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U.S. Investment Management:Issues for Public Funds

FLAR/CAF Legal Seminar of Central Banks and Multilateral Institutions of Latin America

Bogota, ColombiaAugust 29, 2013

Presented byJay G. Baris

Barbara R. Mendelson

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Caveat• This outline is for informational purposes only and does not constitute

legal advice or create an attorney-client relationship• Consult your own attorney for legal advice on the issues discussed in

this outline• IRS Circular 230 Disclosure

• To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein

• This outline may constitute attorney advertising

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Introduction• Topics for discussion

• Overview of U.S. Financial Regulators• Principal U.S. Financial Laws• Standard of Care• Prudent Man Rule • Prudent Investor Standard• Fiduciary Standard• Investment of Public Funds• Investment Advisers Act of 1940• Selecting an Investment Adviser• U.S. Regulatory Environment

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U.S. Financial Regulators• Banking Regulators

• Comptroller of the Currency (part of U.S. Treasury)• National banks and trust companies

• Board of Governors of Federal Reserve System• Member banks (including national banks and state-chartered banks)

• Federal Deposit Insurance Corporation• Regulates banks with respect to deposit insurance

• State banking commissioners• Regulate state-chartered banks

• Securities Regulators• Securities and Exchange Commission

• Regulates broker-dealers, investment advisers, investment companies, securities exchanges and offerings of public securities

• Financial Institutions Regulatory Association• Regulates broker-dealers (self-regulatory)

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U.S. Financial Regulators• Commodities Regulators

• Commodity Futures Trading Commission• Regulates commodity pool operators (CPOs), commodity trading advisors

(CTAs) and commodity exchanges• National Futures Association (NFA)

• Regulates CPOs and CTAs

• State Insurance Regulators• No federal regulation of insurance companies

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Principal U.S. Financial Laws• Major Securities Laws

• Securities Exchange Act of 1933• Regulates public offering of securities

• Securities Exchange Act of 1934• Regulates trading of securities and exchanges

• Investment Company Act of 1940• Regulates investment companies and business development companies

• Investment Advisers Act of 1940• Regulates investment advisers

• Major Commodity Laws• Commodity Exchange Act

• Notable Recent Amendments• Sarbanes-Oxley Act of 2002• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

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Standard of Care• Standard of care for investment advisers and managers of public

funds• State statutory and common law

• Prudent Investor Rule• Investment Advisers Act of 1940 (Advisers Act)

• Investment advisers are fiduciaries• Employee Retirement Income Security Act of 1974 (ERISA)

• Standard of care for managing retirement assets

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Prudent Man Rule• Until the mid-1990s, the common law standard of care for trustees

making of trust investments was the “prudent man” or “prudent person” standard.

• Model Act • Fiduciary shall “exercise the judgment and care under the circumstances then

prevailing, which men of prudence, discretion and intelligence exercise in the management of their own affairs”

• Restatement• a trustee owes a duty to the beneficiary in administering a trust “to exercise

such care and skill as a man of ordinary prudence would exercise in dealing with his own property . . .”

• Supreme Judicial Court of Massachusetts (1830)• When investing, a trustee “is to observe how men of prudence, discretion and

intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested”

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Prudent Man Rule• Judicial interpretations of the Prudent Man Rule severely limited how

trustees could invest• Most important consideration – preservation of capital

• Fiduciary’s primary responsibility was never to lose money while investing• Investments were expected to generate income

• Non-income producing assets were suspect or inappropriate• Each investment was judged independently, without regard to how other

investments performed• Trustee could be liable for losses incurred in a portfolio even if the portfolio’s

overall performance was excellent

• These standards made it difficult for fiduciaries to invest in anything other than U.S. government securities and high-grade corporate bonds

• In the 1980s, there was a push to change this standard to consider portfolio theory investing

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Prudent Investor Standard• The Prudent Man Rule gave way to the Prudent Investor Rule

• Codified in the Uniform Prudent Investor Act (UPIA) in 1995

• Significant change in how fiduciaries may invest assets• The standard of prudence applies to any investment as part of the total portfolio,

rather than to individual assets• Hindsight no longer a component of the investment standard

• Tradeoff in all investing between risk and return is the fiduciary’s central consideration

• Eliminates restrictions on specific types of investments• Trustee can invest in anything that plays an appropriate role in achieving

risk/reward objectives (and that meets requirements of prudent investing)• Derivatives, interests in limited partnerships, futures and not imprudent per se

• Diversification requirement integrated into definition of prudent investing• Fiduciary may delegate investment authority, subject to safeguards

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Prudent Investor Standard• Almost all states have adopted versions of UPIA

• 44 states plus the District of Columbia • 5 states have adopted their own modified versions

• As a preliminary matter, the Prudent Investor Rule provides:• A trustee owes a fiduciary duty to the beneficiary• The prudent investment rule is a default rule

• A trust may expand, restrict or eliminate its provisions• Trustee not liable to beneficiary if it acts in reasonable compliance with the rule

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Prudent Investor Standard• What is the prudent investor standard?

• A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill and caution

• A trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonable suited to the trust

• Fiduciary may add “risk” to a portfolio without fear of liability for the loss on a single investment, viewed after the fact

• For example, market risk, liquidity risk, counterparty risk, inflation risk• Inherent in this standard is that fiduciary must follow portfolio theory of investment

• Hedge against some risk, but some measure of risk will always remain• No carte blanche to speculate or make high-risk/high-yield investments only• OK to combine element of risk with traditionally conservative investments

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Prudent Investor Standard• Express authority to delegate investment authority

• Delegation to committees, officers, or employees of the institution or the fund• May contract with independent investment advisers, investment counsel or

managers, banks or trust companies• Change reflects tremendous complexity involved in investing• To delegate investment authority, a fiduciary must

• Use reasonable care and skill in selecting an adviser• Establish the scope and terms of the delegation, consistent with the purpose

and terms of the trust, and• Periodically review the adviser’s actions in order to monitor the adviser’s

performance and compliance with the terms of the delegation• If the fiduciary meets these standards, it should not be held liable for the losses

incurred by the adviser

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Prudent Investor Standard• What constitutes a “prudent investment”? UPIA provides guidance

with 8 factors1. General economic conditions

2. The possible effect of inflation or deflation

3. The expected tax consequences of investment decisions or strategies

4. The role that each investment or course of action plays within the overall trust portfolio (e.g., financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property)

5. The expected total return from income and capital appreciation

6. Other resources of the beneficiaries

7. Needs for liquidity, regularity of income and preservation or appreciation of capital

8. The asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries

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Prudent Investor Standard• Diversification

• A trustee shall diversify investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying

• Duty of loyalty• A trustee shall invest and manage the trust assets solely in the interest of the

beneficiaries

• Impartiality• If a trust has two or more beneficiaries, the trustee shall act impartially in investing

and managing the trust assets, taking into account different interests

• Investment costs• A trustee may incur costs that are appropriate and reasonable in relation to the

assets, the purposes of the trust, and the skills of the trustee

• Reviewing compliance• Determined in light of the facts and circumstances at the time of the action, not in

hindsight

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Fiduciary Standard• General fiduciary principals

• A fiduciary has a duty of care and undivided loyalty to its clients• Contrast fiduciary duty standard that applies to investment advisers to “suitability”

standard that applies to broker-dealers• Broker-dealers are not subject to a fiduciary standard unless duly registered)• “Suitability” means that the investment they choose must be suitable for

investor

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Investment of Public Funds• Standard of care for investing public funds varies from state to state• Example: Alaska’s standards for investments of the Alaska

Permanent Fund (APF) (Alaska Statutes Sec. 37.13.120)• The Board shall “adopt regulations specifically designating the types of income

producing investments eligible for investment of fund assets”• The prudent investor rule applies

• As applied to the investment activity of the APF, the prudent investor rule means that “judgment and care under the circumstances then prevailing that an institutional investor of ordinary prudence, discretion and intelligence exercises in the designation and management of large investments entrusted to it, not in regard to speculation, but in regard to the permanent disposition of funds, considering the preservation of the purchasing power of the fund over time while maximizing the expected total return from both income and the appreciation of capital”

• The corporation may not borrow money or guarantee a loan of others, except that the corporation may, directly or indirectly, borrow money if the borrowing is nonrecourse to the corporation and the fund

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Investment of Public Funds• Alaska’s standards for investments of APF, continued

• Diversification of assets• Board shall “maintain a reasonable diversification among investments unless,

under the circumstances, it is clearly prudent not to do so”• The board shall invest the assets of the APF in “in-state investments to the

extent that in-state investments are available” and if the in-state investments• Have a risk level and expected return comparable to alternative investment

opportunities, and

• Are eligible for investment of fund assets under the prudent investor rule

• The corporation may enter into and enforce all contracts necessary, convenient or desirable for managing the fund’s assets and corporate operations, including contracts for future delivery to implement asset allocation strategies or to hedge an existing equivalent ownership position in an investment

• By accepting delegation of investment authority, an adviser submits to the jurisdiction of the state of Alaska (Alaska Stat. Sec. 13.36.240(d))

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Investment Advisers Act of 1940• The Investment Advisers Act of 1940 (IAA) created federal fiduciary

standards for investment advisers• IAA does not specify precise fiduciary responsibilities• The U.S. Supreme Court has interpreted Section 206 broadly because of the

fiduciary relationship of trust and confidence between the investment adviser and the client

• The IAA “reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship” as well as an intent to eliminate or expose conflicts of interest that might incline an investment adviser to provide advice that was not disinterested (SEC v. Capital Gains Research Bureau Inc.)

• As fiduciaries, investment advisers owe their clients “utmost good faith,” “full and fair disclosure of all material facts” and “reasonable care to avoid misleading them”

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Investment Advisers Act of 1940• Duty of care standard – Section 206

• Broad anti-fraud standard similar to that of other securities laws• Applies to all investment advisers, whether or not registered with the SEC• In general, Section 206 prohibits

• Any device, scheme, or artifice to defraud any client or prospective client• Any transaction, practice or course of business that operates as a fraud or a

deceit upon any client or prospective client• Trading any security with a client without following certain procedural steps• Any act, practice, or course of business that is fraudulent, deceptive or

manipulative, for which the SEC has the rule-making authority

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Investment Advisers Act of 1940• Compliance obligations of registered advisers

• Subject to examination by Office of Compliance Inspections and Examinations• Non-U.S. registered advisers must provide SEC with access to non-U.S.

personnel with respect to all activities• Substantive requirements include

• Filing requirements • Internal compliance program• Record keeping• Custody• Principal trades with clients• Anti-fraud• Restrictions on advertising and public communications• Restrictions on performance fees• Pay-to-play

• Generally, substantive requirements of Advisers Act do not apply to non-US clients of non-U.S. registered advisers

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Investment Advisers Act of 1940• Compliance obligations of registered advisers

• Must establish compliance procedures reasonably designed to detect and prevent violations of federal securities laws, which should address, at a minimum:

• Portfolio management processes• Trading practices

• Soft dollars• Side-by-side trading• Trade aggregation (bunching)

• Proprietary trading of adviser and its personnel• Personal trading by supervised persons• Accuracy of disclosures • Safeguarding of client assets• Creation and maintenance of records• Marketing• Valuation of assets• Safeguarding of private information• Business continuity

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Selecting an Investment Adviser• Tips for choosing an investment adviser

• Conduct rigorous due diligence• Legal qualifications

• Regulatory examinations

• Disciplinary history

• Background and experience of managers and analysts

• Pending enforcement and litigation

• Recent settlements

• Nature of business• Culture of transparency

• Turnover of personnel

• Financial stability

• Recent events

• Insurance

• Disclosure documents• Form ADV

• Performance disclosures (no cherry picking)

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Selecting an Investment Adviser• Tips for choosing an investment adviser

• Conduct rigorous due diligence (continued)• Portfolio management process and controls

• Experience with mandate

• Culture of compliance

• Nature and quality of compliance program

• Review of compliance policies

• Staffing of compliance function

• Experience of compliance officer

• Risk management

• Whistleblowing

• Conflicts of interest• Trade allocation

• Aggregation of trades

• Code of ethics (personal trading of employees)

• Process for correcting trade errors

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Selecting an Investment Adviser• Tips for choosing an investment adviser

• Conduct rigorous due diligence (continued)• Valuation procedures

• Use of pricing agents and override procedures

• Understanding of derivatives• Trading capacity

• Business continuity• Disaster recovery

• Succession planning

• Privacy and data protection• Safeguarding information

• Record keeping

• Regulatory filings

• Document due diligence review

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Selecting an Investment Adviser• Tips for choosing an investment adviser

• Conduct rigorous due diligence (continued)• Meet portfolio managers in person• Check references

• Ongoing oversight of investment advisers• Certifications• Review internal and third party assessments• Contractual notifications of material events

• Violations of investment guidelines• Compliance issues• Lawsuits and enforcement actions• Regulatory examinations and communications with regulators• Staff changes

• Periodic in-person meetings• Investment advisory contract

• Should address standard of care, indemnification, investment restrictions, among other things

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U.S. Regulatory Environment• Enforcement trends

• SEC enforcement cases on the rise – reflects more aggressive approach• YTD, as of August 6, 2013:

• Number of entities and individuals charged – 161• Number of CEOs, CFOs, and other senior officers charged – 66• Number of individuals barred or suspended – 36• Penalties ordered or agreed to – $1.53 billion• Disgorgement and prejudgment interest ordered or agreed to – $800 million• Other monetary relief – $400 million• Total penalties, disgorgement and other monetary relief – $2.73 billion

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U.S. Regulatory Environment• Enforcement trends

• Focus on insider trading• Number of insider trading actions in FY 2012 – 58 • Number of insider trading actions over past three years – 168 (more than any

previous three-year period)• High profile cases against hedge funds and their managers

• Focus on investment advisers and investment companies• Number of actions in 2012 – 147

• Focus on financial fraud and disclosure• Number of actions in 2012 – 79

• Total number of enforcement actions in 2012 – 734

• Enforcement lawyers participate in routine examinations of investment advisers

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U.S. Regulatory Environment• Recent rulemaking concerns

• Identity theft• Implementation of Dodd-Frank Act• “Pay to play”• Fiduciary standard for broker-dealers• Use of derivatives by investment companies• Money market funds• General solicitation and advertising in private offerings• Risk management• Shareholder access