Ropes & Gray's Investment Management Update: April 2015 – May 2015

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

Registered Fund Adviser and Chief Compliance Officer Agree to Settle SEC Action Based on Inaccurate and Incomplete 15(c) Information

On April 21, 2015, the SEC settled an action brought against an investment adviser, Kornitzer Capital Management, Inc. ("KCM"), and Barry E. Koster ("Koster"), KCM's CFO and CCO, for allegedly furnishing inaccurate and incomplete information to the board of the Buffalo Funds in connection with the advisory contract renewal process conducted pursuant to Section 15(c) of the 1940 Act. The settlement order asserts that, in connection with the advisory contract review process, the Buffalo Funds' board requested an analysis of KCM's profitability in managing the Buffalo Funds, including an explanation of KCM's expense allocation methodology. In response to that request, Koster, acting on behalf of KCM, prepared and provided to the board the requested analysis and explanation of KCM's expense allocation methodology, which specifically represented that KCM allocated all employee compensation expenses to the Funds "based on estimated labor hours." In fact, the settlement order alleges that Koster adjusted the allocation of the compensation of KCM's CEO to the funds in a manner designed, in part, to achieve year-over-year consistency of KCM's reported profitability in managing the Buffalo Funds. Koster did not disclose this information to the board.

The SEC found that KCM's failure to disclose the allocation methodology was a violation of Section 15(c), and that Koster caused the violation by KCM. Without admitting or denying fault, KCM and Koster agreed to cease and desist from future violations of Section 15(c) and to pay to the SEC civil penalties of $50,000 and $25,000, respectively.

REGULATORY PRIORITIES CORNER

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

Petition for Rehearing in Northstar v. Schwab Denied by Ninth Circuit

In Northstar Financial Advisors Inc., v. Schwab Investments, the United States Court of Appeals for the Ninth Circuit recently ruled that three novel state law claims were validly pled by a plaintiff seeking to represent a class of mutual fund shareholders.1 The state law claims alleged in this case were based on theories of breach of contract against the fund, breach of fiduciary duty against the trustees and adviser, and breach of the investment advisory agreement against the adviser. The district court judge had previously dismissed the plaintiff's claims in a 2011 ruling. The Ninth Circuit's decision became final on April 28, 2015, when the defendants' motion for rehearing and for rehearing en banc was denied.

Supreme Court Widens SEC's Reinterpretive Reach

As a general matter, when a federal agency, including the SEC, first issues a rule interpreting one of its regulations, it is generally not required to follow the notice-and-comment rulemaking procedures under the federal Administrative Procedure Act ("APA"). In a March 9, 2015 decision, Perez v. Mortgage Bankers Association, the Supreme Court rejected the argument that an agency must use the APA's notice-and-comment procedures when it wishes to issue a new interpretation of a regulation that deviates significantly from one the agency has previously adopted. From time to time, the SEC issues interpretive guidance with respect to the rules it has promulgated. In view of the Mortgage Bankers decision, the SEC now has greater latitude in changing its prior interpretive guidance.

SEC's Risk Alert Regarding Never-Before-Examined Investment Company Initiative

On April 20, 2015, the SEC's Office of Compliance Inspections and Examinations ("OCIE") issued a National Exam Program Risk Alert to provide further information concerning...