SEC Provides Answers on Custody Rule
The SEC recently published answers to “frequently asked questions” about the revised custody rule (Rule) under Rule 206(4)-2 of the Investment Advisers Act of 1940 (The SEC’s “Staff Responses to Questions About the Custody Rule” can be found at http://www.sec.gov/divisions/investment/custody_faq_030510.htm.)
As reported in our January 2010 edition of the Investment Management Update, revisions to the Rule were intended primarily to help avoid and detect fraud (as in the Madoff case) where a registered investment adviser (RIA) might serve, or utilize an affiliated person to serve, as the custodian for client cash or securities. Among other things, the Rule now requires the RIA to obtain “internal control reports” conducted by a qualified and independent accountant under certain circumstances and have “surprise examinations” conducted by such an accountant under most cases when the RIA is deemed to have custody of client cash or securities.
Answers the SEC provided include:
SEC Adopts Rule Restrictions on Short Sales
In a move described by the SEC to help preserve investor confidence and promote market efficiency, the SEC adopted a new rule to place certain restrictions on short selling of a stock when experiencing significant downward pressure.
This so-called “alternative uptick rule” was created to restrict short selling in a stock whose price has dropped 10 percent or more from the stock’s closing price on the previous day. Once the circuit breaker is triggered, the alternative uptick rule would allow short selling in that stock only at a price above the current national best bid for that day and the day thereafter. The rule applies to all equity securities listed on national securities exchanges, whether traded on an exchange or over the counter. The restrictions, when triggered, should provide long sellers the opportunity to sell their shares before any short sellers.
In a short sale, an investor who believes that the price of the stock will decline borrows stock and sells it. If the investor guesses right, the investor makes a profit by buying back the stock (at the reduced stock price) to cover the short position and returns the borrowed shares.
In adopting this rule, it appears that the SEC attempted to bridge a divide between those who would have banned short sales versus those who believe that short selling is an important investment tool and any drastic restrictions will hurt market liquidity. The SEC narrowly adopted the rule (by a three to two vote) reflecting the close division between those who oppose short selling in any form versus those who believe short selling can be beneficial.
This rule follows recent SEC actions to rein in short selling after the market sell-off about two years ago. For a period in 2008, the SEC adopted emergency measures to ban short sales in most financial stocks and made permanent a temporary rule to end “naked” short sales.
For more complete information about the alternative uptick rule, see http://www.sec.gov/rules/final/2010/34-61595.pdf.
Investment Adviser to Mutual Fund Has Fiduciary Obligation to Negotiate Best Possible Service Provider Arrangements and to Candidly Disclose Material Features of Arrangements
In a recent ruling, the Second Circuit emphasized the fiduciary duties and disclosure obligations that an investment adviser has to a mutual fund that it advises. Specifically, the court’s ruling indicates that an investment adviser to a mutual fund has a fiduciary obligation to negotiate the best possible service provider arrangements for the fund, and an obligation to disclose candidly to shareholders of the fund the material features of such arrangements.
The case involved a family of mutual funds and an advisory affiliate of the funds’ investment adviser that accepted compensation from a service provider to the funds without disclosing this compensation to shareholders of the funds. Specifically, the adviser recommended, and the funds implemented, a new arrangement under which an advisory affiliate of the adviser became the funds’ transfer agent. The advisory affiliate then hired the funds’ former third-party transfer agent to continue to provide most transfer agency services, at a substantial profit to the advisory affiliate. The plaintiff shareholders alleged that the adviser had concealed from the funds’ directors and shareholders that the third-party transfer agent would have provided the same services much more cheaply and also had entered into a secret side letter to provide millions of dollars in additional revenue to various advisory affiliates.
The Second Circuit, in an unanimous opinion, ruled that the plaintiff shareholders had properly stated a claim under the anti-fraud rules against the mutual funds’ investment adviser. The lower court had dismissed the claim, ruling that the alleged disclosure failures were immaterial because the funds disclosed the total fees paid by the funds. However, the Second Circuit disagreed and found that the alleged disclosure failures were material because, among other things, (1) the funds’ shareholders “could not divine from the disclosures” that they were at “the mercy of a faithless fiduciary,” and (2) the funds’ prospectus disclosure was incorrect as it included the fees payable to the advisory affiliate as “other expenses” when, in reality, these fees included kickbacks.
The court reasoned that under the circumstances alleged in the complaint, the investment adviser to the mutual funds had an obligation to negotiate the best possible transfer agent arrangements for the funds, and an obligation to disclose candidly to shareholders of the funds the material features of any transfer agent arrangements that the adviser crafted on behalf of the funds.
The Second Circuit also ruled that the plaintiff shareholders had adequately alleged loss causation, as they had alleged that the investment adviser’s misrepresentations caused shareholders to make and maintain investments in the funds that were subject to excessive fees and expenses, and that the periodic deduction of those fees and expenses reduced the value of the investments over time. The court ruled that this met the legal requirement that the plaintiff shareholders show not only that had they known the truth they would not have acted but also that they suffered actual economic loss.
With Continued Focus by SEC on Derivatives and Short Selling, Mutual Fund Directors Should Ensure Proper Oversight of a Fund’s Trading Practices
The SEC continues to focus on derivatives, short selling, and other trading practices employed by mutual funds and others. In such an environment, fund directors should ensure that they are properly overseeing the fund’s securities trading practices. Directors should not micromanage the minutiae of individual securities trading practices, but they must exercise knowledgeable and meaningful oversight. Key to their oversight role is an understanding of the risks related to the fund’s securities trading practices and the fund’s disclosure of these risks and securities trading practices in its prospectus and statement of additional information. Set forth below are a few tips for addressing the oversight of a fund’s securities trading practices:
Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:
Terry D. Nelson
Peter D. Fetzer