At publication time, Congress was still working on legislation to address the current market crisis.

For a detailed analysis of the reactions to the market crisis in this regard see the WilmerHale Alert dated September 25, 2008 available at
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8491
For an analysis of the revised draft of an Economic Recovery and Corporate Accountability Act see the WilmerHale Alert dated September 26, 2008 available at
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8494
 

On September 23, 2008, the U.S. Senate passed a bill (H.R. 6049) including clean energy tax incentives, AMT protection and extensions of various family and business tax cuts. The U.S. House of Representatives passed a similar bill (H.R. 7060) on September 26, 2008. The bill included some revenue raising provisions, including provisions that would tax service providers on a current basis if such service providers receive deferred compensation from a tax indifferent party, such as an offshore corporation in a low or no-tax jurisdiction. The provision is effective for compensation which is attributable to services performed after December 31, 2008. Deferred compensation that is attributable to services performed before January 1, 2009 will be included in income in the earlier of the taxable year in which the right to the deferred compensation ceases to be subject to a substantial risk of forfeiture or the last taxable year before 2018.

Beginning in 2009, this bill would effectively eliminate the ability of U.S. fund managers to defer fee income from funds organized as offshore corporations. Deferred fees for such arrangements in existence prior to the end of 2008 would be “grandfathered” but only for an additional ten years, through 2018. Under the bill, deferral arrangements currently in place that expire after the end of 2018 could be amended to bring the payout within the 10-year period without any penalty.

For more information see the materials available at:
http://finance.senate.gov/press/Bpress/2008press/prb092308E.pdf 
http://waysandmeans.house.gov/news.asp?formmode=release&id=697 

Note: At time of publication, the text of the bills were not available.

Richard H. Baker, President and CEO of the Managed Funds Association (“MFA”), issued several statements in response to the SEC’s actions on short selling. The MFA stated that it is troubled by the SEC’s unprecedented actions in response to the crisis. Specifically, the MFA stated that it opposes “restrictions on short selling and maintain that short selling is an essential risk management tool and a critical component of ensuring market stability and not a contributor to market volatility.” The MFA contends that restricting short selling has not been shown to provide an ultimate benefit to the stock it is meant to protect. To prove this point, the MFA pointed out that when the first emergency order was enacted in July 2008 and later extended, the stock prices of the 19 financial sector securities went up initially, but by the time the order expired, the majority of those securities had declined in value during the time of the order.

In addition, the MFA voiced its opposition to the requirement for institutional investment managers to publicly disclose their short positions. The MFA stated that the disclosure requirement does not address the SEC’s concerns and will be harmful to institutional investment managers’ investors and their underlying businesses. Also, the MFA noted that it is seeking immediate exemptions from the SEC actions and revisions that clarify certain compliance issues.

For more information see the News Releases available at
http://www.managedfunds.org/downloads/MFA%20Opposes%20SEC%20Emergency%20Ban%20and%20Disclosure%20Requirements%20_2_.pdf;
http://www.managedfunds.org/downloads/MFA%20Responds%20to%20SEC%20Actions%20on%20Short%20Selling.pdf  

On September 22, 2008, New York Governor David A. Paterson announced that New York State will, beginning on January 1, 2009, regulate a portion of the credit default swap market that has been unregulated.

On September 21, 2008, the Fed approved the applications of Goldman Sachs and Morgan Stanley to become bank holding companies, pending a statutory five-day anti-trust waiting period. The Fed authorized the Federal Reserve Bank of New York to provide credit to the U.S. and London-based broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley to provide increased liquidity to these firms as they transition to managing their funding within a bank holding company structure.

For more information see the Fed Press Release available at
http://www.federalreserve.gov/newsevents/press/bcreg/20080921a.htm  

On September 21, 2008, the Fed approved the applications of Goldman Sachs and Morgan Stanley to become bank holding companies, pending a statutory five-day anti-trust waiting period. The Fed authorized the Federal Reserve Bank of New York to provide credit to the U.S. and London-based broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley to provide increased liquidity to these firms as they transition to managing their funding within a bank holding company structure.

For more information see the Fed Press Release available at
http://www.federalreserve.gov/newsevents/press/bcreg/20080921a.htm  

• All money market mutual funds that are regulated under Rule 2a-7 of the Investment Company Act of 1940 and are publicly offered and registered with the SEC will be eligible to participate in the program.
• Eligible funds include both taxable and tax-exempt money market funds. The Treasury and the Internal Revenue Service intend to issue guidance that will confirm that participation in the temporary guaranty program will not be treated as a federal guaranty that jeopardizes the tax-exempt treatment of payments by tax-exempt money market funds.
• The temporary guaranty program will be designed to provide coverage to shareholders for amounts held by them in such funds as of the close of business on September 19, 2008.

The Treasury also stated that further details on other aspects of the temporary guaranty program and the required documentation for funds to participate will be provided in the coming days.

For more information see the Treasury Press Release available at
http://www.treas.gov/press/releases/hp1151.htm

FINRA announced that it has reached agreements in principle relating to charges concerning the sale of auction rate securities with five member firms. Each firm has agreed to offer to repurchase at par auction rate securities that were purchased by individual investors and some institutions during a specific time period. The firms have also agreed to make whole individual investors who sold auction rate securities below par after Feb. 28, 2008. The firms will pay fines and also have agreed to have an independent, non-industry arbitrator resolve investor claims for any consequential damages.

In addition, each firm will provide notice to its eligible customers promptly. Repurchases of auction rate securities must begin no later than 30 days after the settlement is approved and must be completed no later than 60 days after settlement approval. Starting six months after the settlement is approved, each firm must make its best efforts to provide liquidity to all other investors who purchased during the same time period but who were not eligible for the initial repurchase. Best efforts may include offers to repurchase auction rate securities and/or offers of low- or no-interest loans.

For more information see the FINRA Press Release available at
http://www.finra.org/Newsroom/NewsReleases/2008/P117019  

FINRA issued a regulatory notice to member firms stating that they may exchange customer assets that are invested in specified money market funds (the “Funds”) in bulk for shares of another money market fund or for deposits in an FDIC-insured bank without complying with all of the requirements of NASD Rule 2510(d), provided written notification is sent out promptly thereafter. To qualify for this exception:

The bulk exchange must be limited to situations involving mergers and acquisitions of funds, changes of clearing members and exchanges of funds used in sweep accounts;
The negative response letter must contain a tabular comparison of the nature the amount of the fees charged by each fund;
The negative response letter must contain a comparative description of the investment objectives of each fund and a prospectus of the fund to be purchased; and
The negative response feature must not be activated until at least 30 days after the date on which the letter was mailed.
For more information see the FINRA Regulatory Notice available at
http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p117042.pdf   
 

On September 22, 2008, the SEC granted a temporary order permitting two money market funds (the “Funds”), to suspend the right of redemption and postpone payment for pending redemption requests. The temporary order was granted pursuant to section 22(e)(3) of the Investment Company Act of 1940. Specifically, the temporary order permits the (a) suspension of the right of redemption of the Funds’ outstanding redeemable securities, and (b) postponement of payment for the Funds’ shares which have been submitted for redemption for which payment has not been made. The SEC’s action is based on findings of the Funds’ board, including the board’s independent directors. The order does not have a specific expiration date, but will be in effect until the markets are liquid to a degree that enables each Fund to liquidate portfolio securities without impairing the net asset value of each Fund, or the SEC, on its own initiative, rescinds the order. The temporary order is in effect as of September 17, 2008. Of note, the temporary order was not preceded by a notice of application nor did it allow interested persons to request a hearing.

For more information see the SEC Order available at
http://www.sec.gov/rules/ic/2008/ic-28386.pdf.

The SEC adopted final rules to allow certain foreign institutions to file beneficial ownerships reports on Schedule 13G to the same extent as would be permitted by their U.S. counterparts, where specific conditions are satisfied. Specifically, Schedule 13G will be available to foreign institutions: (a) governed by a regulatory system substantially comparable to the U.S. regulatory system for domestic institutions; and (b) that acquire and hold the equity securities in the ordinary course of business and not with the purpose or effect of influencing or changing control of the issuer, nor in connection with or as a participant in any transaction that has such a purpose or effect, including any transaction subject to Rule 13(d)-3(b) under the Securities Exchange Act of 1934. A foreign institution, similar to a domestic institution, will need to determine whether it is qualified to use the short-form Schedule 13G at any time it exceeds the beneficial ownership threshold. If eligible to File on Schedule 13G as a qualified institutional investor, the financial institution has to provide the certification required by Schedule 13G.

The SEC announced an expansion to its investigation of possible market manipulation in securities of financial institutions by obtaining statements under oath from market participants. Specifically, investors with significant trading activity in financial issuers or positions in credit default swaps, such as hedge fund managers, broker-dealers, and institutional investors, will be required, under oath, to disclose their positions to the SEC and provide certain other information. NYSE Regulation and FINRA will be conducting a separate, parallel inquiry in coordination with the SEC by making on-site visits to various broker-dealers to address concerns about recent short selling activity.

In addition, the SEC approved a formal order of investigation that permits SEC enforcement staff to obtain additional documents and testimony by subpoena. The SEC’s actions aim to evaluate recent reports of trading irregularities and allegations of false rumor mongering, abusive short selling and possible manipulation of financial stocks.

For more information see the SEC Press Release available at
http://www.sec.gov/news/press/2008/2008-214.htm  

The SEC approved two sets of amendments to its emergency order banning short selling in financial securities. Specifically, the amended order kept in place the exception contained in the original order for short selling related directly to bona fide market making in derivatives, including over-the-counter swaps, in the securities of any included financial firm. However, this exemption now requires that, for new positions, a market maker may not sell short if the market maker knows a customer or counterparty is increasing an economic short position in the shares of the included financial firm. The provisions of these amendments relating to short selling are similar, but not identical, to those concepts imposed by the U.K. Financial Services Authority (“FSA”). Unlike the FSA, the SEC stated that it does not have statutory authority over swap contracts and other non-security over-the-counter derivatives.

The amended order also states that the listing exchanges may select the individual financial institutions with securities covered by the order. Issuers can opt out by notifying the exchanges to exclude their securities from the list.

In addition, the amended order revised the reporting of new short sales of certain publicly traded securities by investment managers. Under the amended order, the information disclosed by investment managers on new Form SH will be not become available to the public via the SEC’s EDGAR website until 2 weeks after it is electronically filed with the SEC.

Lastly, the SEC staff has posted an FAQ regarding the SEC's emergency order concerning disclosure of short selling on its website to assist in the understanding and application of the order.

For more information see the SEC materials available at
http://www.sec.gov/news/press/2008/2008-213.htm
http://www.sec.gov/news/press/2008/2008-217.htm
http://www.sec.gov/news/press/2008/2008-218.htm; the Amended Emergency Orders at
http://www.sec.gov/rules/other/2008/34-58611.pdf
http://www.sec.gov/rules/other/2008/34-58591a.pdf; and the FAQs at
http://www.sec.gov/divisions/marketreg/shortsaledisclosurefaq.htm

*Please note that these amendments are current as of the date of publication.

Prior to the Fed’s and the Treasury’s moves to assist money market funds, several experienced significant redemption pressures and were forced to take drastic measures in response. On September 17, 2008, a U.S. money market fund valued its shares at less than $1. Losses tied to investments in now bankrupt Lehman Brothers, Inc. caused the fund to value its shares at $0.97. This was the first time a money market fund was unable to maintain a $1 net asset value since 1994 and the first significant failure by a money market fund. This caused widespread response from many fund companies seeking to reassure investors that their investments in their money market funds remained safe.
On September 18, 2007, another fund company closed a $15 billion dollar money market fund due to massive redemptions the day before. The fund board decided to close the fund and disperse its assets to investors in the hopes that this will prevent a situation where the earliest redeeming investors are favored over those who seek to redeem later. The fund last priced at $1 and is now in liquidation.

Other money market funds were quick to issue statements to the public to ease investors’ concerns.

For more information, see
http://www.ignites.com/articles/20080917/sapped_lehman_money_fund_breaks_buck; http://www.ignites.com/articles/20080918/funds_scramble_quell_rising_money_fund; and http://biz.yahoo.com/ap/080918/putnam_fund_liquidates.html?.v=1  

On September 18, 2008, the Federal Reserve (the “Fed”) announced that it will intervene in the markets for commercial paper and U.S. agency debt in an effort to help stem the redemption pressure facing money market funds in the U.S. The Fed will extend loans to banks to purchase ``high-quality'' asset-backed commercial paper from money market funds. The emergency lending is one of the many steps the government is talking in an effort to return stability and confidence to the financial markets hit by massive redemptions and significant losses.

The Fed indicated that prime money market funds hold about $230 billion in asset- backed commercial paper that banks can buy with the Fed funds and $69 billion of the agency debt.

http://www.bloomberg.com/apps/news?pid=20601087&refer=&sid=aIPswrxo1ZkQ  

On September 19, 2008, U.S. Treasury Secretary Henry Paulson announced that the Treasury is seeking to buy up bad mortgage debt. Paulson indicated that the package will be in the hundreds of billions of dollars and will require legislation from Congress. The plan is for the government to purchase the illiquid debt and thereby unclog credit markets by unburdening current holders of their bad debts. Treasury officials plan to meet with members of Congress over the weekend and offer a package of proposed legislation which the Treasury would like Congress to enact as early as next week.

Paulson also indicated that both Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities and in an effort to increase the availability of capital for new home loans, the Treasury will expand the mortgage-backed securities purchase program that it announced earlier this month

For more information see the Secretary’s comments available at
http://www.ustreas.gov/press/releases/hp1149.htm  

On September, 18, 2008, the U.S. Treasury announced that it plans to use $50 billion dollars to insure the money market mutual funds $1 share price, both for retail and institutional funds. The Treasury indicated that it believes the failure of money markets to price their shares at $1 is contributing to a lack of confidence and liquidity in the market. The Treasury noted that the program will provide support to investors in funds that participate and those funds will not "break the buck".

The Treasury will support the program by tapping the assets of the Exchange Stabilization Fund (“ESF”). The legal basis of the ESF is the Gold Reserve Act of 1934, as amended (the “GRA”). The GRA provides that "the Department of the Treasury has a stabilization fund … Consistent with the obligations of the Government in the International Monetary Fund on orderly exchange arrangements and an orderly system of exchange rates, the Secretary …, with the approval of the President, may deal in gold, foreign exchange, and other instruments of credit and securities.” Apparently the ESF’s power to deal in “securities” is to be deployed to allow the ESF to offer money market fund $1 NAV insurance.

For more Information see the Treasury Release available at
http://www.ustreas.gov/press/releases/hp1147.htm; and
http://www.treas.gov/offices/international-affairs/esf/  

The SEC brought two fraud cases this week; in one it charged three individuals with conducting a Ponzi scheme; and in the other it charged a registered investment adviser with defrauding investors by investing their assets in vehicles that turned out to be Ponzi schemes and the adviser did not disclose this to the investors once the adviser realized the true nature of the schemes.

For more information, see the SEC Releases available at
http://www.sec.gov/news/press/2008/2008-202.htm;
http://www.sec.gov/litigation/litreleases/2008/lr20719.htm;
http://www.sec.gov/news/press/2008/2008-203.htm; and the Order available at http://www.sec.gov/litigation/admin/2008/ia-2778-o.pdf  

On September, 16, 2008, the SEC’s Jamie Eichen, Assistant Chief Accountant in the Division of Investment Management, spelled out guidance for fund auditors and accountants while speaking at the Investment Company Institute’s Tax and Accounting Conference.

The SEC noted that many closed end funds fail to disclose the distribution yield of derivative and other instruments apart from overall fund performance. She states that funds must clearly disclose what portion of their yield is actually a return of capital. Another issue is when funds compare yield of a derivative-heavy product to performance of a broad-based index. The SEC also reminded funds that the data included in their financial report should be the same data used in other publications (including on fund websites). The SEC also noted that disclosures and presentations of expenses are often problematic for accountants and attention should be paid to rules around disclosing things like voluntary fee waivers in an appropriate fashion. Funds should also have procedures in place for reviewing data compiled by vendors.

For more information, see http://www.ignites.com/articles/20080917/spells_financial_reporting_pitfalls  

On September 17, 2008, the SEC sought to provide some clarity for operators of money market funds in an effort to ease concerns that if they provide support to their money market funds that such support will result in on-balance-sheet accounting. A number of money market sponsors have agreed to give credit support with respect to individual issues held in their funds. The Office of the Chief Accountant indicated that it believes that on-balance sheet accounting for supported money market funds is not required if “the sponsoring financial institution does not absorb the majority of the expected future risk associated with the money market fund’s assets, including interest rate, liquidity, credit and other relevant risks that are expected to impact the value of the money market fund assets.”

For more information see the Release at
http://www.sec.gov/news/press/2008/2008-205.htm  

In another response to the recent market developments, on September 17, 2008, the SEC issued three new rules aimed at protecting against abuses related to naked short sales.

For additional analysis of the SEC’s actions in this regard see the WilmerHale Alert dated September 18, 2008 available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8471.

A brief summary of the rules follows.

• Temporary Rule 204T under Regulation SHO. This Rule enhances delivery requirements on sales of equity securities that occur on or after September 18, 2008, at 12:01 a.m. In particular, clearing firms must settle sales of equity securities that clear through a registered clearing agency by delivering shares by the close of business on settlement date (generally T+3). In the event of a failure to deliver, the fail must be closed out by the clearing firm no later than the beginning of trading on the day after settlement date (generally T+4) through a purchase or borrow of securities of like kind or quantity. The rule allows the clearing firm until the beginning of trading on T+6 to effect a close-out in connection with a failure to deliver if it can demonstrate that the failure to deliver resulted from a long sale. If any fail is not closed out within the specified period, the clearing firm and any introducing broker from which it receives trades for clearance and settlement will be prohibited from effecting any short sales in the security for any customer or proprietary account unless the security is pre-borrowed. This pre- borrow requirement remains in effect until the fail is resolved through settled purchases.
• Amended Rule 203(b)(3) of Regulation SHO. This amendment eliminates the current exemption from the close-out requirement for options market makers that sell short to hedge options positions established before the securities became threshold securities. Going forward, options market makers will be treated in the same way as other market participants. For positions existing on September 17, 2008, in connection with which an options market maker previously had been relying on the exemption (e.g., positions that, as of September 17, 2008, had aged beyond day 13 in reliance on the exemption), the Commission will allow 35 days to effect close-outs.
• Rule 10b-21 under the Exchange Act. This Rule provides that it is a fraudulent practice if a person fails to deliver a security by settlement date and such person misrepresented its intention or ability to deliver the security on or before settlement date.

For more information, see the SEC Release available at
http://www.sec.gov/news/press/2008/2008-204.htm; new rules available at
http://www.sec.gov/rules/other/2008/34-58572.pdf  

On September 18, 2008, the SEC took temporary emergency action to prohibit short selling in financial companies, among other steps, in an effort to stem the tide of losses and strengthen investor confidence in the face of one of the most difficult weeks for the U.S. economy in history.

For a detailed analysis of the SEC’s actions in this regard see the WilmerHale Alert dated September 19, 2008 available at http://wilmerhaleupdates.com/ve/ZZkKI59t298261wR909. A brief summary of the rules follows.

Exercising its powers under Section 12(k) of the Securities Exchange Act of 1934 (the “Exchange Act”) the SEC:

• temporarily prohibited short selling in 799 financial firms.
• established a new form, Form SH, on which institutional money managers who previously were required to file only Form 13F will be temporarily required to file the new weekly Form SH disclosing certain short sale positions for every week in which they have effected short sales.
• temporarily eased restrictions on the ability of securities issuers to re-purchase their securities in connection Rule 10b-18 under the Exchange Act.

The SEC action followed action by the U.K. Financial Services Authority (“FSA”) to ban short selling in 30 financial stocks through January 16, 2009. The FSA moved to prohibit the active creation or increase of net short positions in publicly quoted financial companies from midnight on September 18, 2008.

In addition, the FSA will require daily disclosure of all net short positions in excess of 0.25 per cent of the ordinary share capital of the financial companies held at market close on the previous working day.

For more information see the SEC Release available at
http://www.sec.gov/news/press/2008/2008-211.htm; and the Emergency Orders at http://www.sec.gov/rules/other/2008/34-58592.pdf;
http://www.sec.gov/rules/other/2008/34-58591.pdf;
http://www.sec.gov/rules/other/2008/34-58588.pdf; and new Form SH and its Instructions at http://www.sec.gov/about/forms/formsh.pdf;
http://www.sec.gov/about/forms/formsh_instructions.pdf

For more information on the U.K. developments see the FSA Release available at http://www.fsa.gov.uk/pages/Library/Communication/PR/2008/102.shtml  

The U.S. financial markets saw major developments almost daily this week as Lehman Brothers, Inc. filed for Chapter 11 bankruptcy at the start of the week. The FSA seized Lehman’s U.K. operations, leaving trades unsettled and collateral in limbo. The FSA then addressed short selling of financial stocks.

The SEC began taking its own steps to curb short selling, first abusive naked short selling, and then short selling of any financial company securities (See SEC Actions below). Major pension funds also joined in to help slow short selling by refusing to lend their shares to short sellers.

Insurance giant AIG received a loan from the Federal Reserve of $85 billion. The Fed took a 79.9 % equity stake in the company.

Money market funds faced redemption pressure. Actual or perceived exposure to troubled securities lead to the inability of a fund to continue to price its shares at $1 for the first time since 1994 and caused the closing and liquidation of another. The U.S. Treasury moved later in the week to provide a program in which money market funds could tap into a pool of funds to assist them in making sure they are able to maintain a $1 net asset value. (See U.S. Treasury Actions and Other Actions below). This met with strong objections from the banking community.

The Treasury announced that it will ask Congress to approve the purchase of bad mortgage debt from companies struck by the crisis. The Treasury sees this as the way to unlock the liquidity jam that has persisted since the crisis began. (See U.S. Treasury Actions below).

For more information on these developments see
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amrQtoxTGmgU;
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aBPOapW_kJkM;
http://www.reuters.com/article/marketsNews/idUSN1844668920080918;
http://www.ignites.com/articles/20080917/sapped_lehman_money_fund_breaks_buck; http://www.ignites.com/articles/20080918/funds_scramble_quell_rising_money_fund; and
http://www.bloomberg.com/apps/news?pid=20601087&sid=aSRNsND9VcL8&refer=home  

A bill, entitled the “Securities Act of 2008” passed the House of Representatives. The 2008 bill would amends the federal securities laws in numerous ways, including the Investment Advisers Act of 1940 (the “Advisers Act”) and the 1940 Act. The bill would 1) amend Section 204 of the Advisers Act so as to assure the confidentiality of SEC examination records; 2).clarify that Section 205 (concerning advisory fees including performance fees) does not apply to state registered advisers; 3) amend both acts to authorize the SEC to assess and impose civil penalties in a cease and desist proceeding; 4) amend Section 36(a) of the 1940 Act which relates to breaches of fiduciary duty involving personal misconduct to apply to any person who at the time of a specified alleged misconduct was: an officer or director of an investment company; 5) amend the Advisers Act to empower the SEC to bar certain persons from being associated with an investment adviser, and to allow nationwide service of subpoenas in any action instituted by the SEC.

For more information, see
http://www.govtrack.us/congress/bill.xpd?bill=h110-6513; and
http://www.sec.gov/news/press/2008/2008-195.htm  

On September 10, 2008, the Attorney General for California settled a case against a large broker-dealer related to revenue sharing arrangements. Under the settlement, the company agreed to pay $7.5 for the company’s failure to disclose revenue sharing arrangement that it had in place with mutual fund companies to the companies’ clients. The company previously settled a revenue sharing case with the SEC in 2004.

For more information, see http://ag.ca.gov/newsalerts/release.php?id=1607; and http://ag.ca.gov/cms_attachments/press/pdfs/n1607_final_agreement.pdf  

On August 20, 2008, a fund complex was sued by shareholders in its funds alleging that the fund’s adviser paid brokers inappropriate distribution fees not authorized by a Rule 12b-1 plan which were also allegedly inadequately disclosed to shareholders. The Complaint alleges that while the funds’ prospectuses indicated that brokers “may” receive additional compensation, the funds knew they had agreements in place to pay the additional compensation so disclose that they “may” do so is misleading.

For more information, see http://www.ignites.com/articles/20080905/wamu_principal_with_revenue_sharing_suit  

On September 10, 2008, the Secretary of State for Massachusetts settled an auction rate securities (“ARS”) case with a large broker-dealer. As part of the settlement, the company has agreed to buy back approximately $4.5 billion in ARS held by customers who can not sell the securities due to the illiquidity in the ARS market that began back in February. This is the latest in a string of ARS settlements tied to the failure of ARS auctions following the sub-prime lending crisis fallout.

For more information, see http://online.wsj.com/article/SB122105925516519555.html  

On August 28, 2008, shareholders filed a class action lawsuit against a bond index fund claiming that the fund invested in CMOs which amounted to a deviation from its stated investment objective. The suit also alleges that the fund concentrated its investments in CMOs by investing more than 25% of its assets in them. Such concentration would be in violation of one of the fundamental objectives of the fund which was to not to concentrate investments in any one industry. The fund’s investment objective was to track a given index and the index did not hold the CMOs that the fund invested in, which resulted in losses for the fund investors at a time when the index return was positive according to the Complaint. The Complaint also describes that the fund should not have changed investment objectives without shareholder votes. The suit alleges that the fund, by its actions, violated Section 13 of the 1940 Act, breached fiduciary duty, breached contracts, and breached the covenant of good faith and fair dealing.

The fund involved in the case previously expressed, in a Statement of Additional Information, that CMOs are not part of any industry for purposes of the fund’s concentration policy. The Complaint notes this, but indicates that the plaintiffs believe the CMOs were all part of the same industry and that by concentrating in them the fund violated its concentration policy.

For more information, see http://www.ignites.com/articles/20080910/schwab_legal_woes_grow_another_bond;
PACER users (subscription and login required) also see the Motion and Order at
https://ecf.cand.uscourts.gov/cgi-bin/HistDocQry.pl?104963369204363-L_795_0-1  

On September 7, 2008, the U.S. Treasury announced that it would acquire $1 billion in preferred shares in Fannie Mae and Freddie Mac, and pledged to provide as much as $200 billion to the companies in financial assistance. The Treasury's plan puts the two companies under a conservatorship, giving control to their regulator, the Federal Housing Finance Agency which has assumed the powers of the shareholders, directors and management.

The conservatorship has affected mutual funds in obvious ways in as much as Fannie and Freddie stock (adversely) and bond (favorably) prices have affected fund holdings. Importantly, fund companies have been examining the impact on their derivative instruments and under Investment Company Act of 1940 (the “1940 Act”) Rules 2a-7 and 5b-3(c)(2).

For more information, see http://online.wsj.com/article/SB122079276849707821.html;
http://www.ignites.com/articles/20080908/fannie_freddie_takeover_savaging_funds; http://online.wsj.com/article/SB122083521070808711.html;; and http://www.ignites.com/articles/20080910/payday_pimco_total_return  

On September 4, 2008, FINRA announced that it had barred two brokers and suspended another in connection with the sale of collateralized mortgage obligations (“CMOs”). FINRA is in the midst of an ongoing investigation into abuses in the marketing and sales of mortgage-backed securities such as CMOs to retail customers and this is the first action resulting from those ongoing investigations. FINRA alleges that the brokers involved in this case sold CMOs to investors with limited investment experience for whom such investments were unsuitable. The brokers allegedly purchased “inverse floater” CMOs, which FINRA describes as thinly traded mortgage-backed securities which are typically highly leveraged and vulnerable to a high degree of price volatility. FINRA notes that the brokers’ impacted customers lost several hundreds of thousands of dollars as a result of the investments. FINRA indicates that it has warned members that inverse floater CMOs are only suitable for sophisticated investors with higher risk profiles for the last fifteen years.

For more information, see the FINRA News Release available at http://www.finra.org/Newsroom/NewsReleases/2008/P039153  

On September 10, 2008, the SEC named Michael Dicke as Associate Regional Director for Enforcement in its San Francisco Regional Office. Mr. Dicke is a twelve year SEC veteran who will oversee the group responsible for investigating and litigating federal securities law violations in Northern California, Oregon, Washington, Montana, Idaho, and Alaska. Mr. Dicke replaces Marc Fagel, who moved up to become the Regional Director of the Office.

For more information, see the SEC Release available at
http://www.sec.gov/news/press/2008/2008-192.htm  

On September 11, 2008, the SEC charged a large financial services company with failing to adopt adequate policies and procedures as required of an investment adviser under the Safeguards Rule of Regulation S-P. According to the Administrative Order, the company identified potential weaknesses in its procedures to protect information from “hacking” in 2006 but did not address them and in 2007 and early 2008 customers experienced incidents of “hacking” in which unauthorized persons traded or attempted to trade in customer accounts. The SEC charged that the company had failed to implement increased security measures in response to the weaknesses it had identified and additionally failed to adopt written policies and procedures.

The firm involved agreed to settle the action without admitting or denying the SEC’s findings. As part of the settlement, the firm agreed to cease and desist from committing future violations of the Safeguards Rule, to pay the $275,000 penalty, and to other remedial actions.

For more information, see the SEC Releases available at
http://www.sec.gov/news/press/2008/2008-193.htm; and
http://www.sec.gov/litigation/admin/2008/34-58515.pdf  

On September 3, 2008, the U.S. District Court for the Southern District of New York denied motions to dismiss filed by two former brokers in a case that was brought by the SEC in 2006 based on market timing allegations. The SEC alleged in its Complaint that four brokers committed fraud against several mutual fund companies in violation of Section 17(a) of the Securities Act of 1933 (“Securities Act”) and Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) (and Rule 10b-5 thereunder), in part by hiding their identities. The Complaint alleges that the fund companies attempted to block brokers that they believed were engaging in market timing and that the brokers involved then used different account numbers and different broker identification numbers in order to avoid detection of the fund companies and continue market timing.

Among other issues specific to the case, addressed the question of market timers that hide their identity. The Court dismissed the defendant’s argument that he owed no duty to the funds to provide accurate identifying information because the defendant owed no duty to disclose information, even if material, under the applicable securities laws because he was not a fiduciary as to the funds. The Court indicated that a duty to identify themselves plausibly arose based on the fact that the funds had explicitly notified the defendant that they no longer wanted him to trade in its shares. The Court also noted that the provision of inaccurate identification at one point would render misleading any disclosure of identification by the defendant at a subsequent point in time.

For more information, see
http://www.ignites.com/articles/20080908/brokers_motions_dismiss_timing_suit_denied  

On August 28, 2008 and August 29, 2008, shareholders filed two lawsuits in U.S. District Courts in California and New York against a number of mutual fund companies, and executives who control those companies and the funds’ directors, in connection with the fund companies’ investments in offshore internet gambling businesses. In both cases, the plaintiffs’ claims are based on allegations that the funds’ investments in offshore internet gambling businesses: (1) were illegal under 18 U.S.C. § 1955 which makes it a felony to own an illegal gambling business and therefore also violated the Racketeering Influenced and Corrupt Organizations Act (“RICO”), (2) breached fiduciary duties, and (3) amounted to negligence. The plaintiffs case is based on the premise that the investments caused fund shareholders to suffer damages in 2006 when United States law enforcement officials began arresting principals of, and otherwise targeting for prosecution, the offshore internet gambling businesses.

For more information, see http://www.bloomberg.com/apps/news?pid=newsarchive&sid=arTJfW09d524;
http://www.reuters.com/article/companyNewsAndPR/idUSN2947282120080829; and
PACER users (subscription and login required) also see the Complaints and case documents at
https://ecf.cand.uscourts.gov/cgi-bin/HistDocQry.pl?550731379770882-L_795_0-1
https://ecf.nysd.uscourts.gov/cgi-bin/HistDocQry.pl?552584797539789-L_413_0-1

On August 29, 2008, the Independent Directors Council (“IDC”) of the Investment Company Institute (“ICI”) filed a comment letter objecting to the SEC’s proposed rule on nationally recognized statistical rating organizations (“NRSRO”). On September 4, 2008, the Securities Industry and Financial Markets Association (“SIFMA”) also filed a comment letter objecting to the proposal.

As we previously reported, the SEC’s proposed rule would make various changes under the Investment Company Act of 1940 (the “1940 Act”) including to amend Rule 2a-7, which governs the operation of money market funds, to eliminate references to ratings, while offering protections similar to the current rule’s reliance on NRSRO ratings, and to amend Rule 5b-3, which allows investment companies to treat the acquisition of a repurchase agreement as an acquisition of securities collateralizing the repurchase agreement for purposes of Sections 5(b)(1) and 12(d)(3) of the 1940 Act, if the obligation of the seller to repurchase the securities from the fund is “fully collateralized,” as defined in the 1940 Act, would be amended to eliminate the requirement that collateral other than cash or government securities be rated by an NRSRO, and instead require the investment company’s board of directors (or its delegate) to determine that such collateral securities present minimum credit risk and are highly liquid. The IDC focused on the proposal to increase fund directors’ participation in detailed credit analysis of individual securities. Of note for money market funds, both SIFMA and the IDC strongly objected to the removal of references to ratings in the 2a-7 context in their comment letters.

For more information, see the IDC Letter available at http://memos.ici.org/intradoc/groups/attachments/documents/attachment/22832.pdf; and the SIFMA Letter available at http://www.sifma.org/assets/0/232/234/274/6437ecc7-543b-4533-846c-a79ab5720850.pdf;
and http://www.reuters.com/article/fundsFundsNews/idUSN0429200520080904?pageNumber=1&virtualBrandChannel=0; and WilmerHale’s July 11, 2008 News Summary discussing the Proposed Rules at
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8447  

On August 29, 2008, the Investment Company Institute (“ICI”) filed a comment letter in support of the SEC’s proposal to permit funds to provide investors with a summary prospectus, and make additional information available on the internet or upon request. The SEC initially released the proposal to streamline fund disclosures on November 15, 2007 and reopened the comment period of July 31, 2008. The ICI’s comment letter continues to press the case for a simple summary proposal with performance updates and holdings information made available over the internet.

For more information, see the ICI Letter available at
http://members.ici.org/doclink.do?file=22836; and the SEC’s reopened Proposed Rule available at
http://www.sec.gov/rules/proposed/2008/33-8949.pdf  

FINRA will conduct a special meeting on November 21, 2008, to elect an individual to fill the vacant Small Firm Governor seat. A formal notice of the meeting, including the precise time and location, will be mailed on or about October 24, 2008. The individual nominated by the NASD Group Committee of the FINRA Board for election to the Small Firm seat is Mari J. Buechner. Ms. Buechner is the President and Chief Executive Officer of Coordinated Capital Securities, Inc. (CCS), a full-service broker-dealer and investment advisory firm located in Madison, WI. In 2008, Ms. Buechner was appointed as an at-large member of FINRA’s Small Firm Advisory Board. She is a member of FINRA’s Independent Dealer/Insurance Affiliate Committee and has been active in District 8 Committees as well. She is also a Board member of the Financial Services Institute.

For more information, see the FINRA Election Notice available at http://www.finra.org/web/groups/rules_regs/documents/notice_to_members/p039122.pdf; and WilmerHale’s July Investment Management News Summary discussing the available seat at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8447

On August 22, 2008, the Department of Labor (“DOL””) announced publication of two proposed rules under the Pension Protection Act of 2006 (“PPA”), intended to provide greater access of investment advice for individuals with 401(k) type plans and individual retirement accounts (“IRAs”). The DOL previously solicited public comments in December 2006.

As a “fiduciary,” as defined under the Employee Retirement Income Security Act (“ERISA”), an investment advisor is prohibited from rendering investment advice to plan participants regarding investments that result in the payment of additional advisory and other fees to the advisor or its affiliates. However, Section 601(b) of the PPA amended the Internal Revenue Code of 1986 to add an exemption allowing the provision of investment advice to a participant or beneficiary of certain plans, so long as the investment advice is provided under an “eligible investment advice arrangement.”

Subject to certain additional conditions, the proposed rules permit advisers who are ERISA fiduciaries to dispense investment advice to participants either (a) through the use of a computer model certified as unbiased, or (b) through an adviser compensated on a “level-fee” basis. Under the proposal, the adviser is responsible for determining whether an eligible investment expert, either itself or one of its employees, possesses the requisite training and experience to certify whether a given computer model meets the requirements of the proposal. In addition, the proposed regulation includes a non-mandatory model form that advisors may use to satisfy the exemption’s fee disclosure requirement. The DOL also is proposing a class exemption that permits advisors to provide individualized advice to an individual after giving advice generated by use of a computer model, or, in the case of IRAs with respect to which modeling is not feasible, the furnishing of certain investment education material.

For more information, see the Department of Labor News Release available at http://www.dol.gov/opa/media/press/ebsa/ebsa20081195.htm; and the proposed regulation in the Federal Register available at http://www.dol.gov/federalregister/PdfDisplay.aspx?DocId=21243

In a case that could test the SEC’s jurisdiction to regulate swap contracts, the SEC and the Securities Industry and Financial Markets Association (“SIFMA”) are locked in a battle over municipal swap agreements in a case in the U.S. District Court for Northern Alabama. Earlier in August, SIFMA filed an amicus brief in support of defendants involved in a case brought by the SEC which alleges fraud in swap transactions. The defendants have attempted to defend part of the case by arguing that the SEC does not have enforcement authority over the swaps involved because the swaps were not securities-based and were instead based on a municipal swap index linked to interest rates, which was created by SIFMA. SIFMA’s brief indicates to the Court that the municipal swap index is an index of interest rates and not securities.

The SEC, in a response brief filed on August 27, 2008, argues that it does have enforcement authority over the municipal securities interest rate index swaps because they fall under the definition in Section 206B of the Gramm-Leach-Bliley Act (as amended by the Commodity Futures Modernization Act of 2000) as agreements “of which a material term is based on the price, yield, value, or volatility of any security or any group of index of securities, or any interest therein.” The SEC’s argument is that municipal interest rates are bond yields, in this case the yield on variable rate demand notes.

For more information, see
http://www.financial-planning.com/asset/article/686611/news/sec-sifma-slugfest-over-municipal-swaps.html?pg=&topicName=news; and
PACER users (subscription and login required) also see the Amicus Brief and Response Brief at https://ecf.alnd.uscourts.gov/cgi-bin/HistDocQry.pl?124613823941661-L_413_0-1

On September 2, 2008, the SEC announced that it will hold its third annual Seniors Summit on September 22, 2008 at SEC Headquarters. The SEC has brought more than 50 enforcement actions in the past two years against investment professionals based on claims of defrauding retirees and other older investors. The SEC’s examination and inspection program also conducts targeted examinations to detect fraud and other violations of securities laws that may harm senior investors. This year’s summit will include a session dedicated to educating investment advisers and brokers on practices that firms use in dealing with senior investors.

For more information, see the SEC Release available at http://www.sec.gov/news/press/2008/2008-186.htm  

The SEC’s Complaint alleges that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder, and Section 17(a)(1), (a)(2) and (a)(3) of the Securities Act of 1933 (“Securities Act”).

For more information, see the SEC Releases available at
http://www.sec.gov/news/press/2008/2008-187.htm
ttp://www.sec.gov/litigation/litreleases/2008/lr20698.htm; and the Complaint at http://www.sec.gov/litigation/complaints/2008/comp20698.pdf

The fund industry is being warned not to be caught off guard by the November 1, 2008 deadline upcoming for implementation of certain policies and procedures to comply with the Federal Trade Commission's “Red Flag” Rules. For impacted funds, the rules requires, at a minimum that it implement an identity theft prevention program must provide policies and procedures that address each of the following elements: (i) identification of red flags indicating identity theft; (ii) detection of red flags in appropriate accounts; (iii) an appropriate response when a red flag is detected; and (iv) periodic updates to ensure the identification and detection procedures are appropriate for its business and responds to industry experiences. The Rule also provides specific guidelines regarding the risks and issues that should be considered for each element of the Program.

For more information, see
http://www.ignites.com/articles/20080828/industry_caught_guard_impending_rule; and WilmerHale’s August 1, 2008 News Summary discussing the Rule available at
http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8447; and WilmerHale’s Email Alert regarding the Rule http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8451  

On August 22, 2008, 19 members of the House of Representatives, including 12 members of the Financial Services Committee which oversees the SEC, signed on to a letter asking the SEC to extend the comment period on the SEC’s proposed Rule 151A covering indexed annuities.

Proposed Rule 151A would provides that indexed annuities are not exempt from the definition of “securities” under Section 3(a)(8) of the Securities Act. The insurance industry has argued that the SEC is over-reaching into the regulation of a product that is already covered by state insurance regulators. The congressional members who signed the letter express agreement with the insurance industry and suggest to the SEC that it extend the comment period, consult with state insurance regulators, and rethink the proposal.

For more information, see
The SEC’s Proposed Rule available at http://www.sec.gov/rules/proposed/2008/33-8933.pdf; and WilmerHale’s June 27, 2008 News Summary discussing the Proposed Rule available at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8359