Financial Services Alert - January 8, 2013

A New Jersey federal court recently denied an investment adviser’s motion to dismiss an action brought by a shareholder in six mutual funds, asserting claims for excessive management fees in violation of Section 36(b) of the Investment Company Act of 1940 (“ICA”).  However, the court dismissed without prejudice Plaintiffs’ claims for excessive Rule 12b-1 distribution fees.

Excessive Management Fee Claim.  Plaintiffs claim that the fees charged by the funds’ investment adviser are excessive to the extent that they exceed the fees the adviser paid to the funds’ sub-advisers, on the ground that the sub-advisers allegedly perform most of the investment management services for the funds.  Plaintiffs further allege that adviser’s management fees are excessive as compared to fees charged by the adviser’s competitor, Vanguard, and fees charged by the adviser to its institutional clients.

The court dismissed Plaintiffs’ prior complaint because Plaintiffs’ assertion that the management fees were excessive in comparison to the sub-advisory fees were “conclusory and unsupported,” but allowed Plaintiffs to amend their allegations.  The court noted that Plaintiffs’ amended complaint now includes “eight additional pages and multiple tables” detailing the investment management services provided by the adviser and the sub-advisers to the funds and the overlap between the two, and asserts that the adviser charges the funds anywhere between three to five times the amount the adviser pays its sub-advisers for “substantially the same services.”  Specifically, Plaintiffs now allege that the investment management services provided by the sub-advisers represent “the most expensive and important services required” by the funds’ investment management agreement, and that any additional supervisory functions performed by the adviser were insignificant and were covered by separate service agreements that compensated the adviser.  The court declined to consider the adviser’s argument that it provides the funds with extensive administrative and investment management services that are not delegated to the sub-advisers, concluding that such an argument goes to the merits of the case and is more appropriate for summary judgment. 

The court further held that the amended complaint sufficiently “beefs up” Plaintiffs’ allegations that Vanguard effectively charges management fees that are 50 times less than those charged by the adviser.  While it acknowledged other courts’ conclusions that comparisons to Vanguard – a not-for-profit entity that markets itself as a low-cost mutual fund provider – generally are of little value, the court gave some limited weight to such a comparison in this context because the adviser and Vanguard used the same sub-adviser.  The court also held that Plaintiffs’ comparison of the adviser’s fees charged to one of the funds at issue and the fees it charged to two of its institutional clients were sufficiently detailed to survive a motion to dismiss, but had probative value only as to that one fund. 

Although not addressed in the adviser’s motion to dismiss, the court considered additional allegations relating to the Section 36(b) analysis.  The court found that Plaintiffs adequately pleaded that the adviser failed to share with them any meaningful benefits from the economies of scale enjoyed by the funds because the adviser’s “breakpoints” – the point at which a fee rate decreases when net assets increase – were set too high and spaced too far apart when compared to the breakpoint schedule for fees paid to the sub-adviser.  The court also stated that the allegations created an inference that the board may not have considered important facts in approving the management fees.  Lastly, the court found that the adviser’s profitability in retaining approximately $100 million of the $150 million in management fees for allegedly providing “minimal supervisory services” to the funds weighed in favor of sustaining Plaintiffs’ claims at this early pleadings stage. 

Excessive Rule 12b-1 Distribution Fee Claims.  Plaintiffs alleged that charging Rule 12b-1 distribution fees and front-end sales loads to shareholders who owned Class A fund shares was duplicative and therefore excessive.  The court dismissed this claim without prejudice, noting that the SEC has recognized that charging both fees is customary and that Plaintiffs lacked any other substantive basis for their “sparse and conclusory” claim.  The court also dismissed without prejudice Plaintiffs’ claims concerning the distribution fees charged to Class B shares, holding that Plaintiffs lacked standing to assert those claims because none of them owns Class B shares.

Kasilag v. Hartford Investment Financial Services, LLC, Civil No. 11-1083 (D.N.J. Dec. 17, 2012).

The OCC has issued guidance (the “Guidance”) relating to the transition period for compliance with Section 716 of the Dodd-Frank Act, known as the “Swaps Push-Out Rule.”  The OCC stated in the Guidance that it would consider favorably requests for a transition period from insured depository institutions that are, or may become, subject to the Swaps Push-Out Rule.  The Swaps Push-Out Rule prohibits providing federal assistance, such as federal deposit insurance or access to the discount window, to swaps entities, including federal depository institutions that are swap dealers.  Further, the Swaps Push-Out Rule provides for an appropriate transition period for insured depository institution swap entities to divest or cease nonconforming swap activities.  The effective date for the Swaps Push-Out Rule is July 16, 2013.

The Guidance states that the prohibition on federal assistance does not apply during the transition period.  Further, the Guidance provides that the transition period, which begins on the effective date, initially may be up to 24 months, as determined by the insured depository institution’s appropriate federal banking agency in consultation with the CFTC and the SEC. The appropriate federal banking agency, after consulting with the CFTC and SEC, may extend the transition period for up to one additional year.

Written requests for transition periods must be submitted by January 31, 2013.  The Guidance requires each request to be written and specify the transition period appropriate to the institution, up to a two-year transition period commencing from July 16, 2013.  The request must also outline how the institution plans to comply with the Swaps Push-Out Rule and how the transition period would mitigate adverse effects on the institution. 

On December 26, 2012, the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) issued FinCEN Notice 2012-2 (the “Notice”), extending until June 30, 2014  the date for filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (“FBAR”), by certain individuals with signature or other authority only over certain foreign financial accounts.  The Notice further extends the deadlines that were previously extended pursuant to several prior Notices (the “Prior Notices”), as discussed in the February 21, 2012 Financial Services Alert.  In the Notice, FinCEN stated that it was further extending the deadlines in the Prior Notices in light of ongoing consideration of questions regarding the filing requirement and its application to such individuals.

Individuals Covered by the Prior Notices

FinCEN Notice 2012-2 relates to certain exceptions provided in the Final Rule issued by FinCEN that went into effect on March 28, 2011.  (The Final Rule was discussed in the March 1, 2011 Financial Services Alert.)  In particular, the Final Rule provides filing relief in the form of exceptions for certain officers and employees with signature or other authority over, but no financial interest in, a foreign financial account owned or maintained by an entity described in 31 CFR §§1010.350(f)(2)(i)-(v) of the Final Rule (a “specified entity”) that is the employer of the excepted officer or employee.  Notice 2012-2 and the Prior Notices provide relief to individuals described in the following two categories:  (1) an employee or officer of a specified entity who has signature or other authority over and no financial interest in a foreign financial account of a “controlled person” of the entity; or (2) an employee or officer of a “controlled person” of a specified entity who has signature or other authority over and no financial interest in a foreign financial account of the entity, the “controlled person,” or another “controlled person” of the entity.  For this purpose, a “controlled person” means a United States or foreign person more than 50 percent owned (directly or indirectly) by a specified entity.

Notice 2012-2 and the Prior Notices also provide administrative relief in the case of officers and employees of investment advisers registered with the Securities and Exchange Commission (the “SEC”) with signature or other authority over, but no financial interest in, foreign financial accounts of persons that are not registered investment companies.  (These individuals are not covered by the exception in §101.350(f)(2)(iii) of the Final Rule for officers and employees of Authorized Service Providers who have signature or other authority over, but no financial interest in, a foreign financial account owned or maintained by an investment company that is registered with the SEC.)

Extension Provided by the Notice

The extension until June 30, 2014 in the Notice applies to FBARs that would have been due on June 30, 2013 for the reporting of signature authority held during the 2012 calendar year, as well as the reporting of signature authority held in prior years for which the deadlines were previously extended by the Prior Notices.  For all other individuals with an FBAR filing obligation, the filing due date remains unchanged.

The CFTC’s Division of Swap Dealer and Intermediary Oversight (the “Division”) has issued an additional no-action letter (the “New No-Action Letter”) permitting foreign-owned U.S. banks to exclude the swap activity of their foreign affiliates, or the U.S. branches of such affiliates, from the calculations of swap activity for purposes of the de minimis exception included in the definition of “swap dealer.” The relief follows a previous no-action letter (the “Previous No-Action Letter”) issued on December 20, 2012 (discussed in the December 26, 2012 Financial Services Alert).  The CFTC press release accompanying the New No-Action Letter explained that the New No-Action Letter extends the relief provided in the Previous No-Action Letter “to foreign-owned U.S. banks with differing ownerships structures, including state-chartered banks regulated by the Federal Reserve or the Federal Deposit Insurance Corporation.”

Conditions.  Relief is conditioned on satisfaction of a number of requirements.  For example, the bank must be wholly owned, directly or indirectly, by a foreign entity that is registered with the CFTC as a swap dealer; an entity that directly or indirectly owns the U.S. bank must be registered with and subject to oversight and supervision by the Federal Reserve as a bank holding company and must file its financial statements with either the SEC or the Federal Reserve; no swap obligations of the foreign-owned U.S. bank may be guaranteed or otherwise supported by its foreign affiliates; and the foreign-owned U.S. bank must not rely on its foreign affiliates for operational servicing of its swaps business and must make its own credit determinations with respect to its swaps activities. 

Broader Relief.  The relief in the New No-Action Letter is generally somewhat broader than that provided in the Previous No-Action Letter.  For example, the Previous No-Action Letter provided relief only to foreign-owned U.S. banks whose “direct parent entity” is a financial holding company that files its financial statements with the SEC.  The New No-Action Letter, in contrast, provides relief to foreign-owned U.S. banks for which a direct or indirect owner is a bank holding company (a broader category than that of “financial holding company”) that files its financial statements with either the SEC or the Federal Reserve. 

Claiming Relief.  Banks wishing to avail themselves of the relief must e-mail certain information to the CFTC.  The process for doing so is the same under the New No-Action Letter as under the Previous No-Action Letter.  Banks that have already submitted a claim of relief under the Previous No-Action Letter may wish to make a similar submission explicitly claiming relief under the New No-Action Letter as well, in case their situation changes in the future such that they no longer qualify under the Previous No-Action Letter but continue to qualify under the New No-Action Letter.  Those that have not yet claimed the relief may wish to explicitly refer to the New No-Action Letter to clarify their claim under the New No-Action Letter’s broader provisions.