On July 20, 2004, the FPA sued the SEC in the U.S. Court of Appeals for the District of Columbia Circuit, challenging proposed Rule 202(a)11-1 under the Advisers Act (SEC Release Nos. 34-42099; IA-1845; File No. S7-25-99 (November 4, 1999)). The proposed rule would allow a broker-dealer to provide investment advice to customers, regardless of the form of compensation, provided: (i) the advice is provided on a non-discretionary basis, (ii) the advice is solely incidental to the brokerage services; and (iii) the broker-dealer discloses to its customers that their accounts are brokerage accounts. Under the current rule, a broker-dealer may qualify for a limited exemption from the Advisers Act for investment advice given to clients, provided (i) the advice is incidental to brokerage services, and (ii) the broker-dealer does not receive special compensation for such advice.

In a letter to the SEC, dated June 21, 2004, the FPA made the following arguments in support of its request that the SEC withdraw or, at a minimum, revise the proposed Rule:

Non-Compliance with Administrative Procedures Act (“APA”). The SEC provided “no-action” relief to broker-dealers in the proposing release with no clear deadline for taking action on the proposed Rule. Accordingly, the SEC’s “de facto” adoption of the Rule proposal violated the letter and intent of the APA.

Failure to Provide Clear Regulatory Guidance. During the lengthy intervening period since the Rule was proposed, the SEC received numerous comment letters requesting clarification on what is meant by “solely incidental” advice under the Rule. The SEC has failed to provide clear guidance to affected parties on other key terms in the Rule, including the distinction between “full service brokerage” and “financial planning” services.

Misinterpretation and Misapplication of Discretionary Exemption Authority. In creating a new class of exempted broker-dealers under the Rule, the SEC misinterpreted congressional intent by eliminating a statutory “special compensation” element that required broker-dealer registration as advisers under the Advisers Act. Also, the SEC does not have the authority to exempt a class of persons under Section 202(11) of the Advisers Act unless a final rule providing for the exemption is adopted. In this case, no final rule has been adopted.

Absence of Rule Enforcement. The SEC has not provided any evidence of enforcement activity or oversight with respect to the de facto exemption for broker-dealers under the Advisers Act, which has been in effect since the proposed Rule was released in 1999, notwithstanding the marketing emphasis by brokerage firms on investment advice and financial planning. In addition, the proposed Rule has created problems with “reverse churning” of fee-based brokerage accounts, a development under the Rule that is being investigated by the NASD.

Inconsistent Application of Disclosure Standards to Brokerage Transactions. The proposed Rule only requires disclosure to new brokerage customers that the fee-based programs are “brokerage accounts” but not of any conflicts of interest in the broker-customer relationship. However, the SEC has recently taken action to require the disclosure of conflicts by broker-dealers effecting securities transactions involving mutual fund shares. The same investor protection concerns demand that disclosure requirements be applied fairly to all investment products.

The FPA maintains that the SEC should withdraw the proposed Rule but stated in the June 21st letter to the SEC that, if the proposed Rule is not withdrawn, it should at a minimum be revised to include the following elements:

• Consistent with current SEC rule proposals for disclosure in connection with point-of-sale mutual fund transactions, the Rule should require disclosure of all material facts and conflicts regarding any advice offered in the fee-based brokerage accounts.
• The SEC should prohibit brokers who claim the “solely incidental” exemption from marketing their services as advisory services by prohibiting use of the terms “financial,” “retirement,” “wealth,” or similar terms in combination with “advice,” “consult,” “counsel,” “plan,” or any similar combination of words suggesting comprehensive financial planning services.
• The Rule should treat all brokerage discretionary accounts as advisory accounts, regardless of the method of compensation.
• Broker-dealers offering fee-based programs should be prohibited from using client testimonials in advertising materials consistent with the same prohibition on client testimonials by investment advisers.
• The SEC should offer guidance or examples in a final Rule of additional “bright line” factors that clarify what advice to customers is solely incidental to full brokerage services.

Financial Planning Association v. SEC, D.C. Cir., Civil Action No. [not available], 7/20/04); BNA Securities Regulation & Law Report, Vol. 36, No. 30 (July 26, 2004. The FPA’s letter to the SEC can be viewed at http://www.sec.gov/rules/proposed/s72599/fpa062104.pdf.

In a memorandum dated July 23, 2004, the Investment Company Institute (“ICI”) reported that, in response to an inquiry by ICI members regarding Rule 38a-1 under the Investment Company Act of 1940 (the “Investment Company Act”), the SEC staff stated that, under certain circumstances, a fund’s CCO may rely on a summary prepared by a fund’s service provider or a third party of the service provider’s compliance policies and procedures. The memorandum stated that in an informal discussion with SEC staff, the staff stated that Rule 38a-1 is intended to provide a CCO flexibility in determining what information he or she will review.

According to the ICI memorandum, the SEC staff indicated that the CCO should consider the fund’s compliance risk exposure in light of the operations and services provided by the relevant service provider, as well as the fund’s past experience with that service provider when determining whether it would be appropriate to rely upon a summary. The ICI memorandum provided as an example that the SEC would expect the CCO of a money market fund to review a subadviser’s Rule 2a-7 compliance policies and procedures because such policies and procedures address a core risk exposure of the fund. In contrast, the CCO could choose to rely upon summaries of policies and procedures regarding areas that do not present the same degree of compliance risk for the fund, such as the subadviser’s code of ethics. According to the ICI memorandum, the SEC staff further indicated that, under circumstances where a service provider presents limited risk exposure, the CCO could reasonably decide to rely upon a summary of all of the service provider’s policies and procedures. The memorandum cited the following examples of situations with limited risk exposure:

• where a subadviser manages a portion of the fund’s assets; or
• where, based upon the fund’s long-standing relationship with a subadviser and the subadviser’s experience, the CCO has confidence that the subadviser’s policies and procedures are reasonably designed to prevent violations of the federal securities laws.

The ICI memorandum notes that the SEC staff emphasized the fact that a fund’s CCO must have a reasonable belief that the information he or she relies upon regarding the fund’s compliance policies and procedures is sufficient to enable the fund’s board to determine that such policies and procedures are reasonably designed to prevent violation of the federal securities laws.

Investment Company Institute Memorandum No. 17809 (July 23, 2004).

On June 24, 2004, the NASD filed with the SEC rule amendments designed to eliminate exemptions from the continuing education “Regulatory Element” requirements which would require all registered persons, regardless of the length of time they have been registered, to participate in the Regulatory Element of the NASD’s Continuing Education Requirements, which includes teaching and training designed to address current regulatory concerns and new products and trading strategies. The NASD and the Securities Industry/Regulatory Council on Continuing Education (“Council”) are seeking to repeal the “grandfathering” exemptions based upon their determination that significant regulatory developments have occurred over the past few years, and the current exemptions do not ensure that the approximately 135,000 registered persons currently exempt from the Regulatory Element are kept informed about industry rules, regulations and practices. In addition, the Regulatory Element will launch a new content component addressing ethics issues.

The current schedule for exempt registered persons to comply with the Regulatory Element will be phased in over a three-year period beginning in 2005. The effective date of the amendment will be announced by the NASD not later than 60 days following SEC approval. Regulatory Register, Vol. 19, No. 7 (July 2004).

The SEC is extending, until January 1, 2006, an order under Section 17(e) of the Exchange Act permitting broker-dealers that are not publicly held (“non-public broker-dealers”) to file with the SEC financial statements which have been certified by an independent public accountant rather than by a registered public accounting firm. The order would expire earlier if rules requiring PCAOB registration of auditors of non-public broker-dealers are enacted that set an earlier date.

Section 17(e)(1)(A) of the Exchange Act requires that every registered broker-dealer annually file with the SEC a certified balance sheet and income statement. The Sarbanes-Oxley Act of 2002 (the “Act”) established the PCAOB and amended Section 17(e) to require that the accounting firm certifying the financial statements be a “registered public accounting firm” instead of “an independent public accountant”. The Act established a deadline for registration with the PCAOB of auditors of financial statements of publicly held broker-dealers, but did not provide a deadline for registration of auditors of non-public broker-dealers. The application of PCAOB registration requirements and procedures to auditors of non-public broker-dealers is still being considered. The SEC has therefore determined that extending the order until January 1, 2006 is consistent with the public interest and the protection of investors.

SEC Release No. 34-50020 (July 14, 2004).

• a branch or registered reps with a prior disciplinary history;
• a large number of customer complaints, arbitrations or litigations;
• aberrations from the norm in profit or loss;
• marketing of new products;
• concentration of sales of illiquid or risky investments;
• questionable or frequent transfers of cash or securities in accounts;
• significant switching activities; and
• remoteness from the main office.

Section 15(b)(4)(E) of the Securities Exchange Act of 1934 (“Exchange Act”) authorizes the SEC to censure, place limitations on activities, or suspend or revoke the registration of any broker-dealer, or any associated person, for failure to reasonably supervise another person who commits a violation if the person is subject to his or her supervision. In addition, NASD Rule 3010(a) requires broker-dealers to establish and maintain written procedures reasonably designed to achieve compliance with applicable securities laws, rules and regulations. Ms. Gadziala explained that the NASD has stated the supervision must be designed to monitor all securities-related activities and to detect and prevent compliance problems, whether at a registered branch, an offsite location, an unregistered office, or by an independent contractor.

Ms. Gadziala cited the following as an example of key areas that should be covered by branch office supervision:

• safeguarding customer funds and securities;
• maintaining books and records;
• communications with customers;
• supervision of customer accounts;
• transmittal of customer funds; and
• validation of customer account information.

She explained that written policies and procedures, on their own, are not sufficient to achieve compliance and must be coupled with effective implementation, including (a) making the policies and procedures available to all relevant employees and training the employees to properly implement them; (b) employing qualified staff and adequate resources dedicated to compliance and supervision; and (c) creating appropriate systems and controls to monitor compliance and confirm that any responsibility to supervise is being diligently exercised. Ms. Gadziala stated that concerns and weaknesses should be detected and problems addressed promptly. She also cited documentation as a critical element to any branch office supervisory program.

Ms. Gadziala cited Staff Legal Bulletin No. 17 on supervision, which was recently issued by SEC’s Division of Market Regulation and discusses supervisory tools that, based on SEC examinations and enforcement actions, are characteristic of “good supervisory procedures.” She listed the following examples from the bulletin as policies and procedures suggested for an effective supervisory system:

1. Firms are urged to conduct random, surprise inspections to enhance supervision, assisting in the early detection of misconduct, deterring future wrongdoing and mitigating customer harm;
2. Firms should consider centralized technology to monitor trading and funds transfers, as well as personal computers, assisting in the detection of misappropriation, selling away, unauthorized trading or other illegal activity;
3. The supervisory structure should include explicit delineation of the supervisory hierarchy with assignment of specific supervisory responsibilities and sufficient resources to implement those responsibilities. Independence of the supervisors is an important consideration;
4. Firms should be cautious about hiring registered reps with a disciplinary history and should implement a system of heightened supervision as appropriate;
5. Firms should implement special monitoring procedures for outside business activities of their employees to detect financial misconduct, to verify customer address changes, to deter misuse of signature guarantee stamps, and to review incoming and outgoing correspondence; and
6. Education for registered reps as well as education and awareness for customers are also important elements of an effective supervisory system.

Ms. Gadziala concluded by alerting firms to the following “problem areas” which are currently areas of focus for the SEC examination program:

• Late trading and market timing;
• Excessive markups in fixed income securities;
• Breakpoint violations in the sales of mutual funds;
• Inappropriate sales of hedge funds;
• Unsuitable sales of Section 529 plans;
• Unsuitable sales or switching of variable annuities;
• Misappropriation of customer funds;
• Excessive fees or commissions; and
• Incomplete or inaccurate disclosure.

Ms. Gadziala’s speech can be viewed at:http://www.sec.gov/news/speech/spch071304mag.htm.

On July 2, 2004, the U.S. Court of Appeals for the Seventh Circuit issued a ruling against a brokerage firm that may require a new level of scrutiny by brokerage firms offering checking services. The court held that the brokerage firm, after depositing a check from a customer opening a brokerage account, had a “duty of inquiry,” which it failed to meet prior to following the customer’s instructions to wire most of the money out of the new account shortly after the account was opened. The customer presented the brokerage firm with a forged check made out to the brokerage firm and drawn on the account of a life insurance company. The customer fraudulently made it appear that he was an employee of the insurance company and was depositing a distribution from the company’s benefits plan. Although the brokerage firm checked with the insurance company’s bank to ensure the check had cleared before wiring most of the customer’s money out of the new brokerage account to various institutions, it had not performed any other due diligence to determine if the check was valid, such as contacting the insurance company. After the insurance company discovered that the customer was not an employee, its own insurance company covered the amount of the forged check and subsequently sued both the company’s bank and the brokerage firm.

In reversing the lower court’s ruling, the court determined that the brokerage firm owed a legal duty of care to make some inquiry to determine whether the check was valid. While the court stated that there was no case law which imposed such a duty on non-banks, the court reasoned that to hold otherwise would confer a “windfall competitive advantage” on the brokerage industry such that a firm’s cost of liability insurance and of scrutinizing checks submitted for payment could be reduced to the extent that the firm would have a cost advantage to lure customers from banks that cannot avoid such costs. The court concluded that Schwab failed to satisfy its duty of care by making no inquiry into the validity of the check.. Travelers Casualty and Surety Co. of America v. Wells Fargo Bank N.A., 7th Cir., No. 03-1833, July 2, 2004.

On June 23, 2004, FASB issued an “Exposure Draft” regarding a new accounting standard entitled Fair Value Measurements, which would apply to financial and non-financial assets and liabilities required to be measured at fair value under existing accounting standards.

Prior to the development of the Exposure Draft, there was limited guidance for applying the fair value measurement objective in generally accepted accounting principles (“GAAP”). FASB believes that differences in that guidance created inconsistencies which added to the complexity in GAAP. In response, FASB developed a framework clarifying the fair value measurement objective and its application, taking into consideration the need for increased consistency and comparability in fair value measurements and enhanced disclosures about fair value measurements.

Differences between the Exposure Draft and Current Practice:

The proposed standard would require that the fair value of financial instruments traded in active dealer markets, where bid and asked prices are more readily and regularly available than closing prices, be estimated using (1) bid prices for long positions (assets), and (2) asked prices for short positions (liabilities), except as otherwise specified for offsetting positions. Alternative methods currently allowed under SEC ASR No. 118, Accounting for Investment Securities by Registered Investment Companies, would be prohibited.

The proposed standard would require that the fair value of restricted securities (securities for which sale is legally restricted by governmental or contractual requirements for a specified period) be estimated using the quoted price of an otherwise identical unrestricted security, adjusted for the effect of the restriction. The guidance in the proposed Exposure Draft would apply to all restricted securities, including equity securities with restrictions that terminate within one year which are included in the scope of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.

The proposed standard would require that, in the absence of quoted prices for identical or similar assets or liabilities, fair value be estimated using multiple valuation techniques consistent with the market approach, income approach, and cost approach whenever the information necessary to apply those techniques is available without undue cost and effort. In all cases, the valuation techniques used for those estimates would emphasize relevant market inputs, including those derived from active markets.

The Exposure Draft provides the following guidance for how to measure fair value:

1. Definition of Fair Value. The Exposure Draft defines fair value as “the price at which an asset or liability could be exchanged in a current transaction between knowledgeable, unrelated willing parties.” The objective of the measurement is to estimate the price for an asset or liability in the absence of an actual exchange transaction for that asset or liability.
   Valuation Techniques. The Exposure Draft clarifies and incorporates the guidance in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements, for using present value techniques to estimate fair value.
2. Active Markets. The Exposure Draft clarifies that valuation techniques used to estimate fair value should emphasize market inputs, including those derived from active markets. Active markets are defined as those in which quoted prices are “readily” and “regularly” available. Readily available means that pricing information is currently accessible, and regularly available means that transactions occur with sufficient frequency to provide pricing information on an ongoing basis.
3. Valuation Premise. The Exposure Draft provides general guidance for selecting the valuation premise that should be used for estimates of fair value.
4. Fair Value Hierarchy. The Exposure Draft establishes a fair value hierarchy consisting of three levels, giving highest priority to market inputs that reflect quoted prices in active markets for identical assets and the lowest priority to inputs developed based on an entity’s own internal estimates and assumptions.
5. Pricing in Active Dealer Markets. The Exposure Draft requires that the fair value of financial instruments traded in active dealer markets where bid and asked prices are more readily and regularly available than closing prices be estimated using bid prices for long positions and asked prices for short positions, except as otherwise specified for offsetting positions.
6. Measurement of Blocks. For large positions of unrestricted securities with quoted prices in active markets (“blocks”) held by broker-dealers and certain investment companies, the AICPA Audit and Accounting Guides permit fair value to be estimated using blockage factors (adjustments to quoted prices) in limited circumstances. In those cases, the unit of account is a block. FASB determined that for measurement of blocks held by broker-dealers and certain investment companies, current practice as permitted under the guides, should remain unchanged until such time as FASB fully considers those issues.
7. Restricted Securities. The Exposure Draft requires that the fair value of restricted securities be estimated using the quoted price of an otherwise identical unrestricted security, adjusted for the effect of the restriction.
8. Fair Value Disclosures. The Exposure Draft requires expanded disclosures about the use of fair value to remeasure assets and liabilities recognized in the statement of financial position. The Exposure Draft encourages disclosures about other similar remeasurements, such as fair value, that represent current amounts to improve the quality of information provided to users of financial statements.

The proposed Exposure Draft would be effective for financial statements issued for fiscal years beginning after June 15, 2005, and interim periods within those fiscal years. FASB plans to hold a public roundtable meeting with respondents to the Exposure Draft on September 21, 2004. The Exposure Draft can be viewed atwww.fasb.org/draft/index.shtml. Investment Company Institute Memorandum 17744 (July 1, 2004).

On July 8, 2004, the SEC issued proposed Regulation S-AM to implement the affiliate marketing provisions of Section 214 of the Fair and Accurate Credit Transactions Act of 2003 (“FACT”), which added new Section 624 to the Fair Credit Reporting Act (“FCRA”). Section 624 establishes conditions that must be met before a person may use certain information to solicit a consumer for marketing purposes if that information is obtained from an affiliate. FACT also requires the SEC and certain other federal agencies to adopt rules implementing the limitations imposed by Section 624, in response to which the SEC proposed Regulation S-AM.

Specifically, Section 624 states that a person that receives “eligibility information,” which is any information that, if communicated, would be a “consumer report” (the “receiving affiliate”), about a consumer from its affiliate (the “communicating affiliate”) may not use that information to make a marketing solicitation to that consumer unless the consumer was provided with notice of the information-sharing and (2) was given a reasonable opportunity to opt out of having the information used for marketing purposes. New Regulation S-AM proposes that the communicating affiliate will be responsible for satisfying the notice requirement. Section 624 limits the scope of the notice and opt-out requirements, specifying that the requirements do not apply when:

1. the receiving affiliate has a pre-existing business relationship with the consumer;
2. the information is used to perform services for another affiliate (subject to certain conditions);
3. the information is used in response to a communication initiated by the consumer; or
4. the information is used to make a solicitation authorized or requested by the consumer.

Applicability. The SEC noted its determination that Congress, in drafting FACT to require the adoption of rules by the SEC, intended the SEC’s rules to apply to brokers, dealers, investment companies, investment advisers and transfer agents registered with the SEC. Proposed Regulation S-AM includes examples intended by the SEC to provide guidance regarding how the rules are likely to apply in specific situations. Comments must be received on or before August 13, 2004. Release Nos. 34-49985, IC-26494, IA-2259; File No. S7-29-04 (July 8, 2004).

• Each of the five brokerage firms permitted registered representatives to process mutual fund orders after the close of the market.
• None of the firms had adequate systems in place to ensure that only those orders received before that days market close received that days NAV.

In addition, one of the five firms was also cited for failing to comply with the new record keeping rule (effective May 2003), which requires firms to record the time of receipt of orders to buy or sell mutual fund shares.

Member firms are required to implement systems to guarantee that all mutual fund orders processed after the close of the market were received during normal trading hours. According to the release, the NASD reminded member firms in 2003 that it realizes there may be situations in which firms legitimately receive orders before the close of trading but enter these orders after the markets close. However, the NASD stressed that such firms bear the burden of demonstrating that they have in place procedures designed to prevent the occurrence of late trading. NASD Special Notice to Members 03-50 (September 2003).

NASD News Release (June 24, 2004).http://www.nasdr.com/news/pr2004/release_04_043.html.

On June 28, 2004, at the 2004 Mutual Fund Compliance Programs Conference sponsored by the Investment Company Institute and the Independent Directors Council, a representative from the OCIE delivered remarks prepared by Ms. Richards regarding the need for the new Compliance Rule in creating a culture of compliance in the mutual fund industry. In her remarks, Ms. Richards outlined four specific areas to be focused on in complying with the new Rule:

1. Chief Compliance Officer.

The Chief Compliance Officer will be responsible for administering the funds compliance program. Ms. Richards noted that while the Rule does not list the specific attributes the CCO must possess, the SEC has stated that the CCO should be competent and knowledgeable regarding the federal securities laws and should be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the fund. Ms. Richards stated that the SEC will look to the CCO as its ally in the examination process.

Ms. Richards suggested that fund firms consider not placing the CCO within the company's legal department, which could lead to conflicts in the implementation and examination of the compliance program. Ms. Richards stated that for those companies that decide to have the CCO report to the legal department, counsel will have to clearly articulate instances of client privilege and show great effort to segregate any dual responsibilities. Ms. Richards noted that routine compliance monitoring is not subject to attorney-client privilege. All reports required under the federal securities laws are meant to be made available to the SEC staff for examination, and therefore are not subject to the attorney-client privilege, work product doctrine or other similar protections.

Ms. Richards addressed the fact that many fund firms are currently considering outsourcing the CCO function, which is not precluded by the Rule. Ms. Richards noted her reservations with regard to outsourcing, stating that the CCO must have intimate knowledge of the firms operations in order to administer an effective compliance program, and it would therefore be logical to infer that a reasonable amount of time would have to be spent not only overseeing the structure of the compliance program but its implementation as well. Ms. Richards stated that the decision must be made by the funds board, and the board should be aware that if the compliance program is not effective due to the ineffective implementation of the funds procedures and the cause is insufficient CCO involvement or expertise, the fund firm will not be in compliance with the Rule.

Ms. Richards discussed compensation of the CCO and stated that, with the goal of promoting independence, compensation should be designed to reinforce or incentivize the objectivity of the CCO, and to motivate the CCO to perform fully his or her responsibilities. Ms Richards suggested consideration of the following factors in creating a compensation and incentive program for compliance staff:

• Is the CCO administering a compliance environment that not only addresses and supports the goals of all the federal securities laws but the intent of those laws?
• Is the program structured to and does it in fact prevent, detect and correct violations?
• Does the program support open communication between the funds service providers and those with compliance oversight?
• Is the program proactive, seeking to identify potential risk rather than reactive, merely plugging holes as they arise?

Finally, Ms. Richards cautioned fund firms to be sure to provide the CCO with the resources necessary to perform the required functions, which includes the technological and staff support necessary to properly administer a firms compliance program.

2. Adopting Policies and Procedures.

Ms. Richards stated that a funds compliance policies and procedures should allow for reasonable oversight of compliance by the funds adviser, principal underwriter, administrator, transfer agent and other service providers to enable a firms compliance personnel to be able to perform their jobs effectively.

In developing and adopting written compliance policies and procedures, Ms. Richards suggested that firms begin by considering the funds risks, identifying known and potential unknown conflicts of interest involving the advisers interest, employees interests, service providers interests, and advisory clients and shareholders interests. Ms. Richards stated that in considering new policies and procedures to address these conflicts, firms should involve all senior management and appropriate business units in the process at the outset to foster the compliance-oriented environment the firm is seeking to create.

3. Annual Review of Compliance Policies and Procedures.

Ms. Richards stated that the new Rule requires the CCO to conduct an annual review of the adequacy of the compliance policies and procedures of the fund and its service providers, as well as the effectiveness of their implementation. The CCO is also required to deliver a written report to the funds board on (1) the operation of those policies and procedures, (2) any material changes during the year, (3) any material changes recommended, and (4) any material compliance matters that occurred since the date of the last report. Serious compliance issues must be raised to the board without delay. In reviewing the operation of firms compliance programs and for compliance with the rule, the examination staff will expect to see these annual reports, and copies of all briefing materials presented to the funds board in connection with the boards review of the compliance policies and procedures, as well as a summary of the boards deliberation process.

Ms. Richards stated that while the SEC set forth its expectations and guidelines for the annual review, if the compliance program is to be dynamic, it must be subjected to continual assessment and reassessment, particularly in light of new risks, continually be asking the following questions:

• Are we detecting problematic conduct with this policy?
• Based on what we've detected, should we alter our policy?
• Is there a better way to detect problematic conduct?
• Are we preventing problematic conduct with this policy?
• Were the actions we took, once problematic conduct was detected, adequate to deter problematic conduct by this individual or others?

4. Obligations of a Fund’s Board.

Ms. Richards stated that under the new Rule, the funds board, including a majority of its independent members, must approve the policies and procedures of the fund and each of its service providers, including its investment adviser(s), principal underwriter, administrator and transfer agent. The approval must be based on a finding by the board that the policies and procedures are reasonably designed to prevent violations of the federal securities laws.

With respect to service providers, the board may evaluate a third party report, including a SAS 70 report, if the report:

• describes the service providers compliance program as it relates to the types of services provided to the fund;
• discusses the types of compliance risks material to the fund; and
• assesses the adequacy of the service providers compliance controls.

If the funds board chooses to accept a third-party report, the fund must also take into account other relevant information, such as its own experience with the service provider. To ensure that the board is fully informed of changes that may affect its views of service providers, Ms. Richards suggested that one of the boards directives to its CCO be to conduct a periodic review of the service providers program in light of changes that may affect risks to the funds.

Ms. Richards noted that to assist the board in its fiduciary role with regard to fund shareholders, and to ensure that it is aware of the SEC staffs examination findings, the SEC initiated a policy to provide copies of examination deficiency letters relating to a fund to the funds board.

Ms. Richards concluded her remarks with a summary of the questions the SEC staff will be asking of fund firms after October 5, 2004:

• Has there been an honest effort on the part of all parties to establish an effective compliance program?
• Has the CCO diligently and intelligently administered that program?
• Is the program being reviewed and updated frequently in light of the nature of the firms business and the risks it faces?
• Has the firm created a vibrant culture of compliance?

The SEC voted to adopt new Rule 204A-1 under the Investment Advisers Act of 1940 (the Advisers Act), which requires registered investment advisers to adopt codes of ethics (1) setting forth standards of conduct expected of advisory personnel, and (2) addressing conflicts that arise from personal trading by advisory personnel. The rule does not require the adviser to adopt particular standards, but the standards chosen must reflect the advisers fiduciary obligations and those of its supervised persons, and must insure compliance with the federal securities laws. In addition, the SEC is adopting certain amendments to Rule 17j-1 under the Investment Company Act of 1940 (the Investment Company Act) and Form ADV to conform certain applicable provisions to new Rule 204A-1.

Protection of Material Non-Public Information.

The proposed rule contemplated requiring codes of ethics to prevent access to material nonpublic information about the advisers securities recommendations and client securities holdings and transactions by individuals who do not need the information to perform their duties. However, in response to concerns expressed by commenters, the SEC determined such a requirement may be impractical, particularly in smaller fund firms with limited office space. The SEC reminded firms that they must maintain and enforce policies and procedures to prevent the misuse of material nonpublic information, and advisers should carefully consider how to control dissemination of sensitive information both within their organizations and outside them.

Personal Securities Trading.

Each advisers code of ethics must require an advisers access persons to periodically report their personal securities transactions and holdings to the advisers chief compliance officer (CCO) or other designated persons. The code of ethics must also require the adviser to review those reports to allow the adviser and the SEC's examination staff to identify improper trades or patterns of trading by access persons.

1. Personal Trading Procedures. The SEC suggested that advisory firms consider addressing the following issues in drafting their procedures governing employees personal securities trading:

• Prior written approval before access persons can place a personal securities transaction (pre-clearance).
• Maintenance of lists of issuers of securities the firm is analyzing or recommending for client transactions, and prohibitions on personal trading in securities of those issuers.
• Maintenance of restricted lists of issuers about which the firm has inside information, and prohibitions on any trading (personal or for clients) in securities of those issuers.
• Blackout periods when client securities trades are being placed or recommendations are being made and access persons are not permitted to place personal securities transactions.
• Reminders that investment opportunities must be offered first to clients before the adviser or its employees may act on them, and procedures to implement this principle.
  Prohibitions or restrictions on short-swing trading and market timing.
• Requirements to trade only through certain brokers, or limitations on the number of brokerage accounts permitted.
• Requirements to provide the adviser with duplicate trade confirmations and account statements.
• Procedures for assigning new securities analyses to employees whose personal holdings do not present apparent conflicts of interest.

2. Access Persons Subject to the Reporting Requirements. Under Rule 204A-1, the advisers code must require access persons to report their personal securities transactions and holdings. An access person is a supervised person who (a) has access to nonpublic information regarding clients purchase or sale of securities, (b) is involved in making securities recommendations to clients, or (c) has access to such recommendations that are nonpublic. A supervised person who has access to nonpublic information regarding the portfolio holdings of affiliated mutual funds is also an access person.

The SEC noted that Rule 204A-1 contains a presumption that, if the firms primary business is providing investment advice, then all of its directors, officers and partners are access persons.

3. Initial and Annual Holdings Reports. The code of ethics must require a complete report of each access person securities holdings at the time the person becomes an access person and at least once a year thereafter. The holdings reports must be current as of a date not more than 45 days before the individual becomes an access person (initial report) or the date the report is submitted (annual report).

4. Quarterly Transaction Reports. The code of ethics must require quarterly reports of all personal securities transactions by access persons, which are due no later than 30 days after the close of the calendar quarter. The code of ethics may excuse access persons from submitting transaction reports that would duplicate information contained in trade confirmations or account statements that the adviser holds in its records, provided the adviser has received those confirmations or statements not later than 30 days after the close of the calendar quarter in which the transaction takes place.

The SEC did not adopt a proposed requirement that would require access persons that had no personal securities transactions during the quarter to submit a report confirming the absence of transactions.

5. Exceptions From Reporting Requirements. Rule 204A-1 permits three exceptions to personal securities reporting. No reports are required:

• for transactions effected pursuant to an automatic investment plan;
• for securities held in accounts over which the access person had no direct or indirect influence or control; and
• in the case of an advisory firm that has only one access person, so long as the firm maintains records of the holdings and transactions that Rule 204A-1 would otherwise require to be reported.

6. Reportable Securities. Access persons must submit holdings and transaction reports for reportable securities in which the access person has, or acquires, any direct or indirect beneficial ownership. An access person is presumed to be a beneficial owner of securities that are held by his or her immediate family members sharing the access persons household.

Rule 204A-1 treats all securities as reportable securities, including shares of mutual funds advised by the access persons employer or an affiliate, with five exceptions designed to exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to reveal:

• transactions and holdings in direct obligations of the government of the United States;
• money market instruments;
• shares of money market funds;
• transactions and holdings in shares of other types of mutual funds, unless the adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund; and
• transactions in units of a unit investment trust if the unit investment trusts assets are invested exclusively in unaffiliated mutual funds.

Initial Public Offerings and Private Placements.

The code of ethics must require that access persons obtain the advisers approval before investing in an initial public offering (IPO) or private placement. Advisory firms with only one access person are not required to have that access person pre-clear these investments.

Reporting Violations.

Under Rule 204A-1, an advisers code of ethics must require prompt internal reporting of any violations of the code to the advisers CCO or to other persons designated in the code of ethics. However, an advisory firm that designates someone other than the CCO to receive reports of code violations from supervised persons must have procedures requiring that the CCO also receives reports periodically of all violations. The SEC reminded advisers that it is incumbent on them to create an environment that encourages and protects supervised persons who report violations.

Educating Employees About the Code of Ethics.

Under Rule 204A-1, an advisers code of ethics must require the adviser to provide each supervised person with a copy of the code of ethics and any amendments and require each supervised person to acknowledge, in writing, his or her receipt of those copies. Although not required, the SEC noted that it expects most advisory firms will ensure their employees have received adequate training on the principles and procedures of their codes. The SEC suggested periodic training sessions with new and existing employees to remind them of their obligations, or requiring employees to certify that they have read and understood the code of ethics, and requiring annual recertification that the employee has re-read, understands and has complied with the code.

Adviser Review and Enforcement.

Rule 204A-1 requires that advisers maintain and enforce their codes of ethics. The SEC anticipates that the advisers CCO, or persons under his or her authority, will have primary responsibility for enforcing the code of ethics. Enforcement of the code must include reviewing access persons personal securities reports, including:

• an assessment of whether the access person followed required internal procedures;
• a comparison of the personal trading to any restricted lists;
• an assessment of whether the access person is trading for her own account in the same securities he or she is trading for clients, and if so whether the clients are receiving terms as favorable as the access person takes for himself or herself;
• periodically analyzing the access persons trading for patterns that may indicate abuse, including market timing;
• investigating any substantial disparities between the quality of performance the access person achieves for his or her own account and that the access person achieves for clients; and
• investigating any substantial disparities between the percentage of trades that are profitable when the access person trades for his or her own account and the percentage that are profitable when the access person places trades for clients.

Recordkeeping.

Rule 204-2 under the Advisers Act is amended to reflect new Rule 204A-1. Because codes of ethics will already cover personal securities transaction and holdings reports, Rules 204-2(a)(12) and (13) have been simplified:

• Rule 204-2(a)(12), as amended, requires each adviser to keep copies of its code of ethics, records of violations of the code and actions taken as a result of the violations, and copies of its supervised persons written acknowledgment of receipt of the code. Rule 204A-1 requires prompt internal reporting of violations of the code of ethics, but does not require advisers to keep records of these whistleblower reports, in response to commenters concerns that such a requirement could have a chilling effect on employees willingness to report violations.
• Rule 204-2(a)(13), as amended, covers records of access persons personal trading. It requires advisers to keep a record of the names of their access persons, the holdings and transaction reports made by access persons, and records of decisions approving access persons acquisition of securities in IPOs and limited offerings.

The SEC proposed but, in response to concerns of commenters, is not requiring records of access persons personal securities reports and duplicate brokerage confirmations, or account statements in lieu of those reports, to be maintained electronically.

The standard retention period required for books and records under Rule 204-2 is five years, in an easily accessible place, the first two years in an appropriate office of the adviser. As applied in new Rule 204A-1:

Codes of ethics must be kept for five years after the last date they were in effect.

Supervised person acknowledgements of the code must be kept for five years after the individual ceases to be a supervised person.

The list of access persons must include every person who was an access person at any time within the past five years.

Amendment to Form ADV. As proposed, Part II of Form ADV is amended to require advisers to describe their codes of ethics to clients and, upon request, to furnish clients with a copy of the code.

Amendments to Rule 17j-1. As proposed, Rule 17j-1 is revised to state that no report would be required under Rule 17j-1 to the extent that †the report would duplicate information required under the Advisers Act recordkeeping rules. The following four changes are made to Rule 17j-1:

1. The information in initial and annual holdings reports must be current as of a date no more than 45 days before the individual becomes an access person under the rule (initial holdings report), or submitting the report (annual holdings report).
2. Quarterly transaction reports are due no later than 30 days after the close of the quarter, rather than 10 days, as currently provided.
3. Quarterly transaction reports need not be submitted for transactions effected pursuant to an automatic investment plan.
4. The definition of access person is revised to include an advisory person of a fund or its investment adviser. The SEC eliminated the revenue-based test for determining whether an adviser primary business is advising funds and other advisory clients and replaced it with the legal presumption that directors, officers and general partners are access persons if the firms primary business is providing investment advice.

The effective date of the new rule is August 31, 2004. The compliance date for the new rule is January 7, 2005. SEC Release Nos. IA-2256, IC-26492; File No. S7-04-04 (July 2, 2004).

On June 21, 2004, the Financial Planning Association (the “FPA”), which represents about 28,000 financial planners, asked the SEC to withdraw or substantially alter a 1999 proposal that would regulate whether brokers could provide investment advisory services and fee-based brokerage accounts without registering as investment advisers. The proposal, the FPA said, would allow a broker-dealer to provide investment advice to customers, regardless of the form of its compensation, provided:

• the advice is provided on a nondiscretionary basis;
• the advice is “solely incidental” to the brokerage services; and
• the broker-dealer discloses to its customers that their accounts are brokerage accounts.

The FPA argued that the proposal is overreaching and detrimental to consumer protection. According to the FPA, the proposal allows brokers to present themselves as fiduciary advisers receiving a fee for advice even though they may be more governed by sales motivation. The FPA argued that the SEC has not complied with the Administrative Procedure Act (APA) because the Division of Investment Management has said it will not seek enforcement action against brokerage firms in this area of regulation. This, FPA said, amounts to an ad hoc adoption of the proposal, without adherence to the APA. In addition, the association urged that the SEC exceeded its exemptive authority under the Investment Advisers Act of 1940 (the “Advisers Act”).

The FPA called for the SEC to require broker-dealers offering fee-based programs to comply with current registration requirements under the Advisers Act. Alternatively, the FPA urged that if the SEC decides to adopt the rule in some form, it should

• require disclosure of conflicts regarding advice offered in fee-based brokerage accounts. Further, the group said,
• bar brokers who claim the solely incidental exemption from marketing their services as advisory service
• treat all brokerage discretionary accounts as advisory accounts, regardless of the method of compensation.

Require that broker-dealers offering fee-based programs be prohibited from using client testimonials in advertising materials, consistent with the same prohibition on investment advisers.

BNA Securities Regulation and Law Reporter, Volume 36 Number 26 (Monday, June 28, 2004).

As reported in last week’s Industry News Summary, on June 23, 2004, the SEC voted to adopt final rules regarding disclosure of the factors considered by a board of trustees in approving a fund’s investment advisory contracts. The final rules, which have since been released, require fund proxy statements and shareholder reports to discuss, in reasonable detail, the material factors and conclusions that formed the basis for the board of trustees’ approval of an investment advisory or subadvisory agreement.

The amendments require the following disclosures in shareholder reports and fund proxy statements seeking approval of advisory contracts:

• General Discussion. A general discussion of the board’s selection of an adviser and its approval of the advisory fee and any other amounts to be paid under the advisory contract.
• Specific Factors. A discussion of specific factors, including, but not limited to:
  

The SEC clarified that if any of the enumerated factors is not relevant to the board’s evaluation of an advisory contract, the discussion must note this and explain the reason(s) why that factor is not relevant.

Comparisons of Service Fees. Whether the board relied on comparisons of the services and fees under the advisory contract with those of other advisory contracts (e.g. contracts with the same adviser and advisers of different funds or other types of clients, such as pension funds and institutional investors). If the board relied upon such comparisons, the discussion must describe the comparisons that were relied on and how they assisted the board in concluding that the contract should be approved. The SEC noted that the rule amendments do not an enumeration of the types of comparison that the board did not use.

Evaluation of Fund Factors. A discussion of the board’s evaluation of the factors considered by the board in approving the advisory contracts, stating how the board evaluated each factor. In the adopting release, the SEC noted this requirement is intended to clarify existing requirements regarding Statement of Additional Information (“SAI”) and proxy statement disclosure, which state that conclusory statements or a list of factors will not be considered sufficient disclosure. A fund’s discussion must relate the factors to the specific circumstances of the fund and the investment advisory contract. The release noted that it will not be sufficient to state that the board considered the amount of the advisory fee without stating (i) what the board concluded about the amount of the fee, and (ii) how that affected its determination that the contract should be approved.

Contracts Covered in Shareholder Reports

The shareholder report disclosure requirements apply to any new investment advisory contract or contract renewal approved during the semi-annual period covered by the report. Unlike the proposed rule, the final rule also applies to contract that were approved by shareholders during the relevant period. The SEC reasoned that more comprehensive disclosure will better enable shareholders to remain up-to-date on advisory contract approvals, regardless of whether they were involved in the original approval of the contract.

Prospectus and SAI Disclosure

In response to commenters, the SEC stated that because fund shareholder reports will now contain disclosure with respect to all advisory contracts approved by the board, it is removing as duplicative the existing requirement for disclosure in the SAI of Forms N-1A, N-2, and N-3 with respect to the board’ approval of any existing advisory contract. However, the new rule requires that a fund prospectus state that a discussion regarding the board’s basis for approving any investment advisory contract is available in the fund’s annual or semi-annual report to shareholders, as applicable. The disclosure will be required to indicate the dates covered by the relevant shareholder report, so that a shareholder may easily request the appropriate report. In addition, the disclosure must appear adjacent to other prospectus disclosure about the fund’s investment adviser.

Compliance Date

The effective date of the rule is August 5, 2004. All fund reports to shareholders with respect to periods ending on or after March 31, 2005, and all proxy statements filed on or after October 31, 2004, will be required to comply with the amendments. In addition, all initial registration statements on Forms N-1A, N-2, and N-3, and all post-effective amendments that are annual updates to effective registration statements, filed on or after the transmission to shareholders of a report containing the required disclosure must include the prospectus disclosure stating that a discussion regarding the board’s basis for approving any investment advisory contract is available in the fund’s shareholder reports. 

SEC Release Nos. 33-8433; 34-49909; IC-26486; File No. S7-08-04 (June 23, 2004).