On May 6, 2004, the IRS issued Revenue Procedure 2004-28, which describes conditions under which a RIC may treat its investment in a repurchase agreement as a Government security for purposes of RIC asset diversification test in Section 851(b)(3) of the Internal Revenue Code. The revenue procedure applies to repurchase agreements that, within the meaning of Rule 5b-3(c)(1) under the 1940 Act, are “Collateralized Fully” with securities that qualify as Government securities for purposes of Section 851(b)(3). A RIC that has invested in a repurchase agreement to which this revenue procedure applies may treat its position in that repurchase agreement as a Government security for purposes of Section 851(b)(3) even if the taxpayer is not treated as the owner of the underlying securities for federal tax purposes. This revenue procedure is effective for repurchase agreements held by a RIC on or after August 15, 2001.

http://www.treas.gov/press/releases/reports/js1517_reporevproc200428.pdf

In a letter dated April 30, 2004, the ICI requested that the following items concerning RICs be included on the 2004-2005 IRS/Treasury Guidance Priority List (the “2004-2005 business plan”).

1. Continuity of Business Enterprise Requirements. The ICI requested that the 2004-2005 business plan include a new project clarifying the application of the “business continuity” requirement to RICs under Section 368 of the Internal Revenue Code and Treas. Reg. § 1.368-1(d)(2). The ICI’s letter stated that this clarification is necessary because it is difficult to ascertain the intended scope of the business continuity test as applied to RICs under existing guidance. As a result, many RICs engaging in merger transactions must rely on the “asset continuity” test, which can limit a portfolio manager’s ability to dispose of portfolio securities acquired from a target RIC and place significant compliance burdens on funds. In addition, the ICI letter stated that the existing guidance relating to RICs on the business continuity test may be inconsistent with more recent merger guidance in other contexts.
   
2. Ownership Tracking Requirements. The ICI requested that amendments be made to the regulations under Sections 382 and 383 of the Internal Revenue Code with respect to ownership tracking requirements that apply to participant-directed retirement accounts holding RIC shares. The requested amendments would permit a RIC to look through the participant-directed retirement accounts and treat each participant who holds less than 5% of the RIC’s shares as part of the RIC’s direct public group. This change could prevent a large collection of small investors making independent investment decisions from being treated as a single entity for ownership change purposes.
   
3. Redemption Fees. The ICI requested clarification that redemption fees paid by a RIC’s shareholders to the RIC through a reduction in redemption proceeds are not income to the RIC. The ICI believes that clarifying guidance is necessary because redemption fees are becoming more prevalent in the RIC industry and may soon be required for most funds under proposed SEC rules.
   
4. PFIC Mark-to-Market Regulations. The ICI’s letter pointed out that the final PFIC mark-to-market regulations (TD 9123) published on April 29, 2004 note that comments received relating to the impact of the PFIC rules on RICs were beyond the scope of the regulations project. The ICI suggested that a regulations project be opened to address those issues.
   
5. Severely Distressed Debt and Speculative Debt. The ICI suggested that the business plan include guidance on the tax treatment of severely distressed debt and speculative debt. The letter noted that in some cases it is unclear how the original issue discount and market discount rules should apply to these types of debt and, in other cases, application of these rules may create inappropriate results.
   
6. Investment by a RIC in Another RIC. The ICI requested guidance allowing a RIC to look through an underlying RIC in determining whether the upper-level RIC satisfies the requirements to pay exempt-interest dividends or to pass-through foreign tax credits.

In addition to these new projects, the ICI requested prompt guidance on projects concerning RICs that were included on the 2003-2004 business plan but that have not yet been issued or finalized.

ICI Memorandum No. 17459 (May 4, 2004); ICI Letter to U.S. Department of the Treasury and Internal Revenue Service (April 30, 2004).

On April 7, 2004, the Securities Exchange Commission (“SEC”) approved the new NASD rules regarding emergency preparedness, which require NASD members to establish and maintain a business continuity plan and to provide NASD with certain emergency contact information. The requirements of the new rules are summarized below.

Business Continuity Plans (NASD Rule 3510)

Rule 3510 requires each NASD member to create and maintain a written business continuity plan establishing procedures to be followed in the event of an emergency or significant business disruption. The procedures must be reasonably designed to enable the member to meet its existing obligations to customers and must address the member’s existing relationships with other broker-dealers and counter-parties. The business continuity plan must be made available to NASD staff promptly upon request.

An NASD member must update its business continuity plan in the event of a material change in its operations, structure, business or location. In addition, each member must review its plan annually to determine whether any modifications are necessary in light of changes to its operations, structure, business or location.

A business continuity plan must, at a minimum, address the following:

• Data back-up and recovery (hard copy and electronic);
  
• All mission critical systems;
  
• “Financial and operating assessments” (as defined in the rule);
  
• Alternate communications between customers and the member;
  
• Alternate communications between the member and its employees;
  
• Alternate physical location of employees;
  
• Critical business constituent, bank, and counter-party impact;
  
• Regulatory reporting;
  
• Communications with regulators; and
  
• How the member will assure customers’ prompt access to their funds and securities in the event that the member determines that it is unable to continue its business.

While a plan need not address any of the above categories that is not applicable, the plan must document the rationale for not including the category. If a member relies on another entity for any one of the categories or any “mission critical system” (as defined in the rule), its plan must address that relationship.

Each member is required to designate a member of senior management who is also a registered principal to approve the plan and to be responsible for conducting the annual review. A member must also disclose to its customers how its plan addresses the possibility of a future significant business disruption and how the member plans to respond to events of varying scope. This disclosure must be made in writing to customers upon account opening, posted on the member’s web site, and mailed to customers upon request.

Emergency Contact Information (NASD Rule 3520)

Each NASD member must report to NASD certain emergency contact information, including designation of two emergency contact persons. The emergency contact persons must be members of senior management and registered principals. A member must promptly update its emergency contact information in the event of any material change and must review and, if necessary, update its information within 17 business days after the end of each calendar quarter. This review and any update can only be conducted by the member’s Executive Representative or his or her designee. Members are required to have adequate controls and procedures to ensure that only the Executive Representative or designee may perform the review and update.

Rule 3510 will become effective for clearing firms on August 11, 2004 and for introducing firms on September 10, 2004. Rule 3520 will become effective for all firms on June 14, 2004.

NASD Notice to Members, 04-37 (May 2004); SEC Release No. 34-49537, File Nos. SR-NASD-2002-108 and SR-NYSE-2002-35.

On April 28, 2004, DOL proposed amendments to Part II of PTE 75-1. PTE 75-1 is a class exemption that permits the purchase or sale of a security in a principal transaction between an employee benefit plan and a broker-dealer, reporting dealer, or a bank. The proposed amendments would clarify the exemption for purchases or sales of mutual fund securities currently in PTE 75-1, Part II(d) by repositioning the exemption provision in a new paragraph (2). The language of the provision would also be amended to clarify the exemption’s scope. While the original language states that the exemption is not available if “a fiduciary with respect to the plan” is “a principal underwriter for, or affiliated with, such investment company,” the proposed language would clarify that this limitation applies only to a “fiduciary with respect to the plan who makes the decision on behalf of the plan to enter into the transaction.”

Written comments and requests for a public hearing must be received by DOL on or before June 14, 2004. DOL’s notice of the proposed amendments is available at www.dol.gov/ebsa/regs/fedreg/notices/2004009632.htm.

In a letter to the SEC dated April 26, 2004, the ICI comments on proposed rule and form amendments that would require a fund to provide disclosure in its shareholder reports regarding the reasons for the board’s approval of an investment advisory contract.

In its letter, the ICI responds to the SEC proposal’s possible implication that fund fees are excessive by pointing to studies showing that the overall cost of investing in mutual funds has declined over time, and that assets and new investments are concentrated in lower cost funds. In addition, the letter discusses evidence against the claim cited in the proposing release that pension fund advisory fees are substantially lower than mutual fund advisory fees.

The ICI also makes the following recommendations on the proposed amendments:

Compliance with Disclosure Obligation

Although the letter supports requiring funds to provide sufficient disclosure on the board’s basis for its approval of advisory contracts, it urges the SEC to consider the need to balance the desire to maximize transparency against (1) the need to avoid overwhelming investors with excessively detailed and voluminous disclosure and (2) the need to support directors’ continued candid and rigorous execution of their contract review responsibilities. The letter states that the adopting release should clarify that directors are not required to reach, and funds are not required to disclose, a conclusion regarding each factor considered by the board in its evaluation of an advisory contract. It also requests that the SEC eliminate from the final rule the proposed requirement that funds disclose whether boards relied on comparisons of the services to be rendered and the amounts to be paid under the advisory contract with those of contracts with pension funds and institutional clients. The letter further recommends that the SEC remove from the proposal references to the board’s “selection” of the investment adviser to avoid confusion and misconceptions regarding the board’s role.

Location of Disclosure

The letter recommends that summary information about the basis for the board’s approval of the investment advisory contract be provided in fund prospectuses with a cross reference to more detailed disclosure in the statement of additional information. This would replace the proposed requirement that detailed disclosure be provided in shareholder reports.

Disclosure Regarding Board Approval of Subadvisory Contracts

The letter recommends that the SEC require more streamlined disclosure in the context of board approval of contracts with unaffiliated subadvisers, such as disclosure that explains the basis for board approval of such subadvisory contracts on an aggregate basis.

Transition Period

The letter recommends requiring compliance with the new requirements in disclosure documents filed with the SEC following a twelve-month transition period.
ICI Memorandum No. 17425 (April 27, 2004); ICI Comment Letter (April 26, 2004).

On March 19, 2004, the NASD submitted to the SEC, on behalf of the Task Force, a status report detailing the progress that has been made toward implementing the recommendations set forth in a July 2003 Task Force report (See Industry News Summary dated April 16, 2004 and for weeks 7/7/03 to 7/28/03). Among other things, the status report notes that the recommendation to develop common definitional terms among members of the working group of the Task Force was expected to be completed by the end of April 2004. On April 28, 2004, the ICI announced that a working group completed such common definitional standards to define breakpoint opportunities. The Task Force’s final list of common definitional standards includes both (1) recommended terms and (2) terms that the Task Force recommends that members not use in describing breakpoint opportunities.

The ICI urges mutual fund members that offer breakpoint discounts to review their prospectuses and statements of additional information and make any necessary revisions as soon as reasonably practicable to ensure that language used to define breakpoint eligibility conforms to the common definitional standards. The ICI also urges funds that produce communications relating to breakpoints for broker-dealers or their customers to use the approved terms in such materials as appropriate.

ICI Memorandum No. 17438 (April 28, 2004); NASD Status Report, Implementation of Recommendations of Joint NASD/Industry Task Force (March 19, 2004), available at www.nasdr.com/breakpoints_status.asp.

As reported initially in last week’s Industry News Summary, the SEC proposed new rules under the Investment Advisers Act of 1940 (the “Advisers Act”) that would except thrifts providing investment advice solely as part of certain trust department fiduciary services and clarifying the scope of the Advisers Act’s application to thrifts that are already registered as investment advisers. In addition, the SEC proposed a new rule that would exempt thrift institutions’ collective trust funds from the registration and reporting requirements of the Securities Exchange Act of 1934 (the “Exchange Act”). The proposed new rules would also effect minor changes to Form ADV.

Certain Thrift Institutions Not Investment Advisers

1. Fiduciary Purpose. The proposed rules would establish an exception from the Advisers Act for a thrift institution that:

• performs advisory services solely in its capacity as trustee, executor, administrator, or guardian for trusts, estates, guardianships and other accounts created and maintained for a “fiduciary purpose”; and
• does not hold itself out generally to the public as providing investment advisory services (except in connection with the ordinary advertising of its services as trustee, executor, administrator, or guardian for these fiduciary accounts).

To meet the “fiduciary purpose” requirement, the customer account must be established and maintained for a reason other than money management. Thus, “fiduciary purpose accounts” would include those established in connection with estate planning, conservatorships and guardianships, and those established for minors under the Uniform Gifts to Minors Act (“UGMA”). Accounts established primarily for money management, custodial or administrative purposes, e.g., managed agency accounts, individual retirement account (IRA) trusts, indenture trusts, college savings trusts, Employee Retirement Income Security Act (“ERISA”) trusts, “rabbi” trusts, and most revocable inter-vivos trusts, would not be included within this exception.

2. Collective Trust Funds. In addition, the proposed rules would establish an exception from the Advisers Act for thrift institutions’ provision of investment advisory services to collective trust funds excepted from the definition of “investment company” under section 3(c)(11) of the Investment Company Act of 1940. The proposed rule would also except a thrift from the Advisers Act with respect to accounts invested solely in one or more of the thrift’s sponsored collective trust funds.

This proposed exception would be available to savings associations that have deposits insured by the Federal Deposit Insurance Corporation (the “FDIC”). These institutions include federal savings associations, federal savings banks, and state-chartered savings associations.

Clarification of Scope of the Advisers Act

The proposed rules would clarify that the Advisers Act does not apply to all the customer relationships of a registered thrift that is required to maintain its registration as an investment adviser because of the scope of its advisory business or marketing activities. Under the proposed rule, so long as the thrift confirms that it will provide the SEC with access to all of its trust department records, the Advisers Act would apply to the thrift institution only with respect to those customer accounts that the require the thrift to be subject to the Advisers Act. Section 204 of the Advisers Act already subjects to examination by SEC representatives all records of any investment adviser, including a thrift institution that provides advisory services.

Exemption under Exchange Act

The Proposed new rules would exempt thrift-sponsored collective trust funds from the registration and reporting requirements of the Exchange Act.

Amendment to Form ADV

Proposed minor amendments to Form ADV and its instructions would be made to identify registered investment advisers that are thrift institutions and to ask whether the adviser is actively engaged in business as a thrift institution.

SEC Release Nos. 34-49639, IA-2232.