Commissioner Atkins and IM Director Donohue Speak at Independent Directors Conference
11.28.2007 SEC Commissioner Paul Atkins and Division of Investment Management Director Buddy Donohue spoke at a conference in San Francisco for independent mutual fund directors sponsored by the Independent Directors Council (IDC).
Mr. Atkins spoke about the recently proposed mutual fund disclosure reform. The proposal would require the inclusion of single-fund summaries at the beginning of fund prospectuses and permits the distribution of a Summary Prospectus in lieu of the statutory prospectus. The statutory prospectus, SAI and shareholder reports would be online so that investors could access more information about matters in which they are interested. They would also be available in paper to anyone who asked.
He noted the SEC's tendency over the years with the prospectus has been to pile additional disclosures into it, to require that funds disclose more and more. The result has been a "hulking" prospectus that is daunting to the average lawyer, let alone to the average investor. According to a recent Investment Company Institute ("ICI") survey, less than 40% of investors look to a prospectus as a source of information prior to purchasing a mutual fund.
With respect to independent directors, he stated that they now make up three quarters of nearly 90% of fund boards according to your newly released survey, and 100% of the membership of certain board committees such as valuation, audit, nomination, and so forth. Mr. Atkins stated that directors' list of duties is longer than ever as the SEC relies more heavily on them than ever before. The net result is significant responsibility for independent directors. As a consequence, independent directors are devoting more time to their board obligations. According to the results of an ICI/IDC survey, one third of fund complexes surveyed annually held five or more regularly scheduled meetings during 2006. Only 18% held that many meetings ten years earlier. Regular meetings are often supplemented by other meetings to address matters that may come up in between the regular meetings.
He stated that valuation is one area in which SEC guidance is needed. Recent events in the markets have heightened attention on valuation. According to Mr. Atkins, it is time that the SEC undertake a more formal process of addressing this issue.
He also spoke about Rule 12b-1, class action litigation and Sarbanes-Oxley Act Section 404. IM Director Buddy Donohue spoke at the same conference. He began his speech with a discussion about the Director Outreach Initiative. The goal of the initiative is to answer a simple but important question, namely: What can or should the SEC do in order to aid fund directors in the performance of their duties' Rather than guess how fund directors would respond to this question, he believes it is critical to obtain direct input from directors themselves so that the Division of Investment Management can make informed recommendations for the SEC's consideration.
In 2007, he met with thirteen mutual fund boards and he will meet with seven more this year. He stated that fund directors can add value for shareholders with respect to the fair valuation of portfolio securities. He added that the events of this past summer involving the sub-prime market underscore the importance of the role of directors as outlined in the statutory requirement to fair value in Section 2(a) of the 1940 Act. He reminded the audience that the SEC in 2003 adopted its rule requiring compliance programs for investment companies and advisers, and elaborated on four important fair value requirements:
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Funds must adopt policies and procedures that monitor for circumstances that may necessitate the use of fair value prices.
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They must establish criteria for determining when market quotations are no longer reliable for a particular portfolio security.
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Funds must provide one or more methodologies for determining the current fair value of a security.
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Funds must regularly review the appropriateness and accuracy of their valuation methodologies and make any necessary adjustments.
He stated that directors should ask a fund manager about the liquidity, or more importantly, the illiquidity of securities in the fund. Key attributes of investment companies, especially open-ended companies, are accurate determinations of net asset value and maintenance of the liquidity that investors rely on. Mr. Donahue stated that if an adviser is having difficulty pricing a security or if securities pose liquidity challenges, query whether those securities belong in a mutual fund.
Director Donohue next updated the audience about the proposed reforms of Rule 12b-1. The SEC solicited public comment on Rule 12b-1 and received more than 1450 comment letters (including a letter from the IDC). Approximately 1000 of these letters are form letters that were sent by financial planners and registered representatives who oppose substantive reform of Rule 12b-1. An additional 400 or so individualized letters were sent in by financial planners, the majority of whom also oppose substantive rule reform. The SEC received approximately 25 letters from mutual funds, large broker-dealers, insurance companies, industry associations and counsels. The majority of these letters also oppose significant rule reform, but riddled throughout are various levels of support for changing the name of the fee, requiring additional disclosure and revising the role of the fund board in approving the distribution plan. Finally, the SEC received approximately 10 letters from investors most of whom support substantive reform or repeal of the rule. He stated that the staff is currently evaluating the many comments we received. Once that process is complete, the staff will formulate a recommendation to the full Commission. Mr. Donohue also spoke about soft dollars and chief compliance officers.
Please click http://www.sec.gov/news/speech/2007/spch112807ajd.htm for a copy of his speech.
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Action Involving Seniors Brought Agasint Hedge Fund
11.26.2007 The SEC obtained a temporary restraining order from a court against Alex Rabinovich, Rabinovich & Associates, LP, a hedge fund managed by Rabinovich, and Joseph Lovaglio.
The SEC alleged that the firm operating out of a storefront boiler room in Brooklyn, New York have been selling limited partnership interests in the hedge fund and other securities to
investors, including senior citizens and retirees. The SEC further alleged that the firm obtained investments in the hedge fund by cold-calling and have made, and are continuing to make, fraudulent statements to investors and prospective investors in the hedge fund, including: (1) false claims that the hedge fund has been extraordinarily profitable whereas the hedge fund's actual performance has been dismal; and (2) false representations that the firm is a Wall Street firm and a member of the NASD, the New York Stock Exchange, and the Securities Investor Protection Corporation. Also, the firm allegedly has failed to disclose to investors that Rabinovich has been barred by the NASD from associating with any broker or dealer and that there is a pending action by the Financial Industry Regulatory Authority, Inc. (FINRA) seeking to bar Lovaglio from associating with any broker or dealer.
According to the SEC, the firm has raised at least $550,000 from at least twenty-three investors and have lost most of that money, even while providing investors with quarterly account statements that reflect large gains and "dividends" in every period. The SEC further charges that investors are located across the country and the firm targets senior citizens and unsophisticated investors -- at least eleven of the Fund's investors are allegedly sixty years old or older, including three who are in their seventies and three who are in their eighties.
Finally, the SEC charged certain principals of the firm with defrauding investors and prospective investors, unlawfully operating as unregistered broker-dealers and offering and selling securities in an unregistered offering.
Please click http://www.sec.gov/litigation/litreleases/2007/lr20372.htm to access the administrative order.
Please click
http://www.sec.gov/news/speech/2007/spch101907ajd.htm for a copy of his speech.
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Enhanced Disclosure and New Prospectus Delivery Option for Mutual Funds
11.16.2007 The SEC proposed amendments to disclosure rules that would require that all mutual fund investors receive a clear, concise summary of key information needed to make an informed investment decision. The rule changes would also encourage funds to harness the power of the Internet to allow investors to choose the format in which they receive more detailed information and to provide that information in a more user-friendly format than is available today.
The proposed rules include the following.
- Summary Information at the Front of the Prospectus. The proposal would amend Form N-1A, the form used by mutual funds to register under the Investment Company Act of 1940 and to offer securities under the Securities Act of 1933, by requiring every mutual fund to include key information in plain English in a standardized order at the front of the mutual fund statutory prospectus. Like the risk/return summary that is currently included at the front of every mutual fund prospectus, this summary would include a fund's investment objectives and strategies, risks, and costs. It also would include brief information regarding top ten portfolio holdings, investment advisers and portfolio managers, purchase and sale procedures and tax consequences, and financial intermediary compensation. The proposed amendments would require that the summary information be presented separately for each fund covered by a multiple fund prospectus. This requirement is intended to assist investors in finding important information regarding the particular fund in which they are interested.
- New Prospectus Delivery Option for Mutual Fund Securities. The proposed rule would permit a person to satisfy its mutual fund prospectus delivery obligations under the securities laws by sending or giving key information to investors in the form of a "summary prospectus" and providing the summary prospectus, statutory prospectus, shareholder reports, and other information on an Internet Web site in a format that enhances investors' ability to effectively use the more detailed information in those documents. In addition, the statutory prospectus and other information would be provided in paper to any investor who prefers to review more detailed information in that format. The summary prospectus would contain the same information in the same order as the required summary at the front of the statutory prospectus.
The proposed rule would require that the Internet version of the summary prospectus and statutory prospectus be presented in a user-friendly format that permits investors, financial intermediaries, analysts, and other users to move readily back and forth between related information in the summary prospectus and the statutory prospectus. This is intended to allow investors and others to efficiently access the particular information in which they are interested. The proposed rule would also require that persons accessing the Internet information be able to permanently retain an electronic version of the summary prospectus, statutory prospectus, and other information. The proposal is intended to take advantage of technological developments and the expanded use of the Internet in order to provide investors with information that is easier to use and more readily accessible, while retaining the comprehensive quality of the information that is available to investors today
Please click http://www.sec.gov/rules/proposed/2007/33-8861.pdf to access a copy of the proposed rule.
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No-Action Letter Issued Allowing Certain Affiliated Transactions
11.16.2007 The staff of the SEC issued a no-action letter to Old Mutual Advisor Funds ("OMAF I") and Old Mutual Advisor Funds II ("OMAF II") allowing certain portfolios of OMAF I to sell their portfolio securities and other assets to certain portfolios of OMAF I and OMAF II in exchange for shares of those portfolios. Such sales would otherwise be prohibited by Section 17(a) of the Investment Company Act of 1940, as amended (the "1940 Act").
Seven portfolios of OMAF I are asset allocation portfolios (the "Asset Allocation Portfolios"), each of which allocates its assets to various "sleeves." Each sleeve is managed by one of 12 affiliated subadvisers. Old Mutual Capital, Inc. ("OMCAP"), the adviser to OMAF I and OMAF II, with the assistance of an unaffiliated subadviser, Ibbotson Associate Advisors, LLC ("Ibbotson"), serves as "manager of managers" to each Asset Allocation Portfolio and allocates and rebalances the assets within each of these sleeves based on the sleeves' investment styles.
Each sleeve is effectively treated as a separate portfolio with segregated assets that track its cash separately, although cash currently is swept into a common money market sweep vehicle. The portfolio securities in each sleeve are segregated on the books of the custodian, the fund accounting agent and the sub-administrator, including to the extent that one subadviser manages more than one sleeve for an Asset Allocation Portfolio.
OMAF I sought no-action relief to restructure the management of the Asset Allocation Portfolios into a fund-of-funds structure in reliance on section 12(d)(1)(G) of the 1940 Act, so that each Asset Allocation Portfolio would invest directly in other funds of OMAF I and OMAF II that have substantially similar mandates to the sleeves currently utilized under the manager-of-managers structure ("Target Portfolios"). Specifically, the investment objectives and policies of each Target Portfolio would be substantially similar to the mandate of its corresponding sleeve in the Asset Allocation Portfolios, and that each Target Portfolio would be managed in a substantially similar manner as each corresponding sleeve. The purpose of the restructuring was to allow the Asset Allocation Portfolios to save proxy solicitation costs associated with selecting new subadvisers or investment sleeves, to timely add investment options, and to increase the diversification of assets.
OMCAP proposed to effect such a restructuring by having each Asset Allocation Portfolio deliver assets, excluding cash, of a particular sleeve in kind (the "in-kind consideration") to acquire shares of its corresponding Target Portfolios (the "in-kind purchases").
The Asset Allocation Portfolios and the Target Portfolios (together, the "Participating Funds") would engage in an in-kind purchase under the following circumstances:
1. An in-kind purchase will not dilute the interests of the shareholders of either Participating Fund;
2. The in-kind consideration accepted by a Target Portfolio will consist of assets that are appropriate, in type and amount, for investment by the Target Portfolio in light of its investment objectives and policies, and current holdings;
3. Each sleeve of each Asset Allocation Portfolio will transfer all of its assets in consideration for the purchase of shares of one corresponding Target Portfolio(s);
4. An Asset Allocation Portfolio and its corresponding Target Portfolio has the same policies and procedures for determining their net asset values, and will follow those policies and procedures in determining the amount of Target Portfolio shares to sell to an Asset Allocation Portfolio. An Asset Allocation Portfolio and its corresponding Target Portfolio will ascribe the same value to the in-kind consideration;
5. The transfer of the in-kind consideration from an Asset Allocation Portfolio will be effected simultaneously with the transfer of the shares from the Target Portfolios;
6. The Participating Funds will effect the in-kind purchases pursuant to procedures adopted by the Board on behalf of each Participating Fund, including a majority of the Independent Trustees, that are reasonably designed to provide that the purchases in-kind are effected in a manner consistent with (1) through (5) above;
7. Within the seven days following the 40-day period immediately after completion of the in-kind purchases, the Board, including a majority of Independent Trustees, on behalf of each Participating Fund, will determine that all of the in-kind purchases involving the Participating Funds:
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were effected in accordance with these procedures;
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did not favor an Asset Allocation Portfolio to the detriment of any other shareholder of the corresponding Target Portfolio or favor the Target Portfolio to the detriment of the Asset Allocation Portfolio; and
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were in the best interests of each Participating Fund.
8. OMAF I and OMAF II will maintain and preserve certain records about the transaction for a period of not less than six years from the end of the fiscal year in which the purchase occurred.
The proposed restructuring is similar to the in-kind purchase transactions described in Gartmore Variable Insurance Trust (pub. avail. Dec. 29, 2006) (the "Gartmore Letter"). The Gartmore Letter provided no-action assurances under section 17(a) of the 1940 Act in connection with in-kind purchase transactions between certain funds and their affiliated funds. The consideration involved in the in-kind purchase transactions in the Gartmore Letter came entirely from simultaneous in-kind redemption transactions. Unlike the arrangement in the Gartmore Letter, the facts in this no-action letter do not involve a simultaneous in-kind redemption.
OMCAP successfully argued that no Asset Allocation Portfolio (or its affiliate) would overreach a Target Portfolio by causing the Target Portfolio to accept unwanted portfolio securities as in-kind consideration because, pursuant to the Proposed Representations, the in-kind consideration would be consistent with each Target Portfolio's investment objectives, policies, and current holdings. OMCAP further argued that the ability of an Asset Allocation Portfolio (or its affiliate) to overreach a Target Portfolio in this manner is limited because each sleeve of each Asset Allocation Portfolio will transfer all of its assets to its corresponding Target Portfolio, which has investment objectives and policies that are substantially similar to the mandate of the sleeve, and is managed in a substantially similar manner as the sleeve.
Please click http://www.sec.gov/divisions/investment/noaction/2007/oldmutual111607-17a.pdf for a copy of the no-action letter.
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OCIE Director Announces Forensic Testing
11.14.2007 After providing a brief background on the CCOutreach program, Director Lori Richards stated that CCOs have requested more information about "forensic" testing. She stated that information about forensic testing is now posted on the SEC's website at www.sec.gov/info/ccoutreach.htm. The posting, according to Ms. Richards, answers the basic question -- "what the heck is 'forensic testing' anyway?" It summarizes some of the forensic tests that can be used in the key compliance control areas. She stated that OCIE examiners use many of these tests to detect possible violations. In her view, they can just as easily be used by CCOs as part of their compliance controls. She further stated that none of these forensic tests are mandated. Instead, OCIE is making available the information with the hope that firms will find it useful as they consider forensic tests that might enable them to better oversee their firm's compliance activities.
Please click http://www.sec.gov/news/speech/2007/spch111407lar.htm for a copy of her speech.
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Court Dismisses SEC Civil Market Timing Case Against Fiduciary Trust Executives
11.13.2007 The U.S. District Court for the District of Massachusetts entered a judgment dismissing a civil fraud action against three former executives of Putnam Fiduciary Trust Company (PFTC), a Boston-based registered transfer agent. The SEC alleged that six former PFTC executives engaged in a scheme that defrauded a defined contribution plan client and group of Putnam mutual funds of approximately $4 million. The case was dismissed against Virginia Papa, of Newton, Massachusetts, a former managing director and director of defined contribution servicing; Sandra Childs, of Duxbury, Massachusetts, a former managing director who had overall responsibility for PFTC's compliance department; and Kevin Crain, of Princeton, New Jersey, a managing director who had responsibility for PFTC's plan administration unit. The Court found that the SEC's complaint did not allege sufficient conduct by those three parties to sustain fraud claims against them.
The Court denied motions to dismiss by three other defendants: Karnig Durgarian, of Hopkinton, Massachusetts, a former senior managing director and chief of operations for PFTC, as well as principal executive officer of certain Putnam mutual funds from 2002 through 2004; Donald McCracken, of Melrose, Massachusetts, a former managing director and head of global operations services for PFTC; and Ronald Hogan, of Saugus, Massachusetts, a former vice-president who had responsibility for new business implementation at PFTC.
The SEC alleged that the defendants' misconduct arose out of PFTC's one-day delay in investing certain assets of a defined contribution client, Cardinal Health, Inc., in January 2001. The markets rose steeply on the missed day, causing Cardinal Health's defined contribution plan to miss out on nearly $4 million of market gains. According to the complaint, rather than inform Cardinal Health of the one-day delay and the missed trading gain, the defendants decided to improperly shift approximately $3 million of the costs of the delay to shareholders of certain Putnam mutual funds through deception, illegal trade reversals and accounting machinations. The complaint also alleges that the defendants improperly allowed Cardinal Health's defined contribution plan to bear approximately $1 million of the loss without disclosing to Cardinal Heath that they had done so. The complaint further alleges that certain defendants also took steps to cover-up the wrongful conduct and, as a result, the conduct was not discovered until January 2004.
See http://www.sec.gov/litigation/litreleases/2007/lr20373.htm for a copy of the administrative action.
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SEI Money Market Fund Obtains No-Action Relief to Enter Into an Arrangement Addressing Sub-Prime Problems
11.9.2007 CSEI Daily Income Trust Money Market Fund (the "Fund") and SEI Investments Company ("SEI") received no-action relief from the SEC to enter into arrangement addressing certain non- or underperforming portfolio assets consisting of interests in pools containing sub-prime mortgages.
The Fund is an SEC-registered money market fund that seeks to maintain a stable net asset value per share of $1.00 and uses the amortized cost method of valuation in valuing its portfolio securities as permitted by Rule 2a-7 under the 1940 Act. It holds notes (the "Notes") issued by several issuers identified in a schedule to the Capital Support Agreement (the "Agreement"). One of the issuers of the Notes, Cheyne Finance LLC, has defaulted under the terms of its Notes due to its failure to comply with certain financial requirements. The Fund seeks to sell the Notes issued by Cheyne Finance LLC.
The Fund and SEI received no-action relief to enter into the Agreement to prevent any losses realized upon the ultimate disposition of the Notes from causing the Fund's market based net asset value ("NAV") per share to fall below a minimum permissible NAV specified in the Agreement. SEI represented to the SEC that:
- the Agreement would be entered into at no cost to the Fund;
- generally upon the sale or other disposition of a Note, the Agreement would obligate SEI to make a cash contribution to the Fund (up to a maximum amount specified in the Agreement) sufficient to restore the Fund's NAV to the minimum permissible NAV; and
- SEI would not obtain any shares or other consideration from the Fund for its contribution.
SEI's obligations under the Agreement would be guaranteed in the form of a letter of credit ("Letter of Credit") for the benefit of the Fund issued at the expense of SEI by a bank with the highest short-term credit rating. The Fund would draw on the Letter of Credit in the event that SEI failed to make a cash contribution when due under the Agreement. The SEC staff stated that if the Agreement is deemed to be a security within the meaning of Section 2(a)(36) of the 1940 Act, it would be an Eligible Security as defined in Rule 2a-7 because the Letter of Credit is the equivalent of a Guarantee that is a First Tier Security, as those terms are defined in Rule 2a-7, with respect to the Agreement. The incoming letter noted that the Agreement would terminate following a change in the Letter of Credit issuer's short-term credit ratings as specified in the Agreement, unless SEI puts in place a substitute arrangement that is a First Tier Security within 15 calendar days after such occurrence, and the Letter of Credit issuer's ratings qualify as Second Tier Securities, as defined in Rule 2a-7, during the 15 calendar day period.
Please click http://www.sec.gov/divisions/investment/noaction/2007/seiditmmf110907.pdf for a copy of the no-action letter.
A sister money market fund received substantially similar relief in Prime Obligation Fund (pub. avail. Nov. 8, 2007). See http://www.sec.gov/divisions/investment/noaction/2007/seiditpof110807.pdf for a copy of the no-action letter.
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OCIE Associate Director Gohlke Speaks About Mutual Fund Directors' Responsibilities with Respect to Derivatives
11.8.2007 Gene Gohlke, Associate Director of OCIE, gave a speech entitled "If I Were a Director of a Fund Investing in Derivatives -- Key Areas of Risk on Which I Would Focus" at the Mutual Fund Directors Forum Program in New York, New York.
He began by noting that fund directors are responsible for:
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overseeing your fund's investments to make sure that the risks assumed by the fund are consistent with the risk disclosures the fund has made to its shareholders;
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establishing fair value procedures the fund is to use in pricing its derivative (and other) positions for which there are no readily available market quotations;
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approving codes of ethics of both the fund and its investment adviser to ensure that the ethical principals established are appropriate in light of the environment in which the fund and adviser operate;
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determining that all of the fund's compliance policies and procedures and those of its service providers are reasonably designed to prevent violations of the securities laws.
He next discovered specific areas of risk. Mr. Gohlke stated that if he was a director he would be interested in the following:
- the specific derivative instruments in which the fund will be investing, the way in which each instrument will be used in achieving the fund's investment objectives and the significant risks associated with each instrument;
- the information needed to make informed investment decisions and the sources of such information;
- the means by which sources of information will be compensated;
- how and by whom will that information be used; and
- contingency plans to obtain information if the primary sources become unavailable.
Mr. Gohlke next stated that, as a director, he would want to understand the process that is used to ensure that the ongoing level of risk to which the fund is exposed from its investments in derivatives is being fully and fairly described and illustrated in various disclosure documents provided to fund shareholders and that the language used to describe such risks is likely to be understood by the average investor in the fund.
He also stated that, as a fund director, he would engage in a continuing dialogue with the fund's CCO regarding how the CCO, giving due regard for all of the other responsibilities that come with the position, can assist the Board in effectively monitoring the fund's investments in derivatives, including the risks it is taking, the returns being earned for assuming those risks and how these risks and returns can most effectively be communicated to fund shareholders.
In closing, Mr. Gohlke stated that as a fund director, he would not want to micro-manage the fund's investments in derivatives. However, recognizing that such investments can create a significant risk exposure for fund shareholders he would want either to receive or, at least, have access to reports prepared for other persons that would give the Board the information it needs to effectively oversee the fund's investments in derivatives in a manner that is likely to be consistent with the expectations of fund shareholders.
Examples of information for a fund investing in derivatives Mr. Gohlke would want to have access to on a regular basis (weekly /monthly), perhaps in the form of "dashboard reports" delivered in paper format or available in an on-line space on the group's internal web site, include the following:
- Average daily gross and net assets
- Average of daily assets in illiquid positions as a percentage of daily net assets
- Average of daily assets earmarked or in segregated accounts for Section 18 purposes as a percentage of daily net assets
- Average daily net sales/redemptions as a percentage of net assets
- Number of days during period in which the change from the previous day's NAV per share exceeded the per share value at risk for that period
- Total return for the period compared to total return for the period on a relevant market index
- Average daily total amount of assets for which fair value was used in calculating NAV as a percentage of average daily gross assets
In addition to a regular flow of information as described above, he would have standing instructions with the fund's CCO and its service providers that he will want to be informed regarding unusual or exceptional matters that may arise regarding the fund's investments in derivatives. Examples of such matters could include, failure of a counterparty to a position held by the fund to perform as required; significant operational or control breach at a service provider; pricing model unraveling requiring a change in fair value procedures; and a sudden, material change in a measure that is otherwise reported to the Board on a periodic basis.
Please click http://www.sec.gov/news/speech/2007/spch110807gg.htm for a copy of his speech.
