On January 13th and 14th, the FCIC, a bipartisan panel Congress established to examine the causes of the financial crisis, held its first public hearings. The first day of hearings included three panels of witnesses who were leaders of major financial institutions, market participants and economists. The second day included two panels of federal, state and local officials, including Attorney General Eric Holder, FDIC Chairman Sheila Bair, SEC Chairman Schapiro, and President of the North American Securities Administrators Denise Voigt Crawford.

For a summary of the first day of hearings, please see:
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9359 

For copies of the written testimony and other information about the FCIC, please see:
http://www.fcic.gov/hearings/  
http://www.fcic.gov/  

On January 7th, the FDIC released a set of questions and answers seeking to clarify the types of private investors excluded from requirements for bidders for failing banks or thrifts that are outlined in the Final Statement of Policy on Qualifications for Failed Bank Acquisitions released on August 26, 2009.

For a summary of the questions and answers, please see:
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9242 

For the questions and answers, please see:
http://www.fdic.gov/regulations/laws/faqfbqual.html  

On January 13th, the Enforcement Division announced the creation of a new Office of Market Intelligence, which will be led by Thomas Sporkin and will be responsible for the collection, analysis, and monitoring of the tips, complaints, and referrals that the SEC receives. The Division also announced leaders of the five national units established to focus on particular specialized areas of securities law. Asset Management will focus on investment advisers, investment companies, hedge funds and private equity funds, and will be led by Bruce Karpati and Robert Kaplan. Market Abuse will focus on large-scale market abuses and complex manipulation schemes, and will be led by Daniel Hawke. Structured New Products will focus on complex derivatives and financial products, and will be led by Kenneth Lench. Foreign Corrupt Practices will focus on violations of the Foreign Corrupt Practices Act and will be led by Cheryl Scarboro. Municipal Securities and Public Pensions will focus on misconduct in the municipal securities market and in connection with public pension funds, and will be led by Elaine Greenberg. On January 4th, the SEC also announced that Carlo di Florio was named the Director of OCIE.

For more information, please see:
http://www.sec.gov/news/press/2010/2010-5.htm  
http://www.sec.gov/news/press/2010/2010-1.htm  

On January 11th, the staff of the Division of Trading and Markets extended prior no-action relief¹ permitting a broker-dealer to rely on an investment adviser’s performance of the broker-dealer’s customer identification program (CIP) obligations under 31 CFR 103.122. The rule requires broker-dealers to implement a CIP that includes procedures to verify the identities of customers, maintain related records, determine whether a customer appears on a terrorist list, and provide customers with notice that the broker-dealer will obtain information to verify their identities. A firm may rely on other financial institutions to perform any of these requirements if the firm’s customer also is a customer of the institution and, among other requirements, the institution is subject to an “AML Program Rule.” Under the terms of the rule, broker-dealers may not rely on registered investment advisers to perform CIP obligations because they are not subject to an AML Program Rule.²

With some modifications, the staff extended its prior no-action position for an additional 12 months. The staff will not recommend enforcement action under Exchange Act Rule 17a-8 if a broker-dealer treats an investment adviser as if the adviser was subject to an AML Program Rule provided that the other provisions of the CIP rule are met and: (1) reliance on the adviser is reasonable under the circumstances; (2) the adviser is registered with the SEC; (3) a contract between the adviser and broker-dealer requires the adviser to annually certify to the broker-dealer that it has implemented its own AML Program consistent with the requirements of 31 U.S.C. 5318(h); and (4) the adviser performs the specified requirements of the broker-dealer’s CIP. The staff modified the conditions to require SEC registration rather than registration with any functional regulator, and to require that the adviser’s AML Program be consistent with the requirements of 31 U.S.C. 5318(h).³ The no-action position will be withdrawn on January 10, 2011, without further action. A footnote also stated that if FinCEN re-proposes an AML Program rule for investment advisers before January 10, 2011, the staff will reconsider this position.

For a copy of the letters, please see:
http://www.sec.gov/divisions/marketreg/mr-noaction/2010/sifma011110.pdf  

¹In 2004, the staff stated that it would not recommend enforcement action if a broker-dealer treated a registered investment adviser as if it were subject to an “AML Program Rule” for purposes of the CIP rule. The letter stated that the position would be withdrawn in 2005 if advisers were not required to comply with an AML Program Rule. Because the SEC did not adopt such a rule, the staff granted similar relief in 2005, 2006 and 2008. The 2008 no-action position expired on January 12, 2010.
²FinCEN withdrew its proposed AML program rule for registered investment advisers.
⁴31 U.S.C. 5318(h) requires institutions to establish programs to guard against money laundering through financial institutions that include internal policies, procedures and controls; a compliance officer; ongoing employee training programs; and an independent audit to test the programs. The statute also permits the Secretary of the Treasury to prescribe minimum standards.

On January 11th, the SEC filed a complaint in a federal court in Florida charging two individuals with securities fraud in connection with their management of three hedge funds. The SEC alleged that from at least 2003 through January 2009, the fund managers misled fund investors by distributing offering materials, account statements and newsletters that significantly overstated the funds’ historical performance and asset values, which were allegedly based on false information provided by another investment adviser.¹ The SEC alleged that the managers recklessly relied on this information without auditing or examining the funds’ securities accounts, reviewing the funds’ monthly securities account statements, implementing policies or procedures to monitor the adviser’s control of the funds’ assets, or taking any other adequate measures to ensure the information was accurate. The SEC further alleged that the managers ignored several red flags, including the adviser’s threats that he would stop providing advice if the managers audited the funds and the adviser’s refusal to provide securities account statements to the managers’ accountant. Additionally, the SEC alleged that the managers misrepresented in the funds’ offering materials that they actively managed the funds’ investment and trading activities when the other investment adviser actually controlled these activities without the managers’ meaningful approval, supervision or oversight.
The SEC sought a permanent injunction, disgorgement of illegal gains, and civil money penalties for violating Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder, Section 17(a) of the Securities Act of 1933, and Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) and Rule 206(4)-8 thereunder. Without admitting or denying the allegations, the individuals consented to permanent injunctions against future securities fraud violations and a bar from associating with an investment adviser for five years.

For more information, please see:
http://www.sec.gov/news/press/2010/2010-4.htm  
http://www.sec.gov/litigation/complaints/2010/moody011110.pdf  

On January 13th, the SEC voted to publish for public comment a proposed rule regarding sponsored access and a concept release regarding market structure developments. The proposed rule would require broker-dealers with market access or that provide market access to others to establish pre-trade risk management controls and supervisory procedures, which would effectively prohibit broker-dealers from providing customers with “naked” or “unfiltered” access to an exchange or alternative trading system. The concept release requested comment on various market structure developments, including the U.S. market structure, high frequency trading, and non-displayed or dark liquidity.

For summaries of the releases, please see:
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9360  
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9372  
http://www.wilmerhale.com/files/upload/Securities_Alert_1_20_10.pdf  

For the concept release, please see:
http://www.sec.gov/rules/concept/2010/34-61358.pdf  

For the proposed rule release, please see:
http://www.sec.gov/rules/proposed/2010/34-61379.pdf  

On December 28th, the U.S. District Court for the Central District of California issued findings of fact and conclusions of law in a case concerning whether fees charged to a family of funds violated Section 36(b) of the Investment Company Act of 1940. The case is the most recent of only a handful of Section 36(b) cases tried to completion. The plaintiffs had alleged, among other things, that the investment advisory, 12b-1 and administrative services fees charged by the defendants were excessive.

The court concluded that the proper legal standard to be applied to the 36(b) claims is the Gartenberg standard, and rejected both the Jones and Gallus standards. To violate Section 36(b) under the Gartenberg standard, the adviser “must charge a fee so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arms-length bargaining.” In Jones, the Seventh Circuit had stated that “a fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation” and found that unless an adviser “pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services[,]” courts in the Seventh Circuit would be deferential to the advisory fee negotiated by independent trustees. In Gallus, the Eighth Circuit had concluded that the proper approach is to look “to both the adviser’s conduct during negotiation and the end result” and rejected the argument that “an adviser cannot be liable for breach of fiduciary duty as long as its fees are roughly in line with industry norms.” The court here found the plaintiffs failed to establish that the fees were disproportionate to services rendered and did not prove a breach of fiduciary duty with respect to fees. However, the court noted that the Gartenberg standard “establishes a very low threshold for the mutual fund companies and a very high hurdle for a plaintiff.”

While the court was satisfied that the independent directors had met their obligation under the Gartenberg standard, the court also found that the independent directors “did not diligently inquire into some issues of importance and failed to recognize the consequences of some of the information presented to them.” The court was critical of some of the information the adviser provided to the boards noting that the adviser never provided certain information such as data showing the compensation paid to the employees of the defendants.

For more information, please see: In re American Mutual Funds Fee Litigation, No. 04-5593 (C.D. Cal., Dec. 28, 2009).

On December 18th, an Administrative Law Judge (“ALJ”) issued an Initial Decision barring an individual who served as an unregistered adviser to a hedge fund and three individual accounts from association with any investment adviser. The ALJ found that from April 2003 through October 2005, the adviser secretly cherry-picked profitable trades for his personal account at the expense of his clients by purchasing securities throughout the day and delaying allocation to either his personal account or his clients’ accounts until the end of the day, when he knew whether they had appreciated in value. On July 24, 2009, the United States District Court for the Southern District of New York had enjoined the adviser from future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Advisers Act; ordered the adviser to disgorge $303,472, plus pre-judgment interest of $102,975; and ordered him to pay a $100,000 civil penalty.

For more information, please see:http://www.sec.gov/litigation/aljdec/2009/id392bpm.pdf  

On December 23rd, the SEC announced that an investment adviser and its principal have agreed to settle the SEC’s pending civil action against them. The complaint, filed in the United States District Court for the Southern District of Ohio on April 8, 2009, alleged that the principal misappropriated at least $2.3 million from two elderly clients between June 2000 and March 2009 through various means including forged and falsely notarized funds transfer instructions, and used those funds for her personal expenses and benefit.

Under the settlement, the principal and the firm admitted to the allegations in the complaint and consented to the entry of permanent injunctions against each of them based on their violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Advisers Act. The final judgment will also enjoin the firm from violating Section 204 of the Advisers Act and Rule 204-2 thereunder, and the adviser from aiding and abetting those violations. The proposed settlements are subject to the Court’s approval.

In a related criminal proceeding, on October 14, 2009, the United States District Court for the Southern District of Ohio sentenced the adviser to 66 months incarceration based upon her plea of guilty to criminal charges stemming from the same conduct alleged in the complaint. The court also ordered her to pay restitution in the amount of $2,663,681.44.

For more information, please see: http://www.sec.gov/litigation/litreleases/2009/lr21352.htm  

The staff of the Division of Investment Management has published frequently asked questions and answers about new disclosure requirements for registered investment companies under the recently adopted amendments. The FAQ provides guidance on how the effective date applies to the filing of proxy statements, registration statements and post-effective amendments.

Registration Statements and Post-Effective Amendments: According to the FAQ, any registration statement or post-effective amendment to a registration statement for an existing fund with a fiscal year end on or after December 20, 2009 must comply with the form amendments if filed on or after February 28, 2010.

If a fund’s fiscal year ends before December 20, 2009, the fund’s registration statements and post-effective amendments will not be required to be in compliance with the new disclosure requirements unless they are filed after the end of the fund’s 2010 fiscal year, even if filed on or after February 28, 2010.

Proxy Statements: Any proxy statement for an existing fund with a fiscal year end on or after December 20, 2009 must be in compliance with the new proxy disclosure requirements if filed on or after February 28, 2010. If the fund is required to file a preliminary proxy statement and expects to file its definitive proxy statement on or after February 28, 2010, then the preliminary proxy statement must be in compliance with the new proxy disclosure requirements, even if filed before February 28, 2010.

If a fund’s fiscal year ends before December 20, 2009, the fund’s proxy statements will not be required to be in compliance with the new disclosure requirements unless they are filed after the end of the fund’s 2010 fiscal year, even if filed on or after February 28, 2010.

Multiple Series: If an existing fund has multiple series, and the fiscal year of any series ends on or after December 20, 2009, any post-effective amendment to the fund’s existing registration statement must comply with the form amendments if the amendment is filed on or after February 28, 2010, and the amendment is filed to make changes that affect a series with a fiscal year that ends on or after December 20, 2009.

New Funds: If a new fund first files its registration statement on or after December 20, 2009, compliance with the amendments would be required for the registration statement to be declared effective on or after February 28, 2010.

If an existing fund adds a new series by filing a post-effective amendment on or after December 20, 2009, compliance with the amendments would be required for the registration statement to be declared effective or become effective automatically on or after February 28, 2010.

For more information, please see: http://sec.gov/divisions/investment/guidance/icproxydisclosuretransition.htm  

On December 23rd, the SEC adopted as final Rule 206(3)-3T under the Advisers Act, which provides relief to persons registered as both investment advisers and broker-dealers from providing transaction-by-transaction written notice and consent under Section 206(3) of the Advisers Act for principal trades executed with clients on a non-discretionary basis. The rule applies to many former fee-based brokerage accounts that transitioned to investment advisory accounts in light of the decision by the U.S. Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC. Rule 206(3)-3T will expire on December 31, 2010.

For more information, please see: http://www.sec.gov/rules/final/2009/ia-2965.pdf  

On December 30th, the SEC published final rule amendments to rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”) and an interpretive release providing guidance for independent public accountants about their engagements performed under the rule.

Surprise Exam Requirement: The amendments require registered advisers that have most forms of custody (themselves or through a related person) to undergo an annual surprise exam by an independent accountant. The SEC believes that the surprise exam requirement will deter fraud, and if a fraud does occur, the exam will increase the likelihood that the fraud is uncovered. The adopting release referred to recent enforcement cases where advisers misappropriated client assets that were maintained by an independent qualified custodian. 

Advisers that serve as trustee to a trust, have power of attorney or the ability to write checks on a client’s account are deemed to have a significant level of control over clients’ assets, even if the assets are held by an independent custodian. Such advisers - but not advisers that are deemed to have custody by their deduction of fees from client accounts - are required to undergo a surprise exam. The release explained that the broad access that trustees typically have to trust assets makes the protections of the surprise examination important for those clients.

If the accountant finds missing assets or material discrepancies during the surprise exam, it would be required to notify the SEC within one day. The accountant is also required to file a statement with the SEC upon resignation or dismissal. The SEC believes that it is important that the public have access to the termination statements, as disclosure of a termination could provide useful information to the clients and the staff. The termination statement should include an explanation of any problems but is not required to state a reason for the termination or resignation. The SEC did not define or provide examples for the term “problem.”

The SEC addressed commenters’ assertion that the surprise examinations would take longer than 120 days. Since the SEC’s interpretive release no longer requires accountants to verify all client assets and permits sampling, the SEC believes that 120 days will be sufficient for an accountant to complete the examination.

The amendments extend the surprise examination requirement to certain privately offered securities (which previously were excepted from all of the requirements of the custody rule). This change did not address concerns of commenters that it was unclear how the rule’s requirements should be applied to certain assets such as loans or swaps (which may not be securities at all) or to certain other assets that did not meet all elements of the rule’s definition of excepted privately placed securities. The SEC did not expand the custody rule to require accountants to test valuation as part of the surprise exam.

Internal Control Report: In addition to the surprise exam, if an adviser or a related person holds actual custody as a qualified custodian in connection with the adviser’s advisory services, the entity that serves as custodian must undergo an annual review of its internal controls. The review must be conducted by an independent accountant registered with Public Company Accounting Oversight Board (“PCAOB”). The internal control report need not extend to the adviser’s or a related person’s custody of assets (such as certain privately placed securities or non-securities) that are not required to be held by a qualified custodian. The SEC stated that a Type II SAS 70 report or an AT Section 601 Compliance Attestation would be sufficient to satisfy the requirement of an internal control report.

Affiliated Custodians Operationally Independent of Advisers: The surprise exam is not required (but an internal control report is still required) if assets are held by a related person that is operationally independent of the adviser (the exam is required in all cases if the adviser itself hold actual custody as a qualified custodian). The conditions for being operationally independent are that: client assets are not subject to the claims of the adviser’s creditors; advisory personnel have no access to client assets; personnel of the two firms are not under common supervision; and advisory personnel do not hold any position with the related person or share premises with the related person. Unlike the similar test under the old Crocker no-action letter, the test for operational independence is satisfied only if all of the criteria are met. Advisers relying on the operational independence exception are required to make and keep a memorandum describing the relationship with the related person, and the basis for determining that it has overcome the presumption that it is not operationally independent of the related person. The “operationally independent” test appears to be unavailable in circumstances similar to those in the Madoff Ponzi scheme; thus, the adopting release emphasized in a footnote that the SEC would not consider a related person “that shared management persons” with the adviser to be operationally independent.

Delivery of Account Statements: The amendments require that registered advisers reasonably believe that the client’s custodian delivers the account statements directly to the client, and do not allow account statements to be delivered by the adviser. The amended rule requires that an adviser’s reasonable belief must be formed by the adviser after due inquiry. The SEC did not prescribe a single method for forming this belief. For example, an adviser may form a reasonable belief after due inquiry if the custodian provides the adviser with a copy of the account statement that was delivered to the client.
The amendments require advisers to include a legend in the notice sent to clients when a custodial account is opened on their behalf, and when there are changes to the information required in that notification. The legend should urge clients to compare the account statements they receive from the custodian with those they receive from the adviser. The legend must be included only if the adviser elects to send its own account statements to clients.

Independent Custodians: The SEC did not require the use of fully independent custodians, as it was concerned that such a requirement could make unavailable advisory accounts for smaller investors maintained by the adviser or its affiliated brokerage firm or bank. However, the SEC encouraged the use of independent custodians as a best practice.

Pooled Investment Vehicles: An adviser need not separately comply with the surprise exam requirement with respect to assets of a pooled investment vehicle that is audited by a PCAOB registered accountant and provides its audited GAAP financials to all investors. The amendments added the requirement of an independent public accountant registered with, and subject to regular inspection by, the PCAOB because the SEC has greater confidence in the quality of such audits.

The amendments add specific rules for the situation when the investors in a pooled investment vehicle are themselves pooled vehicles that are related persons of the adviser. For example, the SEC was concerned about the meaningful application of the custody rule in situations where all of the investors in a pooled investment vehicle are special purpose vehicles (“SPVs”), which are themselves pooled investment vehicles that are related persons of the adviser. In such situations, a literal application of the rule would result in statements being sent to the adviser itself. Accordingly, the SEC stated in the adopting release that advisers to a pooled investment vehicle that use SPVs should send financial statements to the underlying beneficial owners rather than the SPVs. Alternatively, the assets of the SPVs could be treated as assets of the investing pooled vehicle and covered by the pooled vehicle’s financial statement audit or surprise exam.

Compliance Policies and Procedures: The SEC recommended that the advisers with custody of client assets consider instituting policies and procedures to prevent misappropriation or misuse of assets. It stated that such policies and procedures could include: conducting background and credit checks on employees; requiring authorization of more than one employee before the movement of assets; limiting the number of employees who interact with custodians; requiring that any problems be brought to the immediate attention of the management of the adviser; and periodic testing by the CCO of the effectiveness of the firm’s controls. Although the final amendments do not require surprise exams of assets managed by advisers with the ability to deduct fees, the SEC remained concerned about the risk that advisers might collect excessive or otherwise inaccurate fees and provided guidance about the steps that should be part of an adviser’s compliance policies and procedures to ensure accurate computation of fees.

Form ADV Amendments: The SEC is requiring advisers to report all related persons who are broker-dealers in Item 7 and Section 7.A of Schedule D of Form ADV. Note that there is no requirement to report all related persons who are banks. Advisers that have found a related person to be operationally independent must report this finding in Section 7.A of Schedule D.

The SEC has added an instruction to Item 9 clarifying that an adviser must separately report the amount of assets of which it has custody. The SEC also revised an existing instruction to Item 9.A to specify that, in addition to advisers that have custody only because they have authority to deduct fees, advisers that have custody because an operationally independent related person maintains client assets may also answer “no” to Item 9.A.

Dates: The rule will be effective on March 12, 2010. An investment adviser required to undergo a surprise exam must do so by December 31, 2010. Advisers that become subject to the rule after March 12, 2010 must undergo a surprise exam within six months of becoming subject to the requirement. An adviser also required to obtain an internal control report must do so within six months of becoming subject to the requirement. SEC-registered advisers must provide responses to the revised Form ADV in their first annual amendment after January 1, 2011.

Interpretive Release

At the same time, the Commission also issued an interpretive release, providing guidance about the responsibilities of accountants in performing surprise exams and preparing internal control reports. The interpretive release in part replaces the previous guidance from 1966, which was universally regarded as outdated.

Independent Verification of Funds and Securities: According to the interpretive release, to independently verify that client funds and securities are held properly, independent public accountants should obtain records of accounts that detail funds and securities of which the adviser has custody and the identification of the qualified custodian of those funds and securities, as well as records of accounts that were closed during the period or have a zero balance. Of key importance, the interpretive release suggests a sampling approach for verification in place of the prior accounting guidance’s requirement to verify all client assets. Accountants should obtain records or transactions in each selected client’s account occurring since the date of the last examination. Accountants’ procedures should include confirmation of funds and securities with the qualified custodian and the client, and reconciliation of confirmations received and other evidence obtained to the adviser’s records. For privately offered securities, the accountant’s verification procedures should include confirmation with the issuer of, or counterparty to, the security. Where confirmation replies are not received, the accountant should perform alternative procedures.

Internal Control Report: The internal control report should address control objectives and associated controls related to the areas of client account setup and maintenance, authorization and processing of client transactions, and client reporting. Control objectives should also include a reconciliation of funds and securities to depositories and other unaffiliated custodians by means of either direct confirmation on a test basis with the unaffiliated custodian, or other procedures to verify that the data used in reconciliations by the qualified custodian is unaltered.

Note that the amended rule and the requirements of Regulation S-X for auditor independence do not preclude the accountant that performs the surprise exam from also preparing the internal control report. The SEC noted that accountants preparing an internal control report may rely on their own relevant audit work previously performed for other purposes, including for purposes of complying with requirements under the Securities Exchange Act of 1934.

For more information, please see: http://sec.gov/rules/final/2009/ia-2968.pdf and http://sec.gov/rules/interp/2009/ia-2969.pdf