SEC Rules and Regulations

Naked Short Sale Emergency Order Expires - SEC to Propose New Rules

As reported in the August 4, 2008 Investment Management Regulatory Update, in July, the SEC issued and later extended an emergency order imposing restrictions on "naked" short sales of the securities of certain financial institutions.  Although the order expired and was not re-extended on August 13, 2008, public statements by SEC Chairman Christopher Cox indicate that the SEC plans to propose new rules regarding short sales.

According to Cox, proposed rules could be released shortly and would likely be broader than the emergency order.  In a recent Op-Ed published in the Wall Street Journal, Cox indicated that he believes the emergency order's prohibition on naked short sales of the securities of financial institutions should be extended to the market as a whole.  Regulation SHO already restricts naked short sales, but allows a short sale if the broker-dealer has "reasonable grounds" to believe that the security can be borrowed.  According to Cox, the SEC is considering the elimination of the "reasonable grounds" exception.  Another proposal, Cox says, would require traders to report any substantial short positions, similar to the way substantial long positions must be reported. 

Separately, a number of Congressmen have called for the SEC to reinstate the "uptick rule."  The rule required that short sale trades could only be executed at a price above the previous trade in the security, but was rescinded in July 2007.  In testimony before the House Financial Services Committee, Cox defended the repeal of the rule, claiming that it had been ineffective, but also indicated that the SEC was considering whether to adopt a similar but potentially more effective measure.

SEC Issues Proposed Guidance for Registered Fund Boards on Soft Dollars

On July 30, 2008, the SEC published for comment guidance to boards of directors of registered investment companies on the use of soft dollars (the "Proposed Guidance").  According to the Proposed Guidance, to satisfy its fiduciary duties to a fund, the board of a registered investment company must exercise oversight of the investment adviser to the fund, including oversight of the adviser's best execution and soft dollar practices.  Soft dollars create a conflict of interest for advisers because, as fiduciaries themselves, advisers are required to obtain best execution for securities transactions they conduct on behalf of their fund clients; however, the use of brokerage commissions to pay for research and other products may incentivize advisers to disregard their obligations in this regard.  The Proposed Guidance proposes numerous considerations for boards in fulfilling their supervisory responsibilities over an adviser's best execution and soft dollar practices.

Among other things, with respect to investment advisers' best execution practices, the Proposed Guidance suggests that fund directors should request data from a fund's investment adviser, including "(i) the identification of broker-dealers to which the adviser has allocated fund trading and brokerage; (ii) the commission rates or spreads paid; (iii) the total brokerage commissions and value of securities executed; and (iv) the fund's portfolio turnover rates."  In addition, the Proposed Guidance recommends that fund directors ask the adviser how it determines best execution and evaluates execution quality, including the execution of "execution-only" trades, fixed-income transactions and international trading activities, as well as who negotiates commissions and how transaction costs are measured. 

Furthermore, the Proposed Guidance advises fund directors to evaluate the adviser's compliance policies and procedures with respect to the use of soft dollars and the safe harbor for soft dollar use under Section 28(e) of the Securities Exchange Act of 1934.  Under the Section 28(e) safe harbor, the investment adviser is responsible for determining in good faith that the amount of commission paid is reasonable in relation to the value of brokerage and research services received, but the Proposed Guidance reminds investment company directors to consider whether the adviser's compliance policy is designed to ensure compliance with the safe harbor.  In particular, the Proposed Guidance recommends that fund directors inquire as to how the adviser determines what kind and how much research to purchase, how it makes broker allocations (by a broker vote process or otherwise), and how it evaluates the value of products purchased with soft dollars.  The Proposed Guidance also proposes that if a fund's board believes that brokerage commissions could be used to greater benefit of the fund, the board should so direct the adviser.  In addition, the Proposed Guidance suggests that fund boards evaluate an adviser's use of soft dollars within the context of compensation paid to the adviser under Section 15(c) of the Investment Company Act of 1940.

The SEC is soliciting comments on the Proposed Guidance, specifically with respect to whether the Proposed Guidance accurately describes how the broker-dealer market works with respect to funds and investment advisers; how changes in the brokerage industry should affect a fund board's oversight of the fund's adviser; what information might help directors review an adviser's trading practices and procedures and use of soft dollars; examples of effective practices used by fund boards to evaluate whether an adviser has made a good faith determination under Section 28(e); and whether additional disclosure regarding trading practices and the use of soft dollars should be made to investors.  The SEC comment period ends on October 1, 2008.

SEC Issues Proposed Guidance on the Use of Corporate Websites

As reported in the July 30, 2008 Client Newsflash, on July 30, 2008, the SEC announced that it would publish interpretive guidance on the use of corporate websites as a means to disseminate information to investors.  On August 7, 2008, the SEC published the proposed guidance (the "Proposed Guidance").  The Proposed Guidance covers whether and when information posted on a corporation's website is "public" for purposes of the applicability of Regulation FD, satisfaction of Regulation FD's public disclosure requirement, and considerations related to the antifraud provisions of the securities laws.

Of particular interest to investment advisers is a footnote in the Proposed Guidance that "any SEC-registered investment adviser (or investment adviser that is required to be SEC-registered) that includes, in its website or in other electronic communications, a hyperlink to postings on third-party websites, should carefully consider the applicability of the advertising provisions of the Investment Advisers Act of 1940 ("Advisers Act")."  Section 206(4) of the Advisers Act and Rule 206(4)-1(a) issued thereunder make it a fraudulent act for an investment adviser to refer to testimonials about itself or advice rendered by it in its advertisements.

The SEC comment period ends on November 5, 2008.


New York State Court Decision Rules Hedge Fund Investors Cannot Directly Sue Prime Brokers

A New York State Supreme Court decision on July 1, 2008, dismissed claims by a failed hedge fund's investors against the fund's prime broker (Eurycleia Partners LP v. UBS Securities LLC, No. 600874/07 (N.Y. Sup. Ct. July 23, 2008)).  Plaintiffs in the case, limited partners in the hedge fund Wood River Partners L.P. ("Wood River"), claimed damages from UBS based on allegations that UBS had contributed to Wood River's collapse in 2005.  Among other things, the plaintiffs' $200 million damages action alleged that UBS breached a fiduciary duty it owed to the plaintiffs and aided and abetted breaches of fiduciary duty by the fund's principals.

Wood River failed after it acquired an alleged 30% stake in telecommunications equipment manufacturer Endwave Corp., in violation of the investment strategy described in its offer documents and without disclosing the size of its position to the SEC.  Due to a decrease in the share price of Endwave, and consequently in the value of its portfolio, Wood River was unable to meet redemption requests in the summer of 2005 and collapsed.  The SEC thereafter investigated the fund and instituted an action to take it into receivership.  Wood River's founder, John Whittier, was indicted and pleaded guilty to violations of the securities laws.

The plaintiff limited partners asserted that UBS, as Wood River's prime broker and custodian, knew that Wood River owned sufficient Endwave stock to trigger SEC reporting obligations but did nothing to remedy the fact that it had not made the required filings.  In addition, plaintiffs alleged that UBS manipulated the market for Endwave stock by creating a short market that contributed to a drop in Endwave's share price.

UBS moved to dismiss all claims against it on the ground that the plaintiffs lacked standing to directly assert causes of action against UBS because, as limited partners in Wood River, their claims were derivative in nature.  Taking all alleged facts to be true (as required in reviewing a motion to dismiss), the court agreed with UBS, acknowledging that "UBS's alleged misconduct resulted in a direct injury to the partnership," and the plaintiffs' losses only flowed from that harm.  Therefore, claims could only be asserted by or on behalf of the partnership, not the investors themselves.

In addition, the court determined that the plaintiffs failed to demonstrate that UBS's position as prime broker and custodian for Wood River created a fiduciary relationship with Wood River's limited partners, stating that "allegations, without more, are not sufficient to establish the existence of a fiduciary relationship."  Finally, the court stated that the aiding and abetting cause of action failed because the plaintiffs had not pleaded facts sufficient to demonstrate that UBS had substantially assisted Wood River's principals in breaching their fiduciary duty to the limited partners.

Hedge Fund Adviser Sanctioned for Unauthorized Transfers between Funds

The SEC recently charged a hedge fund adviser and one of its employees in an administrative proceeding for transferring cash from two of the funds it advised in order to satisfy the margin calls of a third.  The adviser and its employee consented to a settlement of the proceedings without admitting wrongdoing.

Aeneas Capital Management, L.P. ("Aeneas") serves as the investment adviser for three separate hedge funds, Aeneas Evolution Portfolio, Ltd. ("Evolution"), Aeneas Portfolio Company, L.P. ("Portfolio") and Priam Holdings, Ltd. ("Priam").  Thomas C. Palmer served as the director of operations for Aeneas and was responsible for overseeing and managing the funds' margin balances.   

Priam invested primarily in issuers trading on the Malaysian securities exchanges.  According to the SEC, Priam received a number of margin calls within a short period of time on one of its highly leveraged investments.  Unable to satisfy the margin calls with its own assets, Palmer instructed Aeneas' prime broker to initiate five separate cash transfers from Evolution and Portfolio to Priam, totaling $13.4 million.  Palmer told the prime broker that the transfers were loans from Evolution and Portfolio to Priam, although the SEC claims there was no contemporaneous loan documentation.  The SEC's order also noted that the funds' offering documents did not disclose the possibility of such types of transfers and that such transfers were not consistent with the adviser's fiduciary obligations.  The transfers were later reversed and repaid in full, with interest, to Evolution and Portfolio.

The SEC charged Palmer with willfully aiding, abetting and causing Aeneas to violate the antifraud provisions of Sections 206(1) and 206(2) of the Investment Advisers Act of 1940, and charged Aeneas under Section 206(e)(6) for failing to reasonably supervise Palmer.  Palmer consented to a cease-and-desist order, a suspension from association with an investment adviser for twelve months and a civil money penalty of $65,000.  Aeneas consented to a censure and a civil money penalty of $150,000.

New York Attorney General Announces Settlements with Firms Over Auction Rate Securities

Over the last few weeks, New York Attorney General Andrew Cuomo has announced preliminary settlements with several investment firms that marketed auction rate securities ("ARS").  Eight banks, including Citigroup, UBS, Morgan Stanley, JPMorgan, Wachovia, Merrill Lynch, Goldman Sachs and Deutsche Bank, have agreed to buy back nearly $60 billion of ARS from retail customers, charities and small to mid-sized businesses.  The settlements settle allegations that the banks misrepresented ARS as safe, cash-equivalent products.  Under the agreements, without admitting wrongdoing, the banks have agreed to repurchase the securities from eligible customers, generally by the end of 2008.  In addition, they will participate in an arbitration procedure to resolve claims of consequential damages suffered by investors who were not able to access their funds and will pay fines totaling over $500 million.  Some of the settlements also require the banks to repurchase ARS from institutional investors and to provide no-cost loans to eligible customers until their ARS are repurchased.

ARS are debt or preferred stock issued by municipalities, student loan pools and closed-end funds whose interest or dividend rate is reset periodically through auctions held by sponsor banks.  The once-$330 billion market for ARS froze in February 2008 when banks stopped supporting auctions for which there was not enough investor demand.  Since February, investors in ARS have been unable to exit the market, and various state and federal regulators have been investigating whether banks and brokerages improperly marketed the securities as highly liquid, cash-equivalents despite increasing liquidity risk.

Cuomo has also announced that his office continues to investigate down-stream brokerages, such as Fidelity and Charles Schwab, as well as individuals at the banks and brokerages.  The SEC is party to several of the preliminary settlements, but has also announced that it may levy additional fines in the future.

See a copy of the New York State Attorney General's Office releases regarding the settlements:

Insider Trading Charge Dismissed in SEC Suit over Pre-PIPE Short Sale

On August 20, 2008, a federal court dismissed the remaining charge of insider trading in a case the SEC brought against a trader for short-selling public shares of a company while the trader was committed to purchase shares in a pending but unannounced PIPE offering.  As reported in the December 13, 2007 Investment Management Regulatory Update, the court previously dismissed the SEC's charge that the defendant engaged in the sale of unregistered securities by covering his short sale with securities he purchased in the PIPE.

John Mangan was employed by the broker-dealer that was acting as a placement agent for a PIPE offering by CompuDyne Corporation.  Because of his position, he was aware of the planned PIPE and convinced his business partner to purchase shares in the PIPE on their behalf.  The PIPE shares priced at $12 while public CompuDyne shares previously closed at $17.38.  On the morning after pricing but before the PIPE transaction was announced, Mangan placed an order to sell short public shares of CompuDyne.  By the time the short sale order was executed the stock had dropped from the previous close to $14.16.  The PIPE was announced later in the day and the stock closed at $14.25.  Mangan later covered his short positions using shares he purchased in the PIPE.

The SEC charged Mangan with (i) engaging in the sale of unregistered securities in violation of Section 5 of the Securities Act of 1933 (the "Securities Act") and (ii) insider trading in violation of Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.  The court previously dismissed the sale of unregistered securities charge, finding that no sale of unregistered securities had occurred, leaving only the insider trading issue.

Dismissing the remainder of the case, the court found that the SEC had failed to prove that Mangan traded based on information that was material and nonpublic  (SEC v. Mangan, No. 3:06CV531 (W.D.N.C. Aug. 20, 2008)).  The court determined that materiality must be determined with reference to the time that the trades actually occurred.  Since the short sales were executed at $14.16 and by market close after the disclosure of the PIPE the shares were trading at $14.25-a nine cent difference-the court found the disclosure of the information that Mangan was in possession of was viewed as immaterial by the market.  Therefore, according to the court, the SEC had failed to prove that the information Mangan traded on was material at the time he traded.

Seventh Circuit Divided over Revisiting Excessive Fees Ruling

As reported in the June 5, 2008 Investment Management Regulatory Update, in May, a three-judge panel of the U.S. Court of Appeals for the Seventh Circuit issued an opinion breaking with Second Circuit precedent on how courts should analyze whether fees that an investment adviser charges registered investment companies are "excessive."  In an unusual procedure, one of the Seventh Circuit judges not on the panel that issued the ruling requested a rehearing of the decision by the full court.  When the request for a rehearing failed to gain majority support (the judges split five to five with one recusal), Judge Richard Posner issued an opinion strongly dissenting from the panel's approach.   

Section 36(b) of the Investment Company Act of 1940 assigns the adviser of a registered investment company fiduciary duties with regard to its receipt of compensation from the company.  In Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982), the Second Circuit held that the duty is violated if the fee charged is "so disproportionately large that it bears no reasonable relationship to the service rendered and could not have been the product of arm's-length bargaining."  The Seventh Circuit panel's recent decision, however, split with Gartenberg and held that it is not for a court to decide whether a fiduciary's fees are "reasonable," but whether they were fully and fairly disclosed (Jones v. Harris Associates L.P., 527 F.3d 627 (7th Cir. 2008)).  Market forces and competition constrain fees, according to the panel, because when fees are unreasonable in relation to the returns, investors move their money elsewhere.

In what some have said amounts to a call for Supreme Court review of the issue, Judge Posner, joined by four other dissenting judges, criticized the panel's departure from the Gartenberg standard.  According to Posner, because mutual funds are generally captive to the advisers that created them, the arms-length bargaining process required for a competitive market never occurs.  In contrast, Posner points out, where arms-length bargaining does occur, such as for equity pension fund portfolio managers, the advisory fees tend to be significantly lower.

SEC Charges Mutual Fund Manager for Violating Socially Responsible Investing Restrictions

On July 30, 2008, the SEC charged Pax World Management Corp. ("Pax") for violating its own "socially responsible investment" or "SRI" criteria.  The SRI restrictions included, among others, that Pax would not purchase for the funds it advises securities of companies that earn revenue from the manufacture of alcohol or gambling products, that derive over 5% of their revenue from U.S. defense contracts or that did not meet the funds' environmental and labor standards.

According to the SEC's July 30 order, the SEC found that from 2001 to 2005 Pax had purchased securities for its funds that violated the restrictions it had set forth in the funds' prospectuses and other filings.  The SEC also found that Pax had not followed its own SRI compliance policies and procedures.  Beginning in 2005, Pax began to take certain remedial measures, including replacing certain investment and compliance professionals, adopting a new compliance manual and implementing SRI compliance software.

The SEC charged Pax with violations of Section 206(2) of the Investment Advisers Act of 1940 (the "Advisers Act") for engaging in fraud upon clients and prospective clients; Section 13(a)(3) of the Investment Company Act of 1940 (the "Investment Company Act") for causing the funds it advised to deviate from their stated investment policy without authorization by shareholder vote; and Section 34(b) of the Investment Company Act for making untrue statements of material fact in the funds' registration statements and other filings made pursuant to the Investment Company Act.

Without admitting or denying the findings in the SEC's order, Pax agreed to be censured, to cease and desist from future antifraud and filing violations of the Advisers Act and Investment Company Act and to pay a fine of $500,000.


SEC Launches AML Compliance Initiatives

In an effort to help mutual funds understand and comply with their anti-money laundering ("AML") obligations, on August 7, 2008, the SEC announced two new compliance initiatives.  First, the SEC unveiled a new website, called the "AML Source for Mutual Funds", which provides links to "key AML laws, rules and related guidance."  Second, the SEC created a dedicated phone line for securities firms to alert the SEC of suspicious activity reports the firms have filed that they believe require immediate attention.