United States: Fund Alert, February 2000

In a recent no-action letter the Division of Investment Management of the SEC (the "Division"), permitted an investment company operating as a master-feeder fund to satisfy redemption requests from affiliated shareholders with in-kind distributions of portfolio securities. In Signature Financial Group, Inc. (pub. avail. December 28, 1999), the Division determined that Section 17(a) of the Investment Company Act of 1940, as amended (the "Act"), should govern the proposed redemptions, but that a fund could effect the redemptions without disturbing the underlying principles of Section 17(a). Section 17(a) generally prohibits "affiliated persons" from selling securities and other property to - or purchasing them from - an affiliated investment company.

Signature Financial Group ("Signature") developed the "hub and spoke" investment structure, a two-tier, master-feeder structure in which feeder funds ("spoke funds") invest in a common master fund ("hub fund"). Spoke funds may be registered investment companies or other unregistered entities, such as offshore funds or institutional investors. In its letter, Signature explained that certain circumstances might call for a spoke fund to make a complete or partial withdrawal from a hub fund to serve best the interests of its investors. Redemptions in-kind would benefit fund management, as well as redeeming and non-redeeming investors, by alleviating certain burdens associated with large cash redemptions. Signature was concerned, however, that the Division would find that such redemptions violated Section 17(a) of the Act, such that a redeeming spoke fund might be deemed to be purchasing the portfolio securities it receives from the hub fund. Likewise, a hub fund might be seen as selling portfolio securities to a redeeming spoke fund and/or purchasing the redeeming spoke fund’s interests in the hub fund. In Signatures’s view, these interpretations of Section 17(a) would prohibit spoke funds from investing in hub funds because those investments would be considered sales to affiliated persons.

Signature made a variety of arguments in its letter. It reasoned that Section 17(a) should not prevent the proposed redemptions because Congress had provided adequate safeguards for redemptions in other sections of the Act. Signature noted that Congress took deliberate action to ensure fair and timely redemptions in Sections 22, 23 and 12((d)(1)(e) of the Act. Signature asserted that Congress’ failure to address in-kind redemptions specifically meant that Congress wished to provide investment companies with the flexibility to determine whether to make redemptions in-kind or in cash. Signature also noted that treating in-kind redemptions as purchases or sales under Section 17(a) would nullify the effect of Section 12(d)(1)(E), which generally permits feeder funds to own securities of master funds without limitations. Specifically, Signature theorized that once a spoke fund had acquired 5% or more of the securities of the hub fund and had become an affiliated person of the hub fund, Section 17(a) would prohibit the spoke fund from making additional purchases or redemptions. Finally, Signature pointed out that, when determining which funds to distribute in an in-kind redemption, fund directors and advisers must comply with strict fiduciary duties and other specific obligations relating to valuation and redemptions. These duties would prevent the fund from making distributions that would be detrimental to its other shareholders.

Upon consideration, the Division confirmed that a redemption in-kind from a hub fund to a spoke fund that is a registered investment company would involve separate transactions subject to the provisions of Section 17(a). These transactions would include:

(1) the spoke fund’s redemption of its holdings of the hub fund's shares, which could be viewed as a sale of securities by an affiliated person (the spoke fund) to a registered investment company (the hub fund);

(2) the spoke fund’s receipt of portfolio securities from the hub fund, which may be viewed as a purchase of securities by an affiliated person (the spoke fund) from a registered investment company (the hub fund);

(3) the hub fund’s distribution of portfolio securities to the spoke fund, which may be viewed as a sale of securities by an affiliated person (the hub fund) to a registered investment company (the spoke fund); and

(4) the hub fund’s redemption of its shares, which may be viewed as a purchase of securities by an affiliated person (the hub fund) from a registered investment company (the spoke fund).

A redemption in-kind between a hub fund and an affiliated shareholder that is not a registered investment company (including unregistered feeder funds) also would be governed by Section 17(a) for transactions comparable to (1) and (2).

The Division next discussed the distinction between in-kind redemptions and cash redemptions. Cash redemptions do not trigger the protections of Section 17(a). Section 17(a)(1) prohibits affiliated persons from selling securities or other property to a registered company unless the sale involves exclusively securities that the buyer issues. Under the Division’s interpretation of that section, the only security that could be involved in such a transaction would be thefund’s shares. Consequently, the Division asserted that such redemptions would be impermissible under a literal reading of Section 17(a) because both fund shares and portfolio securities would be involved in the transaction.

The Division found this interpretation to be consistent with the purpose of the Section, which is to curtail transactions in which one or more parties can influence the actions of the investment company. According to the Division, more potential for abuse and overreaching by affiliated persons exists with in-kind redemptions than with cash redemptions. For example, a fund’s investment adviser seeking an in-kind redemption from the fund could cause the fund to distribute its most valuable portfolio securities to the adviser.

In spite of the above, the Division conceded that in-kind redemptions could be beneficial to funds and shareholders if they are effected fairly and are subject to certain guidelines. Accordingly, the Division outlined the following circumstances under which funds may make in-kind redemptions to affiliates without obtaining an exemptive order:

(1) To avoid dilution of the remaining shareholders’ interests, the redemption in-kind must be made at approximately the affiliated shareholder’s proportionate share of the distributing fund’s current net assets;

(2) The methodology used to compute the distributing fund’s net asset value must be employed when valuing the distributed securities;

(3) The redemption in-kind must be consistent with the policies and undertakings of the distributing fund;

(4) No affiliated shareholder or party who can, or has incentive to, influence the redemption in-kind may choose or influence the choice of the distributed securities.

(5) The distributing fund’s board of directors must approve the redemption in-kind, including a majority the disinterested directors of the fund.

(6) The distributing fund must maintain a copy of the board’s procedure and records for each redemption. The copy must identify the redeeming shareholder and must describe the composition of the fund’s portfolio immediately before the distribution, each distributed security and the terms of the in-kind distribution. The document must also maintain valuation information and materials for six years from the end of the fiscal year in which the in-kind redemption occurs.

The Division noted that for transactions going forward, those funds that have already obtained exemptive orders for in-kind redemptions may rely either on those orders or on the Signature letter. Funds that follow the guidelines set forth in the letter will not need to seek exemptive orders for redemptions in-kind.

John M. Baker 202-261-3512

Jana L. Cresswell 215-564-8048

Diane J. Drake 215-564-8067

Lisa A. Duda 215-564-8143

Steven M. Felsenstein 215-564-8074

Robert K. Fulton 215-564-8042

Deborah R. Gatzek 650-378-1330

Alan R. Gedrich 215-564-8050

Nadia M. Jannetta 215-564-8014

Lisa M. King 215-564-8077

Stephen W. Kline 610-640-5801

Duane L. Lassiter 215-564-8010

Bruce G. Leto 215-564-8115

Lisa L. B. Matson 215-564-8003

Barbara A. Nugent 215-564-8092

Michael P. O’Hare 215-564-8198

Mark H. Plafker 215-564-8024

Jennifer M. Rogers 215-564-8128

Mark A. Sheehan 215-564-8027

Merrill R. Steiner 215-564-8039

Bibb L. Strench 202-261-3580

Sinclair A. Ziesing 215-564-8055

Zachary P. Alexander 215-564-8043

Rekha D. Packer 215-564-8096

William S. Pilling, III 215-564-8079

William P. Zimmerman 215-564-8124

John J. Hunter 215-564-8072

James F. Podheiser 215-564-8111

Fund Banking Issues

David F. Scranton 610-640-5806

Sheela P. Dattani 302-576-5852

Ellisa Opstbaum Habbart 302-576-5851

Andrew G. Kerber 302-576-5872

Information contained in this publication should not be construed as legal advice or opinion, or as a substitute for the advice of counsel. The enclosed materials may have been abridged from other sources. They are provided for educational and informational purposes for the use of clients and others who may be interested in the subject matter.