SEC Rules & Regulations y Update

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ContentsSEC Rules & Regulations . . . . . . . 1

SEC Enforcement Actions . . . . . . . 9

NASD Developments . . . . . . . . . . 14

Industry Update . . . . . . . . . . . . . . 16

August 2006

A Summary of Current Investment

Management RegulatoryDevelopments

SEC Rules & Regulations

Chairman Cox Testifies on the State of Hedge FundRegulation Following the Recent Goldstein Decision

On July 25, 2006, the U.S. Senate Committee on Banking, Housing, and UrbanAffairs (“Committee”) held a hearing on the regulation of hedge funds in thewake of the D.C. Circuit’s decision in Goldstein v. SEC, No. 04-1434, 2006U.S. App. LEXIS 15760 (D.C. Cir. June 23, 2006), to vacate the SEC’s con-troversial rule requiring registration of many hedge fund advisers (“HedgeFund Rule”). See Registration Under the Advisers Act of Certain Hedge FundAdvisers, 69 Fed. Reg. 72,054 (Dec. 10, 2004). Chairman Richard Shelby (R-AL) and ranking member Paul Sarbanes (D-MD) presided over the hearing,which was attended by only a handful of senators. SEC Chairman ChristopherCox, Under Secretary of the Treasury for Domestic Finance Randal Quarles,and Chairman of the Commodity Futures Trading Commission Reuben JefferyIII testified. The focus of the hearing, however, was on Chairman Cox and hisview of the post-Goldstein landscape.

When asked by Senator Hagel if, post-Goldstein, the SEC possesses the author-ity it needs to safeguard investors and the national securities markets from therisks posed by hedge funds, Chairman Coxresponded that, while hedge funds remainsubject to SEC regulation and enforcementunder the antifraud, civil liability and otherprovisions of the federal securities laws, ingeneral “[t]he regulatory regime vis-à-vishedge funds is inadequate.” Goldstein, Chairman Cox said, had left a “gaping”regulatory hole. Chairman Cox noted, for example, that the SEC lacks “basiccensus data” about hedge funds. He stated unequivocally that, in light of thenear calamity caused by the 1998 collapse of Long Term Capital Managementand the estimated $1.2 trillion dollars managed by hedge funds today, “[h]edgefunds are not, should not be, and will not be unregulated.”

Chairman Cox did not focus exclusively on the risks posed by hedge funds, butalso discussed the salutary effects they have on the national securities markets.He noted that hedge funds contribute to capital formation, market efficiency,

SEC to take several emergency initiatives in thewake of Goldstein

New York • Menlo Park • Washington DC • London • Paris • Frankfurt • Madrid • Hong Kong • Tokyo2

DInvestment Management Regulatory UpdateA Summary of Current Investment Management Regulatory Developments August 2006

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price discovery and liquidity, that their role in the derivatives market helpscounterparties reduce or manage risk, and that they provide a way for institu-tional investors to reduce their exposure to downside risk. Because hedgefunds provide benefits along with posing risks, he counseled the Committeeagainst overregulation. “As a general principle . . . I would counsel that to themaximum extent possible our actions should be non-intrusive.” The govern-ment, Chairman Cox said, should not interfere with hedge funds’ investmentstrategies or operations, including the use of derivatives trading, leverage andshort selling. Legislation should not “trammel upon” hedge funds’ creativity,liquidity or flexibility, there should be no portfolio disclosure, and hedge fundsshould be permitted to charge their clients performance fees. When asked bySenator Shelby why any legislation should not require more portfolio disclo-sure, Chairman Cox responded that the benefits of nondisclosure simply out-weigh the risks. He stated that a hedge fund’s ability to keep its trading strate-gies and portfolio composition a secret is the key to its success. He also statedthat he believed there is “broad consensus” among the five Commissioners onthis point.

Chairman Cox discussed the SEC’s efforts to address the regulatory issues cre-ated by Goldstein. To that end, he informed the Committee that he had direct-ed the SEC staff to undertake a comprehensive review of the D.C. Circuit’sdecision, and he outlined three emergency measures that he intended to proposeto the full Commission.

First, he proposed a new antifraud rule under Section 206(4) of the InvestmentAdvisers Act of 1940 (“Advisers Act”). He noted that, while the D.C. Circuithad held that the antifraud provisions of Sections 206(1) and (2) apply only to“clients” and not investors, the court itself pointed out that Section 206(4) is notlimited to fraud against “clients.” “The result,” Chairman Cox said, “would bea rule that could withstand judicial scrutiny, and which would clearly state thathedge fund advisers owe serious obligations to investors in the hedge funds.”He said the SEC staff is currently evaluating the SEC’s authority to promulgatethis rule.

Second, in order to “insure that hedge fund advisers who were relying on thenow-invalidated rule are not suddenly in violation of our regulatory require-



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ments when the court issues its final mandate in mid-August,” he proposed anemergency action so that all transitional and exemptive rules contained in thevacated Hedge Fund Rule are restored to their full legal effect. This proposalindicates that the SEC views Goldstein as vacating not just the client countingrule for “private funds,” but also all of the other rules and amendments prom-ulgated in the same rulemaking as the Hedge Fund Rule. For example, he pro-posed an emergency action to restore, to advisers who registered under thevacated Hedge Fund Rule, the qualified exemption from the recordkeepingrequirement for performance data relating to periods prior to their registration.According to Chairman Cox, if the SEC did not restore the exemption, advis-ers who remain registered but did not create records for the periods prior to theregistration would lose the ability to use their performance track record. This,he said, would have the “perverse[]” effect of discouraging hedge fund advis-ers from voluntarily remaining registered. Similarly, Chairman Cox proposedto restore the grandfathering provision that permitted newly registered advisersto maintain their fee arrangements with existing clients, even if those arrange-ments were not otherwise compliant with Rule 205-3’s prohibition on chargingperformance fees to non-“qualified clients.” Moreover, he proposed an emer-gency action to restore the extension of time for advisers of funds of hedgefunds to provide their audited financial statements under Rule 206(4)-2 underthe Advisers Act.

In this same vein, he proposed a rule to clarify the status of offshore advisersof offshore funds. Under the vacated Hedge Fund Rule, offshore advisers tooffshore funds were required to register—assuming their funds had more than14 U.S. investors—but they were subject to more limited regulation under theAdvisers Act. Cox believed that Goldstein had “creat[ed] doubt whether reg-istered offshore advisers will be subject to all of the provisions of the[Advisers] Act with respect to their offshore hedge funds.” Goldstein therefore“created a disincentive for offshore advisers to remain voluntarily registered,”which, Chairman Cox told the Committee, he had directed the SEC staff to“address.”

Third, he proposed amending the definition of “accredited investor” as itapplies to retail investment in unregistered hedge fund offerings under



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Regulation D under the Securities Act of 1933. Hedge funds, he said, are notfor “mom and pop” investors and the current definition of accredited investor,Commissioner Cox stated, “is not only out of date, but wholly inadequate toprotect unsophisticated investors from the complex risks of investment in mosthedge funds.” By way of example, he pointed out that one definition of an“accredited investor” is “[a]ny natural person whose individual net worth, orjoint net worth with that person’s spouse, at the time of his purchase exceeds$1,000,000,” and that a person’s net worth includes his house. TheCommissioner found it alarming that, under this definition of “accreditedinvestor,” a California couple—where the median home price is well over$500,000—would qualify to invest in an unregistered hedge fund with just over$200,000 each in other assets. Chairman Cox noted that the Hedge Fund Rulehad effectively raised this net worth threshold in many cases because, pursuantto Rule 205-3 under the Advisers Act, registered advisers can only charge per-formance fees (unless another exemption applies) to clients with a joint networth of more than $1,500,000. Chairman Cox said that he would like to seethis higher threshold restored.

A copy of Chairman Cox’s testimony is available at: http://www.sec.gov/news/testimony/2006/ts072506cc.htm.

SEC Staff Indicates that Cash Solicitation Rule DoesNot Apply to Hedge Fund Advisers

Robert Plaze, Associate Director of the SEC’s Division of InvestmentManagement, has reportedly indicated that the SEC does not view Rule 206(4)-3 under the Investment Advisers Act of 1940 (the “Cash Solicitation Rule”) asapplying to the solicitation of investors for hedge funds managed by registeredinvestment advisers. Reports of Mr. Plaze’s comments follow earlier reportsthat, in a recent outreach meeting with chief compliance officers, the staff of theSEC’s Northeast Regional Office announced that investment advisers would nolonger be cited for failing to comply with the Cash Solicitation Rule withrespect to such solicitations. While this position has not yet been confirmed inwriting, Davis Polk understands that the SEC will soon issue written guidance onthe application of the Cash Solicitation Rule to registered hedge fund advisers.

SEC is reportedly close toissuing written guidanceon the application of theCash Solicitation Rule to hedge fund advisers

http://www.sec.gov/news/testimony/2006/ts072506cc.htm

http://www.sec.gov/news/testimony/2006/ts072506cc.htm



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Senior SEC Staff Member Testifies on SEC Concernswith Side Letters

In her recent testimony before the Senate Committee on Banking, Housing andUrban Affairs, Susan Ferris Wyderko, Director of the SEC’s Office of InvestorEducation and Assistance, discussed the SEC’s views on side letters used byhedge fund advisers. According to Ms. Wyderko, the SEC is most concernedwith side letters that “involve material conflicts of interest that can harm theinterests of other investors.” As the primary examples of this type of side let-ter, Ms. Wyderko cited “those that give certain investors liquidity preferencesor provide them with more access to portfolio information.” Other side letters,however, “address matters that raise few concerns, such as the ability to makeadditional investments, receive treatment as favorable as other investors, orlimit management fees and incentives.” A copy of Ms. Wyderko’s testimony isavailable at: http://www.sec.gov/news/testimony/ts051606sfw.htm.

SEC Issues Interpretive Guidance on “Soft-Dollar” UseUnder Section 28(e) of the Exchange Act

On July 18, 2006, the SEC issued interpretive guidance (the “Release”) thatdefines the scope of the safe harbor under Section 28(e) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), which permits money managersto use client commissions, or “soft dollars,” to purchase “brokerage andresearch services.” The SEC’s guidance is effective as of July 24, 2006, butmarket participants may continue to rely on its prior interpretations of Section28(e) until January 24, 2007.

Fiduciary principles generally require money managers to seek the best execu-tion for client trades. However, Section 28(e), originally enacted in 1975,allows money managers to use client commissions to purchase “brokerage andresearch services” under certain circumstances without breaching the fiduciaryduties they owe to their clients. More specifically, Section 28(e) includes a safeharbor that allows a money manager to cause an account to pay more than thelowest available commission if such manager determines in good faith thatsuch commission is reasonable in relation to the value of the brokerage andresearch services received.

SEC takes a dim view of side letters that benefit one investor atthe expense of others

http://www.sec.gov/news/testimony/ts051606sfw.htm



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Consistent with the SEC’s proposed guidance which was published for com-ment in October 2005 (the “Proposed Guidance”) and is described in greaterdetail in the November 2005 Investment Management Regulatory Update, theRelease articulates a framework for analyzing the availability of the safe har-bor for any particular product or service. Specifically, in assessing whether aproduct or service falls within the safe harbor, an investment manager must: (a)determine whether the product or service is research or brokerage within themeaning of Section 28(e)(3); (b) determine whether the eligible product orservice actually provides “lawful and appropriate assistance” to the manager inthe performance of his decision-making responsibilities; and (c) make a goodfaith determination as to whether the amount of client commissions is reasonablein light of the value of the products or services provided by the broker-dealer.

With respect to the first step, to qualify as “research services” under Section28(e), products or services must constitute “advice,” “analyses” or “reports.”Adopting the analysis of this statutory requirement set forth in the ProposedGuidance, the Release provides that, in order to be considered research, theproduct or service must demonstrate an “expression of reasoning or knowl-edge” relating to the subject matter set forth in Section 28(e)(3)(A) or (B) (i.e.,the securities or financial markets). In contrast, items with inherently tangibleor physical attributes are generally excluded from the research category. In itsdiscussion of the application of this interpretation, the Release provides exam-ples of eligible research items, including traditional research reports on partic-ular issuers or securities, discussions with research analysts and certain finan-cial newsletters and trade journals, to name a few. Among the examples of inel-igible research items are mass-marketed publications, travel, entertainment andmeals associated with attending seminars or conferences, and various overheaditems. In addition, computer hardware, including terminals and accessories,and the delivery of research (e.g., telephone lines and computer cables) areineligible as research under the safe harbor.

The SEC also addresses the scope of “brokerage services” under Section 28(e).Under Section 28(e), a person provides brokerage services when he or she“effects securities transactions and performs functions thereto (such as clear-ance, settlement, and custody) or required in connection therewith . . . .”

SEC narrows the Section28(e) safe harbor for use of soft dollars bymoney managers



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Interpreting this statutory language in the Release, the SEC adopts a temporalstandard, which was introduced in the Proposed Guidance, to distinguishbetween those products and services that are eligible as “brokerage” and thosethat are not. Specifically, eligible brokerage services occur during the periodthat “begins when the money manager communicates with the broker-dealerfor the purposes of transmitting an order for execution and ends when funds orsecurities are delivered or credited to the advised account of the account hold-er’s agent.” The following are examples of items that are eligible as brokerageaccording to the Release: trading software; communications services related tothe execution, clearing and settlement of securities transactions; and incidentalbrokerage services associated with clearance, settlement and short-term cus-tody services. The SEC cites overhead, such as telephones, computer terminalsand software functionality used for recordkeeping or administrative purposesand expenses related to compliance responsibilities, as ineligible. In contrast,“research” includes services provided before the communication of an order.

As in the Proposed Guidance, the Release retains the concept of “mixed-use”items—i.e., items that are partly eligible and partly ineligible for the safe har-bor—a concept that the SEC introduced in its 1986 soft-dollar guidance. As inthe Proposed Guidance, the SEC’s Release indicates that the safe harbor pro-tects only the use of client commissions for the eligible portion of the mixed-use items. The Release thus reemphasizes the need for managers to documentadequately allocations between eligible and ineligible aspects of such “mixed-use” items.

As noted above, in addition to determining that an item properly qualifies asresearch or brokerage, an adviser must also determine that (a) it provides “law-ful and appropriate assistance” to him in the performance of his investmentdecision-making responsibilities and (b) the amount of client commissionsused to purchase the item is reasonable. As before, conduct not protected bySection 28(e) may constitute a breach of fiduciary duty, as well as a violationof the securities laws, particularly the Investment Advisers Act of 1940 and theInvestment Company Act of 1940.



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The Release also provides detailed guidance on the status of third-partyresearch, commission-sharing arrangements and other related topics that arebeyond the scope of this summary. For a more detailed discussion of theRelease, please ask your Davis Polk contact for a copy of the Davis PolkInterested Persons Memorandum, dated August 1, 2006, regarding the Release.A copy of the Release is available at: http://www.sec.gov/rules/interp/2006/34-54165.pdf.

SEC’s Changes to Executive Compensation DisclosureRequirements Affect Investment Companies

On July 26, 2006, the SEC issued a press release (the “Release”) announcingits long-anticipated decision to adopt changes to the rules governing disclosureof executive compensation in proxy statements, registration statements andother filings (the “New Rules”). While the text of the New Rules has not yetbeen published in the Federal Register, it is our understanding that the NewRules were adopted substantially as proposed. Davis Polk will be monitoringcommentary and analyzing the text of the adopting release, once published.The New Rules impact business development companies (“BDCs”) and otherinvestment companies in several ways. First, according to the Release, the newexecutive compensation disclosure requirements will apply in their entirety toBDCs. Second, the New Rules change for all investment companies the dis-closure requirements relating to certain interests, transactions and relationshipsof independent directors by, among other things, increasing the threshold fordisclosure from $60,000 to $120,000. Third, the proxy rules applicable to allinvestment companies will be reorganized to “reflect organizational changesproposed for operating companies.”

Investment companies will generally be required to comply with the NewRules as of December 15, 2006.

The SEC’s press release regarding the New Rules is available at:http://www.sec.gov/news/press/2006/2006-123.htm.

Executive compensationrequirements will applyto BDCs and the threshold for disclosureof independent directortransactions will be increased for allinvestment companies

http://www.sec.gov/news/press/2006/2006-123.htm

http://www.sec.gov/rules/interp/2006/34-54165.pdf

http://www.sec.gov/rules/interp/2006/34-54165.pdf



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SEC Enforcement Actions

SEC Settles Charges that a Financial Newsletter is anInvestment Adviser in Violation of the Advisers Act

On June 22, 2006, the SEC issued an order in settlement of charges that WeissResearch, Inc., a publisher of newsletters about securities, its owner MartinWeiss and its editor Lawrence Edelson (collectively, the “Respondents”) vio-lated various provisions of the Investment Advisers Act of 1940 (the “AdvisersAct”). Weiss Research, which has not been registered as an investment advis-er pursuant to Section 203(a) of the Advisers Act since 1997, publishesnewsletters that provide general commentary about the securities markets aswell as “premium services” newsletters that recommend specific securitiestransactions.

In its order, the SEC found that, between September 2001 and April 2005,Weiss Research enabled its premium services subscribers to engage in “auto-trading,” whereby subscribers authorized their broker-dealers to execute auto-matically all transactions recommended in the Weiss Research newsletters. Inaddition, Weiss Research allegedly misled its subscribers in a number ofways—by disseminating advertisements that selectively highlighted profitabletrades and presented an unrealistic picture of Weiss Research’s success rate andby representing that subscribers would receive expert trading advice fromEdelson despite his actual lack of involvement.

The SEC found that Weiss Research met the definition of “investment adviser”under Section 202(a)(11) by engaging in the business of advising others as tothe buying and selling of securities in response to market activity for an annualfee. Although Section 202(a)(11)(D) carves out an exception to the definition of“investment adviser” for “the publisher of any bona fide newspaper, news mag-azine or business or financial publication of general and regular circulation,”the exclusion applies only so long as communications between the newsletterand its subscribers remain “entirely impersonal and do not develop into thekind of fiduciary, person-to-person relationships that . . . are characteristic ofinvestment advisers-client relationships.” Lowe v. SEC, 472 U.S. 181, 210

Weiss Research isordered to pay apenalty of $350,000and to disgorge over$1.6 million forAdvisers Act violations



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(1985). According to the SEC, Weiss Research’s auto-trading program renderedit ineligible for the Section 202(a)(11)(D) exception. As such, the SEC found,Weiss Research violated Section 203(a) of the Advisers Act by failing to regis-ter as an investment adviser and Martin Weiss aided and abetted its violation.

In making claims about profitability and past performance in advertisementsthat were inconsistent with overall past performance and mischaracterizingEdelson’s role, Weiss Research was also found to have violated, and MartinWeiss and Edelson to have willfully aided and abetted violations of, Sections206(2) and 206(4) of the Advisers Act and Rule 206(4)-1(a)(5) thereunder,which specifically prohibits an adviser from using false or misleading adver-tisements. In addition, the SEC found that Weiss had willfully violated, andMartin Weiss and Edelson willfully aided and abetted violations of, Rule206(4)-1(a)(2) under the Advisers Act, which makes it unlawful for an advis-er’s advertising to refer to specific past recommendations without providing acomplete list of all recommendations made within one year.

Without admitting or denying the SEC’s findings, the Respondents agreed tosettle the charges against them. The SEC ordered each of the Respondents tocease and desist from further violations of Advisers Act Sections 206(2) and206(4) and Rules 206(4)-1(a)(2) and (5) thereunder; the SEC also ordered eachof Weiss Research and Martin Weiss to cease and desist from further violationsof Section 203(a) as well. In addition to various remedial undertakings, WeissResearch was ordered to pay over $1.6 million in disgorgement and prejudg-ment interest and a civil penalty of $350,000. Martin Weiss and Edelson wereordered to pay a civil penalty of $100,000 and $75,000, respectively.

A copy of the SEC’s order is available at: http://www.sec.gov/litigation/admin/2006/ia-2525.pdf.

http://www.sec.gov/litigation/admin/2006/ia-2525.pdf

http://www.sec.gov/litigation/admin/2006/ia-2525.pdf



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Jury Finds CEO of Adviser to PIMCO Mutual FundsLiable for Improper Market Timing

On June 30, 2006, the SEC announced that, in a civil suit brought by the SEC,a federal jury found Stephen J. Treadway, the former chairman of the board ofthe trustees of the PIMCO equity mutual funds, liable for defrauding investorsthrough an undisclosed market-timing arrangement with Canary CapitalPartners LLC (“Canary”). Treadway was also the chief executive officer ofPIMCO Advisors Fund Management LLC (“PAFM”), which along with PEACapital LLC (“PEA”) is the adviser to the PIMCO funds, and PIMCO AdvisorsDistributors LLC (“PAD” and together with PAFM and PEA, the “PIMCOEntities”), the funds’ distributor. The SEC filed charges on May 6, 2004, (andan amended complaint on November 10, 2004) in the U.S. District Court forthe Southern District of New York.

Previously, on June 16, 2006, Kenneth W. Corba, the former chief executiveofficer of PEA agreed to settle substantially similar civil fraud charges broughtagainst him by the SEC. Corba agreed to pay a $200,000 civil penalty and con-sented to an order barring him from association with any investment adviser (withthe right to reapply after one year), without admitting or denying the allegations.

In its complaint, the SEC alleged that, from February 2002 until April 2003, thePIMCO Entities enabled Canary to execute more than $4 billion in market-tim-ing trades in PIMCO mutual funds through approximately 108 round-triptrades. The PIMCO Entities allegedly did so in exchange for long-terminvestments (i.e., so-called “sticky assets”) by Canary in a mutual fund and ahedge fund from which PAFM and PEA earned management fees. Accordingto the SEC, Corba negotiated the market-timing arrangement with Canary,while Treadway approved it. Corba and Treadway allegedly discussed theCanary arrangement approximately once per month but, despite increasingreservations, allowed it to continue. In addition, according to the SEC’s com-plaint, the PIMCO funds’ prospectuses, as both Treadway and Corba knew,failed to disclose the Canary market-timing arrangement and were thereforefalse and misleading.

Stephen Treadway is found liable forimproper market timing in PIMCOmutual funds



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After an eight-day trial before the Honorable Victor Marrero, the jury foundTreadway liable for violating (and/or for aiding and abetting violations of)Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereun-der, Sections 17(a)(2) and (3) of the Securities Act of 1933, Section 206(2) ofthe Investment Advisers Act of 1940 and Sections 34(b) and 36(a) of theInvestment Company Act of 1940.

As discussed in the October 2004 Investment Management Regulatory Update,the PIMCO Entities agreed in September 2004 to pay $50 million to settle therelated SEC charges against them.

A copy of the SEC’s release announcing the jury verdicts is available at:http://www.sec.gov/news/digest/2006/dig070306.txt. A copy of the SEC’soriginal complaint against Treadway, Corba and the PIMCO Entities is avail-able at: http://sec.gov/litigation/complaints/comp18697.pdf.

SEC Settles Charges that Major Wall Street FirmFailed to Maintain and Enforce Inside InformationPolicies

On June 27, 2006, the SEC issued an order in settlement of charges thatMorgan Stanley & Co. Incorporated and Morgan Stanley DW Inc. (collective-ly, the “Respondents”), both of which are registered broker-dealers and invest-ment advisers, failed to maintain adequate policies and procedures to preventemployees from misusing material nonpublic information (“inside informa-tion”). The charges alleged that the Respondents violated Section 204A of theInvestment Advisers Act of 1940 (the “Advisers Act”) and Section 15(f) of theSecurities Exchange Act of 1934 (the “Exchange Act”), which require regis-tered investment advisers and registered brokers and dealers, respectively, tomaintain and enforce written policies and procedures reasonably designed toprevent misuse of inside information in violation of the federal securities laws.

In its order, the SEC found that, from as early as 1997 until 2006, theRespondents’ policies and procedures suffered from a number of systemic defi-ciencies. For example, from 1997 until 2005, the Respondents allegedly failed

Major Wall Street firmagrees to pay $10 millionin settlement of chargesover deficient insidertrading policies

http://www.sec.gov/news/digest/2006/dig070306.txt

http://sec.gov/litigation/complaints/comp18697.pdf



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to conduct surveillance of trading of the securities of approximately 3,000issuers that appeared on the firm’s “Watch List.” (Among their other policiesand procedures designed to prevent misuse of inside information, theRespondents maintained a so-called Watch List of companies about which theypossessed material nonpublic information.) The SEC also found that, from2000 until 2004, the Respondents failed to conduct surveillance of hundreds ofthousands of employee and employee-related accounts (whether or not withinthe Respondents) to determine whether securities had been traded based oninside information. Moreover, from 1997 to 2006, the Respondents’ writtenpolicies relating to Watch List surveillance allegedly failed to give adequateinstructions to personnel on how to conduct such surveillance. As a result ofsuch deficiencies, the SEC found, the Respondents may have failed to detectillegal insider trading by them, their employees or persons related to theiremployees.

Without admitting or denying the SEC’s findings, the Respondents agreed to becensured, to pay a civil penalty of $10 million and to cease and desist fromfuture violations of Section 204A of the Advisers Act and Section 15(f) of theExchange Act. The Respondents are also required to retain an independentconsultant to review and report on their procedures for (i) preventing futuremisuse of inside information and (ii) for examining retrospectively the tradingthat was not previously monitored.

A copy of the SEC’s order is available at: http://www.sec.gov/litigation/admin/2006/34-54047.pdf. A copy of the SEC’s press release announcing thesettlement is available at: http://www.sec.gov/news/press/2006/2006-103.htm.

http://www.sec.gov/litigation/admin/2006/34-54047.pdf

http://www.sec.gov/litigation/admin/2006/34-54047.pdf

http://www.sec.gov/news/press/2006/2006-103.htm



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NASD Developments

SEC Approves Amendments to Mutual FundAdvertising Rules Proposed by the NASD

In a release dated July 5, 2006 (the “Release”), the SEC announced its approvalof a NASD proposal to amend two NASD rules—Rule 2210 and Rule 2211—relating to advertising by mutual funds. As approved, the amendments (the“Approved Amendments”) will require mutual fund advertisements that con-tain performance information also to include certain expense and standardizedperformance information. These new requirements are intended to improveinvestor awareness of the costs associated with buying and owning a mutualfund and to facilitate the comparison of funds.

Specifically, the Approved Amendments will require NASD members toinclude the following information in advertisements and other communica-tions with the public that present performance information for non-moneymarket funds: (a) the fund’s standardized performance information, calculatedin accordance with Rule 482 under the Securities Act of 1933 and Rule 34b-1under Investment Company Act of 1940 and set forth in a type size at least aslarge as that used for any non-standardized performance information; (b) thefund’s maximum sales charge imposed at the time of purchase or the maxi-mum deferred sales charge; and (c) the fund’s total annual operating expenseratio as stated in the fund’s most recent prospectus (i.e., gross of any feewaivers and expense reimbursements). All such information must be set forthclearly and prominently.

In response to letters from five commenters, the Approved Amendments differin three notable ways from the amendments that were originally proposed bythe NASD in March 2004 (the “Initial Proposal”). First, whereas the InitialProposal would have mandated that all required performance information andfee disclosures in advertisements (other than radio, television and video adver-tisements) be set forth in a prominent “text box” containing only the requiredinformation, the Approved Amendments will restrict the text box requirementto print advertisements (i.e., not websites or other electronic advertisements)

Amendments to NASDRules 2210 and 2211will require disclosure of expense ratios in performance advertising



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and will permit other pertinent comparative data and disclosures required byRules 482 and 34b-1 to be included in the text box. In addition, funds will beable to use hyperlinks to show such standardized performance information andother disclosures, subject to certain conditions.

Second, whereas the Initial Proposal would have required performance salesmaterial to show a fund’s annual operating expenses gross of fee waivers andreimbursements, the Approved Amendments clarify that, in addition to theunsubsidized expense ratio, the materials may also include the expense ratio netof fee waivers and reimbursements as long as the subsidized ratio is presentedin a fair and balanced manner in accordance with Rule 2210.

Third, the Initial Proposal stated that the NASD would publish a Notice toMembers announcing SEC approval within 60 days of such approval and that30 days thereafter the new requirements would become effective. However,the Approved Amendments provide that the rule change will take effect sixmonths following the end of the calendar quarter after publication of the Noticeto Members. In addition, NASD members will be permitted to file with theNASD on a case-by-case basis templates to show how performance sales mate-rial will be revised to satisfy the new rule requirements.

Comments on the Approved Amendments may be submitted on or beforeAugust 2, 2006.

A copy of the Release is available at: http://sec.gov/rules/sro/nasd/2006/34-54103.pdf. A copy of the Approved Amendments is available at:http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_015684.pdf.

http://sec.gov/rules/sro/nasd/2006/34-54103.pdf

http://sec.gov/rules/sro/nasd/2006/34-54103.pdf

http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_015684.pdf

http://www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_015684.pdf



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Industry Update

U.S. Pension Bill Passes the Senate WithoutAmendment

The U.S. Senate passed a version of the pension bill on August 4, 2006 beforethe start of its summer recess. The bill, which was passed by the House ofRepresentatives on July 28, had been negotiated among members of the Houseand Senate conference committee charged with reconciling the pension billspassed by each chamber earlier this year. The bill passed by Congress includesa plan asset provision, which leaves the test at 25% for benefit plan investorsin a private investment fund (determined on a class-by-class basis), butexcludes governmental and non-U.S. plans from the definition of benefit planinvestors.

There had been haggling to get thebill bundled with estate tax and min-imum wage reforms, but the Houseand Senate approved the pensionbill separately so that they couldbegin their summer recess. For the bill to become law, President Bush mustsign it. If he does so, the plan asset change will be effective immediately.

ContactsIf you have questions about the

foregoing, please contact the following:

Marlene Alva212-450-4467

[email protected]

Nora Jordan212-450-4684

[email protected]

Yukako Kawata212-450-4896

[email protected]

Leor Landa212-450-6160

[email protected]

Danforth Townley212-450-4240

[email protected]

Caroline Adams212-450-4061

[email protected]

Gregory Rowland212-450-4930

[email protected]

This memorandum is a summary for generalinformation only. It is not a full analysis of

the matters presented and should not berelied upon as legal advice.

Bill would exclude gov-ernmental and non-U.S. pension plansfrom the plan asset test

mailto:[email protected]







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SEC Rules & Regulations y Update