The SEC amended Form N-4, the registration form for insurance company separate accounts that are registered as unit investment trusts and offer variable annuity contracts. The amendments revise the fee table to require disclosure of the range of total expenses for all of the mutual funds offered through the separate account, rather than separate disclosure of the expenses of each fund, as Form N-4 currently requires. Registrants may continue to include disclosure of the fees and expenses for each mutual fund in the fee table, in addition to the required disclosure of the range of expenses.

The amendments to the fee table of Form N-4 require, among other things:

• disclosure of the range of total expenses of each mutual fund offered through the separate account. As adopted, however, the amendments would not require a range for each category of expenses, as was originally proposed. The amendments require inclusion of a statement referring investors to the mutual fund prospectuses for more information concerning fees and expenses;
• disclosure of the maximum fees that may be charged by any of the mutual funds offered through the separate account;
• disclosure of operating expenses before expense reimbursement and fee waiver arrangements (expenses after reimbursement or waiver could be disclosed in a footnote);
• that the expense example be based on the maximum expenses charged by any mutual fund offered through the separate account. Registrants also would be permitted to provide an additional example, based on the minimum expenses charged by any of the mutual funds. Alternatively, registrants would be permitted to include expense examples for each of the mutual funds;
• a modification of the calculation of the annual contract fees in the expense example, including both general account and separate account assets (rather than just separate account assets) in the denominator for purposes of calculating annual contract fees on a percentage basis;
• a narrative preceding the expense example to clarify that expenses reflected in the example include separate account fees and charges, as well as maximum expenses charged by any of the mutual funds offered through the contract;
• disclosure of all recurring fees and charges, including fees and charges for all optional features, regardless of whether any of these features are mutually exclusive. Registrants may, however, indicate through a footnote that charges for certain features shown in the fee table are mutually exclusive.

In addition, the SEC is adopting conforming amendments to the fee table of Form N-6, the registration form for variable life insurance policies, to be consistent with the amendments to the fee table for Form N-4. The effective date of these amendments is December 23, 2002. All new registration statements and annual update post-effective amendments filed on or after January 1, 2003, must comply with these amendments. The final compliance date for filing amendments is January 1, 2004. A registrant may, at its option, comply with the requirements of these amendments to Forms N-4 and N-6 at any time after the effective date. SEC Release No. 33-8147; IC-25802; File No. S7-07-02 (November 13, 2002)

On October 25, 2002, the Treasury issued an interim final rule that defers the application of Section 352 of the Patriot Act to certain financial institutions pending further study. Section 352 of the Patriot Act requires all financial institutions, as defined by the Bank Secrecy Act, to establish an anti-money laundering (“AML”) program. On April 29, 2002, the Treasury issued a series of interim final rules implementing Section 352 of the Patriot Act by prescribing AML programs for certain financial institutions, including mutual funds. The Treasury, however, temporarily deferred, until October 24, 2002, the application of Section 352 to all other financial institutions, including closed-end investment companies, unit investment trusts, and unregistered investment companies. For these financial institutions, compliance with Section 352 is not required until the Treasury completes its study of their industries and issues final rules applicable to them, which are expected within the next few months. The temporary deferrals do not relieve any business from any existing obligation to report transactions in cash or currency, or certain monetary instruments, that exceed $10,000. Department of Treasury, 31 CFR Part 103.

Separately, in a press release issued on October 11, 2002, the Treasury advised all financial institutions that they will not be required to comply with Section 326 of the Patriot Act or the proposed rules issued by the Treasury on July 23, 2002 until final implementing regulations are issued and become effective. Section 326 of the Patriot Act directs the Treasury to issue regulations requiring financial institutions to establish minimum procedures for the identification and verification of customers who open new accounts. The final rules will provide financial institutions with a reasonable amount of time in which to achieve compliance. However, financial institutions are reminded that they must continue to comply with any existing obligation to guard against money laundering and the financing of terrorism through adequate customer identification procedures. The press release noted that financial institutions should already be taking steps to ensure appropriate customer identification. Department of the Treasury, Press Release PO-3530 (October 11, 2002).

The SEC recently proposed a rule pursuant to the Sarbanes-Oxley Act of 2002 (the “Act”) that would prescribe standards of conduct for attorneys of issuers of securities (including mutual funds). Section 307 of the Act requires the SEC to prescribe minimum standards of professional conduct for attorneys appearing and practicing before the SEC in any way in the representation of issuers. The standards must include a rule requiring an attorney to report evidence of a material violation of securities laws or breach of fiduciary duty or similar violation by the company or any agent thereof to the chief legal counsel or the chief executive officer (“CEO”) of the company (or the equivalent). If the recipient of the attorney’s report does not respond appropriately to the evidence, the attorney is required to report the evidence to the company’s audit committee, another committee of independent directors, or the full board of directors. The proposed rule is designed to implement this directive and is intended to protect investors and increase their confidence in public companies by ensuring that attorneys who work for those companies do not ignore evidence of material misconduct.

The proposed rule’s reporting obligation is triggered only when an attorney becomes aware of information that would lead a reasonable attorney to believe a material violation has occurred, is occurring, or is about to occur. The attorney is initially directed to make this report to the issuer’s chief legal officer (“CLO”), or to the CLO and CEO. Absent exigent circumstances, the attorney is also obligated to take reasonable steps to document his or her reports, as well as any response received from the CLO or CEO and retain the documentation for a reasonable time. The proposed rule obligates the issuer’s CLO, when presented with a report of a possible material violation, to conduct a reasonable inquiry to determine whether the reported material violation has occurred, is occurring, or is about to occur. A CLO must notify the reporting attorney of the CLO’s conclusion and take reasonable steps to ensure that the issuer adopts appropriate remedial measures and/or sanctions, including appropriate disclosures. Furthermore, the CLO is required to report “up the ladder” within the issuer what remedial measures have been adopted or sanction imposed and to advise the reporting attorney of his or her conclusions.

The reporting attorney who receives an appropriate response within a reasonable time and has taken reasonable steps to document his or her report and the response to it has satisfied his or her obligations under the rule. If a reporting attorney does not receive an appropriate response within a reasonable time, he or she must report the evidence of a material violation to the issuer’s audit committee, or (if the issuer does not have an audit committee) to another committee or independent directors, or (if the issuer does not have such a committee) to the full board. The proposed rule would also provide an alternative system for reporting evidence of material violations, if established, to an issuer’s qualified legal compliance committee.

Under the proposed rule, outside attorneys who have made a report, have not received an appropriate response and reasonably believe that the reported material violation is ongoing or is about to occur and is likely to result in substantial injury to the financial interest of the issuer or of investors must withdraw from the representation, notify the SEC of their withdrawal, and disaffirm any submission to the SEC that they have participated in preparing which is tainted by the violation. In-house attorneys employed by the issuer are required to disaffirm any tainted submission they have participated in preparing, but are not required to resign. If an attorney reasonably believes that a material violation has already occurred and has no ongoing effect, the attorney is permitted, but not required, to take these steps, so long as he or she also reasonably believes that the reported material violation is likely to have caused substantial injury to the financial interest of the issuer or of investors.

The proposed rule also describes (1) specific circumstances authorizing an attorney to disclose confidential information related to his or her appearance and practice before the SEC in the representation of an issuer, (2) the respective responsibilities of supervisory and subordinate attorneys (both in-house and outside counsel) and (3) sanctions. Violation of the proposed rule will subject the violator to all the remedies and sanctions available under the Securities Exchange Act of 1934, including injunctions, and cease and desist orders. Comments must be received by December 18, 2002. SEC Release Nos. 33-8140; 34-4686; IC-25829 (November 21, 2002).

The staff of the SEC’s Division of Investment Management recently granted no-action relief under section 17(j) and rule 17j-1 of the 1940 Act excusing access persons of certain mutual funds, their investment advisors and principal underwriters (collectively, the “applicants”) from the requirement to report their personal transactions in and holdings of shares of certain Canadian mutual funds. These Canadian funds (“eligible Canadian mutual funds”) are not registered under the 1940 Act but operate and are regulated in substantially the same manner as U.S. registered open-end management investment companies. The staff also granted no-action relief under section 204 and rule 204-2(a)(12) of the Investment Advisers Act of 1940 (the “Advisers Act”) excusing the investment advisor applicants from the requirement to make and keep records of personal trading transactions of their advisory representatives in shares of eligible Canadian mutual funds.

Rule 17j-1(d) under the 1940 Act, among other things, requires every access person of a fund and its investment advisor or principal underwriter, to report to the fund, investment advisor or principal underwriter certain personal transactions in and holdings of “covered securities”. Shares of U.S. registered open-end funds, but not shares of Canadian registered funds, are exempted from the definition of “covered securities”. Rule 204-2(a)(12) under the Advisers Act requires every investment advisor registered or required to be registered under the Advisers Act to make and keep a record of every transaction in a security by the investment advisor or any of its advisory representatives. However, transactions in shares issued by U.S. registered open-end funds are excepted from this record-keeping requirement.

In extending these exemptions to eligible Canadian mutual funds, the staff stated that its position is based mainly on the applicants’ representation that these funds issue shares redeemable on demand, calculate net asset value on a daily basis in a manner consistent with Section 2(a)(41) of the 1940 Act and Rule 2a-4 thereunder, and issue and redeem shares at the net asset value next determined after receipt of the relevant purchase or redemption order consistent with the “forward pricing” principles of Rule 22c-1 under the 1940 Act. The staff’s position was also based on the representation that there is no secondary market in shares of eligible Canadian mutual funds. SEC No-action Letter; WSB File No. 0909200216, Manufacturers Adviser Corp. (Sept. 10, 2002).

The United States District Court for the District of Massachusetts (the “Court”) held that the only private remedies available under the Advisers Act are rescission of an investment advisory contract and restitution of fees paid thereunder, as provided in Section 215. The plaintiffs brought suit against their investment advisers for various claims arising from the failure of an investment strategy. The suit alleged, among other things, that the defendants breached their fiduciary duties as investment advisers, rendered negligent investment advice, and employed a scheme to defraud the plaintiffs. The plaintiffs alleged that the defendants violated Section 206 of the Advisers Act and demanded a judgment for damages plus interest and costs, and such other relief as the court deems appropriate. The Court cited the Supreme Court decision, Transamerica Mortgage Advisers, Inc. v. Lewis, 444 U.S. 11, 24-25 & n.14 (1979), which held that a limited private right of action for rescission and restitution was implied under Section 215 of the Advisers Act, but a private right of action for damages was not implied under Section 206. The Court also noted that nothing in the structure of the Securities Law Enforcement Remedies Act of 1990, Pub. L. No. 101-429 indicates a Congressional intent to provide a remedy to private litigants beyond the restitution of advisory fees. Filson v. Langman, 2002 U.S. Dist. LEXIS 22036 (D. Mass) (November 13, 2002).

New York has amended its laws relating to investment advisors and federally covered advisors to become more uniform with similar laws of the remaining 49 states in several respects.

Massachusetts recently amended its laws relating to investment advisor registration and “federal covered advisor” notification requirements with the goal of becoming more uniform with similar laws of the remaining 49 states. Massachusetts law defines “federal covered advisor” to include only investment advisors registered with the Securities and Exchange Commission (“SEC”). This significant change is already in effect for certain federal covered advisors located or doing business in Massachusetts.

Massachusetts was unique among the 50 states in that it did not include federal covered advisors with assets under discretionary management in excess of $100 million within the definition of investment advisor. As a result, these advisors were not subject to notification requirements and their representatives were not subject to registration as investment advisory representatives.

Current Massachusetts Law. Massachusetts treats state regulated investment advisors and federal covered advisors the same for purposes of determining whether registration or notification is required. Following the recent amendments, the exemptions from registration and notification requirements now in effect are:

• Exclusion for Certain Types of Entities. An investment advisor or a federal covered advisor is exempt from registration and notification requirements respectively if it is a bank, savings institution or trust company or a registered broker-dealer, or an agent acting under the control and supervision of the registered broker-dealer.
• Exclusion for Advisors Dealing Exclusively with Institutional Clients. An investment advisor or a federal covered advisor is exempt from registration and notification requirements respectively if its only clients in Massachusetts are other investment advisors, broker-dealers, banks, savings institutions, trust companies, insurance companies, investment companies as defined in the 1940 Act, employee benefit plans with assets of not less than $5,000,000, and governmental agencies or instrumentalities or other financial institutions or institutional buyers. Massachusetts regulations define “institutional buyer to include (1) an investing entity whose only investors are accredited investors as defined under Rule 501(a) of the Securities Act, each of whom has invested a minimum of $50,000, (2) a non-profit organization described in Section 501(c)(3) of the Internal Revenue Code with a securities portfolio of more than $25 million, or (3) an entity whose only investors are financial institutions and institutional buyers as defined herein.
• Exemption for Massachusetts Based Advisors with No Massachusetts Clients. An investment advisor or a federal covered advisor with a place of business in Massachusetts but having no clients in Massachusetts is exempt from registration and notification requirements respectively as long as it is registered with the SEC or with at least one jurisdiction where it has clients.
• De Minimis Exemption for Out-of-State Advisors. An investment advisor or a federal covered advisor is exempt from registration and notification requirements respectively if it has no place of business or other physical presence in Massachusetts and, during any 12-month period, it has no more than five clients in Massachusetts.

In summary, the exemption for federal covered advisors with assets under discretionary management in excess of $100 million has been repealed. Investment advisors and federal covered advisors whose clients are exclusively institutional clients as defined, remain exempt from registration or notification requirements. The five-client de minimis exemption remains unavailable to investment advisors or federal covered advisors with a place of business in Massachusetts.

Notification in Massachusetts can be quickly achieved by depositing $300 into the investment adviser’s Daily IARD Account and then submitting through the IARD system an amendment to Form ADV that checks off the Massachusetts box under the state notifications section. This notification will automatically renew for calendar year 2003, and payment for this renewal will need to be submitted with the final renewal invoice in January 2003.

The CFTC received two proposals that would provide exemptions for hedge funds and other unregistered funds from registration as CPOs. In addition, as described below, fund managers may seek to claim no-action relief even while the proposals are pending. Currently, the operator of a collective investment vehicle that trades commodity interest contracts, whether or not for bona fide hedging purposes or otherwise, must be registered as a CPO with the CFTC. Although CFTC Rule 4.5 provides a limited exception for certain otherwise regulated “eligible persons”, such as advisors to registered investment companies, there is no exception for operators of unregistered funds, such as hedge funds. Accordingly, the operator of a hedge fund that makes any investment in a commodity futures contract (including any indirect investment through another unregistered fund) must register as a CPO. Although these CPOs may seek a partial exemption from the requirements of Section 4.7 under the Commodity Exchange Act (the “Commodity Act”) for CPOs offering participations in pools solely to Qualified Eligible Persons (“QEPs”), there is no exemption from registration as a CPO.

Proposed De Minimis Exemption. Proposed Rule 4.13(a)(3) under the Commodity Act would add a CPO registration exemption for CPOs who operate pools that use commodity futures or commodity options contracts only as follows:

• solely for bona fide hedging purposes (as defined in Rule 1.3(z)(1) under the Commodity Act);
• in addition, for non-hedging purposes solely incidental to the pool’s other trading activity, provided that the aggregate initial margin and premiums required to establish non-hedging positions for any pool does not exceed 5% of the liquidation value of the pool’s portfolio (after taking into account unrealized profits and unrealized losses on these contracts and excluding the “in the money” amount of any option that is in the money at the time of purchase);
• so long as interests in the pool are offered exclusively to “accredited investors” as defined in Rule 501(a) of Regulation D under the Securities Act of 1933 (the “Securities Act”); and
• subject to certain other conditions, including: not marketing the pool as a commodity pool or vehicle for trading commodity interests; disclosing to prospective investors in writing the purpose of and limitations on the scope of commodity futures and commodity options trading in which it intends to engage; submitting to special calls of the CFTC to demonstrate compliance with the proposed rule; and maintaining books and records.

In addition, a corresponding proposed rule, Rule 4.14(a)(10) under the Commodity Act, would provide an exemption to the operators of these pools from registration as a commodity trading advisor (“CTA”). The CTA exemption would apply to those persons who advise only pools operated by persons that are eligible for, and have claimed exemption under, the CPO provisions described above.

• interests in all pools operated by such CPO are privately offered (i.e., exempt from registration under the Securities Act and not marketed to the public in the United States);
• all individual investors investing in an eligible pool are QEPs as defined in Rule 4.7 (generally, persons with other investments with an aggregate market value of at least $2 million);
• all entities investing in an eligible pool are “accredited investors” as defined in Rule 501(a) under the Securities Act;
• neither the CPO nor any of its principals is subject to any statutory disqualification set forth in Sections 8a(2) or 8a(3) of the Commodity Act (subject to certain exceptions and waivers); and
• year-end certified financial statements are delivered annually to pool participants and filed with the CFTC.

In addition, proposed Rule 4.9 would require that CPOs file a notice of eligibility with the CFTC before the date when the CPO intends to operate an eligible pool (or commence operating an existing pool as eligible, provided that existing investors receive prior notice and an opportunity to redeem). The notice must also contain a representation that the CPO will submit to special calls of the CFTC to demonstrate compliance with the proposed rule. The notice must be updated if it becomes inaccurate or incomplete.

• participants in a pool for which the CPO claims relief must be limited to: “accredited investors” as defined in Rule 501(a) under the Securities Act, “knowledgeable employees” as defined in Rule 3c-5 under the Investment Company Act of 1940 (the “1940 Act”), non-U.S. persons, and certain QEPs; and
• the aggregate notional value of each such pool’s commodity interest positions (whether entered into for bona fide hedging purposes or otherwise) does not exceed fifty percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such position.

Further no-action relief is available for a “fund of funds” if the underlying funds that trade commodity interests have themselves claimed the no-action relief. A claim for no-action relief must be filed with the CFTC, and the party seeking such relief must make a one-time disclosure to pool participants. Such a claim will be effective upon filing, as long as it is materially complete. 

The CFTC is seeking comments on the exemption criteria of each proposed rule, as well as the no-action relief and other related issues. Comments are due by January 2003. Federal Register, Vol.67 No. 219 (November 13, 2002). 

The CFTC recently proposed an amendment to its Rule 4.5 that would expand the ability of certain regulated entities, including registered investment companies, insurance company separate accounts, bank trust funds and ERISA pension plans, that are currently excluded from the definition of commodity pool operator (“CPO”) to trade commodity interests.

Currently, the rule permits these entities to trade commodity futures and options without having to register with the CFTC as CPOs if they restrict their non-hedge trading to positions that do not require more than 5% of the liquidation value of the portfolio to be committed as margin or premium, after taking into account unrealized profits and unrealized losses (the “5 percent test”). The proposal would create an alternative test based on the notional value of non-hedge positions, where the aggregate notional value of these positions does not exceed the liquidation value of the qualifying entity’s portfolio, after taking into account unrealized profits and unrealized losses (the “notional test”). “Notional value” would be calculated for futures by multiplying for each such position the size of the contract, in contract units, by the current market price per unit and for options by multiplying for each such position the size of the contract, in contract units, by the strike price per unit.

The proposal would not affect any other provision of the rule, including the unlimited use of commodity interests for bona fide hedging purposes. The CFTC has determined that, pending action on this proposal, it will not commence any enforcement action against an eligible person for failing to register as a CPO, where the eligible person operates a qualifying entity in accordance with the proposed amendment. Neither eligible persons who have claimed relief under Rule 4.5 nor eligible persons who claim such relief in the future need to take any additional action to operate their qualifying entities in accordance with the notional test. Rather, making the representations currently required by the rule in a Notice of Eligibility filed with the National Futures Association and the CFTC, including the representation concerning the 5 percent test, is all that is required. Comments on the proposed rule are due by December 12, 2002. Federal Register, Vol.67 No. 208 (October 28, 2002).

The IRS concluded that contract holders of variable life insurance contracts, rather than the insurance company, would be the actual owners of certain underlying investments of the insurance company separate account. The IRS determined that since the contract holders were permitted to allocate their premiums among different hedge funds and the hedge funds were available to a limited sector of the general public, the contract holders would be deemed to be the owners of the interests in the hedge funds under the investor control rules. The insurance company argued that the investor control rules should be inapplicable because (1) the hedge funds would be only available to certain investors, rather than the general public, and (2) there would be material economic differences between the direct ownership of assets in a hedge fund and the ownership of these assets through a variable life insurance contract as a result of death benefit provisions and mortality charges. The IRS disagreed. Accordingly, the contract holders would be required to include currently in gross income any gains and income from their interests in the hedge funds. IRS Private Letter Rulings, PLR 200244001 (November 4, 2002).