SEC PERMITS BROKERS TO CHARGE ASSET-BASED FEES WITHOUT HAVING TO REGISTER AS ADVISERS
12.22.2004 The SEC approved a temporary rule that will let broker-dealers collect asset-based and fee-based compensation until April 15, 2005, without having to comply with the Investment Advisers Act of 1940 (Advisers Act). Thus, broker-dealers can charge clients asset-based fees instead of commissions. Financial planners and others in the advisory industry have fought the rule because they believe that brokers that charge asset-based fees should be dually registered as investment advisers so that they are subject to the Advisers Act. Prior to 1999, broker-dealers that were not registered under the Advisers Act only could charge their customers commissions based on the securities transaction. The SEC proposed a rule in 1999 and issued a no-action letter where it assured broker-dealers that the SEC would not take action against them if they set asset-based and fee-based prices. The temporary rule supersedes the no-action letter.
The SEC also re-opened the comment period for 30 days, requesting another round of public comments on the new broker-dealer compensation proposal. Specifically, the SEC is seeking comments on modifications to the rule to add disclosure about the differences between brokerage and advisory accounts and to provide more guidance on advice that is considered incidental to brokerage activities. The SEC also is seeking comments on whether all advertisements, agreements and contracts relating to a brokerage account that should be exempt from the Advisers Act under the rule should contain a prominent statement that the account is a brokerage, not an advisory account, and that the firm�s obligations may differ with respect to its fiduciary relationship with clients. This additional disclosure will emphasize the obligation of broker-dealers to explain to customers the differences between brokerage and advisory accounts.
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EDWARD JONES SETTLES REVENUE SHARING CHARGES
12.22.2004 Edward D. Jones & Co., L.P., a brokerage firm headquartered in St. Louis, Missouri, settled charges with the SEC that it failed to adequately disclose millions of dollars in incentives, commonly known as revenue sharing payment that it received from a select group of mutual fund complexes. Edward Jones entered into revenue sharing arrangements with seven mutual fund complexes, which paid it between $44 million and $68 million per year since 1999. Edward Jones designated the mutual fund complexes as �Preferred Mutual Fund Families.�
The SEC alleged that Edward Jones failed to disclose that it received tens of millions of dollars from the Preferred Mutual Fund Families each year, on top of commissions and other fees, for selling their mutual funds. Edward Jones also failed to disclose that such payments were a material factor, among others, in becoming and remaining a Preferred Mutual Fund Family. According to the SEC, over 95% of Edward Jones� sales of mutual fund shares during the five years have been sales of the seven Preferred Families.
Edward Jones was order to pay $75 million in disgorgement and civil penalties, all of which will be placed in a fund for distribution to certain Edward Jones customers.
Please click http://www.sec.gov/litigation/admin/33-8520.htm for the administrative order.
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CFTC AMENDS LARGE TRADING POSITION RULES
12.21.2004 The CFTC amended its large trader reporting rules, which require futures commission merchants, clearing members, foreign brokers, and traders to report certain position and identifying information to the CFTC when the positions of traders equal or exceed CFTC set contract reporting levels. The final rules, among other things, raise contract reporting levels.
Please click http://www.sec.gov/litigation/litreleases/lr18984.htm for the release adopting the rule.
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NASD SANCTIONS H&R BLOCK FINANCIAL ADVISORS FOR AIDING AND ABETTING HEDGE FUND TIMING SCHEME
12.21.2004 The NASD censured and fined H&R Block Financial Advisors, Inc. (H&R Block), a registered adviser and broker-dealer, for enabling a hedge fund customer in its Orlando, Florida branch office to engage in deceptive practices to market time mutual funds. The NASD found that H&R Block recruited and hired two brokers in September 2002 knowing the brokers were going to open accounts for hedge funds that intended to actively trade or market time in mutual funds that discouraged or limited such trading.
The NASD stated that through the Orlando brokers and the Orlando branch office manager, H&R Block enabled the hedge fund customer, whose trading exceeded funds� prospectus limitations, to evade mutual fund restrictions. H&R Block received 44 restriction letters designed to block this hedge fund customer�s market timing activities. After H&R Block received these letters, the firm, through the Orlando brokers and branch office manager, enabled the hedge fund to use related accounts to continue trading in restricted funds.
Please click http://www.nasd.com/stellent/idcplg?IdcService=SS_GET_PAGE&ssDocName=NASDW_012819&ssSourceNodeId=5 for a copy of the release announcing the action.
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SEC PROPOSES NEW TRADING RULES RELATED TO MARKET INFORMATION
12.16.2004 The SEC reproposed rules under Regulation NMS governing the dissemination of market information. The rules are designed to modernize and strengthen the regulatory structure of the U.S. equity markets. The SEC proposed the following four sets of rules:
- Trade-Through Rule. This rule would require trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible.
- Access Rule. This rule would require fair and non-discriminatory access to quotations, establish a limit on access fees to harmonize the pricing of quotations across different trading centers, and require each national securities exchange and national securities association to adopt and enforce rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations.
- Sub-Penny Rule. This rule would prohibit market participants from accepting, ranking, or displaying orders, quotations, or indications of interest in a pricing increment smaller than a penny, except for orders, quotations, or indications of interest that are priced at less than $1.00 per share.
- Market Data Rules. These rules would update the requirements for consolidating, distributing, and displaying market information, as well as amendments to the joint industry plans for disseminating market information that would modify the formulas for allocating plan revenues and broaden participation in plan governance.
Please click http://www.sec.gov/rules/proposed/34-50870.pdf to access a copy of the rule release.
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COMMITTEE FORMED TO EXAMINE IMPACT OF SARBANES-OXLEY ACT ON SMALLER PUBLIC COMPANIES
12.16.2004 The SEC established an advisory committee to assist it in examining the impact of the Sarbanes-Oxley Act and other aspects of the federal securities laws on smaller public companies. The advisory committee will be known as the Securities and Exchange Commission Advisory Committee on Smaller Public Companies. The committee will focus on:
- frameworks for internal control over financial reporting applicable to smaller public companies, methods for management�s assessment of such internal control, and standards for auditing such internal control;
- corporate disclosure and reporting requirements and federally-imposed corporate governance requirements for smaller public companies, including differing regulatory requirements based on market capitalization, other measurements of size or market characteristics;
- accounting standards and financial reporting requirements applicable to smaller public companies; and
- the process, requirements and exemptions relating to offerings of securities by smaller companies, particularly public offerings.
The committee will consider whether the costs imposed by the current securities regulatory system for smaller public companies are proportionate to the benefits, identifying methods of minimizing costs and maximizing benefits, and facilitating capital formation by smaller companies. The Chairman also stated the SEC expects the committee to provide recommendations as to where and how the SEC should draw lines to scale regulatory treatment for companies based on size.
Please click http://www.sec.gov/news/press/2004-174.htm for a copy of the press release announcing the formation of the committee.
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PCAOB TO TAKE A GREATER ROLE IN SETTING AUDITOR INDEPENDENCE STANDARDS
12.15.2004 The Public Company Accounting Oversight Board (PCAOB) proposed certain ethics and independence rules to promote the ethics and independence of registered public accounting firms that audit and review financial statements of U.S. public companies, including investment companies. The proposed rules will:
- treat a public accounting firm as not independent of an audit client if the firm, or an affiliate of the firm, provides any service or product to an audit client for a contingent fee or a commission, or receives from an audit client, directly or indirectly, a contingent fee or commission;
- treat a public accounting firm as not independent if the firm, or an affiliate of the firm, provides assistance in planning, or provides tax advice on, certain types of potentially abusive tax transactions to an audit client or provides any tax services to certain senior officers of an audit client;
- require public accounting firms to provide certain information to the audit committee of an audit client in connection with seeking pre-approval to provide non-prohibited tax services to the audit client; and
- require public accounting firms to be independent of their audit clients throughout the audit and professional engagement period.
Most accounting firms already are subject to similar auditor independent rules, including Rule 2-01 of Regulation S-X of the Securities Act of 1933.
Please click http://www.sec.gov/news/press/2004-151.htm for a copy of the press release announcing the postponement.
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BROKERAGE FIRM SETTLES CHARGES RELATED TO OFFERING AN IMPROPER SYSTEMIC MUTUAL FUND SHARE PURCHASE PLAN
12.14.2004 First Command Financial Planning, Inc., a registered broker-dealer headquartered in Fort Worth, Texas, settled charges with the SEC that the firm violated Section 17(a)(2) of the Securities Act of 1933 by using misleading sales materials to offer and sell mutual-fund investments through an installment method called a systematic investment plan (systematic plan). First Command�s customer base consists almost entirely of active-duty and retired U.S. Military personnel.
The systematic plans allowed investors to accumulate mutual-fund shares indirectly by making fixed monthly contributions over a period of at least 15 years. Systematic-plan investors were charged an upfront load on the plans equal to 50% of the plan�s first 12 monthly payments.
According to the SEC order, First Command offered and sold systematic plans by, in part, making misleading statements and omissions concerning: (a) comparisons between the systematic plan and other mutual-fund investments; (b) the availability of the Thrift Savings Plan, a Federal Government-sponsored retirement savings and investment plan, which offers military investors many of the features of a systematic plan at lower costs; and (c) the efficacy of the upfront load in ensuring that investors remain committed to the systematic plan.
Please click http://www.sec.gov/litigation/admin/33-8513.htm for a copy of the administrative order.
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FRANKLIN TEMPLETON SETTLES IMPROPER DIRECTED BROKERAGE CHARGES
12.13.2004 Franklin Advisers, Inc. (Franklin Advisers) and Franklin Templeton Distributors, Inc. (FTDI) settled charges with the SEC that Franklin Advisers and FTDI, without proper disclosure, used fund assets to compensate brokerage firms for recommending the Franklin Templeton mutual funds over others to their clients. Franklin Advisers is the investment adviser of, and FTDI is the principal underwriter and distributor for, the Franklin Templeton mutual funds.
The SEC found, and Franklin Advisers and FTDI neither admitted nor denied, that between 2001 and 2003, FTDI had shelf space agreements with 39 broker-dealers pursuant to which FTDI allocated $52 million from brokerage commissions related to trades of fund shares (which were fund assets) to the broker-dealers in exchange for shelf space. The SEC found that these agreements were not properly disclosed to the fund boards or the fund shareholders. The SEC noted that the use of brokerage commissions to compensate brokerage firms for marketing created a conflict of interest between Franklin Advisers and the funds because Franklin Advisers benefited from the increased management fees resulting from increased fund sales, and consequently had an incentive to use these brokerage firms, whether or not the brokerage firms were best for the fund shareholders. FTDI, in the SEC�s view, benefited from the arrangements by avoiding paying for shelf space out of its own assets.
Please click http://www.sec.gov/litigation/admin/34-50841.htm for a copy of the administrative order.
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ROYE SPEAKS ON FUND GOVERNANCE
12.9.2004 Paul Roye, the Director of the SEC�s Division of Investment Management, spoke about best practices in fund governance at the Fund Governance Program Presented by the Mutual Fund Directors Forum and Fund Directions in New York on best practices. He focused on the three main functions of mutual fund directors: (1) managing conflicts of interest; (2) approving the advisory contract and advisory fees; and (3) selecting and nominating candidates for independent directors.
With respect to conflicts of interest, he noted that the SEC has long recognized the important role that independent directors play in managing conflicts. This recognition is evidenced in part by the SEC placing reliance on independent director oversight in connection with many of fund transactions permitted by its exemptive rules. Each of these transactions involves potentially serious conflicts of interest between funds and their managers, and would otherwise be prohibited by the Investment Company Act. He further noted that a fund's CCO can be an important resource for directors in helping to identify conflicts of interest and ensuring that controls are in place to manage those conflicts.
He next discussed advisory fees. Mr. Roye stated that the SEC has stressed that fund shareholders stand to benefit substantially when the process of negotiation between fund independent directors and investment advisers leads to lower fees. In connection with some of the mutual fund enforcement actions of the past year, the SEC has refused to make fee reductions a component of settlements. Instead, the SEC has expressed its belief that the best way to ensure that funds obtain fair and reasonable fees is through �a marketplace of vigorous, independent and diligent mutual fund boards, coupled with fully informed investors who are armed with complete, easy-to-digest disclosure about the fees paid and the services rendered.�
He also spoke about selecting and nominating candidates to serve as independent directors. He encouraged directors in selecting and nominating other independent directors to identify individuals who have the background, experience, and independent judgment to represent the interests of fund investors.
The last topic Mr. Roye spoke about was the independent chairman. He stated that directors should select an independent chairman who will be �willing to stand up to management when necessary.� In many ways, the SEC intended the independent chairman to be �a counterweight to management-and to buffer the control and influence that management can have in the boardroom.�
Please click http://www.sec.gov/news/speech/spch120904pfr.htm for a copy of the speech.
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ENFORCEMENT DIRECTOR SPEAKS AT MUTUAL FUND CONFERENCE
12.6.2004 Stephen Cutler, the Director of the SEC�s Division of Enforcement, spoke about recent enforcement actions in the mutual fund industry at the 2004 Investment Company Institute Securities Law Developments Conference in Washington, D.C.
He began by discussing improvements made at the Division of Enforcement, including taking better advantage of the knowledge of those in the SEC's operating divisions and offices, more frequent cross-divisional meetings, and increased coordination in the handling of enforcement referrals. He next stated that the SEC is focusing more closely on the role of the gatekeepers in the industry - including executives of investment management firms, directors, and lawyers - and will not hesitate to hold them accountable when we determine they have played a significant role in a company's wrongdoing.
With respect to enforcement actions, Mr. Cutler stated that the SEC�s enforcement actions have revealed at many firms �a culture that focused too heavily on the bottom line - in other words, revenues for the adviser and its affiliates - at the expense of fund shareholders.� He further noted that the recent enforcement actions in the mutual fund area demonstrate that some industry executives failed to make honest a core value, as evidenced by cases involving:
- personal trading by fund executives at the expense of ordinary fund shareholders;
- the approval of market timing arrangements that were inconsistent with firms' representations to shareholders and, in many cases, firms' own internal policies;
- knowing or reckless misrepresentations of net asset values; and
- the charging of performance-based fees in a manner that significantly benefited the advisory firm at the expense of the funds.
With respect to fund directors, Mr. Cutler noted that the SEC has not, to date, brought an action against any independent directors in connection with the market timing and late trading abuses, or in connection with payments for shelf space. The SEC recognizes that, in some of these cases, the independent directors were victims of the inadequate or misleading information conveyed to them by the funds' adviser or its affiliates. Going forward, the SEC will continue to closely examine the role of directors and will bring charges against them if the SEC finds they have failed in their duty to protect fund shareholders against management's overreaching.
Please click http://www.sec.gov/news/speech/spch120604smc.htm for a copy of the speech.
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ROYE SPEAKS ON NEW HEDGE FUND ADVISER REGISTRATION RULE
11.30.2004 Paul Roye, the Director of the SEC�s Division of Investment Management, spoke about the new hedge fund adviser registration rule at the SIA Hedge Funds Conference: New Regulation: Weighing the Impact in New York.
He reviewed the origin of the hedge fund adviser rule, noting that the SEC�s decision to both propose and adopt the hedge fund adviser registration initiative was shaped by considerable study, consultation and thoughtful review. He spoke about reasons for the rule: (1) tremendous growth of hedge funds, (2) need for data, (3) broader hedge fund investor demographics, including lower income investors, and (4) the increase number of hedge fund fraud cases.
He stated that the SEC�s goal is to develop �an oversight regime for the hedge fund industry that imposes minimal regulatory burdens and hindrances on its participants while providing the SEC the tools to fulfill its investor protection mandate.� He concluded that with respect to hedge fund advisers currently registered with the SEC, he has seen �no credible evidence that the Investment Advisers Act of 1940 has in any way impeded their ability to employ successful investment strategies or to effectively compete with other financial institutions that manage securities portfolios in this country or abroad.�
Please click http://www.sec.gov/news/speech/spch113004pfr.htm for a copy of the release announcing the action.
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