The Investment Company Institute (“ICI”) recently issued a comment letter in which it recommended that the Federal Energy Regulatory Commission (“FERC”) exempt SEC-registered investment companies and investment advisers that make passive investments in utility companies from books and records access requirements imposed by the Public Utility Holding Company Act of 2005. The ICI argued that it is highly unlikely that the share holdings of these passive institutional investors would have any effect on utility rates. The ICI suggested that, in order to limit the exemption to passive investments, the FERC could model the exemption on existing securities regulations that distinguish passive institutional investors from those that invest with the purpose of changing or influencing control of the issuer. Thus, the ICI recommended that the SEC exempt from the federal books and records access requirements any registered investment company and any registered investment adviser that owns, controls, or holds, with the power to vote, securities of a public utility company or holding company of a public utility company, so long as the investment company or investment adviser has acquired the securities in the ordinary course of business and without the purpose or effect of changing or influencing control of such public utility or holding company. The ICI letter is posted at http://www.ici.org/statements/cmltr/05_ferc_puhca_com.html#TopOfPage.

BNA Securities Regulation and Law Report (October 31, 2005)

In a no-action letter dated October 12, 2005, the SEC responded to a request for guidance on when a foreign bank derives a “substantial portion” of its business from extending commercial and other types of credit and accepting demand and other types of deposits for purposes of Rule 3a-6(b) under the 1940 Act.

Background

Rule 3a-6, which was designed to put foreign banks selling securities in the United States on an equal footing under the 1940 Act with U.S. banks, allows certain foreign banks to make public offerings of their securities in the United States without registering as investment companies under the 1940 Act. Specifically, Rule 3a-6 provides that a foreign bank shall not be considered to be an investment company under the 1940 Act if the foreign bank is:

• Regulated as a banking institution by a country’s or subdivision’s government or any agency thereof;
• Engaged substantially in commercial banking activity; and
• Not operated for the purpose of evading the provisions of the 1940 Act.

Rule 3a-6(b)(2) defines “engaged substantially in commercial banking activity” as:

“engaged regularly in, and deriving a substantial portion of its business from, extending commercial and other types of credit, and accepting demand and other types of deposits, that are customary for commercial banks in the country in which the head office of the banking institution is located.” [emphasis added].

Request for Guidance

In a request for no-action guidance, the SEC staff was asked to interpret “substantial portion” for purposes of determining whether a foreign bank may rely on Rule 3a-6 because it derives “a substantial portion of its business from, extending commercial and other types of credit, and accepting demand deposits . . . .” The request noted that certain members of the securities bar currently interpret the “substantial portion” wording of Rule 3a-6(b)(2) as applying to each of two banking functions, extending credit and accepting deposits, individually rather than collectively, and that those members of the securities bar generally have been comfortable opining that a 20% or greater activity level is sufficient for each prong. The request expressed concerned that, under this interpretation, foreign banks, unlike U.S. banks, could, for example be forced to maintain a higher level of deposits than would otherwise be economically warranted by the relative costs of deposits and alternative sources of funding. As a result, these foreign banks could find themselves on unequal footing with U.S. banks due to the need to comply with a rule that was intended to promote equality between U.S. and foreign banks.

Accordingly, an alternative “ten percent” interpretation was proposed, under which a foreign bank would be deemed to derive a “substantial portion” of its business from commercial banking activity if the average of the separate percentages obtained by computing the entity's: (1) credit extension revenues as a percentage of the foreign bank's revenues; (2) receivables from credit activities as a percentage of the foreign bank's assets; and (3) aggregate deposits as a percentage of the foreign bank's liabilities, exceeds ten percent.

Staff Response

The SEC staff declined to provide an interpretation based on particular minimum percentages of any of (i) the bank's liabilities (in the case of deposits), (ii) assets or (iii) revenues (in the case of credit extensions). However, the SEC staff did provide a list of factors that, if present, would support the conclusion that a foreign bank derives a “substantial portion” of its business from extending commercial and other types of credit and accepting demand and other types of deposits. Specifically, in order to meet this standard, the SEC staff generally would expect a foreign bank to:

In addition, the SEC staff acknowledged that there may be other factors that would support a conclusion that a foreign bank derives a “substantial portion” of its business from extending commercial and other types of credit and accepting demand and other types of deposits, and that it may be possible for a foreign bank to satisfy this standard even when fewer than all of the foregoing factors are present.

Seward & Kissel, SEC No-Action Letter File No. 132-3(October 12, 2005)

The SEC published for comment a release incorporating interpretive guidance on money managers’ use of client commissions to pay for brokerage and research services while falling within the safe-harbor under Section 28(e) of the Securities Exchange Act of 1934. The interpretive guidance would clarify the scope of the Section 28(e) safe harbor and provide guidance on commission-sharing arrangements under this statutory provision. The interpretive guidance in the release, once finalized, would replace in part the SEC’s prior interpretive guidance in Securities Exchange Act Release No. 23170 (1986). Specifically, the release would interpret the scope of the safe harbor as follows:

• Eligibility of brokerage and research services for safe harbor protection is governed by the criteria in Section 28(e)(3), consistent with the SEC’s 1986 “lawful and appropriate assistance” standard.
• “Research services” are restricted to “advice,” “analyses,” and “reports” within the meaning of Section 28(e)(3).
• Physical items, such as computer hardware, which do not reflect the expression of reasoning or knowledge relating to the subject matter identified in the statute, are outside the safe harbor.
• Market, financial, economic, and similar data would be eligible for the safe harbor.
• “Brokerage services” within the safe harbor are those products and services that relate to the execution of the trade from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account.
• Mixed-use items must be reasonably allocated between eligible and ineligible uses, and the allocation must be documented so as to enable the money manager to make the required good faith determination of the reasonableness of commissions in relation to the value of brokerage and research services.

 

The release reiterated the statutory requirement that money managers must make a good faith determination that commissions paid are reasonable in relation to the value of the products and services provided by broker-dealers in connection with the managers’ responsibilities to the advisory accounts for which the managers exercise investment discretion.

Finally, the release reiterated that under Section 28(e), broker-dealers must be financially responsible for the brokerage and research products that they provide to money managers, and they must be involved in “effecting” the trade.

Comments may be submitted on or before 30 days after publication in the Federal Register. A detailed analysis of the proposed interpretive guidance will be included with the next Investment Management Industry News Summary.

(SEC Rel. 34-52635; File No. S7-09-05)

The Securities and Exchange Commission (“SEC”) approved a common definition of “branch office” in the securities industry, as well as a new, centralized branch office registration system through the Central Registration Depository (CRD®). To facilitate the system’s development, the SEC approved a new Form BR that will replace the current NYSE Branch Office Application Form, Schedule E of Form BD and certain state branch office forms. Form BR will enable firms to register branch offices and file notices of branch office openings and closings electronically with NYSE Regulation, NASD and the states via a single filing through the CRD system. The SEC’s action is the result of a joint regulatory initiative by the NASD, NYSE Regulation and the North American Securities Administrators Association (“NASAA”).

Historically, various regulatory bodies have defined the term “branch office” differently. Those disparate definitions resulted in conflicting requirements that created significant redundancies for securities firms, such as the need to file different application forms with multiple regulatory organizations to register or renew the registration of branch office locations, as well as having to coordinate multiple registration and notification filing deadlines.

The new SEC-approved changes are expected to alleviate these redundancies by standardizing the criteria for determining whether a business location requires registration as a branch office. The new branch office definition became immediately effective with NYSE Regulation and will become effective on May 1, 2006 with the NASD. Each state has its own timetable for making the new definition effective.

On October 31, 2005 the securities industry will make the transition to a centralized, CRD-based branch office application system that will allow firms, via the new form BR, to submit a single filing to simultaneously fulfill the branch office registration/approval requirements of the NASD, NYSE Regulation and most states. Firms will also benefit from on-line broker licensing work queues, electronic notifications and other features available through the CRD system.

According to NASD Vice Chairman Mary L. Schapiro, the branch office-related changes are part of NASD’s rule modernization initiative, which is aimed at streamlining and updating NASD Rules while preserving investor protection. Ms. Schapiro noted that regulators will be able to identify registered representatives with specific office locations, and that will allow regulators to more effectively examine those locations, and that the changes will also reduce inconsistencies among regulators, which will provide substantial economies and efficiencies for firms.”

Detailed information on the branch office-related changes is available through NYSE’s Information Memo numbers 05-74 and 05-75, and NASD Notice to Members 05-66 and Notice to Members 05-67.

NASD Press Release (October 6, 2005)

The NASD announced that it fined eight broker-dealers — including seven retail firms and one mutual fund distributor — more than $7.75 million for directed brokerage violations. The sanctions are the latest actions resulting from an NASD enforcement sweep focusing on the receipt or payment of directed brokerage in exchange for preferential treatment for certain mutual fund companies. All of the cases involve violations of the NASD’s Anti-Reciprocal Rule, which prohibits member firms from favoring the sale of shares of mutual funds on the basis of brokerage commissions received by the firm. Among other things, the rule prohibits a firm from recommending funds or establishing preferred lists of funds in exchange for receipt of directed brokerage.

The NASD said in a statement that the seven retail firms operated “preferred partner” or “shelf space” programs, providing benefits to specific mutual fund complexes in return for directed brokerage. The participating mutual fund complexes received higher visibility on the firms’ internal Web sites, increased access to the firms’ sales forces, participation in “top producer” and training meetings and promotion of the preferred funds on a broader basis than was available to other fund complexes. In return for these benefits, the participating mutual fund complexes paid additional fees to the broker-dealers. The additional fees were usually based on a combination of sales and/or assets under management by the brokerage firms. Further, certain of the complexes participating in the preferred partner programs paid part or all of the revenue sharing fees by directing brokerage from trades in the portfolios they managed to the firms.

The NASD stated that, among other things, the mutual fund complexes directed trades to the trading desks of designated third parties, which then remitted a portion of the trading commissions to the retail broker-dealer firms. According to the NASD, the retail firms provided no services in connection with the trades. The commissions paid under these arrangements were sufficiently large to pay for the preferred benefits received by the funds as well as the costs of trade execution. The NASD stated that the retail broker-dealer firms monitored the amount of directed brokerage received to ensure that the mutual fund complexes were satisfying their revenue sharing obligations under the arrangements.

The penalty assessed against one of the retail broker-dealer firms also reflected alleged violations of NASD rules on the use of “non-cash compensation.” Instead of giving equal weight to the sales of all mutual funds as required by NASD rules, the broker-dealer firm allegedly provided registered representatives with double production credits for sales of mutual funds offered by participants in its preferred partner program towards qualification for attendance at a rewards conference. The fine assessed to another of the retail broker-dealer firms reflected its alleged failure to retain e-mails as required by the federal securities laws and NASD rules.

In addition to the retail broker-dealers, one mutual fund distributor was censured and fined as part of the actions. According to the NASD, the mutual fund distributor paid for some of its shelf space obligations by having its affiliated investment adviser direct portfolio transactions to, or for the benefit of, brokerage firms to which the distributor owed revenue sharing fees.

NASD Press Release (October 10, 2005); BNA Securities Law Daily (October 12, 2005)

The NASD issued a Notice to Members indicating that certain amendments to NASD Rule 2790 will become effective on November 2, 2005. Rule 2790 (Restrictions on the Purchase and Sale of IPOs of Equity Securities), often referred to as the “new issue” rule, replaced the old “hot issue” interpretation (Free-Riding and Withholding Interpretation IM-2110-1) and has been in effect on a mandatory basis since March 23, 2004. The amendments include the following:

• amendments to subparagraph (i)(9) of Rule 2790 to exclude from the definition of “new issue” securities offerings of business development companies, direct participation programs and real estate investment trusts;

• an amendment to the exemption for foreign investment companies in subparagraph (c)(6) of Rule 2790 to clarify the scope of the exemption as reflected in an NASD staff memorandum dated August 6, 2004 (i.e., that the exemption applies to foreign investment companies listed on a foreign exchange only if they are listed “for sale to the public”); and

• amendments to Rule 2790 to codify the filing requirement for distribution information.

NASD Notice to Members 05-65

In a recent speech to members of the Managed Funds Association, SEC Commissioner Paul Atkins noted that the SEC staff is contemplating requiring periodic reports by hedge fund advisers and other ways to get information from the industry. Atkins suggested that the SEC staff is considering new ways to obtain information about hedge fund advisers because the staff believes that information disclosed on hedge fund advisers’ Form ADVs is inadequate. He noted that investors who have performed even the most minimal level of due diligence about an adviser are unlikely to learn anything new from Form ADV. He also stated that Form ADV also does not provide the necessary input for the SEC’s risk-based examination model.

In addition, Atkins advocated close coordination between the SEC and the Commodity Futures Trading Commission, the Treasury Department, the Federal Reserve Board, and the Department of Labor to determine how to allocate regulatory responsibilities with regard to hedge fund advisers. He indicated that systemic concerns about hedge funds should be handled by the President’s Working Group (comprising the heads of Treasury, the Federal Reserve, the CFTC, and the SEC). Atkins also encouraged SEC cooperation with foreign regulators in the area of hedge fund regulation.

Atkins, along with Commissioner Cynthia Glassman, cast a dissenting vote in the SEC’s 3-2 approval of rules requiring most hedge fund advisers to register with the SEC by January 31, 2005. Atkins has repeatedly criticized the new registration requirement and called for the SEC to “deliberate carefully” before deciding whether to undertake additional regulation of hedge fund advisers. He called upon new SEC Chairman Christopher Cox to take a “reasoned approach” towards the implementation of the new rule.

Atkins praised the MFA’s 2005 Sound Practices as offering better solutions than registration to the issues facing the hedge fund industry. He stated that investors can take greater comfort in knowing that a hedge fund adviser has implemented the MFA’s Sound Practices than in knowing that it has registered with the SEC. The Sound Practices set forth guidelines for hedge fund advisers to implement such functions as risk monitoring, valuation, business continuity, and disaster recovery planning.

Atkins voiced his concern that the SEC’s staff examiners who oversee registered advisers will be overwhelmed by the increase in registered advisers and by practices within the hedge fund industry, such as investment strategies and structures that are often more complex than those of other investment advisers. Although the SEC’s Office of Compliance Inspections and Examinations will commence an in-depth series of hedge fund training sessions for its examiners, Atkins noted that this will divert substantial time and resources from the oversight of mutual funds and other registered advisers. Atkins estimated that there are fewer than 200,000 investors in hedge funds, a tiny number compared to more than 90 million mutual fund investors.

Further, Atkins suggested that registration of hedge fund advisers is not likely to be an effective tool to identify or combat fraudulent activity in the hedge fund industry because, among other things, persons seeking to engage in fraudulent activity are not likely to comply with the registration requirements. He noted that existing registration requirements do not prevent criminal activity by unregistered advisers and broker-dealers. Moreover, Atkins noted that advisers to private funds that implement a lock-up period of more than two years, including hedge funds, as well as most venture capital funds and private equity funds, are not required to register. This could lead to inconsistent regulation and could present an attractive alternative to hedge fund investment.

Atkins’ speech is posted at http://www.sec.gov/news/speech/spch092905psa.htm.

BNA Securities Regulation & Law Report Volume 37 Number 40 (October 10, 2005)

The SEC and the NASAA announced a one-year waiver of certain system fees paid by investment advisers and all investment adviser representatives for registration in the Investment Adviser Registration Depository (“IARD”) program. Separately, NASAA also announced that it is reducing by 30 percent system fees paid by state-regulated investment advisers on an on-going basis. The IARD system is an Internet-based national database sponsored by NASAA and the SEC and operated by NASD.

IARD provides a single nationwide database for the collection and dissemination of information about individuals and firms in the investment advisory business; and offers investment advisers and representatives a single system for filing state and federal registration and disclosures. IARD system fees are used for user and system support along with periodic enhancements to the system. The system is designed to provide streamlined registration procedures for investment advisers and their representatives, promote consistency, and allow investors to research the employment and disciplinary histories of more than 21,000 investment adviser firms and eventually 200,000 individual investment adviser representatives.

NASAA is waiving payment of IARD system renewal fees by state-regulated investment advisers and all investment adviser representatives. Currently, state-regulated investment adviser firms pay an annual system fee of $100, and individual representatives pay an annual system fee of $45. In addition, the system fees paid by state-regulated investment advisers will be reduced by 30 percent to $70 on an on-going basis. NASAA’s board of directors approved the waiver and system fee reduction and will continue to monitor the system’s revenues to determine whether future fee adjustments are warranted.

The SEC has approved a waiver of IARD filing fees for all SEC-registered advisers with respect to Form ADV annual updating amendments filed from November 1, 2005 through October 31, 2006. Currently, SEC-registered adviser firms pay an annual IARD fee of $100, $400, or $550, depending on their assets under management. The SEC also announced that current projections of fee revenues and system expenses cause it to believe that a reduction in annual IARD filing fees will be necessary to more closely align those fees with the costs of filings. The SEC plans shortly to solicit public comment on potential IARD fee alternatives following the waiver period, including reductions in fees or an extension of the waiver.

The SEC and NASAA observed that revenue from IARD system fees had exceeded original projections. More investment advisers and investment adviser representatives have registered through the system than originally anticipated, the regulators said. Numbers of SEC-registered advisers have also grown and many advisers have moved to higher fee categories because they have more assets under management.

SEC Press Release 2005-145