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IC Chapter 7.doc IC Chapter 7.doc Document Transcript

  • 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 Chapter 7. Shareholder Expenses and Rights A. Investment Adviser Fees Disclosure Regarding Approval of Investment Advisory Contracts by Directors of Investment Companies Investment Company Act Release No. 26350 Securities and Exchange Commission February 19, 2004 69 Fed. Reg. 7852 Unlike most business organizations, registered management investment companies (Afunds@ ) are typically organized by an investment adviser that is responsible for the day-to-day operations of the fund. In most cases, the investment adviser is organized as a corporation, whose shareholders may have an interest in the fund that is quite different from the interests of the fund=s shareholders. One of the key areas where the interests of fund shareholders and shareholders of the investment adviser diverge is fees. While fund shareholders ordinarily prefer lower fees to achieve greater returns, shareholders of the fund=s investment adviser often want to maximize profits through higher fees. The Investment Company Act relies on fund boards of directors to police conflicts of interest, including conflicts with respect to fees to be received by investment advisers. Section 15(a) makes it unlawful for any person to serve as an investment adviser to a fund, except pursuant to a written contract that has been approved by a majority vote of the fund=s shareholders and that continues in effect for not more than two years, unless its continuance is approved at least annually by the board of directors or a majority vote of the shareholders. In addition, Section 15(c) requires that the terms of any advisory contract, and any renewal thereof, be approved by a vote of the majority of the disinterested directors. Section 15(c) also requires a fund=s directors to request and evaluate, and an investment adviser to a fund to furnish, such information as may reasonably be necessary to evaluate the terms of any advisory contract. As part of their fiduciary duties with respect to fund fees, boards of directors are required to evaluate the material factors applicable to a decision to approve an investment advisory contract. ...
  • 3 Gartenberg v. Merrill Lynch Asset Management, Inc. 694 F.2d 923 (2d Cir. 1982), cert. denied, 461 U.S. 906 (1983) OPINION OF THE COURT Irving L. Gartenberg and Simone C. Andre, two shareholders of the Merrill Lynch Ready Assets Trust, a money market fund (the "Fund"), appeal from a judgment of the Southern District of New York, Milton Pollack, Judge, entered after a non-jury trial, dismissing their consolidated derivative actions against the Fund and its affiliates, Merrill Lynch Asset Management, Inc., the adviser and manager of the Fund (the "Manager") and Merrill Lynch, Pierce, Fenner & Smith, Inc. (the "Broker"). The plaintiffs claimed violations of ' 36(b) of the Investment Company Act of 1940 (the "Act"). The principal claim is that the fees paid by the Fund to the Manager for various services, including investment advice and processing of daily orders of the Fund's shareholders, were so disproportionately large as to constitute a breach of fiduciary duty in violation of ' 36(b). We affirm the judgment dismissing the complaint. . . . The Fund, organized in 1975 as a no-load, diversified, open-end investment company, invests in short-term money market securities expected to pay the highest current income consistent with preservation of capital and maintenance of liquidity, such as short-term securities of the U.S. Government or its agencies, bank certificates of deposit, and commercial paper. An investor may purchase and redeem shares of the Fund without any charges or penalties. There is a daily declaration of dividends, reflecting the net income of the Fund's portfolio. As the district court noted, the purchaser's investment in the Fund is more like a bank account than the traditional investment in securities. Idle money can be invested in the Fund for as little as a day and put to work earning interest. The ease of entrance and egress for the investor, coupled with the ability to share in high yields which the modest investor could not obtain through a bank deposit and might not be able to realize alone, has with the rise (until recently) of interest rates attracted an increasing number of investors. As a result the size of the Fund increased enormously over a few years, from $288 million in April 1977 to over $19 billion as of September 1981. The Fund has an 8-person Board of Trustees, of whom 2 are interested and 6 are independent and unaffiliated. The operations of the Fund are conducted by the Manager, which provides the Fund with office space and facilities, administrative staff, equipment, portfolio management, compliance with SEC and state recordkeeping and reporting requirements, and services to Fund shareholders. For the processing of approximately 80% of the purchases and redemptions of shares of the Fund the Manager uses the Broker, another Merrill Lynch affiliate, which is the largest registered broker-dealer in the United States, with 408 domestic offices located in numerous cities and towns, in which more than 7,000 account executives View slide
  • 4 are located. In addition, the Manager uses the vast facilities of the Merrill Lynch organization and its affiliates to render special services to the Fund. For example, Merrill Lynch Economics, Inc. provides economic research and forecasting services while Merrill Lynch Government Securities, Inc. provides expertise with respect to U.S. government and agency securities. A customer located anywhere in the United States can call the nearest office of the Broker or the Bank of New York, the Fund's custodian and transfer agent, order the purchase or redemption without charge of shares of the Fund, and through use of wires and computers the transaction will be carried out immediately. An average of 30,000 such orders are processed daily by the Broker's large organization. Under the foregoing management the Fund has performed reasonably well in terms of average percentage yields for its shareholders. Its average percentage yields from 1978 through 1980 were slightly above the average for all similar funds. In 1980 it ranked 37th out of 76 money funds in terms of yield. For all of these services the Manager charges the Fund an advisory fee based on a percentage of the average daily value of the Fund's net assets. The fee rate is graduated downward as the Fund's total assets increase in value. Since 1979 the schedule called for payment of 0.50% (1/2 of 1%) of the Fund's average daily value of net assets under $500 million and for various intermediate percentages as the value of the net assets increases down to 0.275% for assets in excess of $25 billion, resulting in an effective rate of 0.288%. This schedule is the product of a series of negotiations by the 6 independent Fund Trustees with the Manager over the period from 1977 to 1979, which resulted in reductions in the effective rate as the Fund grew in size. Three studies were made at the Fund's instance to determine the estimated cost of the processing services provided by the Broker through the Manager to the Fund, two by the Merrill Lynch organization's internal accounting staff [the "Diemer estimate" and the "Fitz-Gerald estimate"] and one by the independent accounting firm of Peat, Marwick, Mitchell & Co. ("PMM"). The estimates ranged from $2.02 to $7.50 per Fund order. The earlier internal study which produced the lowest figure did so mainly because it used a modified "incremental" cost method of accounting, based on the assumption that most costs would have been incurred by the Broker even if it had processed no Fund orders. By the time the PMM study was conducted in late 1979, however, modified full cost accounting methods were used for the reason that Fund orders represented a sizeable proportion of all business processed by the Broker; indeed, by April 1981 Fund orders accounted for 37% of all Broker business, necessitating the hiring by the Broker of close to 3,000 non-sales personnel. Had the Manager been required to reimburse the Broker for these costs instead of their being absorbed by the Broker as another Merrill Lynch affiliate, the Broker'sI net profit after taxes would have been greatly reduced, resulting in a figure ranging from a 38.4% profit to a substantial loss depending on which cost accounting study I I Editor's note: The court evidently intended to refer to the Manager, not the Broker. View slide
  • 5 was used. In 1980, for instance, the last calendar year for which full figures are available, the Manager's fee was slightly over $33 million on the Fund's average net assets of $11.16 billion. Based on the volume of orders generated by 675,324 purchasers, the Broker's processing costs, estimated according to the PMM study, were so large that the Manager suffered a loss during 1980. Judge Pollack, construing the legislative history of the Act, decided that the standard for determining whether the Manager had been guilty of a breach of fiduciary duty in violation of ' 36(b) was not whether its fees were "reasonable" as urged by plaintiffs but whether they were unfair to the Fund and shareholders, which was to be determined by reference to the nature, quality and extent of the [M]anager's services to the Fund, the money market fund industry practice and level of management fees, and to a lesser extent the Manager's net earnings as a result of providing the services. After reviewing the evidence and appraising the live witness- es who testified, he concluded that the compensation paid to the Manager was fair. The package of services described above was found to be extensive and valuable, providing Fund customers with the vast facilities of the Merrill Lynch organization, which were not available to non-Merrill Lynch funds. The Manager's fee schedule was found by Judge Pollack to "bear a fair relation to the subject matter from which they are derived". He further found that "the total fee was fair to the Fund" after taking into consideration the nature and extent of the services, the fees charged by other advisers to other money market funds, the overall cost to the Merrill Lynch organization of providing the services, and the fee schedule's allowance for economies of scale by reducing the rate as the Fund's net assets increased. Judge Pollack also gave weight to the process by which the 6 noninterested trustees of the Fund approved of its management agreement with the Manager. The trustees, who were represented by capable independent counsel, were found to be competent, independent and conscientious in the performance of their duties. They were furnished with sufficient information to evaluate the contract. They thoroughly reviewed and weighed all facts pertinent to the fee, many of which are now part of the record, before approving the Manager's fee after negotiations. The district court rejected plaintiffs' argument that in determining the fairness of the Manager's compensation the court must take into account as an offset to the Manager's fee the value to the Merrill Lynch organization of "fall-out" business generated by Fund customers who, after opening up a no-charge Fund account, transact other financial business with the Merrill Lynch Broker, such as purchases of stocks and bonds, for which the customer is charged a fee or commission. Thirty- eight percent of new Fund customers for the third quarter of 1979 transacted some non-Fund business through the Broker by January 1980. The fall-out benefit argument was rejected on the ground that any such offset could not be measured since it could not be established with certainty and without heavy expense what portion of the increase in brokerage business would have gone to the Broker without regard to the Fund. Judge Pollack further reasoned that the idea of an offset lacked logic since the customer would in any event have to pay a brokerage fee on non-Fund
  • 6 business. The possible benefit to the Merrill Lynch organization from a "float" resulting from its having the use of redemption funds before paying them to the redeeming Fund customer was found unpersuasive since it was obvious to all concerned. Plaintiffs' claim that there was unnecessary duplication in the Manager's services based on the Bank of New York's obligation to perform them was rejected for lack of proof. The district court further found that an adequate disclosure of the pertinent facts needed to determine the fairness of the Manager's fee had been made to the Fund's trustees and shareholders. Discussion Section 36(b) of the Investment Act of 1940, which governs this case, provides that "the investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services" paid by the investment company or its security holders and that in an action by a security holder on behalf of the investment company against the adviser or affiliate "[i]t shall not be necessary to allege or prove that any defendant engaged in personal misconduct" but "the plaintiff shall have the burden of proving a breach of fiduciary duty." Appellants contend that the district court erred in rejecting a "reasonableness" standard for determining whether the Manager performed its "fiduciary duty" in compliance with ' 36(b). They further urge that the district court erred in relying primarily, in determining whether there was a breach of fiduciary duty, on other money market funds' level of management fees and on the Broker's costs. They argue that since each investment company fund is a captive of its manager, from which it cannot as a practical matter divorce itself, and since there is no possibility that a competitor will take the fund's business from its manager by offering a lower rate, the manager sets its own fee and the fund has no practical alternative but to pay it. It is contended that the test should therefore be what rate would have resulted from arm's-length negotiations in light of the services to be rendered. Appellants further contend that under this standard the fee in this case would have been substantially lower because of economies of scale, the Fund's massive bargaining power as the largest fund in history, and the Broker's duplication of services which the Bank of New York was already required to render. In short it is argued that a fee percentage which may have been reasonable when the Fund was freshly-launched became unreasonable when the Fund grew to its present huge size. In support of their advocacy of a "reasonableness" standard as the test by which a fiduciary's conduct under ' 36(b) should be governed, appellants point to excerpts from the Act's tortuous legislative history, just as the district court relied on other portions of the same history apparently rejecting that criterion in favor of a "breach of fiduciary duty" standard. The legislative history contains statements of legislators and legislative reports pointing in both directions. Bills introduced in
  • 7 1967 and 1968, which would have imposed a "reasonableness" test, failed of passage. When the mutual fund industry objected to this standard, a bill was introduced in 1969 containing ' 36(b) in its present form, which was enacted in 1970. The Senate Report on the bill and the House Committee Report accompanying the companion bill do not define the term "fiduciary duty" as used in the bill or how it was to be distinguished from the term "reasonable" that had been used in predecessor bills. See Investment Company Amendments Act of 1970, S.Rep. No. 91-184, 91st Cong., 2d Sess. (1970), reprinted in [1970] U.S. Code Cong. & Ad. News 4897 . . . . The Senate Report does state that an adviser-manager would not be precluded from earning a profit on services provided by it to a fund, that a "cost-plus" type of contract is not required, and that the court is not authorized "to substitute its business judgment for that of a mutual fund's board of directors in the area of management fees," id. at 4902-03. On the other hand, the same Report states that a "corporate waste" standard would be "unduly restrictive," [id.] at 4901, and Congressman Moss, Chairman of the Committee on Interstate and Foreign Commerce, who was one of the chief sponsors of ' 36(b), explained to the House that "[t]his [bill], by imposition of the fiduciary duty, would in effect require a standard of reasonableness in the charges". Thus there was no attempt to set forth a definitive test by which observance or breach of fiduciary duty was to be determined. In short, the legislative history of ' 36(b) indicates that the substitution of the term "fiduciary duty" for "reasonable," while possibly intended to modify the standard somewhat, was a more semantical than substantive compromise, shifting the focus slightly from the fund directors to the conduct of the investment adviser- manager. As the district court and all parties seem to recognize, the test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all of the surrounding circumstances. The Senate recognized that as a practical matter the usual arm's length bargaining between strangers does not occur between an adviser and the fund, stating: "Since a typical fund is organized by its investment adviser which provides it with almost all management services and because its shares are bought by investors who rely on that service, 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, supra, [1970] U.S. Code Cong. & Ad. News at 4901. To be guilty of a violation of ' 36(b), therefore, the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining. To make this determination all pertinent facts must be weighed. We disagree with the district court's suggestions that the principal factor to be considered in evaluating a fee's fairness is the price charged by other similar advisers to funds managed by them, that the "price charged by advisers to those funds establishes the free and open market level for fiduciary compensation," that the
  • 8 "market price ... serves as a standard to test the fairness of the investment advisory fee," and that a fee is fair if it "is in harmony with the broad and prevailing market choice available to the investor". Competition between money market funds for shareholder business does not support an inference that competition must therefore also exist between adviser-managers for fund business. The former may be vigorous even though the latter is virtually non-existent. Each is governed by different forces. Reliance on prevailing industry advisory fees will not satisfy ' 36(b). We do not suggest that rates charged by other adviser-managers to other similar funds are not a factor to be taken into account. Indeed, to the extent that other managers have tended "to reduce their effective charges as the fund grows in size," the Senate Committee noted that such a reduction represents "the best industry practice [which] will provide a guide," S.Rep. No. 91-184, supra, [1970] U.S. Code Cong. & Ad. News at 4902. However, the existence in most cases of an unseverable relationship between the adviser-manager and the fund it services tends to weaken the weight to be given to rates charged by advisers of other similar funds. Report of the Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess. (1966) 131, 148.2 A fund cannot move easily from one adviser-manager to another. Therefore 2 2 The following statement in the Report of the Securities and Exchange Commission on The Public Policy Implications of Investment Company Growth, while directed to mutual funds, is pertinent to money market funds: "It has been the Commission's experience in the administration of the Act that in general the unaffiliated directors have not been in a position to secure changes in the level of advisory fee rates in the mutual fund industry. In most instances the adviser serves as, or is closely affiliated with, the fund's principal underwriter which maintains a distributing organization for the fund's shares. The organization that has developed over a period of years to manage the fund's portfolio and to furnish it with some, and in certain cases virtually all, of the nonadvisory services necessary to its operation belongs to the adviser and not to the fund. Indeed, in some cases all of the fund's records are maintained by the fund's adviser. Although the unaffiliated directors under State law have an unqualified right of access to these records, the adviser, as a practical matter, is in a position to seriously hamper any employment of that right which might interfere with or threaten the adviser's operation of or control over the fund. "Thus, negotiations between the unaffiliated directors and fund advisers over advisory fees would lack an essential element of arm's- length bargaining -- the freedom to terminate the negotiations and to bargain with other parties for the same services. In view of the fund's dependence on its existing adviser and the fact that many shareholders may have invested in the fund on the strength of the adviser's reputa-
  • 9 "investment advisers seldom, if ever, compete with each other for advisory contracts with mutual funds." Id. at 126. One reason why fund competition for shareholder business does not lead to competition between adviser-managers for fund business is the relative insignificance of the adviser's fee to each shareholder. The fund customer's share[] of the advisory fee is usually too small a factor to lead him to invest in one fund rather than in another or to monitor adviser-manager's fees. "Cost reductions in the form of lower advisory fees ... do not figure significantly in the battle for investor favor." Id. Hence money market funds do not generally advertise that their advisory fees may be lower than those charged by advisers to other funds. The disparity is competitively insignificant. In the present case, for instance, the alleged excessive Manager's fee amounts to $2.88 a year for each $1,000 invested. If rates charged by the many other advisers were an affirmative competitive criterion, there would be little purpose in ' 36(b). Congress, however, recognized that because of the potentially incestuous rela- tionships between many advisers and their funds, other factors may be more important in determining whether a fee is so excessive as to constitute a "breach of fiduciary duty." These include the adviser-manager's cost in providing the service, the nature and quality of the service, the extent to which the adviser-manager realizes economies of scale as the fund grows larger, and the volume of orders which must be processed by the manager. The legislative history of ' 36(b) makes clear that Congress "intended that the court look at all the facts in connection with the determination and receipt of such compensation, including all services rendered to the fund or its shareholders and all compensation and payments received, in order to reach a decision as to whether the adviser has properly acted as a fiduciary in relation to such compensation." S.Rep. No. 91-184, supra, [1970] U.S. Code Cong. & Ad. News at 4910. As the district court recognized, the expertise of the independent trustees of a fund, whether they are fully informed about all facts bearing on the adviser-manager's service and fee, and the extent of care and conscientiousness with which they perform their duties are important factors to be considered in deciding whether they and the adviser-manager are guilty of a breach of fiduciary duty in violation of ' 36(b). But even if the trustees of a fund endeavored to act in a responsible fashion, an adviser- manager's fee could be so disproportionately large as to amount to a breach of fiduciary duty in violation of ' 36(b). Moreover, an intent to defraud need not be proved to establish a violation. Section 36(b)(1) expressly relieves the plaintiffs of tion, few unaffiliated directors would feel justified in replacing the adviser with a new and untested organization simply because of difficulty in obtaining a reduction in long-established fee rates which are customary in the industry." H.R. Rep. No. 2337, 89th Cong., 2d Sess. 131 (1966).
  • 10 the necessity of alleging or proving that any defendant engaged in personal misconduct. Nor do we subscribe to the district court's suggestion that because ' 36(b) was adopted in response to public concern over fees charged to investors in front-end load equity funds, the standard for determining whether there has been a breach of duty in avoiding excessive fees should be different or lower for managers of no-load money market funds, which are a recent, post-statute phenomenon. A potential for abuse of fiduciary relationship regarding fees charged for management and advisory services exists with respect to both types of fund since the adviser-manager's fee remains insignificant to each shareholder, whether or not a load factor inhibits redemption of shares.3 Application of the foregoing standards to this case confirms that plaintiffs have failed to meet their burden of proving that the fees charged by the Manager to the Fund were so excessive or unfair as to amount to a breach of fiduciary duty within the meaning of ' 36(b). There is no evidence that the services rendered by the Manager have not been of the highest quality, bringing to bear the expertise and facilities of the huge, far-flung Merrill Lynch organization. The average investor in the Fund, while not realizing the highest possible yield for his investment, has enjoyed a better-than-average return. The substantial increase in the Manager's fee, from $1,578,476 in 1977 to $39,369,587 for the year ending June 1981, resulted from the tremendous increase in the size of the Fund, from $428 million to over $19 billion during the same period. This increase multiplied the number of customers, daily transactions and other activities which the Manager and the Merrill Lynch organization handled as part of the service for the fee, thereby increasing costs proportionately. The orders processed annually by the Manager for the Fund increased from 2,486,782 in 1979 to 6,096,537 for the 12-month period ending June 30, 1981. Appellants' contention that since the Manager's own administrative expenses did not increase proportionately during the period after 1978, its profit margin was 96% for the 12-month period ending September 30, 1981, is unrealistic and was properly rejected by the district court. Proceeding on the erroneous theory that only the administrative costs incurred by the Manager itself may be considered, appellants ignore the heavy costs incurred by other Merrill Lynch affiliates in processing the increased volume of purchases and redemptions of Fund shares which were under the Manager's guidance. Since the Manager and Broker were divisions of one economic unit, the district court was entitled to deduct these costs in calculating the Manager's net profits. To limit 3 3 Appellants' argument that the lower fees charged by investment advisers to large pension funds should be used as a criterion for determining fair advisory fees for money market funds must also be rejected. The nature and extent of the services required by each type of fund differ sharply. As the district court recognized, the pension fund does not face the myriad of daily purchases and redemptions throughout the nation which must be handled by the Fund, in which a purchaser may invest for only a few days.
  • 11 consideration to the Manager's own administrative expenses would be to exalt form over substance and disregard the expressed Congressional intent that "all the facts in connection with the determination and receipt of such compensation" be considered. Although the court reduced the after-tax profits by determining the Manager's tax liability before deducting the processing costs, deduction of the costs before determining after-tax liability would nevertheless result in profits that could hardly be labelled so excessive as to constitute a breach of fiduciary duty. For instance, when processing costs are deducted before determining tax liability, the Manager's fee of $39,369,587 for the year ending June 30, 1981, would result in a 38.4% after-tax profit if the Fitz-Gerald estimate of processing costs were adopted, 9.8% after-tax profit under the Diemer estimate and a $7.7 million loss under the PMM estimate. 4 4 4 These percentages were arrived at by the following calculations: Using Using Fitz-Gerald Diemer Using PMM Estimate of Estimate of Estimate of Processing Processing Processing Costs Costs Costs Adviser's fee $39,369,587 $39,369,587 $39,369,587 Less direct costs 1,567,847 1,567,847 1,567,847 Less processing costs 10,534,805 30,848,477 45,541,131 ----------- ----------- ------------ Pre-tax profit (loss) 27,266,935 6,953,263 (7,739,391) Less tax at 44.5% 12,133,786 3,094,202 -- After tax profit 15,133,149 3,859,061 -- Percentage of adviser's fee that goes to after-tax profit 38.4% 9.8% -- . . . Merrill Lynch & Co. allocates its overall tax liability to its subsidiaries, including the Fund; the overall Merrill Lynch 1980 tax rate of 44.5% has therefore been applied to all of these profit figures. Appellants' contention that the PMM cost study improperly included selling or distribution expenses that may not be taken into consideration in determining whether the Manager's fee was excessive, see SEC Rule 12b-1, 17 C.F.R. ' 270.12b-1, must be rejected, since the latter is limited to promotional expenses (e.g., advertising, sales literature) designed to create new sales of no benefit to existing shareholders and the record reveals no such promotion of Fund sales by the Merrill
  • 12 No cost studies showing a higher after-tax profit were offered by appellants, who had the burden of proof. Moreover, after good-faith bargaining at arm's length between the 6 independent Fund trustees and the Manager, the latter's rate was graduated downward to reflect the economies that might be realized from the increase in value of the net assets. In view of these circumstances we cannot label clearly erroneous the district court's finding that no breach of fiduciary duty was shown. Faced with these facts appellants respond that the Fund and the Manager, by having the processing of purchasing and redemption orders done by the Broker, were wastefully duplicating the services of its transfer agent, the Bank of New York, which was obligated, among its other duties, to accept Fund purchase and redemption orders. For these services the Bank of New York charged the Fund $13 per shareholder's account per year regardless of the number of transactions. For its services as transfer agent in the year 1980 the bank received $12,404,444 from the Fund. The services rendered to shareholders by the Merrill Lynch organization, however, greatly exceeded those that could be furnished by the Bank of New York, which performs the duties required of it as Transfer Agent under its agreement with the Fund at only one main office located in New York City. Purchasers of shares are attracted to the Fund by the convenience and flexibility of the huge Merrill Lynch Broker's organization with its network of over 400 offices and 7,000 account executives in the United States alone. A simple telephone call or visit by a Fund customer to an account executive in the nearest Merrill Lynch branch office is all that is needed to effectuate in-person Fund services. Most of the transactions through the bank, on the other hand, apparently are effectuated by mail or wire and involve other complications. Thus, although customers could open Fund accounts through the Bank of New York, approximately 80% of the 1980 Fund purchase and redemption orders were initiated through the Broker and approximately 99% of the half-million new Fund accounts in 1980 were opened through the Broker's branch office system. If the Fund did not have the Broker's network to provide the in-person services sought by customers and to handle the millions of orders executed annually but instead were restricted to use of the limited facilities of the Bank of New York, it would be unable to function effectively at its present high-volume level. There is no evidence that the Bank of New York is prepared to expand its location and services to the level provided by the Broker. A more serious problem is posed by appellants' claim that in negotiating the Manager's fee the Merrill Lynch Fund and Manager failed to take into account that the Merrill Lynch Broker has gained large "fall-out" financial benefits annually in the form of commissions on non-Fund securities business generated by Fund customers and interest income on funds (known as the "float") held by the Broker from the date when a redemption check is issued by the Fund to its customer until the date it clears. If these benefits were taken into consideration, the argument goes, they would constitute a very substantial offset calling for a lower fee to the Manager than that paid by the Fund. Therefore, appellants contend, the Manager and the Fund, by Lynch organization.
  • 13 failing to offset these benefits, were guilty of a breach of fiduciary duty in violation of ' 36(b). The record reveals that a large percentage of persons who opened accounts with the Broker as Fund customers, e.g., some 38% of those who opened such accounts in the third quarter of 1979, later did some non-Fund business with Merrill Lynch, generating commissions for the Broker. Robert Diemer, the Broker's Director of Financial Services, testified that processing of Fund accounts helped to attract new equity security business which increased the Broker's commission revenue. These benefits to an affiliate in the Merrill Lynch organization, to the extent quantifiable, should be taken into account in determining whether the Manager's fee meets the standard of ' 36(b). Although the independent trustees may have been aware of these benefits, we are unpersuaded by the district court's suggestion that they cannot be measured or quantified because of inability to determine "whether customers who normally did an above-average level of brokerage business also tended to have Fund accounts" or to ascertain "what portion of the [increased brokerage business] would ... have gone to Merrill Lynch in any event." It would not seem impossible, through use of today's sophisticated computer equipment and statistical techniques, to obtain estimates of such "fall-out" and "float benefits" which, while not precise, could be a factor of sufficient substance to give the Funds' trustees a sound basis for negotiating a lower Manager's fee. However, the burden was on appellants, not the defendants, to adduce evidence demonstrating that the benefits were so substantial that they rendered the Manager's fee so disproportionately large as to label its negotiation a "breach of fiduciary duty" within the meaning of ' 36(b). Since appel- lants failed to offer such evidence, the dismissal of their contention must be affirmed. Since the district court properly took into consideration the fact that the Merrill Lynch organization's costs of processing Fund orders are substantial and the record fails to show that the Manager's profits were so disproportionately large as to amount to a breach of fiduciary duty, we find no merit in appellants' further argument that the Manager violated ' 36(b) by failing to disclose to the Fund's trustees relevant cost information and potential benefits. As Judge Pollack found, the Trustees were aware of or could obtain the essential facts needed to negotiate a reasonable fee. Similarly the Fund stockholders, before approving the management agreement between the Manager and the Fund, were made aware through proxy materials that the non-affiliated Fund trustees, who were the shareholders' watchdog representa- tives, had considered extensive relevant information before continuing in effect the Fund's agreement with the Manager. Since the trustees have the primary responsibility under the Act, ' 36(b) does not require that the Fund shareholders be furnished with additional information over and above that provided. Our affirmance is not a holding that the fee contract between the Fund and the Manager is fair and reasonable. We merely conclude that on this record appellants failed to prove by a preponderance of the evidence a breach of fiduciary duty. Whether a violation of ' 36(b) might be established through more probative evidence of (1) the Broker's processing costs, (2) the offsetting commission benefits realized
  • 14 by the Broker from non-Fund securities business generated by Fund accounts, and (3) the "float" interest income gained by the Broker from its method of handling payment on Fund redemptions, must therefore remain a matter of speculation. Indeed, the independent trustees of the Fund might well be advised, in the interests of Fund investors, to initiate such studies. ...
  • 15 Jones v. Harris Associates, L.P. ---- F.3d ---, 2008 WL 2080753 (7th Cir. May 19, 2008) EASTERBROOK, Chief Judge. Harris Associates advises the Oakmark complex of mutual funds. These open-end funds (an open-end fund is one that buys back its shares at current asset value) have grown in recent years because their net returns have exceeded the market average, and the investment adviser's compensation has grown apace. Plaintiffs, who own shares in several of the Oakmark funds, contend that the fees are too high and thus violate § 36(b) of the Investment Company Act of 1940, a provision added in 1970. The district court concluded that Harris Associates had not violated the Act and granted summary judgment in its favor. *** The district court followed Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir.1982), and concluded that Harris Associates must prevail because its fees are ordinary. Gartenberg articulated two variations on a theme: [T]he test is essentially whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all of the surrounding circumstances. And [t]o be guilty of a violation of § 36(b) ... the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining. Oakmark Fund paid Harris Associates 1% (per year) of the first $2 billion of the fund's assets, 0.9% of the next $1 billion, 0.8% of the next $2 billion, and 0.75% of anything over $5 billion. The district court's opinion sets out the fees for the other funds; they are similar. It is undisputed that these fees are roughly the same (in both level and breakpoints) as those that other funds of similar size and investment goals pay their advisers, and that the fee structure is lawful under the Investment Advisers Act. See [Investment Advisers Act § 205]. The Oakmark funds have grown more than the norm for comparable pools, which implies that Harris Associates has delivered value for money. Plaintiffs contend that we should not follow Gartenberg, for two principal reasons:
  • 16 first, that the second circuit relies too much on market prices as the benchmark of reasonable fees, which plaintiffs insist is inappropriate because fees are set incestuously rather than by competition; second, that if any market should be used as the benchmark, it is the market for advisory services to unaffiliated institutional clients. The first argument stems from the fact that investment advisers create mutual funds, which they dominate notwithstanding the statutory requirement that 40% of trustees be disinterested. Few mutual funds ever change advisers, and plaintiffs conclude from this that the market for advisers is not competitive. The second argument rests on the fact that Harris Associates, like many other investment advisers, has institutional clients (such as pension funds) that pay less. For a client with investment goals similar to Oakmark Fund, Harris Associates charges 0.75% of the first $15 million under management and 0.35% of the amount over $500 million, with intermediate break-points. Plaintiffs maintain that a fiduciary may charge its controlled clients no more than its independent clients. Like the plaintiffs, the second circuit in Gartenberg expressed some skepticism of competition's power to constrain investment advisers' fees. Competition between [mutual] funds for shareholder business does not support an inference that competition must therefore also exist between adviser-managers for fund business. The former may be vigorous even though the latter is virtually non- existent. Each is governed by different forces. The second circuit did not explain why this is so, however. It was content to rely on the observation that mutual funds rarely advertise the level of their management fees, as distinct from the funds' total expenses as a percentage of assets (a widely publicized benchmark). Holding costs down is vital in competition, when investors are seeking maximum return net of expenses-and as management fees are a substantial component of administrative costs, mutual funds have a powerful reason to keep them low unless higher fees are associated with higher return on investment. A difference of 0.1% per annum in total administrative expenses adds up by compounding over time and is enough to induce many investors to change mutual funds. That mutual funds are “captives” of investment advisers does not curtail this competition. An adviser can't make money from its captive fund if high fees drive investors away. So just as plaintiffs are skeptical of Gartenberg because it relies too heavily on markets, we are skeptical about Gartenberg because it relies too little on markets. . . . Two courts of appeals (in addition to the second circuit) have addressed claims against the advisers of open-end mutual funds. One circuit has followed Gartenberg.See Midgal v. Rowe Price-Fleming International, Inc., 248 F.3d 321 (4th Cir.2001). The other has concluded that adherence to the statutory procedures, rather
  • 17 than the level of price, is the right way to understand the “fiduciary” obligation created by § 36(b). See Green v. Fund Asset Management, L.P., 286 F.3d 682 (3d Cir.2002). Our own Green opinion, though it dealt with the obligations of advisers to closed-end funds, indicated sympathy for the third circuit's position. Having had another chance to study this question, we now disapprove the Gartenberg approach. A fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation. The trustees (and in the end investors, who vote with their feet and dollars), rather than a judge or jury, determine how much advisory services are worth. Section 36(b) does not say that fees must be “reasonable” in relation to a judicially created standard. It says instead that the adviser has a fiduciary duty. That is a familiar word; to use it is to summon up the law of trusts. . . . And the rule in trust law is straightforward: A trustee owes an obligation of candor in negotiation, and honesty in performance, but may negotiate in his own interest and accept what the settlor or governance institution agrees to pay. . . . When the trust instrument is silent about compensation, the trustee may petition a court for an award, and then the court will ask what is “reasonable”; but when the settlor or the persons charged with the trust's administration make a decision, it is conclusive. . . . It is possible to imagine compensation so unusual that a court will infer that deceit must have occurred, or that the persons responsible for decision have abdicated-for example, if a university's board of trustees decides to pay the president $50 million a year, when no other president of a comparable institution receives more than $2 million-but no court would inquire whether a salary normal among similar institutions is excessive. Things work the same way for business corporations, which though not trusts are managed by persons who owe fiduciary duties of loyalty to investors. This does not prevent them from demanding substantial compensation and bargaining hard to get it. Publicly traded corporations use the same basic procedures as mutual funds: a committee of independent directors sets the top managers' compensation. No court has held that this procedure implies judicial review for “reasonableness” of the resulting salary, bonus, and stock options. These are constrained by competition in several markets-firms that pay too much to managers have trouble raising money, because net profits available for distribution to investors are lower, and these firms also suffer in product markets because they must charge more and consumers turn elsewhere. Competitive processes are imperfect but remain superior to a “just price” system administered by the judiciary. However weak competition may be at weeding out errors, the judicial process is worse-for judges can't be turned out of office or have their salaries cut if they display poor business judgment. Lawyers have fiduciary duties to their clients but are free to negotiate for high hourly wages or compensation from any judgment. Rates over $500 an hour and contingent
  • 18 fees exceeding a third of any recovery are common. The existence of the fiduciary duty does not imply judicial review for reasonableness; the question a court will ask, if the fee is contested, is whether the client made a voluntary choice ex ante with the benefit of adequate information. Competition rather than litigation determines the fee-and, when judges must set fees, they try to follow the market rather than demand that attorneys' compensation conform to the judges' preferences. . . . A lawyer cannot deceive his client or take strategic advantage of the dependence that develops once representation begins, but hard bargaining and seemingly steep rates are lawful. The list could be extended, but the point has been made. Judicial price-setting does not accompany fiduciary duties. Section 36(b) does not call for a departure from this norm. Plaintiffs ask us to look beyond the statute's text to its legislative history, but that history, which Gartenberg explores, is like many legislative histories in containing expressions that seem to support every possible position. Some members of Congress equated fiduciary duty with review for reasonableness; others did not (language that would have authorized review of rates for reasonableness was voted down); the Senate committee report disclaimed any link between fiduciary duty and reasonableness of fees. . . . Statements made during the debates between 1968 and 1970 rest on beliefs about the structure of the mutual-fund market at the time, and plaintiffs say that because many members of Congress deemed competition inadequate (and regulation essential) in 1970, we must act as if competition remains weak today. Why? Congress did not enact its members' beliefs; it enacted a text. A text authorizing the SEC or the judiciary to set rates would be binding no matter how market conditions change. Section 36(b) does not create a rate-regulation mechanism, and plaintiffs' proposal to create such a mechanism in 2008 cannot be justified by suppositions about the market conditions of 1970. A lot has happened in the last 38 years. Today thousands of mutual funds compete. The pages of the Wall Street Journal teem with listings. People can search for and trade funds over the Internet, with negligible transactions costs. “At the end of World War II, there were 73 mutual funds registered with the Securities and Exchange Commission holding $1.2 billion in assets. By the end of 2002, over 8,000 mutual funds held more than $6 trillion in assets.” . . . Some mutual funds, such as those that track market indexes, do not have investment advisers and thus avoid all advisory fees. (Total expenses of the Vanguard 500 Index Fund, for example, are under 0.10% of assets; the same figure for the Oakmark Fund in 2007 was 1.01%.) Mutual funds rarely fire their investment advisers, but investors can and do “fire” advisers cheaply and easily by moving their money elsewhere. Investors do this not when the advisers' fees are “too high” in the abstract, but when they are excessive in relation to the results-and what is “excessive” depends on the results available from other investment vehicles, rather than any absolute level of compensation.
  • 19 New entry is common, and funds can attract money only by offering a combination of service and management that investors value, at a price they are willing to pay. Mutual funds come much closer to the model of atomistic competition than do most other markets. Judges would not dream of regulating the price of automobiles, which are produced by roughly a dozen large firms; why then should 8,000 mutual funds seem “too few” to put competitive pressure on advisory fees? A recent, careful study concludes that thousands of mutual funds are plenty, that investors can and do protect their interests by shopping, and that regulating advisory fees through litigation is unlikely to do more good than harm. See John C. Coates & R. Glenn Hubbard, Competition in the Mutual Fund Industry: Evidence and Implications for Policy, 33 Iowa J. Corp. L. 151 (2007). It won't do to reply that most investors are unsophisticated and don't compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest. . . . As it happens, the most substantial and sophisticated investors choose to pay substantially more for investment advice than advisers subject to § 36(b) receive. A fund that allows only “accredited investors” (i.e., the wealthy) to own non- redeemable shares is exempt from the Investment Company Act. See Investment Company Act § 6(a)(5)(A)(iii).1 Investment pools that take advantage of this exemption, commonly called hedge funds, regularly pay their advisers more than 1% of the pool's asset value, plus a substantial portion of any gains from successful strategies. . . . When persons who have the most to invest, and who act through professional advisers, place their assets in pools whose managers receive more than Harris Associates, it is hard to conclude that Harris's fees must be excessive. Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark funds. Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets. Mutual funds may grow or shrink quickly and must hold some assets in high-liquidity instruments to facilitate redemptions. That complicates an adviser's task. Joint costs likewise make it hard to draw inferences from fee levels. Some tasks in research, valuation, and portfolio design will have benefits for several clients. In competition those joint costs are apportioned among paying customers according to their elasticity of demand, not according to any rule of equal treatment. Federal securities laws, of which the Investment Company Act is one component, work largely by requiring disclosure and then allowing price to be set by competition in which investors make their own choices. Plaintiffs do not contend that Harris Associates pulled the wool over the eyes of the disinterested trustees or otherwise hindered their ability to negotiate a favorable price for advisory services. The fees are 1 [Professor Bradford’s Note: This is incorrect. Hedge funds are excepted from the definition of “investment company” by either § 3(c)(1) or § 3(c)(7) of the Investment Company Act.]
  • 20 not hidden from investors-and the Oakmark funds' net return has attracted new investment rather than driving investors away. As § 36(b) does not make the federal judiciary a rate regulator, after the fashion of the Federal Energy Regulatory Commission, the judgment of the district court is affirmed.
  • 21 Green v. Nuveen Advisory Corp. 295 F.3d 738 (7th Cir. 2002) OPINION OF THE COURT The plaintiffs in this case are common shareholders of six closed-end, tax- exempt municipal bond funds. They allege that Nuveen, the funds' investment adviser, breached its fiduciary duty under ' 36(b) of the Investment Company Act of 1940 ("ICA" or "the Act") by receiving compensation based on a percentage of the daily net assets of the funds. Such an arrangement, plaintiffs contend, creates an inherent conflict of interest in violation of the Act. The district court granted summary judgment in favor of the defendant, finding that the plaintiffs failed to produce evidence establishing a breach of fiduciary duty under ' 36(b). For the reasons stated herein, we affirm the decision of the district court. I. Background The six funds at issue are closed-end,1 tax-exempt, leveraged2 companies that invest in tax-free municipal bonds. The stated primary objective of the funds is to provide shareholders current income exempt from regular federal income tax. The stated secondary objective is to enhance portfolio value relative to the municipal bond market "through investments in tax-exempt Municipal Obligations that, in the opinion of the adviser, are underrated or undervalued or that represent municipal market sectors that are undervalued." Each of the funds uses leverage to increase the amount of current income generated. That is, each of the funds issues preferred stock, used as a leveraging tool, as well as common stock. The sale of common stock provides the majority of the capital with which the funds purchase long-term municipal bonds. The proceeds from the sale of preferred stock, sold at a dividend rate that is based upon short-term tax-exempt interest rates, are invested into additional long-term municipal bonds that 1 1 A closed-end investment company, unlike a traditional open-end mutual fund, has fixed capitalization and may sell only the number of shares of its own stock as originally authorized. It does not redeem its securities at the option of the shareholder. Shares of a closed-end fund are traded on a secondary market; that is, its stock, like that of any publicly owned corporation, is usually listed on a national exchange. The most pertinent difference between open-and closed-end investment companies is that closed-end funds are authorized under the ICA to use leverage to increase the stream of current income through the sale of preferred stock . . . . 2 2 Leverage exists "when an investor achieves the right to a return on a capital base that exceeds the investment which he has personally contributed to the entity or instrument achieving a return."
  • 22 pay rates of return that exceed the preferred-share dividend amount. The difference between the dividend paid to the preferred shareholders and these long-term interest rates amounts to additional income to common shareholders. So long as the long- term rates exceed the short-term dividend rates, which they do under normal market conditions, common shareholders receive greater current income than they would if the identical fund were not leveraged. It is undisputed in this case that the long-term always exceeded the short-term rates. The Nuveen funds were leveraged for the entire time period in question. Being a common shareholder of a leveraged investment company is not without risks. The dividends and values of preferred shares are set; the holders of preferred shares always have a prior claim on the funds' assets. Therefore, a decrease in the value of those assets is borne only by the holders of common shares. Generally, the more highly leveraged the fund, the greater the risk of loss resulting from decreased portfolio value. Each of the six funds' prospectuses informed its common shareholders that leverage creates increased volatility in the value of their shares. Under the ICA, each investment company must have a board of directors, at least 40% of which is disinterested from the fund and its advisers. A majority of the directors of each of the funds at issue in this case is unaffiliated with Nuveen. The directors maintained ultimate control over the extent of the funds' leverage and the decisions as to whether to deleverage at a given time; they did, however, rely upon Nuveen for recommendations on leverage decisions. Nuveen operates and manages the funds in question. Its compensation is based on a percentage of the daily net assets of the funds, including the value of assets attributable to outstanding preferred shares. Thus, assuming the number of outstanding common shares remains fixed, the more highly leveraged the fund, the higher Nuveen's compensation. The six funds issued preferred shares equaling approximately 35% of the funds' total assets to create leverage. Because an adviser's services and costs increase, to some extent, as its fund's assets increase, almost all investment companies and 100% of the 202 current closed end, leveraged municipal bond funds, base adviser compensation on net or total assets. II. Discussion ... The logic of the plaintiffs' underlying contention is easy to understand, but their conclusion is ultimately false. With the current compensation structure, the more highly leveraged a closed-end fund, the more compensation its advisers receive. A fund's interests may not always be best served by being highly leveraged. 7 Therefore, the plaintiffs conclude, assuming that the funds' advisers are the decision makers -- an assumption that has proven incorrect in this case, as will be discussed 7 7 As discussed above, plaintiffs have produced no evidence that, in this case, the funds' objectives actually would have been better served by deleveraging.
  • 23 below -- the advisers have a personal monetary incentive to act in a manner that may not be best for the common shareholders of the funds, creating an impermissible conflict of interest. This incentive alone, the plaintiffs argue, violates the ICA ' 36(b). Under this provision, an investment company's adviser owes the shareholders a fiduciary duty "with respect to the receipt of compensation for services." Two primary issues arise with regard to this contention: first, does the alleged conflict of interest alone violate ' 36(b) of the Act, and second, does such a conflict exist in this case. The district court answered both questions in the negative. Congress enacted the ICA in 1940 to provide a comprehensive federal program to address mismanagement and abuse of investment companies that had become prevalent in the depression era. Because Congress recognized the potential for a fund's adviser to self-deal under a compensation scheme based on a percentage of fund assets, it mandated that forty percent of a fund's board of directors be unaffiliated with the fund's adviser. These independent directors were directly accountable to shareholders and were, among other duties, responsible for determining adviser compensation and approving, by majority, all agreements with advisers. In 1970, recognizing that the potential for abuse called for greater and more easily enforced protection for investors, Congress amended the Act. The ICA, as amended, included ' 36(b) which created a statutorily imposed fiduciary duty upon advisers regarding their compensation. Plaintiffs argue that this provision prohibits a closed-end fund's adviser from receiving fees that are based upon a percentage of the fund's assets because the inherent conflict of interest in such an arrangement breaches its fiduciary duty. Nuveen had a duty, they contend, to avoid a fee structure that creates an incentive to consider its own interests when making leverage decisions for the funds. We disagree. First, while an abuse of this inherent conflict may violate ' 36(b), its mere existence does not. This holding comports with congressional intent as well as the case law that has developed interpreting the Act. Second, the evidence shows that Nuveen did not have the authority to make final leveraging decisions for the funds. Although ' 36(b) does not explain the term "fiduciary duty," the legislative history surrounding the ICA's 1970 amendment makes clear that the enactment of the provision was not "intended to provide a basis . . . to undertake a general revision of the practices or structures of the investment company industry." H.R. Rep. No. 91-1382 (1970). Congress was well aware, when it amended the Act, that the most common investment company adviser compensation scheme was based on a percentage of assets. "[Advisers'] fees are usually calculated at a percentage of the funds' net assets and fluctuate with the value of the funds' portfolio." S. Rep. No. 91-184 (1969). The very awareness of this structure, and the potential for abuse carried with it by creating various monetary incentives for advisers, prompted Congress to impose a fiduciary duty. By passing ' 36(b), it attempted to diminish the risk of adviser self-dealing under the predominant industry practice, not to fundamentally revise the system itself. Moreover, Congress has amended the Act,
  • 24 including ' 36(b), several times, never indicating that the fee structure as applied to leveraged, closed-end funds was impermissible. The existence of a compensation scheme that could create an incentive for advisers to keep an investment fund leveraged to an extent that may not be best for the fund's common shareholders does not, by itself, create a breach of fiduciary duty under ICA ' 36(b).8 Congress enacted ' 36(b) to provide a narrow federal remedy that "is significantly more circumscribed than common law fiduciary duty doctrines . . . ." For example, a shareholder may sue only the recipient of the fees in question and has the burden of proving the breach of duty; recovery is limited to actual damages; and damages are recoverable only for the one-year period before the filing of the action. Although the existence of a potential conflict like the one plaintiffs assert may create a valid breach of fiduciary duty claim under the common law standard -- a question we do not entertain -- it does not violate ICA ' 36(b). Moreover, ' 205 of the Investment Advisers Act, a companion statute to the ICA, expressly approves of investment compensation contracts which, like this one, are "based upon the total value of a fund over a definite period." . . . The plaintiffs in this case produce no evidence showing that Nuveen actually abused its position, thus breaching its ' 36(b) fiduciary duty. Although they attempt in a secondary argument to show an actual conflict resulting from a leveraging decision in 1994, this time period was before they were shareholders, and before the Act's recoverable one-year period began. This contention, therefore, carries no weight. Moreover, even if these procedural bars were ignored, plaintiffs fail to show that an actual conflict existed. They assert that the advisers received compensation in breach of their fiduciary duty by maintaining preferred share leverage to increase their fees, resulting in a decrease in portfolio value. They do not dispute, however, that any loss was unrealized, offset by leveraged-enhanced gains the following year, 8 8We note that although two of our sister circuits have held that ' 36(b) is limited to allegations of excessive fees relative to services provided, Migdal v. Rowe Price- Fleming Int'l, Inc., 248 F.3d 321 (4th Cir. 2001); Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982), we, like the Third Circuit, see Green v. Fund Asset Mgmt., 286 F.3d 682 [3rd Cir. 2002], view the provision slightly more broadly. For example, in the improbable case that: 1) the adviser to a closed-end, equity- leveraged fund with an asset-based compensation scheme received additional fees by increasing or maintaining leverage when it predicted that short-term interest rates would exceed long-term rates for a protracted period of time, causing the common shareholders to lose current income; and 2) the adviser, not the board of directors, made final leveraging decisions, a common shareholder's ' 36(b) claim might survive summary judgment. Even in that case, it is important to remember, the receipt of fees and the compensation structure, not the leveraging decision, would be at issue, and damages would be limited to the amount of compensation received. . . . Because the question raised by the hypothetical case above is not before us today, however, we decline to address the merits of the issue.
  • 25 that they would have sacrificed additional income had the funds been deleveraged, that even in the year they reference, the funds outperformed taxable bond funds that did reduce leverage, and that the funds' prospectuses adequately informed them that the funds use leverage which creates increased volatility in portfolio value. The funds each have a secondary objective of enhancing portfolio value through investing in underrated or undervalued municipal bonds, not through leverage decisions. Moreover, the plaintiffs fail to show that Nuveen predicted the interest rate changes when the funds decided to maintain leverage in 1994; therefore, its argument that the advisers made a decision that negatively impacted the common shareholders in order to increase compensation must fail. . . . Throughout this litigation, the plaintiffs have maintained that if the advisers controlled the use of leverage, the fee structure itself would violate ICA ' 36(b) because of the impermissible incentive it creates. Even if we agreed with this contention, the undisputed facts show that it was not Nuveen who controlled the use of leverage, but the funds' directors. The allegedly improper incentive, therefore, is minimal. The plaintiffs do not dispute the fact that the board of directors, the majority of whom were unaffiliated with Nuveen, had ultimate control over the extent of the funds' leverage; they contend only that the directors relied on Nuveen's recommendations. Assuming that this is true, however, it remains undisputed that Nuveen did not have the authority to increase or decrease leverage -- that power lay only with the independent board of directors. Summary judgment was appropriate based on this reason alone. Finally, for each applicable year, the disinterested directors for each of the funds approved the advisory compensation agreements at issue. Because Congress expressly ordered that we give board of director approval "such consideration ... as is deemed appropriate under all the circumstances," [' 36](b)(2), we find that this factor, too, supports the district court's summary judgment ruling. . . .
  • 26 B. Voting Rights Depositors Investment Trust Securities and Exchange Commission No-Action Letter Publicly Available May 7, 1984 1984 SEC NOACT LEXIS 1510 LETTER TO SEC This office represents Depositors Investment Trust ("DIT") which is a diversified, open-end, series-type, registered management investment company currently consisting of three different series of shares, the Capital Growth Fund, the Aggressive Growth Fund and the Current Income Fund (the "Funds"). . . . On behalf of DIT we have recently obtained a private letter ruling from the Internal Revenue Service (the "Ruling") to the effect that, contingent upon amending the DIT Declaration of Trust as described below, each Fund will be treated as a separate corporation for federal income tax purposes. . . . Article V, section 1 of the DIT Declaration of Trust provides that shareholders shall have the power to vote in the election of trustees and on other customary matters and provides further, in pertinent part: "On any matter submitted to a vote of Shareholders, all Shares of the Trust then entitled to vote, irrespective of series, shall be voted in the aggregate and not by series, except (1) when required by the 1940 Act, Shares shall be voted by individual series, in which event, unless otherwise required by the 1940 Act, a vote of Shareholders of all Shares of the Trust, irrespective of series, shall not be required ... " It is a condition to the effectiveness of the Ruling that this provision be amended to provide: "On any matter submitted to a vote of Shareholders, all Shares of the Trust then entitled to vote shall be voted by individual series, except (1) when required by the 1940 Act, Shares shall be voted in the aggregate and not by individual series ..." DIT plans to seek shareholder approval of such an amendment at a meeting of shareholders . . . for the purpose of considering such amendment, electing trustees and other customary matters. In discussing the above change in voting rights with representatives of the IRS the question arose whether the election of Trustees would be on a series-by-series basis or whether the provisions of the 1940 Act would require that in the election of Trustees Shares of the Trust vote together and not by individual series. We advised representatives of the IRS that we were uncertain whether it would be in conformity with the 1940 Act to require that the Trustees of DIT must be elected by a plurality vote of the Shareholders of each series. We agreed, however, to seek an interpretation from the Commission on this question and to conduct series-by-series voting for Trustees if the Commission concludes that it is permitted under the 1940 Act. Briefly stated, our doubts concern the proper interpretation of Sections 16(a) and 18(i) of the 1940 Act. Section 16(a) provides in relevant part: "No person shall serve as a director of a registered
  • 27 investment company unless elected to that office by the owners of the outstanding voting securities of such company ..." This section appears to indicate an election by all share- holders of the investment company acting as a single group, but would not seem to prohibit requiring that no person serve as a trustee unless elected by a plurality vote of each series. Section 18(i) provides in relevant part: "except ... as otherwise required by law, every share of stock hereafter issued by a registered management company ... shall be a voting stock and have equal voting rights with every other outstanding voting stock: Provided, that this subsection shall not apply to ... shares issued in accordance with any rules, regulations, or orders which the Commission may make permitting such issue." (Emphasis added.) Section 2(a)(42) of the 1940 Act defines a voting security as one which entitles the holder to vote for the election of directors of a company and defines percentages of the voting securities in terms of a percentage of the aggregate votes which the holders of all the outstanding voting securities of such company are entitled to cast. ... We would appreciate your interpretation regarding the proper application of Sections 16(a) and 18(i) . . . to the election of the trustees of DIT if the proposed amendment to its Declaration of Trust is effected. . . . SEC REPLY Section 18(i) of the Investment Company Act of 1940 states, in pertinent part, that, except as otherwise required by law, every share of stock issued by a registered management company shall be a voting stock and have equal voting rights with every other outstanding voting stock. If a series investment company could require its directors to be elected by the shareholders of each series, and not by the shareholders as a whole, each voting stock might not have equal voting rights. For example, in an investment company with two series, one series having 100,000 shares and the other having three, the vote of two shares in the latter series would have voting power equal to 50,001 shares of the former series. Thus, we believe that, unless otherwise required by law, section 18(i) requires the election of the trustees of Depositors Investment Trust to be by the shareholders of the entire investment company as a group.
  • Sentinel Group Funds, Inc. Securities and Exchange Commission No-Action Letter Publicly Available October 27, 1992 1992 SEC NOACT LEXIS 1061 LETTER TO SEC Sentinel Group Funds, Inc. (the "Company") is an open-end, diversified, management investment company registered under the Investment Company Act of 1940, as amended (the "1940 Act"). On behalf of the Company, we respectfully request (i) your concurrence in our position that the voting rights of the several classes of common stock of the Company, as such voting rights are proposed to be amended, and as described below, constitute "equal voting rights" as required by section 18(i) of the 1940 Act, and (ii) your assurance that the staff (the "Staff") of the Securities and Exchange Commission (the "Commission") will not recommend that the Commission institute enforcement proceedings against the Company if it amends its Articles of Incorporation to provide for such voting rights. I. Description of the Company The Company . . . currently has six classes of common stock outstanding, each of which is a separate fund with its own distinct investment objective and policies. The six current classes of common stock (the "Funds") and their investment objectives are set forth below. Sentinel Growth Fund -- seeks growth of capital through equity participation in companies having growth potential believed by management to be more favorable than that of the U.S. economy as a whole. Sentinel Common Stock Fund -- seeks a combination of growth of principal and income, current return and relatively low risk through investment in common stocks of many well-established companies. Sentinel Balance[d] Fund -- seeks a conservative combination of stability, income and growth through investments in both stocks and bonds with at least 25% of its net assets in fixed-income senior securities. Sentinel Bond Fund -- seeks a high level of continuing income consistent with the preservation of capital through investments in fixed income securities. Sentinel Tax-Free Income Fund -- seeks a high level of current income, exempt from federal income taxes, consistent with the preservation of capital, through investments primarily in a diversified portfolio of municipal bonds. Sentinel Government Securities Fund -- seeks a high level of current income consistent with the preservation of capital through investments primarily in securities issued or guaranteed by the U.S. Government or its agencies or instrumentalities, and, to a limited extent, in repurchase agreements with respect to such securities. This Fund
  • may also invest to a limited extent in high quality money market instruments which are not issued by a government entity. . . . The numbers of shares outstanding and the net asset value per share for each Fund as of August 20, 1991 are set forth below. Shares N.A.V. Fund Outstanding Per Share Sentinel Growth Fund 3,500,000 $16.19 Sentinel Common Stock Fund 23,326,932 26.82 Sentinel Balanced Fund 6,269,509 13.75 Sentinel Bond Fund 6,405,146 6.32 Sentinel Tax-Free Income Fund 2,304,831 12.60 Sentinel Government Securities Fund 4,219,351 9.85 II. The Proposed Acquisition and Amendment of Voting Rights The Company currently proposes to acquire all of the assets, and assume all of the liabilities (the "Acquisition"), of Sentinel Cash Management Fund, Inc., a no-load money market mutual fund (the "Cash Fund"), in exchange for shares of a proposed new series, Sentinel 100% U.S. Treasury Money Market Fund (the "New Money Market Fund"). The investment objective of the proposed New Money Market Fund is to seek a high level of current income consistent with the preservation of capital and the maintenance of liquidity by investing exclusively in direct obligations of the U.S. Treasury which have remaining maturities of 397 days or less. The New Money Market Fund will seek to maintain its net asset value at a constant $1.00 per share. As the Cash Fund had 57,413,357 shares outstanding as of August 20, 1991, it is anticipated that the New Money Market Fund will issue approximately 60,000,000 shares at the closing of the Acquisition. Sentinel Advisors, Inc. ("SAI"), investment adviser to both the Company and the Cash Fund, believes that it is in the best interests of the Cash Fund's shareholders to amend the Cash Fund's investment objective and policies to restrict its investments to U.S. Treasury money market instruments. In connection with this change, SAI believes that making the Cash Fund a series of the Company, rather than a separate corporation, will benefit Cash Fund shareholders in several significant ways. As a Fund of the Company, many of the operating expenses of the New Money Market Fund will be lower than the operating expenses of the Cash Fund, potentially reducing the expense ratio of the New Money Market Fund as compared to the Cash Fund. Such expense savings will be due in part to the lower advisory fee charged by the Company at certain higher net asset levels. In addition, the costs of printing and mailing separate prospectuses, statements of additional information and shareholder reports will be significantly reduced. Other fixed costs will be allocated among the Funds in proportion to the assets
  • or the number of shareholder accounts, in accordance with the policies of the Company. Moreover, the Company will continue to offer full exchange rights between the Funds, including the New Money Market Fund . . . . ... In connection with the Acquisition, the Company proposes to submit to its shareholders, with each Fund voting as a separate class, a proposal to amend its Articles to provide that each share will have, instead of one vote, one vote for each dollar of net asset value per share. As a result, on issues in which the various Funds vote together as a single class, such as the election of directors and selection of independent accountants, voting power would be allocated in proportion to the value of each shareholder's investment, rather than in proportion to the number of shares held. Of course, on matters on which each Fund votes as a separate class, this change is not meaningful, since the net asset value of all shares within a given Fund is equal. ... Because the New Money Market Fund's net asset value per share will ordinarily be $1.00, if the Acquisition were to be effected without the change in voting rights, voting power would be dramatically and unfairly skewed in favor of the New Money Market Fund class. Recognizing this problem, the Board of Directors of the Company conditioned its approval of the Acquisition on the approval by the Company's shareholders of the proposed amendments to the Articles which change the relative voting rights. . . . III. Legal Analysis It is our view that the proposed change in voting rights of the various classes of common stock described above would not contravene what is meant by "equal voting rights" as such term[] is used in section 18(i) of the 1940 Act. Section 18(i) provides in relevant part that: "every share of stock hereafter issued by a registered management investment company ... shall be a voting stock and have equal voting rights with every other voting stock ..." The 1940 Act does not contain a specific definition of, and there is no legislative history discussing the meaning of, "equal voting rights" in Section 18(i). . . . The Commission [has] established a principle of reasonableness for determining the meaning of "equal voting right" within the context of Section 18(i) in particular and the 1940 Act in general. . . . In the Company's case, we believe that amending the Articles to provide for one vote for each dollar of net asset value per share ("dollar-based voting") will provide a more equitable distribution of voting rights to the Company's shareholders than the one- share-one-vote system currently in effect. Open-end investment companies issue and redeem large numbers of their shares each day, and frequently shares are freely exchangeable among funds at relative net asset values. No investor makes his investment with the idea that he will acquire a certain fixed percentage of the investment company's voting power. Rather, he expects that his voting power will be proportionate to his
  • economic interest. In the case of a series fund, the net asset values of each series diverge over time, perhaps very widely as in the case of the Company. In this context, dollar- based voting provides shareholders, in substance, with "equal voting rights" while one- vote-one-share voting may not. For example, on August 20, 1991, the offering price of a share of the Sentinel Common Stock Fund of the Company was approximately $30 per share and the net asset value was approximately $27 per share. If the New Money Market Fund had been a series of the Company on that date, an investor who had $30 to invest could have purchased 30 shares of the New Money Market Fund or one share of the Common Stock Fund. Under the one-share-one-vote voting system, an investor who chose to invest $30 in the New Money Market Fund would have received 30 times the voting power received by an investor who chose to invest $30 in the Common Stock Fund. Under the dollar- based voting system, the Common Stock Fund investor would receive 27 votes for his $30 investment (with approximately $3 being applied to the sales load) and the New Money Market Fund investor would receive 30 votes for his $30 investment. Surely the more equitable result is for two shareholders who invest the same amount of money on the same day to have approximately equivalent relative voting power. Similarly, under a one-share-one-vote rule, an existing Common Stock Fund shareholder who exchanged his shares into shares of the New Money Market Fund would, by the exchange alone, and without any new investment, increase his relative voting power 30- fold. Again, it would be more equitable for a shareholder to have the same relative voting power regardless of the extent to which he exercises his exchange rights. If the Acquisition had taken place on August 20, 1991, the outstanding shares of the New Money Market Fund would have accounted for approximately 55.5% of the outstanding shares of the Company but would have accounted for only approximately 6.1% of the net asset value of the Company. Thus, after the Acquisition, voting rights for the Company's shareholders would be much more equitably allocated on a dollar- based voting basis than on a one-share-one-vote basis. As noted above, the Company will submit the amendment to the Articles to the shareholders of each Fund as a separate class. To amend the Articles, each Fund must vote, by at least a majority of its outstanding shares, to approve the amendment. The proposed amendment will not dramatically change the existing balance of voting power, and so cannot be seen as disenfranchising any existing voting group. Set forth below is a comparison of the relative voting power of each class, with assets and number of shares as of August 20, 1991, before and after the Acquisition and amendment of the Articles: Before After changes changes Sentinel Growth Fund 7.6% 6.0% Sentinel Common Stock Fund 50.7% 66.8% Sentinel Balanced Fund 13.6% 9.2% Sentinel Bond Fund 13.9% 4.3% Sentinel Tax-Free Income Fund 5.0% 3.1%
  • Sentinel Government Securities Fund 9.2% 4.4% Sentinel 100% U.S. Treasury Money Fund -- 6.1% The Acquisition will also be submitted for approval by at least a majority of the outstanding shares of the Cash Fund. The proxy materials will discuss the fact that if the Cash Fund shareholders approve the Acquisition, they will lose the power to vote as a separate body on certain issues, and that they must weigh this loss of separate voting power against the benefits of the Acquisition. ... SEC REPLY Your letter of September 5, 1991, requests our assurance that we would not recommend enforcement action to the Commission under Section 18(i) of the Investment Company Act of 1940 (the "1940 Act") if Sentinel Group Funds, Inc. ("Company") amends its articles of incorporation to provide shareholders with one vote for each dollar of net asset value per share. ... You state that the proposed reallocation of voting rights of the various classes would not violate the equal voting rights requirement of Section 18(i). The 1940 Act does not define "equal voting rights," and the legislative history does not discuss the meaning of that phrase. The Commission stated that, given the absence of any definition or discussion at the Congressional hearings as to the meaning of the equal voting rights requirement, the general purposes of the statute should guide the determination whether a given proposal violates that requirement. The Commission further stated that "an inflexi- ble adherence to any rigid interpretation could produce grave distortions of the apparent intent of Congress ... and that each such case must be decided on the particular factors involved." On the basis of the facts and representations in your letter, we would not recommend enforcement action to the Commission under Section 18(i), if the Company amends its articles of incorporation to provide for dollar-based voting as described in your letter. Because our position is based on the facts and representations in your letter, you should note that different facts or circumstances may require a different conclusion. Further, this response expresses the Division's position on enforcement action only and does not purport to express any legal conclusion on the issues presented.
  • New America Fund, Inc. Securities and Exchange Commission No-Action Letter Publicly Available July 8, 1972 1972 SEC NOACT LEXIS 2754 LETTER TO SEC This firm acts as special counsel to New America Fund, Inc. ("Fund") a registered closed-end diversified management (investment) company . . . . Fund Management Corporation (formerly known as Letter Management Corporation) ("Advisor") has been Manager and Investment Adviser to the Fund since September 20, 1968, the effective date of a Registration Statement filed under the Securities Act of 1933, as amended, (the "1933 Act") covering the initial public offering of the Fund's shares. No other registration statements have been filed on behalf of the Fund since September, 1968. . . . [The Prospectus for] the Fund dated September 20, 1968 ("Prospectus"), pursuant to which 6,000,000 shares of the Fund were offered and sold to the public[,] sets forth . . . certain policies and investment restrictions applicable to the operations of the Fund and states that "none [of these policies and investment restrictions] may be changed without the prior consent or vote of the holders of a majority of [the fund's] outstanding voting securities." One such restriction states (on page 10 of the Prospectus) that the Fund "will not invest more than five per cent of its total assets . . . in the securities of any one issuer and will not purchase more than ten per cent of the outstanding voting securities of any one issuer." . . . ... The principal investment objective of the Fund at the time of the public offering was to invest at least 80% of the total value of its assets in Restricted Securities.I At the Annual Meeting of Stockholders held on December 16, 1971, stockholders of the Fund voted to adopt a proposal modifying the principal investment objective and investment policy of the Fund to permit the Fund to invest up to 100% of its total assets in freely marketable securities. The Fund has, as at 12/31/71, assets of $29,239,448. During the past year, management of the Fund has been evaluating alternatives for expanding financial service opportunities which would enable the Fund to participate in a program for the enhancement of positive social goals. Management believes that the programs established by the Small Business Administration afford such an opportunity and, accordingly is contemplating formation of a Small Business Investment Company ("SBIC") whose primary purpose will be the making of long-term loans and the providing of equity capital to small business concerns. We have been advised that in the course of the organization of the SBIC, all of the outstanding stock of the SBIC will consist of one class of common stock which will be owned by the Fund and will be I IEditor's note: Restricted securities are defined as securities that are not acquired in a public offering and/or that are subject to resale restrictions. See 17 C.F.R. ' 230.144(a) (3).
  • capitalized by an investment by the Fund of $1,250,000 (5% of the value of the present assets of the Fund). A license application has been filed and is pending with the Small Business Administration to obtain the necessary authority to complete the formation and licensing of the SBIC. . . . The SBIC will not in the immediate future utilize the services of an investment advisor. The Fund intends to advise its stockholders in advance of the completion of the formation of the SBIC of the Fund's intent to form and capitalize the SBIC as a wholly-owned subsidiary. ... The principle problem which has necessitated this letter pertains to the investment policy enunciated in the Fund's Prospectus dated September 20, 1968 with regard to the limitations placed on investments by the Fund both as to amount of money and percentage of voting securities in/or of any one issuer and, as a result of this restriction, the necessity of obtaining stockholder approval for the formation of the SBIC by the Fund. . . . . . . [W]e are of the opinion that nothing contained in the [Investment Company] Act or the rules and regulations promulgated thereunder would prohibit the Fund from proceeding with the formation of the SBIC without the necessity of obtaining stockholder approval for the following reasons: 1. The Fund does not intend to otherwise change its investment policy as originally enunciated (except as modified by stockholders of the Fund in December, 1971); that is, except for the Fund's ownership of 100% of the issued and outstanding stock of the SBIC (purchased at a cost equal to [5%] of the value of the Funds assets), the Fund will continue its policy of not investing more than 5% of its assets in the securities of any issuer and will not purchase more than 10% of the outstanding voting securities of any one issuer. 2. Stockholders of the Fund will be apprised of the Fund's intention to complete the formation of the SBIC well in advance of actual capitalization of the SBIC and the time at which it will commence doing business so that any stockholder who either originally or subsequent to the initial public offering, purchased shares of the Fund in reliance on this particular restriction on Fund investment, will have an opportunity to dispose of their shares should they desire to do so. ... 5. The necessity of obtaining stockholder approval to the formation of the SBIC would be a timely and expensive procedure requiring either a special meeting of stockholders of the Fund or a delay in the formation of the SBIC until the next annual meeting of stockholders in December, 1972. Based on all of the facts set forth herein it is our opinion that . . . the Fund is not required to obtain the approval of its stockholders pursuant to Section 8(b)(2) and 13(a) (3) of the [Investment Company Act] for the formation of the SBIC and the purchase of 100% of the common stock of the SBIC at a cost not to exceed 5% of the value of the total assets of the Fund at the time of the purchase.I I I Editor's note: Section 8(b) of the Investment Company Act reads as follows: Every registered investment company shall file with the
  • SEC REPLY Based on the foregoing, we decline to take a no-action position with regard to the Fund's proposal to deviate from its stated investment restriction without prior shareholder approval because the proposed course of action would not be in accord with basic principles of fairness to shareholders. Commission, within such reasonable time after registration as the Commission shall fix by rules and regulations, . . . a registration state- ment, in such form and containing such of the following information and documents as the Commission shall by rules and regulations prescribe as necessary or appropriate in the public interest or for the protection of investors: (1) a recital of the policy of the registrant in respect of each of the following types of activities, such recital consisting in each case of a statement whether the registrant reserves freedom of action to engage in activities of such type, and if such freedom of action is reserved, a statement briefly indicating, insofar as is practicable, the extent to which the registrant intends to engage therein: (A) the classification and subclassifications, as defined in sections 4 and 5, within which the registrant proposes to operate; (B) borrowing money; (C) the issuance of senior securities; (D) engaging in the business of underwriting securities issued by other persons; (E) concentrating investments in a particular industry or group of industries; (F) the purchase and sale of real estate and commodities, or either of them; (G) making loans to other persons; and (H) portfolio turn-over (including a statement showing the aggregate dollar amount of purchases and sales of portfolio securities, other than Government securities, in each of the last three full fiscal years preceding the filing of such registration statement); (2) a recital of all investment policies of registrant, not enumerated in paragraph (1), which are changeable only if authorized by shareholder vote; (3) a recital of all policies of the registrant, not enumerated in paragraphs (1) and (2), in respect of matters which the registrant deems matters of fundamental policy; . . . . Under sections 4 and 5, to which the preceding section refers, an investment company is a face-amount certificate company, a unit investment trust, or a management company. A management company is classified as either an open-end company or a closed-end company and, in addition, as either a diversified company or a non- diversified company. Section 13(a) of the Investment Company Act provides that "no registered
  • Note In 1996, the Division of Investment Management advised closed-end mutual funds that it had received a number of complaints from investors who allege that they have been misled in connection with public offerings by closed-end investment companies. . . . The complaints we have received all relate to corporate actions that closed-end funds have indicated, in various disclosure documents, that they will take in an effort to minimize the discounts at which their shares trade from their net asset values. Many funds, for example, commit to consider and/or to conduct tender offers for all or some of their outstanding shares or to submit to their shareholders proposals to convert to open-end investment companies. Whether a fund is obligated to carry out such a commitment typically depends on whether certain conditions are met, such as the fund board's determining that proceeding with the corporate action is in the best interests of the fund and its shareholders. Many of the investors who have contacted us about closed-end funds claimed that they were misled about the certainty of the commitments that were made in the fund's offering materials. We have reviewed disclosure documents of a number of closed-end funds whose prospectuses discuss open-end conversions or other corporate actions designed to deal with discounts from net asset value. . . . The Division believes that vague references (or the absence of references) to the conditional or discretionary nature of the actions to be taken may be misleading to investors, raising concerns under the anti-fraud provisions of the federal securities laws. In a footnote, the Division added: Descriptions of these corporate actions and related conditions in prospectuses as well as in advertising and sales literature should be clear and balanced. See paragraph (b)(3)(i) of rule 156 under the Securities Act of 1933 (statements regarding the benefits of a method of operation may be misleading if equal prominence is not given to the limitations of that method). Investment Company Institute (publicly available Feb. 15, 1996), 1996 SEC NOACT LEXIS 322. The problem outlined by the Division was the subject of an inquiry submitted the following year by the Dessauer Global Equity Fund (publicly available April 3, 1997), investment company shall, unless authorized by the vote of a majority of its outstanding voting securities . . . (3) deviate from its policy in respect of concentration of investments in any particular industry or group of industries as recited in its registration statement, deviate from any investment policy which is changeable only if authorized by shareholder vote, or deviate from any policy recited in its registration statement pursuant to section 8(b)(3) . . . ."
  • 1997 SEC NOACT LEXIS 502. The Division summarized and responded to the proposal of the fund as follows: Your letter . . . requests our assurance that we would not recommend enforcement action to the Commission under Section 13(a)(1) of the Investment Company Act of 1940 (the '1940 Act') against Guinness Flight Investment Management Limited . . . ('Guinness Flight'), Dessauer Asset Management Company ('DAMCO'), or The Dessauer Global Equity Fund (the 'Fund') if, upon the occurrence of certain events described in the Fund's prospectus, the Fund converts from a closed-end to an open-end investment company without seeking and obtaining authorization of the holders of a majority of the Fund's outstanding voting securities. The Fund is a closed-end investment company . . . . The Fund will be managed jointly by Guinness Flight and DAMCO, both registered investment advisers. The Fund's investment objective is to seek capital growth through investments in companies organized in countries around the world. You state that the Fund's Declaration of Trust includes a provision that requires the Fund to convert automatically from a closed-end to an open-end fund upon the occurrence of certain events (the 'Automatic Conversion Provision'). Specifically, the Automatic Conversion Provision provides that the Fund will convert to an open-end fund if, at any time after the Fund has been in operation for 18 months, the Fund's shares trade at more than a specified discount to net asset value as calculated on the last business day of any week and for each of the next 14 business days thereafter. The Automatic Conversion Provision does not require that the Fund seek and obtain the authorization of the Fund's shareholders.2 You represent that, if and when the events specified by the Automatic Conversion Provision occur, the Fund's officers and trustees promptly will take all necessary steps to convert the Fund to an open-end investment company.3 The disclosure in the Fund's registration statement 2 2 You also represent that the Fund's Declaration of Trust provides that the Automatic Conversion Provision may be amended only upon approval of 80% or more of the Fund's outstanding voting securities. 3 3 You represent that the conversion will be effected even if the Fund ceases to trade at a discount before the date the conversion is completed. Promptly after the Automatic Conversion Provision is triggered, a press release will be issued to announce that the Fund will convert as soon as reasonably possible to an open-end investment company, and to disclose the projected conversion date. You represent that the Fund promptly will take all steps necessary to convert to an open-end investment company, including the filing of a registration statement on Form N-1A. [Editor's note: Open-end investment companies register with the Commission using Form N-1A; closed-end investment companies register using Form
  • on Form N-1A relating to the Fund's investment objective and policies will be substantially identical to the disclosure in the Fund's registration statement on Form N-2. You further represent that conversion of the Fund into an open-end investment company will not disadvantage the Fund or its shareholders because the Fund's investment operations prior to the conversion will be entirely consistent with the operations of an open- end investment company.4 Section 5(a) of the 1940 Act classifies all management investment companies as either 'open-end' or 'closed-end' companies. Section 5(a)(1) defines an 'open-end company' as 'a management company which is offering for sale or has outstanding any redeemable security of which it is the issuer.' Section 5(a)(2) defines a 'closed-end company' as 'any management company other than an open-end company.' Section 13(a)(1) of the 1940 Act prohibits a management investment company from changing its subclassification as defined in Section 5(a)(1) or 5(a)(2) of the 1940 Act unless authorized by a vote of a majority of its outstanding voting securities.I Section 8(b) of the 1940 Act provides, in relevant part: Every registered investment company shall file with the Commission . . . a registration statement . . . containing . . . (1) a recital of the policy of the registrant . . . consisting of a statement whether the registrant reserves freedom of action to engage in activities of such type, and if such freedom of action is reserved, a statement briefly indi- cating, insofar as is practicable, the extent to which the registrant intends to engage therein: (A) the classification and subclassifications, as defined in sections 4 and 5, within which the registrant proposes to operate . . . . N-2.] 4 4 For example, in accordance with the Commission's position on illiquid investments by open-end investment companies, you represent that the Fund's registration statement will state that the Fund may not invest more than 15% of its net assets (at the time of investment) in illiquid assets. Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612; Guide 4 to Form N-1A. I I Editor's note: Section 13(a) reads in pertinent part as follows: No registered investment company shall, unless authorized by the vote of a majority of its outstanding voting securities -- (1) change its subclassification as defined in section 5(a)(1) and (2) of this title or its subclassification from a diversified to a non-diversi- fied company; ...
  • The legislative history of the 1940 Act suggests that Congress intended Sections 8 and 13 to require a fund to make adequate disclosure of its fundamental policies, and not change those policies without the approval of a majority of the fund's shareholders. Section 8(b) was intended 'to apprise the prospective purchaser of the investment company's security of the nature of its activities.'6 The language of Section 8(b)(1) (A) indicates that Congress intended to permit funds to retain a degree of flexibility with respect to their subclassifications, so long as the fund discloses all material facts with respect to its proposed activities, and the circumstances under which the flexibility will be exercised.7 Congress enacted Section 13(a) to prevent an investment company from changing fundamental investment or management policies without the knowledge and authorization of its shareholders.8 6 6 Investment Trusts and Investment Companies: Hearings on S. 3580 before the Senate Subcomm. on Banking and Currency, 76th Cong., 3d Sess., Part I, 188 (1940) (statement of David Schenker of the Securities and Exchange Commission). Mr. Schenker's testimony also referred to the requirements of Sections 5, 8(b)(1) and 13 as 'integrally interrelated' so as to meet the 'problem of disclosure to stockholders.' Id. 7 7 Cf. American Research and Dev. Corp. ('ARD'), 23 S.E.C. 481 (1946). ARD involved a closed-end fund that disclosed its intention to operate as a nondiversified company; pending the full investment of its assets, however, the fund would in fact be a diversified company. Once fully invested, the fund would automatically convert to the status of a nondiversified company. The Commission found that despite the requirement in Section 13(a) that shareholders approve changes to a fund's subclassification, such approval would not be necessary because the fund would be operating within the subclassification 'which the registrant proposed to operate,' as required by Section 8(b)(1). ARD at 490, quoting Section 8(b)(1). The Commission determined that apprising investors as to how the registrant intended to operate met the statutory purposes of Section 13(a)(1) of the 1940 Act because, if fully disclosed, there would be no substantial injury to the fund's shareholders. 8 8 . . . Prior to the enactment of the 1940 Act, there was no legal requirement for a management investment company to adhere to any announced investment policies or purposes. Such policies frequently were changed radically without shareholder approval and even without their knowledge. The shareholders of the company had no assurance of the stability of any announced investment policies and no vote in management's determination to change the company's existing policies.
  • 40 You represent that, in accordance with Section 8(b)(1)(A) of the 1940 Act, the Fund will disclose prominently in its prospectus the existence, terms and implications of the Automatic Conversion Provi- sion. The Fund's prospectus also will explain clearly the differences between an open-end company and a closed-end company, including the differences in methods of distributing and redeeming shares of the Fund, and will disclose prominently any new fees that may be imposed on the Fund or its shareholders after the Conversion Date. You acknowledge that, upon the occurrence of certain specified events, the Fund's subclassification under Section 5(a) would change without shareholder approval. You maintain, however, that this change would not occur in violation of Section 13(a)(1), but rather would be in accordance with the Fund's policy on its subclassification, as disclosed in the prospectus. You therefore maintain that, because the Fund is not changing its disclosed policies regarding its subclassification, no shareholder vote should be required. You also state that, because no material change in the investment operations of the Fund will occur as a result of or in connection with a conversion to open-end status, the concerns underlying Section 13(a) are not implicated. We would not recommend enforcement action to the Commission under Section 13(a)(1) of the 1940 Act if the Fund converts from a closed-end to an open-end company upon the occurrence of the events specified in the Automatic Conversion Provision without the authorization of the majority of the Fund's outstanding voting securities. This response is based on the representations made in your letter, particularly the following: (1) the Fund's investment operations will not be changed in any material respect as a result of or in connection with the conversion; (2) the events that will trigger the conversion are entirely objective and readily verifiable; (3) the Automatic Conversion Provision will be included in the Fund's initial governing documents; (4) the Fund's prospectus prominently will describe the Automatic Conversion Provision and the events that will trigger a conversion; (5) the Automatic Conversion Provision may be amended only as specified in the Fund's prospectus; and (6) the Fund's advertisements and sales literature, including dealer-only sales material, used to market shares of the Fund will discuss the Automatic Conversion Provision and the events that will trigger a conversion.
  • 41 You should note that different facts or representations may require a different conclusion.9 9 9 This response is limited to the conversion of a fund from closed-end to open-end status, and expressly does not address any other instances in which shareholder approval is required by the 1940 Act.