A federal court has dismissed charges against a mutual fund adviser and distributor that they violated the fiduciary duties imposed by Section 36(b) of the Investment Company Act and Massachusetts law by continuing to authorize and receive distribution and service fees from shareholders even though no additional shares were being sold to new investors.

The case involved a series of principal-protected funds that were launched in 2001. The funds have a defined life cycle consisting of an “Offering Phase,” a “Guarantee Period,” and an “Index Plus LargeCap Period.” Shares of the fund were sold to the public during the Offering Phase. In the Guarantee Period, no additional shares are sold to the public, but existing investors may purchase additional shares by reinvesting dividends. In the Index Plus LargeCap Period, shares are offered only to existing shareholders. The funds at issue in the litigation were in the Guarantee Period. The funds offered four classes of shares—A, B, C, and Q—all with 12b-1 fees of various levels. Shareholders of all classes pay the distributor an annual service fee of 0.25% of net assets, and class B and C shareholders pay an additional distribution fee of 0.75% of net assets. All shareholders also are charged annual advisory fees of 0.80% of net assets.

Ruling on a motion to dismiss the amended complaint, the court found that, with respect to the distribution fee, the plaintiffs did not allege that the distribution fees were disproportionate and unrelated to the sales-related services incurred when shares were marketed and sold to the public. Instead, plaintiffs alleged only that the ongoing fees exceeded the minimal sales-related expenses incurred during the Guarantee Period. These allegations failed to allow for the situation, permitted by Rule 12b-1, in which advisory firms may recover certain sales-related expenses previously incurred when distributing the fund’s shares. The plaintiffs also failed to allege that the service fees exceeded the ongoing expenses for maintaining shareholder accounts. Accordingly, the court dismissed the Section 36(b) claims with respect to the distribution and service fees. The court also dismissed related state law claims against the adviser, distributor, and fund trustees on the grounds that the plaintiffs did not make pre-suit demands on the fund’s board of trustees prior to commencing their derivative action and did not comply with a state universal demand statute with respect to the claim against the trustees.

Separately, the court declined to dismiss a count alleging that the advisory fees were excessive, finding that the complaint alleged sufficient facts to state a claim that the fees were so disproportionately large that they did not bear a reasonable relationship to the advisory services actually rendered on behalf of the funds.

ING Principal Protection Funds Derivative Litigation, Civ. Act. No. 03-12198-JLT (D. Mass. May 9, 2005)

In response to concerns about the implementation of internal control reporting provisions under Section 404 of the Sarbanes-Oxley Act, the SEC staff issued guidance attempting to address certain concerns and improve the implementation process. Concerns centered on the significant and perhaps unnecessary costs and burdens involved in implementation of the new requirements. A Commission statement accompanying the guidance noted that the staff will continue to monitor the implementation of the internal control reporting requirements, particularly for smaller public companies and foreign private issuers, who may find the process most burdensome.

In the introduction to its guidance statement, the staff emphasized that internal financial reporting controls are not a one-size-fits-all proposition—management has the responsibility to determine the form and level of controls appropriate for an organization and to perform their assessment and testing of controls in keeping with that determination. Reasoned judgment and a risk-based approach should be used to avoid unnecessary, mechanistic reviews that may focus on details to the exclusion of the identification of risks, which is the purpose of the process. Accordingly, public accounting firms should recognize that there is a zone of reasonable conduct that should be recognized as acceptable in the implementation of Section 404.

One of the key concerns identified in the report was a chilling effect in the level and extent of communications between auditors and management regarding accounting and financial reporting issues because of concerns that discussions of internal controls could itself be deemed a deficiency. The staff noted that investors benefit when auditors and management engage in dialogue and stated its view that auditor-management interactions will not affect auditor independence so long as management, and not the auditor, makes the final determination as to the accounting used and the auditor does not design or implement accounting policies.

Commission Statement on Implementation of Internal Control Reporting Requirements, SEC News Release No. 2005-74 (May 16, 2005); Staff Statement on Management’s Report on Internal Control Over Financial Reporting (May 16, 2005) (SEC staff guidance).

The SEC Office of Compliance Inspections and Examinations released a report summarizing its findings of an examination sweep into the practices of pension consultants. The sweep was initiated as part of the SEC’s program to identify and investigate risks in the securities industry and involved 24 pension consultants that are SEC-registered investment advisers (of 1,742 advisers who indicated on Form ADV that they provide pension consulting services). The examinations covered the period from January 1, 2002 to November 30, 2003 and examined the following practices: (1) the products and services provided to pension plan clients and any products or services provided to money managers or mutual funds; (2) the method of payment for services; and (3) the disclosure provided to clients. The goal of the study was to examine conflicts of interest that may compromise the fiduciary duty that investment advisers owe their clients.

The staff report briefly discussed the following summary findings of the sweep with respect to the 24 consultants that were examined:

• More than half (13) of the pension consultants or their affiliates provided products and services to both pension plan advisory clients and money managers and mutual funds on an ongoing basis, and another quarter (6) had one-time only or other limited business arrangements with money managers during the inspection period. Of these, 3 provided no disclosure to pension plan advisory clients of the services provided to money managers and 16 provided only limited disclosure.
  
• A majority of the pension consultants have affiliated broker-dealers or relationships with unaffiliated broker-dealers that allow the consultants to obtain payment for services with brokerage “commission recapture” programs. These commission recapture programs, which are generally not well documented, allow pension plan advisory clients to direct that a portion of brokerage commissions be rebated to the plan or be used to pay the pension consultant’s fee.
  
• Many pension consultants have affiliates that also provide services to pension plan clients, leading to conflict of interest issues that have not been adequately disclosed or addressed. Based on recommendations of the consultants, many pension plan clients choose to use an affiliate of the consultant to provide various services, including investment management, brokerage management, and transition management.

The report also noted that many of the pension consultants believe they do not have any fiduciary relationships with their advisory clients, perhaps because they have taken actions to insulate themselves from being considered a “Fiduciary” under ERISA. The report recommended that pension consultants enhance their compliance policies and procedures to ensure that the adviser is fulfilling its fiduciary obligations to pension plan clients.

Staff Report Concerning Examinations of Select Pension Consultants (May 16, 2005); SEC Releases Staff Report Describing Findings from Examinations of Select Pension Consultants, SEC News Release No. 2005-75 (May 16, 2005). 

A broker-dealer, without admitting or denying the SEC findings, settled SEC charges that it had sold mutual funds without providing appropriate breakpoint discounts after having been notified of problems with breakpoints during an SEC examination. The broker-dealer was examined by the Commission staff in 2001 and was notified of one instance where it failed to give the appropriate breakpoint discount and others where customers were sold shares in amounts approximately $1000 below a breakpoint. An evaluation of the NASD-ordered self-assessment conducted by the broker-dealer calculated that the broker-dealer failed to give its customers appropriate breakpoint discounts in approximately 24% of eligible mutual fund transactions in 2001 and 2002, resulting in approximately $201,000 of missed discounts. The SEC charged that the broker-dealer violated Rule 10b-10 under the Exchange Act by not reporting on the confirmation front-end sales loads that it received, and, in cases where applicable breakpoints were not applied, for failing to sufficiently inform customers what they were paying for their shares. The broker-dealer agreed to cease and desist from future violations of Rule 10b-10 and to provide refunds with prejudgment interest of all improperly assessed sales charges.

In re SunTrust Securities Inc., Securities Exchange Act Release No. 51700 (May 17, 2005).

The NFA published guidance to help its members avoid recurring registration deficiencies that it has noted during examinations over the past few years. The NFA noted that the deficiencies appear to be unintentional and involve the areas of reporting of principals, reporting terminations of associated persons and principals, and the failure to update registration records following changes in the firm’s operations. Modifications to NFA registration can be processed through its Online Registration System and a Self Examination Checklist prepared by the NFA is available on its website at www.nfa.futures.org/compliance/selfexam.asp.

Common Registration Deficiencies, NFA Member Advisory (May 6, 2005)

In a May 11, 2005 letter to the SEC, the Committee on Investment Management Regulation of the Association of the Bar of the City of New York (the “Committee”) requested that the SEC use the public rulemaking process to provide written guidance on the obligation of investment advisers to retain and produce e-mail. The Committee noted that current guidance on e-mail retention and production has developed through the inspection and enforcement process, resulting in ambiguities regarding an adviser’s obligations.

With respect to retention, advisers are unsure how to comply with the retention requirements as they apply to e-mail because, if some e-mail is not retained, advisers fear they may be forced to prove that no required records have been deleted. As a result, many advisers feel compelled to retain all e-mail communications for five years, which is burdensome. The Committee called on the SEC to clarify what types of procedures to retain some, but not all e-mail would be viewed as reasonable. The Committee also urged the SEC to affirm the interpretation that only communications between an investment advisory firm and third parties need to be maintained, but that internal communications are not covered by the applicable retention requirement.

With respect to e-mail production, the Committee expressed concern over SEC staff requests that an adviser produce all firm e-mail, or all e-mail of certain individuals, in an electronically searchable format. The concern is that advisers are being asked to produce e-mail communications that are not required records and that the rules do not specify in what format e-mail should be retained and produced.

Letter to Jonathan G. Katz, Re: Retention and Production of E-Mail by Investment Advisers, from Committee on Investment Management Regulation of The Association of the Bar of the City of New York (May 11, 2005).

An IDC Task Force (“Task Force”) concluded that a unitary or cluster board structure is the most efficient structure for a mutual fund family and is consistent with good governance. The Task Force further argued that any arbitrary limit on the number of funds within a complex that could be overseen by a board of directors would be counterproductive and harmful to fund shareholders.

According to an industry study, as of year-end 2002, 77% of fund complexes participating in the study had a unitary or pooled board structure, in which a single board of directors oversees all of the investment companies. Another 15% of fund complexes had a cluster board structure, in which a complex has several different boards overseeing different groups of investment companies. The Task Force argued that significant efficiencies are realized when a single or limited number of boards oversees all of the funds within a complex. These efficiencies are possible because funds within the complex generally share the same investment adviser and other key service providers, which allows directors to deal with similar issues in a uniform manner, utilize common oversight mechanisms for the funds, and develop substantial expertise in fund operations. Perhaps most significantly, multiple fund oversight increases a board’s authority and influence with fund management and key service providers, enhancing the board’s effectiveness in representing shareholder interests. In contrast, limiting the number of funds overseen by directors could introduce inefficiencies and increase costs for shareholders by, among other things, duplicating board expenses, complicating the resolution of issues that may be common to all funds in a family, and complicating communications with the adviser and service providers.

The Task Force urged boards to use their annual assessment process to analyze issues that may influence effective oversight of multiple funds and identified several strategies that board members may use to facilitate oversight of multiple funds.

The Independent Directors Council was launched by the Investment Company Institute in May 2004 as an expansion of the Director’s Program. The IDC is supported by its own staff and resources, but has space in the ICI offices. The report is available on the IDC website at www.idc1.org.

Director Oversight of Multiple Funds, Independent Directors Council Task Force Report (May 2005).

Representatives Paul Ryan (R-Wisc.) and William Jefferson (D-La.) introduced legislation to defer taxes on reinvested capital gains from mutual funds until the shares are sold. The Generating Retirement Ownership Through Long-Term Holding Act (the “GROWTH Act,” H.R. 2121), introduced on May 5, has received strong backing from the Investment Company Institute (“ICI”), which contends that the measure would increase long-term savings and investment and bolster economic growth. ICI President Paul Schott Stevens advocated adoption of the legislation in a speech at the ICI’s annual membership meeting, reasoning that it would put mutual fund investors on equal footing with direct equity investors, who do not pay any capital gains taxes until an investment is sold. Stevens responded to concerns that the legislation would cost too much by referring to the finding of a Joint Economic Committee study that “deferring taxes on a mutual fund's capital gain will ultimately increase federal revenue, by producing larger account balances and higher tax revenues when sold.” The ICI has supported similar legislation when introduced in previous Congresses.

Funding Our Future: Ensuring a Strong Public and Private Retirement System (speech) Paul Schott Stevens, President, Investment Company Institute (May 11, 2005).

NASD rules require that research analysts register with the NASD after passing research analyst examinations. The rules became effective on March 30, 2004, but allowed a one-year grace period for those already functioning as research analysts, provided that their firm applied for research analyst registration within 60 days of the effective date of the new requirement.

The NASD asserted that a broker-dealer failed to apply for the research analyst designation for its analysts by the deadline, and thus failed to qualify for the one-year grace period. The firm’s research analysts issued reports for several weeks after the registration deadline but before the firm realized its failure to submit registration applications and then continued to issue reports until the NASD denied the firm’s request for an extension of the filing deadline. When its extension request was denied the firm stopped issuing research reports until its analysts has qualified for registration through examination. The broker-dealer neither admitted nor denied the NASD’s charges, but consented to the entry of NASD’s findings and a $100,000 fine.

SunTrust Capital Markets Fined $100,000 for Failing to Register Research Analysts Under New Rules, NASD News Release (May 9, 2005).

The SEC named Linda Chatman Thomsen as the Director of the Division of Enforcement on May 12 to succeed Stephen M. Cutler, who announced his departure in April. Thomsen joined the SEC staff in 1995 as Assistant Chief Litigation Counsel and has served as Deputy Director under Cutler since January 2002. Before joining the SEC, Thomsen was in private practice with the law firm of Davis Polk & Wardwell and also served as an Assistant United States Attorney for the District of Maryland.

Linda Chatman Thomsen Named Director of the Division of Enforcement, SEC News Release No. 2005-73 (May 12, 2005).

On May 12, 2005, the SEC staff began posting comment and response letters relating to disclosure filings on EDGAR. As the SEC staff indicated last year, letters relating to disclosure filings made after August 1, 2004 and reviewed by either the Division of Corporate Finance or the Division of Investment Management will be made publicly available as a matter of course. Letters will be released no earlier than 45 days after review of the associated disclosure filing is complete. Comment and response letters had previously been released only in response to FOIA requests. The practice going forward is to automatically release all comment letters and the “redacted” versions of filers’ response letters, which omit certain information for which the filer has requested confidential treatment. Anyone wishing to see the portions of a response letter that are the subject of a confidential treatment request must still submit a FOIA request for the information. Staff comment letters are filed in EDGAR with the form type “upload” and filer response letters are filed with the form type “corresp”; both can be located in the EDGAR archive with a keyword search.

SEC Staff to Begin Publicly Releasing Comment Letters and Responses, SEC News Release No. 2005-72 (May 9, 2005); SEC Staff to Publicly Release Comment Letters and Responses, SEC News Release No. 2004-89 (June 24, 2004).

The SEC has approved amendments to NASD Rule 2711 on Research Analysts and Research Reports. The amendments, intended to strengthen existing rules insulating research from investment banking influences, prohibit a research analyst from participating in an investment banking road show or otherwise discussing investment banking transactions with a customer in the presence of investment banking department personnel or company management. Investment banking personnel, in turn, are prohibited from directing a research analyst to engage in investment banking sales or marketing efforts or other communication with a customer about an investment banking transaction. Research analysts are still permitted to communicate with customers and internal personnel about an investment banking transaction, provided that company management and investment banking personnel are not present and the communication is fair, balanced, and not misleading given the context. The amendments take effect on June 6, 2005.

NASD Notice to Members 05-34, Research Analysts and Research Reports (May 2005)

In January 2004, NASD charged a broker-dealer firm with violations of the NASD suitability rules in connection with an active campaign to switch customers from variable annuity contracts issued by one insurer to contracts issued by another that had agreed to a fee sharing arrangement with the firm. The NASD argued that the firm’s president and other senior managers aggressively encouraged the sales force to switch customers from one variable annuity to another without regard for whether the switches were in the customers’ best interests. Customers subjected to switching allegedly paid close to $10 million in surrender charges while the firm earned commissions on each exchange and received additional payments through the fee sharing arrangement. The complaint charged that some customers were also steered to a more expensive annuity product that provided larger commissions to the sales force, but fewer benefits and less flexibility than another annuity from the same insurer that was also sold by the firm.

As part of the settlement, the firm agreed to reimburse to customers all surrender charges incurred in the exchanges and pay to the purchasers of the more expensive annuity the increased costs they incurred. The firm also agreed to a $5 million fine. The firm’s former president and national sales manager both received a six-month suspension and $150,000 fine.

NASD News Release, “Waddell & Reed, Inc. Agrees to Pay $5 Million Fine, up to $11 Million in Restitution to Settle NASD Charges Relating to Variable Annuity Switching,” (April 29, 2005).

A former postal worker settled SEC charges that he traded and tipped on misappropriated information that he obtained from the “Inside Wall Street” column of Business Week magazine as it passed through a postal sorting facility where he worked. According to the SEC, during the late 1990s the postal worker intercepted the magazine on its way to subscribers and shared information from the column with a friend, who in turn paid the postal worker $10,000. The postal worker and his friend generally acted on positive information about companies mentioned in the column by purchasing company stock on Thursday afternoons and selling the stock the next day following publication after the price increased. The former postal worker, who had been charged with violations of the antifraud provisions of the Securities Exchange Act of 1934, was ordered to disgorge profits of approximately $154,000, supplemented by a civil penalty for the same amount and prejudgment interest.

SEC v. Davi Thomas, 03-CIV-4087 (ADS) (E.D.N.Y.), Litigation Release No. 19212 (May 2, 2005).

Three former executives of an investment adviser have settled SEC administrative actions alleging that they in effect approved excessive short-term trading arrangements in mutual funds managed by the adviser in exchange for investment of long-term assets in hedge funds also managed by the adviser. The SEC charged that the market timing arrangements were prohibited joint transactions that were potentially harmful to the affected mutual funds, and that the adviser did not disclose the arrangements in the funds’ prospectus or inform the funds’ boards or shareholders of the conflict of interest created by the arrangements. The alleged conflict of interest was that the adviser received increased advisory fees because of the committed long-term assets in the hedge fund and the additional assets in the mutual funds, but the short-term trading allowed by the adviser was potentially harmful to the mutual funds.

The adviser settled related SEC charges in December 2003 and paid a substantial monetary penalty. Each of the former executives was charged with aiding and abetting the adviser’s violation of sections 206(1) and 206(2) of the Investment Adviser’s Act of 1940 and section 17(d) of the Investment Company Act of 1940. One of the former executives was also charged with a violation of section 34(b) of the Investment Company Act for signing off on misleading statements in a fund prospectus.

As part of the settlements, each of the former executives was suspended from associating with an investment adviser or investment company for twelve months and prohibited from serving as an officer or director of an investment adviser or investment company for three years. Each also was ordered to pay disgorgement of $1 and civil penalties ranging from $150,000 to $375,000.

In the Matter of Gerald T. Malone, Investment Advisers Act Release No. 2378 (April 28, 2005); In the Matter of John D. Carifa, Investment Advisers Act Release No. 2379 (April 28, 2005); In the Matter of Michael J. Laughlin, Investment Advisers Act Release No. 2380 (April 28, 2005).

The SEC submitted a staff report to the Senate Appropriations Committee to provide a justification for the requirement that the chair of a mutual fund’s board of directors be an independent director. The Commission vote to release the report was divided, with Commissioners Glassman and Atkins dissenting from the report’s dissemination and conclusions.

The report was required by the Consolidated Appropriations Act, 2005, which instructed the SEC to submit a report by May 1, 2005 that (i) provides a justification for the independent director rule and (ii) analyzes whether mutual funds chaired by independent directors have better performance, lower expenses, or better compliance records than funds chaired by interested directors.

The justification provided by the report is, in sum, that an independent chair will enhance independent oversight of conflicts of interest and can improve compliance by ensuring that independent directors focus on the long-term interests of a fund’s investors and have the power and authority to check the adviser where conflicts of interest may exist.

With respect to the second question, the report noted that the data is inconclusive on whether funds chaired by independent directors have better performance or lower expenses and that it is not possible to conduct a compliance comparison because there is no clear method for measuring the quality of compliance by funds and advisers. The report then argued that the independent chair rule, in conjunction with other recent reforms, should lead to enhanced compliance and suggested monitoring to determine whether the rule is having its intended effect and whether revisions are needed. Attached to the report as an appendix was a letter in support of the independent chair rule from all of the living former Chairmen of the SEC.

Commissioners Glassman and Atkins explained their dissent in a sharply worded letter to the Senate Appropriations Committee, arguing that the report does not provide a valid justification for the independent chair rule and relies solely on conjecture to conclude that the independent chair requirement might positively affect compliance. They claimed they were not given any opportunity to provide constructive input into the report and concluded their letter by stating that “the report fails to respond constructively to your inquiry and offers no evidence to support its premises.”

Exemptive Rule Amendments of 2004: The Independent Chair Condition (April 2005) (Staff Report); Letter from Commissioners Glassman and Atkins re: Staff Report on the Exemptive Rule Amendments of 2004: The Independent Chair Condition (April 29, 2005).

The Association announced at its annual conference in Seattle on April 14, 2005, that its membership voted to change the name of the organization to the Investment Adviser Association. A press release announcing the name change noted that the name change is intended to reflect the fact that every member firm of the Association is registered as an “investment adviser” under the Investment Advisers Act of 1940.

The Association has begun taking steps to implement the name change in recent weeks. The new web site address of the Association is: www.investmentadviser.org. New staff e-mail addresses are listed on the web site. The Association’s mailing address and telephone and fax numbers remain the same.

On April 28, 2005, the FPA filed a petition in the U.S. Court of Appeals for the District of Columbia Circuit challenging the SEC’s final rule exempting certain broker dealers from registration under the Investment Advisers Act of 1940. The FPA contends that this rule, “Certain Broker-Dealers Deemed not to be Investment Advisers,” issued on April 12, 2005, should be vacated on the ground that it does not carry out Congress’ intent to protect investors. James A. Barnash, President of the FPA, argued that by formalizing two different levels of consumer protection for the same advisory services (i.e., one applicable to those broker-dealers subject to the rule, the other to those who qualify for the exemption), the rule creates a double standard for the delivery of financial advice under which broker-dealers are encouraged to engage in self-dealing with their clients without disclosing conflicts of interest. The SEC staff reportedly has declined to comment on this matter. A summary of the final rule release can be found in the April 15, 2005 issue of the WilmerHale Investment Management Industry News Summary.
BNA Securities Regulation & Law, Volume 37, Number 18, Monday, May 2, 2005, Financial Planning Association News Release, April 28, 2005.

SEC registrants, including registered investment companies and other filers, may now voluntarily submit financial information relating to specified EDGAR filings under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 (the “1940 Act”) using eXtensible Business Reporting Language (“XBRL”). Several filers have already participated in the XBRL program. According to Allen Beller, Director of the SEC’s Division of Corporate Finance, the use of XBRL benefits all parties in the “financial information supply chain.” For example, easy access to tagged financial information is expected to benefit regulators and investors for analytical and review purposes. The SEC stated that it looks forward to further assessing these potential benefits, as more registrants begin to participate in the program. The full text of the voluntary program release can be found at http://www.sec.gov/spotlight/xbrl.htm.

SEC Encourages Participation in its XBRL Voluntary Program, SEC Press Release 2005-64.