Investment Management Industry News Summary - July 2003

The German Finance Ministry introduced proposed legislation that, if adopted, will replace Germany’s current law on investment funds, and will have the effect of eliminating tax discrimination against non-German investment funds. Currently, German investors receive favorable tax treatment with respect to dividends received from German funds. Under the proposed legislation, dividends received from non-German funds would be subject to the same favorable taxation as dividends received from German funds. The proposed legislation would also improve tax treatment of capital gains realized from the sale of shares of non-German funds.

The U.S. District Court for the Southern District of New York recently dismissed a lawsuit filed against a mutual fund by a shareholder alleging that the fund’s prospectus and registration statement failed to disclose certain conflicts of interest among the fund and its investment adviser and their affiliated broker dealer.

Specifically, the shareholder alleged that the fund and its affiliates violated antifraud Sections 11 and 12(a)(2) of the Securities Act of 1933 by failing to disclose:

• that the fund’s broker-dealer affiliate provided investment banking services to the companies in which the fund invested;
• the conflicts that were alleged to have made certain research reports issued by the affiliated broker-dealer misleading with respect to companies in which the fund invested; and
• that the fund had invested in companies at market prices that were inflated as a result of the allegedly misleading research reports which were intended to obtain investment banking business for the affiliated broker-dealer.

In granting the fund’s motion to dismiss the claim, the court the court stated that there is no legal obligation under any SEC regulation to make the disclosures that the shareholder alleged were omitted. The court noted that it has been well-recognized for decades that investment advisers to mutual funds are affiliated with broker-dealers that engage in investment banking activities. Moreover, the court noted that information alleged to have been omitted from the fund’s prospectus and registration statement was nevertheless publicly available information. The court also noted that none of the fund’s investments was inconsistent with its policy of investing in technology companies that are, or are likely to develop to be, market leaders.

The court also dismissed a claim by the shareholder brought under Section 34(b) of the Investment Company Act of 1940, which provides in relevant part that it is unlawful for any person to make an untrue statement of material fact in any registration statement. The court concluded that Section 34(b) does not provide a private right of action and that claims thereunder must be stated derivatively and not directly. The court also found that the shareholder failed to state a claim under antifraud Section 10(b) of the Securities Exchange Act of 1934 because, as discussed above, no duty to disclose was established, and because the shareholder failed to establish scienter on the part of the fund or its advisers or directors.

In re: Merrill Lynch & Co. Global Technology Fund Securities Litigation (02-CV-7854) (S.D.N.Y. July 2, 2003).

The DOL issued an advisory opinion addressing whether a trust company’s receipt of 12b-1 and sub-transfer fees from mutual funds, the investment advisers of which are affiliates of the trust company, for services relating to plan investments in mutual funds, would violate the prohibited transaction rules of the Employee Retirement Income Security Act of 1974 (“ERISA”). The advisory opinion concluded that the receipt of such fees by the trust company would not violate ERISA’s prohibited transaction rules where the decision to invest in the mutual funds offered under the plan is made by a plan fiduciary who is independent of the trust company (and its affiliates) or by plan participants.

Under the advisory opinion, the trust company provided directed trustee and non-fiduciary services to participant-directed and other defined contribution plans through bundled services arrangements. An affiliate of the trust company served as the investment adviser to certain mutual funds that were made available under the trust company’s client plans (as a condition of engagement, at least one affiliated fund was required to be offered as an investment option under the bundled services arrangement, but the trust company was not able to assert any influence with respect to the selection of the investment options). Fee information (including 12b-1 fees) was disclosed by the trust company to potential clients with regard to each affiliated fund offered as well as other actively-managed mutual funds in the same category. If the plan fiduciary chose not to replace an affiliated fund that it dropped, the trust company would continue to provide plan services under the bundled services arrangement (but the trust company could withdraw or make an offer to the plan fiduciaries to renegotiate the plan service fees if the arrangement is no longer profitable).

In the advisory opinion, the DOL observed that the plan sponsor or other fiduciary independent of the trust company maintained complete control of the selection of funds in which the plan invests. The DOL noted that the trust company had no role in the selection of investment options beyond requiring, as a condition of initial engagement of the trust company as a bundled provider, at least one affiliated fund to be offered by the plan. Moreover, a plan fiduciary independent of the trust company or its affiliates selects the plan’s investment options.

The advisory opinion, however, cautions that if the trust company were to provide to the plan “investment advice” as defined in ERISA, it would be in a violation of a prohibited transaction exemption as a result of its causing the plan to invest in a mutual fund that pays a fee to an affiliate of the trust company. The advisory opinion also reminded plan fiduciaries of their duties under ERISA.

As previously announced, the NASD, in a July Notice to Members, released the full text of its revised rules regarding communications with the public. The new rule:

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

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

In addition, the amendments will substantially shorten and simplify the standards applicable to communications with the public, which are currently contained in Rule 2210(d). The amendments relocate certain of these standards to new Interpretive Material 2210-1, Guidelines to Ensure that Communications Are Not Misleading.

The amendments also broaden the definition of “communications with the public” to include not only advertisements, sales literature, and correspondence, but also public appearances, institutional sales material, and independently prepared reprints.

In its Notice to Members, the NASD notes that advertisements and sales literature concerning registered investment companies that are not governed by Rule 2210(c)(3) or Rule 2210(c)(4) still must be filed with the NASD within 10 business days of first use or publication. This 10-business-day filing requirement also continues to apply to advertisements and sales literature concerning public direct participation programs and advertisements concerning government securities.

The new rule and amendments will take effect on November 3, 2003.

Last January, the Chairman of the SEC requested that NASD, together with the Investment Company Institute and the Securities Industry Association, convene a task force (the “Task Force”) to recommend industry-wide changes to address errors and failures in providing breakpoint discounts to investors in connection with the purchase of mutual fund shares that carry a front-end sales load. The Task Force recently published a report of its findings and recommendations to address these errors and failures and ensure that processes are in place so that investors are provided any breakpoint discounts to which they are entitled. The Task Force’s recommendations were grouped into three categories:

1. Assessing and understanding breakpoint discounts. To address communication issues and lack of uniformity:

• The mutual fund industry should adopt common definitions of terms frequently used in describing breakpoint opportunities such as “spouse” and “minor child.” (but the Report emphasizes that this recommendation is not intended to mean that funds can or should conform the bases on which they offer breakpoints to investors).
• Mutual funds should create a central, comprehensive database (easily accessible to broker-dealer representatives) of pricing methods, breakpoint schedules, and the linkage rules used to determine when a breakpoint has been reached.
• Mutual funds should provide, in a prominent and clear format, additional prospectus and website disclosure concerning pricing methods, breakpoint schedules, and linkage rules.
• Confirmations should be revised to disclose the entire percentage sales load charged on each front-end load mutual fund purchase transaction.

2. Gathering and communicating relevant information. To assist broker-dealers in communicating with investors about breakpoint opportunities and to gather the data necessary to fully deliver all appropriate breakpoint discounts:

• Broker-dealers should require their registered representatives to maintain evidence that they have communicated the availability of breakpoint discounts to investors and made the necessary inquiry to gather the relevant data to calculate breakpoint discounts before transactions are processed.
• Broker-dealers should record and update, whenever necessary, an investor’s linkage information, preferably using a standardized worksheet that the NASD expects to develop.
• The SEC should require mutual fund prospectuses to: (1) disclose that investors may need to provide their broker-dealers with information necessary to take full advantage of breakpoint discounts; and (2) clearly explain whether breakpoint discounts are available based upon the historical cost of the investor’s total investment or whether they are available based only upon the net asset value of the investor’s holdings or the public offering price and (3) state whether the investor must keep the records necessary to demonstrate his or her historical costs.
• Mutual fund confirmations should include a legend alerting investors that they may be eligible for breakpoint discounts.
• Broker-dealers, at or prior to the confirmation of the investor’s initial purchase, should provide each investor with a written statement: (1) alerting the investor to the breakpoint opportunities; (2) referring the investor to appropriate materials to determine breakpoint eligibility; and (3) explaining that the broker-dealer requires certain information to identify and link related accounts, and, if applicable, to obtain discounts based on historical costs.
• Continuing education requirements for registered representatives should be enhanced to place greater focus on breakpoint rules, terms, and considerations.
• Participants in the sale of mutual funds and regulators should develop appropriate educational materials that clearly explain breakpoint opportunities to retail investors.
  

3. Meeting challenges in processing breakpoint information. To provide for better collection and sharing of information that is necessary to ensure that an investor receives any applicable breakpoint discounts:

• Non-omnibus broker-dealers should transmit tax identification number (“TIN”) and broker-dealer information number (“BIN”) data to mutual funds to assist in the linking of accounts. The Report identifies methodologies to facilitate wider access through Fund/SERV.
• Transfer agents should perform automated searches of the TIN and/or the BIN and letter of intent data supplied by the broker-dealers to calculate and verify breakpoint discounts across broker-dealers on transactions that are executed on a fully disclosed basis.

The House Committee on Financial Services approved an amended version of the Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420), which is intended to increase transparency of mutual fund fees and costs and take steps to strengthen corporate governance and management at mutual fund companies. Shortly thereafter, Committee Chairman Michael Oxley (R-OH) and Capital Markets Subcommittee Chairman Richard Baker (R-LA) issued a letter to the SEC urging that the SEC use its regulatory authority to implement those elements or themes of the bill that do not require actual legislative action. Specifically, the letter urged action by the SEC on the following.

Increased Fee and Expense Disclosures. Specifically, include the following additional disclosures:

• estimated operating expenses based on a $1,000 investment in the fund;
• on all account statements, a legend stating that investors have paid fees on their investment;
• details of the fund portfolio manager’s compensation;
• portfolio turnover rate and implications of high turnover; and
• information about soft dollar and directed brokerage arrangements, revenue sharing payments, and breakpoint discounts.

Increase oversight of soft dollar, directed brokerage and revenue sharing arrangements. Specifically:

• require an annual report from the funds’ adviser to its board detailing such arrangements;
• expressly subject the board to a fiduciary duty to review such arrangements;
• provide investors with an annual summary of the report to the board; and
• require maintenance records with respect to soft dollar arrangements.
  
  
• Increase to two-thirds of the board the minimum number of directors who are not “interested” persons.
• Clarify the use of the term “no-load” with respect to funds that charge a Rule 12b-1 fee.
• Require funds to inform their boards of significant deficiencies identified by the SEC in an inspection.
• Implement the proxy voting transparency rules that the SEC adopted this year.
• Adopt the SEC’s rule proposal requiring funds to have a chief compliance officer.
• Require brokers to disclose information about differential compensation and conflicts of interest associated with the sale of a particular fund, along with information about commissions that may be charged based on the class of shares purchased.

The letter also requests that the SEC address certain additional issues, including improved disclosure of transaction costs, use of soft dollar arrangements, the increased rate of arbitration claims involving mutual funds, and methods for increasing shareholder participation in the proxy process. The letter requests a progress report from the SEC by October 1, 2003.

The German Finance Ministry introduced proposed legislation that, if adopted, will replace Germany’s current law on investment funds, and will have the effect of eliminating tax discrimination against non-German investment funds. Currently, German investors receive favorable tax treatment with respect to dividends received from German funds. Under the proposed legislation, dividends received from non-German funds would be subject to the same favorable taxation as dividends received from German funds. The proposed legislation would also improve tax treatment of capital gains realized from the sale of shares of non-German funds.

The U.S. District Court for the Southern District of New York recently dismissed a lawsuit filed against a mutual fund by a shareholder alleging that the fund’s prospectus and registration statement failed to disclose certain conflicts of interest among the fund and its investment adviser and their affiliated broker dealer.

Specifically, the shareholder alleged that the fund and its affiliates violated antifraud Sections 11 and 12(a)(2) of the Securities Act of 1933 by failing to disclose:

• that the fund’s broker-dealer affiliate provided investment banking services to the companies in which the fund invested;
• the conflicts that were alleged to have made certain research reports issued by the affiliated broker-dealer misleading with respect to companies in which the fund invested; and
• that the fund had invested in companies at market prices that were inflated as a result of the allegedly misleading research reports which were intended to obtain investment banking business for the affiliated broker-dealer.

In granting the fund’s motion to dismiss the claim, the court the court stated that there is no legal obligation under any SEC regulation to make the disclosures that the shareholder alleged were omitted. The court noted that it has been well-recognized for decades that investment advisers to mutual funds are affiliated with broker-dealers that engage in investment banking activities. Moreover, the court noted that information alleged to have been omitted from the fund’s prospectus and registration statement was nevertheless publicly available information. The court also noted that none of the fund’s investments was inconsistent with its policy of investing in technology companies that are, or are likely to develop to be, market leaders.

The court also dismissed a claim by the shareholder brought under Section 34(b) of the Investment Company Act of 1940, which provides in relevant part that it is unlawful for any person to make an untrue statement of material fact in any registration statement. The court concluded that Section 34(b) does not provide a private right of action and that claims thereunder must be stated derivatively and not directly. The court also found that the shareholder failed to state a claim under antifraud Section 10(b) of the Securities Exchange Act of 1934 because, as discussed above, no duty to disclose was established, and because the shareholder failed to establish scienter on the part of the fund or its advisers or directors.

In re: Merrill Lynch & Co. Global Technology Fund Securities Litigation (02-CV-7854) (S.D.N.Y. July 2, 2003).

The DOL issued an advisory opinion addressing whether a trust company’s receipt of 12b-1 and sub-transfer fees from mutual funds, the investment advisers of which are affiliates of the trust company, for services relating to plan investments in mutual funds, would violate the prohibited transaction rules of the Employee Retirement Income Security Act of 1974 (“ERISA”). The advisory opinion concluded that the receipt of such fees by the trust company would not violate ERISA’s prohibited transaction rules where the decision to invest in the mutual funds offered under the plan is made by a plan fiduciary who is independent of the trust company (and its affiliates) or by plan participants.

Under the advisory opinion, the trust company provided directed trustee and non-fiduciary services to participant-directed and other defined contribution plans through bundled services arrangements. An affiliate of the trust company served as the investment adviser to certain mutual funds that were made available under the trust company’s client plans (as a condition of engagement, at least one affiliated fund was required to be offered as an investment option under the bundled services arrangement, but the trust company was not able to assert any influence with respect to the selection of the investment options). Fee information (including 12b-1 fees) was disclosed by the trust company to potential clients with regard to each affiliated fund offered as well as other actively-managed mutual funds in the same category. If the plan fiduciary chose not to replace an affiliated fund that it dropped, the trust company would continue to provide plan services under the bundled services arrangement (but the trust company could withdraw or make an offer to the plan fiduciaries to renegotiate the plan service fees if the arrangement is no longer profitable).
In the advisory opinion, the DOL observed that the plan sponsor or other fiduciary independent of the trust company maintained complete control of the selection of funds in which the plan invests. The DOL noted that the trust company had no role in the selection of investment options beyond requiring, as a condition of initial engagement of the trust company as a bundled provider, at least one affiliated fund to be offered by the plan. Moreover, a plan fiduciary independent of the trust company or its affiliates selects the plan’s investment options.

The advisory opinion, however, cautions that if the trust company were to provide to the plan “investment advice” as defined in ERISA, it would be in a violation of a prohibited transaction exemption as a result of its causing the plan to invest in a mutual fund that pays a fee to an affiliate of the trust company. The advisory opinion also reminded plan fiduciaries of their duties under ERISA.

As previously announced, the NASD, in a July Notice to Members, released the full text of its revised rules regarding communications with the public. The new rule:

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

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

In addition, the amendments will substantially shorten and simplify the standards applicable to communications with the public, which are currently contained in Rule 2210(d). The amendments relocate certain of these standards to new Interpretive Material 2210-1, Guidelines to Ensure that Communications Are Not Misleading.

The amendments also broaden the definition of “communications with the public” to include not only advertisements, sales literature, and correspondence, but also public appearances, institutional sales material, and independently prepared reprints.

In its Notice to Members, the NASD notes that advertisements and sales literature concerning registered investment companies that are not governed by Rule 2210(c)(3) or Rule 2210(c)(4) still must be filed with the NASD within 10 business days of first use or publication. This 10-business-day filing requirement also continues to apply to advertisements and sales literature concerning public direct participation programs and advertisements concerning government securities.

The new rule and amendments will take effect on November 3, 2003.

The House Committee on Financial Services approved an amended version of the Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420), which is intended to increase transparency of mutual fund fees and costs and take steps to strengthen corporate governance and management at mutual fund companies. Shortly thereafter, Committee Chairman Michael Oxley (R-OH) and Capital Markets Subcommittee Chairman Richard Baker (R-LA) issued a letter to the SEC urging that the SEC use its regulatory authority to implement those elements or themes of the bill that do not require actual legislative action. Specifically, the letter urged action by the SEC on the following.

Increased Fee and Expense Disclosures. Specifically, include the following additional disclosures:

• estimated operating expenses based on a $1,000 investment in the fund;
• on all account statements, a legend stating that investors have paid fees on their investment;
• details of the fund portfolio manager’s compensation;
• portfolio turnover rate and implications of high turnover; and
• information about soft dollar and directed brokerage arrangements, revenue sharing payments, and breakpoint discounts.

Increase oversight of soft dollar, directed brokerage and revenue sharing arrangements. Specifically:

• require an annual report from the funds’ adviser to its board detailing such arrangements;
• expressly subject the board to a fiduciary duty to review such arrangements;
• provide investors with an annual summary of the report to the board; and
• require maintenance records with respect to soft dollar arrangements.
  

• Increase to two-thirds of the board the minimum number of directors who are not “interested” persons.
• Clarify the use of the term “no-load” with respect to funds that charge a Rule 12b-1 fee.
• Require funds to inform their boards of significant deficiencies identified by the SEC in an inspection.
• Implement the proxy voting transparency rules that the SEC adopted this year.
• Adopt the SEC’s rule proposal requiring funds to have a chief compliance officer.
• Require brokers to disclose information about differential compensation and conflicts of interest associated with the sale of a particular fund, along with information about commissions that may be charged based on the class of shares purchased.

The letter also requests that the SEC address certain additional issues, including improved disclosure of transaction costs, use of soft dollar arrangements, the increased rate of arbitration claims involving mutual funds, and methods for increasing shareholder participation in the proxy process. The letter requests a progress report from the SEC by October 1, 2003.

Letter dated July 30, 2003 to SEC Chairman Donaldson from Congressmen Oxley and Baker.

The Maryland Circuit Court for the City of Baltimore upheld a bylaw amendment which raised the threshold for the election of directors for a closed-end fund organized as a Maryland corporation from a plurality to a majority of the outstanding shares. The plaintiff had challenged the bylaw amendment on the grounds that it was invalid under Maryland law because it was not authorized by the Maryland General Corporations Laws. A similar bylaw amendment was upheld recently by the Fourth Circuit Court of Appeals. (See Industry News Summary for the week of 2/10/03 to 2/17/03). Hale and Dorr and local counsel defended the Fund against the lawsuit. The Maryland court granted the fund’s motion for summary judgment. Bradshaw vs. The SmallCap Fund, Inc., Case No. 24-C-03-003732 (June 24, 2003)

The CFTC has adopted amendments to Rule 1.35(a-1) under the Commodity Exchange Act to expand the availability of bunching orders to all customers, simplify the process for placing the bunched orders and clarify the respective responsibilities of account managers and futures commission merchants (“FCMs”). Currently, Rule 1.35(a-1) does allow certain account managers to bunch orders for customers. However, these account managers may only allocate bunched orders to individual accounts at the end of the day when the accounts are for “eligible customers”(e.g., sophisticated customers) and when the account managers make certain disclosures regarding their allocation methodology, the standard of fairness of their allocations, their composite or summary data of the trades, and whether they have any interest in the bunched order.

In amending the rule the CFTC noted that that all customers, not just sophisticated customers, deserve to have their orders filled efficiently and at the most favorable terms under the circumstances. The CFTC commented that bunched orders can meet these objectives because bunched orders can provide better pricing and execution. Accordingly, the CFTC amended Rule 1.35(a-1) to expand the eligibility to all customers who provide written investment discretion to account managers.

The amendment also converts the disclosure requirement of current Rule 1.35(a-1) to an information availability requirement. Under the amended rule, account managers are required to make the following information available to customers upon request: (1) the general nature of the allocation methodology the account manager uses; (2) summary or composite data sufficient for that customer to compare its results with those of other relevant customers and, if applicable, any account in which the account manager has an interest; and (3) whether accounts in which the account manager may have any interest may be included with customer accounts in bunched orders eligible for post-execution allocation.

The amended rule also provides that account managers must observe three requirements when allocating bunched orders on a post-execution basis:

• Allocations must be fair and equitable. No account or group of accounts may receive consistently favorable or unfavorable treatment.
• Account managers must use an allocation methodology sufficiently objective and specific to permit independent verification of the fairness of the allocation. While account managers may exercise discretion over the allocation methodology in order to treat all customers fairly, the CFTC must be able to reconstruct the allocation methodology sufficiently to verify that the account manager is acting without bias.
• The account manager must provide information to FCMs no later than a time sufficiently before the end of the day the order is executed to ensure that clearing records identify the ultimate customer for each trade.

Finally, the amended rule expands the class of account managers permitted to bunch orders to include commodity trading advisers (“CTAs”) and investment advisers who are exempt from registration, or are excluded from the definition of CTA or investment adviser by operation of law or rule. In addition, the amended rule allows foreign advisers who exercise discretionary trading authority over the accounts of non-U.S. persons to be eligible account managers regardless of whether the foreign adviser has been granted an exemption pursuant to CFTC Rule 30.10.

The amended rule will take effect on July 11, 2003. The Federal Register: June 11, 2003 (Volume 68, Number 112)

In the July 2003 Notice to Members, the NASD clarified the supervisory obligations and recordkeeping requirements of NASD members as they apply to instant messaging. Instant messaging is an expanding technology which alerts users of the same internet provider to the presence on-line of other users, and allows those users to communicate with each other through the computer on a real time basis.

The NASD commented that the informality of instant messaging does not exempt it from the general standards applicable to all forms of communication with the public and that members need to evaluate instant messages according to their “content and audience”. Depending upon their content and audience, an instant message could be either sales literature or correspondence. The NASD reminded members that compliance with its rules depends upon clear supervision and review procedures that are consistently applied. The NASD cautioned that if a member is unable to include instant messaging within an adequate supervisory program, the member must prohibit the use of instant messaging in customer communications. The NASD also added that members must be sure that their use of electronic communications, including instant messaging, enables them to make and keep the records required by the SEC and NASD. NASD Notice to Members (July 2003).

The SEC has issued a concept release seeking comments on various issues relating to credit rating agencies, including whether credit ratings should continue to be used for regulatory purposes under the federal securities laws, and, if so, the process of determining whose credit ratings should be used and the level of oversight to apply to such credit rating agencies.

Credit rating agencies are recognized as nationally recognized statistical rating organizations ("NRSROs”) by the SEC staff through the no-action letter process. Although the SEC originated the use of the term "NRSRO" for a narrow purpose in its own regulations, the ratings by NRSROs are now widely used as benchmarks in legislation, regulation and private financial contracts. The SEC noted that it submitted to Congress in January 2003 its report on the role and function of credit rating agencies in the operation of the securities markets in response to the Congressional directive contained in Section 702 of the Sarbanes-Oxley Act of 2002. Building upon that report to Congress, the SEC is now seeking comment on the following issues relating to NRSROs:

Alternatives to NRSRO designation: The SEC noted that several commenters have expressed the view that the SEC should cease using the NRSRO designation in its rules and regulations. Several different reasons have been put forth in support of this view, including that the NRSRO designation acts as a barrier to entry into the credit rating business and that the SEC lacks the legal authority to regulate or impose requirements on NRSROs. In the release, the SEC identified several areas where the NRSRO designation is used in its rules and suggested alternatives to the continued use of that designation. For example, the SEC noted that it could eliminate the objective test from Rule 2a-7 under the Investment Company Act of 1940, which requires money market funds to invest in certain “high quality” securities, and rely solely on a subjective qualitative test performed by the money market fund’s adviser. The SEC is seeking comment on the advisability of eliminating the NRSRO designation from its rules and appropriate alternatives.

Recognition Criteria: Before recognizing a credit rating agency as an NRSRO, the SEC staff first determines that the rating agency satisfies certain established criteria. The SEC noted that the single most important criterion is that the rating agency is widely accepted in the U.S. as an issuer of credible and reliable ratings by the predominant users of securities ratings. The SEC further noted that concerns have been raised that the criteria impose barriers to entry into the business of acting as a credit rating agency and that the current NRSRO recognition process is not sufficiently transparent. In addition, in light of recent corporate failures, concerns have also been raised regarding the performance of the credit rating agencies. The SEC is seeking comments on how it could seek to improve the transparency of the NRSRO recognition process, assuming it retains the NRSRO designation.

Examination and oversight of NRSROs: While each of the current NRSROs is registered as an investment adviser under the Investment Advisers Act of 1940, SEC rules do not require such registration. The SEC noted that commenters have disagreed on whether NRSROs should or could be subject to this amount of regulatory oversight, or even greater regulatory oversight. Some have indicated that greater regulation is essential given the importance of their credit ratings to investors and the influence such ratings can have on the securities markets while others question the authority of the SEC to impose greater oversight and whether greater oversight would be feasible. The SEC is seeking comments on whether it can and should increase its ongoing oversight of NRSROs.

Conflicts of Interest: The SEC commented that conflicts of interest may arise in several areas within a credit rating agency. Credit rating agencies’ reliance on issuer fees could lead to a conflict of interest and the potential for rating inflation. The SEC noted that the NRSROs have represented that they have implemented a number of policies and procedures designed to ensure the independence and objectivity of the ratings process, such as requiring ratings decisions to be made by a ratings committee, imposing investment restrictions, and adhering to fixed fee schedules. In addition, they have represented that rating analyst compensation is merit-based (e.g., based on the demonstrated reliability of their ratings), and is not dependent on the level of fees paid to the NRSRO by issuers that the analyst rates. The SEC also commented that conflicts of interest may arise when credit rating agencies offer consulting or other advisory services to the entities they rate. The SEC noted that the NRSROs have generally represented that they have established extensive guidelines to manage conflicts in this area, including firewalls to separate their ratings services from other ancillary businesses and that advisory services presently represent a very small portion of their total revenues. Concern has also been expressed that subscribers may have preferential access to rating analysts and, as a result, inappropriately may learn of potential rating actions or other nonpublic information. The SEC is seeking comment on the ways in which it these potential conflicts of interest can be addressed.

Alleged anti-competitive, abusive and unfair practices: The SEC noted that some commenters have alleged that certain of the larger credit rating agencies have abused their dominant market position by engaging in certain aggressive competitive practices. Others have questioned the propriety of rating agencies’ attempting to induce an issuer to pay for a rating the issuer did not request (e.g., by sending a bill for an unsolicited rating, or sending a fee schedule and "encouraging" payment). The SEC is soliciting comments on how to address these practices.

Information flow: The SEC noted that several commenters have stressed the importance of transparency in the ratings process. Among other things, they assert that fluctuations in security prices in response to rating actions could often be less pronounced if credit rating agencies disclosed more information about the assumptions underlying their ratings, such as specific events that might prompt a rating change, as well as the information and documents reviewed by them in reaching a ratings decision, such as whether the issuer participated in the rating process. The SEC is seeking comment on ways in which information flow from credit rating agencies can be improved to address these issues.

The SEC is requesting comments on these NRSRO-related issues by July 28, 2003. SEC Release No. 33-8236 (June 4, 2003).