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.