(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

SEC Prohibits Use of Directed Brokerage to Distribute Fund Shares

The SEC adopted amendments to prohibit the use of brokerage commissions to finance the distribution of fund shares. The commissioners also voted unanimously to adopt new disclosure requirements about fund portfolio managers. The NASD is expected to adopt a parallel amendment to its rules to prohibit broker-dealers from selling shares of a fund if the fund's manager or distributor considers the sale of fund shares in selecting broker-dealers to execute the transactions. The SEC staff also advised that it is considering additional recommendations for further amendments to the rule based on the hundreds of comment letters received.

The prohibition on directing fund portfolio brokerage transactions to broker-dealers to compensate them for promoting the sale of fund shares is intended to eliminate a serious conflict of interest between funds and their advisers that can compromise the best execution for the transaction. The SEC recognized that funds may need to use selling brokers to effect portfolio securities transactions in order to obtain the best execution, however, and will permit the use of selling brokers as long as the fund or its adviser has adopted policies and procedures to prevent the consideration of brokers' distribution efforts and any agreements under which a fund is expected to direct brokerage commissions for distribution.

Some of the commenters had urged the SEC to adopt a safe harbor in connection with the prohibition on directed brokerage, but the staff concluded that it was unnecessary. Chairman William Donaldson asked what the staff will look for when it examines funds' policies and procedures. Associate Director Robert Plaze said the staff will look at the role of the chief compliance officer and suggested that chief compliance officers should test for a correlation between distribution and sales to ensure there are no informal arrangements. The NASD's rule will apply to broker-dealers selling fund shares to help ensure that informal arrangements do not exist.

Commissioner Harvey Goldschmid said that prohibiting directed brokerage makes sense. The practice has grown dramatically in recent years, he noted, and in his view, best execution is the issue of most concern because it is difficult to monitor. Best execution will not cure directed brokerage, he added. Associate Director Plaze agreed that best execution is very hard to enforce. The staff recognized that selling brokers are needed in today's market, he said, so it would not support a rule to prohibit their use.

Commissioner Paul Atkins asked the staff to streamline the release and make it clearer. He said the release should contain the same plain English that is expected of others. Commissioner Roel Campos said he has no doubt that some funds will try to shift costs to make up for the lack of directed brokerage, so the SEC is not finished examining this area.

Portfolio Manager Disclosure

The amendments to Forms N-1A, N-2, N-3 and N-CSR were adopted with modifications from the proposing release. The new disclosure will require the identification of portfolio management team members primarily responsible for managing the portfolio. If there are more than five members, funds must disclose information about the five with the most primary responsibilities. Funds will also be required to disclose in their statements of additional information any other accounts managed by the fund's manager, such as hedge funds or pension plans, and the total assets in those accounts. Funds must explain any conflicts of interest that may arise in connection with the management of multiple accounts.

Funds will also be required to disclose in their statements of additional information the structure of their compensation arrangements for portfolio managers, such as performance benchmarks and the period for reaching those benchmarks. Funds must also disclose information about the shares the managers own in the funds they manage. The SEC will encourage funds to make their statements of additional information more readily available to shareholders by posting them on their Web sites.

Commissioner Cynthia Glassman, while voting for the amendments, said that she continues to be concerned about information overload and thought the staff's estimates of the costs of the amendments seemed low. Commissioner Atkins agreed with Ms. Glassman and emphasized the need for a full-scale review of the SEC's disclosure requirements.

In his opening remarks, Chairman Donaldson noted that after yesterday's meeting, only three rulemaking initiatives remained outstanding out of the 13 initiatives begun last fall to address problems in the mutual fund industry. He expects the Commission to act on those proposals this year.

¨ The adopting releases will be published in a forthcoming REPORT.