United States: SEC Settles Administrative Proceeding with Pension Consultant over Failure to Properly Disclose Potential Conflicts of Interest
(Financial Services Alert - Developments of Note)

1. SEC Settles Administrative Proceeding with Pension Consultant over Failure to Properly Disclose Potential Conflicts of Interest
2. Federal District Court Dismisses Suit Brought by Investor against Hedge Fund Consultant over Bayou Fund Investment Recommendation
3. IRS Finalizes Regulations to Simplify Reporting when Foreign Tax Benefits Pass to RIC Shareholders
4. FRB Rules Disease Management and Mail Order Pharmacy Services are "Complementary" to Insurance Underwriting
5. OCC Confirms National Banks May Provide Normal Banking Services to the Private Manager of a State Lottery

6. Limited Relief Provided by IRS under Section 409A

The SEC settled administrative proceedings brought against a pension consultant registered as an investment adviser (the "Adviser") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), regarding findings by the SEC that the Adviser had misrepresented and failed to disclose to potential clients material information about certain potential financial conflicts of interest, as discussed in greater detail below. The settlement also related to the Adviser’s president who served as the firm’s chief compliance officer ("CCO") and was responsible for its marketing materials during the relevant time period. The Adviser provided investment consulting services primarily to pension plans, profit sharing plans, endowment funds and other large institutional clients seeking assistance in developing appropriate investment strategies and in selecting money managers whose investment styles met client objectives. The Adviser also monitored and evaluated the performance and investment styles of money managers that clients engaged for consistency with client objectives.

Money Manager Screening Process. In broad terms, the Adviser’s process for working with clients involved identifying a client’s investment objectives and then conducting a manager search that commenced with a quantitative screening of money managers in the identified investment style category. The money managers identified by the quantitative screening would then undergo a qualitative screening that considered client directions or preferences and focused on areas such as manager reputation, organization, personnel and processes. Upon the completion of the screening process, the Adviser would recommend three to five money managers for client consideration. A client then made a final selection, often without any additional guidance from the Adviser. In the quantitative phase of the Adviser’s selection process, it used two proprietary databases consisting of statistical performance results, company profiles and descriptions of investment products. A money manager wishing to be included in these databases and considered for recommendation to the Adviser’s clients had to provide the Adviser with current performance results as well as company and product specific profile questionnaires; the Adviser did not charge money managers to be included in these databases.

Database Subscription Service. Through a separate department within its organization, the Adviser sold subscriptions for periodic reports generated from the data contained in one of the databases described above and sold those subscriptions to some of the same money managers that the Adviser was evaluating for, and in some cases recommending to, its clients. A money manager that purchased a subscription received quarterly reports illustrating its performance in relation to relevant market indices and the performance of its peers, and a meeting where a principal of the Adviser would meet with the money manager subscriber to explain how the money manager’s product was viewed by the Adviser during the manager selection process. In addition, subscribers were entitled to priority sponsorship opportunities at certain of the Adviser’s client events. The gross annual revenues from these subscriptions were approximately $600,000.

Disclosure Issues. While the Adviser made disclosures about the subscription sales in its Form ADV Part II, which it provided to all its actual and prospective clients, the Adviser also provided certain clients and prospective clients with written responses to requests for proposals and requests for information that the SEC viewed as failing to disclose sufficient information about the subscription service, such as revenues generated, that could enable clients and prospective clients to understand the potential conflicts of interest inherent in such sales. In addition, the SEC found that certain responses contained material omissions or materially misleading statements which, among other things, created the false impression that the Adviser did not have any potential conflicts of interest and that its only source of revenue was fees paid by clients seeking advice on investment strategies and money manager selection. The SEC found that these disclosure shortcomings violated Section 206(2) of the Advisers Act which prohibits "any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client." (Proof of scienter is not required to establish a violation of Section 206(2).) In discussing an Adviser’s obligation to disclose all actual and potential conflicts of interest, the SEC cited a release relating to a 1998 settlement of proceedings under Section 206(2) in which it stated that potential conflicts of interest are material matters that must be disclosed, and held that the registered adviser that was the subject of those proceedings was required to "disclose its receipt of third-party payments, even if it had concluded that the payments did not influence the manner in which it advised its clients."

Remedial Measures and Sanctions. At the president’s direction, the Adviser discontinued sale of the subscriptions at the end of 2005 and appointed a new CCO, who, among other things, implemented new policies and procedures relating to the Adviser’s preparation, review and distribution of written materials to clients and prospective clients designed to ensure that those documents are accurate and complete. Among other sanctions, the Adviser and its president were ordered to pay civil money penalties of $175,000 and $40,000, respectively.

The U.S. District Court for the Southern District of New York (the "Court") dismissed a complaint filed by an investor (the "Investor") over the alleged recommendation by a registered investment adviser (the "Adviser") of an investment in one of the Bayou group of hedge funds ("Bayou") that was part of a highly publicized fraud for which various Bayou principals were convicted in 2005. The suit named the Adviser and its two principals alleging that they had violated Section 10(b) of the Securities Exchange Act of 1934, as amended; that the Adviser had breached the investment advisory contract between the Adviser and the Investor; and that the Adviser had breached the Adviser’s fiduciary duty to the Investor. The principal focus of the complaint was a written presentation (the "Presentation") sent by the Adviser to the Investor’s sole shareholder sometime in 2001, approximately four years before the Bayou fraud became known. The Presentation described a five step due diligence process used by the Adviser to select hedge fund investments for clients. The due diligence involved a range of assessments including review of written responses to a request for information, quantitative analysis, on-site visits, review of portfolio positions and characteristics and a legal/audit review. The Presentation also indicated that the Adviser conducted ongoing due diligence after recommending that clients invest in a particular hedge fund. The plaintiff Investor alleged that the Adviser defrauded it by representing that before recommending the Bayou investment to the Investor, the Adviser had conducted due diligence with respect to Bayou in accordance with the process described in the Presentation when, as indicated by Bayou’s subsequent failure, the Adviser’s due diligence had fallen short of the practices described in the Presentation and prevailing industry standards. The Investor also alleged that it was defrauded by the fact that, prior to recommending the Bayou investment, the Adviser provided incorrect information about the independence of the Bayou’s accountant, Bayou’s profitability, the experience of one of Bayou’s principals and the fund’s investment strategy.

The Section 10(b) Claim. The Court focused its analysis of the Plaintiff’s claim under Section 10(b) of the 1934 Act on the adequacy of the pleading with respect to scienter, particularly with regard to the standards of pleading required by the Private Securities Litigation Reform Act ("PSLRA") and controlling case law in the Second Circuit. The Court noted that the Investor sought to plead scienter based on allegations that the Adviser was reckless in failing to uncover the Bayou fraud when it promised to conduct due diligence in accordance with the Presentation, but subsequently failed to perform even rudimentary due diligence. In order to satisfy the standard for pleading under Section 10(b) in the Second Circuit, the Court noted that the Plaintiff must allege facts approaching a knowledgeable participation in the fraud or a deliberate and conscious disregard of facts. The Court also noted the heightened standard recently announced by the U.S. Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) ("Tellabs") (as discussed in a Goodwin Procter Client Alert dated June 27, 2007 available on the firm’s website at http://www.goodwinprocter.com/getfile.aspx?filepath=/Files/Publications/CA_Tellabs_6_27_07.pdf). Tellabsheld that in examining whether pleaded facts give rise to a strong inference of scienter under PSLRA, that Court must take into account plausible opposing inferences, and that moreover, for an inference of scienter to be strong, the inference must be more than merely reasonable or permissible, but must be cogent and compelling, at least as compelling as any opposing inferences. On this basis, the Court observed that successfully pleading a Section 10(b) violation based on a defendant’s recklessness involved overcoming two stiff challenges in the Second Circuit: the strength of the recklessness allegations must be greater than for allegations of ordinary fraud, and the inference of recklessness must survive the Tellabscompeting inferences analysis; the Court concluded that the plaintiff’s 10(b) claim survived neither. First, the Court noted that courts have consistently found that a defendant’s failure to comply with self-imposed standards, which may exceed industry standards, is not sufficient to assign Section 10(b) liability and similarly, failure to perform due diligence commensurate with industry standards is inadequate to plead scienter without proof of intent to defraud. In addition, the Court found that the plaintiff’s allegations seeking to establish scienter based on recklessness failed to adduce any specific facts that met the heightened standard applied in the Second Circuit, e.g., the plaintiffs did not allege that the Adviser knew, or even suspected that Bayou was a fraudulent enterprise, nor that the Adviser recommended Bayou with the intent to cause the Investor to lose money or to assist in the fraud being perpetrated by Bayou. Finally, under the Tellabs competing inferences analysis, the Court cited the substantial competing inference that the Adviser’s due diligence process would not have uncovered Bayou’s fraudulent enterprise, one which Bayou concealed from investors, the public, investment advisers, other industry professionals and regulators, including the SEC, for nine years, and found the plaintiff’s inference of recklessness the less compelling of the two.

The Breach of Contract/Fiduciary Duty Claims. The Court dismissed the plaintiff’s claim averring breach of contract for failure to conduct initial and ongoing due diligence on the grounds that the alleged oral contract between the Investor and the Adviser relating to the Adviser’s performance of such due diligence was void under New York’s Statute of Frauds. The Court dismissed the Investor’s claim that the Adviser breached its fiduciary duty as the Investor’s investment adviser on the grounds that (a) a no implied private right of action for damages exists under Section 206 of the Investment Advisers Act of 1940, as amended, and (b) any such claim under New York state law is preempted by the Martin Act, which provides that the New York Attorney General has sole discretion to investigate securities violations within or from the state of New York, and does not provide for a private right of action.

Having found that the Plaintiff failed to state a claim on which relief could be granted, the Court dismissed the Plaintiff’s amended complaint in its entirety.

The IRS finalized regulations (T.D. 9357) under Section 853 of the Internal Revenue Code (the "Code") that simplify the reporting requirements of both regulated investment companies ("RICs") and their shareholders when a RIC elects to forgo a foreign tax credit or deduction in order to allow the favorable tax treatment to pass through to the RIC’s shareholders. The final regulations slightly modify the proposed regulations, previously discussed in the September 26, 2006 edition of the Alert. Generally, shareholders of a RIC do not take into account a RIC’s deductions and credits when determining their individual incomes. Section 853 of the Code provides an exception, however, whereby a RIC with at least 50 percent of its assets invested in the securities of foreign corporations may elect to forgo its RIC-level deductions and credits for foreign taxes and, instead, pass such items through directly to its shareholders.

Under the new regulations, a RIC making an election under Section 853 of the Code will report to each shareholder only the shareholder’s proportionate share of creditable foreign taxes paid, income from sources within countries described in Section 901(j) of the Code, and income from other foreign countries or possessions of the United States. Such reporting will be made on an aggregate basis. This change alters the previous requirement that RICs report such information to shareholders on a detailed, country-by-country basis. Additionally, the regulations extend the deadline by which RICs must notify shareholders that the Section 853 election has been made to 60 days after the close of the RIC’s taxable year. On their individual returns, shareholders will use Form 1116 to report foreign tax information on an aggregate basis.

The changes reflect modifications made in 1976 to the Code’s foreign tax credit provisions. The 1976 changes altered the application of the foreign tax credit limitation such that it is now applied on a separate category of income basis, rather than on a country-by-country basis.

The regulations became effective on August 24, 2007, and are applicable to RIC taxable years ending on or after December 31, 2007. For reporting purposes, however, a taxpayer may rely on the current regulations for a taxable year ending on or after December 31, 2007 and beginning before August 24, 2007.

The FDIC requested that the FRB evaluate whether disease management and mail order pharmacy services are "complementary" to a financial activity (health insurance underwriting) and thus permissible for a financial holding company ("FHC") under the Bank Holding Company Act ("BHC Act"). The FDIC made the request because a health insurer engaging in those activities had applied to establish an industrial loan company ("ILC"), and the FDIC has imposed a moratorium on applications for ILCs engaged in any nonbanking activity not permissible for an FHC under Section 4 of the BHC Act.

In evaluating the request, the FRB noted that Congress deemed health insurance a permissible financial activity for FHCs. Disease management involves services designed to help plan members maintain healthy lifestyles and properly manage medical conditions. The mail order pharmacy services involve filling prescriptions, providing related information to customers, and tracking potential issues with drug usage. The FRB determined that these activities were complementary to health insurance underwriting, in part, because they help the employers who obtain health insurance from the company to manage and reduce the risks of providing health insurance. Because the FRB holds that complementary services should be limited in size relative to the financial activities to which they relate, the FRB also conditioned its determination on a commitment that these activities would not comprise more than 2 percent of the insurer’s consolidated assets or more than 5 percent of its consolidated annual revenues, and also limited to 5 percent of total consolidated capital the asset size of the subsidiaries engaged in these activities.

In Interpretive Letter 1085 ("Letter 1085") the OCC confirmed that a national bank may accept deposits from and provide normal banking services to a state lottery and the private manager of the state lottery without violating 12 U.S.C. § 25a. The private manager in Letter 1085 is subject to extensive oversight and regulation by the state government that sponsors the lottery. Letter 1085 states that 12 U.S.C. § 25a was enacted to prohibit national banks from dealing in lottery tickets (e.g., selling lottery tickets at branches) or publicizing any participant or winner of the lottery, but expressly allows a national bank to take deposits from, offer a checking account to, cash checks for, or provide a letter of credit and other lawful banking services to a state lottery. Pursuant to this authority, Letter 1085 concludes that national banks may accept deposits from, or provide other normal banking services to, a state lottery or its private manager.

The Treasury Department and the Internal Revenue Service issued Notice 2007-78 which provides limited additional transition relief under Section 409A of the Internal Revenue Code of 1986, as amended ("Section 409A"). Section 409A is the tax provision applicable to non-qualified deferred compensation arrangements, including deferred compensation plans, SERPs and certain severance and bonus arrangements. Specifically, the Notice provides a limited extension to December 31, 2008 to adopt certain (but not all) amendments to deferred compensation arrangements that are subject to Section 409A. The Notice also provides some additional guidance on certain issues raised by employment agreements and cashout features. In light of the limited scope of the Notice, employers should still plan to amend their deferred compensation arrangements by the original December 31, 2007 deadline.

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