MORGAN LEWIS ON ECURITIES S A NEWSLETTER FROM THE SECURITIES PRACTICE www.morganlewis.com FALL 2004 A YEAR IN TURMOIL FOR MUTUAL FUNDS — IN THIS ISSUE VIEWS OF AN INDUSTRY INSIDER BY THOMAS S. HARMAN Amid the frenetic backdrop of regulatory catch-up and leap-frog in the mutual fund industry over the last year, it 2 OUTSIDE DIRECTORS AND is important to step back and observe the larger trends and try to discern what has fundamentally changed. That RED FLAGS involves focusing on the industry’s primary regulator, the SEC. OBTAINING A LISTING ON Initially outflanked by New York maintained. It has adopted signifi- 3 THE LUXEMBOURG STOCK Attorney General Eliot Spitzer, the cant revisions to substantive rules, EXCHANGE SEC has responded vigorously to e.g., Rule 12b-1, to prohibit the alleged abuses in the Mutual Fund practice of tying portfolio execution EXPANDED NEW FORM 8-K Industry. It has employed virtually to fund distribution, and Rule 22c- 4 REQUIREMENTS BECAME all of its tools: information-gather- 1, the forward pricing rule, a EFFECTIVE IN AUGUST ing, jawboning, disclosure fundamental bulwark of the rulemaking, rulemaking that For further information, or to receive Investment Company Act of 1940. MORGAN LEWIS NEWS reshapes business practices, corpo- this newsletter by e-mail only, contact It has even proposed a rule that 11 rate governance rulemaking and David Sirignano at 202.739.5420 or would require funds to impose a 2% enforcement actions. The enforce- [email protected], who redemption fee on certain short-term focuses on SEC regulation, or ment actions, notably, often investors. Further, it has proposed Thomas Harman at 202.739.5662 involved well-known fund families, or [email protected], who revisions to require most private significant sanctions and coordina- focuses on investment management fund advisers to register under the tion with state authorities–all of and mutual funds. Investment Advisers Act of 1940. which is unprecedented in the regu- lation of mutual funds. One literally In short order, the SEC also Last but not least, the SEC has has to go back to the 1920s and began to flex its rulemaking muscles instituted and settled a score of 1930s to find a similar moment in in a variety of ways. It has administrative proceedings against history when the misdoings and proposed and adopted new disclo- large fund families. The monetary alleged misdoings of mutual funds sure enhancements, i.e., market damages and fines alone, putting were so prominently in the press. timing and portfolio holding disclo- aside other remedies, have exceeded sure, that arguably look like $2 billion. Significantly, the SEC The information gathering regulation through disclosure. It has resisted wrapping advisory fee began almost immediately after has adopted proposed rules whose reductions into its settlements Eliot Spitzer announced his first fate previously seemed uncertain, (unlike Mr. Spitzer), thus staying This newsletter is provided as a general settled action early September e.g., quarterly disclosure of portfo- consistent with its historical reti- informational service to clients and friends of Morgan, Lewis & Bockius LLP.It 2003. It continues to grind away. lio schedules and the chief cence to being a rate-making should not be construed as imparting Since then, the SEC has demanded compliance officer rule. It has agency. Instead, the SEC has incor- legal advice on any specific matter. information from large segments of adopted a rule that would require porated procedural reforms into its the industry relating to, among advisers to have codes of ethics settlements, e.g., independent other things, market timing, portfolio similar to those required of mutual chairman of the board, board elec- valuation by international stock funds. It has adopted new rules to tions every five years. By so doing funds, pension consultants, mutual strengthen corporate governance, it jump-started its fund corporate fund transfer agents and fund rela- e.g., independent chairman of the governance reforms. tionships with investment bankers, board, 75% of the board must be © 2004 Morgan, Lewis & Bockius LLP and has made two different queries independent, and records of board What, then, should one take All Rights Reserved. regarding index funds. deliberations regarding advisory away from all this? First, the SEC is agreements must be kept and moving aggressively to address continued on page 6 MORGAN LEWIS ON SECURITIES 1 FOCUS ON ENFORCEMENT AND LITIGATION OUTSIDE DIRECTORS AND RED FLAGS BY JOHN F.X. PELOSO AND BEN A. INDEK In the wake of recent corporate scandals, by failing to ensure that the company’s public fund directors, are living up to their fiduciary there has been a sharpened focus on the role of filings were accurate.”3 obligations and the spirit underpinning all of outside directors. As an example, SEC our securities laws.” Enforcement Chief Stephen Cutler announced an Specifically, the complaint alleges that intention to target outside directors for falling Peselman signed restatements of financial FIDUCIARY DUTIES: THE PROVINCE 1 “asleep at the switch.” That statement and results that contained misstatements and con- OF STATE LAW others by SEC officials, together with a related tradicted earlier statements he had signed. In civil action against an outside director, indicate doing so, Peselman “ignored . red flags.” The Chancellor action and the public that the SEC has trained its sights on outside “Indeed,” the complaint continues, “Peselman comments of Messrs. Donaldson and Cutler directors who the SEC believes may have failed had completely neglected to fulfill his duties as together reflect the SEC’s intent to target to react to red flags warning of corporate a director and as an audit committee member. outside directors for negligent activity (or inac- impropriety and failed to fulfill their fiduciary He failed to oversee Chancellor’s financial tivity) and breaches of fiduciary duty, duties. This article will consider the SEC’s reporting, exercising no care to ensure that the presumably invoking the antifraud provisions of stated initiative in this area in the context of company had appropriate accounting proce- the federal securities laws. The obvious traditional standards of liability for outside dures and internal controls and that its financial question is whether the federal securities laws directors as recently analyzed in state and records were adequate . .”4 provide the statutory basis for the Commission federal courts. to pursue that campaign. Calling the case against Peselman “the first THE CHANCELLOR CASE salvo in this area” and a model for such enforce- Almost 30 years ago, in Sante Fe Industries, ment actions, Enforcement Chief Cutler stated Inc. v. Green, 430 U.S. 462 (1977), the United In April 2003, the SEC filed a complaint that he was unaware of any other SEC action States Supreme Court considered and expressly against the Chancellor Corporation, and certain against an outside director not directly involved rejected the application of the antifraud provi- individuals associated with Chancellor, including in fraud. According to Cutler, “[t]his case sig- sions of Section 10(b) and Rule 10b-5 to all outside director Rudolph Peselman, detailing a nifies the Commission’s willingness to pursue breaches of fiduciary duty. Rather, the Court “multi-faceted financial fraud” involving “the cases against outside directors who were recognized that a “claim of fraud and fiduciary creation of false corporate documents and ficti- reckless in their oversight of management and breach . states a cause of action under any tious accounting entries” leading to alleged asleep at the switch.”5 part of Rule 10b-5 only if the conduct alleged material overstatements of revenue, income can fairly be viewed as ‘manipulative or decep- and assets.2 Cutler’s comments were echoed in a speech tive’ within the meaning of the statute.” by SEC Chairman William H. Donaldson.6 Twenty years later, this principle was reiterated By naming the outside director as a defen- Commenting on the Commission’s investigation by the Court in United States v. O’Hagan, 521 dant, Chancellor raised more than a few of mutual funds, the Chairman stated that the U.S. 642 (1997). In ruling on the government’s eyebrows. Although the complaint alleges that SEC is “carefully looking at the role that inde- misappropriation theory of insider trading, the Peselman violated, inter alia, Section 10(b) of pendent directors played, if any, in the problems Court recognized as a predicate for liability the Exchange Act, and Rule 10b-5 thereunder, at these firms. We are asking whether the direc- under Section 10(b) in that context that there he is not charged with direct participation in tors were aware of these abuses, and whether needed to be an underlying breach of fiduciary the accounting fraud. Rather, in its release there were red flags that were ignored.” duty. Although finding such a duty in that case, announcing the complaint, the SEC asserts that Donaldson added that the SEC would pursue the Court nevertheless again stated that Peselman violated the antifraud provisions of aggressively those who harmed investors, “even “§ 10(b) is not an all-purpose breach of fidu- the federal securities laws “by signing a number if they turn out to be fund directors.” Mirroring ciary duty ban; rather it trains on conduct of false financial statements and, as an outside the reference to fiduciary duties in the involving manipulation or deception.” (In director with fiduciary responsibilities, by Chancellor action, the Chairman concluded his O’Hagan, the Court found this requirement sat- ignoring clear warning signs that financial remarks by stating: “Investors must be able to isfied by the defendant’s trading activity using improprieties were ongoing at the company and see for themselves that fund companies, and the information obtained by the breach of duty.) continued on page 6 1 SEC to Target Directors in Fraud Cases, Cutler Says, Bloomberg Report (August 20, 2003).