2nd Quarter 2013

Regulatory & Legislative Update

Citi OpenInvestorSM

Securities and Fund Services

2 Securities and Fund Services

The SEC stated in its release that it could adopt either alternative by itself or a combination of the two. Neither alternative would permit the continued use of amortized cost as a method of valuation on securities with remaining maturities in excess of 60 days. In addition, the proposal contains multiple new (or enhanced) requirements to improve risk disclosures through fund websites and required SEC filings. It also contained several proposed changes to money market fund diversification requirements related to the aggregation of affiliates, a look-through to sponsors of asset-backed securities, and removal of the 25 percent guarantor basket, as well as seeking comment on several additional possible changes. The proposed amendment is out for public comment until September 17, 2013.

The SEC indicated that the compliance date for the floating net asset value alternative (if adopted) would be two years from the effective date of the final amendments. The compliance date for standby liquidity fees and redemption gates (if adopted) would be one year after the effective date of the final amendments. The compliance date for any amendments not related to either of the two alternatives would be nine months after the effective date. While the potential changes resulting from the rule proposal are enormous in terms of their system, pricing, compliance and settlement implications,

Regulatory & Legislative Update2nd Quarter 2013

The second quarter was highlighted by the Securities and Exchange Commission’s (the “SEC’s”) issuance of its money market fund reform proposal on June 5th. The proposed amendments to Rule 2a-7 under the Investment Company Act of 1940 (the “1940 Act”) and several corresponding reporting and record keeping rules weighed in at 698 pages. The primary thrust of the rule proposal was around two alternatives designed to address money market funds’ susceptibility to heavy redemptions, improve their ability to manage and mitigate potential contagion from such redemptions and increase the transparency of their risks, while preserving their benefits as much as possible. The first alternative would require prime and tax-exempt institutional money market funds to sell and redeem shares based on the current market-based value of the securities in their portfolios, rounded to the fourth decimal (e.g. $1.0000). The second alternative would require non-U.S. government money market funds to impose a liquidity fee if a fund’s weekly liquid assets fell below 15% of its total assets (unless a fund’s board determines that such a fee is not in the best interests of the fund) and would permit such funds to temporarily suspend redemptions (i.e. “gate” the funds).

it is also difficult to commit a tremendous amount of energy and resources to the proposed amendments until there is a greater indication of the likely direction of any final rules. In the meantime, it is important to follow developments in this area and consider the likely impact of the different rules to compliance and operational requirements, should they become final.

Another major development during the period was the six-month delay of many FATCA compliance dates. On July 12, 2013, the Internal Revenue Service (the “IRS”) issued Notice 2013-43, which pushed back the definition of pre-existing obligations and the requirement for due diligence on new foreign financial institution (“FFI”) accounts until July 1, 2014. Thus, FATCA withholding requirements on new FFI accounts are also delayed until July 1, 2014. Likewise, withholding requirements for pre-existing FFI accounts are delayed by six months, starting on January 1, 2015 for prima facie FFI accounts.

The IRS Notice also announced a delay in opening its FATCA registration portal from July 15, 2013 until August 19, 2013 and indicated that Global Intermediary Identification Numbers, or “GIINs,” would not be issued until sometime next year. The Notice indicated that the deadline for FFIs to register on-line and still appear on the first FFI list published by the IRS was now April

By: Chuck Booth Director of Regulatory Administration and Compliance Support Services

3Regulatory & Legislative Update | 2nd Quarter 2013

25, 2014 and that the list would be published by June 2, 2014. Reporting requirements are still scheduled to begin on March 31, 2015. However, the reports now only require information for calendar year 2014 and each year thereafter, rather than 2013 too.

Additionally, on June 25, 2013, the U.S. Court of Appeals for the D.C. Circuit ruled in favor of the Commodity Futures Trading Commission (the “CFTC”) by granting summary judgment in its favor with respect to an appeal by the Investment Company Institute (the “ICI”) and the U.S. Chamber of Commerce. The appeal was the result of a defeat in a lower court by the ICI and the Chamber of Commerce asserting that the CFTC had not met its regulatory obligations when it amended Rule 4.5 under the Commodity Exchange Act because it had not satisfactorily analyzed the costs and benefits of the new rules. With the culmination of this case, the CFTC is likely to turn its attention to finalizing the harmonization proposal it had issued in February 2012. Following its finalization, commodity pools that are registered funds will be faced with new reporting, record keeping and disclosure requirements.

In other news, on April 10, 2013, the SEC and the CFTC jointly approved final rules requiring mutual funds, broker dealers and registered investment advisers to adopt written programs designed to detect and respond to red flags commonly associated with identity theft. The rules largely mirror the existing red flag rules enforced by the Federal Trade Commission (the “FTC”) since 2008. In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act transferred enforcement authority for these regulations to the SEC and the CFTC. In the adopting release, the SEC indicated that the new rules do not create any additional identity theft program requirements beyond those in place under current FTC rules. The compliance date for the new rules is November 20, 2013.

On May 2nd, the SEC settled administrative proceedings with Gemini Fund Services, LLC (“Gemini”) and its subsidiary, Northern Lights Compliance Services, LLC (“Northern Lights”), regarding procedures and disclosures required by Section 15(c) of the 1940 Act for its umbrella trusts, Northern Lights Funds Trust and Northern Lights Variable Trust (The “Trusts”). The SEC had alleged that the Board had caused violations of Section 34(b) of the 1940 Act

by allowing untrue or misleading statements regarding its deliberations and review of advisory contracts to appear in the Trusts’ financial reports. The SEC also alleged that the Board and Northern Lights caused violations of Rule 38a-1 under the 1940 Act by not following the Trust’s compliance procedures and that Gemini caused various record keeping and disclosure violations regarding the Board’s investment adviser contract renewal approval process. Basically, the SEC alleged that the Trusts used boilerplate language to meet its Section 15(c) obligations regarding the factors considered when approving an investment advisory agreement. All of the Respondents agreed to cease and desist from causing future violations of the relevant laws and rules thereunder and Gemini and Northern Lights agreed to each pay a $50,000 civil monetary penalty.

Another case that caused quite a stir during the quarter was the SEC’s June 13th settlement with eight former Directors of the Morgan Keegan Funds regarding alleged violations of the Funds’ fair valuation process from January 2007 to August 2007. The SEC had claimed that the Funds’ Directors had caused the Fund to violate Rule 38a-1 regarding its compliance procedures relating to fair valuation. The SEC Order indicated that during the relevant period, a significant portion of the Funds’ portfolios consisted of subordinated tranches of various securitizations that were required to be fair valued in accordance with Section 2(a)(41)(B) of the 1940 Act. The Directors had delegated the responsibility for the fair value determinations to the Funds’ Adviser and, according to the SEC, failed to provide adequate oversight of the process. Thus, when fair valuations were ultimately brought into question by the Commission staff, the SEC concluded that the Directors had caused the Funds’ violation of Rule 38a-1 regarding its procedures that provide for the oversight of compliance by the Adviser. The SEC did not levy any monetary penalties against the Directors but did order that they cease and desist from causing any future violations of Rule 38a-1.

The second quarter, although largely dominated by the proposed amendments for money market funds, represented a mixed bag of regulatory and legislative issues for the industry. The FATCA delay is welcome news, but the CFTC victory could signal another surge in derivative rule making aimed at mutual funds. Also, while the new identity theft rules will not represent much

The second quarter, although largely dominated by the proposed amendments for money market funds, represented a mixed bag of regulatory and legislative issues for the industry.

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of a change to our procedures, the Morgan Keegan and Gemini cases signal the SEC’s willingness to use Rule 38a-1 as the sword it was originally intended to be when things go awry or the SEC suspects a fund or its board is asleep at the wheel. 2013 is shaping up to be an interesting year from a regulatory standpoint, and we will all just have stick around to see how the story ends.