The SEC has denied the Investment Company Institute’s ("ICI") petition to institute rulemaking to regulate portfolio investment programs as investment companies under the Investment Company Act of 1940 (the "1940 Act"). In its response to the rulemaking petition, the SEC noted that the portfolio investment programs allow investors to make their own investment decisions and to create portfolios of securities based on their own objectives. The SEC further noted that each investor in the program is the beneficial owner of the securities in his or her portfolio, unlike traditional investment companies in which investors hold undivided interests in a pool of securities. As the direct beneficial owners of the securities, investors in the programs have the right to vote and to receive dividends, confirmations, proxy statements and other documents. Each investor also has the right to withdraw or pledge the securities and sell the securities at any time.

The ICI maintained that portfolio investment programs raise investor protection issues. The SEC responded by noting that sponsors of the programs are subject to regulation under other federal securities laws. Specifically, most have registered as broker-dealers under the Securities Exchange Act of 1934 (the "1934 Act") and are thus prohibited from engaging in sales practices that may be harmful to investors. In addition, some sponsors are registered as investment advisers under the Investment Advisers Act of 1940 (the "Advisers Act"). The SEC stated that it took into consideration that there are few portfolio investment programs in existence and that they have not been in operation for a significant amount of time. The SEC noted that, as the programs develop, it will continue to consider whether any regulatory action is necessary. However, the SEC concluded that rulemaking would not be the best use of its resources at this time. SEC Today, Volume 2001-165 (August 24, 2001).

On August 21, 2001, the Investment Counsel Association of America ("ICAA") sent a letter to Paul Roye, Director of the SEC’s Division of Investment Management, containing a comprehensive proposal to the SEC to overhaul Rule 206(4)-1 under the Advisers Act. Rule 206(4)-1 governs advertising by investment advisers. The ICAA recommended that the rule be revised to incorporate a general anti-fraud standard like that applicable to investment company advertising. The rule currently makes certain advertising practices per se fraudulent.

The ICAA asserted that the SEC’s application and interpretation of the 40-year old advertising rule has significantly limited an adviser’s ability to satisfy the soaring demand by advisory clients for information about and from advisers. The letter noted that the SEC has generally restricted advisers from furnishing to their clients and consultants particular types of information, including the names of an adviser’s existing clients and testimonials from those clients, quarter-end portfolio holdings of advisers and the adviser’s gross performance results. The letter noted that banks and broker-dealers, which increasingly compete with advisers to provide advisory services, are routinely permitted to provide their customers with this information without being deemed to commit per se fraud. In addition, investors and prospective investors in mutual funds are entitled to more information from mutual funds than from their adviser.

The ICAA also argued that the current advertising rule is part of a regulatory scheme that is confusing for advisers to understand and difficult for the SEC to enforce. The ICAA noted that in order to understand the regulatory scheme an adviser must "decipher a thicket of no-action letters and enforcement proceedings". The ICAA proposal would:

• repeal the specific prohibitions contained in Rule 206(4)-1 and replace them with a general anti-fraud standard along the lines of Rule 156 under the Securities Act of 1933 governing investment companies (i.e., that an advertisement must not contain any untrue statement of a material fact or omit to state any material fact needed to make the statement in light of the circumstances of its use not misleading);
• establish minimum standards for performance results prepared for retail clients; and
• recommend that the SEC staff issue an interpretive release that clarifies and consolidates the substance of the relevant no-action letters and other SEC pronouncements in this area, and rescinds or supersedes prior positions that conflict with this proposal.

The ICAA proposal would treat retail customers differently from institutional customers, as defined in the Advisers Act. Specifically, performance presentations for retail clients would also have to disclose:

• The type of accounts or strategy presented;
• A description of how the average annual total return performance history was calculated;
• The average annual total returns of an appropriate securities benchmark index;
• The number of clients whose accounts are included in the average annual total returns presented in the advertisement;
• The total assets of all client accounts included in the returns advertised; and
• The length of, and the date of the last day in, the period used to compute the adviser’s performance history.

Securities Regulations & Law Report, Volume 33, Number 35 (September 30, 2001).

The SEC and the CFTC have adopted the first joint rules to permit the trading of security futures products in the United States. These joint rules establish the method for computing whether an index is a narrow-based security index or not (i.e., is a broad-based security index) by specifying how "market capitalization" and "dollar value of average daily trading volumes" should be determined for purposes of the CFMA's definition of narrow-based security index. The rules also list the conditions under which an index underlying a futures contract to sell a security traded on or subject to the rules of a foreign board of trade may be excluded from the definition of "narrow-based security index."

Under the Commodity Exchange Act ("CEA") and the Exchange Act, an index is a "narrow-based security index" if it has any one of the following four characteristics:

• its has nine or fewer component securities;
• any one of its component securities comprises more than 30% of its weighting;
• the five highest weighted component securities together comprise more than 60% of its weighting; or
• the lowest weighted component securities comprising, in the aggregate, 25% of the index's weighting have an aggregate dollar value of average daily trading volume of less than 50,000,000 (or in the case of an index with 15 or more component securities, 30,000,000).

Any security index that has none of these four characteristics is, in effect, a broad-based security index and would be subject only to the jurisdiction of the CFTC. The definition of narrow-based security index also excludes from its scope certain security indexes that satisfy specified criteria. For example, if each component security in the index is one of the 750 securities with the largest market capitalization and one of the 675 securities with the largest dollar value of average daily trading volume, the index is considered to be broad-based. The effective date for the new rules is August 21, 2001. SEC Release No. 34-44724 (August 20, 2001).

SEC Chairman Harvey Pitt provided House Financial Services Committee Chairman Michael Oxley with a status report on the implementation of trading in single stock futures products. Congressman Oxley had written a letter to the SEC, the Commodity Futures Trading Commission ("CFTC") and the Internal Revenue Service ("IRS") urging regulators to meet the statutory deadlines for permitting trading in single stock futures by implementing rules under the Commodity Futures Modernization Act of 2000 ("CFMA").

The CFMA, which became law December 21, 2000, lifted the 19-year ban on trading of single-stock and narrow-based stock index futures (collectively referred to as "security futures products") in the United States by providing for the joint regulation of security futures products by the SEC and CFTC. Pursuant to the CFMA, futures contracts on narrow-based indexes are to be regulated jointly by the SEC and CFTC while futures contracts on broad-based indexes are to be regulated under the exclusive jurisdiction of the CFTC. The CFMA provides that principal-to-principal transactions in security futures products may begin on August 21, 2001 and non-principal-to-principal transactions may begin on December 21, 2001.

Chairman Pitt outlined the actions the SEC is taking to permit principal-to-principal transactions among eligible contract participants. First, the SEC is assisting the National Futures Association ("NFA") in developing anti-fraud, anti-manipulation, sales practice, business conduct, examination of qualification and related disciplinary rules. He also noted that the SEC has adopted new notice registration rules for designated contract markets and registered derivatives transactions execution facilities. He further noted that the SEC anticipates that it will issue final rules to permit CFTC-registered futures commission merchants and introducing brokers to notice register as broker-dealers for the limited purpose of effecting transactions in security futures products. In addition, the SEC and CFTC are in the process of adopting final rules governing the method for determining market capitalization of average daily trading volume relating to the definition of a narrow-based security index (See summary below).

Chairman Pitt wrote that the SEC is considering whether it should publish interpretive guidance to assist national securities exchanges and associations in developing listing standards that conform to the requirements of the CFMA. The SEC is also consulting with the CFTC on whether to issue interpretive guidance or a rule to help markets that trade security futures products coordinate procedures for conducting market surveillance, maintaining audit trails and imposing trading halts and circuit breakers with the markets that trade the underlying and related securities.

He noted that the SEC is working closely with the CFTC, the NASD, the NFA and the NYSE to develop examination and qualification requirements, margin requirements, dual trading prohibitions, risk disclosure documentation and other information to permit customer trading in security futures products. He added that the SEC and the CFTC are working to avoid any duplicate or inconsistent regulations governing customer trading in these products. BNA, Inc. Securities Regulation and Law Report, Volume 33 Number 33 (August 20, 2001).

The SEC has granted exemptive and no-action relief from certain rules and regulations under the 1934 Act to allow secondary market transactions in securities of exchange traded funds ("ETFs") and the creation and redemption of such securities. The American Stock Exchange LLC ("AMEX") had sought no-action relief from those rules and regulations under the 1934 Act in order to expedite the start-up of secondary market trading of new ETFs and to reduce some of the regulatory burdens on trusts or funds that issue ETFs. Previously, ETFs could not begin secondary market trading until they had received exemptive or no-action relief from those same rules and regulations under the 1934 Act. Specifically, the staff granted exemptive and no-action relief from Section 11(d)(1) of the 1934 Act, Rules 10a-1, 10b-10, 10b-17, 11d1-2, 14e-5, 15c1-5 and 15c1-6 thereunder, and Rules 101 and 102 of Regulation M, to all ETFs trading on any registered national securities exchange that have obtained Rule 19b-4(e) listing approval from the SEC. To rely on this relief, ETFs must comply with the following conditions:

• Fund shares (which the staff defined as shares, portfolio deposit receipts or units of beneficial interest issued by ETFs for trading) must be issued by an open-end management company or a unit investment trust registered under the 1940 Act;
• The ETF must consist of a basket of 20 or more component stocks, and no one stock can constitute more than 25% of the total value of the ETF;
• At least 85% of the ETF must be comprised of component stocks that have a minimum public float value of at least $150 million and a minimum average daily trading volume ("ADTV") of at least $1 million during each of the previous two months of trading prior to formation of the ETF. However, if the ETF has 200 or more component stocks, then only 75% of the component stocks must meet the $150 million public float and the $1 million ADTV threshold;
• Each component stock must be listed on a national security exchange or the Nasdaq stock market, which may include the Nasdaq SmallCap Market;
• Fund shares may only be issued or redeemed in creation unit aggregations of 50,000 shares or more. The value of each creation unit must be at least $1 million at the time of issuance; and
• The ETF must be passively managed and track a particular index whose components are publicly available. The intra-day proxy value of the ETF and the value of the benchmark index must be publicly disseminated throughout the trading day.

The SEC noted that the relief was also subject to certain rule-specific terms. For example, the staff granted an exemption from Rule 10b-10 to permit broker-dealers who create or redeem Fund shares on behalf of their customers to confirm these creation or redemption transactions without providing a statement of the identity, price and number of shares of each individual component stock tendered to or delivered by the ETF as part of the creation or redemption transaction. The exemption does not apply to purchases and sales of fund shares in the secondary market, and is subject to the following conditions:

• any confirmation statement of the creation or redemption of fund share transactions that omits any of the information specified in paragraph (a) of Rule 10b-10 will contain a statement that this omitted information will be provided to the customer upon request;
• all requests for omitted information will be fulfilled in a timely manner in accordance with paragraph (c) of rule 10b-10, and
• confirmation statements of fund share creation and redemption transactions will contain all of the information specified in paragraph (a) of rule 10b-10 other than identity, price and number of shares of each component stock tendered or received by the customer in the transaction. The staff stated that it will continue to consider on a case-by-case basis requests for relief for ETFs not meeting the above conditions.

American Stock Exchange LLC, SEC No-Action Letter (August 17, 2001).

The SEC adopted new rules and amended existing rules to implement provisions in the CFMA that allow futures markets (1) to register as national securities exchanges by filing a written notice with the SEC and (2) to file proposed rule changes using an expedited process. Because security futures products are securities under the Securities Exchange Act of 1934 (the "Exchange Act"), Section 5 of the Exchange Act requires any organization, association or group of persons that constitutes, maintains or provides a marketplace or facilities for bringing together purchasers and sellers of security futures products to register with the SEC as a national securities exchange.

New section 6(g) of the Exchange Act provides an expedited process for an exchange that lists or trades security futures products to register with the SEC as a national securities exchange, provided that the exchange:

• is a board of trade that has been designated as a contract market or is registered as a derivative transaction execution facility; and
• does not act as a marketplace for transactions and securities other than security futures products.

New rule 6a-4 under the Exchange Act and Form 1-N specify (1) the types of markets that can register as national securities exchanges solely for the purposes of trading security futures products and (2) the information these markets must provide to the SEC. The new rule and form generally require futures markets to submit information which is comparable to that required to be provided by conventional securities exchanges. The SEC also proposed to amend Exchange Act rules 6a-2 and 6a-3 to exclude security futures product exchanges from the requirements of those rules.

The new rules and rule amendments will become effective upon their publication in the Federal Register. SEC Release No. 34-44692, August 13, 2001.

The SEC has asked the Supreme Court to review the 4th Circuit Court of Appeals' decision in SEC v. Zandford because it conflicts with the SEC's interpretations of the scope of liability under section10(b) of the Exchange Act. The case involves a stockbroker who sold securities in a customer's account without the customer's knowledge and kept the proceeds from the sale. The stockbroker was found guilty on 13 counts of wire fraud for this action. The SEC subsequently brought a civil action against the stockbroker charging him with violations of section10(b) and rule 10b-5. The District Court granted the SEC's motion for summary judgment, enjoined the stockbroker from future violations of the anti-fraud provisions and ordered him to disgorge his illegally obtained funds.

The 4th Circuit Court of Appeals reversed the grant of summary judgment and remanded the case with directions to dismiss the SEC's complaint. The Appeals Court concluded that the stockbroker's alleged fraudulent activities were not sufficiently connected to a securities transaction to merit liability under section10(b). The Appeals Court held that the security sales were incidental to the stockbroker's scheme to defraud his customer and that the goal of section10(b) would not be served by expanding its scope to include claims amounting to breach of contract or common law under state law.

In its petition for a writ of certiorari, the SEC argued that the Appeals Court's decision conflicts with earlier Supreme Court decisions and with countless SEC decisions. The SEC maintains that the Appeals Court erred in holding that the stockbroker's alleged fraudulent conversion of his client's securities and the proceeds of selling those securities were not "in connection with" those sales in violation of section10(b). The SEC argued that the fraud was interrelated and connected to securities sales because the sales were the direct result of the deception and the means by which the stockbroker accomplished his fraud. The SEC further argued that the criminal conviction established that the stockbroker defrauded his customer and that the lower court erred in holding that the securities sales were incidental to the scheme to defraud because the sales lay at the heart of the fraudulent scheme. The SEC cited a prior case in which the Supreme Court held that the existence of liability for the same actions under state law does not preclude liability under section10(b). Finally, the SEC argued that the Supreme Court should grant its writ of certiorari because letting the Appeals Court ruling stand would leave a gap in investor protection. SEC Today, Volume2001-154 (August 9, 2001).

On August 1, 2001, the Senate approved Washington attorney Harvey Pitt as a chairman of the SEC, for a term expiring June 5, 2002. In May, President Bush indicated he would designate Mr. Pitt chairman of the agency, and the Senate Banking Committee formally endorsed Mr. Pitt on July 24, 2001.

With the death of commissioner Paul Carey in June, there currently are only two commissioners: Acting Chairman Laura Unger and Isaac Hunt Jr. Once he is sworn in, Pitt will serve the remainder of Carey's term, at which time he would be reappointed for another five-year term expiring in 2007. Meanwhile, the terms of both Unger and Hunt already have expired, but they are eligible to be reappointed. Even with the addition of Mr. Pitt, the agency still will be short two commissioners.BNA Securities Regulations and Law Report, Vol. 33 No. 31, August 6, 2001.

The SEC recently issued an order further extending (until May 12, 2002) the deadlines for banks to comply with the broker-dealer registration requirements contained in the Gramm-Leach-Bliley Act. The SEC also indicated that it anticipates amending the interim final rules it issued on May 11, 2001 concerning these requirements, and the SEC issued a notice extending the comment period on the rules until September 4, 2001. The SEC does not expect banks to develop compliance systems until the SEC amends its rules. Banks have indicated that they may need as much as a year to develop compliance systems to adapt to the Gramm-Leach-Bliley Act and the rules. The SEC expects to extend the compliance date further so that banks will have sufficient time to respond to changes to the rules.

The Gramm-Leach-Bliley Act repealed a full exception that had allowed banks to engage in securities activities without registering as a broker or dealer and replaced the full exception with new functional exceptions. The new functional exceptions became effective May 12, 2001. On May 11, 2001, the SEC issued interim final rules defining terms in the statutory exceptions and granting banks additional exemptions from broker-dealer registration. The SEC gave banks until October 1, 2001, and with respect to their non-compliant compensation arrangements, until January 1, 2002 to bring their activities into compliance. These time periods have now been extended until May 12, 2002.

The SEC granted the latest extension to provide the SEC with time to explore with banks possible means of reducing compliance costs. The extension also will allow the SEC time to amend its rules while providing banks additional time to seek compliance advice regarding issues under the Gramm-Leach-Bliley Act and to explore forming relationships with broker-dealers if necessary. In July, the Director of the Division of Market Regulation informed the American Bankers Association Securities Association that requests for extensions of time for banks to come into compliance could be appropriate and would be carefully considered. This extension of time addresses these requests. SEC Press Release, 2001-73, July 18, 2001.