Investment Management Industry News Summary- November 2004

Investment Management Industry News Summary- November 2004

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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The NASD Mutual Fund Task Force (“Task Force”) Submits Recommendations on Soft Dollars, Portfolio Transaction Costs to SEC

November 19, 2004 10:13 AM

The Task Force was formed in May 2004 and its purpose is to examine ways to improve the transparency of mutual fund portfolio transaction costs and distribution arrangements. On November 11, 2004 the Task Force issued a report on soft dollars and portfolio transaction costs, completing the first phase of its examination.

Background

Section 28(e) of the Securities Exchange Act of 1934 (“Exchange Act”) provides a safe harbor to an investment adviser from claims that it breached its fiduciary duty by causing clients to pay more than the lowest available commission rates if the investment adviser determined that the rate was “reasonable in relation to the value of the brokerage or research services” received from the broker-dealer.

However, regulators and other industry observers have expressed concerns that:

  • the ability of an investment adviser to use soft dollars to obtain research and other services that the adviser otherwise would have to pay for from its own assets potentially creates incentives for the adviser to enter into brokerage arrangements that may not serve a client’s best interests; and
  • accounting conventions presently limit the manner in with such portfolio transaction costs are disclosed

Recommendations

In furnishing its recommendations the Task Force states that it considered the benefits provided to all investors through the widespread availability of research of all types to all investment advisers balance against the need to address the potential conflicts of interest and disclosure issues that the use of soft dollars raise.

The Task Force’s recommendations to the SEC were to:

  • Narrow its interpretation of the scope of “research services” for purposes of the safe harbor set forth in Section 28(e), to better tailor the safe harbor to the types of services that principally benefit clients rather than the adviser. The Task Force further recommended that the SEC include an illustrative list of what items would be included in or excluded from the definition;
  • Ensure that a fund board obtains appropriate information regarding a fund adviser’s brokerage allocation practices, including soft dollar products and services received and total commissions directed to such brokers from all of the adviser’s clients;
  • Mandate enhanced disclosure in fund prospectuses to foster better investor awareness of soft dollar practices. Such disclosure would include whether the adviser obtains (i) proprietary and (ii) third-party research through the use of soft dollars;
  • Consider soft dollar issues raised by other managed advisory accounts;
  • Apply disclosure requirements to all types of commissions (i.e., traditional commissions, commission equivalents, and any other remuneration eligible for the Section 28(e) safe harbor);
  • Explicitly require that advisers provide certain information concerning portfolio transaction costs to fund boards; and
  • Require enhanced disclosure to fund shareholders about portfolio transaction costs. The Task Force expressed the need for both easily quantifiable total commission dollars (including all types of commissions as described above), but also narrative disclosure about intangible costs that are difficult to quantify, such as execution costs associated with principal trades, market impact costs and opportunity costs.

The Task Force’s recommendations attempt to limit research activities bought with soft dollars to those where the benefit goes to the investors and not to the advisers, and require that advisors give more complete information on soft dollar practices to fund boards. The second phase of the Task Force’s assignment will focus on distribution arrangements, including Rule 12b-1 fees and revenue sharing. This phase is expected to take several months to complete.

NASD Task Force Repost on Soft Dollar and Portfolio Transaction Costs (November 11, 2004). NASD New Release (November 17, 2004).

Note to readers: Due to the Thanksgiving holiday, there will be no Investment Management Industry News Summary next week.

 
 



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 staff issues guidance regarding the application of Rule 38a-1 to closed-end funds’ principal underwriters

November 19, 2004 10:10 AM
Rule 38a-1 under the 1940 Act requires registered investment companies to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, including policies and procedures that provide for the oversight of compliance by each adviser, principal underwriter, administrator, and transfer agent of an investment company. The rule also requires that each investment company annually review the adequacy of the compliance policies and procedure of the investment company’s investment advisers, principal underwriters, administrators, and transfer agents. The rule also requires that an investment company’s chief compliance officer annually review these service providers’ policies and procedures and report to the board on their operation and any material changes.

In the ICI Letter the staff noted that Rule 38a-1 was intended to require investment companies to adopt and implement written policies designed to prevent violation of the federal securities laws by service providers, including principal underwriters, that provide ongoing services to investment companies. However, the staff agreed with the ICI’s contention that there is a distinction in the context of closed end funds, where an underwriting syndicate has a brief and limited relationship with the fund, and that relationship ceases once the shares are offered to the public. Accordingly, the staff agreed that closed-end funds need not comply with the provisions of Rule 38a-1 with respect to principal underwriters of closed-end funds, unless such underwriters undertake to regularly serve as principal underwriter for the fund.

The staff also noted that, in accordance with Section 2(a)(20) of the 1940 Act, Rule 38a-1 does not require an investment company’s compliance policies and procedures to cover an investment adviser that does not regularly furnish investment advice to the investment company, including investment advisers that only provide isolated research reports to an investment company or its adviser.

Investment Company Institute, SEC No Action Letter (November 10, 2004).
 
 



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 staff issues guidance regarding the application of Rule 38a-1 to closed-end funds’ principal underwriters

November 19, 2004 10:02 AM
In a recent no-action letter to the Investment Company Institute (the “ICI Letter”) dated November 10, 2004, the SEC staff provided assurances that it would not recommend enforcement action if a closed-end fund does not comply with Rule 38a-1 under the Investment Company Act of 1940, as amended (the “1940 Act”), with respect to any principal underwriter of the fund that does not provide ongoing services to the fund.
Rule 38a-1 under the 1940 Act requires registered investment companies to adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws, including policies and procedures that provide for the oversight of compliance by each adviser, principal underwriter, administrator, and transfer agent of an investment company. The rule also requires that each investment company annually review the adequacy of the compliance policies and procedure of the investment company’s investment advisers, principal underwriters, administrators, and transfer agents. The rule also requires that an investment company’s chief compliance officer annually review these service providers’ policies and procedures and report to the board on their operation and any material changes.

In the ICI Letter the staff noted that Rule 38a-1 was intended to require investment companies to adopt and implement written policies designed to prevent violation of the federal securities laws by service providers, including principal underwriters, that provide ongoing services to investment companies. However, the staff agreed with the ICI’s contention that there is a distinction in the context of closed end funds, where an underwriting syndicate has a brief and limited relationship with the fund, and that relationship ceases once the shares are offered to the public. Accordingly, the staff agreed that closed-end funds need not comply with the provisions of Rule 38a-1 with respect to principal underwriters of closed-end funds, unless such underwriters undertake to regularly serve as principal underwriter for the fund.

The staff also noted that, in accordance with Section 2(a)(20) of the 1940 Act, Rule 38a-1 does not require an investment company’s compliance policies and procedures to cover an investment adviser that does not regularly furnish investment advice to the investment company, including investment advisers that only provide isolated research reports to an investment company or its adviser.

Investment Company Institute, SEC No Action Letter (November 10, 2004).
 
 



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.

Reports indicate that proposed spending legislation may require the SEC to rethink independent chair requirement

November 19, 2004 9:59 AM

The Wall Street Journal recently reported that a proposed spending bill that includes over $900 million in funding for the SEC may require the agency to analyze and report on whether mutual funds chaired by independent directors perform better, have lower expenses, or have better compliance records than mutual funds chaired by interested directors. Language added to the bill by Senator Judd Gregg (R, NH) would require the SEC to submit the report by April 2005 and “act upon the recommendations” of the study no later than January 2006. According to the Journal’s sources, SEC officials are keeping a close eye on the bill and are concerned it ultimately could lead to the reversal of the recently adopted fund governance rules that require mutual fund boards to have independent chairpersons and at least 75% independent directors. The Journal reported that, although the initial language introduced by Senator Gregg called for the SEC to submit findings to Congress by March 30th, seek public comment, and make a determination by the end of June on whether to “reaffirm” its stance on the independent chairperson requirement, a compromise had been submitted, which would require the SEC to submit a report showing “justification” for the rule, along with an economic analysis comparing funds with independent and non-independent chairpersons. House and Senate negotiators are believed to be close to finalizing the year-end omnibus spending bill.


The Wall Street Journal (November 17, 2004 and November 18, 2004)

 
 



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.

OCC permits bank to issue financial warranties for “principal protected funds.”

November 12, 2004 10:35 AM
On September 7, 2004, the OCC issued a letter (the “Letter”) permitting a national bank and a subsidiary (the “Bank”) to issue certain financial warranties that would guarantee the principal amount and a fixed return on a specified mutual fund (the “Fund”) for qualifying investors. The financial warranties guarantee that the investment structuring advice and monitoring services provided by the Bank to the Fund will perform as designed.

Background

The Fund is a type of mutual fund that is generally referred to as a “principal protected” fund. The Fund offers a “guaranteed amount” representing return of principal plus a minimum annual return to investors who hold shares for seven years and who reinvest all dividends and distributions in additional shares of the Fund. The Fund also offers the potential of positive equity market-based returns in excess of the minimum guaranteed amount depending on the performance of the Fund’s investment assets. The life of the Fund is divided into three phases: an Offering Period, a Guarantee Period, and a Post-Guarantee Period. During the Guarantee Period, the Fund’s assets are allocated between equity and debt securities (primarily zero coupon U.S. government securities) based on a pre-determined model. The Bank provides structuring assistance and asset allocation advice, including investment constraints and pre-defined triggers upon the occurrence of certain events that would require liquidation of Fund assets and investments in zero-coupon bonds maturing at preset dates. These controls are designed to ensure that the Fund does not lose principal and provides the guaranteed return. If the Fund’s investment program does not produce a sufficient return to ensure the guaranteed amount for shareholders on the maturity date, the Bank’s financial warranty provides the financial result guaranteed to investors. The Bank receives an on-going fee that reflects payment for the Bank’s package of services provided to the Fund, including the financial warranty.

The Letter

In the Letter, the Bank asserted that the financial warranty should be viewed as a permissible guarantee under a recent OCC interpretive ruling that codified a national bank’s authority to guarantee an obligation of another if the national bank has a “substantial interest” in the transaction (i.e., when the guarantee is for the bank’s own benefit or in furtherance of its interests). A “substantial interest” exists if the guarantee provided by the bank is “incidental” to another of its authorized activities. The bank stated that its involvement and interest in the structuring and performance of the overall Fund product satisfies the “substantial interest” requirement. The Bank provided detailed financial advice and consultation with respect to the creation and implementation of the Fund, and will continue to provide on-going financial counseling and monitoring related to the Fund’s actual operation.

The OCC noted in the Letter that it is well established that national banks may provide those types of activities, and a bank may provide a guarantee if the guarantee qualifies as “incidental” or “convenient” or “useful” to the performance of the business of banking. The OCC noted that the Bank’s interest in the financial warranty advances the Bank’s own interest in providing financial activities related to principal protected funds and is not merely an interest created by the guarantee itself. Accordingly, the Bank may provide the financial warranty as a guarantee under the circumstances represented by the Bank.

The OCC noted in the Letter, however, that for the Bank to permissibly engage in the issuance of the financial warranty, the Bank must have effective risk management procedures and internal controls to conduct the activities safely and soundly. The OCC has indicated that an effective risk measurement and management process includes appropriate oversight and supervision, managerial and staff expertise, comprehensive policies and operating procedures, risk identification and measurement, and management information systems, as well as an effective and independent risk control function that oversees and ensures the appropriateness of the risk management process. Thus, the OCC’s conclusion regarding the legal permissibility of the Bank’s financial warranty is subject to OCC Supervisory staff concluding that the Bank has such risk measurement and management processes in effect with respect to its financial warranty product. The OCC also noted in the Letter that the Bank would need to seek a regulatory capital opinion concerning the treatment of the financial warranties for capital purposes.

OCC Interpretive Letter #1010, October 2004, 12 CFR 7.1017.
 
 



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.

Provisions of “American Jobs Creation Act of 2004” will affect investment companies

November 12, 2004 10:27 AM

The “American Jobs Creation Act of 2004” (the “Act”) that was recently enacted on October 22, 2004 has a number of federal income tax provisions that affect regulated investment companies (each, a “RIC”). Below is a summary of some of these new rules.

U.S. Withholding Tax on Foreign Investors

Under the Act, dividends paid by a RIC to non-U.S. shareholders that are derived from short-term capital gains and qualifying net interest income (including income from original issue discount and market discount), and that are properly designated by a RIC as “interest-related dividends” or “short-term capital gain dividends,” generally will not be subject to U.S. withholding tax commencing in 2005. In order to be able to make such a designation, the income earned by the RIC must be of a type that would not be subject to federal income tax if earned directly by the non-U.S. shareholder.

In addition, pursuant to the Act, distributions of a RIC attributable to gains from sales or exchanges of “U.S. real property interests” (as defined in the Internal Revenue Code and Treasury Regulations) (including certain U.S. real property holding corporations) generally will be subject to withholding tax and may give rise to an obligation on the part of the non-U.S. shareholder to file a U.S. tax return. The provisions contained in the Act relating to distributions to shareholders who are non-U.S. persons generally will apply to distributions with respect to taxable years of a RIC beginning after December 31, 2004 and before January 1, 2008.

RIC Good Income and Diversification Tests Expanded to Include Certain Publicly-Traded Partnerships

The Act has expanded both the good income and diversification qualification tests for RICs found in Sections 851(b)(2) and (3) of the Code. For the purposes of the good income test, the net income derived from an interest in a qualified publicly-traded partnership (a “QPTP”) now will be includable as a permissible source of income. A QPTP generally is defined to include all publicly-traded partnerships (“PTPs”) other than certain PTPs that meet a passive-type income exception under Section 7704(c) of the Code. The character of the income derived by a RIC from the interest in a QPTP will not be subject to the look-through rule that generally applies to partnerships and trusts.

In addition, both prongs of the RIC diversification test under Section 851(b)(3)(A) and (B) of the Code have been expanded to include the securities of a QPTP. As a result, under the first prong, the equity securities of a QPTP now will be included in the outstanding voting securities of an issuer and, under the second prong, no more than 25% of the RIC’s total assets will be permitted to be invested in the securities of one or more OPTPs. A RIC that invests in a QPTP, however, will be subject to the passive loss rules under Section 469(k)(4) of the Code with respect to items attributable to an interest in a QPTP. Each of these changes will be effective for taxable years of a RIC beginning after October 22, 2004.

Deficiency Dividend Procedure Expanded

Previously, if a RIC discovered that it had failed to comply with the distribution requirements under Subchapter M of the Code for a prior tax year, a deficiency dividend procedure was available to the RIC only if a “determination” first was made either by a court or the IRS as to the adjustments required to be made to the RIC’s income for such year. The deficiency dividend procedure now has been expanded to permit a RIC to unilaterally identify its failure to pay the required amount and to make its own determination of such adjustments by amending or supplementing its tax return for the relevant tax year. This change is effective for taxable years of a RIC beginning after October 22, 2004.

Dividends-Received Deduction and Qualified Dividend Income Holding-Period Requirements Affected By Certain Qualified Covered Call Options

The Act modifies the holding-period requirements for the dividends-received deduction by providing that a shareholder may not include in its holding period for stock any time during which it is protected from risk of loss in the stock by writing an “in-the-money” qualified covered call option. In addition, this change also applies to the stock holding-period requirements for qualified dividend income. These provisions generally are effective for positions established on or after October 22, 2004.

Qualified Dividend Income Changes for Dividends from Foreign Corporations

The Act eliminates the foreign personal holding company and foreign investment company rules with respect to taxable years of foreign corporations beginning after December 31, 2004 and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end. Prior to the Act, all dividends received by a RIC from such companies were automatically ineligible for the maximum 15% U.S. federal income tax rate on qualified dividend income. Because the Act has eliminated this rule, dividends received from such companies may potentially qualify for the 15% U.S. federal income tax rate on qualified dividend income. It should be noted, however, that all dividends received by a RIC from passive foreign investment companies will remain ineligible for treatment as qualified dividend income.

Minimum Holding Period for Foreign Tax Credit on Withholding Taxes on Income Other Than Dividends

Effective for taxes paid or accrued after November 21, 2004, the Act creates new holding-period requirements that a taxpayer must meet in order to obtain a foreign tax credit for foreign withholding taxes on income other than dividends. Prior to the Act, taxpayers were able to obtain a foreign tax credit with respect to foreign withholding taxes, but with respect to foreign taxes paid on dividends, the foreign tax credit was only allowed with respect to shares meeting certain holding requirements. While the holding-period requirements necessary for the foreign tax credit on dividends remain unchanged, the Act places similar holding period requirements on all other types of property.

Thus, in order to obtain a tax credit for the foreign withholding taxes on any item of income or gain with respect to any property, the taxpayer must hold the property for more than 15 days during the 31-day period beginning 15 days before the right to receive payment arises. Also, a foreign tax credit will be denied to the extent that a recipient is under an obligation to make related payments with respect to positions in substantially similar or related property.

Straddles

The Act has also made several changes to the tax rules that apply to straddles, including changes to the identified straddle rules, the repeal of the stock exception to the straddle rules, and new rules for physically settled positions in a straddle. These changes are effective for positions established on or after October 22, 2004.

Spot Exchange Rate

For all taxable years beginning after December 31, 2004, the Act requires RICs using the accrual method to translate foreign income taxes paid or accrued by a RIC into U.S. dollars using the spot exchange rate as of the date the income is accrued by the RIC.

 
 



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 declines the Commodity Futures Trading Commission’s (“CFTC”) request for a rehearing on the court’s ruling that speculative foreign currency transactions with rollover features are not futures contracts

November 5, 2004 11:04 AM
On October 20, 2004, a divided U.S. Court of Appeals for the Seventh Circuit rejected the CFTC’s request for a rehearing of its June ruling that speculative foreign currency transactions with a rollover feature are not futures contracts, but are spot sales for delivery.
The litigation began when the CFTC filed an enforcement action against the defendants and alleged that the defendants fraudulently solicited customers in foreign currency futures trading with high pressure tactics, false promises of large profits, misleading promotional materials, and material omissions about the defendant’s compensation arrangements. The CFTC asserted that all but one of the defendant’s customers lost money in 2002, for a total loss of $1.4 million, but the defendant collected $1.4 million in compensation during the same year.

The district court concluded that it lacked jurisdiction over the complaint because the investors were not trading futures contracts. The court said its understanding of the defendants' trades, based on the evidence, was that the defendants entered into, on the customer's behalf, an offsetting transaction that would prevent the need to deliver or take delivery of the underlying currency. Thus, defendants’ customers were not trading in futures contracts. Rather, the district court said, they were speculating in spot contracts by rolling over positions and entering into offsetting trades. The CFTC appealed, and the appeals court affirmed that the CFTC lacks jurisdiction over the instruments. The CFTC filed a petition for rehearing or rehearing en banc on August 11, which was denied.

Dissenting from the denial of rehearing, Judge Kenneth Ripple declared that the “analysis presented by the panel opinion cannot be squared with our prior precedent; it creates a conflict among the circuits; and it creates significant enforcement problems” for the CFTC. Ripple noted that the “present case deals with speculative transactions for the sale or purchase of foreign currency; the contract called for settlement within forty-eight hours, however, every two days, the transaction was rolled forward and the customer maintained a position in an open currency market.” According to Ripple, the "approach employed by the panel to reach [the position that the rollover did not convert these spot transactions into futures contracts] departs substantially from our precedent. It squarely rejects the relevance of delivery in the context of financial futures."

Securities Regulation & Law Report, Volume 36 Number 43, November 1, 2004 (ISSN 1522-8797); CFTC v. Zelener, U.S. Court of Appeals (7th Circuit), No. 03-4245, 10/20/04.
 
 



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 proposes new rules on the definition of “eligible portfolio company” under the Investment Company Act of 1940 (the “1940 Act”)

November 5, 2004 11:00 AM

On November 1, 2004, the SEC published for comment two new rule proposals under the 1940 Act to expand the definition of an “eligible portfolio company.” The proposed rules are designed to promote the flow of capital to small developing and financially troubled companies and to realign the definition and the investment activities of business development companies (“BDCs”) with the purposes of the Small Business Investment Incentive Act of 1980 (“SBIIA”).

Background

In 1980, Congress enacted the SBIIA, and the 1940 Act was amended to establish BDCs as a new type of closed-end investment company. The primary purpose of the amendments was to make capital more readily available to small developing and financially troubled businesses. As a result, the amendments relieved BDCs from some of the restrictions under the 1940 Act applicable to registered closed-end investment companies so long as the BDC invested at least 70% of its total assets in securities of specified issuers, including securities of “eligible portfolio companies” as defined in Section 2(a)(46) of the 1940 Act.

An “eligible portfolio company” is currently defined under Section 2(a)(46)(C)(i) of the 1940 Act to include any issuer that does not have any class of securities as to which a member of a national securities exchange, broker, or dealer may extend margin credit pursuant to the rules or regulations adopted by the Federal Reserve Board. In 1998, the Federal Reserve Board expanded the definition of a margin security to include all securities that trade on a national securities exchange or are listed on the NASDAQ stock market, as well as any security, regardless of whether it is publicly or privately offered, that is not an “equity security” within the meaning of Section 3(a)(11) of the Securities Exchange Act of 1934. The Federal Reserve Board’s expansion of the definition of a margin security had the unintended effect of limiting the investment opportunities for BDCs.

Proposed new rules

The proposed new rules are intended to realign the definition of “eligible portfolio company” with the purpose of the SBIIA by (1) defining eligible portfolio company with reference to whether an issuer has any class of securities listed on a national securities exchange or NASDAQ and (2) permitting BDCs to make certain additional “follow-on” investments in those issuers even after they list their securities on an national securities exchange or NASDAQ.

Proposed Rule 2a-46 would modernize the definition of “eligible portfolio company” by creating a new, objective standard. The proposed rule is intended to recapture the types of issuers that Congress originally intended to make eligible for BDC investments as part of a BDC’s 70% basket (i.e., those issuers that do not have ready access to the public capital markets but may have lost their status as eligible portfolio companies because they have issued marginable securities, as well as certain financially troubled issuers). The proposed rule would define “eligible portfolio company” to include either (1) any issuer that does not have any class of securities listed on a national securities exchange or NASDAQ or (2) any issuer that has a class of securities listed on a national securities exchange or NASDAQ, but (a) that has received notice from the national securities exchange or NASDAQ that it does not meet the quantitative continued listing standards of the national securities exchange or NASDAQ and (b) does not satisfy the initial quantitative requirements for listing a class of its securities on any national securities exchange or NASDAQ.

Proposed Rule 55a-1 would conditionally permit a BDC to make follow-on investments in certain issuers that met the definition of eligible portfolio company under proposed Rule 2a-46 when the BDC made its initial investment(s) in the issuer, but that do not meet that definition at the time of the follow-on investment because the issuer subsequently listed a class of securities on a national securities exchange or on NASDAQ. The proposed rule would permit BDCs to purchase the securities in non-public offerings from the issuer or certain of its affiliates.

Comments should be received on or before January 7, 2005. SEC Release No. IC-26647; File No. S7-37-04.

 
 



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 extends time for banks to comply with Gramm-Leach Bliley Act (“GLBA”) broker registration requirements

November 5, 2004 10:56 AM

On November 2, 2004, the SEC announced in a press release that it issued an order further extending until March 31, 2005, the compliance dates for banks with respect to certain broker registration requirements contained in the GLBA. The SEC does not expect banks to develop compliance systems to meet the terms of the “broker” exceptions until the SEC amends its rules.


The GLBA repealed a full exception that had allowed banks to engage in securities activities without registering as a broker or dealer and replaced the full exception with new functional exceptions. The new functional exceptions were to become effective on May 12, 2001. On May 11, 2001, the SEC adopted interim rules (“Interim Rules”) that, among other things, gave banks time to fully comply with the more narrowly tailored exceptions from broker-dealer registration and extended the temporary exemption from the definition of “broker” to November 12, 2004. This exemption has now been extended to March 31, 2005, pending the SEC’s consideration of comments received on Proposed Regulation B.


In June 2004, the SEC proposed to revise and replace the Interim Rules with Regulation B. Proposed Regulation B would require banks and other financial institutions to begin complying with the final GLBA bank broker rules on January 1, 2006. SEC press release 2004-151.

 
 



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 extends compliance date for new code of ethics rule under the Investment Advisers Act of 1940 (the “Advisers Act”)

November 5, 2004 10:45 AM
According to an Investment Company Institute (“ICI”) memorandum, the SEC has extended the compliance date of new Rule 204A-1 under the Advisers Act. Rule 204A-1 requires each registered investment adviser to adopt a code of ethics by January 7, 2005. The ICI communicated to the SEC the difficulties investment advisers were experiencing in complying with the January 7th compliance date. In response to these concerns, the compliance date has been extended from January 7, 2005 to February 1, 2005. The extension will appear in the release adopting Rule 203(b)(3)-2 requiring hedge fund advisers to register with the SEC. Investment Company Institute Memorandum dated October 29, 2004 (18144).
 
 



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.

Securities and Exchange Commission (“SEC”) is conducting telephonic sweep of chief compliance officers (“CCOs”)

November 5, 2004 10:38 AM

The SEC’s Philadelphia Field Office has commenced a telephone call campaign (in lieu of a letter sweep) to investment advisers asking about status of the recently effective compliance rules. The telephonic inquiries are conducted by a single staff member and appear to be based upon a script of questions. SEC Staff members have described the inquiries as a method for gathering information from a firm’s compliance department. Advisers should have senior compliance personnel prepared to answer these and related questions, and should communicate to all members of the compliance department that any such inquiry should be directed to the appropriate senior level person. To date, the staff’s questions generally have included the following:

  • The full name of the firm’s CCO
  • If the person on the call had been formally named CCO, and if so when
  • If all of the mutual funds advised by the firm have named CCOs
  • If the boards of the mutual funds advised by the firm approved the CCOs
  • If the firm has completed its compliance policy and procedure manual
  • Whether the policies and procedures are new or were in existence before the adoption of the compliance rules
  • Whether all areas covered by the rules have been addressed in the firm’s policies and procedures
  • Whether any of the adviser’s policies and procedures are incomplete
  • To whom does the CCO report (name and title)
  • To the extent the firm serves as subadviser to any mutual funds:
    • whether the CCO anticipates communicating directly with the boards of any of such funds, and whether the firm’s CCO was appointed as CCO of any of the subadvised funds
    • whether the person on the call knows the names of the CCOs of all the funds for which the firm serves as investment adviser
  • The most challenging aspect of implementing the compliance rules
 
 



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.