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SEC Adopts Rule on Investment Advisor Year 2000 Reports

Fall 1998

Our Securities Practice Group would be happy to assist you with any questions relating to this article.

As of November 13, 1998, most investment advisers registered under the Investment Advisers Act of 1940 (the "Advisers Act") will be required to file reports with the SEC regarding their plans for addressing the Year 2000 computer problem1. This new filing requirement is part of the SEC's broader initiative of ensuring that the securities industry is prepared for the Year 2000. After the reports are submitted, the SEC will make the data publicly available, and, after review, may make findings or conclusions regarding the adequacy of advisers' Year 2000 compliance plans.

New Rule 204-5 under the Advisers Act applies to each investment adviser registered with the SEC that (1) has at least $25 million of assets under management or (2) serves as an adviser to an investment company registered under the Investment Company Act of 1940. These advisers will be required to file a new form, ADV-Y2K, with the SEC no later than December 7, 1998, and an updated form no later than June 7, 1999. The filings must disclose the actions that advisers and, if applicable, the registered investment companies they manage have taken in order to prepare for the Year 2000 problem.

While the Advisers Act requires no particular preparation plan, the SEC highly recommends that advisers consider the six steps it has identified to prepare for the Year 2000 computer problem. These steps are: (1) identification of potential Year 2000 problems, (2) assessment of steps to avoid Year 2000 problems, (3) implementation of steps to avoid Year 2000 problems, (4) internal testing of software designed to avoid Year 2000 problems, (5) point-to-point testing of software designed to avoid Year 2000 problems and (6) implementation of tested software that will avoid Year 2000 problems.

New Form ADV-Y2K.
The new form, ADV-Y2K, has two parts. All advisers required to file the form must complete the first part, while the second part applies only to advisers of registered investment companies. Part I elicits information in the following areas: (1) the adviser's Year 2000 compliance plan, (2) resources and personnel to address Year 2000 issues, (3) systems that may be affected, (4) the adviser's progress in addressing Year 2000 issues, (5) contingency plans, (6) the readiness of third parties and (7) whether, and the means by which, the adviser takes into consideration the Year 2000 preparedness of issuers of securities the adviser recommends to clients.

Part II of the form must only be completed by advisers to registered investment companies and requires information about the Year 2000 preparations made by registered investment companies.

SEC Releases Inspection Report on Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds

The disclosure of soft dollar practices by securities industry participants is often inadequate or wholly lacking, according to a new report released by the SEC. The SEC made a number of recommendations about improving disclosure after conducting an inspection sweep of the uses of soft dollars by broker-dealers, investment advisers and investment companies from November 1996 through April 1997.

The Use of Soft Dollars.
The term "soft dollars" refers to the allocation by investment advisers of commission dollars to the research component of services provided by broker-dealers in executing securities transactions. Because the adviser itself benefits from the research paid for by client commissions, and because the client may pay more than the lowest commission rate available so that the adviser may obtain research, the use of soft dollars can be seen as raising issues under traditional fiduciary principles. Congress created a safe harbor to protect advisers from claims of breach of fiduciary duties in Section 28(e) of the Securities Exchange Act of 1934. To be covered by the safe harbor of Section 28(e), the adviser must determine in good faith that the amount of commission paid was reasonable in relation to the value of the brokerage and research services provided. Section 28(e) also requires disclosure of soft dollar policies and practices. The SEC findings reveal, however, that advisers often fall short in complying with the disclosure provisions required by Section 28(e).

SEC Findings.
The SEC inspection found that most products and services obtained by advisers with soft dollars are considered research and thus fall within the safe harbor of Section 28(e). Although research products and services are covered by the safe harbor, the SEC found that advisers frequently did not provide sufficient disclosure so that clients or potential clients could understand the advisers' soft dollar practices, as required by Section 28(e). The advisers frequently relied on boilerplate language rather than providing adequate detail about the products and services they received in exchange for soft dollars.

The SEC also found that many broker-dealers and advisers used soft dollars to provide and receive non-research products, such as office rent and equipment, cellular phone services, legal expenses, personal travel and hotel and rental car expenses. While the use of soft dollars for non-research products and services can be lawful if meaningful disclosure is made, most of these non-research items were not disclosed. For mixed-use items with both research and non-research benefits, advisers are required to make a reasonable allocation between hard and soft dollars in accordance with the projected uses of the product. However, advisers examined by the SEC frequently made inaccurate or questionable mixed-use allocations.

The SEC report further reveals that advisers do not maintain sufficient management or control over their soft dollar practices and many advisers do not keep adequate records of soft dollar transactions.

SEC Recommendations.
As part of its report, the SEC made a number of recommendations to improve compliance by advisers and broker-dealers with soft dollar requirements. The report recommends that formal action be taken by the SEC to (1) provide additional guidance with respect to the scope of Section 28(e) and the obligations of advisers and broker-dealers, (2) adopt record-keeping requirements related to soft dollars, (3) modify the Form ADV to require more meaningful soft dollar disclosure and (4) encourage firms to adopt internal controls relating to soft dollar

Follow-up Action Plan.
While the SEC report does not require any current action on the part of investment advisers, advisers may want to take the opportunity to review their Form ADV disclosure and internal policies and procedures on soft dollar practices to ensure adequate disclosure and compliance with current requirements.

If you have any questions regarding the SEC's Year 2000 or Soft Dollar Practices reports, require further information about the reports or would like a copy of the Form ADV-Y2K or the reports, please do not hesitate to contact any of the members of Godfrey & Kahn's Investment Management Practice Group at (414) 273-3500.

1 This well-publicized problem refers to the possibility that on January 1, 2000, computer systems using only two digits to identify the year might malfunction as a result of incorrectly reading the date 01/01/00 as January 1, 1900 rather than January 1, 2000.

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