The SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management provided interpretive guidance on how the effects of a carryover or reversal of prior year financial statement misstatements should be considered in quantifying current year financial statement misstatements, as set forth in Staff Accounting Bulletin No. 108 (the “Bulletin”).

The interpretive guidance set forth in the Bulletin is designed to address the use by registrants of two different methods for quantifying the amount of misstatements that were not corrected at the end of the prior year: (1) the income statement approach and (2) the balance sheet approach.

Under the income statement approach, the error is quantified as the amount by which the current year income statement is misstated (i.e., as though the error originated in the current year, thereby ignoring the “carryover effects” of prior year misstatements). Under the balance sheet approach, the error is quantified as the cumulative amount by which the current year balance sheet is misstated (i.e., regardless of the year the error originated).

The Bulletin states that registrants should quantify misstatements using both income statement and balance sheet approaches, and evaluate the error measured under each approach. The Staff noted in its press release announcing the Bulletin that exclusive reliance on either the income statement approach or the balance sheet approach would not be sufficient. The Bulletin noted that the primary weakness of the income statement approach is that it does not consider the correction of prior year misstatements in the current year (i.e., the reversal of the carryover effects) to be errors. The Bulletin further noted that the primary weakness of the balance sheet approach is that it can result in the accumulation of significant misstatements on the balance sheet that are individually deemed immaterial in part because the amount that originates in each year is quantitatively small.

Thus, a registrant’s financial statements would require adjustment when either approach results in a misstatement that is material, after considering all the relevant quantitative and qualitative factors. The staff noted in its press release to the Bulletin, however, that it would not object if a registrant recorded a one-time cumulative effect adjustment to correct errors existing in prior years that previously had been considered immaterial – qualitatively and qualitatively – based on appropriate use of the registrant’s previous approach (either income statement or balance sheet), so long as all relevant qualitative factors were considered. Finally, when first applying the guidance in the Bulletin, a registrant need not restate its financial statements for fiscal years ending on or before November 15, 2006 “if management properly applied its previous approach.”

SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management Release Staff Accounting Bulletin 108, SEC Press Release No. 2006-153 (Sept. 13, 2006), available at http://www.sec.gov/news/press/2006/2006-153.htm. A copy of Staff Accounting Bulletin No. 108 is available at http://www.sec.gov/interps/account/sab108.pdf.

The Second Annual Investment Management Compliance Testing Report was released this week, representing the polling of 450 compliance professionals spanning a diverse cross-section of the industry’s registered investment advisers, though weighing more heavily in favor of small to mid-sized firms.

Wide variance remains evident in the internal compliance testing practices used by investment advisory firms, but the widespread nature of internal compliance testing in general amongst investment advisers is clear. A full 57% of firms polled conduct compliance testing on an ongoing basis, while 30% test annually, 11% test quarterly and 2% test monthly.
With respect to entertainment and gift-giving restrictions, the report found that a full 85% of firms reported having a written policy governing gifts and entertainment, but only 35% of firms have actually tested compliance with the policy. Such an internal policy is often a firm’s primary source of guidance on the subject, given that no regulatory authority clearly addresses entertainment expenses and the $100 limit per year on broker-gifts put forth by the Financial Industry Regulatory Authority (“FINRA”) is relatively narrow.

With respect to the prevention of insider trading, approximately 60% of firms report having no active detection or testing. And 85% of respondents indicated that their firm had not yet assessed whether employees were gaining access to material non-public information more generally to identify those in need of testing.

As for following up with individual employees, over 50% of firms report not checking the timeliness of the filings required of certain employees, such as holdings and transaction reports. A similar number of firms fail to compare the personal trades made by an employee against those for which pre-clearance was actually obtained.

The primary reasons given for the less rigorous compliance testing practices of certain investment advisory firms included the small size of the firm, the high quality of the firm’s personnel and the nature of the firm’s investments.

BoardIQ, “Compliance Survey Gives Details on Testing Practices,” (September 18, 2007).

In a report released September 17, 2007, GAO recommended a number of improvements to be made by the SEC in its enforcement investigation process and distribution of captured funds to victims. The report suggests that the SEC: 1) establish written policies for approving new enforcement investigations, 2) expedite the closure of stalled investigations, and 3) make concrete plans for a new office to facilitate the Fair Fund victim-restitution program.

The report found that the lack of written procedures governing the review and approval of new investigations continues to hinder the SEC’s move to centralize this process under the SEC’s Division of Enforcement, slowing the staff’s work and preventing effective oversight.

Also of concern are the “time-consuming administrative requirements” necessary to close an investigation. The burdensome process is the primary reason given by SEC officials for the backlog of open investigations which, although no longer active, continue to have negative reputational and business consequences for the subject of the investigation.

A “largely decentralized approach” is cited by the report as the root of the SEC’s delay in distributing to victims approximately 79% of the $8.4 billion captured in enforcement actions under the Fair Fund victim-restitution program. Decentralization leads to delay by impeding the development of uniform procedures and specialized staff necessary to find harmed investors, address the complexity of individual cases and solve related tax issues.

The SEC publicly endorsed GAO’s recommendations prior to their formal release in the September 17, 2007 report and is committed to “moving with alacrity” towards their implementation, according to SEC Chairman Christopher Cox. Efforts already underway include plans to close approximately 450 investigations on an expedited basis and steps towards creation of the new centralized Fair Fund office within the Division of Enforcement, to be called the “Office of Distributions, Collections, and Financial Management.”

BNA Securities Law Daily, “GAO Recommends SEC Update Policies on Opening, Closing Probes,” (September 18, 2007).

A copy of the GAO report (GAO-07-820), “Securities and Exchange Commission: Additional Actions Needed to Ensure Planned Improvements Address Limitations in Enforcement Division Operations,” can be obtained at: http://www.gao.gov/new.items/d07830.pdf 

In response to Congressional requests, the US Government Accountability Office (GAO) recently issued a report on the status of the risk-based examination process being implemented by the SEC’s Office of Compliance Inspections and Examinations (OCIE). The risk-based examination process was adopted in 2005 to better allocate scarce SEC resources and entails a shift in focus from the routine testing of all registered investment advisers and companies towards a more targeted approach, concentrating on those firms perceived to be the greatest comparative risk to investors.

Under the risk-based examination process, each investment adviser receives a risk-rating from OCIE. The high-risk rating is automatically assigned to the nation’s 20 largest investment advisers, as calculated on the basis of assets under management. All other investment advisers receive a risk-rating upon completion of their routine OCIE examination. For the approximately 70% of investment advisers who have not been subject to OCIE examination since risk-rating was introduced in 2002, an algorithm is used by the SEC to issue a risk-rating on the basis of publicly available information about the adviser thought to indicate risks inherent in the firm’s business.

The report found the accuracy of high-risk ratings to be questionable, with 75% of investment advisers initially rated as high-risk in 2006 subsequently being reclassified into a lower-risk category. Low-risk ratings appear more reliable, however, with only 9% of investment advisers initially rated as low-risk in 2006 subsequently being reclassified into a higher-risk category.

To improve the accuracy of OCIE’s risk-rating methodology, GAO suggests that OCIE begin reviewing the compliance reports that firms are currently required to prepare and maintain on-site and then factoring into its calculations a firm’s efforts to mitigate risk.

Investment Company Institute “GAO Report on OCIE’s Risk-Based Examination Program,” (September 17, 2007).

A copy of the GAO report (GAO-07-820) “Securities and Exchange Commission: Steps Being Taken to Make Examination Program More Risk-Based and Transparent,” can be obtained at: http://www.gao.gov/new.items/d071053.pdf

Numerous private equity and hedge fund advisers received a challenging examination letter in August of 2007 from the New York regional office of the U.S. Securities and Exchange Commission (SEC). The selection of the letter’s recipients does not appear to be targeted, and a response from the investment adviser is generally expected within two weeks.

The 27 page letter requests that recipients furnish to the SEC a comprehensive list of the adviser’s: 1) clients, employees and relatives of employees who serve as officers or directors of publicly traded companies, and 2) any business relationships with broker-dealers who have previously referred clients or investors to the adviser. The letter also requires the adviser to provide narrative description of its business in multiple sections.

The information requested by the letter appears to be broader in scope than that historically required of investment advisers by the SEC. Significant concern has arisen amongst the letter’s recipients as a result of the expense of compiling such information in short order and the risk of incurring criminal liability for false statements made in haste.

SEC spokesman John Nestor has described the examination letter as a “new information request to help firms identify an adviser’s access to non-public information, and the controls advisers may have put in place to prevent insider trading.” The examination letter may alternatively be viewed as an SEC response to the recent congressional investigative report noting the need for improvement in the SEC’s management of enforcement investigations.

Ignites, “Attorneys Crying Foul Over SEC Exam Letter,” (September 6, 2007).

CNNMoney.com, “SEC Eyes Insider Trading at Hedge Funds: Agency Sends Hedge Funds and Private Equity Firms a List of Questions to Figure Out which Employees and Clients Could Acquire Key Information,” (September 18, 2007).

A copy of the letter can be obtained at: http://acacompliancegroup.com/news/documents/SEC_NYRO_Request_List-Aug2007.pdf 

On September 7, 2007, during a House Ways and Means Committee (Committee) hearing, Representative Sander Levin (D-MI) introduced legislation that would allow tax-exempt entities to invest directly in US-based hedge funds without being subject to tax for “unrelated business taxable income” (UBTI). Levin stated that the Committee is reviewing the entire US tax code to make it as fair as possible. Levin explained that the current rules were not intended to apply to this kind of investment and the proposed legislation would permit all tax-exempt entities, including foundations, to invest directly in onshore hedge funds without being subject to UBTI.

The text of the proposed legislation is available at: http://www.house.gov/apps/list/press/mi12_levin/levin.pdf 

The CFA Institute recently adopted new guidance to clarify the types of records firms should maintain to satisfy the Global Investment Performance Standards (GIPS) requirements. This guidance is effective October 31, 2007.

The guidance does not contain any new requirements and is not intended to be an all-inclusive list of all records a firm must maintain. The guidance relates only to those records necessary to satisfy the GIPS standards and the guidance emphasizes that a firm must continue to meet any and all applicable regulatory record-keeping requirements. The guidance, among other things, provides that a firm must maintain sufficient records for each performance period presented in a GIPS compliant presentation to: (1) permit the recalculation of portfolio-level returns, (2) permit the recalculation of composite-level returns, (3) provide support for why a portfolio was assigned to a specific composite or was excluded from all composites, (4) provide support for any claim of GIPS compliance on a firm-wide basis, (5) evidence the maintenance of all policies and procedures that support the claim of GIPS compliance, and (6) ensure that the records and information provided by third-party service providers meet the GIPS standards. The guidance also provides that a firm should maintain any additional records, such as marketing materials, internal and third-party systems control reports, third-party service agreements, board and committee meeting minutes, client fee schedules and agreements, other fee data and underlying benchmark data (if not publicly available), necessary to support a claim of GIPS compliance.

The CFA Institute’s guidance can be obtained at: http://www.gipsstandards.org/standards/guidance/develop/pdf/recordkeeping.pdf 

On September 10, 2007, during a panel discussion at the SEC’s annual Seniors Summit, Mary Shapiro, FINRA Chief Executive Officer, discussed the status of new regulatory sweeps. She announced that the first new sweep relates to whether brokers are using “professional” designations to mislead and defraud investors. She explained that the second new sweep examines whether early retirement seminars are designed to entice older workers to liquidate their retirement funds and invest them with a specific firm or representative. In addition, FINRA is in the process of conducting sweeps relating to the protection of seniors and the sale of collateralized mortgage obligations, as well as the sale of life settlements.

At the Seniors Summit, Lori Richards, Director of the SEC’s Office of Compliance Inspections and Examinations, also discussed the findings of a year long multiple regulator sweep of “free lunch seminars” offered by financial institutions seeking to sell various financial products using the offer of a free lunch to encourage attendance. Many sponsors of these seminars also offer door prizes, such as free golf and vacation deals, to increase attendance. The SEC, FINRA and many state securities regulators conducted sweeps in connection with free lunch seminars held in Florida, California, Texas, Arizona, North Carolina, Alabama and South Carolina and the regulators examined advertisements and sales literature, customer transactions, and supervisory systems, and policies and procedures. The regulators issued deficiency or caution letters to 78 percent of the entities examined. Problems included misleading sales materials (57 percent), supervision deficiencies (59 percent), unsuitable recommendations regarding the purchase of securities (23 percent) and fraud (13 percent).

BNA Securities Law Daily, Sweep of “Free Lunch” Seminar Sponsors by SEC, FINRA, NASAA Reveals Problems (September 11, 2007).

On September 5, 2007, the SEC settled an administrative proceeding against an investment adviser and its chief compliance officer (CCO) relating to allegations that the adviser breached its fiduciary duty by failing to disclose material information in its marketing materials about certain sources of revenue that created potential conflicts of interest.

According to the settlement order, the adviser provided non-discretionary investment consulting services primarily to pension plans and other large institutional investors to assist in the development of investment strategies and the recommendation of prospective money managers. The adviser also sold subscriptions for periodic reports based on information compiled from the adviser’s proprietary databases, which contained performance results, company profiles and descriptions of various investment products. The settlement order alleges that, because the adviser received compensation from some of the money managers it recommended to its clients for subscriptions to these reports, the adviser should have disclosed this potential conflict of interest to its clients in all of its marketing materials. Although the subscription service was disclosed in the adviser’s Form ADV Part II, the adviser’s marketing materials did not disclose sufficient information about the subscription service to enable clients and prospective clients to understand the potential conflicts of interest inherent in such sales. Instead, the adviser made materially misleading statements that created the false impression that the adviser did not have any potential conflicts of interest.

Although the CCO caused the adviser to discontinue its subscription services, and the adviser hired a new CCO, the adviser and the former CCO were censured and ordered to pay civil money penalties of $175,000 and $40,000, respectively.

SEC Administrative Proceeding File No. 3-12746, Release No. 2642 (September 5, 2007) can be obtained at: http://www.sec.gov/litigation/admin/2007/ia-2642.pdf.

On September 7, 2007, the SEC approved new FINRA Rule 2821, which is intended to improve broker dealer sales practices concerning purchases and exchanges of deferred variable annuities. The Rule would apply only to an investor’s initial purchase of or exchange into a deferred variable annuity product and not to reallocations or subsequent premium payments made after the initial purchase or exchange.

The Rule is intended to supplement, not replace, NASD’s other rules relating to suitability, supervisory review, supervisory procedures and training. Thus, to the extent the Rule does not apply to a particular transaction, NASD’s general rules on these matters would continue to govern when applicable. The Rule has four major components:

• Suitability Requirements. In order to recommend the purchase or exchange of a deferred variable annuity, a member is required under the Rule to have a reasonable basis to believe that each transaction is suitable in accordance with the NASD’s general suitability rule, Rule 2310. In particular, the member must have a reasonable basis to believe, among other things, that the customer has been informed of various features of variable annuities and would benefit from certain features of deferred variable annuities. In addition, the Rule also requires, among other things, that a registered representative consider the types of charges that would be incurred by the customer, any loss of existing benefits and any potential benefits from product enhancements and improvements. The Rule requires that the associated person recommending the transaction document these considerations, as well as any other customer-specific information, taken into account and sign the documentation.
• Principal Review. The Rule requires a registered principal to review the transaction and approve the transaction prior to submission of the application no later than seven business days after the customer signs the application. The Rule also requires the registered principal to document and sign documentation evidencing the review.
• Supervisory Requirements. Members are required to develop and maintain supervisory procedures that are reasonably designed to achieve compliance with the Rule. The Rule also requires surveillance procedures and corrective policies and procedures to address inappropriate exchanges and associated persons involved in inappropriate exchanges.
• Training Requirements. Members are required to develop and implement training programs that are tailored to educate registered representatives and registered principals on the features of deferred variable annuities and the requirements of the Rule.
  
  

The SEC's release approving the Rule can be obtained at: http://www.sec.gov/rules/sro/nasd/2007/34-56375.pdf.

The SEC’s release granting exemptions from Rules 15c3-1 and 15c3-3 under the Securities Exchange Act of 1934 is available at: http://www.sec.gov/rules/exorders/2007/34-56376.pdf.

On September 5, 2007, Eric Sirri, Director of the SEC’s Division of Market Regulation commented before the House Financial Services Committee on recent events in the US credit and mortgage markets. He explained that, in light of the recent developments in the subprime mortgage and credit markets, the SEC has begun a review of credit rating agencies’ policies and procedures regarding ratings of residential mortgage-backed securities (RMBSs) and collateral debt obligations (CDOs), the advisory services such agencies provide to underwriters and mortgage originators, their conflicts of interest, disclosures of their rating processes, the agencies’ rating performance after issuance, and the meanings of the assigned ratings. During questioning by the Committee, Sirri identified two types of conflicts of interest: (1) the manner in which credit rating agencies are compensated (either by the underwriters or customers), and (2) the methodology used and meaning of ratings.

In addition to the SEC’s review of credit agencies, a rating agency’s spokesman stated that the New York Attorney General has issued subpoenas in connection with its investigation of credit rating agencies’ policies and procedures.

BNA Securities Law Daily, “SEC, New York Attorney General Probing Policies, Actions by Credit Rating Agencies,” (September 10, 2007).

A copy of Mr. Sirri’s comments before the House Financial Services Committee can be obtained at: http://www.house.gov/apps/list/hearing/financialsvcs_dem/090507.shtml.