NASD fined a brokerage firm more than $1.1 million for violating the NASD’s Anti-Reciprocal Rule by receiving directed brokerage in exchange for providing preferential treatment to twelve mutual fund complexes. The firm consented to the entry of NASD’s findings but did not admit or deny the allegations. Under the Anti-Reciprocal Rule, firms are prohibited from recommending funds or establishing preferred lists of funds in exchange for receiving brokerage commissions from those funds.

NASD found that mutual funds paid the firm an extra fee to receive enhanced access to the firm’s sales persons through participation in “top producer” and training meetings, identification on the firm’s intranet and identification in internal marketing publications. NASD also found that three of the fund complexes paid the extra fees with mutual fund assets instead of the complexes’ own funds by directing to the firm $2.7 million in portfolio brokerage commissions. The other nine fund complexes paid the extra fees in cash.

Additional alleged violations included failing to promptly forward customer checks that the firm received in connection with certain transactions, not maintaining electronic communications in violation of the books and records requirements, and not establishing and maintaining supervisory systems and procedures to detect and prevent these violations.

NASD New Release, NASD Fines AIG Affiliate American General Securities, Inc. Over $1.1 Million for Directed Brokerage Violations (Apr. 5, 2006).

A U.S. Court of Appeals held that provisions in a contract allowing a profit sharing plan to engage in market timing were enforceable against an insurance company. The Court reversed a District Court’s sua sponte grant of summary judgment in favor of the defendants and remanded the case. The trustees of the plan directed the allocation of assets of several variable life insurance policies among various insurance company sub-accounts that invested in mutual funds. The policies’ contracts permitted the plan to make daily transfers in unlimited amounts via phone, facsimile, or other electronic means without paying a transfer fee, which facilitated the trustees’ market timing strategy, and allowed the plan to receive that day’s NAV for trades executed up to one hour after the NYSE closed. Several years after the contracts were executed, the insurance company refused to honor these provisions, which eliminated the trustee’s late trading and market timing strategies. The trustees sued the insurance company, seeking damages for breach of contract and specific performance of the contracts’ market timing provisions.

Although the Court of Appeals agreed that the late trading provisions were illegal because they violated the forward pricing rule (Investment Company Act Rule 22c-1), the Court held that these provisions were not “an essential and non-severable part of the contracts.” The Court found that the primary purpose of the disputed contracts was to insure the lives of the contract holders while providing savings and investment opportunities for the insurance plan, and that this purpose was not “meaningfully impaired” by disregarding the late trading provisions. The Court noted that the value of the late trading provisions was small compared to the overall benefit of the policies, and that the trustees continued to place sub-account transfers for more than one year after the insurance company informed the plan that it would not permit late trading.

The Court also held that recent regulatory attention regarding market timing did not constitute “supervening impracticability” that would excuse the defendant’s performance under Pennsylvania law. The increased burden of the regulatory developments does not constitute impracticability, the Court found, and changed circumstances may not have occurred since market timing and funds’ dislike of the practice were well known when the contract provisions were drafted. Finally, the Court concluded that the provisions did not violate public policy because market timing, although disruptive and disfavored, is not illegal. The Court suggested that the District Court may consider on remand the impact on the rights of the parties of a recently promulgated rule, Rule 22c-2(a), which allows funds to require a redemption fee if fund shares are redeemed within seven days of their purchase.

Prusky v. Reliastar Life Ins. Co., 2006 U.S. App. LEXIS 6864 (3rd Cir. 2006).

The Staff of the Division of Investment Management granted no-action relief to an investment adviser that proposed to deliver its brochure to prospective investors at in-person meetings after initial solicitation materials are sent to customers of certain retailers pursuant to an agreement between the adviser and the retailers. Rule 206(4)-3 under the Investment Advisers Act of 1940 (“Advisers Act”) provides that if an investment adviser pays a cash fee to a solicitor, the solicitor must furnish the prospect at the time of the solicitation with the investment adviser’s brochure and a separate written document describing the compensation arrangement between the adviser and the solicitor.

The investment adviser proposed to contact, through a third party vendor, customers of certain retailers through a form of mass mailing referred to as co-branding letters. The investment adviser proposed to pay a fee to the retailers for each customer that responds to the adviser’s offer, meets with the adviser, or purchases a financial advisory service from the adviser. If a customer responds to the mailings by returning a reply card or calling a toll-free number, the vendor would send financial planning information and the retailer’s solicitor brochure to the customer. In some cases, the vendor also would include an invitation to attend a free in-person meeting with a representative of the investment adviser.

The Staff agreed that the investment adviser could provide its brochure to the customer at the initial in-person meeting with the customer, rather than mailing it with the mass mailing or in response to the receipt of a reply card. The Staff noted that the initial mailings will alert customers to a retailer’s bias at the time of the solicitation and before the customers decide to ask for additional information about the adviser, and will disclose that the adviser will provide additional materials about the adviser’s services and about the retailer’s compensation when the customer meets with the adviser’s representative. Additionally, the retailers’ involvement in the solicitation will be limited to providing customer information, honoring any incentives offered in the mailings and including their branding in the mailings. The Staff also noted that the mailings will be more similar to advertisements by the adviser than solicitations by the retailer, and that the expense of sending the adviser’s brochure with the mass mailings or after the receipt of a reply card was unduly burdensome given the nature of the mailings.

Ameriprise Financial Services Inc., SEC No-Action Letter (April 5, 2006).

NASD filed a complaint charging a brokerage firm, two of its former registered representatives, its president and its chief of compliance with violations related to the facilitation of late trading and improper market timing of mutual funds on behalf of hedge fund clients. NASD alleged that the brokers’ hedge fund customers sent send emails or faxes containing “indications of interest” in proposed mutual fund transactions that the hedge funds might or might not execute that day, but those indications of interest were not the customers’ actual orders. Subsequent to sending the indication of interest, the customers would telephone the representatives and verbally instruct them which of the indications of interest to enter as actual orders. NASD also alleged that the registered representatives effected transactions that the representatives knew or should have known violated restrictions and directives issued by mutual funds and clearing firms to restrict clients’ market timing trades. The complaint alleged that the registered representatives helped clients to open multiple accounts with different names and branch codes to hide the clients’ identities and their evasion of market timing restrictions, and failed to honor a directive from a clearing firm to stop trading in certain funds until the brokerage firm provided a written commitment to abide by funds’ trading limits.

The misconduct would not have occurred, NASD alleged, if the chief of compliance had not failed to perform supervisory duties that had been delegated to him which would have enabled him to discover the representatives’ activity. For example, the complaint alleges that he did not institute procedures to prevent late trading and prohibited market timing activities, and that because he did not review incoming and outgoing correspondence, he did not see communications from funds and a clearing firm complaining about the market timing activities. NASD also charged the president with failing to ensure that the chief of compliance was performing supervisory duties that had been assigned to him. Finally, NASD charged the firm for failing to maintain books and records by failing to record the time that client orders for mutual fund transactions were received.

NASD News Release, NASD Charges A.B. Watley and Former Brokers With Facilitating Mutual Fund Late Trading and Market Timing for Hedge Funds (Apr. 6, 2006).

On March 31, 2006, the MSRB filed interpretive guidance with the SEC relating to customer protection obligations of brokers, dealers, and municipal securities dealers (“dealers”) marketing 529 College Savings Plans. The proposed interpretation would strengthen existing disclosure obligations for dealers selling out-of-state 529 college savings plan interests by requiring such dealers to disclose that:

In a speech at the Securities Industry Association’s Anti-Money Laundering Conference on March 29, 2006, OCIE Director Lori A. Richards commented on anti-money laundering (“AML”) compliance efforts and discussed certain issues that OCIE has encountering during AML examinations. First, Richards noted the importance of firms looking at their business on an “enterprise-wide basis” when crafting and implementing AML programs. In particular, Richards stated that firms’ AML officers must seek to establish strong lines of communication with branch offices, which often have the closest relationships with customers and are therefore best positioned to detect red flags relating to AML compliance. Similarly, Richards stated that firms must be vigilant in examining any third-party service providers who perform AML functions, so as to ensure compliance, and stressed the importance of considering the impact on AML operations of any merger or acquisition, which may alter a firm’s risk profile, customer base or transaction mix, geographic presence, or need for enhanced training. Richards also stressed the need for firms to ensure that their automated systems are aggregating information in an effective manner, so that the firm receives a full picture of customers’ flow of funds, and the importance of maintaining acceptable documentation of firm AML compliance efforts. Additionally, Richards stressed the importance of introducing and clearing firms maintaining a close relationship as part of an effective compliance program and noted specifically that examiners will ask about firms’ receipt and use of exception reports provided by clearing brokers. Finally, Richards discussed the need for firms to demonstrate their effective identification and tracking of customers that fall within the definition of “foreign financial institutions” and stressed more generally the importance of ensuring that a firm’s AML training program is tailored to its business and risk profile.

Director Richard’s speech is available at: http://www.sec.gov/news/speech/spch032906lar.htm

In a speech before the National Association of Securities Professionals on March 29, 2006, SEC Commissioner Roel Campos commented on both the Commission’s proposal on point of sale disclosures and Rule 202(a)(11)-1. With respect to the point of sale proposal, Campos focused on what information should be included in point of sale disclosures and how that information should be disclosed. In addressing these two issues, Campos cited investor feedback to show that such point of sale disclosures should contain (1) information about both sales loads and ongoing fund expenses, as well as (2) information about key conflicts of interest, including whether a broker receives special compensation for selling a fund, whether the firm favors the sale of particular funds by paying differential compensation to sales personnel, and whether the firm is affiliated with the mutual fund complex. Campos then stated that the Commission is carefully evaluating how customers should receive this type of information and suggested that the use of a layered information delivery approach — under which all investors receive the requisite disclosures at the point of sale and are then given the opportunity to review quantitative information related to the disclosures through the use of the Internet — may provide a solution. With respect to the Commission’s adoption of rule 202(a)(11)-1 under the Advisers Act, Campos reiterated the Commission’s arguments in support of the rule, i.e., that the premises upon which the broker-dealer exception was based have broken down over time as the line between the functions performed by BD firms and investment advisers has blurred. Campos then expressed his support for quickly moving forward with a study to explore more broadly what protections should be afforded investors who deal with broker-dealers and investment advisers.

Commissioner Campos’ speech is available at: http://www.sec.gov/news/speech/spch032906rcc.htm

On March 23, 2006, the Financial Planning Association (“FPA”) filed its opening brief challenging the SEC’s adoption of rule 202(a)(11)-1 under the Investment Advisers Act of 1940 (“Advisers Act”). Rule 202(a)(11)-1 (the “Broker-Dealer Rule”) provides an exemption from the Advisers Act for broker-dealers who receive fee-based brokerage compensation, provided that certain conditions are met. It was adopted on January 14, 2005 after initially being proposed in November of 1999.

The FPA argues that the rule improperly rewrites the Advisers Act’s existing broker-dealer exception in Section 202(11)(C) by exempting broker-dealers who receive “special compensation” in the form of fee-based brokerage compensation. The FPA asserts in its brief that the SEC lacks the authority to make such a change through rulemaking. Moreover, the FPA argues that even if the Commission does possess the authority to make such a change, the current rule is nonetheless inconsistent with the intent of the Advisers Act. FPA also asserts that the SEC’s adoption of the Broker-Dealer rule violated the Administrative Procedures Act in that the SEC’s rationale for adopting the rule does not support the rule it actually adopted and criticizes the SEC’s cost-benefit analysis.

The FPA Briefs available at: http://www.fpanet.org/member/govt_relation/loader.cfm?url=/commonspot/security/getfile.cfm&PageID=45131

On April 7, 2006, the U.S. Court of Appeals for the D.C. Circuit held, in U.S. Chamber of Commerce v. SEC, that the SEC’s fund governance rulemaking violated the notice and comment provisions of section 553 of the Administrative Procedures Act (“APA”) and vacated both the independent chair and 75% independent director requirements of the fund governance rule. However, in recognition of the fact that an estimated 60% of the mutual fund industry is already in compliance with these requirements, the court postponed its order for ninety days in order to give the SEC the opportunity to conduct a notice and comment rulemaking. The court directed the SEC to file a status report with the court within ninety days.

In reaching its decision, the court focused on the SEC’s extensive reliance on materials that were not part of the rulemaking record in estimating the costs associated with the two requirements. The court said that the SEC’s use of such material was so extensive that it should have re-opened the comment period for the proposed rules under section 553(c).

The D.C. Circuit previously remanded the case to the Commission after finding that the SEC had violated the APA by failing to determine the cost of the independent chair and 75% independent director requirements and by failing to address a proposed alternative to the independent chair condition.

See Chamber of Commerce v. SEC, 2006 WL 890669, (D.C. Cir. Apr. 07, 2006) (No. 05-1240)

On April 10, 2006, SEC Chairman Christopher Cox announced that fund lawyer Andrew “Buddy” Donohue will join the Securities and Exchange Commission as its next Director of the Division of Investment Management. Mr. Donohue, 55, is Global General Counsel for Merrill Lynch Investment Managers and is also Chairman of the firm’s Global Risk Oversight Committee. Before Merrill, Mr. Donahue spent more than a decade as Executive Vice President, General Counsel, Director, and member of the Executive Committee for Oppenheimer Funds.