A recent article in the Journal of Securities Law, Regulation & Compliance -- How Hedge Fund Advisers Can Reduce Insider Trading Risk -- discusses some approaches that hedge fund managers use to prevent insider trading violations. These approaches include avoiding agreements to keep information confidential and giving heightened attention to business communications between hedge fund personnel and close family members or personal friends. The article also describes the many legitimate reasons that analysts at money managers have to communicate in private with senior management of public companies and ways hedge fund advisers can police the insider trading risks associated with those communications. Finally, it discusses several methods to reduce these risks, such as notifying potential counterparties and their agents that the adviser does not want to receive unsolicited information about possible deals and, when feasible, creating a procedure within the adviser to direct all communications about possible investment opportunities to a person in an area walled off from trading decisions.

The article was written by Andrew Vollmer, a partner in the WilmerHale Securities Litigation and Enforcement Group; Mr. Vollmer was Deputy General Counsel of the Securities and Exchange Commission from 2006 until early 2009.

For a longer description of the article, see:
http://www.wilmerhale.com/publInvestmentCompanyActtions/whPubsDetail.aspx?publInvestmentCompanyActtion=9540    

This is the link to the full article:
Journal of Securities Law, Regulation & Compliance, Vol. 3, No. 2, p. 106 (2010)
http://www.henrystewart.com/jsc/tocs.aspx  

On June 2, 2010, a Minnesota state court jury ordered a major U.S. bank to pay $30.1 million in damages to four non-profit organizations that claimed the bank misrepresented the safety of investments made by the bank with collateral for plaintiffs’ securities that were loaned as part of a securities lending program and that the bank did not return the loaned securities when plaintiffs requested it to do so. During 2007, the value of the investments had declined and certain investments had defaulted. The jury found the defendant bank liable for breach of fiduciary duty and violations of Minnesota’s Consumer Fraud Act. The jury appeared to have awarded plaintiffs their pro rata share of defaulted securities in the collateral pools, but rejected a much larger claim for $374 million, that would have provided restitution to plaintiffs for market declines in the value of collateral pool assets, that would have had to be sold at discounts to par in order to repay borrowers. The jury also rejected the plaintiffs’ request for punitive damages.

For more information, please see the Court’s website:
http://www.courts.state.mn.us/district/2/?page=868  
Docket No. 62-cv-08-10825

See also the following:
http://www.businessweek.com/news/2010-06-04/wells-fargo-spared-punitive-damages-for-fraud-by-minnesota-jury.html  
http://www.businessweek.com/news/2010-06-03/wells-fargo-loses-minnesota-trial-for-nonprofit-investor-losses.html  

On June 8, 2010, the U.S. District Court for the Northern District of California dismissed a fund shareholder’s claim alleging that a distribution agreement was unenforceable because it violated the Investment Company Act. Plaintiff alleged that asset-based 12b-1 distribution fees were special compensation to broker-dealers for advisory services which had been the subject of Financial Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007) and were unlawful under the Investment Advisers Act of 1940 (“Advisers Act”) and rule 38a-1 under the Investment Company Act. Plaintiff further alleged that since the distribution agreement provided for the payment of 12b-1 fees, it created a violation of section 47(b) of the Investment Company Act.

The Court distinguished 12b-1 distribution fees from fee-based brokerage, which had been challenged by financial planners in the Financial Planning case. It added that payment of special compensation to a broker-dealer would not create a violation of the Advisers Act, but would necessitate registration under the Advisers Act by the broker-dealer. The Court further reasoned that section 47(b) does not create a private right of action. In this case, since the facts alleged by plaintiff did not constitute a violation of rule 38a-1 under, or any other violation of, the Investment Company Act, there was no basis for a claim under section 47(b).

For further information, please see the order dated June 8, 2010, available on PACER, at:
https://ecf.cand.uscourts.gov/cgi-bin/login.pl  
Docket No. 1:09-cv-4775

On June 16, 2010, the SEC proposed amendments to rules 156 and 482 under the Securities Act of 1933 and rule 34b-1 under the Investment Company Act of 1940 (the “Investment Company Act”) to require certain types of disclosures in the marketing of target date mutual funds. The proposed rules would address target date fund naming, advertising materials and risk and would attempt to reduce the potential for investor confusion in connection with this type of fund.

The proposed rules would define a target date fund as an “investment company that has an investment objective or strategy of providing varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures that changes over time based on an investor’s age, target retirement date, or life expectancy.” The proposed rules would also distinguish between a target date fund’s “target date” and its “landing point.” The target date would be the date used in the fund’s name (or if there is no date in the name, the date in the prospectus that the investor is expected to retire or cease purchasing fund shares). The landing point would be the first date at which the target date fund reaches its final asset allocation among types of investments.

The proposed changes would generally require advertisements for any target date fund to include:
• A statement advising an investor (i) “to consider, in addition to age or retirement date, other factors, including the investor’s risk tolerance, personal circumstances, and complete financial situation” and (ii) that an investment in a target date fund “is not guaranteed and it is possible to lose money” by investing in the fund, including after the target date;
• A “tag line” with disclosure of the intended asset allocation of the fund at the target date immediately adjacent to the first use of the fund’s name (for target funds with a target date in their name); and
• A table, chart, or graph showing the fund’s “glide path” – i.e., the asset allocation over the fund’s entire life, including at inception, intervals of no more than five years, the target date and the landing point; and an explanatory statement indicating that asset allocation changes over time; the landing point, that the asset allocation becomes fixed at the landing point and the intended asset allocation at the landing point; and the extent to which intended asset allocations may be modified without a shareholder vote.

The specifics disclosures required by the amended rules would vary depending on factors such as the number of funds covered in the marketing materials, when in the life of the fund the marketing material is used and the marketing material media.

The proposed rule amendments would add the following to the current list of factors pertinent to consideration of whether a statement in investment company sales literature is misleading:
• Whether the statement emphasizes a single factor (such as an investor’s age or tax bracket) as the basis for determining that an investment is appropriate; or
• Whether the statement makes express or implied representations that investing in the security is a simple investment plan that requires little monitoring by the investor.

While the SEC voted unanimously to propose these rule amendments, Commissioner Troy Paredes expressed concerns that investors may end up placing undue emphasis on a fund’s asset allocation at the target date, precisely because this information is prominently disclosed, at the expense of other relevant disclosures.

The SEC sought public comment on a number of particular aspects of the rule proposal. The comment period will expire 60 days following publication of the proposing release in the Federal Register.

For more information, please see:
http://www.sec.gov/news/press/2010/2010-103.htm  
http://www.sec.gov/news/speech/2010/spch061610mls.htm  
http://www.sec.gov/rules/proposed/2010/33-9126.pdf  

On May 28, 2010, the FTC extended its deferral of enforcement of the Identity Theft Red Flags Rule (“Red Flags Rule”) until December 31, 2010. This deferral was in response to the request of several members of Congress who sought sufficient time to finalize legislation that would define the scope of entities covered by the Rule.

The Red Flags Rule was promulgated pursuant to the Fair and Accurate Credit Transactions Act of 2003 and directed regulators, including the FTC, to create rules for creditors and financial institutions to protect against identity theft. The final Red Flags Rule became effective on January 1, 2008, with compliance originally required by November 1, 2008.

For more information, please see:
http://www.ftc.gov/os/2010/05/100528redflagsrule.pdf  
http://www.ftc.gov/redflagsrule  

On May 27, 2010, the SEC filed a settled civil enforcement action against a hedge fund manager and its chairman and chief executive officer for insider trading in the securities of an issuer that had been the subject of rumors that it would miss its earnings estimates. According to the SEC’s complaint, the CEO sought earnings information from an individual who was an employee of the issuer and who had been recently hired by the CEO to work at the hedge fund (the “tipper”). After the tipper confirmed that the issuer would meet its earnings estimates, the CEO traded the issuer’s securities on behalf of the hedge fund before the public earnings announcement.

The hedge fund manager and the CEO agreed to settle the SEC’s charges, without admitting or denying the allegations against them, and to pay approximately $18 million in disgorgement of trading profits and interest and $10 million in penalties.

The SEC also separately brought cease and desist proceedings against the tipper related to the same conduct. Those proceedings include allegations that the tipper concealed his receipt of inside information from the SEC staff and failed to disclose email relating to the earnings information despite subpoenas and direct questions that required him to do so.

For more information, please see:

http://www.sec.gov/news/press/2010/2010-88.htm  
http://www.sec.gov/litigation/litreleases/2010/lr21540.htm  
http://www.sec.gov/litigation/complaints/2010/comp-pr2010-88.pdf  
http://www.sec.gov/litigation/admin/2010/34-62186.pdf  

On May 17, 2010, the staff of the SEC Division of Trading and Markets denied no-action relief to a firm that sought to assist a company in obtaining financing and to be paid for its services based on a portion of the financing obtained, without the firm’s registering as a broker-dealer under Section 15(a) of the Securities Exchange Act of 1934. The SEC staff reiterated its long-standing position that a person’s receipt of transaction-based compensation in connection with effecting, inducing or attempting to induce transactions in securities is a hallmark of broker-dealer activity typically requiring registration.

In this case, the staff believed that the firm’s proposed introduction of only those persons with a potential interest in investing implied that the firm anticipated both pre-screening potential investors and pre-selling the company’s securities and that the link between compensation directly tied to successful investment in the company’s securities (transaction–based compensation) would give the firm a “salesman’s stake” in the proposed transactions and would create heightened incentive for the firm to engage in sales efforts. Accordingly, the staff concluded that the proposed activities would require broker-dealer registration.

For more information, please see:
http://www.sec.gov/divisions/marketreg/mr-noaction/2010/brumbergmackey051710.pdf  
For further information on remarks by Director Donohue on the application of broker-dealer registration to participants in the private fund industry, see:
http://www.wilmerhale.com/publications/periodicals/investment_management/blog.aspx?DateFrom=4/1/2010&DateTo=5/1/2010&All=null  

On May 25, 2010, the staff of the SEC Division of Investment Management released responses to questions relating to rule 2a-7 under the Investment Company Act of 1940, as amended (“Investment Company Act”), in light of recent amendments to the rule. In general, these questions and answers provide practical guidance relating to compliance dates and implementation of the rule amendments, as well as the provisions in the amendments relating to liquidity, stress testing, quality and website posting of funds’ investments.

Among the liquidity provisions in the amended rule is a “Daily Liquid Asset” requirement for taxable money market funds. This requirement provides that a taxable money market fund can only acquire securities that will mature within one business day (“daily liquid assets”) when the fund has less than 10% of its total assets invested in daily liquid assets. The staff takes the position in response to Question II.5 that a taxable money market fund operating in a master-feeder structure as permitted by Section 12(d)(1)(E) of the Investment Company Act cannot look through to its master fund for purposes of compliance with this requirement. In order to comply with the Daily Liquid Assets requirement, the feeder fund must either invest in a master fund that guarantees redemptions in one day or hold 10% of its total assets in US treasury securities (or other daily liquid assets that are not investment securities for purposes of Section 12(d)(1)(E)).

For more information, please see:
http://www.sec.gov/divisions/investment/guidance/mmfreform-imqa.htm  

On May 20, 2010, the staff of the SEC Division of Investment Management posted additional responses to questions on rule 206(4)-2, the “Custody Rule” under the Advisers Act. The new responses address the definition of custody and fee deductions, as well as pooled investment vehicles.

The new responses relating to the definition of custody indicate, among other things, that if an adviser has custody of a client’s assets that include a swap agreement, any collateral in connection with the swap agreement must be maintained with a qualified custodian. If the qualified custodian is a related person of the adviser, then the internal control report and surprise examination provisions of the rule are also applicable.

The new responses relating to pooled investment vehicles explain that, if audited financial statements for the pool are not distributed to investors as contemplated by rule 206(4)-2(b)(4), then the adviser to the pool must comply with the rule by having a reasonable basis, after inquiry, for believing that the custodian sends quarterly account statements to each investor in the pool and by obtaining an annual surprise examination of the pool’s assets. The responses further point out that privately offered securities held by an unaudited pool should be held by a qualified custodian; any account statement required to be sent to investors in the pool should include a statement of funds and securities held, and transactions entered into, by the pool; and the surprise examination should include confirmation with investors in the pool of the funds and securities held by the pool and of contributions and withdrawals by the investor to and from the pooled since the last examination.

For more information, please see:
http://www.sec.gov/divisions/investment/custody_faq_030510.htm  

As described in WilmerHale’s recent Regulatory Reform Alert, “Are We Almost There Yet? Financial Reform Makes it to Conference,” on May 20, 2010, the Senate passed the “Restoring American Financial Stability Act of 2010” (“Senate Bill”). As the House of Representatives had earlier passed the “Wall Street Reform and Consumer Protection Act of 2009,” the two bills will move to conference where the two chambers will seek to harmonize the most comprehensive and complex financial regulatory legislation since the 1930s. Both House and Senate leaders have indicated their intent to have legislation on the President’s desk by the July recess.

The Senate Bill incorporates virtually all of the Obama Administration’s priorities as laid out in the Administration’s 2009 White Paper. Title IV (Private Fund Investment Advisers Registration Act of 2010) and Title IX (Investor Protections) of the Senate Bill are of particular interest to the investment management industry.

Title IV requires registration of most hedge fund advisers under the Investment Advisers Act of 1940, as amended (“Advisers Act”), but exempts advisers to venture capital funds. It also authorizes the Securities and Exchange Commission (the “SEC”) to exempt single family offices and advisers to private equity funds, although the latter will have recordkeeping and reporting obligations.

Title IX covers a large number of securities areas, including SEC enforcement-related issues, fiduciary standards for broker-dealers, credit rating agencies, asset-backed securitization and credit risk retention, executive compensation and proxies, municipal securities, management and self-funding of the SEC, and issues relating to the Public Company Accounting Oversight Board, among others. The Senate Bill also codifies the existing Investor Advisory Committee and an Investor Advocate to represent the interests of investors to the SEC.

For further information on the private fund registration provisions and other securities-related provisions of the Senate Bill, please see the WilmerHale Regulatory Reform Alert, “Are We Almost There Yet? Financial Reform Makes it to Conference” at:

http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9513