A Compilation of Enforcement and Non-Enforcement Actions

30 September 2013 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • SEC to Monitor Fund Performance Claims 
  • Suit Against Exchange Traded Funds’ Investment Adviser Dismissed 
  • Counterparty Risk Management Practices for Mutual Funds

Enforcement Matters

  • SEC Charges 23 Registrants with Rule 105, Regulation M Violations 
  • Late Trading Violation by Investment Adviser

Non-Enforcement Matters

SEC to Monitor Fund Performance Claims

Now that new Rule 506(c) is effective allowing issuers relying on the securities registration exemption under Rule 506 to conduct general solicitation and advertising provided the issuer’s securities are purchased only by persons that have been verified to be accredited investors, some managers of private funds may take the opportunity to promote their “private” fund offerings to the public. According to Norm Champ, Director of the SEC’s Division of Investment Management, the Division will be closely monitoring private fund performance claims by such issuers.

Any item of public advertising in connection with the offering of securities by a private fund issuer must not violate the “anti-fraud” provisions under the Securities Act of 1933. Such provisions prohibit fraudulent and misleading statements. In addition, the Investment Advisers Act of 1940 prohibits investment advisers while managing a private fund from violating the anti-fraud provisions. According to the Director, the Division of Investment Management has set up a separate group to monitor performance claims by advisers with respect to private funds. In addition, the group will monitor the adequacy of the verification process utilized by the private funds and its sponsors to ensure that each investor is accredited.

The SEC’s proposed amendments to Rule 506(c) include specific requirements for private fund issuers such as the filing with the SEC of general solicitation and advertising materials 15 days prior to use. Issuers and sponsors of private funds should seek the advice of securities counsel prior to utilizing general solicitation or advertising to ensure that: (i) they have adequate procedures in place for verification that each investor is an accredited investor; (ii) general solicitation or advertising materials to be utilized would not violate the anti-fraud provisions; (iii) policies and procedures within the adviser’s written compliance manual are adopted to address Rule 506(c) requirements; and (iv) compliance with all reporting obligations, when the SEC’s proposed rules are adopted regarding such requirements.

Suit Against Exchange Traded Funds’ Investment Adviser Dismissed

As reported previously, shareholders of a family of exchange-traded funds brought suit against the ETFs’ investment adviser and trustees for allegedly excessive compensation paid to a securities lending agent affiliated with the investment adviser. The plaintiffs argued primarily that the fee split between the ETFs and the affiliated securities lending agent harmed shareholders by “siphoning off securities lending profits” for the benefit of the affiliated securities lending agent at the expense of the ETFs. They allege that the ETFs received 60% of securities lending income and the affiliated securities lending agent received the remaining 40%, and that the amount received by the affiliated securities lending agent was disproportionate to the performance of the agent.

The plaintiffs sought relief under Section 36(b) of the Investment Company Act of 1940, which provides a right of action for excessive fund advisory compensation, as well as under Section 47(b), which provides a right of rescission for contracts made in violation of the 1940 Act, and Section 36(a), which authorizes the SEC to bring actions for breach of fiduciary duty.

The court ruled that the Section 36(b) claim was precluded by Section 36(b)(4), which provides that the subsection does not apply to compensation in connection with transactions subject to Section 17 or rules, regulations, or orders thereunder. The ETFs’ investment adviser had an exemptive order from Sections 17(a) and 17(d) for its securities lending agent relationship, and the court ruled that the order removes the transaction at issue from the scope of Section 36(b). The court distinguished a no-action letter on which the plaintiffs relied, Norwest Bank Minnesota (May 25, 1995), because no exemptive order was involved in the Norwest letter. The court also found that no private right of action was available under Sections 47(b) or 36(a), a view consistent with that taken by other courts that have considered those provisions in recent years.

Counterparty Risk Management Practices for Mutual Funds

The SEC’s Division of Investment Management has issued guidance for money market funds on counterparty risk management practices with respect to tri-party repos (IM Guidance Update 2013-03 (July 2013)). While the guidance speaks specifically to money market mutual funds and tri-party repurchase agreements, the guidance is useful to mutual funds in general, as it identifies some best practices in risk management respecting counterparty default.

A repo, or repurchase agreement, is an agreement to purchase securities for cash, combined with an agreement to resell those securities at a specified price and time. In substance, a repo functions as a fully collateralized short-term lending arrangement. A tri-party repo is a repo in which a clearing bank (JPMorgan Chase or Bank of New York Mellon) acts as third-party agent to provide collateral management services and to facilitate the exchange of cash against collateral between the two repo counterparties.

The staff guidance notes with respect to repos (and by analogy, to swaps and other derivatives in which there is counterparty risk) that as a matter of prudent risk management, funds and their investment advisers should consider the legal and operational steps they may need to take if a counterparty fails and the securities default. Among the steps that funds should take are the following:

  • Review the master agreements and related documentation to consider any specified default procedures. If these procedures call for notifications or other documents, a fund may consider having templates prepared in advance. 
  • Consider operational aspects of managing a repo default. A fund should evaluate whether the systems at the fund or its custodian are capable of appropriately holding, valuing, trading and accounting for the collateral underlying such securities. 
  • Consider, to the extent possible, whether there are potential legal considerations under the Investment Company Act of 1940 or otherwise that a fund could consider in advance or will need to evaluate at the time of any default. 
  • Evaluate what notifications and information the investment adviser should provide to a fund’s board of directors regarding the default and what disclosures, if any, the fund should provide to its shareholders.

Enforcement Matters

SEC Charges 23 Registrants with Rule 105, Regulation M Violations

As reported in previous newsletters, the SEC has made it a priority to seek enforcement action against investment advisers, among others, for short selling violations in connection with participations in public stock offerings.

On September 16, 2013, the SEC announced that it had initiated enforcement actions separately against 23 investment advisers for violations of Rule 105 of Regulation M. The Rule prohibits the short sale of an equity security during a restricted period (generally 5 business days before a public offering) and the purchase of the same security through the offering. The Rule, through its trading prohibitions, serves to promote offering prices that are set by natural forces of supply and demand rather than by manipulation. The underlying premise of the Rule is to help prevent short selling that may reduce proceeds received by the issuer in the public offering by artificially depressing the market price just before the issuer prices its public offering.

All but one of the 23 firms charged has settled the matter with the SEC. All of the firms violated Rule 105 of Regulation M by purchasing shares from an underwriter, broker or dealer participating in the public offering just after selling the same security short during the restricted period.

The SEC, at the same time of the announcement of the enforcement actions against the 23 firms, issued a “risk alert” to highlight the risks to investment advisers, broker-dealers and investment companies for not complying with Rule 105 (see http://www.sec.gov/about/offices/ocie/risk-alert-091713-rule105-regm.pdf). Such parties should review the SEC’s alert and determine if it has in place adequate written policies and procedures to prevent such violations.

Each of the firms charged and have agreed to settle with the SEC are subject to a Cease and Desist Order, disgorgement of ill-gotten gains with interest, and a civil penalty.

According to the SEC, since 2010, it has collected disgorgements, penalties and interest in excess of $42 million based on violations of Rule 105 in over 40 actions regarding registrants and/or individuals. The vast majority of these cases (over 75%) include investment advisory firms.

Late Trading Violation by Investment Adviser

A federal appeals court panel generally upheld an SEC enforcement action against investment advisers that engaged in fraudulent late trading of mutual fund shares. The panel was reviewing a district court finding that held the advisers liable for fraud.

The basis for the district court’s imposition of fraud liability on the investment advisers was the practice of late trading in the mutual fund market. The court found that the advisers engaged in deceitful behavior because they sought out brokers who would engage in late trading and knew that the trade sheets were time-stamped before 4 p.m., even though they had no intention of trading before that time. The advisers also issued a false and deceitful letter of assurance that they were not engaging in late trading.

The federal appeals court panel reviewed the district court’s findings, and rejected the argument that the investment advisers may not be held liable because they did not communicate directly with the mutual funds. The investment advisers had argued that, because they never communicated directly with the mutual funds, they could not be held liable as “makers” of any false statements under Janus Capital Group, Inc. v. First Derivative Traders, where the Supreme Court held that a mutual fund investment adviser could not be held liable in a private action under Rule 10b-5 for making false statements in mutual fund prospectuses filed by the fund because the fund retained ultimate control over the content of the prospectuses. The panel rejected this argument in the late trading context and concluded the advisers were “makers” of the false statements.

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

Michael G. Dana
Miami, Florida