SEC Division of Investment Management Director Speaks on Soft Dollars
10.30.2006 SEC Investment Management Director Buddy Donohugh spoke about soft dollars and other topics at the SIA Institutional Brokerage Conference in New York. He described the SEC's next soft dollar initiative, which will involve providing additional disclosure and related guidance to fund boards regarding soft dollars and brokerage practices.
Concerning brokerage execution and directed brokerage, Donohugh said that investment advisers may not think that the broker-dealer to which its clients directs the adviser to send a trade is actually the broker-dealer that is best suited to execute it. However, if the adviser's client directs that the adviser to send trades to a particular broker-dealer, it is the client's right and then it becomes the adviser's responsibility to do so. In many cases, he cautioned, the request is not a direction from the client but may be framed as a request that "subject to best execution" the adviser place a trade with a particular broker-dealer.
Donohugh further noted that there is increasing client pressure on investment advisers to be in a position to demonstrate that they are properly meeting their best execution obligation. Their institutional clients, fund boards and others are focusing on execution quality, and where possible, seeking quantifiable measures, from a practical if not a legal perspective. He added that since basic brokerage is now becoming more of a commodity, at least for many large-cap equity trades, any time that an adviser is paying more than just a bare-minimum execution-only rate for a client trade, the adviser may open itself up to questioning from its clients regarding whether the additional cost was appropriate.
Please click http://www.sec.gov/news/speech/2006/spch103006ajd.htm to access a copy of the speech.
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SEC and NASAA to Continue to Waive IARD System Fees
10.26.2006 The SEC and NASAA will continue to waive, for two years, the annual system fees paid by investment adviser firms to maintain the IARD system. For the next two years, NASAA will reduce by one-third the system fees paid by investment adviser representatives. The initial and renewal investment adviser representative fee will be 30 USD, reduced from 45 USD.
Please click http://www.sec.gov/news/press/2006/2006-182.htm to access a copy of the release about the fees.
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SEC Adopts Business Development Company Rules
10.25.2006 The SEC adopted new rules under the Investment Company Act of 1940 that more closely align the permissible investment activities of business development companies (BDCs) with the purpose Congress intended. The SEC also reproposed for comment an additional definition of eligible portfolio company. These new rules will facilitate small business capital formation by providing added flexibility for BDCs to invest larger amounts in more types of smaller companies, consistent with the purpose of the 1940 Act.
Congress established BDCs in 1980 as a new type of closed-end investment company to make capital more readily available to small, developing, and financially troubled companies that do not have ready access to the public capital markets or other forms of conventional financing. To encourage investment in these smaller companies, the Investment Company Act of 1940 requires BDCs to have at least 70% of their portfolio invested in certain assets, including securities of "eligible portfolio companies," at the time they make any new investments.
The 1940 Act defines eligible portfolio company to include domestic operating companies that, among other things, do not have any class of securities that are marginable under rules promulgated by the Federal Reserve Board. In 1998, for reasons unrelated to small business capital formation, the Federal Reserve Board expanded its definition of margin security to include all publicly traded equity securities and most debt securities. These 1998 amendments had the unintended effect of reducing the number of companies that met the definition of eligible portfolio company.
The new rules under the 1940 Act address the impact of the Federal Reserve Board's 1998 amendments on the definition of eligible portfolio company:
- Rule 2a-46 defines an eligible portfolio company to include all private companies and companies whose securities are not listed on a national securities exchange; and
- Rule 55a-1 conditionally permits a BDC to include in its 70% basket follow-on investments in a company that met the new definition of eligible portfolio company at the time of the BDC's initial ownership in it, but no longer meets that definition.
Please click http://www.sec.gov/rules/final/2006/ic-27538.pdf to access a copy of the adopting release.
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Hedge Fund Adviser Indicted
10.25.2006 Anthony P. Postiglione, Jr. and William J. Lennon, the principals of Fountainhead Asset Management, LLC, the investment adviser they founded and which served as investment adviser to the Fountainhead Fund, LP, a hedge fund, were indicted by a grand jury convened by the United States Attorney for the Eastern District of Pennsylvania.
The 20-count criminal indictment charges Postiglione and Lennon with misrepresenting the risks of the hedge fund to the early investors, and creating and sending to investors false and misleading account statements and newsletters that represented the hedge fund was making money, when it was not. According to the indictment, the hedge fund investors, who never received accurate quarterly statements throughout the time of their investment, lost almost 2 m USD. In addition, Postiglione is charged with obstruction of justice based on allegations that, in August 2004, he intended to obstruct the criminal investigation by knowingly falsifying a document. If convicted, Postiglione faces a maximum of 385 years imprisonment, 3 years of supervised release, and a 4,760,000 USD fine; Lennon faces a maximum 365 years imprisonment, 3 years of supervised release, and a 4,510,000 USD fine.
Please click http://www.sec.gov/litigation/litreleases/2006/lr19885.htm to access a copy of the administrative order.
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OCIE Director Speaks on the Process of Compliance
10.17.2006 Lori A. Richards, Director of the SEC's Office of Compliance Inspections and Examinations, spoke at the National Membership Meeting of the National Society of Compliance Professionals Washington, D.C. on the process of compliance. After discussing the culture of compliance, she stated that a strong compliance program will have an identifiable process. The process of compliance is important, because if structurally sound, the compliance process will help the firm to avoid and detect violations and deal with them effectively.
Richards then shared the following examples of practices OCIE has observed:
Oversight:
- Because "tone at the top" is a key part of any effective compliance program, the firm's board, senior management and other key executives make it clear that they expect the firm and all of its employees to operate ethically and consistent with fiduciary and legal obligations. The mission and mandate of the CCO and the compliance program is communicated to all employees by the senior-most person or governing authority (the CEO or the board).
- The CCO provides regular reports of compliance problems, issues, concerns to the board or to the audit committee, and meets with the board to discuss the state of compliance at the organization. The CCO also discusses compliance initiatives and new regulatory requirements.
- CEOs speak often about the firm's culture and emphasize that doing what's right is expected. They repeat, repeat, repeat this message in many different ways - in written messages to the firm's employees, to its service providers, and to its shareholders. Perhaps most importantly, in meetings and in private conversations, they make it clear that the decision-making process will be guided by this philosophy.
- One of the best ways to make the firm's culture of compliance evident to employees is for firm leaders to make decisions that demonstrate intolerance for non-compliance, even if it means losing the trade, the client, or the deal.
- Some firms have established a Compliance Committee, composed of compliance, legal, and senior management, to review compliance issues and serve as the final escalation level for issues. Minutes record the issues presented and their resolution. Issues addressed included both regulatory compliance and compliance with firm policies.
- Similarly, firms have established a top-level management committee to identify and manage conflicts of interest and potential compliance issues.
Polices and procedures:
- The SEC has seen the adoption of new and more thoughtful policies and procedures to prevent and detect violations. New SEC and SRO rules requiring that all firms have adequate written compliance policies and procedures have taken effect, and these rules have had a significant impact in this area. Many firms revisited their old procedures and tuned them up. Many firms that did not have written policies do so now.
- The new rules do not mandate specific policies and procedures, but rather require that firms determine which policies and procedures will best work for them. (As an aside, examiners will evaluate these policies and procedures against one test - are they effective in detecting, reducing and correcting compliance problems?)
- Many firms have engaged in a "risk assessment" effort to identify areas of compliance risk within the firm and within different organizational units of the firm.
- Firms have established a "mapping" process to track compliance risks to supervisory procedures, to make sure that there are no gaps. Supervisory procedures are then specifically tailored to particular business lines.
- Many firms have revised their codes of ethics in light of recent disclosures of abusive trading by firm employees, and conflicts of interests in the giving/receiving of gifts and entertainment, political contributions and donations, and maintaining multiple lines of business that could create conflicts of interest.
- Firms have a process to track the development, maintenance, and updating of all written policies and procedures. Specific staff are assigned responsibility for maintaining, reviewing, and updating specific procedures.
- Firms follow their policies and procedures, all of them. This communicates respect for policies and procedures, and shows employees that the firm has an institutionalized compliance program, and that it's serious about the program.
Delegation of Responsibilities:
- A critical element of any sound compliance program is effective delegation. There must be a linkage - from the compliance risk, to the compliance control, to how it is to be implemented (frequency and methodology), to, finally, who will implement it. Without effective delegation, we often see a "who's on first?" comedy of disorganization.
- More firms are incorporating compliance, including the prevention of problems, in employee and supervisory evaluation standards and using it as a factor impacting compensation.
- It's become clearer to many firms that have multiple geographic locations that branch managers have responsibilities beyond production and sales training.
Training:
- The SEC has seen training programs for firm employees that were very engaging entertaining - and that really focused on how compliance guidelines applied to employees in the specific context of their work. One training module incorporated new risk areas based on trends noted from customer complaints and branch office audits.
- The SEC has also seen compliance programs that are "branded" within firms using ad campaign-like tactics - to get the word out to employees that compliance is an easy resource to use and a part of the team.
Monitoring and Auditing:
More firms are using automated resources to identify, monitor, report, and document compliance risk. However, many firms could devote more resources to technology that would effectively identify problems, particularly when dealing with vast quantities of information that simply cannot be monitored manually.
At some firms, compliance staff have online access to information that allows them to monitor and to follow up on exceptions quickly and easily, e.g., customer statements, new account forms, trade confirmations, trade blotters, and order tickets. In fact, some firms have developed automated systems that flag transactions that appear inconsistent with the customer's investment objectives. Some firms track transactions that were rejected after being flagged and reviewed, but others maintain no record of whether the unsuitable transactions were corrected.
Firms have and use internal auditors, with resources and the mandate to do their job.
Many firms have established internal "hotlines" for employees to report misconduct. Employees can help identify questionable conduct before it becomes a problem and can help identify problems that should be remedied.
Some firms have trained supervisors to be more open to hearing bad news. Managers who subtly send the message that they only want to hear good news will not know what's really going on in their organization. There are many examples of otherwise non-culpable employees trying to cover up compliance problems just to avoid having to tell the boss about them.
Enforcement and Discipline:
- Firms take immediate action to discipline employees who engage in intentional violations of the law, even big producers.
- When problems are found, they're dealt with quickly and appropriately, including discipline, redress for investors, adjustments to policies, notifying the regulator or making public disclosure if appropriate.
Response, Prevention and Evaluation:
- Many firms are struggling now with how to measure their compliance programs. Finding the right metric of "effectiveness" is not easy. Certainly you want to measure outcomes - i.e., is the compliance program reducing or eliminating violations or infractions? And, you also want to measure the incidence of new problems - is the compliance culture serving to reduce the rate at which new types of problems occur?
- Many firms integrated the testing aspect of their annual review into an ongoing process to regularly review policies and procedures, improve them, and question frequently whether they can be improved. Compliance policies should not be static and written in stone. They can be improved over time with the benefit of the lessons learned from using them.
- Many private firms are offering products to help firms gauge their compliance culture, largely through surveys and interviews.
- Finally, many firms seem more apt to keep their regulator informed about problems they're seeing, within the firm or within the broader industry.
Lastly, Richards reviewed the following issues that OCIE examiners are concerned about:
- Insider trading and front-running,
- What are you using your clients' money for,
- Seniors,
- Supervision,
- Trading Issues,
- Controls to prevent theft and misrepresentations, and
- AML.
Please click http://www.sec.gov/divisions/investment/noaction/2006/citigroup092606.htm to access a copy of the speech.
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Hedge Fund Charged with Late Trading
10.11.2006 The SEC issued an order against Steven B. Markovitz, who according to the SEC, engaged in late trading on behalf of a hedge fund. Late trading violates the federal securities laws related to the price at which mutual fund shares must be bought or sold and defrauds investors by giving the late trader an unfair advantage. Markovitz, according to the SEC, violated and aided and abetted violations of the antifraud and mutual fund pricing provisions of the federal securities laws. The order requires Markovitz to pay to the United States Treasury (i) 1 USD in disgorgement and (ii) 400,000 USD in a civil money penalty. The matter is related to Millennium Partners, L.P., et al., Administrative Proceeding File No. 3-12116 (Dec. 1, 2005).
Please click http://www.sec.gov/litigation/complaints/2006/comp19862.pdf to access a copy of the administrative order.
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Closed-End Fund Receives No-Action Relief to Conduct a Delayed at the Market Public Offering
10.5.2006 The SEC issued a no-action letter under Section 5 and 6(a) of the Securities Act of 1933 permitting Nuveen Virginia Premium Income Municipal Fund ("Fund") to conduct a delayed at the market public offering of its common shares pursuant to the shelf registration provisions of Rule 415(a)(1)(x) and Rule 415(a)(4) under the Securities Act of 1933.
The Fund is a diversified, closed-end management investment company registered under the Investment Company Act of 1940. The Fund sought no-action relief to conduct a delayed at the market shelf offering of its common shares under Rule 415(a)(1)(x) and Rule 415(a)(4) so that the Fund could issue new shares when the Fund's shares are trading at a premium to net asset value (NAV). The Fund did not want to register a traditional, non-shelf offering because of the risk that the market price of the Fund's shares would decline below NAV before the Securities Exchange Act of 1934 was completely sold.
The no-action relief is similar to the relief granted in Pilgrim America Prime Rate Trust (pub. avail. May 1, 1998). The relief granted in the Pilgrim letter was based, in part, on an effort by Pilgrim to file with the SEC, and mail to shareholders, quarterly reports that comply in all material respects with the disclosure requirements of Form 10-Q. Nuveen argued that recent enhancements in closed-end fund reporting requirements under the Exchange Act make the additional quarterly reporting obligations imposed on Pilgrim unnecessary. In Nuveen's view, the information required to be filed with the SEC under the Securities Exchange Act of 1934, including the information required on new Forms N CSR and N-Q, provides a steady stream of high-quality information about the Fund. The SEC staff agreed and stated that it would not recommend enforcement action under Section 5 or 6(a) of the Securities Act to the SEC if the Fund conducts a delayed at the market offering of its common shares pursuant to the shelf registration provisions of The no-action relief is similar to the relief granted in Pilgrim America Prime Rate Trust (pub. avail. May 1, 1998). The relief granted in the Pilgrim letter was based, in part, on an effort by Pilgrim to file with the SEC, and mail to shareholders, quarterly reports that comply in all material respects with the disclosure requirements of Form 10-Q.
Please click http://www.sec.gov/divisions/investment/noaction/2006/nuveen100606.htm to access a copy of the no-action letter.
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ICI Comments on Cross Trading Exemption for ERISA Plans
10.5.2006 The Pension Protection Act signed into law by President Bush on August 17, 2006, includes an exemption from ERISA's prohibited transaction rules for cross trading by investment managers of certain actively-managed plans. The Act mandated the Department of Labor to adopt regulations governing the content of cross-trading policies and procedures.
The Investment Company Institute (ICI), the trade group for the investment company industry, recommended in a comment letter to the Department of Labor that it recognize the significant protections for plans and plan participants afforded by the specific conditions of the legislation, particularly the independent pricing requirement. The conditions address potential concerns that a manager might be tempted to use cross trades to "dump" securities or otherwise provide an advantage to one client at the expense of another. The Department's compliance regulation, according to the ICI, should require that a manager's policies and procedures be reasonably designed to meet the conditions of the exemption and be periodically reviewed for adequacy and effectiveness of implementation. This approach, according to the ICI, is consistent with prior Department of Labor exemptions and SEC rule 17a-7, the mutual fund cross-trading rule.
The ICI also stated that the Department of Labor should use its exemptive authority to allow all plans to enjoy the benefits of cross trading. The Pension Protection Act limits the statutory exemption to plans with assets of at least 100 m USD. As a consequence, many plans that could benefit from the cost savings associated with cross trading cannot use the exemption. The ICI believes that plans with assets below 100 m USD also should be permitted to engage in cross trades, with appropriate investor safeguards.
Please click http://www.ici.org/new/06_erisa_ici_tmny.html to access a copy of the ICI comment letter.
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SEC Associate Director Speaks on Identity Theft
10.5.2006 OCIE Associate Director John Walsh discussed identity theft at the National Regulatory Service's 21st Annual Fall Compliance Conference in Scottsdale, Arizona. He began by stating that OCIE continues to conduct examinations of advisory and brokerage firms' controls to prevent identity theft. Such controls are sometimes called "information security" or "safeguarding" controls.
Walsh suggested that advisers/brokers ask the following questions:
- How do our branch managers protect customers from rogue brokers?
- How do our portfolio managers protect clients from unauthorized investments?
- How do our custodians protect investors' assets from misappropriation?
- How do we protect our customers' personal information from identity thieves?
He reviewed what identity theft is, why it is a problem and how it is impacting the securities industry. Specifically, he reviewed four variations of identity theft:
- Family fraud: usually a spouse, child, or in-law, uses personal knowledge of the customer to gain access to the customer's account. Most commonly, the identity thief then loots the account.
- Classic account takeover: a stranger to the customer gains access to the account and then loots it. In many cases the looting is implemented by selling all the positions in the account and wiring the proceeds to a foreign jurisdiction, usually a very distant foreign jurisdiction.
- Trading account takeover: a stranger takes control of an account, but removes no money. Instead, he or she uses the account to trade.
- Alias fraud: the identity thieves play with their own money but they use the victim's identity as cover. Generally, they steal the victim's identity and use that identity to open an account. The thief then funds the account and uses it for trading or money laundering schemes.
Walsh next spoke about which securities laws govern identity theft. For broker-dealers, funds and advisers, identity theft is reached by at least two areas of the federal securities laws. First, many identity theft schemes at securities firms fall within the prohibitions of the anti-fraud provisions, including Securities Act Section 17(a), Exchange Act Section 10(b), and Rule 10b-5 thereunder. Over the years, the Commission has brought several identity theft-type cases under the anti-fraud provisions.
The second area under the federal securities laws relevant to identity theft is Regulation S-P, the Commission's privacy regulation. The Safeguarding portion of the regulation, 17 C.F.R. 248.30(a), requires broker-dealers, investment companies, and SEC-registered investment advisers to adopt written policies and procedures that are reasonably designed to safeguard customer records and information.
Walsh then reviewed how OCIE is addressing identity theft and discussed a new sweep examination program that is being conducted by OCIE and the San Francisco District Office.
OCIE is reviewing firms on both sides of the industry: both broker-dealers and advisory complexes, and their policies and procedures for preventing identity theft. "We hope to find robust controls to comply with Regulation S-P and to prevent the types of identity theft frauds illustrated by the SEC's enforcement cases. However, because the sweep is under way I will not discuss its size or any possible findings. Suffice to say we are pursuing it actively," Walsh said.
Walsh concluded with a list of recommendations. First he referred the audience to "Safeguarding Confidential Customer Information," NASD Notice to Members 05-49 (July, 2005), in which the NASD stated that firms should consider, at a minimum:
- Whether the firm's policies and procedures adequately address the technology it has in use;
- Whether the firm has taken appropriate technological precautions to protect customer information;
- Whether the firm is providing adequate training to its employees, both in how to use its technology and in ensuring that customer records and information are kept confidential; and
- Whether the firm is conducting, or should conduct periodic audits to detect potential vulnerabilities in its systems and to ensure that its systems are in practice protecting customer records and information from unauthorized access.
Next, he recommended that the firm's security managers should be asked: how do they know that their policies and procedures are adequate; that their technological precautions are appropriate; that employee training is adequate? The NASD suggests one way to answer these questions: conduct a periodic audit. Has your firm ever had such an audit? If not, what can your information security managers offer as a demonstrable basis for their answers?
Third, he recommended a review of the firm's "front-end access controls" for on-line accounts. In general terms, NIST recommends that you protect the highest level risks with multi-factor authentication.
Fourth, he recommended that a firm should review the educational materials provided to customers to make sure they cover identity theft.
Fifth and finally, he recommended that firms keep an eye out for new developments involving identity theft.
Please click http://www.sec.gov/news/speech/2006/spch100506jhw.htm to access a copy of the speech.
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CCOutreach Program Registration Announced
10.5.2006 The SEC announced the opening of registration for the annual CCOutreach National Seminar for mutual fund and investment adviser Chief Compliance Officers. The National Seminar will be held on November 14, 2006, at the Commission's Washington, D.C., headquarters. The CCOutreach National Seminar will include panel discussions with SEC staff and CCO representatives on the latest compliance developments relevant to CCOs. The National Seminar follows a series of regional seminars held by the SEC examination staff and will address questions and issues raised at those programs.
Please click http://www.sec.gov/info/cco/ccons2006reg.htm to access information about the program
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Former Broker Charged with Late Trading
10.3.2006 The SEC filed an enforcement action in U.S. District Court against Gene T. Mancinelli, a former broker at Wall Street Access, a registered broker-dealer. In its complaint, the SEC alleges that Mancinelli permitted his hedge fund customers to late trade and deceptively market time mutual funds. Specifically, from April 2001 through October 2001, Mancinelli accepted and executed more than 2,000 late trades in mutual funds for one hedge fund customer. Mancinelli routinely permitted this customer to place orders to purchase, redeem or exchange mutual fund shares well after 4:00 p.m. ET, the time as of which funds calculate their net asset value (NAV). Mancinelli was aware that the late trades would receive that day's NAV as opposed to the next trading day's NAV. Additionally, Mancinelli utilized deceptive tactics, such as using multiple accounts and multiple broker numbers, to hide the identity of his market timing customers from mutual funds, and otherwise to facilitate his customers' market timing strategies.
Please click http://www.sec.gov/litigation/complaints/2006/comp19857.pdf to access a copy of the administrative action.
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Connecticut Enforcement Unit Focuses on Hedge Funds
10.1.2006 The Connecticut Department of Banking has set up a new enforcement unit that will investigate hedge funds. According to some sources, Connecticut has the second most hedge fund advisers of any state. Established approximately six months ago, the hedge fund unit investigates short sales, fails to deliver, manipulation, tainted research, and other hedge fund issues.
The hedge fund unit has five enforcement personnel and two examination staff. The group does not do examinations and is different from the task force set up by Connecticut's attorney general. That reviews issues related to hedge funds but does not have the authority to investigate them.
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