A Compilation of Non-Enforcement Actions

10 August 2010 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Proposes Elimination of Rule 12b-1

The SEC proposed regulations that will replace Rule 12b-1 with new regulations “designed to enhance clarity, fairness and competition when investors buy mutual funds,” according to SEC Chairwoman Mary Schapiro.

Rule 12b-1, which came into effect in the late 1970s, was designed to assist the struggling investment fund industry to finance marketing expenses. Three decades later, the investment fund industry is no longer struggling, and such fees now represent billions of dollars passed on to investors annually. According to the SEC, mutual fund investors in 2009 paid about $9.5 billion in 12b-1 fees.

In its current form, Rule 12b-1 allows mutual funds to pay broker-dealers out of the fund’s assets without providing investors in the fund details about such fee amounts and why they are being paid. Because of the sheer amount of fees being paid out by the funds under the cloak of Rule 12b-1, the SEC believes that a new regulatory framework is necessary to protect investors from excessive fees and provide more transparency about such fees.

The SEC’s goal in eliminating Rule 12b-1 is to limit mutual fund sales charges, provide transparency to fee practices, and stimulate competition among broker-dealers who are currently bound by the sales terms set by the fund.

The SEC’s proposal will seek to strike a balance so that sales charges for one class of a mutual fund will not exceed the highest front-end fee charged for another class of the mutual fund. In addition, the proposal would require mutual funds to clearly disclose all distribution fees and the total sales charge that an investor will have to pay. The new regulations would allow broker-dealers to set their own sales charges for the sale of mutual funds by charging the investors directly.

The new proposal also will change mutual fund director oversight duties, as there will be automatic limits on fund fees and charges and directors would no longer need to approve annual fund distribution charges.

The proposed regulations are subject to a 90-day comment period before the SEC may act on the proposal.

SEC Approves Changes to Part II of Form ADV

On July 21, 2010, the SEC approved changes to Part II of Form ADV, which serves as a registered investment adviser’s principal disclosure document for its clients and prospective clients. Part II of Form ADV, also referred to as the investment adviser’s “brochure,” provides mostly “check the box” information about the investment adviser’s investment strategies, fees, qualifications, and business practices.

The current format, according to the SEC, does not serve to provide the client and prospective client with disclosure that is always clear or written in plain English.

The new format as approved by the SEC will require the investment advisory firm to provide its readers with a narrative brochure organized in a consistent and uniform manner as well as disclosure of the advisers fees, conflicts of interest, disciplinary information, and business practices written in plain English. The adviser also must provide to clients “supplements” to the brochure with background information about the specific individuals who will provide the advisory services to the client.

Once the brochure has been prepared by the advisory firm to comply with the amendments, the brochure will be filed electronically on the SEC’s Web site and will be available to the general public for review. Currently, only the advisory firm’s Part I of Form ADV is required to be filed with the SEC and made available to the general public.

The changes become effective 60 days after publication in the Federal Register. Most advisory firms will be required to have complied with the amended Part II of Form ADV requirements by the end of the first quarter of 2011.

New Act Means Regulatory Changes for Investment Advisers

As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Private Fund Investment Advisers Registration Act of 2010 (Act) was enacted as of July 21, 2010.

The Act amended certain provisions of the Investment Advisers Act of 1940 (Advisers Act) that will require many of the investment advisers to private investment funds to register with the SEC as an investment adviser under the Advisers Act, and will increase certain recordkeeping and reporting requirements for such advisers.

The provisions pertaining to investment advisers become effective one year from the date of the Act (July 21, 2011).

The changes applicable to investment advisers under the Act are as follows:

  • The “private adviser” exemption from registration under the Advisers Act is eliminated. This will result in many of the unregistered investment advisers to private funds who rely on this exemption from registration to register with the SEC unless one of the new exemptions created is applicable.
  • Certain new registration exemptions are created:
    • Advisers to “venture capital funds” will not have to register. The SEC is required to define the term “venture capital fund” by July 21, 2011. Although an adviser to such a fund may be exempt from registration, it will still be required to new recordkeeping and reporting requirements to be established by rule by the SEC.
    • Certain non-U.S. advisers may be able to qualify for an exemption from registration if it has no place of business in the United States, has fewer than 15 clients in the United States, has aggregate assets under management for U.S. clients of less than $25 million, does not hold itself out to the public in the United States as an investment adviser, and does not provide advice in the United States to a mutual fund or business development company.
    • The SEC is directed to provide an exemption for advisers to “private funds” who have assets under management of less than $150 million and provide advice to no other persons.
    • Advisers that provide advice to one or more small business investment companies will be exempt from the registration requirements.

In addition, the Act provides that an investment adviser to a private fund may not rely on the intrastate exemption from registration.

The Act also increases the number of investment advisers that will come under the state registration requirements versus the federal registration requirement under the Advisers Act. Advisers with less than $100 million of assets under management will no longer be permitted to register under the Advisers Act. Exceptions to the $100 million assets under management requirement are allowed for investment advisers that would be required to register in 15 or more states, manage mutual funds or business development companies, or are not required to be registered and subject to examination in their home states.

For registered investment advisers that manage private funds, the SEC has been granted additional authority to require enhanced recordkeeping, reporting, and inspection of such funds. The SEC is expected to elaborate on such requirements by rule but at the very least, the private fund advisers will be required to maintain records and provide reports to the SEC that include (i) the amount of assets under management and use of leverage (including off-balance-sheet leverage); (ii) counterparty credit risk exposure; (iii) trading and investment positions; (iv) valuation policies and practices of the private fund; (v) types of assets held; (vi) side arrangement or side letters with investors; and (vii) trading practices.

The Act requires the SEC to make available to the Financial Stability Oversight Council (Council) copies of information provided by investment advisers to the SEC. It also empowers the SEC to require any adviser to disclose the identity of investments or affairs of any client to the SEC for determination of systemic risk. Such information is required to be maintained on a confidential basis by both the SEC and the Council.

For purposes of charging a client an “incentive” fee, the SEC is authorized under Rule 205-3 under the Advisers Act by not later than one year from the date of the Act, and every five years thereafter, to adjust the thresholds for qualification as a “qualified client” under the Rule. Under current law, a qualified client is a person who has a net worth in excess of $1.5 million or has at least $750,000 of assets under management with the adviser.


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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