Proposed Hedge Fund Rules
11.30.2006 The SEC announced that it would hold an open meeting on December 13, 2006, to consider two new hedge fund rules. The proposals are:
- a new rule under the Investment Advisers Act of 1940 to prohibit advisers from making false or misleading statements to investors in hedge funds; and
- a new rule under the Securities Act of 1933 to revise the criteria for natural persons to be considered "accredited investors" for purposes of investing in certain privately offered investment vehicles.
Please click http://www.sec.gov/news/openmeetings/2006/ssamtg121306.htm to access a copy of the SEC announcement.
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NYSE and NASD to Merge Regulatory Units
11.29.2006 The NASD and New York Stock Exchange announced that they would merge their regulatory units. The merged self-regulatory organization ("SRO") will be responsible for:
- Broker-dealer examinations;
- Enforcement; and
- Arbitration and mediation functions.
It will also be responsible for regulating the following markets:
- Nasdaq;
- American Stock Exchange;
- International Stock Exchange;
- Chicago Climate Exchange; and
- OTC Bulletin Board.
The New York Stock Exchange will continue to self-regulate its own market, but not broker-dealers.
The new SRO will have a 23-person board of governors, with 11 seats held by public governors.
Please click http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017973 to access a copy of the press release announcing the merged SRO.
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Adviser Aided and Abetted Mutual Fund's Violation of Borrowing and Concentration Policies
11.29.2006 Houston-based investment adviser FCA Corp ("FCA") and its president Robert W. Scharar settled charges with the SEC, which alleged that they aided and abetted and caused violations of Section 13(a) of the Investment Company Act of 1940 by borrowing money contrary to the recitals of policy contained in the registration statements of the Commonwealth International Series Trust ("Commonwealth"), a registered investment company. The SEC also found that FCA and Scharar violated Section 34(b) of the 1940 Act by making materially misleading statements regarding borrowing in Commonwealth's SEC filings. From late 2002 through 2004, two of the Commonwealth Funds, the Australia/New Zealand Fund ("ANZ Fund") and the Japan Fund, suffered extraordinary levels of "market-timing" activity. FCA and Scharar caused the Commonwealth Funds to obtain a line of credit and permitted the ANZ Fund and the Japan Fund to borrow more often, and in greater amounts, than allowed by investment restrictions contained in the Funds' registration statements. The improper borrowing caused the ANZ Fund and the Japan Fund to incur additional interest costs in the amounts of $11,875 and $5,531, respectively, which FCA has since repaid to the Funds plus interest.
Please click http://www.sec.gov/litigation/admin/2006/ia-2569.pdf to access a copy of the administrative order.
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Federated Funds Obtain No-Action Relief Under Rule 17a-7
11.15.2006 Section 17(a) of the Investment Company Act of 1940 prohibits any affiliated person of a mutual fund, or any affiliated person of such a person, from selling securities to, or purchasing securities from, the fund. Rule 17a-7 generally exempts from the prohibitions of Section 17(a) certain purchases and sales of securities between funds that are affiliated solely by reason of having a common investment adviser ("17a-7 transactions"). As relevant here, Rule 17a-7 requires that:
- the 17a-7 transactions involve securities for which market quotations are readily available;
- the 17a-7 transactions are effected at the independent current market prices of the securities; and
- the "current market price" for certain securities (such as municipal securities) is calculated by averaging the highest and lowest current independent bid and offer price determined on the basis of a reasonable inquiry.
In United Municipal Bond Fund (pub. avail. Jan. 27, 1995) (the "1995 letter"), the SEC agreed not to recommend enforcement action to the SEC under Section 17(a) of the 1940 Act against certain affiliated funds if they engaged in 17a-7 transactions involving municipal securities for which market quotations were not readily available. In the 1995 letter, the prices of the municipal securities that were to be used in the 17a-7 transactions were the same as the prices that were to be used to determine the funds' net asset values per share ("NAV"), consistent with Section 2(a)(41) of the 1940 Act and Rule 2a 4 thereunder. These prices were provided by Muller Data Corporation, now operating as FT Interactive Data ("FTID"), an independent pricing service.
In the no-action letter granted to the Federated Municipal Funds, the SEC extended the no-action position in the 1995 letter to permit certain affiliated funds advised by Federated Investment Management Company (and other commonly controlled investment advisers) that invest primarily in municipal bonds (the "Municipal Funds") to use Standard & Poor's Securities Evaluations, Inc. ("SPSE"), an independent pricing service, rather than FTID, as its independent pricing service and engage in 17a-7 transactions under substantially similar circumstances.
In the no-action letter, the SEC noted that before causing funds that it manages to enter into 17a-7 transactions, an investment adviser should carefully consider, among other things, its duty to seek best execution for each fund and its duty of loyalty to each fund. In particular, the investment adviser to the fund seeking to sell securities in a 17a-7 transaction should ensure that the selling fund's total proceeds are the most favorable under the circumstances. The investment adviser also should ensure that the buying fund's total cost is the most favorable under the circumstances. If the adviser to the selling fund can obtain greater proceeds for that fund by selling the security in the market, rather than by selling it to the other fund in a 17a-7 transaction, the adviser should sell the security in the market. The same principle applies to the buying fund's participation in a 17a-7 transaction.
In addition, consistent with an investment adviser's duty of loyalty, the SEC believes that an investment adviser should not cause funds to enter into a 17a-7 transaction unless doing so would be in the best interests of each fund participating in the transaction. Thus, for instance, the buying fund should not participate in a 17a-7 transaction that benefits only the selling fund; if the buying fund were to participate in such a transaction, it may forgo an opportunity to make a better investment in a different security.
Please click http://www.sec.gov/divisions/investment/noaction/2006/fmf112006.htm to access a copy of the no-action letter.
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SEC General Counsel Speaks at Mutual Fund Directors Conference
11.15.2006 Brian Cartwright, the General Counsel of the SEC, spoke about how investment company directors can be more effective at the 2006 Investment Company Directors' Conference in Washington, D.C.
First, a director must make the commitment to spend the extra time it takes to stay on top of regulatory developments, learn about recent industry innovations and engage in a dialogue with his or her fellow independent directors from other fund complexes. An effective director arrives at board meetings well-prepared, having taken the time to thoroughly review the board materials in advance. The director comes armed with insightful questions. He or she closely follows developments with the funds he or she oversees. The effective director engages in an on-going dialogue with fund management, fund counsel and your fellow directors to keep abreast of compliance issues and business developments.
Second, directors must be vigilant. A vigilant director has a healthy degree of skepticism, stays alert, spots negative trends, and follows up with management on outstanding issues.
Third, an effective director knows there's a line between productively probing and challenging and being needlessly aggressive. To be effective, independent directors must work together with management and affiliated directors as a team. One strong personality should not dominate board discussions.
An effective independent director must be independent beyond the technical sense that qualifies a person as independent for purposes of the Investment Company Act of 1940.
Cartwright noted that even the advantages of commitment, vigilance and independence can be blunted by inadequate board process and procedure. The SEC's General Counsel stated that careful consideration paid to the "mechanics" of board meetings - schedules, agendas and board materials - can significantly improve board effectiveness.
Board members should work with management to make sure the board is receiving the kinds of information it needs, in a form it can use, starting with the board materials that arrive before the meeting. The board should insist that the written materials provided to the board be of high quality, relevant and appropriately concise. The nature of the agenda and the way the meeting is organized also can facilitate or hinder effectiveness.
Please click http://www.sec.gov/news/speech/2006/spch101906lar.htm to access a copy of the speech.
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SEC Provides Investors New Online Search Capabilities
11.14.2006 The SEC announced that it has enhanced its EDGAR computer database system to allow investors to search the contents of the disclosure documents filed electronically with the SEC using a new full-text search tool on the SEC's website. The newly searchable information includes registration statements, annual and quarterly reports, and other filings by companies and mutual funds filed during the past four years on the SEC's EDGAR database. The new search capability is designed to liberate investors, researchers, and analysts from the more time-consuming and less reliable chore of accessing information in public filings one by one.
Each year 15 to 18 million pages of filings are submitted to the SEC by more than 15,000 public companies and other filers via the EDGAR system. The EDGAR full-text search allows users to enter a keyword or conceptual search query and retrieve a list of related filings.
Searchers may also make use of "Boolean operators" and "wildcard" capabilities.
A full text search of a filing includes all data in the filing as well as any attachments. Other features of the EDGAR Full-Text Search tool include:
- Search by specific filing type;
- Search by company name;
- Search by Central Index Key ("CIK") code;
- Search by industry or Standard Industrial Classification ("SIC") code; and
- Search results limited by date range.
The EDGAR full-text search tool is available on the SEC website at "http://searchwww.sec.gov/EDGARFSClient/jsp/EDGAR_MainAccess.jsp">http://searchwww.sec.gov/EDGARFSClient/jsp/EDGAR_MainAccess.jsp.
Please click http://www.sec.gov/news/digest/2006/dig111406.txt to access the announcement about the new search tool.
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Broker-Dealer Sanctioned for Unsuitable 529 Plan Sales
11.14.2006 1st Global Capital Corp. ("1st Global") settled charges brought by the SEC, which had alleged that the firm violated certain Municipal Securities Rulemaking Board ("MSRB") rules in connection with its offer and sale of investments in tax-advantaged qualified tuition savings plans, commonly known as Section 529 College Savings Plans ("529 Plans"). 1st Global is a broker-dealer, with its principal offices in Dallas, Texas. 1st Global has a network of over 1,200 registered representatives ("RRs") located throughout the country. The vast majority of 1st Global's RRs are certified public accountants or tax accountants.
The SEC alleged that 1st Global recommended and sold investments in particular classes of 529 Plan units without necessarily having reasonable grounds to believe that its recommendations were suitable, based upon 529 Plan fee structures and customer needs and objectives. The SEC also alleged that 1st Global failed to deal fairly with its customers in connection with sales of 529 Plan unit investments. As a result, 1st Global, according to the SEC, willfully violated MSRB Rules G-17 and G-19, and Section 15B(c)(1) of the Securities Exchange Act of 1934, by making unsuitable recommendations in connection with the offer and sale of 529 Plan investments.
Typically, units of 529 Plans are denominated as Class A which charge a front-end load, while other classes, such as Class B and Class C, have different sales charge and expense characteristics. The SEC staff analyzed 101 accounts (from over 4,000 529 Plan accounts). In 69 of the accounts analyzed, 1st Global RRs failed to recommend the lowest-cost class of units that 1st Global offered of the particular fund in the customer's 529 Plan. The difference between the value of the class of units purchased and the value of the lowest-cost unit class available, at the end of the expected holding period, ranged from less than 1% to over 10%. In 33 of the 69 accounts analyzed, the SEC found that additional cost to investors (including foregone earnings) equaled or exceeded 5% of the amount of the original investment (assuming 10% growth).
In some instances, the SEC found that 1st Global sold classes of units other than the lowest-cost unit class part because 1st Global failed to evaluate adequately the substantial effect of an anticipated lengthy holding period on comparative unit class costs, particularly for small investments. For example, one 1st Global customer invested $11,000 each for five-month-old twins in Class C units of a popular 529 Plan investment. If he had purchased Class A units in the same investment, his investment for each child would be worth an estimated $4,100, or 9%, more than the value of Class C units when the children reach college age, or over 37% of the original investment amount (based on 10% earnings growth assumptions). Similarly, another customer invested $6,000 each for two-and-a-half-year-old triplets in Class B units of a different Alliance College Bound Fund mutual fund. Had this customer purchased Class A units in the same investment, each child's account would have been worth almost $400, or 1.75%, more than the value of Class B units when the children reach college age, or over 6.3% of the original investment amount. A third customer invested $4,000 for a 19-month-old in Class C units of a different 529 Plan. If this customer had purchased Class A units in the same investment instead, it would be worth an estimated $1,200, or almost 9%, more than the value of Class C units when the child reaches college age, or over 29% of the original investment amount. Such differences in performance may be significant, particularly to parents with limited resources.
Please click http://www.sec.gov/litigation/admin/2006/34-54754.pdf to access a copy of the administrative order.
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Hartford Settles Directed Brokerage Case
11.8.2006 Hartford Investment Financial Services, LLC ("Hartford Investment"), HL Investment Advisors, LLC ("HL Advisors") and Hartford Securities Distribution Company, Inc. ("Hartford Distribution") settled charges with the SEC that the group had made material misrepresentations and omitted to state material facts to shareholders of various Hartford Funds and the Boards of Directors of those Funds relating to their use of $51 million of Fund assets in the form of directed brokerage commissions to satisfy financial obligations to certain broker-dealers for the marketing and distribution of the Funds.
The SEC alleged that Hartford Investment and Hartford Distribution typically agreed to remunerate broker-dealers for the special marketing and distribution benefits based on either a specific percentage of gross sales of the Hartford Funds or the value of Hartford Fund shares held by the broker-dealers' customers for more than one year ("aged assets"), or, in some cases, both. The special marketing and distribution benefits that Hartford Investment, HL Advisors and Hartford Distribution received were referred to as "shelf space" and included:
- inclusion of the Funds on the broker-dealers' "preferred list" of mutual funds;
- participation in the broker-dealers' national and regional conferences that were held to educate and train registered representatives regarding the Hartford Funds;
- access to the broker-dealers' sales force;
- links to Hartford's website from the broker-dealers' websites; and
- articles in the broker-dealers' publications highlighting new products and services.
According to the SEC, Hartford Investment and HL Advisors made some disclosure of shelf space payments, but misrepresented that the shelf space was not paid for by shareholders. Specifically, Hartford Investment disclosed in its Funds' prospectuses that:
ADDITIONAL COMPENSATION TO BROKERS: In addition to the commissions described above, the distributor pays additional compensation to dealers based on a number of factors described in the fund's statement of additional information. This additional compensation is not paid by you.
Similarly, the Funds' SAI, according to the SEC, misrepresented that shareholders do not pay for shelf space. Specifically, the SAIs represented that Hartford Investment, Hartford Distribution and their affiliates pay, "out of their own assets," compensation to brokers-dealers for shelf space.
Contrary to those representations, the SEC found that Hartford Investment and Hartford Distribution often used the brokerage commissions generated by the Funds' portfolio transactions, which are assets of the Funds and their shareholders, to meet their financial obligations under the shelf space arrangements.
The SEC also found that Hartford Investment and HL Advisors used directed brokerage to meet Hartford Investment and Hartford Distribution's obligations under the shelf space arrangements. Had these obligations been satisfied with cash payments, those cash payments would have come from Hartford Life and its affiliates' assets. In order to reduce Hartford Life and its affiliates' expenses, officers of Hartford Investment and Hartford Distribution instructed their staff that it was their preference to satisfy the financial obligations under the shelf space arrangements by directing brokerage commissions to broker-dealers rather than paying in cash.
The SEC also found several other violations, including failure to disclose to the Funds' board of directors the nature of these arrangements, failure to follow directed brokerage procedures and failure to accurately disclose the directed brokerage arrangement in the SAI.
Please click http://www.sec.gov/litigation/admin/2006/33-8750.pdf to access a copy of adminstrative order.
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SEC Freezes Assets of a San Francisco Hedge Fund Manager
11.8.2006 The SEC filed fraud charges against Edward Ehee, the head of several San Francisco-based hedge funds, and two investment advisers he controls, accusing them of misappropriating millions of dollars from investors nationwide. The federal district court in San Francisco also issued an order freezing the assets of Ehee, the two firms, and the hedge funds, as well as three family members who received investor money. According to the SEC, Ehee told investors he would place their money into hedge funds and invest the assets of the hedge funds consistent with various trading strategies. In fact, Ehee, according to the SEC, obtained significant sums long after he had closed one fund's brokerage accounts and ceased any investment activity. Ehee converted fund money to personal use and used money raised from new investors to pay off previous investors. He provided investors with false account statements showing their money was safe and generating positive returns. He also provided one investor with fabricated financial statements and audit reports from an accounting firm that had never actually audited the fund.
Please click http://www.sec.gov/litigation/complaints/2006/comp19905.pdf to access a copy of the administrative order.
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Former PIMCO Equity Funds Chairman Barred from the Advisory Industry
11.8.2006 The SEC barred Stephen J. Treadway, the former top executive of the PIMCO equity mutual funds, from associating with any investment adviser, with a right to reapply after one year. The SEC order was based on the entry of a federal court injunction, all of which was part of Treadway's settlement to resolve the SEC's charges against him for approving an undisclosed market timing arrangement. In June 2006, a federal court jury in the SEC's fraud action found Treadway liable for committing securities fraud, breaching his fiduciary duty, and other violations of the federal securities laws.
During the period of his misconduct, Treadway was the CEO of PIMCO Advisors Fund Management LLC, a registered investment adviser; the CEO of PIMCO Advisors Distributors LLC, a registered broker-dealer; and the chairman of the board of trustees of the PIMCO Funds: Multi-Manager Series.
The SEC's complaint, filed in May 2004, alleged that Treadway defrauded investors by approving, but not disclosing, a market timing arrangement that allowed Canary Capital Partners LLC to market time certain of the PIMCO equity funds. Treadway approved this trading arrangement in approximately January 2002, before Canary's trading started, and despite knowing that the disclosures in the funds' prospectus represented to investors that the funds discouraged and restricted market timing. Treadway did not disclose his knowledge of the Canary market timing deal to the board of trustees until approximately September 2003, when Canary's trading activities were being investigated by government authorities. From February 2002 through April 2003, Canary engaged in over 100 round-trip transactions in the aggregate amount of over $4 billion in several PIMCO mutual funds pursuant to the special market timing arrangement that Treadway approved.
Please click http://www.sec.gov/litigation/admin/2006/ia-2566.pdf to access a copy of the administrative order.
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State Street Receives ETF Exemptive Order
11.1.2006 SSgA Funds Management, Inc. ("State Street") and exchange-traded funds ("ETFs") advised by State Street received a notice of a proposed exemptive order to permit open-end management investment companies (mutual funds) and unit investment trusts to acquire shares of State Street ETFs. The order also amends a prior order to permit:
- dealers to sell shares of certain ETFs to purchasers in the secondary market unaccompanied by a prospectus when prospectus delivery is not required by the Securities Act of 1933;
- under certain circumstances, ETFs that track certain foreign equity securities indexes to pay redemption proceeds more than seven days after the tender of shares in large aggregations for redemption; and
- additional ETFs that track certain foreign equity securities indexes to rely on the prior order.
The fund-of-fund relief allows mutual funds unaffiliated with State Street ETFs to invest in such ETFs at higher levels than ordinarily permitted in fund-of-fund arrangements. This allows the State Street ETFs to be competitive with a number of other sponsors of ETFs that have received similar exemptive relief.
Please click http://www.sec.gov/news/digest/2006/dig110306.txt to access a copy of the notice of the exemptive relief.
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Connecticut Enforcement Unit Focuses on Hedge Funds
10.1.2006 The Connecticut Department of Banking has set up a new enforcement unit that will investigate hedge funds. According to some sources, Connecticut has the second most hedge fund advisers of any state. Established approximately six months ago, the hedge fund unit investigates short sales, fails to deliver, manipulation, tainted research, and other hedge fund issues.
The hedge fund unit has five enforcement personnel and two examination staff. The group does not do examinations and is different from the task force set up by Connecticut's attorney general. That reviews issues related to hedge funds but does not have the authority to investigate them.
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