A review of the responsibilities for investment companies and their investment advisers under the Sarbanes-Oxley Act. 

http://www.wilmerhale.com/files/Publication/cf116631-e42e-4242-a009-f4c918a16a19/Presentation/PublicationAttachment/919d6f0b-12bc-4898-8f9e-956cfd03d449/Sarbanes_Oxley_SpecialReport.pdf

The SEC imposed sanctions and a cease-and-desist order against a registered investment adviser and its president for causing clients to pay unnecessary execution costs and failing to seek best execution. Best execution generally refers to an investment adviser's obligation to seek to execute securities transactions for clients on terms that are the most favorable to the client under the circumstances. The SEC found that the adviser and its president failed to seek best execution because they engaged in an undisclosed trading practice that caused certain clients to pay unnecessary execution costs. According to the findings of the SEC’s order, the undisclosed trading practice involved cross trades between client accounts. Specifically, the adviser would buy securities in the open market, allocate the shares to a first group of clients, and shortly thereafter sell some of the shares from the first group to a second group of clients in a cross trade. The adviser would determine the price of the cross trade and the commissions paid to effect the trade, and always chose a crossing price that was higher than the initial purchase price paid by the first group of clients. As a result, the second group of clients that purchased in the cross trades paid higher execution costs for their shares than the first group that purchased from the open market. From 1997 through 1999, the second group of clients paid approximately $310,000 in higher prices and commissions than if such clients had acquired the shares at the same per share cost as the first group. In addition to a cease and desist order, a civil penalty and reimbursement of client costs, the adviser agreed to retain an independent consultant to conduct a compliance audit of its policies and procedures for detecting and preventing securities law violations.

The SEC proposed a new rule and rule amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) that would address an investment adviser’s fiduciary obligation to clients who have given the adviser authority to vote their proxies. The proposed rule would require certain advisers to adopt and implement procedures for voting proxies, describe those procedures to their clients, and disclose how clients may obtain information about how the adviser has voted proxies. The SEC is also proposing amendments to rule 204-2 under the Advisers Act to require advisers to keep certain records regarding their proxy votes on behalf of clients.

Under the proposed rule, it would be a violation of the antifraud provisions of the Advisers Act for an investment adviser to exercise voting authority with respect to client securities, unless the adviser has adopted and implements written policies and procedures that are reasonably designed to ensure that the adviser votes proxies in the best interest of its clients, the adviser discloses to clients how they may obtain information on how the adviser voted their proxies, and the adviser has disclosed its proxy voting procedures to its clients.

Written Policies and Procedures. Although most advisers’ proxy voting policies include a number of common elements, the SEC is not proposing to specify the procedures or policies that advisers must adopt. As proposed, the rule would require that the proxy voting policies and procedures:

• be in writing;
• describe how the adviser addresses material conflicts between its interests and those of its clients with respect to proxy voting;
• address how the adviser resolves those conflicts in the best interest of clients.

In addition, the SEC believes that effective proxy voting policies and procedures of an adviser should identify personnel responsible for monitoring corporate actions, describe the basis on which decisions are made to vote proxies, and identify personnel (or groups) involved in making voting decisions and those responsible for ensuring that proxies are submitted in a timely manner. The extent to which the adviser relies on the advice of third parties or delegates to committees should also ordinarily be covered by the policies. The scope of the policies and procedures will turn on the nature of the adviser’s advisory business, the types of securities portfolios it manages, and the extent to which clients, such as registered investment companies, have adopted their own procedures. The SEC stated, however, that procedures that “merely declare that all proxies will be voted in the best interests of clients” would not be sufficient to meet the requirement of the proposed rule.

The proposed rule would also require advisers to

• disclose to clients how they can obtain information from the adviser on how the adviser voted their proxies. Unlike the SEC’s investment company proposals, however, the proposed rule would not prescribe the nature, format, or scope of the information that must be disclosed; and
• describe their proxy voting policies and procedures to clients and, upon request, furnish a copy of the policies and procedures to clients.

Advisers Subject to the Rule. The rule would apply to only to advisers that are registered with the SEC and have voting authority with respect to client securities. Advisers whose clients retain voting authority would not be required to adopt procedures or policies and would not be required to make any disclosures to clients under the rule. The rule would therefore not apply if an adviser provides a client with advice only as to how the client should vote a proxy. However, the Advisers Act’s general anti-fraud provisions would continue to apply, requiring the adviser to disclose any market conflict that it may have to the client receiving the advice.

The SEC proposed amendments to certain rules and forms to require mutual funds to disclose how they vote proxies relating to portfolio securities they hold. At present, mutual funds are not required to disclose either their proxy voting policies and procedures or their proxy voting records. Under the proposed amendments, a fund would be required to disclose in its Statement of Additional Information the policies and procedures that it uses to determine how to vote proxies relating to securities held in its portfolio, including:

• procedures that a fund uses when a vote presents a conflict between (1) the interests of fund shareholders and (2) those of the fund’s investment adviser, principal underwriter, or any affiliated person of the fund, its investment adviser, or principal underwriter, and
• any policies or procedures of the fund’s investment adviser, or any other third party, that the fund uses, or that are used on the fund’s behalf, to determine how to vote proxies relating to portfolio securities.

The SEC is also proposing to require each fund to

• file its complete proxy voting record as part of its report on proposed Form N-CSR;
• make both its proxy voting record and proxy voting policies and procedures available to its shareholders upon request, on its website and on the SEC’s website; and
• disclose in its annual and semi-annual reports to shareholders proxy votes (or failures to vote) that are inconsistent with the fund’s proxy voting policies and procedures and the reasons why the fund voted, or failed to vote, in a manner inconsistent with its proxy voting policies and procedures.

Comments must be received on or before December 6, 2002.

On October 22, the SEC proposed rules implementing Sections 404, 406 and 407 of the Sarbanes-Oxley Act. The proposed rules would require disclosure of information about internal control reports, company codes of ethics and audit committee financial experts. A discussion of the application of the proposed rules to registered investment companies will be included in Hale and Dorr’s comprehensive Special Report on the application of Sarbanes-Oxley to investment companies, which will be circulated to our Investment Management Group Industry News Summary readers this week.

In remarks to reporters following his speech at a conference on investment management regulation in Washington sponsored by the American Law Institute-American Bar Association, Paul Roye, director of the SEC’s Division of Investment Management, said October 17, 2002 that the SEC’s investigation into hedge fund practices, begun in May, is about halfway finished, and includes scrutiny of registered funds of hedge funds. Mr. Roye noted that a registered fund of hedge funds essentially opens up hedge fund investment to the average person – for example, someone who can afford to invest $50,000. Roye noted that they have appeared in the past year and grown steadily in number to about 20 funds. The funds are closed end funds and are not listed on an exchange, but they still have to compute their net asset value per share (NAV). Most funds of hedge funds are offered as private placements, and not to the public.

Mr. Roye declined to say when the investigation will be concluded, remarking only, “There’s a lot going on.” One issue being examined is whether the fact that hedge funds are largely unregulated creates a regulatory arbitrage or disparity with mutual funds, which are regulated. This includes looking for fraud and conflicts of interest in hedge fund management, Mr. Roye said. SEC officials have stated that regulation of hedge funds beyond the SEC’s existing antifraud jurisdiction will be considered if investors are being injured. He noted that the SEC staff is concerned about disclosure and suitability issues. In addition, a key area of concern is in the valuation of the hedge fund holdings of the fund, particularly in light of a conflict of interest on the part of hedge fund managers. If the underlying hedge fund has, like a mutual fund, invested in listed securities and other investments that are definitively valued, the staff is less worried, according to Mr. Roye. If, however, the hedge fund holds derivatives and other assets that are not as easily valued, questions may arise.

Although the independent audit serves as one control on the valuation of the underlying hedge fund, Roye suggested that the staff of the SEC believes that the manager of a fund of hedge funds cannot “blindly trust” the manager of the underlying hedge fund with regard to what the hedge fund is worth. “We think they have a duty to dig deeper,” he emphasized, indicating that this is one point on which the investigation has focused.

Speaking on a October 17, 2002 panel on enforcement and compliance at an investment management regulation conference in Washington sponsored by the American Law Institute-American Bar Association, Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), stated that OCIE is modifying its approach to examinations of investment companies and investment advisers by focusing on firms’ compliance systems the office. The change shifts the staff’s inspection, or exam, activities away from test checking, which has been used primarily until now, Mr. Gohlke said. It also entails more frequent inspections and the use of more SEC staff, which, Mr. Gohlke said, the agency will be able to afford with new monies authorized by the Sarbanes-Oxley Act. Instead of a five-year exam cycle for advisers and funds, those firms will be inspected a minimum of every four years, but often as frequently as every two years, depending on how good their risk management and compliance systems are, Mr. Gohlke related.

In the past five years, according to Mr. Gohlke, OCIE has conducted 6,915 exams of investment advisers and 1,323 exams of fund complexes. This means that every adviser and fund complex in existence since Oct. 1, 1997, was inspected within the five-year cycle ending Sept. 30, 2002. Under the new regime for exams, Gohlke said, OCIE is changing how it selects firms for inspection and what is done during inspection. Firms will be inspected more or less frequently, Mr. Gohlke explained, depending on their assets under management, the complexity of their organizational structure, the presence of risk factors in their operations, and the quality of their internal controls and compliance processes. OCIE has broken down investment management firms into three groups for purposes of determining the frequency of inspections.

• In the first group are the 100 largest investment adviser firms. The top 20 will be examined every two years, while the remaining 80 firms will be on a cycle of between two and four years. Inspections will be conducted every two years for firms that have lower quality risk management and compliance systems.
• In the second group are the remaining 7,600 investment advisers. These firms will also be on a cycle of between two and four years, depending on control procedures, the extent to which they have custody of client assets, and whether there is side-by-side management of a private investment pool along with a registered fund, for example.
• Finally, in the case of newly registered advisers and newly formed fund families, OCIE hopes to conduct an initial inspection within the first 12 months.

Under the new scheme of inspections, Mr. Gohlke said, no firm would remain uninspected for more than a four-year period, and “quite a few firms would be inspected every two to three years.” During inspections, each firm will be given a chance to make its case that its control systems are effective and that problems are found and corrected quickly. The inspections staff will want to see compliance manuals, but manuals will not suffice, he said. While the staff will not specify specific documents that it wishes to see, it is looking for documents that demonstrate the effectiveness of the compliance systems. These documents would include exception reports, compliance work papers, compliance check lists, and reconciliation papers. What is desired by the staff is not “blank report formats,” Mr. Gohlke explained, but the output of the compliance system. He noted that these records are not required to be kept under the SEC’s rules, but that if the firm does not keep them, it will be deemed “high risk” and will be subject to inspections every two years.

The way in which OCIE seeks documents, Mr. Gohlke said, is that it sends out document request lists identifying documents that show what compliance mechanisms are in place for best execution, allocation of initial public offerings, personal trading, and other activities. Mr. Gohlke added that OCIE’s request informs firms that if their controls are “not good,” then other documents will have to be provided to the staff, including quarterly reports, for example. 

On September 19, 2002, the U.S. District Court for the District of Maryland ruled that a registered closed end fund bylaw requiring a majority of shares outstanding to elect a director is invalid under Maryland law. As a result of the court’s ruling, two insurgent director candidates who received a majority of the votes cast at the annual stockholders meeting – but not a majority vote of all the outstanding shares – must be seated on the board.

The bylaw at issue provides that “‘[d]irectors shall be elected by vote of the holders of a majority of the shares outstanding and entitled to vote thereon.’” The plaintiff together with other stockholder interests controlled or advised by the same individual (the “Stockholder”) had acquired 30.6 percent of the outstanding shares of the fund. The fund held its annual meeting last August. “The meeting was preceded by a vigorous proxy contest between management and [the Stockholder],” the court recounted. One of the items on the agenda was the election of two directors. Management supported one slate, whereas the Stockholder supported a different slate. Each nominee on the Stockholder’s slate received approximately 58.84% of the votes cast, which constituted only 47.3% of the outstanding shares. Therefore, the court noted that if the fund’s bylaw requiring a director to be elected by a majority of the shares “outstanding and entitled to vote thereon” is valid, the Stockholder’s slate did not win seats on the Board. The court, however, found that the bylaw is invalid under Maryland law, and therefore entered a judgment requiring the fund to seat the Stockholder’s nominees as directors.
In reaching its decision, the court noted that section 2-506(a)(2) of the Maryland General Corporation Law provides that “[u]nless this article or the charter of a corporation provides otherwise, at a meeting of stockholders ... [a] majority of all the votes cast at a meeting at which a quorum is present is sufficient to approve any matter which properly comes before the meeting.” It was not disputed that a quorum was present at the fund’s stockholders meeting, that the election of directors was properly before the meeting, and that the fund’s charter does not require a vote greater than “a majority of all the votes cast” for the election of directors. Therefore, unless the Maryland Law itself provides otherwise, the fund’s bylaw provision is invalid.

Although the court noted that the fund’s argument “is not without superficial appeal,” it determined that the legislative background makes clear that a corporation can establish a supermajority vote requirement for the election of directors only by charter provision.