SEC Rules and Regulations
SEC Postpones Discussion of New Hedge Fund Measures
After planning to discuss two hedge fund-related measures at an open meeting held on December 4, 2006, the SEC revised its agenda on December 1 to withdraw both items. The withdrawn items are: (1) whether to propose a new antifraud rule under the Investment Advisers Act of 1940 to prohibit advisers from making false or misleading statements to investors in certain pooled investment vehicles they manage, including hedge funds; and (2) whether to propose a new rule under the Securities Act of 1933 to increase the $1 million threshold for natural persons to be considered “accredited investors” for purposes of investing in certain privately offered investment vehicles. As such, both measures would have responded to the June 23, 2006, decision of the U.S. Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), to vacate the SEC’s controversial rule requiring many hedge fund advisers to register. As discussed in greater detail in the August 2006 Investment Management Regulatory Update, Chairman Christopher Cox discussed both potential measures in testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on July 25, 2006. An SEC spokesman reportedly explained that the discussion of the measures was postponed because the SEC wanted “another week to make sure the technical language of the antifraud provision appropriately addresses the court’s decision.” These topics are expected to come up at the next scheduled SEC open meeting on December 13, 2006. Significant further developments will be monitored and addressed in future newsletters.
SEC Interpretations
SEC Responds to Closed-End Funds Regarding Applications for Exemptive Relief from Section 19(b) of Investment Company Act
On October 31, 2006, SEC spokesman John Heine reportedly confirmed that the SEC has sent letters to approximately two dozen closed-end funds laying out proposed terms for an exemption from the restrictions of Section 19(b) of the Investment Company Act of 1940 (the “40 Act”) and Rule 19b-1 thereunder. According to Heine, the SEC will discuss the particulars with applicants on a case-by-case basis and no timetable has yet been set for granting or denying the exemptive relief.
Pursuant to Section 19(b) of the 40 Act and Rule 19b-1 thereunder, closed-end funds may not distribute realized net long-term capital gains more than once every 12 months. Therefore, while closed-end funds may pay managed distributions (i.e., regular dividends that do not depend on the amount of income a fund earns or capital gains it realizes) to stockholders from net investment income, short-term capital gains or paid-in capital, without first obtaining exemptive relief, funds must obtain an exemptive order before paying distributions from long-term capital gains.
Prior to 2004, the SEC routinely granted exemptive relief from the restrictions of Section 19(b) and Rule 19b-1 (a “19(b) Order”). However, in 2004, the SEC imposed a temporary moratorium on processing applications for 19(b) Orders to allow it to consider the disclosure accompanying managed distributions that pay dividends from long-term capital gains. As a result, the applications of many closed-end funds remain on hold, and the funds themselves are in limbo.
One example of a fund whose application for a 19(b) Order has been pending since 2004 is the Boulder Fund Complex. In a letter dated June 1, 2006, representatives of the Boulder Fund Complex asked the SEC about the status of the Boulder Funds’ April 2004 application for exemptive relief. The Boulder Funds' letter expressed concern that the SEC’s unresponsiveness would “have a long-term negative impact on the market valuations” for the Boulder Funds and that funds with applications pending generally were at a “distinct disadvantage” compared to those whose applications were processed prior to the moratorium. The letter added that there did not appear to be any “public policy reason why investors should not have the opportunity to select a closed-end fund with a periodic fixed distribution policy” and that investors in the Boulder Funds had been given sufficient disclosure.
In its August 4, 2006, response, the SEC explained that, before issuing a 19(b) Order, it needs to consider public interest concerns, including the goal of investor protection. In particular, the SEC stated that it had been “carefully evaluating the continuing appropriateness and effectiveness of the conditions under which existing 19(b) Orders have been issued in light of (a) the policies and purposes underlying Section 19(b) of the 40 Act and Rule 19b-1 thereunder and (b) the manner in which some funds have implemented their managed distribution plans and have directly and indirectly communicated information about their plans to investors.” The SEC indicated that it was “nearing completion” of its evaluation and “would soon be in a position to resume processing applications for 19(b) Orders.” Based on Heine’s comments, it appears that the SEC may now be moving forward with that process.
SEC Enforcement Actions
SEC Settles Charges that Investment Advisers Failed to Disclose Material Facts Regarding Revenue-Sharing Arrangements
On November 8, 2006, the SEC announced the settlement of charges that three subsidiaries of Hartford Financial Services Group Inc.—Hartford Investment Financial Services, LLC (“Hartford Investment”), HL Investment Advisers, LLC (“HL Advisers”) and Hartford Securities Distribution Company, Inc. (“Hartford Distribution” and, collectively, the “Respondents”)—misrepresented and failed to disclose to fund boards and shareholders their practice of directing brokerage commissions to broker-dealers in exchange for the marketing and distribution of fund shares. Hartford Investment serves as the registered investment adviser, distributor and underwriter for 51 retail mutual funds (the “Retail Funds”); HL Advisers serves as the registered investment adviser for the 36 funds supporting Hartford’s variable and fixed annuity products (the “HLS Funds” and, together with the Retail Funds, the “Funds”); and Hartford Distribution, a registered broker-dealer, serves as the underwriter to, and distributor of the shares of, the HLS Funds and group and registered annuity products.
According to the SEC’s order (the “Order”), between January 2000 and December 2003, Hartford Investment and Hartford Distribution, with the knowledge and approval of HL Advisers, entered into revenue-sharing agreements with 73 broker-dealers whereby the Hartford entities directed brokerage commissions (which are a fund asset) to these broker-dealers in exchange for special marketing and distribution benefits (also known as “shelf space”) for the Funds. Such benefits included placement on preferred fund lists, increased access to broker-dealers’ sales forces, placement on websites and participation in conferences. The SEC alleged that, by remunerating the broker-dealers for these benefits, the Respondents incentivized the broker-dealers to increase sales of the Funds, which, in turn, increased the management fees and sales charges paid to the Respondents.
As fiduciaries, Harford Investment and HL Advisers owed a duty to the Funds’ boards to disclose the existence and details of such revenue-sharing arrangements, but, according to the SEC, failed to do so. In addition, according to the Order, the Funds’ prospectuses and statements of additional information misled shareholders by stating that Hartford Investment and Hartford Distribution pay for shelf space out of their own assets, not those of the Funds. The SEC also found that, by using fund assets to satisfy their own financial obligations under the revenue-sharing arrangements, the Respondents violated their own written guidelines.
Based on such conduct, the SEC found that Hartford Investment and HL Advisers violated, and Hartford Distribution caused and aided and abetted violations of, Section 206(2) of the Investment Advisers Act of 1940, which prohibits fraud against clients, and Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, which prohibit the making of untrue statements of material fact in the offer or sale of securities. In addition, the SEC concluded that Hartford Investment and HL Advisers violated Section 34(b) of the Investment Company Act of 1940 by making untrue or materially misleading statements in a registration statement.
The Respondents neither admitted nor denied the SEC’s findings. In addition to censuring the Respondents and ordering them to cease and desist from future violations of the securities laws, the SEC ordered the Respondents to pay, jointly and severally, disgorgement of $40 million and a civil penalty of $15 million, all of which will be distributed to the affected Funds. The Respondents must also comply with certain remedial undertakings.
Industry Update
SEC Chairman Notes the Quickening Pace of Enforcement Actions in the Second Half of 2006
In a statement issued on November 2, 2006, SEC Chairman Christopher Cox reportedly discussed the marked increase in the pace of SEC enforcement actions in the second half of fiscal 2006. According to Cox, 308 enforcement actions were brought from April through September of 2006, as compared to only 266 actions brought in the previous six months. Notably, the investment adviser and investment company area constituted 17% of all enforcement actions in fiscal 2006 and, as such, was the second-highest area of enforcement, with financial disclosure and reporting in first place. Other areas of enforcement included delinquent filings, broker-dealer, securities offerings, insider trading and market manipulation.
A copy of Cox’s statement was not available at press time.
SEC Staffer Michael Garrity Discusses the Results of Sweep Exams of Funds
In remarks before an audience of chief compliance officers of investment advisers and investment companies at the SEC’s CCOutreach National Seminar on November 14, 2006, Michael Garrity, assistant director in the SEC’s Boston district office, discussed sweep exams performed by the SEC in the last three years. The sweeps fell into two main categories: (1) risks that are not identified; and (2) insufficient risk control. According to Garrity, unidentified risks are those associated with new products, business lines or regulatory requirements, while insufficient risk controls occur when a business grows faster than its internal controls.
One of the SEC’s unidentified risk sweeps related to mutual fund investment in exchange traded funds (“ETFs”). Under the Investment Company Act of 1940 (the “40 Act”), mutual funds are limited in the amount of exposure they can have to other funds, including ETFs. Because ETFs act like mutual fund structures by holding baskets of equities or other securities, yet trade like individual stocks, investing in ETFs may bring a mutual fund into conflict with the 40 Act’s restrictions. According to Garrity, more than half of the mutual funds examined in the SEC’s sweep improperly invested in ETFs, either by failing to identify ETFs as covered by the 40 Act’s restrictions on fund exposure, or by failing to test for fund exposure altogether.
Another unidentified risk that Garrity highlighted related to performance fees charged by funds and their third-party intermediaries. Although performance fees are generally prohibited by Section 205 of the Investment Advisers Act of 1940, they are permitted pursuant to certain exceptions. According to the SEC’s sweep related to this issue, a number of funds employ performance fees to link the interests of advisers with those of investors, but approximately two-thirds of the advisers examined did not satisfy one of the Section 205 exceptions. The staff attributed this error to “a failure to focus on a methodology for imposing performance fees.”
Overcharges by broker-dealers which offer separately managed accounts provided an example of inadequate risk control. In some instances, these overcharges were attributable simply to a miscalculation of fees.
Garrity also discussed redemption fees, which are used to discourage market timing. Under the 40 Act, fund boards must either adopt redemption fees or expressly reject them. The SEC’s sweeps found that most funds were relying on third-party brokerage firms or transfer agents to impose a redemption fee and had inadequate controls in place to monitor these fees. For funds whose assets are held in omnibus accounts, Garrity advised that the best course of action is for a transfer agent to track activity on an individual basis, maintain individual records and impose fees based on individual records. Based on the sweeps, Garrity noted that several funds failed to disclose adequately: (1) reliance on intermediaries; (2) redemption fee waivers; (3) mistakes in redemption fees which resulted from manual calculation errors; and (4) incorrect coding of accounts.
SEC Is Moving Toward Bringing Enforcement Actions over Hedge Fund “Side Pocket” Abuses
In remarks at a recent hedge fund compliance conference, Bruce Karpati, the SEC assistant regional director for New York, reportedly warned that side pockets, which have long been a concern for regulators, are increasingly becoming an SEC enforcement priority. According to Karpati, side pockets, which are sub-accounts containing separate share classes that typically represent illiquid investments, can motivate hedge fund managers to conceal under-performing assets, thus making investor losses appear lower than they actually are. Karpati highlighted a March 2006 enforcement action against Global Crown Capital, LLC, an investment adviser whose principals are alleged to have fraudulently concealed hedge fund losses by setting up a “redemption reserve” that was not disclosed to investors. By adding the reserve’s dollar amount to the net income statement, the principals allegedly made investor losses appear lower than they actually were.
In his remarks, Karpati also reportedly highlighted hedge fund asset valuation, trading abuses and asset allocation practices of hedge fund advisers as additional SEC enforcement priorities.
A copy of Karpati’s remarks was not available at press time.
Director of SEC’s Division of Investment Management Gives Keynote Address at SIA Institutional Brokerage Conference
On October 30, 2006, in comments made at the Securities Industry Association’s Institutional Brokerage Conference, Andrew J. Donohue, director of the SEC’s Division of Investment Management, discussed investment adviser brokerage practices.
On the topic of best execution, Donohue expressed his concern that although investment advisers understand the best execution requirement, in practice advisers may not be “truly seeking best execution.” Rather, Donohue stated that other considerations may be influencing advisers in placing client trades. As an example of such a consideration, Donohue cited the practice of directing brokerage to particular brokers in order to meet or offset the advisers’ own revenue-sharing obligations. Donohue highlighted Rule 12b-1(h) under the Investment Company Act of 1940, which requires registered funds to implement policies and procedures to prevent the practice of directing brokerage in exchange for distribution-related activities. In particular, Donohue reminded his audience that Rule 12b-1(h) applies to “all of a mutual fund’s portfolio trades and arrangements with both brokers and dealers, and does not refer only to brokerage, as did the prior NASD rule.”
On a practical level, Donohue advised that asset managers should consider “one key question” before placing a trade—namely, “[a]m I using this broker dealer on the basis chosen because it is best for my client, or because of other considerations?” According to Donohue, “[i]f the answer is ‘because it is best for my client,’ the analysis is done, the adviser has generally met its fiduciary obligations, and the trade should go forward as contemplated.” Donohue advised that there may be other considerations, however, some of which are “legitimate” and some of which are “more troublesome.” He described two scenarios. The first involved a client who directs the adviser to use a particular broker-dealer. In such a case, the adviser is obligated to follow the client’s instructions, regardless of whether the broker-dealer is best suited to execute the client’s trade. The second scenario occurs when a client directs its adviser to use a particular broker-dealer “subject to best execution.” Here, according to Donohue, an adviser is in a more difficult position as other considerations involved in the decision to use one broker-dealer over another may entail benefits to the adviser itself. Donohue advised that, in his view, “personal benefits or considerations should not be a motivating factor in an adviser’s determination regarding how, where, when and with whom to place a client trade.” To the extent such factors are being considered, Donohue “strongly encourage[d]” his audience to rethink its practices, disclosure and control structures.
Donohue also discussed the impact of technological advancements on monitoring advisers’ fulfillment of their best execution obligations. Specifically, Donohue encouraged advisers to use technological developments to better serve their clients and noted that clients are increasingly asking advisers to prove that they are satisfying their best execution obligations. In connection therewith, Donohue noted that it is now objectively easier to measure whether an adviser is truly seeking best execution and also reminded advisers to bear in mind that “not every trade is the same, and some trades may easily be routed to low-cost, alternative trading platforms.”
In addition, Donohue addressed the issue of how advisers allocate the use of research obtained through soft dollars and cited certain situations which raise “questions of fairness and equity that advisers would be wise to consider.” Such situations involve clients who direct brokerage and advisers who manage assets in other circumstances that limit their brokerage placement discretion. According to Donohue, advisers must still fulfill their best execution obligations in these situations. In addition, Donohue noted that clients with such restrictions may benefit from research obtained through the commission dollars of other clients, and he encouraged investment advisers to consider the conflicts created by such situations and whether sufficient disclosure is made.