By Yin Wilczek

The Securities and Exchange Commission Oct. 26 unanimously adopted a rule that will require hedge and other private fund advisers to report information—scaled to the size and types of funds—that will be used by the Financial Stability Oversight Council to assess systemic risk.

The final rule—a joint rulemaking by the SEC and the Commodity Futures Trading Commission—was substantially modified from a proposal issued in January (43 SRLR 198, 1/31/11) to ease the requirements for industry. The changes include higher reporting thresholds, less reporting detail, less frequent reports, and extension of compliance deadlines.

The CFTC is expected to consider adoption of the rule within the next week. The SEC will not post its adopting release or new Form PF—the form on which the systemic risk data is reported—unless and until the CFTC approves the rule.

Coordination, Consultation

In her opening remarks, SEC Chairman Mary Schapiro said the new rule and Form PF—for “private funds”—was the result of consultations with FSOC and international regulators, and input from industry participants. As a result, Form PF “will address the dramatic lack of private fund information available to regulators today while easing the burden on private fund managers producing the data, so that the same data collection approaches and protocols apply cross-border where appropriate,” she said.

The requirements for hedge and other private fund advisers to report systemic risk data and to register with the SEC were both mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Confidential Data

In recommending that the commission adopt the systemic risk reporting rule, Eileen Rominger, director of the SEC’s Division of Investment Management, stressed that the information provided will be kept confidential—a concern that many participants voiced. “Division staff is focused on helping design controls and systems for the use and handling of Form PF data in a manner that respects the sensitivity of this data, and is consistent with the enhanced protections established in the Dodd-Frank act,” she said.

Rominger added that two factors also should help reduce the sensitivity of the reported information. First, Form PF does not require the reporting of position-level data, she said. Second, most of the filing deadlines have been significantly extended…

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The Securities and Exchange Commission Aug. 31 voted unanimously to issue a concept release soliciting public comments on issues raised by mutual funds, exchange-traded funds, and other investment companies’ use of derivatives.

The comments received in response to the release will inform a study by staff in the SEC’s Division of Investment Management as to whether regulatory actions and guidance are warranted to update 1940 Investment Company Act provisions.

The SEC, at the same meeting, also unanimously agreed to issue an advance notice of proposed rulemaking to solicit comment on possible amendments to a rule that excludes certain asset-backed securities issuers from the definition of “investment company.” Moreover, it agreed to issue a concept release to seek comments on interpretive issues raised by a Company Act provision that excludes companies that acquire mortgages and mortgage-related instruments from the act’s requirements.

Staff Study

Significant losses in mutual funds during the financial crisis of 2008 and 2009 prompted a new focus by the SEC on derivatives and leverage. In March 2010, the SEC announced that staff would study the use of derivatives by ETFs and mutual funds given the questions surrounding the risks associated with the derivative instruments underlying many funds (42 SRLR 568, 3/29/10; 42 SRLR 621, 4/5/10).

When enacted in 1940, the Company Act—which imposes leverage, valuation, diversification, and industry concentration requirements for funds—did not contemplate the use of derivatives. The staff study, which is ongoing, potentially could result in regulatory changes or additional guidance to enhance the current framework. As part of the study, staff has suspended consideration of exemptive relief for exchange-traded funds that propose to invest significantly in derivatives.

At the meeting, SEC Chairman Mary Schapiro said that the commission’s approach to regulating fund use of derivatives has “developed on an ad hoc basis as new derivative instruments were introduced and new derivative hedging strategies gained popularity.”

“The current derivatives review gives us the opportunity to re-think our approach to regulating funds’ use of derivatives,” she continued. The input from commenters—especially those who use derivatives—would help the SEC to “get it right.”…

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An investment adviser that is a legally separate entity from the mutual fund that files an allegedly misleading prospectus cannot be held primarily liable in a private action under Securities and Exchange Commission Rule 10b-5 for “mak[ing]” a false statement, even if the adviser took part in drafting the challenged statement, the U.S. Supreme Court held by a 5–4 vote June 13 (Janus Capital Group Inc. v. First Derivative Traders, U.S., No. 09-525, 6/13/11).

In a decision that adhered to a narrow view of primary liability in a private 10b-5 suit, Justice Clarence Thomas wrote for the court, “For purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” Here, that entity was the mutual fund; there were no allegations that the adviser “in fact filed the prospectuses and falsely attributed them” to the mutual fund, he said.

Thomas asserted that the ruling “follows from” Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A., 511 U.S. 164 (1994), which held that “Rule 10b-5′s private right of action does not include suits against aiders and abettors.” The ruling “also accords with the narrow scope that we must give the implied private right of action” under Rule 10b-5, he added.

Attorneys for the defendants and a supporting amicus told BNA June 13 that the ruling is the “logical culmination” in a trilogy of cases beginning with Central Bank and ending here, and it “should be the third strike” for plaintiffs’ lawyers who have sought to expand the scope of Rule 10b-5 liability.

The author of a brief supporting the plaintiffs told BNA the court’s ruling could provide some bad actors a “road map” for committing fraud while insulating the perpetrators from liability.

Misleading Prospectus Alleged

In this case, investors in Janus Capital Group Inc. (JCG), creator of the Janus Investment Fund (the fund), alleged that the fund’s prospectus gave the “misleading impression” that JCG and its wholly owned subsidiary, Janus Capital Management LLC (JCM), the fund’s investment adviser and administrator, would take steps to curb “market timing” by investors in the fund. “Market timing” is a trading strategy that exploits time delay in mutual funds’ daily valuation, which usually occurs at the close of major U.S. markets. It is not illegal, but can harm other investors in the fund.

In a separate proceeding, the New York attorney general sued JCG and JCM, alleging that they entered into secret agreements to allow market timing in several funds run by JCM. When those charges became public, the fund lost value, and the stock price of JCG—which derived a significant part of its income from JCM’s management fees—dropped 25 percent.

The plaintiff JCG investors alleged that JCG and JCM “materially misled the investing public” and that class members had relied on the integrity of JCG’s market price. They sought damages against both entities under Section 10(b) of the 1934 Securities Exchange Act and Rule 10b-5, and against JCG as a “controlling person” under Section 20(a) of the 1934 Act for the acts of JCM.

The district court dismissed for failure to state a claim. The U.S. Court of Appeals for the Fourth Circuit reversed (41 SRLR 918, 5/18/09), finding that “JCG and JCM, by participating in the writing and dissemination of the prospectuses, made the misleading statements contained in the documents” (emphasis by the appeals court). It found the investor reliance element of Rule 10b-5 met with respect to JCM, because investors would infer that it had played a role in preparing or approving the prospectuses, but not with respect to JCG, which could be held liable only as a controlling person of JCM.

‘Ultimate Control’ Key

The Supreme Court reversed as to JCM, thus obviating any “controlling person” liability of JCG (the only form of liability that the investors continued to pursue against JCG). Rule 10b-5 makes it unlawful for “any person, directly or indirectly … [t]o make any untrue statement of a material fact” in connection with the purchase or sale of securities. “To be liable, therefore, JCM must have ‘made’ the material misrepresentations in the prospectuses,” the court said. “We hold that it did not.”…

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