Investment Management Developments

SEC Staff Guidance for Money Market Funds

August 10, 2010 SEC No-Action Letter

On August 10, 2010, the staff of the Securities and Exchange Commission's (SEC) Division of Investment Management (Staff) issued a no-action letter, permitting money market funds to treat a short-term floating rate security that is subject to a demand feature (conditional or unconditional) as having a maturity equal to the period remaining until the principal can be recovered through demand for purposes of calculating the fund's weighted average portfolio maturity under Rule 2a-7(c)(2)(iii) under the Investment Company Act of 1940 (1940 Act).

SEC Staff Q &A on Rule 30b1-7 under the 1940 Act and Form N-MFP

The Staff also recently posted on the SEC's website questions and answers (Q&A) regarding Rule 30b1-7 under the 1940 Act and Form N-MFP. In the Q&A, among other things, the Staff discussed:

• Scope of Rule 30b1-7. Pursuant to Rule 30b1-7, all funds subject to Rule 2a-7 under the 1940 Act are required to file Form N-MFP with the SEC, even if they do not use the Amortized Cost Method or Penny Rounding Method.
• Shadow Prices (Items 18, 25, 45 and 46). Items 18 and 25 of Form N-MFP require each money market fund to disclose the market-based net asset value (shadow price) of the series and each class, including the date on which it was calculated. Items 45 and 46 require disclosure of the market price of each security. The Q&A clarifies that the market price of each security should be as of the last business day of the month, rather than the date the shadow price was calculated. The Q&A also clarifies that, if a money market fund's dividend and accounting policies assure that there will be no deviation between the market-based net asset values of the classes offered by the fund, the fund may use the same market-based net asset value for each class without a separate calculation. This could be the case, for example, where a fund has a policy of paying daily dividends equal to the full amount of accrued income of each class.
• Master-Feeder Funds. A feeder fund that is a money market fund should disclose the securities it holds (i.e., the investment in the master fund) rather than the holdings of the master fund. The feeder fund should calculate its weighted average maturity and weighted average life in accordance with Rule 2a-7(d)(8) under the 1940 Act. The Q&A also discussed how feeder funds should respond to certain specific items of Form N-MFP.
• Capital Support Agreements. The Q&A clarifies that the value of a capital support agreement that does not relate to a particular security should not be reflected in the value of any particular security. The capital support agreement should be treated as a separate security for purposes of Form N-MFP.
• Funds Only Registered Under 1940 Act. The Q&A clarified that a fund that is only registered under the 1940 Act will not be deemed to violate the prohibition on general solicitation and advertising in Rule 502(c) of Regulation D under the Securities Act of 1933 (Securities Act), so long as it limits the information on Form N-MFP to the required information and does not otherwise use the Form N-MFP filing to offer its securities publicly or to condition the market for the offering of its securities. A fund following this guidance should be deemed to comply with the exemption contained in Section 4(2) of the Securities Act if it otherwise complies with Rule 506 of Regulation D.
• 7-Day Gross Yield (Item 17). A tax-exempt fund that holds taxable paper should not adjust the gross yield to reflect federal income taxes that would be imposed on the taxable paper. Similarly, a state tax-exempt fund that holds paper from out of state should not adjust the gross yield to reflect state-level taxes that would be imposed on the out-of-state paper.
• Investment Categories (Item 31). Item 31 requires a fund to indicate the specific category most closely identified with each portfolio security. The Q&A clarifies that a fund must use the categories that are specified in Form N-MFP.
• Repurchase Agreements (Item 32). A fund should still respond to Items 32a through 32f even if it is not treating the acquisition of the repurchase agreement as the acquisition of the underlying securities for purposes of diversification.
• Demand Features and Guarantees (Items 37 and 38). If a fund is not relying on a demand feature or guarantee to determine the quality, maturity or liquidity of a security, information regarding the demand feature or guarantee does not need to be provided in response to these items.
• Percentage of Net Assets Invested in Security (Item 42). The percentage of a fund's net assets invested in the security should be based on amortized cost if the fund is using the Amortized Cost Method of valuation.

August 19, 2010 No-Action Letter

On August 19, 2010, the Staff issued a no-action letter to the Investment Company Institute (ICI) stating that it would not recommend that the SEC institute an enforcement action under Section 2(a)(41) of the 1940 Act if a money market fund board did notdesignate nationally recognized statistical rating organizations (NRSROs) or make related disclosures in its statement of additional information (SAI) before the SEC completed its review of Rule 2a-7 as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Because that letter did not discuss or reference Items 34, 37, 38 and 39 of Form N-MFP, which require money market funds to report information regarding their designated NRSROs and the credit ratings given by those NRSROs, it is currently unclear whether money market funds are similarly relieved of their obligation to designate NRSROs for purposes of Form N-MFP filings.

Copies of the no-action letters can be found at: http://www.sec.gov/divisions/investment/noaction/2010/ici081010.htm and http://www.sec.gov/divisions/investment/noaction/2010/ici-nrsro081910.htm , respectively. The Q&A can be found at http://www.sec.gov/divisions/investment/ guidance/formn-mfpqa.htm .

ABA and SEC Guidance on Investment Company Use of Derivatives and Related Disclosure

Over the past year, the SEC has placed greater focus on the use of derivatives by investment companies and their disclosures regarding such use. Products of that scrutiny have recently emerged in the form of a Report of the Task Force on Investment Company Use of Derivatives and Leverage (ABA Report) and an SEC letter to the ICI regarding derivatives-related disclosure by investment companies (SEC Letter).

ABA Report

The ABA Report identifies common practices and approaches of investment companies regarding derivatives and leverage, and suggests certain changes to the current regulatory framework including, but not limited to:

• Diversification. The ABA Report recommends that funds measure diversification for purposes of Section 5(b) of the 1940 Act by looking at reference assets, when applicable.
• Counterparties. The ABA Report recommends that the SEC regulate counterparty risk through Section 12(d)(3) of the 1940 Act, including risk related to counterparties that are not in a traditional securities-related business.
• Limits on leverage. The ABA Report recommends that the SEC issue guidance to set forth a principles-based approach to segregation that would encompass all types of derivatives. It further recommends that funds establish minimum amounts of required segregated assets based on the risk profiles of the derivative instruments, and establish policies and procedures that address both the value of assets and the types of assets that are appropriate for risk-adjusted segregated amounts.
• Concentration. The ABA Report notes that many funds measure concentration based on reference assets and believes that this measurement is appropriate.
• Fund names. The ABA Report recommends that the SEC clarify that, under Rule 35d-1 of the 1940 Act, whether a fund invests in a manner that is consistent with its name should be determined by looking to its reference assets Investment Management Developments September 2010
• Disclosure. The ABA Report recommends that funds enhance disclosure regarding how derivative instruments affect actual investment results.
• Director oversight. The ABA Report recommends that the SEC emphasize that the role of a fund board with respect to the fund's use of derivatives and leverage is one of oversight, rather than micro-management.

SEC Letter

The SEC is currently conducting a review to evaluate the use of derivatives by investment companies and has observed that derivatives-related disclosure in fund registration statements is often either highly abbreviated (briefly identifying a variety of derivative products or strategies) or highly technical (covering a variety of potential derivative transactions at great length without explaining their relevance to the fund's investments). The SEC Letter expresses the Staff's concern that highly abbreviated disclosure may not be appropriately tailored to address the specific derivative instruments in which a fund invests, and highly technical disclosure may not be understandable by, or useful to, investors. The Staff was also troubled by some fund complexes' use of the same "standardized" derivatives-related disclosure for funds with significantly different exposure to derivatives. The SEC Letter recommends that all funds that use or intend to use derivative instruments review their disclosure to assess its accuracy and completeness in light of actual fund operations, taking care to also assure that the disclosure is understandable by investors. Principal investment strategies disclosure regarding derivatives should be tailored to each fund and should address strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance. Additionally, principal strategies and risks disclosure should identify the types of derivatives used by the fund, and the purpose and extent of their use.

Additionally, the SEC Letter reminds investment companies that Management's Discussion of Fund Performance in annual shareholder reports should be consistent with operations reflected in the financial statements, and funds whose performance was materially affected by derivatives should include discussions to that effect. The SEC Letter also discusses FASB Accounting Standards Codification Topic 815: Derivatives and Hedging, noting that funds could improve their disclosure by providing qualitative information about how the funds achieved their objectives and strategies through their use of derivatives and explaining the relevance of any credit spreads disclosed.

A copy of the ABA Task Force Report is available at: http://meetings.abanet.org/webupload/commupload/CL410061/sitesofinterest_files/ DerivativesTF_July_6_2010_final.pdf . A copy of the SEC letter is available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf .

U.S. Supreme Court Agrees to Hear Case Involving Fraud Liability of Adviser for Statements in Fund Prospectuses

The U.S. Supreme Court recently has agreed to hear Janus Capital Group Inc. v. First Derivative Traders, a case involving the scope of "primary liability" in private securities actions. The case arises as a result of a decision of the U.S. Court of Appeals for the FourthCircuit, which found that an investment adviser to a group of mutual funds could be held primarily liable in a private securities fraud action under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder for "helping" or "participating" in the preparation of false or misleading prospectuses for the funds, even though the alleged misleading statements were not directly and contemporaneously attributed to the adviser. The Fourth Circuit's decision highlights a split of authority in the Courts of Appeals over the scope of "primary liability" in private securities actions. The Second Circuit, for example, has concluded that a service provider can be held primarily liable only for statements that were directly and contemporaneously attributed to the service provider.

In 2003, First Derivative Traders, individually and on behalf of certain shareholders of Janus Capital Group Inc. (JCG), brought a class action lawsuit against JCG and its wholly-owned subsidiary Janus Capital Management LLC (JCM). JCM is the investment adviser to the Janus mutual funds. The complaint alleges that the defendants were responsible for misleading statements in prospectuses for certain Janus funds during the class period. The allegedly misleading statements represented that the Janus funds' managers did not permit, and took active measures to prevent, market timing in the funds. Plaintiffs further allege that, when it came to light that the funds in fact permitted select investors to engage in market timing, other investors withdrew assets from the funds. As a result, according to plaintiffs, the value of JCM's advisory and management business, and hence JCG's stock price, declined and caused them injury.

The district court dismissed the complaint. It held that because JCM did not prepare the prospectuses or directly make the statements, the claims against JCM and JCG were therefore merely ones for "aiding and abetting" a securities law violation. "Aiding and abetting" is a form of "secondary" liability that cannot be enforced by a private plaintiff under the Supreme Court's 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver.

Plaintiffs appealed to the Fourth Circuit, which reversed the district court's decision. It held that plaintiffs asserted a viable claim for "primary liability" under Section 10(b) of the Exchange Act by alleging that by "participating in the writing and dissemination of the prospectuses, [JCM and JCG] made the misleading statements contained in the documents." The Fourth Circuit then analyzed whether "interested investors...would attribute the allegedly misleading statement to the defendant." The Fourth Circuit noted, among other things, plaintiffs' claims that JCM was "responsible for the day-to-day management of [the] investment portfolio and other business affairs of the funds" and statements in the prospectuses describing JCM's management role. Therefore, the Fourth Circuit concluded that "interested investors would have inferred that if JCM had not itself written the policies in the Janus fund prospectuses regarding market timing, it must at least have approved these statements." Accordingly, the Fourth Circuit reinstated plaintiffs' securities fraud claim against JCM. As to JCG, the Fourth Circuit held that it would not "be apparent to the investing public that [JCM's] parent company, which sponsors a family of funds, participates in the drafting or approving of prospectuses issued by the individual funds." However, while the Fourth Circuit held that JCG could have no direct federal securities fraud liability, it could be held liable as a "control person" for JCM's securities fraud. JCG and JCM then filed a certiorari petition with the Supreme Court, seeking review of the Fourth Circuit's decision. In its petition to the Supreme Court, defendants argued that the case presents a split of authority among the circuits regarding the scope of primary liability in private securities actions. Defendants certified the following questions to the Court: (1) whether the Fourth Circuit erred in concluding – in direct conflict with decisions of the Fifth, Sixth, and Eighth Circuits – that a service provider can be held primarily liable in a private securities fraud action for "help[ing]" or "participating in" another company's misstatements; and (2) whether the Fourth Circuit erred in concluding – in direct conflict with decisions of the Second, Tenth, and Eleventh Circuits – that a service provider can be held primarily liable in a private securities fraud action for statements that were not directly and contemporaneously attributed to the service provider.

Because a private cause of action may result in liability for only "primary" actors under the antifraud provisions of the securities laws, this case will determine whether many groups – including parent corporations, officers, directors and service providers like investment advisers, attorneys, and accountants – are "primary" defendants who can be privately sued. Accordingly, the Supreme Court's decision may significantly expand the class of defendants that can be sued in private class action securities litigation.

The case will be heard during the Court's next term, beginning October 4, 2010. It will likely be decided during the first half of 2011.

Ninth Circuit Finds No Private Right of Action Under Section 13(a) of the Investment Company Act

The U.S. Court of Appeals for the Ninth Circuit has overturned a District Court decision that recognized an implied private right of action under Section 13(a) of the 1940 Act. Section 13(a) requires shareholders to approve an investment company's deviations from its investment policy. The court, in Northstar Financial Advisors Inc. v. Schwab Investments, rejected the implied cause of action, stating that "[n]either the language of § 13(a), the structure of the [1940 Act], nor the statute's legislative history, including the addition of § 13(c), the [Sudan Accountability and Divestment Act of 2007 (SADA)], reflect any congressional intent to create, or recognize a previously established, right of action to enforce § 13(a)."

The Ninth Circuit heard the case on an interlocutory appeal after a California district court found a private cause of action under Section 13(a). Plaintiff Northstar had alleged that the Schwab Total Bond Market Fund had deviated from its investment objective in violation of Section 13(a) of the1940 Act in two ways. First, although its disclosed objective was to track a specific index, the fund made sizeable investments in non-agency collateralized mortgage obligations (CMOs) that were substantially riskier than the securities in the index. Second, although the fund's stated investment objective prohibited industry concentrations greater than 25 percent of total fund assets, it invested over 25 percent in CMOs. The district court held that whether investments in non-agency CMOs were inconsistent with the fund's index-tracking objective and whether mortgage-backed securities are properly considered an "industry" were factual questions that could not be resolved on the pleadings. The district court also held that the fund's reclassification of mortgage-backed securities may have violated its disclosed industry concentration policy. Proceedings on these issues were stayed during Schwab's appeal of the district court's ruling. The Ninth Circuit opinion in Northstar v. Schwab examined Section 13(a) for "rights-creating language" that would imply Congressional intent "to confer upon shareholders the right to sue an investment company for violating the statute's requirements." Finding none, it noted that the Second Circuit's examination of private causes of action under other sections of the 1940 Act was instructive in assessing whether private suits could be maintained under Section 13(a). The court agreed with the Second Circuit "that the structure of the [1940 Act] does not indicate that Congress intended to create an implied private right to enforce the individual provisions of the Act." The opinion also emphasized that the 1940 Act's "thorough delegation of authority to the SEC to enforce" it "strongly suggests Congress intended to preclude other methods of enforcement." The court rejected Northstar's argument that SADA created a private right of action, stating that SADA barred actions far beyond the scope of Section 13 and that subsequent amendment by Congress in the Comprehensive Iran Sanctions, Accountability and Divestment Act of 2010, indicated legislative intent that no such right of action be created. The remaining issues in Northstar v. Schwab were remanded to the district court for further proceedings.

SEC Releases Proposed Amendments to Target Date Retirement Fund Names and Marketing

The SEC has proposed rule amendments that, if adopted, would require three changes for target date retirement funds and one change for all mutual funds. First, funds that include a target date in its name must disclose the fund's asset allocation at the target date immediately adjacent to the first use of the fund's name in marketing materials. Next, all marketing materials for target date funds need to include a table, chart, or graph depicting the fund's asset allocation over time, together with a statement that would highlight the fund's final asset allocation. Additionally, the marketing materials must include a statement explaining that target date funds should not be selected based solely on age or retirement date and that the stated asset allocations may be subject to change. Finally, the SEC is proposing rule amendments that, if adopted, would provide greater guidance regarding statements in marketing materials for all mutual funds.

Target date funds are mutual funds that allocate their investments among various asset classes, automatically adjusting their asset allocations, or glide paths, to become more conservative as their target date approaches. The glide paths stop adjusting once the fund reaches it landing point, the final asset allocation among types of investments. Since the inception of target date funds in the mid-1990s, assets held by these investment vehicles have grown considerably. Currently, the SEC estimates that about $270 billion are invested in registered target date funds.

In 2008, target date funds did not perform as many investors expected. Funds with the same target date had widely divergent performance figures. For example, funds with a 2010 target date had losses ranging between -4 percent and -41 percent, with the average being about -24 percent. Consequently, the SEC and others have expressed concern that the names of target date funds lead investors to make incorrect assumptions about income guarantees and asset allocation/risk exposure of the funds on certain dates.

Proposed Amendments

The SEC's proposed amendments would impact Rules 156 and 482 under the Securities Act and Rule 34b-1 under the 1940 Act. The proposed amendments change the content requirements of marketing materials for target date funds as well as the antifraud guidance for all mutual funds.

Content Requirements for Target Date Fund Marketing Materials

The proposed amendments to Rule 482 under the Securities Act and Rule 34b-1 under the 1940 Act would include the following three requirements for target date fund marketing materials:

• A fund that includes the target date in its name (e.g. funds named "Portfolio 2020" or "Retirement Fund 2020") would have to disclose the fund's intended asset allocation at the target date. The types of investments would need to appear immediately adjacent to the first use of the fund's name in the marketing materials. The SEC intends for the asset allocation disclosure to help investors assess variability among target date funds and whether the intended allocation meets personal risk tolerance levels.
• Marketing material, whether or not the fund has a date in its name, would need to include a prominent table, chart, or graph clearly depicting the fund's glide path or asset allocation over the entire life of the fund. The visual illustration would need to be immediately preceded by a statement explaining the asset allocation changes over time until it eventually reaches a landing point, and the final asset allocation at the landing point. The SEC stated that disclosing more information about the landing point should highlight that the glide paths of many target date funds are constructed to continue well into an investor's retirement, with landing points sometimes falling 20 or 30 years after retirement.
• Marketing material would need to include a statement explaining that the target date fund should not be selected based solely upon any single factor, such as the investor's age or retirement date, but in conjunction with the investor's risk tolerance, personal circumstances, and complete financial situation. Additionally, the statement should clarify that the fund is not a guaranteed investment and that it is possible to lose money in the fund, including before, at, and after the target date. Finally, the statement should detail the extent to which the intended asset allocation may be subject to change without a shareholder vote. The SEC stated that disclosing more information about the risks of target date funds will enable investors to better assess a fund's long-term performance profile.

Antifraud Guidance for All Mutual Funds:

The proposed amendments to the SEC's antifraud guidance in Rule 156 of the Securities Act would apply to all mutual funds, not only target date funds. The proposed amendments would provide that a statement in marketing materials suggesting securities are an appropriate investment could be misleading in two different circumstances. The first instance when an investment company's marketing materials could be misleading is if the material emphasizes a single factor, such as an investor's age or tax bracket, as the basis for determining that an investment is appropriate. The second situation when marketing material would be considered misleading is if it suggests or represents, whether expressor implied, that choosing the fund is a simple investment plan or that it requires little or no monitoring by the investor.

Impact on Fund Directors

In addition to proposing the changes to content requirements for fund marketing materials and the antifraud guidance, the SEC stated that it would expect target date fund boards of directors to monitor both the frequency and nature of the portfolio manager's deviations from the fund's glide path. Boards of directors would need to oversee the target date fund with more scrutiny than was previously expected. This oversight could include establishing a system for portfolio managers to report changes to the glide path on an ongoing basis.

While the proposal does not amend prospectus disclosure requirements or the fund names rule, the SEC is seeking comments on whether any such changes should be made. The comment period closed on August 23, 2010. Notably, in its comment letter regarding the proposed rules, the ICI cautioned the SEC to avoid the slippery slope of "singling out the marketing materials of a segment of the investment company industry for different treatment based on investment objective and type of investor." To that end, the ICI requested that the SEC eliminate the requirements for tag line disclosure and the disclosure of asset allocations for marketing materials relating to a single fund. The ICI also asked the SEC to reexamine the proposed approach of requiring target date funds to disclose the percentage of assets allocated to types of securities as opposed to types of funds. The ICI also pointed out the potentially broad and unintended consequences of limiting funds' ability to highlight critical information, including emphasis on a single factor as the basis for determining the appropriateness of an investment. For example, the ICI notes that funds that include "tax free" in their name could be criticized for emphasizing a single factor.

A copy of the SEC's proposed amendments is available at: http://www.sec.gov/rules/proposed/2010/33-9126.pdf .

SEC Issues Concept Release on the U.S. Proxy System

The SEC recently issued a concept release to solicit comment on various aspects of the U.S. proxy system. The release highlighted the following principal areas of interest: enhancement of the accuracy, transparency and efficiency of the voting process; improvement of shareholder communications and participation; and the alignment of voting power with economic interest.

Accuracy, Transparency and Efficiency of the Voting Process

The SEC noted that, in connection with securities lending transactions and "fails to deliver," it is possible for the number of securities held by a broker-dealer at the Depository Trust Company (DTC) not to match the number credited to the broker-dealer's customer accounts, raising a concern about the varying means by which intermediaries reconcile these differences and the impact they may have on the accuracy of the votes' allocation among beneficial owners. The release seeks comment on whether investors would find disclosure on these allocation methods helpful or whether another regulatory response may be appropriate. The release also expressed concern that the inability for shareholders to confirm the timely receipt and accurate tabulation of their votes may impair confidence in the proxy system, and it suggests as a solution the creation of a unique identifying code which could be used to create an audit trail. A concern was raised that some investors that engage in securities lending may learn of material votes too late to recall loaned securities prior to a vote's record date. The release suggested requiring the filing of a report on Form 8-K to disclose the meeting's agenda prior to the record date or asking the NYSE and other Self-Regulatory Organizations (SROs) to adopt rules requiring public dissemination of a notice in advance of the record date. It also suggested amending Form N-PX to require disclosure of the number of portfolio securities for which a fund does not vote proxies because the securities were on loan. The release also articulated concerns about the fees charged for distribution of proxy materials, including that they may not "reflect reasonable rates of reimbursement" in light of the notice and access model of distribution and that financial intermediaries may lack incentives to reduce distribution costs for issuers. The SEC considered creating a central data aggregator that would permit an issuer to designate an agent for the distribution of its materials or asking SROs to review their fee schedules.

Shareholder Communication, Participation and Information

The SEC noted that commentators have raised issues regarding the costs and efficiency of communication between issuers and shareholders, particularly when shares are held in street name. The release suggested eliminating beneficial owners' option to object to the disclosure of their identities to issuers or encouraging beneficial owners not to object to this disclosure, in order to permit issuers to more easily communicate directly with shareholders. The SEC raised a concern regarding the level of participation in proxy voting by retail investors and sought comment on possible regulatory responses, including improved investor education, enhancements to brokers' websites, adoption of advance voting instructions, facilitation of discussion among voters and refinements to the notice and access model for distribution of proxy materials. The release also requested comment on whether the SEC should reconsider permitting or requiring interactive data tagging for proxy statements and voting information.

Alignment of Voting Power and Economic Interest

Finally, the release highlighted concerns related to proxy voting advisory firms, such as conflicts of interest that may arise when a firm recommends votes to shareholders of an issuer while also providing consulting services to the same issuer and those that may result from the potential for such firms to make recommendations based on materially inaccurate or incomplete information. The release suggested requiring additional disclosure related to conflicts of interest and the firm's controls and procedures for ensuring accuracy of issuer data, and it also considered prohibiting certain types of conflicts. It noted that some states, including Delaware, now permit use of dual record dates, with a voting record date as late as the date of the meeting itself, and sought comment on whether regulatory action should be taken to accommodate issuers that wish to use separate record dates where permitted by state law. The release also articulated a concern with circumstances where a share's voting rights have been "decoupled" from an economic stake in the issuer, such as when an investment is hedged, and requested comment on a range of regulatory responses from adopting new disclosure requirements to prohibiting voting in circumstances of negative economic interest. In addition to the specific questions highlighted in the release, the SEC invited other comments on the proxy system that commentators may have, including comments on any costs or benefits of possible regulatory action. Comments are due by October 20, 2010.

A full copy of the concept release can be found at: http://www.sec.gov/rules/concept/2010/34-62495.pdf

Further Changes Proposed to Securities Exchange Rules to Address Market Volatility

The SEC, national securities exchanges and Financial Industry Regulatory Authority (FINRA) recently proposed changes to certain rules governing the process for breaking erroneous trades and the addition of the stocks in the Russell 1000 Index and certain ETFs to the circuit breaker rules to further address extreme market volatility, such as that which occurred on May 6, 2010.

The first proposal sets forth uniform standards for breaking clearly erroneous trades, which are in contrast to the current standards that allow the exchanges discretion to select a different percentage threshold at which they would break trades. Under the proposed rules, where stocks are subject to the new single stock circuit breakers, trades would be broken: 1) for stocks priced $25 or less, if the trades are at least 10 percent away from the circuit breaker trigger price; 2) for stocks priced between $25 and $50, if they are 5 percent away from the circuit breaker trigger price; and 3) for stocks priced more than $50, if they are 3 percent away from the circuit breaker trigger price. Where circuit breakers are not yet applicable, trades would be broken: 1) for events involving between 5 and 20 stocks whose executions occurred within a period of 5 minutes or less, if the trades are at least 10 percent away from the reference price; and 2) for events involving more than 20 stocks whose executions occurred within a period of 5 minutes or less, if they are at least 30 percent away from the reference price. The rules are proposed to be in effect on a pilot basis through December 10, 2010.

The second proposal expands the new circuit breaker program (discussed in our June 2010 Investment Management Developments available here) to include all stocks in the Russell 1000 Index and certain exchange traded funds. Trading in a security in the circuit breaker program is paused for a five-minute period if the security experiences a 10 percent price change over the preceding five minutes.

Copies of the SEC press releases regarding these proposals are available at: http://www.sec.gov/news/press/2010/2010-104.htm and http://www.sec.gov/news/press/2010/2010-117.htm .

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