The HFWG, a group of executives from 14 hedge fund managers that is analogous to the President’s Working Group on Financial Markets in the United States, published recommendations for voluntary hedge fund governance and disclosure best practice standards in the UK in light of the Financial Services Authority’s regulatory requirements. The funds represented on the working group include representatives from US funds. Although launched in the UK, the best practice standards are designed to be capable of global application. The draft standards focus on five broad areas: disclosure, valuation, risk management, fund governance, and activism. The HFWG is soliciting comments and expects to issue a final report in January 2008.

Copies of Parts 1 and 2 of the paper, Hedge Fund Standards: Consultation Paper, can be found at http://www.hfwg.co.uk/sites/10085/files/HFWG%20Paper%20Part%201%20Final.pdf and http://www.hfwg.co.uk/sites/10085/files/HFWG%20Paper%20Part%202%20Final.pdf, respectively.

The U.S. District Court for the District of Connecticut dismissed all claims in a suit by mutual fund investors alleging that the advisers, distributor and trustees for 54 mutual funds used fund assets to pay excessive commissions in exchange for “shelf space” at brokerage firms in violation of the 1940 Act, the Advisers Act of 1940 (Advisers Act), and state common law. The plaintiffs sought to bring a class action suit on behalf of investors in the mutual funds from February 4, 1999 through November 17, 2003, and the class had not been certified at the time of the decision. The plaintiffs alleged that in order to receive higher fees (calculated as a percentage of the assets under management), the defendants directed brokerage, engaged in revenue sharing, and entered into soft dollar arrangements with brokers in exchange for the brokers agreeing to promote the funds’ shares. The plaintiffs also alleged that the defendants did not adequately disclose these arrangements to investors. The court made the following findings:

• There is no private right of action under the following sections of the 1940 Act: Section 34(b) for misrepresenting or omitting material facts in registration statements and other documents required by the 1940 Act, Section 36(a) for breach of fiduciary duties or Section 48(a) for control person liability.
  
• The plaintiffs’ allegations that the defendants violated their fiduciary duties with respect to compensation for their services under Section 36(b) of the 1940 Act were inadequate because the plaintiffs did not allege that the defendants’ compensation was disproportionately large, did not bear a reasonable relationship to the services provided and could not have been the product of arm’s length bargaining.
  
• The plaintiffs could not pursue a derivative claim on behalf of the mutual funds under the Advisers Act seeking recission of the advisory agreements and recovery of the fees paid because the plaintiffs did not adequately plead futility of demand on the directors under Massachusetts law.
  
• The plaintiffs’ common law claims under state law for breach of fiduciary duty and unjust enrichment were pre-empted by federal law because the Securities Legislation Uniform Standards Act pre-empts state law class action claims brought by holders of securities.

Alexander v. Allianz Dresdner Asset Mgmt. of Amer. Holding, Inc., Civ. Action No. 3-04-cv-280 (CFD), 2007 WL 2717877 (CFD) (D. Conn. 2007).

In a complaint filed in the US District Court for the Southern District of New York, the SEC charged a hedge fund, its adviser, and an individual, who was both managing director of the fund and a principal of the adviser, with violating Rule 105 of Regulation M under the Securities Exchange Act of 1934. The SEC alleged that in at least 18 public offerings between 2001 and 2004, the defendants realized more than $1.48 million in profits when they purchased shares in registered public offerings to cover short sales that they had made at higher prices for the same securities during the five business days before the offerings were priced. Additionally, the SEC alleged that the defendants tried to conceal trades by engaging in sham riskless cross trades of the same number of shares at the same prices. The fund’s managing director profited from the trades, the SEC alleged, and directed, authorized and supervised these activities through the fund’s adviser. The SEC seeks a permanent injunction against all of the defendants prohibiting further violations of Rule 105, the payment of disgorgement and prejudgment interest from all of the defendants, and the payment of a civil penalty from the managing director.

Rule 105, at the time of the alleged violations, prohibited using securities purchased in a registered public offering to cover short sales made during the five business days before the public offering was priced. The SEC noted that the alleged activities also would have violated amended Rule 105 (effective on October 9, 2007), which prohibits persons with a restricted period short position in a security from purchasing that security in a registered offering. This complaint is another illustration of the SEC’s commitment to prosecute hedge funds and their advisers for improper trading activities.

The release announcing the charges, Litig. Rel. No. 20332 (Oct. 15, 2007), and the SEC’s complaint in the matter, 07 Civ. 8849 (Oct. 15, 2007), can be found at http://www.sec.gov/litigation/litreleases/2007/lr20332.htm and
http://www.sec.gov/litigation/complaints/2007/comp20332.pdf, respectively.

Andrew Donohue, the Director of the Division of Investment Management at the SEC, recently spoke about managing operational risk for mutual funds at the Investment Company Institute 2007 Operations and Technology Conference. He also discussed anticipated SEC staff recommendations, including the possible amendment of Rule 12b-1 and codification of individual exemptive orders provided to exchange traded funds that exempt them from certain provisions of the Investment Company Act of 1940 (the “1940 Act”).

Mr. Donohue suggested that firms look at operational risks from a new standpoint rather than just using algorithms that consider past events and known risks and contingencies. He expressed concerns about firms keeping pace with the fast-moving technological and product developments in the industry and about how firms’ operational systems work together. Mr. Donohue noted that small errors can be magnified and cause catastrophic problems. For example, failing to send prospectuses to large numbers of clients can be caused by incorrect coding. He also voiced concerns about funds’ increasing investments in complex instruments, including over-the-counter derivatives and credit default swaps, the ability of funds’ back offices to handle the documentation, settlement, valuation and confirmation processes for these trades, and firms’ ability to clear these products. Finally, Mr. Donohue noted that funds’ risks may change when they outsource critical functions because gaps may be created in their operations systems and coordination may become more difficult.

Mr. Donohue also spoke at the 2007 Managed Account Solutions Conference and addressed regulatory issues for separately managed accounts. The topics he discussed included advisers’ best execution responsibilities, best execution and trading disclosures to separately managed account clients, and possible amendments of Rule 3a-4 under the 1940 Act.

Copies of Mr. Donohue’s speeches can be found at http://www.sec.gov/news/speech/2007/spch101807ajd.htm and
http://www.sec.gov/news/speech/2007/spch101907ajd.htm.

The NYSE settled disciplinary actions with 14 members and one former member for alleged activities that included: (1) violating NYSE Rule 401(a) by failing to ensure delivery of prospectuses to customers who purchased registered securities, and (2) violating NYSE Rule 1100(b) by failing to deliver product descriptions and other disclosure documents to investors who had invested in exchange traded funds (ETFs). Without admitting or denying the NYSE’s findings, the firms agreed to be censured and to pay fines ranging from $375,000 to $2.25 million. Each of the member firms also agreed to certify that the firm’s policies and procedures are reasonably designed to ensure compliance with applicable federal securities laws and NYSE rules.

In a press release announcing the settlements, the NYSE noted that although some firms relied upon outside vendors, an internal prospectus fulfillment facility, or issuers’ financial printers to deliver documents to customers, firms are solely responsible for, and may not delegate, their compliance with the federal securities laws and NYSE rules.

The NYSE press release announcing the settlements and links to each settlement can be found at www.nyse.com/press/1191838488330.html.

Andrew Donohue, the Director of the Division of Investment Management at the SEC, spoke about distributions for closed end funds at the Investment Company Institute’s Closed End Fund Workshop, and about anticipated SEC staff recommendations regarding Form ADV Part 2, soft dollars, and books and records at IA Week’s Fall Compliance Conference.

Mr. Donohue urged fund managers and directors to consider whether a managed distribution plan is in the best interests of closed end fund investors, taking into account whether the plan reduces the fund’s NAV discount, includes a partial return of capital, and can be implemented for the life of the fund. He stated that fund investors should know if distributions they receive include a return of capital. The SEC’s four recent enforcement actions relating to failure to send return of capital notices further illustrate its concern with this issue.

Mr. Donohue expects the SEC soon will consider the re-proposal of Form ADV Part 2, including electronic filings that would be available on the SEC’s website. By the end of the year, the SEC staff also plans to recommend guidance for mutual fund boards and compliance professionals about monitoring conflicts of interests in connection with soft dollar arrangements. Finally, Mr. Donohue explained that the SEC staff is considering electronic record retention, the extent of an adviser’s obligation to retain e-mails and text messages, how to better harmonize the recordkeeping requirements for advisers and broker-dealers, and the extent of an adviser’s obligations to produce records to examination staff under the Advisers Act and Investment Company Act of 1940 recordkeeping provisions.

Copies of Mr. Donohue’s speeches can be found at http://www.sec.gov/news/speech/2007/spch101107ajd.htm; http://www.sec.gov/news/speech/2007/spch100107ajd.htm. The releases announcing the settlements relating to failure to distribute return of capital notices, Inv. Adv. Act Rel. No. 2666 (Sept. 28, 2007), Inv. Adv. Act Rel. No. 2665 (Sept. 28, 2007), Inv. Adv. Act Rel. No. 2664 (Sept. 28, 2007), and Inv. Adv. Act Rel. No. 2663 (Sept. 28, 2007), can be found at http://www.sec.gov/litigation/admin/2007/ia-2666.pdf, http://www.sec.gov/litigation/admin/2007/ia-2665.pdf, http://www.sec.gov/litigation/admin/2007/ia-2664.pdf, and http://www.sec.gov/litigation/admin/2007/ia-2663.pdf, respectively.

As discussed in the WilmerHale Email Alert, Under the SEC Spotlight: Hedge Funds and Short Sale Activity, dated October 19, 2007, the SEC settled with an unregistered hedge fund adviser and its chief executive officer, senior managing director and head trader for engaging in improper short sales in the securities of a financial holding company located in New Orleans following Hurricane Katrina. The SEC found that: (1) the adviser willfully violated Section 10(a) of the Securities Exchange Act of 1934 and Rule 10a-1, and Section 17(a)(2) of the Securities Act; (2) the CEO and two employees willfully aided and abetted the Section 10(a) and Rule 10a-1 violations; and (3) the CEO failed reasonably to supervise firm personnel as required by Section 203(e)(6) of the Advisers Act. The SEC found that the adviser entered into swap transactions on behalf of the fund, which resulted in the fund retaining the economic risk but not the ownership of the financial holding company shares. Following Hurricane Katrina, the adviser expected losses and sold the company’s stock short; however, in order to avoid the then-applicable “tick test” and the locate rules, the adviser marked short sales orders as “long” and falsely told broker-dealers that the adviser had located stock to borrow for the short sales. Through these improper trading practices, the SEC found that the adviser avoided over $6.5 million in losses. Without admitting or denying the SEC’s findings, the adviser agreed to cease-and-desist from future violations, the adviser, CEO and two employees were censured, the adviser agreed to pay more than $8 million and employ an independent consultant, and the CEO, managing director and head trader agreed to pay $100,000, $50,000 and $40,000, respectively.

In the SEC press release, the Division of Enforcement indicated that this action is part of the SEC’s effort to ensure that hedge funds comply with the securities laws and trading rules. The settlement also illustrates the SEC’s commitment to regulate the trading activities of hedge fund advisers that are not registered investment advisers with the SEC. For a discussion of focus areas for policies and procedures for hedge fund managers in connection with short sale activities, see the WilmerHale Email Alert.

A copy of the settlement, Inv. Adv. Act Rel. No. 2670 (Oct. 10, 2007), and the related press release SEC Press Rel. No. 2007-216 (Oct. 10, 2007), can be found at http://www.sec.gov/litigation/admin/2007/33-8857.pdf and http://www.sec.gov/news/press/2007/2007-216.htm, respectively. The WilmerHale Securities Alert discussing this matter can be found at http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=8078.

An administrative law judge barred the managing member of a hedge fund’s general partner from associating with any broker-dealer or investment adviser after the managing member pled guilty to making a false statement to the SEC during an investigation into his trading practices. In a voluntary phone interview with SEC investigators, the manager stated that he did not know who possessed trading authority over the hedge fund’s brokerage account even though he knew that he personally possessed such trading authority, and such information was material to trading activity under investigation by the SEC. Among other findings, the judge rejected arguments that hedge funds are “exempt from the Advisers Act” as a result of the decision in Goldstein v. SEC. The judge noted that Goldstein concerns registering hedge fund advisers and does not concern the SEC’s authority to enforce the securities laws and to sanction or bar persons from association with registered or unregistered investment advisers under Section 203 of the Investment Advisers Act of 1940 (Advisers Act).

A copy of the decision, Initial Decision Rel. No. 335 (Oct. 9, 2007), can be found at http://www.sec.gov/litigation/aljdec/2007/id335cff.pdf.

The SEC settled a civil action in the District Court for the Southern District of Florida against a bank for allowing its name and logo to be used in connection with an alleged Florida-based offering fraud by a firm. The settlement coincided with the SEC’s issuing a cease-and-desist order settling allegations that the bank caused the firm’s violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 (Securities Act) by allowing the firm to use the bank’s name in marketing materials that falsely suggested that the firm’s retirement and college “trust plans” were co-developed by the bank and that investors’ funds would be “totally safe” in a trust account at the bank. In reality, the firm deposited funds in an ordinary checking account in its own name and took up to 95% of the invested amounts to pay expenses and fees. In addition, the bank actively assisted the firm in selecting mutual funds with high front end loads as investment options for the trust plans. Neither the amount of the loads, nor the bank’s role in fund selection, was disclosed to investors. Finally, the bank also sent the firm’s investors a letter on the bank’s letterhead announcing its relationship with the firm and inviting the investors to transfer their funds to the bank without disclosing the costs associated with the transfer. Without admitting or denying the SEC’s allegations in the civil case, the bank also consented to pay a $10 million penalty, $463,893 in disgorgement and $36,667 in prejudgment interest.

This settlement illustrates the value to service providers of controlling the use of their corporate name and monitoring third party offering and marketing materials that use the service provider’s name or logo. If a firm fails to assure its name is used in association only with truthful and accurate materials, it may be exposed to regulatory risk, as well as reputational risk.

The releases announcing the settled civil action, SEC Litig. Rel. No. 20328 (Oct. 12, 2007), and the administrative settlement, Sec. Act Rel. No. 8844 (Sept. 19, 2007), can be found at http://www.sec.gov/litigation/litreleases/2007/lr20328.htm and http://www.sec.gov/litigation/admin/2007/33-8844.pdf, respectively.

The fee rate for the registration of securities (including investment company securities) will increase five days after the enactment of the SEC’s regular fiscal year 2008 appropriation to $39.30 per million.

The release announcing the fee rate adjustments, SEC Press Rel. No. 2007-207 (Sept. 28, 2007), can be found at http://www.sec.gov/news/press/2007/2007-207.htm.

The SEC instituted separate administrative and cease-and-desist proceedings against two registered investment advisers and their control persons related to the maintenance and production of their books and records, among other issues. An administrative law judge will hear the matters.

• In one of the proceedings, the SEC alleged that the adviser willfully violated the examination and reporting requirements of Advisers Act Section 204 and Rules 204-1 and 204-2(f), and that the adviser’s sole principal aided, abetted and caused these violations. The principal allegedly refused to produce or allow the SEC to inspect his advisory records, ultimately claiming the records had been destroyed by a fire or inadvertently sold by a storage company. The adviser also allegedly maintained a website after discontinuing its business that advertised its advisory programs and falsely stated that it was “subject to periodic SEC examinations.”
• In the other proceeding, the SEC alleged that the adviser willfully violated the books and records and reporting requirements under Advisers Act Sections 203A and 204, and Rules 203A-1, 204-1, and 204-2, and that the owner, president and chief executive officer aided, abetted and caused those violations. The adviser allegedly failed to keep cash receipt journals, disbursement records, general and auxiliary ledgers, and financial statements relating to the advisory business, and failed to file Form ADV and Form ADV-W. The SEC also alleged that the owner has a history of disregarding the Advisers Act books and records and reporting requirements, including a settlement against him in 1996 based, in part, on identical violations as those currently alleged.

The releases announcing these proceedings, Inv. Adv. Act Rel. No 2651 (Sept. 24, 2007) and Inv. Adv. Act Rel. No. 2660 (Sept. 26, 2007), can be found at http://www.sec.gov/litigation/admin/2007/ia-2651.pdf and http://www.sec.gov/litigation/admin/2007/ia-2660.pdf, respectively.

The SEC settled with the manager and co-owner of a registered investment adviser that managed hedge funds, finding that the manager willfully violated Sections 206(1) and 206(2) of the Advisers Act, Section 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Specifically, the SEC found that the manager fulfilled a redemption request made to one fund, that had insufficient liquidity, by transferring money out of another fund, without authorization to do so. Additionally, the SEC found that the offering memoranda for the hedge funds misstated material facts regarding the manager’s education. The manager did not admit or deny the SEC’s findings.

The SEC ordered the manager to pay a civil money penalty of $35,000 and to cease and desist from future violations, barred the manager from association with an investment adviser for three years, prohibited the manager from serving as an employee, officer, director, advisory board member, investment adviser, depositor, or principal underwriter for a registered investment company, and prohibited the manager from serving as an affiliated person of any such entity.

The release announcing the settlement, Inv. Adv. Act Rel. No. 2662 (Sept. 27, 2007), can be found at http://www.sec.gov/litigation/admin/2007/33-8848.pdf.

A registered investment adviser and its CCO consented to the SEC’s findings that: (1) the adviser violated Section 204 of the Investment Advisers Act of 1940 (Advisers Act) and Rules 204-2 and 204A-1 by failing to adopt and maintain accurate written acknowledgements of employees’ receipt of the adviser’s code of ethics; (2) the adviser violated Section 206(4) of the Advisers Act and Rule 206(4)-7 by failing to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act; and (3) the CCO aided, abetted and caused the adviser’s violations. The adviser and the CCO did not admit or deny the SEC’s findings.

The SEC alleged that the CCO revised the adviser’s code of ethics to comply with Rule 204A-1 after the rule’s February 1, 2005 compliance date, provided written acknowledgement forms to the adviser’s supervised persons starting in March, 2005, and instructed the supervised persons to backdate the forms. The CCO also purchased pre-packaged a compliance manual from a compliance outsourcing firm in 1990 and an updated version in 2003 before Rule 206(4)-was finally adopted. The CCO did not revise the former and marked up the latter version only by hand. As of October, 2004 these two documents, a 1989 version of the Advisers Act, a 1987 SEC release and an e-mail retention policy comprised the entirety of the Adviser’s compliance program materials. In addition, the pre-packaged materials were designed for discretionary money managers. The adviser served as a pension consultant and had a broker-dealer subsidiary that was created to provide a commission recapture plan to clients. The CCO did not revise the pre-packaged manuals based on the risk factors and conflicts of interest applicable to the adviser’s operations.

The SEC barred the CCO from association with a broker, dealer or investment adviser in a compliance capacity, censured the adviser and CCO, and ordered that the adviser and CCO cease and desist from further violations and pay a civil money penalty of $20,000 and $10,000 respectively.

The release announcing the settlement, Inv. Adv. Act Rel. No. 2669 (Oct. 4, 2007), can be found at http://www.sec.gov/litigation/admin/2007/34-56612.pdf.

Commissioner Annette Nazareth announced that she intends to leave the SEC and return to the private sector, but did not announce a specific date for her departure. Commissioner Nazareth’s term ended on June 5, 2007, but she may remain in her position until a successor is appointed, up to 18 months beyond the term’s end.

The release announcing Commissioner Nazareth’s intention to leave the SEC, SEC Press Rel. No. 2007-210 (Oct. 2, 2007), can be found at http://www.sec.gov/news/press/2007/2007-210.htm.

The California Corporations Commissioner proposed rule amendments that would eliminate the current state licensing exemption for advisers to hedge funds. Currently, advisers with an office in California and exempt from federal registration requirements under 203(b)(3) of the Advisers Act, do not have to obtain a license from the California Department of Corporations if the adviser has fewer than 15 clients, and either $25 million or more in assets under management or provides advice only to venture capital companies, as defined in the rule (Rule 260.204.9 under the Corporate Securities Law of 1968 (“CSL”)). The new proposal will eliminate the 15 client trigger and the $25 million threshold. What this means is, if the amendment goes into effect, California hedge fund advisers with less than $25 million under management will have to obtain a state license and advisers with $25 million or more will have to choose whether to be licensed in California or to register with the SEC.

California advisers to venture capital companies will retain their licensing exemption. Also, advisers with a place of business in another state and fewer than six clients in California during the prior twelve months will continue to be exempt from California’s licensing requirements under Section 25202 of the CSL. It is not yet known whether or how California will enhance its regulatory oversight of state licensed advisers.

The notice, Document PRO 41/06 - A, can be found at http://www.corp.ca.gov/pol/rm/4106a.pdf. The text of proposed changes, Document 41/06 - B (Aug. 8, 2007), can be found at http://www.corp.ca.gov/pol/rm/4106b.pdf. The initial statement of reasons for the amendments, Document PRO 41/06 - C, can be found at http://www.corp.ca.gov/pol/rm/4106c.pdf.

Two Bear Stearns funds organized as limited liability companies in the Cayman Islands have been denied the Chapter 15 bankruptcy protections generally afforded to such foreign entities while undergoing liquidation proceedings abroad. Instead of shielding the funds’ US assets from seizure by creditors for the duration of the liquidation proceedings in the Cayman Islands, the US Bankruptcy Court in Manhattan gave the funds until September 29, 2007 to file for Chapter 11 or Chapter 7 protection.

Chapter 15 of the Bankruptcy Code was enacted by Congress to facilitate the fair and efficient handling of multi-national or cross-border insolvencies, by staying U.S. courts and creditors while another jurisdiction having sufficient contacts with the insolvent entity takes the first stab at bankruptcy proceedings. Where there is little connection between the insolvent entity and the first jurisdiction in which the bankruptcy proceeding was brought, however, little deference is required to a seemingly opportunistic or evasive offshore bankruptcy filing.

Such was Judge Burton Lifland’s reasoning with respect to the Bear Stearns funds, which he found to have no employees or managers in the Cayman Islands, few liquid assets outside the U.S. and only 2 of 5 directors residing in the Caribbean. Other factors of relevance to a court considering Chapter 15 protections were recently posted by dms Management, Ltd., a Cayman company specializing in the provision of independent directors for offshore funds. The factors listed by dms Management, Ltd. include:

• location of the full board of directors and regular board meetings outside of the U.S.,
• use of an offshore bank account to receive subscriptions and pay redemptions and expenses,
• maintenance of share registration and subscription services outside the U.S.,
• establishment of the investment manager as an offshore entity to oversee the actions of the U.S.-based investment adviser, and
• establishment of a physical presence offshore where investor relations, expense approval, etc. are performed by a fund employee or delegate.

HedgeWorld, “Two Firms Offer Reassurance on Chapter 15 Fall-Out,” (September 19, 2007).

CNBC, “Bear Stearns funds liquidators won’t seek bankruptcy protection due to legal costs,” (September 24, 2007).

In re Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd., 2007 WL 2479483, (Bankr. S.D. NY, Aug. 3, 2007).

An August 10, 2007 letter from the IAA to the SEC has been released expressing the IAA’s concern at harmonizing the broker-dealer and investment adviser record-keeping requirements. Although the IAA is in full support of the SEC’s “comprehensive review and wholesale rethinking” of investment adviser record-keeping requirements, the IAA discourages harmonization to the extent it imposes on investment advisers the “business as such” standard currently imposed only on broker-dealers by Rule 17a-4(b)(4) under the Exchange Act.

The “business as such” standard arising from Rule 17a-4(b)(4) and applicable to broker-dealers is significantly more burdensome and confusing than the unrelated “business as such” language currently present in the record-keeping rules applicable to investment advisers. As applied to investment advisers, the Rule 17a-4(b)(4) “business as such” standard would generally require the maintenance for 5 or 6 years of “all communications received and copies of all communications sent by such [investment adviser] (including inter-office memoranda and communications) relating to [its] business as such.”

The IAA notes that the precise scope of this language will likely be as difficult for investment advisers to interpret and apply, as it has proven to be for broker-dealers. Any interpretation, however, is anticipated to increase the volume and duration of the records being kept by investment advisers. Such burdens likely outweigh the intended benefit to dual registrants of a single consolidated record-keeping regime, says the IAA letter, because only 6% of investment advisers are dually registered as broker-dealers (with an additional 9% of investment advisers employing or serving as a registered representative of a broker-dealer).

On September 19, 2007, the SEC adopted an interim final temporary rule (Interim Rule) providing limited relief to certain investment advisers from the principal trading requirements of the Investment Advisers Act of 1940 (Advisers Act), and proposed an interpretive rule to clarify the application of the Advisers Act to certain activities by broker-dealers. The Interim Rule applies to non-discretionary advisory accounts, which include many former fee-based brokerage accounts transitioned to investment advisory accounts in light of the decision by the US Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC.

The Interim Rule provides relief to persons registered as both investment advisers and broker-dealers (dual registrants) from the transaction by transaction written notice and consent requirements under Section 206(3) of the Advisers Act for principal trades executed with clients on a non-discretionary basis. A dual registrant must disclose when it may engage in principal trades with the client, the nature and significance of the related conflicts of interest, and how the firm addresses these conflicts, and then must obtain from the client a blanket revocable written consent authorizing the dual registrant to act as principal. Before each principal trade, the dual registrant also must disclose to the client and the client must agree orally or in writing that the dual registrant may trade as principal. Finally, the principal trade for which the dual registrant is seeking relief must be: (1) done for a brokerage account subject to the Exchange Act, (2) in securities issued and underwritten by someone other than the dual registrant or its affiliates (with the exception of investment grade debt securities), and (3) reported to the client in a standard confirmation notice containing additional disclosures and at the end of each year in an itemized annual report. The Interim Rule does not relieve a dual registrant from the obligation to disclose all material conflicts of interest to the client, or from any other obligations under the Advisers Act.

The effective date for the Interim Rule was September 30, 2007 and the Commission is inviting comments by November 30, 2007. With respect to existing fee-based brokerage clients that convert their accounts to non-discretionary investment advisory accounts, the Commission is allowing dual registrants to obtain the blanket written consent required by the Interim Rule and to provide the first Form ADV brochure no later than January 1, 2008. The Interim Rule will continue to provide limited relief until December 31, 2009, by which time the SEC intends to have analyzed and effected any appropriate regulatory responses that are suggested in a related study by the RAND Corporation that is currently underway.

The SEC also proposed an interpretive rule regarding certain activities by broker-dealers that were addressed in the vacated Rule 202(a)(11)-1 and its adopting release, including providing advisory services under a separate contract or for a separate fee, providing discretionary brokerage and discount brokerage services, and providing services as a dual registrant. Comments on the proposed rule are sought by November 2, 2007.

The SEC considered these rules after the court granted the SEC’s motion to stay the issuance of the court’s mandate in Financial Planning Association v. SEC until October 1, 2007. The SEC announced in a filing with the court on September 25, 2007 that it will not seek a further stay of the court’s mandate.

Reuters, “US SEC Helps With Move From Fee-Based Accounts,” (September 19, 2007).

Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007), March 30, 2007.

Financial Planning Association v. SEC: Status Report of the SEC, (D.C. Cir. 2007), September 25, 2007.

A copy of the SEC press release can be obtained at: http://sec.gov/news/press/2007/2007-193.htm.

A copy of the final interim rule can be obtained at: http://sec.gov/rules/final/2007/ia-2653.pdf.

A copy of the proposed rule can be obtained at: http://sec.gov/rules/proposed/2007/ia-2652.pdf.

Rules implementing the bank-as-broker provisions of the Gramm-Leach-Bliley Act were adopted by the SEC on September 19, 2007, approved by the US Federal Reserve on September 24, 2007 and endorsed by the Federal Deposit Insurance Company, the Office of Thrift Supervision and the Office of the Comptroller of the Currency.

The Gramm-Leach-Bliley Act was passed in 1999 to synchronize the regulation of financial service providers (i.e., banks, thrifts, broker-dealers, investment advisers, insurance companies, etc.) which historically had been subject to differing regulatory authorities and regimes. The intent was to stimulate price competition and innovation in financial products while ensuring uniform investor protection.

One important provision of the Gramm-Leach-Bliley Act amended the definition of “broker” in the Securities Exchange Act of 1934 (Exchange Act) so that banks would no longer be completely exempt from registration and regulation as broker-dealers. However, the necessary enacting legislation was never passed due to disagreement among the multiple regulatory authorities and parties to be regulated.

Enactment of Regulation R resolves the impasse by applying the broker registration requirements to banks, while still excepting them from such registration when engaged solely in traditional banking activities. The activities in which a bank can engage while still excepted from registration as a broker under Regulation R include:

• providing nominal incentive compensation to bank employees for referring bank customers to a broker-dealer,
• effecting securities transactions as a trustee or fiduciary so long as the bank’s chief compensation, as a whole, is not derived from such transactions,
• sweeping deposits into no-load money market accounts, and even load money market accounts if certain additional requirements are met like providing customers with a prospectus,
• taking securities orders as custodian for retirement accounts, or if on an accommodation basis, for certain other custodial accounts, so long as no bank employees receive compensation,
• transacting in certain mutual fund shares and variable insurance products that are registered, funded by a separate account and not listed on an exchange or interdealer quotation system,
• transacting in a company’s securities for no commission where the only parties to the transaction are the company, its transfer agent and its employee benefit plan, and
• lending securities for which the bank does not act as custodian.

Regulation R went effective on September 28, 2007 but its full effect will not be felt until the first day of each bank’s fiscal year commencing after September 30, 2008 when the transitional exemption provided by Regulation R expires.

Reuters, “US Fed Approves SEC Broker Exception for Banks,” (September 24, 2007).

Reuters, “Update 1 - U.S. SEC Approves Broker Exception Rule for Banks,” (September 19, 2007).

A copy of the SEC press release can be obtained at: http://sec.gov/news/press/2007/2007-190.htm.

A copy of the final rule can be obtained at: http://sec.gov/rules/final/2007/34-56502.pdf.