The NASD Board of Governors approved a proposed rule setting forth the requirements for anti-money laundering compliance programs for NASD members. The proposed rule serves to implement part of the recently enacted anti-terrorism legislation, the USA Patriot Act, which requires that financial institutions, including broker-dealers, establish anti-laundering compliance programs by April 24, 2002. (See Industry News Summary for the period 12/31/01 to 1/14/02). The USA Patriot Act, among other things, requires all broker-dealers to track and report suspicious transactions by filing Suspicious Activity Reports, develop comprehensive anti-money laundering compliance programs, institute special due diligence checks for certain customers, and close accounts with foreign shell banks that have no physical operations. The Department of Treasury recently proposed regulations for the reporting of suspicious transactions by broker-dealers and on the handling of correspond accounts of foreign banks. Following the Treasury’s approval of its regulations in this area, NASD members will need to incorporate these requirements into their anti-money laundering compliance programs.

The proposed rule would require member firm to develop, and a member of the firms’ senior management to approve, anti-money laundering programs assigned to achieve and monitor compliance with the Bank Secrecy Act and related regulations. Specifically, the rule would require member firms to:

• Establish and implement policies and procedures that can be reasonable expected to detect and cause the reporting of transactions that raise suspicion of money laundering;
• Establish and implement policies, procedures and internal controls reasonably designed to achieve compliance with the Bank Secrecy Act and regulations thereunder;
• Provide for independent testing for compliance to be conducted by member personnel or by a qualified outside party;
• Designate an individual or individuals responsible for implementing and monitoring the day-to-day operations and internal controls of the program; and
• Provide ongoing training for appropriate personnel.

Following SEC approval of the NASD’s proposed rule, NASD Regulation stated that it will incorporate compliance checks into its examination program and will assist members in establishing best practices methodology.

The Players Association of the National Football League (the “Association”) sought assurance from the staff of the Division of Investment Management of the SEC that it could establish a registered financial advisors program (the “Program”) to protect NFL players from fraud in connection with their investments without violating certain provisions of the Investment Advisers Act of 1940 (the “Advisers Act”). Specifically, the Association sought assurance from the staff that it would not be deemed an investment adviser as defined in Section 202(a)(11) of the Advisers Act as a result of its operation of the Program and that it would not be deemed a solicitor for purposes of Rule 206(4)-3 under the Advisers Act if the investment advisers participating in the Program make limited cash payments to the Association.

Under the Program, financial advisers would voluntarily register and agree to be regulated by the Association for the benefit of the players. The eligibility requirements relate to the adviser’s educational training and work experience, legal regulation, and whether an adviser has been subject to certain disqualifying events such as a past felony conviction, civil judgments involving fraud, or disciplinary actions by regulatory bodies. The Program’s regulations generally address matters including the financial adviser's compliance with federal and state laws and regulations and professional licensing requirements, maintenance of liability insurance and disclosure to players of advisory fees and the risks of recommended financial strategies and investments. The Association would invite as many financial advisers as possible to participate in the Program subject to the eligibility requirements.
After eligible financial advisers have begun to register with the Program, the Association will provide a list of registered financial advisers to the players, which will be updated regularly. The list will contain certain limited information about the financial adviser, such as its name, address, contact information, and a brief description of the adviser’s services. The content of the description would be prepared by the registered financial advisers. The advisers list will be presented alphabetically by firm and by state or multi-state region in which the adviser is based. The Association will have no role in the dealings or transaction between players and registered financial advisers, except in connection with monitoring and providing players with confirmation of its belief concerning the adviser’s compliance with the Program’s regulations and disciplining registered investment advisers who fail to comply with the regulations. The financial advisers would pay the Association an application fee of $1,000 and an annual fee of $500 to participate. The fees would be used to defray program expenses. The dues which players pay to the Association for membership services would include access to Program.

The staff concluded that the Association would not be "advising" others through the Program within the meaning of section 202(a)(11) and, therefore, would not be an investment adviser under the Advisers Act. In reaching this conclusion, the staff noted several facts about the operation of the Program, including:

• The list of financial advisers would be organized in a manner that does not recommend one adviser over another;
• The criteria used to select investment advisers is not highly selective;
• None of the eligibility requirements or Program regulations relates to an adviser's financial performance;
• The Association will not advise players as to the merits or shortcomings of any particular adviser;
• Players will directly hire and fire listed advisers and may choose not to use a participating adviser.
• The Association’s role will be to monitor compliance with the Program’s regulations and to discipline any advisers who violate the regulations.
• The Association will not be affiliated in any way with any adviser that participates in the Program.

The staff also concluded that the Association would not be deemed a solicitor under Rule 206(4)-3 because it would not be referring clients or prospective clients to the financial advisers participating in the Program. Rule 206(4)-3 prohibits any investment adviser that is required to be registered with the SEC from paying a cash fee, directly or indirectly, to a solicitor with respect to solicitation activities unless certain conditions imposed under the rule are met. Paragraph (d)(1) of the rule defines "solicitor" as "any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser." The staff noted that the Program was designed to help players locate investment advisers rather than serving as a means of soliciting clients for specific participating advisers. The staff further noted that the fees paid by the advisers to participate in the Program are flat fees and are not related to the number of referrals to or clients obtained by the investment advisers. The staff also noted that the fees that advisers pay to participate in the Program will be disclosed to the players. National Football League Players Association, SEC No-Action Letter (January 25, 2002)

The SEC settled charges against a New York-based broker-dealer and investment bank (the “Company”) for abusive practices relating to the allocation of stock in “hot” initial public offerings (“IPOs”). The SEC had filed a complaint in U.S. District Court for the District of Columbia charging the Company with violating certain conduct rules of the National Association of Securities Dealers, Inc. (“NASD”) which prohibit profit-sharing in customer accounts and unjust or inequitable conduct. The SEC also charged that the Company violated the SEC’s books and records requirements for broker-dealers. The complaint included the following allegations:

• The Company, as lead underwriter for several hot IPOs, had control over the allocation of most of the shares in these IPOs. In exchange for the highly-coveted stock in these IPOs, the Company wrongfully extracted from certain customers a large share of the huge profits these customers made in quickly selling (or flipping) the IPO stock bestowed on them by the Company.
• Specifically, from April 1999 through June 2000, the Company allocated shares of IPOs to more than 100 customers who, in return, funneled between 33% and 76% of their IPO profits to the Company. These customers typically flipped the stock on the day of the IPO. The customers then transferred a share of their flipping profits to the Company by paying excessively high brokerage commissions (ranging from $0.19 per share to $3.15 per share) on trades in highly liquid, exchange traded shares which were unrelated to the IPO shares.
• The profit sharing activity was pervasive at the Company. Senior executives who were in managerial and supervisory roles knew of the practices described in the complaint, encouraged many of the practices described in the complaint, directed company employees to urge customers to maintain specified ratios and commissions to IPO profits, and, in some instances, personally engaged in some of the practices described in the complaint.
• Company employees informed the relevant customers, both implicitly and explicitly, that they were expected to pay back to the Company a portion of the profits earned on their IPO flipping in order to continue to receive allocations. Customers who refused to funnel a portion of their profits to the Company, received smaller allocations, and in some instances, were denied allocations all together.
• The profit-sharing customers received no more than 10% of the IPO stock allocated by the Company in each offering. IPO flipping was so profitable, however, that the Company wrongfully obtained tens of millions of dollars in IPO profits through this improper conduct.

The Company agreed to pay a total of $100 million to settle the SEC’s action and a related action announced by the NASD Regulation. Specifically, the Company will pay disgorgement totaling $70 million in civil penalties and fines totaling $30 million. As part of the settlement, the Company has undertaken to change its methods of allocating IPO stock, as well as its supervision of those activities. The Company will also retain an independent consultant to conduct a review of the Company’s new policies and procedures after one year and adopt the recommendations of the independent consultant. The SEC reported that the $100 million civil penalty was one of the largest every imposed on a broker-dealer by the SEC and that it took the unusual step of seeking a federal court injunction to enforce the NASD conduct rules because of the nature and scale of the misconduct alleged in the complaint. SEC Press Release, January 22, 2002.

The staff of the Division of Investment Management of the SEC provided additional guidance about mutual fund after-tax returns by supplementing its Frequently Asked Questions Bulletin to address the disclosure of the performance of predecessor unregistered pooled vehicles. In this supplement, the staff explained how a fund should comply with the after-tax disclosure requirements when dealing with a predecessor unregistered pooled vehicle.

The staff conditionally permits funds which convert from an unregistered pooled vehicle to a registered mutual fund to include in the calculation of standardized total returns the performance of the predecessor unregistered pooled vehicle. The staff imposes several conditions on a fund when quoting a predecessor’s performance, including that the investment policies, objectives, guidelines and restrictions of the successor fund are materially equivalent to those of the predecessor pooled vehicle and that the pooled vehicle was not created for the purpose of establishing a performance record (i.e., no incubator funds). In this supplement, the staff noted that many funds are unable to compute standardized after-tax returns for a pre-registration period because of the different tax treatment of the unregistered predecessor funds for those years. When that occurs, the staff advised that a fund may include after-tax returns for the fund’s post-registration statement period only. The staff added that the fund must also include standardized before-tax returns for the post-registration period in order to permit comparisons over the same periods. The staff advised that the fund may continue to include the before-tax returns of the unregistered predecessor fund from the date of inception of the predecessor unregistered fund in the risk-return section of the prospectus.

The staff provided the following example for additional guidance: A fund has six years of performance as a registered entity and three years of performance as an unregistered entity and is unable to compute standardized after-tax returns for the three years prior to registration because of different tax treatments in those years. The staff advised that the fund may include in the risk-return summary standardized after-tax returns for one year, five years and six years reflecting the post-registration period, as long as it also includes standardized before-tax returns for those periods. The fund may also include standardized before-tax returns for nine years reflecting the date of inception of the predecessor unregistered pooled vehicle if it is eligible to rely on the staff’s previous no-action positions.

The staff of the Division of Investment Management of the SEC has recently taken the position that funds must treat "broker non-votes" as present at shareholder meetings with respect to proposals that require the approval by a majority of the fund’s outstanding “voting securities,” as defined in Section 2(a)(42) of the Investment Company Act of 1940 (a "1940 Act Majority"). Proposals that require approval by a 1940 Act Majority include the approval of investment advisory agreements, underwriting agreements and Rule 12b-1 plans. The SEC staff’s position is not applicable to proposals that do not require approval by a 1940 Act Majority. The staff believes that its position would override contrary state law provisions.

Therefore, a broker non-vote, like an abstention, will have the effect of a vote “against” any proposal requiring approval by a 1940 Act Majority. Many funds currently treat broker non-votes as not being present at shareholder meetings for purposes of determining whether a quorum exists, and therefore as having no effect on the outcome of a vote. These funds may be required to amend their by-laws (and possibly declarations of trust or other governing documents) to comply with the SEC staff's position. If you have any questions regarding treatment of broker non-votes at fund shareholder meetings, please contact Len Pierce or Tim Silva of Hale and Dorr.

In its first enforcement action involving fraudulent pro forma financial reporting, the SEC instituted cease and desist proceedings against a publicly traded company for making misleading statements in the company’s third quarter 1999 earnings release. The SEC found that the release cited pro forma figures which touted the company’s purportedly positive results of operations but failed to disclose that those results were primarily attributable to an unusual one-time gain rather than to operations.

The company had issued a press release on October 25, 1999 announcing its quarterly results. The release used net income and earnings per share (“EPS”) figures that differed from net income and EPS calculated in conformity with generally accepted accounting principals (“GAAP”) in that the net income and EPS figures excluded a $81.4 million one-time charge. However, the stated net income included an undisclosed one-time gain of $17.2 million. There was no mention of the one-time gain in the text of the release and the financial data included in the release gave no indication of the one-time gain because all revenue items were reflected in a single line item. The SEC noted that on October 25, the day the earnings release was issued, the price of the company’s stock rose 7.8%. On October 28, the day on which analysts’ reports and a news article revealing the impact of the one-time gain were published, the stock price fell approximately 6%.

The SEC found that the company violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder through the conduct of its CEO, CFO and Treasurer. The SEC concluded that the misleading impression created by the reference to the exclusion of the one-time charge and the undisclosed inclusion of the one-time gain were reinforced by the company’s announcement that its quarterly earnings exceeded analysts’ expectations. If the one-time gain had been excluded from the results as had the one-time charge, the SEC determined that the results would have failed to meet analysts’ expectations and that the difference was material. SEC Press Release, January 16, 2002.

The SEC staff has advised an investment banking firm (the “Company”) that it will not permit the Company to omit from its proxy materials a stockholder proposal relating to the independence of the Company’s securities analysts. Specifically, the proposal requests that the Company’s board of directors adopt, implement and enforce a code of conduct governing the independence of the Company’s securities analysts. The code would ban analyst’s ownership of covered securities, the involvement of analysts in underwriting sales teams and the linking of analyst’s compensation to the financial performance of the Company’s investment banking business. The Company sought to omit the proposal pursuant to Rule 14a-8(i)(7) under the Securities Exchange Act of 1934 (the “1934 Act”), which permits the exclusion of proposals which relate to the ordinary business operations of a company, and pursuant to Rule 14a-8(i)(3) under the 1934 Act, which permits the exclusion of materially false or misleading statements in proxy solicitation materials. The proposal was submitted by the AFL-CIO Reserve Fund.

The Company argued to the SEC staff that the stockholder proposal dealt with matters that were fundamentally related to the ordinary business of the Company and was thus excludable under Rule 14a-8(i)(7). The Company stated that the adoption of a code of conduct would constrain management decisions regarding the compensation of employees and further explained that employee security ownership and trading policies are integral to the operation of a global investment banking and securities firm. The Company argued that inflexible policies could adversely affect management’s ability to attract and retain highly qualified personnel. The Company also argued that this was an issue that was too complex for stockholders to render an informed judgment on. The Company stated that it did not believe the proposal raised a significant social policy. Finally, the Company argued that it believed that several of the stockholder’s statements in its supporting statement were misleading and that the stockholder’s proposal was thus excludable under Rule 14a-8(i)(3).

The SEC staff advised the Company that the proposal could not be excluded under the ordinary business exception. The staff noted that there is widespread debate concerning analyst independence and increasing recognition that this issue raises significant policy issues. The staff also stated that the Company could not exclude the entire proposal as false and misleading if the stockholder corrected the misstatements in its supporting statement. Goldman Sachs Group, Inc., SEC No-Action Letter (January 15, 2002).

The SEC censured an accounting firm for engaging in improper professional conduct because it purported to serve as an independent accounting firm for an audit client at the same time that it made substantial financial investments in the client. The SEC found that, from May through December 2000, the firm held a substantial investment in a U.S. registered money market fund which was part of a larger family of mutual funds. According to the SEC’s order, the accounting firm initially invested $25 million in the fund on May 5, 2000, and at one point the firm owned shares representing 15% of the fund’s net assets. The auditing firm audited the financial statements of the fund at a time when the auditing firm’s independence was impaired. The fund family included the auditing firm’s report in 16 separate filings it made with the SEC on November 9, 2000. The SEC further found that the auditing firm confirmed its independence from the funds it audited, including the money market fund, during the period in which the auditing firm was invested in the fund.

The SEC also found that the firm:

• had no procedures directing its treasury department personnel to check the firm’s “restricted entry list” to confirm that a proposed investment was not restricted;
• had no specific policies or procedures requiring any participation by a firm partner in the investigation and selection of money market investments; and
• had no policies or procedures designed to put the firm’s audit professionals on notice of where the firm’s cash was invested, requiring them to check a listing of the firm’s investments, prior to accepting new audit engagements or confirming the firm’s independence from audit clients.

Steven M. Cutler, the SEC’s Director of Enforcement, stated that the SEC’s decision to censure the accounting firm reflected the seriousness with which the SEC treats violations of the auditor independence rules, even in the absence of demonstrated investor harm or deliberate misconduct. In addition to censuring the firm, the SEC ordered the firm to undertake certain remedies designed to prevent and detect future independence violations caused by financial relationships with, and investments in, the firm’s audit clients. SEC Press Release, January 14, 2002.

The Division of Corporate Finance of the SEC (the “Division”) has advised a company that it may not omit from its proxy materials a stockholder proposal recommending the adoption of a policy to prohibit the company’s independent accountants from providing non-audit services to the company. The stockholder, a U.S. registered S&P 500 index fund, submitted the proposal to the company, citing the new proxy statement rules that require companies to disclose how much they pay their accounting firms for both audit and non-audit services. The stockholder argued that the results of that disclosure have been startling, with a majority of the Fortune 500 companies reporting in a survey that they paid nearly three times more for non-audit services than the amount they paid in audit fees. The stockholder stated that it believed it would be in stockholders’ best interests if the company’s board adopts a policy that any firm appointed as the company’s independent accountants may provide only audit services and no other services to the company.

The company, in a letter to the Commission seeking to omit the proposal, argued that the stockholder proposal related to the selection of the company’s independent accountants, including the criteria used in the engagement, and may be omitted from proxy statements because these matters relate to the company’s ordinary business. The company also stated that its independent accountants provide a number of services in addition to their core auditing functions. The company explained that its decisions to engage its accounting firm for non-auditing services must satisfy two conditions:

• the accountant firm’s expertise and knowledge of the company will provide assurance of high quality results, and
• the engagement is consistent with maintaining auditor independence.

The company noted that the decisions are regularly reviewed by the company’s audit committee. The company also noted that it has internal control procedures to ensure that its audits are conducted in an objective and impartial manner. The Division noted that the wide-spread debate over the impact of non-audit services on auditor independence has created a significant policy issue that goes beyond ordinary business. The Division advised the company that it may not omit the stockholder proposal. Walt Disney Co., SEC no-action letter (December 18, 2001).

The Department of the Treasury (“Treasury”) has issued two new rule proposals to implement provisions of the recently enacted Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (the “USA Patriot Act”) governing

• broker-dealer suspicious activity reporting; and
• correspondent accounts for foreign banks, including a prohibition on correspond account for all foreign shell banks.

• is conducted or attempted by, at or through a broker-dealer;
• involves or aggregates funds or other assets of at least $5,000; and
• is either (a) a transaction involving a known or suspected federal criminal violation committed or attempted against or through a broker-dealer, or (b) is a transaction that the broker-dealer knows, suspects or has reason to suspect:

• involves funds derived from an illegal activity or intended or conducted in order to hide or disguise funds or assets derived from illegal activity;
• designed, whether through structure or other means, to evade the requirements of the Bank Secrecy Act; or
• appears to serve no business or apparent lawful purpose, for which the broker-dealer knows of no reasonable explanation for examining the available facts relating to the transaction and the parties.

The notice of proposed rulemaking indicates that a determination as to whether a report is required must be based on all the facts and circumstances related to the transaction and customer of the broker-dealer in question. The proposed rule would provide two exceptions from the reporting requirements. First, lost, stolen, missing or counterfeit securities would continue to be reported under the requirements of Rule 17f-1 under the 1934 Act. Second, possible violations of the federal securities laws or self-regulatory organization (“SRO”) rules by the broker-dealer or any officer, director or employee or other registered representative generally would be excepted from the suspicious activity reporting requirements if it is reported to the SEC or SRO.

Under the proposal, reports of suspicious transactions would have to be made within 30 days after the broker-dealer becomes aware of the transaction. The reports would be made on Form SAR-BD. These broker-dealer suspicious activity reports would be maintained by FinCEN in an automated database. Broker-dealers would be required to maintain copies of the form and supporting documentation for five years after the filing of the Form SAR-BD. Financial institutions and their representatives are prohibited from notifying any person involved in the suspicious transaction that the transaction has been reported. The proposed rule contains a safe harbor that protects a broker-dealer and any representative that makes a report from liability to any person who is subject of the report, and for failure to disclose the fact of such reporting. Comments on the proposed rule must be filed with FinCEN by March 1, 2002.

Handling of correspondent accounts of foreign banks. The Treasury Department has also issued a proposed rule to implement Sections 313(a) and 319(b) of the USA Patriot Act that prohibit certain financial institutions, including broker-dealers, from providing correspondent accounts to foreign shell banks and requires financial institutions to take reasonable steps to ensure the correspondent accounts provided to foreign banks are not being used indirectly to provide banking services to foreign shell banks. The proposed rule defines “foreign shell bank” as a foreign bank without a physical presence in any country. Physical presence means a place of business that is maintained by a foreign bank and is located at a fixed address, other than solely a post office box or an electronic address, in a country in which the foreign bank is authorized to conduct banking activities. The foreign bank must, at the fixed address, (i) employ one or more individuals on a full-time basis, (ii) maintain operating records related to its banking activities, and (iii) be subject to inspection by the banking authority that licensed that bank to conduct banking activities. Correspondent accounts may be used to facilitate money laundering, terrorist financing, or other criminal transactions, and may be used to disguise the nature, location, source, ownership, or control of the proceeds of unlawful activity.

The proposed rule requires certain financial institutions that provide correspondent accounts to foreign banks to maintain records of the ownership of such foreign banks and of their agents in the United States designated for service of legal process, and require the termination of correspondent accounts of foreign banks that fail to turn over their account records in response to a lawful request of the Treasury Secretary or the U.S. Attorney General. The proposed rule defines the term “correspondent account” with respect to broker-dealer accounts to cover any account the broker-dealer provides in the U.S. to a foreign bank that permits the foreign bank to engage in securities transactions, fund transfers, or other financial transactions through that account.

• To comply with the proposed rule, the financial institution must ensure that each foreign bank to which it provides a correspondent account is not a shell bank, and take reasonable steps to ensure that correspondent accounts provided to the foreign bank are not being used to indirectly provide banking services to foreign shell banks. The proposed rule does not prescribe the manner in which a covered financial institution must satisfy these obligations. However, it does provide a safe harbor if a covered financial institution uses the model certifications provided as appendices to the proposed rule. A covered financial institution must retain the original of any document provided by a foreign bank, and the original or a copy of any document relied upon by the financial institution for purposes of the proposed rule for at least five years after the institution no longer maintains any account for the foreign bank. Comments on the proposed rule are due by February 11, 2002.

 

In response to a SEC concept release issued in November 2001 seeking comment on various issues relating to regulatory oversight of actively managed exchange created funds (“ETFs”), the Investment Company Institute (“ICI”) filed a comment letter with the SEC. In the letter, the ICI identified three areas in which actively managed ETFs may raise investor protection concerns not present with existing ETFs. Currently, the SEC has only permitted the registration of passively managed ETFs which track the performance of equity market indices. The SEC has received applications for ETFs that would track the performance of fixed income indices and has begun to receive applications for actively managed ETFs. In its release, the SEC noted that receiving public comment on the issues this product raises would assist the SEC in determining the appropriate means by which to regulate this product in a manner consistent with the protection of investors while balancing its goal of not stifling new and innovative investment products.

The ICI has identified three particular areas in which actively managed ETFs may raise investor protection concerns not present with the existing passively managed ETFs. The ICI noted that there may be additional issues that would warrant further comment once it is clearer how the funds will be structured and operated.

Portfolio holdings disclosure – For a variety of reasons, including logistical burdens and increased trading costs associated with disclosing portfolio holdings on a real-time basis, it is likely that all or part of the portfolio of an actively managed ETF will not be publicly disclosed. As a result, the ETF may be unable to maintain a market value that tracks net asset value (“NAV”). To avoid this problem, the ETF might seek to selectively disclose its portfolio holdings, such as to creation unit holders but not to retail investors. The ICI argued that such selective disclosure would, when made to allow a shareholder to trade on a basis of it, be fundamentally at odds with the core principles of the federal securities laws. Accordingly, the ICI urged the SEC not to grant exemptive relief to any actively managed ETF that would selectively disclose information about the fund’s portfolio holdings. The ICI suggested that, at the very least, any such relief should be conditioned upon the fund providing to investors clear and prominent disclosure that highlights the risk that the fund’s shares may not trade a prices close to NAV and identifies the difference between these funds, passively managed ETFs, and traditional mutual funds.