Financial Services Weekly News Roundup - April 2015 #5


Ninth Circuit Denies Rehearing of Northstar v. Schwab. On April 28, the U.S. Court of Appeals for the Ninth Circuit denied the petition of Schwab Investments’ (Schwab) for rehearing and rehearing en banc in the case of Northstar Financial Advisors v. Schwab Investments (Northstar). In Northstar, as reported in the March 18 Roundup, the Ninth Circuit had held that, under the particular facts alleged, shareholders could sue (1) the trustees of a mutual fund organized as a Massachusetts business trust directly under state law for breach of fiduciary duty, (2) the fund's adviser directly under state law for breach of the investment advisory agreement, and (3) the fund itself under state law for breach of a contract based on the language in the prospectus. Schwab had sought rehearing, and the Investment Company Institute and Independent Directors Council had filed an amicus brief in support of rehearing. The panel voted 2 to 1 to deny rehearing. The full Ninth Circuit did not vote to rehear the case en banc. As a result, the Northstar decision remains binding precedent for courts in the Ninth Circuit (which includes federal courts in Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington). Schwab's one remaining avenue of appeal is to seek certiorari from the Supreme Court. Northstar Financial Advisors v. Schwab Investments, No. 11-17187 (9th Cir. amended Apr. 28, 2015).

Regulatory Developments

SEC Staff Issues FAQs on 2014 Money Market Fund Reforms

The SEC’s Division of Investment Management issued FAQs on the significant money market fund reforms adopted by the SEC in July 2014. The FAQs, which the Division expects to update and supplement from time to time as needed, address the following broad topic areas: Form N-MFP, Form N-CR, Form N-1A, website disclosure, funds that invest in securities maturing in 60 days or less, amortized cost, compliance dates, retail money market funds, insurance separate accounts, fees and gates, treasury money market funds, government money market funds, transitions and reorganizations, registration fee credits, treatment of floating NAV money market funds as “cash items” for purposes of investment company status determinations, diversification, performance record, asset-backed securities, suspension of redemptions under Rule 22e-3, and maturity.

SEC Staff Issues FAQs on Valuation Guidance for Registered Funds Provided in Release Adopting Money Market Fund Reforms

The SEC’s Division of Investment Management also published FAQs that address valuation guidance for all registered funds provided by the SEC when it adopted significant money market fund reforms in July 2014. The FAQs, which the Division expects to update and supplement from time to time as needed, address (1) board oversight of the use of evaluated prices and (2) the use of amortized cost to value securities with remaining maturities of 60 days or less.

SEC Examination Staff Issues Risk Alert on Never-Before-Examined Registered Investment Company Initiative

Following up on the January 2015 announcement of its 2015 examination priorities, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert providing additional details on its Never-Before-Examined Registered Investment Company Initiative. The Initiative, which is principally directed at registered fund complexes launched one or more years ago, will consist of focused, risk-based examinations looking at two or more of the following areas: (1) compliance policies and procedures, particularly relating to proxy voting for portfolio securities and fund shares, registration statement updates and periodic reports, and codes of ethics for identifying and mitigating conflicts of interest; (2) annual contract review with a focus on board determination of advisory fee reasonableness and on adviser management of conflicts of interest related to the receipt of advisory fees; (3) fund advertising and distribution with a focus on the review and approval of fund advertisements and the disclosure of breakpoints and related procedures regarding the granting of breakpoints; (4) valuation of fund assets and NAV calculation, including board oversight of valuation; and (5) use of leverage and derivatives along with related disclosure regarding derivatives use and risks.

MSRB Releases Content Outline for Municipal Advisor Exam

The Municipal Securities Rulemaking Board (MSRB) on April 22 announced that it had released the content outline for the first qualifying examination for individuals who provide municipal advisor services to state and local governments. The content outline has been filed with the SEC for immediate effectiveness. The MSRB announcement states that all municipal advisor representatives and principals will be required to pass the new exam, called the Series 50 exam, within one year of its launch, and that the MSRB expects to launch the exam in 2016. The announcement includes information about a webinar scheduled for June 11 which will “review the content outline, provide more information about participating in the pilot and discuss the administration of the exam,” with a link to the webinar registration form.

Ontario Securities Commission Publishes Proposed Rule Providing Exemption from Registration for U.S. Broker-Dealers and Advisers

On April 23, the Ontario Securities Commission (OSC) announced that it has published proposed OSC Rule 32-505 -- Conditional Exemption from Registration for United States Broker-Dealers and Advisers Servicing U.S. Clients from Ontario. The Rule, which was published as an expedited rule not requiring comment, will come into force no later than July 7, 2015. It provides exemptions from the relevant dealer and adviser registration requirements under the Ontario Securities Act, subject to certain conditions, for U.S. broker-dealers and U.S. advisers that are trading to, with, or on behalf of, clients that are resident in the U.S. (U.S. clients), or acting as advisers to U.S. clients, but that trigger the requirement to register as a dealer or adviser in Ontario because they have offices or employees in Ontario. The exemptions in the Rule are not available to U.S. broker-dealers that trade to, with, or on behalf of, persons or companies that are resident in Ontario (Ontario residents), or U.S. advisers that act as advisers to Ontario residents. Goodwin Procter does not advise on Canadian securities law. We can recommend Canadian counsel if you would like more information.

Enforcement & Litigation

Supreme Court Will Not Review Third Circuit Decision Affirming Dismissal of 401(k) Excessive Fee Claims Against Insurer

The Supreme Court denied the plaintiffs’ petition for certiorari seeking review of the Third Circuit’s decision in Santomenno v. John Hancock Life Ins. Co. In that decision, the Third Circuit affirmed dismissal of all claims in a 401(k) excessive fee suit against the insurer, rejecting arguments that it is an ERISA fiduciary with respect to its fees. The Third Circuit held, among other things, that the insurer owes no fiduciary duty with respect to the terms of its service agreement so long as the plan trustees had the ultimate authority to accept or reject those terms. The court also held that the insurer is not a fiduciary with respect to the composition of its investment platform and the fees of those investments, which are merely product design features that trustees elect. Please see the September 29, 2104 ERISA Litigation Update for more detail on the Third Circuit’s decision. Santomenno v. John Hancock Life Ins. Co., No. 13-3467, 2014 WL 4783665 (3d Cir. Sept. 26, 2014). Goodwin Procter represented the defendants-appellees in this case.

SEC Settles with Adviser and its CFO Over Profitability Information Provided to Registered Funds’ Board as Part of Advisory Contract Renewal Materials

The SEC settled administrative proceedings against Kornitzer Capital Management, Inc. (KCM), a registered investment adviser, and Barry E. Koster, KCM’s chief financial officer and chief compliance officer, based on the SEC’s determination that information regarding the profitability of KCM’s advisory contracts with the Buffalo Funds, a family of registered open-end funds, provided to the funds’ common board of trustees was not consistent with KCM’s obligation under Section 15(c) of the Investment Company Act of 1940 to provide the board with information reasonably necessary for its evaluation of those advisory contracts. The SEC found that in the profitability analyses provided for its 2010 through 2012 fiscal years, KCM purported to allocate employee compensation expense to the funds based on estimates of its employees’ labor hours devoted to the funds when, in actuality, it considered other undisclosed factors that were designed in part to achieve year-to-year consistency of KCM’s profitability with respect to the funds. In KCM’s 2013 fiscal year, its CEO’s compensation increased by more than 70% from the prior year. The SEC found that, in part, to avoid showing a significant reduction in KCM’s profitability with respect to the funds, just 25% of the CEO’s compensation for 2013 was allocated to managing the funds, which was not consistent with the methodology disclosed to the funds’ board under which the CEO’s compensation was to be allocated “based on a ‘percentage (estimate) of time working on the Buffalo Funds and intangible value to the Buffalo Funds based on leadership, decision making and management responsibilities.’” KCM and Koster agreed to pay civil money penalties of $50,000 and $25,000, respectively. In the Matter of Kornitzer Capital Management, Inc. and Barry E. Koster, SEC Release No. IC-31560 (Apr. 21, 2015).

FINRA Orders Firm to Pay Fine and Restitution for Unsuitable Sales of Reverse Convertibles

On April 23, FINRA announced that it had entered into a Letter of Acceptance, Waiver and Consent (AWC) with RBC Capital Markets settling alleged rule violations involving supervisory failures resulting in sales of unsuitable reverse convertibles. According to FINRA, reverse convertibles are “interest-bearing notes in which repayment of principal is tied to the performance of an underlying asset, such as a stock or basket of stocks. Depending on the specific terms of the reverse convertible, an investor risks sustaining a loss if the value of the underlying asset falls below a certain level at maturity or during the term of the reverse convertible.” FINRA warned in Regulatory Notice 10-09 about the need for member firms to perform a suitability analysis in connection with the sale of reverse convertibles. FINRA found that while RBC had suitability guidelines, it failed to have a supervisory system reasonably designed to identify transactions for supervisory review when reverse convertibles were sold to customers, and that, consequently, the firm failed to detect the sale by 99 of its registered representatives of 364 reverse convertibles in 218 accounts that were unsuitable for those customers. RBC had previously made payments to some customers pursuant to the settlement of a class action. In the AWC, RBC agreed to payment of approximately $434,000 in restitution to the remaining customers and a $1 million fine.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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