Industry Update

Pay-to-Play Arrangements Come to Forefront

Pay-to-play arrangements involving payments to intermediaries to influence public pension fund investment decisions have recently come to the fore on a number of fronts: 

  • New York State Attorney General Andrew M. Cuomo's Office has recently announced an expansion of a two-year investigation in the pay-to-play schemes involving New York State and City pension funds as well as a settlement agreement with The Carlyle Group ("Carlyle") pursuant to which Carlyle agreed to pay $20 million to the State of New York and adopt Cuomo's Public Pension Fund Reform Code of Conduct (the "Code of Conduct"). 
  • SEC Chairman Mary L. Schapiro has asked the SEC staff to revisit a rule first proposed in 1999, but never finalized, that would curtail political contributions by investment advisers. 
  • The SEC recently charged a Los Angeles placement agent in connection with a New York State pension fund corruption investigation. 
  • In response to these developments, the California Public Employees' Retirement System ("CalPERS"), the nation's largest public pension fund, recently instituted a new placement agent policy mandating the disclosure and registration of intermediaries hired by external managers of CalPERS' funds. 

We discuss each of these developments below.

New York State Attorney General Announces Expanded Investigation and Carlyle Settlement

On May 1, 2009, Attorney General Cuomo announced "a new phase" in his expanding investigation into kickback schemes involving New York State and City pension funds.  The investigation has uncovered a web of pay-to-play arrangements between investment firms and numerous former New York State Comptroller's Office officials, in connection with which Cuomo's office has issued subpoenas to over 100 investment firms and their agents.  Cuomo has also announced that his office is coordinating with 36 Attorneys General's offices to establish a multi-state task force to facilitate a nationwide approach to pension fund abuse prosecutions and reforms.  The New York Attorney General is also working closely with the SEC, which is conducting its own parallel investigation into New York State and City pension fund corruption.

On May 14, 2009, Attorney General Cuomo announced a settlement agreement with Carlyle pursuant to which Carlyle agreed to pay $20 million to the State of New York and adopt Cuomo's Code of Conduct to end the Attorney General's investigation of Carlyle and its employees in connection with the broader inquiry into improper pay-to-play practices at the New York State Common Retirement Fund (the "NYCRF"), the state's $122 billion pension fund.

The Attorney General had been investigating Carlyle's 2003 solicitation arrangement with Henry Morris, chief political aide to Alan Hevesi, the State Comptroller at the time.  As the sole trustee and manager of the NYCRF, the New York State Comptroller is in charge of the pension fund's investment decisions.  Carlyle had had limited success in procuring investments from the NYCRF prior to 2003, when a partner at Riverstone Holdings, LLC ("Riverstone"), one of Carlyle's joint venture partners, gained an introduction to Morris through Barrett Wissman, a hedge fund manager.  The Riverstone partner subsequently arranged for Morris to provide placement agent services for various Carlyle funds.  As a result of Morris' intermediary services, Carlyle obtained almost $730 million in investment commitments from the NYCRF in five funds between 2003 and 2005.  In connection with these investments, Carlyle paid $13 million in placement agent fees to Searle & Company ("Searle"), a broker-dealer associated with Morris.  Of these fees, Searle paid approximately $7.3 million to a shell company owned by Morris and $5.3 million to an entity controlled by Wissman.

Although the Riverstone partner knew that Searle had paid Wissman a portion of the placement agent fees that Searle had received from Carlyle, Carlyle was unaware of the payment to Wissman and consequently did not disclose it.  Carlyle was also unaware that shortly after the NYCRF made an investment in one of the five funds mentioned above, the Riverstone partner invested $100,000 in a movie produced by the brother of the then-Chief Investment Officer to the State Comptroller, David Loglisci, and therefore also did not disclose that amount.  Carlyle employees also contributed approximately $78,000 to Hevesi's campaign in 2005 and 2006, with some of the contributions having been solicited by Morris directly.

The Code of Conduct.  In settling with the Attorney General, Carlyle became the first company to adopt the Code of Conduct which, among other things, prohibits an investment firm from paying intermediaries to influence public pension fund investment decisions.  The Code of Conduct, if adopted, applies to an investment firm's interactions with all public pension funds located in the United States and is summarized below.

  • Prohibition on Placement Agents and Lobbyists.  The firm may not employ any third-party intermediary to communicate or interact with a public pension fund for any purpose that involves a transaction or investment between the firm and the public pension fund.  However, the firm may use consultants and investment banks for other services, including the preparation of marketing materials or conducting due diligence.
  • Restrictions on Campaign Contributions.  The investment firm (including its principals, agents, employees and family members) may not conduct business with a public pension fund for a period of two years after making a campaign contribution to an official with influence over the public pension fund's investment decisions or a candidate for such a position.  Contributions of $300 or less to elected officials or candidates for whom the contributor may vote are not subject to this restriction.
  • Disclosure Requirements.  The firm must make semi-annual disclosures on its website regarding its political contributions, investment fund personnel and compensation paid to third parties in connection with investments or transactions between the investment firm and public pension funds.  
  • Standard of Conduct.  The firm's interactions with public pension fund officials and advisers must comply with a heightened standard of conduct that prohibits, among other things, (i) gifts of more than nominal value to public pension fund employees and officials and (ii) employment of a former public pension fund official or employee within two years of such person's affiliation with the public pension fund.
  • Conflicts of Interest Policies.  The firm must promptly disclose any conflict of interest to the affected public pension fund or, if such disclosure would be ineffectual, to an appropriate law enforcement official.  The investment firm must also promptly cure such conflict of interest.
  • Ongoing Compliance Requirements.  The investment firm must submit a yearly certification of compliance with the Code of Conduct to the Office of the New York Attorney General and any pension fund that requests it.  Violations of the Code of Conduct may result in the termination of existing investments and/or a ban on future business interactions with the affected fund for up to ten years, as well as potential criminal, civil and administrative action.

SEC Reconsiders 1999 Pay-to-Play Proposal

The SEC is revisiting a 1999 proposal that would prohibit investment advisers from managing public pension fund money for two years after making certain political contributions and expects to consider proposed regulations this summer, Chairman Schapiro informed the Senate Subcommittee on Financial Services and General Government on June 2, 2009.  "So called 'pay-to-play' practices by investment advisers to public pension plans must be curtailed," she said.  Chairman Schapiro's testimony comes in the midst of the SEC's investigations into pay-to-play practices involving public pension funds in California, New Mexico and New York.

In 1999, the SEC proposed, but never finalized, a new rule (the "Proposed Rule") under the Investment Advisers Act of 1940 (the "Advisers Act") that was designed "to prevent advisers from participating in pay-to-play practices and protect clients from the consequences of pay-to-play."  The framework for the Proposed Rule was based on Municipal Securities Rulemaking Board ("MSRB") rule G-37, which ended municipal underwriters' participation in play-to-play practices in 1994.

The Proposed Rule would prohibit investment advisers from providing advisory services for compensation to a government entity within two years after the adviser, or any of its partners, executive officers or solicitors, made a contribution to any elected official who could influence the selection of the adviser, or to any candidate for such a position.  This two-year "time-out" would also be triggered when the adviser, or any of its partners, executive officers or solicitors, solicited contributions for an elected official or candidate.  A de minimis exception would permit contributions of $250 or less to elected officials or candidates for whom the person making the contribution is entitled to vote.

Notably, the prohibitions would apply both to registered investment advisers and to unregistered advisers for certain hedge funds, private equity funds and other "private investment companies" which would be investment companies under section 3(a) of the Investment Company Act of 1940 but for the exceptions under sections 3(c)(1) and 3(c)(7) therein.  Registered investment advisers with government clients would also be required to make and keep certain records regarding their political contributions and solicitation activities, as well as of their partners, executive officers and solicitors.

We will continue to monitor any developments with respect to any proposed pay-to-play regulations.

SEC Charges Los Angeles Placement Agent in New York Pension Fund Investigation

On May 12, 2009, the SEC charged Julio Ramirez, a Los Angeles-based unlicensed placement agent, with aiding and abetting fraudulent conduct in connection with a NYCRF-related kickback scheme.  The civil action, filed in the Southern District of New York, illustrates the wide geographic reach of the SEC's and the New York Attorney General's investigations into improper pay-to-play practices involving the NYCRF.

The SEC claims that Ramirez helped Morris, chief political aide to former New York State Comptroller Hevesi, secure kickback payments from the investment management firm Aldus Equity Partners ("Aldus") in exchange for Morris' assistance in obtaining a NYCRF investment in Aldus.  The amended complaint asserts that Ramirez informed Saul Meyer, an Aldus founding principal, that Aldus would be unable to obtain an investment from the NYCRF unless the investment management firm paid Morris a fee.  Aldus allegedly paid over $300,000 to a shell company owned by Morris as consideration for the $175 million NYCRF investment in Aldus secured by Morris.  According to the SEC, Morris subsequently paid Ramirez a portion of this kickback fee, which payment was not disclosed to the NYCRF.

The complaint charges Ramirez with aiding and abetting violations of the anti-fraud provisions of the Securities Exchange Act of 1934 (the "Exchange Act") and seeks permanent injunctions against future federal securities law violations, disgorgement of unlawful gains and financial penalties.

In a parallel criminal action by the New York Attorney General, Ramirez has pled guilty to securities fraud under New York's Martin Act for his involvement in investment transactions with the NYCRF.

CalPERS Adopts Placement Agent Policy

CalPERS, the nation's largest public pension fund, recently implemented a new placement agent policy that requires the disclosure and registration of placement agents hired by external managers of CalPERS' funds.  The CalPERS policy, which became effective upon its adoption on May 11, 2009, was developed in response to the recent pay-to-play allegations leveled at various public pension funds.  It applies to new agreements with external managers as well as to existing agreements, if the terms of the existing agreement are amended or if CalPERS increases its financial commitment under the agreement.  Managers of partnerships or other investment vehicles in which CalPERS is the majority investor are also subject to the policy.

Key requirements of the CalPERS policy include:

  • Disclosure. Managers subject to the policy must disclose the retention of any placement agents, a description of the compensation to be paid and services to be performed, as well as detailed background information about the placement agent.  The manager must also provide CalPERS with a copy of the placement agent retention agreement, a resume for each of the placement agent's principals, the names of any current or former CalPERS affiliates who suggested the retention of the placement agent and information as to whether the placement agent is registered as a lobbyist.  Managers must vouch for the accuracy of the information disclosed and must provide CalPERS with updated information within 14 calendar days of the date that the manager knew or should have known of any change in the information.
  • Registration. Placement agents hired by managers subject to the policy must be registered as broker-dealers with the SEC or the Financial Industry Regulatory Authority.
  • Sanctions for Violations.  In the event that the manager knew or should have known of a material omission or inaccuracy in the placement agent disclosure information or other violation of the policy, CalPERS is entitled to (i) receive reimbursement of any management fees for two years or an amount equal to the placement agent's fee, whichever is greater, (ii) terminate its contract with the manager or withdraw from the investment vehicle without penalty and (iii) impose a two-year ban on soliciting new investments from CalPERS on any manager or placement agent who materially violates the policy.

The CalPERS policy may become a template for other public pension funds.

SEC, DOL to Hold Hearing on Target Date Funds

On May 12, 2009, the SEC announced that it will hold a joint hearing with the U.S. Department of Labor on June 18 to examine issues relating to so-called "target date funds" and other similar investment options.  A target date fund invests in a mix of equities, fixed-income securities and other instruments and resets its asset mix as the fund approaches its target date.  Target date funds generally advertise that their mix will be more conservative as their target date approaches, making them a popular choice for investors saving for retirement.  According to the SEC's press release, with the growing popularity of the target date funds and similar investment options, investors, including 401(k) plan sponsors and participants, need to be able to adequately evaluate the risks associated with these investment options.  The joint hearing "will focus generally on issues facing investors in these types of products, and will explore topics such as portfolio composition, risk, and disclosure."  The joint hearing will be held at the Department of Labor, with witnesses including "representatives of plan participants and beneficiaries, plan sponsors, investor organizations, academia and the financial services industry."

In her testimony before the Senate Subcommittee on Financial Services and General Government on June 2, 2009, SEC Chairman Mary L. Schapiro said that the SEC is "closely reviewing" the disclosure of asset allocations by target date funds.  In her testimony, Chairman Schapiro stated that the joint hearing will consider, among other issues, whether the use of a target date in a fund's name may be "misleading or confusing to investors" and whether additional controls over the use of a target date in a fund's name are needed.  She also noted that the investment results of target date funds in 2008 were "troubling," with the average loss among 31 funds with a 2010 retirement date reported to be almost 25 percent.

SEC RULES AND REGULATIONS

SEC Publishes Proposed Amendments to the Custody Rule

On May 20, 2009, the SEC published proposed amendments to the "Custody Rule," i.e., Rule 206(4)-2 under the Investment Advisers Act of 1940 (the "Advisers Act"), and related forms.  In its current form, Rule 206(4)-2 requires an adviser with custody of client assets to take specific measures to safeguard these assets from loss, theft or misappropriation. Among other things, these measures include maintaining client assets with a "qualified custodian," the definition of which is set forth under the rule, and having a reasonable belief that the qualified custodian holding the assets provides account statements to the adviser's clients. The proposed amendments involve several revisions to the requirements under the existing rule. In a statement made prior to the publication of the proposed amendments, SEC Chairman Mary L. Schapiro said that these amendments are a response to the Madoff and other investment scams and "directly address the shortfalls of the current custody control regulations" highlighted by these scams. 

Annual Surprise Examination of Client Assets.  The proposed amendments would require all registered investment advisers with custody of client assets to engage an independent public accountant to conduct a "surprise examination" of client assets at least on an annual basis.  In a surprise examination, an independent public accountant confirms the existence of all client cash and securities under the adviser's custody, reconciles all such cash and securities to the adviser's books and records of client accounts and confirms the information gathered by the accountant with the adviser's clients.  The time for the surprise examination must be chosen by the independent public accountant without prior notice or announcement to the adviser and must change from year to year.

When the SEC originally adopted the Custody Rule in 1962, all advisers with custody of client assets were required to be subject to a surprise examination.  In 2003, the SEC amended the Custody Rule to except from the surprise examination requirement (i) advisers who have "a reasonable basis" to believe that their qualified custodians provide account statements directly to their clients, (ii) advisers to pooled investment vehicles that are audited at least annually and distribute the audited financial statements to their investors and (iii) advisers holding private placement securities on behalf of their clients, but only with respect to these securities.  The proposed amendments would eliminate these three exceptions to the surprise examination requirement. 

Furthermore, the proposed amendments would require an adviser with custody of client assets to enter into a written agreement with the independent public accountant engaged to conduct the annual surprise examination that would require the accountant to (i) file a certificate on Form ADV-E within 120 days of the time chosen by the accountant for the surprise examination, rather than the current requirement of 30 days from the completion of the surprise examination, describing the nature and scope of the examination, (ii) notify the SEC within one business day if the accountant identifies any material discrepancies during the examination and (iii) file Form ADV-E within four business days of the termination of its engagement, with an accompanying statement disclosing the date of the termination and any problem relating to the examination's scope or procedures that contributed to the termination.  According to the SEC's press release announcing the proposed amendments, these measures are designed to alert the SEC to potential problems and would provide the SEC with valuable information for assessing risks.

Custody by an Adviser and Its Related Persons.  Rule 206(4)-2 in its current form deems an adviser to have custody of client assets if it holds, directly or indirectly, client assets or has authority to obtain possession of client assets.  An adviser is considered to have authority over a client's assets if it has the power to deduct advisory fees from a client account, write checks or withdraw funds on behalf of a client or by acting in a capacity that gives the adviser authority to withdraw funds or securities from a client's account, such as the general partner of a limited partnership.

The proposed amendments would deem an investment adviser to also have custody when a "related person" of the adviser holds, directly or indirectly, client assets "in connection with" the advisory services provided by the adviser.  A "related person" would be any person, directly or indirectly, controlling or controlled by the adviser, or any person under the common control with the adviser.  One main result of this amendment would be to deem an adviser under common control with a broker-dealer to have custody of client assets held by the broker-dealer as a qualified custodian if the adviser provides advisory services with respect to such assets.  The proposing release noted that the "in connection with" limitation would prevent the adviser from being deemed to have custody of client assets held by the related person broker-dealer with respect to which the adviser does not offer advice.

The rule, as amended, would replace a 1978 interpretive letter previously issued by the SEC staff that indicated five factors to be considered in determining whether an adviser has "indirect" custody of a client's assets.  Under the interpretive letter, the determination of "indirect" custody is a fact-specific inquiry, the outcome of which may vary from case to case.  In the SEC's release adopting the 2003 amendments to the Custody Rule, the SEC cited the 1978 interpretative letter and stated that an adviser may have custody of client assets when the adviser or its personnel have access to those client assets through a related person.  The rule, as amended, would simply impute a related person's custody of client assets to the adviser regardless of the separation between the adviser and the related person.

The proposed amendments would also require advisers and their related persons who hold client assets as qualified custodians to obtain an internal control report from an independent public accountant registered with, and subject to the inspection by, the Public Company Accounting Oversight Board ("PCAOB").  Under the proposed amendments, this internal control report must include an opinion from the accountant, issued in accordance with PCAOB standards, on "the description of controls placed in operation relating to custodial services" as well as "tests of operating effectiveness" of these controls.  What is commonly referred to as a "Type II SAS-70 Report" would be sufficient for purposes of satisfying this internal control report requirement.  According to the SEC's proposing release, the adviser or a related person acting as the qualified custodian presents a heightened risk of fraud by the custodian and this heightened risk justifies the requirement of a Type II SAS-70 report.

Along the same vein, if an adviser (or its related person) maintains client assets as the qualified custodian, the proposed amendments impose additional requirements in connection with the annual surprise examination.  In these cases, the independent public accountant engaged by the adviser to perform the annual surprise examination also must be registered with the PCAOB and subject to regular inspection by the PCAOB and must carry out the examination in accordance with the rules of the PCAOB.  (Note that the surprise examination requirement generally only requires that the examination be conducted by an independent public accountant, not necessarily one registered with and inspected by the PCAOB.  Nor must the examination generally be conducted in accordance with the rules of the PCAOB.)

Delivery of Account Statements and Notice to Clients.  Another proposed amendment would eliminate the option, currently available under the Custody Rule, for an adviser to send account statements to clients directly, rather than through its qualified custodian, if the adviser chooses to undergo an annual surprise examination.  Instead, the proposed amendment would require that the qualified custodian send the account statements to the adviser's clients and that the adviser have a reasonable basis to believe that the qualified custodian is sending account statements to the adviser's clients at least quarterly.  The proposed amendment would also make it an explicit requirement that the adviser carry out "due inquiry" in order to form such reasonable belief. 

Moreover, the proposed amendment would revise the content of the notice that an adviser is required to send to a client upon opening custody accounts on behalf of that client.  Specifically, the proposed amendment would require the adviser to instruct the client to compare the account statements from the qualified custodian with those from the adviser.  Currently under the Advisers Act, advisers are not required to send their own account statements to clients.  The proposing release asks for comment as to whether advisers who elect to send account statements to clients should be required to include such a legend instructing them to compare the custodian's statements with the adviser's statements.  It also asks whether all advisers that have custody should be required to deliver account statements and include such a legend.

The SEC believes that these measures would make it harder for the adviser to falsify account statements and easier for the client to identify discrepancies in account statements.

Liquidation Audit.  Another proposed amendment would clarify the scope of the exemption that exempts an adviser to a pooled investment vehicle from the requirement that a qualified custodian send quarterly account statements to the investors in the pool if the pool is subject to an annual financial audit and distributes audited financial statements to the investors within 120 days of the pool's fiscal year end.  It is not apparent from the language of the current rule whether an adviser may rely on this exemption if such pool is liquidated at a time other than the end of its fiscal year.  The proposed amendment would clarify that the adviser can avail itself of this exemption regardless of whether the pool is liquidated at the end of its fiscal year.

Dually Registered Broker-Dealers/Investment Advisers.  The proposed amendments explicitly would apply to advisers that are also registered as broker-dealers, despite the acknowledged overlap of the proposed requirements with existing broker-dealer requirements.  The proposed amendments also request comment on the alternative of requiring an independent qualified custodian to hold client assets.  The proposal notes that this requirement would preclude a dually registered broker-dealer from retaining custody of securities if it provided advice, which is a central element of discretionary accounts and wrap fee programs.

Other Proposed Changes.  In addition to the proposed amendments described above, the SEC has also proposed (i) certain amendments to Part 1A and Schedule D of Form ADV to provide the SEC with additional data on advisers' custody practices, (ii) certain amendments to Form ADV-E, including the requirement that the form and the accompanying accountant examination certificate be filed electronically and (iii) a requirement that an adviser subject to the internal control report requirement retain a copy of the internal control report for five years.

The SEC is seeking public comment on the proposed amendments through July 28, 2009.

SEC Releases Voluntary Client Asset Confirmation Letter

The SEC's Office of Compliance Inspections and Examinations has released a "Routine Account Information Confirmation" form letter, which it will send to clients of securities firms and registered investment advisers to request independent verification of client account balances.  As of May 13, 2009, every SEC request for an independent verification of client assets will be in this form.  The letter asks recipients to confirm their account balance, deposit and withdrawal information as of a specific date.  Recipients are also invited to share additional information about the account in question or any other account the recipient has with the specified firm.  Client participation is voluntary.  The letter emphasizes that the SEC's confirmation request "should in no way be construed, in and of itself, as an indication of any problem or irregularity by the firm being inspected," noting that the request "may be made in any type of examination."

Since the Madoff and other recent investment scams have come to light, the SEC has been looking at custody issues generally.  While members of the SEC staff have publicly mentioned that they intended to start securing independent verification of client assets by clients, this form letter was recently posted to the SEC's website without further announcement or clarification.  The frequency with which the SEC plans to seek such independent confirmations from clients is unclear.

Litigation

SEC Sanctions Adviser for 15(c) Process Violations

On May 27, 2009, the SEC imposed sanctions against New York Life Investment Management LLC ("NYLIM"), a registered investment adviser and an indirect wholly owned subsidiary of New York Life Insurance Company ("New York Life"), for violating Sections 15(c) and 34(b) of the Investment Company Act of 1940 (the "Investment Company Act") and Section 206(2) of the Investment Advisers Act of 1940 (the "Advisers Act") on multiple occasions in connection with a mutual fund advised by NYLIM, the MainStay Equity Index Fund (the "Equity Index Fund").

According to the SEC's order, the Equity Index Fund aims to mirror the performance of the S&P 500 index before expenses and is a series of The MainStay Funds, a family of mutual funds.  According to the Equity Index Fund's initial prospectus, NYLIFE LLC, another wholly owned subsidiary of New York Life, provided shareholders of the Equity Index Fund with an unconditional guarantee (the "Guarantee").  Under the Guarantee, if the value of a shareholder's investment in the Equity Index Fund on the tenth anniversary of such investment was less than the value of the shareholder's original investment, NYLIFE LLC promised to reimburse the shareholder for the amount of such shortfall.  Set forth below is a brief description of the contract renewal process, commonly referred to as the "15(c) process," relating to the investment advisory contract between NYLIM and the Equity Index Fund (the "Advisory Contract") in each of 2002, 2003 and 2004:

The 2002 15(c) Process.  The Board of Trustees of The MainStay Funds (the "MainStay Board") held meetings to consider the renewal of the Advisory Contract in March 2002 and again in June 2002 (when the starting date for the annual contract renewal period was changed from May 1 to August 1).  During the MainStay Board's meeting in March 2002, NYLIM urged the MainStay Board to consider the Guarantee in evaluating the management fees that NYLIM proposed to charge the Equity Index Fund, which, according to a report from a third-party independent consultant, were the highest among the Equity Index Fund's peer group of index funds.  Neither during the March 2002 meeting nor during the subsequent June 2002 meeting did NYLIM provide the MainStay Board with information regarding the estimated cost or value of the Guarantee, or disclose the fact that NYLIFE LLC had established a reserve of $2 million for the Guarantee in its 2001 year-end financial statements.  During both the March and June 2002 meetings, the MainStay Board approved the Advisory Contract as NYLIM proposed.

The 2003 15(c) Process.  In January 2003, NYLIFE LLC increased the reserve that it had established for the Guarantee from $2 million to $11.9 million, as reflected in its 2002 year-end financial statements.  When the MainStay Board met in June 2003 to consider the renewal of the Advisory Contract, NYLIM provided the MainStay Board with its internal profitability analysis, which indicated a negative profit margin resulting from an increase of $9.9 million in expense associated with the revised reserve for the Guarantee.  NYLIM simply presented the increase to the reserve as a line item on the profitability analysis, without explaining, among other things, the assumptions used to calculate the reserve or the fact that the expense represented an increase in the estimate of the reserve relating to the Guarantee.  Moreover, as in the past, NYLIM claimed that the higher fees it charged were due to the Guarantee.  Again, the MainStay Board approved the Advisory Contract as NYLIM proposed.

The 2004 15(c) Process.  When the MainStay Board met in June 2004 to consider the Advisory Contract renewal, NYLIM for the first time disclosed information concerning the assumptions used to calculate the reserve amount and explained the reason why NYLIM believed that the reserve amount should be included in its profitability analysis.  It also provided the MainStay Board with information regarding the estimated cost of the Guarantee.  NYLIM continued to insist that it charged higher management fees to the Equity Index Fund due to the Guarantee, while asserting at the same time in prospectuses, annual reports and registration statements filed with the SEC that the Guarantee was provided to the shareholders of the Equity Index Fund at "no cost" even though the shareholders paid for the Guarantee indirectly through the higher management fees charged to the fund.  The MainStay Board did not approve the renewal of the Advisory Contract during its June 2004 meeting.

In connection with the three 15(c) processes summarized above, the SEC found that NYLIM committed multiple violations of the Investment Company Act and the Advisers Act.  First, the SEC concluded that NYLIM violated Section 15(c) of the Investment Company Act, which requires an investment adviser to a mutual fund to provide the mutual fund with "such information as may reasonably be necessary to evaluate the terms of" the advisory contract between the investment adviser and the mutual fund.  According to the SEC, while NYLIM urged the MainStay Board to consider the Guarantee in assessing its management fees, NYLIM failed to provide the MainStay Board with information necessary to evaluate the cost associated with the Guarantee in violation of Section 15(c).

Second, the SEC found that NYLIM violated Section 206(2) of the Advisers Act by failing to disclose material facts to the MainStay Board on multiple occasions.  Section 206(2) makes it unlawful for an investment adviser to engage "in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client."  In SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the U.S. Supreme Court stated that the Advisers Act imposes on an investment adviser a fiduciary duty to its clients to act in "utmost good faith," to provide "full and fair disclosure of all material facts" and to use reasonable care to avoid misleading its clients.  According to the SEC, in connection with the 2002 15(c) process, NYLIM failed to provide the MainStay Board with information concerning the estimated cost or value of the Guarantee or to disclose NYLIFE LLC's reserve for the Guarantee.  In connection with the 2003 15(c) process, NYLIM failed to inform the MainStay board that the $9.9 million expense in its profitability analysis represented an increase in the estimate of the reserve for the Guarantee, that the amount of the reserve reflected the present value of all future payments to be made under the Guarantee, or that the cost of the Guarantee could have been apportioned to future years.  Furthermore, NYLIM did not provide the MainStay Board with any information regarding the assumptions used to calculate the reserve or inform the MainStay Board why in NYLIM's view the full amount of the $9.9 million increase to the reserve should be included in its profitability analysis for the Equity Index Fund. 

Third, the SEC found that NYLIM violated Section 34(b) of the Investment Company Act for making false and misleading statements in its filings with the SEC.  Section 34(b) prohibits any person from making "any untrue statement of a material fact" in any document filed with the SEC or to omit to state "any fact necessary in order to prevent the statements made" in such document "from being materially misleading."  According to the SEC's order, from March 2002 through June 2004, NYLIM claimed in its filings with the SEC that there was no charge to the Equity Index Fund or its shareholders for the Guarantee.  The SEC found that those statements were "false and misleading," as evidenced by NYLIM's repeated assertions that the Guarantee justified NYLIM's higher management fees.

Without admitting or denying any wrongdoing, NYLIM settled the SEC's administrative proceedings by agreeing to (i) accept a censure, (ii) cease and desist from committing or causing any violations and any future violations of Section 206(2) of the Advisers Act and Sections 15(c) and 34(b) of the Investment Company Act, (iii) pay a total payment of $6,100,784 ($3,950,075 in disgorgement, $1,350,709 in prejudgment interest and $800,000 in civil penalty), (iv) establish a "Fair Fund" for the $6,100,784 payment pursuant to Section 308(a) of the Sarbanes-Oxley Act and (v) perform certain additional undertakings enumerated in the SEC's order.

The SEC noted in its order that on June 30, 2004 NYLIM amended the prospectus for the Equity Index Fund and for the first time disclosed that NYLIM took into account the Guarantee in setting the management fees charged to the Equity Index Fund.  In July 2004, the MainStay Board voted to lower the management fees paid to NYLIM and to put a cap on the fund's expense ratio.

SEC Sanctions Adviser for Proxy Voting Rule Violations

On May 7, 2009, the SEC imposed sanctions against West Palm Beach, Florida-based INTECH Investment Management LLC ("INTECH") and its former chief operating officer, David E. Hurley ("Hurley"), for inadequately describing INTECH's proxy voting policies and procedures to clients and failing to address a material potential conflict of interest in those proxy voting policies and procedures in violation of Section 206(4) of the Investment Advisers Act of 1940 (the "Advisers Act") and the "Proxy Voting Rule," i.e., Rule 206(4)-6 under the Advisers Act.  According to the SEC's press release, this is the first SEC enforcement action for a Proxy Voting Rule violation.

Section 206(4) of the Advisers Act prohibits an investment adviser from engaging "in any act, practice, or course of business which is fraudulent, deceptive or manipulative."  Under Rule 206(4)-6(a), it is a violation of Section 206(4) for a registered investment adviser to exercise voting authority with respect to client securities unless the investment adviser implements and adopts written policies and procedures "reasonably designed to ensure" that the investment adviser votes the client securities "in the best interest of clients," including procedures for addressing material conflicts that may arise between the investment adviser and its clients.  Under Rule
206(4)-6(c), an investment adviser exercising voting authority with respect to client securities is required to describe to clients its proxy voting policies and procedures.

According to the SEC's order, INTECH managed portfolios for institutional clients such as pension plans, foundations and unions and exercised proxy voting authority on behalf of some of its clients.  During 2002, INTECH followed a set of proxy voting guidelines offered by Institutional Shareholder Services ("ISS"), a third-party proxy voting service provider.  As a result of following these guidelines, INTECH received inquiries and complaints from some of its union-affiliated clients. On January 1, 2003, INTECH switched from a set of generally applicable proxy voting guidelines offered by ISS to another set of ISS proxy voting guidelines that followed proxy voting recommendations made by the AFL-CIO.  The switch applied to the securities held by all of INTECH's clients, not just those held by its union-affiliated clients.  As a result of the switch, INTECH was able to improve its score and ranking in an annual AFL-CIO survey that ranked investment advisers according to their adherence to the AFL-CIO's proxy voting recommendations.

INTECH adopted written proxy voting policies and procedures and distributed those policies and procedures to its clients in connection with the Proxy Voting Rule, which became effective March 10, 2003.  Hurley, as INTECH's then chief operating officer, reviewed and revised counsel's drafts of those policies and procedures.

The SEC found that INTECH violated Rule 206(4)-6(a) by failing to address in its written proxy voting policies and procedures the potential conflict created by INTECH following the ISS guidelines favored by the AFL-CIO for all of its clients.  Rather than addressing the potential conflict, INTECH assured its clients that because it relied on the proxy voting service offered by ISS, an independent third party, INTECH did not foresee that any conflicts would arise in its proxy voting process.  Moreover, the SEC found that INTECH did not sufficiently describe to its clients its proxy voting policies and procedures in violation of Rule 206(4)-6(c) because INTECH failed to disclose that the ISS guidelines it selected were based on AFL-CIO proxy voting recommendations.

Without admitting or denying any wrongdoing, INTECH and Hurley settled the administrative proceeding by agreeing to a censure, to cease and desist from committing or causing any violations or any future violations of Section 206(4) and Rules 206(4)-6(a) and 206(4)-6(c) and to pay a penalty of $300,000 and $50,000, respectively.

The SEC noted in its order that in August 2006 INTECH addressed the potential conflict caused by the selection of the AFL-CIO based ISS guidelines by disclosing the arrangement in a letter to its clients and by subsequently allowing its clients to choose from several sets of voting recommendations.

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If you have any questions regarding the matters covered in this Regulatory Update, please contact any of our Investment Management Group lawyers listed below or your regular Davis Polk contact:

John Crowley, Partner
212-450-4550 | john.crowley@dpw.com

Nora Jordan, Partner
212-450-4684 | nora.jordan@dpw.com

Yukako Kawata, Partner
212-450-4896 | yukako.kawata@dpw.com

Leor Landa, Partner
212-450-6160 | leor.landa@dpw.com

Danforth Townley, Partner
212-450-4240 | danforth.townley@dpw.com

Sophia Hudson, Associate
212-450-4762 | sophia.hudson@dpw.com