On May 21, 2008, by a vote of 263 to 160, the House of Representatives passed a bill (H.R. 6049) introduced by Chairman Charles Rangel (D-NY) that would amend the Internal Revenue Code of 1986 (the “Code”) to eliminate the benefits of deferred taxation on compensation payable to investment advisers of certain hedge funds, targeting offshore funds in particular. The bill would be effective with respect to fees for services rendered after December 31, 2008, and also would apply to amounts deferred for services performed before 2009 to the extent the amounts are not otherwise included in taxable income prior to 2018.  

A summary of the proposed bill can be found in the WilmerHale Investment Management Industry News Summary (May 16, 2008) at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8322.

The text of the bill can currently be found at http://www.rules.house.gov/110/text/110_hr6049.pdf.

The Ways and Means Committee Report regarding the bill can be found athttp://www.rules.house.gov/110/text/110_hr6049rpt.pdf.

The SEC filed a civil injunctive action in the U.S. District Court for the Southern District of New York against the principal and portfolio manager of a hedge fund, alleging antifraud violations related to the misrepresentation of the fund’s performance. Without admitting or denying the SEC’s allegations, the principal consented to the entry of a final judgment permanently enjoining him from future violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder. The settlement is subject to court approval.

The SEC alleged that the principal and his partners materially misrepresented the hedge fund’s performance in correspondence, account statements, and promotional materials to conceal the fund’s losses and to cause investors and prospective investors to think that the fund was achieving modest and steady growth. The SEC also alleged that with the principal’s knowledge, the fund created an accounting firm to issue and certify sham audits of the fund’s performance, and distributed fabricated audit opinions by the firm attesting to the accuracy and truthfulness of the fund’s financial statements. This false information enabled the fund to attract millions of dollars in new capital, the SEC alleged. Although the principal dissociated himself from the hedge fund in or around October 2001, four years before the conduct was discovered by the SEC, the SEC alleged that he did not attempt to expose the fund’s continuing scheme. These civil charges are noteworthy in that they underscore the SEC’s expectation of self-reporting and informing regulators about the continuing activities of co-conspirators.

Previously, the principal pled guilty to one count of criminal conspiracy, was sentenced to fifty-one months in prison, and was ordered to pay $6,259,650 in criminal restitution for his conduct in this matter.

The SEC’s complaint can be found at http://www.sec.gov/litigation/complaints/2008/comp20595.pdf.

The U.S. Court of Appeals for the Seventh Circuit rejected a claim that advisory fees charged to a fund family were excessive and violated Section 36(b) of the Investment Company Act of 1940. The decision is notable because the Court articulated a new standard for reviewing advisory fee challenges under Section 36(b) and rejected the long-standing Gartenberg test. The Court criticized the Gartenberg approach as “rate regulation” and adopted an approach showing greater deference to competitive market forces.

Further discussion of the implications of this case can be found in the WilmerHale Email Alert at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8329.

The decision can be found at Jones v. Harris Associates, No. 07-1624, 2008 WL 2080753 (7^th Cir. 2008).

On May 21, 2008, the SEC voted unanimously to propose that mutual funds be required to provide the risk and return summary information in their public filings in an interactive data format, by labeling the information using computer tags. The tags would allow investors to access and compare information about the investment objectives and strategies, risks, performance, fees, and expenses of the more than 8,000 mutual funds in the industry. Investors would be able to review information in charts and graphs online, or download information into spreadsheets. If the proposal is adopted, mutual funds would be required to provide tagged information beginning with registration statements effective after December 31, 2009, and would have to post the interactive data on their websites. Comments are due by August 1, 2008.

Already more than twenty mutual funds voluntarily submit information to the SEC in this format. The SEC also launched a website that enables investors to use an interactive data viewer to analyze and compare charts and graphs of the information that has been submitted.

This proposal follows the SEC’s proposal on May 14, 2008 to require U.S. public companies to provide financial information using interactive data.

At the time of this publication, the SEC rule release proposing the rule was not available.

The press release announcing the proposed rule can be found at http://www.sec.gov/news/press/2008/2008-94.htm.

Chairman Cox’s speech during the SEC’s open meeting can be found at http://www.sec.gov/news/speech/2008/spch052108cc.htm.

The Interactive Risk and Return Summary Report Viewer can be found at http://a.viewerprototype1.com/viewer.

FINRA proposed rules in four regulatory notices published on May 14, 2008, as part of the process to develop a rulebook for member firms that consolidates the rules of the National Association of Securities Dealers (“NASD”) and New York Stock Exchange (“NYSE”). Comments are due by June 13, 2008. Among the proposals are new supervision and supervisory control rules, Rules 3110 and 3120, that are largely based on, and would respectively replace, existing NASD Rule 3010 regarding supervision and NASD Rule 3012 regarding supervisory control systems. They also would incorporate requirements from NYSE rules, including heightened compliance reporting for designated firms.

These proposed rules are intended to provide firms with greater flexibility to tailor their procedures to reflect their business, size and organizational structure, and to clarify supervisory requirements. NASD Rule 3040 regarding the supervision of associated persons’ outside securities activities and certain provisions in NASD Rule 3012 would be consolidated into FINRA Rule 3110, in order to group all provisions relating to supervisory systems together. Certain provisions from NYSE rules would be incorporated on a tiered basis, and the FINRA rules would codify staff guidance and eliminate obsolete or duplicative requirements. Additional material would be added to the Supplementary Material, including several provisions in the NASD Rules, and other NASD rule provisions would be rewritten as standalone rules.

The other rules FINRA proposed address financial responsibility, books and records requirements, and investor education and protection.

For more information regarding this topic, see the WilmerHale Securities Briefing Series at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8330; http://www.wilmerhale.com/files/upload/SecuritiesBriefingMay2008.pdf.

The release announcing the proposed supervision and supervisory control rules, FINRA Notice to Members 08-24 (May 2008), can be found at http://www.finra.org/web/groups/rules_regs/documents/notice_to_members/p038506.pdf.

The litigation release announcing the related settlements can be found at http://www.sec.gov/litigation/litreleases/2006/lr19729.htm.

The litigation release announcing the charges can be found at http://www.sec.gov/litigation/litreleases/lr19404.htm

The Court’s decision in the related case can be found at SEC v. K.W. Brown & Co., No. 05-80367-CIV, 2007 WL 5160312 (S. D. Fla. 2007).

The Court’s initial decision can be found at SEC v. Bolla, 401 F.Supp.2d 43 (D.D.C. 2005). Additional decisions can be found at SEC v. Washington Investment Network, 475 F.3d 392 (D.C.Cir. 2007); SEC v. Bolla, 519 F.Supp.2d 76 (D.D.C. 2007).

On May 15, 2008, the House Ways and Means Committee (the “Committee”) approved a bill (H.R. 6049) introduced by Chairman Charles Rangel (D-NY). The bill proposes an amendment to the Internal Revenue Code of 1986 (the “Code”) which is designed to eliminate the benefits of deferred taxation on compensation payable to investment advisers of certain hedge funds, targeting offshore funds in particular. Last year, Mr. Rangel attempted to win approval of similar provisions including a broader provision aimed at carried interests generally (as reported in the November 2, 2007 edition of the Investment Management News Summary), but those proposals were not contained in the final form of the legislation approved by the Senate. This time, however, Mr. Rangel’s deferred compensation provision is the key revenue raiser in a package that would extend several popular tax programs, including the research and development credit for businesses and certain renewable energy incentives. While election year politics are uncertain, the bill is thought to have sufficient support to advance to passage, although it is not clear whether Mr. Rangel’s proposal, in its current form, will be enacted.

Under the bill, individuals would be taxed on a current basis on vested deferred compensation from tax indifferent parties, such as offshore corporations (including offshore hedge funds in tax haven jurisdictions) or partnerships with principally foreign or US tax exempt partners. Thus, while the focus of this and earlier versions of the legislation appears to be offshore deferrals, the statutory language could be interpreted to pick up deferred compensation related to domestic funds whose investors are largely exempt from US taxation. There is a special rule in the proposal that would permit Treasury to issue regulations that would postpone income inclusion related to gains from the sale of specific investment assets until the time the asset is sold, although it is not clear how or when this regulation-writing authority would be implemented. There is also uncertainty about whether the definition of deferred compensation plan in the bill could extend to certain partnership interests.

Under current law, executives and employees can generally defer paying tax on compensation until it is received. In exchange for this deferral, the employer’s deduction is also generally deferred; thus, at a high level, the US tax system is indifferent to whether compensation is deferred or paid currently. Moreover, it is thought that the cost of the deferred deduction on the employer creates a tension between employee and employer that curbs excessive deferrals of compensation. Where, however, an individual is paid deferred compensation by a tax indifferent party such as an offshore hedge fund, there is no offsetting deduction that is deferred and there is thought to be no tension between the employer and the employee as to the deferral opportunity. According to Mr. Rangel’s description of the provision, the U.S. Treasury therefore bears the expense of delayed collection of the taxes associated with the compensation without benefiting from a delayed deduction by the corporate taxpayer.

The bill requires the Department of Treasury to issue guidance which will provide for a transition period during which deferred compensation arrangements attributable to services performed on or before December 31, 2008 may be amended to conform the date of distribution to the requirements of the bill without violating the requirements of Section 409A of the Code. The bill would be effective with respect to fees for services rendered after December 31, 2008 and would also apply to amounts deferred for services performed before 2009 to the extent the amounts are not otherwise included in taxable income prior to 2018.

A description of the bill can be found at
http://waysandmeans.house.gov/media/pdf/110/bill.pdf

The Committee’s press release regarding the bill can be found at
http://waysandmeans.house.gov/news.asp?formmode=release&id=654

The text of the bill can currently be found at:
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_bills&docid=f:h6049rh.txt.pdf  

On May 7, 2008, a Pennsylvania U.S. District Court judge sentenced a broker-dealer registered representative and an investment adviser for their roles in securities fraud perpetrated in connection with market timing activities. According to the SEC’s press release, this was the first criminal case brought in connection with market timing.

According to the Information filed March 20, 2007 by the U.S. Attorney for the Eastern District of Pennsylvania, the registered representative and the investment adviser participated in fraudulent activities over the course of almost four years, which allowed the investment adviser to make more than 26,000 market timing trades of shares of various mutual funds. The registered representative, who was associated with two SEC registered brokers at the time of the fraudulent activity, assisted the investment adviser in intentionally evading the controls of mutual funds designed to restrict market timing by using multiple account numbers and limiting trade amounts.

In the related civil case, filed by the SEC in 2005, a U.S. District Court judge entered a final judgment which permanently enjoined the registered representative from violations of anti-fraud prohibitions of federal securities laws. The registered representative was ordered to pay disgorgement of over $500,000 (although much of that amount was later waived). On April 10, 2006, the SEC instituted a settled administrative proceeding which barred the registered representative from association with any broker or dealer. On May 7, 2008 the investment adviser pled guilty to securities fraud and was ordered to forfeit profits and pay fines totaling over $1 million, and the registered representative also pled guilty to securities fraud, was sentenced to one year and one day in prison and ordered to pay a fine of $7,500.

The litigation release announcing the sentencing can be found at
http://www.sec.gov/litigation/litreleases/2008/lr20567.htm

The litigation release regarding the related civil case can be found at
http://www.sec.gov/litigation/litreleases/2006/lr19647.htm

The order in the related administrative proceeding can be found at
http://www.sec.gov/litigation/admin/2006/34-53622.pdf  

The SEC has adopted an amendment to Rule 2a-46 (the “Rule”) under the Investment Company Act of 1940 (the “Investment Company Act”), which expands the category of “eligible portfolio company” (“EPC”) business development company (“BDC”) investments.

BDCs, which elect to be regulated under certain provisions of the Investment Company Act, are investment vehicles that invest in small companies for which capital may not be otherwise available. The Investment Company Act requires BDCs to invest at least 70 percent of their assets in securities of EPCs.

The Investment Company Act definition of EPC includes domestic operating companies that do not have securities that are “marginable” under Federal Reserve Board rules. For reasons unrelated to BDCs, the Federal Reserve Board’s margin rules have been amended since the adoption of the Investment Company Act definition of EPC and now include all publicly traded equity securities and some debt securities. These amendments have resulted in the exclusion of a number of small companies with publicly traded securities from EPC status. In 2006, the SEC adopted the Rule and requested comments on proposed amendments to the Rule to reverse the effect of the Federal Reserve Board amendments and expand the definition of EPC to include certain small companies whose securities are traded on a national securities exchange.

An overwhelming majority of commenters supported the SEC’s proposal to amend the Rule’s definition of EPC to include companies with market capitalization of less than $250 million. This approach to the amendment of the Rule is derived from the definition of “micro-cap” issuer widely used in U.S. securities markets. Commenters and the SEC agree that issuers with market capitalizations of less than $250 million “have limited (if any) analyst coverage, have lower trading volume and are owned by fewer institutional investors than companies with higher market capitalizations” and therefore have trouble accessing public capital that is available to larger issuers.

The SEC has amended Rule 2a-46 to add new paragraph (b) which provides for any issuer that “has securities listed on a national securities exchange, but has an aggregate market value of outstanding voting and non-voting common equity of less than $250 million” to be included in the definition of EPC. The SEC estimates that the amendment will allow BDCs to include the securities of an additional 1,649 companies in their 70 percent EPC “basket,” providing those companies with greater access to capital through BDC financing.

The adopting release can be found at
http://www.sec.gov/rules/final/2008/ic-28266.pdf  

On April 28, 2008, an SEC administrative law judge (the “ALJ”) dismissed all charges of major violations of federal securities laws against two former Executive Vice Presidents (“EVPs”) of a mutual fund adviser (the “Adviser”) and dismissed all charges against an Assistant Vice President (the “AVP”) of the Adviser.

The SEC’s complaint alleged that all three officers of the Adviser allowed market timing transactions by two broker-dealers, willfully violating various antifraud provisions of federal securities laws. The ALJ found that none of the defendants acted with scienter and therefore dismissed all scienter-based violations. The ALJ also found that the SEC failed to prove that any of the defendants acted deceptively or failed to disclose the existence of market timing. The ALJ found that the AVP did not negotiate a “sticky assets” deal in exchange for market timing capacity in another fund managed by the Adviser and the ALJ found that he could not have been negligent because he lacked control over the market timers.

Ultimately, the ALJ found (i) that one of the EVPs, a portfolio manager, acted negligently in allowing the market-timers to trade in the fund he managed, and (ii) that the other EVP, who could have stopped market-timing activity but decided not to, also acted negligently. Accordingly, the ALJ imposed a cease and desist order on the two EVPs

The ALJ initial decision can be found at
http://www.sec.gov/litigation/aljdec/2008/id348cff.pdf  

On May 1, 2008, the California Department of Corporations (the “Department”) announced their intention to abandon a proposal it announced on October 12, 2007 to amend the California Corporate Securities Law of 1968. The proposed amendment would have required California investment advisers with more than five clients in California to obtain a license from the Department. The proposed amendment would have applied to investment advisers exempt from SEC registration requirements pursuant to Rule 203(b)(3) (the “De Minimis Exemption”) under the Investment Advisers Act of 1940, the exemption commonly utilized by hedge fund and private equity fund advisers to avoid SEC registration. The proposed amendment would not have required licensing in connection with venture capital activities.

In 2002, the Department adopted an exemption from registration for investment advisers that (i) do not hold themselves out generally to the public as such, (ii) have fewer than 15 clients, (iii) are exempt from SEC registration under the De Minimis Exemption and (iv) either have at least $25 million in assets under management or provide venture capital investment advice only.

Only two other states, New York and Connecticut, currently have similar exemptions. The Department reportedly concluded that action on the proposed amendment was “premature,” leaving the door open for possible action on the proposed amendment in the future.

On May 8, 2008, FINRA announced that a member firm (the “Broker”) has agreed to settle charges and consent to entry of FINRA findings in connection with Broker employees’ improper trade allocations, supervisory deficiencies and various other charges.

The former head trader of the Broker, who was barred from association with any FINRA-registered firm in 2006, was found to have allocated profitable trades to his wife at the expense of Broker clients. The trades allegedly resulted in over $270,000 of improper profits. The Broker was charged with supervisory deficiencies in connection with the former head trader’s actions. FINRA found that the Broker failed to maintain a restricted list prior to 2005, despite the Broker’s representation of certain issuers in investment banking deals. FINRA also found that the Broker failed to report that its parent entered into a consulting contract with a FINRA-barred individual and found deficiencies in anti-money laundering compliance, complaint reporting and review of markups on equity transactions.

The Broker did not admit or deny any FINRA allegations, but consented to entry of FINRA findings and payment of $750,000 for the above-mentioned deficiencies and violations of FINRA rules and federal securities laws. The supervisor of the former head trader was ordered to pay a $25,000 fine and was suspended for six months from association with any FINRA-registered firm.

The FINRA news release can be found at http://www.finra.org/PressRoom/NewsReleases/2008NewsReleases/P038461  

On May 6, 2008, SEC Commissioner Paul Atkins announced that he will leave the SEC at the end of this, his second term as SEC Commissioner. Commissioner Atkins was appointed in August 2002 by President Bush. His departure ends almost ten years of service with the SEC which began with a four year stint as a staff member with two former SEC Chairmen, Richard Breeden and Arthur Levitt.

Commissioner Atkins has been praised for his commitment to balancing the costs and benefits of regulation, including his efforts in connection with the implementation of the Sarbanes-Oxley Act of 2002. During his time as Commissioner, Commissioner Atkins has traveled to four continents to discuss cooperative enforcement and investor protection with foreign regulators. He has made a personal commitment to investor education and held more than 40 town hall meetings with students, small businesses, retirees and U.S. military personnel, both within the U.S. and abroad.

During his tenure as Commissioner, Commissioner Atkins has dissented from some key SEC investment management rules. In 2003, Commissioner Atkins was the only dissenting Commissioner in connection with the SEC’s rule amendments requiring investment companies to disclose proxy voting policies and proxy voting records. In December 2004, Commissioner Atkins, along with Commissioner Cynthia Glassman, dissented from the SEC’s final rule requiring registration of hedge fund advisers. In 2005, Commissioners Atkins and Glassman dissented from the SEC’s final mutual fund corporate governance rules.

Commenting on Commissioner Atkins’ departure, SEC Chairman Christopher Cox stated “At a time when the men and women of our armed services are being called upon to make extraordinary sacrifices, Paul Atkins has led the agency’s investor education initiatives at military bases across the country and around the world.”

Commissioner Atkins’ term expires June 5th, and he plans to end almost six years in office when his successor takes office. Commissioner Atkins’ departure creates a third vacancy on the five-member SEC.

The press release can be found at
http://www.sec.gov/news/press/2008/2008-78.htm  

The SEC’s Division of Investment Management has recommended that the SEC amend Rule 2a-46 under the Investment Company Act of 1940 (the “Investment Company Act”) to expand the category of “eligible portfolio company” for business development company (“BDC”) investments.

The Investment Company Act requires BDCs to invest at least 70 percent of their total assets in “eligible portfolio companies.” The definition of “eligible portfolio company” currently includes privately held companies and publicly held companies whose securities are not listed on a national securities exchange. The Division of Investment Management recommends that the SEC adopt a rule amendment to include exchange-listed securities of certain smaller companies in the definition of “eligible portfolio company,” which would allow BDCs to invest a larger percentage of their capital in such smaller companies. The SEC press release does not specify which exchange-listed securities will fall within the amended definition of “eligible portfolio company.”

The SEC press release can be found at
http://www.sec.gov/news/press/2008/2008-81.htm