SEC Adopts New Rules on Independent Directors. SEC Releases Report on Mutual Fund Fees and Expenses.

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Senate Banking Committee Chairman Phil Gramm (R-Texas) and Sen. Chuck Schumer (D-N.Y.) have introduced Senate bill S.143, the "Competitive Market Supervision Act" to reduce the transaction, registration, and merger/tender fees collected by the SEC. Currently, these fees yield revenue of $2.3 billion, more than six times the SEC's annual budget. This excess revenue is used to fund other federal programs.

The gap between fee revenues and the annual level of the SEC budget resulted from an explosion in the volume of securities transactions in recent years. Specifically, securities transaction fee collections and collections of registration fees required by Section 31 and Section 6(b), respectively, of the Securities Act of 1933 (the "Securities Act"). Under the proposed bill, Section 6(b) fees would be reduced from $250 for every $1 million of securities offered to $67. Beginning in fiscal year 2007, the fee would be further reduced to $33.

The bill includes guaranteed floors and ceilings to ensure that the SEC is fully funded at all times. For instance, the bill provides temporary fee increases if collections fall below 100 percent of the SEC's appropriated budget; and temporary fee reductions if collections exceed specified transaction fee caps by more than 5 percent. The caps set a limit on how much the SEC can collect in a given fiscal year.

As part of the mechanism for adjusting fee rates, the SEC would be required on a monthly basis to report to its congressional oversight committees a projection of the aggregate amount of fees from all sources likely to be collected by the SEC during the current fiscal year. Securities and Regulation Law Report, Vol. 33, No. 4, January 29, 2001.

An administrative law judge has sanctioned a former mutual fund portfolio manager and two of his associated companies, a registered investment adviser and a registered broker-dealer. The manager and the companies formerly managed a government bond mutual fund. The judge found that manager had marketed the fund as a safe, stable investment but invested heavily in volatile inverse floaters that exposed the fund to significant losses when interest rates rose in 1994.

Additionally, the judge found the manager and the companies did not inform the board of directors of the fund of their soft dollar arrangements, which included payments to a business partner. The judge concluded that the manager and the companies violated several antifraud provisions of the securities laws. The judge fined the manager $250,000 and fined the companies $500,000 each. Additionally, all were ordered to cease and desist from violations of the antifraud provisions of the securities laws. Additionally, the manager was barred from the securities industry and the investment adviser and broker-dealer registrations of the companies were revoked. Fundamental Portfolio Advisors, Inc., Lance M. Brofman and Fundamental Service Corporation, Initial Decision Release No. 180, SEC File No. 3-9461, January 29, 2001.

In a report released January 25, 2001, the SEC’s OCIE reported on its survey of broker-dealers that offer online trading. OCIE noted that its staff based it report after examining a wide range of broker-dealers, with a wide variety of trading volume on their respective websites. Among other suggestions, OCIE urged online broker-dealers to consider:

• enhancing their web sites to aid investor education, including providing a basic explanation of securities trading;
• providing a disclosure statement concerning margin, including the fact that a firm can sell a client’s securities to cover loans and a reminder that customers can lose more than they deposited into their account;
• ensuring that advertisements are balanced in explaining both the risks and reward involved in securities trading;
• ensuring that orders are being executed on the most favorable terms;
• reviewing their operational capacity, including a review of the capacity of telephone systems and backup systems, the flexibility in adding capacity during heavy volume periods and providing alternatives to their clients when the internet is overloaded or too slow;
• bolstering security through techniques and devices such as encryption and firewalls;
• carefully monitoring employees for misuse of the internet;
• taking steps to prevent duplicate orders; and
• clearing up the process of investing in initial public offerings.

OCIE noted that online broker dealers with sites exemplifying what it considered to be "good" disclosure were those sites which explained how orders are executed and explained the inherent risks of investing, including the possibility of system delays and outages and their effect on trades. Securities Regulation and Law Report, Vol. 33, No. 4, January 29, 2001.

A California Court of Appeal concluded that a brokerage firm has no duty to supervise the sale of financial products by the firm’s registered representative to individuals who are not customers of the firm.

According to the appeals court, during 1996 and 1997, the plaintiffs purchased promissory notes from a registered representative of the defendant brokerage firm, a registered broker-dealer and investment adviser. In October 1997, the company that issued the promissory notes was barred by a federal court from offering and selling the notes because its alleged role in a "Ponzi scheme." Shortly thereafter, the firm terminated its relationship with the representative, who later was charged by the SEC and California regulators with federal and state securities law violations. Thereafter, the plaintiffs filed suit against, among others, the representative and the firm. The plaintiffs later dismissed their suit against the representative when he filed for bankruptcy.

According to the court, all but one of the plaintiffs' claims against the firm were premised on a theory of vicarious liability. The plaintiffs claimed that the representative had actual or ostensible authority to act on the firm's behalf and sought to impose vicarious liability on the firm for misrepresentation, breach of fiduciary duty, fraud, negligence, and breach of an oral contract. In the remaining claim, the plaintiffs contended that the firm was directly liable for negligently failing to supervise the representative in his capacity as a registered representative of the firm.

The firm countered with a motion to dismiss by contending that it was not vicariously liable for the representative's alleged misconduct because the sale of the promissory notes was not within the scope of the representative’s agency relationship. The firm claimed that its "only purpose is to act as a management company" for an affiliated trust fund. The firm further argued that it had no duty to supervise the representative with respect to his sale of investment products, such as the promissory notes, in which the firm had no financial interest. The lower court granted the firm’s motion to dismiss and the plaintiffs subsequently appealed.

The appeals court affirmed the lower court decision. The appeals court explained that the representative was not an employee of the brokerage firm but instead was a registered representative of the firm. The court pointed out that the relationship between the firm and the representative was defined by a sales representative agreement in which the firm appointed the representative its agent to sell and distribute participation agreements in the firm’s affiliated trust fund. It noted that under the agreement, the representative was an independent contractor, not an employee of the firm, and was subject to the firm 's supervision with respect to sales of the participation agreements. The court also noted that the agreement provided that the representative was free to engage in other business activities, provided such activities were kept "strictly separate" from the firm.

In concluding that the complaint properly was dismissed below, the appeals court stated that, "we do not believe [the firm] subjected itself to the requirements of federal (or state) securities laws with respect to its responsibility to supervise the outside activities of its registered representatives." Specifically, the court found nothing in the sales agreement or in the record to suggest that the firm "desired or felt obligated to adopt the supervisory requirements of federal or state securities laws, or the rules of the NASD, with respect to the sales by its representatives of competing investment products."

The appeals court concluded that the firm was not vicariously liable for the representative's conduct based on his alleged "actual authority to sell non-[firm] investments." It pointed out that according to the registered representative, he never told the plaintiffs or others that the firm sponsored or promoted the promissory notes. "[T]he limitations set forth in the sales representative agreement, coupled with the absence of substantial evidence of apparent or actual authority beyond that specified in the agreement, eliminates any basis upon which to impose vicarious liability on [the firm] under the doctrine of respondeat superior," the court concluded. Asplund v. SIFE, Cal. App., A089432, 12/11/00.

The SEC’s Division of Corporate Finance permitted a provider of an online database of market information to include prospectuses for offshore offerings in its database. The Division found that, subject to certain conditions, this presentation would not violate Regulation S of the Securities Act of 1933 (the "1933 Act"). The provider noted in its request for relief that its database includes company reports from various countries around the world. The provider’s customers use the database as a source of information on global corporations. The provider noted that it intends to provide its subscribers with access to final prospectuses used in international securities offerings.

The provider sought the no-action position from the staff to ensure that, by making final prospectuses and related documents available to subscribers, it would not cause the issuers, the distributors or their affiliates to be deemed to be engaged in directed selling efforts in the U.S., as defined under and prohibited by Regulation S. Under Regulation S, an issuer does not have to register its securities with the SEC as long as it sells its shares outside of the U.S. The shares must be owned by non-U.S. entities for at least one year after the offering. Under Regulation S, the issuer does not have to pay SEC registration fees or report trading activity in the securities to the SEC.

Regulation S sets forth a number of conditions which must be met before a securities offering may take place outside of the U.S. without registration. For example: 

• each purchaser of the securities must certify that it is not a U.S. person;
• each purchaser must agree to resell the securities only in accordance with Regulation S;
• the securities must contain a legend describing the Regulation S restrictions;
• the issuer is required to refuse to register any transfer not made in accordance with Regulation S; and
• each confirmation of a purchase of such shares must contain a notice to the purchaser describing the Regulation S restrictions.

As a condition of the relief, the staff noted that the provider stated that it would provide its subscribers with a cautionary screen requiring subscribers to agree not to distribute any prospectuses obtained from the database outside of their own organizations. In addition, the provider noted that it believed that its actions would not make it a distributor of any issuer’s securities. The provider also noted that it believed that it should not be considered an affiliate of any of the entities that provide prospectuses merely because the provider made them available on its website. Finally, the provider noted that the entities that provide the documents will already have agreed not to initiate contacts with U.S. persons other than in exempt transactions under the Regulation S safe harbor from registration.

The staff noted that in granting the requested relief, the staff relied on the provider’s counsel’s opinion that the availability of the database to subscribers in the U.S. did not constitute a directed selling effort in the U.S. under Regulation S. The staff also noted that entities that provide documents to the provider are contractually obligated not to offer or sell to persons in the U.S. from issuances outside the U.S. absent an appropriate exemption. Perfect Information no-action letter, December 22, 2000.

On January 23, 2001, the SEC approved the National Association of Securities Dealers Inc.'s ("NASD") proposed price reporting and dissemination system of trading in the corporate bond market. The new system, the Trade Reporting and Comparison Entry Service ("TRACE") is designed to make corporate bond prices easier to obtain and, thus, easier to trade.

The new system culminates an effort begun in 1998, when SEC staff conducted a review of the U.S. debt market, with a particular focus on price transparency. The review concluded that the corporate bond market could improve the availability of price information. In light of these findings, SEC Chairman Arthur Levitt called upon the NASD to take the following actions:

• adopt rules requiring dealers to report all transactions in U.S. corporate bonds and preferred stocks to the NASD and to develop systems to receive and redistribute transaction prices on an immediate basis;
• create a database of transactions in corporate bonds and preferred stocks to enable regulators to take a proactive role in supervising the corporate debt market; and
• create a surveillance program, in conjunction with the development of a database, to better detect fraud and foster investor confidence in the fairness of the corporate debt market.

In October 1999 the NASD filed a proposed rule which the SEC approved in amended form. The amended proposal requires NASD members to report transaction information on specified U.S. corporate bonds and establishes a transaction dissemination facility. In its amended proposal, the NASD states that it intends to use TRACE reports to develop a database of transactions that will enable NASD Regulation to take a more proactive role in supervising the corporate debt market. Federal Register, Volume 66, Number 19, January 29, 2001.

The SEC has adopted rule and form amendments (the "rules") that require mutual funds to disclose after-tax returns in fund prospectuses. The rules require a fund to disclose its standardized after-tax returns for 1-, 5-, and 10-year periods. After-tax returns, which will accompany before-tax returns in fund prospectuses, will be presented in two ways: (i) after taxes on fund distributions only; and (ii) after taxes on fund distributions and a redemption of fund shares. In its release, the SEC noted that its goal in requiring disclosure of standardized mutual fund after-tax returns is to help investors to understand the magnitude of tax costs and compare the impact of taxes on the performance of different funds.

Types of return to be disclosed. Under the rules, funds will be required to calculate after-tax returns using a standardized formula similar to the formula currently used to calculate before-tax average annual total return. Funds must disclose after-tax returns for 1-, 5-, and 10-year periods on both a "pre-liquidation" and "post-liquidation" basis.

• Pre-liquidation after-tax return assumes that the investor continued to hold fund shares at the end of the measurement period, and, as a result, reflects the effect of taxable distributions by a fund to its shareholders but not any taxable gain or loss that would have been realized by a shareholder upon the sale of fund shares.
• Post-liquidation after-tax return assumes that the investor sold his or her fund shares at the end of the measurement period, and, as a result, reflects the effect of both taxable distributions by a fund to its shareholders and any taxable gain or loss realized by the shareholder upon the sale of fund shares.
• Pre-liquidation after-tax return reflects the tax effects on shareholders of the portfolio manager's purchases and sales of portfolio securities, while post-liquidation after-tax return also reflects the tax effects of a shareholder's individual decision to sell fund shares.

The rules require disclosure of three types of return, all of which are net of all fees and charges:

• before-tax return (which is currently required);
• return after taxes on distributions (pre-liquidation); and
• return after taxes on distributions and redemption (post-liquidation).

Location of required disclosure. Under the rules, funds will disclose after-tax returns in the performance table in the risk/return summary of the prospectus. Funds must also provide after-tax returns in any fund profile. In lieu of requiring after-tax performance in annual reports, funds will now be required to state in the Management's Discussion of Fund Performance that the performance table and graph do not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares.

Format of disclosure. The rules require before and after-tax returns to be presented in a standardized tabular format. Consistent with the modifications to the types of returns required, funds must present before- and after-tax returns as follows:

On January 18, 2001, the SEC adopted new rule 35d-1 under the Investment Company Act of 1940 (the "1940 Act") to address investment company names that the SEC believes could mislead an investor about a company's investment emphasis. Section 35(d) of the 1940 Act prohibits an investment company from using a name that the SEC determines to be materially deceptive or misleading.

The new rule applies to all registered investment companies, including mutual funds, closed-end investment companies, and unit investment trusts ("UITs"). The rule requires an investment company with a name that suggests a particular investment emphasis to invest consistently with its name. Under the new rule, an investment company with a name that suggests that the company focuses on a particular type of security (e.g., the ABC Stock Fund, the XYZ Bond Fund, or the QRS U.S. Government Fund) must invest at least 80% of its net assets in the type of security indicated by its name. Funds that select a name that does not connote a particular investment emphasis will not be required to comply with the 80% investment requirement.

The SEC noted that Rule 35d-1 does not codify current positions of the Division of Investment Management (the "Division") regarding investment company names such as "balanced," "index," "small, mid, or large capitalization," "international," "global," "growth" and "value." The SEC commented that these terms connote types of investment strategies as opposed to types of investments. The SEC noted that it will continue to review investment company names not covered by the proposed rule. The SEC also noted that in determining whether a particular name is misleading, it will consider whether a reasonable investor could conclude based on the name that the company invests in a manner that is inconsistent with the company's intended investments or the risks of those investments.

Fund policy on change in name. Contrary to the SEC’s earlier proposal, the new rule as adopted does not require that the 80% investment requirement be a fundamental policy (i.e., a policy that may only be amended by a shareholder vote). Instead, an investment company may adopt a policy that it will provide notice to shareholders at least 60 days prior to any change to its 80% investment policy.

The 80% investment requirement must, however, be adopted as a fundamental policy for tax-exempt investment companies. The SEC noted that this requirement is consistent with the long-standing position of the Division that a tax-exempt fund may not change its tax-exempt status without shareholder approval. Under the new rule, a tax-exempt investment company must adopt a fundamental policy: (i) to invest at least 80% of its assets in investments the income from which is exempt, as applicable, from federal income tax or from both federal and state income tax; or (ii) to invest its assets so that at least 80% of the income that it distributes will be exempt, as applicable, from federal income tax or from both federal and state income tax. These requirements are consistent with current Division positions, and would apply to a company's investments or distributions that are exempt from federal income tax under both the regular tax rules and the alternative minimum tax rules.

Names suggesting geographic focus. Rule 35d-1, as adopted, requires that an investment company with a name that suggests that it focuses its investments in a particular country or geographic region adopt a policy to invest at least 80% of its assets in investments that are tied economically to the particular country or geographic region suggested by its name. The investment company also must disclose in its prospectus the specific criteria that are used to select investments that meet this standard.

Names suggesting guarantee or approval by the U.S. Government. Rule 35d-1, as adopted, prohibits an investment company from using a name that suggests that the company or its shares are guaranteed or approved by the United States government or any United States government agency or instrumentality. The prohibited types of names include names that use the words "guaranteed" or "insured" or similar terms along with the words "United States" or "U.S. government."

Names and average weighted portfolio maturity and duration. Investment companies investing in debt obligations may continue to use names describing the maturity of their portfolio instruments. These names include, for example, "short-term," "intermediate-term," or "long-term" bond or debt funds. The SEC has reaffirmed its long-standing position requiring an investment company that includes the words "short-term," "intermediate-term," or "long-term" in its name to have a dollar-weighted average maturity of, respectively, no more than 3 years, more than 3 years but less than 10 years, or more than 10 years, respectively. The Division has concluded that it will continue to apply these maturity criteria to investment companies because they provide reasonable constraints on the use of those terms.

Time of application of the 80% investment requirement. The 80% investment requirement generally applies at the time an investment company makes an investment. Thus, a fund that falls below the 80% floor through market fluctuations or sales of portfolio securities is not in violation of the policy. The fund's next investment, however, must be insecurities consistent with its name. The SEC has, however, included a grandfather provision so that a UIT that has made an initial deposit of securities prior to the rule's compliance date will not be required to comply with the 80% investment requirement. The SEC noted that because of the fixed nature of UIT portfolios, such UITs would not be able to adjust their portfolios to comply with the rule.

Assets to which requirement applies. As adopted, the 80% investment requirement will be based on an investment company's net assets plus any borrowings for investment purposes. This is a modification from the proposed requirement that would have based the 80% investment requirement on a company's net assets plus any borrowings that are senior securities under section 18 of the 1940 Act. The SEC believes that the use of net assets rather than total assets more closely reflects an investment company's portfolio investments.

Temporary departure from 80% requirement. Consistent with current Division positions, the rule, as adopted, requires investment companies to comply with the 80% investment requirement "under normal circumstances." The SEC noted that the "under normal circumstances" standard will provide funds with flexibility to manage their portfolios, while requiring that they would normally have to comply with the 80% investment requirement.

The SEC also noted that this standard will still permit investment companies to take "temporary defensive positions" to avoid losses in response to adverse market, economic, political, or other conditions and will permit investment companies to depart from the 80% investment requirement in other limited, appropriate circumstances, particularly in the case of unusually large cash inflows or redemptions. For example, a new investment company will be permitted to comply with the 80% investment requirement within a reasonable time after commencing operations. The SEC commented that the Division takes the view that an investment company generally must not take in excess of six months to invest net proceeds to operate in accordance with its investment objectives and policies.

Rule 35d-1 will become effective March 31, 2001, but investment companies have until July 31, 2002, to comply with the rule's requirements. SEC Release IC-24828, January 18, 2001.

The SEC received a rulemaking petition from the American Federation of Labor and Congress of Industrial Organizations ("AFL-CIO") seeking improvements in the quality and frequency of mutual fund portfolio disclosure. The AFL-CIO also asked the SEC to require mutual funds to disclose the policies or guidelines they use to vote fund shares on proxy proposals. The AFL-CIO’s petition for additional disclosure is similar to previous requests by the Financial Planning Association, Fund Democracy, LLC, the Consumer Federation of America and the National Association of Investors Corp.

In its petition, the AFL-CIO noted that actively managed mutual funds have high portfolio turnover rates. However, funds are only required to report their portfolio holdings every six months, making it difficult for investors to determine how their money is being invested. The AFL-CIO explained that such infrequent disclosure makes it difficult to detect portfolio overlap among different funds in the same fund family that are supposed to be following different investment strategies.

Further, the AFL-CIO cited research which noted that "style drift" is common among mutual funds. Style drift occurs when a fund that described itself as following a particular investment style or as investing in a particular asset class actually invests outside those areas in an attempt to improve performance.

The AFL-CIO’s petition also noted abuses such as "portfolio pumping" and "window dressing." (For a discussion of these practices and the SEC’s current investigation into these practices, see the Industry News Summary for the week of 11/24/00 – 12/01/00). The AFL-CIO claims that current disclosure practices hide these abuses from the public. The AFL-CIO asks the SEC to require mutual funds to disclose their portfolio holdings during each month within 60 days after the end of the month, with exceptions as the SEC deems necessary. The AFL-CIO also asks the SEC to boost from 65% to 85% the threshold that funds must hold in assets suggested by the name of the fund.

In addition to seeking the disclosure of portfolio holdings, the AFL-CIO also asks the SEC to require funds to disclose their voting policies and guidelines. This disclosure will prevent fund advisers from placing their own interests above the interests of the fund, the AFL-CIO argued. SEC Today, December 27, 2000.

On January 10, 2001, the SEC’s Division of Investment Management (the "Division") released its report on Mutual Fund Fees and Expenses, a study of trends in mutual fund fees and expenses for the past twenty years. The report:

• describes the legal framework governing mutual fund fees,
• analyzes how fees have changed over time,
• identifies factors that may influence the current level of fees, and
• recommends initiatives designed to improve the oversight of fund fees and the disclosure that investors receive about fees.

In its report, the Division found that:

• Overall, mutual fund expense ratios (i.e., a fund's total expenses, including Rule 12b-1 fees, divided by its average net assets) have increased since the late 1970s, although they have declined in three of the last four years.
• Although fund expense ratios rose on average during the past 20 years, the overall cost of owning fund shares may not have risen if changes in sales charges are considered.
• The Division attributed the increase in expense ratios primarily to changes in the manner that distribution and marketing charges are paid by mutual funds and their shareholders. For instance, many funds have decreased or replaced front-end charges, which are not included in a fund's expense ratio, with ongoing rule 12b-1 fees, which are included in a fund's expense ratio.
• Mutual funds with the largest proportion of defined contribution retirement plan assets (e.g., 401(k) plans) generally have lower expense ratios than other funds.
• Index funds and funds that are available only to institutional investors generally have lower expense ratios than other types of funds.
• In a sample of the largest 1,000 funds, funds that are part of large fund families (in terms of asset size) tend to have lower management expense ratios than funds that are part of small fund families. The Division noted that these findings may reflect economies for the investment adviser generally.
• Mutual fund expense ratios generally decline as the amount of fund assets increases.
• Specialty funds have higher expense ratios than equity funds, which, in turn, have higher expense ratios than bond funds. International funds have higher expense ratios than comparable domestic funds.
• Of the 100 largest mutual funds, most have some type of fee breakpoint schedule that reduces the management fee rate as the asset size of the fund or the fund family increases.

The Division’s recommendations centered on disclosure and corporate governance initiatives instead of mandatory fee caps or other regulatory intervention. In particular, the Division suggested:

• requiring the disclosure of additional types of fee information to facilitate investors' awareness of fund fees and investors' ability to understand their effect. In particular, the Division cited a General Accounting Office recommendation that mutual funds and/or broker-dealers be required to send fund shareholders account statements that include the dollar amount of the fund's fees that each shareholder has indirectly paid.
• that the fund industry and the SEC encourage fund shareholders to pay greater attention to fees and expenses. In particular, the Division stressed that investors should be able to compare the fees of their fund to the fees of other funds and other types of investments.
• that additional required fee information, including the dollar amount of fees, be provided in semi-annual and annual shareholder reports. The Division stated that this approach would enable investors to not only compare the fees of funds but also to evaluate the fee information that would be contained in the reports to shareholders alongside other key information about the fund's operating results, including management's discussion of the fund's performance.

In addition, the Division suggested alternative methods of presenting additional information about actual costs. The Division suggested that the SEC require shareholder reports to include a table showing the cost in dollars incurred by a shareholder who invested a standardized amount (e.g., $10,000) in the fund, paid the fund's actual expenses, and earned the fund's actual return for the period. In addition, the Division suggested that the table include the cost in dollars, based on the fund's actual expenses, of a standardized investment amount (e.g., $10,000) that earned a standardized return (e.g., 5%). The Division noted that investors could then easily compare funds to one another because the only variable for this calculation would be the level of expenses.

The Division also recommended that the SEC adopt the proposed rules that would require mutual funds to report their investment returns on an after-tax basis.

The Division also recommended that the current statutory framework be enhanced to strengthen the ability of independent directors to monitor fund fees and expenses. In addition, the Division suggested that the SEC consider the following recommendations:

• The SEC should continue to emphasize that mutual fund directors exercise vigilance in monitoring the fees and expenses of the funds that they oversee. Fund directors should, for example, attempt to ensure that an appropriate portion of the cost savings from any available economies of scale is passed along to fund shareholders.
• The SEC should continue to encourage efforts to educate directors about issues related to fund fees and expenses, including the types of information that they may request when they review the funds' management contracts, and the techniques that are available to evaluate the information that they receive.
• The SEC should consider whether rule 12b-1 under the Investment Company Act of 1940 needs to be modified to accommodate changes in the mutual fund industry.
  

The U.S. House of Representatives has established a new Committee on Financial Services whose jurisdiction includes banks and banking, insurance generally, and securities and exchanges. The new committee replaces the former House Banking Committee, with jurisdiction over securities and exchanges transferred from the former Commerce Committee, which has been renamed as the Energy and Commerce Committee. The Energy and Commerce Committee will retain jurisdiction over matters relating to regulation and SEC oversight of multi-state public utility holding companies, and the Committee on Agriculture will retain jurisdiction over commodity exchanges. House Republican leaders named Representative Michael Oxley (R-Ohio) as Chairman of the new financial services committee.

Representative introduces bill to limit taxes on capital gains. Representative Jim Saxton (R-N.J.) recently introduced a bill in the House of Representatives to limit the capital gains taxes paid by fund shareholders. The Saxton bill would give mutual fund shareholders a $3,000 exclusion from immediate tax on fund capital gains distributions, and for couples a $6,000 break. According to the Congressman's staff, 44 million Americans own fund shares that are not held in tax-deferred accounts such as a 401(k) plan or an IRA. The bill, if passed, would apply retroactively to tax years beginning after 1999.

On January 2, 2001, the SEC announced that it adopted new rules and amendments relating to the role of independent directors of investment companies. The rule adoptions mark the culmination of the SEC’s reevaluation of the role of mutual fund independent directors that began in May 1998. In its release, the SEC stated that the new rules and amendments are designed to, among other things, reaffirm the "important role" that independent directors play in protecting fund investors. The SEC adopted amendments to ten commonly used exemptive rules under the Investment Company Act of 1940 (the "1940 Act").

Fund governance changes. Funds relying on the exemptive rules (including Rule 12b-1) must ensure that:

• independent directors constitute at least a majority of the fund’s board of directors, rather than the 40 percent currently required by the 1940 Act;
• independent directors select and nominate other independent directors; and
• any legal counsel for the fund’s independent directors be an "independent legal counsel."

Although most funds already have a majority of independent directors, the SEC has set the compliance date for this condition for July 1, 2002.

The SEC noted in its release that it is not requiring independent directors to retain independent counsel, but any person who acts as legal counsel to the independent directors must be independent. A person will be considered an "independent legal counsel" under the amendments if the independent directors determine that any representation of the fund's investment adviser, principal underwriter, administrator or their controlling persons during the past two fiscal years was sufficiently limited that it would be unlikely to adversely affect the professional judgement of the person providing the legal representation. The counsel must provide the independent directors with information necessary for the directors to make the independence determination and the counsel must update the directors if the information changes. Independent directors must determine the independence of their legal counsel at least annually and must record the basis for their determination in the board's meeting minutes. The effective date for the legal counsel provision is July 1, 2002.

Fund disclosure changes. The amendments require funds to provide better information about directors to their shareholders, including:

• basic information about the identity and experience of directors;
• fund shares owned by directors;
• information about directors that may raise conflict of interest concerns; and
• information about the board's role in governing the fund.

The SEC requires the disclosure of basic information about directors to be presented in an easy-to-read tabular format. The table must appear in a fund's annual report to shareholders, its Statement of Additional Information and any proxy statement for the election of directors. 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.

Other changes. The SEC also amended or adopted the following rules under the 1940 Act:

New Rule 10e-1 suspends temporarily the board composition requirements if a fund fails to meet the requirements due to the death, disqualification or resignation of a director. The requirement is suspended for 90 days if the board can fill the vacancy, or for 150 days if a shareholder vote is required.

Amended Rule 17d-1(d) requires that joint insurance policies not exclude coverage for litigation between advisers and independent directors.

New Rule 32a-4 exempts funds from obtaining a shareholder vote on a fund’s independent public accountant if the funds have audit committees composed wholly of independent directors.

New Rule 2a19-3 conditionally exempts persons from being disqualified as independent directors solely because they own shares of an index fund that invests in the investment adviser or the underwriter of the fund, or their controlling persons. The relief is available so long as the fund's investment objective is to replicate the performance of one or more broad-based indices.

The SEC also rescinded Rule 2a19-1, which defines when a fund director is considered to be independent. The SEC noted that the Gramm-Leach-Bliley Act amended Section 2(a)(19) to establish new standards for determining independence and that these amendments eliminated the need for the exemptive relief provided by Rule 2a19-1. The rescission of Rule 2a19-1 becomes effective May 12, 2001, the effective date of that section of the Gramm-Leach-Bliley Act.

Except as noted above for specific rules or conditions, the new rules and amendments become effective February 15, 2001. SEC Rel. Nos. 33-7932, 34-43786, IC-24816, January 2, 2001.

The American Institute of Certified Public Accountants has issued a revised audit guide for investment companies. The revised guide provides guidance to auditors of investment companies in preparing financial statements in conformity with generally accepted auditing principles, and assist independent auditors in performing efficient and effective audits on those financial statements. The updated guide provides new guidance on:

• accounting for offering costs,
• amortization of premium or discount bonds,
• liabilities for excess expense plans,
• reporting complex capital structures,
• payments by affiliates, and
• financial statement presentation and disclosures for investment companies and nonpublic investment partnerships.

The revised Guide will be effective for fiscal years beginning after December 15, 2000.

The district court for the Southern District of New York recently decided three separate cases involving the interpretation of sections 16 and 13(d) of the Securities Exchange Act of 1934 (the "Exchange Act") and rules 16a-1 and 16a-2 thereunder. In each case, the court denied the defendants’ motions to dismiss.

Section 16(b) of the Exchange Act prohibits directors, officers and beneficial owners of more than 10% of the equity shares of an issuer (each, an "insider") from purchasing and selling shares of the issuer within any period of less than six months. It is a strict liability standard under which an insider’s profits will be subject to disgorgement, regardless of whether the insider actually had material nonpublic information about the issuer. Rule 16a-1 under the Exchange Act defines "beneficial owner" for purposes of section 16(b) as any person who is deemed a beneficial owner pursuant to section 13(d) of the Exchange Act.


Rule 16a-1 expressly excludes, however, securities holdings of eleven listed institutions, including registered investment advisers and investment companies, that (1) are held in fiduciary or customer accounts maintained for the benefit of third parties in the ordinary course of business and (2) are acquired "without the purpose or effect of changing or influencing the issuer." Shares held by these excluded institutions are not counted for purposes of calculating whether the 10% threshold of section 16(b) has been exceeded.

In each of the three cases, the court addressed whether beneficial ownership of securities by an institution that otherwise would qualify for an individual institutional exemption under rule 16a-1(a) nonetheless falls within the scope of section 16’s prohibitions by being part of a "group" that includes non-exempt members.

In Strauss v. Kopp Advisory, et.al., a registered investment adviser and its parent, a registered investment company, the president of these entities and 20 unnamed defendant accounts managed by the other defendants were sued by a shareholder of Digital Link Corporation ("Digital"). The plaintiff alleged that the defendants acted as a "group," collectively held over 25% of Digital common stock and engaged in transactions prohibited by Section 16(b). In response, the defendants filed a motion to dismiss.

According to the court, the determination of what constitutes a section 16(b) "beneficial owner" is a two step analysis. First, the definition of "beneficial ownership" from section 3(d) is used to determine status as a ten percent holder. Second, once an insider is determined to be a beneficial owner, the reporting and short-swing profit provisions of section 16 apply only to those securities in which the insider has a "pecuniary interest."

The defendants argued that the registered investment adviser, parent company and investment company qualified for the exemptions in rule 16a-1. The court ruled that the defendants’ argument failed to address the plaintiffs’ allegation that the defendants were part of a "group" that also included certain individual accounts that did not qualify for any listed exemption in rule 16a-1. The court found that rule 16a-1 requires that each member of an alleged group qualify for one of the exclusions from section 16 regulation or the entire group loses its exclusion. The court determined that because the individual accounts were not able to qualify for one of the rule 16a-1 exclusions, the group was subject to regulation under section 16.

Next, the court considered whether the insiders had a "pecuniary interest." The court noted that section 16(b) disgorgement obligations only apply to those securities in which the insider has a direct or indirect pecuniary interest. The defendants argued that they did not have a pecuniary interest in the stock since they were not the direct owners of Digital stock. The defendants claimed that their interest in Digital’s securities derived entirely from asset-based fees. The court noted that "Rule 16a-1(a)(2)(ii) does not provide that investment advisers with asset-based remuneration cannot be beneficial owners for section 16(b) purposes, but rather that asset-based compensation alone does not constitute pecuniary interest for section 16 purposes." The court concluded that the plaintiff shareholder was entitled to attempt to establish through discovery whether the defendants had a pecuniary interest in Digital stock by means other than asset-based advisory fees. The same judge in Strauss heard a second case involving similar issues, Morales v. Adept Technology, Inc., Kopp Holding Company, et. al., and thus ruled in a similar manner on similar issues.

In Rosen v. Brookhaven Capital Management, the plaintiffs filed suit against various investment adviser and limited partnership defendants that owned more than 10% of the stock of Egghead.com. The plaintiffs alleged that the defendants constituted a group under section 13(d) of the Exchange Act, that the group owned more than 10% of the stock of Egghead.com, that the group engaged in certain short-swing stock transactions within a 6-month period; and that they were liable for at least $7 million in disgorgeable profits from the trading.

The plaintiffs argued that the exclusion from the term "beneficial owner" under rule 16a-1 for any registered investment adviser is limited to that investment adviser acting independently. The plaintiff argued that an adviser loses this exemption if it becomes part of a group whose other members are not also eligible for exemption under rule 16a-1. Contrary to the court in Strauss and Morales, the Rosen court concluded that individual defendants could avail themselves of individual exclusions from rule 16a-1(a)(1) even though the defendants may also be a "group" under section 13(d). The court then denied the defendants’ motion to dismiss to give the plaintiffs the opportunity through investigation and discovery to prove the defendants’ purpose and intent in acquiring the shares of Egghead.com.

Under section 311 of the Taxpayer Relief Act of 1997, taxpayers (other than corporations) and pass-through entities may elect to treat certain assets held on January 1, 2001 as if they were sold and re-acquired on the same date. The IRS recently released new Instructions to Form 4797 stating that mutual funds are pass-through entities which may elect such treatment.

Mutual fund companies may make this election for any capital asset. A mutual fund company may find that making the election for a capital asset will be beneficial if the company plans to hold the asset for more than five years after the election is made. Shareholders of the mutual fund company will be taxed on the future gain on such an asset at a reduced capital gain tax rate of 18% to the extent the gain would have been taxed at the current rate of 20%. A mutual fund company that makes this election for an asset, however, must also recognize immediate capital gain, if any, on the deemed asset sale. An asset for which the election is made will be deemed to be sold and reacquired on January 1, 2001, for its fair market value on that date (unless the asset is readily tradeable stock, in which case the asset will be deemed to have been sold and reacquired on January 2, 2001, at its closing market price on that date). The mutual fund company will not be allowed a loss for a deemed sale in any tax year.

Before making this election with respect to an asset, a mutual fund company should determine whether the benefit of a reduction in the capital gain tax rate for future gains will outweigh the cost of recognizing immediate capital gain rather than deferring tax on any gain to a later year. For example, a mutual fund company may consider making this election for an asset that has not appreciated substantially as of January 1, 2001, but is expected to appreciate substantially in future years (assuming the company also plans to hold the asset for more than five years from the date of election).

A mutual fund company may make the election by reporting the deemed sale on its tax return for the tax year that includes the date of the deemed sale (if a calendar year taxpayer, its 2001 tax return). If a company fails to make an election on a timely filed return, the company can make the election by filing an amended return within six months of the due date of its return (excluding extensions). The Instructions to Form 4797 provide specific reporting requirements for making the election. Once an election is made, the company may not revoke it.