The IRS recently released a revenue procedure providing for automatic permission for certain master-feeder structures to aggregate built-in gains and losses on securities contributed from the feeder funds to the master fund for purposes of making partnership allocations under Section 704(c) of the U.S. Internal Revenue Code of 1986 (the "Code"). The "aggregation" method allows a partnership to track gain and loss on partnership property in the aggregate among partners, rather than on a security-by-security basis, which is administratively burdensome. Currently, although the regulations provide for use of the aggregation method for property already in a partnership, they do not provide for aggregation of any property contributed to the partnership by a partner. However, in recent years the IRS has been accepting master-feeder funds’ requests for private letter rulings permitting the use of aggregation for contributed securities. This revenue procedure is intended to eliminate these requests.

The revenue procedure provides for automatic permission for "qualified" master-feeder structures meeting the following requirements:

• Each partner in the master fund must be a feeder fund, or an investment adviser, principal underwriter or manager of the master fund;
• Each feeder fund must contribute only cash and/or a portfolio of diversified stocks and securities that meets the 25% and 50% tests under Section 368(a)(2)(F)(ii) of the Code;
• Each partner in the master portfolio that is an investment advisor, principal underwriter or manager must contribute only cash and/or services;
• The master fund must be treated as a partnership for federal tax purposes and qualify as a securities partnership under the regulations under Section 704 of the Code;
• Each feeder fund must qualify as a regulated investment company ("RIC");
• The master fund must be registered as an investment company under the 1940 Act; and
• Any contributions and corresponding allocations of tax items for property contributed to the master portfolio must not be made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners’ aggregate tax liability.

Master-feeder structures that do not qualify for automatic permission must submit a ruling request before aggregating contributed property. The request must contain certain representations set forth in the revenue procedure and must included detailed information about the master partnership, each partner and the property to be contributed.

Pending requests for private letter rulings for "qualified" master-feeder structures that are eligible for the automatic permission may be withdrawn with a refund of the user fee. IRS Rev. Proc. 2001-36.

The Investment Company Institute (ICI) recently reported that, prior to the examination of one of its investment company members, the SEC’s Office of Compliance and Inspections and Examinations requested an extensive list of documents relating to compliance with Regulation S-P. The investment company is affiliated with a bank holding company, a bank, a broker-dealer and an investment adviser. The list included:

• Any written plan for implementing Regulation S-P.
• Any budget reports or written materials describing plans for funding Regulation S-P implementation during fiscal 2000 and 2001.
• Any organizational charts or written materials describing staffing for implementation of Regulation S-P.
• Any reports or other written materials provided to the directors/trustees in connection with implementation of Regulation S-P.
• Any documents relating to any steering committee, any progress reports, and any internal or external auditors’ reports relating to implementation of Regulation S-P.
• Detailed information regarding affiliated and unaffiliated third parties with whom information is shared, as well as documentation describing the sharing procedures.
• Procedures followed to identify consumers and customers and to monitor changes in status of each of these groups.
• Procedures followed to identify the types of nonpublic information, lists of types of nonpublic information, as well as procedures addressing how such information is collected and monitored, and by whom.
  
• Procedures followed for sharing and monitoring the sharing of nonpublic information, as well as steps taken to ensure that third parties will protect the confidentiality of such information.
• Form of privacy notice and details relating to delivery and monitoring of the delivery process.
• Form of "opt-out" notice and policies and procedures relating to implementation and monitoring of opt-out procedures.
• Any documentation relating to training provided to employees regarding Regulation S-P.
• Any documentation relating to compliance and internal controls, policies and procedures established for the purpose of implementation of Regulation S-P.
• Any documentation of policies and procedures adopted to safeguard customer records and information.
• The ICI noted that no other members have reported such detailed examinations on compliance with Regulation S-P, and that other members have reported that the portion of recent examinations relating to Regulation S-P has been limited to SEC staff questions about implementation of the policy and review of the privacy notice. ICI Memorandum No. 13511.

The SEC has adopted amendments to Rule 31a-2 under the Investment Company Act of 1940 (the "1940 Act") and Rule 204-2 under the Investment Advisers Act of 1940 (the "Advisers Act") to allow registered investment companies and registered investment advisers to store all required records on electronic storage media such as magnetic disks, tape and other digital storage media. The amendments are intended to expand the ability of advisers and funds to use electronic storage media to maintain and preserve records. The amendments were prompted by the recent enactment of the Electronic Signatures in Global and National Commerce Act (the "Electronic Signatures Act"), which is intended to facilitate the use of electronic records and signatures in interstate and foreign commerce. The SEC also interpreted Rules 31a-2 and 204-2 to be the exclusive means by which funds and advisers can comply with the recordkeeping provisions of the Electronic Signatures Act.

Prior to the rule amendments, the SEC staff had issued no-action letters to permit funds and advisers conditionally to convert records into an electronic format and retain them electronically. In March of this year the SEC proposed rule amendments to incorporate these no-action letters into Rules 31a-2 and 204-2, while eliminating many of the conditions that apply only to electronic records created from non-electronic originals. The SEC also proposed to clarify the obligation of funds and advisers to provide copies of their records to SEC examiners, and to incorporate terminology used in electronic recordkeeping rules under the Securities Exchange Act of 1934 into the rules. The SEC is adopting the rule amendments substantially as proposed, with a few changes in response to concerns expressed by commenters.

Under the amended rules, funds and advisers are permitted to maintain records electronically if they establish and maintain procedures:

• to safeguard the records from loss, alteration, or destruction,
• to limit access to the records to authorized personnel, the SEC, and (in the case of funds) fund directors, and
• to ensure that electronic copies of non-electronic originals are complete, true, and legible.

In response to a suggestion of one commenter, the rules are being expanded to include all records that are required to be maintained and preserved by any rule under the 1940 Act or the Advisers Act so that it is clear that if funds and advisers keep records electronically they must comply with the conditions of the rules. The SEC also amended the rules to clarify the obligation of funds and advisers to provide copies of their records to SEC examiners. The amendments make clear that funds and advisers may be requested to promptly provide:

• legible, true, and complete copies of records in the medium and format in which they are stored, and printouts of such records; and
• means to access, view, and print the records.

The SEC is did not adopt a proposed amendment that would have stated that records were to be provided in no case more than one business day after a request. Some commenters were concerned that such an amendment could preclude funds and advisers from reaching an accommodation with the examination staff to produce certain documents immediately and other documents, that are not immediately accessible, on a delayed basis. In the adopting release, the SEC agreed that such arrangements when entered into and performed in good faith by funds or advisers can facilitate the examination process. Further, the release stated that, while the "promptly" standard imposes no specific time limit, the SEC expects that a fund or adviser would be permitted to delay furnishing for more than 24 hours electronically stored records only in unusual circumstances, and that in many cases funds and advisers could, and therefore will be required to, furnish records immediately or within a few hours of request. SEC Rel. IC-24991; IA-1945.

In response to a request for comments by the Securities and Exchange Commission (SEC) in connection with its annual joint conference with state securities regulators (commonly known as the Section 19(c) Conference), the ICI filed a comment letter recommending that the SEC encourage states to eliminate any filing or fee requirements that cannot be accommodated through the Investment Adviser Registration Depository (IARD) system. In its letter, the ICI noted that approximately 18 states require federally-registered investment advisers to file a hard copy of Part II of Form ADV. Because this document cannot currently be filed through IARD, the ICI argued that states requiring advisers to file a hard copy of Part II of Form ADV were bifurcating the notice filing process, thereby diminishing the efficiencies of the IARD.

In addition, the ICI letter noted that some states continue to asses fees that cannot be paid through the IARD because either the state’s period of effectiveness is not compatible with the IARD or the state assesses fees unrelated to IARD filings. The ICI recommended that the SEC and the state regulatory authorities work together to eliminate any fees relating to a notice filing that cannot be accommodated through the IARD. ICI Letter to Jonathan A. Katz, April 19, 2001.

NASDR recently censured and fined a brokerage firm, one of its employees, and his supervisor for violating NASD rules in connection with the sale of Class B mutual fund shares. NASDR found that, over a two-year period, the employee engaged in a pattern of making unsuitable recommendations of Class B shares to customers. Specifically, NASDR alleged that he recommended that each of 15 customers purchase over $250,000 in Class B shares (with higher ongoing expenses than Class A shares and a sales charge upon redemption, unless held for six years), when it would have been more cost-effective for those customers to purchase Class A shares (which had a front-end sales load, but lower ongoing expenses than the Class B shares). NASDR found that these recommendations exceeded the fund’s maximum purchase limitation of $250,000 on Class B shares and were unsuitable in light of the amount sold, the sales and distribution charges incurred and because the customers could have purchased the A Shares with substantially lower sales charges.

NASDR also found that the firm and the employee earned sales commissions of over $290,000, or four percent of the purchase on the sale of the Class B shares, whereas commissions on the equivalent sales of Class A shares would have been less than half of this amount. In addition, NASDR alleged that the firm failed to supervise the employee "by not having a system in place to detect sales in excess of the maximum purchase limits on the funds it sold."

Additionally, NASDR found that the employee recommended to 29 customers that they liquidate another mutual fund and purchase, in the aggregate, over $500,000 of Class B shares. These customers were eligible to purchase the Class A shares, which would have been the more cost-effective purchase at the time. The firm and the employee earned $21,000 on the sale of these Class B shares, and would not have earned any sales commission on the sale of the Class A shares. NASDR News Release (April 18, 2001).

The SEC staff recently rejected a request for no-action relief by a closed-end fund seeking to omit from its proxy materials a shareholder proposal that would require the fund to submit its investment advisory agreement to a non-binding shareholder vote on an annual basis. The proposal, if approved, would amend the fund’s by-laws to require that the fund’s investment advisory agreement be submitted to a shareholders each year, and that if the shareholders do not approve its continuance, the board of directors of the fund may subsequently do so if not inconsistent with state or federal law.

The fund sought to omit the proposal in reliance on a rule under the Exchange Act that allows companies to omit shareholder proposals that would cause the company to violate a state, federal or foreign law. The fund argued that the proposal would require the fund to submit the advisory agreement to a shareholder vote even if the directors had already approved its continuance, and that this result would improperly divest the board of its ability to approve the continuance of the fund’s advisory agreement. The SEC staff, however, distinguished this case from precedent on the grounds that the board explicitly maintained its right to approve the continuance of the agreement, even if the shareholders vote against its continuance. Further, the staff reasoned that the proposal would not preclude the board from voting on the continuance of the advisory agreement at any time it desired. The SEC staff also disagreed with the fund’s argument that the proposal violated the rule against resubmission of proposals, in that it would effectively allow the shareholder to submit a prior proposal to terminate the advisory agreement which was previously submitted and voted. NO-ACT, WSB File No. 0430200108, Lincoln Nat'l. Convertible Securities Fund, Inc., (Apr. 26, 2001).

The U.S. District Court for the Southern District of New York granted a motion to dismiss securities fraud claims made by investors against the custodian and clearing broker (the "Prime Broker") for an offshore hedge fund. The securities class action alleged that the fund’s investment manager and its principal defrauded investors by creating fictitious monthly account statements that showed profitable performance, while the fund actually suffered substantial losses. The plaintiffs alleged that the fund’s Prime Broker extended margin credit to the fund that exceeded margin regulations, and tipped certain investors with whom the Prime Broker and executives had social or business relationships as to the fund’s problems. However, in allowing the motion to dismiss the claims against the Prime Broker, the court observed that the plaintiffs failed to point to any authority "for holding a clearing broker liable to investors for aiding and abetting a fraud [under New York law] because it violated margin requirements or over-extended credit."

The court also addressed the motion to dismiss claims against the fund’s administrator and certain of its affiliates, and the fund’s auditors and certain of its affiliates. The plaintiff alleged that the fund’s Bermuda-based administrator and certain of its affiliates used the fictitious statements by the investment manager to prepare materially inflated net asset value calculations and to disseminate them to investors, despite receiving statements from the Prime Broker reflecting the fund’s actual losses. The plaintiff also alleged that the fund’s Bermuda-based auditing firm, together with certain affiliates, issued clean, unqualified auditing reports attesting to the accuracy of the fund’s financial statements despite numerous warning signs regarding the fund’s financial difficulties, as well as having complete access to the books of the fund, including both the fictitious statements and the accurate records maintained by the Prime Broker. In the case of both the Bermuda-based administrator and auditing firm, the court denied the motion dismiss, allowing the claims to proceed. In the case of the U.S. parents and affiliates, as well as certain other affiliates, however, the court granted the motion to dismiss, citing insufficient allegations that these entities knew of or assisted in the alleged fraud. BNA Securities Regulation & Law Report, Volume 33, No. 19, May 14, 2001.

The SEC recently announced that it adopted interim final rules that address the bank exceptions to broker-dealer registration in the Gramm-Leach-Bliley Act. These statutory provisions, which were effective as of May 12, 2001, replace the banks' long-standing full exception from broker-dealer registration with 15 functional exceptions. Banks that limit their securities activities to these 15 functions remain excepted from broker-dealer registration. Banks that engage in additional securities activities, however, either will need to register as broker-dealers or to shift those additional activities to registered broker-dealers.

The interim final rules respond to questions raised in recent months by banks, securities firms, and other interested groups about the application of the broker-dealer exceptions. The SEC is soliciting comments on all aspects of the interim final rules and will amend them as appropriate in response to comments received. Some of the interim final rules address interpretive questions received by the SEC by defining key terms used in the 15 new exceptions. Other rules provide targeted exemptions that are consistent with the functional exceptions.

The SEC also adopted temporary exemptions that give banks additional time to comply with the new statutory requirements. These rules will extend the full exception for banks from broker-dealer registration until October 1, 2001. They also will give banks until January 1, 2002 before their compensation arrangements must meet the conditions of certain statutory exceptions from the definition of broker as well as the compensation provisions of the newly granted exemptions. In addition, the rules give banks a temporary exemption that protects them from rescission actions arising from a failure to correctly determine broker-dealer status. Finally, the SEC is adopting a rule that will treat savings associations and other thrifts—which are not considered "banks" under the federal securities laws—the same as banks for broker-dealer registration purposes. SEC News Digest, Issue 2001-93, May 14, 2001.

On May 10, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) announced that they proposed joint rules to implement new statutory provisions relating to security futures products.

The Commodity Futures Modernization Act of 2000 (CFMA), enacted last December, lifted the ban on the trading of futures contracts on single stocks and narrow-based security indexes—collectively referred to as security futures products. The CFMA also established a framework for the joint regulation of security futures products by the CFTC and SEC. Futures contracts on broad-based indexes are under the exclusive jurisdiction of the CFTC.

The joint rules proposed by the CFTC and SEC relate to the distinction between broad-based and narrow-based security indexes. The CFMA itself defines the criteria for an index to be considered "narrow-based," including, among other factors, the market capitalization of each security in the index and the dollar value of that security's average daily trading volume. The statute requires the two agencies to jointly specify the methods that must be used to determine these values. The proposed rules are designed to fulfill that statutory mandate, as well as to address other issues that arise in the application of the definition of narrow-based security index.

Trading in security futures products may begin on August 21, 2001, provided that certain regulatory requirements are met. The period for public comment on the proposed rules will end 30 days from the date of their publication in the Federal Register. A copy of the proposed rules is available on the websites of the CFTC and the SEC, respectively. After considering any comments, the agencies expect to adopt final rules prior to August 21, 2001. SEC News Digest, Issue 2001-92, May 11, 2001.

On May 9, the SEC instituted and settled administrative proceedings against a principal and his broker-dealer and investment adviser firms for the firms' failure to establish, maintain and enforce policies and procedures reasonably designed to prevent the misuse of material nonpublic information.

The SEC's order found that the principal and the firms engage in merger arbitrage and "investment initiatives." In the investment initiatives, the principal has made director nominations and shareholder proposals for companies in which the firms have made a substantial investment. The shareholder proposals are designed to change the companies' governance, such as modifications to "shareholder rights plans." According to the order, in carrying out the initiatives, the principal and an employee of the firms often interact with other market participants who possess material nonpublic information concerning the targets of the initiatives. The principal also directs all trading at the firms, including hedging and other trading related to the investment initiatives. The order found that the principal's firms, taking into consideration the nature of their businesses, lacked adequate safeguards to prevent the misuse of material nonpublic information to which the principal or the employee may be exposed.

The order found that the parties willfully violated the sections of the Securities Exchange Act of 1934 (the "Exchange Act") and the Investment Advisers Act of 1940 that require broker-dealers and investment advisers to maintain procedures to detect and prevent insider trading. In addition to censuring the parties and ordering them to cease and desist from such violations, the SEC imposed civil penalties totaling $450,000. The order also required that the parties hire an independent consultant to undertake a compliance review of the firms' policies and procedures and implement any corrective measures that are recommended. SEC Rel. 34-44283; IA-1943; File No. 3- 10479.

The U.S. Court of Appeals for the Fourth Circuit recently upheld the dismissal of a claim against certain investment advisers for breach of fiduciary duty under Section 36(b) of the Investment Company Act of 1940 (the " 1940 Act"). The claim alleged that the investment advisers breached their fiduciary duty under Section 36(b) by:

• receiving excessive fees from the funds they advised, and
• failing to negotiate their advisory agreements with the funds at arm’s-length.

The later allegation was based on the plaintiffs’ claim that the independent directors of the funds were not disinterested because of their level of compensation and the fact that they served on multiple fund boards within the fund complex. The Appeals court upheld the lower court’s dismissal, in which it found that the plaintiffs had failed to plead sufficient facts to maintain their claims.

Claim of Excessive Advisory Fees. The plaintiffs’ allegation that the defendants breached their fiduciary duty under Section 36(b) of the 1940 Act by receiving excessive compensation was based on the following:

• the amount of fees charged by the two funds;
• the fact that two or three similar funds offered lower fee rates than the funds in this case, while simultaneously outperforming them;
• the fact that the two funds in question did not meet their preselected benchmark performance standards; and,
• the fact that despite the funds’ underperformance, the defendant investment advisers’ earnings increased by more than 20%.

The court noted that "to violate Section 36(b), ‘the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.’" Accordingly, in order to determine whether a fee is excessive for purposes of Section 36(b), a court must examine the relationship between the fees charged and the services rendered by the investment advisers. Because the plaintiffs failed to allege any facts pertinent to the relationship between fees and services, the court found that the plaintiffs failed to allege sufficient facts about the services the defendants offered in return for those fees. Similarly, the court did not find persuasive the plaintiff’s allegations that the fees were excessive based upon the funds’ performance, stating that allegations of underperformance alone are insufficient to prove that an investment adviser’s fees are excessive.

Claim Challenging the Directors’ Independence. The court next considered the plaintiffs’ claim that the disinterested directors of the funds were, in fact, interested parties because:

• they served on the boards of between 22 and 38 other funds within the same complex;
• they received aggregate compensation of either $65,000 or $81,000;
• their obligations to so many funds meant that they could not spend enough time on each particular fund; and
• they were dependent on the investment advisers for information and for their positions on the boards.

In considering these allegations, the court noted that Section 36(b) of the 1940 Act is sharply focused on the question of whether the fees themselves were excessive, and not on the status of the directors who approved. Nevertheless, the court addressed the plaintiffs’ evidence on this issue and found that

• neither the 1940 Act nor the SEC proscribes the use of multi-board members within mutual fund complexes;
• membership on the boards of several funds within a complex is the prevailing practice in the industry; and
• the SEC has recently reaffirmed its position that a director of a fund who also is a director of another fund managed by the same adviser generally would not be viewed as an interested person solely as a result of this relationship;

Moreover, several courts have likewise held that the fact that a director serves on multiple boards within a fund complex is insufficient to demonstrate control.

Accordingly, the court held that the plaintiffs failed to allege any facts that, if true, would support a claim that the disinterested directors were actually interested. In affirming the lower court’s dismissal of the plaintiffs’ complaint the court stated that the 1940 Act balances the tension between protecting mutual fund investors from overly generous charges by investment advisers and shielding fund management from an outbreak of harassing lawsuits. The court concluded that any change in this balance will have to come from Congress. Migdal v. Rowe Price Flemming, et al., U.S. Appeals Court for the Fourth Circuit, Case No. 00-1420 (May 1, 2001).