American Funds Distributor Fined for Directed Brokerage Violations
8.30.2006 The NASD fined American Funds Distributors, Inc. ("AFD") $5 million for violating the NASD's Anti-Reciprocal Rule by directing brokerage to broker-dealers firms that were the top sellers of American Funds mutual funds from 2001 through 2003. Over $98 million of directed brokerage commissions were paid by AFD's parent company, Capital Research and Management Company ("CRMC"), which is also the investment adviser to American Funds.
The Anti-Reciprocal Rule was intended to abolish "reciprocal business practices in connection with the distribution of mutual fund shares, i.e., the use of portfolio brokerage of mutual funds to reward broker-dealers for sales of mutual fund shares." In the administrative action, the NASD panel stated that AFD's use of brokerage commissions to reward top-selling firms was precisely what the rule was intended to proscribe.
The NASD found that AFD requested and arranged for CRMC to direct brokerage to its 50 leading retail broker-dealers and that AFD gave CRMC specific execution revenue targets for those broker-dealers. AFD’s request to direct brokerage was conditioned upon past sales of American Fund shares. The NASD panel was not persuaded by AFD’s argument that the obligations to direct brokerage was not binding. In the view of the NASD, the brokerage was the property of the American Funds and AFD had no authority to obligate the Funds to pay any commissions, much less specific amounts of directed brokerage to broker-delaers.
Please click http://www.nasd.com/PressRoom/NewsReleases/2006NewsReleases/NASDW_017294 to access a copy of the press release announcing the administrative action.
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Delaware Service Company Charged with Making Improper Distributions
8.30.2006 Section 19(a) of the Investment Company Act of 1940 makes it unlawful for an investment company to pay any dividend or make any distribution in the nature of a dividend payment, wholly or partly, from any source other than net income unless such payment is accompanied by a written statement which adequately discloses the source of such payment (a “19(a) notice”). Rule 19a-1 under the 1940 Act requires every such written statement to clearly indicate what portion of the payment per share is made from a list of enumerated sources, including “[p]aid-in surplus or other capital source.” Section 19(a) and Rule 19a-1 are intended to afford shareholders adequate disclosure of the sources from which dividend payments are made.
Delaware Service Company (“DSC”) provides accounting and administrative services to all open and closed-end registered investment companies in the Delaware Investments complex. DSC contracts directly with each fund in the complex and is paid for accounting and administrative services based on the funds’ average net assets.
Three closed-end funds (the “Funds”) administered by DSC had so-called “managed distribution policies.” These Funds’ annual reports stated that they would pay regular distributions at a specified annual rate. Each Fund was designed and managed to attract investors seeking a steady stream of income.
Two of the Funds made monthly distributions. Consequently, Section 19(a) required those Funds to estimate whether a particular month’s distribution was derived from a source other than net investment income as of the end of that month. The other Fund made quarterly distributions. Consequently, Section 19(a) required this Fund to estimate whether a particular quarter’s distribution was derived from a source other than net investment income as of the end of that quarter. Section 19(a) requires registered investment companies to identify the source of dividends paid from sources other than accumulated undistributed net income (or net income for the current or preceding fiscal year) determined in accordance with good accounting practice.
The SEC stated that from January 2000 through March 2004, the Funds paid a total of 98 dividends that included a return of shareholders’ capital. None of the distributions was accompanied by the required 19(a) notice. As a result of the conduct described above, the SEC found that DSC willfully aided and abetted and caused the Funds’ violations of Section 19(a) and Rule 19a-1.
In addition, on March 14, 2002, DSC sought an exemption from the SEC for two of the Funds to allow them to distribute long-term capital gains more than once a year. The exemption was granted, in part, on the basis of DSC’s representation in its application that it was providing the required 19(a) notices to shareholders of the Funds. That representation was an untrue statement of material fact in violation of Section 34(b) of the 1940 Act.
Please click http://www.sec.gov/litigation/admin/2006/ic-27473.pdf to access a copy of the administrative order.
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SEC Issues No-Action Letter Addressing Audits of Hedge Funds by Accountants that Provide Non-Audit Services to the Hedge Funds’ Adviser
8.28.2006 Rule 206(4)-2 under the Investment Advisers Act of 1940, the adviser custody rule, requires a hedge fund adviser to, among other things: (1) maintain client funds and securities with a qualified custodian; (2) provide certain information to clients concerning the arrangement with the qualified custodian; and (3) send (or have the qualified custodian send) account statements to clients on a quarterly basis. In lieu of distributing quarterly account statements, a hedge fund adviser may arrange for an annual audit of the hedge fund and distribute the audited financial statements to the hedge fund's investors within 120 days of the end of the hedge fund's fiscal year ("audit exception"). The audit exception specifically requires the accountant to be independent in accordance with the SEC's independence rules.
A number of hedge fund advisers were not registered with the SEC prior to January 1, 2005, but were required to register with the SEC under Section 203(a) of the Advisers Act because the SEC’s adoption of amendments to Rule 203(b)(3)-2 eliminated their ability to rely upon the "private adviser" registration exemption contained in Section 203(b) of the Act. On June 23, 2006, the U.S. Court of Appeals District of Columbia Circuit issued a decision that vacated the hedge fund adviser rule in Goldstein v. Securities and Exchange Commission, No. 04-1434 (D.C. Cir. June 23, 2006). Because of that ruling, the SEC felt it necessary to issue the no-action letter described below clarifying the application of the custody rule to these advisers.
In the letter, the SEC staff stated that an accountant would be independent for purposes of the custody rule even if it has performed certain non-audit services or had certain relationships with a hedge fund or its affiliates (including its adviser), provided:
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those services or relationships would not impair the accountant's independence under independence standards that were applicable to an audit of a hedge fund prior to registration by the adviser;
- those services or relationships prohibited by the SEC's independence rules cease no later than June 30, 2007; and
- the hedge fund discloses in the footnotes to its financial statements: (a) that the accountant was independent under independence standards that were applicable to an audit of a hedge fund prior to registration by the adviser, (b) that the accountant was not independent under the SEC's independence rules, (c) the general reasons why the accountant was not independent under the SEC's independence rules, and (d) a brief description of the relief and the duration of the relief granted by the staff.
Please click http://www.sec.gov/divisions/investment/noaction/2006/deloitte082806.htm to access a copy of the no-action letter.
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Prudential Equity Group Settles Market Timing Charges
8.28.2006 Prudential Equity Group, LLC, formerly known as Prudential Securities Inc. (“PSI”), settled charges related to a fraudulent market timing scheme perpetrated by PSI registered representatives (collectively, the “Representatives”) whose business involved market timing to defraud at least fifty mutual funds and their long-term shareholders.
The SEC alleged that the Representatives used deceptive trading practices to conceal their identities, and those of their customers, to evade mutual funds’ prospectus limitations on market timing. These practices included the use of multiple broker identifying numbers and multiple customer accounts; the use of accounts coded as confidential in PSI’s systems; and the Representatives’ use of “under the radar” trading to avoid notice by mutual funds. Typically, mutual funds screened for market timing trades only above a designated dollar amount. The practice of “under the radar” trading refers to the Representatives’ splitting of one trade into numerous smaller ones to avoid detection by mutual funds.
Several mutual fund companies identified the Representatives’ use of deceptive trading practices and notified PSI of the Representatives’ conduct. In May 2002, PSI itself determined that its top-producing registered representative used deceptive trading practices to avoid notice by mutual funds. The SEC stated that despite PSI’s increasing awareness of the Representatives’ fraudulent market timing practices, the firm elected to continue the business of market timing. In the SEC’s views, PSI’s policies and procedures were ineffective in curtailing the Representatives’ fraud and were largely not enforced.
The SEC also stated that PSI failed to make and keep required records concerning the Representatives’ trading practices. As a result of the conduct described above, PSI violated the antifraud and books and records provisions of the federal securities laws.
Please click http://www.sec.gov/litigation/admin/2006/34-54371.pdf to access a copy of the administrative action.
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Information About Advisers Now Available on the Internet
8.28.2006 The SEC posted a file containing information about investment advisers. This is a frequently requested document under FOIA, and it includes, in ASCII text, the SEC region name, SEC file numbers, names, addresses, telephone numbers, and disclosure information of investment advisers who are registered with the SEC.
Please click http://www.sec.gov/foia/docs/invafoia.htm to access a copy of the SEC release announcing the availability of this information.
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ICI Submitted Two Comment Letters Related to Fund Governance Rules
8.21.2006 The Investment Company Institute, the trade group for the mutual fund industry, submitted two comment letters to the SEC regarding the proposed independent chairman and 75% independent director rules.
In January 2004, the SEC proposed amendments to improve the governance standards of investment companies that provided for greater independence of fund boards. The rules were adopted in July of that year. Since that time, the U.S. Chamber of Commerce has twice challenged the governance rules in lawsuits: the first alleged that the SEC did not provide evidence supporting the need for the new governance rule; the second that the SEC did not adequately consider the costs of implementing the proposed rules. The U.S. Court of Appeals for the District of Columbia ruled in the Chamber's favor in both instances, remanding the rule back to the SEC for further consideration.
In its comment letter, the ICI said that it continues to believe that the choice of a chairperson should be left to the board’s independent directors. The ICI also stated that it supports a requirement that two-thirds of a board's members be independent, rather than the SEC’s 75 percent proposal. In its letter, the ICI discusses the costs involved in reaching and maintaining a supermajority of independent directors.
The ICI's Small Funds Committee also submitted a letter to the SEC, which focuses on the impact of the SEC's mandatory requirements on small fund complexes.
Please click http://www.ici.org/statements/cmltr/06_sec_gov_com.html#TopOfPage to access a copy of the general ICI letter.
Please click http://www.ici.org/statements/cmltr/06_sec_gov_small_com.html#TopOfPage to access a copy of the ICI Small Funds Committee letter.
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SEC No-Action Letter Issued Addressing Court Decision that Vacated SEC Hedge Fund Adviser Registration Rule
8.8.2006 The SEC issued a no-action letter addressing issues raised by the U.S. Court of Appeals for the D.C. Circuit in Goldstein v. SEC decision, which vacated SEC rule amendments to Rule 203(b)(3)-2 requiring most hedge fund advisers to register as investment advisers with the SEC.
The no-action letter announces that hedge fund advisers may withdraw their registrations if they do so by February 1, 2007, even if they temporarily held themselves out to the public as investment advisers or had more than fourteen clients.
When the SEC adopted the Rule 203(b)(3)-2 amendments, it also adopted an amendment to rule 204-2 that provided that the records of a hedge fund are records of the adviser (and thus subject to examination by the SEC staff). Even though the hedge fund adviser rule was vacated, the SEC reiterated that registered investment adviser must make records available for examination in accordance with section 204 of the Investment Advisers Act of 1940. It noted that an adviser may not evade this requirement by holding records by or through any other person, including a related person or hedge fund.
The no-action letter also addressed the grandfathering, transition and other miscellaneous relief necessitated by the vacating of the Rule 203(b)(3)-2 amendments. The purpose of the letter was to eliminate disincentives for voluntary registration, and enable hedge fund advisers who are already registered under the rule to remain registered. For example, the no-action letter allows registered advisers to continue to rely upon several exemptive rules that were adopted at the same time as the hedge fund rule amendments, including exemptions related to:
- Records supporting presentations of performance information;
- Performance-based fees; and
- Custody.
Please click http://www.sec.gov/divisions/investment/noaction/aba081006 to access a copy of the no-action letter.
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Foreign Adviser Located in the U.S. Is Not Required to Register with the SEC as an Adviser
8.7.2006 The CAAM-AI Group manages various funds of hedge funds, which invest in hedge funds managed by persons located in the United States and Europe, and one member of the CAAM-AI Group, CAAM-AI, Ltd., also manages one managed account program organized in Bermuda (the funds of hedge funds and managed account program, collectively, the “Funds”). None of the Funds is organized in the United States, and none of the Funds permits investments by persons residing in the United States or by any person defined as a “U.S. person” under Regulation S under the Securities Act of 1933.
CAAM-AI, Inc. provides advice only to three of its affiliates in the CAAM-AI Group and that advice relates only to the Funds. In particular, CAAM-AI, Inc. provides advice to CAAM-AI, Ltd., CA-AIPG Milan and CAAM-AI, SAS, which are investment managers located outside of the United States and are regulated by non-U.S. regulatory bodies having jurisdiction over their activities.
The incoming letter noted that the SEC staff in Gim-Seong Seow (Oct. 30, 1987) took the position that even if a US resident adviser provides investment advisory services exclusively to foreign clients, it is still required to register under the Advisers Act. The incoming letter argued that this position should not be taken with respect to CAAM-AI, Inc. for a variety of reasons, including that the affiliates were already subject to foreign regulatory schemes.
The SEC staff elected to grant no-action relief, but on different grounds. The SEC stated that Section 203A(a)(1) of the Investment Advisers Act of 1940 provides that: “No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser -- (A) has assets under management of notless than $25,000,000 . . .” “Assets under management” means “the securities portfolios with respect to which an investment adviser provides continuous and regular supervisory or management services.”
The staff noted that CAAM-AI, Ltd., CA-AIPG Milan and CAAM-AI, SAS, the foreign entities, had ultimate decision-making authority pursuant to their investment management contracts with the individual Funds. CAAM-AI, Inc., the U.S. entity, does not have the authority to decide which securities, i.e., interests in the underlying hedge funds, to purchase or sell for CAAM-AI Ltd., CA-AIPG Milan or CAAM-AI, SAS. Furthermore, CAAM-AI, Inc. is not responsible for arranging or effecting the purchase or sale of interests in the fund of hedge funds. CAAM-AI, Inc. also did not have the authority to decide which managers to hire or fire for the managed account program.
As a result of its limited role, it was the SEC staff’s view that CAAM-AI, Inc. did not have any “assets under management” for purposes of the SEC’s $25 million threshold because it did not exercise continuous and regular management services over assets managed by the foreign entities. Thus, it was not an investment adviser eligible to register with the SEC pursuant to Section 203A(a)(1) of the Investment Advisers Act of 1940. Such an adviser, however, could potentially have to register as such in a state.
Please click http://www.sec.gov/divisions/investment/noaction/2006/creditagricole080706.pdf to access a copy of the no-action letter.
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SEC Will Not Appeal Hedge Fund Adviser Registration Decision
8.7.2006 The SEC will not appeal the D.C. Circuit Court of Appeals' decision in Goldstein v. SEC that vacated the SEC's hedge fund adviser registration rule. In the SEC’s view, further appeal would be futile since the appellate court's decision was based on multiple grounds and was unanimous.
Thee SEC, however, is moving forward with an agenda of hedge fund rulemaking and staff guidance. Among the possible new proposals is a new anti-fraud rule under the Investment Advisers Act that would have the effect of “looking through” a hedge fund to its investors. The SEC is also considering whether it should increase the minimum asset and income requirements for individuals who invest in hedge funds.
Please click http://www.sec.gov/news/digest/2006/dig080806.txt to access the release announcing the SEC's decision.
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NASD To Offer a Compliance Boot Camp
8.7.2006 The NASD is offering a "Compliance Boot Camp," an intensive program on the fundamentals of securities regulation and compliance, designed for staff members who are new to compliance, or to the securities industry. While the boot camp is primarily designed for broker-dealer compliance professionals, many topics are also of interest to all types of investment management compliance professionals.
Study topics include:
- The role of the compliance professional
- Ethics
- Registration, qualifications and continuing education
- Regulatory filings and associated deadlines
- Preparing for a regulatory examination
- Handling customer complaints
- Suitability
- Anti-money laundering
- Advertising regulation
- Supervision
Please click http://www.nasd.com/EducationPrograms/ConferencesEvents/NASDW_017037 to access a copy of the release announcing the boot camp.
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SEC to Hire Outside Vendor to Study Roles of Investment Advisers and Broker-Dealers
8.1.2006 The SEC issued an RFP to conduct the first stage of a major study comparing how the different regulatory systems that apply to broker-dealers and investment advisers affect investors. Broker-dealers are regulated under the Securities and Exchange Act of 1934. Investment advisers are regulated under the Investment Advisers Act of 1940.
In 2005, the SEC adopted a rule that allows broker-dealers to offer fee-based brokerage accounts without being required to register with the SEC as investment advisers. The rule has become quite controversial, and has resulted in a lawsuit challenging the rule. In response to the numerous comment letters about the rule, the SEC felt it necessary to have a more in-depth understanding about the similarities and differences between the services offered by investment advisers and broker-dealers. One of the ways the SEC has elected to obtain this knowledge is by bringing in an outside contractor to gather information about these industries.
The contractor will:
- consult with the SEC's staff,
- collect and categorize, empirical data from a wide variety of sources, and
- analyze this data.
The information studied will include marketing, sales, and delivery data about financial products, accounts, programs and services offered by broker-dealers and investment advisers to individual investors. Under the RFP, the contractor will summarize and evaluate the data for the SEC's use in assessing the current legal and regulatory environment.
Please click http://www.sec.gov/rules/final/34-51523.pdf to access the release for the SEC rule leading to the study.
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Court Issues Motion Causing Plaintiffs to Drop Mutual Fund Excessive Fee Case
8.2006 In a mutual fund fee case, the U.S. District Court for the Western District of Missouri granted a motion in July, 2006 that was filed by the investment adviser to the American Century Funds preventing plaintiffs from introducing evidence that the level of management fees paid by pension funds and other institutional clients to the adviser was lower than the fees paid by the mutual fund. The court stated that such evidence had no bearing on whether the American Century mutual funds paid excessive management fees. Specifically, the court stated that such information "is irrelevant to Plaintiffs’ claims involving mutual fund fees under Section 36(b) of the Investment Company Act." After the granting of the motion, the plaintiffs dropped their suit against the adviser.
The case is one of many cases where plaintiffs have alleged that mutual fund fees are "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining," the standard developed in the Gartenberg v. Merrill Lynch Asset Management case. This standard is used by courts to determine whether a fund adviser has breached its fiduciary duty with respect to the receipt of compensation by the fund.
The ruling is significant, especially in light of the SEC’s disclosure rule that requires mutual funds to disclose whether or not their boards considered information about other, non-fund management fees, when deliberating about the level of the fund manager’s fees.
Please click http://lawfuel.com/show-release.asp?ID=7174 for a press release about the motion.
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