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States' Rights

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As part of a multi-pronged legislative agenda for 2007, state securities regulators plan to lobby hard to have equity-indexed annuities defined as securities, ensure the SEC’s proposed accredited investor minimum of $2.5 million for hedge funds is upheld, push Congress to review the securities arbitration system, convince lawmakers to reinstate state regulatory oversight of Regulation D offerings, and preserve the authority of state regulators–particularly in light of the consolidation of the NASD and NYSE regulatory arms.

While that may seem like a full plate for securities regulators to pursue this year, Joseph Borg, president of the North American Securities Administrators Association (NASAA) nevertheless laid out the state regulators’ pro-investor 2007 agenda for reporters in late January.

The debate of whether to define equity-indexed annuities as securities (EIAs) has been brewing for some time, with the main sticking point being that while the products have an insurance component, they are sold as securities. Borg said state regulators want Congress to take up the issue this year and for the SEC to respond with a ruling, as “EIAs have not been defined” by the Commission.

State securities regulators will also prod Congress to reexamine the securities arbitration system to ensure it’s working for investors. Borg said state securities regulators want Congress to determine if there is sufficient disclosure of potential conflicts by panel members; the fairness of selection, qualification, and composition of panels; whether arbitrators are adequately trained; if explanations of awards are sufficient; whether the system is fast and economical for investors; and if the arbitration process should be optional for investors.

As for hedge funds, Borg said NASAA approves of the SEC’s new proposed rule that changes the accredited investor definition by requiring investors to have an additional $2.5 million in certain types of investments, excluding their primary residence. However, state securities regulators are wary of public pension plan money being subject to undue risk when invested in hedge funds, Borg said. ERISA states that hedge funds and their managers are trustees if more than 25% of a fund’s assets are from pension funds. However, the Pension Protection Act removes public pension funds from the 25% calculation–a move whose wisdom state securities regulators question.

Extending the Accredited Investor Standard

Those same regulators would also like the proposed accredited investor standard to include “all related applications,” Borg said, such as Rule 506 offerings under Regulation D, not just hedge funds. He said the scope of “covered securities” in Section 18(b) of the Securities Act of 1933 has expanded since the National Securities Markets Improvement Act of 1996 (NSMIA) was enacted. More issuers, Borg said, “are using Rule 506 and the listing standards on some of the exchanges are deteriorating, so that more securities fall within the ‘covered security’ definition and are being offered to the public with little or no scrutiny.” Because Rule 506 offerings are provided “special status of private placements” and are exempt from federal and state registration laws, Borg said, there is no regulatory review. “NSMIA has preempted the states from prohibiting Regulation D offerings even where the promoters or broker/dealers have a criminal or disciplinary history,” he said, thus NASAA wants Congress to reinstate state regulatory authority over Reg D offerings.

Speaking of hedge funds, Robert Plaze, associate director of the SEC’s Division of Investment Management, told a group of lawyers at the ALI-ABA investment advisor regulation conference in Washington in late January that of the 10,483 advisory firms that are registered with the SEC, 22% of those advisors are “core hedge fund advisors.” Since the Goldstein ruling, which shot down the SEC’s rule that hedge fund managers must register with the Commission, 259 hedge fund advisors have withdrawn their registration, while 61 advisors have registered since the ruling. The total number of hedge fund advisors now registered is 2,200, Plaze said, with more advisors contemplating deregistering. “Hedge funds have withdrawn their registration either because they went out of business or they just decided to withdraw,” Plaze said.

Gene Gohlke, associate director of the SEC’s Office of Compliance Inspections and Examinations, added on a separate panel that while SEC exams are not focusing specifically on hedge fund managers, 20% of advisors that the SEC examines “have something to do with hedge funds.”

Peter Rosenblum, a lawyer with Foley Hoag in Boston, who spoke on a panel at the ALI-ABA conference with Plaze, added that the wave of hedge funds that have started up in the last five years are the ones that have “resisted registration fiercely,” unlike the more established hedge funds, which consider registration to be not such a big deal. Rosenblum added that hedge funds’ “large investors” continue to pressure hedge funds to deregister, as they consider registration to be a “distraction” and costly, and these investors argue they’re capable of performing their own due diligence.

A Bigger SEC Budget, and a Jump in State Actions

Meanwhile, President Bush’s $2.9 trillion budget for the government’s 2008 fiscal year gives the SEC more dough to crack down on wrongdoers. The budget allocates $905.3 million to the SEC, which is a bump up from the $877.1 million the administration requested in 2007. The SEC’s enforcement division would get $321 million of that total, which is a 3.5% increase over 2007 figures. The Office of Compliance Inspections and Examinations (OCIE) would get $213 million, a 3.9% hike over last year.

State securities regulators reported 3,635 enforcement actions–administrative, civil, and criminal–in the 2004-2005 reporting period, a 23% increase over the 2,964 actions taken during the 2002-2003 reporting period. Between 2004 and 2005, 26% of all the state enforcement actions dealt with the financial exploitation of seniors, according to NASAA, with 34% of all “successfully concluded enforcement actions” involving either variable or equity-indexed annuities. Patty Struck, administrator of the Division of Securities in Wisconsin, told attorneys at the ALI-ABA event that within the last year, 44% of the complaints securities regulators have received came from seniors.

NASAA also reports in a recent release that monetary fines and penalties ordered during the 2004 and 2005 reporting period totaled $61 million. During the 2002 and 2003 reporting period, penalties and fines totaled $822 million, NASAA says, which included amounts ordered stemming from settlements related to several large Wall Street investigations.

Struck told ALI-ABA attendees that state securities regulators are also developing a model exam program to create uniformity across the states when examining advisors and broker/dealers. Right now, she said, only 43 states currently have exam programs. “There is so much overlap between advisors and B/Ds that we want to have consistent exams,” she said, noting that state regulators are now coordinating exam policies with B/D groups.

As for SEC exams, Jeffrey Morton, a lawyer with Adviser Compliance Associates in Morristown, New Jersey, told ALI-ABA event attendees that because of the conflicts that are imbedded in advisory firms, a trend he’s noticing is that more and more compliance and legal departments at advisory firms are getting the business side involved in exposing where conflicts of interest arise.

As for the outcome of the SEC’s study of broker/dealer and advisor regulation–which isn’t expected until 2008–Mari-Anne Pisarri, a lawyer with Pickard and Djinis in Washington, told ALI-ABA attendees that any outcome would have to address the fundamental problem that advisors and B/Ds “are dealing with 1934 and 1940 rules that don’t reflect today’s reality.”