United States: Mutual Fund Adviser Sanctioned For Deficiencies In Custody Of Funds’ Derivatives Collateral And Directed Brokerage Compliance

On February 12, 2015, the SEC announced that Water Island Capital LLC ("Water Island") agreed to settle enforcement proceedings arising from alleged violations of the Investment Company Act of 1940 (the "1940 Act") found during an SEC exam of Water Island and the mutual funds it advises (the "Funds"). The alleged violations related to custody of cash collateral posted as security for derivatives transactions and the requirements of Rule 12b-1(h) under the 1940 Act (which governs the direction of fund portfolio transactions to brokers that sell fund shares), as well as weaknesses in the design of the Funds' compliance program. The settlement imposed only a modest monetary penalty, and the underlying facts are not recited in great detail in the SEC's order, but the enforcement action nevertheless illustrates an SEC focus on technical compliance with the 1940 Act rules in the context of mutual funds implementing "alternative" investment strategies. 

Custody Violation: Section 17(f)(5) 

In the words of the settlement order (the "Order"), Water Island serves as the investment adviser to several "alternative mutual funds" that engage in specialized trading strategies, including merger arbitrage. To implement these strategies, the Funds trade derivatives, including swaps. The Order alleges that during a nine-month period in 2012, Water Island permitted the Funds' broker-dealer counterparties to hold approximately $247 million of the Funds' cash as collateral for certain total return and portfolio return swaps, rather than maintaining it with the Funds' custodian in a tri-party arrangement. The size of these positions was significant relative to Water Island's total assets under management of approximately $3.5 billion. 

Section 17(f)(5) of the 1940 Act requires that if a fund maintains its securities and similar investments in the custody of a qualified bank, then it must also maintain the cash proceeds from the sale of such securities and similar investments in the custody of a qualified bank. The Order alleges that Water Island did not ensure the transfer of the cash assets to the Funds' bank custodian, and states that Water Island could have complied with these requirements if it had followed the "standard industry practice" of maintaining the swaps-related cash collateral at the Funds' bank custodian pursuant to a tri-party agreement among the custodian, the Funds and the counterparty. While the Order does not explore broader industry practice, we note that the custom of leaving cash collateral with the broker-dealer counterparty is commonplace for hedge fund managers and other managers of alternative investments outside the 1940 Act fund context. 

Directed Brokerage Violation: Rule 12b-1(h)

Rule 12b-1(h) under the 1940 Act prohibits an open-end fund from compensating a broker-dealer for promoting or selling fund shares by directing brokerage transactions to that broker. Under the rule, a fund is permitted to direct portfolio transactions to brokers that sell fund shares, but only if the fund or its adviser has implemented policies and procedures reasonably designed to, among other things, ensure that the selection of brokers for portfolio transactions is not influenced by considerations about the sale of fund shares. 

The Funds adopted directed brokerage policies and procedures under Rule 12b-1(h), which Water Island was responsible for implementing. The Order alleges that Water Island failed to implement the Rule 12b-1(h) policies and procedures by failing to create and maintain an approved list of executing brokers for the Funds, and by failing to maintain documentation reflecting the monitoring of the Funds' compliance with those policies and procedures.

Further Observations

In accepting Water Island's offer of settlement, the SEC imposed a modest civil money penalty in the amount of $50,000. This relatively minor penalty may reflect that the two violations were technical in nature and did not result in alleged loss to investors. Although it is highly unusual for the SEC to bring enforcement actions for violations of Section 17(f)(5) or Rule 12b-1(h), the proceedings are indicative of some of the SEC's current examination and enforcement priorities. By bringing this enforcement action, the SEC seems to be seizing an opportunity to send an educational message to managers of so-called "alternative" funds that they must strictly comply with all the requirements applicable to operating a registered fund under the 1940 Act, including implementing compliance policies and procedures adopted by the funds. The action for custody violations with regard to collateral on derivatives, in particular, illustrates a willingness to pursue enforcement for trading practices that may be commonplace among private fund managers, but that run afoul of the more stringent protections imposed by the 1940 Act, even in situations where no harm to shareholders is alleged. Recently, the SEC has expressed a heightened level of concern with regard to the management of registered funds employing so-called alternative strategies, and these types of funds (and their advisers) have been subjected to more intense scrutiny in recent SEC examinations, including additional required questions and requests reserved for funds that the examination staff decides to classify as alternative investment companies. 

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions