Investment Management Industry News Summary - September 2003

Investment Management Industry News Summary - September 2003

Publications

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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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SEC adopts amendments to investment advisers’ custody rules

September 29, 2003 3:14 PM

The SEC has adopted amendments to the rule under the Investment Advisers Act of 1940 (the “Advisers Act”) governing investment advisers’ custody of client assets. The amendments, among other things, require advisers with custody of client assets to maintain those assets with broker-dealers, banks, or other qualified custodians and clarify circumstances under which an adviser is deemed to have custody of client assets.

Definition of “custody.” The amended rule includes a definition of “custody” (which was previously defined only in the instructions to Form ADV). Under the rule, custody is defined as “holding, directly or indirectly, client funds or securities or having any authority to obtain possession of them.” Accordingly, an adviser must comply with the rule when it has access to client funds and securities as well as when the adviser holds those assets. In addition, the rule provides examples that illustrate the application of the definition. These examples:

  • clarify that an adviser has custody when it has any possession or control of client funds or securities (i.e., an adviser that holds clients’ stock certificates or cash, even temporarily). The inadvertent receipt of customer assets is not considered custody so long as the adviser returns the assets to the sender within three business days after receiving them. An adviser’s possession of a check drawn by the client and made payable to a third party would not be considered custody of client.

  • clarify that an adviser has custody if it has the authority to withdraw funds or securities from a client’s account, including deduction of advisory fees or other expenses. (Nevertheless, the instructions to Item 9 of Form N-1A clarify that an adviser may answer “No” to having custody of client assets if it solely deducts fees from client accounts and does not otherwise have custody).

  • clarify that an adviser has custody if it is the legal owner of the client assets or has access to those assets (e.g., a firm that acts as both general partner and investment adviser to a limited partnership).

Use of “qualified custodians.” The rule requires that advisers maintain both client funds and securities with a “qualified custodian” in an account either under the client’s name or under the adviser’s name as agent or trustee for its clients. (Previously the rule required advisers to maintain client funds with a bank, but did not allow client securities in an adviser’s custody to be held in a brokerage account or with any other type of financial institution). “Qualified custodians” includes regulated financial institutions that customarily provide custodial services – banks, savings associations, registered broker-dealers and registered futures commission merchants. For securities primarily traded in a country other than the United States, and for cash and cash equivalents reasonably necessary to effect transactions in those securities, the amended rule treats as “qualified custodians” those financial institutions that customarily hold financial assets in that country and that hold the client assets in customer accounts segregated from their proprietary assets. In addition, advisers or affiliates of advisers that are also “qualified custodians” could maintain their own clients’ assets, subject to the account statement requirements described below and the custody rules imposed by the regulators of the advisers’ custodial functions. Moreover, the amended rule allows an adviser to use a mutual fund transfer agent in lieu of a qualified custodian with respect to mutual fund shares and provides exceptions for certain privately issued securities.

Delivery of account statements to clients. As amended, the rule exempts advisers from the requirements to send quarterly account statements and to undergo annual surprise examinations if the qualified custodian sends quarterly account statements directly to each advisory client (or the client’s independent representative). Nevertheless, to accommodate advisers that do not disclose the identity of their clients to their custodians, the amended rule requires an adviser to continue sending quarterly account statements to each client that does not receive account statements directly from the qualified custodian and to undergo an annual surprise examination to verify the funds and securities of those clients. The amended rule also contains a special provision requiring account statements (whether delivered by the qualified custodian or the adviser) to be sent directly to the limited partners of a limited partnership (or to their independent representative) if the adviser to the limited partnership also acts as its general partner and has custody of client assets.

Certain exemptions. The amended rule includes the following exemptions:

  • Registered Investment Companies. Because registered investment companies and their advisers must comply with the strict requirements of section 17(f) of the Investment Company Act of 1940 (the “1940 Act”) and the custody rules thereunder, application of the Advisers Act custody rule does not materially change custody requirements for investment company assets.
  • Pooled Investment Vehicles. Advisers are exempt from the reporting requirements of the rule for client assets held in pooled investment vehicles such as limited partnerships or limited liability companies if the pooled investment vehicle (i) has its transactions and assets audited at least annually; and (ii) distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 90 days of the end of its fiscal year.

Note: The proposed rule would have exempted audited pools completely, but the adopted rule exempts these pools only from the reporting requirement and not the requirement that assets be held with a qualified custodian. If a pool complies with the rule, it will not be subject to annual surprise audits and will not need to rely on the independent verification process outlined in SEC staff no-action letters.Registered Broker-Dealers. The amended rule eliminates the exemption for registered broker-dealers because they are generally qualified custodians and therefore do not need a separate exemption.

Elimination of balance sheet requirement. The amended rule also eliminates the requirement that advisers with custody include a balance sheet in their client brochures. The release adopting the amendments notes that the current rule now requires advisers to disclose to their clients any financial condition that is reasonably likely to impair the adviser’s ability to meet its contractual commitments to its clients. This disclosure requirement did not exist when the audited balance sheet requirement was originally adopted.

Compliance date. The compliance date for the amended rule is April 1, 2004.
 
 
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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

DOL confirms that delivery of profile satisfies prospectus delivery requirement

September 29, 2003 8:32 AM

The DOL recently issued an advisory opinion confirming that the delivery of a fund profile to participants and beneficiaries may satisfy the prospectus-delivery requirements of ERISA section 404(c). Section 404(c) of ERISA provides a safe harbor for ERISA fiduciaries to a defined contribution plan that allows participants to exercise control over their account who is otherwise a fiduciary shall be liable under ERISA’s fiduciary provisions for any loss, or provided trust among other things, the participants are provided or have the opportunity to obtain sufficient information to make informed decisions with regard to the investment alternatives available under the plan.


With regard to mutual fund investments by a plan participant under section 404(c), the plan fiduciary must provide to participants a copy of the most recent prospectus that was provided to the plan, either immediately before the participant’s initial investment or immediately following the initial investment. In addition, Section 404(c) requires that a participant be provided, either directly or upon request, various pieces of information based on the latest information available to the plan, including copies of any prospectuses.

Observing that the 404(c) regulations do not define the term “prospectus” and that a profile provides a clear summary of key and useful information about a mutual fund, the DOL concluded that the term includes a fund profile. The DOL also noted that should a participant wish to obtain additional information, a profile provides information on how to obtain a full prospectus. If a participant specifically requests a full prospectus, however, such a prospectus must be provided.

(DOL Advisory Opinion 2003 – 11A)

 
 
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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

DOL proposes to amend QPAM exemption

September 29, 2003 8:29 AM

The DOL recently proposed amendments to ERISA’a class prohibited transaction exemption for accounts managed by qualified professional asset managers, or “QPAMs.” The proposed amendments would increase the minimum assets under management and net worth requirements for an investment adviser to qualify as a QPAM and would ease compliance with certain of the other conditions under the QPAM exemption. Specifically, the proposed amendments would:

  • increase the minimum assets that an investment adviser must have under its management in order to qualify as a QPAM to $85 million as of the last day of the investment adviser’s most recent fiscal year (the current minimum is $50 million);

  • increase the minimum net worth required in order for an investment adviser to qualify as a QPAM to $1 million (the current minimum is $750,000);

  • eliminate the one year look-back which currently makes the exemption unavailable to a transaction with a person if that person or its affiliate had exercised the power to appoint the QPAM within the one year period preceding the transaction;

  • clarify that authority to appoint or terminate the QPAM would disqualified from relief under the QPAM exemption only if such authority related to the assets actually involved in the transaction, as opposed to any assets of the plan;

  • clarify that a person’s ability to cause a plan to invest in a commingled fund managed by the QPAM would not disqualify that person from the exemption if the plan’s interest in the fund is less than 10% of the fund;

  • narrow the definition of “affiliate” for purposes of disqualification (by narrowing limiting partnerships to those in which a person owns 10% or more and narrowing entities employing a person at issue to relationships to those in which the person is a highly compensated employee); and

  • narrow the provision that deems certain parties in interest “related” by (i) increasing the percentage interest that the QPAM may have in such person from 5% to 10%, (ii) increasing the percentage interest that persons controlling or controlled by the QPAM may have in such person from 5% to 20%, (iii) increasing the interest that such person may have in the QPAM from 5% to 10% and (iv) increasing the interest that persons controlling or controlled by such person may have in the QPAM from 5% to 20%, (v) clarifying that shares held or controlled in a fiduciary capacity need not be considered in determining affiliation, and (vi) limiting the date as of which such affiliations must be determined to the last day of the QPAM’s most recent fiscal quarter.

Comments on the proposed amendments are due to the DOL by October 20, 2003.

 
 
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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

NASD proposes requiring disclosure of certain arrangements relating to mutual fund shares

September 29, 2003 8:25 AM

In a recent notice to members, the NASD proposed amendments to Rule 2830 that would require point-of-sale disclosure of revenue sharing and differential cash compensation arrangements relating to the sale of investment company securities.
The proposal would amend the definition of “cash compensation” in Rule 2830 to expressly include gross dealer concessions as well as any cash payment received as a condition for inclusion of an investment company on a preferred or select sales list, in any other sales program, or as an expense reimbursement. In addition, the proposal would add definitions of “differential cash compensation” and “gross dealer concessions” to Rule 2830.

Under the proposal, any NASD member that has, within the previous 12 months, received cash compensation (other than sales charges or service fees disclosed in the prospectus fee table), or that uses differential cash compensation policies in compensating associated persons, would have to disclose:

  • that information about an investment company’s fees and expenses may be found in its prospectus and that the company’s policies regarding selection of brokers (including soft dollar practices) may be found in the statement of additional information (SAI);

  • if applicable, (i) that the member receives cash payments from an offeror, other than sales charges (including 12b-1 fees) or service fees disclosed in the prospectus fee table, (ii) the nature of any such payments received in the last 12 months, and (iii) the name of each offeror that made such a payment, listed in descending order based upon the amount of compensation received;

  • if applicable, (i) that an associated person receives different rates of compensation for different investment company products that may provide an incentive to offer specific products to the customer, (ii) a description of the arrangements, and (iii) the names of any investment companies favored by these arrangements; and
  • a web page or toll-free telephone number that a customer may use to obtain updated information about revenue sharing and differential cash compensation arrangements.

The required disclosures would have to be updated semi-annually and would have to be made in writing to the customer when the customer establishes an account with the NASD member or the member’s clearing broker (or, if no account is established, at the time that the customer first purchases shares of an investment company). Also, for accounts existing when the rule amendments become effective, the later of (a) 90 days after the effective date or (b) the time the customer first purchases investment company shares after the effective date.

The proposal would also modify the NASD’s current cash compensation prospectus disclosure requirements to clarify a member’s obligation not to accept any sales charges or service fees that are not described in a fund’s prospectus. In addition, if a special sales charge or service fee arrangement is made available to some, but not all, members who distribute a fund’s securities (e.g., an offeror pays a higher percentage of a fund’s sales charges to one member than it pays to other members), the details of the arrangement must be described in the fund’s prospectus.

The NASD is seeking comment on a number of issues including, for example, whether NASD should require prospectus (rather than SAI) disclosure of special cash compensation arrangements, whether money market funds should be excluded from the differential cash compensation provision, and whether NASD should pursue any of various alternative approaches to disclosure of revenue sharing and differential cash compensation arrangements. Comments are due by October 17, 2003.

 
 
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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC adopts amendments to mutual fund advertising rules

September 29, 2003 8:19 AM

The SEC has adopted long-anticipated rule amendments that require enhanced disclosure in investment company advertisements and eliminate the “substance of which” requirement. The amendments are designed to encourage advertisements that convey balanced information to prospective investors, particularly with respect to past performance. Specifically, the amendments:

  • Amend Rule 482 under the Securities Act of 1933 (the “Securities Act”) to:
    • eliminate the “substance of which” requirement (conforming amendments are proposed to Forms N-1A, N-3, N-4 and N-6);

    • require funds that advertise performance information to make available total returns that are current through the most recent month end by providing a toll-free number or website (the proposed rule did not allow for website disclosure) to investors where total-return information is provided within seven business days (rather than three calendar days as originally proposed) after the most recent month end;

    • require that fund advertisements include improved narrative information, including (1) a statement that past performance does not guarantee future results; (2) a statement that current performance may be lower or higher than the quoted performance figures and (3) the toll-free number and website information for obtaining current data (described above);

    • require that fund advertisements (i) state that investors should consider the fund’s investment objectives, risks, and charges and expenses carefully before investing; (ii) explain that the prospectus contains this and other information about the investment company; and (iii) identify a source from which an investor may obtain a prospectus; and state that the prospectus should be read carefully before investing; and

    • require that fund advertisements present explanatory information more prominently by requiring that (i) narrative disclosures in print advertisements be at least as large and of a style different from, but at least as prominent as, that used in the major portion of the advertisement and (ii) narrative disclosures regarding fund performance in both print and radio/television advertisements be presented in close proximity to the performance data.
  • Rescind the applicability of Rule 134 under the Securities Act to mutual funds (and thereby excluding mutual funds from relying on Rule 134). Rule 134 specifies certain categories of information (other than performance) that a fund may advertise, and advertisements that comply with Rule 134 do not give rise to “prospectus” liability.

  • Amend mutual fund advertising rules to add specific language to reemphasize that fund advertisements are subject to the anti-fraud provisions of the federal securities laws. The proposed amendments would add language to Rule 482 and Rule 34b-1 under the 1940 Act to the effect that compliance with these rules does not alter the obligations of that funds, underwriters and dealers are subject to the anti-fraud provisions of the federal securities laws with respect to fund advertisements. The new language would cross-reference Rule 156 under the Securities Act, which provides guidance about the factors to be weighed in determining whether fund advertisements are misleading.

  • Amend Rule 156 to provide further factors to be weighed in determining whether fund advertisements are misleading. Specifically, it is proposed that the language of Rule 156 be modified to state more explicitly that portrayals of past income, gain or growth of assets may be misleading if the portrayals omit explanations, qualifications, limitations or other statements necessary or appropriate to make these portrayals of past performance not misleading.

  • Reorganize Rule 482 to make it easier to use, including reordering provisions and adding headings.

  • Amend Forms N-1A, N-3, and N-4 to eliminate requirements for disclosure of the method of calculating performance, the length and the last day of the base period used and (in Form N-1A only) the income tax rate used.

  • The compliance date for the amendment eliminating the “substance of which” requirement from rule 482 will take effect on November 15, 2003. Fund advertisements submitted for publication after March 31, 2004, should comply with all other amendments adopted in this release.

(SEC Rel Nos. Nos. 33-8294; 34-48558; IC-26195; File No. S7-17-02)

 
 
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.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Implications for Mutual Funds of Canary Capital Action

September 12, 2003 8:44 AM

On September 3, 2003, New York State Attorney General Eliot Spitzer brought an action against a hedge fund manager for violations of New York law in connection with its investments in mutual funds. The action was contemporaneously settled with the imposition of restitution obligations or fines of $40 million payable by the hedge fund manager. In announcing the settlement, the Attorney General indicated that additional actions may be brought against others involved in the alleged scheme. The allegations raised by the Attorney General have significant potential implications for the industry’s reputation and the manner in which mutual funds interact with financial intermediaries. Two different types of conduct were alleged by the Attorney General, and gaining an understanding of the distinction between the two asserted violations is the first important step in being able to develop a strategy to address these issues.

The New York Complaint

The Late Trading Violations

The first and most egregious conduct involved intentional violations of Rule 22c-1 under the Investment Company Act of 1940, as amended (the “1940 Act”). This rule, known as the “forward pricing rule,” is one of the principal investor protection elements of the 1940 Act. All purchase and redemption orders received before a fund’s close of business, usually designated by reference to the close of the New York Stock Exchange at 4:00 p.m. Eastern Time (the “close of business”), are processed at a price based on the fund’s net asset value as of the close of business on the day received. Under Rule 22c-1, all purchase and redemption orders received after the close of business are processed at a price based on the next day’s net asset value. Under guidance from the Securities and Exchange Commission (“SEC”), fund groups are permitted to receive purchase and redemption orders from certain intermediaries after the fund’s close of business if the intermediary is merely processing orders that it received from its clients prior to the fund’s close of business. The purpose of the forward pricing rule is to ensure that all investors purchase and redeem shares based on the same net asset value.

The Attorney General alleged that Canary Capital Partners, LLC and Canary Investment Management, LLC, two unregistered hedge fund management firms (together, “Canary”), worked with asset management personnel at Bank of America (“BoA”) to make investments in mutual funds, including BoA’s Nations Funds, as late as 6:30 p.m. at the price established for such funds as of 4:00 p.m. These practices allegedly permitted Canary to make profits based on market-moving events occurring after 4:00 p.m. that indicated that the value of a fund’s portfolio would be higher or lower once trading resumed the next day. For example, if a positive post-market close announcement by a high tech company suggested that the market for small cap stocks would trade up when the markets reopened, Canary was able to purchase a small cap stock fund based on its net asset value as of 4:00 p.m. before the positive effect of that announcement was reflected in the value of a fund’s portfolio holdings. The increase in value that would otherwise be realized by shareholders of the fund as of the close of business was diluted and realized in part by Canary. Initially, Canary allegedly provided trades to BoA before 4:00 p.m., which BoA would destroy and not transmit to the fund companies if Canary after 4:00 p.m. elected not to proceed with the trade. Subsequently, BoA is alleged to have provided Canary with direct electronic access to its settlement system so Canary could post its own trades after 4:00 p.m. For these opportunities that are not available to other investors, Canary allegedly provided BoA with economic benefits including a 1% wrap fee, a line of credit on terms favorable to BoA, and “sticky” or long-term investments of other Canary monies in some of the Nations Funds. The complaint alleges that senior personnel in BoA’s fund operation knew of and approved these arrangements. The complaint also alleges that BoA provided Canary with specific non-public information about its funds’ portfolios and that Canary, employing such fund portfolio information, was able to make profits after hours even on “bad news” by engaging in derivative transactions with BoA whereby Canary sold short baskets of securities mimicking a fund’s portfolio. The complaint also alleges that Security Trust Company (“STC”), a provider of corporate trust services to retirement plans, institutional investors and financial advisers, allowed Canary to trade as late as 9:00 p.m. in a broad range of mutual funds. STC allegedly took steps to camouflage the trades and shared in Canary’s gains.

Market Timing

Assuming the allegations regarding late trading are true, the activities involved were clearly in violation of the 1940 Act. The second element of the complaint brought by the Attorney General has potentially broader implications for the industry because it paints with one brush conduct that self-evidently violates the 1940 Act and conduct that is less clearly problematic and more pervasive in the industry. In addition to violations of the forward pricing rule, the Attorney General alleged that Canary engaged in frequent market timing transactions. These transactions were allegedly accomplished with the cooperation of management of the fund companies despite the funds having stated policies against market timing. Market timers seek to profit by purchasing shares of a fund that values its assets as of 4:00 p.m. but bases that valuation upon the market value of portfolio securities the principal market for which closed earlier in the day. The closing market price of these portfolio securities, therefore, does not reflect market developments between such close and 4:00 p.m. For a domestic stock fund, market timing is generally not an issue because a fund’s portfolio securities and the fund’s shares are valued at approximately the same time. For this reason, market timers tend to focus on international funds and foreign country or regional funds. Market timers anticipate higher prices in foreign markets based on late rallies in the U.S. markets. They execute this strategy by purchasing fund shares at the closing price on the day of the rally and selling them the next day to realize the quick one-day profit. In 2001, the SEC staff wrote a series of letters to all major fund groups, urging them to protect their shareholders from market timers by employing “fair pricing” techniques for close-of-business prices when significant events have occurred that indicate that fair pricing may be more accurate than simply relying on closing prices of portfolio securities. In light of current developments, management companies and fund boards will want to re-examine these letters and consider to what extent foreign securities should be fair valued in the absence of some significant market development.

While not illegal per se, these quick purchases and sales by fund market timers generate portfolio transaction costs that derogate performance for long-term fund shareholders and transfer a portion of the potential gain from the fund’s portfolio to the market timer. Most large fund families discourage market timers with exchange limitations or redemption fees, especially on international funds, and employ other policies that purport to prevent market timers from investing in their funds. Market timers, however, often invest through large brokerage firms, and their identities are often hidden from fund distributors and transfer agents. The complaint referred extensively to differences between a fund’s anti-market-timing policies as disclosed in prospectuses and the actual conduct of the management company in asserting possible misrepresentations by fund groups, including BoA’s Nations Funds, Janus, Banc One and Strong. For these market-timing devices to have succeeded, exchange limits and redemption fees intended to discourage market timers were allegedly routinely ignored or waived.

While the status of such transactions under New York law, which is the basis for the Attorney General’s complaint, has yet to be determined, market timing itself does not violate the 1940 Act. Mangement companies that facilitate market timing in violation of prospectus disclosure, however, may be violating the federal securities laws or their fiduciary obligations to shareholders, particularly if the facilitation of market timing transactions is coupled with an economic benefit to the manager. The complaint alleges that this economic benefit exists by virtue of the investment management fee alone.

Other Regulatory Responses

Regulators in Massachusetts, in an investigation that also implicates market timing, reportedly are probing the Boston office of Prudential Securities for information about market timers moving large sums of money in and out of mutual funds to the possible detriment of smaller shareholders and in violation of the policies of those funds. Brokers participating in these transactions earn substantial commissions, which allegedly induced them to switch the customer identification numbers on orders placed by them in order to help their market-timing customers avoid the redemption fees imposed to discourage market timing.

Whether as a result of illegal forward trading or market timing in violation of sound fund management practices, other shareholders of the affected funds allegedly lost value in their investments at the gain of Canary and others similarly engaged. This apparent abuse of longer-term shareholders has already spawned class action lawsuits against Janus and Strong, as well as emphatic statements from SEC Chair William H. Donaldson, who called the conduct “reprehensible” and the Investment Company Institute (“ICI”) which issued the following statement on September 4th:

“If, as alleged yesterday, certain fund managers have violated legal standards or their own policies in return for payments from hedge funds, we urge strong and prompt remedial action by government officials.”

SEC Enforcement Chief Steven Cutler has praised Mr. Spitzer’s efforts and the SEC has already sent letters to fund groups representing approximately 75% of mutual fund assets under management, requesting a description of their practices with respect to market timing and fund trading practices and a reply on or before September 15th. We understand that the SEC staff has been refusing requests for extensions of this deadline. Despite the brief period given to respond, the SEC has requested that a copy of the reply be given to the fund board and that the reply indicate whether the board has reviewed and approved it.

What should investment management firms and mutual fund boards be doing in light of the Canary Capital actions?

Investment management firms and the boards of the mutual funds they manage should anticipate that that the conduct exposed in the Canary Capital matter will be under intense regulatory, board and shareholder focus for at least the next several months. Many investment management firms have received information requests from the SEC or subpoenas from state Attorney’s General offices. Responding to the SEC’s concerns, the ICI has urged its members immediately to (1) seek assurances from selling broker-dealers and other intermediaries that they are following all relevant rules, regulations and internal policies regarding timely handling of mutual fund orders and (2) review the sufficiency of market timing and fair valuation policies and procedures for addressing concerns in this area. Even fund complexes that have not received requests from regulatory authorities are well advised to follow the ICI’s recommendation and to consider what other actions may be appropriate. While the issues raised most directly impact broker-sold funds, even no-load funds should review the market timing and valuation aspects of these issues.

Investment Management Firms

What are some of the basic questions that investment management companies should be asking themselves? The nature and scope of the inquiry should, of course, be guided by the nature of the fund complex’s sales arrangements and past practices. However, the following are some basic questions that all broker-sold funds should be considering. Annex A to this memorandum includes a checklist of certain actions that fund groups should consider taking.

Late Trading

  • Assurances from Sales Staff and Intermediaries. Fund complexes should confirm that no inappropriate late trading arrangements exist as to their funds and that intermediaries who have legitimately been authorized to submit orders after the establishment of a fund’s net asset value (the “Pricing Time”) are processing and submitting only orders received by the intermediary before the Pricing Time. An internal inquiry of senior sales staff as to the absence of any intentional accommodation of late trading is advisable even if there is no reason to suspect such activities. Similarly, promptly following through with the ICI recommendation regarding obtaining assurances from intermediaries is strongly recommended. Fund groups that do not tthe intermediary allows a third party to process orders in fund shares through the intermediary, that the intermediary has received reasonable assurances from that third party it is adhering to the standards in (i) and (ii). Annex B includes a draft request and certification that could be sent by fund groups to intermediaries. Fund groups should consider whether to make the scope broader to include all the sales policies that are implemented through intermediaries. Fund groups should also determine what actions they will take if, after a reasonable period, an intermediary fails to provide those assurances. For example, fund groups should consider whether the fund group should cut off sales through that intermediary or whether there are less dramatic actions available that can prompt compliance.

  • Further Scrutiny for Implicated Parties. Certain intermediaries have already been implicated in the Canary Capital matter, and the possibility exists that additional intermediaries will be drawn into the late trading scandal. If a fund group uses an intermediary as to which credible evidence of abuse exists, what should the fund group do? In those circumstances, the type of assurance letter discussed above and attached as Annex B would not be adequate since the response would have little credibility. In those cases, a fund group should consider requiring the intermediary to provide tangible evidence that the abuses have been addressed by the intermediary and that adequate procedures are now in place to prevent abuses in the future. The tangible evidence might come in the form of a review report by a third party, such as an accounting or law firm (e.g., “SAS 70” report). The fund group may also require that the intermediary provide data regarding any past late trading that was permitted to be conducted through that fund group so the degree of harm done to shareholders can be assessed and the appropriateness of further action considered. What action to take in the meantime is a difficult decision. In some ways the best course would be to cut off shareholder transactions through that intermediary until adequate assurances have been obtained. However, the intermediary may be the gatekeeper for a material portion of your fund group’s shareholders and the source of significant new sales. Fund groups should consider whether cutting off that channel is in the best interest of the funds’ current shareholder base, regardless of whether or not those shareholders come through that intermediary.

  • Practical Limitations. Management companies should not assume responsibility for compliance issues that they cannot control. Through certifications, representations in agreements and discussions with intermediaries, management companies should be placing themselves in a position such that they can reasonably conclude that the Canary Capital type abuses are not occurring through their funds. However, there are limits on a fund group’s ability ake these steps are likely to be explaining, upon SEC inspection or at a board meeting, why they failed to do so. The assurances requested from the intermediaries should at a minimum confirm that (i) the intermediary effects transactions in fund shares at that day’s net asset value only if the order is received prior to the Pricing Time, (ii) the intermediary has adequate internal controls and procedures to provide reasonable assurance that purchase and sale orders are processed at the correct net asset value and timely transmitted to the funds and (iii) if to police intermediaries. Overly broad promises to regulators or boards that a fund group will ensure that these abuses do not occur will likely go unfulfilled.

Market Timing

  • Review of Policies, Disclosures and Agreements. Management companies should review their policies, disclosures and agreements with respect to market timers. The review should focus on the overall fairness of the fund group’s practices and the consistency of the fund’s practices and disclosure. While the position espoused in the Canary Capital action that permitting market timing in a fund is per se illegal may not be on firm legal footing, fund groups should not be intentionally benefiting one set of shareholders over others. Practices with respect to exchange limitations and redemption fees should both be scrutinized. A fund’s policies on market timers should be consistently applied, with any exceptions based upon the benefits to the fund and not the management company. In many cases, exceptions will be appropriate for operational or fairness reasons. Agreements providing for exceptions may also eliminate one set of restrictions and impose another that the fund group has determined offer adequate protection but also permit the funds to attract certain investors who otherwise would not invest in the funds.

  • Accuracy of Disclosure. Funds’ disclosure documents should be reviewed to ensure that any anti-market timing policy is correctly expressed and, if exceptions to the policy are made, that such flexibility is disclosed. While the extent of resources that can be devoted to market timers will depend upon the size of the fund group, large groups should seek to identify the market timing activity that is conducted through their funds to determine if the fund group’s current policies and procedures are adequate to protect shareholder interests and if strongly stated prospectus disclosures on these policies and procedures can be supported.

  • Fair Valuation. In the absence of some inside help, market timers depend upon some timing difference in the pricing of a fund’s shares and the closing of the market for the fund’s portfolio securities. That is why international funds are most susceptible to market timers. Fund valuation policies almost universally provide for a security to be fair valued if there are developments that are likely to effect the value of that security since the close of the market upon which its valuation is normally determined. If a management company determines that a fund is a frequent target of market timers, the fund group should consider whether its valuation procedures are adequate or if the existing procedures are being adequately implemented to identify portfolio positions that should be fair valued. The appropriate answer is not to fair value all portfolio securities the primary market for which closes before the Pricing Time; however, the process that triggers a fair value review should be evaluated to determine if the threshold is being set too high for these types of securities.

  • Review of Special Arrangements. Senior management and legal officers of fund groups should understand all special arrangements that exist with an intermediary that is an important distributor of fund shares. In most cases these arrangements will be permissible but management should have an understanding of the overall impact of these arrangements and evaluate whether they raise legal, fiduciary or reputational issues. Some arrangements, such as facilitating late trading, would be impermissible. Other practices, such as the selective sharing of portfolio information, would need to be carefully scrutinized as to compliance with the law and promoting the best interests of all shareholders. Unless the fund group has a clear understanding the purpose for which the third party will use the requested information, the fund group is unlikely to be in a position to evaluate the appropriateness of such selective disclosure. Other arrangements could have legitimate purposes but become questionable, on a reputational if not legal basis, if the fund group has an express or implied quid pro quo benefit from the intermediary. In light of the Canary Capital action, it would be prudent to review the continued appropriateness of any “sticky asset” understandings. As in most regulatory issues, the regulators are focused upon “the tone from the top.”

Boards

What actions should boards of mutual funds take? Certainly boards will want to be assured by their management companies that no late trading is occurring in the funds and that the inquiries recommended by the ICI have been undertaken and adequate responses obtained. If a response to regulatory inquiry is being made, the board should be advised of the inquiry and the response. Boards should also review the funds’ policies with respect to market timers. Boards should seek to understand the degree to which market timers invest in the funds. In that regard, if any exceptions to a policy preventing or limiting market timers are allowed, boards should understand the contractual or other arrangements that the funds have and the basis for concluding that such arrangements are in the funds’ best interests. If a board determines that a fund is a frequent vehicle for market timers, the board should evaluate whether the fund’s practices in valuing its portfolio securities are adequate.

Questions and Contacts

If you have any questions on these matters, please contact any of the partners of the Investment Management Group or the Hale and Dorr LLP attorney with whom you most often work.

 
 
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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