On October 30, 2003 the ICI urged the mutual fund industry to implement fundamental reforms to combat trading abuses. The ICI presented the following recommendations to the Securities and Exchange Commission (the “SEC”):

• To address late trading, the SEC has recommended that all mutual fund trades be reported to the fund or the fund’s transfer agent by 4 p.m. (Eastern Standard Time) each day. Currently mutual fund intermediaries are permitted to accept orders until 4 p.m. and then may transmit these orders to the fund or the fund’s transfer agent for several hours after the 4 p.m. deadline. Mr. Haaga noted the ICI Executive Committee is aware that imposing a 4 p.m. deadline would alter longstanding business practices throughout the mutual fund industry. He stated that the ICI considered a range of policy options before deciding to impose a 4 p.m. deadline, including: (i) exceptions to the 4 p.m. deadline for entities subject to full SEC regulation; (ii) procedural options that would close the late trading window substantially, but not completely; and (iii) reliance on anticipated technological developments, which the ICI determined could not be completed on a timely enough basis to address the industry’s current needs.
  
  
• To address market timing, the SEC recommended that a mandatory, minimum industry-wide 2% redemption fee for non-money market fund shares held for five days or less be imposed. According to ICI President Matthew Fink, because the fund would receive 100% of redemption fee proceeds, the proposed fees would benefit the fund’s long-term shareholders. Redemption fees are not sales charges and thus are not paid to the fund’s manager or any selling agents. The ICI determined that a uniform, industry-wide minimum requirement is necessary to ensure that the fees’ desired deterrent effect on market timing would also prevent these abuses in omnibus accounts. The ICI recommended that the SEC consider exempting from the mandatory redemption fee funds that are designed for short-term trading, which prominently disclose that fact.
  
  
• To address personal trading, the SEC recommended that mutual fund advisers clarify or amend their codes of ethics to cover all transactions by affiliated personnel in mutual fund shares sponsored by the adviser. The ICI noted that it will consider additional options in this area, including whether it should supplement its Report of the Advisory Group on Personal Investing.

On October 29, 2003 the SEC announced it had charged the former portfolio manager of certain hedge funds (the “Portfolio Manager”) with fraud for overstating the value of the hedge funds. Simultaneously, the U.S. Attorney for the Southern District of New York announced that it had indicted the Portfolio Manager on criminal charges for violating certain antifraud provisions of the federal securities laws and with aiding and abetting various books-and-records requirements and reporting provisions applicable to registered investment advisers and broker-dealers.

The SEC’s complaint alleges that the Portfolio Manager:

• From at least 1998 until January 2002, knowingly and recklessly overstated the value of convertible bonds and preferred stock held by the funds, resulting in the dissemination of materially false and misleading fund valuations and performance figures to investors and prospective investors, and the filing of false reports with the SEC;
  
• Contrary to representations in the funds’ offering materials, valued the convertible bonds and convertible preferred stock in which the funds were invested at prices materially higher than market prices or the fair value of such securities, which resulted in inflated performance figures and in some years converted losses to reported profits;
  
• Priced the funds’ convertible securities without regard to prices obtained in recent sales;
  
• Frequently disregarded the views of his traders that his valuations were too high;
  
• Failed to maintain records supporting his valuations; and
  
• Refused to explain his valuations to management when questions arose after his departure.

Stephen M. Cutler, Director of the SEC’s Division of Enforcement, stated that the SEC is committed to pursuing federal securities laws violations, including those committed by hedge funds. SEC Release No. 2003-143.

On October 24,2003 the SEC proposed two set of rules to create two voluntary frameworks for the consolidated supervision of broker-dealers and their affiliates on a group-wide basis.

Alternative net capital calculation. Under the first voluntary framework, the SEC has proposed a voluntary alternative method for computing net capital charges for certain broker-dealers. If the broker-dealer is part of a holding company, that holding company must have a group-wide internal risk management control system and must consent to group-wide SEC supervision. Under the proposal, a broker-dealer that maintains net capital of at least $500 million could apply to the SEC for a conditional exemption from the application of the standard net capital rule calculation and, upon SEC approval, elect to calculate certain of its market and credit risk capital charges using the firm's own internal mathematical models for risk measurement, including internally developed value-at-risk models and scenario analyses.

Among other things, the consolidated group would be required to comply with stringent rules regarding its group-wide internal risk management control system and would make periodic reports to the SEC, which would include group-wide financial and risk management information.

Supervised investment bank holding company. Under the second voluntary framework, the SEC would permit a broker-dealer’s holding company to register with the SEC as a supervised investment bank holding company (“supervised IBHC”). Under the proposed rules, the holding company would be eligible to file a written notice of intention (“Notice of Intention”) with the SEC to become a supervised IBHC only if it is not affiliated with certain types of banks and has a “substantial presence” in the securities markets. The proposed supervised IBHC framework would establish regulatory requirements for supervised IBHCs.

Notice of Intention. To elect to become a supervised IBHC, a holding company would file with the SEC a Notice of Intention to become supervised by the SEC. An IBHC would be eligible to file a Notice of Intention to be supervised as a supervised IBHC only if it:

• Has a subsidiary broker-dealer that can evidence a “substantial presence” in the securities business, which can be demonstrated by a showing that the broker-dealer maintains net capital of at least $100 million; and
  
• Is not affiliated with (i) an insured bank (with certain exceptions) or a savings association, (ii) a foreign bank or foreign company, or (iii) a foreign bank that controls a corporation organized for the purpose of engaging in international or foreign banking.

Internal risk management control system requirements. The proposed rules would require a supervised IBHC to implement a risk management control system appropriate for its business and organization. The SEC noted that these control systems should adequately address the risks posed by the firm’s business, including market, credit, operational, funding, and legal risks.

The proposed rule would require that a supervised IBHC establish, document and maintain procedures for the detection and prevention of money laundering and terrorist financing as part of its internal risk management control system. These procedures should include appropriate safeguards at the holding company level to prevent money laundering through affiliates.

The proposed rule also would require that a supervised IBHC periodically review its internal risk management control system for integrity of the risk measurement, monitoring, and management process, and accountability, at the appropriate organizational level, for defining the permitted scope of activity and level of risk.

Record creation, maintenance, and access requirements. The proposed rules would require a supervised IBHC to create and retain records, furnish copies thereof, and make such reports as the SEC may require by rule.

Reporting requirements. The proposed rules would require a supervised IBHC to file periodic reports with the SEC, including monthly and quarterly risk reports and an annual audited report containing consolidated financial statements. In addition, the supervised IBHC would be required to submit a supplemental report, prepared by an independent public accountant, regarding the accountant’s review of the supervised IBHC’s internal risk management control system. This review would have to be accomplished using procedures agreed upon by the accountant and the supervised IBHC.

Withdrawal from supervision. The proposed rules would permit a supervised IBHC to withdraw from SEC supervision by filing a notice of withdrawal with the SEC, which would take effect one year after it is filed with the SEC.

Comments on both proposed rules must be received by the SEC no later than February 4, 2004. SEC Release No. 34-48694; File No. S7-22-03.

The SEC settled an administrative proceeding against an investment adviser (the “Adviser”) for violations relating to material misstatements and omissions in a registered investment company’s (the “Fund”) disclosure documents as well as purposefully attempting to manipulate the Fund’s net asset value. In addition, the Adviser was charged with aiding and abetting the Fund’s violation of Section 13(a)(3) of the Investment Company Act, which prohibits a registered investment company from deviating from its concentration of investments and its fundamental investment policy absent shareholder approval. Section 34(b) of the Investment Company Act prohibits any person from making false statements in registration statements and other records required under the Investment Company Act.

The SEC alleged that the Adviser, which served as investment adviser to the Fund, materially deviated from the Fund’s stated investment objective without shareholder consent. The Fund’s prospectuses, annual and semi-annual reports, and marketing materials emphasized the relatively conservative composition of the Fund portfolio. The Fund’s disclosure documents stated that it would invest exclusively in short to intermediate term fixed income securities issued by the U.S. government or governmental agencies and instrumentalities. The SEC noted that initially, the Adviser had invested the Fund’s assets in Treasury securities and pass-through mortgage backed securities issued by government-chartered corporations such as the Federal National Mortgage Association. These investments were permitted by the Fund’s prospectus. The SEC then noted that in 1991, without the consent of the Fund’s shareholders, the Fund began investing more in collateralized mortgage obligations (“CMOs”) and other complex mortgage securities. The SEC stated that the Fund’s disclosure documents did not disclose the effect of the Fund’s being predominantly invested in CMOs, or that the percentage of CMOs contained in the portfolio significantly increased the Fund’s sensitivity to changes in interest rates until the Fund’s collapse in value in April 1994.

The SEC also alleged that the Adviser had misled investors by comparing the Fund’s performance to a Treasury Bond index which did not contain CMOs. The SEC also noted that the Adviser emphasized weighted average portfolio life as an appropriate risk indicator. The SEC commented that this was a misrepresentation because weighted average life was not an appropriate risk measure for a fund invested in inverse floaters.

The SEC also found that the Adviser caused the Fund’s net asset value to be miscalculated by deliberately smoothing or ratcheting down over the course of several days prices that the Adviser knew to be stale. The SEC commented that it appeared that the Adviser sought to prevent an abrupt drop in the Fund’s NAV. The SEC concluded that, contrary to the Adviser’s daily pricing file policy, changes to individual security prices used to calculate the Fund’s final NAV were deliberately inaccurate and found the Adviser’s actions were reckless. The settlement order revoked the Adviser’s investment adviser registration and required the Adviser to pay a civil penalty of $2,005,000. SEC Administrative Proceeding, File No. 3-9657 (August 26, 2003).

On October 8, 2003, the SEC proposed new Rule 14a-11 under the Securities Exchange Act of 1934 (the “Exchange Act”) and related rule amendments to require companies (including investment companies), in certain circumstances, to include in their proxy materials shareholder nominations for directors, as well as disclosure relating to those nominees. The nomination procedure would be required only of companies as to which one or more specified events has occurred that provides evidence of shareholder dissatisfaction with the effectiveness of the company’s proxy process. The proposed rules would require companies that trigger the procedures to include in their proxy materials the names of, and certain other information regarding, shareholder nominees.

In its proposing release, the SEC noted that the proposed rules are intended to improve disclosure to shareholders and to enhance the participation of long-term shareholders (or groups of shareholders) with significant holdings in the proxy process for the nomination and election of directors. However, the SEC also noted that the proposed rules would not grant shareholders a right to nominate directors where such right would be inconsistent with state law. The SEC stated that should a particular state permit companies to prohibit shareholder nominations through provisions of its governing instruments, then Rule 14a 11 would be inapplicable to a company that validly includes these prohibitions in its governing instruments.

Triggering Events. As proposed, the nomination procedure would be triggered by the occurrence of either of the following proxy-related events at a company’s annual meeting held after January 1, 2004:

• At least one of the company’s nominees for the board of directors for whom the company solicited proxies received “withhold” votes from the holders of more than 35% of the votes cast at an annual meeting at which directors were elected; or
  
  
• A shareholder proposal that the company become subject to the shareholder nomination procedure of proposed Rule 14a-11 (a “direct access” proposal) was submitted for a vote of shareholders at an annual meeting by a greater than 1% shareholder entitled to vote on the proposal, and that proposal received more than 50% of the votes cast on that proposal at the meeting.

The SEC commented that it proposed the above criteria as evidence of shareholder dissatisfaction with the effectiveness of a company’s proxy process.

In addition to the trigger events contemplated above, the SEC is considering a third triggering event. Specifically, if a shareholder proposal, other than a direct access proposal, was submitted for a vote of shareholders at an annual meeting by certain qualified shareholders and (i) the proposal received more than 50% of the votes cast on that proposal; and (ii) the board of directors failed to implement the proposal by the 120th day prior to the date the company mailed its proxy materials for the next annual meeting, the company’s proxy process would be deemed ineffective for purposes of the proposed rules.

Shareholder Qualifications. Shareholders qualified to submit “direct access” proposals would consist of a single shareholder or group of shareholders that held more than 1% of the company’s securities entitled to vote on the proposal for one year and who were able to provide evidence of these holdings of the company. The SEC noted that should the SEC adopt a nomination procedure that includes the third “non-implementation” trigger, the proposing shareholder should provide evidence to the company that he or it satisfies the above criteria when proposals are submitted.

Shareholder eligibility to submit a nomination to the company’s board differs from the qualifications necessary for shareholders to submit a routine proposal under the proxy rules. To be eligible to submit a nomination, the proposed rules would require a single shareholder or group of shareholders (the “Nominating Shareholders”) to demonstrate continuous beneficial ownership of more than 5% of the company’s securities for at least two years as of the date of the nomination.

Nominee Qualifications. The SEC noted that nominees must meet certain criteria requiring the nominee to be independent of the Nominating Shareholder. Under the proposed rules, the nominee may not:

• be the Nominating Shareholder, or if applicable, a member of the shareholder group or a member of the immediate family member of the Nominating Shareholder or any member of the shareholder group;
  
• be an employee, director, officer or affiliate of any Nominating Shareholder that is an entity;
  
• have accepted directly or indirectly any compensation from the Nominating Shareholder or any affiliate of the Nominating Shareholder;
  
• control the Nominating Shareholder.

In addition, shareholder nominees for investment company directorships are limited to persons who are not “interested persons” pursuant to the Investment Company Act.

Limitation on Number of Nominees. The SEC noted that it does not intend the proposed rules to be available to persons seeking control of the company. As a result, companies would not be required to include every nominee that satisfies the eligibility criteria above. Instead, companies with eight or fewer directors would only be required to include one shareholder nominee. Companies with more than eight and less than 20 directors would be required to include up to two eligible nominees. Companies with more than 20 directors would be required to include up to three eligible nominees. If more eligible candidates are nominated than there are available seats, the company will be permitted to include only the nominee(s) of the Nominating Shareholder with the largest beneficial ownership at the time of the delivery of the shareholder’s notice of intent to nominate a director pursuant to the rule.

Notice to Company. Under the proposed rules, a Nominating Shareholder must provide notice to the company of its intent to require that the company include the nominee on the proxy card no later than 80 days prior to the date the company mails its proxy materials for the annual meeting.

Limited Exemption for Shareholders from Certain of the Proxy Rules. The proposed rules also provide limited exceptions from the proxy rules to enable shareholders to form a Nominating Shareholder group to aggregate securities holdings to meet the minimum ownership threshold of 5%. The proposed rules would permit shareholders to communicate with each other without filing and disseminating a proxy statement. The proposed rules would exempt from the filing requirements a shareholder who solicits 30 or fewer persons and a shareholder who circulates a limited purpose written communication that is filed with the SEC. Under the proposed rules, the written communication may only consist of:

• a statement of the shareholder’s intent to form a Nominating Shareholder group in order to nominate a director under the proposed rules;
  
• the percentage of securities that the shareholder(s) beneficially owns; and
  
• the means by which contacted holders may get in touch with the soliciting party.

The proposed rules would require that any soliciting material published, sent or given to shareholders in accordance with the above exemption be filed with the SEC by the Nominating Shareholder under the company’s file number under the Investment Company Act of 1940 (the “Investment Company Act”) no later than the date the material is first published, sent or given to shareholders.

Determination to Exclude a Shareholder Nominee. A company may determine that it may exclude a shareholder nominee from its proxy materials. Under proposed Rule 14a 11, the company may determine:

• the shareholder nomination procedure of Rule 14a-11 is inapplicable to the company;
• the Nominating Shareholder has not complied with the requirements of Rule 14a-11;
• the nominee does not meet the eligibility requirements;
• any representation required to be included in the notice to the company is false in any material respect; or
• the company has received more nominees than it is required to include and the Nominating Shareholder is not entitled to have its nominee included.

The SEC noted that if a company determines that it is entitled to exclude a nominee, it must provide the Nominating Shareholder with written notice of the determination within a sufficient amount of time to permit the Nominating Shareholder to consider the validity of the decision. The notice must include the following information:

• a description of the determination made by the board of directors, including an affirmative statement of its determination to exclude the nominee;
• a discussion of the specific requirement(s) of proposed Rule 14a-11 that the board has determined permit the company to exclude the nominee; and
• a discussion of the specific basis for the belief of the board that the company is permitted to exclude the nominee.

In addition, the company would be required to include in its proxy statement for the meeting that it has made a determination not to include the nominee as well as disclosure of the information relating to that determination included in the notice to the Nominating Shareholder. 

Determination to Include a Shareholder Nominee. The proposed rules require a company that determines that it must include the shareholder nominee(s) to advise the Nominating Shareholder of this determination. This notice must also include disclosure as to whether the company intends to oppose or support the nominee in the company’s proxy statement. The company must also advise the Nominating Shareholder that he or she has the option of submitting a statement of not more than 500 words supporting the nominee(s) and the date by which this statement must be provided to the company. The proposed rules also require that the company include in its proxy statement the website address on which the Nominating Shareholder intends to solicit proxies in favor of its nominee and include the name of the nominee on the company’s proxy card.

Disclosure on Form N-CSR. Because the proposed shareholder nomination procedure would operate only upon the occurrence of specified triggering events, the SEC has proposed requiring companies to notify shareholders when a triggering event has occurred. Specifically, the SEC has proposed that investment companies include additional disclosure on Form N-CSR, such as the shareholder vote with regard to any of the nomination procedure triggering events and, if applicable, that the company would be subject to the shareholder nomination procedure as a result of such vote.

Disclosure on Form 8-K. A Nominating Shareholder is required to provide notice a reasonable time before the company mails its proxy materials for the current year. Open-end investment companies typically do not hold annual meetings. If a company did not hold an annual meeting during the prior year, or the date of the meeting has changed more than 30 days from the prior year, it is required to file a Form 8-K to notify any potential Nominating Shareholder of the date of the upcoming shareholder meeting. Comments must be received by the SEC no later than December 22, 2003. SEC Release Nos. 34-48626; IC-26206; File No. S7-19-03.

The SEC has proposed new rules under the Investment Company Act of 1940 (the “1940 Act”) to relax the restrictions on an investment company’s ability to invest in shares of another investment company. The proposed rules codify and expand on a number of exemptive orders the SEC has previously issued permitting funds to invest in other funds.

Currently, Section 12(d)(1) of the 1940 Act prohibits fund-of-funds arrangements in which one investment company (the “acquiring fund”) invests in shares of another (the “acquired fund”). Section 12(d)(1)(A) prohibits a registered open-end fund (and companies or funds it controls) from:

• acquiring more than 3% of an acquired fund’s voting securities;
• investing more than 5% of its total assets in any one acquired fund; or
• investing more than 10% of its total assets in all acquired funds.

Section 12(d)(1)(B) prohibits a registered open-end fund from selling securities to any fund (including unregistered funds) if, after the sale, the acquiring fund would:

• together with companies and funds it controls, own more than 3% of the acquired fund’s voting securities; or
• together with companies and funds it controls, and with other funds and companies they control, own more than 10% of the acquired fund’s voting securities.

Proposed Rule 12d1-1: fund investments of cash in money market funds. The SEC has proposed new Rule 12d1-1 to permit funds to invest in shares of affiliated and unaffiliated money market funds. Rule 12d1-1 would permit “cash sweep” arrangements in which a fund invests all or a portion of its available cash in a money market fund rather than directly in short-term instruments. Under the proposed rule, a fund could invest in affiliated money market funds; subject to certain restrictions, unaffiliated money market funds; and unregistered money market funds that voluntarily operate subject to the limitations of Rule 2a-7 and whose investment adviser is registered with the SEC. Proposed Rule 12d1-1 would be available to closed-end funds, business development companies, and unregistered funds that invest in registered money market funds. Exemptive orders permitting cash sweep arrangements have become routine over the last 20 years. The SEC noted that since 1982, it has issued more than 80 exemptive orders permitting these types of arrangements.

The SEC is also proposing to eliminate most of the conditions included in exemptive orders that permit these cash sweep arrangements. A fund would no longer be prohibited from investing more than 25% of its assets in shares of money market funds. In addition, fund directors would not be required to make special findings that investors are not paying multiple advisory fees for the same services. Instead, funds would be permitted to pay duplicative advisory fees at the investing fund level and at the money market fund level without reducing the advisory fee at the investing fund level. However, the SEC is proposing to retain a requirement that the acquiring fund either (i) refrain from paying any sales load, distribution fees, or service fees on acquiring fund shares, or (ii) if the acquiring fund pays these loads or distribution fees, the acquiring fund’s investment adviser waives a sufficient amount of its advisory fee to offset these costs.

Proposed Rule 12d1-2: affiliated funds of funds. Proposed Rule 12d1-2 provides relief from certain Section 12(d)(1)(G) limitations on investments by funds in unaffiliated funds. Under the proposed rule, an affiliated fund of funds would be permitted to acquire up to 3% of the securities of funds that are not part of the same group of investment companies, subject to the limits of Section 12(d)(1)(A) or 12(d)(1)(F). In addition, the proposed rule would permit an affiliated fund of funds to invest directly in stocks, bonds, and other types of securities if these investments are consistent with the fund’s investment policies. Finally, the proposed rule would permit an affiliated fund of funds to invest in either affiliated or unaffiliated money market funds.Proposed Rule 12d1-3: unaffiliated funds of funds. Proposed Rule 12d1-3 would permit funds relying on Section 12(d)(1)(F) to charge sales loads greater than 1 ½ percent, provided that the aggregate sales load any investor pays (i.e., the combined distribution expenses of both the acquiring and acquired funds) does not exceed the limits on sales load established by the National Association of Securities Dealers, Inc. for funds of funds.

New Fee Table Disclosure. The SEC also proposes amending Form N-1A to require registered open-end funds investing in shares of another fund to include in the fee table section of the prospectus an additional line item, setting forth the acquiring fund’s pro rata portion of the cumulative expenses charged by the acquired funds. Those costs would be included in the acquiring fund’s total annual operating expenses and would be reflected in the expense example. The proposed disclosure requirements also would apply with respect to investments in any unregistered fund. The SEC also proposes to amend Form N-2 to include similar disclosure. As a result, a registered closed-end fund of hedge funds would be required to include a pro rata portion of the hedge fund’s expenses in its fee table. The proposal also would require separate accounts to include in their registration forms disclosures regarding the expenses of acquired funds. Comments must be received by December 3, 2003. SEC Release Nos. 33-8297; IC-26198; File No. S7-18-03.

The ICI Board unanimously recommended that mutual funds adopt two additional best practices regarding corporate governance as described below. The ICI Board also renewed its recommendation that all mutual funds adopt and implement the 15 best practices recommended for mutual fund directors by the ICI’s 1999 Advisory Group.

Prohibiting “close family members” from serving as independent directors. The ICI Board recommended that mutual funds adopt policies prohibiting close family members of an employee, officer or interested director of the fund, its adviser or principal underwriter from serving as independent directors. The ICI Board noted that the 1940 Act currently prohibits “members of the immediate family” of an affiliated person of a fund, its adviser or principal underwriter from serving as independent directors. “Members of the immediate family” is defined to include any parent, spouse of a parent, child, spouse of a child, spouse, brother or sister and include step and adoptive relationships. The ICI Board commented that while this definition is “broad,” it does not include close relatives such as uncles, aunts or cousins. The ICI Board noted that regardless of the experience such a family member may bring to the board, these types of “close family relationships” may create the appearance that the person’s independence could be compromised. The ICI Board thus recommended that investment company members adopt policies adhering to the more stringent definition by prohibiting close family members, including aunts, uncles and cousins, of an affiliated person of the fund, its adviser or principal underwriter from serving as an independent director of the fund.

Implementing audit committee requirements similar to those applicable to operating companies under Section 301 of the Sarbanes-Oxley Act of 2002. The ICI noted that under rules adopted pursuant to Section 301 of the Sarbanes-Oxley Act, national securities exchanges are prohibited from listing any security of an issuer unless:

• the members of the issuer’s audit committee meet specified independence criteria;
• the issuer’s audit committee is directly responsible for the appointment, compensation, retention, and oversight of the work of any registered public accounting firm employed by the issuer for the purpose of preparing or issuing an audit report or related work, and each such firm reports directly to the audit committee;
• the audit committee has established procedures for the receipt, retention, and treatment of complaints received by the issuer regarding accounting, internal accounting controls, or auditing matters, and for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters;
• the audit committee has the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties; and
• the issuer provides for appropriate funding, as determined by the audit committee, to compensate both the registered public accounting firm retained by the issuer to render or issue an audit report and any advisers employed by the audit committee.

The ICI Board noted that while the above standards do not apply to open-end mutual funds, many funds have voluntarily chosen to implement them. As a result, the ICI Board recommends that investment company members apply standards similar to those above. ICI press release, October 7, 2003.

On October 6, 2003, SEC Chairman Donaldson addressed the recent allegations regarding the late trading and market timing of fund shares. He stated that the SEC is aggressively investigating the allegations and is committed to holding those responsible for violating the federal securities laws accountable. He also noted that the SEC is seeking restitution for mutual fund investors that have been harmed by these abuses. Chairman Donaldson reported that the SEC is considering the following issues for possible rulemaking:

Late Trading. The staff may propose new rules designed to prevent late trading abuses by requiring that a fund (rather than an intermediary such as a broker-dealer or other unregulated third party) receive orders for fund shares prior to the time the fund prices its shares. This would mean that the fund would have to receive the order by approximately 4:00 p.m. for the investor to receive that day’s price. Fund intermediaries typically are permitted to accept orders until 4:00 p.m. and then batch and transmit the orders to the fund later that same day. The requirement that a fund receive all orders by 4:00 p.m. may present operational difficulties for fund intermediaries who will be required to begin the batching and transmission of orders earlier than 4:00 p.m. The staff is also considering whether to require funds to have additional procedures and control in place to prevent late trading and ensure compliance with the new pricing requirements.

Market Timing. The staff may propose new rules to curb market timing abuses by:

• requiring explicit disclosure in fund offering documents of market timing policies and procedures;
• requiring funds to have procedures to enhance compliance with representations regarding market timing policies and procedures;
• emphasizing the obligation of funds under certain circumstances to minimize market timing arbitrage opportunities; and
• reinforcing the obligation of fund directors to consider the adequacy and effectiveness of fund market timing practices and procedures.

Chairman Donaldson stated that these were not the only measures under consideration, and he has asked the staff to consider whether additional requirements are necessary to reinforce funds’ and advisers’ obligations to comply with their fiduciary duties and to prevent the misuse of material non-public information. SEC Press Release 2003-136, October 9, 2003.

The NASD released an interpretive letter dated October 2, 2003 to the Security Industry Association (“SIA”) clarifying certain issues relating to the sales of hedge funds and funds of hedge funds in response to the SIA’s request.

Suitability. In the letter, the NASD clarified that when a member’s due diligence on a fund of hedge funds establishes a sufficient basis to evaluate the merits and risks of the investment at the fund level, then it would generally not require, for regulatory purposes, further due diligence into the underlying funds. The NASD noted that the determination of whether to conduct due diligence at the underlying fund level is fact specific and depends on the information and findings at the fund of hedge funds level.

Risk Factors Considered. The NASD also clarified that its April 22, 2003 news release announcing it had fined a member for failing to adequately disclose the risks of investing in hedge funds was not intended to list the risk factors that must be included in hedge fund sales literature used by members. In the news release the NASD cited nine specific hedge fund risks that the member had failed to include in its sales material. The NASD reminded the SIA that NASD Conduct Rule 2210(d)(1) requires members to include only those disclosures that are necessary to ensure that each piece of sales material is fair and balanced, which the NASD noted does not translate to a requirement that a list of risk factors must be included on each piece of hedge fund sales literature.

Hedge Fund Sales Material. In response to the SIA’s inquiry regarding the permissibility of including related performance information in hedge fund marketing materials, the NASD noted that it had proposed amendments that would amend its advertising rules to permit related performance information in mutual fund and variable product sales material. Related performance would include the performance of another fund managed by the same manager as the recommended fund. The NASD responded that it would consider whether to amend a pending rule proposal to propose permitting the use of related performance information for hedge fund sales material. However, because of the pending rule proposal, the NASD stated it does not believe that it would be appropriate to exempt, or otherwise interpret NASD rules to permit, related performance information for hedge fund sales material. BNA Securities Regulation & Law Report, Volume 35, Number 40, October 13,2003.