NASD chairman Frank Zarb wrote a letter to the North American Securities Administrators Association, the umbrella group for state securities regulations, proposing to streamline the process by which brokerage firms obtain state licenses. Mr. Zarb proposed using the NASD's Central Registration Depository ("CRD"), a national database of broker information to centralize administrative functions such as billing.

Mr. Zarb also proposed permitting established broker-dealers to do business in a new state through a single filing with the NASD as long as the broker-dealer has a clean regulatory record. He emphasized that broker-dealers would still be required to comply with each state's substantive securities regulations.

In his letter, Mr. Zarb commented that broker-dealers, particularly small ones, incur heavy administrative costs due to the disparate registration requirements of different states. He noted that broker-dealers must comply with duplicative state administrative requirements including the filing of tax returns, audited financial reports and selling agreements. Wall Street Journal, October 19, 1999.

A revised EDGAR filer manual became effective on October 18, 1999. The new version of the filer manual incorporates changes resulting from the decision by CompuServe to discontinue its EDGAR services. Previously, CompuServe provided services such as: the Public Data Network ("PDN") for transmitting EDGAR filings, private electronic mailboxes to receive EDGAR acceptance and suspense notifications, the EDGAR company database and an electronic bulletin board. TRW, the developer of the EDGAR system, has contracted with UUNET to provide the mailbox and PDN services. The EDGAR bulletin board and EDGAR company database will no longer be available but filers may obtain similar information from the SEC's website.

The revised EDGAR Manual contains updated information on obtaining a Form ID, the uniform Application for Access Codes to file on EDGAR. SEC Release Nos.33-7752; 34-41986; 35-27081; 39-2376; IC-24075 ; October 20, 1999.

The SEC is seeking comment on the regulation of short sales of securities. In a concept release, the SEC seeks comment on, among other things, whether the SEC should:

• limit short sales of exchange listed securities under advancing market conditions;
• provide an exception for actively traded securities;
• focus short sale restrictions on certain market events and trading strategies.
• revise short sale regulations in response to certain market developments;
• revise the definition of "short sale";
• extend short sale regulation to non-exchange listed securities; and
• eliminate short sale regulation altogether.

Comments must be received by December 27, 1999. SEC Release No. 34-42037, October 22, 1999.

Speaking at the American Law Institute-American Bar Association Conference on Investment Management Regulation, Robert E. Plaze, associate director of the SEC's Division of Investment Management, announced several rulemaking initiatives by the SEC. Under the first initiative, the SEC will propose a rule to exempt full service broker-dealers who offer discount services on the Internet from the registration requirements of the Investment Advisers Act of 1940 (the "Advisers Act"). The SEC recently reexamined the legal treatment of broker-dealers in light of recent shifts from the traditional fixed commission system. With online trading, differences in brokerage fees paid for the execution of the same trade evolved. Under one scenario, a customer pays a fee to a broker for executing a trade; in the other, the customer pays a lower fee for execution online via the broker. Mr. Plaze explained that the difference in price gives the appearance that full service broker-dealers receive special compensation for investment advice, an activity which triggers regulatory and reporting requirements under the Advisers Act.

Mr. Plaze stated that the proposed rule will exempt broker-dealers from the Advisers Act by distinguishing between "the nature of the service rather than the form of compensation." Mr. Plaze added that the distinguishing characteristic that would reclassify a broker dealer as an investment adviser will be whether the broker dealer has discretionary authority to execute trades on behalf an investor.

Mr. Plaze also reported on other future SEC initiatives, including: (i) adoption of a rule permitting investment companies to send a single prospectus to a household in which there are multiple shareholders; and (ii) amendment of Form ADV, the registration form for investment advisers, to allow electronic filing by mid-2000.

Barry Miller, associate director of the SEC's Division of Investment Management, commented on upcoming SEC initiatives in investment company prospectus disclosure. Mr. Miller stated that in the near future, the SEC will address the issue of the placement of the fee table in investment company prospectuses. Mr. Miller also commented that investment companies need to improve disclosure relating to distinctions between funds in multiple fund prospectuses. He noted that risk disclosure in multiple fund prospectuses tends to be quite generic and not fund specific. BNA Securities Law Report, October 22, 1999.

Paul Roye, director of the SEC's Division of Investment Management, announced on October 14, 1999 that the SEC would issue an interpretive release clarifying the point at which a financial adviser may "cross the line" in rendering financial advice and be considered an investment adviser with fiduciary obligations under the Investment Advisers Act of 1940 (the "Advisers Act").

The interpretive release stems from an administrative action where the SEC charged a financial advisory firm with failing to tell four of its municipal advisory clients that it received brokerage commissions in connection with the client's investments of certain bond proceeds ( In re O'Brien Partners Inc., Release Nos. 33-7594, IA-1772, October 27, 1998). The firm agreed to a consent order resolving charges that it was an investment adviser for purposes of the Advisers Act because it was compensated for the advice it gave its municipal clients concerning their investment of bond proceeds in securities. In remarks at the SEC's first annual Municipal Market Roundtable, Mr. Roye reminded participants that the three elements of a fiduciary relationship are compensation, provision of advice and a history of providing financial advice. Securities Regulation and Law Report, October 15, 1999.

Concurrent with the proposed rules on independent directors, the SEC issued a release on interpretive matters concerning independent directors of investment companies. In this release, the SEC expressed its views concerning a number of issues under the 1940 Act that relate to independent directors and briefly described the role of the SEC in connection with certain disputes between independent fund directors and fund management.

In the release, the SEC addressed the following topics:

Material business and professional relationships for purposes of Section 2(a)(19) of the 1940 Act. The SEC has the authority to issue an order under Section 2(a)(19) of the 1940 Act when it finds that a person has or had a "material business or professional relationship" with certain specified persons and entities, including fund affiliates. However, Section 2(a)(19) does not specify which relationships may deemed material. The SEC decided to clarify its views on the issue because some fund complexes have declined to nominate otherwise qualified candidates as independent directors due to concerns that the SEC will commence proceedings under Section 2(a)(19) making the directors interested persons of the fund.

The SEC commented that it believes that a fund director may be determined to have a material business relationship if he or she currently holds or held, at any time since the beginning of the last two completed fiscal years of the fund, certain positions with a fund or its affiliates. The SEC noted that it would consider a position that a director holds to be material within Section 2(a)(19) if it would tend to impair the director's independence by providing incentives for the director to place his or her own interests over the interests of fund shareholders. The SEC identified level of responsibility and level of compensation as two key factors in determining whether a director's position with a fund or its affiliate would tend to impair his or her independence.

The SEC specifically identified service as the fund's portfolio manager during the two-year period to be a relationship it would consider material. The SEC also stated that, depending on the facts and circumstances, a former director, officer or employee of the fund's investment adviser or principal underwriter, or a fund director who at any time during the two-year period also was a director, officer or employee of a current or former holding company of the fund's investment adviser may be viewed as having had a material business or professional relationship.

The SEC clarified that a fund director may be treated as interested if he or she has, at any time during the two-year period, directly or indirectly engaged (or proposed to engage) in any material transactions (or proposed material transactions) with any fund or its affiliates. The SEC advised that these transactions could be single or multiple and may be structured as service arrangements including legal, investment banking and consulting services or other business transactions, such as business and personal loans and real estate purchases.

Clarification by the SEC that actions taken by fund directors within the scope of their duties generally would not be deemed joint transactions. Section 17(d) of the 1940 Act and Rule 17d-1 thereunder prohibit an affiliated person of an investment company from participating in or effecting any transaction in connection with any joint enterprise, other joint arrangement or profit-sharing plan in which the investment company is also a participant. A joint enterprise, other joint arrangement or profit-sharing plan is broadly defined in rule 17d-1(c) to include any written or oral plan, contract, authorization or arrangement or any practice or understanding concerning an enterprise or undertaking whereby the investment company and the affiliate have a joint or a joint and several participation, or share in the profits of such enterprise or undertaking.

Fund directors commonly authorize the use of fund assets to make payments from which the directors may personally benefit, such as director salaries, board meeting expenses, proxy expenses and legal fees of counsel to the independent directors. The SEC clarified that, as a practical matter, it believes that interpreting rule 17d-1 so broadly as to encompass these actions could impede, or in some cases prevent, fund directors from taking actions that would be in the best interests of shareholders. Instead, the SEC reiterated its belief that actions of fund directors taken in their capacities as directors would not constitute joint arrangements for purposes of rule 17d-1. The SEC clarified that a prohibited joint arrangement requires "some element of combination" between the fund and its affiliate and that it must involve activities that are beyond the scope of the directors' duties to the fund.

Guidance from the SEC regarding when a fund may pay an advance of legal fees to its directors. The SEC has taken the position that the prohibitions of Section 17(h) apply to advances for legal fees, as well as to payments for settlements and judgments. Section 17(h) generally prohibits a fund from including in its organizational documents any provision that protects a director or officer of a fund against any liability to the fund or its shareholders by reason of willful misfeasance, bad faith, gross negligence or reckless disregard of his or her duties as director or officer (collectively, "disabling conduct").

The SEC has also taken the position that, before advancing legal fees to a director, a fund's board must either (1) obtain assurances, such as by obtaining insurance or receiving collateral provided by the director, that the advance will be repaid if the director is found to have engaged in disabling conduct, or (2) have a reasonable belief that the director has not engaged in disabling conduct and ultimately will be entitled to indemnification. The SEC has stated that a reasonable belief may be formed either by a majority of the independent directors of the investment company, or based on a written opinion provided by independent legal counsel that in turn is based on counsel's review of the readily available facts. The SEC intends these positions to permit a fund to protect its directors against the legal costs of defending and resolving lawsuits, while preventing or minimizing the risk that a fund's assets will be used to indemnify directors for legal fees that are incurred as a result of the directors' disabling conduct.

The SEC also addressed the degree of due diligence an independent third party must employ in making its reasonable belief determination. The SEC reiterated its position that a full trial-type inquiry was unnecessary and that the directors or counsel could rely on a review of the readily available facts. The SEC commented that the review need only be sufficient to form the basis of a reasonable, but not necessarily conclusive, belief. The SEC noted, however, that it believes that directors and counsel should give certain information significant weight when making a reasonable belief determination. For example, the SEC believes that the directors and counsel would be precluded, in most cases, from making a reasonable belief determination once a court (or other body before which the relevant proceeding was brought) found that a director had engaged in disabling conduct, notwithstanding the possibility that the director might prevail on appeal.

Guidance from the SEC concerning the circumstances under which open-end funds may compensate fund directors with fund shares. The SEC emphasized its belief that funds should enact policies that encourage their independent directors to invest the compensation they receive from the funds in shares of the funds. The SEC noted that effective fund governance can be enhanced when funds align the directors' interests with the shareholders'. To encourage fund complexes to institute similar policies, the SEC clarified the circumstances in which open-end funds may compensate directors directly with fund shares consistent with Section 22(g). Section 22(g) generally provides that no open-end fund may issue any of its securities for services or for property other than cash or securities.

The SEC stated that it would not recommend enforcement action under Section 22(g) if a fund directly compensated its directors with fund shares, provided that a fixed dollar value is assigned to the directors' services prior to the time that the compensation is payable. The SEC noted that compensating directors in this manner is functionally equivalent to paying the directors in cash and does not present the dangers of dilution and the overvaluation of services that Section 22(g) was designed to protect.

Role of the SEC in disputes between independent directors and fund management. The SEC addressed recent criticism levied against it for not intervening in disputes between independent directors and fund management. The SEC stated that its response to internal fund disputes usually takes two forms: (1) the SEC will conduct an investigation or examination which is not made public or (2) the SEC may decide that enforcement action is not warranted based on all available information, including nonpublic information. The SEC stated that its critics are incorrect in presuming that, because the SEC has not made any public statement or not taken any public action in connection with an internal fund dispute, that the SEC has not investigated any allegations made by the parties or failed to take appropriate action.

The SEC clarified its role and procedures in connection with internal fund disputes. The SEC reiterated that its role, as a general matter, is to interpret, administer and enforce the federal securities laws for the protection of investors. The SEC stated that it considers its role to be providing guidance regarding the requirements of the federal securities laws, investigating possible violations of these laws and instituting enforcement actions in appropriate circumstances when the SEC believes that these laws have been violated . SEC Release IC-24083, October 14, 1999.

On October 14, 1999, the SEC proposed rules and rule amendments to enhance the effectiveness of mutual fund independent directors. The SEC proposed amendments to the ten exemptive rules that provide funds and advisers relief from various statutory prohibitions designed to prevent conflicts of interest. The SEC selected those rules that exempt funds or their affiliated persons from provisions of the Investment Company Act of 1940 (the "1940 Act") and have as a condition the approval or oversight of independent directors. The rules include, among others, rule 10f-3, rule 12b-1, rule 17a-7 and rule 18f-3.

To the extent a fund relies on any of the rules, the proposed amendments would require the fund to comply with the following requirements:

• Independent directors constitute at least a majority of the board of directors. The SEC requests comment on whether it should adopt this simple majority requirement or a two-thirds majority requirement, as suggested by the recent Investment Company Institute Advisory Group Report.
• Independent directors select and nominate other independent directors.
• Any legal counsel for the independent directors be an independent legal counsel that does not also represent the fund's adviser or other affiliates. A person would qualify as an independent legal counsel if the fund reasonably believes that the person and his or her firm, partners and associates have not acted as legal counsel for the fund's investment adviser, principal underwriter, administrator or any control persons of those entities at any time since the beginning of the fund's last two completed fiscal years.

The SEC also proposed new rule amendments that would:

• Prevent an otherwise qualified individual from being unnecessarily disqualified from serving as an independent director merely because he or she owns shares of an index fund that invests in the adviser or underwriter of the fund or their controlling persons.
• Protect the independence of independent directors by requiring that joint "errors and omissions" insurance policies cover lawsuits brought against them by investment advisers.
• Exempt funds with independent audit committees from the requirement to seek shareholder approval of the fund's auditor.
• Require funds to retain any records they rely on to assess the independence of independent directors.
• Temporarily suspend the independent director minimum percentage requirements if a fund falls below the required percentage due to an independent director's death or resignation.

The SEC also proposed disclosure requirements that would require funds to provide better information about directors, including:

• basic information about the identity and business experience of directors,
• fund shares owned by directors,
• information about the directors' potential conflicts of interest, and
• the board's role in governing the fund's operations.

Comments on the rule proposals are due by January 28, 2000. SEC Release IC-24082, October 14, 1999.

The U.S. District Court of the Northern District of Illinois held that the CFTC's requirement that the publisher of a newsletter dispensing "impersonal" futures market information register with the CFTC was a prohibited attempt to regulate speech and thus violated the publisher's free speech rights under the First Amendment to the U.S. Constitution.

The publisher distributed publications about the securities and commodity futures markets. One of the publications detailed a computerized commodity futures trading system which the publisher operated. The system tracked specific commodity futures contracts trading activity and would issue buy or sell recommendations which the publisher included in its mailings.

The CFTC launched an investigation into the publisher's activities and determined that the publisher was supplying investment advice on commodity futures trading. The CFTC subsequently required the publisher to register with the CFTC as a commodity trading advisor. The publisher filed suit arguing that the CFTC's registration requirement and Section 4m(l) of the Commodity Exchange Act (the "CEA") violated the publisher's First Amendment rights. The CFTC argued that the registration requirement is a "legitimate regulation on the entry into the business of providing commodity trading advice."

The court found that the CFTC's registration requirement was an attempt to regulate speech and not an attempt to regulate the profession of providing investment advice. The court also found that Section 4m(1) of the CEA was an "unconstitutional prior restraint as applied to providers of impersonal commodity trading advice." In support of its opinion that the publisher was distributing impersonal futures market information, the court found that the publisher:

• provides the same information to each subscriber;
• does not have discretionary control over its customer accounts;
• does not execute trades on behalf of its customers; and
• does not tell its customers to follow or ignore any of its recommendations.

The court stated that its conclusion was consistent with the U.S. Supreme Court's 1985 opinion in Lowe v. SEC, 472 U.S. 181 (1985). In that opinion, the Court held that publishers of non-personalized advice about stock trading could not be required to register with the SEC as investment advisers.

Mindful of the CFTC's "legitimate interest in minimizing the amount of false or fraudulent information," the court upheld the CFTC's application of the antifraud provisions to the publisher. The court found that the antifraud provisions of the CEA continue to apply to the publisher even though its activities are limited to providing impersonal investment advice. Securities Regulation & Law Report, October 8, 1999.

On October 7, 1999, the NASD Board of Governors approved a new rule proposal on "hot issues" to replace the current free-riding and withholding interpretation. A "hot issue" is a newly offered security that typically experiences immediate, sizable appreciation after its initial offering due to heavy demand. NASD stated that it proposed the new rule to:

• protect the integrity of the public offering process by ensuring that member firms make a bona fide public offering of securities at the public offering price;
• ensure that hot issues are not withheld for a member firm's benefit or to reward individuals in a position to direct future business to the firm; and
• ensure that industry insiders do not take advantage of their position to purchase hot issues for their own benefit at the expense of public customers.

The proposed new rule will:

1. Define those securities that are considered hot issues by establishing a threshold premium of five percent. If, within the first five minutes of trading, the volume weighted price of a public offering is five percent or more above the offering price, the offering is considered "hot." Currently, under the free-riding and withholding interpretation, a hot issue is defined as any security that trades "at a premium" to its initial offering price whenever secondary market trading begins.

2. Limit the application of the rule to equity offerings and offerings of securities with an equity component, such as a convertible security or a debt security bundled with a warrant. Offerings of non-investment grade debt will not be considered hot issues.

3. Eliminate the existing vague classification of "conditionally restricted" person status. The NASD has proposed that hedge fund managers, investment advisers and other investment or portfolio managers would be prohibited from purchasing hot issues for their personal accounts. This reflects the NASD's emphasis on preventing sales of hot issues to persons who are in a position to direct investments by accounts under their discretion. The NASD also decided that individuals who participate in investment clubs and family partnerships should not be restricted from purchasing hot issues.

The proposed rule will be submitted to the SEC for review and to the public for comment. NASD Press Release, October 7, 1999.

On October 6, 1999, the SEC proposed new requirements for corporate audit committees aimed at improving the reliability and credibility of financial statements released by public companies. The SEC expects that the proposed disclosures will help inform investors about the role audit committees play in overseeing the preparation of financial statements and emphasize to audit committees the importance of their participation in the financial reporting process. In its proposals, the SEC has implemented some of the recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees that were released in February, 1999.

The SEC's proposed rules would require companies:

• to have their quarterly financial statements (Forms 10-Q and 10-QSB) reviewed by independent auditors before filing them with the SEC;
• to provide in their proxy statements a report from the audit committee that discloses whether the audit committee has reviewed and discussed certain matters with management and the auditors and whether anything came to the attention of audit committee members that caused them to believe that the audited financial statements contain any materially misleading statements or omit any material information;
• to disclose in their proxy statements whether the audit committee has a written charter and to file a copy of the charter with the SEC every three years; and
• whose securities are listed on the New York Stock Exchange (the "NYSE") or American Stock Exchange (the "Amex") or are quoted on the Nasdaq Stock Market, to disclose certain information about any audit committee member who is not "independent" within the definition proposed by each exchange. All other companies would be required to disclose, if they have an audit committee, whether the members are "independent" based on the definition proposed by the self-regulatory organizations.

The SEC also proposed the creation of a safe harbor for the information required to be disclosed under the proposals to protect companies and their directors from certain liabilities under the federal securities laws.

The SEC's requirement regarding audit committee disclosure about their oversight responsibility regarding the company's financial statements differs from the Blue Ribbon Committee's recommendation. The Blue Ribbon Committee recommended that an audit committee state that it believes that the company's financial statements were fairly presented in conformity with Generally Accepted Accounting Principles ("GAAP") in all respects. Respondents were concerned that the requirement amounted to an audit committee certification of conformity with GAAP which would require that the audit committee be experts in GAAP. The SEC modified this requirement to acknowledge that in performing its oversight function, the audit committee's opinion will be limited to the advice and information it receives in its discussions with management and the independent auditors.

The SEC also reported that the NYSE, the Amex and the National Association of Securities Dealers, Inc. ("NASD") made simultaneous rule proposals regarding their listing standards for companies on their respective exchanges. These rule proposals would require companies to:

• define "independence" more rigorously for audit committee members;
• require audit committees to include at least three members, comprised solely of "independent" directors who are financially literate, with some exceptions for smaller issuers;
• require companies to adopt written charters for their audit committees; and
• require at least one member of the audit committee to have accounting or financial management expertise.

The SEC requests comment on whether any or all of the proposals should apply to investment companies registered under the Investment Company Act of 1940. The requirements for audit committee disclosure as currently proposed would only apply to closed-end funds. Comments on the proposals must be submitted no later than November 28, 1999. SEC Release No. 34-41987; File No. S7-22-99.