Investment Management Industry News Summary-August 2004

Investment Management Industry News Summary-August 2004

Publications

This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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GAO issues report on effect of SEC’s “Hard 4 p.m.” and mandatory redemption fee proposals on pension plan participants

August 27, 2004 10:21 AM

In July 2004, the GAO issued a report entitled “Mutual Funds SEC Should Modify Proposed Regulations to Address Some Pension Plan Concerns.” The report finds that the SEC’s “Hard 4 p.m.” and mandatory redemption fee proposals could have a distinct, adverse effect on pension plan participants and recommends that the SEC adopt modifications or alternatives to the proposed regulations that would prevent plan participants from being more adversely affected than other investors.

Effect of Fund Trading Abuses on Plan Participants

The report finds that the extent and cost to long-term mutual fund investors of late trading and market timing is unclear although the cumulative effect may have been significant. It does not appear that such trading abuses affected pension plan participants differently from other long-term investors.

GAO identifies three negative effects of abusive short-term trading on long-term shareholders: (1) greater transaction costs because fund managers have to more frequently buy or sell shares of the underlying securities in the fund’s portfolio to match demand for fund shares; (2) lower investment returns over the long term when fund managers hold a greater percentage of the fund’s assets in cash in order to accommodate short-term traders’ redemptions; and (3) long-term shareholders’ gains are diluted if short-term traders buy fund shares and redeem them before their money can be invested in the fund’s portfolio and, conversely, long-term investors share a higher proportion of the fund’s decrease in value if short-term traders redeem fund shares before their value decreases.

The report notes that market timing can harm plan participants if a plan sponsor fails or refuses to limit a participant’s market timing. In the case of pension plans, a fund company’s ability to restrict only the participant, and not the entire plan, may be limited because the shares of all participants are held in the record keeper’s omnibus account. If a plan does not stop a participant engaged in market timing, a fund has few means of stopping the market timer aside from restricting access to the fund for all the plan’s participants. Plan sponsors sometimes have been reluctant to impose redemption fees or trading restrictions on plan participants for fear of suits for fiduciary violations.

Regulatory Actions to Address Abusive Trading

The report outlines steps that the SEC and Department of Labor (“DOL”) have taken to address abusive mutual fund trading. Such steps include the agencies’ investigations and enforcement actions, the SEC’s proposed regulations targeting late trading and market timing, such as the “Hard 4 p.m.” and mandatory redemption fee proposals and the DOL’s February 2004 guidance to plan fiduciaries. The report notes that, while DOL is not involved in the process of drafting the SEC’s proposed regulations, it is considering how the regulations would affect pension plans and anticipates providing interpretive assistance to plan sponsors and record keepers regarding any ERISA issues in implementing the SEC’s final rules.

Benefits and Costs to Plan Participants of SEC’s Proposed Regulations

The report finds that, while the SEC’s proposed Hard 4 p.m. and mandatory redemption fee rules would benefit all mutual fund investors by stopping late trading and reducing market timing, they would also impose certain costs on plan participants. In addition to the costs to all mutual fund companies and intermediaries for systems upgrades and other changes, the Hard 4 p.m. proposal could distinctly affect plan participants because it creates potential complications for the processing of certain transactions unique to defined contribution plans, such as loans.

Furthermore, the report finds that the mandatory redemption fee proposal could result in plan participants paying fees intended to deter short-term trading, including market timing, even on certain transactions where there is clearly no intent to engage in abusive trading. These include rebalancing the allocation of plan assets among funds, transferring retirement savings from one fund to another, and taking plan loans. The SEC’s proposal limits the application of the redemption fee by (1) mandating a “first-in, first-out” method for calculating redemption fees, (2) allowing a de minimis exception, and (3) limiting the rule’s holding period to five days. However, the report states that some funds may choose not to apply the de minimis exception, resulting in some participants paying redemption fees. It points out that plan sponsors and administrators have argued that it would be unfair to penalize plan participants when there is clearly no intent to engage in abusive trading.

SEC Comments

Appendix III to the GAO’s report reproduces a letter from Paul Roye, Director of the SEC’s Division of Investment Management, commenting on a draft of the report. The letter states that the SEC agrees with the GAO’s analysis and is considering modifications to the proposals.

GAO Report, GAO-04-799 (July 2004), available at http://www.gao.gov/new.items/d04799.pdf.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC adopts form amendments requiring enhanced disclosure regarding portfolio managers

August 27, 2004 9:42 AM

On August 23, 2004, the SEC released amendments to Forms N-1A, N-2 and N-3 that are intended to improve the disclosure provided by funds regarding their portfolio managers. The amendments extend the existing requirement that a fund provide basic information in its prospectus regarding its portfolio managers to include the members of management teams, and require a fund to disclose additional information about its portfolio managers, including other accounts that they manage, compensation structure, and ownership of fund securities.

Identification of Portfolio Management Team Members

The amendments to Forms N-1A and N-2 will require funds to identify in their prospectuses each member of a committee, team, or other group of persons associated with the fund or its investment adviser that is jointly and primarily responsible for the day-to-day management of the fund’s portfolio. The amendments will require funds to state the name, title, length of service, and business experience of each member of a portfolio management team. The amendments to Form N-3 will require disclosure regarding portfolio managers, including members of portfolio management teams, similar to the disclosure that will be required by Forms N-1A and N-2. Currently, Form N-3 does not require disclosure about portfolio managers. Closed-end funds will be required to provide on-going disclosure regarding their portfolio managers in their annual and semi-annual Form N-CSR filings.

The release notes that, under the amendments, disclosure is only required with respect to members of a management team who are jointly and primarily responsible for the day-to-day management of the fund’s portfolio. To the extent that a fund is managed by a committee, team, or other group that includes additional members who are not jointly and primarily responsible for day-to-day management, identification of these individuals is not required. Unlike the proposed version of the amendments, the final amendments provide that if more than five persons are jointly and primarily responsible for the day-to-day management of a fund’s portfolio, the fund need only provide the required information for the five persons with the most significant responsibility. The determination of the members of a portfolio management team who are jointly and primarily responsible for the day-to-day management of a fund’s portfolio will depend on the facts and circumstances of the particular fund.

The amendments also require a fund to provide a brief description of each member’s role on the management team (e.g., lead member). The SEC modified the proposal to clarify that a fund’s description of a member’s role on a committee, team, or group must include a description of any limitations on the person’s role and the relationship between the person’s role and the roles of other persons who have responsibility for the day-to-day management of the fund’s portfolio. The amended requirement is intended to provide investors with a clearer understanding of what an identified portfolio manager does and does not do in the course of day-to-day management of the fund, and the ways in which the responsibilities of any identified portfolio manager relate to those of other members of a portfolio management team, including members who may not be identified in the prospectus as portfolio managers. It will also assist investors in funds with large management teams, such as research-driven funds, in understanding how the responsibilities of an identified portfolio manager may differ from those of a manager who manages a fund on his or her own or with a small team of other managers.

Disclosure Regarding Other Accounts Managed and Potential Conflicts of Interest

The amendments require a fund to provide disclosure in its Statement of Additional Information (“SAI”) regarding other accounts for which the fund’s portfolio manager is primarily responsible for the day-to-day portfolio management. If a committee, team, or other group that includes the portfolio manager is jointly and primarily responsible for the day-to-day management of an account, the fund is required to include that account in responding to the disclosure requirement. This disclosure requirement, as well as the disclosure requirements discussed below regarding compensation structure and ownership of fund securities, apply to any portfolio manager who is required to be identified in the prospectus. If a fund identifies more than five persons as portfolio managers in its prospectus, it need only provide the required disclosure regarding other accounts managed, compensation, and securities ownership for the five persons with the most significant responsibility for the day-to-day management of the fund’s portfolio.

The amendments require a fund to disclose the number of other accounts managed by a portfolio manager, and the total assets in the accounts, within each of the following categories: registered investment companies; other pooled investment vehicles; and other accounts. For each such category, a fund is also required to disclose the number of accounts and the total assets in the accounts where the advisory fee is based on account performance.

The amendments, as adopted, also require a fund to describe any material conflicts of interest that may arise in connection with the portfolio manager’s management of the fund’s investments, on the one hand, and the investments of the other accounts, on the other. This description would include, for example, material conflicts between the investment strategy of the fund and the investment strategy of the other accounts managed by the portfolio manager and material conflicts in allocation of investment opportunities between the fund and such other accounts. A conflict would be material if there is a substantial likelihood that disclosure of the conflict would be viewed by a reasonable investor as significantly altering the “total mix” of information available about the fund.

The SEC is not adopting its proposal to require a fund to include a description of the policies and procedures used by the fund or its investment adviser to address conflicts of interest. The SEC’s recently adopted compliance rules require investment advisers to implement policies and procedures that address conflicts arising from management of multiple funds and accounts, such as the allocation of investment opportunities and the allocation of aggregated trades. The SEC believes that the requirement to adopt policies and procedures to address conflicts, coupled with the disclosure of other accounts managed and the material conflicts of interest that may arise, should sufficiently address potential conflicts of interest without burdening investors with extensive, technical disclosure. It emphasizes that fund boards of directors and investment advisers are responsible for addressing conflicts of interest that may arise from a portfolio manager’s management of multiple accounts, and the disclosure we are requiring does not diminish this responsibility.

No Prohibition on Portfolio Manager also Managing Hedge Fund

Based on comments submitted in response to the Proposing Release, the SEC determined not to prohibit portfolio managers of funds from managing certain types of accounts, such as hedge funds. The SEC agreed with several commenters that a prohibition could reduce investors’ access to talented portfolio managers and could have a particularly disruptive effect on smaller investment management firms that may not have the resources to maintain separate staffs for different types of accounts.

Disclosure of Portfolio Manager Compensation Structure

The amendments require that a fund provide in its SAI portfolio manager compensation disclosure, including a description of the structure of, and the method used to determine, the compensation received by a fund’s portfolio manager from the fund, its investment adviser, or any other source with respect to management of the fund and any other account included by the fund in response to the disclosure requirement described above regarding other accounts managed by the portfolio manager. This disclosure requirement applies to any portfolio manager who is required to be identified in the prospectus. The amendments do not require disclosure of the value of compensation received by a portfolio manager.

For purposes of the disclosure requirement, compensation includes, without limitation, salary, bonus, deferred compensation, and pension and retirement plans and arrangements, whether the compensation is cash or non-cash. For each type of compensation, a fund is required to describe with specificity the criteria on which that type of compensation is based, for example, whether compensation is fixed, whether (and, if so, how) compensation is based on the fund’s pre- or after-tax performance over a certain period, and whether (and, if so, how) compensation is based on the value of assets held in the fund’s portfolio.

Disclosure of Securities Ownership of Portfolio Managers

The amendments require that a fund disclose in its SAI the securities ownership in the fund of each portfolio manager who is required to be identified in the fund’s prospectus. This disclosure is intended to help investors assess the extent to which the portfolio manager’s interests are aligned with theirs. The SEC modified its proposed disclosure requirement with respect to securities ownership in order to address concerns raised by commenters. In particular, it limited the requirement to a portfolio manager’s ownership of equity securities in the fund itself. The disclosure requirement adopted applies to fund securities beneficially owned by a portfolio manager. For purposes of the requirement to disclose a portfolio manager’s beneficial ownership of fund securities, “beneficial ownership” will be determined in accordance with rule 16a-1(a)(2) under the Securities and Exchange Act of 1934. The amendments also include a requirement that funds disclose portfolio managers’ ownership of securities in the fund using the following dollar ranges: none, $1-$10,000, $10,001-$50,000, $50,001-$100,000, $100,001-$500,000, $500,001-$1,000,000, or over $1,000,000.

Date of Disclosure

The required information regarding other accounts managed by a portfolio manager, compensation structure, and ownership of fund securities must be provided as of the end of the fund’s most recently completed fiscal year. However, in the case of an initial registration statement or an update to a fund’s registration statement that discloses a new portfolio manager, information with respect to any newly identified portfolio manager is required to be provided as of the most recent practicable date. The date as of which the information is provided must be disclosed. In effect, a fund is required to disclose changes to this information with respect to a previously identified portfolio manager once a year, as part of its post-effective amendment that is an annual update to its registration statement.

Compliance Date

The form amendments will become effective October 1, 2004. All initial registration statements on Forms N-1A, N-2, and N-3, and all post-effective amendments that are annual updates to effective registration statements on these forms, filed on or after February 28, 2005, must include the disclosure required by the amendments. All post-effective amendments that add a new series, filed on or after February 28, 2005, must comply with the amendments with respect to the new series. Every annual report by a closed-end fund on Form N-CSR filed for a fiscal year ending on or after December 31, 2005, and every semi-annual report by a closed-end fund on Form N-CSR filed after the first such annual report, must include the disclosure required by the amendments.

SEC Release Nos. 33-8458, 34-50227, IC-26533; File No. S7-12-04.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

CFTC issues Enforcement Advisory identifying cooperation factors that may reduce sanctions in enforcement actions

August 20, 2004 10:44 AM
On August 11, 2004, the CFTC issued an Enforcement Advisory identifying cooperation factors that the Division of Enforcement may take into account when recommending enforcement sanctions for violations of the Commodity Exchange Act. The Advisory outlines three broad categories of cooperation and identifies several factors within each category by which cooperation may be measured. The categories of cooperation are (1) good faith in uncovering and investigating misconduct, (2) cooperation with the Division of Enforcement’s staff in reporting the misconduct and the company’s actions with respect to it, and (3) efforts to prevent future violations. It also notes additional factors that lend weight or perspective to the cooperation factors, including details about the corporate structure, nature of the misconduct, harm caused and other factors. In addition, the Advisory states that the Division of Enforcement is least likely to recommend reduced sanctions when a company hides or misrepresents information about the misconduct, impedes Division efforts to obtain information, and creates a drain on government resources by prolonging the Division’s investigation unnecessarily. CFTC Enforcement Advisory (August 11, 2004).
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC reopens comment period on rule proposal regarding full service brokers that charge asset-based fees

August 20, 2004 10:39 AM

On August 19, 2004, the SEC reopened the public comment period on proposed rule 202(a)(11)-1 under the Advisers Act to address the application of the Advisers Act to brokers offering full service brokerage service, including advice, for a fee based on the amount of assets in customers' accounts, instead of traditional commissions, mark-ups and mark-downs. The rule was originally proposed on November 4, 1999. Comments should be received by the SEC on or before September 22, 2004.

As reported in the July 2, 2004 Industry News Summary, the Financial Planning Association (the “FPA”), an industry trade group representing financial planners, asked the SEC on June 21, 2004 to withdraw or substantially alter the rule proposal. On July 20, the FPA filed suit against the SEC in the U.S. Court of Appeals for the District of Columbia Circuit, challenging the proposed rule. According to the FPA, the proposal allows brokers to present themselves as fiduciary advisers receiving a fee for advice even though they may be motivated more by sales considerations. SEC Release Nos. 34-50213, IA-2278; File No. S7-25-99; Financial Planning Association v. SEC, No. 04-1242 (D.C. Cir.) (case docketed on July 20, 2004).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC releases rule proposal requiring registration of hedge fund advisers

August 20, 2004 10:28 AM
As reported in the July 16, 2004 Industry News Summary, the SEC voted on July 14, 2004 to propose new Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”) to require certain hedge fund advisers to register with the SEC, and related rule amendments. The SEC published the proposing release on July 20, 2004. Please see the attached special report for more information.
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Securities and Exchange Commission (“SEC”) votes to prohibit directed brokerage arrangements and require manager compensation disclosure

August 20, 2004 10:26 AM
At an open meeting held on August 18, 2004, the SEC voted to adopt amendments to Rule 12b-1 under the Investment Company Act of 1940 (the “Investment Company Act”) that would bar funds from rewarding broker-dealers who sell fund shares by directing brokerage transactions to those broker-dealers. The SEC also voted to adopt form amendments that would require a fund (1) to provide prospectus disclosure regarding how a portfolio manager’s compensation is determined and (2) to disclose additional information about its portfolio managers such as interests in the funds they manage and other similar accounts in its Statement of Additional Information (and, for closed-end funds, in reports on Form N-CSR). Detailed summaries of the rule amendments will be provided in the Industry News Summary following publication of the adopting releases. Dow Jones News Service (August 18, 2004).
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

NASD, NYSE and NASAA seek comment on new branch office registration form; NASAA releases model branch office definition rule

August 13, 2004 10:54 AM

On August 4, 2004, NASD, the NYSE and NASAA released for comment a proposed uniform branch office registration form (Form BR). The form will enable broker-dealer and investment adviser firms to register branch offices electronically with NASD, the NYSE, and states through the Central Registration Depository (CRD®) and the Investment Adviser Registration Depository (IARD). In addition, NASAA released for comment a proposed Model Rule defining “branch office” that can be adopted by states. The Model Rule tracks the language in the definition agreed upon by NASD and the NYSE. Comments to NASD and NASAA are due by September 3, 2004; comments to the NYSE should be received by September 10, 2004.


Memo 04-43 (August 9, 2004), available at:
http://apps.nyse.com/commdata/PubInfoMemos.nsf/AllPublishedInfoMemosNyseCom/85256A71006FB86385256EE4005597B9/$FILE/Microsoft%20Word%20-%20Document%20in%2004-43.pdf 

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC releases 2004-2009 Strategic Plan

August 13, 2004 10:50 AM

On August 5, 2004, the SEC posted its Strategic Plan for 2004-2009 on its web site. The Strategic Plan identifies the vision, mission, values, and goals shaping the SEC’s activities during the next five years and details the initiatives being undertaken to achieve its goals. The SEC approved the plan on July 9, 2004. The 2004-2009 Strategic Plan is available on the SEC’s web site at: www.sec.gov/about/secstratplan0409.pdf.


SEC Press Release (August 5, 2004), available at http://www.sec.gov/news/press/2004-107.htm.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC brings first enforcement action against insurance companies for alleged market timing violations

August 13, 2004 10:48 AM

On August 9, 2004, the SEC brought the first enforcement action charging insurance companies with securities fraud for facilitating market timing of mutual funds through the sale of variable annuities. The insurance companies identified by the SEC include subsidiaries of a major insurer which conducted the variable annuity business, the company which purchased the variable annuity business from the major insurer (the “new owner”) and the new owner’s subsidiary through which the variable annuity business was conducted. The SEC stated that the insurance companies agreed to settlements that include a total payment of $20 million in disgorgement and penalties as well as undertakings of compliance reforms.

In its orders, the SEC found that from late 1999 through October 2002, the insurance company through which the variable annuity business was conducted sold variable annuity products to hedge funds and other individuals and entities to market time the mutual fund portfolios offered through the variable annuities. The company’s employees were aware that these market timers had no interest in the tax deferral or retirement features of variable annuities. However, the prospectuses of the variable annuity products stated that the products were “not designed for professional market timing organizations” and indicated that the insurance company in its “sole discretion” could restrict exchanges “that we consider disadvantageous” to other annuity contract holders. The prospectuses failed to disclose that the insurance company was marketing and selling the products to market timers and also failed to disclose the risk that market timing might have a negative impact on other variable annuity purchasers’ investment returns.

In October 2002, the insurance company was acquired by the new owner and renamed. The new owner and the renamed insurance company continued to allow a group of hedge funds and other select customers to engage in market timing through the variable annuity products. Nevertheless, the insurance company’s prospectuses repeated the above language from the previous prospectuses. Furthermore, the prospectuses reserved the right to limit any “substantive” transfers that the company determined “in its sole discretion, could adversely affect the management of the investment portfolio.” The insurance company failed to disclose that it was selling the products to market timing customers, and was facilitating the market timers in carrying out a market timing strategy.

The SEC found that, in some cases, mutual fund advisers were aware of and permitted the market timing of the mutual funds. In other cases, the insurance company did not inform the underlying fund complexes that insurance company employees tolerated and actively solicited market timers. Many of these complexes prohibited market timing or did not tolerate timers.

Ultimately, hedge funds and other market timers invested approximately $120 million in the variable annuities. In one of the variable annuity products, the market timing assets greatly exceeded the assets of other variable annuity purchasers. The SEC found that the market timers’ frequent trading diluted the value of the underlying mutual funds that were timed and caused the funds to incur additional costs.

The SEC’s orders find that the insurance companies violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 34(b) of the Investment Company Act of 1940. The orders require the companies to cease and desist from violating these provisions. The companies consented to entry of the respective orders without admitting or denying the findings.

Under the settlements, three of the insurance companies will pay $15 million, including disgorgement of $7.5 million and civil penalties of $7.5 million. The new owner and the insurance company through which the variable annuity business was conducted will pay $5 million, including disgorgement of $3.5 million and a civil penalty of $1.5 million. These amounts will be distributed to shareholders of mutual funds affected by the market timing. In addition, the new owner and the insurance company will undertake compliance measures to protect against future violations, including retaining an independent consultant to review compliance procedures designed to prevent and detect market timing.

SEC Press Release (August 9, 2004), available at http://www.sec.gov/news/press/2004-109.htm.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC adopts new Regulation SHO on short sales

August 13, 2004 10:46 AM
On July 28, 2004, the SEC published a release adopting Regulation SHO under the Securities Exchange Act of 1934 (the “Exchange Act”). The regulation provides a new regulatory framework governing the short sales of securities. Please see the attached WilmerHale Securities Law Developments Newsletter on Regulation SHO for more information.
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

NASD fines large broker-dealer $2.2 million for late reporting and temporarily prohibits the firm from registering new brokers

August 6, 2004 1:20 PM
On July 29, 2004, NASD announced that it censured and fined a broker-dealer $2.2 million for more than 1,800 late disclosures of reportable information about its brokers. The late reports concerned, among other things, customer complaints and disciplinary actions by regulators. The NASD also charged the broker-dealer for supervisory failures relating to the late filings. In addition, the NASD prohibited the broker-dealer from registering any new brokers for one week, required it to hire an independent consultant to assess the firm’s supervisory systems and procedures in the reporting area, and imposed specific ongoing reporting obligations. The broker-dealer agreed to the sanctions while neither admitting nor denying the allegations.

NASD News Release (July 29, 2004), available at http://www.nasdr.com/news/pr2004/ release_04_052.html.
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

>Mutual Fund Directors Forum (the “MFDF”) transmits to SEC report on best practices for mutual fund directors

August 6, 2004 1:05 PM

On July 28, 2004, the MFDF transmitted to the SEC its report, “Best Practices and Practical Guidance for Mutual Fund Directors,” containing recommendations to mutual fund directors in several key areas. The report states that the MFDF, a nonprofit membership organization for independent fund directors, developed the “best practices” described in the report at the request of SEC Chairman William H. Donaldson. The MFDF's recommendations are summarized below.

Independence of Fund Independent Directors

The MFDF’s report recommends the following measures designed to promote an “environment of independence,” in which the independent directors may best be able to ensure that the fund is operated at all times in the best interests of the shareholders and without undue influence from the fund’s adviser and its affiliates:

  • A fund’s board should adopt a statement of fundamental ethical principles to the effect that all actions taken on behalf of the fund must be in the best interests of its shareholders. The principles could be set out in the fund’s code of ethics contemplated by Rule 17j-1 under the Investment Company Act, in another written document that the directors determine is appropriate, or on the fund's website.
  • The chairman of a fund’s board of directors should be a person who is independent of the investment adviser and of entities affiliated with the adviser.
  • At least 75 percent of a fund’s directors should be persons who are independent of the investment adviser and of entities affiliated with the adviser.
  • The definition of “independent of the investment adviser” should be broader than the definition of “interested person” in the Investment Company Act, adding a requirement that such “independent director” should not have been affiliated with the fund’s adviser or its affiliates for at least 5 years.
  • A fund’s independent directors should retain knowledgeable independent legal counsel to advise them on an ongoing basis and should have express authority to employ staff, other independent consultants and advisors to assist them in carrying out their fiduciary duties to the fund’s shareholders.
  • A fund’s independent directors should be solely responsible for determining the level of their compensation. In principle, a director’s compensation should be commensurate with, among other things: (1) the nature and extent of committee assignments and other specific roles undertaken by the director in fulfilling his or her duties and responsibilities to the fund and its shareholders; (2) the complexity of the fund’s and fund complex’s operations; and (3) the fund’s investment strategies, policies and objectives.

Oversight of Soft Dollar, Directed Brokerage and Revenue Sharing Arrangements

The MFDF recommends the following best practices for fund boards with respect to transactions in portfolio securities. The report states that the practices apply primarily to secondary market transactions involving equity securities where commission rates are not fixed.

Best Execution

  • A fund’s board should require the fund’s adviser to develop written policies on execution of portfolio transactions, which should be designed to help ensure that the adviser seeks best execution on all brokerage transactions. Directors should instruct their fund’s adviser that research received by it not be considered as a factor in best execution.
  • A fund’s board should request and review regular reports from the fund’s adviser on execution of portfolio transactions. Reports should include information on the quality of execution. Directors should also consider the impact of commission rates on the ability to obtain best execution. With respect to commission rates, the MFDF recommends that directors: (1) request reports summarizing commissions per share paid to broker-dealers, (2) seek explanations for commissions that exceed the usual and customary commission paid in a particular securities market, and (3) encourage their fund’s adviser to explore alternative execution channels through which brokerage can, where appropriate, be effected at commission rates below the usual and customary rates.

Directed Brokerage

  • A fund’s board should not permit the fund’s adviser to consider a broker-dealer’s sale of the fund’s shares or shares of other funds in the complex as a factor in allocating trades to broker-dealers.
  • A fund’s board should request and review reports on the quality of the execution a fund receives on transactions in its portfolio securities that are placed with broker-dealers in arrangements involving expense reducing directed brokerage (the practice of directing transactions in a fund’s portfolio securities to broker-dealers who pay a rebate to the fund or use a portion of the commissions received in a trade to pay some of the fund’s operating expenses).

Soft Dollars

  • Independent directors should not permit the fund’s adviser to participate in soft dollar arrangements in trades for the fund. For purposes of this recommendation, “soft dollars” means arrangements under which, in addition to execution of securities transactions, proprietary or third party research services or products are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.
  • Transactions with Affiliates

    • Independent directors should require that any trades placed with an affiliated broker-dealer receive the most favorable commission rates that the broker-dealer gives to comparable clients.
    • Independent directors should review the quality of the execution a fund receives on any transactions placed with an affiliated broker-dealer. The directors should compare the quality of the execution on these trades to the quality on trades placed with unaffiliated broker-dealers.

    Revenue Sharing

  • Independent directors should require that fund management disclose revenue sharing arrangements to the board, should review any revenue sharing arrangements annually, and should consider revenue sharing arrangements to be part of the contract renewal process, where applicable. For purposes of this recommendation, “revenue sharing” means arrangements under which a fund’s adviser, distributor, administrator, or other agent intending to directly or indirectly promote the distribution of fund shares makes payments to others that exceed the amount of commissions normally associated with sales loads or normally derived from Rule 12b-1 plan proceeds. To provide adequate information to the independent directors, it is recommended, at a minimum, that:

    • Revenue sharing arrangements be presented annually to the board.
    • If the entity involved in revenue sharing arrangements is subject to annual contract renewal (such as an investment adviser), the information should be considered as a part of the contract renewal process.
    • The information presented should include the types of entities to which revenue sharing payments are made, the structure of the payments made under each type of arrangement, the services received for the payments and the total amount paid, both in dollars and basis points.

  • Independent directors should require that pertinent revenue sharing information be disclosed to shareholders. Until the SEC adopts measures that would increase disclosure to shareholders with respect to revenue sharing arrangements, a fund’s directors should discuss with management:

    • Having the fund’s prospectus and annual report include a general description of existing revenue sharing arrangements and the range of any regular payments made (in basis points), and referring the reader to the Statement of Additional Information (“SAI”) for more information.
    • The desirability of the fund’s SAI providing more specific information about revenue sharing practices, including a description of the types of entities that are paid, information about the types of services and marketing or distribution benefits received or anticipated for such payments, and the range of payments made (in basis points) for each type of arrangement.
  • Review of Management Agreements and Management Fees

    The MFDF recommends that, depending on all the circumstances, a fund’s board and its independent directors adopt the following procedures in connection with their consideration of the renewal of the fund’s advisory relationship:

    Valuation and Pricing

    The MFDF recommends the following best practices relating to directors’ oversight of funds’ valuation and pricing procedures: A fund’s board should establish a standing valuation and pricing committee to provide objectivity and the committee should have a written charter.

    • A fund’s board should assure that factors and decisions it used in determining any fair valuations are documented in detail.
    • A fund’s board should request that the adviser identify new situations that may require fair valuations.
    • A fund family’s valuation and pricing procedures should assure that, in general, the same valuation is used consistently for a security throughout the fund family, including its public and private funds.
    • A fund’s board, or the board valuation and pricing committee, should establish valuation and pricing procedures that are consistent with current regulatory guidance and the fund’s public disclosures.

    Effectiveness of Fund Independent Directors with Respect to Conflicts of Interest

    The MFDF recommends the following measures to address potential conflicts of interest not addressed by the above recommendations, which deal with specific areas of potential conflict between a fund and its adviser:

    • A fund’s board should establish a process for identifying and reviewing conflicts of interest. The MFDF recommends that directors consider assigning to a committee of the board the express responsibility for addressing potential conflicts of interest that may arise between the fund and its adviser or affiliates due to other business activities of the adviser or affiliates. The board should require that conflicts arising from the adviser’s other business activities be identified by the adviser and others and reported periodically to the committee. The board should also require that the adviser establish a review process to identify potential conflicts of interest that may arise between the fund and the adviser or between the fund and any affiliated person of the adviser.
    • A fund’s independent directors should establish guidelines for ownership of fund shares by directors.
    • Independent directors should make disclosure of their fund share ownership easily accessible.
    • A fund’s board should conduct an annual self-evaluation review designed to enable each member of the board to evaluate (1) his or her effectiveness as a director of the fund, (2) the effectiveness of the committee structure implemented by the board, and (3) the effectiveness of the board as a whole.
    • Each independent director of a fund should participate in ongoing educational and informational programs designed to enhance knowledge of issues relating to fund oversight.

    The MFDF’s report is available on the group’s website (www.mfdf.com), athttp://66.216.74.187/PDFs/best_pra.pdf.

     
     



    This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
    IRS CIRCULAR 230 DISCLOSURE:
    To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

    SEC adopts final rule amendments regarding investment company governance by fund boards

    August 6, 2004 11:10 AM

    On July 27, 2004, the SEC adopted a series of rule proposals intended to improve the governance standards of investment companies. Compliance is required by January 16, 2006. The SEC amended ten exemptive rules under the Investment Company Act to require that any fund that relies upon any of those rules satisfy the following:

    • at least 75% of the directors of the fund must be directors or, if a board has only three directors, all but one of the directors must be independent;
    • the chairman of the board must be independent;
    • the board must perform a self-assessment at least once annually;
    • the independent directors must meet separately at least once a quarter; and
    • the independent directors must be affirmatively authorized to hire their own staff.

    The vast majority of mutual funds rely on one or more of the ten exemptive rules affected. The SEC also amended Rule 31a-2 to require funds to retain copies of written materials that boards consider when approving advisory contracts.

    Board Composition. The amendments require that independent directors constitute at least 75% of the board or, if the fund has only three directors, all but one of the directors must be independent. The SEC believes that “a fund board whose independent directors constitute at least 75% of the fund board should strengthen the hand of the independent directors when dealing with fund management, and may assure that independent directors maintain control of the board and its agenda.

    Independent Chairman. The amendments require that the board chair be independent. Although the SEC did not attempt to establish any specific role for a board chair beyond that required by state law, it stated that the board chairman can play an important role in setting the agenda of the board, and in establishing a boardroom culture that can foster the type of meaningful dialogue between fund management and independent directors that is critical for healthy fund governance. The SEC further commented that the chairman can play an important role in providing a check on the adviser, in negotiating the best deal for shareholders when considering the advisory contract, and in providing leadership to the board that focuses on the long-term interests of investors.

    Annual Self-Assessment. The amendments require fund directors to evaluate, at least once annually, the performance of the fund board and its committees. This evaluation must include a consideration of the effectiveness of the committee structure of the fund board and the number of funds on whose boards each director serves. According to the SEC, “[t]his annual self-assessment requirement is intended to improve fund performance by strengthening directors’ understanding of their role and fostering better communications and greater cohesiveness. Moreover, the requirement should help fund boards to identify potential weaknesses and deficiencies in the board’s performance.” The assessment need not focus on the performance of any individual directors. Although the SEC did not expressly require that the assessment be put in writing, it said it “would expect that the minutes of the board would reflect the substance of the matters discussed during the board’s annual self-assessment.

    Separate Sessions. The amendments require independent directors to meet quarterly in a separate session at which no interested directors are present. Although the SEC did not specifically identify what must be considered at those sessions, it said “we would expect that the independent directors would use this forum to discuss, among other things, their views on the performance of the fund adviser and other service providers.

    Independent Director Staff. The amendments require funds to authorize the independent directors to hire employees and to retain advisers and experts necessary to carry out their duties. The SEC expects that this amendment “should help independent directors address complex matters and provide them with an understanding of the practices of other mutual funds.”

    Recordkeeping for Approval of Advisory Contracts. The SEC amended rule 31a-2, the fund recordkeeping rule, to require that funds retain copies of the written materials that directors consider in approving an advisory contract under Section 15 of the Investment Company Act.

    SEC Release No. IC-26520; File No. S7-03-04.

     
     



    This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
    IRS CIRCULAR 230 DISCLOSURE:
    To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

    Fifty-nine days and counting until compliance program rules deadline

    August 6, 2004 10:57 AM
    Fifty-nine days and counting until compliance program rules deadline. The October 5, 2004 deadline for compliance with new rule 206(4)-7 under the Investment Advisers Act of 1940 (the “Advisers Act”) and new rule 38a-1 under the Investment Company Act of 1940 (the “Investment Company Act”) is now 59 days away. These rules require advisers and funds to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and designate a chief compliance officer to be responsible for administering the policies and procedures.

    Please contact any of the following partners and counsel in the Investment Management Group at WilmerHale if you have questions regarding the new compliance rules:


    Joseph Barri        Christopher Harvey         David Phelan
    Leonard Pierce     Pamela Wilson                Charles McCain
    Timothy Silva       James Anderson             Robert Bagnall
    Matt Chambers     Sara Emley                    Richard Jackson
    Martin Lybecker    Kevin McEnery               Marianne Smythe
    Beth Stekler         Cherie Weldon               Coleen Doherty-Minicozzi
     
     



    This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
    IRS CIRCULAR 230 DISCLOSURE:
    To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.