The SEC’s Cox Requests More Authority And A First Against A Fund Advisor

The market crisis continues to dominate the news as the SEC seeks new regulatory powers while expanding its enforcement investigations in an effort to determine what happened. The Commission also filed its first ever administrative action against a mutual fund advisor for the improper payment of administrative fees.

Market crisis

SEC Chairman Christopher Cox, along with the Treasury Secretary, Chairman of the Federal Reserve and others, testified on Tuesday before the Senate Committee on Banking, Housing and Urban Affairs regarding the proposed $700 billion bail out of the mortgage market. In his prepared testimony, the SEC Chairman reiterated the Commission’s recent actions regarding the market crisis, including a discussion of the new rules temporarily limiting short trading.

The Division of Enforcement is devoting what the Chairman called “an extraordinary level” of resources to the current market crisis. The division has over 50 pending law enforcement investigations in the subprime area. This includes a “sweeping investigation” into market manipulation of financial institutions focused on broker-dealers and institutional investors and their trading activity in credit default swaps. The Division is focusing on the CDS market because it is “completely lacking in transparency and completely unregulated,” but involves $58 trillion. According to Chairman Cox, the investigations focus on “using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer” a significant potential for abuse. The Chairman went on to note that a CDS buyer is “tantamount” to a short seller of the bond underlying the instrument. CDS buyers can “naked short” the debt of the companies without restriction. This is of “great concern,” the Chairman told the Senate Committee.

In his testimony, Chairman Cox reiterated his earlier call for authority to regulate investment banks, which he characterized as a failure of the Gramm-Leach-Bailey Act. He also asked for regulatory authority over the CDS market. During questioning by the Committee, the Chairman reiterated these requests for additional authority for the Commission.

The day before the Chairman’s testimony, New York State announced that its insurance department is imposing certain restrictions on the credit derivative market. The new rules are apparently directed at safeguarding companies that buy the instruments. The state will require companies to obtain an insurance license in order to issue a credit default swap to borrowers who also own the bonds or loans they are designed to protect. This would not apply to so-called “naked” credit default swaps. The new rules also impose certain capital requirements.

AmSouth settlement

In In the Mater of AmSouth Bank, N.A., Adm. Proc. File No. 3-13230 (Sept. 23, 2008), the Commission brought its first case against a mutual fund advisor that secretly used part of its administrative fees paid by fund shareholders to pay for marketing expenses. According to the Order for Proceedings, AmSouth entered into undisclosed side agreements with BISYS Funds Services, the administrator of AmSouth Funds, under which BISYS rebated about $16 million of its $49 million administrative fee. The rebates were used to pay expenses unrelated to marketing. Those expenses included salary, bonus, benefits and country club membership for the president of the AmSouth Funds. In addition, BISYS paid AmSouth an additional $1.161 million in what was called consulting fees in exchange for AmSouth recommending to the trustees that BISYS provide securities lending services to the AmSouth Funds. None of these side agreements were disclosed to AmSouth Funds’ independent trustees or the Funds’ shareholders.

To resolve the matter, AmSouth and AmSouth Asset Management, Inc., a registered investment advisor, agreed cease and desist from committing violations of Sections 206(1) and 206(2) of the Investment Advisers Act and from committing or causing any violations or future violations of Sections 12(b) and 34(b) of the Investment Company Act and Rule 12b-1 thereunder. AmSouth also agreed to pay a total $7.7 million in disgorgement, $2.2 million in prejudgment interest and a $1.5 million penalty.

SEC Modifies Its Emergency Short Sale Rules And Suggests They May Be Extended

The SEC amended its emergency short sale rules in two orders entered on Sunday, September 21, 2008. First, the SEC made certain technical and conforming amendments to its order prohibiting short sales in shares of 799 financial institutions. The original order contained certain exceptions. Specifically, that order provided a limited exception for certain bona fide market makers, block positioners and other market makers obligated to quote in the over the counter markets. The order also provided an exception to allow short sale that occur from the automatic exercise of an equity option held prior to its effective date.

The order entered on Sunday left in place the initial exceptions, but adds a new limitation. Under the modified order, a market maker cannot sell short if he or she knows that the customer or counterparty is increasing an economic net short position in one of the shares of one of the listed financial institutions. This amendment conforms the Commission’s ban with one entered by the U.K. Financial Services Authority.

On September 18, 2008, the FSA entered an order which generally prohibits short selling in certain securities. That order applies to the shares of 32 companies. The order exempts from its prohibition and disclosure obligations regarding short positions transactions by market makers. It defines market makers as “an entity [who] ordinarily as part of their business dealing as principal in equities, options or derivatives … to fulfill orders received from clients, to respond to a client’s requests to trade or to hedge positions arising out of those dealings.” It is due to expire on January 16, 2009, in contrast to the SEC’s initial order which is due to expire on October 2, 2008.

The second order issued on Sunday suggests however, that the current expiration date may be extended. At the time the initial short sale ban was instituted last week, the Commission also imposed certain disclosure obligations on large institutional money managers discussed here. That order provided in part the disclosures would be made available to the public. Under the modification approved on Sunday, the SEC will delay disclosing the short positions of the funds for two weeks after filing.

The order also notes that the SEC may extend its emergency order beyond the initial ten business day period. However, any extension will not exceed more that “30 calendar days in total duration,” according to the order.