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Another Mutual Fund Firm Fined for Distribution-In-Guise

Another mutual fund manager was censured and penalized ($22.6 Million) for paying distribution and marketing fees mis-characterized as sub-TA fees, in violation of Section 12(b) and Rule 12b-1 of the Investment Company Act.  The SEC alleges that the fund sponsor, through the manager and distributor, used fund assets to pay for distribution but told intermediaries and the Board that such amounts were for sub-TA (shareholder) services and would be paid out of the manager’s revenue rather than fund assets.  Additionally, the SEC charges that, even if the amounts were paid for legitimate sub-TA services, such amounts exceeded the caps set by agreements with the funds.

OUR TAKE: Many in the fund industry were waiting for the regulatory shoe to drop after the SEC first announced the distribution-in-guise sweep two years ago.  This makes 2 cases in 2 days against large fund companies.  Compliance officers must do their own sweep to determine whether fund sponsors are properly compensating intermediaries.


Fund Company Fined $4.5 Million for Unlawful Distribution-in-Guise

A mutual fund manager agreed to pay a $4.5 Million fine and reimburse the funds another $1.25 Million for making unlawful distribution and sub-transfer agency payments to intermediaries.  The SEC maintains that the fund company claimed to make payments solely out of its revenues but, as a result of a technical misclassification, paid amounts directly out of fund assets in violation of Rule 12b-1.  The SEC also asserts that the respondent paid sub-TA fees in excess of Board-approved caps disclosed in the registration statement.  The SEC charges violations of the antifraud provisions of the Advisers Act and the Investment Company Act (Sections 206(2) and 34(b), respectively) and Section 12(b) and Rule 12b-1 of the Investment Company Act for making distribution payments without proper Board and shareholder approval and disclosure.

OUR TAKE: This the SEC’s second major case pursuant to its distribution-in-guise initiative (See Fund Sponsor to Pay $40 Million for Using Fund Assets to Pay for Distribution).  Fund firms must make sure that sub-TA payments do not include payments for any kind of distribution or marketing services.  Also, Boards must vet and approve all such plans that make use of fund assets.


BD Pays $2.3 Million for Sales Charge Violations


A large retail broker-dealer agreed to pay $2.3 Million in restitution because the firm failed to offer load-waived class A shares.  Instead, the eligible customers – retirement plans and charitable organizations – either paid the loads or were directed to higher-expense Class B or C shares.  FINRA faults the firm for over-relying on its financial advisers to determine the applicability of sales charge waivers while failing to properly notify and train them.  Also, the firm failed to adopt adequate controls to detect clients that were entitled to the waivers.  The firm was not fined, presumably because FINRA lauded the respondent for detecting and self-reporting the issues.

OUR TAKE: An adequate compliance program cannot rely on those that need to be monitored to effect proper compliance and surveillance.  An independent function should be tasked with surveillance and implementation.


Adviser Failed Best Execution When Recommending 12b-1 Fund Class


An investment adviser agreed to pay over $2 Million in disgorgement, interest and penalties for failing to buy the least expensive share class of recommended mutual funds.  The SEC maintains that the respondent, an investment adviser representative of a large advisory firm, recommended Class A shares that carried a 12b-1 fee instead of lower-expense institutional shares.  The adviser received a portion of the 12b-1 fees from the clearing firm as revenue sharing.  The SEC did not absolve the adviser even though he received approval for the practice after consulting his firm’s management.  The SEC asserts that the adviser violated his obligation to seek best execution for securities transactions.

OUR TAKE: The SEC requires advisers to recommend the lowest-expense share class available, which requires more diligence by advisers before making recommendations.  It is also noteworthy that the SEC uses an expansive interpretation of an adviser’s best execution obligations, which historically has centered on brokerage commissions.


SEC Staff Allows More Flexible Fund-of-Funds Structures


The staff of the SEC’s Division of Investment Management has provided no-action relief that allows open-end investment companies to invest in closed-end investment companies that hold themselves out as part of the same investment group.  Without the no-action relief, a narrow reading of Section 12(d)(1)(G) and Rule  12d1-2 of the Investment Company Act would only allow open-end funds to invest in related funds only if such funds were open-end.  In general, Section 12(d)(1) limits fund-of-funds structures, absent specific conditions, because fund-of-funds have the potential to create complex products with layered fees and conflicts of interest.

OUR TAKE: This no-action relief provides practical flexibility to create fund-of-funds structures within the same group of companies, which should save costs and avoid artificial product engineering.


Principals Close Shop for Failure to Disclose Investments in Affiliated Mutual Fund

excessive fine for mutual fund

The principals of an investment adviser/fund manager agreed to wind down their firm and pay fines for failing to properly disclose conflicts of interest when they invested clients’ money in an affiliated mutual fund.  The SEC asserts the respondents invested 35% of client assets in an affiliated mutual fund, which resulted in clients paying an asset management fee of 1.3% of assets plus fund fees exceeding 2.95%.  The firm did amend its Form ADV to describe the conflict, but, according to the SEC, the respondents did not deliver the amended Form ADV to clients before investing assets in the affiliated fund.  The SEC also notes that the respondents failed to heed advice of a compliance consultant about Form ADV disclosure and delivery.  The SEC claims the respondents violated Section 206(2) (anti-fraud), Rule 206(4)-7 (compliance rule), and Rule 204-3 (brochure delivery).

The real issue in this case is that the adviser was charging clients over 4.00% in fees and expenses, which may be a breach of fiduciary duty no matter how much disclosure is provided.  The failure to deliver the Form ADV just made the case easier for SEC Enforcement.  Also, you should always listen to your compliance consultant.


Federal Court Vacates SEC Rule Requiring Shareholder Nominations

The United States Court of Appeals for the District of Columbia has vacated the SEC’s proxy access rule (14a-11) that would have required public companies including investment companies to include shareholder director nomination in proxy materials.  The Court ruled that the SEC acted in an arbitrary and capricious manner in violation of the Administrative Procedure Act because it failed to adequately “consider the rule’s effect upon efficiency, competition, and capital formation” as required by the Exchange Act and the Investment Company Act.  The Court opined that the SEC failed to quantify or justify the potential costs of the Rule, including the costs of proxy battles and the impact of special interests, and failed to offer empirical evidence of its benefits. 
OUR TAKE: This decision, along with last year’s decision vacating the rule regulating equity indexed annuities, will make it much more difficult for the SEC to promulgate regulations because the Court is mandating empirical and economic analysis.  Expect challenges to the raft of Dodd-Frank rules. 

Federal Court Dismisses CDO Fraud Case Based on Transactional Locus

The U.S. District Court for the Southern District of New York has dismissed a securities fraud claim made by an offshore hedge fund that purchased CDOs sponsored and sold by a large U.S. investment bank. The Court cited the recent Supreme Court case Morrison v. National Australia Bank, which applies a transactional test, rather than the old conduct and effects test, to determine whether a securities fraud claim is subject to U.S. jurisdiction. The Court opined that the plaintiff did not provide sufficient facts to allow the Court “to draw the reasonable inference that the purchase or sale was made in the United States.” The dismissal without prejudice allows the plaintiff to re-plead its case and provide the relevant facts.

OUR TAKE: This is a very aggressive reading of Morrison because of the substantial sales activities that emanated from the U.S. The lower courts will continue to wrestle with this transactional standard applied to multi-jurisdictional securities fraud cases.

SEC Pursues Trustee for Allowing Unauthorized Investments

The SEC has instituted administrative proceedings against the trustee responsible for ensuring that a hedge fund did not mis-use investor funds.  The SEC alleges that the trustee allowed the hedge fund and its principals to use funds for unauthorized investments that included significant conflicts of interest..  Employing a somewhat novel structure to assure investors that their funds were protected, the hedge fund signed a trust indenture appointing a trustee with the responsibility for ensuring that no proceeds would be released for purposes not authorized by the trust indenture.  The SEC alleges that the respondent violated his contractual and fiduciary responsibilities by allowing unauthorized uses of proceeds and failing to disclose conflicts of interest.  The SEC charges that the respondent’s conduct aided and abetted the primary securities law violations.
OUR TAKE: The SEC is ready, willing and able to prosecute fund trustees with responsibility for safeguarding investor assets.

SEC Sues Head of Collateral Manager for Omissions in Structured Product Offering Docs

 The SEC has filed an action against the Managing Director of the registered investment adviser that served as the collateral manager for failed structured products.  The SEC alleges that the defendant participated in marketing and preparing marketing materials without disclosing that a hedge fund also participated in the collateral selection process and sold many of the securities short.  The SEC charges that the defendant was partially motivated by his desire to obtain employment with the hedge fund.  The fund sponsor agreed to pay over $150 Million to settle charges related to the offerings. 
OUR TAKE:  The SEC is on firm ground when it posits that the offering documents and pitch books should have disclosed the hedge fund’s participation in the collateral selection process.  It is less clear whether an employee of the firm responsible for collateral selection has securities fraud liability for material omissions.