Risk & Reward

Coronavirus and Cancellations: What Your Organization Should Know

There are many questions about the novel COVID-19 virus still being answered. Amid issues of general health and safety, many of our clients are facing tough decisions about their regularly held events, which are often essential parts of a nonprofit organization’s mission and services. Whether your organization puts on association member meetings, trade shows, educational conferences or other events where large groups meet, you may be facing difficult decisions about whether to hold the event and what consequences to expect if you cancel.

Cancellation Clauses: What happens if we cancel our event?
Most contracts provide for an orderly way of canceling them in the event circumstances change. However, because a hotel or resort relies on income scheduled from these events, there is usually a cost associated with cancellations. These costs will escalate as the event date gets closer and it becomes harder for the venue to replace your event with other paying customers. Escalating cancellation clauses provide for a stepped increase of costs, often described as liquidated damages that will be due upon cancellation. These increase at increments and vary from one contract to another. Another option within the contract may be a clause governing attrition rates for room revenue, space rentals, and food and beverage guaranteed minimum purchases. A good first step to getting a handle on the consequences of cancellation is to identify potential costs based on the liquidated damages or attrition percentages, keeping in mind any dates on which those damages and percentages increase.

Force Majeure: Can’t we avoid liability if the cancellation is for circumstances beyond our control?
It’s likely the contract also includes terms under which the contract can be canceled without incurring the liquidated damages or attrition percentage amounts. Often this is termed a force majeure clause, although some contracts provide for similar terms under sections addressing performance, frustration or impossibility of completing the contract bargain. The purpose is to allow the parties to exit a contract without penalty where the purpose of the contract has been thwarted by circumstances that were not foreseeable by either of the parties at the time the contract was made. The terms here are contract-specific, so it’s important to read them closely; the same COVID-19-caused cancellation may have different effects on whether you can cancel the contract without damages depending on how this clause is phrased. These are the key items to look for:

  • Does the force majeure clause list circumstances that trigger it in an exhaustive way (it lists only those events to which it applies) or in a non-exhaustive way (it gives examples of what events would qualify but leaves room for other events)?
  • In the case of COVID-19, is there a specific allowance for epidemic/pandemic events or public health emergencies?
  • Is there an option for curtailment of transportation that might apply even if the specific location of the event is not placed off-limits by public health or local government officials? A widespread suspension of travel at the federal level or among significant private transportation carriers could have a similar effect.
  • Does any non-performance clause require a certain level of attrition among your attendees in order to apply? Some hotel contracts require 30% to 50% of your attendees are unable to arrive at the location in order for force majeure circumstances to apply.
  • What notice requirements are there to exercise this option? Many contracts request notice as soon as reasonably possible or within 10 days of the force majeure event. Successfully using this provision will mean making sure you comply with the notice requirements.

Insurance Options: How are we going to cover the losses from a cancellation?
For many conferences, conventions and trade shows, the best option is to have event cancellation insurance coverage in place. If you purchased this coverage, check the requirements of your coverage to ensure your event is covered for this purpose. And make sure to put your insurance carrier on notice as soon as it becomes clear the event will need to be canceled and comply with any requirements or limits.

If you do not have event cancellation insurance coverage in place, your general business liability insurance is the next place to turn. In a few cases, there is coverage for events beyond normal business operations, but these are not common. If your event is actually a regular part of your business operations, it is possible that coverage for business income loss would apply. However, that is the exception rather than the norm for most nonprofit organizations with annual events, and frequently, business income loss coverage is strictly tied to the geographic location of the regular business location of the company.

As a final fallback to limit damages and recover costs, you can also approach the venue to open a discussion of other options. A hotel, resort, or event space may be willing to come up with a way to work around the damages, such as by postponing the event, providing a future credit, or waiving some of the damages based on your relationship where there may be a history of events held by your organization at this location.

Factors Influencing Decisions: How can we decide when the situation is evolving daily?
As you consider whether to hold or cancel an event, the following list of questions may help you come to a decision that’s driven by facts and not fears.

How close to the dates of the event is it? If the event isn’t for three to six months, circumstances may have changed drastically by then. Consider whether you can wait a bit longer for more information or need to make a decision now.

  • Does your venue (hotel, restaurant, resort, meeting center, etc.) have an escalating cancellation clause? If so, what are the key dates at which damages will increase? This may alter your thinking on the question above if you are leaning toward canceling.
  • Where will the event be held? It’s unlikely that any area of the country will be entirely free of COVID-19 cases, but some regions will be more affected than others — either in the incidence of infection or in a locality’s ability to deal with the health crisis.
  • Are your event sponsors (funding the event) and speakers (providing the substance) going to be able to attend the event? This is particularly important if their respective companies are restricting travel or if their own business (for example, medical staff) will need to divert its staffing resources to other areas.
  • Are attendees actively canceling their participation, or are they looking to the event planners to make the decision before they respond?
  • If you go forward with the event, what precautions will be taken at the event location, and are there others you should consider adding? Additionally, how can you best communicate this decision to your members?
  • Can you use technology to continue the event in a modified form? For example, speakers who can’t travel could provide their talks by videoconference, attendees who have corporate travel restrictions can attend virtually, etc. This may not help with attrition costs for room revenue or food and beverage minimum guaranteed sales, but it would at least allow you and your members to have some of the benefits of the gathering.
  • Do you have event cancellation insurance coverage to recoup costs? Is there any chance your business liability policy could cover some or all of the event under business income losses? While cost recovery takes a backseat to health and safety, knowing your potential loss and possible recovery may help when it is a close call.

We will continue to monitor the situation for our clients and advise on this and other legal issues related to COVID-19. While a special event is its own circumstance, we are also advising on employment practices, insurance coverage, and other workplace and business issues being created by the uncertainty surrounding this public health crisis.

ERISA Excerpt: COVID-19 Checklist & Considerations for Private Fund Advisers

ERISA excerpt from yesterday’s blog post, COVID-19 Checklist & Considerations for Private Fund Advisers:

  • Non-ERISA Funds. Private funds that are structured to avoid being subject to the U.S. Employee Retirement Income Security Act of 1974 (ERISA) by reason of the significant participation/25% exception should carefully monitor to ensure that redemptions out of a fund do not result in “benefit plan investors” (i.e., ERISA plans, individual retirement accounts, and “plan assets” fund-of-funds, etc.) holding 25% or more of any equity class of the fund. For a description of the significant participation test, please see our recent client alert here.
    • The fund sponsor/manager may have contractually committed to preventing the fund from holding “plan assets,” in which case it should refer to, and comply, with such commitments. Amendments to these terms will likely require consent of the ERISA plan, and even potentially governmental plan, investors.
    • If redemptions inadvertently cause the fund to hold “plan assets,” the sponsor/manager may face significant obstacles in terms of ERISA compliance. For example, special care should be taken where the investment manager is newly formed, where a performance fee is paid to the investment manager, and/or where the investment manager enters into transactions with affiliates.
  • ERISA Funds. Sponsors and managers of funds that are structured to operate as “plan assets” vehicles, and, therefore, comply with ERISA, will likely be relying upon the QPAM Exemption. The QPAM Exemption contains multiple technical conditions, some of which may be stressed in volatile times. For example, the QPAM Exemption would not cover transactions otherwise consummated by the investment manager on behalf of the fund if one or more investing plans of an employer (or affiliates of the employer) constitute more than 20% of the total client assets (e., inside and outside of the fund) managed by the investment manager at the time of the transaction. Investment managers that lose numerous, or particularly important, clients could potentially run afoul of this condition, which would mean they would have to rely on some alternative exemption, such as Section 408(b)(17) of ERISA, for its trading. Finally, in terms of significant volatility of pricing, investment managers operating ERISA “plan assets” funds should be careful about using their own valuation methodologies of fund holdings so as to avoid potential self-dealing concerns.

COVID-19 Checklist & Considerations for Private Fund Advisers

With COVID-19 concerns and market volatility, advisers should consider compliance challenges that are likely to arise. This COVID-19 Checklist & Considerations for Private Fund Advisers highlights key compliance issues, questions and considerations with respect to the COVID-19 outbreak and government response. Please note that if an adviser does not document its compliance efforts, the Securities and Exchange Commission (SEC) will assume that such efforts did not occur. This checklist is not exhaustive and does not, for example, cover Commodity Futures Trading Commission considerations, which are discussed in a separate client alert.

Authors:
Nicole Kalajian – Counsel, Chicago
John Hamilton – Counsel, New York
Prufesh Modhera – Chair, Private Funds Group, Washington, DC
Sara Crovitz – Partner, Washington, DC
George Michael Gerstein – Co-Chair, Fiduciary Governance Group, Washington, DC

COVID-19 Coverage: Part 3 of 1940 Act Issues to Consider During the Pandemic

Stradley’s Coronavirus Task Force will be updating this high-level overview of coronavirus disease 2019 (COVID-19) related issues for registered investment companies and fund managers as developments warrant.

NEW ISSUES:

  • State and Local Closures: Several states, counties and cities (e.g., California, Pennsylvania, New York and Illinois) have announced business closures in connection with “shelter-in-place” public health efforts to slow the spread of COVID-19. Some of the orders may contain broad exceptions for the financial services industry, while others may not. Beyond the direct impact on firms in those localities, review the location of service providers and the terms of these orders carefully to determine whether necessary support functions will remain available. (New 3/23/2020)
  • Transfer Agents: The SEC provided a broad exemption for the period from March 16 to May 30 from requirements applicable to transfer agents except for the safeguarding requirement. Transfer agents relying on the relief must provide notice to the SEC by May 30. The SEC encourages transfer agents and the issuers for whom they act to inform affected security holders. (New 3/23/2020)
  • Tax implications for funds with institutional shareholders: For institutional funds with few shareholders, beware that the fund could fall into personal holding company status if at any time during the last half of the taxable year more than 50 percent in value of the fund’s shares are owned, directly or indirectly, by or for not more than 5 “individuals.” For purposes of this rule, employee pension trusts, private foundations, trusts forming part of a plan providing for the payment of supplemental unemployment compensation benefits, and a trust, a portion of which is permanently set aside or to be used exclusively for charitable purposes, are considered individuals. (New 3/23/2020)

UPDATED ISSUES:

  • Market closures and market restrictions: A list of securities market closures and market restrictions is available here(Updated 3/23/2020)
  • Money Market Mutual Funds:
    • Form N-CR: Several money market funds have filed on Form N-CR to report financial support, and one money market fund has filed on Form N-CR to report a downward deviation of its shadow price by more than ¼ of 1 percent. An amended report is required to be filed within four business days of the provision of financial support or downward deviation that describes the reason for the support and terms of the support or the reason for the deviation, as applicable.
    • Purchases by Affiliated BanksThe Federal Reserve Board has issued a template exemptive letter allowing banks to purchase assets from affiliated money market funds, subject to certain conditions, including that the assets must be investment grade and purchased at fair market value.1 In addition, the SEC staff has granted no-action relief to permit certain bank affiliates of money market funds to purchase securities from the funds in accordance with the Federal Reserve Board guidance, but otherwise pursuant to rule 17a-9, subject to certain conditions.2 The SEC no-action letter does not affect the ability of other money market fund affiliates to purchase assets from the fund in accordance with rule 17a-9.
    • Liquidity Facility: The Federal Reserve Board has announced a Money Market Mutual Fund Liquidity Facility (MMLF) that is intended to assist money market funds in meeting demands for redemptions.Under the MMLF, the Federal Reserve Bank of Boston will lend to depository institutions and bank holding companies, taking as collateral assets purchased by the borrower from prime money market funds (i) concurrently with the borrowing or (ii) or on or after March 18, but before the opening of the facility. The facility is similar to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility that operated from late 2008 to early 2010 but will purchase a broader range of assets. The Federal Reserve Board expanded the facility to cover certain assets purchased from tax-exempt municipal money market funds.4 The Federal Reserve Board has announced that the facility will open today, March 23, and full documentation and additional guidance are now available.5
    • Guaranty: In addition, there are proposed congressional actions that would temporarily permit the use of the Exchange Stabilization Fund to guarantee money market funds. The Exchange Stabilization Fund was used for this purpose in 2008, but current law prohibits its use for the establishment of any future guaranty programs for the United States money market fund industry, so this would require legislation. See 12 U.S.C. § 5236. (Updated 3/23/2020)
  • Exchange-traded funds: For an ETF that invests in foreign markets that close, the ETF may wish to consider whether to invest in alternative instruments, such as ADRs, in order to achieve the desired exposure to the foreign securities. In circumstances where there is no ability to make additional investments in appropriate alternative instruments, an ETF may wish to stop accepting creation unit purchases. The Commission previously has noted that ETFs generally may suspend the issuance of creation units only for a limited time and only due to extraordinary circumstances, such as when the markets on which the ETF’s portfolio holdings are traded are closed for a limited period of time.ETF issuers should be aware that any decision to suspend creations could have an impact on the arbitrage efficiency of the ETF and could lead to greater deviations between the market price of the ETF shares and the NAV of the shares. Like other open-end funds, ETFs cannot suspend redemptions unless the New York Stock Exchange is closed or there is appropriate guidance from the SEC. ETFs are permitted to charge transaction fees of up to 2% on redemptions. Such fees are designed to offset the costs of redemptions to the ETF. Some fixed-income ETFs that deliver cash redemptions instead of in-kind redemptions reportedly have increased their transaction fees on redemptions in light of increased transaction costs in the bond market. (Updated 3/23/2020)
  • CPO NFA Filings: The CFTC staff has provided no-action relief to commodity pool operators that extends certain filing deadlines.7 With respect to Form CPO-PQR filings under CFTC Regulation 4.27, Small and Mid-Sized CPOs have until May 15, 2020 to submit their annual filings for 2019, while Large CPOs have until July 15, 2020 to submit their filings for Q1 2020. For pool annual reports under CFTC Regulations 4.7(b)(3) or 4.22(c) that are due on or before April 30, 2020, the deadline for filing and distributing the report, which must include certified financial statements, has been extended until 45 days after the due date specified in the regulations. For monthly or quarterly reports to pool participants under CFTC Regulation 4.7(b)(2) or 4.22(b) for all reporting periods ending on or before April 30, 2020, the deadline for distribution to participants has been extended to 45 days after the end of the reporting period (instead of 30 days as stated in the regulations). The National Futures Association has issued similar relief for CPO Members and has provided commodity trading advisor Members with similar relief for NFA Form PR filings.8 (Updated 3/23/2020)

ISSUES:

  • Liquidity risk management: Current developments raise a number of issues for the management of funds’ liquidity risk:
    • Assessment, management, and periodic review of liquidity risk: Funds should review fund liquidity risk in light of current and reasonably expected market events and redemption patterns and may need to consider appropriate mitigating steps for strengthening the fund’s ability to meet redemptions, including readying borrowing and other liquidity facilities.
    • Classification of portfolio investments: Rule 22e-4 requires funds to review their portfolio investments’ liquidity classifications more frequently than monthly if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect classifications. Such reviews should focus especially on holdings that could be considered illiquid investments as a result of these developments or that could fall out of highly liquid investment status. An important consideration will be a review of the reasonably anticipated trading sizes in light of redemption expectations. Funds should be alert to the possibility that vendor classifications may be based on historical rather than current data.
    • Highly liquid investment minimum: For funds that currently hold primarily highly liquid assets, and therefore are not required to have an HLIM, the program administrator may need to examine whether the fund can still qualify for that status. For HLIM funds, the HLIM may need to be reviewed under the required factors in light of current market and redemption developments and, if a shortfall is reasonably anticipated, a shortfall response plan should be developed, which must include a plan for reporting shortfalls to the fund’s board.
    • Illiquid investments: During this period of extreme market volatility, the fund should monitor closely whether there is a need to reclassify holdings as illiquid investments. Funds should be prepared to file Form N-LIQUID if the fund’s illiquid assets exceed 15% of its net assets. The program administrator should have guidance designed to prevent purchases that would violate the prohibition on acquiring illiquid investments when over the 15% limit. We do not yet know if the SEC will provide guidance relieving funds from filing Form N-LIQUID in the event of foreign or other market closings that are beyond the scope of existing guidance on extended foreign holidays.
    • Redemptions in kind: Funds may wish to consider whether redemptions in kind would be an appropriate tool for large redemption requests, including whether operational logistics are in place to accommodate any such redemption requests. (Updated 3/19/2020)
  • SEC Filings: The SEC’s 1940 Act Order (cited below) provides relief from the timeliness requirements of Form N-CEN, Form N-PORT, and Form N-23C-2 when a fund is unable to meet a deadline due to circumstances related to current or potential effects of COVID-19. The relief for Forms N-CEN and N-PORT applies to filing obligations for which the original due date is on or after March 13 but on or prior to April 30, 2020, while the relief for Form N-23C-2 extends to June 15, 2020. A separate order under the Investment Advisers Act of 1940 provides timeliness relief for Form ADV and Form PF filings and for Form ADV Part 2 client delivery obligations, when the original due date is on or after March 13 but on or prior to April 30, 2020,9 and the SEC has posted staff guidance that Form ADV does not have to be updated to reflect temporary teleworking locations.10 The SEC previously provided relief from timeliness requirements for certain filings under the Securities Exchange Act of 1934.11 Note that filings not covered by the orders continue to be required on a timely basis, including filings on Form N-LIQUID, Form N-CR, and Form N-MFP, although it is possible that the SEC will consider issues with these forms on an individualized basis. The SEC provided information on contacting the staff with issues, including issues with these filings, in a press release announcing the actions.12 (Updated 3/19/2020)
  • Form CRS: We understand that the SEC staff is considering whether brokers and advisers should be given relief from the Form CRS deadline. Unless such relief is given, compliance with the Form CRS requirement will be required as of June 30, 2020. (New 3/19/2020)
  • SEC Comment Periods: The SEC has issued a statement noting that the Commission and staff have historically considered comments submitted after a comment period closes but before adoption of a final rule or order.13 For certain pending rule proposals, including proposals concerning auditor independence, the accredited investor definition, and fund investments in derivatives, the SEC stated that it will not take final action before April 24 in order to allow commenters additional time if needed. (New 3/19/2020)
  • MiFID II Reporting: Under the MiFID II delegated regulation, investment firms providing the service of portfolio management and subject to MiFID II must inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10% and thereafter at multiples of 10%, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next business day.14 (New 3/19/2020)
  • Fund Boards: Fund directors should stay up to speed on current market events so they can properly apply their business judgment as necessary from a governance standpoint. In many cases, fund boards are receiving periodic status reports or attending status updates from fund advisers. Examples of areas for directors to consider include, for funds, fund flows, liquidity levels, valuation, and performance; and for fund advisers, status of operations under business continuity plans, market assessments, and the assessment of critical fund service providers. Board reporting from fund advisers is particularly important during times of market stress. To strike an appropriate balance between staying apprised and being efficient and respectful of fund advisory personnel time, boards may seek to channel questions or communications through independent counsel or the board chair/lead independent director. (New 3/19/2020)
  • In-person board meetings: On March 13, the SEC issued an order under the Investment Company Act of 1940 (“1940 Act Order”), allowing fund boards to meet telephonically or by video conference to consider and vote on matters that would otherwise require an in-person vote.15 The relief applies whenever reliance upon it is necessary or appropriate due to circumstances related to current or potential effects of COVID-19 and is available until June 15, 2020. The SEC’s Division of Investment Management previously provided no-action relief for the period from March 4 to June 15.16
  • Delivery of prospectuses and shareholder reports: The 1940 Act Order also provides relief from the obligations to timely transmit annual and semiannual reports to shareholders and to file them with the SEC. The relief applies when the original due date is on or after March 13 but on or prior to April 30, 2020, and the fund is unable to prepare or transmit the report due to circumstances related to current or potential effects of COVID-19. In addition, the SEC announced that it would not provide a basis for an SEC enforcement action if a fund does not timely deliver a current prospectus because of circumstances related to COVID-19 when delivery was originally required during this period. The position is not available to an initial purchase by the investor of the fund’s shares.
  • Business continuity plans: Business continuity at the current time is key. In most cases, those plans already are in effect. Consideration should be given to contingency planning in the event that fund managers, transfer agents, pricing services, or other service providers are unable to provide services because of employee absences. Funds and fund managers should make and communicate revisions to their plans as they adjust to the developing environment.
  • Valuation: Funds should examine whether they are able to obtain valid prices for their investments, especially in markets that may be closed or have limited availability. Experience from the 2008 financial crisis shows that vendor reassurances as to the quality of their pricing information may provide false comfort, so vendor prices should be checked for reliability. At this time, we do not expect the SEC to provide relief from the daily pricing requirement.
  • Redemptions: Under Section 22(e) of the 1940 Act, open-end funds generally may not suspend the right of redemption unless the New York Stock Exchange is closed, or the SEC provides guidance that daily redemptions are not required because trading is restricted or an emergency exists. At this point, funds should assume that they must continue to provide daily redemptions. Funds should review any borrowing arrangements that may need to be utilized. We are closely monitoring for any relevant guidance from the SEC or its staff on this topic.
  • Cybersecurity: Firms are at increased risk of cyberattacks, particularly with the use of remote offices and telework. Anxious employees may be more vulnerable to email phishing attacks. Employees should be reminded of the continued need for vigilance.
  • Prospectus disclosures: Funds should review their prospectus disclosures, and particularly their risk disclosures. It may be appropriate to add a pandemic risk factor if this risk is not already addressed. However, funds have different risk profiles, and there is no one-size-fits-all solution for the necessary disclosures.
  • Annual meetings: The SEC staff has provided guidance to both operating companies and funds that are intended to provide regulatory flexibility to companies seeking to change the date and location of the meetings and use new technologies, such as “virtual” shareholder meetings that avoid the need for in-person shareholder attendance, while at the same time ensuring that shareholders and other market participants are informed of any changes.17 The guidance notes that the ability to conduct a “virtual” meeting is governed by state law, where permitted, and the issuer’s governing documents.

Please do not hesitate to reach out to your Stradley Ronon contact, or to any member of Stradley’s Coronavirus Task Force, with any questions and concerns you may have during this period. You can reach Sara Crovitz at 202.507.6414 or scrovitz@stradley.com, or John Baker at 202.419.8413 or jbaker@stradley.com.

________________

1 Money Market Mutual Funds Template Letter (Mar. 17, 2020), https://www.federalreserve.gov/supervisionreg/legalinterpretations/fedreserseactint20200317.pdf.

2 Investment Company Institute, SEC No-Action Letter (Mar. 19, 2020), https://www.sec.gov/investment/investment-company-institute-031920-17a.

3 Press Release, Federal Reserve Board broadens program of support for the flow of credit to households and businesses by establishing a Money Market Mutual Fund Liquidity Facility (MMLF) (Mar. 18, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200318a.htm.

4 Press Release, Federal Reserve Board expands its program of support for flow of credit to the economy by taking steps to enhance liquidity and functioning of crucial state and municipal money markets (Mar. 20, 2020) https://www.federalreserve.gov/newsevents/pressreleases/monetary20200320b.htm.

5 Policy Tools: Money Market Mutual Fund Liquidity Facility, https://www.federalreserve.gov/monetarypolicy/mmlf.htm.

6 Exchange-Traded Funds, Release Nos. 33-10695, IC-33646 (Sept. 25, 2019), 84 Fed. Reg. 57162, 57178 (Oct. 24, 2019).

7 Press Release No. 8136-20, CFTC Issues Third Wave of Relief to Market Participants in Response to COVID-19 (Mar. 20, 2020), https://www.cftc.gov/PressRoom/PressReleases/8136-20.

8 Notice to Members I-20-15 (Mar. 23, 2020), https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=5218.

9 Release No. IA-5463 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ia-5463.pdf.

10 Using IARD, Form ADV: Item 1.F, https://www.sec.gov/divisions/investment/iard/iardfaq.shtml#item1f.

11 Release No. 34-88318 (Mar. 4, 2020), https://www.sec.gov/rules/other/2020/34-88318.pdf.

12 Press Release 2020-63, SEC Takes Targeted Action to Assist Funds and Advisers, Permits Virtual Board Meetings and Provides Conditional Relief from Certain Filing Procedures (Mar. 13, 2020), https://www.sec.gov/news/press-release/2020-63.

13 Comment Periods for Certain Pending Actions, https://www.sec.gov/rules/proposed.shtml.

14 European Commission Delegated Regulation art. 62, https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-2398-EN-F1-1.PDF.

15 Release No. IC-33817 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ic-33817.pdf. The various forms of relief provided by the SEC are subject to conditions that are set out in the respective orders, such as subsequent ratification of votes, notice to the SEC of filing delays, and website disclosure of issues with the delivery of shareholder reports, prospectuses, and Form ADV client brochures.

16 SEC Division of Investment Management, Staff Statement on Fund Board Meetings and Unforeseen or Emergency Circumstances Related to Coronavirus Disease 2019 (COVID-19) (Mar. 4, 2020), https://www.sec.gov/investment/staff-statement-im-covid-19.

17 Staff Guidance for Conducting Annual Meetings in Light of COVID-19 Concerns (Mar. 13, 2020), https://www.sec.gov/ocr/staff-guidance-conducting-annual-meetings-light-covid-19-concerns.

COVID-19 Coverage: Part 2 of 1940 Act Issues to Consider During the Pandemic

Stradley’s Coronavirus Task Force will be updating this high-level overview of coronavirus disease 2019 (COVID-19) related issues for registered investment companies and fund managers as developments warrant.

  • Market closures and market restrictions: A list of securities market closures and market restrictions is available here. (New 3/19/2020)
  • Money Market Mutual Fund Liquidity Facility: The Federal Reserve Board has announced a Money Market Mutual Fund Liquidity Facility (MMLF) that is intended to assist money market funds in meeting demands for redemptions.1 Under the MMLF, the Federal Reserve Bank of Boston will lend to depository institutions and bank holding companies, taking as collateral assets purchased by the borrower from prime money market funds (i) concurrently with the borrowing or (ii) or on or after March 18, but before the opening of the facility. The facility is similar to the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility that operated from late 2008 to early 2010, but will purchase a broader range of assets. In addition, the Department of the Treasury reportedly is seeking congressional action that would temporarily permit the use of the Exchange Stabilization Fund to guarantee money market funds. The Exchange Stabilization Fund was used for this purpose in 2008, but current law prohibits its use for the establishment of any future guaranty programs for the United States money market fund industry, so this would require legislation. See 12 U.S.C. § 5236. (New 3/19/2020)
  • Liquidity risk management: Current developments raise a number of issues for the management of funds’ liquidity risk:
    • Assessment, management, and periodic review of liquidity risk: Funds should review fund liquidity risk in light of current and reasonably expected market events and redemption patterns, and may need to consider appropriate mitigating steps for strengthening the fund’s ability to meet redemptions, including readying borrowing and other liquidity facilities.
    • Classification of portfolio investments: Rule 22e-4 requires funds to review their portfolio investments’ liquidity classifications more frequently than monthly if changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect classifications. Such reviews should focus especially on holdings that could be considered illiquid investments as a result of these developments or that could fall out of highly liquid investment status. An important consideration will be a review of the reasonably anticipated trading sizes in light of redemption expectations. Funds should be alert to the possibility that vendor classifications may be based on historical rather than current data.
    • Highly liquid investment minimum: For funds that currently hold primarily highly liquid assets, and therefore are not required to have an HLIM, the program administrator may need to examine whether the fund can still qualify for that status. For HLIM funds, the HLIM may need to be reviewed under the required factors in light of current market and redemption developments and, if a shortfall is reasonably anticipated, a shortfall remediation plan should be developed.
    • Illiquid investments: During this period of extreme market volatility, the fund should monitor closely whether there is a need to reclassify holdings as illiquid investments. Funds should be prepared to file Form N-LIQUID if the fund’s illiquid assets exceed 15% of its net assets. The program administrator should have guidance designed to prevent purchases that would violate the prohibition on acquiring illiquid investments when over the 15% limit. We do not yet know if the SEC will provide guidance relieving funds from filing Form N-LIQUID in the event of foreign or other market closings that are beyond the scope of existing guidance on extended foreign holidays.
    • Redemptions in kind: Funds may wish to consider whether redemptions in kind would be an appropriate tool for large redemption requests, including whether operational logistics are in place to accommodate any such redemption requests. (Updated 3/19/2020)
  • Exchange-traded funds: For an ETF that invests in foreign markets that close, the ETF may wish to consider whether to invest in alternative instruments, such as ADRs, in order to achieve the desired exposure to the foreign securities. In circumstances where there is no ability to make additional investments in appropriate alternative instruments, an ETF may wish to stop accepting creation unit purchases. The Commission previously has noted that ETFs generally may suspend the issuance of creation units only for a limited time and only due to extraordinary circumstances, such as when the markets on which the ETF’s portfolio holdings are traded are closed for a limited period of time.2 ETF issuers should be aware that any decision to suspend creations could have an impact on the arbitrage efficiency of the ETF and could lead to greater deviations between the market price of the ETF shares and the NAV of the shares. Like other open-end funds, ETFs cannot suspend redemptions unless the New York Stock Exchange is closed or there is appropriate guidance from the SEC. (Updated 3/19/2020)
  • SEC Filings: The SEC’s 1940 Act Order (cited below) provides relief from the timeliness requirements of Form N-CEN, Form N-PORT, and Form N-23C-2 when a fund is unable to meet a deadline due to circumstances related to current or potential effects of COVID-19. The relief for Forms N-CEN and N-PORT applies to filing obligations for which the original due date is on or after March 13 but on or prior to April 30, 2020, while the relief for Form N-23C-2 extends to June 15, 2020. A separate order under the Investment Advisers Act of 1940 provides timeliness relief for Form ADV and Form PF filings and for Form ADV Part 2 client delivery obligations, when the original due date is on or after March 13 but on or prior to April 30, 2020,3 and the SEC has posted staff guidance that Form ADV does not have to be updated to reflect temporary teleworking locations.4 The SEC previously provided relief from timeliness requirements for certain filings under the Securities Exchange Act of 1934.Note that filings not covered by the orders continue to be required on a timely basis, including filings on Form N-LIQUID, Form N-CR, and Form N-MFP, although it is possible that the SEC will consider issues with these forms on an individualized basis. The SEC provided information on contacting the staff with issues, including issues with these filings, in a press release announcing the actions.6 (Updated 3/19/2020)
  • Form CRS: We understand that the SEC staff is considering whether brokers and advisers should be given relief from the Form CRS deadline. Unless such relief is given, compliance with the Form CRS requirement will be required as of June 30, 2020. (New 3/19/2020)
  • CPO NFA Filings: We understand that the CFTC staff is considering extending relief to commodity pool operators to postpone the deadline for filing annual audited financial statements and extending the requirement to furnish monthly or quarterly reports to pool participants under CFTC Regulations 4.7 and 4.22 and related regulations. Unless and until such relief is provided, CPOs continue to be subject to existing deadlines. We also understand that firms seeking an extension to file pool financial statements with the National Futures Association must individually file extension requests using NFA’s EasyFile system.7 NFA can only grant a Rule 4.22(f) extension if the firm files the request before the statement’s due date. Otherwise, the firm must obtain relief from the CFTC. (New 3/19/2020)
  • SEC Comment Periods: The SEC has issued a statement noting that the Commission and staff have historically considered comments submitted after a comment period closes but before adoption of a final rule or order.8 For certain pending rule proposals, including proposals concerning auditor independence, the accredited investor definition, and fund investments in derivatives, the SEC stated that it will not take final action before April 24 in order to allow commenters additional time if needed. (New 3/19/2020)
  • MiFID II Reporting: Under the MiFID II delegated regulation, investment firms providing the service of portfolio management and subject to MiFID II must inform the client where the overall value of the portfolio, as evaluated at the beginning of each reporting period, depreciates by 10% and thereafter at multiples of 10%, no later than the end of the business day in which the threshold is exceeded or, in a case where the threshold is exceeded on a non-business day, the close of the next business day.9 (New 3/19/2020)
  • Fund Boards: Fund directors should stay up to speed on current market events so they can properly apply their business judgment as necessary from a governance standpoint.  In many cases, fund boards are receiving periodic status reports or attending status updates from fund advisers. Examples of areas for directors to consider include, for funds, fund flows, liquidity levels, valuation, and performance; and for fund advisers, status of operations under business continuity plans, market assessments, and the assessment of critical fund service providers.  Board reporting from fund advisers is particularly important during times of market stress. To strike an appropriate balance between staying apprised and being efficient and respectful of fund advisory personnel time, boards may seek to channel questions or communications through independent counsel or the board chair/lead independent director. (New 3/19/2020)
  • In-person board meetings: On March 13, the SEC issued an order under the Investment Company Act of 1940 (“1940 Act Order”), allowing fund boards to meet telephonically or by video conference to consider and vote on matters that would otherwise require an in-person vote.10 The relief applies whenever reliance upon it is necessary or appropriate due to circumstances related to current or potential effects of COVID-19 and is available until June 15, 2020. The SEC’s Division of Investment Management previously provided no-action relief for the period from March 4 to June 15.11
  • Delivery of prospectuses and shareholder reports: The 1940 Act Order also provides relief from the obligations to timely transmit annual and semiannual reports to shareholders and to file them with the SEC. The relief applies when the original due date is on or after March 13 but on or prior to April 30, 2020, and the fund is unable to prepare or transmit the report due to circumstances related to current or potential effects of COVID-19. In addition, the SEC announced that it would not provide a basis for an SEC enforcement action if a fund does not timely deliver a current prospectus because of circumstances related to COVID-19, when delivery was originally required during this period. The position is not available to an initial purchase by the investor of the fund’s shares.
  • Business continuity plans: Business continuity at the current time is key. In most cases, those plans already are in effect. Consideration should be given to contingency planning in the event that fund managers, transfer agents, pricing services, or other service providers are unable to provide services because of employee absences. Funds and fund managers should make and communicate revisions to their plans as they adjust to the developing environment.
  • Valuation: Funds should examine whether they are able to obtain valid prices for their investments, especially in markets that may be closed or have limited availability. Experience from the 2008 financial crisis shows that vendor reassurances as to the quality of their pricing information may provide false comfort, so vendor prices should be checked for reliability. At this time, we do not expect the SEC to provide relief from the daily pricing requirement.
  • Redemptions: Under Section 22(e) of the 1940 Act, open-end funds generally may not suspend the right of redemption unless the New York Stock Exchange is closed, or the SEC provides guidance that daily redemptions are not required because trading is restricted or an emergency exists. At this point, funds should assume that they must continue to provide daily redemptions. Funds should review any borrowing arrangements that may need to be utilized. We are closely monitoring for any relevant guidance from the SEC or its staff on this topic.
  • Cybersecurity: Firms are at increased risk of cyberattacks, particularly with the use of remote offices and telework. Anxious employees may be more vulnerable to email phishing attacks. Employees should be reminded of the continued need for vigilance.
  • Prospectus disclosures: Funds should review their prospectus disclosures, and particularly their risk disclosures. It may be appropriate to add a pandemic risk factor if this risk is not already addressed. However, funds have different risk profiles, and there is no one-size-fits-all solution for the necessary disclosures.
  • Annual meetings: The SEC staff has provided guidance to both operating companies and funds that is intended to provide regulatory flexibility to companies seeking to change the date and location of the meetings and use new technologies, such as “virtual” shareholder meetings that avoid the need for in-person shareholder attendance, while at the same time ensuring that shareholders and other market participants are informed of any changes.12 The guidance notes that the ability to conduct a “virtual” meeting is governed by state law, where permitted, and the issuer’s governing documents.

Please do not hesitate to reach out to your Stradley Ronon contact, or to any member of Stradley’s Coronavirus Task Force, with any questions and concerns you may have during this period. You can reach Sara Crovitz at 202.507.6414 or scrovitz@stradley.com, or John Baker at 202.419.8413 or jbaker@stradley.com.

____________________

1 Press Release, Federal Reserve Board broadens program of support for the flow of credit to households and businesses by establishing a Money Market Mutual Fund Liquidity Facility (MMLF) (Mar. 18, 2020), https://www.federalreserve.gov/newsevents/.
2 Exchange-Traded Funds, Release Nos. 33-10695, IC-33646 (Sept. 25, 2019), 84 Fed. Reg. 57162, 57178 (Oct. 24, 2019).
3 Release No. IA-5463 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ia-5463.pdf.
4 Using IARD, Form ADV: Item 1.F, https://www.sec.gov/divisions/investment/iard/.
5 Release No. 34-88318 (Mar. 4, 2020), https://www.sec.gov/rules/other/2020/34-88318.pdf.
6 Press Release 2020-63, SEC Takes Targeted Action to Assist Funds and Advisers, Permits Virtual Board Meetings and Provides Conditional Relief from Certain Filing Procedures (Mar. 13, 2020), https://www.sec.gov/news/press-release/2020-63.
7 See CPO Help Guide: Filing Extensions and Notice Filings with NFA, https://www.nfa.futures.org/electronic-filing-systems/.
8 Comment Periods for Certain Pending Actions, https://www.sec.gov/rules/proposed.shtml.
9 European Commission Delegated Regulation art. 62, https://ec.europa.eu/transparency/regdoc/.
10 Release No. IC-33817 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ic-33817.pdf. The various forms of relief provided by the SEC are subject to conditions that are set out in the respective orders, such as subsequent ratification of votes, notice to the SEC of filing delays, and website disclosure of issues with the delivery of shareholder reports, prospectuses, and Form ADV client brochures.
11 SEC Division of Investment Management, Staff Statement on Fund Board Meetings and Unforeseen or Emergency Circumstances Related to Coronavirus Disease 2019 (COVID-19) (Mar. 4, 2020), https://www.sec.gov/investment/staff-statement-im-covid-19.
12 Staff Guidance for Conducting Annual Meetings in Light of COVID-19 Concerns (Mar. 13, 2020), https://www.sec.gov/ocr/staff-guidance-conducting-annual-meetings-light-covid-19-concerns.

COVID-19 Coverage: Part 1 of 1940 Act Issues to Consider During the Pandemic

In light of the outbreak of coronavirus disease 2019 (COVID-19) and operational disruptions throughout the world, below is a short list of issues that registered investment companies and fund managers should consider at the current time.

  • In-person board meetings: On March 13, the SEC issued an order under the Investment Company Act of 1940 (“1940 Act Order”), allowing fund boards to meet telephonically or by video conference to consider and vote on matters that would otherwise require an in-person vote.1 The relief applies whenever reliance upon it is necessary or appropriate due to circumstances related to current or potential effects of COVID-19 and is available until June 15, 2020. The SEC’s Division of Investment Management previously provided no-action relief for the period from March 4 to June 15.2
  • SEC filings: The 1940 Act Order also provides relief from the timeliness requirements of Form N-CEN, Form N-PORT, and Form N-23C-2, when a fund is unable to meet a deadline due to circumstances related to current or potential effects of COVID-19. The relief for Forms N-CEN and N-PORT applies to filing obligations for which the original due date is on or after March 13 but on or prior to April 30, 2020, while the relief for Form N-23C-2 extends to June 15, 2020. A separate order under the Investment Advisers Act of 1940 provides timeliness relief for Form ADV and Form PF filings and for Form ADV Part 2 client delivery obligations, when the original due date is on or after March 13 but on or prior to April 30, 2020.3 The SEC previously provided relief from timeliness requirements for certain filings under the Securities Exchange Act of 1934.Note that filings not covered by the orders continue to be required on a timely basis, including filings on Form N-LIQUID, Form N-CR, and Form N-MFP, although it is possible that the SEC will consider issues with these forms on an individualized basis. The SEC provided information on contacting the staff with issues, including issues with these filings, in a press release announcing the actions.5
  • Delivery of prospectuses and shareholder reports: The 1940 Act Order also provides relief from the obligations to timely transmit annual and semiannual reports to shareholders and to file them with the SEC. The relief applies when the original due date is on or after March 13 but on or prior to April 30, 2020, and the fund is unable to prepare or transmit the report due to circumstances related to current or potential effects of COVID-19. In addition, the SEC announced that it would not provide a basis for an SEC enforcement action if a fund does not timely deliver a current prospectus because of circumstances related to COVID-19, when delivery was originally required during this period. The position is not available to an initial purchase by the investor of the fund’s shares.
  • Business continuity plans: Business continuity at the current time is key. In most cases, those plans already are in effect. Consideration should be given to contingency planning in the event that fund managers, transfer agents, pricing services, or other service providers are unable to provide services because of employee absences. Funds and fund managers should make and communicate revisions to their plans as they adjust to the developing environment.
  • Liquidity risk management: Fund holdings might become illiquid or less liquid should markets close or freeze up, or if market depth in some securities or asset classes is significantly reduced. Under these circumstances, liquidity risk management program administrators should be prepared to reclassify the liquidity classifications for some classes of investments and to take any other actions necessary to manage liquidity under their liquidity risk management programs. If a fund’s illiquid assets exceed 15% of its net assets, or if its highly liquid investments fall below its highly liquid investment minimum (“HLIM”) for more than seven consecutive calendar days, the fund will be required to promptly report to the fund’s board and to the SEC on Form N-LIQUID. Program administrators should have these communication protocols prepared. In addition, for those funds that currently hold primarily highly liquid assets, and therefore are not required to have an HLIM, the administrator should examine whether the fund can still qualify for that status.
  • Valuation: Funds should examine whether they are able to obtain valid prices for their investments, especially in markets that may be closed or have limited availability. Experience from the 2008 financial crisis shows that vendor reassurances as to the quality of their pricing information may provide false comfort, so vendor prices should be checked for reliability. At this time, we do not expect the SEC to provide relief from the daily pricing requirement.
  • Redemptions: Under Section 22(e) of the 1940 Act, open-end funds generally may not suspend the right of redemption unless the New York Stock Exchange is closed, or the SEC provides guidance that daily redemptions are not required because trading is restricted or an emergency exists. At this point, funds should assume that they must continue to provide daily redemptions. Funds should review any borrowing arrangements that may need to be utilized. We are closely monitoring for any relevant guidance from the SEC or its staff on this topic.
  • Cybersecurity: Firms are at increased risk of cyberattacks, particularly with the use of remote offices and telework. Anxious employees may be more vulnerable to email phishing attacks. Employees should be reminded of the continued need for vigilance.
  • Prospectus disclosures: Funds should review their prospectus disclosures, and particularly their risk disclosures. It may be appropriate to add a pandemic risk factor if this risk is not already addressed. However, funds have different risk profiles, and there is no one-size-fits-all solution for the necessary disclosures.
  • Annual meetings: The SEC staff has provided guidance to both operating companies and funds that is intended to provide regulatory flexibility to companies seeking to change the date and location of the meetings and use new technologies, such as “virtual” shareholder meetings that avoid the need for in-person shareholder attendance, while at the same time ensuring that shareholders and other market participants are informed of any changes.6 The guidance notes that the ability to conduct a “virtual” meeting is governed by state law, where permitted, and the issuer’s governing documents.
  • Exchange-traded funds: ETFs should consider many of the issues outlined above, including the ETF-specific provisions in the liquidity risk management rule, as well as the potential widening of premiums or discounts.
  • Money market funds: Money market funds may face their own liquidity and valuation challenges and reporting requirements, which will vary depending on the type of money market fund at issue.

Please do not hesitate to reach out to your Stradley Ronon contact, or to any member of Stradley’s Coronavirus Task Force, with any questions and concerns you may have during this period. You can reach Sara Crovitz at 202.507.6414 or scrovitz@stradley.com, or John Baker at 202.419.8413 or jbaker@stradley.com.

_________

1 Release No. IC-33817 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ic-33817.pdf. The various forms of relief provided by the SEC are subject to conditions that are set out in the respective orders, such as subsequent ratification of votes, notice to the SEC of filing delays, and website disclosure of issues with the delivery of shareholder reports, prospectuses, and Form ADV client brochures.
2 SEC Division of Investment Management, Staff Statement on Fund Board Meetings and Unforeseen or Emergency Circumstances Related to Coronavirus Disease 2019 (COVID-19) (Mar. 4, 2020), https://www.sec.gov/investment/staff-statement-im-covid-19.
3 Release No. IA-5463 (Mar. 13, 2020), https://www.sec.gov/rules/other/2020/ia-5463.pdf.
4 Release No. 34-88318 (Mar. 4, 2020), https://www.sec.gov/rules/other/2020/34-88318.pdf.
5 Press Release 2020-63, SEC Takes Targeted Action to Assist Funds and Advisers, Permits Virtual Board Meetings and Provides Conditional Relief from Certain Filing Procedures (Mar. 13, 2020), https://www.sec.gov/news/press-release/2020-63.
6 Staff Guidance for Conducting Annual Meetings in Light of COVID-19 Concerns (Mar. 13, 2020), https://www.sec.gov/ocr/staff-guidance-conducting-annual-meetings-light-covid-19-concerns.

How Hedge Funds Can Avoid Becoming Subject to ERISA

The U.S. Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that governs the management and investment of U.S. private sector employee benefit plans. It aims to protect plan participants from conflicts of interest and imprudent decision-making. ERISA imposes stringent standard of care requirements on “fiduciaries” and prohibits a wide range of transactions absent adherence to an exemption. A breach of a fiduciary duty under ERISA or a non-exempt prohibited transaction under ERISA or Section 4975 of the U.S. Internal Revenue Code of 1986 (Code) can result in severe penalties, including civil liability and excise taxes.

Numerous hedge fund sponsors/managers try to avoid becoming subject to ERISA due its technical requirements and potential liability. The most prominent way in which sponsors/managers avoid ERISA is by structuring its fund to fall within a safe harbor, the significant participation test. This client alert focuses on that safe harbor. (Sponsors and managers of other alternative funds, such as private equity, may rely on other safe harbors). We will address in a future client alert the ramifications for a fund sponsor/manager if its hedge fund becomes subject to ERISA.

A hedge fund manager is a fiduciary under ERISA if it has discretionary management over “plan assets.” An ERISA plan’s investment in a hedge fund would generally convert the fund into a “plan assets” ERISA investment vehicle. A hedge fund that holds “plan assets” would subject the investment manager to ERISA, including strict fiduciary duties and prohibited transaction restrictions.

However, Department of Labor (DOL) regulations provide a safe harbor from “plan assets” status on which many hedge funds rely. Simply, a hedge fund avoids becoming subject to ERISA if “benefit plan investors” hold less than 25% of each equity class (excluding any interests held by the general partner or investment manager). This test is conducted on a class-by-class basis. Section 3(42) of ERISA and applicable DOL regulations define “benefit plan investors” (BPIs) as plans subject to the fiduciary responsibility provisions of ERISA, plans subject to Section 4975 of the Code (e.g., IRAs), and fund investors that are themselves plan asset vehicles. Subscriptions from governmental plans and non-U.S. plans are not counted toward the 25% limit. Subscription booklets will often include an ERISA questionnaire to ascertain whether a potential investor is a BPI for purposes of determining whether the fund falls within the safe harbor.

Fund sponsors/managers need to be vigilant and recognize that the test is recalculated at the time of each new subscription, transfer and redemption into and out of the hedge fund. If the 25% threshold is met or exceeded, the fund immediately becomes an ERISA “plan assets” vehicle and the investment manager must comply with ERISA. Hedge fund sponsors/managers that wish to avoid this result will typically have certain rights to ensure the fund stays within the safe harbor. The sponsor/manager will probably have the right to require BPIs to redeem out of the fund if the 25% threshold may be breached. The sponsor/manager should also have the right to approve any prospective transfer of interests. Most BPIs do not object to these types of provisions. Some ERISA plan investors may negotiate certain rights in a side letter, such as a requirement that the mandatory redemption provisions be implemented against all BPIs in an equitable manner. It would be important to evaluate whether granting too many, or certain, rights in a side letter inadvertently creates a new “class,” thereby undermining the strategy of avoiding “plan assets” status.

The significant participation test is tested on an entity-by-entity basis. This means that, in a master-feeder structure, each feeder fund and the master fund are all tested separately. Some fund sponsors attempt to “hardwire” their feeder funds as a way to increase ERISA capacity while still falling within the safe harbor. Under this structure, the offshore feeder fund would hold “plan assets” because 25% or more of its share class will be held by BPIs, whereas both the domestic feeder fund and master fund would avoid holding “plan assets” by satisfying the significant participation test. Both feeders would have to invest all of their investible assets in the master fund. Some take the position that, even though the offshore feeder holds “plan assets,” the investment manager is not an ERISA fiduciary because the manager effectively has no discretion or ability to trade out of the feeder. This allows hedge fund sponsors/managers to increase ERISA capacity while avoiding ERISA compliance. Hardwiring may not be feasible for all funds, so this should be considered early in the structuring process.

The safe harbor/significant participation test does not address the idiosyncratic issues associated with governmental plans. These plans are not subject to ERISA and they have their own set of rules and investment restrictions. Governmental plans may have their own “look through” to the hedge fund’s operations, regardless of whether the fund holds “plan assets” under ERISA. It is important for hedge fund sponsors/managers to independently confirm whether the laws applicable to governmental plan investors could extend to the hedge fund.

The safe harbor also does not cure prohibited transactions that arise from subscribing to the hedge fund. For example, a prohibited transaction exists if the seller of the fund’s interests is a “party in interest” to the BPI. Subscription materials will typically ask for a representation from the BPI that the subscription is either not a prohibited transaction or that such prohibited transaction is covered by an exemption. Another example of a potential prohibited transaction is when principals of the fund sponsor wish to invest their IRAs in the fund. Irrespective of whether the fund holds “plan assets,” such subscription gives rise to prohibited transaction concerns and should be addressed accordingly. The most likely approach to addressing that prohibited transaction is to waive all fees with respect to the IRA’s investment in the fund.

Only ‘Actual’ Knowledge of Disclosure Triggers Three-Year Limitations Period for ERISA Fiduciary Breach Claims

Overview
The U.S. Supreme Court’s unanimous decision in Intel Corp. Investment Policy Committee et al. v. Sulyma sharpens the ‘actual’ knowledge standard that triggers the three-year limitations period for breach of fiduciary duty claims arising under the Employee Retirement Income Security Act. Under Sulyma, the statutory phrase ‘actual’ knowledge means what it says: the three-year period is limited to circumstances where a plaintiff/participant actually knows of the disclosure evidencing the alleged breach. Absent proof of such knowledge, ERISA’s longer six-year repose period applies.

Background and Analysis
Plaintiff Sulyma worked at Intel between 2010 and 2012 and participated in two of Intel’s ERISA retirement plans, investing in target date and other funds managed by an Intel investment committee responsible for making the funds’ asset allocations. Over time, the committee increased the funds’ allocations to alternative investments, increasing the funds’ cost and resulting in performance that lagged index funds with greater equity exposure. In October 2015, Sulyma sued the Intel committee and other plan administrators on behalf of a putative class for breach of fiduciary duty under ERISA, complaining of allegedly imprudent investments and inadequate disclosures regarding the same.

Intel had disclosed these investment decisions to all plan participants, including Sulyma, through various notices and plan documents distributed by email and made available through an online benefits website. The documents disclosed the existence of the alternative investments and the basis for allocating some of the funds’ assets to alternatives, including hedge funds, private equity funds and commodities. Sulyma received the emails and accessed some of this information online, but testified that he did not “remember reviewing” the disclosures and was “unaware” while working at Intel that the monies he had invested in the funds had been reinvested in hedge funds and private equity. He recalled viewing account statements sent by mail, which noted that his plans were invested in “short-term/other” assets but did not specify the investments.

Intel moved to dismiss the case because Sulyma filed more than three years, but less than six years, after Intel issued relevant disclosures to plan participants, including Sulyma. The District Court granted summary judgment in favor of the Intel defendants, and the Ninth Circuit reversed, focusing on the plain meaning of ‘actual’ knowledge. In adopting the Ninth Circuit’s reasoning, which echoed most other Circuits, the Supreme Court emphasized that where ERISA utilizes ‘actual’ rather than a constructive or implied knowledge standard, the term “actual” must be given its plain meaning and requires “more than evidence of disclosure alone.” To meet the ‘actual’ knowledge requirement, a plaintiff/participant “must in fact have become aware of” the disclosure underlying the alleged breach of fiduciary duty. The Supreme Court recognized that ‘actual’ knowledge can be proved through “inference from circumstantial evidence,” including electronic records showing a plaintiff/participant viewed the relevant disclosure and evidence suggesting that she understood and took action in response to the information in the disclosure. Importantly, the Intel defendants did not argue that ‘actual’ knowledge was established in these ways. Instead, they argued “only that they need not offer any such proof,” an argument that the Court rejected.

Takeaways

  • To the extent that the Court’s ruling diminishes the protections afforded to plan fiduciaries under ERISA’s limitations framework, the Court deferred such policy considerations to Congress.
  • The opinion leaves room for plan fiduciaries to argue that evidence of a plaintiff/participant’s “willful blindness” to disclosures supports a finding of ‘actual’ knowledge.
  • When crafting disclosures, fiduciaries should take care to use plain language that is accessible and understandable for the average participant.
  • Dissemination of disclosures should be tracked, with acknowledgments sought where appropriate, to confirm plan participants are reading and comprehending such information.
  • When considering challenges to class certification, fiduciaries may find utility in highlighting the individualized nature of probing the ‘actual’ knowledge of plaintiff/participants.
Territory of Massachusetts

Massachusetts Broker-Dealers Now Owe Fiduciary Duties to Retail Customers

The Massachusetts Securities Division (MSD) on Friday1 issued Final Regulations that impose a fiduciary standard of care on broker-dealers and their agents when they make recommendations and provide investment advice to customers with respect to an investment strategy, the opening of, or transferring of assets to, any type of account, or the purchase, sale or exchange of any security.2 The MSD made a number of important changes from its proposal, which we highlight below, but one notable change worthy of mention at the outset is that investment advisers and investment adviser representatives are not subject to the Final Regulations. Here are the key points:

  • The Final Regulations’ effective date will be March 6, 2020; however, the Final Regulations will not be enforced until September 1, 2020.3 This gives firms some time to review their policies and procedures for compliance with the Final Regulations.
  • The standard of care consists of the duty of care and the duty of loyalty.
    • Duty of Care: The duty of care requires a broker-dealer or agent to use the care, skill, prudence, and diligence that a person acting in a like capacity and familiar with such matters would use, taking into consideration all of the relevant facts and circumstances. For purposes of this paragraph, a broker-dealer or agent shall make reasonable inquiry, including the risks, costs, and conflicts of interest related to all recommendations made and investment advice given, the customer’s investment objectives, risk tolerance, financial situation, and needs, and any other relevant information.
    • Duty of Loyalty: The duty of loyalty requires a broker-dealer or agent to disclose all material conflicts of interest, make all reasonably practicable efforts to avoid conflicts of interest, eliminate conflicts that cannot reasonably be avoided, and mitigate conflicts that cannot reasonably be avoided or eliminated, and make recommendations and provide investment advice without regard to the financial or any other interest of any party other than the customer.
      • The duty of loyalty cannot be satisfied without disclosure of all material conflicts of interest.
      • MSD emphasized in the adopting release of the Final Regulations, “not all conflicts must be avoided. Likewise, not all conflicts must be eliminated. Accordingly, conflicts that arguably could be avoided or eliminated do not need to be if it would not be reasonable for a broker-dealer or agent to do so.”
      • The MSD conceded that transaction-based compensation “cannot reasonably be avoided or eliminated.” Moreover, the recommendation and sale of proprietary products, and sales in principal transactions also cannot reasonably be avoided or eliminated. MSD indicated that, in this instance, “the broker-dealer and agent may mitigate this conflict by, for example, ensuring that the fee earned for the recommendation is reasonable and complying with the remainder of the fiduciary duty.”
      • The adopting release emphasized that disclosure of conflicts alone does not satisfy the duty of loyalty.
      • The Final Regulations creates a presumption that a recommendation made in connection with any sales contest violates the duty of loyalty.4
    • As a general matter, the broker-dealer’s fiduciary duty runs during the period in which incidental advice is made in connection with the recommendation of a security to the customer.5 Only when the broker-dealer or its agent act “outside the traditional broker-dealer customer relationship” will the fiduciary duties apply for a longer period:
      • Where the broker-dealer or agent has discretionary authority over the customer’s account (ongoing duration).
      • Where there is a contractual obligation that imposes a fiduciary duty (duration based on contract).
      • Where the contract provides that the broker-dealer or agent shall monitor of the account (duration based on contract).
    • Though the proposal covered advice on commodities and insurance products, MSD opted not to include them within the scope of the Final Regulations.
    • The Final Regulations no longer include a presumption that the use of certain titles by a broker-dealer or agent imposed an ongoing duty.
    • The term “customer” includes current and prospective customers, but does not include: (a) a bank, savings and loan association, insurance company, trust company, or registered investment company; (b) a broker-dealer registered with a state securities commission (or agency or office performing like functions); (c) an investment adviser registered with the SEC under Section 203 of the Investment Advisers Act of 1940 or with a state securities commission (or agency or office performing like functions); or (d) any other institutional buyer, as defined in 950 CMR 12.205(1)(a)6. and 950 CMR 14.401. The MSD declined to clarify whether a customer needed to have a legal address in Massachusetts or otherwise be a resident of the Commonwealth.
    • Broker-dealers not subject to these fiduciary duties remain subject to the existing suitability standard.
    • The Final Regulations retain the exclusion for person acting in the capacity of a fiduciary to an employee benefit plan, its participants, or its beneficiaries, as those terms are defined in the Employee Retirement Income Security Act (ERISA). Moreover, the Final Regulations retain the provision that they do not establish any capital, custody, margin, financial responsibility, making and keeping of records, bonding, or financial or operational reporting requirements for any broker-dealer or agent that differ from, or are in addition to, the requirements established under 15 U.S.C. § 78o(i).

It is possible the Final Regulations will be challenged in Federal court on preemption grounds. If the Final Regulations withstand court scrutiny, then it is also possible other states will move forward with their own versions modeled off the Final Regulations.

*Aliza Dominey also contributed to this client alert.


1 We were somewhat surprised by how quickly MSD moved toward finalization after the comment period closed on January 7, 2020 re. the proposed regulations, especially because Governor Charlie Baker released a comment letter asking the MSD to delay a final promulgation of these rules.

2 The failure to adhere to the fiduciary standard of utmost care and loyalty will be deemed a dishonest or unethical practice under M.G.L. c. 110A, § 204(a)(2)(G).

3 Unlike the Department of Labor Fiduciary Rule transition period, the Final Regulations do not appear to leave open the possibility of enforcement via private rights of action.

4 The proposal also created a presumption that recommendations made in connection with implied or express quota requirements or other special incentive programs constituted breaches of the duty of loyalty. This additional presumption did not make it into the Final Regulations.

5 The proposal imposed a fiduciary duty during any time in which the broker-dealer or agent received ongoing compensation or provided investment advice to the customer in connection with other non-brokerage financial advice. Commenters expressed concern to the MSD that this proposed provision may violate the “incidental” exemption from the Investment Advisers Act of 1940. The MSD removed this provision from the Final Regulations.

6 New JerseyNevadaNew YorkMaryland and Illinois have all floated legislative or regulatory fiduciary proposals. None have been finalized yet.

 

SEC Updates Form CRS FAQs

On February 11, 2020, the staff of the Securities and Exchange Commission (SEC) updated its Frequently Asked Questions on Form CRS with regard to a number of topics:

Legal Representative:  Similar to the update on Regulation Best Interest, the staff clarified that the term “legal representative” would not cover regulated financial services industry professionals including a workplace retirement plan representative (e.g., plan sponsor, trustee, other fiduciary), except in limited circumstances.  The staff further noted, however, that a formerly regulated financial services industry professional who is not currently regulated, would be considered a “non-professional” and, thus, a covered legal representative.

Delivery requirements: The staff clarified that where one adviser (Firm A) provides advice to another unaffiliated adviser (Firm B) but has no advisory contract (oral or written) with Firm B’s clients, absent other facts or circumstances that would indicate that Firm A provides investment advisory services to Firm B’s retail investor clients, Firm A would not be required to deliver a Form CRS to Firm B’s retail investor clients. The staff also indicated that an amendment to an existing account agreement solely to add another account holder or beneficiary would not trigger a Form CRS delivery requirement but that converting an account at a dual registrant from a brokerage account to advisory account (and presumably vice versa) would require delivery of Form CRS even if the investor initially received Form CRS upon opening the original account. The staff also clarified that a broker-dealer acting solely as a qualified custodian to an investment adviser’s retail investment advisory clients would not need to deliver a Form CRS. Finally, the staff discussed when a state-registered adviser transitioning to SEC registration is required to deliver its Form CRS.

Affiliates: The staff clarified that affiliated investment advisers (or affiliated broker-dealers) may create and deliver a combined Form CRS. The staff also indicated that a firm with multiple affiliates can combine disclosure in one Form CRS, but the staff cautioned that the page limits still apply and that the firm “should be mindful of the potential that additional information from multiple affiliates could “obscure or impede understanding.”  It also should be mindful that it is required “to present brokerage and investment advisory information with equal prominence and in a manner that clearly distinguishes and facilitates comparison.”

Sub-advisers: The staff stated that in circumstances where an adviser replaces a sub-adviser, and there are no changes to the advisory agreement, services, investments, or conflicts of interest that would make the information in the adviser’s Form CRS materially inaccurate, the staff would not object if the firm does not consider this a material change that would require the adviser to amend its Form CRS. The staff did not clarify the types of changes to the advisory agreement, services, investments or conflicts that would be considered material changes.

Disciplinary history: The staff clarified that a firm that reports disciplinary history related to its parent company in response to Item 11 on the firm’s Form ADV and Items 11A-K on the firm’s Form BD must answer “yes” to Item 4 in Form CRS.

Foreign language: Finally, the staff stated that it would not object to the delivery of a complete translation of Form CRS in a foreign language so long as the firm also delivers a separate English Form CRS at the same time.