May 2010
Inside this issue:
Supreme Court Upholds
Gartenberg Standard in Jones v.
Supreme Court Upholds Gartenberg Standard
in Jones v. Harris
Net Asset Values (NAVs)........... 5
On March 30, 2010, the Supreme Court issued its highly anticipated decision in
Jones v. Harris Associates, L.P. In a unanimous opinion, the Court concluded
that the Second Circuit’s 1982 decision in Gartenberg “was correct in its
basic formulation of what Section 36(b) requires: to face liability under
Section 36(b), an investment adviser 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.”
SEC to Evaluate Fund Use of
Background
Harris ......................................... 1
SEC Adopts Amended Money
Market Fund Rules .................... 3
SEC Charges Fund Adviser and
Others with Fraudulently Inflating
Derivatives ................................. 6
California Court: Funds Must Get
Shareholder Approval to Change
Industry Classifications .............. 7
SEC v. Tambone: First Circuit
Declines to Expand Rule 10b-5
Liability to Cover Implied
Statements ................................ 8
Court Rules Adviser Defrauded
Funds......................................... 9
SEC Speaks: 2010 ................. 11
SEC Names Kathleen Griffin
as First Chief Compliance
Officer ...................................... 12
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Section 36(b) under the Investment Company Act imposes a fiduciary duty on
mutual fund advisers as to their fees and authorizes civil actions by the SEC and
shareholders for breach of that duty. For over 25 years, Gartenberg has served as
the predominant framework for judicial and regulatory interpretations of
Section 36(b) and for the annual review by a fund board of an investment
advisory contract under Section 15(c) of the Act.
In Jones, the plaintiffs alleged that fees charged by their funds’ adviser were
excessive as compared to fees charged to the adviser’s institutional clients. The
Seventh Circuit Court of Appeals disapproved of Gartenberg, in its review of the
plaintiffs’ appeal against the lower court’s grant of summary judgment for the
defendant adviser, and adopted a new, market-based standard for the evaluation
of investment advisory fees under Section 36(b).
The Seventh Circuit’s panel opinion in Jones created a Circuit split that
questioned the substantive standard required by Section 36(b). The Supreme
Court agreed to hear the case, and oral arguments presented to the Court focused
on the nature of the adviser’s fiduciary duty under Section 36(b), the role of a
fund board in evaluating advisory fees, appropriate fee comparisons and the role
of the courts in Section 36(b) cases.
The Supreme Court Weighs In
With its Jones opinion, the Supreme Court embraced the Gartenberg standard as
the appropriate approach for the review of challenged advisory fees. The
Gartenberg framework, Justice Alito wrote, accurately reflects the “delicate
compromise” between shareholder and adviser interests that Congress
“embedded in §36(b).” The opinion also noted that Gartenberg “has been
adopted by other federal courts, and ‘the SEC’s regulations have recognized, and
formalized, Gartenberg-like factors.’”
On Advisers’ Fiduciary Duty
In reaching its decision in Jones that the
Gartenberg formulation “was correct,” the Court
explored the history of the fiduciary duty
established by Section 36(b). The essence of the
test as to whether a fiduciary duty has been
violated, the Court explained, “is whether or not
under all the circumstances the transaction carries
the earmarks of an arm’s length bargain.”
According to the Court, “[t]he Gartenberg
approach fully incorporates this understanding of
the fiduciary duty . . . Gartenberg insists that all
relevant circumstances be taken into
account . . .”
On Comparative Fees
Discussing the usefulness, within the Section
36(b) calculus, of comparing a mutual fund’s
advisory fees to the fees charged by its adviser to
other clients, the Court reasoned that “[s]ince the
Act requires consideration of all relevant
factors . . . we do not think that there can be
any categorical rule regarding the comparisons
of the fees charged different types of clients.
Instead, courts may give such comparisons the
weight that they merit in light of the similarities
and differences between the services that the
clients in question require.” Warning against
“inapt comparisons,” the Court noted that:
there may be significant differences
between the services provided by an
investment adviser to a mutual fund and
those it provides to a pension fund which
are attributable to the greater frequency of
shareholder redemptions in a mutual fund,
the higher turnover of mutual fund assets,
the more burdensome regulatory and legal
obligations, and the higher marketing
costs. If the services rendered are
sufficiently different that a comparison is
not probative, then courts must reject such
a comparison. Even if the services
provided and the fees charged to an
independent fund are relevant, courts
should be mindful that the Act does not
necessarily ensure fee parity between
mutual funds and institutional clients.
The Court also warned, as did the Gartenberg
court, against placing too much emphasis on a
2
May 2010
comparison of one fund’s advisory fees against
fees charged to other mutual funds by other
advisers. “These comparisons are problematic
because these fees, like those challenged, may not
be the product of negotiations conducted at arm’s
length.”
On the Role of Independent Directors
The Court’s opinion appears to be a major
affirmation of the crucial role of informed and
diligent fund directors in overseeing fees and
monitoring conflicts of interest. Citing its own
precedent, the Court reasoned that “[u]nder the
Act, scrutiny of investment adviser
compensation by a fully informed mutual fund
board is the ‘cornerstone’ of the . . . effort to
control conflicts of interest within mutual
funds.” The Court also acknowledged that the
Act “instructs courts to give board approval of an
adviser’s compensation ‘such consideration . . . as
is deemed appropriate under all the
circumstances.’” “Gartenberg heeds these
precepts,” the Court stated, “as it advises that ‘the
expertise of the independent trustees of a fund,
whether they are fully informed about all facts
bearing on the [investment adviser’s] service and
fee, and the extent of care and conscientiousness
with which they perform their duties are
important factors to be considered in deciding
whether they and the [investment adviser] are
guilty of a breach of fiduciary duty . . . .’”
The Court also stressed that “where a board’s
process for negotiating and reviewing investmentadviser compensation is robust, a reviewing court
should afford commensurate deference to the
outcome of the bargaining process. Thus, if the
disinterested directors considered the relevant
factors, their decision to approve a particular fee
agreement is entitled to considerable weight, even
if a court might weigh the factors differently.”
The Court also considered the possibility that “a
fee may be excessive even if it was negotiated by
a board in possession of all relevant information,”
but emphasized that under any circumstances
“Section 36(b) does not call for judicial secondguessing of informed board decisions.”
Investment Management Update
SEC Adopts Amended
Money Market Fund Rules
Responding to the extreme turbulence
experienced by the money market fund sector in
2007 and 2008, the SEC has adopted amendments
to the rules governing money funds under the
Investment Company Act. For the most part, the
new rules track the amendments proposed by the
SEC in June 2009 as well as the recommendations
of the ICI’s Money Market Working Group. The
amended rules are “designed to make money
market funds more resilient to certain shortterm market risks, and to provide greater
protections for investors in a money market
fund that is unable to maintain a stable net
asset value per share.”
•
limit money funds to acquiring only secondtier securities with remaining maturities of 45
days or less;
•
require money funds’ boards to:
•
o
designate four or more NRSROs, any
one or more of whose short-term
credit ratings the fund uses to
determine whether a security is an
eligible security, and
o
determine at least annually that the
designated NRSROs issue credit
ratings that are sufficiently reliable;
and
require money funds to identify the
designated NRSROs in their statements of
additional information.
Among other things, the amendments establish
new liquidity standards, increase money funds’
obligations relating to the designation of ratings
organizations and reporting, and permit money
funds that have “broken the buck” to suspend
redemptions, thereby allowing the orderly
liquidation of the fund’s assets. Importantly, the
amendments do not eliminate the stable $1.00
NAV for money market funds as was suggested in
the Obama Administration’s White Paper on
Financial Regulatory Reform, issued on June 17,
2009.
The new requirements stand to insert money fund
boards into the management of credit risk to an
unprecedented degree. Indeed, the SEC
explained in the adopting release that the rule
amendments regarding credit quality of money
funds’ portfolios intentionally “shift
responsibility to money market fund boards
for deciding which NRSROs they will use in
determining whether a security is an eligible
security for purposes of the rule.”
Credit Quality
The SEC adopted its proposed reductions to
Rule 2a-7’s maturity limits for money funds’
maximum dollar-weighted average maturity and
weighted average life, and also adopted rule
changes regarding the U.S. Government securities
in which money funds may invest “in order to
reduce the exposure of money market fund
investors to certain risks, including interest rate
risk, spread risk, and liquidity risk.”
In the face of strong opposition to its proposal to
require money funds to invest only in the highestquality, “first-tier” securities,1 the SEC elected to:
•
reduce the amount of total assets that money
funds can invest in second-tier securities;
•
reduce the amount of total assets that money
funds can invest in second-tier securities of
any one issuer;
1
A “first-tier security” is: (i) a rated security that has
received the highest short-term rating from the
requisite nationally recognized statistical rating
organizations (“NRSROs”); (ii) an unrated security
determined by the fund’s board to be of comparable
quality; (iii) a security issued by a registered market
fund; or (iv) a Government security.
Portfolio Maturity
Portfolio Liquidity
The amendments to Rule 2a-7 establish
provisions to mitigate the effect of having to sell
portfolio securities into a declining market. The
new provisions reflect the SEC’s belief that “it
is incumbent upon the management of each
fund and its board of directors to evaluate the
fund’s liquidity needs and to protect the fund
and its shareholders from the harm that can
3
occur from failure to properly anticipate and
provide for those needs.” They include:
•
restrictions on the acquisition of illiquid
securities, including a 5% portfolio limit on
illiquid securities;
•
a new cash test based on the fund’s legal right
to receive cash within the prescribed time
periods rather than the ability to find a buyer
for the security; and
•
heightened portfolio liquidity standards,
including:
o
a general requirement that at all times
a money fund must hold highly liquid
securities sufficient to meet
reasonably foreseeable redemptions,
o
a minimum daily liquidity
requirement for taxable money funds,
and
o
a minimum weekly liquidity
requirement for all money funds.
In addition, the rule amendments require the
boards of money funds using the amortized cost
method to adopt procedures for periodic stress
testing of the fund’s portfolio “at such intervals as
the fund board of directors determines appropriate
and reasonable in light of current market
conditions.” This stress testing is designed to
evaluate the ability of a money fund to maintain a
stable NAV based upon certain hypothetical
events, such as increases in short-term interest
rates or shareholder redemptions, a security’s
downgrade or default, and widening or narrowing
of spreads between yields of an appropriate
overnight rate benchmark and those of the fund’s
securities.
Additional Provisions
The new rules also impose new requirements on a
variety of other issues:
Repurchase Agreements. Funds are required to:
(i) limit investments in repurchase agreements, or
“repos,” to those collateralized by cash or U.S.
Government securities in order to obtain special
treatment under the diversification provisions of
Rule 2a-7 (the special treatment allows the
acquisition of the repo to be treated as an
acquisition of the underlying collateral); and
4
May 2010
(ii) reinstate the requirement that the board or
its delegate has evaluated the creditworthiness
of the counterparty and whether or not the
repo is collateralized fully.
Disclosure of Portfolio Information. New
portfolio holdings disclosure requirements are
designed to “provide investors with a better
understanding of the fund’s investment risks, and
may allow investors to exert influence on risktaking by fund advisers and thus reduce the
likelihood that a fund will break the buck.”
Processing of Transactions. A money fund
must now have the operational capacity to
“break the buck” and to continue to process
investor transactions in an orderly manner,
including the capacity to sell and redeem
shares at prices that do not correspond to the
stable $1.00 NAV.
Exemption for Purchases of Distressed
Securities by Affiliates. As long as certain
conditions are complied with, a money fund’s
affiliate may now purchase a distressed portfolio
security from the fund, even if the security
continues to be an “eligible security,” without the
need to seek no-action relief from the SEC staff
as was required during the height of the crisis in
2008.
Fund Liquidation—New Rule 22e-3. The new
Rule “permits a money market fund that has
broken the buck, or is at imminent risk of
breaking the buck, to suspend redemptions
and postpone the payment of proceeds pending
board-approved liquidation proceedings.”
Under Rule 22e-3, a fund may suspend
redemptions if: (i) the board, including a
majority of the independent directors, determines
that the deviation between the fund’s amortized
cost NAV and the market-based NAV may result
in material dilution or other unfair results; (ii) the
board, including a majority of the independent
directors, irrevocably approves the liquidation of
the fund; and (iii) the fund, prior to suspending
redemptions, notifies the SEC of its decision to
liquidate and suspend redemptions. The new rule
allows the SEC to rescind or modify the relief
provided by the rule. Thus, the SEC could
require a fund to resume honoring redemptions.
Investment Management Update
Dissent of SEC Commissioner Kathleen L.
Casey
In a public speech made following adoption of the
reformed money fund rules, SEC Commissioner
Kathleen L. Casey explained why she did not
support the new amendments. Although while the
enhancements to liquidity and maturity
requirements in the amended rules were positive
steps towards money market reform, she said, the
amended rules “simply do not go far enough . . .
and collectively, they do not address fundamental
issues at the heart of Rule 2a-7.” “Absent more
fundamental changes” to the Rule, Commissioner
Casey warned, “money market funds will remain
susceptible to runs and we would be furthering the
view that these funds are implicitly guaranteed or
insured by the U.S. Government.”
Commissioner Casey expressed her belief that to
prevent another collapse from happening in the
future, “either money market funds will require
recourse to dedicated liquidity facilities, in which
case, in my view, they should be regulated as
banks are, or they should move to a floating NAV,
which would unyoke them from one another and
allay fears that a decline in the value of one fund
would lead to a run with the resultant choking of
short-term credit markets and the tie-up of
investor assets that we witnessed in 2008.”
Commissioner Casey also disagreed with the
approach taken to NRSROs, as doing “nothing to
reduce inappropriate investor and regulatory
reliance on credit ratings” and would have
embraced a shadow-pricing “regimen that would
provide investors with closer-to-real-time
information about the market values of
investments in fund portfolios.”
SEC Charges Fund Adviser and
Others with Fraudulently
Inflating Net Asset Values
(NAVs)
On April 7, the SEC instituted administrative
proceedings against the investment adviser and
distributor of several open-end and closed-end
funds, as well as the portfolio manager of the
funds and the head of fund accounting, alleging
they fraudulently overstated the value of certain
securities in the funds’ portfolios backed by
subprime mortgages. The securities in question
were to be priced internally based on valuation
procedures adopted by each fund’s board of
directors. The charges stem from the alleged
failure of the respondents over a six-month
period in 2007 to follow the funds’ valuation
procedures, resulting in a material inflation of
the funds’ NAVs.
In a letter to investors, the funds’ distributor has
stated its intent to challenge the SEC’s position
and asserted its belief that the funds were
managed in accordance with their prospectuses
and applicable laws.
Fund Valuation Procedures
Each of the funds had in place valuation
procedures for pricing securities and each fund’s
board of directors had delegated responsibility for
pricing the fund’s securities in accordance with
the procedures to the fund’s distributor. The
funds’ procedures for fair-valued securities
required that they be valued “in good faith” by
the distributor’s Valuation Committee, which was
composed of representatives of fund accounting,
the adviser and the distributor. Among the
factors to be considered were fundamental
analytical data relating to the investment, an
evaluation of the forces that influenced the
market in which the securities were purchased or
sold and events affecting the security.
The procedures also required written
documentation of the fair value determination
and periodic validation of prices through
means such as broker-dealer quotes. Brokerdealer quotes could only be overridden if there
was a “reasonable basis to believe that the
price provided [did] not accurately reflect the
fair value of the portfolio security.” Any
determination to override a broker-dealer
price was to be documented and provided to
the Valuation Committee for review.
Allegations of Misconduct
In its order, the SEC alleged that during a sixmonth period in 2007:
•
the funds’ portfolio manager caused 262 price
adjustments to be sent to fund accounting,
many of which were arbitrary and did not
reflect fair value;
5
•
the price adjustments were routinely used to
calculate the NAVs of the funds without
supporting documentation;
•
fund accounting routinely allowed the funds’
portfolio manager to determine whether
broker-dealer quotes received as part of the
pricing validation process were used or
ignored and did not record which dealer
quotes had been overridden at the portfolio
manager’s instruction;
•
the funds’ portfolio manager manipulated
quotes obtained from at least one brokerdealer by causing the broker-dealer to alter or
withhold quotes by failing to disclose to fund
accounting his receipt of quotes from the
broker-dealer that were lower than the
valuations being used by the funds;
•
the funds’ portfolio manager made fraudulent
misrepresentations and omissions of material
fact directly to the funds’ investors concerning
the funds’ performance in signed letters to
investors included in the funds’ annual and
semi-annual reports reporting on the funds’
performance based on NAV; and
•
the funds’ investment adviser and portfolio
manager defrauded the funds by providing a
quarterly valuation packet to the funds’ boards
reflecting inflated prices for certain securities.
SEC Charges
The SEC alleged that the respondents failed to
comply with the funds’ procedures in that, among
other things: (i) the Valuation Committee left
pricing decisions to lower level employees who
lacked appropriate training or qualifications to
make fair value pricing determinations;
(ii) accounting personnel relied on the portfolio
manager’s price adjustments without obtaining
any support for the adjustments or applying the
factors set forth in the procedures and failed to
record which securities had been assigned prices
by the portfolio manager; (iii) fund accounting
personnel gave the portfolio manager excessive
discretion in validating the prices of portfolio
securities by allowing him to determine which
dealer quotes to use and which to ignore, again
without obtaining any support; and (iv) the
Valuation Committee and fund accounting did not
ensure that the fair value prices assigned to many
6
May 2010
of the portfolio securities were periodically reevaluated consistent with procedures requiring
quarterly reports to the funds’ boards, allowing
the securities to be carried at stale values for
months. The SEC noted the Valuation
Committee’s alleged failure to supervise fund
accounting’s application of the valuation factors
and lack of knowledge concerning which
securities were valued by the portfolio manager.
The SEC alleged that the funds’ distributor
recklessly published the inaccurate NAVs and
sold shares to investors based on inflated prices
and that the head of fund accounting did nothing
to remedy the deficiencies in the implementation
of the valuation procedures or to ensure the fairvalued securities were accurately priced and
NAVs accurately calculated.
The respondents are required to file an answer to
the SEC’s allegations within 20 days and a public
hearing on the matter will be convened within 60
days before an administrative law judge who will
issue an initial decision.
SEC to Evaluate Fund Use
of Derivatives
Recently, the SEC announced its intention to
begin evaluating the use of derivatives by a
number of investment vehicles, including mutual
funds and exchange-traded funds (“ETFs”). The
effort is intended to assure the SEC that its
“regulatory protections keep up with the
increasing complexity of these instruments and
how they are used by fund managers.”
Until completion of this review, the SEC will not
approve any new or pending exemptive requests
to form ETFs that would “make significant
investments in derivatives.” According to Buddy
Donohue, Director of the SEC’s Division of
Investment Management, the deferral is necessary
“to be sure that the regulatory protections for
investors in these products are keeping up with
the increasing complexity of the derivative
instruments these types of ETFs use.” The
deferral does not affect existing ETFs or other
types of fund applications.
Investment Management Update
The SEC plans to examine various issues related
to funds’ use of derivatives, including whether:
•
“current market practices involving
derivatives are consistent with the leverage,
concentration and diversification provisions of
the Investment Company Act;
•
funds that rely substantially upon derivatives,
particularly those that seek to provide
leveraged returns, maintain and implement
adequate risk management and other
procedures in light of the nature and volume
of the fund’s derivatives transactions;
•
fund boards of directors are providing
appropriate oversight of the use of derivatives
by funds;
•
existing rules sufficiently address matters
such as the proper procedure for a fund’s
pricing and liquidity determinations regarding
its derivatives holdings;
•
existing prospectus disclosures adequately
address the particular risks created by
derivatives; and
•
funds’ derivative activities should be subject
to special reporting requirements.”
In a recent speech, Mr. Donohue noted that during
the past two decades “investment companies have
moved from relatively modest participation in
derivatives transactions limited to hedging or
other risk management purposes to a broad range
of strategies that rely upon derivatives as a
substitute for conventional securities.” He noted
that new types of registered investment companies
have emerged, such as “absolute return funds,
commodity return funds, alternative investment
funds, long-short funds and leveraged and inverse
index funds.”
Furthermore, Mr. Donohue noted that it is “not
uncommon for investment companies with
traditional investment objectives to obtain
synthetic market exposure through derivative
products.” As an example, he cited leveraged
ETFs, which “are designed for the singular
purpose of achieving a leveraged return through
the use of derivatives, in most cases to a degree
not possible using traditional investments.”
According to Mr. Donohue, the significant use
of derivatives “create[s] different exposures,”
which are not necessarily based on the amount
of money invested or the types of instruments
a fund holds. He noted that the SEC must
respond to ensure that the letter of the
Investment Company Act and its underlying
purposes “to address the speculative character
of shareholders interests arising from excessive
borrowing or the issuance of excessive
amounts of senior securities and to assure full
disclosure of investment strategies and risks”
are upheld.
Mr. Donohue also stressed that as the SEC refines
“the appropriate regulatory framework for
derivatives usage by funds, effective board
oversight in this area . . . is critically
important.” He warned that “it is becoming
increasingly apparent that the more
traditional approaches to risk, while
important, are not enough” and that with
“derivatives, the necessity of a robust, nontraditional analysis is clear.” He noted that
boards must consider the more apparent risks that
derivatives present such as “market, liquidity,
leverage, counterparty, legal and structure risks.”
He emphasized that, in addition, however, boards
should closely oversee less obvious risks, for
example, the difficulty of pricing certain
derivatives, such as “collateralized debt
obligations, collateralized mortgage obligations
and swaps.”
California Court: Funds
Must Get Shareholder
Approval to Change
Industry Classifications
The U.S. District Court for the Northern District
of California recently ruled that a fund may not
change a previously disclosed policy not to
concentrate its assets in a particular industry
without shareholder approval.
The Court followed the reasoning in an amicus
brief filed by the SEC, which stated that, if the
fund sponsor’s argument was upheld, the
shareholders, “having been explicitly and
unambiguously informed that the fund would
not invest more than 25% of its assets in
[mortgage-backed securities], could ‘suddenly
awake’ to find that the fund had invested more
7
than 50% of its assets in [mortgage-backed
securities] without having any say in the
matter.” The Court rejected the views expressed
by the Investment Company Institute, which had
filed an amicus brief in support of the fund
sponsor’s position, arguing that a fund board
“has the discretion to change a previously
disclosed industry classification unless that
classification has been explicitly and clearly
incorporated by reference into the fund’s
[fundamental] concentration policy.”
Background
The sponsor’s YieldPlus Fund, an ultra-short bond
fund, disclosed in its 1999 registration statement
that the fund would not “concentrate,” or invest
more than 25% of its assets, in a particular
industry. The Court stated that the federal
securities laws require that “once a mutual fund
registered a policy in respect of concentration of
investments in an industry, it could deviate from
that policy only by a majority vote of the
shareholders.”
In 2001, the fund amended its registration
statement to state that it would treat non-agency
mortgage-backed securities as a separate industry
for purposes of its policy not to concentrate. In
2006, with approval by the board, the fund
amended its registration statement to state that it
no longer considered non-agency mortgagebacked securities a separate industry. As a result,
the plaintiffs allege, by 2008 the fund’s
investments in those securities grew to more than
50% of its assets, causing the fund to experience
significant losses when the housing market
collapsed.
any reasonable way,” it noted that once the
promoter has “drawn a clear line and thereafter
gathers in the savings of investors, the promoter
must adhere to the stated limitation unless and
until changed by a stockholder vote.” The Court
further stated that the change in the classification
of non-agency mortgage-backed securities was an
“entire repudiation of a clear-cut definition
that had become a fixture of the fund on which
shareholders were entitled to depend for the
safety of their savings.”
Following the Court’s decision, and without
admitting liability, Schwab agreed to settle the
federal securities law claims and pay $200
million to the plaintiffs in the class action lawsuit
to avoid going to trial. The settlement remains
subject to approval by the Court. A California
state law claim remains open and the SEC has an
ongoing investigation of the fund.
SEC v. Tambone: First
Circuit Declines to Expand
Rule 10b-5 Liability to
Cover Implied Statements
In SEC v. Tambone, the U.S. Court of Appeals for
the First Circuit, sitting en banc, rejected what it
termed the SEC’s “expansive interpretation”
of Rule 10b-5(b) under the Exchange Act and
refused to impose liability under the Rule on
persons who merely use statements drafted by
others to sell securities. The Court affirmed the
District Court’s dismissal of the SEC’s
Rule 10b-5(b) claims against two former
executives of the principal underwriter and
distributor of a mutual fund complex.
Court Decision
In the class action lawsuit, the Court rejected the
fund sponsor’s argument that the disclosure in the
fund’s registration statement allowed the board to
change industry classifications without
shareholder approval, stating that “[t]he industry
definition would have been understood by
reasonable investors to be an integral part of
the concentration policy represented to be
inviolate without shareholder approval.”
In addition, even though the Court acknowledged
that a fund promoter may “define an industry in
8
May 2010
Background
In 2006, the SEC filed a civil complaint against
two former senior executives of a mutual fund
underwriter and distributor alleging they
knowingly allowed certain customers to engage
in market timing activities while continuing to
use prospectuses containing specific language
that the funds prohibited market timing. The
complaint alleged that the conduct violated
Rule 10b-5, among other provisions of federal
securities laws.
Investment Management Update
Rule 10b-5(b) Claims
Under Rule 10b-5(b), it is unlawful “for any
person, directly or indirectly, … to make any
untrue statement of a material fact or to omit to
state a material fact necessary in order to make the
statements made, in the light of the circumstances
under which they were made, not misleading.”
In Tambone, the SEC advocated a broad
interpretation of what it means to “make” a
statement under the Rule. The SEC argued that a
person can make a statement within the meaning
of the Rule either (i) by using or disseminating a
statement without regard to who wrote the
statement or (ii) by implication, in that
securities professionals who direct the offering
and sale of shares on behalf of an underwriter
make a statement to the effect that the
disclosures in a prospectus are truthful and
complete.
The Court rejected the SEC’s interpretation
finding it “inconsistent with the text of the
Rule and with the ordinary meaning of the phrase
‘to make a statement,’ inconsistent with the
structure of the Rule and relevant statutes, and in
considerable tension with Supreme Court
precedent.”
The Court’s Analysis
In reaching its decision, the Court focused, in part,
on the plain meaning of the language in
Rule 10b-5(b) and in particular the meaning of “to
make” a statement. Citing several common
dictionary definitions of the word “make,” i.e., to
create, compose or cause to exist, the Court
concluded that “the SEC’s purported reading of
the word is inconsistent with each of these
definitions.” The Court also contrasted the words
used in Rule 10b-5(b) with those used in other,
related laws and concluded that the word “make”
in the Rule was deliberate and important: “Word
choices have consequences, and this word choice
virtually leaps off the page. There is no principled
way that we can treat it as meaningless.”
The Court also reviewed the SEC’s interpretation
of Rule 10b-5(b) in the context of a previous
Supreme Court decision and concluded that to
allow the SEC’s interpretation of Rule 10b-5(b)
would be “to impose primary liability on the
defendants for conduct that constitutes, at
most, aiding and abetting (a secondary
violation)” and “would create unacceptable
tension with the substantial body of case law
that has evolved post-Central Bank.”
Last, the Court rejected the SEC’s implied
statement theory on the grounds that it
“effectively imposes upon securities professionals
who work for underwriters an unprecedented
duty” to disclose, as it would “impose primary
liability under Rule 10b-5(b) on these securities
professionals whenever they fail to disclose
material information not included in a prospectus,
regardless of who prepared the prospectus.”
Conclusion
The Court reversed the panel opinion on the
Rule 10b-5(b) claims resulting in their dismissal
as to the defendants.
In its opinion, the Court found “noteworthy” that
the SEC did not pursue an argument it made in
the lower court that “the defendants made the
alleged misstatements through their involvement
with the preparation of the prospectuses.”
Because the SEC did not make this argument on
appeal, the Court declined to address this
alternate theory of liability. Thus, it remains
unresolved whether primary Rule 10b-5 liability
could be imposed on an underwriter for making
misstatements in a prospectus where the
underwriter participated in the preparation of the
prospectus.
Court Rules Adviser
Defrauded Funds
The U.S. Court of Appeals for the Second Circuit
held in a recent class action that an adviser
breached its fiduciary duty to shareholders after
negotiating lower fees with its transfer agent and
failing to pass the savings on to its managed
funds. The Court stated that the adviser had:
•
made material misrepresentations to the
funds’ boards and shareholders regarding the
details of a renegotiated contract with the
transfer agent, such that “shareholders were
being grossly overcharged for transfer
agent services”; and
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•
“was reaping the benefits” by “essentially
pocket[ing] money belonging to the Funds.”
The decision overturned a district court ruling
from 2007 that rejected the plaintiffs’ fraud
claims.
Background
According to the Court, the funds had an
independent, third-party transfer agent. In 1997
the adviser “initiated a formal study” to determine
whether it “could take over the transfer agent
functions, rather than continue to contract with an
outside agency.”
The adviser “created a transfer agent
subsidiary . . . [that] then contracted with the
Funds to provide transfer agent services.” The
subsidiary “contracted with [the original transfer
agent] to provide most of the same transfer agent
services it had previously provided but at a
much lower rate.” The subcontract was
memorialized in a side letter, which the court said
“allegedly guaranteed [the adviser] millions of
dollars in additional revenue, without
providing commensurate benefit to the funds.”
The Court found the role of the subsidiary as a
transfer agent “was a circumscribed one”:
•
The subsidiary’s “role was confined to
operating [a] call center”; and
•
The original third-party transfer agent
“continued to perform the same services it had
previously performed at a substantially
reduced rate.”
The Court found that “[d]espite the fact that [the
original transfer agent] substantially reduced the
rate it charged for transfer agent services, and
despite the fact that [the subsidiary’s]
circumscribed role was confined to operating the
call center, [the subsidiary] charged the Funds
substantially more in transfer agent fees than it
paid” to the subcontracted third party.
Disclosure Omissions
The plaintiffs alleged that the adviser “concealed
critical aspects of its scheme from the Funds’
boards of directors.” In meetings held in 1999,
the boards received information on the
renegotiated plan, including a memorandum about
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May 2010
the contract. However, the presentations on the
renegotiated fees allegedly “failed to inform the
boards about the details of the side letter.” The
Court found that in 2003 the adviser “issued
written supplements to the Fund prospectuses
disclosing the existence of the side letter, and
disclosing that [the adviser] had not informed
the Funds’ boards of the side letter at the time
that they approved the transfer agent
contracts.”
Investors also were not told about these
details, according to the Court. In prospectuses
issued between 2000 and 2002, the adviser
“categorized fees that it ultimately pocketed as
‘other fees’ rather than management fees”, the
Court stated, “under the guise of providing
transfer agent services through [the subsidiary],
despite [its] greatly diminished role in providing
such services.” Nor did the adviser disclose that
the subsidiary “would perform only minimal
functions but would then pocket the difference
between what it charged the funds and what it
paid” the subcontracted transfer agent. “First and
foremost,” the Court stated, “what the Fund
investors could not divine from the disclosures
was that they were at the mercy of a faithless
fiduciary.”
As a result, the Second Circuit found “that the
defendant’s misrepresentations were material
because there exists a substantial likelihood that a
reasonable investor would consider it important
that her fiduciary was, in essence, receiving
kickbacks.” The Court held that any “rational
mutual fund investor would be highly leery of
dealing with a fiduciary” such as the adviser “and
its affiliates who, in violation of the law, lined
their pockets at the expense of investors whose
interests they were obligated to protect.”
The Second Circuit added that the adviser “had
an obligation to negotiate the best possible
arrangement for the Funds” and was
“obligated to disclose candidly to shareholders
the material features of the arrangements they
crafted. . . . These obligations required the
defendants to make clear to both the Board and
the Funds’ shareholders” that the adviser “was
assuming nearly the full benefit of the discounts
generated” by the subcontracted third party.
Investment Management Update
SEC Speaks: 2010
Division of Risk, Strategy and Financial
Innovation
SEC staff summarized recent regulatory initiatives
and discussed the SEC’s creation of a new Risk,
Strategy and Financial Innovation Division during
the 2010 SEC Speaks conference in March.
Henry Hu, Director of the new Risk, Strategy and
Financial Innovation Division—called Risk Fin—
led a panel discussion about the role of risk
management within SEC enforcement and
regulation. Mr. Hu noted that the “silo-like”
structure of the SEC presented a challenge to
Risk Fin’s ability to analyze complex financial
products. He remarked that in the financial
markets, the traditional understanding of the
respective “bundled rights” of stocks and bonds
has been “decoupled” through the development of
derivatives, hedge funds and other complex
financial products, but that the regulatory
structure had not adapted. Mr. Hu observed that
Risk Fin would need to “bore through silos
that have compartmentalized the collective
expertise of the SEC.”
Summary Prospectus Implementation
Barry Miller, the Associate Director primarily
responsible for implementation of mutual fund
disclosure, reviewed the staff’s experience with
implementation of the new summary prospectus
requirement. Mr. Miller listed fee table footnotes
and risk summaries as items that had resulted in
staff comments on the new format and mentioned
that funds “should not be surprised” to receive
comments about existing disclosure in addition to
the new requirements. He noted that
approximately 3,500 summary prospectuses
have already been filed with the SEC. The
panel also discussed the SEC’s plans to solicit
data from funds “over time” to study the success
of the Internet delivery options allowed by the
summary prospectus rules.
Derivative Study and ETF Exemptive
Applications
Mr. Donohue discussed the SEC’s recent
statement that it would study the use of
derivatives by mutual funds, exchange-traded
funds and other investment companies.
Mr. Donohue observed that, while the statement
was the first official announcement, the SEC has
been reviewing derivatives for over a year. The
study’s goal is to ensure that investment
companies are using derivatives in a manner
that is consistent with the limitations of the
1940 Act.
Elizabeth Osterman, the Associate Director who
oversees exemptive applications for the Division
of Investment Management, discussed the deferral
of ETF applications pending the outcome of the
derivatives study. Ms. Osterman commented that
ETF exemptive relief applications may still be
processed for consideration so long as the
investment strategy does not rely on a significant
amount of derivatives and the ETF makes a
representation to limit its use of derivatives.
Gregg Berman, Senior Policy Advisor in the Risk
Fin Division, asserted that risk management is not
measuring what can go wrong, but rather
“understanding how financial instruments
behave.” Mr. Berman concluded that SEC
regulations should lead to “disclosure with a
purpose” so that investors are able to “digest,
analyze and act on” the disclosure.
New Disclosure and Education Initiatives
Susan Nash, the Associate Director in charge of
the Office of Disclosure & Insurance Product
Regulation, summarized three areas where the
SEC anticipates releasing new regulations:
variable annuity summary prospectuses,
shareholder reports and target date funds.
Ms. Nash stated the SEC hopes to implement the
summary prospectus format for variable annuity
products, but that modifications would be
necessary to accommodate the complex nature of
variable annuities. Ms. Nash indicated there
would be increased scrutiny of variable annuity
disclosure due to the current administration’s
emphasis on increasing their use in 401(k) plans.
Ms. Nash reported that the staff would also be
working on implementing a more user friendly
format for shareholder reports.
Finally, Ms. Nash discussed an effort in
conjunction with the Department of Labor to
11
educate investors about the risks related to target
date funds. The agencies are designing new
investor education materials to alert investors that
target date funds are not individually tailored to
each investor’s particular needs.
SEC Names Kathleen
Griffin as First Chief
Compliance Officer
In early April, the SEC named Kathleen M.
Griffin as the agency’s first Chief Compliance
Officer to head a new compliance unit within
the SEC’s Office of Ethics Counsel. The
appointment marks the latest step in what the SEC
describes as “a series of measures undertaken to
strengthen the SEC’s internal compliance
program.”
centralize oversight responsibility for
employee securities transactions and financial
disclosure reporting.” According to the
announcement, responsibility for coordinating
compliance had previously been divided between
two offices. The new position will consolidate
the “compliance functions within one office [and]
is intended to eliminate the potential for any
inefficiency or redundancy.”
“We have established a system of real-time
financial reporting and we are fortunate to have a
proven compliance professional like Kathleen on
board to greatly strengthen our program,” SEC
Ethics Counsel William Lenox said.
Ms. Griffin previously acted as Vice President,
Senior Compliance Manager, and Deputy Code of
Ethics Officer for Putnam Investments, a global
money management firm.
In announcing the appointment, the SEC stated
that the role “was created to streamline and
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May 2010