On January 22, 2003, the SEC adopted new Form N-CSR, the new form for investment companies filing annual and semi-annual shareholder reports. Recently, the SEC issued a response to frequently asked questions about the certified shareholder reports (the “FAQ”). In the FAQ, the staff reminded investment companies:

• that certified shareholder reports filed on Form N-CSR are designated as reports required by Sections 13(a) and 15(d) of the Securities Exchange Act of 1934 (the “1934 Act”) and Section 30 of the 1940 Act;
• that Form N-CSR should contain a copy of any required shareholder report, additional information about disclosure controls and procedures and the certification required by Section 302 of the Sarbanes-Oxley Act of 2002; and
• that all certifications to Form N-CSR be filed as one exhibit to Form N-CSR and must be named EX-99.CERT.

The SEC also reminded investment companies that Form N-CSR was amended to require:

• a Sarbanes-Oxley code of ethics to be filed as an exhibit to the annual report (for annual reports for fiscal years ending on or after July 15, 2003);
• disclosure of information related to audit and non-audit services and fees paid to the auditor of the financial statements of the investment company (for annual reports for fiscal years ending on or after July 15, 2003); and
• disclosure about a closed-end fund’s proxy voting policies and procedures (for annul reports filed on Form N-CSR after July 1, 2003).

SEC Today, Volume 2003-36, February 25, 2003.

Effective Feb. 25, 2003, the fee rate pursuant to Section 6(b) of the Securities Act of 1933 (the “1933 Act”) applicable to the registration of securities decreased to $80.90 per million. The Section 6(b) rate is the rate used to calculate the fees payable with the Annual Notice of Securities Sold Pursuant to Rule 24f 2 under the Investment Company Act of 1940 (the 1940 Act”).

The ICI is reportedly preparing a letter to the OMB urging the OMB to reconsider the burden to investment companies of complying with the recently adopted rule requiring proxy voting disclosure. The ICI is drafting the letter in response to the SEC’s request for comments regarding the new rule under the Paperwork Reduction Act of 1995. Reportedly, the ICI will argue that the rule’s paperwork burden on investment companies is an “excessive means” of reaching the SEC’s goal of improving fund transparency.

In its letter, the ICI will reportedly address two issues for evaluation under the Paperwork Reduction Act: (1) whether the rule proposal is excessively burdensome and (2) whether the SEC considered alternatives to the rule that would reduce the burden. The ICI will measure “burden” in terms of hours of work and dollars anticipated to be spent on compliance with the new rules. In response to the proposing release for the rule, the ICI estimated, based on a survey of fund complexes conducted on its behalf by a third party, that proxy voting record disclosure would cost approximately $3,380 per fund in start-up costs, and $5,530 per year in ongoing costs, according to the final release.

The new rule, adopted in late January, requires funds to file with the SEC and to make available to their shareholders their proxy voting policies and procedures, as well as the specific proxy votes that they cast in shareholder meetings of issuers of portfolio securities. Investment companies must file their first report of proxy voting records on Form N-PX not later than Aug. 31, 2004, for the 12-month period beginning July 1, 2003, and ending June 30, 2004. BNA Securities Regulation & Law Report, Vol. 35, No. 8, February 24, 2003.

The SEC has designed a fake hedge fund web site to warn investors to exercise caution when investing in hedge funds. Recently, the SEC launched an investigation into the $600 billion hedge fund industry and is expected to issue a report on its findings. The SEC has previously commented on its concerns regarding investor protection when hedge funds are sold to the “average” retail investor.

The SEC’s fictitious hedge-fund site, at http://www.growthventure.com/grdi, touts the fund’s expected investment returns, stating, “according to The Stock Report, GRDI Select, L.P. is positioned for a 22% return during the first quarter after launch. Thereafter, returns can be expected to grow at an average rate of no less than 32%, based upon similar returns from funds run by the experienced investment team at GRDI using similar strategies and the latest technology.”

By attempting to access an application form, visitors are informed that the website is fake and that it has been posted by the SEC. In its description, the SEC site notes it created the fake site using words and concepts from information presented to investors in hedge fund fraud cases prosecuted by the SEC. The SEC warned investors about the dangers of investing in unregistered offerings. The web site is also linked to an SEC bulletin in which the SEC recommends that investors:

• review a fund’s prospectus or offering memorandum and related materials to satisfy oneself that the level of risk involved in the fund’s investment strategies is suitable to one’s personal investing goals, time horizons, and risk tolerance.
• learn about the fund’s valuation process and the extent to which the fund’s securities are valued by independent sources.
• consider that hedge funds may invest in highly illiquid and hard-to-value securities.
• perform due diligence on fees which impact an investor’s return on investment. The SEC notes that hedge funds typically charge an asset management fee of 1% or 2% of assets, but that the fund manager may receive an additional performance fee that could amount to 20% of the fund’s profits.
• consider the potential for layering of fees in funds investing in portfolios of hedge funds: the asset management fee and a performance fee based on profits at both the investing fund level and the underlying fund level.
• investigate the background of the hedge fund’s managers to ensure that they are qualified to manage money and that they do not have a disciplinary history within the securities industry.

BNA Securities Regulation & Law Report, Vol. 35, No. 8, February 24, 2003.

Constellation Financial Management, L.L.C. (the “Adviser”) requested no-action relief from the SEC’s Division of Investment Management (the “Division”) regarding its ability to charge clients a contingent fee based solely on the amount of assets that the client originally invested in the asset allocation program (the “Constellation Program”).

The staff noted that the Adviser stated that the Constellation Program was “substantially similar” to the asset allocation program described in a request submitted to the staff by Bisys Fund Services, Inc., dated September 1, 1999 (the “Bisys Letter”). Under the Bisys Letter, an asset allocation program was marketed to investors through registered broker-dealers. Under the program the brokers provided services including:

• determining the potential client’s eligibility for the program,
• discussing the recommended asset allocation with the client,
• opening the client’s account,
• receiving the client’s initial and subsequent investments,
• arranging for the purchase of the eligible mutual funds recommended by the investment adviser,
• answering client inquiries,
• reviewing the client account’s performance,
• providing annual tax reporting, and
• meeting annually with the client to reassess the propriety of the current asset allocation strategy.

In return for these services, the program sponsor pays the broker a fee equal to a percentage of the client’s initial and subsequent investments through the Bisys program.

In the Bisys Letter, the clients also paid a separate fee to the program sponsor to help the sponsor recoup expenses paid out as broker fees. The clients are permitted under the program to use one of two payment options: 1) a front-end fee to the program sponsor at the initiation of the advisory relationship and upon each subsequent investment that is equal to the amount paid by the program sponsor as the broker fee or 2) a deferred contingent fee which is assessed only if the client terminates an investment in the Bisys program within the first three years of the investment.

In the Bisys Letter, the contingent fee charged to clients is applied to the lesser of (i) the amount invested in the program by the client (without giving effect to any appreciation in the value of the investment) and (ii) the value of the client’s account at the time the client terminates his or her participation in the program. In contrast, the Adviser wrote that it intended to charge a contingent fee based solely on amounts invested in the program by the client, without giving effect to any appreciation or depreciation in the value of the client’s account. The Adviser claimed that by basing the contingent fee on the original cost, the program sponsor would be able to match its financing costs with the source of revenues. The Adviser requested assurance that the Division would not recommend enforcement action under Section 206 of the Investment Advisers Act of 1940 (the “Advisers Act”) if the Adviser used original cost to calculate the contingent fee.

The Division noted that Sections 206(1) and 206(2) of the Advisers Act make it “unlawful for any registered or unregistered investment adviser to employ any device, scheme or artifice to defraud or to engage in any transaction, practice or course of business, that operates as a fraud or deceit on clients or prospective clients.” The Division noted that as a fiduciary, an adviser is held to the highest standards of conduct and must act in the best interest of its clients. The Division further noted that it has taken the position that certain fees that may have the effect of penalizing a client for ending the advisory relationship or that may make a client reluctant to terminate an adviser may be inconsistent with the adviser’s fiduciary duty under Section 206.

The Division stated that in its response to the Bisys Letter, it expressed its view that a contingent fee paid to an investment adviser by a client for services previously rendered to the client would not violate Section 206 solely because such fee was paid upon termination of the client’s investment in the program. The Division noted that it had based its conclusion on a number of factors, including that the contingent fee did no more than compensate the investment adviser for services already provided to the client and would be fully disclosed and discussed in a separate document that the investment adviser provided to each client. The Division agreed that the Adviser’s use of the original cost to calculate the contingent fee should not lead to a different conclusion. The Division based its position on the Adviser’s representation that, aside from the use of original cost to calculate the contingent fee, the Constellation Program is substantially similar in all respects to the program described in the Bisys Letter, including that the contingent fee:

• Does no more than compensate the program sponsor for services already rendered by the broker to the client;
• Permanently declines to zero after three years from the date that a client invests assets in the program; and
• Never exceeds the amount of the front-end fee, which is equal to the amount of the broker’s fee.

Constellation Financial Management, L.L.C. no-action letter, January 9, 2003.

The SEC has proposed amendments to its rules of practice to improve the timeliness of administrative proceedings. In proposing the rules, the SEC noted its interest in promoting the timely adjudication and disposition of administrative proceedings. The SEC last adopted revisions to its rules of practice in 1995. The SEC noted that the 1995 revisions were designed to improve efficiency, but did not impose firm deadlines for completion of the proceedings. Instead the 1995 revisions included a series of non-binding goals for the completion of each step in the administrative process. The 1995 rules provided a 10 month guideline for completion of the hearing and issuance of the initial decision by the administrative law judge (the “ALJ”) and an 11 month target for completion of deliberations by the SEC when it reviews appeals of ALJs’ initial decisions. The SEC acknowledged that since 1995, the SEC and its ALJs have generally failed to meet these goals.

As a result, the SEC determined that timely completion of proceedings could be achieved only through the adoption of mandatory deadlines. The SEC has proposed procedures that would specify that in every non-settled administrative proceeding, the order instituting proceedings would specify the maximum time for completion of the hearing and issuance of the initial decision. The SEC noted that this deadline would be either 90, 180, or 270 days, in the SEC’s discretion, after consideration of the type of proceeding, the complexity of the matter, and its urgency.

To complement this new procedure, the SEC is also proposing to amend its procedural rules to make explicit a policy of “strongly disfavoring” extensions, postponements or adjournments except in circumstances where the requesting party makes a strong showing that the denial of the request or motion would “substantially prejudice” its case. The SEC acknowledged that this proposed amendment would effect a “significant change” in administrative cease and desist proceedings. The SEC noted that the Securities Exchange Act of 1934 (and parallel provisions in the other Federal securities laws) requires that the notice instituting proceedings requires the SEC to set a hearing date between 30 and 60 days after service of the notice unless an earlier or a later date is set by the SEC with the consent of the respondent.” The SEC further noted that under current practice, parties routinely request extensions of the 60-day deadline, and that the hearing officers routinely grant such requests. The SEC warned that the proposed amendment would no longer permit these extension requests, absent a strong showing of substantial prejudice.

The SEC noted that the proposed revisions relate solely to agency organization, procedures, or practice and, therefore, it is not legally required to provide notice or an opportunity for public comment. However, the SEC determined that it would be useful to publish the proposed rule changes for notice and comment, before adoption. Comments on the proposed rules are due March 21, 2003. SEC Release 33-8190, February 12, 2003.

SEC Proposes "Self Compliance" by Funds and Advisers.

http://www.wilmerhale.com/files/Publication/8d1b8979-c44f-4590-88bc-d692e823f22b/Presentation/PublicationAttachment/790156bf-bc3a-4343-beaf-aa2256e71d21/IM%2002-20-03.pdf

In a press release, NASD announced it has formed a 22-person task force to explore ways in which mutual fund companies and brokerage houses can assure that investors are not overcharged when making purchases of front-end loaded funds. The NASD stated the task force will “explore and recommend operational changes and ways to improve investor education in this area and explore the potential for simplifying and enhancing disclosure of [quantity and other front-end load] breakpoints.” Mary Schapiro, NASD vice chairman and president of regulatory policy and oversight, will chair the panel.

In the release, NASD noted that it, the SEC, and the New York Stock Exchange are examining selected firms that sell front-loaded funds in an effort to determine whether they are correctly implementing purchase aggregation breakpoints when selling funds. The breakpoints are not mandated and are set voluntarily by mutual fund companies. NASD News Release February 18, 2003.

As expected, William Donaldson was confirmed as the new chair of the SEC. During Senate hearings, Mr. Donaldson stated that his first priority as new SEC chairman would be to name a chairman to the Public Company Accounting Oversight Board. He also expressed an interest in continuing the ongoing investigation of the increasing “retailization” of hedge funds and the attendant risks to less sophisticated investors.

FinCEN has proposed an amendment to Bank Secrecy Act regulations to require reporting of suspicious transactions in mutual fund shares. The amendment would require mutual funds to file suspicious activity reports (“SARs”) for suspicious transactions of $5,000 or more. The requirement would be limited to open-end management investment companies. In proposing the amendment, FinCEN noted that mutual funds present “real opportunities” for money laundering because of their accessibility and the ability of shareholders to redeem shares quickly. FinCEN noted that it would require SARs for transactions whether or not they involve currency.

Reporting categories. The amendment establishes four categories of transactions that require reporting:

• Transactions involving funds derived from illegal activity, or intended or conducted in order to hide or disguise funds derived from such illegal activity, as part of a plan to violate or evade federal law;
• Transactions designed to evade the requirements of the Bank Secrecy Act;
• Transactions that appear to serve no business or apparent lawful purposes and for which the mutual fund knows of no reasonable explanation after examining the available facts relating to the transaction and the parties; and
• Any other transactions that involve the use of the mutual fund to facilitate criminal activity.

Delegation of reporting. FinCEN noted that mutual funds may contractually delegate the reporting obligation to an affiliated or unaffiliated service provider. FinCEN further noted that the mutual funds would retain responsibility for assuring compliance with the rule and must actively monitor the procedures for reporting suspicious transactions.

Comments on the proposal are due March 24, 2003. Federal Register, Vol. 68, No. 13, January 21, 2003.

On February 13, 2002, the SEC adopted amendments to rule 17f-4 under the Investment Company Act of 1940 (the “1940 Act”). Section 17(f) of the 1940 Act governs the custody of a fund’s assets, including its portfolio securities. Section 17 (f) requires a fund to maintain its securities and other investments with certain types of custodians under conditions designed to assure the safety of the fund’s assets. It permits a fund to maintain its securities in a securities depository, subject to rules adopted by the SEC. The SEC adopted rule 17f-4 to establish conditions for the use of securities depositories by funds. The conditions were designed to limit potential risks to funds using securities depositories. Rule 17f-4 permits funds to place and maintain financial assets with a securities depository subject to certain conditions. In adopting the amendments to the rule, the SEC noted that the amendments update and simplify rule 17f-4 to reflect business and legal developments in the industry since the original adoption of the rule in 1978. The amendments:

1. permit additional types of investment companies to rely on the rule,
2. allow depositories to perform additional functions under the rule,
3. eliminate a number of specific custodial compliance requirements of rule 17f-4, and require instead that a fund’s custodian, when using a depository, exercise due care in accordance with reasonable commercial standards.

U.S. depositories. Rule 17f-4 permits funds to keep and maintain securities and other assets in a “securities depository” subject to regulation in the United States. Under the rule, a “securities depository” is a “clearing corporation” that is registered with the SEC as a clearing agency, or a federal reserve bank or other person authorized to operate the federal book-entry system for U.S. Treasury securities. The SEC amended the rule so that it no longer restricts the functions that a depository may perform. As a result, a fund may use a depository that holds securities that are acquired or disposed of by bookkeeping entry as well as those that are conveyed by physical delivery.

Second, the custodian must provide, promptly upon request by the fund, such reports as are available about the internal accounting controls and financial strength of the custodian. If the fund deals directly with a depository, the depository’s contract or written rules for its participants must provide that the depository will provide similar financial reports.

Treatment of U.S. and foreign depositories. The Depository Trust Company, the predominant U.S. securities depository, has established linkages with several foreign custodians and depositories through which it holds assets with those foreign institutions. In the Proposing Release, the SEC had requested comment on whether a fund, when it holds securities with a U.S. depository that are ultimately custodied with a foreign custodian or depository, should be subject to rules 17f-5 or 17f-7, which establish conditions for the custody of fund assets with foreign custodians and depositories. In response to several comments the SEC has decided not to amend the rule to require the application of our foreign custody rules when a fund holds securities through a U.S. depository that has a linkage to a foreign custodian or depository. The SEC noted that currently, U.S. depositories register with the SEC as clearing agencies under the Securities Exchange Act of 1934, and are subject to rigorous standards for their operations. The SEC further noted that it approves each proposed linkage to a foreign custodian or depository only when the custodian or depository will provide a level of protection equivalent to that which a U.S. clearing agency must provide. The SEC stated that this is a standard considerably higher than required of fund boards to apply in selecting a foreign custodian.

The rules are effective on March 28, 2003. Release No. IC-25934, February 13, 2003.

SEC Adopts Proxy Voting Rules.

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The U.S. Court of Appeals for the Fourth Circuit (the “Appeals Court”), reversing a lower court decision, held that a fund by-law requiring directors to be elected by a majority of shares eligible to vote was permissible under Maryland corporate law. The Appeals Court additionally found that the “holdover” of incumbent directors did not violate the Investment Company Act of 1940 (the “1940 Act”).

The U.S. Court of Appeals for the Fourth Circuit (the “Appeals Court”), reversing a lower court decision, held that a fund by-law requiring directors to be elected by a majority of shares eligible to vote was permissible under Maryland corporate law. The Appeals Court additionally found that the “holdover” of incumbent directors did not violate the Investment Company Act of 1940 (the “1940 Act”).

The plaintiff was a large shareholder of the fund and held nearly 40% of the fund’s shares. At an election for two directors at the fund’s annual meeting in 2002, the shareholder supported two nominees over the two incumbents. Each nominee received approximately 60% of the votes cast or 47% of the outstanding shares eligible to vote. Each incumbent received approximately 40% of the votes cast or 35% of the outstanding shares eligible to vote. The fund’s by-laws provided that directors be elected by a majority of the outstanding shares eligible to vote. The fund therefore determined that the election had failed and no candidate had been elected, resulting in a holdover of the two incumbent directors.

The shareholder amended a pre-existing suit against the fund in the federal District Court to include a complaint that the by-law for electing directors violated Maryland law and that the holdover violated federal law. The shareholder also sought a preliminary injunction prohibiting the incumbents from participating in board meetings. The District Court granted the shareholder’s request for a preliminary injunction and enjoined the fund from convening a meeting of its board until the court issued a final order. The District Court later granted summary judgment for the shareholder and required the fund to seat the shareholder nominees as directors. The fund then appealed the District Court decision.

The Appeals Court noted that Maryland General Corporation Law § 2-404(d) states: “Unless the charter or by-laws of a corporate provide otherwise, a plurality of all the votes cast at t a meeting at which a quorum is present is sufficient to elect a director.” The Appeals Court found that the fund’s by-law requirement of election by a majority of shares eligible to vote “plainly established” a higher voting requirement than under Maryland law for the election of new directors. The Appeals Court ruled that because this heightened voting requirement was not inconsistent with the law or the fund’s charter, it could properly be included in the fund’s by-laws. Because the shareholder nominees did not receive the required number of votes under the by-law provision, the nominees could not be seated as members of the fund’s board of directors.

The Appeals Court also considered whether the holdover of the incumbent directors violated the 1940 Act. The Appeals Court determined there was no conflict between Maryland law and federal law because the 1940 Act is silent on the issue of failed elections. Instead, the Appeals Court relied on Maryland law, which authorizes the use of holdovers. Badlands Trust Company v. First Financial Fund, Inc., 4th Cir., No. 02-2088, January 30, 2003.

In a January 31, 2003 speech at an industry conference, Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations, listed the focus areas for investment adviser examinations in 2003. Mr. Gohlke noted that anti-money laundering measures, business continuity plans, and “side-by-side” evaluations would be three primary focus areas in 2003.

In a January 31, 2003 speech at an industry conference, Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations, listed the focus areas for investment adviser examinations in 2003. Mr. Gohlke noted that anti-money laundering measures, business continuity plans, and “side-by-side” evaluations would be three primary focus areas in 2003.

Mr. Gohlke commented that anti-money laundering programs are currently a routine focus of examinations of investment companies and transfer agents for investments companies. He noted that if the U.S. Treasury Department were to require investment advisers to have anti-money laundering programs, the programs and procedures would be similarly scrutinized as part of the routine examinations of investment advisers.

Regarding the importance of business continuity plans, Mr. Gohlke commented that the only set of circumstances in which a firm may not be required to have a continuity plan is if the firm discloses outright to its clients that it lacks such a program, and that a catastrophe could put it out of business.Mr. Gohlke noted that “side-by-side evaluations” apply to registered investment advisers that manage several categories of funds, including unregistered pooled vehicles such as hedge funds. He further noted that the SEC is examining the procedures utilized by investment advisers to identify and mitigate conflicts of interests between hedge fund clients and other clients. BNA Securities Regulation & Law Report, Vol. 35, No. 6, February 10, 2003.

On February 6, 2003, the SEC voted to adopt Regulation AC, which will require research analysts to certify the truthfulness of the views they express in research reports and public appearances, and to disclose whether they have received any compensation related to the specific recommendations or views expressed in those reports and appearances. Under Regulation AC, the term “research analyst” would not include an investment adviser, such as a mutual fund portfolio manager, who is not principally responsible for preparing research reports, even if the investment adviser is a registered person of a member.

• a statement by the research analyst certifying that the views expressed in the research report accurately reflect such research analyst’s personal views about the subject securities or issuers; and
• a statement by the research analyst certifying whether the analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in the research report.

If the analyst received related compensation, the statement will include the source, amount, and purpose of such compensation, and further disclose that such compensation may influence the recommendation in the research report.

Public appearances. Regulation AC will require broker-dealers to make a record related to public appearances by research analysts. Specifically, a broker or dealer who publishes, circulates, or provides a research report by a research analyst will be required to make a record within 30 days after each calendar quarter in which the research analyst made the public appearance, that will include:

• a written statement by the research analyst certifying that the views expressed in each public appearance accurately reflected such research analyst’s personal views about the subject securities or issuers; and
• a written statement by the research analyst certifying that no part of such research analyst’s compensation was, is, or will be directly or indirectly related to any specific recommendations or views expressed in any public appearance.

In cases where the broker or dealer does not obtain a statement by the research analyst in connection with public appearances as described above, the broker or dealer will be required to disclose in all research reports prepared by that analyst for the next 120 days that the research analyst did not provide the certifications.

The regulation will be effective 45 days from the date of its publication in the Federal Register. SEC Release 2003-21, February 6, 2003.

On February 6, 2003, the SEC approved certain measures affecting banks and their activities as dealers under the Gramm-Leach-Bliley Act of 1999 (the “G-L-B Act”). The G-L-B Act, which amended the Securities Exchange Act of 1934 (the “1934 Act”) to eliminate the blanket exception for banks from the definitions of “broker” and “dealer,” provides banks with four exceptions from the definition of “dealer” and eleven exceptions from the definition of “broker.” The SEC adopted rules amending definitions of terms used in an exception for banks in the definition of “dealer” in Section 3(a)(5) of the 1934 Act, amending an exception for banks from the definition of dealer for certain de minimis riskless principal transactions, adding a new exemption from broker-dealer registration with respect to certain bank securities lending transactions, and extending an exemption from rescission liability for contracts entered into by banks in a dealer capacity until March 31, 2005.

Definitions of terms used in asset-backed exception to dealer registration requirement. The asset-backed transactions exception from the definition of dealer permits a bank to issue and sell securities backed by obligations originated by the bank and its affiliates, or other obligations originated by other banks and their affiliates in a syndicate. The SEC clarified that the statutory exception permits banks to issue and sell asset-backed securities to qualified investors, but does not allow banks to deal in asset-backed securities. The SEC noted that this exception is not broad enough to permit banks to regularly purchase and sell these securities in the secondary market. The amendments will, among other things:

• modify the definition of “originated” so that banks may use distribution channels (such as automobile dealers, mortgage companies, and other banks), even though the bank does not “make and fund” the loan at the exact time that the loan is made;
• retain the standard for “predominantly originated” at 85 percent; and
• retain the requirement that when a syndicate of banks issues asset-backed securities through a grantor trust or other separate entity, each bank selling the securities, and thus, acting as a dealer in the transaction, must have originated at least 10 percent of the value of the pool of obligations backing the securities.

Exemption from the definition of dealer for banks engaged in “riskless principal” transactions. The de minimis exception from the definition of dealer permits banks to engage in up to 500 transactions per year without broker-dealer registration. The SEC permitted “riskless principal” transactions to count toward that total in its existing rules. The rule amendment provides that both legs of a riskless principal transaction are counted as one transaction solely for purposes of the de minimis exemption. 

Exemption for non-custodial securities lending from dealer and broker registration and custodial lending from dealer registration. The SEC added a new exemption from the definitions of broker and dealer for banks that engage in certain non-custodial securities lending transactions with “qualified investors.” The exemption will permit banks to engage in certain non-custodial securities lending transactions with “qualified investors,” as defined in the 1934 Act, without registration as a broker or dealer under the securities laws. For purposes of this exemption, banks may also engage in securities lending transactions with other pension plans that may not meet the restrictions applicable to qualified investor pension plans that have $25 million in investments and are managed on a discretionary basis.

Exemption from rescission liability. The SEC also amended rule 15a-8 under the 1934 Act to provide relief from rescission liability for contracts entered into by banks in a dealer capacity until March 31, 2005. The SEC noted that this additional period will allow banks to perfect their internal controls for dealer transactions without the threat of private liability for inconsequential violations during the current transition period. The compliance date for these amendments is Sept. 30, 2003. SEC Release No. 2003-21, February 6, 2003.

The Sarbanes-Oxley Act of 2002 mandates that the SEC issue rules prescribing minimum standards of professional conduct for attorneys appearing and practicing before it in any way in the representation of issuers. The Act requires that these minimum standards 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 issuer or any agent thereof to appropriate officers within the issuer and, thereafter, to the highest authority within the issuer, if the initial report does not result in an appropriate response.

On November 21, 2002, the SEC published for comment proposed Part 205, entitled “Standards of Professional Conduct for Attorneys Appearing and Practicing before the SEC in the Representation of an Issuer.” The proposed rule prescribed minimum standards of professional conduct for attorneys appearing and practicing before us in any way in the representation of an issuer. The proposed rule included several controversial provisions including one which covered lawyers licensed in foreign jurisdictions, whether or not they were also admitted in the United States. In addition, under certain circumstances, these provisions permitted or required attorneys to effect a so-called “noisy withdrawal” by notifying the SEC that they have withdrawn from the representation of the issuer, and permitted attorneys to report evidence of material violations to the SEC.

The SEC commented that the proposing release generated significant comment and extensive debate. The SEC reported that as a result, the final rule has been significantly modified to address these comments and suggestions. For instance, the final rule excludes attorneys who (1) are admitted to practice law in a non-U.S. jurisdiction, (2) do not hold themselves out as practicing, or giving legal advice regarding, U.S. law; and (3) conduct activities that would constitute appearing and practicing before the SEC only incidentally to a foreign law practice or in consultation with U.S. counsel. In addition, the triggering standard for reporting evidence of a material violation has been modified to clarify and confirm that an attorney’s actions will be evaluated against an objective standard.

The SEC also extended the comment period on the “noisy withdrawal” and related provisions of the proposed rule. The SEC will issue a separate release soliciting comment on this issue. In that release, the SEC will also propose and solicit comments on an alternative procedure to the “noisy withdrawal” provisions. Under the proposed alternative, in the event that an attorney withdraws from representation of an issuer after failing to receive an appropriate response to reported evidence of a material violation, the issuer would be required to disclose its counsel’s withdrawal to the SEC as a material event. Implementation of the final rule will be 180 days after publication in the Federal Register.

On Friday, January 24, 2003, the SEC submitted a report to Congress outlining the SEC’s plans to investigate whether the predominant credit rating agencies have engaged in anticompetitive practices. The report cited the following areas to be examined by the SEC:

• whether the criteria for awarding rating agencies the designation of “nationally recognized statistical rating organization” (NRSRO) exclude smaller competitors;
• whether conflicts of interest result when rating agencies receive compensation from companies whose debt securities are rated by the agency; and
• whether additional disclosure is needed on how the rating agencies determine the creditworthiness of securities issuers.

Rating agencies are currently not subject to oversight by the SEC. Rating agencies have received criticism recently in the wake of corporate scandals such as those involving Enron Corp. and various telecommunications companies. Enron, for instance, filed for bankruptcy protection four days after receiving investment grade ratings on its debt from all three major rating agencies. The SEC plans to issue a concept release on the subject requesting comments from the public. The Wall Street Journal, January 27, 2003.

SEC also requests comment on initiatives involving the private sector in oversight of the investment management industry. On February 4, 2003, the SEC proposed rules to require the adoption of internal controls and compliance procedures by funds and advisers. In addition, the SEC decided to seek comment on additional ways in which it could expand the role of the private sector in fostering compliance by investment companies and investment advisers with the federal securities laws.

The SEC noted that the Investment Company Act of 1940 (the “1940 Act”) provides a comprehensive regulatory structure designed to protect largely passive investors in funds, while the Investment Advisers Act of 1940 (the “Advisers Act”), which contains a less detailed regulatory scheme, imposes a broad fiduciary duty on advisers, requiring them to act in the best interest of their clients. The SEC noted that its examination of funds and advisers is a key element of the SEC’s investor protection program.

The SEC reported that approximately 5,030 funds and 7,790 advisers are currently registered with the SEC. The SEC further reported that collectively, these funds and advisers control over $21 trillion of assets, and engage in tens of millions of transactions each year. The SEC noted that its current resources permit routine examinations of each of the 966 fund complexes and each adviser only once every five years, and that during these examinations the SEC is unable to review every transaction. In addition, the SEC commented that, over time, the staff has learned to regard weak controls as an indicator that undetected (and uncorrected) violations may have occurred, and has assumed that, until improved controls are implemented, investors are at risk. Accordingly, the SEC reported that its staff focuses its examination efforts on testing the effectiveness of controls and related compliance procedures.

The SEC noted that its ability to protect fund investors and advisory clients has come to rely upon the effectiveness of these compliance programs. The SEC further noted that neither the federal securities laws nor the rules under either the 1940 Act or the Advisers Act require funds and advisers to adopt and implement comprehensive compliance programs. The SEC stated that, because of the importance of these compliance programs to investors and to the administration of the SEC’s examination authority, it is proposing two new rules (one for funds and one for advisers) that would require funds and advisers to:

1. adopt and implement policies and procedures designed to prevent violations of the securities laws,
2. review these policies and procedures at least annually for their adequacy and the effectiveness of their implementation, and
3. designate a chief compliance officer responsible for administering the policies and procedures.

The SEC is proposing new rule 38a-1 under the 1940 Act and new rule 206(4)-7 under the Advisers Act (collectively, the “Proposed Rules”). The Proposed Rules would require all investment companies and advisers registered with the SEC to adopt and implement internal compliance programs containing elements described in the rules.

Adoption and implementation of policies and procedures. The Proposed Rules would require funds and advisers to adopt and implement policies and procedures reasonably designed to prevent violation of the federal securities laws. They must be written and, in the case of a fund, must be approved by the fund’s board of directors, including a majority of the fund’s independent directors. Under the Proposed Rules, a fund’s policies and procedures must be designed to prevent violation of the federal securities laws by the fund, its investment adviser, principal underwriter, and administrator in connection with their provision of services to the fund. An adviser’s policies and procedures must be designed to prevent violation of the Advisers Act by the adviser and its supervised persons.

The SEC noted that the Proposed Rules do not enumerate specific policies that funds and advisers must include in their required policies and procedures. Instead, the SEC advised funds and advisers to take into consideration the nature of their organizations’ operations. Further, the SEC advised funds and advisers that the policies and procedures should be designed to:

• prevent violations (by, for example, separating operational functions such as trading and reporting),
• detect violations of securities laws (by, for example, requiring a supervisor to review employees’ personal securities transactions), and
• correct promptly any material violations.

The SEC reported that it would expect that policies and procedures of funds and (to the extent relevant) advisers would, at a minimum, address:

• portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with guidelines established by clients, disclosures, and regulatory requirements;
• trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (“soft dollar arrangements”), and allocates aggregate trades among clients;
• proprietary trading of the adviser and personal trading activities of supervised persons;
• the accuracy of disclosures made to investors, including information in advertisements;
• safeguarding of client assets from conversion or inappropriate use by advisory personnel;
• the accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
• processes to value client holdings and assess fees based on those valuations;
• safeguards for the protection of client records and information; and
• business continuity plans.

The SEC commented that fund procedures would ordinarily cover a number of additional areas, including:

• pricing of portfolio securities and fund shares;
• processing of transactions in fund shares;
• identification of affiliated persons with whom the fund cannot enter into certain transactions, and compliance with exemptive rules and orders that permit these transactions;
• compliance with fund governance requirements; and
• prevention of money laundering.

The SEC noted that funds and advisers could delegate compliance functions to service providers, but that the policies and procedures should provide for effective oversight of these service providers.

Annual review. Under the Proposed Rules, each fund and adviser must review its policies and procedures at least annually to determine their adequacy and the effectiveness of their implementation. The SEC commented that these provisions are designed to require advisers and funds to evaluate periodically whether their policies and procedures continue to work as designed and whether changes are needed to assure their continued effectiveness.

Chief compliance officer. The Proposed Rules would require that each fund and adviser designate an individual responsible for administering the compliance policies and procedures. The SEC recommended that the chief compliance officer be competent and knowledgeable regarding the applicable federal securities laws and be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the adviser or the fund complex. The SEC expects that the primary effect of this requirement would be to require compliance personnel to report to one individual with overall responsibility to coordinate the fund’s (or firm’s) compliance efforts and to establish procedures for the annual review of its compliance programs.

The Proposed Rules would require, in the case of a fund, the fund’s board of directors, including a majority of the independent directors, to approve the chief compliance officer. Proposed rule 38a-1 would require the chief compliance officer to furnish the fund’s board of directors annually with a written report on the fund’s policies and procedures, including:

1. any material changes to the policies and procedures since the last report,
2. any recommendations for material changes to the policies and procedures as a result of the annual review, and
3. any material compliance matters requiring remedial action that occurred since the date of the last report.

The SEC noted that the proposed rule would require board oversight of the fund’s compliance program, but would not require directors to become involved in the day-to-day administration of the program.

Recordkeeping. The Proposed Rules would require funds and advisers to maintain a copy of their policies and procedures. Funds would be required to retain the annual written report by the fund’s chief compliance officer. Advisers would be required to retain records documenting their annual review. Funds and advisers would be required to retain the required documents for five years.

Request for Comment on Further Private Sector Involvement