Pending Mutual Funds Legislation

The SEC has settled an administrative proceeding brought against an investment adviser (the “Adviser”) for violations of Sections 206(2) and 207 of the Investment Advisers Act of 1940 (the “Advisers Act”). The SEC alleged that the adviser had failed to disclose to its referred clients that (i) the Adviser faced a potential conflict of interest in receiving referrals from registered representatives ("RRs") of full service broker-dealers, and (ii) other brokerage options were available where client transactions could be effected at lower commission rates. The SEC also alleged that the adviser had failed to review the direction and placement of brokerage transactions for its referred clients in light of its duty to seek to obtain best execution in an evolving market for custody and execution services.

Section 206(2) of the Advisers Act makes it unlawful for an adviser to engage in any transaction, practice or course of business that operates as a fraud or deceit upon any client or prospective client. The SEC noted that the existence of a conflict of interest is a material fact that an investment adviser must disclose to its clients because it "might incline an investment adviser -- consciously or unconsciously -- to render advice that was not disinterested." The SEC stated that it believes an adviser has a conflict of interest when it directs client brokerage to RRs who refer new clients to the adviser. The SEC also noted that any arrangement to direct brokerage in exchange for benefits to the adviser is material and must be disclosed in the adviser’s Form ADV.

In this case, the SEC alleged that the brokerage of the Adviser’s referred clients remained with the referring firms without disclosure by the Adviser of a potential conflict of interest or of other brokerage options, and these clients paid higher trading commissions. The SEC found that, during the period January 1, 1999 to June 30, 2000, clients referred by the RRs paid commissions of about $0.35 per share, while the Adviser’s other clients paid a "free" commission rate of $0.08 per share through a lower-cost bank clearing service. The SEC also found that those clients who paid the higher commission rates did not appear to receive any corresponding benefit such as better execution services. Further, the Adviser did not periodically and systematically review its brokerage arrangements and disclose to those clients that other brokerage arrangements which may have provided better execution were available.

The SEC also found that the Adviser generally did not ask all of its referred clients to make a decision about brokerage. The SEC stated that the fact that some of the Adviser’s clients would likely have approved of brokerage being directed to their referring RR's firm does not excuse the Adviser's failure to properly explain the conflict of interest that existed and the available brokerage options. The SEC found that the Adviser willfully violated Section 206(2) of the Advisers Act by failing to (i) seek to obtain best execution for its referral clients; (ii) disclose the potential conflict of interest it faced in receiving referrals from RRs who stood to benefit from providing custody and execution services; and (iii) disclose other available brokerage options to its referred clients.

Section 207 of the Advisers Act makes it unlawful for any person willfully to make any untrue statement of a material fact or omit to state any material fact required to be stated in a report filed with the SEC. The SEC found that the Adviser willfully violated Section 207 because (i) Adviser’s Form ADV filings from at least December 1998 until January 2002 failed to disclose the potential conflict of interest inherent in the receipt of referrals from RRs of full service broker-dealers who also provide custody and execution services; and (ii) the filings falsely disclosed that the Adviser would seek to obtain best execution in conducting trading activities when, in fact, it did not do so for many of its referral clients.The settlement order requires the Adviser to pay a civil penalty of $100,000 and to comply with certain undertakings including the maintaining of a director of compliance and the inclusion of necessary disclosure in its advisory contracts and Form ADV. The Adviser has also agreed to mail its revised Form ADV and advisory contract to all clients who utilize full service broker-dealers and to conduct periodic and systematic evaluations of its brokerage arrangements and the alternatives available to analyze whether best execution is being obtained for its clients. SEC Administrative Proceeding, File No. 3-11126 (May 15, 2003).  

The SEC has adopted what it terms as “technical” changes to SEC rules and forms implementing Section 302 of the Sarbanes-Oxley Act of 2002 for registered investment companies in order to conform to the changes that the SEC has adopted for operating companies. These changes result in an expanded Section 302 certification relating to the establishment and maintenance of internal control over financial reporting. In the same release, the SEC adopted rules implementing Section 404 of the Sarbanes-Oxley Act to require companies subject to the reporting requirements of the Securities Exchange Act of 1934, other than registered investment companies, to include in their annual reports a report of management on the company's internal control over financial reporting.

In the release, the SEC also provided guidance on the distinction between internal control over financial reporting and disclosure controls and procedures, and required registered investment companies to file their Section 906 certifications as an exhibit to Form N-CSR in accordance with the interim guidance provided earlier by the SEC.

Section 302 Certification. The SEC amended Rule 30a-3 under the 1940 Act and Item 10 of Form N-CSR to now require every registered management investment company to maintain internal control over financial reporting. The amendments use the same term "internal control over financial reporting" and definition that the SEC is using in the rules it has adopted for operating companies. Included below is the complete text of the fourth and fifth Sections 302 certifications showing the added requirements. The first, second and third Section 302 certifications were unaffected by these amendments.

The fourth and fifth certification under Section 302 now read as follows (new text is in bold and italics):

4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal half-year (the registrant's second fiscal half-year in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting;

5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

Disclosure Controls and Procedures vs. Internal Control over Financial Reporting. The SEC commented that there is substantial overlap between internal control over financial reporting and disclosure controls and procedures, but that many companies will design their disclosure controls and procedures so that they do not include all components of internal control over financial reporting. The SEC noted that it expects disclosure controls and procedures will include those components of internal control over financial reporting that provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles. However, the SEC added that in designing their disclosure controls and procedures, companies can be expected to make judgments regarding the processes on which they will rely to meet applicable requirements. In doing so, some companies might design their disclosure controls and procedures so that certain components of internal control over financial reporting, such as those pertaining to the accurate recording of transactions and dispositions of assets or to the safeguarding of assets, are not included.

Evaluation of Disclosure Controls and Procedures. The SEC noted in the release that it has not adopted proposed amendments that would have required the evaluation by an investment company's management of the effectiveness of its disclosure controls and procedures to be as of the end of the period covered by each report on Form N-CSR. Instead, such evaluation continues to be required within 90 days prior to the filing date of the report.

Compliance with new rules. Registered investment companies must comply with the rule and form amendments applicable to them on and after August 14, 2003, except as follows. Registered investment companies must comply with the amendments to Rule 30a-3 that require them to maintain internal control over financial reporting with respect to fiscal years ending on or after June 15, 2004. In addition, registered investment companies must comply with the portion of the introductory language in paragraph 4 of the Section 302 certification that refers to the certifying officers' responsibility for establishing and maintaining internal control over financial reporting, as well as paragraph 4(b) of the Section 302 certification, beginning with the first annual report filed on Form N-CSR for a fiscal year ending on or after June 15, 2004. SEC Release No. IC-26068 (June 5, 2003).

Richard H. Baker, Chairman of the House Capital Markets Subcommittee, introduced new mutual fund legislation on June 11, 2003 aimed at improving transparency for investors and strengthening mutual funds’ corporate governance standards. The Capital Markets Subcommittee held a hearing on the legislation on June 18, 2003.

Improve mutual fund disclosure. The Mutual Funds Integrity and Fee Transparency Act of 2003, H.R. 2420 (the “Bill”) would direct the SEC to issue rules requiring funds to provide investors with improved disclosure, in a document other than the prospectus or Statement of Additional Information, regarding the following:

• Estimated operating expenses, in dollar amounts, incurred by each shareholder;
• Portfolio transaction costs, in a way that will facilitate comparison among funds;
• How portfolio managers are compensated, in a way which will help fund shareholders evaluate the incentives that are provided to the portfolio managers;
• Policies and practices with respect to soft dollar arrangements;
• Directed brokerage arrangements used to obtain fund distribution; and
• Revenue sharing arrangements used to obtain fund distribution.

Chairman Baker commented that he believes by increasing the level of transparency the Bill will give investors access to value-added information with which to compare the costs of different funds and other financial products to help them make informed investment decisions.

Strengthen Board oversight. The Bill would also seek to strengthen the oversight by fund directors of soft-dollar and certain other distribution arrangements. The Bill would require fund investment advisers to submit an annual report to directors on directed brokerage, soft-dollar arrangements and revenue sharing. The Bill would establish a fiduciary duty on the part of the fund’s board of directors to supervise the adviser’s direction of the fund’s brokerage transactions and to determine that the direction of fund brokerage is in the best interests of fund shareholders. The Bill would also require the board to determine that any revenue sharing payments are consistent with the provisions of the Investment Company Act of 1940 (the “1940 Act”) in that they are not disguised payments from fund assets, and that such payments are in the best interest of the fund’s shareholders. In addition, the Bill would require the SEC to conduct a study of soft-dollar arrangements and consider the implications of repealing the safe harbor for them. Chairman Baker noted that he believes that increasing director scrutiny and responsibility regarding these arrangements will guard against the potential conflicts of interest they can create.

Enhance corporate governance. The Bill would also seek to enhance corporate governance and management integrity by establishing several new requirements for mutual funds:

• Requiring two-thirds of all mutual fund directors to be independent;
• Requiring the chairman of the board to be independent; and
• Strengthening the definition of an independent director by authorizing the SEC to issue rules to exclude from that definition persons with business or close family relationships with the fund company.

Audit Committee Requirements. The Bill would require all mutual funds to abide by the same audit committee standards required of exchange-listed companies under the Sarbanes-Oxley Act of 2002. These include requiring all audit committee members to be independent directors and requiring audit committees to establish procedures for (i) the receipt, retention, and treatment of complaints regarding accounting, internal controls, or auditing matters; and (ii) the confidential, anonymous submission by employees of the fund and its affiliated persons of concerns regarding accounting or auditing matters. The Bill would also require that audit committees have the authority to engage independent counsel and other advisers, as it determines necessary to carry out its duties. H.R. 2420, “Mutual Funds Integrity and Fee Transparency Act of 2003” (June 11, 2003).

On May 28, 2003, President Bush signed the Jobs & Growth Tax Relief Reconciliation Act of 2003 into law. The new law includes an estimated $330 billion in tax reductions and $20 billion in aid to the states over ten years, many of which are effective immediately. The new law impacts how mutual funds and their shareholders are taxed.

Summary of the Tax Law Changes for Mutual Funds

The following summary prepared by Hale and Dorr discusses the provisions of the new law that affect regulated investment companies (each a “RIC”) and their shareholders. If you have any questions or would like further information, please contact Roger Ritt or Amelia Bormann of the Hale and Dorr Tax Department.

General

For taxable years beginning after December 31, 2002, the maximum individual federal income tax rate is reduced from 38.6% to 35%.

Capital Gains

The maximum individual federal income tax rate on most long-term capital gains is reduced from 20% to 15% for sales or exchanges that are taken into account on or after May 6, 2003. This applies to individual shareholders who sell shares in a RIC on or after May 6, 2003, and to capital gain dividends received by individual shareholders from a RIC in respect of sales or exchanges of stock or securities by the RIC on or after May 6, 2003.

Dividends

• The maximum individual federal income tax rate on “qualified dividend income” is reduced to 15% for dividends received after December 31, 2002. This applies to individual shareholders of a RIC who receive dividends from the RIC attributable to “qualified dividend income” received by the RIC after December 31, 2002.
  
  
• If 95% or more of the RIC’s “gross income” (as specially defined) consists of “qualified dividend income”, then all dividends distributed by the RIC to individual shareholders (whether in the form of qualified dividends or capital gain dividends) will qualify for the 15% maximum rate. For this purpose, gross income from sales or other dispositions of stock or securities by the RIC includes only the excess of net short-term capital gain over net long-term capital loss.
  
  
• Dividends from qualified foreign corporations as well as domestic corporations are eligible for the maximum 15% rate on “qualified dividend income”. A qualified foreign corporation includes:
  
  
• A foreign corporation incorporated in a possession of the United States;
• A foreign corporation eligible for the benefits of certain comprehensive income tax treaties with the United States; and
• A foreign corporation if the stock with respect to which the dividends are paid is readily tradable on an established securities market in the United States. A corporation will be treated as having stock that is readily tradable on such a market if an American Depository Receipt (“ADR”) backed by such stock is so traded.

The following dividends do not qualify for the maximum 15% rate:

• Dividends from foreign personal holding companies, foreign investment companies and passive foreign investment companies (“PFICs”).
• Dividends on stock to the extent the RIC is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.
• Dividends on stock not held by the RIC for 60 days during the 120-day period beginning on the date 60 days before the ex-dividend date. In the case of preferred stock, the holding period is 90 days during the 180-day period beginning 90 days before the stock became ex-dividend. It is likely that an individual holder of RIC shares must also satisfy the holding period requirements with respect to the holder’s RIC shares. The holding period is reduced for any period in which a holder has diminished its risk of loss by holding one or more other positions with respect to substantially similar or related property.

Substitute payments received in lieu of dividends (such as in the case of lending securities) do not qualify for the maximum 15% rate.

Backup Withholding

• The backup withholding rate has been reduced to 28% for payments made after December 31, 2002.
  
  
• Payors are not required to refund overwithholding that occurred prior to, and as a result of, implementation of the new rate.
  
  
• Treasury Notice 1036 provides that the backup withholding rate is decreased to 28% effective for payments after May 28, 2003 (or as soon as possible thereafter).

Sunset

• Absent further legislation:
  
  
• The maximum 35% individual federal income tax rate will cease to apply for taxable years beginning after December 31, 2010.
• The maximum 15% individual federal income tax rate on long-term capital gains will cease to apply for taxable years beginning after December 31, 2008.
• The maximum 15% individual federal income tax on qualified dividend income will cease to apply for taxable years beginning after December 31, 2008.
• The 28% backup withholding will increase to 31% for payments made after December 31, 2010.

On June 18, 2003, Paul F. Roye, Director of the Division of Investment Management, testified before the House Capital Markets Subcommittee on behalf of the SEC on the Bill introduced by Chairman Baker. Mr. Roye indicated that the SEC supports the Bill, noting that it can provide investors with important information regarding their investments in mutual funds and strengthen the corporate governance standards of mutual funds. Mr. Roye went on to discuss the SEC’s view on the various aspects of the Bill.

Improve mutual fund disclosure. Mr. Roye commented that the SEC supports the intent of the Bill to improve the transparency of costs and other information to mutual fund investors. He stated, however, that the SEC believes that the Bill should preserve the SEC’s flexibility to determine the appropriate disclosure document or documents for each of the mandated disclosures and not preclude any particular document. His comments on each of the proposed new disclosure items are summarized below:

• Estimated operating expenses, in dollar amounts, incurred by each shareholder: Mr. Roye noted that the SEC has already proposed new disclosure requirements in 2002 that would achieve the same objectives as proposed in the Bill and which are intended to increase investors’ understanding of the recurring expenses that they pay to invest in a fund. Specifically, the SEC has proposed to require mutual funds to disclose in their annual and semi-annual reports to shareholders fund expenses borne by shareholders during the reporting period in dollar amounts.
• The structure of an individual portfolio manager’s compensation: Mr. Roye commented that the SEC believes this information would be useful in supplementing existing disclosure of the advisory fee. He commented that disclosure that a manager is compensated, for example, based on the fund’s performance for a particular period (e.g., 3 months, 1 year, or 5 years) may shed light on the manager’s incentives to maximize short-term or long-term performance. Similarly, disclosure of whether a portfolio manager’s compensation is based on a fund’s pre-tax or after-tax returns would be useful in assessing whether a fund is an appropriate investment for a taxable or tax-deferred account.
• Portfolio transaction costs to facilitate comparison among funds: Mr. Roye commented that while fund commission charges can be readily ascertained, other types of transactions costs, such as spreads, market impact, and opportunity costs, can only be estimated. For that reason, he stated the provisions of the Bill which would require funds to quantify their total transaction costs would not be feasible in practice. He noted that there are a variety of approaches which could achieve the objectives of the Bill and deserve further consideration. These approaches include adding disclosure of the fund’s average and range of commission costs, giving greater prominence to the portfolio turnover ratio as that is a good proxy for transaction costs and/or requiring all funds to include in the prospectus a discussion of the impact of their investment objectives, strategies, and management style on portfolio turnover and overall transaction costs.
• Soft dollar arrangements, directed brokerage and revenue sharing: He noted that the SEC is concerned about the growth of soft dollar arrangements and the conflicts they may present to money managers, including fund advisers. He added that the SEC agrees that fund directors and investors should be provided with better information about soft dollar arrangements and directed brokerage. Mr. Roye also noted that the SEC has previously recognized this as an area deserving further consideration and has directed the staff to make recommendations regarding improved disclosure of revenue-sharing payments.

Strengthen Board oversight. Mr. Roye stated that the SEC supports the Bill’s provisions in this area. He commented that they acknowledge the important role that fund boards play in the supervision of fund brokerage arrangements by recognizing a federal duty to supervise the adviser’s use of the fund’s brokerage, and by requiring advisers to provide fund boards with information sufficient to fulfill that obligation and safeguard the interests of fund shareholders. He stated that the provisions also add what the SEC believes may be a new duty with respect to scrutinizing revenue sharing arrangements, which he reiterated has become increasingly important in the distribution of fund shares and can raise difficult issues.

Enhance Corporate Governance. He stated that the SEC strongly supports the Bill’s provisions in this area. He noted that the amendments to the definition of independent directors would permit the SEC to close “gaps” in the 1940 Act that have permitted persons to serve as independent directors who do not appear to be sufficiently independent of fund management. For example, currently a fund manager’s uncle is permitted to serve on the fund’s board as an independent director. In other cases, former executives of fund management companies have served as independent directors.

Audit Committee Requirements. In the case of the audit committee changes, he noted that while mutual fund financial statements are often simpler than those of operating companies, their underlying financial systems, reporting mechanisms, and internal controls are sufficiently complex that funds would benefit from each of the corporate governance reforms embodied in section 301 of the Sarbanes-Oxley Act and the SEC’s implementing rules.

Mr. Roye also commented that the SEC supports including a required report on Section 28(e) in this legislative package. Once the reforms called for in the Bill that relate to soft dollars are implemented, he noted that the SEC and Congress will need to consider whether further revisions are appropriate. Testimony of Paul F. Roye, Director, Division of Investment Management, SEC, Before the House Subcommittee on Capital Markets (June 18, 2003).

The NASD has announced its intent to sell its entire interest in AMEX to the private equity firm GTCR Gold Rauner LLC for approximately $110 million. The transaction must be approved by both the NASD’s and AMEX’s boards of governors, Amex members, and the SEC before it can be consummated. The NASD commented that the goal of the transaction is to divest the NASD of its remaining interests in any stock markets to focus entirely on its duties as a self regulatory organization. The NASD had sold its interest in Nasdaq in March 2002. The NASD commented that it intends to use the proceeds from the transaction to fulfill all of its obligations to enhance Amex's infrastructure and operations which it undertook in 1998 when it acquired AMEX. NASD Press Release (June 2, 2003)