Investment Management Regulatory Update

Investment Management Regulatory Update
August 2006
SEC Rules & Regulations
Chairman Cox Testifies on the State of Hedge Fund
Regulation Following the Recent Goldstein Decision
On July 25, 2006, the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (“Committee”) held a hearing on the regulation of hedge funds in the
wake of the D.C. Circuit’s decision in Goldstein v. SEC, No. 04-1434, 2006
U.S. App. LEXIS 15760 (D.C. Cir. June 23, 2006), to vacate the SEC’s controversial rule requiring registration of many hedge fund advisers (“Hedge
Fund Rule”). See Registration Under the Advisers Act of Certain Hedge Fund
Advisers, 69 Fed. Reg. 72,054 (Dec. 10, 2004). Chairman Richard Shelby (RAL) and ranking member Paul Sarbanes (D-MD) presided over the hearing,
which was attended by only a handful of senators. SEC Chairman Christopher
Cox, Under Secretary of the Treasury for Domestic Finance Randal Quarles,
and Chairman of the Commodity Futures Trading Commission Reuben Jeffery
III testified. The focus of the hearing, however, was on Chairman Cox and his
view of the post-Goldstein landscape.
When asked by Senator Hagel if, post-Goldstein, the SEC possesses the authority it needs to safeguard investors and the national securities markets from the
risks posed by hedge funds, Chairman Cox
responded that, while hedge funds remain
subject to SEC regulation and enforcement
A Summary of
Current Investment
Management Regulatory
Developments
under the antifraud, civil liability and other
provisions of the federal securities laws, in
general “[t]he regulatory regime vis-à-vis
SEC to take
several emergency
initiatives in the
wake of Goldstein
hedge funds is inadequate.” Goldstein, Chairman Cox said, had left a “gaping”
regulatory hole. Chairman Cox noted, for example, that the SEC lacks “basic
Contents
SEC Rules & Regulations . . . . . . . 1
SEC Enforcement Actions . . . . . . . 9
census data” about hedge funds. He stated unequivocally that, in light of the
near calamity caused by the 1998 collapse of Long Term Capital Management
and the estimated $1.2 trillion dollars managed by hedge funds today, “[h]edge
funds are not, should not be, and will not be unregulated.”
NASD Developments . . . . . . . . . . 14
Chairman Cox did not focus exclusively on the risks posed by hedge funds, but
Industry Update . . . . . . . . . . . . . . 16
also discussed the salutary effects they have on the national securities markets.
He noted that hedge funds contribute to capital formation, market efficiency,
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price discovery and liquidity, that their role in the derivatives market helps
counterparties reduce or manage risk, and that they provide a way for institutional investors to reduce their exposure to downside risk. Because hedge
funds provide benefits along with posing risks, he counseled the Committee
against overregulation. “As a general principle . . . I would counsel that to the
maximum extent possible our actions should be non-intrusive.” The government, Chairman Cox said, should not interfere with hedge funds’ investment
strategies or operations, including the use of derivatives trading, leverage and
short selling. Legislation should not “trammel upon” hedge funds’ creativity,
liquidity or flexibility, there should be no portfolio disclosure, and hedge funds
should be permitted to charge their clients performance fees. When asked by
Senator Shelby why any legislation should not require more portfolio disclosure, Chairman Cox responded that the benefits of nondisclosure simply outweigh the risks. He stated that a hedge fund’s ability to keep its trading strategies and portfolio composition a secret is the key to its success. He also stated
that he believed there is “broad consensus” among the five Commissioners on
this point.
Chairman Cox discussed the SEC’s efforts to address the regulatory issues created by Goldstein. To that end, he informed the Committee that he had directed the SEC staff to undertake a comprehensive review of the D.C. Circuit’s
decision, and he outlined three emergency measures that he intended to propose
to the full Commission.
First, he proposed a new antifraud rule under Section 206(4) of the Investment
Advisers Act of 1940 (“Advisers Act”). He noted that, while the D.C. Circuit
had held that the antifraud provisions of Sections 206(1) and (2) apply only to
“clients” and not investors, the court itself pointed out that Section 206(4) is not
limited to fraud against “clients.” “The result,” Chairman Cox said, “would be
a rule that could withstand judicial scrutiny, and which would clearly state that
hedge fund advisers owe serious obligations to investors in the hedge funds.”
He said the SEC staff is currently evaluating the SEC’s authority to promulgate
this rule.
Second, in order to “insure that hedge fund advisers who were relying on the
now-invalidated rule are not suddenly in violation of our regulatory require2
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ments when the court issues its final mandate in mid-August,” he proposed an
emergency action so that all transitional and exemptive rules contained in the
vacated Hedge Fund Rule are restored to their full legal effect. This proposal
indicates that the SEC views Goldstein as vacating not just the client counting
rule for “private funds,” but also all of the other rules and amendments promulgated in the same rulemaking as the Hedge Fund Rule. For example, he proposed an emergency action to restore, to advisers who registered under the
vacated Hedge Fund Rule, the qualified exemption from the recordkeeping
requirement for performance data relating to periods prior to their registration.
According to Chairman Cox, if the SEC did not restore the exemption, advisers who remain registered but did not create records for the periods prior to the
registration would lose the ability to use their performance track record. This,
he said, would have the “perverse[]” effect of discouraging hedge fund advisers from voluntarily remaining registered. Similarly, Chairman Cox proposed
to restore the grandfathering provision that permitted newly registered advisers
to maintain their fee arrangements with existing clients, even if those arrangements were not otherwise compliant with Rule 205-3’s prohibition on charging
performance fees to non-“qualified clients.” Moreover, he proposed an emergency action to restore the extension of time for advisers of funds of hedge
funds to provide their audited financial statements under Rule 206(4)-2 under
the Advisers Act.
In this same vein, he proposed a rule to clarify the status of offshore advisers
of offshore funds. Under the vacated Hedge Fund Rule, offshore advisers to
offshore funds were required to register—assuming their funds had more than
14 U.S. investors—but they were subject to more limited regulation under the
Advisers Act. Cox believed that Goldstein had “creat[ed] doubt whether registered offshore advisers will be subject to all of the provisions of the
[Advisers] Act with respect to their offshore hedge funds.” Goldstein therefore
“created a disincentive for offshore advisers to remain voluntarily registered,”
which, Chairman Cox told the Committee, he had directed the SEC staff to
“address.”
Third, he proposed amending the definition of “accredited investor” as it
applies to retail investment in unregistered hedge fund offerings under
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Regulation D under the Securities Act of 1933. Hedge funds, he said, are not
for “mom and pop” investors and the current definition of accredited investor,
Commissioner Cox stated, “is not only out of date, but wholly inadequate to
protect unsophisticated investors from the complex risks of investment in most
hedge funds.” By way of example, he pointed out that one definition of an
“accredited investor” is “[a]ny natural person whose individual net worth, or
joint net worth with that person’s spouse, at the time of his purchase exceeds
$1,000,000,” and that a person’s net worth includes his house.
The
Commissioner found it alarming that, under this definition of “accredited
investor,” a California couple—where the median home price is well over
$500,000—would qualify to invest in an unregistered hedge fund with just over
$200,000 each in other assets. Chairman Cox noted that the Hedge Fund Rule
had effectively raised this net worth threshold in many cases because, pursuant
to Rule 205-3 under the Advisers Act, registered advisers can only charge performance fees (unless another exemption applies) to clients with a joint net
worth of more than $1,500,000. Chairman Cox said that he would like to see
this higher threshold restored.
A copy of Chairman Cox’s testimony is available at: http://www.sec.gov/news/
testimony/2006/ts072506cc.htm.
SEC Staff Indicates that Cash Solicitation Rule Does
Not Apply to Hedge Fund Advisers
SEC is reportedly close to
issuing written guidance
on the application of the
Cash Solicitation Rule
to hedge fund advisers
Robert Plaze, Associate Director of the SEC’s Division of Investment
Management, has reportedly indicated that the SEC does not view Rule 206(4)3 under the Investment Advisers Act of 1940 (the “Cash Solicitation Rule”) as
applying to the solicitation of investors for hedge funds managed by registered
investment advisers. Reports of Mr. Plaze’s comments follow earlier reports
that, in a recent outreach meeting with chief compliance officers, the staff of the
SEC’s Northeast Regional Office announced that investment advisers would no
longer be cited for failing to comply with the Cash Solicitation Rule with
respect to such solicitations. While this position has not yet been confirmed in
writing, Davis Polk understands that the SEC will soon issue written guidance on
the application of the Cash Solicitation Rule to registered hedge fund advisers.
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Senior SEC Staff Member Testifies on SEC Concerns
with Side Letters
SEC takes a dim view
of side letters that
benefit one investor at
the expense of others
In her recent testimony before the Senate Committee on Banking, Housing and
Urban Affairs, Susan Ferris Wyderko, Director of the SEC’s Office of Investor
Education and Assistance, discussed the SEC’s views on side letters used by
hedge fund advisers. According to Ms. Wyderko, the SEC is most concerned
with side letters that “involve material conflicts of interest that can harm the
interests of other investors.” As the primary examples of this type of side letter, Ms. Wyderko cited “those that give certain investors liquidity preferences
or provide them with more access to portfolio information.” Other side letters,
however, “address matters that raise few concerns, such as the ability to make
additional investments, receive treatment as favorable as other investors, or
limit management fees and incentives.” A copy of Ms. Wyderko’s testimony is
available at: http://www.sec.gov/news/testimony/ts051606sfw.htm.
SEC Issues Interpretive Guidance on “Soft-Dollar” Use
Under Section 28(e) of the Exchange Act
On July 18, 2006, the SEC issued interpretive guidance (the “Release”) that
defines the scope of the safe harbor under Section 28(e) of the Securities
Exchange Act of 1934 (the “Exchange Act”), which permits money managers
to use client commissions, or “soft dollars,” to purchase “brokerage and
research services.” The SEC’s guidance is effective as of July 24, 2006, but
market participants may continue to rely on its prior interpretations of Section
28(e) until January 24, 2007.
Fiduciary principles generally require money managers to seek the best execution for client trades. However, Section 28(e), originally enacted in 1975,
allows money managers to use client commissions to purchase “brokerage and
research services” under certain circumstances without breaching the fiduciary
duties they owe to their clients. More specifically, Section 28(e) includes a safe
harbor that allows a money manager to cause an account to pay more than the
lowest available commission if such manager determines in good faith that
such commission is reasonable in relation to the value of the brokerage and
research services received.
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Consistent with the SEC’s proposed guidance which was published for comment in October 2005 (the “Proposed Guidance”) and is described in greater
detail in the November 2005 Investment Management Regulatory Update, the
Release articulates a framework for analyzing the availability of the safe harbor for any particular product or service. Specifically, in assessing whether a
product or service falls within the safe harbor, an investment manager must: (a)
determine whether the product or service is research or brokerage within the
meaning of Section 28(e)(3); (b) determine whether the eligible product or
service actually provides “lawful and appropriate assistance” to the manager in
the performance of his decision-making responsibilities; and (c) make a good
faith determination as to whether the amount of client commissions is reasonable
in light of the value of the products or services provided by the broker-dealer.
With respect to the first step, to qualify as “research services” under Section
SEC narrows the Section
28(e) safe harbor for
use of soft dollars by
money managers
28(e), products or services must constitute “advice,” “analyses” or “reports.”
Adopting the analysis of this statutory requirement set forth in the Proposed
Guidance, the Release provides that, in order to be considered research, the
product or service must demonstrate an “expression of reasoning or knowledge” relating to the subject matter set forth in Section 28(e)(3)(A) or (B) (i.e.,
the securities or financial markets). In contrast, items with inherently tangible
or physical attributes are generally excluded from the research category. In its
discussion of the application of this interpretation, the Release provides examples of eligible research items, including traditional research reports on particular issuers or securities, discussions with research analysts and certain financial newsletters and trade journals, to name a few. Among the examples of ineligible research items are mass-marketed publications, travel, entertainment and
meals associated with attending seminars or conferences, and various overhead
items. In addition, computer hardware, including terminals and accessories,
and the delivery of research (e.g., telephone lines and computer cables) are
ineligible as research under the safe harbor.
The SEC also addresses the scope of “brokerage services” under Section 28(e).
Under Section 28(e), a person provides brokerage services when he or she
“effects securities transactions and performs functions thereto (such as clearance, settlement, and custody) or required in connection therewith . . . .”
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Interpreting this statutory language in the Release, the SEC adopts a temporal
standard, which was introduced in the Proposed Guidance, to distinguish
between those products and services that are eligible as “brokerage” and those
that are not. Specifically, eligible brokerage services occur during the period
that “begins when the money manager communicates with the broker-dealer
for the purposes of transmitting an order for execution and ends when funds or
securities are delivered or credited to the advised account of the account holder’s agent.” The following are examples of items that are eligible as brokerage
according to the Release: trading software; communications services related to
the execution, clearing and settlement of securities transactions; and incidental
brokerage services associated with clearance, settlement and short-term custody services. The SEC cites overhead, such as telephones, computer terminals
and software functionality used for recordkeeping or administrative purposes
and expenses related to compliance responsibilities, as ineligible. In contrast,
“research” includes services provided before the communication of an order.
As in the Proposed Guidance, the Release retains the concept of “mixed-use”
items—i.e., items that are partly eligible and partly ineligible for the safe harbor—a concept that the SEC introduced in its 1986 soft-dollar guidance. As in
the Proposed Guidance, the SEC’s Release indicates that the safe harbor protects only the use of client commissions for the eligible portion of the mixeduse items. The Release thus reemphasizes the need for managers to document
adequately allocations between eligible and ineligible aspects of such “mixeduse” items.
As noted above, in addition to determining that an item properly qualifies as
research or brokerage, an adviser must also determine that (a) it provides “lawful and appropriate assistance” to him in the performance of his investment
decision-making responsibilities and (b) the amount of client commissions
used to purchase the item is reasonable. As before, conduct not protected by
Section 28(e) may constitute a breach of fiduciary duty, as well as a violation
of the securities laws, particularly the Investment Advisers Act of 1940 and the
Investment Company Act of 1940.
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The Release also provides detailed guidance on the status of third-party
research, commission-sharing arrangements and other related topics that are
beyond the scope of this summary. For a more detailed discussion of the
Release, please ask your Davis Polk contact for a copy of the Davis Polk
Interested Persons Memorandum, dated August 1, 2006, regarding the Release.
A copy of the Release is available at: http://www.sec.gov/rules/interp/2006/3454165.pdf.
Executive compensation
requirements will apply
to BDCs and the
threshold for disclosure
of independent director
transactions will
be increased for all
investment companies
SEC’s Changes to Executive Compensation Disclosure
Requirements Affect Investment Companies
On July 26, 2006, the SEC issued a press release (the “Release”) announcing
its long-anticipated decision to adopt changes to the rules governing disclosure
of executive compensation in proxy statements, registration statements and
other filings (the “New Rules”). While the text of the New Rules has not yet
been published in the Federal Register, it is our understanding that the New
Rules were adopted substantially as proposed. Davis Polk will be monitoring
commentary and analyzing the text of the adopting release, once published.
The New Rules impact business development companies (“BDCs”) and other
investment companies in several ways. First, according to the Release, the new
executive compensation disclosure requirements will apply in their entirety to
BDCs. Second, the New Rules change for all investment companies the disclosure requirements relating to certain interests, transactions and relationships
of independent directors by, among other things, increasing the threshold for
disclosure from $60,000 to $120,000. Third, the proxy rules applicable to all
investment companies will be reorganized to “reflect organizational changes
proposed for operating companies.”
Investment companies will generally be required to comply with the New
Rules as of December 15, 2006.
The SEC’s press release regarding the New Rules is available at:
http://www.sec.gov/news/press/2006/2006-123.htm.
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SEC Enforcement Actions
SEC Settles Charges that a Financial Newsletter is an
Investment Adviser in Violation of the Advisers Act
Weiss Research is
ordered to pay a
penalty of $350,000
and to disgorge over
$1.6 million for
Advisers Act violations
On June 22, 2006, the SEC issued an order in settlement of charges that Weiss
Research, Inc., a publisher of newsletters about securities, its owner Martin
Weiss and its editor Lawrence Edelson (collectively, the “Respondents”) violated various provisions of the Investment Advisers Act of 1940 (the “Advisers
Act”). Weiss Research, which has not been registered as an investment adviser pursuant to Section 203(a) of the Advisers Act since 1997, publishes
newsletters that provide general commentary about the securities markets as
well as “premium services” newsletters that recommend specific securities
transactions.
In its order, the SEC found that, between September 2001 and April 2005,
Weiss Research enabled its premium services subscribers to engage in “autotrading,” whereby subscribers authorized their broker-dealers to execute automatically all transactions recommended in the Weiss Research newsletters. In
addition, Weiss Research allegedly misled its subscribers in a number of
ways—by disseminating advertisements that selectively highlighted profitable
trades and presented an unrealistic picture of Weiss Research’s success rate and
by representing that subscribers would receive expert trading advice from
Edelson despite his actual lack of involvement.
The SEC found that Weiss Research met the definition of “investment adviser”
under Section 202(a)(11) by engaging in the business of advising others as to
the buying and selling of securities in response to market activity for an annual
fee. Although Section 202(a)(11)(D) carves out an exception to the definition of
“investment adviser” for “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation,”
the exclusion applies only so long as communications between the newsletter
and its subscribers remain “entirely impersonal and do not develop into the
kind of fiduciary, person-to-person relationships that . . . are characteristic of
investment advisers-client relationships.” Lowe v. SEC, 472 U.S. 181, 210
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(1985). According to the SEC, Weiss Research’s auto-trading program rendered
it ineligible for the Section 202(a)(11)(D) exception. As such, the SEC found,
Weiss Research violated Section 203(a) of the Advisers Act by failing to register as an investment adviser and Martin Weiss aided and abetted its violation.
In making claims about profitability and past performance in advertisements
that were inconsistent with overall past performance and mischaracterizing
Edelson’s role, Weiss Research was also found to have violated, and Martin
Weiss and Edelson to have willfully aided and abetted violations of, Sections
206(2) and 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder,
which specifically prohibits an adviser from using false or misleading advertisements. In addition, the SEC found that Weiss had willfully violated, and
Martin Weiss and Edelson willfully aided and abetted violations of, Rule
206(4)-1(a)(2) under the Advisers Act, which makes it unlawful for an adviser’s advertising to refer to specific past recommendations without providing a
complete list of all recommendations made within one year.
Without admitting or denying the SEC’s findings, the Respondents agreed to
settle the charges against them. The SEC ordered each of the Respondents to
cease and desist from further violations of Advisers Act Sections 206(2) and
206(4) and Rules 206(4)-1(a)(2) and (5) thereunder; the SEC also ordered each
of Weiss Research and Martin Weiss to cease and desist from further violations
of Section 203(a) as well. In addition to various remedial undertakings, Weiss
Research was ordered to pay over $1.6 million in disgorgement and prejudgment interest and a civil penalty of $350,000. Martin Weiss and Edelson were
ordered to pay a civil penalty of $100,000 and $75,000, respectively.
A copy of the SEC’s order is available at: http://www.sec.gov/litigation/
admin/2006/ia-2525.pdf.
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Jury Finds CEO of Adviser to PIMCO Mutual Funds
Liable for Improper Market Timing
Stephen Treadway
is found liable for
improper market
timing in PIMCO
mutual funds
On June 30, 2006, the SEC announced that, in a civil suit brought by the SEC,
a federal jury found Stephen J. Treadway, the former chairman of the board of
the trustees of the PIMCO equity mutual funds, liable for defrauding investors
through an undisclosed market-timing arrangement with Canary Capital
Partners LLC (“Canary”). Treadway was also the chief executive officer of
PIMCO Advisors Fund Management LLC (“PAFM”), which along with PEA
Capital LLC (“PEA”) is the adviser to the PIMCO funds, and PIMCO Advisors
Distributors LLC (“PAD” and together with PAFM and PEA, the “PIMCO
Entities”), the funds’ distributor. The SEC filed charges on May 6, 2004, (and
an amended complaint on November 10, 2004) in the U.S. District Court for
the Southern District of New York.
Previously, on June 16, 2006, Kenneth W. Corba, the former chief executive
officer of PEA agreed to settle substantially similar civil fraud charges brought
against him by the SEC. Corba agreed to pay a $200,000 civil penalty and consented to an order barring him from association with any investment adviser (with
the right to reapply after one year), without admitting or denying the allegations.
In its complaint, the SEC alleged that, from February 2002 until April 2003, the
PIMCO Entities enabled Canary to execute more than $4 billion in market-timing trades in PIMCO mutual funds through approximately 108 round-trip
trades. The PIMCO Entities allegedly did so in exchange for long-term
investments (i.e., so-called “sticky assets”) by Canary in a mutual fund and a
hedge fund from which PAFM and PEA earned management fees. According
to the SEC, Corba negotiated the market-timing arrangement with Canary,
while Treadway approved it. Corba and Treadway allegedly discussed the
Canary arrangement approximately once per month but, despite increasing
reservations, allowed it to continue. In addition, according to the SEC’s complaint, the PIMCO funds’ prospectuses, as both Treadway and Corba knew,
failed to disclose the Canary market-timing arrangement and were therefore
false and misleading.
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After an eight-day trial before the Honorable Victor Marrero, the jury found
Treadway liable for violating (and/or for 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.
As discussed in the October 2004 Investment Management Regulatory Update,
the PIMCO Entities agreed in September 2004 to pay $50 million to settle the
related SEC charges against them.
A copy of the SEC’s release announcing the jury verdicts is available at:
http://www.sec.gov/news/digest/2006/dig070306.txt.
A copy of the SEC’s
original complaint against Treadway, Corba and the PIMCO Entities is available at: http://sec.gov/litigation/complaints/comp18697.pdf.
SEC Settles Charges that Major Wall Street Firm
Failed to Maintain and Enforce Inside Information
Policies
Major Wall Street firm
agrees to pay $10 million
in settlement of charges
over deficient insider
trading policies
On June 27, 2006, the SEC issued an order in settlement of charges that
Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc. (collectively, the “Respondents”), both of which are registered broker-dealers and investment advisers, failed to maintain adequate policies and procedures to prevent
employees from misusing material nonpublic information (“inside information”). The charges alleged that the Respondents violated Section 204A of the
Investment Advisers Act of 1940 (the “Advisers Act”) and Section 15(f) of the
Securities Exchange Act of 1934 (the “Exchange Act”), which require registered investment advisers and registered brokers and dealers, respectively, to
maintain and enforce written policies and procedures reasonably designed to
prevent misuse of inside information in violation of the federal securities laws.
In its order, the SEC found that, from as early as 1997 until 2006, the
Respondents’ policies and procedures suffered from a number of systemic deficiencies. For example, from 1997 until 2005, the Respondents allegedly failed
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to conduct surveillance of trading of the securities of approximately 3,000
issuers that appeared on the firm’s “Watch List.” (Among their other policies
and procedures designed to prevent misuse of inside information, the
Respondents maintained a so-called Watch List of companies about which they
possessed material nonpublic information.) The SEC also found that, from
2000 until 2004, the Respondents failed to conduct surveillance of hundreds of
thousands of employee and employee-related accounts (whether or not within
the Respondents) to determine whether securities had been traded based on
inside information. Moreover, from 1997 to 2006, the Respondents’ written
policies relating to Watch List surveillance allegedly failed to give adequate
instructions to personnel on how to conduct such surveillance. As a result of
such deficiencies, the SEC found, the Respondents may have failed to detect
illegal insider trading by them, their employees or persons related to their
employees.
Without admitting or denying the SEC’s findings, the Respondents agreed to be
censured, to pay a civil penalty of $10 million and to cease and desist from
future violations of Section 204A of the Advisers Act and Section 15(f) of the
Exchange Act. The Respondents are also required to retain an independent
consultant to review and report on their procedures for (i) preventing future
misuse of inside information and (ii) for examining retrospectively the trading
that was not previously monitored.
A copy of the SEC’s order is available at: http://www.sec.gov/litigation/
admin/2006/34-54047.pdf. A copy of the SEC’s press release announcing the
settlement is available at: http://www.sec.gov/news/press/2006/2006-103.htm.
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NASD Developments
SEC Approves Amendments to Mutual Fund
Advertising Rules Proposed by the NASD
Amendments to NASD
Rules 2210 and 2211
will require disclosure
of expense ratios in
performance advertising
In a release dated July 5, 2006 (the “Release”), the SEC announced its approval
of a NASD proposal to amend two NASD rules—Rule 2210 and Rule 2211—
relating to advertising by mutual funds. As approved, the amendments (the
“Approved Amendments”) will require mutual fund advertisements that contain performance information also to include certain expense and standardized
performance information. These new requirements are intended to improve
investor awareness of the costs associated with buying and owning a mutual
fund and to facilitate the comparison of funds.
Specifically, the Approved Amendments will require NASD members to
include the following information in advertisements and other communications with the public that present performance information for non-money
market funds: (a) the fund’s standardized performance information, calculated
in accordance with Rule 482 under the Securities Act of 1933 and Rule 34b-1
under Investment Company Act of 1940 and set forth in a type size at least as
large as that used for any non-standardized performance information; (b) the
fund’s maximum sales charge imposed at the time of purchase or the maximum deferred sales charge; and (c) the fund’s total annual operating expense
ratio as stated in the fund’s most recent prospectus (i.e., gross of any fee
waivers and expense reimbursements). All such information must be set forth
clearly and prominently.
In response to letters from five commenters, the Approved Amendments differ
in three notable ways from the amendments that were originally proposed by
the NASD in March 2004 (the “Initial Proposal”). First, whereas the Initial
Proposal would have mandated that all required performance information and
fee disclosures in advertisements (other than radio, television and video advertisements) be set forth in a prominent “text box” containing only the required
information, the Approved Amendments will restrict the text box requirement
to print advertisements (i.e., not websites or other electronic advertisements)
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Investment Management Regulatory Update
D
A Summary of Current Investment Management Regulatory Developments
August 2006
and will permit other pertinent comparative data and disclosures required by
Rules 482 and 34b-1 to be included in the text box. In addition, funds will be
able to use hyperlinks to show such standardized performance information and
other disclosures, subject to certain conditions.
Second, whereas the Initial Proposal would have required performance sales
material to show a fund’s annual operating expenses gross of fee waivers and
reimbursements, the Approved Amendments clarify that, in addition to the
unsubsidized expense ratio, the materials may also include the expense ratio net
of fee waivers and reimbursements as long as the subsidized ratio is presented
in a fair and balanced manner in accordance with Rule 2210.
Third, the Initial Proposal stated that the NASD would publish a Notice to
Members announcing SEC approval within 60 days of such approval and that
30 days thereafter the new requirements would become effective. However,
the Approved Amendments provide that the rule change will take effect six
months following the end of the calendar quarter after publication of the Notice
to Members. In addition, NASD members will be permitted to file with the
NASD on a case-by-case basis templates to show how performance sales material will be revised to satisfy the new rule requirements.
Comments on the Approved Amendments may be submitted on or before
August 2, 2006.
A copy of the Release is available at: http://sec.gov/rules/sro/nasd/2006/3454103.pdf.
A copy of the Approved Amendments is available at:
http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_01
5684.pdf.
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Investment Management Regulatory Update
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A Summary of Current Investment Management Regulatory Developments
August 2006
Industry Update
U.S. Pension Bill Passes the Senate Without
Amendment
The U.S. Senate passed a version of the pension bill on August 4, 2006 before
Contacts
If you have questions about the
foregoing, please contact the following:
Marlene Alva
212-450-4467
marlene.alva@dpw.com
the start of its summer recess. The bill, which was passed by the House of
Representatives on July 28, had been negotiated among members of the House
and Senate conference committee charged with reconciling the pension bills
passed by each chamber earlier this year. The bill passed by Congress includes
a plan asset provision, which leaves the test at 25% for benefit plan investors
in a private investment fund (determined on a class-by-class basis), but
excludes governmental and non-U.S. plans from the definition of benefit plan
investors.
Nora Jordan
212-450-4684
nora.jordan@dpw.com
Yukako Kawata
212-450-4896
yukako.kawata@dpw.com
Leor Landa
212-450-6160
leor.landa@dpw.com
There had been haggling to get the
bill bundled with estate tax and minimum wage reforms, but the House
and Senate approved the pension
Bill would exclude governmental and
non-U.S. pension plans
from the plan asset test
bill separately so that they could
begin their summer recess. For the bill to become law, President Bush must
sign it. If he does so, the plan asset change will be effective immediately.
Danforth Townley
212-450-4240
danforth.townley@dpw.com
Caroline Adams
212-450-4061
caroline.adams@dpw.com
Gregory Rowland
212-450-4930
gregory.rowland@dpw.com
This memorandum is a summary for general
information only. It is not a full analysis of
the matters presented and should not be
relied upon as legal advice.
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