The SPARK Institute, representing the interests of the defined contribution marketplace, released its guidelines regarding best practices for frequent trading monitoring by retirement plan record keepers. The best practice summary is intended to support compliance with SEC Rule 22c-2, the redemption fee rule, and is designed to be used in conjunction with sample contract language previously released by the Institute. The guidelines address transactions subject to monitoring, round-trip identification periods, monitoring periods, warning notices, and purchase restriction periods.

The SPARK Institute, Inc., Memorandum, June 29, 2006, available at: http://www.rgwuelfing.com/pdf/Frequent-Trade-Best-Practices-06292006.pdf.

According to a study by the Investment Company Institute (“ICI”), mutual fund fees and expenses fell in 2005 to their lowest levels in more than 25 years. Average fees and expenses for stock funds, for bond funds and for money market funds all declined in 2005. Since 1980, average fees and expenses have dropped more than 50% for stock and bond funds and about 25% for money market funds. The ICI study points to the increasing popularity of low-cost funds and lower expense ratios in the funds already owned by investors as the two primary reasons for lower stock fund costs.

Investment Company Institute, Research Fundamentals, June 2006, Volume 15, Number 4, available at: http://www.ici.org/home/fm-v15n4.pdf

An opinion of Judge Loren E. McMaster of the California Superior Court, dated May 25, 2006, concluded that the National Securities Markets Improvement Act (“NSMIA”) preempted state regulation of the contents of a fund prospectus, although NSMIA did not preempt state anti-fraud enforcement actions. The California Attorney General had alleged in its complaint, in substance, that it was a violation of state law for a broker-dealer that received “shelf space” from a fund to sell fund shares pursuant to a prospectus that failed to disclose these payments. Stating that NSMIA prohibits enforcement of state laws that prohibit, limit or impose conditions on any security offering, including mutual funds, the Court dismissed the Attorney General’s complaint.

Last November, the California Superior Court reached a similar conclusion in a suit against American Funds, in which the California Attorney General had sought injunctive relief to force American Funds to modify disclosures in its prospectuses, a decision where an appeal is pending.

People v. Edward D. Jones & Co., Cal.Super.Ct., Case No. 04AS05097, May 25, 2006.

On June 30, 2006 a federal court jury in the Southern District of New York found Stephen J. Treadway liable for defrauding fund investors through an undisclosed market timing arrangement with a hedge fund. The case involved over $4 billion and 100 round-trip exchanges. The former fund chairman had also been chief executive officer of the funds’ adviser and distributor. The jury found the defendant liable for violations (and/or aiding and abetting violations) of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, Sections 17(a)(2) and (3) of the Securities Act of 1933, Section 206(2) of the Investment Advisers Act of 1940, and Sections 34(b) and 36(a) of the Investment Company Act of 1940.

SEC v. Stephen Treadway, 04 Civ. 3464, 2006 U.S. Dist. LEXIS 45936 (S.D.N.Y. June 30, 2006) and “Jury Finds Former PIMCO Equity Funds Chairman Defrauded Investors in Market Timing Case,” SEC Press Release No. 2006-108 (June 30, 2006), available at http://www.sec.gov/news/press/2006/2006-107.htm

The first NASD webcast in a new “What to Expect” series for compliance managers is intended to explain in plain English the procedure of a routine NASD examination. All NASD firms are placed on a two or four-year routine exam cycle based on a firm’s risk profile as determined by prior sales data and past regulatory history. Firms receive about two weeks’ notice of an upcoming exam. The NASD webcast provides an exam preparation checklist that suggests selecting firm employees to be responsible for each area of the exam, preparing copies of records prior in advance, and organizing documentation in the same order as the NASD request. The checklist for the day of the exam calls for preparing workspace for the examiner, providing photocopying access to the examiner, and coordinating the schedule of the firm personnel who may need to be interviewed. Cooperation is stressed as a key to a successful exam.

After the on-site inspection is completed, an “exit conference” is conducted with key members of the firm to review findings and any potential deficiencies. The NASD examiners then meet with supervisors and staff attorneys before forwarding exam results to district management for review and approval. If the exam reveals no violations, a letter to this effect is sent to the firm. Certain deficiencies may be addressed informally through a compliance conference or letter of caution, while more serious deficiencies may result in formal disciplinary action.

NASD Webcast: The “What to Expect” Series, “What to Expect: Preparing for an NASD Routine Examination” (May 2006).

The SEC recently approved amendments to NASD Rules 2210 and 2211 relating to disclosure of fees and expenses in mutual fund performance sales material. This amendment generally requires that advertisements containing performance information present the following expense and performance information in a text box:

In addition, non-standardized fund performance, the performance of a relevant benchmark index, a comparison of a fund’s expense ratio to other similar funds and disclosures required by Rule 482 and Rule 34b-1 can be included in the text box. The amendment excludes web sites and other electronic advertisements from the requirement that expense and performance information be presented within a text box. The amendments will be effective six months after the end of the calendar quarter in which NASD publishes a Notice to Members regarding the amendments.

On July 11, 2006, the SEC published a Concept Release concerning Management’s Report on Internal Control over Financial Reporting as a step toward improving implementation of the Sarbanes-Oxley investor protection law. The SEC characterized the release as a prelude to forthcoming guidance for management in assessing a company's internal controls for financial reporting. The SEC anticipates that this guidance will cover at least the following areas:

On July 17, 2006, the SEC announced that Kathleen Blake had been sworn in as a Commissioner. Ms. Blake had previously been Staff Director of the Senate Committee on Banking, Housing and Urban Affairs. She succeeds Cynthia Glassman who had announced her intention to leave the Commission when her term ended in June.

“Kathleen Casey Sworn In as 88th SEC Commissioner,” SEC Press Release No. 2006-118 (July 17, 2006), available at: http://www.sec.gov/news/press/2006/2006-118.htm

On July 14, 2006, the SEC issued a release proposing amendments to Regulation SHO under the Securities Exchange Act of 1934. The proposed amendments reflect the SEC’s ongoing policy concern that persistent failures to deliver could be an indication that some market participants are engaged in the practice of “naked short selling.” The proposed amendments are intended to further reduce the number of fail to deliver positions in certain threshold securities by eliminating or limiting certain exceptions to Regulation SHO’s mandatory closeout requirement. The proposed amendments also would update the market decline limitation applicable to certain index arbitrage transactions. Comments on the proposed amendments are due on or before September 19, 2006. Further information regarding this SEC release is available in the WilmerHale Securities Email Alert, dated July 28, 2006, available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=3292.

See Amendments to Regulation SHO, Exchange Act Release No. 34-54154, (July 21, 2006), available at: http://www.sec.gov/rules/proposed/2006/34-54154.pdf.

As reported in the July 26, 2006 WilmerHale Securities Email Alert, on July 25, 2006 Securities and Exchange Commission Chairman Christopher Cox announced in testimony before the US Senate Committee on Banking, Housing and Urban Affairs that he would recommend several emergency actions following the invalidation of the SEC's hedge fund adviser registration rule, Rule 203(b)(3)-2, by the US Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, No. 04-1434. Chairman Cox indicated that the emergency actions would fall into three categories:

Further information regarding this testimony is available in the WilmerHale Securities Email Alert, available at: http://www.wilmerhale.com/publications/whPubsDetail.aspx?publication=3292

SEC Chairman Christopher Cox, Testimony Concerning Regulation of Hedge Funds before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, (July 25, 2006), available at http://www.sec.gov/news/testimony/2006/ts072506cc.htm.

On June 23, 2006, the U.S. Court of Appeals for the D.C. Circuit unanimously held, in Goldstein v. SEC, that the SEC’s rules requiring registration of hedge fund advisers (the “hedge fund rule”), adopted in 2004, are arbitrary and granted the petitioners’ request to vacate and remand the rule to the SEC. Before the SEC’s adoption of the hedge fund rule, reflected in amendments to Rule 203(b)(3)-1 and the adoption of Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the “Advisers Act”), most hedge fund managers had been exempt from registering with the SEC as investment advisers under Section 203(b)(3)’s “private adviser exemption,” which is available to advisers with 15 or fewer “clients.” Specifically, even large hedge fund managers were able to take the view that they had fewer than 15 clients, and therefore been exempt from registration, because the hedge funds themselves, rather than such funds’ underlying investors, were viewed as these advisers’ “clients.” However, the hedge fund rule changed this longstanding approach, requiring an investment adviser to a private fund to treat investors in the fund as clients for purposes of determining the number of clients the adviser has. As a result of this change, many hedge fund advisers were required to register with the SEC as investment advisers by February 1, 2006. Philip Goldstein, whose firm is general partner and investment adviser to Opportunity Partners L.P., a hedge fund, challenged the SEC’s authority to adopt the rule.

In vacating the rule, the court held that the SEC’s construction of the term “client” was unreasonable, stating that the SEC’s “interpretation … comes close to violating the plain language of the statute.” In reaching this decision, the court first noted that the construction of the term “client” advanced by the SEC is inconsistent with other sections of the Advisers Act. Specifically, under Section 202(a)(11) of the Advisers Act, an investment adviser is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings…” [emphasis added]. Although an investor in a fund may benefit from a hedge fund manager’s advice indirectly, the court noted that only the fund itself is directly provided with investment advice. Accordingly, the court stated that “[i]f the person or entity controlling the fund is not an ‘investment adviser’ to each individual investor, then a fortiori each investor cannot be a ‘client’ of that person or entity.”

Similarly, the court also noted that it would be impossible for an investment adviser to owe a fiduciary duty to both a private fund and the fund’s investors, as such a relationship would inevitably produce conflicts of interest. Although the SEC sought to address this issue by arguing that under its construction investors constitute “clients” only for purposes of determining whether a hedge fund manager is required to register as an adviser, the court stated that “[the SEC] cannot explain why ‘client’ should mean one thing when determining to whom fiduciary duties are owed, and something else entirely when determining whether an investment adviser must register under the Act.” Moreover, the court also noted that the hedge fund rule’s construction of the term “client” under the statute is directly inconsistent with the [SEC]’s previous views, as the SEC provided guidance in both 1985 and 1997 indicating that an adviser’s “client” for purposes of Section 203(b)(3) is the private fund rather than the fund’s investors. The court said that the hedge fund rule might be more understandable if there had been a change in the advisory relationship between hedge fund advisers and investors, but that the SEC did not cite any evidence of this and that “there is a disconnect between the factors the [SEC] cited and the rule it promulgated.” The court further stated that absent this sort of justification, the SEC’s decision to carve out an exception from the Rule 203(b)(3)-1 safe harbor for hedge fund advisers “appears completely arbitrary.” Accordingly, although the court acknowledged that it may be understandable that “the [SEC] wanted a hook on which to hang more comprehensive regulation of hedge funds . . . . the [SEC] may not accomplish its objective by a manipulation of meaning.”

The court ordered that the issuance of its mandate be delayed until after the period permitted for the SEC to petition for a rehearing or a rehearing en banc. At present, it is unclear what actions the SEC will take in response to the decision. In a statement released concerning the decision, SEC Chairman Christopher Cox stated that “[t]he court's finding, that despite the [SEC]'s investor protection objective its rule is arbitrary and in violation of law, requires that going forward we reevaluate the agency's approach to hedge fund activity. I have instructed the SEC's professional staff to promptly evaluate the court's decision, and to provide to the [SEC] a set of alternatives for our consideration.”

We also understand that legislation may be introduced that could, if enacted, provide the statutory authority on which the SEC could require hedge fund advisers to register under the Advisers Act. According to a press release, Rep. Barney Frank of Massachusetts, Ranking Member of the House Financial Services Committee, has announced that he will introduce such legislation, possibly as early as today.

See Goldstein v. SEC, 2006 WL 1715766 (D.C. Cir. June 23, 2006) (No. 04-1434).Rep. Frank’s press release is available at http://www.house.gov/banking_democrats/pr06282006.html.

On July 18, 2006, the SEC published an interpretative release that provides guidance on money managers’ use of client commissions to pay for brokerage and research services under the “soft dollars” safe harbor, which is set forth in Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”). Section 28(e) authorizes a person who exercises investment discretion with respect to an account (a “money manager”) to cause the account to pay more than the lowest available commission if the money manager determines in good faith that the amount of the commission is reasonable in relation to the value of the brokerage and research services.

Framework for Analyzing the Scope of the “Brokerage and Research Services” under Section 28(e)

The SEC stated that the analysis of whether a particular product or service falls within the safe harbor should involve three steps.

Eligibility Criteria for “Research Services”

Section 28(e)(3) restricts “research services” to “advice,” “analyses,” and “reports.” The SEC stated that, to treat an item as eligible research, a money manager must conclude that the research reflects the substantive content and relates to the subject matters identified in Section 28(e)(3). The SEC provided examples of eligible research, including traditional research reports, discussions with research analysts, meetings with corporate executives to obtain oral reports on the performance of a company, research-related seminars and conferences, software that provides analyses of securities portfolios, and corporate governance research and rating services. The SEC elaborated that eligible research may also include: market research and data; advice from broker-dealers on order execution, strategies and market participants; and software that provides this type of information. The staff noted that proxy services may be treated as mixed-use items, as appropriate.

The SEC stated, however, that mass-market publications that are in general circulation to the retail public are not eligible research. In addition, the SEC explained that inherently tangible products and services, such as travel, entertainment, and meals associated with attending seminars or meeting with corporate executives, analysts or other individuals who may provide eligible research are not eligible under the safe harbor. Similarly, the SEC provided examples of overhead items are not eligible research services under the safe harbor: office equipment, furniture, business supplies, salaries (including research staff), rent, accounting fees and software, website design, email software, internet service, legal expenses, personnel management, marketing, utilities, membership dues, professional licensing fees, software to assist with administrative functions, computer hardware and delivery mechanisms associated with computer hardware or associated with the oral delivery of research.

Eligibility Criteria for “Brokerage Services”

The SEC stated that, for the purposes of the safe harbor, eligible “brokerage” service begins when the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution and ends when funds or securities are delivered or credited to the advised account or account holder’s agent. The SEC explained that, under this temporal standard, communications services related to the execution, clearing and settlement of securities transactions and other functions incidental to effecting securities transactions (i.e., connectivity services between the money manager and the broker-dealer and other relevant parties such as a custodian) are eligible under Section 28(3)(c)(3). In addition, the SEC stated that software used in connection with routing trades and providing algorithmic trading strategies is within the temporal standard and thus are eligible “brokerage” under the safe harbor.

The SEC noted, however, that hardware, such as telephones and computer terminals, software used for record keeping or administrative purposes and analytical software used to test hypothetical situations (e.g., for asset allocation or for portfolio modeling) do not qualify as “brokerage” under the safe harbor because these items are not integral to the execution of orders by a broker-dealer and fall outside the temporal standard. Similarly, the SEC noted that compliance testing and expenses, trade financing, and error correction services are not eligible brokerage services under the safe harbor. Finally, the SEC noted that short-term custody related to effecting specific transactions and settlement of those trades constitutes eligible brokerage services, whereas long-term custody and record keeping provided after settlement of transactions are not considered to be eligible brokerage services.

Lawful and Appropriate Assistance

In addition to satisfying the specific criteria of the statute, eligible research and brokerage services must provide the money manager with “lawful and appropriate assistance” in making investment decisions.

Mixed-Use Items

For mixed-use items, the SEC reiterated the guidance provided in the 1986 release that a money manager must reasonably allocate the cost of a product or service between its eligible and ineligible uses, and maintain adequate books and records to enable a good faith determination of such uses.

Good Faith Determination of Reasonableness

The SEC also reaffirmed the money manager’s obligation and burden of proof under Section 28(e) to make a good faith determination that commissions paid are reasonable in relation to the value of the brokerage and research services received.

Third Party Research

The SEC stated that third-party research arrangements can benefit advised accounts by providing greater breadth and depth of research. As a result, the SEC stated that it believes that the safe harbor equally encompasses third-party research and proprietary research.

Client Commission Arrangements

This interpretative release also addressed client commission arrangements under Section 28(e), which requires that a broker-dealer “providing” research must also be involved in “effecting” the transaction. In order for the Section 28(e) safe harbor to apply, an “effecting” broker-dealer must either execute, clear, or settle the trade, or perform at least one of four functions and allocate the other functions to other broker-dealers. The four functions consist of the following: (1) taking financial responsibility for all customer trades until the clearing broker-dealer has received payment, (2) maintaining records relating to customer trades, (3) responding to customer comments concerning the trading process, and (4) generally monitoring trades and settlements.

The SEC has interpreted the requirement that research services be “provided by” the broker-dealer to allow a money manager to use client commissions to pay for research from a third party other than the executing broker-dealer, so long as the broker-dealer (not the money manager) has the legal obligation to pay for the third party research or pays the research party directly, thereby “providing” the brokerage and research services required under Section 28(e).

The SEC recently adopted three new rules under the Investment Company Act of 1940 (the “1940 Act”) that broaden the ability of an investment company (“fund”) to acquire shares of another fund. The SEC also adopted related amendments to Forms N-1A, N-2, N-3, N-4 and N-6 that require that the expenses of the acquired funds be aggregated and shown as an additional expense in the fee table of the fund of funds.

Background

Section 12(d)(1) of the 1940 Act restricts the ability of a fund to invest in shares of another fund in order to prevent abuses that might result from the ability of the acquiring fund to control the assets of the acquired fund and using those assets to enrich itself at the expense of the acquired fund’s shareholders.

Section 12(d)(1)(A) prohibits a registered fund and its controlled companies or funds from:

Section 12(d)(1)(B) prohibits a registered open-end fund from selling securities to any fund (including unregistered funds) if, after the sale, the acquiring fund would:

New Rules 12d1-1, 12d1-2 and 12d1-3 codify and expand upon a number of exemptive orders issued over the years by the SEC that permitted certain fund of funds arrangements.

New Rule 12d1-1: Investments in Money Market Funds

New Rule 12d1-1 allows funds to invest in shares of money market funds in excess of the limits of Section 12(d)(1). The rule is designed to permit “cash sweep arrangements” in which a fund invests all or a portion of its available cash in a money market fund, rather than directly in short-term instruments. The exemption allows the acquired fund to be in a different fund complex or in the same fund complex. New Rule 12d1-1 also permits funds to invest in an unregistered money market fund that operates like a money market fund registered under the 1940 Act (i.e., by acquiring only eligible investments as defined in Rule 2a-7 under the 1940 Act and complying with all the other provisions of Rule 2a-7). In addition, the unregistered money market fund’s adviser must be registered as an investment adviser with the SEC, and the acquiring fund must have a reasonable belief that the unregistered money market fund operates like a registered money market fund and complies with certain provisions of the 1940 Act. Although Section 12(d)(1) does not restrict investments in unregistered money market funds, Rule 12d1-1 provides relief from the affiliated and joint transaction prohibitions of Sections 17(a) and (d) in the case of an unregistered money market fund that is affiliated with the acquiring fund (e.g., as a result of having common or related advisers or the acquiring fund owning more than 5% of the acquired fund). The exemptions of new Rule 12d1-1 are also available to closed-end funds, including business development companies. Finally, new Rule 12d1-1 permits unregistered funds to invest their cash in registered money market funds without regard to the Section 12(d)(1) limits.

Although most of the conditions attached to past exemptive orders are not reflected in the new rule, the rule provides that an acquiring fund is prohibited from paying a sales load, distribution fee or service fee on acquired fund shares, or if it does, the acquiring fund’s investment adviser must waive a sufficient amount of its advisory fee to offset these costs. Unlike the SEC’s prior exemptive orders, the rule does not otherwise limit advisory fees or require directors to make any special findings that investors are not paying multiple advisory fees for the same service.

New Rule 12d1-2: Affiliated Fund of Funds

In order to facilitate legitimate fund of funds arrangements, Congress created certain exceptions to the limits of Section 12(d)(1)(A) and 12(d)(1)(B). One of these exceptions is Section 12(d)(1)(G), which permits a registered open-end fund or a unit investment trust (“UIT”) to acquire an unlimited amount of shares of other registered open-end funds and UITs that are a part of the same “group of investment companies” (i.e., in the same fund complex). However, this exception is subject to certain limitations.

New Rule 12d1-2 provides exemptions from the Section 12(1)(G) limitations on investments that an affiliated fund of funds can make. In particular, new Rule 12d1-2 permits an affiliated fund of funds to:

New Rule 12d1-3: Unaffiliated Fund of Funds

Section 12(d)(1)(F) provides an exemption from the limits of section 12(d)(1) by permitting a registered fund to invest all of its assets in other registered funds if:

New Rule 12d1-3 permits funds relying on Section 12(d)(1)(F) to charge sales loads greater than 1.5%, provided that the aggregate sales load any investor pays (i.e., the combined distribution expenses of both the acquiring and acquired funds) does not exceed the limits established by the rules of the National Association of Securities Dealers, Inc. for funds of funds. The new rule is intended to provide funds with greater flexibility in structuring sales loads while protecting shareholders by limiting the aggregate distribution fees (rather than only sales loads) they pay.

Form Amendments

The SEC adopted amendments to disclosure requirements that require each fund (other than a feeder fund) investing in shares of other funds to disclose in its prospectus fee table the expenses of the funds in which it has invested. Form N-1A for open-end management funds was amended to require any registered open-end fund investing in shares of another fund to include in its prospectus table an additional line item titled “Acquired Fund Fees and Expenses” in the shareholder fee table and to include the costs of the acquired funds in the acquiring fund’s total annual fund operating expenses as well as the “Example” portion of the fee table.

To determine and present “Acquired Fund Fees and Expenses,” the acquiring fund would be required to:

The SEC also amended Form N-2 for closed-end management funds to require that a registered closed-end fund of funds (and a closed-end “fund of hedge fund”) include its pro rata portion of the cumulative expenses charged by the acquired funds as a line item in its fee table. In addition, each acquiring closed-end fund must determine expenses attributable to investments in acquired funds during the most recent fiscal year and expenses attributable to any intended investments assuming those investments had been held by the acquiring fund during the most recent fiscal year. For the presentation of acquired hedge fund fees, which are typically more variable than mutual fund fees, the SEC has revised instructions to require that a fund of hedge funds include a footnote to the new line item that discloses the typical performance fee charged by the acquired hedge funds in which it invests and alerts investors that the disclosed hedge fund fees are based on historical expenses and could be substantially higher or lower due to fluctuations in hedge fund performance.

Amendments to forms N-3, N-4 and N-6 require separate accounts to include similar disclosures regarding the expenses of acquired funds in their prospectuses.

Timing of New Rules and Amendments

New Rules 12d1-1, 12d1-2, and 12d1-3 are effective on July 31, 2006. All new registration statements on Forms N-1A, N-2, N-3, N-4, and N-6, and all post-effective amendments that are annual updates to effective registration statements on any of those forms filed on or after January 2, 2007 must include the new disclosure required by the amendments. SEC Final Rule Release Nos. 33-8713; IC-27399; File No. S7-18-03 (June 20, 2006).