A Compilation of Enforcement and Non-Enforcement Actions

28 December 2010 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non Enforcement Matters

Is an SRO in the Cards for Investment Advisers?

Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act directs the SEC to review whether Congress should create a self-regulatory organization (SRO) to regulate investment advisers. Dodd-Frank also requires those SEC investment advisers with less than $100 million of assets under management to deregister with the SEC and register at the state level while the SEC will continue to register those investment advisers with at least $100 million of assets under management.

The SRO, if approved by Congress, would be created under the authority of the SEC to register, examine, and create rules for investment advisers. The Financial Industry Regulatory Authority (FINRA), the primary SRO for registered broker-dealers, has made it known that an SRO should be created for the purpose of regulating investment advisers and that FINRA should be that SRO. However, the North American Securities Administrators Association (NASAA), which represents the securities commissioners of the 50 states, has stated that an SRO is neither necessary nor a good idea as the state securities commissioners and the SEC can collectively regulate the investment adviser industry in a more efficient manner than an SRO.

NASAA, in its opposition to an SRO, argues that an SRO is not an effective regulator because the SRO is accountable to the same members it is required to regulate. What NASAA will not openly acknowledge is that the states are experiencing their own severe fiscal problems and may not be in a position to take on the extra burden of regulating an additional 4,100 investment advisers who will be forced, by next July, to switch from SEC registration to state registration.

In a recent letter to the SEC, the Investment Advisers Association (IAA) again voiced its opposition to creating an SRO for investment advisers (the IAA sent a letter to the SEC in October stating the same objection). The IAA recognizes that the SEC currently does not examine registered investment advisers on a frequent enough basis; therefore, it supports an increase in congressional funding so that the SEC can employ a sufficient number of examiners to generate an effective examination program. The IAA argues that an SRO would be a heavy, unnecessary burden for the investment advisory industry.

The best guess at this point is that the July 2011 deadline will come and go without the SEC making a recommendation to Congress to create an SRO until there is some experience with the full effect of the Dodd-Frank legislation. Currently, the SEC has approximately 450 examiners to examine approximately 12,000 registered investment advisers. It might come down to Congress’ realization that due to federal budget constraints, an SRO would be more cost effective because the industry would, through membership fees, fund the operations of the SRO versus Congress providing additional funding to the SEC to hire more examiners.

Get Ready for New SEC Pay-to-Play Regulation

The compliance date for the new SEC pay-to-play rule (Rule 2.06(4)-5) under the Investment Advisers Act of 1940 is March 14, 2011. The rule regulates certain pay-to-play practices by advisers who provide investment advisory services to governmental entities. The rule became effective on September 13, 2010.

As of March 14, 2011, investment advisers will be prohibited from providing investment advisory services to a governmental entity for compensation for two years after there has been a contribution by the adviser or by one of its “covered” associates to an official of the governmental entity who is in a position to influence the selection of the adviser. Such contributions made prior to the rule effective date are not subject to the rule. A “covered associate” is: (i) a general partner, managing member, or executive officer or other individual with a similar status or function with the adviser; (ii) any employee who solicits a governmental entity for the adviser and any person who supervises such employee; or (iii) any political action committee (PAC) controlled by the adviser or by one of its covered associates. “Government entity” means all state and local governments, their agencies, instrumentalities, and all pension funds, including participant-directed plans.

The rule applies to both registered advisers and those advisers who rely on an exemption from registration. Accordingly, this rule will apply to general partners of private funds who have government pension plans as investors.

The rule does not preempt state or local regulations pertaining to pay-to-play activities and such state or local regulations may be materially different or applied inconsistently with the SEC’s pay-to-play rule.

The rule provides a de minimus exemption for individuals to contribute no more than $350 per election to an official or candidate for whom the individual is entitled to vote and no more than $150 per election to an official or candidate for whom the individual is not entitled to vote.

It will be important for investment advisers to screen new hires to determine if they have made payments to any governmental entity. The rule does not prohibit the adviser from providing advice to the governmental entity if a payment was made any time during the two-year look back period, but the adviser would not be able to collect compensation for providing the investment advice during the two-year period.

The rule also prohibits the adviser from compensating a solicitor to solicit government entities for investment unless the solicitor is (i) an executive officer, general partner, managing member (or person with similar function), or employee of the adviser or (ii) a registered investment adviser or broker-dealer. This particular provision of the rule does not take effect until September 13, 2011.

The SEC, in conjunction with the new pay-to-play rule, amended its recordkeeping requirements (under Rule 204-2) to require certain records of contributions made either by the adviser or one of its covered associates to governmental entities.

All investment advisers, whether registered or exempt from registration, should act now to ensure compliance with the rule by the effective date through the preparation and dissemination of written policies and procedures designed to prevent and detect violations of the rule.

SEC Continues to Focus on the Use of Derivatives by Mutual Funds, Requiring Careful Attention by Directors

SEC comments from recent reviews of mutual fund prospectuses reflect the SEC’s continued focus on the use of derivatives by funds. These comments make it clear that the SEC wants funds to focus on their actual use of derivatives and the related risks of those derivatives. Specifically, a fund should identify in its prospectus any derivatives that the fund uses to a significant extent, and describe the purpose that those derivatives are intended to serve in its portfolio. Inclusion of this disclosure in the prospectus, in the view of the SEC, is necessary to ensure that a fund is not offering its securities by means of a false, misleading, or deceptive statement of a material fact in the fund’s prospectus.

Recent SEC comments also reveal that the SEC staff is concerned with whether certain derivatives are appropriate for mutual funds. These comments request supplemental information and analysis about certain types of derivatives in which a fund invests. Presumably, the comments stem from the current regulatory focus on the risks of derivatives, and the fact that, over time, funds have significantly increased their use of derivatives both for risk management purposes and as a substitute for direct investment when the desired direct investment is less liquid or is restricted.

While it is unclear what final actions the SEC might take regarding the use of derivatives by mutual funds, it remains clear that fund directors have oversight responsibilities for their fund’s derivative trading practices. Key to their oversight role is an understanding of the risks related to the fund’s derivative trading practices and the fund’s disclosure of these risks and derivative trading practices in its prospectus and statement of additional information. Indeed, a director’s general fiduciary duties include an obligation to review the derivatives trading practices of his or her fund to determine whether any of the derivative strategies pose potential risks to the fund’s shareholders.

Directors should focus closely on the use of derivatives and their impact on mutual fund performance. For example, certain derivative products once thought to be relatively safe are now posing unexpected risks. In addition, particular care must be taken if derivates are used by portfolio managers to enhance performance. To help fulfill the directors’ oversight responsibilities, the directors need to ensure that they understand the investment manager’s expertise in analyzing and investing in the derivatives used by the fund; the investment manager’s ability to account for and settle derivatives; the investment manager’s policies and procedures for monitoring and mitigating the risks related to the derivatives; and the disclosure related to derivatives in the fund’s prospectus.

Directors should not assume that portfolio managers fully understand the risks of the derivatives the fund uses and should expect that portfolio managers be able to explain in plain terms the uses and risks of any derivates in which the fund is investing. They should also seek to understand the types of derivatives in which a fund may invest, how they work, and the fund’s exposure. If directors do not understand the fund’s derivatives trading practices and the related risks, they should ask questions until they understand, at a minimum, how the fund uses various derivatives (and the related risks), the investment rationale for the derivatives, and the investment manager’s expertise and experience with such derivatives.

Lastly, directors should ensure that a mutual fund’s prospectus contains complete disclosure of all pertinent information regarding the nature and consequences of a fund’s participation in derivative trading practices. Specifically, the SEC has indicated that disclosure material should focus on the potential risk of loss presented to a fund and its investors by those practices; the identification of the derivative trading practices as separate and distinct from the underlying securities; the differing investment goals inherent in participating in the derivatives trading practices as compared to those of investing in the underlying securities; and any other material information relating to such strategies and the fund’s participation in such strategies.

Whether a mutual fund needs to include disclosure in its prospectus about derivatives trading practices will depend on the extent to which these strategies have a significant role in achieving a fund’s investment objectives. In large part, the answer depends on whether the derivatives trading practices pose the risk of substantial gains or losses for the fund.

SEC No-Action Letter Position Removes Important Anti-Takeover Device for Closed-End Mutual Funds

SEC staff has determined that a closed-end fund that opts into the provisions of the Maryland Control Share Acquisition Act (MCSAA) acts in a manner inconsistent with the Investment Company Act. This position effectively removes an important anti-takeover device for closed-end funds.

Section 3-702(a)(1) of the MCSAA provides that holders of control shares acquired in a control share acquisition have no voting rights with respect to such control shares except to the extent approved by the stockholders at a meeting by the affirmative vote of two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.

The provisions of the MCSAA seek to compel prospective acquirers to deal directly with a corporation’s management, rather than obtaining significant voting power through market purchases of such corporation’s shares. Once holders of control shares lose their voting rights with respect to such control shares, such holders may not vote their control shares unless and until the corporation’s stockholders vote to approve the restoration of the voting rights associated with the shares by an affirmative vote of two-thirds of the votes entitled to be cast at a special meeting called for such purpose, excluding all interested shares. The MCSAA applies only to certain Maryland corporations, and is not applicable to registered open-end management investment companies. However, closed-end funds may elect to opt into such provisions.

Closed-end funds considering opting into the MCSAA have wondered whether such election would violate Section 18(i) of the Investment Company Act. Section 18(i) of the Investment Company Act provides, in pertinent part, that except as otherwise required by law, “every share of stock hereafter issued by a registered management company … shall be a voting stock and have equal voting rights with every other outstanding voting stock …” In arguing that closed-end funds should be permitted to opt into the MCSSA, various positions have been advanced, which were rejected by the SEC.

The SEC stressed in its response that Congress adopted Section 18(i) to address the use of “various devices of control” by investment company insiders that were intended to effectively deny public shareholders “any real participation in the management of their companies,” with Section 18(i) being structured to address this concern by ensuring that each investment company shareholder has a vote proportionate to his or her stock holdings.

In the SEC’s view, the Investment Company Act imposes on investment companies a unique governance system that seeks to reduce the conflicts of interest that are inherent in the investment company form. This system is dependent on shareholders’ ability to exercise voting rights that serve as a check on investment company insiders. Further, in the SEC’s view, shareholders’ voting rights are fundamental to the equitable operation of investment companies, and exist in addition to voting rights that are provided under applicable state law.

The arguments that the SEC rejected in reaching its position include the following:

  • The argument that the acquisition of control shares by an acquiring person is a voluntary action that should be treated similarly to other voluntary shareholder actions that restrict the voting of shares, such as the granting of proxies, but do not violate the voting stock requirement of Section 18(i). In the SEC’s opinion, “this view ignores the fact that the Investment Company Act proscribes actions by investment companies — not shareholders — and underestimates the profound difference between surrendering voting rights freely and without coercion, on the one hand, and losing them by virtue of fund provisions or actions, on the other.”
  • The argument that the equal voting rights requirement of Section 18(i) is not violated by control shares because the characteristics of the security — including any contingent disenfranchisements — are identical when issued. In the SEC’s view, this position ignores the plain meaning of the words “equal voting rights” and the intent of Section 18(i), as meaningful protection can only be provided if the right to equal voting rights continues past the point of issuance.
  • The argument that the disability triggered by a control share acquisition under the MCSAA is intended to attach personally to the holder of the control shares and not to the shares themselves. In the SEC’s view, this argument is without merit as “any interpretation of Section 18(i) that envisages personal discrimination against an investment company shareholder would be flatly inconsistent” with the special protection that Congress mandated for investment company shareholders.

Enforcement Matters

Investment Adviser Registration Revoked for Making False Filings

In a recent action, the SEC revoked the registration of Thrasher Capital Management, LLC, an investment adviser for, among other things, making false filings with the SEC (Investment Advisers Release No. 3108, November 16, 2010). According to the SEC’s complaint, the investment adviser failed to provide books and records as requested by the SEC. In addition, the investment adviser made false representations in its Form ADV relating to its ownership structure and services to high-net-worth individuals. The false ownership representation was the result of the adviser’s omission of the name of the persons who had a significant ownership stake in the firm within its Form ADV. Such conduct, according to the SEC, constituted violations by the adviser of Section 204 and Section 207 of the Investment Advisers Act. In addition to the revocation of the adviser’s SEC registration, its CEO was suspended from association with any investment adviser for nine months.

The lessons to be learned from this enforcement action are to: (i) provide the books and records requested by the SEC (as long as the books and records requested are required to be maintained by the investment adviser under the Investment Advisers Act); and (ii) review the Form ADV periodically (at least annually) to ensure that the information contained in the form is accurate and complete.


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