Financial Services Alert - November 2, 2010 November 02, 2010
In This Issue

Federal District Court Dismisses Amended Complaint in Derivative Suit Based on Alleged Unlawfulness of Asset-Based Rule 12b-1 Payments by Mutual Fund Distributor to Selling Broker-Dealers

The U.S. District Court for the Northern District of California granted a motion to dismiss the amended complaint in a derivative suit brought by a mutual fund shareholder against the fund’s distributor and trustees alleging (a) a violation of Section 47(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), by the distributor, and (b) state law claims of (i) breach of contract by the distributor, (ii) breach of fiduciary duty by the defendant trustees, and (iii) waste of fund assets by the defendant trustees.  Section 47(b) provides that “[a] contract that is made, or whose performance involves, a violation of [the 1940 Act], or of any rule, regulation, or order thereunder, is unenforceable by either party . . . unless a court finds that under the circumstances enforcement would produce a more equitable result than nonenforcement and would not be inconsistent with the purposes of [the 1940 Act].” 

The suit claimed that because the fund’s Rule 12b-1 payments to brokers to sell and service fund shares are calculated on the fund’s net asset value, such asset-based compensation constitutes “special compensation” with respect to brokerage accounts and is unlawful under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  Plaintiff based his theory on a decision in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), which overturned a new SEC rule but did not address Rule 12b-1 payments.  He further alleged that the trustees’ malfeasance and/or failure to exercise adequate oversight in approving that compensation violated their duties under the 1940 Act, including Rule 38a-1 under the 1940 Act (which is the compliance program rule for registered funds).  In June 2010, the court granted defendants’ motion to dismiss the complaint, but allowed leave to amend the Section 47(b) claim.  For more detail on Plaintiff’s theory and the court’s prior decision, see the June 15, 2010 Alert.

The court granted the defendants’ motion to dismiss the amended complaint with prejudice as to the Section 47(b) claim.  Consistent with its prior decision, the court found that a claim under Section 47(b) could not be sustained because the plaintiff had failed to allege predicate violations of the 1940 Act under either Section 36(a) or Rule 38a-1.  The court noted that Section 36(a) does not create a federal fiduciary duty or regulate the improper use of fund assets, nor does it provide a right of action for such claims, but rather authorizes the SEC to file a breach of fiduciary duty action.  The court also stated that Rule 38a-1 does not impose on funds a duty to ensure that broker-dealers comply with registration requirements.  Having dismissed the Section 47(b) claim, the court declined to exercise supplemental jurisdiction over the state law claims, and dismissed them without prejudice to re-filing in state court.  Smith v. Franklin/Templeton Distributors, No. C 09-4775 PJH (N.D. Cal. Oct. 22, 2010)

Goodwin Procter LLP represented the independent trustees in this proceeding.

DOL Issues Final Regulation on Disclosure Requirements for Participant-Directed ERISA Plans

The Department of Labor (the “DOL”) issued a final regulation (the “Final Regulation” or “Regulation”) under Section 404(a) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  The Regulation sets forth fiduciary requirements for disclosure to participants in individual account plans that provide for the direction of investments by participants (e.g., most so-called 401(k) plans).  The Regulation was initially proposed in July 2008 and was discussed in the July 29, 2008 Alert.  The Final Regulation will apply for plan years beginning on or after November 1, 2011.

Scope of the Regulation

The Final Regulation generally applies to all participant-directed individual account plans subject to ERISA’s fiduciary rules (except for certain plans that involve individual retirement accounts). The Regulation requires that specific disclosures relating to a plan and its “designated investment alternatives” be made to each participant or beneficiary who has the right to direct the investment of assets held in, or contributed to, his or her individual account under the plan.  (For purposes of the Final Regulation, “designated investment alternative” means any investment alternative designated by the plan.  It does not include brokerage windows, self-directed brokerage accounts, or similar arrangements.)

The Regulation imposes these disclosure obligations on the plan administrator (which, under ERISA, is generally the plan sponsor or a person or committee named as administrator in the plan document).  However, the plan administrator is not liable for the completeness or accuracy of information provided by plan service providers or issuers of investment alternatives designated by the plan, so long as the plan administrator relies reasonably and in good faith.  As a practical matter, it is likely that plan administrators will look to service providers and issuers of designated investment alternatives for the required information. 

Plan-Related Disclosures

The Final Regulation requires that the general plan information, the plan administrative expense information, and the individual participant expense information described below be provided on or before the date on which a participant or beneficiary can first direct his or her investments (the “Initial Investment Date”) and at least annually thereafter.  If there is a change to this information, the plan generally must furnish each participant and beneficiary a description of such change at least 30 days, but not more than 90 days, in advance of the effective date of such change.  In addition, as indicated below, certain information must be provided at least quarterly.

General Plan Information.  The required general information regarding the plan may be disclosed through the plan’s summary plan description (“SPD”).  This information includes:

  • An identification of any designated investment alternative offered under the plan;
  • An explanation of the circumstances under which participants and beneficiaries may give investment instructions;
  • An explanation of any specified limitations on such instructions under the terms of the plan, including any restrictions on transfer to or from a designated investment alternative;
  • A description of or reference to plan provisions relating to the exercise of voting, tender and similar rights appurtenant to an investment in a designated investment alternative as well as any restrictions on such rights;
  • An identification of any designated investment managers; and
  • A description of any brokerage windows, self-directed brokerage accounts, or similar plan arrangements that enable participants and beneficiaries to select investments beyond those designated by the plan.

Administrative Expenses Information.  This information includes explanation of any fees and expenses for general plan administrative services (e.g., legal, accounting, recordkeeping) that may be charged against the individual accounts of participants and beneficiaries and that are not reflected in the total annual operating expenses of any designated investment alternative, and the basis on which such charges will be allocated to each individual account.

In addition, the plan administrator must disclose the following information at least quarterly:

  • The dollar amount of the fees and expenses described above that are actually charged during the preceding quarter to the participant’s or beneficiary’s account for such services;
  • A description of the services to which the charges relate (e.g., plan administration, including recordkeeping, legal, accounting services); and
  • If applicable, an explanation that, in addition to the fees and expenses disclosed, some of the plan’s administrative expenses for the preceding quarter were paid from the total annual operating expenses of one or more of the plan’s designated investment alternatives (e.g., through revenue sharing arrangements, Rule 12b-1 fees or sub‑transfer agent fees).

Individual Expense Information.  This information includes an explanation of any fees and expenses (1) that may be charged against the individual account of a participant or beneficiary on an individual, rather than on a plan-wide, basis (e.g., fees related to processing plan loans or qualified domestic relations orders, fees for investment advice, fees for brokerage windows, commissions, redemption fees, and optional rider charges in annuity contracts) and (2) that are not reflected in the total annual operating expenses of any designated investment alternative.

In addition, plan administrators must disclose, at least quarterly:  the dollar amount of the individual fees and expenses that are actually charged during the preceding quarter to the participant’s or beneficiary’s account; and a description of the services to which the charges relate  (e.g., loan processing fee).

Investment-Related Disclosures

The Final Regulation requires plan administrators to disclose the following information before the Initial Investment Date, and at least annually thereafter:

  • With respect to each designated investment alternative offered under the plan—(A) The name of each designated investment alternative and (B) the type or category of the investment (e.g., money market fund, balanced fund (stocks and bonds), large-cap stock fund, employer stock fund, employer stock fund or employer securities);
  • Performance data such as (i) the average annual total return of the investment alternative for 1‑, 5-, and 10-calendar year periods (or for the life of the investment alternative, if shorter) ending on the date of the most recently completed calendar year or (ii) the fixed or stated annual rate of return and term of an investment alternative;
  • The name of an appropriate broad-based securities market index for each investment alternative and its returns over the same periods for which the investment alternative’s performance is shown;
  • The amount and a description of each shareholder-type fee and a description of any restriction or limitation that may be applicable to a purchase, transfer, or withdrawal of the investment in whole or in part (such as round trip, equity wash, or other restrictions);
  • The total annual operating expenses of the investment expressed as a percentage (i.e., expense ratio);
  • The total annual operating expenses of the investment for a one-year period expressed as a dollar amount for a $1,000 investment;
  • A statement indicating that fees and expenses are only one of several factors that participants and beneficiaries should consider when making investment decisions, and that cumulative effect of fees and expenses can substantially reduce the growth of a participant’s or beneficiary’s retirement account in whole or in part;
  • An internet website address for each designated investment alternative where participants can find the following information with regard to the alternative:  name; objectives or goals; principal strategies (including a general description of the types of assets held by the investment) and principal risks; portfolio turnover rate; performance data; and fee and expense information.

The Final Regulation includes a safe harbor comparative chart with the required investment-related disclosures. 

In addition, the Regulation requires the plan administrator to provide participants and beneficiaries with information received by the plan relating to the exercise of voting and similar rights relating to a designated investment alternative in which the participant or beneficiary is invested (to the extent such rights are passed through to participants and beneficiaries).  Further, the plan administrator must provide certain information upon request by a participant or beneficiary – e.g., prospectuses, financial reports, or similar documents relating to designated investment alternatives that have been provided to the plan; a statement of the unit value of a designated investment alternative (as well as the date of valuation); and a list of assets comprising the portfolio of each designated investment alternative that is considered to hold “plan assets” under the applicable DOL regulation.

Changes to ERISA Section 404(c) Regulation

The DOL also amended its regulation under Section 404(c) of ERISA.  Under Section 404(c), if certain conditions are satisfied with respect to an individual account plan with investments directed by participants (or beneficiaries), fiduciaries will not be held liable under ERISA for the results of the participant’s (or beneficiary’s) exercise of control over his or her account.  One of the conditions to the relief under Section 404(c) is that the participant (or beneficiary) be provided with the information specified in the DOL regulation under Section 404(c).  The amendment to the Section 404(c) regulation provides that the required information under that section includes the information that is required to be provided under the Section 404(a) Final Regulation, described above.

The amendment also incorporates into the Section 404(c) regulation a statement that Section 404(c) does not serve to relieve a fiduciary from his or her duty to prudently select and monitor any service provider or designated investment alternative under the plan.  While the DOL had previously (e.g., in litigation) taken the position described in this statement, this position was not previously set forth in the Section 404(c) regulation.

FINRA Seeks Comment on Proposal to Require Member Firms to Provide Disclosure to Retail Customers of Services, Conflicts and Duties

On October 27, 2010, FINRA published Regulatory Notice 10-54 (the ‘Notice”) requesting comment on a proposal to require member firms to provide disclosure documents to retail customers.  In the Notice, FINRA describes the proposal as arising out of the same concerns that led Congress to require, in the Dodd-Frank Wall Street Reform and Consumer Protection Act, that the SEC study whether a fiduciary standard should be applied to broker-dealers and issue rules accordingly.

According to FINRA, the disclosure document, which would be similar in purpose to Part 2 of Form ADV, the client disclosure document for registered investment advisers, would provide useful information about the types of accounts and services offered by the member firm, its associated conflicts of interest and any limitations on duties owed to customers, regardless of the ultimate contours of any heightened standard of care for broker-dealers. 

The Notice does not include the text of a proposed rule, but instead lists subject matter to be considered for inclusion in the proposed disclosure document, including:

  • the scope of products and services provided to retail customers by the firm;
  • any limitations on products offered, including the fact, if true, that the firm only offers the products of certain sponsors or issuers;
  • all fees associated with each brokerage account and the services provided for each fee;
  • financial or other incentives that a firm or its sales people have to recommend certain products, investment strategies or services over similar ones;
  • conflicts that may arise between the firm and its customers and those that may arise in meeting the competing needs of multiple customers, and how the firm manages the conflicts; and
  • limitations on the duties the firm owes its customers.

FINRA requests comment on the scope of disclosure, its form and content, and the method and timing of delivery.  Comments are due by December 27, 2010.

SEC Proposes Rules Relating to Disclosure of Proxy Votes on Certain Executive Compensation Matters

The SEC proposed rules that would require certain institutional investment managers (“Managers”) to file annual disclosures with the SEC regarding their votes on executive compensation and certain “golden parachute” compensation arrangements.  The current proposal is part of a rulemaking initiative by the SEC to implement elements of new Section 14A of the Securities Exchange Act of 1934 (“1934 Act”), which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in July.  Section 14A requires certain issuers to provide shareholders with an advisory vote on executive compensation, the frequency of advisory votes on executive compensation and on “golden parachute” compensation arrangements (“Section 14A Votes”).  The SEC has proposed rules designed to implement these advisory vote requirements as discussed in the October 26, 2010 Alert.  The current proposal is designed to implement the requirement under Section 14A that Managers report their Section 14A Votes.

Class of Reporting Persons

The proposed rules would require every institutional investment manager that is required to file reports on Form 13F under Section 13(f) of the 1934 Act to file their record of Section 14A Votes annually on Form N-PX.  In general, Form 13F filers are non-natural persons investing in or buying and selling exchange-traded equity securities for their own account and any persons exercising investment discretion with respect to the account of others that have an aggregate fair market value on the last trading day of any month or calendar year of at least $100 million.

Scope of Reporting Obligations

Managers would be required to report their record for each of their Section 14A Votes on Form N-PX, the same form on which registered funds are required to report their complete proxy voting records.  A Manager would only be required to report Section 14A Votes if the Manager, directly or indirectly had or shared the power to vote, or to direct the voting of, the security.  The SEC also has proposed that a Manager report Section 14A Votes with respect to “any security” over which it has voting power. 

Time of Reporting

The proposed rules would require Managers to report their Schedule 14A Votes annually not later than August 31 of each year, for the most recent twelve-month period ended June 30. A Manager would not be required to file a Form N-PX report for the twelve-month period in which the Manager’s initial Form 13F filing is due.  In addition, a Manager would not be required to file a report on Form N-PX with respect to any shareholder vote at a meeting that occurs after September 30 of the calendar year in which the Manager’s final filing on Form 13F is due. 

Joint Reporting

To prevent duplicative reporting, the proposed rules permit a single Manager to report Section 14A Votes when multiple Managers share voting power and permit a Manager to reference Form N-PX reports of a registered fund to satisfy its reporting obligations.  If a Manager’s Section 14A Votes are reported by another Manager, the non-reporting Manager must file a Form N-PX that identifies each Manager and registered fund that is reported on its behalf.

Form N-PX

Form N-PX would be amended to include three parts: (i) the Cover Page, (ii) the Summary Page and (iii) required proxy voting information.  Some of the proposed changes to Form N-PX would also affect fund filers.  Proxy voting information would need to be presented in the following order: (i) the name of the issuer of the security; (ii) the exchange ticker symbol of the security; (iii) the CUSIP number for the security; (iii) the shareholder meeting date; (iv) a brief identification of the matter being voted on; (v) for fund reports (and not from Managers) whether the matter was proposed by the issuer or a security holder; (vi) the number of shares the reporting person was entitled to vote (for funds) or had or shared voting power over (for Managers); (vii) the number of shares that were voted; (viii) how those shares were voted; (ix) whether the vote was for or against management’s recommendation; and (x) identification of each Manager on whose behalf the Form N-PX is filed and who had or shared voting power. 

Requests for Confidential Treatment

The SEC has proposed providing instructions on Form N-PX regarding how to request confidential treatment of the information filed on Form N-PX, the required content of such confidential treatment request and the required filing of information that is no longer entitled to confidential treatment.  In this regard, the SEC asks for, among other things, comments as to when confidential treatment of such information should be granted.

Compliance Dates

If the proposed amendments are adopted, the SEC expects Managers to file their first reports covering Section 14A Votes at meetings that occur on or after January 21, 2011 and ending on June 30, 2011.  The reports would be required to be filed no later than August 31, 2011.  Funds would comply with the amendments to Form N-PX in their reports for the period ending June 30, 2011, except that for votes at meetings that occur before January 21, 2011, funds would be permitted to include the information currently required by Form N-PX. 

Public Comment

The comment period for the proposed rules ends on November 18, 2010.

President’s Working Group Reports on Money Market Fund Reform Options

The President’s Working Group on Financial Markets (“PWG”) released a report outlining possible options for operational and regulatory money market fund reform (the “Report”).  The Report discusses a number of alternatives for addressing the phenomenon of mass redemptions of money market funds (“MMFs”) and the systemic risks posed by substantial MMF redemptions, but offers no recommendations, instead urging that the Financial Stability Oversight Council (“FSOC”) created by the Dodd-Frank Wall Street Reform and Consumer Protection Act consider the alternatives and take appropriate steps.  The Report responds to a June 2009 request from the U.S. Treasury Department in its white paper Financial Regulatory Reform: A New Foundation, that PWG prepare a report analyzing fundamental changes to address systemic risks associated with MMFs.  In January 2010, the SEC amended rules governing MMFs in an effort to bolster MMFs’ resiliency and ability to withstand mass redemptions (as discussed in the March 5, 2010 Alert).  The Report recognizes that those amendments are designed to make MMFs more resilient by, for example, increasing liquidity requirements, but opines that additional measures should be taken to address certain other features of MMFs that contribute to their susceptibility to mass redemption activity.

The Report analyzes and sets forth a number of “further reforms that, individually or in combination, might mitigate systemic risk by completing the SEC’s changes to MMF regulation.”  (The Report does not address any options that have not already been discussed over the past two years.)  Certain of the potential reforms discussed could be adopted by the SEC under existing authority, while others would require coordinated action with other regulators and potentially, legislative activity.  In all, the report discusses the following eight policy options, and outlines potential advantages and disadvantages of each option:

  • requiring MMFs to have floating net asset values;
  • establishing private emergency liquidity facilities for MMFs;
  • requiring mandatory redemptions in kind for large redemptions from MMFs;
  • requiring insurance for MMFs;
  • establishing a two-tier system of MMFs with enhanced protection for stable NAV MMFs;
  • establishing a two-tier system of MMFs with stable NAV MMFs reserved for retail investors only;
  • regulating stable NAV MMFs as special purpose banks; and
  • enhanced constraints on unregulated MMF substitutes.

As noted above, the Report offers no recommendations, instead urging that FSOC consider the options and take appropriate steps.  The Report notes that the SEC, as the primary regulator of MMFs, will be issuing a notice and request for comment regarding further MMF reform.  Following a comment period, there will be a series of meetings with various stakeholders, interested persons, experts and regulators.

SEC Requests Comment on Extension of Private Rights of Action under the Securities Laws to Include Transnational Securities Fraud

Earlier this year, in Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010), the U.S. Supreme Court found that investors could not bring so-called “F-Cubed” securities fraud actions, in which a foreign investor seeks to bring suit in U.S. courts based on allegations of fraud concerning securities issued by foreign companies and traded on foreign exchanges.  Although the Securities Exchange Act of 1934 (the “1934 Act”) does not contain an express private right for F-Cubed securities fraud actions, several lower courts had previously found such a private right of action to be implied in the 1934 Act.  The Morrison decision held that Section 10(b) of the 1934 Act had no such extraterritorial application and therefore only applied to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.”  Shortly after Morrison, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended the 1934 Act to expressly allow the Department of Justice and the SEC to bring transnational securities fraud actions and directed the SEC to solicit comment and conduct a study concerning private rights of action in cases of transnational securities fraud.

Section 929P of the Dodd-Frank Act specifically allows for action brought or instituted by the SEC or the United States alleging a violation of the antifraud provisions of the 1934 Act involving (1) conduct within the U.S. that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the U.S. and involves only foreign investors; or (2) conduct occurring outside the U.S. that has a foreseeable substantial effect within the U.S.  In addition seeking public comment on this question, Section 929Y(a) directs the SEC to solicit comment on whether the scope of the 1934 Act should be extended to provide for private rights of action to the same extent as those now provided to the Commission in Section 929P, or to some other extent. 

Pursuant to Section 929Y(a), the SEC has recently issued a request for public comment on a variety of issues concerning the potential for allowing F-Cubed securities fraud actions.  These topics on which the SEC has sought comment include, but are not limited to, (1) the costs and benefits of such actions, (2) alternative remedies available to investors outside of the United States, and (3) the implications of private transnational securities fraud actions for international comity and international relations.  Comments are due no later than February 18, 2011.  The SEC must subsequently prepare a study on this matter and submit it to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House not later than January 21, 2012.