A Compilation of Enforcement and Non-Enforcement Actions

29 April 2010 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Investment Management Concerns
Based upon recent comments from Andrew Donohue, the Director of the SEC’s Division of Investment Management, the following represent the Division’s areas of concern that may require regulatory fixes.

One area of concern for the Division is the increasing use of derivatives by mutual funds and the additional risks they provide to investors. Mr. Donahue stated that the Investment Company Act of 1940, which was enacted into law long before the advent of derivative investments, might not effectively regulate the increasing use of derivatives by mutual funds. For example, the Division is looking into whether the restrictions on the use of leverage under the Act are stringent enough to cover the amount of exposure, concentration, and possible lack of diversification that often accompanies the use of derivative investments employed by some of the mutual funds registered under the Act. In addition, the Division questions whether the funds’ boards of directors are up to reviewing such investments. The Division will be asking for insight by regulatory experts, academics, and investor advocates to determine the appropriate degree of such investments under the Act.

Another area of concern is the systematic risk in money market funds. During the height of the 2008 financial crisis, there were lessons learned about the vulnerability of the $1-per-share price. The Division believes that liquidity and systematic risk issues with respect to money market funds have not been addressed and need to be before another financial crisis.

A third area of concern, according to Mr. Donohue, is the increased use of collective investment trust platforms. Such platforms consist of trust accounts that have been pooled and operated by a trust company or a bank. Often, an outside investment management company is engaged to manage the assets of the pool and to market and distribute interests in the pool. Although such pools have been around for a long time, they are being used on an increasing basis, particularly for retirement funds. The Division will look at the exemption from registration under the Act for such pools to determine if there is still a sufficient public policy reason to continue with the exemption for such pools or require some degree of registration under the Act.

SEC Releases Information on Inspections and Examinations
During a recent “SEC Speaks” program (March 26, 2010), the SEC disclosed information about its 2009 inspections and examinations program. Generally, such disclosure provides registrants and their counsel a good indication of what to expect when the SEC arrives for an inspection or examination.

During 2009, the SEC conducted 1,244 examinations of registered investment advisers and 316 examinations of investment companies. Of that amount, 60 percent of the investment advisers received deficiency letters, eight percent were the subject of enforcement referrals, and 35 percent received no further action. Of the 316 investment companies examined during 2009, 35 percent received deficiency letters, five percent were the subject of enforcement referrals, and 62 percent received no further action.

The areas of most common deficiencies found by the SEC during its examinations of investment advisers were inadequate disclosures to clients and late or incomplete filings with the SEC, failure to comply with the compliance rule, especially with respect to the adequacy of compliance procedures, personal trading where provisions are not being followed, and lack of personal securities transaction review, lack of necessary disclosures in performance advertising and marketing, and inadequate internal controls with respect to portfolio management. For investment companies, the areas of most common deficiencies found by the SEC were the inadequacy of compliance procedures, inadequate disclosures, lack of or incomplete filings with the SEC, inadequate oversight of service providers and internal controls, personal trading and lack of personal securities transaction review, and inadequate internal controls over pricing and calculation of NAV.

Out of the examinations conducted, 33 percent found “significant” violations and 94 percent were handled by deficiency letters leading to corrective actions of all deficiencies.

The SEC’s focus in conducting its examinations program of investment advisers in 2010 appears to be third-party asset verification, recruiting additional staff with specialized experience, expanding and targeting training of staff who conduct the examinations, and integrating broker-dealer and investment exams.

The staff’s focus during 2010 examinations will apparently be on custody arrangements and safety of client assets, money market funds, complex/structural products with respect to liquidity and valuation, and the use of non-public information in making investment decisions.

Supreme Court Rules That Gartenberg Is the Law of the Land With Respect to Reasonableness of Mutual Fund Fees
In a recent decision, the U.S. Supreme Court affirmed by a unanimous vote that the standards used by courts to settle disputes over the reasonableness of fees charged by mutual fund advisers as set out in Gartenberg v. Merrill Lynch were the appropriate standards, overturning a May 2008 decision by the U.S. Court of Appeals for the Seventh Circuit.

The Court’s decision sent the case brought by a group of shareholders alleging that a certain mutual fund investment adviser charged excessive fees back to the lower court for further proceedings. This lawsuit is just one of several currently pending in which the plaintiffs claim that advisory fees for mutual funds are excessive.

The Second Circuit’s decision in the Gartenberg case, which was affirmed by the Court, held that in order to find that the adviser’s fees were excessive and therefore a violation of Section 36(b) under the Investment Company Act of 1940, the “adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length collective bargaining.” The Gartenberg court pointed to certain factors that could be used to determine where the adviser’s fee is reasonable. Those factors include what the fees are charged by advisers at similar funds and the nature and quality of the services provided by such advisers. The Gartenberg standard has been used by the mutual fund industry and its boards of directors for the past three decades. In its decision, the Seventh Circuit went beyond the Gartenberg standards and concluded that investors alleging excessive fees also must show that the fund’s adviser misled the fund’s board of directors.

Whether or not the Court’s decision rejecting the lower court’s ruling and affirming Gartenberg was a victory for the mutual fund industry or plaintiff-investors depends on whose “spin” you believe. The mutual fund industry apparently believes that the Court’s decision brings clarity to the issue and affirms the standards used by the industry for more than 30 years. On the other hand, some attorneys representing investor-plaintiffs in such cases view the decision as backing principals friendly to fund shareholders and rejecting the industry’s interpretation of Gartenberg. Some observers believe that the Court’s ruling will pressure fund companies to reduce the gap between what individual fund investors pay in fees versus what big institutional clients pay. Most observers believe that the decision keeps the door open for investor-plaintiffs to challenge mutual fund fees but only slightly and under limited circumstances. It should be clear to all observers that the decision provides more clarity for mutual fund boards of directors in determining the factors to consider while reviewing the appropriateness of the mutual fund fees. That clarity provided in the Court’s ruling also underscores to fund managers the importance of examining their fee structures with the services they provide and whether it is appropriate for one client to pay more fees than another.

Enforcement Matters

Investment Adviser Charged With Fraud
An Ohio-based investment adviser was recently charged by the SEC with fraud with respect to his investment strategy, client account statements, and use of investor funds.

According to the SEC complaint filed in the U.S. District Court in Cleveland, Ohio (SEC v. Enrique F. Villalba, Jr. U.S. District Court for the Northern District of Ohio, Civil Action No. 5:10-CV-00649-DDD), Enrique F. Villalba, Jr. solicited investors in several states through his investment advisory business, Money Market Alternative L.P., by touting an investment strategy purported to be conservative and relatively risk-free and that investors would realize an eight- to 12-percent return while investing conservatively. Instead, Mr. Villalba invested predominately in commodity futures.

The result, according to the SEC’s complaint, was that instead of preserving the estimated $39 million of investor funds, more than $17 million was lost in commodity future investments and approximately $4.1 million was misappropriated by Mr. Villalba for his own business purposes. The SEC further alleges that he provided investors with false quarterly statements that concealed the losses on investments and his misappropriations. According to the SEC, Mr. Villalba defrauded his clients and breached his fiduciary duty as an investment adviser. The SEC seeks a permanent injunction, disgorgement, and financial penalty in its case. In addition, the SEC has also filed information against Mr. Villalba in a related criminal action.

For more information about this matter, see SEC Litigation Release No. 21464/March 29, 2010.

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

Peter D. Fetzer
Milwaukee, Wisconsin