Investment Management Industry News Summary - August 2007

The Treasury Department issued final regulations that eliminate country-by-country reporting by a regulated investment company (RIC) to its shareholders of foreign source income that the RIC takes into account and foreign taxes that it pays. RICs must continue to provide aggregate per-country information to the IRS, but will report only summary foreign income and foreign tax amounts to their shareholders.

The final regulations retain the general requirement that a RIC file as part of its annual return an election under the Internal Revenue Code (the “Code”) section 853 to pass through to its shareholders the credit for foreign taxes paid by the RIC (the "foreign pass-through election"). A RIC making a foreign pass-through election must provide the following information to the IRS:

• the total amount of foreign-source taxable income received per country;
• the total amount of foreign taxes paid (per country) to which the election applies;
• the total amount of foreign taxes paid (per country) to which the election does not apply (e.g., by reason of Code section 901(j)-(l), described below);
• the date, form and contents of the notice to the RIC's shareholders of its foreign pass-through election; and
• the proportionate share of creditable foreign taxes paid (per country) and foreign income received (per country) that is attributable to one share of the RIC's stock.

The regulations clarify that the foreign pass-through election is not applicable to taxes for which a RIC would not be allowed a credit by reason of:

• Code section 901(j) (denial of credit for taxes paid to certain countries, including countries with which the United States does not have diplomatic relations);
• Code section 901(k) and (l) (denial of credit for withholding taxes paid where certain holding period requirements are not met); or any similar provision.

The new regulations are applicable for RIC taxable years ending on or after December 31, 2007. For reporting purposes, however, a taxpayer may rely on the current regulations for a taxable year ending on or after December 31, 2007, and beginning before August 24, 2007.

The FINRA rulebook currently consists of both NASD Rules and certain NYSE Rules that FINRA has incorporated (Incorporated NYSE Rules). The Incorporated NYSE Rules apply solely to those members of FINRA that are also members of NYSE on or after July 30, 2007, referred to as “Dual Members.” Dual Members also must comply with NASD Rules.

Firms that were members only of NASD as of July 30, 2007 remain subject only to NASD Rules, provided they do not become NYSE members. Similarly, a firm that becomes a new member of FINRA only (and not a member of NYSE) will be subject only to NASD Rules. All FINRA members are subject to the FINRA By-Laws and Schedules to the By-Laws.

In interpreting each rule, FINRA will continue to apply the same interpretive materials that NASD or NYSE applied prior to the consolidation. For example, FINRA will consider existing NASD interpretive letters and Notices to Members in applying NASD Rules and the NYSE Rule Interpretations Handbook and Information Memos in applying the Incorporated NYSE Rules. Changes to rulebooks, filings, registration and technology interfaces will be implemented over time as the rulebooks are consolidated.

FINRA also issued guidance for Dual Members in connection with routine examinations, filings, registration and testing, and other miscellaneous items. The FINRA guidance can be obtained at: www.finra.org.

On August 22, 2007, the SEC settled an action against a hedge fund manager (“Respondent”) in connection with late trading of mutual fund shares. The SEC alleged that the Respondent violated Rule 22c-1(a) under the 1940 Act by repeatedly placing orders to buy, redeem or exchange mutual fund shares after the 4:00 p.m. market closing time while still receiving the current day’s mutual fund price. The SEC alleged that the hedge fund placed over a two-year period approximately 2,700 or 84% of its trades after 4:00 p.m. by taking advantage of a loophole in a broker’s mutual fund order clearing system.

The SEC ordered the Respondent to: (1) cease and desist any from committing any future violations of Rule 22c-1(a), (2) be barred from association with any investment adviser (with right to reapply) for eighteen months, (3) be prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or any of their affiliates, and (4) pay a civil money penalty of $100,000.

SEC Release Nos. IA-2638, IC-27932, Administrative Proceeding File No. 3-12734) (August 22, 2007) can be obtained at: http://www.sec.gov/litigation/admin/2007/ia-2638.pdf 

On August 23, 2007, the SEC filed an emergency action with the federal district court in Sacramento, California to shut down a $25 million Ponzi scheme that victimized hundreds of senior citizens and other investors nationwide who purchased interests in life insurance policies. The SEC complaint alleges that the father and daughter team sold these insurance policies primarily to the elderly and used the proceeds for their own personal use and to cover premiums on insurance policies owned by other groups of investors. The SEC complaint charges the defendants with violating the antifraud and registration provisions of the federal securities laws, and seeks permanent injunctions, disgorgement and civil penalties.

The SEC press release on this action highlights that the SEC has brought over 40 enforcement actions over the past two years against frauds targeting retirees and senior citizens, which will be a focus of the SEC’s second annual Seniors Summit to be held on September 10, 2007 in Washington D.C. The Seniors Summit will further examiner how regulators, community organizations, and others can coordinate efforts to educate and protect senior citizens from abusive sales practices and investment fraud.

On August 23, 2007, the SEC filed an emergency action with the federal district court in Sacramento, California to shut down a $25 million Ponzi scheme that victimized hundreds of senior citizens and other investors nationwide who purchased interests in life insurance policies. The SEC complaint alleges that the father and daughter team sold these insurance policies primarily to the elderly and used the proceeds for their own personal use and to cover premiums on insurance policies owned by other groups of investors. The SEC complaint charges the defendants with violating the antifraud and registration provisions of the federal securities laws, and seeks permanent injunctions, disgorgement and civil penalties.

The SEC press release on this action highlights that the SEC has brought over 40 enforcement actions over the past two years against frauds targeting retirees and senior citizens, which will be a focus of the SEC’s second annual Seniors Summit to be held on September 10, 2007 in Washington D.C. The Seniors Summit will further examiner how regulators, community organizations, and others can coordinate efforts to educate and protect senior citizens from abusive sales practices and investment fraud.

The staff of the SEC issued a letter to the Investment Company Institute (“ICI”) to remind its members that a fund’s use or disclosure of Rule 22c-2 information for marketing purposes is prohibited under the Gramm-Leach-Bliley Act’s privacy rules, unless the intermediaries’ consumers have been given notice and the opportunity to opt out of this information sharing. Rule 22c-2 under the Investment Company Act of 1940 (“1940 Act”) requires funds to enter into written agreements with their financial intermediaries that require the intermediaries to provide certain shareholder identity and transaction information upon request by the fund. Under Rule 22c-2, funds must be able to request and promptly receive shareholder identity and transaction information pursuant to these agreements by October 16, 2007,

ICI Members can access the memorandum to members and the letter from Associate Director Plaze at: http://members.ici.org/doclink.do?file=21544 

On August 8, 2007, the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) issued a final rule to implement the provisions of Section 312 (“Section 312”) of the USA PATRIOT Act (the “Patriot Act”) on correspondent accounts for certain foreign banks (the “2007 Final Rule”). The 2007 Final Rule completes FinCEN’s implementation of Section 312. Most regulations implementing Section 312 were issued on January 4, 2006 (“2006 Final Rules”). Section 312 imposes substantial due diligence requirements on U.S. financial institutions, including mutual funds, that maintain correspondent accounts for foreign financial institutions, and especially foreign banks, and private banking accounts for foreign individuals. The 2007 Final Rule is substantially similar to a proposed rule issued on January 4, 2006 and becomes applicable on February 5, 2008 for correspondent accounts for foreign banks established on or after February 5, 2008 and on May 5, 2008 for correspondent accounts for foreign banks established before February 5, 2008.

The 2007 Final Rule mandates that U.S. financial institutions (i.e., banking entities, broker-dealers, futures commission merchants and introducing brokers, and mutual funds, but not investment advisers or unregistered investment companies) perform “enhanced” due diligence on accounts maintained for high-risk foreign banks operating under (1) an “offshore banking license,” which is a license that prohibits the bank from conducting banking activities with the citizens of, or in the local currency of, the jurisdiction that issued the license; (2) a banking license issued by a foreign country designated as non-cooperative with anti-money laundering principles or procedures by an intergovernmental group or organization of which the U.S. is a member (e.g., the Financial Action Task Force) and with which designation the U.S. concurs; or (3) a banking license issued by a foreign country that has been designated by the Secretary of the Treasury as warranting special measures due to money laundering concerns (i.e., countries subject to a final rule under Section 311 of the Patriot Act). FinCEN has not published or directed U.S. financial institutions to a definitive list of jurisdictions providing “offshore banking licenses.”

After confirming that a foreign bank is operating under one of the three banking licenses described above, a U.S. financial institution should then assess the risk of money laundering through the foreign bank’s correspondent account. Based on that risk assessment, the 2007 Final Rule requires covered financial institutions to apply a set of due diligence procedures, which must include, at a minimum, reasonable steps to (1) conduct enhanced scrutiny of each correspondent account to guard against money laundering and to identify and report any suspicious transactions (which should include, as appropriate, obtaining and considering information relating to each foreign bank’s anti-money laundering program, reasonably monitoring transactions to, from, or through the correspondent account, and obtaining information about the foreign bank’s payable-through accounts); (2) obtain information about any correspondent accounts maintained at the foreign bank for other foreign banks using the correspondent account at the U.S. financial institution; and (3) determine, for any foreign bank whose shares are not publicly traded, the identity of each owner of the foreign bank and the nature and extent of each owner’s ownership interest. If a U.S. financial institution cannot perform adequate enhanced due diligence with respect to a correspondent account for a foreign bank, the 2007 Final Rule requires the U.S. financial institution to develop procedures to address the situation.

Although mutual funds are subject to the 2006 Final Rules and the 2007 Final Rule, mutual funds may not have customers that are foreign financial institutions for purposes of the due diligence requirements of the 2006 Final Rules or the 2007 Final Rule. When mutual fund shares are purchased or sold through Fund/Serv for foreign financial institutions, U.S. financial institutions that are members of the National Securities Clearing Corporation (“NSCC”) currently purchase or sell the shares on behalf of the foreign financial institutions. In guidance issued after the 2006 Final Rules, FinCEN acknowledged that foreign financial institution customers (including foreign banks) purchasing or redeeming mutual fund shares through Fund/Serv do not currently have account relationships with the mutual fund for the purpose of Section 312. As a result, the mutual fund has an account relationship with the NSCC member, rather than with the NSCC member’s foreign financial institution customer.

Final Rule, “Financial Crimes Enforcement Network; Anti-Money Laundering Programs; Special Due Diligence Programs for Certain Foreign Accounts,” Fed. Reg. 44768 (Aug. 9, 2007), can be found at: http://www.sec.gov/about/offices/ocie/aml2007/72fr44768-75.pdf; Department of the Treasury Financial Crimes Enforcement Network, Guidance, “Application of the Regulations regarding Special Due Diligence Programs for Certain Foreign Accounts to NSCC Fund/SERV Accounts” (May 3, 2006), can be found at: http://www.fincen.gov/guidance05032006.pdf.

On August 15, 2007, the SEC settled with a registered investment adviser for allegedly failing to file Forms 13F with the SEC for the period between 2002 and mid-2005. A brief summary of the SEC’s allegations and the terms under which the matter was settled is below.

Section 13(f) of the Exchange Act requires institutional investment advisers who exercise investment discretion over at least $100 million of certain securities, including exchange-traded equities and certain convertible debt securities (“Section 13(f) Securities”), to file a Form 13F quarterly with the SEC disclosing the Section 13(f) Securities under management. The purpose of this disclosure requirement is to collect and disseminate to the public information about the holdings and investment activities of institutional money managers in order to assist investors, issuers and government regulators.

Beginning in 2001, the investment adviser’s assets under management exceeded the $100 million threshold of Section 13(f) Securities, obligating the investment adviser to file a Form 13F each quarter starting in 2002. However, the investment manager failed to file any Forms 13F until July of 2005, when the SEC’s examination staff began questioning the investment adviser about the absence of such filings.

Based on the forgoing, the investment adviser agreed to settle the charges, without admitting or denying the SEC’s findings, by agreeing to the issuance of a censure, a cease-and-desist order from future violations of Section 13(f) of the Exchange Act and Rule 13f-1 thereunder, and the payment of a $100,000 civil penalty.

On August 15, 2007, the SEC settled with a registered investment adviser and its principal for allegedly making false and misleading statements concerning the investment adviser’s soft dollar practices, failing to provide books and records requested by SEC staff during an onsite inspection, and modifying books and records. A brief summary of the SEC’s allegations and the terms under which the matter was settled is below.

The principal, on behalf of the investment adviser, represented to an advisory client and the SEC’s examination staff that the investment adviser used soft dollars generated by the account only for research and brokerage services covered by the safe harbor provided by Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). Despite these representations, the investment adviser knowingly used client commissions, totaling approximately $350,000, to cover its operating expenses, including salary, rent, and health insurance.

In order to accomplish this fraud, the investment adviser, through its principal, established a separate entity that was used to secure soft dollar payments from broker-dealers. The entity’s only asset was an electronic database that was sold to it by the investment adviser for $1 and then licensed back to the investment adviser for $100 per hour. The entity’s sole purpose was to provide a vehicle through which the investment adviser and its principal could secure soft dollar payments from broker-dealers to cover the investment adviser’s operating expenses by representing to the broker-dealers that the payments were for research.

In an attempt to conceal the entity’s role from the SEC’s examination staff during a 2005 inspection, the principal failed to provide to the examination staff a key agreement relating to the entity. The principal then provided the SEC examination staff with a modified version of a second agreement that he represented to be the original. The modification “was designed to cloud the true nature” of the entity’s role.

Prior to reaching a settlement with the SEC, the investment adviser voluntarily returned to affected clients the entire amount of all soft dollar payments made by broker-dealers to the entity (approximately $350,000). As part of the settlement, the investment adviser and its principal, without admitting or denying the SEC’s findings, agreed to the issuance of a censure, a cease-and-desist order, and payment of civil penalties of $100,000 and $50,000, respectively. The investment adviser also agreed to provide a copy of the SEC’s order to all existing investors and prospective investors for one year.

The release announcing the settlement, Invest. Adv. Act Release No. 2633 (August 15, 2007), can be found at: http://www.sec.gov/litigation/admin/2007/ia-2633.pdf.

On Thursday, August 2, 2007, U.S. District Court Judge Colleen McMahon of the Southern District of New York dismissed a lawsuit filed by an investor in a now-defunct hedge fund against the registered investment adviser consulting firm that recommended the investment.

According to the plaintiff, the defendant consulting firm represented that it would conduct a five-step due diligence process before making a hedge fund recommendation to a client. The plaintiff claimed that the consulting firm provided the plaintiff with various positive reports about the hedge fund that were later found to be inaccurate when the hedge fund was exposed as a fraud. The plaintiff argued this showed that the consulting firm failed to conduct adequate due diligence on the hedge fund. The plaintiff argued that the defendant consulting firm (1) committed a Section 10(b) violation by failing to uncover the hedge fund as a fraud, (2) breached its oral contract with the investor by recommending the hedge fund investment without conducting both the initial and ongoing due diligence that the defendant consulting firm had promised, and (3) breached its fiduciary duty to the plaintiff as its investment adviser.

Section 10(b) Violation

With respect to the plaintiff’s claim that the defendant committed a Section 10(b) violation by failing to uncover the hedge fund as a fraud, Judge McMahon stated that the consultant’s “failure to discover the fraud merely places it alongside the SEC, the IRS and every other interested party” that had reviewed the hedge fund’s finances. In addition, Judge McMahon stated that “[t]he failure to conduct due diligence is not the same thing as knowing of or closing one’s eyes to a known ‘danger,’ or participating in the fraud.” Judge McMahon also noted that the plaintiff was required to satisfy the heightened standard for pleading fraud recently announced by the U.S. Supreme Court case Tellabs Inc. v. Makor Issues & Rights Ltd. and that the plaintiff had failed to meet this heightened standard.

Oral Contract

The plaintiff’s claim of breach of contract was summarily dismissed by Judge McMahon because the alleged contract was oral and ongoing and “[u]nder New York’s Statute of Frauds, an agreement that by its terms cannot be performed within one year of its creation is void unless it is in writing.”

Breach of Fiduciary Duty

The plaintiff initially claimed that the consulting firm breached its fiduciary duty to the plaintiff as its investment adviser. The defendant consulting firm moved “to dismiss this claim on the basis that it is preempted by the Martin Act, New York’s blue sky law, which authorizes only the New York attorney general to enforce its provisions.” The plaintiff then claimed “that this cause of action ‘is created by federal statute’ and it ‘would be meaningless for an investment advisor to have fiduciary duties to individual customers, if the customers had no individual recourse for the breach of those duties.’” Judge McMahon ruled that “breach of fiduciary duty claims arising in the securities context” are “preempted by the Martin Act” and that “it is well-settled that ‘no implied private right of action for damages exists under Section 206 of the Investment Advisers Act of 1940’” (quoting In re Merrill Lynch & Co., Inc. Research Reports Sec. Litig., 272 F. Supp. 2d 243, 256 (S.D.N.Y. 2003)).

In light of the foregoing, Judge McMahon dismissed the plaintiff investor’s complaint for failure to state a claim upon which relief can be granted.

In Re Bayou Hedge Fund Litigation, No. 06-MDL-1755 (CM), Decision and Order Granting Defendants’ Motion to Dismiss (S.D.N.Y. Aug. 2, 2007).

The SEC recently announced that on August 6, 2007, the Honorable Naomi Reice Buchwald, United States District Judge for the Southern District of New York, entered a final judgment by consent against a hedge fund manager. The SEC alleged that the hedge fund manager repeatedly made material misrepresentations to investors regarding the oversight and diversification of two hedge funds he managed. The complaint alleged that despite promising investors that the funds would be broadly diversified, the hedge fund manager nonetheless amassed a position in a small-cap stock that far exceeded the cap on individual long positions set forth in the funds’ offering memoranda and that eventually exceeded more than forty percent of the small-cap issuer’s outstanding shares. According to the SEC, notwithstanding this extraordinarily large position, the hedge fund manager also failed to file the stock ownership reports that were required to be filed when the funds’ position in the small-cap issuer exceeded the reporting thresholds. The SEC’s complaint further alleged that, as president of the investment adviser to one of the hedge funds, the hedge fund manager’s material misrepresentations also defrauded his advisory client, the board of directors of that fund and prospective fund clients.

The final judgment permanently enjoins the hedge fund manager from future violations of Section 17(a) of the Securities Act of 1933; Sections 10(b), 13(d) and 16(a) of the Securities Exchange Act of 1934 and Rules 10b-5, 13d-1, 13d-2, 16a-2, and 16a-3 thereunder; and Sections 206(1) and (2) of the Investment Advisers Act of 1940. The final judgment also ordered the hedge fund manager to pay disgorgement of $5,535,571, plus prejudgment interest thereon of $798,339, for a total of $6,333,910, representing the hedge fund manager’s ill-gotten gains from the fraud alleged by the SEC. The hedge fund manager may offset from this total the amount of forfeiture and restitution payments paid by him in a parallel criminal case brought by the U.S. Attorney’s Office for the Southern District of New York. The hedge fund manager consented to entry of the final judgment without admitting or denying the SEC’s allegations.

The release announcing the settlement, SEC Litigation Release No. 20234 (August 9, 2007), can be found at: http://www.sec.gov/litigation/litreleases/2007/lr20234.htm.

As reported in the June 12, 2007 edition of the WilmerHale Investment Management Industry News Summary, the SEC recently voted to propose measures to modernize and improve its capital raising and reporting requirements for smaller companies. On August 3, 2007, the SEC published the associated proposing release. Two issues of significant interest proposed in the release are discussed below.

Proposed Rule 507

The release proposes a new offering exemption rule, Rule 507 of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), which would permit issuers to engage in limited advertising in a covered offering where each purchaser meets the definition of “large accredited investor.” However, this rule would not be available to “pooled investment vehicles that rely on the exclusion from the definition of ‘investment company’ provided by Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940.”

The proposed definition of large accredited investor for purposes of Rule 507 would consist of the same categories of entities and individuals that qualify for accredited investor status under Rule 506, but with significantly higher and slightly different dollar-amount thresholds. Legal entities would be required to have $10 million in investments and individuals would be required to own $2.5 million in investments or have an annual income of $400,000 (or $600,000 with one’s spouse) to qualify as large accredited investors. Instead of a total ban on general solicitation and general advertising, as is the case in Rule 506 transactions, issuers in Rule 507 transactions could publish a limited announcement of the offering. Under the SEC proposal, “the announcement would be required to state prominently that sales will be made to large accredited investors only, that no money or other consideration is being solicited or will be accepted through the announcement, and that the securities have not been registered with or approved by the Commission and are being offered and sold pursuant to an exemption.” In addition, “[a]t the issuer’s option, the announcement also could contain the following additional information:

• The name and address of the issuer;
• A brief description of the business of the issuer in 25 or fewer words;
• The name, type, number, price, and aggregate amount of securities being offered and a brief description of the securities;
• A description of what the term large accredited investor means;
• Any suitability standards and minimum investment requirements for prospective purchasers in the offering; and
• The name, postal or email address, and telephone number of a person to contact for additional information.”
  
  

Revisions to “Accredited Investor” Standard

The SEC is also proposing to revise the term “accredited investor” in Regulation D to add an “investments-owned” standard and provide for future inflation adjustments. Rule 501(a) currently provides generally that certain legal entities must have total assets in excess of $5 million to qualify as accredited investors, that individuals and spouses may qualify if they have a net worth above $1 million, and that individuals also may qualify if they have an annual income above $200,000 (or $300,000 with one’s spouse). The SEC is proposing to add an “investments-owned” standard in Rule 501(a). For legal entities that are currently required to satisfy the $5 million assets test, the proposed amendment would provide an additional alternative standard under which the entity would qualify as an accredited investor if it owned investments of more than $5 million. For individuals and spouses, the proposed amendment would provide a new alternative standard of owning $750,000 in investments (excluding one’s personal residence) that could be used instead of the current net worth standard of $1 million or annual income standard of $200,000 (or $300,000 with one’s spouse). In addition, the SEC is also proposing that all dollar-amount thresholds in Rule 501 of Regulation D be adjusted for inflation on a going forward basis, starting on July 1, 2012 and every five years thereafter, to reflect any changes in the value of the Personal Consumption Exemption Chain-Type Price Index (or any successor index), as published by the Department of Commerce.

The comment period for the proposed revisions will close 60 days after publication in the Federal Register.

SEC Proposed Rules, “Revisions of Limited Offering Exemptions in Regulation D” (Release Nos. 33-8828; IC-27922; File No. S7-18-07). A copy of the proposed rules is available at http://www.sec.gov/rules/proposed/2007/33-8828.pdf.

On June 22, 2007, a digital media services and software company that did not fall squarely within any exemption from the definition of investment company filed an application seeking a declaration that it was primarily engaged in a business other than that of investing in securities, as provided in Section 3(b)(2) of the Investment Company Act. Applying the traditional “Tonopah” criteria, the requested relief was granted on July 24, 2007.

On August 1, 2007, the SEC published the notice of application for an exemption from Section 17(a) of the Investment Company Act to permit certain money market funds to engage in principal transactions with affiliates. The application had initially been filed in 2003. This SEC action is notable since so few firms have been granted this relief over the years.

In a July 12, 2007 no-action letter, the staff of the Division of Investment Management provided guidance with respect to Rule 3a-8(a)(1) under the Investment Company Act. This rule provides a non-exclusive safe harbor from the definition of investment company for research and development companies that meet the rule’s conditions. One of the conditions is that the ratio of the company’s research and development expenses for the last four fiscal quarters combined are a “substantial” percentage of total expenses for the same period. The no-action letter establishes that 20% is a substantial percentage for this purpose.

SEC Order, RealNetworks, Inc., Release No. 27888 (July 24, 2007), available at http://www.sec.gov/rules/ic/2007/ic-27888.pdf; Notice of Application, Release No. 27877 (June 28, 2007), available at http://www.sec.gov/rules/ic/2007/ic-27877.pdf.

Notice of Application, Lehman Brothers Asset Management LLC et al, Release No. 27920 (August 1, 2007), available at http://www.sec.gov/rules/ic/2007/ic-27920.pdf.

The staff of the SEC’s Division of Investment Management and Office of Compliance Inspections and Examinations recently provided guidance to newly-registered investment advisers. According to the staff, the guide “is intended to assist newly-registered investment advisers in understanding their compliance obligations.” The guide covers all of the major investment adviser compliance areas, including:

• the fiduciary duty that investment advisers owe to their clients;
• adviser compliance programs;
• Form ADV and other required filings;
• brochure delivery;
• code of ethics covering personal and insider trading;
• maintenance of books and records; and
• the adviser’s duty to seek best execution for clients’ securities transactions.

The full text of the guide is available on the SEC’s website.

SEC Guidance, “Information for Newly-Registered Investment Advisers”, available at http://www.sec.gov/divisions/investment/advoverview.htm.

On August 2, 2007, the SEC settled a civil action in the U.S. District Court for the Eastern District of Wisconsin against a former mutual fund manager for alleged violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder. The complaint alleged that the mutual fund manager caused a micro cap fund he managed to sell shares of a security issued by a company developing a new drug while the manager was in possession of material, non-public information misappropriated from a relative. According to the complaint, the relative was conducting a study of the drug that was critical to Food and Drug Administration approval and communicated to the mutual fund manager that the study was unsuccessful. Upon receipt of this information, the manager instructed his traders to “aggressively sell” all of the securities of the drug company held by the fund. When the study results were announced, the price of the securities fell by 42%. By selling the shares before the announcement, the SEC alleged that the mutual fund manager avoided a loss of $954,776 in the fund. Without admitted or denying the charges, the mutual fund manager agreed to pay $954,776 in disgorgement, a $954,776 fine, and $315,286 in prejudgment interest. In addition, the mutual fund manager agreed to be enjoined from future securities law violations.

The release announcing the settlement, SEC Litigation Release No. 20222 (August 2, 2007) can be found at: http://www.sec.gov/litigation/litreleases/2007/lr20222.htm.

As reported in the July 18, 2007 edition of the WilmerHale Investment Industry News Summary, the SEC voted unanimously on June 11, 2007 to adopt a new antifraud rule (Rule 206(4)-8) under Section 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) to protect investors and prospective investors in hedge funds, other private investment funds and mutual funds. The SEC issued the adopting release for the new rule on August 3, 2007. The effective date is September 10, 2007.

In substance, Rule 206(4)-8 provides that it is unlawful for any investment adviser (whether or not registered) to a pooled investment vehicle to make material, misleading statements or omissions or otherwise engage in fraudulent or deceptive actions as to any investor or prospective investor in the vehicle. As stated in the release, the “principal benefit of the rule is that it clearly enables the SEC to bring enforcement actions under the Advisers Act, if an adviser to a pooled investment vehicle disseminated false or misleading information to investors or prospective investors or otherwise commits fraud with respect to any investor or prospective investor.” The adopting release provides the following examples of conduct prohibited by the new rule: “false or misleading statements made...to existing investors in account statements as well as to prospective investors in private placement memoranda, offering circulars, or responses to ‘requests for proposals,’ electronic solicitations, and personal meetings arranged through capital introduction services.” The release also makes it clear that the standard for violation of the rule is negligent, not intentional, misconduct. This point prompted Commissioner Paul S. Atkins to author a concurrence, arguing that the standard should be intentional misconduct. Finally, the release establishes that investors have no private rights of action with respect to the rule.

SEC Final Rule, “Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles”, Release No. IA-2628; File No. S7-25-06, available at http://www.sec.gov/rules/final/2007/ia-2628.pdf; Commissioner Paul S. Atkins, Concurring Opinion, available at http://www.sec.gov/rules/final/2007/ia-2628-psaconcurrence.pdf 

On July 31, 2007, SEC Chairman, Christopher Cox testified before the Senate Banking committee regarding the SEC’s work to protect investors and encourage efficiency in the markets and regulatory actions of the commission. Chairman Cox covered a wide range of SEC initiatives in his testimony and in response to questions from the committee and the press. Of particular note, Chairman Cox discussed the use of soft dollars, hedge fund enforcement efforts, and hedge fund taxation.

Use of Soft Dollars

Chairman Cox discussed his May 17, 2007 letter to Committee Chairman Senator Christopher J. Dodd (D-CT) that expressed concerns about the use of soft dollars. He explained that the SEC is currently focused on disclosure “because soft dollars are enshrined in Section 28(e).” In addition, Chairman Cox stated his belief that problems associated with the use of soft dollars are “built in” to the system, because soft dollars induce “money managers to direct trades to broker-dealers that offer research that the money manager wants, rather than [those] that can best execute the advisory clients’ transactions.” Senator Charles Schumer (D-NY) took a different view. He expressed his interest in facilitating a well-regulated independent research industry supported by soft dollars. Senator Schumer noted that he eagerly anticipated the SEC’s issuance of updated soft dollar guidance, and Chairman Cox replied that soft dollar guidance would be issued “ASAP.”

Hedge Fund Enforcement Efforts; Hedge Fund Working Group

In prepared testimony, Chairman Cox reported that the SEC had “created a hedge fund working group within …[its] Enforcement Division to, among other things, coordinate and enhance …efforts to combat hedge fund insider trading, including by working with other federal law enforcement agencies and self-regulatory organizations.” Chairman Cox also stated that the SEC had brought a number of enforcement actions against hedge funds and their portfolio managers who, the SEC alleged, made millions of dollars by trading illegally on inside information regarding upcoming public announcements of private investment in public equity (PIPE) stock offerings. In addition, Chairman Cox described cases brought by the SEC against hedge fund managers that it charged with trading on the basis of inside information ahead of mergers and acquisitions. Chairman Cox stated that the new anti-fraud rule (described below) should put everyone on notice of the SEC’s intention to exercise this anti-fraud enforcement authority.

Hedge Fund Taxation

Senator Dodd, in his opening remarks, commented on recently introduced legislation that would change the tax treatment of publicly-traded partnerships and carried interest. Senator Dodd expressed his concern about the potential adverse effects these proposals would have on capital formation and job creation, and on institutional investors like pension funds and college endowments.” While Chairman Cox did not offer an opinion regarding tax policy, he indicated that as a result of any change in the tax treatment “it is entirely possible that we will have an unintended consequence of fewer public companies and barriers to becoming public.”

Statement of Chairman Christopher Cox, July 31, 2007, available at http://www.sec.gov/news/testimony/2007/ts073107cc.htm; Cox Explains Reasoning Behind Soft Dollar Letters, IM Insight News (August 3, 2007).

On August 9, Commissioner Roel E. Campos announced he was leaving the SEC next month to return to the private sector.

On July 26, 2007, SEC Chairman Christopher Cox delivered a SEC staff white paper to Congress that calls for improvements in accounting and disclosure in the municipal securities market (the “White Paper”). The White Paper discusses the size and importance of the municipal securities market, the significant ways in which the municipal securities market has changed over time, recent enforcement actions, and areas of possible legislative reform. Noting that the municipal securities market lacks many of the systemic protections customary in other sectors of the U.S. capital markets, the White Paper calls for expanded SEC authority over the municipal securities market to provide investors in municipal securities with access to full, accurate and timely information like that enjoyed by investors in many other U.S. capital markets and suggests that the following steps be taken to improve the extent, quality and availability of municipal issuer information:

• Make available to investors municipal issuer offering documents and periodic reports that contain information similar to that required of issuers for offerings of corporate securities;
• Make available to investors without charge municipal issuer offering documents and periodic reports on a timely basis through an easily accessible venue (such as a system similar to EDGAR);
• Mandate municipal issuer use of “generally accepted” governmental accounting standards;
• Encourage and support timely development of high-quality governmental accounting standards by, for example, providing an independent funding mechanism for the Governmental Accounting Standards Board (“GASB”) and require or permit SEC oversight of the GASB (as is currently provided by Sections 108 and 109 of the Sarbanes-Oxley Act for the Financial Accounting Standards Board);
• Apply to non-governmental conduit borrowers the registration and disclosure standards that would apply if they issued their securities directly without using municipal issuers as conduits;
• Require issuers of municipal securities to establish policies and procedures for disclosure that are appropriate for the particular issuer; and
• Clarify the legal responsibilities of issuer officials for the disclosure documents they authorize, the responsibilities of underwriters with respect to the offering statements they use in underwriting municipal offerings, and the securities law responsibilities of bond counsel and other participants in offerings.

The White Paper makes clear that the staff does not advocate the wholesale application of the regulatory model applicable to public company securities to the municipal securities market, nor does the staff advocate the amendment of existing exemptions from the securities laws that are applicable to municipal securities (such as private offering exemptions and Section 3(a)(11) of the 1933 Act). Rather, the White Paper states that legislative revisions should be “tailored to accommodate the unique character of municipal issuers and special attributes of the municipal securities markets.”

The White Paper, “Disclosure and Accounting Practices in the Municipal Securities Market,” is available at http://www.sec.gov/news/press/2007/2007-148wp.pdf. The related SEC press release, “SEC Chairman Cox Calls for Improved Investor Protections in the Market for Municipal Securities” (July 26, 2007) is available at http://www.sec.gov/news/press/2007/2007-148.htm.

Background. On July 27, 2007, the SEC published a Companion Release to provide interpretive guidance and proposed amendments to clarify the meaning of the exclusion for shareholder proposals relating to the election of directors provided by Rule 14a-8(i)(8) under the Exchange Act. Rule 14a-8(i)(8) sets forth one of the several bases upon which a company may exclude a shareholder proposal from its proxy materials. Specifically, it provides that a company may exclude a shareholder proposal that “relates to an election of membership on the company’s board of directors…” In administering this exclusion, the SEC staff has permitted companies to exclude any shareholder proposal that may result in a contested election. The SEC staff’s rationale for permitting such exclusion is based on the premise that Rule 14a-8 is not the proper means for conducting election campaigns, and that the exclusion is critical to prevent the circumvention of other proxy rules that are currently in place to ensure that investors receive adequate disclosure in election contests.

Second Circuit Decision in the AIG Case. Contrary to the SEC staff’s historical position on this exclusion, the Second Circuit held in the AIG Case that a company may not rely on Rule 14a-8(i)(8) to exclude a shareholder proposal seeking to amend the company’s by-laws to establish a procedure under which a company would be required to include shareholder nominees for director in the company’s proxy materials. The Second Circuit interpreted the Rule’s exclusion to limit its application to shareholder proposals used to oppose solicitations dealing with an identified board seat in an upcoming election and rejected a broader interpretation that the exclusion applies to any shareholder proposal that would institute procedures to make such election contests more likely.

Confirmation of SEC’s Interpretation. In an effort to eliminate any uncertainty or confusion arising from the Second Circuit’s decision, the SEC issued the Companion Release to confirm the SEC’s position that a shareholder proposal that could result in an election contest may be excluded under Rule 14a-8(i)(8). The Companion Release clarifies that the SEC’s view is that a proposal may be excluded under Rule 14a-8(i)(8) if it either would result in an immediate election contest (e.g., by making or opposing a director nomination for a particular meeting), or would set up a process for shareholders to conduct an election contest in the future.

The Companion Release specifically notes that the staff has taken the position that a shareholder proposal may be excluded under Rule 14a-8(i)(8) if it could have the effect of, or proposes a procedure that could have the effect of, any of the following: (1) disqualifying board nominees who are standing for election; (2) removing a director from office before his or her term expires; (3) questioning the competence or business judgment of one or more directors; or (4) requiring a company to include a shareholder’s nominees for director in the company’s proxy materials or otherwise result in a solicitation on behalf of shareholder nominees in opposition to management-chosen nominees. Conversely, the staff has taken the position that a shareholder proposal may not be excluded under Rule 14a-8(i)(8) if it relates to any of the following: (a) qualifications of directors or board structure (as long as the proposal will not remove current directors or will not disqualify current nominees); (b) voting procedures (such as majority or cumulative voting); (c) nominating procedures; or (d) reimbursement of shareholder expenses in contested elections.

Proposed Clarifying Amendments to Rule 14a-8(i)(8). The SEC is also soliciting comment as to whether it should adopt amendments to Rule 14a-8(i)(8) to further clarify the rule’s application. Specifically, the Companion Release proposes amending Rule 14a-8(i)(8) to state: “If the proposal relates to a nomination or an election for membership on the company’s board of directors or analogous governing body or a procedure for such nomination or election” (proposed new text underlined). If the proposed amendment is adopted, the SEC intends to clearly indicate that the term “procedure” relates to procedures that would result in a contested election, either in the year in which the proposal is submitted or in subsequent years, consistent with the SEC’s interpretation of Rule 14a-8(i)(8), as clarified in the Companion Release.

Comments on the Companion Release must be received by 60 days after the publication of the Companion Release in the Federal Register.

SEC Proposed Rules and Interpretations, “Shareholder Proposals Relating to the Election of Directors” (Release Nos. 34-56161; IC-27914; File No. S7-17-07). A copy of the proposed rules and interpretation is available at http://www.sec.gov/rules/proposed/2007/34-56161.pdf.