Mutual Fund Advisers Found to Have Violated Rule 19a-1
9.28.2007 The SEC settled enforcement actions against four investment advisers for violations of Section 19(a) of the 1940 Act and Rule 19a-1 thereunder. The SEC found that during the period 2001 through 2004, the advisers knew that certain closed-end funds they managed were making distributions to fund investors that were entirely or partly funded from shareholder capital or capital gains, but failed to send the required Section 19(a) notices to shareholders.
The four advisers that were responsible for providing the notices to fund shareholders are:
- AllianceBernstein, L.P.
- Putnam Investment Management, LLC
- Salomon Brothers Asset Management Inc.
- Smith Barney Fund Management LLC
In connection with the settlement, the SEC found that from January 2002 through July 2004, two closed-end funds that Alliance managed made 22 distributions that were funded entirely from shareholder capital or capital gains. From August 2000 through May 2002, four closed-end funds that Putnam managed made 42 distributions that were funded in part from shareholder capital. From March 2001 through September 2004, three closed-end funds that Smith Barney managed made 89 distributions that were funded in part from shareholder capital. From January 2001 through April 2003, two closed-end funds that Salomon Brothers managed made 47 distributions that were funded in part from shareholder capital. None of the funds' distributions to shareholders were accompanied by the required Section 19(a) notice even though each adviser was obligated to send such notices.
In addition, the SEC found that Smith Barney and Salomon Brothers filed annual reports on behalf of certain funds they managed that reported in the Management Discussion of Fund Performance (MDFP) sections of the reports an annual dividend without disclosing that a
portion thereof included a return of shareholder capital. Likewise, the MDFP section of certain funds' annual reports provided annualized yield figures that assumed a dividend paid entirely from net income, although actual distributions were partly from shareholder capital.
The SEC found that by failing to disclose that a portion of the reported dividends came from shareholder capital, the statements implied that distributions were entirely from net income. By filing annual reports that contained material omissions or misstatements regarding these measures of fund performance, Smith Barney and Salomon Brothers violated Section 34(b).
Please click http://www.sec.gov/litigation/admin/2007/ia-2663.pdf for a copy of the administrative order related to AllianceBernstein.
Please click http://www.sec.gov/litigation/admin/2007/ia-2664.pdf for a copy of the administrative order related to Putnam.
Please click http://www.sec.gov/litigation/admin/2007/ia-2665.pdf for a copy of the administrative order related to Salomon Brothers.
Please click http://www.sec.gov/litigation/admin/2007/ia-2666.pdf for a copy of the administrative order related to Smith Barney.
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Federal Regulators Adopt Regulation R
9.27.2007 The Board of Governors of the Federal Reserve System (the “Board”) and Securities and Exchange Commission (“SEC”) Commission jointly are adopting a single set of final rules that implement certain of the exceptions for banks from the definition of the term “broker” under Section 3(a)(4) of the Securities Exchange Act of 1934 (“Exchange Act”). In developing these rules, the Board and SEC consulted with, and sought the concurrence of, the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of Thrift Supervision (“OTS”).
Networking Exception
A bank employee may receive a referral fee under the networking exception and Rule 700 for each referral made to a broker-dealer, including separate referrals of the same individual or entity. In addition, nothing in the statutory networking exception or the final rules limits or restricts the ability of a bank employee to refer customers to other departments or divisions of the bank itself, including, for example, the bank’s trust, fiduciary or custodial department.
Specifically, the third-party brokerage exception (“networking exception”) in Section 3(a)(4)(B)(i) of the Exchange Act permits a bank to avoid being considered a broker if, under certain conditions, it enters into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to bank customers. The networking exception does not address the type or amount of compensation that a bank may receive from its broker-dealer partner under a networking arrangement. New Rule 700 defines the term “nominal one-time cash fee of a fixed dollar amount” to mean a cash payment for a referral in an amount that meets any one of four alternative standards: the first based on twice the average hourly base wage established by the bank for the employee’s job family; the second based on 1/1000th of the average annual base salary established by the bank for the employee’s job family; the third based on twice the employee’s actual base hourly wage; and the fourth based on a specified dollar amount ($25), indexed for inflation. Rule 700(c) provides that a referral fee paid to any bank employee will be considered “nominal” if it does not exceed $25. A bank may pay the referral fee only in cash. A bank, therefore, may not pay referral fees in non-cash forms, such as vacation packages, stock grants, annual leave, or consumer goods.
Rule 700(e) defines a referral as an action taken by one or more bank employees to direct a customer of the bank to a broker-dealer for the purchase or sale of securities for the customer’s account.
Under the networking exception, a nominal fee paid to an unregistered bank employee for referring a customer to a broker-dealer may not be contingent on whether the referral results in a transaction. This limitation is designed to allow banks to reward bank employees for introducing customers to a broker-dealer without giving unregistered bank employees a direct financial interest in any resulting securities transaction at the broker-dealer. The final rule provides that a referral fee will be considered “contingent on whether the referral results in a transaction” if payment of the fee is dependent on:
- whether the referral results in a purchase or sale of a security;
- whether an account is opened with a broker-dealer;
- whether the referral results in a transaction involving a particular type of security; or
- whether the referral results in multiple securities transactions.
A referral fee may be contingent on whether a customer (1) contacts or keeps an appointment with a broker-dealer as a result of the referral; or (2) meets any objective, base-line qualification criteria established by the bank or broker-dealer for customer referrals, including such criteria as minimum assets, net worth, income, or marginal federal or state income tax rate, or any requirement for citizenship or residency that the broker-dealer, or the bank, may have established generally for referrals for securities brokerage accounts.
Under Rule 700(b)(1) of the final rules, compensation paid by a bank under a bonus or similar plan is specifically excepted from “incentive compensation” if it is paid on a discretionary basis and based on multiple factors or variables, provided that:
- those factors or variables include multiple, significant factors or variables that are not related to securities transactions at the broker-dealer;
- a referral made by the employee is not a factor or variable in determining the employee’s compensation under the plan; and
- the employee’s compensation under the plan is not determined by reference to referrals made by any other person.
A bonus or similar plan will be considered “discretionary” under the final rule if the amount an employee may receive under the plan is not fixed in advance and the employee does not have an enforceable right to payments under the plan until the amount of any payments are established and declared by the bank. A plan may, however, include targets or metrics that must be met in order for any bonus to be paid, provided the plan is otherwise a “discretionary” plan.
The safe harbor provisions of Rule 700(b)(2) are designed to allow banks to avoid having to analyze whether a particular bonus program meets the requirements of the exception in paragraph (b)(1) in circumstances where the general structure of the program clearly reduces the potential for sales practice concerns in connection with a referral to a broker-dealer. Rule 700(b)(2) cover any bonus or similar plan that is based on the overall profitability or revenue of:
The bank, either on a stand-alone or consolidated basis;
- Any affiliate of the bank (other than a broker-dealer), or any operating unit of the bank or an affiliate (other than a broker-dealer), if the affiliate or operating unit does not over time predominately engage in the business of making referrals to a broker-dealer; or
- A broker-dealer if: (A) Such measure of overall profitability or revenue is only one of multiple factors or variables used to determine the compensation of the officer, director or employee; (B) The factors or variables used to determine the compensation of the officer, director or employee include multiple significant factors or variables that are not related to the profitability or revenue of the broker-dealer; (C) A referral made by the employee is not a factor or variable in determining the employee’s compensation under the plan; and (D) The employee’s compensation under the plan is not determined by reference to referrals made by any other person.
Exemption for Referrals Involving Institutional Customers and High Net Worth Customers
Regulation R permits a bank, subject to certain conditions, to pay an employee a contingent referral fee of more than a nominal amount for referring an “institutional customer” or “high net worth customer” to a broker-dealer with which the bank has a contractual or other written networking arrangement.
“Institutional customer” means:
- any corporation, partnership, limited liability company, trust, or other non-natural person that has, or is controlled by a non-natural person that has, at least: (i) $10 million in investments; or (ii) $20 million in revenues; or (iii) $15 million in revenues if the bank employee refers the customer to the broker-dealer for investment banking services; or
- natural person who, either individually or with his or her spouse, has at least $5 million in net worth excluding the primary residence and associated liabilities of the person and, if applicable, his or her spouse.
For purposes of determining whether a natural person meets the $5 million net worth test, the assets of a person include:
- any assets held individually;
- if the person is acting jointly with his or her spouse, any assets of the person’s spouse (whether or not such assets are held jointly); and
- if the person is not acting jointly with his or her spouse, 50% of any assets held jointly with such person’s spouse and any assets in which such person shares with such person’s spouse a community property similar shared ownership interest.
Regulation R requires that a high net worth or institutional customer referred to a broker-dealer under the exception receive disclosures that clearly and conspicuously disclose (i) the name of the broker-dealer; and (ii) that the bank employee participates in an incentive compensation program under which the bank employee may receive a fee of more than a nominal amount for referring the customer to the broker-dealer and that the payment of the fee may be contingent on whether the referral results in a transaction with a broker-dealer.
Suitability
Under Regulation R, for contingent referral fees payable under the exemption, the written agreement between the bank and the broker-dealer must provide for the broker-dealer to conduct a suitability analysis of each securities transaction that triggers any portion of the contingency fee in accordance with the rules of the broker-dealer’s applicable SRO as if the broker-dealer had recommended the securities transaction. This analysis must be performed by the broker-dealer before each securities transaction on which the referral fee is contingent is conducted. For non-contingent referral fees payable under the exemption, the written agreement must provide for the broker-dealer to conduct, before the referral fee is paid, either (1) a sophistication analysis of the customer being referred; or (2) a suitability analysis with respect to all securities transactions requested by the customer contemporaneously with the referral in accordance with the rules of the broker-dealer’s applicable SRO as if the broker-dealer had recommended the securities transaction. Under the sophistication analysis option, the broker-dealer must determine that the customer has the capability to evaluate investment risk and make independent decisions, and determine that the customer is exercising independent judgment based on the customer’s own independent assessment of the opportunities and risks presented by a potential investment, market factors, and other investment considerations.
Good Faith Compliance and Corrections by Banks
Under Regulation R, a bank that acts in good faith and that has reasonable policies and procedures in place to comply with the requirements of the exemption will not be considered a “broker” under Section 3(a)(4) of the Exchange Act solely because the bank fails, in a particular instance, to determine that a customer is an institutional or high net worth customer, provide the customer the required disclosures, or provide the broker-dealer the required information concerning the bank employee receiving the referral fee within the time periods prescribed.
Trust and Fiduciary Activities
Trust activities of a bank related to brokerage are governed by the Gramm-Leach-Bliley Act. Section 3(a)(4)(B)(ii) of the Exchange Act (the “trust and fiduciary exception”) permits a bank, under certain conditions, to effect securities transactions in a trustee or fiduciary capacity without being registered as a broker. A bank must effect such transactions in its trust department, or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards.
In addition the bank must be “chiefly compensated” for such transactions, consistent with fiduciary principles and standards, on the basis of:
- an administration or annual fee;
- a percentage of assets under management;
- a flat or capped per order processing fee that does not exceed the cost the bank incurs in executing such securities transactions; or
- any combination of such fees.
Banks relying on this exception may not publicly solicit brokerage business, other than by advertising that they effect transactions in securities in conjunction with advertising their other trust activities. In addition, a bank that effects a transaction in the United States of a publicly traded security under the exception must execute the transaction in accordance with Exchange Act Section 3(a)(4)(C).
This Section requires that the bank direct the trade to a registered broker-dealer for execution, effect the trade through a cross trade or substantially similar trade either within the bank or between the bank and an affiliated fiduciary in a manner that is not in contravention ofiduciary principles established under applicable federal or state law, or effect the tradesome other manner that the SEC permits.
Rule 721 provides that a bank meets the “chiefly compensated” condition in the trust and fiduciary exception if the “relationship-total compensation percentage” for each trust or fiduciary account of the bank is greater than 50 percent. The “relationship-total compensation percentage” for a trust or fiduciary account is calculated by:
- dividing the relationship compensation attributable to the account during each of the immediately preceding two years by the total compensation attributable to the account during the relevant year;
- translating the quotient obtained for each of the two years into a percentage; and
- then averaging the percentages obtained for each of the two immediately preceding years.
Rule 722 also allows a bank to use a bank-wide approach to the “chiefly compensated” condition as an alternative to the account-by-account approach. To use this bank-wide methodology, the bank must meet two conditions. First, the “aggregate relationship-total compensation percentage” for the bank’s trust and fiduciary business as a whole must be at least 70 percent. The “aggregate relationship-total compensation percentage” of a bank operating under the bank-wide approach is calculated in a similar manner as the “relationship-total compensation percentage” of an account under the account-by-account, except that the calculations would be based on the aggregate relationship compensation and total compensation received by the bank from its trust and fiduciary business as a whole during each of the two immediately preceding years. In other words, the percentage would be determined by:
- dividing the relationship compensation attributable to the bank’s trust and fiduciary business as a whole during each of the immediately preceding two years by the total compensation attributable to the bank’s trust and fiduciary business as a whole during the relevant year;
- translating the quotient obtained for each of the two years into a percentage; and
- then averaging the percentages obtained for each of the two immediately preceding years.
Second, the bank must comply with the conditions in the trust and fiduciary exception (other than the compensation test in Section 3(a)(4)(B)(ii)(I)) and comply with Section 3(a)(4)(C) (relating to trade execution) of the Exchange Act.
A bank has the flexibility to elect to use a calendar year or the bank’s fiscal year for purposes of complying with the compensation provisions of either the account-by-account or bank-wide approach. In addition, whether a bank decides to use the account-by-account approach or the bank-wide approach, the bank’s compliance with the relevant compensation restriction is based on a two-year rolling average of the compensation attributable to the trust or fiduciary account or the bank’s trust or fiduciary business, respectively.
Relationship Compensation
Both the account-by-account and bank-wide approaches are based on the ratio of the relationship compensation attributable to a trust or fiduciary account or a bank’s trust and fiduciary business to the total compensation attributable to the account or business. The definition of relationship compensation is any compensation that a bank receives that is attributable to a trust or fiduciary account and that consists of:
- an administration fee,
- an annual fee (payable on a monthly, quarterly or other basis),
- a fee based on a percentage of assets under management (an “AUM fee”),
- a flat or capped per order processing fee, paid by or on behalf of a customer or beneficiary, that is equal to not more than the cost incurred by the bank in connection with executing securities transactions for trust or fiduciary accounts; or
- any combination of these fees.
The final rules also continue to list all 12b-1 fees that are paid on the basis of assets under management and attributable to a trust or fiduciary account (under the account-by-account test) or the bank’s trust and fiduciary business as a whole (under the bank-wide test) as examples of AUM fees that are relationship compensation.
Rule 721 provides additional examples of the types of fees that qualify as relationship compensation under the statute and the rules. For example, the modified rule includes additional examples of an administration fee, compensation received by a bank (1) for disbursing funds from, or for recording payments to, a trust or fiduciary account; (2) in connection with securities lending and borrowing transactions conducted for a trust or fiduciary account; and (3) for custody services provided to a trust or fiduciary account (whether or not separately charged). In addition, the Agencies have included (1) as an example of an annual fee, an annual fee paid for assessing the investment performance of a trust or fiduciary account or for reviewing such an account’s compliance with applicable investment guidelines or restrictions, and (2) as an example of an assets under management fee, a fee based on the financial performance, such as capital gains or capital appreciation, of trust or fiduciary assets under management
Rules 721 and 722 provide that, if a bank effects a securities transaction for a trust or fiduciary customer in accordance with the terms of an exception or exemption other than Rule 721 or Rule 722, the bank may, at its election, exclude the revenues associated with those transactions from the applicable relationship-total compensation calculation in Rule 721 or Rule 722.
In addition, compensation that is not derived from the provision of trust or fiduciary services should not be included in a bank’s relationship or total compensation under either the account-by-account or bank-wide alternative. Such compensation includes, for example, (1) revenue earned by a trust or fiduciary department from providing back-office services to an affiliated or unaffiliated party, (2) revenue from the sale of an office or assets of the trust department, or from the provision on a stand-alone basis of other services (such as custody services or the sale of portfolio management software to a third party that independently operates and uses the software in connection with its own business) that do not involve trust or fiduciary services as defined in section 3(a)(4)(D) of the Act; and (3) internal payments or credits allocated to a bank’s trust or fiduciary department or unit from another department or unit of the bank for deposits and other similar services not involving a security.
Advertising Restrictions
Regulation R provides that a bank complies with the advertising restriction applicable under either Rule 721 or 722 if advertisements by or on behalf of the bank do not advertise that the bank provides securities brokerage services for trust or fiduciary accounts except as part of advertising the bank’s broader trust or fiduciary services, and do not advertise the securities brokerage services provided by the bank to trust or fiduciary accounts more prominently than the other aspects of the trust or fiduciary services provided to such accounts. An “advertisement” for these purposes means any material that is published or used in any electronic or other public media, including any Web site, newspaper, magazine or other periodical, radio, television, telephone or tape recording, videotape display, signs or billboards, motion pictures, blast e-mail, or telephone directories (other than routine listings). Other types of material or information that is not distributed through public media, such as mailings or e-mails to a bank’s own customers, are not considered an advertisement.
Sweep Accounts
Section 3(a)(4)(B)(v) of the Exchange Act, called the “sweep exception,” excepts a bank from the definition of “broker” to the extent it “effects transactions as part of a program for the investment or re-investment of deposit funds into any no-load, open-end management investment company registered under the Investment Company Act that holds itself out as a money market fund.” To provide banks with guidance on the sweep exception, Regulation R defines several terms used in the exception, including the terms “money market fund” and “no-load.”
Regulation R defines a “money market fund” for purposes of the sweep exception to mean an open-end investment company registered under the Investment Company Act of 1940 that is regulated as a money market fund pursuant to Rule 2a-7 under that Act. A class or series of securities of an investment company will be considered “no-load” if (1) the class or series is not subject to a sales charge or a deferred sales charge; and (2) total charges against net assets of the class or series of securities for sales or sales promotion expenses, personal service, or the maintenance of shareholder accounts do not exceed 0.0025 of average net assets annually. A bank may effect transactions under the sweep exception and Rule 740 as part of a program to sweep deposit funds of, or collected by, another bank into a no-load money market fund in accordance with the exception and the Rule.
Rule 741 permits banks, without registering as a broker, to effect transactions on behalf of a customer in securities issued by a money market fund under certain conditions. To qualify for this exemption, the bank must provide the customer, directly or indirectly, some other product or service, the provision of which would not, in and of itself, require the bank to register as a broker-dealer under Section 15(a) of the Exchange Act. Examples of other products or services that may be a qualifying “other” product or service include an escrow, trust, fiduciary or custody account, a deposit account or a loan or other extension of credit.
Custody
Section 3(a)(4)(B)(viii) of the Exchange Act provides banks with an exception from the “broker” definition for certain bank custody and safekeeping activities (“custody and safekeeping exception”). In particular, this exception allows a bank to perform the following activities as part of its customary banking activities without registering as a “broker”:
- Providing safekeeping or custody services with respect to securities, including the exercise of warrants and other rights on behalf of customers;
- Facilitating the transfer of funds or securities, as a custodian or a clearing agency, in connection with the clearance and settlement of its customers’ transactions in securities;
- Effecting securities lending or borrowing transactions with or on behalf of customers as part of the above described custodial services or investing cash collateral pledged in connection with such transactions;
- Holding securities pledged by a customer to another person or securities subject to purchase or resale agreements involving a customer, or facilitating the pledging or transfer of such securities by book entry or as otherwise provided under applicable law, if the bank maintains records separately identifying the securities and the customer; and
- Serving as a custodian or provider of other related administrative services to any individual retirement account, pension, retirement, profit sharing, bonus, thrift savings, incentive, or other similar benefit plan.
Rule 760 allows banks to continue to accept securities orders in a custodial capacity and to permit bank customers to take advantage of those order-taking services subject to important conditions designed to limit the scope of the activity and provide appropriate investor protections.
Rule 760 and the other final rules do not implement the statutory custody and safekeeping exception. A bank does not need to rely on the custody exemption in Rule 760 to the extent the bank conducts other custodial activities permitted by Section 3(a)(4)(B)(viii)(I)(aa)-(ee) (e.g., exercising warrants or other rights with respect to securities or effecting securities lending or borrowing transactions on behalf of custodial customers) or another of the final rules (e.g., Rule 772, which permits banks to effect securities lending or borrowing transactions on behalf of certain non-custodial customers).
In addition, a bank would not have to rely on Rule 760 to the extent the bank holds securities in custody for a customer and provides clearance and settlement services to the account in connection with such securities, but the bank does not accept orders for securities transactions for the account or engage in other activities with respect to the account that would require the bank to be registered as a broker.
Rule 760 provides that a bank will not be considered a broker to the extent that, as part of its customary banking activities, the bank accepts orders to effect transactions in securities in an “employee benefit plan account” or an “individual retirement account or similar account” for which the bank acts as a custodian.
Rule 760(a)(2) provides that a bank relying on the exemption may not advertise that it accepts orders for securities transactions for employee benefit plan accounts or individual retirement accounts or similar accounts for which the bank acts as custodian, except as part of advertising the other custodial or safekeeping services the bank provides to these accounts.
Regulation R allows banks to continue to accept securities orders for custodial accounts other than employee benefit plan and individual retirement and similar accounts as an accommodation to the customer, subject to certain conditions designed to help ensure that these services continue to be provided only as an accommodation to customers and that a bank does not operate as a securities broker out of its custody department. The rule prohibits a bank that accepts accommodation orders for a custody account from charging or receiving any fee that varies based on (1) whether the bank accepted the order for the transaction or (2) the quantity or price of the securities to be bought or sold.
Under the final rule, the bank’s advertisements may not state that the bank accepts orders for securities transactions for a custodial account (other than an employee benefit plan or individual retirement account or similar account). In addition, the bank’s sales literature: (1) may state that the bank accepts securities orders for such an account only as part of describing the other custodial or safekeeping services the bank provides to the account, and (2) may not describe the securities order-taking services provided to such an account more prominently than the other aspects of the custody or safekeeping services provided by the bank to the account.
Regulation R imposes certain restrictions on the ability of a bank to provide investment advice or research concerning securities to an account for which it accepts accommodations orders, make recommendations concerning securities to the account, or otherwise solicit securities transactions from the account.
These restrictions, however, do not prohibit the bank from advertising its custodial services and disseminating sales literature that meets the conditions in the exemption.
Rule 760(d)(2) requires a bank that accepts orders for a custody account under the rule to comply with Section 3(a)(4)(C) of the Exchange Act in handling any order for a securities transaction for the account. Under this provision, (i) the bank must direct the trade to a registered broker-dealer for execution, or (ii) the trade must be a cross trade or other substantially similar trade of a security that is made by the bank or between the bank and an affiliated fiduciary and is not in contravention of fiduciary principles established under applicable Federal or State law, or (iii) the trade must be conducted in some other manner permitted under rules, regulations, or orders as the SEC may prescribe or issue.
The exemption in Rule 760 is available only for an “account for which the bank acts as a custodian.” Regulation R defines this term to mean an account that is:
- an employee benefit plan account for which the bank acts as a custodian;
- an individual retirement account or similar account for which the bank acts as a custodian;
- an account established by a written agreement between the bank and the customer that sets forth the terms that will govern the fees payable to, and rights and obligations of, the bank regarding the safekeeping or custody of securities; or
- an account for which the bank acts as a directed trustee.
Administrators/Recordkeepers and Subcustoidans
Rule 760(e) permits a bank that acts as a non-fiduciary and non-custodial administrator or recordkeeper for an employee benefit plan for which another bank acts as a custodian to accept orders for the account under Rule 760. In addition, a new paragraph (f) of the rule permits a bank that acts as a subcustodian for any type of account for which another bank acts as custodian to accept orders for the account under Rule 760.
The rule generally prohibits a recordkeeper/administrator bank or subcustodian bank relying on the exemption from executing a cross-trade or netting orders with or for the relevant account. The rule, however, rule permits the administrator/recordkeeper bank or subcustodian bank to cross or net orders for shares of open-end investment companies not traded on an exchange. In addition, the final rule permits the administrator/recordkeeper bank or subcustodian bank to cross orders between or net orders for accounts of the custodian bank that contracted with the administrator/recordkeeper bank or subcustodian bank for services.
The following other exemptions relating to the securities “broker” activities of banks were adopted:
- Exemption for Regulation S Transactions with Non-U.S. Persons and Broker-Dealers
- Exemption for Non-Custodial Securities Lending Transactions
- Exemption for Banks Effecting Certain Excepted or Exempted Transactions in Investment Company Securities and Variable Insurance Products
- Exemption for Certain Transactions involving a Company’s Securities for its Employee Benefit Plans and Participants
- Temporary and Permanent Exemption for Contracts Entered Into by Banks from Being Considered Void or Voidable
Please click http://www.sec.gov/rules/final/2007/34-56502.pdf to access a copy of the adopting release.
Please click http://www.sec.gov/rules/final/2007/34-56502.pdf to access a copy of the release adopting the rules.
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Adviser Charged with Maintaining Improper Referral Fee Arrangement
9.26.2007 In an administrative action the SEC alleged that that Albert L. Coles and his investment advisory firm, Financial Designers Associates, Inc. (FDA) failed to disclose to FDA clients payments Coles received from a company in which he advised FDA clients to invest. Between 2002 and 2006, Coles received approximately $361,307 in undisclosed referral fees, and accrued interest on the fees, from this company. Coles and FDA falsely represented in various client disclosures, including FDA's Form ADV, that FDA and Coles were compensated solely by FDA clients and received no payments for the investments recommended by FDA. The undisclosed payments created a conflict of interest compromising the objectivity of FDA's investment recommendations to clients.
The SEC censured FDA and Coles and directs them to cease and desist from committing or causing any violations and any future violations of Sections 206(1), 206(2) and 207 of the Advisers Act. The Order also directs Coles to pay $361,307 in disgorgement and a $40,000 civil penalty.
Please click
http://www.sec.gov/litigation/admin/2007/ia-2654.pdf for a copy of the adminstrative order.
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Hedge Fund Charged with Overstating Performance
9.26.2007 The SEC charged a San Francisco hedge fund manager with defrauding investors by overstating the fund's profitability and misusing fund assets. The SEC alleged that Alexander James Trabulse sent account statements to investors in his Fahey Fund that inflated the fund's returns by as much as 200 percent, while using investor money to purchase cars and finance shopping sprees for his family members.
Trabulse founded the Fahey Fund in 1997 and raised about $10 million from approximately 100 investors. According to the SEC, he told investors the fund invested in financial instruments like stocks, derivatives, and foreign currency. The complaint alleges that Trabulse lured investors by touting the fund's spectacular performance, when in reality the statements he provided to investors bore no relation to the fund's actual performance.
The SEC alleged that Trabulse misused fund assets to pay for a wide variety of personal expenses, using the fund's bank account to pay for cars, a home theater system, and his ex-wife's overseas shopping allowance. He gave one relative free reign to use the fund's bank accounts for personal use, according to the SEC.
The SEC's complaint alleges Trabulse violated the antifraud and registration provisions of the federal securities laws, and seeks disgorgement, penalties, and other relief. The SEC also has named as relief defendants several entities associated with Trabulse that received assets through Trabulse's fraud.
Please click http://www.sec.gov/litigation/litreleases/2007/lr20300.htm to access a copy of the administrative order.
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Market Timing Charges Brought Against Mutuals.com
9.26.2007 2007 In an administrative action the SEC alleged that that Mutuals.com, Inc., Connely Dowd Management, Inc., and MTT Fundcorp, Inc. (collectively, “Mutuals.com”) and the firms' three principals, Richard Sapio, Eric McDonald and Michele Leftwich, defrauded hundreds of mutual funds and their shareholders by engaging in a series of deceptive activities designed to circumvent the restrictions on market timing imposed by those mutual funds.
Specifically, Mutuals.com engaged in the following deceptive conduct from at least
July 2001 until September 2003:
- use of multiple accounts established for the same client;
- use of multiple registered representative numbers established for the same registered representative;
- use of multiple branch codes for the same physical location;
- use of affiliated broker-dealers; and
- use of multiple clearing broker-dealers.
In addition, the SEC alleged that during 2003, Mutuals.com also systematically engaged in late trading of the shares of the same mutual funds by effecting orders that it received after the 4:00 p.m. ET close of the market at the current day's net asset value. This scheme allowed Mutuals.com clients and customers to capitalize on news events or market changes occurring after the 4:00 p.m. ET close of the stock market. During the relevant period, Mutuals.com received wrap fees totaling $4.5 million.
Please click http://www.sec.gov/litigation/admin/2007/33-8847.pdf to access a copy of the administrative order.
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SEC Reinstates Certain Investment Adviser Interpretive Positions
9.24.2007 Section 202(a)(11)(C) of the Investment Advisers Act of 1940 (the “1940 Act”) excepts from the definition of “investment adviser” a broker or dealer “whose performance of [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.” In 2005, the SEC adopted the original rule 202(a)(11)-1 under the Advisers Act, the principal purpose of which was to deem broker-dealers offering “fee-based brokerage accounts” as not subject to the Advisers Act. The rule also included several interpretations of section 202(a)(11)(C). On March 30, 2007, the Court of Appeals for the District of Columbia Circuit (the “Court”), in Financial Planning Association v. SEC (the “FPA decision”), vacated the original rule 202(a)(11)-1 on the grounds that the Commission did not have the authority to except broker-dealers offering fee-based brokerage accounts from the definition of “investment adviser.” Though the Court did not question the validity of our interpretive positions, it vacated the entire rule, leaving the SEC’s interpretations potentially in doubt.
The SEC has decided to repropose the interpretive positions
Proposed rule 202(a)(11)-1(a)(1) would provide that a broker-dealer that separately contracts with a customer for, or separately charges a fee for, investment advisory services cannot be considered to be providing advice that is solely incidental to its brokerage.
Under the proposed rule, the exception provided by section 202(a)(11)(C) of the Act is unavailable for any account over which a broker-dealer exercises investment discretion, regardless of the form of compensation and without regard to how the broker-dealer handles other accounts.
With respect to financial planning, the SEC proposes to consider the results of a study it commissioned by the RAND Corporation (“RAND Study”) comparing the levels of protection afforded customers of broker-dealers and investment advisers under the federal securities laws. The RAND Study is expected to be delivered to us no later than December 2007, several months ahead of schedule.
Under proposed rule 202(a)(11)-1(b), a broker-dealer will not be considered to have received “special compensation” for purposes of section 202(a)(11)(C) of the Advisers Act (and therefore will not be subject to the Act) solely because the broker-dealer charges a commission, mark-up, mark-down or similar fee for brokerage services that is greater or less than one it charges another customer.
Finally, the SEC proposes that a broker-dealer that is registered under both the Exchange Act and the Advisers Act is an investment adviser solely with respect to those accounts for which it provides advice or receives compensation that subject the broker-dealer to the Advisers Act.
Please click
http://www.sec.gov/rules/proposed/2007/ia-2652.pdf for a copy of the release proposing the rule.
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SEC Proposes Rule That Would Permit Dually Registered Broker-Dealers to Engage in Principal Trades with Advisory Clients
9.24.2007 The SEC adopted an interim final temporary rule under the Advisers Act as part of its response to a recent court decision of the U.S. Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC (482 F.3d 481 (D.C. Cir. 2007)), which provided that broker-dealers were not exempt from the Advisers Act if they offered discretionary fee-based brokerage accounts. The temporary rule provides an alternative method for investment advisers that are registered with the SEC as broker-dealers to meet the requirements of Section 206(3) of the Advisers Act when they act in a principal capacity with respect to transactions with of their advisory clients.
Temporary rule 206(3)-3T permits an adviser, with respect to a non-discretionary advisory account only, to comply with section 206(3) by:
- making certain written disclosures;
- obtaining written, revocable consent from the client prospectively authorizing the adviser to enter into principal transactions;
- making certain oral or written disclosures and obtaining the client's consent orally or in writing prior to the execution of each principal transaction;
- sending to the client confirmation statements disclosing specified information; and
- delivering to the client an annual report itemizing the principal transactions.
The SEC is accepting comments on the interim final rule until November 30, 2007. The rule will expire and no longer be effective on December 31, 2009.
Please click http://www.sec.gov/news/press/2007/2007-167.htm to access the press release about interactive data.
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Adviser Refuses to Allow SEC to Inspect Its Business
9.24.2007 The SEC brought an action against Amaroq Asset Management, LLC (Amaroq), a registered investment adviser, and its sole principal, former NFL player Dwight Andree Sean Oneal Jones, 44, of Missouri City, Texas. The SEC alleged that Jones, who at one point claimed to manage over $40 million in assets for his clients, refused to produce or allow the inspection of his advisory business records, as required under the Advisers Act. After repeatedly failing to respond to the SEC staff, the SEC alleged that Jones ultimately claimed that all his records had either been destroyed in a fire or inadvertently sold by a storage company. The SEC also alleged that although Jones claims that Amaroq discontinued business in 2004, Amaroq continued to maintain a website until mid-2007 mentioning its wealth management programs and that it was subject to periodic SEC examinations.
The SEC’s Division of Enforcement alleged that through its conduct, Amaroq willfully violated the examination and reporting requirements of Section 204 of the Advisers Act and Rules 204-1 and 204-2(f) thereunder, and that Jones willfully aided and abetted and caused Amaroq's violations.
Please click http://www.sec.gov/litigation/admin/2007/ia-2651.pdf to access a copy of the administrative action.
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SEC Issues Custody No-Action Letter
9.20.2007 The SEC staff issued a no-action letter under Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder (“Custody Rule”) stating any investment adviser (“adviser”) that promptly forwards, to its client or a qualified custodian, certain client funds or securities that the adviser inadvertently receives will not violate the Custody Rule in the situations and under the circumstances described below within five business days of the adviser’s receipt of such assets, to its client (or former client) or a qualified custodian:
- When an adviser makes filings made with the Internal Revenue Service, state and other governmental taxing authorities (together, “Tax Authorities”); those services include completing tax forms and filing them with the Tax Authorities. The Tax Authorities sometimes send client tax refunds to the adviser’s address;
- Advisers sometimes file proofs of claim for their clients and complete other documentation related to class action lawsuits and other legal actions. The administrators of funds established to distribute the settlement proceeds of these actions sometimes send client settlement assets to the advisers; and
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Advisers may receive stock certificates or dividend checks in the name of their clients. Advisers also may receive stock certificates (or evidence of new debt) in a class action lawsuit involving bankruptcy where shares are issued in a newly organized entity, or as a result of a business reorganization.
In taking this position, the SEC stated that it expects that an adviser that inadvertently receives client assets from third parties in more than rare or isolated instances would adopt and implement written policies and procedures reasonably designed to ensure that the adviser: (1) promptly identifies client assets that it inadvertently receives; (2) promptly identifies the client (or former client) to whom such client assets are attributable; (3) promptly forwards client assets to its client (or former client) or a qualified custodian, but in no event later than five business days following the adviser’s receipt of such assets; (4) promptly returns to the appropriate third party any inadvertently received client assets that the adviser does not forward to its client (or former client) or a qualified custodian, but in no event later than five business days following the adviser’s receipt of such assets; and (5) maintains and preserves appropriate records of all client assets inadvertently received by it, including a written explanation of whether (and, if so, when) the client assets were forwarded to its client (or former client) or a qualified custodian, or returned to third parties.
Please click http://www.sec.gov/divisions/investment/noaction/2007/iaa092007.pdf to access a copy of the no-action letter.
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Evergreen Asset Management Settles Market Timing Charges
9.20.2007 The SEC settled administrative charges brought against Evergreen Investment Management Company, LLC, Evergreen Investment Services, Inc., Evergreen Service Company, LLC, and Wachovia Securities, LLC (collectively, “Wachovia”). The SEC had alleged various violations of the federal securities laws committed by Wachovia in connection with their roles in creating and/or implementing two market timing agreements that permitted, in each case, a registered representative to make, on behalf of certain of his customers, frequent trades in certain Evergreen funds in excess of the exchange limits set forth in the funds’ prospectuses and (b) misleading disclosure in fund documents concerning exchange limits.
Market timing, while not illegal per se, can harm other mutual fund shareholders because it can dilute the value of their shares, if the market timer is exploiting pricing inefficiencies, or disrupt the management of the mutual fund’s investment portfolio and can cause the targeted mutual fund to incur costs borne by other shareholders to accommodate frequent buying and selling of shares by the market timer.
The SEC alleged that in January 2000, William M. Ennis, then the senior vice president of Evergreen Investment Company but who is no longer an officer, employee or affiliate of Wachovia, agreed to permit a registered representative of Wachovia Securities to market time one or more Evergreen funds on behalf of certain of his customers even though the prospectus for each Evergreen fund limited exchanges to three per calendar quarter and five per calendar year. The registered representative subsequently made approximately 386 exchanges into and out of the Evergreen Small Company Growth Fund (now known as the Mid Cap Growth Fund) from approximately January 2001 through March 2003. This timing activity harmed the fund. From January 2001 through March 2003, Ennis signed several Small Company Growth Fund registration statements, each of which incorporated the fund’s prospectus and the exchange limits contained therein. At no point during the period in which the registered representative was making these exchanges did Ennis or anyone else at Evergreen disclose the market timing arrangement to the fund’s board of trustees. Moreover, in January 1999, EIMCO personnel entered into a short-lived agreement with a registered representative of Prudential Securities, Inc. that permitted the registered representative to exceed the exchange limit in the Evergreen Municipal Bond Fund.
During the relevant period, EIMCO was responsible for operating each Evergreen fund in conformity with the terms of its prospectus. Beginning at least in September 1998, EIMCO’s failure to adequately enforce the exchange restrictions set forth in each Evergreen fund prospectus resulted in a substantial amount of exchange activity occurring beyond those limits in several Evergreen funds. This excessive exchange activity imposed costs and management disruptions on the funds, impaired their performance, rendered their prospectuses materially misleading and diluted their value. At no point during this period did EIMCO disclose to any fund board that the prospectus-based exchange restrictions were not being enforced. In addition, during this period, EIMCO either filed or directed EIS to file with the SEC registration statements on behalf of each affected fund, all of which incorporated the materially misleading exchange limit provision set forth in the fund prospectus.
Please click http://www.sec.gov/litigation/admin/2007/34-56462.pdf to access a copy of the administrative order.
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SEC 2007 Seniors Summit Held
9.7.2007 Various securities regulators, including the SEC, released a joint report summarizing the results of their examinations of "free lunch" investment seminars.
The year-long examination was conducted by the SEC, the Financial Industry Regulatory Authority (FINRA) and state securities regulators (members of NASAA, the North American Securities Administrators Association). The regulators scrutinized 110 securities firms and branch offices that sponsor sales seminars and offer a free lunch to entice attendees.
The report's key findings include:
- 100% of the "seminars" were instead sales presentations.
While many sales seminars were advertised as "educational," "workshops," and "nothing will be sold," they were intended to result in the attendees' opening new accounts and, ultimately, in the sales of investment products, if not at the seminar itself, then in follow-up contacts with the attendees.
- 59% reflected weak supervisory practices by firms.
While some exams found effective supervisory practices, many examinations found indications that firms had poorly supervised these sales seminars, including failure to review seminar presentations or materials as required.
- 50% featured exaggerated or misleading advertising claims.
Examples included "Immediately add $100,000 to your net worth," "How to receive a 13.3% return," and "How $100K can pay 1 Million Dollars to Your Heirs."
- 23% involved possibly unsuitable recommendations.
In 25 of the 110 examinations, examiners found indications that unsuitable recommendations were made, for example, a risky investment recommended to an investor with a "conservative" investment objective, or an illiquid investment recommended to an investor with a short-term need for cash.
- 13% appeared to be fraudulent and have been referred to the most appropriate regulator for possible enforcement or disciplinary action.
Examiners found indications of possible fraudulent practices in 14 examinations that involved apparent serious misrepresentations of risk and return, possible liquidation of accounts without the customer's knowledge or consent, and possible sales of fictitious investments.
Free lunch seminars often have names like "Seniors Financial Survival Seminar" or "Senior Financial Safety Workshop," and offer "free" advice by "experts" on how to attain a secure retirement, or offer financial planning or inheritance advice. The advertisements often imply that there is an urgency to attend: "limited seating available" or "call now to reserve a seat."
The examinations were conducted between April 2006 and June 2007 in areas of the country that have large populations of retirees: Florida, California, Texas, Arizona, North Carolina, Alabama and South Carolina.
The report's recommendations include:
- The report recommends that financial services firms review their supervisory practices and take steps to supervise sales seminars more closely, and redouble their efforts to ensure that the investment recommendations they make to seniors are suitable in light of the particular customer's investment objectives. The report also includes a list of supervisory practices that appeared to be effective.
- The report also recommends that ongoing investor education efforts for seniors should provide education with respect to "free lunch" sales seminars. Specifically, senior investors should understand that these are sales seminars that result in the sales of financial products, and they may be sponsored by an undisclosed company with a financial interest in product sales.
Please click http://www.sec.gov/spotlight/seniors/sec2007seniorsmediakit.htm to access information about the summit.
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Pension Consultant/Registered Adviser Charged with Disclosure Violation
9.4.2007 The SEC brought an action against Callan Associates (Callan), a privately-owned pension consultant and registered investment adviser. Callan provides investment consulting services to institutional retirement plans, endowments, foundations and investment managers.
The SEC found that Callan made an incomplete disclosure of a potential conflict of interest in the Part II of its Form ADV. In particular, the SEC found that upon the sale of its affiliated brokerage firm to BNY Brokerage, Inc. (BNY) in late 1998, Callan agreed to refer clients to BNY as its preferred securities broker. The SEC alleged that, between 1999 and 2005, Callan represented in SEC filings and client communications that it received only fixed payments from BNY for the sale of the brokerage. In fact, according to the SEC, a portion of the payments Callan received from BNY were contingent on Callan clients generating a certain level of commissions for BNY. The SEC found the omission of this potential conflict caused Callan's SEC filings to be misleading in violation of the Advisers Act.
Please click http://www.sec.gov/litigation/admin/2007/ia-2650.pdf to access a copy of the administrative order.
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Pension Consultant/Registered Adviser Charged with Failing to Disclose Conflict of Interest
9.5.2007 The SEC brought an action against Yanni Partners, Inc. and Theresa A. Scotti. The SEC found that Yanni, a registered investment adviser and pension consultant located in Pittsburgh, Pennsylvania, provided investment advice to pension plans, profit sharing plans, endowment funds, and other large institutional clients. From at least January 2002 through May 2005, Yanni breached its duty to its clients and prospective clients by misrepresenting and omitting to disclose material information about certain potential financial conflicts of interest.
The SEC found that Yanni's clients included private and public pension funds which were represented by board members or other persons who themselves owed fiduciary duties to the funds and their beneficiaries. These clients, according to the SEC, came to Yanni seeking advice in developing appropriate investment strategies and in selecting money managers to invest the funds entrusted to their care. While Yanni's principal business was investment consulting, it also sold subscription services to some of the same money managers it was recommending to its clients. These sales, which generated approximately $600,000 of gross revenues annually, created a potential conflict of interest, which Yanni should have disclosed to its clients and prospective clients. However, Scotti provided them with marketing materials and other documents which, as a result of their negligence, contained materially misleading statements and omissions about these potential conflicts of interest. As a result of such misconduct, the SEC found that Yanni and Scotti willfully violated the anti-fraud provisions under Section 206(2) of the Investment Advisers Act of 1940.
Please click http://www.sec.gov/litigation/admin/2007/ia-2642.pdf to access a copy of the administrative order.
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Investment Adviser Representative Charged with Defrauding Seniors
9.4.2007 The SEC brought a securities fraud action against a Honolulu-based investment adviser representative who targeted and defrauded members of the senior and retirement communities in Hawaii. The SEC's action was against Mark K. Teruya (Teruya) and his company, Senior Resources of Hawaii, Inc. Teruya is a representative of an SEC-registered investment adviser, which was not named in the action.
According to the SEC, since at least 2004 and continuing as recently as August 2007, Teruya, through Senior Resources, had on multiple occasions fraudulently induced clients to sign a series of pre-printed, fill-in-the-blank forms by misrepresenting the purpose of the forms, the reasons that they needed prospective clients' signatures on the forms, and the way in which they would use the forms. The SEC alleged that Teruya used the signed forms to sell the seniors' existing securities holdings without their knowledge or authorization. The complaint also alleges that Teruya, who is also a licensed insurance agent, then used the proceeds of the unauthorized sales to purchase equity-indexed annuities for which he received
substantial, undisclosed commissions totaling about $2 million.
The complaint alleges that each month the defendants lured about 75 senior citizens, mostly retirees in their 60s, 70s, and 80s, to free breakfast and dinner seminars focusing on retirement financial planning. The complaint alleges that the defendants targeted seniors through advertisements in local newspapers, and direct mail invitations.
The advertisements featured eye-catching headlines, such as "7 Seldom Heard, Significant Financial Opportunities [That] May Be Available to Many Retirees," and "10 Common Costly Financial Mistakes Hawaii Retirees May Make and Ways to Avoid Them."
As alleged by the SEC, the adviser then offered seminar attendees free one-on-one consultations with Teruya, a self-proclaimed "certified retirement financial adviser." The complaint further alleges that, during these individual meetings, defendants fraudulently induced the seniors to sign the blank forms.
Please click http://www.sec.gov/litigation/litreleases/2007/lr20287.htm to access a copy of the administrative order.
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SEC Announces CCOutreach Registration
9.2.2007 The SEC announced that the CCOutreach National Seminar will be held from 9 a.m. to 5 p.m. on November 14th at the SEC’s headquarters at 100 F Street, N.E., Washington, D.C. 20549. Attendance is limited to 500, with CCOs given priority on a first-come, first-served basis. The seminar also will be webcast at www.sec.gov.
The CCOutreach National Seminar is designed to allow CCOs to interact directly with SEC staff and discuss the critical compliance functions they perform on a daily basis on behalf of mutual fund investors and advisory clients. The event will include panel discussions on the latest compliance developments relevant to CCOs, and will address questions and issues raised at a recent series of regional seminars held by SEC examination staff. The SEC’s CCOutreach program is sponsored jointly by the agency’s Division of Investment Management and the Office of Compliance Inspections and Examinations.
Please click http://www.sec.gov/info/ccoutreach.htm for registration materials and other information for the CCOutreach National Seminar.
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