United States: Investment Management Legal And Regulatory Update - April 2012

SEC Considering Money Market Fund Reforms

The SEC is considering a controversial new plan to stabilize money market funds. One proposal would adopt a floating net asset value for money market funds. Another proposal would include a capital buffer or a holdback provision requiring money market funds to hold back 3 to 5 percent of shareholder redemption proceeds temporarily when they attempt to liquidate their holdings.

Money market fund managers strongly oppose the reforms, with some even threatening legal action against the SEC if the new regulations are passed. Critics maintain that the changes would raise costs, limit liquidity, lower yields and result in significant tax, operational and accounting consequences that will make money market funds more difficult to work with and drive out investors. Fidelity and Federated Investors have preemptively filed letters with the SEC to express concern over the proposals being considered.

Corporate investors, which represent a significant percentage of money market fund assets, have also reacted negatively to the proposals, leading to concern that cash currently invested in money market funds could be moved to banks, Treasury bills or overseas investments. Commentators note that the simplicity, stability and liquidity of money market funds -- the features that make them particularly attractive to companies -- would be negatively impacted by the floating net asset value and holdback provisions.

The SEC is expected to propose a rule in the coming weeks. At an industry conference in late March, however, SEC Commissioner Elisse Walter asked industry participants to provide additional input, which suggests that a proposal may not be immediately forthcoming. Moreover, at least three of the five SEC commissioners must vote to approve any proposal and it is unclear whether Chairman Schapiro has enough support to issue the proposed rules.

Sources: Andrew Ackerman and Kirsten Grind, U.S. Sets Money-Market Plan, The Wall Street Journal, February 7, 2012; Joe Morris, SEC Staff Settles on Floating NAV, Buffer, Ignites, February 7, 2012; Beagan Wilcox Vloz, Fidelity, ICI Rally Against Money Fund Reforms, Ignites, February 13, 2012; Peter Ortiz, Federated Escalates Money Fund Fight, Ignites, March 1, 2012; SEC Commissioner Elisse B. Walter, Remarks at the 2012 Mutual Funds and Investment Management Conference, March 19, 2012; Emily Chasan, Paving Over a Parking Spot?, The Wall Street Journal, March 27, 2012.

Eighth Circuit Affirms Lower Court Decision in Excessive Fee Suit

In Gallus, et al. v. Ameriprise Financial, Inc., et al., the Eighth Circuit Court of Appeals reviewed an excessive fee claim for a second time, affirming the district court's grant of summary judgment in favor of the defendants. In an important reaffirmation of Jones v. Harris, the court held that the plaintiffs failed to show that the advisory fees charged by Ameriprise violated any fiduciary duties, even though the board of directors' process in reviewing the fees may have been deficient. In its first ruling, the Court of Appeals had reversed a district court summary judgment ruling in favor of Ameriprise, holding that unscrupulous behavior by the adviser during the negotiation of fees could constitute a breach of fiduciary duty even if the adviser's fees were not excessive. After deciding Jones v. Harris, the Supreme Court vacated that holding and the district court reinstated its summary judgment ruling in favor of Ameriprise because plaintiffs had failed to show the advisory fees were excessive under the Gartenberg standard. The plaintiffs then appealed the district court's holding for a second time.

The Court of Appeals noted that under Jones v. Harris, a court's review of whether an adviser breached its §36(b) fiduciary duties should "sharply focus" on whether the fees were excessive, but it should also evaluate the fee negotiation process, which determines the degree of deference to give to the board of directors' decision to approve the fees. The Court of Appeals noted that while the board's review process was robust, the plaintiffs maintained that it relied too heavily on a comparison between Ameriprise's fees and those charged by other advisers and the board was not apprised of all relevant information regarding the fee discrepancy between Ameriprise's mutual fund and institutional clients. Nonetheless, after Jones, a flawed negotiation process is not by itself sufficient to survive a summary judgment motion. Rather, the plaintiffs failed to show that the fees were outside of the range of what would have been negotiated at arm's length and, therefore, did not meet their evidentiary burden.

Sources: Gallus v. Ameriprise, Eighth Circuit Court of Appeals, Case No. 11-1091, March 30, 2012; Joe Morris, Ameriprise Wins Excessive-Fee Case, Ignites, April 2, 2012.

CFTC Rescinds and Narrows Registration Exemptions for Funds

The Commodity Futures Trading Commission (CFTC) adopted amendments that will require advisers to mutual funds that invest more than a limited amount in commodity interests for other than bona fide hedging purposes to register as commodity pool operators (CPOs). The CFTC also rescinded Rule 4.13(a)(4), which exempted sponsors of private funds offered only to certain highly sophisticated investors. Lastly, to facilitate compliance for investment companies, the CFTC proposed amendments to harmonize CFTC and SEC disclosure, reporting, and recordkeeping requirements.

Amendments to Rule 4.5. Rule 4.5 was amended to remove the blanket exclusion from the definition of CPO for investment companies and to reinstate trading thresholds and marketing restrictions that were in place prior to 2003. If an investment company cannot satisfy the amended rule, its investment adviser will be required to register as a CPO.

• Bona Fide Hedging. Investment companies that use commodity interests solely for bona fide hedging purposes are excluded from the definition of CPO.
• 5 Percent Threshold. An investment company will be exempt if the aggregate initial margin and premiums required to establish positions in commodity futures, commodity options or swaps for speculative trading do not exceed five percent of the liquidation value of its portfolio, taking into account unrealized profits and losses.
• Net Notional Value Test. As an alternative to the five percent threshold, an investment company will be exempt if the net notional value of its speculative commodity interest positions does not exceed 100 percent of the liquidation value of the fund's portfolio, taking into account any unrealized profits or losses. Notional value is defined by asset class.
• Marketing Restrictions. Investment companies relying on Rule 4.5 cannot market themselves as vehicles for trading commodity futures, commodity options or swaps. Factors the CFTC will consider in determining whether an entity is marketed as a vehicle for investing in commodities markets include:
• • the name of the fund;
  • whether the primary investment objective of the fund is tied to a commodity index;
  • whether the fund makes use of a controlled foreign corporation (CFC) for its derivatives trading;
  • whether the fund's marketing materials reference the benefits of derivatives; and
  • whether the fund explicitly offers a managed futures strategy.

Use of CFCs. Investment companies often use CFCs, wholly-owned offshore subsidiaries, to invest in commodity interests. CFCs fall within the statutory definition of a commodity pool and a CFC is not excluded from the definition of a CPO because its parent company (i.e., the mutual fund) is excluded under Rule 4.5. Operators of CFCs have been exempt from registration under Rule 4.13(a)(4) where the sole participant in the CFC is the investment company. With the rescission of the 4.13(a)(4) exemption (discussed below), operators of CFCs will be required to register unless another exemption is available.

Rescission of 4.13(a)(4) Exemption. Rule 4.13(a)(4) provided an exemption for sponsors of commodity pools (including private funds) that were offered only to certain sophisticated investors (with respect to natural person investors, "qualified eligible persons" (QEPs) and with respect to institutions, QEPs or accredited investors). The CFTC rescinded this exemption. However, the CFTC maintained the de minimis exemption under Rule 4.13(a)(3), which is available to private funds that are offered only to accredited investors, knowledgeable employees or QEPs and that are subject to a 5 percent trading threshold or 100 percent notional value test, similar to amended Rule 4.5.

Annual Notice Requirement. Entities relying on Rule 4.5 or Rule 4.13 were required to file a notice at the outset of relying on the exemption. Going forward, they must affirm the original notice on an annual basis through an electronic filing with the National Futures Association within 60 days of calendar year end.

Compliance Dates. The effective date of the rescission of Rule 4.13(a)(4) is April 24, 2012. Compliance with the changes to Rule 4.5 will be required by the later of December 31, 2012 or 60 days after the effective date of the yet-to-be issued CFTC rule defining the term "swap." Entities that have claimed the exemption under 4.13(a)(4) have until December 31, 2012 to comply with the rescission of that exemption.

Proposed 4.5 Harmonizati Amendments. To facilitate compliance for sponsors of investment companies that will be required to register as CPOs due to amendments to Rule 4.5, the CFTC is proposing amendments to certain regulations to avoid duplicative, inconsistent and possibly conflicting disclosure and reporting requirements. The CFTC has proposed:

• Allowing investment companies to satisfy disclosure document delivery and acknowledgment requirements and monthly account statement delivery requirements by making the documents available on their websites.
• Changing CFTC disclosure regulations so that certain required disclosures (e.g., performance of commodity pools, cautionary statements, break-even points, fees and expenses) may be presented in the prospectus or SAI.
• Requiring CPOs and commodity trading advisors to file updates to disclosure documents every 12 months instead of every nine months to create consistency with the SEC's prospectus updating schedule.
• Harmonizing the respective CFTC and SEC periodic and annual report certification language.

Comments on the proposed amendments are due by April 24, 2012. The CFTC is specifically seeking comment on whether there are any additional CFTC regulations that need to be harmonized, and whether a family office exemption from registration as a CPO should be adopted.

Source: Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg. 11252,

February 24, 2012; Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg. 11345, February 24, 2012.

Department of Labor Finalizes Rule on Fee Disclosure

The U.S. Department of Labor (DOL) has finalized its regulation detailing the steps retirement plan fiduciaries and service providers must take to avoid engaging in nonexempt prohibited transactions after June 30, 2012.

Overview. The Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (Code) generally prohibit using plan assets to directly or indirectly pay for services to an employee pension or welfare benefit plan. Section 408(b)(2) of ERISA affords an exemption for any contract or reasonable arrangement for necessary services "if no more than reasonable compensation is paid therefor." The new regulation specifies that a service arrangement between a "covered plan" and a "covered service provider" will not be reasonable and cannot qualify for the statutory exemption unless the new fee disclosure requirements are satisfied.

Covered Plans. The regulation covers most retirement plans that are subject to ERISA, including defined benefit plans as well as defined contribution or individual account plans. The exceptions are 403(b) accounts frozen prior to 2009 and individual retirement accounts, including those funded through simplified employee pension and SIMPLE arrangements.

Covered Service Providers (CSPs). The new disclosure obligations will apply to any service provider that has a contract or arrangement with a covered plan and that reasonably expects that at least $1,000 in direct or indirect compensation will be paid to itself, an affiliate or a subcontractor for services in the following categories:

• Category A. Services as a fiduciary or registered investment adviser, including: services provided to the covered plan as an "ERISA fiduciary" and services provided directly to the covered plan as a registered investment adviser under the Investment Advisers Act of 1940 or state law.
• Category B. Recordkeeping or brokerage services provided to a covered plan that is an "individual account plan" which permits participants to direct the investment of their accounts in one or more "designated investment alternatives" through a platform or similar mechanism (not including a self-directed brokerage account).
• Category C. Any other services for indirect compensation. Indirect compensation is compensation paid to a CSP, affiliate or subcontractor by someone other than a CSP, affiliate, subcontractor, the plan sponsor or the plan, itself. Common examples include the receipt of 12b-1, sub-transfer agent and recordkeeping fees paid by mutual funds.

Required Disclosures. A CSP must provide a responsible plan fiduciary with the following information:

• If the CSP will provide services as an ERISA fiduciary or as an investment adviser, a clear statement to that effect.
• A description of all services to be provided to the covered plan under the contract or arrangement.
• A description, in the aggregate or by service, of all direct compensation the CSP, an affiliate or a subcontractor reasonably expects to receive in connection with the services provided to the covered plan under the contract or arrangement.
• A description of all indirect compensation the CSP, an affiliate or a subcontractor reasonably expects to receive for the services provided to the covered plan under the contract or arrangement, including the services to be compensated, the payor and the arrangement with the payor.
• For compensation paid among the CSP, an affiliate or subcontractor, identification of the payer, recipient and services performed if the compensation is (a) determined on a transaction basis (e.g., commissions, soft dollars, finder's fees or similar incentive compensation based on business placed or retained), or (b) charged directly against the covered plan's investment and reflected in its net value (e.g., 12b-1 fees).
• A description of any compensation the CSP, affiliate or subcontractor reasonably expects to receive when the contractor arrangement terminates. If any fees are prepaid, there must also be a description of how such amounts will be calculated and refunded upon termination.
• An indication whether each category of compensation will be billed to the covered plan or deducted directly from plan accounts or investments.

Delivery. The regulations generally require that all disclosures be provided in writing, but that does not preclude the use of electronic media. For example, information can be posted on a website if it is readily accessible to plan fiduciaries who have received clear access instructions. Required disclosures can be provided from multiple sources. The regulation also allows a description or estimate of compensation to be expressed as a monetary amount, formula, percentage of the covered plan's assets or a per capita charge for each participant or beneficiary.

Deadlines. July 1, 2012 is the deadline for required disclosures regarding contracts or arrangements in existence on that date. Thereafter, so-called "initial disclosures" are due a reasonable period of time before a contract is entered into, extended or renewed. If a CSP learns of a change in information previously disclosed, it must report the change as soon as practicable, generally within 60 days. However, there is an exception allowing changes in certain investment information to be disclosed annually.

Source: DOL Final Rule, Reasonable Contract or Arrangement Under Section 408(b)(2) - Fee Disclosure, 77 Fed. Reg. 5632, February 3, 2012.

SEC Changes Qualified Client Threshold for Performance Based Compensation

The SEC amended Rule 205-3 under the Advisers Act, which permits an investment adviser to charge performance-based compensation to "qualified clients." The amendments:

• codify increases to the qualified client threshold that became effective by order in July 2011 in accordance with the Dodd-Frank Act;
• exclude the value of the primary residence when calculating the net worth of the investor;
• detail how the SEC will adjust the dollar thresholds for inflation every five years; and
• clarify that the prohibition on performance-based compensation does not apply to advisory contracts entered into when an adviser was not required to register with the SEC.

Qualified Clients. Qualified clients are natural persons or companies that at the time of contracting with the adviser satisfy either the assets under management test or the net worth test. The assets under management test requires the client to have at least $1,000,000 managed by the adviser. The prior threshold was $750,000. The calculation of assets under management can include assets the client is contractually obligated to invest in private funds managed by the adviser. The net worth test requires that the client has a net worth of at least $2 million. The prior net worth test was $1.5 million. The SEC increased the threshold for both tests by order in July 2011 and is now codifying those changes.

The amended rule will become effective on May 22, 2012. Every five years the SEC will adjust the qualified client thresholds for inflation. The next adjustment will occur on or about May 1, 2016.

The changes to the threshold calculations apply only to new contractual arrangements. They do not apply to new investments made by clients who met the definition of qualified client when they entered into the advisory contract even if they subsequently do not meet the dollar amount thresholds of the rule. However, if additional persons or companies become parties to pre-existing contracts, the conditions of the rule in effect at that time will apply to new parties to the existing contract.

Changes to Net Worth Test. The SEC amended the net worth test to exclude the value of a person's primary residence. The revised test also excludes debt secured by the primary residence, up to the fair market value of the residence. There is an exception for debt secured by the primary residence in the 60 days prior to entering into the investment advisory contract, which must be included in the net worth calculation as a liability.

Sources: SEC Final Rule, Investment Adviser Performance Compensation, Release No. IA-3372, February 15, 2012.

DFI Adopts Registration Exemption for Advisers to Private Funds

The Wisconsin Department of Financial Institutions (DFI) recently issued an order creating a state-level exemption from registration for advisers to private funds. To qualify for the exemption, the adviser must advise only funds that meet the definition of a qualifying private fund in SEC Rule 203(m)-1.

Advisers to qualifying private funds are exempt from registration provided neither the adviser nor its affiliates is subject to disqualification under Rule 262 of Regulation A, commonly known as the "bad boy" provision. Additionally, private fund advisers are required to electronically file with the DFI the reports and amendments that an exempt reporting adviser is required to file with the SEC, including Form ADV and annual updates to Form ADV. The initial filing was due by March 30, 2012.

For advisers that exclusively advise venture capital funds as defined in SEC Rule 203(l)-1, there are no further requirements. Advisers to qualifying private funds that are not venture capital funds must satisfy three additional requirements:

1. the owners of non-venture capital private funds must all be accredited investors (subject to a grandfathering provision);
2. the adviser must disclose all services to be provided to the beneficial owners of the fund, the duties owed by the adviser to the owners, and any other material information affecting the rights of the beneficial owners; and
3. the adviser must annually deliver audited financial statements of the fund to the beneficial owners.

Sources: DFI Final Order Granting Exemption From the Registration Requirements For Investment Advisers to Private Funds and Their Investment Adviser Representatives, File No. 617868-56, February 17, 2012.

JOBS Act Permits Advertising in Rule 506 Offerings

The Jumpstart Our Business Startups Act (JOBS Act), signed into law on April 5, 2012, will eliminate the ban on general solicitation and advertisements for companies engaged in Rule 506 private offerings if all purchasers are accredited investors. The JOBS Act would allow hedge funds, private equity funds and venture capital funds to use advertising to solicit accredited investors.

Rule 502 of Regulation D currently prohibits the use of general solicitation or advertising in connection with the sale of interests in private offerings. The JOBS Act directs the SEC to amend Rule 506 of Regulation D to provide that the prohibition against general solicitation or advertising does not apply to Rule 506 private offerings if all sales are made only to accredited investors. This means that it will likely be possible for hedge funds and other private companies that raise capital to engage in traditional marketing activities, like sponsorships and newspaper, radio and television advertising.

The SEC is required to act within 90 days of the President's approval of the bill (i.e., by July 4, 2012). Until the SEC issues final regulations, the scope of permitted advertising will not be certain.

The JOBS Act also contains two new exemptions from broker-dealer registration, for certain intermediaries in Rule 506 private placements and for crowdfunding portals.

Sources: Jumpstart Our Business Startups Act, H.R. 3606; Beagan Wilcox Volz, What Does Hedge Fund Advertising Mean for Mutual Funds, Ignites, March 30, 2012.

SEC Enforcement Update

The SEC's Office of Compliance Inspections and Examinations (OCIE) is moving away from cyclical exams and towards a more risk-based examination policy of investment companies and advisers. Factors OCIE has indicated will be relevant in calculating risk are whether the firm has been the subject of a tip, complaint or referral (TCR); whether the firm has entered a new business area or significantly changed personnel; and whether the firm has demonstrated aberrational performance or has a history of compliance problems. The OCIE's risk-based approach will focus on promoting compliance, finding fraud, monitoring market risk and assisting in the formulation and revision of SEC policy. Mutual fund firms' control environment, asset valuation, conflicts of interest and asset verification are expected to be areas of focus for OCIE in 2012.

Enforcement Actions. Two recent enforcement actions against advisers involved mutual fund valuation.

Sources: Mark Schoeff Jr., SEC Critics See Exam Process as Opaque, Investment News, March 18, 2012; Dan Butcher, Archive: The SEC's Enforcement Priorities for 2012, Ignites, February 1, 2012; In the Matter of UBS Global Asset Management, SEC Administrative Proceeding File No. 3-14699, January 17, 2012; In the Matter of Lisa B. Premo, SEC Administrative Proceeding File No. 3-14697, January 17, 2012.

SEC Releases Alert on Investment Adviser Use of Social Media

Advisers that use social media, such as blogs and social networking sites, are required to adopt, and periodically review the effectiveness of, policies and procedures regarding social media. Among other compliance challenges, advisers' use of social media must comply with the antifraud provisions of the federal securities laws and the compliance and recordkeeping provisions of the Advisers Act. OCIE recently reviewed the use of social media by advisers and issued a risk alert to highlight its observations.

Guidelines. The risk alert identifies a series of factors the SEC believes are relevant to complying with regulatory obligations. Advisers should consider:

• adopting usage guidelines that specify appropriate use of social media;
• monitoring content to identify communications that would implicate the fiduciary duties or other regulatory issues;
• adopting specific content restrictions;
• the frequency of monitoring of social media sites;
• pre-approving all content to be posted on a social media site;
• allocating additional resources to monitor the activity of firm personnel on social media sites;
• restricting use of certain social media sites based on factors such as the site's privacy policy, control of content and advertising practices;
• training personnel on compliant use of social media;
• requiring personnel to confirm and certify their understanding and compliance with the adviser's social media policy; and
• adopting policies to regulate use of personal and third-party social media sites to conduct business.

Third-Party Content. To avoid violations of an Advisers Act rule that prohibits publishing testimonials about advisers or its representatives, advisers should adopt policies concerning the use of social media that allows for interaction with third-party users. Third party use of a social plug-in such as a "like" button on an adviser's profile on a social media site could be deemed a testimonial if it is a statement of a client's experience with the adviser.

Recordkeeping. Recordkeeping requirements for advisers do not distinguish between various media of communication, including paper and electronic communications. The SEC views the content of the communication as determinative of whether it is subject to recordkeeping requirements. Advisers should consider their policies for retaining communications made via email, discussion board, text, direct messaging and chat rooms to ensure they comply with the Advisers Act. Furthermore, advisers should consider adopting policies to determine when social media needs to be retained, the format for retention, and the retention period.

Source: Investment Adviser Use of Social Media, National Examination Risk Alert, January 4, 2012.

SEC and CFTC Propose Joint Rules on Identity Theft

The SEC and CFTC have proposed joint rules that would require covered financial institutions under their jurisdiction to develop and implement written identity theft prevention programs (also known as "red flags" programs). The proposed rules were required by the Dodd-Frank Act, which added the SEC and CFTC to the list of federal agencies that were required to issue rules to prevent identity theft. The proposed rules are substantially similar to the rules previously adopted by the federal banking regulators and the Federal Trade Commission in 2007. The proposing release noted that it is likely that most of the entities covered by the proposal (including mutual funds, investment advisers and broker-dealers) already comply with existing rules to prevent identity theft, and therefore may only be required to supplement programs already in place.

Covered Entities. The SEC's rules would apply to broker-dealers that offer custodial accounts and margin accounts and investment companies that permit investors to make wire transfers to other parties or that offer check-writing privileges. The SEC has asked for comment (due May 7, 2012) on whether they should omit investment advisers from the list of entities covered by the proposed rule. The CFTC's rules would apply to commodity trading advisors, CPOs and others that hold a transaction account belonging to a customer.

Covered Account. Red flags programs should focus on "covered accounts" for indicia of possible identify theft. A covered account would be:

• any account the entity offers or maintains primarily for personal, family or household purposes that is designed to permit multiple payments or transactions, including brokerage accounts and mutual fund accounts; or
• any other account for which there is a reasonably foreseeable risk to customers.

Establishment of Identity Theft Prevention Program. Covered entities are required to develop programs that include reasonable policies to identify relevant red flags for covered accounts. While the rule allows for covered entities to determine which red flags are relevant for their business, the proposed guidelines provide the following examples:

• alerts or warnings from consumer reporting agencies;
• presentation of suspicious documents;
• presentation of suspicious personal identifying information;
• unusual use of, or other suspicious activity related to, a covered account; and
• notice from customers, victims of identity theft, law enforcement authorities or other persons regarding possible identity theft.

Detect Red Flags. The proposed rule requires entities to have policies in place to detect red flags. For new accounts, the proposed rule would require that covered entities obtain and verify identifying information about persons opening a covered account. For existing accounts, entities must authenticate customer identities, monitor transactions and verify the validity of customer address changes.

Respond to Red Flags. The identity theft program should incorporate reasonable policies to respond appropriately to red flags that are detected. An appropriate response is determined by the degree of risk posed by the red flag.

Periodic Updates and Administration. Covered entities are required to update the program to reflect changes in risks to customers or to the safety and soundness of the financial institution. The rule would require approval of the program by either the board of directors or an appropriate committee of the board of directors. The rule would also require subsequent oversight of the identity theft program by the board of directors, or a designated senior management employee. Staff responsible for development, implementation and administration of the program must submit a report on compliance to the board or a designated senior management employee at least annually. Additionally, covered entities would be required to train staff and oversee service provider agreements.

Source: Identity Theft Red Flags Rules, Joint Proposed Rules and Guidelines, SEC Release No. IC-29969, February 28, 2012.

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