The Supreme Courts Janus Decision: No Inside this issue: Secondary - - PDF document

The Supreme Court’s Janus Decision: No Secondary Liability, but Many Secondary Questions .................................. 1 D.C. Circuit Strikes Down SEC Proxy Access Rule ............ 5 Congressional Panel Considers Systemic Risk of Mutual Funds............................. 6 Floating NAV Proposal Dominates SEC Systemic Risk Roundtable ........................ 8 Custodians Alleged to Overcharge in Foreign Exchange Transactions ............. 9 SEC Issues Report on Review of Reliance on Credit Ratings............................ 9

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Inside this issue: August 2011

The Supreme Court’s Janus Decision: No Secondary Liability, but Many Secondary Questions

The U.S. Supreme Court’s recent decision in Janus Capital Group, Inc. v. First Derivative Traders raises questions for fund directors about the allocation of liability for prospectus errors and whether directors should take additional measures either to protect their funds and themselves from liability for prospectus errors or to provide their funds’ investment adviser with additional incentive to ensure the accuracy and completeness of fund prospectuses. The Janus Decision. The Janus case is unusual in that the plaintiffs, who alleged that the prospectuses of certain Janus funds contained material misstatements, were suing as shareholders of the investment adviser’s parent company, Janus Capital Group, Inc. (“Janus Capital”), not as fund shareholders. Plaintiffs claimed that shares of Janus Capital lost value when its assets under management declined because of regulatory action against company affiliates in the 2003 market-timing scandal. Plaintiffs brought an action against Janus Capital for alleged misstatements about market timing in the funds’ prospectuses, under the Securities Exchange Act of 1934 (“1934 Act”) Rule 10b-5, which declares it unlawful “to make any untrue statement of a material fact” in a prospectus. The Court, in a 5-4 decision, ruled in favor of Janus Capital, finding, in effect, that the only person who can be liable under Rule 10b-5 is the person “making” the statement, in this case the funds that issued the prospectuses. The Court held that the Janus funds ultimately controlled the content of their own prospectuses; therefore, the funds, and not the other persons or entities who contributed information to the document, were the makers of the statements in question. The Court observed that the Securities and Exchange Commission (“SEC”) has authority to bring a case for aiding and abetting violations of Rule 10b-5, under which the various contributors to the prospectus might have been liable, but that there is no private right of action for aiding and abetting such a violation. The Janus decision represents a determined effort by the Court not to allow such secondary liability to slip in through a back door. The decision is noteworthy for the complete absence of language found in many earlier decisions stating that the federal securities laws are “remedial statutes” and should be interpreted broadly in accordance with their remedial intent. Allocation of Liability After Janus. The Janus decision did not significantly change registration statement liability for funds, their directors or their advisers. However, given the structure of the typical investment company complex, in which the funds have no employees of their own and employees of the adviser and the administrator provide all of the funds’ officers and all services necessary to the funds’ day-to-day operation, the decision has left many in the industry

2 August 2011

scratching their heads. If the adviser is not responsible for the prospectus content, who is? Some have expressed concern that under the Janus ruling, fund directors may face increased liability for prospectus errors. They question whether, if the adviser is not the maker of the statements in the fund’s prospectus, that leaves fund directors in the position of being the only responsible party. But is that right? The role of a board of directors is generally oversight, not execution. Rather, it is the officers of a corporation who are responsible for its executive function. It is arguable whether even they would be deemed to have made the statements contained in a fund’s prospectus under the Supreme Court’s new interpretation of Rule 10b-5, but one would think the light would shine on them before it falls on independent directors. Perhaps more to the point, very few prospectus liability cases are brought under Rule 10b-5. The rule imposes on the plaintiff the burden of proving that the defendant acted with scienter (or at least with recklessness), and that the plaintiff (or the market) relied on the false statement. Plaintiffs’ counsel typically find it much more appealing to bring prospectus cases under Section 11 of the Securities Act of 1933 (“1933 Act”), which imposes liability for losses stemming from a registration statement that was materially false or misleading at the time it went effective. Section 11 liability falls on the fund, its directors, certain officers and anyone who has “expertised” the allegedly false portion of the prospectus (e.g., the auditors). The plaintiff is not required to prove scienter or even

• recklessness. Defendants in such cases may have

defenses available, but they are just that –

• defenses. The burden falls on the defendants to

establish those defenses once the plaintiff has asserted a prima facie case. Clearly, the Janus case did nothing to change liability under Section 11, since that question was not before the Court. And although the adviser itself may not be a defendant in a Section 11 case, the fund’s inside directors and certain officers, who typically are significant players in the advisory organization, likely would be defendants. Fund officers and directors do have available under Section 11 a “due diligence” defense; however, the officers and inside directors, precisely because they are insiders, may have a more difficult time than would the independent directors in establishing that they did not know the truth of the matter at the heart of the plaintiff’s claim. Advisers and their affiliates are potentially liable under other provisions of the federal securities laws as well. For example, plaintiffs may sue a fund’s distributor – often an affiliate of the adviser – under Section 12 of the 1933 Act for selling shares by means of a materially false

• prospectus. Additional provisions of the federal

securities laws, enforceable only by the government, also might be used to impose monetary liability and other penalties on an adviser for misstatements in the fund’s

• prospectus. Thus, the Janus case did very little

to alter the potential liability of advisers, funds, or fund officers and directors in cases where a fund’s prospectus is arguably false. That said, however, the discussion generated by the case would seem to present directors with the opportunity to consider several matters that could be important in allocating liability in a case alleging a false prospectus. These matters are (1) the best way for fund directors to carry out their “due diligence” regarding the content of fund registration statements; (2) the provisions of advisory, administrative and distribution contracts that allocate liability between those entities and the fund for prospectus misstatements and omissions; and (3) various avenues for indemnification and shared liability, including D&O/E&O coverage and an indemnification agreement with the adviser. Due Diligence. As noted, Section 11 of the 1933 Act provides fund directors, among others, with a defense against liability based on their having performed due diligence to assure themselves of the accuracy and completeness of the registration

• statement. In the wake of Janus, some boards of

directors are reviewing carefully the manner in which such a defense might be established. The investment process is largely intangible, and director due diligence might therefore be enhanced by a focus on process and safeguards.

• Certainly, it may be important to show that

a director or his/her delegate (e.g., a board

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Investment Management Update

committee or counsel) reviewed the prospectus carefully.

• In this day of complex securities and

investment strategies, directors may be well advised to consider additional measures consistent with their traditional oversight role. Some boards are asking how the prospectus is prepared and vetted, and by

• whom. Who signs off on each section of the

prospectus, and what records are kept of the sign-off? Does a person familiar with the risks of the investment program, other than the portfolio manager, review and sign off on the risk disclosure? Does the Chief Compliance Officer or someone else regularly review the portfolio to make sure it remains within the limits stated in the prospectus and statement of additional information? What comments were received from the SEC staff during the initial or annual update filing of the registration statement, and how were they addressed? Does independent board counsel

• r outside fund counsel play a meaningful role

in preparing and vetting the document? Do his or her comments and concerns carry weight with the adviser? Contractual Provisions. Fund directors also may want to review provisions in the advisory or distribution contracts allocating liability for false statements in or omissions from the prospectus. The contracts may say nothing at all about the subject, or the fund may undertake to indemnify the adviser or distributor for such liability, unless it stems from information in the prospectus that was provided to the fund by the adviser or distributor in writing.

• Directors may want to consider whether

such provisions are appropriate in the investment company context, where the adviser typically provides all operating staff for the fund and has the primary knowledge about the fund’s activities and processes described in the prospectus.

• Directors also may want to consider how

such provisions will operate in practice. Given the process by which prospectuses typically are drafted, involving a lengthy exchange of information and comments among employees of the adviser or distributor (who may also be fund officers) and fund counsel, could one ever reconstruct in retrospect which information had been “provided by” an officer of the adviser, acting as such? Insurance, Indemnification and Shared

• Liability. Fund directors also may want to

consider whether they and their funds can improve the benefits they might expect to receive under liability insurance, indemnification provisions or other approaches. D&O/E&O Insurance. While fund directors generally assume that they have insurance coverage for prospectus liability, some insurers have argued that Section 11 claims are not covered.

• Certain insurers have focused on the

definition of “Loss,” which in certain policies contains a carve-out excluding from coverage amounts paid that are “uninsurable” as a matter of public policy.

• Certain insurers have argued that public

policy should preclude coverage for Section 11 claims on the basis that such claims arguably seek disgorgement or restitution of an ill-gotten gain. Policyholders have vigorously contested such arguments, and courts have reached mixed results based on the policy language at issue and controlling law.

• In certain cases, policyholders have argued

that when an insurer has expressly afforded broad coverage for “Securities Claims” (which is often defined to include claims under the 1933 Act and the 1934 Act), an insurer should not be able to rely on a vague “public policy” exception to deny coverage for Section 11 claims.

• Policyholders also have contested whether

Section 11 claims in fact seek disgorgement

• f an ill-gotten gain.
• Further, policyholders have argued that

“public policy” should not preclude coverage for the settlement of a disputed claim when there has been no judgment establishing that some illegal conduct occurred. These

4 August 2011

arguments might have particular force with respect to directors (as opposed to the fund or adviser), given that directors receive only a set fee from the fund for their services and do not share in amounts obtained through an allegedly false prospectus. In any event, it should be noted that many insurers are now offering new policy language

• r endorsements that expressly confirm the

intent to provide coverage for Section 11

• claims. Policyholders may wish to ensure that

their policies contain the broadest language available.

• Indemnification. In the wake of Janus, some

have raised the prospect of fund directors seeking an agreement that the adviser will indemnify the fund and the directors for liability resulting from a prospectus

• misstatement. Such indemnification

presumably would be available only when the parties could not obtain payment under the insurance policy or when the directors could not obtain indemnification from the fund under its charter and bylaws. Some have questioned whether an agreement for such director indemnification would be legally enforceable.

• Section 17(h) of the Investment Company Act
• f 1940 (“1940 Act”) does provide a limit on

director indemnification, in that it prohibits “any . . . instrument pursuant to which [a registered investment company] is organized

• r administered” from containing any

provision to protect a director or officer of such company against liability to the company

• r its shareholders “to which he would
• therwise be subject by reason of willful

misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of his office.”

• However, an agreement between an

investment adviser and each director of a fund would not seem to be “an instrument pursuant to which [a registered investment company] is

• rganized or administered.” And, the fact that

an investment company director has been found liable under Section 11 does not mean that the director necessarily has engaged in “willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of his office.” It implies only that the plaintiff made a prima facie case that the registration statement was false when it became effective, and that the director failed to establish the defense of having made a “reasonable investigation” of the facts underlying the statements in

• question. Difficult questions of fiduciary duty

could arise if such an indemnification agreement might involve a higher advisory fee to compensate the adviser for added risk. The SEC also asserts that it may be “against public policy” for directors to receive indemnification for Section 11 liability.

• The SEC argues that such indemnification

tends to undermine the purpose of such liability, which is to strongly encourage directors to do their jobs in probing the accuracy of prospectus disclosure. Be that as it may, such a position would seem to stand public policy on its head where it is used to prevent indemnification by the party that is in the best position to assure the accuracy of the registration statement. None of these questions would seem to affect an agreement whereby the adviser undertakes to indemnify the fund for prospectus liability costs. Shared Liability. Directors might avoid all of these questions with another approach – asking the advisory organization to sign the fund’s registration statement. Section 11, besides imposing liability on the issuer and its officers and directors, also imposes liability on “every person who signed the registration statement.” All parties except the fund, but including the adviser, would have access to Section 11’s due diligence defense. As between the adviser and the outside fund directors, however, the adviser would seem to be in the weaker position to establish such a defense. Accordingly, such a practice would seem to rectify any imbalance that fund directors believe may have been created by the Janus decision. Such an arrangement would certainly provide additional assurance – if any is needed – that the adviser has a strong financial interest in the accuracy of the fund’s prospectus. It may, however, raise other concerns, such as whether

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Investment Management Update

the “deep pockets” of the adviser would attract more strike suits. These questions must be considered carefully before proceeding.

D.C. Circuit Strikes Down SEC Proxy Access Rule

The U.S. Court of Appeals for the D.C. Circuit dealt the beleaguered SEC another blow on July 22, 2011, when, at the behest of the Business Roundtable and the Chamber of Commerce of the United States, it struck down the SEC’s recently adopted proxy access rule that required public companies, including mutual funds, to provide proxy disclosure and require a shareholder vote related to shareholder-nominated candidates for the company’s board of directors. The SEC adopted Rule 14a-11 under the 1934 Act to allow corporate shareholders to nominate a candidate for election to their corporation’s board

• f directors through procedures less onerous than

the normal proxy contest rules. Adopted by a divided SEC vote of three to two, the rule generally permitted shareholders – who continuously have held at least 3% of the voting power of the corporation for the prior three years – to require the corporation (subject to certain exceptions) to include in its proxy statement information about the shareholder nominee. The effective date of the rule had been stayed pending the outcome of this case. The case was the third instance in recent memory that the Court criticized the SEC for “fail[ing] adequately to consider [a] rule’s effect upon efficiency, competition, and capital formation.” The Court, in a unanimous opinion, harshly chastised the SEC for having “inconsistently and

• pportunistically framed the costs and benefits of

the rule; failed adequately to quantify the certain [sic] costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.” The Court also noted that the SEC’s “decision to apply the rule to investment companies was also arbitrary.” The Court agreed with the allegations that the SEC had inadequately considered various economic consequences of the rule by not quantifying the costs companies would incur

• pposing shareholder nominees or substantiating

the rule’s predicted benefits, particularly in the context of union and state pension fund shareholders and mutual fund issuers. The view

• f the petitioners, with which the Court agreed,

was that issuers would oppose shareholder nominees with greater intensity, at a greater cost, than presumed in the SEC’s analyses. For example, the Court quoted a Chamber of Commerce submission to the SEC commenting that boards would expend significant time and money opposing shareholder nominees through “significant media and public relations efforts, advertising . . . , mass mailings, and other communication efforts, as well as the hiring of

• utside advisors and the expenditure of

significant time and effort by the company’s employees.” With regard to those allegations, the Court concluded that the SEC did not sufficiently provide reasonable explanations for its determination that the eventual costs may be less than commenters’ estimates. Moreover, where the SEC relied on published reports as an empirical basis for determining that the rule would improve board performance and increase shareholder value by facilitating the election of dissident shareholder nominees, the Court concluded that the studies relied on by the SEC were “relatively unpersuasive.” The Court was also not impressed by the SEC’s determination that the ownership and holding period requirements for shareholders entitled to propose nominees limited the number of

• pportunities for reliance on the rule. There the

Court agreed with the allegations that union and state pension funds might use the rule “as leverage to gain concessions, such as additional benefits for unionized employees, unrelated to shareholder value,” and criticized the SEC for “ducking a serious evaluation of the costs” that companies might incur in fighting these special

• interests. In keeping with its lack of deference to

the SEC’s process, the Court also called the SEC’s reasoning “inconsistent and therefore arbitrary” because it “anticipated frequent use of [the rule] when estimating benefits, but assumed infrequent use when estimating costs.”

6 August 2011

A separate portion of the Court’s opinion dealt with the unique issues presented by mutual funds, particularly those with unitary boards – where one group of directors sit as the board of all funds in a complex – or cluster boards – where each of two or more groups of directors oversees a distinct set of funds in a complex. For one thing, the Court stated that the SEC “did almost nothing to explain” what benefits the rule could add for fund shareholders, given the significant regulatory protection already provided by the Investment Company Act of 1940. The Court also stated that the SEC “failed to deal with” the concerns about increased costs imposed by the rule on unitary or cluster boards “with the introduction of shareholder- nominated directors who sit on the board of a single fund, thereby requiring multiple, separate board meetings and making governance less efficient.” In addressing the SEC’s explanations justifying application of the rule in this context, the Court was its harshest. First, responding to the SEC’s views that costs would be lower for funds because, among other things, their shareholders were primarily retail investors who would not meet the ownership and holding requirements, the Court criticized the SEC for not taking into account that less frequent use of the rule also reduces the rule’s expected benefits. Second, the Court characterized the SEC’s assertion that unitary and cluster boards could mitigate disruptions through use of confidentiality agreements as “without any evidentiary support.” Moreover, continuing its theme that the SEC had not adequately addressed concerns raised during the comment process, the Court continued that the SEC’s position was “unresponsive to the contrary claim of [funds] that confidentiality agreements would be no solution because the shareholder-nominated director would have no fiduciary duty to other funds in the complex and, in any event, could not be ‘legally

• bliged’ to enter into a confidentiality

agreement.” Finally, the Court quoted the SEC’s adopting release to the effect that increased costs and decreased efficiency of a unitary or cluster board would only occur if in fact the shareholder- nominated director was elected, and that the proxy materials could lay out the costs and benefits of that board structure and the impact of electing a shareholder-nominated director. That rationale the Court characterized as “tantamount to saying the saving grace of the rule is that it will not entail costs if it is not used, or at least not used successfully to elect a director.” That, said the Court, is an “utterly mindless reason” for applying the rule to funds.

Congressional Panel Considers Systemic Risk of Mutual Funds

On June 24, 2011, a Subcommittee of the House Financial Services Committee held a hearing to discuss oversight of the mutual fund industry. The hearing was well attended by members of both parties and, in contrast to some recent

• versight hearings, was non-partisan. The

hearing separately focused on (i) money market fund (“MMF”) reform options and (ii) the possibility of any type of mutual funds being considered systemically important financial institutions (“SIFIs”), subject to heightened supervision and regulation by the Board of Governors of the Federal Reserve System (“Federal Reserve”). Suggested MMF Reform Options Floating Net Asset Value (“NAV”). The hearing appears to have been organized in part as a counter to the May 10, 2011 roundtable (“Roundtable”) hosted by the SEC, at which banking regulators and others advocated for the adoption of a floating NAV to mitigate the systemic risk of MMFs, particularly the risk of runs on the MMF industry. In October 2010, the President’s Working Group

• n Financial Markets (“Working Group”) had

issued a report finding that the SEC’s 2010 MMF reforms were inadequate to mitigate MMF susceptibility to runs and the related instability such a run might cause. In response, the SEC is considering various additional reforms proposed by the Working Group. Of these reforms, the

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Investment Management Update

floating NAV continues to be the dominant proposal. Echoing views expressed by bank regulators at the Roundtable, Subcommittee Chairman Garrett (R- NJ) and Congressmen Royce (R-CA) and Neugebauer (R-TX) expressed concerns that the stable NAV creates a perception that MMFs are government-guaranteed. Advocates of the floating NAV proposal argue that a floating NAV would clarify that MMFs are investments subject to losing value.

• Mr. Paul Schott Stevens of the Investment

Company Institute (“ICI”); Mr. Scott Goebel

• f Fidelity Management & Research Company

(“Fidelity”); and Mr. Mercer Bullard of the University of Mississippi School of Law, testified that moving to a floating NAV would end investors’ use of MMFs – because of various

• bligations to seek, as well as conveniences of

investing in, a stable value instrument – and do nothing to reduce any possible systemic risks.

• Mr. Stevens argued that the resulting decline of

the MMF industry would, in turn, negatively impact access to short-term funding by corporations and state and local governments. During his opening statements, Chairman Garrett made similar comments, pointing out that any reform that led to the demise of the MMF industry would create a significant risk that the money invested in MMFs would migrate to unregulated sectors of the economy.

• Mr. Andrew “Buddy” Donohue, former Director
• f the SEC’s Division of Investment

Management, also made similar comments, noting that if MMFs were no longer attractive investment

• ptions, institutional investors may access the

commercial paper market through unregulated pools.

• Mr. René Stulz, a professor at The Ohio State

University, was the only witness who believed that moving to a floating NAV was an option that should be studied. While acknowledging that some operational difficulties would need to be considered, Mr. Stulz argued that a floating NAV has the advantage of full transparency

• ver other reform options.

Capital Buffers and Other Reform Proposals. The witnesses also discussed other options for reducing any systemic risk associated with

• MMFs. Mr. Goebel and Mr. Stulz both favored a

capital buffer requirement, but each had a somewhat different approach to this option. As advocated by Mr. Goebel on behalf of Fidelity, MMFs would hold back a portion of the yield shareholders would otherwise receive to gradually build a capital buffer. As advocated by Mr. Stulz, MMF sponsors would contribute a capital buffer all at once. During times of financial distress, the capital buffer would provide the MMF with liquidity and help to absorb losses.

• Mr. Stevens spoke favorably of the capital buffer
• ption, but also advocated the ICI’s

recommendation to create a liquidity bank. Under this approach, MMFs would contribute capital to a liquidity bank, which would serve as a source of liquidity and as a market maker for commercial paper during times of crisis. In rare circumstances, this bank would also have access to the Federal Reserve’s Discount Window. Mutual Funds as SIFIs Under the financial regulatory reforms mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), the Financial Stability Oversight Council (“FSOC”) is currently developing criteria for identifying SIFIs. Chairman Garrett, Congressman Dold (R-IL), and Congressman Perlmutter (D-CO) expressed concern over the

• ngoing lack of clarity regarding the FSOC’s

criteria for designating SIFIs.

• Mr. Stulz asserted that the final SIFI criteria

should be objective and quantifiable, adding that he expected there to be no more than 50 SIFIs. Chairman Garrett then asked Mr. Stulz to aid in setting forth designation criteria, and Mr. Stulz agreed to follow up with a list of criteria for the hearing record. Congressman Perlmutter added his belief that although the criteria should be

• bjective, it was difficult for regulators to predict

in advance where systemic risk would develop and, therefore, regulators should consider a broad array of factors. Later in the hearing, Congresswoman Maloney (D-NY) expressed her concern that the FSOC was not giving enough weight to the statutory criteria that SIFIs be highly leveraged. She noted that

8 August 2011

• ne of the main problems of failing firms during

the crisis was their use of excessive leverage, which mutual funds are prohibited from having under the 1940 Act. All of the witnesses agreed that mutual funds, with the exception of MMFs, did not pose risks to the broader financial markets. No member

• f the Committee challenged this assertion.

Although industry participants avoided conceding that MMFs do pose a risk to the financial system, the two academics on the panel, Mr. Stulz and

• Mr. Bullard, testified that MMFs could

contribute to systemic risk, and therefore could be SIFIs, citing events when the Reserve Primary Fund broke the buck. The European debt crisis was discussed as well, but the panelists generally downplayed any potential negative impact it could have on MMFs and the larger U.S. financial system.

Floating NAV Proposal Dominates SEC Systemic Risk Roundtable

At a May 10, 2011 roundtable, the SEC assembled a panel of regulators and industry representatives to discuss various options for reducing the systemic risk associated with MMFs, namely the possibility of a run on the fund. Although various proposals were on the agenda, a proposal to convert the MMF’s stable NAV to a floating NAV dominated the conversation. The strongest push to eliminate the stable NAV came from Paul Volcker, former Chairman of the Federal Reserve Board. He said that MMFs were created as “pure regulatory arbitrage” in

• rder to pay interest on demand deposits and are

“incontestably” prone to runs. He asserted that the simplest solution is to adopt a floating NAV, which would eliminate what some view as an implicit $1-per-share guarantee associated with MMFs. Similarly, Sheila Bair, Chairman of the Federal Deposit Insurance Corporation, argued that the stable NAV model is “broken” because, in her view, its implied government guarantee creates a moral hazard. To her, this gives MMFs the “best

• f both worlds”—the ability to offer a higher

yield and an implicit government guarantee, all without bank-like regulation and capital requirements. Although generally conceding that runs on MMFs pose a systemic risk, investors, money managers, and representatives of the mutual fund industry defended the status quo. According to Robert Brown, president of the money market group at Fidelity, a lack of portfolio transparency – not the stable NAV – caused the flight from MMFs in September 2008, when the Reserve Primary Fund broke the buck.

• Mr. Brown asserted that new requirements to

disclose a MMF’s portfolio composition will prevent sophisticated investors from pulling their money out of MMFs in periods of illiquidity. Seth Bernstein, head of fixed income at J.P. Morgan Asset Management, argued that mechanisms to enable MMF boards of directors to suspend redemptions and liquidate will mitigate the possibility of a run threatening the entire system. Travis Barker, Chair of the Institutional Money Market Funds Association, questioned whether a floating NAV would reduce systemic risk at all. He pointed out that MMFs in other countries have floating NAVs and they are as susceptible to a run as are MMFs with stable NAVs. The strongest advocate for the MMF industry was John “Jerry” Hawke, former Comptroller of the Currency. After Mr. Volcker openly questioned whether MMFs serve any public good meriting a government backstop, Mr. Hawke defended them as providing a mechanism for investors to manage their cash and maintain liquidity and diversification. Mr. Hawke insisted that MMFs need a mechanism for managing liquidity crises; they do not need bank-like

• regulation. Like Mr. Barker, he pointed out that

a floating NAV would not prevent future runs. In the middle of the discussion, Mary Schapiro, SEC Chairman, redirected the conversation to the institutional investors on the panel, explicitly asking them how important the stable NAV is to

• them. Kathryn Hewitt, representing the

Government Finance Officers Association, and Carol DeNale, Senior Vice President and

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Investment Management Update

Treasurer at CVS Caremark, stated firmly that they would not invest in any MMF with a floating NAV. It is not clear, however, where else they would invest because they also said they would not invest in bank deposits. They reasoned that bank deposits cannot match the diversification benefits of an MMF. At the end of the meeting, the panel discussed

• ther possible reform options as alternatives to

the floating NAV. These options include imposing bank-like capital reserve requirements or creating a liquidity bank with access to the Federal Reserve’s Discount

• Window. Several members of the panel,

including Mr. Volcker, cautioned the industry against embracing the liquidity bank as it would

• nly invite the Federal Reserve Board to

indirectly regulate the MMF industry. Ms. Bair argued that any system that left in place what she views as an implicit government guarantee would serve only to institutionalize, not reduce, systemic risk.

Custodians Alleged to Overcharge in Foreign Exchange Transactions

With a number of pending legal actions alleging that custodian banks are systematically

• vercharging for foreign exchange (“Forex”)

transactions, investment firms are looking closely at the Forex pricing practices of their

• custodians. These pressures could ultimately

increase custodian transparency in the Forex market. The cost of converting U.S. dollars to a foreign currency has historically been viewed as a minor administrative expense. These Forex costs are

• ften bundled with other custodial services and

reported on periodic statements. Individual Forex trades are generally not time-stamped on such

• statements. The lack of detailed information,

for example, could enable a custodian to charge the highest price of the day when the actual price at the time of the transaction is much lower. An academic report prepared by researchers at the Brandeis International Business School and Williams College illustrates the disparity in Forex pricing when investment firms do not scrutinize a custodian’s pricing. In the report, a custodian’s average margin on all trades against the U.S. dollar was 20.8 basis points. When clients called the custodian’s traders directly to negotiate the price, that average margin shrank to 3.4 basis points. Various lawsuits and reports by whistleblowers allege that several of the major custodians in the Forex market deliberately hide or manipulate the spread between what clients are charged for Forex transactions and the actual costs. The SEC and the Massachusetts Securities Division, among

• thers, are investigating such claims.

This attention has led many investment firms to more closely scrutinize the Forex pricing practices of their custodians. As custodial contracts are renewed, investment firms are expected to push for increased transparency in Forex pricing. These negotiations may also lead to changes in how bundled custodial services are priced.

SEC Issues Report on Review of Reliance on Credit Ratings

As required by the Dodd-Frank Act, the SEC issued a report in July 2011 that reviewed SEC action taken to modify any rules requiring the use of an assessment of the credit-worthiness

• f a security or money market instrument or

referring to credit ratings. The Act required every federal agency, by July 21, 2011, (i) to review its regulations requiring “the use of an assessment of the credit- worthiness of a security or money market instrument” and “any references to or requirements in such regulations regarding credit ratings” and (ii) to “modify any such regulations . . . to remove any reference to or requirement of reliance on credit ratings and to substitute . . . such standard of credit-worthiness [that the agency] shall determine as appropriate”

10 August 2011

and to “seek to establish . . . uniform standards of credit-worthiness” within the context of the entities regulated. The Act also required each agency to transmit a report to Congress containing a description of any modifications made. In its report, the SEC described its proposed rule revisions issued pursuant to these requirements, including:

• Proposed amendments to six sets of rules and

forms under the 1933 Act and 1934 Act that rely on, or make special accommodations for, securities ratings. These amendments generally relate to qualifications of operating companies to use short-form registration statements for capital-raising filings.

• Proposed amendments to Rule 2a-7 under

the 1940 Act that requires money market funds to invest in highly liquid, short-term instruments of the highest quality. These proposals, which we have described in detail in earlier articles, are designed to appropriately achieve the same purpose as the ratings requirement, according to the SEC, and would remove references to credit ratings affecting the following five elements of Rule 2a-7:

• Determination of whether a security is

an eligible security – under the proposed amendments, the fund board (or its delegate) would be responsible for determining whether securities present minimal credit risks;

• Determination of whether a security is

a first tier security – under the proposed amendments, the fund board (or its delegate) would similarly be responsible for determining whether each portfolio security is a “first tier”

• r a “second tier” security, subject to

standards intended to replicate the credit quality standards articulated by the credit rating agencies;

• Credit quality standards for securities

with a conditional demand feature – under the proposed amendments, the fund board (or its delegate) would be required to determine that the security subject to a conditional demand feature is of high quality and subject to very low credit risk;

• Requirements for monitoring

securities for ratings downgrades and other credit events – the proposed amendments require the fund board (or its delegate) to promptly reassess whether a security that has been downgraded continues to present minimal credit risks and take appropriate action; and

• Stress testing – the proposed

amendments require that a money market fund’s stress testing procedures include as a hypothetical event an adverse change in the ability

• f a portfolio security issuer to meet

its short-term financial obligations.

• Proposed amendments to Form N-MFP, for

monthly electronic filings of portfolio holdings by money market funds, which would eliminate items requiring disclosure of ratings information.

• Proposed amendments to Rule 5b-3 under the

1940 Act, providing mutual funds technical relief related to the acquisition of repurchase agreements, which would require a fund board (or its delegate) to determine whether the collateral supporting the obligation of the seller to repurchase the securities is: (i) issued by an issuer that has the highest capacity to meet its financial

• bligations; and (ii) sufficiently liquid that it

can be sold at approximately its carrying value in the ordinary course of business within seven calendar days.

• Proposed amendments to investment

company registration forms – Forms N-1A, N-2 and N-3 – which would revise the reference to credit ratings in the table, chart or graph depicting portfolio holdings.

• Proposed amendments to seven technical

rules under the Exchange Act related to broker-dealer financial responsibility, distributions of securities and confirmations

• f transactions.

11

Investment Management Update

• The confirmation rule, Rule 10b-10

under the Exchange Act, requires a broker-dealer to inform the customer if the confirmation is unrated, which the SEC proposed be deleted.

• Proposed amendments to technical

requirements related to asset-backed securities.