In a recent speech to the Investment Company Institute's annual Mutual Fund Compliance Conference, Lori A. Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), offered practical guidance on three "critical" areas of fund compliance: pricing, portfolio trading and disclosure. 

Pricing

According to Ms. Richards, the more difficult a portfolio security is to value, the more the mutual fund board of directors should be involved in understanding the pricing methodology. Ms. Richards stated that accurate mark-to-market valuation and daily pricing of a fund's portfolio securities instill confidence in investors, who want to buy and sell fund shares at the real value of the fund's portfolio that day. Fund boards are required to establish procedures to price portfolio assets at their "fair value" in the event that market prices are not readily available. Fair value is the amount a fund would expect to receive upon the current sale of the security. 

Based on OCIE's recent examinations, Ms. Richards suggested that compliance officials at the conference should consider the following practices:

• Making sure that there are good checks and balances in the valuation process.
• If valuation committees are established by fund boards or advisers, having written policies and regular meetings, and keeping minutes.
• Understanding the pricing process, particularly in the case of difficult to value securities, including the criteria considered and the valuation methods used.
• If using a pricing service, understanding exactly what services that pricing service provides.
• Using two pricing services to obtain two independent pricing recommendations and checking for discrepancies.
• Not relying solely on the portfolio manager for valuations because, while the portfolio manager can be used to review valuations of individual securities, he or she has a built-in conflict of interest.
• If using an automated checking routine that searches for day-to-day price changes in individual securities that exceed some threshold percentage, making sure that someone actually checks on the reasons for the increase or the decrease in the prices.
• Having controls on when it overrides prices from external sources (e.g., a pricing service or broker-dealer), including policies outlining when overrides are allowed and procedures to ensure supervisors' approval and documentation of all overrides.
• Making sure that someone who is not involved in the pricing process, such as compliance staff, reviews all overrides to look for individual overrides that aren't supportable, and for patterns of overrides that suggest problems. Also, providing a periodic report to the board on all overrides and the reasons for them.
• Monitoring for ‘stale pricing’ to determine if someone is overriding incorrectly or if, in fact, something wrong with the input.

 In other remarks, Richards recommended that when fair value is used, an adviser should compare any sales in the market to the fair value for accuracy. Be sure that, over time, fair values are not consistently high or low compared to actual sales prices, she told the compliance conference. In addition, she suggested providing this data periodically to the fund board, which oversees the process.

Ms. Richards also advised her audience to take "shadow pricing" of money market funds seriously. She noted that most money market funds use amortized cost to value their portfolios and compute their daily net asset values, and are required to shadow price. Shadow pricing gauges the difference between the amortized cost value and the market value of a money market fund’s portfolio. Ms. Richards stated that, when there is a deviation between the two measures, an adviser should take appropriate action to bring these two values back in line.

Portfolio Trading

In the area of portfolio trading, Ms. Richards set forth several practices that OCIE thinks should be considered, including:

• the establishment by some advisers of a committee to review trade placement and best execution, which aids in identifying all factors that are important to the firm in routing trades;
• the establishment of criteria to measure these factors, including maintaining documentation of the process;
• the provision to the fund's board of enough information to fulfill its oversight responsibilities; and
• a process to identify, question, resolve, and disclose conflicts of interest in trade placement.

Disclosure

Finally, Ms. Richards focused on disclosure by an adviser to its clients and potential clients. She cautioned conference attendees about several situations that especially require disclosure to be "precise, accurate, and fulsome," including:

• using performance numbers in advertisements or client presentations;
• disclosing the firm's policies for obtaining best execution;
• routing fund portfolio orders to the broker-dealers that sell the fund's shares;
• routing customer orders to broker-dealers in exchange for client referrals;
• allocating investment opportunities among clients on other than a pro-rata or other basis that is fair to all clients; and
• advertising performance numbers that were generated under circumstances or conditions that are not likely to be repeated.

In a recent letter to the SEC, the Financial Planning Association (the "FPA") voiced its strong opposition to any SEC plans to develop an exemption for thrift institutions under the Investment Advisers Act of 1940 (the "Advisers Act"). The exemption initiative, which Paul F. Roye, director of the SEC's Division of Investment Management described and endorsed in March 26 and May 4 speeches in Washington and New York, would build on the existing bank exemption from the Advisers Act. The exemption would be created by amending the definition of "bank" in the Advisers Act to include thrift institutions.

If such an exemption is granted, the FPA said, thrift customers could face risks that they would not face if the Advisers Act applied. According to the FPA, these risks, it said, would result from:

• the practice of recommending sales of securities from the thrift's affiliated brokerage firm's inventory;
• the absence of minimum competency standards;
• the lack of restrictions on advertising the performance of a thrift's "model" portfolios;
• the lack of general disclosure requirements to provide information about the thrift's investment practices and other general aspects of the firm; and
• the inability of SEC examiners to conduct routine examinations of a thrift's advisory activities--examinations that would reveal undesirable practices, including commingling of client funds; unsuitable investment recommendations; and failure to disclose to investors a thrift employee's disciplinary history.

In the letter, the FPA criticized the SEC for not adhering to "functional regulation" principles, which would mitigate against such an exemption. Functional regulation is the concept of having the same expert regulator overseeing like activities, regardless of the type of entity engaging in those activities. The FPA urged that by defining "bank" to include thrift institutions in the Advisers Act, the SEC would act inconsistently with its own public policy arguments strongly supporting functional regulation of the financial services industry.

Moreover, the letter expressed concern that a new exemption for thrifts would:

• reduce investor protection by eliminating disclosure to investment adviser clients of conflicts of interest, qualifications, and other critical information;
• further "erode the level playing field for investment advisers and financial planners by adding to the list of exempted industries that wish to provide identical or similar advisory services;" and
• be outside of the SEC’s rulemaking authority by providing exemptive relief to a specific industry group in contravention of the congressional intent of the Gramm-Leach-Bliley Act.

The FPA urged the SEC not to a engage in a piecemeal approach to requests by industry groups who seek exemptions from the Advisers Act for competitive reasons. Rather, the FPA called on the SEC to place a moratorium on any new exemptions from the Advisers Act until it undertakes a comprehensive analysis of investment adviser activities by other industries, and determines in a public forum what exemptions are necessary. (BNA Securities regulation and Law report, Vol. 33, No. 4 (June 18, 2001).

The SEC recently issued an interpretive release on the applicability of E-SIGN to SEC recordkeeping requirements. The release provides that E-SIGN is not applicable to manually-signed signature pages or other documents authenticating signatures appearing in typed form in documents filed with the SEC via EDGAR, or which are permitted to be filed in paper form. It states that issuers should continue to retain paper copies of these documents. The release also provides that certain other identified records may be retained in electronic form.

E-SIGN seeks to promote electronic commerce by encouraging the use of electronic records and signatures. Generally, E-SIGN provides that a signature, contract or other record relating to any transaction within its scope may not be denied enforceability solely because it is in electronic form or solely because an electronic signature or electronic record was used in its formation. E-SIGN also encourages the electronic storage of records and authorizes regulatory agencies to set standards and formats for retention of electronic records. Specifically, under E-SIGN, an electronic record satisfies the record retention provisions of a statute, regulation or other rule if the electronic record

• accurately reflects the information set forth in the contract or other records; and
• remains accessible to all persons who are entitled to access by statute, regulation or rule of law, for the period required by such statute, regulation or rule of law, in a form that is capable of being accurately reproduced for later reference.

Although E-SIGN generally supersedes pre-existing regulatory requirements that a record be kept in paper form if the record is generated for a business, consumer or commercial transaction, E-SIGN does not supersede record-retention rules for records generated principally for governmental purposes. Accordingly, in its interpretive release, the SEC states that E-SIGN does not apply to the provision in Regulation S-T that requires issuers to retain manually-signed signature pages or other documents that signatories must execute in order to authenticate conformed (typed) signatures that appear in electronically filed documents (i.e., documents filed via EDGAR). The SEC reiterated that these documents must be manually executed before or at the time the issuer makes an electronic filing. The filer must retain the documents for a period of five years and furnish them upon request to the SEC staff upon request. The SEC further noted that this interpretation applies to comparable requirements under Securities Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Exchange Act").

The SEC stated that in its view, the requirements to retain authenticated original documents are not subject to E-SIGN because these are records generated principally for governmental purposes rather than in connection with a business, consumer or commercial transaction. Moreover, the SEC noted that governmental filings, to which these documents relate, are expressly excluded from E-SIGN. The SEC did, however, note that other rules under Regulation S-T, the Securities Act and the Exchange Act requiring issuers to retain records that do not expressly require that the records be maintained in paper form may be interpreted by issuers as allowing the use of electronic records, provided that the storage method selected offers the same assurances of accuracy and accessibility as are provided by paper retention. (SEC Rel. Nos. 33-7985; 34-44424; IC-25003. )

17f-7 Risk Profiles Due By July 2ndAs described in last week’s Industry News Summary, the compliance deadline for the amendments to Rule 17f-5 and new Rule 17f-7 is July 2, 2001. This means, among other things, that funds should be sure that their custodians have provided the fund or its adviser with a risk analysis describing the custodial risks of using each foreign depository.

The ICAA recently issued a comment letter on the SEC’s April 2000 proposed amendments to Form ADV Part II, which proposed amendments, if adopted, would update and revise Form ADV to accommodate electronic filing in the Investment Adviser Registration Depository (IARD). The ICAA’s letter, which supplements a June 2000 comment letter, urges the SEC to make certain modifications to the rules governing the proposed brochure and brochure supplement that comprise Part II of Form ADV.

The ICAA noted that, after lengthy discussion with the staff of the SEC’s Division of Investment Management, it now understands that the staff’s intent in proposing the rule amendments was not to require a detailed and lengthy discussion of advisers’ internal policies and procedures, but rather to disclose potential or actual conflicts and briefly describe policies and procedures for handling such conflicts. Nevertheless, the ICAA reiterated its suggestion that the SEC decrease the length and complexity of the proposed narrative brochure by eliminating the following requirements:

• listing of firm periodicals or reports;
• listing of wrap fee programs;
• discussion of third party fees or expenses;
• discussion of cash balance practices;
• discussion of commission recapture;
• disclosure of performance standards and verification; and
• inclusion of the index under Item 19.

The ICAA stated that it believes that these proposed disclosures would not provide material or meaningful information to clients, and that narrowing the scope of the disclosure would better focus client attention on the more important items to be evaluated.

The letter urges the SEC to narrow the scope of the brochure supplement to cover only those advisory employees who make discretionary decisions or substantially formulate advice regarding investment strategies for clients (rather than those advisory personnel who merely communicate investment advice to the client who receives the supplement, as specified in the proposal). The letter also suggests several alternative means of disclosing the qualifications of members of a team or committee of portfolio managers, and recommends that the SEC set forth a facts-and-circumstances analysis--using seven specified factors--for an advisory firm to determine whether a supervised person has substantial responsibility for formulating the advice a client receives.

The letter recommends that brochure supplements be delivered only to retail clients, not to all clients. Under the ICAA recommendation, retail clients would include natural persons other than "qualified clients" as defined in Rule 205-3 under the Investment Advisers Act of 1940. In order to be a qualified client, a natural person must have a net worth of $1.5 million or $750,000 in assets under management with the adviser.

In addition, the letter recommends that stickers to brochure supplements be required only to disclose new disciplinary events, whereas the SEC proposal would require that advisory firms sticker brochure supplements whenever they become "materially inaccurate." The ICAA expressed concern that the stickering requirement could prove extremely burdensome and costly for advisory firms.

Finally, the letter urges the SEC to ease the burdensome delivery requirements of the proposal, which would require advisory firms to deliver a reprinted brochure or sticker to every client and prospective client each time the brochure is amended, as well as to summarize separately the material changes in the brochure for clients and to offer clients a copy of the brochure annually. In lieu of the SEC’s annual offer-with continuous-stickering approach, the ICAA recommends that the SEC require that advisers deliver an updated brochure to clients on an annual basis. This requirement would be conditioned on:

In what is believed to be the first ever case alleging "portfolio pumping," the SEC recently filed securities fraud charges in the United States District Court for the Southern District of New York against an individual principal of two investment management entities, the investment management entities, and three hedge funds managed by the investment management entities. The defendants were charged with market manipulation and with fraudulently inflating and misrepresenting the value of one of the hedge funds. Among other things, the SEC charged that the principal manipulated upward the market price of the common stock of a company in which the hedge fund held an interest at the end of each month during the last five months of 2000. This conduct is commonly known as "portfolio pumping." The SEC alleges that the principal caused approximately $2.4 million in fund redemptions to be made at the inflated fund values for his and his entities’ benefit to the detriment of the fund’s other investors.

The SEC's complaint alleges that, beginning in August 2000, the principal caused the month-end net asset value of the hedge fund to be fraudulently inflated in two ways:

• The principal manipulated the month-end closing price of a small capitalization (bulletin board) company in which the hedge fund was heavily invested. The company’s common stock price was used to determine the value of the preferred stock and common stock warrants in the hedge fund’s portfolio. At the end of each month from August through December 2000, the principal and the hedge fund’s management company purchased large quantities of the company’s common stock through brokerage accounts held for the benefit of other affiliated hedge funds. The defendants’ purchases on these days accounted for 80% or more of the retail purchase volume in the company’s stock. These purchases manipulated the company’s stock price upward at the end of each month, in some cases more than doubling it.
• For the months of November and December 2000, the company warrants were assigned arbitrary values in one of the hedge fund’s portfolios, which values were higher even than the price of the underlying common stock.

The SEC's complaint alleged that, by artificially inflating the value of the hedge funds’ portfolios, the defendants:

• caused additional investors to subscribe to the funds at inflated net asset values; and
• realized redemptions of more than $2.4 million from the funds for the benefit of the principal and the management companies, and to the detriment of other investors.

Among other relief, the SEC seeks an immediate freeze of $1 million in the principal’s assets, representing an amount that the principal redeemed for his personal benefit . SEC v. Burton Friedlander, et al., Civil Action No. 01 Civ. 4658, SDNY (LR-17021).

Fund groups maintaining assets with foreign custodians and depositories should be aware that the compliance deadline for the amendments to Rule 17f-5 and new Rule 17f-7 is July 2, 2001. On or before the compliance deadline:

• A fund’s board must have taken all actions necessary to delegate to its custodian responsibilities as "Foreign Custody Manager" under amended Rule 17f-5 (or the board itself must have made the requisite determinations under that rule)
• A fund’s assets maintained with foreign depositories must be maintained with "eligible securities depositories" as defined in the rule;
• A fund’s custodian must provide the fund or its adviser with a risk analysis describing the custodial risks of using each foreign depository; and
• A fund's contract with its custodian must provide for a minimum standard of care requiring the exercise of "reasonable care, prudence and diligence" in performing custodial duties under the rule.

The requirements applicable to registered investment companies, investment advisers and broker-dealers under Regulation S-P have a mandatory compliance date of July 1, 2001. These rules generally require these entities to:

• Implement policies and procedures to protect "nonpublic personal information" of individuals who are your customers; and
• Issue initial and annual privacy notices to individuals who are or become customers.

Special Alert for Hedge Fund Sponsors

At the June 5, 2001 meeting, the EU Council of Ministers (the "Council") formally adopted a common position on the pending UCITS I and UCITS II proposals.

• The UCITS I proposal would amend the UCITS Directive to provide UCITS funds with greater flexibility in the types of investments they may make (e.g., investments in other funds, including non-UCITS funds, and money market instruments).
• The UCITS II would (1) impose requirements on management companies of UCITS funds, (2) provide a limited "passport" for management companies to operate throughout the European Union and to manage pension funds, and (3) allow for a simplified prospectus for UCITS funds that all member states must accept.

In adopting a common position, the Council made certain changes to the preliminary text, which had been agreed to by the counsel in October 2000 (for UCITS I) and in March 2001 (for UCITS II). Of note, in UCITS II, the Council introduced specific rules for self-managed investment companies that have not designated a management company to avoid any distortion of competition between UCITS funds constituted as investment companies and UCITS funds managed by management companies.

The Council now has adopted formally common positions on both proposals and has forwarded them to the Parliament for a second reading. It is expected that the Parliament will begin its second reading of both UCITS proposals this fall. (Investment Company Institute Memorandum 13596 (June 7, 2001) ; Council of the European Union, Interinstitutional File 1998/0242 (COD).)

The United States District Court for the District of New Jersey recently granted defendants’ motion to dismiss claims for breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940 in a case brought by shareholders against seven closed-end municipal bond funds, their advisers and certain officers of the funds and the advisers.

The central issue related to the funds’ use of leverage. According to the plaintiffs, the calculation of the advisory fee created greater incentive to keep the funds leveraged, even when this may not have been in the best interest of shareholders. The plaintiffs alleged that:

• the conflict of interest created by the fee arrangement, as well as the issuance of preferred stock in connection with the leveraging strategy, was not adequately disclosed; and
  
• the fact that the advisers collected their fee in the face of such a conflict of interest amounted to a per se breach of fiduciary duty. In granting defendants’ motions for summary judgment, the court rejected both of these claims.

The court, however, found that the plaintiffs failed to prove a breach of fiduciary duty under Section 36(b). In addition, the court rejected plaintiffs’ attempt to incorporate state law fiduciary duty doctrines into Section 36(b) and plaintiffs’ contention that the defendants’ prospectus disclosure of the method of calculating advisory fees was inadequate. Moreover, the court found that the officers’ receipt of salaries was insufficient to subject them to liability under Section 36(b).

Because the plaintiffs had waived any claim that the advisers’ fee was excessive, their recovery hinged on a finding that the receipt of compensation in the face of a conflict of interest was per se a breach of fiduciary duty. In reaching its decision, the court declined to limit the application of Section 36(b) to recovery of excessive advisory fees (i.e., it declined to follow the Gartenberg precedent). Nevertheless, the court found plaintiffs’ allegations supporting this claim inadequate. Even if the advisers calculated their fees in a manner that represented an actual conflict with the interests of the shareholders and the funds, the court found that this is not per se a breach of fiduciary duty by the funds’ directors. The court emphasized that the approval of the advisory agreement by the funds’ directors is strong evidence against the contention that the advisers breached their fiduciary duty to the funds or their shareholders. Green v. Fund Asset Mgmt., L.P., et al., C.A. No. 97-3502 (DRD)(D.N.J. June 5, 2001).