On November 9, 2006, the ICI released Electronic Recordkeeping & Communications Guidance for Investment Companies and Investment Advisers (2006) (the “Guidance”). According to the ICI, the Guidance “is designed to provide funds and their advisers with issues and factors to consider with regard to the creation and maintenance of electronic records – regardless of the electronic media used (e.g., email, instant messaging).” First, the Guidance details the record keeping requirements and rules associated with the 1940 Act and the Advisers Act. Second, the Guidance provides parameters for the production of electronic records in SEC examinations, SEC investigations, and in civil litigation. Third, the Guidance discusses the general principles that a fund or its adviser may want to consider in crafting and implementing an effective records management program. The Guidance emphasizes that there is “no one-size-fits-all records management program” and that “the records management approach for any fund or its adviser will depend significantly upon its mission, resources, needs, size and legal responsibilities at any given time.”

The Guidance discusses the ambiguity about the application of the recordkeeping rules to emails and other electronic communication, and notes that, although the SEC staff has acknowledged that advisers need not save email communications that do not contain information required to be maintained under the recordkeeping rules, the staff has indicated that advisers should have procedures reasonably designed to ensure that all required records are retained. The Guidance notes that there is no need to retain all electronic information ever generated or received, but as part of a records management program, funds and advisers may want to ensure that information and records are retained “only so long as they have value as defined by business or legal requirements.” The Guidance states that “electronic records and documents that no longer have continuing value to the organization may be destroyed or deleted, subject to the obligation to preserve data in anticipation of litigation. The retention of unnecessary information increases an organization’s costs, burdens, and ability to fashion and adequate and timely defense in litigation.” The Guidance also provides specific issues to consider in formulating a record management program, including (1) identifying records to preserve, (2) establishing a retention schedule, (3) ensuring that records are retrievable, (4) segregating required and non-required records, (5) using third party records storage facilities, and (6) properly disposing of records.

ICI Paper, “Electronic Recordkeeping & Communications Guidance for Investment Companies and Investment Adviser (2006)” available to ICI members at http://www.ici.org.

At the Securities Industry Association’s Compliance Seminar held on November 13, 2006, SEC Commissioner Annette Nazareth encouraged broker-dealer compliance and legal officers to carefully scrutinize any investment product or sales practice that might be used to defraud seniors. Commissioner Nazareth emphasized the SEC’s commitment to protect seniors against fraud and highlighted a number of measures implemented by the SEC to protect seniors. These measures include enforcement actions, examinations, and education. Commissioner Nazareth stated that the SEC has been examining firms that target seniors to determine whether they use “high-pressure tactics to sell unsuitable products.” Commissioner Nazareth emphasized that in-house compliance measures are the front-line defense against fraud. She also said that problems with fundamental issues, such as inadequate compliance policies and procedures or inadequate supervision, provide an environment in which unsuitable sales practices could be used to defraud seniors. Commissioner Nazareth finished her keynote address by asking the members of the audience to scrutinize their own firm’s policies, procedures, and practices to protect seniors.

Securities Industry Association – Compliance & Legal Division’s New York Fall Compliance Seminar, more information available at: http://www.siacl.com/.“Nazareth Urges Compliance Officers to Watch for Scams to Defraud Seniors,” BNA Securities Law Daily, November 14, 2006.

On November 8, 2006, the SEC accepted an offer of settlement with and issued an order (the “Order”) concerning a dually registered investment adviser/broker-dealer that served as the investment adviser, distributor and underwriter for a mutual fund complex, and its affiliates (the “Respondents”). In the Order, the SEC alleged that the Respondents made material misrepresentations and omitted to state material facts to the funds’ shareholders and the funds’ Boards of Directors about their use of fund assets to pay for the marketing and distribution of the funds and annuities.

The Order stated that the Respondents entered into revenue sharing agreements with various broker-dealers, whereby the Respondents agreed to pay these broker-dealers for sales of fund shares in exchange for special marketing and distribution benefits, referred to as “shelf space,” involved:

The Order stated that the purpose of these special marketing and distribution benefits was to incentivize broker-dealers to increase sales of the funds, which in turn, resulted in an increase in the investment management fees and sales charges received by the Respondents.

The Order stated that the funds’ prospectuses and statements of additional information misrepresented that the distributor used its own assets to pay for the additional compensation to broker-dealers for the shelf-space, and that these costs were not paid by the funds’ shareholders. The Order noted that the Respondents failed to disclose to the funds’ shareholders and the funds’ Board of Directors that, instead of only using its own assets through cash payments to the broker-dealers, it directed approximately $51 million of the funds’ assets, in the form of brokerage commissions, to certain broker-dealers to satisfy some of the funds’ shelf space obligations. The Order also noted that the Respondents violated their own guidelines, which prohibited directing brokerage commissions based on the broker-dealer’s future sale or promised future sale of shares of the funds, marketing or referral arrangements, or in exchange for placements of the funds on a preferred list.

Without admitting or denying any wrongdoing, the Respondents agreed to pay $55 million in disgorgements and penalties. In addition, the Respondents were censured and ordered to cease and desist from committing or causing violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Section 206(2) of the Advisers Act, and for two of the Respondents, Section 34(b) of the 1940 Act. The Respondents voluntarily agreed to certain undertakings, including:

At the SEC’s CCOutreach National Seminar held on November 14, 2006 for chief compliance officers of investment advisers and investment companies, Michael Garrity, Assistant Director of the SEC’s Boston District Office, among others, participated in a panel entitled “Lessons Learned from Sweep Exams.” The panel generally discussed (1) the sweep process, (2) common problems found in sweeps, (3) examples of effective compliance policies and procedures, and (4) the results of the sweeps. Mr. Garrity noted that a common problem found in sweeps related to a lack of internal controls.

According to Mr. Garrity, sweeps involving a lack of internal controls generally fall into two categories: (1) unidentified risks or (2) inadequate risk controls. Mr. Garrity explained that unidentified risks occur when fund groups offer new products, enter new business lines, or face a “new or arcane requirement.” Inadequate risk controls often result when “a business grows faster than the internal controls that have been placed on it” and “controls are not recalibrated or beefed up to meet the new risk or the new conflicts.” Mr. Garrity summarized internal controls sweeps including those involving the following areas

SEC’s CCOutreach National Seminar for Investment Adviser and Investment Company Chief Compliance Officers, Panel: “Lessons Learned from Sweep Exams,” by Mavis A. Kelly, Michael Garrity, Daryl Hagel, and Douglas Scheidt, November 14, 2006, webcast available at:

http://www.sec.gov/info/ccoutreach.htm.

The SEC’s Enforcement Division and Office of Compliance Inspections and Examinations (“OCIE”) will soon be evaluated by the General Accountability Office (“GAO”). Senator Charles Grassley (R-Iowa), Chairman of the Senate Finance Committee, requested the review, ostensibly to ensure effective management of the SEC’s increased funding following the Sarbanes-Oxley Act. However, press accounts have suggested that the review was triggered by recent allegations regarding the Enforcement Division’s role in the investigation of a hedge fund adviser. Senator Grassley has asked the GAO to focus its review on the SEC’s protocols for handling investigations and overseeing SROs.

GAO will Review SEC Enforcement, OCIE, Agency’s Oversight of SROs for Grassley: Securities Regulations & Law Report, Volume 38, Number 43/October 30, 2006, available at: http://ippubs.bna.com/ip/BNA/SRLR.NSF/85256269004a991e8525611300214487/8a00b2e5af3dcc808525721400720046?OpenDocument

A survey by the ICI indicates that nearly 55 million households, including 96 million individuals, in the U.S. own mutual funds. According to the survey, this is the highest level of ownership in the U.S. since 2001. Among other findings, the ICI survey noted:

ICI Report, “Ownership of Mutual Funds and Use of Internet, 2006,” available at: http://www.ici.org/pdf/fm-v15n6.pdf

The U.K.’s Financial Services Authority (“FSA”) has announced plans for increased surveillance of the private equity industry in response to the private equity sector’s growing role in the U.K. financial markets and in merger transactions. An FSA review earlier this year revealed increased lending to the private equity sector, which raised concerns about market abuse, conflicts of interest, excessive leverage and unclear ownership of economic risk. Proposals for enhancing supervision over the private equity industry have included facilitating the listing of private equity funds in the U.K. and further developing the FSA’s expertise in the area of alternative investments.

“UK’s FSA to Scrutinize Lending to Private Equity,” Reuters (November 6, 2006)

It has been reported that DOJ has commenced an informal probe into anti-competitive behavior in the private equity sector. According to press reports, the increase in multi-party deals in an industry characterized by close continuing relationships between buyout firms may be among the reasons for the DOJ’s concerns. It is expected that the DOJ will subject auctions between consortiums of buyout teams to special scrutiny given the greater potential for bid-rigging and information-sharing throughout the bidding process.

“Merrill Arm Draws U.S. Questions In Informal Probe of Private Equity,” The Wall Street Journal (November 6, 2006)

In an October 24, 2006 speech to the National Futures Association’s Workshop of Commodity Pool Operators and Commodity Trading Advisors, CFTC Commissioner Walter Lukken discussed a number of recent developments that suggest the hedge fund industry should consider adopting a system of formalized self-regulation. Among these developments, Mr. Lukken described:

On November 6, 2006, the NASD announced that it had fined two member firms $500,000 each for failing to establish systems and procedures to supervise personnel who made sales of Section 529 college savings plans and ordered both firms to compensate customers who were disadvantaged by the firms’ inaction. Without admitting or denying the findings, both entities consented to findings by the NASD that the firms lacked procedures for determining investor suitability for 529 plan purchases, training 529 plan sales representatives or reviewing recommended 529 plan purchases.

NASD News Release, NASD Fines Chase Investment Services, MetLife Securities $500,000 Each for Supervisory Violations in 529 College Savings Plan Sales, available at: http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017771

The NASD has fined a firm, along with its CEO, President, Head Trader, and Financial and Operations Principal, for selling short shares of companies from which they had agreed to purchase private investment in public equity (“PIPE”) securities. The firm’s failure to borrow unrestricted shares and intent to cover the short sales with the restricted shares to be purchased in the PIPE transactions constituted an unregistered securities distribution in violation of federal securities laws. The NASD also found that the firm failed to maintain adequate written supervisory procedures and records, failed to maintain sufficient net capital to operate a securities business and failed to ensure proper registration of its CEO and President. The NASD imposed a $200,000 fine among other sanctions.

NASD News Release, NASD Fines EKN Financial Services, Suspends Principals for Securities Registration Violations in PIPE Deals, available at: http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017730

At the Securities Industry Association’s Institutional Brokerage Conference on October 30, 2006, Andrew Donohue, Director of the SEC’s Division of Investment Management (“IM”), discussed IM staff concerns about efforts by investment advisers to meet their duty to seek best execution. Mr. Donohue also addressed the increasing prevalence of technology in the brokerage industry and certain issues relating to the use of soft dollar research.

Mr. Donohue reminded advisers that the SEC adopted Rule 12b-1(h) under the Investment Company Act of 1940 to prevent mutual funds from using directed brokerage in exchange for distribution-related services and that the SEC Rule is broader than Conduct Rule 2830(k) of the National Association of Securities Dealers (“NASD”) that prohibits similar conduct. He also reminded advisers that SEC Rule 12b-1(h) is applicable to all of a mutual fund’s portfolio trades, including principal trades, and that advisers should expand their trading desks’ internal controls to include principal trades. Mr. Donohue recommended that advisers take into consideration conflicts of interest when determining where to place a client’s trade, and he encouraged advisers to ask themselves whether they are using a particular broker-dealer because it is in a client’s best interests or because of other considerations.

Mr. Donohue also highlighted certain technologies that have increased the automation of brokerage, trade routing and trade allocation, and explained that such technologies are causing “best execution to be increasingly subject to objective measurement and third-party evaluation.” With respect to best execution for non-equity securities, especially fixed-income securities, Mr. Donohue acknowledged that it is often difficult to quantify overall trading costs or to determine execution quality; however he encouraged advisers to “develop meaningful, quantifiable fixed income execution measures and methods of evaluation” to assist them with meeting their best execution obligations.

Finally, Mr. Donohue addressed the issue of using research obtained with soft dollars generated by one client’s portfolio transactions for the benefit of another client. Although Mr. Donohue acknowledged that Section 28(e) of the Securities Exchange Act of 1934 does not oblige an adviser to use research obtained through soft dollars for the benefit of the client account that generated the soft dollars, he encouraged advisers to consider the conflicts of interest that these situations create and to evaluate whether their clients understand the conflicts or should be provided with additional disclosure.

Speech by SEC Staff: “Keynote Luncheon Address Before the SIA Institutional Brokerage Conference,” by Andrew J. Donohue, October 30, 2006, available at: http://sec.gov/news/speech/2006/spch103006ajd.htm

On October 24, 2006, the NYSE proposed an amendment to NYSE Rule 452, which would prohibit broker discretionary voting in elections of directors of NYSE listed companies. The amendment, which is subject to SEC approval, follows the recommendations of the Proxy Working Group formed in April of 2005 to examine the proxy voting process. NYSE President Catherine R. Kinney, stated that “The goal of the NYSE has been to not allow the broker to vote on any proposal that substantially affects the rights of shareholders.” This amendment would be effective for shareholder meetings held after January 1, 2008.

The Investment Company Institute (“ICI”), in its July 18, 2006 letter to Ms. Kinney regarding the Proxy Working Group’s report, argued that because shareholders typically neither understand the proxy voting process, nor vote their shares, a ban on broker voting would make achieving quorums more difficult and impose an additional hurdle in the already expensive and time-consuming director election process. The ICI letter had recommended that the NYSE continue to consider uncontested director elections “routine,” and thus allow brokers to continue to vote uninstructed shares.

In connection with its other recommendations aimed at improving communications, the Proxy Working Group has created subcommittees to examine the shareholder communication process and fees and costs in connection with proxy solicitation and to educate investors in an attempt to encourage shareholder participation in proxy voting.

Press Release, “NYSE Adopts Proxy Working Group Recommendation to Eliminate Broker Voting In 2008” (October 24, 2006), available at: http://www.nyse.com/press/1161166307645.html. ICI Comment Letter re: Report and Recommendation of the Proxy Working Group to the New York Stock Exchange (July 18, 2006), available at: http://www.ici.org/statements/cmltr/06_nyse_proxy_com.html.

On October 24, 2006, the NASD announced a $2.25 million fine and 60-day suspension imposed against a hedge fund manager and registered broker. The fine, which was imposed in connection with market timing of variable annuities, is the largest NASD fine ever against an individual for market timing.

The manager’s market timing hedge fund established 19 limited partnerships, which appeared to be separate entities. These limited partnerships, which were all under common ownership, each had separate names and tax identification numbers. The manager never disclosed the common ownership and used the limited partnerships to avoid variable annuity sub-account market timing restrictions. The manager executed approximately 1,000 trades and made approximately $750,000 through his deceptive practices. The manager consented to the entry of NASD’s findings, but neither admitted nor denied the allegations.

News Release, “NASD Fines Hedge Fund Manager $2.25 Million for Deceptive Market Timing in Variable Annuities” (October 24, 2006), available at: http://www.nasd.com/pressroom/newsreleases/2006newsreleases/NASDW_017689.

On October 26, 2006, the SEC announced that the former chairman of a large mutual fund complex had agreed to settle an SEC fraud action in connection with his approval of undisclosed market timing arrangements. The complaint alleged that, without disclosure to the board of trustees, the fund executive approved a market timing trading arrangement before the trading began despite prospectus representations that market timing was discouraged and restricted. Additionally, the complaint alleged that the fund executive’s approval resulted in over 100 round-trips and over $4 billion in aggregate trades.

Without admitting or denying any wrongdoing, the fund executive agreed to pay a $261,215 civil penalty and $49,304 in prejudgment interest, and to disgorge $261,215 for his violation of federal securities laws. Under the final judgment, the fund executive is also permanently enjoined from breaching his fiduciary duties under the 1940 Act, making false statements in mutual fund prospectuses, future violations of antifraud provisions of federal securities laws, serving as an officer or director of any registered investment company and associating with any investment adviser for a period of one year.

In June of 2006, a federal court jury had found the fund executive liable for violations (and/or aiding and abetting violations) of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, Sections 17(a)(2) and (3) of the Securities Act of 1933, Section 206(2) of the Investment Advisers Act of 1940, and Sections 34(b) and 36(a) of the 1940 Act. The consent to final judgment filed in the federal court for the Southern District of New York resolved all SEC charges against the fund executive.

SEC Litigation Release No. 19888/October 26, 2006, available at: http://www.sec.gov/litigation/litreleases/2006/lr19888.htm. SEC Press Release No. 2006-108 (June 30, 2006), available at: http://www.sec.gov/news/press/2006/2006-107.htm

Closed-end funds have historically been limited to just yearly distributions of realized net long-term capital gain under Section 19(b) of the 1940 Act, though more frequent distributions are permitted for short-term gains, net investment income and return of capital.

The SEC has recently indicated increased receptivity to granting exemptions to permit more frequent distributions of realized net long-term capital gains. On October 31, 2006, an SEC spokesman confirmed that nearly two dozen closed-end funds have been sent letters from the SEC proposing terms on which exemptive relief for more frequent distributions would likely be granted, pending the usual case-by-case SEC examination.

Press Release: Broker/Dealer Compliance, Volume 08, Number 44/November 1, 2006, available at: http://pubs.bna.com/ip/BNA/BDC.NSF/381e76eb405ee10d85256b57005a60be/04808d079acdcf7a8525721900016e5e?OpenDocument  

The SEC’s Enforcement Division and Office of Compliance Inspections and Examinations (“OCIE”) will soon be evaluated by the General Accountability Office (“GAO”). Senator Charles Grassley (R-Iowa), Chairman of the Senate Finance Committee, requested the review, ostensibly to ensure effective management of the SEC’s increased funding following the Sarbanes-Oxley Act. However, press accounts have suggested that the review was triggered by recent allegations regarding the Enforcement Division’s role in the investigation of a hedge fund adviser. Senator Grassley has asked the GAO to focus its review on the SEC’s protocols for handling investigations and overseeing SROs.

GAO will Review SEC Enforcement, OCIE, Agency’s Oversight of SROs for Grassley: Securities Regulations & Law Report, Volume 38, Number 43/October 30, 2006, available at: http://ippubs.bna.com/ip/BNA/SRLR.NSF/85256269004a991e8525611300214487/8a00b2e5af3dcc808525721400720046?OpenDocument

On October 25, 2006 the SEC adopted new rules under the Investment Company Act of 1940 (the “1940 Act”) that expand the definition of “eligible portfolio company” for BDCs under Rule 2a-46 of the 1940 Act and re-proposed for comment further expansion of the definition. The SEC also adopted new Rule 55a-1 under the 1940 Act, which expands the permissible follow-on investments that may be included in the 70% basket of a BDC’s assets that must always remain invested in eligible portfolio companies. The newly adopted rules take effect on November 30, 2006.

Under amended Rule 2a-46, the definition of an eligible portfolio company is expanded to include all private domestic operating companies, as well as those public domestic operating companies that do not have securities listed on a national exchange. The previous definition of eligible portfolio companies included only those issuers that did not have securities for which margin credit could be extended pursuant to Federal Reserve Board rules.

Under amended Rule 55a-1, follow-on investments in entities that were eligible portfolio companies at the time of the BDC’s initial investment, but are no longer, will nonetheless be counted as investments in eligible portfolio companies for purposes of satisfying the requirement that BDCs must have 70% of their assets invested in eligible portfolio companies, provided the following two conditions are met. At the time of the follow-on investment, the BDC (1) must own at least 50% of (a) the portfolio company’s equity securities, including securities convertible or exchangeable into equity, and (b) the greatest amount of the portfolio company’s debt securities previously held by the BDC at any time during the period when the company was an eligible portfolio company, and (2) must be one of the 20 largest holders of record of the company’s outstanding voting securities.

Under re-proposed Rule 2a-46(b), the definition of eligible portfolio companies would be further expanded to encompass those companies that are listed on an exchange yet have relatively small market capitalization or public float. The SEC has proposed a benchmark of less than $150 or $250 million in market capitalization or less than $75 million in public float, but is seeking comment as to a better benchmark. Comments are due by December 30, 2006.

SEC Final Rule Release No. IC-27538; Proposed Rule Release No. IC-27539/October 26, 2006, 

available at:http://sec.gov/rules/final/2006/ic-27538.pdf.