Financial Services Alert - November 22, 2011 November 22, 2011
In This Issue

Federal District Court Refuses to Dismiss Section 11 and Section 12(a)(2) Claims, Rejecting Argument That Decline in Mutual Fund’s Net Asset Value Only Results from Changes in Value of Fund Holdings, Not Prospectus Misrepresentations

The United States District Court for the District of Colorado (the “Court”) denied a motion to dismiss a complaint filed against the adviser, distributor and trustees of several mutual funds alleging misrepresentations in the funds’ offering documents that violated Sections 11 and 12(a)(2) of the Securities Act of 1933.  The complaint claimed, among other things, that the funds were marketed as stable investments focused on preservation of capital, when in reality they utilized extremely risky strategies by investing in low quality, unrated or illiquid bonds, or highly leveraged derivative instruments known as “inverse floaters.” 

After finding that the alleged misrepresentations and omissions may have been material to fund investors, the Court rejected defendants’ argument that declines in mutual fund value are always the result of factors other than prospectus misrepresentations, because (i) the net asset value (“NAV”) of fund shares is determined by a daily valuation of fund assets and liabilities and (ii) mutual funds are not traded on secondary markets.  The Court found that the plaintiffs’ losses were plausibly linked to the alleged misstatements and omissions because the funds’ underlying assets (and hence its NAV) allegedly declined when long-term and derivative holdings had to be liquidated “for reasons obscured or undisclosed in Fund offering statements.” 

The Court thus disagreed with a recent decision by the United States District Court in the Southern District of New York, Yu v. State Street Corporation, which had concluded that whatever defendants may have misrepresented about the diversification, liquidity and credit quality of the fund’s portfolio, it was “simply irrelevant to loss causation” under the 1933 Act.  (For more on the Yu decision, see the April 12, 2011 Financial Services Alert.)  The Court noted that establishing loss causation would involve complex legal and factual determinations, and was unwilling to hold that misrepresentations in open-end mutual fund prospectuses “are categorically excluded from investors’ reach under the 1933 Act.”  Rather, the Court noted that “[t]he fact that the pro rata ‘price’ of a mutual fund’s aggregate holdings is set by mathematical formula rather than the actual market does not mean that the underlying value of those aggregated holdings cannot be squandered or diminished (and thereby reflected in NAV) by actions or materializations of risk about which purchasers of fund shares have been misled.”

In re Oppenheimer Rochester Funds Group Securities Litigation, No. 1:09-md-02063-JLK-KMT (D. Colo. Oct. 24, 2011).

Basel Committee Issues Revised Rules on Central Counterparty Exposures and FAQs on Counterparty Credit Risk

The Basel Committee on Banking Supervision (the “BCSB”) issued revised draft rules (the “Revised Rules”) under its Basel III framework setting out new capital reserve requirements for banks’ exposures to central counterparties (“CCPs”).  The Revised Rules incorporate a number of technical changes made principally at the request of the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions.  These changes relate to the scope of the Revised Rules, the capitalization of trade exposures, the capitalization of default fund exposures, and indirect access-related issues.  The Revised Rules do not change the risk weight for trade exposures ‑  trade exposures to a qualifying CCP will be subject to a 2 percent risk weight under the new Basel III rules.  The BCSB will accept comments on the revised proposal through November 25, after which a final proposal will be issued by the end of the year.  The final rules should be implemented by January 2013.

The BCSB also issued a set of frequently asked questions that relate to the counterparty credit risk sections of the Basel III rules.  These frequently asked questions provide technical and interpretive guidance regarding the default counterparty credit risk charge, the credit valuation adjustment risk capital charge and asset value correlations.

SEC Settles Administrative Proceeding Against Registered Fund Adviser Over Misrepresentations in Board Materials and Shareholder Reports Regarding Subadviser

The SEC settled administrative proceedings against the investment adviser (the “Adviser”) to a registered closed-end fund (the “Fund”) related to the Adviser’s oversight of a subadviser engaged by the Fund (the “Subadviser”) and representations regarding the subadviser’s services made to the Fund’s board in connection with contract renewals and to Fund investors in shareholder reports.  This article summarizes the SEC’s findings in the settlement order, which the Adviser neither admitted nor denied.

Background.  At the time it engaged the Adviser, the Fund also entered into an agreement with the Subadviser (the “Subadvisory Agreement”) under which the Subadviser would provide “such investment advice, research and assistance, as [the Adviser] shall from time to time reasonably request.”  The Subadvisory Agreement did not grant the Subadviser investment discretion or authority over Fund assets.  The Subadviser’s performance of the Subadvisory Agreement during the period from 1996 to 2007 (the “relevant period”) consisted of providing the Adviser with the following two reports on a monthly basis: (a) a two‑page list of the market capitalization of the composite stock market index for the Fund’s target country and (b) a two-page comparison of the Fund’s monthly performance versus that of local market competitors.  The Adviser did not request, or have any other contact with the Subadviser, regarding the reports, and did not use them in managing the Fund.  During the relevant period, the Fund paid the Subadviser approximately $1.8 million in accordance with a fee rate calculated as a percentage of Fund net assets. 

The Adviser was also a party to the Subadvisory Agreement, under which the Adviser was responsible for overseeing the Subadviser.  Separately, the Adviser agreed with the Fund to serve as its primary investment adviser and its administrator; in the latter capacity, the Adviser was responsible for overall management and administration of the Fund, including the preparation of the Fund’s annual and semi-annual reports, preparation of materials for meetings of the Fund’s Board of Directors and compliance monitoring.

Contract Renewal Materials.  Beginning in 1994, the Subadviser submitted annual reports (the “Subadviser Reports”) to the Fund’s Board of Directors for consideration in connection with the Board’s annual review and renewal of the Fund’s advisory arrangements.  These reports represented that the Subadviser provided the following services to the Adviser: (a) research on companies in the Fund’s target market; (b) statistical reports to assist investment decision-making; (c) intelligence on local corporate developments; and (d) advice on changes in economic and political conditions in the Fund’s target market.  The Subadviser Reports also identified key Subadviser personnel and included the Subadviser’s unaudited financial statements.  The Adviser included the Subadviser Reports in the materials provided to the Board as part of the annual review and renewal process for the Fund’s various advisory arrangements.  In each of 2006 and 2007, the Adviser’s submissions to the Fund’s Board also included an annual compliance program review prepared pursuant to Rule 38a-1 under the Investment Company Act of 1940 (the “1940 Act”) which stated that the Subadviser provided research and investment advisory services to the Adviser.

Shareholder Report Disclosure.  The notes to the financial statements in the Fund’s shareholder reports during the relevant period, which were prepared by the Adviser, stated that for an advisory fee the Subadviser provided the Adviser with investment advice, research and assistance under the terms of a contract.

Termination of the Subadvisory Contract.  In late 2007, in response to inquiries by SEC staff regarding the Fund’s relationship with the Subadviser, the Adviser conducted an investigation, ultimately acknowledging to the Fund’s Board that (i) the reports provided by the Subadviser fell short of what was described in the reports provided in connection with the contract renewals and (ii) certain internal controls needed improvement.  The Board terminated the Subadviser in February 2008.

Violations.  The SEC found the following violations of law:

Section 15(c) – By misrepresenting to the Fund’s Board the services provided by the Subadviser, the Adviser violated its duty under Section 15(c) of the 1940 Act to provide the Fund’s Board with information necessary for the Board to evaluate the nature, quality and cost of the Subadviser’s services in connection with the Board’s annual review of the Fund’s advisory arrangements.

Section 206(2) – By misrepresenting to the Fund’s Board the services provided by the Subadviser, the Adviser failed to fulfill its fiduciary duty under Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) to fully and fairly disclose all material facts to clients and to use reasonable care to avoid misleading clients.

Section 206(4) and Rule 206(4)-7 – The Adviser violated the Advisers Act’s compliance program requirements by failing to implement appropriate procedures to oversee (i) the services provided by the Subadviser and (ii) the information provided to the Board regarding those services as part of the advisory contract renewal process.

Section 34(b) –  By preparing and distributing on the Fund’s behalf shareholder reports with misleading descriptions of the services provided by the Subadviser, the Adviser violated requirements regarding the accuracy and completeness of documents transmitted pursuant to the 1940 Act.

Sanctions and Remedial Undertakings.  The Adviser agreed to reimburse the Fund for fees paid to the Subadviser during the relevant period less a credit for amounts already reimbursed by the Adviser.  The Adviser also agreed to a civil penalty of $1.5 million. 

The settlement order includes remedial undertakings related to the advisory contract renewal process and the Adviser’s oversight not only of advisers and sub-advisers, but also principal underwriters, administrators, and transfer agents (collectively with advisers and subadvisers, “service providers”).  The order prescribes the following specific procedures:

  • Adviser personnel with direct knowledge of the particular service provider’s agreement and services must review and verify any information or representations provided by an adviser, sub‑adviser or principal underwriter as part of the Section 15(c) contract renewal process;
  • each unaffiliated service provider that is not a subadviser must provide an annual certification that it has performed the services contracted for;
  • each unaffiliated subadviser not exercising investment discretion must provide a quarterly certification regarding the performance of its contractual obligations;
  • certain senior personnel of the Adviser must provide a quarterly certification regarding each unaffiliated subadviser’s performance of services contracted for, and those certifications must be reviewed by Adviser administrative personnel prior to the payment of an unaffiliated subadviser’s fees; and
  • with respect to any registered investment company sponsored by the Adviser for which it acts as investment adviser, Adviser personnel with sufficient knowledge of a service provider’s agreements and services must review any description of the service provider contained in a registration statement, application, report, account, record, or other document filed or transmitted pursuant to the 1940 Act, including financial statements and marketing materials.

GAO Study Recommends Additional Coordination Among Regulators Implementing the Dodd-Frank Act

The Government Accountability Office (the “GAO”) released a study assessing the coordination among federal financial regulators when preparing rules implementing the Dodd-Frank Act.  The GAO found that the Dodd-Frank Act, while requiring interagency coordination when designing certain regulations, grants regulators discretion as to the extent and scope of coordination with other agencies when preparing other rules required by the Dodd-Frank Act.  The GAO study found that financial regulators do not have formal protocols in place for interagency cooperation on Dodd-Frank rulemaking.  While acknowledging that federal financial regulators have begun taking measures “to address challenges associated with promulgating hundreds of new rules required under the Dodd-Frank Act,” the GAO provided four recommendations for improving the efficiency and effectiveness of such efforts.  Specifically, the GAO recommended that:

  • federal financial regulators should take steps to better ensure that the specific practices in the Office of Management and Budget’s regulatory analysis guidance are more fully incorporated into their rulemaking policies and consistently applied;
  • the Financial Stability Oversight Council (“FSOC”) should work with the federal financial regulatory agencies to establish formal coordination policies that clarify issues such as when coordination should occur, the process that will be used to solicit and address comments, and what role FSOC should play in facilitating coordination;
  • federal financial regulatory agencies should develop plans that determine how they will measure the impact of Dodd-Frank Act regulations; and
  • the FSOC should direct the Office of Financial Research to work with regulators to identify and collect data necessary to analyze the impact of the Dodd-Frank Act regulations on, among other things, the stability, efficiency and competitiveness of US financial markets.

Banking Agencies Issue Statement to Clarify Supervisory and Enforcement Responsibilities For Federal Consumer Financial Laws

The OCC, FRB, FDIC, NCUA and CFPB issued a joint statement that banks, thrifts and credit unions with more than $10 billion in total assets based on June 30, 2011, call report data will be subject to direct CFPB supervision, examination and enforcement with respect to federal consumer financial protection laws.  After the initial determination, financial institutions generally will not be reclassified unless four consecutive quarterly call reports indicate that the institution has over $10 billion in total assets.  Under the Dodd-Frank Act, the CFPB has the exclusive authority to examine for compliance with federal consumer financial laws and primary authority to enforce those laws for institutions with more than $10 billion in total assets.  Institutions with $10 billion or less in total assets will be supervised by their primary federal regulator with respect to federal consumer financial protection laws.

FinCEN To Develop Rules Requiring Investment Advisers To Establish Anti-Money Laundering Programs

In a speech given at the American Bankers Association/American Bar Association AML Enforcement Conference, FinCEN Director James H. Freis, Jr. stated that “FinCEN is currently revisiting the topic of investment advisers, building on the changes to that industry pursuant to the Dodd-Frank Act, the SEC rules implementing Dodd-Frank and other changes, and is working on a regulatory proposal that would require investment advisers to establish AML programs and report suspicious activity. We look forward to working with the SEC as well as the States as we move forward.”  The Alert will follow this initiative as it develops.