Articles Posted in Registered Investment Companies

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The Securities and Exchange Commission (“SEC”) issued a cease-and-desist order on February 19, 2015 against SEC-registered Logical Wealth Management, Inc. and owner, Daniel J. Gopen, (together, “Respondents”).  The list of violations the SEC found the Respondents committed is extensive and includes improper registration, compliance, and recordkeeping. The SEC found the Respondents exaggerated their assets under management in order to register with the SEC, falsely reported their place of business as Wyoming, a state in which advisers are not regulated, and did not have compliance policies and procedures in place or books and records available to the SEC.  The SEC has ordered the Respondents to cease and desist, revoked Logical Wealth’s registration, barred Mr. Gopen from any advisory activity and imposed a $25,000 civil penalty.

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By William M. Sullivan, Jr. and Jay B. Gould

Under the Second Circuit’s new ruling, prosecutors have two large hurdles they must clear to convict under securities laws. First, they must prove that a defendant knew that the source of inside information disclosed tips in exchange for a personal benefit. Second, the definition of “personal benefit” is tightened to something more akin to a quid pro quo exchange.

For years, insider trading cases have been slam dunks for federal prosecutors. The United States Attorney’s Office in the Southern District of New York had compiled a remarkable streak of more than eighty insider trading convictions over the past five years. But that record has evaporated thanks to the United States Court of Appeals for the Second Circuit’s ruling in United States v. Newman, in which the Second Circuit concluded that the district court’s jury instructions were improper and that the evidence was insufficient to sustain a conviction.

The Second Circuit relied upon a thirty year old Supreme Court opinion, Dirks v. SEC, 463 U.S. 646 (1983), and highlighted the “doctrinal novelty” of many of the government’s recent successful insider trading prosecutions in failing to follow Dirks. Accordingly, the Court overturned insider trading convictions for Todd Newman and Anthony Chiasson because the defendants did not know they were trading on confidential information received from insiders in violation of those insiders’ fiduciary duties. More broadly, however, the Court laid down two new standards in tipping liability cases, both likely to frustrate prosecutors for years to come.

Tougher Disclosure Requirements

Section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission rules 10b-5 and 10b5-1 generally prohibit trading on the basis of material nonpublic information, more conventionally known as insider trading. In addition, federal law also prohibits an individual (the “tipper”) from disclosing private information to an outside person (the “tippee”), if the tippee then trades on the basis of this private information. This disclosure—a breach of one’s fiduciary duty—is known as tipping liability. As with most crimes, tipping liability requires scienter, a mental state that demonstrates intent to deceive, manipulate, or defraud. In these cases, the government must show that the defendant acted willfully—i.e., with the realization that what he was doing was a wrongful act under the securities laws.

Until last week, willfulness had been fairly easy to show, and that was one of the principal reasons for the government’s string of successes. Prosecutors only had to prove that the defendants traded on confidential information that they knew had been disclosed through a breach of confidentiality. In Newman, however, the Second Circuit rejected this position outright. The Court held that a tippee can only be convicted if the government can prove that he knew that the insider disclosed confidential information in exchange for a personal benefit, and one that is “consequential” and potentially pecuniary.

This distinction may seem minor, but its impact is enormous. The government now must prove—beyond a reasonable doubt, no less—that a defendant affirmatively knew about a personal benefit to the source of the confidential information. From the prosecution’s perspective, this is a massively challenging prospect.

Tightened “Personal Benefit” Standards

The Second Circuit also clarified the definition of “personal benefit” in the tipping liability context. Previously, the Court had embraced a very broad definition of the term—so broad, in fact, that the government argued that a tip in exchange for “mere friendship” or “career advice” could expose a trader to tipping liability.

The Court retreated from this position and narrowed its standard. Now, to constitute a personal benefit, the prosecution must show an exchange “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” —in other words, something akin to a quid pro quo relationship. This, too, complicates a prosecution’s case significantly.

Implications of the Ruling

What effect will this ruling have moving forward? Of course, one effect is obvious from the start: prosecutors are going to have a much more difficult time proving tipping liability. But as with many new appellate cases, it may take some time to see how this rule shakes out on the ground in the trial courts. Here are a few things to keep in mind over the next few months and years.

  • This ruling may cause some immediate fallout. For example, there are currently several similar cases in New York that are pending for trial or appeal, and these may now result in acquittals or vacated convictions. In fact, some defendants who previously took guilty pleas in cooperation with Newman and Chiasson’s case are considering withdrawing their pleas in light of this decision. Moving forward, look to see the SEC and potential defendants adjusting their behavior and strategies in light of this ruling. In fact, just this week, a New York Federal Judge expressed strong reservations about whether guilty pleas entered by four defendants in an insider trader case related to a $1.2 billion IBM Corp. acquisition in 2009 should remain in light of Newman.
  • This is also welcome news for tippees who did not interact directly with the source of the inside information. Although the source of the leak may still be prosecuted as usual, this ruling may shield a more remote party from an indictment. As the Newman court noted, the government’s recent insider trading wins have been “increasingly targeted at remote tippees many levels removed from corporate insiders.” Now, without clear evidence that the insider received a quantifiable benefit and that the tippee was aware of such benefit for providing the information, cases against such “remote tippees” will be tremendously more difficult to prove.
  • But, caution should still reign where tippees deal more directly with tippers. The tippees in this case were as many as three or four steps removed from the tippers. It is not difficult to imagine the Court coming out the other way if Newman and Chiasson had been dealing with the tippers themselves.
  • One enormous question mark is to what extent the standards expressed in this case will affect the SEC’s civil enforcement suits. We will have to wait and see, but traders should still use caution. Because civil suits require a substantially lower burden of proof and lesser standard of intent compared to criminal cases, it is possible that these new rules may offer little protection from a civil suit. Additionally, SEC attorneys will probably emphasize this distinction to courts in an attempt to distinguish their enforcement suits from Newman and Chiasson’s criminal case, but whether this tactic is effective remains to be seen.
  • Although the Court refined the meaning of a personal benefit, the definition is still purposefully flexible. This case tells us that abstract psychic benefits—friendship, business advice, church relationships—are not enough, but what about anything just short of exchanging money, favors, or goods? We don’t yet know, and for that reason clients should exercise care.
If you have any questions about the content of this alert,   please contact the Pillsbury attorney with whom you regularly work, or the   authors below.
Jay B. Gould (bio)San Francisco

+1.415.983.1226

jay.gould@pillsburylaw.com

 William M. Sullivan (bio)Washington, DC

+1.202.663.8027

wsullivan@pillsburylaw.com

 

The authors wish to thank Robert Boyd for his valuable assistance with this client alert.

 

About Pillsbury Winthrop Shaw Pittman LLP
Pillsbury is a full-service law firm with an industry focus on energy & natural resources, financial services including financial institutions, real estate & construction, and technology. Based in the world’s major financial, technology and energy centers, Pillsbury counsels clients on global business, regulatory and litigation matters. We work in multidisciplinary teams that allow us to understand our clients’ objectives, anticipate trends, and bring a 360-degree perspective to complex business and legal issues—helping clients to take greater advantage of new opportunities, meet and exceed their objectives, and better mitigate risk. This collaborative work style helps produce the results our clients seek.

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The U.S. Commodity Futures Trading Commission (CFTC) announced that on December 16, 2014, the U.S. District Court for the Northern District of Illinois entered a Consent Order for permanent injunction against AlphaMetrix, LLC (AlphaMetrix), a Chicago-based Commodity Pool Operator (CPO) and Commodity Trading Advisor (CTA), and its parent company AlphaMetrix Group, LLC (AlphaMetrix Group). The Order requires AlphaMetrix to pay restitution of $2.8 million and a civil monetary penalty of $2.8 million and requires AlphaMetrix Group to pay disgorgement of $2.8 million. The Order also prohibits AlphaMetrix from further violating anti-fraud provisions of the Commodity Exchange Act (CEA), as charged.

The Order stems from CFTC charges that AlphaMetrix failed to pay at least $2.8 million in rebates owed to some of its commodity pool participants by investing the rebate funds in the pools and instead transferred the funds to its parent company, which had no entitlement to the funds. Nevertheless, AlphaMetrix sent these pool participants account statements that included the rebate funds as if they had been reinvested in the pools, even though they were not (see CFTC Press Release 6767-13, November 6, 2013).

A civil action filed by the court-appointed receiver remains pending in the U.S. District Court for the Northern District of Illinois. In that action, the receiver seeks to recover funds from former officers of AlphaMetrix and AlphaMetrix Group.

The CFTC cautions victims that restitution orders may not result in the recovery of money lost because the wrongdoers may not have sufficient funds or assets.

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The Securities and Exchange Commission (SEC) yesterday adopted a series of amendments to the rules that govern money market funds.  The most controversial of these amendments will require institutional prime and tax-exempt money market funds to maintain a floating net asset value (NAV) and will allow the boards of institutional and retail prime and tax-exempt money market funds to impose liquidity fees and to suspend redemptions temporarily if the funds’ weekly liquid assets fall below a certain threshold.  Funds will have two years to comply with these amendments.

Retail and government funds will be not subject to the floating NAV requirement.  A retail fund is defined as a fund that has policies and procedures reasonably designed to limit all beneficial owners to natural persons.  A government fund is defined as a fund that invests 99.5% of its assets in cash and government securities.  Floating NAVs will be rounded to the fourth decimal place.  In conjunction with the SEC amendments, the Treasury Department and the Internal Revenue Service proposed rules providing a simplified tax accounting method to track gains and losses on floating NAV money market funds and providing relief from the wash sale rules.

If a money market fund’s weekly liquid assets fall below 30% of its total assets, a fund board would be permitted to impose a liquidity fee of up to 2% on redemptions and to suspend redemptions (impose a “gate”) for up to 10 business days.  If the liquid assets fall below 10%, the fund would be required to impose a liquidity fee of 1%, unless the fund board determines that a lower or higher fee (ranging from no fee to a 2% fee) would be in the best interest of the fund.  Government funds would not be subject to these requirements, but could voluntarily opt into them if previously disclosed to investors.

Concern has been expressed that the floating NAV requirement will impose new costs on money market funds, prompt institutional investors to shift cash to government funds, bank deposits and unregulated funds, and impair the short-term funding of businesses and governments.  Concern has also been expressed that the liquidity fee and gate requirements will trigger runs.

The SEC at the same time adopted less controversial amendments to the diversification, disclosure and stress testing requirements for money market funds, as well as to the reporting requirements for money market funds and for private funds that operate like money market funds.  In addition, it reproposed amendments to remove references to credit ratings in the rules and forms relating to money market funds.

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Written by: G. Derek Andreson

The U.S. Securities and Exchange Commission (“SEC”) is poised to modify its “no-admit, no-deny” policy to seek more admissions of wrongdoing from defendants as a condition of settlement in enforcement cases. The change comes on the heels of recent criticism of the policy from two federal judges and a U.S. Senator and would result in potentially far-reaching consequences for companies, their directors, officers, and employees.

The Proposed Policy Change
At the Wall Street Journal CFO Network’s Annual Meeting on Tuesday, June 18, SEC Chairman Mary Jo White announced her intention to require more admissions of wrongdoing from defendants in the settlement of enforcement actions. Prior to this announcement, the SEC only required such admissions in a narrow sub-set of cases in which parties admitted certain facts as part of a guilty plea or other criminal or regulatory agreement. Such an approach would represent a radical departure from the SEC’s longstanding no-admit, no-deny policy, under which defendants settle cases without admitting or denying wrongdoing. Chairman White emphasized that the no-admit, no-deny policy will still be used in the “majority” of cases and that “having ‘no-admit, no-deny’ settlement protocols in your arsenal as a civil enforcement agency [is] critically important to maintain.”1

 

Details are still forthcoming on the scope of the proposed changes to the SEC policy, which will require approval from a majority of the five SEC commissioners. However, Chairman White presumably would not have announced her intention to depart from tradition and require admissions of wrongdoing in certain settlements if such a change lacked majority support from the other Commissioners. In a memo written to the Enforcement Division staff, the Division’s Co-Directors, George Canellos and Andrew Ceresney, have suggested that the SEC would only require admissions of wrongdoing where it would be in the public interest. According to the memo, this may include “misconduct that harmed large numbers of investors or placed investors or the market at risk of potentially serious harm; where admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct; or when the defendant engaged in unlawful obstruction of the Commission’s investigative processes.”2

READ MORE…

 

Read this article and additional publications at pillsburylaw.com/publications-and-presentations.

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On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk.  The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges.  This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)

As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology.  The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).

The Staff intends to focus its attention on the areas set forth below.   

New and Emerging Issues.

The Staff believes that new and emerging risks related to IA-ICs include the following:

  • New Registrants.  The vast majority of the approximately 2,000 new investment adviser registrants are advisers to hedge funds or private equity funds that have never been registered, regulated, or examined by the SEC.  The Presence Exam initiative, which is a coordinated national examination initiative, is designed to establish a meaningful “presence” with these newly registered advisers.  The Presence Exam initiative is expected to operate for approximately two years and consists of four phases: (i) engagement with the new registrants; (ii) examination of a substantial percentage of the new registrants; (iii) analysis of the examination findings; and (iv) preparation of a report to the industry on the findings.  The Presence Exam initiative will not preclude the SEC from bringing enforcement actions against newly registered advisers.  The Staff will give a higher priority to private fund advisers that it believes present a greater risk to investors relative to the rest of the registrant population or where there are indicia of fraud or other serious wrongdoing.  We expect to see the SEC bring enforcement actions against private equity and hedge fund managers for issues related to valuations, calculation of performance-related compensation and communications to investors that describe valuations and performance-related compensation.
  • Dually Registered IA/BD.  Due to the continued convergence in the investment adviser and broker-dealer industry, the Staff will continue to expand coordinated and joint examinations with the broker dealer examination program of dually registered firms and distinct broker-dealer and investment advisory businesses that share common financial professionals.  It is not uncommon for a financial professional to conduct a brokerage business through a registered broker-dealer that the financial professional does not own or control and to conduct investment advisory business through a registered investment adviser that the financial professional owns and controls, but that is not overseen by the broker-dealer.  This business model presents many potential conflicts of interest.  Among other things, the Staff will review how financial professionals and firms satisfy their suitability obligations when determining whether to recommend brokerage or advisory accounts, the financial incentives for making such recommendations, and whether all conflicts of interest are fully and accurately disclosed.
  • “Alternative” Investment Companies.    The NEP will also focus on the growing use of alternative and hedge fund investment strategies in registered open-end funds, exchange-traded funds (“ETFs”), and variable annuity structures.  The Staff intends to assess whether: (i) leverage, liquidity and valuation policies and practices comply with regulations; (ii) boards, compliance personnel, and back-offices are staffed, funded, and empowered to handle the new strategies; and (iii) the funds are being marketed to investors in compliance with regulations.
  • Payments for Distribution In Disguise.    The Staff will also examine the wide variety of payments made by advisers and funds to distributors and intermediaries, the adequacy of disclosure made to fund boards about these payments, and boards’ oversight of the same.  With respect to private funds, the Staff will examine payments to finders or other unregistered intermediaries that may be conducting a broker dealer business without being registered as such.  Payments made pursuant to the Cash Solicitation Rule will also be a focus of private fund payment arrangements.

Ongoing Risks.

The Staff anticipates that the ongoing risks selected as focus areas for IA-ICs in 2013 will include:

  • Safety of Assets.  The Staff has indicated that recent examinations of investment advisers have found a high frequency of issues regarding the custody and safety of client assets under the Investment Advisers Act of 1940 (“Advisers Act”) Rule 206(4)-2 (the “Custody Rule”).   The staff will focus on issues such as whether advisers are: (i) appropriately recognizing situations in which they have custody as defined in the Custody Rule; (ii) complying with the Custody Rule’s “surprise exam” requirement; (iii) satisfying the Custody Rule’s “qualified custodian” provision; and (iv) following the terms of the exception to the independent verification requirements for pooled investment vehicles.  Many private equity funds and fund of funds have been slow to adopt policies and procedures that comply with the Custody Rule.
  • Conflicts of Interest Related to Compensation Arrangements.  The Staff expects to review financial and other records to identify undisclosed compensation arrangements and the conflicts of interest that they present.  These activities may include undisclosed fee or solicitation arrangements, referral arrangements (particularly to affiliated entities), and receipt of payment for services allegedly provided to third parties. For example, some advisers that place client assets with particular funds or fund platforms are, in return, paid “client servicing fees” by such funds and fund platforms. Such arrangements present a material conflict of interest that must be fully and clearly disclosed to clients.  These types of compensation arrangements are commonplace among private equity fund advisers, many of which have just recently registered.  In fact, many private equity funds have compensation arrangements that the Staff believes requires broker dealer registration.  We believe that the Staff will make this point quite clearly by bringing enforcement actions against certain private equity fund general partners for engaging in unregistered broker dealer activity.  Enforcement actions are viewed as an effective way to get the message across to an industry that has long ignored this particular issue.
  • Marketing/Performance.  Marketing and performance advertising is viewed by the Staff as an inherently high-risk area, particularly among private funds that are not necessarily subject to an industry standard for the calculation of investment returns.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The Staff will also focus on the accuracy of advertised performance, including hypothetical and back-tested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.   The Staff is starting to think about how the anticipated changes in advertising practices related to the JOBS Act will affect their reviews regarding registrants’ use of general solicitations to promote private funds.  Whether private funds will be permitted to advertise performance under the JOBS Act rules remains to be seen.  Certainly, there have been loud and influential voices that advocated for the position that the SEC should continue to study performance advertising by private funds before allowing it in the adoption of the highly anticipated rules.
  • Conflicts of Interest Related to Allocation of Investment Opportunities.  Advisers managing accounts that do not pay performance fees (e.g., most mutual funds), side-by-side with accounts that pay performance-based fees (e.g., most hedge funds) face potential conflicts of interest.  The Staff will attempt to verify that the registrant has controls in place to monitor the side-by-side management of its performance-based fee accounts and non-performance-based fee accounts with similar investment objectives, especially if the same portfolio manager is responsible for making investment decisions for both kinds of client accounts or funds.  For certain types of strategies, such as credit strategies, where one fund may be permitted to invest in all securities in the capital structure, whereas other funds may be limited in what they can purchase by credit quality or otherwise, these potential conflicts of interest are particularly acute.  Fund managers must have policies in place that account for these potential conflicts, manage the conflicts and document the investment resolution.
  • Fund Governance.  The Staff will continue to focus on the “tone at the top” when assessing compliance programs.  The Staff will seek to confirm that advisers are making full and accurate disclosures to fund boards and that fund directors are conducting reasonable reviews of such information in connection with contract approvals, oversight of service providers, valuation of fund assets, and assessment of expenses or viability.  Chief Compliance Officers will want to make sure that those items that are required to be undertaken in the compliance manual actually occur as stated and scheduled.

Policy Topics.

The staff anticipates that the policy topics for IA-ICs will include:

  • Money Market Funds.  The SEC continues to delude itself regarding the regulation of money market funds.  This once sleepy and relatively benign product is now the pillar of the commercial paper market and functions like and deserves the regulation of a banking product.  But the SEC, and the mutual fund trade organization, are loathe to cede authority to banking regulators for this “dollar per share”  product.  Accordingly, the SEC will continue to try to find ways for thinly capitalized advisers to offer and manage  money market funds by requiring money market funds to periodically stress test their ability to maintain a stable share price based on hypothetical events, such as changes in short-term interest rates, increased redemptions, downgrades and defaults, and changes in spreads from selected benchmarks (i.e., basically, all of the market events that have proven fatal to money market funds in the past and which will be so again as long as these funds remain fundamentally flawed).
  • Compliance with Exemptive Orders.  The staff will focus on compliance with previously granted exemptive orders, such as those related to registered closed-end funds and managed distribution plans, employee securities companies, ETFs and the use of custom baskets, and those granted to fund advisers and their affiliates permitting them to engage in co-investment opportunities with the funds.  Exemptive orders are typically granted pursuant to a number of well-developed conditions with which the registrant promises to adhere.  The market timing and late trading scandals of 2003 illustrated that once a registrant has obtained an exemptive order, it may or may not abide by all of the conditions of that order.
  • Compliance with the Pay to Play Rule.  To prevent advisers from obtaining business from government entities in return for political “contributions” (i.e., engaging in pay to play practices), the SEC recently adopted and subsequently amended, a pay to play rule. The Staff will review for compliance in this area, as well as assess the practical application of the rule.  Advisers should be aware that most states have their own pay to play rules and many of them have penalties that are far more onerous than the SEC’s rule.

We will continue to monitor this and other new developments and provide our clients with up to date analysis of the rules and regulations that may affect their businesses.

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Written by:  Jay B. Gould 

The recently enacted JOBS Act[1] requires the Securities and Exchange Commission (“SEC”) to promulgate rules that would effectively repeal the ban on general solicitation and general advertising under Rule 506 of Regulation D by private issuers, including private funds.  Pursuant to the JOBS Act, the SEC has 90 days from the date of enactment (July 4, 2012) to adopt rules implementing this provision.   In advance of publishing proposed rules, the SEC has started accepting comment letters on all aspects of the JOBS Act, including the repeal of the ban on general advertising.  

Unsurprisingly, the Investment Company Institute (“ICI”), the lobby organization for mutual funds and other registered funds, has submitted a comment letter requesting that the SEC take a slow and deliberate approach to permitting private funds to generally advertise and solicit investors.  How slow and deliberate?  The ICI suggests that performance advertising by hedge funds should be prohibited altogether until the SEC has had the opportunity to study hedge fund advertising, “gain experience with private fund advertisements,” and craft a rule similar to Rule 482 to which mutual fund advertising is subject.  The ICI tells us that Rule 482 is the culmination of 60 years of experience and that the SEC “should follow the same path here,” referring to advertising by hedge funds and other private funds.  60 years?  Really? 

The ICI has a long and storied history of blocking financial innovation and expansion of investment opportunities for the investing public.  You may recall that the ICI sued the Office of the Comptroller of the Currency in an attempt to block banks from acting as investment advisers to mutual funds, a case that they ultimately lost at the Supreme Court.  It is hardly surprising then that the mutual fund lobby would line up against competition by the private funds industry, even at a time when the registered funds and private funds businesses are converging at a rapid pace in terms of product offerings, investment strategies, and regulatory oversight and reporting.  Last August the SEC issued a “concept release” that requested comment on whether registered funds should be able to use the same sorts of investment techniques and to the same extent as private funds, such as hedging, shorting, and use of leverage.  Further action in this regard, coupled with the new reporting obligations of private funds as a result of Dodd Frank (e.g., Form PF) will serve to further blur the lines between registered and unregistered funds. 

In addition to “urging” a ban on performance advertising and promoting the idea of other “content restrictions” by hedge funds and other private funds, the ICI suggests that private fund advertising should be subject to FINRA review to the same extent as mutual fund advertising, and that private fund advertising be clearly distinguished from mutual fund advertising.  The ICI further suggests that the SEC should raise the net worth threshold for “accredited investors” in order to insure that private fund investors have the requisite sophistication to withstand the riskiness associated with private funds (See legalaffairs March–April 2004 issue).  The ICI endorses a $600,000 annual income and $3 million net worth standard, a measure that would further reduce the potential private fund investor pool and drive more investors to the registered world. 

More balanced voices have also started to comment on this issue, so it remains to be seen how much weight the SEC will ultimately attribute to the ICI comment letter.  You may view all of the comment letters regarding the repeal of the ban on general solicitations here.    And you are encouraged to submit your own.

[1]   The Jumpstart Our Business Startups Act.

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Written by Jay Gould

On Wednesday, November 16, 2011, the SEC charged Morgan Stanley Investment Management (“MSIM”) with violating securities laws in a fee arrangement that costs a fund and its investors approximately $1.8 million in sub-adviser fees.

MSIM is the primary adviser to The Malaysia Fund (the “Fund”), a closed-end investment company that invests in equity securities of Malaysian companies.  AMMB Consultant Sendirian Berhad (“AMMB”) was an SEC registered adviser located in Malaysia.  AMMB is a wholly owned subsidiary of AM Bank Group, one of the largest banking groups in Malaysia.  Pursuant to a Research and Advisory Agreement entered into by the Fund with AMMB and MSIM in 1987, AMMB undertook to provide advice, research and assistance to MSIM for the benefit of the Fund.  Every year AMMB submitted a report to MSIM which MSIM provided to the Fund’s board of directors in its evaluation for the renewal of the advisory and sub-advisory agreements.  The board evaluated and approved AMMB’s sub-adviser agreement based on representations from MSIM that AMMB was providing advisory services to the Fund.  AMMB did not actually provide those advisory services.  MSIM also prepared and filed the Fund’s annual and semi-annual reports to investors that inaccurately represented AMMB’s services. 

The SEC found that “MSIM failed its duty to provide the fund’s board members with the information they needed to fulfill their significant responsibility of reviewing and approving the sub-adviser’s contract.”  In addition, MSIM did not adopt and implement policies and procedures governing the advisory contract renewal process and its oversight of AMMB.

According to the SEC’s order, MSIM willfully violated Section 15(c) and 34(b) of the Investment Company Act and Section 206(2) and (4) of the Investment Advisers Act of 1940, and Rule 206(4)-7 thereunder. 

The SEC ordered MSIM to pay the Fund $1.845 million as reimbursement of the advisory fees the Fund paid to AMMB from 1987 to 2008.  MSIM was also ordered to pay $1.5 million penalty fee.  MSIM agreed to pay over $3.3 million to settle the SEC’s charges. 

A full text of the SEC release and order are available here.

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Following the September 2008 run on money market funds, which began following the failure of Lehman Brothers Holdings, Inc., the Treasury Department requested that the President’s Working Group on Financial Markets (“PWG”) prepare a report on the regulatory changes needed to address systemic risk and to reduce the susceptibility of money market funds to runs. On October 21, 2010, the PWG responded with its report entitled “Money Market Fund Reform Options.” The policy options discussed in the report include:

  • requiring money market funds to have floating net asset values;
  • creating emergency liquidity facilities funded by the money market fund industry;
  • requiring large redemptions to be paid in kind, rather than in cash; and
  • mandating participation in an insurance system.

The report emphasized that new measures intended to mitigate money market fund risks would also likely reduce the appeal of money market funds to many investors and cause investors to shift assets to unregulated funds with stable NAVs, such as offshore money market funds, enhanced cash funds, and other stable value vehicles. As such funds are subject to little or no regulatory oversight, the growth of unregulated money market funds would likely increase systemic risks. Therefore, any policies intended to reduce the risks associated with money market funds would need to limit the potential for regulatory arbitrage by imposing enhanced constraints on unregulated money market fund substitutes (for example, by providing that the exemptions from registration under the Investment Company Act of 1940 provided by Sections 3(c)(1) and 3(c)(7) thereunder are not available to investment vehicles maintaining a stable net asset value).

The Financial Stability Oversight Council will further examine the reform options discussed in the report in order to identify those most likely to reduce money market funds’ susceptibility to runs.

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Earlier this year the SEC staff commenced a review to evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies, including, among other things, whether existing prospectus disclosures adequately address the particular risks created by derivatives.  In a July 30, 2010 letter to the Investment Company Institute, the SEC staff indicated that the initial results of its review are not encouraging.

It found that funds are providing generic disclosure about derivatives that is not adequately tailored to the specific investment strategies of the fund and does not emphasize the specific types of derivatives used by the fund, the extent of their use and the purpose of using derivatives transactions.  As a result, investors may not be receiving the disclosure they need in order to understand the risks associated with their investment in a fund.  The staff urged all funds that use derivatives to assess the accuracy and completeness of their disclosure, tailor their disclosure to include a description of the fund’s expected uses of derivatives and their relative importance and ensure that such disclosure is presented in an understandable manner using plain English.

Although the staff’s letter only addresses the disclosure provided by registered investment companies, hedge funds and other private funds are subject to anti-fraud principles requiring them to disclose all material information to investors and, therefore, should also take into account this guidance when preparing derivatives-related disclosure.