Investment Management Industry News Summary - January 2000

Investment Management Industry News Summary - January 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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DOL Issues Opinion Clarifying Application of Prohibited Transactions Rules to the Payment of Performance Based Compensation to Advisers

January 28, 2000 12:43 PM

The DOL issued an advisory opinion in which it concluded an ERISA plan's (a "Plan") payment of performance based fees to an investment adviser does not, in itself, violate Section 406(b) of ERISA. However, the DOL was unable to provide similar relief when considering the validity of the compensation arrangement "in operation" due to the possibility that the investment adviser's provision of services under the performance based fee structure could result in a divergence of interests between the investment adviser and the Plan in violation of Sections 406(b)(1) and (b)(2) of ERISA.

By written agreement with several Plans, the adviser invests certain Plan assets in commodity futures contracts and in options on commodities and commodity futures contracts. For some clients and some trading programs, the adviser's fee includes an annual performance fee. Any earned performance fee is paid on an agreed-upon date at the end of an annual performance period, which is generally December 31 of each year. The performance fee is established, through arms-length negotiation, as a specified percentage of the amount by which "cumulative profits" of a Plan's account at the end of a performance period exceeds the highest level of cumulative profits for the account as of the end of any prior performance period. Under the terms of some of its performance based fee arrangements, the adviser is entitled to a performance fee only if the cumulative profits of an account, in addition to exceeding the highest level of prior cumulative profits for that account, also exceed a preestablished "hurdle rate" which is based on the performance of an index selected by the Plan's independent fiduciary. Client Plans must pay a fixed fee and brokerage costs regardless of whether the adviser earns a performance fee for any performance period.

The DOL concluded that the performance-based compensation depended solely on a comparison of an account's current performance to its prior performance and, in some cases, to an independent performance standard. Accordingly, the adviser was not exercising any of its fiduciary authority or control to cause the Plan to pay an additional fee. Therefore, the DOL concluded that the payment of a performance fee did not, by itself, violate Section 401(b)(1). Similarly, the DOL concluded that the fee arrangement would not constitute a violation of Section 406(b)(2) because the adviser did not appear to be acting on behalf of, or representing, a person whose interests were adverse to the Plan. Section 406(b)(1) prohibits a Plan fiduciary from dealing with Plan assets in his own interest or for his own account. Section 406(b)(2) prohibits a Plan fiduciary, in his individual or any other capacity, from acting in any transaction involving the Plan on behalf of a party (or representing a party) whose interests are adverse to the interest of the Plan or the interests of its participants and beneficiaries.

The DOL did not, however, rule on the validity of the compensation arrangement in operation, concluding that if the adviser's provision of services under the performance based fee structure resulted in a "divergence of interest" between the adviser and the Plan, Sections 406(b)(1) and (b)(2) could be violated. For example, the DOL noted that if an account incurred substantial losses in a short period of time, the Plan's interest in minimizing loss and the adviser's interest in earning the performance fee may cause the adviser's appetite for risk to exceed the level of risk tolerance appropriate for the Plan. The DOL also indicated that this conflict might affect the adviser's allocation of investment opportunities between the account of a Plan and other client accounts.

The advisory opinion also underscored the duties of Plan fiduciaries in hiring investment advisers, noting that a Plan fiduciary must prudently consider its decision to enter into a performance based compensation arrangement. The Plan fiduciary must also fully understand the risks involved in the particular types of investments made by the adviser and regularly monitor the activities of the adviser, taking action where appropriate. This monitoring must be adequate in light of the particular nature of the investments and fee arrangement. The DOL commented on the potential for co-fiduciary liability arising from a breach committed by any Plan fiduciary. Department of Labor Advisory Opinion (December 9, 1999).

 
 



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 Orders Securities Markets to Begin Trading in Decimals on July 3, 2000

January 28, 2000 12:38 PM

The SEC ordered all U.S. securities markets, including the New York Stock Exchange, all of the regional stock exchanges and the Nasdaq stock market, to begin quoting securities prices in decimals by July 3, 2000. The SEC order requires the markets to submit a decimals pricing implementation plan within 45 days and requires the options and equity markets to phase-in decimal pricing by year end. During the phase-in period, the markets can quote equity securities in pricing increments of up to $.05. The markets must also create and conduct a pilot program during the phase-in period in which a sample of securities will be quoted in $.01 increments. At the end of the six-month phase-in period, the markets must submit a study to the SEC regarding the impact of decimal pricing on trading and capacity. The study will also address whether a uniform pricing increment is needed, and if so, what that increment should be.

The SEC stated that it believes that decimal trading will benefit investors by allowing greater competition and by making it easier for investors to compare prices. The SEC also believes that decimal trading will bring about consistency with foreign markets which now trade in decimals. SEC Release No. 34-42360 (January 28, 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.

Commenters Urge Modification to Householding Rules

January 28, 2000 12:33 PM

The Investment Company Institute ("ICI") has proposed certain changes to the SEC's proposed rule governing the householding of proxy and information statements as well as changes to the SEC's final rules governing the householding of prospectuses and shareholder reports. The SEC adopted new rules under the Securities Act of 1933 (the "1933 Act") enabling issuers and broker-dealers to satisfy prospectus delivery requirements for two or more investors sharing the same address by sending a single prospectus (i.e., "householding" the prospectus). The SEC adopted similar amendments to the proxy rules governing the delivery of annual reports to shareholders and to the rules under the 1940 Act governing the delivery of semi-annual reports to mutual fund shareholders. The SEC also proposed amendments to the proxy rules to permit companies and other persons to satisfy the proxy and information statement delivery requirements with respect to two or more shareholders sharing the same address by sending a single proxy or information statement to the shareholders. (See Industry News Summary for the week of 11/1/99 to 11/8/99).

The ICI urged the SEC to shorten the 90-day notice requirement in the case of proxy and information statements so that it conforms to the 60-day notice requirement for prospectuses and shareholder reports. The ICI commented that the extra 30 days for proxy mailings is not necessary and would impose additional complexities and costs on mutual funds designing their computer systems to implement both a 60-day and 90-day notice period. The ICI also commented that the requirement that the implied consent notice be mailed separately from other shareholder communications is not necessary and will impose additional costs on funds. The ICI suggested that the notice and the envelope containing the information include a prominent legend advising of an "important notice regarding the delivery of shareholder documents."

The ICI also urged the SEC to change the requirement that householding pursuant to implied consent may be used only for persons who share the same last name. The ICI noted that many married women no longer take their husband's last names. The ICI also urged the SEC to allow more flexibility in the addressing of householded material, noting that the conventions adopted by the SEC conflict with many funds' standard practices. The ICI commented that as long as the correct street address appears, each shareholder will have access to the material regardless of the first line of the address. The comment period on the SEC's proposal governing the delivery of proxy and information statements closed January 18, 2000. SEC Today, Vol. 2000-14, Friday, January 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.

U.S. District Court Denies Adviser's Motion to Dismiss Amended Complaint Challenging Director Independence

January 28, 2000 10:37 AM

The U.S. District Court for the Southern District of New York denied an investment adviser's motion to dismiss a shareholder's amended complaint alleging breach of fiduciary duty by the adviser under Sections 36(a) and (b) of the Investment Company Act of 1940 (the "1940 Act"). The plaintiff, a shareholder of Brazilian Equity Fund, Inc. (the "Fund"), alleged that less than 40% of the directors of the funds advised by the adviser, including the Fund, were independent because the directors received substantial fees from the funds for their service on multiple fund boards. This board composition would violate Section 10(a) of the 1940 Act.

The plaintiff further alleged that the advisory agreement between the adviser and the Fund could not have been properly approved as required by Section 15(c) of the 1940 Act because the directors had been "interested persons" under the 1940 Act. As a result, any compensation paid to the adviser was wrongly received. The plaintiff concluded that the fees paid to the adviser under the advisory agreement should be disgorged pursuant to Section 36(b) of the 1940 Act.

The court had previously dismissed plaintiff's Section 36(b) claim on the grounds that plaintiff failed to make any specific allegations that the fee paid to the adviser was excessive. (See Industry News Summary for week of 3/29/99 to 4/5/99). The plaintiff then amended his complaint to bring a shareholder derivative claim under Section 36(a) under the 1940 Act and added additional facts to support his Section 36(b) claim.

In its motion to dismiss plaintiff's Section 36(a) claim, the adviser argued that the plaintiff: (1) failed to name the Fund as a defendant; (2) failed to make pre-suit demand on the Fund's board of directors; and (3) failed to state a claim. The court granted the adviser's motion to dismiss plaintiff's Section 36(a) claim for failure to join the Fund as a defendant, but granted plaintiff leave to amend in his complaint and anticipated that he would do so. Turning to the adviser's second objection, the court determined in reliance upon an earlier court decision that well-compensated service on multiple boards of funds managed by a single fund adviser can, in certain circumstances, be indistinguishable in all relevant respects from employment by the Fund adviser, which "admittedly renders a director interested." The court then held that the plaintiff alleged facts sufficient to maintain a course of action predicated on the adviser's control over the non-employee directors. The court then stated that the adviser's third objection was based on the assumption that the plaintiff had not adequately pled that the non-employee directors were "interested." The court indicated that it had directly rejected this point in its consideration of the adviser's second objection.

The court then denied the adviser's motion to dismiss the Section 36(b) claim, noting that the 6-factor test set forth in Gartenberg v. Merrill Lynch Asset Management, Inc. to determine whether fees charged by an adviser were disproportionate to the services rendered is not appropriately applied at the pleadings stage. The court stated that the inquiry at this stage should be whether the amended complaint alleges sufficient facts to make out a claim under the more general Gartenberg formula that "the adviser must charge a fee that is so disproportionately large that it bears no reasonably relationship to the services rendered." Under this formulation, the court noted that it is impossible to say, as a matter of law, that the allegations provided by the plaintiff are not sufficient to state a claim under Section 36(b). Plaintiff had alleged in the amended complaint: (1) that the adviser's fee was twice the amount of the average advisory fee in the 1960s; (2) that of 85 world equity funds, only 18 had a higher expense ratio than the fund and of the 67 remaining funds, the fund reported the worst 1-year market return: a loss of 53.5%; (3) that the adviser only provides services for which it receives compensation; (4) that the adviser operates to benefit itself rather than the shareholders; and (5) that during the 1998 and 1997 fiscal years, the adviser's net fees equaled 42.3% and 46.0% of the fund's total investment income. Strougo v. Bea Associates, 98 Civ. 3725 (S.D.N.Y. Jan. 19, 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.

NASD Urges Disclosure to Customers Engaging in Extended Hours Trading

January 17, 2000 3:32 PM

The NASD issued Notice to Members 00-07 to remind members of their obligation under the NASD's advertising rules to disclose to customers the material risks of extended hours trading. The Notice also includes model risk disclosure for extended hours trading.

The NASD noted that a number of member firms have begun to offer their retail customers various opportunities to trade stocks after regular market hours in what is know as "extended hours trading." The NASD cautioned that extended hours trading can entail significant additional risks over trading during regular market hours, including: lower liquidity; changing prices; unlinked markets; exaggerated effects from news announcements; and wider spreads. The NASD stated that, in light of these material risks, members have an obligation to disclose these risks of extended hours trading to their customers before permitting them to engage in extended hours trading. The NASD commented that in preparing disclosure regarding extended hours trading, members should review the types of disclosure suggested in Notice to Members 99-11, which describes the types of general disclosure the firms may use to inform their customers about the risks associated with stock volatility. The NASD commented that members may need to develop additional disclosures to address such issues as options trading, options exercises, the effect of stock splits, dividend payments, and any additional risks that may arise in the future. NASD Notice to Members 00-07, January 10, 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.

NASD Board Unanimously Approves Major Restructuring

January 17, 2000 3:28 PM

The Board of Governors of the NASD unanimously approved a major restructuring of the NASD on January 4, 2000. Specifically, the Board authorized the NASD staff to proceed with the proposed restructuring and recapitalization of the NASDAQ stock market and to conduct a vote of NASD membership to approve the restructuring. The restructuring will be effected through the sale of a substantial stake in NASDAQ to a limited number of market participants and issuers and to all NASD members in two private placements of stocks and warrants. After the restructuring is completed, the NASD expects to retain a minority stake of approximately 22% in NASDAQ.

According to the NASD, the goals of the restructuring are to:

  • streamline NASDAQ's corporate governance so that NASDAQ can more efficiently respond to changing market conditions and institute new market driven innovations;
  • separate NASDAQ from the NASD and NASD Regulation in an attempt to minimize potential conflicts of interests;
  • strategically re-align the ownership of NASDAQ by enlisting a broad class of investor-owners interested in NASDAQ's long term success;
  • create a financially stronger NASDAQ that is better able to address competitive challenges and to invest in new technology; and
  • generate proceeds of up to $500 million that will support the operation of the NASD, which will continue to own NASD Regulation and will remain the principal self-regulatory organization responsible for the securities markets.
 
 



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.

Delaware Supreme Court Restores Breach of Fiduciary Claim Against Broker

January 17, 2000 3:24 PM

The Delaware Supreme Court in O'Malley et al v. Boris, Del., No. 59 (December 8, 1999) reinstated a class action claim alleging that a broker violated its fiduciary duty to its clients by failing to provide full disclosure regarding a change in the money market fund used for its sweep accounts. Specifically, the plaintiffs alleged that the broker-dealer breached its fiduciary duties of disclosure and loyalty by changing the sweep account fund for its benefit and by failing to provide the affected clients with adequate disclosure of the joint venture between the broker and the money market fund.

The broker had notified its money market sweep account clients in September 1996 through a negative response letter stating that cash balances in client accounts would be swept into a different money market fund beginning November 1, 1996 unless clients objected. A copy of the new money market fund's prospectus was included with the negative response letters. The plaintiffs did not object to the change at the time but later learned that the broker had entered into a joint venture agreement with the money market fund whereby the broker would acquire a 20.2% interest in the venture in return for using the fund as a sweep vehicle. The lower court dismissed the plaintiffs' complaint, having found that the prospectus and notification letter "strongly implied" the nature of the broker's interest in the joint venture and that the disclosures made by the broker were adequate as a matter of law.

In reinstating the suit, the Delaware Supreme Court rejected the broker's argument that plaintiffs' state law claim alleging breach of fiduciary duty was preempted by federal law. The broker had argued that the National Association of Securities Dealers ("NASD") regulates the use and content of negative response letters by broker-dealers in NASD Rule 2510(d)(2). The court concluded that there was no direct conflict between the NASD's rule governing negative response letters and the broker's fiduciary duty under state law because full disclosure of the broker's interest in the money market fund would not interfere with the purpose or effectiveness of the NASD rule allowing negative response letters.

The court then addressed the broker's argument that it had provided adequate disclosure of the broker's ownership interest in the money market fund's sponsor. The lower court had found, based on the prospectus disclosure, that a reasonable investor would determine that the broker was using its customer base to participate in the venture with the money market fund. The Delaware Supreme Court concluded that the prospectus disclosure left open at least two reasonable possibilities as to how the broker-dealer acquired its initial 20% interest in the fund sponsor: (1) by investing its own money, or (2) by transferring its clients' money. The court stated that it could not conclude that reasonable investors, knowing that the broker stood to profit from the switch in sweep account funds, would not consider it important to know what the broker exchanged for its initial share in the venture.

The court then turned to the question of whether something less than a direct statement of the material facts satisfied the broker's fiduciary duties to its customers. The court stated that full disclosure requires more than strong inferences and that investors should not be required to correctly "read between the lines" to learn all the material facts to the transaction at issue. The court concluded that under these circumstances the information about how the broker acquired its interest cannot be deemed to have been disclosed and thus the plaintiffs' disclosure claim must be reinstated.

 
 



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.

Court of Appeals Upholds SEC's Sanctions Against Investment Adviser

January 17, 2000 3:17 PM

The U.S. Court of Appeals in Valicenti Advisory Services, Inc. v. SEC, Docket No. 99-4002 (2d Cir. Nov. 30, 1999) upheld the findings and the sanctions imposed by the SEC in an enforcement proceeding against an investment adviser and its sole owner relating to the use of marketing materials. The SEC had alleged that during 1992 the adviser had distributed to prospective clients a chart that purported to show the adviser's rate of returns on its "total portfolio" between 1987 and 1991. A footnote to the chart indicated that the displayed figures represented a composite of discretionary accounts with a balanced objective.

The SEC found the adviser's chart to be materially misleading because:

  • a reasonable investor would have understood a "composite" to include all "discretionary accounts with a balanced objective";
  • the chart reflected the performance of only a selected portion of the adviser's balanced accounts; and
  • the rate of return indicated on the chart was more than seven percentage points higher than it would have been had the chart included all of the adviser's balanced accounts for the year.

In addition, the SEC found that the adviser deliberately disregarded its marketing manager's recommendation that the chart disclose additional information such as the methodology used to create the composite, the number of accounts reflected in the composite and the value of the largest and smallest accounts in the composite. Based on these findings, the SEC censured the adviser and its owner, assessed a $75,000 fine and required the adviser to send copies of the SEC's opinion and order to all existing clients and prospective clients for the next year.

The adviser appealed the SEC's decision, arguing that it did not act with intent to mislead and that the chart was not in fact materially misleading. The adviser also argued that it was denied due process by the SEC and that the SEC had abused its discretion in imposing sanctions. The court found in favor of the SEC on all issues raised on appeal.

  • Scienter: The court commented that the adviser essentially argued that the court should draw inferences from the evidence contrary to those drawn by the SEC. The court concluded that it could not find that the SEC lacked such relevant evidence as a reasonable mind might accept as adequate to support its conclusion. Accordingly, the court upheld the SEC's findings that the adviser acted with the deliberate intent to defraud.
  • Materiality: The court deferred to the SEC's finding and affirmed that the 7% disparity between reported and actual performance made the chart materially misleading.
  • Denial of Due Process: The adviser argued that the SEC had not promulgated regulations articulating specific standards for performance advertising. As a result, the adviser did not receive fair notice of what constitutes a regulatory violation. The court stated that due process requires that laws give the person of ordinary intelligence a reasonable opportunity to know what is prohibited. The court rejected the adviser's due process claim noting that, because the adviser was a registered adviser and its owner had worked in the investment advisory industry since 1967, it could not credibly claim lack of fair notice of the rules against defrauding investors.
  • Abuse of Discretion Imposing Sanctions: The court noted that abuse could be found if the sanctions were either unwarranted in law or without justification in fact. The court concluded that, having upheld the SEC's finding that petitioners acted with intent to defraud, the monetary sanctions, the cease and desist order and the client notification requirement were all justified under the circumstances. The court also rejected the adviser's argument that the SEC abused its discretion by imposing the client notification requirement. The court noted that the Investment Advisers Act of 1940 explicitly permits the imposition of sanctions that are plausibly more severe than the client notification requirement, including the revocation of the adviser's registration and suspension for up to 12 months. Each of these sanctions would likely result in greater loss of income and stigmatization than having to furnish copies of the SEC's opinion and order to existing and prospective clients for one 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.

SEC Adopts Updated EDGAR Filer Manual

January 17, 2000 8:38 AM

The SEC has adopted an updated edition of the EDGAR Filer Manual and is providing for its incorporation by reference into the Code of Federal Regulations. The new edition of the EDGAR Filer Manual (Release 6.75) will be effective on January 24, 2000. The SEC has updated the manual to add new form types and delete several old ones. Electronic copies of the electronic Filer Manual are available on the SEC's web site.

 
 



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.

Court Rules Third-Party Administrator to Company Retirement Plan Did Not Become an ERISA Fiduciary

January 10, 2000 3:12 PM

The Ninth Circuit Court of Appeals, in CSA 401(k) Plan v. Pension Professionals, Inc., affirmed the District Court's ruling that a third-party service provider did not become an ERISA fiduciary when, after discovering that a plan fiduciary may have embezzled plan assets, it notified plan trustees of the deficiencies and took affirmative steps to encourage repayment. In the case, Pension Professionals, Inc. ("PPI") was hired by a company to prepare financial reports and to perform other third-party administrative services for the company's employee benefit plan (the "Plan"). The terms of the agreement between the company and PPI specified that PPI was to provide its services as a third-party administrator and not as a fiduciary of the Plan. Six months after starting, PPI discovered that certain employee contributions had not been deposited in the Plan by the Plan's trustees, who were executive officers of the company. PPI suspected that the company's CEO, co-trustee of the Plan, was embezzling the funds. PPI formally notified the Plan's trustees, including the CEO, that the failure to deposit employees' funds into the retirement accounts violated IRS and Department of Labor regulations and could be classified as both embezzlement and a breach of their fiduciary duties under ERISA. PPI agreed to continue its services as third-party administrator for the Plan only after the CEO agreed to meet certain conditions, including the repayment of the misappropriated funds and the disclosure to participants of the situation. PPI later received falsified financial statements from the company and resigned as third-party administrator. PPI did not notify law enforcement authorities or Plan participants of the suspected embezzlement.

The court concluded that PPI was not liable as an ERISA fiduciary because its action upon the discovery of the missing funds did not rise to the level of exercising discretionary authority or control over the Plan. The Court also stated that ERISA does not impose "good samaritan" liability and that, as a non-fiduciary, PPI did not have a duty to report its suspicions regarding the embezzlement to Plan participants. CSA 401(k) Plan v. Pension Professionals, Inc., 1999 U.S. App. LEXIS 30404 (9th Cir., Nov. 23, 1999).

 
 



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.

IRS Provides Penalty Relief for Y2K Related Problems

January 10, 2000 3:08 PM

The IRS announced that it has taken steps to provide penalty and interest relief to taxpayers and businesses who might be unable to comply with the tax laws because of Y2K related problems beyond their control. The IRS noted that it can provide Y2K tax penalty and interest relief in cases where:

  • Taxpayers make a reasonable effort to become Y2K compliant.
  • A Y2K failure significantly affects the taxpayer's ability to comply with the tax laws, such as inability to file on time or make tax payments or deposits on schedule.
  • The tax law violation was unavoidable due to a Y2K failure or as a result of a Y2K related effort to prevent disruption of essential services.
  • Taxpayers alert the IRS about the problem.

According to the announcement, taxpayers that encounter Y2K problems having an impact on their tax returns or other elements involving tax or compliance generally should: (1) notify the IRS as soon as possible after the discovery by calling 1-800-829-1040; (2) take prompt action to fix the Y2K problem after discovery; and (3) consider alternative ways to comply with the tax law.

The IRS noted that if a business filer's return is ordinarily due on January 31, 2000 and is affected by Y2K related computer problems, the business filer should contact the IRS as soon as possible. The IRS also noted that businesses encountering problems distributing Forms W-2 or 1099 should notify employees or payees of any delay and may request a 15-day extension of time by making an extension request in writing to the IRS before January 31, 2000. If businesses have a Y2K related problem involving federal tax deposits, they are instructed to notify the IRS within five days of discovering the problem, take appropriate steps to fix the problem within 30 days of discovery and pursue alternative ways to make the deposits. IRS News Release. December 22, 1999.

 
 



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 Generic Comment Letter for Investment Company CFOs

January 10, 2000 3:02 PM

John S. Capone, Chief Accountant of the SEC's Division of Investment Management, issued the Division's annual industry comment letter to assist investment companies and their independent public accountants with certain accounting matters. The comments address a number of issues that have come to light during the staff's review of registrants' filings. A summary of the Division's comments follows:

Management's statement regarding compliance with Forms N-17f-1, N-17f-2 and ADV-E: Rules 17f-1 and 17f-2 under the Investment Company Act of 1940 (the "1940 Act") require an independent accountant to conduct an examination when the securities held by a regulated entity are maintained in the custody of a member of a national securities exchange or when the fund itself maintains custody. Rule 206(4)-2 under the Investment Advisers Act of 1940 requires a similar examination when the adviser has custody of client assets. In each case the independent accountant must issue a report attesting to the management's compliance with these rules. This report is based upon a statement from management of the fund's adviser that it has complied with the rules. The staff noted that a complete filing requires registrants to attach management's statement regarding compliance to the auditor's report on Forms N-17f-1, N-17f-2 and ADV-E.

Accounting for reimbursement of expense waivers: The staff urged fund management to consider the collectability of any receivable from an adviser, particularly in circumstances where the adviser is not fully paid as frequently as the adviser receives payment for services under the advisory agreement. The staff reminded auditors of the funds' financial statements of the requirement under generally accepted auditing standards to satisfy themselves that receivables from an adviser or third party are properly valued to reflect collectability concerns. The staff noted that when receivables from fund advisers under expense reimbursement plans have been outstanding for periods beyond one year, the fund should set aside corresponding valuation reserves reducing the outstanding receivable balance for potentially uncollectable amounts.

Financial highlights and fee table disclosures: The staff noted that a number of registrants have incorrectly calculated the ratio of expenses to average net assets ("the expense ratio"). The staff clarified that the expense ratio is calculated by dividing total expenses by average net assets and that it is incorrect to reduce total expenses by brokerage offsets, custodial credits and/or other expense reductions when calculating the expense ratio. It is also inaccurate to exclude interest and dividend expenses attributable to securities sold short from total expenses. The staff reminded registrants that total expenses may only be reduced by fee waivers or reimbursements in the financial highlights table. The staff noted that only contractual waivers or reimbursements may be used to reduce expense percentages in a prospectus fee table. Registrants may not reduce fund expense ratios with custodial credits and/or other third party offset arrangements.

Holding period for seed capital shares: The staff commented that it has received a number of comments regarding the holding period for shares purchased pursuant to Section 14(a) of the 1940 Act as part of the fund's initial registration with the SEC. Section 14(a) has been interpreted to mean that a new investment company cannot make a public offering of its securities unless the company has a bona fide net worth of $100,000. That amount cannot be loaned or redeemed as a temporary accommodation by persons who made the investment nor can there be any intention when the investment is made to redeem or dispose of the investment.

The staff noted that some registrants appear to believe that the holding period for seed capital shares is related to the period over which a fund amortizes the organizational costs. That view appears to have been the result of the staff's position that if any original shares are redeemed during the five-year amortization period, then the redemption proceeds must be reduced by any unamortized organizational costs. The staff noted that registrants have incorrectly interpreted this requirement to suggest that there is a minimum five-year holding period for seed capital shares. The staff also noted that the ability to capitalize and amortize organizational costs over a five-year period was eliminated with the implementation of AICPA SOP 98-5. The staff commented that the legality of a sponsor redeeming seed capital shares depends on the facts and circumstances of the redemption and is not based on the accounting for organization costs.

Adviser accounting for offering costs: The staff noted that the Financial Accounting Standards Board ("FASB") concluded in Emerging Issue Task Force Topic No. D-76 that an adviser could not capitalize the offering costs of closed-end funds because the adviser was not receiving both a continuing distribution fee and a contingent deferred sales charge or early withdrawal charge. In an update to Topic No. D-76, the FASB staff concluded that an adviser to a hybrid closed-end fund may capitalize initial offering costs if the adviser receives both the distribution fee and early withdrawal charges. The staff commented that it would not object to the capitalization of initial offering costs by these advisers if the investment company registrant has received an exemptive order permitting both distribution fees and early withdrawal charges.

Independence Standards Board recordkeeping requirements: The staff noted that the Independence Standards Board issued a standard which requires auditors to discuss their independence with either the company's audit committee or board of directors. Auditors must disclose, in writing, all relationships between the auditor and its related entities that may impact an auditor's independence. Auditors must also affirm, in writing, that in their judgment they are independent of the company. The staff reminded registrants that this correspondence is subject to inspection during periodic and other reviews.

Issuance of AICPA Audit and Accounting Guide: The American Institute of Certified Public Accountants ("AICPA") approved the AICPA Audit and Accounting Guide for Investment Companies on September 14, 1999. The staff noted that the audit guide outlines changes to existing practices that, in certain areas, differ from the requirements of Regulation S-X under the federal securities laws. The staff reminded registrants that, notwithstanding the audit guide, the financial statements of registered investment companies must be prepared in accordance with the requirements of Regulation S-X.

Financial statements submitted via EDGAR: The staff reminded registrants that all semi-annual and annual reports must be filed with the SEC within 10 days of distribution to shareholders. December 30, 1999.

 
 



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 Fines Adviser for Employee's Unauthorized Trading

January 10, 2000 2:59 PM
The SEC censured and fined an investment adviser for allowing a trader to lose more than $16 million of clients' money in unauthorized derivative trades. The adviser was cited for inadequate oversight and failure to supervise the former derivatives trader. According to the SEC's findings, the former fixed income derivatives trader executed more than 100 unauthorized trades between July 1997 and October 1998 in twelve accounts, including mutual fund accounts. The adviser's derivatives trading desk had authority over the former trader's trading strategy but allowed the former trader to exceed the limits set by the trading desk. The SEC found that the former trader also made unauthorized trades, mostly in the U.S. Treasury futures market, by forging the signatures of portfolio managers on their order tickets or by not submitting order trade tickets at all. Over the 15 month period, the former trader was responsible for losses of $13 million for one mutual fund client and losses of $16.3 million overall. The SEC barred the former trader from working for any investment adviser or investment company for a period of five years. The former trader's supervisor at the adviser was fined $10,000 and suspended for nine months from supervisory roles at investment advisory firms. The Wall Street Journal, Thursday, December 23, 1999.
 
 



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 Issues Notice to Members Concerning Amendments to Sales Charge Rules

January 3, 2000 2:46 PM

The NASD recently issued a notice to members summarizing the SEC's approval of amendments to NASD Conduct Rule 2830 governing mutual fund sales charges. (See Industry News Summary, Week of November 15-29, 1999). Generally, the amendments revise Rule 2830 to:

  • provide maximum aggregate sales charge limits for fund-of-funds arrangements;
  • permit mutual funds to charge installment loads;
  • prohibit loads on reinvested dividends;
  • impose redemption order requirements for shares subject to contingent deferred sales charges; and
  • eliminate duplicative prospectus disclosure.
 
 



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.

DOL Proposes Class Exemption for Cross Trades of Securities by Index and Model-Driven Funds

January 3, 2000 9:39 AM

The DOL recently published notice of a proposal that would exempt from the prohibited transactions provisions of the Employee Retirement Income Security Act of 1974 ("ERISA") and the Federal Employees' Retirement System Act ("FERSA"), cross trades between certain "passive" ( i.e., index and model-driven) large accounts and funds (collectively, "funds") where at least one of the funds holds plan assets subject to ERISA or FERSA. The proposal also would exempt cross trades between a large account and another fund, where at least one of the funds holds plan assets subject to ERISA or FERSA, in connection with certain portfolio restructuring programs.

The proposed exemption would be subject to the following conditions:

  • the cross trade must be executed at the closing price;
  • the cross trade must have occurred as a direct result of certain "triggering events" (defined to include, for example, a change in the index underlying an index fund) if the cross trade involves a model-driven fund, the cross trade must not take place within 10 business days following any change made by the manager to the model underlying the fund; the manager must allocate among cross-trade opportunities among all funds on an objective basis which has been previously disclosed to the authorizing fiduciaries of plan investors; and no more than 10 percent of the assets of the fund at the time of the cross trade may be compromised of employee benefit plans maintained by the manager for its own employees and which the manager exercises investment discretion.

The proposed exemption also would be subject to the following restrictions:

  • Eligible securities would include only those securities that are widely traded (in the case of equity securities) and for which independent market quotations are readily available;
  • The manager may not receive a brokerage fee or commission in connection with the cross trades;
  • The cross trade may not involve any security issued by the manager unless the manager has obtained a separate prohibited transaction exemption; and
  • Participation in cross trading must be authorized in writing by future participating plans, and notice of implementation must be provided to existing investors at least 45 days prior to implementation.

In addition, the proposed exemption includes disclosure requirements, annual notice requirements and extensive recordkeeping requirements. Written comments on the proposed exemption are due on or before February 14, 2000. Federal Register, Vol. 64, No. 240, Wednesday, December 15, 1999, Notices, 70057.

 
 



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 Permits Mutual Fund to Redeem Affiliate's Shares By Means of an In-Kind Distribution

January 3, 2000 9:32 AM

The SEC recently granted no-action relief from Section 17(a) of the Investment Company Act of 1940 (the "1940 Act") to an open-end mutual fund seeking to satisfy a redemption request from an affiliated person of the fund by means of an in-kind distribution of portfolio securities. Section 17(a) of the 1940 Act prohibits any affiliated person of a mutual fund, or any affiliated person of an affiliated person of a fund, from knowingly selling securities (other than shares of the fund) directly to, or purchasing securities directly from, the fund. Accordingly, an in-kind redemption involving an affiliated person of the fund, if deemed a "purchase" or "sale" of securities, could be prohibited under Section 17(a) of the 1940 Act. If prohibited, such transactions could not be effected without the benefit of an exemptive order from the SEC staff.

In its no-action letter, the SEC staff stated that, unlike a cash redemption, in which the only securities involved are shares of the fund, an in-kind distribution does involve a "sale" and a "purchase" of securities and is thus not excepted from Section 17(a). The staff, however, also recognized that there are benefits to redemptions in kind and that, in certain circumstances, redemptions in kind involving affiliated persons can be effected fairly without implicating the concerns underlying Section 17(a) (i.e., prohibiting purchase or sale transactions when a party to the transaction has both the ability and the pecuniary incentive to influence the actions of the fund). Therefore, the staff agreed that a fund may make a redemption in kind to an affiliated shareholder without obtaining an exemptive order, provided that the following conditions are satisfied:

  • the redemption in kind must be effected at approximately the affiliated shareholder's proportionate share of the distributing fund's current net assets, and thus must not result in the dilution of the interests of the remaining shareholders;
  • the distributed securities must be valued in the same manner as they are valued for purposes of computing the distributing fund's net asset value;
  • the redemption in kind must be consistent with the distributing fund's redemption policies and undertakings, as set forth in the fund's prospectus and statement of additional information;
  • neither the affiliated shareholder nor any other party with the ability and pecuniary incentive to influence the redemption in kind may select, or influence the selection of, the distributed securities; the redemption in kind must either:

(a) be approved by the fund's board, including a majority of the independent trustees/directors, after the board makes findings that (i) the redemption will be effected in a manner consistent with the above conditions, (ii) the redemption will not favor the affiliated shareholder to the detriment of any other shareholder (and, in a master-feeder structure, the redemption will not favor the master fund to the detriment of the feeder fund), and (iii) the redemption will be in the best interest of the distributing fund; or

(b) be effected pursuant to procedures adopted by the fund's board, including a majority of the independent trustees/directors, provided that (i) the procedures must specify the method(s) of selection of portfolio securities and be designed to effect redemptions in a manner consistent with the above conditions, (ii) the board, including a majority of the independent directors/trustees at least quarterly must determine that all in-kind redemptions to affiliated shareholders during the quarter were effected in accordance with the procedures, did not favor the affiliated shareholder to the detriment of any other shareholder (and, in a master-feeder structure, did not favor the master fund to the detriment of the feeder fund), and were in the best interest of the distributing fund, and (iii) the fund's board, including a majority of the independent trustees/directors, must make and approve such changes as it deems necessary for monitoring compliance with the above conditions; and

  • the fund must maintain and preserve for a period of at least six years (and at least two in an easily accessible place) a copy of the board's procedures (if any), and records relating to all in-kind distributions, including the composition of the fund's portfolio immediately before the distribution, a description of each security distributed, the terms of the distribution and the information upon which the valuation was based.

The SEC staff noted that adoption of procedures requiring a pro rata redemption in kind (even with certain limited adjustments) generally would address the affiliated transaction concerns. A fund board could, however, adopt procedures or approve a particular transaction using methods other than a pro rata distribution and still address these concerns (e.g., in a master-feeder context, where a pro rata redemption in kind could result in a taxable event to the feeder fund, a master fund board could approve procedures that would require a distribution to a feeder fund of the securities originally contributed by that feeder fund). Finally, the staff noted that those funds having received exemptive orders permitting redemptions in kind may continue to rely on those exemptive orders or may rely on the newly released no-action letter. It is worth noting that the staff did not limit its position to any particular type of affiliated persons as it generally has in exemptive orders. In addition, it should be noted that the no-action letter addresses only in-kind redemptions and not in-kind purchases by affilitaes, which would raise similar issues under Section 17(a). Signature Financial Group, Inc. Ref No. 99-825, Pub. Avail. December 28, 1999.

 
 



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.