SEC Chairman Harvey L. Pitt announced that the SEC has commenced a formal inquiry into market practices concerning research analysts and the potential conflicts that can arise from the relationship between research and investment banking. He stated that the inquiry will be conducted jointly with self-regulatory organizations such as the New York Stock Exchange (“NYSE”) and the National Association of Securities Dealers (“NASD”), New York Attorney General Eliot Spitzer and the states. The inquiry is intended to determine the necessity of additional rule making and whether any laws have been violated.

In a related action, Mr. Pitt announced that the SEC will consider analyst rules proposed by the NYSE and the NASD at an open meeting scheduled for May 8, 2002. These rules are intended to address the conflicts that can arise when research analysts recommend securities in public communications. SEC Press Release, April 25, 2002.

The Treasury has issued new interim rules that will extent the anti-money laundering requirements of the USA Patriot Act to five new sectors of the financial services industry: (i) mutual funds (as described above); (ii) credit card system operators; (iii) money services business; (iv) SEC registered brokers and dealers; and (v) futures commission merchants and introducing brokers that are registered with the Commodity Futures Trading Commission. Treasury officials noted that they expect the new anti-money laundering rules will also be extended to cover insurance companies and hedge funds shortly. The new regulations took effect on April 24th and covered businesses have 90 days from that date to formulate their anti-money laundering programs. BNA Securities Regulations and Law Report, Vol. 34, No. 17 (April 29, 2002).

The Treasury further noted that with respect to omnibus accounts, a mutual fund’s anti-money laundering compliance program could have a more limited scope. The Treasury noted that its rule does not require a mutual fund to obtain any additional information regarding individual transactions that are processed through another entity’s omnibus account. The Treasury stated that it does not expect that mutual funds will scrutinize activity in omnibus accounts to the same extent as individual accounts. Nevertheless, mutual funds would need to analyze the money laundering risk posed by particular omnibus accounts based upon a risk-based evaluation of relevant factors regarding the entity holding the omnibus account, including the type of entity, its location, type of regulation and the viability of its anti-money laundering program.

On April 23, 2002, the Treasury Department (the “Treasury”) issued interim final rules governing the implementation of anti-money laundering programs by mutual funds. The interim final rules require mutual funds to develop and implement anti-money laundering programs which are reasonably designed to prevent them from being used to launder money or finance terrorist activities by July 24, 2002. Previously, mutual funds were required to implement anti-money laundering programs by April 24, 2002.

Section 352(a) of the USA Patriot Act, which became effective on April 24, 2002, amended Section 5318(h) of the Bank Secrecy Act (“BSA”). As amended, Section 5318(h)(1) requires every financial institution to establish an anti-money laundering compliance program that meets certain minimum standards. The BSA defines “financial institutions” to include “investment companies”. In the release adopting the interim final rules, the Treasury noted that it has not previously defined the term “financial institution” for purposes of the BSA. For purposes of the Section 352 requirement that financial institutions establish anti-money laundering compliance programs effective April 24, 2002, the Treasury stated that it has limited the application of this interim rule to mutual funds (i.e., open-end investment companies). Accordingly, entities such as hedge funds, private equity and venture capital funds, closed-end investment companies and unit investment trusts (“UITs”) are not currently required to comply with the interim rule requiring financial institutions to establish anti-money laundering compliance programs. The Treasury noted that it is likely that these entities will be required to establish anti-money laundering programs pursuant to Section 352 in the future. The Treasury noted that it will consider the type of anti-money laundering programs that would be appropriate for the issuers of closed-end investment companies and UITs given their differences from open-end investment companies, including the extent to which they pose a money laundering risk that is more effectively covered by the anti-money laundering program of another financial institution involved in their distribution, such as a broker-dealer.

In the release, the Treasury noted that because of the vulnerability of mutual funds to money laundering, it has not exercised its authority to temporarily exempt mutual funds from the Section 352 requirement to implement anti-money laundering programs. The interim rules require the mutual fund’s board to approve the programs, although that approval could be obtained at the board’s first regularly scheduled meeting after the program is adopted. The Treasury also provided the following guidance on complying with each of the four required elements of any anti-money laundering program:

• Establish and implement policies, procedures and internal controls reasonably designed to prevent the mutual fund from being used to launder money or finance terrorist activities: Because mutual funds operate through a variety of different business models, the Treasury noted that one generic anti-money laundering program for this industry is not possible. The policies and procedures and internal controls should be reasonably designed to detect activities indicative of money laundering and should be reasonably designed to assure compliance with the BSA requirements. Currently, the only BSA regulatory requirement applicable to mutual funds is the obligation to report on Form 8300 the receipt of cash or certain non-cash instruments totaling more than $10,000 in one transaction or in two or more related transactions. The program should also be reasonably designed to detect and report not only transactions required to be reported on Form 8300 but also to detect activities designed to evade such requirements. Mutual funds will be required to comply with the BSA requirements regarding accountholder identification and verification pursuant to Section 326 of the USA Patriot Act, which requirements will be set forth in regulations which must be issued by October 26, 2002. Mutual funds are also likely to become subject to additional BSA requirements, including filing suspicious activity reports.

The Treasury also noted that because mutual funds typically conduct their operations through separate entities, such as a broker-dealer or a transfer agent, some elements of the compliance program will be best performed by personnel of those separate entities. The Treasury acknowledged that it is permissible for a mutual fund to contractually delegate the implementation and operation of its anti-money laundering program to another affiliated or unaffiliated service provider. The Treasury cautioned that any mutual fund delegating responsibility for aspects of its anti-money laundering program to a third party must obtain written consent from the third party ensuring the ability of federal examiners to obtain information and records related to the anti-money laundering program and to inspect the third party for purposes of the program. The Treasury cautioned that the mutual fund remains responsible for assuring compliance with this regulation. For example, the Treasury noted that it would not be sufficient for the mutual fund to simply obtain a certification from its delegate that it has a satisfactory anti-money laundering program.



• Provide for independent testing of compliance to be conducted by company personnel or by a qualified outside party: The Treasury noted that such testing may be accomplished either by employees of the fund, its affiliates or unaffiliated service providers so long as those same employees are not involved in the operation or the oversight of the program. The frequency of that review would depend on factors such as the size and complexity of the mutual fund complex and the extent to which its business model may be more subject to money laundering than other institutions. A written assessment or report should be part of the review, and any recommendations resulting from that review should be promptly implemented or submitted to the board for consideration.
  
  
• Designate a person responsible for implementing and monitoring the operations and internal controls of the program: The Treasury noted that a mutual fund must charge an individual (or committee) with the responsibility of overseeing the anti-money laundering program. The person (or group of persons) should be competent and knowledgeable regarding the BSA requirements and money laundering issues and risks, and empowered with full responsibility and authority to develop and enforce appropriate policies and procedures throughout the fund complex. Although in many cases the implementation and operation of the compliance program will be conducted by entities and their employees other than the mutual fund, the Treasury noted that the person responsible for the supervision of the overall program should be a fund officer.
  
  Provide ongoing training for appropriate persons: The Treasury commented that employees of the fund (and its affiliated third-party service providers) must be trained in BSA requirements relevant to their functions and in recognizing the possible signs of money laundering that could arise in the course of their duties. This training could be conducted by outside or in-house seminars, and it could include computer-based training. The level, frequency and focus of the training would be determined by the responsibilities of the employees and the extent to which their functions bring them in conduct with BSA requirements or possible money laundering activity.

Mutual funds are required to comply with the anti-money laundering by July 24, 2002. The Federal Register, Vol. 67, No. 82 (April 29, 2002).

The U.S. Court of Appeals for the Third Circuit (the “Court”) affirmed a district court’s decision to dismiss a case against seven closed-end fund investment advisers. The plaintiffs, who were stockholders of the funds, alleged that the advisers’ fee arrangement with the funds created a conflict of interest that violated their fiduciary duties under Section 36(b) of the Investment Company Act of 1940. The closed-end funds involved were publicly traded municipal bond funds which invested primarily in long-term high-yield municipal bonds. Each fund has two classes of stock outstanding, common and preferred. To earn extra income for the funds and the holders of the common stock, the funds “borrow” money by selling preferred shares which pay dividends to the preferred holders at lower short-term rates of between 2% to 4%. The funds invest the proceeds from the issuance of preferred stock in long-term bonds paying higher rates of return, thus capturing the interest-rate spread between the dividend yield on the preferred stock and the yield on the long-term bonds purchased by the fund.

The plaintiffs alleged that because the value of the long-term bonds which are purchased using proceeds from the sale of preferred stock are included in the total assets upon which the advisory fees are charged, the advisers have a “strong incentive” to keep the funds fully leveraged. The plaintiffs allege that this incentive creates an actual conflict of interest between the funds and their advisers that amounts to a breach of fiduciary duty under Section 36(b). The plaintiffs also alleged that the failure to adequately disclose this conflict of interest in the prospectuses is a separate breach of fiduciary duty.

After reviewing the text of Section 36(b) and its legislative history, the Court concluded that potential conflicts of interest in mutual fund fee arrangements are not per se violations of an adviser’s fiduciary duty. The Court held that an actual breach must be alleged and proven. The Court noted that conflicts of interest are inherent to mutual fund fee arrangements because the typical fund is created and managed by the adviser. However, while Section 36(b) was designed to address this conflict it provides only a very specific and narrow federal remedy that is more limited than the remedy available under common law. Specifically, the Court held that Section 36(b) is more limited in that:

• a shareholder may sue only the recipient of the fee;
• recovery is limited to actual damages resulting from the breach;
• damages are not recoverable for violations that occur prior to one year before the suit was filed;
• and plaintiff has the burden of proving a breach of fiduciary duty, in contrast with the common law rule that requires a fiduciary to justify its conduct.

The court concluded that because the plaintiffs had not been able to point to any instance where the advisers had improperly maximized their fees by failing to deleverage the funds and because they had not alleged any actual damages that they or the funds suffered, the plaintiffs do not have a cognizable claim under Section 36(b). The Court also affirmed the district court’s finding that the method of calculating fees was adequately disclosed in the funds’ prospectuses. The Court did reverse the district court’s dismissal of the plaintiffs’ common law breach of duty claims, holding that those claims were not preempted by Section 36(b). Green v. Fund Asset Management L.P., 3rd Circuit, No. 01-2736 (April 18, 2002).

The SEC has published for comment rule amendments to the Investment Advisers Act of 1940 (the “Adviser’s Act”) which would permit certain investment advisers that provide advisory services primarily through the Internet to register with the Commission instead of with state securities authorities. The SEC noted that the amendments are designed to alleviate the burden of multiple state regulation on advisers whose businesses aren’t connected with any particular state and for whom state registration would be a hardship.

The investment advisers covered by proposed Rule 203A-2(f) under the Advisers Act, which the SEC refers to as Internet investment advisers, must provide substantially all of their advisory services through interactive websites. Clients visiting these websites answer on-line questions about their finances, investment objectives and investment time horizon, risk tolerance and investment restrictions. The Internet investment adviser’s computer-based application or platform processes and analyzes the client’s responses to generate the personalized investment advice that is communicated to the client through the website. The interactive website may be reached at any time by a person residing in any state or outside the United States.

The SEC commented that it has drafted the proposed rule to make it unavailable to advisers that merely have websites as marketing tools or that use Internet vehicles such as e-mail, chat rooms, bulletin boards and web casts or other electronic media to communicate with clients. Instead, eligibility for the exemption would turn on whether the adviser conducts substantially all of its advisory business through an interactive website. The proposed rule defines “interactive website” as a website in which computer software-based models or applications provide investment advice to clients based on information that each client supplies through the website. The proposed rule also defines the term “substantially all” to mean that at least 90% of the investment adviser’s clients obtain advice exclusively through the Internet interactive website.

The SEC noted that most Internet investment advisers are not eligible to register with the SEC because they do not have at least $25 million in assets under management or advise a registered investment company. The SEC also noted that most of these advisers do not initially qualify to use the SEC’s multi-state advisory exemption which permits an adviser that does not meet the statutory thresholds to register with the SEC if it would otherwise have to register with the securities authorities of at least 30 states. Because an Internet investment adviser’s clients can come from anywhere at any time, the adviser would have to wait until it has registration obligations in 30 states before registering with the SEC and canceling its state registration, which the SEC views as unduly burdensome and impractical. Advisers registering with the SEC under the new exemption would be required to keep records demonstrating that they meet the conditions of the proposed rule. Comments on proposed rule are due on or before June 6, 2002. SEC Release No. IA-2028 (April 12, 2002).

The SEC has proposed a rule amending Form 8-K under the 1934 Act to require companies with a class of equity securities registered under Section 12 of the 1934 Act to report information about:

• each director’s and executive officer’s transactions in company equity securities (whether or not of the class registered under Section 12), including the acquisition and disposition of derivative securities, and the exercise, termination or settlement of derivative transactions;
• each director’s and executive officer’s adoption, modification or termination of a contract, instruction or written plan for purchase of sale of company equity securities intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) under the 1934 Act; and
• each loan of money to a director or executive officer made or guaranteed by the company or an affiliate of the company.

Rule 10b5-1(c) provides an affirmative defense to allegations of illegal insider trading by providing that a corporate insider’s purchase or sale was not “on the basis of” material non-public information under certain circumstances. These circumstances can be shown by demonstrating that before the insider became aware of the information, he or she (i) contracted to purchase or sell the security, (ii) instructed another person to purchase or sell the security for the instructing person’s account, or (iii) adopted a written plan for trading securities. Under the SEC’s proposal, these arrangements would have to be disclosed on Form 8-K.

Reports or transactions with loans with an aggregate value of $100,000 or more would be due within two business days. Reports of transactions with a smaller aggregate value, grants and awards pursuant to employee benefit plans, and Rule 10b5-1 arrangements generally would be due by the close of business on the second business day of the following week. Reports of transactions and loans with an aggregate value of less than $10,000 would be deferrable until the aggregate cumulative value of those unreported events for the same director or executive officer exceeds $10,000.

The SEC commented in the proposing release that some of the information a company would report with respect to directors’ and executive officers’ transactions in company equity securities is also reportable by officers and directors under Section 16(a) of the 1934 Act. However, the SEC noted that Section 16(a) requires disclosure that may be filed too slowly for the public to obtain the maximum benefit from the information and that reports are not always readily accessible because they are not required to be filed electronically. The SEC stated that it believes that these proposed reports would protect investors and promote fair dealing in the company’s securities by enabling investors to make informed decisions on a more timely basis. As proposed, the categories of transactions to be reported currently on Form 8-K would not replicate all the transactions that officers and directors must report under Section 16(a), but only those most related to the purpose of the newly proposed current disclosure. Comments on the proposed rule are due on or before 60 days after publication in the Federal Register. SEC Release No. 34-45742 (April 12, 2002).

The SEC has proposed rules and form amendments which would accelerate the filing of quarterly and annual reports by certain domestic reporting companies that are required under the Securities Exchange Act of 1934 (the “1934 Act”). The proposed rules and form amendments would apply to domestic reporting companies which have:

• a public float of at least $75 million;
• have been subject to the 1934 Act reporting requirements for at least 12 calendar months; and
• have previously filed at least one annual report.

The proposed rules and form amendments would shorten the filing deadlines for these companies from 45 to 30 days after the end of a period for quarterly reports and from 90 to 60 calendar days after fiscal year end for annual reports. The SEC stated in the proposing release that companies that meet the public float and reporting history requirement at the end of their first fiscal year ending after October 31, 2002 would be subject to the accelerated filing deadlines.

The SEC has also proposed amendments to Regulation S-K requiring companies subject to the accelerated filing deadlines to disclose in their annual reports where investors can obtain access to company filings. The proposed amendments also require these companies to also disclose whether the company provides free access to its reports on Forms 10-K, 10-Q and 8-K on its Internet website as soon as reasonably practicable, and in any event on the same day as those reports are electronically filed with or furnished with the SEC. If the company does not make its filings available on its Internet website, the company must disclose the reasons why it does not do so.

The SEC noted in the release that many companies currently provide website access to their 1934 Act reports in a variety of ways, including by establishing a hyperlink to the reports via a third-party service in lieu of maintaining the reports themselves. In such cases, the SEC encouraged companies to hyperlink directly to the company’s reports or to a list of its reports instead of just to the home page of the third-party service. The SEC also commented that hyperlinking to its EDGAR system would not allow a company to state that it provides website access to its reports on the same day those reports are filed with the SEC because filings on the EDGAR website currently are posted after a 24-hour delay. The SEC commented that it anticipates eliminating this 24-hour delay for filings posted to a website in the future. Comments are due on the proposals 30 days after their publication in the Federal Register. SEC Release No. 34-45741 (April 12, 2002).

The SEC has adopted a new registration form for insurance company separate accounts that are registered as unit investment trusts (“UITs”) and that offer variable life insurance policies. The new Form N-6 is to be used by these separate accounts to both register under the Investment Company Act of 1940 (the “1940 Act”) and to offer their securities under the Securities Act of 1933 (the “1933 Act”).

Variable life separate accounts, as UITs, are currently required to register on Form N-8B-2 under the 1940 Act and to register their securities on Form S-6 under the 1933 Act. The SEC commented that these forms were designed for non-separate account UITs and were adopted before the establishment of the first separate accounts used to fund variable life insurance policies. The SEC further commented that while much of their required disclosure is useful, the forms request some information that is not typically of consequence to a buyer of variable life insurance. In addition, many matters that would be significant to a buyer of a variable life insurance policy are not addressed at all by the forms. The SEC also noted that these forms do not reflect fundamental improvements that the SEC has made to other investment company registration forms which facilitate clearer and more concise disclosure to investors. The SEC commented that new Form N-6 represents an improvement over the existing forms in the following ways:

• Tailored registration form – Form N-6 will eliminate requirements in the current registration forms that are not relevant to variable life insurance. Form N-6 also will include items that are specifically addressed to variable life insurance products, such as descriptions of contractual provisions relating to premiums, death benefits, cash values, surrenders and withdrawals, and loans.
• Plain English – The SEC’s plain English rule will apply to the front and back covers and the risk/benefit summary in the variable life insurance prospectus.
• Reducing complex and lengthy prospectus disclosure – Form N-6 will streamline variable life prospectus disclosure by adopting a two-part format consisting of a simplified prospectus and a statement of additional information which would be provided to investors upon request.
• Standardized fee information – Form N-6 will require variable life insurance registrants to provide a uniform, tabular presentation of fees and charges in order to improve the disclosure to investors of the often complex charges associated with variable life insurance policies and increase the comparability of charges among policies.
• Integrated disclosure document - Form N-6 will provide variable life insurance registrants with an integrated form for 1940 Act and 1933 Act registrations.

The SEC has also amended Form N-1A to eliminate the existing exclusion from the fee table requirement for mutual funds that offer their shares as investment options for variable life insurance policies or variable annuity contracts. The SEC commented that this change is intended to ensure that variable life investors have access to complete information about the underlying mutual fund fees and expenses.

All new registration statements filed on or after December 1, 2002 for separate accounts that are registered as UITs and that offer variable life insurance polices must comply with Form N-6. All existing insurance company separate accounts registered as UITs and which currently offer variable life insurance policies with effective registration statements must comply with Form N-6 for post-effective amendments that are annual updates to the registration statements filed on or after December 1, 2002 and no later than December 1, 2003. All new registration statements and post-effective amendments that are annual updates to effective registration statements filed on or after September 1, 2002 must comply with the amendment to Form N-1A. SEC Release No. IC-25522 (April 12, 2002).