Fraud Charges Brought Against Hedge Fund Adviser
5.29.2007 The SEC brought administrative charges against Albert E. Parish, Jr., charging Mr. Parish with fraud in connection with the operations of a hedge fund. The hedge funds invested in commodities and securities futures products, bonds,
stocks, and hard assets such as expensive watches, jewelry and fine
art.
The SEC alleged Parish misused and
misappropriated investor funds, falsely stated to investors that their
funds were invested, sent out false account statements indicating that
investors funds were fully invested and earning returns, and otherwise
engaged in a variety of conduct which operated as a fraud and deceit
on investors.
Please click http://www.sec.gov/news/press/2007/2007-61.htm to access the press release announcing the appointment.
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IM Director Speaks at SIFMA Hedge Fund Conference
5.23.2007 SEC Investment Management Director Buddy Donohue spoke at the Securities Industry and Financial Markets Association ("SIFMA") Conference in New York. He began by updating the audience on the regulatory developments related to the hedge fund industry and discussing the SEC's recent activities in this area. He noted that it has now been almost a year since the DC Court of Appeals vacated the SEC's rule requiring hedge fund managers to register with the SEC.
Director Donohue noted that although many advisers to hedge funds did withdraw their registrations following the D.C. Circuit's decision in June last year, a significant number have voluntarily maintained their registrations. Specifically, about 2,000 of the approximately 10,000 investment advisers currently registered with the Commission indicate they advise at least one hedge fund. While about 350 hedge fund advisers appear to have withdrawn their registration as a result of the court decision, the SEC has also seen 83 advisers register since the decision for a net reduction of only about 270 advisers.
Next, the Director covered the SEC's recent rule-making activity related to hedge funds. In December last year, the SEC proposed an anti-fraud rule under the Investment Advisers Act that would clarify, in light of the DC Circuit's decision, the ability of the Commission to bring an enforcement action against investment advisers, including those that advise hedge funds. The SEC also proposed to revise the availability of Regulation D to hedge funds relying on the section 3(c)(1) exclusion provided by the Investment Company Act. In addition to the current accredited investor requirements for individuals ($1 million net worth or $200,000 of income ($300,000 with spouse)), these investors would also have to have $2.5 million in investments.
Director Donohue then spoke about how the SEC's inspection arm, OCIE, and its Enforcement division have been active with respect to hedge funds. One area of particular focus has been insider trading and policies and procedures designed to prevent insider trading.
He next reviewed a number of self-imposed mechanisms that have developed as the hedge fund industry has evolved and become more mature and established.
He concluded his speech by covering mutual fund products registered with the SEC that have the same structure and attributes of certain hedge funds. An example is the so-called long/short, or 130/30 funds that have gained increased popularity in the past year.
Please click http://www.sec.gov/news/speech/2007/spch052307ajd.htm to access a copy of the speech.
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SEC Issues Q&A Guidance on New Prospectus Fund of Fund Fee Table Disclsoure Rule
5.23.2007 The staff of the SEC's Division of Investment Management issued an interpretive release in a question and answer format that addresses issues raised in connection with amendments to the fee table adopted in the Fund of Funds release in June 2006 and effective this year. That disclosure rule (Item 3 of Form N-1A) requires funds to disclose in their fee tables the expenses of investing in other funds under a line item titled �Acquired Fund Fees and Expenses� (�AFFE�). Specifically, Item 3 requires a fund that invests in other funds (Acquired Funds) to disclose the fees and expenses associated with those investments. An �Acquired Fund� includes any company that would be an investment company under section 3(a) of the Investment Company Act but for the exceptions to that definition provided in sections 3(c)(1) and 3(c)(7) of the Act. The Q&A only refers to Item 3 of Form N-1A; however, the guidance applies equally to similar items in Forms N-2 and N-3.
Notable guidance provided by the staff i the Q&A include:
- a fund does not include in the fee table expenses associated with investments in structured finance vehicles, collateralized debt obligations, or other entities not traditionally considered pooled investment vehicles;
- The expense ratio does not include expenses an Acquired Fund has incurred through its investment in other companies.
- Open-end feeder funds filing on Form N-1A must disclose in their fee tables the aggregate expenses of the feeder fund and the master fund.
Please click http://www.sec.gov/divisions/investment/guidance/fundfundfaq.htm to access the Q&A.
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BISYS Settles Financial Reporting, Books-and-Records, and Internal Control Related Charges
5.23.2007 The BISYS Group, Inc., a leading transfer agent and administrator for the mutual fund industry, settled charges with the SEC that it violated the financial reporting, books-and-records, and internal control provisions of the Securities Exchange Act of 1934. BISYS agreed to settle the case, without admitting or denying the SEC's allegations. BISYS will pay approximately $25 million in disgorgement and prejudgment interest.
alleges that from July 2000 through December 2003, former BISYS officers and employees engaged in a variety of improper accounting practices that resulted in an overstatement of the company's reported financial results for the fiscal years ended June 30, 2001, 2002, and 2003 by roughly $180 million. The improper accounting practices were primarily based in the company's Insurance Services division, but also occurred in other divisions of the company.
The SEC complaint alleged that the improper accounting practices were a product of a corporate focus by former management on meeting aggressive, short-term earnings targets and a lax internal control environment. The SEC alledged:
- The Insurance Services division of BISYS responded to the corporate focus on making numbers by engaging in improper accounting practices.
- BISYS failed to adopt and implement adequate controls over the accounting function of the acquired companies as they were integrated. Among other things, BISYS lacked adequate controls for reconciling account balances or tracking receivables and lacked controls adequate to ensure that the assumptions used in estimating revenue and renewal commissions were valid.
- With respect to Insurance Services, BISYS improperly recorded as its own revenue commissions earned by companies acquired by BISYS before they were acquired; failed adequately to reserve against a substantial aging receivable balance; improperly accounted for renewal and bonus commissions; and made other improper accounting entries that overstated revenue or reduced expenses.
- The improper accounting practices within the Insurance Services division resulted in an overstatement of BISYS's reported pre-tax earnings by roughly $118 million for the fiscal years ended June 30, 2001, 2002, and 2003, and by 34.3%, 38.9%, and 20.6%, respectively, in each of those fiscal years. The improper accounting practices in BISYS's other divisions overstated the company's pre-tax earnings by an additional $60.9 million for the same period.
- BISYS filed annual and quarterly reports with the SEC that included financial statements that were inaccurate and misleading. In addition, the company's overstated financial results were incorporated in annual reports to shareholders, press releases, and offering documents including registration statements.
- BISYS violated the financial reporting, books-and-records, and internal controls provisions of the Exchange Act. The complaint further alleges that BISYS received approximately $20 million in ill-gotten gains as a result of its issuance of convertible debt, stock, and options at prices that were inflated as a result of its violations.
Please click http://www.sec.gov/litigation/litreleases/2007/lr20125.htm to access a copy of the administrative action.
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Mutual Funds Directors Forum Issues Rule 12b-1 Best Practices Report
5.16.2007 The Mutual Fund Directors Forum released the Best Practices and Practical Guidance for Directors under Rule 12b-1. The Mutual Fund Directors Forum is an independent nonprofit organization that serves the independent directors of U.S. mutual funds.
The report states that 12b-1 fees today are used primarily for two purposes:
- To offer purchasers of fund shares the alternative of paying for the services of a broker or other intermediary through a continuing 12b-1 fee rather than through the traditional front-end load, and
- to compensate brokers and sellers of fund shares for shareholder accounting and other services provided to fund shareholders.
The Forum noted that Rule 12b-1 has departed from its original contemplated purpose, which was to allow the use of mutual fund assets for fund distribution for limited periods of time. The report urges thoroughgoing regulatory reform, but provides "best practices" guidance for fund directors to oversee Rule 12b-1 plans in the current regulatory environment.
The report offers guidance and states that, in appropriate circumstances, that fund directors may wish to consider whether fund shareholders have effectively agreed to pay specific amounts to support distribution of the fund to them. The report further states that fund management companies face a conflict in administering 12b-1 funds, as they have an incentive to use fund assets to promote distribution of fund shares in order to increase the rate of growth in fund assets and thereby increase their own profitability, and that 12b-1 fees paid to fund affiliates may deserve additional scrutiny, particularly if made under circumstances where competitive factors do not operate.
Please click
http://www.mfdf.com/UserFiles/File/12b-1Report.pdf to access the report.
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Court Narrows SEC's Interpretation Regarding When Operating Companies with Significant Investment Security Assets Are Subject to the 1940 Act
5.15.2007 The U.S. Court of Appeals for the Seventh Circuit in SEC v. National Presto Industries, No. 05-4612 (7th
Cir. May 15, 2007) ruled against the SEC in an
appeal from a district court decision that a company was an inadvertent
investment company. The ruling addresses the issues of when companies that conduct
business operations while holding significant investment securities risk becoming an inadvertent investment company, subject to registration under the 1940 Act.
An investment company is an issuer that is or holds itself
out as being engaged primarily in the business of investing,
reinvesting, or trading in securities. A company is also an
investment company, and required to register as such with the SEC, if it holds investment securities having
a value exceeding 40% of the value of its total assets (exclusive of
Government securities and cash items) on an unconsolidated basis, unless
it is primarily engaged in a business or businesses other than that of
investing, reinvesting, owning, holding, or trading in securities (or
another exception from the definition is available). A company can seek
an order from the SEC that it is primarily engaged in a non-investment
company business, and many companies with substantial financial reserves
do so as a precaution.
National Presto Industries sells cookware, which it once manufactured in
the United States, but it has sold its cookware plants.
It has acquired some operating companies with a portion of the
proceeds from the sales, but it continues to have most of its assets in
investment securities, from which it derives much of its income. The
SEC in 2002 brought an action against National Presto as an unregistered
investment company, and the district court in 2005 granted the SEC
summary judgment and ordered the company to register. National Presto appealled to
the Seventh Circuit.
The SEC noted that the
principal relevant considerations established by courts and the SEC in determining whether an issuer is
principally engaged in a non-investment company business are 1) the
company's historical development; 2) its public representations of
policy; 3) the activities of its officers and directors; and, most
important, 4) the nature of its present assets; and 5) the sources of
its present income. The SEC cited Tonopah Mining Co., 26 S.E.C. 426 (1947). The
Seventh Circuit, after ruling that National Presto's securities holdings
were in fact investment securities, said that all of these factors,
except the nature of its assets, argued against investment company
status. The court futher stated that "what principally matters is the beliefs the company is
likely to induce in investors. Will its portfolio and activities lead
investors to treat a firm as an investment vehicle or as an operating
enterprise?" The court concluded that reasonable investors would treat
National Presto, which got over 60% of its net income from operating
sources in the past three years, as an operating company rather than a
competitor with a closed-end fund. The court's analysis implies that if
a company gets more than half of its net profits from non-investment
sources, the income factor will support non-investment company status.
National Presto, which had registered as an investment company with the SEC,is free to drop its 1940 Act
registration without SEC approval.
Please click http://www.ca7.uscourts.gov/tmp/3G1FFSV4.pdf to access a copy of the case.
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Former Mutual Fund Executive Found to Have Aided and Abetted Prohibited Brokerage Arrangement
5.14.2007 The SEC brought administrative charges against Stephen J. Treadway, the former Chief Executive Officer of PA Fund Management LLC
(PAFM), the investment adviser to the PIMCO Funds, and PA Distributors
LLC (PAD), the distributor for the PIMCO Funds, and the former
Chairman of the PIMCO Funds Multi-Manager Series (MMS Funds) Board of
Trustees (MMS Board). The SEC alleged that Mr. Treadway did not ensure that PAFM fulfilled its fiduciary
duty to disclose to the MMS Board that the MMS Funds' brokerage
commissions were being directed to broker-dealers to reduce PAD's
payments for increased "shelf space" within the broker-dealers'
distribution systems and that a corresponding conflict of interest
existed for PAFM.
The SEC found that between 2000 and 2003,
PAD entered into shelf space arrangements with nine broker-dealers to
promote the sale of all PIMCO Funds distributed by PAD. Treadway and
other members of PAD approached PEA Capital LLC (PEA), the sub-adviser
to the MMS Funds, to discuss whether PEA would be able to direct
brokerage commissions on the MMS Funds' portfolio transactions, but
did not tell PEA that directing brokerage commissions to certain
broker-dealers would reduce PAD's cash payments for the shelf space
arrangements. As the CEO of PAFM and PAD, Treadway approved of PAD's
participation in the shelf space arrangements and negotiated the terms
of some of the arrangements.
The SEC also found that by encouraging PEA's use of fund assets to
benefit and defray the expenses of PAD, a third party to the
MMS Funds, Treadway created a conflict of interest that he, as the CEO
of PAFM and PAD and the individual through which PAFM addressed the
MMS Board, should have disclosed. According to the SEC, Treadway, when acting on
behalf of PAFM and PAD, and when addressing the MMS Board, failed to
disclose this conflict of interest and did not ensure that anyone else
disclosed this information. As a result, the SEC found that Treadway
willfully aided and abetted and caused PAFM's violation of Section
206(2) of the Investment Advisers Act of 1940.
Please click
http://www.sec.gov/litigation/admin/2007/ia-2602.pdf to access a copy of the administrative action.
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SEC Will Not Appeal Decision Throwing Out Broker-Dealer Exemption from the Advisers Act
5.14.2007 The SEC announced that it
will not appeal the adverse decision by the U.S. Court of Appeals for
the D.C. Circuit, which on March 30 ruled against an SEC rule excepting
some broker-dealers from regulation as investment advisers. Instead, the SEC will ask for a 120-day stay of the court's ruling to allow investors
and their brokers to respond. The SEC said it will consider whether
further rulemaking or interpretations are necessary regarding the
application of the Investment Advisers Act of 1940 to these accounts and
the issues resulting from the court's decision.
According to the SEC press release, the court ruling
affects an estimated one million brokerage accounts, holding an
estimated $300 billion in assets. The SEC also announced that he has approved
additional emergency funding to accelerate an on-going RAND Corporation
study of the marketing, sale, and delivery of financial products and
services to investors, allowing the study to be delivered by December
2007, several months ahead of schedule. The study is intended to provide
an empirical foundation for considering improvements in regulatory and
legislative rules in this area.
Please click http://www.sec.gov/news/press/2007/2007-95.htm to access a copy of the press release.
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SEC Chairman Cox Speaks at ICI General Membership Meeting
5.10.2007 SEC Chairman Cox spoke at the Investment Company Institute's 2007 General Membership Meeting in Washington, D.C. He first spoke about the SEC's proposed a new rule that will enable mutual funds to submit the information in the risk/return summary portion of the prospectus in a tagged, electronic format. Since this information includes the objectives and strategies of the fund, as well as the risks and expenses involved in an investment decision, putting it into an interactive format will be especially useful for investors. He stated that it will allow them to access the data they need quickly and reliably. He mentioned the difficulty that investors face today without interactive data in their attemp to compare mutual funds. He walked the audience through an example.
He next spoke about how the SEC is also examining the adequacy of disclosures about the entirety of what goes into a typical 401(k) plan. The SEC is interested in both the disclosures by the constituent investments in the 401(k), and the aggregate disclosures by the plan � including the overall expenses, and the overall performance of all the investments in the account.
He closed his speech by congratulating those mutual fund complexes that are preparing to use interactive data in their mutual fund prospectuses. He urged the other complexes to consider doing so.
Please click http://www.sec.gov/news/speech/2007/spch051007cc.htm to access a copy of the speech.
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Zurich Capital Markets Settles Charges Brought by the SEC for Allegedly Financing of Hedge Funds' Illegal Market Timing
5.7.2007 Zurich Capital Markets Inc. ("ZCM") settled administrative charges brough by the SEC for allegedly financing of hedge funds' illegal market timing. The SEC stated that ZCM played a role in providing financing to hedge fund clients that engaged in market timing of mutual funds and facilitating the hedge funds' deceptive trading tactics.
Specifically, the SEC found that ZCM aided and abetted four hedge funds that were carrying out schemes to defraud mutual funds that prohibited market timing. ZCM's hedge fund clients knew that many of these mutual funds prohibited market timing. In an effort to avoid being detected and potentially blocked from making market-timing trades in these funds, each of these hedge funds and ZCM disguised their identities. For example, ZCM created seemingly unaffiliated SPVs in whose name multiple brokerage accounts were opened, thus enabling ZCM's hedge fund clients to disguise their identities and market time mutual funds.
The SEC order found that ZCM profited from the fees it received from the business of providing derivative financing to hedge funds engaging in a mutual fund market-timing strategy. As a result, the Commission's Order finds that ZCM willfully aided and abetted and caused violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
The SEC ordered ZCM, a New York-based subsidiary of Zurich Financial Services, to pay $16.8 million consisting of $12.8 million in disgorgement and prejudgment interest and a $4 million penalty.
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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