United States: SEC Approves Soft Dollar Interpretive Release
Financial Services Alert – Developments of Note

1. SEC Approves Soft Dollar Interpretive Release
2. Federal Banking Regulators State that Proposed Legislation Should Not Deter Qualified Individuals from Serving as Bank Directors and Officers
3. IRS Issues Notice on New Legislation Imposing Excise Taxes on Tax-Exempt Organizations Participating in Prohibited Tax Shelters and Similar Transactions
4. SEC Approves NASD "Text Box" Disclosure Requirements for Mutual Fund Performance Ads
5. SEC Reverses In Part Administrative Law Judge’s Dismissal of Charges in Class B Shares Proceeding

6. SEC Staff Grants Extension of No-Action Relief That Permits Broker-Dealers to Rely on Registered Advisers to Perform AML Customer Identification Programs

The SEC approved the issuance of an interpretive release regarding the safe harbor afforded by Section 28(e) of the Securities Exchange Act of 1934, as amended. The SEC has not made the interpretive release itself available, but did issue a press release providing some details (summarized below) regarding its forthcoming soft dollar guidance. Much of what is mentioned in the press release appears to echo the proposed interpretive release (see the October 25, 2005 Alert), but any definitive judgments on that issue must await issuance of the final interpretive release itself.

• 3 Step Analytic Process - the analysis of "brokerage and research services" under Section 28(e) requires a three-step process: the application of eligibility criteria; the money manager’s lawful and appropriate use of the items; and the money manager’s good-faith determination that the commissions paid are reasonable in light of the value of the services received.

• Computer Hardware - computer hardware is not eligible for the safe harbor as research.

• Mass-marketed Publications - mass-marketed publications are not eligible for the safe harbor – a reversal of prior SEC guidance.

• Eligible Brokerage Services - products and services that relate to the execution of the trade from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account, are eligible for the safe harbor.

• Commission-Sharing Arrangements - the safe harbor is available when a money manager does business with a broker-dealer that is involved in "effecting" the money manager’s trades and "provides" the research. In order to be "effecting" transactions, the broker-dealer must either execute, clear, or settle the trade, or perform one of four specified functions and allocate the other functions to other broker-dealers. A broker-dealer that is effecting transactions for the advised accounts (but not providing research directly) provides research if it is either legally obligated to pay for the research or pays the research preparer directly and takes steps to see that the services to be paid for with client commissions are within Section 28(e).

Effectiveness/Transition Period - The interpretive release will be effective upon publication in the Federal Register, but market participants may rely on prior SEC soft dollar guidance for a period of six months following the release’s publication.

Parallel provisions of the pending federal regulatory relief legislation that would amend the Federal Deposit Insurance Act (Section 405 of H.R. 305 and Section 702 of S. 2856, collectively, the "Proposed Legislation") have been introduced at the request of federal banking regulatory agencies (the "Agencies") and are designed to strengthen the Agencies’ authority to take actions to sanction violations by banks and savings associations ("Banks") or their directors or other Institution–Affiliated Parties ("IAPs") of provisions of written conditions and agreements. The Proposed Legislation is intended to address certain limitations imposed by court decisions that conditioned Agencies’ ability to enforce such conditions and agreements on a showing by the applicable Agency that the individual would be "unjustly enriched" or that he or she had recklessly disregarded applicable law, applicable regulations or a prior order of the Agency. The Proposed Legislation would, accordingly, give the Agencies more authority to compel Bank directors and other IAPs to stand behind their Bank financially under certain circumstances, including when the Bank is in a troubled condition.

Three bank trade associations, America’s Community Bankers, the American Bankers Association and the Independent Community Bankers of America (the "Trade Associations") jointly wrote to the OCC, FDIC and OTS seeking clarification of how and when the Agencies intended to use this new authority if the Proposed Legislation were enacted. In a July 6, 2006 response to the Trade Associations, the Agencies did not provide any details on how they would use the proposed authority, but said that they recognized the importance of seeing that Banks continue to be able to attract and retain qualified directors and officers and that the Agencies have no intention "to deter qualified individuals from service as directors and officials of insured institutions." The Agencies also stated that, under the Proposed Legislation, they would only force directors or other IAPs to surrender the director’s/IAP’s own assets if the individual had signed a written agreement with the Agency agreeing to stand behind the Bank financially. While some Trade Associations appear to have been reassured by this response from the Agencies, another trade associations, the American Association of Bank Directors as well as certain banking lawyers have expressed concerns that Bank directors and other IAPs may, under certain circumstances, feel that they have no effective way, short of resignation, of resisting an Agency’s efforts to have the IAP enter into such an Agreement. The House and Senate have each passed regulatory relief legislation, but differences in their bills have not yet been resolved. Accordingly, it is not certain that the Proposed Legislation will be enacted.

The IRS issued Notice 2006-65 (the "Notice") requesting comments and providing some interim guidance on the recently enacted Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA"). TIPRA includes new excise taxes and disclosure rules that target certain prohibited tax shelter transactions ("PTSTs") to which a tax-exempt organization ("TEO") is a party. Such TEOs include, but are not limited to, charities, churches, VEBAs, other 501(c) entities, state and local governments, qualified pension plans, individual retirement accounts and similar tax-favored savings arrangements. The managers of TEOs, and in some cases the TEOs themselves, can be subject to the excise tax provisions of TIPRA. The entity-level excise tax each year for engaging in a transaction which a TEO knows or should have known is a PTST is the greater of (1) the TEO’s after-tax net income attributable to the PTST for the year or (2) 75% of the proceeds received by the TEO attributable to the transaction for the year. However, this entity-level excise tax does not apply to qualified pension plans, individual retirement accounts and similar tax-favored savings arrangements. If the TEO does not know or have reason to know that the transaction is a PTST, or if the transaction is listed by the IRS as being a PTST after the TEO becomes a party to it, the excise tax each year is equal to 35% of the greater of (1) the TEO’s after-tax net income attributable to the PTST for the year or (2) 75% of the proceeds received by the TEO attributable to the transaction for the year. The IRS may impose additional penalties if the TEO does not meet certain disclosure requirements relating to its participation in a PTST. The manager of a TEO (including, for this purpose, qualified pension plans, individual retirement accounts and similar tax-favored savings arrangements) may also be subject to an excise tax of $20,000 for each approval of a transaction or other act causing the TEO to be a party to a PTST. In addition, taxable entities that are party to a PTST with a TEO may also be exposed to penalties if they fail to disclose certain information to the relevant TEO regarding the transaction.

PTSTs include a wide range of transactions, including certain confidential transactions, some transactions in which tax benefits are subject to contractual protection and "listed transactions" detailed on the IRS website. For two separate reasons, there is substantial uncertainty regarding what a PTST is and how the new rules will be applied. First, in addition to the "listed transactions" detailed on the IRS website, PTSTs also include transactions that are "substantially similar" to these "listed transactions." Second, because TIPRA imposes liability on TEOs after a transaction is listed as a PTST, TEOs may find themselves facing a TIPRA excise tax for engaging in a transaction that was not a "listed transaction" at the time but is later determined to be a listed transaction. The Notice indicates that additional guidance from the IRS will be forthcoming in the near future. The excise taxes relating to TEOs and managers under TIPRA are effective for taxable years ending after May 17, 2006, but no excise tax applies to any income or proceeds a TEO or manager obtains on or before August 15, 2006 from a transaction.

The SEC approved an NASD proposal that amends NASD Conduct Rules 2210 and 2211 to require member communications with the public, other than institutional sales material and public appearances, that present non-money market mutual fund performance information to include certain maximum sales charge and annual fund operating expense information. The mandated sales charge and expense information must be derived from the most recent fund prospectus, and the expense information may not reflect the effect of any fee waivers or reimbursements. The amendments require this information and the standardized performance figures required under SEC mutual fund advertising rules (Rule 482 under the Securities Act of 1933, as amended, and Rule 34b-1 under the Investment Company Act of 1940, as amended), to be set forth prominently, and in print advertisements, to appear in a text box. The amendments also conform NASD mutual fund performance advertising requirements to those under SEC rules e.g., the SEC rules’ prominence and proximity requirements. The NASD has agreed to permit the filing of templates on a case-by-case basis to show compliance with these new mutual fund performance advertising requirements.

NASD Response to Public Comment. As a result of public comment, the amendments reflect a number of changes from the modifications to NASD Conduct Rules 2210 and 2211 originally proposed by the NASD in 2004. The NASD eased the text box requirements so they apply only to print advertisements and permit the inclusion of other disclosures in the text box. As a consequence, under the amendments, websites and other electronic advertisements may present required performance information through the use of hyperlinks, subject to certain conditions. Where the text box is required, it may include comparative performance and fee data, such as non-standardized fund performance, relevant benchmark performance or comparison of a fund’s expense ratio to peer universe averages. In response to concerns expressed by commenters regarding their ability under prior versions of the amendments to disclose a fund’s current expense ratio net of fee waivers and reimbursements, the NASD indicated that the amendments do not preclude a member firm from presenting a fund’s expense ratio net of fee waivers and reimbursements, as long as the sales material also presents the unsubsidized expense ratio, and the member presents the subsidized expense ratio in a fair and balanced manner in accordance with the standards of NASD Conduct Rule 2210. In this regard, the NASD noted that it would expect sales material that includes a subsidized expense ratio to disclose whether the fee waiver or reimbursement arrangement were voluntary or mandated by contract, and its period of effectiveness. The SEC is soliciting additional comment on the amendments, which must be received by August 2, 2006.

Effectiveness. According to formula provided in its filing with the SEC, the amendments should be effective March 31, 2007. Within 60 days of SEC approval, the NASD will issue a Notice to Members announcing SEC approval, with the effective date of the new requirements to be six months after the next calendar quarter end following publication of the Notice to Members.

On its review of an administrative law judge’s dismissal of charges brought by the SEC’s Division of Enforcement (the "Division") against a registered representative ("RR"), the broker-dealer (the "BD") of which the RR was an associated person and the BD’s president (see the March 1, 2005 Alert), the SEC found that the RR had violated the anti-fraud provisions of the federal securities laws in connection with the sale of Class B shares of mutual funds to certain customers. The SEC also found that the Division had not established that the BD and its president failed to exercise regular reasonable supervision of the RR regarding those sales.

Negligent Omission. While the Division brought charges against the RR under a range of antifraud provisions in the federal securities laws (Section 17(a) of the Securities Act of 1933, as amended (the "1933 Act"); Section 10(b) of the Securities Exchange Act of 1934, as amended (the "1934 Act"), and Rule 10(b)-5 thereunder; and Section 206(1) and 206(2) of the Investment Advisers Act of 1940, as amended), the SEC found only that the RR had violated Section 17(a)(2) and 17(a)(3) of the 1933 Act by negligently failing to make certain disclosures to customers in connection with the RR’s recommendation to purchase Class B shares. The SEC found that while the RR had disclosed that all of a customer’s money would "go to work" if invested in Class B shares (a statement designed to address the customers’ desire to avoid up front charges) and that Class B shares had a contingent deferred sales charge, the RR failed to disclose the differences between the cost structure of Class A shares and the cost structure of Class B shares and the potential impact of those differences on customers’ investment returns. In this regard, the SEC observed that each investor qualified for at least one breakpoint discount on Class A shares. The SEC also noted that each of the customers intended to hold the investments made through the RR for the long term without withdrawals and, with only one exception, was investing in tax-advantaged accounts. The SEC acknowledged that the customers were given and executed various kinds of disclosure statements indicating, at a minimum, that mutual fund share classes differed in terms of fees and compensation structures, but also cited customer testimony indicating that, in fact, they had little, if any, awareness of mutual fund share class differences.

The SEC further found that notwithstanding the fact that the RR was effecting his customers’ stated desire to avoid up-front fees in their investments, the omission of cost structure and related return impact information on Class A and Class B shares was material because it meant that the RR’s customers did not have the "total mix of information" necessary to make their investment decisions. The SEC’s opinion noted that the RR had received numerous compliance alerts and other documentation, discussing differences in cost structure between mutual fund share classes, and observed that these documents would have given notice to a reasonable securities professional that some analysis of the impact of the different cost structures on the return of investment was required before recommending one class of shares rather than another, especially in amounts above breakpoint levels of the other class. The SEC found that the RR’s failure to perform any mathematical analysis of (or make any sort of inquiry regarding) class cost structure differences to support his recommendation of Class B shares, was a departure from the applicable standard of care, and thus negligent.

The SEC dismissed various defenses raised by the RR including an assertion that disclosures regarding mutual fund class cost structure differences were not customary securities industry practice during the relevant period, to which the SEC responded that it and the courts had repeatedly held that a practice may be prevalent in the industry and still be fraudulent. The SEC also dismissed the RR’s defense based on the contention that under certain circumstances, Class B shares may offer better performance than Class A shares, on the basis that the circumstances cited by the RR were not those of the customers in question. The SEC entered a cease-and-desist order against the RR and ordered the RR to disgorge an amount representing the difference in commissions that the RR received for selling Class B shares and the commissions the RR would have earned had it instead sold Class A shares to the customers at issue.

Reasonable Supervision. The SEC dismissed charges brought by the Division under Sections 15(b)(4)(E) and 15(b)(6) of the 1934 Act alleges that the BD and its president failed to exercise reasonable supervision with a view to preventing the RR’s antifraud violations. The SEC noted that although the evidence and arguments presented by the Division were not without force, the SEC found that the BD and its president had implemented procedures addressed specifically to disclosure by the BD’s associated persons of material facts with respect to the difference in cost structure between Class A and Class B shares that could reasonably have been expected to prevent the RR’s violations – through written materials and through specific oversight and investigation of individual offices and transaction, both of which the SEC discussed in some detail in its opinion. The SEC also noted that the mutual fund transaction amounts at issue in the proceeding represented a relatively small proportion of the RR’s business. (The administrative law judge also dismissed the charges against the BD and its president, but for different reasons - she found that the Division had failed to establish that the RR had committed any violations.)

The staff of the SEC’s Division of Market Regulation issued a no-action letter that extends no-action relief granted in 2004 to permit a registered broker-dealer to rely on a registered investment adviser to perform the broker-dealer’s anti-money laundering ("AML") customer identification program ("CIP") with respect to shared customers. The relief is conditioned on the arrangement for reliance meeting the applicable conditions of the broker-dealer CIP rule other than the requirement that the adviser be subject to a rule requiring it to maintain an AML program (an "AML Rule"). (An AML Rule for advisers has been proposed but not adopted. See the May 6, 2003 Alert.) The relief is automatically withdrawn upon the earlier of the effectiveness of an AML Rule for registered investment advisers or January 12, 2008.

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