Auditor Charged with Conducting Flawed Audit of Hedge Funds
7.31.2006 The SEC brought charges against Lawrence A. Stoler, who was the engagement partner on the audits of the Lipper convertible hedge funds - Lipper Convertibles, L.P. ("Convertibles"), Lipper Convertibles Series II, L.P. ("Series II"), and Lipper Fixed Income Fund, L.P. (the "Funds"). The SEC found that Stoler engaged in improper professional conduct in the audits of the Funds' financial statements for the year ended December 31, 2000.
According to the SEC, Stoler failed to adequately assess the substantial evidence produced by the audits that the Funds' portfolio manager, Edward J. Strafaci, was materially overstating the value of the convertible bonds and convertible preferred stock in which the Funds were invested, and unquestioningly relied on a purported confirmation process that was significantly flawed. The SEC found that, under Stoler's supervision, the audits amounted to a mechanical execution of tests, without real regard for the results of those tests, and that Stoler failed to exercise due professional care and professional skepticism, failed to obtain sufficient competent evidential matter to support the unqualified audit opinions he signed, and failed to adequately supervise the work of assistants. The SEC thus found that Stoler's conduct in the 2000 audits constituted a single instance of highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which Stoler knew, or should have known, that heightened scrutiny was warranted, and thus constituted improper professional conduct under SEC rules.
Please click http://www.sec.gov/litigation/admin/2006/33-8726.pdf to access a copy of the administrative action.
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Legg Mason and Citigroup Receive No-Action Letter Permitting Brokerage Services to Remain in Place After Sale of Mutual Funds
7.26.2006 On December 1, 2005 ("Closing Date"), Citigroup sold to Legg Mason, Inc. ("Legg Mason") substantially all of its business of acting as investment adviser through one or more of its affiliated investment advisers ("Citigroup Advisers") to numerous existing open- and closed-end registered investment companies (the "Funds").
Prior to the Closing Date, certain broker-dealers of Citigroup provided distribution services for the Funds ("Citigroup Principal Underwriters"). Legg Mason and Citigroup agreed that Citigroup, including certain Citigroup dealers ("Affiliated Dealers") would continue to distribute shares of the Funds for a period of at least three years after the Closing Date on at least as favorable a basis as provided prior to the Closing Date.
Pursuant to the new principal underwriting agreements with the Funds, the Citigroup Principal Underwriters have agreed to act as agents for the Funds to: (1) offer shares of the Funds and accept purchases, redemptions and exchanges of such shares; (2) review and submit to the NASD any marketing materials they prepare; (3) maintain anti-money laundering programs, and know-your-customer and privacy policies; (4) maintain applicable records of their activities; (5) maintain policies and procedures for share transactions with investors and intermediaries; and (6) finance the sale of Class B Shares and pay for the printing of certain related marketing materials. Affiliated Dealers are responsible for: (1) offering shares of the Funds; (2) forwarding purchase, redemption and exchange orders from their customers through Citigroup Principal Underwriters to the Funds; and (3) using marketing materials furnished by the Funds' principal underwriters in offering shares of the Funds. The Affiliated Dealers have provided (and will continue to provide) such services for the Funds on behalf of Citigroup Principal Underwriters directly and through their employees ("Distribution Services"). As payment for providing the Distribution Services for the Funds, the Citigroup Principal Underwriters have received (and will continue to receive) front-end and deferred sales charges from investors ("Loads"), distribution and shareholder servicing payments from the Funds pursuant to the Funds' plans adopted under Rule 12b-1 under the 1940 Act ("12b-1 Fees"), and revenue sharing payments from the investment advisers to the Funds ("Revenue Sharing Payments").
Finally, Citigroup Principal Underwriters and another Citigroup Company, CitiStreet LLC, received prior to the Closing Date (and have continued to receive since the Closing Date) compensation for providing (and continuing to provide since the Closing Date) sub-accounting services for some of the Funds.
Section 15(f) of the 1940 Act establishes a non-exclusive safe harbor for the receipt of any amount or benefit by an investment adviser to a registered investment company or an affiliated person of such adviser in connection with the sale of securities of, or a sale of any other interest in, the adviser that results in an assignment of the fund's advisory contract, provided that two conditions are satisfied. First, under Section 15(f)(1)(A), at least 75% of the directors of a Fund's board must not be interested persons of either the fund's investment adviser or its predecessor adviser for three years following the sale of securities of, or a sale of any other interest in, the adviser that results in an assignment of the fund's advisory contract. Second, an "unfair burden" may not be imposed on the Fund as a result of the transaction or any terms of the transaction.
Section 15(f)(2)(B) defines "unfair burden" to include: "any arrangement, during the two-year period after the date on which any [transaction described in Section 15(f)] occurs, whereby the investment adviser or, [its] predecessor or successor investment advisers ... or any interested person of any such adviser ... receives or is entitled to receive any compensation directly or indirectly (i) from any person in connection with the purchase or sale of securities or other property to, from, or on behalf of such company, other than bona fide ordinary compensation as principal underwriter for such company, or (ii) from such company or its security holders for other than bona fide investment advisory or other services."
The SEC staff granted the following no-action relief to Citigroup:
- the Distribution Compensation directly received (and to be received) by the Citigroup Principal Underwriters, and indirectly received (and to be received) by the employees of the Citigroup Principal Underwriters, the Affiliated Dealers and employees of the Affiliated Dealers under the circumstances described in your letter, constitutes “ordinary compensation as principal underwriter” for the Funds for purposes of Section 15(f)(2)(B)(i); and
- the sub-accounting services constitute “other services” for purposes of Section 15(f)(2)(B)(ii).
Please click http://www.sec.gov/divisions/investment/noaction/2006/citigroup072606.pdf to access a copy of the no-actionl letter.
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FISERV Executive Charged with Market Timing
7.26.2006 The SEC brought charges against Robert
P. Hetzer, of Hollywood Beach, Florida, who was the former senior vice president in charge of mutual fund
trading at Fiserv Securities, Inc. ("FSI"), a registered broker-dealer. The SEC found between January 2001 and October 2002, Hetzer
engaged in late trading of mutual funds for his own benefit in two
personal accounts he opened while employed at FSI. Late trading refers to the practice of placing orders to buy or redeem
mutual fund shares after the time as of which a mutual fund has
calculated its net asset value, usually as of the close of
trading at 4:00 p.m. Eastern Time, but receiving the price based
on the prior NAV already determined as of that day.
The SEC stated that Hetzer entered 855 mutual fund trades in his personal accounts between
4:00 p.m. and 5:30 p.m. ET, and improperly received the current day's
NAV. Hetzer accomplished this by deliberately misusing FSI's
computerized trade-processing system, which was intended to permit
trade entry after 4:00 p.m. ET, and receive that day's NAV, only in
limited circumstances involving errors, other technical problems and
legitimate delays in processing orders. As a result of his illegal
trading, Hetzer enriched himself and caused harm to mutual fund
shareholders.
In addition, the Order finds that Hetzer caused FSI to violate its
dealer agreements with mutual funds by entering his trades after 4:00
p.m. ET. FSI's dealer agreements contained provisions obligating FSI
to comply with all of the terms of the funds' prospectuses, including
provisions regarding the time for submitting trades.
Please click http://www.sec.gov/litigation/admin/2006/34-54219.pdf to access a copy of administrative action.
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SEC Chairman Cox Testifies About Hedge Fund Regulation
7.25.2006 SEC Chairman Christopher Cox testified before the Senate Committee on Banking, Housing and Urban Affairs, on hedge fund regulation. Cox requested Congress to pass legislation that would provide for more oversight of hedge funds. He believes that the current regulatory scheme is inadequate. He noted the recent the D.C. Circuit decision in Goldstein that overturned the SEC's hedge fund adviser rule. Cox said as a consequence: “We must move quickly to address the hole that the Goldstein decision has left. Some improvements will be possible through administrative action. Others, however, may well require legislation.”
Cox also stated that the SEC is considering changing the definition of the “accredited investor” to include investors with a net worth of $1.5 million or more, as opposed to the current $1 million threshhold.
Please click http://www.sec.gov/news/testimony/2006/ts072506cc.htm to access a copy of the testimony.
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Waddell Reed Settles Market Timing Charges
7.24.2006 Waddell & Reed, Inc. (W&R), a registered broker-dealer and investment
adviser, Waddell & Reed Investment Management Company (W&R Investment
Management), a registered investment adviser, and Waddell & Reed
Services Company (W&R Services), a registered transfer agent, settled market timing charges.
The SEC found that beginning in December 1998 and continuing through
the fall of 2003, W&R Services and/or W&R collected a total of $3.6
million in asset-based fees from three market timers (the Fee Paying
Timers). The SEC further found that W&R Investment Management
allowed the Fee Paying Timers to time certain Waddell & Reed funds in
a manner that it knew or had reason to believe would be harmful to
shareholders in exchange for fees paid to W&R Services and W&R, and it
allowed the Fee Paying Timers to time the Waddell & Reed Advisors
International Growth Fund despite having been notified that timers
were harming the fund through dilution. These actions created a
conflict of interest that W&R Investment Management knowingly or
recklessly failed to disclose to the board of directors and
shareholders of the funds. The Order further finds that W&R and W&R
Services negotiated written agreements with the Fee Paying Timers,
from which they financially benefited, that caused W&R Investment
Management to breach its fiduciary duty to the funds' board and
defraud the funds' shareholders.
Please click http://www.sec.gov/litigation/admin/2006/34-54193.pdf to access a copy of the administrative action.
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SEC Publishes Soft Dollar Guidance
7.18.2006 The SEC posted its guidance on the permissible use of of soft dollars. This interpretive release with respect to the scope of “brokerage and research services” and client commission arrangements under Section 28(e) of the Securities Exchange Act of 1934. Section 28(e) of the Securities Exchange Act of 1934 provides a
“safe harbor” that permits money managers to use client commissions to acquire “brokerage
and research services” as specified in the statute.
Under the proposed interpretation, in order for a particular product to constitute research
services, the money manager must conclude that it constitutes “advice,” “analysis” or
“reports” (the precise terms used in Section 28(e)). In reaching its conclusion, the money
manager must determine:
- that the research product “reflects substantive content – that is,
the expression of reasoning or knowledge;”
- that the content meets the substantive standards described in Section 28(e)(3)
“Brokerage services” under the safe harbor “relate to execution of securities transactions.”
In addition, clearance and settlement services are also eligible.
The interpretive release was effective upon publication in the Federal Register, but market participants may rely on prior SEC soft dollar guidance for a period of six months following the release’s publication.
Please click http://sec.gov/rules/interp/2006/34-54165.pdf to access a copy of the guidance.
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Final Rule Adopted Permitting Trading of Futures on Debt Indexes and Debt Securities
7.10.2006 The SEC and CFTC jointly issued final rules that will permit trading of futures on debt indexes and debt securities. Joint rulemaking is necessary because, under current regulations, trading futures on debt and debt indices is essentially forbidden. The federal law that governs the subject, however, specifically gives joint rulemaking authority to the two agencies to permit the trading of futures on indices composed of debt securities.
the final rules provide that a future on a debt security index not subject to SEC regulation must be broad-based. This requirement is designed to ensure that the securities making up the index are not readily susceptible to manipulation.
The rules exclude certain debt indices from the definition of a “narrow-based security index,” by providing criteria that are specifically relevant to debt securities. Futures contracts on debt securities indices that are excluded from the definition of “narrow-based securities index” under the rules will trade subject to regulation by the CFTC. Security futures on debt securities and narrow-based debt indices can be traded on futures exchanges and securities exchanges subject to joint regulation by the CFTC and SEC.
Please click http://sec.gov/rules/interp/2006/34-54165.pdf to access a copy of the guidance.
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IFMG Settles Revenue Sharing Charges
7.13.2006 IFMG Securities, Inc.
(IFMG), a registered broker-dealer, settled charges with the SEC for failing to disclose adequately
material information to its customers in the offer and sale of mutual
fund shares and variable insurance products.
The SEC found from at least January 2000 through November
2003, IFMG, a subsidiary of Sun Life Financial (U.S.) Holdings, Inc.,
gave preferred sales treatment to certain mutual fund complexes and
variable insurance product issuers participating in its revenue
sharing program (the Preferred Program) in exchange for revenue
sharing payments. Five mutual fund families and between six and twelve
insurers offering variable insurance products (the Preferred
Families), at various times, participated in IFMG's Preferred Program.
IFMG provided financial incentives to its registered representatives,
including reducing the commission paid for the sale of products whose
advisers or insurers did not participate in its Preferred Program, to
sell funds from the Preferred Families over other funds. Preferred
Families received other forms of preferential sales treatment
including placement on a preferred list, prominent billing in new
business presentations and enhanced access to its sales force. IFMG
did not adequately disclose the existence of its Preferred Program,
the receipt of revenue sharing payments pursuant to the Preferred
Program or the potential conflicts of interest created by these
payments.
Please click http://www.sec.gov/litigation/admin/2006/33-8720.pdf to access a copy of the administrative action.
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NASD Posts Web Cast on Breakpoints
7.7.2006 The NASD has posted a webcast that explores mutual fund breakpoints and the impact that breakpoint discounts can have on evaluating mutual fund share class suitability. The webcast highlights the various ways to reach a breakpoint threshold and provides an overview of the NASD Breakpoint Search Tool, an NASD resource that helps representatives determine what breakpoints apply for a particular fund or funds.
Please click http://www.nasd.com/EducationPrograms/OnlineLearning/Webcasts/NASDW_016917.
to access the webcast.
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Adviser Charged with Overstating the Number of its Clients in Form ADV
7.6.2006 The SEC brought charges against Warwick
Capital Management, Inc. (Warwick) a Bronx, New York based investment
adviser and its owner Carl Lawrence. The SEC order states that Warwick distributed through third-party subscription services
false and misleading information about Warwick that:
- overstated
Warwick's assets under management;
- overstated the number of
Warwick's clients;
- falsely represented performance returns that
Warwick and Lawrence knew were false and misleading;
- falsely
represented that Warwick was in compliance with the Association for
Investment Management and Research Performance Presentation Standards;
- falsely claimed that Warwick was registered with the Commission;
and
- overstated the length of time Warwick had been in the
investment advisory business. In its Form ADV filings from 1998
through 2000, Warwick and Lawrence also overstated the number of
clients Warwick had and its assets under management.
Please click http://www.sec.gov/litigation/admin/2006/ia-2530-o.pdf to access a copy of the administrative action.
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