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News January 7, 2008 Issue

2007: The Year in Review

2007 was a relatively quiet year for the investment management industry. SEC rulemaking slowed down. There seemed to be fewer enforcement actions. Congress turned its attention elsewhere.

But, of course, every year has its moments. Hereís a look back:


William Galvin, head of the Massachusetts Securities Division, sues hedge fund manager Phillip Goldstein, his advisory firm, Bulldog Investors, and other related persons for conducting a general solicitation via Goldsteinís website. Galvin alleges that the information about Goldsteinís hedge funds made available on the website fell outside the boundaries of the SECís Reg. D exemption for private offerings. Goldstein responds by calling Galvin a "bully" and a "pompous ass" in the press. More formally, Goldstein appeals an administrative order issued by Secretary Galvinís office and launches an attack of his own, filing a civil rights action in Massachusetts state court seeking to stop Galvin from shutting down his website. Goldstein asserts that Galvin has run afoul of the First Amendment and Commerce Clause by banning truthful and non-misleading advertising to the general public. In December, the Massachusetts court denies Goldsteinís request for a preliminary injunction against Galvinís advertising ban, although it acknowledges that Goldsteinís communications were not misleading nor related to unlawful activity.


Speaking of Goldstein: The deadline for hedge fund managers to deregister and take advantage of the Goldstein v. SEC transitional relief (provided in an SEC staffís August 2006 no-action letter) comes and goes. Of the roughly 1,260 advisers that registered with the SEC because of the hedge fund rule, approximately 323 withdrew their registration by the February 1 deadline.

Ethiopis Tafara, director of the SECís Office of International Affairs, co-authors a law review article titled "A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework." The article, which appears in the Harvard International Law Journal, prompts a full-fledged policy debate: To what extent should the SEC rely on foreign regulatory schemes when deciding whether to allow foreign firms and issuers to conduct business in the U.S. without fully complying with U.S. law? In June, the SEC holds a roundtable on the issue, by then dubbed "mutual recognition."

The Department of Labor issues a new rule specifying what sorts of policies and procedures an adviser must have in order to rely on the Pension Protection Actís ERISA cross-trade exemption.

In a no-action letter to Heitman Capital Management, the SEC staff states that an adviserís use of advisory contract hedge clauses containing a gross negligence standard, accompanied by a non-waiver provision, would not per se run afoul of the Advisers Actís anti-fraud provisions. The staff said that whether a particular hedge clause would be fraudulent would depend on the relevant facts and circumstances.


IM Division director Buddy Donohue announces that he has embarked on his own personal "Director Outreach" program, in an effort to improve the dialogue between SEC regulators and independent fund directors. By the end of the year, Donohue has attended twenty board meetings.

Californiaís Department of Corporations sends a privacy compliance survey to approximately 3,250 SEC-registered investment advisers (namely, firms that notice filed in California). Questions quickly arise about the stateís authority to require SEC-registered advisers to participate in the survey. Trade groups issue publications indicating that participation may not be mandatory. As of yearís end, no adviser appears to have been sanctioned for failing to participate in the survey.

Virginia Smith, Director of Enforcement for DOLís Employee Benefits Security Administration, delivers a hair-raising speech at the Investment Adviser Association/IA Week conference. Smithís remarks leave some in the audience with the impression that DOL officials were poised to throw them in the slammer if they so much as bought an ERISA client a cup of coffee. Word mustíve gotten back to Smithís colleagues, because two months later, weíre told, a different DOL official prefaced his remarks at another industry conference with the following: "Youíre not going to jail."

In a 2 to 1 decision, the U.S. Court of Appeals for the District of Columbia sides with the Financial Planning Association in the long-running FPA v. SEC case, vacating the SECís fee-based brokerage rule. The SEC keeps the industry in suspense for a bit, but eventually announces that it will not seek a rehearing of the courtís decision. The SEC asks the court to postpone the effectiveness of its ruling for four months, until October 1, to give the industry time to transition the zillions of fee-based brokerage accounts into other types of accounts. Again, the SEC keeps the industry waiting and wondering, but just a few days before the October 1 due date, adopts a temporary rule allowing dual registrants to conduct principal trades without complying with the trade-by-trade written notice requirement of Section 206(3).


Following a year-long series of lectures on the topic of improving mutual fund regulation, Peter Wallison of the American Enterprise Institute and Robert Litan of the Brookings Institution publish their book, "Competitive Equity: A Better Way to Organize Mutual Funds." Among other things, the authors recommend that Congress amend the Investment Company Act to permit a new investment vehicle, the "managed investment trust," which would not have a board of directors. In December, the Investment Company Institute cites the book in suggesting to Treasury Secretary Paulson that Congress might want to consider permitting a new type of "streamlined investment company structure" that, among other things, reflects the "economic reality" that an "investment company is an investment product established by its investment adviser/sponsor."

The SEC announces an enforcement proceeding against Geoffrey Brod, formerly a portfolio manager at Aeltus Investment Management (now ING Investment Management). The SEC claims that Brod made roughly 3,500 personal trades over a four-year period without reporting a single one, as required by ICA Rule 17j-1 as well as his firmís code of ethics. Brod eventually settles with the SEC in October, agreeing to be permanently barred from associating with any investment adviser or investment company.

The Department of Labor issues a "request for information" soliciting public comment on the types of disclosures that 401(k) plan participants and other retirement plan investors should receive about their investment fees and expenses.


The AFL-CIO urges the SEC to regulate Blackstone Group as an investment company, arguing that the manager structured its pending IPO so as to hide the fact that the group is actually an offering of interests in a pool of investment securities, rather than in an investment manager. A month later, Senators Max Baucus (D-MT) and Chuck Grassley (R-IA) introduce legislation that would tax publicly-traded partnerships that directly or indirectly derive income from investment advisory services. That bill dies in committee. Two other initiatives ó taxing the carry, and prohibiting managers from using offshore tax havens to avoid taxes ó also fail to gain traction, but provide full employment for hedge fund industry lobbyists.

A federal court, in the May 15 SEC v. National Presto Industries decision, sheds new light on the application of the Tonopah factors used in assessing investment company status.

SEC Chairman Christopher Cox asks Congress to (gasp!) "repeal or substantially revise" Section 28(e), the soft dollar safe harbor. Coxís request, made in separate letters to the Chairs of the Senate Banking Committee and House Financial Services Committee (Senator Chris Dodd (D-CT) and Representative Barney Frank (D-MA), respectively), is subsequently criticized by Senator Chuck Schumer (D-NY). In July, Schumer sends a letter of his own over to Cox, saying there could be "significant drawbacks" to "drastic legislative changes" in the soft dollar arena. With that, the whole thing seems to go away.

The Federal Trade Commission sues hedge fund manager James Dondero for failing to make pre-acquisition filings required by the Hart-Scott-Rodino Act. That Act requires certain persons making acquisitions to file notifications with the FTC and the Department of Justice and to observe a waiting period before consummating the acquisition.


OCIE and the IM Division release their first "ComplianceAlert," featuring discussions about closed-end fund distributions, performance advertising, disaster recovery programs, and other topics.

The SEC holds a roundtable on 12b-1 reform. Discussion centers on whether or not 12b-1 fees should be assessed at the account level. By the end of the year, thereís no sign of a reform proposal, save a December speech delivered by IM Division director Donohue in which he floats a list of his 12b-1 related concerns. However, he promises that 12b-1 reform will be a top priority in the coming year.

The SEC sues Allied Capital Corporation, a Washington, D.C.-based closed-end fund, for failing to establish adequate controls around its fair valuation process. Among other things, the SEC claims that the fund did not maintain adequate written documentation of its valuations.

Massachusetts Secretary Galvin sues UBS for providing gifts and entertainment to hedge fund managers in an effort to induce them to remain checked-in to UBSís "hedge fund hotels." Galvin asserts that UBS did not properly monitor and supervise its gift-giving practices.


The SEC adopts Rule 206(4)-8, a new Advisers Act anti-fraud rule that makes it unlawful for advisers to defraud or deceive investors in their pooled investment vehicles. Commissioner Paul Atkins and certain industry participants express concern about the ruleís negligence-based standard, arguing that a violation of the rule should require a finding of intentional misconduct (a.k.a. scienter). Critics also argue that the rule should define the types of fraudulent conduct that it prohibits. Undeterred, the rule goes into effect September 10.

The SEC crafts a "welcome letter" for newly-registered advisers, as well as a plain English summary of the key provisions of the Advisers Act.


The SEC sues a portfolio manager for engaging in insider trading on behalf of a mutual fund that he managed. Joe Frohna, formerly a portfolio manager of a U.S. Bancorp Asset Management micro-cap fund, allegedly engaged in insider trading in shares in a pharmaceutical company that was in the process of developing a new drug. Frohna received the inside information from his brother, who was involved in the drugís trial.

The SEC proposes a host of changes to Reg. D. While the changes would hold the current "accredited investor" thresholds steady at $1 million net worth and $200,000 income ($300,000 with spouse), they also would permit private offerings available only to a new category of "large accredited investors" to be advertised via tombstone ads.

We all learn what subprime loans are and how theyíve been rolled into CDOs and how the whole thing is going to hell in a handbasket.

The U.S. Government Accountability Office releases yet another report about the SECís examination program, this time focusing on OCIEís identification of higher versus lower-risk firms and its use of exit procedures at the end of exams.

The SEC sues Schultze Asset Management and its founder, George Schultze, for fraudulently representing to an advisory client that the clientís commissions were being used to obtain products and services that fell within the Section 28(e) safe harbor. According to the SEC, the soft dollar payments were instead being used to cover Schultzeís salary and other operating expenses.

The SEC sues Quattro Global Capital for allegedly failing to file any Form 13Fs for over three years, despite being required to do so.

In a letter sent to ICI acting general counsel Mary Podesta, the SEC staff reminds registered funds that the information they receive from intermediaries under their new Rule 22c-2 information sharing agreements canít be used for marketing purposes, unless the intermediaryís consumers have been given notice of such use and the opportunity to opt-out.

Highlighting an adviserís duty to monitor for execution quality even when clients have directed brokerage to their long-standing brokers, the SEC sues adviser Folger Nolan for failing to do just that.

The granular inspection request letter being used by the SECís New York Regional Office begins to make waves. Industry participants ó later joined by the U.S. Chamber of Commerce ó complain vociferously about the letterís breadth and depth. In October, OCIE officials state that the NYRO letter is a "pilot" and that aspects of the letter may be rolled out nationwide. The hullabaloo dies down in December, when OCIE chief counsel John Walsh announces that industry feedback has prompted OCIE to reconsider the more troublesome aspects of the letter.


ACA Compliance Group, the Investment Adviser Association, IM Insight, and Old Mutual Asset Management release the results of their 2007 Investment Management Industry Compliance Testing Survey. The survey, which compiles over 450 responses from CCOs and other compliance professionals working at SEC-registered investment advisers, contains a number of interesting findings, such as this one: 78 percent of adviser CCOs wear two or more hats.

The SEC sues pension consultant Yanni Partners and its CCO for failing to adequately disclose a conflict of interest presented by a revenue stream received from the very money managers that the firm was recommending to its pension clients.

The National Society of Compliance Professionals issues a new code of ethics for compliance professionals.

The SEC sues pension consultant Callan Associates for failing to disclose that it was receiving annual payments on the sale of its formerly-affiliated broker-dealer to BNY Brokerage. Per the terms of that deal, Callan received installment payments that were contingent on Callanís sending a certain level of commissions to BNY.

The SEC adopts a temporary rule allowing certain types of advisers to engage in principal trades with their advisory clients, without providing trade-by-trade written notice. The new interim final rule, Rule 206(3)-3T, is intended to allow customers with fee-based brokerage accounts to continue to invest in municipal securities and other types of dealer instruments after their accounts are converted to advisory accounts.

The IM Division grants long-anticipated custody relief in the form of a no-action letter to the Investment Adviser Association. The relief allows advisers to forward inadvertently-received third party checks to clients or their custodians.

We begin to think that maybe that subprime thing wasnít as bad as we first thought.


The SEC sues Consulting Services Group and its former CCO for adopting an off-the-shelf compliance manual without tailoring the manual to the firmís activities. The SEC also alleges that the CCO urged employees to backdate their code of ethics acknowledgements.


The Managed Funds Association issues an updated and expanded version of its "Sound Practices for Hedge Fund Managers."

OCIE associate director Gene Gohlke lays out a list of twelve key questions he would ask if he were a director of a fund investing in derivatives.

Credit markets get the heebie-jeebies again. Banks and Bear Stearns hedge funds take write-downs. The federal government eventually gets involved, facilitating superfunds, setting up call-in numbers for subprime borrowers, and what-not. Money market funds start hiccuping, with a handful of funds seeking relief from the Division of Investment Management allowing them to extricate themselves from a toxic holding one way or another without breaking a buck. The Fed helpfully cuts rates. Thereís a run on a state
investment fund. The whole thing is quite fascinating and more than a little spooky.

The CFA Institute announces that GIPS-compliant firms will not be required to obtain an outside verification. But outside verification is still strongly encouraged, they say.

OCIE and the IM Division conduct their third annual CCOutreach National Seminar. IM chief counsel Doug Scheidt sheds light on the staffís current thinking on valuation practices.

The Commission votes to propose changes to the mutual fund disclosure regime: A new summary prospectus, a new summary section in the full prospectus, and Internet-based disclosure. It takes a few weeks before people actually get around to reading through the mammoth release.

DOL adopts changes to Form 5500 Schedule C that will require ERISA plans to find out and disclose how their service providers ó such as their investment advisers ó are compensated for providing services.


OCIE chief counsel Walsh describes OCIEís new standard nationwide exam letter, which will feature industry-friendly changes from the approach piloted in the NYRO letter.

DOL issues its long-anticipated proposal to amend DOL Rule 408b-2, which implements the ERISA Section 408(b)(2) service provider exemption. The proposal would effectively require all advisers with ERISA clients to amend their advisory contracts to insert new representations requiring full disclosure of all direct and indirect compensation received by the adviser related to the ERISA account, as well as the adviserís conflicts of interest.

The subprime crisis continues in full swing. IM Insightís told that right before the Christmas break, Washington D.C. policy makers were under the impression that the subprime crisis "was as bad as it had ever been."

Happy New Year!