The Hon. Nathaniel M. Gordon of the United States District Court of Massachusetts dismissed with prejudice claims against two former executives of a fund distributor in connection with undisclosed market timing arrangements in an affiliated mutual fund complex. The SEC alleged that the defendants had entered into secret arrangements with certain preferred customers allowing those customers to engage in frequent short-term trading of the funds and accepting so-called “sticky assets” as long-term investments in the funds to obscure these arrangements. Previous claims against the two executives were dismissed by the court on findings that the defendants could not be primarily liable under Section 10(b), and Rule 10b-5, or Section 17(a) of the Securities Act of 1933, as amended, for misrepresentations and omissions because the statements in the prospectuses could not be attributed to them. The SEC refiled claims against the defendants alleging the same violations and also alleging that the defendants aided and abetted the securities law violations of the distributor and adviser. The court dismissed the refiled complaint on grounds that the SEC had not pled the securities fraud claims with sufficient particularity, that the executives were not personally liable for violations of federal securities laws, and that the SEC failed to establish aiding and abetting liability.


SEC v. James Tambone and Robert Hussey, (417 F. Supp. 2d 127 (Dec. 27, 2006)). See also, Litigation Release No. 19962 (Jan. 9, 2007), available at http://www.sec.gov/litigation/litreleases/2007/lr19962.htm.

The SEC’s interpretative release providing guidance on money managers’ use of client commissions to pay for brokerage and research services under the “soft dollars” safe harbor, set forth in Section 28(e) of the Securities Exchange Act of 1934, as amended, went into effect on January 24, 2007. Money managers now have to determine that a particular product or service falls within the 28(e) safe harbor by considering whether:

• the product or service complies with the specific statutory limits of Section 28(e)(3) (i.e., whether the product or service constitutes eligible “research” or eligible “brokerage”);
• the eligible product or service provides lawful and appropriate assistance in the investment decision-making process (for mixed-use products and services, the manager must reasonably allocate the costs according to the use of the product or service); and
• the client commissions are reasonable, as determined by the manager in good faith, in relation to the value of the products or services received from the broker-dealer.
  
  
  

The SEC, along with the Federal Reserve Bank of New York, has joined the FSA and other foreign regulators to examine the lending practices of banks and securities firms with respect to hedge funds. At the Reuters Regulation Summit held on January 9, 2007, SEC Commissioner Paul Atkins commented that the regulators are seeking “…comfort as to what their lending practices are, collateralization, that they have robust value-at-risk models, that they are gauging accurately what the risk is at the hedge funds, [and] that they understand what their counter-parties and creditors are doing.” Commissioner Atkins stated that the investigation would help regulators understand best practices with respect to prime brokerage and is not likely to result in new lending rules.

“SEC Looking at Hedge Fund Borrowing,” J. Giannone, Reuters, (January 9, 2007), available at http://today.reuters.com.

The SEC announced that it has signed a Memorandum of Understanding (“MOU”) with the College of Euronext Regulators, which includes the U.K. Financial Services Authority (the “FSA”), the Dutch Authority for the Financial Markets, the French Autorité des Marchés Financiers, the Belgian Banking Finance and Insurance Commission and the Portuguese Comissão do Mercado de Valores Mobiliários. The MOU aims to facilitate cooperation between the regulators in light of the pending merger of the NYSE Group, Inc and Euronext N.V into NYSE Euronext, Inc. The MOU sets forth the regulators’ intention to work together “…to promote investor protection, foster market integrity, and maintain investor confidence and systemic stability.” The MOU will go into effect when Euronext Paris S.A. declares that the NYSE Euronext, Inc. offer has reached the threshold for acceptance.

“SEC, Euronext Regulators Sign Regulatory Cooperation Arrangement” SEC Press Release No. 2007-8 (January 25, 2007), available at http://www.sec.gov/news/press/2007/2007-8.htm.

An investment adviser and its affiliated broker-dealer settled proceedings with the SEC for alleged improper market timing arrangements. Without admitting or denying the facts alleged, the respondents agreed to pay $30 million in disgorgement and $10 million in civil penalties. Under the settlement, respondents also agreed to: (a) form a Code of Ethics Oversight Committee to oversee all matters relating to issues arising under the advisers' Code of Ethics; (b) hire an Independent Compliance Consultant to conduct a comprehensive review of the respondents’ supervisory, compliance and other policies and procedures designed to prevent and detect breaches of fiduciary duty, breaches of the Code of Ethics and federal securities law violations by the adviser and its employees; and (c) have a compliance review by an independent third party in 2008.

In the Matter of Fred Alger Management, Inc. and Fred Alger & Co., Inc. Investment Advisers Act Release No. 2575 (Dec. 21, 2006), available at http://www.sec.gov/litigation/admin/2007/34-55118.pdf.

A hedge fund, its adviser and one of its former portfolio managers settled with the SEC in connection with investments in three PIPE transactions. The SEC alleged that the portfolio manager made material misrepresentations to the PIPE issuers and used wash sales and matched orders to conceal his use of PIPE shares to cover short positions entered into before the effective date of registration, in violation of the anti-fraud provisions of the Securities Act and that the former portfolio manager’s conduct violated, and caused the hedge fund and the adviser to violate, the registration provisions of the Securities Act. Without admitting or denying the facts alleged, the hedge fund agreed to pay $435,596 in disgorgement and prejudgment interest, the adviser agreed to pay $60,000 in civil penalties and its former portfolio manager agreed to pay $110,000 in civil penalties and to be banned from the investment advisory industry for 3 years.

In the Matter of Spinner Asset Management, LLC and Spinner Global Technology Fund, Ltd. Investment Advisers Act Release No. 2573 (Dec. 20, 2006), available at http://www.sec.gov/litigation/admin/2006/33-8763.pdf. See also “SEC Files Fraud Charges Against Former Hedge Fund Portfolio Manager Joseph J. Spiegel for Engaging in Illegal “PIPE” Trading Scheme” Litigation Release No. 19956 (Jan. 4, 2007), available at http://www.sec.gov/litigation/litreleases/2007/lr19956.htm.

The former CEO of a mutual fund investment adviser settled with the SEC for allegedly failing to ensure that the adviser fulfilled its fiduciary duties. The SEC alleged that the investment adviser entered into arrangements with more than 80 broker-dealers in which the adviser directed brokerage transactions to the broker-dealers in return for “shelf space” (i.e. heightened visibility at the brokerage firm to promote the sale of the adviser’s funds), and that the adviser did not adequately disclose these arrangements to the board, particularly with respect to the conflicts of interest they presented to traders in satisfying their best execution obligations. The SEC charged the former CEO of the adviser with knowing that these arrangements presented a significant conflict of interest and failing to alert the mutual fund board to the issue. The former CEO agreed to pay $75,000 in civil penalties. The adviser had previously settled fraud charges with the SEC in connection with these same facts, agreeing to pay $40 million dollars for allegedly providing inadequate disclosure of these shelf-space arrangements.

In the Matter of Lawrence J. Lasser. Investment Advisers Act Release No. 2578 (Jan. 9, 2007), available at http://www.sec.gov/litigation/admin/2007/ia-2578.pdf  See also In the Matter of Putnam Investment Management, LLC. Investment Advisers Act Release No. 2370 (Mar. 23, 2005), available at http://www.sec.gov/litigation/admin/ia-2370.pdf.

On December 13, 2006, the NASD announced a settlement with four NASD member organizations over charges that they had allegedly failed to implement adequate supervisory systems and procedures to identify opportunities for investors to purchase Class A shares of mutual funds without a front-end sales charge through available NAV transfer programs for which the clients had qualified. The NASD explained that during 2002-2004, certain mutual fund families offered NAV transfer programs eliminating front-end sales charges for certain customers. Under such programs, customers who redeemed fund shares for which they had paid a sales charge were permitted to use the proceeds, within a prescribed time period, to purchase Class A shares of another fund at NAV (i.e., without paying another sales charge). As a result of the member firms’ alleged failure to properly supervise the identification and implementation of these NAV transfer programs, the NASD fined the firms a total of $850,000 and ordered remediation of $43.8 million to thousands of eligible clients who paid front-end sales charges unnecessarily. The NASD said that it gave one of the firms credit for promptly and comprehensively assessing the extent of customer harm and beginning the process of identifying customers to make restitution, albeit after the commencement of the NASD’s investigation, in determining its sanction.

NASD News Release, NASD Fines Four Firms for Supervisory Failures Relating to Mutual Fund Sales Charge Waivers, December 13, 2006, available at: http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_018080.

On December 11, 2006, Lori J. Schock, Acting Director of the SEC’s Office of Investor Education and Assistance, provided the Public Fund Boards Forum with an update regarding some of the SEC’s major initiatives to protect large and small investors. Her speech highlighted three such initiatives that the SEC has recently undertaken namely, the protection of seniors, financial literacy, and interactive data.

The Protection of Seniors

According to Ms. Schock, “[p]rotecting seniors from investment scams may be one of the most important issues of our time” and has been a “key area of focus for the Commission in 2006.” She asserted that America’s aging population and growing life expectancy, combined with fewer guarantees of financial security, have the makings of a “perfect storm.” In response, Ms. Schock said that the SEC has implemented a “comprehensive national strategy” that includes three main components: (i) the enforcement of the federal securities laws, (ii) examinations to prevent fraud on seniors, and (iii) education of senior investors. Ms. Schock highlighted some recent SEC enforcement cases involving the offering of “unregistered promissory notes” and promising of unrealistically high rates of return to seniors. Ms. Schock also said that SEC examiners are focusing on the manner in which seniors may be exposed to “high-pressure tactics to sell unsuitable products.” She also discussed the SEC’s educational efforts aimed at seniors, such as the Seniors Summit that was recently held at SEC headquarters.

Financial Literacy

Ms. Schock stated that the SEC “routinely creates and disseminates neutral, unbiased information on saving and investing.” Ms. Schock expressed concern over the fact that only 52% of high school seniors passed a basic financial literacy test and that less than half of the students understood the impact inflation has on savings. She said that while the Commission cannot tell investors which products to purchase, it tries to provide them with the information they need to assess various products and investment strategies. She also highlighted the SEC’s use of its own fake investment scams on the internet as a means of reaching investors with a message about the necessity of researching before investing.

Interactive Data

Ms. Schock concluded with a discussion of the benefits of interactive data. She explained that interactive data means using technology to provide investors with quicker access to the information they want, in an easily usable format. She also stated that she believes that interactive data will be beneficial as it will feed into analytical tools created by securities analysts, private software developers, web publishers, and others.

“An Update From the SEC for Institutional Investors: Remarks Before the Public Fund Boards Forum,” by Lori J. Schock, San Francisco, CA, December 11, 2006, is available at: http://www.sec.gov/news/speech/2006/spch121106jdm.htm.

On December 11, 2006, Joseph D. McGrath, Professional Accounting Fellow in the SEC’s Office of the Chief Accountant, addressed the American Institute of Certified Public Accountants at their 2006 National Conference on Current SEC and PCAOB Developments. McGrath shared his views regarding, among other things, the application of fair value when accounting for certain items in the wake of FASB’s adoption of Statement No. 157 in September 2006. Statement No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosure regarding fair value measurements.

Mr. McGrath focused particularly on the recognition of inception gains (or “day one gains”) on certain derivative transactions. Prior to Statement No. 157, inception gains for derivative transactions were prohibited in the absence of: (i) quoted market prices in an active market; (ii) observable prices of other current transactions; or (iii) other observable data supporting the valuation technique. Mr. McGrath noted that under Statement No. 157, fair valuation is no longer limited to the transaction price. In fact, Statement No. 157 states that the entity “shall consider factors specific to the transaction and the asset or liability.” According to McGrath, “[o]ne such factor is whether the transaction occurs in a market other than the entity’s principal market.” For example, a dealer’s fair value is not necessarily the transaction price, since the principal market to exit the transaction may be different.

Mr. McGrath said that while this could increase the incidence of recognition of inception gains, he cautioned that there continue to be many instances in which inception gains are not appropriate. He said that Statement No. 157 does not allow the practice of “marking to model” when the transaction occurs in the entity’s principal market, rather transaction prices generally must be used and the model generally must be calibrated to match the transaction price. As an example, he said that, with certain exceptions, if a “securities dealer transacts with another in the dealer market . . . transaction price would likely be the best estimate of the fair value” and “there would not be any inception gain.”

Mr. McGrath also cautioned that the use of a pricing model would not always “automatically lead to day two gains even in situations where there was not an inception gain.” He said that “[a]ssuming an entity uses a pricing model to value its transaction in subsequent periods, . . . the pricing model should be calibrated, so that the model value at initial recognition equals the transaction price.” Therefore, he asserted, the use of a pricing model to determine fair value would not result in day two gains unless there were changes in the underlying market conditions.

Speech by SEC Staff: “Remarks Before the 2006 AICPA National Conference on Current SEC and PCAOB Developments,” by Joseph D. McGrath, Washington, DC, December 11, 2006, available at: http://www.sec.gov/news/speech/2006/spch121106ljs.htm.

The SEC staff has responded to an Investment Company Institute (“ICI”) request regarding the application of Fin 48, entitled “Accounting for Uncertainty in Income Taxes,” to the fund industry. Fin 48 uniquely affects investment companies because they are required to calculate their net asset value (“NAV”) in accordance with GAAP daily. Therefore, investment companies must apply FIN 48 on a daily basis, whereas other corporations only need to apply it to their periodic financial statements. The ICI explained that a fund’s net asset value would be inaccurate whenever FIN 48 requires it to recognize tax liabilities that the fund would not be required to pay.

Due to uncertainty in the application of existing tax rules to investment companies, funds often rely upon informal Internal Revenue Service guidance and practices in determining the technical merits of their tax positions. The ICI expressed concern that these types of informal guidance and practices cannot be considered in applying FIN 48. The SEC staff responded that they “do not believe Interpretation 48 places any limits on the type of evidence that an enterprise can look to in making its determination of the technical merits of a tax position.” The staff further stated “informal guidance of the taxing authority is often an important form of evidence that one looks to when assessing the technical merits of a tax position.” Finally, the SEC staff agreed to delay the required implementation date of FIN 48 for the fund industry, saying that they would not object “if a fund implements Interpretation 48 in its NAV calculation as late as its last NAV calculation in the first required financial statement reporting period for its fiscal year beginning after December 15, 2006.” Accordingly, funds with a December 31 fiscal year end must begin implementing FIN 48 by June 29, 2007.

Letter to ICI re: Implementation of FASB Interpretation No. 48, available at http://www.sec.gov/rules/proposed/2006/33-8766.pdf; FASB Summary of Interpretation No. 48, available at http://www.fasb.org/st/summary/finsum48.shtml.

The SEC announced that it is reopening the comment period on its June 2006 request for additional comment regarding amendments to investment company governance provisions. The amendments, which were first proposed on January 15, 2004, would require investment companies relying on certain exemptive rules to have: (i) a board comprised of at least 75 percent independent directors, and (ii) a board chaired by an independent director. A federal appeals court invalidated the amendments on April 7, 2006, because the court found that the SEC failed to seek comment on the data used to estimate the costs of the amendments. However, the court suspended issuing its mandate to allow the SEC to request further comment. The purpose of reopening the comment period is to permit public comment on two papers prepared by the Office of Economic Analysis (the “OEA”) in response to the court order and issued on December 29, 2006.

One paper, entitled “Power Study as Related to Independent Mutual Fund Chairs,” examined the question of whether existing empirical studies support the hypothesis that there is a significant relationship between fund governance and performance. The OEA concluded that the existing studies have not consistently documented such a relationship, and discussed factors that could cause this result.

The other paper, entitled “Literature Review on Independent Mutual Fund Chairs and Directors,” reviewed the financial economics literature relating to mutual fund governance. This report concluded that boards with greater independence are more likely to negotiate and approve lower fees, merge poorly performing funds more quickly and provide more protection of investors against late trading and market timing. However, the report also concluded that there is little consistent evidence that board composition is related to better fund performance.

Comments are due by February 27, 2007.

Investment Company Act Release No. 27600 (Dec. 15, 2006) is available at http://www.sec.gov/rules/proposed/2006/ic-27600.pdf; “Power Study as Related to Independent Mutual Fund Chairs” is available at http://www.sec.gov/rules/proposed/s70304/oeamemo122906-powerstudy.pdf; “Literature Review on Independent Mutual Fund Chairs and Directors” is available at http://www.sec.gov/rules/proposed/s70304/oeamemo122906-litreview.pdf 

 

As reported in the December 15, 2006, edition of the WilmerHale Investment Industry News Summary, the SEC voted unanimously on December 13, 2006, to propose a new antifraud rule under Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) for the benefit of investors in hedge funds and other private investment funds, and a new, narrower category of “accredited investor” under the Securities Act of 1933 rules for purposes of investment in funds that rely on Section 3(c)(1) of the Investment Company Act of 1940 (“Investment Company Act”). The SEC has since issued the proposing release.

Proposed Antifraud Rule

The SEC proposed a new antifraud rule under the Advisers Act in response to the federal court’s decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), overturning rules that would have required the registration of hedge fund managers under the Advisers Act. Proposed Rule 206(4)-8(a) under the Advisers Act provides that

It shall constitute a fraudulent, deceptive or manipulative act, practice or course of business . . . for any investment adviser to a pooled investment vehicle to:

(1) Make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle; or

(2) Otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.

Proposed Rule 206(4)-8(b) defines “pooled investment vehicle” as any investment company, any private investment fund that relies on either Section 3(c)(1) or 3(c)(7) of the Investment Company Act for exclusion from that Act’s definition of investment company. This proposal does not exclude private equity or venture capital funds, unlike the Securities Act rule proposal discussed below.

In the release, the SEC stated that the proposed rule would not be limited to fraud in connection with the purchase and sale of a security. Rather, the prohibition against investment advisers making false or misleading statements to investors in a pool would apply regardless of whether the pool is offering, selling or redeeming securities. Among other things, this means that the prohibition will not be limited to statements made in the fund’s offering documents, which already are subject to the antifraud provisions of Securities Exchange Act of 1934 Section 10(b) and Rule 10b-5, but rather will cover all forms of communication with investors and prospective investors, including periodic reports and investor letters. The SEC further asserted that the rule would not require the Commission to prove that the adviser acted with scienter, would not create a private right of action against an adviser, would not create a fiduciary duty to investors or prospective investors in a pool that is not otherwise imposed by law, and would not alter any duty or obligation an investment adviser has under the Advisers Act or other federal or state law or regulation to investors in a pool.

Proposed Securities Act Rules

The SEC also perceived a need to provide additional protections to individual investors who invest in private investment funds by raising the eligibility requirements associated with such investments. The SEC proposed new rules 216 and 509 under the Securities Act of 1933 (“Securities Act”) to create a new category of “accredited investor,” defined as an “accredited natural person” (i.e., accredited investors who are individuals) that would apply to the offer and sale of securities issued by “private investment vehicles” that rely on Section 3(c)(1) of the Investment Company Act for exclusion from the definition of investment company. The term “accredited natural person” generally would include any natural person who meets or, in the case of proposed 509(a) only, who the issuer reasonably believes meets (i) either the net worth or income test of Rule 215 or Rule 501(a), as applicable, and (ii) owns at least $2.5 million in “investments,” which is defined in the rule. The two tests must be met at the time of investment in a “private investment vehicle,” which is defined as any issuer that would be an investment company but for the Section 3(c)(1) exclusion. The $2.5 million in investments test would be subject to adjustment for inflation every five years, beginning in 2012.

The proposed rules would apply to private investment vehicles that offer and sell their securities in reliance upon Regulation D or Section 4(6) of the Securities Act. The proposed rules would not apply to the offer and sale of securities issued by “venture capital funds,” i.e., business development companies as defined in Section 202(a)(22) of the Advisers Act. The SEC explained that this exclusion reflects the SEC’s recognition that venture capital funds play an important role in providing capital to small businesses.

Comments on both the Investment Company Act and Securities Act proposed rules are due by March 9, 2007.

Securities Act Release No. 8766 (Dec. 27, 2006), available at http://www.sec.gov/rules/proposed/2006/33-8766.pdf 

WilmerHale Investment Management News Summary, December 13, 2006, available at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=3504.