Investment Management

Posted on Wednesday, March 8 2017 at 10:41 am by

SEC Issues Guidance to Ease Fund Implementation of “Clean Shares”

By Andrew Sachs and John I Sanders

In January, we authored a post[i] discussing an SEC no-action letter, dated January 11, 2017, to Capital Group (the “Capital Group Letter”), the parent company of American Funds.[ii]  In the Capital Group Letter, the SEC agreed that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus”, does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in so-called “Clean Shares”.[iii]

Clean shares are mutual fund shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[iv]  We noted in January that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by a broker would give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally, and we anticipated that many mutual fund companies would explore the concept of Clean Shares.

On February 15, 2017, just a month after publication of the Capital Group Letter, the SEC was compelled to issue guidance (the “FAQ”) addressing some of the questions it had received from mutual fund companies to-date.[v]  Below, we summarize FAQ as it relates to Funds seeking to implement Clean Shares.

Initial Implementation of Clean Shares

A mutual fund company issuing Clean Shares must, of course, amend its registration statement to include disclosure of the new share class.  Such an amendment might be affected through a Rule 485(a) filing or through a Rule 485(b) filing, depending on whether the amendment is “material”.[vi]  Typically, funds prefer Rule 485(b) filings because they become effective immediately,[vii] while Rule 485(a) filings are subject to a 60 day review.[viii]

In the FAQ, the SEC confirmed that “Funds should create these new Clean Shares, like any new class, by making a filing under Rule 485(a).”  To minimize the burdens of filing under Rule 485(a), if the only disclosures being amended are those describing the new share class, we advise mutual fund companies to seek selective review of the Rule 485(a) filing.  The request for a selective review should be made in the cover letter accompanying the 485(a) filing and must include (i) a statement as to whether the disclosure in the filing has been reviewed by the staff in another context; (ii) a statement identifying prior filings that the registrant considers similar to, or intends as precedent for, the current filing; (iii) a summary of the material changes made in the current filing from the previous filings; and (iv) any specific areas that the registrant believes warrant the SEC staff’s particular attention.[ix]

Adding Clean Shares to Multiple Funds

A mutual fund family adding Clean Shares to multiple funds need not file Rule 485(a) filings for each fund.  Instead, the FAQ confirms that mutual funds companies introducing Clean Shares across multiple funds can request Template Filing Relief pursuant to Rule 485(b)(i)(vii).  A registrant requesting Template Filing Relief would make a single Rule 485(a) filing with a Template Filing Relief request for all other funds with “substantially identical disclosure”.[x]

We note, however, that a request for Template Filing Relief must include (i) the reason for making the post-effective amendment; (ii) the identity of the Template filing;[xi] (iii) the identity of the registration statements that intend to rely on the relief (“Replicate filings”).[xii]  Additionally, the registrant must represent to the SEC that (i) the disclosure changes in the template filing are substantially identical to disclosure changes that will be made in the replicate filings; (ii) the replicate filings will incorporate changes made to the disclosure included in the Template filing to resolve any staff comments thereon; and (iii) the replicate filings will not include any other changes that would otherwise render them ineligible for filing under rule 485(b).[xiii]  Selective Review and Template Filing Relief can save registrants adding Clean Shares to existing funds time and money.

Existing Share Classes Qualify as Clean Shares

One of the more interesting aspects of the FAQ was the acknowledgement by the SEC that certain existing share classes of funds (such as institutional class shares) might already meet the requirements of Clean Shares, thereby offering a path to offering Clean Shares to many registrants without a Rule 485(a) filing.[xiv] In such a case, the SEC noted that a 485(a) filing would not be necessary “solely to add the prospectus disclosure described in the [Capital Group Letter]”[xv] where the fund already offers a share class that meets the requirements of the Capital Group Letter.[xvi]  Instead, a Rule 485(b) or Rule 497 filing will suffice.

Conclusion

The introduction of Clean Shares to the mutual fund industry presents an opportunity for mutual fund companies to improve the competitive position of their products, and we anticipate that there will be continued interest in Clean Shares even if the Department of Labor’s Conflict of Interest Rule does not become effective.[xvii]  If you have questions about Clean Shares of the SEC’s recent guidance, we encourage you to contact us.

 

[i] Andrew Sachs and John I. Sanders, Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry, Kilpatrick Townsend: Investment Management News and Notes (Jan. 27, 2017), http://blogs.kilpatricktownsend.com/investmentmanagement/.

[ii] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm (“Capital Group Letter”).

[iii] Id.

[iv] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[v] SEC, Frequently Asked Questions on IM Guidance Update 2016-06 (Mutual Fund Fee Structures, available at https://www.sec.gov/divisions/investment/guidance/frequently-asked-questions-mutual-fund-fee-structures.htm (“FAQ”).

[vi] 17 CFR 230.485(a)-(b) (2017).

[vii] 17 CFR 230.485(b) (2017).

[viii] 17 CFR 230.485(a) (2017).

[ix] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[x] Id.

[xi] This identifying information should include the name of the Fund and the registrant, the Securities Act file number, and the filing date of the rule 485(a) filing.

[xii] This identifying information should include the name of the registrant, the Securities Act file number, and the series and class name for each of the Funds that intend to rely on the relief.

[xiii] SEC: IM Guidance 2016-06, available at https://www.sec.gov.

[xiv] FAQ, supra note 7.

[xv] Id. at Question 5.

[xvi] See, Capital Group Letter, supra note 2 (Listing the registrant’s representations to the SEC:  The broker will represent in its selling agreement with the fund’s underwriter that it is acting solely on an agency basis for the sale of Clean Shares; The Clean Shares sold by the broker will not include any form of distribution-related payment to the broker; The fund’s prospectus will disclose that an investor transacting in Clean Shares may be required to pay a commission to a broker, and if applicable, that shares of the fund are available in other share classes that have different fees and expenses; The nature and amount of the commissions and the times at which they would be collected would be determined by the broker consistent with the broker’s obligations under applicable law, including but not limited to applicable FINRA and Department of Labor rules; and Purchases and redemptions of Clean Shares will be made at net asset value established by the fund (before imposition of a commission).

[xvii] Paul Foley and John I. Sanders, Department of Labor Set to Eliminate the Fiduciary Rule, JD SUPRA (March 3, 2017), http://www.jdsupra.com/legalnews/department-of-labor-set-to-eliminate-92801/.

Posted on Friday, January 27 2017 at 10:34 am by

Effects of the DOL Fiduciary Rule Reach Mutual Fund Industry

By Andrew Sachs and John I. Sanders

The Department of Labor finalized the so-called “Fiduciary Rule” in April 2016 and announced it would go into effect in April 2017.[i]  Since the finalization of the Fiduciary Rule, the annuities,[ii] brokerage,[iii] and advisory industries[iv] have all seen substantial changes to products or fee structures.  Now, the effects of the rule have reached the mutual fund industry as well, with the SEC’s recent approval of American Funds’ “Clean Shares” – shares stripped of any front-end load, deferred sales charge, or other asset-based fee for sales or distribution that are sold by brokers who set their own commissions in connection with such sales.[v]

On January 11th, the SEC issued a no-action letter to Capital Group, the parent company of American Funds.[vi]  The no-action letter stated that the SEC concurred with Capital Group’s view that Section 22(d) of the Investment Company Act of 1940 (the “Act”), which prohibits selling securities except at “a current public offering price described in the prospectus,” does not apply to brokers when acting as agent on behalf of its customers and charging customers commissions for effecting transactions in Clean Shares.[vii]

At least one publication predicts that thousands of mutual funds will create similar classes of shares.[viii]  We believe that the ability to replace the distribution fees typically charged by its mutual funds with commissions charged by the broker will give funds a new measure of flexibility to meet the demands of the Fiduciary Rule and competition generally.  For those wishing to more fully understand the costs and benefits of adopting a similar share class, we are here to help.

Andrew Sachs is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem office. John I. Sanders is an associate in the firm’s Winston-Salem office.

 

[i] Department of Labor, Fact Sheet: Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle Class Families Billions of Dollars Every Year, https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/dol-final-rule-to-address-conflicts-of-interest.

[ii] Greg Iacurci, Insurers Developing Fee-Based Fixed-Index Annuities Post-DOL Fiduciary Rule, INVESTMENT NEWS (July 14, 2016), http://www.investmentnews.com/article/20160714/FREE/160719964/insurers-developing-fee-based-fixed-indexed-annuities-post-dol.

[iii] Katherine Chiglinsky and Margaret Collins, AIG CEO Blames Obama Retirement Rule for Broker-Dealer Exit, BLOOMBERG (Jan. 27, 2016), http://www.bloomberg.com/news/articles/2016-01-27/aig-broker-dealer-exit-fueled-by-obama-retirement-rule-ceo-says.

[iv] Darla Mercado, How the New “Fiduciary” Rule Will Actually Affect You, CNBC (Oct. 13, 2016), http://www.cnbc.com/2016/10/13/how-the-new-fiduciary-rule-will-actually-affect-you.html.

[v] John Waggoner, Brace for Thousands of New DOL Fiduciary-Friendly Mutual Fund Share Classes, INVESTMENT NEWS (Jan. 6, 2017), http://www.investmentnews.com/article/20170106/FREE/170109955/brace-for-thousands-of-new-dol-fiduciary-friendly-mutual-fund-share.

[vi] SEC, Response of the Office of Chief Counsel Division of Investment Management, available at https://www.sec.gov/divisions/investment/noaction/2017/capital-group-011117-22d.htm.

[vii] Id.

[viii] Waggoner, supra note 5.

Posted on Tuesday, January 24 2017 at 3:08 pm by

Constitutionality of SEC Judges Questioned

By Paul Foley and John I. Sanders

Among the many provisions of the Dodd-Frank Act were some that gave the SEC greater ability to hear cases and levy punishments in internal administrative courts without resort to ordinary federal courts.[i]  These provisions resulted in alarming results, including a 90% success rate for the SEC in front of its own newly-minted administrative law judges.[ii]  For comparative purposes, the SEC’s previous success rate was below 70%.[iii]

A legal challenge brought against the SEC argued that these judges are “inferior officers” that, pursuant to the Appointments Clause of the U.S. Constitution,[iv] must be appointed by an executive branch member and approved by the Senate.  Because such steps were never taken, the judges’ actions would be unconstitutional if they are, in fact, found to be “inferior officers”.  The 10th Circuit has agreed with the plaintiffs, but the SEC is expected to appeal.[v]

If the challenge is ultimately successful, there will be two significant impacts.  First, the cases decided by the SEC’s judges may be void.  Second, the SEC will be forced to use the old, less certain procedure of bringing enforcement actions in federal district court.  If you’d like to know more, I encourage you to read a succinct review of the matter in today’s Wall Street Journal.[vi]

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem, North Carolina offices.  John I. Sanders is an associate based in the firm’s Winston-Salem office.

[i] Giles D. Beal IV, Judge, Jury, and Executioner:  SEC Administrative Law Judges Post-Dodd Frank, 20 N.C. Banking Inst. 413 (2016), available at https://litigation-essentials.lexisnexis.com/webcd/app?action=DocumentDisplay&crawlid=1&doctype=cite&docid=20+N.C.+Banking+Inst.+413&srctype=smi&srcid=3B15&key=e7ef73edd6e64a6ec56e122360340a35.

[ii] Jean Eaglesham, SEC Wins with In-House Judges, Wall St. Journal (May 6, 2015), http://www.wsj.com/articles/sec-wins-with-in-house-judges-1430965803.

[iii] Id.

[iv] U.S. Const. art. II, sec. 2, cl. 2.

[v] Alison Frankel, 10th Circuit Strikes Down SEC ALJ Regime, Debates Reach to Other Agencies, Reuters (Dec. 28, 2016), http://www.reuters.com/article/otc-sec-idUSKBN14H1S3.

[vi] David B. Rivkin Jr. and Andrew M. Grossman, When is a Judge Not Really a Judge?, Wall St. Journal (Jan. 23, 2017), http://www.wsj.com/articles/when-is-a-judge-not-really-a-judge-1485215998.

Posted on Friday, February 28 2014 at 9:32 pm by

SEC Provides No-Action Relief for M&A Brokers

On January 31, the staff of the Securities and Exchange Commission (“SEC”) issued a no-action letter (“No-Action Letter”) [1] permitting an “M&A Broker”, under certain circumstances, to facilitate mergers, acquisitions, business sales, and business combinations (together, “M&A Transactions”) in connection with the transfer of ownership of a “privately-held company” (any company that does not have any class of securities registered, or required to be registered, with the SEC under Section 12 of the Securities Exchange Act of 1934 and is not required to file periodic information, documents, or reports under Section 15(d) of the Exchange Act) without the M&A Broker registering as a broker-dealer under section 15(b) of the Exchange Act. The specific terms and conditions in the No-Action Letter are outlined below.

While the details of the definition of M&A Broker are complicated, the No-Action Letter has caught the securities industry by surprise. The No-Action Letter provides a potential exemption from SEC broker-dealer registration for many M&A industry consultants commonly referred to as “business brokers”, even if they are paid “finders” or “success” fees for securities-based M&A transactions between privately-held companies. In particular, the No-Action Letter permits an M&A Broker [2] to (i) advertise a privately-held company for sale with information such as the description of the business, general location, and price range, (ii) participate in the negotiations of the M&A Transaction, (iii) advise the parties to issue securities, or otherwise to effect the transfer of the business by means of securities, or assess the value of any securities sold, and (iv) receive transaction-based or other compensation, without registering as a broker-dealer with the SEC.

In particular, the SEC noted the following regarding M&A Brokers:

  • M&A Brokers may not have the ability to bind a party to an M&A Transaction.
  • M&A Brokers may not directly, or indirectly through any of its affiliates, provide financing for an M&A Transaction.
  • M&A Brokers may not have custody, control, or possession of or otherwise handle funds or securities issued or exchanged in connection with an M&A Transaction or other securities transaction for the account of others.
  • M&A Transactions may not involve a public offering, but instead must be conducted in compliance with an applicable exemption from registration under the Securities Act of 1933.
  • No party to any M&A Transaction may be a “shell company”,[3] other than a “business combination related shell company”.[4]
  • M&A Brokers representing both buyers and sellers must provide clear written disclosure as to the parties represented and obtain written consent from both parties to the joint representation. In addition, an M&A Broker facilitating an M&A Transaction with a group of buyers may do so only if the group is formed without the assistance of the M&A Broker.
  • The buyer, or group of buyers, in any M&A Transaction must, upon completion of the M&A Transaction, control and actively operate the company or the business conducted with the assets of the business.[5]
  • No M&A Transaction may result in the transfer of interests to a passive buyer or group of passive buyers.
  • Any securities received by the buyer or M&A Broker in an M&A Transaction will be restricted securities within the meaning of Rule 144(a)(3) under the Securities Act because the securities would have been issued in a transaction not involving a public offering.
  • M&A Brokers and each officer, director or employee of an M&A Broker: (i) cannot have been barred from association with a broker­dealer by the SEC, any state or any self-regulatory organization; and (ii) may not be suspended from association with a broker-dealer.

Future Considerations

The No-Action Letter is a welcome step towards clarifying the registration requirements for M&A Brokers; however, it remains to be seen what, if any, effect it will have on determinations under state securities laws and their varied definitions of “brokers”, “dealers” and “finders”. Although it is reasonable to assume that states that have adopted laws similar to federal law in this area may likewise adopt the interpretation presented in the No-Action Letter, only time will tell if this proves to be the case. We also recommend that individuals and companies looking to rely on the No-Action Letter to avoid SEC broker-dealer registration carefully consider the No-Action Letter’s requirements for transactions to fit under its parameters (namely, the requirements that qualifying transactions involve a buyer that will take voting control, assume executive officer or management positions or otherwise have the power to exert control over the seller after the transaction). Additionally, we note that the No-Action Letter does not address continuing issues regarding broker-dealer registration of private equity fund advisers that receive deal-based fees, who likely would not be able to comply with the M&A Broker definition. Nevertheless, the No-Action Letter’s stark departure from the SEC’s historical position that transaction-based compensation is the “hallmark of broker-dealer activity” is a positive step towards addressing, at the federal level, at least some of these issues.

For more information on the No-Action Letter, please contact any member of the Investment Management Team.


[1] SEC No-Action Letter re: M&A Brokers, dated January 31, 2014. A copy of the No-Action Letter is available here.

[2] An “M&A Broker” is defined in the No-Action Letter as a person engaged in the business of effecting securities transactions solely in connection with the transfer of ownership and control of a privately-held company (defined below) through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or its assets, whether through the power to elect officers and approve budgets or by service as an executive or other executive manager, among other things.

[3] A “shell” company is defined in the No-Action Letter as a company that: (1) has no or nominal operations; and (2) has: (i) no or nominal assets; (ii) assets consisting solely of cash and cash equivalents; or (iii) assets consisting of any amount of cash and cash equivalents and nominal other assets. In this context, a going concern need not be profitable, and could even be emerging from bankruptcy, so long as it has actually been conducting business, including soliciting or effecting business transactions or engaging in research and development activities.

[4] A “business combination related shell company” is defined in the No-Action Letter as a shell company (as defined in Rule 405 of the Securities Act) that is (1) formed by an entity that is not a shell company solely for the purpose of changing the corporate domicile of that entity solely within the United States or (2) formed by an entity defined in Securities Act Rule 165(f) among one or more entities other than the shell company, none of which is a shell company.

[5] A buyer, or group of buyers collectively, would have the necessary control if it has the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. The necessary control will be presumed to exist if, upon completion of the transaction, the buyer or group of buyers has the right to vote 25% or more of a class of voting securities; has the power to sell or direct the sale of 25% or more of a class of voting securities; or in the case of a partnership or limited liability company, has the right to receive upon dissolution or has contributed 25% or more of the capital. In addition, the buyer, or group of buyers, must actively operate the company or the business conducted with the assets of the company.

 

 

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