• excludes all communications to institutional investors from member pre-use approval and NASD filing requirements and from many of the NASD’s content standards;
• excludes form letters and group e-mail sent to existing retail customers and fewer than 25 prospective retail customers from the same requirements, provided that a member has developed appropriate policies and procedures to supervise and review the communications;
• excludes independently prepared reprints, and excerpts from those reprints, from the filing and many of the content standards; and
• excludes press releases that are made available only to the media from the filing requirements.

Under the new rule, no member could treat a communication as having been distributed to an institutional investor if the member had reason to believe that the communication or any excerpt thereof would be forwarded or made available to any person other than an institutional investor. “Institutional investor’’ would include persons described in NASD Rule 3110(c)(4), which defines ‘‘institutional account’’ to include any entity with total assets of at least $50 million. It would also include governmental entities and their subdivisions and certain employee benefit plans that have at least 100 participants. The new rule will take effect on November 3, 2003. Federal Register (Vol. 68, No. 96. Monday, May 19, 2003).

The U.S. Court of Appeals for the Ninth Circuit held that a violation of Section 206(1) of the Investment Advisers Act of 1940 (the “Advisers Act”) does not require a showing of specific intent to defraud but only knowing or reckless conduct. Section 206(1) provides that it is unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly to employ any device, scheme, or artifice to defraud any client or prospective client.

The case involved the petition by two registered investment advisers (the “petitioners”) for review of a determination by the SEC that the petitioners knowingly or recklessly made materially false statements and omissions to their clients and in their filings with the SEC. The SEC did not allege that the petitioners had acted with the specific intent to defraud. Specifically, the SEC found that the petitioners falsely represented that they received no referral fees from the sale of shares of an investment fund and had no financial interest in any of the recommendations they made to their clients. The court found that the SEC’s findings were supported by substantial evidence.

The court noted that in the Ninth circuit a violation Section 10(b) of the 1934 Act and Rule 10b-5 thereunder may be supported by “knowing or reckless conduct,” without a showing of “willful intent to defraud.” A similar showing is required for violations of Section 17(a)(1) of the Securities Act of 1933 (the “1933 Act”). The court noted that it has never considered what constitutes scienter under Section 206(1) of the Advisers Act, but because its language is nearly identical to that of Section 17(a)(1), the court held that the same definition — knowing or reckless conduct — applies to Section 206(1) of the Advisers Act. Accordingly, the court denied the petitioners’ petition. Vernazza v. SEC (9th Cir., No. 01-71857) (April 24, 2003).

Following its two-day hedge fund roundtable held in on May 14 and 15, 2003, the SEC announced that it would leave open the period for public comment until July 7, 2003. The roundtable is a part of the SEC's formal fact-finding investigation of the hedge fund industry launched in the spring of 2002. The roundtable covered a number of topics, including: (1) the structure, operation and compliance activities of hedge funds; (2) marketing issues; (3) investor protection issues; (4) the current regulatory scheme; and (5) whether additional regulation is warranted. Comments can be sent electronically to [email protected] or in hard copy to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609.

The SEC has issued an interpretive release addressing Rule 17a-4 under the 1934 Act which permits broker-dealers to store required records in electronic form. Under the rule, electronic records must be preserved exclusively in a non-rewritable and non-erasable format. The SEC noted that it has received requests from broker-dealers for guidance on whether this requirement limits them to using optical platters, CD-ROMs, DVDs or similar physical mediums where data is permanently written onto the medium to achieve this result or whether they may use an electronic storage record system.

In the release, the SEC clarified that Rule 17a-4 does not require the use of any particular type of technology or method to satisfy the non-rewritable and non-erasable requirement. A broker-dealer would not violate the rule if it uses an electronic storage record system that prevents the overwriting, erasing or otherwise altering of a record during its required retention period through the use of integrated hardware and software control codes. The SEC advised that if the electronic storage record systems contain integrated system codes which prevent anyone from overwriting the records and the codes used by these systems cannot be turned off to remove this feature, these systems would satisfy the non-rewritable and non-erasable requirement of the rule. The SEC noted that the non-erasable and non-rewritable aspect of their storage would not need to continue beyond the required record keeping period.

The SEC also commented that storage systems that only mitigate the risk a record will be overwritten or erased would not satisfy the rule. These systems may use software applications such as authentication and approval policies to protect electronic records, passwords or other extrinsic security controls but which maintain the records in a manner that is rewritable or erasable. For example, they may limit access to records through the use of passwords or create a "finger print" of the record based on its content. If the record is changed, the fingerprint will indicate that it was altered but the original record would not be preserved. The SEC advised that the ability to overwrite or erase records stored on these systems makes them non-compliant with Rule 17a-4(f). SEC Release No. 34-47806 (May 7, 2003).

The SEC has adopted new Rules 13b-2(b) and (c) under the Securities Exchange Act of 1934 (the “1934 Act”) which prohibit officers and directors of an issuer, and persons acting under the direction of an officer or director, from taking any action to coerce, manipulate, mislead, or fraudulently influence the auditor of the issuer's financial statements if that person knew or should have known that such action, if successful, could result in rendering the financial statements materially misleading. These new rules implement Section 303 of the Sarbanes-Oxley Act of 2002 and supplement current rules which address the falsification of books, records and accounts and making false or misleading statements or omissions to accountants.

In the case of registered investment companies, the new rules extend the prohibition on improper influence on the conduct of audits to cover not only officers and directors of the investment company itself, but also officers and directors of the investment company's investment adviser, sponsor, depositor, trustee, and administrator. The SEC noted that these service providers perform virtually all of the management, administrative, and other services necessary to the investment company's operations, including preparation of the financial statements.

In the release, the SEC noted that the term “direction” encompasses a broader category of behavior than "supervision”, and that someone may be acting under the direction of an officer or director even if they are not under the supervision or control of that officer or director. The SEC commented that such persons might include not only the issuer's employees but also customers, vendors or creditors who, under the direction of an officer or director, provide false or misleading confirmations or other false or misleading information to auditors. Such persons may also include lower level employees of the issuer and attorneys, securities professionals, or other advisers who, for example, pressure an auditor to limit the scope of the audit, to issue an unqualified report on the financial statements when such a report would be unwarranted, to not object to an inappropriate accounting treatment, or not to withdraw an issued audit report on the issuer's financial statements. The new rules take effect on June 27. 2003. SEC Release No. 34-47890 (May 20, 2003).

The SEC announced that effective Oct. 1, 2003, or 5 days after the date on which the SEC receives its fiscal 2004 regular appropriation if that date comes later, the Section 6(b) fee rate applicable to the registration of securities, the Section 13(e) fee rate applicable to the repurchase of securities, and the Section 14(g) fee rates applicable to proxy solicitations and statements in corporate control transactions will be increased to $126.70 per million from the current rate of $80.90 per million. In addition, the Section 31 fee rate applicable to securities transactions on the exchanges and Nasdaq will be reduced to $39.00 per million from the current rate of $46.80 per million. SEC Press Release 2003-57 (April 30, 2003).

Overview

The Securities and Exchange Commission (“SEC”) has adopted new rules and amendments to existing rules relating to the voting of proxies by or on behalf of registered management investment companies (“funds”) and other advisory accounts at shareholders meetings of issuers of portfolio securities held by funds and other advisory accounts. We previously reported extensively on the proxy-voting rulemaking applicable to funds in our Special Report dated March 12, 2003. This report covers the new rule and rule amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) that address an SEC registered adviser’s fiduciary obligation to its non-fund clients when the adviser has authority to vote their proxies. The new rule requires an investment adviser that exercises voting authority over client proxies: (1) to adopt policies and procedures reasonably designed to ensure that the adviser votes proxies in the best interests of clients, (2) to disclose to clients information about those policies and procedures, and (3) to disclose to clients how they may obtain information on how the adviser has voted their proxies. The rule amendments also require advisers to maintain certain records relating to proxy voting. Compliance by advisers is required on or before August 6, 2003. See “Effective Date and Compliance,” below.

Discussion

Under new rule 206(4)-6 it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Advisers Act for an investment adviser to exercise voting authority with respect to client securities, unless

• the adviser has adopted and implemented written policies and procedures that are reasonably designed to ensure that the adviser votes proxies in the best interests of its clients,
• the adviser describes its proxy-voting policies and procedures to its clients and provides copies of them on request, and
• the adviser discloses to clients how they may obtain information on how the adviser voted their proxies.

Advisers Subject to the Rule

The new rule applies to all investment advisers registered with the SEC that exercise proxy-voting authority over client securities. Although commenters on the proposing release had argued for exemptions for certain types of advisers, the SEC concluded that none persuasively argued why an adviser that accepts voting authority should be exempt from requirements designed to ensure that it satisfies its fiduciary obligations to its clients. Accounts that invest only in interest-bearing securities, certain derivatives and other non-equity investments (“non-equity accounts”) are not expected to generate proxy solicitations and, accordingly, advisers of these accounts are generally not subject to the rule. In the unlikely event that an adviser of non-equity accounts were to receive a proxy solicitation with respect to a portfolio investment, the adviser should seek the advice and consent of the accountholder with respect to the voting of the proxy rather than the adviser’s exercising proxy voting authority.

Advisers that have implicit as well as explicit voting authority must comply with rule 206(4)-6. The new rule applies when the investment advisory contract is silent on proxy voting but the adviser’s voting authority is implied by an overall delegation of discretionary authority. The rule does not apply to advisers that merely advise their clients about voting proxies but do not have authority to vote them. Advisers seeking to avoid the burdens of this rule should incorporate in their client contracts specific language stating that the adviser has no proxy-voting authority with respect to client securities. If this section of our report sounds familiar, it is probably because the Department of Labor first took a similar position in 1988, subsequently codified in 1994, with respect to an adviser’s obligation to vote proxies for its ERISA accounts in the absence of language, expressly withholding voting authority or assigning it to a third party, in the advisory contract.

It is important to note that, under the new rule, an adviser commits fraud per se if it votes client proxies on or after August 6, 2003, without having adopted the requisite policies and procedures and having complied with other requirements of the new rule. See “Effective Date and Compliance,” below.

The Massachusetts DOR issued a private letter ruling in response to a request from Hale and Dorr for assurance that the DOR would not treat the provision of certain administrative services by a Massachusetts company (the “Company”) and its offshore affiliates to offshore investment funds as subjecting the funds to Massachusetts taxation. The related funds could conduct all of their operations outside of Massachusetts, except that they may engage the Company and certain of its offshore affiliates to provide the funds with administrative services.

The administrative services which would be provided by the Company inside or outside Massachusetts include:

• The calculation and publication of net asset values and subscription and redemption prices for a fund, together with related financial and accounting services;
• Investor recordkeeping and reporting;
• General administration and accounting; and
• Management reporting.

The offshore affiliates of the Company would provide additional services, such as (i) shareholder services, (ii) the services of a corporate secretary, (iii) providing and maintaining a registered office at an offshore location, and (iv) preparing regulatory filings for compliance with offshore jurisdiction laws. While the Company would generate and maintain corporate records and books of account for the funds in conducting the duties listed above, each fund would be responsible for keeping and maintaining its own principal corporate records and books of account at an offshore location. The Company may also provide an employee or officer to act as a director of a fund, but no director or shareholder meetings of a fund would be conducted in Massachusetts. The Company would not execute any contracts on behalf of the funds, except for certain contracts related to the purchase, sale or management of fund investments. Finally, the Company intends to advertise its services for investment funds, including offshore funds, in published marketing materials and through Websites.

The Massachusetts DOR ruled that

• the provision of accounting, pricing, information, and the enumerated administrative services by the Company for the funds,
• the provision of shareholder, accounting, pricing, information and other administrative services, the maintenance of records and reports and the maintenance of registered offices for the funds in offshore locations by the affiliates, and
• the solicitation by the Company of sales of all of the enumerated administrative services to be provided by the Company and the affiliates, would not cause the funds to be subject to Massachusetts taxation. Letter from the DOR to Hale and Dorr LLP (April 15, 2003)

At a panel discussion on the Sarbanes-Oxley Act of 2002 sponsored by the Mass. Society of Public Accountants at which Joseph Barri of Hale and Dorr was a panelist, Paul Cellupica, Assistant Director of the Division of Investment Management of the SEC, indicated that the SEC would be reviewing for accuracy certain N-CSR disclosures. Specifically, he commented that the SEC staff would be reviewing the claim that, notwithstanding the absence of an audit committee financial expert, the audit committee has comparable expertise among its members. He indicated that the staff may look at the documentation behind this claim, which should not lightly be made.

In connection with the roundtable on hedge funds to be held by the SEC on May 14-15, 2003, the ICI submitted a letter to the SEC setting forth its views on hedge fund regulation. In its letter the ICI stated that, because of the significant increase in the number of individuals investing in or otherwise having exposure to hedge fund investments, it believes it is the right time for the SEC to re-evaluate its historical “hands off” approach to hedge funds. The ICI stressed that the SEC’s regulations should, as a general matter, ensure that no investor would confuse a hedge fund with a highly regulated investment vehicle like a mutual fund and that no investor would be inadvertently drawn to investing in hedge funds.

Preserving the Private Offering: The ICI commented that to accomplish these goals the SEC should continue to strictly interpret and enforce the private placement requirements as they apply to hedge funds. The ICI argued that by repealing or materially weakening the private placement requirements applicable to hedge funds, such as by authorizing advertisements for hedge funds in media of general circulation, the SEC would be fostering widespread investor confusion and undermine public confidence in the key investor protections that characterize the regulated markets. The ICI also noted that the SEC should be concerned by attempts to attract less sophisticated investors to hedge funds, the so-called “retailization” of the hedge fund market. The ICI stated that it believes the accredited investor standard by itself may not be sufficient to ensure that only sophisticated investors participate in hedge funds, but indicated that a higher standard, like the $1.5 million net worth requirement in the Advisers Act for registered advisers to charge a performance fee, would be more appropriate.

The ICI distinguished registered closed-end funds that invest primarily in hedge funds from products that simply pool investments by otherwise ineligible investors for the purpose of investing in hedge funds. The ICI noted that registered funds of hedge funds, which are subject to comprehensive regulation under the Investment Company Act of 1940 and SEC oversight, offer their shareholders a different risk profile than a direct investment in any of the underlying hedge funds. The ICI did recommend strict regulation of the sale practices of the persons selling registered funds of hedge funds because these types of funds are generally not appropriate investments for most retail investors.

Registration of Hedge Fund Advisers: The ICI also commented that it believes investment advisers to hedge funds should be required to register under the Investment Advisers Act of 1940. The ICI stated that it believes such registration would involve minimal costs and burdens for the hedge fund sponsor, but would offer significant public benefits. Specifically, the ICI noted that registration would help the SEC to monitor the activities of these advisers and their impact on the securities markets and would help to provide hedge fund investors with additional protections in areas such as advertising, proxy voting and record keeping which would compliment the anti-fraud provisions which all advisers are already subject to. The ICI noted that many foreign jurisdictions outside of the U.S. require hedge fund managers to register, such as the United Kingdom, but that such regulation has not hampered the growth of hedge funds in those jurisdictions. Letter from Craig S. Tyle of the ICI to Jonathan G. Katz of the SEC, April 30, 2003.

The Financial Crimes Enforcement Network (“FinCEN”) of the Department of the Treasury has proposed amendments to certain rules under the Bank Secrecy Act (“BSA”) to (i) require investment advisers that manage client assets and commodity trading advisers (“CTAs”) that direct client accounts to establish anti-money laundering (“AML”) programs meeting minimum requirements, and (ii) delegate to the SEC for investment advisers, and to the Commodity Futures Trading Commission (“CFTC”) for CTAs, its authority to examine for compliance with the program requirements.

Amendments relating to Investment Advisers: Investment Advisers are not currently included within the definition of ‘financial institutions’ under the BSA. FinCEN has proposed including investment advisers within that definition solely for purposes of requiring them to establish an AML program which meets certain minimum requirements.

The proposed rule, as amended, would apply to: (1) all investment advisers registered with the SEC that have any discretionary or non-discretionary authority to manage a client’s assets and (2) advisers relying on the private adviser exemption under Section 203(b) of the Investment Advisers Act of 1940 (the “Advisers Act”) which have more than $30 million in assets under management. This would require unregistered advisers of hedge funds with more than $30 million in assets to adopt an AML program. Advisers which are dually registered as broker-dealers are not required to establish multiple AML programs. The rule amendments would not apply to state registered advisers.

The proposed amendment would require investment advisers subject to the rule to develop and implement their own AML procedures which are reasonably designed to prevent the firm from being used to launder money or finance terrorist activities. Each adviser’s AML program would have to be approved in writing by its board of directors/trustees or, if it doesn’t have such a governing body, by its general partner, sole proprietor or persons in similar capacities. An adviser’s AML program, like those required of mutual funds beginning in 2002, would be required to contain the following four elements:

• Establish and implement policies, procedures and internal controls reasonably designed to prevent the investment adviser from being used to launder money or finance terrorist activities, including to achieve compliance with applicable provisions of the BSA and FinCEN’s implementing regulations;
• Provide for independent testing of compliance to be conducted by company personnel or by a qualified outside party;
• Designate a person or persons responsible for implementing and monitoring the operations and internal controls of the program; and
• Provide ongoing training for appropriate persons.

The Treasury noted that the adviser’s AML program would need to analyze the money laundering risk posed by a particular investment vehicle by using a risk-based evaluation of relevant factors, including (i) the type of entity; (ii) its location; (iii) the statutory and regulatory scheme of that location; and (iv) the adviser’s historical experience with that entity or the references of other financial institutions.

The Treasury commented that an adviser would not need to consider for purposes of its AML program a client which is a pooled investment vehicle which is itself subject to AML program requirements under BSA rules. However, the Treasury cautioned that pooled investment vehicles that are not subject to AML requirements under the BSA and that are administered by a third party may provide the adviser with little or no information about the investors in the pooled vehicle or their transactions. For those investment vehicles, the adviser would need to establish procedures to assess the risk of money laundering given the identity of the entity that created and administers the pooled vehicle and the nature of the vehicle itself. The Treasury provided the example of an employee retirement plan sponsored by a public corporation that only accepts payroll deductions or rollovers from similar plans which the Treasury indicated presents no realistic risk of money laundering. The Treasury contrasted that with an offshore investment vehicle not subject to any AML program requirements, as the type of advisory client that would present a more significant risk.

The Treasury commented that it is permissible for an adviser to delegate contractually appropriate parts of the implementation and operation of the AML program to another affiliated or unaffiliated entity. However, the adviser would remain responsible for the effectiveness of its program as a whole.

The proposed rule would delegate examination authority to the SEC to ensure investment adviser compliance with the AML program requirements. Those advisers not registered with the SEC but subject to the rule would be required to file a brief notice with FinCEN, providing identifying information about the firm to enable FinCEN to ensure its compliance.

Finally, the Treasury commented that it is considering whether advisers should be subject to additional BSA requirements, including the filing of suspicious activity reports and complying with accountholder identification and verification procedures. Advisers are currently required to file reports on Form 8300 disclosing the receipt of cash totaling more than $10,000 in one transaction or two or more related transactions. Federal Register, Vol. 68 No. 86 (May 5, 2003).

Amendments relating to CTAs: Unlike investment advisers, CTAs were already included within the definition of ‘financial institution’ under the BSA but the Treasury had temporarily exempted them from complying with the AML program requirements. Under the proposed amendments, only CTAs that direct client accounts would be subject to the AML program requirements. When evaluating clients for purposes of its AML program, the CTA would be able to exclude those clients from review under its AML program for which it doesn’t direct accounts. AML programs for CTAs would be required to have the same four required elements as would investment advisers’ programs. Federal Register, Vol. 68 No. 86 (May 5, 2003).

Treasury Proposes to Extend Anti-Money Laundering Program Requirements to Investment Advisers.

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