SEC Rules and Regulations

SEC Issues Exemptive Relief for Actively Managed ETFs; Proposes Rule to Codify Existing Exemptive Relief for Index-Based ETFs

On February 27, 2008, the SEC granted exemptive orders under the Investment Company Act of 1940 (the “Investment Company Act”) that will permit four exchange-traded fund trusts and their sponsors to launch the first actively managed exchange-traded funds (“ETFs”).  The orders were granted to (i) Barclays Global Fund Advisors and iShares Trust, (ii) Bear Stearns Asset Management, Inc. and Bear Stearns Active ETF Trust, (iii) PowerShares Capital Management LLC and PowerShares Actively Managed Exchange-Traded Fund Trust and (iv) WisdomTree Asset Management, Inc. and WisdomTree Trust. 

An ETF is a hybrid investment vehicle that shares certain characteristics of both open-end and closed-end registered investment companies.  ETFs are typically organized and registered as open-end funds under the Investment Company Act, but their shares trade on exchanges, like shares of closed-end funds.  This hybrid structure requires an ETF to obtain an exemptive order from the SEC in order not to run afoul of the Investment Company Act.  The SEC had previously granted exemptive relief only to ETFs that seek to track a published stock index.

ETF shares are created and redeemed in large blocks (usually 50,000 or 100,000 shares), called “Creation Units,” by broker-dealers, institutional investors and other market intermediaries that have agreed to act as “authorized participants” with the ETF.  Each day, the ETF publishes its “Deposit Basket,” which lists the names and quantities of underlying securities that an authorized participant has to deliver in-kind in order to receive a Creation Unit.  The Deposit Basket for an index-based ETF will correspond to the stocks in the tracking index.  Conversely, an authorized participant can deliver a Creation Unit of ETF shares to the ETF and receive, as redemption proceeds, the underlying shares of the Deposit Basket. The authorized participant or the ETF generally will make a small cash payment at the time of any creation or redemption, which represents the difference between the market value of the Deposit Basket and the net asset value of the ETF.

Each of the actively managed ETFs will utilize a similar in-kind creation and redemption process and has obtained exemptive relief similar to the relief granted to index-based ETFs under the Investment Company Act.  However, the Deposit Basket of the actively managed ETFs will not be based on a stock index, but instead will be determined by the ETF’s investment adviser on each trading day. 

Fund sponsors have long sought SEC approval for actively managed ETFs, surmising that investors might find the pricing transparency of such ETFs attractive and that actively managed ETFs could have tax advantages over traditional mutual fund investments.  The SEC has been studying actively managed ETFs at least since 2001, when it issued Investment Company Act Release No. IC-25258, a “concept release” that sought comment on various issues relating to actively managed ETFs.  Industry participants have noted, however, that actively managed ETFs may not catch on immediately with investors, given that the newly formed ETFs will lack performance history upon which investors can evaluate an investment, and are expected to have higher fees than index-based ETFs.

Codification of Exemptive Relief and Amendments to Form N-1A.  Separately, the SEC on March 11, 2008 proposed new rules under the Investment Company Act to codify existing exemptive relief granted to ETFs under the Act, allow investment companies to increase their holdings in ETFs and amend Form N-1A, the registration statement used by open-end funds, to accommodate ETFs.  The deadline for submitting comments on the proposal is May 19, 2008.  We will discuss the details of the proposed rules separately in a forthcoming update. 

SEC Proposes Amendments to Form ADV

On March 4, 2008, the SEC issued a release (the “Release”) proposing amendments (the “Amendments”) to Part 2 of Form ADV (“Part 2”).  The Amendments are largely similar to the amendments proposed by the SEC in April 2000 (which were discussed in the May 2000 Investment Management Regulatory Update).  The deadline for submitting comments on the Amendments is May 16, 2008.

The SEC proposed amendments to both Part 1 and Part 2 of Form ADV in 2000.  The Part 1 amendments were adopted in October of that year, but the SEC deferred adoption of the Part 2 amendments so that it could consider the many comment letters it received.  The Release states that the SEC is now re-proposing a modified version of the 2000 amendments because it “continue[s] to believe that we need a better approach to client disclosure than the current ‘check-the-box’ approach.”

The proposed Amendments are voluminous and describe many new substantive and procedural requirements in detail.  Most significantly, the Amendments provide for the following:

Narrative disclosure.  Part 2 will take the form of a narrative brochure for prospective and existing clients that will be written in plain English, which differs from the current “check-the-box” format.  The Release contemplates that Part 2 will comprise two subparts.  Part 2A, the “Firm Brochure,” will describe the adviser’s services, fees, business practices and conflicts of interest with clients.  Part 2B, the “Brochure Supplement,” will provide information about advisory personnel on whom clients rely for investment advice. 

Electronic filing.  Advisers will file the Firm Brochure electronically via the Investment Adviser Registration Depository (“IARD”) system.  Currently, only Part 1 of Form ADV is filed electronically, while Part 2 is filed in hard copy.  The Firm Brochure and any updates will be publicly accessible through IARD. 

In addition, the SEC expects to withdraw Rule 206(4)-4 under the Investment Advisers Act of 1940 (the “Advisers Act”), which requires advisers to disclose certain financial and disciplinary information to clients.  If adopted, the amended Part 2 would render Rule 206(4)-4 disclosure redundant.

Part 2A: The Firm Brochure.   The Firm Brochure will comprise 19 separate items.  The Release states that “[m]uch of the information that would be required in the brochure concerns conflicts between an adviser’s own interests and those of its clients and is disclosure the adviser already must make to clients, as a fiduciary, under the [Advisers] Act’s anti-fraud provisions.”  The SEC thus views the proposed disclosure requirements as providing advisers with “guidance on fulfilling their statutory disclosure obligations to clients.”  The Release emphasizes that, in addressing conflicts of interest, advisers will be required not only to disclose the existence of potential conflicts, but to describe those conflicts and their potential impact on clients. 

As under current requirements, an adviser would be required to deliver its current Firm Brochure before or at the time it enters into an advisory contract with a client.  Advisers would not be required to deliver brochures to certain clients receiving only impersonal investment advice, or to clients that are registered investment companies and, under the Amendments, would also not be required to deliver brochures to business development companies that are subject to Section 15(c) of the Investment Company Act of 1940.  In addition to the initial delivery requirement, the Amendments would require an adviser to deliver its current brochure to existing clients at least once each year no later than 120 days after the end of the adviser’s fiscal year, and deliver an interim update only when the adviser amends its brochure to add a disciplinary event, or to materially change information already disclosed regarding disciplinary events.

Part 2B: The Brochure Supplement.  The Brochure Supplement will provide basic educational, professional and disciplinary background information on supervised persons who provide advisory services to a particular client.  According to the Release, the SEC contemplates that a supplement will be less than a page long.  The Release contemplates that a client will be given a Brochure Supplement for each supervised person who (i) formulates investment advice for that client and has direct client contact or (ii) makes discretionary investment decisions for that client’s assets, even if the supervised person has no direct client contact.

To reduce the potential administrative burden of delivering and updating the Brochure Supplement, the Amendments would not require delivery to certain classes of clients that the SEC believes will independently be able to access the information provided in the supplement.  In addition, advisers would not be required to deliver Brochure Supplements annually, but only when information in a supplement becomes materially inaccurate.  The Brochure Supplements and amendments would not need to be filed with the SEC, and thus would not be available publicly on the IARD website.

Filing Requirements, Public Availability and Transition.  If the Amendments are adopted, new applicants for registration as investment advisers would not be required to include their brochures as part of their initial application for registration until six months after the effective date of the Amendments.  Advisers already registered with the SEC would need to comply with the new Part 2 requirements by the date of their next required annual updating amendment to Form ADV following the effective date of the Amendments.

SEC Proposes Rule Changes for Investment Company Disclosure to Comply with Sudan Accountability and Divestment Act

On February 15, 2008, the SEC proposed amendments to Form N-CSR and Form N-SAR that would require certain disclosures by registered investment companies that divest from securities pursuant to the Sudan Accountability and Divestment Act of 2007 (the “Sudan Act”).  Among other things, the Act provides that a registered investment company may not be subject to any civil, criminal or administrative action that is based solely upon the investment company’s divesting from, or avoiding investment in, securities issued by persons that the investment company has reason to believe conduct or have direct investments in certain business operations in Sudan.  In order to take advantage of this safe harbor, an investment company must make certain disclosures in connection with its divestment, and the Act requires the SEC to promulgate rules mandating this disclosure by April 30, 2008.  For a detailed discussion of the Act, please see the January 2008 Investment Management Regulatory Update.

With respect to securities from which an investment company has divested, the proposed amendments would require disclosure of:

  1. the issuer’s name;
  2. the exchange ticker symbol;
  3. the CUSIP number;
  4. the total number of shares or, for debt securities, principal amount divested; and
  5. dates that the securities were divested.

In addition, if an investment company continues to hold any securities of the divested issuer, it would be required to disclose items (1) to (3) and the total number of shares or, for debt securities, principal amount held on the date of filing.  The disclosure would need to be filed on the next Form N-CSR or Form N-SAR that an investment company files following the divestment (management investment companies would provide the disclosure on Form N-CSR while unit investment trusts would provide the disclosure on Form N-SAR). 

To lessen the compliance burden for any investment company that divests securities in accordance with the Act in the five business-day window before the date of filing its Form N-CSR or Form N-SAR, the company may disclose the divestment either in that filing or in an amendment thereto.  The amendment would need to be filed no later than five business days after the initial filing.  For purposes of determining when a divestment should be reported, if a company divests its holdings in a particular security in a related series of transactions, the company may deem the divestment to occur at the time of the final transaction in that series.  This allows investment companies the ability to choose whether to report each transaction in the next Form N-CSR or Form N-SAR immediately following that transaction, or to report the entire series on the Form N-CSR or Form N-SAR following the final transaction in the series.  An investment company that opts for the latter must separately specify items (4) and (5) above for each transaction.  According to the proposed amendments, this flexibility aims to reduce opportunities for third parties to exploit information about ongoing divestments through predatory trading practices.

The deadline for comments on the proposed amendments is March 17, 2008.

Fidelity Required to Include Shareholder Proposal Regarding Genocide and Human Rights in Proxy Materials

The SEC has declined to provide no-action relief to a group of registered mutual funds (the “Funds”) advised by Fidelity Management & Research Company (“Fidelity”) that sought to omit from their proxy materials a shareholder proposal relating to investments in companies that contribute to genocide or other crimes against humanity (the “Proposal”).

The Proposal, comprising a shareholder resolution and supporting statement, was submitted for inclusion in the Funds’ proxy materials pursuant to Rule 14a-8 under the Securities Exchange Act of 1934 (the “Exchange Act”).   The resolution reads as follows:

In order to ensure that Fidelity is an ethically managed company that respects the spirit of international law and is a responsible member of society, shareholders request that the Fund’s Board institute oversight procedures to screen out investments in companies that, in the judgment of the Board, substantially contribute to genocide, patterns of extraordinary and egregious violations of human rights, or crimes against humanity.

Subsection (i) of Rule 14a-8 sets forth numerous bases on which a company may exclude a shareholder proposal from its proxy materials.  The Funds argued that the Proposal dealt with matters relating to ordinary business operations, i.e., the selection of investments, and therefore was excludable under subsection (i)(7).  The Funds also argued that the Proposal could be excluded pursuant to subsection (i)(3), because it contained materially false or misleading statements in violation of Rule 14a-9 under the Exchange Act.  The Funds argued that the Proposal was misleading because it “impugn[ed] the character” of Fidelity by implying that Fidelity was not an ethically managed company.  The Funds further argued that the Proposal was misleading because it was so vague that it would be possible for the Funds to implement the Proposal, if approved by shareholders, in a manner significantly different from that envisioned by the shareholders who voted for it.

In a letter from its Office of Disclosure and Review, the SEC stated that it was unable to provide the requested relief under either of the provisions cited by the Funds. 

The non-binding Proposal was submitted by 14 shareholders of the Funds, coordinated by the organization Investors Against Genocide.

SEC Issues Notice of Application for an Exemptive Order Allowing Triangle Capital Corporation to Issue Restricted Stock to Non-Employee Directors and Other Key Personnel

On February 20, 2008, the SEC published Investment Company Act Release No. 28165 (the “Notice”), a notice of application for an exemptive order under Section 6(c) of the Investment Company Act.  If granted, the order will allow Triangle Capital Corporation (“Triangle”), a publicly traded closed-end investment company that has elected to be treated for regulatory purposes as a business development company (“BDC”) under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”), subject to certain conditions, to issue restricted stock to its non-employee directors and certain other key personnel.  Unless the SEC orders a hearing, it will issue an order exempting Triangle’s proposal from Sections 23(a), 23(b), 63, 57(a)(4) and 57(i) of the Act as well as Rule 17d-1 under the Act.  Interested parties have until March 17, 2008 to request a hearing.

The order would allow Triangle to amend and restate its 2007 Equity Incentive Plan (as amended and restated, the “Plan”) to include performance-based grants of restricted stock to its non-employee directors and certain key employees.  The Plan would require approval by Triangle’s shareholders before going into effect.  Pursuant to the Plan, Triangle would offer its non-employee directors, and certain other employees, restricted stock that would be: (i) subject to forfeiture, (ii) non-transferable except by gift, will or intestacy and (iii) during the restricted period, non-saleable or otherwise able to be encumbered.  Triangle would limit the amount of restricted stock that it may issue pursuant to the Plan to the sum of 10% of its outstanding common shares on the effective date of the Plan and 10% of the outstanding number of its common shares issued during the term of the Plan (other than shares issued via employee compensation plans). 

Additionally, Triangle proposed limiting the amount of its shares issued to any one person pursuant to the Plan to 100,000 shares per year, and capping the total amount of shares that any one person may receive under the Plan to 25% of the shares reserved for issuance under the Plan.  Triangle’s non-employee directors would receive $30,000 worth of restricted shares at the beginning of each year that they serve as a director of Triangle, and such shares would be restricted for a period of one year from the date of their issuance.

Sections 23(a), 23(b) and 63 of the Investment Company Act would prohibit the Plan absent an exemptive order issued pursuant to Section 6(c) of the Act.  In its application, Triangle cited three concerns that these sections are intended to address.  First, there is a concern that offering shares of the investment company to insiders of the investment company would allow them to exert undue control over the company.  Second, complicating the structure of an investment company makes it difficult to value the company’s stock.  Third, the sale of shares of an investment company at a price below its current net asset value dilutes existing shareholders’ equity.

Triangle argued that none of the aforementioned concerns would be implicated by the Plan.  First, as discussed above, Triangle proposed placing numerous quantitative restrictions on the ownership level that company insiders would be able to achieve under the Plan.  Second, Triangle noted that numerous non-investment company corporations have similar plans, which “are commonly known to investors” and do not unduly complicate assessing the value of a company’s common stock.  Third, Triangle asserted that the dilutive effect of the Plan would be fully disclosed to, and ratified by, its shareholders, who would stand to gain more from Triangle’s increased ability to attract and retain talented directors and employees than they would stand to lose via dilution. 

Additionally, Triangle noted that Section 61(a)(3)(B) of the Investment Company Act allows a BDC, such as Triangle, to issue warrants, options and rights pursuant to compensation plans.  Given the similarity of common stock to these other securities, compensation plans offering stock should also be permitted, according to Triangle.
Additionally, Section 57(a)(4) of the Investment Company Act and Rule 17d-1 under the Act, absent an exemption, would also prohibit Triangle, as a BDC, from enacting its Plan.  Specifically, Section 57(a)(4) and Rule 17d-1 in conjunction prohibit the employees and directors of a BDC from participating in a “joint enterprise or other joint arrangement or profit sharing plan,” which could be interpreted to include Triangle’s Plan.

Triangle asserted that it should receive an exemption from Section 57(a)(4) of the Act and Rule 17d-1, because its Plan would inure to the benefit of all of Triangle shareholders, not just the individuals participating in the Plan.  Specifically, Triangle asserted that the Plan would help to attract the best employees and directors to Triangle and would align the interests of these individuals with those of Triangle’s shareholders.

Triangle agreed that the order requesting relief would be subject to the conditions enumerated below:

  • Before being enacted, the Plan would be approved by Triangle’s shareholders in accordance with Section 61(a)(3)(A)(iv) of the Investment Company Act.
  • A majority of Triangle’s directors would approve the issuance of restricted shares pursuant to the Plan after determining that such issuance was “in the best interests of Triangle and its shareholders.”
  • At the time of issuance, the amount of Triangle’s outstanding warrants, options, rights and restricted shares issued pursuant to the Plan would not, in the aggregate, exceed 25% of the total amount of outstanding voting securities of Triangle.  Notwithstanding the foregoing, if Triangle’s directors, officers and employees would own more than 15% of Triangle’s outstanding warrants, options, rights and restricted stock issued pursuant to the Plan, then at the time of issuance, no more than 20% of the voting securities of Triangle could be represented by warrants, options, rights and restricted stock issued pursuant to the Plan.
  • Triangle would limit the amount of restricted stock that it would issue pursuant to the Plan to the sum of 10% of its outstanding common shares on the effective date of the Plan and 10% of the outstanding number of its common shares issued during the term of the Plan (other than shares issued via employee compensation plans).
  • At least annually, and at all times prior to any issuance of restricted stock pursuant to the Plan, Triangle’s board would conduct a review of the impact of the Plan on Triangle’s earnings and NAV.  Should Triangle’s board determine that the Plan was negatively impacting Triangle’s shareholders, Triangle’s board would be authorized to prevent additional issuances of restricted stock pursuant to the Plan.

Litigation

Investors of Ritchie Multi-Strategy Global, LLC Seek Disclosure Through Involuntary Bankruptcy Proceeding

Overview

On December 26, 2007, certain investors in Ritchie Multi-Strategy Global, LLC ("Ritchie Onshore") filed an involuntary bankruptcy petition in the United States Bankruptcy Court for the Northern District of Illinois (the "Bankruptcy Court"), and filed a motion (the "Disclosure Motion") to compel Ritchie Onshore and its investment manger, Ritchie Capital Management, LLC ("RCM") to provide extensive disclosures to the Petitioning Investors. 1

The investors, namely Benchmark Plus Partners, LLC, Benchmark Plus Institutional Partners, LLC and Sterling Low Volatility Fund QP (collectively, the "Petitioning Investors"), assert that by virtue of their purportedly contractual relationship with Ritchie Onshore they are unsecured creditors of Ritchie Onshore and have standing to bring an involuntary bankruptcy petition against Ritchie Onshore.  The Petitioning Investors purport to have claims of approximately $46 million.

Background

At one point, according to the Petitioning Investors, RCM managed portfolios, including Ritchie Onshore, valued at approximately $3 billion.  In April 2007, the equity interests in the investment portfolios of Ritchie Onshore and its sister fund, Ritchie Multi-Strategy Global, Ltd., a Cayman Islands exempt company (together with Ritchie Onshore, the "Funds") were sold to Rhone Holdings II, LP ("Rhone II") an acquisition vehicle of Reservoir Capital Group.

In exchange for the Funds’ investment portfolios, Rhone II agreed to pay a total of $285 million, which was structured as follows: (i) up-front payment of 50% of the agreed-upon purchase price; (ii) three additional installment payments of 10% of the purchase price each on the first, second and third anniversaries of the closing and (iii) an earnout payment ranging from 10 to 30% of the total purchase price.  Among other terms of the deal, RCM would continue to manage the Funds' portfolios for Rhone II, and certain of the Funds' assets were excluded from the transaction under the premise that Rhone II would liquidate them with the guidance of RCM and distribute the resulting proceeds to the Funds.  The Funds' investors, including the Petitioning Investors, acquiesced to the transaction, which was consummated in the spring of 2007.

The Petitioning Investors allege that the circumstances surrounding the sale of the Funds' portfolios to Rhone II were not properly disclosed to them. The involuntary bankruptcy petition and the Disclosure Motion are intended to force Ritchie Onshore to reveal several aspects of the transaction, including "the details of RCM's marketing efforts, potential bidders who were contacted, their level of interest, offers from other parties, [and] the basis for the decision of RCM and the Funds to sell to Rhone II."  The Petitioning Investors have also requested that the Bankruptcy Court order the production of documents relating to any assets excluded from the Rhone II transaction, particularly any designated investments of the Funds, the organizational structure of Funds after the Rhone II transaction and any compensation received by RCM or any other Ritchie management entities pursuant to the Rhone II transaction.  The Petitioning Investors allege that their attempts to acquire this information through negotiations with RCM and the Funds have proved fruitless.

The Current Litigation

Both the involuntary petition and the Disclosure Motion are currently being actively litigated.2   Ritchie Onshore and RCM have filed motions (i) to dismiss the involuntary petition of the Petitioning Investors, (ii) opposing the Disclosure Motion and (iii) seeking to compel the Petitioning Investors to post a bond.  For their part, the Petitioning Investors have challenged each of these motions.

The Court has already resolved the bond issue.  If Ritchie Onshore and RCM are successful in getting the Petitioning Investors' involuntary petition dismissed, the Court has ordered that Ritchie Onshore and RCM may "set off" the claims of the Petitioning Investors by the amount of its legal fees.  If Ritchie Onshore and RCM are unsuccessful in getting the involuntary petition dismissed, no bond need be posted by the investors

Ritchie Onshore and RCM challenged the Disclosure Motion—arguing that it was (i) premature given the outstanding motion for summary judgment filed by Ritchie Onshore and RCM and (ii) contrary to the discovery process applicable to involuntary petitions under the Bankruptcy Rules.  A hearing on this motion was originally scheduled for February 26, 2008, but it has been continued and rescheduled for April 3, 2008.

With respect to the involuntary petition, the key issue is whether the Petitioning Investors, who had purchased interests in Ritchie Onshore, an Illinois limited liability company are holders of "claims" within the meaning of the Bankruptcy Code, and therefore have standing to file an involuntary petition against Ritchie Onshore.

The Petitioning Investors assert a variety of arguments supporting their position that they hold "claims" against Ritchie Onshore and therefore have standing to pursue their involuntary petition.  Primarily, they assert that they have exercised their contractual right of redemption of their investment in the Fund as set forth in the applicable subscription agreements and that because Ritchie Onshore has not fully satisfied its redemption obligations, the Petitioning Investors purport to have rights under applicable Illinois corporate law that are recognizable "claims" within the meaning of Section 101(5) of the Bankruptcy Code.

RCM and Ritchie Onshore contest these legal conclusions in addition to disputing many of the underlying facts alleged by the Petitioning Investors and assert the following alternative arguments: (i) the rights of the Petitioning Investors against Ritchie Onshore are not "claims" but rather are "equity securities" within the meaning of Section 101(6) of the Bankruptcy Code with no legally recognizable "right to payment" and (ii) even if the rights of the Petitioning Investors are "claims" within the meaning of Section 101(6) of the Bankruptcy Code, they are, by the terms of the subscription agreements, either "contingent" claims or claims that "are the subject of a bona fide dispute" and therefore are claims that Section 303(b)(1) of the Bankruptcy Code explicitly excludes from giving their holder the standing to bring an involuntary bankruptcy petition against a debtor."  To support its arguments RCM and Ritchie Onshore point to RCM's broad discretion under the governing documents to postpone the effective date of the redemption requests to argue that the Petitioning Investors do not yet have a vested claim against Ritchie Onshore.

We will continue to monitor further developments concerning this ongoing matter.

1 The involuntary bankruptcy of Ritchie Onshore has been docketed in the United States Bankruptcy Court for the Northern District of Illinois as In re Ritchie Multi-Strategy Global, LLC, 07-24236 (Bankr. N.D. Ill. 2007).  Note that the involuntary bankruptcy of Ritchie Onshore is unrelated to, and distinct from, the voluntary chapter 11 cases of Ritchie Risk-Linked Strategies Trading (Ireland), Ltd. and Ritchie Risk-Linked Strategies Trading (Ireland) II, Ltd., which have been pending in the United States Bankruptcy Court for the Southern District of New York since June 20, 2007.

2 Additionally, RCM has filed a lawsuit in Cook County Circuit Court against the Petitioning Investors, seeking redress for alleged violations of the confidentiality provisions of the governing documents of Ritchie Onshore stemming from the Petitioning Investors' filing of the involuntary petition and the Disclosure Motion.

Industry Update

U.S. Supreme Court Holds that Trust's Investment Advisory Fee Deduction Subject to 2% Floor

On January 16, the U.S. Supreme Court held in Knight v. Commissioner, 128 S. Ct. 782 (2008) that deductions for investment advisory fees paid by a trust are subject to the 2% floor under Internal Revenue Code Section 67.  

Section 67 provides that certain "miscellaneous itemized deductions" are deductible by an individual only to the extent that the aggregate amount of the deductions exceeds 2% of the taxpayer's adjusted gross income.  Writing for a unanimous court, Chief Justice John Roberts affirmed decisions of the Internal Revenue Service, the U.S. Tax Court, and U.S. Court of Appeals for the Second Circuit, which held that because such fees were costs of a type that could be incurred if the property were held individually rather than in trust, their deduction by the trust at issue was subject to the 2% floor.

Although the Supreme Court affirmed the Second Circuit's holding in Knight, it rejected the Second Circuit's approach, which asked whether the cost at issue "could" have been incurred by an individual.  Instead, the Court adopted the test used by the Fourth and Federal Circuits, which looks to whether costs would "commonly" or "customarily" be incurred by individuals in determining whether they are subject to the 2% floor.   

In Knight, the trustee argued that he had engaged an investment adviser to provide advice with respect to investing the trust's assets because of the state's uniform "prudent investor" act, which required him to obtain such services.  Although the Supreme Court recognized that some trust-related investment advisory fees may be fully deductible "if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts," the Court found that there was nothing in the record to suggest that the investment advisor in Knight charged the trustee anything extra, or treated the trust any differently than it would have treated an individual with similar objectives because of the trustee's fiduciary obligations.

Director of SEC Division of Investment Management Provides Guidance to Independent Mutual Fund Directors

In a recent speech at the Mutual Fund Directors Forum Second Annual Directors' Institute, Andrew J. Donohue, Director of the SEC Division of Investment Management, offered his views regarding Sections 15(c) and 36(b) of the Investment Company Act of 1940 (the "Investment Company Act" or the "Act") and the role of independent directors generally.

Historical background.  Section 15(c) of the Investment Company Act has a lengthy legislative history dating back to the original passage of the Act in 1940, noted Donohue, while Section 36(b) is a comparatively more recent addition that was added to the Act by the Investment Company Amendments Act of 1970. 

Despite modifications over the years, the central focus of Section 15(c) has remained the same, said Donohue.  Namely, Section 15(c) requires a majority of a mutual fund's independent directors to approve the mutual fund's adviser's investment advisory contract.  (Earlier iterations of Section 15(c) allowed a majority of a mutual fund's shareholders to approve the fund's contract with its investment adviser as an alternative to the approval of the fund's independent directors.) 

Section 36(b), added to the Investment Company Act in 1970, imposes upon a mutual fund's investment adviser a fiduciary duty with respect to the compensation received by such adviser for its services.  Section 36(b) also gives investors in the mutual fund a private right of action to seek redress for breaches of the adviser's fiduciary duty.  However, the legislative history of Section 36(b), according to Donohue, strongly suggests that the informed decision of a mutual fund's board to approve the compensation of the fund's investment adviser should be given much deference by a court reviewing a breach of fiduciary duty charge against the adviser. 

Guidance for independent directors.  Both Sections 15(c) and 36(b) are of critical importance for today's independent mutual fund directors, according to Donohue, and in light of these sections of the Act, as well as other applicable regulations and judicial opinions, Donohue urged the independent directors of mutual funds to "engage, in person, in a detailed analysis of the investment advisory contract with each aspect of the analysis well documented."

A detail-driven 15(c) process benefits investors, and such a process also helps to insulate the mutual fund's adviser and directors from legal challenges regarding the appropriateness of the adviser's contract, according to Donohue.  Donohue said that the legislative history of Section 36(b) suggests that a court generally will not substitute its judgment for that of the independent directors regarding the appropriateness of the mutual fund's adviser's management fees pursuant to the investment advisory contract so long as the adviser had furnished the fund's board with "robust" information and the independent directors of the mutual fund's board, so informed, approved the advisory contract.

Additionally, Donohue advised independent directors to consider the seminal case with respect to Section 36(b) of the Act, Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F.2d 923 (2d Cir. 1982).  The takeaway from Garternberg, suggested Donohue, is that independent directors should extensively document their Section 15(c) process and the resulting decision.  Donohue said, "[b]y extensively documenting their decision, the independent directors have a record demonstrating that they conscientiously performed their duties and, in my view, are more likely to have their business judgment relied upon."

Priorities and 2008 agenda.  Donohue and his staff plan on continuing to focus on the role of independent directors of mutual funds in 2008.  Of particular interest to Donohue is the suggestion that several fund directors presented to him in discussions in 2007 regarding the delegation of certain of their duties to officers of the mutual fund, particularly their chief compliance officers.  Donohue and his staff are currently analyzing whether it would be more efficient for officers of mutual funds to assume some of the tasks traditionally performed by directors.