DP&W Investment Management Regulatory Update

SEC Rules and Regulations

SEC Adopts Temporary Rule on Principal Trades under the Advisers Act and Proposes Amendments to Interpretive Rules Regarding Broker-Dealers

On September 19, 2007, the SEC unanimously voted to adopt, on an interim final basis, temporary Rule 206(3)-3T under the Investment Advisers Act of 1940 (the "Advisers Act"), which provides temporary relief for certain nondiscretionary advisory accounts (including accounts that until now were operated as fee-based brokerage accounts) from the principal trading restrictions of Section 206(3) of the Advisers Act.  The SEC release containing the temporary rule (the "Temporary Rule Release") was published on September 24, 2007.  The rule took effect on September 30, 2007, and will expire on December 31, 2009.  The SEC has asked for comments on the rule by November 30, 2007.

Under Section 206(3) of the Advisers Act, an investment adviser is prohibited from knowingly selling any security to, or purchasing any security from, a client as a principal for its own account, unless the adviser discloses in writing to such client the capacity in which such adviser is acting and obtains the client's consent.  Such disclosure must be made, and the client's consent obtained, on a transaction-by-transaction basis.  In April 2005, the SEC had adopted Rule 202(a)(11)-1 under the Advisers Act, which, subject to several conditions, exempted from regulation under the Advisers Act (including the principal trading restrictions thereunder) broker-dealers that provide incidental investment advisory services and receive fee-based compensation.  However, the U.S. Court of Appeals for the District of Columbia Circuit vacated Rule 202(a)(11)-1 in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. Mar. 30, 2007), as is discussed in greater detail in the April 2007 Investment Management Regulatory Update, which took effect on October 1.  As a result of the decision, fee-based brokerage customers must now decide whether to convert their accounts to fee-based accounts subject to the Advisers Act or to commission-based brokerage accounts.  According to the Temporary Rule Release, Rule 206(3)-3T was adopted to allow investors to make an informed decision in this regard, while continuing to have access to certain securities held in the principal accounts of certain advisory firms.

Under Rule 206(3)-3T, registered investment advisers that are also registered as broker-dealers under Section 15 of the Securities Exchange Act of 1934 (the "Exchange Act") can comply with the principal trading restrictions set forth in Section 206(3) of the Advisers Act with respect to non-discretionary advisory accounts if, among other things,

  1. the adviser has made written disclosure to its client regarding the conflicts arising from principal transactions and the manner in which the adviser addresses those conflicts;
  2. the client has executed a written, revocable consent prospectively authorizing the adviser to enter into principal transactions;
  3. prior to the execution of each principal transaction, the adviser informs its client, orally or in writing, of the capacity in which it may act with respect to such transaction and the client consents, orally or in writing, to having the adviser act in such capacity;
  4. at or before completion of each such transaction, the adviser sends to the client written confirmation disclosing that the adviser disclosed to the client the capacity in which the adviser acted and the client's authorization of the transaction; and
  5. at least annually, the adviser sends to the client a report itemizing the principal transactions executed in reliance on Rule 206(3)-3T, and the date and price of such transactions.

An investment adviser/broker-dealer may rely on Rule 206(3)-3T only with respect to brokerage accounts that are subject to the Exchange Act and the rules thereunder, as well as the rules of the self-regulatory organizations of which the broker/dealer is a member.  The temporary rule will not be available for principal trades in securities that are issued or underwritten by the adviser or its affiliates, other than trades in investment grade nonconvertible debt securities that are underwritten by such adviser or its affiliates.  It should also be noted that an investment adviser/broker-dealer that complies with Rule 206(3)-3T is not exempt from the other provisions of the Advisers Act or other applicable provisions of federal law and has to comply with the fiduciary duties thereunder (including, for example, the duty to seek best execution and the duty to disclose material facts relating to conflicts of interest).

The Temporary Rule Release provides for a transition period until December 31, 2007, during which investment advisers/broker-dealers can rely on the temporary rule without obtaining their clients' written consent (although they must comply with the other requirements of the temporary rule).  Also during the transition period, advisers are not required to deliver a disclosure statement pursuant to Rule 204-3 under the Advisers Act to the fee-based brokerage customers that convert to non-discretionary advisory accounts.

At the same time as it adopted Rule 206(3)-3T, the SEC voted in favor of a proposal to reinstate three interpretative rules under the Advisers Act that were previously vacated in connection with Rule 202(a)(11)-1.  The proposed interpretive rules are contained in a separate release (the "Proposed Rule Release") that was also published on September 24, 2007.  Comments on the proposed rules must be submitted by November 2, 2007.

The first interpretive rule would provide guidance as to when investment advice provided by a broker-dealer is "solely incidental" to the conduct of the broker-dealer's business within the meaning of Section 202(a)(11)(C) of the Advisers Act.  The advice would not be considered "solely incidental" if the broker-dealer charges a separate fee or enters into a separate agreement for advisory services with the client.  In addition, the exercise of investment discretion would preclude the characterization of the advice as being "solely incidental," unless the investment discretion were granted on a temporary or limited basis only.  The second interpretive rule would clarify that a broker-dealer would not be deemed to receive "special compensation" within the meaning of Section 202(a)(11)(C) of the Advisers Act "solely because it charges a commission, mark-up, mark-down, or similar fee for brokerage services that is greater than or less than one that it charges to another customer."  Finally, the third interpretive rule would provide that broker-dealers that are also registered as investment advisers will be considered investment advisers only with respect to those accounts for which they provide services that subject them to the Advisers Act.

We will monitor further developments in this area.

SEC Interpretations

No-Action Letter Provides Guidance on Applicability of Custody Rule to Investment Advisers that Inadvertently Receive Client Assets

On September 20, 2007, the SEC's Division of Investment Management (the "Division") issued a no-action letter in response to a request by the Investment Adviser Association (the "IAA") regarding compliance with Section 206(4) of the Investment Advisers Act of 1940 (the "Advisers Act") and Rule 206(4)-2 thereunder (the "Custody Rule") in cases where an investment adviser inadvertently receives client assets from third parties.

The Custody Rule provides, inter alia, that an adviser registered (or required to be registered) with the SEC violates Section 206(4) of the Advisers Act if it has "custody" of client assets, unless a qualified custodian maintains those assets and certain other conditions are satisfied.

The IAA sought assurances that the Division would not recommend enforcement action against investment advisers that inadvertently receive client assets from third parties and promptly forward those assets to the relevant client or a qualified custodian (instead of sending the assets back to the third parties from whom they were received). In particular, the IAA identified the following as client assets that investment advisers frequently receive from third parties:

In the case of each of these specific assets, the Division stated that it would not recommend enforcement action if the investment adviser promptly (within 5 business days of receipt) forwards such assets to its client or a qualified custodian. In addition to considering only situations involving the assets listed above, the Division expressly limited its no-action relief to situations in which an adviser (a) has used reasonable best efforts to instruct the third party to deliver client assets to the client or a qualified custodian, (b) has no control over the third party and (c) has not directly or indirectly caused the third party to deliver client assets to the adviser. The Division also clarified that if an adviser inadvertently receives client assets from third parties "in more than rare or isolated instances," such adviser would be expected to implement written policies and procedures to ensure that "the adviser:

  1. promptly identifies client assets that it inadvertently receives;
  2. promptly identifies the client (or former client) to whom such client assets are attributable;
  3. promptly forwards client assets to its client (or former client) or qualified custodian, but in no event later than five business days following the adviser's receipt of such assets;
  4. promptly returns to the appropriate Third Party any inadvertently received client assets that the adviser does not forward to its client (or former client) or a qualified custodian, but in no event later than five business days following the adviser's receipt of such assets; and
  5. maintains and preserves appropriate records of all client assets inadvertently received by it, including a written explanation of whether (and, if so, when) the client assets were forwarded to its client (or former client) or a qualified custodian, or returned to Third Parties."

Finally, the Division noted that even if an adviser inadvertently receives client assets from third parties only in "rare and isolated instances," such adviser would be expected to act in a manner consistent with the requirements set forth above.


Bankruptcy Court Denies Chapter 15 Protection to Insolvent Bear Stearns Funds

On August 30, 2007, the U.S. Bankruptcy Court for the Southern District of New York (the "New York Court") denied petitions seeking to recognize the liquidation of the Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd. and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund, Ltd. (together, the "Funds") in the Grand Court of the Cayman Islands (the "Cayman Court") under Chapter 15 of the U.S. Bankruptcy Code (the "Code") (Cases No. 07-12383 (BRL) and 07-12384 (BRL)).

Both Funds were organized as Cayman Islands-exempted limited liability companies with registered offices in the Cayman Islands.  However, the Funds' investment manager, administrator, assets, books and records, and investor registers were all located/maintained outside of the Cayman Islands.  As a result of the sub-prime mortgage crisis, the Funds suffered significant devaluations of their asset portfolios and, upon resolutions of their respective boards of directors on July 30, 2007, filed petitions in the Cayman Court for their winding-up and for the appointment of provisional liquidators.  The petitions were granted on July 31, 2007.  On the same day, the provisional liquidators filed petitions with the New York Court for the recognition of the Cayman Islands liquidations as "foreign main proceedings" or, alternatively, as "foreign nonmain proceedings" within the meaning of Chapter 15.  On August 9, 2007, the New York Court issued a preliminary injunction that protected the Funds against third-party claims and seizure of assets.

In its decision of August 30, 2007, however, the New York Court denied the petitions of the provisional liquidators and thereby denied the Funds Chapter 15 protection.  In so doing, the court held that the liquidation in the Cayman Islands was not a "foreign main proceeding" because the Funds' center of main interests ("COMI"), as defined in Section 1502(4) of the Code, was not located in the country of the foreign proceeding (i.e., the Cayman Islands) but rather in the U.S.  According to the court, the presumption that a debtor's registered office is its COMI was rebutted in this case because the Funds' only connection to the Cayman Islands was the fact that they were registered there.  In reaching this conclusion, the court also noted that the Funds had no employees or managers in the Cayman Islands (although two directors did reside in the Cayman Islands), the investment manager and administrator, together with the Funds' books and records, were in New York, and, prior to the proceedings, all of the Funds' liquid assets were in the U.S.  Furthermore, the court found that the liquidation in the Cayman Islands was not a "foreign nonmain proceeding" because the Funds did not have an "establishment... for the conduct of nontransitory economic activity" (i.e., a local place of business) in the Cayman Islands as required by Section 1502(5) of the Code.  In coming to this conclusion, the New York Court considered that, under Cayman Islands law, exempted companies are, in fact, prohibited from engaging in business in the Cayman Islands except in furtherance of business that is otherwise conducted outside of the Cayman Islands.

It should be noted that the New York Court's denial of the request for recognition as a "foreign main proceeding" or "foreign nonmain proceeding" was without prejudice to the Funds' ability to file for relief under Chapters 7 or 11 of the Code in the district in which the Funds' management functions are primarily located.

Industry Update

SEC Sends Controversial Examination Letter to Hedge Fund Advisers in Push to Curb Insider Trading

The SEC's New York Regional Office recently sent a 27-page examination letter to hedge fund advisers requesting detailed information on a wide range of topics.  Christopher Cox, Chairman of the SEC, told reporters on September 19 that more than two dozen hedge fund advisers had received the examination letter so far and that additional advisers may also receive it.  Industry observers criticized the letter, citing the nature and extent of the information requested, some of which had not been asked for before.  In reply, however, Gene Gohlke, associate director in the SEC's Office of Compliance and Examinations, reportedly said that the New York staff was merely spelling out in greater detail what the SEC has been expecting firms to provide during examinations for some time.  According to Cox, Gohlke and SEC Regional Director Mark Schonfeld, the new questions in the examination letter are aimed at detecting insider trading.

In addition to certain general information about advisers' businesses, the letter requests copies of policies and procedures and solicits detailed information regarding the following topics: risk management and internal controls; registration and disclosure; portfolio management/trading; brokerage arrangements; trade allocations; conflicts of interest/insider trading; valuation; custody; performance advertising/marketing; information processing, reporting and protection; compliance program/internal controls; business continuity plan; and service providers.

The requests for detailed information include the following:

Industry observers have noted that many advisers may not have the requested information readily available and would have to spend a considerable amount of time and resources to gather it and that, in some instances, it might even be impossible to do so.  Gohlke has reportedly indicated that, although the letter gives advisers two weeks to provide the requested information (instead of the usual 24-36 hours), the SEC will allow more time if an adviser can show that two weeks are not enough.

SEC Asks Investment Company Institute to Remind its Members of the Prohibition Against Using 22c-2 Information for Marketing Purposes

In a letter dated August 21, 2007, the SEC asked the Investment Company Institute (the "ICI") to remind its members that a fund's use or disclosure for marketing purposes of information received from intermediaries pursuant to Rule 22c-2 under the Investment Company Act of 1940 (the "Investment Company Act") "is prohibited under the Gramm-Leach-Bliley Act's privacy rules, unless the intermediaries' consumers have been given notice and the opportunity to opt out of this information sharing."

Pursuant to Rule 22c-2, open-end management investment companies that are registered (or that are required to register) under Section 8 of the Investment Company Act must enter into written agreements with each of their financial intermediaries.  Under those agreements, the intermediaries must agree to provide to the funds, upon request, certain investor identity and transaction information.  Rule 22c-2 requires that funds be able to request and receive such information under agreements with intermediaries by October 16, 2007.

In its letter, the SEC reminds the ICI that the use of such information is governed by Regulation S-P, which does not permit a fund to use the information for marketing purposes unless the privacy policies of the intermediaries disclose the intended use and the consumer has not opted out, subject to certain exceptions—namely, (i) for "processing and servicing transactions at the consumers' request" and (ii) for "complying with applicable legal requirements."