On February 10, 2004, Senators Peter Fitzgerald (R-IL), Susan M. Collins (R-ME) and Carl Levin (D-MI) introduced the Reform Act, which was referred to the Committee on Banking, Housing, and Urban Affairs. The Act’s primary purpose is to improve the governance and regulation of mutual funds under the securities laws. The Reform Act’s key provisions are summarized below.

Fund Governance

Independent Directors

• At least 75% of a mutual fund’s board, including the board’s chairman, must be independent.
• An independent director would need to be approved or elected by the fund’s shareholders every five years and determined by the board annually to be independent and not to have any material relationships with the fund or its “significant service providers.”
• A committee comprised only of independent directors would be responsible for (1) selecting director nominees; (2) adopting qualification standards for director nomination that would be disclosed in the fund’s registration statement and (3) determining director compensation.
• The definition of “interested person” under the Investment Company Act of 1940 Act (the “1940 Act”) would be expanded to include any person who:
  • has acted (or whose partner or employee has acted ) as legal counsel for a fund, its adviser or its principal underwriter within the preceding five years;
  • has served as an officer, director or employee, of an adviser or principal underwriter to a fund (or of any control entity of any of these) within the preceding ten years;
  • has served as an officer, director, employee within the preceding ten years, of any entity that has within the preceding five years acted as a significant service provider to the fund (or control entity of such service provider); and
  • is a member of a class of persons that the SEC, by rule or regulation, determines not to be independent.
• The SEC would be directed to conduct a study of (1) whether any limits should be placed on the director compensation and (2) whether service on multiple fund boards, or receipt substantial compensation from the adviser compromises independence.

Fiduciary Duties

• Section 10 of the 1940 Act would be amended to provide that fund directors have a fiduciary duty to act with loyalty and care, in the best interests of shareholders. The SEC would be directed to promulgate rules clarifying the scope of this fiduciary duty, requiring at a minimum that directors:
  • determine the extent to which independent and reliable sources of information are sufficient to discharge director responsibilities;
  • negotiate management and advisory fees with due regard for the actual cost of such services, including economies of scale and evaluate the totality of fees with reference to the interests of shareholders;
  • evaluate the quality of the management of the company and potentially superior alternatives;
  • evaluate the quality, comprehensiveness, and clarity of disclosures to shareholders regarding costs;
  • evaluate any distribution or marketing plan of the company, including its costs and benefits, and evaluate the size of the portfolio of the company and its suitability to the interests of shareholders; and
  • implement and monitor policies to ensure compliance with applicable securities laws and with respect to predatory trading practices.
• Section 36 of the 1940 Act would be amended to provide that the fiduciary duty of an adviser (1) may require reasonable reference to the adviser’s actual costs and economies of scale with respect to any compensation received and (2) includes a duty to supply such material information as is necessary for the independent directors of a fund employing the adviser to review and govern the fund.
• The SEC would be directed to promulgate rules to facilitate the process through which a fund’s independent directors may terminate an adviser in the good faith exercise of their fiduciary duties, without undue exposure to financial or litigation risk.

Independent Accounting and Auditing. Mutual funds would be subject to audit committee standards similar to those imposed on listed companies by section 301 of the Sarbanes-Oxley Act of 2002 and Rule 10A-3 under the Securities Exchange Act of 1934 (the “Exchange Act”).

Prevention of Fraud; Internal Compliance and Control Procedures

• Section 17(j) of the 1940 Act would be expanded to cover fraud in connection securities issued by a fund or its affiliate (currently Section 17(j) only covers fraud in connection with securities held or to be acquired by the fund). The SEC would be directed to adopt rules requiring that funds, advisers and principal underwriters adopt codes of ethics and provide detailed disclosures in periodic report to shareholders and on an electronic public database.
• The SEC would be directed to issue rules requiring funds and advisers to implement and review periodically policies and procedures reasonably designed to prevent violations of securities and certain other federal laws and funds to appoint a chief compliance officer responsible for overseeing such policies and procedures, and whose compensation would be approved by the fund’s independent directors to whom he or she would be required to report annually.
• The SEC would be directed to issue rules requiring each senior executive officer, or other officer designated by the SEC, of a fund’s adviser to certify in periodic shareholder reports that:
  • procedures are in place for verifying that the fund’s net asset value complies with the Reform Act and the rules and regulations thereunder;
  • for multi-class funds procedures are in place to ensure that, if the fund’s shares are offered as different classes of shares, such classes are designed in the interests of shareholders, and could reasonably be an appropriate investment option for a shareholder;
  • procedures are in place to ensure that information about the fund’s portfolio securities is not disclosed in violation of the securities laws or the fund’s code of ethics;
    the fund’s independent directors have reviewed and approved the compensation of the fund’s portfolio manager; and
  • the fund has established and enforces a code of ethics.
• A fund, as well as its adviser, principal underwriter or significant service provider (or any officer, employee, contractor, subcontractor, or agent of such entity), would be prohibited from retaliating against an employee because of any lawful act by the employee.

Fund Transparency

Cost Consolidation and Clarity. The SEC would be directed to develop a standardized method (1) of calculating a fund’s expense ratio that accounts for as many operating costs to shareholders as practicable and (2) of computing a fund’s transaction cost ratio that fairly accounts for actual transaction costs to shareholders, including brokerage commissions and bid-ask spread costs. The expense ratio and transaction cost ratio would have to be disclosed, both separately and as a total investment cost ratio, in a fund’s annual report and prospectus, as well as in any other filings the SEC determines appropriate. In addition, the actual dollar amount of the projected annual costs of each fund shareholder would have to be disclosed in the shareholder account statement.

The SEC would be directed to define all specific allowable types or categories of fees and expenses that fund shareholders may bear. No other fee or expense could be borne by fund shareholders unless the SEC found that it fairly reflects the services provided to, or is in the best interests of, shareholders of (1) a particular fund, (2) specific types or categories of funds or (3) funds in general. The SEC would also be directed to promulgate rules as necessary (1) to promote the standardization and simplification of the disclosure of funds’ cost structures and (2) to ensure that the shareholders of such funds receive all material information regarding such costs in a manner that is non-misleading and facilitates comprehension and comparison of such costs to the extent practicable.

The SEC would have to issue rules requiring (1) disclosure of all types of fees, expenses, or costs borne by fund shareholders in any prospectus or annual or periodic report filed with the SEC, (2) a clear definition of each such fee, expense, or cost and (3) information as to where shareholders may find out more information concerning such fees, expenses, or costs.

Adviser Compensation and Ownership of Fund Shares. The SEC would be directed to require the following disclosures:

• disclosure to fund shareholders of (1) the amount and structure of, or the method used to determine, the compensation paid by the fund to the portfolio manager or portfolio management team of the adviser and (2) the portfolio manager or portfolio management team’s ownership interest in the fund; and
• disclosure to the fund’s board of all transactions in the fund’s securities by the portfolio manager or management team of the fund’s adviser.

A fund would have to make these disclosures in its registration statement and in any other filings that the SEC determines appropriate.

Point of Sale and Additional Disclosure of Broker Compensation. Section 15(b) of the Exchange Act would be amended to require a broker to disclose in writing, at or before the time of purchase, to each person that purchases the shares of a registered fund (1) the source and amount of any compensation received or to be received by the broker in connection with such transaction and (2) such other information as the SEC determines appropriate. These disclosures could not be made exclusively in a fund’s registration statement or prospectus, or any other SEC filing.

Breakpoint Discounts. The SEC would be directed to issue rules requiring disclosure by a fund, in any quarterly or other periodic report filed with the SEC, of information concerning discounts on front-end sales loads for which shareholders may be eligible, including the minimum purchase amounts required for such discounts.

Portfolio Turnover Ratio. The SEC would be directed to require by rule that a fund disclose the its portfolio turnover rate, with an explanation of its meanings and implications for cost and performance, in any quarterly or periodic report filed with the SEC and in any prospectus.

Proxy Voting Policies and Record. Section 30 of the 1940 Act would be amended to require:

• a fund to file with the SEC, not later than August 31 of each year, an annual report containing the proxy voting record of the registrant and the fund’s policies with respect to the voting of such proxies for the most recent year ending on June 30; and
• that the financial statements of a fund state that information regarding how the fund voted proxies and proxy voting policies relating to portfolio securities during the most recent year ending on June 30 is available without charge from the fund upon telephone request or through the fund’s website, and on the SEC’s website.

This disclosure is currently required by SEC rule

Customer Information from Account Intermediaries. The SEC would be required to issue rules requiring each account intermediary of a fund to provide to the fund, with respect to each account serviced by the intermediary, the information necessary for the fund to enforce its investment, trading, and fee policies. The information provided would have to include (1) the name under which the account is opened with the intermediary, (2) the taxpayer identification number of such person, (3) the mailing address of such person and (4) individual transaction data for all purchases, redemptions, transfers, and exchanges by or on behalf of such person.

Advertising. The SEC would be directed to promulgate rules with respect to the advertising of a fund regarding (1) unrepresentative short-term performance, (2) performance based upon an undisclosed or improbable event and (3) performance based upon incomplete or misleading data. A fund would also have to disclose, in its annual report and any prospectus, dollar-weighted returns and time-weighted returns for each of (1) the preceding fiscal year, (2) the preceding five fiscal years, (3) the preceding ten fiscal years and (4) the life of the fund. The SEC would be able to omit or require additional disclosures, and to require that performance-related advertising be accompanied by benchmarks to facilitate non-misleading disclosures. In addition, a fund that discloses a subsidized yield in any publication would also have to disclose the amount and duration of the subsidy in the same publication.

Fund Regulation and Oversight

Prohibition of Asset-Based Distribution Expenses. Rule 12b-1 under the 1940 Act would be repealed starting 180 days after the enactment of the Reform Act. Section 12 of the 1940 Act would be amended to provide that distribution expenses incurred by an adviser may be paid out of the management fee received by the adviser, and to prohibit a fund from paying asset-based fees (as defined by the SEC) to any broker or dealer in connection with the offer or sale of the securities of the fund.

The SEC would be directed to issue rules that:

• require that any sums expended by the adviser of a fund to promote or facilitate the sale of the securities of such fund be disclosed to the fund’s board;
• require that such sums be accounted for and identified in the fund’s expense ratio; and
• authorize a fund’s board to prohibit its adviser from using any compensation received from the fund for distribution expenses that the board determines not to be in the best interest of the fund’s shareholders.

Prohibition on Revenue Sharing, Directed Brokerage, and Soft Dollar Arrangements. Section 12A would be added to the 1940 Act to prohibit (1) an adviser from entering into a revenue sharing arrangement with a broker or dealer with respect to fund securities, (2) a fund, or any affiliate of such fund, from entering into a directed brokerage arrangement with a broker or dealer and (3) a fund or adviser from entering into a soft-dollar arrangement with any broker or dealer. The SEC could adopt rules to further refine these prohibitions.

Moreover, the SEC would be directed to narrow the soft-dollar safe harbor under section 28(e) of the Exchange Act to promote parity as the SEC determines appropriate between funds governed by section 12A and funds not governed by section 12A.

Market Timing. The SEC would be directed to require by rule (1) disclosure in any fund registration statement of the fund’s market timing policies and the procedures adopted to enforce such policies and (2) that any fund that declines to adopt restrictions on market timing disclose such fact in its registration statement and in any advertising or other publicly available documents, as the SEC determines necessary. A fund’s market timing policies would be deemed “fundamental investment policies” for purposes of the 1940 Act.

Elimination of Stale Prices. No more than 90 days after the enactment of the Reform Act, the SEC would have to prescribe standards concerning a fund’s obligation under the 1940 Act to apply and use fair value methods of determining net asset value when market quotations are unavailable or do not accurately reflect the fair market value of the fund’s portfolio securities, in order to prevent dilution of the interests of long-term shareholders or as necessary in the public interest or for the protection of shareholders. The SEC rule or regulation would identify, in addition to significant events, the conditions or circumstances from which such an obligation would arise and the methods by which fair value methods would be applied.

Prohibition of Short Term Trading; Mandatory Redemption Fees. Section 17 of the 1940 Act would be amended to prohibit “short-term transactions” (to be defined by SEC rule) in a fund’s or fund affiliate’s securities by certain persons, except for money market funds, other funds whose investment policy expressly permits short-term transactions, or other categories of funds specified by SEC rule. The SEC would be directed to issues rules requiring any fund that does not allow market timing practices to charge a redemption fee on short-term redemptions of the fund’s securities. In applying this mandatory redemption fee, shares would be considered on a last in, first out basis.

Prevention of After-Hours Trading. The SEC would be directed to issue rules to prevent transactions in fund securities in violation of section 22 of the 1940 Act, including after-hours trades that are executed at a price based on a net asset value that was determined as of a time prior to the actual execution of the transaction. The SEC would determine the circumstances under which to permit, subject to SEC rules and an annual independent audit of such trades, the execution of after-hours trades that are provided to a fund by a broker, dealer, retirement plan administrator, insurance company, or other intermediary, after the time as of which the net asset value was determined.

Ban on Joint Management of Mutual Funds and Hedge Funds. Individuals would be prohibited from serving as portfolio managers or advisers to a mutual fund while also serving as such to a private fund. Exceptions could be made in exceptional circumstances when necessary to protect the interest of shareholders, provided that there is (1) enhanced disclosure by the mutual fund to shareholders of any conflicts of interest raised by such joint management and (2) fair and equitable policies and procedures for the allocation of securities to the portfolios of the jointly managed companies, and (3) certification by the mutual fund’s independent directors, in the periodic report to shareholders or other appropriate disclosure document, that such policies and procedures are fair and equitable.

Selective Disclosures. The SEC would be directed to promulgate such rules as it determines necessary to prevent the selective disclosure by a fund of material information relating to the fund’s portfolio. The SEC’s rules would have to treat selective disclosures of material information by a fund in substantially the same manner as selective disclosures by other public issuers.

Studies

The SEC would be directed to study and report on certain topics, such as investment adviser conflicts of interest, trends in arbitration clauses between brokers-dealers and investors, effects of additional regulation of alternative investment vehicles, such as hedge funds, and the means of enhancing the role of the Internet, EDGAR and other electronic databases in educating investors and providing timely information. In addition, the U.S. Comptroller General, with the SEC’s cooperation, would be required to study and report on the coordination between the SEC headquarters, its regional offices, and state regulatory and law enforcement agencies, and the sufficiency of the SEC’s organizational structure with respect to the regulation of investment companies and whether a separate regulatory entity would improve or impair effective oversight.

S.2059, “Mutual Fund Reform Act of 2004,” available at http://thomas.loc.gov/cgi-bin/query/z?c108:S.2059.

On February 12, 2004, the SEC issued a no-action letter to the Securities Industry Association stating that broker-dealers may rely on registered investment advisers to meet customer identification program requirements with respect to shared customers, even though advisers are not subject to an anti-money laundering program rule.

Paragraph (b)(6) of the customer identification rule adopted jointly by the Department of the Treasury and the SEC under the USA Patriot Act (the “CIP Rule”) permits broker-dealers to rely on certain other financial institutions to undertake the required elements of the rule with respect to shared customers if, among other things, the other financial institution is subject to an anti-money laundering program rule. Since advisers currently are not subject to an anti-money laundering program rule, they do not meet this condition. Although the Department of Treasury has proposed an anti-money laundering program rule for advisers, final rules have not been adopted.

The no-action letter clarifies that a broker-dealer may rely on an adviser in undertaking the requirements of the CIP Rule with regard to shared customers, provided that the following requirements and conditions in paragraph (b)(6) of the CIP Rule are met:

• such reliance is reasonable under the circumstances;
• the adviser is regulated by a Federal functional regulator; and
• the adviser enters into a contract requiring it to certify annually to the broker-dealer that it has implemented an anti-money laundering program, and that it will perform specified requirements of the broker-dealer’s customer identification program.

The letter will be withdrawn by the SEC without further action on the earlier of (1) the date upon which an anti-money laundering program rule for advisers becomes effective, or (2) February 12, 2005.

Securities Industry Association, SEC No-Action Letter, February 12, 2004.

On February 17, 2004, DOL issued a Statement outlining factors plan fiduciaries should consider and steps they should take to fulfill their fiduciary duties with respect to reported and potential late trading and market-timing abuses by mutual funds and pooled investment funds. The Statement also clarifies that the DOL’s regulation under Section 404(c) of the Employee Retirement Income Security Act (“ERISA”) permits plan sponsors and fiduciaries to take certain actions to address identified market-timing activity.

The Statement emphasizes ERISA’s requirement that fiduciaries discharge their duties prudently. This standard of care mandates that, in deciding whether to make any changes in mutual fund investments or investment options, fiduciaries undergo a deliberative process in which they are as well informed as possible under the circumstances and document their decisions.

The Statement provides that, in cases where specific funds have been identified as under investigation by government agencies, fiduciaries should consider the following factors:

• the nature of the alleged abuses
• the potential economic impact of those abuses on the plan’s investments,
• the steps taken by the fund to limit the potential for such abuses in the future, and
• any remedial action taken or contemplated to make investors whole.

If such information has not been provided or is not available, a plan fiduciary should consider contacting the fund directly to obtain specific information. In deciding whether to participate in settlements or lawsuits, a plan fiduciary must weigh the costs to the plan against the likelihood and amount of potential recoveries.

Since late trading and market-timing abuses may occur in mutual funds and pooled investment funds not yet identified by regulators, fiduciaries must consider whether they have sufficient information to conclude that such funds have procedures and safeguards limiting their vulnerability to abuse.

Permitted Restrictions

The Statement also clarifies that Section 404(c) under ERISA, which relieves plan fiduciaries from liability for the results of investment decisions made by plan participants and beneficiaries, permits plan fiduciaries to take certain steps to address identified market-timing activity. It describes two examples of approaches to limiting market-timing that do not, in and of themselves, violate the “volatility” and other requirements set forth in DOL’s regulation under Section 404(c), provided that they are permitted under the plan’s terms and are clearly disclosed to participants and beneficiaries. These examples are (1) offering mutual fund or similar investments that impose reasonable redemption fees on share sales, and (2) reasonable plan or investment fund limits on the number of times a participant can move in and out of a particular investment within a particular period. However, the Statement notes that imposing trading restrictions that are not contemplated under a plan’s terms raises issues concerning the application of Section 404(c), and also raises issues as to whether such restrictions constitute a “blackout period” that requires advance notice to affected participants and beneficiaries.

Duties of Fiduciaries in Light of Recent Mutual Fund Investigations, Statement of Ann L. Combs, Assistant Secretary, Employee Benefits Security Administration, February 17, 2004, available at http://www.dol.gov/ebsa/newsroom/sp021704.html.

As reported in last week’s Industry News Summary, at an open meeting held on February 11, 2004, the SEC took action to propose rule and form amendments under the Investment Company Act of 1940 (the “1940 Act”) that would require funds to provide enhanced disclosure regarding board approval of investment advisory contracts. The proposal, which has since been released, would require fund shareholder reports to discuss, in reasonable detail, the material factors and conclusions that formed the basis for the board’s approval of an investment advisory agreement. This requirement would apply to any new investment advisory contract or contract renewal, including subadvisory contracts, approved during the semi-annual period covered by the report, other than a contract that was approved by shareholders.

The proposal also would require funds to include the following disclosures in shareholder reports, statements of additional information (“SAIs”) and relevant proxy statements:

If adopted, the proposed amendments would apply to all fund reports to shareholders, all registration statements and post-effective amendments that are either annual updates to effective registration statements or that add a new series, and all fund proxy statements filed on or after the effective date of the amendments.

Comments on the proposed amendments must be received by the SEC on or before April 26, 2004.

SEC Release Nos. 33-8364, 34-49219, IC-26350; File No. S7-08-04.

On December 13, 2003, President Bush signed into law the “Intelligence Authorization Act for Fiscal Year 2004” (Pub. Law 108-177), which amends the definition of “financial institution” as used in Section 3414 of the “Right to Financial Privacy Act” to include an investment banker or investment company.

This amendment subjects investment companies to Section 3414’s requirement that a financial institution, such as an investment company, produce a customer’s or entity’s financial records in response to a request from a specified U.S. Government official as well as its prohibition of a financial institution and its officers, employees and agents disclosing to any person that a Government authority has sought or acquired access to a customer’s financial records. Section 3414 also requires a financial institution to comply with a request for a customer’s or entity’s financial records made pursuant to the “Right to Financial Privacy Act” by the Federal Bureau of Investigation when a Director or a Director’s authorized designee certifies in writing to the financial institution that such records are sought for foreign counter intelligence purposes to protect against international terrorism or clandestine intelligence activities, provided that such an investigation of a U.S. person is not conducted solely upon the basis of activities protected by the first amendment of the Constitution of the United States.

The text of Pub. Law 108-177 is available at http://thomas.loc.gov/. See 12 U.S.C. 3414 for Section 3414 of the Right to Financial Privacy Act; see also 31 U.S.C. 5312(a)(2).

On November 17, 2003, the SEC asked the NASD to form a task force of industry professionals to assist the SEC in its efforts to combat abusive short-term trading in mutual fund shares, and to report its findings by January 2004. At the SEC’s request, the task force focused on the impact of omnibus account processing of mutual fund transactions on the imposition of a mandatory redemption fee. The report identifies a number of steps that the SEC could mandate to facilitate the imposition of such a fee in an omnibus environment, and also identifies supplemental steps that could be taken to curb abusive short-term trading.

Consensus Recommendations

There was a general consensus among Task Force members that a redemption fee, if mandated by the SEC, should be imposed under the following conditions:

• the fee should be assessed at the recordkeeper (usually the intermediary) level (for example, broker-dealers, bank trust departments and TPAs) based only on positions held through that intermediary;
• the fee should not be assessed on de minimis trades;
• mutual funds or their designated transfer agents should have access to information on investor trading activities to, at a minimum, audit whether intermediaries are applying the rules properly; and
• to avoid confusion and inefficiencies, the SEC should establish the size of the redemption fee and the holding period that would trigger application of the fee.

Non-Consensus Issues

There was, however, no general consensus among Task Force members on a number of issues related to the fee, such as

• the length of the holding period;
• whether all of a shareholder’s accounts with an intermediary should be aggregated for purposes of assessing a redemption fee;
• the appropriateness of excepting certain transactions from the fee;
• the assessment of redemption fees on a Last-In, First-Out (LIFO) or First-In, First-Out (FIFO) basis; and
• periodic reporting of customer transactions to mutual fund transfer agents by intermediaries processing transactions on an omnibus basis.

Other Considerations

Task Force members generally concluded that, absent a significant holding period requirement, such as 30 to 90 days, redemption fees alone will not deter market timing abuses, and several members recommended that supplemental steps be taken. Many Task Force members concluded that mutual funds or their designated transfer agents should have access to shareholder-specific information that enables them to assess a shareholder’s trading across all accounts and intermediaries. This would enable a fund or its transfer agent to effectively enforce exchange limitations and oversee the “big picture” of a shareholder’s trading in the fund’s securities for problematic behavior. Some Task Force members also favored the creation of a database listing those investors that have been denied access to funds based on apparent trading abuses.

NASD Report of the Omnibus Account Task Force (January 2004)

On February 3, 2004, the SEC’s Division of Investment Management responded to a number of questions about amended rule 206(4)-2, the custody rule under the Investment Advisers Act of 1940 (the “Advisers Act”). The Adopting Release for the amended custody rule can be found at http://www.sec.gov/rules/final/ia-2176.htm.

SEC Division of Investment Management, Staff Guidance, February 3, 2004.

On February 12, 2004, the SEC and NASD announced enforcement and disciplinary actions against fifteen broker-dealer firms for failure to deliver mutual fund breakpoint discounts during 2001 and 2002. The SEC and NASD’s joint press releases state that the firms have agreed to compensate customers for the overcharges, pay fines in an amount equal to their projected overcharges that total over $21.5 million, and undertake other corrective measures.

As published in a Joint SEC/NASD/NYSE Report, the SEC and NASD had previously determined that many investors were not receiving correct breakpoint discounts on their mutual fund purchases. To resolve this, each of the firms agreed to:

• review all front-end load mutual fund trades in excess of $2,500 conducted between January 1, 2001 and November 3, 2003;
• provide written notification of the firm’s problem delivering breakpoint discounts to each customer who purchased front-end load mutual funds from January 1, 1999 through November 3, 2003, and advise these customers that they may be entitled to a refund;
• provide refunds where appropriate; and
• pay a fine equal to the amount of the firm’s projected overcharges.

The Joint SEC/NASD/NYSE Report of Examinations of Broker-Dealers Regarding Discounts on Front-End Sales Charges on Mutual Funds outlines the original examination findings underlying these breakpoints actions. The Report is available at http://www.nasdr.com/pdf-text/bp_joint_exam.pdf and at http://www.sec.gov/news/studies/breakpointrep.htm.

SEC Press Release, February 12, 2004, available at http://www.sec.gov/news/press/2004-17.htm; NASD Press Release, February 12, 2004, available at http://www.nasdr.com/news/pr2004/release_04_009.html.

On February 5, 2004, the SEC issued an Order in which it announced the settlement of charges against an investment adviser to a large mutual fund complex, as well as its chief executive officer, and its president and chief investment officer. The same day, the Attorney General of New York and the New Hampshire Bureau of Securities Regulation announced the settlement of related state charges. The SEC and state actions involved charges that the adviser knowingly allowed widespread market timing activity in certain mutual funds contrary to prospectus disclosures.

Voluntary Undertakings. In determining to accept the settlement offers, the SEC considered the adviser’s cooperation with the SEC during its investigation and efforts voluntarily undertaken by the adviser, including:

• At least 75% of the trustees as well as the chairman of the board of any retail fund will be independent.
• Any person who acts as counsel to the independent trustees of any retail fund will be an “independent legal counsel”.
• No action will be taken by the board of any retail fund or by any committee thereof unless approved by a majority of the independent members of the board or committee. Any action proposed and approved by a majority of the independent trustees and not the full board will be disclosed in the fund’s shareholder report.
• Commencing in 2005 and at least once every five years thereafter, each retail fund will hold a shareholder meeting to elect trustees.
• Each retail fund will designate an independent compliance officer who reports to the fund’s board.

Disgorgement and Civil Money Penalties

Required Undertakings. The SEC Order requires the adviser to comply with the following additional undertakings.

General Compliance. The adviser will:

• maintain a Code of Ethics Oversight Committee having responsibility for all matters relating to issues arising under its Code of Ethics. The Committee will hold at least quarterly meetings to review violations of and policy matters relating to the Code of Ethics. The adviser will report at least quarterly to its Compliance or Audit Committee on issues arising under the Code of Ethics, including violations, to the extent relating to fund business. Any material violation will be reported promptly to the Compliance or Audit Committee.
• establish an Internal Compliance Controls Committee to be chaired by its chief compliance officer. The independent compliance officer of the trustees of the retail funds will be invited to attend and participate in committee meetings provided that his or her involvement will be limited to compliance issues relating to the retail funds. The Internal Compliance Controls Committee will provide reports on internal compliance matters to the Compliance or Audit Committee of the retail funds at least quarterly. The adviser will also provide such reports to the Risk Review or Audit Committee of its parent company.
• establish and staff a full-time senior-level position responsible for compliance matters related to conflicts of interests. This officer will report directly to the chief compliance officer of the adviser.
• require that its chief compliance officer or a member of his or her staff review compliance with the policies and procedures established to address investment adviser and investment company compliance issues and report any violations to the Internal Compliance Controls Committee.
• require its chief compliance officer to report at least quarterly to the independent trustees of the retail funds any breach of fiduciary duty and/or federal securities laws to the extent relating to fund business of which he or she becomes aware. Any material breach will be reported promptly.
• establish a corporate ombudsman to whom employees may convey concerns about business matters that they believe implicate matters of ethics or questionable practices. The adviser will review matters to the extent relating to fund business brought to the attention of the ombudsman, along with any resolution of such matters, with the independent trustees of the retail funds with such frequency as the independent trustees may instruct.

Distribution of Disgorgement and Penalty. The adviser will retain the services of an Independent Distribution Consultant acceptable to the SEC and the independent trustees of the retail funds. The Independent Distribution Consultant will develop a Distribution Plan for the distribution of the total disgorgement and penalty to the mutual funds and their shareholders to compensate the funds’ shareholders for losses attributable to late trading and other market timing trading activity, according to a methodology developed in consultation with the adviser and the independent trustees of the affected retail funds and acceptable to the SEC. The Independent Distribution Consultant will submit the Distribution Plan to the SEC for approval and will take all necessary and appropriate steps to administer the final plan.

At an open-meeting held on February 11, 2004, the SEC adopted several rule amendments requiring mutual funds to provide enhanced disclosure regarding costs, portfolio investments and performance. The SEC also proposed rule amendments that would require enhanced disclosure regarding the reasons for a mutual fund board’s approval of an investment advisory contract and would change rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”) to prohibit mutual funds from directing commissions from their portfolio brokerage transactions to broker-dealers as compensation for distributing fund shares.

Shareholder Reports and Quarterly Portfolio Disclosure

The SEC adopted the following rule amendments requiring enhanced disclosure of costs, portfolio investments, and performance:

On February 5, 2004, the ICI filed a letter with the SEC providing comment and recommendations on provisions of recently adopted rule 38a-1 under the 1940 Act (the “compliance program rule”) that were added to the rule after its proposal. The two most important points the ICI raises in its letter are summarized below.

Board Approval of Chief Compliance Officer’s (“CCO”) Compensation

The ICI recommends that the SEC replace the rule’s requirement that a fund’s board approve the CCO’s compensation with a requirement that the CCO’s compensation be reported to the board on a periodic basis. It states that the “approval” requirement is unnecessary in light of other provisions added to the rule and raises logistical and other concerns.

The Board’s Exclusive Authority to Fire the CCO

The ICI expresses concern at the potential employment law implications of the rule’s requirement that a fund’s board approve termination of the CCO’s employment. It recommends that the SEC permit the entity that employs the CCO to terminate his or her employment without approval of the fund’s board, so long as such termination would not violate the rule’s prohibition against coercing or fraudulently influencing the CCO in the performance of his or her responsibilities.

ICI Comment Letter, February 5, 2004.

On February 5, 2004, the ICI filed with the SEC a letter responding to the SEC’s request for public comment on proposed amendments to Form N-1A that would require mutual funds to make additional disclosures regarding market timing, fair valuation and disclosure of portfolio securities in their prospectuses and statements of additional information. (See the Industry News Summary for the week of 12/08/03 to 12/15/03). In its letter, the ICI makes the following comments:

Market Timing

• The ICI seeks clarification that a fund’s disclosure regarding its market timing policies and procedures is not required to detail the precise ways in which the fund seeks to deter market timers.
• The ICI recommends modifying the proposal to delete the requirement that funds describe their policies and procedures for detecting market timing activity.
• The ICI recommends modifying the proposal to permit funds to reserve, as part of their market timing policies, limited discretion to impose greater restrictions on market timers than those in the fund’s stated policies, provided there is appropriate disclosure and board oversight.
• The ICI recommends modifying the proposal to exclude exchange-traded funds from the proposed disclosure requirements relating to market timing.

Fair Value Pricing

• The ICI seeks clarification that a fund’s required explanation of the circumstances in which it will use fair value pricing should be a general discussion of the types of situations in which the fund may be likely to use such pricing.
• The ICI recommends modifying the proposal to require that a fund’s prospectus include a brief description of the objectives, rather than the effects, of using fair value pricing.

Portfolio Securities

• The ICI seeks clarification as to the application of the proposed disclosure requirements relating to disclosure of portfolio holdings to a fund’s agreements with affiliated or third-party service providers.
• The ICI seeks clarification that a fund may identify by category both the persons who receive information about its portfolio securities and the persons who may authorize disclosure of its portfolio securities.
• The ICI would not support the application of Regulation Fair Disclosure (i.e., Reg FD) to a fund’s disclosure of information about it portfolio securities.

The ICI also recommends modifying the proposed compliance date to correlate with the compliance date for new Rule 38a-1 under the 1940 Act.

ICI Comment Letter, February 5, 2004.

On January 27, 2004, in testimony before the U.S. Senate Subcommittee on Financial Management, the Budget, and International Security, New York Attorney General Eliot Spitzer announced that in the coming weeks his office may investigate management fees charged by subadvised mutual funds. The Attorney General testified that mutual funds that employ subadvisors often impose on investors the fund’s own costs as well as the costs of the subadvisor. As a result of this “premium” or “mark-up,” investors of subadvised funds are charged more for advisory services than the cost to the fund for such services. He stated that his sense is that these “premiums” are often as much or more than the fees charged by the subadvisor itself, and raise the question of what service is provided to investors to justify such charges.

State of New York Attorney General Eliot Spitzer Before the United States Senate Government Affairs Committee Subcommittee on Financial Management, the Budget, and International Security, Oversight Hearing on Mutual Funds: Hidden Fees, Misgovernance and Other Practices that Harm Investors, January 27, 2004, available at www.senate.gov.

At an open-meeting held on February 11, 2004, the SEC adopted several rule amendments requiring mutual funds to provide enhanced disclosure regarding costs, portfolio investments and performance. The SEC also proposed rule amendments that would require enhanced disclosure regarding the reasons for a mutual fund board’s approval of an investment advisory contract and would change rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”) to prohibit mutual funds from directing commissions from their portfolio brokerage transactions to broker-dealers as compensation for distributing fund shares.

Shareholder Reports and Quarterly Portfolio Disclosure

The SEC adopted the following rule amendments requiring enhanced disclosure of costs, portfolio investments, and performance:

• Enhanced mutual fund expense disclosure in shareholder reports. The amendments will require mutual funds to disclose fund expenses borne by shareholders during the reporting period in their shareholder reports. Shareholder reports will be required to include the cost in dollars associated with an investment of $1,000 based on the fund’s actual expenses for the period and based on an assumed return of 5 percent per year. The disclosure will also be required to include the fund’s expense ratio and the account values as of the end of the period for an initial investment of $1,000.
  
• Quarterly disclosure of fund portfolio holdings. The amendments will require a fund to file its complete portfolio holdings schedule with the SEC on a quarterly basis. These filings will be publicly available through the SEC’s Electronic Data Gathering, Analysis, and Retrieval System (EDGAR).
  
• Use of summary portfolio schedule. The amendments will permit a fund to include a summary portfolio schedule in its semi-annual reports that are delivered to shareholders in lieu of the complete schedule, provided that the complete portfolio schedule is filed with the SEC and is provided to shareholders upon request, free of charge. The summary portfolio schedule will include each of the fund’s 50 largest holdings in unaffiliated issuers and each investment that exceeds one percent of the fund’s net asset value.
  
• Exemption of money market funds from portfolio schedule delivery requirements. The amendments will exempt money market funds from including a portfolio schedule in reports to shareholders, provided that this information is filed with the SEC and is provided to shareholders upon request, free of charge.
  
• Tabular or graphic presentation of portfolio holdings in shareholder reports. The amendments will require reports to shareholders to include a tabular or graphic presentation of a fund’s portfolio holdings by identifiable categories (e.g., industry sector, geographic region, credit quality, or maturity).
  
• Management’s discussion of fund performance. The amendments will require a mutual fund to include Management’s Discussion of Fund Performance (MDFP) in its annual report to shareholders. Currently, a fund is permitted to include MDFP in either its prospectus or its annual report to shareholders.

The new requirements will apply to shareholder reports and quarterly portfolio disclosure for reporting periods ending on or after 120 days following publication in the Federal Register.

Disclosure Regarding Approval of Investment Advisory Contracts

The SEC proposed the following rule amendments to require funds to provide enhanced disclosure regarding the reasons for the fund board’s approval of an investment advisory contract:

• Selection of adviser and approval of advisory fee. The proposals would clarify that the fund should discuss both the board’s selection of the investment adviser and its approval of amounts to be paid under the advisory contract.
  
• Specific factors. The fund would be required to include a discussion of (1) the nature, extent, and quality of the services to be provided by the investment adviser; (2) the investment performance of the fund and the investment adviser; (3) the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the fund; (4) the extent to which economies of scale would be realized as the fund grows; and (5) whether fee levels reflect these economies of scale for the benefit of fund investors.
  
• Comparison of fees and services provided by adviser. The fund’s discussion would be required to indicate whether the board relied upon comparisons of the services to be rendered and the amounts to be paid under the contract with those under other investment advisory contracts, such as contracts of the same and other investment advisers with other registered investment companies or other types of clients (e.g., pension funds and other institutional investors).

Prohibition on the Use of Brokerage Commissions to Finance Distribution

The SEC’s proposed amendment to rule 12b-1 under the 1940 Act would:

• prohibit funds from compensating a broker-dealer for promoting or selling fund shares by directing brokerage transactions to that broker-dealer;
  
• prohibit “step-out” and similar arrangements under which a fund directs brokerage commissions to selling brokers that do not execute fund portfolio securities transactions as compensation for selling fund shares; and
  
• require funds that use a selling broker-dealer to execute portfolio securities transactions to adopt, and the fund’s board of directors (including its independent directors) to approve, policies and procedures reasonably designed to prevent: (i) the persons who select executing broker-dealers from taking into account brokers’ distribution efforts; and (ii) any agreement under which the fund is expected to direct brokerage commissions for distribution.

The SEC also is requesting comment on the need for additional changes to rule 12b-1 to address other issues that have arisen under the rule, such as the current practice of using 12b-1 fees as a substitute for a sales load. In addition, the SEC is requesting comment on an alternative approach to rule 12b-1 that would require distribution-related costs to be deducted directly from shareholder accounts rather than from fund assets. Finally, the SEC is seeking comment on whether rule 12b-1 continues to serve the purpose for which it was intended, and whether it should be repealed.

Comments on the proposed rule amendments and additional request for comment will be due approximately 60 days after the proposed rule is published in the Federal Register. SEC Press Release, February 11, 2004 (Release No. 2004-16).