Investment Management Industry News Summary - January 2003

Investment Management Industry News Summary - January 2003

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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SEC adopts final rule requiring proxy voting policies and procedures for investment advisers

January 31, 2003 9:07 AM

The SEC has adopted and published new rule 206(4)-6, which prohibits an investment adviser from exercising voting authority as to client securities, unless (1) the adviser has adopted and implemented written policies and procedures that are reasonably designed to ensure that the adviser votes proxies in the best interest of its clients, (2) the adviser describes its proxy voting procedures to its clients and provides copies on request, and (3) the adviser discloses to clients how they may obtain information on how the adviser voted their proxies. Last week’s News Summary contained a brief description of the requirements of the new rule. This week’s Summary contains an expanded description, including final compliance dates.

Advisers subject to the rule. The rule applies, as proposed, to all SEC registered investment advisers registered with us that exercise proxy voting authority over client securities.

Advisers that have implicit as well as explicit voting authority must comply with rule 206(4)-6. The rule thus applies when the advisory contract is silent but the adviser’s voting authority is implied by an overall delegation of discretionary authority. The rule does not apply, however, to advisers that provide clients with advice about voting proxies but do not have authority to vote the proxies.

Policies and procedures. Under rule 206(4)-6, advisers that exercise voting authority with respect to client securities must adopt written proxy voting policies and procedures. They must be reasonably designed to ensure that the adviser votes in the best interest of clients. These procedures must also describe how the adviser addresses material conflicts between its interests and those of its clients with respect to proxy voting.

 

The SEC is not requiring specific policies or procedures for advisers. However, the SEC noted that an adviser’s proxy voting policies and procedures should be designed to enable the adviser to resolve material conflicts of interest before voting client proxies.

 

Voting client proxies. An adviser’s duty of care requires an adviser with voting authority to monitor corporate actions and vote client proxies. Therefore, the adviser should have procedures in place designed to ensure that it fulfills these duties. The SEC noted that it did not conclude that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations. However, the SEC further noted that an adviser may not ignore or be negligent in fulfilling the obligation it has assumed to vote client proxies.

 

Resolving conflicts of interest. An adviser’s policies and procedures under the rule must also address how the adviser resolves material conflicts of interest. The SEC noted that an adviser’s policy of disclosing conflicts to clients and obtaining their consents before voting would satisfy the requirements of the rule and, when implemented, fulfills the adviser’s fiduciary obligations under the Advisers Act. The SEC commented that, in the absence of client disclosure and consent, it believes that an adviser that has a material conflict of interest with its clients must take other steps designed to ensure, and must be able to demonstrate that those steps resulted in, a decision to vote the proxies that was based on the clients’ best interest and was not the product of the conflict.

 

The SEC cited various methods that advisers may use to ensure that proxy votes are voted in their clients’ best interest and not affected by the advisers’ conflicts of interest:

  1. an adviser that votes securities based on a pre-determined voting policy could demonstrate that its vote was not a product of a conflict of interest if the application of the policy to the matter presented to shareholders involved little discretion on the part of the adviser.
  2. an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.
  3. an adviser could also suggest that the client engage another party to determine how the proxies should be voted, which would relieve the adviser of the responsibility to vote the proxies.

The SEC noted that other policies and procedures are also available. The SEC further noted that their effectiveness (and the effectiveness of any policies and procedures) will depend on how well they insulate an adviser’s proxy voting decision from the conflict.

Disclose how to obtain voting information. Rule 206(4)-6 requires advisers to disclose to clients how they can obtain information from the adviser on how their securities were voted. The SEC noted that public disclosure is unnecessary for advisers to communicate to each client how the adviser has voted that client’s proxies. The SEC also noted that public disclosure of proxy votes by some advisers would reveal client holdings and thus client confidences.

Describe policies and procedures. Rule 206(4)-6 also requires advisers to describe their proxy voting policies and procedures to clients, and upon request, to provide clients with a copy of those policies and procedures. The SEC stated that the description should be a concise summary of the adviser’s proxy voting process rather than a reiteration of the adviser’s policies and procedures, and should indicate that a copy of the policies and procedures is available upon request.

Recordkeeping. Under rule 204-2, as amended, advisers must retain:

  1. their proxy voting policies and procedures;
  2. proxy statements received regarding client securities;
  3. records of votes they cast on behalf of clients;
  4. records of client requests for proxy voting information, and
  5. any documents prepared by the adviser that were material to making a decision how to vote, or that memorialized the basis for the decision.

The amendments permit an adviser to rely on proxy statements filed on the EDGAR system instead of keeping its own copies, and to rely on proxy statements and records of proxy votes cast by the adviser that are maintained with a third party such as a proxy voting service, provided that the adviser has obtained an undertaking from the third party to provide a copy of the documents promptly upon request.

Effective date. Advisers must comply with the new rule and amendments by August 6, 2003. By this date, advisers subject to the new rule must have adopted and implemented the required proxy voting policies and procedures. Also by this date, advisers must have provided clients with a description of their policies and procedures, and disclosure of how the clients may obtain information from the adviser on how it voted with respect to their securities.

The SEC noted that advisers may choose any means to make this disclosure, provided that it is received by clients by August 6, 2003. The SEC further noted that an adviser could send clients the disclosure together with a periodic account statement, deliver it in a separate mailing, or include it in its brochure (or Part II of Form ADV). The SEC commented that advisers that use their brochure or Part II to make the disclosure must deliver (not merely offer) the revised brochure to existing clients within 180 days after publication, and should accompany the delivery with a letter identifying the new disclosure. SEC Release No. IA-2106, January 31, 2003.

 
 
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 rules requiring disclosure of proxy voting policies and procedures and voting record of investment companies

January 31, 2003 8:56 AM

The SEC has published the final rules requiring investment companies that invest in voting securities to disclose their proxy voting policies and procedures and voting records. Last week’s News Summary contained a brief description of the requirements of the new rules. This week’s Summary contains an expanded description.

Proxy voting policies. The final rules require open-end funds to disclose in their statements of additional information (“SAIs”) the policies and procedures that they use to determine how to vote proxies relating to securities held in their portfolios. Closed-end funds are required to disclose their proxy voting policies and procedures annually on Form N-CSR. The SEC commented that this disclosure should include the procedures that a fund uses when a vote presents a conflict between the interests of fund shareholders, on the one hand, and those of the fund’s investment adviser, principal underwriter, or an affiliated person of the fund, its investment adviser, or principal underwriter, on the other. It also includes any policies and procedures of a fund’s investment adviser, or any other third party, that the fund uses, or that are used on the fund’s behalf, to determine how to vote proxies relating to portfolio securities.

The final rules include a requirement that a fund disclose in its shareholder reports that a description of the fund’s proxy voting policies and procedures is available (1) without charge, upon request, by calling a specified toll-free (or collect) telephone number; (2) on the fund’s website, if applicable; and (3) on the SEC’s website. A fund will be required to send this description of the fund’s proxy voting policies and procedures within three business days after receipt of the request, by first-class mail or other means designed to ensure equally prompt delivery.

The SEC noted that the final rule does not to prescribe more specific guidelines or requirements for the proxy voting policies and procedures that a fund must disclose in its SAI or Form N-CSR (for closed-end funds). Instead, the SEC noted that funds should be allowed the flexibility to determine the content that would be appropriate for this disclosure.

The SEC also noted that the only content required by the rule is disclosure of funds’ general proxy voting policies and procedures, as well as policies for voting on specific types of issues. The SEC provided examples of general proxy policies and procedures that have been adopted by some funds and for which disclosure would be appropriate:

  • The extent to which the fund delegates its proxy voting decisions to its investment adviser or another third party, or relies on the recommendations of a third party;
  • Policies and procedures relating to matters that may affect substantially the rights or privileges of the holders of securities to be voted; and
  • Policies regarding the extent to which the fund will support or give weight to the views of management of a portfolio company.

The SEC also cited the following examples of specific types of issues that are covered by some funds’ proxy voting policies and procedures and for which disclosure would be appropriate:

  • Corporate governance matters, including changes in the state of incorporation, mergers and other corporate restructurings, and anti-takeover provisions such as staggered boards, poison pills, and supermajority provisions;
  • Changes to capital structure, including increases and decreases of capital and preferred stock issuance;
  • Stock option plans and other management compensation issues; and
  • Social and corporate responsibility issues.

In the adopting release, the SEC clarified that a fund may satisfy the requirements for a description of its policies and procedures by substituting a copy of the policies and procedures themselves.

Disclosure of proxy voting record. The SEC adopted amendments that will require each fund to file with the SEC its proxy voting record and make this record available to its shareholders. The SEC did not, however, adopt its proposal to require a fund to disclose in its annual and semi-annual reports to shareholders information regarding any proxy votes that are inconsistent with its proxy voting policies and procedures.

 

In the adopting release, the SEC noted the strong opposition from commenters on the requirement to provide disclosure of actual proxy votes cast. The SEC stated that it carefully considered these comments, but the SEC determined that requiring funds to disclose their complete proxy voting records will benefit investors by improving transparency and enabling fund shareholders to monitor their funds’ involvement in the governance activities of portfolio companies. The SEC further noted that it believes that fund shareholders who are interested in this information have a fundamental right to know how the fund has exercised its proxy votes on their behalf.

 

In response to comments that proxy vote disclosure will “politicize” the process of proxy voting by funds to the detriment of fund shareholders, the SEC agreed with commenters that fund shareholders could be adversely affected if disclosure of fund proxy votes results in significant politicization of the proxy voting process by non-shareholder interest groups and interference with funds’ ability to change corporate governance practices through “behind the scenes” communications. Therefore, the SEC has asked its staff to monitor the effects of the disclosure and report back to the SEC on the operation of the rules, and whether there have been any unintended consequences as a result of the disclosure, no later than December 31, 2005.

 

Disclosure of complete proxy voting record. The SEC adopted new rule 30b1-4 under the 1940 Act, which requires a fund to file with the SEC its complete proxy voting record on an annual basis. This rule will require a fund to file new Form N-PX, containing its complete proxy voting record for the twelve-month period ended June 30, by no later than August 31 of each year. Form N-PX will be required to be signed by the fund, and on behalf of the fund by its principal executive officer or officers.

 

Funds will be required to disclose the following information on Form N-PX for each matter relating to a portfolio security considered at any shareholder meeting held during the period covered by the report and on which the fund was entitled to vote:

  • the name of the issuer of the portfolio security;
  • the exchange ticker symbol of the portfolio security;
  • the CUSIP number for the portfolio security;
  • the shareholder meeting date;
  • a brief identification of the matter voted on;
  • whether the matter was proposed by the issuer or by a security holder;
  • whether the fund cast its vote on the matter;
  • how the fund cast its vote (e.g., for or against proposal, or abstain; for or withhold regarding election of directors); and
  • whether the fund cast its vote for or against management.
 

A fund also will be required to make its proxy voting record available to shareholders.

 

A fund will be required to include in its annual and semi-annual reports to shareholders as well as its SAI a statement that information regarding how the fund voted proxies relating to portfolio securities during the most recent twelve-month period ended June 30 is available (1) without charge, upon request, by calling a specified toll-free (or collect) telephone number; or on or through the fund’s website at a specified Internet address; or both; and (2) on the SEC’s website. If a fund discloses that its proxy voting record is available by calling a toll-free (or collect) telephone number, it must send the information disclosed in the fund’s most recently filed report on Form N-PX within three business days after receipt of a request for this information, by first-class mail or other means designed to ensure equally prompt delivery.

If a fund discloses that its proxy voting record is available on or through its website, it must make available free of charge the information disclosed in the fund’s most recently filed report on Form N-PX on or through its website as soon as reasonably practicable after filing the report with the SEC. A previously filed Form N-PX for a prior period would not be required to be made available on a fund’s website.

 

Disclosure of proxy votes that are inconsistent with a fund’s policies and procedures. The SEC has determined not to adopt the proposed requirement that a fund disclose in its annual and semi-annual reports to shareholders proxy votes (or failures to vote) that are inconsistent with the fund’s proxy voting policies and procedures. Similarly, the SEC did not require additional disclosure regarding specific votes that presented conflict of interest situations. The SEC stated that disclosure of a fund’s complete voting record will enable shareholders to monitor how the fund voted in specific instances and whether the vote is in the shareholders’ best interests. The SEC also noted that requiring additional public disclosure about conflicts of interest would significantly increase the complexity and cost of the proxy vote disclosure.

 

Effective date and compliance date. The effective date of these amendments is April 14, 2003. Investment companies must file their first report on Form N-PX not later than August 31, 2004, for the 12 month period beginning July 1, 2003, and ending June 30, 2004.

 

All initial registration statements on Forms N-1A, N-2, or N-3, and all post-effective amendments that are annual updates to effective registration statements on these forms, filed on or after July 1, 2003, must include the disclosure regarding the fund’s proxy voting policies and procedures. Every annual report by a closed-end fund on Form N-CSR filed on or after July 1, 2003, must include the disclosure regarding the fund’s proxy voting policies and procedures.

 

All initial registration statements on Forms N-1A, N-2, or N-3, and all post-effective amendments that are annual updates to effective registration statements on these forms, filed on or after August 31, 2004, must include the disclosure regarding the availability of the fund’s proxy voting record. Every report to shareholders of a fund registered on Forms N 1A, N-2, or N-3 that is transmitted to shareholders on or after August 31, 2004, must include the disclosure regarding the availability of a fund’s proxy voting record. Every report to shareholders of a fund registered on Forms N-1A, N-2, or N-3 that is transmitted to shareholders on or after the effective date of an initial registration statement or post-effective amendment that is required to include a description of the fund’s proxy voting policies and procedures (or, in the case of a closed-end fund, the filing date of its first annual report on Form N-CSR filed on or after July 1, 2003) must include the disclosure regarding the availability of the fund’s proxy voting policies and procedures. SEC Release Nos. 33-8188, 34-47304, IC-25922, January 31, 2003.

 
 
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 Open Meeting Agenda

January 27, 2003 12:28 PM

At the SEC’s open meeting on February 4, 2003, the SEC will consider recommending for public comment proposed rules under the Investment Company Act of 1940 (the “1940 Act”) and the Investment Advisers Act (the “Advisers Act”) to require each investment company and investment adviser registered with the SEC to (1) adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws, (2) review those policies and procedures annually for their adequacy and the effectiveness of their implementation, and (3) appoint a chief compliance officer to be responsible for administering the policies and procedures.

The Wall Street Journal additionally reported that the SEC will seek comment on a proposal to establish a self-regulatory organization similar to the National Association of Securities Dealers to oversee the investment management industry.

 
 
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 rules and amendments regarding proxy voting disclosure by investment companies and investment advisers

January 23, 2003 12:32 PM

On January 23, 2003, the SEC voted to adopt rule amendments that require investment companies to disclose their proxy voting policies and procedures and the actual proxy votes cast. The SEC also adopted a new rule and rule amendments that require registered investment advisers to adopt proxy voting policies and procedures, including procedures to address material conflicts of interest that may arise between the adviser and its clients. In its adopting release, the SEC noted that the rule and rule amendments were designed to ensure that advisers vote proxies in the best interest of their clients and provide clients with information about how their proxies are voted.

Investment company requirements. The amendments affecting investment companies require the following:

 

Proxy voting policies and procedures. The amendments require a fund to disclose in its registration statement the policies and procedures that it uses to determine how to vote proxies relating to portfolio securities. This disclosure includes the procedures that a fund uses when a vote presents a conflict between the interests of fund shareholders, on the one hand, and those of the fund’s investment adviser, principal underwriter, or certain of their affiliates, on the other. Disclosure of proxy voting policies and procedures will apply to registration statement filings made on or after July 1, 2003.

 

Investment company proxy voting record. The amendments will require a fund to file new Form N-PX, containing its complete proxy voting record for the 12-month period ended June 30 by no later than August 31 of each year. Funds will be required to disclose the following information for each matter on which a fund was entitled to vote:

  • information identifying the matter voted on;
  • whether the matter was proposed by the issuer or by a security holder;
  • whether and how the fund cast its vote; and
  • whether the fund cast its vote for or against management.
 

Funds will be required to make their first proxy voting disclosures not later than August 31, 2004, for the 12 months ending June 30, 2004

 

Availability of proxy voting information to fund shareholders. An investment company is now required to state in its reports to shareholders that information about the its proxy voting policies and procedures is available without charge, upon request, by calling a specified toll-free telephone number; on the fund’s web site, if applicable; and on the SEC’s web site. A fund will be required to state in its registration statement and reports to shareholders that the fund files its proxy voting record with the SEC and that the record is available on the SEC’s web site and from the fund. A fund will be permitted to make the proxy voting record available either on its Web site or upon request.

 

Investment adviser amendments. The amendments affecting investment advisers will require the following:

 

Investment adviser proxy voting policies and procedures. The new rule will require investment advisers that exercise proxy voting authority over client securities to adopt and implement written policies and procedures for voting client proxies. The policies and procedures must be reasonably designed to ensure that the adviser votes client securities in the best interests of clients, and they must address how the adviser addresses material conflicts of interest that may arise between the adviser and its clients.

 

Proxy voting information for advisory clients. The new rule requires investment advisers to describe their proxy voting policies and procedures to clients, and furnish a copy of them to clients upon request. The rule also requires investment advisers to tell clients how they can obtain information from the adviser on how the clients’ securities were voted. Investment advisers must have their proxy voting policies and procedures in place, and must have informed their clients of those policies and procedures, within 180 days after the publication of the rule amendments in the Federal Register.

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

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

SEC adopts Form N-CSR and rules related to disclosure of code of ethics, membership of financial experts on audit committees and proxy voting

January 22, 2003 1:36 PM

At its open meeting on Wednesday, January 22, the SEC adopted amendments requiring investment companies to file shareholder reports on Form N-CSR accompanied by a certification from the investment company's principal executive and financial officers of the information contained in these reports. The amendments replace the certification requirements of Form N-SAR with the certification requirements of Form N-CSR. In addition, the Commission voted to adopt rule and form amendments that will require investment companies to include new disclosures on Form N-CSR and Form N-SAR in order to implement the "code of ethics" and "financial expert" requirements of the Sarbanes-Oxley Act of 2002.

At a specially scheduled open meeting on Thursday, January 23, the SEC adopted new rules regarding proxy voting disclosure by investment companies and investment advisers. The SEC adopted new Rule 30b1-4 and new Form N-PX under the Investment Company Act of 1940 (the “1940 Act”). The new rules require investment companies to disclose the policies and procedures they used to determine how to vote proxies relating to portfolio securities. The new rules also require investment companies to file with the SEC on an annual basis, and make available to shareholders, their proxy voting records on new Form N-PX.

The SEC also adopted a new rule and amendments to its recordkeeping rules for registered investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”). The new rule requires investment advisers to adopt proxy voting policies and procedures, describe the policies and procedures to clients, provide clients with copies on request, and disclose how clients can obtain information about how the adviser voted their proxies. The recordkeeping amendments would require advisers to keep certain records regarding client proxies.

A full report on the new rules will be provided in next week’s Industry News Summary.

 
 
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 regarding hedge fund sales

January 22, 2003 1:24 PM

The NASD issued a recent Notice to Members (the “Notice”) outlining the NASD’s concerns about the sales practices of NASD members when selling direct interests in hedge funds and indirect interests through funds of hedge funds. The NASD intended the Notice to highlight NASD members’ obligations when recommending hedge funds and funds of hedge funds to retail investors.

In the Notice, the NASD noted that most investment funds available to retail investors are investment companies that are registered with the SEC under the 1940 Act. The NASD noted that the 1940 Act provides investors with a variety of protections, including regulations that, among other things:

  1. require a certain degree of liquidity;
  2. limit how much can be invested in any one investment;
  3. require that fund shares be redeemable;
  4. protect against conflicts of interests;
  5. assure fairness in the pricing of the fund shares;
  6. require disclosure of information about a fund’s management, holdings, fees and expenses, and performance; and
  7. limit the use of leverage.

The NASD further noted that registered investment companies are registered with the SEC under the Securities Act, which provides further investor protection by requiring disclosure regarding the characteristics and risks of the securities being offered.

The NASD noted that by contrast, most hedge funds are investment companies that are exempt from registration with the SEC under either the 1940 Act or the Securities Act. The NASD noted that because neither the hedge fund nor the securities offered are registered, the range of protections outlined above are not provided. As a result, hedge fund interests may only be offered privately to certain qualified investors who meet certain financial standards.

The NASD noted that while certain funds of hedge funds are registered with the SEC, the underlying investments of these funds are in unregistered hedge funds. The NASD concluded that, as a result, these funds of hedge funds pose similar risks to investors that a direct investment in unregistered funds would. The NASD stated that it was concerned because registered funds of hedge funds may be offered to investors meeting far lower financial standards than those investors eligible to invest directly in the underlying unregistered hedge fund.

In the Notice, the NASD reminded members of their obligations concerning the sale of hedge funds in the following areas:

Promotion of hedge funds. The NASD noted that it is concerned that sales material and oral presentations that promote hedge funds (or funds of hedge funds) may not be balanced by a fair presentation of the risks and potential disadvantages of hedge fund investing. In particular, the NASD noted that members may not claim that hedge funds offer superior professional management with more investment flexibility, protection against declining markets, and better returns due to the imposition of performance fees (e.g., fees charged by the hedge fund adviser based on the fund’s investment performance), unless these statements are fair, accurate, and without exaggeration. The NASD additionally noted that members must balance sales material or oral presentations that promote the advantages of hedge fund investing with full disclosure of the risks that hedge funds present, including, as applicable, the fact that hedge funds (or funds of hedge funds):

 
  • often use leverage and other speculative investment practices that may increase the risk of investment loss;
  • can be highly illiquid;
  • are not required to provide periodic pricing or valuation information to investors;
  • may involve complex tax structures and delays in distributing important tax information;
  • are not subject to the same regulatory requirements as mutual funds; and
  • often charge high fees.

The NASD reminded members that they must provide investors with any prospectus or other disclosure document of the hedge fund (or fund of hedge funds) but also noted that providing a prospectus does not satisfy the duty to provide balanced sales materials and oral presentations.

Reasonable-basis suitability. Under reasonable-basis suitability, a member that directly or indirectly recommends hedge funds to investors must reasonably believe that the product is suitable for investors. Members discharge this requirement by conducting due diligence with respect to the hedge fund, or in the case of a fund of hedge funds, with respect to the underlying hedge funds. The NASD noted that members have a heightened responsibility to investigate the hedge funds and funds of hedge funds that they recommend to customers because these investment products are unregistered. The NASD recommended that members perform “substantial” due diligence into a hedge fund, including, but not limited to:

  • an investigation of the background of the hedge fund manager,
  • reviewing the offering memorandum,
  • reviewing the subscription agreements, examining references, and
  • examining the relative performance of the fund.

The NASD also noted its concern about the offering of hedge funds, historically available only to high net worth individual investors and institutions, as an asset class to retail investors. The NASD urged members to consider whether the fact that certain hedge funds are now available to a broader segment of investors may itself be a “red flag that casts doubt on the desirability and suitability of these funds” for retail investors.

Customer-specific suitability. To satisfy the requirement of customer-specific suitability, a member must determine that its recommendation to invest in a hedge fund or a fund of hedge funds is suitable for that particular investor. NASD Rule 2310 requires that members ensure that a recommendation is suitable for a specific customer by examining:

  1. the customer’s financial status,
  2. the customer’s tax status,
  3. the customer’s investment objectives, and
  4. such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

The NASD noted that some member firms rely heavily on an investor’s status as an accredited investor under Regulation D of the Securities Act as the single criterion for satisfying their suitability obligations in connection with the sale of hedge funds. The NASD noted that a customer’s specific level of assets does not, by itself, satisfy a member’s obligations under the suitability rule.

Internal controls. The NASD noted that each member’s internal controls, including supervision and compliance, must ensure that sales of hedge funds and funds of hedge funds comply with all relevant NASD and SEC rules. Members must include written procedures for supervisory personnel to review compliance with NASD and SEC rules, the accuracy of information gathered, and the appropriateness of the suitability determinations made by their associated persons. Beyond establishing written supervisory procedures, members also must be able to demonstrate adherence to these procedures.

 

Training. The NASD reminded members that they must train associated persons about the characteristics of and risks associated with hedge funds before they allow associated persons to recommend hedge funds or funds of hedge funds. The NASD noted that training may be tailored to the individual characteristics of the member firm by taking into consideration the type of firm and the firm’s size, customer base, and resources. The NASD urged members that sell hedge funds to include hedge funds as part of the Firm Element of their Continuing Education Program. NASDR Notice to Members 03-07, February 2003.

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

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

SEC adopts new Form N-CSR and disclosure requirements regarding investment company codes of ethics and membership on audit committees of “financial experts”

January 22, 2003 12:43 PM

On January 22, 2003, the SEC adopted new rules, rule and form amendments, and new Form N-CSR under the 1940 Act to implement the certification requirement of Section 302 of the Sarbanes-Oxley Act of 2002 (the “Act”). The amendments require an investment company to file semi-annual reports on Form N-CSR and to include the certification specified by Section 302 of the Act in these semi-annual reports. The amendments remove the certification requirement from Form N-SAR with respect to all investment companies. The SEC additionally adopted rules requiring investment companies to maintain, and regularly evaluate the effectiveness of, controls and procedures designed to ensure that the information required in reports on Form N-CSR is recorded, processed, summarized, and reported on a timely basis. Finally, the SEC adopted amendments to Form N-CSR and Form N-SAR to require disclosure regarding the investment company’s code of ethics and membership on the company’s audit committee of a “financial expert.”

Certified shareholder reports. The SEC amended Rule 30b2-1 under the 1940 Act to require an investment company to file a report with the SEC on new Form N-CSR containing (1) a copy of any required shareholder report, (2) additional information regarding disclosure controls and procedures, and (3) the certification required by the Act. The certification is required of each principal executive officer and financial officer and parallels the form of the certification the SEC has prescribed for other reporting forms required by the Securities Exchange Act of 1934 (the “Exchange Act”), such as Forms 10-K and 10-Q. The certification must be filed as an exhibit to Form N-CSR. The certification requirement also applies to amendments of certified shareholder reports on Form N-CSR.

Scope of certification requirement. The SEC adopted, as proposed, the requirement that all of the information filed on Form N-CSR, including all of the information in a shareholder report filed as part of Form N-CSR, be certified. This would include information that is included voluntarily, such as the Management’s Discussion of Fund Performance (“MDFP”). MDFP typically includes narrative disclosure of the factors that materially affected a fund’s performance during the reporting period, a line graph comparing the fund’s performance to that of an appropriate broad-based market index, and a table of average annual total returns for the fund. The SEC noted that the certification required for MDFP is that, based on the certifying officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report.

Disclosure controls and procedures. The SEC adopted new Rule 30a-3 which requires investment companies to maintain, and regularly evaluate the effectiveness of, controls and procedures designed to ensure that the information required in filings on Form N-CSR is recorded, processed, summarized, and reported on a timely basis. The SEC also adopted the requirement of Rule 30a-3(b) that an investment company, under the supervision and with the participation of the principal executive and financial officers, conduct an evaluation of its disclosure controls and procedures within the 90-day period before the filing date of each Form N-CSR requiring certification under 1940 Act Rule 30a 2.Section 302 of the Act does not require evaluations of disclosure controls and procedures with respect to non-Exchange Act filings, and the SEC determined that it would not extend the certification requirement to filings under the Securities Act of 1933 (the “Securities Act”) or the 1940 Act, such as the investment company’s registration statement.

Code of ethics. The SEC has adopted its proposed amendments implementing Section 406 of the Act with respect to disclosure regarding an investment company’s code of ethics. The new amendments require an investment company to:

  • disclose annually whether it has adopted a code of ethics that applies to the investment company’s principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the investment company or a third party (“Executive Officers”);
  • if the investment company has not adopted a code of ethics, explain why it has not done so;
  • describe briefly the nature of any amendment to, or waiver from a provision of, the code of ethics in its report on Form N-CSR or Form N-SAR, as applicable. In the alternative, the investment company may disclose this information on its website within five business days following the date of the amendment or waiver, if the investment company has disclosed in its most recently filed report on Form N-CSR or Form N-SAR its intention to provide disclosure in this manner and its internet address, it makes the information available on its website for a 12-month period, and it retains the information for a period of not less than six years following the end of the fiscal year in which the amendment or waiver occurred.

The final rules reflect changes similar to those the SEC recently made to corresponding disclosure requirements for operating companies. These modifications include:

  • elimination of the component of the definition of a code of ethics requiring the code to promote the avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the code of any material transaction or relationship that reasonably could be expected to give rise to such a conflict;
  • allowing a company to choose among three alternative methods of making its code of ethics publicly available, including:
  1. filing a copy of the code as an exhibit to its annual report on Form N-CSR or Form N-SAR;
  2. posting the text of the code on the company’s website and disclosing, in its most recent report on Form N-CSR or Form N-SAR, its Internet address and the fact that it has posted the code of ethics on its Internet website; or
  3. providing an undertaking in the company’s most recent report on Form N CSR or Form N-SAR to provide a copy of the code to any person without charge upon request, and explaining how such a request may be made;

Investment companies are required to provide the disclosure in Item 2 of Form N-CSR. The SEC noted that Rule 17j 1 under the 1940 Act requires investment companies, and their investment advisers and principal underwriters, to adopt codes of ethics designed to prevent fraud resulting from personal trading in securities by portfolio managers and other employees. The SEC commented, however, that the new amendments address a broader range of conduct than currently covered by Rule 17j-1, including disclosure provided in filings with the SEC; compliance with governmental laws, rules, and regulations; and ethical conduct generally, including the ethical handling of actual or apparent conflicts of interest. Investment companies must comply with the code of ethics disclosure requirements for fiscal years ending on or after July 15, 2003.

Audit committee financial experts. The SEC also adopted its proposals implementing Section 407 of the Act requiring disclosure regarding membership on the audit committee of “financial experts.” Under the provisions adopted, an investment company must disclose annually that its board of directors has determined that the company either: (1) has at least one “audit committee financial expert” serving on its audit committee, and if so, the name of the expert and whether the expert is “independent”; or (2) does not have an audit committee financial expert serving on its audit committee and an explanation for why the investment company does not have such an expert. Every investment company subject to the audit committee disclosure requirements would, however, have to determine whether or not it has at least one audit committee financial expert; a company will not satisfy the new disclosure requirements by stating that it has decided not to make a determination or by simply disclosing the qualifications of all of its audit committee members. Furthermore, if the company’s board determines that at least one of the audit committee members qualifies as an expert, the company must accurately disclose this fact. The SEC will not consider it appropriate for a company to disclose that it does not have an audit committee financial expert if its board has determined that such an expert serves on the audit committee.

The rules, as adopted, reflect modifications that are similar to those that the SEC recently made to the proposed financial expert disclosure requirements for operating companies. These modifications include:

  • use of the term “audit committee financial expert” rather than “financial expert;”
  • modification to require a company to disclose that its board of directors has determined that the company either has at least one audit committee financial expert serving on its audit committee or does not have an audit committee financial expert serving on its audit committee;
  • modification of the proposals to permit an investment company to disclose that it has more than one audit committee financial expert on its audit committee;
  • elimination of the requirement that an audit committee financial expert must have gained the relevant expertise with a company that was required to file reports pursuant to Section 13(a) or 15(d) of the Exchange Act;
  • addition of a requirement that if a person qualifies as an audit committee financial expert by virtue of possessing “other relevant experience,” the company’s disclosure briefly list that person’s experience; and
  • elimination of the list of factors that a the board of directors should consider in evaluating the education and experience of an audit committee financial expert candidate.

Under the new requirements, an "audit committee financial expert" means a person who has the following attributes:

  1. an understanding of generally accepted accounting principles and financial statements;
  2. the ability to assess the general application of these principles in connection with the accounting for estimates, accruals, and reserves;
  3. experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising one or more persons engaged in these activities;
  4. an understanding of internal controls and procedures for financial reporting; and
  5. an understanding of audit committee functions.

The SEC noted that a person must have acquired these attributes through:

  1. education and experience as a principal financial officer, principal accounting officer, controller, public accountant, or auditor or experience in one or more positions that involve the performance of similar functions;
  2. experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor, or person performing similar functions;
  3. experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing, or evaluation of financial statements; or
  4. other relevant experience.

The SEC cautioned that in naming an audit committee financial expert, the board consider any disciplinary actions to which a potential expert is, or has been, subject in determining whether that person would be a suitable audit committee financial expert.

The SEC further noted that while investment company financial statements may, in many cases, be simpler than those of some operating companies, the underlying financial systems, reporting mechanisms, and internal controls are sufficiently complex that an investment company’s audit committee may benefit from having one or more members who meet the definition of audit committee financial expert. Investment companies must comply with the audit committee disclosure requirements for fiscal years ending on or after July 15, 2003.

 
 
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.

House Committee requests study on mutual fund disclosure and announces possible inquiry into soft dollar arrangements

January 20, 2003 1:58 PM

Michael Oxley, Chairman of the House Financial Services Committee, and Richard Baker, Chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, jointly announced a request by the two committees addressed to the General Accounting Office (“GAO”) to conduct a follow up to a 2000 report the GAO conducted on mutual fund disclosures. The topics the chairmen requested that the GAO cover in the report include:

  • current trends in mutual fund fees, including but not limited to advisory fees, Rule 12b-1 fees, sales loads and other fees;
  • disclosure and impact of mutual fund fees and disclosures of the exact amount of such fees;
  • transparency of brokerage commissions paid on fund portfolio transactions and their impact on returns;
  • the role of fund directors, especially independent directors, on fund fees;
  • the use of soft dollar arrangements between funds and brokerage houses; and
  • an analysis of the founding and decline of equity funds since 1997.

The chairmen requested that the report be completed by April 15, 2003.
Separately, on January 15, 2003, Mr. Oxley announced that his committee may explore soft dollar arrangements between mutual fund companies and brokerage firms. Mr. Oxley stated that a relationship involving soft dollars may lead to an annual commitment for a certain level of trading by a mutual fund company which may compromise a mutual fund manager’s obligation to execute transactions in the best interest of shareholders. He also stated that soft dollar obligations may lead to a “type of churning [which] may be a contributing factor to poor mutual fund performance and poor after-tax performance for the investing public.” BNA Securities Regulation & Law Report, Vol. 35, No. 3, January 20, 2003.

 
 
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 announces action plan regarding mutual fund sales loads

January 16, 2003 1:44 PM

On January 16, 2003, the SEC issued a press release announcing the SEC’s joint efforts with the National Association of Securities Dealers, Inc. (“NASD”), among others, to ensure that investors are charged the correct sales loads on their mutual fund transactions. In the release, the SEC outlined a multifaceted action plan consisting of:

1. Reports of current policies and procedures. The SEC and NASD have requested reports from all NASD member firms on the adequacy of the firms’ policies and procedures to ensure that larger mutual fund investors receive promised sales load charge reductions. Additionally, NASD is surveying all of its members to obtain data on their mutual fund sales. These actions follow up on the SEC staff's alert to all brokerage firms and NASD's Notice to Members, issued on Dec. 23, 2002, urging firms to conduct an immediate review of the adequacy of their existing sales load policies and procedures.

2. Examinations of selected firms. Currently, the SEC and NASD, along with the New York Stock Exchange, are conducting examinations of selected firms that sell shares of mutual funds with front-end sales loads. The examinations are designed to determine whether mutual fund purchasers receive promised sales load reductions for making larger investments. The investment levels required to obtain a reduced sales load are commonly referred to as “breakpoints.” The SEC and NASD expect to issue a joint statement of the examination results and firm responses in early February.

3. Formation of working committee. SEC Chairman Harvey L. Pitt has asked NASD, the Securities Industry Association, and the Investment Company Institute to convene a working committee under NASD's leadership to explore and recommend ways in which the mutual fund and brokerage industries can prevent abuses and eliminate errors in the calculation of sales loads, make operational changes to ensure the accuracy of and assist brokers in calculating sales loads, improve investor education on sales loads, and simplify or enhance disclosure of sales load reductions.

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

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

SEC adopts final rules implementing Sarbanes-Oxley Act of 2002

January 15, 2003 1:46 PM

On January 15, 2003, the SEC voted to adopt several rules and amendments concerning provisions of the Sarbanes-Oxley Act of 2002 (the “Act”).

1.Conditions for use of non-GAAP financial information. Section 401(b) of the Act requires the SEC to adopt rules regarding the use in any public disclosure or release of “pro forma financial information” by a public company. The SEC adopted rules that define the category of “pro forma financial information” and outline a two-step approach to regulate the use of that financial information. The SEC voted to adopt new Regulation G, which will apply whenever a company publicly discloses or releases material information that includes a non-GAAP financial measure. This regulation will prohibit material misstatements or omissions that would make the presentation of the material non-GAAP financial measure, under the circumstances in which it is made, misleading, and will require a quantitative reconciliation (by schedule or other clearly understandable method) of the differences between the non-GAAP financial measure presented and the comparable financial measure or measures calculated and presented in accordance with GAAP.

2. Rules restricting insider trading during pension fund blackout periods. As directed by the Act, the SEC, after consultation with the Secretary of Labor, has adopted new Regulation Blackout Trading Restrictions (“Regulation BTR”) under the Securities Exchange Act of 1934 (the “1934 Act”). Regulation BTR prohibits any director or executive officer of an issuer from, directly or indirectly, purchasing, selling or otherwise acquiring or transferring any equity security of the issuer during a pension plan blackout period that prevents plan participants and beneficiaries from engaging in transactions involving issuer equity securities held in their plan accounts.

Persons subject to trading prohibition. Regulation BTR applies to the directors and executive officers of domestic issuers, foreign private issuers, banks and savings associations, small business issuers and, in rare instances, registered investment companies.

Transactions subject to trading prohibition. The trading prohibition is limited to equity securities that a director or executive officer “acquires in connection with his or her service or employment as a director or executive officer.” Regulation BTR will specify the instances where an acquisition of equity securities by a director or executive officer is “in connection with” his or her service to, or employment with, an issuer. Regulation BTR applies to indirect, as well as direct, acquisitions and dispositions of equity securities where a director or executive officer has a “pecuniary interest” in the transaction.

Regulation BTR will exempt from the statutory trading prohibition several categories of transactions that occur automatically, are made pursuant to an advance election or are otherwise outside the control of the director or executive officer, including:

  • acquisitions of equity securities under dividend or interest reinvestment plans;
  • compensatory grants and awards of equity securities pursuant to programs under which grants and awards occur automatically;
  • exercises, conversions or terminations of certain derivative securities, which, by their terms, occur only on a fixed date, or are exercised, converted or terminated by a counter-party who is not subject to the influence of the director or executive officer;
  • acquisitions or dispositions of equity securities involving a bona fide gift or a transfer by will or the laws of descent and distribution;
  • acquisitions or dispositions of equity securities in connection with a merger, acquisition, divestiture or similar transaction occurring by operation of law; and
  • increases or decreases in equity securities holdings resulting from a stock split, stock dividend or pro rata rights distribution.

Blackout period. Regulation BTR provides that, in the case of a domestic issuer, the trading prohibition is triggered only if the ability of U.S. pension plan participants to trade in an issuer's equity securities through their individual plan accounts is temporarily suspended for more than three consecutive business days and this temporary suspension affects 50% or more of the participants under all pension plans with individual accounts maintained by the issuer.

Remedies. A violation of the trading prohibition by a director or executive officer is a violation of the Exchange Act, subject to possible SEC enforcement action. In addition, the Act provides that an issuer, or a security holder on its behalf, may bring an action to recover the profits realized by a director or executive officer from a prohibited transaction during a blackout period. Regulation BTR will take effect on January 26, 2003.

 

3. Disclosure requirements regarding audit committees and codes of ethics. The SEC adopted rules requiring public companies subject to the reporting requirements of the Exchange Act to disclose information about audit committee financial experts and corporate codes of ethics.

 

Audit committee financial experts. Under the new rules, a company will be required to annually disclose whether it has at least one “audit committee financial expert” on its audit committee, and if so, the name of the audit committee financial expert and whether the expert is independent of management. A company that does not have an audit committee financial expert will be required to disclose this fact and explain why it has no such expert. The rules expand the proposed definition of the term “financial expert” and also substitute the designation “audit committee financial expert” for “financial expert.” The rules define “audit committee financial expert” to mean a person who has the following attributes:

 
  • an understanding of financial statements and generally accepted accounting principles;
  • an ability to assess the general application of such principles in connection with the accounting for estimates, accruals and reserves;
  • experience preparing, auditing, analyzing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising one or more persons engaged in such activities;
  • an understanding of internal controls and procedures for financial reporting; and
  • an understanding of audit committee functions.
 

A person can acquire such attributes through any one or more of the following means:

 
  • education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions;
  • experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions, or experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements; or
  • other relevant experience.
 

An individual will have to possess all of the attributes listed in the above definition to qualify as an audit committee financial expert. The rules provide a safe harbor to make clear that an audit committee financial expert will not be deemed an “expert” for any purpose, including for purposes of Section 11 of the Securities Act of 1933 (the “Securities Act”), and that the designation of a person as an audit committee financial expert does not impose any duties, obligations or liability on the person that are greater than those imposed on such a person as a member of the audit committee in the absence of such designation, nor does it affect the duties, obligations or liability of any other member of the audit committee or board of directors.

 

Codes of ethics. Under the adopted rules, a company will be required to disclose in its annual report whether it has a code of ethics that applies to the company's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions (“Management Officers”). The rules will define a code of ethics as written standards that are reasonably necessary to deter wrongdoing and to promote:

 
  • honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships;
  • full, fair, accurate, timely, and understandable disclosure in reports and documents that a company files with, or submits to, the SEC and in other public communications made by the company;
  • compliance with applicable governmental laws, rules and regulations;
  • the prompt internal reporting of code violations to an appropriate person or persons identified in the code; and
  • accountability for adherence to the code.

A company will be required to make available to the public a copy of its code of ethics, or the portion of the code that applies to the company's Management Officers. A company can make the code of ethics available to the public by filing it as an exhibit to its annual report, providing it on the company's Internet Web site, or as otherwise set forth in the final rule.

Companies will be required to provide the new disclosures regarding financial experts and codes of ethics in annual reports for fiscal years ending on or after July 15, 2003. SEC Press Release 2003-6, January 15, 2003.

 
 
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 Open Meeting Update

January 13, 2003 2:13 PM

At the SEC’s open meeting on January 15, the SEC adopted several final rules implementing provisions of the Sarbanes-Oxley Act. The final rules include requirements regarding the disclosure of non-GAAP financial measures and a revised definition of “financial expert” for purposes of a company’s audit committee. These issues will be discussed in more detail in next week’s Industry News Summary.

In addition, the SEC has announced the topics to be discussed at its next open meeting on January 22. Among the issues the SEC will consider include (1) a requirement for registered investment companies to file, and for the principal executive and financial officers to certify, shareholder reports on new Form N-CSR and (2) adopting rules requiring disclosure of proxy voting policies and procedures for investment companies and investment advisers.

 
 
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.

Supreme Court (the “Court”) declines to review case regarding investment adviser compensation and director independence

January 13, 2003 2:02 PM

On January 13, 2003, the Court decided not to review a case brought by a mutual fund shareholder claiming that the directors of the fund were under the control of the fund’s manager and investment adviser (collectively, the “advisers”) in violation of the 1940 Act and that the fund’s advisers received excessive compensation. Previously, the U.S. Court of Appeals for the Circuit affirmed a lower court’s dismissal of the action.

The shareholder had filed suit against his fund’s advisers alleging that none of the fund’s directors met the requirements for independence under Section 10(a) of the 1940 Act. The shareholder claimed that the directors were not independent due to their service on other boards for various funds within the same fund complex as the plaintiff’s fund. The plaintiff further claimed that as a result of their service on the various boards, the directors received “a large aggregate compensation for their combined services.”

The shareholder further claimed that the independent directors were “controlled” by the advisers because of the allegedly excessive fees paid. The shareholder claimed that because the directors were not independent, the fund’s management and distribution agreements were not properly approved by a majority of non-interested directors as required by Section 15(c) of the 1940 Act. The shareholder further alleged that by receiving funds from invalid agreements, the defendants breached their fiduciary obligations under Section 36(b) of the 1940 Act. Section 36(b) imposes a fiduciary duty on mutual fund advisers with respect to receipt of compensation. The shareholder alleged that the advisers’ fees were “so disproportionately large” that the fees amounted to a breach of the advisers’ fiduciary duty.

The lower court had previously dismissed the suit for failure to state a claim upon which relieve can be granted. The appeals court affirmed and concluded that the shareholder did not allege sufficient facts indicating that the fees received were disproportionate to services rendered. The appeals court also noted that independent directors are not “interested” merely because they participate on multiple boards and receive compensation therefrom. The appeals court further noted that the director compensation from multiple board membership was insufficient to rebut the statutory presumption against control without other indicia of control. Krantz v. Prudential Investments Fund Management LLC, U.S., No. 02-835, January 13, 2003).

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

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

CFTC extends comment period for proposal to exempt certain pooled investment vehicles from registration

January 10, 2003 1:56 PM

The CFTC has extended to January 23, 2003, the comment period on its advance notice of proposed rulemaking that provides registration relief for certain operators and advisors of pooled investment vehicles. The notice requested public comment on proposals by the National Futures Association and the Managed Funds Association to implement permanent rule changes expanding the categories of commodity pools whose operators and advisors need not register with the CFTC. Currently, CFTC’s rules provide exemptions for certain very small pools and for certain otherwise regulated entities, such as mutual funds, insurance companies, and pension funds. The NFA and MFA proposals would add a new category for pools that limit participation to certain sophisticated investors. CFTC Press Release 4736-03, January 10, 2003.

 
 
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 fee rate advisory

January 8, 2003 2:41 PM

SEC funding for fiscal 2003 has been extended on existing terms through January 31, 2003. Therefore, the fee rate pursuant to Section 6(b) of the 1933 Act used to calculate the fees payable with the annual notice of securities sold pursuant to Rule 24f-2 under the 1940 Act will remain at the current rate of $92.00 per million. Five days after enactment of the SEC’s “regular” appropriation, the fee rate for Section 6(b) of the 1933 Act will be reduced from $92 per million to $80.90 per million.

 
 
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 proposes audit record retention rule

January 8, 2003 2:37 PM

As required by Section 802 of the Sarbanes-Oxley Act of 2002, the SEC has proposed a rule requiring accounting firms to retain audit records for a five-year period. The rule would apply to all workpapers and other documents that form the basis of the audit or review, as well as to all other documents and records that (1) are created, sent or received in connection with the audit or review and (2) contain conclusions, opinions, analyses, or financial data related to the audit or review. Materials would have to be retained whether they support or cast doubt on the final conclusions reached by the auditor. Non-substantive materials, however, would not have to be retained.

The rule would apply to audits and reviews of all reporting companies under the Securities Exchange Act of 1934 (the “1934 Act”), all companies with registration statements under the Securities Act of 1933 (the “1933 Act”), and all registered investment companies (whether or not 1934 Act reporting companies). It would apply to domestic and foreign accounting firms conducting audits or reviews of foreign issuers' financial statements. However, it would not apply to audits of broker-dealers and investment advisers that are not 1934 Act reporting companies or registered under the 1933 Act.

 
 
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 exemptive rules governing affiliated transactions between investment companies and their affiliated persons

January 8, 2003 2:34 PM

On January 8, 2003, the SEC voted to adopt a new rule and several rule amendments governing exemptions for transactions between investment companies (referred to herein as “funds”) and their affiliated persons. The Investment Company Act of 1940 (the “1940 Act”) contains a number of provisions that prevent persons who may be in a position to take advantage of a fund from entering into transactions or arrangements with the fund. These include prohibitions on affiliated transactions and joint transactions with affiliated persons. By adopting the new rule and amending other rules, the SEC has codified a number of exemptive orders that have been previously issued to investment companies, permitting affiliated and joint transactions with two types of affiliates described below.

Transactions with Portfolio Affiliates. “Portfolio affiliates” are companies that are considered affiliated persons of the fund because the fund controls the company or holds five percent or more of the company’s voting securities. The SEC has determined that this type of affiliated person is unlikely to be in a position to take advantage of the fund. The SEC noted that the current exemptive rule pre-dates the widespread organization of mutual funds into fund complexes. As a result, while Rule 17a-6 and 17d-1(d)(5) under the 1940 Act permit a fund to engage in principal transactions and enter into joint arrangements with its own portfolio affiliates that would otherwise be prohibited by Section 17 of the 1940 Act, other funds that are under common control with the fund may not enter into similar arrangements. The amendments expand the rules to permit funds to enter into transactions and arrangements with portfolio affiliates of other funds in the same fund complex (i.e., companies 5% or more of whose securities are owned by other funds in the fund complex). These funds would be subject to the same conditions under which a fund may enter into transactions and arrangements with its own portfolio affiliates.

Previously, a fund could not rely on the exemptions in Rules 17a-6 and 17d-1(d)(5) to enter into principal transactions or joint arrangements with portfolio affiliates if certain persons (“Prohibited Participants”) have a financial interest in a party to the transaction or arrangement (other than the fund itself). Prohibited Participants include a fund’s investment adviser, officer and principal underwriter. The SEC has amended the rules to permit a portfolio affiliate to enter into a transaction or arrangement with a Prohibited Participant if the Prohibited Participant’s financial interest is determined by the fund’s board of directors not to be “material.” The SEC suggested that in determining whether the financial interest is material, the board consider whether the nature and extent of the interest in the transaction is sufficiently small that a reasonable person would not believe that the interest affected the determination of whether to enter into the transaction or arrangement or the terms of the transaction or arrangement.

Transactions with Subadviser Affiliates. Similar to the above amendments regarding portfolio affiliates, the SEC has expanded certain exemptions to take into account the current complexity of modern fund organizations. Because fund advisers are “affiliated persons” of a fund, an adviser to a fund may not engage in transactions with the fund (or any other fund in the fund complex) such as selling securities to the fund. The SEC has, however, issued a number of exemptive orders permitting subadvisers to enter into transactions and arrangements with other funds in the complex that other subadvisers advise. The SEC has determined that these transactions do not involve self-dealing because the subadviser participating in the transaction is not the subadviser making the decision on behalf of the fund to enter into the transaction.

 

1. Principal transactions with subadvisers. Section 17(a) of the 1940 Act prohibits a subadviser that is an affiliated person of a fund from borrowing money or other property from, or selling or buying securities or other property to or from, the fund or any fund under common control. The SEC has adopted new Rule 17a-10 to permit a subadviser (i) to enter into transactions with funds the subadviser does not advise but which are affiliated persons of a fund that it does advise (e.g., other funds in the same fund complex) and (ii) along with a subadviser’s affiliated persons, to enter into transactions and arrangements with funds the subadviser does advise, but only with respect to discrete portions of the subadvised fund for which the subadviser does not provide investment advice.

The new rule is subject to two conditions: (i) the subadvisory relationship must be the sole reason for the prohibition pursuant to Section 17(a) and (ii) the participating subadviser and any subadviser of the participating fund must be prohibited by their advisory contracts from consulting with each other concerning transactions of the participating fund.

2. Transactions with subadvisers as brokers. Section 10(f) of the 1940 Act prohibits a fund from purchasing any security during an underwriting or selling syndicate if the fund has certain affiliated relationships with a principal underwriter of the security. Section 10(f) is intended to protect fund shareholders by preventing an affiliated underwriter from placing or “dumping” unmarketable securities with the fund. Rule 10f-3 provides an exemption from the prohibition in section 10(f) if certain conditions are satisfied. One of Rule 10f-3's principal conditions is that a fund relying on the rule, together with any other fund advised by the fund's adviser, purchase no more than 25% of the offering.

The SEC noted that when a fund has multiple advisers or subadvisers, Section 10(f) can limit significantly the fund's ability to purchase securities in an offering. Pursuant to Section 10(f), a fund is subject to the prohibition if any of its advisers (in the case of a series fund) or subadvisers (in the case of a multi-managed fund) participated in the underwriting or selling syndicate (or are affiliated persons of participants), regardless of whether the adviser or subadviser that recommended the purchase was a participant in the syndicate. The SEC has amended Rule 10f-3 to deem each series of a series company (“series”) and the “managed portions” of a fund's portfolio to be separate registered investment companies for purposes of Section 10(f) and Rule 10f-3. As a result, a fund would be subject to the limitation only when an adviser recommending the transaction (or its affiliated person) is a participant in the transaction and thus in a position to take advantage of the fund.

The SEC also adopted parallel amendments to Rule 10f-3 to revise the way that funds must aggregate purchases to determine compliance with the percentage limits of Rule 10f-3. The amendments require that purchases need be aggregated only by funds with respect to which the adviser that is a participant in the underwriting or selling syndicate exercises investment discretion. If multiple investment advisers provide investment advice to a fund (e.g., a principal adviser and one or more subadvisers) but only one of those advisers (or its affiliated persons) is a participant in the underwriting or selling syndicate, Rule 10f-3's percentage limit would apply only to purchases by the funds and accounts of the participating investment adviser.

3. Ownership of securities issued by subadvisers. Section 12(d)(3) of the 1940 Act generally prohibits funds, and companies controlled by funds, from purchasing securities issued by a registered investment adviser, broker, dealer, or underwriter (“securities-related businesses”). Rule 12d3-1 permits a fund to invest up to five percent of its assets in securities of an issuer deriving more than 15% of its gross revenues from securities-related businesses, but a fund could not rely on Rule 12d3-1 to acquire securities of its own investment adviser or any affiliated person of its own investment adviser. As a result, a fund could not rely on Rule 12d3-1 to acquire securities issued by any of its subadvisers.

The SEC has amended Rule 12d3-1 to permit a fund to purchase securities issued by its subadvisers (or affiliated persons of its subadvisers) in circumstances in which the SEC has determined the subadviser would have little ability to take advantage of the fund, because it is not in a position to direct the fund's securities purchases. The exemption in Rule 12d3-1 would be available in circumstances identical to those in which the subadviser (or affiliated person) would be permitted by Rule 17a-10 to enter into a principal transaction with the fund.

The effective date of the rule and rule amendments is February 24, 2003. The compliance date for the rule and rule amendments is April 23, 2003.

 
 
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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