Investment Management Industry News Summary - Novermber 2001

Investment Management Industry News Summary - Novermber 2001

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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SEC issues fee rate advisory

November 28, 2001 2:09 PM

On November 28, 2001, President Bush signed the fiscal 2002 appropriations bill that funds the SEC. Effective November 28, the fee rate on filings made pursuant to Section 6(b) of the Securities Act of 1933 decreased from $250 per $1,000,000 to $239 per $1,000,000, or .000239 of the aggregate offering amount.

 
 



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.

FBI reportedly investigating possible use by terrorists of hedge funds to launder funds

November 21, 2001 2:27 PM

As part of the ongoing investigation by the FBI and the U.S. Treasury Department into possible money laundering networks in the U.S., the FBI has begun questioning whether hedge funds could be used to launder money. Reportedly, authorities are interested in probing hedge funds because they routinely accept subscription money through intermediaries who do not always divulge the identity of the client, they are open to investors worldwide and they are not as stringently regulated as registered investment companies. Authorities have cited possible ways in which a terrorist organization could invest in financial markets through hedge funds. Specifically, authorities note that a terrorist organization could place money in a bank or offshore holding company which could then invest in a hedge fund or a hedge fund of funds. Authorities also theorize that fund of funds firms which do not “aggressively” check the identity of their investors could also be used unwittingly as investment vehicles for terrorist organizations. Wall Street Journal, November 21, 2001.

 
 



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 releases handbook on investment management services

November 15, 2001 3:31 PM

The OCC recently released a handbook regarding the oversight of investment management services provided by national banks, whether directly or through affiliated investment advisory entities. The OCC noted that it is the primary regulator supervising a national bank's investment advisory activities that are not conducted by an investment adviser registered with the SEC or individual states. It further noted that national banks that manage or advise private trust accounts, collective investment funds, institutional accounts, personal investment portfolios, and other unregistered investment funds are not required to register as investment advisers with the SEC. As a result, OCC examiners assess the risks, risk management systems and compliance with applicable law of national banks providing investment management services for these types of accounts.

The OCC noted that it uses these handbooks as guidance for its national bank examiners when they examine large banks that engage in these activities. In particular, the handbook contains an overview of the investment management business, its associated risks and the OCC's view of an appropriate risk management framework. In the handbook, the OCC states that its primary supervisory focus regarding bank subsidiaries or affiliated registered investment advisers is to assess the potential material risks that the adviser poses to the national bank and the effectiveness of the bank's oversight systems for monitoring and controlling those risks. The OCC notes that its risk assessments will generally include a review of:

  • the adviser's strategic plan and its impact on the bank;
  • the significance of current and planned revenue from the adviser in relation to bank revenue;
  • the amount of capital provided to and used by the adviser;
  • the impact on the bank's liquidity from providing resources to the adviser either through direct funding or from reputation risk; and
  • systems for monitoring revenue sensitivity to changing market conditions at the adviser and bank levels.

The OCC noted that its risk assessment includes examination of a bank's management of the following risks:

  • Investment risk or including financial exposure to changes in interest rates, equity and debt markets, inflation, foreign exchange rates, commodity prices and other global economic and political conditions.
  • Transaction risk or the current and prospective risk to earnings and capital arising from fraud, error and the inability to deliver products or services, maintain a competitive position and manage information. The OCC further describes transaction risk as equivalent to operating risk or the risk which arises every day as transactions are processed.
  • Compliance risk or the current and prospective risk to earnings and capital arising from violations of or noncompliance with laws, rules, regulations, internal policies and procedures and ethical standards. The OCC noted that compliance risk could lead to diminished reputation, reduced franchise value, limited business opportunities, reduced expansion potential and an inability to enforce contracts.
  • Strategic risk or the current and prospective risk to earnings and capital arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes.
  • Reputation risk or the current and prospective risk to earnings and capital arising from negative public opinion.

The OCC also provided its recommendations on how national banks should manage the risks associated with providing investment management services. The OCC stated that an effective risk management system is characterized by active board and senior management risk supervision and sound processes for risk assessment, control and monitoring. In particular, the OCC recommended that a bank's board or directors and senior management:

  • establish strategic direction, risk tolerance standards and an ethical culture consistent with the bank's strategic goals and objectives;
  • establish an appropriate organizational structure with clear delineation of authority, responsibility and accountability through all levels of the organization;
  • develop and implement a comprehensive and effective risk management system; and
  • monitor the implementation of investment management risk strategies and the adequacy and effectiveness of risk management processes.

OCC Comptroller's Handbook, Investment Management Services, August 2001.

 
 



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 amendments to rules governing investment companies' use of U.S. securities depositories

November 15, 2001 2:16 PM

On November 15, 2001, the SEC issued a release proposing amendments to rule 17f-4 under the 1940 Act. Rule 17f-4 permits registered investment companies to maintain assets with U.S. securities depositories. The SEC noted that custody practices and commercial law relating to custody arrangements with securities depositories have changed substantially since it adopted rule 17f-4 in 1978. As a result, the SEC has proposed the amendments to update and simplify rule 17f-4 to reflect these business and legal developments. The proposed amendments would:

  • Permit additional types of custodians to operate depositories. Rule 17f-4 currently permits investment companies to maintain assets with a depository established by a registered clearing agency and the book-entry system of the Federal Reserve. The SEC has proposed increasing the scope of the rule to permit investment companies to maintain assets with a registered transfer agent for the purpose of holding shares of another open-end investment company. This amendment, the SEC noted, acknowledges that in certain situations, an investment company transfer agent acts as the functional equivalent of a depository.

  • Broaden the categories of companies permitted to rely on the rule. The proposed amendments would broaden the rule to permit any registered investment company, including a unit investment trust or a face-amount certificate company, to use a securities depository.

  • Eliminate certain custodial compliance requirements of the rule that the SEC believes are no longer necessary. Currently, rule 17f-4 requires that, if an investment company holds securities in a depository through a custodian or its agents, the custodian must maintain the investment company's securities in a depository account for the custodian's customers that is segregated from the depository accounts for the custodian's own securities and must identify on the custodian's records a portion of the total customer securities as belonging to the investment company. The current rule also requires the custodian to send to the investment company confirmation of transfers to or from the investment company's account with the custodian. Finally, the current rule requires a depository that deals directly with a investment company to deliver the investment company's securities to an appropriate successor if the depository no longer acts for the investment company. The SEC has eliminated all of these requirements because of recent revisions to commercial law.

    Instead, the proposed amendments would substitute more general compliance requirements for custodians and depositories. For instance, the rule would require the investment company's contract with its custodian to provide that the custodian take all actions reasonably necessary or appropriate under applicable commercial and regulatory law to safeguard assets held by the custodian or assets maintained elsewhere for the benefit of the investment company.
  • Eliminate requirements that investment company directors approve the investment company's direct arrangements with depositories and arrangements by custodians with depositories. Instead, the rule would permit the investment company to approve its custodian's arrangements with depositories. The SEC noted that, while investment company directors should monitor the investment company's dealings with its own custodian, close involvement in approving arrangements with domestic depositories appears unnecessary. The amendments would permit the investment company itself to approve arrangements with depositories and with custodians that use depositories.

    Comments on the proposed amendments to Rule 17f-4 must be submitted to the SEC no later than January 31, 2002. SEC Rel. No. IC-25266, November 15, 2001.

 

 
 



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 permits closed-end fund to reimburse shareholder for proxy solicitation expenses

November 15, 2001 2:11 PM

The SEC’s Division of Investment Management recently issued a no-action letter permitting a closed-end fund to reimburse a shareholder’s proxy solicitation expenses related to the election of the shareholder as a director of the fund. The shareholder filed a proxy solicitation in connection with the fund’s annual meeting in which he nominated himself for director. In his solicitation, the shareholder nominee noted that he planned to seek reimbursement from the fund for expenses related to the solicitation. The shareholder was subsequently elected to the board of directors. The board of the fund later resolved to reimburse the shareholder for his expenses related to the proxy solicitation, subject to confirmation from the staff of the SEC that it would not recommend enforcement action if the fund reimbursed the expenses.

In its request for no-action relief, counsel to the fund noted that the reimbursement may be considered a joint transaction with an affiliate and thus prohibited by section 17(d) of the Investment Company Act of 1940 (the “1940 Act”) and rule 17d-1 thereunder. Counsel to the fund argued that the reimbursement would not constitute a joint enterprise, arrangement or profit sharing plan in violation of section 17(d). Counsel also argued that the shareholder nominee was not an affiliated person of the fund at the time the expenses were incurred. Counsel noted that if the shareholder had not been successful in his nomination, he would not have become an affiliate of the fund and the reimbursement would not present an issue under section 17(d). Counsel to the fund further noted that the shareholder and the fund were adversaries throughout the proxy contest and that shareholders knew when they elected the shareholder nominee that he planned to seek reimbursement of his expenses. Finally, counsel asserted that the shareholder pursued objectives that he believed to be in the best interests of fund shareholders.

The staff concluded that, while it did not necessarily agree with the fund’s legal analysis, it would not recommend enforcement if the fund reimbursed the shareholder for his expenses related to a proxy solicitation in which he sought to be elected as a director. In granting the fund’s no-action request, the staff directed any persons considering issues related to the reimbursement of investment company proxy solicitation expenses to its decision in Sequoia Partners, L.P. (Rel. No. IC-20644, October 24, 1994). In Sequoia, the staff denied the request for an exemption from certain provisions of the 1940 Act regarding the reimbursement of certain proxy solicitation expenses because it found that the proposed reimbursement was part of a negotiation designed to benefit a shareholder which owned greater than 25% of the outstanding fund shares at the expense of the other shareholders. Mexico Equity and Income Fund, Inc., no-action letter, November 15, 2001.

 
 



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 amendments to rule regarding investment company mergers or consolidations (collectively, "mergers")

November 12, 2001 2:32 PM

The SEC has proposed amendments to rule 17a-8 under the Investment Company Act of 1940 (the "1940 Act") which permits affiliated registered investment companies and series or portfolios of registered investment companies ("funds") to merge without first obtaining an exemptive order from the SEC. Currently, rule 17a-8 permits such a merger only when the participating funds are affiliated solely by reason of having common investment advisers, directors, and/or officers. The amendments would expand the availability of the rule to include the merger of funds that are affiliated for other reasons, such as when the funds have common large shareholders. The amendments also would permit a fund and an affiliated bank common trust fund or collective trust fund to merge under the rule.

Section 17(a) of the 1940 Act prohibits an affiliated person of a fund from selling any security or other property ("assets") to or buying assets from the fund ("affiliated transactions"). Mergers of affiliated funds involve the purchase or sale of fund assets from or to an affiliated person and thus are prohibited by section 17(a). After issuing numerous exemptive orders under the statute, the SEC adopted rule 17a-8 in 1980 to permit mergers between funds if they are affiliated solely by reason of having common investment advisers, officers, and/or directors. In adopting rule 17a-8, the SEC concluded that investors in affiliated funds merging under the rule would be protected because affiliates of the merging funds whose interests were limited to serving as adviser, director or officer of the merging funds would not have both the ability and the pecuniary incentive to affect the terms of the merger, and because compliance with the rule's conditions would preclude the types of abuses that occurred in connection with fund mergers before 1940.

The proposed amendments would (i) make the rule available to affiliated funds regardless of the source of affiliation, (ii) make the rule available for mergers involving certain types of unregistered entities, (iii) include in the rule certain factors that fund directors must consider, if relevant, in assessing mergers, and (iv) require that the merger be approved by the shareholders of each merging fund that will not survive the merger.

Mergers between registered investment companies. In its proposing release for the amendments to rule 17a-8, the SEC noted that it has issued many exemptive orders permitting affiliated fund mergers that were unable to take advantage of the rule because the funds were affiliated for reasons other than having a common adviser, director or officer. In many of these cases, an affiliate of the merging funds (often an investment adviser) held more than five percent of one or both merging funds, giving the affiliated party both the incentive (a substantial economic interest in the terms of the merger) and the means (influence that comes with being a large shareholder) to affect the terms of the merger for its own benefit. The SEC further noted that in each case, after reviewing the exemptive application, the SEC determined that the merger was fair and did not involve overreaching.

As a result, the SEC has proposed extend rule 17a-8 to permit mergers between registered funds regardless of the nature of the affiliation. In extending relief, the SEC noted that it would rely on the fund board (including independent directors) to scrutinize the merger, and would require the merger to be approved by the shareholders of any fund not surviving the merger. The SEC also would add a provision to rule 17a-8 designed to prevent the use of the rule to circumvent the prohibitions against affiliated transactions.

Board determinations. The SEC noted that rule 17a-8 require fund boards to review mergers of affiliated funds. Relief under rule 17a-8 is conditioned on a determination by the board (including a majority of independent directors) of each participating fund that the merger is in the best interests of the fund. In addition, a fund board must determine that the merger will not dilute the interests of the merging fund's shareholders.

The proposed amendments would require directors to consider the following factors in determining whether the merger is in the best interests of the fund:

  • direct or indirect federal income tax consequences of the merger to fund shareholders;
  • fees or expenses that will be borne directly or indirectly by the fund in connection with the merger;
  • effects of the merger on annual fund operating expenses and shareholder fees and services; and
  • changes in the investment objectives, restrictions, and policies after the merger.

The SEC warned that its examinations staff, in the course of its periodic and other reviews of fund compliance, would review the board's analysis of the specific factors included in rule 17a-8.

Shareholder voting. The SEC noted that because many funds are organized or reorganized as business trusts, which may not be required to receive shareholder approval before being acquired by another fund, it is proposing to amend the rule to require that shareholders of acquired funds have an opportunity to vote on affiliated mergers. The SEC stated that while a fund's board of directors is well-equipped to assess a merger, individual shareholders are best able to gauge the impact of the merger in light of their personal circumstances.

Echo voting. The SEC noted that an affiliate of one fund could have the ability to affect the terms of the merger if it held a large position in the acquired fund. The SEC has proposed to require that if an owner of more than five percent of the shares ("owner affiliate") of the acquired fund is itself another merging fund, or an investment adviser, principal underwriter, or owner affiliate of another merging fund ("related shareholder"), the related shareholder must vote its shares in the same proportion as non-related shareholders ("echo voting").

The SEC also has proposed two exceptions to the echo voting requirement. First, a related shareholder's securities could be voted in accordance with instructions received from the beneficial owner of the securities, provided that the beneficial owner is not also a related shareholder. Second, a related shareholder's securities could be voted in accordance with instructions received from a person appointed to provide guidance on the voting of securities by a fiduciary of a plan under the Employee Retirement Income Security Act.

Recordkeeping. The SEC has proposed, as a condition of rule 17a-8, that the acquiring fund preserve written records that document the merger and its terms. The records would include, among other things, the minute books setting forth the board's determinations and the bases for those determinations, any supporting documents provided to the directors in connection with the merger, the independent evaluator's report in the case of a merger with an unregistered entity, and documentation of the prices at which securities were transferred in the merger.

Mergers of registered investment companies and certain unregistered entities. The SEC has also proposed to amend rule 17a-8 to exempt mergers of funds with bank common trust funds or bank collective trust funds as long as the survivor of the merger is a registered investment company. Currently, rule 17a-8 is available for mergers involving only registered investment companies or series thereof.

Funds merging with affiliated common and collective trust funds under the proposed amendments to rule 17a-8 would also have to comply with a special pricing condition. When two funds merge, each board, as part of its determination that the interests of existing shareholders will not be diluted, usually conclude that the merger is occurring on the basis of the relative NAVs of the merging funds. The proposed rule would require that the board of directors of any fund that is merging with an affiliated unregistered entity approve procedures for the valuation of the unregistered entity's assets. These procedures, among other things, must provide for the preparation of a report by an independent evaluator that sets forth the current fair market value (as of the date of the merger) of each asset that will be transferred by the unregistered entity to the fund in the merger.

Prohibition of reliance on rule 17a-8 for certain transactions. Finally, the SEC proposed to make the rule's exemptive relief available only for mergers that are not part of a plan or scheme to evade the affiliated transaction prohibitions of section 17(a) of the Act. Comments on the proposed amendments are due to the SEC by January 18, 2002. SEC Release No. 25259 .

 
 



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 chairman reviews upcoming SEC initiatives

November 9, 2001 2:16 PM

At a recent conference on securities regulation, SEC chairman Harvey Pitt reviewed the SEC’s calendar of upcoming initiatives. Mr. Pitt commented that the SEC will take a “fresh look” at recent guidance on the use of the internet in securities offerings. In particular, he noted that the review will cover the SEC’s 1995, 1996 and 2000 interpretive releases on electronic communications. Mr. Pitt noted that the audience could preview the SEC’s intended direction by reviewing its recent decision to declare effective the registration statement of an all-electronic, variable annuity separate account product. Mr. Pitt noted that the other initiatives on the SEC’s agenda include:

  • Moving toward “real-time enforcement” by quickly identifying potential securities law violations and taking immediate action to undo any damage to investors. He noted that the SEC is looking at “creative ways” to segment cases to permit public identification of wrongdoing while simultaneously providing interim relief before assets are dissipated.
  • Encouraging self-reporting, self-correction and self-remediation by entities regulated by the SEC.
  • Stamping out recidivism by imposing significant sanctions and aggressively seeking criminal prosecutions for multiple violations of the law.
  • Supplementing and improving the existing disclosure system for SEC registrants by moving towards a system of "current disclosure" and plain-English financial statements. Mr. Pitt noted that “current disclosure” would require registrants to update disclosure immediately for information of “unquestionable significance” rather than update on a fixed periodic basis whether or not material changes have occurred. He also noted that he would encourage simplifying financial statements by converting them into simple and precise English. Mr. Pitt encouraged increased use of technology to help further these initiatives. For example, he noted that one could provide a site with a simplified, summarized, plain-English disclosure and then hyperlink those disclosures to more detailed disclosures.

 

 
 



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 issues concept release regarding exchange-traded funds ("ETFs")

November 8, 2001 2:43 PM

On November 8, 2001, the SEC issued a concept release on ETFs. Calling them "one of the notable developments in the area of investment management over the past few years," the SEC noted the current assets held by ETFs to be approximately $66 billion. ETFs are investment companies that are registered under the 1940 Act as open-end funds or UITs. ETFs possess characteristics of traditional open-end funds and UITs, which issue redeemable shares, and of closed-end funds, which generally issue shares that trade at negotiated prices on national securities exchanges and are not redeemable. The SEC noted that all existing ETFs traded in the United States are based on specific domestic and foreign market indices. An "index-based ETF" seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.

Because of their unique operations, index-based ETFs first must apply to the SEC to obtain exemptive relief from certain provisions of the 1940 Act. An actively managed ETF also would be required to obtain exemptive relief from the Act. Like existing ETFs, an actively managed ETF would be registered under the 1940 Act (as an open-end fund rather than a UIT, because a UIT cannot be managed) and would issue and redeem its shares only in large aggregation "units" of ETF shares. The ETF would list its shares on a national securities exchange, and investors would trade the ETF shares throughout the day at market prices in the secondary market.

The SEC noted increasing interest in actively managed ETFs. The SEC commented that before it can grant the exemptions necessary to permit the introduction of actively managed ETFs, it must conclude that the exemptions are in the public interest and consistent with the protection of investors and the purposes of the 1940 Act. The SEC noted that it has issued this release to seek comment from the public regarding actively managed ETFs. Specifically, the SEC seeks comments on the following broad issues:

  • How are actively managed ETFs likely to be structured, managed and operated?
  • How will investors use, and benefit from, actively managed ETFs?
  • Would the exemptive relief that the SEC has granted to index-based ETFs be appropriate for actively managed ETFs?
  • Are there any new regulatory concerns that might arise in connection with actively managed ETFs?

The SEC also seeks comments on the following specific areas:

Index-based ETFs vs. actively managed ETFs. For purposes of this release, the SEC assumed that any ETF that would not seek to track the performance of a market index by either replicating or sampling the index securities in its portfolio would be an actively managed ETF. Actively managed ETFs also would include any ETF that, although it may be using a market index as a benchmark for measuring its performance, pursues an investment objective that is not tied to the index. The SEC seeks comment on whether this distinction is an appropriate method of distinguishing between index-based and actively-managed ETFs.

Operational issues relating to actively managed ETFs. The unique structure of an ETF - in which investors can buy and redeem aggregation units at NAV, and can sell and purchase individual ETF shares in the secondary market at market price - is designed, among other things, to ensure arbitrage opportunities that would reduce any deviations between the NAV and the market price of ETF shares. The expectation that the market price of ETF shares would track NAV (and the performance of an index) is important to many of the uses of ETF shares as index-based securities. An ETF also is thought to offer advantages over a closed-end fund structure in which discounts from NAV are common.

The SEC requests comment on whether it is important that ETFs be designed to enable arbitrage and thereby minimize the probability that ETF shares will trade at a large premium or discount. The SEC also requests comment on whether it should be concerned if ETF shares trade at a significant premium or discount.

The SEC also requests comments on two factors it feels may contribute significantly to the effectiveness of arbitrage in the ETF structure: the transparency of an ETF's portfolio and the liquidity of the securities in the ETF's portfolio.

With regard to the transparency of an ETF's portfolio, the SEC is interested in comments about:

  • The level of transparency in portfolio holdings necessary to allow for effective arbitrage activity in the shares of an actively managed ETF;
  • Whether an actively managed ETF should be required to disclose the full contents of its portfolio;
  • Whether it is sufficient for an actively managed ETF to disclose only a sample of its portfolio or the general characteristics of its portfolio;
  • How frequently the investment adviser of an actively managed ETF would need to disclose the portfolio securities or characteristics of the ETF portfolio; and
  • Whether frequent disclosure of portfolio holdings lead to "front running" of the ETF portfolio, or "free riding," where other investors would mirror the investment strategies of an actively managed ETF while the ETF investors pay the advisory fees.

With regard to the liquidity of an ETF's portfolio, the SEC is interested in comments about the following:

  • Whether actively managed ETFs should be limited to certain investment objectives or policies that are designed to ensure that the portfolio securities are sufficiently liquid to permit effective arbitrage;
  • Whether an actively managed ETF should be permitted to invest in securities other than equity securities; and
  • Whether an actively managed ETF should be permitted to invest in any illiquid securities or securities that are not registered under section 12 of the Securities Exchange Act of 1934.

Other Operational Issues. The SEC also requests comment on other issues that could cause an actively managed ETF to operate differently than an index-based ETF. Such issues include clearance and settlement procedures and possible deviations between the market price of shares.

Uses, Benefits and Risks of Actively Managed ETFs. The SEC noted that in granting exemptions under section 6(c), it must find that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the 1940 Act. As a result, the SEC has requested comment on the principal uses of actively managed ETFs by investors, ways in which investors may use actively managed ETFs and the benefits that actively managed ETFs may be expected to bring.

Exemptive relief for actively managed ETFs. The SEC seeks comment on the exemptive relief from the 1940 Act ETFs routinely request. ETFs request relief from the following provisions of the 1940 Act:

  • Section 5(a)(1) to limit redemptions of shares to large aggregation units
  • Section 22(d) for ETF shares to trade at negotiated prices
  • Section 17(a) for in-kind transactions between an ETF and certain affiliates
  • Section 22(e) to permit certain ETFs to redeem shares in more than seven days

Potential New Regulatory Issues 

In evaluating any specific proposal for an actively managed ETF, the SEC will consider whether the proposal presents any new regulatory concerns. As a result, the SEC has requested public comment on the following potential new regulatory issues:

Potential discrimination among shareholders. The SEC commented that section 1(b)(3) of the 1940 Act states that the public interest and the interest of investors are adversely affected when investment companies issue securities containing inequitable or discriminatory provisions. The SEC noted that one potential difference between the existing ETFs and an actively managed ETF is that, in the latter case, significant deviations could develop between the market price and the NAV of the ETF shares. The SEC requests comment on whether investors with sufficient financial resources to purchase aggregation units would be in a different position than retail investors who buy and sell ETF shares at market price.

Potential conflicts of interest for an ETF's investment adviser. The SEC stated that section 1(b)(2) of the 1940 Act states that the public interest and the interest of investors are adversely affected when investment companies are organized, operated, managed, or their portfolio securities are selected, in the interest of persons other than shareholders, including directors, officers, investment advisers, or other affiliated persons, and underwriters, brokers, or dealers. The operation of an ETF may lend itself to certain conflicts for the ETF's investment adviser, who has discretion to specify the securities included in the baskets. The SEC noted that while an index ETF would not raise as many of these issues, the same would not appear to be the case for an actively managed ETF. The increased investment discretion of the adviser to an actively managed ETF would seem to increase the potential for conflicts of interest.

Prospectus delivery in connection with secondary market purchases. Open-end funds and UITs are required to deliver a prospectus in connection with a sale of their shares. Specifically, section 24(d) of the 1940 Act provides, in relevant part, that the prospectus delivery exemption provided to dealer transactions by section 4(3) of the Securities Act of 1933 does not apply to any transaction in a redeemable security issued by an open-end fund or UIT. For transactions in ETF shares in the secondary market, the Commission has granted exemptions under section 6(c) of the Act from section 24(d) to permit dealers selling shares of certain ETFs to rely on the prospectus delivery exemption provided by section 4(3) of the Securities Act.

The SEC noted that ETFs also have agreed that dealers selling their shares will provide investors with a "product description" describing the ETF and its shares. The product description contains information about the ETF shares that is tailored to meet the needs of investors purchasing the shares in the secondary market. The product description provides a plain English description of the salient features of the ETF shares, including the fact that the shares are index-based securities and the manner in which the ETF shares trade on the secondary market. The product description also discloses that the ETF shares are not redeemable individually, and that an investor selling the shares in the secondary market may receive less than the NAV of the ETF shares. The SEC requests comment on whether relief from prospectus delivery requirements would be consistent with the public interest and the protection of investors.

The concept of an actively managed ETF as a class of a multiple class, open-end fund. The SEC noted that an open-end fund may establish a multiple class arrangement generally to offer investors a choice of methods for paying distribution costs or to allow the fund to use alternative distribution channels more efficiently. A multiple class arrangement requires an exemption from sections 18(f)(1) and 18(i) of the 1940 Act. Rule 18f-3 under the 1940 Act provides establishes a framework governing the multiple class arrangements of open-end funds. Rule 18f-3 addresses issues that may create various conflicts among the different classes of shares of a fund. One requirement of rule 18f-3 is that, other than certain differences allowed by the rule, each class must have the same rights and obligations as each other class.

The SEC noted that it had previously issued an order to permit certain existing index funds to create a class of shares ("ETF class") that would be listed on a national securities exchange and traded in the secondary market at negotiated prices in the same manner as shares of ETFs. The SEC seeks comments whether actively managed mutual fund would seek to introduce exchange-traded classes. The SEC also seeks comment on whether ETF classes of actively managed funds present any issues with respect to exemptions from section 18 that do not exist with respect to ETF classes of index funds. Comments on the concept release are due to the SEC no later than January 14, 2002. SEC Release No. IC-25258.

 
 



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 warns SEC-regulated entities to expect questions regarding Regulation S-P compliance as part of routine inspections

November 5, 2001 3:00 PM

Gene Gohlke, associate director of the SEC's Office of Compliance Inspections and Examinations ("OCIE"), recently spoke at an industry panel regarding current OCIE inspection priorities. Mr. Gohlke commented that SEC-regulated entities such as brokers, dealers, investment companies, registered investment advisers and registered transfer agents should be prepared to be inspected by OCIE staff for compliance with Regulation S-P. He noted that Regulation S-P requires SEC-regulated entities to disclose to individuals their policies concerning the protection of personal information, including the method by which an individual can "opt out" of the transmission of personal information to unaffiliated parties. Regulation S-P also requires SEC-regulated entities to establish procedures to protect the security, confidentiality and integrity of customer records and information.

Mr. Gohlke warned that on a recent inspection, OCIE staff found that one firm had a server outside the firm's firewall. The firm used the server "extensively" for e-mail to communicate with the firm's clients. OCIE staff noted that because the server was outside the firm's firewall, the server was susceptible to hackers and thus, client personal information was accorded "no privacy." Mr. Gohlke cited this as an example of a violation of Regulation S-P. Securities Regulation & Law Report, Vol. 33, No. 43, November 5, 2001.

 
 



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's Division of Investment Management (the "Division") releases responses to frequently asked questions regarding after-tax return requirements

November 5, 2001 2:53 PM

On November 5, 2001, the staff of the Division released a set of responses to frequently asked questions about the new rules regarding the presentation of after-tax returns (the "FAQ"). Amendments to Form N-1A require mutual funds to disclose in their prospectuses after-tax returns based on standardized formulas comparable to the formula currently used to calculate before-tax average annual total returns. In its preface to the FAQ, the Division noted that many of the questions it has received involve the tax treatment of distributions, redemptions, and other events that must be considered in calculating after-tax returns. The Division further noted that the responses to these questions generally follow the applicable federal tax law.

In the FAQ, the Division provides guidance on the following subjects:

Tax rates. The FAQ provides a chart which specifies (1) the applicable federal individual income tax rates for calculating after-tax returns for the years 1985 through 2001 and (2) the applicable federal corporate tax rates for calculating the impact of undistributed capital gains on after-tax returns for the years 1985 through 2001. The Division directed questions about which rate should be used to Instruction 4 to Item 21(b)(2) of Form N-1A and Instruction 4 to Item 21(b)(3) of Form N-1A. The Division noted that these instructions require taxes due on distributions to be calculated using the "highest individual marginal federal income tax rates." The Division also noted that Instruction 7(d) to Item 21(b)(3) of Form N-1A provides that capital gains taxes upon redemption are to be calculated using the "highest federal individual capital gains tax rate for gains of the appropriate character."

Capital gains and losses, reinvested dividends and cost basis. The FAQ addresses the application of capital gain and loss netting rules in computing return after taxes on distributions and redemption of fund shares; the method of adjustment to tax status of prior distributions and cost basis of shares where a fund distributes a non-taxable return of capital; calculating the effect of taxes for dividends declared daily but paid monthly; the cost basis of shares acquired with reinvested dividends; and the treatment of capital gains if a fund retains them rather than distributes them as a dividend. The FAQ also clarifies the application of Internal Revenue Code Section 852(b)(4) to the computation of after-tax returns.

The FAQ also addresses the after-tax impact of foreign tax credits, the treatment of redemption fees and contingent deferred sales loads in calculating after-tax returns, the acceptable sources of data in calculating historical tax characterizations of distributions and related tax adjustments. Finally, the FAQ clarifies that a fund is not required to include the new after-tax return disclosure in its prospectus until it files its first annual update on or after February 15, 2002. The Division further clarified that merely including after-tax returns in advertisements and sales materials used on or after December 1, 2001 (the compliance date for after-tax return advertisements and sales materials) does not require a fund to immediately revise the risk/return summary of its prospectus to include the new after-tax return disclosure.

 
 



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.

Compliance Reminder

November 5, 2001 2:51 PM

On January 2, 2001, the SEC released its final rules regarding independent directors of investment companies. All new registration statements and post-effective amendments that are annual updates to effective registration statements, proxy statements for the election of directors and reports to shareholders filed on or after January 31, 2002 must comply with the disclosure amendments in the final rules. Firms that have not done so already should begin revising their standard directors and officers questionnaires to elicit information designed to meet the new disclosure requirements.

If you have any questions regarding these requirements or about revising your firm's directors and officers questionnaire, please contact David C. Phelan at (617) 526-6371 or Michelle H. Rhee at (617) 526-6064.

 
 



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 director of Division of Investment Management comments on issues affecting disaster recovery and insurance products

November 2, 2001 2:22 PM

In remarks delivered at an October conference, Paul Roye, director of the Division of Investment Management, discussed various issues affecting disaster recovery and insurance products. Mr. Roye stressed that the events of September 11 highlight the need for the investment management industry to review contingency planning and emergency procedures. Mr. Roye noted that this review should include re-examination of a firm’s fair valuation policies and use of pricing services, including back-up or secondary pricing services. Mr. Roye also urged attendees to consider whether their firms have contingency plans in the event that the firm’s building is inaccessible. He recommended that the contingency plan should include consideration of whether the firm has effective offsite backup of essential records, satellite office facilities or effective procedures enabling employees to work from home.

Mr. Roye also reviewed several regulatory issues affecting the insurance products area. Mr. Roye commented on the SEC’s continuing review of the appropriateness of selected sales practices including exchanges into “bonus annuities” which come with longer surrender periods and higher surrender and asset-based charges. He noted that the SEC continues to question whether these products are in the best interest of contractholders.

Mr. Roye also commented on recent developments regarding the regulatory burden in certain cases under section 26(c) of the 1940 Act. Section 26(c) requires SEC approval of investment substitutions by unit investment trusts. Mr. Roye noted that Congress adopted section 26(c) to enable large UIT shareholders to substitute unsatisfactory investments without costly redemptions and/or reinvestments. He also noted that, in reviewing substitution applications, the SEC attempts to determine the overall impact of the substitution on contract owners. Mr. Roye commented that the SEC scrutinizes expense ratios, the investment objectives and policies of the substitute and replaced funds and the existence and nature of any affiliation between the insurance company and the affected funds. He further commented that the SEC particularly focuses on whether the new substitute fund has higher investment advisory or rule 12b-1 fees that, absent a substitution, could not be imposed without a shareholder vote.

Mr. Roye noted that the SEC has eased certain regulatory burdens under section 26(c). He cited a recent no-action letter which permitted an insurance company to transfer funds received from the liquidation of an unaffiliated underlying fund to a money market subaccount without obtaining a section 26(c) order. Mr. Roye noted that the liquidation had been approved by the underlying fund’s board of directors because the fund lacked the potential for growth and was experiencing increasing expenses. Mr. Roye further noted that there was no affiliation between the insurance company and the funds involved in the transactions, which suggested to the staff that the transaction was not undertaken to enrich the insurance company or the funds’ affiliates to the detriment of contract owners. Mr. Roye also noted that the insurance company sent notices to the contract owners giving them an opportunity to select an alternative investment.

Mr. Roye also commented on the increasing use of subadvisers in insurance products. He directed the attendees’ attention to a recent administrative proceedings against a fund’s investment adviser and subadviser. The portfolio manager of the subadviser had defrauded a mutual fund and an offshore fund by concealing from the funds and the investment adviser that issuers of portfolio securities held by the funds were suffering financial problems. The portfolio manager then inflated the value of the troubled securities and caused one of the funds to materially overstate its net asset value. (See Industry News Summary for the Week of 09/24/01 to 10/01/01). Mr. Roye noted that the SEC has “repeatedly emphasized” the duty to supervise and has sanctioned advisers that did not establish and implement procedures reasonably designed to prevent and detect violations of the federal securities laws. SEC Today, November 2, 2001.

 
 



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.