Financial Services Alert - January 8, 2008 January 08, 2008
In This Issue

Goodwin Procter to Host Webinar: “The Rise of ERISA Litigation and its Impact on Collective Trusts” – 2/7/2008 at Noon (Eastern Standard Time)

Goodwin Procter will host a free one hour webinar at noon (EST) on February 7, 2008 that will address the recent waves of ERISA litigation and related regulatory investigations – particularly those involving collective trusts and allegations of excessive fees charged by service providers, in addition to “stock drop” cases (as discussed in the December 25, 2007 and January 1, 2008 Alerts).  Goodwin Procter litigators will also share their views on the trends of these areas of litigation and discuss steps that financial service firms can take now to prevent, or at least defend against, these kinds of regulatory investigation or litigation.

  • Hosted by Gregory Lyons, Chair, Goodwin Procter Financial Services practice group
  • Speakers include Goodwin Procter partners Jack Cleary and James Fleckner

FINRA Proposes to Delay Effective Date for Principal Review and Approval Provisions of New Variable Annuity Sales Rule

The Financial Industry Regulatory Authority (“FINRA,” formerly the NASD) has proposed to delay the effective date of certain provisions of new NASD Rule 2821, which establishes new suitability, supervisory and training requirements for sales and exchanges of deferred variable annuities.  The rule’s requirements were summarized in the September 18, 2007 Alert.  As reported in the November 20, 2007 Alert, FINRA initially set May 5, 2008 as the effective date for Rule 2821.  In Release No. 34‑57050 (Dec. 27, 2007) (the “Proposing Release”), the SEC announced that FINRA is proposing to delay the effective date of the principal review and approval requirements in Rule 2821(c) until August 4, 2008.  (FINRA is not proposing to change the May 5, 2008 effective date for the remainder of the rule.)  The Proposing Release notes that in response to concerns expressed by affected firms after the announcement that the principal review and approval requirements had been adopted, FINRA determined it would be prudent to give further consideration to Rule 2821(c).  Some of the industry concerns described in the Proposing Release were as follows:

  • whether the seven business day review beginning with signature of the application is the appropriate review period;
  • whether broker-dealers that do not make any recommendations to customers should be subject to the principal approval requirements; and
  • whether insurance companies should be permitted to deposit customer funds in a suspense account prior to the completion of principal review.
The Proposing Release indicates that if, based on its review, FINRA concludes that further rulemaking is warranted, it will file a separate rule change proposal with the SEC.  Comments on FINRA’s proposal to delay Rule 2821(c)’s effectiveness and on the issues discussed in the Proposing Release are due no later than January 24, 2008.

Federal District Court Dismisses Mutual Fund Excessive Fee Litigation

The US District Court for the Southern District of New York (the “Court”) dismissed a lawsuit filed by mutual fund shareholders against the funds’ affiliated investment advisers and distributor.  Plaintiffs alleged defendants breached their fiduciary duty to shareholders under the Investment Company Act of 1940, as amended (the “1940 Act”), by charging excessive fees.  The federal district court characterized the lawsuit as an attempt to reconfigure allegations contained in prior complaints, after noting that substantially the same counsel for plaintiffs had represented shareholders in two previous analogous cases in which defendants had similarly prevailed.  In re Scudder Mut. Funds Fee Litig., No. 04 Civ. 1921 (DAB), 2007 WL 2325862 (S.D.N.Y. Aug. 14, 2007), and In re Evergreen Mut. Funds Fee Litig., 240 F.R.D. 115 (S.D.N.Y. Feb. 5, 2007).  The Court’s decision came on a motion under Rule 12(b)(6) of the Federal Rules of Civil Procedure by the defendant advisers and distributor that the suit be dismissed on the grounds that the plaintiffs’ allegations in the complaint failed to state any claim on which the Court could grant relief.

The Shareholders’ Allegations.  Plaintiffs alleged defendants breached their fiduciary duty under Section 36(b) of the 1940 Act by charging fees which were disproportionate and not reasonably related to the services for which the fees were charged.  The claims related to investment advisory, Rule 12b-1, transfer agency, and administrative fees.  Section 36(b) provides that an investment adviser has a fiduciary duty to shareholders with respect to the receipt of compensation for services by the adviser and its affiliates.  Among other things, plaintiffs alleged that (a) defendants failed to reduce fees in line with the economies of scale created by the funds’ growth, (b) the funds’ poor performance as compared to that of other mutual funds revealed shareholders did not receive superior investment advice in exchange for higher fees paid, and (c) defendants used the higher fees to offset revenue-sharing payments (payments made to broker‑dealers selling the funds in order to receive preferential treatment in one or more aspects of the broker‑dealers’ selling programs). 

The Court’s Gartenberg Analysis.  In granting defendants’ motion to dismiss, the Court applied the Gartenberg factors as interpreted by the Federal Court of Appeals for the Second Circuit in a 2006 decision affirming a district court’s dismissal of an attempted Section 36(b) suit under Rule 12(b)(6) for failure to state a claim.  Amron v. Morgan Stanley Investment Advisors, Inc. 464 F.3d 338 (2d Cir. 2006) (“Amron”).  (The Gartenberg factors used by the courts in deciding Section 36(b) suits were identified by the Second Circuit in a 1982 decision as the appropriate considerations for determining whether a Section 36(b) violation has occurred, i.e., whether a fee “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.”  Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923, 928 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983).)  The Court examined the facts alleged by the plaintiffs with respect to each Gartenberg factor under the pleading requirements enunciated in Amron and found plaintiffs’ complaint did not meet the requisite standard for any factor.

Nature and Quality of the Services Provided - Although plaintiffs claimed that the performance of the funds was below that of others in the industry, the Court noted performance is but one measure of services provided, and plaintiffs failed to allege any deficiencies with respect to other services provided to fund shareholders, including, for example, telephone assistance or transaction-related services.  In finding that the plaintiffs had failed to satisfy this factor, the Court cited Amron’s holding that facts simply alleging underperformance without more were insufficient to satisfy the first Gartenberg factor.

Profitability of the Mutual Fund to the Adviser-Manager - Plaintiffs alleged the funds were extremely profitable to defendants, citing the net income shown in the defendants’ parent’s financial statements for its asset management business.  Plaintiffs made further broad allegations regarding profitability in the mutual fund industry in general.  The Court observed that it was not clear what portion of the parent’s profits were attributable to the fees that were the subject of the complaint.  In finding that the plaintiffs had not met their burden of pleading on the second Gartenberg factor, the Court cited Amron’s holding that allegations regarding high fees were irrelevant to the issue of profitability without facts regarding fund operating costs.  The Court also stated that the complaint’s industry-wide commentary regarding profitability was akin to the kind of non-specific allegations the Amron court had found insufficient to withstand a motion to dismiss.

Fall-Out” Benefits to the Adviser. - The Court determined plaintiffs’ allegations regarding “fall-out” benefits received by the defendants from directed brokerage, soft dollar payments and transfer agency fees essentially focused on the propriety of those fees as opposed to their amount, as to which the plaintiffs made no allegations.  The Court characterized the test under Section 36(b) as basically an economic one where the improper use of fees is not excessive per se.  The Court went on to hold that the plaintiffs had not met their burden of pleading under this Gartenberg factor, because absent any information as to the size of fees used to generate “fall-out” benefits, mere allegations of impropriety did not satisfy this factor. 

Economies of Scale – On this factor as well as on the profitability factor, the Court focused on plaintiffs’ failure to allege any facts relating to the costs of operating the funds.  The Court held that allegations of the size of the funds and their rates of growth were insufficient to satisfy this factor as were plaintiffs’ general allegations regarding theoretical economies of scale.  The Court stated that Amron had made clear that in order to allege facts sufficient to satisfy this factor, a plaintiff must include facts relating to the costs of performing fund transactions or facts regarding the relationship between such costs and the number of transactions performed. 

Comparative Fee Structures - In assessing plaintiffs’ allegations that the funds’ expense ratios were higher than those of other funds with similar objectives, the Court cited Amron’s position that whether a mutual fund has a higher fee than another fails to raise sufficient suspicion under this factor and the fact that similar allegations by the plaintiffs in Amron were found inadequate. 

Independence and Conscientiousness of the Trustees - Plaintiffs claimed the directors suffered from a lack of experience and likely were not able to devote the time necessary to oversee the number of funds in their charge.  The Court characterized these allegations as conclusory and insufficient as a matter of law.   Citing Amron, the Court also concluded that the plaintiffs’ allegations failed to overcome the 1940 Act’s “express presumption that ‘mutual fund trustees and natural persons who do not own 25% of [a fund’s] voting securities are disinterested.’”  (It is worth noting that an “interested person” analysis under the 1940 Act definition of that term is substantially broader than this statement in the Court’s opinion and its predicate in Amron would suggest; in particular, any such analysis would address issues such as a trustee’s ownership or other interests in, or relationships with the adviser, the distributor or their parent companies.)

On the basis of the foregoing, the Court dismissed the plaintiffs’ complaint with prejudice.

OCC and FRB Provide Guidance Concerning Risk-Based Capital Treatment for Synthetic Securitizations

The OCC and FRB released a joint interpretive letter (the “Joint Letter,” OCC Letter #1091), examining the risk-based capital treatment of certain synthetic securitizations of home equity lines of credit and home equity loans.  In the case of the described synthetic securitization, the bank regulators stated that the arrangement generally qualified for the risk-based capital treatment described in earlier issuances from the regulators.  (See, Joint Agency Guidance on Synthetic Collateralized Loan Obligations, OCC Bulletin 99-43, FRB SR Letter 99-32; Capital Treatment of Recourse, Direct Credit Substitutes, and Residual Interests in Assets Securitizations, 66 Fed. Reg. 59,613 (Nov. 29, 2001) (“Capital Rule”); OCC Letters # 945 (Nov. 2002) & 988 (Apr. 2004); FRB Letter (July 14, 2005)).  For externally-rated retained subordinated and senior positions held by the bank that complied with the requirements outlined in the earlier agency guidance, the bank was permitted to apply risk-based capital formulas.  Where the bank retained an unrated equity position, the bank was required to hold dollar-for-dollar capital against that position.

The Joint Letter notes that eligibility of externally-rated positions for risk-based capital treatment is determined by the Capital Rule issued by the federal banking regulatory agencies in 2001.  The external ratings must come from at least two nationally recognized statistical rating organizations and be based on the same criteria used to rate traded positions.  If the ratings criteria are met, required capital will be determined based on the risk weight of the assets. 

In the situation described in the Joint Letter, the maturity of the synthetic securitization would occur prior to the maturity of the reference assets.  As a result, the bank was permitted to apply lower risk weights to only a portion of the outstanding notional value of certain trances near the end of the arrangement.

FDIC Board of Directors Votes to Amend Statement of Policy on Bank Merger Transactions

The Board of Directors of the FDIC voted to amend the FDIC’s Statement of Policy on Bank Merger Transactions (the “Statement”).  The Statement provides guidance to the public and the banking industry on bank merger applications to the FDIC. 

The Statement, as amended (the “Amended Statement”), reflects changes to the Bank Merger Act made by the Financial Services Regulatory Relief Act of 2006 that: (1) eliminated the need for the FDIC to obtain a competitive factors report from the other three Federal banking agencies in processing a merger application; and (2) eliminated both the post-approval Department of Justice waiting period and the need to obtain competitive factors reports, when the proposed merger solely involves an insured depository institution and one or more of its affiliates.

The Amended Statement also reflects the merger of the Bank Insurance Fund (“BIF”) and the Savings Association Insurance Fund (“SAIF”) into the FDIC’s Deposit Insurance Fund pursuant to the Federal Insurance Reform Act of 2005.  In a related change, the Amended Statement deletes all discussion of Oakar transactions (mergers involving a member of BIF and a member of SAIF).

In addition to certain technical amendments, the Amended Statement adds text to reflect that in evaluating a merger transaction, the FDIC must consider the effectiveness of merging insured depository institutions (including their respective overseas branches) in combating money-laundering activities.

The Amended Statement will become effective upon its publication in the Federal Register.

SEC Publishes Rand Broker-Dealer/Investment Adviser Report

The SEC made available the report it commissioned from the Rand Corporation to examine (a) investment advisers’ and broker-dealers’ practices in marketing and providing financial products and services to individual investors, and (b) investors’ understanding of the differences between investment advisers’ and broker-dealers’ financial products and services, duties and obligations.  The SEC began the process of commissioning the report in connection with its 2005 adoption of rule amendments addressing the application of the Investment Advisers Act  to broker-dealers offering certain types of brokerage programs.  Following a March 2007 decision of the Court of Appeals for the D.C. Circuit that overturned that rulemaking (as discussed in the April 10, 2007 Alert), the SEC accelerated the report’s delivery date to December 31, 2007, three months earlier than originally scheduled.  The SEC has indicated that it expects the report to inform its ongoing consideration of the appropriate regulatory regimes for the broker-dealer and adviser industries.