On August 17, 2009, New York State Attorney General Andrew Cuomo filed a lawsuit in New York State Court against a major broker-dealer charging the firm with fraud for falsely representing that auction rate securities (“ARS”) were liquid and short-term investments and failing to disclose the inherent liquidity risks associated with ARS.

According to the complaint, the firm’s brokers made misrepresentations regarding the liquidity risks of ARS by (1) comparing them to more liquid asset classes, such as certificates of deposit and money market funds, (2) claiming that ARS were suitable instruments for cash management, or (3) otherwise representing to clients that they would always have liquidity. Further, the complaint alleges that while the broker-dealer publicized its extensive expertise in the fixed income arena, the firm’s fraud was made possible due to the firm’s failure to properly train brokers regarding ARS. Finally, the complaint alleges that the firm knew or should have known about increasing problems in the ARS market based on its knowledge of failures in the auction markets as early as August 2007 and daily reports from the ARS underwriters (“ARS Underwriters”) demonstrating decreasing demand for ARS in the final months of 2007.

The Attorney General’s complaint seeks, among other things, to compel the broker-dealer to repurchase ARS from its customers holding the securities, as well as penalties, costs, disgorgement, and restitution.

In a letter released on August 16, 2009, the broker-dealer responded to the Attorney General’s announcement of its intention to file the complaint by contesting the facts, and by pointing out that it had not underwritten the ARS held by its customers, that the Attorney General has settled claims regarding ARS with certain ARS Underwriters and that it was unfair for the Attorney General to attempt to force the broker-dealer to repurchase the remaining ARS held by its clients after the Attorney General had settled with certain ARS Underwriters. The ARS Underwriters had agreed to repurchase more than $50 billion in ARS they had underwritten from their own clients but not from clients of other firms, such as the broker-dealer.

For a copy of the complaint, please see:

http://www.oag.state.ny.us/media_center/2009/aug/pdfs/People%20of%20the%20State%20of%20New% 20York%20v.%20Charles%20Schwab%20&%20Co.,%20Inc.%20-%20Summons%20and%20Complaint%20(08.17.09).pdf

For a copy of the firm’s response, please see:

http://www.aboutschwab.com/media/pdf/letter_NYAG.pdf

On August 17, 2009, the Federal Reserve Board (the “Fed”) and the United States Department of Treasury (“Treasury”) announced that they approved certain extensions to the Term Asset-Backed Securities Loan Facility ("TALF"). The Fed and Treasury approved the extension of loans under TALF against newly issued asset-backed securities (“ABS”) and legacy commercial mortgage-backed securities (“CMBS”) through March 31, 2010. In addition, the Fed and Treasury approved lending under TALF against newly issued CMBS through June 30, 2010. The Fed and Treasury had previously approved all TALF loans through December 31, 2009. Finally, the Fed and Treasury announced that they do not foresee any additional types of collateral to be eligible for TALF in the future. However, the Fed and Treasury indicated that they are prepared to reconsider their decisions if financial or economic developments indicate that providing TALF financing for investors’ acquisitions of additional types of securities is warranted.

For more information, please see:

http://www.federalreserve.gov/newsevents/press/monetary/20090817a.htm

On August 21, 2009, Senator Ted Kaufman (D-DE), called on the SEC to undertake an independent “zero-based regulatory review” using independent third-party experts from across the country. Further, Kaufman asked the SEC to conduct an analysis of the current market structure from the bottom-up, prior to the implementation of any piecemeal changes to current regulations, which could intensify potential execution inequities. The Senator believes that actions taken by the SEC over the past few decades have promoted the development of financial markets favoring the most technologically advanced traders over less technologically savvy retail investors.

In a letter to SEC Chairman Schapiro, Kaufman recommended, among other things:

• a ban on flash orders (selectively displayed orders);
• that high frequency trading strategies aimed at taking advantage of market structure arbitrage be heavily scrutinized and in certain instances, be potentially prohibited;
• that liquidity rebates be reconsidered;
• that the SEC regulate the co-location of servers at execution venues to ensure fair access; and
• that execution audits at all market centers be uniform and improved.

For more information, please see:

http://kaufman.senate.gov/press/press_releases/release/?id=ac51e2a5-e413-4f52-ad37-8cf9d080e744

On August 14, 2009, the SEC staff released a no-action letter indicating that it would not recommend enforcement action under certain recordkeeping rules against investment advisers (“Adviser Participants”) that outsource the maintenance and preservation of trade confirmations to a service provider of post-trade applications, as long as certain conditions are met. The recordkeeping rules under the Investment Advisers Act of 1940 (the “Advisers Act”) generally require an investment adviser to, among other things, make and keep originals of all trade confirmations, and, under the service provider’s proposal, the Adviser Participants would be able to rely on the service provider to make and keep required confirmations on behalf of the Adviser Participants.

The conditions to the staff’s no action position included the following:

• the service provider will store at least two electronic copies of all confirmations sent to an Adviser Participant for not less than five years from the end of the fiscal year during which the last entry was made on the confirmation and one or more copies of each confirmation will be stored in a secure facility separate from the facility used to store the other copies;
• during the required retention periods, Adviser Participants will have the ability to access confirmations at any time from the service provider;
• the service provider’s internal systems for creation and retention of confirmations will comply with the requirements of Rule 204-2(g) of the Advisers Act; and
• in case either the Adviser Participant or the service provider ceases operations, the service provider will comply with specific requirements so that documents will continue to be available for regulatory purposes.

For more information, please see:

http://www.sec.gov/divisions/investment/noaction/2009/omgeo081409.htm

On August 20, 2009, the SEC and the Commodity Futures Trading Commission (“CFTC”) announced that the two agencies will hold joint meetings seeking public input regarding the harmonization of market regulation. The meetings are the result of a mandate from the White House in its June 17, 2009 White Paper on Financial Regulatory Reform, which recommended the two agencies complete a report to Congress by September 30, 2009. The report should identify all conflicts in federal statutes and regulations regarding similar types of financial instruments and either explain why the differences are critical to accomplishing underlying policy objectives with respect to investor protection, market integrity, and price transparency or recommend changes to the existing legal and regulatory frameworks which would harmonize the differences.

According to SEC Chairman Mary Schapiro, the meetings are intended to leverage the progress made by the SEC and the CFTC regarding the design of a framework for regulating over-the-counter derivatives. Chairman Schapiro stated the meetings will assist with the harmonization of both agencies’ regulations in order to increase transparency, decrease regulatory arbitrage and rebuild market confidence.

The meetings will be held on September 2 and 3, 2009 at the CFTC and the SEC, respectively. The public comment period ends on September 14, 2009.

For more information, please see:

http://www.sec.gov/news/press/2009/2009-186.htm

On August 17, 2009, the SEC announced that it is seeking further public comment on a rule proposal for an alternative uptick rule (the “Alternative Uptick Rule”). The Alternative Uptick Rule would only allow short sales at a price above the current national best bid. It would offer an alternative to the two approaches proposed by the SEC in April 2009. Although the SEC sought comment on the Alternative Uptick Rule in April 2009, it was not one of the proposed approaches.

The April 2009 rule proposal offered two price test proposals and two circuit breaker proposals. The first price test proposal would be based on the current national best bid (“Proposed Modified Uptick Rule”) and the second price test proposal would be based on the last sale price (“Proposed Uptick Rule”). The first circuit breaker proposal would temporarily prohibit short selling in a particular security during severe declines in price. The second circuit breaker proposal would temporarily implement either the Proposed Modified Uptick Rule or the Proposed Uptick Rule on short sales in a particular security during severe declines in price. The two price test proposals from April 2009 would require monitoring of the sequence of bids or last sale price, but this would not be required under the Alternative Uptick Rule.

While the initial comment period for the April 2009 proposals ended on June 19, 2009, the SEC announced that it has reopened the comment period until September 21, 2009 to help ensure that the public has a full opportunity to provide comments on the Alternative Uptick Rule, the other proposed approaches, and any other matter relating to this issue.

The proposing release can be found at:

http://www.sec.gov/rules/proposed/2009/34-60509.pdf

The Technical Committee of the International Organization of Securities Commissions (IOSCO) published guidance for investment advisers on due diligence good practices regarding investments in structured finance instruments by collective investment schemes offered to retail investors. The Committee recommended five guiding principles and three specific due diligence steps and also analyzed the role of third parties in these types of investments. The guiding principles, or “messages” include:

1. The due diligence process should be specifically tailored to the unique characteristics of the structured finance instruments;

2. An adviser should only recommend investments in instruments it understands;

3. The due diligence process should remain a value-added process – and avoid becoming “box-checking” step;

4. Due diligence should be structured around understanding the instrument’s underlying assets, its structure, and how it complies with the mandate of the collective investment scheme; and

5. Due diligence should continue from when the initial investment is contemplated until the SFI matures or is divested.

The Committee also recommended three specific due diligence steps, focusing on the need for an adviser to fully understand and evaluate cash flow structure, underlying assets, and risks for each structured finance instrument. The Committee also emphasized the need for advisers to continually evaluate how each instrument fits with the collective investment scheme mandate.

Finally, the Committee cautions against relying on third parties, such as credit rating agencies, in lieu of conducting independent due diligence. When using third party analysis, the adviser should understand and be able to effectively evaluate the methodology behind and basis for each opinion.

For more information, please see:

http://www.iosco.org/news/pdf/IOSCONEWS163.pdf

On August 11, 2009, the Chairman Mary Schapiro announced that Erik Spitler has been named Counselor to the Chairman and the new Director of the Office of Legislative Affairs. Prior to joining the SEC, Mr. Spitler spent eighteen years at the Federal Deposit Insurance Corporation, most recently as the Director of its Office of Legislative Affairs.

For more information, please see:

http://www.sec.gov/news/press/2009/2009-181.htm

On August 4, 2009, the SEC staff published a no-action letter which provides foreign funds with additional flexibility when investing in U.S. investment companies. Investment Company Act Sections 12(d)(A)(ii) and (iii) currently prohibit a fund from investing more than five percent of its assets in a single fund and from investing more than ten percent of its assets in one or more funds. In its August 4th letter, the Staff indicated that, provided certain conditions were met, it would not recommend enforcement action if a foreign fund were to exceed these limits when investing in a U.S. fund. Specifically, the foreign fund may exceed these limits if it:

• Does not purchase more than 3 percent of the shares of the U.S. fund;
• Does not offer or sell securities in the U.S. or to any U.S. person; and
• Executes each transaction in a manner consistent with the definition of “offshore transactions”.

In addition, the U.S. fund in which the foreign fund invests must comply with the restrictions of Section 12(d)(1)(B), which prohibits a fund from selling more than 3 percent of a fund’s shares to another fund or more than 10 percent of a fund’s shares to one or more funds.

For more information, please see:

http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9212

On August 3, 2009, the SEC issued the proposing release for its rule to regulate campaign contributions by investment advisers. The proposed rule would apply to registered investment advisers and those advisers relying on the exemption from registration found in Section 203(b)(3). In short, the proposed rule would:

• Impose a two-year ban on receiving compensation for advisory services to a government entity if an adviser contributes to an elected official who is in a position to influence the award of advisory contracts;
• Prohibit an adviser from compensating, directly or indirectly, any third party for soliciting advisory business from any government entity on the adviser’s behalf; and
• Prohibit an adviser from soliciting from others, or coordinating, contributions to these elected officials or payments to political parties where the adviser is providing or seeking government business.

The proposed rule would define “advisory services” to include directly managing or advising funds run by government entities, or managing or advising a private investment pool in which a government fund invests.

Technically, the proposed rule does not prohibit advisers from contributing to elected officials who can influence the award of advisory services. However, the proposed rule would prohibit the adviser from receiving compensation from the government client for two years following such a contribution. Government entities under the proposed rule would include all state and local governments, their agencies and instrumentalities, and all public pension plans and other collective government funds, such as 529 and 403(b) plans.

The two-year ban on compensation for advisory services would be triggered by contributions made to candidates, successful candidates, and incumbents. The ban would be triggered by contributions made by the adviser’s general partners, managing members, executive officers, employees who solicit government clients on behalf of the adviser, or other individuals with a similar status or function. The proposed rule does contain a de minimus exception for contributions under $250 made by individuals who are entitled to vote for the elected official to whom they contribute.

The proposed rule would explicitly prohibit an adviser from compensating finders, pension consultants, solicitors, or placement agents for soliciting government investment business. The breadth of this prohibition may have consequences beyond those intended by the Commission. The proposed rule provides that “an investment adviser to a covered investment pool in which a government entity invests or is solicited to invest shall be treated as though that investment adviser were providing or seeking to provide investment advisory services directly to the government entity.” Covered investment pools would include mutual funds, hedge funds, private equity funds, and other collective investment pools. As a result, this prohibition could apply to advisers to hedge funds or private equity funds in which government funds invest that use marketing personnel who are registered as associated persons of third-party broker-dealers when the cost of those employees is reimbursed by the adviser. It could also apply to no-load mutual funds that are investment option under a 529 Plan or 403(b) Plan where the fund uses third-party broker-dealers as principal underwriters and the adviser compensates the broker-dealer for these services.

Finally, the SEC is proposing to amend the cash solicitation rule and prohibit advisers, whether registered or required to be registered with the SEC, from relying on the cash solicitation rule to pay third-party solicitors for soliciting government clients.

Comments on the proposed rule are due to the SEC by October 6, 2009.

For more information, please see:

http://www.sec.gov/news/press/2009/2009-168.htm

The proposing release can be found at:

http://www.sec.gov/rules/proposed/2009/ia-2910.pdf 
 

On August 5, 2009, in an effort to expedite investigations, the SEC amended its rules governing the conduct of investigations to authorize the Director of the Enforcement Division to issue formal orders of investigation. Currently, a formal order of investigation, which grants the staff subpoena power, must be issued by the Commission. In the August 5th amendment, the SEC authorized the Enforcement Director to issue the orders without first seeking the Commission’s approval. This delegated authority will be in force for 1 year, at which time the Commission will re-evaluate whether the delegation should be extended. However, even if the delegation is not continued, all orders issued by the staff during this time will remain in effect.

In an August 5, 2009 speech, the current Division Director, Robert Khuzami, described plans to delegate this decision-making authority to senior officers on staff, which will include associate regional directors, (such as the head of the Enforcement Division in each regional office).

The adopting release and final rule can be found at:

http://www.sec.gov/rules/final/2009/34-60448.pdf

For a more detailed discussion of other planned changes to the Enforcement Division, including plans to establish a group within the Division that focuses exclusively on asset management issues, please see:

http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=9231

On August 7, 2009, the SEC adopted a rule that was originally proposed in 2004, limiting the extent to which consumer information which a covered entity receives from its affiliate may be used for marketing purposes. Compliance is required by January 1, 2010.

Reg S-AM applies to all investment advisers and transfer agents that are registered with the SEC, as well as investment companies and all brokers and dealers other than notice-registered broker-dealers (each a “covered entity”). Reg S-AM provides that absent notice and an opportunity to opt out, a covered entity may not use “eligibility information” regarding a consumer to market its products or services to that consumer when the information is provided by an affiliate of the covered entity or a service provider acting on behalf of the covered entity.

“Eligibility information” is broadly defined to include any information about a consumer the communication of which would be a consumer report as defined in the Fair Credit Reporting Act (“FCRA”). The exclusions from a consumer report identified in the FCRA do not apply for purposes of Reg S-AM. Examples of eligibility information include: a consumer’s account history and personal identifiers such as names, addresses, email addresses, etc.

Specifically, the covered entity may not use consumer information received from an affiliate to:

1. identify the consumer or type of consumer to receive a marketing solicitation;

2. establish the criteria used to select the consumer to receive a marketing solicitation; or

3. decide which of its products or services to market to the consumer or tailor its marketing solicitation to that consumer

when, as a result, the affiliate does market its products or services to that consumer.

The restrictions do not apply if the consumer is given sufficient notice of the information sharing and a reasonable opportunity to opt out, and the consumer has not opted out. The method by which a consumer may opt out must also be reasonable and simple. The notice and opt out opportunity can be combined with the initial and annual privacy notices required by Regulation S-P. In addition, under certain circumstances, a pre-existing relationship between the consumer and the covered entity, employee benefit plans, marketing by service providers, and customer-initiated communications may be excluded from the provisions of Reg S-AM. Finally, the rule does not restrict the use of eligibility information received from an affiliate in general marketing efforts that are “directed at the general public, such as radio, television, general circulation magazine, billboard advertisements, or publicly available Web sites that are not directed to particular consumers.”

The Regulation does not prohibit covered entities from sharing information with affiliates in accordance with Regulation S-P.

For more information, please see:

http://www.sec.gov/rules/final/2009/34-60423.pdf

The proposing release can be found at:

http://www.sec.gov/rules/proposed/34-49985.htm