DC 9567487 v4

Mutual Fund Pricing and Fair ValuationFranklin H. Na

Overview— Valuation procedures are important for

individual accounts, hedge funds, bank funds or registered investment companies

Improper valuation can impact fee and performance calculations

Focus on mutual fund valuations because relatively well developed

2

Overview—The Importance and the Complexity

of Valuation Determinations Rule 22c-1 (the “forward pricing rule”) effectively requires

that open-end investment companies accurately value their portfolio securities on a daily basis.

Accuracy in the daily pricing of portfolio securities is essential.

Valuation must be accomplished quickly, usually in the roughly 2-hour period between the NYSE close and the NASD reporting deadline.

Nevertheless, for a long time–probably for about half of the current life span of the 1940 Act–this did not appear to be a particularly difficult or challenging endeavor.

This is no longer true for most funds.

3

Regulatory FrameworkSection 2(a)(41) and Rule 2a-4 view valuation issues interms of a simple dichotomy between Market Value andFair Value. Securities “for which market quotations are readily available” are to

be valued at “market value.” All other securities are to be valued at “fair value as determined in

good faith by the board of directors.” The special responsibilities placed on fund boards for fair value

determinations, appear to arise out of a kind of objective vs. subjective distinction: The implicit notion is that market valuations are essentially objective, while fair

valuations require more judgment (i.e., are more subjective) and thus require more direct board involvement.

4

Regulatory Framework (continued)

When should securities be fair valued? When market quotations are not readily available. When market quotations are not reliable. This may (but will not necessarily) occur if:

sales have been infrequent; there is a thin market for the security; or the validity of the market quotations appears questionable

due to (among other things): an unreliable source; staleness; significant post-quotation events.

5

Regulatory Framework (continued)

The Effect of Significant Events The question of how significant events should affect

fund valuations dates back at least to a 1981 no-action letter issued to Putnam.

This letter established the principle that it is appropriate to use fair value methodologies to reflect material events that occur after the closing of the relevant foreign markets but before the fund’s normal pricing time.

6

Regulatory Framework (continued)

The Effect of Significant Events (continued)

In 2001, the Staff effectively mandated fair valuation when a “significant event” occurs.

But questions remain: When is an event “significant?”

What should be the basis for a fair valuation when a significant event occurs?

7

Regulatory Framework (continued)

Bases for Making Fair Value Determinations No single correct way. Methodologies and factors that may be used

include: multiples of earnings; discount from market of similar, freely traded securities; for debt instruments, yield to maturity; fundamental analytical data; and combinations of the foregoing.

8

Delegation and Controls Despite the emphasis on board responsibility, delegation

of day-to-day responsibility for fair valuation determinations is both necessary and contemplated by SEC guidelines.

For most funds, direct board determinations of valuations and “continuous” board review of day-to-day decisions is impractical.

The appropriate role for the board is to act as the highest level of oversight in a multi-tiered system of supervision and controls.

Effective controls are central to the discharge of the board’s responsibilities.

9

Delegation and Controls (continued)

The key elements of an effective control system include: Identification of acceptable sources of regular pricing information,

preferably from third parties, and verifying that those sources have internal controls for verifying the validity of the information they provide.

Review and supervision by the primary pricing group–generally fund accounting or administrators or the fund's custodian.

Oversight of the primary pricing group by a special valuation committee or other supervisory personnel within fund management.

10

ASC 820 (formerly, FAS 157)Eliminating the Market Value/Fair Value Dichotomy FASB’s ASC 820 does not reflect the same market value/fair

value dichotomy that is reflected in the 1940 Act. Instead, ASC 820 makes clear that market quotations–

whether obtained from an exchange closing price or from dealer quotes–are merely means (“inputs”) for determining the fair value of an asset.

ASC 820 establishes a somewhat different dichotomy–between “observable” and “unobservable” inputs.

ASC 820 presents a hierarchy of these inputs that is substantially similar to what is called for under existing SEC guidance.

11

ASC 820 (formerly, FAS 157) (continued)

Techniques, Approaches and Inputs (continued) The heart of ASC 820 is a hierarchy of valuation “inputs”

that are to be used to apply the chosen valuation approach and technique. Inputs are divided into two categories:

observable and unobservable. “Observable” inputs are based on market data obtained

from sources independent of the reporting entity.

“Unobservable” inputs reflect the reporting entity’s own assumptions as to how market participants would approach pricing.

12

The Fair Value Hierarchy

Level 1–the highest level of inputs–comprises unadjusted quoted prices in active markets for identical assets.

Level 2 inputs are inputs other than quoted prices that are “observable” either directly or indirectly.

Level 3 inputs are those that are unobservable.

ASC 820 (formerly, FAS 157) (continued)

13

Disclosure ASC 820 requires that entities (including mutual funds)

disclose the following information at the end of each reporting period: The fair values of their assets; The “level” within the fair value hierarchy in which the assets fell; For the assets valued using Level 3 (unobservable) inputs,

a reconciliation showing beginning and ending balances broken down to show gains and losses, purchases and sales and transfers in and out of the Level 3 input category.

ASC 820 (formerly, FAS 157) (continued)

14

15

Correction of Pricing Errors Errors of less than 1¢ per share are immaterial

and do not require corrective action.

Errors of 1¢ or more per share require financial adjustments in favor of the fund, but no payments to affected shareholders or reprocessing of shareholder accounts is required unless the errors amount to at least ½ of 1% of per share NAV.

DC 767627 v4

Investment Objectives and PoliciesMark C. Amorosi

Investment Objectives An investment objective is a short statement that

describes what the fund seeks to achieve for its shareholders.

A fund may (but is not required to) designate its investment objective as a fundamental policy (i.e., changeable only with shareholder approval).

If the investment objective is not fundamental, the fund must disclose this fact in its prospectus.

1

Fundamental Policies Section 8(b) of the 1940 Act requires a

registered fund to recite in its registration statement its policies with respect to certain types of investments and investment practices.

Section 13 makes it unlawful for a registered fund to deviate from any policies set forth in response to Section 8(b) without a vote of a “majority of the outstanding voting securities” of the fund.

2

Fundamental Policies Concentration Senior Securities Borrowing Money Underwriting

Commodities Loans Real Estate

3

Fundamental Policies –Concentration

Section 8(b)(1)(E) requires a registered fund to disclose in its registration statement its policy with respect to concentrating its investments in a particular industry or group of industries.

The SEC staff takes the position that investment (including holdings of debt securities) of more than 25% of the value of a fund’s assets in any one industry represents concentration.

4

Fundamental Policies –Concentration (continued)

If the fund intends to concentrate its investments in an industry or group of industries, the fund is required to disclose in its prospectus the industry or group of industries in which it will concentrate.

If the fund does not intend to concentrate its investments, it may not invest in any given industry, if upon making the investment, more than 25% of the value of the fund’s assets would be invested in such industry.

If securities of a given industry come to constitute more than 25% of the value of the fund’s assets due to market movements (as opposed to portfolio transactions), the fund generally is not required to sell the excess and it is not treated as a violation of its policy on concentrating investments.

5

Fundamental Policies – Senior Securities and Borrowing Money Sections 8(b)(1)(B) and (C) require a registered fund to

disclose in its registration statement its policy with respect to the issuance of senior securities and borrowing money.

Section 18(f) prohibits a registered open-end fund from issuing any senior security.

Section 18(g) defines a senior security as “any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness, and any stock of a class having priority over any other class as to distribution of assets or payment of dividends ....”

6

Fundamental Policies – Senior Securities and Borrowing Money

(continued)

Exceptions for borrowing money: Section 18(g) states that a senior security does not include a borrowing

from a bank which is “for temporary purposes only” and does not exceed 5% of the fund’s assets at the time the loan was made.

Section 18(f) provides that a registered open-end fund may borrow money, provided that (1) the borrowing is from a bank and (2) the fund has “asset coverage” (as defined in Section 18(h)) at least equal to 300% of such borrowings.

7

The definition of “senior security” has been construed broadly by the SEC and its staff to apply to a wide variety of portfolio transactions, including futures contracts and options on futures contracts; forward commitment contracts, future commitments; and when-issued securities.

The SEC has taken the position that Section 18 restrictions do notapply to the above types of portfolio transactions if a fund “covers” such transactions (e.g., enters into an offsetting portfolio transaction) or if it “segregates” assets (e.g., places liquid assets in a separate account, or marks such assets on the fund’s books, at least equal in value to the obligation undertaken by the fund).

Fundamental Policies – Senior Securities and Borrowing Money

(continued)

8

Fundamental Policies –Underwriting

Section 8(b)(1)(D) requires a registered fund to disclose in its registration statement its policy with respect to underwriting securities of other issuers.

“Underwriter” is defined in Section 2(a)(40) of the 1940 Act generally to mean “any person who has purchased from an issuer with a view to, or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking…”

Funds commonly seek to provide flexibility for circumstances where a fund may be deemed to be an underwriter in connection with its regular investment program.

9

Fundamental Policies –Commodities

Section 8(b)(1)(F) requires a registered fund to disclose in its registration statement its policy with respect to purchase or sale of commodities or commodities contracts.

The Internal Revenue Code generally limits the ability of registered funds to invest directly in commodities.

Funds commonly seek to preserve the ability to make commodities-related investments to the extent permissible, such as through the acquisition of securities or other instruments backed by commodities or securities of companies engaged in commodities businesses and through the acquisition of commodities due to ownership of securities or other instruments.

10

Fundamental Policies –Making Loans

Section 8(b)(1)(G) requires a registered fund to disclose in its registration statement its policy with respect to making loans.

The SEC staff has taken the position that the making of a loan does not include the purchase of a portion of an issue of debt securities, whether or not the purchase was made upon the original issuance of the securities.

Funds commonly seek to (1) provide flexibility to invest in a wide range of debt instruments and (2) reserve the right to make loans of portfolio securities in connection with securities lending programs.

11

Fundamental Policies –Real Estate

Section 8(b)(1)(F) requires a registered fund to disclose in its registration statement its policy with respect to the purchase or sale of real estate and real estate mortgage loans.

The SEC staff generally takes the position that an interest in real estate includes securities of companies whose assets consist substantially of real property and interests therein, but does not include securities of companies whose investments in real estate are incidental to another business which is primary (e.g., banks).

The Internal Revenue Code generally limits the ability of registered funds to invest directly in real estate.

Funds commonly seek to preserve the ability to make real estate-related investments, such as through the acquisition of securities or other instruments backed by real estate or securities of companies engaged in real estate businesses and through the acquisition of real estate due to ownership of securities or other instruments.

12

Fund Diversification Section 5(b) of the 1940 Act classifies management companies as

“diversified” or “non-diversified” investment companies. A “diversified” investment company must satisfy certain requirements. At least 75% of the fund’s total assets must be represented by (i) cash and cash

items (including receivables), (ii) Government securities (as defined in the 1940 Act), (iii) securities of other investment companies, and (iv) securities of other issuers, provided that the investment represented by securities of other issuers does not exceed 5% of the total assets of a fund or 10% of the voting stock of the issuer.

If an investment company does not satisfy these requirements, it is a “non-diversified” company and must describe itself as such. Its disclosures, if it is offering its securities to the public, must note that status and the risks thereof.

There are separate diversification standards for registered investment companies under the Internal Revenue Code.

13

Fund Names Section 35(d) Prohibits a fund from using as its name any

words which the SEC finds by rule or order to be “materially deceptive or misleading.”

Rule 35d-1 Defines certain “materially deceptive or

misleading” names for purposes of Section 35(d).

14

Rule 35d-1: Scope Rule 35d-1 addresses four categories of fund

names: Names suggesting guarantee or approval by the U.S.

government; Names suggesting investment in certain investments

or industries; Names suggesting investment in certain countries or

geographic regions; and Names suggesting that a fund’s distributions will be

exempt from federal and/or state income tax.

15

Rule 35d-1: U.S. Government Rule 35d-1 prohibits the use of any name

suggesting that the fund or its shares are “guaranteed” or “approved” by the U.S. Government.

This prohibition includes use of any name that uses the terms “guaranteed” or “insured” or similar terms in connection with “U.S. Government.”

16

Rule 35d-1: Investments/Industries

Rule 35d-1 prohibits the use of any name suggesting that the fund focuses its investments in a particular type of investment, or in investments in a particular industry, unless: The fund has a policy of investing at least 80% of the

value of its assets in the particular type of investment, or in investments in the particular industry, suggested by its name; and

This policy is either fundamental or changeable only with at least 60 days prior notice to shareholders.

17

Rule 35d-1: Countries/Regions Rule 35d-1 prohibits the use of any name suggesting

that the fund focuses its investments in a particular country or geographic region, unless: The fund has a policy to invest at least 80% of the value of its

assets in investments that are tied economically to the particular country or region suggested by its name;

The fund discloses in its prospectus the criteria used to select these investments; and

This policy is either fundamental or changeable only with at least 60 days prior notice to shareholders.

18

Rule 35d-1: Tax-Exempt Funds Rule 35d-1 prohibits the use of any name suggesting

that the fund’s distributions are exempt from federal and/or state income tax, unless the fund has adopted a fundamental policy: To invest at least 80% of the value of its assets in investments

the income from which is exempt from federal and/or state income tax (as applicable); or

To invest its assets so that at least 80% of the income that it distributes is exempt from federal and/or state income tax (as applicable).

19

20

Rule 35d-1: Compliance Considerations

The 80% tests apply at the time of investment.

The 80% tests apply “under normal circumstances.”

“Assets” is defined in the rule to mean “net assets, plus the amount of any borrowings for investment purposes.”

Strict prior notice requirements apply to changes to the 80% investment policies.

DC 1370939 v5

Transactions With AffiliatesAlan C. Porter

1

Legislative Policy“In the exhaustive study of the industry which preceded passage of the [1940] Act it was found that, in many instances, investment companies had been operated in the interests of their managers rather than in the interests of their shareholders.”

“Congress determined that the [1933 and 1934 Acts] were inadequate to meet the problems which had been revealed . . . and passed a special regulatory statute – the Investment Company Act.”

SEC Report on the Public Policy Implicationsof Investment Company Growth (1966)

2

Is There a Prohibited Transaction?

AdviserII

Fund B

≥ 5%

SMAs

AdviserI

− ? ? ?

Fund A

Parent

Issuer

3

“Affiliated Person” – Section 2(a)(3)

Director Officer Partner Employee Investment Adviser

One-Way Affiliations

A director, officer, or investment adviser is an “affiliated person” of the fund; but

The fund is not an “affiliated person” of its directors, officers, or investment adviser.

4

A person directly or indirectly controlling, controlled by, or under common control with, another person;

A person directly or indirectly owning, controlling, or holding with power to vote, 5% or more of the outstanding voting securities of another person; and

A person 5% or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person.

Two-Way Affiliations

A 5% shareholder is an “affiliated person” of a fund; and the fund is an “affiliated person” of its 5% shareholder.

5

OwnershipOwnership is not defined in the 1940 Act. It can include both legaland beneficial ownership.

1934 Act Rule 13d-3 defines beneficial ownership based on

Voting power

Investment power

1934 Act Rule 16a-1 defines beneficial ownership based on

Direct or indirect pecuniary interest

6

Control is presumed when a person directly or indirectly owns beneficially more than 25% of the outstanding voting securities of a company.

“Voting security” is defined in Section 2(a)(42).

The statutory presumption of control is rebuttable.

Natural persons are presumed not to be controlled.

“Control” – Section 2(a)(9)“[T]he power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company.”

7

Fund Family Affiliations “The nature of the advisory relationship has been considered to carry with it a strong indication of control. [However,] investment companies with a common investment adviser are not necessarily under common control.” Fundtrust, 1987 SEC No-Act. LEXIS 2085 (pub. avail. May 26, 1987).

Funds under common control are first-tier affiliates of each other.

8

Fund Family AffiliationsNeither Fund A nor Fund B is an affiliated person of Adviser. Thus, Fund A and Fund B are not second-tier affiliates (an affiliated person of an “affiliated person”) of one another.

But if Fund A and Fund B are under common control, then they are first-tier affiliates and the affiliation is two-way ─ Fund A is an affiliated person of Fund B and vice versa.

One Way – – One Way

Two Way

Adviser

Fund BFund A

9

Categories of Prohibited Transactions Principal Transactions

Section 17(a)

Section 17(d) / Rule 17d-1

Agency Transaction

Section 17(e)

Underwritings

Section 10(f)

10

Section 17(a)

1) Knowingly selling any securities or other property (except fund shares) to the fund;

2) Knowingly purchasing any securities or other property (except fund shares) from the fund;

3) Borrowing money or other property from the fund; or

4) Loaning money or other property to the fund in contravention of SEC regulations.

Section 17(a) prohibits first-tier and second-tier affiliates of a fund, acting as principal, from:

11

Section 17(d) and Rule 17d-1 prohibit first-tier and second-tier affiliates of a fund, acting as principal, from engaging in a joint arrangement with the fund.

Section 17(d) and Rule 17d-1

Rule 17d-1(c) defines a joint arrangement as:

“a written or oral plan, contract, authorization or arrangement, or any practice or understanding concerning an enterprise or undertaking whereby a [fund] and [a first-tier or second-tier affiliate] have a joint or a joint and several participation, or share in the profits . . . .”

12

Section 17(e)Section 17(e) prohibits first-tier and second-tier affiliates of a fund:

1) Acting as agent, from accepting any compensation for the purchase or sale of any property to or from the fund (except in the course of its business as an underwriter or broker); or

2) Acting as broker, from receiving a commission, fee, or other remuneration for effecting a securities transaction for the fund which exceeds:

A. the “usual and customary broker’s commission” if the saleis effected on an exchange; or

B. 2% of the sales price in a secondary distribution; or

C. 1% of the purchase or sale price for other sales.

13

Section 10(f)Section 10(f) prohibits a registered investment company from knowingly purchasing securities underwritten by a fund

Officer

Director

Advisory Board Member

Investment Adviser

Employee, or

Affiliated person of any such person

14

Section 17(b)

The SEC may, upon application by any person, issue an order permitting a prohibited principal transaction. The SEC must findthat the transaction is:

Reasonable and fair and does not involve overreaching on the part of any person concerned; and

Consistent with the policy of each fund concerned and with the general purposes of the Investment Company Act.

Statutory Exemptions

15

Section 6(c)

The SEC may, upon application, conditionally or unconditionally exempt any person, security or transaction, or any class of persons, securities or transactions, from any provision of or rule under the Investment Company Act. The SEC must find that the requested exemption is:

Necessary or appropriate in the public interest; and

Consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Investment Company Act.

16

Selected Exemptive Rules

Rule 17a-7 – Portfolio Cross Transactions

Rule 17a-8 – Fund Reorganizations

Rule 17a-9 – Purchase of MMF Portfolio Securities

Rule 17d-1(c) – Certain Joint Arrangements

Rule 17e-1 – Transactions with Affiliated Brokers

17

Portfolio Cross TransactionsRule 17a-7 permits purchase or sale transactions between:

Affiliated funds; and

Fund and non-fund accounts affiliated solely by reason of having a common adviser.

18

The transaction must be a purchase or sale, for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available.

The transaction must be effected at the independent “current market price” of the security.

The transaction must be consistent with the policies of each participating fund.

No brokerage commission, fee (except customary transfer fees) or other remuneration may be paid in connection with the transaction.

Conditions

19

The “current market price” of a security is:

For securities whose principal market is an exchange:

the last sale price on the exchange or,

if there are no reported transactions that day, the average of the highest current independent bid and lowest current independent offer on the exchange.

For other securities:

the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry.

20

The fund board (including a majority of the independent directors) must:

Adopt procedures which are reasonably designed to provide that all conditions of the rule will be met; and

Determine at least quarterly that all transactions during the preceding quarter were in compliance.

The fund board must also satisfy the governance standards defined in Rule 0-1(a)(7).

Additional Conditions

21

Fund Reorganizations

Rule 17a-8 permits reorganization transactions between:

Affiliated funds;

A fund and an affiliated common or collective trust; and

A fund and an affiliated insurance company separate account.

22

Conditions The fund board (including a majority of the independent directors)

must determine that:

Participation in the transaction is in the best interests of the fund; and

The interests of the fund’s existing shareholders will not be diluted as a result of the transaction.

The board must request and evaluate information necessary to make these determinations and give appropriate weight to all pertinent factors.

The board’s determinations and the bases for them must be fully recorded in the fund’s minute book.

23

Approval by an acquired fund’s shareholders is required, unless:

The fundamental policies of the surviving fund are not materially different;

The advisory contact of the surviving fund is not materially different;

The independent directors elected by acquired fund shareholders will comprise a majority of the independent directors of the surviving fund; and

The 12b-1 fees paid by the surviving fund are not greater than those authorized by the acquired fund.

Additional Condition

24

Purchase of MMF Portfolio Securities

Rule 17a-9 permits a first-tier or second-tier affiliate to purchase a portfolio security from a money market fund if:

The purchase price is paid in cash;

The purchase price is equal to the greater of the amortized cost value of the security or its market price; and

Any profit on a subsequent sale is paid to the fund.

25

Certain Joint ArrangementsRule 17d-1(d)(c) provides an exemption for certain joint arrangements, including:

Joint liability insurance policies, provided:

Premiums are allocated in a fair and reasonable manner; and

The policy does not exclude coverage for bona fide claims made against an independent director by another insured.

Assumption by an adviser of expenses incurred in connection with a fund reorganization.

26

Affiliated Brokerage

Rule 17e-1 provides a safe harbor from Section 17(e)(2)’s restriction that a fund not pay an affiliated broker in excess of the usual and customary broker's commission.

27

Conditions Commissions paid by the fund must be reasonable and fair in

comparison to what others charge for comparable transactions.

The fund board (including a majority of the independent directors) must:

Adopt procedures which are reasonably designed to provide that the commissions paid by the fund meet this standard; and

Determine at least quarterly that transactions during the preceding quarter were in compliance.

The fund board must also satisfy the governance standards defined in Rule 0-1(a)(7).

28

Portfolio Cross TransactionFund’s portfolio manager has decided to sell Apple stock; the portfolio manager of Adviser’s separately managed account (SMA) has decided to purchase Apple stock.

???

Does Section 17(a) prohibit a cross transaction between Fund and SMA?

Adviser

Fund AAppleStock

Fund SMA

29

Yes, but . . .

Rule 17a-7 provides an exemption for this transaction if Fund and SMA are first-tier or second-tier affiliates solely by reason of having a common adviser or advisers that are affiliated persons of each other.

30

What if the portfolios of the SMAs managed by Adviser hold in the aggregate 5% or more of Fund’s shares?

In such case, Rule 17a-7 would not be available because Fund and SMA would not be affiliated solely by reason of having a common adviser.

≥ 5%SMAsFund

Adviser

31

Transaction With Upstream Affiliate

≥ 5%

SMAs

Parent

Issuer

Fund A’s portfolio manager wants to buy securities issued by a subsidiary of Parent (Issuer). SMAs over which another subsidiary of Parent (Adviser I) has investment discretion hold in the aggregate 5% or more of Fund B (another fund in Fund A’s fund family).

AdviserI

Fund BFund A

AdviserII

32

The SEC may collapse a holding company structure for purposes of Section 17(a).

Section 17(a)(1) prohibits Issuer from knowingly selling securities to Fund A (its second-tier affiliate) in a principal transaction.

Adviser I is Fund B’s first-tier affiliate (indirect 5% owner) and second-tier affiliate of Fund A.

≥ 5%

SMAs

AdviserI

Fund A and Fund B are first-tier affiliates (under common control).

Fund B

AdviserII

Is the purchase prohibited?

− ? ? ?

Fund A

Parent

Issuer

33

Takeaways Be alert for potential affiliated transaction issues;

violations can result in significant liability for a fund affiliate.

Diagram the relationships for analysis.

Talk it through with a knowledgeable colleague.

Follow fund compliance procedures when effecting transactions pursuant to an exemptive rule.

Questions?

DC 767936 v4

Fund Codes of EthicsMark C. Amorosi

Rule 17j-1 Rule 17j-1 prohibits any affiliate of a fund

or its adviser or principal underwriter from engaging in fraudulent conduct in connection with the purchase or sale of a “Covered Security” held or to be acquired by the fund.

1

Rule 17j-1: “Covered Security” Defined

The rule applies to any “Covered Security” which includes all securities, except: U.S. government securities; Banker’s acceptances or CDs; Commercial paper; and Shares of registered open-end funds.

2

Rule 17j-1: Code Requirement Each fund, adviser and affiliated principal

underwriter must adopt a written code of ethics to prevent “Access Persons” from engaging in prohibited conduct.

Fund board of directors/trustees (including a majority of the independents) must approve such codes.

Fund board also must approve any material changes to such codes within 6 months.

3

Rule 17j-1: “Access Person” Defined

“Access Person” of a fund or adviser generally includes: Any director, officer, general partner or employee of the fund or

adviser who, in connection with his/her regular duties, makes, participates in, or obtains information regarding, transactions in Covered Securities by a fund, or whose functions relate to the making of any recommendations with respect to such transactions; and

Any natural person in a control relationship to the fund or adviser who obtains information concerning recommendations made to the fund with regard to fund transactions in Covered Securities.

4

Rule 17j-1: “Access Person” Defined (continued)

“Access Person” of a principal underwriter generally includes any director, officer or general partner who, in the ordinary course of business, makes, participates in or obtains information regarding, fund transactions in Covered Securities, or whose functions or duties in the ordinary course of business relate to the making of any recommendations to the fund regarding fund transactions.

5

Rule 17j-1: Code Administration Funds, advisers and affiliated underwriters are

required to: Use reasonable diligence and implement procedures

to ensure code compliance; Furnish a written report to the fund’s board at least

annually describing any issues and material violations arising under the code since the last report;

Certify at least annually that they have adopted procedures reasonably necessary to prevent “Access Persons” from violating the code; and

Maintain records required by the rule.

6

Rule 17j-1: Required Reports Access Persons must submit the following

reports: Initial Holdings Report; Annual Holdings Reports; and Quarterly Transaction Reports.

Independent directors/trustees generally do not have to submit reports, but are required to submit Quarterly Transaction Reports under certain circumstances.

7

Rule 17j-1: Required Pre-Approvals

“Investment Personnel” must pre-clear purchases in any IPO or private placement.

8

Rule 17j-1: Disclosure A fund must disclose in its prospectus or SAI

whether: The fund and its adviser and underwriter have

adopted codes of ethics; and The codes permit personnel subject to the codes to

invest in securities for their own accounts, including securities in which the fund may invest.

A fund and its adviser and underwriter also must file their codes of ethics with the SEC as an exhibit to the fund’s registration statement.

9

DC 1256383 v4

Duties of Directors and Trustees

Donald W. Smith

1

Expectations of Shareholders Fund Management SEC Mandates Plaintiffs Bar Increasing Complexity of Fund Operations

Competing/Conflicting Pressures on Boards

Focus on role of independent or “disinterested” fund trustees and directors Almost always, a majority of a fund’s board

is independent 1940 Act, SEC and best practices

composition requirements

Independent Directors of Mutual Fund Boards

2

Fund boards have distinctly different function than boards of operating companies

Primary purpose is to monitor and manage conflicts with outside service providers—especially the sponsoring investment adviser

Secondary purpose is to supervise various compliance functions

Unlike boards of operating companies, the 1940 Act and SEC rules and pronouncements assign a number of specific duties to mutual fund boards

Role of the Fund Board

3

The specific duties expected of mutual fund boards often are much more granular and detailed than those of non-mutual fund boards

Examples of key conflict management and compliance functions: brokerage and soft dollars, securities lending, valuation, annual advisory contract reviews, approval of fund compliance program, and affiliated transactions

Also, general corporates duties such as: election of officers, approval of material service contracts, approval of share issuance, interaction with auditors and declaration of dividends

However, fund boards are not expected to manage or supervise most day-to-day operations of the adviser and manager

Difficult balance to strike

Role of the Fund Board (continued)

4

Who qualifies as an independent director under the 1940 Act

Business relationships that must be disclosed Common issues regarding independence Material business relations with the adviser and other

service providers Relationships with subadvisers Updating questionaires

Independent Directors

5

Board practices formally mandated by the SEC Nomination of independent directors by

independent directors Annual self-assessments Fair valuation of portfolio securities “Independent Counsel” requirement Approval of compliance policies and

procedures

SEC Requirements

6

SEC Requirements (continued)

An increasing number of requirements are being imposed on fund boards by the SEC staff through published guidance, the examination process and settled enforcement actions. These often appear to significantly

decrease the ability of boards to delegate functions to management.

7

2004 – Rules requiring enhanced disclosure regarding board consideration of advisory contracts

2010 – Additional disclosure required about the board’s leadership structure, including: whether the same person serves as both principal executive officer and board

chair; whether the board chair is an “interested person” of the fund; a description of the board’s role in risk oversight why the registrant has determined that its leadership structure is appropriate, given

the specific characteristics or circumstances of the registrant.

Adopting Release recognized that “different leadership structures may be suitable for different companies depending on factor such as the size of a company, the nature of a company’s business, or internal control considerations, among other things”

Governance Disclosure Rules

8

What standards must a director meet under state law Duty of loyalty Duty of care

Business judgment rule Protects the board, but requires extensive process

and documentation to be effective

Fiduciary Duty and Business Judgment

9

Review of advisory contracts Gartenberg standard Harris Supreme Court decision Disclosure of factors considered and

findings made Review of changes in control of adviser

and merger transactions

Review of Advisory Contracts

10

Advancement of legal expenses Indemnification by the fund Insurance

Protection from Liability for Directors

11

The Audit Committee Relationship with auditor Auditor independence and pre-approvals Audit Committee Financial Expert Audit Committee charter

The Board’s Role in the Audit Process

12

Valuation Oversight of Intermediaries Risk management and alternative investments Money fund matters Securities lending Enhanced oversight of fixed income funds Emphasis on enforcement Use of Rule 38a-1

Significant Current Topics

13

DC 9866372 v6

Update on 36(b) LitigationJeffrey B. Maletta

Section 36(b) Overview A unique provision addressed to a single issue:

whether adviser (or affiliate) charges an excessive fee

Distinct from other litigation involving funds Federal securities law cases alleging disclosure

violations…“prospectus liability” cases State law derivative cases to recover money for or

protect fund from injuries allegedly inflicted on fund by adviser, directors, or third parties

2

Section 36(b) Designed to Address Excessive Fee Concerns

Less than arm’s-length relationship Existing fund governance not effective Market not effective Shareholders tend not to move State corporate law ineffective

Action for “waste” Difficult substantive standard Demand required Approval of fees by directors or shareholders

3

The Solution: Section 36(b)For purposes of this subsection, the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company, or by the security holders thereof, to such investment adviser or any affiliated person of such investment adviser.

4

Section 36(b): Substantive Solution

Fiduciary duty of adviser Fiduciary standard of compensation Fiduciary may not charge an “excessive” fee Fee must have the “earmarks of an arm’s

length bargain”

5

Section 36(b) Procedural Features Direct shareholder action A single shareholder may sue Limitation on “damages” to one year prior to the

filing of the complaint Defendants limited to recipients of compensation No need to prove personal misconduct; but

plaintiff has burden to show breach of fiduciary duty

Board and/or shareholder approval not dispositive

6

The Gartenberg Standard Gartenberg v. Merrill Lynch Asset Mgmt., Inc. (2d Cir. 1982)

To violate Section 36(b), “the adviser-manager must charge a feethat is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining”

“[T]he test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm’s length in the light of all of the surrounding circumstances”

Supreme Court adopts in Jones v. Harris Associates LP (2010)

7

Gartenberg Factors Consideration of “all facts in connection with the

determination and receipt of such compensation,” including: the nature and quality of services rendered the profitability of the fund to the investment adviser fall-out benefits economies of scale comparative fee structures, and the independence of the unaffiliated directors and the care and

conscientiousness with which they performed their duties

Supreme Court endorses in Jones v. Harris

8

Current Section 36(b) Cases Manager of manager cases

Adviser/Manager contracts with fund Adviser “subcontracts” portfolio management services

Plaintiffs’ theory: subadviser does the work Subadviser provides most services Manager role is minimal Manager expenses are largely fixed

Plaintiffs focus on manager’s portion of fee paid by fund—does that amount bear a reasonable relation to services rendered by manager

9

Profitability Analysis Total advisory fee = 100 Total expenses = 60; 40 to subadviser

Profit = 100 – 60 = 40%100

10

Profitability – Plaintiff-Style Total fee to adviser Adviser’s share of fee = 60 Adviser’s expenses = 20

Profit = 60 – 20 = 40 = 67%100 60

11

Profitability Plaintiff – Style II Plaintiffs challenge expenses ─ particularly

allocation of costs from outside the adviser Total fee = 100 Adviser’s share of fee = 60 Adviser’s expenses under plaintiff theory = 10

Profit = 60 – 10 = 50 = 83.3%60 60

12

Manager of Manager Cases AXA (D. NJ) Hartford (D. NJ) ING/Voya (D. Del.) SEI (E.D. Pa.)* Russell (D. Mass.) Principal (S.D. Iowa)

13

Variation: Services Sold Separately

Adviser provides subadvisory services to other funds at rate lower than adviser charges proprietary fund

Plaintiff focuses on difference between advisory and subadvisory rates

14

Plaintiff’s Profitability Analysis Total advisory fee = 100 Price of adviser’s services when acting as

subadviser to another fund = 40 Fee for “other” services = 60 Expenses associated with other services = 20

Profit = 60 – 20 = 67%60

15

Adviser Subadvising Other Funds BlackRock (D. NJ) Harbor (N.D. Ill.) JP Morgan (S.D. Ohio) Davis (S.D.N.Y.) First Eagle (D. Del.)

16

Plaintiff Advantages “Notice” pleading Motions to dismiss remain difficult Notice pleading No class certification or demand requirements Little or no discovery burden

17

Plaintiff Advantages Superficial appeal: It’s all about stock picking Large absolute numbers Large funds generate large fees Adviser/subadviser fee ratios

Similarity between investment management and subadvisory agreements

Focus on single fund

18

Motions to Dismiss More difficult than in securities class actions Historically some success Migdal Amron Davis

Inferences drawn in favor of plaintiff No bright-line test

19

Role of Independent Directors Not parties Most important fact witnesses Defending their business judgment Cooperating with, but independent from, adviser

and its counsel

20

Issues Unbundling services

Plaintiff attempts to break services provided under IMA into separate pieces and examine profitability of each piece

Cost allocation Plaintiff focuses on direct costs incurred by adviser (e.g., number

of employees) and challenge allocation of expenses

Overlap in services Plaintiff contends that to the extent adviser is providing services,

they are duplicative

21

Defenses Integrity of 15(c) process

How much do directors see

Focus of independent directors Can they explain their decision as an appropriate judgment

Focus on the “fee as a whole Are the shareholders paying a fair or reasonable price for what

they are receiving notwithstanding how fee is divided

Overall profitability Is profit appropriate in light of risks borne by adviser

22

Status of Current Cases One motion to dismiss denied on the merits – Hartford Five pending motions

Harbor (also pending motion to designate additional case filed in September as related)

BlackRock JP Morgan First Eagle Davis

Recently Amended Complaint SEI – amended after motion granted on timeliness grounds

Pending motion for reconsideration Principal (both defendants have, however, answered)

23

Status of Advanced Cases AXA

Expert discovery in process

Hartford Fact discovery closes December 2014

Russell Case reassigned and trial date cancelled ADR and status conference with new judge early January 2015 Fact discovery scheduled to close December 31, 2014

ING Early stages of fact discovery ─ set to close July 2015 Answers filed

24

DC 9568129 v3

Litigation Issues in Investment Management – The Attorney-Client Privilege and Attorney Work Product ProtectionStephen G. Topetzes

1

Introduction – Special Challenges in the Fund Context

Investment company litigation is often more complex than “regular” securities or corporate litigation

Structure of the fund family results in multiple separate entities fulfilling functions that are often performed within a single corporate entity

This separation of responsibility and interests creates the arm’s-length and potentially adversarial relationships in some situations and common interests in others. This reality shapes the manner and degree to which privileges or protections may apply to interactions between lawyers and individuals.

2

PRINCIPAL SERVICES OF FUND VENDORS

3

Introduction (continued)

Combination of common and competing interests cancreate issues in litigation

Director performance Decision-makers in fee litigation Decision-makers and defendants in other cases Responsibility for/role relative to valuation Role relative to service provider oversight

Adviser personnel as Fund Officers or Directors Which “hat” are you wearing? Are there conflicts or appearance problems? Role relative to oversight of affiliated and unaffiliated service providers

Application of attorney-client privilege When does it apply? How may it be waived?

4

Recurring Issues –“Hardy Perennials”

Perils of unvarnished (unprivileged) expression in: E-mails Notes Minutes

Excessive detail Lack of focus/Inadequate record of deliberative process

Possible Game Changer: How the “multiple hat” phenomenon and potentially competing interests are reflected in the documentary record

5

Role of Independent Directors Independent Directors – directors who are not

“interested parties” within the meaning of ICA –are the “watchdogs” for the Fund shareholders. Burks v. Lasker, 441 U.S. 471 (1979)

Among other things, they oversee the relationship between adviser and fund which is “fraught with potential conflicts of interest.” Daily Income Fund Inc. v. Fox, 464 U.S. 523, 536 (1984), quoting Burks v. Lasker.

6

Role of Independent Directors (continued)

Independent Directors are critical participants in virtually all fund litigation Key witnesses in fee and other service

provider-related litigation Evaluate shareholder demands in derivative

cases Defendants in class and derivative actions Authorize suits on behalf of the Fund

7

LitigationPossible Alignments: Shareholder on behalf of the Fund v. Adviser, et al. Shareholders v. Fund, Directors, Adviser, et al. Fund v. Third Parties

8

Board Action – A Deliberative Process

Directors do not act in a vacuum. They aregenerally participating in a process that is designedto allow them to reach a business judgment. 15(c) process

Fees for third-party providers

Possible error by adviser or service providers

Non-routine matters where adviser conflicted

Whether to litigate

9

Board Action – A Deliberative Process (continued)

Record will be examined for consistency,deliberateness and completeness Materials and minutes should reflect a process One meeting vs. multiple meetings Pre-meeting review of materials Fund-specific consideration and decision-making may be

focused in isolation Length of meetings and pre-meeting preparation may be

examined Evidence of negotiation or bargaining

10

The Business v. Litigation Expectations

Common Enterprise v. Marketplace Reasonable people v. Hard bargainers Cooperators v. Adversaries

THE CURRENT AGENDA – Possible Litigation and Enforcement Threats

• Excessive Fee Litigation (as discussed in prior presentation)

• Compliance with Section 15(c)• Compliance with Exemptive Orders• Conflicts

• Who is getting paid? For what? Is there an undisclosed financial interest?

• Is it linked (directly or indirectly) to distribution/marketing/referrals?

• Service Provider Oversight• What did board or fund management do initially?• How did they respond to “red flag”?

• Underperformance/Troubled Holdings or Strategies• Disclosure/Valuation/Performance Reporting/Marketing

11

12

Attorney-Client Privilege –Elements

(1) communication(2) made between privileged persons(3) in confidence(4) for the purpose of obtaining or providing legal

assistance for the client

Restatement (Third) of the Law Governing Lawyers(“Restatement”) § 68

13

Communication Any expression through which a privileged

person conveys information to another privileged person

AND

Any document or other record revealing that expression

Restatement § 69

14

“Privileged Persons” Clients Lawyers for the client Agents of either who facilitate communications

between them Agents of the lawyer who facilitate the

representation

Restatement §70

15

In ConfidencePerson communicating reasonably believes

no one other than a privileged person, or

another person with whom communications are protected will learn of the contents

Restatement §71

16

Obtaining or Providing Legal Assistance

Predominant purpose Dual role of employee Dual role of counsel

17

Who Are You Representing? Who is Representing You?

What “hat” are you wearing? Why does it matter? Possible counsel arrangements: Fund Adviser Independent Directors Fund and Independent Directors Fund and Adviser Individual

18

With Whom Are You Communicating?

Independent Directors Inside Director Fund Officer Adviser Employee Third-Party Service Provider Agents of the above

19

Is That Individual a “Client”?

Advisor personnel serving as fund officers

Advisor personnel performing advisory services for fund

Client: FundDirectors

Third-party service provider

20

What Are You Communicating About?

Fund interests Adviser interests Mutual interests Individual interests Legal or business issues

21

Is this individual a “client” constituent?

Is the context of your communication confidential?

What’s the purpose of your communication?

Is Communication Privileged?

22

Review: Know your privileges and protections

Attorney Client Privilege FRCP 26(b)(1) Protects all confidential communications made between an

attorney and client for the purpose of procuring or delivering legal advice.

Applies only to actual communications, not the facts within the communications.

Upjohn – Privilege applies to communications between company employees and counsel acting on behalf of the company.

Re: Corporate interests - Company “owns” privilege – neither employees nor former employees can waive.

23

Review: Know your privileges Work Product Doctrine FRCP 26(b)(3) Protects from discovery documents prepared by a

client or her/his attorney in “anticipation of litigation.” Opinion work product – e.g., attorney notes of

witness interviews that contain explicit mental impressions and/or legal strategies – more protected than factual work product (access only upon showing of substantial need/undue hardship).

24

Extending and Losing the Privilege or Protection

Common Interest Waiver

25

Attorney-Client Privilege –Common Interest

Clients with separate counsel who have a common interest in a litigated or nonlitigated matter may agree to exchange privileged information. Restatement § 76 Interests need not be congruent Communications must relate to matter of common interest Direct communications among clients generally are not

privileged

26

Attorney Client Privilege – Waiver The attorney-client privilege is waived if the client, lawyer or some other authorized agent discloses the communication in a nonprivileged communication In most contexts, a voluntary waiver of a privilege

communication results in a waiver of all communications concerning the subject matter

Restatement § 79