Investment Management Industry News Summary - February 2000

Investment Management Industry News Summary - February 2000

Publications

This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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Fiscal 2001 Budget Proposal Addresses Taxation of Mutual Funds and Their Shareholders

February 28, 2000 2:14 PM

The Clinton Administration's budget proposal for the fiscal year beginning October 1, 2000 includes numerous tax provisions that, if enacted, would directly or indirectly affect mutual funds and their shareholders. These proposals (several of which previously have been proposed) include:

Capitalization of commissions by mutual fund distributors. As proposed, mutual fund distributors would capitalize commissions paid on the sale of shares that impose a contingent deferred sales charge on redemptions (i.e., "B shares") and amortize those amounts over the period during which the contingent deferred sales charge is scheduled to be paid.

Limitation on dividends paid deduction for redemptions. In computing investment company taxable income, mutual funds are allowed a deduction for dividends paid, which under current law generally includes the portion of a share redemption that is properly chargeable to the fund's accumulated earnings and profits. This proposal, however, would allow a mutual fund to claim a dividends paid deduction with respect to a redemption only if the redemption represents a "net contraction" of the mutual fund as measured by the number of shares outstanding (i.e., a dividends paid deduction would not be available with respect to a redemption that is accompanied by near simultaneous investments in the fund by other investors).

Withholding tax exemption for certain bond fund distributions. Under current law, interest income and short-term capital gains received by a U.S. money market or bond mutual fund are recharacterized as dividend income (subject to U.S. withholding tax) when distributed to foreign investors. This proposal would treat all income received by a U.S. mutual fund that invests "substantially all of its assets" in U.S. debt securities or cash as interest that is exempt from U.S. withholding tax. A fund generally will not fail the test if it also holds investments in certain foreign debt instruments not subject to foreign tax under applicable local law.

Translation of foreign withholding taxes by accrual basis taxpayers. This proposal would modify current law so that, in general, regardless of the method of accounting of the taxpayer, foreign withholding taxes would be translated at the spot rate on the date of payment (rather than using the average exchange rate for the taxable year, as required by current law in some cases).

"Tax credit" bonds that provide a federal income tax credit rather than an interest payment. This proposal would authorize new types of "tax credit" bonds (and expand authority for an existing type) designed to improve public school construction and modernization. The holder of a tax credit bond would accrue federal income tax credits on a quarterly basis (allowable against the Alternative Minimum Tax, as well as regular tax liabilities). Ownership of the bonds and the tax credits could be "stripped," and credits would be transferable through repurchase agreements. The Treasury Department would provide regulations regarding the treatment of credits that flow through from a mutual fund to its shareholders.

Contributions of appreciated property to swap funds. Under current law, a taxpayer generally must recognize gain upon the transfer of appreciated assets to a partnership in exchange for partnership interests if (i) the transfer results in a diversification of the taxpayer’s interest and (ii) more than 80% of the partnership's assets are readily-marketable stocks or securities. Because limited and preferred interests in partnerships holding real estate are not considered readily-marketable securities, it is possible to structure a swap fund that holds 21% of its assets in such real estate partnerships and allows investors to transfer appreciated assets into the fund and achieve diversity without recognizing gain on the transferred securities. This proposal would require a taxpayer to recognize gain upon the transfer of marketable stock or securities to passive investment vehicles, including mutual funds, investment funds whose shareholders are "qualified purchasers" as defined in Section 3(c)(7) of the Investment Company Act of 1940, and funds marketed or sold to investors as providing a means of tax-free diversification (i.e., swap funds). The proposal would, however, except certain transfers of already diversified pools of stocks and securities, including transfers involving master-feeder fund structures (see Industry News Summary for the Week of 7/26/99 to 8/2/99, which described the industry’s concern with respect to the original the House bill).

Income-Stripping Transactions. Current law allows certain income-stripping transactions deliberately to be structured to mismatch income and related deductions (i.e., a taxpayer who owns income producing property may "strip" and sell the right to receive future income on the property, thereby generating current income on the sale and, because no basis is allocated to the right to receive income, creating a built-in loss on the property itself). Under this proposal, however, a strip of a right to receive future income from income-producing property would generally be characterized as a secured borrowing (rather than a separation in ownership). Accordingly, the proposal avoids the need for a basis allocation rule upon the creation of the strip. In addition, this debt characterization would ensure that the ongoing accounting treatment from the transactions clearly reflects income. The proposal also limits the taxpayer's ability to use income-stripping transactions to create foreign tax credit opportunities.

Mandatory accrual of market discount. This proposal would eliminate the option to defer the inclusion of market discount income until the sale of the discounted instrument. Instead, accrual-basis taxpayers holding market discount instruments would be required to include market discount in income on a constant-yield method as it accrues. The holder's yield for purposes of determining and accruing market discount would be limited to the greater of (1) the original yield-to-maturity of the debt instrument plus 5 percentage points, or (2) the applicable Federal rate at the time the holder acquired the debt instrument plus 5 percentage points. Mutual fund industry trade groups are generally opposed to this proposal because it will lead to accelerated inclusion of market discount in, and potentially over-inclusion of, a fund's taxable income.

Increased penalties for failure to file correct information returns. This proposal would increase the penalty for failure to correct information returns from the current $50 per return to the greater of $50 per return or five percent of the aggregate amount to be reported correctly, in most cases capped at $250,000. The proposal would, however, provide an exception if the aggregate amount reported on all returns filed by the taxpayer during the calendar year was at least 97 percent of the amount required to be reported.

Modification of straddle rules. This proposal would modify and clarify the straddle rules as follows:

  • Repeal of the existing exception for actively trading stock. Therefore, under the proposal, offsetting actively-traded stock positions generally would be subject to the straddle rules.
  • Clarify that issuers of debt instruments with components linked to the value of personal property (e.g., stock), will be treated as having an interest in the personal property, which may constitute the leg of a straddle.
  • Provide that loss recognition on one leg of a straddle would be capitalized into the other leg of the straddle, thus eliminating the need for an identification rule when the legs are different sizes. The proposal would also provide for allocation procedures in cases where two or more positions constitute a single leg of a straddle.
  • Require a taxpayer that settles an option or forward contract by delivering property to treat the settlement as a two-step transaction for purposes of applying the straddle rules (i.e., to treat the option or forward contract as if it were terminated for its fair market value immediately before the settlement).
  • Clarify the situations in which interest and carrying charges are considered properly allocable to a straddle, and therefore, must be capitalized. Specifically, the proposal would clarify that interest is properly allocable to a straddle if the interest accrued on a straddle-related debt instrument.
 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC Files Amicus Brief on Pending Lawsuit, Addresses Adequacy of 12b-1 Fee Disclosures

February 28, 2000 2:08 PM

In response to a request from the Second Circuit Court of Appeals, the SEC recently filed an amicus brief (a brief filed by a person who is not a party to the case, but who nevertheless has a strong interest in the subject matter) addressing issues raised about the application of Rule 10b-10 under the Securities and Exchange Act of 1934 to Rule 12b-1 fees and other types of payments (other than sales loads) made to broker-dealers who distribute mutual fund shares. Rule 10b-10 requires that broker-dealers provide certain information to customers before or at the completion of a transaction, including among other things the amount and source of any remuneration to be received by the broker-dealer in connection with the transaction, both from the customer and from any other sources. In several cases pending before the appeals court, customers have sued their broker-dealers, alleging that the broker-dealers failed to adequately disclose compensation the broker-dealers received for automatically sweeping cash balances in customers' accounts into money market mutual funds. Specifically, the customers have alleged that the funds' money market prospectuses did not adequately disclose "the precise amount of the sales load or other charges or a formula that would enable the customer to calculate that amount." In a 1979 SEC no-action letter, the SEC staff expressed the view that if a mutual fund prospectus contains disclosure of the precise amount of sales loads and other charges (or a formula), then a broker-dealer's trade confirmation need not set forth the fund's sales loads or other charges.

In its brief, the SEC agreed that disclosure required under Rule 10b-10 is not limited to transaction-based fees, but also includes asset-based fees, such as 12b-1 fees. The SEC stated, however, that the 1979 no-action letter was concerned solely with the disclosure of charges paid by the customer and thus did not address 12b-1 fees or payments to broker-dealers by a fund's adviser out of its own resources. Accordingly, the "precise amount" requirement of the no-action letter did not apply to such fees. The SEC further stated that "a broker-dealer's obligation under Rule 10b-10 to disclose the amount of 12b-1 fees it receives is satisfied if the customer receives a prospectus containing the information called for by Form N-1A." Moreover, with respect to other adviser-paid fees, the SEC stated that Rule 10b-10 would be satisfied by prospectus disclosure stating that the adviser paid "significant amounts" from its own resources for distribution expenses, combined with disclosure in the statement of additional information of the total amount in dollars that the adviser had paid broker-dealers for distribution expenses. Investment Company Institute Memorandum to SEC Rules Members No. 13-00, February 16, 2000.

SEC proposes next stage for its Electronic Data Gathering, Analysis, and Retrieval ("EDGAR") system. The SEC recently issued a release proposing new rules and amendments to existing rules and forms in connection with the next stage of modernization of its EDGAR system. When the programming for the next stage of modernization is accomplished, EDGAR will include the following new features that the SEC addresses in the release:

  • the ability to include graphic and image files in HTML filings;
  • the ability to use hyperlinks in HTML filings, including links between documents within a submission and to previously filed documents on the SEC's public web site; and
  • the addition of the Internet, and removal of diskettes, as an available means of transmitting filings to the EDGAR system.

The release also proposes to eliminate Financial Data Schedules and requests comment concerning future EDGAR rulemaking projects in connection with EDGAR modernization and making more SEC filings mandatory on the EDGAR system. The release provides for a comment period of 30 days from the date of publication in the Federal Register.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Arizona Securities Division Allows Dealers to Advertise on Internet Without Registration

February 21, 2000 2:05 PM

The Arizona Securities Division (the "Division") recently adopted a rule allowing dealers to disseminate general information over the Internet without having to register in the state. Under specified conditions, dealers and salespersons who direct product and service information "generally to anyone having access to the Internet" will not be deemed, solely based on that activity, to be selling securities in Arizona for registration purposes.

Among other conditions, the Internet communication must contain a statement that the dealer or salesman may only sell, purchase, or offer to sell or buy any securities in Arizona if it first complies with or is exempt from the state's registration requirements. The Internet communication must also be subject to a mechanism, policy, or procedure designed to ensure that the dealer or salesperson complies with registration requirements before selling, buying, or offering to sell or buy in Arizona. Additionally, the communication must not:

  • effect or attempt to effect securities transactions,
  • render investment advice for compensation, or
  • solicit or negotiate on an individual basis the sale of investment advisory services in Arizona.

The rulemaking notice stated that the rule relieves dealers and salesman of registration requirements only; antifraud and other regulations will still apply. BNA Securities Regulation and Law Report, Vol. 32 No. 7 (Feb. 21, 2000).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

U.S. Court of Appeals Upholds Sanction Imposed by the Commodity Futures Trading Commission ("CFTC"), Despite Circumstantial Evidence

February 21, 2000 2:01 PM

The U.S. Court of Appeals for the Seventh Circuit recently upheld sanctions imposed by the CFTC on four Chicago Board of Trade floor traders for their allegedly unlawful activities in trading wheat futures. Based on evidence that the traders bought and sold among themselves identical quantities of the same wheat futures contract "spread" at identical prices without incurring any profit or loss on the trades, the CFTC determined that the trades, more likely than not, were pre-arranged and non-competitive. Because the circumstances of the trades gave rise to an inference of non-competitiveness or pre-arrangement strong enough to establish liability, the CFTC ordered the traders to cease and desist from future violations, and imposed a six-month trading ban and a $50,000 fine on each trader.

Although the court agreed with the traders that there was no "direct" evidence of non-competitiveness or pre-arrangement and that the only evidence was circumstantial, the court applied deferential standard to the CFTC's sanctions. The court held that "whether a particular set of circumstances supports an inference of non-competitive trading on the futures market is an issue peculiarly within the [CFTC's] area of expertise." The court determined that because the CFTC hears these cases on a regular basis, it is in the best position to draw the line between evidence that establishes culpability and that which does not. The court further stated that circumstantial evidence can suffice to meet the burden of proof. The court did note, however, that the CFTC "must do more than present suspicious circumstances suggesting the possibility of knowing wrongdoing." Elliott v. Commodity Futures Traduing Commission, 2000 U.S. App. LEXIS 1354 (7 th Cir., February 3, 2000).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

U.S. District Court Rules that Prospectus Delivery Does Not Cure Broker-Dealer's Misrepresentation

February 21, 2000 1:57 PM

The U.S. district court for the Southern District of Florida recently ruled that delivery of a prospectus did not "cure" prior misrepresentations and omissions allegedly made by a broker-dealer in connection with the sale of a closed-end term trust fund.

Investors allege that the broker-dealer developed certain term trust funds to exploit investors and presented the funds to investors as a "very safe alternative" to their low risk investments, despite the investors' claims that the term trusts were, in fact, "extremely high risk bond funds." The investors further allege that the broker-dealer failed to inform them of the "true risks" of investing. The broker-dealer, however, sought a motion to dismiss the investors' claims because any "omissions" were fully disclosed in the final prospectus, which were delivered to investors after their purchase of shares.

The court cited the "bespeaks caution" doctrine, which recognizes that, if information is available to the investor before the investment decision fully discloses the risks with meaningful cautionary language, the court may find the alleged misrepresentation insufficient to form the basis of a fraud claim. The court noted, however, that if information is provided after a fraudulently induced purchase, risk disclosures cannot be used to "cure" the alleged prior fraud. Because the prospectuses were delivered to investors after their purchase of shares, and because investors allegedly were not informed of their rescission rights, the court ruled that the information contained in the prospectuses could not "cure" the alleged omissions. Further, the court ruled that, even though federal securities laws permit prospectus delivery concurrent with confirmation of a transaction, it does not follow that such a prospectus can be used to "cure" prior alleged misrepresentations or omissions.

The result in this case is contrary to the U.S. district court for the Southern District of New York's dismissal of a related class action lawsuit in 1996 on the grounds that the prospectus adequately disclosed the risks of investing in the term trusts. Crowell v. Morgan Stanley Dean Witter, 2000 U.S. Dist. LEXIS 811, (January 27, 2000).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

SEC Seeks Comments on Issues Relating to Market Fragmentation

February 21, 2000 1:48 PM

The SEC recently published notice of a proposal by the New York Stock Exchange ("NYSE") to rescind a rule that, subject to certain exceptions, prohibits members and their affiliates from effecting transactions in NYSE-listed securities "off-board," or away from a national securities exchange. The rule's restrictions on off-board trading have been frequently criticized as inappropriately attempting to restrict competition among market centers. Rescission of the rule would allow NYSE members to act as over-the-counter market makers or dealers in all NYSE-listed securities. Consequently, a significant amount of order flow that currently is routed to the NYSE may be divided among a number of different dealers in the over-the-counter market, where there may be a reduced opportunity for order interaction.

The SEC is concerned that customer limit orders and dealer quotes may be isolated from other buying and selling interests (i.e., in other market centers), resulting in a system that fails to reward, and thereby inhibits, aggressive price quoting by dealers. In light of this concern, the SEC is seeking to evaluate the effects, if any, of market fragmentation on the national market system. In particular, the SEC is attempting to determine what steps are necessary to minimize any negative effects of fragmentation on the national market system's ability to meet investor needs, such as "vigorous quote competition," innovative competition among market centers and assuring the practicability of best execution for all investor orders, no matter where they originate within the national market system.

Proposed approaches to address fragmentation. In its release, the SEC sets forth six proposed approaches to address market fragmentation. The SEC states that the approaches (if determined necessary) could apply either individually or in some combination. These approaches are:

  • Require greater disclosure by market centers and broker-dealers concerning trade execution and order routing. Required disclosures could include information about the nature of broker-dealers order flow, the percentage of market orders that receive price improvement, their speed in displaying limit orders, their fill rates and times for limit orders, etc.
  • Restrict internalization and payment for order flow arrangements by reducing the extent to which market makers may trade against customer order flow by matching other market center prices. For example, the NYSE is proposing that broker-dealers be allowed to buy from or sell to their customers only at a price that is better than the national best bid and offer ("NBBO") for that security.
  • Require exposure of market orders to price competition. This could be done, for example, by requiring that price improvement be provided to a specified percentage of orders for a specified period of time, or by requiring that a market maker, before executing an order as principal in a security whose quoted spread is greater than a minimum variation, publish for a specified length of time a bid or offer that is some variation better than the NBBO for that security.
  • Adopt an intermarket prohibition against market makers trading ahead of previously displayed and accessible investor limit orders. Under this option, each market center would be responsible for providing notice to other market centers of the price, size and time of its investor limit orders entitled to priority, as well as participation in a linkage system that would allow automatic execution against the displayed trading interest. Before executing a trade as principal against customer flow, market makers would be required to satisfy, or seek to satisfy, previously displayed investor limit orders at that (or a better) price.
  • Provide intermarket time priority for limit orders or quotations that improve NBBO. To qualify for priority, the limit order or quotation would have to be widely displayed and accessible through automatic execution. Only the first trading interest at the improved price would be entitled to priority. Subsequent orders or quotations that merely matched the improved price would not be entitled to enhanced priority.
  • Establish a national market linkage system that provides price/time priority for all displayed trading interests. Under this system, all orders and quotations of all market centers would be fully transparent to all market participants and would be executed in accordance with strict price/time priority. Market makers could execute transactions as principal only if they provided price improvement. The SEC noted that such a system would not itself be a market center.

The SEC release sets forth a significant amount of data about market fragmentation and calls for alternative approaches to address the concern. The release calls for a 60-day comment period on market fragmentation. SEC Rel. No. 34-42450; File No. SR-NYSE-99-48 (Feb. 23, 2000).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Court Rules on the Applicability of ERISA to Group IRAs

February 14, 2000 1:54 PM

The U.S. Court of Appeals for the Ninth Circuit recently upheld a dismissal of a class action lawsuit by participants in a collectively-bargained group individual retirement annuity plan. The appeals court agreed that the participants had failed to raise a genuine issue of fact in their contention that the IRA plan was covered by certain provisions of ERISA. The participants alleged a wide range of ERISA violations, including reporting and disclosure violations, and contended that ERISA requires the inclusion of employees with one year of service and 1000 hours of workload per year.

The appeals court ruled that the plan fell within the definition of "employee pension benefit plan," and was thus subject to Title I of ERISA, but would be excluded from coverage of Parts 2 and 3 of Title I of ERISA if it was an "Individual Retirement Account" or "Individual Retirement Annuity" (collectively, "IRAs") as defined by Section 408 of the Internal Revenue Code of 1986 (the "Code"). Under ERISA regulations, some IRAs fall within the scope of ERISA and others do not. Certain IRAs which meet the definition set forth in Section 408 of the Code, are excluded from the general applicability of Parts 2 and 3 of Title I of ERISA. The plan presented considerable evidence that the plan qualified as an IRA within the definition of Section 408(b) of the Code, which defines "Individual Retirement Annuity" as an annuity contract, or an endowment contract, issued by an insurance company which meets the following requirements:

  • the contract is not transferable by the owner;
  • under the contract (a) the premiums are not fixed, (b) the annual premium on behalf of any individual will not exceed $2,000, and (c) any refund of premiums will be applied before the close of the calendar year following the year of the refund toward the payment of future premiums or the purchase of additional benefits;
  • the contract is subject to prescribed rules regarding distributions and incidental death benefits; and
  • the entire interest of the owner is nonforfeitable.

Because the IRA was not subject to Parts 2 and 3 of Title I of ERISA, which includes fiduciary duty provisions, the ERISA breach of duty claims raised by the participants were without merit. Cline v. Industrial Maintenance Engineering & Contracting Co., 2000 U.S. App. LEXIS 248 (9th Cir., January 11, 2000).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Industry Trade Groups Urge Department of Labor ("DOL") to Broaden Exemptive Relief for Cross Traders Among ERISA Funds

February 14, 2000 10:41 AM

Representatives of industry trade groups recently testified on active cross-trade issues at a hearing held by the DOL's department of Pension and Welfare Benefits Administration. Although the DOL recently proposed exemptive relief for cross-trades among index funds and model-driven funds holding assets subject to the Employee Retirement Income Security Act of 1974 ("ERISA"), the proposal did not extend exemptive relief to actively managed ERISA accounts. (See Industry News Summary, Weeks of 12/20/99 to 1/3/99). Industry groups argued that, if appropriate conditions were imposed, the potential benefits of allowing pension plans to engage in active cross trades would outweigh the risks of potential abuses related to these trades.

Securities industry representatives who spoke at the hearing argued that cross trades provide increased savings to plans by eliminating transaction costs, improving market efficiency and saving time. In response to criticism that many retirement plan fiduciaries do not have the level of sophistication necessary to monitor cross trades by investment managers, some securities industry advocates proposed limiting cross trades to plans with at least $25 million in assets, or permitting smaller plans to engage in cross trades only if they retain an independent fiduciary.

Other conditions proposed by the ICI include the following:

  • no commission or brokerage fee be paid in connection with a transaction, other than the customary transfer fees;
  • the security that be the subject of the cross trade be one for which market quotations are readily available;
  • the transaction be consistent with the investment objectives and policies of the ERISA plan;
  • sufficient disclosure be provided to the plan, including a notice describing cross-trading procedures and applicable safeguards, quarterly reports to ERISA plans on cross trades executed for these plans, and annual notice to ERISA clients enabling them to terminate the program; and
  • the transaction be effected at the current market price in accordance with specific objective and methodologies.

BNA Securities Regulation & Law Report, Volume 32, No. 6, 2/14/00. Statement of Craif Tyle, ICI Submitted to the DOL Hearing on Active Cross-Trades Issues, 2/10/00.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Investment Company Institute ("ICI") Files Comment Letter on Fund Governance Proposals

February 14, 2000 10:35 AM

The ICI recently filed a comment letter with the Securities and Exchange Commission ("SEC") on the SEC's proposed rule and rule amendments designed to enhance the independence and effectiveness of fund directors and provide investors greater information about fund directors. (See Industry News Summary, Week of 10/11/99 to 10/18/99). In its letter, the ICI generally supports the SEC's proposals, but expresses concerns about certain proposals.

Proposed Amendments to Exemptive Rules. The letter states that the ICI accepts the SEC's general approach of tying reliance on selected exemptive rules to compliance with conditions designed to enhance the independence of a fund's independent directors. In particular, the letter:

  • supports the proposed condition that would require a simple majority (as opposed to a two-thirds super-majority) of independent directors on the board; and
  • supports the proposed condition that would require independent directors to select and nominate other independent directors.

The letter also supports the concept of independent directors having counsel that can render impartial and objective advice, but strongly urges the SEC not to address the issue of counsel to the independent directors through rulemaking. The letter suggests that if the SEC remains convinced that a rule is necessary, it should take a process-based approach that would require independent directors, in the exercise of their business judgment, to make an annual finding that their counsel is able to render impartial and objective advice.

Other Proposed Rules and Rule Amendments. With respect to several other proposed rules and rule amendments, the letter:

  • supports conditioning the ability to purchase joint insurance policies on the absence of any exclusion for bona fide claims against co-insureds;
  • supports allowing funds with independent audit committees to forego the need for shareholder ratification of the selection of independent public accountants; and
  • expresses appreciation for the SEC's intent to clarify a potential issue raised by independent directors' ownership of index fund shares, but opposes the promulgation of a rule implying that owning a mutual fund would result in the directors' beneficial ownership of the fund's underlying portfolio securities.

Proposed Disclosure Requirements. With respect to the proposed rule and form changes relating to disclosure, the letter:

  • generally supports the SEC's proposal to require disclosure of certain basic information about directors in fund annual reports, SAIs and proxy statements;
  • strongly supports the SEC's decision not to propose requiring director information in the prospectus;
  • generally supports the proposed disclosure of directors' ownership of funds in the fund complex, but recommends requiring this disclosure within prescribed dollar ranges of ownership rather than in specific dollar amounts;
  • opposes requiring additional disclosure in fund proxy statements about certain positions, interests, transactions and relationships of directors and their family members with the fund and various related persons and entities;
  • recommends that, in lieu of providing this type of disclosure in the SAI, funds be required to maintain records, which would be available to the SEC, concerning the positions, interests, transactions and relationships of independent directors and their family members with the fund and various related persons and entities; and
  • recommends that the SEC narrow the scope of information about positions, interests, transactions and relationships that would have to be included in the records (for example, by revising the proposed definition of "immediate family member" for this purpose to cover only family members residing with the director or any dependents of the director).

ICI Comment Letter re. Role of Independent Directors of Investment Companies, January 28, 2000.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Five Hedge Funds Issue Industry Report and Joint Recommendations

February 7, 2000 1:07 PM

Five of the largest U.S.-offered hedge funds released a report formally responding to recent calls for industry reform, including proposed legislation that would increase hedge fund oversight and require regular public disclosure by hedge fund managers. The report seeks to promote risk management and internal controls designed to reduce the possibility that a fund will fail due to unexpected market events and to reduce the likelihood of systematic consequences resulting from a fund's default or failure. The report recommends that hedge fund managers:

  • establish risk monitoring systems that are independent from the funds' portfolio management operations;
  • perform periodic "stress tests" to determine how changes in market conditions would affect their portfolios; and
  • develop and monitor several measures of risk and make periodic reports to lenders and counterparties (but the report does not recommend mandatory borrowing limits).

The report sets forth recommendations for internal controls only and does not endorse any regulatory oversight. The report states that "the recommendations were developed in the belief that the most effective form of oversight is self-evaluation combined with self-discipline." In fact, the report states that the recommendations might not be appropriate for smaller funds. Wall Street Journal (February 8, 2000, C20) reporting on Sound Practices for Hedge Fund Managers.

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

New Form ADV Will Not Require Listing All Soft Dollar Arrangements

February 7, 2000 1:02 PM

According to Gene Gohlke, associate director of the SEC's Office of Compliance, Inspections and Examinations and other participants at a January conference, the revisions to Form ADV will require more specificity about a number of disclosures, including brokerage practices, soft dollar arrangements and conflicts of interest. Read More

U.S. District Court Grants Summary Judgement Against Shareholders Alleging Misrepresentation

February 7, 2000 12:54 PM

The U.S. District Court granted summary judgment and dismissed on the merits an amended class action complaint filed by shareholders in a mutual fund that was negatively affected by the devaluation of the Mexican peso in 1994.

The fund held significant investments in Mexican and Argentine government securities just prior to December 1994. In December 1994, the Mexican government devalued the peso over 15 percent against the U.S. dollar and allowed the peso to float freely against the dollar. Consequently, the peso fell rapidly against the dollar and the fund's net asset value fell dramatically. Shareholders of the fund filed a class action suit in 1995 alleging, among other things, that the name of the fund was misleading, the fund had changed its investment objective without a shareholder vote, the risks of investing in the fund were not properly disclosed and the fund had falsely represented that it would use hedging techniques to reduce currency risk.

The district court granted the fund's motion to dismiss the allegations for failure to state a claim. The shareholders then filed an amended complaint that alleged, among other things, that the fund prospectuses falsely stated that the fund would use hedging techniques to proceed when it knew or recklessly disregarded the fact that these techniques to proceed were too expensive to be used. Specifically, the amended complaint asserted:

"the fund's representations that . . . hedging techniques were possible and that the fund was authorized to use [them] for the purpose of limiting foreign currency risk were false, since the fund knew or recklessly disregarded the fact that no hedging techniques were economically feasible and that the fund would not and could not use hedging techniques to attempt to limit foreign currency risk."

Upon appeal, in October 1998, the appeals court reversed the district court decision in part and affirmed in part. Specifically, the court allowed the suit to proceed based on the claim regarding hedging techniques. The appeals court found that the fund's representations concerning the availability of hedging techniques would have misled a reasonable investor and was consequently an actionable claim.

Despite the appeals court's reinstatement of the hedging claims in 1998, the district court dismissed the amended complaint, finding evidence that, contrary to the shareholders' allegations, the fund did have viable "opportunities" to hedge Mexican peso risk during the period in question. The court specifcally noted four methods available to the fund to hedge such risk: (i) forward contracts on the Mexican peso, (ii) coberturas, another type of forward contract, (iii) tesbonos, a peso-denominated Mexican government security with a dollar-adjusted return, and (iv) options on the Mexican peso. Moreover, the court held that, based on the fact that the prospectus never guaranteed or promised that the fund would hedge its currency risk, there can be no recoverable damages if the managers legitimately exercised their discretion and decided not to hedge. In re Alliance North American Government Income Trust Inc. Securities Litigation, No. 95 Civ. 0330, 1999 U.S. Dist. LEXIS 18449 (S.D.N.Y. December 1, 1999 ).

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

U.S. District Court Grants Motion to Dismiss Claims Against Fund Adviser and Portfolio Manager

February 7, 2000 12:49 PM

The U.S. District Court for the Southern District of New York recently granted a motion to dismiss a class-action lawsuit brought against the investment adviser and the portfolio manager of two mutual funds. The complaint alleged that the funds performed poorly throughout the class period and violated the Investment Company Act of 1940 by:

  • deviating from the funds' "fundamental" investment policies without obtaining shareholder approval;
  • participation by the funds' portfolio manager in undisclosed, self dealing transactions, including accepting compensation from non-fund parties;
  • making false and misleading statements about the adviser's research capabilities, the level of the funds' board oversight and the profitability of investments;
  • failing to adequately disclose the fund's emphasis on small, highly illiquid and volatile "micro-cap" companies with little or no revenues and earnings; and
  • breach of fiduciary duty to the shareholders.

Before addressing the merits of the complaint, the court was asked to dismiss the action on the grounds that the suit was improperly brought as a direct claim (rather than a derivative claim). Federal courts look to state law to determine whether a claim brought under the 1940 Act is direct or derivative. Because the funds at issue are Maryland corporations, the court applied Maryland law, which requires that the court to examine the nature of the wrongs alleged in the complaint to determine whether it states a direct or derivative cause of action. Under Maryland law, an injury that falls equally on all shareholders, with no special relationship between the plaintiff and defendant creating a duty other than the duty owed to the corporation, there is no direct cause of action. In applying the law to this case, the court determined that there was no direct cause of action because the plaintiffs merely alleged an "undifferentiated harm" that was suffered by all shareholders and derived from the funds themselves. Accordingly, the court granted the motion to dismiss these claims. The court did, however, grant the plaintiff shareholders leave to amend the complaint within 10 days. In re Dreyfus Aggressive Growth Mutual Fund Litigation, 98 Civ. 4318, 2000 U.S. Dist. LEXIS 94 (S.D.N.Y. January 5, 2000)

 
 



This Summary, which draws from a wide range of sources, endeavors to condense important investment management regulatory news of the preceding week into one, easily digestible source. This Summary is not intended as legal advice. Readers should not act upon information contained in this Summary without professional legal counsel. This Summary may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts.

IRS CIRCULAR 230 DISCLOSURE:
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.