An SEC administrative law judge recently issued an initial decision that a registered investment adviser and a principal of the adviser violated the antifraud provisions of the federal securities laws. The adviser violated its fiduciary duty to its clients by urging them to

• invest in securities issued by the adviser's parent without disclosing that the parent was in perilous financial condition; and
• move their accounts to a broker-dealer with whom the principal was going to be affiliated, without disclosing a conflict of interest stemming from a commission sharing arrangement.

According to the decision, the principal caused and aided and abetted these violations, as well as the adviser's violations of regulations under Section 204 of the Advisers Act that require the adviser to keep its registration current and to maintain specific financial and business records. The investment adviser was ordered to disgorge $95,000 with prejudgment interest and ordered to pay a civil penalty of $150,000; the principal was ordered to pay a civil penalty of $15,000, was ordered to cease and desist from violating the securities laws, and was barred from association with a broker, dealer or investment adviser. The parties have twenty-one days to file for SEC review of the initial decision. In the Matter of Feeley and Willcox Asset Management Corporation, Initial Decision No. 165; File No. 3-9571.

The SEC recently announced the filing of securities fraud and other charges in the U. S. District Court for the District of Columbia against four individuals arising out of their management of two investment advisory firms. The SEC's complaint alleges that the defendants

• defrauded their investment advisory clients by failing to disclose their switch from a conservative investment approach to a high-risk strategy involving short-selling of high-technology stocks;
• failed to disclose that, contrary to express representations, they were paid commissions on trades;
• arbitrarily assigned baseless values to client accounts;
• mailed false account statements to clients that contained baseless account values; and
• unfairly favored certain clients over others in distributions.

In addition, the defendants allegedly prepared and distributed a brochure entitled "Investing in the Nineties At a Glance," which misrepresented that they were engaged in a conservative investment strategy, and included false historical performance data. The complaint also alleges that the defendants sold unregistered securities to their clients in the form of the adviser's in-house managed investment funds.

Without admitting or denying the SEC's allegations, the defendants consented to the entry of permanent injunctions against future violations, and also agreed to additional sanctions to be entered in a related SEC administrative proceeding. In addition to injunctions entered by the federal court, the defendants agreed to sanctions to be entered in a SEC administrative proceeding. SEC v. James L. Foster, et al., Civil Action No. 1:00CV01192, D.C.D.C. (LR-16567)

In a report transmitted to the SEC on May 16, 2000, the ICAA urged the SEC to require that advisers adopt code of ethics procedures reasonably designed to prevent "pay-to-play" abuses, rather than the strict liability standard proposed by the SEC in August 1999 (see Industry News Summary, week of 8/2/99 to 8/9/99). The ICAA defines "pay-to-play" to mean political contributions by investment advisers made for the purpose of obtaining or retaining advisory contracts with government entities (such as public pension funds).

In its report titled "Pay-to Play and the Investment Advisory Profession," the ICAA advised the SEC to:

• require every federally-registered investment adviser to adopt a code of ethics; and
• require investment advisers generally to adopt policies and procedures reasonably designed to prevent pay-to-play abuses.

The report also enumerated the ICAA's industry "best practices," which include an overall prohibition against pay-to-play procedures. Industry critics of the SEC's proposed rule have argued that rule imposed on the municipal securities industry (upon which the SEC's proposed rule is based) is not appropriate to apply to the investment adviser industry and have questioned the constitutionality of the proposed rule. BNA Securities Regulation and Law Report, Volume 32, No. 20, May 22, 2000.

The Security and Exchange Commission (SEC) recently held a roundtable on investment adviser regulatory issues, including a panel on technology and investment adviser regulation. At the roundtable, the ICI submitted a paper titled "Investment Advisory Services in the Internet Age - Ensuring Investor Protection." Recognizing that the Internet is growing in importance as a medium by which the average investor obtains investment advice, the ICI's paper describes how technology may affect the manner in which investment advice is provided to investors and raises questions concerning the possible implications of these changes for federal oversight of investment advisers and the various advisory services they provide. In the paper, the ICI urges the SEC to re-evaluate the current regulatory framework for investment advisers, including the Investment Advisers Act of 1940 (the "Advisers Act) in light of technological advances and the proliferation of investment advice provided through the Internet.

Review of online advisory services. The ICI notes that the Advisers Act became law in a paper-based environment, and at a time when the scope of services provided by investment advisers generally were narrower and more personalized. In the current environment, the spectrum of investment advisory services provided through the Internet are very broad, ranging from generic to highly personalized: educational materials, online "newsletters," bulletin boards, research, financial models, computerized investment advice (including so-called "neural networks"), personalized services that may be supplemented with periodic telephone consultations and portals that provide investment advice plus direct access to any number of advisory and/or broker/dealer services.

The ICI notes that the availability on the Internet of these and other types of investment advisory services has the potential to offer many advantages to investors, including instantaneous access to investment advice, lower costs, improved efficiency and reduced paperwork. Nevertheless, the ICI states that the proliferation of investment advisory services through the Internet (and the ease with which such advice may be offered online) also have increased the potential for precisely the types of abuses that the Advisers Act was designed to address, including fraudulent practices such as scalping or front-running. Moreover, investors have little means to distinguish legitimate sites from those of advisers attempting to engage in fraud or misconduct. Accordingly, the ICI calls for a comprehensive review of online services that would enable the SEC to determine the extent of abuses through Internet advisory services and whether additional statutory authority (and/or other prophylactic measures) are needed to address investor protection concerns.

Evaluation of current advisory scheme. The ICI also states that the SEC should consider whether the application of the definition of "investment adviser" is clear in the context of online services. For example, the ICI notes that it is unclear whether the publisher's exclusion from the definition of investment adviser applies to online services (e.g., under what circumstances a subscription-based Internet service is a publication of "general and regular circulation"). The ICI suggests that the SEC may wish to consider whether it should, by rule or interpretation, provide further guidance as to its views on how online services may or may not come within the current definition. In particular, the ICI questions the adequacy of the current interpretations of when an individual entity is providing "advice" or receiving "compensation." The ICI also suggests that the SEC consider whether the scope of the Advisers Act should be broadened to allow the SEC, for example, to impose disclosure requirements on some advisers that are currently only subject to antifraud provisions of the Advisers Act.

Rule 3a-4 under the Investment Company Act of 1940 (the "1940 Act"). The ICI also urges the SEC to reassess the Rule 3a-4 safe harbor from registration under the 1940 Act for certain discretionary investment advisory programs. The ICI questions whether, in light of technological advances, including the ability of advisers to market these programs over the Internet, the safe harbor is still serving the objective of ensuring individualized treatment and regulatory oversight. The ICI is concerned that the minimum account size for these programs may no longer significantly more than those for most mutual funds, and that a greater number of smaller investors may be participating. Consequently, the ICI raises the question of whether some or all aspects of mutual fund regulation (or other independent regulatory oversight) would be appropriate in the case of investment advisory programs that are widely marketed to retail investors.

Investment Advisory Services in the Internet Age - Ensuring Investor Protection, Investment Company Institute, presented at Roundtable on Investment Adviser Regulatory Issues, Technology and Investment Adviser Regulation, May 23, 2000.

The SEC recently submitted an amicus brief which supported the theory that investment companies as well as individual shareholders have an implied private right of action for breach of fiduciary duty under section 36(a) of the 1940 Act. Section 36(a) authorizes the SEC to bring an action in federal district court alleging that a person serving in certain capacities for an investment company has breached a fiduciary duty to the investment company. The SEC argued that breach of fiduciary duty claims brought by the plaintiff shareholder against the investment advisers and directors of three closed-end funds were derivative of claims belonging to the closed-end funds themselves.

The plaintiff, a shareholder in the three closed-end funds, contended that shares in the funds traded at substantial discounts to the funds' net asset values. The plaintiff argued that the fund directors and investment advisers failed to take "any meaningful steps" to reduce the discount. These steps, the shareholder charged, could have included "open-ending the funds, engaging in substantial share repurchase programs, making tender offers for outstanding stock, converting to an interval fund and/or merging with an open-end fund."

The shareholder brought suit in federal district court, alleging a breach of fiduciary duty under section 36(a) of the 1940 Act. The district court, applying the law of Maryland, held that the claims asserted were derivative of claims of the companies, rather than direct claims of the shareholder. Therefore, the court said, the shareholder should have made demand on the funds' directors before bringing suit. Since the plaintiff failed to do so and failed to show that demand would be futile, the district court dismissed the claims. On appeal, the shareholder argued, among other matters, that she brought her claims directly, not derivatively, and that there is no implied private right of action under section 36(a) that could be asserted by the funds themselves.

The SEC, in its brief, did not express any view about whether under state law, the plaintiff's claims were properly characterized as derivative. It addressed only the question of whether an investment company itself, and not just its shareholders, has an implied private right of action under section 36(a). The SEC asserted that, in making its ruling, the district court "assumed" that investment companies have an implied private right of action under section 36(a), "since otherwise the claims here could not be derivative." The SEC then argued that, based on this decision, there is such a private right of action for investment companies.

The SEC argued that the appeals court had previously recognized that section 36(a) can be asserted derivatively and that the court "necessarily recognized that investment companies can sue under the statute." The SEC also contended that the statutory role of independent directors, recognized by the U.S. Supreme Court in Burks v. Lasker, could not be fulfilled unless an investment company has an implied right of action to assert claims under section 36(a). The SEC pointed out the significant role of independent directors in safeguarding shareholders' interests. The SEC also argued that, in view of the SEC's current initiatives to strengthen the role of independent directors, it would be "anomalous" to argue that fund directors do not have the right to initiate a lawsuit under section 36(a) on behalf of the investment company for which they serve as directors. Securities Regulation and Law Report, May 22, 2000.

Paul Roye, the director of the SEC's Division of Investment Management, recently discussed the SEC's current regulatory agenda at two separate industry conferences. Mr. Roye remarked that the SEC intends to pursue the initiatives to improve fund governance, enhance disclosure and modernize the regulatory structure.

Fund governance reforms. Mr. Roye commented on the status of the SEC's proposed rules designed to enhance the effectiveness of fund directors. He remarked that the SEC will likely scale back its proposal requiring disclosures about directors' family members. However, he reiterated the SEC's recommendation that independent counsel be provided for directors, remarking that this was one of the "strongest pieces" of the proposal.

Internet "incubator" companies. Mr. Roye commented on the recent rise in the number of internet holding companies. He noted that these companies posed a challenge to SEC staff in determining whether they should be regulated as investment companies under the Investment Company Act of 1940 (the "1940 Act"). Section 3(a)(1)(C) of the 1940 Act defines as an investment company any company with at least 40% of its assets in investment securities (which excludes U.S. government securities and securities issued by majority owned subsidiaries). Mr. Roye noted that application of this test is difficult because it is highly factual in nature and the factual circumstances involving internet holding companies are novel and different. Several internet holding companies have sought exemptive relief under Section 3(b)(2) of the 1940 Act which excepts from the definition of "investment company" those companies that the SEC declares to be "primarily engaged" in a business other than investing, reinvesting, owning or holding securities. In particular, Mr. Roye noted that the staff is exploring guidelines for determining whether a company is "primarily engaged" in a business other than that of an investment company.

Proposed privacy rules. Mr. Roye noted that the SEC will adopt proposed Regulation S-P, which would implement the provisions of the Gramm-Leach-Bliley Act protecting the privacy of personal financial information, in a matter of days. The new rules will require brokers, dealers, investment companies and registered investment advisers to disclose their policies on protecting personal information and to inform customers how they can opt out of having the information shared with unaffiliated third parties. (For more detailed information on the SEC's proposed rule, see the Industry News Summary for the week of 2/28/00 - 3/6/00).

Proposed amendments to rule 10f-3. Mr. Roye commented that the SEC plans to propose amendments to rule 10f-3 under the 1940 Act. Rule 10f-3 permits a fund to buy securities from an affiliated underwriting or selling syndicate. He noted that the SEC would propose amendments expanding the rule to cover purchases of government securities issued by government agencies or government sponsored enterprises such as the Federal National Mortgage Association.

Cross-border transactions. Mr. Roye noted that the SEC will likely adopt a rule to permit Canadian nationals who reside in the U.S. and hold certain tax-deferred retirement accounts in Canada to manage their investments by purchasing and selling foreign securities in those accounts. The new rule will permit Canadian funds to offer and sell securities to U.S. resident participants without having to register as investment companies under the 1940 Act.

Variable annuity sales. Mr. Roye noted that the SEC has recently focused on the suitability of "bonus" transactions offered in connection with the sale of variable annuities. In particular, he reported that the SEC will issue an investor brochure cautioning investors that these bonus programs may have higher expenses that ultimately outweigh the benefits of the bonus credit.

Mr. Roye also noted that the SEC plans to propose amendments to rule 17a-8 under the 1940 Act regarding fund mergers and revisions to Form N-6 for variable life insurance products.

At another industry conference, Mr. Roye also commented on other SEC initiatives:

Fund performance. Mr. Roye noted that the SEC considered performance advertising "a high priority." He also noted that SEC had recently settled a case in which the SEC alleged advertisements for a mutual fund failed to disclose that the fund's strong gains over a period of time were due to the fund's investment in "hot" initial public offerings. (See the Industry News Summary for the week of 5/8/00 - 5/15/00). Mr. Roye reported that the SEC is currently investigating other fund advertisements and that the SEC's examination staff is reviewing fund advertising for accuracy.

Fund fees. Mr. Roye reported that the SEC and the General Accounting Office will separately issue reports regarding fund fees some time in the summer. Mr. Roye noted that while the SEC "has no interest" in setting industry fees, it will issue guidance on redemption fees. Specifically, the SEC will reiterate its longstanding view that funds should not charge redemption fees exceeding 2% of assets. Mr. Roye noted that the SEC realizes that funds have legitimate reasons to impose redemption fees to discourage "hot" money from flowing into and out of funds, but that the SEC considers a redemption fee of 1% to be adequate to curb these flows.

Annual delivery of prospectuses. Mr. Roye noted that the SEC will consider abandoning a requirement that fund companies provide an annual copy of the prospectus to shareholders. He noted that while investors would still receive a prospectus when they initially invest in a fund, the SEC may consider a proposal which would allow fund to mail the shorter profile prospectus as the annual update. SEC Today, May 22, 2000 and Wall Street Journal, May 22, 2000.

On May 16, 2000, NASDR announced a settlement in which it censured and fined a mutual fund distributor and NASD member $100,000 for distributing allegedly inaccurate mutual fund advertisements and for violating other NASD advertising rules. NASDR found that, from April through September 1997, the firm published eight advertisements containing inaccurate graphs showing the performance of a mutual fund. The graphs depicted the performance of a hypothetical $10,000 investment in the fund. NASDR found that the ads did not accurately portray increases and decreases in the value of the investment.

Despite being cautioned by NASDR not to use the ads because of the errors, the firm continued to use them. NASDR noted that several ads showed dollar values along the vertical axis that did not correspond to actual performance over time. NASDR found that some ads purportedly depicted the performance of a $10,000 hypothetical investment since the fund's inception as approximately $29,000 in the graph, when in fact it was $22,000. NASDR also found that, when the firm updated several of its performance ads, it continued to use the erroneous graph lines rather than re-draw and re-plot them.

NASDR alleged that the firm also published an advertisement in March 1997 which contained a straight line sloping upward from the lower left to the upper right of the advertisement. At the beginning of the line, the advertisement stated, "you are here," and at the top of the line, "your future is here." NASDR found that the advertisement violated its advertising rules because it failed to convey the risks of fluctuating prices inherent in investing.

In addition, NASDR also found that the firm used advertisements and sales literature without first obtaining registered principal approval and failed to properly file items with NASD Regulation's Advertising/Investment Companies Regulation Department. As part of its settlement with NASDR, the firm agreed to a fine and a censure, and has undertaken to file in advance with NASDR for a period of six months all advertisements depicting performance information through the use of graphs, bar charts, or pie charts. NASDR Press Release, May 16, 2000.

On May 10, 2000, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency and the Office of Thrift Supervision approved an interagency final rule to protect consumers' financial privacy. The final rule implements provisions of the Gramm-Leach-Bliley Act, which requires financial institutions to adopt rules concerning the notice requirements and restrictions on the institution's ability to disclose nonpublic personal information to unaffiliated third parties. (For similar proposed rules by the SEC, see the Industry News Summary for the week of 2/28/00 - 3/6/00). The privacy rules for banking institutions will be effective as of November 13, 2000 but compliance will be voluntary until July 1, 2001.

The privacy provisions of the new law require financial institutions annually to disclose their privacy policies and give consumers the right to opt out of allowing their financial institution to disclose information about them to non-affiliated third parties. Under the final rule, information is categorized as "publicly available" and excluded from the definition of "nonpublic personal information" if a financial institution "reasonably believes that the information is lawfully made available to the general public" from certain public sources. Each banking regulator included sample clauses for the appropriate disclosure form in the final rule.

Under the final rule, the financial institution must provide initial notice no later than when a customer relationship is established. The final rule permits a financial institution to deliver the initial privacy notice to one party in a joint account instead of to both. The final rule also permits the financial institution to provide only one opt out notice to holders of a joint account, but requires the institution to be prepared to honor an opt out notice filed by either account holder.

Finally, the final rule permits financial institutions to send annual notices once every 12 months, not necessarily on a customer's anniversary date. Under the final rule, the institution may define the 12 consecutive month period. Securities Regulation and Law Report Vol. 32, No. 19, May 15, 2000.

A mutual fund firm agreed to pay almost $3 million to settle charges that the firm misled investors about the performance of one of its mutual funds. The SEC accused the firm of misallocating "hot" initial public offerings ("IPOs") to inflate the first-year returns of one of its funds, a growth stock fund, advertising these returns in a misleading way and failing to properly supervise the personal trading of the fund's manager.

During the fund's first year, the SEC found that the portfolio manager allocated more IPO investments to the fund than to other funds he managed for the firm. The SEC noted that the fund's prospectus disclosed that investments in initial public offerings would be allocated equitably among the firm's family of funds. The SEC found that the firm failed to properly review the IPO allocations to assess whether their overall effect was to favor one fund over others under the portfolio manager's supervision.

The SEC claimed that these allocations of "hot" IPOs had a large impact on the fund's performance and that the firm failed to disclose the impact even though it was "questionable" whether the firm could replicate this performance as the fund grew larger. The New York Attorney General also found that the fund failed to disclose that the fund had purchased numerous positions in risky, micro-capitalization securities.

The SEC also charged that the manager created a potential conflict of interest between the manager and the funds he managed when he purchased securities of companies for the fund after purchasing shares of the companies for himself. The SEC claimed that the fund's investments might have made his own holdings more valuable. The SEC found the firm failed to take appropriate steps to prevent violations of the firm's code of ethics relating to this potential conflict of interest.

As part of the settlement, the firm will pay $950,000 to the SEC and will contribute $1.6 million toward investor education programs at the State University of New York. The firm will also pay $400,000 to cover the cost of the New York Attorney General's investigation. The SEC fined the portfolio manager $50,000 and barred him from working for any investment adviser for nine months. Also as part of the settlement, the firm agreed to retain an independent consultant to conduct a comprehensive review of its policies regarding allocating IPO investments and detecting conflicts of interest among its portfolio managers. Securities Regulation and Law Report, Vol. 32, No. 19, May 15, 2000.

Arthur Levitt, chairman of the SEC, delivered an address on the importance of safeguarding the independence of the accounting profession. In his address, Mr. Levitt announced the following initiatives:

• proposed SEC rulemaking to clarify activities that may be improper for an independent auditor of financial statements to perform for audit clients;
• support for a plan by the profession's independent overseer, the Public Oversight Board, to enhance its powers and responsibilities; and
• a self-evaluation by each of the major accounting firms of past compliance with the SEC's and the profession's financial investment rules and each firm's system of internal controls for monitoring those investments.

Mr. Levitt announced that the SEC will propose rules to address the conflicts created by the accounting profession's increased consulting and other non-audit work for its public company audit clients. He noted that the proposed rules will also examine conflicts caused by affiliations with other business and strategic alliances. The SEC will consider the following questions when drafting the proposed rules:

• What, if any, are the appropriate limits on the types of services an audit firm can render to a client?
• How should audit firms be structured to assure independence?
• What, if any, are the consequences of public ownership of an audit firm or an affiliate?
• Should audit firms be permitted to affiliate with entities that provide to the firms' audit clients services that the firms themselves would not be allowed to provide?

The SEC will consider whether the rules should establish general principles, require disclosure or clearly define appropriate services to address potential conflicts.

Mr. Levitt noted that the SEC intends to work with the Independence Standards Board to modernize current financial investment rules which prohibit investment by firm professionals in an audit client. He also noted that the SEC intends to issue rule changes by this summer regarding mutual fund investments, family relationships and dual income families. SEC Press Release, May 10, 2000.

The SEC brought an action against two broker dealer representatives for alleged fraud and misrepresentation in a scheme involving switching large mutual fund accounts from one type of fund to another. The SEC accused the representatives of moving client accounts in and out of Class B shares of funds as part of a market timing investment method, misrepresenting the reasons for the actions and failing to disclose commission credits.

In its initial decision, the ALJ found that the representatives failed to disclose that large investments in Class A shares entitled investors to breakpoint discounts and that comparable discounts on sales charges were not available for large investments in Class B shares.

The ALJ wrote that the "core fraud" perpetrated by the representatives was the manner in which the respondents marketed their asset allocation strategies and mutual fund timing programs. The ALJ found that the representatives did not fully explain to prospective investors how breakpoints on Class A shares and CDSCs on Class B shares could affect the recommended asset allocation and timing programs. The ALJ rejected the representatives' argument that delivery of a prospectus was legally sufficient disclosure of material facts addressed in the prospectus. The ALJ noted that required material disclosure was not the prospectuses and that the representatives should have provided this disclosure to their clients.

The ALJ found that the representatives had devised a scheme to avoid detection by fund groups that monitor market timers and shareholders that make large purchases and redemptions of shares. The ALJ noted that while the act of switching is not illegal, the representatives had an obligation to disclose the scheme, especially to the extent that the activity may have been unnecessary.

The ALJ found that the SEC failed to prevail on several elements of its case against the representatives. For instance, the ALJ found that the SEC failed to present sufficient evidence to prove that the respondents had an implied obligation under the Investment Advisers Act of 1940 to disclose that there were larger commission credits associated with one type of share purchase over another. The ALJ also held that the respondents had no obligation to disclose exact commission credits.

The ALJ did conclude, however, that both representatives misled clients by failing to properly disclose breakpoint advantages and the back-end costs associated with investments in Class B shares. The ALJ determined that if the Class A-share breakpoint had been properly explained to the clients, the clients may have chosen to buy a class of shares.

The ALJ issued a cease and desist order, imposed a civil penalty, and suspended the respondents for three and six months, respectively, from association with a broker or dealer. SEC Initial Decision Release No. 160; Administrative Proceeding File No. 3-9784.

In remarks at an industry conference for investment advisers, Lori Richards, Director of OCIE, advised investment advisers on the elements of an effective compliance system. Ms. Richards also announced the SEC's release of an open letter to investment advisers describing compliance problems discovered during recent examinations (see the Industry News Summary for the week of 4/24/00-5/1/00).

Ms. Richards recommended that investment advisers:

• provide adequate supervision of all advisory personnel;
• empower all levels of staff with respect to each staff member's role in the compliance system;
• provide compliance policies in writing;
• regularly assess the adequacy of compliance policies;
• review exceptions to written policies;
• document all exceptions including, if applicable, any special review and approval by compliance staff;
• take advantage of technology to improve compliance and efficiency;
• pay special attention to areas of business that generate revenue and focus on "high flying" portfolio managers;
• review the advisory firm's procedures in light of high profile enforcement cases;
• view incidents in the aggregate versus individually for patterns that warrant further scrutiny; and
• generously provide for adequate skilled compliance staff to comprehensively cover all operational areas.

The SEC Today, May 2, 2000.

The SEC has adopted amendments to existing rules and forms in connection with the next stage of modernization of the SEC's EDGAR system.

Beginning May 30, 2000, EDGAR will include the following new features:

The ability to include graphic and image files in HTML documents;the ability to use hyperlinks in HTML documents, including links between documents within a submission and to previously filed documents on the SEC’s EDGAR database at www.sec.gov; and the addition of the Internet as an available means of transmitting filings to the EDGAR system.

The SEC also removed the requirement for filers to submit Financial Data Schedules, effective January 1, 2001. The SEC has also removed diskettes as an available means of transmitting filings to the EDGAR system, effective July 10, 2000. All other rule changes are effective May 30, 2000. SEC Release Nos. 33-7855, 34-42712, 35-27172, 39-2384 and IC-24400; April 25, 2000.

The staff of the SEC's Office of Compliance Inspections and Examinations ("OCIE") sent a letter to registered investment advisers summarizing violations of the Investment Advisers Act of 1940 (the "Advisers Act") found by OCIE staff during examinations of investment advisers. In its letter, OCIE staff grouped its findings into the following categories:

Duty to disclose. OCIE staff reminded advisers of their obligation to disclose any facts that might cause the adviser to render advice that is not disinterested. OCIE staff cited the following examples of failures to disclose material information to clients:

failure to disclose all fees that a client would pay in connection with the advisory contract, including how fees are charged, and whether fees are negotiable; failure to disclose an affiliation with a broker-dealer or other securities professionals or issuers; and if an adviser has discretionary assets under management, failure to disclose that it is in a precarious financial condition that is likely to impair its ability to meet contractual commitments to clients.

Trade allocations. Examples of how an adviser can defraud clients by allocating trades inequitably among clients include:

disproportionate allocation of hot initial public offerings ("IPOs") to favored accounts, and inadequate disclosure of the practice to all clients; delayed allocation of a trade among its clients' accounts based on subsequent market movements; and failure to use the average price paid when allocating securities to accounts participating in bunched trades and failure to adequately disclose the adviser's allocation policy.

Advertising representations to clients. The Advisers Act prohibits advisers from making misleading statements or omitting material facts in connection with conducting an investment advisory business. OCIE cited the following as examples of false advertising or other misrepresentations to clients found during examinations:

• the use of testimonials, which include any statement of a client's experience with the adviser or a client's endorsement of the adviser;
• a representation or implication that the adviser has been sponsored, recommended or approved, or that the SEC has passed upon its abilities or qualifications in any respect. The staff has also taken the position that the use of the initials R.I.A. ("Registered Investment Adviser") following a name on printed materials is misleading because it suggests that the person to whom it refers has a level of professional competence, education, or other special training;
• a reference to past specific profitable recommendations made by the adviser, if the advertisement does not set out a list of all recommendations made by the adviser within the preceding period of not less than one year;
• a representation that any graph, chart, formula or other device can, in and of itself, be used to determine which securities to buy or sell, or when to buy or sell such securities, or can assist persons in making those decisions if the advertisement does not also prominently disclose the limitations and the difficulties regarding its use;
• a representation that a report, analysis or other service was provided without charge, if the report, analysis, or other service was provided with some obligation.

Performance claims. Examples of performance claims that may be fraudulent include:

• inaccurately stating that the presentation complies with the Performance Presentation Standards of the Association of Investment Management and Research;
• creating distorted performance results by constructing composites that include only selected profitable accounts or selected profitable periods;
• comparing the adviser's performance to inappropriate indices;
• representing or implying that model performance is actual performance;
• failing to deduct the adviser's fees from performance calculations without disclosure;
• representing falsely the adviser's total assets under management, credentials, or length of time in business; or
• incorporating a predecessor adviser's performance into the adviser's advertised performance returns in a misleading or otherwise inappropriate manner.

Personal trading. Examples of advisers' abusive personal trading activities prohibited by the Advisers Act include:

• trading in securities for personal accounts, or for accounts of family members or affiliates, shortly before trading the same securities for clients (i.e., front-running), and thereby receiving better prices; and
• directing clients to trade in securities in which the adviser has an undisclosed interest, causing the value of those securities to increase to the adviser's benefit.

Advisory agreements. The SEC stressed that advisers should review investment advisory agreements to ensure that they operate in conformity with representations made in investment advisory contracts. Examples of when an adviser would be cited for failure to fulfill a contractual obligation include:

• calculating advisory fees differently than the methodology agreed to in the contracts;
• failing to comply with clients' wishes about directed brokerage arrangements; and
• causing clients to invest in securities that are inconsistent with the level of risk that clients have agreed to assume.

Referral arrangements. OCIE noted that during an examination of an adviser that pays a cash fee for client referrals or solicitations, the staff will confirm that the adviser maintains required records of these arrangements, including copies of: the written agreements between the adviser and the referring party; the referring party's written disclosure documents; and all clients' acknowledgments of receipt of written disclosure documents from the adviser and the referring party (which must be signed and dated). Also, the examination staff will confirm how the adviser ascertained whether the referring parties have complied with their contractual obligations.

Use of brokerage. The OCIE staff believes that the following actions violate the Advisers Act:

• allocation of client brokerage to a broker in exchange for client referrals without full disclosure of the practice, or the fact that clients pay higher brokerage commissions and do not obtain the best price and execution; and
• allocation of client brokerage to a broker in exchange for research or other products without disclosure.

Custody or possession of client assets. OCIE staff identified certain practices that constitute custody under the Advisers Act even though the adviser may not have physical possession of client assets. For example, an adviser has custody if it:

• has a general power of attorney over a client's account;
• has signatory power over a client's checking account;
• maintains an omnibus-type account in its own name at a broker or bank in which client securities are maintained after trades settle;
• obtains its advisory fees by directly billing client custodians without effective oversight by the client or an independent party;
  serves as a trustee of client trusts; or
• acts as the general partner of a limited partnership client.

Inadequate internal control and supervisory procedures. OCIE also encouraged advisers to institute and monitor internal control and supervisory procedures. OCIE cautioned against the following types of weaknesses in internal controls:

• operating procedures which permit a portfolio manager to value the securities recommended, or override values provided by a custodian, for purposes of reporting to clients and calculating advisory fees without any independent review;
• establishing comprehensive written control procedures, without properly monitoring business activities for compliance with these procedures; and
• failing to institute an oversight process, other than that performed by the portfolio manager responsible for managing an account, to determine whether risks taken in managing client portfolios are consistent with each client's stated investment objectives and/or to measure and evaluate each client's risk tolerance.

SEC Letter to Registered Investment Advisers, May 1, 2000.

The SEC adopted new rule 17f-7 under the Investment Company Act of 1940 (the "1940 Act") and amendments to rule 17f-5, the rule governing the custody of the assets of investment companies with custodians outside the United States. The new rule and rule amendments permit funds to maintain their assets in foreign securities depositories based on conditions that reflect the operations and role of these depositories.

The rule and amendments:

establish basic standards for foreign depositories that funds may use, generally require that a fund's contract with its global custodian obligate the custodian to analyze and monitor the custody risks of using a depository, and require that a fund's contract with its global custodian obligate the custodian to provide information about the risks to the fund or its adviser, as well as any information regarding material changes in the risks.

Unlike amended rule 17f-5, rule 17f-7 does not permit delegation of authority under the rule. The fund or its adviser must make the decision to maintain fund assets with a depository, based upon information provided by the global custodian.

The SEC extensively revised rule 17f-5 in 1997 to expand the types of foreign banks and securities depositories that may serve as custodians of fund assets and require that the selection of a foreign custodian be based on whether the fund's assets will be subject to reasonable care if maintained with that custodian. In 1998, the SEC suspended the compliance date for most of the amendments. Representatives of funds and bank custodians then submitted a proposal to further amend rule 17f-5 to change the standards by which foreign depositories are evaluated. Last year, the SEC proposed amendments to rule 17f-5 and a new rule 17f-7.

New rule 17f-7 permits a fund to maintain assets with a foreign securities depository if the depository is an "eligible securities depository." An eligible securities depository must act as or operate a system for the central handling of securities that is regulated by a foreign financial regulatory authority. In addition, an eligible securities depository must:

hold assets on behalf of the fund under safekeeping conditions no less favorable than those that apply to other participants; maintain records that identify the assets of participants, and keep its own assets separated from the assets of participants; provide periodic reports to participants; and undergo periodic examination by regulatory authorities or independent accountants.

Rule 17f-7 requires that a fund's primary custodian furnish the fund or its investment adviser an analysis of the custody risks of using an eligible securities depository before the fund places its assets with the depository. The rule does not identify specific factors to be considered in analyzing risks. The release adopting the rule states that the SEC expects the risk analysis to cover a depository's expertise and market reputation, the quality of its services, its financial strength, any insurance or indemnification arrangements, the extent and quality of regulation and independent examination of the depository, its standing in published ratings, its internal controls and other procedures for safeguarding investments, and any related legal protections. Under proposed rule 17f-7, the SEC would have permitted a fund to rely on indemnification or insurance that adequately protects the fund from all custody risks of using the depository, as an alternative to the risk analysis and monitoring requirement. However, under rule 17f-7 as adopted, insurance and indemnification arrangements are merely factors that a risk analysis would cover.

The fund's contract with its primary custodian also must require the custodian to monitor the custody risks of using an eligible securities depository on a continuing basis, and promptly notify the fund or its adviser of any material change. Rule 17f-7 requires the fund's contract with its primary custodian to provide that the primary custodian will agree to exercise reasonable care, prudence and diligence in performing its duties under the rule, or adhere to a higher standard of care.

Rule 17f-7 does not specifically assign a role to the fund's board. The decision whether to place fund assets with a depository should be made by the adviser (subject to oversight of the fund's board) or the fund, after consideration of the information provided by the primary custodian or its agent, and based on standards of care that are generally applicable to fund advisers and directors. The decision to place fund assets with a depository does not have to be made separately, but may be made in the overall context of the decision to invest in a particular country.

Amended rule 17f-5 will continue to govern a fund's use of foreign bank custodians. As amended, the rule excludes arrangements with foreign securities depositories from its scope because they are addressed by rule 17f-7. Amended rule 17f-5 clarifies that when a depository arrangement involves one or more foreign bank custodians through which assets are maintained with the depository, rule 17f-5 applies to the fund's or its custodian's use of each foreign bank subcustodian, while rule 17f-7 applies to the subcustodian's use of the depository itself.

New rule 17f-7 and the amendments to rule 17f-5 will be effective June 12, 2000. Compliance with the new rule and rule amendments is not required until July 2, 2001. In the interim, a fund may operate its foreign custody arrangements in accordance with the new rule and amendments or with the 1997 Amendments to rule 17f-5. Alternatively, it may comply with "old" rule 17f-5 as it existed before the 1997 Amendments (but subject to the definition of an eligible foreign custodian under the 1997 Amendments). SEC Release Nos. IC-24424, IS-1221; File No. S7-15-99; April 27, 2000.