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Insight Center: Publications

Investment Management Update

Authors: Joseph V. Del Raso, John P. Falco, John M. Ford, Gregory J. Nowak, Todd R. Kornfeld, Terrance James Reilly, Theodore D. Edwards, Ausra Ragauskaite, Christopher M. Trueax, Kyle F. Whiteman, Darlene Lee and Barbara H. Grugan

October 2019

Covering legal developments and regulatory news for registered funds, their advisers and industry participants through September 30, 2019.

RULEMAKING AND GUIDANCE

SEC Adopts ETF Rule

On September 25, 2019, the Securities and Exchange Commission (SEC) unanimously adopted Rule 6c-11 under the 1940 Act to modernize the regulation of exchange-traded funds by establishing a clear and consistent framework for the vast majority of ETFs operating today. The SEC stated that the Rule also will allow ETFs to come to market more quickly, and without the time or expense of applying for individual exemptive relief. In addition, the SEC voted to issue an exemptive order that further harmonizes related relief for broker-dealers.

ETFs relying on the Rule and related exemptive order will have to comply with certain conditions designed to protect investors, including conditions regarding transparency and disclosure. The Rule becomes effective 60 days after its publication in the Federal Register. One year after the Rule’s effective date, the SEC will rescind exemptive relief previously granted to ETFs that fall within the Rule’s scope. The SEC will also rescind the master-feeder relief granted to ETFs that do not rely on the relief as of the date of the proposal (June 28, 2018); this is to prevent the formation of new master-feeder arrangements.

The SEC will not rescind the relief from section 12(d)(1) and sections 17(a)(1) and (a)(2) under the 1940 Act relating to fund of funds arrangements involving ETFs. ETFs relying on the Rule that do not already have fund of funds relief may enter into fund of funds arrangements, provided that they satisfy the terms and conditions for fund of funds relief in recent ETF exemptive orders.

ETFs have become enormously popular in the investment company industry. Since 1992, the SEC has issued more than 300 exemptive orders allowing for the launch of more than 2,000 ETFs. The SEC had originally proposed a rule codifying its exemptive order conditions in 2008. That version of a rule was never adopted. This Rule was initially proposed in June 2018; the SEC adopted the Rule largely as proposed in 2018, with certain important changes. Key aspects of the Rule as adopted are discussed below.

Scope of Rule

The Rule defines an ETF as a registered, open-end management investment company that (1) issues (and redeems) creation units to (and from) authorized participants in exchange for a basket and a cash balancing amount (if any) and (2) issues shares that are listed on a national securities exchange and traded at market-determined prices.

The Rule will only be available to ETFs organized as open-end funds. ETFs organized as unit investment trusts (UITs), ETFs structured as a share class of a multiclass fund or a master-feeder arrangement, leveraged and inverse ETFs, and nontransparent ETFs are not able to rely on the Rule and instead must continue to operate under their existing exemptive orders or obtain new exemptive relief.

Index-Based ETFs and Actively Managed ETFs. Consistent with the proposal, the Rule will provide exemptions for both index-based ETFs and fully transparent, actively managed ETFs, but will not, by its terms, establish different requirements based on whether an ETF’s investment objective is to seek returns that correspond to the returns of an index. The historical distinction between index-based ETFs and actively managed ETFs is largely a product of ETFs’ historical evolution and individual exemptive relief process. The Rule thus levels the playing field between index-based and actively managed ETFs.

Leveraged/Inverse ETFs. As adopted, the Rule will exclude ETFs that seek to provide leveraged or inverse investment returns over a predetermined period of time. Further, the adopting release makes it clear that the Rule also excludes ETFs that track indices with embedded leverage. These ETFs will instead continue to operate pursuant to their existing exemptive orders. The SEC stated that leveraged/inverse ETFs present unique issues and concerns that are more appropriately addressed outside the context of the Rule.

Exemptive Relief Under ETF Rule

In general, the Rule codifies the relief provided by exemptive orders from various provisions of the 1940 Act (e.g., section 22(d), Rule 22c-1, section 17(a) and section 22(e)). Key areas of relief are discussed below.

Treatment of ETF Shares as Redeemable Securities. The Rule makes it clear that an ETF is an open-end company that issues redeemable securities. Importantly, the adopting release clarifies that even shares of ETFs ineligible to rely on the Rule will qualify as "redeemable securities" for purposes of Rules 101(c)(4) and 102(d)(4) of Regulation M and Rule 10b-17(c) under the Exchange Act in connection with secondary market transactions in ETF shares and the creation and redemption of creation units. ETFs relying on the Rule similarly will qualify for the "registered open-end investment company" exemption in Rule 11d1-2 under the Exchange Act.

Trading of ETF Shares at Market-Determined Prices. The Rule will provide exemptions from section 22(d) and Rule 22c-1 of the 1940 Act to permit secondary market trading of ETF shares at market-determined prices, as opposed to net asset value. These exemptions are customary in exemptive relief currently obtained by ETFs.

Affiliated Transactions. The Rule will provide exemptions from sections 17(a)(1) and (a)(2) of the 1940 Act with regard to the deposit and receipt of baskets by a person who is an affiliated person of an ETF (or who is an affiliated person of such a person) solely by reason of (1) holding with the power to vote 5 percent or more of an ETF’s shares or (2) holding with the power to vote 5 percent or more of any investment company that is an affiliated person of the ETF.

A number of commenters also recommended expanding the relief to cover additional types of affiliated relationships, such as exempting broker-dealers that are affiliated with the ETF’s investment adviser or permitting an ETF’s investment adviser or its affiliates to transact with the ETF to provide in-kind seed capital to the ETF. The SEC declined to do so, explaining that the Rule was intended to codify existing relief for ETFs, and expanding the scope of affiliated persons covered by the exemption would constitute novel section 17(a) relief.

Additional Time for Delivering Redemption Proceeds. The Rule includes an exemption from section 22(e) of the 1940 Act, which will permit an ETF to delay satisfaction of a redemption request in the case of certain foreign investments for which a local market holiday or the extended delivery cycles of another jurisdiction make timely delivery unfeasible for up to 15 days. Unlike the proposal, this exemption has no sunset provision.

Conditions for Reliance on the Rule

The Rule requires ETFs to comply with certain conditions in order to operate within the scope of the 1940 Act. These conditions are generally consistent with those required by the exemptive relief previously granted by the SEC.

Listing on a National Securities Exchange. The Rule defines an "exchange-traded fund," in part, to mean a fund that issues shares that are listed on a national securities exchange and traded at market-determined prices. This is a fundamental characteristic of ETFs. An ETF that has its shares delisted would therefore fall outside the scope of the Rule. However, circumstances such as a trading suspension, a trading halt or a temporary noncompliance notice from the exchange would not constitute a "delisting" for purposes of the Rule. An ETF also may request temporary relief from the SEC to permit the ETF to suspend redemptions for a limited period of time where necessary to protect ETF shareholders.

Portfolio Holding Disclosure. The Rule requires daily transparency of portfolio holdings in a standardized manner before the opening of regular trading on the ETF’s primary listing exchange. This requirement is different than what was originally proposed. The proposal would have required an ETF to disclose its basket and portfolio holdings before it accepted creation unit orders. This requirement was not adopted, and the Rule therefore accommodates T-1 orders, even when basket and portfolio holding information is unavailable.

Custom Baskets. The Rule will require an ETF to adopt and implement written policies and procedures governing the construction of baskets and the process that the ETF will use for the acceptance of baskets. The Rule will also permit the use of custom baskets if the ETF has adopted written policies and procedures that (1) set forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders, including the process for any revisions to, or deviations from, those parameters, and (2) specify the titles or roles of employees of the ETF’s investment adviser who are required to review each custom basket for compliance with those parameters.

Website Disclosure. The following information must be disclosed publicly and prominently on the ETF’s website:

  • NAV per share, market price, and premium or discount, each as of the end of the prior business day
  • a table and chart showing the number of days the ETF’s shares traded at a premium or discount during the most recently completed calendar year and calendar quarters of the current year
  • for ETFs whose premium or discount was greater than 2 percent for more than seven consecutive trading days, disclosure that the premium or discount was greater than 2 percent, along with a discussion of the factors that are reasonably believed to have materially contributed to the premium or discount
  • median bid-ask spread over the most recent 30 calendar days.

Amendments to Form N-1A

The SEC adopted several changes to Form N-1A that are designed to provide ETF investors with additional information regarding ETF trading and associated costs:

  • added the term "selling" to current narrative disclosure requirements to clarify that the fees and expenses reflected in the expense table may be higher for investors if they buy, hold and sell shares of the fund (Item 3)
  • streamlined narrative disclosures relating to ETF trading costs, including bid-ask spreads (Item 6)
  • required ETFs that do not rely on Rule 6c-11 to disclose median bid-ask spread information on their websites or in their prospectus (Item 6)
  • excluded ETFs that provide premium/discount disclosures in accordance with
  • Rule 6c-11 from the premium and discount disclosure requirements in Form N-1A (Items 11 and 27)
  • eliminated disclosures relating to creation unit size and disclosures applying only to ETFs with creation unit sizes of fewer than 25,000 shares (Items 3, 6, 11 and 27).

The Rule represents a major regulatory step in recognizing both the importance and maturation of ETFs as a fixture within the mutual fund industry and could spur a second rush to market by those fund sponsors that have remained on the sidelines thus far. The impact of that rush on the existing fund segment could result in a further transformation of the fund industry that could reverberate for years to come.

The SEC’s final rule is available at https://www.sec.gov/rules/final/2019/33-10695.pdf.

ADI 2019-08 — Improving Principal Risks Disclosure

The SEC’s Division of Investment Management Disclosure Review and Accounting Office recently issued an Accounting and Disclosure Information (ADI) providing advice on enhancing principal risk factor disclosures in mutual fund summary prospectuses.

Among its recommendations, the ADI encourages funds to list their principal risk factors in order of importance, rather than alphabetically. In the SEC Staff’s view, ordering principal risk factors by significance better highlights the risks investors should consider most carefully. The ADI acknowledges the SEC Staff’s awareness that this is a subjective determination. It also notes the SEC Staff’s preference for tailoring risk factors to specific funds within a fund complex, rather than relying "on generic, standardized risk disclosures across funds."

Notwithstanding the SEC Staff’s position, registrants should carefully consider re-ordering their principal risk factors based on a subjective ranking of risks in the manner suggested by the ADI as to whether such action would possibly increase the risk of future shareholder litigation under the federal securities laws.

In addition, the ADI encourages funds to consider adding a disclosure that "a fund is not appropriate for certain investors given the fund’s characteristics." The SEC Staff suggests that this disclosure should be included near the description of the types of investors the fund is intended for, if such a description is included.

Finally, the ADI provides three additional points of clarification regarding summary prospectuses: (1) it reminds funds that the purpose of a summary prospectus is to concisely provide key information to investors; (2) it recommends disclosing nonprincipal risks and investment strategies in a fund’s statement of additional information rather than in its prospectus; and (3) it encourages funds to periodically review their risk disclosures to ensure they remain accurate and adequate.

The ADI represents the views of the Division of Investment Management. The ADI is not a rule, regulation or statement of the SEC. Further, the SEC has neither approved nor disapproved its content.

The ADI is available at https://www.sec.gov/investment/accounting-and-disclosure-information/principal-risks/adi-2019-08-improving-principal-risks-disclosure.

SEC Risk Alert: Investment Adviser Principal and Agency Cross Trading Compliance Issues

On September 4, 2019, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert that lists the most common compliance issues identified by OCIE in its investment adviser exams related to principal trading and agency cross trade transactions under section 206(3) of the Investment Advisers Act of 1940, as amended.

Section 206(3) applies when an investment adviser effects a principal or agency transaction for a client through a broker-dealer that is affiliated with the investment adviser. The OCIE Staff cautioned that compliance with the disclosure and consent provisions of section 206(3) alone may not satisfy an investment adviser’s fiduciary obligations with respect to a principal or agency cross trade. The OCIE Staff also expressed its view that section 206(3) should be read with Advisers Act sections 206(1) and (2) to require the investment adviser to disclose facts necessary to alert the client to the investment adviser’s potential conflicts of interest in a principal trade or agency cross transaction.

Common investment adviser compliance deficiencies or weaknesses related to principal trading and section 206(3) and 206(3)-2 requirements not being followed included:

  • failing to make required written disclosures
  • failing to obtain appropriate prior client consents
  • failing to provide sufficient disclosure regarding the potential conflicts of interest and terms of the transaction
  • obtaining client consent to a principal trade after the completion of the transaction.

OCIE Staff noted deficiencies where investment advisers effected trades between advisory clients and an affiliated pooled investment vehicle but failed to recognize that the investment adviser’s significant ownership interests in the pooled investment vehicle would cause the transaction to be subject to section 206(3). In other instances, the investment adviser recognized that a transaction was subject to the consent requirements of section 206(3) but failed to obtain effective consent from the pooled investment vehicle before completing the transactions.

Regarding agency cross transactions, OCIE Staff observed:

  • investment advisers that disclosed to clients that they would not engage in agency cross transactions but that, in fact, engaged in agency cross transactions in reliance on Rule 206(3)-2
  • investment advisers that could not produce any documentation that they had complied with the written consent, confirmation or disclosure requirements of the rule.

OCIE Staff also noted investment advisers that did not have — or failed to follow — policies and procedures relating to section 206(3) even though the investment advisers engaged in principal trades and agency cross transactions.

The Risk Alert is available at https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Principal%20and%20Agency%20Cross%20Trading.pdf.

SEC Clarifies Investment Advisers’ Proxy Voting Responsibilities and Application of Proxy Rules to Voting Advice

On August 21, 2019, the SEC issued guidance to clarify investment advisers’ fiduciary obligations when voting client proxies. On the same day, the SEC also issued an interpretation of Rule 14a-1(l) under the Securities Exchange Act of 1934 that proxy voting advice constitutes "solicitation" under the federal proxy rules. In that interpretive guidance, the SEC clarified that the antifraud provisions of Rule 14a-9 apply to proxy advice. While the new guidance does not impose any additional responsibilities on investment advisers or their administrative service providers, it does clarify the scope of their existing obligations and suggests instances where advisers and their service providers should consider whether enhancements to the process for fulfilling their existing obligations may be appropriate. The guidance is effective as of its publication in the Federal Register.

Guidance on Proxy Voting Responsibilities of Investment Advisers

The SEC’s guidance on investment advisers’ proxy voting responsibilities is designed to address the scope of their fiduciary obligations to their clients and assist them in adhering to those obligations. The guidance notes that investment advisers "are fiduciaries that owe each of their clients duties of care and loyalty with respect to services undertaken on the client’s behalf." Those fiduciary duties extend to voting proxies if the investment adviser accepts responsibility to do so.1 With respect to voting, this fiduciary duty is proportional to the scope of voting authority a client grants the investment adviser (and that the investment adviser agrees to accept), and it requires the investment adviser to use that authority to vote in the client’s best interests. The guidance discusses the interplay of these fiduciary obligations with the requirement of Rule 206(4)-6 under the Investment Advisers Act of 1940 that investment advisers vote proxies pursuant to written policies and procedures that are reasonably designed to ensure voting is done in the best interests of clients.

In issuing the guidance, the SEC was motivated by its interest in how these fiduciary duties and written proxy policies and procedures may be affected when investment advisers delegate proxy voting responsibilities to third parties, particularly proxy advisory firms. The guidance provides a number of factors and considerations that investment advisers should evaluate and apply when using proxy advisory firms to vote client proxies.

The SEC’s guidance is conveyed in a question and answer format. Some of the questions and corresponding advice contained in the guidance include:

  • How can an investment adviser and its client agree on the scope of the investment adviser’s authority and responsibility with respect to voting that client’s proxies? The SEC notes that the scope of this authority and responsibility is the product of an agreement between the parties, provided there is full disclosure and informed consent. Accordingly, an investment adviser can tailor the scope of responsibility it is willing to accept and, in fact, is not required to accept this responsibility, though at all times it remains a fiduciary of the client.
  • What steps can an investment adviser that has assumed authority to vote proxies on behalf of a client take to demonstrate that it makes voting determinations in the client’s best interests and in accordance with its written proxy policies and procedures? Investment advisers may need to take reasonable investigations into proxy voting matters and consider whether certain items require more careful analysis. The SEC also recommends that investment advisers using proxy advisory firms take additional steps, such as sampling pre-populated votes or conducting a deeper analysis.
  • What are some of the considerations that an investment adviser should take into account if it retains a proxy advisory firm to assist with its proxy voting responsibilities? An investment adviser should assess, among other things, the adequacy and quality of the proxy advisory firm’s staffing, personnel and/or technology in order to evaluate its overall ability to analyze the matters to be voted on. An investment adviser should also consider whether the proxy firm has adequately disclosed its methodologies in formulating voting recommendations and the nature of any third-party information sources it uses to make voting recommendations. The investment adviser should also make a reasonable review of the proxy advisory firm’s policies and procedures regarding conflicts of interest.
  • What steps should an investment adviser that retains a proxy advisory firm take when it identifies errors or problems with respect to the proxy firm’s methodologies, practices or policies? An investment adviser should ensure its own proxy voting policies and procedures are reasonably designed to ensure that its voting determinations are not based on materially inaccurate or incomplete information.

While the guidance does not impose new affirmative obligations on investment advisers, taken as a whole, it emphasizes investment advisers’ fiduciary obligations and encourages compliance with those obligations by focusing time and energy on the written policies and procedures required by Rule 206(4)-6 under the Advisers Act. The guidance also encourages investment advisers to ensure they are fully informed about the quality and record of any proxy advisers they may retain, and to take the time and resources to diligently investigate proxy voting matters that may require significant attention.

Interpretation and Guidance on the Applicability of the Federal Proxy Rules to Proxy Voting Advice

The SEC also released on August 21 interpretive guidance affirming that the federal proxy rules apply to any solicitation for a proxy with respect to registered securities. This interpretive guidance, also provided in the form of questions and answers, addresses the general applicability of section 14(a) of the Exchange Act to solicitations for proxies, which it interprets to include advice provided by proxy advisory firms. The SEC drew on the broad definition of "solicitation" under the Exchange Act (defined in Rule 14a-1(l) thereunder), which means "a communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy." Because proxy advisory firms provide advice with respect to proxy matters in the form of a description and recommended vote, in order to assist investment advisers in their fiduciary obligations to investors, the SEC believes that proxy advice should be considered a solicitation and subject to the federal proxy rules.

The August 21 interpretive guidance affirms that proxy advisory firms may take advantage of the exemptions from the information and filing requirements of the federal proxy rules, found in Exchange Act Rule 14a-2(b). These exemptions, among other things, provide relief from the requirement to file a proxy statement.

Among other significant items presented in the interpretive guidance, the SEC affirmed that Exchange Act Rule 14a-9 applies to proxy voting advice. Rule 14a-9 prohibits solicitations from containing any false or misleading statements or omissions with respect to any material fact. The rule also covers opinions, reasons, recommendations or beliefs, which the SEC noted can, in some instances, constitute statements of material fact.

Because of this obligation, the SEC noted that proxy advisory firms may need to provide more information about their underlying methodologies and the source of information used to generate proxy advice in order to comply with Rule 14a-9. In particular, the SEC encouraged proxy advisory firms to consider disclosing "an explanation of the methodology used to formulate its voting on a particular matter . . . where the omission of such information would render the voting advice materially false or misleading" and sources of information underlying the advice beyond publicly available information. Proxy advisory firms may also need to consider whether to disclose material conflicts of interest that arise in connection with proxy advice.

The SEC’s press release, which contains links to the guidance and interpretive guidance, is available at https://www.sec.gov/news/press-release/2019-158.

SEC Staff Expands Scope of Qualifying Assets Under Section 3(c)(5)(C) in No-Action Relief

In a no-action letter dated August 15, 2019, the SEC Staff granted no-action relief to Redwood Trust, Inc., allowing Redwood to include mortgage servicing rights and cash proceeds from real estate-related assets as qualifying assets under section 3(c)(5)(C) of the 1940 Act. Redwood is an internally managed residential mortgage finance company that elected to be treated as a real estate investment trust for federal income tax purposes. Redwood, through its wholly owned subsidiaries, acquires and sells mortgages, mortgage-backed securities and other real estate-related assets.

Section 3(c)(5)(C) of the 1940 Act generally excludes from the definition of an investment company any entity that is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type, or periodic payment plan certificates and that is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The Staff has previously taken the position that an issuer may rely on section 3(c)(5)(C) if it meets the factors of the asset composition test:

  • at least 55 percent of its assets consist of "mortgages and other liens on and interests in real estate" (qualifying interests) and an additional 25 percent of its assets consist primarily of "real estate-type interests"
  • at least 80 percent of its total assets consist of qualifying interests and real estate-type interests
  • no more than 20 percent of its total assets consist of assets that have no relationship to real estate.

Mortgage Servicing Rights

Redwood and its affiliates frequently sold mortgage loans to third parties while retaining the mortgage servicing rights associated with those mortgages (created MSR), such that Redwood continued to remain responsible for servicing the associated loan and received a portion of the interest and fees collected from the borrower in exchange for its servicing activities.

The Staff agreed with Redwood that created MSRs may be treated as qualifying interests for purposes of the asset composition test in utilizing section 3(c)(5)(C) because these assets are acquired as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans.

Cash Proceeds

Redwood also stated that it receives cash proceeds from principal amortizations, interest payments and payoffs in connection with its real estate-related assets, as well as from the sale of such assets and that, where cash proceeds are reinvested in real-estate related assets within 12 months of their receipt, the cash proceeds should be treated in the same manner as the assets from which they were derived for purposes of the asset composition test.

The Staff stated that it would not recommend enforcement if, for purposes of the asset composition test under section 3(c)(5)(C) of the 1940 Act, an issuer characterizes cash proceeds of real estate-related assets in the same manner as the assets from which the cash proceeds were derived, provided that (1) the proceeds are invested in cash items (as that term has been defined for purposes of section 3(a)(1)(C) of the 1940 Act and Rule 3a-1 thereunder) and (2) this characterization is maintained only until the proceeds are distributed or reinvested in new assets or 12 months after receipt, whichever comes first.

The Redwood no-action letter is available at https://www.sec.gov/investment/redwood-trust-081519-3c5.

SEC Risk Alert: Observations From Examinations of Investment Advisers — Compliance, Supervision and Disclosure of Conflicts of Interest

On July 23, 2019, the OCIE issued a Risk Alert in which OCIE Staff shared its observations from the examination of more than 50 investment advisers in 2017 that had previously employed, or currently employ, any individual with a history of disciplinary events. According to the Risk Alert, the examinations focused on investment advisers’ practices in certain areas including compliance programs, supervisory oversight practices, disclosures and conflicts of interest. The Staff noted that investment advisers were identified for examination through a review of information about disciplinary events and other legal actions involving supervised persons of the investment adviser, including legal actions that are not required to be reported on Form ADV (e.g., private civil actions).

According to the Risk Alert, the examinations did not focus solely on supervisory practices as they related to the individuals with prior disciplinary histories, but rather on the investment adviser’s "tone at the top" and its compliance culture and practices firmwide. Nearly all of the examined investment advisers received deficiency letters.

With respect to firms that employed persons with disciplinary histories, the Staff observed that firms provided inadequate information regarding disciplinary events and failed to adopt and implement compliance policies and procedures to address risks associated with hiring and employing individuals with prior disciplinary histories.

Regarding firmwide practices, the Staff noted various deficiencies in supervision and setting appropriate standards of business conduct for supervised persons. Examples included practices where the investment adviser failed to (1) oversee whether fees charged by supervised persons were disclosed or whether the services clients paid for were ever performed; (2) provide sufficiently specific guidance to supervised persons who prepared their own advertising materials and websites; and (3) review activities of supervised persons, including supervised persons with disciplinary histories, working from remote locations as part of its monitoring activities. In many instances, the Staff observed that investment advisers were unaware that geographically dispersed supervised persons were operating in a self-directed manner that was not consistent with the firm’s policies and procedures.

With respect to the conflicts disclosure, the Staff highlighted undisclosed compensation arrangements, which, in the Staff’s view, could have impacted the impartiality of the advice provided to the firm’s clients.

In the Risk Alert, the Staff offered several ways to improve and heighten compliance and supervision practices when hiring supervised persons that have reported disciplinary events to the investment adviser.

The Risk Alert is available at https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Supervision%20Initiative.pdf.

BNY Mellon Family of Funds – No-Action Relief Under Section 15(a) of the Investment Company Act of 1940

On July 9, 2019, the Staff of the SEC’s Division of Investment Management issued a no-action letter in which the Staff provided its assurance that it would not seek enforcement action if funds or investment advisers with existing "manager-of-managers" relief relied on an exemptive order recently issued to Carillon Series Trust and its investment adviser (the Carillon Order). The no-action letter indicated that funds and investment advisers would be permitted to enter into sub-advisory agreements with affiliated investment advisers without being required to seek amendments to their existing exemptive orders, provided that they remain in compliance with the terms of the Carillon Order.

The Carillon Order, issued by the SEC on May 29, 2019, exempted Carillon from section 15(a) of the 1940 Act, and permitted Carillon to select a sub-adviser that is an affiliate of its investment adviser and to materially amend its sub-advisory agreement without first obtaining shareholder approval. The Carillon Order further included certain relief with respect to disclosure of the form and amounts of fees paid to sub-advisers of Carillon funds. Before the issuance of the Carillon Order, exemptive relief had only been granted to permit funds and investment advisers to enter into and amend sub-advisory agreements with certain wholly owned and nonaffiliated sub-advisers. The relief granted under the Carillon Order expanded funds’ and investment advisers’ ability to enter into and amend sub-advisory agreements to include certain affiliated sub-advisers, conditioned upon compliance with the terms and conditions of the order.

The no-action letter permits funds operating under their existing manager-of-managers relief to rely on the relief granted in the Carillon Order without first seeking amendments to their existing exemptive relief, subject to satisfaction of certain conditions set forth in the Carillon Order. The letter notes that funds that wish to rely on their existing manager-of-managers relief are required to obtain shareholder approval with regard to their use by affiliated sub-advisers, either presently or in the future. The letter also notes that funds may rely on their prior manager-of-managers relief with regard to the types of sub-advisers included in the relief, though they may instead opt to comply with the conditions in the Carillon Order, provided the fund does so with respect to all existing and future sub-advisers going forward.

The BNY Mellon Family of Funds no-action letter is available at https://www.sec.gov/investment/bny-mellon-family-funds-070919-15a.

The SEC’s notice of Carillon’s application is available at https://www.sec.gov/rules/ic/2019/ic-33464.pdf, and the accompanying order is available at https://www.sec.gov/rules/ic/2019/ic-33494.pdf.

LITIGATION AND ENFORCEMENT

Closed-End Proxy Battle Between Neuberger Berman and Hedge Fund Firm Saba Capital Management

Saba Capital Management, L.P., an SEC-registered investment adviser based in New York City and known for undertaking activist campaigns in closed-end funds in which it invests, has engaged in a proxy contest with the Neuberger Berman High Yield Strategies Fund Inc. (the Fund), a closed-end fund advised by Neuberger Berman Investment Advisers LLC. In proxy filings related to the Fund’s annual meeting of stockholders on October 3, 2019 (the Meeting), Saba put forth several proposals, including the election of its own slate of nominees to be directors, the termination of the Fund’s advisory contract with Neuberger, and a request that the board consider a self-tender offer for all outstanding shares of the Fund at net asset value, where if more than 50 percent of Fund shares are tendered, the tender offer will be discontinued and the Fund will instead liquidate or convert to an open-end mutual fund. In its own proxy filings, the Fund urged shareholders to reject Saba’s proposals and to reelect the Fund’s incumbent Class II directors. The Fund further maintained that Saba is seeking short-term profits to the detriment of long-term stockholders, and highlighted assorted other harmful consequences that it believes would occur upon the adoption of Saba’s proposals.

Recently, Saba has also been prominently engaged in activist campaigns with respect to closed-end funds advised by Invesco Advisers, Inc., BlackRock Advisors, LLC, Clough Capital Partners L.P., and Franklin Advisers, Inc., among others. In several instances, following these activist campaigns, Saba has entered into standstill agreements with funds in which the funds have agreed to the commencement of tender offers and managed distributions programs in exchange for the withdrawal of proposals put forth by Saba. In other instances, including the campaigns targeting the Fund and BlackRock’s funds, the disputes with Saba are ongoing. Saba filed lawsuits in Delaware Chancery Court regarding two of the BlackRock funds and in Maryland Circuit Court regarding one of the BlackRock funds. On June 27, 2019, in a memorandum opinion, the Delaware Chancery Court granted Saba injunctive relief and permitted votes in favor of Saba’s nominee to be counted at the funds’ annual meetings, following the funds’ invoking of a provision in their bylaws to request supplemental information to be provided via questionnaire for the Saba nominees. The requested supplemental questionnaire had not been completed by the requested timeline and the BlackRock funds had declared the nominations invalid.

Saba’s campaign against the Fund has involved recrimination from both Saba and the Fund. Notably, the Fund claimed, in a proxy filing, that Saba knowingly fails to comply with regulatory requirements designed to ensure the fair and efficient operation of the Saba Closed-End Funds ETF, an exchange-traded fund that it sub-advises. In particular, the Fund alleges that Saba is not in compliance with exemptive relief granted by the SEC, in which it agreed that the daily creation basket published by the ETF will correspond pro rata to the positions in the fund’s portfolio except in very limited and narrow circumstances. The Fund further claimed that this violation of the ETF’s exemptive relief has allowed Saba to maintain ownership stakes in certain closed-end funds so that Saba can exert influence on the funds. In its own proxy filings, Saba highlighted the discount to net asset value at which the Fund has historically traded, the Fund’s total expense ratio, and the fact that, of the Fund’s 12 trustees, only one trustee has an investment in the Fund. As of the Meeting’s July 15, 2019 record date, Saba held 19.13 percent of the Fund’s common stock, based on SEC filings submitted by Saba.

Second Circuit Finds Implied Private Right of Action Under Section 47(b), Creates Circuit Split

In Oxford University Bank v. Lansuppe Feeder, Inc., the U.S. Court of Appeals for the Second Circuit held that section 47(b) of the 1940 Act creates an implied private right of action that several other courts had previously declined to recognize. The August 5, 2019 ruling is the first to recognize an implied private right of action under section 47(b), and potentially increases the scope of litigation risk for mutual funds, advisers and their sponsors.

Section 47(b) provides that "[a] contract that is made, or whose performance involves, a violation of [the 1940 Act] . . . is unenforceable by either party." Previously, the only private right of action recognized under the 1940 Act was under section 36(b), which allows mutual fund shareholders to sue an investment adviser for charging excessive fees in violation of their fiduciary duty.

The dispute here stemmed from litigation between senior and junior noteholders of a special purpose investment vehicle (SPV) that defaulted on its interest payments to senior noteholders. The senior noteholders requested that the trustee liquidate the SPV in accordance with the SPV’s indenture. Consistent with the SPV’s distribution waterfall, senior noteholders would have received substantial compensation and junior noteholders would have received nothing upon liquidation.

Junior noteholders sued to rescind the indenture and to reorder the priority of liquidation distributions. The basis for their suit was their claim that the SPV’s indenture violated the 1940 Act because a number of notes issued by the SPV had been sold in the secondary market to investors that were not qualified purchasers, as the indenture required. The district court found that section 47(b) does not provide a private right of action, and dismissed the junior noteholders’ claim seeking rescission.

The Second Circuit’s decision focused on the text of section 47(b) and its legislative history. It stated that "[t]he text of Section 47(b) unambiguously evinces Congressional Intent to authorize a private action." In reaching this conclusion, the court focused on language in the statute that they stated "necessarily presuppose[d] that a party may seek rescission in a court by filing suit." For example, section 47(b)(1) renders contracts that violate the 1940 Act "unenforceable by either party" [emphasis added]. This language was "effectively equivalent to providing an express cause of action." The Second Circuit acknowledged that the Third Circuit reached the opposite conclusion with respect to section 47(b) in 2012. However, the Second Circuit found the Third Circuit’s reasoning wholly unpersuasive.

Despite finding a private right of action under section 47(b), the Second Circuit dismissed the claims of the junior noteholders on the ground that, while the resales to non-qualified purchasers may have violated the 1940 Act, the indenture did not. Further, the panel stated that the junior noteholders were not seeking rescission, but to selectively rewrite portions of the indenture that were unfavorable to them.

In so holding, the Second Circuit created a circuit split and increased the likelihood that the issue will be decided by the Supreme Court. The Second Circuit’s decision also increases the scope of litigation risk for mutual funds and investment advisers within the Second Circuit. Developments in this space may have broad implications for mutual funds and their investment advisers, and should be watched closely.

SEC AND SRO NEWS

Allison Herren Lee Sworn In as SEC Commissioner

On July 8, 2019, Allison Herren Lee was sworn in as an SEC commissioner. She was previously nominated by President Trump and unanimously confirmed by the U.S. Senate.

Commissioner Lee has an extensive career practicing securities law, including more than a decade with the SEC. Her roles at the SEC have included serving as counsel to Commissioner Kara Stein and as senior counsel in the Division of Enforcement’s Complex Financial Instruments Unit. Her government service also includes a period as a Special Assistant United States Attorney. Commissioner Lee also has experience in private practice and was previously a partner at Sherman & Howard LLC, where she focused on securities, antitrust and commercial litigation.

Commissioner Lee’s term expires on June 5, 2022.

The SEC’s press release on Commissioner Lee is available at https://www.sec.gov/news/press-release/2019-121.

SEC Names Sagar Teotia as Chief Accountant

On July 3, 2019, the SEC announced that Sagar Teotia had been named as the agency’s chief accountant. Teotia has been serving as acting chief accountant following the departure of Wesley R. Bricker in June. Teotia has served as the SEC’s deputy chief accountant since 2017 and previously served as a partner in Deloitte LLP’s national office. As chief accountant, he will serve as the SEC’s principal adviser on accounting and auditing matters, lead the Office of the Chief Accountant, and assist the SEC in its oversight of the Financial Accounting Standards Board and Public Company Accounting Oversight Board.

The SEC’s press release on Teotia is available at https://www.sec.gov/news/press-release/2019-80.

Endnote

1 It should be noted, however, that the SEC’s view in the guidance is that an investment adviser with discretionary authority to manage a client’s portfolio has implied responsibility for proxy voting unless the investment adviser affirmatively agrees, through full and fair disclosure, with the client to not take on that responsibility, and receives informed consent from the client. This means that investment advisers should affirmatively address the scope of their intended proxy voting responsibilities with their clients and recognize they will be deemed to have that responsibility unless they seek to waive it through agreement with their clients.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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