Welcome to the Winter 2006 Editionof K&LNG’s Investment Managementnewsletter keeping you abreast ofnews and developments in today’sregulatory and operatingenvironments.

Diane E. AmblerEditor

Contents

Major Changes to ERISA 1Fiduciary Requirements

FASB Interpretation No. 48: 1Accounting for Uncertainty inIncome Taxes

Compliance Corner 2

Recent and Anticipated 3Developments Regarding Hedge Funds

Consolidation of NASD and NYSE 3Regulation of Securities Firms

The Section 28(e) Safe Harbor 4and Commission Sharing Arrangements

Recent Evolution of the 5ETF Market

Kirkpatrick & Lockhart Nicholson 10Graham LLP and Preston Gates & Ellis LLP Announce Combination

Upcoming Events 11

Current Developments and 11Dates to Remember

LAWYERS TO THE INVESTMENTMANAGEMENT INDUSTRY

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Winter 2006

Kirkpatrick & Lockhart Nicholson Graham LLP’s

Investment Management Update

The Pension Protection Act of 2006(the “Act”) signed into law on August17, 2006 makes the most significantchanges to the Employee RetirementIncome Security Act of 1974 (“ERISA”)fiduciary responsibility requirementssince ERISA was enacted in 1974.Highlights of the changes include:

■ New rules for determining whetherunregistered investment fundshold “plan assets”;

■ Exemption for investment adviceprovided by a person with an interestin the investments to which the advice relates;

■ Prohibited transaction exemptions fora number of investment-relatedtransactions and for a broad category ofservice providers;

■ Broker-dealer exemption from thefidelity bonding requirement; and

■ Default options and other new rulesfor participant-directed plans.

Major Changes to ERISA Fiduciary RequirementsBy William A. Schmidt

(Continued on page 8)

FASB Interpretation No. 48:Accounting for Uncertainty in Income TaxesBy Theodore L. Press and Roger S. Wise

Although mutual funds and privateinvestment funds, including hedge funds,generally do not pay income taxes, theyare subject to Financial AccountingStandards Board Interpretation No. 48:Accounting for Uncertainty in IncomeTaxes (“FIN 48”), which significantlychanges how companies must recognize,measure, and disclose income tax benefitsin their financial statements. Released onJuly 13, 2006, FIN 48 is effective for fiscalyears beginning after December 15, 2006,

(Continued on page 6)

which means January 1, 2007, for a calendar-year company. Funds may need to recordliabilities on their financial statements to theextent the tax positions reflected on theirincome tax returns do not meet FIN 48’srequirements. In the case of a mutual fund,such a liability could cause a reduction in itsnet asset value (“NAV”). Funds will needto begin establishing procedures to reviewand support tax positions reflected on theirtax returns and to monitor these positionson an ongoing basis.

NASD Requires Added Disclosures for Mutual FundPerformance DataBy Francine J. Rosenberger

CCoommpplliiaannccee CCoorrnneerr

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K&LNG’s Investment Management Update

The National Association of SecuritiesDealers, Inc. (“NASD”) recently imposednew disclosure requirements on non-moneymarket fund performance presentations inadvertisements, sales materials and membercorrespondence. On September 1, 2006, theNASD issued a notice of amendments toRules 2210 and 2211 that will require promi-nent disclosure of a fund’s annual operatingexpense ratio, gross of any applicable feewaivers or expense reimbursements. Thedisclosure requirements do not apply tomoney market fund performance presenta-tions. The effective date of these rulechanges is April 1, 2007.

These amendments significantly expandthrough more detailed requirements the dis-closure standards for non-money marketmutual fund performance presentations inNASD member advertisements, sales mate-rials and correspondence. The rules previ-ously provided only general content stan-dards for mutual fund advertisements, salesmaterials, institutional sales materials andcorrespondence, led by the guiding principlethat all member communications be basedon the principles of fair dealing and goodfaith. The newly amended rules now requirenon-money market mutual fund advertise-ments, sales materials and member corre-spondence that present performance data todisclose the following specifics:

■ the fund’s standardized performanceinformation as described in Rule 482under the Securities Act of 1933 andRule 34b-1 under the InvestmentCompany Act of 1940

■ the fund’s maximum front-end or back-end sales charges, to the extent applicable

■ the fund’s total annual operatingexpense ratio, gross of any fee waivers or expense reimbursements, as stated in the fee table of the fund’s prospectus.

This information must be presented promi-nently. In addition, if fund performance isincluded in any member print advertisement,the newly required information must be pre-sented in a prominent text box. These newrequirements do not apply to member insti-tutional sales materials or public appearances.

Expense Ratio

Although the NASD had not previouslyinterpreted these rules to require a fund’stotal annual operating expense ratio, theamendments reflect the NASD’s determina-tion that this information is important topotential investors because of the impact ofexpenses on a fund’s performance. Theexpense ratio to be reflected is that whichappears in the fund’s currently effectiveprospectus as of the date of submission of theadvertisement for publication, the date of dis-tribution of sales material to the public, or thedate of the correspondence.

The expense ratio is to be gross of any appli-cable waivers or expense reimbursements,even if the prospectus disclosure is net of feewaivers or reimbursements. Importantly, theamended rules do not preclude the perform-ance materials from also presenting a fund’snet expense ratio as long as the member pres-ents both expense ratios in a fair and bal-anced manner in accordance with the stan-dards of NASD Rule 2210. If expenses arereflected on a net basis, the disclosure shouldalso address (1) whether the fee waivers orexpense reimbursements were voluntary ormandated by contract and (2) the time periodduring which the fee waiver or expense reim-bursement obligation remains in effect. Inprint advertisements, a member may showthe net expense ratio in the text box with thegross expense ratio as long as they are pre-sented in a fair and balanced manner.

Prominence

The NASD has stated that it will apply thesame prominence and proximity standards fordisclosure of expense ratios as those used forstandardized performance and sales chargesunder SEC rules.

Text Box Requirement

Amended Rule 2210 now requires that per-formance information appearing in memberprint advertisements must present therequired information in a prominent text box.The text box may contain only the requiredinformation, as well as disclosures requiredunder Rule 482 and Rule 34b-1, except that itmay also contain comparative performance andfee data.

Print advertisements include printed newspa-pers, magazines and other periodicals. Thetext box requirement does not apply to printedsales literature, such as fund fact sheets,brochures or form letters, not does it apply toweb sites, television or radio communicationsor other forms of electronic communications.

Re-Filing of Materials to be Usedafter Compliance Date

Performance sales material used on or afterApril 1, 2007 will be required to meet theamended disclosure standards of Rule 2210.The NASD has indicated that it is not neces-sary to re-file previously filed materials wherethe only revision is the addition of the expenseratio. However, all performance print advertise-ments must be re-filed to reflect the addition ofthe text box, because it alters the content andpresentation of the performance information. �

3WINTER 2006

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The hedge fund industry is nothing if notfluid and dynamic. Here are some observa-tions about current developments.

SEC Proposes New Rules Aimedat Hedge Funds

Since the SEC has indicated it will notappeal the Goldstein decision, which invali-dated the hedge fund manager registrationrule, it will be looking for other ways tomonitor and regulate the hedge fund indus-try. At a meeting on December 13, 2006,the SEC proposed a new anti-fraud ruleunder the Investment Advisers Act of 1940(the “Advisers Act”) to make clear that theinvestment manager of a hedge fund owes afiduciary duty directly to the investors in thehedge fund, not just to the hedge funditself. The SEC considers this rule to beimportant because the Goldstein court foundthat only the hedge funds managed by anadviser—and not the investors in the hedgefunds—count as clients toward the limit of14 clients for purposes of the Section203(b)(3) exemption. (Section 203(b)(3) ofthe Advisers Act generally provides anexemption from registration to an adviserthat has fewer than 15 clients and does nothold itself out to the public as an investmentadviser.) The proposed rule would apply toall hedge fund managers, whether or notthey are registered under the Advisers Act.

At the meeting on December 13 the SECalso proposed amendments to the privateoffering rules under the Securities Act of1933 to revise the criteria for natural personsto be considered “accredited investors” forpurposes of investing in hedge funds andother private investment pools that rely onthe Section 3(c)(1) exception under theInvestment Company Act of 1940. Thefinancial criteria for natural persons have notbeen increased since Regulation D wasadopted in 1982. Under the proposed rule,

to be an accredited investor for purposes ofan offering by a hedge fund that is relyingon Section 3(c)(1), a natural person wouldbe required to meet the net worth orincome test in Rule 501 of Regulation Dand would be required to own at least $2.5 million in investments, as defined inthe rule. Regulation D is, of course, used bycompanies of all sorts to raise capital withouthaving to register securities for sale underthe Securities Act of 1933. The proposedrule would increase the financial standardsfor accredited status of natural personsinvesting in certain hedge funds and otherprivate investment pools only, leaving thestandards for other securities offeringsunchanged.

The hedge fund industry and others willhave 60 days in which to comment on theproposed rules.

Voluntary Deregistration ofHedge Fund Managers underthe Advisers Act

In the wake of the invalidation of Rule203(b)(3)-2 by the Goldstein decision, manyhedge fund managers who qualify for theSection 203(b)(3) exemption have deregis-tered. Before deregistering, it is importantfor a manager to comply with any applicablestate law requirements, possibly includingrequirements to register as an investmentadviser on the state level.

Many other advisers who would be permit-ted to deregister have elected not to do so.The principal motivation for remaining reg-istered is to meet one of the requirementsfor being a Qualified Professional AssetManager under ERISA. Since benefit planinvestment in hedge funds has become sosubstantial, many managers find thatQPAM status is essential.

Recent and AnticipatedDevelopments Regarding Hedge FundsBy Nicholas S. Hodge

Consolidation ofNASD and NYSERegulation ofSecurities FirmsBy Diane E. Ambler

(Continued on page 9)

In a stunning step intended to enhance theintegration and simplification of U.S. securi-ties regulation, SEC Chairman Coxannounced NASD and NYSE plans to con-solidate into a single SRO the regulation ofall brokers and dealers doing business withthe public in the U.S. The new entity—under the leadership of Mary Schapiro asCEO and Rick Ketchum as non-executiveChairman of the Board of Governors for athree-year transition period—will be respon-sible for member examination, enforce-ment, arbitration and mediation functions,as well as other current NASD market regu-lation functions. NYSE Regulation, forwhich Rick Ketchum will remain as CEO,will continue to oversee the NYSE market,conduct market surveillance, perform relat-ed enforcement functions and review listedcompany compliance. The new SRO isexpected to begin operations in the secondquarter of 2007.

Currently, almost 200 of the 5100 firms reg-ulated by the NASD are also members ofthe NYSE and are regulated by both organi-zations. These 200 dually regulated firmsare among the industry’s largest. The gov-erning body of the new SRO reflects theintention to provide a balanced voice for allfirms, large and small. It is proposed that ofthe 23 seats proposed for the Board ofGovernors, three seats each will be desig-nated for election by large firms (500 ormore registered persons) and small firms(150 or fewer registered persons); and oneseat each will be designated for election bymedium-sized firms (151 to 499 registeredpersons), NYSE floor members, independ-ent dealer/insurance affiliated firms andinvestment companies. In addition to these10 seats to be held by Industry Governors,11 additional seats will be held by PublicGovernors, and the Chairman and the CEOwill also serve on the Board.

(Continued on page 10)

The Section 28(e) Safe Harbor andCommission Sharing ArrangementsBy C. Dirk Peterson

The SEC recently clarified the extent towhich “client commission arrangements”satisfy the safe harbor under Section 28(e) ofthe Securities Exchange Act of 1934 in along-anticipated interpretive release pub-lished in July 2006. In an earlier interpretiverelease, in October 2005, the SEC solicitedcomment on a range of issues under Section28(e), including the permissibility of clientcommission arrangements. Since the codifi-cation of Section 28(e) in 1975, the SEC hasissued four major interpretive releases aboutSection 28(e), published several reports andissued a release concerning certain risklessprincipal trades, and its staff has issued sev-eral interpretive letters concerning the scopeof Section 28(e) through the no-actionprocess. This article focuses on the SEC’sinterpretation of Section 28(e) clarifyingreliance on the safe harbor for certain typesof client commission arrangements.

Section 28(e) provides a safe harbor permit-ting money managers with investment dis-cretion over the management of client assetsto use client commissions to acquire broker-age and research services, assisting in themanagement of the money manager’saccounts. The safe harbor protects themoney manager from allegations of actingunlawfully or breaching fiduciary dutiesunder state and federal law, such as theInvestment Advisers Act of 1940 and theEmployee Retirement Income Security Actof 1974, to the extent that the money man-ager (i) uses client commissions to receivebrokerage and research services to assist it inthe management of its client accounts and(ii) does not pay the lowest possible com-mission rate for the execution of client port-folio trades.

Client commission arrangements center onstructuring the delivery of research to amoney manager from an independentresearch provider, which the SEC permitsand refers to as third-party research arrange-ments. If the third-party research providerintends to receive a share of commissionsfrom portfolio trading (as opposed to a flatfee, subscription fee or other non-transac-tion-based compensation), it must be a reg-

4 WINTER 2006

could apply to third-party or independentresearch arrangements insofar as portfoliotrades were executed by an executing bro-ker-dealer who passed a portion of the com-missions to a research provider that was its“normal and legitimate correspondent.”This standard was intended to distinguishthird-party research arrangements from“give-ups,” an industry vestige of the fixedcommission era predating Section 28(e) inwhich a broker-dealer was allocated commis-sions in connection with the execution ofportfolio trades in the absence of providingany discernable service or product of valuein the transaction process.

To ensure coverage within the safe harbor,the normal and legitimate correspondentstandard required the research provider toenter into a traditional clearing agreementwith the executing firm. Clearing agree-ments are subject to NASD and NYSE rulesgoverning the allocation of responsibilitiesbetween the two firms in reference to spe-cific functions. These rules also require thefiling of the agreement with the NASD orthe NYSE for approval. The functions spec-ified in traditional clearing arrangements,though, often do not accurately reflect thelimited functions of third-party researchproviders, namely their limited client con-tact, minimal transaction oversight and lackof order routing or execution capabilities.The failure of the normal and legitimate cor-

K&LNG’s Investment Management Update

istered broker-dealer because the researchprovider is, in theory, nominally part of thechain of distribution in a securities transac-tion and receives a share of commission rev-enue—a hallmark of broker-dealer status.The payment arrangements in this contextmay take the form of commission sharingarrangements between the research providerand the executing firm.

Although some third-party researchproviders are registered with the SEC asbroker-dealers, they do not maintain or carrycustomer brokerage accounts per se or exe-cute client portfolio transactions. Rather,another firm will carry and execute portfoliotrades and allocate a portion of the commis-sion (sometimes at the direction of themoney manager) to the research provider topay for research obtained by the moneymanager. The structure of this type ofclient commission arrangement implicatescertain of the statutory elements of Section28(e), which requires the research to be“provided by” the broker-dealer “effecting”the portfolio securities transactions.

The SEC has previously clarified that the“provided by” and “effecting” elements ofthe safe harbor are not so limited that theyapply to soft-dollar research arrangementssolely with full service firms that distributetheir own proprietary or in-house researchand execute portfolio trades. For example,the SEC has indicated that the safe harbor

(Continued on page 5)

5WINTER 2006

respondent standard to account for the evo-lution of third-party research arrangementscreated administrative and contract draftingdifficulties structuring them in a traditionalintroducing-clearing format for purposes ofNASD or NYSE approval.

In the July 2006 release, the SEC acknowl-edged the importance and evolution of third-party arrangements. The SEC’s interpretiveposition, by reference to four minimum fac-tors, attempted to insert much-needed flexi-bility to accommodate permissible third-partyresearch arrangements, keeping with the

intent of the safe harbor and distinguishingthem from impermissible give-ups. Underthe terms of the July 2006 release, a third-party research provider wishing to receive ashare of the commissions may rely on thesafe harbor only if it satisfies one of four min-imum functions: (i) take financial responsi-bility for all customer trades until settlement;(ii) undertake record-keeping responsibilityreflecting trading activity; (iii) monitor andrespond to client comments about the trad-ing process; and (iv) generally monitor trad-ing and settlement. The SEC did not elabo-rate on the scope of any of these four mini-mum functions.

The SEC’s new position leaves openadministrative issues, such as whether clientcommission arrangements would be

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deemed to be normal and legitimate corre-spondence relationships, and, if so, whetherthe commission sharing agreement wouldneed to be filed with the NASD or NYSEunder rules governing introducing and clear-ing relationships. If these filing andapproval obligations are required, neitherthe SEC nor the NASD or NYSE has pro-vided guidance on how these arrangementsare expected to comply with NASD andNYSE rules governing introducing andclearing arrangements.

The SEC has invited further comment in itsJuly 2006 release, but has not guaranteed thatit will issue another release in response. �

RECENT EVOLUTION OF THE ETF MARKETBy Robert J. Borzone, Jr.

As exchange traded fund (ETF) providersincreasingly seek exemptive relief to launchnew and innovative offerings, the SEC hastaken action to facilitate growth in the ETF market.

Innovative ETFs Approved

Based on an ETF exemptive order issuedby the SEC in June 2006, and with the assis-tance of K&LNG, WisdomTree Trustlaunched the first family of ETFs based onaffiliated indexes. Previous open-end ETFshave tracked benchmark indexes created bythird parties. The WisdomTree ETFs arebased on proprietary fundamentally-weight-ed indexes developed by WisdomTree

Investments, Inc. The WisdomTreeIndexes weight-constituent-companies byeither cash dividends paid, dividend yield orearnings, providing investors with an alterna-tive to traditional market capitalization-weighted indexes. The WisdomTree ETFsalso obtained an exemptive order that per-mits investment companies to invest in theWisdomTree ETFs in excess of the normallimits imposed by section 12(d)(1) of theInvestment Company Act on one invest-ment company buying shares of another.Also in June 2006, the SEC issued an orderto ProShares to introduce “leveraged” ETFsthat seek a multiple or inverse multiple ofthe return of various indexes.

Class Relief for Transactions in ETF Shares

In October 2006, the Division of MarketRegulation expanded the scope of the classrelief for Creation Unit transactions and sec-ondary market transactions from certainSecurities Exchange Act, Regulation M andRegulation SHO rules for registered and list-ed ETFs meeting minimum Creation Unitbasket size and composition requirements,and index composition and disseminationrequirements. For example, the class relief,which is also subject to certain “rule specif-ic” requirements, permits persons who maybe deemed to be participating in a distribu-tion of ETF shares to bid for or purchaseshares during their participation in such adistribution, and permits ETFs to redeemtheir shares during the continuous offeringof their shares. ETFs, broker-dealers andothers relying on this relief are still subject tothe anti-fraud and anti-manipulation provi-sions of the Securities Exchange Act.

Generic AMEX ListingStandards for Certain ETFs

In November 2006, the SEC approved newAmerican Stock Exchange generic listingstandards for ETFs based on internationalor global indexes (or on indexes previously

Section 28(e) Safe Harbor(continued from page 4)

(Continued on page 6)

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K&LNG’s Investment Management Update

Major Changes (continued from page 1)

The changes are intended primarily to relaxsome of ERISA’s most stringent require-ments. ERISA’s fiduciary responsibilitystandards and prohibited transaction restric-tions, however, are—and remain—complex.This is an overview of the most significantchanges affecting plan sponsors, investmentmanagers and advisers and other plan serv-ice providers.

ERISA “Plan Assets” Regulation

The Act drastically reduces the scope of thedefinition of “benefit plan investor”—a keyterm of the Department of Labor’s “planassets” regulation.

The regulation provides that a privateinvestment fund manager is considered tobe an ERISA fiduciary with respect toERISA plans that invest in the fund if “ben-efit plan investors” hold 25 percent or moreof the value of any class of equity interests inthe fund. The regulation defines the term“benefit plan investor” to include not onlyplans subject to ERISA or the parallel pro-hibited transaction excise tax provisions ofsection 4975 of the Internal Revenue Code(the “Code”), but also other employee bene-fit plans that are not subject to ERISA, suchas governmental plans, church plans, and for-

eign plans. Private investment funds whoseassets are treated as “plan assets” also areconsidered benefit plan investors.

The Act modifies the definition of benefitplan investor to include only plans subject toERISA or to the prohibited transactionexcise tax provisions of section 4975 of theCode. Thus, for example, the assets of aprivate fund in which ERISA plans invest20 percent and in which governmental plans invest 80 percent are not considered to be plan assets.

The Act also provides that, if a plan-assetfund invests in another private fund, onlythat portion of the investing fund that isattributable to benefit plan investors is

taken into account for purposes of applyingthe 25 percent test to the second fund. Forexample, if ERISA plans own 50 percent ofthe equity interests in a private fund andthat fund invests $10 million in another pri-vate fund, only $5 million of the investmentis taken into account for purposes of apply-ing the 25 percent test to the second fund.

These changes, which became effective asof August 18, 2006, permit private fundmanagers to raise significantly more capitalfrom ERISA-covered plans without beingsubject to the ERISA fiduciary responsibili-ty requirements and permit plans to takeadvantage of opportunities to invest in pri-vate funds that were otherwise unavailableto them.

approved by the SEC for the trading ofETFs, options or other index-based securi-ties). Existing ETF providers can nowlaunch new international ETFs withoutwaiting for AMEX to file a rule change withthe SEC. The listing standards require thecomponents of the ETF’s underlying indexto be adequately capitalized, sufficiently liq-uid, listed on an exchange and subject tolast-sale reporting. As a result, no one stockwould dominate the index, the index com-ponents would be transparent, and the ETFshould be sufficiently broad-based in scopeto minimize potential market manipulation.Other listing standard changes affectingETFs include specific delisting criteria,NAV dissemination requirements and trad-ing halt rules. ETFs listed under the new

listing standards are still subject to all otherAMEX rules. AMEX previously had gener-ic listing standards only for ETFs based onindexes that consist of stocks listed and trad-ed on U.S. exchanges.

Streamlining ExemptiveApplication Review

Since September 2006, Buddy Donohue,Director of the SEC’s Division ofInvestment Management, has spoken pub-licly about the Division’s efforts to evaluateand improve its process for reviewing ETFexemptive order applications. Efforts he hasmentioned include streamlining the reviewof routine index ETF exemptive orderapplications, expanding the future reliefcontained in ETF orders, considering ETF-specific disclosure requirements, and per-mitting the electronic filing of exemptiveorder applications. In December 2006, Mr.

Donohue stated that the Division staff isworking on an Investment Company Actrule that, if adopted, would eliminate theneed for certain index-based ETFs to obtainindividual exemptive relief before beinglaunched. Although routine ETFs wouldbenefit from such a rule, novel or unusualETF offerings would likely still require indi-vidual exemptive relief.

Future Action

Although the SEC issued a concept releaseon actively managed ETFs in November2001, and exemptive applications for active-ly managed ETFs have been filed, noactively managed ETF has yet beenapproved or launched. As issues such as thedefinition of an index and need for portfoliotransparency are resolved, we expect to seemore regulatory action and evolution in theETF market. �

Recent Evolution(continued from page 5)

(Continued on page 7)

7WINTER 2006

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it is required to issue a class exemption forinvestment advice to these plans.

The investment advice exemption appliesto advice provided after December 31, 2006.

Relaxation of the ProhibitedTransaction Restrictions

The Act introduces a number of newexemptions from ERISA’s “party in inter-est” prohibited transaction restrictions (andthe corresponding prohibited transactionexcise tax provisions of the Code).Although these exemptions generallyenable plan managers to avoid prohibitedtransactions, they all are subject to various,sometimes complicated, conditions.Highlights of the exemptions follow:

■ A blanket exemption for ttrraannssaaccttiioonnssiinnvvoollvviinngg ppeerrssoonnss wwhhoo aarree ppaarrttiieess iinniinntteerreesstt ssoolleellyy bbyy rreeaassoonn ooff pprroovviiddiinnggsseerrvviicceess ttoo aa ppllaann (or by reason of arelationship to a service provider), ifthe plan pays no more than, or receivesno less than, “adequate consideration”(generally, fair market value).

■ An exemption permitting aninvestment manager to engage inddiissccrreettiioonnaarryy ccrroossss ttrraaddiinngg of publiclytraded securities for large (assets of atleast $100 million) accounts, if certainrequirements are met.

■ An exemption making it clear thatfiduciaries do not engage in prohibitedtransactions by using eelleeccttrroonniicc ttrraaddiinnggnneettwwoorrkkss.

■ An exemption facilitating ffoorreeiiggnneexxcchhaannggee ttrraannssaaccttiioonnss.

■ An exemption permitting bblloocckk ttrraaddeessinvolving the assets of certainemployee benefit plans.

The new exemptions apply to transactionsoccurring on or after August 18, 2006.

The Act adds a provision permitting ccoorrrreecc--ttiioonn ooff iinnaaddvveerrtteenntt pprroohhiibbiitteedd ttrraannssaaccttiioonnssiinnvvoollvviinngg sseeccuurriittiieess within 14 days after thetransaction occurs and providing for abate-ment of the prohibited transaction excise taxwhen such correction occurs. This provisionapplies to transactions discovered, or whichshould have been discovered, on or afterAugust 18, 2006.

Investment Advice

The Act includes a new prohibited transac-tion exemption that allows fiduciaries to provide investment advice to defined contri-bution plan participants, even thoughinvestments based on the advice may affectthe compensation received by the fiduciaryor its affiliates. Under previous Departmentof Labor (“DOL”) interpretations, suchadvice would involve a prohibited transac-tion in the absence of an exemption. (Thescope of existing exemptive relief, more-over, is unclear.)

The new exemption permits banks, insur-ance companies, registered investmentadvisers or registered broker-dealers (andtheir affiliates) to provide investment adviceto plan participants pursuant to an “eligibleinvestment advice arrangement.” In thecase of ERISA-covered plans, an eligibleinvestment advice arrangement must satisfyone of two conditions: either (1) the feesreceived by the fiduciary may not varydepending on the investment option select-ed by the participant (the uniform feeapproach); or (2) the advice must be basedon a computer model that operates in amanner that is not biased in favor of invest-ments offered by the fiduciary (or by a per-son with a material affiliation or contractualrelationship with the fiduciary). As a practi-cal matter, the computer-based adviceapproach represents the most significantchange from previous law. A computer-based advice program must be certified asmeeting the requirements of the Act by anindependent financial expert, and the fidu-ciary must arrange for an independentexpert to conduct an annual audit of theadvice program.

For the time being, the exemption is of lim-ited utility with respect to plans – principal-ly individual retirement accounts – that arenot subject to ERISA but are subject to theprohibited transaction excise tax provisionsof the Code. The computer-based adviceapproach is unavailable for non-ERISAplans until the DOL has studied the issueand made a determination of whether itwould be feasible to provide advice to theseplans pursuant to a computer model. If theDOL is unable to make this determination,

New Fidelity BondingRequirements

The Act contains a new eexxeemmppttiioonn ffrroommEERRIISSAA’’ss bboonnddiinngg rreeqquuiirreemmeennttss ffoorr rreeggiiss--tteerreedd bbrrookkeerr--ddeeaalleerrss. The maximum bondamount—currently $500,000—also isincreased to a maximum of $1,000,000 perplan in the case of plans holding employersecurities.

The new bonding exemption for broker-dealers applies for plan years beginning afterAugust 17, 2006. The increase in the maxi-mum bond amount applies for plan yearsbeginning after 2007.

New Rules AffectingParticipant-Directed Plans

The Act makes a number of importantchanges to the operation of participant-directed plans.

First, plan sponsors who select third-partyfiduciary investment advisers for participant-directed plans will not be consideredresponsible for the specific investmentadvice provided to plan participants. Plansponsors continue to be responsible for mak-ing a prudent selection of any such invest-ment adviser and for monitoring the advis-er’s performance.

Second, relief from fiduciary liability forlosses resulting from participant investmentdecisions provided by section 404(c) ofERISA is extended to certain “default”investment options which satisfy regulationsthe DOL is required to issue no later thanFebruary 18, 2007, although the relief iseffective for plan years beginning after 2006.

Third, the relief provided by section 404(c)extends to certain changes made to partici-pant investment options, if the participant isprovided prior written notice of suchchanges. This change is effective for planyears beginning after 2007.

Finally, the Act directs the DOL to issue aregulation clarifying that the DOL’s inter-pretive position that plan fiduciaries mustpurchase only the “safest available annuity’does not apply to the purchase of annuitiesavailable as an optional form of distribution.This regulation is to be final no later thanone year from the date of enactment. �

Major Changes(continued from page 6)

K&LNG’s Investment Management Update

8 WINTER 2006

FIN 48 applies to business enterprises, not-for-profit organizations, and pass-throughentities and entities eligible for a 100% divi-dends-paid deduction “that are potentiallysubject to income taxes.” This final catego-ry includes partnerships (including limitedliability companies and other entities classi-fied as partnership for tax purposes), regis-tered investment companies, and real estateinvestment trusts.

Under FIN 48, a company’s financial state-ments must reflect a liability for any unrec-ognized tax benefits—the differencebetween the tax position taken (or to betaken) in a tax return and the benefit recog-nized and measured under FIN 48. Thisliability could also include interest andpenalties on the unrecognized tax benefit.FIN 48 requires a two-step process that sep-arates the recognition of a tax benefit fromits measurement.

A company may recognize a tax benefit in itsfinancial statements if it concludes that thebenefit is “more likely than not” to be sus-tained on examination, including resolutionof any related appeals or litigation processes.This analysis presumes that the tax positionwill be examined by a taxing authority that

FASB Interpretation(continued from page 1)

has full knowledge of all relevant informa-tion. Thus, the likelihood of a tax positionbeing audited cannot be taken into account.To support the technical basis for a tax posi-tion, a company may rely on explicit legalauthorities, such as statutes and regulations,and on administrative practices and prece-dents of taxing authorities, so long as thosepractices are “widely understood.” In manyinstances, a company may find it helpful toobtain an opinion of legal counsel that a par-ticular position meets the more-likely-than-not standard. On October 16, 2006, theInternal Revenue Service introduced a pro-gram that provides expedited resolution ofuncertain tax positions, but it appears thatfew (if any) taxpayers have taken advantageof this program.

Assuming that the recognition threshold ismet, a tax position is measured as the largestamount of tax benefit with a greater than50% likelihood of being realized upon ulti-mate settlement with a taxing authority thathas full knowledge of all relevant informa-tion. This requires consideration of thecumulative probabilities of the possible esti-mated outcomes, a process that can best beshown with an example. Assume a compa-

ny recognizes the benefit of a $100 deduc-tion because it concludes that the deductionis more likely than not to be sustained. Tomeasure the benefit, the company con-cludes that there is a 5% probability of thefull $100 deduction being sustained, anadditional 25% probability of an $80 deduc-tion being sustained (for a cumulative proba-bility of 30%), and an additional 25% proba-bility of a $60 deduction being sustained(55% cumulative probability). Because $60is the largest amount of benefit with agreater than 50% likelihood of being real-ized, the company would recognize a taxbenefit of $60 in its financial statements.

A tax benefit that cannot be recognized ini-tially is reflected in the set of financial state-ments for the first subsequent period inwhich the more-likely-than-not threshold ismet. Thus, a company might initially accruea liability for an unrecognized tax positionand then reverse the liability in a later set offinancial statements because, for example,the statute of limitations with respect to thatposition has expired. Similarly, a tax benefitmight need to be de-recognized (and a lia-bility recorded) if the position later fails tomeet that threshold. These changes are tobe based on an evaluation of new informa-tion—such as the expiration of the statute oflimitations or a court decision—rather thanmerely a new interpretation of existing infor-mation.

If there is a reasonable possibility that theamount of an unrecognized tax benefit willsignificantly increase or decrease within thenext 12 months, the company must disclosethe nature of the uncertainty regarding thetax position, the nature of the event thatcould occur within the next 12 months thatcould cause the change, and an estimate ofthe range of reasonably possible change (or astatement that such an estimate cannot bemade). Otherwise, the financial statementsmust only include quantitative information:a table detailing changes in uncertain taxpositions during the reporting period. Inthis way, FIN 48 was intended to balancethe need to give investors information aboutthe company’s uncertain tax positions

(Continued on page 9)

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9WINTER 2006

against the concern that such disclosurecould provide taxing authorities with a “roadmap” of the most vexing issues.

The first set of financial statements to whichFIN 48 applies must reflect any material taxbenefits for any open years that are not rec-ognizable under FIN 48. For a calendar-year fund, any such cumulative catch-upadjustments would reduce the January 1,2007, NAV calculation.

For mutual funds, the most significantuncertain federal tax positions will be thosethat affect qualification for pass-through tax-

ation under Subchapter M of the InternalRevenue Code, the calculation of the divi-dends-paid deduction, and the characterand timing of recognition of certain deriva-tives and foreign currency positions.

Qualification issues also may apply to part-nerships relying on the “qualifying income”exception to treatment as a corporationunder the publicly traded partnership rules.Funds will also need to address state, local,and foreign tax issues. The ability to rely on“widely understood” administrative practiceto recognize a tax benefit will be helpful,particularly for mutual funds, because spe-cific guidance on many issues is lacking, butfunds may still need to accrue a liability foran unrecognized tax benefit, either because

the position does not meet the recognitionthreshold or because the benefit is meas-ured at less than 100%. The InvestmentCompany Institute noted, during the com-ment period on FIN 48, the clear potentialfor liabilities to be overstated (and thenreversed in later periods) and thus for funds’NAVs to be affected by potential tax liabili-ties that are unlikely ever to be paid.

Funds will need to establish procedures toidentify and assess the support for tax posi-tions reflected in their tax returns and tomonitor these positions for subsequentchanges. Funds will also need to maintainappropriate documentation backing upthese positions. �

Apparent Shift in SEC positionregarding Marketing of Hedge Funds

Since the issuance of the Dana no-actionletter in 1994, many investment managersand their counsel have understood that themarketing of interests in a hedge fund by asolicitor was subject to two distinct regula-tory schemes: The marketer must be regis-tered as a broker/dealer under federal andstate law; and the investment manager ofthe hedge fund, if registered under theAdvisers Act, must comply with the solici-

tor’s rule under the Investment Advisers Actof 1940. The solicitor’s rule, Rule 206(4)-3,imposes disclosure requirements and otherrequirements that are intended to assurethat the person being solicited is not misledabout the role of the solicitor in the market-ing process. The Northeast Regional Officeof the SEC, in an apparent reversal of theposition taken by the SEC Staff in the Danano-action letter, has recently indicated thatcompliance with Rule 206(4)-3 in these cir-cumstances is unnecessary. We are hopingfor more definitive guidance from the SECin this regard. �

Ratings of Hedge Funds

In September Moody’s Investors Serviceissued its first public rating of the risk associ-ated with a particular hedge fund. Standard& Poor’s and Fitch Ratings are also develop-ing criteria for evaluating hedge funds. Thecriteria focus not on the hedge fund itself,but on the hedge fund manager’s ability toexecute the investment program, taking intoaccount regulatory compliance, administra-tive systems and policies, and other indiciaof operational risk.

SEC Audits

Recent SEC audits of registered investmentadvisers have been rigorous. The SEC hasfocused on personal trading by firm employ-ees and principals, on performance advertis-ing, and on solicitor fees.

Hedge Funds(Continued from page 3)

FASB Interpretation(continued from page 8)

10 WINTER 2006

K&LNG’s Investment Management Update

SRO Consolidation (Continued from page 3)

All NASD member firms will receive a one-time payment of $35,000 in recognition of cost savings expected to result from the merger. Inaddition, certain member fees will also be reduced for a period of five years after the closing. NASD’s current committee structure is notexpected to change.

The plan, which is not yet reflected in a definitive agreement, is also subject to a number of conditions before it can be implemented,including an NASD member vote on certain amendments to the NASD by-laws. Required review and approval by the SEC, subject topublic comment, appears a relative certainty given Chairman Cox’s resounding support of the proposal and the apparent leadership of SECCommissioner Nazareth in facilitating the talks leading to the agreement. This step could well be the first of several intended to enhancethe effectiveness of U.S. securities regulators in an increasingly global marketplace. �

Kirkpatrick & Lockhart Nicholson Graham LLP andPreston Gates & Ellis LLP Announce CombinationEffective January 1, 2007—Investment ManagementPractice will Extend to Far EastKirkpatrick & Lockhart Nicholson GrahamLLP (K&LNG) and Preston Gates & EllisLLP recently announced that their partners

combined firm will be Kirkpatrick &Lockhart Preston Gates Ellis LLP, and thefirm will be branded as “K&L Gates.”K&L Gates will comprise approximately1,400 lawyers and 21 offices located in North America, Europe and Asia. The com-bination will rank as one of the most sub-stantial in the history of the legal profession,and it will create one of the world’s largestlaw firms.

Among its many benefits, the combinationextends K&LNG’s investment manage-ment law capacity to offices in the PacificNorthwest and Asia. �

have voted overwhelmingly in favor of aproposed combination of the two firmseffective January 1, 2007. The name of the

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Please visit our website atwww.klng.com, for more informationon the following investment manage-ment events in which K&LNG attorneyswill be participating:

MMiicchhaaeell SS.. CCaacccceessee:: Hedge FundAccounting and Administration Forum II,Financial Research associates LLC,December 11-12, 2006, New York, NY

KK&&LLNNGG 22000066 IInnvveessttmmeenntt MMaannaaggeemmeennttTTrraaiinniinngg SSeemmiinnaarr, December 12-13, 2006,Los Angeles, CA and San Francisco, CA

CCaarryy JJ.. MMeeeerr,, MMaarrkk DD.. PPeerrllooww aannddMMiicchhaaeell SS.. CCaacccceessee:: The Annual HedgeFunds Business Operations Forum and theFirst Annual Meeting of the Hedge FundBusiness Operations Association, December 13-14, 2006, New York, NY

DDiiaannee EE.. AAmmbblleerr,, MMiicchhaaeell SS.. CCaacccceesseeaanndd RRiicchhaarrdd DD.. MMaarrsshhaallll:: Best Practicesfor Conducting the Required AnnualCompliance Review, Financial ResearchAssociates, January 17, 2007, New York, NY

MMiicchhaaeell SS.. CCaacccceessee:: Multi-Managed andSub-Advised Funds Forum, FinancialResearch Associates, January 30-31, 2007,New York, NY

DDiiaannee EE.. AAmmbblleerr:: Third Annual BestExecution Conference: How to Measure It—How to Achieve It, Financial MarketsWorld, January 23, 2007, New York, NY

RRoobbeerrtt AA.. WWiittttiiee:: Securities Lending:Micromanagement v. Effective Oversight,Mutual Fund Directors Forum, January 25, 2007, New York, NY

RRoobbeerrtt AA.. WWiittttiiee: The Thirteenth AnnualBeneficial Owners’ Summit on Domestic andInternational Securities Lending, InformationManagement Network, February 4-7,2007, Scotsdale, AZ

WWiilllliiaamm AA.. SScchhmmiiddtt:: Pension Protection ActDevelopments Conference, InvestmentCompany Institute, February 7, 2007,Washington, DC

DDiiaannee EE.. AAmmbblleerr:: 2nd Annual Marketing & Advertising Compliance Forum, FinancialResearch Associates/Legal EducationAssociates, March 29-30, 2006, New York, NY

Industry Events

11WINTER 2006

www.klng.com

IInnddeeppeennddeenntt CChhaaiirr RRuullee—At its meeting on December 13th, theCommission announced that it decided to reopen the public com-ment period on the cost analysis of implementing the IndependentChair rule. This rule, which was to have gone into effect this pastJanuary, has been on hold after having been struck down twice bythe U.S. Court of Appeals for the District of Columbia.

All SEC-registered Investment Advisers with a December 31 fiscalyear must file an AAnnnnuuaall UUppddaattiinngg AAmmeennddmmeenntt to their FormADV, Part I, within 9900 days of their fiscal year end. For December31, 2006 fiscal years, the Annual Updating Amendment must befiled by MMaarrcchh 3311,, 22000077. Form ADV, Part I, is filed with the SECelectronically via the Investment Advisers Registration Depository.

RRuullee 2222cc--22 CCoommpplliiaannccee DDaatteess—In early October, the SEC extend-ed certain of the compliance dates to implement the provisions of

Current Developments and Dates to Remember…..new Rule 22c-2. The compliance date by which funds must enterinto shareholder information agreements with their intermediarieswas extended by six months to AApprriill 1166,, 22000077. The compliancedate by which funds must be able to request shareholder identityand transaction information pursuant to those agreements wasextended by twelve months to OOccttoobbeerr 1166,, 22000077. The SEC did not,however, extend the compliance date by which a fund’s board mustconsider the adoption of a redemption fee policy, which remained atthe original compliance date of OOccttoobbeerr 1166,, 22000066.

The new prohibited transaction exemption that allows fiduciaries toprovide investment advice to defined contribution plan participantsapplies to advice provided after DDeecceemmbbeerr 3311,, 22000066. For furtherdetails see please see the article entitled Major Changes to ERISAFiduciary Requirements found on the first page of this newsletter. �

Kirkpatrick & Lockhart Nicholson Graham (K&LNG) has approximately 1,000 lawyers and represents entrepreneurs, growth and middle market companies, capitalmarkets participants, and leading FORTUNE 100 and FTSE 100 global corporations nationally and internationally.

K&LNG is a combination of two limited liability partnerships, each named Kirkpatrick & Lockhart Nicholson Graham LLP, one qualified in Delaware, U.S.A. andpracticing from offices in Boston, Dallas, Harrisburg, Los Angeles, Miami, Newark, New York, Palo Alto, Pittsburgh, San Francisco and Washington and oneincorporated in England practicing from the London office.

This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon inregard to any particular facts or circumstances without first consulting a lawyer.

Data Protection Act 1988—We may contact you from time to time with information on Kirkpatrick & Lockhart Nicholson Graham LLP seminars and with our regularnewsletters, which may be of interest to you. We will not provide your details to any third parties. Please e-mail london@klng.com if you would prefer not toreceive this information.

IRS Circular 230 Notice:

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including anyattachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting,marketing, or recommending to another party any transaction or matter addressed herein.

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If you have questions or would like more information about K&LNG’s Investment Management Practice, please contactone of our lawyers listed below:

BOSTONJoel D. Almquist 617.261.3104 jalmquist@klng.comMichael S. Caccese 617.261.3133 mcaccese@klng.comMark P. Goshko 617.261.3163 mgoshko@klng.comThomas Hickey III 617.261.3208 thickey@klng.comNicholas S. Hodge 617.261.3210 nhodge@klng.comGeorge Zornada 617.261.3231 gzornada@klng.com

LONDONPhilip Morgan +44.20.7360.8123 pmorgan@klng.com

LOS ANGELESWilliam P. Wade 310.552.5071 wwade@klng.com

NEW YORKRobert J. Borzone, Jr. 212.536.4029 rborzone@klng.comJeffrey M. Cole 212.536.4823 jcole@klng.comAlan M. Hoffman 212.536.4841 ahoffman@klng.comBruce J. Kahne 212.536.4019 bkahne@klng.comBeth R. Kramer 212.536.4024 bkramer@klng.comRichard D. Marshall 212.536.3941 rmarshall@klng.comScott D. Newman 212.536.4054 snewman@klng.com

SAN FRANCISCOElaine A. Lindenmayer 415.249.1042 elindenmayer@klng.comDavid Mishel 415.249.1015 dmishel@klng.comMark D. Perlow 415.249.1070 mperlow@klng.comRichard M. Phillips 415.249.1010 rphillips@klng.com

WASHINGTON, DCClifford J. Alexander 202.778.9068 calexander@klng.comDiane E. Ambler 202.778.9886 dambler@klng.comMark C. Amorosi 202.778.9351 mamorosi@klng.comCatherine S. Bardsley 202.778.9289 cbardsley@klng.comArthur J. Brown 202.778.9046 abrown@klng.comArthur C. Delibert 202.778.9042 adelibert@klng.comJennifer R. Gonzalez 202.778.9286 jgonzalez@klng.comRobert C. Hacker 202.778.9016 rhacker@klng.comKathy Kresch Ingber 202.778.9015 kingber@klng.comMichael J. King 202.778.9214 mking@klng.comDeborah A. Linn 202.778.9874 dlinn@klng.comCary J. Meer 202.778.9107 cmeer@klng.comDean E. Miller 202.778.9371 dmiller@klng.comR. Charles Miller 202.778.9372 cmiller@klng.comCharles R. Mills 202.778.9096 cmills@klng.comR. Darrell Mounts 202.778.9298 dmounts@klng.comC. Dirk Peterson 202.778.9324 dpeterson@klng.comDavid Pickle 202.778.9887 dpickle@klng.comAlan C. Porter 202.778.9186 aporter@klng.comTheodore L. Press 202.778.9025 tpress@klng.comFrancine J. Rosenberger 202.778.9187 francine.rosenberger@klng.comRobert H. Rosenblum 202.778.9464 rrosenblum@klng.comWilliam A. Schmidt 202.778.9373 william.schmidt@klng.comLori L. Schneider 202.778.9305 lschneider@klng.comLynn A. Schweinfurth 202.778.9876 lschweinfurth@klng.comDonald W. Smith 202.778.9079 dsmith@klng.comFatima S. Sulaiman 202.778.9223 fsulaiman@klng.comMartin D. Teckler 202.778.9890 mteckler@klng.comRoger S. Wise 202.778.9023 rwise@klng.comRobert A. Wittie 202.778.9066 rwittie@klng.comRobert J. Zutz 202.778.9059 rzutz@klng.com

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12 WINTER 2006 © 2006 KIRKPATRICK & LOCKHART NICHOLSON GRAHAM LLP. ALL RIGHTS RESERVED.

K&LNG’s Investment Management Update