Investment Management Industry News Summary - July 2001

The NRS and ICAA recently compiled and published the results of a joint report based on information derived from all Form ADV Part I filings made by SEC-registered investment advisers via the Investment Adviser Registration Depository (IARD) during 2001.

The report, which analyzes and disseminates aggregate data relating to advisers' ADV Part I filings, includes the following preliminary findings:

• As of the date of publication 6,649 advisers had submitted Form ADV, Part I via the IARD, and more than 650 additional advisers had applied for IARD accounts but not yet filed Form ADV electronically.
• 95% of registered advisers reported that they provide continued and regular supervisory services.
• 50% of registered advisers have discretionary assets under management of less than $100 million, whereas 5% of registered advisers (approximately 311 firms) manage $14.787 trillion of the reported $17 .957 trillion in discretionary assets under management.
• 68% of registered advisers are organized as corporations and 20% are organized as limited liability companies (with most of the other firms split between limited liability partnerships and sole proprietors).
• Nearly 6% of registered advisers are also registered with a foreign regulator.
• Nearly 47% of registered advisers have between one and five employees, and nearly 20% have between six and 10 employees.
• 64% of registered advisers do not use third-party solicitors, whereas 30% use between one and five persons or firms to solicit clients on their behalf.
  
• 11% of registered advisers act as portfolio managers for wrap fee programs and 5% act as sponsors of wrap fee programs.
• 24% of registered advisers sell products or services other than investment advice to advisory clients.
• There is an accelerating trend toward registered advisers' affiliation with other entities, such as broker-dealers, investment companies, insurance companies, futures/commodities advisers, and other investment advisers.
• 36% of registered advisers offer fixed fee arrangements, 23% offer performance-based fee arrangements and only 12% are compensated in any way based on commissions.
• 65% of registered advisers have discretion to determine the transacting broker or dealer.
• 58% of registered advisers receive soft dollar credits.
• 43% of registered advisers compensate employees or third parties for client referrals.
• Only 10% of advisers have custody over client securities (and 11% have custody over client cash or bank accounts).

The report is available in full at www.icaa.org or www.nrs-inc.com. NRS and ICAA: Evolution/Revolution, A Profile of the U.S. Investment Advisory Profession (July 2001).

This report summarizes recent developments regarding firms' practices and policies relating to analysts' recommendations, which have come under scrutiny from regulators and the legislature in recent weeks. Sell-side analysts are conducting internal examinations as a result of this scrutiny, and some have already begun to implement new policies. It is likely that the collective result of these developments will have a significant and lasting effect on the investment management industry.

• May 17 House subcommittee opens hearings. On May 17, the House Financial Services Capital Markets Subcommittee opened hearings on analysts' practices and whether analysts' reports and recommendations are biased by the business of their firms' underwriting departments.
  
• June 12 Securities Industry Association (SIA) endorses "best practices" for research analysts. On June 12, the Securities Industry Association (SIA) endorsed a compilation of "best practices" (i.e., voluntary standards) to be followed by brokerage firms to ensure the ongoing integrity of securities research and analysis. The SIA is a trade group consisting of nearly 700 securities firms (including investment banks, broker-dealers, and mutual fund companies).

SIA's best practices are intended to address all aspects of the research department's role within a firm to ensure that research is objective, independent, and of the highest integrity. The practices cover disclosure, recommendations, compensation, the relationship to investment banking and other business units, the relationship with the companies covered by analysts, the research process, and personal trading and investment.

Among the key recommendations:

• Research departments should not report to investment banking or any other business units that might compromise their independence
• Analysts should be encouraged to indicate both when a stock should be bought and when it should be sold, and management should support the use of the full ratings spectrum
• Analyst recommendations should be tracked, and performance should be measured and reviewed regularly
• Analyst recommendations should not be submitted to investment banking departments for review or approval
• Analysts should not trade against their recommendations and should disclose their holdings in companies they cover
• Analysts' pay should not be directly linked to investment banking transactions, sales, and trading revenues or asset management fees
• Procedures should be put in place to separate investment banking and research operations

The best practices also called for objectivity and clear statements of rationale and disclaimers in the research process, as well as personal trading restrictions and disclosure of conflicts of interest by analysts.

Securities Industry Association, "Best Practices For Research, Before You Invest, Investigate."

In the wake of investor complaints of overly optimistic research by analysts and a high profile arbitration case over a technology analyst’s recommendations, Merrill Lynch & Co. announced a new policy prohibiting analysts from buying stock in the companies they cover. Under the policy, the firm will give analysts in companies they cover a "brief window" to choose one of three options. The can either:

• sell all of their holdings in stocks they cover;
• transfer shares to a non-discretionary managed account; or
• keep all of their shares subject to new disclosure rules and stricter policies, under which they can sell shares only if they have both long- and short-term ratings of "neutral" or lower.

Other brokerage firms are examining their practices and will likely adopt similar policies.

The SEC recently adopted new Rule 5b-3 under the investment Company Act of 1940 (the "1940 Act"). The new rule codifies and updates SEC staff interpretive and no-action letters and is intended to adapt the 1940 Act to economic realities of repurchase agreements and pre-refunded bonds and to reflect recent developments in bankruptcy law protecting parties to repurchase agreements. Specifically, Rule 5b-3 permits a mutual fund, subject to certain conditions, to treat a repurchase agreement as an acquisition of the underlying collateral in determining whether it is in compliance with:

• the prohibition on fund acquisition of an interest in a broker-dealer in Section 12(d)(3) of the 1940 Act. Section 12(d)(3) of the 1940 Act generally prohibits a fund from acquiring an interest in a broker, dealer, or underwriter. Because a repurchase agreement may be considered to be the acquisition of an interest in the counterparty, Section 12(d)(3) may be interpreted to limit a fund's ability to enter into repurchase agreements with many of the firms that act as counterparties; and
  
• the investment criteria for diversified funds set forth in section 5(b)(1) of the 1940 Act. Section 5(b)(1) limits the amount that a fund that holds itself out as being a diversified investment company may invest in the securities of any one issuer (other than the U.S. Government). This provision may limit the amount of repurchase agreements that a diversified fund may enter into with any one counterparty.

Rule 5b-3 also provides for similar "look-through" treatment for purposes of Section 5(b)(1) of the 1940 Act in the case of an investment in state or municipal bonds, the payment of which has been fully funded by escrowed U.S. government securities.

Requirements as to Collateral

Rule 5b-3 allows mutual funds to treat the acquisition of a repurchase agreement as an acquisition of the underlying securities for purposes of Sections 5(b)(1) and 12(d)(3) if the obligation of the seller to repurchase the securities from the fund is "collateralized fully."

A repurchase agreement is "collateralized fully" if:

• the value of the underlying securities (reduced by the costs that the fund reasonably could expect to incur if the counterparty defaults) is, and at all times remains, at least equal to the agreed resale price;
• the fund has perfected its security interest in the collateral;
• the collateral is maintained in an account of the fund with its custodian or a third party that qualifies as a custodian under the 1940 Act;
• the collateral for the repurchase agreement consists entirely of: (A) cash items; (B) U.S. government securities; (C) securities that at the time the repurchase agreement is entered into are rated in the highest category; or (D) unrated securities that are of comparable quality to securities that are rated in the highest rating category, as determined by the fund's board of directors or its delegate; and
• the repurchase agreement qualifies for an exclusion from any automatic stay of creditors' rights against the counterparty under applicable insolvency law in the event of the counterparty's insolvency.

Although the SEC staff did not adopt some commenters’ recommendation to eliminate altogether the rule's requirements regarding the credit quality of the collateral, the staff did eliminate the requirement, included in earlier staff no-action positions, and in the proposing release of September 1999, that the fund's board of directors or its delegate evaluate the creditworthiness of the counterparty to a repurchase agreement.

Pre-Refunded Bonds

Rule 5b-3 codifies, for purposes of Section 5(b)(1), the conditions specified in the staff's no-action position permitting a fund to treat an investment in a "refunded security" as an investment in the escrowed U.S. government securities. A "refunded security" is defined as a debt security the principal and interest payments of which are to be paid by U.S. government securities that have been irrevocably placed in an escrow account and are pledged only to the payment of the debt security. Under the rule,

• The escrowed securities must not be redeemable prior to their final maturity.
• The escrow agreement must prohibit the substitution of the escrowed securities unless the substituted securities are also U.S. government securities.
• An independent certified public accountant must certify to the escrow agent that the escrowed securities will satisfy all scheduled payments of principal, interest and applicable premiums on the refunded securities.

This treatment corresponds to the treatment that has been given to pre-refunded bonds in Rule 2a-7 under the 1940 Act.

Additional Relief

Amendment to Rule 12d3-1.The release adopting the new rule also eliminated a note appended to Rule 12d3-1 under the 1940 Act. The note previously made that rule unavailable for repurchase agreements. Rule 12d3-1 provides limited exemptive relief from the prohibition in Section 12(d)(3) of the 1940 Act against a fund acquiring an interest in a broker-dealer, underwriter and certain other securities-related businesses. Specifically, Rule 12d3-1 provides an exemption for purchases of securities of any entity that derived fifteen percent or less of its gross revenues from specified securities related activities in its most recent fiscal year, unless the acquiring company would control the entity after the purchase. If the entity derived more than fifteen percent of its gross revenues from securities related activities, Rule 12d3-1 provides a limited exemption based on the amount and value of the securities purchased. With the elimination of the note, mutual funds may rely on rule 12d3-1 even if the repurchase agreement does not meet the requirements for "look-through" treatment in Rule 5b-3.

Conforming Amendments to Rule 2a-7. In the release adopting the SEC staff also adopted conforming amendments to rule 2a-7 under the 1940 Act. These amendments replace the definitions of "collateralized fully," "event of insolvency," and "refunded security," currently set forth in Rule 2a-7, with cross-references to the corresponding definitions in Rule 5b-3.

The SEC recently denied a hearing request submitted by Fund Democracy, LLC on an application submitted by a mutual fund and its adviser. The application was a routine "manager of managers" application, seeking relief from Section 15(a) of the 1940 Act and Rule 18f-2 thereunder, to permit the fund to hire new subadvisers and materially amend subadvisory agreements without shareholder approval.

The standard applied by the SEC in determining whether to grant a hearing to an interested person is whether a hearing is "necessary or appropriate in the public interest or for the protection of investors."

In its hearing request Fund Democracy asserted that:

• a fund that has only one subadviser should not be entitled to the manager of managers exemptive relief (i.e., should not be able, among other things, to hire a new subadviser or reallocate fees between the adviser and the subadviser without shareholder approval); and
• the conditions governing the manager of managers exemptive relief are insufficient to assure that funds relying on the relief hold themselves out to the public as operating pursuant to the manager of managers structure.

In denying the hearing request, the SEC found that the issues raised in the request had been considered and decided by the SEC in previously granting nearly 70 "manager of managers" order for exemptive relief starting in 1995 (the "previous orders"). The previous orders allow funds that utilize the manager of managers structure to avoid the costs and burdens associated with seeking shareholder approval of subadvisory agreements.

When the SEC first granted manager of managers exemptive relief in 1995, it recognized that certain funds may employ subadvisers in a capacity similar to that of individual portfolio managers. Under the terms and conditions of the previous orders, the adviser was required to provide general management and administrative services to the fund and, subject to review and approval of the fund's board of directors, set the fund’s overall investment strategies, select subadvisers, allocate the fund’s assets among subadvisers, monitor and evaluate the performance of the subadvisers, and ensure that the subadvisers comply with the fund's investment objectives, policies and restrictions. The SEC determined that, in such an arrangement, irrespective of the number of subadvisers employed or the frequency with which subadvisers are changed, relief from the shareholder approval requirements in section 15(a) of the 1940 Act and Rule 18f-2 under the 1940 Act for subadvisory agreements was appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act.

The SEC further found that in previous orders it also has specifically considered the advisory fee arrangement of funds operating pursuant to a manager of managers structure. The previous orders permit the adviser to allocate and reallocate advisory fees between itself and the subadviser(s), and among subadvisers, without a shareholder vote, provided that the aggregate advisory fee paid by the fund remains subject to approval by the shareholders, and subject to certain other conditions listed in the previous orders.

Finally, the SEC found that the conditions set forth in the previous orders are appropriate to assure that funds relying on the manager of managers exemptive relief adequately disclose to the public the manner in which these funds operate.

Hillview Investment Trust II, et al.; SEC Rel. No. 25055; Federal Register: (Vol. 66, No. 130) July 6, 2001.

The Board of Governors of the NASD approved for comment a proposed amendment to the NASD's rules that for the first time would require analysts and other brokerage employees to disclose potential conflicts of interest when they recommend a security during a television interview or other public appearance and strengthen and broaden existing disclosure requirements when recommendations are made in advertisements and sales literature, including analyst research reports. The proposal, if adopted, would mandate specific and prominent disclosures in written materials, effectively prohibiting inconspicuous boilerplate disclosure.

According to the accompanying press release, the proposed rule is the first action by NASD Regulation as part of an ongoing effort to address potential conflicts of interest presented by analyst recommendations. In its press release, the NASD also urged the SEC to develop similar rules for investment advisers so that investors will have the same disclosure whether the analyst works for a brokerage firm or is associated with an investment advisory firm.

Currently, NASD Conduct Rule 2210(d)(2)(B) requires specific disclosures in advertisements and sales literature. However, the current rule does not require an analyst or NASD member firm to disclose ownership interests in a recommended equity security; rather, it only requires disclosure if an officer, partner or member of the firm owns options, rights or warrants to purchase shares of the recommended security. The proposed amendment to Rule 2210 would add the following requirements for written advertisements and sales literature:

• The person(s) responsible for a recommendation would be required to disclose any financial interest they have in the recommended security;
• NASD member firms would be required to disclose if they own five percent or more of the total outstanding shares of any class of security of the recommended issuer.
• NASD member firms would be required to disclose compensation received from a recommended issuer for any investment banking services provided to the issuer within the last 12 months (this would replace the current requirement to disclose if a firm was a manager or co-manager of a public offering within three years).

The proposed rule amendments would require similar disclosures by analysts who make recommendations during public appearances (including television interviews, seminars and interactive electronic forums).

The NASD specifically requested comment on whether the proposal should be expanded to require firms to disclose the nature of investment banking services provided to the issuer of a recommended security, and whether firms should disclose ownership interests of less than five percent of the issuer's stock. Comments are due by August 15, 2001.

On June 28, the SEC issued an Investor Alert in which the SEC advised investors that they should not rely solely on an analyst's recommendation when deciding whether to buy, hold or sell a stock. The Investor Alert discussed analysts' potential conflicts of interest and provided tips for researching investments.

Specifically, the Investor Alert listed certain factors that create pressure on an analyst's independence and objective and, in the SEC's view, should be taken into account by investors before making an investment decision. These include:

• The analyst's firm may be underwriting the offering;
• Favorable research reports enhance relationships with the covered client, whereas unfavorable reports may alienate long-term investment banking clients;
• Positive reports attract new clients;
• Analyst reports can help generate brokerage commissions on covered securities;
• Brokerage firms' compensation arrangements can put pressure on analysts to produce positive reports (i.e., bonus compensation often is tied to investment-banking profitability); and
• Analysts, their firms, and/or other employees often have stakes in the covered companies (which increasingly include pre-IPO shares).

In addition to listing the potential conflicts of interest, the SEC:

• warned that, although the rules of the National Association of Securities Dealers, Inc. (NASD) require disclosure of conflicts in certain situations, these disclosures commonly appear only in the footnotes of written research reports or in small print on the back cover;
• noted that investors can research beneficial ownership through a company's registration statement, and also on Schedule 13D and 13G filings for 5% owners, as well as Forms 3, 4 and 5 filings for officers, directors and 10% owners, and Form 144 filings for restricted stock sales;
• warned that research reports issued shortly before the expiration of a "lock-up" period may be particularly subject to conflicts of interest; and
• advised that investors conduct independent research and consult multiple sources before making investment decisions.

SEC Investor Alert "Analyzing Analyst Recommendations" June 28, 2001. 

On June 27, House Financial Services Capital Markets Subcommittee Chairman Richard Baker (R-La.) announced that he is establishing a board to review the SIA's proposed best practices for research analysts. The review board consists of 13 members, including securities industry executives, regulators and academics. Together with Rep. Paul Kanjorski (D-Pa.), Baker solicited comments on the SIA proposals, including formally soliciting written responses from selected review board members by no later than August 21, 2001. Baker had criticized the SIA's voluntary guidelines for failing to impose sanctions for noncompliance.

BNA Securities Regulation and Law Report, Vol. 33, No. 26 (July 2, 2001).