1




                   From

Readings on the Investment Company Act
    and the Investment Advisers Act




            ...
2
               Chapter 3. Structural Aspects
                of an Investment Company

A. Name


                       ...
3
approval of registrant and its securities by the United States, in violation of Sections
35(a) and 35(d) of the Act. In ...
4
other advantages for government personnel over other mutual funds. It asserts that
the name merely implies and was inten...
5
they vary greatly in their incomes and family responsibilities and they are engaged in
a great variety and range of occu...
6
        Nor do we perceive any advantage to government personnel in the fact that
registrant's board of directors is in ...
7
'Government' and 'Government Personnel' were used in a number of official
government publications to refer to the United...
8
                    Civil and Military Investors Mutual Fund, Inc.
                       v. Securities and Exchange Com...
9
Therefore, in the Commission's view, it is irrelevant that the means of acquisition of
petitioner's shares -- the accumu...
10
                                            Note

         In The First Safe Fund (publicly available January 9, 1972),...
11
have connotations of savings accounts, which are commonly government-guaranteed.
Accordingly, we are not able to state ...
12
                                          Note

To implement amended section 35(d), the Securities and Exchange Commiss...
13
        The terms >international= and >global,= however, connote
        diversification among investments in a number ...
14
Q. How does rule 35d-1 apply to a fund that uses the term >high-
yield= in its name?
A: The term >high-yield= is genera...
15
achievement of current income and does not suggest a type of
investment. For example, fund companies offering a group o...
16
                                 Discussion Problem 3.1


        Morningstar, one of the major services that monitors ...
17
B. Financial Requirements


                                   In the Matter of
                   Robbinsdale Federati...
18
The fund will not retain any investment adviser or manager on a permanent basis and
will act as its own underwriter.
  ...
19
bare minimum11 needed by an investment company.12 Absent other factors which
would provide some assurance of financial ...
20
C. The Board of Directors:                         Interested and Affiliated
Persons

                *Section 9 Of The...
21
operative; a person who falls within ' 9(a) is automatically barred unless the SEC uses
its ' 9(c) power to grant an ex...
22

                                               Note

             In enacting the Investment Company Act (ICA), the U....
23
      'independent watchdogs,'', who would 'furnish an independent check
      upon the management' of investment compa...
24
                Independent directors play a critical role in policing the
       potential conflicts of interest betwe...
25
       $ Rule 15a-4(b)(2), under which the board of an investment company can,
       without the approval of the share...
26
                  *The    Chamber of Commerce Case

        In January 2004, the SEC proposed to add additional conditi...
27
                             EuroPacific Growth Fund, et al.
                Securities and Exchange Commission Release...
28
company that is primarily engaged in the mortgage banking business. One of Irwin
Financial's indirect wholly-owned subs...
29
affiliated person of Irwin Securities, Mr. Kling currently is considered an interested
person of the Funds.
         .....
30
investment adviser (Capital Research), and just a minority of the independent
directors of the Funds will be affiliated...
31
                        SAFECO Asset Management Company
                 Securities and Exchange Commission No-Action L...
32
position with regard to Dr. Odegaard's status in the context of Section 2(a)(19) of the
Act in order that he be able to...
33
                                         Note

       In a 1999 release, the Commission discussed section 2(a)(19)(B)(i...
34
The Rule applies only to an index fund whose index is Abroad-based.@ According
to the Commission, Aa >broad-based index...
35
                            Twentieth Century Investors, Inc.
                  Securities and Exchange Commission No-A...
36
as a person having a beneficial interest in securities issued by the investment advisor
or principal underwriter. It is...
37
                   Interpretive Matters Concerning Independent Directors
                                  of Investmen...
38
the level of the director's responsibility in the position and the level of compensation
or other benefits that the dir...
39
business transactions, such as business and personal loans, and real estate purchases.41
In addition, a material busine...
40
        A fund director may be deemed to have indirectly engaged in a material
transaction with a Specified Entity thro...
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  1. 1. 1 From Readings on the Investment Company Act and the Investment Advisers Act Larry D. Barnett School of Law Widener University Wilmington, Delaware Copyright © 2008 by Larry D. Barnett All rights reserved Additional materials © 2008 by C. Steven Bradford
  2. 2. 2 Chapter 3. Structural Aspects of an Investment Company A. Name In the Matter of Civil and Military Investors Mutual Fund, Inc. Securities and Exchange Commission Release No. IC-2723 June 9, 1958 1958 SEC LEXIS 405 ... This is a proceeding to determine whether the name of Civil and Military Investors Mutual Fund, Inc. ('registrant'), a registered investment company, and specifically the words 'Civil and Military Investors' in such name, are deceptive or misleading in violation of Sections 35(a) and 35(d) of the Investment Company Act of 1940 ('Act').1 ... In November 1954, registrant was organized under the name 'Government Personnel Mutual Fund, Inc.' and became registered with us as an investment company. In the course of proceedings pursuant to Section 35 of the Act with respect to such name, registrant changed its name to 'The Private Investment Fund for Governmental Personnel, Inc.' After hearings we found, among other things, that such name, and specifically the words 'Governmental Personnel' therein, were deceptive and misleading as implying that registrant's securities had investment and other advantages for the civilian and military government personnel to whom sales were to be restricted, in violation of Section 35(d) of the Act, and as implying 1 Section 35(a) of the Act provides: 'It shall be unlawful for any person, in issuing or selling any security of which a registered investment company is the issuer, to represent or imply in any manner whatsoever that such security or company has been guaranteed, sponsored, recommended, or approved by the United States or any agency or officer thereof.' Section 35(d) of the Act provides in pertinent part: 'It shall be unlawful for any registered investment company hereafter to adopt as a part of the name or title of such company, or of any security of which it is the issuer, any word or words which the Commission finds and by order declares to be deceptive or misleading.'
  3. 3. 3 approval of registrant and its securities by the United States, in violation of Sections 35(a) and 35(d) of the Act. In March 1957 registrant adopted its present name. Registrant is a Delaware corporation with its principal office in Washington, D.C. . . . It proposes to operate as an open-end, diversified, management investment company seeking long-term growth of principal and income primarily through diversified holdings of selected common stocks. The sale of registrant's shares will not be restricted to personnel of federal, state and local governments, including military personnel, although sales efforts will be directed to them. Registrant's directors include former high government officials and a retired general. We stated in The Private Investment Fund for Governmental Personnel, Inc.4 that, in determining whether the name of an investment company is deceptive or misleading, we must carry out the Congressional policy . . . of affording broad protection to investors against fraud and misrepresentation of all types in the sale of securities. We must give due recognition, as have the courts, to the fact that 'the investing and usually naive public needs special protection in this specialized field'; and must take into account the effect which the name may have not only on the sophisticated and informed investor, but also on the unwary and the ignorant. Actual deception of investors need not be shown, it being sufficient if the name of the company is found to have a tendency or capacity to deceive or mislead; and it is appropriate to take into account that a newly adopted name not only does not have the benefit of any clarifying effect which long usage might have supplied but also has no trade value which might warrant permitting continued use of a misleading name in conjunction with a qualifying statement designed to prevent deception. With these as general guiding principles, we turn to a consideration of the issues presented. Implication of Investment and Other Advantages With respect to the issue presented of whether registrant's name is deceptive or misleading within the meaning of Section 35(d) of the Act as implying investment and other advantages for government personnel that do not in fact exist, the contentions of [our Division of Corporate Regulation] and registrant are almost identical with those advanced in the Private Investment Fund case, and the evidence presented is substantially the same. The Division contends that registrant's name, no less than its previous name, indicates that the sale of registrant's shares will be directed to government personnel and accordingly implies that registrant will provide unique investment or other advantages for them. It asserts that government personnel are not a homogeneous group having a special investment need, and that they will be misled by the name into believing that they are, that registrant will serve such need, and that other investment companies will not do so. Registrant admits that its new name will indicate to government personnel that the fund is directed to them, but it denied that the name implies investment or 4 4 37 S.E.C. 484, 487-8 (1957).
  4. 4. 4 other advantages for government personnel over other mutual funds. It asserts that the name merely implies and was intended to imply features which registrant believes will 'interest and appeal to' government personnel as investors. Registrant argues that there is a degree of homogeneity in government personnel and asserts that they have greater stability of income and employment than non-governmental personnel, higher median income, more established fringe benefits, greater proportionate participation in the United States Savings Bond program and a greater preference for mutual fund periodic purchase plans, and do not have the same opportunity to participate in employee stock purchase plans. Registrant claims that the stability of governmental personnel would cause registrant to enjoy a redemption experience superior to that of mutual funds generally, and sufficiently good to justify an offering of shares to such personnel on terms which would be markedly better than those offered by funds organized in the past 10 years and would compare favorably with the terms prevailing in the industry. It points to the fact that sales commissions will be a maximum of 71/2% of the public offering price, and asserts that no significant fund has been organized in the past 10 years with a sales load as low. It states that registrant is the only fund of general distribution which will offer a program for the accumulation of shares with periodic investments of $50 or $100 at a sales load of 71/2%, that the accumulation of shares will be possible with an initial payment of only $50 without payment of a bank service charge and as little as $25 with a 25 cents bank service charge, periodic payments and bank charges thereafter being in the same small amounts, and that such initial minimum payments are considerably lower than are generally required by other mutual funds. Registrant also points out that while it will pay the standard management-advisory fee of 1/2 of 1% per annum of average net assets, unlike most funds it will pay progressively lower fees on assets in excess of $25 million, and that while several major funds also apply lower fees on assets in excess of certain amounts, such amounts are considerably greater than $25 million. In addition, registrant asserts that it offers other features which it believes will appeal to government personnel such as an all-common stock portfolio which would provide a degree of protection against inflation and a board of directors which includes men of outstanding reputation and experience in government service. We are of the opinion that registrant's present name, like its previous name, implies that registrant is particularly suited to meet the investment needs of government personnel and will provide investment or other advantages for them not available in other mutual funds. Since in our view such advantages do not in fact exist, such implication renders the name misleading and deceptive. We are unable to find that governmental personnel constitute a homogeneous group with a peculiar investment need or with characteristics which would give financial advantages to a mutual fund directed to them and would make the fund specially suited to them. Such personnel have widely varying financial positions and investment needs, particularly since the group consists not only of federal employees, but also of state, county and municipal employees, and all classes of military personnel. Like private employees,
  5. 5. 5 they vary greatly in their incomes and family responsibilities and they are engaged in a great variety and range of occupations. Whether or not the median income and stability of employment of government personnel are greater than in the case of private employees, we think that such a comparison is not a valid one, and that a more appropriate comparison would be between such government personnel as are likely to become mutual fund investors and potential investors generally.8 In any event, we do not consider that the average median income of so heterogeneous a group as that to which registrant's shares are to be offered is particularly significant. While generally speaking the employment of civilian government personnel is relatively stable, it has not been shown that such investors are in a significantly more favorable situation than investors who are not civilian government employees. Nor does the record indicate the suitability of a special common stock investment program for so diverse a group as civil and military personnel. While their salary levels are in large part established by legislative action and may to some extent tend to lag in periods of inflation, the record does not show that government personnel have not provided themselves with as much protection against inflation through acquisition of common stock or otherwise and have a greater need for investment in diversified common stocks than non-governmental personnel. The alleged fact that a larger percentage of federal than private employees purchase United States Savings Bonds does not indicate the suitability of a common stock fund for those government workers who own little or no bonds, as compared to a form of investment which consists largely or partly of bonds, or other senior securities. And while federal employees have certain uniform fringe benefits such as retirement rights and sick leave, many private corporations provide similar benefits. In any event, registrant proposes to follow the same basic investment policy -- that of long- term growth of principal and income primarily through diversified holdings of selected common stocks -- as that of a number of other mutual funds which are available generally to government employees whose financial situation makes investment in such a fund desirable. With respect to registrant's 7 1/2% sales charge and . . . [terms for the accumulation of shares through periodic investments], the record indicates that these features are not significantly more favorable, and in some respects are less favorable, than the terms available in other mutual funds. . . . With respect to the reductions in registrant's management-advisory fees on assets in excess of $25 million, whether such lower charges will ever become effective will of course depend upon future sales of registrant's shares, and any benefit to be derived therefrom by the shareholders will depend upon whether registrant's total expenses, including the management-advisory fee, are less than those of other mutual funds. 8 8 While, as registrant points out, government personnel do not have as great a proportion of low incomes as non-government personnel, neither do they have as great a proportion of high incomes.
  6. 6. 6 Nor do we perceive any advantage to government personnel in the fact that registrant's board of directors is in part composed of men who formerly occupied important positions in the federal government and have experience with problems of government personnel. There is no indication that these men have had any investment or financial experience which would qualify them as investment managers, and their familiarity with the problems of government personnel will provide no apparent advantage for such personnel in their capacity as investors. Registrant asserts that the names of other mutual funds registered with us, such as a number which begin with the name of a state and Teachers Association Mutual Fund of California, Inc., indicate that such funds are directed to particular groups, and contends that it would be arbitrary to require registrant, as a condition to using its name, to show unique investment advantages for the group to which its fund is directed. However, we think that registrant's name presents a materially different situation. The use of the name of a state in the title of a fund does not in our opinion imply that the fund is designed to meet the investment needs of the residents of the particular state, nor does it imply other advantages to such residents. With respect to the Teachers Association fund, the name of that fund is identified with and descriptive of an existing local organization of teachers, California Teachers Association-Southern Section, which authorized and approved the creation of the fund. The fund sells shares exclusively to members and employees of that Association and their families, and the officers and directors of the fund include officers, directors and members of the Association. The shares are distributed and sold through a wholly-owned subsidiary of the Association, no sales being made through brokers or dealers, and the sales load is only 2% and covers all distribution expenses. While the fund pays a management-advisory fee of 1% as compared to the prevailing fee of 1/2 of 1%, the manager of the fund pays all other expenses except taxes and interest, whereas registrant must pay all expenses, including the management-advisory fee, custodian fees, transfer agent fees, legal and accounting fees, and fees of technical advisors, and is entitled to reimbursement of such expenses by its distributor only to the extent that they exceed 1% of registrant's average net assets. We conclude that the implication inherent in registrant's name that the fund has special investment or other advantages for government employees or military personnel that, as we have found, do not in fact exist, renders that name misleading and deceptive within the meaning of Section 35(d) of the Act. Implication of Approval by United States Registrant contends that its name, and specifically the use of the words 'Civil and Military' in such name, does not convey a misleading impression of recommendation, sponsorship or approval of registrant or its securities by the United States in violation of Sections 35(a) and 35(d) of the Act. In The Private Investment Fund for Governmental Personnel, Inc., we found that the fact that the words
  7. 7. 7 'Government' and 'Government Personnel' were used in a number of official government publications to refer to the United States government and its employees, together with the implication in the name that the fund was directed exclusively to such employees, and the Federal government's increasing interest and participation in projects for the welfare of its employees such as group life insurance, created the implication of at least approval of registrant and its shares by the United States. In the instant case, however, we do not think that the phrase 'Civil and Military', in association with the word 'Investors', carries an official flavor such as we found attached to the words 'Governmental Personnel'. Accordingly, we are of the opinion that neither registrant's name in its entirety, nor the words 'Civil and Military' in such name, would be likely to carry an implication that registrant or its securities have been sponsored, recommended, or approved by the United States. We accordingly find that registrant's name does not violate Section 35(a) of the Act. Conclusion We have found that registrant's name implies that registrant will provide special investment and other advantages for government personnel that do not in fact exist. Accordingly, we shall issue an order declaring registrant's name and specifically the words 'Civil and Military Investors' in such name to be deceptive and misleading in violation of Section 35(d) of the Act. ... By the Commission . . .
  8. 8. 8 Civil and Military Investors Mutual Fund, Inc. v. Securities and Exchange Commission 288 F.2d 156 (D.C. Cir. 1961) OPINION OF THE COURT Petitioner Civil and Military Investors Mutual Fund, Inc., seeks review of an order of the respondent Securities and Exchange Commission declaring petitioner's name to be deceptive and misleading in violation of Section 35(d) of the Investment Company Act of 1940 . . . . Petitioner, an investment company registered under the Act, proposes to sell mutual fund shares by means of 'Accumulation Plans.'1 . . . [I]n 1957 petitioner adopted its present name, 'Civil and Military Investors Mutual Fund, Inc.' . . . [T]he Commission found that the present name 'implies that (petitioner) will provide special investment and other advantages for government personnel that do not in fact exist,' and issued an order declaring it deceptive and misleading. Petitioner then filed a motion before the Commission seeking modification of this order because of changes in the terms of the offering . . . . The principal changes were two: (1) elimination of a 71/2% sales commission; and (2) the decision to sell its shares only to Federal, state and local government employees. . . . . . . [T]he Commission entered an order denying the petition for modification, stating, in part, in its findings: 'We are unable to find that either the changed terms of the proposed offering or the asserted interest of government personnel in accumulation plans renders not deceptive or misleading the implication which is inherent in (petitioner's) name that (petitioner) is particularly suited to meet the investment needs of such personnel.' ... Petitioner urges that its name is intended to imply, and does imply, only that its sales will be restricted to government employees, and not that this group will derive special advantages from the plan. At the same time it contends that its plan does provide advantages for government personnel, in that the terms of acquisition will be of special interest to such personnel. The Commission, on the other hand, argues that the name does not merely describe the group addressed, but raises an expectation in that group of an investment advantage which goes to the very heart of the transaction. There is, concededly, nothing unique about the type of securities the Fund proposes to acquire, or the financial terms offered. Many investment companies offer accumulation plans. Many do not charge a sales commission. 1 1 Unlike the method of share acquisition known as 'Regular Account' buying, by which investors purchase specified numbers of shares in distinct transactions, the 'Accumulation Plan' permits investors to make payments of a specified sum on a regular or irregular basis, with each payment being used in full to buy as many shares as possible plus a fractional share.
  9. 9. 9 Therefore, in the Commission's view, it is irrelevant that the means of acquisition of petitioner's shares -- the accumulation plan buying provisions -- may be a desirable arrangement, since the implication raised by the name suggests more than that. But in any case, the Commission contends, petitioner failed to establish even that the accumulation plan feature is of unique interest to government employees. We believe, taking the record as a whole, that the Commission's determination has substantial evidentiary support. We cannot say that it was unreasonable for the Commission to conclude that the name in question implies a unique and material advantage to a particular group, and that the expectations raised by the name may have a harmful tendency to mislead and deceive prospective investors. The Commission has not found an actual intent to deceive, on the part of petitioner and its managers, and we find no suggestion of any such intent. What it has found is a harmful tendency inherent in the name itself. That is enough. The Commission is entitled to insist that the public be led to look to the essential merits of an investment offered to it, rather than to matters extraneous to those merits. We find in this case no such arbitrary or unreasonable action as would warrant disturbing the Commission's determination. Affirmed.
  10. 10. 10 Note In The First Safe Fund (publicly available January 9, 1972), 1972 SEC NOACT LEXIS 159, the Commission staff received an inquiry regarding a proposed open-end investment company that would have ". . . protection of capital as its primary objective. The company will have two funds, one fund for investing in United States government securit[ies] and high quality corporate and utility bonds, and a second fund for investing in high grade municipal tax-exempt bonds. . . . [T]he proposed name of the company is 'The First Safe Fund'. . . ." The staff responded: "In our view use of the word 'safe' in the proposed Fund's name would be misleading within the meaning of Section 35(d) of the Investment Company Act because it could be taken to mean that, in addition to principal, investment return of a particular rate is assured, which, of course, is not the case as government, corporate and utility bond rates vary. Also, since the Fund will invest in government securities, use of the word 'safe' might imply government guarantee of the Fund. The latter implication is prohibited by Section 35(a) of the Act." In Wright Investors Service (publicly available March 14, 1974), 1974 SEC NOACT LEXIS 1785, a mutual fund was being organized ". . . that will combine the advantages of a fund offering current high interest rates with those of a fund offering potential equity growth, through the medium of a single investment company. The proposed Fund [to be named the Wright Savings and Equity Shares] will also permit virtually unrestricted exchange privileges between 'Savings' and 'Equity' Shares within the Fund at little or no cost to the individual investor. It is our belief that such a Fund will meet the needs and the demands of the small investor who seeks profes- sional management." The SEC staff concluded that ". . . in our view, use of the word 'Savings' in the proposed Fund's name would be misleading within the meaning of Section 35(d) of the Investment Company [Act] of 1940. The reason for our view is that the name could be taken to mean that the 'savings shares' being offered are comparable to savings accounts in a bank, which are commonly insured by the federal government. It may occur to you that some explanation in the prospectus would obviate this problem, but under applicable Commission decisions, an explanation in the company's prospectus to the effect that the shares are not insured by the federal government would not cure the deceptive or misleading character of the name. . . ." In National Securities & Research Corporation (publicly available January 21, 1974), 1974 SEC NOACT LEXIS 1331, the name of a registered investment company was to be changed from the "National Securities Funds" to the "Savest Funds." The company explained that " 'Savest' is, of course, a meld of 'save' and 'invest.' Mutual funds are designed as a savings vehicle in which a broad cross section of the public may accumulate a professionally managed investment program for long term goals." The staff, however, concluded the new name would violate the Investment Company Act: "it [is] our view that the name 'Savest' is misleading within the meaning of Section 35(d) . . . in that it sounds like 'Safest' and may also
  11. 11. 11 have connotations of savings accounts, which are commonly government-guaranteed. Accordingly, we are not able to state that we would not recommend any action to the Commission if the name is used."
  12. 12. 12 Note To implement amended section 35(d), the Securities and Exchange Commission adopted Rule 35d-1 to specify names that are materially deceptive or misleading. Investment Company Names, Release No. IC-24828, 66 Fed. Reg. 8509 (Feb. 1, 2001). At the time the Rule was promulgated, four out of five registered investment companies were estimated to have names that were subject to the Rule. Id. at 8515 n.49. Read Rule 35d-1. In the Release adopting the Rule, the Commission pointed out that: the 80% investment requirement is not intended to create a safe harbor for investment company names. A name may be materially deceptive and misleading even if the investment company meets the 80% re- quirement. Index funds, for example, generally would be expected to invest more than 80% of their assets in investments connoted by the applicable index. . . . Id. at 8511. The Commission elaborated further on the scope of the Rule, saying that: the rule does not apply to fund names that incorporate terms such as >growth= and >value= that connote types of investment strategies as opposed to types of investments. The Division [of Investment Management] will continue to scrutinize investment company names not covered by the proposed rule. In determining whether a particular name is misleading, the Division will consider whether the name would lead a reasonable investor to conclude that the company invests in a manner that is inconsistent with the company's intended investments or the risks of those investments. Id. at 8514. The terms >small, mid, or large capitalization= and >index= suggest a focus on a particular type of investment, and investment companies that use these terms will be subject to the 80% investment requirement of the rule. The term >balanced,= however, does not suggest a particular investment focus, but rather a particular type of diversification among different investments, and >balanced= funds will not be subject to the rule. The Division takes the position that an investment company that holds itself out as >balanced= should invest at least 25% of its assets in fixed income senior securities and should invest at least 25% of its assets in equities. . . . The term >foreign= indicates investments that are tied economically to countries outside the United States, and an investment company that uses this term would be subject to the 80% requirement.
  13. 13. 13 The terms >international= and >global,= however, connote diversification among investments in a number of different countries throughout the world, and >international= and >global= funds will not be subject to the rule. We would expect, however, that investment companies using these terms in their names will invest their assets in investments that are tied economically to a number of countries throughout the world. . . . Id. at 8514 n.42. Following the Release that adopted Rule 35d-1, the staff of the Division of Investment Management explained how the Rule applies to a number of situations. Investment Company Institute (publicly available Dec. 4, 2001), 2001 SEC NOACT LEXIS 824. In a question-and-answer format, the staff wrote inter alia: ... Q: Are funds with the term >municipal= in their names treated like tax-exempt funds under rule 35d-1(a)(4)? A: Yes. The terms >municipal= and >municipal bond= in a fund's name suggest that the fund's distributions are exempt from income tax. Therefore, funds that use these terms in their names would be expected to comply with rule 35d-1(a)(4). However, funds that use the term >municipal= rather than >tax-exempt= may count securities that generate income subject to the alternative minimum tax toward the 80% investment requirement, while funds that use the term >tax- exempt= may not. ... Q: Does rule 35d-1 apply to funds that use the terms >small-cap,= >mid-cap,= and >large-cap?= A: Yes. Terms such as >small-, mid-, or large-capitalization= suggest a focus on a particular type of investment, and investment companies that use these terms will be subject to the 80% investment requirement of the rule. As a general matter, an investment company may use any reasonable definition of these terms and should define these terms in its discussion of its investment objectives and strategies in its prospectus. In developing a definition of the terms >small-, mid-, or large-capitalization,= registrants should consider all pertinent references, including, for example, industry indices, classifications used by mutual fund rating organizations, and definitions used in financial publications. Definitions and disclosure inconsistent with common usage, including definitions relying solely on average capitalization', are considered inappropriate by the staff.
  14. 14. 14 Q. How does rule 35d-1 apply to a fund that uses the term >high- yield= in its name? A: The term >high-yield= is generally understood in the financial and investment community to describe corporate bonds that are below investment grade, commonly defined as bonds receiving a Standard & Poor's rating below BBB or a Moody's rating below Baa. Therefore, a fund using the term >high-yield= in its name generally must have a policy to invest at least 80% of its assets in bonds that are below investment grade. However, a fund that uses the term >high-yield= in conjunction with a term such as >municipal= or >tax-exempt= that suggests that the fund invests in tax-exempt bonds would not be required to invest at least 80% of its assets in bonds that meet these rating criteria. Because the market for below investment grade municipal bonds is smaller and relatively less liquid than its taxable counterpart, tax-free high-yield bond funds have historically invested to a greater degree in higher grade bonds than taxable high-yield funds. As a result, the use of the term >high-yield= together with a term suggesting that the fund invests in tax-exempt bonds suggests that the fund has an investment strategy of pursuing a higher yield than other municipal or tax-exempt bond funds. ... Q: Does rule 35d-1 apply to a fund that uses the term >tax-sensitive= in its name? A: No. The term >tax-sensitive= connotes a type of investment strategy rather than a focus on a particular type of investment. Therefore, use of the term >tax-sensitive= in a fund's name will not require the fund to comply with the 80% investment requirement of rule 35d-1. We remind funds, however, that a particular fund name may be misleading under the antifraud provisions of the federal securities laws, even if it is not covered by rule 35d-1. In determining whether a particular name is misleading, the Division considers whether the name would lead a reasonable investor to conclude that the fund invests in a manner that is inconsistent with the fund's intended investments or the risks of those investments. Q: How does rule 35d-1 apply to a fund that uses the term >income= in its name? A: Rule 35d-1 would not apply to the use of the term >income= where that term suggests an investment objective or strategy rather than a type of investment. When used by itself, the term >income= in a fund's name generally suggests that the fund emphasizes the
  15. 15. 15 achievement of current income and does not suggest a type of investment. For example, fund companies offering a group of >life cycle= funds, each of which invests in stocks, bonds, and cash in a ratio considered appropriate for investors with a particular age and risk tolerance, sometimes use the term >income= to describe the fund that places the greatest emphasis on achieving current income. Similarly, the term >growth and income= does not suggest that a fund focuses its investments in a particular type of investment, but rather suggests that a fund invests its assets in order to achieve both growth of capital and current income. Likewise, the term >equity income= suggests that a fund focuses its investments in equities and has an investment objective or strategy of achieving current income. By contrast, a term such as >fixed income= suggests investment in a particular type of investment and would be covered by rule 35d-1. ... Q: Would rule 35d-1 require a fund that uses a term such as >intermediate term bond= in its name to invest at least 80% of its assets in intermediate term bonds? A: No. The Division takes the position that a >short-term,= >intermediate-term,= or >long-term= bond fund should 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. Such a fund should, however, invest at least 80% of its assets in bonds in order to comply with rule 35d-1. Compliance with the Division=s maturity guidelines is not intended to act as a safe harbor in determining whether a name is misleading. There may be instances where the dollar-weighted average maturity of a fund's portfolio securities may not accurately reflect the sensitivity of the fund's share price to changes in interest rates. ...
  16. 16. 16 Discussion Problem 3.1 Morningstar, one of the major services that monitors and evaluates mutual funds, studied fifteen stock funds whose names contained the phrase "blue chip" and concluded that "these funds employ a very different definition of the term blue chip than do the news media or the general public." Don Phillips, True Blue?, MORNINGSTAR INVESTOR 3 (May 1995). The portfolios of the fifteen funds generally consisted of growth stocks of mid-size domestic companies whose earnings per share had increased much more rapidly than earnings per share in the market as a whole. "These are hardly the characteristics of mature, staid businesses," Morningstar noted, implying that stock should be deemed "blue chip" only if the company issuing the stock is "mature" and "staid." Id. The definition of "blue chip" found in other sources is not inconsistent. For example, one source uses the term "blue chip" to refer to the securities of companies that have been able to maintain earnings and pay dividends over a long period of time, with the result that the securities carry a below- average risk investors will lose principal or suffer a decline in income. DAVID L. SCOTT, WALL STREET WORDS 36 (rev. ed. 1997). Another source defines "blue chip" as common stock issued by a company that has achieved national recognition, that has acquired a reputation for quality in its management and products, and that has had a long history of growth in profits and the payment of dividends. John Downes & Jordon E. Goodman, BARRON'S FINANCE & INVESTMENT HANDBOOK 202 (4th ed. 1995). Given their portfolios, the fifteen funds can be expected to perform quite differently than the Dow Jones Industrial Average, which is composed of thirty "blue chip" stocks. Downes & Goodman, supra, at 608. Thus, the Morningstar study reported that on one day in 1995 the Dow Jones Industrial Average rose 0.7% but the net asset value of the shares of the fifteen funds either remained unchanged or declined. Six of the funds on this day saw the net asset value of their shares fall by 0.5% or more. Should the Securities and Exchange Commission regulate use of the phrase "blue chip" in the names of stock mutual funds? If so, under what conditions should a stock fund be allowed to include "blue chip" in its name? What requirements should be imposed on the portfolio of such a fund?
  17. 17. 17 B. Financial Requirements In the Matter of Robbinsdale Federation Investment Fund, Inc. Securities and Exchange Commission Release No. IC-8525 October 1, 1974 1974 SEC LEXIS 2584 ... These are proceedings with respect to an application filed pursuant to Section 6(b) of the Investment Company Act of 1940 by Wilson Anderson, Jr. ("applicant"), on behalf of Robbinsdale Federation Investment Fund, Inc. ("fund"), a proposed open-end investment company, requesting exemptions from all or some of the provisions of that Act.I Applicant and the eight other organizers of the fund are school teachers employed by the Robbinsdale, Minnesota school district, and are among approximately 1,000 such teachers who are members of the Robbinsdale Federation of Teachers ("RFT"). The fund will issue redeemable securities without sales load and will purchase securities for investment. Participation will be limited to RFT members and former members and their immediate families.2 Management of the fund's portfolio will be vested in a board of directors elected by the shareholders, with costs of administration paid out of the proceeds from sale of the fund's shares. I I Editor's note: Section 6(b) of the Investment Company Act provides that, "[u]pon application by any employees' security company, the Commission shall by order exempt such company from the provisions of this title and of the rules and regulations hereunder, if and to the extent that such exemption is consistent with the protection of investors. In determining the provisions to which such an order of exemption shall apply, the Commission shall give due weight, among other things, to the form of organization and the capital structure of such company, the persons by whom its voting securities, evidences of indebtedness, and other securities are owned and controlled, the prices at which securities issued by such company are sold and the sales load thereon, the disposition of the proceeds of such sales, the character of the securities in which such proceeds are invested, and any relationship between such company and the issuer of any such security." An employees' securities company is defined in section 2(a)(13) of the Investment Company Act. 2 2 Former RFT members and their immediate families would not be eligible to make further purchases of fund shares after termination of RFT membership.
  18. 18. 18 The fund will not retain any investment adviser or manager on a permanent basis and will act as its own underwriter. ... We thus come to the request for an exemption from Section 14(a) of the Act, which applicant states is most crucial and without which the fund will not be organized. Section 14(a) among other things provides that a registered investment company shall not make a public offering of its securities unless it has a net worth of at least $100,000, or it has received firm agreements from not more than 25 persons to purchase its securities in an aggregate amount which when added to its net worth will equal at least $100,000. In the latter event arrangements must be made whereby any proceeds paid in will be refunded on demand in the event the net proceeds received by the company do not result in its having a net worth of at least $100,000 within 90 days after its Securities Act registration statement becomes effective. The application states that it is anticipated that most if not all fund shareholders will purchase their stock through small monthly payments of $10 to $20 per month. Applicant estimates that it would be at least two years before investments in the fund aggregated $100,000. Applicant argues that the primary objective of the minimum capital requirement of Section 14(a) is to prevent a "fly-by-night" irresponsible promoter from forming an investment company on a shoestring, and that there is no need for the requirement in this case. Applicant contends that there are no promoters involved with the fund,9 arguing that the fund's organizers will be on an equal footing with their fellow employee-investors and will not stand to profit except to the extent that the fund's shares appreciate, and so the question of financial responsibility is moot. It is true that one of the objectives of Section 14(a) was to discourage the formation of investment companies by the "fast-buck, fly-by-night, office-in-your- hat, tipster-with-some-fancy-ideas promoter." We agree with applicant that this is not such a case. And we sympathize with the desire of a group of apparently responsible persons to reduce the cost and burden of acquiring an investment in a varied portfolio of securities. But guarding against the danger of irresponsible promoters is not Section 14(a)'s sole purpose. It also seeks to protect public investors against the likelihood that their investment in a new company will be consumed by inescapable overhead and operating expenses, such as filing and printing costs and legal and accounting fees. Moreover, if a fund has only enough capital to purchase very small amounts of securities, its brokerage costs may be so high as to defeat the very purpose for which it was formed. This is not to say that we would necessarily require applicant to have the $100,000 net worth specified by Section 14(a). But the proposed fund, at least for some time to come, will lack any semblance of the capital Congress considered the 9 9 To the contrary, applicant and the other organizers are promoters within the meaning of Section 2(a)(30) of the Act, which defines a promoter of a company as one "who, acting alone or in concert with other persons, is initiating or directing . . . the organization of such company."
  19. 19. 19 bare minimum11 needed by an investment company.12 Absent other factors which would provide some assurance of financial stability,13 we are constrained to deny this application. Accordingly, IT IS ORDERED that the application on behalf of Robbinsdale Federation Investment Fund, Inc. for exemption from all or some of the provisions of the Investment Company Act be, and it hereby is, denied. By the Commission. . . . 11 1 Section 1(b) of the Act declares that the national public interest and the interests of investors are adversely affected "(8) when investment companies operate without adequate assets or reserves." See also testimony . . . that it was felt that any amount less than $100,000 would be too small to cover the necessary overhead and operating expenses of a minimum company, and testimony . . . that investors had suffered substantial losses in small investment companies where expenses devoured all of their income even when they were not fly-by-nights, and that the Commission did not contemplate undoing the effect of the $100,000 requirement in Section 14(a) through the issuance of rules or the use of exemptive actions pursuant to Section 6. Hearings on H.R. 10065 before a Subcommittee of the House Committee on Inter- state and Foreign Commerce, . . . (1940). 12 2 Neither extended discussion nor statistical compilations are needed to demonstrate that the $100,000 deemed essential by the Congress of 1940 was a far higher figure in real terms than that same $100,000 is today. 13 3 Cooperation of the employer with the employees in the management of the company is not essential to its status as an employees' securities company. But Congress apparently contemplated such cooperation, . . . and the existence of such cooperation could under certain circumstances offer sufficient assurance of organizational and financial stability to supplant the requirements of Section 14(a). Thus, . . . where an exemption from various provisions of the Act, including Section 14(a), was granted pursuant to Section 6(b), the Commission noted among other factors conducive to the granting of the exemptions that the employer matched the contributions of each employee to the special fund in that case, that all expenses of the special fund were to be paid by the employer, and that the employer guaranteed that on liquidation each employee would receive an amount at least equal to his contributions . . . .
  20. 20. 20 C. The Board of Directors: Interested and Affiliated Persons *Section 9 Of The Investment Company Act Section 9 of the Investment Company Act is commonly referred to as the Act's "bad boy" provision (although it covers "bad girls" as well). You should read ' 9(a), (b), and (c). Section 9(a) prohibits certain persons from serving as an "employee, officer, director, member of an advisory board, investment adviser, or depositor of any registered investment company, or principal underwriter for any registered open-end company, registered unit investment trust, or registered face-amount certificate company."2 Three categories of persons are automatically subject to the ' 9(a) prohibition: (1) persons who have been convicted in the last ten years of certain securities-related crimes;3 (2) persons who, because of misconduct, have been enjoined by a court from engaging in specified securities activities;4 (3) any company that has an affiliated person who falls within one of the first two categories.5 The SEC may grant an exemption to anyone subject to the ' 9(a) prohibition if it finds that the prohibition, as applied to that person is "unduly or disproportionately severe or that the conduct of such person has been such as not to make it against the public interest or protection of investors to grant such application."6 Section 9(b) allows the SEC to extend the prohibition to additional persons who don't fall within ' 9(a) if it finds that those persons have engaged in certain specified securities violations.7 Section 9(b) is not a self-operative provision; a person who has engaged in one of the activities listed in ' 9(b) but who does not fall within ' 9(a) is not barred unless the SEC enters an order barring him. Section 9(a), on the other hand, is self- 2Investment Company Act ' 9(a). 3Investment Company Act ' 9(a)(1). 4Investment Company Act ' 9(a)(2). 5Investment Company Act ' 9(a)(3). The definition of "affiliated person" is in ' 2(a)(3) of the Act. 6Investment Company Act ' 9(c). 7Investment Company Act ' 9(b).
  21. 21. 21 operative; a person who falls within ' 9(a) is automatically barred unless the SEC uses its ' 9(c) power to grant an exemption.
  22. 22. 22 Note In enacting the Investment Company Act (ICA), the U.S. Supreme Court has I found, Congress was concerned about the potential for abuse inherent in the structure of investment companies. A mutual fund is a pool of assets, consisting primarily of portfolio securities, and belonging to the individual investors holding shares in the fund. Congress was concerned because '[m]utual funds, with rare exception, are not operated by their own employees. Most funds are formed, sold, and managed by external organizations, [called 'investment advis- ers,'] that are separately owned and operated. . . . The advisers select the funds' investments and operate their businesses. . . . Since a typical fund is organized by its investment adviser which provides it with almost all management services . . . , a mutual fund cannot, as a practical matter sever its relationship with the adviser. Therefore, the forces of arm's-length bargaining do not work in the mutual fund industry in the same manner as they do in other sectors of the American economy.' S. Rep. No. 91-184, p. 5 (1969). As a consequence, '[t]he relationship between investment advisers and mutual funds is fraught with potential conflicts of interest'. . . . The cornerstone of the ICA's effort to control conflicts of interest within mutual funds is the requirement that at least 40% of a fund's board be composed of independent outside directors.11 ' 10(a). As originally enacted, ' 10 of the Act required that these 40% not be officers or employees of the company or 'affiliated persons' of its adviser. 54 Stat. 806. In 1970, Congress amended the Act to strengthen further the independence of these directors, adding the stricter requirement that the outside directors not be 'interested persons.' See '' 10(a), 2(a)(19). To these statutorily disinterested directors, the Act assigns a host of special responsibilities involving supervision of management and financial auditing. . . . Congress' purpose in structuring the Act as it did is clear. It 'was designed to place the unaffiliated directors in the role of I I Quoted passages are from Burks v. Lasker, 441 U.S. 471, 480-485 (1979). 11 1 Under certain circumstances, independent directors must constitute a majority rather than 40% of the board. See ' 10(b).
  23. 23. 23 'independent watchdogs,'', who would 'furnish an independent check upon the management' of investment companies, Hearings on H. R. 10065 before a Subcommittee of the House Committee on Interstate and Foreign Commerce, 76th Cong., 3d Sess., 109 (1940). This 'watchdog' control was chosen in preference to the more direct controls on behavior exemplified by the options not adopted. Indeed, when by 1970 it appeared that the 'affiliated person' provision of the 1940 Act might not be adequately restraining conflicts of interest, Congress turned not to direct controls, but rather to stiffening the requirement of independence as the way to 'remedy the act's deficiencies.' S. Rep. No. 91-184, pp. 32-33 (1969). Without ques- tion, '[t]he function of these provisions with respect to unaffiliated directors [was] to supply an independent check on management and to provide a means for the representation of shareholder interests in investment company affairs.' Id., at 32. In short, the structure and purpose of the ICA indicate that Congress entrusted to the independent directors of investment companies, exercising the authority granted to them by state law, the primary responsibility for looking after the interests of the funds' shareholders. . . . The Securities and Exchange Commission has explained the function of independent directors as follows:I The critical role of independent directors of investment companies is necessitated, in part, by the unique structure of investment companies. Unlike a typical corporation, a fund generally has no employees of its own. Its officers are usually employed and compensated by the fund's investment adviser, which is a separately owned and operated entity. The fund relies on its investment adviser and other affiliates -- who are usually the very companies that sponsored the fund's organization -- for basic services, including investment advice, administration, and distribution. Due to this unique structure, conflicts of interest can arise between a fund and the fund's investment adviser because the interests of the fund do not always parallel the interests of the adviser. An investment adviser's interest in maximizing its own profits for the benefit of its owners may conflict with its paramount duty to act solely in the best interests of the fund and its shareholders. ... I I Interpretive Matters Concerning Independent Directors of Investment Companies, Investment Company Act Release No. 24083, 64 Fed. Reg. 59877, 59877-59878 (Nov. 3, 1999).
  24. 24. 24 Independent directors play a critical role in policing the potential conflicts of interest between a fund and its investment adviser. The [Investment Company] Act requires that a majority of a fund's independent directors: approve the fund's contracts with its investment adviser and principal underwriter; select the independent public accountant of the fund; and select and nominate individuals to fill independent director vacancies resulting from the assignment of an advisory contract. In addition, rules promulgated under the Act require independent directors to: approve distribution fees paid under rule 12b-1 under the Act; approve and oversee affiliated securities transactions; set the amount of the fund's fidelity bond; and determine if participation in joint insurance contracts is in the best interest of the fund. Each of these duties and responsibilities is vital to the proper functioning of fund operations and, ultimately, the protection of fund shareholders. In addition to the requirements of federal law, directors must abide by standards of care prescribed by state statutory and common law. Specifically, directors are subject to state law duties of care and loyalty.13 The duty of care generally requires that directors act in good faith and with that degree of diligence, care and skill that a person of ordinary prudence would exercise under similar circumstances in a like position. The duty of loyalty generally requires that directors exercise their powers in the interests of the fund and not in the directors' own interests or in the interests of another person or organization. Since July 2002, the Commission has required noninterested persons to comprise a majority of the board of directors of registered investment companies that utilize any of ten specified rules of the Securities and Exchange Commission to gain an exemption from a provision of the Investment Company Act. The noninterested directors of these investment companies, moreover, must be recruited and named by other noninterested directors. Role of Independent Directors of Investment Companies, Release No. IC-24816, 66 Fed. Reg. 3734 (Jan. 16, 2001). The ten rules are: $ Rule 10f-3, under which an investment company can acquire securities in a primary offering when the underwriting syndicate includes a broker-dealer affiliated with the investment company; $ Rule 12b-1, under which an investment company can use its assets to pay the expenses of distributing the shares it issues; 13 3 The business judgment rule generally protects fund directors from liability for their decisions so long as the directors acted in good faith, were reasonably informed, and rationally believed that the action taken was in the best interests of the fund. . . .
  25. 25. 25 $ Rule 15a-4(b)(2), under which the board of an investment company can, without the approval of the shareholders of the company, approve an interim contract with an investment adviser when Aa previous contract [is] terminated by an assignment by an investment adviser or a controlling person of the investment adviser in connection with which assignment the investment adviser or a controlling person directly or indirectly receives money or other benefit@ (17 C.F.R. ' 270.15a-4(b)(2)); $ Rule 17a-7, under which securities transactions are allowed between an investment company and another client of the adviser of the investment company; $ Rule 17a-8, under which mergers are permitted between certain affiliated investment companies; $ Rule 17d-1(d)(7), under which an investment company and its affiliates can purchase joint liability insurance policies; $ Rule 17e-1, under which an investment company may pay commissions to affiliated brokers in connection with the sale of securities on an exchange; $ Rule 17g-1(j), under which investment companies can maintain joint- insured fidelity bonds; $ Rule 18f-3, under which an investment company can issue multiple classes of voting stock; and $ Rule 23c-3, under which a registered closed-end investment company can offer to repurchase, at periodic intervals, shares it has issued to investors. The activities to which these rules apply Arequire the independent judgment and scrutiny of independent directors in overseeing activities that are beneficial to funds and investors, but involve inherent conflicts of interest between the funds and their managers.@ Id. at 3736. In mandating that noninterested (i.e., independent) directors form a majority of the board of an investment company that relies on any of these rules, the Commission explained that: A majority requirement will permit, under state law, the independent directors to control the fund's >corporate machinery,= i.e., to elect officers of the fund, call meetings, solicit proxies, and take other actions without the consent of the adviser. As a result, independent directors who comprise the majority of a board can have a more meaningful influence on fund management and represent shareholders from a position of strength. In short, a board with a majority of independent directors can be more effective in representing investors than a board with a majority of >inside= directors. Id.
  26. 26. 26 *The Chamber of Commerce Case In January 2004, the SEC proposed to add additional conditions to the ten rules specified in the previous note. For a fund to take advantage of the ten exemptions, at least 75% of its directors would have to be independent and the chairman of the fund’s board of directors would have to be independent. The SEC approved the new rules in August 2004, but the amended rules were promptly challenged by the U.S. Chamber of Commerce. In June 2005, the D. C. Circuit Court of Appeals held that the SEC violated the Administrative Procedure Act by failing to consider the costs of the proposed rules and by giving inadequate consideration to proposed alternatives. Chamber of Commerce v. SEC, 412 F.3d 133, 143-145 (D.C. Cir. 2005). The Court of Appeals remanded the rules proposal to the SEC. Eight days later, on essentially the same administrative record, the SEC once again voted to adopt the amendments. The rush was in part because the two conditions had originally passed by a 3-2 vote and the SEC Chairman, one of the proponents, was scheduled to retire the next day. The Chamber of Commerce again challenged the rules and again won. The Court of Appeals held that the SEC violated the Administrative Procedure Act by relying on cost data outside the original rulemaking record. See Chamber of Commerce v. SEC, 443 F.3d 890 (2006). On December 15, 2006, the SEC proposed the governance rules once again and reopened the comment period.
  27. 27. 27 EuroPacific Growth Fund, et al. Securities and Exchange Commission Release No. IC-23307 July 15, 1998 63 Fed. Reg. 38219 Action: Notice of application for an order under section 6(c) of the Investment Company Act of 1940 (the "Act") for relief from section 2(a)(19) of the Act. Summary of Application: Applicants request an order under section 6(c) of the Act declaring that a director on the boards of certain registered investment companies[,] who also is an outside director for the parent company of a registered broker-dealer, will not be deemed an "interested person" of the registered investment companies. Applicants: EuroPacific Growth Fund ("EUPAC"), the New Economy Fund ("NEF"), New Perspective Fund, Inc. ("NPF"), SMALLCAP World Fund, Inc. ("SCWF"), The Investment Company of America ("ICA") (collectively, the "Funds"); Capital Research and Management Company ("Capital Research"); and American Funds Distributors, Inc. ("AFD"). Hearing or Notification of Hearing: An order granting the application will be issued unless the SEC orders a hearing. Interested persons may request a hearing by writing to the SEC's Secretary . . . . Applicants Representations: 1. Each of the Funds is an open-end management investment company registered under the Act. . . . 2. Capital Research, an investment adviser registered under the Investment Advisers Act of 1940, serves as investment adviser to the Funds and certain other registered investment companies. The Funds and these investment companies, together with any future registered investment company advised by Capital Research, are referred to as the "American Funds." AFD, a wholly-owned subsidiary of Capital Research, is the principal underwriter of the Funds. 3. Each Fund has a board of directors ("Board"), a majority of whom are not "interested persons" within the meaning of section 2(a)(19) of the Act. ICA and NPF also have advisory boards, as defined in section 2(a)(1) of the Act, whose members consult with Capital Research and the Funds' Boards. 4. William H. Kling serves as a director of NEF, SCWF, NPF and EUPAC, and as an advisory board member of ICA. Mr. Kling's principal occupation is as President of Minnesota Public Radio. Mr. Kling also is a non-employee director of Irwin Financial Corporation ("Irwin Financial").1 Irwin Financial is a bank holding 1 1 In 1996, Mr. Kling's aggregate compensation from Irwin Financial was
  28. 28. 28 company that is primarily engaged in the mortgage banking business. One of Irwin Financial's indirect wholly-owned subsidiaries is Irwin Securities, a broker-dealer registered under the Securities Exchange Act of 1934 (the "1934 Act"). Approximately 0.4% of Irwin Financial's net revenues comes from Irwin Securities.2 5. Irwin Securities is a small firm. It does not execute any portfolio transactions for the Funds. Irwin Securities provides de minimis distribution services to the Funds. The gross sales by Irwin Securities of Fund shares during the period 1991 through 1996 was approximately $3.55 million, or 0.003% of the total gross sales of Fund shares by all broker-dealers for the same period. The fees received by Irwin Securities from the sale of Fund shares for the past five years represented approximately 0.017% of Irwin Financial's total net revenues. The Funds have adopted plans pursuant to rule 12b-1 under the Act [17 C.F.R. ' 270.12b-1] and make payments to their distributors, including Irwin Securities, pursuant to those plans.I Applicants' Legal Analysis: 1. Section 2(a)(19)(A)(v) of the Act defines an "interested person" of a registered investment company to include any broker-dealer registered under the 1934 Act or any affiliated person of the broker-dealer.II Applicants state that Mr. Kling may be deemed an affiliated person of Irwin Securities by virtue of his position as a director of Irwin Financial, an entity that controls Irwin Securities within the meaning of section 2(a)(9) of the Act. Because Mr. Kling may be deemed an approximately $16,000. As a non-employee director, Mr. Kling also participates in Irwin Financial's mandatory and non-mandatory stock options plans. In April 1997, Mr. Kling was granted 400 stock options, 100 of which are currently vested. The exercise price of the options is $23.375 per share. The market value of Irwin Financial's common stock as of the close of trading on February 26, 1998 was $47.25 per share. In addition, as of March 11, 1997, Mr. Kling beneficially owned 3,404 shares, or approximately 0.03%, of Irwin Financial's common stock, with market value on February 26, 1998 of approximately $160,839. The applicants represent that Mr. Kling's ownership of Irwin Financial's common stock is not material to Mr. Kling since it does not represent a material portion of his financial holdings generally. 2 2 This figure is based on Irwin Financial's net revenues in 1996. I IEditor's note: Under a Rule 12b-1 plan, the assets of an investment company are assessed an annual fee to defray the cost of marketing and selling the shares of the company. John Downes & Jordon E. Goodman, BARRON'S FINANCE & INVESTMENT HANDBOOK 658-659 (4th ed. 1995). I IIEditor=s note: The current version of section 2(a)(19)(A)(v) became effective in May 2001. Pub. L. No. 106-102, 113 Stat. 1338 (1999).
  29. 29. 29 affiliated person of Irwin Securities, Mr. Kling currently is considered an interested person of the Funds. ... 3. Applicants believe that, because Mr. Kling's affiliation with Irwin Securities is solely the result of his position as a non-employee director of Irwin Financial, and because Irwin Securities provides only de minimis distribution services to the Funds, it would be more appropriate to treat Mr. Kling as an independent director. Applicants thus request an order under section 6(c) of the Act declaring that Mr. Kling will not be deemed an interested person under section 2(a) (19) of the Act.3 4. Section 6(c) of the Act provides, in part, that the Commission may exempt any person from any provision of the Act or any rule under the Act if and to the extent the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. Applicants contend that their request for relief from interested person status for Mr. Kling meets this standard because Mr. Kling's relationship with Irwin Securities is attenuated and poses no real or potential conflict of interest and because Irwin Securities' only business relationship with the Funds involves a de minimis amount of distribution services for the Funds. 5. Applicants state that, in his position as a non-employee director of Irwin Financial, Mr. Kling has no authority or responsibility for the operations of Irwin Securities and does not control or influence the day-to-day management of Irwin Securities. Applicants also represent that Mr. Kling has no material business or professional relationship with Irwin Financial, Irwin Securities, American Funds, Capital Research, AFD or any affiliated person of these entities. Applicants' Conditions: Applicants agree that the order granting the requested relief will be subject to the following conditions: 1. [While Mr. Kling serves as an independent director of the American Funds, Irwin Securities will not execute any portfolio transactions for the Funds or for their 3 3Applicants are not requesting relief from the provisions of rule 12b-1(b)(2) that require a rule 12b-1 plan to be approved by the directors of an investment company "who are not interested persons of the company and have no direct or indirect financial interest in the operation of the plan or in any agreements related to the plan." Applicants state that they intend to treat Mr. Kling as a director who meets these requirements, based on Mr. Kling's lack of material business or professional relationship with Irwin Financial and applicants' belief that Mr. Kling's ownership of Irwin Financial's common stock is not a material portion of Mr. Kling's financial holding[s] generally. Applicants represent that, should Mr. Kling develop a direct or indirect financial interest in the operation of the American Funds' rule 12b-1 plans, he will no longer be treated as meeting the above requirements of rule 12b-1.
  30. 30. 30 investment adviser (Capital Research), and just a minority of the independent directors of the Funds will be affiliated with broker-dealers.] 2. No more than 1% of Irwin Financial's gross revenues will come from the distribution of any one American Fund's shares; and no more than 5% of Irwin Financial's gross revenues will come from the distribution of all of the American Funds' shares; 3. No more than 1% of any one of the American Fund's shares, and no more than 5% of all of the American Funds' shares, will be distributed by Irwin Securities; and 4. Irwin Securities will not serve as a "regular broker or dealer," as that term is defined in rule 10b-1 under the Act,II for any American Fund. By the Commission. In the Matter of EuroPacific Growth Fund, et al. Securities and Exchange Commission Release No. IC-23374 August 4, 1998 1998 SEC LEXIS 1640 . . . No request for a hearing was filed, and the Commission did not order a hearing. The matter has been considered and it is found, on the basis of the information set forth in the application, that the requested exemption is appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act. Accordingly, IT IS ORDERED, pursuant to section 6(c) of the Act, on the basis of the representations and conditions set forth in the application, effective immediately, that Mr. Kling will not be deemed an interested person of the Funds within the meaning of section 2(a)(19) of the Act. II I Editor's note: Rule 10b-1, 17 C.F.R. ' 270.10b-1, states in part: AThe term regular broker or dealer of an investment company shall mean: ... (c) One of the ten brokers or dealers that sold the largest dollar amount of securities of the investment company during the company's most recent fiscal year.@
  31. 31. 31 SAFECO Asset Management Company Securities and Exchange Commission No-Action Letter Publicly Available December 2, 1977 1977 SEC NOACT LEXIS 2834 LETTER TO SEC This letter is a request for a 'no-action' position from the staff with regard to the status of a director of the SAFECO funds . . . in the context of Section 2(a)(19) of the Investment Company Act of 1940 ('the Act'). . . . The four SAFECO funds are managed by SAFECO Asset Management Company and their shares are distributed by SAFECO Securities, Inc., both wholly- owned subsidiaries of SAFECO Corporation. SAFECO Corporation is a publicly held holding company. Its principal subsidiaries are property and casualty, life and title insurance companies. The board of directors of each of the four SAFECO funds is composed of five directors, two of whom are 'interested persons' as that term is defined by Section 2(a) (19) of the Act. Late in September 1977 one of the 'disinterested' directors resigned to become a director of a national bank. The remaining directors narrowed their choice of a successor to this position to Dr. Charles E. Odegaard, President Emeritus of the University of Washington. It was determined that Dr. Odegaard was a Trustee of The Teachers Insurance and Annuity Association . . . and a Member of the College Retirement Equities Fund ('CREF'). As trustee and member his sole function is along with the other trustees and members to meet once per year and elect the operating boards of the Teachers Insurance and Annuity Association and CREF. No compensa- tion is paid to these trustees and members. Both the Association and CREF sell annuities and Dr. Odegaard is an annuitant of both. While the Association owns no SAFECO Common Stock, CREF owns a very small percentage. At September 30, 1977, there were 13,036,958 shares of SAFECO Common Stock outstanding. At that date the total assets of CREF were $4,100,000,000. CREF owned 83,000 shares of SAFECO Common Stock or 0.08% of its total assets and 0.63% of the total SAFECO Common Stock outstanding. ... The fact that Dr. Odegaard is an annuitant of CREF came to our attention recently. We do not believe it changes his status in the context of Section 2(a)(19) (B)(iii) of the Act, but wanted to confirm this with the staff. . . . It is our position that the very small ownership of SAFECO Common Stock by CREF does not present an interest which would prevent Dr. Odegaard from acting as a 'disinterested' director or cause him to be an 'interested person.' The stock held by CREF is too small to affect the control of SAFECO Corporation and represents only a minuscule part of its assets. We request that the staff take a 'no-action'
  32. 32. 32 position with regard to Dr. Odegaard's status in the context of Section 2(a)(19) of the Act in order that he be able to participate as other than an 'interested person.' ... SEC REPLY Based on the foregoing, it appears that Dr. Odegaard comes squarely within the definition of interested person in Section 2(a)(19)(B)(iii) of the Investment Company Act of 1940. As a CREF variable annuitant he has an indirect beneficial interest in a security issued by the controlling person of the Funds' investment adviser and principal underwriter. For this reason we cannot give the no-action assurance you request. However, if you believe the facts so warrant, you may wish to consider filing an application pursuant to Section 6(c) of the Act to exempt Dr. Odegaard from the definition of interested person.I I I Editor's note: In response to an application filed by the SAFECO Funds under section 6(c), the Securities and Exchange Commission declared Dr. Odegaard not to be an interested person. Employing the language of section 6(c), the Commission "found that the granting of the application is appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Act." Investment Company Act Release No. 10164 (March 20, 1978), 1978 SEC LEXIS 1994.
  33. 33. 33 Note In a 1999 release, the Commission discussed section 2(a)(19)(B)(iii) in the context of a proposed rule dealing with ownership by a director of shares of an index fund: Section 2(a)(19) disqualifies an individual from being considered an independent director if he knowingly has any direct or indirect beneficial interest in a security issued by the fund's investment adviser or principal underwriter, or by a controlling person of the adviser or underwriter. A fund director, for example, who owns securities issued by the fund's adviser (or its parent company) could not be an independent director. This provision was designed to ensure that an independent director does not have a financial interest in the organizations that are closely associated with the fund or that would benefit from payments that the independent director is charged with scrutinizing. If a director owns securities of an index fund that seeks to replicate a securities market index that includes securities of the fund's adviser (or principal underwriter or a controlling person of the adviser or principal underwriter), an issue could arise whether the director knowingly has an indirect beneficial interest in the securities of the adviser (or principal underwriter or controlling person). We believe that this attenuated interest in the adviser's or underwriter's securities is not the type of interest Congress intended to prohibit independent directors from owning when it adopted section 2(a)(19). An index fund's investment decision-making process is dictated by the goal of mirroring the performance of a market index, and thus is largely mechanical. Because index fund portfolios typically are spread among a large number of issuers, ownership of their shares is unlikely to have a material effect on the independent judgment of a fund director. Role of Independent Directors of Investment Companies, Release No. IC-24082, 64 Fed. Reg. 59826, 59838 (Nov. 3, 1999). The Rule adopted by the Commission became effective in 2001 and reads as follows (17 C.F.R. ' 270.2a19-3): If a director of a registered investment company (>Fund=) owns shares of a registered investment company (including the Fund) with an investment objective to replicate the performance of one or more broad-based securities indices (>Index Fund=), ownership of the Index Fund shares will not cause the director to be considered an >interested person= of the Fund or of the Fund's investment adviser or principal underwriter (as defined by section 2(a)(19)(A)(iii) and (B) (iii) of the Act).
  34. 34. 34 The Rule applies only to an index fund whose index is Abroad-based.@ According to the Commission, Aa >broad-based index= is an index that >provides investors with a performance indicator of the overall applicable stock or bond markets, as appropriate. An index would not be considered to be broad-based if it is composed of securities of firms in a particular industry or group of related industries.=@ Role of Independent Directors of Investment Companies, Release No. IC-24816, 66 Fed. Reg. 3734 , 3740 n.66 (Jan. 16, 2001). Although A[t]he new rule does not address an independent director's ownership of securities of an actively managed fund that owns shares of the fund's adviser, underwriter or any of their controlling persons,@ the Commission stated that Awe do not believe an independent director who owns shares of an actively managed fund would ordinarily >knowingly= have an indirect beneficial interest in the issuers of securities the fund holds, and thus ownership of such fund would not cause a director to be an >interested person= as defined by section 2(a)(19) of the Act.@ Id. at 3740 n.65.
  35. 35. 35 Twentieth Century Investors, Inc. Securities and Exchange Commission No-Action Letter Publicly Available February 19, 1972 1972 SEC NOACT LEXIS 805 LETTER TO SEC You are aware of my letter of June 11, 1971 with respect to Twentieth Century's unaffiliated director, Frederick J McCoy. He owns 3.3% of the common stock and 5% of the preferred stock of the investment adviser, and 2.5% of the common stock and 5% of the preferred stock of the principal underwriter. Accordingly, while unaffiliated, he is an interested person of the investment advisor and of the principal underwriter under Section 2(a)(19)(B)(iii) because he has a beneficial interest in securities issued by the investment advisor and the principal underwriter. In my letter of June 11 I suggested that he could make a bona fide gift of the stock to a member of his family and thus avoid being an interested person. I still have not received a reply in writing to my letter of June 11, but Mr. Golden has read me his reply over the phone. His letter is to the effect that if Dr. McCoy were to make a gift to a person who he is legally obligated to support then he would have an indirect beneficial interest in the securities and would still be an interested person under the sub-paragraph just cited. I have now inquired by telephone whether the same result were to follow if he were to make a gift to a member of his family who he is not obligated to support. In particular, he is thinking of giving the stock to his parents, who are independent and who he does not support. You have responded orally that since Dr. McCoy's parents are members of his immediate family, he would still be an interested person if he were to give the stock to them. I respectfully submit that such a conclusion misconstrues the statute. Subsection (19)(B)(ii) refers to a member of the immediate family of any natural person who is an affiliated person. Thus, if Dr. McCoy's parents are affiliated persons, then he is an affiliated person also. However their stock ownership is not sufficient to make them affiliated, and accordingly he is not affiliated either. If they are not affiliated, then he is not affiliated, and neither is he, under Paragraph (ii), interested. I see nothing in the statute which makes a person interested because a member of his immediate family is interested, and that is what prompted my inquiry in the first place. Since the family relationship was so carefully made significant as to affiliated persons, the failure to do so in case of interested persons indicates a deliberate intention to render the family relationship immaterial in the definition of interested persons. The only conceivable way in which Dr. McCoy, if he were to make the gift to his parents, could be characterized as interested would be under Sub-paragraph (iii),
  36. 36. 36 as a person having a beneficial interest in securities issued by the investment advisor or principal underwriter. It is my belief that if he were to give the stock away, and particularly if he has no obligation to support the donee, that he would no longer have any direct or indirect beneficial interest in the securities. ... I should mention, by way of background, that Dr. McCoy's first choice would be to sell the stock, but there is no market for it, and it is extremely difficult to find a buyer. Accordingly his only practical alternatives are to make a gift or to resign from the Board. We are reluctant to see him follow the latter course, because we value his judgment. SEC REPLY Based on the foregoing, and your oral representation that Dr. McCoy's parents are persons of independent means who are not expected in the foreseeable future to become dependents of Dr. McCoy, and if as asserted in your letter Dr. McCoy makes a bona fide gift to his parents retaining no direct or indirect beneficial interest in the securities, and following the transfer neither of his parents is an affiliated person of the investment adviser or underwriter, this Division will not recommend any action to the Commission if Dr. McCoy is not treated as an 'interested person' as that term is defined in Section 2a 19(B) of the Act for the purposes of complying with the requirements of Section 10 of the Act, in reliance upon your opinion as counsel that he is not an 'interested person' as defined.
  37. 37. 37 Interpretive Matters Concerning Independent Directors of Investment Companies Investment Company Act Release No. 24083 Securities and Exchange Commission November 3, 1999 64 Fed. Reg. 59877 ... The Commission has the authority to issue an order under [subsections (A) (vii) and (B)(vii) of] section 2(a)(19) of the [Investment Company] Act when it finds that a person has or had a "material business or professional relationship" with certain specified persons and entities, including some fund affiliates ("Specified Entities"). Section 2(a)(19) does not define a "material business or professional relationship." The legislative history, however, indicates that a business or professional relationship would be material if it "might tend to impair the independence of [a] director." 33 The legislative history also states that "[o]rdinarily, a business or professional relationship would not be deemed to impair independence where the benefits flow from the director of an investment company to the other party to the relationship. In such instances the relationship is not likely to make the director beholden to that party."34 . . . [The staff is here providing] guidance about the types of professional and business relationships between a director and a Specified Entity that may be considered to be material. . . .36 Positions as Material Business or Professional Relationships The staff believes that a fund director may be treated as "interested" [under sections 2(a)(19)(A)(vii) and (B)(vii)] if he or she currently holds or held, at any time since the beginning of the last two completed fiscal years of the fund (the "two-year period"), certain positions with a Specified Entity. The staff would consider a position that a director holds with a Specified Entity as a "material business or professional relationship" if it would tend to impair a director's independence by providing incentives for the director to place his or her own interests over the interests of fund shareholders. The key factors in evaluating whether a director's position with a Specified Entity would tend to impair his or her independence include 33 3 H.R. Rep. No. 1382, 91st Cong., 2d Sess. 14 (1970); S. Rep. No. 184, 91st Cong., 1st Sess. 33 (1969). 34 4 Id. 6 36The examples discussed in this release are not exhaustive and are provided for illustrative purposes only. There may be other relationships that would be viewed by the staff as material under section 2(a)(19).
  38. 38. 38 the level of the director's responsibility in the position and the level of compensation or other benefits that the director receives or received from the position. For instance, the staff would consider an individual who served as the fund's portfolio manager during the two-year period to have had a material business or professional relationship with the fund and its investment adviser. . . . The staff believes that a fund's former portfolio manager must be viewed as having had a material business or professional relationship with the fund and its adviser because he or she would have had significant responsibilities with the fund and the adviser, and likely would have received substantial compensation and other benefits from the adviser and/or the fund. Indeed, the staff would view the former portfolio manager's position as material due to the manager's responsibility in the position even if the manager had not received substantial compensation from [the] adviser or the fund. Similarly, the staff believes that former directors, officers, and employees of the fund's investment adviser or principal underwriter could be viewed as having had a material business or professional relationship with a Specified Entity, depending on the facts and circumstances.38 In addition, a fund director who at any time during the two-year period also was a director, officer or employee of a current or former holding company of the fund's investment adviser may be treated as interested by reason of a material business or professional relationship with the controlling person of the fund's adviser (a Specified Entity). As described above, the staff's analysis of the materiality of the relationship would focus on, among other things, the level of the director's responsibility with the holding company and the level of compensation or other benefits that the director received from the position. The staff believes that not every position that a director holds or held with a Specified Entity would be deemed to impair his or her independence. For example, a director of a fund who also is a director of another fund managed by the same adviser generally would not be viewed as an interested person of the fund under section 2(a) (19) solely as a result of this relationship. Material Transactions as Material Business or Professional Relationships The staff believes that a fund director may be treated as "interested" if he or she has, at any time during the two-year period, directly or indirectly engaged (or proposed to engage) in any material transactions (or proposed material transactions) with a Specified Entity. Such a relationship could result from a single transaction or from multiple transactions. These transactions may be structured as service arrangements, including legal, investment banking, and consulting services, or other 8 38In addition, the staff notes that many former officers and employees of a fund's investment adviser or principal underwriter may own securities issued by the adviser or underwriter. Such persons are interested persons of the fund by virtue of sections 2(a)(19)(A)(iii) and (B)(iii).
  39. 39. 39 business transactions, such as business and personal loans, and real estate purchases.41 In addition, a material business or professional relationship with a Specified Entity may result from a fund director's position with, or ownership interest in, an entity that engages in material transactions with a Specified Entity. For example, the staff believes that a fund director may be treated as "interested" if the fund's investment adviser manages or managed for the director, at any time during the two-year period, an advisory or brokerage account, and the adviser favors, or creates the expectation that it will favor, the account over the other accounts that it manages. In the staff's view, a director would receive favored treatment, for instance, if the adviser charged the director no fees or fees that were lower than the fees that it charged for similar types of accounts, or accorded the director's account special treatment regarding portfolio management decisions or securities allocations. By favoring the director's account over other accounts that it manages, the adviser may create an incentive for the director to act in a manner that will preserve or increase the favorable treatment. In this instance, significant economic benefits from the relationship between the director and the adviser would flow to the director, or the director may have the expectation that significant economic benefits would flow in the future to the director.44 The staff believes that a fund director who serves as a chief executive officer of any company for which the chief executive officer of the fund's adviser serves as a director also may be treated as "interested." The relationship between the fund director and the adviser's chief executive officer may tend to impair the director's independence because the adviser's chief executive officer has the power to vote on matters that affect the director's compensation and status as chief executive officer of the company. In this instance, the fund director may act with respect to fund matters in a manner to preserve his or her relationship with the company and with the adviser's chief executive officer, rather than in the interest of the fund's shareholders.45 1 41See, e.g., Alpha Investors Fund, SEC No-Action Letter (Jan. 9, 1972) (director who is a partner at a law firm that provides legal services to an entity that controls the fund's adviser may be interested under section 2(a)(19)(B)[(vii)] because the director has a material business or professional relationship with that entity). 44 4 For an example of a relationship in which the staff believed that significant economic benefits did not flow to the director, see Securities Groups, SEC No-Action Letter (Apr. 20, 1981) (staff stated that a nominated director's participation in a symposium sponsored by the parent of the fund's adviser did not constitute a material relationship because "the $2,000 paid to him for taking part in that seminar is not so significant as to tend to impair his independence were he to serve as a disinterested director of the fund"). 5 45See Southwestern Investors, Inc., SEC No-Action Letter (June 13, 1971) (fund director who is an officer and director of company A may not be disinterested if the
  40. 40. 40 A fund director may be deemed to have indirectly engaged in a material transaction with a Specified Entity through his or her interest in a company that conducted business with the Specified Entity.46 In determining whether the director would have a material business or professional relationship with a Specified Entity due to his or her interest in the company and the company's transaction with the Specified Entity, the staff would look to the nature and significance of the director's interest in the company and the company's interest in the transaction. In particular, the staff would focus on the significance of any economic or other benefit that would flow to the director. For example, a fund director who had a controlling interest in a company that conducted material business with a fund would likely receive significant economic benefits, either directly or indirectly, as a result. Such a director may be treated as interested because the director may have a material business or professional relationship with the fund as a result of having indirectly engaged in a material transaction with the fund. A material relationship resulting from a proposed material transaction with a Specified Entity might include the negotiation of a service contract between a company controlled by the director and the Specified Entity. During the negotiation of such a contract (and even if such contract is never finalized), the director may be concerned about interests other than those of the fund and its shareholders. As a result, the process of negotiating a material transaction may tend to impair the director's independence, and thus may itself create a material business or professional relationship with a Specified Entity for purposes of section 2(a)(19). ... president of a company that indirectly controls the fund's investment adviser and principal underwriter also serves as a director of company A). . . . 46 6 See also The MONY Fund, Inc., SEC No-Action Letter (Jan. 29, 1972) (director who is a senior officer of a company that contracted with company A, which wholly owns the fund's investment adviser, to find a vice president for company A, may have a material relationship with a controlling person of the fund's adviser).

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