Ropes & Gray’s Investment Management Update October – November 2023

The following summarizes recent legal developments of note affecting the mutual fund/investment management industry.

OCTOBER ALERTS

Since our prior Investment Management Update, in separate Alerts, we covered the SEC’s adoption of new rules concerning short sales reporting and securities lending reporting, and the SEC’s changes to reporting requirements for significant shareholders. Each Alert is summarized below with a hyperlink to the full text of the Alert.

SEC Adopts New Reporting Regime for Short Sales
October 24, 2023
On October 13, 2023, the SEC adopted a new disclosure regime that requires investors to report information about certain short sales to the SEC. New Rule 13f-2 under the Exchange Act will require “institutional investment managers” that engage in short sales of “equity securities” in excess of certain thresholds to file new Form SHO with the SEC monthly. Form SHO will be confidentially filed with the SEC and will include detailed information about short sales in certain equity securities. The SEC will aggregate the reported information by security and publicly disclose only that aggregated information (without identifying any investors) monthly.

SEC Adopts Rule to Enhance the Transparency of Securities Lending Market
October 20, 2023
On October 13, 2023, the SEC issued a release adopting new Rule 10c-1(a) (the “Rule”) under the Exchange Act “to increase the transparency and efficiency of the securities lending market” by requiring certain persons to report information about securities loans to a registered national securities association (an “RNSA”). For each “covered securities loan,” the Rule requires a “covered person” to provide to an RNSA the material terms of the transaction – in the format and manner required by the RNSA – by the end of the day on which the securities loan is made or the terms of the loan are modified. In addition, the Rule requires (i) certain confidential information to be reported to an RNSA to enhance its oversight and enforcement functions, and (ii) an RNSA to make certain information it receives, including daily information pertaining to aggregate transaction activity and the distribution of loan rates for each reportable security, available to the public. Currently, FINRA is the only RNSA.

SEC Adopts Substantial Changes to Reporting Requirements for Significant Shareholders
October 16, 2023
On October 10, 2023, the SEC adopted substantial amendments to the reporting regime for beneficial owners of significant equity stakes in public companies. Among other things, the amendments:

• accelerate the filing deadlines for Schedule 13D and Schedule 13G;
• provide a specific deadline for when amendments to Schedule 13D and some Schedule 13Gs must be filed in lieu of the current “promptly” standard;
• require more frequent amendments to Schedule 13G filings; and
• clarify that cash-settled derivatives should be disclosed in Schedule 13Ds.

* * *

The following summarizes additional recent legal developments of note affecting the mutual fund/investment management industry.

SEC Division of Examinations Announces 2024 Priorities

For the first time in more than a decade, on October 16, 2023, the SEC Division of Examinations (the “Division”) published its annual Examination Priorities prior to the calendar year covered in the publication. In the 2024 Examination Priorities, the Division highlighted the following examination issues relevant to registered funds and their advisers:

• Assessments of funds’ “compliance programs and fund governance practices, disclosures to investors, and accuracy of reporting to the SEC.”
• Reviews of funds’ “valuation practices, particularly for those addressing fair valuation practices” and the effectiveness of funds’ liquidity risk management programs.

The Division additionally stated that focus areas of examinations may include the following:

• Reviewing whether funds have adopted effective written compliance policies and procedures concerning the “oversight of advisory fees and implemented any associated fee waivers and reimbursements.” In particular, the Division will focus on:
  • Advisers charging “different advisory fees to different share classes of the same fund;”
  • Sponsors offering identical strategies “through different distribution channels but that charge differing fee structures;”
  • Funds with “high advisory fees relative to peers;”
  • Funds with “high fees and expenses, particularly funds that also have weaker performance relative to their peers;” and
  • “[B]oards’ processes for assessing and approving advisory and other fund fees.”
• Reviewing derivatives risk management programs to determine whether funds “have adopted and implemented written policies and procedures reasonably designed to prevent violations of” the SEC’s derivatives rule. This may include (i) reviewing the “adoption and implementation of a derivatives risk management program, [related] board oversight,” and “disclosures concerning the [funds]’ use of derivatives” for potentially misleading statements, and (ii) reviewing “procedures for, and oversight of, derivative valuations.”
• Reviews for “compliance with the terms of exemptive order conditions.”

As is typical, the Division stated that they will prioritize examinations of funds that have never been examined (including recently registered funds) and funds that have not been examined in “a number of years.”

Observations. The Division states that it will focus on sponsors offering identical strategies “through different distribution channels but that charge differing fee structures.” However, in its 2010 decision, Jones v. Harris Associates L.P., the U.S. Supreme Court ruled on the meaning of an investment adviser’s “fiduciary duty with respect to the receipt of compensation for services” under Section 36(b) of the 1940 Act.¹ In addition, the Court discussed a related question – the weight a court should give in applying the “so disproportionately large” standard (part of the applicable legal standard) to comparisons between the fees that an adviser charges a mutual fund and the fees that it charges its institutional clients. It is worth quoting extensively from the Jones opinion, as it provides guidance for courts in determining whether an adviser is liable under Section 36(b) based on such comparisons. Regarding the weight courts should give to certain fee comparisons, the Court said:

• There is no “categorical rule regarding the comparisons of the fees charged different types of clients. . . . Instead, courts may give such comparisons the weight that they merit in light of the similarities and differences between the services that the clients in question require, but courts must be wary of inapt comparisons. . . . [T]here may be significant differences between the services provided by an investment adviser to a mutual fund and those it provides to a pension fund which are attributable to the greater frequency of shareholder redemptions in a mutual fund, the higher turnover of mutual fund assets, the more burdensome regulatory and legal obligations, and higher marketing costs.”
• “If the services rendered are sufficiently different that a comparison is not probative, then courts must reject such a comparison. Even if the services provided and fees charged to an independent fund are relevant, courts should be mindful that the [1940] Act does not necessarily ensure fee parity between mutual funds and institutional clients.”
• “Only where plaintiffs have shown a large disparity in fees that cannot be explained by the different services in addition to other evidence that the fee is outside the arm’s-length range will trial be appropriate.”
• “[C]ourts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers. These comparisons are problematic because these fees . . . may not be the product of negotiations conducted at arm’s length.”

Notably, the Division does not explain what use it intends to make of its “different distribution channel” fee comparisons as part of its focus on “boards’ approval of the advisory contract and [fund] fees.” While the stated priorities are couched in terms of fund policies and procedures, it bears watching whether the Division may in fact attempt to regulate the substance of fund fees through examination deficiencies it will purport to find in “boards’ processes for assessing and approving advisory and other fund fees.”

Federal Court Rejects Activist’s Challenge to Closed-End Funds’ Forum Selection Bylaws

A September 26, 2023 decision by the U.S. District Court for the Southern District of New York addressed the validity, under Maryland law, of closed-end funds’ forum selection bylaw clauses.² Judge Jed Rakoff presided over the matter and authored the court’s opinion.

Background. An activist investor (“Saba”) filed a suit against 16 closed-end funds organized under Maryland law – 13 of which are corporations and three of which are statutory trusts – alleging that the 16 funds each had adopted a bylaw resolution (opting in to the Maryland control share statute) that violates the “one share, one vote” requirement under Section 18(i) of the 1940 Act. The funds filed a motion to dismiss the complaint because of forum selection clauses in 14 of the funds’ bylaws, which the funds argued required the suit to be brought in a Maryland state or federal court.

The Ruling. Judge Rakoff rejected Saba’s argument that Maryland’s corporate statutes do not permit corporations to adopt forum selection bylaws for claims under the federal securities laws. The corporate statute provides that the “charter or bylaws of a corporation may require . . . that any internal corporate claim be brought only in courts sitting in one or more specified jurisdictions” (and the relevant Maryland statute for statutory trusts is far broader).³ In addition, a different Maryland corporate statute allows bylaws to “contain any provisions not inconsistent with law or the charter of the corporation for the regulation and management of the affairs of the corporation.” Finding no Maryland caselaw construing the interplay of these two Maryland corporate statutes, Judge Rakoff relied on similar provisions under Delaware law, as interpreted by the Supreme Court of Delaware. He noted that:

• In 2020, the Supreme Court of Delaware addressed the interplay of two provisions in Delaware’s corporate code similar to the Maryland statutes.⁴ The Delaware court held that the broader Delaware statute permitting any “provisions . . . not contrary to the laws of this State” allows corporate bylaws to include forum selection clauses even for federal claims, notwithstanding that the more specific Delaware statute regarding forum selection clauses (like Maryland’s statute) mentions “internal corporate claims.” Thus, the court held, for internal corporate claims, bylaws may require a Delaware forum. For other claims, the broader statute controls.
• The Supreme Court of Delaware had rejected the same argument that Saba was making in the case at bar – that because the statute speaking to forum selection clauses specifically mentions “internal corporate claims,” permissible corporate forum selection bylaws are limited to that type of claim.
• Saba had (i) acknowledged that “Maryland’s law follows the model, set by the Delaware legislature . . . of codifying a corporation’s ability to require (via a forum selection clause) an internal corporate claim to be decided in the state of incorporation,” and (ii) cited the Delaware decision in its brief “to elucidate the meaning of [the Maryland statute that mentions internal corporate claims]” and stated that “the Maryland legislature enacted a virtually identical provision to Delaware’s.”

Accordingly, Judge Rakoff held that Saba had failed to show that Maryland law prohibits forum selection bylaws for claims under the 1940 Act. In addition, Saba did not address the broader language of Maryland’s statute permitting statutory trusts to adopt forum selection bylaws. Thus, Saba’s argument would not even apply to the closed-end funds that were Maryland statutory trusts.

Turning to the language of the funds’ forum selection bylaws, Judge Rakoff held that the forum selection bylaw clauses of five funds were drafted broadly enough to include claims under the federal securities laws, thereby requiring a Maryland forum.⁵ The court granted the motion to dismiss for these five funds. In contrast, the court interpreted the scope of the forum selection bylaw clauses of the remaining funds to not include claims arising under the federal securities laws (and, for two funds’ bylaws, lacked an applicable forum selection clause).⁶ The court denied the motion to dismiss for these funds.

REGULATORY PRIORITIES CORNER

The following brief updates exemplify certain trends and areas of current focus of regulatory authorities.

FSOC Adopts a New Process for Determining Nonbank Supervision by the Fed

Overview

Section 113 of the Dodd–Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) authorizes the Financial Stability Oversight Council (the “Council”) to subject a “nonbank financial company” to supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), including the Federal Reserve’s prudential standards. The definition of a nonbank financial company in the Dodd-Frank Act includes investment companies and investment advisers that have registered with the SEC.

To designate a nonbank financial company for Federal Reserve supervision, the Council must consider 10 specific but non-exhaustive considerations under Section 113 and conclude either that (i) “material financial distress” at the nonbank financial company or (ii) “the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities” of the nonbank financial company, “could pose a threat to the financial stability of the United States” (the “Section 113 Tests”).

On November 3, 2023, the Council published a release (the “Release”) adopting interpretive guidance (the “New Guidance”) regarding the process the Council will employ to determine whether a nonbank financial company should be designated as subject to the Federal Reserve’s supervision. Concurrent with the publication of the New Guidance, the Council issued a separate release containing its new Analytic Framework for Financial Stability Risk Identification, Assessment, and Response, which contains a detailed explanation of how the Council will identify, evaluate and address potential risks to U.S. financial stability.

The New Guidance describes the process that the Council will employ when evaluating whether a nonbank financial company could pose a threat to the financial stability of the United States pursuant to Section 113 of the Dodd-Frank Act. In addition, the New Guidance rescinds in its entirety prior guidance on the same topic adopted in 2019 (the “2019 Guidance”) to reverse changes made during the Trump Administration to the Section 113 nonbank financial company designation process.

Process for Nonbank Financial Company Determination

The New Guidance describes a detailed two-stage process that the Council will follow when evaluating a nonbank financial company under Section 113 of the Dodd-Frank Act. The process described in the New Guidance is identical to the process proposed by the Council in April 2023 and is described in more detail in a May 2023 Ropes & Gray Alert. Briefly stated, following the prescribed process, the Council may make a “Final Determination” notifying the nonbank financial company in writing that it will be subject to supervision by the Federal Reserve. The written notice will include an explanation of the basis for the Council’s decision. As permitted under the Dodd-Frank Act, a nonbank financial company that is subject to a Final Determination may bring an action in a U.S. district court for an order requiring the Council to rescind its Final Determination. The Dodd-Frank Act provides that the court’s review of such an action “shall be limited to whether the [Final Determination] made . . . was arbitrary and capricious.”

Rescission of the 2019 Guidance

The Release states that the New Guidance “removes three significant but inappropriate prerequisites to the exercise of the Council’s nonbank financial company designation authority that were created by the [2019 Guidance].” The Council has determined that these three steps are “not legally required, are not useful or appropriate, and would unduly hamper the Council’s ability to use the statutory designation authority in relevant circumstances.” The eliminated steps and the Council’s associated rationale are described below.

Elimination of an Activities-Based Approach and Reliance on Primary Regulators. The 2019 Guidance stated that the Council would identify, assess, and address potential risks and threats to U.S. financial stability by following a process that began with an “activities-based approach.” The activities-based approach meant the Council would rely on existing regulators to deal with potential threats to financial stability before the Council would evaluate a nonbank financial company under Section 113. In addition, the 2019 Guidance generally limited the use of designations under Section 113 to situations where a potential risk or threat could not be adequately addressed by existing regulators.

The Release rescinds the 2019 Guidance’s activities-based approach because it generally allowed the Council “to consider a nonbank financial company for potential designation only after the Council completed a multi-step process in which the Council would wait for existing regulators to address identified risks to financial stability,” thereby obstructing the Council’s ability to address risks to financial stability in a timely manner.

Elimination of a Cost-Benefit Analysis. The 2019 Guidance provided that the Council would perform a quantitative cost-benefit analysis, whenever possible, prior to designating a nonbank financial company under Section 113. The Release notes that the Dodd-Frank Act does not require a cost-benefit analysis prior to the designation of a nonbank financial company under Section 113. Instead, the “statute instructs the Council to focus on potential threats to financial stability, not the costs of designation to the company under review or to others.”

In addition, the Release observes that a cost-benefit analysis to assess the incremental costs resulting from a Section 113 designation and the potential benefits resulting from mitigating the threat a nonbank financial company’s “material financial distress or activities could pose to financial stability would be impossible to perform with reasonable precision.” In general, specific regulatory requirements for previously designated nonbank financial companies “have been determined after the [Section 113] designation, in order to enable the requirements to be appropriately tailored to risks posed by the company.”

Elimination of the “Likelihood of Material Financial Distress.” The 2019 Guidance also stated that “the Council will assess the likelihood of the company’s material financial distress.” The New Guidance eliminates this “likelihood assessment” from the Council’s Section 113 determinations.

The Council believes that assessing the likelihood of a nonbank financial company company’s material financial distress is “neither required nor appropriate.” The Release notes that a likelihood assessment does not appear among the relevant Dodd-Frank Act provisions and “fits poorly with the statutory standard for designation.” In particular, the Council is authorized to designate a company under Section 113 if it “determines that material financial distress at the U.S. nonbank financial company . . . could pose a threat to the financial stability of the United States” (i.e., the first of the two Section 113 Tests). The statute directs the Council to evaluate whether a company’s material financial distress could pose a threat to financial stability – not to assess how likely such distress is to occur. Instead, the Release notes, “the Council presupposes a company’s material financial distress, and then evaluates what consequences for U.S. financial stability could follow.” If the consequences “could pose a threat to the financial stability of the United States,” designation of the company under Section 113 is warranted.

Updates to Form ADV Frequently Asked Questions

On October 26, 2023, the Division of Investment Management staff published an Information Update to announce that the Division had provided a comprehensive update to the “Frequently Asked Questions on Form ADV and IARD” (the “FAQs”). The updated FAQs provide additional guidance from the staff concerning specific questions concerning Form ADV and the IARD system, and includes both technical updates to previously existing questions as well as new FAQs on a variety of topics (among other topics with new FAQs: information regarding the investment adviser registration and withdrawal processes, registration information for robo-advisers, classification of ETFs for Schedule D purposes, the filing of Form CRS for newly registering advisers, and information for the public regarding historical Form ADV). The Information Update also provides a link to a marked version of the FAQs to highlight the updates provided by the staff.

ADDITIONAL ROPES & GRAY ALERTS AND PODCASTS SINCE OUR AUGUST – SEPTEMBER UPDATE

Ropes & Gray Crypto Quarterly: Digital Assets, Blockchain and Related Technologies Update
November 20, 2023
The landscape of government enforcement, private litigation, and federal and state regulation of digital assets, blockchain and related technologies is constantly evolving. Each quarter, Ropes & Gray attorneys analyze government enforcement and private litigation actions, rulings, settlements, and other key developments in this space. We distill the flood of industry headlines so that you can identify and manage risk more effectively. This newsletter includes takeaways from this quarter’s review.

DOL’s Latest Attempt to Define Who Is an Investment Advice Fiduciary under ERISA: Initial Considerations for Asset Managers
November 8, 2023
After months of anticipation, on October 31, 2023, the U.S. Department of Labor (“DOL” or “Department”) unveiled its first new fiduciary rule proposal (the “Proposal”) since the Obama administration’s 2016 rule. Rebranded the “Retirement Security Rule,” the Proposal signifies the latest attempt by the DOL in its ongoing quest to modernize its long-standing fiduciary definition (often referred to as the five-part test). The DOL explained that it is updating the rule to keep up with the substantial evolution of the retirement plan landscape since the rule’s adoption in 1975—most notably, the shift away from defined benefit pension plans to individual account plans like 401(k) plans as well as IRAs—and to address perceived gaps in the existing regulatory structure in order to better protect retirement investors. While the Proposal appears to succeed in filling many of these perceived gaps, it would also introduce new uncertainty into many everyday interactions between financial institutions and retirement plans.

SEC Grants Permanent Relief from Rule that Could Have Required Private Company Issuers of Rule 144A Fixed Income Securities to Make Financial Statements Publicly Available
November 7, 2023
On October 30, 2023, the SEC granted permanent relief from Rule 15c2-11 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) for fixed-income securities traded under Rule 144A under the Securities Act of 1933, as amended. Absent that relief, beginning in early 2025, broker-dealers would have been prohibited from publishing quotations for Rule 144A fixed-income securities if the issuer of those securities did not make certain financial information publicly available.

ESG and Public Pension Investing in 2023: A Year-to-Date Recap and Analysis
November 7, 2023
Since 2021, Ropes & Gray has been actively tracking the various approaches states have taken on how or whether environmental, social and governance (“ESG”) factors should be applied to the investment decisions for public retirement systems. States have used legislative, administrative and enforcement mechanisms to address this area, which has been complemented by Congressional Republicans’ various attempts to shine a spotlight on ESG in recent months. Judging by the significant uptick in activity this year at both the state and federal levels, the fight over ESG in public investments is far from over and may even be just beginning.

This whitepaper seeks to provide context for understanding what has happened in the states in 2023 along with considerations that asset managers should be mindful of when engaging with public retirement plans. In the first part of this paper, we provide an overview of current trends in state ESG legislation and regulation along with background for how we got to this point. In the second part, we provide a recap of what has transpired in each state along with an assessment of the state’s policymaking regarding ESG and public pension investments.

SEC Adopts New Reporting Regime for Short Sales
October 24, 2023
On October 13, 2023, the SEC adopted a new disclosure regime that requires investors to report information about certain short sales to the SEC. New Rule 13f-2 under the Exchange Act will require “institutional investment managers” that engage in short sales of “equity securities” in excess of certain thresholds to file new Form SHO with the SEC monthly. Form SHO will be confidentially filed with the SEC and will include detailed information about short sales in certain equity securities. The SEC will aggregate the reported information by security and publicly disclose only that aggregated information (without identifying any investors) monthly.

CFTC Proposes New Disclosure Requirements for Certain Commodity Pool Operators and Trading Advisors
October 23, 2023
The U.S. Commodity Futures Trading Commission (“CFTC”) recently proposed an amendment to Rule 4.7 (the “Proposal”) that would (i) introduce new minimum disclosure requirements for commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) who operate pools and trading programs pursuant to CFTC Rule 4.7 (“Rule 4.7 CPOs and CTAs”), (ii) increase the monetary thresholds to qualify as a Qualified Eligible Person (“QEP”); and (iii) codify routinely issued exemptive relief allowing CPOs of funds-of-funds operated under Rule 4.7 to choose to distribute monthly account statements within 45 days of month-end.

SEC Adopts Rule to Enhance the Transparency of Securities Lending Market
October 20, 2023
On October 13, 2023, the SEC issued a release adopting new Rule 10c-1(a) (the “Rule”) under the Exchange Act “to increase the transparency and efficiency of the securities lending market” by requiring certain persons to report information about securities loans to a registered national securities association (an “RNSA”). For each “covered securities loan,” the Rule requires a “covered person” to provide to an RNSA the material terms of the transaction – in the format and manner required by the RNSA – by the end of the day on which the securities loan is made or the terms of the loan are modified. In addition, the Rule requires (i) certain confidential information to be reported to an RNSA to enhance its oversight and enforcement functions, and (ii) an RNSA to make certain information it receives, including daily information pertaining to aggregate transaction activity and the distribution of loan rates for each reportable security, available to the public. Currently, FINRA is the only RNSA.

SEC Adopts Substantial Changes to Reporting Requirements for Significant Shareholders
October 16, 2023
On October 10, 2023, the SEC adopted substantial amendments to the reporting regime for beneficial owners of significant equity stakes in public companies. Among other things, the amendments:

• accelerate the filing deadlines for Schedule 13D and Schedule 13G;
• provide a specific deadline for when amendments to Schedule 13D and some Schedule 13Gs must be filed in lieu of the current “promptly” standard;
• require more frequent amendments to Schedule 13G filings; and
• clarify that cash-settled derivatives should be disclosed in Schedule 13Ds.

PErspectives | Private Wealth for Private Equity Markets
October 10, 2023
This is Issue No. 11 of PErspectives—our periodic publication featuring news, trends and legal developments in the private equity (“PE”) industry. PE managers, recognizing the potential private wealth presents for PE’s next round of growth, are investing in building out teams and designing frameworks that will enable retail investors to access PE exposure, but also manage the liquidity and timeline hurdles inherent in traditional PE fund structures.

In this piece, we examined the market forces behind the push to “democratize” PE and the focus of PE managers on raising more capital from individual investors and retirement plans. We also took a look at the historic challenges—both regulatory and operational—that have restricted PE managers from raising capital from retail investors, the structures developed to access this capital and how technology and evolving regulation could help PE managers open up their platforms to a wider retail investor base.