Financial Services Alert - June 24, 2014 June 24, 2014
In This Issue

Goodwin Procter Alert: Supreme Court Ruling in Halliburton II is a Partial Win for Defendants Facing Securities Class Actions

A new client alert discusses how the U.S. Supreme Court’s decision in Halliburton Co. v. Erica P. John Fund, Inc., although it does not overturn the Court’s prior ruling in Basic v. Levinson, which created the presumption of reliance, nevertheless represents a partial win for defendants in that it allows a defendant in putative securities class action to introduce evidence at the class certification stage that the alleged misstatement or omission did not affect the price of a security.

SEC Settles with Exempt Reporting Adviser over Pay-to-Play Violations

The SEC settled public administrative proceedings against TL Ventures Inc., a venture capital fund adviser (the “Adviser”), over violations of Rule 206(4)-5 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) resulting from its failure to observe the two-year timeout on receiving compensation with respect to certain public plans invested in the Adviser’s funds.  The timeout was triggered when a principal owner of the Adviser (the “Principal”) made campaign contributions to a Philadelphia mayoral candidate and to the Governor of Pennsylvania.  This article provides selected highlights of the SEC’s findings set forth in the settlement order (which the Adviser has neither admitted nor denied). 

Background

The Adviser manages venture capital funds that invest in early-stage technology companies.  The Adviser relies on the exemption from registration under the Advisers Act available to an adviser whose only clients are “venture capital funds” as defined under Rule 203-l(1) under the Advisers Act.  The Adviser raised its last fund in 2008.  In  2000, the City of Philadelphia Board of Pensions and Retirement (the “Philadelphia Retirement Board”) invested in one of the Adviser’s funds.  In 1999 and 2000, the Pennsylvania State Employees’ Retirement System (“SERS”) invested in two of the Adviser’s funds.  The Adviser received advisory fees attributable to the respective investments by the Philadelphia Retirement Board and SERS in the Adviser’s funds.

Campaign Contributions

In April 2011, the Principal made a $2,500 campaign contribution to the campaign of a candidate for Mayor of Philadelphia.  In November 2011, the Principal made a $2,000 campaign contribution to the Governor of Pennsylvania.

The Pay-to-Play Rule

In relevant part, Rule 206(4)-5 prohibits an “exempt reporting adviser” like the Adviser from receiving advisory fees attributable to the investment of a government entity in a private fund managed by the Adviser within two years after a contribution by certain personnel of the Adviser to an incumbent, candidate or successful candidate for elective office of a government entity if the office is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity or has authority to appoint any person who is directly or indirectly responsible for, or can influence the outcome of, the hiring of an investment adviser by a government entity.  A “government entity” is any state or political subdivision of a state, including, among other things, a pool of assets sponsored or established by the state or political subdivision or any agency, authority or instrumentality thereof, including, but not limited to a “defined benefit plan” as defined in the Internal Revenue Code, or a state general fund.

The SEC found that each of the Mayor of Philadelphia and the Governor of Pennsylvania had the ability to influence the selection of investment advisers for their respective retirement funds.  The Mayor of Philadelphia has authority to appoint the City’s Director of Finance, Managing Director and City Solicitor, each of whom serves on the nine member Philadelphia Retirement Board, which has influence over the retirement fund’s investments including the selection of investment advisers and pooled investment vehicles.  The Governor of Pennsylvania has authority to appoint six members of the eleven member SERS board, which has influence over investments by the SERS pension fund including the selection of investment advisers and pooled investment vehicles.

Violation

The SEC found that the Adviser willfully violated Rule 206-4(5).  The SEC noted that, according to case law, “a willful violation of the securities laws means merely that that ‘the person charged with the duty knows what he is doing.’”  There is no requirement that there be an awareness of violating a rule or statute.  In addition, Rule 206(4)-5 does not require a showing of a quid pro quo arrangement or actual intent to influence an elected official or candidate.

Sanctions

Among other sanctions, the Adviser must pay disgorgement of $256,697 and prejudgment interest of $3,197.  Under this settlement order, the Adviser is also subject to a civil money penalty of $35,000 that appears to be attributable at least in part to a separate violation of the Advisers Act’s registration requirements that was also part of the settlement, as discussed here.

In the Matter of TL Ventures Inc., SEC Release No. IA-3859 (June 20, 2014).

SEC Integrates Two Exempt Reporting Advisers to Determine Advisers Act Registration Status

The SEC settled public administrative proceedings against TL Ventures Inc., a venture capital fund adviser (the “VC Fund Adviser”) and Penn Mezzanine Partners Management, L.P. (the “Private Fund Adviser” and with the VC Fund Adviser, the “Advisers”) over findings that the Advisers should have been regarded as a single advisory organization in determining whether to rely on registration exemptions or register under the Investment Advisers Act of 1940 (the “Advisers Act”).  This article provides selected highlights of the SEC’s findings set forth in the respective settlement orders for each Adviser (which neither Adviser has admitted nor denied). 

Exempt Reporting Adviser Status

Beginning on March 29, 2012, each of the Advisers claimed an exemption from registration under the Advisers Act as “exempt reporting advisers.”  The Venture Capital Fund Adviser claimed to be an investment adviser whose only clients are “venture capital funds” as defined under Rule 203-l(1) under the Advisers Act, and thus to be exempt from registration under Section 203(l) of the Advisers Act from registration as an investment adviser.   In its March 2014 exempt reporting adviser report on Form ADV, the Venture Capital Fund Adviser reported regulatory assets under management of approximately $178 million.  The Private Fund Adviser claimed its only clients were “private funds” representing less than $150 million in regulatory assets under management, and that it could therefore rely on the “private fund adviser” exempt from registration under Advisers Act Rule 203(m)-1 and Advisers Act Section 203(m).  In its March 2014 exempt reporting adviser report on Form ADV, the Private Fund Adviser reported regulatory assets under management of approximately $51 million.

Integration

The settlement order states that “the facts and circumstances surrounding their relationship indicate that the two advisers were under common control, were not operationally independent of each other and thus should have been integrated as a single investment adviser for purposes of the applicable registration requirement and the applicability of any exemption.  Once integrated, [the Venture Capital Fund Adviser and the Private Fund Adviser] would not have qualified for any exemption from registration and therefore should have been registered effective March 30, 2012.” 

The settlement order cites the following in discussing the integration of the Advisers:

  • The Venture Capital Fund Adviser and the Private Fund Adviser reported that they are under common control with each other. 
  • Various employees and associated persons of the Venture Capital Fund Adviser held ownership stakes in the Venture Capital Fund Adviser and in the general partner and management company entities of the Private Fund Adviser;  among those, two persons, one of whom was a managing director of the Venture Capital Fund Adviser, held in the aggregate a majority ownership interest in the Venture Capital Fund Adviser and indirectly held in the aggregate more than a 25%, but less than a majority, ownership interest in the Private Fund Adviser.
  • The Venture Capital Fund Adviser and the Private Fund Adviser had several overlapping employees and associated persons, including individuals who provided investment advice on behalf of both the Venture Capital Fund Adviser and the Private Fund Adviser.  For example, two of the three members of the Private Fund Adviser’s investment committee, which had sole and exclusive authority to approve any investment by the Private Fund Adviser’s fund, were also managing directors of the Venture Capital Fund Adviser and were significantly involved in providing investment advice for the Venture Capital Fund Adviser.
  • The Venture Capital Fund Adviser and the Private Fund Adviser had significantly overlapping operations and no policies and procedures designed to keep the entities separate. 
    • Marketing materials for the Private Fund Adviser made reference to the Venture Capital Fund Adviser and the Private Fund Adviser as being a “partnership” and referenced the Private Fund Adviser’s ability to leverage and benefit from this relationship, including outsourcing its back office functions to the Venture Capital Fund Adviser.  
    • Managing directors of the Venture Capital Fund Adviser who served on the Private Fund Adviser’s investment committee solicited potential investors for the Private Fund Adviser’s funds, including soliciting past investors in the Venture Capital Fund Adviser’ funds.  
    • Neither Adviser had adequate information security policies and procedures in place to protect investment advisory information from disclosure to the other.  
    • Employees and associated persons of the Private Fund Adviser routinely used their Venture Capital Fund Adviser email addresses to conduct business and communicate with outside parties about and on behalf of the Private Fund Adviser.

The SEC determined that after giving effect to this integration, the Venture Capital Fund Adviser could not rely on the venture capital fund adviser exemption because its clients were not solely venture capital funds and (b) the Private Fund Adviser could not rely on the private fund adviser exemption because the combined regulatory assets under management of the two Advisers exceeded $150 million.  Accordingly, the SEC found that each should have registered with the SEC as March 30, 2012.

Violations

The SEC found that each of the Advisers willfully violated (i) Section 203(a) of the Advisers Act, which prohibits the use of any means of interstate commerce by an investment adviser that has not complied with the Advisers Act’s registration requirements or properly relied on an exemption and (ii) Section 208(d) of the Advisers Act which prohibits any person from doing indirectly, or through any other person, anything that would be unlawful for such person to do directly under the Advisers Act.

Sanctions

Each of the Advisers agreed to a censure and a cease and desist order.  (The Venture Capital Fund Adviser, whose order also related to violations of the Advisers Act’s pay-to-play rule, as discussed here, agreed to a civil money penalty of $35,000 that appears to be at least in part attributable to the pay-to-play rule violations.)  Each Adviser’s settlement order notes that the SEC considered remedial acts being undertaken by the Adviser, “including steps to reorganize operations and separate its advisory functions from the other Adviser, as well as the adoption of policies and procedures reasonably designed to ensure compliance with the applicable rules.”  The SEC did not direct the Advisers to register.

In the Matter of TL Ventures Inc., SEC Release No. IA-3859 (June 20, 2014).

In the Matter of Penn Mezzanine Partners, L.P., No. IA-3858 (June 20, 2014).

Goodwin Procter Alert: SEC Approval of Amendments to FINRA Corporate Financing Rules Will Reduce Burdens on Parties in Public Offerings

A new client alert discusses amendments to FINRA corporate financing and underwriter conflicts of interest rules recently approved by the SEC that will affect not only underwriters and issuers in public offerings, but investment banks acting as independent financial advisors to issuers, and investment funds and other investors that are significant stockholders in public companies.

FINRA Fines Broker-Dealer for Failing to Apply Class A Sales Charge Waivers for Certain Eligible Customers on its Mutual Fund Platform

On June 16, 2014, the Financial Industry Regulatory Authority, Inc. (“FINRA”) accepted a Letter of Acceptance, Waiver and Consent (the “AWC”) from Merrill Lynch, Pierce, Fenner & Smith Incorporated (the “Firm”) regarding an alleged failure to waive mutual fund sales charges for certain eligible customers.  FINRA found that from at least January 2006 through December 2011 (the “Relevant Period”), the Firm failed to establish, maintain, and enforce a supervisory system and written procedures reasonably designed to ensure eligible accounts received sales charge waivers as set forth in the mutual funds’ prospectuses.  As a result, the Firm failed to provide certain customer accounts with sales charge waivers for which they were eligible.  This article summarizes FINRA’s findings, which the Firm neither admitted nor denied in connection with executing the AWC.

Applicable FINRA Rules

NASD Rule 3010 requires member firms to establish and maintain a supervisory system reasonably designed to achieve and monitor the member’s compliance with the requirements of applicable securities laws and regulations, and with applicable NASD and FINRA rules.  NASD Rule 3010 also requires that the supervisory system, at a minimum, establish and maintain written procedures required by the Rule.  FINRA Rule 2010, identical to NASD Rule 2110, requires that a member firm, in the conduct of its business, observe high standards of commercial honor and just and equitable principles of trade.  (FINRA Rule 2010 replaced NASD Rule 2110 on December 15, 2008.  Any conduct prior to that date was subject to NASD Rule 2110; conduct on or after that date was subject to FINRA Rule 2010.)

In agreeing to the AWC, FINRA cited to the settlement of disciplinary proceedings with the Firm in each of 2008 (the “2008 AWC”), 2010 (the “2010 AWC”) and 2012 (the “2012 AWC”) relating to similar violations of FINRA and NASD Rules, including violations of NASD Rules 2110 and 3010 and FINRA Rule 2010, during and prior to the Relevant Period which resulted in fines paid by the Firm, undertakings to FINRA from the Firm, and remediation to affected customers from the Firm.  The FINRA notices with respect to the relevant disciplinary history can be found at: 2008 AWC2010 AWC and 2012 AWC.  

The Firm’s Mutual Fund Platform

The Firm maintained a retail brokerage platform on which it offered the customers in question the opportunity to purchase mutual funds from approximately 120 mutual fund families.  As described in their prospectuses and statements of additional information, these mutual funds offered their shares in several classes that differ in the nature and amount of the sales charges paid directly by shareholders, and in the continuing asset-based fees assessed on each class, with the result that the return to customers would vary depending on the class purchased.  Most of the mutual funds offered on the Firm’s platform disclosed in their prospectuses that they waive up-front sales charges for retirement plans, and 13 of them disclosed in their prospectuses that they offered such waivers to charitable organizations.

Failure to Provide Sales Charge Waivers to Eligible Accounts

During the Relevant Period, the Firm sold Class A shares with a front-end sales charge, or Class B or C shares with back-end sales charges and higher ongoing fees and expenses, to tens of thousands of retirement plan and charitable organization customers eligible to purchase Class A shares without a sales charge.  In doing so, the Firm failed to identify and apply sales charge waivers to eligible retirement and charitable organization accounts.  Moreover, the Firm became aware of its failure to identify and apply sales charge waivers to certain retirement account customers in 2006, but elected not to notify its customers or inform and adequately train its financial advisors to ensure that eligible customers received the waivers, and did not report its findings to FINRA until November 2011. The Firm first became aware of its failure to provide sales charge waivers to eligible charitable organizations accounts in or around April 2010, and did not report its findings to FINRA until January 2011.

The Violations

Set forth below is a summary of the specific violations cited by FINRA.

Failure to Identify and Apply Sales Charge Waivers to Retirement Accounts.  FINRA found that, during the Relevant Period, the Firm violated NASD Rule 2110 and FINRA Rule 2010 by failing to ensure that certain eligible retirement accounts received available sales charge waivers.  Specifically, FINRA found that the Firm failed to adequately identify and apply sales charge waivers to certain retirement account customers.  Because the Firm maintained the accounts on the Firm’s retail brokerage platform, FINRA found that the Firm treated these accounts similarly to other retail customer accounts for purposes of determining share class eligibility for mutual fund purchases, and routinely sold Class A shares with sales charges, or Class B or Class C shares that charged higher expense ratios than Class A shares, rather than selling them Class A shares without the sales charge under the waiver available to retirement plans.    The Firm learned it was not providing sales charge waivers to eligible retirement account customers in early 2006.  However, the Firm failed to notify its financial advisors of this failure and left the issue unresolved for over six years until December 2011.  The Firm self-reported the issue to FINRA in November 2011 and developed a remediation plan to restore affected customers to substantially the same financial position they would have been in if they had purchased Class A shares without sales charges.

Failure to Identify and Apply Sales Charge Waivers to Charitable Organizations.  FINRA found that, from January 2004 through August 2011, the Firm violated NASD Rule 2110 and FINRA Rule 2010 by failing to ensure that certain eligible 501(c)(3) charitable organizations received available sales charge waivers.  As with certain retirement account customers, the Firm routinely treated qualified charitable organizations as ordinary retail accounts for purposes of determining their eligibility for sales charge waivers.  Of the approximately 120 fund families available for purchase by charitable organizations on the Firm’s retail platform, 13 offered sales charge waivers to charitable organizations.  FINRA found that the Firm repeatedly sold such organizations Class A shares with sales charges, or Class B or Class C shares that charged higher expense ratios than Class A shares, rather than selling them Class A shares without the sales charge under the waiver available to charitable organizations.  FINRA found that the Firm became aware of the failure to provide sales charge waivers to these qualified accounts around April 2010 and self-reported to FINRA in January 2011. The Firm subsequently developed a plan to restore affected customers to substantially the same financial positions they would have been in, had they purchased Class A shares without a sales charge.

Failure to Establish an Adequate Supervisory System and Written Procedures.  FINRA found that, during the Relevant Period, the Firm violated NASD Rules 3010 and 2110 and FINRA Rule 2010 by failing to establish and maintain an adequate supervisory system and written procedures to identify and apply Class A sales charge waivers to eligible retirement account and charitable organization customers, who, as a consequence, did not receive the benefit of the available sales charge waivers.

For example, FINRA found that the Firm’s policies and procedures for mutual fund purchases on the retail brokerage platform were not designed to adequately supervise the administration of mutual fund sales charge waivers for certain retirement accounts.  In addition, the Firm did not maintain adequate policies, procedures or practices to train its financial advisors to identify and apply manual sales charge waivers to eligible retirement account customers.  The Firm also did not provide its financial advisors or supervisors with any other guidance or training to help them identify mutual funds that offered sales charge waivers to retirement account customers.  FINRA found that the Firm unreasonably relied upon its financial advisors to determine opportunities for customers to receive Class A shares with sales charge waivers while failing to have adequate written policies or procedures to help financial advisors or supervisors make this determination, and controls to detect instances in which sales charge waivers should have been applied.

With respect to charitable organization customers, FINRA found that the Firm failed to maintain an adequate system and written procedures reasonably designed to identify applicable sales charge waivers in mutual fund prospectuses for charitable organizations because, among other things, (i) the Firm’s supervisory procedures did not require any actions to determine whether special pricing provisions available to charitable organizations on Class A shares were provided to qualifying customers and (ii) the Firm did not have any systematic controls in place to prevent or detect instances where the waiver should have been, but was not, provided.  Although the mutual fund prospectuses disclosed the sales charges waiver available to charitable organizations, the Firm failed to identify the availability of the waiver and communicate that information to its financial advisors, and did not have procedures in place to monitor whether financial advisors were informing customers of available sales charge waivers or ensuring that eligible customers were receiving such waivers.

FINRA found that after the Firm became aware of these issues, it failed to implement a supervisory system to follow up and ensure that eligible customers purchased Class A shares with sales charge waivers.  For example, FINRA determined that the Firm began developing technological improvements to more readily identify retirement account customers eligible for sales charge waivers two years after becoming aware of the problem, but never fully funded or implemented the developments.  FINRA found that the Firm had concluded that the cost of implementing system updates to automatically apply waivers to charitable organization customers would be prohibitive.  As a result, FINRA found that the Firm failed to establish and maintain an adequate supervisory system and written procedures to ensure that eligible retirement account and charitable organization customers purchased Class A shares with sales charge waivers.

Sanctions

The Firm consented to a censure and a fine of $8 million.  The Firm has voluntarily paid remediation of approximately $64.8 million to certain retirement plan account and charitable organization customers affected by this issue.  As part of the settlement, the Firm has agreed to provide additional restitution in the amount of $24.4 million to affected customers.

Merrill Lynch, Pierce, Fenner & Smith Inc., Letter of Acceptance, Waiver and Consent No. 2011029999301 (June 16, 2014).

Federal Banking Agencies Issue Final Version of Addendum to Interagency Policy Statement on Income Tax Allocation

The FRB, FDIC and OCC (collectively, the “Agencies”) issued a final version of an addendum (the “Addendum”) to their “Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure” (the “Policy Statement”).  The Addendum directs insured depository institutions (“IDIs” and each an “IDI”) and their holding companies (the IDIs with their holding company are collectively referred to as a “Consolidated Group”) to review and revise their tax allocation agreements to ensure that the agreements expressly acknowledge that the holding company receives a tax refund from a taxing authority as agent for its subsidiary IDIs and other affiliates.  The Addendum also clarifies how the restrictions concerning transactions among affiliates under Section 23A and 23B of the Federal Reserve Act apply to tax allocation agreements. 

The Addendum supplements the Policy Statement, which was issued by the Agencies in 1998.  Since 1998, disputes have arisen between holding companies that are in bankruptcy and their affiliated failed IDIs with respect to the ownership of tax refunds, and the Agencies’ purpose in issuing the Addendum is to avoid future disputes regarding this issue.  Often such a dispute has arisen when the FDIC as receiver of a failed IDI seeks to obtain income tax refunds as a recovery for the receivership and is opposed by the creditors of the IDI’s parent holding company who argues that the tax refunds should be treated as an asset of the holding company’s bankruptcy estate.  The Addendum is substantially identical to a proposed version of the Addendum that was issued by the Agencies in December 2013.

Finally, in the Addendum, the Agencies provide a model paragraph (the “Model Paragraph”) that reflects the Agencies’ guidance in the Addendum, and Consolidated Groups are directed to amend their tax allocation agreement to include either the Model Paragraph or substantially similar language.

The text of the Model Paragraph is as follows:

The [holding company] is an agent for the [IDI and its subsidiaries] (the “Institution”) with respect to all matters related to consolidated tax returns and refund claims, and nothing in this agreement shall be construed to alter or modify this agency relationship.  If the [holding company] receives a tax refund from a taxing authority, these funds are obtained as agent for the Institution.  Any tax refund attributable to income earned, taxes paid, and losses incurred by the Institution is the property of and owned by the Institution, and shall be held in trust by the [holding company] for the benefit of the Institution.  The [holding company] shall forward promptly the amounts held in trust to the Institution.  Nothing in this agreement is intended to be or should be construed to provide the [holding company] with an ownership interest in a tax refund that is attributable to income earned, taxes paid, and losses incurred by the Institution.  The [holding company] hereby agrees that this tax sharing agreement does not give it an ownership interest in a tax refund generated by the tax attributes of the Institution.”

Consolidated Groups are required to amend their respective tax allocation agreement to reflect the requirements of the Addendum by October 31, 2014.