A Compilation of Non-Enforcement Actions

30 March 2010 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

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:

  • March 12, 2010 is the effective date when qualified custodians must comply with the requirement to send their quarterly statements to the RIA’s clients (accordingly, statements ending on March 31, 2010 must be sent by the qualified custodians to such clients).
  • The surprise examination must commence prior to December 31, 2010, but does not need to be completed until 120 days after commencement. If the RIA serves as the qualified custodian, the initial surprise examination must commence no later than six months after obtaining the internal control report.
  • An RIA who provides investment advice to a pooled investment vehicle may rely on the annual audit provision (which serves to eliminate the surprise examination requirement) if the RIA or a related person has a written agreement in place with a qualified independent accountant to have the audit of the pooled investment vehicle’s financial statements conducted for the fiscal year ended on or after January 1, 2010.
  • For those RIAs subject to the internal control report requirements on the date of the Rule’s effectiveness (March 12, 2010), the initial internal control report is due by September 12, 2010. For those RIAs newly subject to the Rule requirement, the internal control report requirement must be met within six months of becoming subject to the requirement.
  • RIAs must provide written responses to questions with respect to custody of client cash or securities, as contained within revised Part I of Form ADV, in their first annual updating amendment to Part I of Form ADV after January 1, 2011.

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:

  • Directors must be diligent and inquiring. If they exercise their powers to inquire, challenge, and investigate, then the fund and its shareholders will be better protected.
  • Based on SEC guidance, a director’s general fiduciary duties include an obligation to review the securities trading practices of his or her fund to determine whether any of the strategies pose potential risks to the fund’s shareholders. The SEC is particularly concerned that a fund’s prospectus and other disclosure documents properly identify and describe the potential risks of loss that investors might suffer.
  • Educate yourself about the securities trading practices of the fund. The investment adviser to the fund is a good source for information and an understanding of the fund’s securities trading practices and their impact on the fund’s portfolio structure, risk, and performance.
  • Ask questions concerning why and how the fund uses various trading practices and the related risks. Also seek to understand the investment rationale for the trading practices and the investment adviser’s expertise and experience with such practices.
  • Documents filed with the SEC and provided to investors and to shareholders pursuant to the federal securities laws (registration statements, periodic reports, sales literature, and proxy statements) should contain complete disclosure of all pertinent information regarding the nature and consequences of a fund’s participation in various securities trading practices.
  • Directors should determine whether the securities trading practices of the fund are consistent with the policies that the fund has recited in its disclosure materials. For example, the SEC has indicated that it might be inappropriate for a fund that has designated the preservation of capital or the growth of capital through “conservative” investment strategies as a fundamental policy to engage to a material extent in securities trading practices such as reverse repurchase agreements, firm commitment agreements, and standby commitment agreements.
  • Certain trading practices undertaken by a fund, particularly derivative transactions, may involve the issuance of senior securities subject to the prohibitions and asset coverage requirements of Section 18 of the Investment Company Act. The SEC has issued a General Statement of Policy indicating the staff’s view that certain instruments held by a fund would not be deemed subject to Section 18 if the fund’s obligation, with respect to any such instrument, was “covered” by assets established and maintained by the fund. Directors of a fund that is engaged in the securities trading practices that might involve the issuance of senior securities should request reports showing that review of the fund’s portfolio and custodial accounts has “covered” the fund’s obligations where necessary.


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
Madison, Wisconsin
608.258.4215
tnelson@foley.com

Peter D. Fetzer
Milwaukee, Wisconsin
414.297.5596
pfetzer@foley.com

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