SEC Rules and Regulations

SEC Proposes New Rules Relating to Exchange Traded Funds

In a release issued on March 11, 2008 (the “Release”), the SEC proposed two new rules under the Investment Company Act of 1940 (the “Investment Company Act”) relating to exchange traded funds (“ETFs”).  If adopted, new Rule 6c-11 will allow ETFs to operate without first obtaining SEC exemptive relief from certain provisions of the Investment Company Act, and new Rule 12d1-4 will permit investments in ETFs by investment companies in excess of the limits established by Section 12(d)(1) of the Investment Company Act.  The SEC also proposed amendments to Form N-1A that will apply to ETFs, and amendments to existing Rule 12d1-2 that will expand the universe of investments that can be made by certain affiliated funds-of-funds. 

Proposed Rule 6c-11.  ETFs are hybrid investment vehicles that share certain characteristics of both open-end and closed-end registered investment companies.  Nearly all ETFs are organized and registered as open-end companies under the Investment Company Act, but their shares trade on exchanges, like shares of closed-end companies.  (A handful of ETFs are organized as unit investment trusts (“UITs”) rather than open-end funds.)  Since the first ETFs were launched in the early 1990s, the hybrid structure has required an ETF (or its sponsor) to obtain prior individual exemptive relief from the SEC. 

ETF shares are created and redeemed in large blocks (usually 50,000 or 100,000 shares), called “creation units,” by broker-dealers, institutional investors and other market intermediaries that have agreed to act as “authorized participants” with the ETF.  Each day, the ETF publishes its “deposit basket,” which lists the names and quantities of the underlying securities that an authorized participant has to deliver in-kind in order to receive a creation unit.  All currently operating ETFs are “index-based,” meaning that the deposit basket corresponds to the stocks in a published stock index.  However, in February, the SEC granted exemptive relief that will permit the launch of the first “actively managed” ETFs, for which the deposit basket will be determined by the ETF’s investment adviser on each trading day.  (The exemptive relief permitting actively managed funds was discussed in the March 2008 Investment Management Regulatory Update.)

Rule 6c-11 would accommodate both index-based and actively managed ETFs that are organized as open-end funds (i.e., the rule would not apply to UITs) and that fulfill the rule’s definition of “exchange-traded fund.”  This definition generally requires, among other things, that (i) the fund issues and redeems its shares in creation units in exchange for specified securities or other assets (“basket assets”), with the current per-share value of the basket assets regularly disseminated by the relevant securities exchange, (ii) the fund’s shares trade on a national securities exchange, (iii) the fund holds itself out as an ETF, with shares that may be purchased individually on an exchange, but are not sold or redeemed individually by the fund and (iv) each day, the fund discloses the prior day’s closing market price and net asset value per share (“NAV”), and any difference between the market price and NAV (i.e., the premium or discount).  In addition, an actively managed ETF will be required to disclose the identities and weights of its portfolio assets each day, and an index-based ETF will be required to disclose the identities and weights of the securities in its tracking index each day. 

Consistent with previously granted exemptive orders, Rule 6c-11 would offer relief from Sections 2(a)(32), 5(a)(1), 22(d), 22(e), 17(a)(1) and 17(a)(2) of the Investment Company Act, and Rule 22c-1 thereunder.  Notably, however, the proposed rule does not incorporate previously granted exemptive relief from Section 24(d) of the Investment Company Act, which permitted broker-dealers to deliver a “product description,” in lieu of a prospectus, for secondary market transactions in ETF shares.  The Release also indicates the SEC’s intention to rescind the existing relief.  The SEC offered two reasons for this.  The first is that, notwithstanding currently available relief, most broker-dealers deliver a statutory prospectus in secondary market transactions.  The second is that, if the SEC’s recent proposal regarding “summary prospectus” disclosure is adopted, a broker-dealer will be permitted to fulfill the delivery obligation by delivering the summary prospectus, with the statutory prospectus available on an Internet website.  (The SEC’s summary prospectus proposal was discussed in the December 2007 Investment Management Regulatory Update.

Proposed Rule 12d1-4.  Section 12(d)(1) of the Investment Company Act generally prohibits, among other things, any investment company (an “acquiring fund”) from purchasing more than 3% of the voting securities of a registered investment company.  If adopted, Rule 12d1-4 would permit an acquiring fund that does not otherwise “control” an ETF to acquire up to 25% of the voting securities of the ETF (the “acquired ETF”). 

In order to prevent an acquiring fund from “coercing” an acquired ETF or its adviser through the threat of large-scale redemptions of the acquired ETF’s shares, the proposed rule provides that an acquiring fund may not redeem shares that it acquired in reliance upon the rule-i.e., any shares of the acquired ETF in excess of the 3% limit (“Exempted Shares”) could only be disposed of by the acquiring fund through secondary market sales.  A mirror provision would also prohibit an acquired ETF, its principal underwriter or a broker or dealer from redeeming Exempted Shares submitted for redemption by an acquiring fund, but would provide a safe harbor for any such redeeming entity that (i) receives a representation from the acquiring fund that none of the shares to be redeemed are Exempted Shares and (ii) has no reason to believe that any such shares are Exempted Shares. 

In order to prevent overly complex structures, the rule also would not permit an acquired ETF itself to be a fund-of-funds.  Sales charges and service fees charged by an acquiring fund would be limited to those set forth in the FINRA sales charge rule, and the acquiring fund would be subject to the disclosure rules in Form N-1A regarding fees and expenses relating to investments by a fund in other funds. 

Proposed Amendments to Form N-1A.  According to the Release, the proposed amendments to Form N-1A for ETFs are “designed to meet the needs of investors (including retail investors) who purchase shares in secondary market transactions,” rather than financial institutions that act as authorized participants.  Among other things, these amendments would require an ETF to disclose (i) returns based on market share price as well as NAV, (ii) historical information about the premium and/or discount of the ETF’s market price relative to NAV and (iii) in the case of an index-based ETF, the ETF’s performance relative to its tracking index.  If the SEC adopts the summary prospectus for open-end funds, an ETF’s summary prospectus will require information similar to the foregoing. 

Proposed Amendments to Rule 12d1-2.  Section 12(d)(1)(G) of the Investment Company Act provides an exception to the limits of Section 12(d)(1) that permits a registered open-end investment company or UIT to acquire shares of certain affiliated funds.  In 2006, the SEC adopted Rule 12d1-2, which allowed funds relying on Section 12(d)(1)(G) to invest in certain unaffiliated investment companies as well as other non-investment company securities.  The proposed amendments to Rule 12d1-2 would expand the rule to permit funds operating under the rule to invest in assets or instruments other than “securities,” as well as to invest in ETFs in reliance on proposed Rule 12d1-4.

Regulatory Actions

FINRA Settles Cases Against Five Firms for Improper Sales of Mutual Fund Shares and Supervisory Violations and Issues Fines of $2.4 Million

On February 28, 2008, the Financial Industry Regulatory Authority (“FINRA”) announced an agreement to settle cases against five firms for improper sales of Class B and Class C mutual fund shares and failure to implement supervisory systems which would allow eligible investors to purchase Class A mutual fund shares at net asset value (“NAV”) through NAV transfer programs.  As part of the settlement, FINRA imposed fines totaling $2.4 million against Prudential Securities, UBS Financial Securities, Inc. (“UBS”) and Merrill Lynch & Co. (“Merrill Lynch”).  The three firms also agreed to pay an estimated $25 million in restitution for eligible customers who were denied the benefit of NAV transfer programs.  The remediation plans will cover over 27,000 fund transactions involving 5,300 households. 

In addition to the share class sales violations, FINRA found that Prudential Securities, UBS and Merrill Lynch failed to install reasonable supervisory systems and procedures to enable investors to obtain sales charge waivers through NAV transfer programs.  From 2001 through 2004, securities firms offered NAV transfer programs as a benefit for eligible customers.  If a customer redeemed fund shares for which it had already paid a sales charge, proceeds from the redemption could be used to purchase Class A shares of a new mutual fund at net asset value.  However, because of inadequate systems at Prudential Securities, UBS and Merrill Lynch, customers were exposed to higher fees and contingent deferred sales charges over a two-year period.

One of the firms involved in the settlement, Wells Fargo Investments (“Wells Fargo”), was also found to have insufficient supervisory systems and procedures relating to NAV transfer programs, but was not fined by FINRA because the firm responded to its misconduct with immediate remedial action, prior to FINRA’s inquiry into the misconduct.  Upon discovery of the failure to provide NAV pricing to eligible customers, Wells Fargo initiated corrective measures and repaid approximately $612,000 to investors holding Class A shares. 

Each of the firms agreed to a settlement and consented to FINRA’s findings without admitting or denying the allegations.  A non-governmental regulator, FINRA was formed in 2007 following the consolidation of the National Association of Securities Dealers and NYSE Member Regulation. 


Bulldog Investors Announces Plans to Sue the SEC to Lift Ban on Hedge Fund Advertising

Phillip Goldstein, founder of the hedge fund group Bulldog Investors (“Bulldog”), has announced plans to sue the SEC on constitutional First Amendment grounds over its prohibition against advertising and general solicitation in connection with private securities offerings. 

Bulldog is currently seeking assurance from the staff of the SEC that it will not recommend enforcement action if Bulldog operates an open website.  According to Goldstein, the website would provide general information about the Bulldog funds but would not accept investments from unaccredited investors or allow any direct transactions.  Through its no-action request, Bulldog is asking the SEC to clarify the issue of what types of information a private fund can put on its public website without running afoul of securities laws.

The Bulldog website, which is currently offline, is also the subject of an ongoing enforcement action brought by Massachusetts Secretary of the Commonwealth William F. Galvin.  In that action, the Massachusetts Securities Division charged  that Bulldog and others used the website to solicit an unaccredited Massachusetts investor, in violation of Massachusetts securities laws.  The Commonwealth ordered Bulldog to pay a $25,000 fine.  On March 23, 2007, Bulldog and others filed a motion for a preliminary injunction, alleging that the enforcement action violated Bulldog’s First Amendment rights.  In December 2007, the Massachusetts Superior Court denied the plaintiff’s motion.  Using the four-part test of commercial speech regulation from the leading case Central Hudson Gas & Elec. v. Public Serv. Comm’n, 447 U.S. 557 (1980), the court concluded that the regulation (1) serves a substantial government interest because it protects the integrity of capital markets and helps to ensure that investors receive full and accurate disclosure before making investment decisions and (2) is narrowly tailored to achieve the government interest because it is part of an overall registration and disclosure scheme, the goal of which is to protect investors.

In a public statement, Goldstein asserted that there is “significant uncertainty as to whether a hedge fund can legally operate an open website . and to respond to inquiries from website users.”  Mr. Goldstein has said that if the SEC does not issue adequate relief he will file a declaratory action in federal court to challenge the ban on First Amendment grounds.  No complaint has been filed as of yet, and Bulldog has said that it is currently in ongoing communications with the SEC to “try to resolve this without litigation.”

Goldstein previously sued the SEC in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), challenging its rule regarding the registration of hedge fund advisers under the Investment Advisers Act of 1940 (the “Hedge Fund Rule”).  The D.C. Circuit vacated the Hedge Fund Rule on June 23, 2006.

Industry Update

SEC Issues No-Action Relief to JPMorgan Chase Relating to the Proposed Bear Stearns Acquisition

On March 16, 2008, the SEC’s Division of Investment Management (the “Division”) issued two no-action letters in response to a request by JPMorgan Chase & Co. (“JPM”) regarding compliance with Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) and Sections 15(a), 17(a) and 17(d) of the Investment Company Act of 1940 (the “Investment Company Act”) and Rule 17d-1 thereunder.  JPM’s request arose in connection with its proposed acquisition of Bear Stearns and the related change of control of Bear Stearns Asset Management (“BSAM”).

In the first letter, JPM sought temporary relief from certain principal trading restrictions under the Investment Company Act and Advisers Act.  JPM sought assurances that the Division would not recommend enforcement action if, following the change of control (which JPM presumed to have occurred prior to its request, even though the transaction has not yet closed), (a) JPM and any of its affiliates engaged in certain principal transactions with registered investment companies (“RICs”) for which BSAM is an investment adviser, (b) BSAM and its affiliates engaged in certain principal transactions with RICs for which JPM is an investment adviser, (c) both BSAM and JPM engaged jointly in such principal transactions and (d) JPM and its affiliates engaged in such principal transactions with non-RIC advisory clients of BSAM (and vice-versa).

JPM identified several specific scenarios where compliance with Investment Company Act and Advisers Act restrictions on principal transactions would be particularly difficult.  First, before the change in control, RICs advised by BSAM may have entered into transactions with JPM, but such transactions might not have settled or might otherwise have been open or pending (such as repos or swaps).  JPM was concerned that such trades could violate Section 17(a) of the Investment Company Act because JPM was an affiliated person of the RICs after the change in control.  Similarly, JPM had entered into transactions with non-RIC advisory clients of BSAM that would be pending at the time of the change in control and, prior to settlement, JPM would not be able to make the required disclosures and obtain the required consents under Section 206(3) of the Advisers Act.  JPM requested temporary relief (for 15 business days) from both the Investment Company Act and the Advisers Act with respect to these transactions.

The Division, citing the “extraordinary circumstances” present, granted temporary relief under the Investment Company Act for 15 business days after the change in control, on the conditions that JPM and BSAM provide the board of directors of the relevant RIC material information regarding the relevant principal transactions and such board of directors approve the transactions after a determination that each is “ fair and reasonable.”  There are also various record keeping requirements related to the RIC board approvals.

Similarly, the Division granted temporary relief (15 business days) under the Advisers Act so long as JPM and BSAM make the required disclosures under Section 206(3) within 15 business days after each principal transaction and keep records of the material terms of each such transaction.

In the second letter, JPM sought relief from Section 15(a) of the Investment Company Act if, following the change in control, BSAM continues to act as investment adviser to certain mutual funds (the “Funds”), notwithstanding the termination of existing advisory contracts between BSAM and the Funds, which may have been deemed to have occurred as a result of an “assignment” of the contracts under Section 15(a)(2) due to the change in control.  JPM asserted that under the “extraordinary circumstances” present, it would not be practical for Fund boards to meet in person and approve new advisory contracts prior to the change in control, as required under Section 15(a).  The Division granted the requested relief, permitting BSAM and the Funds to enter into and act under new advisory contracts for a ten-day period following the change in control, without prior, in-person board approval, provided that the Fund boards thereafter promptly meet and approve the advisory contracts as required by Rule 15a-4(b)(1)(ii) under the Investment Company Act, which does not require an in-person meeting of the board.

SEC Commissioner Paul S. Atkins Considers Mutual Recognition of Foreign Investment Companies; Suggests Creation of "New Products Czar"

In a March 17, 2008 speech at the Investment Company Institute’s 2008 Mutual Funds and Investment Management Conference, SEC Commissioner Paul S. Atkins discussed a variety of regulatory issues, including, but not limited to, the mutual recognition of foreign investment companies and the creation of a “new products czar” at the SEC.

Section 7(d) of the Investment Company Act of 1940 (the “Investment Company Act”) makes it difficult for foreign investment companies to operate in the United States, said Atkins.  Pursuant to Section 7(d) of the Investment Company Act, foreign investment companies must apply for, and receive, an exemptive order from the SEC before they may register as an investment company in the United States or issue securities publicly in the United States.  Atkins noted that, in 1992, the Staff of the Division of Investment Management suggested amending Section 7(d) of the Investment Company Act to provide for the mutual recognition of foreign investment companies pursuant to “bilateral memoranda of understanding.”  Atkins questioned whether it is again time to consider amending Section 7(d), and added that the SEC is considering the issue.  Regulators, said Atkins, not only should “facilitate [the] internationalization of the financial markets,” but “must” do so.

Additionally, Atkins critically considered the structure of the SEC, which is currently organized “according to statute” and not according to “how investors invest or how the marketplace functions.”  Due in part to this organizational structure, suggested Atkins, the SEC needlessly impedes the development of new financial products.  Therefore, according to Atkins, the SEC should have a “ new products czar.”  Among other duties, the “new products czar” would be responsible for shepherding new products “through the SEC process and that of other agencies, if necessary,” said Atkins.

Director of SEC's Division of Investment Management Compares U.S. and U.K. Approaches to the Regulation of Private Funds; Discusses Hedge Fund Insider Trading Policies and "Hedge Fund-Type" Registered Funds

In a March 10, 2008 speech at the 9th Annual International Conference on Private Investment Funds held in London, England, Andrew J. Donohue, Director of the SEC’s Division of Investment Management, compared and contrasted the private fund regulatory schemes of the United States and the United Kingdom and discussed the SEC’s focus on hedge funds’ insider trading policies and its oversight of “hedge fund-type” registered funds.

Comparison of regulatory regimes.  Generally, the regulation of private funds in the United Kingdom is considered to be principles-based, whereas the regulation of private funds in the United States is considered to be rules-based, noted Donohue.  Donohue asserted that neither country’s regulatory system is entirely principles or rules based; instead, “each country regulates [private funds] through a combination of these two regulatory strategies.”  Indeed, according to Donohue, the US regulatory regime for private funds has been unfairly “pigeonholed as rigid and overly demanding.”  A more accurate view, suggested Donohue, takes into account the ability of US regulators to adopt principles-based regulations and to allow the private funds industry to self-regulate through the creation and adoption of voluntary best practices.

As an example of the “hybrid” regulatory approach to private funds taken by the United States, Donohue cited the Investment Advisers Act of 1940 (the “Advisers Act”).  The US Congress, according to Donohue, drafted the Advisers Act in a manner that reflects a principles-based approach to the regulation of investment advisers in its (nearly) singular focus on investment advisers’ fiduciary duty to their clients.  The SEC, said Donohue, has supplemented the comparatively broad-based provisions of the Advisers Act with specific rules “on those regulatory issues that it believes call for a certain level of specificity, such as investment adviser recordkeeping.”

Donohue noted that he considers the UK regulatory regime for private funds “very relevant to our own.”  In particular, Donohue said that he intends to take into consideration the “global nature of [the] industry” in formulating regulations concerning the registration of advisers of hedge funds with the SEC.  Finally, Donohue lauded the collaboration between industry participants and regulators in both the United Kingdom and the United States in formulating principles-based voluntary best practices guidelines through the President’s Working Group on Financial Markets in the United States and the Hedge Fund Working Group in the United Kingdom.

Hedge fund insider trading policies.  Donohue stated that the SEC has, through its examinations of registered hedge fund advisers, noticed that many such firms lack comprehensive insider trading policies.  SEC examiners, according to Donohue, inspect insider trading policies to ensure that they address: (i) firm and client-specific circumstances, (ii) “the affiliations of investors in the [firm’s fund(s)] and the likelihood that those investors could be mined for non-public information” and (iii) the firm’s investment strategies.  The SEC uses “forensic tests” to identify irregular “investment decisions,” which may indicate problems with a hedge fund’s compliance with its insider trading policies or the policies themselves.

“Hedge-fund like” registered funds.  Donohue noted that he has a variety of concerns with respect to “registered funds that engage in typical hedge fund investment strategies” (e.g., 130/30 or long/short funds).  Such “hedge-fund like” registered funds might present conflicts of interest issues “when an adviser is managing both a long/short fund and a traditional mutual fund in a side-by-side arrangements,” said Donohue.  Additionally, Donohue urged managers of such registered funds to “adapt their operational processes,” particularly with regard to valuation procedures, in order to appropriately manage these more complex products.

Director of SEC's Office of Compliance Inspections and Examinations Discusses Risk-Based Exam Program, Industry Communication Initiatives and Top 10 Compliance Issues

In a March 20, 2008 speech at the IA Compliance Best Practices Summit 2008, Lori A. Richards, Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), outlined OCIE’s risk-based exam program and industry communication initiatives and enunciated OCIE’s Top 10 compliance issues.

Risk-based exam program.  Since 2001, the number of staff at OCIE has remained constant, while the number of registered investment advisers has grown by more than 40%, according to Richards; therefore, OCIE does not plan on inspecting each and every registered investment adviser but instead relies on a risk-based exam program in order to maximize its limited resources by selecting only certain registered investment advisers for examinations.  Richards said that pursuant to its risk-based exam program, OCIE intends to (i) randomly examine a certain number of all registered investment advisers and (ii) increasingly focus on examining: (a) newly registered investment advisers, (b) large investment advisory firms, (c) firms that have historically shown weak compliance controls and (d) firms engaged in activities that OCIE deems particularly risky from a compliance standpoint.

Richards stated that firms selected for an examination by OCIE should be aware that OCIE examiners will focus on the firm’s compliance controls.  OCIE examiners will pay particular attention to, and request more information from, firms that exhibit weak (or non-existent) compliance controls, cautioned Richards.

The OCIE staff is sensitive to the fact that different types of registrants may face different compliance issues; however, Richards said that certain issues, such as the prevention of insider trading and ensuring best execution, cut across registrant classifications.  Therefore, Richards noted, in order to streamline the examination process for certain dual registrants (i.e., firms that function as both broker-dealers and investment advisers), OCIE is considering a pilot program that would have one examination team simultaneously examine the investment advisory and broker-dealer units of such dual registrants.  Richards believes that such an examination would “allow[] examiners to see the 'whole picture’ of a firm’s various activities, providing clear benefits for regulatory oversight.”

Industry communication initiatives.  Richards highlighted three of OCIE’s communication initiatives that she feels will “help firms to foster healthy compliance programs” and “reduce their risks of having compliance violations in the first place.”  The first, CCOutreach, is intended to help investment advisers and mutual fund chief compliance officers communicate with OCIE outside of the examination process.  Second, OCIE published a “plain English” guide to the Investment Advisers Act of 1940 (the “Advisers Act”) and distributed it to 3,500 new investment advisers.  Finally, OCIE created an online publication, ComplianceAlerts, that is intended to share compliance issues that OCIE encounters during its examination process with the broader compliance community.

Top 10 compliance issues.  Richards presented OCIE’s Top 10 compliance issues but cautioned her audience to remember that, during routine examinations, OCIE’s staff will be focused primarily on compliance controls and OCIE’s examiners may focus on other topics not listed as part of the Top 10 compliance issues.

  1. Controls over Valuation.  OCIE examiners are focusing on valuation controls in their examinations of all registrants, regardless of type, according to Richards.  Examiners are increasing their scrutiny of how firms price complex structured products and other illiquid securities, because, Richards said, clients “can be harmed if the adviser overcharges its advisory fee based on overvalued holdings.”  Richards stated that OCIE is also interested in determining, among other things, whether (i) firms understood the nature of these complex securities before purchasing then, (ii) firms had plans for valuing them in place at the outset, (iii) firms properly disclosed the risks of such products to their clients and (iv) the individuals responsible for valuing such securities possessed the requisite level of sophistication.  Finally, Richards observed that OCIE is concerned that any valuation given to securities, “reflect[s] prices at which the security could actually be sold.”
  2. Controls over Non-Public Information/Personal Trading/Code of Ethics.  Incidents of insider trading have increased, said Richards, and, therefore, she reminded advisers of their duty pursuant to Section 204A of the Advisers Act to “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of their business, to prevent the misuse of material non-public information by the registered entity or its associated persons.”  OCIE is particularly focused on the controls put in place by registered investment advisers to prevent insider trading “in client, proprietary, or employee accounts,” noted Richards.  Richards also identified new lines of inquiry that registered investment advisers should pursue with respect to insider trading, as these lines of inquiry will be pursued by OCIE should the adviser be examined.  According to Richards, registered investment advisers should ask the following questions:  “[h]ow could my employees come into possession of material non-public information; what procedures can I put in place to prevent it; [a]nd, what tests can I employ to determine whether there are indications of insider trading at my firm?”
  3. Dealing with Senior Investors.  Richards noted that more senior-citizen investors are participating in the markets, and OCIE is focused on ensuring that these investors receive the appropriate protections.  OCIE intends to scrutinize several aspects of firms’ relationships with senior-citizen investors, including, but not limited to, firms’ marketing efforts directed at seniors and ongoing relationship and product suitability reviews for their senior-citizen clients.  Additionally, OCIE is working with the North American Securities Administrators Association (“NASAA”) and the Financial Industry Regulatory Authority (“FINRA”) to “identify effective practices used by financial services firms in dealing with senior investors.”  OCIE, NASAA and FINRA plan on sharing the results of this project with the public, said Richards, and these organizations are aware that a “one-size fits all” approach to the issue is not in anyone’s best interests.
  4. Compliance and Supervision.  Each adviser faces unique risks, and OCIE examiners focus on determining whether each adviser has assessed its unique risk profile and developed and implemented a compliance program tailored to address these risks, said Richards. Richards also noted that identifying conflicts of interest stemming from revenue-sharing between advisers and broker-dealers is a priority for OCIE examiners.
  5. Portfolio Management.  OCIE examiners endeavor to determine whether registered investment advisers are, consistent with their obligations, selecting suitable securities for their clients and providing all appropriate disclosures.  Richards said that examiners will pay close attention to client investments in structured products and derivatives as well as money market funds and Rule 2a-7 under the Investment Company Act of 1940.
  6. Brokerage Arrangements and Best Execution.  Registered investment advisers have a fiduciary duty to their clients with respect to selecting brokers.  OCIE examiners, said Richards, investigate whether an adviser “seeks best execution, whether it uses soft dollars consistent with its disclosures, and whether the adviser periodically and systematically evaluates the costs and benefits of its brokerage arrangements.”  The undisclosed use of soft dollars and quid pro quo arrangements between brokers and advisers are of particular concern to OCIE examiners, declared Richards.
  7. Allocations of Trades.  Advisers must disclose certain trade allocation policies to clients, and OCIE examiners are “interested” in the content of such policies and whether they were adequately disclosed and effectively implemented, said Richards.  Additionally, she noted that examiners intend to focus on “cherry-picking” and “favoritism” in allocations of securities to relatives and clients with performance-fee accounts.
  8. Performance Advertising, Marketing and Fund Distribution Activities.  Richards said that OCIE “continue[s] to find deficiencies” in firms’ marketing and advertising materials.  Examiners will look to see if firms are accurately and fairly describing performance information and conflicts in marketing and sales materials and will assess firms’ controls with respect to monitoring such publications for accuracy, added Richards.
  9. Safety of Clients’ and Funds’ Assets.  Advisers must safeguard the assets entrusted to them against theft, loss and abuse.  OCIE examiners will assess whether firms have put in place procedures to ensure the safety of client and fund assets, said Richards. 
  10. Information and Protection (books and records, disclosures, and filings).  OCIE examiners, said Richards, inspect the policies, procedures and systems of registered investment advisers to ensure that “relevant and timely information” is reflected in the firms’ books and records as well as in “reports to clients and regulators.”  Additionally, Richards noted that examiners try to determine whether firms have in place appropriate safeguards and back-up systems to protect sensitive data from hackers and natural disasters, respectively.

Government Accountability Office Releases Report on the Role of Federal Regulators and Market Participants in Strengthening Market Discipline of Hedge Funds

In January 2008, the US Government Accountability Office (“GAO”) released a report titled “Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed.”  The GAO report was commissioned in June 2006 by leading members of the House Financial Services Committee who were concerned about effective market discipline in hedge fund-related activities, “especially as the pension assets of more and more Americans are invested in hedge funds.”  According to the report, the GAO was charged with examining the risks that hedge funds may pose to the financial markets and discussing the ways in which hedge fund creditors and counterparties and federal financial regulators could address those risks.

The GAO found that while hedge funds are generally subject to limited direct oversight by federal regulators, agencies such as the SEC and the Commodity Futures Trading Commission monitor hedge fund activities and related risks through consolidated supervision of large securities firms and participants in the futures markets.  The GAO also determined that creditors, counterparties and other market participants play a primary role in “constraining risk taking and leveraging” by hedge fund advisers.  In addition, based on annual survey data from 2001 through 2006 from the industry publication Pensions & Investments, the GAO reported that pension plan investments in hedge funds have increased, but that such investments remain a small percentage of the total assets of pension plans. 

The GAO reviewed and analyzed regulatory examination documentation and enforcement cases from banking, securities and futures markets regulators such as the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Federal Deposit Insurance Corporation, the SEC, the CFTC and the National Futures Association.  Based on its review, the GAO estimated that the SEC regulates approximately 1,991 hedge fund advisers that are registered as investment advisers, including 49 of the largest US hedge fund advisers that account for about one-third of hedge fund assets under management in the United States.  In addition to enforcing regulatory reporting requirements that registered hedge fund advisers must comply with, the SEC conducts inspections of high-risk investment advisers every three years.  According to SEC officials, the GAO reported that 294 of the 321 hedge fund advisers examined in 2006 received deficiency letters from the SEC, with the greatest deficiencies in the following areas: (1) information disclosures, reporting and filing; (2) personal trading and (3) compliance policies.  Despite these types of regulatory activities, the SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with the SEC as investment advisers.  The GAO found that with limited authority for direct regulation, the SEC largely monitors hedge fund activities through supervision of certain large, internationally active US securities firms with significant hedge fund activities by virtue of its Consolidated Supervised Entity (“CSE”) program, launched in 2004.  The CSE program allows the SEC to monitor risk management practices of securities firms that have significant interaction with hedge funds through affiliates previously not overseen by federal regulators.  The CFTC operates in a similar manner: through its market surveillance, regulatory compliance surveillance and delegated examination programs, the CFTC can provide oversight of persons registered as commodity pool operators and commodity trading advisors that operate or advise hedge funds trading in the futures markets.

The GAO report also considered the role of non-regulatory actors, such as investors, creditors and counterparties, in moderating the amount and type of risk that hedge fund advisers assume.  These market participants “regulate” hedge funds by reinforcing sound management practices and avoiding excessive risk-taking and leveraging by hedge fund advisers.  Hedge fund advisers have responded to increased efforts at conducting due diligence and ongoing management of credit terms by investors, creditors and counterparties with improved disclosure and increased transparency.  However, the GAO identified key limitations to the ability of market participants to impose market discipline.  First, since many large hedge funds use multiple prime brokers, the ability of any one single broker to accurately assess a client’s total leverage would be significantly handicapped.  Also, creditors and counterparties may lack the necessary information and skills to understand the complex financial instruments and investment strategies employed by hedge funds to properly evaluate risk exposures.  Finally, creditors may compromise certain credit standards to attract and retain hedge fund clients. 

The GAO concluded its report by exploring the potential for systemic risk from hedge fund-related activities.  The federal agency report recommended continued cooperation among investors, creditors, counterparties, hedge fund advisers and regulators.  Citing recent collaborations between US federal banking regulators and bank regulators of Germany and Switzerland, as well as the establishment of private sector committees by the President’s Working Group on Financial Markets, the GAO viewed such initiatives as “positive steps” taken to address systemic risk and to better prepare for a potential financial crisis. 

As part of its report on market discipline of hedge funds, the GAO also provided information on pension plan investments in hedge funds.  Survey data from Pensions & Investments indicated that of the largest pension plans in the United States, the percentage of defined benefit plans reporting investments in hedge funds increased from 11% in 2001 to 36% in 2006.  The Pensions & Investments’ survey also showed that the largest defined benefit plans reporting investments in hedge funds preferred to invest through fund-of-funds vehicles.  Based on September 2006 data, defined benefit plans with the largest reported hedge fund investments for 2006 included plans such as the Pennsylvania State Employees’ Retirement System, the New York State Common Retirement Fund and the California Public Employees’ Retirement System.