Industry Update

SEC Delivers Congressionally Mandated Report on Mark-to-Market Accounting

On December 30, 2008, the SEC Office of the Chief Accountant and Division of Corporation Finance issued a report to Congress on mark-to-market accounting standards as provided by FAS 157, Fair Value Measurements ("FAS 157").  As previously reported in the November 5, 2008 Investment Management Regulatory Update, FAS 157 and related guidance established a single definition of fair value and a framework for measuring fair value with respect to generally accepted accounting principles (GAAP) in inactive markets.  The report, which was mandated by the Emergency Economic Stabilization Act of 2008, recommends that FAS 157 not be suspended, but that certain improvements to current practices be implemented. 

The report notes that FAS 157 does not, in itself, require mark-to-market or fair value accounting.  Instead, various other accounting standards require fair value accounting of which mark-to-market accounting is a subset.  Notably, the report recommends against the suspension of existing fair value and mark-to-market accounting standards because, among other things, such suspension would erode investor confidence in financial reports.  In further support of this recommendation, the report also notes that fair value and mark-to-market accounting do not appear to have caused the failures of banks or other financial institutions. 

The report includes a number of recommendations to improve the application of existing accounting standards.  For instance, the report recommends providing additional guidance on best practices for determining fair value in illiquid or inactive markets, enhancing existing disclosure and presentation requirements, and having the FASB assess the utility of including credit risk in the measurement of liabilities.  Other recommendations include readdressing the accounting methods applied with respect to financial asset impairments and addressing the need for simplified accounting for investments in financial assets. 

In comments relating to the report, SEC Chairman Christopher Cox noted that “[i]t will be a useful source of information and guidance not only to policymakers in Congress but also to the independent standard-setters.”

Sec Rules and Regulations

SEC Adopts Rule Providing for Regulation of Indexed Annuities

On December 17, 2008, the SEC announced that it had adopted a new rule allowing it to regulate certain equity-indexed annuities.  The new rule clarifies the status of equity-indexed annuities[1] as securities under the federal securities laws. 

Section 3(a)(8) of the Securities Act of 1933 (the “Securities Act”) provides an exemption from the provisions of the Securities Act for, among other things, annuity contracts and optional annuity contracts issued by corporations that are subject to the supervision of a state insurance or bank commissioner, or any agency or officer performing like functions.  According to the SEC press release announcing the new rule, the final rule (which has not yet been published) defines equity-indexed annuities issued on or after January 12, 2011 as not being “annuity contracts” or “optional annuity contracts” for purposes of the Section 3(a)(8) exemption if the amounts payable by the insurer under the contract are more likely than not to exceed the amounts guaranteed under the contract.  As a result of the new rule, equity-indexed annuities issued after January 12, 2011 will be subject to investor protections against fraud and misrepresentation under the federal securities laws and concomitant regulation by the SEC. 

Under the new rule, an insurer’s determination at or prior to the issuance of a contract as to whether the amounts payable under such contract are more likely than not to exceed the amounts guaranteed under such contract will be conclusive if, inter alia, the insurer’s methodology and actuarial, economic and other assumptions are reasonable. 

SEC Chairman Christopher Cox noted that the new rule will benefit senior investors, to whom equity-indexed annuities have been heavily marketed, by providing protection against “abusive sales practices by unscrupulous marketers.” 

The SEC’s adoption of the new rule has met with criticism, however, most notably from U.S. House of Representatives Financial Services Committee Chairman Barney Frank, who stated that he “regret[s] the fact that the SEC has moved ahead in the very last days of an outgoing administration on something this controversial,” adding that he is sorry that SEC Chairman Cox “did not respond to a large number of requests to defer action until a new administration can deal with it.”

SEC Adopts Rules Requiring Mutual Funds to Provide Information in Interactive Data Format

On the December 17, 2008, the SEC adopted final rules—the proposals for which were discussed in the July 14, 2008 Investment Management Regulatory Update—that will require mutual funds to provide risk/return summary information to the SEC in an interactive data format using eXtensible Business Reporting Language (“XBRL”).  The rules will require mutual funds to utilize data tags in providing such information as objectives, strategies, risks, performance and costs in their public filings, and to post such interactive data on their websites.  The deadline for mutual funds to begin complying with these requirements is January 1, 2011. 

The final rules have not yet been published but based on the SEC staff’s oral statements, the final rules, like the proposed rules, will not change what is currently required to be disclosed, but instead will require information to be provided in an additional format in a new exhibit.  As soon as mutual funds submit risk/return summary information to the SEC, the information will become immediately available through the SEC’s Interactive Data Electronic Applications system (“IDEA”).

XBRL is a programming language that allows bits of data to be tagged with a predefined list of identifiers which define what each bit of data represents.  The data can then be searched, downloaded into spreadsheets or reorganized for analytical purposes. 

The SEC expects that the use of XBRL will facilitate the comparison of performance across mutual funds, assist in automating regulatory filings and information processing, and increase the speed, accuracy and usability of disclosure.

SEC Approves Exemptions Relating to Central Counterparty for Credit Default Swaps

On December 23, 2008, the SEC announced that it has approved temporary exemptions under the federal securities laws to facilitate the establishment of a central counterparty (“CCP”) for credit default swaps.  The exemptions, which are effective until September 25, 2009, will enable LCH.Clearnet Ltd. to operate as a CCP for credit default swaps and facilitate the prompt implementation and use of centralized clearing by market participants.  The exemptions are subject to certain conditions which, according to the SEC, are designed to promote oversight and investor protection while avoiding delays in CCP implementation that may result from the application of “all the particulars of the securities laws.”  The SEC is soliciting comment on all aspects of the exemptions. 

As previously reported in the December 3, 2008 Investment Management Regulatory Update, the SEC, the Federal Reserve Board (“FRB”) and the Commodity Futures Trading Commission (“CFTC”) executed a Memorandum of Understanding (“MOU”) in November 2008 as part of the agenda of the President's Working Group on Financial Markets to establish one or more CCPs for the credit default swap market.  In furtherance of this agenda, the exemptions approved on December 23 were developed by the SEC in consultation with the aforementioned regulatory bodies, along with the Federal Reserve Bank of New York and the U.K. Financial Services Authority. 

SEC Approves Measures to Strengthen Oversight of Credit Rating Agencies

As reported in the December 4, 2008 Davis Polk & Wardwell Client Newsflash, the SEC adopted final rules designed to address perceived conflicts of interest in the credit rating industry, while deferring action on other related proposals originally put forth in June and July 2008 as part of the SEC’s response to the ongoing credit crisis.  The SEC also announced that it would re-propose two rules in modified form.  The new rules apply to each rating agency registered with the SEC as a “nationally recognized statistical rating organization” (“NRSRO”), including Standard and Poor’s Ratings Services, Moody’s Investors Service and Fitch Ratings.

While the SEC has not published the text of the new rules, they are expected to include: a ban on an NRSRO making recommendations to an issuer about how to obtain a desired credit rating; a ban on NRSRO personnel who participate in determining a rating discussing or arranging the fees paid to the NRSRO; a ban on NRSRO personnel receiving gifts or entertainment from a rated issuer valued in excess of $25; internet disclosure of a 10% sample of the NRSRO’s rating actions;  documentation of the rationale for any material deviation in the rating assigned to a structured finance product from the rating implied by the NRSRO’s quantitative model; retention of communications regarding complaints about the performance of a credit analyst relating to a rating; and enhanced disclosure of (i) an NRSRO’s performance measurements, (ii) information regarding the verifications it performs on assets underlying structured finance products, (iii) how its assessment of the quality of asset originators affects its rating of structured finance products and (iv) information about its ongoing credit surveillance policies.

The SEC also re-proposed two rules in modified form relating to (i) public disclosure by NRSROs of the data underlying structured finance ratings and (ii) additional internet disclosure by NRSROs operating on the “issuer-pays” business model.

In addition, the SEC deferred action on proposals that would (i) effectively require NRSROs to change their rating symbols for structured finance products and (ii) decrease the SEC’s reliance on NRSRO credit ratings by substantially eliminating references to NRSRO credit ratings in its rules and forms.

SEC Designates Central Repository for Municipal Securities Disclosure

On December 8, 2008, the SEC announced that it has approved amendments to Rule 15c2-12 under the Securities Exchange Act of 1934 which designate the Municipal Securities Rulemaking Board (the “MSRB”) as the central repository for municipal securities disclosures.  The SEC also announced that pursuant to a concurrent MSRB rule change, the MSRB will make these disclosures available to investors for free through the MSRB’s Electronic Municipal Market Access system (“EMMA”) in the same manner that the SEC currently makes corporate disclosures available through its online system.  The amendments to Rule 15c2-12 and the MSRB rule change will become effective on July 1, 2009.

The amendments to Rule 15c2-12 will require underwriters of primary municipal securities offerings to reasonably determine that municipal issuers have agreed (i) to provide continuing disclosure documents to the MSRB, instead of to multiple nationally recognized municipal securities information repositories and state information depositories and (ii) to provide such information in an electronic format, accompanied by identifying information as prescribed by the MSRB.  The MSRB rule change, as noted above, provides for continuing disclosure information to be made available through EMMA.

Under the current municipal securities disclosure system, investors seeking disclosure information relating to municipal securities—such as annual financial data or material events like downgrades or defaults—must first locate the appropriate repository and then pay fees to obtain such information, which may be subject to delayed delivery via fax or mail.  According to the SEC, the amendments to Rule 15c2-12 and the MSRB rule change will correct deficiencies in this system by providing municipal securities investors with free and instant access to municipal security information in a single, online location and making it easier for such investors to identify municipal issuers who are remiss in their filings.


Cayman Islands Court Denies Investor Standing to Liquidate Hedge Fund

On December 12, 2008, the Cayman Islands Court of Appeals issued a decision that clarified a number of issues of Cayman law on the standing of an investor to petition for the winding up of a fund that has suspended redemption payments.  In October 2007, an investor (“ST Investor”) had submitted a request for redemption of its interest in the Cayman-domiciled Strategic Turnaround Master Partnership, Limited (“Strategic Turnaround”).  According to the redemption request and in accordance with Strategic Turnaround’s Articles of Association, the redemption was to be effective on March 31, 2008 (the “Redemption Date”).  Per the fund’s documents, at least 90% of the redemption proceeds were to be paid to ST Investor by May 1, 2008.  On April 17, 2008, before the redemption payment was made, Strategic Turnaround’s directors resolved to suspend all redemptions because of the volatility and illiquidity of the assets in which the fund was invested.  ST Investor thereafter petitioned for a winding up of Strategic Turnaround on the ground that the fund was unable to pay its debts as they came due.

Initially, a lower Cayman court denied an application by Strategic Turnaround to dismiss ST Investor’s petition, finding that ST Investor had standing to wind up the fund because (i) ST Investor became a creditor of Strategic Turnaround on the Redemption Date; (ii) the suspension of redemptions after the Redemption Date by the fund’s directors was invalid and (iii) the unpaid redemption payment constituted an unpaid debt of the fund to ST Investor.  Strategic Turnaround appealed the lower court’s decision, asserting that Strategic Turnaround’s operative documents allowed it to suspend the payment of redemption proceeds, and therefore that no present debt yet existed upon which ST Investor could assert standing for a winding up of the fund.

The Court of Appeals closely examined Strategic Turnaround’s operative documents and concurred with the lower Cayman court that under Strategic Turnaround’s Articles of Association and offering memorandum, ST Investor became a creditor of Strategic Turnaround on the Redemption Date.  Characterizing redemption as a “process,” the Court of Appeals also held that ST Investor would remain a member of Strategic Turnaround until the payment of the redemption proceeds and the removal of ST Investor from the fund’s register.  Thus, ST Investor would remain subject to Strategic Turnaround’s Articles of Association.

The Court of Appeals nevertheless disagreed with the lower Cayman court in holding that ST Investor could not proceed with its petition to wind up the fund.  The Court of Appeals held that Strategic Turnaround’s directors had the authority to suspend the payment of redemption proceeds after the Redemption Date but before payment of the proceeds pursuant to an express statement in Strategic Turnaround’s offering memorandum that was “not inconsistent” with its Articles of Association.  The Court of Appeals thus held that suspension of the redemption payment suspended the creation of a debt, and in the absence of a presently due and payable debt, ST Investor did not have standing to petition to liquidate the fund.  The Court of Appeals, however, left open the possibility that ST Investor could petition for liquidation under the “just and equitable” prong of Cayman insolvency law.

SEC Issues Relief For Buybacks of Auction Rate Securities

On January 6, 2009, the SEC’s Division of Investment Management issued a letter granting no-action relief under certain provisions of the Investment Company Act of 1940 (the “Investment Company Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”) with respect to purchases by financial industry participants of auction rate securities.  Previously, on September 22, 2008, the SEC’s Divisions of Corporate Finance, Trading and Markets and Investment Management had issued a letter granting global exemptive and no-action relief enabling financial industry participants to purchase auction rate securities free of most Federal securities law restrictions.

As we reported in the September 8, 2008 Investment Management Regulatory Update, in August 2008, the New York Attorney General announced preliminary settlements with investment firms and banks that had marketed auction rate securities, the markets for which had collapsed in February 2008.  Under the settlements, the firms agreed to repurchase auction rate securities from specified eligible customers.  Thereafter, additional governmental bodies reached settlements with other financial industry participants also requiring repurchases of auction rate securities.  Effecting these repurchases implicated a number of provisions, rules and regulations under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Company Act, including those governing tender offers, going private transactions, beneficial ownership reporting and restrictions on affiliated persons of closed-end funds.

In September, Davis Polk & Wardwell, on behalf of several law firms representing various financial industry participants, submitted a request (the “Global Relief Request”) seeking relief from certain of the tender offer and going private rules, including Section 14(d)(5), Regulation 14D and Rules 14d-9, 14e-1(d), 14e-2, 14e-5, 13e-1, 13d-3 and 13e-4 under the Exchange Act.  The Global Relief Request established an “Offer Protocol” pursuant to which firms (“Participating Firms”) who wish to rely on the relief must structure their offers.  The SEC’s response letter (the “Global Relief Letter”) provided exemptive and no-action relief for Participating Firms who comply with the Offer Protocol from the Exchange Act rules listed above.  The Global Relief Letter also stated that the Divisions of Corporate Finance and Investment Management would not recommend enforcement action with respect to Section 30(h) of the Investment Company Act if a Participating Firm satisfies certain transaction and beneficial ownership reporting obligations.

Davis Polk & Wardwell submitted a second request (the “IM Relief Request”) on December 30, 2008, seeking relief from restrictions applicable to affiliated persons of closed-end funds under the Investment Company Act and Section 206(3) of the Advisers Act.

The IM Relief Request first addressed whether, as a result of a Participating Firm’s purchase of auction rate securities that include all or a portion of the preferred stock issued by a closed-end investment company (a “Fund”), the Participating Firm would be deemed to be an affiliated person of the Fund solely because of the Participating Firm’s ownership of such securities.  The IM Relief Request sought assurances that the SEC staff would not recommend enforcement action against a Participating Firm or a Fund under various Investment Company Act provisions restricting affiliated persons of a Fund (the “Affiliate Restrictions”) if the Participating Firm implements the “Voting Protocol” with respect to such Fund.  Under the Voting Protocol, if a Participating Firm holds more than 25% of the outstanding shares of the class of preferred stock of a Fund, the Participating Firm will vote its shares as directed by an independent third party when voting on certain matters.

In addition, the IM Relief Request asked for confirmation that the Division of Investment Management would not recommend enforcement action against a Participating Firm under Advisers Act Section 206(3) if the Participating Firm tendered eligible securities on behalf of a discretionary client if the client had not advised the Participating Firm that it elected not to tender its securities before a specified date and the Participating Firm made certain disclosures about the principal transaction in its offer document.

While a Division of Investment Management staff member provided the requested relief orally on September 22, 2008, on January 6, 2009, the staff confirmed in writing (the “IM Relief Letter”) that it would not recommend that the Commission take enforcement action against a Participating Firm or Fund under the Affiliate Restrictions or Section 206(3) of the Advisers Act under the circumstances set forth in the IM Relief Request.

SEC No-Action Letter Provides Greater Flexibility in Use of Past Recommendations in Investment Adviser Advertisements

On November 7, 2008, the SEC’s Division of Investment Management issued a letter granting no-action relief to TCW Group, Inc. (“TCW”) regarding the distribution by TCW’s wholly-owned investment advisory subsidiaries (“TCW Advisers”) of certain charts (“Charts”) that display the past performance of certain securities holdings.

As described in TCW’s request letter, the Charts, which would be included in marketing materials delivered to prospective investors, display an equal number (but not less than five) of the TCW Advisers’ best and worst performing holdings over a given measurement period.  The calculation of the best and worst performing holdings for a given investment account is determined by multiplying the weight of a holding (the percentage of the holding vis-à-vis the total account) by the holding’s performance over the measurement period.  Based on this formula, for example, a holding that generated a 100% return but only comprised 1% of an account would be deemed to have contributed less positively to a given account than a holding that generated a 20% return but comprised 10% of the account.

The Charts would constitute an “advertisement” for purposes of the Investment Advisers Act of 1940 (the “Advisers Act”) since TCW planned to distribute the Charts to prospective investors who had not specifically requested the information provided in the Charts.  Rule 206(4)-1(a)(2) under the Advisers Act (the “Advertising Rule”) prohibits an investment adviser from distributing “any advertisement . . . [w]hich refers, directly or indirectly, to past specific recommendations of such investment adviser which were or would have been profitable to any person.”  An exception exists for advertisements that list “all recommendations” made by the investment adviser in the previous year (provided that certain other conditions are met).

The SEC adopted the Advertising Rule because it believed that advertisements containing past specific recommendations were inherently misleading in nature.  Specifically, the SEC was concerned that, in the absence of the Advertising Rule, investment advisers could deceptively highlight or “cherry pick” positive past recommendations and omit negative past recommendations.  TCW argued in its request letter, however, that the mechanical and objective manner in which the holdings are selected for and displayed on the Charts avoids the potential for manipulation and deception that the Advertising Rule was designed to prevent.

The Division of Investment Management’s response to TCW stated that, under the facts presented by TCW in its request, it would not recommend enforcement action against TCW under the Advertising Rule to the Commission.  In reaching this conclusion, the staff indicated that it particularly relied on the following representations by TCW with respect to the Charts:

  • the calculation used to determine the best and worst performing holdings in a representative account will be consistently applied to every holding in such account;
  • the Charts’ presentation of information and number of holdings will be consistent from one measurement period to the next;
  • the Charts will show no fewer than ten holdings and an equal number of positive and negative holdings;
  • the Charts will (i) disclose the calculation method used to determine the best and worst performing holdings and (ii) provide a list of each holding’s contribution to the overall account’s performance during the measurement period;
  • the Charts will include information necessary to make the Charts not misleading, including presenting the best and worst performing holdings on the same page with equal prominence, and providing appropriate disclosures in close proximity to the performance information; and
  • each TCW Adviser will maintain, and make available to the SEC staff upon request, records that evidence (i) the methodology used to select the best and worst performing holdings, (ii) a list showing the contribution that each holding made during the measurement period to the overall performance of the account to which the Chart relates and (iii) all supporting data necessary to demonstrate the accuracy of the information presented in the Charts.


If you have any questions regarding the matters covered in this Regulatory Update, please contact any of our Investment Management Group lawyers listed below or your regular Davis Polk contact:

John Crowley, Partner
212-450-4550 |

Nora Jordan, Partner
212-450-4684 |

Yukako Kawata, Partner
212-450-4896 |

Leor Landa, Partner
212-450-6160 |

Danforth Townley, Partner
212-450-4240 |

Sophia Hudson, Associate
212-450-4762 |

1. Equity-indexed annuities are annuities under which payments by the insurer are dependent upon the performance of a securities index.