SEC Rules and Regulations

SEC Issues and Extends Emergency Order Restricting "Naked" Short Selling in the Securities of Certain Financial Firms

As was reported in the July 17, 2008 Client Newsflash, on July 15, 2008, the SEC issued an emergency order imposing restrictions on "naked" short sales in the securities of 19 large financial institutions.  The original order was scheduled to expire on July 29, 2008, but has so far been extended until 11:59 p.m. on August 12, 2008. 

The emergency order prohibits any person from effecting a short sale in the publicly traded securities of the designated financial firms (the "Designated Securities") unless such person or its agent has borrowed or arranged to borrow the security prior to effecting such short sale and delivers the security on settlement date. 

The emergency order was amended on July 18, 2008, in response to certain industry concerns.  Among other things, the amended emergency order exempts certain "bona fide market makers" from the borrow or arrange to borrow requirement of the emergency order, requires broker-dealers to document their compliance and clarifies that the emergency order does not apply short sales of restricted securities of the financial firms-such as those issued pursuant to Rule 144A.

While naked short-sales are already restricted by Regulation SHO, the emergency order adds further restrictions for short sales of the Designated Securities.  Regulation SHO prohibits a broker-dealer from effecting a short sale unless it has "reasonable grounds to believe" that the security can be borrowed.  Under the emergency orders, reasonable grounds to believe that the Designated Securities can be borrowed is insufficient-the securities must actually be borrowed or arranged to be borrowed.

According to the SEC, naked short selling can lead to artificial declines in the price of a security.  When the securities of significant financial institutions are involved, the SEC believes such artificial declines can threaten a disruption of the markets.

The SEC is currently considering rulemaking to apply "additional protections against abusing naked short selling."

SEC Reinterprets the Cash Solicitation Rule

As discussed in the July 17, 2008 Client Newsflash: SEC Issues Interpretative Letter Regarding the Cash Solicitation Rule, the SEC staff recently issued an interpretative letter clarifying that Rule 206(4)-3 (the "Cash Solicitation Rule" or the "Rule"), promulgated pursuant to the Investment Advisers Act of 1940 (the "Advisers Act"), generally does not apply to a cash payment paid by an investment adviser to a person (a "solicitor") if the payment is solely to compensate that solicitor for referring investors to, or soliciting investors for, a privately-offered investment fund managed by the adviser.

In making its determination, the SEC staff departed from a literal reading of the Cash Solicitation Rule.  The SEC staff noted that neither the proposing release nor the adopting release of the Rule "contains any statement directly or indirectly suggesting that the Rule would apply to investment advisers' cash payments to others solely to compensate them for soliciting investors for investment pools managed by the advisers."  The SEC staff further reasoned that the Cash Solicitation Rule is "designed" to apply only to investment advisory contracts and noted that "investors in investment pools (as such) do not typically enter into investment advisory contracts with the investment advisers of the pools."  The SEC staff also stated that the fact that the Cash Solicitation Rule refers to "clients" and "prospective clients" bolsters their interpretation that the Rule does not apply to "investors" and "prospective investors."

Further confirmation of the SEC staff's interpretation can be gleaned from the decision of the U.S. Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).  The court in Goldstein held that, for purposes of the Advisers Act, an investment fund's investors do not count as "clients" of the adviser.  Therefore, reasoned the SEC staff, "the references to 'client' and 'prospective client' in Rule 206(4)-3 under the Advisers Act should not be interpreted to include investors in investment pools or prospective investors in investment pools."

The SEC staff indicated that the question of whether the Cash Solicitation Rule applies in a particular case must be evaluated in light of the particular facts and circumstances, and it would view, as relevant to the analysis, the nature of the arrangement, the relationship between the solicitor and the investment adviser and the purpose of the cash payment. 

The SEC staff also noted that a solicitor, depending on the facts, may be acting as an investment adviser within the meaning of Section 202(a)(11) of the Advisers Act and therefore, even if the Cash Solicitation Rule does not apply, would generally have an obligation under Section 206 thereunder to disclose material conflicts of interest to the persons being solicited or referred.  Thus, the letter suggests that a solicitor may continue to have an obligation to disclose the arrangement and the cash payment to such persons.

SEC Proposes Amendments to Investment Company Act and Advisers Act in Light of Proposed Rule Regarding NRSROs

On July 1, 2008, the SEC issued a release (the "Release") that proposes amendments to various rules under the Investment Company Act of 1940 (the "Investment Company Act") and the Investment Advisers Act of 1940 (the "Advisers Act") in light of the SEC's newly proposed rules regarding nationally recognized statistical rating organizations ("NRSROs").  Specifically, the SEC has proposed amendments to Rules 2a-7, 3a-7, 5b-3 and 10f-3 under the Investment Company Act and Rule 206(3)-3T under the Advisers Act.

Currently, these rules generally allow investment companies, or advisers, as applicable, to rely on the ratings of securities provided by NRSROs as a proxy for such securities' creditworthiness and liquidity.  Andrew J. Donohue, Director of the Division of Investment Management at the SEC, noted that, with the exception of Rule 3a-7 under the Investment Company Act, the proposed amendments replace "references to credit ratings" with "subjective requirements that are designed to achieve the intended purpose of each of [these] rules."  According to Donohue, the proposed amendments would, if enacted, generally require investment companies and advisers to engage in their own "subjective determination[s]" in order to establish these elements for purposes of satisfying certain of the requirements of the rules. 

However, the proposed amendments to Rule 3a-7 would, among other things, "limit the type of investors that may participate in the offerings of the securities [of certain structured finance vehicles] to accredited investors and qualified institutional buyers," said Donohue.  Currently, an issuer of such securities may make sales of the securities to the general public, and maintain its exclusion from regulation under the Investment Company Act, provided that the securities were highly rated by an NRSRO.

The Release noted the SEC's three principal concerns regarding referring to NRSROs in its rules and regulations.  First, the Release suggested that referencing NRSROs in SEC rules and regulations implied "an endorsement of the quality of the credit ratings issued by NRSROs, which may have encouraged investors to place undue reliance on the credit ratings issued by these entities."  The Release also expressed the SEC's concern that the processes used by NRSROs to generate ratings were flawed.  Finally, according to the Release, "by referencing ratings in [its] rules, market participants operating pursuant to these rules may be vulnerable to failures in the ratings process."

Comments on the proposed amendments should be sent to the SEC for receipt on or before September 5, 2008.


SEC Sanctions Brokerage Sales Representative for Aiding Late Trading in Mutual Funds

On July 10, 2008, an SEC administrative law judge ("ALJ") issued an Initial Decision barring a brokerage firm sales representative from the investment industry and imposing monetary fines and penalties for assisting and promoting late trading of mutual funds by hedge funds.

Rule 22c-1(a) under the Investment Company Act of 1940 (the "Investment Company Act") requires trades in mutual funds be priced at the fund's next computed net asset value per share ("NAV").  As mutual funds typically calculate their NAV once daily at 4 p.m., trades received before that time are supposed to be priced at the NAV computed at 4 p.m., while trades received after that time must be priced at the NAV computed at 4 p.m. on the next day.  "Late trading" occurs when a trade is placed after 4 p.m. but is processed based on the NAV calculated at 4 p.m that same day rather than 4 p.m. the next day.  Late trading is illegal because it allows trading based on after-market news while harming mutual fund shareholders whose interests in the fund are diluted.

Joseph VanCook was a sales representative in the New York office of Pritchard Capital, a registered broker-dealer.  Pritchard processed mutual fund trades for its clients through its clearing broker, Banc of America.  Though Banc of America policy required trades to be received by the submitting broker by 4 p.m., its trading terminal allowed Pritchard employees to input or modify trades until 5:30 p.m. in order to correct errors. 

According to the ALJ's decision, VanCook disregarded Banc of America policy as well as the advice of counsel and placed orders for mutual fund trades that were received after 4 p.m. as if they had been received earlier.  VanCook would receive and time stamp trade sheets from clients before 4 p.m., but would allow clients to call to confirm or change their orders after 4 p.m. and would then submit altered trades to Banc of America.  The ALJ further found that VanCook promoted his ability to submit late trades to attract and maintain clients.  VanCook personally received $538,565.70 in compensation based on the late trading activities over the relevant time period. 

The ALJ found VanCook liable for numerous violations of the securities laws:

  • Section 10 of the Securities Exchange Act of 1934 (the "Exchange Act" and Rule 10b-5 thereunder prohibit the making of materially false representations in connection with the purchase or sale of securities.  The ALJ held that by submitting trades after 4 p.m., VanCook misrepresented to Banc of America and the mutual funds that the trades were finalized before 4 p.m.
  • As mentioned above, Rule 22c-1(a) under the Investment Company Act requires mutual fund trades to be priced at the fund's next computed NAV.  While the rule did not directly apply to VanCook, the ALJ found that VanCook's activities aided and abetted and caused primary (though unintentional) violations by Banc of America.
  • Section 17(a)(1) of the Exchange Act and Rule 17a-3(a)(6) thereunder require registered broker-dealers to keep accurate records of each brokerage order, the time received and any related instructions received with the order.  Because VanCook had time stamped possible trade sheets and did not update Pritchard's records for the time the actual final trading orders were received, he aided and abetted and caused the primary violation by Pritchard.

The ALJ ordered that VanCook cease and desist from securities law violations, barred him from association in the investment industry, ordered that he disgorge $538,565.70 in compensation he received as well as pay an additional $100,000 civil monetary penalty.


SEC Conducting Examinations to Review Controls Against the Spreading of False Information and Stock Price Manipulation

On July 13, 2008, the SEC announced that, along with the Financial Industry Regulatory Authority ("FINRA") and the New York Stock Exchange ("NYSE"), it would be conducting examinations in order to prevent the intentional spread of false information intended to manipulate securities prices. 

The SEC, FINRA and NYSE examinations focus on whether investment advisers' and broker-dealers' supervisory and compliance controls are reasonably designed to prevent the intentional spreading of false information and other conduct aimed at manipulating securities prices.  SEC Chairman Christopher Cox called the examinations a "double-check," to ensure that "sturdy controls" are in place to prevent such conduct.

As part of its examinations, the SEC has sent many registered investment advisers letters reminding them of their obligations regarding the intentional dissemination of false information and seeking information regarding the adviser's compliance efforts.  The SEC letters request information such as:

  • copies of the adviser's policies and procedures that are in place to manage compliance risks relating to the misuse of false rumors, and the date these policies and procedures were established;
  • copies of any training or educational material the adviser provides supervised persons relating to the misuse of false rumors;
  • copies of the adviser's policies and procedures that are in place to manage compliance risks relating to the use of electronic communication, such as e-mail and instant messages;
  • copies of the portion of the adviser's code of ethics relating to false rumors, and the date this portion was established;
  • any quality control or forensic tests that the adviser uses to determine that its policies and procedures and code of ethics have been effectively implemented as they relate to false rumors;
  • a description of any violations of the adviser's code of ethics relating to the malicious use of false rumors;
  • demographic information regarding the adviser, such as the number of investment professionals, assets under management and general information regarding any funds advised.

IRS Issues Rulings Addressing Limitations on an Individual Investor's Share of Expenses Incurred by Hedge Funds and Funds of Funds

In July, the Internal Revenue Service (the "IRS") issued two rulings that address certain limitations applicable to an individual U.S. investor's share of expenses incurred by hedge funds and funds of hedge funds that are organized as partnerships.  Revenue Ruling 2008-39 concludes that expenses incurred by funds of hedge funds constitute "miscellaneous itemized deductions," the deductibility of which by individual investors is subject to significant limitations.  Revenue Ruling 2008-38 provides guidance relating to the "investment interest" limitation on a non-corporate investor's share of interest expense incurred by a hedge fund.


In the case of an individual, expenses attributable to the conduct of a trade or business are generally deductible from gross income in determining the amount of "adjusted gross income" ("AGI"), while expenses attributable to investment activities generally constitute "itemized deductions," which are deductible from AGI in determining the amount of taxable income.  Certain investment-related expenses are also "miscellaneous itemized deductions," which are deductible by an individual only to the extent that the aggregate amount of the individual's "miscellaneous itemized deductions" for a taxable year exceeds two percent of the individual's AGI for the taxable year (the "2% floor") and are not deductible for purposes of determining an individual's alternative minimum tax liability.  Passive investing in securities does not constitute the conduct of a trade or business for U.S. federal income tax purposes, but trading in securities (which is generally distinguished from investing by the frequency and volume of portfolio turnover) generally does.  For U.S. federal income tax purposes, the character of a partner's share of items of income, gain, loss and deduction derived by a partnership is determined at the partnership level, and the partner is generally treated as if he or she directly derived the items from the conduct of the relevant partnership activity.  Many hedge funds are treated as engaged in the business of trading in securities.

Revenue Ruling 2008-39:  Miscellaneous Itemized Deductions

Revenue Ruling 2008-39 addresses the question whether the management fee payable by a fund of hedge funds to its manager constitutes a trade or business expense or an investment expense.  Under the facts presented in the ruling, a fund of funds that is treated as a partnership for U.S. federal income tax purposes owns limited partner interests in several hedge fund partnerships each of which is engaged in the business of trading in securities.  In the ruling, the IRS confirms that the management fee incurred by each underlying hedge fund constitutes a trade or business expense and that the character of that expense flows through to the investors in the fund of funds, with the result that individual investors in the fund of funds can deduct their indirect shares of the underlying funds' expenses in determining AGI.  By contrast, the IRS concludes that the management fee incurred by the fund of funds is an investment expense that flows through to individual investors as a "miscellaneous itemized deduction."  In reaching this conclusion, the IRS rejected the view that because the fund of funds is deemed to be engaged in the business conducted by the underlying funds for purposes of characterizing its share of the underlying funds' expenses, the expenses directly incurred by the fund of funds constitute trade or business expenses.  According to the IRS, the question whether the management fee incurred by the fund of funds constitute a business expense or an investment expense must be resolved solely by reference to the activities of the fund of funds, which consist of passive investing in the underlying hedge funds.

Revenue Ruling 2008-39 did not address the question whether a management fee or other expenses incurred by a feeder fund that is formed to hold an interest in an underlying "master" hedge fund are properly characterized as business expenses or investment expenses.  Feeder funds are distinguishable from funds of funds in that they are mere vehicles formed by a single fund manager to permit different types of investors to invest in a single underlying pool of assets.  The manager receives a single fee with respect to the master fund's trading activities, which in many fund structures is charged at the feeder fund level, rather than at the master fund level.  The fund of funds at issue in Revenue Ruling 2006-39, by contrast, invested in several different underlying funds, presumably with managers that were unaffiliated with the manager of the fund of funds, and management fees were charged both at the underlying fund level and at the fund-of-funds level.  Moreover, the fund of funds engaged in the selection of underlying funds, an investment activity that justified the imposition of an additional management fee.  Revenue Ruling 2008-39 would therefore not appear to require that management fees and other expenses payable by a feeder fund be treated as investment expenses even if the master fund is a trader in securities.

Revenue Ruling 2008-38:  Investment Interest

Interest expense and expenses incurred in connection with short sales do not constitute "miscellaneous itemized deductions," but are subject to other limitations on deductibility, including certain capitalization rules.  Under one of these limitations, "investment interest" (defined to include expense incurred in connection with short sales) is deductible by a non-corporate taxpayer only to the extent of the taxpayer's "net investment income" for the relevant taxable year.  "Investment interest" that a taxpayer cannot deduct in any taxable year as a consequence of this limitation will be treated as "investment interest" that may be deducted in subsequent taxable years to the extent that the taxpayer has sufficient "net investment income" in those years.

Reiterating the conclusion of a ruling issued earlier this year, Revenue Ruling 2008-38 states that non-corporate investor's share of interest and short sale expenses incurred by a hedge fund constitutes "investment interest," even if the hedge fund is a trader in securities.  Revenue Ruling 2008-38 then clarifies that, if the hedge fund is a trader, the portion of the investor's share of these expenses that is deductible after the application of the "investment interest" limitation constitutes a trade or business expense that is deductible by the investor in determining AGI, rather than an itemized deduction.  The ruling further states that if less than all of a taxpayer's aggregate "investment interest" for a taxable year constitutes an allocation from a trader hedge fund and the aggregate "investment interest" exceeds the taxpayer's "net investment income" for the taxable year, the taxpayer must adopt a reasonable method to determine the portion of the deduction for "investment interest" that is a trade or business expense and the portion that is an itemized deduction.  For example, suppose that a non-corporate taxpayer's overall "investment interest" for a taxable year is $300x, of which $200x is an allocation of interest expense from a trader hedge fund and $100x is attributable to investment activities, and that, after application of the "investment interest" limitation, the taxpayer may deduct $150x of the "investment interest."  Revenue Ruling 2008-38 states that one reasonable method of determining the portion of the $150x deduction that constitutes a trade or business deduction would be a pro rata allocation under which two-thirds ($200x/$300x) of the deduction, or $100, is a trade or business deduction and one-third ($100x/$300x) of the deduction, or $50, is an itemized deduction.

See a copy of each Revenue Ruling:

SEC ComplianceAlert Cites Compliance Deficiencies

Periodically the SEC staff issues "ComplianceAlerts," which identify certain deficiencies in compliance and supervisory controls the staff has observed in its examinations of registered investment advisers, investment companies, broker-dealers, transfer agents and other types of registered firms.  The stated intent of these ComplianceAlert letters is to encourage chief compliance officers (to whom they are addressed) to review and improve compliance in such areas.

In the most recent ComplianceAlert published this July, the SEC noted that it had observed a number of compliance and controls failures with respect to personal trading by employees of investment firms.  Under Section 204A of the Investment Advisers Act of 1940 (the "Advisers Act") and Rule 204A-1 issued thereunder, registered investment advisers must establish, maintain and enforce a written code of ethics designed to prevent the misuse of material, non-public information by the adviser or any person associated with it.  The SEC found that advisers' codes of ethics frequently did not address all the requirements of Rule 204A-1.  In addition, it observed that advisers and their employees often did not comply with their code of ethics and did not follow reporting requirements or perform compliance monitoring, and disclosed to investors inaccurate information about their firm's trading controls.  The SEC suggested that the following internal compliance controls appeared to effectively assist the prevention of violations of the Advisers Act:

  • written policies and procedures designed to address conflicts of interest with respect to trading in personal and proprietary accounts;
  • accurate restricted lists and watch lists maintained on a current basis;
  • use of time-stamped order tickets;
  • effecting all personal securities transactions through the adviser's trading desk to enable centralized monitoring of trading;
  • consistently bundling trades in client accounts with, or executing such trades prior to, trades in personal or proprietary accounts;
  • strict enforcement of "black-out" periods;
  • prohibiting access persons from engaging in short-term trading;
  • ensuring that exceptions from the code of ethics that were granted were reasonable and documented; and
  • requiring access persons to direct their broker-dealers to provide duplicate trade confirmations and copies of monthly brokerage statements to the adviser.

The ComplianceAlert also highlighted deficiencies in advisers' adherence to appropriate proxy voting policies and procedures.  Under Rule 206(4)-6 under the Advisers Act, registered investment advisers must not exercise voting authority with respect to client securities unless they adopt and implement written policies and procedures designed to ensure that client securities are voted in the best interest of clients, disclose how clients may obtain information about how the adviser voted with respect to their securities and describe to clients their proxy voting policies and procedures.  The SEC examined practices with respect to advisers' use of third-party proxy voting services and found that advisers' oversight of such providers appeared to be weak.  Firms had neither established controls to confirm that the proxy voting service providers' recommendations were consistent with the funds' policies and procedures nor inquired as to whether the providers had conflicts of interest with the funds.

The SEC also reported on recent examinations of high yield municipal bond funds' practices with respect to asset valuations and related liquidity determinations.  Because high yield municipal bonds are infrequently traded, market quotations are frequently not available, and therefore such funds' boards must often establish their assets' fair value for purposes of determining net asset value and liquidity levels.  Among other reasons, this is important to ensure that such funds can satisfy any share redemptions within seven days (as required by Section 22(e) of the Investment Company Act of 1940).  Examiners noted that funds with higher average credit qualities and fewer unrated and/or distressed securities were less likely to have problems making asset valuations and determining liquidity levels.  In addition, the SEC reminded funds that they should disclose the increased risk associated with illiquid securities and the potential problems with reliance on third-party pricing services.  The SEC also cautioned funds regarding asset valuations associated with "cross-trades," that is, asset trades between client accounts.

In addition, the SEC discussed advisers' soft dollar practices.  The use of soft dollars involves a conflict of interest for advisers because, as fiduciaries, they should seek to minimize commission expenses for their clients, and soft dollars may inflate commissions.  The ComplianceAlert reported that examiners have looked carefully at firms' "best execution" analyses, including the value of research paid for with soft dollars when the corresponding commissions are higher than expected, as well as whether advisers adequately disclosed to their investors the existence of a conflict of interest from the receipt of research paid for with soft dollars.

SEC Resumes Granting Closed-End Funds Relief for Managed Distributions under Section 19(b) of Investment Company Act

On July 8, 2008, the SEC published a notice of an application for exemptive relief under Section 19(b) of the Investment Company Act (the "Notice") for the first time in four years (ING Clarion Real Estate Income Fund, et al; Notice of Application (July 8, 2008)).  The application was submitted by ING Investment Management.

Pursuant to Section 19(b) of the Investment Company Act of 1940 and Rule 19b-1 thereunder, closed-end funds may not distribute realized net long-term capital gains more than once every 12 months.  Therefore, while closed-end funds may pay managed distributions (i.e., regular dividends that do not depend on the amount of income a fund earns or capital gains it realizes) to stockholders from net investment income, short-term capital gains or paid-in capital without first obtaining exemptive relief, funds must obtain an exemptive order before paying periodic distributions from long-term capital gains.

Prior to 2004, the SEC routinely granted exemptive relief from the restrictions of Section 19(b) and Rule 19b-1 (a "19(b) Order").  However, in 2004, the SEC imposed a temporary moratorium on processing applications for 19(b) Orders to allow it to consider the disclosure accompanying managed distributions by closed-end funds that pay dividends from long-term capital gains.  As a result, the applications of many closed-end funds remained on hold. 

In December 2006, the SEC distributed revised representations and conditions for 19(b) Orders and the Notice, includes representations and conditions similar to those set forth by the SEC in December 2006.  The Notice is the first to have been issued since 2004, and there remains a substantial backlog of pending applications.

According to the Notice, ING represented that the boards of its funds took several actions relating to its proposed distribution policies, including:

  • reviewing information regarding
    • the purpose and terms of the proposed distribution policies,
    • the likely effects of such policies on the funds' long-term total returns,
    • the relationship between each fund's distribution rate on its common shares under the policy and its total return on NAV per share, and
    • any conflicts of interest between the fund adviser and each fund with respect to adoption of such policy;
  • approving each fund's distribution policy after determining that it was consistent with the fund's investment objectives and in the best interest of the fund's common shareholders; and
  • adopting policies and procedures to ensure that the funds comply with the conditions to the Notice.

The conditions to the relief include:

  • The fund's chief compliance officer must periodically report to the fund's board regarding compliance with the order and at least annually review the adequacy of the fund's policies and procedures.
  • The fund must make certain disclosures to shareholders in each Section 19(a) notice (which is the disclosure notice funds must send to shareholders when making a distribution), including tabular or graphical presentation of the amount of the distribution and its source (e.g., investment income, short-term capital gains, long-term capital gains or return of capital).  The fund must also disclose its fiscal year-to-date cumulative amount of distributions, five-year average annual total return, and cumulative total return.
  • Each shareholder report must describe the terms of the distribution policy and provide the information required in the Section 19(a) notices.
  • In conjunction with the distribution of the Section 19(a) notices, the fund must issue a press release containing the same information and post such information prominently on its website for at least two years.
  • If any broker, dealer, bank or other financial intermediary holds common stock issued by the funds in nominee name, the fund must request the financial intermediary to forward its Section 19(a) notices to all beneficial owners of the fund's shares, at the fund's expense if requested by the financial intermediary.
  • If a fund's shares trade at a specified premium over an extended period, the fund's board must evaluate and determine whether its distribution policy should be continued, amended or terminated.