Financial Services Alert - August 23, 2011

The U.S. District Court for the Northern District of California (the “Court”) ruled on the adequacy of various claims in the complaint filed by the SEC in an administrative proceeding brought against a former bond mutual fund portfolio manager (the “Portfolio Manager”) and an executive (the “Executive”) of the adviser to certain fixed-income funds; the SEC’s claims related to the funds’ investments in non‑agency mortgage-backed securities (“MBS”).  In January 2011, the SEC settled related administrative proceedings against the funds’ investment adviser and affiliated distributor and transfer agent, as discussed in the January 25, 2011 Financial Services Alert.  In relevant part, the SEC’s complaint against the Portfolio Manager and Executive alleged violations of Section 10(b) of, and Rule 10b-5 under, the Securities Exchange Act of 1934 (the “Exchange Act”) (both primary liability and liability for aiding and abetting), Section 17(a) of the Securities Act of 1933 and Section 34(b) of the Investment Company Act of 1940.  The alleged violations focused on the respective roles of the Portfolio Manager and Executive in (a) communications to investors that failed to inform them adequately about the risks of investing in an ultra-short bond fund managed by the Portfolio Manager, in large part by describing the fund as a cash alternative that had only slightly higher risk than a money market fund, and (b) the deviation of the fixed-income funds in question from their concentration policy when they invested more than 25 percent of their assets in MBS.

Janus Decision.  The Court rendered its decision in response to a motion that in light of the U.S. Supreme Court’s ruling in Janus Capital Group v. First Derivative Traders, 131 S.Ct. 2296 (2011), the Court reconsider a prior motion to dismiss the SEC’s charges for failing to state an actionable claim.  In relevant part, the Supreme Court’s decision, which was discussed in the June 14, 2011 Financial Services Alert, dismissed a plaintiffs’ shareholder suit brought against the adviser to a family of mutual funds (the “Adviser”) for allegedly making material misstatements in the funds’ prospectuses regarding the efforts taken to address market timing trading activity in the funds.  The Supreme Court held that the Adviser could not be liable under Section 10(b) of, and Rule 10b-5 under, the Exchange Act because under the facts pleaded by the Adviser had not “made” the statements in question.

Rule 10b-5 - Primary Liability.  The SEC and the defendants agreed that the following statements had been “made” by the defendants within the meaning of Rule 10b‑5: (a) as to the Executive, (i) a fund registration statement signed by the Executive and (ii) a set of questions and answers discussing the ultra‑short bond fund that listed the Executive as the author, which was published on the funds’ website; and (b) as to the Portfolio Manager, (i) an advertisement quoting the Portfolio Manager and containing his picture, (ii) a brochure sent to investors that contained a statement attributed to the Portfolio Manager and (iii) statements by the Portfolio Manager in conference calls with registered investment advisers.  Addressing the defendants’ motion, the Court reviewed two other instances in which the SEC alleged the defendants had made actionable misstatements.  The Court ruled that the Portfolio Manager was sufficiently alleged to have made misstatements in a “Manager’s Discussion” made available to the public and posted on the funds’ external website that the complaint stated had been reviewed by the Portfolio Manager and issued under his title as “Manager.”  The Court noted that “[t]he complaint’s allegations impress upon the reader that [the Portfolio Manager] was the manager being referred to as the speaker in the document, and in addition that he reviewed the document before it was issued, which would only be consistent if he was the “manager” being referred to as the speaker.”  The Court, however, held that the SEC had not sufficiently alleged that the Portfolio Manager was the maker of statements in an advertisement solely because it included his picture.

Rule 10b-5 - Aiding and Abetting Liability.  The defendants argued that the SEC’s claims that the defendants had aided and abetted Rule 10b-5 violations should be dismissed because the SEC had not alleged primary claims of Rule 10b-5 violations that met the requirements of Janus.  In refusing to dismiss these claims, the Court observed that the complaint “still contained direct statements by the defendants that serve as a basis for the direct liability claims against them, and the alleged primary violations by one can still underlie the aiding and abetting claim against the other.”  The Court also rejected the argument that in the case of misstatements alleged to have been made by the funds’ adviser and related entities, the complaint did not identify which entity had made the statements in question as required to meet the Janus standard.  The Court observed that were the SEC to move for leave to file an amended complaint “perhaps it will more clearly attribute each misstatement to a specific Schwab entity pursuant to Janus.”

Section 17(a).  The Court held that Janus did not apply to Section 17(a) because the decision specifically addresses Rule 10b-5, and although Section 17(a) uses the word “make,” its operative language does not, observing that “Section 17(a) makes it unlawful (1) ‘to employ any device, scheme, or artifice to defraud,’ (2) ‘to obtain money or property by means of any untrue statement’ or omission of a material fact, or (3) ‘to engage in’ certain types of transactions (emphasis added).”  The Court also ruled that Janus was inapplicable in the context of Section 17(a) because its rationale relied on prior decisions limiting the scope of implied rights of action under Rule 10b‑5 which could not apply to Section 17(a) given its lack of an implied private right of action.

Section 34(b).  The Court held that Janus did not apply to Section 34(b) for the same reasons cited with respect to Section 17(a) while acknowledging that “Section 34(b) does include the word ‘make,’ in stating: ‘It shall be unlawful for any person to make any untrue statement of a material fact in any registration statement, application, report, account, record, or other document filed or transmitted . . .’.”  The Court went on to reason that “[t]o hold otherwise may cabin Section 34(b) liability only to entity defendants that bear the statutory obligation to file documents with the Commission. This would change the scope of defendants that may be targeted by Section 34(b) based on a Supreme Court decision that in no way even addressed Section 34(b). This order cannot and need not take such a step. Janus was not a touchstone to change myriad laws that happen to use the word ‘make’ — it was a decision interpreting primary liability under Rule 10b-5.”

The SEC issued an order approving a PCAOB rule change that establishes an interim inspection program related to audits of broker-dealers.  The interim program of inspection is designed to allow the PCAOB to begin inspections of relevant audits and auditors and provide a source of information to help guide decisions about the scope and elements of a permanent program.  Under the temporary rule, the PCAOB will publish a report on the interim program no less frequently than every twelve months, beginning twelve months after the date the rule takes effect and continuing until rules for a permanent program take effect.

On July 21, 2011, the staff of the SEC’s Division of Investment Management (the “Staff”) provided additional no-action relief to allow investment advisers to continue engaging auditors registered with, but not subject to, regular inspection by the PCAOB to audit the financial statements of pooled investment vehicles for purposes of complying with the annual financial statement requirement of paragraph (b)(4) of Rule 206(4)‑2 under the Investment Advisers Act of 1940, commonly referred to as the Advisers Act custody rule.  (For a more detailed discussion of this no-action relief, see the August 2, 2011 Financial Services Alert.) The additional relief expires upon the earlier of the approval of a permanent PCAOB inspection program for broker‑dealer auditors or December 31, 2013.

FINRA issued Regulatory Notice 11-39 to respond to questions raised by member firms since the January 2010 issuance of Regulatory Notice 10-06, which provided guidance on the application of FINRA rules governing communications with the public to social media sites and reminded firms of the recordkeeping, suitability, supervision and content requirements for such communications.

The SEC and CFTC are seeking public comment to assist them in conducting a joint study mandated by the Dodd-Frank Act to determine whether stable value contracts (“SVCs”) fall within the definition of the term “swap.”  The Dodd-Frank Act requires the Commissions in making that determination to jointly consult with the DOL, the Treasury, and the state entities that regulate the issuers of SVCs.  If the Commissions determine that SVCs fall within the definition of swap, they must jointly determine if an exemption for SVCs from the definition of swap is appropriate and in the public interest.  Until the effective date of any regulations enacted pursuant to the Commissions’ mandate, and notwithstanding any other provision of the Dodd-Frank Act’s regulatory requirements governing swaps and security-based swaps, those regulatory requirements will not apply to SVCs.  Public comment must be received no later than 30 days after publication of the Commissions’ formal request for comment in the Federal Register.