United States: Fund Boards Annual Review of Repurchase Agreements and Depository Arrangements No Longer Required in Certain Circumstances - Fund Alert, August, 1999

In a No-Action Letter, dated June 15, 1999, issued to the Investment Company Institute (ICI), the staff of the Division of Investment Management of the Securities and Exchange Commission (the SEC) took the position that, under certain circumstances, a fund’s investment adviser, rather than its board, may assume primary responsibility for monitoring and evaluating a fund’s use of repurchase agreements (repos). To fulfill this responsibility, a fund’s adviser must (i) evaluate the creditworthiness of the repo counterparties; and (ii) take steps to ensure that the fund’s repurchase agreements are fully collateralized. The SEC staff further concluded that a fund need not adopt repo procedures, nor must a fund review the form of repo agreement, if the investment adviser performs the procedures described above. However, the SEC staff stated that if a fund board does continue to assume these responsibilities, then the board maintains continued responsibility for reviewing the form, procedures, and any subsequent changes to the repo agreement.

Prior to the SEC’s June 15th No-Action Letter, the ICI drafted a letter requesting that the SEC staff reconsider its traditional position that the fund boards have special monitoring responsibilities with respect to repos. In the letter, the ICI asserted that repo transactions warrant no more board attention than do a fund’s ordinary investments. According to the ICI, having fund boards institute and annually review compliance with repo procedures and forms inevitably leads directors to either "micromanage" operational matters or else to engage in mere ritualistic functions. The ICI referred to these functions as "an ineffective use of the board’s time and limited resources."

In its analysis, the SEC staff revisited its long-standing view that repo agreements represent a purchase of security from a counterparty, or, more specifically, a secured loan made by the fund to that counterparty. It would follow then that the funds run the risk of repo counterparties becoming insolvent, thereby exposing the funds to the possibility that they may be unable to liquidate their collateral for the repo. However, the SEC staff acknowledged that the implementation of certain legislative, administrative and other changes have reduced the exigency of these concerns. These changes include:

• amendments to Sections 436(f) and 559 of the Bankruptcy Code, which provide assurances that the insolvency of a repo counterparty will not prevent a fund from liquidating its collateral;
• policies of the Securities Investor Protection Corporation (SIPC), permitting the liquidation of collateral upon receipt of certain documentation;
• amendments to the Federal Deposit Insurance Act, which provide protections similar to those provided in the amended Bankruptcy Code; and
• amendments to Articles 8 and 9 of the Uniform Commercial Code, which not only permit a repo buyer to obtain "control" of the securities held in a custodial account or by a third party custodian, but also make it easier to have a perfected security interest in the collateral.

In this No-Action Letter, the SEC staff recognizes that a fund's use of repos is now comparable to its other investments and that absent the risk previously inherent in using repos, no reason currently exists to impose special requirements on fund boards with respect to repos. Moreover, the SEC staff also cited a policy reason for its decision — reducing unnecessary burdens on fund boards will ultimately improve fund governance.

The SEC also addressed a related matter in its June 15th No-Action Letter. The ICI requested that the SEC clarify whether or not a fund board is required, under Section 17A of the Securities Exchange Act of 1934, to conduct an annual review the fund’s securities depository arrangements with entities that are not registered clearing agencies. Transfer agents and banks are included among those entities not registered.

The ICI’s confusion stemmed from statements written in previous SEC staff No-Action Letters. In these letters, the SEC staff asserted that under Section 17(f) of the Investment Company Act of 1940 ("1940 Act"), a fund or its custodian bank could maintain fund assets with entities that are not registered clearing agencies, only if the circumstances satisfied the requirements of Rule 17f-4 of the 1940 Act. One of the requirements of Rule 17f-4 was that the fund board conduct an annual review of the fund’s sub-custodial arrangements with securities depositories.

Since the issuance of the aforementioned No-Action Letters, Rule 17f-4 has been amended to eliminate the requirement of board approval. As a result, the ICI took this opportunity to urge the SEC staff to consider several points of interest. The ICI first emphasized how routine these relationships have become. Secondly, it mentioned the fact that the arrangements do not generally involve conflicts of interest. Finally, the ICI stated that these arrangements require a type of expertise better exercised by fund management.

In the June 15th No-Action Letter, the SEC staff decided that if the fund board approves each arrangement (and any subsequent changes thereto), no annual review of depository arrangements between a fund (or its custodian) and the fund's transfer agent (or bank) is necessary.

Pursuant to Section 263 of the Internal Revenue Code (the Code), the IRS treats start-up costs incurred by mutual fund investment advisers as capital expenditures. Start-up costs are those expenses incurred prior to the mutual fund’s "launch date," when its shares are sold to the public. Estimates of these costs range from $50,000 to $300,000. Given the explosive growth of mutual funds over the past two decades (i.e., as of May of 1999, the number had reached 7,444) the IRS has estimated that approximately $450 million have been spent on mutual fund start-up costs since 1990. It would follow, then, that given the time value of money, the IRS would prefer that the start-up costs be capitalized pursuant to Section 263 of the Code rather than deducted pursuant to Section 162 of the Code.

According to a legal memorandum attached to the field agents’ Examination Guide (the Guide), the IRS has decided to treat these start-up costs as capital expenditures under the rationale set forth by the Supreme Court in INDOPCO, Inc. v. Commissioner. The IRS views start-up costs as expenditures for which investment advisors will obtain a long-term benefit (i.e., the contractual right to earn income indefinitely by managing the fund). Although the IRS concludes that these costs should be capitalized, the IRS does not discuss what the amortization period should be, or even if there should be amortization. Moreover, the IRS's tax treatment of start-up costs differs from its treatment of start-up costs for accounting purposes.

The Guide provides the IRS field agent with background information pertaining to mutual funds, as well as "sample information document requests" to assist the field agent in obtaining essential information regarding mutual fund start-up costs. The Guide divides the time period during which a mutual fund's start-up costs accrue into three phases: the "discuss and determine" phase; the "commencement of mutual fund" phase; and the "other administrative operation" phase. The Guide then breaks each of these phases into subparts. The objective of the Guide is twofold — to enable the field agent to ascertain the sum of the start-up costs, and to ensure that such costs are capitalized rather than deducted by the investment advisor. It is worth noting that the first case adjudicating this issue, FMR Corporation v. Commissioner of Internal Revenue, found in favor of the IRS last June.

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