Header graphic for print

The BD/IA Regulator

Providing securities regulatory, enforcement and litigation trends for broker-dealers, investment advisers and investment funds

Conflicts of Interest: When You’re Having Too Much Fun at That Business Lunch

Posted in Fund Regulation, Investment Adviser Regulation, SEC Enforcement

Jay Baris, an editor of the BD/IA Regulator, recently published Conflicts of Interest: When You’re Having Too Much Fun at That Business Lunch in the Learning Curve column of the August 2015 issue of Fund Directions.

In this issue, Jay discusses the challenging new hurdles fund directors face to comply with the 1940 Act’s gifts and entertainment prohibition.

To read the full article, click here.

BDC Master Feeder Funds on the Horizon – No-Action Relief Granted to One Issuer

Posted in Enforcement, SEC Enforcement

The staff of the SEC’s Division of Investment Management said that it would not recommend enforcement action if a business development company (BDC) reorganizes into a master-feeder structure.  The relief will also be available to future Feeder Funds in the same structure.  Other BDCs that wish to utilize a master-feeder structure, however, may not rely on this relief.  The staff indicated that it was “willing to consider similar requests from other BDCs.”

The Structure

Under the proposed arrangement, a Feeder Fund will offer its shares in a continuous public offering for a finite term between 5 and 25 years.  The Feeder Fund will invest all or substantially all of its assets in a Master Fund.  Additional Feeder Funds may be offered in the future.

The Master Fund will invest primarily in privately negotiated loans to private middle market U.S. companies and will continuously offer its common shares on a private placement basis.  It will have an indefinite life and will not list its shares on a securities exchange.  The Master Fund intends to offer a quarterly share repurchase program.  The Master Fund has elected to be treated as a BDC.

Each Feeder Fund will invest substantially all of its assets in the Master Fund and will offer a quarterly tender for a certain amount of its outstanding shares.  Each Feeder Fund’s quarterly tender offer will be conducted in parallel with that of the Master Fund.  As the Feeder Fund approaches the end of its finite term, the Feeder Fund’s board of trustees will authorize its liquidation and dissolution.  The Feeder Fund will affect the dissolution by selling to the Master Fund all of the Master Fund’s shares owned by the Feeder Fund.

The Relief

The SEC staff granted relief from Section 2(a)(48) of the 1940 Act to enable a Feeder Fund to elect to be treated as a BDC notwithstanding that the Feeder Fund’s investment in the Master Fund would not be an investment in an eligible portfolio company and a Feeder Fund would not make significant managerial assistance available to the issuers of securities held by the Master Fund.  In addition, the staff granted relief from Section 55(a) of the 1940 Act, which generally prohibits a BDC from acquiring additional assets unless, at the time of acquisition, at least 70% of its total assets are held in “qualifying assets” including eligible portfolio companies.

Because the Feeder Fund will invest only in shares of the Master Fund it may not satisfy the definition of a BDC in Section 2(a)(48).  In that case, a Feeder Fund might be in violation of Section 7(a) of the 1940 Act, which generally prohibits an investment company, unless it is registered under Section 8 of the 1940 Act, from offering to sell, selling or delivering after sale any security.  Section 8 does not apply to BDCs, and, accordingly, neither the Master Fund nor any Feeder Fund will register under Section 8.  Nonetheless, the staff stated that it would not recommend enforcement action against the Feeder Funds under Section 7(a) if the Feeder Fund elect to be regulated as a BDC.

Section 54(a) of the 1940 Act provides that only a company that meets the Section 2(a)(48) definition of a BDC may elect to be treated as a BDC.  Since the Feeder Fund will invest only in the shares of the Master Fund it could not elect to be treated as a BDC absent the requested relief.  The staff confirmed that it would not recommend enforcement action under Section 54(a) if a Feeder Fund invests only in shares of the Master Fund and thus only indirectly holds interests in the types of securities described in Sections 55(a)(1)–55(a)(3) of the 1940 Act but nevertheless elects to be treated as a BDC.

Since each of the Feeder Funds will have a finite term, the planned liquidation of each Feeder Fund will require the Master Fund to purchase its shares from a liquidating Feeder Fund for cash.  In general, such purchase will be made in compliance with Rule 23c-1, except that the Master Fund will comply with the asset coverage requirements applicable to BDCs (i.e., 200%) rather than the asset coverage requirements included in Rule 23c-1 (i.e., 300%).  In addition, Rule 23c‑1 requires that the seller of a security may not, to the knowledge of the issuer, be an affiliated person of the issuer.  Since each Feeder Fund will be an affiliated person of the Master Fund, the purchase of Master Fund shares from a liquidating Feeder Fund would not be consistent with Rule 23c-1.  The staff said that it would not recommend enforcement action under Section 23(c) and Rule 23c-1.

For a more detailed review of the no-action relief, see our recent client alert.

SEC Staff Provides Guidance to Clarify Application of Rule Requiring Reporting of Personal Securities Transactions by Investment Adviser Personnel

Posted in Investment Adviser Regulation, SEC Enforcement

In a June 2015 Guidance Update, the staff of the Division of Investment Management clarified how the code of ethics reporting rules apply to investment advisers.

Current rules require certain advisory personnel who have access to non-public information regarding securities transactions to report their personal securities transactions to their firms, so that advisers and SEC examiners can identify improper trades or patterns of trading.  The guidance clarifies which types of accounts may take advantage of a regulatory exception to that reporting obligation.

The staff apparently was prompted to issue the guidance based upon its concern that certain advisers have tried to take advantage of the reporting exception in circumstances when the reporting persons – so-called “access persons” – may in fact have some influence or control over such accounts. Rule 204A-1 under the Investment Advisers Act requires an adviser to adopt and maintain a written code of ethics that, among other things, obligates certain access persons ‑ directors, officers and partners and its supervised persons who have access to nonpublic information regarding securities transactions – to report personal securities transactions.

The Rule includes an exception from the reporting obligation for accounts over which an access person has “no direct or indirect influence or control.”  In the guidance, the staff states that blind trusts, which are managed by a third party for the benefit of an access person who has no knowledge of specific investments made by the trustee and no right to intervene in the management of the account, qualify for the exception.

Other accounts, however, may not qualify for the exception.  The guidance states that simply providing a third-party manager with discretionary investment authority over an access person’s personal account, “by itself, is insufficient for an adviser to reasonably believe that the access person had no direct or indirect influence or control over the trust or account.”  The staff said that, in order to take advantage of the reporting exception, an adviser needs to implement compliance “reasonably designed to determine whether the access person actually had direct or indirect influence or control over . . . an account, rather than whether the third-party manager had discretionary or non-discretionary authority.”

Going Forward

Advisers should review their policies and procedures related to personal securities transactions and consider if they need to be amended to ensure, among other things, that access persons fully understand the meaning of the phrase “no direct or indirect influence or control.” Advisers may also want to obtain certifications from access persons and their third-party managers regarding whether an access person has any influence or control over such accounts.  In this regard, however, the staff cautioned that obtaining only a general certification would not necessarily meet the standards outlined in the guidance.

In short, advisers should carefully evaluate whether their existing procedures would enable the adviser to demonstrate that an access person did not, in fact, exercise influence or control over an account.  Current practices of obtaining an annual general certification of non-influence and non control from the access person and his third-party manager may no longer be sufficient to enable an adviser to rely on the reporting exception in Rule 204A-1.

SEC Commissioner: Don’t Hold CCOs Accountable for Misdeeds of Advisers

Posted in SEC Enforcement

SEC Commissioner Daniel Gallagher, in a speech on June 25, 2015, said that a perceived trend by the SEC toward “strict liability” for chief compliance officers (CCOs) is “sending a troubling message.”

The statement explains his vote against bringing two enforcement actions against CCOs.  In one case, the SEC charged a CCO with violating Rule 206(4)-7, popularly known as the adviser compliance rule, in connection with an alleged failure to ensure that the adviser’s compliance program was sufficient to assess and monitor outside activities of employees.  In the second case, the SEC found that a CCO failed to implement compliance policies and procedures that, if carried out appropriately, would have detected an alleged multi-year theft of client assets by the adviser’s president.

This trend toward strict liability, Commissioner Gallaher argued, could encourage CCOs to distance themselves from their firm’s compliance policies and procedures, lest they be held accountable for the adviser’s conduct.  Moreover, this trend could incentivize CCOs to favor less comprehensive policies and procedures that require less monitoring in an effort to avoid potential liability when the SEC “plays Monday morning quarterback.”

Part of the problem, the Commissioner said, is that the compliance rule itself is not a model of clarity and “offers no guidance as to the distinction between the role of CCOs and management in carrying out the compliance function.”  He said that the SEC should not resolve this uncertainty through enforcement actions.

While acknowledging that CCOs should be held accountable for violations of the federal securities laws, he said that the SEC should strive to avoid “perverse incentives” that will flow from targeting CCOs who are “willing to run into the fires that so often occur at regulated entities.”  The SEC, he said, should consider whether to amend Rule 206(4)-7 or provide guidance to clarify the roles and responsibilities of CCOs so that CCOs are not held accountable for the misconduct of others.

In a speech on June 29, 2015, Commissioner Luis Agular said that Commissioner Gallagher’s statement has left the impression that the SEC is too harsh with CCOs, and that CCOs are “needlessly under siege” from the SEC.”  This dialog, he said, “is unhelpful sends the wrong message, and can discourage honest and competent CCOs from doing their work.”  The cases that the SEC has brought against CCOs, he said, do not “signify the beginning of nefarious trend” to targeting CCOs, but rather involve “egregious misconduct” of CCOs.

Both Commissioners found some common ground:  they agree that CCOs play a vital role in protecting investors.

Directors’ Consideration of Adviser Profitability Discussed in Webinar Hosted by Mutual Fund Directors Forum

Posted in Fund Regulation

In a recent webinar hosted by the Mutual Fund Directors Forum (MFDF), Kelley A. Howes, an editor of the BD/IA Regulator, and Sara Yerkey, a partner at Management Practice, discussed best practices for mutual fund directors reviewing adviser profitability in the context of approving investment advisory agreements under Section 15(c) of the 1940 Act.

Under relevant judicial precedent and SEC regulation, adviser profitability is one of several factors that fund directors should consider when evaluating advisory agreements. The lack of clear guidelines regarding what constitutes a reasonable level of profitability, or an appropriate methodology for calculating such profitability, however, makes this factor particularly challenging for directors to evaluate.

The webinar was one of a series of educational events on critical issues for fund directors hosted by MFDF.  A transcript of the webinar is available here.

Still Spry at 75: Reflections on the Investment Company Act and the Investment Advisers Act

Posted in Broker-Dealer Regulation, Investment Adviser Regulation

Jay Baris, an editor of the BD/IA Regulator, recently published “Still Spry at 75: Reflections on the Investment Company Act and the Investment Advisers Act” in the July issue of Investment Lawyer: Covering Legal and Regulatory Issues of Asset Management.

This article reflects on the 75th anniversary of the enactment of two of the crowning legislative achievements of the last century: the Investment Company Act of 1940 (Investment Company Act) and the Investment Advisers Act of 1940 (Investment Advisers Act).

More information:

Investment Management
Jay Baris