Financial Services Alert - February 24, 2009

The Obama administration unveiled the Homeowner Affordability and Stability Plan (“HASP”), which is part of the Financial Stability Plan (“FSP”).  This three-part plan is intended to help 4 million to 5 million borrowers that are “underwater” refinance through Fannie Mae and Freddie Mac, help 3 million to 4 million additional borrowers through the creation of a $75 billion Homeowners Stability Initiative, which includes a $10 billion loan guarantee plan with the FDIC, and provide an additional $200 billion of funding to Fannie Mae and Freddie Mac (each receiving $100 billion).  The $200 billion of funding for Fannie Mae and Freddie Mac does not come from the Troubled Asset Relief Program (“TARP”), but rather the Housing and Economic Recovery Act passed last June.  The size of the retained mortgage portfolios of Fannie Mae and Freddie Mac were increased by $50 billion to $900 billion.  The Obama administration also stated that judicial modification of home mortgages should be allowed during bankruptcy.

Under the HASP, lenders are asked to modify loans so that monthly mortgage payments are no more that 38% of a borrower’s income.  Further reductions in interest payments would be matched dollar-for-dollar by the Treasury to bring the ratio down to 31% of a borrower’s income.  The lower interest rates are intended to be in place five years.  Lenders may choose to reduce principal balances, with the Treasury sharing in the cost.  Servicers will receive $1,000 for each eligible modification under the HASP and up to $1,000 each year for three years as long as the borrower stays current on the loan.  Servicers also may receive $500, and mortgage holders $1,500, for modifications to at-risk loans in which the borrower is still current on payments.  Borrowers may receive up to $1,000 a year for up to five years to reduce principal balances if the borrower stays current on loan payments.  Holders of mortgages modified under the HASP would be provided with an partial guarantee from the FDIC linked to declines in the home price index.  In conjunction with this initiative, the Federal banking regulators will create consistent loan modification guidance and any institution receiving TARP/FSP funds in the future will be required to adhere to those guidelines.

Revised Form D and Mandatory Electronic Filing.  Issuers that rely on, or plan to rely on, the exemption from registration under the Securities Act of 1933 provided by Regulation D (“Reg. D”) should be aware that under rule changes adopted by the SEC in 2008 revisions to Form D and related electronic filing requirements become mandatory March 16, 2009.  Under these rule changes, Form D filings will have to be made electronically on EDGAR, which will cause the filings to be publicly available on the SEC website.  These filings must be made using revised Form D which requires issuers to provide significantly more disclosure about their Reg. D offerings.  (For further detail on the revisions to Form D, which include additional amendment requirements, please see the February 26, 2008 Alert.)

**Action Item for Certain Form D Filers with Ongoing Offerings**

Under the SEC’s new rules for Form D, issuers that filed an initial Form D or an amendment to a Form D with the SEC on or before March 16, 2008 and wish to continue an ongoing securities offering in reliance on Reg. D must file a Form D amendment with the SEC on or before March 16, 2009.    This requirement affects a broad range of issuers, including open-end institutional and hedge funds, as well as private equity, venture and real estate funds with offering periods that extend over the relevant time periods.  Additional information on the requirement is available in a February 23, 2009 Goodwin Procter Client Alert, which can be accessed at http://www.goodwinprocter.com/~/media/C12E2CE0EC45408182D42856B79A3948.ashx.

Need for Advance Planning by Electronic Filers.  In order to make an electronic Form D filing, issuers must have an EDGAR access code. The SEC has said that it expects requests for EDGAR access codes to increase as March 16 approaches, and is recommending that new EDGAR filers request EDGAR access codes well in advance of that date.

The SEC issued the release describing rules adopted at its December 18, 2008 open meeting that will require open-end management investment companies (“funds”)  beginning January 1, 2011 to submit a new exhibit that contains their prospectus risk/return summary information in interactive data format with certain SEC filings and post that information on their websites.  The prospectus risk/return summary contains information about a fund’s investment objectives and strategies, costs, risks, and past performance.  The new rules also expand the SEC’s program allowing issuers to make voluntary filings in interactive date format to permit registered investment companies and certain other issuers to submit exhibits to SEC filings that contain portfolio holdings information in interactive data format.

Background.  Presenting information in interactive data format involves labeling (“tagging”) information in electronic filings using standardized definitions (“tags”), eXtensive Business Reporting Language (“XBRL”) in the case of SEC filings, so that the information can be retrieved, searched and analyzed through automated means.  The use of interactive data format is designed to increase the ability of investors, analysts and others to collect and use information in disclosure documents filed electronically with the SEC.  The new rules build upon the SEC’s voluntary filer program started in 2005.  The 2005 program allowed companies to submit financial statements, on a supplemental basis, in interactive data format.  In 2007, the SEC expanded the program to allow mutual funds to voluntarily submit, on a supplemental basis, information in the risk/return summary in interactive data format. 

Viewers are necessary to convert an interactive data file to viewable form.  The SEC website provides links to a number of viewers for the interactive filings made to date, including a mutual fund comparison tool at http://a.viewerprototype1.com/viewer that demonstrates the use of data tagged information extracted from interactive data filings of risk/return summaries made by funds participating in the voluntary program.  The mutual fund comparison tool allows users to compare mutual fund risk/return summary information, including investment objectives and strategies, risks, costs, and performance, that is submitted in interactive data format. 

Providing Risk/Return Information in Interactive Data Format.  The new rules do not eliminate or alter existing substantive disclosure requirements for risk/return summary information or alter the requirements to provide risk/return summary information as part of filings made in traditional electronic formats.  The interactive data reporting required by the new rules is intended to be disclosure neutral and does not result in funds providing more, less, or different disclosure for any given disclosure item, regardless of the format.  The new rules require that the information contained in the risk/return summary section of the traditional format filing and in interactive data format be the same. 

Under the new rules, funds must submit their risk/return summary information in an interactive data file using the most recent list of XBRL tags released by XBRL U.S. (http://xbrl.us/Pages/default.aspx) for risk/return summary information, as approved for use by the SEC.  The SEC recently conformed the existing list of tags for risk/return summary information to the changes it adopted in November 2008 to the risk/return summary disclosure requirements for fund prospectuses (for a discussion of these changes, see the January 20, 2009 Alert). The list is expected to be finalized and submitted to XBRL International for acknowledgement by the end of January 2009.  Related documents, such as the architecture and technical guides, are also due to be released by the end of January 2009. 

A risk/return summary in interactive data format is created by applying data tags to the various elements of the disclosure using commercially available software that guides the preparer to use the appropriate tags from a standard list.  In instances where none of the standard tags is deemed suitable for a particular element of a fund’s risk/return summary, e.g., a unique narrative disclosure in the expense table, it is possible to create a fund-specific element, called an extension.  In order to promote comparability of risk/return information across funds, the new rules limit the use of extensions to circumstances where the appropriate element does not exist in the standard list of tags.  Although the SEC’s current viewer converts tagged risk/return summary information to viewable format, the SEC is developing a more advanced tool that will allow issuers to view interactive data exhibits and conduct test filings prior to formal submission. This upgraded viewer is expected to be completed by mid-2009.

The new rules do not require the involvement of third parties, such as auditors or consultants, in creating interactive data exhibits to fund filings.

Filings for Which an Interactive Data Exhibit of Risk/Return Information Is Required.  Under the new rules, a fund must submit an interactive data version of its risk/return summary with respect to a registration statement or post-effective amendment that contains risk/return summary information.  The new rules also require a fund to submit an interactive data risk/return summary exhibit with respect to any form of prospectus filed pursuant to Rule 497(c) or (e) under the Securities Act of 1933, as amended (the “1933 Act”) (a “definitive filing”), that contains risk/return summary information that varies from the risk/return summary information in the fund’s registration statement.  (In general terms, Rule 497 spells out the requirements for filing with the SEC the prospectus and statement of additional information used after the effectiveness of a fund’s registration statement.)

An interactive data version of a risk/return summary filed with respect to a registration statement must be filed as a post‑effective amendment under Rule 485(b) under the 1933 Act and must be filed after effectiveness of the related filing, but no later than 15 business days after the effective date of the related filing.  The filing need only consist of the new exhibit, a facing page, a signature page, a cover letter explaining the nature of the amendment, and a revised exhibit index.  An interactive data file required to be submitted with respect to a definitive filing may be submitted with, or up to 15 days after, the definitive filing.

Website Posting.  A mutual fund required to file risk/return summary information in interactive data format must also post that information in interactive data format on its website, if it maintains one, not later than the end of the calendar day it submitted data exhibit to the SEC (as determined by when the filing is deemed officially filed) or was required to submit the filing, whichever is earlier.  An interactive data file must remain on a fund’s website as long as the registration statement to which it relates remains current.  A fund may not meet the website posting requirement using a hyperlink to the SEC website.

Consequences of Failure to Comply.  If a fund fails to file a required interactive data version of its risk/return summary information, or post the required interactive data on its website, by the required due date, its ability to file post-effective amendments to its registration statement pursuant to Rule 485(b) under the 1933 Act, which provides for immediate effectiveness of amendments that make nonmaterial and other changes, such as updating financial statements, will be automatically suspended.   The suspension becomes effective at the time that the filer fails to meet the filing or posting requirement and ends as soon as the filer makes the required submission or posting.  The suspension applies to post-effective amendments filed after the suspension becomes effective, but does not apply to post-effective amendments that were filed before the suspension became effective.  In addition, the suspension does not apply to post-effective amendments filed solely for purposes of submitting interactive data, e.g., to cure the failure causing the suspension.  A suspension applies to all series of a registrant even thought the failure only relates to one series.  A failure to provide a required interactive data submission will not affect a fund’s ability to incorporate by reference the fund’s prospectus or statement of additional information into another document, such as the summary prospectus permitted under recent rule changes adopted by the SEC (for a discussion of the summary prospectus, see the January 20, 2009 Alert).

Hardship Exemption.  A fund may make a written request under Rule 202 of Regulation S‑T for a continuing hardship exemption on the grounds that it is unable to make a mandated electronic filing in interactive data format in a timely manner without undue burden or expense.  Rule 202’s requirement that when a continuing hardship exemption is granted the filing in question must be made in paper form will not apply to a filing in interactive data format.  If a fund does not make the required electronic filing in interactive data format by the end of the period for which an exemption is granted, its ability to file post-effective amendments under Rule 485(b) will be suspended until it makes the required filing.  A similar procedure will apply to the website posting requirement for interactive data.

Liability.  Funds making interactive data submissions of risk/return summary information will be able to rely on a temporary rule that limits a filer's liability for interactive data submissions.  The temporary rule was adopted as part of SEC rules requiring operating companies to file their financial statements in interactive data format and applies through October 31, 2014, over three years after the date on which funds must begin submitting risk/return summary information in interactive data format.  After October 31, 2014, an interactive data submission of risk/return summary information will be subject to the same liability as the traditional filing to which it relates.  The limitations in the temporary rule are similar to those that apply to interactive data submissions under the SEC’s voluntary interactive data program.  Under the temporary rule, an interactive data file is subject to the anti-fraud provisions of Section 17(a)(1) of the 1933 Act, Section 10(b) of and Rule 10b-5 under the Securities and Exchange Act of 1934 (the “1934 Act”), and Section 206(1) of the Investment Advisers Act of 1940 (the “Advisers Act”), except as follows:

• An interactive data file is not deemed filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the 1933 Act, is not deemed filed for purposes of Section 18 of the 1934 Act or Section 34(b) of the Investment Company Act of 1940 (the “1940 Act”), and is not otherwise subject to liability under those sections; and
• A fund is not subject to liability for a failure to comply with Rule 405 of Regulation S‑T, which dictates the tagging requirements for interactive data filings, but shall be deemed to have complied with Rule 405 and is not be subject to liability under the anti-fraud provisions noted above or under any other liability provision if the fund:

1. makes a good faith attempt to comply with Rule 405; and
2.  after the fund becomes aware that the interactive data file fails to comply with Rule 405, promptly amends the interactive data file to comply with Rule 405.  (The new rules define “promptly” as “as soon as reasonably practicable under the facts and circumstances at the time” and include a safe harbor, which generally provides that a correction made by the later of 24 hours or 9:30 a.m. on the next business day after the fund becomes aware of the need for the correction is deemed promptly made.  The safe harbor is not exclusive so that a fund that fails to comply with the safe harbor may still meet the prompt amendment requirement depending on the applicable facts and circumstances.)

(In addition, as with all electronic filings, interactive data submissions are deemed filed for purposes of Rule 103 of Regulation S-T, which provides that the filer is not subject to liability for electronic transmission errors beyond its control if it corrects the problem through an amendment as soon as reasonably practicable after it becomes aware of the problem.)

The adopting release indicates that interactive data in viewable form displayed on the SEC’s website will reflect the related interactive data file and, as a result, such interactive data in viewable form should be treated in the same manner as the related interactive data file in regard to a fund’s failure to correctly tag an interactive data file that results in a failure of the interactive data in viewable form to reflect the related official filing.  The adopting release also states that interactive data in viewable form displayed on other websites will be subject to general antifraud principles applicable to republication of another person’s statements, and consistent with traditional concepts of liability, a fund is not be liable twice for a failure that occurs in both an interactive data file and the related interactive data in viewable form.

Because the SEC believes it is inappropriate for an interactive data submission to alter or differ from the information included in the related official filing, an interactive data submission may not include additional cautionary language. The SEC does, however, intend to modify its interactive data viewer to include a legend that (1) informs users that the information is derived from a portion of the fund’s prospectus; (2) explains that the prospectus contains additional information about the mutual fund; and (3) states that a fund’s prospectus should be read carefully before investing.  In addition, the adopting release encourages third-party viewers to also include this legend, noting that the liability provisions it has adopted attach only to interactive data viewed on the SEC’s viewer.

Voluntary Interactive Data Program – Financial Statements and Portfolio Holdings. The new rules modify the SEC’s voluntary interactive data filing program to allow (i) investment companies registered under the 1940 Act, (2) business development companies, and (3) other entities that report under the 1934 Act, and prepare their financial statements in accordance with Article 6 of Regulation S-X, to submit exhibits under the voluntary interactive data program that contain a tagged schedule of portfolio holdings, specifically Schedule I - Investments in Securities of Unaffiliated Issuers under Regulation S-X, without having to submit other financial information, such as financial statements, in interactive data format. As under the voluntary program currently, a tagged exhibit with portfolio holding information must disclose that (a) the financial information is “unaudited” or “unreviewed,” as applicable, and that the purpose of submitting the tagged exhibit is to test the related format and technology and, as a result, investors should not rely on the exhibits in making investment decisions.

The new rules will not affect the ability of registered investment companies to participate in the voluntary program that permits certain issuers to file their financial statements. (Financial statement filings submitted by investment companies under the voluntary program consist of a complete set of financial statements that reflects all periods presented in the corresponding official EDGAR filing, which may omit notes to the financial statements and related schedules, other than Schedule I – Investments in Securities of Unaffiliated Issuers, and financial highlights or condensed financial information. Voluntary financial statement filings may also include related audit opinions, interim review reports, reports of management on the financial statements, certifications, or Management’s Discussion of Fund Performance.)  In addition, funds may continue to participate in the voluntary program with respect to risk/return summary information up until January 1, 2011, when mandatory submission of risk/return summary information in interactive date format becomes mandatory, as discussed below.

Investment companies may begin submitting tagged portfolio holdings information as part of the voluntary program under the new rules at any time after July 15, 2009.  This effective date is intended to coincide with the release of an updated EDGAR Filer Manual that will incorporate the new list of tags for portfolio holdings information.

Compliance Date.  Compliance with the new rules is required beginning with initial registration statements and post-effective amendments that are annual updates to effective registration statements that become effective after January 1, 2011.  The new rules’ requirements for definitive filings do not apply until a fund has first submitted an interactive data risk/return summary exhibit with its registration statement.  The extended delay before requiring submission of risk/return summary information in interactive data format is intended to allow funds sufficient time to adapt to the recent revisions to Form N-1A affecting the information required in the interactive data submissions.

The U.S. District Court for the Central District of California dismissed a suit brought by a mutual fund shareholder against the fund’s investment adviser and an affiliate of the adviser that served as the fund’s distributor over 12b-1 fees paid by the fund to the distributor.  (12b-1 fees are paid under a plan approved by a mutual fund’s independent directors pursuant to Rule 12b-1 under the Investment Company Act of 1940, as amended (the “1940 Act”), and are the sole means by which a mutual fund may pay for distribution and sales activities.)  The suit was brought under Section 36(b) of the 1940 Act, which in broad terms allows a fund shareholder to sue the fund’s adviser for breach of fiduciary duty with respect to the receipt of compensation, the compensation in this case being 12b-1 fees alleged to have been paid indirectly to the adviser through its affiliate, the distributor.  The plaintiff’s allegations focused on non-compliance with Rule 12b-1’s requirements:  (a) the plaintiff alleged that the portion of the 12b-1 fees used for post-sales activities was per se unlawful because post-sales services cannot be “primarily intended to result in the sale of shares issued by [the fund]” as required by the Rule and (b) the plaintiff alleged that the remainder of the fund's 12b-1 fees were unlawful because they failed to meet the statutory requirement that “there is a reasonable likelihood that the [12b-1 fees] will benefit the company [] and its shareholders.”  

In making these allegations, the plaintiff argued that the multi-factor analysis for suits under Section 36(b) established by the US Court of Appeals for the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc ., 694 F2d 923 (2d Cir. 1982) (“Gartenberg”) was not applicable because if the fees were improper, they were necessarily excessive and disproportionate.  The court noted that under Gartenberg, courts analyze the following factors in seeking to determine whether “the fee charged is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining”: (i) the nature and quality of the services provided by the adviser; (ii) the profitability of the fund to the adviser-manager; (iii) “fall-out” benefits to the adviser from its relationship with the fund; (iv) any economies of scale achieved by the fund and whether those economies are passed on to fund shareholders; (v) the fund’s fee structure relative to those of other similar funds; and (vi) the independence and conscientiousness of a fund’s independent directors.

The court rejected the plaintiff’s argument regarding Gartenberg and applying that standard, found that the complaint failed to allege sufficient facts regarding the disproportionality of the fees charged relative to the services provided to the fund to survive the motion to dismiss.  The court added that an allegation that fees were used for an improper purpose would not by itself state a claim under Section 36(b).  The court also rejected the plaintiff's allegation regarding the per se impermissibility of 12b-1 fees for post-sales services.  The court dismissed the plaintiff’s Section 36(b) claim with leave to amend, making clear that an amended complaint would need to address the Gartenberg standard.

The court also dismissed the plaintiff’s claim under Section 48(a) of the 1940 Act against the adviser alleging that the adviser had caused the distributor to violate its fiduciary duty under 36(b).  (Section 48(a) generally prohibits any party from doing indirectly what the 1940 Act does not permit that party to do directly.)  In dismissing this claim, the court cited a number of recent cases holding that plaintiff’s Section 48(a) does not create a private right of action.  The court dismissed the Section 48(a) claim with prejudice.

As a follow up to the executive compensation restrictions discussed in the February 17, 2009 Alert, Senate Banking Committee Chairman Christopher Dodd wrote a letter to the SEC on February 20^th providing his views on the certification and “say on pay” provisions of the American Recovery and Reinvestment Act of 2009 (the “ARRA”).  Senator Dodd sponsored the amendment to the ARRA which added retroactive executive compensation requirement for all recipients of TARP funds.  In the letter, Senator Dodd stated that he believes that the “say on pay” provisions, which require an annual non-binding shareholder vote on executive compensation, “apply only to preliminary or definitive proxy statements filed with the [SEC] after February 17, 2009, but would not apply to proxies filed earlier.”  Senator Dodd further stated that the requirement that CEOs and CFOs annually certify compliance with the executive compensation and corporate governance standards provided by the ARRA is not effective until the Treasury has established such standards.  The SEC is advising financial institutions that have concerns regarding how these changes may impact planned proxy statement printing and distribution to contact their assigned assistant director in the SEC’s Corporation Finance Division.