On September 18, 2006, an NASD arbitration panel considered a case alleging a violation of whistleblower protections in the Sarbanes-Oxley Act of 2002 (“SOX” or the “Act”). The case involves allegations that a mutual fund salesman (the “Claimant”) was wrongfully terminated as a result of alerting his superiors on two occasions that his employer, a mutual fund distributor (the “Distributor”), had violated securities regulations. The Wall Street Journal reported that the case is perhaps the first to be addressed by an NASD arbitration panel involving such allegations and is unusual among Wall Street wrongful termination disputes because the claim was also filed against five executives of the Distributor individually.

The Claimant alleged that he had been a top salesman at the Distributor, and that he was terminated because he informed his superiors that (i) a sales event was conducted by the Distributor in violation of NASD rules for sales contests that are intended to prevent brokers from selling unsuitable products to investors in order to win sales prizes, and (ii) the Distributor had improperly marketed a mutual fund by suggesting that the fund was substantially similar to another, high performing fund when in fact the two funds had different investment approaches. The Distributor alleged that the Claimant was fired because he failed to meet sales quotas. The Claimant is reportedly seeking more than $10 million in compensation and damages, in addition to other relief.

SOX provides significant whistleblower protections for employees of publicly traded companies, including a broad definition of activities that constitute whistleblowing and “make whole” civil remedies that include reinstatement, back pay with interest, and special damages, including costs of litigation, expert witness fees, and reasonable attorneys fees. In addition, Section 3(b)(1) of the Act provides that any violation of SOX “shall be treated for all purposes in the same manner as a violation of the Securities Exchange Act of 1934 or the rules and regulations issued thereunder . . . and any such person shall be subject to the same penalties, and to the same extent, as for a violation of [the Securities Exchange Act of 1934] or such rules or regulations.”

“NASD to Hear Suit Over Firing of ING Employee,” The Wall Street Journal, C7, September 18, 2006; “Fired Fund Seller Faces Off With ING,” Ignites, September 18, 2006.

On September 15, 2006, the FASB issued Statement of Financial Accounting Standards No. 157 (the “Statement”), which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles (“GAAP”), and expands required disclosures about fair value measurements.

In the summary accompanying the Statement (the “Summary”), the FASB noted that prior to the Statement, there existed different definitions of fair value and limited guidance for applying such definitions that resulted in inconsistencies and added complexity in applying GAAP. Moreover, this guidance was previously dispersed throughout many accounting pronouncements. In developing the guidance in the Statement, the FASB considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about such measurements.

The FASB noted in the Summary that “a single definition of fair value, together with a framework for measuring fair value, should result in increased consistency and comparability in fair value measurements. The expanded disclosures about the use of fair value to measure assets and liabilities should provide users of financial statements with better information about the extent to which fair value is used to measure recognized assets and liabilities, the inputs used to develop the measurements, and the effect of certain of the measurements on earnings (or changes in net assets) for the period. The amendments . . . advance the [FASB’s] initiatives to simplify and codify the accounting literature, eliminating differences that have added to the complexity in GAAP.”

The Statement sets forth the following definition and fair value disclosure guidelines:

The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The FASB is encouraging earlier adoption, provided a company has not yet issued financial statements for that fiscal year.

Financial Accounting Standards Board of the Financial Accounting Foundation, Statement of Financial Accounting Standards No. 157 Fair Value Measurements. A copy of the Statement is available at http://www.fasb.org/pdf/fas157.pdf.

The SEC has settled administrative proceedings against the chairman (the “Respondent”) of an investment adviser (the “Adviser”) who also acted as a portfolio manager and chief executive officer for a money market fund (the “Fund”) for violating the 1940 Act and the Advisers Act. Specifically, the SEC’s order states that the Respondent (i) failed to reimburse Fund expenses, which resulted in a prohibited borrowing from an investment company, (ii) purchased bonds for the Fund that exceeded the maturity limit for money market fund securities under Rule 2a-7 of the 1940 Act, which resulted in the Fund being prohibited from holding itself out as a money market fund; and (iii) failed to maintain accurate books and records.

Of particular note was the Respondent’s illegal failure to reimburse Fund expenses. The Adviser had agreed to voluntarily reimburse the Fund for any expenses that exceeded 0.25% of the Fund’s average daily net assets. Each month, the Fund’s administrator calculated the amount that the Fund’s expenses exceeded the 0.25% cap, sent an invoice to the Adviser for such amount, and recorded a receivable in the Fund’s books. According to the SEC’s order, despite being billed for this receivable on a monthly basis, the Adviser consistently failed to pay the receivable in a timely manner. The staff advised the Adviser in a July 1999 letter that Section 17(a) of the 1940 Act prohibits an investment adviser from borrowing from a registered investment company and that failure to reimburse excess expenses has been held to be an unlawful borrowing under Section 17(a)(3). Notwithstanding this letter and numerous subsequent requests for timely payment from the Fund’s administrator and board, the Adviser continued to be delinquent on its obligation to pay the receivable. By the time the Adviser made payment in full of the receivable, more than four years after the date of the staff’s letter, the receivable represented 3% of the Fund’s assets. The Fund was liquidated less than one year after the date of such payment.

The SEC concluded in its order that the Respondent willfully aided and abetted and caused the Adviser’s violations of Section 17(a)(3) of the 1940 Act, among other violations, which prohibits any affiliated person of a registered investment company from borrowing money or other property from such registered company. The Respondent consented to the entry of the order without admitting or denying the SEC’s findings.

In the Matter of James A. Casselberry, Jr., Investment Advisers Act Rel. No. 2550; Investment Company Act Rel. No. 27481 (Sept. 14, 2006), available at http://www.sec.gov/litigation/admin/2006/ia-2550.pdf.

In two recent public addresses, the SEC’s Director of the Division of Investment Management, Andrew J. Donohue, discussed his views on the importance of compliance and current initiatives at the Division of Investment Management.

Role of Chief Compliance Officers (“CCOs”) and Compliance Professionals

• Director Donohue highlighted the importance for CCOs to “drill down” to test whether personnel are actually performing assigned compliance duties and following compliance procedures. He explained that this would help identify areas where compliance standards are being met and areas requiring additional focus and attention. Director Donohue also encouraged CCOs to implement “forensic testing” as a tool for fulfilling compliance oversight responsibilities, stating that such testing “can enable CCOs to identify patterns or problems that spot checking may not find.”
• Director Donohue emphasized the importance for CCOs, attorneys and compliance professionals to identify and eliminate, or at least establish controls to address, potential conflicts of interest. Similarly, an adviser must update its disclosures to clients to reflect the evolving nature of the adviser’s conflicts.
• Director Donohue explained that investment advisory firms should design compliance programs that are tailored to their business models, products, clients and services and, given the diversity of registered investment advisers, that “[v]ery often, a mandated one-size-fits-all approach to regulatory requirements may not be the best approach and may not work.”

Current Initiatives for the Division of Investment Management

• Director Donohue identified the Investment Adviser/Broker Dealer Study as one of the largest initiatives currently being undertaken by the SEC. He explained that the data from this study should provide the SEC with additional material to make fully informed evaluations regarding the broker-dealer and investment advisory regulatory schemes and how those schemes impact both firms and investors.
• Director Donohue identified the modernization of the books and records rules as another major initiative for the SEC. He explained that he envisioned a comprehensive review of the SEC’s books and records requirements that would take into account currently available technology, which could assist firms in maintaining and producing records in a cost-effective manner.
• Director Donohue identified Form ADV, Part 2 as another major initiative and stated that his staff is working on a recommendation (re-proposed from 2000, when the SEC deferred proposed amendments to Form ADV, Part 2) for the SEC.
• Director Donohue reported that he had also asked his staff to focus on soft dollars, portfolio trading practices and best execution, noting that in addition to the soft dollar guidance issued this summer, the Division of Investment Management is working to respond to a request from SEC Commissioners and fund boards for additional guidance in this area. The Director stated that soft dollars should not be considered in isolation, and that advisers and clients should focus on the influence of soft dollar arrangements on the overall practices of how an adviser places trades and meets its best execution obligations. He further noted that compliance professionals should focus on the conflicts of interest involved in brokerage commissions, adding “[y]our inquiry should not be limited to commissions on equity trades. There are best execution challenges in other asset classes as well, including fixed income.” Director Donohue also stated that best execution inquiries should be made across all accounts and products, including separately managed accounts.
• Director Donohue also reported that Chairman Cox will recommend that the SEC implement a new anti-fraud rule under the Investment Advisers Act of 1940 (the “Advisers Act”) that would permit a “look through” to hedge fund investors.
• Director Donohue also discussed measures that the Division of Investment Management is undertaking or considering to prioritize and streamline the review of ETF applications. He also noted that the staff is beginning to develop a proposal for an ETF rule under the 1940 Act that would permit new ETFs to come to market without first obtaining an exemptive order. Director Donohue stated that such a rule would most likely be tailored to routine, index-based ETFs, the type of ETF with which the staff has substantial experience.

Speech by SEC Staff: Remarks Before the 4^th Annual Art of Indexing Summit by Andrew J. Donohue, September 20, 2006, available at http://www.sec.gov/news/speech/2006/spch092006ajd.htm. Speech by SEC Staff: Keynote Address Before IA Week’s 6^th Annual Fall Compliance Conference, September 25, 2006, available at http://www.sec.gov/news/speech/2006/spch092506ajd.htm .

On September 26, 2006, the SEC voted to adopt amendments to Rule 22c-2 (the “redemption fee rule” or “rule”) under the Investment Company Act of 1940 (the “1940 Act”) to (i) clarify the operation of the rule and (ii) reduce the number of intermediaries with which open-end investment companies (“funds”) must negotiate shareholder information agreements. The SEC also extended the compliance date of the rule from October 16, 2006 to April 16, 2007, with respect to the requirement that funds must enter into shareholder information agreements with their financial intermediaries. See “Compliance Dates” below.

Background

On March 11, 2005, the SEC adopted the redemption fee rule to help address abuses associated with short-term trading of fund shares.[1] As originally adopted, the rule required:

(i) a fund’s board to consider whether or not to impose a redemption fee, and

(ii) a fund or its principal underwriter to enter into a written agreement with each financial intermediary of the fund, whereby the intermediary agrees to provide shareholder information to the fund and execute any instructions from the fund to restrict or prohibit further purchases or exchanges of fund shares by a shareholder who has been identified by the fund as having engaged in transactions that violate the fund’s frequent trading policies (a “shareholder information agreement”).

On February 28, 2006, the SEC proposed certain amendments to the redemption fee rule in an effort to reduce the compliance costs for implementing the rule and to clarify the application of the rule, particularly with respect to shareholder information agreements.[2] The final amendments are summarized below.

Shareholder Information Agreements

The amendments (i) limit the types of intermediaries with which funds must enter into shareholder information agreements, (ii) address the application of the rule when there are chains of intermediaries, and (iii) clarify the effect of a fund’s failure to obtain an agreement with any of its intermediaries.

Small Intermediaries

Intermediary Chains

Effect of Lacking a Shareholder Information Agreement

Operation of the Rule

Redemption Fees

Compliance Dates

In a September 5, 2006 decision, the U.S. Court of Appeals for the Second Circuit (the “Court”) rejected the SEC’s interpretation of the application of Rule 14a-8(i)(8) under the 1934 Act (the “Rule”). The Rule provides that a company may exclude a shareholder proposal from its proxy statement “[i]f the proposal relates to an election for membership on the company’s board of directors or analogous governing body.” The Court held that the Rule applies “to shareholder proposals that relate to a particular election and not to proposals that . . . would establish the procedural rules governing elections generally.”

In this case, a shareholder proposal to amend a company’s by-laws to require the company to publish the names of shareholder-nominated candidates for director positions, together with the names of candidates nominated by the company’s board of directors, was excluded by the company pursuant to the Rule. The shareholder, however, argued that the Rule is limited to proposals that address particular elections, rather than elections generally.

The SEC, in its amicus brief, argued that the Rule permits the exclusion of shareholder proposals that “would result in contested elections” and that “a proposal would result in a contested election if it is a means either to campaign for or against a director nominee or to require a company to include shareholder-nominated candidates in the company’s proxy materials.”

In deciding to reject the SEC’s position, the Court considered both the SEC’s current interpretation of the Rule as set forth in its amicus brief, and the SEC’s interpretation of the Rule from 1976 (the “1976 Interpretation”), the year the rule was amended by the SEC to clarify the purpose of the existing election exclusion. The Court concluded that the 1976 Interpretation “clearly reflects the view that the [Rule] is limited to shareholder proposals used to oppose solicitations dealing with an identified board seat in an upcoming election and rejects the somewhat broader interpretation that the [Rule] applies to shareholder proposals that would institute procedures making such election contests more likely.” The Court noted that, because the SEC’s current interpretation conflicts with the SEC’s 1976 Interpretation, which the SEC had espoused for approximately 16 years before the Division of Corporation Finance began to signal a change of course, the SEC’s current interpretation “does not merit the usual deference we would reserve for an agency’s interpretation of its own regulations.” The Court faulted the SEC for failing to acknowledge a changed position as between the two interpretations or provide a “reasoned analysis” of such change, and gave greater weight to the 1976 Interpretation. The Court expressly stated that in making its ruling, it took no sides in the policy debate regarding shareholder access to corporate ballots, and noted that “Congress has determined that such issues are appropriately the province of the SEC, not the judiciary.” The case was reversed and remanded.

In response to the Court’s decision, the SEC announced that the Division of Corporation Finance will recommend an amendment to Rule 14a-8 under the 1934 Act regarding director nominations by shareholders. In the SEC press release announcing that the proposed amendment would be forthcoming, SEC Chairman Christopher Cox indicated that the revisions would promote a “consistent nationwide application” of Rule 14a-8. The proposed amendment is calendared for the SEC’s October 18, 2006 open meeting.

American Federation of State, County & Municipal Employees, Employees Pension Plan v. American International Group, Inc., 2nd Cir., Docket No. 05-2825-cv, Sept. 5, 2006. Commission Calendars Proposed Amendment to Rule 14a-8 Governing Director Nominations by Shareholders, SEC Press Release No. 2006-150 (Sept. 7, 2006), available at http://www.sec.gov/news/press/2006/2006-150.htm.

[1]Amendment to Instruction 2 to Item 15(b) of Form N-1A; Amendment to Instruction 2 to Item 21.2 of Form N-2; Amendment to Instruction 2 to Item 22(b) of Form N-3.

[2]Amendments to Items 22(b)(7), 22(b)(8), and 22(b)(9) of Schedule 14A; Amendments to Items 12(b)(6), 12(b)(7), and 12(b)(8) of Form N-1A; Amendments to Items 18.9, 18.10, and 18.11 of Form N-2; Amendments to Items 20(h), 20(i), and 20(j) of Form N-3.

[3]The requirements formerly under Item 7 regarding the nominating and audit committees, board meetings, the nominating process, and shareholder communications generally are now included under Item 22(b) by cross-references to the appropriate paragraphs of new Item 407 of Regulation S-K. In addition, amended Item 22(b) incorporates disclosures relating to the independence of members of nominating and audit committees that are similar to those contained in new Item 407(a) of Regulation S-K and that previously were required under Item 7. The proxy disclosure regarding directors who have resigned or declined to stand for re-election previously required under Item 7(g) has been moved to Item 22(b)(17). In addition, certain changes to Item 7 require disclosure of the information required by new Item 407(a) rather than the disclosure that was required prior to the amendments by Item 404(b). The provisions of paragraphs (d)-(h) of Item 7, which duplicated new Item 407, were deleted from Item 7 and now appear in new Item 407.

[4] Item 11 of Form 10-K.

The SEC has settled administrative proceedings against five investment advisers for allegedly charging excessive performance-based fees to mutual fund clients in violation of Section 205(a) of the Investment Advisers Act of 1940 (the “Advisers Act”).

Relevant Statutory and Rule Provisions

Section 205 of the Advisers Act generally prohibits registered investment advisers from entering into advisory contracts that provide for performance-based fees except as provided in Section 205(b) of the Advisers Act. Section 205(b) permits an investment adviser of a registered investment company to charge a performance-based fee as long as such fee

Rule 205-2(b) under the Advisers Act provides that the “specified period” over which the asset value of the fund is averaged must be the same as the period over which the investment performance of the fund and the investment performance of the appropriate index is computed. However, Rule 205-2(c) provides a conditional exemption from this requirement of Rule 205-2(b) only if:

The SEC noted in its orders that “[f]or the purposes of Rule 205-2(c), the rolling period must be the same as the period over which performance is measured.”

Nature of Violations

The SEC found that each investment adviser failed to calculate total fees charged to certain mutual fund clients in compliance with either Rule 205-2(b) or Rule 205-2(c), resulting in such clients being overcharged by all of the investment advisers in the aggregate amount of approximately $7 million in fees between April 1997 and December 2004. In four cases, the SEC found that the investment adviser had calculated the performance fee based on the funds’ average net asset values following the applicable performance measurement period. In the fifth case, the SEC found that, while performance was measured over a 36-month rolling period, the investment adviser had applied its total fee rate to the fund’s daily net asset value (rather than the required sub-period(s) that comprise the rolling period).

Each investment adviser discontinued its non-compliant fee calculation method and subsequently reimbursed the affected funds for the excess fees plus interest during the course of the SEC’s investigation. Pursuant to the SEC’s orders in these proceedings, each respondent was censured and agreed, without admitting or denying the SEC’s findings, to cease and desist from committing or causing any violations and any future violations of Section 205(a) of the Advisers Act.

The SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management provided interpretive guidance on how the effects of a carryover or reversal of prior year financial statement misstatements should be considered in quantifying current year financial statement misstatements, as set forth in Staff Accounting Bulletin No. 108 (the “Bulletin”).

The interpretive guidance set forth in the Bulletin is designed to address the use by registrants of two different methods for quantifying the amount of misstatements that were not corrected at the end of the prior year: (1) the income statement approach and (2) the balance sheet approach.

Under the income statement approach, the error is quantified as the amount by which the current year income statement is misstated (i.e., as though the error originated in the current year, thereby ignoring the “carryover effects” of prior year misstatements). Under the balance sheet approach, the error is quantified as the cumulative amount by which the current year balance sheet is misstated (i.e., regardless of the year the error originated).

The Bulletin states that registrants should quantify misstatements using both income statement and balance sheet approaches, and evaluate the error measured under each approach. The Staff noted in its press release announcing the Bulletin that exclusive reliance on either the income statement approach or the balance sheet approach would not be sufficient. The Bulletin noted that the primary weakness of the income statement approach is that it does not consider the correction of prior year misstatements in the current year (i.e., the reversal of the carryover effects) to be errors. The Bulletin further noted that the primary weakness of the balance sheet approach is that it can result in the accumulation of significant misstatements on the balance sheet that are individually deemed immaterial in part because the amount that originates in each year is quantitatively small.

Thus, a registrant’s financial statements would require adjustment when either approach results in a misstatement that is material, after considering all the relevant quantitative and qualitative factors. The staff noted in its press release to the Bulletin, however, that it would not object if a registrant recorded a one-time cumulative effect adjustment to correct errors existing in prior years that previously had been considered immaterial – qualitatively and qualitatively – based on appropriate use of the registrant’s previous approach (either income statement or balance sheet), so long as all relevant qualitative factors were considered. Finally, when first applying the guidance in the Bulletin, a registrant need not restate its financial statements for fiscal years ending on or before November 15, 2006 “if management properly applied its previous approach.”

SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management Release Staff Accounting Bulletin 108, SEC Press Release No. 2006-153 (Sept. 13, 2006), available at http://www.sec.gov/news/press/2006/2006-153.htm. A copy of Staff Accounting Bulletin No. 108 is available at http://www.sec.gov/interps/account/sab108.pdf.

As reported in a previous issue of the Investment Management Industry News Summary, the SEC recently adopted certain amendments to the disclosure requirements for executive and director compensation, related person transactions, director independence, other corporate governance matters and security ownership of officers and directors. The amendments affect disclosure in proxy and information statements, periodic reports, current reports and other filings under the Securities Exchange Act of 1934 (the “1934 Act”), and in registration statements under the 1934 Act and the Securities Act of 1933 (the “1933 Act”).

The amendments are intended to provide investors with a clearer and more complete picture of the compensation earned by a company’s principal executive officer, principal financial officer, highest paid executive officers and members of its board of directors. They are also intended to provide better information about key financial relationships among companies and their executive officers, directors, significant shareholders and these persons’ immediate family members.

On August 29, 2006, the SEC released its final rule implementing these amendments. Although these amendments primarily apply to public operating companies, the elements that apply to registered investment companies are summarized below.

    Disclosure Changes Affecting Registered Investment Companies

     Portfolio Manager Compensation

• The final rule requires any relocation plans to be included in the description of the portfolio manager compensation set forth in the statement of additional information.[1]  

Threshold for “Interested Persons”

• As proposed, the threshold for disclosure of certain interests, transactions, and relationships of each director or nominee for election as director who is not an “interested person” within the meaning of Section 2(a)(19) of the Investment Company Act of 1940 (the “1940 Act”) has increased from $60,000 to $120,000.[2] This disclosure is required in investment company proxy and information statements and registration statements. The increase in the disclosure threshold corresponds to the increase in the disclosure threshold for amended Item 404 of Regulation S-K from $60,000 to $120,000.

Proxy Statements

• Information that previously was required under Item 7 will instead be required under Item 22(b).[3] The substance of these requirements has not been altered.

Amendments to Form N-CSR

• Item 10 of Form N-CSR has been amended to include a cross reference to new Item 407(c)(2)(iv) of Regulation S-K and to new Item 22(b)(15) of Schedule 14A, in lieu of the former reference to Item 7(d)(2)(ii)(G) of Schedule 14A. The substance of the information required by Item 10 has not been changed.

Changes Affecting Business Development Companies

As proposed, the final rule applies the same executive compensation disclosure requirements to business development companies that apply to operating companies. This change eliminates the inconsistency between Form 10-K (which requires business development companies to furnish all of the information required by Item 402 of Regulation S-K) and the proxy rules and Form N-2 (which require business development companies to provide some of the information from Item 402 and other information that applies to registered investment companies). Under the amendments, the registration statements of business development companies are required to include all of the disclosures required by Item 402 of Regulation S-K for all of the persons covered by Item 402. This disclosure will also be required in the proxy and information statements of business development companies if action is to be taken with respect to the election of directors or with respect to the compensation arrangements and other matters enumerated in Items 8(b) through (d) of Schedule 14A. Business development companies will also be required to make these disclosures in their annual reports on Form 10-K.[4]

• As a result of the amendments, the compensation disclosure in the proxy and information statements and registration statements of business development companies are required to cover the same officers as for operating companies, including the principal executive officer and principal financial officer, as well as the three most highly compensated executive officers that have total compensation exceeding $100,000. In addition, the registration statements of business development companies are no longer required to disclose compensation of members of the advisory board or certain affiliated persons of the company. Finally, the proxy and information statements and registration statements of business development companies are not required to include compensation from the “fund complex,” as was previously required in some circumstances.

Compliance Dates

• Registered investment companies must comply with the final rule’s disclosure requirements in initial registration statements and post-effective amendments that are annual updates to effective registration statements on Forms N-1A, N-2 (except those filed by business development companies) and N-3, and in any new proxy or information statements, filed with the SEC on or after December 15, 2006.
• Companies subject to 1934 Act reporting requirements must comply with the final rule’s disclosure requirements in Forms 8-K for triggering events that occur on or after November 7, 2006 and in Forms 10-K and 10-KSB for fiscal years ending on or after December 15, 2006. Companies other than registered investment companies must comply with these disclosure requirements in 1933 Act registration statements and 1934 Act registration statements (including pre-effective and post-effective amendments), and in any proxy or information statements filed on or after December 15, 2006.

Request for Additional Comment on Disclosure of Compensation Information for Certain Non-Executive Employees

In its initial rule proposal, the SEC sought to require companies to disclose total compensation paid in the last fiscal year to up to three employees who were not executive officers during the period, but whose total compensation exceeded that of any of the company’s named executive officers. Commenters objected to this proposal on various grounds, including materiality, administrative cost and potential competitive harm. The SEC has revised its proposal to apply only to employees who have responsibility for significant policy decisions within the company, a significant subsidiary or a principal business unit, division or function of the company. Comments on this revised proposal must be submitted on or before October 23, 2006.

The NASD has issued a notice to members (“Notice”) announcing that the SEC has approved amendments to NASD Rules 2210 and 2211 regarding mutual fund performance advertising. New Rule 2210(d)(3)(A) requires that all communications with the public, other than institutional sales material and public appearances, that present mutual fund performance data (other than money market funds) must disclose the standardized performance information mandated by Rule 482 under the Securities Act of 1933 and Rule 34b-1 under the 1940 Act. In addition, to the extent applicable, such communications must disclose the maximum sales charge imposed on purchases or the maximum deferred sales charge, and the fund’s total annual operating expense ratio, gross of any fee waivers or expense reimbursements. Both the sales charges and the expense ratio should reflect the amounts stated in the fee table in the fund’s prospectus current as of the date of submission of an advertisement for publication, or as of the date of distribution of other communications with the public. The NASD stated that a fund’s expense ratio also may be presented net of waivers and reimbursements, as long as both the gross and net expense ratios are presented in a fair and balanced manner in accordance with the standards of NASD Rule 2210. The NASD stated that it expects a member that also presents a subsidized expense ratio to disclose in the sales material whether the fee waivers or expense reimbursements were voluntary or mandated by contract, and the time period during which the fee waiver or expense reimbursement obligation, if any, remains in effect.

New Rule 2210(d)(3)(B) provides that all of the information required by paragraph (A) must be set forth “prominently,” and that in any print advertisement, this information must be set forth in a prominent text box that contains only the required information and, at the member’s option, comparative performance and fee data and other disclosures required by Rule 482 and Rule 34b-1. The Notice explains that the text box requirement applies only to advertisements that appear in print advertisements, such as a print newspaper, magazine or other periodical, but not to printed sales literature, such as fund fact sheets, brochures or form letters, nor to Web sites, television or radio commercials, or any other electronic communication. The Notice also states that the NASD will apply the same prominence and proximity standards for disclosure of the expense ratio as those used for standardized performance and sales charges under the SEC rules.

Advertisements that contain mutual fund performance data and are used on or after April 1, 2007, must comply with the new disclosure requirements.

Mutual Fund Performance Sales Material, NASD NTM 06-48 (posted Sept. 1, 2006), available at http://www.nasd.com/web/groups/rules_regs/documents/notice_to_members/nasdw_017302.pdf.

The U.S. District Court for the Eastern District of Wisconsin has granted separate motions for summary judgment filed by two individual defendants in an SEC action relating to charges of insider trading. The SEC’s complaint alleged that, while other investors were not told about problems relating to two high-yield municipal bond funds, the investment adviser’s president tipped an investor about the funds’ liquidity and/or pricing problems prior to a significant devaluation, and the investor thereafter liquidated his shares in one of the funds. The president and investor countered that, while the president did possess material, non-public information relating to the fund in question, he did not communicate that information to the investor. The court found that the evidence showed that the investor’s liquidation of his shares was consistent in amount and timing with a past pattern of sales, thereby overcoming any inference of insider trading based on the evidence the SEC presented.

Of particular note, the order granting the defendants’ motions makes plain the court’s disapproval of statements made in the SEC’s filings opposing the motions for summary judgment. The court chastised the SEC for “a pattern of misquoting an opponent and misrepresenting facts and law,” “playing fast and loose with the facts,” and asserting facts “without any citations to admissible evidence” in the record of the case, in violation of court rules. The Court further admonished the SEC’s counsel to review Wisconsin’s Rules of Professional Responsibility regarding an attorney’s duty to be candid with the court and “to remember that a suit by the SEC is akin to a criminal prosecution in that it is accusing an (sic) private individual of wrong-doing.”

SEC v. Heartland Advisors, et al, No. 03-C-1427 (E.D. Wisc. filed Aug. 31, 2006)

The SEC has settled an administrative proceeding against a fund administrator for allegedly making a false representation in an exemptive application submitted on behalf of two affiliated funds under Section 19(b) of the Investment Company Act of 1940 (the “1940 Act”). Section 19(a) of the 1940 Act makes it unlawful for an investment company to pay any dividend or make any distribution in the nature of a dividend payment, wholly or partly, from any source other than net income unless the payment is accompanied by a written statement adequately disclosing its source (a “19(a) notice”). Rule 19a-1 requires every such written statement to clearly indicate what portion of the payment per share is made from a list of enumerated sources, including “[p]aid-in surplus or other capital source.”

According to the SEC order, three closed-end funds administered by the respondent paid numerous dividends between January 2000 through March 2004 that included a return of shareholders’ capital without providing shareholders with a 19(a) notice. In addition, the SEC alleged that the respondent obtained an exemption in 2002 from the Commission for two of the funds to allow them to distribute long-term capital gains more than once a year. The SEC stated that the exemption was granted, in part, on the basis of the respondent’s representation in its application that it was providing 19(a) notices to shareholders of the funds. The SEC found that the representation was an untrue statement of material fact in violation of Section 34(b) of the 1940 Act. To settle these charges, the respondent was ordered to cease and desist from further violations of Section 34(b) and agreed to pay a civil penalty of $425,000.

In a related matter, the Commission published a notice of intent to rescind the respondent’s 2002 exemptive order on the basis of the order finding violations of Section 34(b). The notice of the Commission’s intention to rescind the exemptive order gives interested persons until Sept. 25, 2006, to request a hearing.

In the Matter of Delaware Service Company, Inc., Inv. Co. Act Rel. No. 27473 (Aug. 31, 2006), available at http://www.sec.gov/litigation/admin/2006/ic-27473.pdf; Delaware Investments Dividend and Income Fund, Inc., et al., Notice of Intention to Rescind an Order, SEC Rel. No. IC-27475 (Sept. 1, 2006), available at http://www.sec.gov/news/digest/2006/dig090606.txt.

The SEC staff said that it will not recommend enforcement action to the Commission under Section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-2, thereunder, against any newly registered hedge fund adviser that relies, for purposes of Rule 204-2(b)(3), on an audit of a limited partnership, limited liability corporation or other pooled investment vehicle (collectively, “hedge fund”) by an accountant that has performed non-audit services for, or had certain relationships with, the hedge fund audit client or its affiliates, including the adviser, that would preclude the accountant from being independent under the Commission’s independence rules. The relief was subject to the following conditions: (a) the services or relationships would not impair the accountant’s independence under independence standards that were applicable to an audit of a hedge fund prior to registration by the adviser; (b) those services or relationships prohibited by the Commission’s independence rules cease by June 30, 2007; and (c) the investment adviser will cause the hedge fund to disclose in the footnotes to its financial statements: (i) that the accountant was independent under independence standards that were applicable to an audit of a hedge fund prior to registration by the adviser; (ii) that the accountant was not independent under the Commission’s independence rules; (iii) the general reasons why the accountant was not independent under the Commission’s independence rules; and (iv) a brief description of the relief and the duration of the relief granted by the staff.

Deloitte & Touche, SEC No-Action Letter (avail. Aug. 28, 2006), available at http://www.sec.gov/divisions/investment/noaction/2006/deloitte082806.htm.

An NASD Hearing Panel censured the underwriter and distributor of mutual funds and imposed a $5 million fine, finding that from 2001 through 2003 the firm directed brokerage commissions to the firms that sold the most of the mutual funds’ shares. The Panel found that the investment adviser for the mutual funds (which was also the firm’s parent company) paid more than $98 million in directed brokerage payments to these brokers.

NASD’s Anti-Reciprocal Rule prohibits NASD members from using brokerage commissions from the sales of a fund’s portfolio securities to reward brokerage firms that sell the funds’ shares. The Panel found that the firm requested and arranged for the investment adviser to direct brokerage to the retail brokerage firms that were the top 50 sellers of the funds’ shares during the prior year. The Panel also found that the target amount of commissions that the firm recommended was based on the specific amount of sales that the retail firm had achieved.

Yet the Panel did not find that the firm engaged in a pattern of intentional or reckless misconduct over a period of years, noting that the firm’s use of directed brokerage was consistent with the practices in the industry at the time, that the regulators did not raise concerns about these practices until 2001, and that the firm voluntarily changed its practices when the regulators started expressing concerns. The Panel also did not impose sanctions for the total directed brokerage payments, as NASD Enforcement requested, noting that the sanctions may only address the firm’s conduct and the adviser, which is not subject to NASD jurisdiction, actually placed and paid the commissions.

The decision will become final after 45 days unless it is appealed to NASD’s National Adjudicatory Council or the Council decides to review the decision.

NASD Hearing Panel Fines American Funds Distributors $5 Million for Directed Brokerage Violations, NASD News Release (Aug. 30, 2006), at http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017294. See, also, Disciplinary and Other NASD Actions (Mar. 2005), at http://www.nasd.com/web/groups/enforcement/documents/monthly_disciplinary_actions/nasdw_013531.pdf.

The SEC proposed to require transfer agents to file registration forms electronically by amending the rules and forms under Section 17A of the Exchange Act. Any entity that performs the function of a transfer agent in connection with a security registered under Section 12 of the Exchange Act currently is required to register with the appropriate regulator agency, which is either the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, or the SEC.

The proposed amendments would require transfer agents to file Form TA-1, Form TA-2 and Form TA-W through the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system. The SEC developed a new application in EDGAR, EDGARLite, to enable filers to prepare the forms electronically using Microsoft InfoPath 2003, a commercial software package, and to submit the completed forms over the Internet. The SEC would not require transfer agents to use EDGARLite to prepare the forms. To comply with the requirement, transfer agents would need a computer system that meets the requirements for the EDGAR Filer Manual, Internet access and a web browser, and would have to apply for EDGAR access before filing.

Proposed Rule: Electronic Filing of Transfer Agent Forms, SEC Rel. No. 34-54356 (Aug. 24, 2006).

A firm that administered three closed-end funds consented to pay a civil money penalty of $425,000 and to cease and desist from committing or causing further violations of Section 34(b) and Section 19(a) of the Investment Company Act or 1940, as amended (“1940 Act”) and Rule 19a-1 promulgated thereunder. Section 19(a) requires an investment company that pays a dividend or makes a distribution payment from any source other than net income to provide a written statement with each payment that discloses the source of the payment. Rule 19a-1 requires the statement to indicate the portion of the payment per share that is made from net income (excluding capital gains), capital gains, or paid-in surplus or other capital source at the time of payment, and requires that inaccurate estimates be corrected.

The SEC alleged that from January 2000 through March 2004, the three closed-end funds paid 98 dividends pursuant to the funds’ managed distribution policy that included a return of shareholders’ capital without providing the required notice. The firm contractually assumed the funds’ responsibilities for determining the amount and composition of the distributions, providing information about the distributions to other service providers, and preparing and filing all reports required by the federal securities laws and regulations. Although the distributions occurred more frequently than once a year and the firm’s projections created a reasonable likelihood that there would be enough net income during the rest of the fiscal year to cover the distributions, Section 19(a) required the fund to estimate whether each distribution was derived from a source other than net investment income as of the time of the distribution (e.g. at the end of the month or quarter when the distribution was paid). Consequently, the SEC alleged that the firm knew or was reckless in not knowing that the distributions included a return of shareholders’ capital when the distribution was made and that the firm violated Section 19(a) and Rule 19a-1 by not providing the required notices. IRS Form 1099-DIV also was insufficient because it was not provided contemporaneously with each dividend.

The SEC also alleged that the firm made an untrue statement of material fact in a document filed with the SEC in violation of Section 34(b) of the 1940 Act. In 2002, the firm represented in an application for exemption under Section 19(b) that the firm provided notices to the funds’ shareholders in accordance with Rule 19a-1. The SEC alleged that this statement was untrue because the firm was not providing these notices at the time of the application.

The SEC considered the firm’s prompt remedial actions and cooperation in determining to accept the offer. The firm did not admit or deny the truth of the SEC’s allegations.

In re Delaware Service Company, Inc., SEC Rel. No. IC-27473 (Aug. 31, 2006).

A financial services firm consented to pay a total of $600 million in connection with alleged market timing in a global civil and criminal settlement with the Securities and Exchange Commission (“SEC”), the U.S. Attorney’s Office for the District of Massachusetts, the Massachusetts Securities Division, NASD, the New Jersey Bureau of Securities, the New York Attorney General’s Office, and the New York Stock Exchange. The firm’s registered representatives allegedly defrauded at least fifty mutual funds and their shareholders from September 1999 through June 2003 by concealing their identities and the identities of their clients to avoid detection while market timing the funds’ shares. The Securities and Exchange Commission (“SEC”) alleged that the firm willfully violated Section 17(a) of the Securities Act of 1933, as amended (“Securities Act”), Section 10(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”) and Rule 10b-5 thereunder, and Section 17(a) of the Exchange Act and Rules 17a-3 and 17a-4 thereunder.

The SEC considered the firm’s cooperation in determining to accept the order. The $600 million settlement included $270 million disgorgement to a distribution fund for the benefit of those shareholders harmed by the fraud, $325 million criminal penalty to the U.S. Department of Justice, and $5 million civil penalty to the Massachusetts Securities Division. The firm also consented to hire an independent distribution consultant, was censured, and agreed to cooperate fully with the SEC in any litigation, investigation or other proceedings involving these matters. The firm did not admit or deny the truth of the findings.

The SEC also filed an action for a civil injunction in the United States District Court for the Southern District of New York, seeking injunctive relief, disgorgement, prejudgment interest, penalties, and other equitable relief against four of the firm’s former registered representatives who allegedly were involved in the deceptive activities and engaged in thousands of market timing trades totaling more than $25 billion. The complaint alleges that the registered representatives violated Section 17(a) of the Securities Act and Section 10(b) and Rule 10b-5 under the Exchange Act.

In re Prudential Equity Group, LLC, SEC Rel. No. 34-54371 (Aug. 28, 2006); SEC v. O’Meally, SEC Litig. Rel. No. 19813 (Aug. 28, 2006), at http://www.sec.gov/litigation/litreleases/2006/lr19813.htm; Prudential to Pay $600 Million in Global Settlement of Fraud Charges in Connection With Deceptive Market Timing of Mutual Funds, SEC Press Release (Aug. 28, 2006), at http://www.sec.gov/news/press/2006/2006-145.htm.

On August 9, 2006, the NASD announced the imposition of $7 million in fines against four broker-dealers affiliated with a large financial services company in connection with the alleged receipt of directed brokerage in exchange for preferential treatment for certain mutual fund companies. NASD charged that the four broker-dealers violated its Anti-Reciprocal Rule, NASD Conduct Rule 2830(k), which prohibits arrangements in which brokerage commissions are used to compensate firms for selling mutual fund shares. The rule is also designed to ensure that execution of portfolio transactions is guided by the principle of "best execution" and not by other considerations.

NASD found that from 2001 through 2003, the four broker-dealers provided a host of marketing benefits to 10 mutual fund complexes that participated in a shelf-space (or revenue-sharing) program. These benefits were generally not provided to non-participants, included yearly sales goals, special placement on the broker-dealer firms' intranet websites, direct links to the websites of the participating fund companies, increased exposure to the registered representatives of the broker-dealer firms, participation in annual national meetings, waiver of ticket charges for registered representatives on sales of participants' funds, and other marketing opportunities.

According to the NASD, mutual funds paid the broker-dealers millions of dollars to participate in the program. Eight of the 10 participating mutual fund complexes paid a portion of their fees by directing approximately $25.7 million in mutual fund portfolio brokerage commissions to the four broker-dealers, despite the fact that none of the firms played any role in the execution of the trades that generated the commissions. The remaining two fund companies paid their fees in cash.

In settling with NASD, the broker-dealers neither admitted nor denied the allegations, but consented to the entry of NASD's findings. To date, NASD has brought more than 30 enforcement actions for similar violations.

NASD Fines Four ING Broker-Dealers $7 Million For Directed Brokerage Violations (August 9, 2006), available at http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017110.

On July 26, 2006, the SEC approved amendments to NASD Rule 2211, which governs NASD member institutional sales material and correspondence. See SEC Rel. No. 34-54217 (July 26, 2006), 71 Fed. Reg. 43831 (Aug. 2, 2006) (File No. SR-NASD-2006-11). The amendments require a registered principal to approve correspondence sent to 25 or more existing retail customers within any 30 calendar-day period if the correspondence makes any financial or investment recommendation or otherwise promotes a product or service of the member.

Rule 2211 was originally approved in 2003 as part of NASD's modernization of its advertising rules. The new Rule included an amended definition of the term "correspondence" to include any written letter or electronic mail message distributed by a firm to one or more of its existing retail customers and to fewer than 25 prospective retail customers within a 30 day calendar day period. Previously, "correspondence" included any written or electronic communication prepared for delivery to a single current or prospective customer, and not for dissemination to multiple customers or the general public.

Firms generally are not required to have a registered principal approve correspondence prior to use, nor are they required to file correspondence with the NASD Advertising Regulation Department. In addition, correspondence is subject to fewer content restrictions than advertisements and sales literature. NASD found that some member correspondence to multiple existing customers raised the same regulatory concerns as member advertisements and sales literature, yet it was not required to be filed with NASD or approved by a principal prior to use. In contrast, had those types of form letters been sent to at least 25 prospective retail customers, such correspondence would have required both registered principal pre-use approval and filing with the Department. As a result, NASD believes it no longer should apply the principal pre-use approval requirement differently to non-clerical correspondence sent to prospective and existing retail customers. The rule change becomes effective on December 1, 2006.

SEC Approves Amendments to NASD Rule 2211 to Require Principal Pre-Use Approval of Certain Member Correspondence Sent to 25 or More Existing Retail Customers within a 30 Calendar-Day Period, NTM 06-45 (posted Aug 24, 2006), available at http://www.nasd.com/web/groups/
rules_regs/documents/notice_to_members/nasdw_017264.pdf.

On July 20, 2006, Internet search company Google Inc. filed an application pursuant to Section 3(b)(2) of the Investment Company Act requesting an order finding and declaring that Google is not an investment company within the meaning of the Act.

Google noted in its application that its Internet, advertising and new media operations generated 92% of its net income last year and that only three of its 9,700 employees are involved in cash management. The application formally requests an exemption under a provision of the Act that permits the SEC to exempt entities that are primarily operating companies. Alternatively, the application requests an exemption under a separate provision that permits exemptions if necessary or appropriate in the public interest and consistent with the provisions and policy of the Act.

The SEC has granted similar exemptive relief to Yahoo! (in 2000) and Microsoft (1988).

"Is Google A Mutual Fund?" Ignites (Aug. 24, 2006), article available at http://www.ignites.com/articles
/20060824/google_mutual_fund.

Numerous organizations submitted letters to meet the August 21, 2006 deadline for the SEC's request for additional comment on the Fund Governance rule. See 71 Fed. Reg. 35,366 (June 19, 2006). The letters, a sampling of which are described below, cover a wide variety of industry and consumer views on the how the SEC should proceed with regard to Rule 0-1(a)(7) under the Investment Company Act of 1940 (the "Act"), recently struck down by a U.S. Court of Appeals. The rule requires that registered investment companies seeking to rely on ten common exemptions available to investment companies under the Act must have a board comprised of directors seventy-five percent of whom are independent and led by an independent chair.

The Investment Company Institute (ICI) submitted a letter urging that the choice of a chair be left to the members of the board. The ICI letter notes that since the Commission first issued its proposal, many fund boards have chosen an independent director as chair, demonstrating that a legal requirement is not necessary to facilitate this approach. The ICI letter also contends that the Commission has not adequately demonstrated the benefits of mandating this governance structure for virtually all fund boards. The ICI letter also supports the view that two-thirds of a board's members should be independent, rather than 75 percent as contemplated under the Governance Rule. The letter also discusses the costs involved in reaching and maintaining a supermajority of independent directors and provides examples to illustrate that a 75 percent requirement amplifies these costs, most notably in terms of reduced flexibility in determining the composition of an investment company board.

The ICI letter is available at http://www.ici.org/statements/cmltr/06_sec_gov_com.html - TopOfPage.

The U.S. Chamber of Commerce, which has led the court battle against the Governance Rule, submitted a letter asserting many of the legal and policy arguments raised in its briefs. In particular, the Chamber of Commerce urges that the Commission should not "intervene in the financial markets nor limit investor choice without first assembling compelling evidence of a need for further regulation, and without establishing as well that the proposed restrictions would in fact deliver the benefits promised." In this regard, the Chamber of Commerce argues, "[t]he independent chair and 75 percent independence provisions fall far short of these requirements."

The Chamber of Commerce letter is available at http://www.uschamber.com/NR/rdonlyres
/ekpqhyo7coc4c2raavkflyfxadfhmjlj6qzkfvffjnjjwyw3qic7ujkezkudw3uaqhyebnhfuec3vsyqpbtcnybjjke/SECcommentletter.pdf.

The Consumer Federation of America and Fund Democracy jointly submitted a letter expressing their "continued strong support for the requirement[s]." The letter points to the fund scandals that surfaced in 2003 as evidence that the independence and effectiveness of fund boards need to be strengthened to protect the interests of shareholders. The letter argues that the benefits of the 75% independent directors and independent chair requirements far outweigh the costs, pointing to a Mutual Fund Directors Forum survey that suggests actual compliance costs are lower than estimates made by the SEC in connection with the original rulemaking.

The CFA/Fund Democracy letter is available at http://www.funddemocracy.com/cmts indy reproposal.pdf.

The Mutual Fund Directors Forum ("MFDF") points to the "significant benefits" enjoyed by fund shareholders when the board of a fund is composed of a supermajority of independent directors under the leadership of an independent chair. While the MFDF letter stops short of endorsing the Governance Rule on behalf of the Forum, and instead advocates that funds should be encouraged as a "best practice" to have an independent chair and a board composed by directors at least three-fourths of whom are independent, the MFDF letter does note that its own board of directors unanimously recommends that the SEC mandate these governance principals. In connection with its recommendations, the MFDF points to a survey in which fifty-one of its seventy-five member groups responded to questions concerning the rule, including the status of the chair (43 of 51 reported an independent chair), costs (including legal costs of compliance, annual costs for payments to independent directors, and other one-time or recurring costs), and status of compliance with a 75 percent independent director standard (90 percent of survey respondents reported meeting this standard).