SEC Rules and Regulations

SEC Expands the Definition of "Eligible Portfolio Company" under the Investment Company Act

Effective July 21, 2008, the SEC has adopted amendments to Rule 2a-46, promulgated pursuant to the Investment Company Act of 1940 (the "Investment Company Act"), that expand the definition of "eligible portfolio company" to include companies listed on a national securities exchange that have less than $250 million in market capitalization.

A business development company ("BDC") is a special type of closed-end investment company created by Congress to provide capital to small or start-up enterprises, among other businesses.  In furtherance of that goal, generally at least 70% of the assets of a BDC must be invested in the securities of certain companies, among them, "eligible portfolio companies."  Generally speaking, "eligible portfolio companies" are small domestic companies that have limited access to the capital markets. 

Prior to this amendment, if a broker-dealer could not extend margin credit with respect to the company's securities pursuant to the rules of the Federal Reserve Board, then the company generally would qualify as an "eligible portfolio company."  According to the release accompanying the amendment, "[a]t the time that Section 2(a)(46) was adopted, Congress generally perceived the Federal Reserve Board's definition of 'margin security' to be a 'rational and objective test for determining whether an issuer has ready access to the securities market[s].'"

However, changes made over time to the Federal Reserve Board's margin rules "for reasons unrelated to small business capital formation" resulted in nearly all exchange-traded securities qualifying as "margin securities," thereby significantly reducing the number of "eligible portfolio companies."  Whether a company's securities were eligible for margin treatment no longer indicated whether the company had access to the capital markets.  Among other attempts to address these changes, in 2006, the SEC adopted Rule 2a-46, which generally defined an "eligible portfolio company" as one that "does not have any class of securities listed on a national securities exchange."

The new amendment to Rule 2a-46, Rule 2a-46(b) puts forth an additional proxy for whether a company has access to the capital markets.  Specifically, the amendment assumes that companies with market capitalizations of $250 million or less are "followed by fewer analysts, have lower institutional ownership and lower trading volume than larger companies."  The SEC hypothesizes that analyst coverage, institutional ownership and trading volume are correlated with access to capital; therefore, the SEC believes that expanding the scope of the definition of "eligible portfolio company" to include certain companies whose shares are exchange-traded will "more closely align[ ] the definition [ ], and the investment activities of BDCs, with the purpose that Congress intended."

SEC Releases Final Rule on Disclosure of Divestment by Registered Investment Companies in Accordance with the Sudan Accountability and Divestment Act of 2007

On April 30, 2008, the SEC announced final amendments to Form N-CSR and Form N-SAR allowing for the disclosure of divestments by registered investment companies opting to do so in accordance with the Sudan Accountability and Divestment Act of 2007 (the "Sudan Act").  The amendments became effective the same day.  For background information, see the January 2008 Investment Management Regulatory Update, which discussed the Sudan Act in greater detail, and the March 2008 Investment Management Regulatory Update, which addressed the proposed amendments.

Pursuant to the amendments, each registered investment company that chooses to divest securities in accordance with the Sudan Act, and that wants to benefit from the Act's limitation on civil and criminal actions related to such divestiture, is required to disclose the divestment on the next Form N-CSR (for management investment companies) or Form N-SAR (for unit investment trusts) that it files following the divestment.

The amended forms require disclosure of the securities divested and the magnitude of the divestment.  For each divested security, the registered investment company must identify:

  • the issuer's name;
  • the exchange ticker symbol;
  • the CUSIP number;
  • the total number of shares or, for debt securities, the principal amount divested; and
  • dates that the securities were divested.

For the purposes of determining when a divestment should initially be reported, if an investment company divests its holdings in a particular security in a related series of transactions, it may deem the divestment to occur at the time of the final transaction.  In that case, the divestments should be disclosed on a single form that separately states each date on which a divestment took place as well as the magnitude of each such divestment.  This allows registered investment companies the ability to choose whether to report each transaction in the next Form N-CSR or Form N-SAR immediately following that transaction, or to report the entire series on the Form N-CSR or Form N-SAR following the final transaction in the series.

If an investment company ultimately makes only a partial divestment and continues to hold any securities of the divested issuer it must disclose the information described above with respect to its remaining holdings as of the filing date. 

The SEC does not treat such disclosures as confidential.

The amendments will terminate one year after related provisions of the Sudan Act terminate, in order to allow sufficient time for companies that divest pursuant to the Sudan Act prior to its termination to declare the divestment after the Act itself has terminated.


Court Grants Motion Dismissing Involuntary Bankruptcy Petition Filed Against Hedge Fund Ritchie Multi-Strategy Global, LLC

On April 16, 2008, the United States Bankruptcy Court for the Northern District of Illinois issued an order dismissing the involuntary Chapter 11 petition filed against hedge fund Ritchie Multi-Strategy Global, LLC ("Ritchie") by certain of its investors (the "Petitioning Investors").

As discussed in greater detail in the March 2008 Investment Management Regulatory Update, on December 26, 2007, the Petitioning Investors asserted that (i) they had duly exercised their contractual rights of redemption of their investment as provided in Ritchie's operative agreements, (ii) Ritchie had failed to satisfy these redemption requests and (iii) this failure gave the Petitioning Investors cognizable "claims" within the meaning of Section 101(5) of the Bankruptcy Code that were "non-contingent, undisputed claims" that allowed them, as petitioning creditors, to file an involuntary bankruptcy petition against Ritchie.  Ritchie moved for summary judgment seeking to dismiss the petition on the grounds that the rights of the Petitioning Investors against Ritchie were not "claims" within the meaning of the Bankruptcy Code or, if they were "claims," were "the subject of a bona fide dispute."  Ritchie also contended that the involuntary petition had to be dismissed because it was generally paying its undisputed debts as they became due.

The court conducted an exhaustive review of both the operative language of the Ritchie operating agreement and subscription agreement and the language of correspondence that Ritchie had sent to its investors during the period in which Ritchie had unsuccessfully attempted to restructure itself and then ultimately decided to sell its assets to Rhone Holdings II, LP ("Rhone II"), an acquisition vehicle of Reservoir Capital Group.

The court found that a number of facts, including a provision in the operating agreement that gave Ritchie's manager broad discretion to postpone the effective date of redemptions, cast sufficient doubt on the matter that it found that no "claim" arose on the date that the Petitioning Investors submitted their redemption requests because payment thereon was "subject to a bona fide dispute" and therefore could not form the basis for an involuntary bankruptcy petition.  However, the court found that a "claim" did arise when Ritchie updated its investors on the Rhone sale and stated in an e-mail, among other things, that "[i]n order to ensure equal treatment of all investors, the managing member of the fund has mandatorily redeemed the interests of all investors in the fund effective as of May 31, 2007."  The court found that there appeared to be no "bona fide dispute" and that each Petitioning Investor had a "claim" as of this date despite Ritchie's contention that its use of the term "effective" in the e-mail was not intended to have formal or legal significance.

Notwithstanding its finding that the Petitioning Investors had undisputed "claims," the court dismissed the action because it found that the Petitioning Investors failed to show, as required by Section 303 of the Bankruptcy Code, that Ritchie was "not paying its debts as such debts became due."  The court observed that, under Ritchie's operating agreement, "under normal circumstances payments of capital withdrawals shall generally be made within 90 days after the effective date," but the court went on to note, however, that:

[i]t can hardly be said under the record presently before the court that 'normal circumstances,' as that phrase is ordinarily interpreted, existed on September 30, 2006 or May 31, 2007 or, [in] either case, 90 days thereafter.  Over 60 percent of the investors by value had sought to withdraw, a restructuring had been attempted and then terminated, and the fund was proceeding with an orderly disposition of its assets.

Because the operating agreement of Ritchie gave its manager discretion to postpone the payment of withdrawal proceeds if it determined that circumstances "do not allow the timely liquidation of such investment" or "in such other circumstances as the managing member may determine," the court found that the Petitioning Investors had "failed to make a sufficient showing that the fund is generally not paying its debts as they become due."

The court granted summary judgment dismissing the involuntary petition, and the Petitioning Investors have not appealed the dismissal.

Seventh Circuit Declines to Follow Gartenberg in Ruling in Favor of Fees Charged by Investment Adviser to Oakmark Mutual Funds

On May 19, 2008, the U.S. Court of Appeals for the Seventh Circuit (the "Seventh Circuit") ruled in favor of Harris Associates L.P. ("Harris Associates") in a case brought under Section 36(b) of the Investment Company Act of 1940 (the "Investment Company Act") by shareholders of certain Oakmark mutual funds advised by Harris Associates.  The plaintiff shareholders alleged that the fees charged by Harris Associates to the Oakmark funds were excessive and therefore in violation of Section 36(b) of the Investment Company Act.  In its ruling, the Seventh Circuit found that the fees charged by Harris Associates to the funds were not excessive, and, in so deciding, rejected the approach of the U.S. Court of Appeals for the Second Circuit (the "Second Circuit") in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982). 

Pursuant to Section 36(b) of the Investment Company Act, an adviser of a registered investment company assumes a fiduciary duty with respect to the receipt of payment for its services from the investment company or its shareholders.  According to Gartenberg, an adviser breaches its fiduciary duty under Section 36(b) where its fee schedule is outside the "range of what would have been negotiated at arm's-length . . ." or is "so disproportionately large that it bears no reasonable relationship to the services rendered."

The district court below found for Harris Associates, citing Gartenberg and concluding that, because the fees Harris Associates charged to its retail mutual funds were "ordinary," the plaintiffs' complaint must fail.  As the Seventh Circuit acknowledged, the fees charged to certain of the Oakmark funds by Harris Associates, which typically were no higher than 1% of a fund's assets under management, were well within industry norms. 

The plaintiffs contended, among other things, that Gartenberg should not be followed in their case because the market for providing investment advisory services to mutual funds is not competitive, which, according to the plaintiffs, was a fundamental premise underlying the Second Circuit's opinion in Gartenberg

Although the Seventh Circuit ruled against the plaintiffs, it did agree that Gartenberg does not provide the proper framework for analyzing claims brought under Section 36(b) of the Investment Company Act.  According to the Seventh Circuit, Section 36(b) "does not say that fees must be 'reasonable' in relation to a judicially created standard.  It says instead that the adviser has a fiduciary duty."  Drawing analogies from the common law governing trusts, corporations and lawyers, the Seventh Circuit stated that "[t]he existence of a fiduciary duty does not imply judicial review for reasonableness; the question a court will ask, if the fee is contested, is whether the client made a voluntary choice ex ante with the benefit of adequate information." 

Proper disclosure of fee arrangements allows the market to ensure that advisers refrain from charging "excessive fees," reasoned the Seventh Circuit.  The Seventh Circuit characterized the mutual fund market as including thousands of different, competing funds, among them index funds with minimal fees.  Therefore, according to the Seventh Circuit, so long as proper disclosures are made, investors may (and frequently do) "fire" advisers who overcharge mutual funds for their services by removing their assets from such funds.

Applying its newly articulated standard to the case, the Seventh Circuit noted that the compensation paid to Harris Associates was approved by the funds' boards of trustees (including, in each instance, the requisite number of disinterested trustees) and properly disclosed to the funds' investors; therefore, it held that Harris Associates did not breach its fiduciary duty pursuant to Section 36(b) of the Investment Company Act.  According to the Seventh Circuit, "[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation."

District Court Finds SEC Lacks Authority to Impose Civil Monetary Penalties for Aiding and Abetting Violations of the Investment Advisers Act

On May 6, 2008, the U.S. District Court for the District of Columbia ruled, in a case of first impression, that the SEC lacked the authority to impose a civil monetary penalty for aiding and abetting violations of the Investment Advisers Act of 1940 (the "Advisers Act") (SEC v. Bolla, No. CIV. A. 02-1506 CKK (D.D.C. May 6, 2008)).

In 2005, Robert Radano was found liable for aiding and abetting violations of Sections 203(f), 206(1), and 206(2) of the Advisers Act in connection with assisting investment adviser Steven Bolla in concealing from clients that Mr. Bolla was previously barred from the industry.  The court ordered civil penalties of $15,000 against Radano, and enjoined him from future Advisers Act violations.  Radano filed a motion to vacate the monetary portion of the judgment, arguing that Section 209(e) of the Advisers Act does not authorize monetary penalties for aiding and abetting violations.

Section 209(e) of the Advisers Act authorizes the SEC to bring a court action to seek, and authorizes a court to impose, civil monetary penalties to be paid by a person who violated the Advisers Act.  Section 209(e), however, does not specifically mention penalties with regard to aiding and abetting violations.

Reversing its own prior ruling, the court granted Radano's motion and vacated the portion of its original order that required Radano to pay the $15,000 fine, noting that "there is no question that Section 209(e) does not explicitly authorize monetary penalties for aiding and abetting violations of the Advisers Act in the district courts."  It concluded that this lack of explicit authorization was "fatal," as in other securities laws Congress has explicitly authorized the SEC to seek penalties against both primary violators and aiders and abettors.  The court noted that in the context of federal securities laws, the Supreme Court has stated that "Congress knew how to impose aiding and abetting liability when it chose to do so.  If. . .Congress intended to impose aiding and abetting liability, we presume it would have used the words 'aid' and 'abet' in the statutory text.  But it did not." 

In reaching its decision, the court rejected the SEC's argument that the legislative history and context indicates that Congress intended the SEC to have the authority to obtain monetary penalties against aiders and abettors.  The SEC argued that the language of Section 209(e) authorizes the SEC to seek a penalty for a "violation" of the Advisers Act, which would also include aiding and abetting the violations of others.

It should be noted that under Section 203(i) the SEC can still obtain monetary penalties against aiders and abettors in cases brought before SEC administrative proceedings as opposed to civil court actions.  Additionally, as a District Court decision, the court's interpretation is not binding on any other courts.

Industry Update

California Decides Not to Proceed with Regulation Requiring Registration of Investment Advisers

On May 1, 2008, the California Department of Corporations ("DOC") announced that it had decided not to proceed with its proposed amendment of Section 260.204.9 of the California Code of Regulations.  As discussed in the November 2007 Investment Management Regulatory Update, the proposed amendment would have required certain investment advisers that conduct business in California, but are currently exempt from registration, to be licensed by the DOC. In the announcement, the DOC cited the concerns raised during the public comment period, further consideration of the rulemaking action and ongoing actions by federal regulators as the basis for its determination that the proposed amendment, at present, is premature.

Should the DOC decide to revisit the regulations, it will have to restart the rulemaking process.

SEC Approves NSCC Rule to Create Alternative Investment Product Processing Service

On May 12, 2008, the SEC approved a proposed rule change filed by the National Securities Clearing Corporation ("NSCC") designed to create a platform to facilitate processing of transactions in alternative investment products ("AIPs") between investors and alternative investment funds. 

The approved rule allows the NSCC to establish an electronic processing platform, called the Alternative Investment Products Service ("AIP Service"), designed to automate the exchange of information and settlement of payments for AIPs such as hedge funds, funds of hedge funds, commodities pools, managed futures, and real estate investment trusts. 

According to the SEC's release approving the rule, the NSCC believes that the AIP Service will be able to automate and streamline many of the processes currently handled manually, such as processing subscriptions, distributions and redemptions, position reporting, and account maintenance.  The NSCC expects the new service will allow for increased efficiency and cost-effectiveness in the $1 trillion industry.

SEC Chairman Christopher Cox Addresses Mutual Fund Leadership Dinner

On April 30, 2008, SEC Chairman Christopher Cox addressed the mutual fund industry at the Folger Shakespeare Library in Washington, D.C.  In his speech, Chairman Cox stressed the importance of fiscal responsibility and highlighted the need for transparency in order to allow investors to better and more easily make educated investment decisions.  Cox also observed that in the current economic "rough seas" many mutual funds have been a "relative safe harbor of calm."

Auction rate securities.  Chairman Cox expressed his concern with the failure of auctions that began earlier this year in the auction rate securities market.  The SEC has worked with the Financial Industry Regulatory Authority to allow brokers to lend money to investors whose funds are tied up in auction rate securities, so long as doing so does not impair the financial condition of the broker-dealer or jeopardize the funds and securities of its customers.  According to Cox, the SEC is currently considering ways to provide relief to investors in closed-end securities.  Any such relief would need to take into account the conflicting interests of the holders of the auction rate preferred shares of the fund and the fund's common shareholders, indicated Cox.  Cox emphasized the receptivity of the SEC's Division of Investment Management to input from fund industry leaders.

Summary prospectus.  The SEC is working on the text of a final rule regarding the summary prospectus.  The rule will clarify the content of the summary prospectus and the frequency of its updating.  Chairman Cox said that despite the emphasis of the mutual fund industry on retail consumers, prospectuses are "widely considered to be too long, too wordy, and too legalistic."  The new summary prospectus, along with data tagging, aims to provide investors with "straight talk."  Cox said that he hopes that the new summary prospectus will also be incorporated in 401(k) plan materials.  In discussing the impact of the new summary prospectus, Cox outlined a vision for the future of mutual fund investing whereby the combination of interactive data, the new summary information and vertical search capabilities will allow investors to instantly gather information on "hundreds, or even thousands of funds in order to do quick and easy comparisons."  Though the final product is still a long way off, it is possible to give the proposed disclosure regime a "test drive" using the SEC's new Mutual Fund Reader, currently available on the Commission's website.

Rule 12b-1.  According to Chairman Cox, Rule 12b-1 is "outdated and in need of reform."  Cox said that he personally supports "scrapping the rule," which he considers confusing to investors, and starting anew.  Said Cox, "[i]f fund assets are to be used to compensate salespeople for distributing fund shares, then that is how those payments should be treated. . .[a]nd. . .disclosed."  In the coming weeks, Cox said the SEC will start to clean up the 12b-1 issue, and he predicted that the result would be the repeal of the rule.