AARP AND NASAA FILE JOINT U.S. SUPREME COURT AMICUS BRIEF REGARDING §10(b) LIABILITY

Last month the AARP and the Northern American Securities Administrators, Inc. (NASAA) joined forces to file an Amicus Brief in the United States Supreme Court in Janus Capital Group, et al v. First Derivative Traders. At issue was the extent to which a person or entity must be involved in drafting false statements in order to be exposed to potential §10(b) liability. According to the Amici, the mutual fund advisers should fall within the reach of §10(b) liability because the fund's advisers were the primary actors relative to the false statements made within the prospectuses for the mutual fund.

Plaintiff's are mutual fund investors in Janus Funds. Janus Management stands accused of engaging in secret market timing deals to the detriment of the Janus Fund investors. On appeal, Janus Management argues that the Court should apply a “Direct Attribution” standard. AARP and NASAA argue that the application of this restrictive standard would allow the fund advisers to dodge liability and shift it to the Fund's innocent shareholders by simply keeping their name off the prospectus. Seems like a fairly compelling argument.

Perhaps the most interesting angle on the Brief, and the issue on appeal, is NASAA's argument that §10(b) must be afforded an expansive application and interpretation in light of the absence of an alternative state court remedy. But its primary basis for this argument is not the absence of a remedy, but the absence of a procedure – class actions. Indeed, the 1998 Securities Litigation Uniform Standards Act (“SLUSA”) imposed heavy restrictions upon the utilization of class litigation in the state courts. The Amici noted as somewhat of an after-thought the absence of a remedy as well, due to the absence of a state common law fraud-on-the-market cause of action.

The Supreme Court heard oral argument on the matter on December 7^th. A transcript or the oral argument can be retrieved by clicking here. The Amicus Brief can be reviewed by clicking here.

Supreme Court Decides Mutual Fund Fees Case, Rejects Test Adopted By 8th Circuit

Last April, the issue of mutual fund adviser’s fiduciary duties concerning fees was before the United States Court of Appeals for the 8th Circuit in the case Gallus v. Ameriprise. Gallus considered the scope of a mutual fund adviser’s fiduciary duties under Section 36(b) of the Investment Company Act of 1940 (“1940 Act”) codified as 15 U. S. C. §80a–35(b).

The Court of Appeals reversed the decision of the United States District Court for the District of Minnesota holding that an inquiry into Section 36(b) does not rely solely on the Gartenberg factors laid out by the Second Circuit in Gartenberg v. Merrill Lynch Asset Management, Inc. The Gartenberg test looks at whether the “fee is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.”

The Court explained that while Gartenberg provides a “useful framework for resolving the claims of excessive fees”, the size of the fee should be considered alongside the mutual fund adviser’s conduct. Thus, the Eighth Circuit read the plain language of Section 36(b) to impose a “duty to be honest and transparent throughout the negotiation process.” In its decision, the Court heavily relied on the decision reached by the 7th Circuit in Jones v. Harris Associates L.P. In Jones, Chief Judge Easterbrook also rejected the proposition that Gartenberg should be the sole test applied to determine the reasonableness of an adviser’s fee. Instead, the Seventh Circuit declared that the focus should be on the fairness and transparency of the process for approving mutual fund adviser fees.

On March 30, 2010, the U.S. Supreme Court rejected the test proposed in the 7th Circuit (and subsequently adopted by the 8th Circuit). The Supreme Court unanimously agreed that Section 36(b) does not extend a duty to the negotiation process between mutual fund advisers and their clients. In addition to reinforcing the Gartenberg test as the appropriate approach in resolving Section 36(b) claims, the Court also clarified several points to create uniform application amongst the Circuits. Namely, the Court explicitly stated:

§ The weight given to comparison of fee size will depend on the circumstances surrounding the parties.

§ It is appropriate for a court to look at the fees an investment adviser charges a captive mutual fund versus the fees charged to independent clients.

§ Courts should give deference to the fee size because pursuant to the ’40 Act, fees must be approved by a “fully informed mutual fund board.” However, the level of deference may vary depending on the approval procedure of the board.

To read the Supreme Court’s full opinion, please click here.

SEC REGULATORY OVERVIEW: COMPLIANCE EXAMINATIONS

Through routine compliance examinations, the SEC keeps a close eye on SEC-registered investment advisors, investment companies, broker-dealers, and other types of registered firms to ensure that these firms are maintaining compliance with federal securities laws, and also to identify any potential weaknesses in the SEC’s compliance and supervisory controls.

In June 2007, the SEC for the first time issued its "ComplianceAlert," which provides financial firms with a periodical summary of select compliance areas the SEC examiners are concerned with, thereby providing firms with a forewarning of these problem areas so that they can review and modify their practices where necessary. In its most recent ComplianceAlert, dated July 2008, the SEC noted concern over the following selected practices by SEC-registered firms:

(a) Investment Advisors/Mutual Funds

a. Personal Trading by Advisory Staff—SEC compliance examiners reviewed advisors’ international compliance controls surrounding their employees’ trading and trading by the firms for their own proprietary accounts.

b. Proxy Voting and Funds’ Use of Proxy Voting Services—SEC compliance examiners reviewed practices with respect to the use of third-party proxy voting services, including oversight and operational aspects of mutual funds’ proxy voting, and how advisors managed conflicts of interest in proxy voting.

c. Valuation and Liquidity Issues in High Yield Municipal Bond Funds—SEC compliance examiners reviewed the portfolio composition, valuation and transaction activity of high yield municipal bond funds.

d. Soft Dollar Practices of Investment Advisors—SEC compliance examiners reviewed the soft dollar arrangements maintained by registered investment advisors, including the arrangements these advisors may have with both third-party and proprietary providers.

(b) Broker-Dealers

a. Examinations of Securities Firms Providing “Free Lunch” Sales Seminars—SEC, compliance examiners, in coordination with FINRA and NASAA, performed over 100 examinations of broker-dealers, investment advisors and other financial services firms that offer “free lunch” sales seminars targeting seniors in particular.

b. Valuation and Collateral Management Processes—SEC compliance examiners, in coordination with FINRA, reviewed large broker-dealer firms to assess their valuation and collateral management practices as they related to subprime mortgage-related products, including the firms’ controls around the valuation process.

c. Broker-Dealers Affiliated with Insurance Companies—SEC compliance examiners conducted targeted reviews of a number of broker-dealer subsidiaries of insurance companies.

d. Supervision of Solicitations of Advisory Services—SEC compliance examiners reviewed broker-dealer firms that had designated their registered representatives as “solicitors” for an investment advisor, including how supervision was implemented for these registered representatives’ activities as solicitors.

e. Mortgage financing as Credit for the Purchase of Securities—SEC compliance examiners conducted risk-targeted examinations of broker-dealer firms to evaluate their practice of recommending that their customers finance the purchase of their securities by obtaining a second or reverse mortgage on their home through a bank affiliated with the broker-dealer.

f. Office of Supervisory Jurisdiction Supervisory Structure—SEC compliance examiners reviewed broker-dealer firms’ supervisory and compliance controls under an Office of Supervisory Jurisdiction (OSJ) structure, including each firm’s supervisory structure and practices, and its supervision of its branch offices.

(c) Transfer Agents

a. Practices with Respect to “Lost SecurityHolders”—SEC compliance examiners reviewed transfer agents in order to understand current practices with respect to the search process performed for “lost” securityholders and the use of third-party “search firms” that search for lost securityholders.

Notably, not all of the above-referenced practices are legal requirements, but instead some are merely suggestions by the SEC compliance examiners. Based upon the SEC’s June 2007 and July 2008 release dates for its prior ComplianceAlert letters, it is likely that the 2009 alert will be released shortly. We will provide you with a summary of the SEC’s most recent compliance concerns at that time.