Financial Services Alert - June 14, 2011

The U.S. District Court for the District of Arizona granted a motion to dismiss a complaint brought by a mutual fund shareholder against the fund’s adviser and distributor, alleging (a) the adviser and distributor violated Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), by receiving excessive Rule 12b-1 distribution fees; (b) the adviser violated Section 36(b) by receiving excessive management fees; and (c) the adviser and distributor violated Section 47(b) of the 1940 Act by entering into unlawful contracts. 

Standing.  The court first resolved a threshold issue by holding that the plaintiff, owner of one class of shares in the fund, had standing to bring Section 36(b) claims on behalf of all classes of shareholders in that particular fund, even if the different share classes are assessed different levels of fees.

Section 36(b) – Excessive Fees.  The court then went on to consider whether the plaintiff stated a claim under Section 36(b).  It applied the standard first articulated in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982) – which the United States Supreme Court recently confirmed in Jones v. Harris Associates, L.P., 130 S. Ct. 1418 (2010) – that the plaintiff must allege “that the adviser-manager . . . charge[d] a fee that 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.”  The court applied the six Gartenberg factors and found that the plaintiff’s allegations “largely consist of general conclusions, not facts,” and failed to show how a particular fee met that standard. 

For example, the court noted that the plaintiff’s allegation that the fund charged the maximum fee allowed by law “does not mean the fee is per se excessive,” and rejected as irrelevant the plaintiff’s point that the Rule 12b-1 fees were nearly as large as the advisory fees.  The court also noted that advisers are entitled to make a profit and that the pure dollar amounts of the fees does not necessarily make them excessive.  The court further rejected the plaintiff’s comparison of fees for the actively managed fund at issue with fee levels of various index funds because the services were different, and noted that “[a]lleging under‑performance in a down economy is particularly unavailing.”  The plaintiff’s allegation of excessive fall-out benefits also failed because he attempted to aggregate the Rule 12b-1 fees and advisory fees to state his claim.  Regarding economies of scale, the court pointed out that the fund has breakpoints “that are more beneficial to shareholders than other comparable funds.”  The court stated that the plaintiff failed to provide any facts to show that the breakpoints were inadequate, and that mere allegations that the fund was large are insufficient.  The court further found that the plaintiff failed to state the cost of any service to show that the fee was disproportionate to the service provided.  Lastly, the court rejected the plaintiff’s argument that the directors were “interested” rather than independent because they were busy and/or received their information from the investment adviser.

Section 47(b) – Rescission.  The court also held that the plaintiff could not assert a claim under Section 47(b), which permits the remedy of rescission for contracts that violate the 1940 Act, because such a claim must be brought by a party to the contract.  Although Section 36(b) claims may be brought by a fund shareholder on the fund’s behalf without complying with the process for derivative actions, the court concluded that the plaintiff here was not “standing in the shoes of the Fund” and thus was not a party to the contracts at issue for purposes of his Section 47(b) claim. 

Dismissal with Prejudice.  Because the plaintiff failed to indicate how he could amend his complaint to state a claim, the court denied leave to amend and dismissed the complaint with prejudice.  Turner v. Davis Select Advisers LP, et al., No. 08-CV-00421-TUC-AWT (D. Ariz. June 1, 2011).

The U.S. Supreme Court (the “Court”) issued a 5-4 decision reversing the May 2009 decision of the U.S. Court of Appeals for the Fourth Circuit (the “Fourth Circuit”) and dismissing a plaintiffs’ shareholder suit brought against the adviser to a family of mutual funds (the “Adviser”) and its publicly traded parent (the “Parent”) for allegedly making material misstatements in the funds’ prospectuses regarding the efforts taken to address market timing trading activity in the funds.  The Court held that the Adviser could not be liable under Section 10(b) of, and Rule 10b-5 under, the Securities Exchange Act of 1934 (the “1934 Act”) because under the facts pleaded by the Adviser had not “made” the statements in question, and that without such liability the Parent could not be held liable as a control person under Section 20 of the 1934 Act. 

In the Court’s view, absent express or implicit attribution to another within a statement, the maker of the statement for purposes of Rule 10b-5 is the person with ultimate authority over the statement, including its content and whether and how to communicate it.  In finding that the Adviser was not such a person with respect to statements in the funds’ prospectuses regarding anti-market timing measures, the Court cited the fact that (a) the Adviser and funds were separate corporate entities, (b) the funds met the statutory requirements under the Investment Company Act of 1940 regarding the independence of their trustees from the Adviser, (c) the funds, not the Adviser, filed their prospectuses with the SEC and (d) nothing on the face of the funds’ prospectuses indicated that their contents were statements by the Adviser as opposed to the funds.  Justice Breyer, writing for the dissenting Justices, concluded that the specific allegations regarding the involvement of the Adviser in drafting the prospectus warranted the conclusion that the Adviser did “make” the prospectus statements for purposes of Rule 10b‑5 liability.

The SEC announced that the agenda for its open meeting at 10 a.m. on June 22 includes consideration of action designed to implement provisions of the Dodd-Frank Act affecting the regulation of investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”), including final rules and rule amendments that would:

• increase the statutory threshold for registration of investment advisers with the SEC;
• require advisers to hedge funds and other private funds to register with the SEC;
• implement new exemptions from the registration requirements of the Advisers Act for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States;
• clarify the meaning of certain terms included in a new exemption for foreign private advisers;
• address reporting by certain investment advisers that are exempt from registration; and
• define “family offices” that will be excluded from the definition of  “investment adviser” under the Advisers Act.

Although the matter was not discussed in the meeting notice, this meeting may also address the widely anticipated delay in the compliance date for the changes to investment adviser regulatory scheme under the Dodd-Frank Act that will become effective on July 21, 2011.

On June 9, 2011, the FRB, FDIC and OCC (the “Agencies”) jointly proposed new guidelines on the structure, content and governance of stress-testing for banks with more than $10 billion in assets (the “Guidelines”).  The Guidelines are distinct and separate from new stress-testing requirements promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act. 

The Agencies state that an effective stress test would be conducted at least annually and be designed to identify vulnerabilities at the institutions, assess capital adequacy and assist with recovery planning.  Stress tests should include activities and exercises tailored to the banking organization’s exposures, activities and risks.  The Agencies emphasize that the stress test must be conceptually sound and be approached as part of a forward-looking and flexible framework.  Stress tests should produce results that are clear, actionable and well supported.  The Agencies emphasize that capital and liquidity requirements should be a special focus of all stress testing.

The Agencies recommend four stress testing approaches.  These are:

• Scenario Analysis - a type of stress testing in which a banking organization applies historical or hypothetical scenarios to assess the impact of various events and circumstances, including extreme ones.  Scenarios usually involve some kind of coherent, logical narrative or “story” as to why certain events and circumstances are occurring
• Sensitivity Analysis - a banking organization’s assessment of its exposures, activities, and risks when certain variables, parameters, and inputs are “stressed” or “shocked” without a specific underlying reason.
• Enterprise-Wide Stress Testing - assessing the impact of certain specified scenarios on the banking organization as a whole, particularly on capital and liquidity.
• Reverse Stress Testing - a tool that allows a banking organization to assume a known adverse outcome, such as suffering a credit loss that breaches regulatory capital ratios or suffering severe liquidity constraints making it unable to meet its obligations, and then deduce the types of events that could lead to such an outcome.

The Agencies have requested comments by July 29, 2011 on all of the Guidelines.

On June 3, 2011, the OCC, FRB, FDIC and OTS issued interagency guidance (the “Guidance”) on Basel II’s advanced measurement approaches (“AMA”) for calculating risk-based capital requirements for operational risk for large, internationally active banking organizations (as implemented in the U.S.).  The Guidance discusses certain common implementation issues, challenges and key considerations for addressing such challenges in implementing a satisfactory AMA framework, with a focus on the combination and use of the four required AMA data elements: (i) internal operational loss event data; (ii) external operational loss event data; (iii) business environment and internal control factors; and (iv) scenario analysis.

With respect to internal operational loss event data, the Guidance provides that banks should use at least five years of data, have documented support for their internal data collection threshold(s), and include legal losses in its quantification processes using a date no later than the date a legal reserve is established.  The Guidance also states that banks should have credible, transparent, systematic and verifiable processes for sourcing, selecting, scaling and modeling external data.  Banks should also have sound practices to ensure a systematic assessment of risk across its organization and have a scenario analysis process that is clearly defined, repeatable and transparent (to ensure the integrity of the process).

The Guidance specifically notes that it is not intended to address the treatment of operational risk in a bank’s internal capital adequacy assessment process.

The staff of the SEC’s Division of Investment Management (the “staff”) issued a no-action letter indicating that it would not recommend enforcement action under Section 12(d)(1)(A) of the Investment Company Act of 1940, as amended (the “1940 Act”) against a registered investment adviser (the “Adviser”) or the registered investment companies it advises or subadvises (each a “Fund” and together, the “Funds”) if a Fund invests in excess of the limits prescribed by Section 12(d)(1)(A) of the 1940 Act in shares of certain foreign investment companies that do not rely on an exclusion from the definition of investment company in the 1940 Act (the “Foreign Funds”).  The Funds focus on investments in listed private equity companies, i.e., companies that (a) have a substantial portion of their assets invested in or exposed to private companies or (b) have a stated intention of doing so.  Because of the limited number of listed private equity companies, the Adviser believes that allowing the Funds to invest in Foreign Funds in excess of the Section 12(d)(1)(A) limits will give the Funds greater flexibility to pursue their investment objectives.  The Foreign Funds are organized outside the U.S. and are traded on one or more organized securities exchanges located outside the U.S.  The Funds acquire shares of Foreign Funds exclusively through secondary market transactions that are “offshore transactions” as defined in Regulation S under the Securities Act of 1933.

Section 12(d)(1)(A) of the 1940 Act prohibits a registered investment company, and any companies controlled by such company, from purchasing or otherwise acquiring any security issued by any other investment company if, immediately after such purchase, (i) the fund owns in the aggregate more than three percent of the outstanding voting stock of the acquired company, (ii) securities of the acquired company represent more than five percent of the assets of the acquiring company, or (iii) securities issued by investment companies represent more than ten percent of the assets of the acquiring company.

In its request for relief, the Adviser noted that the Funds that invest in shares of the Foreign Funds currently comply with the provisions of Section 12(d)(1)(F) of the 1940 Act with respect to such investments.  Section 12(d)(1)(F) of the 1940 Act provides that the limits of Section 12(d)(1) shall not apply to securities of other investment companies purchased or otherwise acquired by a registered investment company if (i) immediately after such purchase or other acquisition not more than three percent of the outstanding voting stock of such issuer is owned by such registered investment company and all affiliated persons of such registered investment company, (ii) certain criteria regarding sales loads are met, and (iii) voting rights are exercised in a manner consistent with Section 12(d)(1)(E). 

In granting the requested relief, the staff cited representations from the Adviser that each Fund will comply with Rule 12d1-3 of the 1940 Act as if it were relying on Section 12(d)(1)(F) with respect to its investments in the Foreign Funds.  Rule 12d1-3 provides that a registered investment company that relies on Section 12(d)(1)(F) of the 1940 Act to acquire shares of an investment company may offer or sell its shares at a price that includes a sales load of more than 1.5 percent if any sales charges and service fees charged with respect to the acquiring investment company’s shares do not exceed the limits set forth in Rule 2830 of the Conduct Rules of the NASD applicable to a fund of funds.

The SEC readopted without change relevant portions of Rules 13d-3 and 16a-1 under the Securities Exchange Act of 1934 (the “1934 Act”) in order to preserve the status quo regarding their application to persons who buy or sell security-based swaps once Section 13(o) of the 1934 Act added by the Dodd-Frank Act becomes effective on July 16, 2011.  Section 13(o) provides that “[f]or purposes of [Section 13 and Section 16 of the 1934 Act], a person shall be deemed to acquire beneficial ownership of an equity security based on the purchase or sale of a security‑based swap, only to the extent that the Commission, by rule, determines after consultation with the prudential regulators and the Secretary of the Treasury, that the purchase or sale of the security-based swap, or class of security-based swap, provides incidents of ownership comparable to direct ownership of the equity security, and that it is necessary to achieve the purposes of this section that the purchase or sale of the security-based swaps, or class of security‑based swap, be deemed the acquisition of beneficial ownership of the equity security.”  The SEC’s action to readopt the existing rule provisions follows consultation with the Secretary of the Treasury, the prudential regulators (consisting of the FRB, the OCC, the Farm Credit Administration, the Federal Housing Finance Agency, and the FDIC) and the CFTC.  The SEC release announcing the readoption states that the SEC staff is engaged in a separate project to develop proposals to modernize reporting under Sections 13(d) and 13(g) of the 1934 Act.

The FRB issued a proposed rule (the “Proposed Rule”) that would require bank holding companies with total consolidated assets of $50 billion or greater (“Covered BHCs”) to submit annual capital plans (“Capital Plans”) to the FRB for review.  There are currently approximately 35 U.S. bank holding companies that would be Covered BHCs and, accordingly, subject to the Proposed Rule.  Under the Proposed Rule a Covered BHC’s board of directors would be required each year to review and approve the institution’s Capital Plan prior to submission to the FRB.  In addition, the FRB would review a Covered BHC’s plan to pay dividends on its stock and make other capital distributions and the FRB could prohibit a Covered BHC from paying a dividend or repurchasing stock.  Moreover, the Proposed Rule would require that a Covered BHC assess its expected uses and sources of funds over the next two years and demonstrate that it has sufficient capital to continue to lend to households and businesses even under adverse economic conditions.  Furthermore, the Proposed Rule would require a Covered BHC, to maintain, until January 1, 2016, even under economically stressful conditions, tier 1 capital of at least 5%.  The FRB stated that it expects to begin review of Capital Plans in 2012.  Comments on the Proposed Rule are due by August 5, 2011.

FINRA issued Information Notice 6/6/11 encouraging its members to make reasonable efforts to assist investment advisers seeking to identify government entity investors in the pooled investment vehicles the advisers manage as they seek to comply with Rule 206(4)-5 under the Investment Advisers Act of 1940, also known as the Pay‑to‑Play Rule.  The Pay‑to‑Play Rule generally prohibits an investment adviser from providing advisory services for compensation to a state or local governmental entity, including a public pension, retirement or 529 plan (a “Government Entity”), for two years after the adviser or certain of its personnel make a contribution to certain elected officials or candidates.  An adviser that manages specified types of pooled investment vehicles (including certain registered investment companies, hedge funds, private equity funds, venture capital funds and collective instrument trusts) must generally treat a Government Entity investor in those pools as if the adviser were providing advisory services directly to the Government Entity, subject to certain limited exceptions.  While most aspects of the Pay-to-Play Rule went into effect in March 2011, advisers have until September 13, 2011 to comply with the Rule’s requirements as to registered investment companies, which apply only if a fund is an investment option of a participant-directed Government Entity plan.  An adviser to a mutual fund seeking to identify any participant-directed Government Entity plan investors that hold fund shares through intermediaries (e.g., broker-dealers that maintain omnibus accounts) will need not only to identify intermediaries that maintain fund accounts and query them regarding underlying participant-directed Government Entity plan investors, but also to put in place mechanisms to address those relationships going forward.  (For an in-depth discussion of the Pay-to-Play Rule, see the July 9, 2010 Goodwin Procter Alert.)

The CFTC voted to propose granting temporary exemptive relief from certain requirements in the Commodity Exchange Act (the “CEA”) resulting from the Dodd-Frank Act that otherwise become effective on July 16, 2011 under the terms of the Act.  The proposed relief contains two principal elements.  The first would provide a temporary exemption from provisions that reference terms such as “swap,” “swap dealer,” “major swap participant,” or “eligible contract participant” that the Dodd-Frank Act requires the CFTC and SEC to “further define” (which the agencies will not have done by July 16); the exemption would continue until the effective date of final rules defining those terms or December 31, 2011, whichever is earlier.   The second element of the CFTC proposal would temporarily exempt certain transactions (primarily in financial and energy commodities) from certain CEA provisions that will apply as a result of the repeal of various CEA exemptions and exclusions under the Dodd-Frank Act; the exemption would apply until the repeal or replacement of certain CFTC regulations or December 31, 2011, whichever is earlier.  Additional details on the CFTC proposal are available in a CFTC Fact Sheet and Q&A, on which this article is based.  A formal release with full details of the proposed exemptive relief will eventually be published for comment in the Federal Register with a 14-day comment period.

The SEC also announced that it will be taking steps in the coming weeks to clarify which elements of the Dodd-Frank Act’s regulatory scheme for security-based swaps, to be overseen by the SEC, will apply beginning on July 16, 2011, the effective date for that scheme under the terms of the Act.  The SEC will also act to address the application of pre‑Dodd-Frank requirements under the Securities Exchange Act of 1934 to security-based swaps.  In each instance, the SEC will consider granting appropriate temporary exemptive relief.