SEC Rules and Regulations

Eaton Vance No-Action Letter and IRS Guidance on Auction Rate Securities with Liquidity Features

On June 13, 2008, the SEC issued a no-action letter (the "Eaton Vance Letter") to Eaton Vance Management and its affiliates ("Eaton Vance") granting relief on several issues relating to proposed offerings by several Eaton Vance funds (the "Funds") of liquidity protected preferred shares ("LPP").  LPP are auction rate or remarketed preferred stock ("ARPS") that possess a liquidity feature designed to allow them to be purchased by money market funds.  (The Eaton Vance Letter applies to LPP that have their rate set by, and are generally resold through, either an auction process or a remarketing. This article uses the term "remarketing" to refer to both an auction process and a remarketing.)

Starting in mid-February of 2008, ARPS remarketings, the process for resetting ARPS dividend rates and the primary means for reselling ARPS, have consistently failed.  These failures have resulted because more ARPS were offered for sale than there were offers to purchase.  The absence of an active secondary market for ARPS has left holders with illiquid securities. 

When the remarketings began failing, there were approximately $64 billion of ARPS issued by closed-end funds outstanding.  The amount of ARPS outstanding has declined as some funds have chosen to redeem or refinance part or all of their ARPS.  Redeeming ARPS poses a challenge to closed-end funds since it reduces the funds' leverage or forces funds to borrow from potentially costlier sources, in either case potentially reducing investment performance.

The Eaton Vance proposal seeks to relieve this situation by creating a new form of ARPS that could be sold to money market funds and the proceeds of which could be used to redeem the existing illiquid ARPS.  The proposed LPP will pay dividends every seven days.  At the end of each seven day period, the LPP will be remarketed through broker-dealers acting as remarketing agents.  The dividend rate will be reset through the remarketing process at the lowest rate at which all orders to sell are filled, but will be subject to a maximum rate (the "Boundary Rate").

The Boundary Rate will be either a certain number of basis points over a reference rate (e.g., LIBOR plus 50 basis points) or a percentage of such reference rate (e.g., x% of LIBOR).  The Boundary Rate will thus adjust automatically when the underlying reference rate changes.  In the event of a failed remarketing, the dividend rate will increase to the Boundary Rate.  However, if a remarketing fails and the Liquidity Provider (as described below) is forced to purchase more than a set percentage of the LPP (the "Trigger Percentage"), the Boundary Rate will increase by a set percentage (the "Raised Boundary Rate").  In such a case, the dividend rate will increase to the Raised Boundary Rate.  The Raised Boundary Rate will continue to increase, up to a specified maximum Raised Boundary Rate, at each subsequent remarketing in which the Liquidity Provider continues to be required to hold more than the Trigger Percentage of LPP.  Upon a successful remarketing, the dividend rate will reset to the rate sufficient to fill all sell orders and the Boundary Rate will revert to the initial Boundary Rate.  This remarketing process is expected to be the primary, and potentially only, process through which the LPP will be sold.

Under Eaton Vance's proposed plan, each of the Funds would enter into an agreement (the "Liquidity Agreement") with a third-party liquidity provider (the "Liquidity Provider").   The Liquidity Provider would be obligated under the Liquidity Agreement to purchase LPP from holders in the event of a (i) failed remarketing of the LPP (to the extent such holders failed to sell their LPP in the failed remarketing) or (ii) failure to renew the Liquidity Agreement (in either case, a "Liquidity Event").  The Liquidity Provider will be paid a fee by the issuing Fund based on both the total amount of the Liquidity Facility as well as on the amounts drawn to purchase LPP.  As a result, if a Liquidity Event occurs, the cost of the Liquidity Facility to the Fund will increase.  In addition, the Liquidity Provider is only permitted to resell through one of the periodic remarketings.  To the extent that the Liquidity Provider has been required to purchase LPP as a result of a Liquidity Event, it will be required to attempt to resell the LPP at each remarketing period.

In addition, the Eaton Vance proposal contemplates granting a right to the Liquidity Provider to put the LPP back to the issuing Fund (the "Fund Put") or to Eaton Vance Corp. ("EVC"), the parent of the Funds' investment adviser (the "EVC Put").  The Eaton Vance proposal contemplates offering the Fund Put only if necessary to attract Liquidity Providers.  The Fund Put would be exercisable one year after the effectiveness of the Liquidity Agreement with respect to those LPP that the Liquidity Provider has held for at least three consecutive months and unsuccessfully attempted to sell in remarketings.  Eaton Vance represented in its proposal that a Fund Put would be granted to the Liquidity Provider only if the Internal Revenue Service (the "IRS") issued guidance indicating that this feature would not cause the LPP to be treated as debt for U.S. federal income tax purposes.

The Eaton Vance proposal contemplates offering the EVC Put only to the Liquidity Provider for the first LPP of the first Fund to issue such securities as an incentive to attract potential Liquidity Providers.  The terms of the EVC Put would be as follows: (1) if, after three months following the effectiveness of the Liquidity Agreement and before the end of the first twelve month term of the Liquidity Agreement, the Liquidity Provider owns all outstanding LPP, the Liquidity Provider would be entitled to put all of the LPP to EVC; or (2) if, at the expiration of the initial term of the Liquidity Agreement, the Liquidity Provider owns any outstanding LPP, the Liquidity Provider may put all the LPP it owns to EVC.

The Eaton Vance Letter also describes certain additional details of the LPP program.  All sales of the LPP, including both the initial issuance and any secondary remarketing, will be restricted to "qualified institutional buyers" ("QIBs") as defined in Rule 144A.  Eaton Vance also represented that the offering memorandum for the LPP will be delivered on every remarketing date, it has no plans to file any registration statements that would permit sales of the LPP to non-QIB investors and the LPP will not be listed on a national securities exchange.  In addition, Eaton Vance represented to the SEC that the Liquidity Provider's purchases and sales of LPP would be subject to the reporting requirements of Section 30(h) of the Investment Company Act and Section 16 of the Securities Exchange Act of 1934 (the "Exchange Act").

In the Eaton Vance Letter, the Division of Investment Management granted relief from several sections of the Investment Company Act of 1940 (the "ICA") governing investments by money market funds (i.e., Sections 34(b) and 35(d) of the ICA and Rules 2a-7 and 22c-1 thereunder) to confirm that LPP are eligible for purchase by money market funds. This relief was necessary, because even though the LPP are substantially similar to a structure earlier approved by the SEC staff for money market funds in a 2002 no-action letter, Merrill Lynch Investment Managers, L.P. (the "Merrill Lynch Letter"), the LPP would not fully comply with the Merrill Lynch Letter.

In particular, the LPP that Eaton Vance proposes to issue will allow holders to put their shares to the Liquidity Provider in only one of the three instances contemplated by the Merrill Lynch Letter, i.e., a failed remarketing of the LPP.  Under the Merrill Lynch Letter, holders could also exercise their put rights in the event of (i) a failure by the issuer to make a scheduled dividend or redemption proceeds payment or (ii) a failure by the issuer to make scheduled payments of the liquidation amounts.  In its no-action request, Eaton Vance argued that these additional opportunities to exercise their put rights would not provide LPP holders with materially more protection.  In addition, Eaton Vance raised a concern voiced by potential Liquidity Providers that allowing holders put rights in the additional instances contemplated by the Merrill Lynch Letter might constitute financial guarantee insurance, requiring Liquidity Providers to register as insurance companies.

The Division of Investment Management also agreed that the LPP would not constitute redeemable securities as defined by Section 2(a)(32) of the Investment Company Act, notwithstanding the Liquidity Agreement or the Liquidity Provider's put rights.  The Funds in question are closed-end funds and are consequently prohibited from offering redeemable securities.

The Division of Corporate Finance provided relief from the tender offer requirements of the Exchange Act (i.e., Sections 13(e) and 14(d) thereof and Rule 13e-4 and Regulations 14D and 14E thereunder) to the Funds, the Liquidity Provider or any other third party in connection with the purchases of LPP that are not otherwise sold in remarketing processes. Eaton Vance requested this relief out of a concern that the SEC might deem purchases of the LPP by the Liquidity Provider to be part of a tender offer and therefore subject to the tender offer rules.

The SEC relief from the tender offer rules was predicated on the following conditions:

  • at the time of the initial issuance and each remarketing, the Funds and the Liquidity Provider will make all offers and sales of LPP and any related security pursuant to an effective registration statement or in reliance on an available exemption from such requirements under the Securities Act of 1933; (in that regard, the Division of Corporate Finance noted that (i) the Fund and the Liquidity Provider intend to sell LPP and any related security only to Qualified Institutional Buyers as defined in Rule 144A under the Securities Act and (ii) all secondary market sales by LPP holders would occur through a remarketing process in transactions that are exempt from the registration requirements under the Securities Act);
  • the terms and conditions of the Liquidity Provider's obligation to purchase unconditionally all LPP subject to sell orders in a remarketing that have not been matched with purchase orders (the "Liquidity Event Feature") are fixed and will apply to each remarketing;
  • the Liquidity Event Feature is open to all LPP holders;
  • the Liquidity Provider will purchase all LPP at a price equal to the $25,000 per share liquidation preference plus accumulated but unpaid dividends;
  • an offering memorandum will be delivered on every remarketing date;
  • any offering memorandum that is provided to investors will describe the operation of the Liquidity Event Feature and explain in detail how a failed remarketing will impact the dividend rate;
  • in the event of a failed remarketing, the paying agent, responsible for recordkeeping of the LPP holders, either directly or through DTC as the securities depository of the LPP, and receiving payments from buyers of the LPP and paying the purchase price to sellers of the LPP, will issue a notice to LPP holders;
  • the Liquidity Provider is required to sell all LPP that it holds, as a result of being required to purchase LPP to prevent a failed remarketing, at the next remarketing with no right to hold the LPP at a particular dividend rate;
  • LPP holders other than the Liquidity Provider will have the ability to revoke their notice to participate in a remarketing until one business day prior to the remarketing date;
  • the Liquidity Provider must sell at the rate set by the remarketing agent pursuant to the terms of the LPP and the Funds's by-laws;
  • payment for the LPP will occur promptly;
  • neither the Liquidity Provider nor the Funds will take any steps to encourage or discourage holders of the LPP from triggering a Liquidity Event Feature; and
  • in the event that the Liquidity Agreement will not be renewed, will otherwise be terminated or a new Liquidity Agreement with a replacement Liquidity Provider will be entered into, holders of the LPP will be notified by the Paying Agent at least two remarketings in advance of such event.

As noted above, Eaton Vance represented in its no-action request to the SEC that it would agree to grant the Liquidity Provider the right to put the LPP to the issuing Fund only if the IRS issued guidance indicating that such a put would not cause the LPP to be treated as debt for U.S. federal income tax purposes.  The IRS granted administrative relief for LPP on June 25, 2008, in its revised Notice 2008-55 (the "Notice"), which amplified administrative relief previously granted on June 13, 2008.  The Notice states that, if certain conditions are satisfied, the IRS will not challenge the equity characterization of LPP issued by registered closed-end funds that invest only in debt instruments and certain incidental investments ("Eligible Issuers").  One important consequence of this relief is that, subject to generally applicable rules, the income of an Eligible Issuer that invests in tax-exempt obligations can "flow through" as tax-exempt income to holders of its LPP.

The Notice applies only to liquidity facilities for ARPS that were outstanding on February 12, 2008, or that directly or indirectly refinance ARPS that were outstanding on that date.  The liquidity facility must initially be established between February 12, 2008, and December 31, 2009, although renewals, replacements or extensions of such liquidity facilities after December 31, 2009, are permissible. 

Under the Notice, holders of LPP can put their shares to the Liquidity Provider only if there has been a failed auction or a failure to renew, replace or extend the Liquidity Agreement.  The Liquidity Provider must be unrelated to the Eligible Issuer and generally cannot have rights greater than any other holder of LPP.  The Liquidity Agreement may give the Liquidity Provider a right to require the Eligible Issuer or a related party to redeem or purchase LPP, but in this case the Liquidity Provider must hold the LPP for at least six months and must offer them for resale at every auction date during that period for an amount equal to par plus accrued and unpaid dividends.

SEC Proposes Rules Requiring Mutual Funds to Provide Information in Interactive Data Format

On June 10, 2008, the SEC proposed rules that would require mutual funds to provide risk/return summary information in interactive data format ("XBRL"). According to the rule release, providing the data in XBRL format would allow the information to be downloaded into spreadsheets or other software and ease investors' ability to analyze data, increasing the speed, accuracy and usability of mutual fund disclosure.

XBRL is a programming language that allows bits of data to be tagged with a predefined list of identifiers which define what each bit of data represents. The SEC plans to use the list of tags developed for mutual funds by the Investment Company Institute.

The proposed XBRL rules would not change what is currently required to be disclosed, but would require information to be provided in an additional format in a new exhibit.

The SEC has requested comments regarding the proposed rule on or before August 1, 2008, and, if the proposed rules are adopted, intends on setting a compliance date of December 31, 2009.

LITIGATION

District Court Affirms Bankruptcy Court Decision to Deny Recognition of Foreign Liquidation Proceedings of Hedge Funds in Cayman Islands

On May 22, 2008, the U.S. District Court for the Southern District of New York (the "District Court") affirmed a bankruptcy court decision that denied a request to recognize the Cayman Islands liquidation proceedings of two Bear Stearns-sponsored hedge funds incorporated in the Cayman Islands (the "Funds") as either "foreign main" or "foreign nonmain" proceedings under Chapter 15 of the U.S. Bankruptcy Code ("Chapter 15"). The decision indicates that U.S. courts may subject foreign-organized funds' applications for relief under Chapter 15 to close scrutiny.

Following a severe devaluation of the Funds' asset portfolios in May 2007, the Funds obtained Cayman court orders appointing liquidators and authorizing the Funds' winding up under Cayman law. The liquidators, acting as the Funds' foreign representatives, subsequently filed petitions in the U.S. Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") seeking recognition in the United States of the Cayman winding-up proceedings as either foreign main or foreign nonmain proceedings under Chapter 15. Such recognition is required under Chapter 15 in order for a foreign representative to obtain protection of assets located in the United States. A bankruptcy court must make its own independent determination as to whether a foreign proceeding qualifies before granting recognition.

As discussed in the October 2007 Investment Management Regulatory Update, on August 30, 2007, the Bankruptcy Court denied both main and nonmain recognition of the Cayman proceedings. The Funds' foreign representatives appealed.

On appeal, the District Court:

  • affirmed the Bankruptcy Court's denial of main recognition of the Cayman proceedings on the basis that each Fund's "center of main interests" ("COMI") was not in the Cayman Islands. The District Court noted that, although the location of a debtor's registered office is presumed to be its COMI, such a presumption is rebuttable and in this case, was rebutted by the fact that, prior to the commencement of the Cayman liquidation proceedings, the Funds' investment manager, books and records and assets were all located in the United States;
  • affirmed the Bankruptcy Court's denial of nonmain recognition of the Cayman proceedings on the basis that the Funds' limited activities in the Cayman Islands did not constitute an "establishment" in the Cayman Islands. "Establishment" is defined in Chapter 15 as "any place of operations where the debtor carries out a non-transitory economic activity." According to the District Court, activities such as auditing, third-party preparation of incorporation papers, and review of insider transactions did not constitute "operations" or "economic activity" of the Funds;
  • rejected the foreign representatives' argument that the Bankruptcy Court ignored principles of comity and cooperation, on the basis that such considerations come into play only after an objective determination that proceedings should be entitled to Chapter 15 recognition.

INDUSTRY UPDATE

Cox Discusses Regulatory Agenda, Future of Financial Reporting

In a recent speech at the Chartered Financial Analysts Institute Conference on Next Generation Asset Management, SEC Chairman Christopher Cox discussed, among other things, the SEC's near-term regulatory agenda. According to Cox, of particular importance to the SEC are the adoption of its proposed ETF exemptive rule, the adoption of a final principal trading rule for broker-dealers and investment advisers, new interpretive guidance for broker-dealers and investment principals, the overhaul or abolition of 12b-1 fees and new interpretive guidance on soft dollars. Cox indicated that the SEC expects to consider these items later this summer. Additionally, said Cox, "there is much more on the horizon."

Cox also stressed the importance of replacing the current EDGAR model with a more user-friendly system of financial reporting based on interactive data. Cox described the SEC's revised system for securities filing as "lead[ing] investors and analysts alike out of darkness, and into light." He noted that the SEC has proposed requiring registered mutual funds to data-tag certain key disclosures with XBRL (for more information, please see our article, "SEC Proposes Rules Requiring Mutual Funds to Provide Information in Interactive Data Format," above). Cox expressed optimism that such a system would facilitate the "identification and comparison of financial data."