NASD recently issued a NTM directing all member firms to immediately review the adequacy of their existing policies and procedures to ensure that investors are charged the correct sales load on mutual fund transactions. According to the NTM, staff of the NASD and SEC are concerned, based on recent examinations, that some member firms have not been charging investors the correct sales loads, particularly in transactions involving letters of intent and rights of accumulation.

As noted in the NTM, the dealer agreements with a mutual fund or mutual fund complex generally require the member to provide assurances that it will apply the appropriate breakpoint in a given transaction or series of transactions. Regardless of whether the dealer agreement actually imposes this obligation, according to the NTM, a broker-dealer must:

• Ensure that its registered representatives and others involved in processing mutual fund transactions understand the terms of the offerings;
• Ascertain the information that should be recorded on the books and records of the member or its clearing firm which is necessary to determine the availability and appropriate level of breakpoints;
• Apprise the customer of the breakpoint opportunity and inquire whether the customer has positions or transactions outside the member that should be considered in connection with the pending transaction;
• Make sure the personnel processing these transactions are appropriately trained to accurately transmit information pertaining to all aspects of a mutual fund order, including any applicable breakpoint, in a manner retrievable by the mutual fund; and
• Have in place appropriate and sufficient procedures, including supervisory procedures, with respect to breakpoint calculations.

To stress the importance of the NTM, the SEC sent a copy of the NTM to NASD members with a letter signed by the Directors of the SEC’s Divisions of Investment Management and Market Regulation. This letter is intended to ensure that member firms, as well as their chief legal and compliance officers, “are aware of, and take immediate action on,” the issues raised in the NTM. According to the SEC’s letter, the SEC will contact member firms “soon after the beginning of the new year to learn your assessment of the adequacy of your policies and procedures; whether your firm is in compliance with those policies and procedures and relevant NASD rules; and what assurances [the member] can offer on a going forward basis that will comply fully with those policies and procedures.” As expressed in the NTM, “NASD and SEC staff consider it essential that mutual fund executions are effected on the terms most advantageous to the customer.” Investment Company Institute Memoranda (December 24, 2002); NASD Notice to Members 02-85 (December 2002).

On December 31, 2002, the SEC, Treasury and the board of governors of the Federal Reserve released a report to Congress under the Patriot Act with recommendations for applying anti-money laundering controls to investment companies. The report provides a comprehensive discussion of the many types of investment companies, including both registered and unregistered investment companies, noting their characteristics and functions. The report identifies existing and recommended regulations for the various categories of investment companies, considering their potential vulnerabilities to money laundering.

The Patriot Act directs the treasury to expand the U.S. anti-money laundering regime to a wide range of industries, including investment companies. Treasury has already issued or proposed regulations applicable to mutual funds and certain unregistered investment companies, such as hedge funds. Such regulations are noted in the report. Treasury expects to issue further regulations consistent with the report’s recommendations in the near future. SEC Press Release No. 2002-180 (December 31, 2002).

The SEC recently published for comment proposed rule and form amendments under the Securities Act of 1933, the Securities Exchange Act of 1934 (the “1934 Act”), and the Investment Company Act of 1940 (the “1940 Act”) to require additional and more frequent disclosure by mutual funds regarding portfolio investments, costs, and past performance. If adopted, the proposed rule and form amendments would:

• Permit a fund to include a summary portfolio schedule in its reports to shareholders, provided that the complete portfolio schedule is filed with the SEC on proposed Form N-CSR semi-annually and is provided to shareholders upon request, free of charge;
• Exempt money market funds from including a portfolio schedule in reports to shareholders, provided that this information is filed with the SEC on proposed Form N-CSR and is provided to shareholders upon request, free of charge;
• Require reports to shareholders by funds to include a tabular or graphic presentation of a fund’s portfolio holdings by identifiable categories;
• Require a fund to file its complete portfolio schedule as of the end of its first and third fiscal quarters with the SEC on new proposed Form N-Q;
• Require open-end funds to disclose fund expenses borne by shareholders during the reporting period in reports to shareholders;
• Require open-end funds to include Management’s Discussion of Fund Performance (“MDFP”) in its annual report to shareholders.

Summary portfolio schedule. The proposed amendments to Regulation S-X would permit funds to include in their reports to shareholders a summary portfolio schedule, Schedule VI – Summary schedule of investments in securities of unaffiliated issuers, in lieu of the full schedule contained in Schedule I – Investment in securities of unaffiliated issuers. The proposed summary portfolio schedule would include, in order of descending value, each of the fund’s 50 largest holdings in unaffiliated issuers and each investment that exceeds one percent of the fund’s net asset value. All securities not listed in the summary schedule would be required to be listed in a category labeled “Other Securities”. The proposed summary schedule would show (1) the name of the issuer and title of the issue; (2) the share or principal balance held at the close of the period; and (3) the value of each item at the close of the period. The proposed summary schedule would also show the percentage value of the issue compared to net assets, and the total value of all investments in securities of unaffiliated issuers. The proposals would also require each type of instrument to be identified by an appropriate symbol or footnote.

As with the current requirements for disclosure of the complete portfolio schedule, the summary schedule would require funds to identify by appropriate symbols each issue of securities that is non-income producing, each issue of securities held in connection with open put or call option contracts or loans for short sales, and each issue of restricted securities. As in the current complete schedule, the proposal would require a fund to also state in a footnote to the summary schedule the following amounts based on cost for federal income tax purposes: (i) aggregate gross unrealized appreciation for all securities in which there is an excess of value over tax cost; (ii) aggregate gross unrealized depreciation for all securities in which there is an excess of tax cost over value; (iii) net unrealized appreciation and depreciation; and (iv) the aggregate cost of securities for federal income tax purposes.

The proposal requires any fund using a summary portfolio schedule to file its complete portfolio schedule with the SEC on proposed Form N-CSR, which would be available on EDGAR. In addition, the proposal requires any fund that uses a summary portfolio schedule to send its complete schedule of investments to shareholders upon request within three business days of receipt of the request, by first-class mail or other means designed to ensure equally prompt delivery, and to disclose in its reports to shareholders that this complete portfolio schedule is available (i) without charge, upon request, by calling a specified toll-free (or collect) telephone number; (ii) on the fund’s website, if applicable; and (iii) on the SEC’s website. Funds would continue to be required to include in their reports to shareholders the other schedules currently required by Regulation S-X.

In a recent no-action letter, the SEC stated that a fund may offer its shareholders the opportunity to exchange their shares of the fund for shares of another fund on a specified delayed basis, so long as the offer is fully and clearly disclosed in the fund’s prospectus. The SEC stated that such exchange offers are consistent with section 11(a) of the 1940 Act, provided that any exchange order would be executed at the relative net asset values (“NAVs”) of the respective fund shares and calculated at a specified time that is later than the time that those funds next calculate their NAVs.

For example, a fund could make a exchange offer under which all exchange orders received before the fund calculates its NAV on any business day would be executed at the relative NAVs of the funds calculated on the next business day. As another example, a fund that normally prices its shares at 4 p.m. could make an exchange offer under which all exchange orders received after 2:30 p.m. on any business day would be executed at the relative NAVs of the funds calculated on the next business day. Both examples would constitute a “specified delayed basis” consistent with the no-action letter.

In the no-action letter, the SEC staff noted that the relief does not address whether a fund may make an exchange offer under which the fund specifies that only the NAV of the acquired fund (i.e., the purchase transaction) will be calculated on a delayed basis. The SEC questioned whether such an exchange offer would be consistent with the 1940 Act. Investment Co. Institute, SEC No-Action Letter (November 13, 2002).

The SEC recently published for comment proposed new rule 3a-8 under the 1940 Act, which would provide a nonexclusive safe harbor from the definition of “investment company” for certain bona fide research and development (“R&D”) companies.


In its release proposing new rule 3a-8, the SEC noted that R&D companies often raise large amounts of capital, invest the proceeds and use the principal and return on these investments to fund R&D activities during their lengthy product development phase. An R&D company also may purchase a non-controlling entity stake in another R&D company as part of a strategic alliance with the other company to conduct R&D products jointly. The proposing release further noted that either or both of these activities may cause an R&D company to fall within the 1940 Act’s definition of “investment company” and to fail to qualify for an exclusion from the definition when using the SEC’s traditional analysis to determine a company’s primary business.

The 1940 Act defines an “investment company”, among other things, to include any company that owns or proposes to acquire certain types of securities having a value exceeding 40 percent of the value of the company’s total assets on an unconsolidated basis (excluding U.S. government securities and cash items). The 1940 Act also provides certain statutory exclusions from the definition of “investment company” for a company that is primarily engaged in a non-investment business and authorizes the SEC to issue orders excluding companies from this definition.

• R&D expenses comprise a substantial percentage of the company’s total expenses for its last four fiscal quarters combined (the proposing release notes that “substantial” is undefined to allow for expense fluctuations, but also indicates that a company’s R&D expenses “certainly” would be substantial if they constitute a majority of the company’s expenses, notwithstanding nonrecurring items or unusual fluctuations in recurring items);
• Revenues from investments in securities do not exceed twice the amount of the company’s R&D expenses;
• No more than five percent of the company’s total expenses in its last four fiscal quarters combined have been devoted to investment advisory and management activities, investment research and selection, and supervisory and custodial fees;
• Investments are used to conserve capital and liquidity until the company uses the investment proceeds for its primary business, subject to certain exceptions; and
• Activities of the company’s officers, directors and employees, its public representations of policies, and its historical development demonstrate that it is primarily engaged in a business or businesses other than investing, reinvesting, owning, holding, or trading in securities.

The proposed rule’s safe harbor would be available to any R&D company that conducts business directly, through majority-owned subsidiaries, or through one or more companies which it controls primarily. The proposed rule requires that an R&D company not hold itself out as being engaged in the business of investing, reinvesting, or trading in securities. Comments must be received by January 15, 2003. SEC Release No. IC-25835; File No. S7-47-02.

The SEC adopted rule 203A-2(f) under the Investment Advisers Act of 1940 (the “Advisers Act”) to exempt certain investment advisers that provide advisory services through the internet (“internet investment advisers”) from the prohibition on SEC registration. The rule amendments permit these internet investment advisers, whose businesses are not connected to any particular state, to register with the SEC instead of with state securities authorities.

The National Securities Markets Improvement Act of 1996 amended the Advisers Act to divide the responsibility for regulating investment advisers between the SEC and state securities authorities. Section 203A of the Advisers Act generally prohibits an investment adviser from registering with the SEC unless that adviser has more than $25 million of assets under management or is an adviser to a registered investment company, and preempts most state regulatory requirements with respect to SEC-registered investment advisers. The $25 million threshold was designed to distinguish investment advisers with a national presence from those that are essentially local businesses. Unlike state-registered advisers, internet investment advisers have no local presence and provide advisory services that are not limited to clients in one state. Internet investment advisers provide investment advice to their clients through interactive websites that enable clients visit these websites and provide information online concerning their personal finances and investment goals. The adviser’s computer-based system processes and analyzes the information provided by each client, and then transmits investment advice back to each client through the website. Clients residing in any state can, upon accessing the website, obtain investment advice at any time. Since internet investment advisers typically are not eligible to register with the SEC because they do not manage the assets of their internet clients and consequently do not meet the $25 million threshold, internet investment advisers have been required as a practical matter to register in all the states absent an exemption.

The new rule 203A-2(f) allows internet investment advisers to register with the SEC, provided that investment advice is provided to all clients exclusively through the adviser’s “interactive website”. However, a de minimus exception permits an adviser relying on the rule to provide investment advice to fewer than 15 clients through other means during the preceding 12 months.

The new rule defines “interactive website” as a website in which computer software-based models or applications provide investment advice to clients based on personal information provided by each client through the website. The rule is thus not available to advisers that merely use websites as marketing tools or that use internet vehicles such as e-mail, chat rooms, bulletin boards and webcasts or other electronic media in communicating with clients. In addition, the exemption is for advisers that provide investment advice to their internet clients “exclusively” through their interactive websites. An adviser relying on the exemption may not use its advisory personnel to elaborate or expand upon the investment advice provided by its interactive website, or otherwise provide investment advice to its clients, except as permitted by the de minimus exception. The new rule also provides that an internet investment adviser may rely on the definition of “client” in rule 203(b)(3)-1 in applying the de minimus exception.

The new rule is unavailable to an internet investment adviser if another adviser in a control relationship relies on the internet investment adviser’s registration under rule 203A-2(f) as the basis for its own registration under rule 203A-2(c). Rule 203A-2(c) exempts an adviser from the prohibition on SEC registration if the adviser controls, is controlled by, or is under common control with, another SEC-registered adviser with the same principal place of business.

The new rule requires an internet investment adviser relying on the exemption to maintain records showing which of its clients that firm advised exclusively through its interactive website and which, if any, of its clients the firm advised through non-internet means. In addition, the SEC is amending Part 1 of Form ADV to add the exemption under the new rule to the list of exemptions in Item 2 of Part 1, in which advisers registering with the SEC indicate the basis for their eligibility to register with the SEC. The rule amendments are effective January 20, 2003. SEC Release No. IA-2091; File No. S7-10-02.

On December 11, 2002, the SEC voted to publish rule proposals under the Investment Company Act of 1940 (the “1940 Act”) that would change reporting requirements for registered funds. Under the proposed rule, registered funds would be required to file their complete portfolio holdings schedule with the SEC on a quarterly basis. However, funds would be permitted to use a summary portfolio schedule in their semi-annual shareholder reports. Funds would also be required to provide a tabular or graphic presentation of portfolio holdings in shareholder reports, enhanced mutual fund expense disclosure in shareholder reports, and management’s discussion of fund performance in their annual reports to shareholders.

The SEC published for comment a proposal by the NASD to amend NASD rule 3011, which requires all NASD members (including mutual fund underwriters) to develop and implement written AML programs.

Rule 3011 sets forth minimum requirements for NASD members’ AML programs. One such requirement is that the NASD member designate an individual or individuals responsible for implementing and monitoring the day-to-day operations and internal controls of the program. NASD is proposing to amend the rule to add requirements that the member: (1) identify such person or persons to the NASD by name, title, mailing address, e-mail address, telephone number, and facsimile number; and (2) promptly notify NASD regarding “any change in such designation(s).

The proposing release explains that the purpose of the rule change is to facilitate the U.S. Department of the Treasury’s efforts to collect contact information pursuant to section 314(a) of the USA Patriot Act and its implementing regulations. According to the proposing release, the NASD intends to initially collect the contact information through the Member Firm Contact Questionnaire on the NASD Website. Form and system changes necessary to collect the information were expected to be completed by November 15, 2002, and NASD members will have until December 31, 2002 to comply with the amended rule and provide contact information to NASD. The Federal Register, Vol. 67, No. 214 (November 5, 2002).