Ropes & Gray’s Investment Management Update August-September 2019 – Wealth Management

Ropes & Gray’s Investment Management Update August-September 2019 – Wealth Management

To print this article, all you need is to be registered or login on

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

SEC Claims Adviser Failed to Disclose Conflicts Arising from
Revenue-Sharing Payments

On August 1, 2019, the SEC filed a complaint in the U.S. District Court for the
District of Massachusetts against Commonwealth Equity Services, LLC
(“CES”), alleging that CES had breached its fiduciary
duty to its advisory clients by failing to disclose its receipt of
certain revenue-sharing payments. The SEC alleged that CES relied
on a third-party broker, National Financial Services, LLC
(“NFS”), to serve as its clearing broker, to execute its
advisory clients’ orders and to maintain custody of the
investments held in the advisory clients’ accounts. NFS offered
a “no transaction fee” (“NTF”) program, through
which CES advisory clients could transact in fund shares without a
transaction fee. NFS also offered a “transaction fee”
(“TF”) program, through which CES advisory clients could
transact in shares from a different set of mutual funds and, for
which, NFS charged a transaction fee. Sponsors of mutual funds paid
NFS fees to make their funds available on the NTF platform, and NFS
paid CES a portion of these fees as revenue sharing (based upon CES
advisory clients’ investments in the mutual funds). NFS also
paid CES, as revenue sharing, a portion of the transaction fees
within the TF program that NFS charged CES’s advisory

According to the SEC’s complaint, CES disclosed in its Form
ADV that it received revenue-sharing payments with respect to
investments in mutual funds within the NTF program offered by NFS.
However, the SEC alleged, CES failed to disclose its conflicts of
interest arising from incentives to invest its advisory clients in
more expensive mutual funds and in more expensive share classes,
for which NFS made greater revenue-sharing payments. With respect
to the mutual fund transactions within the TF program, the SEC
alleged that CES failed to disclose to its advisory clients that it
received revenue-sharing payments from NFS.

The SEC alleged that (i) CES’s failure to disclose its
conflicts of interest constituted a negligent breach of its
fiduciary duty to its advisory clients in violation of Section
206(2) of the Advisers Act and (ii) by failing to adopt and to
implement reasonably designed written policies and procedures for
identifying and disclosing these conflicts of interest, CES
violated Section 206(4) of the Advisers Act and Rule 206(4)-7

In CES’s answer to the SEC complaint, CES offered a
range of affirmative defenses. CES asserted that the SEC complaint
failed to allege facts showing that CES’s disclosure was
insufficient. According to CES, while the level of detail in
CES’s disclosure regarding its receipt of revenue-sharing
payments expanded over time, the conflict disclosures were at all
times sufficient and appropriate when made. In addition, CES
asserted that the SEC’s claim – that CES had an
obligation to make more specific disclosures regarding particular
aspects of its receipt of revenue-sharing payments – deprived
CES of fair notice under the Due Process Clause. CES maintained
that the SEC could have imposed such a requirement by formal
rulemaking under the Administrative Procedures Act, but the SEC had
not done so. According to CES, the SEC “cannot fill this void
by bringing fraud charges to retroactively impose uncabined duties
to disclose particular line items that ex post appear to
be sound.” CES also asserted several other defenses, including
that the SEC’s new claims should be barred by an earlier
settlement reached between the parties.

Observations: In its complaint, the SEC claimed
that CES’s disclosures were insufficient because CES described
its conflicts of interest as merely potential and acknowledged only
that it “may” have incentives to select more expensive
investments based on its compensation, while CES had an
actual conflict that did create the incentives. This claim
echoes the SEC’s recent statement in its June 2019 release,
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers
(the “Conduct

To illustrate what constitutes full and fair disclosure, we are
providing the following guidance on . . . the appropriate level of
specificity, including the appropriateness of stating that an
adviser “may” have a conflict . . . [D]isclosure that an
adviser “may” have a particular conflict, without more,
is not adequate when the conflict actually exists.1

CES asserts that its conflicts disclosure during the relevant
period tracked long-standing industry practice, and that the SEC is
unfairly imposing a new “informed consent” disclosure
standard after-the-fact via enforcement action. This position finds
support in the public statements of at least one commissioner. At
the April 2018 meeting at which the SEC proposed the Conduct
Interpretation, Commissioner Peirce stated that “the proposed
interpretation makes new law . . . The informed consent requirement
is new; the only Commission basis is a mention in an instruction to
Form ADV.”2

Indeed, prior statements about the adequacy of conflicts
disclosure have not addressed such “may” language or
suggested it was inadequate.3 Whether an adviser has
provided full and fair disclosure has focused on disclosure of
material facts, assessed in the total mix of
information.4 To underscore this point, in the
disclosure context, federal courts have dismissed assertions of a
difference between “will” and “may” as a
“semantic quibble” and not, by itself, a material

CES’s defense that the SEC seeks unlawfully to apply
retroactively a new test regarding the adequacy of disclosure is
worth close attention. We will continue to monitor the SEC v.
Commonwealth Equity Services
litigation closely.

DRAO Issues Two Accounting and Disclosure Information

On September 9, 2019, the Division of Investment
Management’s Disclosure Review and Accounting Office
(“DRAO”) issued ADI 2019-08, Improving Principal Risks
(“ADI 2019-08”) describing certain
shortcomings observed by the SEC staff in disclosures of principal
risks in mutual fund summary prospectuses. Among other things, ADI
2019-08 encouraged funds to list their principal risks in order of
importance and stated that funds that, instead, list their
principal risks alphabetically “could obscure the
importance of these key risks.” The staff recognized that
listing principal risks based on importance “requires
subjective determinations.” Therefore, the staff stated, funds
were best positioned to make “these judgments of relative
importance” and, in general, the staff would not comment when
a fund ordered its principal risks by importance.

Note: ADI 2019-08 did not
acknowledge that Form N-1A merely requires a fund to
“summarize the principal risks of investing in the
[f]und” and contains no obligation to list principal risks in
any particular order. The tenor of DRAO’s observations
regarding the order in which principal risks are listed is
consistent with comments that the SEC disclosure staff has been
giving to registered funds and an October 2018 speech by Dalia Blass, Director of the Division
of Investment Management.

In addition, ADI 2019-08:

  • Observed that some fund groups do not
    tailor their principal risk disclosure for each fund within the
    fund group but, instead, rely on “generic, standardized, risk
    disclosures across funds.”

  • Encouraged funds to consider
    disclosing that a fund may be inappropriate for certain types of

On October 2, 2019, DRAO issued ADI 2019-09, Performance and Fee
, describing shortcomings observed by the SEC staff
regarding disclosure of fund performance and fee information. The
shortcomings, among others, included funds that fail to (i) reflect
sales loads in their average annual return tables, (ii) disclose
acquired fund fees and expenses appropriately and (iii) tag their
risk/return summaries in XBRL.


The following brief updates exemplify trends and areas of
current focus of relevant regulatory authorities:

SEC Issues Risk Alert on Principal and Agency Cross Trading
Compliance Issues

On September 4, 2019, the SEC’s Office of Compliance
Inspections and Examinations (“OCIE”) issued a Risk Alert (the “Alert”) summarizing
the most common issues identified by OCIE staff concerning
investment advisers’ compliance with Section 206(3) of the
Advisers Act and Rule 206(3)-2 thereunder, which regulate
securities transactions between an investment adviser, acting as
principal or as agent, and its advisory clients. For example, the
Alert notes that OCIE staff had observed advisers effect principal
transactions between advisory clients and an affiliated pooled
investment vehicle, where the adviser failed to recognize that the
adviser’s greater-than-25% ownership of the pooled investment
vehicle would subject the transactions to Section 206(3)
(referencing the Gardner Russo & Gardner no-action letter). The
Alert does not address principal and agency cross transactions with
a registered fund under Sections 17(a) and 17(e) of the 1940

SEC Settles Enforcement Matter with Mutual Fund Advisers
Concerning Disclosure of Securities Lending Practices

On September 16, 2019, the SEC issued an Order in settlement of proceedings brought
against two investment adviser subsidiaries of an insurance company
in which the SEC asserted that the advisers’ securities lending
activities violated provisions of the Advisers Act. The SEC’s
allegations arose from two practices by the advisers that occurred
after the funds were reorganized in 2006 and converted, for federal
tax purposes, from regulated investment companies to partnerships.
The purpose of the reorganizations and changes in tax status was to
provide the parent insurance company with tax benefits under the
federal dividends received deduction (“DRD”) for
dividends received on securities held by the funds.

According to the Order, the reorganizations and actions by the
advisers and other subsidiaries of the insurance company parent
harmed the funds in two ways. First, the Order stated that the
funds’ affiliated administrator temporarily recalled securities
that the funds had out on loan in advance of the securities’
dividend record dates for the purpose of increasing the parent
company’s DRD on those shares. Recalling the securities
allegedly caused the funds to forego securities lending revenue and
investment income they otherwise would have earned had the
administrator not recalled the securities. The Order stated that
the advisers did not disclose to the funds’ boards the conflict
of interest between the insurance company and the funds in
connection with the securities recalls. Second, the Order stated
that the fund reorganizations subjected the funds to less favorable
tax treatment in certain foreign jurisdictions, and the insurance
company parent failed to reimburse the funds in a timely manner for
this less favorable tax treatment, despite assurances by the
advisers to the funds’ boards that the insurance company would
do so.

Solely for the purpose of the SEC proceedings, and without
admitting or denying the SEC’s allegations in the Order, the
advisers agreed to disgorge $27.6 million and to pay a civil money
penalty of $5 million.

SEC Settles Two Enforcement Matters with Advisers Concerning
Proxy Voting

On September 27, 2019, the SEC issued two similar orders in
settlement of unrelated proceedings brought against two investment
advisers. In the first order, the SEC alleged that Amadeus
Wealth Advisors, LLC (“Amadeus”) voted proxies with
respect to client securities in multiple client accounts,
notwithstanding the fact that Amadeus’ Form ADV and advisory
agreements represented that Amadeus did not accept proxy voting
authority over client securities. In the second order, the SEC similarly alleged that
Three Bridge Wealth Advisors, LLC (“Three Bridge”) voted
proxies for its client securities, notwithstanding the fact that
Three Bridge represented in its Form ADV and advisory agreements
that it did not accept proxy voting authority for client

Note: In the SEC’s recent
Commission Guidance Regarding Proxy Voting
Responsibilities of Investment Advisers
(the “IA
Release”), the SEC stated that “the adviser and its
client may shape that relationship by agreement, provided that
there is full and fair disclosure and informed consent.”
Therefore, according to the IA Release, an adviser and its client
(subject to the persistent conditions of full and fair disclosure
and informed consent) are free to define the scope of the proxy
voting arrangements. These two enforcement matters underscore that
the SEC is serious about holding an adviser to the bargain struck
with clients concerning proxy voting.

IRS PLR May Enhance Marketability of Some Annuities

On August 26, 2019, Allianz Life Insurance Company of North
America (“Allianz”) announced that it had received a favorable
private letter ruling (“PLR”) from the Internal Revenue
Service concerning the federal tax treatment of advisory fees taken
from non-qualified, fee-based annuities. According to the Allianz
announcement, the PLR will permit the payment of advisory fees from
fixed-index or variable nonqualified annuities (i.e., sold
outside a retirement account such as an IRA) without creating a
taxable distribution event. Therefore, the Allianz PLR, which is
similar to an August 6, 2019 PLR received by Nationwide, should
enhance the marketability of these products by fee-based


Since the last issue of our Investment Management Update, we
have also published the following separate Alerts and podcasts of
interest to the investment management industry:

2019 Final ETF Rulemaking – Summary and Analysis

October 15, 2019

The SEC recently adopted a final ETF rule, largely in the form
proposed in June of 2018, but with several important changes in
response to industry.

Credit Funds Report – The Road Ahead: Driving Success in

October 3, 2019

The private credit industry grew by leaps and bounds over the
past decade: AUM jumped to $769 billion as of June 2018, from $275
billion in 2009. In this thought leadership report, Ropes &
Gray collected five articles from members of the firm’s credit
funds team that highlight key issues in the formation and operation
of credit funds. These articles touch on the conflicts inherent in
managing both credit and PE funds, the prevalence of key person
terms, the intricacies of BDC regulation and value-based payment
arrangements in the health care industry, and the potential
changing landscape of foreign credit support.

Flash Analysis: The Final ETF Rule

September 27, 2019

On September 26, 2019, the SEC announced that it had unanimously
adopted Rule 6c-11 (the “ETF Rule”). The ETF Rule was
adopted largely in the form proposed on June 28, 2018, but with
several important changes in response to comments, including the
elimination of the requirements (i) to publish the ETF’s
portfolio holdings prior to the acceptance of a creation or
redemption order for that day, (ii) to include historical bid-ask
spread information in an ETF’s registration statement, and
(iii) to make an interactive bid-ask spread calculator available on
the ETF’s website. At the same time, the SEC issued an
exemptive order providing relief from certain rules under the
Securities Exchange Act of 1934 (“Exchange Act”). The
Exchange Act order may reduce regulatory complexity and eliminate
inconsistencies applicable to most newly launched ETFs by
eliminating the need for those ETFs to comply with the conditions
of certain “class relief” letters.

Whitepaper: Retail Investments in Private Funds: Regulatory
Obstacles and Opportunities

September 24, 2019

Over the past several years, regulators and market participants
increasingly have called for the expansion of investment
opportunities for retail investors and retirees. In this
whitepaper, Ropes & Gray surveys the regulatory obstacles under
the federal securities laws and ERISA that currently limit retail
access to private funds, discusses the rationale for expanding
retail access to private funds, and describes several potential
models for doing so.

Podcast: Fund Subscription Facilities: Key Considerations for
Limited Partners

September 24, 2019

In this Ropes & Gray podcast, asset management partner
Isabel Dische and finance partner Patricia Lynch dove into the use
of capital call facilities by private investment funds.
Specifically, they went into detail on some of the pros and cons
for limited partners of such subscription facilities, recent ILPA
guidelines relating to their use, the market response to the ILPA
guidelines, and their predictions for the future of the market
following the adoption of these ILPA guidelines.

Podcast: Asset Management Regulatory Update: Reg BI, Form CRS, and
SEC’s Fiduciary Duty Interpretation

September 19, 2019

In this Ropes & Gray podcast, asset management counsels
Brynn Rail and David Tittsworth discussed the SEC’s new rules
and interpretations that deal with standards of conduct for brokers
and investment advisers. Specifically, they covered the topics of
Regulation Best Interest (Reg BI), Form Customer Relationship
Summary (Form CRS), and the SEC’s fiduciary duty interpretation
under the Advisers Act.

Second Circuit Affirms Dismissal of Mutual Fund Class Action,
Applies SEC Guidance on Industry Concentration

September 11, 2019

In a decision ratifying the mutual fund industry’s
long-standing treatment of portfolio concentration, the U.S. Court
of Appeals for the Second Circuit affirmed the dismissal of a
putative class action against the Sequoia Fund on September 9. In
Edwards v. Sequoia Fund, Inc., the shareholder-plaintiffs
alleged that the Fund violated its industry concentration policy
when healthcare stocks grew to comprise more than 25% of the
Fund’s assets in 2015, due to strong growth in the value of its
holdings in Valeant Pharmaceuticals, Inc. The Fund’s healthcare
position grew to more than 25% due solely to increases in
Valeant’s share price, not because of any additional share
purchases. Applying SEC guidance from 1983, the Second Circuit
affirmed the trial court’s holding that such
“passive” increases in concentration cannot constitute a
policy violation, defeating the plaintiffs’ claims. The Fund is
represented by a Ropes & Gray litigation team.

Podcast: Federal Court Rejects Mutual Fund Fee Claims and
Recognizes Market Realities

September 4, 2019

In this Ropes & Gray podcast, litigation & enforcement
partners Amy Roy and Rob Skinner discussed the recent decision of a
federal court in Los Angeles, rejecting claims of allegedly
excessive mutual fund advisory fees against Metropolitan West Asset
Management. They discussed the key arguments raised in the trial
over the claims, and the evidence relied upon by the court in
finding in MetWest’s favor across the board.

SEC Issues Guidance to Clarify Investment Advisers’ Proxy
Voting Responsibilities and the Treatment of Proxy Advice Under the
Proxy Rules

August 29, 2019

On August 21, 2019, the SEC published two releases: Commission
Guidance Regarding Proxy Voting Responsibilities of Investment
Advisers (the “IA Release”) and Commission Interpretation
and Guidance Regarding the Applicability of the Proxy Rules (the
“Proxy Release”). The releases were adopted in separate
3-2 votes, with Chairman Clayton and Republican Commissioners
Peirce and Roisman forming the majority in both instances and
Democratic Commissioners Jackson and Lee dissenting.

After years of debate, the IA Release and the Proxy Release
represent a step towards greater SEC oversight of proxy advisory
firms (each, a “Proxy Adviser”) and investment
advisers’ reliance on Proxy Advisers. The oversight comes not
by increased regulation of the Proxy Advisers themselves, but by
providing detailed guidance to (and, thereby, possibly increasing
the burdens on) investment advisers on how to monitor the advice
they receive.


1.Rel. No. IA-5248 (June 5, 2019).

2.Statement at the Open Meeting on Standards of Conduct
for Investment Professionals, Comm. Hester M. Peirce (Apr. 18,
2018) available at

3.See Amendments to Form ADV, Rel. No. IA-3060,
(Jul. 28, 2010) (“An adviser must deal fairly with clients and
prospective clients, seek to avoid conflicts with its clients and,
at a minimum, make full disclosure of any material conflict or
potential conflict.”); SEC v. Capital Gains Research
Bureau, Inc.
, 375 U.S. 180, 194 (1963) (“Courts have
imposed on a fiduciary an affirmative duty of ‘utmost good
faith, and full and fair disclosure of all material

4.See Amendments to Form ADV, supra, at note

The standard of materiality under the Advisers Act is
whether there is a substantial likelihood that a reasonable
investor (here, client) would have considered the information
important. See SEC v. Steadman, 967 F.2d 636, 643 (D.C.
Cir. 1992). Cf. Basic Inc. v. Levinson, 485 U.S. 224,
231-232 (1988); TSC Industries v. Northway, Inc., 426 U.S.
438, 445, 449 (1976). This is a facts and circumstances test,
requiring an assessment of the ‘total mix of information,’
in the characterization of the Supreme Court.

5.See Benzon v. Morgan Stanley Distributors,
, 420 F.3d 598, 612 (6th Cir. 2005); Lubbers v.
Flagstar Bancorp Inc.
, 162 F. Supp.3d 571, 581 (E.D. Mich.
2016); In re AIG Advisor Group Sec. Litig., 2007 WL
1213395 at n.15 (E.D.N.Y.); In re RAC Mortgage Investment Corp.
Sec. Litig.
, 765 F. Supp. 860, 864 (D. Md. 1991).

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

I'm business helper , i have 20 year experience in business management sector. I help many business owners to grow business. My passion is helping fellow entrepreneurs and small business owners succeed.

Leave a Reply

Your email address will not be published. Required fields are marked *