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Author: | Published: 9 Nov 2000
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* The author gratefully acknowledges the assistance of his colleague, Thomas R. Phillips, an associate with Stradley Ronon Stevens & Young, LLP, in the creation of this article.

Over the past year, the booming US economy has led to an enormous influx of US investor dollars into mutual funds. This explosion in the popularity of mutual funds has been accompanied by significant changes in the way mutual funds do business. Sophisticated investors have demanded novel investment vehicles to increase their return. The rise of internet technology has forced regulators to adapt reporting systems to keep pace with investors' need for instant information. And the increased participation of 'ordinary' investors in mutual funds has spurred regulators to enhance protections concerning fraud and self-dealing, privacy and oversight of fund actions. The issues discussed below represent only a small portion of a rapidly-changing mutual fund landscape in the US.

The rise of exchange traded funds

Exchange traded funds (ETFs) are rapidly growing in popularity among investors. Such funds comprise an increasing portion of the activity on the American Stock Exchange and, according to some sources, now hold over $50 billion in assets. EFTs are basically index funds that are traded on the stock exchange in the same manner as shares of stock from major corporations. The organization and trading of ETFs differs in several key respects from other fund investment products. They offer many advantages over ordinary funds — namely, lower operating costs, greater tax efficiency, and the ability to trade intraday. It is the innovative structure of ETFs that is the key to these advantages.

The cornerstone of the ETF structure is the creation unit. A creation unit is typically a block of 50,000 of the ETF's shares. ETFs do not sell or redeem shares for cash, and individual investors do not purchase or redeem shares directly from an ETF. Instead, large investors contribute or re-deed blocks of the underlying securities equivalent to a creation unit. Most individual investor trades are made with other investors through an intermediary at the stock exchange, known as a specialist. If increased or decreased demand for the ETF begins to move its price away from the underlying net asset value, normally the specialist or other arbitrageurs will acquire or redeem creation units to maintain the ETF trading price relative to the index value of the underlying stock.

Exchange traded funds have been formed as unit investment trusts, which are characterized by minimum management discretion in the handling of the portfolio. Instead of an actively managed portfolio, as in the case of many open- and closed-end management companies, a unit investment trust maintains a stable portfolio. Increasingly, ETFs are being created as open-end management companies, although this requires Securities and Exchange Commission (SEC) exemptive relief suspending shareholder redemption rights. Like unit investment trusts, however, ETFs formed as open-end management companies maintain a stable portfolio. As of this writing, there are no actively managed ETFs.

Exchange traded fund portfolios usually track an index by holding all or most of the index's component stocks, with the portfolio changing only when the index changes. Existing ETF products include the Standard & Poor's Depository Receipts (referred to as spiders) that track the S&P 500, and the World Equity Benchmark Shares (WEBS, recently renamed iShares) that track foreign indexes. There is an ETF that tracks the NASDAQ 100 known as Qubes, which earned its name after its trading symbol QQQ.

One of the benefits of the ETF structure is a reduction in capital gains tax. In a traditional mutual fund, the fund manager may be required to sell shares from the fund's portfolio to ensure liquidity for shareholder redemption. When the manager sells those shares, any capital gains are taxed to the other investors. In an ETF transaction, however, large investors can obtain creation units by contributing securities that match the ETF portfolio and can redeem the ETF shares by receiving a pro rata distribution of the ETF's portfolio. These contributions and redemptions can be payments in kind, and therefore, there may be no actual sale of securities from the ETF portfolio. Thus, the transaction typically avoids a taxable realization event for the fund. It should be noted, however, that capital gains will still be realized as a result of index changes, requiring the ETF to buy and sell shares in its component portfolio.

One of the other advantages of ETFs is the ability to trade ETF shares throughout the trading day. Unlike traditional mutual funds that calculate a fund's net asset value once at the end of the trading day when processing investor purchases and redemptions, ETF shares are traded on the exchange in the same way as other stocks. This allows investors to place limit orders and buy on margin. It also causes concern about pricing discrepancies. While that concern is largely mitigated by the specialist's ability to implement arbitraging mechanisms that take advantage of the pricing difference between the ETF trading price and the net asset value of the ETF portfolio, these pricing concerns continue to exist in thinly-traded overseas indexes.

As a result of this structure, ETF shares will generally track the index value, while reducing both capital gains and operating costs. Thus, ETFs offer an attractive alternative to conventional mutual funds for those investors wanting to trade more actively.

Recent developments in investment company corporate governance

During the past two years, there have been significant developments in the corporate governance of investment companies registered with the SEC. In addition to recent litigation regarding the fiduciary duties of mutual fund directors and investment advisers, the Investment Company Institute, the trade group for the investment company industry, in June 1999 released a best practices report for corporate governance of investment companies. The SEC also proposed in October 1999 substantial amendments to rules regulating investment companies that bear on corporate governance issues.

Mutual funds are unique among corporate structures — they are not managed by the fund directors or employees, but are typically managed by an investment adviser that is a separate corporate entity. This structure creates a potential for conflicts of interest in the pricing of advisory and other services provided by the adviser. Congress, recognizing this potential for self-dealing, enacted the Investment Company Act of 1940, which requires that at least 40% of the directors of a fund be independent of the fund and unaffiliated with the investment adviser. Section 36(b) of the 1940 Act also imposes fiduciary duties on investment advisers that receive fees from investment companies.

Recent litigation: in several recent disputes, plaintiffs have asserted that independent directors who serve in well-compensated positions on multiple boards are not sufficiently independent from the investment adviser. Courts have reached conflicting conclusions on whether multiple directorships render a director an "interested person" under the 1940 Act. This particular issue was litigated several times by plaintiff Robert Strougo in Strougo ex rel: Brazil Fund v. Scudder, Stevens & Clark, Inc. (1997) and, most recently, in Strougo v. BEA Associates (January 2000). In BEA Associates, the United States District Court for the Southern District of New York ruled that well-compensated service on multiple boards of funds managed by a single fund adviser can, in some circumstances, be indistinguishable from employment by the fund manager. Guided by a recently-enacted Maryland statute that provided that any person determined not to be an interested person of an investment company under the 1940 Act is deemed an independent and disinterested person under Maryland law, the federal judge in BEA Associates looked to the 1940 Act to determine if the directors were independent.

Under the 1940 Act, an "interested person" is defined to include "any affiliated person" of an investment adviser, which, in turn, is defined to include "any person directly or indirectly... controlled by... such other person." The 1940 Act further defines control as "the power to exercise a controlling influence over the management or policies of a company." There is a rebuttable presumption under the 1940 Act that a natural person is not a "controlled" person. The BEA Associates court determined that, notwithstanding the statutory presumption, well-compensated service on multiple boards of investment companies managed by a single fund adviser can, in some circumstances, render the directors affiliated with the investment adviser, because the adviser generally chooses the directors initially and, thus, is responsible for placing the directors in the position of being able to receive significant compensation from multiple directorships. This power of the adviser can amount to control over the directors, and, consequently, render them "interested persons" under the 1940 Act.

In contrast, other district courts and the appellate court overseeing Judge Sweet's district court have reached a contrary position regarding the impact of multiple directorships. In Kranz v. Fidelity Management & Research Co. (May 2000), a Massachusetts federal district court dismissed a claim for breach of fiduciary duty based on multiple directorships. The plaintiff claimed that nine members of the 12-person boards within the Fidelity fund complex who serve on the boards of all of Fidelity's investment companies and receive substantial salaries were not independent. Relying on the statutory presumption and new SEC proposals that provide that multiple directorships do not make an independent director an "interested person" under the 1940 Act, the judge dismissed the plaintiff's claims regarding multiple directorships. The judge let stand, however, the plaintiff's claim that the adviser's fee was so excessive as to violate section 36(b) of the 1940 Act.

ICI and SEC initiatives concerning best practices and proposed rules: the SEC and industry leaders such as the ICI have recently been engaged in a debate on corporate governance issues. In May 1998, SEC Chairman Levitt announced the formation of an SEC Roundtable on the Role of Independent Investment Company Directors. Following the roundtable, the SEC announced it would publish proposed rules on director independence. The ICI also announced the formation of an advisory group composed of industry representatives, which published a best practices document for fund governance in June 1999, recommending 15 practices for consideration by all investment company boards.

The SEC welcomed the ICI advisory group's proposals and incorporated certain aspects of them into its October 1999 proposed rule changes (Role of Independent Directors of Investment Companies (SEC Release IC-24082)). The SEC has informally indicated that it expects to adopt the final rules sometime this year to take effect in late 2001.

The 1940 Act does not specifically authorize the SEC to set general standards on directors' independence. Rather, the SEC has identified ten 1940 Act rules that exempt funds or their affiliated persons from provisions of the 1940 Act and have as a condition the approval or oversight of independent directors. A majority of funds rely on one or more of these rules to do such things, for example, as adopt 12b-1 plans and maintain joint insured bonds. For funds relying on any of these exemptions, the proposed rules provide that:

  • fund boards must be composed of a majority or a two-thirds supermajority of independent directors (exact requirement yet to be determined);
  • new independent directors must be selected and nominated solely by those who are independent directors; and
  • legal counsel (if any) for the independent directors may not have also represented the fund's investment adviser, principal underwriter, administrator, or any of their control persons for the prior two years, unless the independent directors determine that the representation is or was so limited that it would not adversely affect counsel's ability to provide impartial, objective, and unbiased legal counsel.

In addition, the proposed rules would require a fund to provide specific disclosure concerning the background and qualifications of fund directors, including identity and business background, share ownership in the fund, potential conflicts of interest, and the board's role in governing the fund. The rules would also prevent qualified individuals from being unnecessarily disqualified from serving as independent directors simply because they invest in index funds that hold shares of the fund's adviser or other affiliates; address new requirements for eliminating co-insured exclusions in existing liability insurance; and require independent audit committees and improved record keeping.

The law on corporate governance for investment companies is evolving rapidly. On the foreseeable horizon is the decision in the BEA Associates litigation and the SEC's publication of a final release that will add or amend several rules under the 1940 Act. These developments will surely focus on the role of independent directors and their increasing responsibility for oversight of fund actions.

Regulation S-P implements the privacy protections of the Gramm-Leach-Bliley Act

On November 12 1999, President Clinton signed into law the Gramm-Leach-Bliley Act (formerly known as the Financial Services Modernization Act of 1999) (GLB Act). On June 22 2000, the SEC adopted Regulation S-P, which implements the provisions that require protection for consumer financial information mandated under the GLB Act.

Under the GLB Act, financial institutions are generally prohibited from disclosing to a non-affiliated third party any non-public personal information, unless the financial institution provides notice and the consumer does not direct nondisclosure. These protective provisions apply to virtually every business providing personal, family or household financial services to individuals. Information about companies, or about individuals who obtain financial products or services primarily for business, commercial or agriculture enterprises, is not protected under the GLB Act.

Regulation S-P applies to the financial institutions for which the SEC has enforcement responsibility under the GLB Act, which include all domestic brokers, dealers, investment companies and SEC registered investment advisers. All non-resident brokers, dealers, investment companies and investment advisers are covered by Regulation S-P if they are registered with the SEC.

The Regulation distinguishes between a consumer and a customer. A consumer is deemed to be an individual who obtains a financial product or service that is used primarily for personal, family, or household purposes. A customer is a consumer who has a continuing relationship with an institution. In general, a customer relationship is established when a consumer receives some measure of continued service, such as opening a brokerage account or obtaining investment advice.

Regulation S-P requires a financial institution to provide a clear and conspicuous notice of its privacy policies before it discloses non-public personal information to any non-affiliated third party. The significance of the distinction between a consumer and customer involves the type of notice that is required. A financial institution must give a consumer who is not a customer the required notice only if the institution intends to disclose non-public personal information to a nonaffiliated third party. By contrast, a financial institution must give all customers notice of the institution's privacy policy at the time the customer relationship is established, and annually thereafter. An institution may provide the initial notice to customers within a reasonable time after it establishes the customer relationship if:

  • establishing the customer relationship is not at the customer's election;
  • the notice would otherwise substantially delay the customer's transaction and the customer agrees to receive the notice at a later time (eg a telephone transaction); or
  • a nonaffiliated broker-dealer or investment adviser establishes a customer relationship between a financial institution and a consumer without the institution's prior knowledge.

The required notice must accurately explain the individual's right to opt out, thereby preventing any disclosure to unaffiliated third parties. Institutions may require the consumer to opt out in a particular way, but it must not be too difficult. Institutions must comply with a consumer's opt-out direction as soon as reasonably practicable. The notice and opt-out requirements do not apply if an institution discloses non-public personal information necessary for a transaction that a consumer requests or authorizes, or the disclosure is to maintain or service the consumer's account with the institution.

In a provision of Regulation S-P that has received relatively little attention, financial institutions are required to adopt policies and procedures that address administrative, technical and physical safeguards for the protection of customer records and information. A single set of policies and procedures for a fund complex could satisfy the rule's requirements, as long as those policies and procedures have been determined to be appropriate for each institution to which they apply.

SEC sets new standards for foreign securities depositories

On April 27 2000, the SEC adopted a new rule and rule amendments under the Investment Company Act of 1940 to address custody of investment company assets outside the US. New Rule 17f-7 and amendments to Rule 17f-5 create new standards for maintaining investment company assets with foreign securities depositories.

According to the SEC, amended Rule 17f-5 is still the primary rule governing a fund's use of a foreign bank custodian. Arrangements with foreign securities depositories, however, are now governed by new Rule 17f-7. When a depository arrangement involves a foreign bank custodian that maintains assets with the depository, Rule 17f-5 applies to the use by the fund and the custodian of each foreign bank depository. However, Rule 17f-7 applies to the subcustodian's use of the depository itself.

Depositories are systems for the central handling of securities where the transactions are processed through electronic account records rather than by the delivery of certificates. The new rule and amendments permit investment companies to protect assets while maintaining them with an eligible foreign securities depository. The depository's eligibility is based on conditions reflecting the operations and the role of the depository.

New Rule 17f-7 permits funds to maintain assets in a foreign securities depository if the depository meets certain minimum requirements. First, the depository must be an "eligible securities depository." Secondly, the fund's "primary custodian" (commonly referred to as a global custodian) must provide a risk assessment of the depository to the fund or its adviser. The primary custodian must also monitor the depository and notify the fund of material changes in risks connected with the depository. A primary custodian is defined as a US bank or a qualified foreign bank that contracts directly with the fund to provide custodial services for foreign assets.

To qualify as an eligible securities depository, the depository must either act as, or operate, a system for the central handling of securities. A foreign financial regulator must oversee the system and the depository must undergo examinations by regulatory authorities or independent accountants. Furthermore, the depository must hold assets on behalf of a fund under safekeeping conditions that are "no less favorable" than those for other participants.

A fund or its investment adviser must receive a custodial risk analysis from the primary custodian (or its agent) before it places assets with an eligible securities depository. This analysis must occur on a continuing basis and the custodian must promptly notify the fund of any material change. Rule 17f-7 allows a custodian to tailor its risk analysis to the specific risks involved in the custodial relationship for each particular depository. It does not provide dispositive factors, nor does the rule weigh the types of risks to be considered. Some of the areas to be addressed, however, include a depository's expertise and market reputation, quality of services, financial strength, any indemnification arrangements, internal controls, and any related legal protections.

New Rule 17f-7 and amended Rule 17f-5 took effect on June 12 2000; however, the SEC will not require compliance until July 2 2001. In the meantime, a fund may operate under the Rule 17f-5 requirements that existed before the 1997 amendments, in which case it must use the 1997 definition of eligible foreign custodian. It may also operate under the 1997 amendments until the 2001 compliance date.

Electronic filing for investment advisers

In September 2000, the SEC adopted new rules under the Investment Advisers Act of 1940 creating an electronic filing system for investment advisers. Under the new rules, an investment adviser is required to submit its registration application and other information electronically over the Internet. The new rules also approve revisions to Part I of Form ADV to accommodate electronic filing on the Investment Adviser Registration Depository.

According to the SEC, electronic filing is intended to make it easier for investment advisers to register and for investors to access information. The system will allow the adviser to link forms already supplied in other contexts to avoid duplication, but will not allow an adviser to file a form that is incomplete or inconsistent.

Under the rules, all new advisers registering after January 2001 must apply for initial registration electronically. For advisers that are already registered, transition to electronic filings will occur between January 2 and April 30 2001. All amendments must be made through the electronic system.

In conjunction with the adoption of the new rules, the SEC approved an update to Part I of the Form ADV to make it more compatible with the electronic filing format. The new form is intended to incorporate certain regulatory changes and generally improve the quality of the information supplied by the adviser. Although the SEC originally proposed revisions to Part II of Form ADV that would require advisers to submit a detailed disclosure document in the form of a written brochure, the SEC did not adopt these revisions due in part to the industry's adverse reaction to the proposed changes. The SEC expects to adopt the revisions to Part II at a later time. In the meantime, filing and updating requirements for Part II will be suspended, although advisers still must provide Part II (or an equivalent brochure) to clients and will have to revise that information to the extent necessary to make it not misleading.

To facilitate this effort and to integrate the state securities authorities, the SEC contracted with NASD Regulation, Inc. (NASDR) to develop and operate the Investment Adviser Registration Depository. The information submitted electronically will be stored in the Investment Adviser Registration Depository database that can be accessed via a website.

The SEC and NASDR successfully tested the system during the week of July 17 2000. Beginning on October 2 2000, the SEC will launch the Investment Adviser Registration Depository Pilot Program to begin making electronic filings. All advisers will be required to file electronically by April 2001.

Disclosure of IPO impact on fund performance

The SEC and the National Association of Securities Dealers (NASD) are increasingly conducting special reviews of fund disclosure (including prospectuses and shareholder reports) and marketing materials (including fund web sites, sales literature and advertisements) to determine whether a fund's representations about extraordinary recent fund performance may be misleading to investors. In an April 2000 Notice to Members, NASD cautioned that members who choose to present extraordinary recent fund performance information should do so in a manner designed to lessen the possibility that investors will have unreasonable expectations concerning the future performance of these mutual funds.

Several recent SEC administrative proceedings shed light on specifically prohibited disclosure practices in relation to a fund's investment in initial public offerings (IPOs). In In the Matter of The Dreyfus Corp. and Michael L. Schonberg, Admin. Proc. File No. 3-10201 (May 10, 2000), the SEC found, among other violations, that a fund's failure to disclose the large impact IPOs had on its past performance constituted a material omission. The fund touted an 84.16% return since its inception and a 40.94% return in the first quarter of 1996. The fund in question was the newest of several funds managed by the same portfolio manager. The prospectuses provided that "available investments or opportunities for sales will be allocated equitably to each investment company". The new fund, however, was favoured in the allocation of IPOs and, in particular, received preferential treatment for 'hot' offerings. While the fund's advertising did provide some cautionary notes, the SEC found that the adviser's failure to measure and discuss the specific impact on performance of investment in IPOs in general – and the use of favourable IPO allocation practices in particular – was false and misleading to potential investors.

Continuing its focus on allocations of 'hot' IPOs, the SEC in early September announced the settlement of an administrative proceeding against an investment adviser and its president for allocating shares from initial public offerings to client accounts through an ad hoc process that disproportionately favoured certain clients to the detriment of other clients. The In re F.W. Thompson Co., Release No. IA-1895 (Sept. 7, 2000) case differs from the Dreyfus case, where the favourable allocations were alleged to benefit a mutual fund whose performance could then be heavily advertised, and another case settled earlier this year, where the preferential allocations were found to benefit affiliated mutual fund directors. Instead, there was no allegation in Thompson that any of the favoured clients had an affiliation with the adviser, and the case was based simply on the adviser's failure to adequately disclose an IPO allocation that favoured a certain group of clients. The adviser had no written procedures governing IPO allocations and provided no disclosure to its clients with respect to its allocation practice.

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