• Suitability. When recommending a deferred variable annuity transaction, a registered representative would be required to determine, and prepare a written suitability determination to the supporting, that (1) the customer has been informed of the unique features of the variable annuity; (2) the customer has a long-term investment objective; and (3) the deferred variable annuity and its underlying investment accounts are suitable for the customer (particularly with regard to risk and liquidity).
  
  
• Delivery of Prospectus and Separate Risk Disclosures. A registered firm or its representative would be required to provide the customer with the current prospectus and a separate, brief “plain English” risk disclosure document that highlights the main features of the particular transaction. liquidity issues, including:

• sales charges;
• fees (including mortality and administrative fees, investment advisory fees and charges for riders or special features);
• federal tax treatment for variable annuities;
• any applicable state and local government premium taxes;
• market risk; and
• whether a “free look” period applies to the variable annuity contract (i.e., during which the customer could terminate the contract without paying surrender charges and receive a refund of any purchase payments made)

Principal Review. Review and approval by a registered principal would be required before a registered representative could effect any transaction. Such review and approval would include written approval of the suitability analysis document, as well as a separate exchange or replacement document if the transaction involves an exchange or replacement of an existing variable annuity.
Supervisory Procedures. Registered firms would be required to establish and maintain specific, written supervisory procedures reasonably designed to achieve compliance with the new rule’s standards.
Training. Registered firms would be required to develop and document specific training policies or programs designed to ensure that registered representatives and principals comply with the rule requirements and that such individuals understand the unique features of deferred variable annuities.

In a press release describing the proposed rule, the NASD explained that it believes the above requirements represent an appropriate approach to ensuring adequate protection for investors considering deferred variable annuities. http://www.nasdr.com/news/pr2004/release_04_027.html

• mandatory electronic filing of Form ID via the new EDGAR Filer Management website (see below for information regarding related rule); and
• proposal to expand the information the SEC will require open-end investment companies and insurance company separate accounts to submit electronically through EDGAR regarding their series and classes (or contracts, in the case of separate accounts). This change will facilitate searches for funds that are series of a registrant.

In addition, the final rule updates certain EDGAR company naming conventions, including (i) increasing the company name length from 60 to 150 characters, (ii) supporting the use of additional ASCII characters in the company name, and (iii) supporting the ability to store and disseminate mixed-case company names, instead of all upper case names.

The effective date of this rule was April 26, 2004. SEC Release Nos. 33-8409; 34-49580; 35-27836; IC-26420.

On April 12, 2004, the ICI filed with the SEC a comment letter regarding proposed Rules 15c2-2 (proposed confirmation rule) and 15c2-3 (proposed point of sale disclosure rule) under the Securities Exchange Act of 1934, which would require broker-dealers selling mutual fund shares and other “covered securities” (such as Unit Investment Trusts and “529 plan” securities) to provide customers a confirmation and new point of sale disclosure document about distribution-related costs and conflicts of interest. In its letter, the ICI stated that it supports the enhanced disclosure provided to fund investors and recommended that the SEC make the following changes to the proposal:

Confirmation Rule Proposal:

• Permit broker-dealers to omit from the proposed confirmation any items that would not require affirmative disclosure.
• Require disclosure concerning potential conflicts of interest only in the proposed point of sale disclosure document.
• Delete the proposed requirement relating to disclosure of portfolio brokerage arrangements in light of pending regulatory proposals to prohibit funds from taking into account distribution of fund shares when allocating fund brokerage.
• Delete the proposed requirement to include in the confirmation “confirmation range” disclosure, which the ICI believes would be problematic to implement and not useful to investors.

Point of Sale Disclosure Rule Proposal:

• Amend the definition of “revenue sharing” to better accomplish the SEC’s intent of requiring disclosure of payments that might present a conflict of interest.
• Clarify that, for purposes of Rule 15c2-3, the “point of sale” occurs prior to the time the broker-dealer accepts an order from the customer to purchase covered securities.
• Clarify that an investor’s right to terminate a covered securities transaction ceases when the investor places an order after receiving the disclosure required by the proposed rules.
• Add exceptions to Rule 15c2-3 to address concerns with the rule’s application to direct sold funds, unsolicited transactions, subsequent purchases of the same covered security from the same broker-dealer, and institutional investors.
• Better tailor the exception relating to primary distributors to the primary distributor’s role in the transaction.
• Require Schedule 15D to include a legend that (i) advises an investor to consider the investment objectives and risks of the security carefully before investing, (ii) explains that the prospectus or offering document contains this and other information about the security, (iii) identifies a source from which the investor may obtain the prospectus or offering document, and (iv) states that such document should be read carefully before investing.

Proposed Form N-1A Amendments:

• Do not require prospectus disclosure in both the fee table and the sales load table of information relating to the impact of rounding on sales loads.
• Upon adoption of the proposed Form N-1A revisions, eliminate no longer necessary requirements relating to prospectus disclosure of revenue sharing arrangements.
• In addition, the ICI asked that the SEC provide an adequate transition period prior to enforcing compliance with the new rules. ICI Memorandum No. 17384 (April 14, 2004).

The NASD issued a notice reminding members of the obligation to ensure that their registered representatives understand and inform customers of the risks in addition to the rewards of bonds and bond funds. The notice cited sales practice obligations, including the following:

• Reasonable-basis suitability analysis: understanding the terms, conditions, risks and rewards of the bonds and bond funds that the member sells;
• Customer-specific suitability analysis: making certain a particular bond or bond fund is appropriate for a particular customer before recommending it;
• Providing a balanced disclosure of the risks, costs and rewards associated with a particular bond or bond fund, particularly when selling to retail investors;
• Adequately training and supervising employees who sell bonds and bond funds; and
• Implementing adequate supervisory controls to reasonably ensure compliance with NASD and SEC sales practice rules relating to bonds and bond funds.

The NASD cited the above obligations as being responsive to its concerns that investors may not understand the risks and costs associated with investments in bonds or bond funds. NASD Notice to Members 04-30 (April 2004).

On April 8, 2004, Chairman Donaldson testified before the Banking Commission. Chairman Donaldson testified that, in light of the SEC’s progress, he does not believe mutual fund legislation to be necessary at this time. Specific items that Chairman discussed include the following:

Rulemaking Initiatives

Chairman Donaldson outlined the overall regulatory agenda to adopt rule and rule amendments that will:

• improve fund oversight by enhancing fund governance, ethical standards, and compliance and internal controls;
• address or eliminate certain conflicts of interest in the mutual fund industry that are potentially harmful to fund investors; and
• improve disclosure to fund investors, in particular fee-related disclosure.

Inspection and Enforcement Efforts.

Chairman Donaldson stated that the detection and enforcement piece of the SEC’s agenda relating to mutual funds currently is focused on four types of misconduct:

1. Late trading and abusive timing of mutual fund shares. The SEC has conducted a broad investigation and has brought numerous enforcement actions charging hedge fund managers, broker-dealers, investment advisers, and their associated persons with engaging in late trading and market timing abuses to the detriment of fund investors.
2. Mutual fund sales practices. The SEC is examining what prospective mutual fund investors are and are not being told about revenue sharing arrangements and other incentives provided by mutual fund companies to broker-dealers selling their funds.
3. Sale of different classes of fund shares. The SEC is examining the need for adoption of policies and procedures to require registered representatives to advise clients of the availability of different classes of funds and to fully explain the terms of each, in conjunction with a firm supervisory system that ensures the policies and procedures are being followed.
4. Breakpoint discounts. The SEC is examining the failure of firms to give customers the discounts available on front-end loads for large purchases of Class A shares.

Internal Restructuring at the SEC.

Chairman Donaldson discussed the staff’s focus on internal restructuring of the SEC’s management and functions and cited steps taken by the staff, which included the following:

• Risk teams. The SEC has organized internal risk teams for each major program area that will work in coordination with the new Office of Risk Assessment to push the SEC to identify proactively potential problem areas within the mutual fund and broker-dealer industries.
• Enhanced examination program. In 2003, budget increases allowed the SEC to increase staff for fund examinations by one third, to approximately 500 staff members.
• Soft dollars. The Task Force on Soft Dollars, comprised of SEC staff from five divisions and offices, is meeting with industry representatives with the goal of fully understanding all aspects of how soft dollars are used, and the pros and cons of various alternative reform approaches, including possible unintended consequences.
• Mutual fund surveillance. The SEC formed a Task Force on Self-Reporting Regimes for Mutual Funds to look at both the frequency of reports made by mutual funds to the SEC and the categories of information to be reported.
• Disclosure regime. The SEC formed a Task Force on Disclosure that will examine the value of the various disclosures provided by mutual funds, brokers and issuers to investors as required by SEC rules and regulations.

Hedge Funds.

Chairman Donaldson testified that he has asked the staff to move forward with a rulemaking proposal that would enhance the SEC’s ability to prevent, detect and deter abusive, fraudulent conduct in the hedge fund segment of the investment management industry. As part of this rulemaking, Chairman Donaldson stated that the SEC staff is developing both a form of registration for hedge fund managers and an oversight regime different from that used for more heavily regulated industries, such as mutual funds. Chairman Donaldson noted that he would oppose any regulatory proposal that would impede the ability of hedge funds to function as they currently do, provided the SEC has the ability to ensure managers are not taking advantage of hedge fund investors.

http://www.sec.gov/news/testimony/ts040804whd.htm

As reported in last week’s Industry News Summary, at an open meeting on April 13, 2004 the SEC adopted amendments designed to improve transparency of policies and procedures of mutual funds and insurance company managed separate accounts that offer variable annuities (“variable products”) with respect to market timing, use of fair value pricing and disclosure of portfolio holdings.

Market Timing. The amendments require that a fund:

1. Describe in its prospectus the risks, if any, that frequent purchases and redemptions present for other shareholders of the fund, including:

• dilution in the value of fund shares held by long-term shareholders;
• interference with the efficient management of the fund’s portfolio; and
• increased brokerage and administrative costs.

The disclosure must be specific to the fund, taking into account its investment objectives, policies, and strategies (i.e. a fund that invests in overseas markets should describe, among other things, the risks of time-zone arbitrage).

2. State in its prospectus whether or not the fund’s board has adopted policies and procedures with respect to frequent purchases and redemptions of fund shares and, if not, the specific basis for not having such policies and procedures.

3. Describe in its prospectus, with specificity any policies and procedures for deterring frequent purchases and redemptions of fund shares, including the following:

• whether or not the fund discourages frequent purchases and redemptions of fund shares by fund shareholders;
• whether or not the fund accommodates frequent purchases and redemptions of fund shares by fund shareholders;
• any policies and procedures of the fund for deterring frequent purchases and redemptions of fund shares by fund shareholders, including any restrictions imposed by the fund to prevent or minimize such purchase or redemptions; and
• in its Statement of Additional Information (“SAI”) a description of any arrangements to permit frequent purchases and redemptions, including the identity of the persons permitted to engage in frequent purchases and redemptions and any compensation or other consideration received by the fund, its investment adviser, or any other party pursuant to such arrangements.

Unlike the proposed rule, the final rule does not, however, require that a fund describe its policies and procedures for detecting frequent purchases and redemptions of fund shares. In the adopting release the SEC staff agreed with commenters that such disclosure might provide investors with a “road map” on how to avoid detection.

Nevertheless, a fund must indicate whether each restriction applies uniformly in all cases, or whether the restriction will not be imposed under certain circumstances. For any restriction that will not be imposed under certain circumstances, the fund will be required to describe with specificity the circumstances under which the restriction will not be imposed.

Similar disclosures are required in prospectuses for variable products, with respect to frequent transfers among sub-accounts.

Fair Value Pricing. The amendments require all mutual funds (other than money market funds) and variable products to explain in their prospectuses both the specific circumstances under which they will use fair value pricing and the effects of using fair value pricing. The adopting release noted that funds are required to use fair value prices any time market quotations for their portfolio securities are not readily available, as well as when closing prices cease to be reliable indicators of fair value. The amendments do not, however, require disclosure of the specific methodologies and formulas that a fund uses to determine fair value prices.

Portfolio Holdings Disclosure. The amendments require mutual funds and variable products to disclose their policies with respect to disclosure of portfolio holdings information. A fund will be required to (i) describe in its SAI any policies and procedures with respect to the disclosure of portfolio securities to any person and any ongoing arrangements to make available information about portfolio securities to any person; and (ii) state in its prospectus that a description of the policies and procedures is available in the fund’s SAI, and on the fund’s website (if applicable). The SAI description of a fund’s policies and procedures with respect to the disclosure of its portfolio securities will be required to include:

• how the policies and procedures apply to disclosure to different categories of persons, including individual investors, institutional investors, intermediaries that distribute the fund’s shares, third-party service providers, rating and ranking organizations, and affiliated persons of the fund;
• any conditions or restrictions placed on the use of information about portfolio securities that is disclosed, including any requirement that the information be kept confidential or prohibitions on trading based on the information, and any procedures to monitor the use of this information;
• the frequency with which information about portfolio securities is disclosed, and the length of the lag, if any, between the date of the information and the date on which the information is disclosed;
  any policies and procedures with respect to the receipt of compensation or other consideration by the fund, its investment adviser, or any other party in connection with the disclosure of information about portfolio securities;
• the individuals or categories of individuals who may authorize disclosure of the fund’s portfolio securities;
• the procedures that the fund uses to ensure that disclosure of information about portfolio securities is in the best interests of fund shareholders, including procedures to address conflicts between the interests of fund shareholders, and those of the fund’s investment adviser, principal underwriter, or any affiliated person of the fund, its investment adviser, or its principal underwriter; and
• the manner in which the fund’s board exercises oversight of disclosure of the fund’s portfolio securities.

In addition, a fund’s disclosure of its policies and procedures with respect to dissemination of its portfolio securities will be required to include any policies and procedures of the fund’s investment adviser, or any third party that the fund uses or that are used on the fund’s behalf.

Compliance Date. Registration statements and post-effective amendments filed on or after December 5, 2004, must comply with the amendments. Effective Date: May 28, 2004. SEC Release Nos. 33-8408; IC-26418; File No. S7-26-03.

On March 31, 2004, the SEC settled an enforcement action against an investment adviser, finding that the adviser failed to adequately disclose to the boards of trustees and shareholders of its mutual funds the specifics of its “shelf-space” arrangements with brokerage firms and the conflicts created by those arrangements related to the adviser’s use of fund assets, specifically brokerage commissions on fund transactions, to pay for the marketing and distribution of the funds.

Specifically, the SEC found that:

• Over a one-year period, the adviser entered into bilateral arrangements (known as “Strategic Alliances”) with approximately100 broker-dealers, under which the adviser directed brokerage commissions on fund portfolio transactions to the brokerage firms, and in exchange, the funds received heightened visibility within the brokerage firms’ distribution networks.
• Based upon negotiated formulas, the adviser paid brokerage firms anywhere from 15 to 25 basis points on gross fund sales and/or 3 to 20 basis points on assets held over one year.

According to the SEC, the adviser satisfied the Strategic Alliances by (1) paying cash (known as “hard dollars”), and (2) directing brokerage commissions. The SEC determined that when the adviser satisfied the Strategic Alliances with brokerage commissions, it paid 1.5 times (or some other negotiated multiple of) the amount it would have paid in hard dollars. The SEC found that the adviser did not adequately disclose to the funds’ boards and shareholders the quid pro quo nature of these arrangements and the ancillary conflicts of interest they created.

The SEC’s order found that the adviser willfully violated the antifraud provisions of the Investment Advisers Act of 1940 (the “Advisers Act”) and the Investment Company Act of 1940 (the “Investment Company Act”), determining that:

• as a fiduciary, the adviser had a duty to disclose effectively to the boards any potential conflict of interest created by the use of fund brokerage commissions to satisfy Strategic Alliances; and
• neither the funds’ prospectuses nor statements of additional information adequately disclosed that the adviser directed brokerage commissions to satisfy negotiated Strategic Alliances.

The adviser has agreed to make a nominal disgorgement payment and, in addition, will pay $50 million in civil penalties, to be distributed by the adviser to the funds in accordance with a plan approved by the SEC. In addition, the adviser has suspended its use of fund brokerage commissions to pay for Strategic Alliances. The adviser also has undertaken to adopt the recommendations of an independent consultant it will direct to conduct a review of, and provide recommendations concerning, the adviser’s policies and procedures with respect to its Strategic Alliances. SEC Release No. IA-2224; IC-26409; File No. 3-11450, March 31, 2004.

The NASD recently issued (1) a status report detailing the progress that has been made toward implementing the recommendations of the Task Force with respect to breakpoint discounts and (2) a member alert to provide guidance to NASD members experiencing difficulty in locating customers to whom they owe refunds.

Status Report on Implementation of Task Force Recommendations

On March 19, 2004, the NASD submitted to the SEC, on behalf of the Task Force, a status report detailing the progress that has been made toward implementing the recommendations set forth in a July 2003 Task Force report. According to the report, of the Task Force’s 13 recommendations, seven have been fully implemented, two are in progress with expected completion dates and four have not been implemented because they require coordination with recent SEC proposals.

Fully Implemented Recommendations:

1. New prospectus and website disclosure regarding pricing methods, breakpoint schedules and account linkage rules;
2. A standardized checklist for use by registered representatives at the point of sale to facilitate the identification of breakpoint opportunities;
3. A standardized account information worksheet to record the relevant data regarding a customer’s holdings and the holdings of related parties;
4. New prospectuses disclosure that investors may need to assist in securing breakpoint discounts by providing information to broker-dealers about the investor’s related parties and the cost of investments;
5. A sample written disclosure document for registered representatives to provide to investors at the point of sale explaining breakpoint availability and how those breakpoint discounts may impact the share class decision;
6. Registered representative training; and
7. The SEC, NASD, Investment Company Institute and Securities Industry Association have issued several investor publications on the subject of breakpoint discounts and mutual fund share classes.

Recommendations with Expected Completion Dates

1. Developing common definitional terms among members of the working group (expected completion by the end of April 2004); and
2. Creating a central, comprehensive database of pricing methods, breakpoint schedules and the linkage rules used to determine when a breakpoint has been reached (expected that the National Security Clearing Corporation will have completed the work to make the database available to mutual fund companies by the end of May 2004, and the mutual fund companies will populate the database thereafter).

Remaining Recommendations

The Task Force also has made substantial progress toward implementing the remaining four recommendations, which involve the content of breakpoint confirmations and the introduction of automated processing solutions designed to facilitate the delivery of breakpoint discounts. The NASD noted that the action taken on these recommendations must be coordinated with recent SEC proposals on point of sale and confirmation disclosure and mandatory redemption fees.

NASD Status Report, March 19, 2004

Guidance on Locating Customers

On March 30, 2004, the NASD issued a member alert to provide guidance to NASD members experiencing difficulty in locating customers owed refunds as a result of not receiving the sales load breakpoint discount(s) to which the customer was entitled.

The member alert stated that, at minimum, broker-dealers should:

• attempt to obtain the client’s current address from the mutual fund or mutual fund distributor involved, the fund’s transfer agent, or, if the customer has transferred his or her account, from the new firm;
• offer written agreements to relevant third parties to not use the information for any purpose other than effectuating breakpoint discount refund programs;
• if the mutual fund, fund distributor, transfer agent, or new firm will not provide the customer’s address, request that one or all of the third parties forward the material to the customer; and
• take additional steps, including use of information data base services.

The member alert further stated that any firm that has tried and failed to obtain the information necessary to effectuate refunds should thoroughly document its efforts. Such firms that are required to file a report of their trade-by-trade analysis with the NASD by April 16, 2004, should include in their report a detailed description of the steps taken to locate customers and former customers and, if applicable, an explanation of why those steps failed.

NASD Member Alert, March 30, 2004.

At an open meeting on April 13, 2004, the SEC adopted amendments designed to improve transparency of policies and procedures of mutual funds and insurance company managed separate accounts that offer variable annuities (“variable products”) with respect to market timing, use fair value pricing and disclosure of portfolio holdings.

Market Timing. The amendments will, among other things, require mutual funds and variable products to:

• describe in their prospectuses the risks, if any, that frequent purchases and redemptions present for other shareholders;
• state in their prospectuses whether the fund's board (or equivalent) has adopted policies and procedures with respect to frequent purchases and redemptions and, if not, why not;
• describe with specificity in their prospectuses any policies and procedures for deterring frequent purchases and redemptions.

Fair Value Pricing. The amendments will clarify that mutual funds and variable products are required to explain in their prospectuses both the circumstances under which they will use fair value pricing and the effects of using fair value pricing.

Portfolio Holdings Disclosure. The amendments will require mutual funds and variable products to describe in their Statements of Additional Information any policies and procedures with respect to the disclosure of portfolio securities and any ongoing arrangements to make available information about portfolio securities to any person.

A detailed report will be included in next week’s Industry News Summary. SEC Release No. 2004-50.

• SROs would be required to file their proposed rule changes with the SEC electronically, rather than in paper format;
• SROs would be required to post on their public websites, no later than the next business day after filing with the SEC, a copy of a proposed rule change, facilitating the ability of interested persons to comment on the proposals; and
• SROs would be required to maintain a current and complete version of their rules on their websites.

Comments must be received by the SEC on or before June 4, 2004. SEC Release No. 34-49505; File No. S7-18-04 (March 30, 2004).

On May 24, 2004 the SEC proposed amendments to its rules regarding electronic filing under Regulation S-T, which would require that open-end investment companies and insurance company separate accounts electronically identify in their filings each series and class (or, in the case of separate accounts, contract) to which the filing relates. Specifically, open-end management investment companies and separate accounts which register on Forms N-1A, N-3, N-4 and N-6 (collectively, “Series Funds”) would be required to obtain unique identifiers for each of their series or classes (or contracts) and electronically identify for which series and classes (or contracts) of the Series Fund a particular filing is made. In addition, the SEC proposed to add several investment company filing types to the list of filings that must be made electronically.

Implementation of the proposed rules, if adopted, would require all Series Funds to enter their existing series and class (or contract) identification onto a section of the EDGAR Filing Website (the “Series and Classes (Contracts) Information Page”). Each Series Fund would provide series names, class (or contract) names, and ticker symbols, if any, after which the SEC would issue series and class identifiers, which would be available to the public. Information filed with the SEC containing these identifiers would be searchable by the public and the staff of the SEC using the identifiers and also using the series and class (contract) names without the need for reference to the Series Fund issuing the series and/or class (contract). The information relating to its series and classes (contracts), including their identifiers, would be available to the Series Fund quickly via e-mail notification following the entering of information and at the EDGAR Filing Website. The Series Fund would also use the Series and Classes (Contracts) Information Page to update series and class (contract) information as required upon specified events, such as name change and deactivation, liquidation, or other events resulting in the elimination of a series or class or deregistration of the Series Fund.

Comments must be received by the SEC on or before May 24, 2004. SEC Release Nos. 33-8401; 34-49426; 35-227816; 39-2417; IC-26388 (March 16, 2004).

On March 31, 2004, the United States District Court for the District of Arizona entered a final judgment against the company, finding it effected mutual fund trades for participants in retirement plans and processed data regarding those trades for the plans’ third party administrators (“TPAs”).

The SEC’s complaint alleged the following:

• Late Trading: From May 2000 to July 2003 the company facilitated hundreds of mutual fund trades in nearly 400 different mutual funds by certain hedge funds. Approximately 99% of these trades were transmitted to the company after the 4:00 p.m. Eastern time market close; 82% of the trades were sent to company between 6:00 p.m. and 9:00 p.m. The hedge funds’ late trading was effected by the company through its electronic trading platform, which was designed primarily for processing trades by TPAs for retirement plans. The company repeatedly misrepresented to mutual funds that the hedge funds were a retirement plan account, despite the fact that the company knew the hedge funds were not a TPA or a retirement plan account.
• Market Timing: During its three-year relationship with the hedge funds, the company employed various methods to attempt to conceal the hedge funds’ market timing activities from mutual funds, including a “piggybacking” strategy in which the company set up a sub-account within the account of one of the company’s TPA clients and attached the hedge funds’ mutual fund trades to the trades of this client without the client’s knowledge.

The complaint charged the company, as well as certain officers, with violating the antifraud provisions of the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).

The company was also charged with violating Rule 22c-1 of the Investment Company Act. Rule 22c 1, often referred to as the “forward pricing rule,” prohibits the purchase or sale of mutual fund shares except at a price based on the current net asset value of such shares that is next calculated after receipt of a buy or sell order. The company’s former CEO was also charged with violating Section 37 of the Investment Company Act, which prohibits stealing the assets of a registered investment company.

In accordance with the final judgment, the company paid $1 million in disgorgement on March 31, 2004, when the company was shut down pursuant to orders from its primary regulator, the Office of the Comptroller of the Currency. The company consented to the entry of the judgment without admitting or denying the allegations in the SEC’s complaint. SEC v. Security Trust Company, N.A., Grant D. Seeger, William A. Kenyon, and Nicole McDermott, Civil Action No. CV 03-2323 PHX JWS, D. Ariz. (LR-18653); SEC News Digest, Issue 2004-64, April 2, 2004.

The staff of the SEC recently issued a letter stating it would not recommend enforcement action against two investment advisers if certain funds they advise implement “fulcrum fee” arrangements (i.e., arrangements whereby the adviser’s fee increases and decreases proportionately with the investment performance of the fund relative to the performance of an appropriate index), provided that the fulcrum fee could not result in advisory fees that exceed current rates paid by each fund.

The SEC staff’s no-action relief was conditioned upon, among other things, that:

• each investment advisory agreement, as amended to include the fulcrum fee arrangement, is entered into in accordance with the provisions of Section 15 of the Investment Company Act of 1940 other than requiring a shareholder vote;
• the board of trustees of each fund approves the fulcrum fee arrangement in order to improve the quality of services that the funds’ advisers provide to the funds by aligning the advisers’ interests more closely with those of the funds;
• the fulcrum fee arrangements will not result in any decrease or modification in the nature or level of services that the advisers provide to the funds;
• the rate of the advisory fee that will be paid by a fund under the fulcrum fee arrangement will never exceed the current rate of the advisory fee paid by that fund;
• the rate of the advisory fee that will be paid by each fund under the fulcrum fee arrangement will be both increased by over-performance, and decreased by under-performance; and
• each fund will provide appropriate notice about the arrangement to its existing and prospective shareholders.

In addition, the SEC staff noted that implementation of the arrangements without shareholder approval is consistent with the staff’s rationale in prior no-action letters, in which the staff has reasoned that calling a shareholder meeting for the sole purpose of approving an advisory contract amendment that has no effect other than to reduce the percentage of a fund’s assets to be paid to the adviser would cause shareholders to incur solicitation expenses, and could cause the fund to forgo a possible advisory reduction for a period of time by delaying the effective date of the amended contract. NO-ACT, WSB File No. 0322200407, Gartmore Mutual Funds (March 19, 2004).

On March 25, 2004, the CFTC and the SEC (collectively, the “Commissions”) by joint order under the Commodity Exchange Act (“CEA”) and the 1934 Act (collectively, the “Acts”) are excluding certain securities indexes from the definition of “narrow-based security index” and thus subject to regulation by the CFTC. Specifically, the Commissions are excluding from the definition of the term “narrow-based security index” certain indexes comprised of options on broad-based security indexes.

Futures contracts on single stock or on a narrow-based security index are regulated jointly by the Commissions, whereas futures contracts on a broad-based security index are under the exclusive jurisdiction of the CFTC. Under Section 1a(25) of the CEA and Section 3(a)(55)(B) under the 1934, an index is defined as a “narrow-based security index” if, among other things, it meets one of the following four criteria: 


(i) The index has nine or fewer component securities;
(ii) Any one component security of the index comprises more than 30 percent of the index’s weighting;
(iii) The five highest weighted component securities of the index in the aggregate comprise more than 60 percent of the index’s weighting; or
(iv) The lowest weighted securities comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with 15 or more securities, $30,000,000).

Notwithstanding the initial criteria listed above, the Acts provide that an index is not a narrow-based security index if a futures contract is traded on or subject to the rules of a board of trade and meets certain requirements as established by the Commissions.

In September 2003, CBOE Futures Exchange, LLC (“CFE”) announced plans to trade futures contracts on certain volatility indexes created by the Chicago Board Options Exchange, Inc. (“CBOE”). Each of these volatility indexes is designed to measure the variability of daily returns on a security index (“Underlying Broad-Based Security Index”), as reflected in the prices of options on the Underlying Broad-Based Security Index. The component securities of a volatility index are put and call options on a security index. In light of CFE’s announcement, the Commissions considered whether volatility indexes are narrow-based security indexes.

The Commissions determined that, pursuant to Section 1a(25)(B)(vi) of the CEA and Section 3(a)(55)(C)(vi) of the 1934 Act, an index is not a narrow-based security index, and is therefore a broad-based security index, if all of the following conditions are met:

1. The index measures the magnitude of changes in the level of an Underlying Broad-Based Security Index that is not a narrow-based security index as that term is defined in Section 1(a)(25) of the CEA and Section 3(a)(55) of the 1934 Act over a defined period of time, which magnitude is calculated using the prices of options on the Underlying Broad-Based Security Index and represents (a) an annualized standard deviation of percent changes in the level of the Underlying Broad-Based Security Index; (b) an annualized variance of percent changes in the level of the Underlying Broad-Based Security Index; or (c) on a non-annualized basis either the standard deviation or the variance of percent changes in the level of the Underlying Broad-Based Security Index;
2. The index has more than nine component securities, all of which are options on the Underlying Broad-Based Security Index;
3. No component security of the index comprises more than 30% of the index’s weighting;
4. The five highest weighted component securities of the index in the aggregate do not comprise more than 60% of the index’s weighting;
5. The average daily trading volume of the lowest weighted component securities in the Underlying Broad-Based Security Index upon which the index is calculated (those comprising, in the aggregate, 25% of the Underlying Broad-Based Security Index’s weighting) has a dollar value of more than $50,000,000 (or $30,000,000 in the case of an Underlying Broad-Based Security Index with 15 or more component securities), except if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the Underlying Broad-Based Security Index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting with the lowest ranked security;
6. Options on the Underlying Broad-Based Security Index are listed and traded on a national securities exchange registered under Section 6(a) of the 1934 Act; and
7. The aggregate average daily trading volume in options on the Underlying Broad-Based Security Index is at least 10,000 contracts calculated as of the preceding six full calendar months.

EFFECTIVE DATE: March 25, 2004

CFTC and SEC Release No. 34-49469, Joint Order Excluding Indexes Comprised of Certain Index Options from the Definition of Narrow-Based Security Index pursuant to Section 1a(25)(B)(vi) of the CEA and Section 3(A)(55)(C)(vi) of the 1934 Act, March 25, 2004.

Speaking at the 2004 Mutual Funds Conference, Paul Roye, Director of the SEC’s Division of Investment Management, discussed the financial scandals as well as new imperatives for the mutual fund industry. Mr. Roye attributed the mutual fund industry’s recent problems, in part, to a lack of diligence, weak controls and compliance systems, the failure of funds to fair value price portfolio securities, and the abuse of operational weaknesses that limit a fund’s ability to detect market-timers (i.e., omnibus accounts and fund intermediaries with weak controls). He noted, however, that most of the problems in the industry ultimately resulted from its members losing sight of their fiduciary obligations and the principle of placing the interests of investors first. He stated that the recent wave of abusive activity has seriously compromised investor trust, and he emphasized that integrity and accountability must be the new imperatives for the mutual fund industry.

Mr. Roye stated that, from a regulator’s perspective, many of the criticisms of the SEC’s new rules and proposed rules can be viewed as efforts to avoid accountability, and that while the SEC is always open to constructive criticism and comment on proposed rules the SEC cannot “water down” rules to the point where they enable industry participants to avoid accountability. Mr. Roye announced that the SEC is in the middle of an aggressive rulemaking agenda designed to reinforce fund regulations and to promote a culture of integrity, responsibility and accountability in the fund industry.

He stated that the SEC’s four main goals for its mutual fund regulatory agenda are: (1) to address late trading, market timing and related abuses; (2) to improve the oversight of funds by enhancing fund governance, ethical standards, and compliance and internal controls; (3) to address or eliminate certain conflicts of interest in the industry that are potentially harmful to fund investors; and (4) in a further effort to promote accountability, to improve disclosure (especially fee-related disclosure) to fund investors.

Initiatives to address late trading, abusive market timing and related abuses

a) Late trading. In an effort to address late trading, Mr. Roye noted that the SEC proposed a rule that would require a fund or a certified clearing agency to receive purchase and redemption orders prior to the time the fund prices its shares (typically 4:00 p.m.) for an investor to receive that day’s price. Mr. Roye noted that is clear from the nearly 1,000 comment letters that some believe the hard 4:00 p.m. cut-off is not the preferred approach since it would require some intermediaries to impose cut-offs for orders well before 4:00 p.m. and therefore limit investor flexibility to place orders for fund transactions, particularly in the 401(k) context. As a result, the SEC is studying various alternatives to the proposed hard 4:00 p.m. cut-off.

b) Market timing. Mr. Roye commented that the SEC has stressed that fair value pricing is critical to reducing or eliminating market timing profits and the dilution of shareholder interests. In addition to reiterating the obligations of funds to fair value their securities to reduce market timing arbitrage opportunities, the SEC proposed improved disclosure of a fund’s policies and procedures regarding fair value pricing. The SEC is currently gathering information regarding funds’ fair value pricing practices and evaluating whether to recommend additional measures to improve funds’ fair value pricing. The SEC has also proposed a rule that would require funds to impose a mandatory two percent redemption fee when investors redeem shares within five business days. The combination of the proposed two percent redemption fee and fair value pricing obligations would make market timing less profitable, thereby reducing the incentive to engage in market timing. A significant feature of the proposed rule is the requirement for financial intermediaries to provide funds on at least a weekly basis information regarding the taxpayer ID number and the amount and dates of all purchases, redemptions or exchanges made during the previous week for each shareholder trading through an through an omnibus account. This requirement is intended to facilitate the pass-through of information and enable funds to identify and bar market timers and confirm the proper assessment of fees by fund intermediaries.

c) Enhanced disclosure related to abusive activities. Mr. Roye noted that the SEC has also proposed rules requiring enhanced disclosure of a fund’s anti-market timing policies and information regarding a fund’s disclosure of its portfolio holdings.

Initiatives to enhance oversight

a) Fund governance. Mr. Roye commented that in an effort to promote accountability, improve fund oversight and compliance, strengthen fund boards and reinforce ethical standards, the SEC proposed fund governance rules which require (i) a board comprised of 75% independent directors; (ii) an independent chairman of the board; (iii) independent director authority to hire, evaluate and fire staff; (iv) quarterly executive sessions of independent directors outside of the presence of management; and (v) an annual board self-evaluation. In response to comments that the SEC is interjecting directors into day-to-day management of fund operations, Mr. Roye explained that although the SEC recognizes that the role of fund directors is one of oversight, directors must have sufficient information to carry out their responsibilities. As a consequence, the SEC has required a fund’s chief compliance officer to report to the board and has promoted the authority of independent directors to retain staff and experts in facilitating their oversight responsibility.

b) Adviser codes of ethics and fund transactions reporting. He addressed the proposal that all registered investment advisers adopt codes of ethics that would set forth standards of conduct for advisory personnel. The code of ethics would reflect the adviser’s fiduciary duties, as well as codify requirements to ensure that an adviser’s supervised persons comply with the federal securities laws, report their securities transactions and acknowledge receipt of a copy of the code of ethics. He stated that investment advisers are fiduciaries which must place their clients’ interests before their own. He noted that this bedrock principle, which historically has been a core value of the money management business, appears to have been lost on a number of advisers and their personnel. The SEC believes that prevention of unethical conduct by advisory personnel is a part of the answer to ensure that similar misconduct does not occur in the future.

c) Compliance policies and compliance officer. Mr. Roye stated that the SEC’s new compliance policies and chief compliance officer rules are expected to have a far-reaching positive impact on mutual fund operations and compliance programs. He stated that the SEC envisions the compliance officer not only as the primary architect and enforcer of compliance policies and procedures for the fund, but also as “the eyes and ears of the board” on compliance matters. He noted that in recent enforcement cases, the SEC has often discovered the denial of information to fund directors regarding compliance matters. Mr. Roye stated that he hopes all firms designate a chief compliance officer “who is forceful, scrupulous, qualified and, above all, undaunted in his or her commitment to establishing and enforcing a meaningful compliance program.”

Initiatives aimed at conflicts of interest

a) Directed brokerage. In addition to enhancing fund oversight and compliance, Mr. Roye noted that the SEC is undertaking a series of initiatives aimed at addressing certain conflicts of interest involving funds and those who distribute fund shares. The SEC recently voted to propose an amendment to rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”) to prohibit the use of brokerage commission to compensate broker-dealers for distribution of a fund’s shares. Mr. Roye stated that this prohibition on directed brokerage would force advisers to become accountable to fund investors regarding distribution fees and would eliminate a practice which could compromise best execution of portfolio trades, increase portfolio turnover, and corrupt broker-dealers’ recommendations to their customers.

b) Rule 12b-1. He stated that the SEC has also requested comment on the need for additional changes to rule 12b-1 or even a repeal of the rule since its current use exceeds its original purpose.

c) Soft dollars. He explained that Chairman Donaldson has made the issue of soft dollars a priority and has directed the staff to explore the conflicts inherent in soft dollar arrangements, as well as the scope of the safe harbor contained in Section 28(e) of the Securities Exchange Act of 1934 (the “1934 Act”). He stated that the Division of Investment Management and the Division of Market Regulation are currently working together on this review and will be conducting a thorough analysis to make recommendations to the SEC on this issue.

Initiatives to improve fund disclosure, including fee-related information

a) Shareholder reports disclosure. Mr. Roye explained that the SEC’s initiatives to improve fund disclosure include requiring shareholder reports to disclose dollar-based expense information for a hypothetical $1,000 investment to allow investors to estimate the dollar amount of expenses paid on their own investment in a fund and to compare expenses across various potential fund investments. The SEC is also requiring additional quarterly disclosure of fund portfolio holdings to provide investors with more frequent access to portfolio information.

The SEC has also proposed a requirement to include in shareholder reports a discussion of the material factors regarding a board’s evaluations and conclusions with respect to investment advisory contracts. With this proposal, the SEC is seeking to promote insightful disclosure of the board review process, rather than meaningless boilerplate that is not helpful to investors. In addition, the proposal would require the preservation of documents used by boards in the advisory contract review process. These proposals are intended to encourage fund boards to consider investment advisory contracts more carefully and to promote the accountability of directors in their contract review. Responding to comments that fund directors are not required to “negotiate” advisory contracts, Mr. Roye stated that he disagreed. He explained that Section 15 of the 1940 Act charges directors with one of the most important responsibilities under the statue: to evaluate investment advisory agreements and the compensation paid by the fund on an annual basis. Mr. Roye stated that if, after review all of the relevant factors including the adviser’s cost and profitability as well as economies of scale, the directors’ judgment is that the fee is not reasonable, directors should be negotiating a lower fee. 

b) Mutual fund confirmation form and point of sale disclosure. Mr. Roye noted the SEC has proposed making significant revisions to the mutual fund confirmation form and requiring a point of sale disclosure document for brokers selling fund shares. He stated that these proposals would highlight for customers many of the conflicts that broker-dealers face when recommending certain mutual funds. This would, in turn, enhance the accountability of broker-dealers to their customers when making fund recommendations.

c) Breakpoint disclosure. Mr. Roye noted that the SEC proposed improved prospectus disclosure regarding fund breakpoints in an attempt to address the wide-scale failure to provide appropriate breakpoint discounts on fund purchases.

d) Transaction costs. Mr. Roye stated that the SEC is now in the process of reviewing the comments it received in response to the SEC’s concept release on the methods to calculate and improve the disclosure of a fund’s portfolio transaction costs.

Reassessment of SEC effectiveness

Mr. Roye explained that one of Chairman Donaldson’s goals has been to restore the SEC’s credibility as the investors’ watchdog and that he has undertaken a comprehensive review of every division of the SEC by assessing current needs, resources, reviewing methodology and installing performance measures. Mr. Roye noted that, as a result of a budget increase and Chairman Donaldson’s review, the SEC has increased its examination staff by a third to approximately 500 examiners. With increased staff and new examination protocols, the SEC has enhanced its ability to detect violations of the law.

In an effort to reassess the SEC’s effectiveness, Chairman Donaldson has created a new Office of Risk Assessment that focuses on early identification of new or resurgent forms of fraudulent, illegal or questionable behavior. The Division of Investment Management is in the process of establishing its own risk management group that will report into and work closed with the Office of Risk Management. In addition, Chairman Donaldson has formed a new task force whose mission is to prepare the outlines of a new mutual fund surveillance program by reevaluating the mutual fund reporting regime with respect to both the frequency of reporting and the types of information that should be reported to the SEC in an effort to facilitate industry oversight. 

Conclusion

In conclusion, Mr. Roye stated that the SEC’s goal is to create a fund governance, oversight and regulatory framework that will deter and minimize the recurrence of the types of “abhorrent practices” recently witnessed. He explained that any flexibility permitted by the SEC rules requires that those who are charged with carrying out fiduciary and oversight responsibilities act in the best interest of fund shareholders. On a final note, Mr. Roye stated that although the SEC cannot legislate honesty or mandate integrity, “it is a legal obligation, an unquestioned duty and an implicit promise to fund shareholders when they invest their hard earned dollars in a mutual fund.”

Speech by SEC Staff on “Integrity and Accountability: The New Imperatives for the Mutual Fund Industry,” by Paul F. Roye, March 22, 2004.