Category: Investment Company Act

Qualified Purchasers under the Investment Company Act

In a private fund exempt under 3(c)(1) investors only generally need to be accredited investors (and “qualified clients” if the fund manager is SEC registered. If you have more than 100 investors in the fund you will need to fall under the 3(c)(7) exemption. That means all of your investors must be “qualified purchasers.” A qualified purchaser is a much greater requirement than an accredited investor and a qualified client.

To paraphrase the requirements under Section 2(a)(51) of the Investment Company Act, a “qualified purchaser” means:

  • a person not less than $5 million in investments
  • a company with not less than $5 million in investments owned by close family members
  • a trust, not formed for the investment, with not less than $5 million in investments
  • an investment manager with not less than $25 million under management
  • a company with not less than $25 million of investments

To that list you can also add:

  • A company (regardless of the amount of such company’s Investments) beneficially owned exclusively by Qualified Purchasers.
  • A “Qualified Institutional Buyer” under Rule 144A of the 33 Act (except that “dealers” under Rule 144 must meet the $25 million standard of the 1940 Act, rather than the $10 million standard of Rule 144A). Rule 144A generally defines a “Qualified Institutional Buyer” as institutions, including registered Investment Companies, that own and invest on a discretionary basis $100 million of securities that are affiliated with the institution, banks that own and invest on a discretionary basis $100 million in  securities and have an audited net worth of $25 million, and certain registered dealers.

“Investments” generally means the following:

  1. Securities, including stocks, bonds and notes, other than securities of an issuer that  is under common control with the qualified purchaser.
  2. Real estate held for investment purposes.
  3. Commodity futures contracts, options or commodity futures and options on physical commodities traded on a contract market or board of trade, held for investment purposes.
  4. Physical commodities (e.g., gold and silver), with respect to which futures contracts are traded on a contract market or board of trade, held for investment purposes.
  5. Financial contracts (e.g., swaps and similar individually negotiated financial transactions), other than securities, held for investment purposes.
  6. For an investment company or a commodity pool, any binding capital commitments.
  7. Cash and cash equivalents held for investment purposes. Neither cash used by an individual to meet everyday expenses nor working capital used by a business is considered cash held for investment purposes.

Sources:

Image of Coin Stacks is by Darren Hester under a creative commons license.

Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under .

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

Sources:

Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.

Supreme Court Rules on When Mutual Fund Fees are too High

The Supreme Court issued its opinion in Jones v. Harris Associates, addressing the standard for when mutual fund fees are too high.

Background

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

Judge Easterbrook in the Seventh Circuit rejected the Gartenberg standard and crafted a new one.  The court adopted a standard that an allegation that an adviser charged excessive fees for advisory services does not state a claim for breach of fiduciary duty under § 36(b), unless the adviser also misled the fund’s board of directors in obtaining their approval of the compensation.

Decision

The Supreme Court concludes that

“Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship tothe services rendered and could not have been the product of arm’s length bargaining.”

They also make it clear that the burden of proof is on the party claiming the breach, not the fiduciary.

The Supreme Court found fault is looking almost entirely at the element of disclosure. The result is that the Supreme Court overturned the Seventh Circuit and remanded it back for further proceedings.

What does the standard mean?

The Investment Company Act does not necessarily ensure fee parity between mutual funds and institutional clients. Courts need to look at the similarities and differences in the the services being provided to different clients.

Courts should not rely too heavily on comparing fees charged by other advisers. Fees may not be the product of arm’s length negotiations.

A court should give greater deference to fund fees when a board’s process for negotiating and reviewing compensation is robust. “[I]f the disinterested directors considered the relevant factors, their decision to approve a particular fee agreement is entitled to considerable weight, even if a court might weigh the factors differently.” If a fund adviser fails to disclose material information to the board, the court should use greater scrutiny.

“[A]n adviser’s compliance or non-compliance with its disclosure obligations is a factor that must be considered in calibrating the degree of deference that is due a board’s decision to approve an adviser’s fees.”

The result is that courts should defer to the “defers to the informed conclusions of disinterested boards” and hold “plaintiffs to their heavy burden of proof.”

Sources:

Mutual Fund Advertisements and Social Media

If you want to have a good fishing, go where the fish are

Much has been made about FINRA’s Regulatory Notice 10-06 and how that will affect the social media use by registered representatives. Looking beyond the broker/dealers, I thought it would be interesting to see what mutual fund companies are doing with social media. I’ve started seeing some mutual fund companies starting to dip their toes into web 2.0.

Key Regulations Governing Advertising of Mutual Funds

Mutual funds are highly regulated under the Investment Company Act and the Securities Act. The interests in the funds themselves are securities and are governed by the Securities Act. As a security, that means under Section 5.(b)2 of the Securities Act you can only use a prospectus to advertise it.

Under Rule 482, the SEC allows mutual funds some additional flexibility is advertising their products. If an advertisement meets the disclosure requirements of the rule, then the advertisement will be deemed a “prospectus.” (Which means you won’t be illegally selling securities.)

Required Disclosure under Rule 482

There is long list of requirements in the advertisement. Here are just some of them:

  • Point out that investors need to consider the investment objectives, risks, and charges and expenses of the investment company carefully before investing.
  • Explains that the prospectus and, if available, the summary prospectus contain this and other information.
    identifies a source from which an investor may obtain a prospectus and, if available, a summary prospectus;
  • You should read the prospectus carefully before investing.
  • Advertisements that includes performance data have to point out that past performance does not guarantee future results (along with extensive limitations on how you can disclose performance)
  • Money market funds must point that they are not federally insured and you can lose money. (Hello Reserve Fund!)
  • Disclosure statements can’t be in fine print

Filings

Advertisements then need to be filed with the SEC under Rule 497 or with FINRA. (Most do the FINRA filing.) You have to file the advertisement with  FINRA within 10 days of first use or publication [FINRA Rule 2210(c)].

How can you do all of this with web 2.0?

You can’t.

One key aspect of web 2.0 is that it allows anyone to be a publisher. But now you’re a publisher without any training on how to be a publisher. In the case of mutual fund companies, publishing will have to go through a long process of review and approval before content can be published. Failure to comply has serious consequences.

That doesn’t mean that mutual fund companies cannot use social media. It just means they can only use is it certain ways.

Syndicate Content

If you’ve gone through the trouble and expense of creating compliant content, you should make it available in as many ways as possible. You obviously can’t push all of the required disclosures through the 140 characters of Twitter. But you can send links back to your website where you can make all of the disclosures. If you have video, you can publish the video on Facebook and YouTube.

If you want to have a good day fishing, you need to go where the fish are. (See the picture above.) Push your content to potential customers in the places where they are. Some of them (many of them?) may be spending time on Web 2.0 sites.

Examples

Sources:

Photo © Adrian van Leen for openphoto.net CC:PublicDomain

Private Fund Investment Advisers Registration Act Status

OpenCongress allows you to create custom widgets for the status of bills in Congress. I decided to play around and create one for the House version of the Private Fund Investment Advisers Registration Act.


I’ll create one for the Senate version once they formally introduce the Restoring American Financial Stability Act of 2009.

Will the Supreme Court Affect Mutual Fund Fees?

supreme court

On Monday, the Supreme Court heard the arguments on a case involving mutual fund fees. The case is trying to reconcile the standard for when mutual fund fees are too high.

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

The parties argued their positions Monday in front of the Supreme Court. I was not there, but I thought I could collect some coverage and Tuesday Morning Quaterbacking of the arguments.

According to the coverage, neither party supported Chief Judge Easterbrook’s ruling in the Seventh Circuit. He had found that the marketplace may be trusted to curb excessive fees and that mutual fund investors unhappy with the fees they are charged could withdraw their money and invest it elsewhere.

The mutual fund side argued for the Gartenberg standard: Fees must be “within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances.”

The plaintiff side argued:

“It surely cannot be the case that where you are dealing with a fiduciary duty — which is a higher standard recognized in the law — that you can charge twice as much as what you are obtaining at arm’s length for services that you are providing.”

William Birdthistle thinks:

“If, as some of today’s questions seem to indicate, the eventual decision from the Court in Jones v. Harris will read like Gartenberg with just one additional factor included in an already long and nebulous evaluation, we might have to wait for the next wave of litigation in trial courts to see whether the new Jones standard makes any practical difference on fees. If, on the other hand, the justices highlight and strongly emphasize the institutional/individual fee comparison in an opinion that reads like Posner’s dissent or Ameriprise v. Gallus, the pressure upon the industry to lower fees could be more acute and immediate.”

Anna Christensen thinks:

There did not seem to be five votes for adopting the Seventh Circuit’s market-based approach. The Court may reject that standard and decide little else, perhaps adopting the basic Gartenberg test with some degree of explication, and sending the case back to the court of appeals for application of the test. On the other hand, the Court may decide that as the argument in this case demonstrates, the terms of Gartenberg test do not provide significant guidance on how to identify an unfairly large fee, and use the facts of this case to provide an object lesson to lower courts.

It sounds like the Supreme Court is unlikely to come out with a ruling that dramatically affects the industry. Inevitably, it will require additional work for compliance.

References:

IDC Task Force Report Identifies Key Characteristics for Strong Compliance Programs

IDC

Independent Directors Council published a new task force report on the characteristics of a strong mutual fund compliance program. These include an ethical, compliance-focused “tone at the top;” a collaborative approach by the fund’s chief compliance officer; a risk-based program tailored to the fund and the adviser’s business; transparency and candor among the CCO, fund board, and adviser; and knowledgeable staff armed with appropriate resources.

The adoption of the fund compliance program rule (Rule 38a-1 under the Investment Company Act of 1940) in 2003 presented mutual fund boards with the required addition of a chief compliance officer to administer the fund’s compliance program.

The report does not break any new ground or propose radical changes. But it does provide some resources to think about and evaluate compliance.

One of interesting structural issues with mutual funds is whether the CCO should serve as the fund’s and adviser’s CCO or only as the fund CCO. By separating the role, you remove potential conflicts. Plus, the fund CCO could serve as a useful complement or counterpoint to the adviser’s CCO. But the fund-only CCO may feel like an outsider and a threat since most of the employees will be working for the adviser.

A Flurry of Stories on Mutual Fund Fees

oakmark_logo_new

Over the last few days there has been renewed interest in the upcoming Supreme Court case that will should rule on the fees charged by mutual funds. Back in May, I published Supreme Court to Decide on Investment Company Act Case after they agreed to hear Jones v. Harris Associates, L.P. I didn’t expect much mainstream press coverage of the case until the decision comes out next winter.

Over the weekend, Wall Street Journal columnist Jason Zweig published Can the Supreme Court Undress High Fund Fees? which pointed out that this case will “hit you right in the pocket.” Then The New York Times ran Supreme Court to Hear Case on Executive Pay which portrayed the as one focused on out of control executive pay. It sounds like the press has figured out that the case could have some broad implications on the way mutual funds decide what fees to charge.

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The Jones v. Harris case starts with the claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to its Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

Certainly, mutual funds rarely fire their advisers. But investors do fire the advisers by moving their money to different mutual funds and investments.The decision is likely to focus more on the procedure for setting fees than the absolute value of the fees.

It sounds like this case is getting tarted up as a blast against executive compensation. But really, its about the dense language in the Investment Company Act, fiduciary duty and compliance. Since the decision could have a broad impact on lots of peoples’ investments, it will likely get lots of coverage at the oral arguments on November 2, 2009 and whenever the decision comes out.

References:

Supreme Court to Decide on Investment Company Act Case

oakmark_logo_new

There has been a lot of focus on the Supreme Court’s acceptance of the PCAOB case: Free Enterprise Fund v. PCAOB (08-861). It squarely addresses an interesting administrative law question. I also find it interesting that this case originates from the last bout of financial fraud in the press (the collapse of Enron) and comes to the Supreme Court during the media coverage of the next bout of financial fraud.

Although it is less interesting, the Supreme Court also agreed to hear another case that may interest compliance professionals: Jones v. Harris Associates, L.P., (No. 08-586). This case focuses on the fees paid to the investment adviser of a mutual fund.

Harris Associates advises the Oakmark complex of mutual funds. Plaintiffs own shares in several of the Oakmark funds and contend that their fees are too high and in violation §36(b) of the Investment Company Act of 1940.

The Oakmark Fund paid Harris Associates 1% per year of the first $2 billion of the fund’s assets, 0.9% of the next $1 billion, 0.8% of the next $2 billion, and 0.75% of anything over $5 billion. These fees are roughly the same as other funds of similar size and investment goal. Mutual funds are largely captive to their investment advisers. There is an ability to change advisers and there is a requirement for independent directors. In my view the market really controls the fees. If one fund charges less in fees than another fund with  similar performance  and investment goal, investors will put their money in the less expensive fund.

Plaintiffs’ claim that the fees are excessive because they far exceed those charged to independent clients. Like many investment advisers, Harris charges less for institutional clients that invest in funds similar to the Oakmark funds. The plaintiffs take the position that a fiduciary should not charge a different price to its controlled clients than it does to its independent clients.

Under §36(b) of the Investment Company Act of 1940 the “the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.”

The traditional standard was that a breach of fiduciary duty occurs when the adviser charges a fee that is “so disproportionately large” or “excessive” that it “bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982)

The district court concluded that Harris Associates had not violated the Act and granted summary judgment in its favor. The Court of Appeals for the Seventh Circuit upheld that ruling. But they rejected the traditional standard and crafted a new one. Instead, the court adopted a standard that an allegation that an adviser charged excessive fees for advisory services does not state a claim for breach of fiduciary duty under § 36(b), unless the adviser also misled the fund’s board of directors in obtaining their approval of the compensation. Section 36(b) does not say that fees must be “reasonable” in relation to a judicially created standard.

I find it funny that the plaintiffs had argued that the court should not follow the traditional standard in Gartenberg. They won on that point, but still lost with the new standard.

Since one part of the country is subject to the traditional standard in Gartenberg and another part is subject to this new standard, I assume the Supreme Court took the case to clean up this split. It will give the Court an opportunity to clarify the proper scope of the fiduciary duty that investment advisers owe to fund shareholders with respect to their compensation.

In the end, I do not think the ruling will have much impact on consumers. No plaintiff has succeeded on a § 36(b) claim against a fund advisor. But it is likely to have an impact on compliance and governance programs.

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