Mutual Fund Industry Trends – November 2016 Industry Statistics Net Assets (in billions) Fund Category Stock Hybrid Taxable Bond Municipal Bond Money Market Total

Percentage Change in Net Assets 4.1% 1.9%

Dollar Change in Net Assets (in billions) Change Due to Net Total Cash Change Flows Market $340.1 ($91.3) $431.4 $25.4 ($6.6) $32.0

Sept-16 $8,542.2 $1,400.2

July-16 $8,202.1 $1,374.8

$3,070.7

$2,980.0

3.0%

$90.7

$49.4

$41.3

$664.7

$649.6

2.3%

$15.1

$16.5

($1.4)

$2,672.3

$2,702.5

(1.1%)

($30.2)

($30.9)

$0.7

$16,350.1

$15,909.0

2.8%

$441.1

($62.9)

$504.0

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Stock funds assets rose $340.1 billion. For the quarter ended September 30, 2016, market appreciation was $431.4 billion compared to an appreciation of $146.7 billion for the quarter ending June 30, 2016. The net assets for stock funds increased from $8,202.1 billion as of the end of June 2016 to $8,542.2 billion in September, 2016.

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Hybrid fund assets increased from $1,374.8 billion as of June 30, 2016, to $1,400.2 billion as of September 30, 2016. This compares to an increase of $30.7 billion in the second quarter of 2016. The increase was the result of market appreciation of $32.0 billion and net outflows of $6.6 billion.

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Bond funds had net inflows of $65.9 billion for the quarter ended September 30, 2016, compared to the previous quarter inflows of $40.1 billion. Assets for all bond funds increased $105.8 billion for the quarter ended September 30, 2016, which included market appreciation of $39.9 billion.

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Money market funds had net outflows of $30.9 billion for the three months ended September 30, 2016, compared to the previous quarter outflows of $ 52.2 billion. Money market fund net assets, over the three month period decreased from $2,702.5 billion as of June 30, 2016, to $2,672.3 billion as of September 30, 2016.

Source: Investment Company Institute website

Mutual Fund Industry Trends – November 2016 1

REGULATORY UPDATE SEC Amends Form ADV On August 25, 2016, the SEC adopted amendments to Form ADV and certain recordkeeping rules applicable to investment advisers. The amendments were initially proposed on May 20, 2015, with the comment period ending on August 11, 2015. The final rule will become effective on October 31, 2016, with a compliance date of October 1, 2017. The amendments require advisers registering on Form ADV to report additional information with an emphasis on separately managed accounts (“SMAs”). Additionally, advisers will be required to comply with certain recordkeeping requirements related to communications of performance or securities recommendations. The amendments are intended to provide data regarding a perceived gap in information involving SMAs. As noted above, the amendments require advisers to report more information about their SMAs. SMAs include all advisory accounts but for pooled investment vehicles. Beginning with filings after October 2017, advisers will need to provide information on an aggregate level about the SMAs they manage, regulatory assets under management attributable to SMAs (“RUAM”) and the types of assets held across 12 categories and the use of derivatives and borrowings in the SMAs. Advisers with at least $500 million, but less than $10 billion, in RUAM attributable to SMAs are required to provide certain information as a part of their annual amendment update. Advisers in this category are required to report the amount of RUAM in SMAs and the dollar amount of borrowings attributable to those assets. Advisers with at least $10 billion are required to report the RUAM in SMAs and the dollar amount of borrowings associated with those assets and the derivative exposure in each of six categories of derivatives. The borrowings must be reported based on the total dollar amount of borrowings that corresponds to the different ranges of gross notional exposure. The amendments also require advisers to identify custodians that account for at least 10% of SMA RUAM and the amount held at each custodian. The amendments further require advisers to report any social media accounts used by the adviser where the adviser controls the content, including the addresses of the adviser’s social media pages. Form ADV previously required advisers to only report their website address. The amendments require advisers to report the total number of offices where they offer investment advisory services and the 25 largest offices based on the number of employees. With respect to each office, the adviser must report:

Mutual Fund Industry Trends – November 2016 2

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Central Registration Depository (“CRD”) branch numbers, if applicable;

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The number of employees acting in an advisory capacity;

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The business activities that take place according to a list of activities provided by the SEC; and

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Any other investment activities conducted.

The amendments further require an adviser to disclose whether it Chief Compliance Officer (“CCO”) is employed by a third party. If this is the case, the adviser is required to disclose the name and IRS Employer Identification Number of that third party. The SEC also adopted some significant changes to Rule 204-1 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The amendments require advisers to make and maintain supporting documentation that demonstrates performance calculations or rates of return in any written communications the adviser circulates or distributes to any person.

SEC Increases “Qualified Client” Threshold On June 14, 2016, the SEC issued a final order adopting inflation-based adjustments to the “qualified client” thresholds that investment advisers may rely upon under Rule 205-3 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”) in order to charge performance fees. Section 205 of the Act generally prohibits a registered investment adviser from receiving performance-based fees (a share of capital gains or appreciation); however, the Rule allows advisers to charge such fees in cases where it has an advisory agreement with a “qualified client.” The new net worth requirement for a qualified client, which took effect August 15, 2016, increased from $2 million to $2.1 million after the application of the inflation adjustment. The new threshold applies only to contractual relationships entered into on or after the effective date and does not apply retroactively to previously existing relationships. The threshold for the Rule’s alternative assets-under-management test remains at $1 million because the effect of inflation on that amount did not meet the rounding threshold of $100,000. The order does not impact the exemption against the general performance fee ban available to investment advisers provided by Section 205(b) under the Advisers Act which allows for performance fees to be charged to companies exempted from the definition of an investment company under Section 3(c)(7) of the Investment Company Act of 1940 and nonU.S. residents.

SEC: Final Rules for Liquidity, Reporting and Swing Pricing On October 13, 2016, the SEC adopted new rules and amended existing rules to modernize investment company reporting and disclosure of information. In addition, the SEC adopted a liquidity risk management rule and related disclosure for mutual funds and open-end DTFs.

Mutual Fund Industry Trends – November 2016 3

Finally, the SEC adopted rule amendments that permit, but does not require mutual funds to use swing pricing. The financial reporting changes will require most mutual funds to file a monthly N-Port. The report, due within 30 days after then end of the period, would require general information, certain portfolio –level metrics, security lending information and information regarding each portfolio holding. In addition, new Form N-Cen, would replace Form N-SAR and would require funds to report annual certain census-type information. Compliance date for large funds (greater than $1 billion) would be June 1, 2018 all other funds must comply by June 1, 2019. The Liquidity Rule would require funds to establish written liquidity risk management programs that would “reduce the risk that a fund will be unable to meet its redemption obligation and minimize dilution of shareholder interest by promoting stronger and more effective liquidity risk management practices across open-end funds.” Large fund complexes must comply with the liquidity rule by December 1, 2018. All others must do so by June 1, 2019. Changes to the N-1A must be made by June 1, 2017. The final rule approved by the SEC was granting funds the ability to use swing pricing, The SEC believes that swing pricing could be an effective tool to assist funds in reducing shareholder dilution and may be a component of the liquidity risk management program. Swing pricing allows the allocation of transaction costs to those shareholders purchasing or redeeming. Currently there are numerous operational challenges to implementing swing pricing. The SEC has set a two-year implementation period. All of these new rules will require extensive changes to reporting and disclosure requirements of mutual funds. The ICI is holding a meeting in Boston on November 17, 2016, to begin the process of implementing these rules.

SEC Adopts Rule Requiring Business Continuity Plans On June 28, 2016, the SEC proposed a rule that would require SEC-registered investment advisers to adopt and implement formal business continuity and transition plans (“BCP”) that address operational and other risks related to significant disruptions in an adviser’s operations in order to minimize client impact and investor harm. The Division of Investment Management of the SEC also issued an accompanying Guidance Update regarding business continuity planning for registered investment companies. Though the SEC has required advisers to maintain business continuity plans for some time, the proposed rule increases focus on reliance by advisers and funds on third-party service providers. In the proposal, the SEC also noted its staff has observed that “robustness of these BCPs is inconsistent” and that the proposal is aimed at facilitating the adoption and implementation of robust BCPs for all

Mutual Fund Industry Trends – November 2016 4

advisers. The rule would also require that adequacy and effectiveness of BCPs be reviewed at least annually. Under the proposed rule, an adviser’s BCP would be tailored to risks associated with the adviser’s operations and include the following policies and procedures: 

Maintenance of critical operations and systems, and the protection, backup, and recovery of data;

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Pre-arranged alternative physical location(s) of the adviser’s office(s) and employees;

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Communications with clients, employees, service providers, and regulators;

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Identification and assessment of third-party services critical to operations; and

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Plan of transition that accounts for the possible winding down or transfer of the adviser’s business in the event that the adviser is unable to continue providing services.

The Investment Management Guidance Update provided a summary of observed BCP practices regarding registered fund complexes, including: 

Plans coverage of facilities, technology, employees and activities of the adviser and any critical third-party providers;

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Plans include a broad cross-section of employees from key functional areas;

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Participation in the third-party service provider oversight by Fund CCOs;

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Provision of BCP information and presentations to fund boards by the adviser and critical service providers;

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Annual BCP testing; and

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Reporting of BCP events to fund boards.

The comment period for the proposed rule closed September 6, 2016.

SEC Proposed Changes to S-X and Registration Statements In July, the SEC proposed amendments to disclosure requirements under Regulation S-X. The proposed amendments are as follows: 

Amend 6-04.17 to omit the requirement to separately disclose the three components of distributable income and instead require disclosure of the total distributable income on the balance sheet.

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Delete the requirement in 6-09.7 for parenthetical disclosure of undistributed net income on a book basis in the statement of changes.

Mutual Fund Industry Trends – November 2016 5

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Amend 6.07 to permit a registered investment company to file a statement of comprehensive income instead of a statement of operations, where applicable.

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With the elimination of the concept of extraordinary expenses from GAAP, define extraordinary expenses for Item 3 of the N-1A.

SEC Challenges Employer-Imposed Agreements At issue are provisions in employer-imposed agreements, such as confidentiality agreements, that are in violation of Rule 21F-17 of the Securities Exchange Act of 1934, as amended. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC established a whistleblower program to encourage individuals to provide timely and useful information to them in order to support the SEC’s enforcement operations. The whistleblower program offers monetary incentives to those who voluntarily provide the SEC with information leading to an enforcement action resulting in more than $1 million in monetary sanctions. Rule 21F-17 became effective on August 12, 2011, and provides that no person may take any action to prevent or impede a whistleblower from communicating directly with the SEC regarding potential securities law violations. Over the past year, several companies have paid civil penalties based on employer-imposed agreements. The restrictive provisions have been identified in severance agreements and confidentiality agreements that limit employees’ ability to voluntarily share information with the SEC and possibly pursue a whistleblower claim. The SEC’s Office of Compliance, Inspections and Examinations has been routinely asking registrants during examinations for copies of employment agreements, severance agreements, employment policies and other documents that contain language that may be construed as interfering with the rights of whistleblowers. The SEC’s recent actions indicate that it will continue to prioritize their review of such employer-imposed agreements and policies in the foreseeable future.

Deloitte’s 14th Fair Value Pricing Survey Recently, Deloitte released its 14th Fair Value Pricing Survey. A new major focus found in the survey relates to liquidity. More than 40% of survey participants consider liquidity in some fashion for their portfolio positions and are developing policies in this area. For valuation this is used to determine if there is a need to change the recently quoted price. Other key findings were: 

The most common change to pricing policies include addition of more pricing sources and investment types and pricing committee composition, responsibilities and meeting frequency.



Almost 75% of participants use different pricing sources depending on the asset class.

Mutual Fund Industry Trends – November 2016 6

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A majority would only initiate a pricing challenge when they have conflicting market data.

The full survey can be found at: http://www2.deloitte.com/us/en/pages/financial-services/ articles/fair-valuation-pricing-survey-fourteenth-edition.html.

OCIE National Exam Program Risk Alert – Examinations of Supervision Practices In mid-September, the Office of Compliance Inspections and Examinations (“OCIE”) issued an announcement regarding its intention to examine the compliance oversight and controls of registered investment advisers that have employed or currently employ individuals with a history of disciplinary events. These individuals may present increased risk of future misconduct including harm to clients. OCIE is using its analytical capabilities to evaluate information obtained from a variety of sources to identify the registered investment advisers subject to this examination initiative. The examination initiative will focus on the following areas: 

Compliance Program. Rule 206(4)-7 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) requires registered investment advisers to implement written policies and procedures that are reasonably designed to prevent violations of the Advisers Act. Examinations will include the review of the registered adviser’s practices involving its hiring processes, ongoing reporting obligations, ongoing supervision and complaint procedures. The examination will evaluate the compliance culture as well.

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Disclosures. Advisers Act section 207 provides that any registration application or report filed with the SEC under Section 203 or 204 is unlawful if it contains any untrue statement of material fact or willfully omits to state a material fact which is required to be included. This standard applies to an adviser’s Form ADV Part 1 and brochure. The examination staff will likely cover the registered adviser’s practices regarding its disclosures of regulatory, disciplinary or other actions, focusing on assessing the accuracy, adequacy and effectiveness of such disclosures.

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Conflicts of Interest. As a fiduciary, a registered investment adviser has a duty to make full and fair disclosure of all material facts, including conflicts of interest that may affect the adviser’s relationship with its clients. The examination staff will pay particular attention to conflicts that may exist regarding financial arrangements initiated by supervised persons with disciplinary history.

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Marketing. Rule 206(4)-1 of the Advisers Act prohibits an adviser from including certain representations in its marketing materials and advertisements. The examination will

Mutual Fund Industry Trends – November 2016 7

include a review of a registered investment adviser’s advertisements to identify any conflicts of interest or risks associated with supervised persons with a disciplinary history. The OCIE intends to encourage advisers to reflect upon their risks, practices, policies and procedures in the areas noted above and to consider making improvements in their compliance programs where necessary.

CFTC Issues Two Amendments to Swap Data Reporting This summer the Commodity Futures Trading Commission (“CFTC”) amended its reporting and recordkeeping rules for swap dealers. The amendments alters requirements for cleared swaps in order to address data quality issues identified. Specifically, the amendment clarifies areas of the existing rule and removes valuation and confirmation data reporting requirements for cleared swaps. One of the key changes was that daily valuations no longer have to be reported by cleared swaps, by the swap dealers, or derivative clearing organizations. The CFTC continues to converse with the SEC on reporting requirements.

AXA Prevails in Excessive Fee Case Following Trial On August 25, 2016, after a 25-day trial, a federal court in the District of New Jersey ruled that AXA Equitable Life Insurance Co. and AXA Equitable Funds Management Group (collectively, “AXA”) had no liability for alleged excessive management fees charged to mutual fund investors. The case of Sivolella v. AXA Equitable Life Insurance Co. was the first case alleging excessive management fees in violation of Section 36(b) of the Investment Company Act of 1940 (the “Act”) to proceed to trial since the Supreme Court’s landmark 2010 decision in Jones v. Harris Associates established the legal standard for such cases. The plaintiffs’ central claim was that AXA’s charged excessive fees to mutual funds in its variable annuity products for investment and administrative services and then delegated those duties to subadvisors while retaining a significant portion of the fees charged. The opinion of the court included a detailed factual analysis applying the factors of Gartenberg v. Merrill Lynch Asset Management in ruling that the plaintiffs failed to demonstrate that AXA failed to meet its fiduciary duty in violation of Section 36(b) of the Act. The court rejected the plaintiffs’ theory that AXA improperly retained management fees, noting that AXA also retained responsibility for a certain management services and bore risks as the sponsor and adviser to the funds.

DOL Rule Exempts State Defined Contribution Plans At the end of August, the Department of Labor (“DOL”) handed down a final regulation that makes it easier for states to create their own retirement savings plans for private-sector workers. The final DOL rule allows states to avoid Employee Retirement Income Security

Mutual Fund Industry Trends – November 2016 8

Act (“ERISA”) coverage of their plans if the plans are maintained by the state, require minimal involvement of employers and allow employees to opt out. It is important to note that the rule does not prohibit states from establishing plans that are covered by ERISA. There has been a strong reaction to the rule for a number of reasons, one of which is that the final rule lacks a provision that was included in the proposed rule that prevented states from restricting participants from making withdrawals from their state-plan accounts. This provision prevents participants from moving their money to private-sector IRAs with lower costs and a broader range of investment options. Another point of contention is that some employers could opt to save costs by moving from existing defined contribution plans to state-run plans that do not require employer contributions. The justification for the state-run plans is based on the lack of retirement savings by nearly one-third of U.S. workers who do not have access to employer-sponsored retirement plans. The expansion of state-sponsored plans, with automatic enrollment, gives retirement savings access to millions of American workers.

First Trust to Merge Closed-End Fund into an ETF First Trust’s decision to merge its Dividend and Income Fund (“FAV”) into First Trust High Income ETF (“FTHI”) has potential benefits to shareholders of both funds. In July 2016, the closed-end fund, FAV traded at a discount to NAV, whereas the FTHI bid/ask discount was much smaller. By folding FAV into FTHI, the trading discount can be narrowed because ETFs, unlike closed-end funds, can create new shares when they absorb more assets. FAV total annual expenses amount to 1.48% of managed assets. In comparison, FTHI carried an expense ratio of 0.85%, 63 basis points lower than that of FAV. Even if you exclude the leverage cost, which is supposed to be put into profitable use, the ETF is still 44 basis points cheaper. Both funds write U.S. exchange-traded covered call options, making FAV’s transition to FTHI a relatively easy one because shareholders will not experience too many investment strategy changes. However, FAV did have 17.6% of assets invested in fixed income as of May 2016, whereas FTHI invests primarily in equity securities. In July 2016 FTHI had only about $7 million in assets, whereas FAV’s total managed assets reached approximately $92.4 million. Though some FAV shareholders may take profits because of improved trading discount, many may choose to stay, which will result in an increased number of shares and assets for the ETF. The boost in size could help the fund draw investor attention.

Mutual Fund Industry Trends – November 2016 9

According to the 2016 ICI Fact Book, closed-end funds held assets of $261 billion as of the end of 2015, down from $297 billion at year-end 2006. By comparison, ETFs had $2.1 trillion of assets, up from $423 billion during the same 10-year period. The asset decline of closedend funds and growth of ETFs suggest more closed-end fund providers may contemplate the conversion to ETFs.

S&P 500 Breaks Out REITS In September, the S&P 500 and MSCI indexes removed real estate investment trusts out of the financial services sector and into a sector of its own. As of June 30, REITs had a market value of $609 billion or 20% of the sector.

Intermediary Reaction to Distribution in Guise Examination Reacting to the guidance provided by the SEC in its January Investment Management Guidance Update “Mutual Fund Distribution and Sub-Accounting Fees,” Schwab recently issued a publication designed to assist fund boards. The publication, titled “Schwab’s Mutual Fund Marketplace® Executive Summary 2015” is intended to provide Fund boards with information about Schwab’s business practices in order for fund advisers and boards to understand the scope of the services Schwab provides to its clients. The publication is broken down into two sections: (a) the first section provides and overview of Schwab’s organization and operations and (b) the second section provides information which generally maps to the additional factors that the SEC suggested boards consider in their evaluations.

Fidelity Submits Proposal for Non-Transparent ETFs On August 11, 2016, Fidelity Investments submitted a filing to the SEC seeking permission to offer a new closed-end fund structure that it believes will capture the benefits of ETFs and active portfolio management while not requiring fund holdings to be disclosed on a daily basis. Under the proposed Fidelity offering, which it calls “exchange-traded active funds,” investors would be able to buy and sell the closed-end interval fund shares on an exchange intraday like ETFs. Fidelity would seek to eliminate the problem of discounts and premiums, however, by allowing authorized participants to redeem at net asset value on a weekly basis. Instead of disclosing holdings on a daily basis like traditional ETFs, Fidelity would disclose each fund’s holdings on a monthly basis and publish a “tracking basket” that would provide traders with enough information to arbitrage differences between the price at which the fund trades on an exchange and its net asset value. Fidelity’s proposal represents the next in a line of filings by firms seeking to combine the benefits of ETFs and active management, including Eaton Vance’s NextShares, the first of which were launched earlier this year.

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Morningstar Ratings Changes 2016 Morningstar announced its plans to deliver its new Analyst Rating™ for 300 exchange traded funds (“ETFs”) on October 31, 2016. The analyst rating started in 2011 for traditional mutual funds and features a five-tier scale with three positive ratings of Gold, Silver, and Bronze along with a negative and neutral rating. Analysts assess funds using five key elements: process, performance, people, parent, and price, and categories them using the five-tier system. The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years. Initially, ETFs were seen as a distinct category of fund. These investment products are priced and can be traded throughout the day on major stock market exchanges, unlike traditional mutual funds which are priced once at the end of the day. The lines between ETFs and mutual funds are blurring. Given this trend, Morningstar is combining similar type mutual funds and ETFs within the same comparison group. For example, an S&P 500 Index ETF will now be categorized with comparable S&P 500 index mutual funds. This new Morningstar ranking method will assist consumers looking for a specific category or type of fund to compare mutual funds and ETFs with the same objectives side-by-side. Morningstar will rank ETFs and open-ended mutual funds together using their quantitative algorithm that examines historical data according to the funds' past and risk-adjusted performance. Additionally, in both the U.S. and Australia, the firm expects to give the funds a Morningstar rating, percentage ranks, category averages and other statistical information.

FinCEN Issues Fraud Warning The Financial Crimes Enforcement Network (“FinCEN”) of the U.S. Department of the Treasury recently issued an advisory to financial institutions noting an increase in e-mail based fraud attempts. FinCEN detailed how compromised email accounts are being used to deceive financial institutions and their customers into conducting unauthorized wire transfers. The advisory highlighted how these fraudulent schemes work and provides a reminder that a diligent review and confirmation of all e-mailed transaction instructions should be performed. FinCEN also provided eleven “fraud red flags” that may suggest a fraudulent scheme is occurring and reiterated a financial institution’s obligation to file a Suspicious Activity Report if fraudulent activity is discovered.

Mutual Fund Industry Trends – November 2016 11

FINRA Requires Margin Payments for TBA On August 15th, FINRA issued a regulatory notice adopting a requirements that brokerdealers collect margin on to-be-announced or TBAs. Under Rule 4210 broker-dealers will collect margin from most customers for the majority of TBA transaction, unless the transaction is centrally cleared through a registered agency. The Rule takes effect by December 15, 2017.

FINRA Proposes Changes to Gift and Non-Cash Compensation The Financial Industry Regulatory Authority (FINRA) proposed new rules issued in Regulatory Notice 16-29. The proposal would raise the gift limit from $100 to $175 and include a de minimus threshold below which firms would not have to keep records of gifts given or received. The new rules also impose noncash compensation restrictions on all securities transactions (subject to specified exceptions) and are not limited to mutual funds, variable annuities, direct participation programs and public offerings. Other new limitations and recordkeeping requirements are imposed under the proposed non-cash compensation rule. FINRA’s proposal would also replace previous guidance on business entertainment — allowing “ordinary and usual business entertainment” — with a requirement to implement policies and procedures ensuring no quid pro quos, defining permissible business entertainment, training and recordkeeping. FINRA is also proposing to incorporate into the amended rules a principles-based standard for business entertainment that would require firms to adopt written policies and supervisory procedures for business entertainment. Existing FINRA guidance and interpretive positions are incorporated into the proposed rules and supplemental materials.

FINRA Launches Sweep of Non-Trade Business Development Companies FINRA conducted an inquiry with respect to non-traded Business Development Companies (“BDCs”). The following documents and information for the period from January 1, 2015, through June 30, 2016 was requested: 1. A list of each BDC offered by the firm that includes: (a) the name of the BDC; (b) the S.E.C. File Number for each registration statement (or “offering”); (c) the dates of each offering; and, (d) the firm’s role in each offering, e.g. sole dealer-manager, lead dealermanager, distributor, etc. 2. For each BDC offered: (a) a list of all participating broker-dealers that have a selling agreement with the firm per each registration statement; and, (b) sample copies representative of each type of selling agreement utilized.

Mutual Fund Industry Trends – November 2016 12

3. A list, in excel format, by date, of all broker-dealers that sold the aforementioned identified BDCs to its customers in initial or follow-on offerings that includes for each BDC: (a) the name of the participating broker-dealer; (b) the total number of shares bought and sold; (c) the total dollar value of proceeds; and, (d) the number of customers purchasing the BDC. 4. A copy of the firm’s due diligence procedures and, if not already included in the due diligence procedures, a written description of the due diligence that the firm conducts of the BDC initially and on an ongoing basis as well as a written description of the due diligence that the firm conducts of participating broker-dealers with which the firm has a selling agreement. FINRA is targeting BDCs to see how they are marketed and sold. BDCs are complex and carry high risk so there is concern that retail investors may not fully understand the risks and the potential impact on their portfolios. FINRA has expressed concern about suitability and supervision of complex products.

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ACCOUNTING UPDATE Auditor Independence and the Loan Provision The SEC's Division of Investment Management recently issued a letter that provides registered investment companies (and other entities within an investment company complex) with temporary no-action relief regarding audit services performed by public accounting firms that have certain relationships that might cause non-compliance. Regulation S-X requires an audit firm to be independent of the fund. Recently some questions have arisen dealing with the “loan rule.” Specifically, the loan rule provides that an audit firm is not independent if the audit firm has any loans to or from the client or any beneficial ownership of more than 10% of the audit client’s equity shares. The difficulty in tracking this for large audit firms has raised considerable confusion for many firms. The no-action relief provides relief in the following circumstances: 

When the lending institution—or a broker-dealer subsidiary—holds of record for the benefit of its clients or customers more than 10% of the fund’s outstanding shares.

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When the lending institution is an insurance company that owns more than 10% of the fund’s outstanding shares in a separate account that it maintains on behalf of its insurance contract holders.

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When the lending institution acts as an authorized participant or market maker for an ETF and owns beneficially more than 10% of the ETF’s shares.

Funds may rely on the letter to satisfy a registration or reporting requirement, including financial reporting requirements.

AML Update In July the U.S. Treasury Department of Financial Crimes Enforcement Network (“FinCEN”) adopted rules that will require financial institutions’ AML programs to collect information with respect to certain beneficial owners of fund investors. Whether beneficial ownership information will need to be provided will depend on whether the beneficial owner exceeds an ownership threshold or exercises significant control over the investor. The industry is currently evaluating how to comply with these requirements as the May 11, 2018 effective date nears. In addition, almost a year ago FinCEN proposed rules that would bring investment advisers registered with the SEC within the definition of a “financial institution.” When effective, these rules would require SEC registered investment advisers to also adopt a written AML program, approved in writing by the Board, and with an AML officer and training of the

Mutual Fund Industry Trends – November 2016 14

adviser’s staff. The deadline for public comment passed in 2015 and, while unknown, these rules could theoretically be finalized at some point in the near future.

Advisor Top Trends for Alternatives Investments A recent study conducted by WealthManagement.com and FUSE Research Network surveyed how more than 700 advisors determine how they use, view and define alternative investments. Financial advisors see the use of alternative investments growing both in terms of the number of clients who invest in alternatives and the percentage of each client’s portfolio that alternatives represent. Advisors most often hold mutual funds. Mutual funds outpace the use of ETFs, SMAs, private funds and closed-end funds as the preferred product structure for alternatives. The average advisor using alternatives invests 41% of clients’ assets through mutual funds and nearly 1 in 10 advisors invests in alternatives only through mutual funds. However, most advisors who invest in alternatives use multiple types of products. RIAs tend to invest in alternatives more frequently than advisors in other channels. Insurance firms and bank brokers are least likely to use alternatives. The largest driver of alternatives use comes from the in-house advisor team followed by home-office model portfolios. The primary obstacles to alternatives use are fees/expenses, lack of liquidity, lack of information to help explain benefit/risks to clients, lack of fund or asset manager’s track record, and lack of education from the investment management firm. 71% of advisors surveyed said that lack of liquidity is an obstacle. Advisors’ concerns about the asset class’ lack of liquidity suggest that there may be room for growth in liquid alternatives. As advisors become more comfortable with these products, they may expand their allocations even further.

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FINES SEC Fines 13 Advisors for Repeating F-Squared’s False Claims At the end of August, the SEC imposed penalties on 13 investment advisory firms for repeating false claims made by F-Squared Investments. F-Squared, once a leading exchange traded fund strategist, was charged by the SEC in December 2014 with defrauding investors through false performance advertising and subsequently settled those charges by paying $35 million. An SEC enforcement sweep identified 13 firms that the SEC alleges accepted and negligently relied upon claims by F-Squared that its AlphaSector strategy outperformed the S & P Index for several years. The SEC claims that the firms furthered F-Squared’s misrepresentations by repeating its marketing claims without obtaining sufficient documentation to substantiate the return information. According to the release issued by the SEC, it continues to scrutinize distributors that promoted F-Squared strategies.

SEC Continues to Bring Enforcement Actions Regarding Private Equity Firm Practices In what appears to be a continuing theme, the SEC continues to bring enforcement actions against private equity managers related to disclosure practices and conflicts of interest. In that regard: 





In July the SEC imposed a $300,000 fine upon a sub-adviser whose ADV stated that the firm would generally trade through wrap programs’ broker-dealers when in fact most trades were completed through other brokers. Although such trading was done in order to obtain better execution, the trading away transaction fees resulted in higher costs to shareholders and were not in line with the disclosures in the ADV. Apollo Management agreed to $52.7 million in fines, disgorgement and interest in August. The fine was the result of the firm’s failure to properly disclose the acceleration of portfolio monitoring fees and certain affiliated loan interest accruals. The SEC also alleged that the firm’s weak compliance program allowed a senior partner to obtain reimbursement for unauthorized personal expenses. WL Ross & Co agreed to a $2.3 million settlement and payment of $11.8 million in restitution to investors in August. The settlement was over charges that the firm did not properly offset certain transaction fees against management fees earned by the firm over a 10-year period.

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In September the SEC settled an enforcement action brought against First Reserve Management related to allegations that the firm: (a) failed to disclose certain conflicts of interest; (b) allocated certain fees and expenses to funds without adequate disclosure or consent and (c) received discounts on services provided to the firm without passing on the discount to the funds.

The SEC has increasingly examined private equity advisers, and it appears will continue to do so, with a focus on disclosure practices and identification of conflict of interests.

SEC Enforcement for Auditor Independence Issues In a pair of administrative proceedings, the SEC found that personal actions by the auditors compromised their independence. In one of the proceedings the audit partner “maintained a close personal relationship” with the CFO of a client. The partner spent “extensive leisure time, including trips with the CFP and his family.” In the second proceeding the audit partner had a romantic relationship with the chief accounting officer. The SEC continues to investigate possible violations of the auditor independence rules.

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TAX UPDATE Regulatory

IRS Issues New No-Rule Position under IRC Section 851 and Proposed Regulations on Distributions from CFCs The IRS and U.S. Treasury Department (“Treasury”) issued Revenue Procedure 2016-50 which sets forth areas of the Internal Revenue Code (“Code”) on which the IRS will not issue letter rulings or determination letters (no-rule areas). The Revenue Procedure adds a new paragraph to read as follows: (63) Section 851. -- Definition of Regulated Investment Company.--Any issue relating to the treatment of a corporation as a regulated investment company under section 851 and related provisions that requires a determination whether a financial instrument or position is a security as defined in the Investment Company Act of 1940. Revenue Procedure 2016-50 applies to all request for letter rulings, including any requests pending in the national office and any requests submitted on or after September 27, 2016. The IRS and Treasury issued Proposed Regulation that provides guidance relating to the income test and the asset diversification requirements that are used to determine whether a corporation may qualify as a regulated investment company (“RIC”) for federal income tax purposes. Section A of the preamble concerns the meaning of security. Section B, of the preamble addresses inclusions of a controlled foreign corporation's pro rata share of subpart F income for the year under section 951(a)(1)(A)(i) and of a qualified electing fund's (“QEF”) pro rata share of ordinary earnings and net capital gain for the year under section 1293(a). The proposed regulations amend the current regulations by revising and adding to the regulations under 851 to indicate that amounts included in gross income for the taxable year for a controlled foreign corporation and qualified electing fund are treated as dividends only to the extent that there is a distribution out of the earnings and profits of the taxable year that are attributable to the amounts included in gross income for the taxable year. Amounts included in gross income for the taxable year for a controlled foreign corporation and qualified electing fund are not treated as other income derived with respect to a corporation's business of investing in stock, securities, or currencies. The rule of the proposed regulations applies to taxable years that begin on or after the date that is 90 days after the date of publication in the Federal Register of a Treasury decision adopting the proposed regulations as final regulations.

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IRS and Treasury Release 2016-2017 Priority Guidance Plan – Tax Items The IRS and U.S. Treasury Department (“Treasury”) have released their 2016-2017 Priority Guidance Plan (“Plan”). The Plan contains projects that are priorities for allocation of the resources of their offices during the twelve-month period from July 2016 through June 2017 (the “plan year”). The plan represents projects the IRS and Treasury intend to work on actively during the plan year and does not place any deadline on completion of projects. Projects on the Plan that may be of interest or relate to mutual funds and mutual fund shareholders are: 

Final regulations regarding the amount and timing of, and the withholding obligations on, deemed distributions from conversion ration adjustments on convertible debt and stock.

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Final regulations regarding certain transfers of C corporation property to regulated investment companies.

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Final regulations regarding treatment of certain interests in corporations as stock.

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Regulations relating to the applicable high yield discount obligation rules.

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Regulation relating to diminished risk of loss.

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Regulations relating to the timing and character of payments, including contingent payments, made pursuant to notional principal contracts and prepaid forward contracts.

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Guidance relating to accounting for hedging transactions.

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Guidance relating to investments in stock and securities.

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Regulations on the modification of non-debt financial instruments.

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Regulations on the modification of debt instruments, including issues relating to disregarded entities.

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Final regulation on the application of section 1256 to certain derivative contracts.

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Regulations relating to accruals of interest (including discount) on distressed debt.

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Regulations regarding basis rules for stock and debt.

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Final regulations regarding issues related to the net investment income tax.

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Final regulations regarding series LLCs and cell companies.

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Guidance on passive foreign investment companies.

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Final regulations on dividend equivalent payments.

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Guidance under treaties, including regarding the application of various treaty provisions to hybrid entities and instruments.

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Guidance on foreign currency transactions.

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Guidance including regulations on verification requirements for sponsoring entities; revenue procedures providing updated agreements for foreign financial institutions, qualified intermediaries (including qualified derivatives dealers), and withholding foreign partnerships and withholding foreign trusts and regulations on refunds and credits.

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Guidance regarding the effect of new financial accounting standards on tax accounting.

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Guidance on corrected information returns.

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Guidance regarding partnership audit and adjustment procedures.

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Guidance on safe harbors for de minimis errors on information returns and payee statements.

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Regulations coordinating the entity classification election with elections under subchapter M.

Pension / Retirement

IRS Announces New Procedure for Self-Certifying Waiver of 60-Day Requirement for Rollovers The IRS released Revenue Procedure 2016-47 which provides guidance concerning waivers of the 60-day rollover requirement. Specifically, it provides for a self-certification procedure that may be used by a taxpayer claiming eligibility for a waiver with respect to a rollover into a plan or individual retirement arrangement (“IRA”). It provides that a plan administrator, or an IRA trustee, custodian or issuer (“IRA trustee”) may rely on the certification in accepting and reporting receipt of a rollover contribution. Conditions for self-certification. The IRS must not have previously denied a waiver request with respect to a rollover of all or part of the distribution to which the contribution relates. Reason for missing the 60-day deadline. The taxpayer must have missed the 60-day deadline because of the taxpayer's inability to complete a rollover due to one or more of the following reasons: (a) an error was committed by the financial institution receiving the contribution or making the distribution to which the contribution relates;

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(b) the distribution, having been made in the form of a check, was misplaced and never cashed; (c) the distribution was deposited into and remained in an account that the taxpayer mistakenly thought was an eligible retirement plan; (d) the taxpayer's principal residence was severely damaged; (e) a member of the taxpayer's family died; (f) the taxpayer or a member of the taxpayer's family was seriously ill; (g) the taxpayer was incarcerated; (h) restrictions were imposed by a foreign country; (i) a postal error occurred; (j) the distribution was made on account of a levy and the proceeds of the levy have been returned to the taxpayer; or (k) the party making the distribution to which the rollover relates delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer's reasonable efforts to obtain the information. The contribution must be made to the plan or IRA as soon as practicable after the reason or reasons listed on the preceding paragraph no longer prevent the taxpayer from making the contribution. This requirement is deemed to be satisfied if the contribution is made within 30 days after the reason or reasons no longer prevent the taxpayer from making the contribution. The IRS intends to modify the instructions to Form 5498 to require that an IRA trustee that accepts a rollover contribution after the 60-day deadline report that the contribution was accepted after the 60-day deadline. An appendix contains a model letter that may be used for self-certification. Taxpayers may make the certification by using the model letter in the appendix on a word-for-word basis or by using a letter that is substantially similar in all material respects. A copy of the certification should be kept in the taxpayer's files and be available if requested on audit. The revenue procedure is effective on August 24, 2016.

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Other

2016 Year-End Reporting Layouts and Target Delivery Dates The Investment Company Institute (“ICI”) released their calendar 2016 year-end reporting layouts and target delivery dates. The Primary Layout has been designed to track the IRS Form 1099-DIV. The Secondary Layout provides a means for regulated investment companies (“RICs”) to use to report various additional tax related items. The NRA Layout provides a means for reporting information on IRS Form 1042-S. All calendar 2016 layouts are identical to their respective 2015 layout. Funds are encouraged to provide their year-end tax information to brokers and banks as soon as it is available. The target dates for delivering year-end tax information to brokers and banks will be as follows: Primary Layout - Tuesday, January 17, 2017; Secondary Layout – Monday, January 23, 2017; and NRA Layout – Tuesday, February 7, 2017.

Investment Company Institute's 2016 Tax & Accounting Conference – Tax-Related Panels and Topics The ICI 2016 Tax & Accounting Conference included several financial, regulatory and tax related panels discussing various issues and topics. The tax related panels included tax issues associated with current tax developments included money market fund tax guidance, EU reclaims and Notice 2016-10, section 305(c) proposed regulations, New York state tax update, FBAR, new partnership audit rules and tax reform. International tax issues panel included withholding tax issues in general, EU reclaims, financial transaction taxes, OECD issues: base erosion and profit shifting (“BEPS”) and common reporting standard (“CRS”) and Brexit. Securities lending panel included tax considerations and special tax issues for complex securities. Tax operation issues and practices panel included foreign account tax compliance act (“FATCA”) and common reporting standard (“CRS”), 1940 Act section 19 notices and limits on distributions and strategies for improving fund tax efficiency. Bonds and bond derivatives panel included asset types, risks and associated disclosures for deeply discounted and defaulted bonds and master limited partnership (“MLP”) bonds, and other tax and operational risks for multiple capital gain distributions and section 19(b) and foreign currency bond elections and tax straddles.

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