SEC RULES AND REGULATIONS
SEC Proposes Money Market Fund Reform
In response to the turmoil that rippled through money market funds and credit markets last fall when the Reserve Primary Fund’s net asset value fell below $1.00 or “broke the buck,” the SEC proposed amendments to the regulatory regime for money market funds on June 24, 2009. While the text of the proposed amendments has not yet been released, based on SEC statements released in connection with the announcement, Rule 2a-7 under the Investment Company Act of 1940, which principally governs money market funds, would be amended to require money market funds to:
- hold a specified percentage of their assets in cash or highly liquid securities;
- reduce the weighted average maturity of their portfolio holdings from 90 days to 60 days;
- limit their investments to the highest quality portfolio securities and not invest at all in so-called “Second Tier Securities,” which are currently limited to 5% of a money market fund’s investments;
- periodically stress-test their portfolios; and
- disclose portfolio holdings on a monthly basis.
Further, the proposed amendments would allow a money market fund whose net asset value has fallen below $1.00 to suspend redemptions to allow for an orderly liquidation. In addition, the proposal asks for comment on the following topics, without proposing any changes in their regard at this time:
- whether a “floating net asset value” would better protect investors from runs on money market funds;
- whether money market funds should be required to disclose their market-based net asset value and whether they should no longer be permitted to use amortized cost as a valuation method;
- whether money market funds should be able to redeem investors in kind; and
- whether credit rating references should be deleted from Rule 2a-7 or whether a money market fund should designate three or more credit rating agencies on which the fund would rely in determining whether to invest in a security.
The SEC will seek comments on the proposed amendments for 60 days following their publication.
|See a copy of the press release announcing the proposed amendments|
SEC Publishes Proxy Access Rule Proposal
On June 10, 2009, the SEC published a set of proposed amendments to the proxy rules under the Securities Exchange Act of 1934 (the “Exchange Act”) intended to facilitate shareholders’ rights to nominate corporate board directors. Key issues on proxy access have been long debated, with the SEC having previously published proposals in 2003 and 2007. However, in the aftermath of the financial crisis, the SEC now faces especially strong political pressure to adopt a proxy access rule. Given these circumstances, it appears likely that public companies will become subject to some form of proxy access requirements for the 2010 proxy season. The following update will briefly summarize the proposal and highlight key points pertaining specifically to registered investment companies (“RICs”). A more detailed description and analysis of the proxy access rule proposal as it applies more generally is available in the Davis Polk client memorandum SEC Publishes Proxy Access Proposal.
Proposal Summary. Under current Exchange Act proxy rules, a company is not required to include a shareholder’s nominee for director in the company’s proxy materials and, pursuant to Exchange Act Rule 14a-8(i)(8) (aka, the “election exclusion”), may exclude any shareholder proposal which relates to an election, a nomination, or a procedure for election or nomination of directors. The SEC’s proposal would facilitate proxy access as follows:
- New Exchange Act Rule 14a-11 would permit shareholders who own a specified percentage of a company’s shares for a one-year period to nominate up to 25% of a company’s board and solicit proxies using the company’s proxy statements. Nominating shareholders would be obligated to provide a variety of disclosures regarding the nominees as well as to make certain representations and certifications.
- The Rule 14a-8(i)(8) “election exclusion” would be repealed, meaning that companies would no longer be able to exclude a shareholder proposal relating to the director nomination process as long as the proposal was in compliance with proposed Rule 14a-11.
The proposed rules would apply to all companies subject to the proxy rules other than companies subject to proxy rules solely because they have a class of registered debt. This includes RICs.
Eligibility Issues Under Proposed Rule 14a-11 Pertinent to RICs. Under the proposed new Rule 14a-11, a shareholder or group would be eligible to have information about their nominee included in the company’s proxy materials if they meet certain criteria. RICs are subject to the same eligibility criteria as non-RICS, with certain RIC-specific distinctions.
With respect to the minimum ownership threshold criteria, the nominating shareholder or group of shareholders must beneficially own at least the following percentage, as applicable, of a RIC’s securities that are entitled to be voted on the election of directors at the shareholder meeting:
- 1% for RICs with net assets of $700 million or more;
- 3% for RICs with net assets of $75 million or more but less than $700 million; and
- 5% for RICs with net assets of less than $75 million.
For purposes of determining whether a nominating shareholder or group of shareholders meets the minimum ownership threshold criteria, such nominating shareholder or group of shareholders could rely on the following materials to establish (1) the total securities entitled to be voted and (2) the RIC’s net assets, unless the nominating shareholder or group of shareholders knew or had reason to know that the information reported therein was not accurate:
- For a non-series investment company, the company’s most recent annual or semiannual report filed with the SEC on Form N-CSR. The relevant net assets amount would be the amount of the company’s net assets as of the end of the company’s second fiscal quarter in the fiscal year immediately preceding the fiscal year of the shareholder meeting, as disclosed in the Form N-CSR.
- For a series investment company, the Form 8-K that such company would be required to file with the SEC under the proposed rule within four business days after determining the date of a meeting at which a director election is to be held. Such Form 8-K would disclose the series investment company’s net assets as of June 30 of the calendar year immediately prior to the calendar year of the shareholder meeting, the total number of outstanding shares and shares entitled to be voted at the meeting as of the end of most recent calendar quarter. The relevant net assets amount for purposes of the minimum ownership threshold criteria would be the June 30 net assets amount described above, as disclosed in the Form 8-K. As proposed, the net asset thresholds would apply to the series investment company as a whole, rather than to individual series separately.
The nominating shareholder or each member of a nominating group of shareholders must have beneficially owned the securities used to establish satisfaction of the minimum ownership threshold for at least one year and represent that it intends to hold such securities through the date of the shareholder meeting at which the election is held.
Also under the proposed Rule 14a-11, for non-RIC issuers a shareholder nominee must satisfy the “objective” director independence criteria of the stock exchange on which the issuer’s shares trade in order for information about the nominee to be included in the company’s proxy materials. However, in the case of RICs, the SEC instead requires that any nominee not be an “interested person” of the RIC, as such term is defined in Section 2(a)(19) of the Investment Company Act of 1940. The stated purpose of this difference is to “capture the broad range of affiliations with investment advisers, principal underwriters, and others that are relevant to ‘independence’ in the case of investment companies.”
Nominating Shareholder Notice and Disclosure Requirements. An eligible shareholder or group wishing to submit a nomination would be required to provide a shareholder notice on Schedule 14N to the company no later than the date set out by the company’s advance notice provision. When there is no such provision, shareholder notice would be required 120 calendar days before the date that the company distributed its proxy materials for the prior year’s annual meeting. If the company did not hold an annual meeting during the previous year or if the date of the meeting changed by more than 30 calendar days from the prior year, the company would be required to disclose the date by which the shareholder must submit the required notice in a Form 8-K within four business days after the company determines the anticipated meeting date.
The Schedule 14N must also be filed with the SEC and contain certain information and certifications by the nominating shareholder. Under the proposed rules, a shareholder or group would be liable for any false or misleading statements submitted for inclusion in a company’s proxy materials. Further, the company would not be liable for information contained in the proxy materials that were provided by a nominating shareholder or group, unless the company knew such information to be false or misleading.
Process for Companies Receiving Notice. The SEC proposal outlines the process for a company receiving a Schedule 14N from a nominating shareholder or group. The company must first determine whether the nominee should be excluded or accepted. Acceptable reasons for exclusion under proposed Rule 14a-11(a) include (1) shareholder non-compliance with the requirements of Rule 14a-11, (2) materially false or misleading representations in the Schedule 14N or (3) the company having received more nominees than it is required by Rule 14a-11 to include. Under proposed Rule 14a-11, a company would not be required to include in its proxy materials nominees in excess of 25% of the company’s board of directors. If a company receives nominees in excess of this 25% cap, the competing nominations would be allocated on a first-come first-served basis.
If a company determines that it will exclude a nominee, it must inform the nominating shareholder or group within 14 calendar days after receipt of the Schedule 14N. The shareholder then has 14 calendar days from receipt of notice of exclusion to rectify any deficiency and submit a response to the company. If the company still determines that the nominee is excludable, the company must file a no-action request with the SEC and the nominating shareholder or group no later than 80 days before the company files its proxy statement. The shareholder or group may subsequently submit a response to the SEC within 14 calendar days of receiving this notice. The SEC staff may provide an informal statement of its views on the exclusion to both the company and nominating shareholder or group. The company must provide the nominating shareholder or group with notice of whether it will include or exclude the nominee no later than 30 days prior to filing its proxy statement with the SEC.
Proposed Amendment to Exchange Act Rule 14a-8(i)(8). The SEC also proposes to amend the current shareholder proposal rule which, in its current form, allows a company to exclude from its proxy statement shareholder proposals that relate to a nomination or an election for membership on the company’s board or a procedure for nomination or election. The proposed amendment would allow eligible shareholders to require that a company include in its proxy materials proposals seeking to amend the company’s governing documents related to nomination procedures or disclosures related to shareholder nominations, as long as such proposals do not conflict with proposed Rule 14a-11.
Proposals permitted to be excluded would be those that: (1) would disqualify a nominee who is standing for election, (2) would remove a director from office before term expiration, (3) question the competence, business judgment or character of nominees or directors, (4) nominate a specific individual for election to the board other than pursuant to proposed Rule 14a-11, an applicable state law provision, or a company’s governing documents or (5) could affect the outcome of the upcoming election.
The existing procedural requirements of the current Rule 14a-8 would remain applicable under the proposed amendment, as would eligibility criteria for shareholders. No new disclosures would be required from shareholders submitting a proposal to amend a company’s governing documents. However, new disclosure requirements would apply to a shareholder or shareholder group who make a director nomination on the basis of new bylaw proposals that provide additional means for nomination outside of proposed Rule 14a-11.
The SEC is seeking public comment on the proposed amendments through August 17, 2009.
|See a copy of the proposing release|
|See a copy of the press release announcing the proposed amendments|
SEC, DOL Hold Hearing on Target Date Funds
As reported in the June 8, 2009 Investment Management Regulatory Update, the SEC and the U.S. Department of Labor (“DOL”) held a joint hearing on June 18, 2009 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.
In addition to officials from the SEC and the DOL, participants of the one-day joint hearing included target date fund investors, plan sponsors, investor organizations and academic and industry experts. Among other topics, they discussed the recent performance of target date funds. In a speech at the hearing, SEC Chairman Mary L. Schapiro 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%. Some of the speakers expressed support for regulatory reform such as developing better disclosure rules to help target date fund investors better understand their investments. Others debated whether target date funds’ asset allocations should be regulated or whether such regulation would restrict innovation and investor choice. In her speech, Chairman Schapiro stated that the SEC’s “review of target date funds is one that may most directly affect everyday Americans.”
|See a copy of Chairman Schapiro's speech|
|See a copy of the testimony of some of the witnesses|
Extension of FBAR Filing Deadline for Certain Offshore Investments
Informal comments by representatives of the IRS suggested for the first time on June 12, 2009 that investments in certain types of foreign hedge funds may constitute foreign financial accounts, for which a U.S. investor must file a Report of Foreign Bank and Financial Accounts (an “FBAR”).1 The IRS has not provided any written statement to that effect, however, or any guidance as to which types of funds would constitute foreign financial accounts for which filing is required.
The IRS announced on June 24, 2009 that the following persons have additional time to file FBARs if they have recently learned of their filing obligations and have insufficient time to gather the necessary information to complete the FBARs by the June 30, 2009 FBAR filing deadline:
- any taxpayer that reported and paid tax on all of its 2008 taxable income; and
- any U.S. person that has an obligation to file an FBAR for a foreign financial account if all of the 2008 taxable income with respect to that account is timely reported.
A person taking this approach must file the FBAR by September 23, 2009, attach a statement explaining why the FBAR is filed late and satisfy certain additional filing requirements. The IRS stated that, in this situation, it will not impose a penalty for the failure to file the FBAR.2
There is considerable confusion over whether investments in foreign hedge funds or private equity funds are subject to the FBAR filing requirements. Davis Polk intends to urge the Treasury Department and IRS to provide further guidance on this subject.
Obama Administration Releases White Paper on Financial Regulatory Reform
On June 17, 2009, the Obama Administration released a “White Paper” on financial regulatory reform, setting forth a revised framework for federal supervision and regulation of financial firms. As expected, the White Paper proposes requiring all advisers to private pools of capital, including hedge funds, private equity funds and venture capital funds, to register with the SEC if their assets under management exceed an unspecified “modest” threshold. In addition, advisers would be required to make confidential disclosures about the funds they advise to the SEC to permit a determination of whether the funds pose a threat to financial stability. If a fund is determined to create such a threat by virtue of its size, leverage or interconnectedness with the financial system, it would then be regulated by the Federal Reserve and potentially subject to capital requirements and liquidity standards.
The White Paper calls for the SEC to continue with plans to strengthen the regulatory framework for money market mutual funds and proposes that the President’s Working Group consider fundamental changes that might address more directly the systemic risk associated with money market funds, such as a move away from a stable net asset value. In addition, the White Paper proposes to resolve controversies over the differing duties owed to customers by broker-dealers and investment advisers by legislating a fiduciary duty and customer disclosures for broker-dealers that provide investment advice about securities to retail investors.
|See a copy of the White Paper|
|See a copy of the Davis Polk memorandum entitled A New Foundation for Financial Regulation?|
New Developments Regarding Pay-to-Play Arrangements
As previously reported in the June 8, 2009 Investment Management Regulatory Update, pay-to-play arrangements, which involve payments to intermediaries to influence public pension fund investment decisions, remain a hot topic of investigation and reform. Recent developments at the federal, state and individual fund levels include the following:
- Federal. As part of its broad examination of pay-to-play practices, the SEC has requested information from more than two dozen pension fund managers and financial firms concerning “finders’ fees and other payments, and the work done in exchange for those payments,” a SEC spokesman recently told several new sources, including Bloomberg and The Wall Street Journal.
- State. The New York State Insurance Department issued, as an emergency measure, a 90-day ban on the use of placement agents by investment advisers engaged by the New York State Common Retirement Fund (“NYCRF”) effective June 18, 2009. The next day, on June 19, 2009, a bill prohibiting the use of placement agents or intermediaries in connection with NYCRF investments was introduced in the New York State Assembly and referred to the Committee on Ways and Means.
Across the country, the California Assembly Committee on Public Employees, Retirement and Social Security is considering a bill that would require every California public pension fund to adopt a disclosure policy regarding placement agent fees and campaign contributions, prohibit a member of the board and certain officers and employees of a pension fund from selling or influencing the purchase of an investment product to a California public pension fund for a two-year period after leaving the position (expanding the categories of persons to which this restriction applies and eliminating an exemption for persons who served on a board or as an employee of a pension fund for fewer than five years), and lengthen the solicitation ban imposed on placements agents who violate the policy from two years to five years.
- Public Pension Funds. Following in CalPERS’s footsteps, the Texas Teacher Retirement System, the sixth-largest public pension fund in the United States, has adopted a policy that requires detailed disclosure about, and imposes restrictions (including fee restrictions) on, the use of placement agents.
We will continue to monitor any developments with respect to any proposed pay-to-play investigations and regulations.
|See a copy of the New York State Insurance Department's ban|
|See a copy of the New York State Assembly proposed bill|
|See a copy of the California Assembly proposed bill|
|See a copy of the Texas Teacher Retirement System policy|
SEC Strengthens Examination Oversight
The SEC is in the midst of a “nationwide exam sweep” of firms with “higher potential fraud risk profiles,” said Lori A. Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), in a speech at a Securities Industry and Financial Markets Association seminar on June 17, 2009. Investment advisers that use an affiliate to maintain custody of client assets, hedge funds that appear to have “smooth” or “outlier” returns and broker-dealers that sell “captive or affiliate” hedge funds, as well as firms that use “unknown” auditors or have a disciplinary history, are likely targets for examinations, which include a “routine verification with independent third-party custodians and with advisory clients (on a sample basis) that assets exist as represented by the firm.”
Director Richards explained that this series of focused examinations is one of several changes that the SEC is making to its examination oversight program in order to “sharpen examiners’ ability to detect fraud and other types of violations” in the wake of the revelation of the Madoff scheme and other recent frauds. Other changes include:
- Improved Handling of Tips and Complaints. The SEC has retained the Center for Enterprise Modernization to perform a “comprehensive review” of the procedures used to evaluate the more than 700,000 tips and complaints it receives each year and to create a centralized information system so that the SEC can better track, analyze and “more effectively identify valuable leads for investigations or examinations.”
- Enhanced Due Diligence. As part of a more rigorous “pre-exam due diligence,” examiners will request from the firm to be examined more information about the firm, its employees and affiliates before the OCIE examination takes place. Examiners will also leverage the work performed by the firm’s independent auditor and seek verification from third-party custodians and clients that assets exist as represented by the firm. As previously reported in the June 8, 2009 Investment Management Regulatory Update, the SEC has recently (i) proposed amendments to the “Custody Rule” that would require an annual “surprise examination” by an independent auditor and (ii) released a form letter that it will send to clients of securities firms and registered investment advisers to request independent verification of client account balances.
- New Detection Tools. The SEC is developing a new “fraud module” to help examiners identify not only the obvious “red flags” that indicate potential fraud, but also the more subtle “yellow flags” that suggest that “something may not be quite right with the firm.” Possible “flags” include: a lack of separation of duties and/or dominant control person, self-custody, aberrational performance claims, dire financial condition, poor controls over outside business activities or unusual activity in inter-company accounts.
- A Focus on Dual Registrants. The SEC is training examiners to “better conduct” examinations of firms that are registered as both broker-dealers and investment advisers. Examiners will focus on the overlap between the registered and unregistered entities, particularly where there is a “flow of funds between registered and unregistered entities, and any indication that the firm is seeking to conceal fraudulent activity in an unregistered entity.”
- Enhanced Examiner Expertise. SEC examiners will receive new training in fraud detection and in complex financial products, trading and other areas, such as anti-money laundering.
|See a copy of Director Richards's speech|
SEC Issues No-Action Relief Allowing Mutual Funds and Closed-End Funds to Participate in TALF
On June 19, 2009, the SEC issued a no-action letter which made clear that mutual funds and closed-end funds (either, a “Fund”) may participate in the Federal Reserve’s Term Asset-Backed Securities Loan Facility (“TALF”) program. The letter stated that the SEC would not treat a Fund’s borrowing under TALF as a senior security representing indebtedness for purposes of compliance with the leverage limitations under Sections 18(a)(1), 18(c) and 18(f)(1) under the Investment Company Act of 1940 (the “Investment Company Act”) if the Fund segregates liquid assets (i.e., not the securities that collateralize the TALF loan) in an amount equal to the Fund’s outstanding principal and interest on the TALF loan. The segregation must be done in accordance with the guidance under Investment Company Act Release No. 10666 (April 18, 1979) for segregating assets in connection with reverse repurchase agreements. The effect of such segregation, in combination with the collateralization of the TALF loan, is that a Fund would maintain asset coverage of at least 200%.
In addition, the letter stated that the SEC would not recommend enforcement action under Section 17(f) of the Investment Company Act, or the rules thereunder, against a Fund “with respect to the Fund’s participation in the unique custody arrangements necessitated by the TALF program.” Thus, the letter eliminates the question of whether arrangements under the TALF program whereby a primary dealer may hold Fund assets as agent of the Fund would not comply with the safekeeping concerns underlying Section 17(f) of the Investment Company Act or the specific requirements under Rule 17f-1 thereunder.
|See a copy of the no-action letter|
|See a copy of Investment Company Act Release No. 10666|
FinCEN Moves to Streamline Bank Secrecy Act Requirements for Mutual Funds
On June 5, 2009, the Financial Crimes Enforcement Network (“FinCEN”), a U.S. Department of Treasury agency focused on fighting terrorism financing and money laundering, unveiled proposed amendments to regulations implementing the Bank Secrecy Act (“BSA”). The proposed amendments would relieve mutual funds from requirements to report transactions involving certain negotiable instruments.
Currently, for a transaction in currency above $10,000 by, through or to a mutual fund, the mutual fund is required to document the transaction on IRS/FinCEN Form 8300, whereas a “financial institution” such as a bank or a broker-dealer is required to file a Currency Transaction Report (“CTR”) on FinCEN Form 104 for such a currency transaction. The definition of “currency” includes cash for both the purposes of Form 8300 and the CTR rule, while the definition of “currency” for the purposes of Form 8300 also includes certain negotiable instruments such as cashier’s checks and money orders under certain circumstances.
The proposed amendments would add mutual funds to the definition of “financial institution” in the BSA regulations governing currency transaction reporting. As a result, mutual funds would no longer be required to file a Form 8300 and would only be required to file CTRs for cash transactions.
The proposed inclusion of mutual funds in the definition of “financial institution” under these BSA regulations would also subject mutual funds to requirements to create and retain records for transmittals of funds and to forward information on these transactions to other financial institutions in the payment chain. In its notice of proposed rulemaking, FinCEN noted that it expects that these requirements would have a de minimis impact on mutual funds and their transfer agents because of the record retention requirements currently imposed on such entities under the Investment Company Act of 1940 and the Securities Exchange Act of 1934, respectively.
FinCEN is seeking public comment on the proposed amendments through September 3, 2009.
|See a copy of the press release announcing the proposed amendments|
|See a copy of FinCEN's notice of proposed rulemaking|
Second Circuit Allows Hedge Fund Investors to Move Forward with Suit Against Prime Broker
A Second Circuit decision on June 9, 2009 permitted a group of hedge fund investors to proceed with their claim against the funds’ prime broker (Pension Committee of the University of Montreal Pension Plan v. Banc of America Securities LLC, Docket No. 07-3527-CV (B.D.P), (U.S. Ct. App. 2d Cir. June 9, 2009)). Plaintiffs in the lawsuit, investors in Lancer Offshore, Inc. and OmniFund Ltd. (the “Funds”), two British Virgin Islands-organized hedge funds, allege that the Funds’ prime broker, Banc of America Securities LLC (“BAS”), aided and abetted fraud and breaches of fiduciary duty perpetuated by the Funds’ manager, Lancer Management Group LLC (“Lancer Management”), and Lancer Management’s owner, Michael Lauer.
The plaintiffs’ aiding and abetting claim against BAS rests on allegations that BAS included, in periodic “position reports” it prepared for Lauer and Lancer Management, at their request, inflated values for restricted securities not traded in the open market held by the Funds despite BAS’s actual knowledge of (i) the falsity of the security values reported by Lauer and Lancer Management, (ii) the managers’ use of the falsified position reports to mislead investors and (iii) Lauer and Lancer Management’s intent to inflate the Funds’ NAVs in order to improperly augment the management fees they received from the Funds. To support the allegations that BAS was aware of the falsity of Lauer and Lancer Management’s valuations and that BAS participated in placing false security values in the position reports, the complaint offers specific examples of BAS employees retroactively overriding values assigned to securities by third-party pricing services or generated from purchase price information to reflect unfounded valuations provided by Lauer and Lancer Management. The position reports featured BAS’s name and did not bear a disclaimer indicating that they were not official BAS documents. To support the allegations that BAS actually knew that potential investors would rely on the falsified position reports, the plaintiffs assert that BAS was aware that Lauer and Lancer Management were providing the position reports to the Funds’ auditor, that the auditor would rely on the information therein in calculating the Funds’ NAV, and that the NAV calculation would then be reported to and relied upon by potential investors. Finally, to support allegations that BAS knew that Lauer and Lancer Management used the inflated NAV to improperly increase their management fees, the plaintiffs point to BAS’s experience as a prime broker to hedge funds as an indication that BAS was aware of the significance of NAV statements.
BAS moved to dismiss the claim against it on the ground that the plaintiffs had failed to overcome their burden of proving that BAS proximately caused the plaintiffs’ losses. Taking all alleged facts to be true (as required in reviewing a motion to dismiss), the district court agreed with BAS, acknowledging that the plaintiffs had failed to show how BAS’s position reports materially affected the plaintiffs’ perception of the Funds’ NAVs. The Second Circuit, however, in overturning the lower court’s dismissal of the claim, found that the plaintiffs’ assertions described above “sufficiently alleged proximate causation by setting forth that the investors’ losses were the direct or reasonably foreseeable result of BAS’s role in falsifying and disseminating the BAS reports that were used to prepare the NAV statements and audited financial statements on which the investors relied for financial decisions.”
|See a copy of the decision|
New York State Court Decision Rules Hedge Fund Investors Cannot Directly Sue Hedge Fund's Legal Counsel
On June 4, 2009, a decision issued by the New York State Court of Appeals (“Court of Appeals”), the state’s highest court, affirmed an appellate division’s dismissal of a lawsuit by a failed hedge fund’s investors against the fund’s legal counsel (Eurycleia Partners, LP v. Seward & Kissel, LLP, No. 88, 2009 N.Y. LEXIS 1728 (N.Y. Ct. App. June 4, 2009)). Plaintiffs in the action, 16 limited partners who invested in the hedge fund Wood River Partners, LP (“Wood River”) between 2003 and 2005, brought suit seeking $200 million in damages based on claims that Seward & Kissel, LLP (“S&K”), the fund’s outside counsel, breached a fiduciary duty it owed to the plaintiffs, committed fraud and aided and abetted fraud by the fund’s principals.
As reported in the September 8, 2008 Investment Management Regulatory Update, Wood River failed after purchasing an alleged 35% stake, representing 65% of the hedge fund’s total assets, in telecommunications equipment manufacturer Endwave Corporation (“Endwave”). Wood River’s acquisition of the Endwave stake violated the investment strategy disclosed in its offering memoranda and was not disclosed to the SEC as required by federal securities laws. Endwave’s share price subsequently plummeted, thereby diminishing the value of Wood River’s portfolio. As a result, the hedge fund became unable to meet redemption requests and collapsed in 2005. The SEC thereafter investigated the fund and instituted an action to take it into receivership. Wood River’s founder, John Whittier, was indicted and pleaded guilty to violations of the securities laws.
With respect to the breach of fiduciary duty claim, the plaintiffs alleged that S&K breached its fiduciary duty to the limited partners by, among other things, not informing them that S&K had learned that Wood River had violated securities laws by failing to notify the SEC of the size of the fund’s position in Endwave. With respect to the fraud and aiding and abetting fraud claims, the plaintiffs in the case alleged that S&K falsely stated in Wood River’s offering memoranda that Wood River was in compliance with the fund’s policy prohibiting the investment of over 10% of the fund’s total assets in any given security. To support this allegation, the plaintiffs maintained that, among other things, S&K learned that Wood River had purchased 10% of Endwave’s stock while it continued to issue offering memoranda stating the fund’s investment strategy and the 10% limitation.
When S&K moved to dismiss all claims against it, taking all of the alleged facts to be true (as required in reviewing a motion to dismiss), a trial court denied S&K’s motion to dismiss. Applying the same standard of review, the appellate division subsequently reversed the trial court’s decision, and the Court of Appeals’ decision affirms the appellate division’s dismissal of the case. With respect to the breach of fiduciary duty claim, the Court of Appeals held that the plaintiffs failed to demonstrate that S&K’s role as legal counsel to Wood River created a fiduciary relationship with Wood River’s limited partners. The court stated that “the fiduciary duties owed by a limited partnership’s attorney to that entity do not extend to the limited partners,” and that “S&K’s representation of [the] limited partnership, without more, did not give rise to a fiduciary duty to the limited partners.” Additionally, the court found that the fraud and aiding and abetting causes of action failed because the plaintiffs had not pleaded facts sufficient to demonstrate that S&K had substantially assisted Wood River’s principals in defrauding the limited partners. In particular, the court noted that the plaintiffs’ assertion regarding S&K’s knowledge that Wood River owned 10% of Endwave’s stock did not create a reasonable inference that S&K knew that Wood River had invested over 10% of its own assets in Endwave, especially because the plaintiffs did not allege that S&K knew Wood River’s overall asset levels or at what price it had purchased its stake in Endwave.
|See a copy of the decision|
SEC Sanctions Evergreen for Valuation, Disclosure Violations
On June 8, 2009, the SEC imposed sanctions against Boston, Massachusetts-based Evergreen Investment Management Company, LLC (the “Evergreen Adviser”) and its affiliated registered broker-dealer, Evergreen Investment Services, Inc. (the “Evergreen Distributor”), for violating certain provisions of and rules under the Investment Advisers Act of 1940 (the “Advisers Act”), the Investment Company Act of 1940 (the “Investment Company Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).
The Evergreen Adviser is the registered investment adviser for the Evergreen Ultra Short Opportunities Fund (the “Ultra Fund”), one of the Evergreen family of mutual funds. The Evergreen Distributor is the principle underwriter of the Ultra Fund and other Evergreen funds. The Evergreen Adviser and the Evergreen Distributor were until December 31, 2008 subsidiaries of Wachovia Corporation and are now subsidiaries of Wells Fargo & Company as a result of Wells Fargo’s acquisition of Wachovia.
According to the SEC’s order, the Evergreen Adviser violated Section 206(2) of the Advisers Act by causing the Ultra Fund to overstate its per share net asset value (“NAV”). 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.” When making valuation recommendations to the Ultra Fund’s valuation committee regarding certain residential mortgage-backed securities held by the fund, the Evergreen Adviser ignored readily-available information relating to these securities and instead opted to rely on the inflated prices provided by a Florida-based broker-dealer. As a result, the Ultra Fund overstated its NAV by up to 17% during the period between February 2007 and the fund’s closing in June 2008. Because of the overstated NAV, the Evergreen Adviser was able to generate for itself higher advisory fees paid by the Ultra Fund.
Moreover, the SEC found that the Evergreen Adviser and the Evergreen Distributor violated Section 206(2) by defrauding the Ultra Fund through selective disclosure of material, non-public information. On June 18, 2008, the Ultra Fund’s board decided to liquidate the fund. During the three-week period leading up to the board’s decision, the Ultra Fund continuously reduced its valuations of numerous securities it held. Instead of making this important information publicly available, the Evergreen Adviser and the Evergreen Distributor disclosed the process of re-pricings only to select shareholders or their financial intermediaries, including shareholders who were customers of an affiliated broker-dealer. According to the SEC, by limiting the dissemination of this information, the Evergreen Adviser and the Evergreen Distributor enabled shareholders who received the information to redeem their shares at a price higher than they would have received at the liquidation date, diluting the fund and harming other shareholders.
In addition to the violations described above, the SEC also found additional violations, including that (i) the Evergreen Adviser violated Section 206(2) of the Advisers Act by failing to seek best execution of a trade for the Ultra Fund and favoring another client over the Ultra Fund, (ii) the Evergreen Distributor violated Rule 22c-1(a) under the Investment Company Act by selling and redeeming the Ultra Fund’s shares at a price that was based on an overstated NAV, (iii) the Evergreen Adviser aided and abetted and caused the Ultra Fund’s material overstatement of its NAV and sale and redemption of its shares at a price other than the fund’s correct NAV in violation of Rule 22c-1(a), (iv) the Evergreen Adviser aided and abetted and caused prohibited securities transactions between the Ultra Fund and certain other Evergreen funds in violation of Section 17(a)(2) of the Investment Company Act and (v) the Evergreen Distributor violated Section 17(a) of the Exchange Act and Rule 17a-4(b)4 thereunder by failing to preserve for three years certain business communications in violation of a 2007 order issued by the SEC in a separate enforcement action.
Without admitting or denying any wrongdoing, the Evergreen Adviser and the Evergreen Distributor settled the SEC’s proceedings by agreeing to (i) accept a censure and (ii) cease and desist from committing or causing any future violations of the Advisers Act, the Investment Company Act and the Exchange Act, as applicable. The Evergreen Adviser and the Evergreen Distributor also agreed to pay disgorgement ($2,860,000 for the Evergreen Adviser and $1 for the Evergreen Distributor) plus prejudgment interest ($265,000 for the Evergreen Adviser) and a civil penalty ($2,000,000 each) and to establish a “Fair Fund” pursuant to Section 308(a) of the Sarbanes-Oxley Act. They also agreed to perform certain additional undertakings enumerated in the SEC’s order.
The SEC noted in its order that in agreeing to settle its proceedings the SEC considered the cooperation it received and the remedial acts undertaken by the Evergreen Adviser and the Evergreen Distributor.
|See a copy of the SEC's order|
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