The following brief updates exemplify trends and areas of current focus of relevant regulatory authorities:
SEC Chair Addresses the Mutual Fund Directors Forum
On March 29, 2016, SEC Chair Mary Jo White gave the keynote address at the Mutual Fund Directors Forum annual policy conference in Washington, D.C. in which she covered three topics of interest to independent directors. Chair White first provided her thoughts on the role of independent directors in assessing risks faced by funds. She then described how a board’s role extends only to oversight and not to day-to-day management or to administration of a fund’s compliance policies and procedures. Finally, she shared her thoughts about the limited circumstances in which enforcement actions against fund directors would be appropriate.
Risk Assessment. Chair White gave her views on the role of independent fund directors in assessing risks, citing two recent events. The first event was the August 2015 inability by a major service provider to provide timely NAVs to fund clients. The second event cited was the December 2015 suspension of redemptions by a mutual fund that focused on investments in high yield debt. Chair White stated that it is incumbent upon fund directors to consider what these two examples could mean for their funds prospectively, and that directors must be proactive in addressing risks, instead of reactive.
Chair White also underscored that cybersecurity remains a critical risk. She acknowledged that, while cyberrisks cannot be eliminated, funds and their advisers must nevertheless employ strong, state-of-the-art prevention, detection, and response plans. She added that independent directors must consider whether the funds, advisers and other key service providers are taking appropriate steps.
Finally, Chair White stated that directors also need to consider whether their board currently includes members with the necessary set of diverse skills, experience and expertise and whether the board should hire subject matter experts as consultants to the board. This was particularly important, she said, as areas of risk management – e.g., cybersecurity, derivatives, liquidity and fund distribution – are becoming increasingly complex.
No Day-to-Day Management. Chair White sought to clarify what is not expected of independent directors. She emphasized that strong oversight of a fund should not be confused with the actual management of a fund. She said that the fund’s adviser is normally responsible for day-to-day fund management, and the fund’s chief compliance officer is responsible for administering the fund’s compliance policies and procedures. She said that the “role of the board is to provide independent oversight of these and other critical functions, and to approve compliance policies and procedures, not to perform them.” Chair White acknowledged that the appropriate dividing line between directors’ oversight responsibilities and day-to-day management is a challenge to the SEC as it considers proposed reforms, and she stated that the SEC would continue to focus on this issue.
Enforcement Perspective on Fund Directors. In the final topic of her speech, Chair White sought to reassure directors in light of some SEC enforcement proceedings in which fund directors were named as respondents. She stated that judgments made by directors in good faith in performing their duties responsibly will not be second-guessed by the SEC. Only when directors fail to perform their duties, she said, should they expect action to punish and deter such conduct. As examples, she described two enforcement matters brought during her tenure as SEC Chair that illustrate where directors fell short. In the first, the directors had not, as required, approved any fair valuation methodology or regularly reviewed the application of an approved methodology. Instead, the directors in question had delegated these responsibilities to a valuation committee of their funds’ investment adviser, without setting any parameters or reviewing the committee’s work. In the second enforcement matter, directors were charged with failing to satisfy their obligations under Section 15(c) of the 1940 Act to request and evaluate information that is reasonably necessary for the board to approve the terms of an advisory contract. The directors did not receive certain information they had specifically requested from the adviser, failed to follow up on the lapse, and did not seek clarification with respect to the incomplete, unclear and inaccurate information that had been provided.
William Blair May Face Enforcement Action Arising from SEC Distribution Sweep
In its December 31, 2015 annual report (filed February 29, 2016), the William Blair Funds disclosed that, in November 2014, the SEC had informed the funds’ principal underwriter and distributor and former adviser, William Blair & Company, L.L.C. (“WBC”), that it had opened a non-public investigation with respect to shareholder administration fees paid by certain funds. The annual report further disclosed that WBC had recently received a Wells Notice from the SEC, informing WBC that the SEC staff intended to recommend an enforcement action against WBC to the SEC Commissioners. According to the annual report, WBC submitted a response to the Wells Notice, and WBC believed that any possible claims made by the SEC staff would be without merit. The annual report further noted that, in light of the preliminary concerns expressed by the SEC staff, WBC was waiving the shareholder administration fee for each applicable fund, and that the waiver would not be lifted without approval of the funds’ board of trustees.
SEC Moves Forward on Cybersecurity Exam and Enforcement Initiatives
In panel remarks at the Investment Company Institute’s March conference in Orlando, Andrew Ceresney, Director of the SEC’s Division of Enforcement, stated that the SEC has enforcement actions in the works targeting the cybersecurity measures firms deployed to defend against cyberattacks. To date, the SEC has brought only one cybersecurity deficiency enforcement matter (discussed in this Investment Management Update). In his remarks during the same panel, Marc Wyatt, Director of the SEC’s OCIE, stressed the importance of conducting adequate diligence with respect to service providers’ adherence with their security measures. In a related development, the press has reported that, beginning in March, the OCIE substantially increased its examinations of firms’ cybersecurity practices.
SEC Sanctions Managed Account Sponsor for Placing Clients in Higher Fee Share Classes
On March 14, 2016, the SEC announced it had settled an enforcement proceeding against three dually registered broker-dealer and investment advisory affiliates of American International Group, Inc., alleging breaches of fiduciary duty and multiple compliance failures relating to a fee-based managed account service that invested client assets in higher-fee share classes. In its settlement order, the SEC stated that the respondents had invested client assets in share classes that charged Rule 12b-1 fees despite the fact that the clients were eligible for lower-fee share classes in the same funds that were available without Rule 12b-1 fees. In addition, the SEC stated that the firms failed to disclose their conflicts of interest in the Forms ADV or implement effective compliance policies to monitor advisory accounts to avoid reverse churning of fee-based advisory and wrap accounts (generally, reverse churning refers to the practice where a client is charged a wrap fee that covers all advisory services and trading costs even though the client trades infrequently). Without admitting or denying the findings, the respondents agreed to pay more than $9.5 million to settle the allegations, consisting of a $7.5 million penalty and disgorgement of approximately $2 million in Rule 12b-1 fees.