A Compilation of Non-Enforcement Actions

28 February 2014 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

  • SEC Grants No-Action to Registered Fund for Utilizing Non-Bank to Custody Certain Assets
  • SEC Announces Intention to Examine Advisers Never Before Examined
  • New Front for Activists to Challenge Boards of Closed-End Funds
  • SEC Reminds Funds That Shareholders Should Be Allowed to Vote on Each Material Amendment to Charter Documents

SEC Grants No-Action to Registered Fund for Utilizing Non-Bank to Custody Certain Assets

In a recent no-action request filed with the SEC, a fund registered under the Investment Company Act of 1940 asked if the SEC would take a nonenforcement action if the fund engaged an entity (the Brinks Company or its subsidiaries in the U.S. or in the UK) to maintain custody of the fund’s gold bullion and other precious metals in a vault or other secured custody facility although Section 17(f)(1) under the Investment Company Act requires that a registered fund maintain custody of its assets with a bank or other qualified custodian. Brinks is neither a bank nor a qualified custodian as required under Section 17(f) of the Investment Company Act.

In spite of Brinks not being either a bank or qualified custodian, the SEC stated in its letter to the fund dated February 11, 2014 that it would take a non-enforcement or no-action position if the fund engaged Brinks to act as custodian of the fund’s gold bullion and other precious metals based on certain assurances provided by the fund as to the appropriateness for Brinks to serve as custodian under the circumstances.

In order to convince the SEC to take the no-action position, the fund pointed to the fact that each Brinks’ facility which would maintain custody of such assets is subject to registration under the rules of the NYMEX/COMEX as a licensed depository. In addition, Brinks is a member of the London Bullion Market Association which imposes on its members various requirements for maintaining custody of such assets.

The fund also supported its request by citing that Brinks is a reporting company under the Securities and Exchange Act of 1934 which requires financial and other public disclosures in the U.S. In addition, the fund pointed to the fact that Brinks maintains over $1 billion of insurance coverage, which is available to cover any losses of assets it maintains on behalf of its customers.

The SEC apparently determined it appropriate to grant the no-action request based on: the amount and degree of regulation imposed upon Brinks; the fact that it is a reporting company under the Exchange Act; the amount of insurance coverage it maintains (at least $1 billion); and provided, a majority of the funds’ board members, who are not “interested persons” under Section 2(a)(9) of the Investment Company Act, determine that Brinks’ custody services are in the best interests of the fund and its shareholders. In making this determination, the SEC stated that the board or its delegate should also consider whether the fund’s assets would be subject to reasonable care and if Brinks could provide custodial services at least equal in nature and quality to the services that could be provided by a bank or qualified custodian serving the same market(s).

SEC Announces Intention to Examine Advisers Never Before Examined

On February 20, 2014, the SEC announced that the Office of Compliance Inspections and Examinations (OCIE) would launch an examination initiative zeroing in on investment advisers that have never been the subject of an OCIE examination and have been registered with the SEC for at least three years.

Letters were sent on February 20, 2014 to those advisers who will be the focus of the examination initiative explaining that the adviser may be examined and highlighting the subject areas that will be examined.

The initiative to examine the never before examined registrants, according to the SEC, includes two distinct examination approaches, risk-assessment and focused reviews. The risk assessment approach would include a high-level review of the adviser’s business activities, and more specific focus on the adviser’s compliance program and other records necessary to support the statements made in the adviser’s disclosure documents. The focused review approach will include a comprehensive examination of various high-risk areas of the business and operations of the adviser who is selected for this type of review.

The high-risk areas which may be the primary focus of the focused review examination include: (i) the adviser’s compliance program and whether it is adequate to cover all of the material advisory services of the adviser; (ii) filings and disclosures made by the adviser with the SEC and to clients; (iii) marketing materials utilized by the adviser; (iv) portfolio management practices; and (v) safety of client assets.

The SEC’s recent letter to the targeted advisers describes the examination process and various resources it provides in order to assist registered advisers to prepare for an examination and otherwise to be in compliance with the requirements under the Advisers Act.

New Front for Activists to Challenge Boards of Closed-End Funds

The SEC recently allowed an activist shareholder to include a shareholder proposal in the proxy statement of a closed-end fund that called for the fund’s investment management agreement to be terminated.

Specifically, in a letter dated December 20, 2013, the fund requested confirmation from the Staff of the Division of Investment Management that it would not recommend an enforcement action to the SEC if a shareholder proposal resolving that the fund’s investment management agreement be terminated was omitted from the proxy statement and form of proxy for the fund’s next scheduled shareholder meeting. The fund sought to exclude the shareholder proposal pursuant to Rule 14a-8(i)(2) under the Securities Exchange Act of 1934, which permits a company to exclude a shareholder proposal if such proposal would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject. The fund also argued that it could exclude the shareholder proposal pursuant to Rule 14a-8(i)(4) under the Securities Exchange Act of 1934, which permits a company to exclude any proposal that relates to the redress of a personal claim or grievance against the company or any other person, or if it is designed to result in a benefit to the shareholder making such proposal, or to further a personal interest, which is not shared by the other shareholders at large.

In support of the fund’s grounds for excluding the proposal under Rule 14a-8(i)(2), the fund stated that it believed that the shareholder proposal, if implemented, would cause it to violate the requirements of Section 15(a)(3) of the Investment Company Act. This section provides that an investment advisory agreement with a registered investment company must include a provision that it may be terminated at any time without penalty by the board of directors of the company or by majority vote of the company's outstanding voting securities on not more than 60 days' notice. The fund argued that if the shareholders were to approve the shareholder proposal, the fund would be required to terminate the investment management agreement knowing that the majority vote of shareholders required to effectuate the shareholder proposal was cast in violation of Section 12(d)(1)(F) and Section 17(d) of the Investment Company Act and Rule 17d-1 thereunder because:

  • The majority vote would include the vote of the activist shareholder and its affiliates, which the fund argued were holding fund shares in violation of Section 12(d)(1)(F)(i) of the Investment Company Act;
  • The majority vote would include a vote by an affiliated fund of the activist shareholder that would not involve a pass through vote, which the fund argued was required under Section 12(d)(1)(F);
  • The majority vote would include the vote of the shareholder activist and its affiliates, which the fund argued were holding shares of the fund in violation of Section 17(d) and Rule 17d-1.

In support of the fund’s grounds for excluding the proposal under Rule 14a-8(i)(4), the fund argued that the history and operations of the activist shareholder and its affiliates demonstrated that the shareholder proposal to terminate the advisory agreement was designed to result in a benefit to the activist shareholder, and that other shareholders would not be provided similar benefits.

Despite the fund’s lengthy and cogent arguments, the Staff decided that it was unable to concur with the view that the fund could exclude the shareholder proposal under Rule 14a-8(i)(2) or Rule 14a-8(i)(4). So, the fund was required to include the shareholder proposal in the proxy statement.

SEC Reminds Funds That Shareholders Should Be Allowed to Vote on Each Material Amendment to Charter Documents

The Staff of the Division of Investment Management has issued guidance to funds reminding them that when shareholders are voting on amendments to the charters of investment companies, shareholders should be provided a separate vote on each material amendment to the charters.

Rule 14a-4(a)(3) under the Securities Exchange Act requires that the form of proxy “identify clearly and impartially each separate matter to be acted upon, whether or not related to or conditioned on the approval of other matters ....” Further, Rule 14a-4(b)(1) requires that the form of proxy provide separate boxes for shareholders to choose between approval, disapproval or abstention “with respect to each separate matter referred to therein as intended to be acted upon ....” These rules are commonly referred to as the SEC’s “unbundling” rule, and they are intended to provide a means for shareholders to communicate their views to the board of directors on each matter to be acted upon.

The Staff has commented in the past that proposed amendments to the charters of investment companies should be “unbundled,” providing separate votes for each proposed material amendment. While there is no bright-line test for determining materiality in the context of Rule 14a-4(a)(3), the Staff believes that investment companies should consider whether a given matter substantively affects shareholder rights.

Examples of proposed material amendments to the charters of investment companies that the staff has commented should be presented separately include, among other things, proposals seeking to:

  • Amend voting rights from one vote per share to one vote per dollar of net asset value;
  • Authorize a fund to involuntarily redeem small account balances;
  • Authorize a fund to invest in other investment companies;
  • Change supermajority voting requirements;
  • Authorize the board to terminate a fund or merge with another fund without a shareholder vote; and
  • Authorize the board to make future amendments to the charter without a shareholder vote.

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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