Investment Management Industry News Summary - December 2000

Investment Management Industry News Summary - December 2000

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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Fee Rate Advisory

December 29, 2000 3:42 PM

On December 21, 2000, President Clinton signed the Commerce, Justice, State, and related agencies appropriations bill for the 2001 fiscal year that funds the SEC. Effective December 21, the fee rate on filings made pursuant to Section 6(b) of the Securities Act of 1933 decreased to $250 per $1,000,000, or .00025 of the aggregate offering amount.

SEC charges investment adviser with defrauding investors with hedge funds. The SEC filed an enforcement action charging an investment adviser and his advisory firm, a registered investment adviser, with defrauding investors in three hedge funds. The SEC charged the adviser and his firm with engaging in a scheme to inflate falsely the value of investment portfolios managed for three hedge funds. The SEC alleged that as a result of the scheme, the adviser and his firm overstated the value of the portfolio by $71 million.

According to the SEC, the adviser and his firm purchased options on interest rate swaps ("swaptions"), which are thinly traded, difficult to value financial instruments. The adviser and the firm were required to obtain independent price valuations from broker-dealers for the swaptions. The third party prices were used to prepare monthly and quarterly reports that were provided to investors in the hedge funds. From late 1997 until the first half of 1998, the hedge funds incurred losses in these instruments as interest rates declined. The SEC's complaint alleges that:

  • To conceal the losses, the adviser inflated the values that he reported for certain swaptions in the hedge funds' portfolio by obtaining third party prices for similar but more valuable swaptions. The substitution caused false and misleading valuations to be reported to the hedge fund investors.
  • The adviser forged and altered documents in an effort to cover up the fraudulent conduct. The adviser instructed broker-dealers to return to him pricing sheets with blank bids and then the adviser entered inflated prices for those investments on the pricing sheets.

The SEC charged the adviser and his firm with violations of the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 thereunder and violations of various provisions of the Investment Advisers Act of 1940 (the "Advisers Act). The SEC also charged the adviser with violating a previous cease and desist order issued by the SEC in November 1993. In the previous action, the SEC charged the adviser with violations of the antifraud and recordkeeping provisions of the Advisers Act. The adviser had previously been ordered to cease and desist from future violations of the Advisers Act. In the current action, the SEC is seeking permanent injunctions, disgorgement and civil penalties against both the adviser and the firm. SEC v. Michael Smirlock and LASER Advisers, Inc., 00 Civ. 9680, RO, SDNY.

SEC adopts technical amendments to investment adviser forms and issues warning for late filers. The SEC issued a release adopting technical amendments to forms ADV, ADV-W, ADV-H, ADV-NR and related rules under the Advisers Act. The technical amendments generally (i) clarify filing instructions in the rules and forms, (ii) provide notice to filers of administrative law requirements, and (iii) eliminate minor internal inconsistencies within these forms.

In addition, the SEC has warned that hundreds of investment advisers who have been late in filing forms necessary to obtain password and registration information for the SEC's new electronic registration database, the Investment Adviser Registration Depository (IARD), may face enforcement. All federally-registered advisers must send the forms, called entitlement forms, to get their filing instructions for filing on IARD. The entitlement forms were due in stages but no later than Jan. 8. Robert Plaze, associate director of the SEC, has been quoted as commenting that failure to file "[is] a rule violation and rule violations have consequences." He added that in addition to potential enforcement, firms that file late will not be ready for IARD's live dates early next year.

 
 



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.

Congress Approves Commodity Futures Modernization Act

December 29, 2000 1:39 PM

Congress approved the Commodity Futures Modernization Act (the "Act") which repeals the ban on single stock futures and places the CFTC as the single regulatory body to oversee the multi-trillion dollar swaps market.

The Act excludes from CFTC regulation all bank products, subject to certain conditions. All banking products introduced prior to December 5, 2000 are excluded from CFTC jurisdiction if they were certified by the appropriate banking regulator. Newly developed hybrid banking products are excluded from CFTC jurisdiction if they are predominantly banking products as determined by the bank. If, however, the CFTC disagrees with the bank’s assessment, the CFTC will consult with the Federal Reserve. Any disagreement between the CFTC and the Federal Reserve will be referred to the D.C. Appeals Court on an expedited basis.

Under the Act, the SEC retains enforcement authority over persons engaging in insider trading, manipulation or fraud in connection with equity swaps. The Act does, however, limit the SEC's authority over certain over-the-counter derivatives transactions. The SEC is limited to oversight of transactions conducted on organized exchanges that it already regulates. Security based swap arrangements, for instance, are not securities subject to SEC regulation. Further, the SEC’s jurisdiction is limited to entities for which the securities laws explicitly require registration.

Single stock futures and certain defined indexes listed to trade on national securities exchanges may trade on trading facilities subject to joint SEC and CFTC regulation. Stock futures and stock indexes between eligible contract participants on a principal-to-principal basis may commence trading eight months after the enactment of the bill; general trading may begin one year after enactment. Options on stock futures may not trade until the SEC and the CFTC permit such trading in a joint determination that may take as long as three years after enactment. SEC Today, December 21, 2000.

 
 



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 Grants Exemption to Broker-Dealer's Customers From Short Sale Rule

December 29, 2000 12:49 PM

The SEC's Division of Market Regulation recently granted an exemption from the "short sale rule" to a broker-dealer permitting its customers to execute short-sale transaction on a volume-weighted average price ("VWAP") basis. The broker-dealer's institutional customers, which include mutual funds, commercial banks and investment advisers, wished to sell securities at a price based on the average of weighted prices of transactions that take place during the regular trading hours of a day. According to the broker-dealer, institutions prefer trades executed on a VWAP basis because this ensures that institutions will not sell at the low price for the day.

In its request for relief, the broker-dealer stated that the VWAP transactions would be arranged prior to the opening of regular trading hours and would include a basket of more than 20 securities. The broker-dealer explained that it sought exemptive relief because the pre-opening trade agreed to by the broker-dealer and its customer could be deemed inconsistent with the "tick test" of Rule 10a-1 under the Exchange Act.

The tick test requires that short sales may only be executed in a rising market for the security being sold short. Specifically, a security may only be sold short if (1) the last sale was at a higher price than the sale preceding it and (2) the last sale price is unchanged but higher than the last preceding different sale. The SEC adopted the tick test to prevent the market manipulation that could otherwise be caused by heavy short selling activity to drive the price of a stock down. Such activity could permit a market manipulator to realize profits by purchasing the stock at the depressed price. The broker-dealer's pre-opening arrangement could be deemed inconsistent with the tick test because the transactions could be assigned a final execution price that may be on a minus tick or a zero-minus tick with respect to the last sale reported.

The SEC granted the exemption from Rule 10a-1 subject to the following conditions:

  • persons relying on the exemption may not enter into any pre-arranged matching sale and purchase orders;
  • transactions must not be made for the purpose of creating actual or apparent active trading in or otherwise affecting the price of any securities;
  • the broker-dealer's customers may effect short sales on a VWAP basis if (1) the subject listed security qualifies as an "actively traded security" under Regulation M. If the security is not an actively traded security, the transaction will only be permitted if it is conducted as part of a basket transaction of more than 20 securities in which the listed security does not comprise more than 5% of the value of the based traded; (2) the VWAP value of a listed security being sold short is determined in reference to transactions executed in the consolidated marketplace or in the primary market for the listed security;
  • the broker-dealer may act as principal in these trades only if the broker-dealer's position in the subject security does not exceed 10% of the security’s relevant average daily trading volume as defined in Regulation M; and
  • the broker-dealer must maintain and provide to the SEC, upon request, records relating to each except short sale transaction effected in reliance on this exemption.

Jefferies & Co. Inc., no-action letter, December 7, 2000

 
 



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.

NASDR Files Second Amendment to Proposed Rule Regarding Hot Issues

December 15, 2000 3:37 PM

On November 28, 2000, NASDR submitted for comment its second amendment to proposed NASD Conduct Rule 2790, the proposed Restrictions on the Purchase and Sale of Initial Equity Public Offerings. In this amendment, NASDR made the following changes:

The proposed rule will restrict the purchase and sale of all initial equity public offerings, not just those that open above a certain premium. NASDR has reinstated its proposal to exempt from the scope of the rule secondary offerings, debt securities, convertible securities, preferred securities, and offerings of closed-end funds.

NASDR has amended its definition of portfolio manager for purposes of determining persons restricted from participating in IPOs. NASDR has redefined portfolio manager to be those persons "who have authority to make investment decisions." Amendment no. 2 also treats a portfolio manager and certain members of his or her family as restricted persons other than as to a beneficial interest in the bank, savings and loan institution, insurance company, investment company, investment adviser, or collective investment account over which the person has investment authority. Thus, a manager who is not otherwise restricted may purchase IPOs through a fund he or she manages. However, the manager may not purchase IPOs through a personal account.

NASD has clarified some of the proposed rule's preconditions for sale and documenting sales. In response to comment letters suggesting that NASD members be permitted to develop their own methods to verify whether a customer is eligible to purchase IPOs, NASDR has omitted an annual mailing requirement and permitted the use of electronic or oral communications as long as these responses are documented internally by the member firm. In addition, NASDR reiterated its position that, while members may elect to rely upon counsel or an accountant to investigate the eligibility of an account such as a fund of funds, the proposed rule will not require such verification.

NASDR has also clarified the de minimis exception. Under the proposed rule, an account in which otherwise restricted persons own 5% of the interests may still be eligible to purchase IPOs. However, NASDR has imposed a strict numerical limit of 100 shares that any one person in the account can purchase. In complying with this 100 share limit, NASD members may look through the investing entity to a person's beneficial interest.

NASDR also made changes regarding the application of the proposed rule to owners of broker-dealers, issuer-directed share programs, and ERISA plans. Comments on the proposed rule must be received by December 26, 2000.

 
 



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 Grants Relief Permitting Company to Process Mutual Fund Investments Without Registering as a Broker-Dealer

December 15, 2000 3:30 PM

The SEC has given no-action relief to a large financial services company allowing the company to process mutual fund investments for its customers without registering as a broker-dealer. The order was granted in July but announced in November since the SEC also granted the company's request for confidential treatment for 120 days. Under the no-action letter, the company may offer a processing arrangement to its customers who wish to invest in mutual funds and variable products distributed by three of the company's broker-dealer affiliates.

Under the program, customers may appoint the company as a processing agent to collect payments for mutual fund shares or variable products and to remit those amounts to registered broker-dealers. The company noted that customers must first open an account with one of its affiliated broker-dealers in order to participate in the program and must designate the amount and allocation to be invested on a monthly basis. The registered broker-dealers will be responsible for all securities-related activities and will have the exclusive responsibility for marketing the availability of the company's services.

In its request for no-action relief the company:

  • Stated that it would advise customers that the investment amount sent to the company will not be covered by the Securities Investor Protection Corp. while in the possession of the company.
  • Outlined its security and internal control safeguards, including its intent to obtain a surety bond from an unaffiliated insurance company in an amount at least equal to the amount of funds it collects and remits to broker-dealers.
  • Noted that it will not receive a referral fee from the broker-dealers nor any compensation based on the amount invested by a customer.
  • Stated that it will charge the broker-dealers a fee to offset its expenses for providing the service.

The SEC concluded that the company's activities would constitute the effecting of transactions in securities for purposes of the Securities Exchange Act of 1934 (the "1934 Act") and the company would ordinarily be required to register as a broker-dealer absent an exemption. However, the SEC noted that the company's employees and unregistered affiliates will be strictly prohibited from recommending, answering questions about or engaging in any negotiations involving brokerage accounts or related securities transactions. Further, the company guaranteed the safety of investors' funds and agreed to provide the SEC access to its books and records. Accordingly, the SEC found that the no-action relief was consistent with the public interest and the protection of investors. American Express Travel Related Services Co. no-action letter, November 24, 2000.

 
 



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.

Administrative Law Judge Fines Investment Adviser for Misleading Statements About a Mutual Fund's Risks

December 15, 2000 3:24 PM

On November 30, 2000, an administrative law judge fined an investment adviser more than $2 million for misleading investors about a high-risk mutual fund that claimed to have conservative investment objectives. The SEC filed charges in 1998 following the fund, an institutional government income fund. The SEC charged the adviser and five of its officials with making material misstatements about the fund's investment objectives and/or misstating its net asset value. The SEC also charged the adviser's president with failing to adequately supervise the fund's two portfolio managers and failing to prevent their misconduct. In addition, the SEC charged three other individuals with various accounting responsibilities to the fund.

The SEC alleged that between 1992 and 1994:

  • the adviser and the fund's two portfolio managers made false and misleading statements to investors regarding the risks of investing in the fund;
  • the portfolio managers had invested the fund's assets in interest rate sensitive collateralized mortgage obligation derivatives, causing the fund to be a "high-risk investment" notwithstanding its conservative investment objectives. The administrative law judge concluded that this deviation from the fund's stated investment objective was a reckless violation of the securities laws' antifraud provisions;
  • the adviser and the portfolio managers made false and misleading statements regarding the leveraging of the fund's assets;
  • the adviser and the portfolio managers changed the investment objective without shareholder approval by investing in collateralized mortgage obligation derivatives;
  • the adviser and the portfolio managers falsely represented how the fund's NAV would be calculated. Specifically, the managers told investors that the fund would calculate a current NAV on a daily basis for purchases and redemptions. Instead, most fund securities were priced only on a weekly basis; and
  • the portfolio managers and the accountants engaged in a scheme to override dealer quotations and gradually lower the price of securities in the fund's portfolio to limit reductions in the fund's NAV.

The administrative law judge concluded that the fund misrepresented or failed to disclose numerous material facts concerning fund composition, duration, performance, weighted average life, diversification and leverage in its prospectuses and marketing materials. The judge additionally found the portfolio managers to be liable for negligence.

The judge censured the adviser and ordered it to cease and desist from future securities laws violations, revoked the adviser's investment adviser registration and imposed a $2 million civil penalty. The judge also censured the individuals named in the action. In re Piper Capital Management, Inc, SEC. Admin. Proc. File No. 3-9657, November 30, 2000).

 
 



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 Conducts Probe Into Initial Public Offering Allocations

December 15, 2000 3:15 PM

The SEC and the U.S. Attorney's Office - Southern District of New York have launched a joint inquiry to investigate whether broker-dealers have offered large investors allocations in "hot" initial public stock offerings ("IPOs") in exchange for large trading commissions. Both the SEC and the U.S. Attorney's Office have issued subpoenas to IPO participants and requested trading records and other documents.

The SEC and the U.S. Attorney's Office have specifically targeted IPOs during the last three years when a number of highly anticipated technology offerings began trading at double or more of the initial offering price on the first day of trading. Reportedly, initial offerings have raised $165.8 billion since mid-1998, triggering underwriting fees for broker-dealers totaling $8.7 billion. The SEC and the U.S. Attorney's Office have chosen to more closely examine IPOs from this time period because an unusual number of IPOs skyrocketed in price, allowing investors able to obtain an allocation of the stock to take large profits. In most cases, the broker-dealers allegedly allocated a majority of these hot IPO shares to institutional investors.

An anonymous letter writer alerted the SEC to the potentially illegal practice. The investigation will focus on whether certain investors and dealers linked IPO profits to commission levels, creating a "kickback" to the dealers. For example, in some cases, small investors were able to receive an allocation of hot IPO shares even though their customary brokerage business was not large enough to justify the allocation. The investigation will focus on whether such small investors made a large commission payment to the dealer from whom they received the hot IPO allocation. These commission payments have allegedly run as high as $0.40 to $1.00 a share.

The SEC has begun the investigation with document requests from several major securities firms. The document requests include requests for records of trades of 10,000 shares or more that carried commissions exceeding $0.10 a share and lists of investors in IPOs led by the securities firm. Wall Street Journal, December 7 and 13, 2000.

 
 



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.

NASDR Relaxes Testing Requirements for Bank Employees

December 8, 2000 3:05 PM

In a recent interpretive letter, NASDR has temporarily relaxed its requirements for qualification examinations to ease the transition of certain bank employees to an affiliated broker/dealer. NASDR noted that the recent enactment of the Gramm-Leach-Bliley Act permitted banks to affiliate themselves with broker-dealers, causing current bank employees engaged in similar activities to move to newly affiliated brokers or dealers. As a result of this transition to a broker-dealer, these former bank employees must become "associated persons of a registered broker/dealer" in order to continue to carry out these activities. Individuals must fulfill certain test requirements before they are permitted to be associated with a broker-dealer.

NASDR decided to grant a temporary stay of the requirements to permit these bank employees to register as associated persons without retaking previously passed qualification examinations. Because banks are not members of the NASD, registration for bank employees who previously held NASD licenses will lapse while the individual is employed at a bank. Currently, a person whose registration has been expired for more than two years is normally required to take and pass a new examination. However, NASDR has agreed to toll the two-year grace period during the phase-in period for those bank employees moving into an affiliated broker/dealer whose examination status would otherwise have expired. Thus, if a bank employee's examination status would expire between Nov. 12, 1999 (the date the Gramm-Leach-Bliley Act was enacted), and May 12, 2001 (the date the Act's relevant securities provisions become effective) (the "tolling period"), the employee may register with a broker-dealer without being retested. The tolling applies only with respect to those qualification examinations that the individual has passed and with respect to those activities for which the individual was engaged while employed by the bank.

A bank-affiliated broker/dealer also will be allowed to sponsor and complete registration of unregistered bank employees before those employees are transferred to the broker/dealer. During period between the tolling period, a broker or dealer may sponsor a person as long as there is an intent to employ that person. NASDR also agreed that during the application process, the sponsoring broker or dealer will not be required to supervise the person's securities-related activities carried out on behalf of the bank, as long as the person still is supervised by the bank and does not work on behalf of the broker/dealer. NASDR Interpretive Letter, October 27, 2000.

 
 



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 issues Q and A on Amendments to Rule 17j-1 Under the 1940 Act

December 8, 2000 2:57 PM

The SEC recently issued guidance in a question and answer format on the recent amendments to Rule 17j-1 under the 1940 Act. The guidance answers specific questions in the following areas:

Application of Rule 17j-1 to subadvisers. The SEC reiterated its position that Rule 17j-1 applies to subadvisers of investment companies and that a multi-manager fund must include the code of ethics of each of its subadvisers as an exhibit to the fund's Form N-1A registration statement.

Holdings and transaction reports. The SEC confirmed that an access person could satisfy the initial or annual holdings report requirement by filing a copy of a securities account statement as long as the statement includes (1) all of the information required by Rule 17j-1 and (2) any additional information required by the relevant organization's code of ethics. The SEC also confirmed that while an access person must report the title, number of shares (for equity securities) and the principal amount (for debt securities) of covered securities (as defined in the rule), there is no requirement to provide the market value of any security.

The SEC reiterated its position that Rule 17j-1 requires an access person to include in initial and annual holdings reports the name of any broker-dealer or bank with which the access person has an account in which any securities, not just covered securities, are held. Similarly, access persons are required to report quarterly any account established by the access person in which any securities, not just covered securities, were held. The SEC also reiterated its position that access persons must normally report the holdings and transactions of a spouse, holdings of or transactions in securities by ESOPs or pension or retirement plans in which the access person participates.

The SEC confirmed that an access person may omit from his or her reports and holdings and transactions in securities issued by the fund's adviser and its adviser's affiliates because these securities are prohibited investments for the fund and it is the SEC's belief that transactions in these types of securities do not trigger the types of abuses Rule 17j-1 was designed to prevent. Currently, however, under Rule 17j-1, securities of the adviser or its affiliates would be considered covered securities and are not among the specific securities for which access persons need not provide reports (e.g., shares issued by open-end mutual funds, direct obligations of the U.S. government, etc.). In addition, the SEC did not base this position on an existing no-action letter or exemptive order.

The SEC also confirmed that access persons who are also "advisory representatives" under Rule 204-2 under the Investment Advisers Act of 1940 must also comply with the reporting requirements under Rule 204-2. The SEC noted that Rule 17j-1 provides an exception from the quarterly transaction report requirement if all the information required to be reported would duplicate information provided by the access person in compliance with Rule 204-2.

Review of Reports. The SEC noted that while Rule 17j-1 does not prohibit an access person from reviewing holdings and transaction reports, the staff would not consider an access person who reviews his or her own reports to be "appropriate" management or compliance personnel for review purposes. The SEC confirmed that a third-party administrator may review holdings and transaction reports.

 
 



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.

Director of SEC's Division of Investment Management Addresses Conference on Upcoming SEC Initiatives

December 8, 2000 1:58 PM

In opening remarks at an industry conference, Paul Roye, the Director the SEC's Division Investment Management (the "Division") commented on the SEC's various developments and initiatives effecting the investment management industry. He commented on the following SEC rulemaking initiatives:

Amendments to Rule 17j-1 under the Investment Company Act of 1940 (the "1940 Act"). Mr. Roye reminded participants that certain requirements under revised Rule 17j-1 will go into effect at the beginning of 2001. Mr. Roye advised participants that compliance with the technical requirements of the new rules alone will likely not be sufficient for most advisory firms and that industry members should strive to be "comprehensive" in preventing personal trading abuses. He also noted that on November 27, 2000, SEC staff released a series of questions and answers regarding the Code of Ethics amendments. (See below for a summary of the report).

Proposed rule regarding independent directors. Mr. Roye reminded attendees that the SEC's year-old "governance" proposal would amend certain exemptive rules under the 1940 Act by adding the following conditions to the exemptive rules that any fund must meet to rely on the rules:

  1. independent directors must constitute at least a majority of their board of directors;
  2. independent directors must select and nominate other independent directors; and
  3. any legal counsel for the independent directors must be an independent legal counsel.

Mr. Roye also noted that the SEC has also proposed a number of disclosure requirements regarding directors that would enhance shareholders' ability to evaluate whether the independent directors are effective in their oversight of fund operations.

Mr. Roye reported that the SEC will release the final rule "soon" and that it will reflect some of the numerous comment letters that the SEC received, including the criticism of the proposed disclosure requirements, especially as they related to directors' family members. Mr. Roye confirmed that the final rule will likely retain the provisions regarding independent counsel substantially as proposed.

Improving mutual fund disclosure. Mr. Roye reported that the SEC is considering the following proposals to improve the quality of mutual fund disclosure.

A. Mutual fund fees. Mr. Roye noted that at the request of Congress, the General Accounting Office completed a study this past summer of mutual fund fees and expenses. The study concluded that additional disclosure could help increase investor awareness and understanding of mutual fund fees and, thereby, promote additional competition by funds on the basis of fees. Mr. Roye further noted that the Division is completing its own review of mutual fund fees and expenses which the Division will issue "in the next few weeks." Mr. Roye reported that the Division's recommendation will be to make the actual impact of fees more visible to allow investors to determine the actual dollar amount they have paid in fund expenses during a given period.

B. Fund names. Mr. Roye reported that in the next few weeks the SEC will adopt a new Rule 35d-1 under the 1940 Act to guard against a fund's use of a misleading name. Under the revised rule, the SEC would increase the investment requirement from 65% to 80% in investments reflective of the fund's name. He did not indicate whether the policy would have to be fundamental as contemplated by the rule proposal. Mr. Roye reported that the SEC suggested the increase to help reduce confusion for investors in selecting an investment company for their specific needs and in making asset allocation decisions.

C. After tax disclosure. Mr. Roye noted that SEC's rule proposal to improve disclosure to investors of the effect of taxes on the performance of mutual funds. The proposed amendments would require mutual funds to disclose after-tax returns for 1-, 5-, and 10- year periods, based on a standardized formula, comparable to the formula currently used to calculate before-tax average annual total returns. Mr. Roye announced that under proposed rule, the after-tax returns would be required to be disclosed in the risk/return summary of the prospectus and in Management's Discussion of Fund Performance, typically contained in the annual report. The proposal also would require funds that include after-tax returns in advertisements and other sales materials to include standardized after-tax returns in those materials. Mr. Roye reported that the Division expects to make a recommendation to the SEC regarding adoption early in 2001.

D. Fund advertising. Mr. Roye commented that the Division expects to recommend that the SEC propose amendments to Rule 482 under the Securities Exchange Act of 1934 to enhance funds' ability to provide investors with better and more timely information in fund advertising. The proposal would eliminate the requirement that the "substance" of the information contained in advertisements be included in the statutory prospectus. Mr. Roye reminded participants that compliance with the technical aspects of the rule does not ensure that an advertisement does not run afoul of antifraud prohibitions of the federal securities laws.

E. Shareholder communications. Mr. Roye reported that the SEC is studying how to improve shareholder report and financial statement presentations. The SEC's considerations include:

  • improving the management discussion and analysis portions of shareholder reports;
  • improving the quality of portfolio schedule information;
  • changing the format of and frequency with which portfolio holdings are disclosed.

F. Mr. Roye also highlighted the following three areas that the SEC believes merit increased focus by fund management, compliance personnel and fund directors:

1. Valuation. Mr. Roye reiterated that valuation continues to be an extremely important issue for the SEC. He reported that in addition to fair purchase and redemption pricing, the SEC is concerned that over-valuation of a fund's assets will overstate the performance of the fund, and will result in overpayment of fund expenses that are calculated on the basis of the fund's net assets, e.g. the fund's investment advisory fee.

Mr. Roye noted that the 1940 Act requires funds to value their portfolio securities by using the market value of the securities when market quotations for the securities are "readily available." When market quotations are not readily available, the 1940 Act requires fund boards to determine, in good faith, the fair value of the securities. Mr. Roye further noted that the SEC has stated that, as a general principle, the fair value of a portfolio security is the price that the fund might reasonably expect to receive upon its current sale. Accordingly, he concluded that fair value cannot be based on what a buyer might pay at some later time, or prices which are not achievable on a current basis. Mr. Roye warned participants that failure to adhere to the requirement to fair value portfolio securities when required has resulted in enforcement actions against some funds and even some fund directors.

Mr. Roye also reminded participants that the Division issued an interpretative letter to the ICI providing additional guidance on the fair value pricing process. In the letter, the SEC

  • emphasizes that while no single standard exists for determining fair value in good faith, fund boards should satisfy themselves that "all appropriate factors" have been considered, and should take into account "all indications of value available to them" when fair value pricing a portfolio security;
  • recognizes that fund boards typically are involved only indirectly in the day-to-day pricing of a fund's portfolio securities. The SEC also notes that most boards fulfill their obligation by reviewing and approving pricing methodologies, which are typically recommended and applied by management;
  • affirms that funds may use a number of techniques to minimize the burdens of fair value pricing on their directors, such as delegating certain responsibilities for fair value pricing decisions to a valuation committee but only if adequate procedures are implemented to guide the committee;
  • stresses that the fund's board retains oversight responsibilities for the valuation of the fund's assets;
  • outlines parameters of a board's involvement including approving comprehensive procedures that provide methodologies for how fund management should fair value price portfolio securities. However, the SEC warned that the Board's involvement must be "greater and more immediate" if it has vested a comparatively greater amount of discretion in a committee, or when pricing procedures are relatively vague; and
  • advises that fund directors receive periodic reports from fund management that discuss the functioning of the valuation process and that focus on issues and valuation problems that have arisen.

Mr. Roye also advised participants that fund directors should ensure that appropriate operational procedures and supervisory structures are in place with respect to both "market value" and "fair value" determinations. In particular, Mr. Roye suggested that additional controls may be necessary when a fund uses pricing data from third party sources, such as pricing services and dealers, including those that involve methodologies such as matrix pricing. Mr. Roye recommended that funds incorporate controls at each level of the valuation process and periodically cross-check prices received from pricing services. These cross-checks could include checking quotes received against quotes from other pricing services, from dealers making a market in the relevant securities, or actual sales in particular securities against prices for comparable securities. These cross-checks should generate red flags when there are questions regarding the reliability of prices.

2. Best execution. Mr. Roye reminded participants of the importance the SEC places on best execution. He told participants that Chairman Levitt recently gave a speech in which he focused on the cost of investing, noting that among the most significant costs of investing today are brokerage commissions. Mr. Levitt noted that while retail commissions have dropped to only a fraction of what they were just a few years ago, mutual funds continue to pay full service commissions at five to six cents a share. Mr. Roye reported that the SEC is increasingly interested in determining whether funds can take advantage of electronic markets to drive overall rates lower. Mr. Roye advised participants to consider the following principles:

  • Fund directors have a duty to inquire about the execution process.
  • Fund managers need to negotiate commissions with brokers.
  • Brokerage is an asset belonging to the fund and its shareholders.

3. Portfolio pumping and window dressing. Mr. Roye commented on the SEC's investigation of "portfolio pumping" and "window dressing". (See Industry News Summary for the week of 11/24/00 - 12/01/00). Mr. Roye noted that the SEC's Office of Compliance Inspections and Examinations has formed a task force to look into the practice of portfolio pumping by evaluating trading data of fund portfolio securities that would indicate manipulation. He also noted that the SEC is concerned about the misleading practice known as "window dressing" where advisers buy or sell portfolio securities at the end of a reporting period for the purpose of misleading investors as to the securities normally held by the fund, the strategies engaged in by the advisers or the source of the fund's performance.

 
 



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.

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