A Compilation of Enforcement and Non-Enforcement Actions

24 March 2009 Publication
Author(s): Peter D. Fetzer

Legal News: Investment Management Update


IAA Wants SEC to Review Custody Rule
On March 6, 2009, the Investment Adviser Association (IAA) sent a letter to U.S. Securities and Exchange Commission (SEC) Chair Mary Schapiro, asking the SEC to tighten the exemptions for self-custody under Rule 206(4)-2 (the Custody Rule) promulgated pursuant to the Investment Advisers Act of 1940 (Advisers Act). Under the Custody Rule, advisers may hold client assets with an affiliated broker-dealer, so long as the adviser complies with certain requirements.

The IAA requested that the SEC prohibit self-custody unless firms separate custodial duties from advisory duties. The IAA also proposed a requirement for an independent third-party review to ensure that a firm’s internal controls are sufficient to prevent the kind of fraud that might arise when affiliated custodians control clients’ investments. In addition, the IAA requested that the SEC modify Part 1 of Form ADV to require advisers to disclose whether an affiliated broker-dealer acts as their custodian. Within Part II of Form ADV, IAA proposed disclosure of which advisory assets are maintained by dual registrants or an affiliate and disclosure of those controls the adviser has designed to mitigate the risks involved in self-custody arrangements.

SEC Considering Reinstating Uptick Rule
SEC Chair Mary Schapiro told a congressional committee in March that the SEC is considering reinstating the “uptick rule” as early as April 2009. Under the uptick rule, a trader could not short a stock unless the price of the stock increased over the previous trade price. The goal of the rule is to prevent short sellers from artificially lowering the price of a stock in order to profit. The uptick rule was first introduced in 1938 and was suspended in 2007 by the SEC.

Some critics argue the uptick rule would not substantially alter the practice of short selling. Traders can simply “buy two at market,” artificially creating an uptick on the trade. Additionally, the uptick rule did not apply to certain financial instruments such as futures. In other words, reinstating the uptick rule might not have an impact on the recent short selling any more than it prevented short selling prior to its being taken off the books in 2007.

Hedge Fund Transparency Act Update
Last month, we reported that Senators Chuck Grassley (R-Iowa) and Carl Levin (D-Mich.) introduced the Hedge Fund Transparency Act. Under the bill, hedge funds would have to register as an investment company pursuant to the Investment Company Act of 1940. Criticism is mounting for the likely and apparently unintended collateral damage of this change in law namely, that investment advisers to private funds would lose their exemption from registration under the Advisers Act.

Under the Advisers Act, investment advisers need not register with the SEC if they have fewer than 15 clients (each fund counts as one client) in a 12-month period; if they do not hold themselves out to the public as investment advisers; and if they do not advise registered investment companies. Because hedge funds would now be “investment companies” under the Investment Company Act, investment advisers would presumably lose their exemption from registration when they advise hedge funds. Without an exemption from registration, the hedge fund adviser would be required to register as an investment adviser with the SEC.

Neither Sen. Grassley nor Sen. Levin spoke of this increased registration requirement as the intent of the legislation — or even as a possible outcome of it. However, despite vocal concern for the impact on investment advisers, no legislator has offered an amendment to the legislation as of the date of this publication.

SEC Wants Third-Party Confirmation of Investor Assets, Culture of Compliance
Gene Gohlke, the associate director of the SEC’s Office of Compliance sent a letter to the Managed Funds Association on March 9, 2009, indicating the SEC will begin to contact independent entities to verify assets held by regulated firms. The letter lists several independent entities the SEC may contact to confirm the existence of assets — entities such as banks, broker-dealer custodians, advisory firm auditors, advised clients, investors in hedge funds, National Securities Clearing Corporation, and Depository Trust & Clearing Corporation.

On the heels of Mr. Gohlke’s letter, Lori Richards, director of the SEC’s Office of Compliance, sent a letter to investment advisory firms about the importance of maintaining a “culture of compliance” in the firm. With a quickly changing business landscape, Richards recommends a firm’s compliance officer review four key areas of concern: disclosure, custody, performance claims, and resources supporting compliance.

Disclosure should be evaluated not only from a “what” perspective (i.e., Is the firm disclosing everything it must under the law?) but also from a “when” perspective (i.e., Is the firm’s disclosure in compliance with timing requirements?). Custody, of course, will be a priority for the SEC in light of the recent uncovering of Ponzi schemes. Ms. Richards indicated in her letter that performance claims also are a frequent source of problems for firms. Finally, the firm must devote enough resources to support compliance, perhaps including new technologies to track auditing and risk management.


Failure to Have Written Policy for Preventing Distribution of Confidential Information Results in SEC Order Instituting Proceedings Under the Exchange Act and Advisers Act
The SEC issued an Order Instituting Proceedings Pursuant to the Securities Exchange Act of 1934 (Exchange Act) and the Advisers Act against Merrill Lynch. The SEC alleges that brokers at Merrill Lynch permitted day traders to listen in on Merrill Lynch’s squawk box, which broadcasted customer order information.

The day traders were then able to use that non-public, confidential information — namely forthcoming trades by large, institutional investors — to make their short-term buying and selling decisions. The day traders paid the brokers commissions and made cash payments for this access. Even though Merrill Lynch had policies prohibiting this conduct, it did not have a written policy limiting access to the squawk box. For that reason, the SEC alleges Merrill Lynch was in violation of the Exchange Act and the Advisers Act.

Supreme Court to Review Seventh Circuit’s Dismissal of Investor Lawsuit
The U.S. Supreme Court granted certiorari for a Seventh Circuit case, Jones v. Harris Associates LP, U.S., (No. 08-586, March 9, 2009). In that case, a three-judge panel of the Seventh Circuit dismissed an investor’s claim that a mutual fund adviser received excessive compensation. The Seventh Circuit’s analysis hinged on its decision to evaluate mutual fund compensation in light of marketplace competition.

Over a dissenting minority, the Seventh Circuit denied the request for an en banc hearing of the Seventh Circuit. The dissenters argued that the full Seventh Circuit should have reheard the case in light of the court’s failure to follow a 27-year-old case, Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2d Cir. 1982). The Second Circuit’s Gartenberg case stands for the proposition that fees are excessive when they are so disproportionately large that they could not have resulted from an arm’s-length transaction. Instead of an en banc hearing before the full Seventh Circuit, the case will go to the nation’s highest court.

Legal News: Investment Management Update is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:


Terry D. Nelson
Madison, Wisconsin

Joseph D. Shumow
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin


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