United States: Investment Management Update: June 2013 - July 2013

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry:

Regulatory Developments Promote Flexibility for ETFs 

SEC Relaxes Disclosure Regime for Self-Indexing ETFs

On July 10, 2013, the SEC issued exemptive orders allowing the applicants to utilize "self-indexing" ETFs without imposing certain requirements that were previously included in orders permitting this type of fund. Self-indexing ETFs seek to replicate the holdings of a proprietary index developed and owned by an affiliate of the ETF, the ETF's investment adviser, or the ETF's distributor. Self-indexing allows the ETF sponsor to avoid the costs typically associated with licensing third-party indexes and may also offer the sponsor more flexibility in designing customized ETF investment strategies. 

Before these recent exemptive orders, the SEC generally required sponsors of self-indexing ETFs to address potential conflicts of interest specifically relating to the use of an index developed by an affiliate by imposing a number of conditions. Among other things, these conditions generally included: (i) requirements to promote transparency of the underlying index methodology; (ii) use of an unaffiliated third party to calculate the index; (iii) creation of certain firewall arrangements to separate the fund's adviser and the index provider; and (iv) the adoption of additional policies and procedures to mitigate potential conflicts of interest specific to self-indexing. 

The new exemptive orders eliminate most of these requirements, and instead rely primarily on daily transparency of the ETF's portfolio holdings to address potential conflicts of interest. The ETFs utilizing self-indexing are required to disclose on the sponsor's website, each day before trading begins on the ETF's primary listing exchange, the identities and quantities of the portfolio securities, assets and other positions held by the fund that will form the basis for the fund's calculation of its NAV at the end of the business day. These requirements are the same as the website disclosure requirements applicable to actively managed ETFs. Note that certain of the requirements previously applicable to self-indexing ETFs may still be required, in part, as a result of listing rules imposed by the exchange on which such self-indexing ETFs intend to be listed.

NYSE Euronext Has ETF Plan Approved

The SEC approved a proposed rule change of the NYSE Arca, Inc. exchange to facilitate a plan to increase liquidity for the ETF market. The rule change provides a limited exemption from Rule 102 of Regulation M to establish an exchange-traded product ("ETP") Incentive Program ("Incentive Program"), which provides market makers additional incentives to undertake Lead Market Maker assignments in ETPs. Under the Incentive Program, ETP issuers can choose to pay between $10,000 and $40,000 a year per ETP to the exchange. The exchange will then pay the Lead Market Maker if it meets or exceeds its Incentive Program performance standards (relating to the exchange's requirements to post competitive bid and offer prices along with offering trades of sufficient size to meet certain liquidity standards) for the assigned ETP for a particular month. As part of the conditions imposed under the Incentive Program, the issuer of the participating ETP, or sponsor on behalf of the issuer, must provide prompt, prominent and continuous disclosure on its website in the location generally used to communicate information to investors about a particular security participating in the Incentive Program. The Incentive Program will launch in the second half of 2013 and run as a pilot program for 12 months. For a copy of the order granting the rule change click here.

SEC to Consider Proposal to Streamline Issuance of ETF Exemptive Relief 

In remarks made at the Reuters Global Wealth Management Summit on June 6, 2013, SEC Investment Management Division director Norm Champ said that the SEC will consider a proposal this year which would allow staff to establish guidelines for issuing exemptive relief for "plain vanilla" ETFs. According to news reports, Champ declined to discuss details of the proposed guidelines, including what might constitute a "plain-vanilla" ETF, though he would not rule out the possibility that some actively managed ETFs might qualify The SEC currently gives new ETFs exemptive relief on a case-by-case basis. Champ noted that these reviews take up a significant portion of SEC staff time that could be better used on other matters. 

Court of Appeals Rejects Challenge to CFTC Rule 4.5 Amendments

On June 25, 2013, the U.S. Court of Appeals for the District of Columbia Circuit affirmed the decision of the district court which upheld the validity of amendments to Rule 4.5 promulgated by the U.S. Commodity Futures Trading Commission (the "CFTC"). As discussed in previous Ropes & Gray Alerts, the Investment Company Institute and the U.S. Chamber of Commerce instituted a lawsuit seeking to invalidate these amendments, which significantly reduce the scope of the exemption from CFTC registration previously afforded to registered funds. The text of the Court of Appeals' opinion can be found here, and previous Ropes & Gray Alerts summarizing the district court's decision and amended Rule 4.5 can be found here and here

Appeals Court Affirms Dismissal of Leveraged ETF Class Action

On July 22, 2013, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of a class action brought by purchasers of shares in forty-four leveraged ETFs issued by ProShares. The plaintiffs claimed that ProShares had failed to adequately disclose the risk that the ETF shares could lose substantial value when held for longer than one day. The Second Circuit agreed with the district court's September 2012 ruling that the relevant prospectuses for the ETFs adequately warned investors that the investments could be volatile and that the long-term value of an ETF might diverge significantly from the value of its underlying index. The text of the Second Circuit's opinion can be found here. For our discussion of the district court's decision, please see our August-September IM Update here. Ropes & Gray partners Rob Skinner and Doug Hallward-Driemeier represented ProShares in this case. 

Mutual Fund Insider Trading Case Reversed on Appeal 

In its July 22, 2013 opinion in SEC v. Bauer, the U.S. Court of Appeals for the Seventh Circuit reversed the decision of the district court which had granted summary judgment in favor of the SEC in a case involving alleged insider trading by the general counsel and chief compliance officer of Heartland Advisors, Inc., which acted as the principal underwriter and distributor of the shares of funds issued by Heartland Group, Inc., an open-end management investment company. On appeal, the threshold issue in the case was whether and to what extent insider trading theories apply to mutual fund redemptions. The Court of Appeals noted that the case presented novel questions of law because no federal court has opined on this question. In the proceedings before the district court, the SEC had argued that the defendant was a "traditional insider" and invoked the "classical theory" of insider trading. Under the classical theory, insiders of the corporation, such as officers, directors and employees of the issuer can be held liable because they have a fiduciary duty to the issuer and its shareholders. On appeal, the defendant argued that mutual fund redemptions cannot entail the type of deception of the counterparty on which the classical theory is based, because the counterparty to the transaction is the mutual fund issuer itself, which presumably is fully informed and cannot be deceived through non-disclosure. Perhaps due to the difficulties involved with its earlier approach, on appeal the SEC argued the case on the basis of the "misappropriation theory" of insider trading. The misappropriation theory extends the reach of Rule 10b-5 under the Securities Exchange Act of 1934 to outsiders of the corporation on the basis that they are using confidential information in breach of a duty owed to the source of the information. Finding that it would be fundamentally unfair to decide the case on the basis of a theory that was not argued before the district court, and due to existence of various issues of fact, the court remanded the case to the district court for further proceedings consistent with the decision. 

Regulatory Priorities Corner

The following brief updates exemplify trends and areas of current focus of relevant regulatory authorities:

SEC Announces Three Enforcement Initiatives Employing Advanced Technology and Analytical Resources

On July 2, 2013, the SEC announced three new initiatives that will concentrate its most sophisticated technological and analytical resources on high-risk areas of the market. These initiatives are based in the Division of Enforcement and involve the creation of the following: (i) the Financial Reporting and Audit Task Force, which will concentrate on detecting fraudulent or improper financial reporting relating to the preparation of financial statements, issuer reporting and disclosure, and audit failures; (ii) the Microcap Fraud Task Force, which will investigate abusive trading and fraudulent conduct in the microcap company securities area, especially by targeting "gatekeepers," such as attorneys, auditors, broker-dealers, and transfer agents; and (iii) the Center for Risk and Quantitative Analytics, which will serve as both an analytical hub and source of information about characteristics and patterns indicative of possible fraud or other illegal misconduct. The SEC's release can be found here

FINRA Issues Investor Alert Regarding Alternative Mutual Funds

FINRA issued an Investor Alert on June 11, 2013 to inform investors about mutual funds that invest in alternative assets such as such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities ("alternative mutual funds"). The focus of the alert is to inform investors of the ways in which alternative mutual funds differ from those that invest in traditional stocks, bonds and cash. The alert explains that the strategies employed by alternative mutual funds may have additional risks than are present in strategies employed by traditional funds. For example, the alert states that market-neutral funds, which use long and short positions in stocks to generate returns, tend to have significant portfolio turnover risk that can result in higher costs and that distressed debt funds typically have significant credit risk. The alert also indicates that alternative mutual funds may have higher operating expenses relative to traditional funds. It also cautions that because a fair number of alternative mutual funds were launched after 2008 and have limited performance histories, "it is not known how they will perform in a down market." Please click here for the full text of the alert.

SEC to Require Wrongdoing Admissions in Settling Certain Enforcement Actions

SEC chair Mary Jo White announced at the Wall Street Journal CFO Conference on June 18, 2013 that the SEC plans to begin requiring admissions of wrongdoing from defendants in settlements of certain types of enforcement cases. According to published news articles, Ms. White indicated that such admissions provide important public accountability that is worth the risk that more cases will not settle and thus require additional expenditure of SEC resources as a result of having to take such cases to trial. Ms. White said the new policy would apply to cases such as those involving egregious intentional misconduct, obstruction of an SEC investigation, or widespread harm to investors. The SEC's plans come in response to widespread criticism, including by federal judges, of its current policy of entering settlement agreements that allow defendants to "neither admit nor deny" liability for their actions. 

SEC Issues IM Guidance Update Regarding Counterparty Risk Management Practices with Respect to Tri-Party Repurchase Agreements

In new guidance released on July 17, 2013, the SEC encourages money market funds and investment advisers to carefully consider the risks of counterparty default in tri-party repurchase (commonly known as "tri-party repo") transactions. In a repo agreement, a fund can buy a security from a bank, which in turn agrees to repurchase the security after a pre-agreed time frame. The third party in a tri-party repo is the clearing bank. In its guidance, the SEC recommends that funds and advisers take the following advance steps to prepare to handle a tri-party repo default: (i) review the master repurchase agreements and related documentation to consider any specified repo default procedures; (ii) consider the operational aspects of managing a repo default; and (iii) consider whether there are potential legal considerations under the Investment Company Act of 1940 (such as under Rule 2a-7) or otherwise that the fund could analyze in advance or will need to evaluate in the event of a repo default. The SEC notes that the guidance is addressed largely to money market funds because such funds tend to have more significant holdings of tri-party repos than other types of mutual funds.

Other Developments 

Since the last issue of our IM Update we have also published the following separate Client Alerts of interest to the investment management industry:

IRS Postpones Key FATCA Deadline by Six Months; Updated Ropes & Gray FATCA Timeline Attached 

July 18, 2013

On July 12, 2013, the Internal Revenue Service issued Notice 2013-43, postponing a number of deadlines under the Foreign Account Tax Compliance Act ("FATCA").

General Solicitation and Other Changes to Regulation D: The Impact on Private Funds 

July 15, 2013

On July 10, 2013, the SEC adopted an amendment to Rule 506 of Regulation D ("Rule 506") to allow issuers to engage in "general solicitation" and "general advertising" in certain offerings made under Rule 506, promulgated pursuant to the Jumpstart Our Business Startups Act (the "JOBS Act"). Also on July 10, 2013, the SEC adopted amendments to Rule 506 to disqualify issuers and other market participants from relying on Rule 506 if "felons" and other "bad actors" participate in the Rule 506 offering.

CFTC Adopts Final Cross Border Swaps Guidance

July 12, 2013

On July 12, 2013, the CFTC adopted final guidance regarding the cross border application of the new derivatives requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank"), as well as an interim final exemptive order that phases in the relevant requirements.

SEC Settles with Fund Directors for Failure to Satisfy Valuation Responsibilities

July 3, 2013

On June 13, 2013, the SEC filed an order settling administrative proceedings against eight former directors of five Regions Morgan Keegan open- and closed-end funds that had been heavily invested in securities backed by subprime mortgages in the lead-up to the 2008 financial crisis. In the Order, the SEC found that the Directors caused the Funds to violate Rule 38a-1 under the Investment Company Act of 1940, which requires funds to adopt and implement written policies and procedures reasonably designed to prevent violations of the federal securities laws.

Second Circuit Ruling Strictly Enforces Time Limits on Securities Class Action Claims

July 1, 2013

In a case of first impression, the U.S. Court of Appeals for the Second Circuit ruled on June 27, 2013 that litigation time limits known as "statutes of repose" are not "tolled" or extended by the fact that a would-be plaintiff holding an alleged claim is an unnamed class member in a pending securities class action.

SEC's Cross-Border Working Group Continues to Target China-Based Issuers

June 26, 2013

A pair of recent enforcement actions brought by the SEC reflect the agency's continued focus on China-based issuers listed in the U.S. In the most recent case filed against a China-based issuer, the SEC charged China Media Express and its Chairman and CEO on June 20, 2013 with fraudulently misrepresenting its financial condition to investors in SEC filings dating back to November 2009. The China Media action comes on the heels of the SEC's May 15, 2013 filing against RINO International Corporation ("RINO"), a China-based manufacturer and servicer of equipment for the Chinese steel industry, and its Chairman and CEO. Both companies initially listed on U.S. exchanges via reverse takeover transactions.

SEC Proposes Reforms for Money Market Funds

June 14, 2013

On June 5, 2013, the SEC voted unanimously to propose significant new reforms for money market funds primarily in response to the risk of runs on money market funds during times of economic stress.

Online Currency Exchange Alleged to Have Laundered Billions for Criminal Enterprises Around the World

June 5, 2013

In a three-count indictment unsealed on May 28, 2013, the U.S. Attorney's Office for the Southern District of New York alleged that the owners, founders and managers at Liberty Reserve, an online currency exchange, conspired to launder six billion dollars over the last seven years. The indictment followed a coordinated effort by law enforcement agencies in seventeen countries around the world as part of the largest international money laundering prosecution in history.

CFTC Adopts Final Rules Requiring Execution of Swaps on Organized Facilities

June 4, 2013

On May 16, 2013, the CFTC adopted several rules relating to swap execution. These much-anticipated rules make three significant changes to the regulatory framework for derivatives: first, they create a new regulated entity – the registered swap execution facility ("SEF"); second, they detail the minimum trading functionality required of SEFs; and, third, they implement a trade execution requirement that mandates that certain swaps be executed on a SEF or a designated contract market ("DCM"). Collectively, these rules, together with the mandatory clearing requirement for certain derivatives, will transform how swaps and other derivatives are traded. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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