SEC Rules & Regulations

SEC Proposes Rule Changes Requiring Standardized Summary Information in Prospectuses for Mutual Funds

On November 21, 2007, the SEC proposed rules that, if adopted, would (i) require a mutual fund to provide prospective investors with a brief summary of key information written in plain English in a standardized order at the front of its statutory prospectus and (ii) allow a mutual fund to satisfy its prospectus delivery requirements pursuant to Section 5(b)(2) of the Securities Act of 1933 by sending prospective investors key information in the form of a summary prospectus and making the statutory prospectus available on the Internet.

The SEC identified the following aspects of a mutual fund as key information that would be contained at the front of the statutory prospectus and in the summary prospectus:

  • the fund's investment objectives, primary investment strategies, risks and costs;
  • the fund's performance and top 10 holdings, updated quarterly for purposes of the summary prospectus;
  • the fund's investment advisers and portfolio managers;
  • the fund's purchase and sale procedures;
  • the tax consequences of an investment in the fund; and
  • financial intermediary compensation.

The SEC noted that the key information it has identified for purposes of the proposed rules is largely the same information that is currently in the risk/return section at the beginning of current mutual fund prospectuses.  The SEC suggested that the key information should be presented "succinctly, in three or four pages at the front of the prospectus."  The summary prospectus would contain the same information in the same order as the statutory prospectus.

Additionally, proposed rules would require that each fund covered by a multi-fund statutory prospectus be described sequentially in separate summaries containing the key information identified by the SEC for each such fund at the beginning of the statutory prospectus.  Current rules allow for disclosures covering multiple funds to be integrated in a single statutory prospectus, which the SEC feels can frustrate attempts by investors to find pertinent information regarding the particular fund in which they are interested.

The proposed rules would also allow a mutual fund's summary prospectus to incorporate by reference information from the fund's statutory prospectus, statements of additional information and its most recent shareholder report.  The SEC noted in the release that the summary prospectus is not intended to be a self-contained document but instead is intended to be "one element in a layered disclosure regime that results in simultaneous provisions of information to investors through multiple means."  Among other conditions, in order to take advantage of incorporating information by reference, a mutual fund's summary prospectus would be required to provide links (if the summary prospectus was in electronic form) or specific cross-references (if the summary prospectus was in paper form) to any documents that it incorporated by reference.

Several commissioners expressed hope that the proposed rules would serve to better inform investors about their investments.  By layering information by means of embedded links in the summary prospectus, it is hoped that investors will be more able to compare mutual fund information, according to Andrew J. Donohue, the Director of the SEC's Division of Investment Management.  Chairman of the SEC, Christopher Cox praised the proposal, noting that "[i]nvestors could move from the summary to the details with the click of a mouse."  However, Commissioner Paul Atkins, who acknowledged that the current mutual fund disclosure regime "is impenetrable for many investors," expressed reservations about the requirement in the proposed rules that funds update quarterly the portion of the fund's prospectus covering a fund's top 10 holdings and performance.  Nevertheless, Atkins expressed optimism that the proposed rules represented a step forward with regard to mutual fund disclosure.  Commissioner Kathleen Casey also addressed the industry's liability concerns by highlighting the fact that the proposed rules allow for incorporation of information by reference in the summary prospectus, subject to certain conditions.


Massachusetts Files Complaint Against Bear Stearns in Hedge Fund Case

Massachusetts securities enforcement officials have filed an administrative complaint against Bear Stearns Asset Management, Inc. ("Bear Stearns") (In re Bear Stearns Asset Management Inc., Mass. Sec. Div., Docket No. E-2007-0094, 11/14/07), alleging that between 2004 and 2007, Bear Stearns failed to comply with federal and state securities laws and its own disclosure to investors by failing to obtain the proper consent for hundreds of related party deals and principal transactions.   According to the complaint, these failures amount to violations of Massachusetts securities law, which prohibits fraudulent and deceitful practices in the sale of securities and advisory activities.

Specifically, the complaint alleges that Bear Stearns failed to properly manage conflicts of interest relating to the Bear Stearns High-Grade Structured Credit Strategies Fund (the "High Grade Fund") and the Enhanced Leverage Fund.  The two funds collapsed during June and July 2007, costing investors and creditors billions of dollars.  According to the complaint, investors in the two funds were exposed to significant conflicts of interest because the funds invested in special purpose vehicles structured by the funds' managers and bought and sold securities from those vehicles, as well as from the affiliated broker-dealer, Bear Stearns & Co.  The offering materials for the High Grade Fund stated that in order to manage the risk to investors created by such conflicts, the unaffiliated directors of the fund had to consent to any transactions "involving significant conflicts of interest (including principal trades)."  None of the other documents provided to investors defined what transactions, beyond principal trades, would fall under the category of transactions requiring consent, and Bear Stearns has acknowledged to Massachusetts regulatory officials that "it cannot provide the definition of transactions 'involving significant conflicts of interest' that it used to interpret and comply with its own [disclosure documents]." 

The complaint further alleges that even after Bear Stearns knew or should have known that the necessary conflicts procedures were not being followed with respect to the High Grade Fund, it nonetheless subsequently issued, offered and sold interests in the Enhanced Leverage Fund using offering materials that contained the same assurances and conflicts management procedures described in the offering materials for the High Grade Fund.

The failure to follow proper procedures and obtain the necessary approvals, the complaint states, was attributable partly to the inadequate training and supervision of the staff responsible for conflicts management, who were not aware of when approvals were necessary, and not aware that a failure to obtain approvals could amount to a violation of securities laws.  Furthermore, the complaint states that even when staff did seek consent from unaffiliated directors for certain related party transactions, the information provided to the directors was insufficient to determine whether such transactions should be approved.

The complaint seeks an order that would require Bear Stearns to permanently cease and desist from violating the state securities laws and regulations at issue, censure Bear Stearns, require Bear Stearns to pay an administrative fine in an amount to be determined by the hearing officer and take any further action deemed appropriate for the protection of investors.

Court Dismisses Registration Charges in Suit over PIPE Short Sales

In a bench ruling delivered on October 24, 2007, the court in SEC v. Mangan (W.D.N.C., No. 3:06-CV-531, 10/24/07) dismissed charges that John Mangan, while employed as a registered representative of Friedman, Billings, Ramsey & Co, Inc., violated Section 5 of the Securities Act of 1933 (the "Securities Act") through his short selling of shares of CompuDyne Corp. prior to the public announcement of a PIPE (private investment in public equity) offering by CompuDyne. 

Mangan learned of CompuDyne's anticipated PIPE offering prior to its public announcement through his position with the broker-dealer acting as placement agent for the transaction.  The SEC alleged that both before and after the PIPE was announced, Mangan borrowed and sold short a number of CompuDyne shares.  Mangan then acquired an equal number of shares through the PIPE offering and, after a resale registration statement with respect to the PIPE shares became effective, used those shares to cover his short sales.  The SEC argued that, by short selling CompuDyne securities before the effective date of the resale registration statement and then covering the short sales with the shares received through the PIPE offering, Mangan "effectively sold" the PIPE shares prior to their registration. 

The court dismissed the SEC's charges under Section 5 of the Securities Act, reasoning that even if the facts alleged by the SEC were true, there was no Section 5 violation because "no sale of unregistered securities occurred as a matter of law." 

The court did not dismiss the SEC's charges that Mangan violated the insider trading prohibitions of the Securities Act by selling short on the basis of material nonpublic information, conceding that while it found Mangan's arguments compelling, it was "a very close case." 

Industry Update

Donohue Discusses Regulatory Issues and SEC Initiatives Relating to Separately Managed Accounts

In a recent speech at the 2007 Managed Account Solutions Conference, Andrew J. Donohue, director of the SEC's Division of Investment Management (the "Division"), provided an overview of certain regulatory issues currently relevant to separately managed accounts ("SMAs"), including (i) the possible expansion of recent temporary relief for certain investment advisory accounts from the principal trading restrictions of Section 206(3) of the Investment Advisers Act of 1940 (the "Advisers Act"), (ii) the SEC's acceleration of a study of the broker-dealer and investment advisory industries, (iii) the possible re-proposal of changes to Form ADV, Part 2, (iv) issues relating to trade execution and SMAs and (v) the SEC's review of Rule 3a-4 under the Investment Company Act of 1940 (the "1940 Act").

Principal trading relief. Donohue discussed certain implications of the decision of the U.S. Court of Appeals for the District of Columbia Circuit in Financial Planning Association v. SEC, 482 F.3d 481 (D.C. Cir. 2007) (the "FPA Decision"). 

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 the adviser's own account, unless the adviser discloses in writing to such client the capacity in which the 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.  Rule 202(a)(11)-1 was adopted by the SEC in 2005 to exempt broker-dealers that provided incidental investment advisory services and received fee-based compensation from regulation under the Advisers Act, including the principal trading restrictions of Section 206(3), subject to several conditions.  Rule 202(a)(11)-1 was vacated by the FPA Decision, as discussed in the April 2007 Investment Management Regulatory Update

Donohue noted that, following the FPA Decision, many firms required their fee-based brokerage customers to decide whether to convert their accounts to fee-based accounts that are subject to the Advisers Act, or to traditional commission-based brokerage accounts.  According to Donohue, in discussions with the Division staff following the FPA Decision, broker-dealers argued that the restrictions of Section 206(3) made it impractical for the firms to offer their advisory clients transactions in certain securities that frequently trade on a principal basis, including many kinds of debt obligations (including municipal bonds).  For this reason, broker-dealers believed their fee-based brokerage customers would be unwilling or unable to transition to fee-based accounts subject to the Advisers Act. 

Donohue indicated that the SEC's temporary Rule 206(3)-3T under the Advisers Act (the "Temporary Rule") was adopted in response to these concerns of broker-dealers.  The Temporary Rule, which was discussed in the October 2007 Investment Management Regulatory Update, was adopted by the SEC on an interim final basis in September 2007 and provides temporary relief from the principal trading restrictions of Section 206(3) for certain nondiscretionary advisory accounts, including accounts that were operated as fee-based brokerage accounts prior to the FPA Decision.  Such relief permits an adviser that is also registered as a broker-dealer to give oral disclosure to clients prior to each principal trade, rather than the written disclosure otherwise required by Section 206(3). 

As discussed in the October Update, such relief is subject to numerous conditions, including various written disclosures by the adviser.  In his speech, Donohue indicated that these conditions are designed to prevent overreaching by advisers.  Donohue also indicated, however, that he would seriously consider recommendations that the SEC expand the principal trading relief to include advisers with affiliated broker-dealers, in addition to advisers that are dual registrants, and to include discretionary advisory accounts, including SMA accounts.  While Donohue was not aware of the SEC's having received comments on the topic, he cited a press report suggesting that there was interest among investment advisers in such an expansion.  The comment period for the Temporary Rule closed on November 30, 2007.

Investment adviser/broker-dealer study.  Donohue went on to discuss an upcoming study, commissioned by the SEC and currently being conducted by the RAND Corporation, of "the ways in which broker-dealers and investment advisers market, sell and deliver financial products, accounts, programs and services to individual investors."  The study, which was first proposed in 2005, was previously scheduled for delivery to the SEC in 2008.  However, following the FPA Decision, SEC Chairman Cox requested additional emergency funding to accelerate the study, which is now expected to be completed by the end of the year.  Donohue anticipates that the study will provide insight into the "realities of today's marketplace" and thus allow the SEC to improve investor protection.

Form ADV, Part 2.  Donohue indicated that the Division plans to recommend that the SEC re-propose amendments to Part 2 of Form ADV.  Donohue noted that in 2000, the SEC proposed substantial amendments to both Part 1 and Part 2 of Form ADV, but then delayed the adoption of Part 2 amendments to allow both investment advisers and the SEC to focus on the changes to Part 1 and the transition to electronic filing via the Investment Adviser Public Disclosure website.  Citing significant regulatory and business changes in the investment advisory industry since 2000, Donohue believes that the SEC should re-propose Part 2 in order to solicit a fresh set of comments.   Noting that "[i]n terms of client communication, the importance of Form ADV cannot be overstated," Donohue views this recommendation as one of the most important investment adviser initiatives on the Division's agenda.

Trade execution and SMAs.  In his speech, Donohue also addressed the challenges of achieving "best execution" of trades.  Donohue noted that best execution issues must be addressed not only for equity trades, but for transactions involving other asset classes as well.  Further, products such as SMAs may present different issues and challenges.  Donohue emphasized that clients should be fully informed about, and consent to, any arrangements in which the placement of trades may be "based on or influenced by factors other than an attempt to achieve best execution."  Donohue stated that, in the context of SMAs, this obligation would include disclosing to the client that trades will be placed with the SMA's sponsor, the reasons for placing trades with the sponsor, and the impact that such placement may have on execution of trades, as well as obtaining client consent to such arrangements. 

Review of Rule 3a-4. Finally, Donohue encouraged the submission of views suggesting modifications to the interpretation or implementation of Rule 3a-4 under the 1940 Act, which provides a safe harbor from the definition of "investment company" for programs that provide discretionary investment services to clients. Noting that Rule 3a-4 has remained unchanged since its adoption in 1997, Donohue emphasized the importance of periodically reviewing the rule to assess whether the conditions for taking advantage of the safe harbor adequately account for the variety of managed accounts and investment advisory programs on the market.

Cox Expresses Concerns Regarding Sovereign Wealth Funds

In a recent speech at Harvard University's John F. Kennedy School of Government, SEC Chairman Christopher Cox discussed the implications of the growing size and number of government-owned or controlled corporations and government-owned commercial investment funds.  Cox emphasized the importance of considering the impact this increase could have on the capital markets and on the SEC's ability to effectively achieve its three main goals, which he summarized as protecting investors, maintaining fair and orderly markets and promoting capital formation. 

According to Cox, the increase in government ownership of corporations and investment funds poses an inherent conflict of interest by "breaking the arm's length relationship between government, as the regulator, and business, as the regulated."  Cox believes that, among other things, this blurring of boundaries could increase opportunities for corruption and decrease full and fair disclosure by government-owned or -controlled companies and funds, creating an imbalance between the information available to government and that available to both retail and private institutional investors.  As an example, Cox cited the vast amount of information collected by national intelligence agencies that, left unchecked, has the potential to turn into "the ultimate insider trading tool."  Cox cautioned that even the perception that an information imbalance might exist could threaten investor confidence in the capital markets, which could ultimately cause the market itself to collapse. 

In the same vein, Cox pointed out that sovereign wealth funds have, to date, had a poor track record when it comes to transparency, which raises the question of whether these funds might place government interests over the furtherance of investment returns in allocating resources, and what the impact might be on the pricing of assets and resource allocation in other domestic economies.

Cox's concerns generally encompassed both domestic and foreign government-owned corporations and funds, but he focused on one respect in which investments made by a foreign government differ, from a regulatory perspective, from investments made by the United States government.  Cox noted that, while foreign governments are generally cooperative with the SEC in pursuing foreign private issuers for violations of U.S. securities laws, foreign governments would face a conflict of interest when they themselves, as the controlling persons behind investigated entities, are the targets of insider trading investigations by the SEC.

It remains to be seen, said Cox, whether the growth of government ownership will have a positive or negative effect on investors and on markets, and that it is important to consider how to "maximize the potential benefits and minimize the risks."  He pointed out that the President's Working Group on Capital Markets, the G-7, the World Bank and the International Monetary Fund are already engaged in this analysis.  Cox concluded by assuring that the SEC will "continue to treat government-owned companies and sovereign wealth funds as [they] would any similarly situated private entity" and engage its foreign counterparts in a continuing dialogue about the issues he raised in his speech.

Gohlke Discusses Key Risks for Mutual Funds Investing in Derivatives

In a recent speech to mutual fund directors, Gene Gohlke, Associate Director of the Office of Compliance Inspection and Examinations at the SEC identified twelve key areas of risk that mutual fund directors should consider when investing in derivative products.  These risk areas align with certain general responsibilities of fund directors that Gohlke identified:  (i) to ensure proper disclosure to shareholders, (ii) to establish fair value procedures to price the fund's positions for which market quotations are not readily available, (iii) to approve codes of ethics of the fund and its investment adviser and (iv) to ensure that the fund and its service providers have in place policies and procedures reasonably designed to prevent violations of securities laws.

The twelve areas of risk that Gohlke believes fund directors should focus on can be summarized as follows:

  1. the adequacy of the fund adviser's intellectual and financial resources to successfully participate in the market for derivatives in which the fund invests;
  2. the amount of due diligence in which the fund should engage before investing in a particular derivative product;
  3. the capacity of the fund's investment risk management function to regularly identify, measure, evaluate and manage the fund's ongoing risk exposure;
  4. the full and fair disclosure to shareholders of the investment and operational risks associated with the fund's derivative investments;
  5. the effectiveness of efforts by the fund's service providers to prevent the inappropriate use of non-public information relating to the fund's investments in derivatives;
  6. the effectiveness of the process used to measure the liquidity of the fund's portfolio to ensure that the fund's ongoing liquidity needs can be met;
  7. the capacity of the fund's process for effectively defining and evaluating embedded or economic leverage associated with the fund's positions in derivatives to effectively ensure that the fund's exposure to leverage is within statutory limits and consistent with disclosures made to shareholders;
  8. the reasonableness, in light of current market conditions, of the values for the fund's positions used in calculating its net asset value;
  9. the sufficiency of back office processes to handle the logistics related to the fund's derivative positions;
  10. the effectiveness of the fund's management of material compliance risks relating to the fund's investments in derivatives;
  11. the effectiveness of the fund's Chief Compliance Officer in monitoring and overseeing the fund's exposure to derivatives and the concomitant risks; and
  12. the nature and frequency of information communicated to the Board about the fund's exposure to derivatives' risks and returns.

Gohlke acknowledged that these twelve risk areas raise complex issues for fund managers.  However, because investing in derivatives exposes a fund's shareholders to significant risk, it is critical for fund managers to think practically about policies, processes and systems to minimize and manage those risks.  A fund's investment in derivatives that has not been carefully considered in light of these twelve risk areas has the potential, warned Gohlke, to "quickly dissolve into disaster."