Investment Management Update

by Ballard Spahr LLP

The following are summaries of key developments in the investment management industry. More detailed coverage of these and other topics can be found using this link.

SEC Scrutinizes Annual Advisory Agreement Renewal Process

In July 2014, the SEC settled the previously reported proceeding involving Chariot Advisors, and its former owner, Elliott Shifman, concerning charges of violating and aiding and abetting the violation of Section 15(c) of the 1940 Act.

The SEC found that, in communications during the 15(c) process for a proposed fund, Chariot Advisors lied to the board of The Northern Lights Funds about Chariot’s ability to run an algorithmic currency trading strategy. The SEC found that in PowerPoint presentations, in other written submissions, and during in-person presentations before the board, Shifman stated that Chariot Advisors would use algorithmic currency trading for the fund. According to the SEC’s findings, however, Chariot Advisors did not possess any algorithms for conducting currency trading.

As a result of the proceeding, Shifman was suspended from association with virtually any entity in the securities industry for a period of 12 months and ordered to pay a $50,000 fine.

Although the Chariot Advisors proceeding did not directly implicate the fund board, the action underscores the SEC’s continuing intent to scrutinize the entire 15(c) process and, by implication, warns fund boards to be diligent in their adherence to their 15(c) duties.

Third Circuit Considers Whether 401(k) Recordkeepers Are Fiduciaries

The Third Circuit is considering the question of whether a 401(k) recordkeeper is deemed to be a fiduciary under the Employee Retirement Income Security Act (ERISA). The plaintiffs in Santomenno v. John Hancock alleged that John Hancock acted as a functional fiduciary and breached its fiduciary duty when it charged the trustees of the plaintiffs’ 401(k) plan what they alleged were excessive fees. The lower court held that John Hancock was not a functional fiduciary under ERISA, relying on Renfro v. Unisys Corp., which held that a service provider “owes no fiduciary duty with respect to the negotiation of its fee[s].”

The plaintiffs appealed the decision to the Third Circuit Court of Appeals, which heard argument in June 2014. The plaintiffs argued that John Hancock was a fiduciary for three reasons: John Hancock provided “client and plan specific” investment advice; John Hancock exercised discretionary authority over the management of the plan when it imposed its fees unilaterally; and that John Hancock, not the trustees, had the final say on investment options, thereby making John Hancock a fiduciary under subsection (iii) of 29 U.S.C. 1002 (21) (a).

The large majority of cases to have considered this question have held that the recordkeeper is not an ERISA fiduciary.  However, any decisions are fact specific. If a recordkeeper is routinely deemed to be a fiduciary, the existing equilibrium in the 401(k) space may be upended until this new fact can be properly taken into account in fee setting, contract negotiation, etc.

Municipal Advisor Registration Deadline Imminent

Municipal advisors are required to register with the SEC and the Municipal Securities Rulemaking Board (MSRB) under Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and SEC rules. The registration deadline depends on the date of registration by the municipal advisor under expiring temporary rules. The earliest registration deadline is July 31, 2014.

Supreme Court Allows Anti-Retaliation Suits by Fund Service Providers’ Employees

The U.S. Supreme Court has ruled that the anti-retaliation provision of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) protects employees of investment advisers and other service providers to mutual funds, and other public companies that engage in whistleblowing.

The case came from the U.S. Court of Appeals for the First Circuit, which had ruled that the applicable provision protects only employees of the public company (or mutual fund) itself. The Supreme Court decision allows employees of contractors and subcontractors to public companies to seek reinstatement and compensation if they are discharged or discriminated against for providing information concerning shareholder fraud, certain criminal frauds, or violations of SEC rules to federal regulatory or law enforcement agencies or through internal channels.

The Court concluded that the statutory text, purposes, and history show that the provision covers employees of private contractors and subcontractors, just as it covers employees of the public company—in this case, a mutual fund served by them.

EU Court of Justice Ruling May Allow U.S. Funds To Obtain Tax Refunds

The Court of Justice of the European Union (EU) has ruled that a non-EU investment fund may be able to obtain the same tax exemption available to funds established in an EU member state. The case arose in Poland, where domestic and EU investment funds are exempt from tax, but non-EU funds are subject to tax on the dividend income they receive. A U.S. mutual fund sought a tax refund, arguing that the disparate treatment violated a provision of the Treaty on the Functioning of the European Union (TFEU), which prohibits restrictions on the movement of capital between member states and third countries.

The Court of Justice ruled that the TFEU prohibits the enactment of tax laws of a member state that make dividends payable to a non-EU investment fund ineligible for the applicable tax exemption if the member state and non-member state are bound by an obligation of mutual administrative assistance, which enables the national tax authorities to verify information transmitted by the investment fund. The Court of Justice referred the case back to the Polish court for a determination whether the U.S.-Poland tax treaty meets this standard. The principles of the ruling, which apply across the EU, not just to Poland, could lead to large refunds for U.S. funds.

Investment Adviser Charged with Breaching Fiduciary Duties and Misleading Investors

In April 2014, the SEC charged Total Wealth Management, Inc. (Total Wealth)—as well as its chief executive officer, chief compliance officer, and another employee—with violations of the securities laws.  

The SEC brought a series of allegations against Total Wealth and its Chief Executive Officer and Owner Jacob Keith Cooper, Chief Compliance Officer Nathan McNamee, and Representative Douglas David Shoemaker. The allegations include creating a conflict of interest by paying themselves undisclosed “revenue sharing fees” derived from investments they recommended to investors while misrepresenting the extent of the due diligence that had been conducted on investments, which they recommended; breach of fiduciary duties owed to clients and defrauding clients by not disclosing relevant conflicts of interest and by concealing revenue sharing fees; and creating an entity to receive revenue sharing fees, disguised as fees for consulting that was never provided, to conceal that they were the ultimate recipients of these payments.

The remedial actions that the SEC may seek could include financial penalties, disgorgement, and cease and desist orders.



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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