Court Vacates Rule 202(a)(11)-1
3.30.2007 The U.S. Court of Appeals for the District of Columbia vacated Rule 202(a)(11)-1.
Brokers and dealers are not subject to the requirements of the Investment Advisers Act (�IAA�) where their investment advice is (1) �solely incidental to the conduct of [their] business as a broker or dealer,� and (2) the broker or dealer �receives no special compensation therefor.� The SEC adopted Rule 202(a)(11)-1, which exempted broker-dealers from the IAA when they receive �special compensation therefor.� The Financial Planning Association (�FPA�) brought action against the SEC on the ground that the SEC has exceeded its authority.
Rule 202(a)(11)-1 stated that �fee-based programs,� that a broker-dealer who (1) receives special compensation will not be deemed an investment adviser if (2) any advice provided is solely incidental to brokerage services provided on a customer�s account and (3) specific disclosure is made to the customer. In paragraph (a)(2), on discount brokerage programs, a broker-dealer will not be deemed to have received special compensation merely because it charges one customer more or less for brokerage services than it charges another customer. Paragraph (b) lists three nonexclusive circumstances in which advisory services, for which special compensation is received under paragraph (a)(1), would not be performed �solely incidental to� brokerage: when (1) a separate fee or contract exists for advice; (2) a customer receives certain financial planning services; and, (3) generally, a broker-dealer has investment discretion over a client�s account. Paragraph (c) states a �special rule� that broker-dealers registered under the Exchange Act are investment advisers only for those accounts for which they receive compensation that subjects them to the IAA. Paragraph (d) defines the term �investment discretion,� which appears in paragraphs (a)(1) and (b)(3), to have the same meaning as � 3(a)(35) of the Exchange Act, 15 U.S.C. � 78c(a)(35), except for �discretion granted by a customer on a temporary or limited basis.�
The court ruled that the FPA had standing to bring its petition.
With respect to the proposed rule, the court stated that Section 202(a)(11), the statute, lists exemptions (A)-(E) from the broad definition of �investment adviser� for several classes of persons. Among the IAA exemptions is subsection (C)�s exemption for �any broker or dealer whose performance of such [investment advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.� Beyond the listed exemptions, subsection (F) authorizes the SEC to exempt from the IAA �such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.�
The court found that the SEC, in Rule 202(a)(11), purports to use its authority under subsection (F) to broaden the exemption for broker-dealers provided under subsection (C). The rule is inconsistent with the IAA, however, because it fails to meet either of the two requirements for an exemption under subsection (F). First, the legislative �intent� does not support an exemption for broker-dealers broader than the exemption set forth in the text of subsection (C); therefore, the final rule does not meet the statutory requirement that exemptions under subsection (F) be consistent with the �intent� of paragraph 11 of Section 202(a). Second, because broker-dealers are already expressly addressed in subsection (C), they are not �other persons� under subsection (F); therefore the SEC cannot use its authority under subsection (F) to establish new, broader exemptions for broker-dealers.
Thus, the court ruled that Rule 202(a)(11)-1�s exemption for broker-dealers is broader than the statutory exemption for broker-dealers under subsection (C). Although the SEC maintains that the intent of paragraph 11 is to exempt broker-dealers who receive special compensation for investment advice, the plain text of subsection (C) exempts only broker-dealers who do not receive special compensation for investment advice.
Please click http://www.fpanet.org/member/govt_relation/lawsuit-against-sec-broker-dealer-rule.cfm to access a list of materials related to Rule 202(a)(11)-1, including the court decision above that vacated the rule.
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SEC Reorganizes District and Regional Offices
3.30.2007 Each of the SEC�s current district offices will become regional offices. The district offices are in Atlanta, Boston, Fort Worth, Philadelphia, Salt Lake City and San Francisco. The Commission's existing regional offices are in Chicago, Denver, Los Angeles, Miami and New York City.
The SEC stated that the regional designation for the district offices will facilitate their cooperation with state and federal regulators, law enforcement agencies and consumer groups at the local level to better protect investors no matter where they live or with whom they invest.
The change was effective on April 2, 2007.
Please click http://www.sec.gov/news/press/2007/2007-59.htm to access the press release announcing the new designations.
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IM Director Speaks at Mutual Fund and Investment Management Conference
3.26.2007 Andrew J. Donohue, Director of the SEC�s Division of Investment Management, gave the keynote address at the 2007 Mutual Funds and Investment Management Conference in Palm Desert, California. Director Donohue stated that the Division will reconsider Rule 12b-1, both the rule itself and the factors that fund boards must consider when considering approval or renewal of a Rule 12b-1 plan. This review will be a high priority of the Division. The primary use of 12b-1 fees has shifted from the limited marketing and advertising purposes that were originally envisioned. Instead, it appears that, in many cases, Rule 12b-1 fees are used primarily as a substitute for a sales load or for servicing.
Director Donohue noted that mutual fund disclosure reform and interactive data tagging are a top priority for the Division. The Division�s goal is to facilitate more user-friendly, plain English mutual fund disclosure and streamline the delivery of mutual fund information through the increased use of the Internet, interactive data, and other electronic means of delivery.
He stated that the Division will propose amendments to the investment adviser and investment company books and records rules. In his view, the current requirements in some cases may, at a minimum, be confusing to funds and advisers; in other cases, the requirements may be inadequate for the needs of the SEC�s examiners. His staff will focus on technology-based alternatives.
The Director also noted his concern about increasing use by funds of derivatives and sophisticated financial instruments. In his view, it is imperative that the legal, compliance and accounting groups understand the instrument and implement the proper legal, accounting and compliance techniques and controls. He expressed concern whether many firm systems, particularly compliance systems, may not be sophisticated enough to effectively handle synthetic instruments.
Please click http://www.sec.gov/news/speech/2007/spch032607ajd.htm to access a copy of the speech.
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OCIE Director Speaks at Best Practices Summit
3.23.2007 2007 Lori Richards, Director of the SEC�s Office of Compliance Inspections and Examinations (�OCIE�), spoke at the 9th Annual IA Compliance Best Practices Summit 2007 in Washington, D.C. She reviewed the exams OCIE conducted in 2006. Of the 1,300 exams of advisers that were conducted, 81% resulted in non-public letters informing the registrant of problems and asking for corrective action. The vast majority of firms respond to the deficiency letters by making improvements in disclosures or in compliance controls to prevent the problem from reoccurring.
In about 6% of the exams of advisers, OCIE found indications of very serious violations - mostly fraud of some type - that result in a referral to the SEC's enforcement staff for further investigation. These include cases involving undisclosed side arrangements involving distribution, insider trading involving PIPE deals, service arrangements that benefited the adviser at a fund's expense, cherry-picking by advisers, providing lavish gifts to fund traders in exchange for business, the undisclosed use of soft dollars for things that did not benefit clients, using fund brokerage for revenue-sharing, failure to obtain best execution to the detriment of clients, market timing and late trading and problems in wrap accounts.
In closing, she listed the common deficiencies that were found in 2006:
- Deficiencies in information disclosure, reporting and filings. For example, examinations revealed inaccurate or incomplete disclosures, untimely filings with the SEC, and untimely delivery of the disclosure documents to clients. Examinations found disclosures that were inaccurate or incomplete with respect to firms' conflicts of interests, various compensation arrangements, solicitation arrangements, fee structures and brokerage/soft dollar arrangements.
- Deficiencies with respect to the Compliance Rule. For example, firms' compliance manuals did not address firms' risks, listed risks that did not exist at firms, or established procedures that firms did not follow.
- Deficiencies with respect to personal trading by advisory firm personnel, , including that the firms' code of ethics were deficient or not implemented, employees' trading was not reported or reviewed, and securities were improperly allocated to personal or proprietary accounts.
- Problems in performance advertising and marketing, , including omitting relevant disclosures so as to not make the advertisement misleading and advertising performance that was not accurate.
- Problems in information processing and the protection of customer information. For example, examiners found weaknesses with respect to firms' business continuity plans, Regulation S-P procedures, and the creation and compilation of certain books and records.
Please click http://www.sec.gov/news/speech/2007/spch032307lar.htm to access a copy of her speech.
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Please click http://www.treasury.gov/press/releases/reports/hp272_principles.pdf to access a copy of the guidelines.
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Criminal Charges Brought Against Hedge Fund Adviser for Market Timing
3.22.2007 Criminal charges were brought against Beacon Rock Capital LLC, a Portland, Oregon adviser to hedge funds, for allegedly defrauding mutual funds. It is the first criminal case in U.S. history against a hedge fund adviser for deceptive market timing.
The hedge fund adviser and its principals allegedly used a variety of tactics to market time, including: (1) creating and using multiple account numbers and other identifiers; (2) structuring mutual fund purchases to remain under certain perceived thresholds; (3) opening additional accounts with at least one other clearing firm; and, (4) misrepresenting the adviser�s trading strategy when confronted by mutual funds. The hedge fund adviser made in excess of 26,000 market timing trades, resulting in approximately $2.4 million in net trading profits. According to the charges, the principals repeatedly instructed subordinates to mislead the mutual funds about the hedge funds� trades
Please click http://www.sec.gov/litigation/complaints/2007/comp20051.pdf to access a copy of the criminal action.
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Model Privacy Notice Proposed
3.21.2007 Eight federal regulators proposed a model privacy form that financial institutions can use for their privacy notices to consumers required by the Gramm-Leach-Bliley Act. The eight regulators are:
- Board of Governors of the Federal Reserve System;
- Commodity Futures Trading Commission;
- Federal Deposit Insurance Corporation;
- Federal Trade Commission;
- National Credit Union Administration;
- Office of the Comptroller of the Currency;
- Office of Thrift Supervision; and
- Securities and Exchange Commission.
Privacy notices must describe an institution's information sharing practices, and, for certain types of sharing, consumers have the right to opt out. The notices must be provided when a consumer first becomes a customer of a financial institution and then annually for as long as the customer relationship lasts.
The proposed model privacy form is the "prototype privacy notice" developed by six of these federal agencies after a year-long consumer testing process. Under the proposal, a financial institution that chooses to use the model form would satisfy the disclosure requirements for the notices and so could take advantage of a legal "safe harbor."
Please click http://www.sec.gov/news/press/2007/2007-49.htm to access a copy of the press release announcing the new form and a link to the proposing release and proposed form.
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No-Action Letter Issued Interpreting �Qualified Purchaser�
3.13.2007 The SEC staff issued a no-action letter permitting Goldman Sachs Asset Management, L.P. and its affiliates ("Goldman"), which sponsors certain private funds, to treat certain charitable foundations as qualified purchasers under Section 2(a)(51)(A). To receive this treatment, the foundations must (a) qualify for tax-exempt status under Section 501(c)(3) of the Internal Revenue Code ("Section 501(c)(3)") and (b) be formed as non-profit, non-stock corporations ("charitable corporations").
An issuer is eligible to be excluded from the definition of investment company provided by Section 3(c)(7) of the Investment Company Act, if all of the outstanding securities of the issuer are owned by persons who, at the time of acquisition of the securities, are qualified purchasers as defined in Section 2(a)(51)(A) of the Investment Company Act. Section 2(a)(51)(A) lists four categories of qualified purchasers. Goldman stated that a charitable corporation generally could not satisfy the conditions of any of these four categories.
The three categories are:
- any natural person... who owns not less than $5,000,000 in investments... ;
- any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for two or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons; and
- any trust that is not covered by clause (2) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (1) or (2) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.
Goldman essentially argued that charitable corporations should be treated as charitable trusts for purposes of Section 2(a)(51)(A). The staff agreed and took the position that Goldman and the private funds could treat the following as qualified purchasers:
- a charitable corporation (a) that was not formed for the specific purpose of acquiring an interest in a Private Fund, (b) all of the persons who have contributed assets to which are related in one or more of the ways enumerated in Section 2(a)(51)(A)(ii), and (c) which owns not less than $5 million in "investments" as defined in Rule 2a51-1(b) under the Investment Company Act or;
- a charitable corporation (a) that was not formed for the specific purpose of acquiring an interest in a Private Fund, and (b) each person authorized to make investment decisions with respect to the charitable corporation, and each person who has contributed assets to the charitable corporation, is a qualified purchaser within the meaning of subsections (1) or (2) of Section 2(a)(51)(A) of the Investment Company Act.
Please click http://www.sec.gov/divisions/investment/noaction/2007/gsam031307-3c7.htm to access a copy of the no-action letter.
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CCOutreach Seminar Locations and Schedules Announced
3.5.2007 The SEC's CCOutreach program is designed to enhance communication and coordination with mutual fund and investment adviser chief compliance officers. The regional seminars are hosted by examination staff located in the regional offices and are held in the spring and summer in various cities throughout the country. These seminars are intended to address the "nuts and bolts" of the examination process and are typically limited to 50 to 120 attendees. This year's seminars will discuss the following topics:
- the examination and risk assessment process;
- books and records and disclosures and filings;
- brokerage arrangements, best execution, trade allocation, and soft dollars;
- portfolio management; and
- marketing, performance, advertising, and distribution.
Please click http://www.sec.gov/info/cco/ccorscal2007.htm to access the locations and schedules.
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SEC Brings Charges Against Hedge Fund Adviser
3.2.2007 The SEC brought an administrative action against Kirk S. Wright who, according to the SEC, raised as much as $185 million from up to 500 investors by selling investments in seven hedge funds. The SEC alleged that since at least 2003, the hedge funds, through Wright, have been providing investors with quarterly statements that misrepresented the amount of assets and the rates of return obtained by the respective funds. According to the complaint, without disclosure to investors, virtually all of the assets of the funds have been dissipated.
Please click http://www.sec.gov/litigation/admin/2007/ia-2595.pdf to access a copy of the administrative action.
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SEC Issues No-Action Letter Regarding Reportable Securities for Purposes of a Code of Ethics
3.1.2007 The SEC staff issued a no-action letter to M&G Investment Management Ltd. (�M&G�), permitting M&G�s code of ethics to not include the securities (defined below) as reportable securities with respect to certain of its access persons� transactions and holdings in the securities. M&G is a U.K.-based investment adviser that is registered with the Commission, and is authorized and regulated by the U.K. Financial Services Authority. M&G has a single U.S. client, an investment company registered under the Investment Company Act of 1940, for which M&G acts as one of several sub-advisers (the �Fund�). M&G maintains its principal place of business in London, England. M&G has deemed all of the employees at its London office to be access persons.
M&G anticipates that its access persons will engage in a number of personal securities transactions, including transactions in: (i) certain securities issued by National Savings and Investments; (ii) interests in unit trusts (�UTs�) and open-ended investment companies (�OEICs�) that are authorized by the FSA for sale in the United Kingdom; and (iii) interests in unit-linked life and pension products sold in the United Kingdom (each of these interests collectively referred to as �Securities�). The no-action letter described the attributes of these types of securities.
Rule 204A-1(b) under the Advisers Act provides, as pertinent here, that the code of ethics must require that access persons submit to the investment adviser�s chief compliance officer, or another person who is designated in the code of ethics, reports of the access persons� transactions in and holdings of �reportable securities,� as defined in Rule 204A-1(e)(10). M&G acknowledged that the Securities are reportable securities. However, it successfully argued that the Securities are analogous to securities that Rule 204A-1 excludes from the definition of reportable securities, and that transactions in the Securities by certain of M&G�s access persons do not implicate the concerns that underlie the rule.
The SEC staff granted no-action relief, based on M&G�s representation that M&G�s code of ethics will continue to require execution-related access persons to report their transactions in and holdings of the securities of UTs and OEICs. The SEC staff further stated that the relief that it provided with respect to the treatment of the Securities under Rule 204A-1 of the Advisers Act is applicable under Rule 17j-1 of the Investment Company Act, which sets forth the code of ethics requirements for investment companies and advisers and distributors of investment companies.
Please click http://www.sec.gov/divisions/investment/noaction/2007/mgim030107-204a-1.pdf to access a copy of the no-action letter.
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IM Director Gives Keynote Speech at Mutual Fund Directors Forum
3.1.2007 Andrew J. Donohue, Director of the SEC�s Division of Investment Management, gave the keynote address at the 2007 Mutual Fund Directors Forum in Coral Gables, Florida. Director Donohue stated that he is committed to reaching out to fund directors this year, with the ultimate goal of determining what the SEC and the staff of the Division of Investment Management can do to enable them to be more effective in their oversight role.
Other initiatives on the Division's agenda include:
- additional guidance for fund directors on fair valuation;
- standardized disclosure and fund director guidance on soft dollars and oversight of placement of fund trades;
- revisiting Rule 12b-1; and
- overhauling and modernizing the Investment Adviser and Investment Company books and records rules.
Please click http://www.sec.gov/news/speech/2007/spch030107ajd.htm to access a copy of the speech.
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