At an open meeting held October 26, 2004, the SEC voted 3-2 to adopt rules and rule amendments requiring advisers of hedge funds to register with the SEC as investment advisers under the Investment Advisers Act of 1940 ("Advisers Act") by February 1, 2006. Specifically, the new rule will require advisers of hedge funds with more than $25 million in assets and 15 or more investors, determined on a "look-through" basis, to register with the SEC under the Advisers Act. Previously, advisers were able to count each fund as a single client (and not look through) for purposes of the exemption for advisers with fewer than 15 clients. According to an SEC press release, registration under the new rule will permit the SEC to:

• collect information about the operations of hedge fund advisers;
  
• conduct examinations of hedge fund advisers to identify compliance problems, identify practices that may be harmful to investors and provide a deterrent to unlawful conduct;
  
• require all hedge fund advisers to adopt basic compliance controls to prevent violation of the federal securities laws;
  
• improve disclosure made to prospective and current hedge fund investors; and
  
• prevent felons or individuals with other serious disciplinary records from managing hedge funds.

In its press release, the SEC noted that the new rule contains provisions for advisers located outside the United States that are designed to limit the extraterritorial application of the Advisers Act to offshore advisers to offshore funds that have U.S. investors.

As of the date of this Industry News Summary, the final rule release had not been published.

A more detailed summary of the rule will appear in the Industry News Summary following the release of each rule. SEC Press Release 2004-150 (October 27, 2004).

On October 25, 2004, the NASD announced that it settled charges with a broker-dealer resulting in a censure and fine in the amount of $250,000 for disseminating over a one-year period sales literature, which, according to the NASD, was "inappropriate" in that it:

1. Cited a targeted rate of return without providing a sound basis for evaluating the reasonableness of the stated target.

2. Improperly used hypothetical returns in charts or graphs:

According to the NASD, the broker-dealer used sales pieces showing results for a fund before commencement of operations calculated by selecting a portfolio of individual advisers with whom the fund intended to or had recently begun to invest, and combining the historical performance results of these selected advisers, using a hypothetical allocation of assets. Additionally, certain pieces of sales literature presented hypothetical performance results in a chart or graph in combination with actual historical performance of funds or hedge funds, creating the inaccurate impression that such funds or hedge funds had longer investment track records than they actually possessed.

3. Failed to include adequate risk disclosure:

According to the NASD, certain pieces of sales literature did not contain risk disclosure required in order for the disclosure to be considered full and complete, including that:

1. the funds are speculative and involve a high degree of risk;
2. an investor could lose all or a substantial amount of his or her investment;
3. there is no secondary market nor is one expected to develop for investments in the funds;
4. there may be restrictions on transferring fund investments;
5. the funds may be leveraged;
6. the funds' performance may be volatile;
7. the funds have high fees and expenses that would reduce returns; and
8. there are other specific risks related to the particular funds' investment strategies.

The NASD noted that its recent enforcement actions with regard to hedge fund sales by broker-dealers "underscore [its] commitment to making certain that firms provide the investing public with a sound basis for evaluating hedge fund investments, and adequately disclose all of the risks."

NASD News Release (October 25, 2004).

On October 13, 2004, the SEC proposed amendments to Regulation M under the 1934 Act, which governs the activities of underwriters, issuers, selling security holders and others in connection with offerings of securities and is designed to prohibit activities that have the potential to artificially influence the market for the offered security. The amendments would: (1) prohibit certain market activities believed to undermine the integrity and fairness of the offering process, particularly with regard to the allocation of initial public offerings ("IPOs"), and (2) enhance the transparency of aftermarket activities engaged in by underwriters.

Specifically, according to an SEC press release issued October 13, 2004, the proposed amendments would:

• lengthen the "restricted period" for IPOs, which is the period during which distribution participants must refrain from activity that could stimulate the market for the security in distribution. Under the amendments to Regulation M, the restricted period for an IPO generally would begin when an issuer reaches an understanding with an underwriter to proceed with a distribution, and the restricted period would be lengthened beyond the current period of 5 days;
  
• require syndicate covering bids, indicating that the underwriter is buying shares to cover its short position, to be publicly disclosed to the market. The required disclosure would be similar to what is currently required for stabilizing bids under Regulation M;
  
• prohibit the use of penalty bids, which occur when an underwriter reclaims a selling concession from a syndicate member if the offering security is immediately sold by the initial purchaser. Penalty bids also can function as an undisclosed form of stabilization;
  
• adopt a new rule under Regulation M that would expressly prohibit certain IPO abuses that occurred in the late 1990's and in other "hot issue" periods, including conditioning or "tying" an allocation of shares on agreement by the customer to buy shares in another less desirable offering, or to pay excessive trading commissions on unrelated securities transactions;
  
• require recordkeeping in connection with Regulation M's "de minimis exception," which excepts inadvertent bids and purchases during the restricted period that total less than 2% of the distributed security's average daily trading volume ("ADTV"); and
  
• update the ADTV value and public float value thresholds, which are used to determine a security's restricted period and the availability of the exception for actively-traded securities, to reflect the increase in market value since Regulation M's adoption in 1996.

SEC Press Release No. 2004-145 (October 13, 2004).

The SEC has granted accelerated approval to proposed rule changes to the previously approved (in June 2004) amendments to certain rules regarding NASD members’ supervisory and control procedures. The changes are intended to conform certain parts of the new rule requirements to the New York Stock Exchange’s (NYSE’s) recently approved internal control amendments.

In their entirety, the approved rule changes:

• Eliminate Rule 3010(a)(8), which required a member to identify one or more principals who will review the member’s supervisory system, procedures, and inspections and take or recommend action to achieve the member’s compliance with applicable securities laws and regulations and with NASD rules;
  
• Create Rule 3012 to require a member to designate one or more principals who will establish, maintain, and enforce a system of supervisory control policies and procedures that test and verify that the member’s supervisory procedures are reasonably designed to achieve compliance with applicable securities laws and NASD rules and amend those supervisory procedures where necessary. Rule 3012 also requires that a person senior to or “otherwise independent” of a producing manager perform the day-to-day supervisory reviews of the producing manager’s account activity. However, if a member is so limited in size and resources that it cannot comply with this general supervisory requirement, the member may have a knowledgeable principal perform the supervisory reviews. In addition, a member must have in place heightened supervisory procedures for the supervision of a producing manager who is responsible for 20 percent or more of the revenue generated by the business units supervised by the producing manager’s supervisor.
  
• Amend Rule 3010(c) to codify the minimum inspection cycles for a member’s offices and to require that office inspections include, without limitation, the testing and verification of the member’s policies and procedures, including supervisory policies and procedures in certain specified areas. There is a general requirement that an office inspection may not be conducted by the branch office manager for that office, any person within that office who has supervisory responsibilities, or any individual who is directly or indirectly supervised by such persons. However, if a member is so limited in size and resources that it cannot comply with this limitation, the member may have a knowledgeable principal perform the inspections. Depending upon the position of the person within the member who conducts the inspection, a member must have in place heightened inspection procedures for the inspection of an office if the producing manager is responsible for 20 percent or more of the revenue generated by the business units supervised by the producing manager’s supervisor.
  
• Amend Rule 3110 to require that before any customer order is executed, the account name/designation must be placed upon the memorandum for each transaction. Additionally, no changes to the account name/designation can be made unless previously authorized by a member or a person designated under NASD rules (who must pass a qualifying principal exam). This person, before giving such approval, must be informed of the essential facts and indicate his/her approval in writing on the order or similar record. The facts relied upon by the person in approving the change must be documented in writing and preserved for a period of not less than three years, with the documentation preserved for the first two years in an easily accessible place, as the term “easily accessible place” is used in Rule 17a-4 under the Securities Exchange Act of 1934.
  
• Amend Rule 2510(d)(1) to require that time and price discretionary authority be limited to the day it is granted, absent a specific, written indication signed and dated by the customer. The limitation does not apply to time and price discretion exercised for orders in an institutional account pursuant to valid “good-till-cancelled” instructions issued on a “not held” basis. Any exercise of time and price discretion must be reflected on the order ticket.
  
• The NASD’s Notice to Members provides interpretive guidance on these rule changes and explains the relationship between recently approved (but not yet effective) Rule 3013 and Rules 3012 and 3010. The effective date of the rule changes is January 31, 2005.

NASD Notice to Members 04-71: SEC Approves New Rules and Rule Amendments Concerning Supervision and Supervisory Controls (posted October 4, 2004)

According to recent remarks made at the Practising Law Institute conference by Gene Gohlke, associate director of the SEC’s Office of Compliance, Inspections and Examinations (“OCIE”), OCIE is considering a number of changes to the inspection process for mutual funds, including requiring fund directors to participate in one-on-one interviews with the SEC inspection staff. According to Mr. Gohlke, these interviews would cover a range of topics, from a board’s self-examination process to the process surrounding contract negotiations. In addition, Mr. Gohlke noted that the inspection staff will be comparing board minutes to the information provided in shareholder reports both for consistency, and to determine whether such minutes are “boilerplate.” Mr. Gohlke also noted that the inspection staff will place more emphasis on the disclosure of the factors that the board considered in approving management contracts and whether all such factors have been included in order to “paint a full picture.” Mr. Gohlke also noted that the staff of OCIE is considering whether it should change the structure of its examination process, perhaps focusing more on segmenting by types of funds or on fund groups that present greater risks.

Fund Directions, Vol. 13 No. 10, October 2004.

On October 4, 2004, the SEC adopted certain amendments to Rule 19b-4 and Form 19-b-4 under the Securities Exchange Act of 1934 that require SROs to file all proposed rule changes electronically with the SEC. In addition, the amendments require SROs to post all proposed rule changes, as well as current and complete sets of all rules, on their websites. Proposed rule changes must be posted within two business days after these changes are filed with the SEC, and current and complete versions of rules must be posted within two business days after electronic notification by the SEC that is has approved any proposed changes.

Each duly authorized signatory to an SRO’s proposed rule change will be required to manually sign Form 19b-4, authenticating, acknowledging or otherwise adopting his or her electronic signature. The SRO will be required to retain each manual signature page for not less than five years after the Form 19b-4 is filed with the SEC.

In addition, the amendments will require plan administrators for each of the seven National Market System (“NMS”) Plans to post on their Websites, or on a separate plan Website, a current version of each NMS Plan, as well as proposed amendments to such plan within two business days after the plan participants have been notified by the SEC of the effectiveness of the plan.

According to the SEC release adopting the rule amendments, the SEC believes the amendments will have the following benefits:

• a reduction in the amount of time and labor required to process SRO rule filings by eliminating paper delivery, photocopying and distribution;
  
• a reduction in costs for SROs;
  
• more efficient use of SEC resources; and
  
• more efficient and accurate monitoring by SEC staff of proposed rule changes due to the integration of SRO electronic filing with the internal SEC database that tracks these filings.

Effective Date: Commencing at 5:30 p.m. (Eastern time) on November 5, 2004, SROs will be required to file all Forms 19b-4, and any amendments to these forms, electronically, and the SEC will no longer accept SRO proposed rule changes in paper format.

SEC Release No. 34-50486; File No. S7-18-04 (October 4, 2004).

On September 14, 2004, the DOL proposed certain amendments to Prohibited Transaction Exemption (“PTE”) 84- 24, which is a class exemption that provides relief for certain transactions relating to the purchase, with plan assets, of investment company securities or insurance or annuity contracts, and the payment of associated sales commissions to insurance agents or brokers, pension consultants, or investment company principal underwriters that are parties in interest with respect to such plan. The proposed amendments to PTE 84-24 would extend the exemption to allow these transactions when an affiliate of the insurance agent or broker, pension consultant or investment company principal underwriter is a trustee with investment discretion over plan assets that are not involved in the transaction. In addition, the proposed amendments would modify the current definition of “nondiscretionary trust services” to specifically include services performed as a directed trustee.

The DOL reportedly proposed these amendments to address concerns regarding recent consolidation in the financial services industry.

Comments: comments must be received by the DOL on or before November 15, 2004.

Federal Register, Vol. 69, No. 177 (September 14, 2004).

• the search capability of the EDGAR database to allow more efficient and effective extraction and analysis of specific data;
  
• the capability to perform financial comparisons among registrants within industries; and
  
• the ability to perform financial analysis of registrant financial data (e.g., ratio analysis), and whether it would reduce the resources necessary for data analysis.

The SEC noted that registrants choosing to participate in the program, which is expected to begin in early 2005, also will continue to file financial information in HTML or ASCII format, as currently required.

Comments: comments on the proposed rule amendment must be received by the SEC on or before November 1, 2004.

SEC Release Nos. 33-8496, 34-50453, 35-27894, 39-2498, IC-26622; File Number S7-35-04 (September 27, 2004).

On September 15, 2004, the SEC staff issued a legal bulletin providing guidance on Rule 14a-8 of the Securities Exchange Act of 1934 (the “Exchange Act”) regarding the grounds on which a company may exclude a shareholder proposal from proxy materials. The staff noted that its discussion of Rule 14a-8 in previous legal bulletins has resulted in companies inappropriately excluding from proxy materials certain shareholder proposals. In the September 15, 2004 legal bulletin, the staff stated that, going forward, it would not be appropriate for a company to exclude a shareholder proposal and/or supporting statement language in reliance on Rule 14a-8(i)(3) in the following circumstances:

1. the company objects to factual assertions because they are not supported;
   
2. the company objects to factual assertions that, while not materially false or misleading, may be disputed or countered;
   
3. the company objects to factual assertions because those assertions may be interpreted by shareholders in a manner that is unfavorable to the company, its directors or its officers; and/or
   
4. the company objects to statements because they represent the opinion of the shareholder proponent or a referenced source, but the statements are not identified specifically as such.

 The staff instead believes it would be appropriate for companies to address the above objections in their statements of opposition.

The staff stated that modification or exclusion of a shareholder proposal or a statement in a shareholder proposal may be appropriate under Rule 14a-8(i)(3) in the following circumstances:

1. statements directly or indirectly impugn character, integrity or personal reputation, or directly or indirectly make charges concerning improper, illegal or immoral conduct or association, without factual foundation;
   
2. the company demonstrates objectively that a factual statement is materially false or misleading;
   
3. the resolution contained in the proposal is so inherently vague or indefinite that neither the shareholders voting on the proposal nor the company implementing the proposal, if adopted, would be able to determine with any reasonable certainty precisely what actions or measure the proposal requires. The staff noted that this objection also may be appropriate where the proposal and supporting statement, when read together, have the same result; and/or
   
4. substantial portions of the supporting statement are irrelevant to a consideration of the subject matter of the proposal, such that there is a strong likelihood that a reasonable shareholder would be uncertain as to the matter on which such shareholder is being asked to vote.

The staff noted that a company seeking to exclude a shareholder proposal or statement on the basis that it contains materially false or misleading statements bears the burden of demonstrating objectively that the proposal or statement is materially false or misleading before the staff will concur with the company’s reliance on Rule 14a-8.

SEC Staff Legal Bulletin No. 14B (CF), September 15, 2004.

• an assessment of the adequacy of the firm’s conflict procedures in light of the particular conflicts of interest the firm faces in making voting recommendations, including whether the procedures effectively (1) preclude the natural persons who make the firm’s proxy voting recommendations from obtaining access to information about the firm’s business relationships with issuers, and (2) insulate those persons from direct or indirect influence by the firm’s employees who know of those relationships;
  
• an evaluation of the frequency with which the firm recommends voting in favor of the management of issuers that have engaged the firm to provide corporate services; and
  
• a consideration of other means reasonably designed to ensure the integrity of the proxy voting process.

In addition, the staff noted that because a firm’s business and conflict procedures could change, an adviser should establish and implement measures reasonably designed to identify and address the firm’s conflicts that can arise on an ongoing basis, such as a requirement that the firm update the adviser of any relevant change in its business or conflict procedures.

Institutional Shareholder Services, Inc. NO-ACT, WSB File No. 0920200406 (September 15, 2004). See also, Egan Jones Proxy Services, NO-ACT, WSB File No. 0601200409, May 27, 2004.

• an assessment of the adequacy of the firm’s conflict procedures in light of the particular conflicts of interest the firm faces in making voting recommendations, including whether the procedures effectively (1) preclude the natural persons who make the firm’s proxy voting recommendations from obtaining access to information about the firm’s business relationships with issuers, and (2) insulate those persons from direct or indirect influence by the firm’s employees who know of those relationships;
  
• an evaluation of the frequency with which the firm recommends voting in favor of the management of issuers that have engaged the firm to provide corporate services; and
  
• a consideration of other means reasonably designed to ensure the integrity of the proxy voting process.

In addition, the staff noted that because a firm’s business and conflict procedures could change, an adviser should establish and implement measures reasonably designed to identify and address the firm’s conflicts that can arise on an ongoing basis, such as a requirement that the firm update the adviser of any relevant change in its business or conflict procedures.

Institutional Shareholder Services, Inc. NO-ACT, WSB File No. 0920200406 (September 15, 2004). See also, Egan Jones Proxy Services, NO-ACT, WSB File No. 0601200409, May 27, 2004.

Specifically, NASD new Rule 3013 requires that (1) each member firm designate a principal to serve as Chief Compliance Officer (“CCO”) and (2) each member’s Chief Executive Officer (“CEO”) certify annually to having in place processes to establish, maintain, review, modify, and test policies and procedures reasonably designed to achieve compliance with applicable NASD rules, MSRB rules, and federal securities laws and regulations.

Rule 3013 requires the CEO to certify annually that senior executive management has in place processes to:

• establish, maintain and review policies and procedures reasonably designed to achieve compliance with applicable NASD rules, MSRB rules and federal securities laws and regulations;
  
• modify such policies and procedures as business, regulatory and legislative changes and events dictate; and
  
• test the effectiveness of such policies and procedures on a periodic basis, the timing of which is reasonably designed to ensure continuing compliance with NASD rules, MSRB rules and federal securities laws and regulations.

Rule 3013 also requires the CEO to certify that those processes are evidenced in a report that has been reviewed by the CEO and submitted to the member’s board of directors and audit committee. The processes, at a minimum, must include one or more meetings annually between the CEO and CCO to:

• discuss and review the matters that are the subject of the certification;
  
• discuss and review the member’s compliance efforts as of the date of such meetings; and
  
• identify and address significant compliance problems and plans for emerging business areas.

The new rule is intended to enhance investor protection by ensuring that senior management personnel focus increased attention on their firm's compliance and supervisory systems, and by fostering regular interaction between business and compliance officers.

The NASD will publish a Notice to Members regarding the new certification rule no later than November 9, 2004. The effective date of the rule will be 30 days following publication of that Notice to Members. Firms must designate a CEO by the effective date. CEOs of regulated firms must execute their first certifications within one year after that effective date. SEC Release No. 34-50347; File No. SR-NASD-2003-176.