• The SEC exceeded its statutory authority and improperly usurped the states’ role as the primary authority on matters of corporate governance.
  
• The SEC also ignored basic requirements of notice and comment rulemaking by amending 10 different and long-standing SEC rules without any meaningful discussion of those rules’ current requirements, their original purpose, the manner in which the rules will operate as a result of these wholesale amendments, and why each such change was necessary in light of each rule’s purpose and the SEC’s legitimate objectives.
  
• The SEC’s new governance rule requirements are arbitrary, capricious, and contrary to law. The independent chair requirement will prevent independent directors of mutual funds from deciding for themselves whether an independent or management chair is best for the fund; will strip investors of the option they currently have to invest in a fund chaired by a management director if they so choose; and will force the vast majority of mutual funds to change their governance structure in a manner the record shows will adversely affect the funds, the investing public, and the economy. Yet, the SEC failed to give adequate consideration to alternatives to its independent chair requirement, paid insufficient attention to the comments opposing the requirement, and gave short shrift to empirical evidence of the mandate’s dubious value. The SEC similarly identified no rational basis for selecting 75 percent as the requisite percentage of independent directors, and conceded that it had “no reliable basis” for determining how funds would satisfy that requirement, nor for estimating the costs it would impose.

Plaintiff requested that the court enter a declaratory order that the independent chair requirement and 75 percent independent director requirement are unlawful; enjoin the SEC from implementing and enforcing the requirements or giving them effect in any manner; and such other relief as may be appropriate.

Chamber of Commerce of the United Stated of America vs. United States Securities and Exchange Commission, US District Court (DC), Docket Case Number 1:03-cv-01314-R (September 2, 2004).

The SEC is publishing for comment amendments to Rule 30 under Regulation S-P, which requires financial institutions to adopt policies and procedures to safeguard customer information (“safeguard rule”). The proposed amendments would require reasonable measures to safeguard the proper disposal of consumer information, as well as policies and procedures under the safeguard rule to be in writing.

A. Background

The proposed amendments to Rule 30 under Regulation S-P would implement the provision in Section 216 of the Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”) requiring proper disposal of consumer report information and records. Section 216 directs the SEC and other federal agencies to adopt regulations requiring any person who maintains or possesses a consumer report or consumer information derived from a consumer report for a business purpose to properly dispose of the information. Section 216 of the FACT Act is intended to prevent unauthorized disclosure of information contained in a consumer report and to reduce the risk of fraud or related crimes, including identity theft, by ensuring that records containing sensitive financial or personal information are appropriately redacted or destroyed before being discarded. In accordance with Section 216, the staff of the SEC has coordinated with various federal agencies to develop a proposal regarding the disposal of consumer report information for which it is now requesting public comment.

The SEC's current safeguard rule under Section 30 of Regulation S-P was adopted in 2000. Currently, the rule requires brokers, dealers, and investment companies, as well as investment advisers registered with the SEC, to adopt policies and procedures that address administrative, technical, and physical safeguards for the protection of customer records and information. The proposed amendments to this rule is intended to address weaknesses the staff of the SEC has seen in its examinations of brokers, dealers, investment companies, and registered investment advisers with respect to proper documentation of and compliance with policies and procedures on safeguarding consumer information. As a result, the proposed amendments would require the policies and procedures adopted under the safeguard rule to be in writing.

B. Proposals

Definitions on the “disposal” of “consumer report information” and records

The definition of “consumer report information” would mean “any record about an individual, whether in paper, electronic, or other form, that is a consumer report or is derived from a consumer report.” Under this definition, however, information that is derived from consumer reports but does not identify any particular individual would not be covered under the proposed rule.

The definition of “disposal” would mean the discarding or abandonment of consumer report information, as well as the sale, donation, or transfer of any medium, including computer equipment, upon which consumer report information is stored. The sale, donation, or transfer (for example, for marketing purposes), as opposed to the discarding or abandonment, of consumer report information would not be considered a “disposal” under the proposed rule. If the entity donates computer equipment on which consumer report information is stored, however, the donation would be considered a disposal under the proposal.

Proper disposal of consumer report information

Maintaining or Possessing Information for a Business Purpose. The proposed disposal rule would require brokers and dealers (other than brokers and dealers registered by notice with the Commission under section 15(b)(11) of the Securities Exchange Act of 1934 for the purpose of conducting business in security futures products (“notice-registered broker-dealers”)), investment companies, registered investment advisers, and transfer agents registered with the SEC (collectively, “covered entities”) to dispose properly of consumer report information, or any compilation of consumer report information, if the entity maintains or otherwise possesses the information for a business purpose.

The disposal requirements apply not only to consumer reports, but also to records containing “consumer information, or any compilation of consumer information, derived from consumer reports.” Under the proposal, the phrase “derived from consumer reports” covers all of the information about an individual that is taken from a consumer report, including information that results in whole or in part from manipulation of information from a consumer report or information from a consumer report that has been combined with other types of information. Thus, any covered entity that possesses such information, including an affiliate that has received it, would be obligated to properly dispose of it.

As proposed, “for a business purpose” includes all business reasons for which a covered entity may possess or maintain consumer report information. Covered entities that possess consumer report information in connection with the provision of services to another entity would also be directly covered by the proposed rule to the extent that they dispose of the consumer report information.

Reasonable Measures. The proposed disposal rule would require that any covered entity that maintains or otherwise possesses consumer report information “take reasonable measures to protect against unauthorized access to or use of the information in connection with its disposal.” The SEC noted that recognizes there are few foolproof methods of record destruction, so the proposed rule would not require covered entities to ensure perfect destruction of consumer report information in every instance; rather, it would require covered entities to take reasonable measures to protect against unauthorized access to or use of the information in connection with its disposal.

In determining what measures are “reasonable” under the proposed disposal rule, SEC stated that it expects that entities covered by the rule would consider the sensitivity of the consumer report information, the size of the entity and the complexity of its operations, the costs and benefits of different disposal methods, and relevant technological changes. “Reasonable measures” may require elements such as the establishment of policies and procedures governing disposal, as well as appropriate employee training. The SEC explained that while each covered entity would have to evaluate what is appropriate for its size and the complexity of its operations, it believes that “reasonable” disposal measures for purposes of the proposed disposal rule could include:

Implementing and monitoring compliance with policies and procedures that require the burning, pulverizing, or shredding of papers containing consumer report information so that the information cannot practicably be read or reconstructed;

Implementing and monitoring compliance with policies and procedures that require the destruction or erasure of electronic media containing consumer report information so that the information cannot practicably be read or reconstructed; and

After due diligence, entering into and monitoring compliance with a written contract with another party engaged in the business of record destruction to dispose of consumer report information in a manner that is consistent with this rule.

Procedures to safeguard customer records and information

Written policies and procedures. The SEC is proposing to require that policies and procedures under the safeguard rule must be written. The SEC noted that the written policies and procedures should be reasonably designed, within the circumstances of each particular institution, to achieve the goals set forth in the proposed rule.

The SEC is not proposing specific policies and procedures that all firms subject to the proposed rule must implement. The SEC stated that it is more appropriate for each institution to tailor its policies and procedures to its own systems of information gathering and transfer and the needs of its customers.

Comments should be received on or before October 20, 2004. SEC Release Nos. 34-50361, IA-2293, IC-26596; File No. S7-33-04.

The United States Court of Appeals for the Second Circuit (the “Court of Appeals”) upheld the District Court’s (EDNY) dismissal of a shareholder derivative action on behalf of a fund against its investment adviser. The complaint alleged: (1) a breach of the investment adviser’s fiduciary duties under Section 36(a) of the 1940 Act and (2) negligence, gross negligence and negligent misrepresentation.

Specifically, the plaintiffs alleged that the investment adviser, with actual or imputed knowledge of improprieties within one of the fund’s portfolio companies, caused the fund to purchase a large block of that company’s stock, which subsequently became valueless when those improprieties were made public. Before filing suit, the plaintiffs did not make a demand on the fund board that the fund bring the suit. Rather, the plaintiffs alleged in their complaint that such a demand would be futile because the fund directors are “interested persons” under the 1940 Act and, thus, not independent. The District Court dismissed the complaint for the plaintiff’s failure to fulfill the demand requirements.

A derivative suit permits an individual shareholder to bring suit to enforce a corporate cause of action against officers, directors and third parties to protect the interests of the corporation. In the usual case, a shareholder seeking to assert a claim on behalf of the corporation must first exhaust intra-corporate remedies by making a demand on the directors to obtain the action desired. However, demand may be excused if a shareholder is able to show that demand would be futile. The specifics of what constitutes futility vary from state to state.

In this case, because the fund is a Maryland corporation, Maryland law applies to the futility analysis. According to a Maryland Supreme Court precedent, the exception to the demand requirement for futility is “a very limited exception, to be applied only when the allegations or evidence clearly demonstrate, in a very particular manner, either that (1) a demand, or delay in awaiting a response to a demand, would cause irreparable harm to the corporation, or (2) a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to a demand in good faith and within the ambit of the business judgment rule.

Plaintiffs argued that that the Maryland law of demand is different when applied to registered investment companies than when applied to business corporations. The plaintiffs argued that all the directors of the fund were controlled by the adviser and the adviser’s parent by virtue primarily of the very large directors’ salaries paid to them as the result of their having been selected by the adviser to serve as directors of other funds managed by the adviser, and thus, are interested persons under the 1940 Act or under Maryland law. Plaintiffs alleged that, for this reason, a demand would have been futile.

In upholding the District Court’s dismissal of plaintiff’s complaint, the Court of Appeals stated that neither the statutory nor decisional authority of Maryland supports the plaintiff’s argument that the “interested” status of directors under the 1940 Act is sufficient reason to excuse the demand requirement.

United States Court of Appeals, Second Circuit. Docket No. 03-9233, Scalisi, et al. v. Fund Asset Management, L.P., et al. (August 17, 2004).

The SEC adopted amendments to Rule 12b-1 under the Investment Company Act of 1940 (the “1940 Act”) that prohibit funds from paying for the distribution of their shares with brokerage commissions.

Background

Rule 12b-1 permits funds to use their assets to pay distribution-related costs, subject to certain conditions designed to address concerns about the conflicts of interest arising from allowing funds to finance distribution. Shortly after Rule 12b-1 was adopted, the SEC concluded in 1981 that “it is not inappropriate for investment companies to seek to promote the sale of their shares through the placement of brokerage without the incurring of any additional expense.” Since 1981, fund advisers have been permitted to follow a disclosed policy “of considering sales of shares that the fund issues as a factor in the selection of broker-dealers to execute portfolio transactions, subject to best execution.” After conducting a review of current brokerage practices, the SEC concluded that the practice of using brokerage to reward sales of fund shares involves substantial conflicts of interest that may harm investors in mutual funds in numerous ways, including an adverse impact on best execution and circumventing the National Association of Securities Dealers, Inc. (“NASD”) rules limiting distribution expenses.

Ban on Directed Brokerage

New Rule 12b-1(h)(1) prohibits funds from compensating a broker-dealer for promoting or selling fund shares (a “selling broker”) by directing brokerage transactions to that broker. The prohibition applies both to directing transactions to selling brokers, and to indirectly compensating selling brokers by participation in step-out and similar arrangements in which the selling broker receives a portion of the commission. The ban extends to any payment, including any commission, mark-up, mark-down, or other fee (or portion of another fee) received or to be received from the fund’s portfolio transactions effected through any broker or dealer.

Policies and Procedures

New Rule 12b-1(h)(2) permits a fund to use its selling broker to execute transactions in portfolio securities only if the fund or its adviser has implemented policies and procedures designed to ensure that its selection of selling brokers for portfolio securities transactions is not influenced by considerations about the sale of fund shares. These procedures must be approved by the fund’s board of directors, including a majority of the independent directors, and must be reasonably designed to prevent:

• the person responsible for selecting broker-dealers to effect transactions in fund portfolio securities transactions (e.g., trading desk personnel) from taking into account broker-dealers’ promotional or sales efforts, and
  
• the fund, its adviser and principal underwriter from entering into any agreement or other understanding under which the fund directs brokerage transactions or revenue generated by those transactions to a broker-dealer to pay for distribution of the fund’s shares.

These procedures must be designed to prevent funds from entering into formal or informal arrangements to direct portfolio securities transactions to a particular broker.

The procedures should be incorporated into each fund’s compliance policies and procedures required by Rule 38a-1 under the 1940 Act. The fund’s chief compliance officer should ensure that the required procedures are in place, as well as any other procedures that he or she believes are reasonably necessary to prevent violation of the prohibition against directing brokerage for sales of fund shares. Although not explicitly required by the new rule, the SEC stated in its adopting release that compliance officers of broker-distributed funds should monitor the operation of the policies and procedures, and should consider periodic testing of brokerage allocations to determine whether there is a significant correlation between sales and the direction of brokerage that may suggest the existence of informal arrangements in violation of the rule.

Moreover, the SEC noted in the adopting release that even though funds may find that a broker-dealer who distributes the fund’s shares may also provide best execution, the fact that a selling broker provides best execution would not cure a violation of the new prohibition. The SEC release stated that, although several commenters urged a modification of the rule to incorporate a safe harbor for funds that use selling brokers to execute portfolio securities transactions, the SEC believes that a safe harbor is unnecessary. As described above, the SEC stated that it is requiring instead that funds that select their selling brokers to execute trades implement policies and procedures designed to ensure that those selections are based on the quality of the execution rather than the promotion of fund shares. The inclusion of this requirement acknowledges that, consistent with the new prohibition, funds will still be able to execute portfolio securities transactions through their selling brokers.

Further Amendments to Rule 12b-1

Although the SEC did not adopting any further changes to rule 12b-1, it will continue to review comment letters regarding further amendments to rule 12b-1, including the possible rescission of the rule as well as various other alternatives and approaches.

The compliance date for the amendments to Rule 12b-1 is December 13, 2004. No later than the compliance date, funds must comply with the ban in paragraph (h)(1) of the rule, and funds that use their selling brokers to execute portfolio securities transactions must have in place the policies and procedures prescribed by paragraph (h)(2)(ii) of Rule 12b-1. Funds may make corresponding changes to their registration statements at the time of the next regularly scheduled amendment.

SEC Release No. IC-26591; File No. S7-09-04; 17 CFR Part 270.

On August 20, 2004, the SEC published a revised rule proposal filed by the NASD to amend NASD Rules 2210 and 2211. The amendments would require mutual fund communications with the public that contain performance data to disclose the fund’s fees, expenses and standardized performance. Specifically, the amendments would require that sales material which contains performance information: 

All disclosure would be required to be set forth clearly and prominently, and disclosure of standardized performance would have to be in a type size at least as large as that of the non-standardized performance.

In the SEC’s publication, the NASD responded to the following comments which it received in response to its original proposal filed on November 21, 2003:

1. The proposed rule should be revised to require disclosure in performance advertisements of the same annual expense ratio that appears in a fund’s most recent report to shareholders, rather than disclosure of the expense ratio that appears in the fee table in the fund’s prospectus.

In response to the above comment, the NASD stated that it believes disclosure of fund expenses should be based on the calculation in the prospectus fee table rather than shareholder reports because the calculation in shareholder reports may reflect fee waivers and reimbursement not reflected in the calculation in the fund’s prospectus.

2. The requirement that (1) standardized performance information, (2) the maximum sales charge, and (3) the annual expense ratio be presented in a text box in a performance advertisement be eliminated.

In response to the above comment, the NASD affirmed its belief that the text box requirement will facilitate the ability of any investor to compare expense information for different funds.

3.The type size requirement presented in the proposed rule should be revised to provide that the required information must appear in a type size at least as large as that used in the major portion of a print advertisement.

In response to the above comment, the NASD revised the proposed rule amendments to require that all disclosure be set forth “clearly and prominently”, and that standardized performance information be in a type size at least as large as that of non-standardized performance information. Radio, television and video advertisements would be required to provide the required disclosure with “equal emphasis” to that given to any non-standardized performance.

4. Communications with institutional investors should be excluded from the proposed rule requirements.

In response to the above comment, the NASD revised the proposed rule to exclude the application of the revised rules to institutional sales material and public appearances. In addition, the NASD clarified that the requirements only apply to non-money market, open-end investment companies that register with the SEC on Form N-1A.

Comments on the proposed rule amendments are due by September 17, 2004. SEC Release No. 34-50226; SR-NASD-2004-043 (August 20, 2004).