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.

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)

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 QPTPs. 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.

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.

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.

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