SEC Interpretations: No-Action Letters
SEC Grants No-Action Relief from Investment Company Act Rule 22c-2 for Shareholder Information-Sharing Agreements with Certain Foreign Intermediaries
On February 1, 2007, in response to a request from the Investment Company Institute and the Institute of International Bankers, the SEC granted no-action relief from Rule 22c-2, the redemption fee rule, under the Investment Company Act of 1940 for funds required to have shareholder information-sharing agreements with certain foreign financial intermediaries.
Adopted in 2005 and subsequently amended in 2006, Rule 22c-2 provides that, by April 16, 2007, certain registered investment companies must enter into written shareholder information-sharing agreements with intermediaries (e.g., broker-dealers and retirement plan administrators), which use omnibus accounts to hold shares on behalf of other investors. Under such agreements, intermediaries must provide investor identity and transaction information to the funds upon request. Further, according to Rule 22c-2, such transaction information must be linked to a taxpayer identification number, individual taxpayer identification number, or other government-issued identifier (“GII”).
In its no-action letter, the SEC staff agreed that it would not recommend enforcement action against funds if their information–sharing agreements require foreign financial intermediaries to provide transaction information that is linked to unique identification numbers generated internally by such intermediaries, rather than to GIIs. Certain foreign privacy laws prohibit financial intermediaries from disclosing a shareholder’s GII without first obtaining the shareholder’s consent. According to the SEC, its position would apply only with respect to shareholder accounts established before January 1, 2008, and would be conditioned on the facts and representations set forth in the request letter, particularly the following:
(i) the relief would be limited to foreign financial intermediaries that are subject to foreign laws prohibiting the disclosure of a shareholder’s GII without prior affirmative consent;
(ii) the intermediary would use a single unique identification number for all accounts that have the same beneficial owner or owners;
(iii) GIIs would be required to be disclosed to funds for shareholder accounts established with foreign intermediaries after January 1, 2008 (which, according to the request letter, would provide foreign intermediaries with sufficient time to change their account-opening documentation to obtain shareholder consent to the provision of GIIs to U.S. funds); and
(iv) upon the request of a fund, an intermediary would restrict the ability of a shareholder associated with a particular GII or unique identification number from purchasing additional shares of that fund.
- See a copy of the SEC’s Rule 22c-2 no-action letter
- See a copy of the letter requesting no-action relief
SEC No-Action Letter Provides Guidance For Investment Advisers Regarding the Use of New Omgeo Trade Management Service
On December 14, 2006, the SEC issued a no-action letter in response to a letter request dated December 14, 2006 (the “Request”) from Omgeo LLC (“Omgeo”), regarding the use by investment advisers and broker-dealers of a new trade management service, Omgeo Central Trade Manager (“Omgeo CTM”). In its Request, Omgeo sought assurances that the SEC would not recommend enforcement action against broker-dealers that use Omgeo CTM to satisfy the confirmation requirements of Rule 10b-10 under the Securities Exchange Act of 1934 or against registered investment advisers that treat the information printed or downloaded from Omgeo CTM as satisfying the record-keeping requirements of Rules 204-2(a)(7) and 204-2(b)(3) under the Investment Advisers Act of 1940 (the “Advisers Act”).
Omgeo CTM is a trade management service designed to provide “a more flexible and streamlined process” than existing platforms in achieving trades that are ready for settlement. Unlike older systems, which allowed broker-dealers and advisers to send each other trade information only in a fixed sequence, Omgeo CTM enables each party to enter trade information into a central database simultaneously and whenever each is ready to do so.
Rule 10b-10 requires a broker-dealer to provide its customer with certain information—e.g., the date and time of the trade and the identity, price and number of shares or units purchased or sold—at or before completion of the transaction. According to the representations in the Request, Omgeo CTM would give investment managers access to all of the information required by Rule 10b-10, even though certain features of the system will not be fully operational until the end of the second quarter of 2007. Subject to certain conditions, the SEC granted Omgeo relief from Rule 10b-10, which is consistent with the relief granted in two prior no-action letters.
The SEC also granted no-action relief pursuant to Rules 204-2(a)(7) and 204-2(b)(3) under the Advisers Act. Section 204 of the Advisers Act and Rule 204-2(a)(7) thereunder require investment advisers to keep originals of all written communications received or sent that relate to the receipt, disbursement or delivery of funds or securities, or to the placement or execution of an order to buy or sell any security. In its no-action letter, the SEC stated that it would not recommend enforcement action against an investment adviser that downloads or prints from Omgeo CTM a paper copy of the trade components information (“TCI”) and treats it as an “original” communication, even if the adviser does not receive a Rule 10b-10 confirmation directly from the broker-dealer. Further, the SEC concluded that it would not recommend enforcement action under Rule 204-2(b)(3), which requires investment advisers that have custody or possession of clients’ securities or funds to retain copies of confirmations of all transactions effected by or for the account of any such client, if an investment adviser treats a downloaded or printed TCI as a “confirmation.”
SEC No-Action Letter Provides Relief Regarding Pricing for Rule 17a-7 Transactions and Guidance on Best Execution and Duty of Loyalty
On November 20, 2006, the SEC issued a no-action letter regarding the use of independent pricing services in connection with certain transactions under Rule 17a-7 of the Investment Company Act of 1940 (the “40 Act”). The no-action letter was issued in response to a request (the “Request”) submitted in November 2006 on behalf of a group of investment companies investing primarily in municipal securities (collectively, the “Municipal Funds”), each advised by Federated Investment Management Company.
Section 17(a) of the 40 Act prohibits any affiliated person of a registered fund, and affiliates of such an affiliate, from acting as a principal in the sale or purchase of securities from such fund. However, Rule 17a-7 under the 40 Act provides a general exemption from such prohibition by permitting purchases and sales of securities between funds that are affiliated only by virtue of having a common investment adviser. Rule 17a-7 conditions such exemption, in relevant part, on the following: (i) the transaction must involve securities for which market quotations are readily available; (ii) the transaction must be effected at the independent current market price of the securities; and (iii) the independent current market price must be calculated as specified.
In granting the relief requested, the SEC extended a previous no-action position taken in a 1995 letter to United Municipal Bond Fund, which provided relief from the conditions of Rule 17a-7 to certain affiliated funds engaging in transactions involving municipal securities for which market quotation prices were not readily available. The SEC clarified that it had not intended for the independent pricing service discussed in its 1995 letter to be the sole service that could be used by funds relying on the letter. The SEC concluded that, so long as the Municipal Funds complied with all of the other requirements contained in its 1995 letter (e.g., making certain efforts to corroborate the reliability of the prices supplied by the independent pricing service), the SEC would not seek enforcement action against them. The no-action letter also noted that the use of the Nasdaq Official Closing Price (the “NOCP”), another pricing methodology, would likewise generally be permissible because the manner in which NOCP prices are determined is consistent with the policies underlying Section 17(a) of the 40 Act and Rule 17a-7.
In offering general guidance regarding Rule 17a-7 transactions, the SEC stated that, before causing a fund that it manages to enter into such a transaction, an investment adviser should consider both its duty to seek best execution for each fund and its duty of loyalty. According to the SEC, the adviser should ensure that the selling fund’s total proceeds and the buying fund’s total costs are both as favorable as possible under the circumstances and that, if either party can fare better in the market, the adviser should not execute the cross trade. Similarly, according to the SEC, the duty of loyalty requires that an adviser not enter into a 17a-7 transaction unless doing so would be in the best interests of each participating fund.
SEC Enforcement Actions
SEC Settles Charges that Dually Registered Investment Adviser and Broker-Dealer Understated Advisory Fees
On January 18, 2007, the SEC announced the settlement of charges that Kelmoore Investment Company, Inc. (“Kelmoore”), a registered investment adviser and broker-dealer, understated the total advisory fees charged to five mutual funds (the “Funds”) for which it serves as both adviser and broker-dealer.
According to the SEC’s order settling the charges (the “Order”), from 1999 to 2005, the Funds’ prospectuses stated that Kelmoore charged an advisory fee of 1% of assets under management. However, the SEC found that this 1% fee omitted brokerage commissions that Kelmoore charged for services, which, in the context of advising mutual funds, are typically deemed advisory in nature. In reality, the SEC found, Fund investors paid to Kelmoore advisory fees ranging from 1.5% to over 3% of assets under management. According to the Order, the Funds’ prospectuses materially misled investors by indicating that the 1% fee covered all of Kelmoore’s significant advisory work and by failing to disclose that Kelmoore categorized some of its services as brokerage-related rather than advisory. As a result, prospective investors would have been unable to understand what they were paying in advisory fees or to compare such fees adequately to those of other mutual funds, the SEC found.
According to the SEC’s Order, by misrepresenting the amount of total fees charged for advisory services, Kelmoore willfully violated Section 17(a)(3) of the Securities Act of 1933, which prohibits any person involved in the offer or sale of securities from engaging in transactions, practices or courses of business that operate as a fraud or deceit upon the purchaser. The SEC also found that Kelmoore willfully violated Section 34(b) of the Investment Company Act of 1940 (the “40 Act”), which prohibits investment companies from making untrue statements of material fact in a registration statement, application, report, account, record or other document filed or transmitted pursuant to the 40 Act, or omitting to state facts necessary to make statements not misleading.
Kelmoore settled without admitting or denying the SEC’s findings. In addition to censuring Kelmoore and ordering it to cease and desist from future violations of the securities laws, the SEC ordered Kelmoore to pay a $100,000 penalty and to undertake certain compliance reforms.
SEC Fines Alger Companies $10 Million for Improper Market Timing and Late Trading
On January 18, 2007, the SEC announced the settlement of late-trading and improper market-timing charges against Fred Alger Management, Inc. (“Alger Management”), the registered investment adviser to several mutual funds, including the Alger Fund and Fred Alger & Company, Incorporated (“Alger Inc.” and, together with Alger Management, the “Respondents”), the parent of Alger Management and a registered broker-dealer that serves as the principal underwriter and distributor for the Alger Fund.
According to the SEC’s order settling the charges, between 2000 and 2003, the Respondents permitted certain investors to market time the Alger Fund, in violation of its policy permitting no more than six exchanges per year. In particular, the SEC found that Alger Inc. required investors to place “static” or “buy and hold” investments in certain portfolios in exchange for additional market-timing capacity. According to the SEC, the Respondents failed both to address the complaints of portfolio managers that these market-timing arrangements were decreasing their productivity and to disclose the arrangements to the Alger Fund’s board of trustees. In addition, Alger Inc. allegedly permitted a hedge fund customer to engage in late trading.
Based on this conduct, the SEC found that Alger Management willfully violated Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 and that Alger Inc. willfully aided and abetted these violations. The SEC also concluded that, among other securities law violations, both Respondents violated Section 17(d) of the Investment Company Act of 1940 and Rule 17d-1 thereunder, which prohibit affiliated persons of a registered investment company from participating in transactions in which the investment company is a joint participant without first obtaining SEC approval.
The Respondents settled without admitting or denying the SEC’s findings. In addition to censuring the Respondents and ordering them to cease from future violations of the securities laws, the SEC ordered the Respondents to pay disgorgement of $30 million and a $10 million fine and to comply with certain remedial undertakings.
Industry Update
Senate Finance Committee’s Proposal Would Limit the Amount of Compensation that May Be Deferred
On February 1, 2007, the Senate passed proposed legislation that, if enacted, would significantly limit the annual amount of compensation that may be deferred pursuant to nonqualified deferred compensation plans. This proposal is part of the minimum wage bill that is currently being held by Senate Majority Leader Reid before being sent to the House for a vote. It remains to be seen whether the House will approve the bill and, if so, whether the deferred compensation provisions will ultimately be retained. While there is a good chance that some form of limit will be retained in the final bill, the provisions could change, as a few leading members of the Senate have expressed second thoughts as to whether the proposal casts too broad a net.
The proposal would amend Section 409A of the Internal Revenue Code of 1986 to limit the annual amount of compensation that a service provider (e.g., an employee) can defer from a single service recipient to the lesser of (1) $1 million or (2) the average annual compensation of the service provider during an applicable five-year period (or a lesser period, if the service provider has not been employed by the service recipient for the relevant five years). The proposal would apply to amounts deferred for taxable years after December 31, 2006, and requires the IRS to adopt transition rules to allow service providers and service recipients to change their 2007 arrangements, if necessary, to comply with the new limit.
In calculating amounts deferred by a service provider, with very limited exceptions, all amounts deferred by the provider under any plan or arrangement of a service recipient are taken into account. According to the Senate report relating to this bill, the calculation would also include earnings on prior deferred amounts realized during the relevant year. Failure to comply with the proposed limit would trigger the same penalties as failure to comply with the other provisions of Section 409A. All deferred amounts, including earnings on such amounts, would be both includible in gross income, to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, and subject to an additional 20% penalty, plus an interest charge.
It is not uncommon for private fund managers to use a so-called back-to-back deferral arrangement under which the investment professionals performing the asset management function form a management company to manage a fund and the management company defers the management fee payable by the fund. The management company’s deferral mirrors deferral elections made by the investment professionals so that when the amount deferred by a professional becomes payable to the professional, the amount is paid by the fund to the management company and passed on to the professional. The newly proposed limit does not appear to distinguish between a company and an individual. If the $1 million deferral limit applies to a management company, the professionals who provide services through that company will have to share the $1 million limit, making the limit on their deferrals potentially much lower than $1 million. It remains to be seen whether this and other aspects of the proposal will be corrected before enactment or will have to be addressed in subsequent regulations, assuming that the proposal is enacted in some form.
We will monitor any significant developments regarding this proposal.
SEC Official Discusses Annual Compliance Reviews by Advisers and Investment Companies
On January 26, 2007, in comments made at an investment adviser regulation conference sponsored by the American Law Institute – American Bar Association, Gene Gohlke, an associate director in the Office of Compliance Inspections and Examinations (“OCIE”), reportedly discussed the SEC’s examination of the annual compliance review programs of 158 investment advisers and 24 registered investment companies. Of the advisers that the SEC examined, two-thirds had $500 million or less in assets under management.
According to Gohlke, in 40% of the exams the SEC staff reportedly “could not obtain a reasonable degree of assurance that the [firm’s] compliance program was effective.” In 63% of the exams, the firm’s chief compliance officer conducted the annual review alone and Gohlke reportedly identified a lack of involvement by business people in an annual review as a weakness. Gohlke also highlighted that “annual” compliance review programs should be evaluated over the course of the year, not just in a single day. In addition, Gohlke listed nine questions which an investment adviser should expect to hear during OCIE’s examination of an annual review program: (i) who conducted the review? (ii) what was reviewed? (iii) did the review assess the process by which policies and procedures are implemented? (iv) when did the review occur? (v) how was the review conducted? (vi) what were the findings of the review? (vii) what recommendations were made based on the review? (viii) have those recommendations been implemented? and (ix) where is the documentation answering these questions?
Another SEC official, Joseph Hirsch, branch chief in the SEC’s Northeast Regional Office in New York, reportedly identified the following issues as areas of focus during OCIE’s examinations of investment advisers: portfolio management; brokerage arrangements and best execution; the allocation of trades; personal trading; the pricing of client portfolios; books and records; performance advertising and marketing; and supervision and corporate governance. On the topic of hedge fund advisers, Hirsch commented that, in addition to inspecting advisers’ cash receipts and disbursements journals, the staff examines private placement memorandum disclosure for consistency with disclosure in pitch books, adviser registration forms and requests for proposals. Also noted as areas of concern in the hedge fund context were short selling, the safety of the funds’ assets, disclosure regarding the existence of side pockets, and policies and procedures governing the use of material non-public information by advisory personnel.