The NASD has expelled a brokerage firm and barred its owner and president from serving as a principal of an NASD member for intentionally providing false information in connection with the firm’s application for membership with the NASD. The brokerage firm applied for NASD membership in January 2001. In its application, the NASD reported that the president misrepresented that she was its sole owner and that there were no other principals affiliated with the firm. Specifically, the firm and the president did not disclose that another individual, who was then the subject of an NASD Regulation disciplinary proceeding alleging sales practice violations, was affiliated with the firm. The NASD alleged that the president was aware at the time she filed the application for the firm’s membership that NASD Regulation considered this fact to be material to the application. On March 15, 2001, the NASD reported that the president falsely reaffirmed to NASD Regulation that this individual was not affiliated with the firm and four days later, NASD Regulation approved the firm’s membership. Subsequently, NASD Regulation obtained additional facts and determined that the person was in fact in control of the management and policies of the firm.

NASD Rules require that all information filed with respect to membership be complete, accurate and not otherwise misleading. In addition, an applicant is obligated to correct any inaccurate or misleading information given during the application process. NASD Regulation found that the firm and its president engaged in conduct inconsistent with the NASD rules and with just and equitable principles of trade. NASD Regulation barred the president from association with an NASD member and expelled the firm from the NASD. The expulsion and bar were imposed through a settlement in which the firm and owner did not admit or deny the allegation. NASD Press Release, February 27, 2002.

At a recent speech, the Director of the Division of Enforcement of the SEC, Stephen Cutler, outlined ways in which the SEC’s enforcement program will respond to cases of financial fraud and other reporting problems. Mr. Cutler reported that the number of e-mails to the SEC’s enforcement complaint center have increased significantly over last year’s daily average. Mr. Cutler also highlighted the SEC’s real-time enforcement initiative, noting that the SEC’s primary weapon to stop an ongoing securities fraud is through an emergency court order halting the misconduct and freezing the wrongdoer’s assets. He noted that the SEC has sought 20 temporary restraining orders in the first three months of 2002 compared with 42 in all of 2001. He added that in each of these actions, the SEC has obtained an order to freeze the defendants’ assets. The SEC has also suspended the trading of securities of four public companies in the first four months of 2002, which is twice the number of suspensions in all of 2001.

Mr. Cutler explained that the SEC has become less tolerant of delaying tactics by those under investigation. He noted that the staff will insist on specific deadlines for the production of documents and appearances for testimony. If persons under investigation unreasonably fail to meet those deadlines, he noted that the SEC will seek to enforce its subpoenas in Federal court. He added that the SEC will be more likely than ever to seek civil penalties against public companies that do not cooperate with an investigation. He noted that in the past the SEC was reluctant to impose a civil penalty since it would be passed along to shareholders who have already suffered from an issuer’s securities violations. He stated that he believes, however, that such costs are justified when company management resists cooperation.

Mr. Cutler commented that the SEC will sue categories of wrongdoers in an effort to break cases into smaller pieces to move them along more quickly. He stated that three categories of violators can expect stiffer sanctions: (i) those who interfere with the SEC processes, (ii) repeat offenders, and (iii) deliberate wrongdoers. He added that the SEC must find ways to deter wrongdoing by individuals who hold positions of public trust. He stated that criminal sanctions will be sought where appropriate and in other instances the SEC will seek substantial civil penalties. He noted that monetary penalties are often covered by officer and director insurance policies or are not effective against wealthy wrongdoers. In those cases, he stated that he believes a more appropriate remedy is to bar the person from service as a director or officer. He noted that the SEC has explicit authority to seek officer and director bars. He commented that courts must determine that the conduct demonstrates substantial unfitness to serve before a bar can be imposed and that this standard as interpreted by the courts has proved to be too restrictive for the SEC. Nonetheless, he stated that he is determined to remain aggressive in seeking officer and director bars because the role of directors and officers is far too important to allow individuals to serve in those capacities if their commitment to the interests of shareholders is questionable. He suggested that Congress could help by granting the SEC the authority to impose officer and director bars in administrative proceedings. He stated that this added flexibility would give the SEC a wider range of options in combating financial fraud. SEC Today, Vol. 2002-33 (February 19, 2002).

The staff of the Division of Investment Management of the SEC has issued a letter to the Investment Company Institute (“ICI”) responding to certain questions and issues raised by the ICI regarding the independent legal counsel provision in the fund governance rule amendments adopted by the SEC in January, 2001 (see Industry News Summary for the week of 12/29/00 to 1/5/01). In its letter, the staff addressed the following questions and issues:

• The potential for retroactive loss of exemptive relief if a determination by directors that counsel is independent is overturned: The staff noted that Rule 0-1(a)(6) under the 1940 Act, which defines “independent legal counsel,” relies on independent directors to determine whether a person meets that definition. The staff advised that because this determination is a matter of the directors’ business judgment, it is entitled to substantial deference. The staff further noted that, in the absence of facts showing that the independent directors have not acted in good faith or exercised care and diligence in scrutinizing conflicting representations that counsel may have, the staff would not seek to retroactively question their judgments regarding their selection of counsel. Further, the staff advised that these determinations by independent directors should be given the same deference by courts as other business judgments by directors.
• Adverse effect on funds if the ability to rely on the exemptive rules is lost as a result of the discovery that counsel has performed work for an entity that could effect its status as “independent legal counsel” despite good faith reliance on counsel’s representations: The staff noted that the rule provides that counsel must undertake to provide directors with information necessary to make their “independence” determination. The rule further provides that directors are entitled to rely on information obtained from counsel unless they know or have reason to believe it is false or misleading. Further, the rule provides that if counsel fails to inform the independent directors that it has begun or materially increased representation of a fund management organization, the independent directors can rely on counsel’s previous representation. Therefore, the staff advised that counsel’s failure to fully inform the directors about the existence or extent of a conflicting representation would not invalidate the directors’ determination or compromise the fund’s reliance on the exemptive rules.
• Added restrictions on the independent directors’ ability to retain “special counsel” on matters not involving significant conflicts of interest between funds and fund management: The staff advised that, in its view, the rule clearly contemplates the possibility of directors hiring special counsel under a variety of circumstances. The staff noted that, after assessing their counsel’s potential conflicts based on a variety of factors, the independent directors could retain as special counsel, under appropriate circumstances, a person who has represented or is representing a management organization. The staff further noted that the rule does not restrict counsel for a management organization from representing the fund. The staff stated that “the new rule imposes no limits on directors’ ability to engage a lawyer to act as a special counsel to advise, for example, on a director’s retirement plan. In such a manner, the lawyer will be acting as special counsel to the fund.”

 In closing the letter, the staff expressed its intent to monitor implementation of the independent counsel provision of the new rule amendments and noted that the fund governance rules will be considered in the context of a planned comprehensive review of all SEC regulations.

Michael G. Oxley, Chairman of the House Financial Services Committee, and Richard H. Baker, Chairman of the Capital Markets Subcommittee, introduced legislation to improve auditor accountability and financial reporting in the wake of several recent high profile corporate bankruptcies. The Corporate and Auditing Accountability, Responsibility and Transparency Act (the “Act”) includes a number of measures similar to the proposed corporate disclosure rules announced by the SEC. The auditor independence provisions of the Act would:

• Prohibit firms from offering certain consulting services to the companies they are auditing.
• Establish a new public regulatory board to oversee the accounting industry. Two-thirds of the board’s members would have no association with the accounting industry.
• Require this board to certify accountants that audit public companies’ financial statements and authorize it to punish accountants that violate securities laws or ethical, competency or independence standards.
• Make it unlawful to interfere with the auditing process.

The corporate disclosure provisions of the legislation would:

• Increase the amount of real-time information that is available to the public.
• Require companies to fully disclose any off-balance sheet transactions, such as those with the special purpose entities that lead to the collapse of Enron.
• Require corporate insiders to report sales of company stock to the SEC by the next business day.

In order to protect 401(k) plans, corporate executives would be prohibited from buying or selling company shares if 401(k) plan participants were unable to do so, such as during administrative blackouts. The legislation would also increase the SEC’s budget to $700 million to provide resources to conduct more oversight and audit reviews of the largest companies. The SEC would be directed to study the new analyst conflict of interest rules once they are adopted by the NASD and the NYSE and report to Congress annually on their effectiveness. The SEC would also be directed to study whether additional corporate disclosure is necessary and to look for potential conflicts of interest. Another study would examine the role of the credit rating agencies in the securities markets, including any conflicts of interest in the rating process. Finally, the bill would ask the President’s Working Group on Financial Markets to study current corporate governance standards and whether they are adequately serving investors’ interest. SEC Today, Vol. 2002-31, February 14, 2002.

The U.S. Court of Appeals for the District of Columbia concluded that Fund Democracy, LLC, a self described advocate and information resource for mutual fund shareholders, does not have standing to seek review of the SEC’s decision to deny Fund Democracy’s hearing request. Fund Democracy had originally requested a hearing before the SEC to contest a “manager-of-managers” exemptive application filed by Hillview Investment Trust II and its investment adviser (“Hillview”). The Hillview application sought exemptive relief from Section 15 of the 1940 Act and Rule 18f-2 thereunder to permit Hillview to replace subadvisers and materially modify a subadvisory agreement with an existing subadviser without obtaining shareholder approval of the new agreement or the materially modified agreement. The SEC denied Fund Democracy’s request for a hearing and granted exemptive relief to Hillview. (See Industry News Summary for the week of 7/2/01 to 7/9/01)

The court concluded that Fund Democracy does not have “associational standing” to challenge the SEC’s decision to deny Fund Democracy’s hearing request. The court also concluded that Fund Democracy lacks standing as an “interested person” to challenge the SEC’s refusal to hold a hearing.

The court found that in order to meet the standing requirements, a party must demonstrate that it has suffered a “particularized injury”, which means it has sustained an injury that is:

• actual or imminent;
• traceable to an action being challenged in that law suit; and
• readdressable by the court.

The court found that Fund Democracy does not itself meet that standard. The court also found that Fund Democracy does not have “associational standing”, noting that an association has standing to bring suit on its members’ behalf only when such members otherwise have standing to sue in their own right. The court stated that it was not clear that Fund Democracy had any members which had standing to sue in their own right. In fact, Fund Democracy admitted in its pleadings that it is a one-person business run by its chief executive officer who is also the lawyer representing Fund Democracy before the court. The court also found that Fund Democracy does not have associational standing through its alleged affiliation with Institutional Shareholders Services (“ISS”) which does have identifiable clients and which also objected to the SEC’s denial of a hearing request. The court stated that even if the mutual fund investors who are ISS clients were considered members of Fund Democracy, Fund Democracy did not show that such members would have standing to sue in their own right. In that connection, the court found no evidence that any ISS members own or even are considering purchasing Hillview shares.

Finally, the court concluded that Fund Democracy lacks standing in its alleged status as an “interested person” for purposes of requesting a hearing on the exemptive application. The court stated that even if it assumes Fund Democracy is an “interested person”, it would not necessarily follow that Fund Democracy has standing. The court concluded that agencies like the SEC may permit persons to intervene in agency proceedings who would not have standing to seek judicial review of the agency action. BNA Securities Regulation and Law Report, Vol. 34, No. 6, February 11, 2002.

The NASD has proposed new rules governing securities recommendations made by research analysts. These proposed new rules are intended to address the serious potential conflicts of interest faced by research analysts. Specifically, the NASD noted that conflicts can arise when analysts work for firms that have other business relationships, such as providing investment banking services, with the company being analyzed.

Specifically, the proposed rule would require the following significant changes:

• Investment Banking Department Relationship with Research Department: Under the proposed rule, no research analyst may be supervised or controlled by a firm’s investment banking department. The research department may only check reports for factual accuracy by either the investment banking department or the subject company.
  
• Measures to Prevent Promises of Favorable Research: The proposed rule would require quiet periods during which a firm acting as manager or co-manager of a securities offering may not issue a report on a company. These quiet periods would run for 40 days after an IPO and for 10 days after a secondary offering. The firm would be prohibited from offering or threatening to withhold favorable research to obtain business.
  
• Analyst Personal Trading: Under the proposed rule, no analyst or member of the analyst’s household may purchase or receive an issuer’s securities before its IPO, if the company does the same kind of business that the analyst issues reports about. In addition, no analyst or household member may trade securities issued by companies the analyst follows for the period starting 30 days before the issuance of the research report and ending 5 days after the date of the research report. Neither the analyst nor any household member will be allowed to make trades contrary to the analyst’s current recommendations.
  
• Disclosure of firm/analyst ownership of securities: Under the proposed rule, an analyst must disclose in public appearances and a firm must disclose in research reports that the analyst or a member of his or her household has a financial interest in the securities of a recommended company. Any conflict of interest that is known to exist at the time must also be disclosed in the research report or during the public appearance. Additionally, if a firm, as of 5 business days before the public appearance or publication of a research report, owns 1% or more of an equity class of the company, this must be disclosed in the research report or during the appearance.
  

A registered closed-end investment company (the “Fund”) sought assurance from the staff of the SEC that the Fund could continue to pay its investment adviser an incentive fee, even though certain shareholders of the Fund may not be “qualified clients” as required by Section 205(a)(1) of the Investment Adviser’s Act of 1940 (the “Advisers Act”). The Fund conducted an initial public offering of its shares in June of 2000. The Fund’s shares are not currently listed on any securities exchange but the Fund makes quarterly repurchase offers for its shares pursuant to Rule 23c-3 under the Investment Company Act of 1940 (the “1940 Act”). The Fund pays the investment adviser a management fee based upon a set percentage of the Fund’s average daily net assets and an incentive fee based upon the Fund’s performance pursuant to an advisory agreement between the Fund and the adviser.

Section 205(a)(1) of the Advisers Act prohibits a registered investment adviser from entering into, performing, extending or renewing an advisory contract if the contract provides for compensation to the adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client. Rule 205-3 under the Advisers Act exempts an adviser from the Section 205(a)(1) prohibition if its advisory client is a “Qualified Client” as defined in the Rule. Rule 205-3(d)(1) defines a Qualified Client to include:

• an natural person who, or a company that, immediately after entering into an investment advisory contract that provides for a performance fee, has at least $750,000 under the management of the investment adviser;
• a natural person who, or company that, the investment adviser reasonably believes, immediately before entering into the contract with its clients, either has a net worth of more than $1.5 million or is a qualified purchaser as defined in Section 2(a)(51)(a) of the 1940 Act at the time the contract is entered into; and
• a natural person who, immediately before entering into the contract, is an executive officer, director, trustee, general partner or person serving in a similar capacity, of the investment adviser, or a knowledgeable employee of the adviser as described elsewhere in the rule.

Under Rule 205-3(b), a client includes each equity owner of a registered investment company. In order to be able to rely on Rule 205-3, an adviser to a registered investment company must look through the registered investment company and ensure that each equity owner of the registered investment company is also a Qualified Client.

The Fund stated that it currently prohibits transfers of its shares to anyone who is not a Qualified Client, including by gift or bequest. The Fund asserted in its letter to the SEC that these transfer restrictions may dissuade shareholders and potential shareholders of the Fund from acquiring additional Fund shares in future offerings. The Fund proposed to amend the transfer restrictions so that a Fund shareholder may transfer Fund shares owned by him or her to:

• persons by way of a gift, bequest or pursuant to an agreement related to a legal separation or divorce;
• the shareholder’s estate; and/or
• any company established by the shareholder exclusively for the benefit of (or owned exclusively by) the shareholder, the shareholder’s estate and/or persons described in the first bullet (these methods of transfer are referred to as “permitted transfers” and the recipients as “permitted transferees”).

The Fund represented that it would inform shareholders of their ability to transfer shares to these permitted transferees in its periodic reports to shareholders and, in the event of a future offering, in its prospectus. The Fund also stated that the proposal is intended to accommodate transfers by gift or bequest, for estate planning purposes, or pursuant to a separation or divorce settlement, but is not intended to provide a means for the adviser’s investors to circumvent the purposes of Section 205(a) or the requirements of Rule 205-3 thereunder.

The Fund argued that Rule 205-3(a) under the Adviser’s Act requires that “the client entering into the contract subject to [Section 205 of the Advisers Act be] a [Q]ualified [C]lient.” The Fund also argued that this requirement is intended to apply to any investor who purchases investment company shares, but not to permitted transferees who receive shares as a result of a permitted transfer and who, therefore, are passive assignees of an existing advisory contract. The Fund acknowledged that a permitted transferee may not have the same degree of sophistication in financial matters as a Qualified Client and thus may not fully understand the terms of the performance fee. However, the Fund argued that the permitted transferee does not need the protections of Section 205(a)(1) because he or she does not put his or her own money at risk and is not making an investment decision in connection with the permitted transfer.

The staff allowed the adviser to continue to perform under and renew the advisory agreement with the Fund containing a performance fee notwithstanding the fact that permitted transferees are Fund shareholders. The staff noted that its position is based upon the Fund’s representation that no person, including a permitted transferee, may purchase shares of the Fund unless the person is a Qualified Client at the time of the purchase. The staff also noted that the Fund’s adviser stated that it will comply with Section 205 and Rule 205-3 thereunder in performing under, renewing or extending the terms of the Fund’s advisory agreement with the exception that the permitted transferees may be Fund shareholders. The staff also conditioned its analysis on the fact that the Fund will not submit any matter relating to an increase in, or material amendment requiring shareholder vote to, the performance fee provisions of the advisory agreement unless all of the adviser’s clients subject to the advisory agreement are Qualified Clients as of the record date for the vote. Seligman New Technologies Fund II, Inc., SEC No-Action Letter (February 7, 2002).