Fund A
≥ 5%
Fund B
Fund A and Fund B are first-tier affiliates (under common control).
Adviser I is Fund B’s first-tier affiliate (indirect 5% owner) and second-tier affiliate of Fund A.
The SEC may collapse a holding company structure for purposes of Section 17(a).
Section 17(a)(1) prohibits Issuer from knowingly selling securities to Fund A (its second-tier
affiliate) in a principal transaction.
32
Takeaways
 Be alert for potential affiliated transaction issues;
violations can result in significant liability for a fund affiliate.
 Diagram the relationships for analysis.
 Talk it through with a knowledgeable colleague.
 Follow fund compliance procedures when effecting transactions
pursuant to an exemptive rule.
33
Questions?
Fund Codes of Ethics
Mark C. Amorosi
DC 767936 v4
Rule 17j-1
 Rule 17j-1 prohibits any affiliate of a fund
or its adviser or principal underwriter from
engaging in fraudulent conduct in
connection with the purchase or sale of a
“Covered Security” held or to be acquired
by the fund.
1
Rule 17j-1:
“Covered Security” Defined
 The rule applies to any “Covered Security”
which includes all securities, except:




U.S. government securities;
Banker’s acceptances or CDs;
Commercial paper; and
Shares of registered open-end funds.
2
Rule 17j-1: Code Requirement
 Each fund, adviser and affiliated principal
underwriter must adopt a written code of ethics
to prevent “Access Persons” from engaging in
prohibited conduct.
 Fund board of directors/trustees (including a
majority of the independents) must approve
such codes.
 Fund board also must approve any material
changes to such codes within 6 months.
3
Rule 17j-1:
“Access Person” Defined
 “Access Person” of a fund or adviser generally includes:
 Any director, officer, general partner or employee of the fund or
adviser who, in connection with his/her regular duties, makes,
participates in, or obtains information regarding, transactions in
Covered Securities by a fund, or whose functions relate to the
making of any recommendations with respect to such
transactions; and
 Any natural person in a control relationship to the fund or adviser
who obtains information concerning recommendations made to
the fund with regard to fund transactions in Covered Securities.
4
Rule 17j-1: “Access Person”
Defined (continued)
 “Access Person” of a principal underwriter
generally includes any director, officer or general
partner who, in the ordinary course of business,
makes, participates in or obtains information
regarding, fund transactions in Covered
Securities, or whose functions or duties in the
ordinary course of business relate to the making
of any recommendations to the fund regarding
fund transactions.
5
Rule 17j-1: Code Administration
 Funds, advisers and affiliated underwriters are
required to:
 Use reasonable diligence and implement procedures
to ensure code compliance;
 Furnish a written report to the fund’s board at least
annually describing any issues and material violations
arising under the code since the last report;
 Certify at least annually that they have adopted
procedures reasonably necessary to prevent “Access
Persons” from violating the code; and
 Maintain records required by the rule.
6
Rule 17j-1: Required Reports
 Access Persons must submit the following
reports:
 Initial Holdings Report;
 Annual Holdings Reports; and
 Quarterly Transaction Reports.
 Independent directors/trustees generally do not
have to submit reports, but are required to
submit Quarterly Transaction Reports under
certain circumstances.
7
Rule 17j-1:
Required Pre-Approvals
 “Investment Personnel” must pre-clear
purchases in any IPO or private
placement.
8
Rule 17j-1: Disclosure
 A fund must disclose in its prospectus or SAI
whether:
 The fund and its adviser and underwriter have
adopted codes of ethics; and
 The codes permit personnel subject to the codes to
invest in securities for their own accounts, including
securities in which the fund may invest.
 A fund and its adviser and underwriter also must
file their codes of ethics with the SEC as an
exhibit to the fund’s registration statement.
9
Duties of Directors
and Trustees
Donald W. Smith
DC 1256383 v4
Competing/Conflicting
Pressures on Boards
 Expectations of Shareholders




Fund Management
SEC Mandates
Plaintiffs Bar
Increasing Complexity of Fund Operations
1
Independent Directors of
Mutual Fund Boards
 Focus on role of independent or
“disinterested” fund trustees and directors
 Almost always, a majority of a fund’s board
is independent
 1940 Act, SEC and best practices
composition requirements
2
Role of the Fund Board
 Fund boards have distinctly different function than boards
of operating companies
 Primary purpose is to monitor and manage conflicts with
outside service providers—especially the sponsoring
investment adviser
 Secondary purpose is to supervise various compliance
functions
 Unlike boards of operating companies, the 1940 Act and
SEC rules and pronouncements assign a number of
specific duties to mutual fund boards
3
Role of the Fund Board
(continued)
 The specific duties expected of mutual fund boards often are much
more granular and detailed than those of non-mutual fund boards
 Examples of key conflict management and compliance functions:
brokerage and soft dollars, securities lending, valuation, annual
advisory contract reviews, approval of fund compliance program, and
affiliated transactions
 Also, general corporates duties such as: election of officers, approval
of material service contracts, approval of share issuance, interaction
with auditors and declaration of dividends
 However, fund boards are not expected to manage or supervise most
day-to-day operations of the adviser and manager
 Difficult balance to strike
4
Independent Directors
 Who qualifies as an independent director under
the 1940 Act
 Business relationships that must be disclosed
 Common issues regarding independence
 Material business relations with the adviser and other
service providers
 Relationships with subadvisers
 Updating questionaires
5
SEC Requirements
 Board practices formally mandated by the
SEC
 Nomination of independent directors by
independent directors
 Annual self-assessments
 Fair valuation of portfolio securities
 “Independent Counsel” requirement
 Approval of compliance policies and
procedures
6
SEC Requirements (continued)
 An increasing number of requirements are
being imposed on fund boards by the SEC
staff through published guidance, the
examination process and settled
enforcement actions.
 These often appear to significantly
decrease the ability of boards to delegate
functions to management.
7
Governance Disclosure Rules
 2004 – Rules requiring enhanced disclosure regarding board
consideration of advisory contracts
 2010 – Additional disclosure required about the board’s leadership
structure, including:
 whether the same person serves as both principal executive officer and board
chair;
 whether the board chair is an “interested person” of the fund;
 a description of the board’s role in risk oversight
 why the registrant has determined that its leadership structure is appropriate, given
the specific characteristics or circumstances of the registrant.
 Adopting Release recognized that “different leadership structures may
be suitable for different companies depending on factor such as the
size of a company, the nature of a company’s business, or internal
control considerations, among other things”
8
Fiduciary Duty and Business
Judgment
 What standards must a director meet under
state law
 Duty of loyalty
 Duty of care
 Business judgment rule
 Protects the board, but requires extensive process
and documentation to be effective
9
Review of Advisory Contracts
Review of advisory contracts
Gartenberg standard
Harris Supreme Court decision
Disclosure of factors considered and
findings made
 Review of changes in control of adviser
and merger transactions




10
Protection from Liability
for Directors
 Advancement of legal expenses
 Indemnification by the fund
 Insurance
11
The Board’s Role in the
Audit Process
 The Audit Committee




Relationship with auditor
Auditor independence and pre-approvals
Audit Committee Financial Expert
Audit Committee charter
12
Significant Current Topics








Valuation
Oversight of Intermediaries
Risk management and alternative investments
Money fund matters
Securities lending
Enhanced oversight of fixed income funds
Emphasis on enforcement
Use of Rule 38a-1
13
Update on 36(b) Litigation
Jeffrey B. Maletta
DC 9866372 v6
Section 36(b) Overview
 A unique provision addressed to a single issue:
whether adviser (or affiliate) charges an
excessive fee
 Distinct from other litigation involving funds
 Federal securities law cases alleging disclosure
violations…“prospectus liability” cases
 State law derivative cases to recover money for or
protect fund from injuries allegedly inflicted on fund by
adviser, directors, or third parties
2
Section 36(b) Designed to Address
Excessive Fee Concerns





Less than arm’s-length relationship
Existing fund governance not effective
Market not effective
Shareholders tend not to move
State corporate law ineffective




Action for “waste”
Difficult substantive standard
Demand required
Approval of fees by directors or shareholders
3
The Solution: Section 36(b)
For purposes of this subsection, the investment
adviser of a registered investment company shall
be deemed to have a fiduciary duty with respect to
the receipt of compensation for services, or of
payments of a material nature, paid by such
registered investment company, or by the security
holders thereof, to such investment adviser or any
affiliated person of such investment adviser.
4
Section 36(b): Substantive
Solution
 Fiduciary duty of adviser
 Fiduciary standard of compensation
 Fiduciary may not charge an “excessive” fee
 Fee must have the “earmarks of an arm’s
length bargain”
5
Section 36(b) Procedural Features
 Direct shareholder action
 A single shareholder may sue
 Limitation on “damages” to one year prior to the
filing of the complaint
 Defendants limited to recipients of compensation
 No need to prove personal misconduct; but
plaintiff has burden to show breach of fiduciary
duty
 Board and/or shareholder approval not dispositive
6
The Gartenberg Standard
 Gartenberg v. Merrill Lynch Asset Mgmt., Inc. (2d Cir. 1982)
 To violate Section 36(b), “the adviser-manager must charge a fee
that is so disproportionately large that it bears no reasonable
relationship to the services rendered and could not have been the
product of arm’s-length bargaining”
 “[T]he test is essentially whether the fee schedule represents a
charge within the range of what would have been negotiated at arm’s
length in the light of all of the surrounding circumstances”
 Supreme Court adopts in Jones v. Harris Associates LP (2010)
7
Gartenberg Factors
 Consideration of “all facts in connection with the
determination and receipt of such compensation,”
including:






the nature and quality of services rendered
the profitability of the fund to the investment adviser
fall-out benefits
economies of scale
comparative fee structures, and
the independence of the unaffiliated directors and the care and
conscientiousness with which they performed their duties
 Supreme Court endorses in Jones v. Harris
8
Current Section 36(b) Cases
 Manager of manager cases
 Adviser/Manager contracts with fund
 Adviser “subcontracts” portfolio management services
 Plaintiffs’ theory: subadviser does the work
 Subadviser provides most services
 Manager role is minimal
 Manager expenses are largely fixed
 Plaintiffs focus on manager’s portion of fee paid by
fund—does that amount bear a reasonable relation to
services rendered by manager
9
Profitability Analysis
 Total advisory fee = 100
 Total expenses = 60; 40 to subadviser
 Profit = 100 – 60 = 40%
100
10
Profitability – Plaintiff-Style
 Total fee to adviser
 Adviser’s share of fee = 60
 Adviser’s expenses = 20
 Profit =
60 – 20 =
100
40 = 67%
60
11
Profitability Plaintiff – Style II
 Plaintiffs challenge expenses ─ particularly
allocation of costs from outside the adviser
 Total fee = 100
 Adviser’s share of fee = 60
 Adviser’s expenses under plaintiff theory = 10
 Profit = 60 – 10 = 50 = 83.3%
60
60
12
Manager of Manager Cases
 AXA (D. NJ)
 Hartford (D. NJ)
 ING/Voya (D. Del.)
 SEI (E.D. Pa.)*
 Russell (D. Mass.)
 Principal (S.D. Iowa)
13
Variation: Services Sold
Separately
 Adviser provides subadvisory services to other
funds at rate lower than adviser charges
proprietary fund
 Plaintiff focuses on difference between advisory
and subadvisory rates
14
Plaintiff’s Profitability Analysis
 Total advisory fee = 100
 Price of adviser’s services when acting as
subadviser to another fund = 40
 Fee for “other” services = 60
 Expenses associated with other services = 20
Profit = 60 – 20 = 67%
60
15
Adviser Subadvising Other Funds
 BlackRock (D. NJ)
 Harbor (N.D. Ill.)
 JP Morgan (S.D. Ohio)
 Davis (S.D.N.Y.)
 First Eagle (D. Del.)
16
Plaintiff Advantages
 “Notice” pleading
 Motions to dismiss remain difficult
 Notice pleading
 No class certification or demand requirements
 Little or no discovery burden
17
Plaintiff Advantages
 Superficial appeal: It’s all about stock picking
 Large absolute numbers
 Large funds generate large fees
 Adviser/subadviser fee ratios
 Similarity between investment management and
subadvisory agreements
 Focus on single fund
18
Motions to Dismiss
 More difficult than in securities class actions
 Historically some success
 Migdal
 Amron
 Davis
 Inferences drawn in favor of plaintiff
 No bright-line test
19
Role of Independent Directors
 Not parties
 Most important fact witnesses
 Defending their business judgment
 Cooperating with, but independent from, adviser
and its counsel
20
Issues
 Unbundling services
 Plaintiff attempts to break services provided under IMA into
separate pieces and examine profitability of each piece
 Cost allocation
 Plaintiff focuses on direct costs incurred by adviser (e.g., number
of employees) and challenge allocation of expenses
 Overlap in services
 Plaintiff contends that to the extent adviser is providing services,
they are duplicative
21
Defenses
 Integrity of 15(c) process
 How much do directors see
 Focus of independent directors
 Can they explain their decision as an appropriate judgment
 Focus on the “fee as a whole
 Are the shareholders paying a fair or reasonable price for what
they are receiving notwithstanding how fee is divided
 Overall profitability
 Is profit appropriate in light of risks borne by adviser
22
Status of Current Cases
 One motion to dismiss denied on the merits – Hartford
 Five pending motions
 Harbor (also pending motion to designate additional case filed in
September as related)
 BlackRock
 JP Morgan
 First Eagle
 Davis
 Recently Amended Complaint
 SEI – amended after motion granted on timeliness grounds
 Pending motion for reconsideration
 Principal (both defendants have, however, answered)
23
Status of Advanced Cases
 AXA
 Expert discovery in process
 Hartford
 Fact discovery closes December 2014
 Russell
 Case reassigned and trial date cancelled
 ADR and status conference with new judge early January 2015
 Fact discovery scheduled to close December 31, 2014
 ING
 Early stages of fact discovery ─ set to close July 2015
 Answers filed
24
Litigation Issues in Investment
Management – The AttorneyClient Privilege and Attorney
Work Product Protection
DC 9568129 v3
Stephen G. Topetzes
Introduction – Special Challenges
in the Fund Context
 Investment company litigation is often more complex than
“regular” securities or corporate litigation
 Structure of the fund family results in multiple separate entities
fulfilling functions that are often performed within a single
corporate entity
 This separation of responsibility and interests creates the
arm’s-length and potentially adversarial relationships in some
situations and common interests in others. This reality shapes
the manner and degree to which privileges or protections may
apply to interactions between lawyers and individuals.
1
PRINCIPAL SERVICES OF FUND VENDORS
2
Introduction (continued)
Combination of common and competing interests can
create issues in litigation
 Director performance




Decision-makers in fee litigation
Decision-makers and defendants in other cases
Responsibility for/role relative to valuation
Role relative to service provider oversight
 Adviser personnel as Fund Officers or Directors
 Which “hat” are you wearing? Are there conflicts or appearance problems?
 Role relative to oversight of affiliated and unaffiliated service providers
 Application of attorney-client privilege


When does it apply?
How may it be waived?
3
Recurring Issues –
“Hardy Perennials”
Perils of unvarnished (unprivileged) expression in:
 E-mails
 Notes
 Minutes
 Excessive detail
 Lack of focus/Inadequate record of deliberative process
 Possible Game Changer: How the “multiple hat”
phenomenon and potentially competing interests are
reflected in the documentary record
4
Role of Independent Directors
 Independent Directors – directors who are not
“interested parties” within the meaning of ICA –
are the “watchdogs” for the Fund shareholders.
Burks v. Lasker, 441 U.S. 471 (1979)
 Among other things, they oversee the relationship
between adviser and fund which is “fraught with
potential conflicts of interest.” Daily Income Fund
Inc. v. Fox, 464 U.S. 523, 536 (1984), quoting
Burks v. Lasker.
5
Role of Independent Directors
(continued)
 Independent Directors are critical
participants in virtually all fund litigation
 Key witnesses in fee and other service
provider-related litigation
 Evaluate shareholder demands in derivative
cases
 Defendants in class and derivative actions
 Authorize suits on behalf of the Fund
6
Litigation
Possible Alignments:
 Shareholder on behalf of the Fund v. Adviser, et al.
 Shareholders v. Fund, Directors, Adviser, et al.
 Fund v. Third Parties
7
Board Action – A Deliberative
Process
Directors do not act in a vacuum. They are
generally participating in a process that is designed
to allow them to reach a business judgment.
 15(c) process
 Fees for third-party providers
 Possible error by adviser or service providers
 Non-routine matters where adviser conflicted
 Whether to litigate
8
Board Action – A Deliberative
Process (continued)
Record will be examined for consistency,
deliberateness and completeness
Materials and minutes should reflect a process
One meeting vs. multiple meetings
Pre-meeting review of materials
Fund-specific consideration and decision-making may be
focused in isolation
 Length of meetings and pre-meeting preparation may be
examined




 Evidence of negotiation or bargaining
9
The Business v. Litigation
Expectations
 Common Enterprise v. Marketplace
 Reasonable people v. Hard bargainers
 Cooperators v. Adversaries
10
THE CURRENT AGENDA – Possible
Litigation and Enforcement Threats
•
•
•
•
Excessive Fee Litigation (as discussed in prior
presentation)
Compliance with Section 15(c)
Compliance with Exemptive Orders
Conflicts
•
•
•
•
•
Who is getting paid? For what? Is there an undisclosed financial
interest?
Is it linked (directly or indirectly) to distribution/marketing/referrals?
Service Provider Oversight
• What did board or fund management do initially?
• How did they respond to “red flag”?
Underperformance/Troubled Holdings or Strategies
Disclosure/Valuation/Performance Reporting/Marketing
11
Attorney-Client Privilege –
Elements
(1) communication
(2) made between privileged persons
(3) in confidence
(4) for the purpose of obtaining or providing legal
assistance for the client
Restatement (Third) of the Law Governing Lawyers
(“Restatement”) § 68
12
Communication
 Any expression through which a privileged
person conveys information to another privileged
person
AND
 Any document or other record revealing that
expression
Restatement § 69
13
“Privileged Persons”
 Clients
 Lawyers for the client
 Agents of either who facilitate communications
between them
 Agents of the lawyer who facilitate the
representation
Restatement §70
14
In Confidence
Person communicating reasonably believes
 no one other than a privileged person, or
 another person with whom communications are
protected will learn of the contents
Restatement §71
15
Obtaining or Providing Legal
Assistance
 Predominant purpose
 Dual role of employee
 Dual role of counsel
16
Who Are You Representing?
Who is Representing You?
What “hat” are you wearing? Why does it matter?
Possible counsel arrangements:
 Fund
 Adviser
 Independent Directors
 Fund and Independent Directors
 Fund and Adviser
 Individual
17
With Whom Are You
Communicating?






Independent Directors
Inside Director
Fund Officer
Adviser Employee
Third-Party Service Provider
Agents of the above
18
Is That Individual a “Client”?
Third-party
service provider
Client: Fund
Directors
Advisor
personnel
serving as
fund
officers
Advisor personnel
performing advisory
services for fund
19
What Are You
Communicating About?





Fund interests
Adviser interests
Mutual interests
Individual interests
Legal or business issues
20
Is Communication Privileged?
 Is this individual
a “client”
constituent?
 Is the context
of your
communication
confidential?
 What’s the
purpose of your
communication?
21
Review: Know your privileges
and protections
 Attorney Client Privilege
 FRCP 26(b)(1)
 Protects all confidential communications made between an
attorney and client for the purpose of procuring or delivering legal
advice.
 Applies only to actual communications, not the facts within the
communications.
 Upjohn – Privilege applies to communications between company
employees and counsel acting on behalf of the company.
 Re: Corporate interests - Company “owns” privilege – neither
employees nor former employees can waive.
22
Review: Know your privileges
 Work Product Doctrine
 FRCP 26(b)(3)
 Protects from discovery documents prepared by a
client or her/his attorney in “anticipation of litigation.”
 Opinion work product – e.g., attorney notes of
witness interviews that contain explicit mental
impressions and/or legal strategies – more protected
than factual work product (access only upon showing
of substantial need/undue hardship).
23
Extending and Losing the
Privilege or Protection
 Common Interest
 Waiver
24
Attorney-Client Privilege –
Common Interest
Clients with separate counsel who have a common
interest in a litigated or nonlitigated matter may
agree to exchange privileged information.
Restatement § 76
 Interests need not be congruent
 Communications must relate to matter of common interest
 Direct communications among clients generally are not
privileged
25
Attorney Client Privilege – Waiver
The attorney-client privilege is waived if the client,
lawyer or some other authorized agent discloses
the communication in a nonprivileged
communication
 In most contexts, a voluntary waiver of a privilege
communication results in a waiver of all communications
concerning the subject matter
Restatement § 79
26