1. That the parent notes would not represent more than 5% of the total assets of each fund;
2. Each parent note would have a weighted average interest rate, to be reset monthly and would be greater than or equal to the aggregate interest rates of the downgraded notes they would be replacing;
3. Each parent note would be automatically paid down by an amount equal to the amortized cost (including accrued and unpaid interest) of each downgraded note as each underlying note matures or is sold by the parent;
4. The parent notes would be valued at amortized cost plus accrued interest in accordance with Rule 2a-7 under the 1940 Act;
5. The parent had an A-1+/P-1 short-term rating and therefore, the parent notes would be “first tier securities” as defined under Rule 2a-7 under the 1940 Act;
6. The parent notes would become immediately due and payable in the event the parent’s short-term ratings are downgraded so that the parent notes would not longer be first tier securities;
7. The Board of Trustees of each fund determined that the parent notes would present minimal credit risk to each fund, that disposal of the downgraded notes in the market would not be in best interests of each fund, and that selling the downgraded notes to the parent in exchange for the parent notes would be in the interests of each fund and its shareholders; and
8. The proposed transaction would not require any relief from the requirements, conditions and limitations of Rule 2a-7 under the 1940 Act and the funds would at all times be in full compliance with the requirements of Rule 2a-7.

The no-action letter can be found at: http://www.sec.gov/divisions/investment/noaction/2008/sticlassic010208-17a.pdf

On January 15, 2008, Andrew J. Donohue, Director of IM, gave the keynote address at the Mutual Fund Directors Forum’s Second Annual Directors’ Institute in Fort Myers, Florida. Mr. Donohue provided his views on independent directors’ role in the annual review of the investment adviser contract, pursuant to Section 15(c) of the Investment Company Act of 1940, as amended (the “1940 Act”).

Mr. Donohue provided an extensive historical perspective of the 15(c) review process, tracking the legislative history and citing guidance from significant cases that have helped to shape independent directors’ involvement in annually reviewing the investment adviser contract. He noted that today, the process has evolved to require independent directors to engage, in person, in a detailed analysis of the investment advisory contract with each aspect of the analysis to be well documented. Mr. Donohue stated that while this has necessarily increased the amount of time independent directors have devoted to the annual 15(c) review process, such a detailed process directly benefits the adviser and the independent directors as it minimizes the likelihood of a successful legal challenge by dissenting shareholders. “This is because the legislative history of Section 36(b) suggests that courts generally will not substitute their business judgment for that of the independent directors in the area of management fees and an adviser who provides robust information to the directors to enable them to make an informed decision whether to vote to approve the advisory contract obtains the benefit of the directors’ business judgment.” Mr. Donohue pointed out, though, that “if the directors are not fully informed about all of the facts bearing on the adviser’s services and fees,” then a court would likely give less credibility to the directors’ review of the advisory contract.

Mr. Donohue also discussed the progress of his “Director Outreach Initiative” in which he has visited with various fund boards in order to determine whether directors continue to perform their duties effectively with the increased responsibilities that have been imposed on them in recent years. He reported that fund directors most frequently wanted to discuss Rule 12b-1 fees and soft dollars. In addition, Mr. Donohue noted that a number of directors expressed a strong desire for the SEC to revamp the requirement for the board to review transactions with affiliates on a quarterly basis. Mr. Donohue said that his staff was analyzing whether to permit boards to delegate certain responsibilities.

The text of Mr. Donohue’s speech to the Mutual Fund Directors Forum’s Second Annual Directors’ Institute can be accessed at: http://www.sec.gov/news/speech/2008/spch011508ajd.htm  

On January 17, 2008, Lori Richards, the Director of the OCIE, addressed the Securities Industry & Financial Markets Association (“SIMFA”) Compliance and Legal Division’s January general luncheon meeting in New York, New York. Ms. Richards addressed what she identified as the most frequently-asked questions that OCIE encounters concerning its examinations:

Will my firm be examined?

Ms. Richards stated that OCIE is challenged in that it must oversee the activities of 5,800 broker-dealers, nearly 11,000 investment advisers and about 950 mutual fund complexes with more than 8,000 portfolios and 450 transfer agents. Given OCIE’s limited resources, Ms. Richards stressed that OCIE focuses its efforts on firms that are of such size, “that if anything went wrong, a significant number of investors would be affected.” In addition, she added that OCIE looks at firms where compliance controls or supervision do not appear to be strong, such as firms that have had prior exam or enforcement problems.

What issues are SEC examiners focused on now?

Ms. Richards said that during 2008, OCIE will be working on a pilot program that will include examinations of a number of dually-registered broker-dealers and investment advisers, with a goal of creating a common exam module. She added that OCIE is particularly concerned with:

• Controls over valuation. Particular emphasis is being placed on whether the firm has controls and is implementing such controls when pricing structured products, illiquid securities or other difficult-to-price securities.
• Controls over non-public information. The focus of examiners will be on whether the firm has identified the source and type of non-public information that they and employees may be privy to, whether the firm has crafted and implemented adequate procedures to maintain the confidentiality of that information, and is implementing such procedures.
• Dealing with senior investors. Reviewing firms’ practices concerning marketing and advertising to seniors, account opening procedures, product and account suitability, discerning the changing needs of seniors, and training for firm employees.

What kind of information and documents are examiners likely to request?

Ms. Richards noted that OCIE often receives comments that firms value predictability in the documents that they will need to provide, as they are maintaining such files in a form that makes them readily available for SEC examiners. She commented that while OCIE does attempt tailor its examinations to the particular firm being examined, that “it is not possible to have a one-size-fits-all document request.”

What are possible outcomes of an examination?

Ms. Richards stated that in 2007, approximately 80% of exams of broker-dealers and 70% of those of advisers and funds resulted in deficiency letters. She added that examiners are likely to refer matters to enforcement staff in cases involving fraud, harm caused to investors, if the wrongful actor benefited from the wrongful conduct, and if the firm’s supervisory procedures were inadequate. Ms. Richards added that in 2007, 14% of exams of broker-dealers and 6% of exams of advisers and funds resulted in referrals for enforcement staff review.

What can compliance staff do to ensure the examination goes smoothly?

In order to facilitate a smooth examination, Ms. Richards made a handful of suggestions. First, she offered that the firm should assume that it will be examined, and to view examinations as a routine part of business. Ms. Richards suggested that a firm proactively identify and address the areas of risk in its business on an ongoing basis, “not just those areas where you know regulators have an interest and not just right before an exam.” She also added that it is important to provide accurate, responsive information in a timely way and to be honest with the examiners during the review process.

The text of Ms. Richards’s speech to SIMFA Compliance and Legal Division’s January general luncheon meeting can be accessed at: http://www.sec.gov/news/speech/2008/spch011708lar.htm

On January 18, 2008, the SEC issued its final rule release announcing the adoption of new Rule 14a-17 and adding an exemption to Rule 14a-2 under the Securities Exchange Act of 1934 (the “Exchange Act”) to facilitate electronic shareholder forums. In its release, the SEC noted that the purpose of the changes to the proxy rules is “to facilitate experimentation, innovation, and greater use of the Internet to further shareholder communications.” The SEC hopes to utilize internet-based technology “to better vindicate shareholders’ state law rights, including their right to elect directors, in ways that are potentially both more effective and less expensive for shareholders and companies.”

New Exemption to Rule 14a-2 of the Exchange Act

The release noted that one of the major obstacles of the use of electronic shareholder forums is the concern that a statement made by a participant in an electronic shareholder forum could possibly be construed as a solicitation under the proxy rules. The new exemption to Rule 14a-2 of the Securities Act explicitly states that Rules 14a-3 through 14a-6 (other than Rule 14a-6(g)), Rule 14a-8 and Rules 14a-10 through 14a-15 do not apply to any solicitation in an electronic shareholder forum, provided that the person does not seek the power to act as a proxy for any shareholder. A solicitation on an electronic shareholder forum will be exempt so long as it occurs more than 60 days prior to the date announced by the company for its annual or special meeting of shareholders. If the company announces the meeting less than 60 days before the meeting date, the solicitation may not occur more than two days following the company’s announcement.

New Rule 14a-17 of the Exchange Act

The other primary concern surrounding the use of electronic shareholder forums is the concern that one who establishes, maintains or operates the forum will be liable under the federal securities laws for statements made by forum participants. New Rule 14a-17 of the Exchange Act provides that all shareholders, companies, and third parties acting on behalf of a shareholder or company that establish, maintain, or operate an electronic shareholder forum will not be liable under the federal securities laws for any statement or information provided by another person in the forum if the forum otherwise complies with the federal securities laws, applicable state law and the company’s governing documents.

The amendments become effective on February 25, 2008.

The SEC’s final rule release concerning electronic shareholder forums can be found at: http://www.sec.gov/rules/final/2008/34-57172.pdf  

The Department of Justice (“DoJ”) and the Federal Trade Commission (“FTC”) announced on December 19, 2007, that an investment fund has agreed to pay $1.1 million for failing to timely file Hart-Scott-Rodino Act (“HSR Act”) notifications for three separate stock purchases in 2005. The penalties amounted to more than $3,500 per day for each late notification.

The HSR Act’s filing requirements and waiting periods apply not only to acquisitions of majority ownership in companies, but also to acquisitions of voting securities when certain thresholds are met and the purchaser intends to be anything other than a truly passive investor, regardless of whether the acquisition gives the buyer control of the issuer.

The HSR Act requires that all parties to transactions meeting certain size thresholds notify the FTC and DoJ and abide by certain waiting periods before consummating their transactions. The waiting period permits the agencies to investigate the proposed transaction before closing to determine whether it violates the antitrust laws. The HSR Act’s notification requirements may be triggered when a person proposes to acquire voting securities in an issuer that would result in the acquiring person holding more than $50 million of the voting securities of such issuer. Additional notifications may need to be filed before that person acquires additional voting securities that bring its total holdings total to more than $100 million or $500 million, more than 25% of the issuers’ voting securities if the value of the post-acquisition holdings exceeds $1 billion, or more than 50% of the issuers’ voting securities if the value of the post-acquisition holdings exceeds $50 million. “Passive investments” -- i.e., acquisitions made solely for the purpose of investment -- are exempt from the HSR Act, but only so long as the securities held by the acquiring person do not exceed 10% of the outstanding voting securities of the issuer.

In this case, the fund failed to timely file one notification for an acquisition that passed the $100 million threshold and two notifications for investments that passed the $50 million threshold. The fund had previously failed to make required filings in a timely fashion and had been allowed to make corrective filings without paying any penalties.

The Department of Justice’s Complaint against the investment fund can be found at: http://www.usdoj.gov/atr/cases/f228700/228744.htm 

See also the December 20, 2007, WilmerHale Antitrust and Competition Alert: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8183  

A recent article in the press notes that while many in the industry have supported a proposed FINRA rule that would eliminate redundancy in approval of sales material for mutual fund products, the proposal has generated legal and liability concerns. Under the current rule, sales material for mutual funds and variable insurance products must go through a multilayered review process. This involves having a registered principal at the fund’s or variable product’s underwriter first approve the sales material internally and then filing it with FINRA for inspection. The FINRA proposal would relieve an intermediary’s registered principal from having to review and approve sales material already submitted by a fund underwriter and approved by FINRA’s Advertising Regulation Department.

The article states that many fund shops supported the proposed change during a phone conference hosted by the Investment Company Institute (“ICI”). Industry experts believe that the proposed rule change could generate savings for intermediaries and the ability for fund shops to see their products reach the market in a more timely fashion. Waiting for intermediaries to do their own review of marketing and sales materials can impede funds trying to get their products to market, as intermediaries can hold up a product for months.

Yet some in the industry question whether the proposed rule would alleviate the intermediary firm’s liability in distributing the sales material, because they are relying on FINRA’s approval of the sales materials. Potential complications could arise if, on a later date, FINRA changes its position and attempts to discipline a fund company for distributing improper sales materials, yet the company had been relying on FINRA’s prior approval of such documents.

To date, no public comments have been posted on the SEC’s website concerning FINRA’s proposed rule.

The article “Finra Sales Literature Proposal Causes Concern,” published by Ignites on January 10, 2008 can be accessed at: http://ignites.com/articles/20080110/finra_sales_literature_proposal_causes_concern  

On December 14, 2007, the Enforcement Department of FINRA mailed sweep letters to a number of broker-dealers requesting information concerning the marketing and sale of collateralized mortgage obligations (“CMOs”). FINRA’s letter asked for information about sales of principal only, interest only, and inverse floater tranches of CMOs occurring between June 30, 2006 and July 31, 2007.

“This request should not be construed as an indication that the Enforcement Department or its staff has determined that any violations of the federal securities laws or NASD rules have occurred, or as a reflection upon the merits of the securities involved or any person who effected transactions in such securities,” stated the letter, signed by FINRA senior case manager Claire M. Caten.

The sweep letter called for spreadsheets containing client names, account information, transaction dates, prices per unit of sales, and the registered representative’s identification numbers. It also requested all training and marketing materials related to CMO sales efforts. FINRA is also seeking information about how firms are conducting suitability analyses to identify those investors that are suited for CMO products.

It is important to note that it is common for FINRA to contact broker-dealers when new products are introduced to retail investors. Historical sweep letters have related to broker-dealer practices involving retail hedge fund products and hybrid structured products. The Securities and Exchange Commission (“SEC”) has launched its own examination of CMO marketing and sales practices, and will be coordinating its efforts with FINRA.

The article “FINRA, SEC Join Forces to Probe Sales Practices Involving CMO Products” published by Securities Law Daily on January 10, 2008 can be accessed at: http://ippubs.bna.com/ip/BNA/SLD.NSF/0766b2875010f5e485256b57005d0605/63ed7c8c5b77eaaf852573cc000548b3?OpenDocument  
 

On January 9, 2008, FINRA announced that it levied a $450,000 fine against a brokerage firm for failing to adopt adequate supervisory procedures and systems designed to address its prime brokerage and soft dollar services to hedge funds.

FINRA contended that the firm drafted and distributed hedge fund sales materials that did not adequately disclose material investment risks to potential investors. In addition, FINRA alleged that the firm entered into an improper compensation arrangement with two brokers who also managed hedge funds, allowing them to share in commissions earned from fund trading contrary to representations made in the offering documents and a separate agreement. In addition to the fine, the firm was ordered to retain an independent consultant to conduct a thorough review of the company’s procedures and policies relating to its hedge fund operation.

FINRA alleged that by failing to have policies and procedures to monitor its soft dollar payments, the firm sent two improper soft dollar payments totaling $325,000 to a hedge fund manager, one check for $75,000 for “consulting services” and a $250,000 check for “research expense reimbursement.” FINRA noted that the invoice was “suspect of its face” as it requested that the firm directly pay the hedge fund manager for expenses that allegedly had been provided by a third party, did not specify the research that supposedly had been given to the manager or who had supplied such information, and it failed to detail the “consulting services” the individual provided.

Despite the questionable nature of the invoice, FINRA noted that the firm did not attempt to determine whether the manager was relying on the soft dollar safe harbor under Section 28(e) of the Securities Exchange Act. FINRA stated that “had [the firm] taken such steps, it would have revealed the invoice should not have been paid.”

In addition, FINRA also found that, as part of the firm’s marketing activities for its hedge fund clients, the firm’s employees drafted and distributed sales materials to potential investors that failed to properly disclose the inherent risks of hedge fund investing. FINRA pointed out that such sales materials were not approved by a registered principal or signed, dated, and maintained in the firm’s files for three years, as required by FINRA rules. FINRA also determined that the firm failed to maintain certain e-mails and instant messages of its employees between January 2003 and December 2004, as required by FINRA regulations and applicable federal securities laws, which FINRA said impeded its ability to investigate the firm’s activities.

FINRA also imposed $100,000 fines and 20-day suspensions on the two brokers who helped manage the company’s prime brokerage services business while at the same time serving as the managers of a hedge fund that executed trades at the adviser. As such, FINRA said the two brokers improperly received compensation from a profit pool derived, in part, from commissions on trading by their fund, an arrangement FINRA asserted was contrary to the disclosures found in the fund’s private placement memorandum and a separate agreement.

The FINRA press release can be found at: http://www.finra.org/PressRoom/NewsReleases/2008NewsReleases/P037758.
 

On December 31, 2007, the Sudan Accountability and Divestment Act of 2007 was signed into law and, among other things:

• expressly allows state and local governments to implement measures to divest from, or avoid investing in, securities issued by persons that have certain business operations in Sudan; and
• amends the 1940 Act by creating a safe harbor for registered investment companies that divest from, or avoid investing in, securities issued by persons that have certain business operations in Sudan.

Section 3: State and Local Government Divestment or Prohibition on Investment in Sudan

Section 3 of the bill expressly allows any state or local government to adopt and enforce measures, subject to certain requirements, that permit divestments from, or prohibit the investment of, its “assets” in persons that it determines are conducting or have direct investments in “business operations” in Sudan. Investments in “assets” include a commitment or contribution of assets, a loan or other extension of credit of assets, and the entry into or a renewal of a contract for goods or services. Assets also include public monies; any pension, retirement, annuity, or endowment fund; or similar instrument, but do not include employee benefit plans covered by title I of the Employee Retirement Income Security Act of 1974. “Business operations” include power production activities, mineral extraction activities, oil-related activities, or the production of military equipment. Business operations do not include business operations that the person conducting the business operations can demonstrate:

• are conducted under contract directly and exclusively with the regional government of southern Sudan;
• are conducted under a license from the Office of Foreign Asset Control, or are expressly exempted under federal law from the requirement to be conducted under such a license;
• consist of providing goods or services to marginalized populations of Sudan;
• consist of providing goods or services to an internationally recognized peacekeeping force or humanitarian organization;
• consist of providing goods or services that are used only to promote health or education; or
• have been voluntarily suspended.

The state and local government must make their determination using credible information available to the public. Not later than 30 days after adopting a measure, a state or local government should submit written notice to the Attorney General describing the measure. Any measure taken by a state or local government must meet the following requirements:

• The state or local government must provide written notice and an opportunity to comment in writing to each person to whom a measure is to be applied;
• The measure should apply to a person not earlier than the date that is 90 days after the date on which written notice is provided to the person;
• The measure should not apply to a person that demonstrates to the state or local government that the person does not conduct or have direct investments in business operations; and
• The measure should not be adopted unless the state or local government has made an effort to avoid erroneously targeting the person and has verified that the person is conducting or has direct investments in business operations.

The bill states that any measure meeting these requirements “is not preempted by any Federal law or regulation.”

Section 4: Amendment to 1940 Act

Section 4 of the bill added new subsection (c) to Section 13 of the 1940 Act, which creates a safe harbor for registered investment companies (or any employee, officer, director, or investment adviser) from any civil, criminal, or administrative action if it divests from, or avoids investing in, securities issued by persons it determines are conducting or have direct investments in business operations in Sudan. To make its determination, the investment company must use credible information that is available to the public. The definitions of investments in “assets” and “business operations” are the same for the safe harbor as they are for Section 3 discussed above. The safe harbor does not prevent a person from bringing an action based on a breach of a fiduciary duty owed to that person with respect to a divestment or non-investment decision.

Section 4 of the bill also requires the SEC to prescribe regulations that require registered investment companies to disclose any such divestment in the next periodic report filed under Section 30 of the 1940 Act following such divestiture in accordance with new Section 13(c). The safe harbor applies only to a registered investment company (or any employee, officer, director, or investment adviser) if it makes the disclosure required by the SEC regulation.

See, Investment Company Institute Memorandum, dated January 3, 2008, “President Signs into Law The Sudan Accountability and Divestment Act of 2007. A copy of the bill can be obtained at: http://www.govtrack.us/congress/billtext.xpd?bill=s110-2271.
 

On December 27, 2007, the SEC settled an action against a registered investment adviser and its principal who offered clients a principal guaranteed account but failed to obtain the requisite insurance for its investment program. The investment adviser and its principal, the president and majority owner of the investment adviser, were alleged to have fraudulently marketed and sold to clients “insured” investment programs that purported to guarantee clients against loss of principal if they kept their assets under management with the investment adviser for a continuous five-year period (“five-year program”). For this insured product, the investment adviser charged an annual fee of three percent of assets under management, comprised of a one percent management fee, one percent referral fee paid to solicitor, and one percent fee paid to the insurance company and its agent for insurance and program management.

According to the SEC settlement order:

• The insurance company used for the five-year program stopped accepting new accounts in 2001 and the principal was unable to find a replacement policy. As a result, the principal created his own off-shore captive insurance company but failed to raise capital for the off-shore company.
• The investment adviser and the principal began offering a new insured investment program that was identical to the original program but required seven years of investment in the program (“seven-year program”).
• Unable to gain enough funding for his own off-shore company or to locate any insurers willing to provide a financial guarantee, the principal purchased an errors and omissions insurance policy (“E&O policy”) for the five-year and seven-year programs. When the insurance company that issued the E&O policy learned that investment adviser was representing on its website that the E&O policy operated as a financial guarantee, the insurance company voided the policy. As a result, the principal obtained another E&O policy from a different insurance company that specifically excluded the type of coverage the investment adviser needed to run its insured program.
• At no time during the offering of the seven-year program, and for a specific period during the offering of the five-year program, did the principal or investment adviser have an insurance plan to support the investment programs, despite the fact that the principal told clients that investment adviser had purchased “Registered Investment Advisors Professional Liability Insurance” or other appropriate insurance.
• In addition, the principal and investment adviser failed to disclose to their clients material information regarding the investment adviser’s financial condition and did not maintain certain books and records required under the Investment Advisers Act of 1940 (“Advisers Act”). Due to the fact that there were no insurance policies to fund the insured programs, the investment adviser kept the portion of the management fee that was supposed to go to the insurance company as an undisclosed addition to its management fee. In addition, the investment adviser’s Form ADV contained incorrect information regarding the amount of assets under management and the portion of discretionary assets.
  The SEC settlement order required the investment adviser and principal to cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder; and Sections 204, 206(1), 206(2), 206(4), and 207 of the Advisers Act, and Rules 204-1(a), 204-2(c)(1), 206(4)-1, and 206(4)-4(a)(1) thereunder.

In addition, the SEC settlement order revoked the investment adviser’s registration and barred the principal from association with any investment adviser. Although the SEC settlement order required and over $500,000 in disgorgement payments, the SEC waived the disgorgement payments due to the investment adviser and principal’s inability to pay such amounts.

The SEC settlement action is available at: http://www.sec.gov/litigation/admin/2007/34-57056.pdf.
 

On January 3, 2008, the SEC released a pre-publication version of the report on investment advisers and broker-dealers. The report is the result of a study commissioned by the SEC from the RAND Corporation, a non-profit policy group. The main purpose of the report was to provide the SEC with “a factual description of the current state of the investment advisory and brokerage industries for its evaluation of the legal and regulatory environment concerning investment professionals.” The study focused on investment advisers and broker-dealers that serve retail clients and compared the services they offer, the disclosures they provide, and the ways they are perceived by retail investors. Among other things, the report found that:
 

• Investors generally do not understand the differences between investment advisers and broker-dealers, particularly the differences in the duties owed to clients under the applicable laws and regulations, and that they tended to view them as the same.
• Required disclosures by broker-dealers and investment advisers are often difficult for the average investor to understand, inadequate and poorly explained, and often not fully read by the investor.
• Industry participants tend to favor having regulations based on the type of service provided, rather than the form of compensation paid for such service.
• Dual registrants, in particular, seek guidance from regulators on how to deal with inconsistent and conflicting regulatory requirements. The report noted the difficulty in comparing information about investment advisers and broker-dealers disclosed in the IARD and CRD systems due to inconsistent disclosure requirements and possibly also due to registrants’ misunderstanding of the applicable disclosure requirements.

The report avoided making any regulatory or policy recommendations. However, an SEC spokesman stated that SEC Chairman Cox has asked the staff to develop policy recommendations based on the RAND report findings within the next four months. In addition, Financial Planning Association has requested the SEC to host a roundtable for consumer and industry groups to discuss the RAND report findings.

The RAND Report is available at: http://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf.

On December 20, 2007, the Committee on Investment Management Regulation of the New York City Bar (“Committee”) recommended various actions to reduce unnecessary burdens on independent directors. The Committee noted that, in response to the recent problems in the fund industry and various new regulatory requirements, fund directors have undertaken new duties and have worked with fund advisers and administrators to improve fund governance and disclosures. As a result, fund board meeting agendas and materials have expanded significantly in recent years and meetings have become longer and more frequent. The Committee stated that “many fund directors believe that too much of their time at board meetings is spent on routine compliance work or making required findings that can only be made, as a practical matter, in reliance on representations by an expert third party such as the fund’s adviser or administrator.” As a result, the Committee argues that “it is inappropriate to require directors to devote significant attention to these types of matters, and that this is not in the best interests of funds or their shareholders.”

The Committee outlined four areas where changes could be made to reduce unnecessary burdens on independent directors while improving fund governance and enhancing investor protections.

First, the Committee recommends the elimination of the quarterly review of transactions effected pursuant to exemptive rules, such as Rules 10f-3, 17a-7, and 17e-1. The Committee argues that directors rely heavily on the fund’s adviser, the administrator or the Chief Compliance Officer (“CCO”) to capture the proper data about, identify, and investigate and report on potentially non-compliant transactions. The review of these reports by directors requires them to act as compliance analysts, is not an appropriate use of their time and is not in the best interests of investors. The Committee points out that these exemptive rules were adopted prior to the creation of the CCO role, and it would be reasonable, appropriate, and in the best interests of investors for a new rule amendment to permit (but not require) directors to receive a quarterly report from the CCO on compliance with the fund’s procedures relating to these rules instead of reviewing the reports of each individual transaction.

Second, the Committee recommends the elimination of quarterly reviews required by existing exemptive orders. For the same reason discussed above, the types of conditions raised in exemptive orders that must be reviewed by directors require independent directors to act as compliance analysts, which is not consistent with their supervisory authority over funds. The Committee suggests that the SEC staff consider supporting a blanket order or interpretation from the SEC that effectively amends the terms of existing orders so that directors may satisfy their monitoring responsibilities by receiving and reviewing quarterly reports from the CCO about compliance with policies and procedures adopted in connection with exemptive orders. Further, the Committee suggests that this approach be used in exemptive rules codifying categories of frequently granted exemptive orders.

Third, the Committee stated that there are a number of rules under the Investment Company Act of 1940, as amended (“1940 Act”), that require board determinations imposing unreasonable burdens on directors. For example, Rules 2a-7(a)(10)(ii) and 12(ii) require directors to determine that an “unrated security” is of comparable quality to a “rated security”; Rule 17d-1(d)(7) requires directors to find that each fund’s share of a joint insurance policy premium is fair and reasonable based on the proportionate share of the premium that it would have paid if the insurance were purchased separately by each fund; and Rule 23c-3(b)(10)(iii) requires directors of closed-end interval funds to review portfolio composition in order to assure adequate liquidity to satisfy repurchase obligations. The Committee argues that directors may not be qualified to make these determinations without reliance on others and, in practice, ratify the determination made by the fund’s adviser or some other expert. The Committee recommends that the SEC revise its rules to require that these and other similar determinations that require professional investment expertise be made by the fund’s adviser, subject to the general oversight of the board, and be part of the fund’s overall compliance program. In addition, the Committee recommends that the board be permitted to delegate certain functions, such as in the comparable quality determinations under Rule 2a-7, to the CCO to alleviate the unnecessary burdens.

Finally, the Committee recommends that the SEC support an amendment to the 1940 Act that eliminates fund boards’ responsibility for fair valuing securities because boards often are asked to ratify specific fair values months after the fact and because such a responsibility imposes an unreasonable burden on directors. The Committee states that enormous changes to the fund industry and the financial markets since the imposition of this responsibility have made it neither necessary nor appropriate. The Committee argues that current accounting standards, such as SFAS No. 157, which defines fair value and provides a framework for measure fair value, provide a rigorous framework for determining fair values that are required to be used for a fund’s financial statements. The Committee argues that these accounting standards, board oversight and the existence of a CCO would together be sufficient to mitigate the conflicts associated with pricing securities for which market quotations do not exist.

The letter is available by contacting the New York City Bar at (212) 382-6600.
 

In a December 7, 2007 letter to the U.S. Treasury Department, the Investment Company Institute (“ICI”) outlined four basic recommendations for reform of the regulatory structure. The letter was provided to the Treasury in response to its “Review of the Regulatory Structure Associated with Financial Institutions.”

First, the ICI recommends that products and services offered and sold in a national market be subject to a coherent schedule of national regulation. Specifically, it argues that the SEC should assert its authority as the sole entity to establish regulatory standards for registered investment companies to implement the pre-emptive purpose of the National Securities Markets Improvement Act of 1996 and secure the regulatory efficiencies Congress intended.
Second, the ICI states that U.S. regulators must encourage and permit innovation and adopt global standards if U.S. financial institutions are to succeed against global competitors. Specifically, the ICI recommends that a new form of investment company be created that is modeled on “highly successful fund structures found outside the United States” and would meet the following three standards: (1) be subject to substantially the same tax treatment as that which applies to many foreign investment funds, (2) be structured so that it is “amenable to be sold on a global basis” and not encumbered by state and local corporate laws, and (3) have a strong and effective set of investor protections. In addition, the ICI suggested that the new investment company could adopt a model with a “straightforward fee structure, such as a single, or unitary, fee from which the investment company sponsor would pay virtually all fund expenses and earn a profit” and, over time, could serve as both an attractive domestic and international investment vehicle.

Third, the ICI recommends that the traditional securities regulatory organization and approach should be reformed in light of market realities. It suggests that the SEC adopt a more prudential model of regulation that includes, among other things (1) reorganizing the SEC to improve oversight and rulemaking including returning the inspection and examination functions to the SEC’s operation divisions, (2) providing adequate resources to fund necessary staffing and training levels, (3) limiting sweep examinations to unusual situations and requiring the SEC staff to provide prompt feedback following an examination, and (4) establishing a process for the SEC and all self-regulatory organizations to reexamine existing rules, including those rules that they or industry participants identify as imposing unjustifiable costs or competitive burdens.

Fourth, the ICI states that U.S. regulators should embrace the efficiencies offered by improved technology. Specifically, the ICI recommends that regulators in the U.S. embrace technology to adapt to regulatory needs, such as technological improvements in the conduct of fund examinations and in the dissemination of information regarding retirement plans, among other areas.

The ICI letter can be found at: http://www.ici.org/statements/cmltr/07_treas_reg_structure_com.html#TopOfPage.
 

The DOL has issued proposed regulations that would require investment managers, consultants and others to provide enhanced disclosure of direct and indirect compensation received in connection with services provided to Employee Retirement Income Security Act (“ERISA”) plans. The regulations are not currently effective, but their publication – combined with enhanced annual reporting (Form 5500), fee disclosures and pending litigation involving a number of large plans -- will likely influence ERISA plan fiduciaries in their evaluation of prospective portfolio managers.

The DOL’s proposed rules provide that each contract between a plan and specified “service providers,” including investment managers, bankers, consultants and brokers, must require that the service provider disclose information regarding the compensation that will be received either directly from the plan or indirectly from parties other than the plan. Additionally, the contract must contain a description of all services to be provided to the plan. Finally, information on conflicts of interest must be disclosed. Material changes to previously disclosed information would have to be updated within 30 days of the change.

The preamble of the proposed regulations indicates the breadth of the compensation disclosure intended, including any “gifts, awards, and trips for employees, research, finder’s fees, placement fees, commissions or other fees related to investment products, sub transfer agency fees, shareholder servicing fees, Rule 12b-1 fees, soft dollar payments, float income, fees deducted from investment returns, fees based on a share of gains or appreciation of plan assets, and fees based upon a percentage of plan assets.” While the proposed regulations appear to permit consolidated disclosure of bundled fee arrangements, if a bundled provider receives a separate fee charged directly against a plan’s investment or receives an asset based fee, that compensation arrangement must be separately disclosed.

Comments on the proposal are due by February 11, 2008, and the regulation will become effective 90 days after publication of the final regulation.

The DOL proposal can be found at: http://www.dol.gov/ebsa/regs/fedreg/proposed/2007024064.pdf.
 

The SEC staff announced that it held CCOutreach seminars for Asian-based investment advisers registered with the SEC in Hong Kong and Mumbai, India on December 4 and 6, 2007, respectively. The seminars were hosted by local regulators and included more than 120 participants from registered investment advisers in Hong Kong, Singapore, Australia, and India. These seminars were the first CCOutreach events in Asia for foreign-based registered investment advisers.

Mr. Ethiopis Tafara, Director of the SEC’s Office of International Affairs, stated that “American investors rely on SEC-registered foreign investment advisers for advice and insights when investing globally.” Ms. Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, added that “The CCOutreach program provides an opportunity for SEC staff and industry compliance officers to share information, and to highlight effective compliance practices.” The seminars included a discussion of topical compliance issues including the process for conducting a compliance risk assessment, the establishment and testing of compliance controls, and common deficiencies found in SEC examinations.

SEC Press Release,“SEC Staff Hold First CCOutreach Programs for SEC Investment Advisers in Asia,” announcing the seminars can be found at: http://www.sec.gov/news/press/2007/2007-264.htm.

• There is adequate public information about the issuer;
• Sufficient holding periods are met by the seller of the security, in the case of restricted securities;
• Specified sales volume limitations are met;
• Specified manner of sales requirements are met; and
• Form 144 is filed by the selling security holder if the amount of securities being sold exceeds specified thresholds.

The final rule amendments provide, among other things:

• The holding period requirement for restricted securities of reporting issuers has been shortened from one year to six-months ; non-affiliates of reporting issuers are permitted to resell restricted securities after satisfying a six-month holding period (subject only to the public information requirement in Rule 144(c) until the securities have been held for one-year) and may engage in unlimited public resales under Rule 144 without complying with any other Rule 144 requirements after satisfying a one-year holding period. Restricted securities of non-reporting issuers remain subject to a one-year holding period during which no resales under Rule 144 are permitted.
• The manner of sale requirements now permit the resale of securities through riskless principal transactions and clarify that the posting of bid and ask quotations in alternative trading systems will not be deemed to be a solicitation; the manner of sale requirements have been eliminated altogether for debt securities held by affiliates.
• The sales volume limitations have been amended to permit the resale of debt securities in an amount that does not exceed 10% of a tranche or class, together with all sales of securities of the same tranche sold for the account of the selling security holder within a three-month period.
• The thresholds that trigger Form 144 filing requirements have increased from 500 shares or $10,000 to 5,000 shares or $50,000.

In addition, the final rule amendments codified several Rule 144 staff interpretations pertaining to, among other things, the inclusion of securities acquired under Section 4(6) of the Securities Act in the definition of “restricted securities,” the tacking of holding periods when a company reorganizes or in the case of conversions and exchanges of securities, and the cashless exercise of options and warrants.

The amendments also simplify and streamline portions of Rule 144, such as the “Preliminary Note” to the rule. Lastly, the final rule amends Rule 145 under the Securities Act by revising the resale provision of Rule 145(d) and eliminating the presumptive underwriting provision except with respect to transactions involving blank check or shell companies.

The effective date is February 15, 2008. However, the revised holding periods and other amendments are applicable to securities acquired both before or after February 15, 2008.

SEC Final Rule Release Nos. 33-8869; File No. S7-11-07. The final rule release can be found at: http://www.sec.gov/rules/final/2007/33-8869.pdf.