Investment Management Industry News Summary - March 2002

SEC Commission Isaac Hunt, in testimony before the Senate Committee on Governmental Affairs, said that the SEC plans to examine the competitive impact of the way it designates nationally recognized statistical rating organizations (“NRSROs”). He commented that the SEC published a rule proposal in 1997 that would have adopted a definition of the term “NRSRO” and would have provided criteria that must be satisfied in order for an entity to be recognized by the SEC as an NRSRO. Given the recent focus on rating agency oversight, Mr. Hunt stated that the SEC is unlikely to act on that proposal until all of the relevant issues are addressed.

He noted that the SEC currently designates NRSROs through the no‑action letter process. Three credit rating agencies currently meet the SEC’s requirements and are designated NRSROs. Mr. Hunt noted that the use of the NRSRO concept has increased over time, and has found its way into securities regulations, banking regulations and legislation. He added that the single most important criterion to the SEC in designating an NRSRO is that the rating agency is nationally recognized as an organization which issues credible and reliable ratings by users of securities ratings.

Mr. Hunt commented that the Justice Department and others have raised concerns that the national recognition requirement may create a barrier to entry for new credit rating agencies.He explained that the premise of this argument is that users of the ratings have an incentive to use ratings issued by NRSROs rather than by companies lacking that designation, which makes it more difficult for those lacking the designation to achieve national recognition.He stated that the SEC has not found this to be the case.He pointed to the growth in the businesses of several credit rating agencies that are not recognized as NRSROs, which suggests to him that market participants are seeking credit quality information from numerous sources.However, he noted that the SEC will examine the competitive impact of its NRSRO designations and whether other market based alternatives might address the competitive concerns.

He stated that the current NRSROs are registered with the SEC as investment advisers.He noted that the Investment Advisers Act of 1940 (the “Advisers Act”) requires the rating agencies to have an adequate basis for their ratings and prohibits them from having undisclosed conflicts of interest affecting their ratings.He pointed out that the Advisers Act does not directly address the quality or reliability of the ratings. Given the importance of rating agencies and the influence of ratings on the securities markets, he noted that some have called for additional SEC oversight.He stated that the SEC believes that it has the authority to regulate NRSROs and that the process for designating NRSROs is clear under existing law. He commented that if additional oversight is deemed necessary, the NRSRO designation process might provide the basis for the additional supervision. SEC Today, Volume 2002‑56 (March 22, 2002).

The CFTC has issued an advisory to provide further guidance concerning unregistered entities and intermediaries involved in off exchange foreign currency futures and options trading by retail customers. In December 2000, the Commodity Futures Modernization Act of 2000 (“CFMA”) amended the Commodity Exchange Act (the “CEA”) to clarify the jurisdiction of the CFTC in the area of foreign currency futures and options trading. Generally, the CEA now makes offering foreign currency futures and options contracts to retail customers on an “off exchange” basis, ( i.e., where the contracts are not executed or traded on an organized exchange) unlawful unless the counterparty is a regulated entity enumerated in Section 2(c)(2)(B)(ii) of the CEA.The counterparties enumerated in that section include:

• registered futures commission merchants (“FCMs”) and certain affiliated persons of registered FCMs;
• financial institutions;
• registered broker-dealers and associated persons of registered broker dealers;
• insurance companies and regulated affiliates thereof;
• financial holding companies and investment bank holding companies.

The term “retail customer” as used in the advisory refers to any person other than a person that comes within the definition of an “eligible contract participant” pursuant to Section 1(a)(12) of the CEA.For example, an individual whose total assets do not exceed $10 million would be considered a retail customer.

The CFTC noted that there are entities which offer trading platforms through which customers may trade directly with one another, which are sometimes referred to as matching systems.Under Section 2(c)(2)(B) of the CEA, one of the regulated financial entities enumerated under the CEA must act as the counterparty in off‑exchange foreign currency futures and options transactions with retail customers.To the extent that retail customers trade through one of these matching systems and become counterparties to one another, the requirements of the CEA would not be met.The CFTC advised that the transaction would therefore violate Section 4(a) of the CEA.The CFTC further noted that the fact that a firm operating such a trading platform is registered as an FCM, or as one of the other counterparties enumerated under the CEA, would not be sufficient to meet the requirement under the CEA that the counterparty to a retail customer be one of the enumerated entities listed under the CEA. The CFTC advised that any firms which are operating such a trading platform should cease doing so immediately. The CFTC cautioned that ceasing such activity would not prevent it from taking appropriate action based on previous conduct. CFTC Division of Trading and Markets Advisory Concerning Foreign Currency Trading by Retail Customers, CFTC Advisory (March 21, 2002).

The SEC has announced that it is launching a four month internal study to examine its operations, efficiency, productivity and resources.SEC Chairman Harvey Pitt commented that recent events, including the bankruptcies of Enron and Global Crossing and the recent indictment of Arthur Andersen, have placed continuing extraordinary demands on the SEC’s resources and confirm his initial view that a thorough study is warranted.Mr. Pitt commented that he is committed to undertaking a thorough review of the SEC’s operations, effectiveness and resource needs to see whether the SEC can improve the quality and level of its service to investors and other constituencies while it also institutes meaningful efficiencies.He added that, two weeks ago, in the face of an enormous surge in its enforcement, accounting and disclosure activities, he asked Congress to increase the SEC staffing level by 100.He noted that the special study will enable the SEC to determine whether it needs staffing and other resources beyond the amount it requested, or whether more efficient use of existing staffing and other resources may meet the SEC’s needs.He stated that he firmly believes that this special study is a crucial step in ensuring a strong, vibrant and efficient SEC.

The SEC’s announcement follows a recent report by the U.S. General Accounting Office (“GAO”) which concluded that, in addition to more staff and more money, the SEC needs to improve its strategic planning processes. The SEC noted that the special study is intended, in part, to implement the GAO’s recommendation. SEC Press Release 2002-42 (March 20, 2002).

The U.S. Court of Appeals for the Second Circuit ruled that investors in variable annuity contracts cannot bring private suit under the 1940 Act to recover allegedly unreasonable fees charged by insurance companies that sell the contracts Olmstead v. Pruco Life Insurance Company of New Jersey, (2d Cir. No. 009511, March 7, 2002). The plaintiffs, holders of variable annuity contracts, claimed that the life insurance company through which they purchased their contacts violated Sections 26(f) and 27(i) of the 1940 Act because the fees it charged were excessive and unreasonable in relation to the services provided, the expenses to be incurred, and the risks assumed. Section 26(f) under the 1940 Act makes it unlawful for an insurance company to sell a variable insurance contract unless the fees and charges deducted under the contract, in the aggregate, are reasonable. Section 27(i) of the 1940 Act makes it unlawful for a sponsoring insurance company to sell any such contracts unless it complies with Section 26(f) and regulations issued thereunder.

The Appeals Court stated that, to determine whether a federal private right of action exists, it must look to the intent of Congress. The Appeals Court noted that no provision of the statute explicitly grants a private right of action for violations of either Sections 26 or 27 so that it must presume that Congress did not intend to grant one. The Appeals Court found that that presumption was strengthened by three additional features of the statute. First, neither section contains private rights-creating language as both sections describe actions by insurance companies that are prohibited but do not mention investors. The Appeals Court held that statutes that focus on the person regulated rather than on the individuals protected create no implication of an attempt to confer rights on a particular class of persons.

Second, the Appeals Court noted that Section 42 of the 1940 Act explicitly provides for enforcement of all 1940 Act provisions by the SEC through investigations and civil suits for injunctions and penalties. The Appeals Court found that the express provision of one method of enforcing a substantive rule suggests that Congress intended to preclude others. Finally, the Appeals Court noted that Congress provided in Section 36(b) of the 1940 Act a private right of derivative action for investors in mutual funds alleging that advisers breached certain fiduciary duties. The Appeals Court found that Congress’ explicit provision of a private right of action to enforce one section of the statute suggests that omission of an explicit private right to enforce other sections was intentional. The Appeals Court acknowledged a “long line” of decisions recognizing an implied private right of action as a way to promote the policies served by the 1940 Act. The Appeals Court stated, however, that when those cases were decided, courts had more latitude to weigh statutory policy and other considerations than they do now. The Appeals Court noted that recent U.S. Supreme Court decisions have abandoned the “ancien regime” of implied rights of action and subordinated various tools of determining the existence of a private right of action to the statutory text. The Appeals Court affirmed the lower District Court’s decision that Congress did not intend to create a private right of action for violations of Sections 26(f) and 27(i). BNA Securities Regulation and Law Report, Vol. 34, No. 11 (March 18, 2002).

The SEC has adopted rules to minimize any potential distributions that may occur as a result of the indictment of Arthur Andersen LLP (“Andersen”). The SEC has also modified the requirements of including audited financial statements and registration statements under the Securities Act of 1933 (the “1933 Act”) and in filings required by the Trust Indenture Act of 1939 by registrants that are unable to, or elect not to have, Andersen issue a manually signed audit report, if the audit report was not issued on or before March 14, 2002. The SEC has also issued companion orders relating to the inclusion of financial statements and filings under the Securities Exchange Act of 1934, the Investment Advisers Act of 1940, the Investment Company Act of 1940 (the “1940 Act”) and the Public Utility Holding Act of 1935, where those filings would have included audited financial statements for which Andersen had been engaged as the independent public accountant.

The SEC noted in the release that it has requested and received assurances from Andersen that it will continue to audit financial statements in accordance with generally accepted accounting standards (“GAAS”) and applicable professional and firm auditing standards, including quality control standards. The SEC has also stated that Andersen has informed the SEC that if it becomes unable to provide those assurances, it will advise the SEC immediately.

The release provides that companies to whom Andersen issues a manually signed audit report after March 14, 2002 must file a letter as an exhibit to their filing stating that they have received certain representations from Andersen concerning:

• audit quality controls, including representations regarding the continuity of Andersen personnel working on the audit;
• the availability of national office consultation;
• the availability of personnel at foreign affiliates of Andersen to conduct relevant portions of the audit.

The release stated that as long as Andersen continues to be in a position to provide those assurances, the SEC will continue to accept financial statements audited by Andersen in filings.

The Release further provides that if companies for which Andersen had been engaged as the independent public accountant are unable to obtain from Andersen or elect not to have Andersen issue a manually signed audit report, the SEC is allowing additional time to engage new independent accountants and complete their filings. The release requires adherence to existing filing deadlines, but provides that the SEC will accept filings that include unaudited financial statements from any issuer unable to provide timely audited financial statements when previously audited by Andersen. The release provides that issuers electing this alternative will generally be required to amend their filings within 60 days to include audited financial statements. The SEC noted that its actions do not apply to issuers to whom Andersen had issued a signed audit report on or before March 14, 2002.

The SEC has determined that it is not necessary or appropriate to make this alternative filing framework available in the case of initial public offerings, initial registrations under the 1934 Act, going-private transactions or roll-up transactions. The SEC encouraged companies to contact the staff and request additional consideration of specific situations and the appropriateness of additional SEC or staff action. The SEC noted that investors with questions can call a special hotline maintained by the SEC’s Office of Investor Education at 1-800-SEC-0330 or by e-mail [email protected]. The SEC emphasizes in the release that companies should make their own independent decisions regarding completion of current audits and that these actions are intended only to provide neutral flexibility for companies as they make those decisions. SEC Release No. 33-8070 (March 18, 2002).

The ICI has commented on NASD proposed Rule 3011 which would prescribe minimum standards for anti-money laundering compliance programs established by NASD members pursuant to Section 352 of the Act. The comments addressed the proposed rule’s application to NASD members that underwrite securities issued by registered investment companies.

The ICI noted that it strongly supports effective rules to combat potential money laundering activity in the mutual fund industry. However, the ICI is proposing a narrowly crafted carve-out from proposed Rule 3011 that it believes would not create any gaps in anti-money laundering regulation. Specifically, the ICI recommended that the rule provide a conditional exemption to any NASD member with respect to its activities as a principal underwriter of mutual fund shares. The exception would apply to the sale by an NASD member of shares of a mutual fund that has established its own anti-money laundering program satisfying the requirements of Section 352 of the Act. The exception would not cover the activities of a mutual fund underwriter which are not related to mutual fund underwriting, such as offering brokerage services to clients. The ICI noted that it would expect the underwriter would be subject to Rule 3011 with respect to those other activities.

The ICI commented that it is proposing the exception to avoid unnecessary regulatory duplication, noting that the Act’s requirement to establish an anti-money laundering compliance program by April 24, 2002 applies to mutual funds as well as to broker-dealers. The ICI stated that it believes regulations setting minimum standards for mutual fund compliance programs will be proposed imminently. The ICI further commented that where an underwriter is part of a mutual fund complex, it would be logical for the mutual funds’ anti-money laundering program to cover any related activities of the underwriter. In those circumstances, the ICI argues that there would be no need for the underwriter to comply with a separate, duplicative requirement imposed by the NASD on its members. This is particularly true where, as is frequently the case, the underwriter does not open or hold shareholder accounts or process transactions in fund shares.

The ICI stated that it is also proposing the exception to eliminate what the ICI considers would be an illogical, bifurcated anti-money laundering compliance examination regime that Rule 3011 otherwise would create for mutual fund complexes. The ICI stated that compliance with the anti-money laundering program requirement for mutual funds will likely be examined by the SEC’s Office of Compliance, Inspections and Examinations (“OCIE”). The ICI stated that it believes the OCIE is in the best position to examine mutual funds and their relevant service providers (i.e., underwriters and transfer agents) in a comprehensive and integrated fashion for compliance with applicable anti-money laundering requirements. The ICI argued that subjecting mutual fund underwriters to NASD examination authority for this purpose would create a piece-meal regulatory scheme that would be both duplicative and inefficient. Letter from Craig S. Tyle, General Counsel of the ICI, to Jonathan G. Katz, Secretary, SEC (March 18, 2002).

The USA Patriot Act, enacted on October 24, 2001 (the “Act”), requires all financial institutions, including investment companies (both registered and private) and broker-dealers, to establish and implement an anti-money laundering compliance program on or before April 24, 2002. The program must be designed to ensure compliance with the requirements of the Bank Secrecy Act and Treasury Department regulations. The Act requires the compliance programs to consist of four components:

• Written internal policies, procedures and controls designed to prevent money laundering;
• A designated compliance officer with responsibility for a firm’s anti-money laundering program;
• An ongoing employee training program regarding money laundering; and
• An independent audit function to test the effectiveness of the anti-money laundering compliance program.

The NASD has also proposed new Rule 3011 which prescribes minimum standards required for NASD member firm’s compliance programs which are more comprehensive than the minimum standards under the Act. For more information regarding the preparation or implementation of an anti-money laundering compliance program, please contact Len Pierce at (617) 526-6440 or by email [email protected] or Charles McCain at (617) 526-6276 or by email at [email protected]

The Treasury Department (the “Treasury”) has issued a proposed rule that would facilitate information sharing between federal law enforcement offices and private financial institutions on possible money laundering and terrorist activity. The Treasury also issued an interim rule which will take effect upon publication in the Federal Register that will allow certain institutions to share information among themselves, also for the purpose of thwarting money laundering and terrorism.

Both the proposed rule and the interim rule were authorized under Section 314 of the USA PATRIOT Act (the “Act”). The Act authorized new measures to protect the U.S. financial system from money laundering and terrorism by (i) reducing the barriers to the sharing of financial information among governmental entities as well as financial institutions, (ii) systematically targeting known risks to the financial system, and (iii) providing the Treasury with the ability to identify new risks as they develop and take appropriate action to counter them. Section 314 of the Act improves the exchange of information between the government and financial institutions on the one hand and among financial institutions on the other.

Information Sharing Between the Government and Financial Institutions

The propose rule seeks to utilize the existing communication resources of the Treasury's Financial Crimes Enforcement Network (“FinCEN”) to establish a link between federal law enforcement and financial institutions for the purpose of sharing information concerning accounts and transactions that may involve terrorist activity or money laundering. FinCEN, which is a bureau of the Treasury, maintains a government-wide data access service to assist federal, State, and local law enforcement agencies in the detection, prevention, and prosecution of terrorism, organized crime, money laundering, and other financial crimes. Under the proposed rule, federal law enforcement agencies will have the ability to locate accounts of, and transactions conduct by, suspected terrorist or money launderers by providing their names and identifying information to FinCEN, which will then send that information, both electronically and by fax, to financial institutions so that a check of accounts and transactions can made. If matches are found, law enforcement agencies would then follow up with the financial institution directly.

Information Sharing Among Financial Institutions

In order to facilitate financial institutions' ability to identify and report to the federal government instances of money laundering or terrorism, the Act authorizes the sharing of information among financial institutions about those suspected of terrorism and money laundering. Under the interim rule, certain financial institutions will be able to share information among themselves for the purpose of identifying and reporting suspected terrorism and money laundering. These financial institutions must first notify FinCEN of their intention to share such information and to take adequate steps to protect the confidentiality of the information and to use the information only for the purposes specified in the interim rule.The interim rule defines the term "financial institution" to mean:

• financial institutions subject to suspicious activity reporting, except for money services businesses;
• securities brokers and dealers registered under the Securities Exchange Act of 1934;
• issuers of travelers checks and money orders;
• registered money transmitters;
• and operators of credit card systems that are not money services businesses.

Notification of FinCEN would take the form of a yearly certification which can be completed online at FinCEN's webpage. Comments on the proposed rule are due 30 days after the rule is published in the Federal Register. The Treasury has also issued the provisions of the interim rule as part of the proposed rule to afford the public the opportunity to comment on both rules. Department of the Treasury, 31 CFR Part 103.

Paul Roye, the Director of the Division of Investment Management, discussed current issues at the Division of Investment Management at a recent conference. First, Mr. Roye reported that there has been a 75% increase in Form N-14 filings in the last two years. Form N-14 is the form used to register shares offered in connection with the merger of two mutual funds. He also noted that while investment advisers are now filing electronically on the IARD system, states have not fully implemented the system yet. He advised that states should begin registering investment adviser representatives through the IARD in the coming months. He also noted that amendments to Part II of Form ADV are still pending, but that he hopes the SEC will consider them sooner rather than later this year.

Mr. Roye pointed out that compliance with new Rule 35d-1 under the Investment Company Act of 1940 (the “1940 Act”) governing the use of names by mutual funds becomes effective July 31, 2002. He commented that most funds are choosing to change their investment policies to provide that 80% of their assets are invested in securities that reflect the fund’s name, rather than to change the fund’s name so that Rule 35d-1 would no longer apply. He added that the after-tax disclosure rule’s final compliance date for amendments to N-1A passed on February 15, 2002 and that the staff has received very few comments on the new requirements.

Mr. Roye commented that the staff has received a number of comments in response to the SEC’s concept release on exchange traded funds (“ETFs”). (See Industry News Summary for the period 11/5 to 11/12/01). He noted that the comments which the SEC has received to date have been uniform in pointing out that there is no clear line between actively managed ETFs and the current group of passively managed ETFs which the SEC has allowed. He stated that the SEC has a number of ETF applications pending for debt index ETFs and for enhanced index products that will seek to provide a multiple on an index’s returns, or on the inverse of those returns. He noted that the staff expects further developments in this area this year.

Finally, he commented that when the staff conducts an ‘integrated review’ of a registrant, it reviews annual and semi-annual reports and looks at the fund’s websites and other publicly available information in addition to its registration statement. He noted that the staff has urged funds to keep their websites updated because it has found that some of the information has become stale. He also noted that the staff is concerned that it is finding overly standardized language describing a fund’s performance over the past year. Mr. Roye stated that funds should not be surprised by these ‘integrated reviews’ which are in addition to routine inspections. SEC Today, Vol. 2002-40, February 28, 2002.

The NASD, in a Notice to Members, has provided guidance to member firms on auditor independence by reviewing recent rule amendments adopted by the Securities and Exchange Commission (“SEC”) and by highlighting the criteria that member firms should consider when determining whether or not an auditor’s independence may be impaired. The NASD noted that the NASD Regulation staff will use the same criteria in determining whether or not an auditor’s independence is impaired in any given situation.

In February 2001, the SEC amended its rules governing auditor independence to emphasize that an audit firm cannot be in a position in which it is, or appears to be, auditing its own work.This circumstance could arise if an auditor were to perform accounting and bookkeeping services, or design and implementation of financial information systems to such an extent that it contributes substantively in the creation and maintenance of the client’s books and records. The NASD noted that the American Institute of Certified Public Accountants (“AICPA”) has issued guidelines in its code of professional conduct covering an auditor’s performance of non-audit services for an audit client. The AICPA’s guidelines emphasize that an auditor’s independence could be impaired with respect to the audit client if the auditor was, or would appear to be, serving the audit client in a managerial capacity. The NASD commented that the SEC’s rule amendments took the AICPA’s approach one step further by indicating that if an auditor is involved substantially in creating the audit client’s books and records, it could be considered to effectively control or appear to control the client’s accounting process in preparation of the financial statement. The NASD noted that as a result of the SEC’s amendments, the AICPA is planning to revise its guidelines, especially those sections pertaining to an auditor’s performance of non-audit services for an audit client.

In reviewing the SEC’s rules and AICPA’s guidelines, the NASD highlighted criteria that it believes its member firms should consider when determining whether an auditor’s independence may be impaired. The NASD also advised firms that cannot afford or choose not to employ personnel to perform accounting functions to obtain bookkeeping and accounting services from accountants who are not controlled by the firm’s auditor. As a way to clarify the respective duties and responsibilities of the auditor and audit client, the NASD advised firms to obtain an engagement letter from their auditor that explicitly outlines the nature and scope of the auditor’s services and states categorically that both parties recognize that the broker-dealer is responsible for maintaining the integrity of its accounting system and preparing and presenting its financial statements. The NASD provided a list of actions or services which, if performed in addition to the audit, would indicate that the auditor is not independent:

• posts, classifies or codes the original entry of client transactions;
• reconciles subsidiary ledgers to records of original entries;
• prepares periodic accruals and related adjustments on an on-going basis;
• reconciles client records to bank statements;
• resolves open fails;
• monitors information flow leading to preparation of financial records;
• prepares general ledger and/or financial statements; or
• supervises such tasks.

The NASD also clarified that the following activities, by themselves, would not indicate that the auditor is not independent:

• observing the member’s business operations;
• inquiring about the nature and extent of the member’s accounting practices and procedures;
• reviewing documents of original entries;
• verifying completeness of subsidiary and general ledgers;
• questioning reconciliation differences and open fails;
• testing automated systems for completeness and reliability;
• performing and documenting analytical review of the firm’s operations and financial conditions; and
• determining the representational faithfulness of the member firm’s financial statements.

The NASD encourages member firms to review annually the services performed by their outside auditors to ensure that the auditor’s independence is not impaired. NASD Notice to Members 02-19 (March 2002).

The U.S. Court of Appeals for the Second Circuit overturned a lower court’s decision that a shareholder did not have standing to sue the Fund’s directors, officers and investment adviser for breach of federal and state fiduciary obligations with respect to an alleged coercive rights offering. The suit involves a rights offering to existing shareholders by a registered closed-end fund in June 1996. The fund is a Maryland corporation. The fund had offered one right for each outstanding share of common stock with three rights enabling the holder to purchase one new fund share. The subscription price per share was set at 90% of the market price per share given that the fund shares were trading at a sizeable discount from net asset value (“NAV”).

In the lawsuit, the plaintiff alleged that the rights offering was coercive because it penalized shareholders who did not participate. Under the pricing formula, the plaintiff alleged that the introduction of new shares at a discount to NAV diluted the value of the existing shares. The plaintiff also alleged that because the rights could not be sold on the open market, a shareholder could avoid the effects of dilution and the consequent reduction in the value of his or her net equity position in the fund only by purchasing new shares at the discounted price. Plaintiff further alleged that this pressured shareholders to purchase more shares which enabled the fund to increase its assets. An increase in assets would increase the management fee paid to the fund’s investment adviser because that fee is based on the total assets of the fund. The plaintiff contended that by approving the offering, the fund’s directors breached their duties of loyalty and care under Sections 36(a) and (b) of the 1940 Act and under common law. Plaintiff also alleged that the defendants breached their duty under Section 48 of the 1940 Act because of their positions of authority at the fund.

In 1998, the lower court dismissed the plaintiff’s direct claims on the grounds that the alleged injuries applied to the shareholders as a group, and thus could be asserted only in a derivative action on the fund’s behalf. The Appeals Court overturned that ruling, noting that, under Maryland law’s ‘distinct injury rule’, shareholders of a Maryland corporation may seek compensation in a direct action. The Appeals Court further noted that a shareholder must allege an injury distinct from an injury to the corporation, not necessarily distinct from that of other shareholders, to have standing. Applying this standard, the Appeals Court concluded that one injury – the alleged loss of share value resulting from underwriting fees and transaction costs incurred in the rights offering – does not support a direct claim under Maryland law. The Appeals Court reasoned that such costs to the per share price arose primarily because the costs depleted the corporation’s assets, which is precisely the type of injury to the corporation that can be redressed under Maryland law only through a derivative action.

The Appeals Court concluded that the other claims – those based on harm arising from the alleged coercion – would support a direct action under Maryland law. The Appeals Court reasoned that the shareholders who did not participate in the rights offering may have been injured through a reduction in the net equity value of their holdings, or from an involuntary dilution in equity value. The participating shareholders, on the other hand, may have been injured by paying transaction costs to liquidate other assets to purchase the new shares, or through the impairment of their right to dispose of their assets as they preferred if they purchased new shares to avoid dilution.The Appeals Court concluded that in the case of both participating and non-participating shareholders, it would appear that some of the alleged injuries were to the shareholders alone and not to the fund. The Appeals Court concluded each such harm would constitute a “distinct” injury supporting direct shareholder claims under Maryland law. The corporation cannot bring the action seeking compensation for these injuries because they were suffered by its shareholders, not itself. The Appeals Court remanded the case to the lower court for trial. Strougo v. Bassini, 2nd Circuit, Docket No. 00-9303 (February 28, 2002); BNA, Inc., Securities Regulation and Law Report, Vol. 34, No. 1 (March 11, 2002).

An individual defendant had appealed a District Court’s ruling that he, as a principal of a trading firm (the “Company”), violated federal commodity laws by making fraudulent claims about the Company’s foreign currency contracts.The District Court had ordered the defendant to pay over $5 million in restitution and over $1 million in civil monetary penalties for perpetrating the alleged foreign currency scheme and permanently barred him from the commodities industry. The defendant appealed the decision to the Fourth Circuit Court of Appeals, arguing that the CFTC lacked jurisdiction to regulate the Company because Congress did not intend for the Company's activities to be regulated by the CFTC. The defendant argued that Congress intended to exempt all futures trading from CFTC regulation unless such trading is conducted on a formally organized futures exchange. The defendant also argued that he was not the Company's controlling person, and therefore was not liable for the Company's alleged illegal activities.

The alleged fraudulent activities involved the Company soliciting foreign currency “traders” through job advertisements in several newspapers.Individuals who responded to the ads were invited to attend a brief training program hosted by the Company.At these sessions, the Company’s representatives claimed that the Company had access to the interbank market and that this access would enable the Company’s traders to make significant profits in just a few days. The Company also urged the traders to open their own accounts, and sent them to recruit family members and friends to open accounts with the Company. The district court concluded that the Company’s entire premise was misleading, noting that the nature of the interbank market would make it impossible for the Company to provide its traders with the ability to place trades on the interbank market.Instead, rather than providing customers with access to the interbank market for sophisticated traders, the district court found that the Company was simply “bucketing” customer orders by arranging for a Hong Kong firm to take the opposite side of the customers’ positions.

The Appeals Court rejected the defendant’s argument that the Company’s foreign currency transactions fell under the Treasury Amendment exception to the CEA and thus were outside CFTC jurisdiction.The Appeals Court explained that, from its enactment, the CEA contained antifraud measures designed to protect customers and the overall market.The Appeals Court noted that the CEA has always included an exceedingly broad definition of "board of trade" that encompasses virtually every situation in which futures were or ever could be traded. The Appeals Court stated that the breadth of this definition shows Congress's intent to regulate futures trading as fully as possible.

The Appeals Court noted that for more than five decades foreign currency trading was not a covered commodity.When Congress decided to regulate foreign currency transactions, it decided that certain transactions, such as trading between banks and other sophisticated institutional participants which are not conducted on a “board of trade” would not be subject to CEA regulation. However, the Appeals Court stated that Congress did not intend to enact an exemption any larger than necessary, and that Congress did in fact craft a narrow exemption.

The Appeals Court concluded that transactions in foreign currency are not subject to CFTC jurisdiction if they are large-scale, commercial bilateral transactions between sophisticated financial professionals. On the other hand, transactions are subject to CFTC jurisdiction if they are small, standardized, and mass-marketed to individuals. The Appeals Court found that, under this standard, the Company’s trades were not exempted by the Treasury Amendment, but rather included within the CEA's jurisdiction.

In reaching its decision, the Appeals Court pointed out that Congress had enacted the CFMA to clarify the CFTC's jurisdiction after this litigation began. Under the CFMA, the CFTC has jurisdiction over foreign currency futures with any person who is not an "eligible contract participant." The Appeals Court ruled that the Company’s trades met this test. The Appeals Court remanded the case to the district court for resolution only of the factual question of whether the defendant controlled the Company. Commodities Futures Trading Commission v. Baragosh (C.A.‑4), CCH Commodity Futures Report No.663 (March 8, 2002).

The ICI has filed a comment letter with the Department of Treasury (the “Treasury”) on a proposed rule that would require broker-dealers to file suspicious activity reports (“SARs”) with the Treasury’s Financial Crimes Enforcement Network (“FinCEN”). (See the Industry News Summary for the period 12/31/01 to 1/14/02). Under the proposed rule, transactions would be reportable if they:

• are conducted or attempted by, at, or through a broker-dealer;
• involve or aggregate funds or other assets of at least $5,000;
• and involve any known or any suspected violation of law or regulation, including a violation of federal law, a suspicious transaction relating to money laundering, or a violation of the Bank Secrecy Act (“BSA”).

The ICI commented that it believes it is reasonable and appropriate to subject transactions in mutual fund shares to SAR reporting as part of an overall strategy for guarding against potential money laundering activities in the U.S. financial services industry. However, the ICI commented that the application of the proposed SAR rule to transactions involving mutual fund shares is not clear in all cases. The ICI noted that it is not clear when purchases, redemptions and exchanges of fund shares would be considered to be conducted by, at or through the fund underwriter because the responsibilities of the underwriter and the mutual fund’s transfer agent vary at different fund companies. In some cases, the fund’s transfer agent, rather than its underwriter, is the entity responsible for processing shareholder transactions. In these situations, the ICI noted that it is unclear whether the transactions could be considered to have been conducted “by, at or through” the underwriter, which would not appear to subject the transaction to the proposed rule. This could result in substantially similar transactions receiving different treatment under the rule, based solely on the fund’s distribution and shareholder servicing arrangements. To address this uncertainty, the ICI recommended that the Treasury clarify its intent regarding the application of the proposed rule to transactions involving fund shares.

The ICI noted that the Treasury may be considering proposing an SAR rule specifically applicable to mutual funds. The ICI commented that it would support that approach as it would avoid the problem of different treatment for substantially similar transactions and would allow mutual funds flexibility to determine how their SAR responsibilities will be carried out. The ICI further commented that if the Treasury decides to impose a mutual fund SAR rule, it believes it would be appropriate to exclude mutual fund underwriters from the broker-dealer SAR rule or, at a minimum, to provide that an SAR filed by a mutual fund or its agent pursuant to a mutual fund SAR rule would satisfy any reporting obligation of the fund’s underwriter under the broker-dealer SAR rule with respect to the same transaction. The ICI argued that this framework would reduce the number of redundant reports filed with FinCEN, thereby improving the overall efficiency of the SAR regime.

The ICI further commented on the standard for identifying “suspicious” transactions under the proposed rule, pointing out that it fails to recognize the nature of the information that a mutual fund underwriter would normally have concerning shareholders and their transactions. The ICI noted that a mutual fund, its underwriter and its transfer agent typically have no face-to-face contact with fund shareholders. Rather, contact with investors primarily is written or electronic (e.g., through the mail, over the internet, or over the telephone). The ICI recommended that the Treasury amend the proposed rule to provide that mutual fund underwriters will be required to make determinations of what is “suspicious” based on information obtained by the fund, its underwriter or its transfer agent in the normal course of establishing a shareholder relationship or processing transactions. The ICI also recommended that the Treasury clarify that mutual funds or their underwriters are not required to “look through” retail broker-dealers or other intermediaries who hold shares in their names to report transactions of the customers of those broker-dealers or other intermediaries.The ICI also commented that the proposed rule would impose on broker-dealers two reporting obligations which are significantly broader than those applicable to banks, in that:

• the proposed broker-dealer SAR rule does not appear to be limited to the reporting of known or suspicious federal crimes;
• and the proposed broker-dealer SAR rule does not provide a $25,000 threshold for the reporting of known or suspected federal crimes (other than money laundering or BSA violations) involving an unidentified suspect.

Given that the Treasury’s proposing release provides no policy or other reasons that might justify this disparate treatment, the ICI recommended conforming the broker-dealer rule to the requirements applicable to banks. Finally, the ICI commented that the OCIE would be the most appropriate entity to examine fund underwriters’ compliance with SAR requirements because it would be in a position to examine mutual funds and their relevant service providers in a comprehensive and an integrative fashion for compliance with the applicable anti-money laundering requirements. ICI Letter from Craig S. Tyle to Judith R. Starr, Department of the Treasury, March 1, 2002.

NASD Regulation has proposed amendments to NASD Conduct Rule 3070 to limit reporting of criminal misdemeanors by NASD members and associated persons to certain types of misdemeanors. Under the proposal, members and associated persons would no longer have to report to the NASD an indictment, conviction or guilty or no-contest plea to “any criminal offense other than traffic violations”. Instead, misdemeanor criminal events subject to reporting would be limited to the type of business-related offenses that are required to be reported in response to question 23B(1) of Form U-4. Any felony, however, would still have to be reported.

NASD Regulation noted that the proposed rule change would be consistent with the proposed rule change submitted by the New York Stock Exchange (“NYSE”) to amend NYSE Rule 351(a)(5).This rule change would limit the reporting of criminal offenses to “any felony or misdemeanor that involves the purchase or sale of a security, taking of a false oath, the making of a false report, bribery, perjury, burglary, larceny, theft, robbery, extortion, forgery, counterfeiting, fraudulent concealment, embezzlement, fraudulent conversion or misappropriation of funds or securities, or substantially equivalent activity in a domestic or foreign court.” Comments are due on the NASD Regulations proposed rule amendment by March 29, 2002. SEC Release No. 34-45493 (March 1, 2002)