This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.
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FinCEN Publishes Final Rule Implementing Section 312 of the USA Patriot Act
March 31, 2006 10:52 AM
On January 4, 2006, FinCEN published a final rule implementing Section 312 of the USA Patriot Act, which requires each U.S. financial institution, including mutual funds, that establishes, maintains, administers, or manages a correspondent account or private banking account in the United States for a non-U.S. person, to apply certain anti-money laundering measures and conduct due diligence on such accounts (“Correspondent Account Rule”). The original deadline for financial institutions to implement procedures and perform due diligence with respect to new accounts was April 4, 2006, and with respect to accounts opened prior to April 4, 2006, the deadline was October 2, 2006. In response to industry letters expressing concerns of their members’ ability to comply with this deadline, FinCEN announced on March 24, 2006 a three-month extension for the implementation of the Correspondent Account Rule with respect to new accounts. The new deadline is now July 5, 2006 for new accounts. FinCEN stated that it does not anticipate granting a further extension beyond July 5, 2006. The original October 2, 2006 deadline remains with respect to accounts that are opened prior to July 5, 2006.
For a detailed explanation of the Correspondent Account Rule, please refer to the WilmerHale publication dated March 2006 from the Financial Institutions and Securities Group, which can be viewed at: http://www.wilmerhale.com/files/Publication/691846ee-5158-450a-8f18-7cfd641799da/Presentation/PublicationAttachment/272dacc3-4182-4bcc-913a-af716ac38ed1/FinancialSecurities_03_2006.pdf
On March 2, 2006, FinCEN issued a response to the ICI’s letter requesting clarification of the application of the Correspondent Account Rule with respect to accounts trading through the National Securities Clearing Corporation’s (“NSCC”) Fund/SERV system. As discussed in the Investment Management Industry News Summary dated February 24, 2006, the ICI asked for Treasury to concur with its view that, with respect to accounts opened by U.S. financial institutions with mutual funds for the purpose of effecting transactions in fund shares that are cleared and settled through the National Securities Clearing Corporation’s (“NSCC”) Fund/SERV system (“Fund/SERV accounts”), the Correspondent Account Rule does not apply to the Fund/SERV account established by the mutual fund, but rather applies to the underlying customer account held by the NSCC member firm, even if the firm’s underlying customer is a foreign financial institution. In other words, the ICI’s position is that each NSCC member firm should be the entity responsible for collecting information about its underlying customers to determine whether any of them are foreign financial institutions in order to fulfill the Correspondent Account Rule requirements, rather than requiring mutual funds to identify and verify the NSCC member firm’s customers.
In its response letter dated March 2, 2006, FinCEN agreed with the ICI’s position that the Correspondent Account Rule does not apply to the Fund/SERV account established by the mutual fund, but rather applies to the underlying customer account held by the NSCC member firm. In granting this limited relief to the Correspondent Account Rule, FinCEN stated that the NSCC member must be a U.S. financial institution subject to the provisions of Section 312 [of the Patriot Act]. FinCEN elaborated that, in the event that a foreign financial institution becomes an NSCC member, the mutual fund would be required to treat that foreign financial institution as a correspondent account subject to the appropriate level of due diligence and monitoring as required under the Correspondent Account Rule.
The ICI’s press release concerning FinCEN’s anti-money laundering guidance can be viewed at: http://www.ici.org/issues/fserv/arc-reg/06_treas_aml_interpret_final.html.
FinCEN’s March 2, 2006 response letter to the ICI can be viewed at: http://www.ici.org/ext/06_treas_aml_interpret_att.pdf.
ICI’s February 3, 2006 comment letter to FinCEN can be viewed at: http://www.ici.org/statements/cmltr/06_treas_aml_interpret_com.html - TopOfPage.
SEC Approves New York Stock Exchange (“NYSE”) Hybrid Market Proposal
March 31, 2006 10:36 AM
On March 22, 2006, the SEC announced its approval of the NYSE’s proposed “hybrid market,” which will enable the NYSE to integrate its traditional floor-based auction market with enhanced automated trading functionality. SEC Chairman Cox stated that “the [SEC] supports the markets’ adoption of new trading systems and new technologies in order to deliver improved service to investors. At the same time, with our major exchanges now responsible to their public shareholders for performance, the SEC is redoubling its focus on investor protection, to ensure that competition among markets is conducted on the basis of what’s best for the investing public.” Changes to NYSE’s market structure under the hybrid market model include:
Expanding NYSE’s automatic execution facility so that it will accept more order types and allow executions to occur against liquidity that is priced outside the NYSE’s best bid or offer;
Automating participation by NYSE floor members so that they can electronically provide liquidity that would be available for automatic executions; and
Allowing specialists to create proprietary algorithms so that they can electronically quote and trade. These algorithms should enable specialists to continue to fulfill their obligations to the market in an automated fashion.
BNA Securities Law Reporter, March 23, 2006; NYSE Release No. 34-53539; File No. SR-NYSE-2004-05, March 22, 2006; SEC’s press release concerning approval of the hybrid market can be found on its website at: http://www.sec.gov/news/press/2006-41.htm.
SEC Denies No-Action Relief to Company Requesting to Omit a Shareholder Proposal on Mandatory Retirement Age for Board of Directors and Senior Management
March 31, 2006 10:34 AM
On March 9, 2006, the staff of the SEC’s Division of Corporate Finance stated that a company may not omit from its proxy materials a shareholder proposal requesting that the board adopt a mandatory retirement age of 70 for members of the board of directors and senior management. Under the shareholder’s proposal, no person may be elected or re-elected as a director, or appointed to senior management, if at the time of his or her election, he or she is at least 70 years old. The proponent of the shareholder proposal stated that it was requesting a mandatory retirement age for directors to assist the company with succession planning, lead to improved corporate governance of the company, and ensure that the board periodically benefits from “fresh ideas, viewpoints and expertise of new members.”
The company requested the staff’s concurrence that it may exclude this shareholder proposal from its 2006 proxy materials. The company argued that the proposal should be excluded on a variety of grounds, including Rules 14a-8(i)(2) and 14a-8(i)(3) of the Securities Exchange Act of 1934 (the “Exchange Act”). Under Rule 14a-8(i)(2), a registrant may omit a shareholder proposal from its proxy materials if the proposal would require the registrant to violate any state or federal law. The company argued that the implementation of a mandatory retirement age for members of the board of directors would force the company to violate the Age Discrimination in Employment Act of 1967 and the anti-discrimination provisions of the Texas Labor Code. The company also argued that the shareholder proposal may be excluded under Rule 14a-8(i)(3), which allows a registrant to omit a shareholder proposal from its proxy materials if the proposal “is contrary to any of the [SEC]’s proxy rules.” The company noted that the staff has consistently taken the position that shareholder proposals that are vague and indefinite are excludable under Rule 14a-8(i)(3) because they would be inherently misleading, and the company argued that this shareholder proposal is vague and misleading because it fails to define critical terms and does not provide guidance as to how the proposal should be implemented. The staff responded that it could not concur with the company’s arguments that it could exclude this shareholder proposal from its proxy materials pursuant to Rules 14a-8(i)(2) or 14a-8(i)(3).
SEC No-Action Letter, dated March 9, 2006, to Access Pharmaceuticals, Inc.
SEC Chairman Cox Announces Initiatives Aimed at Protecting Older Investors
March 31, 2006 10:31 AM
In a speech at a conference of the Consumer Federation of America on March 24, 2006, SEC Chairman Christopher Cox announced new initiatives aimed at protecting older Americans who invest in mutual funds and other securities. Cox noted that no less than 75 million Americans are due to turn 60 over the next 20 years, more than 10,000 Americans every day. He noted that senior citizens have been especially vulnerable to securities fraud, and highlighted that the SEC staff is often contacted by seniors who have been harmed by financial professionals who have failed to disclose key features and fees related to investments. Cox commented that the SEC has taken an increased interest in protecting seniors, highlighting that over the past two years, the SEC has brought 26 enforcement actions aimed specifically at protecting elderly investors. Cox also announced the launch of a new SEC website specifically designed to improve investor education among seniors. In addition, Cox declared that regional and district offices have come together to create a comprehensive national strategy for protecting older investors. Under this new initiative, SEC offices from across the country will work closely with state and local law enforcement to better identify and shut down scams aimed at seniors. Cox noted that such efforts were already in place in California and are gearing up in Florida and other states across the nation.
Chairman Cox’s speech is available on the SEC’s website at: http://www.sec.gov/news/speech/spch032406cc.htm.
ICI 2006 Mutual Funds and Investment Management Conference (the “ICI Conference”)
March 24, 2006 11:22 AM
Conference Panelists Discuss Appropriate Use of the Internet to Distribute Information to Shareholders. At the opening session of the ICI’s Conference, panelists examined the opportunities presented by internet technology for rethinking how to best communicate with shareholders and prospective investors. Conference organizers brought together academic and industry experts to compare notes on many aspects of internet usage by mutual fund investors. Panelists criticized current usage of the internet as a huge graveyard for large documents that investors profess not to consult much anyway. Information was defined as "that which reduces uncertainty" and industry participants were encouraged to think of communications to investors in this light. Presenters reported consumer behavior research that showed that approximately 65% of subjects presented with a simple two-bar graph could not answer correctly questions about what that graph communicated. If reliable, such data would call into question assumptions that graphic presentations are an improvement over mere text. They also reported that most investors who accept electronic delivery of required communications request to continue to receive paper copies as well, because the internet does not satisfy the investor's need to keep records for tax reporting and other purposes.
Attendees were skeptical of a demographic analysis of the likelihood of investors using the internet for financial information because the data related primarily to mere ownership of hardware and high-speed access and omitted a breakdown by income and education, raising the concern that greater reliance on the internet for dissemination of information will deprive less wealthy investors of information access. The panel consensus endorsed finding a way to provide investors with choice in the manner of receiving and accessing data and generally favored finding ways to require only high level information, coupled with flexibility for investors to choose which topics they want to explore in greater detail and what medium they want to use to do so. The greatest weakness of this thought provoking program was that not much time was spent exploring why prior attempts to simplify the prospectus and to streamline shareholder communications have failed, or what changes in law or regulation would be required to clarify the liability of issuers who adopt flexible communication strategies.
Mutual Fund Disclosures and the Exemptive Application Process at the Top of SEC’s Regulatory Agenda. Susan Wyderko, acting director of the SEC’s Division of Investment Management, declared at the ICI Conference that mutual fund disclosures and the exemptive application process are two issues at the top of the SEC’s regulatory agenda. Emphasizing that disclosure is important because it should lead to investors making better-informed decisions, Wyderko said that it was time for the SEC to utilize technology to enhance and streamline the disclosure process. She commented that extensive business reporting language (“XBRL”) and layered disclosure are two technologies that can be applied to mutual fund disclosures to make it more effective for investors. “We are in a transition phase. The culture of communication is changing radically and we need to change with it,” Wyderko said. Critics have commented that, with a potential increased use of the internet to disseminate disclosure documents, there is a heightened risk of lawsuits and liability based on these documents.
With regard to the exemptive application process, Wyderko called it a “housekeeping issue,” and acknowledged that applicants might not be getting responses in a timely fashion. “I am aware that we have issues in this area,” she said. “I am working with the staff to address them. It’s not a new problem, but it’s a problem that can be solved.” Wyderko added that if the staff does stop granting exemptions in an area where it had previously granted them, the staff’s change in position should be made public. Ignites, March 23, 2006.
Annual CCO Compliance Report. At the ICI Conference, the SEC staff stated that it is not looking for 100% testing on each component of a registrant’s annual compliance report required by Rule 38a-1 under the 1940 Act. The staff explained that it expects compliance officers to conduct selective, risk-based testing. The SEC staff stated that it will generally expect more from larger firms, and less from smaller firms, and that the comprehensiveness of review, testing and resources devoted to compliance will vary by the size and complexity of a firm’s operations.
Investment Company Institute (“ICI”) and Securities Industry Association (“SIA”) Issue Redemption Fee Rule Guidance
March 24, 2006 10:56 AM
The ICI and SIA have jointly developed model contractual clauses that are intended to help members implement the written agreement requirement of the new redemption fee rule, Rule 22c-2 under the Investment Company Act of 1940 (the “1940 Act”), in time for the October 16, 2006 compliance date. Rule 22c-2 requires funds to have a written agreement with each of their financial intermediaries that requires the intermediary to agree to:
The model clauses, which are attached as Appendix A to this newsletter, may be used either in a stand-alone agreement between a fund and broker-dealer, or in a supplement to an existing agreement. The model clauses track the requirements of the redemption fee rule, except in two instances. Unlike the rule, Section x.1.2 of the model clauses does not address instances in which, due to a “chain of intermediaries,” the intermediary on the fund’s books and records does not have the necessary account information requested by the fund. In addition, Section x.1.2 specifies that any transaction information provided by an intermediary to the fund should be consistent with the National Securities Clearing Corporation Standardized Data Reporting Format, a requirement not listed in Rule 22c-2. Although the ICI and SIA encourage the use of these model clauses, they noted that the use of a “one size fits all” agreement may be impractical and revisions may be necessary to address particular business models and circumstances.
SEC Commissioner Campos Comments on Proxy Rule Proposal
March 24, 2006 10:44 AM
In a speech at the National Association of State Treasurers on March 6, 2006, SEC Commissioner Roel Campos commented on the SEC’s proposed amendments to the proxy rules (“e-proxy proposal”). Under the e-proxy proposal, companies would be allowed to furnish proxy materials to shareholders by posting them on a website. The e-proxy proposal would also permit issuers to include a proxy card in the mailed notice to shareholders, thus separating the proxy card from the rest of the proxy materials. Campos expressed his concerns that such arrangement – allowing companies to separate the proxy card from the rest of the proxy materials - might encourage shareholders to vote their proxies without reading the information in the proxy materials. Campos stated that if this occurs, there is a “risk of undermining the spirit of the rules.” Campos suggested that one solution would be to prohibit issuers from mailing the proxy card with the notice, and require that the proxy card be available only in electronic form with the rest of the proxy materials online. Campos added that the SEC would also examine whether the internet-based availability of proxy materials should be the default method of delivery, or whether shareholders should have to choose to “opt in” to such notice. Under the e-proxy proposal, shareholders would have the option to opt out of the internet-based delivery method to receive free, paper copies of the materials. Proponents suggest that by not requiring the mailing of all proxy materials, it would reduce the costs associated with proxy solicitations, which are ultimately born by shareholders.
Commissioner Campos’ speech is available on the SEC’s website at: http://www.sec.gov/news/speech/spch030606rcc.htm
SEC Denies No-Action Relief to Company Requesting to Omit a Shareholder Proposal in its Proxy Materials
March 24, 2006 10:39 AM
On February 28, 2006, the staff of the SEC’s Division of Corporate Finance provided guidance to a company that it may not omit from its proxy materials a shareholder proposal requesting that the board amend its by-laws to provide procedures for the reimbursement of reasonable expenses incurred by shareholders in contested board elections. Under the shareholder’s proposal, reasonable expenses would include, but not be limited to, legal, advertising, solicitation, printing and mailing costs incurred by a shareholder or group of shareholders in a contested board election. However, reimbursement would only be required for elections that met the following conditions:
Counsel for the company requested the staff’s concurrence that the company may exclude this shareholder proposal from its 2006 proxy materials. Counsel for the company argued that the proposal should be excluded on a variety of grounds, including Rules 14a-8(i)(3), 14a-(i)(8) and 14a-(i)(7) of the Securities Exchange Act of 1934 (the “Exchange Act”). Under Rule 14a-8(i)(3), a registrant may omit a shareholder proposal from its proxy materials if the proposal “is contrary to any of the [SEC]’s proxy rules.” Counsel to the company pointed to two proxy rules: Rule 14a-7(e) and Rule 14a-8, which require security holders soliciting proxies to fund their own solicitation and do not require a registrant to fund an opposition slate. Counsel for the company also argued that shareholder proposals may be excluded under Rule 14a-8(i)(8) of the Exchange Act if the proposal “relates to an election for membership on the company’s board of directors or analogous governing body.” Counsel highlighted the fact that the SEC has consistently permitted the exclusion of shareholder proposals to create procedures that would make election contests more likely. It also argued that the proposal relates to a matter of ordinary business operations, and can therefore be excluded pursuant to Rule 14a-8(i)(7) of the Exchange Act. The staff responded that it could not concur with the company’s arguments that it could exclude this shareholder proposal pursuant to Rule 14a-8(i)(3), Rule 14a-8(i)(8), or Rule 14a-8(i)(7).
Also on February 28, 2006, the staff issued a similar letter to a different company stating that the company could not exclude a shareholder proposal requesting that the board form a committee to explore ways to formulate an equal employment opportunity policy which does not make reference to any matters related to sexual interests, activities or orientation.
See SEC No-Action Letters, each dated February 28, 2006, to The Bank of New York Company, Inc. and American Express Company.
Treasury Department Reviewing Risks Generated by Rapid Growth of Hedge Funds and Derivatives
March 17, 2006 12:51 PM
In a speech at the annual Washington, DC conference of the Institute of International Bankers on March 13, 2006, the Under Secretary of the Treasury for Domestic Finance, Randal K. Quarles, discussed key financial and economic policy developments that Treasury is working on in 2006. He stated that Treasury is focusing on the following areas of particular interest to the Institute of International Bankers: the Basel Accords, regulatory relief, government sponsored entity (“GSE”) reform, and Treasury’s examination of the financial markets.
Quarles explained that U.S. banking agencies have been undertaking a more complete assessment on the results of a study on the quantitative impact of implementation of the Basel II accords. He stated that, beginning in 2008, the 20 U.S. banks that will adopt the new accord will be required to comply with both the existing capital standard and Basel II. He explained that, in 2009, if regulators are satisfied with the results, the banks would be allowed to use the new standard, but with specified limits on how much capital levels could drop. He noted that proposed rulemaking is expected this quarter.
Quarles explained that there are a number of efforts currently underway in Congress to address unnecessary regulatory burdens imposed on financial institutions, including the burdens associated with Bank Secrecy Act regulations.
Quarles stated that the topic of reforming the regulatory structure of housing GSEs – Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System – has been hotly debated for the past few years in Washington and that he believes that this debate will be brought to the forefront in 2006. He explained that the administration’s key focus on GSE reform is to maintain a strong national housing finance system that meets the mortgage credit needs of our nation and provides financing opportunities for new homeowners. He noted that, in light of the recent events at the GSEs, such as significant financial restatements, the need for meaningful reform is clear. He highlighted that the administration is recommending placing limits on and significantly reducing the mortgage portfolios retained by GSEs.
Examination of Financial Markets
Quarles stated that the Treasury Department is studying whether the rapid growth of hedge funds, derivatives, and other complex financial instruments is shifting the level and nature of market risks. Quarles commented that derivatives now serve a key role in capital markets by increasing efficiency, liquidity and the ability to segregate and distribute risk. He indicated that derivative contracts are growing rapidly, as their aggregate value now reaches into trillions of dollars. “[G]iven the explosion in the type and use of derivatives, and institutions that use them,” Quarles said, “…[we] want to ensure that the magnitude of risk and exposure are [sic] properly measured and that investors and market participants have full and adequate disclosure upon which they can make informed decisions.” He also commented that the Treasury Department was reviewing the following structural changes in the markets: (1) the greater systemic importance of a smaller number of large bank-centered financial institutions; (2) the greater role played by non-bank financial institutions; (3) the rapid growth of GSEs and appetite for their securities; (4) the growth of capital accumulation through less-regulated entities such as private equity funds and hedge funds; (5) greater operational demands on the core of the clearing and settlement structure; (6) an increase in the complexity of risk management and compliance challenges; and (7) the extent of global financial integration.
The text of Randal K. Quarles’ March 13, 2006 address to the Institute of International Bankers can be viewed at: http://www.treas.gov/press/releases/js4114.htm .
U.S. District Court (S.D.N.Y.) Rules that Investment Adviser is Not Liable under Section 36(b) of the Investment Company Act of 1940 (“1940 Act”) for Charging 12b-1 Fees from a Fund after it had Closed to New Investors
March 17, 2006 12:40 PM
On March, 2, 2006, Judge Cote of the U.S. District Court for the Southern District of New York granted summary judgment to the defendant investment adviser and ruled that the investment adviser was not liable under Section 36(b) of the 1940 Act for allegedly excessive fees paid by a mutual fund to broker-dealers.
According to the court’s opinion, the plaintiff alleged that the defendant investment adviser violated Section 36(b) by continuing to charge and receive marketing and distribution fees from a no-load fund after the fund was closed to new investors. Pre-trial discovery revealed that the disputed fees were not paid to the defendant investment adviser for marketing and distribution expenses, but instead were service fees paid by the fund to its broker-dealers. The fund paid fees for marketing, distribution and account servicing expenses pursuant to a Rule 12b-1 distribution plan. The fund also entered into servicing agreements with broker-dealers whereby the broker-dealers would provide “shelf space” on their distribution platforms for the fund and service the fund’s shareholder accounts. After the fund closed to new investors, the broker-dealers’ role was limited to the maintenance and servicing of the accounts, but the fund continued to make Rule 12b-1 payments at a constant 0.25% rate both before and after the fund’s closure. Due to a significant increase in assets held by the fund, the amount paid in Rule 12b-1 fees to these broker-dealers had increased substantially. In addition, the defendant investment adviser paid broker-dealers service fees in excess of the 0.25% cap established by the Rule 12b-1 plan.
In its original and amended complaints, the plaintiff alleged that the investment adviser breached its fiduciary duty under Section 36(b) of the 1940 Act by charging the fund for promotion, distribution, and “other expenses” in proportion to the fund’s assets, rather than the services rendered. The court dismissed the plaintiff’s claim with respect to any administrative, transfer agent, and “other fees” on the grounds that the fund’s transfer agent and administrator, rather than the defendant investment adviser, received this compensation. The remaining claims related solely to the marketing, distribution, and servicing fees paid to the defendant investment adviser, which the plaintiff claimed were principally used to compensate the broker-dealers.
The court stated that, under Section 36(b) of the 1940 Act, an investment adviser has a “fiduciary duty with respect to the receipt of compensation for services or of payments of a material nature” made to it or its affiliates by a fund. The court elaborated that this duty extends not only to fees paid for advisory services, but also to other payments made pursuant to Rule 12b-1 plans. The court explained that, in order to fall within the ambit of Section 36(b), however, the adviser or its affiliates must actually receive such compensation. The court stated that no Section 36(b) action could be brought, and no damages or other relief could be granted, against any person other than the recipient of such compensation or payments. The court stated that, therefore, the threshold issue in cases alleging a breach of Section 36(b) fiduciary duty is whether the defendant is a recipient of any of the payments that are the subject of the action. In this case, although the fund made Rule 12b-1 payments to the defendant investment adviser, the defendant investment adviser did not actually retain any of the money that may have been paid to it by the fund. The 12b-1 fees flowed from the investment adviser to the fund’s transfer agent and administrator who, in turn, paid the fund’s broker-dealers. The court concluded that, “although the Second Circuit has never explicitly addressed this point, serving as a pass-through entity for Rule 12b-1 payments does not constitute “receipt” under the 1940 Act.”
The court also addressed the plaintiff’s second theory of liability, that the defendant investment adviser constructively received payments from the fund after the fund was closed to new investors and failed to terminate the service agreements because the investment adviser would have had to assume all of the fund’s obligations to the broker/dealers. The court held that this theory would expand Section 36(b) liability beyond what Congress envisioned. Defendants disputed the plaintiff’s claim that it would have been obligated to pay the Rule 12b-1 fees if the fund had terminated the service agreements. The court ruled that, even if plaintiff’s reading of the contracts was correct, it would not make the defendant investment adviser liable under Section 36(b) of the 1940 Act. The court highlighted the absence of any precedent for defining “recipient” to include parties who do not in fact receive any funds.
The court noted that, because the defendant investment adviser was not a recipient of the Rule 12b-1 payments, it was unnecessary to reach the defendants’ argument that the amount of the service fees paid to the broker-dealers is reasonable as a matter of law. Finally, the court found that, since the defendant investment adviser could not be found to have violated Section 36(b), plaintiff’s demand for an injunction prohibiting the fund from allowing the defendant investment adviser to continue charging improper Rule 12b-1 fees must be denied as moot. Summary judgment was granted for the defendants.
See Pfeiffer v. Bjurman, Barry & Assocs., 03 Civ. 9741 (DLC), 2006 U.S. Dist. LEXIS 7862 (S.D.N.Y. March 2, 2006).
SEC Plans Roundtable Discussions to Promote Use of Internet Technology
March 17, 2006 11:27 AM
On March 9, 2006, the SEC announced it has scheduled a series of roundtable discussions to be held throughout 2006 in Washington, DC, which will focus on increasing the use and implementation of new internet technology to help provide investors and analysts with better financial data about companies and funds. The roundtables will review the results from a pilot program that examined the use of extensible business reporting language (“XBRL”) for company filings with the SEC. These interactive data tags permit internet users to search for individual items of information from multiple companies’ financial reports at the same time, which would make it easier for investors to conduct side-by-side comparisons of mutual funds. A total of 12 companies participated in the voluntary program last year. The forums will also discuss what investors and analysts are seeking with regard to interactive data, how to accelerate the use of XBRL software, and how to best design the SEC’s requirements for company disclosures to take maximum advantage of this interactive data. SEC Chairman Christopher Cox stated that, “it is now within [the SEC’s] reach to get dramatically more useful information in the hands of investors. We look forward to these discussions on implementing interactive data initiatives that can benefit investors as quickly as possible, and we welcome the opportunity to learn from investors and other users of financial information how the SEC can improve [its] own disclosure program.” The first roundtable in the series will be held on Monday, June 12, 2006 from 10:00 am to 12:00 pm. Subsequent roundtable discussions will be held later in the summer and fall.
The SEC’s press release concerning this series of roundtable discussions is posted at the agency’s website at: http://www.sec.gov/news/press/2006-34.htm.
SEC Settles Charges against Three Hedge Funds for Engaging in Illegal “PIPE” Trading Scheme
March 17, 2006 11:16 AM
On March 14, 2006, the SEC filed securities fraud and related charges against three New York-based hedge funds and their portfolio manager for allegedly perpetrating an illegal trading scheme to evade registration requirements in connection with 23 unregistered securities offerings commonly known as “PIPEs” (Private Investment in Public Equity).
In a PIPE transaction, securities are generally issued pursuant to Section 4(2) of the Securities Act of 1933 (the “Securities Act”) or Regulation D under the Securities Act, which provide exemptions from registration for a non-public offering by an issuer. The securities are therefore restricted securities that may not be traded until a resale registration statement is filed with and declared effective by the SEC. Many PIPE investors hedge their investment by selling short the PIPE issuer’s securities before the resale registration statement is declared effective. To cover short positions, PIPE investors must locate and borrow the PIPE issuer’s securities from the public market because shares used to cover a short sale are deemed to have been sold when the short sale was made.
The SEC alleged that the portfolio manger violated Section 5 of the Securities Act by covering the funds’ pre-effective date short positions with the actual PIPE shares rather than shares obtained in the open market. The SEC’s complaint stated that, once the SEC declared the resale registration statement effective, the portfolio manager used the PIPE shares to close out the short positions, a practice that the portfolio manager knew was prohibited by federal securities laws. The SEC’s complaint stated further that the portfolio manager employed a variety of trading techniques, including wash sales and matched orders, to make it appear that he was covering the funds’ short sales with legal, open market stock purchases.
The SEC also alleged that the portfolio manager made materially false representations to the PIPE issuers to induce them to sell securities to the hedge funds. As a precondition of participating in a PIPE, investors are required to represent that they will not sell, transfer or dispose of the PIPE shares other than in compliance with the registration provisions of the Securities Act. PIPE issuers rely on this representation from investors in order to qualify for the private offering exemption from SEC registration. The SEC alleged that the portfolio manager made these representations to the PIPE issuers with the intent to distribute the restricted PIPE securities in violation of the provisions of the Securities Act. The SEC also alleged that the portfolio manager engaged in insider trading by selling the securities of PIPE issuers on the basis of material nonpublic information prior to the public announcement of the PIPEs.
To settle the SEC’s charges, without admitting or denying the allegations, the funds and the portfolio manager consented to the entry of a final judgment permanently enjoining them from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and Sections 5 and 17(a) of the Securities Act. As part of the settlement, the funds and the portfolio manager agreed to pay $15.8 million in disgorgement of profits, penalties and interest.
SEC Litigation Release No. 19607 (March 14, 2006), SEC v. Langley Partners, L.P., North Olmsted Partners, L.P., Quantico Partners, L.P., and Jeffrey Thorp, Civil Action No. 1:06CV00467 (JDB) (D.D.C.).
WilmerHale publishes detailed article on FinCEN Anti-Money Laundering (“AML”) Rules on Foreign Correspondent and Private Banking Accounts
March 10, 2006 1:22 PM
As previously reported, on January 4, 2006, the Treasury Department’s FinCEN published final and proposed rules to implement Section 312 of the Patriot Act. That provision, entitled “Special Due Diligence for Correspondent Accounts and Private Banking Accounts,” is one of the significant amendments made to the Bank Secrecy Act, the statutory framework for federal AML regulations, in the wake of the September 11 terrorist attacks.
A detailed report published by WilmerHale’s Financial Institutions and Securities Groups is posted on WilmerHale’s website at: http://www.wilmerhale.com/files/Publication/691846ee-5158-450a-8f18-7cfd641799da/Presentation/PublicationAttachment/272dacc3-4182-4bcc-913a-af716ac38ed1/FinancialSecurities_03_2006.pdf
DOL Extends Deadline for Filing Forms LM-10 and LM-30 until May 15, 2006
March 10, 2006 1:16 PM
Since 2005, the DOL’s Office of Labor-Management Standards (“OLMS”) has implemented a number of initiatives to educate employers, labor organizations, and employees about the circumstances under which they are required to file Forms LM-10 and LM-30. Employers are required to file Form LM-10 annually with the OLMS if they engage in specific financial transactions or arrangements with a union or a union’s officers or employees (“union officials”). Union officials must file a Form LM-30 annually. Both reports are due within 90 days after a filer’s fiscal year end. Since many filers have a fiscal year ending December 31, their 2005 report is due by March 31, 2006. OLMS posted a Form LM-10 advisory on its web site at www.olms.dol.gov on November 10, 2005, and subsequently received numerous inquiries relating to the reporting requirements. On March 7, 2006, OLMS posted additional Frequently Asked Questions about Form LM-10, some of which also relate to Form LM-30.
On March 8, 2006, OLMS issued another advisory due to the short amount of time remaining before the filing deadline for Forms LM-10 and LM-30 for those filers with a December 31 fiscal year end. In the notice, OLMS stated that although the DOL has no statutory authority to grant extensions of the filing deadlines, for those employers, unions and union officials whose report is due by March 31, 2006, the DOL will not take any enforcement action until May 15, 2006 to compel the filing of delinquent Forms LM-10 and LM-30. A Form LM-10 filed on or before May 15, 2006 will be considered on time for the purposes of the Form LM-10 grace-period provisions discussed in Frequently Asked Questions 66 and 70.
SEC Staff Indicates Guidance on Email Retention To Be Issued Shortly
March 10, 2006 1:14 PM
In a speech at the IA Compliance Best Practices Summit on February 28, 2006 in Washington, DC, Doug Scheidt, associate director of the SEC’s Division of Investment Management, stated that he expects the SEC to issue guidance on email retention in the near future (approximately one month or so). The issue of the need for guidance in this area was a frequent topic at the conference. Scheidt commented that there has been a significant amount of confusion in the industry as to the distinction between those records that are required to be retained (“required records”) as compared to those that are subject to examination by the SEC’s OCIE. According to Scheidt, the SEC has the statutory authority to examine all records of an adviser — not merely required records. As for what types of emails should be considered as required records, Scheidt stated that his interpretation of the applicable rules requires retention of messages that contain advice or recommendations to customers, either in their final form or in a proposal stage. BNA Securities Laws Daily, March 2, 2006.
SEC Staff Clarifies Fiduciary Duty of Advisers to Vote Client Proxies
March 10, 2006 1:07 PM
In a speech at the IA Compliance Best Practices Summit on February 27, 2006, Jennifer Sawin, assistant director in the SEC’s Office of Investment Adviser Regulation, Division of Investment Management, stated that an investment adviser has a fiduciary duty to vote proxies on behalf of its clients, unless otherwise stated in a contract. She explained that although investment advisers may engage in a cost-benefit analysis to weigh whether exercising a vote is in the best interest of the client, they cannot ignore their obligations because it could be viewed as a breach of the duty of care. Sawin noted that advisers are frequently burdened with the costs associated with and unfeasibility of proxy voting in certain circumstances, such as translating voting materials from a foreign language or traveling to a foreign country to vote in person. Swain also noted a number of potential conflicts that could arise for an adviser when voting proxies, including having a business relationship with an issuer, the issuer also being a client, or having a relationship with a third party that has an interest in the vote. To remedy these potential conflicts, she suggested disclosing any and all conflicts to the relevant clients, establishing objective pre-set voting guidelines, and utilizing a third party voting service. She explained, however, that using a third party voting service does not automatically discharge all potential conflicts and advisers should assess the adequacy of the third party service provider’s internal controls to address its own conflicts. Sawin stated that, in connection with exam sweep being conducted out of the SEC’s Boston office that began in November 2005, the SEC is examining the relationships advisers maintain with third party service providers, including how advisers are utilizing third party voting services. BNA Securities Law Daily, March 3, 2006.
SEC Examiners Providing Greater Flexibility In Its Request For Signed Compliance Letters from Chief Compliance Officers (“CCOs”)
March 10, 2006 1:01 PM
According to a recent industry news article, the SEC staff appears to be allowing greater flexibility in its requests to CCOs for letters disclosing compliance violations (“compliance violation letters”). In addition, the SEC staff also appears to have stopped asking CCOs to sign letters on the sufficiency of their compliance staffing (“compliance staffing letters”). In connection with past routine examinations, the SEC staff has asked CCOs to sign a compliance staffing letter stating whether or not they have adequate compliance staffing and resources. For those CCOs who believed they were not given proper resources, the SEC staff asked them to describe what actions they have taken with senior management to try and obtain additional staffing. The staff’s purpose for requesting the compliance staffing letter was to ensure that CCOs have the support of management and the requisite amount of staffing to perform their jobs effectively. The staff’s request, however, often acted as a double-edged sword for most CCOs because few would want to inform the SEC staff that their compliance departments were understaffed and management was not being cooperative, yet CCOs were also reluctant to confirm that they did have adequate staffing in the event the SEC staff later discovered compliance deficiencies.
A speaker at an industry conference stated that, although the SEC staff is no longer asking CCOs for compliance staffing letters, the staff is still asking CCOs to submit compliance violation letters that identify any prior or existing compliance problems. Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), explained at the conference that the staff is wiling to be flexible when making these requests for compliance violation letters. Gohlke elaborated that, instead of requiring signed letters, most examiners would be satisfied with a list of practices and procedures that have been implemented to prevent, detect and correct compliance violations. Ignites Article, SEC Backs Off From CCO Letter Requests, March 8, 2006.
SEC Staff Provides Guidance on Soft Dollar Proposal
March 10, 2006 12:54 PM
On October 20, 2005, the SEC proposed a new and more restrictive interpretation of the statutory safe harbor found under Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), which governs advisers’ use of soft dollar commissions (“Soft Dollar Proposal”). Speaking at the IA Compliance Best Practices Summit on February 27, 2006, Joanne Swindler, assistant director in the SEC’s Division of Market Regulation, explained that commenters on the Soft Dollar Proposal were evenly split on whether market data should be included in the safe harbor and paid for with client commissions, or excluded and paid for with the adviser’s own funds. She explained that commenters were also divided on the appropriate starting point for considering brokerage activity. Some commenters suggested that the starting point should be moved up to when the investment manager makes an investment decision, and others suggested that long-term custody should be covered.
Swindler clarified that the SEC will probably address in its final rule release the use of free services (for example, in the event brokers compete for investment advisory business by offering free services on their website or otherwise) and decide whether advisers must value these services separately or subject them to a mixed-use allocation. She also noted that the SEC will also take a closer look at whether an introducing broker must comply with all four elements outlined in the Soft Dollar Proposal with respect to commission sharing. Finally, in response to questions from commenters on Footnote 108 of the Soft Dollar Release, Swindler explained that the SEC is not seeking to unbundle execution costs from soft dollars. She stated that if a money manager seeks safe harbor protection for both Section 28(e) eligible and ineligible products and services for a bundled commission rate, the manager must use its own funds to pay for the “allocable portion” of the costs of products and services that are not within the safe harbor. BNA Securities Regulation and Law Report, March 6, 2006. The SEC’s proposed soft dollar interpretation is posted on the agency’s website at: http://www.sec.gov/rules/interp/34-52635.pdf.