Registered Funds Alert

May 2016

Table of Contents
Industry Urges SEC to Consider
2
Alternative Approaches to
Derivatives Rule; Questions
Appropriateness of Exposure Limits
The SEC’s proposal to limit derivatives use
by registered funds was met with significant
pushback from the industry. This Alertsummarizes major themes in industry
comment letters on the rule proposal.
Click here for more

The SEC Grants Applicationfor Broader, More Practical
Co-Investment Relief

5After a six-year process, the SEC granted
an exemptive application that would allow
registered funds to co-invest alongside theiraffiliates in a manner that is more practicalthan previously permitted by the SEC.
Click here for more

The SEC’s Evolving
Expectations for Fund Directors

7

Recent signals from the SEC indicate an
expectation that independent directors
should take an increased role in oversight ofcertain areas of fund operations related tothe day-to-day management responsibilities
of an adviser, which is at odds with thetraditional role of an independent director.
Click here for more

SEC Guidance Update Provides
Framework for Evaluating andUpdating Risk Disclosure

9

Recent SEC guidance lays out a frameworkthat may help registered funds and theiradvisers evaluate whether significant
changes in market conditions should bereflected in risk disclosure. Click here for more
Notable Transactions: Q1 201611
A list of notable transactions occurring in
the first quarter of 2016, including M&A
transactions and closed-end fund initialpublic offerings. Click here for more
Simpson Thacher & Bartlett LLPThis latest edition of Simpson Thacher’s Registered Funds Alert discusses:
the industry’s response to a controversial proposal to restrict derivatives
use by registered funds; the SEC’s blessing of an expanded form of
exemptive relief for registered funds to co-invest with affiliates; increased
tension between SEC expectations for independent directors and theirtraditional role of oversight; and the SEC’s framework for identifying andcommunicating changes in risks as a result of significant market events.

Industry Urges SEC toConsider Alternative
Approaches to Derivatives
Rule; Questions
Appropriateness of
Exposure Limits
As discussed in our last Alert, the SEC recently
proposed new Rule 18f-4 (the “Proposing Release”),
which is intended to restrict the use of derivatives
by registered funds. As proposed, Rule 18f-4 would,
among other things, require registered funds toadhere to one of two limits on derivatives use—an
exposure- or risk-based limit. The exposure-based
limit would prevent a fund from having aggregate
exposure to (i) derivatives transactions (basedon notional amount), (ii) “financial commitment
transactions” (based on obligation amount) and (iii)
any senior security (based on total indebtedness),
totaling more than 150% of its net asset value. The
proposed risk-based limit would allow a fund to haveaggregate exposure of up to 300% of its net assets,so long as the fund’s derivatives positions reduce thefund’s overall value-at-risk (“VaR”). The Proposing
Release also sets forth new asset segregation andrisk management requirements. The SEC received
more than 175 comment letters on the proposed rule,
including a letter from Simpson Thacher.
This Alert summarizes notable themes presented
in comments from industry participants. Similar
to comments on the proposed liquidity rule, manyindustry commenters expressed support for the SEC
as the appropriate regulator to address this issue (asopposed to the FSOC or another member of FSOC).1
Commenters also generally expressed support for the
consolidation and modernization of prior informal
and formal guidance, such as Release 10666, into asingle, uniform rule, noting that such a rule would
bring more certainty, clarity and transparency to the
obligations of registered funds.
Challenging the SEC’s Economic Analysis andAssumptions
As an initial matter, the industry raised serious
questions regarding the SEC’s economic analysis
and certain assumptions underpinning the proposed
rule that arose from that analysis. The Investment
1. Notably, FSOC released an update on its review of asset management
products and activities on April 18, 2016, in which it acknowledged the
SEC’s recent data reporting, liquidity and derivatives rulemaking proposals
and appeared inclined to defer to the SEC’s expertise in these areas.

Company Institute (the “ICI”), along with manyothers, urged the SEC to re-evaluate the impact ofthe proposed exposure- and risk-based limits in lightof data submitted by commenters. While the SEC
only analyzed approximately 10% of the industry in
the Division of Economic and Risk Analysis white
paper that accompanied the Proposing Release, theICI analyzed data from 82 complexes with 6,661
funds and $13.6 trillion in assets under management(approximately 59% of the industry) and concluded
that at least 369 funds, with $458 billion in assets
under management either will have to de-registeror substantially change their investment strategies
to continue business as registered funds, with aparticular disparate impact on alternative funds.
Pointing to the ICI’s study, many commenters
indicated that the exposure limits proposed by
the SEC should be re-examined, as it appears that
the SEC underestimated the potential significant
impact of these limits on capital markets andcapital formation. Moreover, many commenters,
including the International Swaps and Derivatives
Association, Inc., also argued that the proposed ruleshould be tabled until the SEC is able to finalize andobserve the effects, both independently as well as
the cumulative burdens, of other recently proposed
rules, such as the data reporting modernization rule,
the liquidity risk management rule and its Title VII
security-based swaps rulemakings.

369

$458

Number of registeredfunds the proposed
rule would require toeither de-register or
substantially change theirinvestment strategies,
according to an ICI study

Totals assets undermanagement of affectedfundsbillion

Proposed Alternatives and Revisions to the
SEC’s Exposure-Based Limit
Commenters raised several issues with the SEC’s
proposed exposure-based limit, including its relianceon notional amount and its seemingly arbitrary capof 150% (or 300% in conjunction with the riskbased limit). A significant theme throughout thecomments, including those submitted by Blackstone
Alternative Investment Advisors LLC (“BAIA”), wasthat “notional exposure is an imperfect indicator ofleverage and risk.” A number of commenters cited
to a recent white paper by James Overdahl of Delta
2Strategy Group, which discusses numerous ways inwhich notional exposure is a poor measure of risk.
Accordingly, commenters suggested a number ofalternative exposure limits based on metrics otherthan notional exposure for the SEC’s consideration(which could be adopted in addition to the proposed
150% notional limit and make the proposed rule
more appropriately tailored to funds that makesignificant use of derivatives). For example, BAIA
recommended an exposure limit based on a fund’s
Portfolio VaR versus a multiple (e.g., 1.5x) of the VaRof a benchmark, such as the S&P 500 Index. In the
BAIA formulation, a fund would be able to choose
a benchmark with a VaR lower than that of the S&P
500 Index but could not choose a benchmark with ahigher VaR.

“

. . . notional exposure is an imperfect indicatorof leverage and risk.

”

A significant number of commenters also suggested
that, if the SEC proceeded with using notional
values, notional values should be adjusted to reflect
more accurately the risk of a derivative instrument’s
underlying reference asset. Commenters pointed
out that risk-adjusted notional amounts havegained wide-spread acceptance from U.S. andforeign regulators in other contexts, such as swap
margin requirements. For interest rate derivatives,commenters suggested duration weighting as amethod of adjusting notional amounts to accountfor risk.
Additionally, commenters asked that the exposure
limit of 150% be increased (e.g., the ICI suggested
raising the limit to 200%) to provide funds withgreater flexibility and mitigate the need for somefunds to deregister or drastically modify theirinvestment strategies. In this connection, it waspointed out that funds are likely to self-impose alower exposure limit to avoid breaching the SEC’s
exposure limit.
Commenters also urged the SEC to expand thedefinition of netting when calculating the exposurebased limit. Under the proposed rule, funds would bepermitted to net notional amounts of any offsetting
derivatives transactions of the same type, withthe same underlying reference asset, maturity andother material terms. For instance, Stone Ridge
Asset Management LLC (“Stone Ridge”) proposedthat funds be permitted to net directly offsetting
transactions that fall into certain specificallydelineated categories. Finally, many commenters also
recommended that the SEC allow for daily rather
than time-of-transaction compliance monitoring.
The proposed rule’s real-time requirement would

be especially problematic for multi-manager funds,
where sub-advisers would be required to report
portfolio limits or VaR in real time.
Alternatives to the SEC’s Risk-Based Limit
Many commenters expressed the opinion that, as
proposed, the risk-based limit is too narrow andwould not serve as a realistic option for funds
that use derivatives to gain market exposure.
Among the alternatives proposed by commenters,
OppenheimerFunds, Inc. suggested revising therisk-based limit by setting a VaR limit for a fund’s
overall portfolio based on a multiple of the fund’s
securities VaR (i.e., the degree to which portfolio
VaR can be increased through derivatives rather
than looking at how portfolio VaR is reduced byderivatives). Under OppenheimerFunds’s approach,a fund could have aggregate exposure of up to 300%of its net assets so long as its full portfolio VaR
did not exceed 150% of its securities VaR—i.e., thefund’s derivatives transactions could not create an
additional risk of loss greater than 50% of the risk ofloss without those derivatives transactions. The ICI
submitted a different alternative, which would allow
a fund to have up to 300% aggregate exposure (or350% if the exposure-based limit is raised to 200%,as the ICI suggested), so long as the derivatives
that make up the additional 150% serve to reduce
the VaR of the rest of the fund’s portfolio, including
the derivatives that comprise the initial 150/200%
of exposure. Thus, a fund could use derivatives formarket exposure up to 150/200%, and any additional
derivatives use would need to reduce risk.
Asset Segregation
A major theme throughout the comments was thatthe proposed exposure- and risk-based limits were
unnecessary, and that the risks associated with afund’s derivatives use would be more appropriately
addressed through asset segregation, in conformity
with past SEC practice. The proposed rule requiresthat funds segregate “qualifying coverage assets,”
which involves different requirements for derivatives
and financial commitment transactions.
With respect to derivatives transactions, funds
would need to maintain assets on a daily basis witha value equal to the mark-to-market value on thatday, plus an additional “risk-based coverage amount”
that reflects an estimate of any additional amountthe fund might owe if it were to exit the transaction
under stressed conditions. With respect to financial
commitment transactions, funds would need tomaintain qualifying coverage assets equal to theamount of the obligations under such transactions,
whether conditional or unconditional.
3

A significant theme in comments, including thosefrom the Investment Adviser Association, was thatthe definition of “qualifying coverage assets,” which
generally limits qualifying coverage assets to cash
and cash equivalents, should be expanded to include
highly liquid assets with haircuts, noting that other
U.S. and international financial regulators haveblessed the approach. As argued by the ICI andmany others, “restricting qualifying coverage assets
to cash and cash equivalents can penalize investors
by creating a ‘cash drag’ on the performance ofa fund that otherwise would be fully invested.”
Further, many commenters also suggested revising
the proposed rule to allow for netting derivatives
transactions with offsetting exposures, with respect
to both derivatives and financial commitment
transactions.
BDC and Fund of Private Fund Issues
As proposed, Rule 18f-4 would apply equally tobusiness development companies (“BDCs”) andclosed-end funds as to other types of funds, suchas mutual funds. As noted in comments from the
U.S. Chamber of Commerce, BDCs are a significant
source of financing for small- and medium-sizedcompanies in the United States, and it is well
documented that financing for such companies has
generally become less available in recent periods
from banks for a variety of reasons, including
regulatory changes. The proposed rule would
drastically limit the ability of BDCs and certain
closed-end funds (including real estate closed-end
funds that make similar types of loan commitmentswith respect to underlying assets) to provide such
crucial financing because it would treat revolving
lines of credit provided by such funds as financial
commitment transactions under the theory thatthey are unfunded commitments. In particular,
Ares Capital Corporation (“Ares”), a specialty financecompany that has elected to be regulated as a BDC,
urged the SEC to exclude conditional loan obligations
from the definition of a financial commitment
transaction. Ares also suggested that, in the eventthat the SEC adopts the rule as proposed, it should
expand the definition of “qualifying coverage assets”
to include available capacity under a fund’s revolving
line of credit, which is typically balanced against afund’s unfunded commitments.
Several commenters, including the Private Equity
Growth Capital Council (the “PEGCC”), raised
concerns that the proposed rule’s treatment of
unfunded commitments to private funds as financial
commitment transactions would unnecessarily
diminish the ability of funds to invest in private
funds. The SEC has allowed funds of private equity
funds, for example, to operate so long as theirinvestors meet certain sophistication criteria. Under
the proposed rule, such funds would be required
to segregate the full amount of all unfunded
commitments to private equity funds, even if there
is little to no chance that some of the commitments
would be called. To illustrate this point, commenterscompared two general types of investments thatfunds of private equity funds typically make—primary commitments to private equity funds thatare in earlier stages of their life cycles and are more
likely to call commitments to make new investments
and secondary investments in later-stage private
equity funds that are past their investment period
and are highly unlikely to call any outstanding
commitments. The PEGCC suggested that funds
be required to segregate an amount based on areasonable estimation of the amount of unfunded
commitments expected to be called in the next
calendar quarter instead of the full amount of theoutstanding obligation.
Role of Board
The proposed rule would also impose on fund boards
three primary new responsibilities: (i) approving
one of the two portfolio limitations; (ii) approving
asset segregation policies and procedures; and(iii) approving a derivatives risk management
program (and any material changes thereto) and if
applicable to the fund, approving the designation ofa derivatives risk manager and reviewing quarterly
reports regarding the program. A significant theme
throughout the comments addressed concernsof the board’s role exceeding typical oversight
responsibilities. For instance, the Independent
Directors Council (the “IDC”) suggested that theboard’s approval of the particular limitation is not anappropriate board role, indicating that the adviser, if
anyone, would be in the best position to make sucha decision. Moreover, the IDC and Mutual Fund
Directors Forum (“the MFDF”) questioned the needfor specific board approval requirements under the
proposed rule when Rule 38a-1 already requires
the board to approve compliance policies andprocedures, including those related to derivatives.
The MFDF and IDC both expressed concern that theapproval of specific asset segregation policies andprocedures might require board members to develop
in-depth knowledge of VaR or other technicalconcepts beyond the scope of their typical oversight
responsibilities. Finally, many also urged the SEC
to decrease the frequency of the derivatives reports
from at least quarterly to at least annually and toeliminate the requirement that a fund board approve
any material changes to the fund’s risk management
program, especially given that Rule 38a-1 requires
the fund’s CCO report to address such changes.

4

Risk Management Program
Under the proposed rule, if a fund has more than
50% notional exposure to derivatives transactions,or engages in any “complex derivatives transactions”
it would be required to adopt a tailored derivatives
risk management program. A fund would be
required to adopt certain policies and procedures
reasonably designed to assess and manage the fund’sderivatives transactions, and to ensure appropriate
asset segregation. Additionally, a “derivatives
risk manager” must be designated to administerthe program.
Generally, most commenters did not oppose the
SEC’s proposal, but noted several modifications,
including a cure period, a de minimis exception andthe ability to appoint a committee or an individual
as the fund’s derivatives risk manager. Many
commenters agreed that a cure period, for example
the five-day period suggested by Guggenheim
Investments, would be helpful for a fund thatseeks to limit its exposure to derivatives to 50% orless of the net assets of the fund, but temporarily
exceeds that threshold. The ICI also suggested ade minimis exception, whereby a fund would beallowed to use a de minimis amount of complex
derivatives transactions without giving rise to therisk management program requirements. Many
commenters, including BlackRock, also urged the
SEC to allow firms to delegate the responsibilitiesof the derivatives risk manager to a group of people,
such as a risk committee, noting that doing so “would
allow firms some flexibility to incorporate the risk
management program into their existing complianceand oversight structures.”
Further, many commenters also asked the SEC toclarify that a fund’s derivative risk manager will
not be personally liable (or the target of any SEC
enforcement actions) for any good faith decisions
he or she makes in such capacity. Similarly, thederivatives risk manager should not be liable forthe performance of derivatives transactions or theireffects on a portfolio in the event that a decision
ultimately turns out to be wrong.

of the requirements of the proposed rule. Notingthat it is unlikely that any final rule would work
for all funds, these commenters argued that a fundshould be exempt from such requirements if it candemonstrate that its strategy does not implicate the
SEC’s concerns regarding excessive borrowing andundue speculation.
Simpson Thacher will be actively monitoring
progress with regard to the derivatives and otherproposals (including data reporting and liquidity
management proposals) and will address any
developments in future Alerts.

The SEC Grants Applicationfor Broader, More Practical
Co-Investment Relief
The Investment Company Act of 1940 has contained
from its enactment a number of prohibitions ontransactions between a registered fund and its
affiliates, including prohibiting joint transactions
that are disadvantageous to a registered fundparticipant. Over the past 25 years, the Staff of the
Securities and Exchange Commission’s Divisionof Investment Management has granted relief
in the form of no-action letters from certain of
these prohibitions by allowing registered funds
to engage in “co-investment” transactions with
their affiliates, so long as they comply with certain
restrictive conditions. Under these no-action letters,a registered fund is permitted to co-invest alongside
an affiliated entity in transactions involving publicly
traded securities and in private transactions where
there is no negotiation of a term other than price andallocations of such opportunities are made fairly andpursuant to board-approved policies.

“

Other Comments. . . the SEC has demonstrated that it may be
open to reconsidering long-standing positions
in order to provide more practical exemptive
relief, if it reflects the realities of the asset
management industry.

Several commenters, including Simpson Thacher
and Stone Ridge, asserted that “grandfathering”
provisions should be incorporated into the rulefor certain funds currently in operation, pointing
to the significant startup capital and resourcesthat have been expended by fund managers. Stone
Ridge also urged the SEC to “embrace its ability
to issue exemptive orders,” arguing that any final
rule should include specific exemptive authority bywhich a fund may be exempted from some or all

Of course, some private co-investment opportunities
do require negotiation of additional terms otherthan price, and in certain instances registered funds
have obtained specific exemptive relief from the
SEC to enter into such transactions, subject to theconditions therein. Six years ago, Apollo Investment
Corporation and its related entities (“Apollo”) applied
for such co-investment relief, but notably requested
a modified version of the more “standard” relief”

5that had been granted to other registered funds
and their affiliates.2 The Apollo application sought
relief that would be more adaptable to the complex
interactions between affiliates often encounteredby larger asset managers with multiple types ofinvestment product offerings. In late March 2016,
after seven rounds of amended applications, the SEC
granted Apollo’s longstanding request. By granting
Apollo’s application the SEC has demonstrated
that it may be open to reconsidering long-standing
positions in order to provide more practicalexemptive relief, if it reflects the realities of the asset
management industry.
Until Apollo’s application was granted, the typicalapplication and order for co-investment relief has
followed a virtually identical framework, regardlessof the relative size, complexity, or sophisticationof the applicant. The SEC has historically required
13 or 14 conditions that control how the applicant
must behave with respect to sharing investment
opportunities if they are to be granted the ability toallow registered funds to engage in co-investment
transactions with affiliates. Generally, the conditions
specify that all investment opportunities presented
to an affiliated adviser that fall within a registeredfund’s investment objectives must be shared with theadviser of the registered fund so that the registeredfund can make an independent decision about
how much it will invest (i.e., quantity of securities
to be purchased). Once all participating affiliatedentities make their independent determinations
as to quantity (as determined by the adviser
to each participating entity), the transaction isprocessed centrally and allocated accordingly. If therequested quantity exceeds what is available, theinvestment opportunity is allocated among all of
the co-investing entities on a pro rata basis, basedon criteria specified in each application. Over threedozen applicants have received relief that follows thisformula since the early 1990s.
Apollo’s application followed the broad strokes ofthe standard framework, but it introduced several
key changes to make the process more workablefor large-scale operations and sought to expand
the universe of allowable transactions further thanwhat had previously been permitted by the SEC.
Of particular note, Apollo sought to curtail thecommand that all investment opportunities within
the scope of a registered fund’s general investment
strategy must be shared with that fund’s adviser.
Given the size and presence of larger asset managers,
the proverbial firehose of investment opportunities
that would have to be shared with the registered
2. An application for similar relief was filed by Ares on November 11,
2008. Ares filed an amendment on March 29, 2016 that closely tracked
the final application submitted by Apollo. The SEC has not yet published a
notice of an intent to grant Ares’ application.

fund’s adviser under the standard relief could quickly
become prohibitively burdensome to evaluate.
Apollo’s solution was to create “Board-Established
Criteria,” which act as an adjustable filter to control
the flow of investment opportunities presented
to the registered fund. Apollo’s application allows
each registered fund’s adviser the opportunity torecommend to the fund board criteria that describe
the characteristics of potential co-investment
transactions that are closely aligned with theregistered fund’s then-current focus, so that thefund may elect to request its adviser only be notified
of matching co-investment opportunities. Apollo’s
application specifies that the criteria must be
objective and testable, and that it must be approvedby a majority of the independent directors of thefund’s board before going into effect. Relatedly,
Apollo also sought the flexibility for affiliated funds
to close on co-investment transactions within 10
days of each other, provided they all commit on thesame day.
The order also granted Apollo the ability toallow registered funds to co-invest in follow-ontransactions even where the original transaction
was not evaluated pursuant to the conditions of
the relief. Under the standard relief, follow-on
investments are arguably only permitted if the
securities at issue were acquired in a co-investment
transaction that was completed in compliance withthe conditions of the exemptive order. For example,
under the standard relief, if a registered fund andan affiliate separately acquired securities from thesame issuer before exemptive relief was obtained
and then a follow-on opportunity arises after
exemptive relief was obtained, the registered fundpotentially might not be able to participate jointly
in the follow-on. Under Apollo’s order, however, solong as the transaction is successfully put through an“enhanced review,” a concept introduced by Apollo
in its application, the registered fund may participate
in the follow-on opportunity alongside affiliates.
The enhanced review is a multi-step procedure that
requires each registered fund’s board to confirm,with the advice of independent counsel, the presenceof certain conditions that are designed to ensure thatthe follow-on opportunity is fair, in the best interestof the registered fund, and otherwise in compliancewith the 1940 Act.
Similarly, the Apollo order broadens the rangeof permissible joint dispositions to include thosewhere the affiliated funds did not first obtain the
securities in reliance on the relief. Under the Apolloorder, should any affiliate elect to sell, exchange
or otherwise dispose of securities also held by aregistered fund, they must alert the registeredfund’s adviser of the potential transaction and the6

opportunity to participate proportionally. If theregistered fund’s adviser recommends joining thetransaction, the registered fund’s board must thencomplete an enhanced review of the transaction
analogous to the procedure for follow-on investments
described above.
In sum, Apollo’s relief (and presumably Ares’
soon to be granted relief) is broader and morescalable than the standard relief and is a betterreflection of the realities facing certain types oflarger asset managers. Though Apollo’s application
took six years to approve, and significantly longer
than contemporaneous requests for the standard
co-investment relief, the fact that the order was
eventually granted is positive news and shows the
SEC may be willing to engage with the industry to
tailor exemptive relief to address specific needs.
Whether this is indicative of a thaw in the SEC’s
general hesitancy to grant novel relief remains tobe seen.

The Role of the Board According to the 1940
Act’s Legislative History
To establish a baseline of expectations forindependent directors, it is helpful to look to thelegislative history of the 1940 Act. There wassignificant discussion regarding the statute’s
requirement that independent directors make up asignificant portion of a fund’s board. The originaldraft of the statute would have required a majorityof the board to be independent. The industry wasvery active in the process of revising the initial draft,and numerous industry representatives appeared
before Congress to share their views and offer
recommended changes. Many of these industry
representatives were asked about their views
regarding the statute’s proposed requirement of
having a majority of independent directors.

“

As the SEC has grown to expect more andmore of independent directors, it raises thequestion of whether there is a point whereindependent directors become too involved in
day-to-day management, potentially decreasing
the value of their oversight and jeopardizing their
independent perspective.

”

The SEC’s Evolving
Expectations forFund Directors
Independent directors of registered funds
are often referred to as “watchdogs” or, more
recently, “gatekeepers,” who guard the interests ofshareholders against the concerns of conflicts ofinterest, self-dealing and other abuses that gave
rise to the 1940 Act. The general consensus among
both the industry and the SEC is that the role ofindependent directors is one of oversight. Reasonableminds disagree, however, on the meaning of“oversight,” and the expectations that the SEC has
for independent directors have evolved over time.
As the SEC has grown to expect more and moreof independent directors, it raises the question ofwhether there is a point where independent directors
become too involved in day-to-day management,
potentially decreasing the value of their oversightand jeopardizing their independent perspective.

While some argued that there was no need forindependent directors, many acknowledged thevalue that independent directors would bring to thetable. While generally supporting a requirement
for independent directors, industry representatives
rallied against the statute’s proposed requirementthat independent directors make up a majorityof a fund’s board. F. Wilder Bellamy, president of
National Bond & Share Corporation (a closed-endfund) stated his view that independent directors
should not control the board because shareholders
are entrusting management, not outsiders, with
their investments. Given the intent behind requiring
independent directors, Mr. Bellamy stated that hebelieved that he did not “see any representation[of shareholder interests] that could be supplied bya majority that could not be supplied by a minority
for, after all . . . the cold light of day is the thing thatkeeps people from doing things that are wrong. As
a rule the minority directors can see that the lightof publicity is turned on transactions just as well as
the majority can.”3 This line of reasoning ultimately
carried the day, as the statute was adopted with arequirement that independent directors comprise
40% of a fund’s board.
3. See Investment Trusts and Investment Companies: Hearings Before a
Subcommittee of the Senate Committee on Banking and Currency, 76th
Cong., 3rd Sess. 423 (1940) (statement of F. Wilder Bellamy, President,
National Bond & Shareholder Corporation).
7

As for the role of fund directors, Arthur Bunker, an
executive vice president of The Lehman Corporation(one of the largest closed-end funds at the time)
described it as follows:“

I think it is fair to say that, in general, thefunction of the directors is to keep the company incontact with the outside world and to be responsible
for the determination of general policy. In thematter of the investment company, this would
mean that they would be responsible for such major
questions as to the general program of acquisition
or disposition of securities and, in a general way, forthe determination of fields of investment.
But this is a very different thing from asking themto pass upon every minute purchase and sale, toexamine every report and recommendation madeby the operating staff, and to consider every daily
investment opportunity which may arise. I am sure
you will agree that these distinctions between theoperating staff and the directorship staff are fairdistinctions. 4”

Mr. Bellamy and others expressed similar
understandings of the role of fund directors.
The SEC’s Current Expectations Regarding
the Role of Independent Directors
Fast-forwarding more than 75 years to the present,
it is clear that fund directors are more involvedin examining reports and recommendations ofmanagement than was contemplated in 1940. While
prominent SEC officials such as Chair Mary Jo
White and David Grim, Director of the Divisionof Investment Management, acknowledge thedistinction between management and oversight, theSEC’s rulemaking, examination and enforcement
initiatives indicate that the SEC expects independent
directors to get increasingly involved in overseeing
day-to-day operations. The problem is that the line
between oversight of day-to-day operations andactual management of such operations is thin andnot always apparent. For example, commenterson the SEC’s recent liquidity management andderivatives rule proposals have expressed concern
regarding provisions that would require directors
to approve detailed policies and procedures andevaluate key thresholds that appear to require
technical knowledge and encroach upon day-to-day
operations and responsibilities of a fund’s adviser.
In a speech at the Mutual Fund Directors Forum2016 Policy Conference, Chair White stated that
4. Id. at 413 (statement of Arthur Bunker, Executive Vice President, The
Lehman Corporation).

certain recent events, including when a service
provider was unable to calculate the net asset valueof funds due to a computer glitch, “raise a numberof new questions for fund directors related to theiroversight of operational risks” and that directors
should be “thinking about and asking fund managers
whether these events could happen at your fund, how
to prevent them from happening, and how to respondpromptly and effectively if they do occur.”5
The notion that independent directors bear some
responsibility for oversight of operations issues
demonstrates how far the 1940 Act framework, inpractice, has drifted from the board being involved
in “major questions as to the general programof acquisition or disposition of securities and, ina general way, for the determination of fields ofinvestment.” This is not to say that fund directors
should shy away from asking fund management
about these issues, but statements like Chair White’s
assume that directors have a responsibility to oversee
day-to-day operational risks. It is not clear that fundboards are designed to do so, even if the SEC believes
that it is their job to do so.
Concerns Regarding Potential Enforcement
Actions Against Independent Directors
The disconnect between the SEC’s expectations andthe traditional role of the board opens the door for
enforcement actions targeting independent directors.
Chair White has put directors on notice, statingthat “[w]hen directors fail to perform their duties,
they should expect action to punish and deter suchconduct.”6“The disconnect between the SEC’s expectations
and the traditional role of the board opens
the door for enforcement actions targeting
independent directors.

”

At the same time, she expressed an expectationthat independent directors need to develop (or hire)
expertise in areas such as cybersecurity, derivatives,
liquidity, trading, pricing and fund distribution. By
expanding the scope of directors’ responsibility toinclude day-to-day operations such as cybersecurity,
trading and pricing, directors could be subject toadditional enforcement risk. Anthony Kelly, co-chiefof the Asset Management Unit of the SEC’s Division
of Enforcement, has stated that the SEC “anticipate[s]5. See Mary Jo White, Chair, SEC, The Fund Director in 2016: Keynote
Address at the Mutual Fund Directors Forum 2016 Policy Conference (Mar.
29, 2016).
6. Id.
8

focusing on gatekeepers, and where appropriate, wewill bring actions.”7
In addition to the expanded scope of director
responsibilities, fear of SEC enforcement targeting
independent directors is further heightened byactions that indicate an apparent willingness on thepart of the SEC to substitute its judgment for that of
the board. A recent enforcement case cited by ChairWhite as a basic failure on the part of independent
directors arguably illustrates that the SEC is willingto bring an action if it disagrees with the judgmentof the independent directors. As discussed in a prior
Alert, in the Commonwealth case, the SEC allegedthat the independent directors failed to fulfill their
duty under Section 15 of the 1940 Act to request
and evaluate such information as “may reasonably
be necessary to evaluate the terms of any contract
whereby a person undertakes regularly to serve or act
as investment adviser.” While the SEC acknowledgedthat the independent directors requested appropriate
information from the funds’ adviser, the alleged
violation was that they did not follow-up with theadviser for information that was missing from theadviser’s responses and therefore did not evaluate all
information necessary to make a determination ofwhether to renew the advisory contracts. While as a
general practice a fund board should seek responses
to all information requested, it is notable in this casethat the adviser was paid no advisory fees for theperiods in question and much of the information
alleged not to have been provided related to fee
comparisons, profitability and economies of scale. It
would not be unreasonable for independent directors
to conclude that evaluating such information was notnecessary to renew an advisory contract pursuant
to which the adviser had not been paid any advisory
fees.
Even more troubling are the mixed messages the
SEC is sending regarding the expectation thatindependent directors are responsible for obtaining
certain types of information from service providers
even if they have no legal mechanism to compel
them to provide it. In a January 2016 guidance
update, summarized in our last Alert, the staff of
the SEC’s Division of Investment Management notedthat independent directors have a Section 15(c)-likeduty under Rule 12b-1 to request and evaluate
all information reasonably necessary to consider
approval or renewal of a Rule 12b-1 plan. In thisrespect, the staff stated its belief that independent
directors should receive information from financial
intermediaries with respect to distribution andservicing arrangements. Many industry observers
have commented that boards have no mechanism
7. See Greg Saitz, Intermediary Won’t Give Up Info? SEC Feels Your Pain,
Ignites, May 3, 2016.

to require financial intermediaries to provide
such information, as they currently have no legal
duty to do so. While some SEC officials, such as
Division of Investment Management branch chief
Thoreau Bartmann, have noted that the SEC
recognizes that “there is a power imbalance” andthat “intermediaries don’t want to provide thisinformation,” other SEC officials have expresseda different view.8 While speaking on a panel at
the Practising Law Institute’s 2016 Investment
Management Institute in New York, Ken Joseph,
Associate Regional Director of the Investment
Adviser/Investment Company Examination
Program in the SEC’s New York regional office,stated that boards have an obligation to haveadequate information no matter what. He expressedthe view that “‘I can’t get the information’ is not avalid excuse. . . there is no carveout in the federal
securities law for ‘I can’t find the information’ or‘they won’t give it to me.’”9 When considered inrelation to the Commonwealth action, this statement
demonstrates how the SEC’s changing expectations
may be putting directors between a rock and ahard place.

SEC Guidance Update
Provides Framework for
Evaluating and Updating
Risk Disclosure
Following recent volatile markets and the SEC’s
ongoing concerns about fund liquidity risks,particularly in light of the dissolution of a highyield open-end fund in December 2015, the staffof the SEC’s Division of Investment Management(“Staff”) issued a guidance update in March 2016
reminding fund complexes of their obligation tomonitor market conditions and assess whether afund’s risk disclosure adequately reflects changing
conditions (“Guidance Update”). The Guidance
Update supplements prior guidance updates issued
in recent years that highlighted the importance ofsummarizing principal risks in the prospectus andreevaluating fund names that suggest protection
from loss.
The Guidance Update emphasizes the importantrole that full and accurate information about fundrisks plays in allowing investors to make informed
investment decisions. As a fund reacts to changing
8. See id.
9. See Greg Saitz, No Excuses in Fight for Broker Information: SEC Official,
Ignites, Mar. 22, 2016.
9market conditions, its risks are dynamic and may
increase or decrease overall risk for investors at
different points in time. Once-adequate disclosure
may become inadequate, or risk disclosure mayneed to be added or moved to become more or lessprominent. Consequently, the Guidance Updatestates that a fund (i) should review its disclosure
risks on an ongoing basis to ensure that they remainadequate in light of current conditions and (ii) if any
disclosure is inadequate, communicate any new or
modified risks to investors.
The Guidance Update places emphasis on heightened
responsibilities for a fund adviser in confirmingthat disclosures remain, in all material respects,
accurate and complete in light of changing market
conditions. Noting that many fund boards requestthat the adviser report on its process for preparing
the fund’s disclosure materials, the Guidance Update
recommends that the adviser go one step further by
providing information to the board on steps taken
to evaluate fund risk disclosures and determine
whether changes are appropriate.
The Staff states that funds should undertake threesteps on an ongoing basis to assess and, if necessary,
revise their risk disclosures to remain suitable inchanging market conditions:• Monitor Market Conditions and their Impact onFund Risks. As part of day-to-day operations,funds should continually monitor market
conditions and assess their impact on the fundand the risks associated with its investments.
• Assess the Adequacy of Risk Disclosures. Once afund determines that changed market conditions
have affected risks associated with the fund,it should assess the change’s significance andmateriality to investors. If it is significant andmaterial, a fund should assess the adequacy of
existing disclosures.
• Communicate with Investors: If the funddetermines that changes to a fund’s risks arematerial to investors and that the current
disclosures are inadequate, it should update
its communications and provide them toinvestors “at the time and in the mannerrequired by the federal securities law and asotherwise appropriate.”

rates. In anticipation of such change many fixedincome funds warned investors of: (i) a possible
decline in the value of fixed-income investments
in response to higher interest rates; (ii) potential
periods of volatility and increased redemptions;and (iii) the sensitivity of longer-term securities tointerest rate changes. Secondly, in light of recent
concerns over whether Puerto Rico would default
on its debt, the Staff similarly commended fundswith significant exposure to Puerto Rico debt fordisclosing in their prospectuses that they invested in
Puerto Rico debt, as well as the factors expected to
impact the value of the Puerto Rico debt held by
the fund.
While some in the industry have expressed concernthat the Guidance Update will encourage funds
to add technical risk disclosure about specificsecurities, an approach that the SEC expressly
disavowed in the 1998 amendments to Form N-1A,
when read more generally, the Guidance Update
seems to be focused on how significant or historicchanges in market conditions can impact existingrisk disclosure. The Guidance Update provides
a framework for funds and advisers to utilize inevaluating risks and risk disclosure in connection
with other significant market changes and events
that may occur in the future (beyond interest rateand liquidity risks). Namely, a fund should (i)monitor market changes that may cause changes in afund’s susceptibility to risk and (ii) review and assess
risk disclosures in light of these market changes,
which requires evaluating whether that impact isboth material and significant to investors. After
employing the framework, a fund should look to the
SEC’s endorsements of the disclosure practices of
fixed-income funds and those holding Puerto Ricodebt in order to extrapolate how those practices
would apply to the risk at hand. For example, theStaff approvingly cited a fund for looking toward
the future and accounting for the interest of longterm investors by disclosing that interest rates are at
historic lows and are likely to increase in the future,and explaining the potential secondary impacts thatwould affect a fund’s fixed-income investments. The
Guidance Update lays out a framework that may
help funds and advisers struggling with whether
to communicate a change in fund risk profile toinvestors.

The Guidance Update adopts an encouraging tone indiscussing two evolving areas in which funds haveprovided “useful” information to investors regarding
current market conditions. The first example relates
to disclosures by certain fixed-income funds in
response to potential changes in government policythat would raise the current historically low interest10M&A Transactions
Acquiror

Acquired or
Target Company

Type of Transactionand Status

Affiliated Managers Group Inc.,a global asset management company
with equity investments in boutiqueinvestment management firms andapprox. $619 billion AUM

Ivory Investment Management LP,
an investment firm utilizing long-short equity
and long-only investment strategies

Investment(terms not disclosed)

Abax Investments (Pty) Ltd, an investment firm
offering South African equity, fixed income, andstrategic and tactical asset allocation strategies anda separate global equity strategy

Investment(terms not disclosed)

Systematica Investments LP, an investment
firm focusing on using science and technology inthe investment process by implementing strategies
such as trend-following and quantitative equity
investing in both traditional hedge fund vehicles
and liquid alternatives

Investment(terms not disclosed)

Financial Institutions, Inc., aprovider of customized investment
management, investment consulting
and retirement plan services withapprox. $1.2 billion AUM

Courier Capital Corporation, a registeredinvestment adviser based in western New York

Investment(terms not disclosed)

BNY Mellon, a global investmentcompany with approx. $1.6 trillion
AUM

Atherton Lane Advisors, LLC, an independent
registered investment adviser that focuses on
wealth management and investment counseling forprivate clients with approx. $2.7 billion AUM

Acquisition (pending)(terms not disclosed)

Lightyear Capital, a private equity
firm, and the Public Sector Pension
Investment Board, a Canadianpension investment manager withapprox. $112 billion AUM

AIG Advisor Group, Inc., a network of U.S.
brokers with more than 5,200 independent advisersand more than 800 full-time employees

Acquisition(terms not disclosed)

Legg Mason Investor Services,
LLC, a global asset management firmwith approx. $671.5 billion AUM

Clarion Partners, a real estate investment firm
and registered investment adviser with morethan 200 domestic and international institutional
investors and approx. $40 billion AUM

Acquisition of 83% interest for$585 million (pending)

Permal, a Legg Mason hedge fund manager, and
EnTrust Capital, an alternative asset manager
operating a fund of hedge funds platform withapprox. $12 billion AUM

Merger (pending)

Delaware Investments, a global
asset manager with approx. $165
billion AUM

Bennett Lawrence Management LLC, an
investment manager focused on developing smalland mid-cap growth strategies with approx. $300
million AUM

Acquisition(terms not disclosed)

Financial Engines, Inc., a
California-based independent
investment adviser founded in 1996

The Mutual Fund Store, a registered investment
adviser with approx. $9.7 billion AUM

Acquisition for $250 million
cash and approx. 9.9 million
shares of Financial Engines’
common stock11

M&A Transactions (continued)
Acquiror

Acquired or
Target Company

Type of Transactionand Status

HarbourVest Partners, an
independent, global private markets
specialist

BAML Capital Access Funds, a private equity
fund-of-funds manager and adviser

Acquisition(terms not disclosed)

PGIM, the investment managementarm of Prudential Financial withapprox. $963 billion AUM

Deutsche Bank’s Indian asset managementbusiness

Acquisition(terms not disclosed)

Mercer Advisors, a wealthmanagement firm with approx. $6
billion AUM

Kanaly Trust, provider of wealth management,
financial planning and trusts-and-estates services
to families, individuals and estates with approx. $2
billion AUM

Merger(pending)

Closed-End Fund
Initial Public Offerings
Nuveen Municipal 2021 Target Term Fund(NYSE: JHA)
Amount Raised(Inception Date):$81 million(January 27, 2016)

Investment Objective/Policies:

The Fund’s investment objectives are to provide a high level of current income exempt
from regular federal income tax and to return $9.85 per share to Common Shareholders
on or about March 1, 2021. The Fund’s subadviser seeks to identify relative value in themarket and select municipal securities across diverse sectors that are underrated orundervalued. In seeking to return the target amount on or about the Termination Date,the Fund intends to utilize various portfolio and cash flow management techniques,
including setting aside a portion of its net investment income, possibly retaining gains
and limiting the longest maturity of any holding to no later than September 1, 2021. As aresult, the average maturity of the Fund’s holdings is generally expected to shorten as theFund approaches its Termination Date, which may reduce interest rate risk over time.

Managers:

Nuveen Fund Advisors and Nuveen Asset Management

Book-runners:

Morgan Stanley, Bank of America Merrill Lynch, Wells Fargo Securities, and Nuveen
Securities

12Simpson Thacher’s dynamic, long-standing Registered Funds Practice encompasses all
aspects of the investment management business. Our practice is multidisciplinary—it brings
together such other areas as securities, mergers and acquisitions, banking, tax and ERISA.

Rajib Chanda • +1-202-636-5543 • rajib.chanda@stblaw.com
Rajib Chanda is a Partner in the Washington, D.C. and New York offices of Simpson Thacher & Bartlett LLP.
Rajib’s practice focuses on all aspects of issues facing registered investment advisers and sponsors of registeredfunds. Rajib has particular experience working with alternative asset managers seeking to access retail investor
channels through mutual funds, business development companies, closed-end funds, exchange-traded funds
and permanent capital vehicles. He also works extensively with more traditional registered fund sponsors andworks closely with the firm’s asset management M&A group on transactions involving registered advisers andfunds. In addition, Rajib provides counsel to boards of registered funds, and has substantial experience advising
companies on issues relating to social media and cybersecurity.

Sarah E. Cogan • +1-212-455-3575 • scogan@stblaw.com
Sarah Cogan is a Partner in the New York office of Simpson Thacher & Bartlett LLP and Head of the Firm’s
Registered Funds Practice. Sarah’s practice encompasses all aspects of the registered funds industry and she
represents closed-end investment companies, open-end mutual funds, investment advisers and independent
directors of investment companies. She has a particular expertise in advising underwriters and sponsors inofferings by closed-end funds and business development companies. In addition, Sarah advises fund clients on
corporate and securities law, including investment management, regulatory, compliance and M&A matters.

The contents of this publication are for informational purposes only. Neither this publication nor the
lawyers who authored it are rendering legal or other professional advice or opinions on specific facts
or matters, nor does the distribution of this publication to any person constitute the establishment of
an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability in connection
with the use of this publication. Please contact your relationship partner if we can be of assistanceregarding these important developments. The names and office locations of all of our partners, as wellas our recent memoranda, can be obtained from our website, www.simpsonthacher.com.

13

SimpsonThacherWorldwide

UNITED STATESEUROPE

SOUTH AMERICANew York
425 Lexington Avenue
New York, NY 10017+1-212-455-2000

LondonCityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

São Paulo
Av. Presidente Juscelino
Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

Houston
600 Travis Street, Suite 5400
Houston, TX 77002+1-713-821-5650
Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500
Palo Alto
2475 Hanover Street
Palo Alto, CA 94304+1-650-251-5000
Washington, D.C.
900 G Street, NW
Washington, D.C. 20001+1-202-636-5500

ASIA

Beijing
3901 China World Tower
1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999
Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600
Seoul
25th Floor, West Tower
Mirae Asset Center 1
26 Eulji-ro 5-gil, Jung-gu
Seoul 100-210
Korea+82-2-6030-3800
Tokyo
Ark Hills Sengokuyama Mori Tower
9-10, Roppongi 1-Chome
Minato-Ku, Tokyo 106-0032
Japan+81-3-5562-6200
14