A registered representative of a broker-dealer registered with the SEC (the “Broker”) requested confirmation from the staff of the SEC’s Division of Market Regulation (the “Staff”) that it would not recommend enforcement action against customers of the Broker if the customers received partial refunds of Rule 12b-1 fees attributable to their investment in certain mutual funds. The 12b-1 fees were paid out of the fund’s assets to broker-dealers that facilitate distribution of the fund’s shares.

To participate in the Broker’s refund program, the fund investors would be required to re-register the applicable shares in the street name of the Broker’s employer or change their “broker of record” for the applicable mutual fund to the Broker’s employer. The Broker noted that the customers should not be deemed to be brokers or dealers under the Securities Exchange Act of 1934 (the “Exchange Act”) as a result of merely owning shares in mutual funds and receiving a partial refund of Rule 12b-1 fees under the arrangement proposed by the Broker. Section 3(a)(4) of the Exchange Act defines the term “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” Section 3(a)(5) of the Exchange Act defines the term “dealer” as “any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.” The Broker argued that by participating in the refund arrangement, customers are not being “engaged in the business” of effecting securities for the account of others. The Broker additionally argued that holding shares in a mutual fund and participating in the refund arrangement would not constitute being “engaged in the business” of buying and selling securities for such person’s own account through a broker or otherwise, provided the person in question does not buy and sell the mutual fund shares as part of a regular business. The Staff agreed with the Broker’s analysis, but noted that any advertising and other communications with the public related to the Broker’s program would be subject to the advertising rules of the National Association of Securities Dealers, Inc. (“NASD”). The Staff additionally noted that it expected that the Broker’s employer, an NASD member, and not any individual registered representative acting in a separate capacity (e.g., investment adviser or insurance agent) would be responsible for soliciting customers for the program.

However, the Division of Investment Management (the “Division”) pointed out that the Broker’s proposal implicated provisions of the 1940 Act, which the Broker did not address. The staff of the Division questioned whether direct or indirect rebates of Rule 12b-1 fees by a fund are consistent with the policies and provisions of the 1940 Act. Citing the Southeastern Growth Fund no action letter (pub. avail. May 22, 1986), the Division noted that a waiver or rebate of an investor’s pro rata portion of expenses incurred under a Rule 12b-1 plan would raise “serious concerns under both Section 36 of the 1940 Act and general fiduciary principles.” Specifically, the Division noted that Rule 12b-1 requires a fund’s board of directors to conclude that there is a reasonable likelihood that a 12b-1 plan will benefit the fund and its shareholders before a fund may implement or continue the plan. The Division additionally noted that Rule 12b-1 also requires the board, in reaching this conclusion, to consider and give appropriate weight to all pertinent factors and record in the fund minutes the basis for the decision to use fund assets for distribution. The Division stated that it believed that a broker-dealer’s practice of rebating to its customers all or a portion of 12b-1 fees paid by the fund to the broker-dealer would be a pertinent factor requiring the board’s full consideration in reaching its conclusion with respect to a fund’s 12b-1 plan. The Division additionally questioned whether a 12b-1 plan under which broker-dealers rebate 12b-1 fees to their customers would benefit the fund and its shareholders. Edward Mahaffy no action letter pub. avail. March 17, 2003.

The SEC has issued a FAQ addressing questions regarding Form N CSR filings via EDGAR. The FAQ addresses a variety of topics including:

• EDGAR submission types for Form N-CSR,
• the name of the Form N-CSR certification exhibit document,
• mechanics of attaching the N-CSR certification exhibit, and
• the name of the code of ethics exhibit.

The FAQ is located at http://www.sec.gov/info/edgar/certinvco.htm.

The OMB has approved the recently adopted rule requiring investment companies to disclose their voting of shares of corporate issuers. Investment companies were hopeful that the OMB would heed their claims that the new rule was overly burdensome and costly for the investment company industry. In a brief statement, the OMB announced that it had “approved the SEC information collection request” included as part of the new rule. The Wall Street Journal, March 28, 2003.

The House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises (the “Subcommittee”) has requested that SEC chairman William Donaldson provide the SEC’s views on a variety of topics regarding mutual fund governance and transparency of mutual fund fees and costs. Subcommittee Chairman Richard Baker wrote that he was concerned about “insufficient transparency of mutual fund fees, costs and operations,” the performance of mutual fund directors and fund distribution practices. He requested the SEC’s views on the following topics:

Transparency of mutual fund fees and costs. The Subcommittee asked for the SEC’s recommendations on promoting greater transparency of fees for investors and an assessment of the “relative utility” of information regarding fund fees and costs provided in shareholder account statements and periodic reports versus the prospectus and statement of additional information. The Subcommittee also asked for an analysis of how disclosure regarding portfolio trading costs could be improved. Finally, the Subcommittee requested that the SEC address how soft dollar arrangements create undisclosed conflicts of interest and whether enhanced transparency and disclosure of actual execution costs would benefit investors.

Portfolio manager information. The Subcommittee requested the SEC’s views on whether disclosure regarding portfolio manager holdings of fund shares would benefit investors.

Mutual fund governance. The Subcommittee requested, among other things, the SEC’s analysis of the current definition of independent directors under the 1940 Act and additionally requested that the SEC provide a discussion of whether the definition is adequate. The Subcommittee requested that the SEC address whether directors are adequately serving fund shareholders’ interests, including oversight of fund fees. The Subcommittee asked for a discussion of the frequency of rejection of management contracts by fund directors in the past ten years.

Fund distribution issues. The Subcommittee asked for the SEC’s views on Rule 12b-1 under the 1940 Act, including a discussion on whether the rule should be updated. The Subcommittee also asked the SEC to describe revenue sharing arrangements, including the impact of their expenses on investors, the legal issues raised by such arrangements with respect to Rule 12b-1 and the transparency of these arrangements and their associated costs.

Finally, the Subcommittee asked for the SEC’s view on a variety of other issues, including the utility of performance information provided to fund investors, mutual fund investments in initial public offerings, proxy voting and fair value pricing of securities. The Subcommittee requested a response from the SEC on these issues by June 11, 2003.

The NASD has posted an Investor Alert with information regarding principal protected funds. In the Alert, the NASD noted the proliferation of these funds (also known as capital preservation or guaranteed funds) during the continuing bear market. The NASD provided investors with a brief overview of the common characteristics shared by principal protected funds, including:

• guarantee of principal,
• lock-up period, and
• investments in a mixture of bonds and stocks.

In addition, the NASD noted that many principal protected funds carry expense ratios that are typically higher than that of non-protected funds. Finally, the NASD raised issues for prospective investors in principal protected funds to consider prior to investing. In particular, the NASD urged investors to consider the following:

1. Investments in principal protected funds are subject to a lock-up period of generally between five and ten years. The NASD cautioned investors to consider whether they would need their investment within that time frame since a redemption from a principal protected fund could cause the investor to lose his or her principal guarantee, pay an early withdrawal penalty and lose some or all of his or her original investment if the share price has fallen since the initial investment.
2. Shareholders in principal protected funds will not receive income from the investment during the lock-up period. The guarantee provided by principal protected funds is based on the assumption that the investor will not redeem his or her shares during the guarantee period and that all dividends and distributions will be reinvested.
3. Unless the shares of a principal protected fund are held in a tax-deferred retirement account, the investor must pay U.S. income tax on the imputed interest from the fund’s zero-coupon bond holdings as it accrues. The NASD noted that investors pay taxes on imputed interest even though they receive no cash distribution from the zero-coupon bonds held in the fund’s portfolio.
4. Investors should consider the fund’s portfolio. For instance, the NASD noted that in a rising stock market, a principal protected fund’s portfolio of zero-coupon bonds and other debt securities would likely lag the market.
5. Investors should investigate the company that issues the guarantee. The NASD noted that while it is uncommon, it is possible that the bank or insurance company backing the guarantee may be unable to meet its obligations.

NASD Investor Alert, March 27, 2003.

In yet another warning to the hedge fund industry of a possible increase in SEC regulation, SEC chairman William Donaldson commented at a recent industry conference that he plans a “long, hard look” at hedge funds. He noted that the allegation of hedge funds wielding “undue influence” on the market and concerns about retail investors buying into hedge funds, traditionally a domain of high net worth, sophisticated investors, were “too important to leave unexamined.” Mr. Donaldson noted that the influence of hedge funds on the market include the possibility that certain investment techniques employed by hedge funds, such as short selling, may act to the detriment of public investors.

Separately, the SEC announced that it will host a series of roundtable discussions on hedge funds on May 14 and 15, 2003. The SEC invited hedge fund investors and managers to meet with the SEC to discuss the SEC’s growing concerns about the industry. The SEC has stated that the roundtable will include discussion on:

• the structure, operation and compliance activities of hedge funds,
• marketing issues,
• investor protection issues,
• the current regulatory scheme, and
• whether additional regulation is warranted.

The hedge fund industry has garnered attention recently because of high profile mistakes by hedge funds in valuation and allegations of fraud and insider trading. The Wall Street Journal, March 25, 2003.

The SEC clarified its position regarding the requirement of certain certifications under the Sarbanes-Oxley Act of 2002 (the “S-O Act”) which carry criminal provisions. Section 302 of the S-O Act required the SEC to adopt final rules under which the principal executive officer(s) and the principal financial officer(s), or persons performing similar functions, of a company filing periodic reports under Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) certify in each quarterly and annual report, among other things, that, based on his or her knowledge, the report does not contain any untrue statement of a material fact and the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the company.

Section 906 of the S-O Act contains a certification requirement that is separate and distinct from the Section 302 certification requirement. Section 906 provides that each periodic report containing financial statements filed by an issuer with the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act must be accompanied by a written statement by the issuer’s chief executive officer and chief financial officer (or the equivalent thereof) certifying that:

• the report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and
• the information contained in the report fairly presents, in all material respects, the financial condition and results of operations of the issuer.

Section 906 expressly provides for criminal penalties for a knowingly or willfully false certification. On January 27, 2003, the SEC adopted Form N-CSR to be used by registered management investment companies to file certified shareholder reports with the SEC, but did not explicitly require Section 906 certifications to be filed with the form.

After discussions with the Department of Justice, the SEC now proposes to amend its rules and forms to require issuers to furnish Section 906 certifications as an exhibit to the periodic reports to which they relate. Specifically, the SEC proposes to amend Rule 30a-2 under the Investment Company Act of 1940 (the “1940 Act”) to require the submission of the Section 906 certifications with the periodic reports on Form N-CSR to which they relate and Item 10 of Form N-CSR to add the Section 906 certifications as a required exhibit.

The SEC noted that unlike the Section 302 certifications, the Section 906 certifications are required only in periodic reports that contain financial statements. In addition, unlike the Section 302 certifications, the Section 906 certifications may take the form of a single statement signed by the fund’s chief executive and financial officers. The SEC stated that a failure to furnish the Section 906 certifications would cause the periodic report to which they relate to be incomplete, thereby violating Section 13(a) of the Exchange Act.

Interim guidance regarding filing procedures. Until the SEC adopts final rules, it encourages issuers to submit Section 906 certifications as an exhibit to their periodic reports. The SEC advised that when periodic reports are filed electronically via EDGAR, the fund should retain the manual signature page for each certification or another document authenticating, acknowledging or otherwise adopting the signature that appears in typed form within the electronic version of the certification. To treat these electronically filed signed statements consistently with other electronically filed signed statements, the fund should insert the following legend after the text of each certification: “A signed original of this written statement required by Section 906 has been provided to [name of fund] and will be retained by [name of fund] and furnished to the Securities and Exchange Commission or its staff upon request.” Comments on the proposed rule are due by May 15, 2003. SEC Releases 33-8212, 34-47551, IC-25967. March 21, 2003.

The CFTC proposed for comment revisions to its requirements for registration of CPOs and CTAs. The proposed revisions are intended to address certain market developments applicable to persons who do not qualify for an exclusion from the CPO definition under Rule 4.5 or an exemption from CPO or CTA registration under the existing regulatory framework.

Rule 4.5 under the Commodity Exchange Act (the “Act”) makes available to certain persons (eligible persons) an exclusion from the definition of CPO with respect to their operation of certain qualifying entities that would otherwise be treated as commodity pools under the Act, but that are already subject to extensive operating requirements of another federal or state regulator. These eligible persons and their qualifying entities include, among other entities, investment companies registered under the 1940 Act. In order to claim exclusion from the CPO definition under Rule 4.5, an eligible person must file a Notice of Eligibility with the National Futures Association (“NFA”) and the CFTC. The Notice must contain specified representations about how the person will operate the qualifying entity, including, a requirement to restrict the amount of the entity’s trading in commodity interests with respect to its non-hedging activity.

Proposed amendment to Rule 4.5: addition of alternative test to 5% test. Currently, the Rule 4.5 exemption provides that the eligible person must operate the qualifying entity so that the entity will use commodity futures or commodity options contracts solely for bona fide hedging purposes. In addition, the qualifying entity must represent that the aggregate initial margin and premiums required to establish commodity futures or commodity options positions will not exceed 5% of the liquidation value of the qualifying entity’s portfolio (the “5% Test”).

The CFTC noted that recently, margin levels for certain stock index futures have significantly exceeded 5% of contract value, thereby limiting the use of such contracts in non-hedging strategies to a much greater extent than other types of contracts with lower margins. The CFTC additionally noted that similar constraints could arise with respect to security futures contracts, because the required margin for security futures is 20% of contract value. In response to these concerns, the CFTC is proposing to amend Rule 4.5 by adding as an alternative to the 5% Test a limitation based on the notional value of non-hedge positions. The alternative limitation would require that the aggregate notional value of the commodity interest positions not exceed the liquidation value of the qualifying entity’s portfolio, after taking into account unrealized profits and unrealized losses on any such contracts it has entered into. For this purpose, the CFTC defines “notional value” for each such futures position to be calculated by multiplying the size of the contract, in contract units, by the current market price per unit and for each such option position by multiplying the size of the contract, in contract units, by the strike price per unit.

Proposed Rule 4.13(a)(3): adding a de minimis trading exemption. Proposed Rule 4.13(a)(3) would provide an exemption from CPO registration where a pool engages in a limited amount of commodity interest trading. A pool would be exempt if (1) it committed no more than 2% of the liquidation value of the pool’s portfolio to establish commodity interest trading positions, whether entered into for bona fide hedging purposes or otherwise or (2) the aggregate net notional value of the pool’s commodity interest trading does not exceed 50% of the pool’s liquidation value. The new rule would also require that each participant in the pool be an “accredited investor” as defined under the Securities Act of 1933 (the “Securities Act”) and would prohibit the pool operator from marketing participations in the pool “as a vehicle for trading in the commodity futures or commodity options markets.”

Proposed Rule 4.13(a)(4): adding an exemption for “sophisticated investor pools.” Proposed Rule 4.13(a)(4) under the Act provides that a person is exempt from CPO registration if interests in the pool for which it seeks to claim relief (1) are exempt from registration under the Securities Act and (2) are offered and sold without marketing in the United States. In addition, the CPO must reasonably believe that: (1) natural person participants are qualified eligible persons (“QEPs”), as that term is defined in Rule 4.7 under the Act; and (2) non-natural person participants are QEPs under Rule 4.7 or accredited investors.

CTA registration exemptions. The CFTC is proposing amendments to its rules to permit exemptions from registration as a CTA advisers who provide advice to commodity pools that meet the requirements of the above proposed new exemptions based upon participant sophistication or trading limitations.

Proposed amendments to Rules 4.21, 4.22 and 4.31 under the Act. The CFTC has also proposed amendments to its disclosure and reporting rules to:

• permit communications with prospective pool participants or clients prior to distribution of the disclosure document;
• remove duplicative disclosure document delivery requirements in the master/feeder fund context; and
• permit distribution of pool account statements electronically with prior consent of the pool participant.

Temporary no-action relief. Until the CFTC finalizes the rules, it is offering temporary no-action relief to persons who qualify under the proposed amendments. A CPO or CTA eligible for no-action relief must (1) file a notice with the CFTC and (2) disclose to its participants and clients (both prospective or existing) prior to engaging in activities that otherwise would require it to register as a CPO or CTA that, among other things, it is not required to register, and is not registered, with the CFTC as a CPO or CTA. Notices should be filed with the NFA and the CFTC prior to the date upon which the CPO or CTA first engages in business that otherwise would require registration.

Effect of final rulemaking on no-action relief. The no-action relief will remain in effect until the CFTC takes final action on the proposed rules. In the event final rules differ from the requirements of the no-action relief, the CFTC will provide affected CPOs and CTAs with sufficient time to comply with the requirements. Comments on the proposed rules are due by May 1, 2003. Federal Register, Vol. 68, No. 51, March 17, 2003.

The NASD has adopted amendments to Interpretive Material 2260 (“IM-2260”) regarding rates of reimbursement to members for expenses incurred in forwarding proxy materials, annual reports, information statements, and other materials. The NASD noted that the amendments establish approved rates of reimbursement that conform to proxy reimbursement rates already adopted by the NYSE and the American Stock Exchange (the “Amex”) and approved by the SEC.

The NASD noted that the SEC’s proxy rules under the Securities Exchange Act of 1934 do not specify the fees that nominees may charge issuers for distributing proxy materials but, instead, provide that issuers must reimburse nominees for “reasonable expenses” incurred. NASD IM-2260 governs the reimbursement of members for costs incurred in forwarding proxy materials, annual reports, information statements, and other materials.

The amendments to IM-2260 conform NASD’s fee structure to that of the NYSE and the Amex, as approved by the SEC. IM-2260, as amended, also permits members to request reimbursement of expenses at less than the rates set forth in IM-2260, but it requires members to notify and obtain consent from the person or the company soliciting proxies for reimbursement at rates higher than the approved rates or for items or services not specifically referenced in IM-2260.

IM-2260, as amended, further advises members that they are not required to transmit more than one annual report, interim report, proxy statement, or other material to beneficial owners with more than one account, and that they may eliminate multiple transmissions of reports, statements, or other materials to beneficial owners having the same address, provided they comply with applicable SEC rules. The NASD noted that IM-2260 continues to provide that a member providing materials may not charge for envelopes that are furnished by the issuer, the trustee, or a person soliciting proxies.

The SEC approved the NYSE’s current fee structure on March 25, 2002, following numerous meetings of the Proxy Voting Review Committee (the “Committee”), a private initiative that was established to review the NYSE’s pilot fee program and the proxy process in general. The SEC found that “the Committee’s recommended fee reductions [for “large issuers”] were reasonable and should help to alleviate the burden and cost that large issuers currently bear in the proxy distribution process and more fairly allocate the cost among large issuers and small issuers.” The SEC concluded that the NYSE’s proposed fee changes were reasonable and fairly allocated, did not discriminate among issuers, and did not impose any unnecessary burdens on competition. On June 3, 2002, the Amex amended its proxy reimbursement fees to conform to those of the NYSE.

By conforming its proxy reimbursement guidelines to those adopted by the NYSE and Amex, NASD noted that it is adopting reimbursement rates that the SEC has already determined are reasonable and fairly allocated, do not discriminate among issuers, and do not impose any unnecessary burdens on competition. The amendments to IM-2260 are effective immediately. NASD Notice to Members 03 15, March 2003.

On March 12, 2003, the GAO testified before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises on recent trends in mutual fund fees and their related disclosure. The study analyzed the mutual fund fees for the 76 largest stock and bond funds offered. A report on the GAO study will be provided in next week’s news summary.

In testimony before the House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Services, the GAO delivered a report updating its 2000 analysis of trends in mutual fund fees. The GAO noted that in its June 2000 report, it found that fees for the largest stock and bond mutual funds had declined from 1990 to 1998 but that not all funds had reduced their fees. The GAO report also noted that mutual funds do not usually compete directly on the basis of their fees. As a result, the GAO had recommended that the SEC consider additional disclosures regarding fees to increase investor awareness and to encourage additional price competition among funds. The 2003 report delivered to the Subcommittee responded to the Subcommittee’s request that the GAO:

1. provide updated information on how mutual fund fees have changed since the June 2000 report,
2. discuss how fund fees are currently disclosed and various alternatives for expanding these disclosures, and
3. provide information on how mutual funds’ trading costs are disclosed.

To evaluate trends in mutual fund fees, the GAO obtained and analyzed data on the fees and other expenses of 76 mature stock and bond mutual funds. At the time the GAO conducted the work for the 2000 report, these were the largest funds in existence during the period 1990-1998. For the 2003 report, the GAO updated the information on these funds’ assets, expenses, and other information from 1999 to 2001. The GAO examined the operating costs that are expressed as a percentage of fund assets (the fund’s operating expense ratio). These expenses include the management fee, other operating expenses (e.g., fund accounting or mailing expenses), and 12b-1 fees. The GAO also examined other costs not included in the expense ratio that also can affect investor returns like commissions to broker-dealers to execute trades.

The GAO’s major findings include the following:

Mutual fund fees appear to have risen recently. The GAO noted that its prior 2000 analysis of large mutual funds showed that expense ratios of the funds decreased between 1990 and 1998. The GAO noted that in contrast, between 1999 and 2001, the average ratio for large stock funds increased somewhat while the average ratio for large bond funds continued to decline. The GAO also noted that the average expense ratio overall of these funds remains lower than their average in 1990. However, since 1998, the majority of stock and bond funds the GAO analyzed had higher expense ratios in 2001 than they did in 1998. The GAO stated that the decline in assets for many stock funds since 2000 may have contributed to the recent increase in expense ratios because many funds have fee schedules with breakpoints that decrease fees as fund assets increase.

The SEC has proposed additional fee disclosures but the GAO noted that other alternatives could provide more specific information. The GAO reported that in response to a recommendation in its 2000 report, the SEC issued proposed rule amendments in December 2002 that would require that mutual funds make additional disclosures of fees to their shareholders. The GAO agreed that these new disclosures would provide additional useful information to investors and would allow for fees to be compared across funds. However, the GAO noted that the SEC proposed that this information be included only in the semiannual shareholder reports, rather than in account specific documents which would customize such information to each individual investor.

The GAO stated that various alternatives to the disclosures that the SEC is proposing could provide information specific to each investor in a more frequently distributed and relevant document to the individual shareholder. Specifically, the GAO noted that an individual shareholder could receive information on the specific dollar amount of fees paid on his/her shares in his/her quarterly account statement, which already presents information on the actual number and value of each investor’s holdings in the fund. The GAO noted that industry participants raised concerns that requiring additional disclosures in quarterly statements or through other documents that investors receive more frequently than the semi-annual report would be costly. The GAO noted that the benefit to investors from receiving this additional information has not been quantified.

Mutual fund trading costs are additional expenses to investors that are not prominently disclosed. The GAO noted that in addition to expenses reflected in the expense ratio, mutual funds incur trading costs that also affect investors’ returns. The GAO noted in particular the brokerage commissions funds pay to broker-dealers when they trade securities on a fund’s behalf. The GAO found that of the 240 stock funds examined for its study, the funds with higher expense ratios also had higher brokerage commission costs. The GAO noted that brokerage commissions are not “routinely or explicitly” disclosed to investors and that there have been increasing calls for disclosure as well as debate on the benefits and costs of added transparency. The GAO further noted that funds disclose the amount of brokerage commissions paid only in the fund’s statement of additional information, which is available to investors only if specifically requested.

The GAO reported that the SEC has not proposed changes to fund disclosure on brokerage commission costs. It further reported that investor advocates have requested additional disclosures about these costs because they would provide useful information to investors. The GAO noted that in response to requests for additional disclosure, industry participants raised concerns over, among other things, whether such disclosures would provide information that could be meaningfully compared across funds and the accuracy of disclosure related to bond fund transactions because bond fund transactions are subject to markups rather than explicit commissions. The full text of the GAO report is available at http://financialservices.house.gov/media/pdf/031203gao.pdf. March 12, 2003.

On March 11, 2003, the SEC, NASD and NYSE released a joint report of their findings during the examinations of 43 broker-dealers. The three agencies conducted the examination to determine whether investors were receiving the benefit of available discounts on front-end sales charges in mutual fund transactions. A report of the sweep results will be provided in next week’s news summary.

On March 11, 2003 the SEC, the National Association of Securities Dealers, Inc. (“NASD”) and the New York Stock Exchange (“NYSE”) issued a joint report on their findings resulting from a three-month examination sweep of selected broker-dealers. From November 2002 through January 2003, SEC, NASD and NYSE examiners reviewed thousands of mutual fund transactions handled by 43 broker-dealers that sell front-end load funds. The broker-dealers selected for review represented a cross-section of all types of broker-dealers that sell front-end load mutual funds to retail customers, but included the largest firms in terms of mutual fund sales. The examiners focused on how well the broker-dealers collected and used information from mutual funds about the availability of sales charge discounts and how well they combined that information with their own customer data to identify opportunities to provide those discounts to their customers.

During the examination process, examiners focused on the following:

• The transaction input process, to determine how mutual fund transactions were entered into the firm’s transaction system and the extent to which order entry mechanics affected a firm’s ability to provide available sales charge discounts.
• The processes and systems employed by broker-dealers to identify, and then effectively utilize opportunities to reduce investor sales charges in purchases of front-end load mutual funds. The examiners reviewed practices regarding
• rights of accumulation in single accounts and in qualified linked accounts;
• letters of intent; and
• reinstatements and exchanges.
• The supervisory systems and procedures established by broker-dealers to ensure that sales charges were accurately calculated and billed.
• The nature and frequency of training provided to sales people about mutual fund sales charge discounts.

The examiners then reviewed samples of front-end load mutual fund purchase transactions at each firm. The examiners looked at samples drawn from four sources: 

1. transactions effected through an intermediary processing service (e.g. , Fund/SERV);
2. transactions effected directly with a mutual fund via applications;
3. top revenue-producing customer accounts (5-10 accounts); and
4. transactions just below the breakpoint.

The regulators reported finding “significant” failures to deliver breakpoint sales load discounts to eligible customers among the transactions reviewed. The regulator’s major findings included the following: 

• Nearly one in three transactions that appeared eligible for a breakpoint discount or sales charge waiver did not receive one. Of the transactions that appeared to be eligible for a discount, the median percentage of transactions that did not receive a discount was 30% at each firm.
• Most firms failed to provide breakpoint discounts in at least some instances. Three firms did not provide a discount on any of the sampled transactions that were eligible for a discount. Only two firms provided customers with all available discounts.
• The average discount not provided was $364 per transaction.
• Most breakpoint problems did not appear to be intentional failures to apply sales load discounts. The most frequent causes were failures to link: (1) a customer’s ownership of different funds in the same mutual fund family to reach the breakpoint amount and (2) a customer’s purchase of fund shares with shares owned by related persons, such as a spouse or minor children.
• Examiners identified only a few questionable transactions for amounts just below the amount that would qualify for a breakpoint discount.
• Examiners also identified other questionable transactions that did not receive eligible sales discounts with respect to reinstatements and exchanges.
• Breakpoint issues were less frequent in firms that process transactions using paper applications rather than by utilizing electronic order processing.

Regulators noted that many firms could improve their compliance and supervisory systems and controls with respect to breakpoint discounts. For instance, regulators noted that few firms require presentation of breakpoint disclosure to customers in writing other than the disclosure contained in a mutual fund’s prospectus or statement of additional information. The examiners also found that less than half of the firms generated exception reports and that the exception reports did not adequately detect all transactions in which customers did not receive the appropriate sales charge. 

The report noted that the NASD is leading an industry task force to explore and recommend ways that the mutual fund and broker-dealer industries can prevent breakpoint problems and eliminate errors in sales load calculations in the future. The report noted that the limited nature of the examination sweep did not allow regulators to determine the full extent of the breakpoint issue industry-wide. As a result of these findings, approximately 2,000 broker-dealers are being required to review samples of their front-end load mutual fund purchase transactions and report the results to NASD. The NASD is requiring broker-dealers selling front-end load mutual funds to assess their own compliance using a specified sampling methodology, developed in conjunction with the SEC. In addition, examiners are following up with the firms already examined to determine whether deficiencies are being corrected and that excessive sales load charges are being refunded to customers.

The CFTC released its fifth annual letter from its Division of Clearing and Intermediate Oversight (the “Division”) (formerly, the Division of Trading and Markets). The Division issued the letter to commodity pool operators registered with the CFTC (“CPOs”) to share the Division’s experience reviewing prior years’ annual pool reports. The Division provides these annual letters to assist CPOs and their independent accountants in complying with Part 4 of the CFTC’s regulations under the Commodity Exchange Act (the “Act”) in connection with the preparation and filing of a pool’s annual financial report. The 2003 letter:

• highlights common deficiencies noted by the Division during its review of the 2001 annual reports,
• discusses several accounting and reporting topics, and
• notes several regulatory changes and proposed changes.

  The Division noted that many of the deficiencies occurred in reports for offshore pools, and advised CPOs to share its 2003 letter with offshore correspondents and local auditors.

  Common deficiencies. The Division noted that many CPOs would avoid common deficiencies if they did the following:

• Filed one copy of the commodity pool’s annual report with the National Futures Association (“NFA”). CPOs are no longer required to file copies of its annual reports with the CFTC. The CFTC noted that on December 18, 2002, it delegated the primary responsibility for regulation of commodity pools, including review of annual reports, to the NFA. Accordingly, for pools with fiscal years ending on or after December 31, 2002, CPOs need only file one copy of each pool’s annual report with the NFA. The Division noted that annual reports must continue to comply with appropriate CFTC rules. In addition, applications for extensions of time to distribute annual reports and claims for exemptions, including those for offshore commodity pools, also should be filed only with the NFA.
• Filed the annual report as soon as possible, but no later than the due date. For pools with a December 31, 2002 year-end, the due date is Monday, March 31, 2003 (unless an extension of time has been requested and granted).
• Included a signed oath or affirmation, as required by Regulation 4.22(h), with each copy of the annual report filed with NFA and all pool participants. The Division noted with approval that a number of CPOs bind the oath as part of the report package or attach it to the cover page.
• Reported special allocations of partnership equity in the manner described in the CFTC Interpretive Letter 94-3, Special Allocations of Investment Partnership Equity.
  
• In computing net asset value:
  • for unitized pools, included information concerning net asset value per outstanding participation unit in the pool as of the end of each of the pool’s two preceding years.
  • for non-unitized pools, provided to each participant the total value of that participant’s interest or share in the pool as of the end of each of the pool’s two preceding fiscal years.

The CFTC had the following additional recommendations for annual reports that are unaudited pursuant to a Rule 4.7 exemption (i.e., commodity pools that offer interests only to qualified eligible participants):

• The pool operator must make a statement to that effect on the cover page of each report and state that a certified audit will be provided on request of a majority of the units of participation in the pool held by investors who are unaffiliated with the commodity pool operator.
• The annual report must be presented and computed in accordance with generally accepted accounting principles consistently applied (“GAAP”).
• The annual report must include appropriate footnote disclosures.

Extended due date for fund-of-funds pools. Regulation 4.22(f)(2) permits a CPO to file a claim for an automatic extension of time to file a pool’s annual report where (1) the pool is invested in other collective investment vehicles and (2) the CPO’s independent accountant cannot obtain the information necessary from the other collective investment vehicles in order to file the annual report for the pool within 90 days of its year-end. Fund-of-funds with a December 31, 2002 year-end may obtain an additional 60 days, extending the due date to Friday, May 30, 2003, by filing the representations outlined in 4.22(f)(2). Regulation 4.22(f)(1) permits a CPO to request an extension of time to file an annual report in the event the CPO finds that it cannot distribute the report within 90 calendar days after the end of the pool’s fiscal year.

The Division noted that in 2001, it received many requests for filing extensions, especially from Rule 4.7 pools. The Division reminded CPOs that delaying delivery of an annual report past mid-year may outweigh the advantage of having the annual report certified. Therefore, the Division reported that it often denied the relief as requested due to the need for the dissemination of timely information and required the requesting CPO to file an unaudited report for the current year.

Applicability of GAAP to commodity pools’ annual financial statements. The Division has noted instances where CPOs filed pool financial statements that failed to comply with GAAP. Rules 4.22(d), 4.12(b)(2)(iii)(B), and 4.7(b)(3)(ii) under the Act require that financial statements of pools be presented and computed in accordance with GAAP, including disclosing risk concentrations (e.g., market and credit risk) and related party transactions, and recognizing the impairment of investment values. The Division reminded CPOs that pools exempt from filing certified financial statements, such as pools qualifying under Regulation 4.7, must nonetheless compute and present their financial statements in accordance with GAAP. The Division also reminded CPOs that for commodity pools one of the most significant, if not the most significant, accounting policy relates to the determination of fair values of investments.

Audit opinion. The Division reminded CPOs that commodity pools are required to present condensed schedules of investments in accordance with GAAP. The Division further noted that it continues to be concerned with the level of disclosure regarding a pool’s investments in other investment companies (“investee pools”) and believes that complete disclosure to the participants in a commodity pool requires that the pool’s financial statements provide information about other funds to which the pool devotes significant portions of its capital. The Division reminded CPOs that it has long considered detailed income, fee and liquidity information for material investee pools and in total for all investee pools “material information,” essential for full disclosure.

Master-feeder structures. The Division encouraged CPOs who elect to present a complete set of master financial statements with each feeder financial statement to bind the two reports together as a single document and to send it to the participants and the NFA. The Division noted that this would help ensure that reports are reviewed as a complete unit.

Final annual reports. The Division reminded CPOs that when a pool ceases trading, the CPO must file a final report as required by Regulation 4.22(c). The Division further noted that the final report should be in the same format and include the same information as the annual report, even if the final report is not for a full 12-month period.

Proposed rules regarding additional relief from registration as a commodity pool operator. The Division noted that the CFTC recently published two proposals it had received for additional CPO registration exemptions (one each from NFA and the Managed Funds Association) and took temporary CPO registration no-action positions (based on investor criteria, amount of trading and a notice filed with the CFTC and NFA claiming the relief). The CFTC noted that it is analyzing the comments it has received on these proposed actions and that the temporary registration no-action relief remains in effect until it takes final action on this rulemaking.

Anti-money laundering and terrorist financing. The Division reminded CPOs that under the USA Patriot Act, persons who are or are required to be registered as futures commission merchants (FCMs), introducing brokers (IBs), CPOs, and commodity trading advisors (CTAs) are subject to new requirements for establishing anti-money laundering programs, reporting suspicious activity, verifying the identity of customers, and dealing with certain types of accounts involving foreign persons. CFTC Release 4760-03, March 7, 2003.

The SEC recently settled an administrative action it brought pursuant to the Investment Advisers Act of 1940 (the “Advisers Act”), the Investment Company Act of 1940 (the “Investment Company Act”) and the Securities Act of 1933 (the “Securities Act”) against two principals of an investment adviser (collectively, “Principals”). Among other findings, the SEC found that the Principals had aided and abetted the investment adviser and an investment company advised by the investment adviser in violating the Advisers Act and the Investment Company Act when the Principals entered on the fund’s books a receivable the receipt of which was “doubtful.”

The SEC found that from January 1999 through June 2000, the receivable was included as an asset in the Fund’s calculation of its net asset value. The SEC further found that the receivable grew steadily over time, reaching a peak of approximately $250,000 by June 2000. The SEC noted that because the entity that was responsible for payment to the fund for the receivable was insolvent during this time period, it was not reasonable to assume that the receivable would be collected. The SEC further noted that despite this, the fund, through the investment adviser, recorded the receivable on its books at full value. The SEC stated that by doing so, the receivable inflated the net asset value of the fund’s three portfolios, causing the fund to sell and redeem shares at artificially high prices.

The SEC noted that from January 1999 to June 2000, the investment adviser did not advise the fund’s shareholders about the doubtful collectability of the receivable. The SEC also noted that the investment adviser did not disclose the doubtful collectability of the receivable to its private advisory clients who were invested in the fund.

In its other unrelated findings, the SEC noted that the fund sold shares during most of this period using an outdated prospectus. The fund’s last prospectus was a post-effective amendment filed May 5, 1998 that contained audited financial statements for the year ended December 31, 1997. The SEC determined that the financial statements were sixteen months old on April 30, 1999 and all sales of the Fund shares thereafter were made pursuant to stale financial statements and information. Additionally, the SEC found that from January 1999 through June 2000, the fund failed to file fiscal year end annual reports and failed to provide to its shareholders a semi-annual report for the year ended December 31, 1999.

The SEC found that based on the conduct described above, the investment adviser, by use of the mails or other means or instrumentalities of interstate commerce, engaged in transactions, practices or courses of business that violated Section 206(2) of the Advisers Act and Section 34(b) of the Investment Company Act, and the Principals willfully aided and abetted and caused the adviser’s violations.

The SEC also found that based on the conduct described above, the Principals willfully aided and abetted and caused the Fund’s violations of Sections 21(b), 22(e), 30(a) and 30(e) of the Investment Company Act and Rules 22c-1, 30a-1 and 30d-1 thereunder, and Section 5(b) of the Securities Act.

Based on the violations, the SEC imposed the following sanctions:

• the Principals were ordered to cease and desist from committing or causing any violation and any future violation of Section 206(2) of the Advisers Act, Sections 21(b), 22(e), 30(a), 30(e) and 34(b) of the Investment Company Act and Rules 22c-1, 30a-1 and 30d-1 thereunder, and Section 5(b) of the Securities Act;
• the Principals were prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter for a period of six months; and
• each Principal was ordered to pay a civil penalty in the amount of $10,000.

SEC Administrative Release No. 3-11049, March 4, 2003.