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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NASD and NYSE Propose to Amend Research Analyst Rules
October 30, 2006 11:16 AM
The NASD and NYSE have each proposed amendments to their respective Research Analyst Rules (NASD Conduct Rule 2711 and NYSE Rule 472, collectively, the “Proposed Rule Amendments”). The Proposed Rule Amendments are intended to implement the recommendations provided by the NASD and NYSE Joint Report: “Operation and Effectiveness of the Research Analyst Conflict of Interest Rules,” and the guidance provided in the NYSE and NASD “Joint Memoranda.”
The Proposed Rule Amendments would directly impact mutual funds and their advisers in the following ways:
The Proposed Rule Amendments would also revise the definition of the terms “Public Appearance,” “Investment Banking Services,” “Household Members,” and “Equity Security” to reflect recent interpretive guidance regarding certain disclosure requirements, compendium reports and third-party research.
Securities and Exchange Commission Release No. 34-54616, “Self-Regulatory Organizations; New York Stock Exchange LLC and the National Association of Securities Dealers, Inc.; Notice of Filing and Immediate Effectiveness of Proposed Rule Changes Relating to NYSE Rule 472 and NASD Rule 2711,” available at: http://sec.gov/rules/sro/nyse/2006/34-54616.pdf; NASD Rule Proposal, SR-NASD-2006-112, available at: http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_017550.pdf; NASD Rule Proposal, SR-NASD-2006-113, available at: http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_017553.pdf; NYSE Proposed Rule, SR-NYSE-2006-77, available at: http://apps.nyse.com/commdata/pub19b4.nsf/docs/D55C985C3A306F2E8525720D004DD0B1/$FILE/NYSE-2006-77app.pdf
SEC No-Action Letter: Closed-End Fund Shelf Offering
October 30, 2006 11:05 AM
A closed-end fund registered under the Investment Company Act of 1940 (“Investment Company Act”) requested assurance from the SEC staff that it would not recommend enforcement action to the SEC under Section 5 or Section 6(a) of the Securities Act of 1933 (“Securities Act”) if the Fund conducted a “shelf offering” of its common shares (i.e. “delayed at the market” public offering of its common shares pursuant to the shelf registration provisions of Rule 415(a)(1)(x) and Rule 415(a)(4) of the Securities Act) without filing and providing to its shareholders quarterly reports that comply in all material respects with the disclosure requirements of Form 10-Q.
The Fund sought to conduct a delayed at the market shelf offering of its common shares in order to issue new shares when the Fund’s shares are trading at a premium to net asset value. The Fund’s common shares are registered under Section 12(b) of the Securities Exchange Act of 1934 and have been listed on the New York Stock Exchange. The Fund files information as required under the Exchange Act and the Investment Company Act (including Forms N-CSR and N-Q).
The Fund’s request was based in part on prior relief granted by the staff to Pilgrim America Prime Rate Trust in 1998 (“Pilgrim No-Action Letter”).However, the Fund, unlike Pilgrim, requested that it be permitted to conduct its delayed at the market public offering without filing and sending to shareholders quarterly reports that comply in all material respects with the disclosure requirements of Form10-Q. The Fund reasoned that, due to enhancements in the reporting requirements applicable to the closed-end funds, the additional conditions that the Fund file and send to shareholders quarterly reports was no longer necessary, and the staff agreed not to recommend enforcement action without imposing the additional conditions.
SEC No-Action Letter, Nuveen Virginia Premium Income Municipal Fund, available at: http://sec.gov/divisions/investment/noaction/2006/nuveen100606.htm. Incoming No-Action Request Letter, available at: http://sec.gov/divisions/investment/noaction/2006/nuveen091406-incoming.pdf.
SEC Focuses on Disclosure of Soft Dollar Conflicts of Interest
October 30, 2006 11:02 AM
Gene Gohlke – Associate Director, OCIE, participated in a panel discussion at the October 19, 2006 National Membership Meeting of the NSCP. Mr. Gohlke noted that the examination staff was closely scrutinizing advisers’ disclosures relating to conflicts of interest stemming from their use of soft dollars and mixed-use items. He indicated that the examination staff found inadequate disclosure to clients of conflicts of interest relating to soft dollars and the impact on the client of these conflicts. Mr. Gohlke also said that the examination staff found inadequate documentation of mixed-use arrangements. Specifically, the examination staff felt that advisers often could not provide support for their allocations between hard and soft dollars or explain the reasoning for such allocations.
“Gohlke Says OCIE Focusing On Disclosure of Soft Dollar Conflicts,” Securities Law Daily, October 20, 2006.
Current Focus of SEC Examinations: Insider Trading and Front-Running; Secret Payments; Doing Business with Seniors; Supervision; Trading; Identity Theft; and AML
October 30, 2006 10:58 AM
On October 19, 2006, Lori Richards – Director, SEC’s Office of Compliance Inspections and Examinations (“OCIE”), discussed the focus of current compliance examinations in a speech at the National Membership Meeting of the National Society of Compliance Professionals (“NSCP”). Ms. Richards advised that the SEC examination staff is particularly concerned with the following issues:
Speech by SEC Staff: “The Process of Compliance,” by Lori A. Richards, National Membership Meeting of the National Society of Compliance Professionals, Washington, DC, October 19, 2006, available at: http://sec.gov/news/speech/2006/spch101906lar.htm
NASD Notice to Members 06-59 “Broker-Dealer and Investment Adviser Renewals”
October 20, 2006 1:02 PM
The NASD Registration Renewal Program will begin on November 6, 2006. This program is designed to simplify the registration renewal process for investment adviser firms and investment adviser representatives, as well for broker-dealers and registered representatives. NASD Notice to Members 06-59 provides general instructions and links to other detailed information regarding such matters as how to obtain preliminary renewal statements; fees for filing through the renewal program; acceptable forms of payment; and how and when a firm can obtain renewal reports.
Limited Availability of IARD System
As a result of the year-end renewal process, IARD and Web CRD will be unavailable for processing filed forms from 6:00 p.m., ET, December 20, 2006, through January 1, 2007. During this period, firms can create pending filings, but they cannot be submitted until on or after January 2, 2007. Also, beginning on November 1, 2006 until 6:00 p.m., ET, December 20, 2006, post-dated Form ADV-Ws, dated December 31, 2006, can be submitted via IARD.
NASD Notice to Members 06-59, “Broker-Dealer and Investment Adviser Renewals, available at: http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_017616.pdf
Investment Adviser Web site available at: http://www.iard.com/renewals.asp for the IARD Renewal Bulletin.
2007 IARD Renewal Calendar is available at: http://www.iard.com/pdf/renewal_calendar.pdf.
NASD Announces New E-Learning Course: “What to Expect: Filing Communications for NASD Review”
October 20, 2006 1:00 PM
The NASD announced that it has made available on its website a new e-learning webcast, “What to Expect: Filing Communications for NASD Review.” The webcast explains what to expect when filing communication materials with NASD’s Advertising Regulation department. The webcast is part of an NASD series of webcasts designed to clarify NASD’s regulatory processes.
NASD Webcast, “What to Expect: Filing Communications for NASD Review” available at: http://www.nasd.com/EducationPrograms/OnlineLearning/WebcastsforComplianceStaff/index.htm. A complete list of NASD “What to Expect” webcasts is available at: http://www.nasd.com/EducationPrograms/OnlineLearning/WebcastsforComplianceStaff/index.htm
European Central Bank President Calls for an International Body with Global Oversight Over Hedge Funds
October 20, 2006 12:58 PM
On October 10, 2006, the President of the European Central Bank, Jean-Claude Trichet, during his testimony in front of the European Parliament’s Committee for Economic and Monetary Affairs, said that a global regulatory response to hedge funds was needed. In response to questions from members of the Committee for Economic and Monetary Affairs relating to whether hedge funds needed more direct oversight or regulation to counter possible systemic risks to financial stability, Mr. Trichet said, “None of us are fully satisfied with the present situation of relying on major financial institutions to ensure their counterparts [that are outside of regulatory oversight] are fit and proper and reliable. We need to improve the situation.” He went on to say that a global response was needed and that any one jurisdiction acting alone would only cause the hedge funds to move to unregulated jurisdictions.
U.S. Senator Seeks Multi-Agency Response on Lack of Hedge Fund Transparency, Expresses Alarm at Risk to Pension Holders
October 20, 2006 12:56 PM
On October 16, 2006, Senator Chuck Grassley, chairman of the Committee of Finance, requested information on the transparency requirements facing hedge funds from the SEC, Department of the Treasury, Department of Labor, Commodity Futures Trading Commission and Pension Benefit Guaranty Corporation. Sen. Grassley also requested information on whether any of these agencies could require hedge funds to be more transparent. Sen. Grassley’s request for this information was in response to his concern that millions of Americans are unknowingly exposed to the risk of hedge funds through pension funds, endowments and other investment pools.
Press Release, “Grassley Seeks Multi-Agency Response on Lack of Hedge Fund Transparency, Expresses Alarm at Risk to Pension-Holders” (October 16, 2006) (Letter is Attached to Press Release), available at: http://grassley.senate.gov/index.cfm?FuseAction=PressReleases.Detail&PressRelease_id=5200
Enforcement Action Relating to Market Timing and Late Trading
October 20, 2006 12:47 PM
On October 12, 2006, the SEC issued an order (the “Order”) relating to administrative proceedings against a registered broker-dealer for allegedly permitting its hedge fund clients to market time and late trade mutual funds. The SEC alleged in the Order that the broker-dealer accepted and executed after 4:00 p.m. more than 2000 trades on behalf of one hedge fund customer for the purchase and sale of mutual funds. The SEC also alleged that a registered representative of the broker-dealer utilized deceptive tactics to hide the identity of his market timing customers from mutual funds and otherwise facilitated his customer’s market timing strategies.
The broker-dealer agreed, without admitting or denying any wrongdoing, to a cease and desist order and a censure, to disgorge $464,897 in profits plus $103,187.41 in interest and to pay a civil penalty of $120,000.
Securities Act of 1933 Release No. 8749 / October 12, 2006, In the Matter of Wall Street Access, available at: http://sec.gov/litigation/admin/2006/33-8749.pdf.
Enforcement Action Relating to Violation of Industry Bar and Late Trading
October 20, 2006 12:33 PM
On October 11, 2006, the SEC filed a settled civil action in the United States District Court for the Southern District of New York against an individual for his violation of an earlier SEC bar order (the “Civil Settlement”). The SEC also issued an order requiring him to pay a fine and disgorge profits relating to his role in the late trading activities of a hedge fund (the “Administrative Order”).
In October 2003, the individual partially settled with the SEC for his role in a hedge fund’s late trading activities, whereby he agreed, without admitting or denying any wrongdoing, to be permanently barred from the advisory and mutual fund industries (the “2003 Settlement”). The 2003 Settlement stipulated that the issue of disgorgement and penalties would be resolved at a later date. While considering the appropriate fines and disgorgement amounts, the SEC discovered that the individual had violated the terms of the 2003 Settlement by forming an investment advisory firm incorporated in the Cayman Islands and providing advisory services to investors.
In the Civil Settlement, without admitting or denying any wrongdoing, the individual agreed to pay a $120,000 civil penalty and to disgorge $50,000 for his violation of the permanent bar in the 2003 Settlement. Also, for his role in the hedge fund’s late trading activities from 1999 to 2003 the SEC issued an order, on consent, whereby the individual, without admitting or denying any wrongdoing, agreed to pay a civil penalty of $400,000 and to disgorge $1.
SEC Litigation Release No. 19862/October 11, 2006, available at: http://sec.gov/litigation/litreleases/2006/lr19862.htm; SEC v. Steven B. Markovitz, Civil Action No. 06 CV 8291 (S.D.N.Y.) (October 11, 2006), available at: http://sec.gov/litigation/complaints/2006/comp19862.pdf; Securities Act of 1933 Release No. 8748 / October 11, 2006, available at: http://sec.gov/litigation/admin/2006/33-8748.pdf; and Securities Act of 1933 Release No. 8298 / October 2, 2003, available at: http://sec.gov/litigation/admin/33-8298.htm.
Prevention of Identity Theft is the Focus of New Sweep and Staff Advice
October 20, 2006 11:20 AM
On October 5, 2006, John H. Walsh, Associate Director – Chief Counsel, SEC’s Office of Compliance Inspections and Examinations (“OCIE”), announced in a speech at the NRS Annual Fall Compliance Conference that his office, along with the SEC’s San Francisco District Office, is conducting a sweep of fund complexes and brokerage firms to assess the adequacy of their privacy protection measures. Mr. Walsh also provided advice for firms to protect their customers’ identities adequately.
Mr. Walsh indicated that the sweep is in response to a change in the risk environment of the securities industry. Mr. Walsh highlighted an apparent increase in the amount of attention identity thieves were paying to the securities industry as well as an increase in the sophistication of attacks by the identity thieves. He also indicated that the sweep is focusing on the policies and procedures of both fund complexes and broker-dealers. Because the sweep was ongoing, Mr. Walsh could not comment on its size or any possible findings.
Staff Advice for Preventing Identity Theft
In addition to announcing the SEC sweep, Mr. Walsh provided advice designed to assist fund complexes and brokerage firms in combating identity theft. Mr. Walsh recommended fund complexes and brokerage firms add the following five actions to their identity theft “to-do list.”
1. Review of NASD’s Notice to Members 05-49, Safeguarding Confidential Customer Information. Although NTM 05-49 is applicable only to brokerage firms, its guidance is useful to brokerage and advisory firms alike. NTM 05-49 suggests that, at a minimum, firms consider:
2. Review NTM 05-49 Questions with Security Staff. Mr. Walsh recommended that firms review the above four questions with their information security staff.
3. Review Front-End Access Controls for On-line Accounts. Mr. Walsh recommended that each firm review its “front-end access controls” for on-line accounts and consider the National Institute of Standards and Technology’s “Electronic Authentication Guidelines” in connection with that review.
4. Review Educational Materials. Mr. Walsh recommended that firms review the educational materials they provide to their customers and consider whether they appropriately seek to educate customers on the dangers of identity theft, the security features the firm offers and the firm’s policy on how any losses related to identity theft will be allocated between the customer and the firm.5. Continuing Education. Finally, Mr. Walsh reminded the firms that they should follow developments regarding identity theft and noted that additional guidance was expected to be published in the coming weeks by the Presidential Task Force on Identity Theft.
Speech by SEC Staff: Compliance Professionals Versus Identity Thieves, By John H. Walsh, NRS 21st Annual Fall Compliance Conference, Scottsdale, Arizona, October 5, 2006, available at: http://sec.gov/news/speech/2006/spch100506jhw.htm; NASD Notice to Members 05-49 - July 2005, available at: http://www.nasd.com/RulesRegulation/NoticestoMembers/2005NoticestoMembers/NASDW_014773, NIST, Electronic Authentication Guidelines, Special Publication 800-63, Version 1.0.2, available at: http://csrc.nist.gov/publications/nistpubs/800-63/SP800-63V1_0_2.pdf; and The Presidential Task Force on Identity Theft, Fact Sheet, available at: http://www.whitehouse.gov/news/releases/2006/05/20060510-6.html.
D.C. Circuit Court of Appeals Hears Oral Arguments Regarding SEC Rule Exempting Certain Broker-Dealers from the Investment Advisers Act of 1940 (“Advisers Act”)
October 13, 2006 1:23 PM
On October 5, 2006, the U.S. Court of Appeals for the District of Columbia Circuit (the “Court”) heard oral arguments in Financial Planning Association v. SEC, a case in which the Financial Planning Association (the “FPA”) is challenging the SEC’s authority to adopt Rule 202(a)(11)-1 (the “Rule”) under the Advisers Act. As adopted by the SEC on April 2005, the Rule permits broker-dealers who offer their services for a fixed or asset-based fee to be exempt from the Advisers Act, provided that the following conditions are met:
In its brief, the FPA argued, among other things, that (1) the Rule improperly deviates from the requirements of Section 202(11)(C) of the Advisers Act, which provides that a broker or dealer may not receive any special compensation to qualify for the exemption from the definition of an investment adviser, and (2) the adoption of the Rule violated the Administrative Procedure Act because the SEC did not show why it was necessary to exempt broker-dealers from the Advisers Act in connection with the use of fee-based accounts. In its reply brief, the SEC argued that the suit should be dismissed because, among other things, (1) the FPA lacks standing to sue, (2) Section 202(a)(11)(F) of the Advisers Act gives the SEC express authority to create exceptions from the definition of investment adviser, and (3) Congress would have intended to except the newly designated class of broker-dealers covered by the Rule.
“FPA, SEC Argue in D.C. Cir. Over Power Of SEC to Create New IAA Exemption for BDs,” Securities Law Daily, October 6, 2006.
SEC Audit Report Makes Recommendations to Improve Timeliness of Exemptive Relief
October 13, 2006 1:17 PM
On September 29, 2006, the SEC Office of Inspector General (“OIG”) published the results of its audit of the exemptive application process in the SEC’s Division of Investment Management’s Office of Investment Company Regulation (“OICR”). The OIG’s objectives in conducting its audit were to determine whether the exemptive application process was timely and to recommend improvements.
The SEC’s guidelines generally require OICR to provide initial comments to applicants within 45 days. The applicant has 60 days to respond to OICR’s comments and amend its application. Upon completing its review, OICR sends a summary notice of the application for publication in the Federal Register. After the end of the notice period (generally 25 days), OICR issues an exemptive order granting the application.
In its audit report, the OIG concluded that approximately 16% of the exemptive applications received initial comments within the 45-day guideline. The OIG’s recommendations to improve the timeliness of processing exemptive applications included the following measures:
IM Exemptive Application Processing (Audit No. 408), September 29, 2006. A copy of the audit report is available at http://www.sec.gov/about/oig/audit/2006/408final.pdf.
FinCEN Issues Guidance on Suspicious Activity Reporting for Mutual Funds
October 13, 2006 1:08 PM
On October 4, 2006, the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) issued guidance (the “Guidance”) on the suspicious activity reporting requirements applicable to open-end investment companies (“mutual funds” or “funds”) under the Bank Secrecy Act (the “BSA”).
On May 4, 2006, FinCEN published its final rule requiring mutual funds to file reports that identify and describe transactions that raise suspicions of illegal activity that may involve money laundering. The requirement to file suspicious activity reports (“SARs”) applies to transactions occurring after October 31, 2006. The final rule requires mutual funds to report to FinCEN any transaction that alone or in the aggregate involves at least $5,000 if the mutual fund “knows, suspects or has reason to suspect” that the transaction: (1) involves funds derived from illegal activity, (2) is designed to evade the requirements of the BSA, (3) has no business or other apparent lawful purpose, or is not the sort of transaction in which the customer would be expected to engage, or (4) involves the use of the fund to facilitate criminal activity.
The Guidance provides the following guidelines:
U.S. Department of the Treasury Financial Crimes Enforcement Network Guidance, “Frequently Asked Questions – Suspicious Activity Reporting Requirements for Mutual Funds,” FIN-2006-G013, October 4, 2006. A copy of the Guidance is available at http://www.fincen.gov/guidance_faqs_sar_10042006.pdf .
Newly Enacted Credit Rating Agency Reform Act Enables Rating Agencies to Become Registered as NRSROs
October 13, 2006 9:52 AM
On September 26, 2006, President Bush signed into law the Credit Rating Agency Reform Act (the “CRAR Act”). The CRAR Act enables a rating agency to become registered with the SEC as a nationally recognized statistical rating organization (a “NRSRO”) by providing data to the SEC that includes performance measurement statistics, procedures and methodologies for rating companies, possible conflicts of interest, and lists of the largest issuers that use that agency. Prior to the enactment of the CRAR Act, the SEC used its own criteria in determining whether to designate an agency as a NRSRO. The new law provides that any credit-rating company that meets the statutory criteria can now receive the NRSRO designation. The CRAR Act also provides that the SEC will oversee NRSROs and issue rules regarding conflicts of interest and misuse of information.
NRSRO status is significant because only NRSRO-rated securities may be used to satisfy the net capital rule as an indicator of liquidity for broker-dealers. In addition, NRSRO ratings are widely used by investors and as benchmarks in legislation, regulatory rulemaking and in monitoring investment risk by regulated entities. Of approximately 130 credit rating agencies, currently only 5 are designated as NRSROs (including Moody’s Investors Service and Standard & Poor’s). The CRAR Act is designed to increase competition in the rating agency industry. One rating agency firm, Egan-Jones, has already announced that it plans to begin rating mutual funds in October 2006. Egan-Jones has reportedly been trying to become a NRSRO since 1998.
“President Signs Bill Reforming Process for NRSRO Designation,” Securities Regulation & Law Report, Volume 38, Number 40, October 9, 2006. “Egan-Jones to Enter Mutual Fund Rating Biz,” Ignites, October 10, 2006.
NASD Revises Best Execution Rule
October 13, 2006 9:40 AM
NASD recently issued a Notice to Members (the “Notice”) regarding certain amendments to NASD Rule 2320(a) (the “Best Execution Rule”) and the adoption of New Interpretive Materials 2320 to provide guidance on the application of the Best Execution Rule.
The amendments to the Best Execution Rule, which are effective November 8, 2006:
New Interpretive Material 2320 clarifies that for the purposes of the Best Execution Rule:
NASD Notice to Members 06-58, October 9, 2006. A copy of the notice is available at http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_017607.pdf.
CA District Court Denies Motion for Class Certification in Case Alleging Excessive Fees
October 13, 2006 9:37 AM
On September 27, 2006, the District Court for the Northern District of California (the “District Court”) denied the plaintiffs’ motion for class certification. The plaintiff shareholders alleged that the defendants (affiliated investment advisers, distributors, principal underwriters, and administrative service providers to the mutual fund complex) charged excessive advisory and distribution fees in violation of Rule 12b-1 under and Section 36(b) of the Investment Company Act of 1940 (the “1940 Act”) and California state law. In denying the plaintiffs’ motion to certify the class of California shareholders for purposes of pursuing the class claims under California state law, the District Court noted that:
Strigliabotti v. Franklin Resources, Inc., U.S. District Court for the Northern District of California, Order Denying Plaintiffs’ Motion for Class Certification, No. C 04-00883 SI, September 27, 2006.
NASD Notice to Members Revising Sanction Guidelines
October 6, 2006 11:08 AM
On September 26, 2006, the NASD issued a Notice to Members revising its sanction guidelines (the “Guidelines”) to clarify that adjudicators should consider a firm’s size and available resources when imposing monetary sanctions for violations that are not egregious and do not involve fraud. In particular, the revised Guidelines provide that adjudicators should consider a firm’s revenues, as well as other factors indicative of firm size, when determining sanctions for non-egregious, non-fraudulent violations. NASD adjudicators may also levy a fine that is below minimum levels otherwise recommended by the Guidelines, when appropriate.
In remarks about the revised Guidelines, NASD Chairman and CEO Mary L. Schapiro stated that “NASD sanctions are intended to be remedial, not punitive. In the absence of fraud or egregious conduct, their purpose is to correct violative conduct, not to damage a firm’s ability to conduct business and to serve the investing public. NASD is committed to being a vigorous regulator, but it is equally committed to fairness in the way sanctions are levied.”
In addition to NASD adjudicators, the NASD’s Departments of Enforcement and Market Regulation, as well as the defense bar, rely on the Guidelines in disciplinary matters. The revised Guidelines were effective immediately upon issuance of the notice to members.
“In Revisions to Sanctions Guidelines, NASD Clarifies Flexibility in Levying Fines,” Securities Regulation & Law Report, Volume 38, Number 39, October 2, 2006. NASD Notice to Members 06-55, September 26, 2006. A copy of the notice is available at http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_017523.pdf.
Second Circuit Affirms Dismissal of Excessive Fee Charges against Adviser and Distributor
October 6, 2006 10:59 AM
On September 26, 2006, the U.S. Court of Appeals for the Second Circuit (the “Court”) affirmed a lower court’s dismissal of charges by mutual fund shareholders that an adviser and distributor violated Section 36(b) of 1940 Act by charging excessive fees to certain mutual funds.
The Court noted that in order to violate Section 36(b) “an adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining,” citing the standard from Gartenberg v. Merrill Lynch Asset Management. Noting that the standard “is not a simple balancing of the size of the fee against the adequacy of the services,” the Court considered the following six factors in applying the Gartenberg standard: (1) the nature and quality of services provided to shareholders; (2) the profitability of the fund to the adviser; (3) fall-out benefits; (4) economies of scale; (5) comparative fee structures; and (6) the independence and conscientiousness of the trustees.
The plaintiffs’ complaints, which were largely identical, (i) focused on the after-tax losses of the funds at issue compared with certain benchmark indices, (ii) claimed that one fund paid more in fees to the adviser than it earned in investment revenue and that the Rule 12b-1 fees conferred no benefit to the fund, (iii) requested discovery as a prerequisite to setting forth details regarding profitability of the funds to the adviser and fall-out benefits, citing the lack of publicly available information, and (iv) as to economies of scale and comparative expense ratios and fees, relied on general criticism of the mutual fund industry and general industry fee trends. Regarding the sixth Gartenberg factor, the independence and conscientiousness of the trustees, the plaintiffs alleged that the independence of certain trustees had been compromised because such trustees sat on the boards of at least 123 other funds in the adviser’s fund family, received in excess of $150,000 in annual compensation from the adviser, were entitled to retirement packages from the adviser, and sat on other corporate, civic and charitable boards.
The Court found that the plaintiffs’ complaints “failed to allege any facts pertinent to the relationship between fees and services.” Specifically, the Court found that the plaintiffs had not set forth facts necessary to a finding that fees were excessive. Regarding the nature and quality of services provided, the Court found that the plaintiffs failed to allege that the performance of the fund was “appreciably worse than comparable funds” and had “demonstrate[d] little, if anything, about the nature or quality of specific services offered to [shareholders].” The Court also cited precedent for the proposition that “allegations of underperformance alone are insufficient to prove that an investment adviser’s fees are excessive.” Regarding the profitability of the fund to the adviser and fall-out benefits, the Court stated that “in establishing that fees are disproportionate to the services provided, it is essential to allege the total amount of fees, which Plaintiffs failed to do.” The Court also found that the plaintiffs’ assertions regarding the size of Rule 12b-1 and advisory fees were “irrelevant to a showing of profitability without some allegation of the corresponding costs incurred in operating the funds.”
The Court found the plaintiffs’ showings on the other factors in the Gartenberg standard, including their allegations as to trustee independence, to be similarly inadequate and lacking in specific facts to survive a motion to dismiss. The Court also noted that both complaints were “strikingly similar” to prior claims brought by the plaintiffs’ counsel, all of which had been dismissed.
“2d Cir. Affirms Dismissal of Claims Morgan Stanley Charged Excessive Fees,” Securities Regulation & Law Report, Volume 38, Number 39, October 2, 2006. Amron v. Morgan Stanley Investment Advisors Inc., 2d. Cir. Docket Nos. 04-3938-cv(L), 04-3940-cv(CON), decided September 26, 2006. A copy of the opinion is available at http://caselaw.lp.findlaw.com/data2/circs/2nd/043938p.pdf.
Recent Settlements Involving Directed Brokerage and Revenue Sharing Violations
October 6, 2006 10:45 AM
On September 28, 2006, the SEC settled administrative proceedings against two affiliated advisers (the “Advisers”) and an affiliated distributor (the “Distributor”) in connection with violations of Section 206(2) of the Advisers Act and Sections 34(b), 17(d) and Rule 17d-1 of the 1940 Act related to directed brokerage and revenue-sharing arrangements. The SEC’s order found that between January 1, 2001 and October 2003, the Distributor entered into revenue sharing agreements with broker-dealers to gain exposure for a fund family advised by the Advisers (the “Funds”). These agreements provided for placement of the Funds on certain broker-dealers’ preferred or recommend fund lists, increased access to broker-dealers’ registered representatives, placement of the Funds on the brokers’ website, and participation in broker-dealer conferences, among other things.
In addition to these revenue sharing agreements, the Distributor also entered into agreements with broker-dealers to direct brokerage commissions on the Fund’s portfolio transactions to certain broker-dealers in exchange for such broker-dealers’ agreements to reduce or eliminate the Distributor’s revenue-sharing costs. The SEC found that, by using the Funds’ assets to obtain credits for directed brokerage, the Advisers and the Distributor avoided using their own assets to pay for the costs of revenue-sharing arrangements, and that this conflict of interest should have been—but was not—adequately disclosed by the Advisers to the Funds’ Board. In addition, the SEC found that the Advisers failed to ensure that the Funds’ prospectuses and statements of additional information adequately described how the Advisers chose broker-dealers for the Funds’ portfolio transactions and that the Distributor used the Funds’ assets to reduce revenue-sharing costs. The SEC stated that the failure to communicate these facts was a material omission that should have been disclosed to avoid misleading the Fund Boards and shareholders.
The SEC also found that the Advisers failed to apply for and obtain an exemption from the provisions of Section 17(d) of 1940 Act that prohibit joint arrangements between an affiliated person of, or principal underwriter for, a registered investment company, acting as a principal, and such registered investment company.
The respondents consented to the entry of the order without admitting or denying the SEC’s findings and agreed to pay $16.3 million in disgorgement and interest to 35 Funds, and a civil penalty in the amount of $ 3.0 million.
On August 31, 2006, a Missouri-based broker-dealer agreed to settle nine class action suits arising from its revenue-sharing arrangements and sales practices. The plaintiffs in the suits alleged that the broker-dealer improperly concealed payments it received from mutual fund companies in exchange for promoting their funds. The settlement provides that the broker-dealer will pay $55 million in cash in compensation to former clients and to cover the plaintiffs’ legal fees and $72.5 million in vouchers to current clients. The settlement includes all clients who bought or held securities in seven fund families between January 1, 1999 and December 31, 2004. Approval of the settlement is pending before the U.S. District Court for the Eastern District of Missouri. The broker-dealer settled related charges with the SEC in December 2004. Pursuant to that settlement order, the broker-dealer agreed to pay $37.5 million in disgorgement and interest, and a civil penalty in the amount of $37.5 million.
“Scudder Settles Revenue-Sharing Case,” Ignites, September 29, 2006. In the Matter of Deutsche Investment Management Americas, Inc., Deutsche Asset Management, Inc., and Scudder Distributors, Inc., SEC Admin. Proc. File No. 3-12442, September 28, 2006, available at http://www.sec.gov/litigation/admin/2006/34-54529.pdf.
“Edward Jones to Pay $127.5 Million to Settle Lawsuits Over Revenue-Sharing Practices,” Securities & Regulation Law Report, Volume 38, Number 37, September 18, 2006. “Ed Jones Settles Rev-Share Lawsuits for $127.5M,” Ignites, September 1, 2006. In the Matter of Edward D. Jones & Co., L.P., SEC Admin. Proc. File No. 3-11780, December 22, 2004.
E-mail Retention Guidance and Examinations of Hedge Fund Advisers
October 6, 2006 9:58 AM
Gene Gohlke, Associate Director in the SEC’s Office of Compliance Inspection and Examinations (“OCIE”) discussed, at a Practising Law Institute program on hedge funds held in New York City on September 27, 2006, the timing of anticipated SEC guidance on e-mail retention and issues arising from examinations of hedge fund advisers. He stated that it was “very difficult to answer” the question of when the SEC will provide guidance on e-mail retention requirements for investment advisory firms and noted the difficulties in creating the appropriate form and wording of such guidance.” Gohlke indicated that the form of guidance might be included in the staff’s revision of the books and records rule under the Investment Advisers Act of 1940 (the “Advisers Act”). Gohlke explained that, when conducting examinations of investment advisers, the staff’s general approach with respect to emails as follows: “If the adviser doesn’t have it and it’s not required [to be kept], we’re not going to say anything.” With respect to firms’ e-mail destruction policies, he also stated that OCIE takes a reasonable approach. “If the firm has a reasonable approach to deleting e-mails and follows up on red flags in the deleting process, and it turns out that one important e-mail was deleted, well, these things happen.”
Mr. Gohlke’s remarks also touched on the types of information the staff is interested in reviewing when examining hedge fund advisers, noting that the records that relate specifically to the adviser’s hedge fund clients are records of the adviser, including trading records and the offering memorandum for the hedge fund. “We think we have access to all records of hedge funds managed by an adviser,” Associate Director Gohlke stated. He also remarked that the staff reviews offering memoranda to see if the risks disclosed are consistent with the risks actually taken by the adviser. Other areas that the staff reviews for consistency with disclosures are the expenses being charged to the fund by the general partner and the fund’s valuations and performance calculations. Associate Director Gohlke also identified the strength of an adviser’s compliance procedures, the disclosure of side letters and any associated conflicts of interest or differences among investors (in particular, with respect to liquidity or transparency of the portfolio), and side pocket investments, as other areas the staff focuses on in conducting inspections.
Mr. Gohlke stated that the staff does not want to “do rulemaking through inspections or through enforcement.” In the area of required compliance and procedures, however, he expressed the view that the staff must nonetheless make some policy decisions in the process of conducting examinations in light of the fact that the SEC’s compliance rule for investment advisers did not provide much guidance.
“Timing of E-mail Retention Guidance Still Uncertain, SEC Inspections Official Says,” Securities Regulation & Law Report, Volume 38, Number 39, October 2, 2006.
Regulatory Scrutiny on Fund Dividend Payment Disclosure
October 6, 2006 9:55 AM
At the Investment Company Institute’s (“ICI”) Tax & Accounting Conference held on September 25-28, 2006, panelists discussed recent regulatory actions involving dividend payment disclosures made by open-end and closed-end funds. Panelist Charles Rizzo, Vice President of Fund Treasury at Goldman Sachs Asset Management, L.P., noted that there has been recent regulatory scrutiny over dividend payment disclosures. He explained that, as a result of SEC sweep exams conducted approximately 12 months ago, Wells Notices were issued to certain firms advising them that they may be subject to regulatory actions relating to this issue. He also discussed recent enforcement actions, including one where a firm was fined for failing to disclose that certain distributions from closed-end funds included a return of capital, rather than solely the income from the fund’s portfolio securities. Mr. Rizzo stated that in light of these developments, many open-end funds are now evaluating whether their dividend disclosures are appropriate.
Section 19(a) of the Investment Company Act of 1940 (the “1940 Act”) provides that if a dividend consists in whole or in part of a return on capital, rather than net income, it must be accompanied by adequate disclosure of the sources of the payment. The provision reflects the concern that if a fund fails to disclose that dividend payments include a return of capital, investors may be misled into believing that the fund has higher than actual earnings.
Another panelist, Jim Campbell, Assistant Chief Accountant of the SEC’s Division of Investment Management, stated that the SEC wants to ensure that investors understand the source of assets that are being paid as dividends. “If a dividend yield includes something other than income, then we believe it should be disclosed,” stated Mr. Campbell. Mr. Campbell stated that fund firms should include these disclosures with the dividend payments. He noted that, in addition to sending the disclosure directly to investors, firms could pursue other means of providing shareholders information, including issuing press releases, posting the information on its website, and providing the information to research firms such as Morningstar.
Mr. Rizzo reported that the ICI has created a working group to evaluate how to make such disclosures meaningful without confusing investors. “Dividend Disclosures Prompt Regulatory Scrutiny,” Ignites, September 27, 2006.