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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SEC and National Association of Securities Dealers, inc. (“NASD”) Settle Charges with a Broker-Dealer Regarding Sales of Systemic Investment Plans
December 30, 2004 2:57 PM
The SEC and NASD each reached a settlement with a registered broker-dealer (the “Broker Dealer”) whose customer base consists almost entirely of active-duty and retired U.S. Military personnel.
The SEC and NASD each reached a settlement with a registered broker-dealer (the “Broker Dealer”) whose customer base consists almost entirely of active-duty and retired U.S. Military personnel. The agencies allege that the Broker Dealer used misleading sales materials to offer and sell mutual-fund investments to its customers through an installment method called a systematic investment plan (systematic plan).
In its Order, the SEC found that since at least January 1999, the Broker Dealer offered and sold systematic plans by making misleading comparisons between the systematic plan and other mutual-fund investments. The Broker Dealer utilized sales scripts that mischaracterized the cost of no-load mutual funds in comparison to its product. In addition, the SEC Order found that the Broker Dealer’s sales materials contained misleading statements and omissions concerning the availability to its customers of a comparable plan sponsored by the Federal Government, which could be obtained at lower costs to the customers.
Congress requires the Securities and Exchange Commission (“SEC”) to report on independent fund chair rule
December 30, 2004 2:46 PM
A provision in the Consolidated Appropriations Act 2005, a spending bill enacted on December 8, 2004, directs the SEC to study the performance of mutual funds under the direction of independent chairpersons and to compare the performance to such funds to the performance of mutual funds under the direction of interested chairmen.
A provision in the Consolidated Appropriations Act 2005, a spending bill enacted on December 8, 2004, directs the SEC to study the performance of mutual funds under the direction of independent chairpersons and to compare the performance to such funds to the performance of mutual funds under the direction of interested chairmen. The Act requires the SEC to submit a report to the Senate Appropriations Committee by May 1, 2005, which provides justification for the SEC rule, released on July 27, 2004, which, among other things, requires the chair of a mutual fund board to be an independent director. The SEC’s report must analyze whether mutual funds chaired by independent directors perform better, have lower expenses, or have better compliance records than mutual funds chaired by interested directors. In addition, the Act requires the SEC to act upon the recommendations of the report by January 1, 2006. Mutual Funds must be in compliance with rule requiring the chairman of the board to be independent by January 16, 2006.
CCH Mutual Funds Guide; Issue No. 841 (December 17, 2004)
ICI submits a comment letter in response to the European Union (“EU”) Commission’s consultation paper on improving shareholder’s rights
December 30, 2004 8:43 AM
ICI recently filed comment letter supporting the EU’s efforts to improve shareholder rights and the ability of shareholders to vote cross border.
ICI recently filed comment letter supporting the EU’s efforts to improve shareholder rights and the ability of shareholders to vote cross border. While acknowledging and supporting the EU’s efforts to improve shareholder rights, the ICI urged the EU to extend those rights to non-EU investors, including US mutual funds. The ICI made the following recommendations to the EU Commission:
Investment Company Institute Letter from Mary S. Podesta to Pierre Delsaux, Head of Unit, European Commission, dated December 15, 2004.
NASD censures and fines mutual fund distributor for failing to prevent market timing
December 22, 2004 12:47 PM
The NASD recently announced that it settled charges with a mutual fund distributor resulting in a censure and fine in the amount of $700,000.
The NASD recently announced that it settled charges with a mutual fund distributor resulting in a censure and fine in the amount of $700,000 for: (1) failing to prevent market timing in certain mutual funds offered by its affiliate, (2) failing to establish and maintain a reasonable supervisory system designed to detect and prevent market timing in violation of the funds' trading policies, and (3) failing to maintain and preserve internal e-mail communications.
The NASD determined that, as the distributor for a family of mutual funds, the distributor was "uniquely situated" to implement prospectus limitations and fund policies and procedures designed to limit or prevent market timing. Specifically, the NASD found that:
In addition to censuring and fining the distributor, the NASD required the distributor to certify: (1) that it has disclosed all instances of fund trading inconsistent with the funds' prospectuses and the distributor's excessive trading policy, and (2) that is has implemented appropriate systems and controls with respect to market timing and preservation of electronic communications.
SEC adopts amendments to Reg. S-P, including requiring proper disposal of consumer records
December 10, 2004 9:03 AM
The SEC recently adopted amendments to Regulation S-P.
The SEC recently adopted amendments to Regulation S-P that:
Regulation S-P currently requires, among other things, that every registered broker, dealer, investment company, and investment adviser adopt policies and procedures that address the administrative, technical, and physical safeguards for the protection of customer records and information. These policies and procedures must be reasonably designed to: (1) insure the security and confidentiality of customer records and information; (2) protect such records from any anticipated threats or hazard to their security or integrity; and (3) protect against unauthorized access to or use of customer records or information that could result in harm or inconvenience to the customer.
The disposal rule applies to any person that (1) is a registered broker or dealer, investment company, investment adviser, or transfer agent and (2) possesses consumer report information for a business purpose. Unlike the remainder of Regulation S-P, which broadly governs the treatment of all nonpublic personal information, the disposal rule only applies to the disposal of information obtained or derived from a “consumer report” as defined in FCRA. The SEC release adopting the amendments clarifies that information that is derived from a consumer report but “does not identify individuals, such as aggregate information or blind data is not covered by the [Rule’s] definition of ‘consumer report information.’”
The disposal rule is intended to provide entities flexibility in determining what constitutes reasonable measures based upon their particular circumstances. As discussed in the release proposing the disposal rule, in making this determination, an entity should consider the sensitivity of its consumer report information, its size and the complexity of its operations, the costs and benefits of different disposal methods, and relevant technological changes. Also, reasonable measures may require elements such as the establishment of policies and procedures governing disposal and appropriate employee training. To the extent an entity already has policies and procedures governing the disposal of information under Regulation S-P, such policies and procedures might be used to satisfy the requirements of the safeguard rule.
The compliance date for the revised rule is July 1, 2005. The SEC has, however, provided registrants until July 1, 2006 to revise their existing contracts with service providers for services involving the disposal or destruction of consumer report information.
SEC releases final rule requiring registration of Hedge Fund Advisers
December 10, 2004 8:55 AM
On December 2, 2004, the SEC published a release (the “Release”) adopting new Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”), which requires hedge fund advisers to register with the SEC, and related rule amendments.
On December 2, 2004, the SEC published a release (the “Release”) adopting new Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”), which requires hedge fund advisers to register with the SEC, and related rule amendments. The Rule requires advisers to “private funds” to “look through” the funds and count the number of investors (rather than the fund) when determining whether the advisers are eligible for the Advisers Act’s exemption for advisers with 14 or fewer clients. A “private fund” is a fund that (1) would be an investment company but for the exceptions in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, (2) permits owners to redeem their ownership interests within two years of purchase, and (3) is offered based on the investment advisory skills, ability or expertise of the adviser.
“Look Through” Provision
Rule 203(b)(3)-2 requires investment advisers to count each owner of a “private fund” as a separate client for the purpose of determining whether the adviser is exempt from registration pursuant to the 14-client limit under Section 203(b)(3). A “private fund” is defined in the Release as any pooled investment vehicle:
The definition of “private fund” expressly excludes any fund that (1) has its principal office and place of business outside the U.S.; (2) makes a public offering of its securities in a country other than the U.S.; and (3) is regulated as a public fund under the laws of that other country. In addition, Rule 203(b)(3)-2(b) expressly requires investment advisers to count separately the shareholders in each registered investment company that invests in the “private fund.”
Rule 203(b)(3)-2 does not require an adviser to count itself or certain of its knowledgeable advisory personnel who are “qualified clients” as a client for purposes of the private adviser exemption. An adviser to a private fund may also exclude the value of its interests, and the interests of these insiders in the private fund when calculating the firm’s assets under management for purposes of the $25 million registration threshold. In addition, under rule 203(b)(3)-2, a hedge fund adviser whose investors include a fund of funds that is itself a “private fund” must look through that “top tier” private fund and count that fund’s investors as clients for purposes of the private adviser exemption. If the fund of funds is a registered investment company, rule 203(b)(3)-2(b) requires the adviser to an underlying private fund to look through the investment company and to count its investors as clients for purposes of the exemption.
The Rule excludes from the definition of “private fund” any fund that does not permit its owners to redeem any portion of their ownership interests within two years after the purchase of those interests. The two year condition applies to each interest purchased or amount of capital contributed to the fund. The exclusion for managers of funds with two-year lock-up periods is intended to distinguish, and exclude from registration requirements, managers of venture capital, private equity and buy-out funds, where capital is generally committed indefinitely and investors generally are not able to request withdrawals or redemptions of capital, but receive distributions periodically when the fund receives proceeds from an investment. The Rule permits a fund to offer redemption rights under extraordinary circumstances (i.e. death of the investor, death of key advisor personnel, merger or reorganization of the adviser, regulatory compliance) without being considered a private fund under the Rule. In its Release, the SEC eliminated the proposed requirement that the circumstances be “unforeseeable.” The redemption test also does not restrict the general partner or investment adviser from initiating distributions payable to all owners, or a class of owners, in accordance with the fund’s governing documents. The Rule also provides an exception to the two-year redemption test for interests acquired through reinvestment of distributed capital gains or income.
The Rule requires hedge fund advisers located offshore to look through all private funds that they manage and count each investor that is a U.S. client as a separate client for purposes of determining whether the offshore adviser is subject to U.S. registration. Applying this concept, if an offshore adviser managed three offshore funds that have in the aggregate 15 or more U.S. residents as investors, the offshore adviser would be required to register as an investment adviser under the Advisers Act. The determination of whether an investor is a U.S. client or a non-U.S. client is made at the time of the investment in the private fund. If an investor is a non-U.S. client at the time of that investment, the adviser may continue to count the investor as a non-U.S. client even if the investor subsequently relocates to the United States.
In a purported effort to ease the transition of newly registered hedge fund managers to being regulated under the Advisers Act, the Release also contains amendments to the recordkeeping provision in Rule 204-2 and the restrictions on charging performance fees in Rule 205-3.
Custody Rule Amendments
Rule 206(4)-2 governs custody of the assets and securities of clients of registered investment advisers. This custody rule permits advisers to pooled investment vehicles to satisfy their obligation to deliver custody account information to investors by distributing the pool’s financial statements, audited in accordance with generally accepted accounting principles, to investors within 120 days after the pool’s fiscal year end. In recognition of the fact that many funds of hedge funds cannot meet this 120-day deadline, the SEC has amended this custody rule to permit an adviser to a fund of hedge funds to satisfy the periodic reporting requirements by distributing audited financial statements to investors within 180 days after the fund's fiscal year end.
Counting Clients For Purposes Other Than Registration Requirements
The Release was not intended to amend advisers’ method of counting clients for purposes the registration requirements discussed above. Rule 222-2 governs the counting of clients for purposes of applying the national “de minimis” standard for state adviser registration and Rule 203A-3(4) concerns supervised persons that must count clients for purposes of the definition of “investment adviser representative.” The Release amends both Rules 222-2 and 203A-3 to clarify that advisers and supervised persons may, for purposes of those rules, count clients as provided in rule 203(b)(3)-1 without regard to the look through requirements in Rule 203(b)(3)-2.
The SEC staff has also amended Form ADV to require advisers that manage “private funds” to identify themselves as hedge fund advisers in Item 7.B of Part 1A of Form ADV and Section 7.B on the Schedule D.
The effective date of the amendments to Rule 206(4)-2 and Form ADV is January 10, 2005. The effective date of the remaining provisions of the Release is February 10, 2005. Advisers must respond to the amended items of Form ADV in their next Form ADV filing after March 8, 2005. By the compliance date, February 1, 2006, each adviser required to register under the new Rule 203(b)(3)-2 must have its registration effective, and must have in place all policies and procedures required under the Advisers Act. In addition, advisers must apply the two-year redemption test to any investments made on or after February 1, 2006, whether those investments are made by new or existing investors, but need not apply this test to investments made prior to the compliance date.
The Release included a dissent from SEC Commissioners Glassman and Atkins. The dissent stated that Commissioners Glassman and Atkins favor collecting information about hedge funds from other regulators and market participants, or through a notice filing requirement. They also stated that mandatory registration is not justified by the growth of hedge funds, and it will not address the growth in hedge fund fraud or the “retailization” of hedge funds. The Commissioners stated that retail investors’ exposure to hedge funds is limited and can be protected through more effective means than registration, such as increasing the sophistication criteria for hedge fund investors or requiring registration for advisers to funds of funds that target to retail investors (as well as their underlying investee funds). Commissioners Glassman and Atkins stated that it is inappropriate for the SEC’s limited resources to be allocated away from protection of mutual fund investors in favor of more sophisticated hedge fund investors. They noted the increased costs that hedge fund advisers will incur because of registration.
SEC Release No. IA-2333; File No. S7-30-04 (December 2, 2004)