August 2010
Inside this issue:
President Signs Dodd-Frank Bill Into
Law—Most Significant Overhaul of
U.S. Financial Regulation Since Great
Depression........................................1
SEC Proposes Major Reform Related
to Distribution Fees ...........................3
Recent Developments Involving
Derivatives
New SEC Guidelines on
Derivatives Disclosure ................. 5
ABA Task Force Issues Report on
Investment Company Use of
President Signs Dodd-Frank Bill Into Law—
Most Significant Overhaul of U.S. Financial
Regulation Since Great Depression
On July 21, President Obama signed the Dodd-Frank Wall Street Reform and
Consumer Protection Act (“Act”), widely viewed as the most sweeping reform
of financial regulation since the Great Depression. Because the mutual fund
industry was not materially implicated in the recent financial crisis, little in the
Act’s 2,300 plus pages applies directly to registered investment companies,
although several of its provisions have implications for the investment
management industry generally. The Act also directs an unprecedented number
of studies and reports to be performed by the SEC, the GAO and other federal
agencies, certain of which will have direct impact on investment companies.
SEC Staff Answers Questions About
In particular, the Act contains provisions for two special studies to be
conducted on investors’ financial literacy and mutual fund advertising. The
Act directs the SEC to conduct a study of the financial literacy of retail
investors, including to determine what information investors need and
methods to increase transparency of expenses and conflicts of interest. The
GAO is also directed to conduct a study on current marketing practices for the
sale of open-end investment company shares, the impact of such advertising
on consumers and recommendations (i) to improve investor protection in mutual
fund advertising and (ii) as to additional information that could assist investors to
make informed financial decisions when purchasing mutual fund shares.
Money Market Reform ....................10
Other important provisions of the Act include:
Derivatives and Leverage............ 7
Supreme Court to Consider Scope of
Third-Party Liability under Section
10(b) in Janus Capital Group Inc. v.
First Derivative Traders.....................8
Director Donohue Discusses New
SEC Initiatives, Ongoing
Challenges ........................................9
SEC Pursues PM Allegedly Using
Insider Information to Advise Family
Members .........................................12
SEC Proposes Tougher Disclosure
Rules for Target Date Funds...........14
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500, FORTUNE 100, and FTSE 100
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visit www.klgates.com.
Financial Stability Oversight Council
The most important changes made by the Act are contained in the broad new
regulatory framework designed to protect the financial system from
systemic risk. The Act establishes a new interagency council—the Financial
Stability Oversight Council—to identify and manage systemic risk. In
addition, systemically important financial companies (including nonbank
financial companies) will be subject to heightened prudential standards and
safeguards.
The Act enumerates a number of factors for the Council to consider in
determining that an entity is systemically important. It is unclear whether and
to what extent large mutual fund complexes could be deemed nonbank
financial companies and subject to enhanced oversight. However,
commenters have observed that over time, the Act may impose additional
regulatory burdens (and hence competitive disadvantages) on fund complexes
affiliated with large banking institutions. In addition, any existing or former
bank holding company with assets of at least $50 billion as of January 10, 2010
that received TARP assistance will be treated
as a nonbank financial company subject to
Federal Reserve supervision.
Office of Credit Ratings (the “OCR”) within
the SEC;
•
increased liability—the Act lowers pleading
requirements, removes safe-harbor
protections, and imposes filing and other
requirements;
The Act dramatically reshapes the universe
of advisers required to register under the
Investment Advisers Act of 1940 (the
“Advisers Act”). Among other matters, it:
•
steps to reduce the impact of conflicts of
interest on the integrity of NRSROs’ issuance
of credit ratings;
•
eliminates the so-called private adviser
exemption for advisers with fewer than 15
clients, upon which most private fund
managers relied to avoid registration;
•
•
disclosure of an array of new information by
NRSROs, such as the performance record of
their credit ratings and the procedures and
methodologies used in the credit ratings
process; and
creates new exemptions for private funds
with assets under $150 million and for
advisers solely to “venture capital funds”
(although the latter will be subject to new
recordkeeping and filing requirements); and
•
removal of statutory and regulatory references
to NRSROs.
Increased Regulation of Private Fund
Advisers/Volcker Rule
•
changes the definition of “accredited
investor.”
In addition, under the so-called “Volcker
Rule,” banking entities will be generally
prohibited from acquiring or retaining any
ownership interest in or sponsoring a hedge
fund or private equity fund.
Derivatives
The Act completely overhauls the OTC derivatives
market in the United States. In general, the
increased transparency and efficiency resulting
from these changes should benefit fund
managers and facilitate board oversight of
derivatives. The principal changes effected by the
Act include:
•
imposing substantial requirements on the
most active OTC derivatives market
participants, major swap participants and swap
dealers, including reporting, capital and
margin requirements;
•
subjecting many derivatives that are currently
traded OTC to central clearing and exchange
trading in regulated trading systems; and
•
establishing more clearly the jurisdiction of
the key regulators of derivatives, the SEC
and the Commodity Futures Trading
Commission, and repealing exemptions and
exclusions that stood in the way of their
regulation of the multi-trillion dollar OTC
market.
Money Market Funds
Money market funds are not covered directly
by the Act—perhaps in deference to the SEC’s
recent rule makings. However, money market
funds and their boards will be impacted by the
enhanced regulation of credit rating agencies,
discussed below. In addition, the issue of
systemic risk posed by money market funds—
and more complicated proposals relating to
imposition of a floating NAV and/or insurance
fund—appears to remain open and may be
addressed in a second round of legislation
expected to follow in the coming year.
Credit Rating Agencies
The Act imposes multiple new requirements
relating to the function and oversight of
nationally recognized statistical rating
organizations (“NRSROs”), including:
•
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increased authority of the SEC with respect
to rulemaking and establishment of an
August 2010
Securities Lending
The Act requires the SEC, within two years, to
promulgate rules designed to increase the
transparency of information available with
respect to lending or borrowing securities. In
addition, the Act amends the Exchange Act to
Investment Management Update
make it unlawful to lend or borrow securities in
contravention of the new SEC rules. Once
effective, these rules should also benefit
independent fund directors in discharging their
obligations to oversee securities lending.
As discussed in more detail below, the proposed
changes would:
•
rescind Rule 12b-1 under the Investment
Company Act and result in the adoption of a
new Rule 12b-2 in its place;
Investor Protection and Management of
the SEC
•
“provide a more appropriate role for fund
directors” by revising directors’ duties with
respect to fund distribution fees “to reflect
current market practices;” and
•
increase disclosure and foster price
competition by permitting the externalization
of distribution costs.
The much publicized Bureau of Consumer
Financial Protection created by the Act does
not have jurisdiction over mutual funds.
However, the Act does establish within the
SEC a new Investor Advisory Committee,
created to advise and consult with the SEC
on investor protection, the effectiveness of
disclosure and other issues.
Several other provisions are designed to
address general concerns with the functioning
of the SEC and require reports to Congress,
including a report by an independent consultant
on the internal operations, structure and
funding of the SEC.
The many new requirements imposed by the
Act mark the beginning of an intensive
regulatory process to implement its
provisions. While some of its provisions will
become effective immediately, Congress has
designed the Act so that its parts will become
effective in several stages. Congress has also
delegated significant regulatory authority to
regulatory agencies, with a mandate to adopt
rules or conduct studies within prescribed times
from enactment. It may be several years
before the final regulatory structure is
complete and its implications fully
understood.
SEC Proposes Major
Reform Related to
Distribution Fees
On July 21, the SEC released its much
anticipated proposal to revisit various aspects
of the current “12b-1” regime. The proposed
reform is a highly significant development
that could cause the industry to re-engineer
how retail mutual funds are marketed and
sold to the public.
The SEC emphatically notes that the proposal is
not meant to “prohibit the use of fund assets to
pay sales costs” or to “disrupt arrangements
that are today deeply embedded in mutual fund
sales and distribution networks, including those
that finance the operation of fund
supermarkets, retirement plan platforms, and
financial planning.” Rather, the proposal is
designed to allow investors “the ability to select
alternate distribution methods” while at the same
time assuring that each shareholder pays “only his
or her proportionate share of distribution related
costs.”
Restructuring Distribution Fees and
Responsibilities of the Board
The SEC’s rule proposal would limit and
reallocate the distribution fees currently paid out
of mutual fund assets under Rule 12b-1.
“Marketing and service fees” would be assetbased charges used to pay for the costs of
marketing the fund and providing ongoing services
to shareholders (including, costs of: participating
in distribution platforms such as fund
supermarkets; paying trail commissions to brokerdealers; compensating retirement plan
administrators; and funding shareholder call
centers, advertising efforts, and the printing and
mailing of fund prospectuses). Marketing and
service fees would be limited to an annual cap
of 25 basis points, but would not have a
cumulative limit.
Proposed new Rule 12b-2 would not require fund
boards to adopt a plan or make “any special
findings,” as Rule 12b-1 currently does. Instead,
fund boards would authorize the use of fund assets
3
to finance distribution activities consistent with
their fiduciary obligations to the fund and fund
shareholders. “The board (including the
independent directors) would oversee the
amount and uses of these [marketing and
service] fees in the same manner that it
oversees the use of fund assets to pay any
other fund operating expenses, particularly
those that create a potential conflict of
interest for the fund’s investment adviser or
other affiliated persons.”
“Ongoing sales charges” would be asset-based
distribution fees in excess of the 25 basis
points permitted under Rule 12b-2 that would
be used to compensate broker-dealers for
selling fund shares. Ongoing sales charges
would be paid “at a rate established by the
fund, provided that the cumulative amount of
the sales charges an investor pays on any fund
shares does not exceed the amount of the
highest front-end load that the investor
would have paid had the investor invested in
another class of shares of the same fund,”
which the SEC terms the “the reference load.”
For example, if a fund’s share class with the
highest front-end sales charge (“FSC”) is
subject to a maximum 6.00% FSC, the fund
could offer another class of shares with a
2.00% FSC and a cumulative ongoing sales
charge of up to 4.00%. A fund that does not
charge an FSC would be required to cap its
ongoing sales charges at the maximum amount
permitted under FINRA rules, currently 6.25%
of the amount invested. Upon reaching the
applicable cumulative ongoing sales charge
limit, a shareholder’s investment would
automatically convert to a no-load share class
of the fund. This new sales charge structure
would be permitted under proposed
amendments to Rule 6c-10 under the
Investment Company Act, which would replace
the provisions of Rule 12b-1 that currently
permit funds to charge these fees for an
unlimited period of time in annual amounts up
to 0.75% of fund assets.
As with the proposed new rule 12b-2 marketing
and service fees, fund boards would not be
required to make any special findings or
approve a plan for ongoing sales charges under
Rule 6c-10. Boards would, however:
4
August 2010
(i) continue to be bound by their fiduciary
obligations under state law and Section 36(a) of
the Investment Company Act “to consider whether
the use of the fund’s assets to pay ongoing sales
charges, within the proposed caps, is in the best
interest of the fund and fund investors;” and
(ii) be guided to “consider the amount of the
ongoing sales charge and the purposes for
which it is used according to the same
procedures they use to consider and approve
the amount of the fund’s other sales charges in
the underwriting contract section” under
Section 15(c) under the Investment Company Act.
Increasing Investor Understanding of
Distribution Fees
The rule proposal reflects the SEC’s desire to
improve the transparency of fund distribution fees
through “enhanced disclosure requirements” for
prospectuses and shareholder reports, as well as
broker-dealer transaction confirmation statements.
With respect to the prospectus disclosure changes,
among other things, Form N-1A would be
amended to:
•
prohibit references to “12b-1 fees” and
require that marketing and service fees and
ongoing sales charges be “specifically
identified and fully disclosed” in the
prospectus fee table;
•
eliminate the prospectus discussion of the
operation of a fund’s Rule 12b-1 plan, and
instead require disclosure regarding:
(i) whether the fund charges marketing and
service fees and/or ongoing sales charges, the
rates of each, and the purposes for which they
are used, (ii) the nature and extent of services
provided in relation to any ongoing sales
charges, and (iii) the time period in which the
shares will automatically convert to a class
without the charge; and
•
require a general description of “the
circumstances under which an investment
in one class may be more advantageous
than another class” for funds offering
multiple classes of shares in a single
prospectus where each class has its own
method of paying distribution fees.
More radically, the rule proposal also would
amend Rule 10b-10 under the Securities
Investment Management Update
Exchange Act of 1934 (the “Exchange Act”)
to require broker-dealer transaction
confirmations to disclose:
•
any applicable marketing and service
fees and/or ongoing sales charges, the
annual amount of that charge or fee, the
aggregate amount of the ongoing sales
charge that may be incurred over time, and
the maximum time period that the customer
will incur the ongoing sales charge;
•
any FSC paid at the time of purchase (in
percentage and dollar terms), the net dollar
amount invested in the fund, and the
amount of any applicable breakpoint used
to calculate the FSC;
•
any contingent deferred sales charge, or
“CDSC,” to be charged upon redemption
of the shares, and the amount thereof; and
•
that in addition to ongoing sales charges
and marketing and service fees, investors
will also incur additional fees and
expenses, including management fees and
other expenses, as set forth in the fund’s
prospectus, that are paid from fund assets
and thus indirectly paid by investors.
If adopted, these proposed rule amendments
would be a notable departure from the status
quo, as broker-dealer confirmations are not
currently required to discuss fund distribution
fees or sales charges.
Fostering Price Competition for the
Benefit of Retail Investors
The rule proposal is intended to “allow for
greater competition among funds and
intermediaries in setting sales loads and
distribution fees generally,” specifically by
allowing funds to sell their shares “through
broker-dealers who establish their own sales
charges.”
Under the current regulatory scheme, brokerdealers sell fund shares pursuant to the terms of
the fund’s prospectus, including its sales charge
structure. The SEC notes that “this means that
dealers cannot compete with each other by
reducing sales charges,” and accordingly
proposes “an elective account level sales charge
alternative.” Proposed new rule 6c-10(c) under
the Investment Company Act “would exempt
certain funds from [existing] requirements” by
permitting a fund, under certain conditions, “to
offer its shares or a class of its shares at a price
other than the current public offering price
stated in its prospectus. A fund could offer
shares to dealers who would then be free to
establish and collect their own commissions or
other types of sales charges to pay for
distribution.” These broker-dealer commissions
and/or sales charges would not be subject to the
Investment Company Act, and, for example,
“could be charged to the investor’s brokerage
account . . . the intermediary could charge this fee
at the time of sale, over time, or upon
redemption.”
The SEC believes that the changes “could
eliminate (or at least ameliorate) dealer
conflicts that may lead them (or their
employees) to recommend funds to customers
based on the amount of the compensation
received from selling the funds, rather than on
the customer’s needs.”
Compliance Timeline
Comments on the SEC’s rule proposal are due by
November 5, 2010. The SEC anticipates allowing
for an initial compliance period of at least
18 months after the effective date of any final
rule release.
Recent Developments
Involving Derivatives
New SEC Guidance on Derivatives
Disclosure
In a July 30 letter to the Investment Company
Institute (“ICI”), the staff of the SEC’s Division of
Investment Management (the “Division”) offered
detailed substantive guidance on the disclosure
regarding derivative instruments that funds include
in their prospectuses, shareholder reports, and
financial statements. The letter comes as the SEC
staff continues to evaluate funds’ use of
derivatives, a review that commenced in March
2010 with the goal of examining whether
additional regulatory protections are necessary for
funds using derivatives. The staff issued the ICI
5
letter prior to the completion of its derivatives
review because “the observations may give
investment companies immediate guidance
to provide investors with more
understandable disclosures related to
derivatives, including the risks associated
with them.”
•
provides a generic purpose for the use of
derivatives, such as “for hedging or nonhedging purposes;” or
•
broadly characterizes the extent of the
transactions by stating, for example, that “the
fund may invest ‘all’ of its assets in
derivatives.”
Guidance on the Prospectus
The SEC staff notes that “all funds that use or
intend to use derivative instruments should assess
the accuracy and completeness of their
disclosure,” including whether it is presented in
understandable “plain English,” each year in
connection with the annual update of their
registration statements.
The SEC staff states that any prospectus
principal investment strategy/risk disclosure
related to derivatives should be “tailored
specifically to how a fund expects to be
managed” and should discuss “the types of
derivatives used by the fund, the extent of
their use, and the purpose for using
derivative transactions.” Taking into account
“the degree of economic exposure the
derivatives create, in addition to the amount
invested in the derivatives strategy,” a fund’s
prospectus should:
•
address the derivatives strategies that the
fund (i) expects to be “most important” to
achieving its investment objective and
(ii) “anticipates will have a significant
effect on its performance;”
•
describe the intended function of
derivatives in the fund’s overall portfolio
(e.g., for purposes of hedging, speculation,
or serving as an economically equivalent
substitute for traditional securities); and
•
provide investors with “a complete risk
profile of the fund’s investments taken as a
whole, rather than a list of the risks of
various derivatives strategies,” reflecting
the fund’s “anticipated derivatives usage.”
Funds should avoid derivatives-related
disclosure that is “generic, even
standardized”—whether abbreviated or highly
technical and complex—including disclosure
that:
•
states as a principal investment strategy that
the fund “will or may engage in derivative
transactions” instead of stating that “the
fund engages in derivative transactions;”
•
“enumerate[s] all or virtually all types of
derivatives as potential investments;”
6
August 2010
Guidance on Shareholder Reports
Explaining that it has observed a variety of
discrepancies between the principal investment
strategies/risks disclosure in fund prospectuses and
the management discussion of fund performance
(MDFP) in fund annual reports, the SEC staff
emphasizes that the adviser’s performance
discussion “is intended to provide shareholders
with information about the factors that
materially affected the fund’s performance
during its most recently completed fiscal year
and also should not be limited solely to
forward-looking information.” More
specifically:
•
funds with significant derivatives exposure in
their financial statements should include a
discussion of the effect of those derivatives on
fund performance in the MDFP;
•
funds whose prospectuses do not disclose
principal investment strategies that include the
use of derivatives should avoid discussion of
derivatives in the MDFP;
•
“the MDFP should be consistent with
operations reflected in the financial
statements, and a fund whose performance
was materially affected by derivatives should
discuss that fact, whether or not derivatives are
reflected in the portfolio schedule at the end of
the fiscal year;” and
•
a fund’s prospectus disclosure—particularly
that regarding the investment objective and
principal investment strategies and risks—
should be fully consistent with the disclosure
Investment Management Update
regarding fund operations included in its
annual report.
Guidance on Financial Statements
The SEC staff also suggests ways that funds
could improve “qualitative disclosures about
their objectives and strategies for using
derivative instruments by addressing the effect
of using derivatives during the reporting
period” in the notes to the financial statements
included in their annual reports, as prescribed
by FASB standards. “The financial
statements and accompanying notes should
inform shareholders how a fund actually
used derivatives during the period to meet
its objective and strategies.” Further, the
SEC staff notes its view that with respect to
counterparties to forward currency and swap
contracts reported in a fund’s schedule of
investments, “the identification of the
counterparty is a material component of the
description and should be disclosed.”
ABA Task Force Issues Report
on Investment Company Use of
Derivatives and Leverage
In a recent report to the Division, the American
Bar Association Task Force on Investment
Company Use of Derivatives and Leverage
“determined to suggest alternative approaches
to dealing with the complicated set of legal
issues that use of derivatives by investment
companies presents.” The report responds to
a question raised by Andrew J. Donohue,
Director of the Division, of “whether the
SEC’s regulation of investment companies’
use of derivatives has resulted in funds
achieving technical compliance with
applicable law but with the potential for
outcomes that might be outside the investor
protection expectations of policy makers.”
He specifically asked the ABA Subcommittee
on Investment Companies and Investment
Advisers to consider whether:
•
funds should have a means to deal
effectively with derivatives outside of
disclosure;
•
a fund’s approach to leverage should address
both implicit and explicit leverage; and
•
a fund should address diversification from
investment exposures taken on versus the
amount of money invested.
Below is a summary of the key recommendations
made by the Task Force.
•
Principles-based approach. The Task Force
recommends a “more principles-based and
flexible approach” to the regulation of
derivatives. In particular, the Task Force
recommends that “funds that invest in
derivative instruments that involve
leverage . . . adopt policies and procedures that
would include, among other things, minimum
asset segregation requirements for each type
of derivative instrument, which would be
based on relevant factors,” including the risk
profile of the instrument. The Task Force
further recommends “that a fund’s policies
and procedures on asset segregation be
subject to approval by the fund’s board of
directors.”
•
Diversification. The Task Force recommends
a “bifurcated approach to regulating
diversification,” in that funds should measure
diversification for purposes of the Investment
Company Act by looking at the assets to
which the fund is trying to gain exposure
through the derivative instrument. Such assets
are often referred to as “reference assets.” The
Task Force also recommends that “broadbased indices or other reference assets such as
commodities or currencies should be excluded
from these calculations.”
•
Counterparties. The Task Force notes that
fund counterparty exposures “present the
concern that a counterparty cannot pay a fund
the amount that the fund is due under the
derivative instrument.” The Task Force
recommends that the SEC regulate
counterparty risk under Section 12(d)(3) of the
Investment Company Act, which the Task
Force believes “offers a better framework for
addressing counterparty exposures because it
applies to all funds without regard to their
diversification status.”
7
•
•
•
•
•
8
Limits on leverage. The Task Force
recommends that the SEC or its staff
regulate compliance with statutory leverage
requirements by applying the principlesbased approach described above, and that
“[f]und policies and procedures should also
describe what will constitute an ‘offsetting
transaction’ for purposes of coverage
requirements.”
Concentration. The Task Force observes
that many funds “typically comply with
their [industry] concentration policies by
looking to the reference asset and not any
counterparty to the derivative instrument.”
The Task Force “believes that this
measurement is appropriate” and is
consistent with the approach recommended
for purposes of the diversification test.
Fund names. The Task Force recommends
that the SEC or its staff clarify that the
“names rule” should be interpreted like the
diversification and concentration tests
noted above, in that “funds would invest in
accordance with their name by looking to
the reference assets.”
Disclosure. The Task Force “recommends
that funds enhance disclosure of how
derivative instruments affect actual
investment results.” The Task Force
offered the portfolio manager letter to
shareholders as an example for placement
of this type of information, given its
“snapshot-in-time” nature.
Director oversight. The Task Force
recommends that, as a general matter,
“directors should oversee fund use of
derivatives in much the same way that
they oversee other aspects of fund
operations, including compliance with its
investment objectives and policies
generally.” That is, the Task Force noted
that “directors should be satisfied that the
fund’s policies and procedures” for
managing risk “are reasonably designed to
achieve their objectives, and monitor the
investment managers’ adherence to those
policies and procedures.”
August 2010
The Task Force recommends that “it would be
prudent for directors to:
•
review each fund’s use of derivatives in order
to ascertain whether such use is appropriate
for the fund, taking into account the fund’s
investment objectives and policies and the
general manner in which the fund is marketed;
•
discuss with management whether the fund’s
use of derivatives is achieving its objectives
within the risk tolerances established by the
fund manager as disclosed in the fund’s
registration statement;
•
be familiar with the public disclosures
concerning derivatives that the fund makes
pursuant to the federal securities laws;
•
be confident that the relevant operations of the
investment manager, including its risk
management systems, are adequate to
accommodate the use of derivatives;
•
discuss relevant information with the fund’s
CCO concerning the fund and investment
manager’s compliance with the legal
requirements that apply to derivatives; and
•
look out for ‘red flags’ that indicate undue risk
or that derivatives are not achieving their
intended use.”
In addition, the Task Force “recommends that
the SEC or its staff emphasize that the role of
the fund board with respect to a fund’s use of
derivatives and leverage is one of oversight,
rather than micro-management.” The Task
Force also suggests that the SEC or its staff should
consider proposing guidance for public comment
on the proper role of fund directors in overseeing
derivatives and leverage.
Supreme Court to Consider
Scope of Third-Party
Liability under Section 10(b)
in Janus Capital Group Inc.
v. First Derivative Traders
On June 28, the U.S. Supreme Court agreed to
consider whether allegedly misleading
statements in a fund prospectus provide an
Investment Management Update
adequate basis to hold the fund’s adviser, a
publicly-held company, liable for securities
law fraud under Section 10(b) and
Rule 10b-5, the anti-fraud provisions of the
Exchange Act in connection with the sale of
the adviser’s publicly traded stock.
The key issue presented is whether the
adviser’s participation in drafting and
disseminating the fund prospectuses can serve
as an adequate basis to hold the adviser
primarily liable for the allegedly misleading
statements contained therein. Historically, the
Court has distinguished between primary and
secondary liability for securities law fraud and
has rejected imposing liability under Section
10(b) on secondary actors. While the Court’s
recent decisions have generally narrowed the
scope of antifraud liability, the Court could
significantly increase potential fraud liability
for publicly owned third-party service
providers, including investment advisers,
distributors, parent companies and others, if it
upholds the decision of the lower court.
Background
In 2003, in the wake of the market-timing
allegations across the fund industry, First
Derivative Traders filed an action against Janus
Capital Management (“JCM”), an adviser to
mutual funds, claiming JCM was responsible
for allegedly misleading statements in Janus
fund prospectuses concerning the funds’
market timing policies, and once the
misleading nature of the statements became
public, it caused a drop in the value of the
JCM’s publicly-traded stock. The district
court dismissed the action, holding that since
JCM did not actually prepare the prospectuses
or directly make any statement, it could not be
held primarily liable in a private securities
fraud action. The court noted that, at most, the
action involved a claim for aiding and abetting
a securities law violation, a form of secondary
liability for which there is no private right of
action. The plaintiffs appealed the case to the
U.S. Court of Appeals for the Fourth Circuit.
Fourth Circuit’s Decision
The Fourth Circuit reversed the district court
and remanded the case for further proceedings.
In reaching its decision, the Fourth Circuit
concluded that the complaint stated a viable
claim for primary liability by alleging that
JCM, “by participating in the writing and
dissemination of the prospectuses,” made the
misleading statements contained in the
prospectuses.
The Fourth Circuit also found that an adviser can
be held liable for a statement in another
company’s prospectus “even if the statement on
its face is not directly attributed” to the adviser
if “interested investors would attribute to the
defendant a substantial role in preparing or
approving the allegedly misleading statement.”
On this second issue, the court concluded that
“given the publicly disclosed responsibilities of
JCM . . . interested investors would have inferred
that if JCM had not itself written the policies [in
the fund prospectuses] regarding market timing, it
must at least have approved those statements.”
Citing a split between the Fourth Circuit and other
circuits over the scope of primary liability in
private securities actions, JCM petitioned the
Supreme Court to review the Fourth Circuit’s
ruling. The Court granted JCM’s petition without
comment.
Director Donohue
Discusses New SEC
Initiatives, Ongoing
Challenges
In a recent keynote speech, Andrew J. Donohue,
the director of the Division, discussed recent SEC
initiatives and rule revisions in response to market
changes, and he reviewed ongoing challenges and
potential SEC action to address them.
Donohue reviewed several recent SEC
initiatives launched “in the aftermath of the
recent market turmoil,” including increased
scrutiny of funds’ use of derivatives and
amendments to custody and money market fund
rules. Donohue then stated that the Division is
reviewing ongoing challenges to the
transparency of fund investments, including:
•
Fund investments in unregistered vehicles.
Donohue noted that some funds have
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increased their investments in unregistered
funds to gain exposure to alternative asset
classes. However, he cautioned that
private investment vehicles “often do not
provide shareholders with the level of
transparency that would be typically
expected for a mutual fund.” He stressed
that funds investing in private investment
vehicles “should determine if any
additional material information may be
necessary so that its prospectus and
shareholder reports are not misleading.”
•
•
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Potential updates to Regulation S-X.
Donohue noted that the last significant SEC
change to Regulation S-X was in 1982 and
that since then, “investment companies
have evolved and are engaging in more
complex investments and investment
strategies that provide more risk to
investors.” As a result, he said, he has
asked the Division’s staff to “compare
the current accounting and reporting
requirements contained within [SEC]
rules to those generally required under”
U.S. generally accepted accounting
principles (“U.S. GAAP”). He stated that
if the staff perceives a need, “we may
recommend amendments, enhancements,
or other clarifications” with respect to any
differences between the SEC regulations
and U.S. GAAP.
Harmonization with international
accounting procedures. Donohue stated
that the SEC recently “reaffirm[ed] its
belief that moving to a single set of highquality globally accepted accounting
standards will benefit U.S. investors and
supported the continued convergence effort
currently under way between the FASB and
the International Accounting Standards
Board.” However, he noted that some
critics have argued that International
Financial Reporting Standards (“IFRS”),
while benefiting operating companies, do
not provide accounting standards relevant
to the investment company industry in
particular. Donohue stated that the
Division will determine “whether IFRS
contains sufficient standards for
investment companies and, to the extent
August 2010
that changes need to be made, what the timing
of those changes would be.” Donohue stated
that he “challenge[s] the industry to take a
closer look at whether it really makes sense
for U.S. funds to take a different direction
when it comes to incorporating the use of”
IFRS.
SEC Staff Answers
Questions about Money
Market Reform
The staff of the Division has released a set of
responses to questions related to the SEC’s recent
amendments to the rules governing money market
funds under the Investment Company Act. The
staff noted that it expects to update the release,
which can be found on the SEC’s website, “from
time to time to include responses to additional
questions.”
Following are summaries of the more significant
answers to the so-called FAQs:
•
Registration statement amendments. Money
market funds need not file post-effective
amendments to their registration statements
under Rule 485(a) under the Securities Act
solely to comply with the rule amendments,
if they would be otherwise eligible for
immediate effectiveness under Rule 485(b)
under the Securities Act. A fund could also
“conclude that investors would be informed
adequately of the Designated NRSROs and
investment policy changes” made in response
to the rule amendments through a supplement,
or “sticker,” filed under Rule 497 under the
Securities Act.
•
Portfolio liquidity. Amended Rule 2a-7(a)
provides that “daily liquid assets” and “weekly
liquid assets” include only securities that will
mature within one or five “business days,”
respectively. The staff has advised that
“mature” “should be understood to mean the
date on which the principal amount must
unconditionally be paid, or in the case of a
security called for redemption, the date on
which the redemption payment must be
made.” Further, the maturity shortening
provisions of Rule 2a-7(d)(1) through (d)(8)
Investment Management Update
“are not always consistent with this
[maturity] requirement and therefore should
not be relied upon in interpreting” the
definitions of “daily liquid assets” and
“weekly liquid assets” under Rule 2a-7, as
amended.
Stress testing for downgrades of and defaults
on securities should “be designed to assist the
board of directors in assessing the effect of
isolated stresses on a [money market]
fund’s shadow NAV. If a downgrade or
default of a portfolio holding is likely to cause
the shadow NAV to deviate by more than
one-half cent per share, the test should
indicate the full extent of the loss a fund might
be expected to incur as a result.”
Money market funds may treat U.S.
Government securities as “weekly liquid
assets,” assuming the notes have remaining
maturities of 60 days or less and were
“issued without an obligation to pay
additional interest on the principal amount,
so that income earned, if any, is solely the
difference between the amount paid at
issuance and the principal amount payable
upon maturity.”
While a money market fund must conduct
monthly or more periodic stress tests, its board
may consider the stress testing reports at
regularly scheduled quarterly meetings. “The
Division [of Investment Management]
believes that a single report presenting data
from each of the monthly stress tests
conducted between [board] meetings would
satisfy the rule . . . [and] encourage[s] reports
to present results (including results previously
reported to the directors) in a manner that
would facilitate directors’ observation of
trends in stress testing results.”
Under Rule 2a-7, as amended, a money
market fund may choose any reasonable
time for determining its total assets,
daily liquid assets, and weekly liquid
assets, “provided that: (a) the
determinations are made at least once
every business day; and (b) the fund
consistently makes the determinations at
the same time or times.” In making such
determinations, a fund must take into
account “whether a subsequent acquisition
complies with the daily or weekly liquid
asset requirement.”
A taxable money market fund that is a
feeder fund within a master-feeder
structure cannot look through to the
portfolio of its master fund for purposes
of compliance with the daily liquid asset
requirement of Rule 2a-7, as amended.
•
Stress testing—Rule 2a-7(c)(11)(v). A
U.S. Treasury money market fund may
refrain from the stress testing for
hypothetical securities downgrades and
defaults, as long as the fund’s board
makes a determination that “these types
of stress events are not relevant for the
particular fund.”
Money market funds are not required to
stress test their portfolios “for the risk of
breaking the buck on the upside,” i.e., to
determine if its NAV is above $1.005 per
share.
In keeping with the “know your customer”
provisions of the rule amendments, “a money
market fund should incorporate an
evaluation of the liquidity needs of its
shareholder base into its stress testing
procedures.”
•
Portfolio quality—designated NRSROs
(Rule 2a-7(a)(11)(i)). The board of a money
market fund is required to (i) designate four or
more NRSROs, any one or more of whose
short-term credit ratings the fund would look
to under the rule in determining whether a
security is an eligible security, and (ii)
determine at least once each calendar year that
the designated NRSROs issue credit ratings
that are sufficiently reliable for that use.
Money market funds boards are not, however,
required to designate four NRSROs for each
type of security that the fund may hold.
A money market fund that invests only in U.S.
Government securities and/or repurchase
agreements backed by U.S. Government
securities does not need to designate
NRSROs or rely on NRSRO ratings.
The designation of NRSROs by a money
market fund’s board might affect a security’s
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status as an eligible portfolio security or as
a first or second tier security. This potential
downgrade of a portfolio security, which
essentially would be treated as a “credit
event,” would require the board to
“reassess whether the security continues to
present minimal credit risks” and take
action accordingly.
•
•
Asset backed securities (“ABS”). In
performing the minimal credit risk
evaluation for ABS in a money market
fund’s portfolio, the board should
“perform the legal, structural, and credit
analyses required to determine that the
particular ABS involves appropriate risk
for the money market fund. This standard
requires the board to consider all elements
relevant to the analyses required to evaluate
the ABS’ risk,” but not does require the
board to consider elements discussed in the
adopting release for the rule amendments
“that the board determines are not
relevant for the particular investment.”
Scope of Rule 30b1-7 and use of
Form N-MFP. Rule 30b1-7 requires every
registered fund that is regulated as a money
market fund under Rule 2a-7 to disclose its
portfolio holdings on Form N-MFP,
including those that do not use the
amortized cost or penny rounding methods
of share pricing.
Form N-MFP requires disclosure of the
shadow price of a money market fund
(series) and of each of its class(es) of
shares. If the fund’s “dividend and
accounting policies assure that there will
be no deviation between the marketbased NAVs of the classes of shares
offered by the fund, the fund may use the
same shadow NAV for each class without
a separate calculation.”
Money market funds may not use
categories other than those specified in
Form N-MFP.
The value of a capital support agreement
that does not relate to a particular
security (for example, an “agreement to
purchase, from time to time, any one of a
number of securities as necessary to
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August 2010
support NAV or to provide liquidity”) should
not be reflected in the value of any
particular security. “The value of the
support agreement itself (if any, as of the date
of valuation) should be disclosed . . . if the
capital support agreement has a value less than
its maximum value (or no value) as of the date
of valuation, the capital support agreement
should be listed at its current value (or as
having a value of zero).”
For money market funds using the amortized
cost method of valuation, the percentage of
the fund’s net assets invested in a given
security should be based on amortized cost.
A money market fund that is a feeder fund
“should disclose the securities it holds (i.e.,
the investment in the master fund),” not the
holdings of the master fund.
SEC Pursues PM Allegedly
Using Insider Information to
Advise Family Members
The SEC recently commenced an enforcement
action against a portfolio manager who, in the fall
of 2008, allegedly knew that the fund he managed
had a “rising level of redemption requests” and a
likelihood that either the “NAV would fall . . . or
that the [fund] would suspend cash redemptions,”
and misused that knowledge “by advising his
family members to sell their shares” in the
fund. The case is the second recently brought
against a portfolio manager for allegedly tipping
inside information about potential losses in a
fund’s portfolio, and it suggests increased
regulatory attention and little tolerance on this
issue.
Background
The SEC’s Division of Enforcement alleged that
David W. Baldt, a former portfolio manager of
two funds at Schroder Investment Management
North America, Inc. (“Schroders”), advised a
family member in October 2008 to redeem her
investment in a short-term bond fund (the “Fund”)
that Baldt managed once he learned that the Fund
faced large redemption requests and possible
liquidation.
Investment Management Update
The SEC’s order alleged that:
•
Several of Baldt’s family members had
invested the bulk of their life savings in
the Fund.
•
In response to “market conditions [that]
were deteriorating” in September 2008,
Schroders’ management directed Baldt
“to sell enough bonds to maintain a cash
cushion . . . so that [the Fund] would have
sufficient liquidity to meet redemption
requests.”
•
Later that month, Schroders learned of a
$12 million redemption in the Fund, and
Schroders management “warned Baldt
that if his team failed to raise the
necessary cash, ‘the alternative may be
to close the funds.’”
•
Baldt argued with management that its
directive to raise cash reserves “was an
imprudent course of action” that would
“lead to added redemptions, further sales
and ‘snowballing poor investment
performance’” that could result in “forced
liquidation.” However, management
reiterated the instruction to raise a 10 to 12
percent cash cushion in the Fund.
•
On October 3, 2008, Baldt learned of an
additional redemption in the Fund of more
than $1 million.
•
That evening, during a phone conversation
between Baldt and a family member, the
family member told Baldt that she had
redeemed some of her shares in the Fund.
He advised her, “Well I’d go the full
route,” and he told the family member
that another mutual relative “ought to
do it as well.”
•
After her discussion with Baldt, the relative
took his statements “as a recommendation
that she should sell of all of her shares in
the Short-Term Fund.” Per Baldt’s
instruction, his family member relayed
the information to the second relative, and
this information was conveyed to a third
family member.
•
In the two trading days immediately
following the October 3 phone
conversation, the three family members
redeemed a total of $200,000 from the
Fund. Moreover, “Baldt’s family members
attempted, but failed, to redeem $3,068,117
worth of Short-Term Fund shares.”
•
A week after these redemptions, Schroders
announced to shareholders that it would close
the Fund. Baldt resigned as portfolio manager
that same day.
Alleged Violations
According to the SEC:
•
When Baldt spoke with his family member on
October 3, he “was aware that the Funds [he
managed] faced two options: the Funds
could either remain open, which Baldt
believed would result in a significant drop
in the Funds’ NAV, or the Funds would be
liquidated in an orderly fashion, resulting in
near-term illiquidity for shareholders.”
•
Baldt “knew the Short-Term Fund was
receiving mounting redemption requests”
and “learned that a broker had discovered that
Schroders was putting out a large percentage
of its municipal bond portfolio to bid and
questioned whether Schroders was in trouble.”
•
Baldt “knew that such information, if it
became known by investors, would likely
cause redemption requests to increase” and
that in response, he tipped a family member
to “redeem all of her shares in the Fund
and told her to advise another family
member to do the same.”
•
The SEC alleges that because of these actions,
Baldt allegedly violated Section 17(a) of the
Securities Act, Section 10(b) of the Exchange
Act and Rule 10b-5, and Sections 206(1) and
206(2) of the Advisers Act when he breached
the fiduciary duty he owed Schroders and the
Fund.
13
SEC Proposes Tougher
Disclosure Rules for
Target Date Funds
The Securities and Exchange Commission has
recently proposed rule changes designed to
“help clarify the meaning of a date in a
target date fund’s name and enhance the
information provided to investors in these
funds as they invest for retirement.” The
SEC’s proposals, which will be open to
comment until August 23, are aimed at
disclosures in target date funds’ marketing and
advertising materials.
Background
Target date funds are designed to make
investing for retirement easier by automatically
changing the fund’s asset allocation over time
to become more conservative as the investor’s
expected retirement date nears. This shift is
often referred to as the fund’s “glide path.”
Target date funds, which currently hold
approximately $270 billion in assets, have
become an increasingly common way to invest
through 401(k) plans. They are often marketed
as a simple “set-it-and-forget-it” approach to
retirement investing. To simplify marketing,
target date funds often contain the year in
which the investor plans to retire in their
names.
The 2008 financial crisis revealed volatility in
many target date funds as well as variability
among some funds that had the same target
dates. According to the SEC, funds with a
2010 target date averaged 24% losses in 2008,
even though many investors expected the
funds’ asset allocations to be relatively
conservative. SEC Chairman Schapiro noted
that “many of these losses were attributed to
target date funds’ sizable allocation to equity
investments.” In addition, the annual returns
for 2010 target date funds offered by different
fund families varied widely, ranging from
approximately 9 to 41% in 2008.
In June 2009, the SEC and Department of
Labor held a joint hearing to consider the issues
facing target date funds. The SEC highlighted
two main concerns: “the potential for a
14
August 2010
target date fund’s name to contribute to
investor misunderstanding about the fund” and
whether the “marketing materials provided to
401(k) plan participants and other investors in
target date funds may have contributed to a
lack of understanding by investors of those
funds and their associated investment strategies
and risks.”
Proposed Rule Changes
In response, the SEC has proposed amendments to
four key areas of mutual fund advertising and
marketing rules under Securities Act Rules 156
and 482 and Investment Company Act Rule 34b-1.
Fund name and target date asset allocation. The
SEC proposed that “marketing materials for a
target date fund that includes the target date in
its name [would be required] to disclose the
asset allocation of the fund among types of
investments.” Under the proposed rule, the
“types of investments—such as equity securities,
fixed income securities, or cash—would need to
appear with the fund’s name the first time the
fund’s name is used.”
Asset allocation illustration. Under the proposal,
marketing materials would be required “to
include a prominent table, chart, or graph that
clearly depicts the asset allocations among types
of investments over the entire life of the fund.”
Additionally, immediately preceding the
illustration, funds will be required to include a
statement explaining that “the asset allocation
changes over time, noting that the asset allocation
eventually becomes final and stops changing;
stating the number of years after the target date at
which the asset allocation becomes final; and
providing the final asset allocation.”
Additional risks and considerations. According
to the proposal, marketing materials also would be
required to include statements informing the
investor:
•
to consider the investor’s risk tolerance,
personal circumstances and complete financial
situation;
•
that an investment in the fund is not
guaranteed and that it is possible to lose
money by investing in the fund, including at
and after the target date; and
Investment Management Update
•
whether, and the extent to which, the
intended percentage allocations of a target
date fund among types of investments may
be modified without a shareholder vote.
Antifraud guidance. Finally, the SEC
proposed changes to its antifraud guidance,
which relates to whether a statement in a fund’s
marketing materials is misleading. The
proposal suggests that such a statement could
be misleading because of:
•
the emphasis it places on a single factor, such
as age or tax bracket, as the basis for
determining that an investment is appropriate;
and
•
representations that investing in the securities
is a simple investment plan or requires little or
no monitoring.
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