The Massachusetts Securities Division has proposed changes to the regulations governing investment advisers that are located in Massachusetts or that otherwise have clients or funds with investors located in Massachusetts. If adopted, the amendments would impact the use of expert networks by investment advisers and eliminate one of the primary exemptions from Massachusetts state-level registration as an adviser.

Under the proposed regulations, it would be considered dishonest or unethical conduct, punishable with administrative fines, censure, suspension or revocation of any registration, for an investment adviser to use a “matching” or “expert network” service (“ENS”) without obtaining a written certification from the expert consultant. The certification from the consultant must 1) describe all confidentiality restrictions that the consultant has, or reasonably expects to have, regarding confidential information, and 2) affirmatively state that the consultant will not provide any confidential information to the adviser.

The requirement to obtain consultant certification would apply to all non-SEC registered investment advisers either (i) with an office located in Massachusetts or (ii) with clients or fund investors located in Massachusetts (irrespective of whether the adviser itself is located or registered in another state). It is unclear at this point whether the requirement would also apply to SEC-registered advisers. At a public hearing held on June 22, 2011, representatives of Secretary of State William Galvin tentatively stated that SEC-registered advisers that do business in Massachusetts would not be subject to the new ENS regulations. At the public hearing, the staff of the Massachusetts Securities Division indicated it was not the intention to bring SEC-registered advisers within the scope of the new ENS rule.

Perhaps more significant because of the potential ramifications for small investment advisers is the proposed elimination of an exemption from Massachusetts state-level registration as an adviser. This proposal would not affect SEC-registered investment advisers. However, non-SEC registered investment advisers either (i) with an office located in Massachusetts or (ii) with clients or fund investors located in Massachusetts (irrespective of whether the adviser itself is located or registered in another state) would no longer be able to rely upon a widely-used exemption from registration in Massachusetts. Currently, such advisers may rely upon an exemption from Massachusetts registration for advisers to “institutional buyers.” Institutional buyer is defined in Section 12.205(b) of the Massachusetts regulations to include funds composed of investors that each contributed at least $50,000 and qualified as an “accredited investor” (as defined in the rules under the Securities Act of 1933). The exemption would be eliminated by the proposed amendment by redefining the term “institutional buyer” in Section 12.205 to no longer include such funds.

The proposed new definition of “institutional buyer” would also include a grandfathering provision, however, to permit advisers that relied upon the exemption prior to the date of the amendment’s implementation to continue to do so, but only so long as no new investors or contributions by existing investors are accepted by the fund. For all other purposes, the exemption would no longer exist, impacting small investment advisers who may need to become registered in Massachusetts unless another exemption is available to them.

The Massachusetts Securities Division has proposed a new exemption from state-level adviser registration that would be applicable to advisers solely to so-called 3(c)(7) funds or venture capital funds. For some non-SEC registered advisers, this new exemption may alleviate the need to register as an investment adviser in Massachusetts. Licensure requirements may apply to individuals who are employed by advisers registered with Massachusetts.

The possible effective date of these proposed amendments is uncertain. With respect to the proposed amendment to the state-level registration rules, a representative from the Massachusetts Securities Division indicated at the June 22, 2011 public hearing that the Division is cognizant of the need to coordinate timing with federal changes in adviser registration requirements under Dodd-Frank. As previously reported, the deadline for investment advisers to comply with the new registration requirements under Dodd-Frank was recently extended by the SEC to March 30, 2012.

The Supreme Court issued a 5-4 decision on June 13, 2011 holding that false statements included in a mutual fund prospectus were “made” by the fund, not the investment adviser to the fund. The Court held that since the false statements were not made by the adviser, the adviser cannot be held liable in a private action under Rule 10b-5 under the Exchange Act of 1934.

The Supreme Court held that for Rule 10b–5 purposes, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not “make” a statement in its own right. The majority held that although JCM, the adviser, may have been significantly involved in preparing the prospectuses, it did not itself “make” the statements at issue for Rule 10b–5 purposes.

In coming to this conclusion, the Court considered the uniquely close relationship between a mutual fund and its investment adviser, but noted that the fund and the adviser are separate legal entities and that the corporate formalities were observed. Accordingly, the Court found that the adviser’s assistance in crafting the prospectus was subject to the fund’s ultimate control, and that reapportionment of liability in light of close relationships between mutual funds and advisers is the responsibility of Congress, not the courts.

Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. --- (2011).

See WilmerHale update at: http://wilmerhaleupdates.com/ve/ZZxt61y82gLF75D2927.  

In one of the few excessive-fee decisions in the wake of Jones v. Harris, on Wednesday June 1, 2011, the United States District Court of Arizona granted an adviser’s motion to dismiss a plaintiff client’s excessive-fees lawsuit. The plaintiff’s complaint alleged, among other things, that the defendant breached its fiduciary duty under Section 36(b) of the Investment Company Act of 1940 (“Section 36(b)”) by charging investment advisory fees and 12b-1 marketing and distribution fees that were excessive and disproportionate to the services provided. In dismissing the case, the court rigorously applied the standards set forth in Gartenberg, and recently clarified in Jones v. Harris. 

The court found that the plaintiff made general allegations about the fees charged, and failed to demonstrate that these fees were not reasonable for the services provided. The court also found that the ratio between 12b-1 fees and advisory fees was irrelevant to a Section 36(b) claim, and thus could not, per se, serve as evidence that fees were disproportionate to the services provided. 

In response to plaintiff’s claims that the fund was “excessively profitable” for the adviser, the court noted that fees are not excessive merely because advisers make a profit, nor do large fees necessarily equal excessive fees. Moreover, the court found that statistical information provided by the plaintiff showed that the ratio between the fund’s fees and net assets remained constant over time. In fact, the court observed that the ratio of 12b-1 fees to net assets had slightly declined.

The plaintiff also alleged that the fund’s fees were excessive as compared to those of other funds. However, the court found the comparison of actively managed funds to index funds to be inapt, and further noted that the plaintiff’s comparison to non-index funds was limited to funds that were recognized in the industry for low fees. As a result, the plaintiff’s comparison was rejected as having little probative value. Similarly, the court rejected the plaintiff’s fall-out benefits argument on the basis that plaintiff did not adequately allege that the 12-b1 fee or advisory fee was excessive on a stand-alone basis. Finally, the court found the plaintiff’s arguments regarding the lack of director independence to be generalities that failed to satisfy the plaintiff’s burden. Accordingly, the court denied plaintiff leave to further amend the complaint and dismissed the plaintiff’s Section 36(b) complaint with prejudice.

On May 10, 2011, the SEC held a roundtable discussion on the systemic risk posed by money market funds. The primary focus of the roundtable was twofold: identify systemic risks posed by money market funds to the broader financial markets, and discuss policy options that would address and mitigate the identified risks. Participants included representatives of various regulators, including the newly created Financial Stability Oversight Council and the FDIC, industry organizations and institutional investors. 

The systemic importance of money market funds became clear during the market crisis in September 2008. As a result of the Lehman collapse, institutional investors made significant redemptions from prime money market funds, resulting in a liquidity crisis that required federal government intervention.  In the wake of the run on money market funds, the SEC made several amendments to existing money market fund regulations, including imposing new liquidity and reporting requirements, and tightening credit quality standards. Shortly after the regulatory reforms, the President’s Working Group on Financial Markets issued a report that evaluated additional reforms required to reduce the risk of money market funds to the U.S. financial markets. The roundtable expands the analysis of the systemic impact of money market funds to include a broader market perspective.

The discussion began with the susceptibility of money markets to runs, their role in the U.S. economy, and whether the benefits and utility outweighed the risks they posed to the financial markets. Several institutional investors emphasized the importance of money market funds to their organizations, and their importance to the economy in general. Participants also expressed concerns that the absence of money market funds would not necessarily remove risks from the financial markets, but shift the risks elsewhere. A few participants noted that the behavior of money market investors did not differ from the behavior of investors in other instruments at the time, and that the runs were a general reflection of diminished investor confidence in the markets. Notwithstanding these views, there appeared to be a general consensus that while money market funds can be successful investment vehicles, they are susceptible to runs during periods of market illiquidity and stress. Accordingly, the discussion shifted to how best to address potential problems, mitigate systemic risk, and fulfill emergency liquidity needs during times of extraordinary market disruption. 

The discussion focused on four policy options to address the risks posed by money market funds: (1) shifting to a floating net asset value (NAV) calculation, (2) bank regulation, (3) a private liquidity bank, and (4) mandatory capital requirements.

Floating NAV: Participants discussed whether shifting from a stable NAV calculation to a market value NAV calculation would mitigate risk. A majority of the industry participants were opposed to a floating NAV regime. The general view was that, while a floating NAV might create a more competitive environment and alter investor psychology regarding the stability of money market funds, it would not address the risk of redemption during times of market disruption. Some participants declared that they would not invest in money market funds with floating NAVs, and stressed the importance of maintaining the critical features of money market funds that made them desirable.

Bank Regulation: Another policy option was the possibility of subjecting money market funds to banking oversight and regulation. Some regulator participants were in favor of subjecting money market funds to capital requirements and other banking regulations, especially if there was to be a possibility of a government guarantee in a liquidity crisis. Industry participants agreed that  transparency would likely have made money market funds less vulnerable to mass redemptions, but pointed out that money market funds and bank deposits served very different purposes. In one commentator’s opinion, using bank regulation as a model for money market fund regulation would be perverse.

Private Liquidity Bank: A representative of the Investment Company Institute presented the option of a using a private liquidity bank to fulfill emergency liquidity requests in a crisis. The entity would be structured as a commercial bank that would build up capital over time, and, as a result of its structure as a commercial bank, have access to the Federal Reserve’s discount window. Some participants expressed concerns about determining sufficient funding in a crisis, while others worried that funding by the Federal Reserve would shift the burden to taxpayers.

Mandatory Capital Requirements: Two industry participants presented different platforms for imposing capital requirements on money market funds. One approach involved creating a reserve within the money market fund by having shareholders internalize the cost of liquidity and fund the capital requirements. The participant expressed the view that, if the liquidity cost is borne by shareholders, there would be less of an incentive to redeem before others. The other approach proposed sponsor or third party funding that could possibly be sourced by federal deposits, highly liquid government securities, insurance accounts or securitization. Roundtable participants generally agreed that imposing capital requirements would address the issues of a liquidity crunch during a market crisis. 

The SEC recently imposed sanctions against an adviser for overcharging advisory clients for commission and other fees, engaging in principal trades without satisfying the perquisite disclosure and consent requirements of the Advisers Act, and failing to adopt written policies and procedures or a written code of ethics, as required by the Advisers Act. In addition to cease-and-desist orders, the Commission imposed disgorgement fines of $369,336.15 plus $38,288.54 in prejudgment interest. The Commission further imposed civil penalties totaling $220,000 against the adviser and its culpable employees, as well as requiring an undertaking to retain an independent compliance consultant to perform periodic compliance reviews over a three-year period.

In a rare and possibly unprecedented enforcement action, the SEC revoked the registration of a Georgia-based investment adviser and transfer agent with no clients, revenue or assets under management. The SEC found that the adviser made false statements to the SEC regarding the amount of assets under management. Between August 2008 and November 2009, the adviser claimed to have $7 million, $25 million, and eventually $235 million in assets under management. In reality, the adviser had no advisory clients, revenues or assets that would require or permit registration with the SEC. In addition, despite indicating on its initial Form ADV that it was a newly formed adviser, the adviser represented on its website that it had “27+ years of unparalleled leadership” in the industry. After the adviser and transfer agent failed to appear at routine examinations and other scheduled meetings with the SEC, the owner eventually admitted that the adviser had no advisory clients or revenue. The SEC found that the conduct violated various fraud and recordkeeping provisions of the Advisers Act, as well as Section 17(b)(1) and 17A(d)(1) of the Securities Exchange Act of 1934 and Rule 17Ad-6 thereunder. In a default judgment against the respondents, due to a failure to answer or otherwise defend the proceeding, the SEC revoked the registration of the adviser and the transfer agent, and ordered each to pay a civil penalty of $325,000.  

The order can be found here: http://www.sec.gov/litigation/admin/2011/34-64483.pdf

The SEC recently charged a former NASDAQ managing director with insider trading based on alleged trading on confidential information obtained while working on NASDAQ’s market intelligence desk. The SEC alleges that the defendant reaped profits of more than $755,000 as a result of illicitly trading on material nonpublic information, frequently on his NASDAQ office computer, through an online brokerage account in his wife’s name. The defendant allegedly traded ahead of nine significant announcements involving NASDAQ-listed companies over a three-year period, utilizing information learned in confidence in his capacity as a NASDAQ employee. The defendant is charged with violations of Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder. The defendant has also been charged in a parallel criminal action by the United States Department of Justice. 

On May 25, 2011, the SEC proposed rules to implement the provisions of Section 926 of the Dodd-Frank Act. Section 926 of the Dodd-Frank Act instructs the SEC to adopt rules disqualifying certain offerings from the private placement exemption from registration under Section 4(2) of the Securities Act of 1933. The proposed amendments to Regulation D would deny the exemption provided by Rule 506 of Regulation D to a private offering if the issuer, specified affiliated persons or certain others involved in the offering are disqualified “Covered Persons.” The Rule 506 exemption is the most commonly used of the three private offering exemptions available under Regulation D, accounting for an estimated 90-95% of all Regulation D offerings. The proposed release also makes conforming amendments to Rule 501 and revises Form D to state that the bad actor disqualifications apply to Rule 506 and Rule 505 transactions. 

In its current form, Rule 506 does not impose any bad actor disqualification on issuers participating in exempt securities offerings and preempts any state law disqualifications. Proposed rule 506(c) would eliminate the Rule 506 exemption for an offering of securities that involves any of the following Covered Persons with respect to whom a Disqualifying Event has occurred:

Covered Persons include

§          the issuer, any predecessor of the issuer, any affiliated issuer;

§          any director, officer, general partner or managing member of the issuer;

§          any beneficial owner of 10% or more of any class of the issuer’s equity securities; or

§          any promoter connected with the issuer in any capacity at the time of the sale or any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale, or any managing member of any compensated solicitor.

Disqualifying Events are defined as:

§          Criminal Convictions: A conviction of any felony or misdemeanor in connection with any purchase or sale of any security, involving the making of any false filing with the SEC, or arising out of conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. The criminal condition would have to have occurred within ten years of the relevant sale (or five years, with respect to issuers, their predecessors and affiliated issuers).

§          Court Injunctions and Restraining Orders: Any order, judgment or decree of any court that restrains or enjoins such person from engaging or continuing to engage in any conduct in connection with the purchase or sale of any security, involving the making of any false filing with the SEC, or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities; provided that such order is entered within five years of the relevant sale.  

§          The Final Order Judgment or Decree: Any final order judgment or decree of a state securities commission; a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission; or a federal banking agency that:  (A) bars a covered person from (1) association with an entity regulated by such commission, authority, agency or officer; (2) engaging in the business of securities, insurance or banking; (3) engaging in savings association or credit union activities; or (B) is based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct and is entered within ten years of the date of the relevant sale.

§          SEC Disciplinary Orders: An order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Securities Exchange Act of 1934 or Section 203(e) or (f) of the Investment Advisers Act of 1940 (the “Adviser’s Act”), that suspends registration as a broker, dealer, municipal securities dealer or investment adviser, place limitation on the activities, functions or operations of the covered person, or bars such person from association with any entity or from participating in the offering of any penny stock.

§          Suspension or Expulsion for SRO Membership: Suspension or expulsion from membership or suspension or an order barring association with a member of a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act that is inconsistent with just and equitable principles of trade. 

§          Stop Orders or Orders Suspending a Regulation A Exemption: Within five years before a relevant sale, subject to a refusal order, stop order, or order suspending the Regulation A exemption (or is the subject of an investigation or proceeding to determine such event) after filing (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the SEC. 

§          US Postal Service False Representation Orders: A U.S. Postal Service false representation order entered within five years of the proposed sale of securities or a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail.

Exceptions and Waivers: Recognizing the difficulty in determining whether disqualifications would apply to Rule 506 sales, the SEC is proposing a reasonable care exception that would apply if an issuer establishes that it did not know, and in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a Covered Person. In addition, in keeping with the congressional mandate to adopt rules substantially similar to Regulation A, the SEC proposes to carry over the waiver provisions of Regulation A by permitting issuers to seek waivers from disqualification upon a showing of good cause

Retroactive Application: Perhaps most controversially, the proposed rules would apply retroactively, and encompass past disqualifying events that occurred within a relevant look-back period, irrespective of whether it was before the passage of the Dodd-Frank Act or the effectiveness of the amendments to Rule 506. 

The SEC has requested comment on a number of issues, including imposing uniform disqualification standards across Regulation D and to other exemptive rules; and extending the benefit of previous waivers granted as to Regulation A, Rule 505 of Regulation D or Regulation E, to cover the new disqualification provisions. Comments are due by July 14, 2011.   

See the text of the proposed rules here: http://www.sec.gov/rules/proposed/2011/33-9211.pdf

See WilmerHale’s publication on the rule here:http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9799

On Wednesday, May 25, 2011, the SEC adopted final rules implementing the “Securities Whistleblower Incentives and Protection” provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The SEC identified the goal of the program as rewarding individuals who act early to expose violations of federal securities laws and provide evidence to aid the SEC in bringing successful enforcement cases. In adopting the final rule, the SEC took into account hundreds of comment letters and form letters from advocacy groups, compliance counsel, law firms, public companies and various other organizations. 

The new Regulation 21F defines a whistleblower as an individual who voluntarily provides original information to the SEC regarding possible securities laws violations that leads to the successful enforcement of an action or related action in any judicial or administrative proceeding brought by the SEC that results in monetary sanctions of more than $1 million. For purposes of calculating the $1 million sanction amount, the rules permit the aggregation of sanctions imposed in multiple proceedings, so long as they arise from a single action.

The final rules do not mandate internal reporting prior to external reporting to the SEC. In a statement, the SEC Chairman Mary Schapiro addressed this hotly contested issue:  “The final recommendation strikes the correct balance between encouraging whistleblowers to pursue the route of internal compliance when appropriate, while providing the option of heading directly to the SEC.” She added that the whistleblower is usually in the best position to choose the most appropriate route to pursue. The final rules provide incentives to encourage internal reporting where appropriate by: (1) taking into consideration the individual’s voluntary participation in the entity’s internal compliance and reporting processes in determining an award amount, (2) crediting and rewarding whistleblowers who report internally by making these whistleblowers eligible for awards if the entity simultaneously or later reports the information to the SEC that leads to a successful enforcement action, and (3) extending the grace period to report possible violations to the SEC after reporting internally from 90 to 120 days. 

The final rules exclude from whistleblower eligibility individuals whose knowledge of possible violations does not constitute independent knowledge. This exclusion covers internal and external counsel and non-attorneys who obtain information from confidential attorney-client communications; employees or other persons associated with public accounting firms; and officer, directors, trustees or partners of an entity who are informed of possible violations as a result of their roles in the entity’s investigative process.

Culpable whistleblowers are not expressly excluded from eligibility, however, culpability will be considered in determining an award amount. For purposes of determining the required $1 million sanction threshold, the SEC will not consider monetary sanctions that the culpable whistleblower is ordered to pay or that an entity is ordered to pay based substantially on the conduct that the culpable whistleblower directed, planned or initiated.

Finally, the rules provide anti-retaliation protection for both external whistleblowers and internal whistleblowers who reasonably believe that a violation has occurred, irrespective of whether the whistleblower is ultimately entitled to an award. However, the anti-retaliation protections for internal reporting are limited to employees of entities that are public companies. The rules become effective on August 12, 2011.   

See WilmerHale’s publication on the rule here: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9795