In a no-action letter dated June 17, 2008, the SEC’s Division of Investment Management stated that it would not recommend enforcement action under the Investment Company Act against private investment funds that qualify for the exclusion of the definition of investment company in Section 3(c)(7) if several family funds that are currently qualified purchasers under Section 2(a)(51)(A)(ii), as family-owned companies, invest in Section 3(c)(7) funds and allow a non-family executive director to invest in the funds. The issue presented in the Cabot Wellington, LLC letter is unusual because, here, the executive director’s potential investment did not threaten the exemption of the family funds, which relies on the Section 3(c)(1) exclusion, but instead affected the ability of the family funds to qualify as Qualified Purchasers and, thus, bear ability to invest in other private funds that rely on Section 3(c)(7).

In reaching its conclusion, the Division noted in particular that (1) the Cabot Wellington, LLC family investment committee would like the executive director to align his interests with the funds; (2) the executive director is primarily responsible for all investment decisions; and (3) the executive director is both a knowledgeable employee and a qualified purchaser in his own right.

 

In a no-action letter to Eaton Vance Management dated June 13, 2008, the SEC’s Division of Investment Management agreed that money market funds that rely on Rule 2a-7 could purchase shares of liquidity protected preferred stock (“LPPs”) issued by Eaton Vance closed-end funds without violating various provisions of the Investment Company Act. The LPPs are a new type of preferred equity security that pay a dividend, the amount of which would be reset weekly, based on a determination of the market clearing rate. Unlike auction rate preferred stock (“ARPs”), LPPs would have liquidity support. Each fund issuing LPPs would enter into a liquidity agreement with a highly- rated liquidity provider that would require the provider to purchase any LPPs that were not matched with purchase orders. The liquidity agreement will also give the liquidity provider the right to put all of its LPPs to the fund.

The Division of Investment Management agreed that it would not recommend enforcement action under Investment Company Act Sections 34(b) or 35(d) or Rule 22c-1 against money market funds if they purchase LPPs, assuming that the money market funds otherwise comply with Rule 2a-7. Also, the Division of Investment Management agreed that the LPPs would not be redeemable securities under Section 2(a)(32). Finally, in the same letter, the Division of Corporation Finance agreed that the LPPs could be sold in remarketings without complying with the tender offer requirements of Rule 13e-4 and Regulations 14D and 14E under the Securities Exchange Act of 1934.

Previously, there was concern that such a liquidity feature would require characterization of LPPs as debt, rather than equity, securities. However, in a Notice dated June 13, 2008 and further revised on June 25, 2008, the Internal Revenue Service issued guidance on ARPs suggesting such securities will be treated as equity securities for federal income tax purposes.

 

In the mid-1990s, the insurance industry began offering a new type fixed annuity contract that contained all of the classic elements of a fixed annuity issued by an insurer’s general account, but also offered participation in an index, such as the S&P 500 Index. Specifically, the contract holder would receive the greater of the promised debt-like return of 3% or 4% no matter what, but also could earn as much as 85% or so of the movement of the index during the contract year. The SEC issued a release in 1998 asking for comments on questions they had about equity index annuity contracts, and whether in particular these types of fixed annuity contracts were “securities” or were “insurance” which is exempted from the Securities Act by Section 3(a)(8) thereof. A number of insurers have issued equity index annuity contracts without registering them under the Securities Act and, until recently, they were a best-selling product.

For purposes of supervising registered representatives of broker-dealers, some brokerage firms have allowed their registered representatives to engage in outside activities (subject to the conditions in NASD Rule 3040) and some have not. See NASD Notice to Members 05-50 (warning supervisors that, if they fail to supervise the outside insurance activities of registered representatives selling equity index annuity contracts and if equity index annuity contracts are ultimately deemed to be “securities” and not insurance, they could face personal liability). Independently, (i) several state attorneys generals brought litigation against broker-dealers selling equity index annuity contracts alleging that they were “securities” and had been sold in a fraudulent manner, (ii) several state attorneys generals sued insurance companies alleging that they had permitted abusive sales practices, and (iii) SEC Chairman Cox made protection of seniors from abusive sales practices one of the hallmark policies of his tenure as Chairman.

On June 26, 2008, the SEC issued a release proposing new Rule 151A regarding equity index annuity contracts and new Rule 12h-7 under the Exchange Act that would exempt insurers deemed to have issued a security from becoming reporting companies. Proposed Rule 151A would provide that indexed annuity contracts would not be excluded by Section 3(a)(8) if (1) amounts payable by the issuer are calculated based wholly or partially on the performance of a security or index of securities and (2) amounts payable by the issuer are more likely than not to exceed the amounts guaranteed. An issuer’s determination, made no later than at the issuance of the contract, as to the determination of amounts payable and guaranteed would be conclusive, if (1) the methodology and economic, actuarial, and other assumptions used are reasonable, (2) the issuer’s computations underlying the determination are materially accurate, and (3) the determination is made not more than six months before the form of contract is first offered and not more than three years before the particular contract is issued.

Rule 151A would be prospective, meaning that it would apply only to annuity contracts that are issued on or after the effective date of the final rule. Comments on the proposal are due by September 10, 2008.

 

On June 25, 2008, the Securities and Exchange Commission voted to propose changes to many SEC rules and forms, including several rules under the Investment Company Act of 1940, to limit the use of nationally recognized statistical rating organizations’ (“NRSROs”) ratings. The changes would replace requirements tied to NRSRO ratings with other requirements designed to achieve the intended purpose of the rules or forms.

Although the SEC's formal proposals have not yet been issued, the statements of members of the Division of Investment Management at the open meeting summarized the principal changes that would affect investment advisers and investment companies. For each of the following rules, the SEC proposes eliminating the reference to credit ratings and instead requiring an investment company or investment adviser to make a determination that securities present minimal credit risk and are sufficiently liquid:

(1) Investment Company Act Rule 5b-3, which allows investment companies to “look through” repurchase agreements to the securities collateralizing the agreement if those securities are highly rated or U.S. government issues;

(2) Investment Company Act Rule 10f-3, which permits investment companies to purchase municipal securities in an underwritten offering from a syndicate that includes an affiliated person if the securities carry an investment grade rating; and

(3) Rule 206(3)-3T under the Investment Advisers Act of 1940, which provides an alternative means for registered broker-dealers to satisfy the notice and consent requirements of Section 206(3) when effecting principal transactions with clients in non-convertible investment grade debt securities.

Rule 2a-7, which requires that (i) a money market fund's portfolio investments be limited to securities that have received one of the two highest short-term ratings from NRSROs, and (ii) the fund's board of directors, or its delegate, determine that the securities present minimal credit risks, would change in four principal ways. First, the reference to ratings would be eliminated and money market funds would themselves be responsible for determining the credit risk of each individual security (although funds may incorporate NRSRO ratings into this analysis). Second, the proposed amendments would require expressly that the securities held by money market funds be sufficiently liquid, by limiting a money market fund's investment in illiquid securities to no more than 10 percent of its total assets. Third, the downgrade and default provisions of Rule 2a-7 would be revised to require a money market fund's board of directors to promptly reassess the risk of the security if and when the investment adviser becomes aware of adverse information. Finally, the proposed amendments would require money market funds to notify promptly the SEC when an affiliate purchases from the fund a security that is no longer an Eligible Security, under Rule 17a-9.

For Rule 3a-7, which excludes from the Investment Company Act structured finance vehicles offered to retail investors that carry an investment grade rating, the SEC voted to propose to amend the rule to limit the type of investors that may participate in offerings of the securities to accredited investors and qualified institutional buyers.

The SEC also voted to propose amendments to various rules under the Securities Act of 1933 and the Securities Exchange Act of 1934, including the shelf registration rule and the net capital rule.

Some of the changes undoubtedly will be controversial. For example, the proposed changes to Rule 2a-7 could greatly increase the costs of operating money market funds.

 

Effective Friday, June 20, new provisions in the Code of Market Conduct will require disclosure of significant short positions in stocks of companies that are undertaking rights issues. The new regime requires managers to monitor UK positions and announcements by UK issuers to see if a UK issuer has announced a rights issue. Affirmative disclosure is required if the manager has a qualifying short position as defined. A significant short position is defined as 0.25% of the issued shares achieved via short selling or by any instruments giving rise to an equivalent economic interest. A manager will have until 3:30 pm the following business day to disclose positions exceeding this threshold to the Regulatory Information Service. Non-disclosure will be regarded as prima facie evidence of market abuse.

The new disclosure requirements apply to both persons with an existing short position of 0.25% or above on June 20 and those who take up a short position after the period has commenced. As currently drafted, once a manager has disclosed a short position, it has no further obligation to disclose either increases or decreases in the position, although the FSA notes that they plan to keep this under review. A manager is required to aggregate all funds over which it has investment discretion, though it need not name the funds individually. In calculating whether a holder has a disclosable short position, a manager should take into account any form of economic interest it has in the shares of the issuer, excluding any interest which it holds as a market maker in that capacity.

The Financial Service Authority also released a series of Frequently Asked Questions on June 18, clarifying the new rule. The FAQs address treatment of options, aggregation of positions, and provide definitions of several terms, including economic interest and rights issue.

Introduced without consultation on June 12, the new rule has caused an uproar in the industry. The rule change likely will affect many US hedge funds and other investors if they have European portfolio strategies.

The FSA announcement can be found in the FSA’s library at the following location:

http://www.fsa.gov.uk/pages/Library/Communication/PR/2008/057.shtml 

 

On June 11, 2008, the U.S. District Court for the Southern District of New York found that a hedge fund that had entered into various total return swaps referencing shares of common stock of CSX Corporation was deemed to be the beneficial owner of the stock for purposes of Section 13(d) of the Securities Exchange Act of 1934. The court based its holding on the anti-evasion provisions in the definition of “beneficial ownership” in Rule 13d-3(b), concluding that the “activist” hedge fund defendants had entered into the swaps with the purpose or effect of preventing the vesting of beneficial ownership as part of a “plan or scheme” to evade the reporting requirements of Section 13(d).

The court concluded that the defendants violated Section 13(d) by failing to file a Schedule 13D within 10 days of entering into total return swaps referencing at least 5 percent of the CSX shares then outstanding. Although the court enjoined future violations of Section 13(d) by the defendants, the court declined to enter an injunction denying the defendants the ability to vote their securities.

The court’s decision, which conflicts with an amicus letter of the SEC’s Division of Corporation Finance, has been appealed by both sides to the United States Court of Appeals for the Second Circuit. Although the opinion is nominally limited to the particular facts in the case, the broad potential applicability of the decision will create significant uncertainties for various participants in the equity markets as to whether and how the decision will be applied to Section 13(d) reporting under different facts.

CSX Corporation v .The Children’s Investment Fund (UK) LLP, et al., Case No. 08 Civ. 2764 (S.D.N.Y.)

 

On June 16, 2008, the SEC published a release proposing new requirements for NRSROs. The SEC is attempting to address concerns about the integrity of NRSROs’ credit rating procedures and methodologies in light of the role NRSROs play in determining credit ratings for securities collateralized by, or linked to, sub-prime residential mortgages. The new rule amendments would regulate conflicts of interests, disclosures, and internal policies and business practices of NRSROs.

The SEC first adopted rules regulating NRSROs in June 2007, shortly after passage of the Credit Rating Agency Reform Act of 2006 and before recent credit market events. The SEC is now responding to those credit market events, and proposed two related actions.

The first action would: (i) would require NRSROs that rate structured finance products to disclose publicly the information provided to the NRSRO and used by it in determining credit ratings; (ii) prohibit NRSROs and their credit analysts making recommendations to issuers and sponsors of structured finance products about how to obtain a desired credit rating; (iii) requiring the separation of personnel who make credit rating determinations from those who negotiate credit rating fees; (iv) prohibiting the receipt by NRSROs and their credit analysts of any gifts that have an aggregate value of no more than $25; (v) requiring NRSROs to make a record of, and disclose, all of their rating actions, including initial ratings, upgrades, downgrades and placements on credit watches; (vi) require disclosure if a credit rating was issued that materially deviated from any quantitative model used by the NRSRO; (vii) maintain records of any complaints regarding the performance of a credit analyst in determining credit ratings; and (viii) require increased disclosures about the procedures and methodologies used by NRSROs.

The second action would require NRSROs to differentiate the ratings they use for structured finance products from the ratings they use on bonds, either by using different symbols or by issuing a report detailing the differences. Commissioner Atkins voted to oppose this proposal, arguing that the proposal had tenuous benefits but large costs and also suggesting that the SEC may not have legal authority to take this action.

The SEC stated that it also intends to propose further rule amendments in the near future that would reduce reliance on NRSROs’ ratings as surrogates for compliance with various regulatory requirements. Many important SEC rules, including Investment Company Act Rule 2a-7, which governs the investments of money market funds, and Securities Exchange Act Rule 15c3-1, which governs the net capital requirements for broker-dealers, turn in part on NRSRO ratings. Amending those rules to reduce reliance on the ratings would appear to be a difficult enterprise.

The proposed new requirements go far beyond the voluntary standards announced by Standard & Poor’s, Moody’s, Fitch, and the New York Attorney General and are certain to be controversial. Comments will be due in late July.

For more information, the complete text of the proposed rule amendments is located here:

http://www.sec.gov/rules/proposed/2008/34-57967.pdf 

 

On June 10, 2008, the SEC published a release seeking comments on a rule that would require mutual funds to provide risk/return summary information in a form that would improve its usefulness to investors. The proposed rule would require mutual funds to provide risk/return summary information both to the SEC and on their websites in interactive data format using the eXtensible Business Reporting Language (“XBRL”).[1] With access to interactive data, investors could then download the data directly into spreadsheets, analyze the data using commercial software, and even apply the data directly to investment models in other software formats.

The proposed rule is intended not only to make risk/return summary information easier for investors to analyze, but also to assist in automating regulatory filings. The SEC argues that by enabling mutual funds to further automate their disclosure process, interactive data has the potential to improve the speed at which mutual funds generate information and eventually to reduce the cost of filing.

Mutual funds have been submitting information in interactive data format to the SEC on a voluntary basis since the SEC’s pilot program began in 2007. The proposed rule would require all mutual funds to provide risk/return summary information in XBRL as an exhibit to their registration statements by December 31, 2009. The SEC is also proposing to allow investment companies to submit portfolio holdings in its interactive data voluntary program without being required to submit other financial information.

Comments on the proposed rule should be submitted on or before August 1, 2008.

The proposed rule can be found at the following location:

http://www.sec.gov/rules/proposed/2008/33-8929.pdf  

The FSA published Principles of Good Practice for the Handling of Inside Information (the “Principles”) that highlight best practices for handling inside information for firms not directly subject to FSA regulation. The Principles are voluntary, and support the idea that unregulated participants in the capital markets accept responsibility for their own conduct. They were created by an industry working group of regulated and unregulated market participants, and are meant to help raise the standards for using and controlling inside information. The FSA outlined the following six principles and further discussed each principle and specific practice suggestions in an annex to the Principles. U.S. firms that are active in markets in the United Kingdom may find these Principles to be particularly useful.

• Policies and Procedures. Firms should recognize their responsibility to control access to, and reduce the risk of misuse of, inside information, and should establish policies and procedures addressing these issues. The handling of price sensitive information, addressing inquiries by external parties such as the media, appointing a senior person to oversee the controls and procedures, and controlling information handled by staff are among the policies firms should consider.
• Awareness and Training. Firms should train and otherwise assist staff to understand the importance of keeping information secret and the liabilities for disclosing information improperly. Among other practices, firms should consider providing training, updating staff as new rules come into effect, and testing staff awareness and understanding periodically.
• “Need to Know” and Other Information Controls. Firms should take steps to limit the number of persons with access to inside information and, if possible, only disclose information to persons who “need to know.” Firms should consider separating deal teams from other parts of the business (where practicable), providing inside information to persons only after they are alerted to their responsibilities regarding the information, limiting the number of insiders, and maintaining a list of the insiders. Additionally, firms may choose to implement policies regarding the secure disposal and use of confidential documents (including using code names, implementing clear desk policies, and establishing procedures for working off-site).
• Passing Price Sensitive Information to Third Parties. Firms should take reasonable care to ensure that third parties are aware of their obligations regarding the use and control of the inside information they receive. Also, they should consider providing the information to third parties as late in the process as possible, orally explaining the responsibilities, and ensuring that the third parties have procedures in place to protect the information.
• Information Technology (“IT”) Security. Firms should address the security of and access to inside information on IT systems, create IT file audit trails, and implement controls to limit access to systems and information. Firms also may consider requiring IT personnel to comply with all insider trading policies and procedures and employing “ethical hackers” to test security against data theft.
• Personal Dealing Policies. Firms should establish policies for trading in personal accounts, which may include trading as power of attorney, through discretionary accounts, and by immediate family members. Firms should consider making specific references in the policies to derivatives and related products, and to the civil and criminal penalties for dealing or enabling dealing on the basis of inside information. Trading restrictions, holdings reports, and logs of trading requests also may be maintained.

The Principles of Good Practice can be found in the FSA’s Market Watch at http://www.fsa.gov.uk/pubs/newsletters/mw_newsletter27.pdf.  

A U.S. Bankruptcy Court for the District of Delaware found that in order for a group of noteholders to appear and be heard in a bankruptcy proceeding, specific information had to be disclosed for each member of the group regarding the nature and amount of the claim or interest in the company that filed for Chapter 11 bankruptcy protection. Under Bankruptcy Rule 2019(a), an entity or committee representing creditors must disclose certain categories of information. The group’s initial disclosure statement disclosed the noteholders’ names and addresses, as required, and the aggregate amount of the bonds held by them, but did not disclose additional information required by Rule 2019(a)(1)-(4).

The judge ruled from the bench that the noteholders constituted a committee or entity, and required them to revise their statement to disclose the information required by Bankruptcy Rule 2019(a)(1), (2) and (3), including the nature and amounts of claims or interests owned by each noteholder, the time the interests were acquired, and the entity at whose instance the group was organized or agreed to act. The judge did not require the noteholders to disclose the items required by Bankruptcy Rule 2019(a)(4), including the amounts paid for the interests and any sales or dispositions of the interests, because the judge did not think these items were relevant to this matter.

The order is noteworthy because the judge tried to reach a compromise between concerns about disclosing proprietary trading strategies to the public and the public’s right to access information in a bankruptcy proceeding. During the hearing, the judge stated that each situation has to be viewed light of the particular dynamics of the case and of the matter within the case, and that the Court must balance the interests of the parties and of the particular context in which the issue arises.

The motions, orders and transcript of the hearing can be found at In re: Sea Containers Ltd., Case No. 06-11156 (Bankr. Del.).
 

The SEC’s Division of Corporation Finance submitted a letter as amicus curiae to the U.S. District Court of the Southern District of New York, arguing that a hedge fund should not be required to report shares held by counterparties in swap transactions. The fund was the long party in cash-settled total return equity swap transactions with several banks that also owned shares of the equity issuer to hedge their positions. The issuer alleged that the fund violated Section 13(d) of the Securities Exchange Act of 1934 (“Exchange Act”) by becoming the beneficial owner of the issuer’s shares without sending required notices.

Section 13(d) requires a person who directly or indirectly becomes the “beneficial owner” of more than five percent of a class of any equity security to send to the issuer, the relevant exchange and the SEC a statement disclosing certain information. Rule 13d-3 defines “beneficial owner” to include a person who: (a) directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares voting power or investment power over the subject equity securities, or (b) creates or uses a contract, arrangement or device with the purpose or effect of divesting, or preventing the vesting of, beneficial ownership over the subject equity securities as part of a plan or scheme to evade the reporting requirements of Section 13. The Court solicited views as to whether the swaps gave rise to beneficial owner status for the fund and as to the mental state required to establish the existence of a plan or scheme to evade Section 13 reporting requirements.

As to the first inquiry, the Division argued that voting power and investment power are based on actual authority to vote, dispose of or direct the voting or disposition of shares, and are not satisfied by the mere presence of economic interests or incentives. A standard cash-settled equity swap agreement did not give the fund actual authority to vote or dispose, or to direct the voting or disposition of, the subject securities. The Division reasoned that, even if the bank counterparties had an economic or business incentive to vote the shares as the fund wished or to dispose of the shares to the fund, in doing so the counterparties still act independently and in their own economic interests without being constrained by the fund’s legal rights or by any understanding, arrangement or other relationship with the fund.

As to the second inquiry, the Division opined that, the fact that a party to an arrangement is motivated, in whole or in part, by the desire to avoid Section 13 reporting obligations is not relevant to determining whether “a plan or scheme to evade” reporting requirements exists. The Division explained that generally, “taking steps with the motive of avoiding reporting and disclosure generally is not a violation of Section 13(d) unless the steps create a false appearance.” Accordingly, a person who enters into a swap will not be deemed to have beneficial ownership under Rule 13d-3 unless the person knows, or is reckless in not knowing, that the transaction would create a false appearance that the person does not own the security.

The Division noted that, while neither it nor the SEC had previously issued public guidance regarding the mental state required by Rule 13d-3(b), the Division’s views as stated in the letter were consistent with SEC guidance on similar language in other rules that a transaction constitutes a “plan or scheme to evade” if it is a sham, i.e., a contract, arrangement or device to create an illusion that is contrary to actual fact. The Division noted that there may be egregious circumstances where “a plan or scheme to evade” exists without evidence of the intent to present a false appearance, but the mere ordinary characteristics of an equity swap do not present such circumstances. Finally, the Division noted that it is considering whether to recommend new rules in this area, and that until such time as new rules may clarify new obligations of swap parties, imputing the existence of beneficial ownership now, absent unusual circumstances, would create uncertainties for investors who have used equity swaps in accordance with accepted market practices understood to be based on reasonably well-settled law.

The Division’s letter can be found as an appendix to the Response to the SEC Amicus Letter, in CSX Corp. v. The Children’s Inv. Fund Mgmt., L.L.P., 08-Civ. 2764 (S.D.N.Y).