From the February 2004 issue of Investment Advisor • Subscribe!

A Flurry of Rules From the SEC

Do you have a chief compliance officer? How about a trading code of ethics? The SEC wants these and more

The New Year had barely begun, but the Securities and Exchange Commission was already bombarding investment advisors and mutual funds with a bunch of proposed regulations. And don't expect the commission to let up anytime soon.

"The SEC is meeting every two weeks and coming out with major rules," says David Tittsworth, executive director of the Investment Counsel Association of America (ICAA) in Washington, D.C. Some of the proposed rules, specifically those requiring advisors to have written compliance programs and to appoint a chief compliance officer (CCO), as well as the rule that requires advisors to have personal trading codes of ethics, "will affect all investment advisors, not just mutual fund managers," he says.

The SEC has expressed interest in having the fund's chief compliance officer and the advisor CCO be the same person, says Caroline Schaefer, an ICAA attorney. ICAA is now drafting a comment letter to send to the SEC that focuses "on the inconsistencies between the fund CCO being an advisor employee, while at the same time the fund board has control over a termination," Schaefer says.

Michael Tannenbaum, co-founder and partner of Tannenbaum, Halpern, Syracuse & Hirschtritt LLP in New York, who leads the firm's financial services, hedge funds, and capital markets practice group, says the SEC's compliance rule is unnecessary because "legitimate" investment managers and advisors already abide by compliance rules. They're just not written down. "Writing [rules] down costs money," Tannenbaum says. "Any time you add infrastructure, either the investing public is going to pay for it, or it's going to end up being another bar to entry into the business for young [hedge fund and investment] managers."

Tannenbaum believes the SEC is pushing advisors to adopt a compliance program and to appoint a compliance officer because if it decides to make all hedge fund managers register with the SEC, it won't have an adequate staff to audit them. The compliance programs are "akin to an internal audit program to take the place of the outside audits," Tannenbaum says, "and that will make some of the SEC audits easier."

Advisors must adopt a compliance program by October 5. But as Tannenbaum notes in his firm's "Bullet Point" newsletter to clients, the SEC has yet "to release any staff guidance as to how to conduct an internal review of an investment advisor's compliance program." He continues: "Not knowing what areas to review may render the annual review obligation a counterproductive exercise, especially if investment advisers are reviewing areas that the SEC does not consider to be critical."

Because the compliance date isn't until October 5, and annual reviews won't start until 2005, Tannenbaum suggests that investment advisors ask the SEC for guidance on what areas to consider when conducting an annual review--guidance perhaps similar to the self-audit guide that the National Futures Association provides to its members.

Mutual Fund Rules

At its meeting last month, the SEC proposed rules designed to protect mutual fund investors. The first rule would require that 75% of a mutual fund's board of directors be independent and that the chairman also be independent.

But Geoff Bobroff, an independent mutual fund consultant in Rhode Island, questions whether such a new structure offers much change. "So much of what the board does, as a general rule, is so regulatory-based, that I don't think giving the board control of the agenda really gives a lot of change to the metrics that the board goes through," Bobroff says. "The question becomes: Does it change the process? I think we'll have to wait and see."

The SEC also proposed increasing the amount of disclosure on mutual fund trade confirmations. The third proposed rule would require advisors to adopt a code of ethics that addresses such issues as personal trading by employees who have access to nonpublic information.

And the hits to the mutual fund industry just keep on coming. On February 11, the SEC plans to consider: a final rule to require funds to disclose semiannually the dollar amount of fees and expenses that shareholders pay; proposed amendments to rule 12(b)-1 that would prohibit funds from using brokerage commissions to pay broker/dealers for selling fund shares; and a proposal to include disclosures in fund annual reports to shareholders about the reasons supporting their directors' decision to approve the fund's investment advisory contract.

On February 25, the SEC plans to consider a proposal that would require mutual funds to impose a mandatory redemption fee on market timers, and any pertinent recommendations from the NASD's Omnibus Account Task Force. And in early March, the commission will consider proposals that would improve disclosure to fund shareholders about their portfolio manager's relationship with the fund.

Curbing Soft Dollars

Another hot-button issue for advisors and mutual funds these days is soft dollars. Will they be abolished or just reined in? The Investment Company Institute (ICI), the mutual fund trade group, thinks the use of soft dollars should be curtailed.

In a December 16, 2003, letter to the SEC, ICI President Matthew Fink urged the commission to revise Section 28(e) of the Securities Exchange Act--the section of the Act that permits the use of soft dollars--so as to exclude certain products and services from the section's safe harbor. They include computer hardware and software and other electronic communications equipment used in connection with trading and investment decisions; publications--including books, periodicals, newspapers, and electronic publications that are available to the general public; and all third-party research services.

"The ICI proposal would effectively eradicate the independent research industry," says John Meserve, president of Westminster Research, a division of BNY Securities Group in New York. Curtailing the use of computer hardware and software as well as electronic publications means that advisors would no longer be allowed to use soft dollars to pay for Bloomberg terminals and access to Reuters newswire reports, Meserve says, which many advisors rely on to perform their jobs.

Chris Wloszczyna, an ICI spokesman, says the ICI would even "look at repeal of soft dollars further down the road." At the current time, however, Wloszczyna says ICI "just wants to restrict the use of soft dollars."

In a speech to mutual fund directors last month, SEC Chairman William Donaldson said he's directed his staff to examine the use of soft-dollar arrangements by investment managers and the scope of the safe harbor contained in Section 28(e) of the Securities Exchange Act. It remains to be seen when the SEC will take any action, however.

Meserve believes that soft dollars have been "significantly misunderstood." He says people fail to realize that Section 28(e), which allows for soft dollars, "applies to Goldman Sachs as well as it does to any third-party broker. Goldman Sachs relies on soft dollars to get paid." One of Westminster's biggest priorities, Meserve says, is "making sure that the currency of independent research, third-party soft dollars, doesn't go away." That's why his firm has been educating regulators "on the benefits of independent research and the importance of third-party brokers as a currency--it's really the lifeblood for independent thinking."

Paying for Research

New York attorney Tannenbaum says he expects the SEC to "cut back" on soft dollars. "Some [hedge fund and investment] managers are acting outside of 28(e) on the theory that any soft dollar is okay, provided they are disclosed properly," he say, but warns that "even disclosure sometimes is not enough." However, Westminster's Meserve is hopeful that soft dollars "are here to stay," especially since the global research settlement that was recently reached between the SEC and 10 big Wall Street firms requires the firms to provide independent research to their clients alongside their own.

Meserve says that Westminster is advocating that "disclosure of soft dollars be equal," meaning that Wall Street firms should be required to conform to the same disclosure rules as independent firms. "If you trade at one of the major full-service firms, you'll get a statement that says that 'these buys and sells are what your total commissions were,'" Meserve says. "If you're involved with a third-party independent research broker, like [Westmin-ster], you'll see an itemized, penny-for-penny record of what your commissions were used for. [Disclosure of soft dollars] is completely opaque at the full-service firms, but completely transparent in the independent research world." Meserve says that House bill H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003, also gives independent firms the short end of the stick by basically imposing "more burden on an independent research broker/dealer than it would on a full-service firm."

Advisors should also be prepared to adopt an anti-money laundering program, if they haven't done so already. The Treasury Department has yet to issue final regulations for advisors, which ICAA's Tittsworth says is surprising. But the regs are inevitable.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.

Reprints Discuss this story
This is where the comments go.