The U.S. Supreme Court has agreed to review a federal appeals court's decision that a payphone purchase-and-leaseback arrangement was not an "investment contract" security under Section 3 of the Securities Exchange Act of 1934. The U.S. Court of Appeals for the Eleventh Circuit had dismissed an enforcement action brought by the SEC against the operator of a payphone program for lack of subject matter jurisdiction.

In 1995, the CEO and majority owner of ETS Payphones Inc. (“ETS”) sought but did not receive no-action assurance from the SEC staff that a payphone sale-and-lease-back program did not involve a security and, therefore, that an offering of the program to the public would not need to be registered under the federal securities laws. Under the leasing program, an investor would buy a payphone from ETS's subsidiary and lease it to ETS at a fixed monthly rate. If at any time the buyer was not satisfied with the arrangement, it could require ETS to buy the phone at a prearranged price, or it could cancel the lease and repossess the phone. When ETS went into bankruptcy and stopped making the lease payments, the SEC sued ETS and the CEO for securities fraud, alleging that the leaseback program was actually a "massive Ponzi scheme" that raised more than $300 million from 10,000 investors.

The appeals court applied the test for an "investment contract" set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and concluded that the investors did not share in the "profits," but received only their fixed lease payments. The appeals court added that even if the lease payments could be called profits, "those returns were not derived from the efforts of [the CEO] or anyone else at ETS; rather, they were derived as the benefit of the investors' bargain under the contract." The appeals court had reversed the decision of the district court which had ruled that it had jurisdiction over the enforcement action because the lease program was an investment contract, and thus a security.

In its Feb. 13 certiorari petition to the Supreme Court, the SEC argued that this case involves a nationwide fraudulent scheme that promised investors a high rate of return on their money with no effort on their part. The SEC also argued that an investment is not precluded from being an “investment contract” simply because the promised return is fixed rather than variable or because the rate of return is contractually guaranteed. The SEC cautioned that the narrow interpretation of the term “investment contract” adopted by the court of appeals incorrectly excludes those investors from the protections of the federal securities laws and opens a significant gap in the protections that those laws provide against securities fraud.

In a March 13 opposition brief, ETS argued that there is no inter-circuit conflict warranting high court review of the controversy. ETS also argued that the court of appeal’s ruling does not conflict with any longstanding SEC interpretation of the securities laws to which deference should be paid, and that the decision has not impaired the SEC's ability to enforce the relevant securities laws. BNA Securities Law Reporter, Volume 35 Number 17 (Monday, April 28, 2003).

The SEC has announced that it will hold roundtable discussions on a wide range of issues relating to the investor protection implications of certain private, unregistered investment pools, commonly known as hedge funds. These discussions will take place on Wednesday, May 14, and Thursday, May 15, in the William O. Douglas Room at the SEC’s headquarters, 450 Fifth Street, N.W., Washington, D.C., beginning at 9 a.m. The roundtable will be open to the public on a first come, first served basis. The SEC noted that the public may submit written comments on the following topics to be discussed at the roundtable on or before April 30, 2003:

• The structure, operation and compliance activities of hedge funds, including the role of hedge fund service providers;
• The marketing of hedge funds;
• Investor protection concerns, including disclosure issues, valuation issues and potential conflicts of interest;
• Current regulation of hedge funds and their managers, and whether additional regulation is necessary; and
• If additional regulation is warranted, what form it might take.

The SEC noted that it has created a website to provide addition information on these issues at http://www.sec.gov/spotlight/hedgefunds.htm, and that it will post any public comments received by the SEC.

The SEC has directed its Division of Corporation Finance (the “Division”) to examine current proxy regulations and develop changes to those regulations to improve corporate democracy. Specifically, the SEC has directed the Division to formulate possible changes in the proxy rules and regulations and their interpretations regarding procedures for the election of corporate directors. This review is intended to address (i) shareholder proposals, (ii) the nomination process, (iii) elections of directors, (iv) the solicitation of proxies for director elections, (v) contests for corporate control, and (vi) the disclosure and other requirements imposed on large shareholders and groups of shareholders. As part of this process, the SEC has asked the Division to consult with all interested parties, including representatives of pension funds, shareholder advocacy groups, and representatives from the business and legal communities. The SEC has requested that the Division provide its recommendations to the SEC by July 15, 2003. SEC Press Release 2003-46 (April 14, 2003).

The SEC voted to require the electronic filing of beneficial ownership reports filed by officers, directors and principal security holders under Section 16(a) of the Securities Exchange Act of 1934. Issuers with corporate websites will also be required to post the actual reports on their websites. The SEC noted that electronic filing and website posting of these reports will result in earlier public notification of insiders' transactions and wider public availability of information about those transactions. The new rules and amendments implement the requirements of the Sarbanes-Oxley Act of 2002.

Under the new rules and amendments:

• Mandated electronic filing will apply to Forms 3, 4 and 5. To facilitate this, the SEC has created a new on-line filing system for these forms.
• Forms 3, 4 and 5 submitted by direct transmission on or before 10 p.m. Eastern time will be deemed filed on the same business day. Temporary hardship exemptions will no longer be available for these forms.
• An issuer that maintains a corporate website will be required to post on that website all Forms 3, 4 and 5 filed with respect to its equity securities by the end of the business day after filing. An issuer will be able to satisfy this requirement by providing direct access to the filing, or by hyperlinking to a third-party website (such as SEC’s EDGAR) if certain conditions are satisfied.
• The new rule amendments will eliminate magnetic cartridges as a means of filing any form electronically.

These new rules and amendments will become effective on June 30, 2003. SEC Press Release 2003-51 (April 24, 2003).

The ICI has submitted a comment letter to the SEC on proposed new Rule 38a-1 under the Investment Company Act of 1940 (the “1940 Act’). The proposed rule would require all registered investment companies to (1) adopt and implement policies and procedures reasonably designed to prevent violations of the federal securities laws, (2) review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and (3) appoint a chief compliance officer to be responsible for administering the policies and procedures. A similar rule was proposed for all registered investment advisers but was not the subject of the comment letter. The ICI also responded to the SEC’s request for comment on possible ways to involve the private sector in fostering compliance by investment companies and investment advisers with the federal securities laws.

In its letter to the SEC, the ICI made the following comments on the SEC’s proposal:

• To better accommodate existing fund compliance structures, Rule 38a-1 should be revised to make it clear that a fund may rely on the compliance policies and procedures of its service providers (i.e., its investment adviser, principal underwriter and administrator).
• Instead of requiring the board to approve all compliance policies and procedures, the rule should require the board to determine that the fund and its service providers have adequate compliance systems in place. To enable the board to make this determination, each fund and service provider should make a written report to the board at least quarterly that summarizes the entity’s relevant compliance policies and procedures and their implementation.
• Instead of requiring the designation of a single chief compliance officer who must be approved by the board, the rule should require each fund and service provider to identify in its annual report to the board the person(s) within the entity charged with the primary responsibility for implementing its compliance policies and procedures.
• The effectiveness of the compliance policies and procedures required by the rule should be measured from the perspective of promoting compliance with the securities laws rather from one of preventing violations of the securities laws.
• The proposed rule should include a safe harbor expressly providing that no person would be liable under the rule solely because of a violation of the securities laws if the person (1) had a reasonable basis to believe the compliance polices and procedures adopted pursuant to the rule were not deficient and (2) reasonably discharged his or her obligations under the rule.
• The ICI supports the SEC’s approach of not prescribing specific provisions which must be included in the fund’s compliance policies or procedures, noting that the rule should provide flexibility regarding what is appropriate for individual funds and their service providers.

The ICI also commented on the ways suggested by the SEC to involve the private sector in fostering compliance:

Letter from Craig S. Tyle of the ICI to Jonathan G. Katz of the SEC, April 17, 2003.

Nasdaq has established a Nasdaq Official Closing Price (“NOCP”) for all Nasdaq national markets and a trade report modifier to identify the official closing price to the public. Currently, Nasdaq does not have or release an official closing price. Instead, market participants generally use a consolidated last sale price disseminated by Nasdaq which is the price of the last trade reported to Nasdaq by any Nasdaq participant prior to 4:01:30 p.m. (the “Consolidated Close”). In the release adopting the NOCP, the SEC noted that Nasdaq believed that the Consolidated Close and individual market close are imperfect measures of the value of Nasdaq issues at the close of normal market hours. Due to disparities in the speed at which market participants report trades within Nasdaq’s 90-second trade reporting window, trades reported at 4:01:30 p.m. can be significantly away from the market when it closes at 4:00:00 p.m. The release noted that NASD members report over 90% of trades to Nasdaq within two seconds of execution. Nasdaq is concerned that the current proxies used for the closing price may no longer reliably and accurately reflect each security’s value at the close of the market.

Nasdaq’s proprietary systems will be programmed to append the new “.M” symbol, which is the modifier for market close, to one trade report message in each Nasdaq national market and small cap security to identify it as the NOCP for that security. The new Nasdaq closing price and modifier will take effect on April 25, 2003.

The NOCP will be based on the price of the last unmodified trade reported to Nasdaq’s proprietary trade reporting system at or before 4:00:02 p.m. (the “Predicate Trade”). Nasdaq systems will “normalize” the price of the Predicate Trade by comparing it to Nasdaq’s best bid and ask prices at the time the Predicate Trade was reported, or, for trades reported after 4:00:00 p.m., by comparing it to Nasdaq’s best bid and offer at 4:00:00 p.m. (“Predicate BBO”). If the price of the Predicate Trade falls within the Predicate BBO, that price becomes the NOCP. If the price of the Predicate Trade falls outside the Predicate BBO, Nasdaq would adjust the price up to the Predicate BBO bid if it is below the bid price or down to the Predicate BBO ask if it is above the ask price.

The Predicate Trade can be any trade that currently updates an individual market close for Nasdaq, subject to certain limitations. First, Nasdaq would only consider trades submitted with the Nasdaq market center identifier. Second, Nasdaq would only consider unmodified trades reported at or before 4:00:02 p.m. The current Consolidated Close disadvantages certain trade types that are reported too quickly to set the closing price, such as trades reported via Nasdaq execution systems or by market participants’ own automated systems. Third, Nasdaq will only adjust the NOCP if the Predicate Trade is cancelled or corrected until 5:15:00 p.m. and would recalculate the NOCP if a Predicate Trade is cancelled or corrected during that time. SEC Release No. 34-47517 (March 18, 2003).

The SEC has adopted new rule 10A-3 under the Securities Exchange Act of 1934 which directs the national securities exchanges and national securities associations (“SROs”) to prohibit the listing of any security of an issuer that is not in compliance with the audit committee requirements mandated by the Sarbanes-Oxley Act. In adopting the new rule, the SEC noted that recent events involving alleged misdeeds by corporate executives and independent auditors have damaged investor confidence in the financial markets and that these events have highlighted the need for strong, competent and vigilant audit committees with real authority. SROs will be required to issue or modify their rules, subject to SEC review, to conform their listing standards to the requirements of the new rule.

Under new Rule 10A-3, SROs will be prohibited from listing any security of an issuer that is not in compliance with the following standards:

• Each member of the audit committee of the issuer must be independent according to specified criteria;
• The audit committee of each issuer must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attestation services for the issuer, and each such registered public accounting firm must report directly to the audit committee;
• Each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters;
• Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties; and
• Each issuer must provide appropriate funding for the audit committee.

The new rule covers the listing of closed-end investment companies and actively managed exchange-traded funds (“ETFs”). ETFs structured as unit investment trusts are excluded from the rule because, like asset-backed issuers, they are not actively managed and do not typically have boards of directors from which audit committee members could be drawn.

Subject to certain limited exceptions, listed issuers must be in compliance with the new listing rules by the earlier of (1) their first annual shareholders meeting after January 15, 2004, or (2) October 31, 2004. Foreign private issuers and small business issuers that are listed must be in compliance with the new listing rules by July 31, 2005. SEC Release No. 34-47654 (April 9, 2003).

Paul Roye, Director of the SEC’s Division of Investment Management (the “Division”), speaking at the ICI Mutual Funds Conference on March 31, 2003 discussed recent developments in the investment management industry and reviewed the Division’s current and future initiatives.


Industry Accountability : Mr. Roye began by addressing the recent corporate scandals that have hindered the American economy and eroded investor confidence. He noted that investors, and thus Congress, are demanding accountability in corporate America and the securities markets. He reiterated the call by William Donaldson, the new SEC Chairman, for businesses to find a new respect for honesty, integrity, transparency and accountability in their operations. Mr. Roye stressed that the fund industry should look inward and demand accountability among its participants. He noted that the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) was one of the most significant pieces of securities legislation in decades, and that much of the Sarbanes-Oxley Act is premised on the need for a heightened level of accountability in the securities industry and corporate America in general.

SEC Rulemaking Initiatives : Mr. Roye then discussed current and future SEC rule-making initiatives. He addressed industry criticism of the new proxy voting disclosure rules by noting that the SEC made significant adjustments to the rules to accommodate industry concerns. He added that he believes the fund industry should focus not on whether funds are the only institutional investors who will be required to disclose their voting records, but on what role the industry can play in improving the governance of America’s corporations. He stated that the SEC determined that the transparency of the proxy voting process should foster investor confidence in the mutual fund industry by facilitating the accountability of fund managers in voting proxies in the best interests of fund shareholders.

Mr. Roye noted that the SEC is close to issuing two new rule proposals intended to improve the presentation in mutual fund shareholder reports and to modernize fund advertising rules. The shareholder report proposal would require funds to disclose their portfolio holdings on a quarterly basis, rather than semi-annually as currently required. Mr. Roye believes that quarterly reporting would allow shareholders to better monitor their investments and make better asset allocation decisions and also allow for greater scrutiny of the composition of fund portfolios and portfolio management techniques. The advertising rule proposal would increase funds’ flexibility in advertising by eliminating the requirement in Rule 482 under the Securities Act of 1933 that fund advertisements relying on that rule contain only information the substance of which is included in the fund’s prospectus. He noted that with increased flexibility, fund managers must employ an increased level of responsibility and accountability to ensure that the advertisements would not violate the antifraud provisions of the securities laws, which would continue to apply to advertisements notwithstanding the technical relaxation proposed.

Mr. Roye also commented on the SEC’s current rule proposal requiring funds to adopt compliance programs and designate compliance officers. He noted that the SEC has proposed this new rule because it wants to prevent the types of scandals that have plagued other segments of the securities industry from occurring in the fund industry. He added that SEC oversight is predicated on the assumption that fund companies and advisers have procedures to comply with the law. However, with the exception of a few discrete areas, there is no specific requirement to adopt a comprehensive set of compliance controls. If adopted, he commented that these rules should help protect investors by improving day-to-day compliance with the federal securities laws, while also increasing the efficiency and effectiveness of the SEC’s examination program. He added that these rule proposals do not require anything more than what well-managed fund companies and advisers should already be doing.

Concept Release Discussing Creation of Self-Regulatory Oversight Body : He also commented on the SEC’s concept release which discusses the creation of a self regulatory body like the NASD to oversee compliance with the federal securities laws in the fund industry. He clarified that issuing this concept release does not necessarily indicate that the SEC will seek to implement additional forms of oversight. Instead, he noted that the SEC’s goal is to have a public dialogue on these issues so that the SEC can consider whether and how the regulatory oversight scheme can be improved in the best interest of investors.

Other Initiatives to Promote Accountability : In addition to its rule-making activity, Mr. Roye noted that the SEC has undertaken two other initiatives that are focused in part on promoting accountability in the fund industry. The first involves the recent sweep of broker-dealers which uncovered significant failures to deliver breakpoint sale load discounts to eligible mutual fund investors. Stressing that this problem must be addressed quickly, he commented that while brokers have a significant role in ensuring that their customers receive appropriate breakpoint discounts, funds also have a role in ensuring that breakpoints are disclosed in a clear and understandable manner, and fund directors have a role in overseeing how their funds are sold. He commented that a working group representing various constituencies, including the ICI, NASD and Securities Industry Association has been formed to address deficiencies in the current structure under which breakpoints are calculated and applied.

The second initiative is the SEC’s fact-finding inquiry regarding hedge funds. He noted that for many hedge funds, the only level of accountability to which they are subject under the federal securities laws are the anti-fraud provisions enforced by the SEC and private litigants. He added that the inquiry was prompted by the perceived growth in these products and the increasing retailization of hedge funds. He noted that this growth has been accompanied by fraud on the part of some hedge fund sponsors.

Congressional Inquiry : Mr. Roye noted that the SEC has received a request from the House Financial Services Committee to provide the SEC’s views, including recommendations for legislative and/or regulatory actions, on a variety of accountability issues relating to fees, including fee transparency, transaction costs, soft dollars, Rule 12b-1 fees, fee levels, revenue sharing payments, fund performance disclosure and the role of independent directors overseeing fund fees.He noted that Congress has raised very fundamental questions, and that he believes Congress is essentially asking regulators and the industry alike whether they can do better for fund investors.

New Approach for Review of Exemptive Applications : Mr. Roye noted that while the SEC’s primary focus remains investor protection, the SEC understands that it must operate efficiently to carry out its mission. Accordingly, he noted that the Division plans to seek permission from the SEC to implement a new exemptive application “triage” system that would (i) eliminate full review for applications containing an attorney’s certification that the relief requested is materially the same as relief previously provided to a similar applicant, (ii) conduct full review on less routine or novel applications, and (iii) refuse to process applications that contain insufficient factual or legal analysis.