MUTUAL FUNDS ATTACK OUTLINE

SECURITIES

I. DEFINITION OF A SECURITY

Definition of a security under 2(a)(36):

(1)Includes: Notes, stocks, bond, evidence of indebtness, investment contract

  • Howey Test:
  • (1) Investment of Money,
  • (2) In a common enterprise (horizontal & vertical),
  • (3) Expectation of profit, (AND)
  • (4) Solely from the efforts of others

(2)Things that are considered to be securities:

  • REITs
  • Variable Annuities
  • Hybrid annuities/ equity indexed annuity—state insurance regulator regulates these as long as it satisfies conditions, they are no longer regulated by the SEC. Dodd-Frank (9)(a)(9)(j)

Definition of an Issuer, 2(a)(22):

(1)An issuer: Every person who issues or purposes to issue any security it has outstanding any security which has issued.

THE INVESTMENT ADVISERS ACT OF 1940

I. DEFINITION OF/ EXCEPTIONS/EXEMPTIONS TO DEF. OF IA:

DEFINITION OF AN IA:

(1)Investment Adviser, 202(a)(11): Investment adviser means any person who for compensation engages in the business of advising others, either directly, or through publishing or writing as to the value of securities or as to the advisability of investing in, purchasing or selling securities for compensation as part of a regular business, issues or promulgating analysis reports concerning securities.

(2)4 elements of an investment adviser under IA Release 1093: Whether someone is an IA is based on the totality of facts and circumstances.

  • (1) Any person, as defined under 202(a)(15): a natural person or a company.
  • A company is defined under 202(a)(5): Corporation, partnership, association…or any group of organized persons, whether incorporated or not—extremely broad. In some states includes trusts.
  • (2) In the business, IA Release 1092: Not episodic, regular advice giving, but does not have to be primary business—whether someone holds themselves out as adviser, charges separate fee for these services.
  • (3)For compensation, IA Release 1092: Receiving any economic benefit, does not have to come directly from client—this is easily triggered and could include tax benefits, good will of employees/employer.
  • (4) Providing advise regarding the value of investing in securities, IA Release 1092: Has to be more than just facts, has to be opinion or analysis involving Securities, i.e., the value, advisability of investing
  • IA Release 1092: Person who solicits clients is not for adviser

(3)Exceptions to definition of Adviser: If exempt form the definition of an investment adviser, the SEC does note have jurisdiction to regulating them under IAA.

  • Banks, 2(a)(11)(A):If the bank is advising a registered IC.
  • Lawyer’s accountants, engineers and teachers if the advice given in incidental to their business, 2(a)(11)(B): Can loose this exemption if get special fee for giving, but if something is being offered for fee not worthwhile to regulate.
  • Any broker or dealer if no special compensation for service, 2(a)(11)(C):
  • Any broker who is regulated under the 34 Act: Any broker, which is regulated under the 1934 act
  • BDs want you to buy: Have an obligation to provide you with advice regarding suitability, but can use sale tactics.
  • If receive money for specific advice blow exemption: If the IA receives specific compensation for providing investment advice then they blow the exemption.
  • Publisher of any bonafide newspaper… of general and regular circulation, 2(a)(11)(D):
  • There is an exemption if the advice is not personal:Exemption for non-personalized publishing activities by press or publications instead of personalized advice form advisers to clients. Needs to be legit and not tout by night. See Lowe.
  • It will not be considered to be bonafida advice, allowing publisher to fall into exception if they are making money form the publication form transactions: If D recommended to buy stock, but after they bought it for themselves, then it will be considered to be outside the exception. Tokyo Joes/Park
  • Any persons who advice, analysis, or report relate only to gov’t securities (at the time) and thought to be trustworthy, 2(a)(11)(E).
  • Any nationally recognized statistical agency org., 2(a)(11).
  • Any family office, as defined buy rule, regulation or order of the Commission, 2(a)(11)(G).
  • Exempts family office if: Gives advice to family members/ clients own and control office, cannot hold yourself out to the public as an IA, can advise only 1 family.
  • Such other persons not with in the intent of this paragraph as the SEC may designate—catch call that gives SEC authority and flexibility, 2(a)(11)(H):
  • Cannot add onto already enumerated categories:Cannot create subclasses of categories that are already exempted above. This type of rule making will not survive Chevron deference. Financial Planning Ass’n. (attempted to add new category to broker-dealer exemption).

II. REGISTRATION REQUIREMENTS

Who has to register w/ SEC:(if exempted still subject to anti-fraud)

(1)If an IA under the act, must register w/ the SEC, 203(a): If do not then cannot make use of the mails or any means or instrumentalities of interstate commerce in connection w/ business of an IA.

(2)If an IA to an adviser, must register even if the adviser is small: 203A.

(3)Hedge Funds: If have more than 15 clients, Hedge Fund adviser must register and the SEC will count through any corporate fictions to the actually investors.

(4)Exceptions to the registration requirements, but still IAs, 203(b):

  • Intrastate exception: If all of your clients reside in one state, state can regulate the activities
  • Advisers who clients are insurance companies: These advisers are state regulated, but the IAA will gap fill.
  • Certain charitable organizations like church plans, tax plans, and those registered w/ the CFTC.
  • Any adviser, who is a foreign private adviser (Dodd-Frank): Any adviser who is a foreign private adviser are carved out from the registration requirements rather than definition of IA, but very limited exemption.
  • Foreign private adviser is an IA who:
  • Do not have a place of business in the US
  • Do not hold themselves out to the public as being an IA in US
  • Do not advise ICs registered under the ICA
  • Fewer than 15 total US clients
  • Less than $25 AUM attributable to US clients (exclude those who have very little minimal involved in the US securities market)
  • Need to count through to private funds as well
  • Exemption to advisers to venture capital funds under 4 part test, 203(l): May still require them to submit info to the Commission in order to keep track of them.
  • Private funds that are under $150M are exempt from registration, but SEC can continue to make reports, 203(m):
  • Different treatment for US and non-US private fund advisers:
  • US—If principle place of business is the US:
  • Exempt only if acts as IA to private fund
  • All assets under management are $150M
  • No other clients
  • Non-US—If principle place of business is outside the US:
  • Only exempt if they have less than $150M AUM
  • Reg S of US persons apply
  • Private fund—fund under ICA relying on 3(c)(1) or (7).
  • Advisers to liquidity funds, PE funds are excluded from registration:
  • Financial Stability Oversight Council (FSOC): Need to submit information, which goes not primary regulator then FSOC committee.
  • File form on PE: Funds, strategies, but kept confidential
  • Supposed to prevent risk: Get rid of the idea of an institution being to big to fail
  • Def. Hedge fund only appears here: Use leverage and advisers charge performance fees up to half of portfolio
  • Private equity fund: Not hedge fund, not VC, but a catch all.
  • Small advisers are excluded from registration under 203A:
  • Thresholds:
  • $100M (counts securities and cash) AUM: Are required to register w/ the SEC.
  • $25M to $100M AUM: Do not have to register with the SEC (unless blow requirements are met). Must register w/ state regulators
  • Under $25M AUM: Prohibited from registering w/ the SEC. Must register w/ state regulators.
  • Conditions which would allow IA under $100M AUM to register:
  • In 15 or more states: Can register with SEC
  • Internet advisers: Register
  • States do not have an IA examination program: May register regardless of size
  • If registered w/ SEC under 203A states cannot regulate them:
  • Preempts states: States may not regulate big advisers
  • General Carve Out: SEC can exempt any one form registration if it determines that
  • It is unfair, burden on interstate commerce or otherwise inconsistent w/ purpose of section, they can allow a group or type of adviser to avoid registering w/ the SEC.

(5)Consequences of registration: Fees, fraud, and fiduciary duties

III. FEES

Permissible/Impermissible Fees, 205:

(1)Cannot charge performance fees: If you are a registered IA or required to be registered (not exempt) you cannot be compensated based on a share of capital gains or appreciation of clients funds.

  • Things that are considered to be performance fees: satisfaction guarantees, offerings to return fees if they give you a bad recommendation, or accepting gratuities based on capital gains are considered to be performance fees.

(2)Advisers may charge fees relating to AUM—incentive to keep principle up and grow assets instead of gambling: Interest more laughed with clients—different incentives.

Carve-Outs:

(1)Can charge fulcrum if you are an adviser to a mutual fund or if the person you are charging a fee too has assets over $1M: Has enough bargaining power to protect themselves

  • Fulcrum fees reward you when you hit a certain bench mark:Fees for increasing and decreasing performance needs to be measured against an independent index, i.e., like the S&P bond index and are structured in a way that if you do not beat the index you do not get a fee.
  • Can charge performance fee if only advise ICs that are exempt form ICA based on 3(c)(7): Funds sold to wealthy people $25M.
  • Can charge performance fee if person advising has over $1M AUM invested or a net worth over $2M, 205-3: They can prove their status above this threshold
  • Based on records: No reason to believe that person does not have this as net-worth
  • Can rely on assertion if client to certain extent: But if you think they are not being truthful need to research.
  • Maintain a file: Need to have basis on which you are relying on the exemption (financial records or tax returns)
  • Usually used by hedge funds: but this carve out continues when Dodd-Frank requires them to register

Must disclose if you are charging more than 3% AUM and compare w/ others:

(1)Not a few cap, but requires you disclose fees, so effect of fee cap: SEC has taken the position if adviser charges more than 3% AUM, this is so far from norm that it needs to be told to people that they are being overcharged—this has the effect of acting like a fee cap.

Cannot assign advisory contact w/o consent of parties, 205:

(1)If adviser is a partnership, have to notify clients if there are any changes to the partnership: B/c partners are personally liable and get equal voting power in managerial aspects.

  • Effect this: no one will change this much—effectively a substantive regulation of fees/fee caps
  • V-Corp: Liable itself if something goes wrong, not personally liable

IV. FRAUD:

It is fraud:

(1)To employ any device, scheme or artifice to defraud any client or prospective client, 206(1): general anti-fraud provision

(2)To engage in any transaction practice or courts of business which operates as fraud or deceit upon any client or prospective client, 206(2): Limited to any client/ prospective client instead of fraud on anyone like securities act

(3)Adviser may not act as a principle for his own account in transaction, 206(3):

  • Principle transactions: acting on IAs own behalf (IA negotiates and profits from transaction). This is usually a conflict of interest.
  • Any transaction: Acting for two clients behalf
  • Acting as agent for client: No conflict
  • Agency cross transaction: acting for two clients and they are both trading on their own accounts.
  • Agency cross transactions: acting for two clients and they are both trading in their own accounts.
  • Potential for conflict, i.e., preference for one client over another
  • Must disclose: If you disclose b/f these types of transactions can get blanket consent as long as you send client trades on quarterly basis so they can evaluate them after the fact.
  • This section creates a duty to give information: and therefore satisfies the common law fraud requirements
  • Allows adviser to make conflict of interest go away with disclosure: Instead of being a total prohibition by congress.

(4)To engage in any act, practice or course of business, which is fraudulent, deceptive or manipulative, 206(4): The Commission shall by rules and regulations define and proscribe the means reasonably designed to prevent such acts, practices

(5)Regulation under 206(4):

  • Rule 206(4)-1:Advertising rules apply to registered IAs
  • Cannot use testimonials:Clients experience or endorsement of IA, this is not enforced very often.
  • Also cannot:
  • Have to provide your stock picks that are good and bad cannot, have to give both
  • Cannot client to have the midas touch, i.e., the secret way to make $$
  • Need to explain risks and limits in strategy
  • Cannot provide loss leaders—if you provide a free service, it has to actually be free
  • You have to clearly disclose a conflict of interest upfront
  • Rule 206(4)-2: Custody of clients funds:
  • If have control or ability to control clients assets/funds special rules apply:
  • Assets need to be kept w/ qualified custodian, i.e., a bank or broker dealer—goal is to have third party verification
  • Assets need to be kept in separate account w/ clients name
  • Custodian needs to send statement directly to client
  • Requirement for surprise audit by accountant—but do not need money if only thing that triggers custody rule is automatic taking of fees.
  • If you are an affiliate of your custodian, need internal report
  • Verification by independent accountant that if advisory has custody those assets are safeguarded.
  • Rule 206(4)-3 Cash Payments for Client Solicitation:
  • If you pay someone for referrals:This may not be the best price for the investor for the trade
  • BD for referrals: Might see you as dumping ground
  • If you have a referral agreement needs to be in writing: Easier for the SEC to follow the cash flow and trace the relationship.
  • Have to disclosedisciplinary history on Form ADV(this used to be Rule 206(4)-4, but rescinded in Rule 206(4)-4 b/c it is part of the Form ADV:
  • It would be fraud not to disclose facts about past discriminatory history or have insolvency problems
  • 206(4)-7—“Putnam Rule”: Used to catch market timers—need to have a compliance program to prevent violations of the act and rules by the IA. The program must be reviewed annually and need chief compliance officers.—also applies to ICs

V. FORM ADV, 203(c)(1):

Requirements:

(1)Plain English: Must write in plain English

(2)Registration becomes effective in 45 days:

(3)The SEC can deny if:

  • Previously lied to Commission in a filing or otherwise
  • Convicted in past 10 years for securities crime
  • Crime punished by more than year of jail time
  • Enjoined from being or being associated with IA by SEC
  • Willfully violated securities laws, or aided and abetted or surprise
  • Any of these bad acts overseas

Parts of Form ADV:

(1)Look to pages 13-14 of long outline.

V. FIDUCIARY DUTIES

Lack of private right of action:

(1)No private right of action under 206: For breach of fiduciary duties suit must be brought by the SEC.

Comes from case SEC v. Capital Gains Research:

(1)Case establishes that advisers have fiduciary obligations to clients under IAA itself to disclose fairly and fully any conflicts of interest.

(2)Disclosure absolves conflicts of interest: As long as client can understand b/c disclosure is full and fair.

(3)Examples of breach of fiduciary duties:

Scalping: Buying securities for self, then recommending to others so the price of the security went up and then they can sell it and make money. Capital Gains

Prefencing brokers for $$: Siphoning trades to a certain broker in exchange for certain perks like tickets, vacations etc. Fidelity Management.

Two fiduciary duties:

(1)Duty of care: Take care of assets as if they were your own

(2)Duty of care: put client’s interest above your own, treat all clients equally instead of preferring one over another

(3)Duty of loyalty: Put client’s interest above your own, treat all clients equally, instead of preferring one over another

  • Need to disclose conflict or somehow to mitigate it
  • If IA have an opportunity that comes for your clients, hot IPO the opportunity belongs to them no the IA—must disclose how you are going to use it—but there is a diminish exception
  • Need to allocate fairly—do not favor some clients over another
  • Need a good reason and to disclose if you do so

Proxies Voting:

(1)If IA is going to exercise voting authority of proxies for securities, need to have written polices and these policies need to be in the interest of the clients, 203(4)-6: If IA going to exercise voting authority on behalf of securities, need to have written policies and these polices need to be in interest of clients and have to address:

  • How you are going to address conflicts of interest btw you and your clients
  • Need to describe to clients, give them a copy if ask, tell them to get info about how proxies are going to be voted after the fact.

Best execution and soft dollar exception:

(1)Best execution: Duty of IA to get best or fair market price/deal for trade services form broker-dealers.

  • Must take reasonable steps: Need to take reasonable steps to get reasonable prices unless client advises you otherwise
  • Best deal: Not only looking at price
  • Duty of loyalty: Choose BD based on client’s interest, not your own
  • Several factors to consider:
  • Commission rates
  • Financial responsiveness
  • Speed with which they can executor your trades
  • Confidentiality
  • Ability to hand participate trade/size
  • Costs

(2)Safe harbor 28(e) of the Exchange Act: In getting best execution, IA will not breach their fiduciary duties when taking into account things other than price when choosing BD, such as soft dollar creditors for directing your trade to a broker, but can be only research.

  • Technically the opportunity credit belongs to the client: b/c anything generated from the investment belongs to the investor
  • It is difficult to define research: research or things relating to researching securities for your clients—soft dollars can be used for research generally relating to clients instead of client who generated them.

INVESTMENT COMPANY ACT OF 1940

I. DEFINITION OF AN INVESTMENT COMPANY

An Investment Company is an Issuer that, 3(a)(1):