Investment Management Update: April 2009

April 30, 2009
10 minutes

8th Circuit Rules on Mutual Fund Fee Standard

In Gallus v. Ameriprise Financial, Inc., the Eighth Circuit reversed a decision of the district court that granted summary judgment against the plaintiffs, who were shareholders of certain mutual funds advised by Ameriprise. The plaintiffs alleged that the adviser breached its fiduciary duties to the funds under Section 36(b) of the Investment Company Act of 1940 (Act) by charging fees that were “excessive.” The district court had previously determined that the evidence developed by the plaintiffs in discovery failed to raise a disputed issue of material fact and that the adviser was therefore entitled to judgment as a matter of law under the standard set forth in Gartenberg v. Merrill Lynch Asset Management, Inc. The Eighth Circuit stated that “the proper approach to Section 36(b) is one that looks to both the adviser’s conduct during negotiations and the end result.” The adviser has a “duty to be honest and transparent throughout the negotiation process.” Although the Eighth Circuit concluded that “the Gartenberg factors provide a useful framework for resolving claims of excessive fees,” the appeals court ruled that the district court had not adequately considered certain parts of the record before granting summary judgment. In particular, the Eighth Circuit held that “the district court should have explored the disputed issues of material fact concerning the similarities and differences between mutual funds and institutional accounts.” The district court also should have considered whether the adviser “purposefully omitted, disguised, or obfuscated information that it presented to the Board about the fee discrepancy between different types of clients.”

SIGTARP Issues Report on TARP Programs

On April 21, 2009, the Office of the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) issued a report to Congress regarding the status of the Troubled Asset Relief Program (TARP) and SIGTARP’s oversight efforts. Over the past several months, TARP has evolved from a $700 billion program focused on the purchase and management of so-called “toxic assets” consisting primarily of troubled mortgages and mortgage-backed securities (MBS) to 12 separate programs involving TARP funds, Federal Reserve loans, FDIC guarantees and private funds, the total of which could reach close to $3 trillion. Of the original $700 billion authorized under the Emergency Economic Stabilization Act of 2008 (EESA), $328.6 billion had been spent as of March 31, 2009.

Under EESA, SIGTARP has the responsibility, among other things, to conduct, supervise, and coordinate audits and investigations of the purchase, management, and sale of assets under TARP. On March 25, 2009, Congress unanimously passed the Special Inspector General for the Troubled Asset Relief Program Act of 2009, which amends EESA to enhance the authority of SIGTARP, including a requirement that the Treasury Secretary must take steps to address deficiencies identified by SIGTARP or certify to Congress that no action is necessary or appropriate. Some of the significant recommendations made by SIGTARP that will be of interest to our investment management clients include: 

  • Requiring TARP recipients to report on their use of TARP funds. This recommendation is focused on capital investment and lending programs (e.g., bank and AIG bail-outs), as well as TARP funding of toxic asset purchases (e.g., transactions under the Public-Private Investment Program (PPIP) and surrenders of collateral under the Term Asset-Backed Securities Loan Facility (TALF)). SIGTARP considers “TARP Recipients” to include not only financial institutions which receive TARP investments or sell TARP assets, but also entities which use TARP funds to purchase TARP assets, such as the proposed Public-Private Investment Funds (PPIFs). Implementation of this recommendation could result in public reporting of such securities positions. 
  • Mitigating the potential risks arising from the proposed expansion of TALF to include legacy residential MBS by imposing heightened screening and eligibility requirements and significantly higher “haircut” percentages for MBS, generally, and legacy residential MBS, in particular. 
  • Imposing strict conflict of interest rules on PPIF fund managers, mandating identification of investors in PPIFs and disclosure of all transactions undertaken by the PPIFs, requiring PPIF fund managers to screen investors under procedures at least as comprehensive as the “Know Your Customer” procedures of commercial banks or retail brokerage operations, permitting SIGTARP and other oversight entities access to books and records regarding PPIF investments (including books and records of private investors relating to PPIF investments), and granting PPIF equity stakeholders (including TARP) most favored nation status to ensure taxpayers benefit from terms at least as favorable as those given to all other parties dealing with the PPIF fund managers. 
  • Curtailing the ability of legacy securities PPIFs to invest through TALF, absent measures such as limiting the use of leverage by the PPIFs or increasing the “haircuts” on securities purchased by PPIFs through TALF. 
  • Enhancing oversight. It is SIGTARP’s view that the documents executed by borrowers, ABS issuers and primary dealers under TALF provide insufficient oversight-enabling provisions and that the Treasury and the Federal Reserve have not established a sufficient compliance protocol regarding TALF. 
  • Disclosure of borrowers who surrender TALF collateral. 
  • Disclosure of transactions in legacy assets for other clients of the PPIF manager.

In addition, SIGTARP urged the Treasury to issue regulations regarding executive compensation requirements for TARP recipients. In a letter dated March 9, 2009 to SIGTARP, the Treasury stated that the executive compensation standards set forth in EESA “did not apply to TALF participants.” SIGTARP notes that “the Treasury has not indicated to what extent the EESA executive compensation restrictions will apply to the participants in the [PPIP] or expanded TALF programs.” According to SIGTARP, the Treasury has stated that “the applicability of the executive compensation regulations, which have not yet been published, will be fact-dependent” and PPIF fund managers that are “co-owners” of the PPIFs “would not be passive investors and could be subject to the executive compensation restrictions.”

SEC Permits Broker-Dealers to Send Quarterly Account Statements to Certain Money Market Fund Customers

The U.S. Securities and Exchange Commission (SEC) granted an exemption pursuant to Rule 10b-10 under the Securities Exchange Act of 1934 (Exchange Act) on April 7, 2009, permitting Legg Mason Investor Services, LLC (LMIS), a broker-dealer which is the underwriter or sponsor of a number of money market funds, to send account statements to money market fund customers on a quarterly rather than monthly basis under certain circumstances. Rule 10b-10(b) requires a broker-dealer to send customers monthly account statements disclosing all transactions in money market funds during the previous monthly period, and to send customers quarterly account statements for all transactions in “periodic plans.” The SEC approved LMIS’s request to not send monthly customer account statements for months when no transactions occur (including the deduction of fees) other than regularly scheduled monthly payments and automatic reinvestment of dividends at the stable $1.00 per share net asset value. LMIS asserted that the money market funds’ monthly payment and reinvestment of dividends at a fixed net asset value per share is similar to transactions in a “periodic plan” as defined in Rule 10b-10(a), for which the Rule requires only quarterly customer account statements. The SEC noted that it has granted similar exemptions to other broker-dealers, and that this exemption extends to any money market funds that LMIS may underwrite in the future. In addition, the SEC extended the exemption to any broker-dealer meeting the conditions listed in the exemption. In order to qualify for the exemption, a broker-dealer must satisfy the following conditions: (1) the broker-dealer must continue to confirm all account activity, except the automatic reinvestment of dividends, as required by Rule 10b-10; (2) the broker-dealer must make available to customers on the internet and by telephone current information on the automatic dividend reinvestment; and (3) the broker-dealer must send quarterly account statements to its customers confirming all account activity, including the automatic reinvestment of dividends.

Test Data Measuring the Effectiveness of Model GLB Privacy Notices Published

The SEC has reopened the period for public comment on proposed amendments to Regulation S-P that were originally published in the Federal Register on March 29, 2007. The proposed amendments implement the privacy provisions of the Gramm-Leach-Bliley Act (GLB Act) and will, if adopted, create a safe harbor for a model form that financial institutions may use to provide disclosures in initial and annual privacy notices required under Regulation S-P. In connection with the development of the model form, an outside consultant, Macro International (Macro), was retained by various federal agencies to conduct quantitative testing to evaluate the effectiveness of four different types of privacy notices. The notices were tested on approximately 1,000 consumers at five retail shopping mall locations around the country. The SEC has placed in the comment file for the proposed rule the following documents related to the testing: (i) the test data collected and provided by Macro together with the codebook that relates to the data; (ii) the report provided by Macro, which includes a summary of the methodology used in collecting the data, the interview protocol, and the four test notices; and (iii) a report describing the results of the test data prepared by Dr. Alan Levy and Dr. Manoj Hastak. The extended comment period expires on May 20, 2009.

SEC Staff Permits Affiliate to Purchase Securities from Funds Without Obtaining an Exemptive Order

The SEC Staff granted no-action relief requested by Regions Financial Corporation (Regions) to allow it to purchase certain distressed fixed-income securities from the Regions Morgan Keegan Funds without obtaining an exemptive order under Section 17(b) of the Investment Company Act of 1940 (Act). The fixed-income securities in question are owned by the funds as a result of their participation in a securities lending program (Program) administered by BNY Mellon. In connection with the Program, the funds owned shares of the BNY Institutional Cash Reserves Fund (BNY Fund), an unregistered fund used as a short-term investment vehicle for the cash collateral received by the funds under the Program. The fixed-income securities held by the BNY Fund include (i) a promissory note issued by Whistlejacket Capital Ltd. or certain of its affiliates and (ii) certain floating rate debt securities of Lehman Brothers Holdings Incorporated (Distressed Securities). The issuers of the Distressed Securities have filed for bankruptcy protection and consequently these securities decreased in value and became illiquid. Previously, BNY Mellon had entered into an agreement with the funds whereby BNY Mellon agreed to provide limited capital support with respect to the decline in value/illiquidity of the Distressed Securities, so long as the funds were participating in the Program. According to the terms of the capital support agreement between the funds and BNY Mellon, when the funds redeem their interests in the BNY Fund they will receive a distribution in-kind of the funds' proportionate share of Distressed Securities. The funds are advised by Morgan Asset Management, Inc. (MAM), an indirect, wholly-owned subsidiary of Regions.

Separately from the issues that arose with respect to the Program, Regions and MAM entered into an agreement with Pioneer Investment Management, Inc. (Pioneer), pursuant to which the funds would be reorganized into new or existing funds managed by Pioneer (Reorganizations). Under the terms of this agreement, the funds must withdraw from the Program prior to or at the completion of the Reorganizations and cannot own any interest in the Distressed Securities. In order to prevent the funds from being disadvantaged by their withdrawal from the Program, Regions (through MAM) agreed to purchase each fund’s proportionate share of the Whistlejacket securities at 100% of par value and each fund's proportionate share of the Lehman securities at 80% of par value. Conceding that the funds would not have sufficient time to obtain an exemptive order from the SEC before the Reorganizations' scheduled closing date, as is normally required for relief under Section 17(b), Regions argued, that in light of "business exigencies and current market conditions," it should be allowed to proceed without an exemptive order. The SEC Staff agreed to grant Regions' request, but noted that its decision was made "in light of the unusual facts and circumstances" of the request and that the no-action letter applies only to the entities seeking the relief and cannot be relied upon by other parties.

Other Developments

Since the last issue of our IM Update we have also published the following separate Client Alert(s) of interest to the investment management industry:

2009 Mutual Funds and Investment Management Conference Report

SEC Proposes Restoring Uptick Rule or Adopting Other Restrictions on Short Sales

For further information, please contact the Ropes & Gray attorney who normally advises you.