Financial Services Alert - July 15, 2014

Goodwin Procter’s Business Litigation and Privacy & Cyber Security Practices issued a new edition of their Business Litigation Reporter with timely summaries of key cases and other developments in dedicated Business Litigation sessions and related courts throughout the country.

In a speech presented to the Practicing Law Institute’s Private Equity Forum on June 30, 2014, Norm Champ, Director of the SEC’s Division of Investment Management (the “Division”), discussed the rise of open-end mutual funds pursuing alternative investment strategies that have historically been the province of private funds ( “Alternative Mutual Funds”).  This article focuses on Mr. Champ’s remarks regarding Alternative Mutual Funds, which addressed (1) regulatory issues related to valuation, liquidity, leverage and disclosure, (2) board oversight, and (3) related action by the Office of Compliance Inspections and Examinations (“OCIE”).  Mr. Champ’s remarks also addressed the Division’s Guidance Updates.

Alternative Mutual Funds

Mr. Champ stated that while there is no clear definition of “alternative” in the mutual fund arena, an Alternative Mutual Fund is generally understood to be a mutual fund whose primary investment strategy involves one or more of the following: (1) non-traditional asset classes (e.g., currencies), (2) non-traditional strategies (such as long/short equity positions), and/or (3) illiquid assets (such as private debt).    

Regulatory Issues 

Mr. Champ discussed the manner in which the Division typically sees Alternative Mutual Funds established, stating that either (1) a traditional registered investment company launches its own Alternative Mutual Fund, possibly with one or more private fund managers as sub-advisers, or (2) a private fund manager launches its own registered investment company.  He stated that each of these structures has unique risks associated with it, such as sub-adviser oversight.  However, he stated that the risks associated with valuation, liquidity, leverage and disclosure are common to all Alternative Mutual Funds.

Valuation. Mr. Champ described the requirements for mutual funds to calculate their net asset value under the Investment Company Act of 1940, as amended (the “1940 Act”), noting in particular the obligation to fair value a holding for which market quotations are not “readily available.”  Mr. Champ stated that one key to effective valuation for an Alternative Mutual Fund is to develop and implement robust valuation policies and procedures which address, among other things, the following issues:(1) the requirement that the fund monitor for circumstances that may necessitate the use of fair value pricing, (2) the provision of a methodology by which a fund determines fair value, (3) the process for price overrides, (4) assurance that controls are in place to review, monitor and approve all overrides in a timely manner, and (5) the prompt notification to, and review and approval by, persons not directly involved in portfolio management.

Liquidity.  Mr. Champ observed that there is a close relationship between the liquidity of a holding and a fund’s ability to value that holding, and that having significant holdings that are fair valued (such as may be the case in an Alternative Mutual Fund) may raise liquidity concerns.  Accordingly, he stated that the Division’s staff generally believes that an Alternative Mutual Fund should consider setting criteria for assessing the liquidity of its holdings in its written policies and procedures.  He noted that ultimate responsibility for assessing liquidity rests with a fund’s board, but that the board may delegate the day-to-day performance of that function to the fund’s adviser, provided the board retains sufficient oversight.  Mr. Champ stated that an Alternative Mutual Fund may want to assess the following factors, among others, when determining the liquidity of a particular asset:  (1) the frequency of trades and quotations for the asset; (2) the number of dealers willing to purchase or sell the asset and the number of other potential purchasers; (3) dealer undertakings to make a market in the asset; and (4) the nature of the asset and the nature of the marketplace in which it trades.

Mr. Champ noted that the Division’s January 2014 Guidance Update entitled “Risk Management in Changing Fixed Income Market Conditions” may be helpful in pointing out additional steps to consider when investing fund assets in illiquid assets other than the fixed income securities specifically mentioned in the Guidance Update.  For a discussion of this Guidance Update see the January 21, 2014 Financial Services Alert.

Leverage.  After noting the limitations on borrowing and prohibition on the creation of senior securities applicable to mutual funds under the 1940 Act, Mr. Champ noted that many derivatives transactions present both the benefits and risks associated with leverage and that while derivatives transactions enable a fund to participate in gains and losses in an amount that exceeds the fund’s initial investment, the incurrence of contingent obligations through derivatives could result in significant payment obligations in the future.  Mr. Champ stated that there are additional steps that advisers to Alternative Mutual Funds may want to consider when engaging in derivative transactions, including putting in place a risk management framework linked to their funds’ use of derivatives, which may include assessing the impact of various market conditions on the funds with respect to their use of derivatives.  Mr. Champ noted that the Division continues to study comments received in response to the SEC’s 2011 concept release on the Use of Derivatives by Investment Companies under the Investment Company Act of 1940 (the “2011 Concept Release”) and consider what further action, if any, to be taken.  (For a discussion of the 2011 Concept Release, see the September 6, 2011 Financial Services Alert.) 

Disclosure.  Mr. Champ noted that clear, concise disclosure, particularly concerning a fund’s principal investment strategies and related risks, is important to promote informed investment decisions.  Mr. Champ discussed relevant SEC guidance, including the 2011 Concept Release referenced above, noting that the Division’s staff remains focused on disclosure issues related to Alternative Mutual Funds.  Mr. Champ stated that the Division’s staff generally believes that: (1) all Alternative Mutual Funds should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English; (2) any disclosure of principal investment strategies related to alternative investment strategies generally should be tailored specifically to how an Alternative Mutual Fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance, with appropriate consideration given to the degree of economic exposure an alternative strategy creates in addition to the amount invested in that strategy; (3) the risk disclosure in the prospectus for an Alternative Mutual Fund should provide an investor a complete risk profile of the fund’s investments taken as a whole, rather than a list of various investment strategies, and reflect anticipated alternative investment or asset usage, including material risks relating to volatility, leverage, liquidity and counterparty creditworthiness associated with trading and investments in alternative investment strategies; and (4) an Alternative Mutual Fund should assess on an ongoing basis the completeness and accuracy of alternative investments-related disclosures in its registration statement in light of its actual operations. 

Board Oversight  

Mr. Champ discussed a fund board’s obligation to review and approve the fund’s compliance program, as well as the adviser’s obligation to provide the board with sufficient and appropriate information to execute its statutory and fiduciary obligations.  He stated that a fund’s board should understand these obligations under the 1940 Act, in particular its obligations with respect to review and approval of policies and procedures with respect to valuation, liquidity, leverage and disclosure.  Additionally, Mr. Champ noted that fund boards may want to implement policies and procedures to monitor for conflicts of interests that can affect Alternative Mutual Funds, including those that may arise when an Alternative Mutual Fund’s adviser or sub-adviser is also engaged in “side-by-side” management of a private fund that uses similar investment strategies.

Mr. Champ urged boards to exercise care in naming Alternative Mutual Funds.  He referred to the Division’s November 2013 Guidance Update entitled “Fund Names Suggesting Protection from Loss,” which was discussed in the November 19, 2013 Financial Services Alert.  He also noted that when an Alternative Mutual Fund’s name suggests a focus on a particular type of investment, the fund needs to have a policy to invest at least 80% of its assets in that type of investment.

Related OCIE Activities

The staff of the SEC’s Division of Investment Management issued IM Guidance Update No. 2014-7 (the “Guidance Update”) to provide guidance on how Rule 206(4)-2 under the Investment Advisers Act of 1940 (the “Custody Rule”) applies when private pooled investment vehicles (“private funds”) use special purpose vehicles (“SPVs”) to own one or more assets or use escrow accounts in connection with the sale of a portfolio company.

Four Scenarios for Special Purpose Vehicles

The Guidance Update elaborates on prior SEC statements regarding the alternatives available to an adviser delivering audited financial statements to private fund investors under the Custody rule (the “Audit Provision”) to either (1) treat an SPV as a separate fund client and comply with the audited financial statement requirements for the SPV separately from the owning private fund or (2) treat an SPV’s assets as assets of the owning private fund and include them within the scope of the owning private fund’s audit.  The Guidance Update addresses the following four scenarios:

1. Single Purpose Vehicle:  a private fund client of the adviser invests in an SPV that makes a single investment.
2. Multi-Fund, Single Purpose Vehicle:  two or more of the adviser’s private fund clients invest in an SPV that makes a single investment.
3. Multi-Purpose Vehicle:  two or more of the adviser’s private fund clients invest in an SPV that makes more than one investment.

In these three scenarios, the staff advised that an audit of a private fund that includes the assets of the SPV will satisfy the Audit Provision as long as the SPV has no owners other than the adviser, the adviser’s related person(s) or private fund clients controlled by the adviser or the adviser’s related person(s).

4. Investment Fund SPV:  one or more of an adviser’s private clients invest alongside third parties (such as pooled investment vehicles controlled by other advisers or persons that are not the adviser, the adviser’s related person(s) or pooled investment vehicles controlled by the adviser) in an SPV that makes one or more investments (an “Investment Fund SPV”).

In this scenario, the staff advised that the Investment Fund SPV should generally be treated as a separate client for purposes of the Custody Rule, which would mean, among other things, that the adviser would comply separately with the custody rule’s audited financial statement distribution requirements for the Investment Fund SPV.

Escrow Accounts

The staff noted that the sale of a portfolio company held by a private fund may involve the creation of an escrow account to serve certain limited purposes (such as to hold a percentage of sale proceeds for indemnification purposes or to provide for adjustments to the sale price of the portfolio company).  These accounts typically hold money that belongs to the adviser’s private fund client and to other sellers that are not clients of the adviser. In addition, these accounts are typically held in the name of a “seller’s representative” appointed by the sellers to act on their behalf with respect to the escrow.

The staff advised that it would not object if an adviser maintains client funds in an escrow account with other client and non-client assets, provided that: (1) the client is a private fund as to which the adviser relies on the Audit Provision, and the portion of the escrow attributable to the private fund is included in its financial statements; (2) the escrow is in connection with the sale or merger of a portfolio company owned by the client (i.e., for indemnification or to adjust the purchase price); (3) both the amount of money held in escrow and the length of time it is held are agreed upon as part of a bona fide negotiation between the buyer and the sellers; (4) the escrow is maintained at a qualified custodian; and (5) the seller’s representative is contractually obligated to promptly distribute, based on a predetermined formula, the money remaining in escrow at the end of the escrow period to the sellers, including the private fund clients.