United States: Investment Management Legal + Regulatory Update – September 2014


Long-Awaited Money Market Fund Rules Adopted

On July 28, 2014, a divided SEC adopted rules that will require floating net asset values (NAVs) for institutional money market funds and give most money market funds the discretion to impose liquidity fees and gates. The 3-2 vote, which closes the latest tumultuous chapter of money market fund regulatory reform, will fundamentally change the way that most money market funds operate.

Importantly, the floating NAV requirement will not apply to retail money market funds (i.e., those sold only to investors who are natural persons) or to any government money market funds (whether or not they are institutional funds).

The new rules will increase the responsibility of money market fund boards. Fund boards will be authorized to temporarily "gate" redemptions and impose redemption fees of up to two percent when a fund's weekly liquidity falls below 30 percent of its total assets. If a fund's weekly liquidity drops to 10 percent, the fund will be required to impose a one percent redemption fee, unless the fund's board determines otherwise. In that case, the board can also impose a redemption fee of up to two percent.

The rules will also impose additional disclosure, reporting, and stress-testing requirements.

According to Chairman Mary Jo White, the new rules strike a balance to address two principal risks that grew out of the 2008 global financial crisis, namely:

  • The "first mover advantage," which encourages investors to be the first to redeem so they can receive the fixed $1 NAV even if the market-based NAV is less than $1 per share; and
  • The fear of widespread investor runs and the "potential for contagion from one fund," which can result in heavy redemptions. Commissioners Kara M. Stein and Michael S. Piwowar voted against the proposals.

In tandem with the Commission's new rules, the Department of the Treasury and the Internal Revenue Service are expected to provide tax relief that will "eliminate significant costs" created by the floating NAV requirements. New IRS rules will let money market fund investors determine gains and losses on a net basis over a year, rather than requiring investors to track individual transactions. Also, the IRS will ease the "wash sale" rules for losses on shares of floating NAV money market funds.

The Commission also proposed amendments to Rule 2a-7 that would remove references to credit ratings, as required by the Dodd-Frank Act. If the amendments are adopted, money market fund boards must determine that portfolio securities have "minimal credit risk" instead of relying in part on objective standards, such as credit ratings. The Commission also proposed a rule that would exempt money market funds from the confirmation requirements of Rule 10b-10 of the Securities Exchange Act of 1934.

Imposing floating NAVs, redemption fees, and gates must be complete by October 14, 2016. The effective date of new reporting requirements is July 14, 2015 and the new diversification and stress test requirements become effective April 16, 2016.

SEC Staff Offers Guidance Regarding Investment Advisers and Proxy Advisory Firms

The SEC's Division of Investment Management and Division of Corporation Finance published joint guidance on June 30, 2014, regarding investment advisers' responsibilities when voting client proxies. The guidance also addressed two exemptions from the federal proxy rules that are often relied upon by proxy advisory firms.

The staff noted that the guidance may require investment advisers and proxy advisory firms to make changes to their systems and processes. The staff stated its expectation that these changes should be made promptly, "but in any event in advance of next year's proxy season."

The guidance reiterated an investment adviser's fiduciary duty to cast proxy votes in a manner that is in accordance with clients' best interests and the adviser's proxy voting procedures. The staff's guidance provided examples of how advisers can demonstrate compliance with this obligation and made clear that advisers and their clients may agree by contract on the manner in which proxy voting authority will be delegated.

The guidance suggested that investment advisers should establish and implement measures reasonably designed to identify and address conflicts that can arise on an ongoing basis. Advisers should also implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of proxy advisory firms and to ensure that the investment adviser, acting through a proxy advisory firm, continues to vote proxies in the best interests of its clients.

The guidance also addressed the application of the proxy rules to proxy advisory firms. In general, the staff said, proxy advisory firms are subject to federal proxy rules because their advice constitutes a "solicitation" of proxies. However, proxy advisory firms are exempt from the information and filing requirements of the proxy rules if they comply with the requirements of exemptions contained in Rule 14a-2(b).

Among other things, Rule 14a-2(b) exempts persons who do not seek the power to act as a proxy for a security holder, such as proxy advisory firms that limit their activities to distributing reports containing recommendations. The Rule also exempts persons that furnish proxy voting advice to another person with whom a business relationship exists, subject to conditions outlined in Rule 14a-2(b)(3).

For more information on the staff's guidance, please see our recent client alert.

SEC Staff Closes Loophole on BDC Asset Coverage Requirements

In a guidance update published on June 30, 2014, the staff of the SEC's Division of Investment Management closed a loophole that allowed business development companies (BDCs) with wholly owned Small Business Investment Company (SBIC) subsidiaries to avoid meeting asset coverage requirements when the SBIC subsidiaries issue debt that is not guaranteed by the Small Business Administration (SBA).

Sections 18(a) and 61(a) of the 1940 Act generally require BDCs to meet asset coverage requirements when they issue "senior securities," including debt instruments. A BDC may be deemed an indirect issuer of any class of "senior security" issued by its direct or indirect wholly owned SBIC subsidiaries.

The SEC has regularly granted BDCs limited exemptive relief from these asset coverage requirements, enabling BDCs to treat certain indebtedness issued by their wholly owned SBIC subsidiaries as indebtedness not represented by senior securities for purposes of determining the BDC's consolidated asset coverage. The SEC exemptive orders are, in part, based upon the representation that SBIC subsidiaries are subject to the SBA's regulation of leverage.

The staff said that it learned that some BDCs have sought to rely on this limited relief in connection with SBICs that have not issued indebtedness that is held or guaranteed by the SBA. The staff took issue with this approach, noting that the requirement that such indebtedness be held or guaranteed by the SBA is implicit in the staff's orders. When an SBIC subsidiary issues debt that is not backed by the SBA, the subsidiary is not subject to the full oversight of the SBA, and thus the protections of Section 18(a) are required.

Going forward, the staff will require that BDC applications for relief from the Section 18 asset coverage requirements include a condition that relief will be granted only if indebtedness issued by wholly owned SBIC subsidiaries is held by or guaranteed by the SBA.

SEC Staff Warns Against "Disclosure Creep"

The staff of the SEC's Division of Investment Management warned against "disclosure creep" invading mutual fund prospectuses in regulatory guidance posted in June 2014.

The staff's guidance breaks no new ground. Rather, it provides a concise primer of Form N-1A's layered prospectus disclosure requirements. Among other things, the guidance reminds registrants to:

  • limit the Summary Section to prescribed disclosures;
  • avoid unnecessary and confusing cross-references;
  • clearly identify principal investment strategies versus non-principal strategies; and
  • generally be mindful of the SEC's plain English requirements.

The staff reminded mutual funds and their service providers that registrants must place disclosures in the right place. Lengthy disclosures about non-principal strategies belong in the statement of additional information, not the Summary Prospectus. In any event, the disclosures must comply with the SEC's plain English requirements.

Registrants should take note that they may be found liable for disclosing too much in the wrong places.

SEC Staff: Measure Percentage Ownership by Fund, Not by Complex

In a recent guidance update, the SEC's Division of Investment Management said that series mutual funds are individual investment companies for purposes of compliance with certain investor protections, including the 1940 Act's restrictions on principal transactions.

Section 17(a) of the 1940 Act generally prohibits an "affiliated person" of a mutual fund, or an affiliated person of an affiliated person (a so-called "second-tier affiliate") from selling any security or other property to the fund. This prohibition can cause compliance headaches when evaluating certain transactions such as repos and swaps.

Here's why: an affiliated person includes any 5 percent shareholder of a mutual fund, so that any financial institution owning 5 percent or more of the fund cannot be a repo or swap counterparty. An affiliated person of that financial institution (the second-tier affiliate) also would be prohibited from acting as a counterparty. Small funds, in particular, can violate Section 17(a) if a repo or swap counterparty, or its affiliate, owns a relatively small position in a fund. To avoid this potential foot fault, funds must monitor ownership and affiliation relationships that may be difficult to track.

Left unsaid in this regulatory guidance is that mutual funds cannot, when measuring 5 percent ownership, take into consideration the entire shareholder base of the corporation or trust that serves as the "umbrella" for a series fund. If a counterparty measured its ownership of a series fund's shares against the total assets of all funds under the umbrella trust, then the counterparty is much less likely to be considered an affiliated person because its percentage of ownership of the entire complex would be much smaller.

In light of this guidance, advisers and fund directors should review their compliance policies and procedures to ensure they are adequate to identify first- and second-tier affiliated persons.

SEC Launches Exam Initiative for Newly Registered Municipal Advisers

The SEC is not wasting any time making sure that newly registered municipal advisers are introduced to their regulator. On August 19, 2014, the SEC announced a two-year examination initiative for municipal advisers that registered with the SEC in accordance with final municipal adviser rules that became effective on July 1, 2014. OCIE's National Examination Program (NEP) stated that the initiative will include "focused, risk-based" examinations of municipal advisers registered with the SEC but not with FINRA.

The examinations will address municipal advisers' compliance with both the final SEC municipal adviser rules and Municipal Securities Rulemaking Board rules as they become final. The examination initiative will proceed in three phases: (1) an "engagement" phase, during which the NEP will reach out to newly registered municipal advisers to inform them of their obligations under the Dodd-Frank Act and related rules; (2) an "examination" phase, during which the NEP staff will review selected municipal advisers' compliance programs in one or more identified risk areas; and (3) an "informing policy" phase during which the NEP will report its observations to the SEC. OCIE said that the particular risk areas that may be included in its examinations will include registration, fiduciary duty, disclosure, fair dealing, supervision, books and records, and training/qualifications.

The NEP noted that the results of OCIE's examinations are typically used by the SEC "to inform rule-making initiatives, to identify and monitor risks, to improve industry practices and to pursue misconduct." In other words, municipal advisers should expect that these examinations will result in additional SEC guidance to municipal advisers regarding how they conduct their businesses.

At this time, there is no indication of how examination participants will be selected, but OCIE has announced that it plans to examine a "significant percentage" of new municipal advisers. Newly registered municipal advisers should plan to participate in OCIE's compliance outreach program, which will take place later this year, to learn about compliance issues and practices, and to understand what to expect from an OCIE examination.

U.S. House Votes to Reauthorize the CFTC and Exclude Most RICs from CPO and CTA Requirements

On June 24, 2014, the U.S. House of Representatives passed a version of the CFTC reauthorization bill, H.R. 4413, that would exclude investment advisers to registered investment companies (RICs) from the definitions of commodity pool operator (CPO) and commodity trading adviser (CTA) if they limit their advice and trading activity to "financial commodity interests."

H.R. 4413 (the Customer Protection and End User Relief Act) included an amendment introduced by Rep. Garrett of New Jersey. The Garrett Amendment, as included in the bill, defines financial commodity interests as futures contracts, options on futures contracts, and swaps involving non-traditional commodities (exempt commodities, such as natural resources and agricultural commodities, are excluded from the definition).

If enacted, the bill will exempt most investment advisers to RICs from CPO and CTA registration and other requirements, including the CFTC's substituted compliance regime. Substituted compliance generally permits investment advisers to RICs to comply with SEC regulatory requirements in place of comparable CFTC requirements (see our related client alert). While intended to relieve some of the burdens imposed by duplicative CFTC and SEC regulations, substituted compliance was viewed by many as insufficient, since it did not cover requirements imposed by the National Futures Association or the CFTC's rules governing commodity interest trading activities.

The Garrett Amendment will not alter the SEC's regulatory oversight or enforcement authority over RICs, nor will it affect the CFTC's jurisdiction over RICs that trade in physical commodities. It is too early to predict whether the Senate will approve the bill that includes the Garrett Amendment.

Banking Regulators: Exit Fees for Bond Mutual Funds?

Should federal regulators impose exit fees on bond funds? Officials at the Board of Governors of the Federal Reserve may think so.

The Financial Times reported on June 16, 2014, that Fed officials have discussed whether regulators should impose exit fees on bond funds to avert a potential run by investors. The Fed apparently is concerned that bond funds are becoming "shadow banks" because investors can redeem their shares on any day, even though funds may face difficulties in selling off assets to meet redemptions in a liquidity crunch.

The FT reported that Jeremy Stein, who recently stepped down as a Fed governor, implied that bond mutual funds resemble banks and "may be the essence of shadow banking. . . ." The discussions at the Fed were at a senior level and have not yet developed into a formal policy.

Commissioner Piwowar Slams "Dodd-Frank Politburo" for Overstepping Authority

In a speech on July 15, 2014, SEC Commissioner Michael S. Piwowar expressed his views about the Financial Stability Oversight Council (FSOC) operating in secrecy as it tries to expand its regulation of financial institutions and the capital markets.

Commissioner Piwowar opened his speech with a number of phrases about FSOC, calling it, among other things:

  • The Firing Squad on Capitalism
  • The Vast Left Wing Conspiracy to Hinder Capital Formation
  • The Bully Pulpit of Failed Prudential Regulators
  • The Dodd-Frank Politburo
  • The Modern-Day Star Chamber
  • The Unaccountable Capital Markets Death Panel

But how does Commissioner Piwowar really feel about FSOC?

FSOC members include the chairs of various commissions and boards (including the SEC), but not the individual commissioners or board members. Commissioner Piwowar complained that FSOC rebuffed his attempt to attend its meetings as a non-participating guest, which, he said, was disappointing but not surprising. But, he said, FSOC also shut out Rep. Scott Garrett, the chairman of the Subcommittee on Capital Markets and Government-Sponsored Enterprises, from FSOC meetings. He called this action "shocking, appalling and downright insubordinate."

Commissioner Piwowar accused FSOC, led by the "alpha dog" Board of Governors of the Fed, of starting a turf war by asserting broad regulatory authority over matters that are exclusively in the SEC's jurisdiction, thus compromising the SEC's mission to protect investors; maintain fair, orderly, and efficient markets; and promote capital formation.

The Commissioner called for more transparency at FSOC and said he supported efforts by Rep. Garrett to make FSOC "accountable and transparent."

The Commissioner, however, stopped short of accusing FSOC of trying to regulate the SEC as a Systemically Important Financial Institution.

To read this Report in full, please click here.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Kelley A. Howes
Daniel Nathan
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