On July 30th, the SEC staff provided informal guidance regarding the disclosures investment companies should make in shareholder reports, financial statements, and prospectuses regarding the use of derivatives. Specifically, the staff discouraged the use of generic or overly technical descriptions, recommending that investment companies use plain English to specify how and why derivatives might be used by a particular fund. The disclosure should not overstate the extent to which a fund may use derivatives, but should include a thorough discussion of the related risks. A fund’s financial statement should provide a clear picture of how a fund has used derivatives during the reporting period to achieve its investment objectives. In addition, each fund should take care to ensure that the disclosures in shareholder reports and prospectuses are consistent with each other and accurately reflect the derivative investment activity represented in the fund’s financial statements. The staff also noted that its comprehensive review of derivative use by investment companies is still underway.

For more information, please see:

http://sec.gov/divisions/investment/guidance/ici073010.pdf

On July 12th, the U.S. Court of Appeals for the District of Columbia formally vacated Rule 151A under the Securities Act, thwarting the SEC’s attempts to regulate indexed annuities. Last summer, the court had remanded the rule to the SEC for further analysis of the effect the rule would have on efficiency, competition, and capital formation. With no further progress by early 2010, the petitioners asked the court for a rehearing – this request was ultimately granted in July when it formally vacate the rule. The court’s latest decision leaves oversight of these products in the hands of individual state insurance regulators.

In addition, the federal financial reform legislation, described in more detail above, contains a provision that further interferes with SEC efforts to treat indexed annuities as securities, requiring the SEC to treat certain indexed annuities and similar products as “exempt securities” under Section 3(a)(8) of the Securities Act.

For more information, please see:

American Equity Investment Life Insurance Company v. SEC, No. 09-1021 (D.C. Cir. July 12, 2010).

On July 21st, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”), expanding federal regulation of numerous aspects of the financial services industry. Key elements of the Act include:

• The Act expands SEC registration requirements to cover advisers to most “private funds.” The registration requirements will apply to advisers with at least $25 million in assets under management, but only where states do not require their registration. For advisers located in states that require registration, the threshold for SEC registration is increased to $100 million in assets under management. Managers of venture capital funds (as defined by the SEC) will be exempt from registration and family offices (as defined by the SEC) will be excluded from the definition of investment adviser;
• The Act makes a number of changes to the regulation of banks and thrifts and their holding companies in order to reduce risks to US financial stability, including the imposition of capital requirements on bank and thrift holding companies. It also implements a compromise version of the “Volcker Rule,” generally barring proprietary trading and hedge fund or private equity fund sponsorship by banking entities but providing a series of exceptions that allow some of these activities to continue;
• Systemic risk will be addressed by the new “Stability Oversight Council” which will be charged with identifying risks to US financial stability, promoting market discipline, and responding to threats to the stability of the US financial system;
• The Act seeks to prevent bailouts as it establishes new liquidation authority, which allows the Federal Deposit Insurance Corporation to unwind failing bank holding companies and nonbank financial companies when necessary to prevent serious adverse effects on national financial stability;
• The Act establishes the “Bureau of Consumer Financial Protection” as an autonomous agency within the Federal Reserve that concentrates rulemaking, supervision and powerful new enforcement tools for consumer protection in a single agency to a degree never before seen in the federal financial regulatory scheme;
• The Act addresses the over-the-counter derivatives market and subjects almost all swaps and security-based swaps to regulation. Most notably, almost all swaps are required to be cleared through a derivatives clearing organization or a clearing agency (collectively, a “DCO”) and traded on an exchange or alternative execution facility. Any swap entered into by a major swap participant or swap dealer – which includes virtually any significant market actor – will generally not be exempt from clearing. There are substantial registration, recordkeeping, and reporting requirements for DCOs, swap repositories, exchanges and alternative execution facilities, as well as for major swap participants and swap dealers;
• The Act includes provisions that address a wide range of investor protection issues relating to the functioning of securities markets and the operation of the SEC. Organized into 10 subtitles, it contains a number of fairly contentious provisions, including the possible extension of a fiduciary duty to broker-dealers, increased civil liability for credit rating agencies, and enhanced liability and enforcement tools; and
• The Act seeks to ensure that certain swaps that will be required to be exchange-traded will not be treated as Section 1256 contracts under the Internal Revenue Code, which requires that covered contracts be marked to market at the end of each tax year so that their gain or loss is recognized each year.

The Act is effective as of July 22, 2010, but effectiveness of particular provisions are set for dates in the future. The Act creates a number of new regulatory, supervisory, and advisory bodies and it touches on the regulation of virtually every aspect of US financial markets and activities. Nevertheless, it also leaves an extraordinary number of matters to be addressed through rulemaking and other regulatory action, giving the regulators significant discretion in many areas. Thus, it will take some time for the final effect of the legislation to emerge.

For a more detailed description of the Act, please see one of the following WilmerHale publications regarding the reform legislation:

Private Fund Manager Registration Act Signed Into Law – available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9571; and
Dodd-Frank Act Expands Federal Regulation of Public Company Governance,

Executive Compensation and Disclosure – available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9575  

On July 27th, the SEC published a request for preliminary public comment to on the obligations and standards of care of broker-dealers and investment advisers providing personalized investment advice about securities to retail investors. Specifically, the SEC is requesting comments and data regarding the effectiveness of the “existing standards of care for brokers-dealers and investment advisers, and whether there are gaps, shortcomings, or overlaps in the current legal or regulatory standards.”

The comments will be incorporated into the study required by the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act. Comments will be accepted for 30 days following publication of the notice in the Federal Register.

 For more information, please see:

http://www.sec.gov/rules/other/2010/34-62577.pdf  

On July 28th, the SEC’s Division of Investment Management released a no-action letter providing assurances that a federally-registered investment adviser would not be deemed to have violated Sections 204 and 204A under the Investment Advisers Act and Rules 204(2) and 204A-1 thereunder if the adviser does not require its access persons to report their transactions or holdings in Qualified Tuition Programs established pursuant to Section 529 of the Internal Revenue Code. These assurances only extend to circumstances where the investment adviser or its control affiliate does not manage, distribute, market, or underwrite the 529 Plan or the investments and strategies underlying the 529 Plan that is a college savings plan.

The staff’s position is based on the understanding that investments in 529 Plans, whether they are college savings plans or prepaid college tuition plans, present little opportunity for the types of abuse that Section 204A and Rule 204A-1 were designed to prevent. For example, the Internal Revenue Code and Department of Treasury guidance strictly limit an account holder’s ability to direct the investments underlying a 529 Plan and there is no secondary market for interests in such plans. The staff’s position extends to Rule 17j-1 under the Investment Company Act, which requires access persons of investment advisers to registered investment companies to report their personal transactions and holdings in “covered securities.”

For more information, please see:

http://www.sec.gov/divisions/investment/noaction/2010/wilmerhale072810.htm  

On July 21st, the SEC proposed new regulations that would eliminate Rule 12b-1 under the Investment Company Act and replace it with Rule 12b-2 in an effort to change how mutual funds approach and disclose distribution fees to fund investors.
Key elements of the proposed rule include:

• Require funds to cease using the term “12b-1 fees” and instead describe distribution fees as “ongoing sales charges” and “marketing and service fees” in the funds’ prospectus, shareholder reports, and confirmations.
• Require funds to differentiate between a “marketing and service fee” and an “ongoing sales charge”
• The marketing and service fee would be tied to the NASD sales charge rule, currently capped at 25 basis points, and used for any distribution-related expense
• The ongoing sales charge would be capped based on the highest fee charged by the fund for shares that have front-end sales loads instead of ongoing sales charges. If a fund does not have a share class with a front-end sales load, the ongoing sales charge would be tied to the aggregate NASD sales charge rule, currently set at 625 basis points.
• Give funds and underwriters the option to sell shares through broker-dealers at competitively established rates, allowing the broker-dealers to establish sales charges for the transactions that reflect the services each broker-dealer provides to the investor.
• Eliminate the need for fund directors to approve and annually re-approve long-term distribution agreements, although directors would still need to monitor and approve the use of fund assets to pay for distribution in accordance with their fiduciary obligations.
• Industry representatives already have raised concerns about potential challenges implementing the rule – particularly in the context of omnibus accounts and the corresponding difficulty calculating and tracking sales charge payments for individual shareholders.
• The public comment period for the rule proposal extends through November 5, 2010.

For more information, please see:

http://www.sec.gov/rules/proposed/2010/33-9128.pdf

On July 21st, the SEC adopted amendments to Form ADV and new rules, originally proposed in 2000 and re-proposed in 2008, governing the primary SEC disclosure document that registered investment advisers must deliver to clients. The new form replaces the “check the box” format with a narrative, plain English brochure that will be filed with the SEC and publicly available on the SEC’s website. (Form ADV Part II is replaced by Form ADV Part 2.) While the new brochure is to be in narrative format, the information must be presented in the same order as the items in the form and must incorporate the form’s headings verbatim. The new brochure must contain disclosures on the following: 

•  The types of advisory services offered and the amount of assets under management;
• The adviser’s compensation structure and whether fees are negotiable, a fee schedule, and types of other fees that clients may pay in connection with the services provided (e.g., brokerage fees, custody fees, and other fund expenses);
• Investment strategies, techniques, and related material risks, detailing any unusual risks;
• Material facts about legal or disciplinary events that involve the integrity of an adviser’s management personnel or that are material to a client’s evaluation of the advisory services;
• The adviser’s code of ethics, personal trading policies, and, if applicable, how the adviser addresses conflicts that arise when the adviser or an affiliate has a material interest in client transactions; and
• The adviser’s brokerage practices and the related conflicts of interest, including selecting broker-dealers, broker-dealer compensation, use of soft dollars, client referrals, directed brokerage, and trade aggregation.

While the new form does not require an adviser to describe its full spectrum of policies and procedures, as proposed originally in 2000, the new form does require the adviser to describe how it will manage the conflicts of interest that are disclosed in the brochure. The adopting release does not contain specific guidance as to what disclosures would satisfy this requirement.

The new form also requires advisers to provide brochure supplements with many details regarding the individuals who will provide services to clients. The supplements may be stand alone documents or be incorporated into the main brochure. The adviser must describe how each of the individuals is compensated and provide information about their education, work experience, outside business activities, and disciplinary history. Notably, if an adviser chooses to identify professional designations held by an employee (e.g., CFA), the supplement also must explain what is involved in earning that designation. In addition, the adviser also must identify each employee’s supervisor and provide contact information for that supervisor so a client knows to whom complaints should be directed. The release gives complex guidance regarding who must receive a copy of the supplement and which employees each supplement must cover. Implementation of the supplement requirement likely will be costly for adviser, as they produce, deliver, and regularly update the supplement to reflect changes in investment teams, either through evolving responsibilities, new arrivals, or departures.

As with the current Form ADV Part II, the adviser must provide each client with a copy of the disclosure document before or at the time a client enters into an advisory contract and either provide, or offer to provide, an updated document each year. Under the new rules, the adviser also must deliver a summary of material changes to each client annually. (The adviser may be required to deliver disclosure of certain changes to its clients promptly.) The SEC’s adopting release clarifies that the new rules do not require advisers to deliver the brochure to investors in private funds. The SEC has directed its staff to coordinate with state officials to ensure that the new Form ADV Part 2 is a uniform SEC-state form.

Registered advisers will need to comply with the new Form ADV Part 2 requirements beginning with the annual updates due by March 31, 2011 (for fiscal years ending on December 31, 2010). Advisers submitting registration applications must begin complying with the new Form ADV Part 2 requirements as of January 1, 2011.

For more information, please see:

http://www.knowledgemosaic.com/gateway/Rules/PRE.2010-127.072210.htm; and

http://www.knowledgemosaic.com/gateway/Rules/FR.ia-3060.072810.pdf