On November 21, 2003, NASD proposed a rule requiring all fund advertisements, sales material and correspondence that provide performance information to include a prominent text box that sets forth the fund’s:

• Standardized performance information (i.e., 1, 5 and 10-year returns);
• Maximum sales charge; and
• Annual expense ratio.

The proposal requires that the standardized information in the text box be presented in at least as large type size as any other performance information included in advertisements. The proposal is intended to promote investor awareness of fund costs, provide comparisons among funds and make standardized performance more prominent. Details of the proposal will be made available in a future Notice to Members. (NASD press release, November 21, 2003.)

On November 19, 2003, the House of Representatives passed the Mutual Fund Reform Bill by a wide margin.

On November 19, 2003, the House of Representatives passed the Mutual Fund Reform Bill by a wide margin. The bill is intended to combat market timing and late trading. The bill:

• permits, but does not require, mutual funds to charge redemption fees in excess of the 2% fee currently permitted;
• bans short term trading of mutual fund shares by the fund’s insiders;
• prohibits a person from managing a hedge fund and a mutual fund simultaneously; firms, however, would still be permitted to manage both types of vehicles;
• requires mutual funds to provide enhanced disclosure to shareholders regarding fees and operations, including portfolio manager compensation;
• requires that two-thirds of a fund’s directors be independent; and
• directs the Securities and Exchange Commission to clarify its rules on fair value pricing.

The Senate will not consider the bill until its next legislative session. We will provide more information upon further developments.

On November 17, 2003, the SEC and NASD settled enforcement proceedings against a broker-dealer for:

1. Failing to disclose to investors the preferential treatment by the broker-dealer of certain funds in exchange for compensation by those funds; and
2. Failing to adequately disclose to investors when recommending sales of Class B shares in amounts of $100,000 or greater, that such shares were subject to higher annual fees and the potentially lower returns than those of Class A shares.

The SEC found that the broker-dealer willfully violated Section 17(a)(2) of the Securities Act of 1933 and Rule 10b-10 under the Securities Exchange Act of 1934. Section 17(a)(2) is an antifraud provision and Rule 10b-10 generally requires broker-dealers to disclose the source and amount of any remuneration received from third parties in connection with a securities transaction. The broker-dealer was censured, ordered to comply with certain undertakings, and fined $50 million to be distributed to affected customers. The NASD censured the broker-dealer and found that the broker-dealer’s conduct violated NASD Conduct Rule 2830(k), which prohibits members from favoring or disfavoring the sale or distribution of mutual funds on the basis of brokerage commissions or other remuneration, or providing incentives or additional compensation for the sale of specific mutual funds based on brokerage commission. 

From January 2000 until 2003, the broker-dealer operated two marketing programs which provided favorable treatment for products offered by 16 of the 115 mutual fund complexes that could be sold by the firm’s sales force, in exchange for brokerage commissions and payments in excess of standard sales loads and Rule 12b-1 payments. The marketing programs provided the following benefits:

• Placement on a “preferred list” of funds which the broker-dealer’s representatives were to look to first in making recommendations;
• Higher visibility and prominence in the broker-dealer’s sales systems and work stations;
• Eligibility for the broker-dealer’s 401(k) programs and the ability to offer offshore fund products to the broker-dealer’s customers;
• Payment of additional incentive compensation to representatives who sold funds on the preferred list; and
• Better access to sales training, customer seminars and other events.

The SEC’s order noted that although the participating funds’ prospectuses and statements of additional information contained various disclosures regarding payments to the broker-dealers, none adequately disclosed the preferred programs or provided sufficient facts about the programs for investors to appreciate the inherent conflicts of interest.

As part of the settlement, the broker-dealer’s undertakings included: disclosing information about the preferred programs on its website; providing customers with a disclosure document concerning the preferred programs and differences in fees and expenses for different mutual fund class shares; offering to convert certain customers’ Class B shares to Class A shares; retaining an independent consultant to review and provide recommendations on the broker-dealer’s disclosures, policies and procedures; and adopting the recommendations of the independent consultant. Details of the settlement are available on the SEC’s website at http://www.sec.gov/litigation/admin/33-8339.htm, and the NASD’s website at http://www.nasdr.com/news/pr2003/release_03_051.html. (See also, Investment Company Institute’s Memorandum, dated November 20, 2003.) 

On November 13, 2003, the SEC accepted an offer of settlement relating to alleged market-timing trades by certain employees of an investment adviser. The SEC found that the adviser committed securities fraud by failing to disclose potentially self-dealing securities trading by several of its employees. The SEC also found that the adviser failed to take adequate steps to detect and deter such trading activity through its own internal controls and supervision of employees, and thereby breached its fiduciary duties in violation of the Investment Advisers Act of 1940. The amount of the civil penalty and other monetary relief to be paid by the adviser will be determined at a later date.

The terms of the settlement include, among other things, undertakings by the adviser to enforce employee trading restrictions (i.e., 90-day or one-year minimum holding periods, depending on the employee’s status), maintain a compliance and oversight infrastructure, retain independent consultants to determine the amount of restitution due to shareholders, retain additional independent consultants to conduct a comprehensive review of the adviser’s supervisory, compliance, and other policies and procedures, and undergo a periodic compliance review.

In the compliance area, the adviser agreed to:

• Require the chief compliance officer to report all breaches of fiduciary duty and violations of federal securities laws to the independent trustees of each fund;
• Maintain a code of ethics oversight committee to review and report violations of the code of ethics to each fund’s board of trustees;
• Create an internal compliance controls committee to review and report compliance matters to each fund’s board of trustees; and
• Once every two years, have an independent, third party review the adviser’s supervisory, compliance and other policies and procedures in connection with the adviser’s duties to the funds.

In the governance area, the funds voluntarily agreed to the following:

• The chairman and at least 75% of each fund’s board of trustees will be independent;
• Any person who acts as counsel to the independent trustees of any fund will be an “independent legal counsel” as defined by Rule 0-1 under the 1940 Act and will not have any employment, consultant, attorney-client, auditing or other professional relationship with the adviser;
• No board action may be taken without approval by a majority of the independent trustees; and the adviser will disclose to fund shareholders any action not approved by the full board, but approved by a majority of the independent trustees;
• Beginning 2004, each fund’s board of trustees will hold elections at least once every five years,; and
• Each fund’s board of trustees will have their own independent administrative staff member who will report to and assist fund boards in monitoring the adviser’s compliance with federal securities laws and fiduciary duties to shareholders.

On November 5, 2003, Senator Daniel K. Akaka (D-HI) introduced the Transparency Act, which was referred to the Committee on Banking, Housing, and Urban Affairs. The Transparency Act requires disclosure of financial relationships between brokers and mutual funds and certain brokerage commissions paid by mutual funds. The Transparency Act, as proposed, provides the following:

1. The Securities and Exchange Commission (the “SEC”) is directed to adopt rules, within one year after the enactment of the Transparency Act, requiring brokers to disclose in writing to customers who purchase shares of open-end funds, the amount of compensation received by the broker in connection with the transaction. This disclosure must be made no later than the date the transaction is completed, and may not be made exclusively in the fund’s registration statement or any other filing with the SEC.
2. The SEC is directed to adopt rules requiring funds to disclose brokerage commissions, both as an aggregate dollar amount and as a percentage of assets, in any disclosure on the amount of fees and expenses that may be payable by shareholders, including any calculations of expense ratios, for the fund’s registration statement or any other SEC filing.
3. Section 10(a) of the Investment Company Act of 1940 (the “1940 Act”) would be amended to require the chairman of the board, as well as 75% of the fund’s board, to be independent. All interested directors must be approved or elected by shareholders every five years, and a majority of the independent directors must determine annually that such director lacks a material conflict of interest.
4. No action of the board may require that an interested director vote on the matter, and the board is required to form a nominating committee comprised solely of independent directors to select nominees and determine qualification standards for election to the board. The qualification standards must be disclosed in the fund’s registration statement.
5. The definition of “interested person” under Section 2(a)(19) of the 1940 Act would be expanded to include legal counsel and “significant service providers” (to be defined by the SEC).
6. The SEC is directed to prescribe rules, within 270 days after the enactment of the Transparency Act, requiring mutual funds to disclose portfolio management compensation structures and ownership of fund shares.

The Transparency Act also directs the SEC to conduct various studies, including a study on the effectiveness of the creation of a “Mutual Fund Oversight Board”, a study on the financial literacy of mutual fund investors, and a study regarding mutual fund advertising. (See s. 1822, “Mutual Fund Transparency Act of 2003”, November 4, 2003; See also, ICI Letter to Members Regarding Proposed Mutual Fund Legislation, November 10, 2003.)

On November 6, 2003, Mary L. Shapiro, NASD Vice Chairman and President of Regulatory Policy and Oversight, testified before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises and the House Financial Services Committee in a hearing on mutual fund trading abuses. Ms. Shapiro stated that the NASD’s involvement with mutual funds is limited to the NASD’s authority to regulate the sales practices of its broker-dealer members. She testified that the NASD’s examination and enforcement focus in this area has concentrated on five main areas: (1) the suitability of the mutual funds sold by brokers; (2) broker sales practices, (3) disclosures provided to investors; (4) compensation arrangements between the funds and brokers; and (5) whether brokers are delivering to their customers the benefits to which the customers are entitled, such as breakpoint discounts.

Ms. Shapiro testified that the NASD “strongly” supports a pending House bill which would require mutual funds and brokers to provide information on mutual fund expenses and conflicts of interests, including sales compensation and revenue sharing arrangements. She noted that the NASD has taken action in this area and discussed the NASD’s recent proposal requiring broker-dealers to provide investors with information about revenue sharing arrangements (i.e., payments for “shelf space”) and “differential compensation” arrangements, which are cash compensation payments by a broker/dealer to a registered representative designed to favor certain products over others. Ms. Shapiro also stated that the NASD supports the adoption of standard definition of the term “no-load fund” for the benefit of investors.

Ms. Shapiro then described the NASD’s recent enforcement efforts regarding cash and non-cash compensation cases. She stated that the NASD is conducting examinations of more than a dozen broker/dealers at different types of firms to determine how mutual funds or their adviser pay to be included on a brokerage firm’s featured mutual fund list, including the fund’s receipt of favored promotional and selling efforts.

On November 4, 2003, Stephen M. Cutler, Director of the SEC’s Division of Enforcement, testified before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises and the Committee on Financial Services on the alleged abuses involving the sale of mutual fund shares. He stated that the SEC has undertaken an aggressive agenda to identify and address problems in the mutual fund industry.
Mr. Cutler stated that the SEC is focusing on four types of misconduct and that its first priority is late trading and timing of mutual fund shares. The second priority focuses on sales practices and abuses regarding disclosure of information, such as brokerage fees and revenue sharing arrangements, to customers. The third priority is the sale of different classes of mutual fund shares, particularly Class B shares that charge contingent deferred sales charges (“CDSC”) and higher rule 12b-1 fees. Mr. Cutler noted that the SEC has brought two enforcement actions involving the sale of Class B shares to investors who were not informed by their registered representatives they could buy Class A shares of the same mutual fund at a lower sales charge. The fourth priority is the abuse surrounding the failure to provide breakpoint discounts.

Mr. Cutler discussed recent enforcement actions relating to mutual fund trading against: broker-dealers, hedge funds and mutual funds. He also discussed the results of the SEC’s recent requests for information sent to 88 of the largest mutual fund complexes in the United States and 34 broker-dealers relating to their policies and practices on pricing of mutual fund orders and adherence to stated policies on market timing. He noted that the SEC has also sought additional information regarding use of fair value pricing procedures from mutual funds susceptible to market timing. He noted that the SEC is still examining the information received as a result of these requests and has sought additional details from many firms. He stated that some firms’ responses are still incomplete, other firms’ responses have warranted aggressive follow-up with on-site SEC inspections and interviews, and other firms have been referred to the enforcement staff for further investigation. According to Mr. Cutler’s testimony, the preliminary results from the requests for information include the following:

Late Trading. Mr. Cutler noted that most broker-dealer firms have policies or procedures prohibiting late trading. However, he also noted that thus far, the SEC has found that several broker-dealers have allowed customers to place or confirm orders after 4:00 p.m. Eastern Time. Mr. Cutler reported that more than 95% of the responding fund groups have prospectus disclosure regarding the time the fund’s NAV is calculated (4:00 p.m. Eastern Time) and also state that the order must be received by an agent of the fund before the NAV is calculated to receive that day’s NAV. He also reported that virtually all funds have contracts with selling intermediaries that require the intermediary to observe the 4:00 p.m. cutoff to receive that day’s NAV. He noted that most fund groups permit late processing of share orders received by an intermediary before the daily order cutoff. He further reported that most funds reported no knowledge of late trading by intermediaries.

Market Timing. Mr. Cutler reported that the SEC found that documents provided by almost 30% of the responding broker-dealers indicated they assisted market timers and that several broker-dealers have allowed customers to place or confirm orders after 4:00 p.m. Eastern Time. Mr. Cutler stated that during the SEC’s review of mutual fund responses, the SEC found that almost all funds have some kind of anti-market timing policy and that most funds have some disclosure in their prospectus or statement of additional information on market timing. He noted that most market timing policies are discretionary.

Mr. Cutler reported market timing is a widespread strategy and that is not always welcomed by funds. He reported that many fund groups’ responses suggested constant monitoring of shareholder activity and remedial measures are taken when disruptive market timing activity is identified. He also reported that fund groups were trying to cope with both individual and institutional investors who engage in market timing and attempt to conceal their identities from funds through intermediaries and omnibus accounts. He stated that most fund groups have active monitoring programs to identify and stop excessive short-term trading, but that half of the fund groups have some kind of agreement or arrangement with certain shareholders to permit certain shareholders to engage in market timing.

Disclosure of Portfolio Holdings. Mr. Cutler reported that more than 30% of responding funds may have provided improper disclosures of portfolio information to certain shareholders, enabling those shareholders to make advantageous decisions when placing orders for fund shares.

Mr. Cutler ended his testimony by stating that the SEC will seek restitution for those who are victims of mutual fund fraud and will continue to work closely with state officials who are also taking steps to protect investors.

On November 4, 2003, the SEC approved final NYSE and NASD rules designed to strengthen director independence and corporate governance for listed companies on the NYSE and The Nasdaq Stock Market, Inc. (“Nasdaq”).

Key provisions of the NYSE rules include the following:

1. Requiring listed company boards to consist of a majority of independent directors;
2. Tightening the definition of independent director and requiring the board to make an affirmative determination of independence;
3. Requiring non-management directors to meet in executive sessions;
4. Requiring listed companies to have a nominating/corporate governance committee and a compensation committee composed entirely of independent directors;
5. Strengthening audit committee membership standards and expanding the audit committee’s responsibilities;
6. Requiring the adoption of corporate governance guidelines and a code of business conduct and ethics; and
7. Requiring the Chief Executive Officer of a listed company to annually certify to the NYSE that s/he not aware of any violation by the company of the NYSE’s corporate governance standards (the “Certification”). The Certification is required to be disclosed in the company’s annual report. In addition, the CEO is required to promptly notify the NYSE in writing after any executive officer of the listed company becomes aware of any material non-compliance with any applicable provisions of the new requirements.

Although the NYSE considers most of these requirements to be unnecessary for closed-end and open-end management investment companies that are registered under the 1940 Act, given extensive federal regulation applicable to them, the rules require closed-end funds to:

• Have an audit committee, composed of at least three members, that satisfies the requirements of Rule 10A-3 under the Securities and Exchange Act of 1934 (the “1934 Act”);
• Comply with the NYSE audit committee charter provision (the “NYSE Audit Committee Charter Provision”), which requires the audit committee to have a written audit committee charter that addresses: (i) the committee’s purpose; (ii) an annual performance evaluation of the audit committee; and (iii) the duties and responsibilities of the audit committee; and
• Comply with the NYSE CEO Certification and notification requirements.

Exchange traded funds would be required to: (1) have an audit committee that satisfies the requirements of Rule 10A-3 under the 1934 Act; and (2) notify the NYSE in writing of any material non-compliance.

The NYSE rules also require audit committee charters of closed-end funds and open-end funds to establish procedures for the confidential, anonymous submission by employees of the fund, investment adviser, administrator, principal underwriter, or any other provider of accounting related services for the fund, of concerns regarding questionable accounting or auditing matters.

Listed companies will have until the earlier of their first annual meeting after January 15, 2004, or October 31, 2004, to comply with the new NYSE listing standards. The NASD rules are similar to the NYSE’s, although distinctions exist to accommodate differences in the nature of the companies listed on the NYSE versus Nasdaq. (SEC Release No. 34-48745, November 4, 2003.) The American Stock Exchange (“AMEX”) has proposed rules similar to those of the NYSE and NASD. The AMEX proposal was recently published by the SEC for comment. (SEC Release No. 34-48706, October 27, 2003.)

SEC Chairman William Donaldson commented on various securities markets issues during testimony before a House of Representatives Financial Services Capital Market Subcommittee hearing on October 30, 2003.

Mr. Donaldson stated that the SEC plans to address what it considers a “significant” market structure issue: fair and efficient access to markets. He stated the SEC is actively re-evaluating the issue of intermarket trade-throughs, which occur when orders are executed in one market at prices inferior to the prices disseminated on another market. Under the trade-through rule, traders are required to send orders to the market with the best price. As a result, orders are mandatorily routed to the exchange that has the best published price at the time the order is executed. Mr. Donaldson explained that if broker-dealers are to achieve best execution in an environment of competing markets, they must be able to identify the location of the best available prices and obtain access to those prices routinely and efficiently. However, the trade-through rule does not reconcile the widely different response times among floor-based exchanges and electronic communications markets. He stated that the challenge before the SEC is to devise standards that allow faster, fully electronic markets and slower, floor-based markets to thrive within a single system of interconnected markets while not losing the benefits of either method of trading.

Mr. Donaldson stated that another challenge facing the SEC involves the collection and reporting of trading information and the influence that resulting revenues have on overall market structure. He acknowledged that the current compensation scheme has created a financial incentive for self-regulatory organizations (“SROs”) to report as many trades as possible. Mr. Donaldson stated the SEC should evaluate whether the current method of distributing market data revenue creates appropriate economic incentives.

Mr. Donaldson stated that the SEC intends to continue its work in ensuring that SROs fulfill these obligations to enforce their rules and the federal securities laws and related rules. Mr. Donaldson also stated that the SEC intends to thoroughly review SROs’ governance practices in the following areas:

• board composition and independence of directors;
• the independence and function of key board committees;
• the transparency of an SRO’s decision-making process; and
• the diligence and competence required of board and committee members and ensuring their focus on the adequacy of regulation.

Mr. Donaldson also commented on the current investigation into market timing and late trading abuses in the mutual fund industry. He noted that the SEC believes the market timing and late trading practices that are currently being investigated are more widespread than the SEC initially anticipated. BNA Securities Regulation & Law Report, Vol. 35, No. 43, November 3, 2003.

The 2003 fiscal year for the SEC ended on September 30, 2003. The fee for filings made pursuant to Section 6(b) of the Securities Act of 1933 is dependent on the enactment of an appropriation for the SEC for the new fiscal year. As of October 31, 2003, no such appropriation had been made. The SEC issued a statement that, pursuant to a continuing resolution, filing fees will remain at the current rate of $80.90 per $1,000,000. The SEC noted that five days after enactment of the SEC’s regular fiscal year 2004 appropriation, the Section 6(b) fee rate applicable to registration of securities, will be increased from $80.90 per million to $126.70 per million. SEC Release No. 2003-146.

In a November Notice to Members (the “Notice”), the NASD reminds its members that fee-based compensation programs (i.e., wrap accounts) must be appropriate for the customer. Fee-based programs typically charge a customer a fixed fee or percentage of assets under management in lieu of transaction-based commissions. The Notice states that while the NASD recognizes the benefits these programs offer for many customers, they are not appropriate in all circumstances.

According to the Notice, it is a violation of NASD Rule 2110 to place a customer in an account with a fee structure that reasonably can be expected to result in a greater cost than an alternative type of account offered by such member that provides the same services and benefits to the customer at a lower cost. The Notice states that, before opening a fee-based account for a customer, members must have reasonable grounds to believe that a fee-based program is appropriate for a particular customer. A member should make reasonable efforts to obtain information about the customer’s financial status, investments objectives, trading history, size of portfolio, nature of securities held, and account diversification. The Notice recommends that members review this and any other relevant information available, before considering whether the fee-based account is appropriate in light of the services provided, the projected costs to the customer, alternative fee structures available, and the customer’s fee structure preferences. The Notice also states that members should disclose to the customer all material components of the fee-based program, including the fee schedule, services provided, and the fact that the program may cost more than paying for the services separately.

The Notice also states that members should implement supervisory procedures to require a periodic review of fee-based accounts to determine whether they continue to be appropriate for their customers. Members may also choose – but are not required – to create reports that compare the asset-based fees to the fees that would have been generated on a transaction basis. Finally, the Notice states that members should review their sales literature, marketing material, and other correspondence related to fee-based programs to ensure the information is balanced and not misleading, and should include in training materials guidelines regarding the establishment of fee-based accounts. (NASD Notice to Members, November 2003, 03-68)

On October 29, 2003, the SEC proposed new Regulation SHO (“Proposed Regulation SHO”) under the Securities Exchange Act of 1934 (“Exchange Act”), which would replace Rules 3b-3, 10a-1 and 10a-2 under the Exchange Act. The SEC also proposed amendments to Rule 105 of Regulation M. Proposed Regulation SHO requires short sellers in all equity securities to locate securities to borrow before selling short, and imposes strict delivery requirements on certain securities that evidence significant failures to deliver. In addition, Proposed Regulation SHO institutes a new uniform bid test (the “Uniform Bid Test”) that permits short sales to be effected at a price one cent above the consolidated best bid. The Uniform Bid Test applies to all exchange-listed securities and Nasdaq National Market System Securities (“NMS Securities”), wherever traded. In addition, the SEC seeks comments on a temporary rule that suspends the operation of the Uniform Bid Test for certain liquid securities during a two-year pilot period (the “Pilot Program”).

A. Locate and Delivery Requirements

In an effort to combat problems surrounding “naked short selling” and extended “fails to deliver” (i.e., selling short without borrowing the necessary securities to make delivery and thereby potentially resulting in a failure to deliver the securities to the buyer), Proposed Regulation SHO establishes a uniform standard specifying procedures for all short sellers to (i) locate securities for borrowing (the “uniform locate rule”) and (ii) comply with delivery requirements for securities that experience significant settlement failures.

Uniform locate rule. Under Proposed Regulation SHO, broker-dealers would be prohibited from executing a short sale for its own account or the account of another person, unless the broker-dealer, or the person for whose account the short sale is executed (1) borrowed the securities, or entered into an arrangement for the borrowing of the security, or (2) had reasonable grounds to believe that it could borrow the securities so that it would be capable of delivering the securities when due. The uniform locate rule further requires that the securities are, in fact identified and located and evidenced in writing prior to the execution of any short sale. An exception to the uniform locate rule is proposed for short sales executed by specialists or market makers in connection with bona fide market making activities. The uniform locate rule will apply to all equity securities, regardless of the exchange on which they are traded.

Delivery requirements. The proposed rules will also include delivery requirements for securities which have been the subject of significant settlement failures (i.e., any security as to which there have been failures or where there are failures to deliver at a clearing agency registered with the SEC. For any security that meets this threshold, the selling broker-dealer must deliver the security no later than two days after the settlement date. If the security is not delivered within two days after the settlement date, the proposed rule generally restricts the broker-dealer’s ability to execute future short sales in the security for a period of 90 days and requires the clearing agency that processed the transaction to take certain actions, including referring the broker-dealer to the National Association of Securities Dealers, Inc. (the “NASD”) and withholding benefits and assessing charges against the party failing to deliver. No exception from these delivery requirements is proposed for short sales in connection with market making. The delivery requirements apply to all equity securities registered under Section 12 of the Exchange Act.

The delivery requirements for long sales of securities registered on a national securities exchange are currently covered by Rule 10a-2 under the Exchange Act. Proposed Rule 203 would replace and modify Rule 10a-2 to make it consistent with the new delivery requirements in the proposed short sale rules.

B. Uniform Bid Test

Current Rules. Rule 10a-1 under the Exchange Act is designed to restrict short sellers from effecting short sales in an exchange-traded security when the price of that security is declining (the “up-tick” rule). Rule 10a 1(a)(1) provides that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick) or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions. These provisions determine the minimum shortable price for short sales and are designed to prevent short selling in a security with a declining trading value.

Proposed Rule. Proposed Rule 201 would replace the up-tick rule with a Uniform Bid Test using the consolidated best bid as the reference point for permissible short sales. Under the Uniform Bid Test, all short sales in exchange-listed and Nasdaq NMS securities, wherever traded, would be effected at a price at least one cent above the consolidated best bid at the time of execution. The Uniform Bid Test would not apply to Nasdaq Small Cap, OTCBB or Pink Sheet securities.

Exceptions. Rule 10a-1 currently contains 13 exceptions designed to permit certain types of trading activities that benefit the markets or carry little risk of market manipulation or destabilization. Proposed regulation SHO incorporates, modifies or eliminates these current exceptions and codifies certain SEC orders providing exemptive relief.

The exceptions proposed to be retained and incorporated under the proposed rule include the following situations, subject to certain conditions:

1. A long seller’s delay in delivery;
2. An error in marking a short sale;
3. Odd lot transactions modified to include all market markers acting in the capacity of an odd-lot dealer;
4. Domestic arbitrage modified to require a person relying on this exception to subsequently acquire or purchase the security upon which the arbitrage is based;
5. International arbitrage modified to incorporate language from the current exception which provides that, for the operations of the international arbitrage exception, a depositary receipt for a security shall be deemed to be the same as the security represented by the receipt;
6. Distributions in connection with over-allotments;
7. Equalizing short sales and trade-throughs to permit a responsible broker-dealer, as defined in Rule 11Ac1-1 under the Exchange Act, to effect a short sale at a price equal to its posted offer when the market is locked or crossed when consistent with best execution obligations, provided however, that the exception would not apply to any broker-dealer who initiated the locked or crossed market;
8. Exchange traded funds;
9. Short sales executed in after-hours crossing sessions at the closing price of the security;
10. Short sales executed on a volume-weighted average price basis; and
11. Short sales by broker-dealers, when consistent with best execution obligations, to fill and execute customer orders required by federal securities laws or SRO rules.

The exceptions proposed to be eliminated are equalizing exceptions which permit:

1. An exchange to make an election to use a tick test that references the last trade price on such exchange for short sales of exchange-listed securities not reported to the consolidated system or made available on a real-time basis; and
2. Short sales of certain securities effected by a registered specialist, exchange market maker or third market maker at a price equal to the last price reported in the consolidated system if transactions in the security are reported pursuant to an effective transaction reporting plan and made available on a real time basis to vendors of market transaction information.

Proposed Regulation SHO does not exempt hedging transactions from short sale regulations. The Uniform Bid Test in Regulation SHO will not be applicable to bonds. The Uniform Bid Test will apply to after-hours trades in all covered securities. In addition, the Uniform Bid Test applies to all short sales in exchange-listed or Nasdaq NMS securities, unless otherwise excepted, regardless of whether the sale was actually executed in the United States.

C. Pilot Program

Under the Pilot Program, proposed temporary Rule 202 suspends the operation of the Uniform Bid Test for specified liquid securities, such as a subset of the Russell 1000 index or such other securities as the SEC designates by order as necessary or appropriate in the public interest. According to the SEC, the Pilot Program would enable the SEC to study the effects of relatively unrestricted short selling on, among other things, market volatility, price efficiency and liquidity. Rule 202 would remain in effect for two years or such shorter period of time as the SEC deems necessary or appropriate in the public interest. Comments on the proposed rules must be received on or before January 5, 2004. (SEC Release No. 34-48709; File No. S7-23-03)

More than five years after the National Association of Securities Dealers, Inc. (“NASD”) first proposed new NASD Rule 2790 (the “rule”) governing purchases and sales of “hot issue” offerings, the SEC has approved the rule as amended by the fifth amendment thereto. Under the rule, a NASD member generally is prohibited from selling a “new issue” to any account in which a “restricted person” has a beneficial interest. The rule now applies to any initial public offering of equity securities (subject to limited exceptions) and not just those that trade at a premium in secondary trading. The term “restricted person” has been modified and includes most broker-dealers, most owners and affiliates of a broker-dealer, and certain other classes of persons. The new rule requires a NASD member, before selling a new issue to any account, to meet certain “preconditions for sale.” These preconditions generally require the member to obtain a representation from the beneficial owner of the account that the account is eligible to purchase new issues in compliance with the rule.

A Special Report to our hedge fund clients on the amended rule is attached and discusses the changes to the hot issue rule in more detail. The NASD is also expected to issue some interpretive guidance on the implementation of the rule. There are a few aspects of the new rule that will be of more general interest to managers of mutual funds and other non-hedge fund institutional accounts. First, mutual funds continue to be clearly exempted from the limitations under the rule, as they are under the current NASD interpretation. Similarly excluded are common trust funds that have investments from 1,000 or more accounts where the trust does not limit the participating accounts principally to trust accounts of restricted persons. Insurance company general, separate and investment accounts are also exempt if the account is funded by premiums from 1,000 or more policyholders and the insurance company does not limit policyholders participating in the account, or in the case of a general account does not limit its policyholders, principally to restricted persons. ERISA plans qualified under Section 401(a) of the Code are exempt provided that the plan is not sponsored solely by a broker-dealer.

The rule generally treats broker-dealers and persons affiliated with broker-dealers as restricted persons. However, with respect to limited business broker-dealers (i.e., a broker only authorized by the NASD to engage in a securities business limited to investment company, variable contract and direct participation program securities), the limited business broker-dealer itself is a restricted person but its officers, directors, partners, associated persons, employees and agents are not restricted persons solely because of that affiliation. The category of restricted persons arising out of affiliation with a bank, S&L, insurance company, investment company, investment advisors or collective investment accounts formerly applied to any senior officers and any other person whose position involved or could influence the purchase and sale of securities. This category of restricted persons now only applies to persons who have authority to buy or sell securities for a bank, S&L, insurance company, investment company, investment advisers or collective investment accounts. Consequently, a narrower group of persons in the business of managing and distributing mutual fund or institutional accounts are restricted persons. (SEC Release No. 34-48701; File No. SR-NASD-99-60).