United States: SEC Amends Rule Governing Personal Trading Practices by Portfolio Managers and Other Mutual Fund Employees - Fund Alert, October 1999

On August 20, 1999, the SEC adopted amendments to Rule 17j-1 under the Investment Company Act of 1940. Rule 17j-1 governs personal trading by mutual fund portfolio managers and other employees, and addresses conflicts of interest that may arise from those trading activities. Specifically, Rule 17j-1 addresses personal transactions conducted by fund personnel in securities currently held or to be held by the fund. The Rule prohibits fraudulent, deceptive or manipulative acts by fund personnel related to such personal transactions. In connection with that prohibition, Rule 17j-1 mandates that funds, their investment advisers and principal underwriters (collectively "subject organizations") create and adopt a code of ethics that contains provisions that are "reasonably necessary" to prevent fraudulent or deceptive behavior. Certain personnel are also required to report their personal securities transactions.

The amendments strengthen the rule by:

(1) increasing the oversight role of an investment company’s board of directors with regard to codes of ethics;

(2) improving the manner in which fund personnel report their personal securities holdings;

(3) requiring pre-clearance of employee purchases of securities sold in IPOs and private placement transactions; and

(4) helping compliance personnel and the U.S. Securities and Exchange Commission’s ("SEC") examinations staff in monitoring potential conflicts of interest and detecting potentially abusive activities.

Related amendments to disclosure forms also require funds to disclose, in their registration statements, information about their policies regarding personal investment activities.

The release recognizes that the current version of Rule 17j-1 requires subject organizations to adopt codes of ethics, but fails to specify the involvement a fund’s board of directors has with the code. By contrast, amended Rule 17j-1 requires the board, along with a majority of independent directors, to approve codes of ethics. The Rule further provides that a majority of the fund’s board, including a majority of independent directors, must approve material changes to the codes of ethics of any investment adviser or principal underwriter of the fund within six months of the change.

Rather than adopting specific and detailed standards to be followed by a fund when reviewing a code of ethics or a material amendment, the amended Rule provides that a fund’s board may approve a code of ethics only if the board finds that the code sets forth procedures "reasonably necessary" to prevent fraud under the rule. In its adopting release, however, the SEC stresses that each fund’s board should determine whether the code should permit personal trading by personnel of a subject organization.

In proposing and adopting the amendments, the SEC believed that it was important that a board’s duties not end with its approval of the code of ethics. As a result, the amended rule requires each subject organization to make reports to its board discussing any issues that develop in connection with the code of ethics. The management of a subject organization must provide a written report to the fund’s board at least once a year that:

(1) discusses code of ethics issues that occurred during the prior year, with particular attention to material code or procedural violations and any sanctions imposed as a result of such violations; and

(2) certifies to the board that the subject organization has taken efforts "reasonably necessary" to prevent code of ethics violations.

The written report is meant to provide a means by which the board may assess the effectiveness of the codes of ethics.

The current version of Rule 17j-1 mandates quarterly reports by access persons of their personal securities transactions. In addition to these quarterly reports, the amended rule requires access persons to complete holdings reports both initially and annually. Initial holdings reports must be completed no later than 10 days after an individual has become an access person and must list all securities beneficially owned by that person. Annual reports must contain similar information, and must be updated more than thirty days prior to the date the report is submitted.

The new Rule 17j-1 provides that all securities transactions and holdings reports must be reviewed for codes of ethics violations and overall compliance with the Rule. Toward this end, subject organizations must establish specific procedures for the review of initial and annual holdings reports by management or compliance personnel. The subject organization also should record the names of those who review the reports.

In adopting the amendments, the SEC noted that investments by fund personnel in IPOs and private placements pose increased potential for conflict between the interests of the individual employee and the fund. The SEC reasoned that such investments generally are reserved for institutional investors or wealthy individual customers. If fund personnel were to invest in IPOs or private placements, the following questions might arise:

(1) whether the investment is a "kickback" for giving business to an underwriter or issuer;

(2) whether fund personnel are taking advantage of an opportunity that should benefit the fund; and

(3) whether fund personnel can remain objective in rendering future investment decisions for the fund, and in maintaining the best interests of the shareholder.

The amended Rule attempts to prevent such conflicts and abuse by requiring fund personnel to secure approval from their fund or its adviser prior to acquiring beneficial ownership in an IPO or private placement. Funds must further maintain records that explain the fund’s decision to approve the transaction. By requiring such approval, the fund or adviser can analyze, on a case by case basis, whether or not the investment could lead to a material conflict. This approach offers more flexibility than a blanket prohibition of such transactions.

The amendments to Rule 17j-1 also change the SEC’s disclosure requirements concerning the personal investment activities of fund personnel. The new requirements mandate that a fund disclose in its SAI the fact that the fund, its investment adviser, and principal underwriter have adopted codes of ethics. A fund must also state in the SAI, that codes of ethics are publicly available through the SEC and that the code allows (or does not allow) personnel to invest in securities for personal benefit. Finally, a fund must file its code of ethics as an exhibit to its registration statement.

The SEC has instituted a number of compliance dates to give entities and individuals adequate time to implement the new mandates of Rule 17j-1. As an initial matter, amended Rule 17j-1 becomes effective on October 29, 1999.

By March 1, 2000, subject organizations must have accomplished three key items. They must have:

(1) identified who is an "access person" under the Rule and notified them of their reporting obligations;

(2) created and implemented a process for the fund and its compliance staff to review transaction and holding reports; and

(3) listed the names of people who must file reports, as well as the names of those responsible for reviewing them.

Subject organizations also must comply with certain mandates of the amended Rule after March 1, 2000:

(1) investment personnel must obtain approval prior to acquiring a beneficial interest in an IPO or private placement;

(2) funds and advisers must maintain a record of when, and on what basis, such approval was granted; and

(3) those becoming access persons on or after March 1, 2000 must file an initial holdings report.

Finally, after March 1, 2000, subject organizations must include codes of ethics as exhibits to registration statements and provide certain other information about the codes.

Quarterly transaction reports must comply with all mandates of the amended Rule, starting with the calendar quarter ending March 31, 2000.

A final compliance date of September 1, 2000, requires the following:

(1) approval by the fund’s board of the codes of ethics of the fund, its principal underwriters, and its investment advisers;

(2) submission of the first code of ethics issues reports to each fund’s board; and

(3) submission of the first annual holdings reports by access persons.

Advisers should be aware that the Financial Accounting Standards Board Emerging Issues Task Force recently announced a "subsequent development" to Topic No. D-76. This expansion of Issue 85-24 clarifies that advisers to certain closed-end interval and offshore funds may capitalize offering costs in the same manner as open-end investment companies that have both Rule 12b-1 distribution fees and Contingent Deferred Sales Charges (CDSCs). The Task Force recognized that those closed-end interval and offshore funds that already incur costs (distribution-related fees) and impose charges (early withdrawal charges) that are "substantially the same" as Rule 12b-1 fees and CDSCs, should receive the same accounting treatment. Topic No. D-76 originally provided that advisers of investment companies without both 12b-1 fees and CDSCs (as technically defined) must expense offering costs as incurred, because such costs are not "assets" for such purposes.

All non-bank sponsors of money market mutual funds should be aware of the recent Oregon appellate decision in Edward D. Jones & Co. v. Mishler that concludes that a broker-dealer offering a money market account that allows checking privileges, honors drafts, accepts deposits, and forwards monthly customer statements to account holders, may be considered a "bank" under the UCC. This case continues a line of precedent in other states, including Pennsylvania , Louisiana, and New York, which has held that broker-dealers, securities firms, insurance companies and others can have the responsibilities, as well as the protections, of a bank under the UCC. As a bank, the broker-dealer must notify its customers of returned items, within the midnight deadline. Under this rationale, an account sponsor may also be a "bank" with the attendant rights and responsibilities of typical commercial banks for payments of items and processes or forwards in the collection system. Although new UCC amendments and other case law leave room to argue that a sponsor of money market accounts with checking privileges is not a "bank," institutions offering money market accounts with check privileges are cautioned to implement policies and procedures to ensure compliance with midnight deadlines and other requirements applicable to banks under the UCC.

UCC Section 1-201(4) provides that "‘Bank’ means any person engaged in the business of banking." Each of the courts reviewing the issue has noted the potentially broad scope of the definition. While the Official Comments to the UCC do not clarify the intentions of the act, case law is consistent with the policy behind the UCC. As one court noted "It would be anomalous to establish one rule for checking accounts administered by a bank, and another rule for checking accounts administered by a brokerage firm…." Another court commented that "the goal of the UCC — ‘to simplify, clarify and modernize the law governing commercial transactions’ (UCC 1-102[2][a]) — is best served by application of a uniform standard."

A number of states, including Illinois, California, Delaware, Massachusetts and Pennsylvania, have added a definition of "bank" to Article 4 in UCC Section 4-105, as part of the adoption of the 1990 uniform amendments to the UCC. That section defines a "bank" as: "A person engaged in the business of banking, including a savings bank, savings and loan association, credit union, or trust company." The amendment’s language does not clearly preclude application to broker-dealers, mutual funds and insurance companies, where the activities are sufficiently bank-like. Indeed, courts seem to have favored a "functional definition" in order to achieve the UCC's policies of uniformity.

A non-bank institution may be tempted to take the position that its activities do not fall within the UCC, due to the lack of clarity in reported cases addressing the new definition of "bank" in UCC Article 4. This position, however, must be taken with careful forethought. While Article 4 sometimes imposes strict liability on banks, it also provides some very helpful protections; and it might prove desirable to assert those protections in the same cases in which exclusion from Article 4 is sought.

It is still possible to argue that the mere offering of a money market account with checking privileges does not render the sponsor a "bank" under the UCC. While the language of a Louisiana decision supports UCC application based on simply offering a "checking account much like that provided by a depositary bank to its depositing customer," other courts might employ a higher threshold. These courts usually considered cases involving extensive bank-like activities. In Mishler, such "bank-like activities" included:

• referring to payment items in the account agreement as "checks;"
• putting the broker-dealer’s name on the checks (although the name of a payable-through bank was also on each check);
• allowing the broker-dealer to make decisions regarding payment of the checks;
• offering immediate availability of funds without waiting for clearance of securities transactions and the like; and
• sending monthly statements to the customer, which bore only the broker-dealer’s name.

Most courts also have not clearly addressed whether (or in what circumstances) the presence of a "payable through" institution would change the applicable rules. A brokerage firm, mutual fund or insurance company might argue that it is acting like any other commercial customer when it issues drafts payable through a bank, and that offering money market draft privileges, by itself, should not render the sponsor a "bank." Because there have not been enough decisions to truly clarify the breadth of the UCC definition of "bank," a careful review of the facts and circumstances of each case will prove to be critical.

It is important to keep in mind that some states may impose licensing or regulatory requirements on any person who offers demand deposits or checking accounts. While the business of "banking" is traditionally considered to include both taking deposits and making loans, recent developments in the law of financial services blur the line between what is — and what is not — a "bank" for licensing and other regulatory purposes. As your institution grows and changes, it is important that you consider not only the narrow question of whether the UCC’s definition of "bank" will apply to money market accounts, but also whether your institution should be complying with state licensing and other regulatory requirements. Such requirements merit consideration, as they may affect your decisions about how you offer money market accounts with checking privileges.

A broker-dealer, mutual fund, insurance company or other sponsor of a money market mutual fund with checking privileges should seriously consider adopting policies and procedures to ensure compliance with the bank obligations of UCC Article 4. Such policies and procedures will protect the institution should future court decisions clearly hold them responsible for "bank" obligations under the UCC. The policies and procedures may also help institutions avoid a variety of losses due to fraud, customer insolvency and the like.

On August 4, 1999, a tax bill was introduced in the House of Representatives that directly impacts investment companies and securities partnerships. H.R. 2705 is the latest (and is intended to be the last) legislation to close down what are known as "swap" or "exchange" funds. Investing in private exchange funds has been an effective asset diversification technique for affluent individuals whose wealth is concentrated in large appreciated holdings of a limited number of stocks. Because a newly-created fund is generally composed of stocks contributed by many different investors — each of whom acquires ownership of a pro rata portion of the entire portfolio — each investor benefits from the diversification provided by the stocks contributed by other investors. The technique works for federal income tax purposes only if the transfer of the appreciated securities to the fund is not taxable as a transfer to an investment company under Section 351(e)(1) or 721(b) of the Internal Revenue Code of 1986, as amended (the "Code").

Congress began to restrict the formation of swap funds in 1966. In 1967, the Treasury adopted regulations that treated a transfer of securities as a taxable transfer to an investment company if the transfer resulted directly or indirectly in diversification of the transferors’ interests and the transfer was made to: (a) a regulated investment company ("RIC"); (b) a real estate investment trust ("REIT"); or (c) a corporation or partnership of which more than 80% of the assets (excluding cash and non-convertible debt instruments) consisted of readily marketable stocks or securities, or interests in RICs or REITS held for investment. "Stocks and securities" are "readily marketable" only if they are part of a class of stock or securities that are: (a) traded on a securities exchange; (b) traded or quoted regularly in the over-the-counter market; or (c) convertible or exchangeable into readily marketable stock. By investing in non-readily marketable securities, new exchange funds continued to be organized. Typically, an exchange fund would avoid "investment company" status by investing 20% of its assets in privately-placed preferred stock not considered to be "readily marketable."

The Taxpayer Relief Act of 1997 (the "1997 Act") broadened the definition of the term "investment company" to treat a wide variety of instruments as "stocks and securities" for purposes of the 80% requirement, including preferred stock, derivative instruments, notional principal contracts, foreign currency, and interests in RICs, REITs, and other similar entities. The 1997 legislation adopted broad, catch-all language. However, according to remarks in the Congressional Record by Congressman Richard E. Neal, who introduced the bill on August 4, 1999, exchange funds continued to be able to "sneak" through a "loophole" left for entities holding more than 20% of their assets in real estate limited partnership interests.

The recent bill, H.R. 2705 makes three changes relating to Section 351(e). These changes are effective for transfers made after the date of action by the Ways and Means Committee, but are not effective for transfers made pursuant to a written binding contract in effect on August 3, 1999, if such contract provides for the transfer of a fixed amount of property.

1. Apparent Expansion of Scope of InstrumentsCovered.

The first change appears to expand the number of instruments covered by the 1997 Act. Whereas Section 351(e)(2)(B) under current law lists specific investments1, Section 731(c)(2)(A) covers any "actively traded" financial instruments and foreign currencies (as defined in Section 1092(d)(1)), and may therefore be more all-inclusive.

2. Application to Real Estate Limited Partnership Interests.

The House Bill also closes the loophole for real estate limited partnership interests. A new clause (vi) is added to Section 351(e)(1)(B) of the Code to treat as "stocks or securities" any interest in any entity "if the return on such interest is limited and preferred." The clause also contains broad, catch-all language. This change suggests that if the bill were enacted into law, exchange funds would have to have more than 20% of their assets invested in real estate, commodities, or other non-security assets.

3. Lack of Exception for Diversified Portfolios

The third change involves the application of Treas. Regs. §1.351-1(c)(6)(i) and is more troublesome to the investment management industry. A new subsection (3) is added to Section 351(e) of the Code treating as a transfer of property to an investment company:

(3) TRANSFERS OF MARKETABLE SECURITIES TO CERTAIN CORPORATIONS - A transfer of property to a corporation if -

(A) such property is marketable securities (as defined in section 731(c)(2)) and

(B) such corporation -

(i) is registered under the Investment Company Act of 1940 as an investment company, or is exempt from registration as an investment company under section 3(c)(7) of the Act because interests in such corporation are offered to qualified purchasers within the meaning of section 2(a)(51) of such Act, or

(ii) is formed or availed of for purposes of allowing persons who have significant blocks of marketable securities with unrealized appreciation to diversify those holdings without recognition of gain.

A corresponding rule for transfers of property to a partnership is provided in new Section 721(b) of the Code, which provides:

(b) SPECIAL RULE - Subsection (a) [providing for nonrecognition of gain] shall not apply to gain realized on a transfer of property to a partnership if, were the partnership incorporated -

(1) such partnership would be treated as an investment company (within the meaning of section 351), or

(2) section 351 would not apply to such transfer by reason of section 351(e)(3).

Treas. Regs. §1.351-1(c)(6)(i) currently provides that "[F]or purposes of paragraph (c)(5) of this section, a transfer of stocks and securities will not be treated as resulting in a diversification of the transferors’ interests if each transferor transfers a diversified portfolio of stocks and securities." H.R. 2705 would eliminate the exception contained in Treas. Regs. §1.351-1(c)(6)(i) for transfers of diversified portfolios, whether from a common trust fund to a RIC, from a RIC to a master partnership, from a master partnership to a feeder RIC, or from a RIC to another RIC (as in the fund-of-funds context).

ICI Memorandum to Tax Members No. 27-99 regarding H.R. 2705 makes reference to the problem for transfers to master partnerships. In remarks made at the ICI Tax and Accounting Conference in San Diego on September 13, 1999, ICI representative Deanna Flores stated that she did not believe that these kinds of transfers were in jeopardy because the problem with the wording of the legislation was unintended and was likely to be fixed.

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