This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
SPARK Institute Issues Redemption Fee Rule Guidance
July 31, 2006 10:29 AM
The SPARK Institute, representing the interests of the defined contribution marketplace, released its guidelines regarding best practices for frequent trading monitoring by retirement plan record keepers. The best practice summary is intended to support compliance with SEC Rule 22c-2, the redemption fee rule, and is designed to be used in conjunction with sample contract language previously released by the Institute. The guidelines address transactions subject to monitoring, round-trip identification periods, monitoring periods, warning notices, and purchase restriction periods.
The SPARK Institute, Inc., Memorandum, June 29, 2006, available at: http://www.rgwuelfing.com/pdf/Frequent-Trade-Best-Practices-06292006.pdf.
ICI Study Indicates Falling Mutual Fund Fees
July 31, 2006 10:25 AM
According to a study by the Investment Company Institute (“ICI”), mutual fund fees and expenses fell in 2005 to their lowest levels in more than 25 years. Average fees and expenses for stock funds, for bond funds and for money market funds all declined in 2005. Since 1980, average fees and expenses have dropped more than 50% for stock and bond funds and about 25% for money market funds. The ICI study points to the increasing popularity of low-cost funds and lower expense ratios in the funds already owned by investors as the two primary reasons for lower stock fund costs.
Investment Company Institute, Research Fundamentals, June 2006, Volume 15, Number 4, available at: http://www.ici.org/home/fm-v15n4.pdf
California Superior Court Rules NSMIA Preempts State Authority With Respect to Content of Fund Prospectus
July 31, 2006 10:23 AM
An opinion of Judge Loren E. McMaster of the California Superior Court, dated May 25, 2006, concluded that the National Securities Markets Improvement Act (“NSMIA”) preempted state regulation of the contents of a fund prospectus, although NSMIA did not preempt state anti-fraud enforcement actions. The California Attorney General had alleged in its complaint, in substance, that it was a violation of state law for a broker-dealer that received “shelf space” from a fund to sell fund shares pursuant to a prospectus that failed to disclose these payments. Stating that NSMIA prohibits enforcement of state laws that prohibit, limit or impose conditions on any security offering, including mutual funds, the Court dismissed the Attorney General’s complaint.
Last November, the California Superior Court reached a similar conclusion in a suit against American Funds, in which the California Attorney General had sought injunctive relief to force American Funds to modify disclosures in its prospectuses, a decision where an appeal is pending.
People v. Edward D. Jones & Co., Cal.Super.Ct., Case No. 04AS05097, May 25, 2006.
Federal Court Jury Finds Former Fund Chairman Defrauded Investors in Market Timing Case
July 31, 2006 10:20 AM
On June 30, 2006 a federal court jury in the Southern District of New York found Stephen J. Treadway liable for defrauding fund investors through an undisclosed market timing arrangement with a hedge fund. The case involved over $4 billion and 100 round-trip exchanges. The former fund chairman had also been chief executive officer of the funds’ adviser and distributor. The jury found the defendant liable for violations (and/or aiding and abetting violations) of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, Sections 17(a)(2) and (3) of the Securities Act of 1933, Section 206(2) of the Investment Advisers Act of 1940, and Sections 34(b) and 36(a) of the Investment Company Act of 1940.
SEC v. Stephen Treadway, 04 Civ. 3464, 2006 U.S. Dist. LEXIS 45936 (S.D.N.Y. June 30, 2006) and “Jury Finds Former PIMCO Equity Funds Chairman Defrauded Investors in Market Timing Case,” SEC Press Release No. 2006-108 (June 30, 2006), available at http://www.sec.gov/news/press/2006/2006-107.htm
NASD Issues Guidance Regarding Routine Examinations
July 31, 2006 10:15 AM
The first NASD webcast in a new “What to Expect” series for compliance managers is intended to explain in plain English the procedure of a routine NASD examination. All NASD firms are placed on a two or four-year routine exam cycle based on a firm’s risk profile as determined by prior sales data and past regulatory history. Firms receive about two weeks’ notice of an upcoming exam. The NASD webcast provides an exam preparation checklist that suggests selecting firm employees to be responsible for each area of the exam, preparing copies of records prior in advance, and organizing documentation in the same order as the NASD request. The checklist for the day of the exam calls for preparing workspace for the examiner, providing photocopying access to the examiner, and coordinating the schedule of the firm personnel who may need to be interviewed. Cooperation is stressed as a key to a successful exam.
After the on-site inspection is completed, an “exit conference” is conducted with key members of the firm to review findings and any potential deficiencies. The NASD examiners then meet with supervisors and staff attorneys before forwarding exam results to district management for review and approval. If the exam reveals no violations, a letter to this effect is sent to the firm. Certain deficiencies may be addressed informally through a compliance conference or letter of caution, while more serious deficiencies may result in formal disciplinary action.
NASD Webcast: The “What to Expect” Series, “What to Expect: Preparing for an NASD Routine Examination” (May 2006).
SEC Approves Amended Proposal Regarding Performance Information
July 31, 2006 10:06 AM
The SEC recently approved amendments to NASD Rules 2210 and 2211 relating to disclosure of fees and expenses in mutual fund performance sales material. This amendment generally requires that advertisements containing performance information present the following expense and performance information in a text box:
In addition, non-standardized fund performance, the performance of a relevant benchmark index, a comparison of a fund’s expense ratio to other similar funds and disclosures required by Rule 482 and Rule 34b-1 can be included in the text box. The amendment excludes web sites and other electronic advertisements from the requirement that expense and performance information be presented within a text box. The amendments will be effective six months after the end of the calendar quarter in which NASD publishes a Notice to Members regarding the amendments.SEC Release No. 34-54103; File No. SR-NASD-2004-043, available at: http://www.sec.gov/rules/sro/nasd/2006/34-54103.pdf.
SEC Issues Concept Release with respect to Sarbanes-Oxley 404 Improvements
July 31, 2006 10:03 AM
On July 11, 2006, the SEC published a Concept Release concerning Management’s Report on Internal Control over Financial Reporting as a step toward improving implementation of the Sarbanes-Oxley investor protection law. The SEC characterized the release as a prelude to forthcoming guidance for management in assessing a company's internal controls for financial reporting. The SEC anticipates that this guidance will cover at least the following areas:
See Concept Release concerning Management’s Report on Internal Control over Financial Reporting, Exchange Act Release No. 34-54122, (July 11, 2006), and “SEC Moves Forward on Sarbanes-Oxley 404 Improvements,” SEC Press Release No. 2006-112 (July 11, 2006), available athttp://www.sec.gov/news/press/2006/2006-112.htm.
Kathleen Blake sworn in as SEC Commissioner
July 31, 2006 10:00 AM
On July 17, 2006, the SEC announced that Kathleen Blake had been sworn in as a Commissioner. Ms. Blake had previously been Staff Director of the Senate Committee on Banking, Housing and Urban Affairs. She succeeds Cynthia Glassman who had announced her intention to leave the Commission when her term ended in June.
“Kathleen Casey Sworn In as 88th SEC Commissioner,” SEC Press Release No. 2006-118 (July 17, 2006), available at: http://www.sec.gov/news/press/2006/2006-118.htm
SEC Proposes Amendments to Regulation SHO
July 31, 2006 9:57 AM
On July 14, 2006, the SEC issued a release proposing amendments to Regulation SHO under the Securities Exchange Act of 1934. The proposed amendments reflect the SEC’s ongoing policy concern that persistent failures to deliver could be an indication that some market participants are engaged in the practice of “naked short selling.” The proposed amendments are intended to further reduce the number of fail to deliver positions in certain threshold securities by eliminating or limiting certain exceptions to Regulation SHO’s mandatory closeout requirement. The proposed amendments also would update the market decline limitation applicable to certain index arbitrage transactions. Comments on the proposed amendments are due on or before September 19, 2006. Further information regarding this SEC release is available in the WilmerHale Securities Email Alert, dated July 28, 2006, available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=3292.
See Amendments to Regulation SHO, Exchange Act Release No. 34-54154, (July 21, 2006), available at: http://www.sec.gov/rules/proposed/2006/34-54154.pdf.
SEC Chairman Cox’s Senate Testimony Addressing SEC Hedge Fund Actions after Goldstein Decision
July 31, 2006 9:53 AM
As reported in the July 26, 2006 WilmerHale Securities Email Alert, on July 25, 2006 Securities and Exchange Commission Chairman Christopher Cox announced in testimony before the US Senate Committee on Banking, Housing and Urban Affairs that he would recommend several emergency actions following the invalidation of the SEC's hedge fund adviser registration rule, Rule 203(b)(3)-2, by the US Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, No. 04-1434. Chairman Cox indicated that the emergency actions would fall into three categories:
Further information regarding this testimony is available in the WilmerHale Securities Email Alert, available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=3292
SEC Chairman Christopher Cox, Testimony Concerning Regulation of Hedge Funds before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, (July 25, 2006), available at http://www.sec.gov/news/testimony/2006/ts072506cc.htm.
U.S. Court of Appeals Vacates Hedge Fund Rule
July 21, 2006 11:39 AM
On June 23, 2006, the U.S. Court of Appeals for the D.C. Circuit unanimously held, in Goldstein v. SEC, that the SEC’s rules requiring registration of hedge fund advisers (the “hedge fund rule”), adopted in 2004, are arbitrary and granted the petitioners’ request to vacate and remand the rule to the SEC. Before the SEC’s adoption of the hedge fund rule, reflected in amendments to Rule 203(b)(3)-1 and the adoption of Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”), most hedge fund managers had been exempt from registering with the SEC as investment advisers under Section 203(b)(3)’s “private adviser exemption,” which is available to advisers with 15 or fewer “clients.” Specifically, even large hedge fund managers were able to take the view that they had fewer than 15 clients, and therefore been exempt from registration, because the hedge funds themselves, rather than such funds’ underlying investors, were viewed as these advisers’ “clients.” However, the hedge fund rule changed this longstanding approach, requiring an investment adviser to a private fund to treat investors in the fund as clients for purposes of determining the number of clients the adviser has. As a result of this change, many hedge fund advisers were required to register with the SEC as investment advisers by February 1, 2006. Philip Goldstein, whose firm is general partner and investment adviser to Opportunity Partners L.P., a hedge fund, challenged the SEC’s authority to adopt the rule.
In vacating the rule, the court held that the SEC’s construction of the term “client” was unreasonable, stating that the SEC’s “interpretation … comes close to violating the plain language of the statute.” In reaching this decision, the court first noted that the construction of the term “client” advanced by the SEC is inconsistent with other sections of the Advisers Act. Specifically, under Section 202(a)(11) of the Advisers Act, an investment adviser is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings…” [emphasis added]. Although an investor in a fund may benefit from a hedge fund manager’s advice indirectly, the court noted that only the fund itself is directly provided with investment advice. Accordingly, the court stated that “[i]f the person or entity controlling the fund is not an ‘investment adviser’ to each individual investor, then a fortiori each investor cannot be a ‘client’ of that person or entity.”
Similarly, the court also noted that it would be impossible for an investment adviser to owe a fiduciary duty to both a private fund and the fund’s investors, as such a relationship would inevitably produce conflicts of interest. Although the SEC sought to address this issue by arguing that under its construction investors constitute “clients” only for purposes of determining whether a hedge fund manager is required to register as an adviser, the court stated that “[the SEC] cannot explain why ‘client’ should mean one thing when determining to whom fiduciary duties are owed, and something else entirely when determining whether an investment adviser must register under the Act.” Moreover, the court also noted that the hedge fund rule’s construction of the term “client” under the statute is directly inconsistent with the [SEC]’s previous views, as the SEC provided guidance in both 1985 and 1997 indicating that an adviser’s “client” for purposes of Section 203(b)(3) is the private fund rather than the fund’s investors. The court said that the hedge fund rule might be more understandable if there had been a change in the advisory relationship between hedge fund advisers and investors, but that the SEC did not cite any evidence of this and that “there is a disconnect between the factors the [SEC] cited and the rule it promulgated.” The court further stated that absent this sort of justification, the SEC’s decision to carve out an exception from the Rule 203(b)(3)-1 safe harbor for hedge fund advisers “appears completely arbitrary.” Accordingly, although the court acknowledged that it may be understandable that “the [SEC] wanted a hook on which to hang more comprehensive regulation of hedge funds . . . . the [SEC] may not accomplish its objective by a manipulation of meaning.”
The court ordered that the issuance of its mandate be delayed until after the period permitted for the SEC to petition for a rehearing or a rehearing en banc. At present, it is unclear what actions the SEC will take in response to the decision. In a statement released concerning the decision, SEC Chairman Christopher Cox stated that “[t]he court's finding, that despite the [SEC]'s investor protection objective its rule is arbitrary and in violation of law, requires that going forward we reevaluate the agency's approach to hedge fund activity. I have instructed the SEC's professional staff to promptly evaluate the court's decision, and to provide to the [SEC] a set of alternatives for our consideration.”
We also understand that legislation may be introduced that could, if enacted, provide the statutory authority on which the SEC could require hedge fund advisers to register under the Advisers Act. According to a press release, Rep. Barney Frank of Massachusetts, Ranking Member of the House Financial Services Committee, has announced that he will introduce such legislation, possibly as early as today.
See Goldstein v. SEC, 2006 WL 1715766 (D.C. Cir. June 23, 2006) (No. 04-1434).Rep. Frank’s press release is available at http://www.house.gov/banking_democrats/pr06282006.html.
SEC Publishes Interpretative Guidance on Use of Soft Dollars
July 21, 2006 11:33 AM
On July 18, 2006, the SEC published an interpretative release that provides guidance on money managers’ use of client commissions to pay for brokerage and research services under the “soft dollars” safe harbor, which is set forth in Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). Section 28(e) authorizes a person who exercises investment discretion with respect to an account (a “money manager”) to cause the account to pay more than the lowest available commission if the money manager determines in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services.
Framework for Analyzing the Scope of the “Brokerage and Research Services” under Section 28(e)
The SEC stated that the analysis of whether a particular product or service falls within the safe harbor should involve three steps.
Eligibility Criteria for “Research Services”
Section 28(e)(3) restricts “research services” to “advice,” “analyses,” and “reports.” The SEC stated that, to treat an item as eligible research, a money manager must conclude that the research reflects the substantive content and relates to the subject matters identified in Section 28(e)(3). The SEC provided examples of eligible research, including traditional research reports, discussions with research analysts, meetings with corporate executives to obtain oral reports on the performance of a company, research-related seminars and conferences, software that provides analyses of securities portfolios, and corporate governance research and rating services. The SEC elaborated that eligible research may also include: market research and data; advice from broker-dealers on order execution, strategies and market participants; and software that provides this type of information. The staff noted that proxy services may be treated as mixed-use items, as appropriate.
The SEC stated, however, that mass-market publications that are in general circulation to the retail public are not eligible research. In addition, the SEC explained that inherently tangible products and services, such as travel, entertainment, and meals associated with attending seminars or meeting with corporate executives, analysts or other individuals who may provide eligible research are not eligible under the safe harbor. Similarly, the SEC provided examples of overhead items are not eligible research services under the safe harbor: office equipment, furniture, business supplies, salaries (including research staff), rent, accounting fees and software, website design, email software, internet service, legal expenses, personnel management, marketing, utilities, membership dues, professional licensing fees, software to assist with administrative functions, computer hardware and delivery mechanisms associated with computer hardware or associated with the oral delivery of research.
Eligibility Criteria for “Brokerage Services”
The SEC stated that, for the purposes of the safe harbor, eligible “brokerage” service begins when the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution and ends when funds or securities are delivered or credited to the advised account or account holder’s agent. The SEC explained that, under this temporal standard, communications services related to the execution, clearing and settlement of securities transactions and other functions incidental to effecting securities transactions (i.e., connectivity services between the money manager and the broker-dealer and other relevant parties such as a custodian) are eligible under Section 28(3)(c)(3). In addition, the SEC stated that software used in connection with routing trades and providing algorithmic trading strategies is within the temporal standard and thus are eligible “brokerage” under the safe harbor.
The SEC noted, however, that hardware, such as telephones and computer terminals, software used for record keeping or administrative purposes and analytical software used to test hypothetical situations (e.g., for asset allocation or for portfolio modeling) do not qualify as “brokerage” under the safe harbor because these items are not integral to the execution of orders by a broker-dealer and fall outside the temporal standard. Similarly, the SEC noted that compliance testing and expenses, trade financing, and error correction services are not eligible brokerage services under the safe harbor. Finally, the SEC noted that short-term custody related to effecting specific transactions and settlement of those trades constitutes eligible brokerage services, whereas long-term custody and record keeping provided after settlement of transactions are not considered to be eligible brokerage services.
Lawful and Appropriate Assistance
In addition to satisfying the specific criteria of the statute, eligible research and brokerage services must provide the money manager with “lawful and appropriate assistance” in making investment decisions.
For mixed-use items, the SEC reiterated the guidance provided in the 1986 release that a money manager must reasonably allocate the cost of a product or service between its eligible and ineligible uses, and maintain adequate books and records to enable a good faith determination of such uses.
Good Faith Determination of Reasonableness
The SEC also reaffirmed the money manager’s obligation and burden of proof under Section 28(e) to make a good faith determination that commissions paid are reasonable in relation to the value of the brokerage and research services received.
Third Party Research
The SEC stated that third-party research arrangements can benefit advised accounts by providing greater breadth and depth of research. As a result, the SEC stated that it believes that the safe harbor equally encompasses third-party research and proprietary research.
Client Commission Arrangements
This interpretative release also addressed client commission arrangements under Section 28(e), which requires that a broker-dealer “providing” research must also be involved in “effecting” the transaction. In order for the Section 28(e) safe harbor to apply, an “effecting” broker-dealer must either execute, clear, or settle the trade, or perform at least one of four functions and allocate the other functions to other broker-dealers. The four functions consist of the following: (1) taking financial responsibility for all customer trades until the clearing broker-dealer has received payment, (2) maintaining records relating to customer trades, (3) responding to customer comments concerning the trading process, and (4) generally monitoring trades and settlements.
The SEC has interpreted the requirement that research services be “provided by” the broker-dealer to allow a money manager to use client commissions to pay for research from a third party other than the executing broker-dealer, so long as the broker-dealer (not the money manager) has the legal obligation to pay for the third party research or pays the research party directly, thereby “providing” the brokerage and research services required under Section 28(e).The SEC will consider further comments on industry practices with respect to client commission arrangements, which may be used to supplement the guidance provided in this release. SEC Release No. 34-54165; File No. S7-13-06 (July 18, 2006).
SEC Publishes New Rules and Disclosure Requirements for “Fund of Funds” Investments
July 21, 2006 10:32 AM
The SEC recently adopted three new rules under the Investment Company Act of 1940 (the “1940 Act”) that broaden the ability of an investment company (“fund”) to acquire shares of another fund. The SEC also adopted related amendments to Forms N-1A, N-2, N-3, N-4 and N-6 that require that the expenses of the acquired funds be aggregated and shown as an additional expense in the fee table of the fund of funds.
Section 12(d)(1) of the 1940 Act restricts the ability of a fund to invest in shares of another fund in order to prevent abuses that might result from the ability of the acquiring fund to control the assets of the acquired fund and using those assets to enrich itself at the expense of the acquired fund’s shareholders.
Section 12(d)(1)(A) prohibits a registered fund and its controlled companies or funds from: