Financial Services Alert - November 19, 2013

The U.S. Court of Appeals for the Second Circuit affirmed the dismissal on a motion for summary judgment of a derivative suit against the independent trustees of a mutual fund group in which the plaintiff shareholder alleged that the trustees had breached their fiduciary duty in approving new advisory agreements for the funds with the funds’ adviser following its sale.  The Second Circuit’s decision follows seven years of litigation encompassing five prior court decisions – two from the U.S. District Court for the Southern District of New York, two decisions from the Second Circuit, and one from the Supreme Judicial Court of Massachusetts (the “SJC”) addressing a question of Massachusetts law certified by the Second Circuit.

Prior Decisions.  The shareholder originally filed the complaint in 2006 in the District Court, having previously made demand on the trustees.  The independent trustees had begun, but not completed, an investigation into the demand’s allegations at the time the suit was filed.  Upon completing their investigation, the independent trustees rejected the shareholder’s demand. The District Court subsequently dismissed the complaint on the grounds that the trustees were independent and had rejected the demand, and that dismissal was therefore required under the Massachusetts statutory codification of the business judgment rule, which it applied to the funds by virtue of their organization as series of a Massachusetts business trust.  The shareholder appealed to the Second Circuit, which in late 2009 certified a question to the SJC regarding the effect under the statutory codification, if any, of the timing of the rejection of demand relative to the commencement of a lawsuit.  In 2010, the SJC ruled that under the Massachusetts codification a corporation may rely on the business judgment rule to obtain dismissal of derivative litigation regardless of whether the demand is rejected before or after commencement of the lawsuit, and clarified that the derivative suit provisions in the Massachusetts statute apply not only to Massachusetts corporations, but also to Massachusetts business trusts, a form of organization used by many mutual funds.  (The SJC decision was discussed in the August 31, 2010 Financial Services Alert.)  In 2011, the Second Circuit remanded the case to the District Court, on the ground that the District Court should have converted the motion to dismiss into a motion for summary judgment.  On remand in 2012, the District Court granted summary judgment in favor of the independent trustees.

Current Decision.  In its most recent appeal to the Second Circuit, the plaintiff argued that material disputes about the trustees' independence precluded summary judgment.  The Second Circuit rejected all of the plaintiff's arguments and held that none of (i) the trustees’ approval of various fund practices that the plaintiff deemed questionable, (ii) the trustees' receipt of substantial compensation for their board service, (iii) the trustees' investigation of their own conduct in response to the shareholder demand, or (iv) the naming of the trustees themselves as defendants cast doubt on the trustees' independence when they rejected the demand.

Halebian v. Berv, 2013 WL 5977962 (2d Cir. Nov. 12, 2013)(summary order).

Goodwin Procter represented the business trust and its independent trustees.

The OCC issued guidance (the “Guidance,” OCC Bulletin 2013-33) that establishes standards that the OCC will use when it requires national banks, federal savings associations or federal branches or agencies (collectively, “Banks”) to employ independent consultants to comply with an enforcement action involving the applicable Bank’s alleged significant violations of law, fraud, or harm to consumers.  In a statement accompanying the Guidance, Comptroller of the Currency Thomas J. Curry stressed that:

 “…while consultants can provide knowledge, expertise and additional resources, [the OCC] must take care to ensure they maintain independence and are subject to appropriate oversight.  The standards [the OCC is] publishing today help [the OCC] achieve those important objectives while ensuring that a consultant’s conclusion is never substituted for the OCC’s supervisory oversight.”

Moreover, the OCC cautioned in the Guidance that a Bank’s use of an independent consultant does not absolve the Bank’s management or board of directors of their responsibility to see that “all needed corrective actions are identified and implemented.”

OCC Assessment of Need for Bank to Retain Independent Consultant in Enforcement Action

The OCC stated in the Guidance that in assessing whether it will require a Bank to retain an independent consultant in an enforcement action, it will consider the following seven factors, among others:

• the severity of the violations (including their impact on consumers, the Bank and others);
• the criticality of the function requiring remediation;
• the OCC’s confidence that Bank management has the ability to identify and correct violations in a timely manner;
• whether the Bank has the expertise, staffing and resources necessary to take the required corrective actions;
• the actions already taken by the Bank to correct the violations or address the problematic issues;
• the type of services the independent consultant would provide; and
• the available alternatives to the engagement of an independent consultant.

OCC Review of the Consultant Proposed by the Bank

If the OCC determines that it will require a Bank to hire an independent consultant in connection with an enforcement order, it will require the Bank to submit information to the OCC regarding the due diligence that the Bank has conducted regarding the independent consultant it proposes to retain.  In particular, the OCC will seek information concerning the qualifications, independence, resources, expertise, capacity, reputation, information security and document security practices, risk management and reporting, conflicts of interest and financial viability of the proposed independent consultant.  The Bank would also be expected to disclose to the OCC professional disciplinary actions, if any, taken against the proposed independent consultant.  In assessing the independence and level of objectivity of the proposed independent consultant, the OCC expects that a Bank’s submission to the OCC in support of a proposed independent consultant will address, among other things:

• the scope and volume of other contracts or services provided (or previously provided) by the independent consultant to the Bank;
• whether the Bank evaluated other independent consultants with the required specialized expertise and level of independence;
• whether the Bank proposed any mitigating actions to address any potential conflict of interest (or the appearance of a conflict of interest);
• the amount of the fees to be paid by the Bank to the independent consultant (and any other financial relationship between the Bank and the proposed independent consultant);
• any business or personal relationship of the independent consultant (or its employees) with a board member or executive officer of the Bank;
• whether a member of the independent consultant’s staff has previously been employed by the Bank; and
• other relevant facts and circumstances.

The Guidance also states that, in reviewing the use of a proposed independent consultant, the OCC will evaluate the terms of the Bank’s proposed engagement contract with the independent consultant (and the work plan suggested by the independent consultant) to determine whether the contract and work plan are consistent with the requirements of the OCC’s enforcement action.  The Guidance states that a Bank should ensure that the engagement contract with the independent consultant provides that the independent consultant will:

• comply with applicable laws and regulations (including those concerning privacy, customer information security and the confidentiality of non-public OCC correspondence and information);
• maintain complete records;
• make all work papers, analyses, drafts and reports available to the OCC (upon the OCC’s request);
• bring to the OCC’s immediate attention disagreements with the Bank about material matters;
• base its conclusions and recommendations on its own independent and expert judgment; and
• provide a final report to the board of directors.

The Guidance also provides that the engagement contract with the independent consultant must:

• identify ongoing requirements concerning reporting by the independent consultant and require that the independent consultant meet these requirements;
• provide that the OCC may meet or discuss matters privately with the OCC;
• provide that the OCC must approve in writing any material modifications to the contract, work plan or staffing;
• provide that the proposed subcontracting of any work be subject to the OCC’s determination that it has no objection to the proposal; and
• provide that the engagement contract shall be terminated by the Bank if so requested by the OCC “without any objection or right of appeal by the consultant.”

The OCC’s Oversight of the Consulting Engagement

In overseeing a consultancy engagement, the Guidance states that the frequency of the OCC’s interactions with the Bank and the independent consultant will depend upon the facts and circumstances of the matter, the Bank management’s expertise and resources, the nature of the independent consultant’s assignment, and the timeline for completion of the consultancy engagement.  Furthermore, the extent and frequency of the OCC’s monitoring of the consultancy will also reflect the scope and direction of the consultant’s engagement, the nature of the deficiencies or violations that the independent consultant will seek to identify (and with respect to which it will be expected to recommend appropriate remedial actions), and the potential harm (and the materiality of such harm) to consumers and the Bank.

As part of the OCC’s assessment of the Bank’s compliance with the enforcement action, the OCC will review the independent consultant’s final written report of findings and recommendations.  The OCC’s review helps it to determine whether all matters for which the independent consultant was engaged were addressed.  If the OCC is not satisfied, it may request that additional work be performed by the Bank or the consultant.  After the final written report has been reviewed by the Bank’s board of directors and the OCC, the Bank is expected to prepare a plan to address the consultant’s findings and to implement the board of directors’ responses to those findings.  The plan, states the Guidance, should be approved by the Bank’s board of directors and is “subject to OCC review and a written determination of supervisory no objection [by the OCC] before [it] can be implemented.”  As part of the OCC’s review, it will consider whether the Bank’s corrective actions will be sustainable.

The National Futures Association (the “NFA”) issued Notice to Members I-13-36 (the “NFA Notice”) which is directed at any commodity pool operator (“CPO”) of a registered investment company (a “RIC”) that has filed a notice with the CFTC claiming the relief provided under CFTC No-Action Letter 13-51.  In general terms, CFTC No‑Action Letter 13-51 allows the CPO of a RIC that trades commodity interests through a wholly-owned subsidiary (known as a controlled foreign corporations (“CFC”)) to report for the RIC and the CFC on a consolidated basis when complying with financial reporting requirements under CFTC Regulations 4.22(c) (Annual Report Filing with the NFA) and 4.27(c) (Reports on Form CPO-PQR).  CFTC No-Action Letter 13-51 is discussed in greater detail in the September 10, 2013 Financial Services Alert.  Under the NFA Notice, any CPO that has filed a notice of claim under CFTC No-Action Letter 13-51 must notify the NFA of the notice filing on or before December 31, 2013.   Prior to notifying the NFA of a notice filing, a CPO must ensure that the RIC and its related CFC(s) have been properly identified to the NFA through the Annual Questionnaire available on NFA's website.  Failure to notify the NFA of reliance on CFTC No‑Action Letter 13-51 will result in a CPO receiving calls for financial reports that may not be necessary.

The Staff of the SEC’s Division of Investment Management issued IM Guidance Update 2013-12 in which the Staff “encourages investment advisers and funds’ boards of directors to carefully evaluate any fund name that suggests safety or protection from loss and to consider whether a name change is appropriate to address any potential for investor misunderstanding.”  The IM Guidance Update reflects the Staff’s determination to “object to names that may create an impression of protection or safety or absence of risk of loss, where the name does not include qualifying language that defines the scope and limits of such protection.”  As a consequence, during the disclosure review process, the Staff has requested that some existing and new funds change their names.  The Staff’s concerns articulated in the IM Guidance Update focus on two particular types of funds that include “protected” in their names:

• managed volatility funds – these funds seek to manage volatility by investing a portion of their assets in cash, short-term fixed income instruments, short positions on exchange-traded futures, or other investments.  The Staff’s concern is that the funds’ names may be misleading because “the degree to which a managed volatility strategy may succeed or fail is uncertain.”   Some managed volatility funds have addressed the Staff’s concern by replacing the term “protected” in their names with terms such as “managed risk.”
• funds with third party contractual protections for NAV – these funds enter into contracts with a third party to make up a shortfall in fund net asset value.   The Staff’s concern is focused on (a) ways in which contractual protections may be limited, such as through provisions that (i) cap the amount of protection, (ii) limit the time period during which third party’s obligation exists, or (iii) terminate the third party’s obligation under certain circumstances in certain scenarios, and (b) the credit risk associated with a third party provider.  To date, the Staff has not identified any fund names using the term “protected” in these circumstances that adequately communicate the limitations of the third party protection.

The IM Guidance notes that the Staff has requested name changes in situations where a fund’s prospectus explains limitations on loss protection not reflected in the fund’s name because the Staff believes that ”in practice, investors sometimes focus on a fund’s name to determine the fund’s investments and risks, either because the name sometimes appears without the clarifying prospectus disclosures (e.g., in advertisements) or because of the prominence of a fund’s name or for other reasons.”