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Ropes & Gray’s Investment Management Update October-November 2019

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry

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Investment Management Update: March 2009


Time to Read: 9 minutes Practices: Investment Management

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The following summarizes recent legal developments of note affecting the mutual fund/investment management industry:

Court Upholds Use of Actively Managed Mutual Funds as 401k Plan Options

The U.S. District Court for the District of Connecticut recently granted summary judgment in favor of United Technologies Corporation (UTC) in a suit by several participants in the company’s employee benefit plan (Plan). Plaintiffs alleged that UTC had breached its fiduciary duties in managing the plan under the Employment Retirement Income Security Act (ERISA) by choosing to have a fund invested in UTC stock hold some of its assets in cash; offering mutual funds with unreasonably high fees and expenses; offering actively managed investment options; paying unreasonably high compensation to the plan’s recordkeeper, as evidenced by certain revenue sharing arrangements; and making misstatements to participants regarding fees and expenses. In granting summary judgment for UTC, the court repeatedly stated that plaintiffs’ allegations (that the plan participants may have been able to enjoy greater fund performance if the Plan had chosen to take different actions) were not sufficient to establish a breach of fiduciary duty where the record showed that the defendants had prudently analyzed its decision. Further, the court noted that even though plaintiffs’ expert suggested that separate accounts may be less expensive than mutual funds, plan fiduciaries did not necessarily have to take such an alternative option because ERISA does not require a fiduciary to select the “best” option, as long as the fiduciary can establish that it engaged in a prudent analysis of its decision.

SEC Settles Squawkbox Case

On March 11, 2009, Merrill Lynch, Pierce, Fenner & Smith Inc. (Merrill Lynch) settled a so called “squawkbox” case filed by the Securities and Exchange Commission (SEC). The settled order alleges that the broker-dealer violated the securities laws by having inadequate procedures for controlling access to information about customer order flow. Without admitting or denying liability, the broker-dealer agreed to pay a $7 million fine. The SEC order also set forth procedures for use of order flow information that may affect the way that brokers-dealers have traditionally used that information to execute trades.

The order alleges that from 2002 to 2004, several Merrill Lynch retail brokers permitted day traders to hear confidential information about large unexecuted block orders. The order information was transmitted over “squawkboxes,” speakers on brokers’ desks over which traders communicate customer order information to assist the brokers in executing the trades.

The settled order alleges that Merrill Lynch brokers gave several day trading firms access to the order flow information by calling the day traders and leaving their headsets near the squawkbox so that that day traders could hear the order information. The SEC alleges that they did so in order to allow the day traders to front-run large orders. It is claimed that the day traders compensated the brokers for the information through commissions or cash payments.

The SEC found this conduct violated Section 15(f) of the Securities Exchange Act of 1934 and Section 204A of the Investment Advisers Act of 1940. These sections require broker-dealers and advisers to establish policies to prevent the misuse of material non-public information. While the misuse of material non-public information often gives rise to insider trading claims, insider trading was not alleged because broker dealers are not required to keep order flow information confidential. To the contrary, as the SEC acknowledged, the “[i]nstitutional customers understand that [a broker-dealer], with appropriate discretion, may share their order flow information with other . . . customers who are reasonably considered potential counterparties.” The order required that Merrill Lynch implement policies and procedures to educate and provide compliance training to its employees about the use of customer order flow information and to tightly restrict access to squawkboxes to only those employees who have a legitimate business need for them. Specifically, the order requires that procedures be adopted to prevent access to information about customer order flow, and to prevent the dissemination of that information to third parties, except “for the purpose of seeking contra-side liquidity.”

U.S. Supreme Court to Review Excessive Fee Standard

In Jones v. Harris Associates, handed down last May, the Seventh Circuit upheld a decision of the district court granting summary judgment against a class of mutual fund shareholders who alleged that an adviser to certain mutual funds had breached its fiduciary duties to the funds by charging fees that were excessive under Investment Company Act Section 36(b). In writing the opinion for the Court of Appeals, Judge Frank Easterbrook disapproved of the standard set in 1982 by the Second Circuit in the well-known case of Gartenberg v. Merrill Lynch Asset Management, Inc., and instead adopted its own “market-based” approach.

The Supreme Court will hear the case during its next term, opening October 5, 2009. Ropes & Gray is representing Harris Associates in connection with this litigation.

SEC Staff Provides ARPs Relief in the Form of Liquidity Protected Preferred Shares

In a recent no-action letter to the Investment Company Institute (ICI), the SEC staff allowed closed-end funds to issue a new type of “liquidity protected” preferred shares (LPP). LPP is designed to address liquidity concerns resulting from the widespread failure of auction rate preferred stock (ARP) auctions since early 2008. While various forms of LPP have been proposed, the common feature of LPP is a liquidity facility that, in the event of a remarketing failure, allows a liquidity provider to purchase LPP at its liquidation preference, in addition to the cost of any accumulated but unpaid dividends.

The Investment Company Act prohibits certain transactions between a fund and an affiliated person of that fund (or an affiliated person of such a person). Section 2(a)(3)(A) of the Investment Company Act defines an affiliated person of a fund to include any person directly or indirectly owning, controlling, or holding with power to vote, 5 percent or more of the outstanding voting securities of the fund. In its application for no-action relief, the ICI noted that, as a result of LPP purchases, many liquidity providers could own more than 5 percent of the outstanding LPP of a closed-end fund, and in many cases would own all of the preferred shares of the fund. The ICI argued that, while a liquidity provider may acquire all of the preferred shares of a closed-end fund, the liquidity provider would still hold substantially less than 5 percent of the outstanding voting securities of the closed-end fund. Furthermore, under Sections 2(a)(3)(C) and (D) of the Investment Company Act, a person is an affiliated person of another person if the person directly or indirectly controls, is controlled by, or is under common control with another person, or if they are an officer, director, partner, etc. of such other person. The ICI noted that even though purchasers of LPP may have the ability to elect directors of a closed-end fund and may have a substantial economic interest in the fund, these liquidity providers should not be considered affiliated persons of the fund by virtue of this “control.” The ICI did concede, however, that such reasoning would not apply in cases where the directors that the liquidity providers elected would either constitute a majority of the entire board of the closed-end fund or a majority of independent directors of that fund, or if the elected directors are officers, directors, partners, etc. of the liquidity provider. The ICI also stated that grounds upon which it was seeking no action relief would not apply to a fund with an atypical share class structure, where preferred shares represented more than 5 percent of a closed-end fund’s outstanding voting securities.

Based solely on the facts and assumptions in the ICI’s letter, the SEC stated that it would not recommend enforcement action against a liquidity provider, or any closed-end fund transacting with the liquidity provider, under any affiliate restrictions that would be triggered solely by the liquidity provider’s purchase of LPP issued by the closed-end fund.

NYSE Proposed Amendment to Broker Discretionary Voting Rule Includes Exception for Registered Investment Companies

On February 26, 2009, the New York Stock Exchange (NYSE) filed a proposed rule change with the SEC to amend NYSE Rule 452 (Rule 452), and its corresponding section in the Listed Company Manual, Section 402.08(19), with respect to broker discretionary voting. Proposed Rule 452 would add uncontested director elections to the list of matters that can be voted on by brokers without receiving client direction. As a result of input from the mutual fund industry, the proposed changes to Rule 452 excluded uncontested elections of directors of registered investment companies from the list of non-discretionary matters. In addition to addressing uncontested director elections, Proposed Rule 452 incorporates the NYSE’s longstanding interpretation of Rule 452 to preclude broker discretionary voting in situations involving any material amendment to an investment advisory contract with an investment company.

SEC Staff Confirms ETFs’ Use of Affiliated Index Provider

In a recent no-action letter, the SEC staff confirmed oral no-action relief previously granted to Barclays Global Fund Advisors (BGFA) and the iShares Trust (Trust) to permit certain exchange-traded funds (ETFs) to continue to use a benchmark index sponsored by index provider who became an affiliated person, or an affiliated person of an affiliated person, of the Trust.

The ETFs operate pursuant to exemptive orders that contain representations that the ETFs will not use a benchmark index created, compiled, sponsored or maintained by an affiliated person, or an affiliated person of an affiliated person, of the Trust or the adviser, promoter or distributor of the ETFs. In this case, the ETFs use benchmark indices (Lehman Indices) sponsored by a division of Lehman Brothers Holdings, Inc. In early September 2008, Lehman sought bankruptcy protection and was acquired by Barclays Capital Inc. (Bar Cap), an affiliate of BGFA. As a result the sponsor of the Lehman Indices (Sponsor) became an affiliated person, or an affiliated person of an affiliated person, of BGFA and the Trust.

In requesting the relief, BGFA noted that the Lehman Indices were not created solely for the ETFs’ use, were created before the ETFs commenced operations, and are used as benchmark indices for mutual funds and ETFs that are not affiliated with the ETFs or BGFA. The SEC staff stated that it would not recommend enforcement action against BGFA or the Trust if the ETFs complied with the following additional conditions:

  1. BGFA and the Sponsor have been and will continue to be separate legal entities that have no overlapping officers, directors or employees; 
  2. There is an effective information barrier between BGFA and the Sponsor, and BGFA has not been and will not be provided with information about a change in index methodology by the Sponsor before such information is provided to other persons outside of the Sponsor; 
  3. BGFA has not had and will not have a preferential ability to influence the index methodology determined by the Sponsor over other institutional investors; and 
  4. BGFA has not sought and will not seek to influence the index methodology determined by the Sponsor in a way that would disproportionately benefit the Barclays organization.

Other Developments

Since the last issue of our IM Update we have also published the following separate alerts of interest to the investment management industry:

ISDA Aims for Fungible CDs with Auction Settlement, Big Bang Protocol and New Standard North American CDS Terms, March 4, 2009

Investment Management Regulatory Reform Update, March 16, 2009

Mandatory Electronic Filing of Form D and New SEC Guidance on Regulation D Rule 506 Offerings, March 25, 2009

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

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