Investment Management Industry News Summary - July 2002

The Treasury Department and its Financial Crimes Enforcement Network (FinCEN) adopted an interim final rule relating to the regulations recently proposed that would implement Section 312 of the USA PATRIOT Act. These regulations require certain financial institutions to adopt due diligence programs covering correspondent accounts for foreign financial institutions and accounts for foreign private banking clients. The interim final rule temporarily defers the application of these regulations to mutual funds pending adoption of a final rule.

The release accompanying the interim final rule notes that this temporary deferral does not in any way relieve any financial institution from compliance with the existing anti-money laundering and anti-terrorism requirements imposed by law, regulation, or rule of a self-regulatory organization. FinCEN anticipates that a final rule will be adopted no later than October 25, 2002.

(Investment Company Institute Memorandum No. 14942 July 22, 2002)

The Department of the Treasury and the SEC jointly issued a proposed regulation to implement Section 326 of the USA PATRIOT Act of 2001. Section 326 requires the Secretary of the Treasury to jointly prescribe with the SEC a regulation that requires investment companies to adopt and implement reasonable procedures to verify customer identities, maintain related records and determine whether customers appear on any government agency lists of known or suspected terrorists.

The proposed rule would apply only to investment companies that are mutual funds (and not, for example, hedge funds or other privately offered investment funds).

For purposes of the proposed rule, “customer” includes only shareholders opening new accounts with the mutual fund, and not a shareholder of record before the effective date of the regulation. However, an existing beneficial or record owner of shares becomes a “customer” if the person:

• becomes a shareholder of record
• is granted trading authorization in a different account after the effective date; or
• opens a different type of account with the mutual fund.

Nevertheless, a person does not become a “customer” simply by exchanging shares of one fund for shares of another fund within the same account (or initiating any other transaction that does not involve the opening of a separate account).

The type of identifying information available. At a minimum, the mutual fund must obtain certain identifying information before an account is opened for the customer (or the customer is granted trading authority over an account):

• name,
• date of birth, if applicable,
• addresses and
• tax identification number (there is a limited exception under the proposed rule for new businesses).

In addition, the release proposing the rule states that mutual funds, in assessing the risk factors listed below, should determine whether obtaining other identifying information is necessary to form a reasonable belief as to the true identity of each customer. The CIP should provide guidelines regarding under what circumstances a mutual fund should obtain additional information and what additional information should be obtained in these circumstances.

• Assessment of relevant risk factors. Under the proposed rule, these risk factors include:

  • the mutual fund’s size;
  • the manner in which accounts are opened, fund shares are distributed, and purchases, sales and exchanges are effected;
  • the mutual fund’s types of accounts; and
  • the mutual fund’s customer base.

According to the release proposing the rule, the degree to which a CIP is effective will depend on a mutual fund’s assessment of these factors and the nature of its response to them (as manifested in the CIP’s procedures and guidelines). In addition, as Section 326 and the proposed rule provide, the reasonableness of the CIP also will depend on what is practicable for the mutual fund.

Under the proposed rule, it is permissible for a mutual fund to contractually delegate the implementation and operation of its CIP to another affiliated or unaffiliated service provider, such as a transfer agent. However, the mutual fund remains responsible for assuring compliance with this rule. Accordingly, the mutual fund must actively monitor the operation of its CIP program and assess its effectiveness.

A mutual fund’s CIP does not have to include verification of individuals’ identities whose transactions are conducted through an omnibus account (although the omnibus account holder is itself a customer for purposes of the proposed rule).

The proposed rule requires a mutual fund’s CIP to address both methods of verification. Depending on the type of customer and the method of opening an account, it may be more appropriate to use either documents or non-documentary methods. In some cases, it may be appropriate to use both methods. Under the proposed rule, the CIP should provide guidelines describing when documents, non-documentary methods, or a combination of both will be used. These guidelines should be based on the mutual fund’s assessment of the factors described above. When those assessments suggest a heightened risk, the mutual fund should utilize additional verification measures.

If a customer whose identification has been verified previously opens a new account, the mutual fund would not need to verify the customer’s identity a second time, provided that the mutual fund continued to have a reasonable belief that it knew the true identity of the customer based on the previous verification.

The SEC recently proposed amendments to the rule under the Investment Advisers Act of 1940 (the “Advisers Act”) governing investment advisers’ custody of client assets. The amendments are intended to conform the rule to modern custodial practices and enhance protections for client assets while reducing burdens on advisers that have custody of client assets. The amendments would, among other things, require advisers that have custody of client assets to maintain those assets with broker-dealers, banks, or other qualified custodians and clarify circumstances under which an adviser is deemed to have custody of client assets.

Definition of “custody.” Currently, “custody” is defined only in the instructions to Form ADV. Under the proposed amendments, that definition would be incorporated into the rule. The proposed definition would provide that an adviser has custody of client assets when it holds, “directly or indirectly, client funds or securities or [has] any authority to obtain possession of them.” Accordingly, an adviser must comply with the rule when it has access to client funds and securities as well as when the adviser holds those assets. In addition, the rule would provide examples that illustrate the application of the definition. These examples would:

• clarify that an adviser has custody when it has any possession or control of client funds or securities (i.e., an adviser that holds clients’ stock certificates or cash, even temporarily). The inadvertent receipt of customer assets would not be considered custody so long as the adviser returns the assets to the sender within one business day after receiving them. An adviser’s possession of a check drawn by the client and made payable to a third party would not be considered custody of client.
  
• clarify that an adviser has custody if it has the authority to withdraw funds or securities from a client’s account, including deduction of advisory fees or other expenses.
  
• clarify that an adviser has custody if it is the legal owner of the client assets or has access to those assets (e.g., a firm that acts as both general partner and investment adviser to a limited partnership).

Use of “qualified custodians.” As amended, the rule would require that advisers maintain both client funds and securities with a “qualified custodian” in an account either under the client’s name or under the adviser’s name as agent or trustee for its clients. (Currently the rule requires advisers to maintain client funds with a bank, but does not allow client securities in an adviser’s custody to be held in a brokerage account or with any other type of financial institution). “Qualified custodians” would include regulated financial institutions that customarily provide custodial services – banks, savings associations, registered broker-dealers and registered futures commission merchants. For securities primarily market traded in a country other than the United States, and for cash and cash equivalents reasonably necessary to effect transactions in those securities, the amended rule would treat as “qualified custodians” those financial institutions that customarily hold financial assets in that country and that hold the client assets in customer accounts segregated from their proprietary assets. In addition, advisers or affiliates of advisers that are also “qualified custodians” could maintain their own clients’ assets, subject to the account statement requirements described below and the custody rules imposed by the regulators of the advisers’ custodial functions.

• Registered Investment Companies. Because registered investment companies and their advisers must comply with the strict requirements of section 17(f) of the 1940 Act and the custody rules thereunder, application of the Advisers Act custody rule would not materially change custody requirements for investment company assets.
  
• Pooled Investment Vehicles. Advisers would be exempt from the rule for client assets held in pooled investment vehicles such as limited partnerships or limited liability companies if the pooled investment vehicle
  
  
  • has its transactions and assets audited at least annually; and
  • distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 90 days of the end of its fiscal year.

The release proposing the amendments notes that this exemption would eliminate a great number of issues and concerns that have arisen under the current rule and that have been addressed in numerous staff no-action or interpretive letters (which, if the rule were adopted as amended, would no longer be applicable).

• Registered Broker-Dealers. As amended, the rule would permit advisers that are also registered broker-dealers or other types of qualified custodians to hold custody of their clients’ funds and securities without being subject to annual surprise examinations so long as they send monthly statements to their clients.

Elimination of balance sheet requirement

As proposed, the amended rule would eliminate the requirement that advisers with custody include a balance sheet in their client brochures. The release proposing the amendments notes that a balance sheet may give an imperfect picture of the financial health of an advisory firm, and that the current rule now requires advisers to disclose to their clients any financial condition that is reasonably likely to impair the adviser’s ability to meet its contractual commitments to its clients. This disclosure requirement did not exist when the audited balance sheet requirement was originally adopted.

The SEC recently sanctioned a registered investment adviser and its principals based on findings of three separate breaches of fiduciary duty demonstrating a pattern of the adviser putting its own interest before the interests of advisory clients. Specifically, the SEC found that:

• The adviser, through its principal, took for itself a limited investment opportunity from a fund it advised. The principal was presented with a limited opportunity to buy certain shares of stock not publicly traded in the United States. A fund advised by the adviser had previously purchased and sold the same stock, and was legally and financially capable of taking the limited investment opportunity. The adviser informed the fund about the opportunity, but failed to disclose that the stock would be bought and sold on the same day, at a profit, with little cost or risk. The adviser then took the investment for itself, thereby foreclosing the fund from making the same investment, and received $21,376 of gains.
  
  
• The adviser, through its principal, gave preferential treatment to certain advisory clients. When ten of twelve investors in a fund advised by the adviser requested that their capital be redeemed, the principal determined to liquidate all of the securities held in the fund and to dissolve the fund. During the course of the liquidation, even though all of the securities in the fund had not yet been sold, the adviser allowed two of the twelve investors to exit the fund at the then-current value (contrary to the fund’s governing documents) because those investors had agreed to invest in another similar fund advised by the adviser. As a result, the other ten investors were left to bear the market risk of the assets remaining in the fund.
  
  
• The adviser, through its principal, distributed proceeds from the liquidation of a fund’s assets as a redemption rather than a liquidation, resulting in a personal benefit to the principal. The principal was the sole beneficiary of a retirement account that was an investor in a fund advised by the adviser. After the adviser disclosed to the fund’s investors that the fund was losing money, all of the investors, other than the principal’s retirement account, instructed the adviser to redeem their capital accounts. The adviser then effectively liquidated the fund. Subsequently, when the last of the fund’s holdings were sold, the value of the fund increased. When distributions were made to all of the investors (other than to the principal’s retirement account) those distributions were made pursuant to the fund’s redemption provision instead of the fund’s liquidation provision. As a result, those investors received only the value of their capital accounts as of the redemption date. Had the principal distributed the proceeds pursuant to the fund’s liquidation provision, all of the investors would have shared in the increased value of the fund. By distributing the fund’s assets in accordance with the fund’s redemption provision rather than the liquidation provision, the principal’s retirement account received a windfall of $60,309.

The U.S. Federal Court of Appeals for the Seventh Circuit recently affirmed a grant of summary judgment in a case alleging breach of fiduciary duty under Section 36(b) of the 1940 Act. Section 36(b) creates a fiduciary duty on the part of investment advisers with respect to the receipt of compensation by from an investment company and authorizes the SEC or any shareholder to bring an action for breach of fiduciary duty to recover any excessive compensation paid to the adviser or its affiliates. The case was brought by common shareholders of six closed-end, tax-exempt municipal bond funds.

The plaintiffs argued that the advisory fee, which was based on a percentage of the daily net assets of the funds, created an incentive on the part of the adviser to excessively leverage the funds. They further argued that this fee arrangement, in turn, created a conflict of interest for the adviser and amounted to a per se breach of fiduciary duty.

The district court had found that the plaintiffs failed to meet their burden of establishing a breach of fiduciary duty under Section 36(b). The Seventh Circuit agreed and stated that, while an abuse of an inherent conflict may violate Section 36(b), the mere existence of the conflict does not. The court noted as significant the fact that the adviser in this case did not have the authority to make final leveraging decisions for the fund because the directors maintained ultimate control over the extent of the funds’ leverage. The appeals court also noted that compensation payable to investment advisers by investment companies is commonly based on a percentage of assets. The mere fact that this scheme could create an incentive for advisers to keep an investment fund excessively leveraged contrary to the best interests of a fund’s common shareholders does not, by itself, create a breach of fiduciary duty under Section 36(b). Moreover, the court observed, these arrangements are expressly authorized by the Investment Advisers Act of 1940.

The court affirmed the lower court’s ruling, finding that the plaintiffs had failed to produce any evidence showing that the adviser actually abused its position. The court determined that the existence of an independent board that ultimately controlled the extent of the funds’ leverage and annually approved the advisory compensation agreements, supports summary judgment in this case.