The NASDR has proposed rule changes to provide an exemption for closed-end management companies periodically offer to repurchase their securities in reliance on Rule 23c-3(b) under the Investment Company Act of 1940 (the "1940 Act"). These closed-end management companies are commonly known as "interval funds." In its proposal, NASDR proposed to amend NASD Conduct Rules 2710 and 2830 to exempt public offerings by interval funds from the filing requirements and limitations on underwriting compensation of Conduct Rule 2710 and, instead, subject these offerings to the sales charge limitations of Conduct Rule 2830.

Conduct Rule 2710 regulates the underwriting terms and other arrangements for public offerings of corporate securities. Closed-end funds are subject to the filing requirements, filing fees and regulations of Conduct Rule 2710, but open-end funds that continuously offer redeemable securities are exempt. Conduct Rule 2710 has historically applied to closed-end funds on the theory that closed-end fund offerings are structured and marketed in a manner parallel to and competitive with corporate securities offerings. For instance, traditional closed-end funds conduct offerings of a fixed number of common shares at specified times, price their shares periodically instead of daily, limit sales compensation of broker-dealers to a discount from a fixed offering price, generally do not redeem their securities and list their securities on a stock exchange.

Interval funds, however, have a hybrid structure. These funds engage in continuous offerings of their securities in accordance with Rule 415 under the 1933 Act, price their shares daily, pay broker-dealers initial and continuing compensation that conforms to the sales charge limitations of Conduct Rule 2830, do not list their securities on a stock exchange and redeem shares by making periodic self-tender offers in compliance with Rule 23c-3(b) under the 1940 Act. Rule 23c-3(b) under the 1940 Act requires an interval fund to establish as a fundamental policy (which can only be changed with shareholder approval) that the fund will make periodic repurchase offers. Conduct Rule 2830 regulates the distribution and sales charges of open-end funds.

NASDR recognized that regulation of interval funds under Conduct Rule 2710 may be inappropriate since the distribution of interval fund shares is arguably conducted and financed in a manner more similar to open-end funds. NASDR has thus proposed that the calculation of members' compensation for the distribution of interval fund shares be regulated under Conduct Rule 2830, and not be subject to the limitations on underwriting compensation imposed by Conduct Rule 2710. Closed-end funds that are not distributed like interval funds will continue to be subject to Conduct Rule 2710. Federal Register, Vol. 65, No. 68, April 7, 2000.

An administrative law judge dismissed charges against a broker-dealer representative for violations of Section 17(a) of the Securities Act of 1933 (the "1933 Act") and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. These provisions are commonly referred to as the "antifraud provisions" of the securities laws. The SEC had instituted proceedings against the representative in connection with his recommendations to purchase and sell particular mutual fund shares and against his chief compliance officer for failure to supervise the representative who committed the violations. Excessive short-term trading or switching between mutual funds and selling amounts of shares that are just under a sales charge breakpoint both violate the antifraud provisions.

The administrative law judge found that the representative's customers held shares of a particular mutual fund for periods ranging from 16 months to several years before becoming dissatisfied and selling the shares. After conferring with the representative, these customers then purchased an arguably riskier mutual fund. However, the judge found that in all cases the representative fully informed customers about the costs and risks of purchasing the new fund and did not improperly pressure the customers to make a change. In addition, the judge found that the SEC has never held that the holding periods in this case could be characterized as "short-term trading" or improper switching.

Because the judge found that the representative had not violated the antifraud provisions, the judge dismissed failure to supervise charges against the chief compliance officer. SEC Initial Decision Release No. 158, Administrative Proceeding File No. 3-9786.

Lori Richards, director of the SEC's Officer of Compliance Inspections and Examinations ("OCIE"), commented at a recent industry conference on the necessity for compliance procedures to accompany the growth in use of the internet by investment advisers, mutual funds and broker-dealers. Ms. Richards reported that OCIE has discovered issues when reviewing broker-dealer, mutual fund and investment adviser web sites including errors in performance calculation, missing legends and materials that have not been cleared by the National Association of Securities Dealers, Inc. ("NASD"). Ms. Richards also reported that OCIE staff has reported finding improper use of indexes and improper representations that back-tested performance is actual performance.

In particular, Ms. Richards warned broker-dealers to consider the following issues:

(i) ensuring payment for order flow, client referrals or other inducements does not interfere with a broker-dealer's duty of best execution;

(ii) a broker-dealer's duty of suitability when making recommendations on line; and

(iii) the broker-dealer's obligation to make full disclosure concerning arrangements the firm has with participants in their chat rooms or bulletin boards.

SEC Today, April 18, 2000.

The SEC's Division of Market Regulation will conduct a roundtable on May 4, 2000 to discuss limit order transparency. A limit order is an order to buy or sell a security at a specific price or better. Currently, limit order books are not open to the public but available to subscribers to a limit order information system. The system enables subscribers to shop for the most favorable prices by informing them about the specialist handling the limit orders, the exchange on which the securities trade, the order quantities and the bid and offer prices. Industry participants such as retail, institutional and wholesale firms, members of the major stock exchanges, mutual fund companies and pension plans have been invited to discuss the following topics:

• the benefits, both to institutional and retail investors, of having open limit order books;
• methods of distributing limit order books, including whether formats should be standardized;
• technical challenges that might be encountered;
• the most effective means of encouraging broad participation in this initiative; and
• a timetable for additional meetings among industry participants to further develop these ideas and outline practical steps toward implementation.

SEC Press Release 2000-50, April 17, 2000.

In a recent notice to members, NASDR reminded members of their responsibility to present mutual fund performance information in a fair and balanced manner. NASDR noted that recent "unusually strong equity market" performance has helped some mutual funds, especially those invested in technology stocks, achieve "extraordinary" performance. In some cases, the NASD has noted that total returns exceeded 100% within a 12 month period. NASDR warned members that they should present performance information in a manner that will not create unrealistic investor expectations regarding future fund performance.

NASDR reminded members that Conduct Rule 2210(d)(1)(A) requires all member communications to be based on principles of fair dealing and good faith. In addition, Conduct Rule 2210(d)(1)(A) prohibits members from omitting any material fact or qualification if the omission would cause the communication to be misleading. NASDR noted that Conduct Rule 2210(d)(1)(B) prohibits member communications from including exaggerated, unwarranted or misleading statements or claims. NASDR also noted that Conduct Rule 2210(d)(1)(D)(iii) requires members to consider the overall clarity of a communication. NASDR pointed out that relegating material disclosures to footnotes may not enhance a reader's understanding of the advertisement and thus may violate Conduct Rule 2210(d)(1)(D)(iii).

NASDR advised that the Conduct Rules taken together may, depending on the particular circumstances surrounding the member communication, require information beyond the technical requirements of Rule 482 under the Securities Act of 1933. NASDR advised members to avoid overemphasizing recent high performance figures or implying that they will recur. In addition, NASDR cautioned that if a fund's performance was primarily due to its investment in an unusually "hot" industry or from an investment in a particular type of security, such as initial public offerings, members should include prominent, cautionary language in the text of the communication that balances the extraordinary performance presentation. In particular, NASDR suggested that the communication disclose:

(1) that the advertised performance was attributable to unusually favorable conditions that are likely not sustainable;

(2) the circumstances surrounding the unusually favorable conditions; and

(3) that the conditions might not continue to exist and that the advertised performance probably would not be repeated in the future.

NASDR Notice to Members 00-21, April 2000.

On April 13, 2000, the SEC suspended the deadlines for decimal pricing of stocks due to the announcement by the National Association of Securities Dealers, Inc. (the "NASD") that it would not be able to meet the originally planned implementation schedule. The SEC also requests comment on two alternatives for initiating decimal pricing in exchange-listed securities this year. The first alternative would require decimal pricing in all exchange-listed securities by September 4, 2000. The second alternative would phase in certain exchange-listed securities on a pilot basis. The phase-in would begin on September 4, 2000 with a small number of securities but would expand to include all listed securities by March 31, 2001. Under either alternative, the NASD would begin trading in decimals by March 31, 2001. SEC Press Rel. 2000-49; Rel. 34-42685; File No. 4-430.

The SEC simultaneously instituted and settled administrative and cease and desist proceedings against a registered investment adviser and its principal for their use of false and misleading advertising of the adviser's investment performance. The SEC found that the adviser had distributed an advertising circular which misrepresented investment performance of the adviser and its principal's professional credentials. In particular, the SEC found that the adviser had misrepresented that its one year annualized return was 54.6% when actual returns were between 15% and 30%. The SEC further found that the adviser had claimed that it had assets under management of $278 million when it only had $30 million and claimed to have 522 clients when it only had approximately 100 clients. The SEC further found that the adviser had misrepresented the principal's experience as an investment adviser and his educational qualifications as well as the qualifications and experience of other members of the adviser's staff.

The SEC found that the adviser had violated Sections 206(1), 206(2) and 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder. The SEC entered a cease and desist order and imposed a financial penalty. The SEC further ordered the adviser and its principal to comply with undertakings to retain an independent consultant to examine and verify to the SEC the adviser's investment returns and assets under management and to send a copy of the order to current clients and to prospective clients for one year. SEC Rel. IA-1868; File No. 3-10188.

An SEC administrative law judge has issued an initial decision finding that an investment adviser to a mutual fund and three directors of the fund improperly put their interests ahead of the fund shareholders' interests in allocating hot initial public offering shares ("hot IPO shares"). A hot IPO is an initial offering of stock that is oversubscribed and is therefore trading at a premium to the initial offering price. In particular, the judge found that the adviser and the directors violated the antifraud provisions of the securities laws. The SEC had alleged that the fund's investment adviser allocated shares of hot IPOs to the three directors and later sold the hot IPO shares on behalf of the directors for a total profit of $103,644. The SEC further alleged that the mutual fund, the adviser and the directors all failed to disclose to the fund's shareholders the allocation and the resulting conflict of interest. The judge issued a cease and desist order, censures and civil penalties. SEC Initial Decision Release 162; AP File No. 3-9546.

In remarks at a recent industry conference, Paul Roye, director of the Division of Investment Management, outlined the SEC's upcoming regulatory initiatives involving investment advisers. In particular, Mr. Roye noted the following initiatives:

Modernization of investment adviser registration. The SEC has proposed requiring investment advisers to file registration materials electronically through a new Investment Adviser Registration Depository. The SEC has also proposed significant revisions to Form ADV (see Industry News Summary for the week of 4/3/00-4/10/00).

Treatment of broker-dealers as investment advisers. The SEC has proposed a rule addressing when broker-dealers are subject to regulation under the Investment Advisers Act of 1940 (the "Advisers Act"). Mr. Roye reported that the SEC is currently reviewing comment letters it has received in response to its proposal.

Pay-to-play proposal. Mr. Roye noted that, despite recent controversies over the SEC's pay-to-play proposal, the SEC remains committed to adopting a rule for investment advisers. Mr. Roye noted that the SEC is considering whether the proposed rule's approach is best suited for the advisory industry or if it places unnecessary burdens on advisers. The proposed rule would prohibit an adviser from providing advisory services for compensation to a government client for two years after the adviser or any of its partners, executive officers or solicitors contributed campaign funds exceeding $250 to certain elected officials or candidates.

Investment adviser advertising. Mr. Roye welcomed comment on the SEC's consideration of modernizing the rules governing investment adviser advertising. Mr. Roye commented that the SEC is considering revising Rule 206(4)-1 under the Advisers Act to more closely mirror Rule 156 under the Securities Act of 1933, a general anti-fraud statute. Mr. Roye further commented that the revision would generally prohibit advisers from using advertising that is materially false or misleading and would provide general guidance on the factors and the kinds of information that may make an advertisement false or misleading. Mr. Roye also reported that the SEC staff will consider whether to require standardized performance calculations for advisers.

Mr. Roye noted that the SEC sees a need to modernize the rules regulating adviser recordkeeping, custody and suitability. Mr. Roye also noted that at the May 23, 2000 roundtable on the regulation of advisers, the SEC will request comment on whether it should require advisers to adopt codes of ethics. SEC Today, April 11, 2000.

The SEC has proposed rules to create an electronic filing system for investment advisers; to substantially update Form ADV, the form of registration for investment advisers, and to require advisers to deliver to clients a plain English narrative brochure.
The SEC has created an internet-based system of electronic filing called the Investment Adviser Registration Depository (IARD), which will permit investment advisers to satisfy state and federal filing requirements with one electronic filing. Under the proposed rules, the IARD will be operated by NASD Regulation, Inc. However, NASDR will not act as a self-regulatory organization for advisers.

In connection with the requirement to file electronically, the SEC is revising Form ADV. Currently, Part I of Form ADV contains information about an adviser's business, the persons who own or control the adviser and whether the adviser or certain of its personnel have been sanctioned for violating the securities or other laws. Part II of Form ADV provides clients with information about business practices, fees and conflicts of interest that the adviser may have with its clients. An adviser is required to provide Part II or a written brochure containing the same information to clients before they engage the adviser.

The SEC has extensively revised Part II to further its goal of providing advisory clients with meaningful, clear disclosure about investment advisers. The SEC has proposed that all advisers provide clients with a narrative brochure containing disclosure about the advisory firm written in plain English and that advisers update the brochure at least once a year to reflect changes. The SEC is also proposing a new supplement to the brochure that contains important information about the advisory personnel with whom clients may be dealing. The proposed changes to Form ADV are discussed below:

Part 1A. Proposed Part 1A would require an adviser to provide information describing itself and its business through a series of fill-in-the-blank, multiple-choice, and check-the-box questions. As proposed, Part 1A consists of the following 12 items:

1. Identifying Information. The SEC would require that the adviser provide identifying information including:

• the CRD number of the adviser (if it has one),
• any web site addresses of the adviser,
• an e-mail address of a contact, and
• the fax number of the adviser.

2. Educational and Business Background. The SEC has proposed to move the disclosure by an adviser on the educational and business background of its personnel from the old Part I to the adviser's brochure or brochure supplements as described below.

3. Disciplinary Disclosure. The SEC has revised the requirements for disciplinary disclosure to:

• permit advisers that are registered as broker-dealers to electronically copy and link disciplinary disclosure made in response to Form BD on NASDR's CRD system without re-typing the data into the IARD;
• require that advisers only report disciplinary events occurring in the past ten years;
• delete the requirement that an adviser report an unsatisfied judgment or lien; bankruptcy; or bond denial, payout, or revocation;
• delete the requirements that an adviser also report a finding by a self-regulatory organization that the adviser violated a rule designated as "minor" under a plan approved by the SEC if the sanction imposed consists of a fine of $2,500 or less and the sanctioned person does not contest the fine;
• require advisers to report actions of foreign courts and regulatory authorities, and cease-and-desist orders issued by the SEC;
• require advisers to report felony criminal indictments and information, and misdemeanor information involving certain offenses, as well as military court convictions, misdemeanor perjury convictions, and conspiracy to commit certain offenses; and
• permit advisers to omit disciplinary information for advisory affiliates no longer associated with the adviser.

4. Control Person Disclosure. The SEC has clarified and simplified the reporting of indirect interests in the adviser when, for example, the adviser is part of a large corporate structure. The SEC will generally no longer require an adviser to report an indirect owner unless the indirect owner owned 25% of a direct owner. The SEC has also clarified the requirements for imputing beneficial ownership of an adviser for reporting purposes.

Part 2. Currently, Part II of Form ADV contains the requirements for the disclosure statement that advisers must provide to prospective clients and offer to clients annually. The disclosure statement contains information about the adviser's fees, business practices, and conflicts of interest. New Part 2 would contain similar disclosure, but advisers would be generally free to structure the disclosure and order the topics in a manner that best conveys the required information.

The new adviser brochure would be organized in two parts: Part 2A, a firm brochure and Part 2B, a brochure supplement for each individual who provides advisory services to clients on the adviser's behalf.

Part 2A: The Firm Brochure. The SEC noted that it will continue to require that an investment adviser deliver its brochure at the start of the advisory relationship and to offer to deliver the brochure annually. The proposed delivery requirements would be very similar to the current ones, with two notable differences. First, an adviser acting as the general partner for a limited partnership must provide a brochure to each limited partner. Second, updates to the brochure must be delivered to clients whenever information in the brochure becomes materially inaccurate.

The SEC has proposed that an adviser provide clients with written brochure updates whenever information in the brochure becomes materially incorrect, and include these updates with brochures delivered to prospective clients. These updates can take the form of either a reprinted brochure or a "sticker," similar to those currently used to update information in mutual fund prospectuses. Advisers that deliver their brochure to clients electronically could also deliver stickers electronically. The SEC would, however, require the adviser to revise (and reprint) its brochure each year as part of its annual updating amendment. Thus, the current brochure that the adviser offers clients annually would be a "clean" document that incorporates the text from all existing stickers from the previous year.

The revised information required in a firm brochure as specified by Part 2A of Form ADV consists of 19 separate disclosure items, including, among other things:

Advisory Business. Advisers would be required to include background information about the advisory firm, including how long it has been in business and the names of its principal owners. The brochure would also describe the types of advisory services offered, whether the adviser tailors services to clients' individual needs, and whether clients may impose individual investment restrictions.

While the SEC will not require all advisers to disclose the details of how they manage client assets, an adviser that holds itself out as specializing in a particular service would have to explain its specialty in detail. An adviser that provides advice about only limited types of securities would have to explain its services and their limitations. In addition, advisers that manage assets would disclose the amount they manage with investment discretion, and the amount without.

Fees and Compensation. The brochure would describe how the adviser is paid for providing advisory services including the adviser's fee schedule, whether fees are negotiable, whether the firm bills clients or deducts fees directly from the clients' accounts, and explain how often the firm assesses fees. Advisers charging fees in advance would also be required to explain how they calculate and refund prepaid fees when a client contract terminates. In addition to information about advisory fees, the SEC proposes to require advisers to describe the types and amounts (or ranges) of other costs, such as brokerage, custody fees, and fund expenses, that clients may pay in connection with advisory services.

An adviser will also be required to disclose any compensation that involves a conflict of interest. For instance, the SEC would require an adviser that receives transaction-based compensation (or whose personnel receive transaction-based compensation) to disclose this practice and the conflict of interest, and to describe the firm's control procedures for addressing the conflict.

Disciplinary Information. This disclosure would include descriptions of, among other events, any convictions for theft, fraud, bribery, perjury, forgery and violations of securities laws by the adviser or one of its executives. The SEC noted that while rule 206(4)-4 under the Investment Advisers Act of 1940 (the "Advisers Act") requires advisers to inform clients and prospective clients promptly about any "legal or disciplinary event that is material to an evaluation of the adviser's integrity or ability to meet contractual commitments to clients," it will not require an adviser to make this disclosure in its brochure. Instead, if an adviser determines that an event is not material and does not disclose it, the adviser must keep a file memorandum to justify the adviser's determination.

Brokerage Practices. Form ADV would require advisers to describe their policies and practices in selecting brokers for client transactions, and in determining the reasonableness of brokers' compensation. Form ADV would specifically require disclosure about the adviser's policies and practices with respect to soft dollars, client referrals, transaction costs and directed brokerage.

In particular, Form ADV would require an adviser to describe the types of conflicts it faces when it accepts soft dollar benefits, and to disclose its procedures for directing client transactions to brokers in return for soft dollar benefits. The item would require the adviser to explain whether it uses soft dollars to benefit all clients or just those accounts whose brokerage "pays" for the benefits, and whether the adviser seeks to allocate the benefits to client accounts proportionately to the brokerage credits those accounts generate. The item would also require the adviser to explain whether it "pays up" for soft dollar benefits.

An adviser would also be required to discuss its practice in using client brokerage to reward brokers that refer clients. The adviser would have to disclose the practice, the conflict it creates, and any procedures it used to direct client brokerage to referring brokers during the last fiscal year, i.e., the system of controls used by the adviser when allocating brokerage.

An adviser would also be required to disclose its practice of negotiating lower commissions or "bunched" trades to obtain volume discounts on execution costs. If the adviser does not bunch trades when it has the opportunity, the brochure would be required to explain that clients may pay higher brokerage costs. Similarly, if the adviser does not negotiate commissions, or limits the extent to which it negotiates them, the brochure would be required to explain that clients may pay higher brokerage costs as a result.

If an adviser permits clients to direct brokerage, Form ADV would require the brochure to explain that the adviser may be unable to get best execution, and that directing brokerage may cost clients more money. If, however, the adviser routinely requests or requires clients to direct brokerage, the brochure would also be required to describe the adviser's policy or practice, to disclose that not all advisers require directed brokerage, and to discuss any broker-dealer relationship that creates a material conflict of interest.

Payment for Client Referrals. The adviser will be required to disclose any payment, whether in cash or otherwise, that the adviser or a related person makes for client referrals. The brochure would also disclose whether the adviser receives any benefit, including sales awards or prizes, from a non-client for providing advisory services to clients.

Proxy Voting Policies. Form ADV would require new disclosure by the adviser to describe its proxy voting practices. Advisers that vote client proxies should disclose their voting policies, practices, and procedures. These advisers would also explain whether a client can direct the vote in a proxy solicitation, and whether clients can find out how the adviser voted their securities on a given issue. Advisers that do not vote client proxies would explain how clients will receive proxies (for example, directly from a transfer agent or custodian or through the adviser), and whether the client can discuss particular proxy solicitations with the adviser.

Part 2B: The Brochure Supplement. Form ADV would require a new disclosure document to supplement the firm brochure. The supplement would provide information about the adviser's advisory personnel whom the SEC refers to as "supervised persons." Advisers would be required to give a client a supplement only for a supervised person who will provide advisory services to that client.

Under the proposed amendments, an adviser must deliver a supplement for a supervised person to a client before or at the same time the supervised person begins to provide advisory services for the client. The proposed rule would require delivery to a client only if it is expected that the supervised person will either (i) regularly communicate investment advice to that client, or (ii) formulate investment advice for that client, including exercising investment discretion over that client's assets. Information required by a supplement include the following information about the supervised person:

• educational background and business experience;
• disciplinary information;
• other business activities, particularly other capacities in which the supervised person participates in the financial markets;
• disclosure whether the supervised person receives transaction-based compensation, including bonuses and non-cash compensation or additional compensation in the form of an economic benefit (such as a sales award or other prize) for providing advisory services;
• disclosure identifying the specific persons who formulates the investment advice provided to the client. If the supervised person does formulate advice for clients, the supplement would also explain how the firm monitors the advice provided.; and
• disclosure regarding whether the supervised person was the subject of a bankruptcy petition during the past ten years.

Comments must be received by the SEC no later than June 13, 2000. Release No. IA-1862; 34-42620; File No. S7-10-00.