United States: SEC Staff Grants No-Action Relief to Permit Funds of Funds to Make In-Kind Exchanges Among Affiliated Mutual Funds
(Financial Services Alert – Developments of Note)

1. MBA Publishes Paper on Likely Effects of Basel II on Residential Mortgage Industry
2. OCC Determines Lending Limits and Public Welfare Investment Authority Distinct
3. SEC Staff Provides No-Action Relief from Affiliated Transactions Prohibitions for Mergers Between Registered Funds and Unregistered Funds Other Than Those Specified in Rule 17a-8
4. SEC Staff Grants No-Action Relief to Permit Funds of Funds to Make In-Kind Exchanges Among Affiliated Mutual Funds
5. OCC Issues Letter Permitting National Bank to Retain MasterCard, Inc. Stock Received in IPO
6. Federal Banking Agencies Issue Interim Rule to Amend and Implement Management Interlock Provision of Regulatory Relief Act

7. Goodwin Procter Client Alert Regarding US Safe Web Act Available on Firm’s Website

The Mortgage Bankers Association published a white paper (the "Paper") on the likely effects of Basel II capital standards on competition within the 1-4 family residential mortgage industry. In addition to providing an overview of the US residential mortgage market and the current and contemplated (Basel II) US capital rules, the Paper posits that a bank’s return on equity ("ROE") increases with its leverage ratio. As a result, if Basel II reduces the capital requirements for the largest US banks, those banks will have higher ROE and will attract more shareholder funds. Moreover, the Paper calculates that a bank’s capital ratio determines the lowest rate it can charge on a loan with the loan remaining profitable. Accordingly, if the capital ratios decrease for the largest banks, the combination of increased shareholder funds and lower required rates will shift prime mortgages more toward them. The Paper focuses on prime mortgages, because they are the types of loans for which smaller banks are most likely to be required by regulation to hold more capital than the economically appropriate level. To maintain sufficient sources of revenue, the US banks not subject to Basel II will then be forced to hold more risky subprime mortgages, or assume more interest rate risk, thereby increasing their relative risk exposure. In light of the foregoing, the Paper also asserts that non-Basel II banks, particularly those with large prime mortgage portfolios, should become more attractive takeover targets for Basel II institutions.

The Paper further asserts that the Basel II banks may for the first time be able to provide credit guarantees more cheaply than, and capture business from, government sponsored enterprises ("GSEs"), such as Fannie Mae and Freddie Mac. This may result in new profit centers for the Basel II banks, namely the guarantee and underwriting businesses currently controlled by the GSEs. This enhanced competition also may benefit the non-Basel II banks, by forcing the GSEs to decrease the guarantee and other fees they charge in connection with mortgage purchases.

The OCC issued an interpretive Letter ("Letter 1076") determining that a national bank’s lending limits (contained at 12 USC 84) and its limits on public welfare investments (contained at 12 USC 24 (Eleventh)) are separate and distinct. Accordingly, a national bank may invest in the debt of an entity qualifying for a public welfare investment up to the statutory public welfare limit (which Letter 1076 noted were amended by the 2006 federal regulatory relief legislation), and also concurrently make a loan to the entity up to statutory lending limits. In reaching this determination, Letter 1076 pointed out that the national bank lending and investment limits (located at 12 CFR Part 1) also have long been viewed as separate and distinct, and 12 CFR 24.1(d) also supports this result. Letter 1076 cautions, however, that national banks must be mindful of the safety and soundness issues raised with credit concentrations, and that the OCC reserves the right to criticize excessive exposure to any entity.

The staff of the SEC’s Division of Investment Management (the "Staff") provided no-action assurances with respect to the affiliated transactions prohibitions of Section 17(a)(1) of the Investment Company Act of 1940, as amended (the "1940 Act"), regarding reorganization transactions in which unregistered church plans would exchange all of their assets for shares of affiliated, newly created registered funds with the same investment objectives, policies and portfolio managers (the "Funds"). The church plans, in which employee benefit plans sponsored by the parent of the Funds’ adviser invest, would not be able to rely on Rule 17a-8 under the 1940 Act to effect the reorganizations because the unregistered church plans, which rely on Section 3(c)(14) of the 1940 Act, fall outside the Rule’s definition of "Eligible Unregistered Funds," which is limited to bank common and collective trust funds and insurance company separate accounts.

Conditions. The terms of the no-action relief are based on conditions the SEC has imposed in granting exemptive relief to permit mergers involving registered funds and non-registered entities that fall outside Rule 17a-8’s scope ("Non-Specified Entities"). These conditions generally require compliance with (a) Rule 17a-8, except for the Rule’s requirement regarding eligible unregistered entities and (b) Rule 17a-7 under the 1940 Act (which allows securities transactions between a registered fund and certain of its affiliates) except for the Rule’s requirement that the transaction be for cash. The conditions of the no-action relief also require the Funds to effect in-kind purchases pursuant to procedures adopted by their Board of Trustees, including a majority of those Trustees who are not "interested persons" within the meaning of the 1940 Act ("Independent Trustees"). These procedures must be reasonably designed to ensure that (a) the in-kind consideration accepted by each Fund is appropriate in type and amount in light of the Fund’s investment objectives and policies and its current holdings; (b) the church plans and the Funds use the same procedures for determining their net asset values, and the Fund’s procedures include the preparation by an independent evaluator of a report to be considered by the Fund’s Board in assessing the value of securities (or other assets) for which market quotations are not readily available; and (c) redemptions of the church plans will be simultaneous with purchases of their corresponding Funds. The Funds must maintain certain records related to mergers conducted in reliance on the no-action relief. Finally, the Adviser must, consistent with its fiduciary duties, disclose to the Independent Trustees the existence of, and all material facts relating to, any conflicts of interest between the Adviser and the Funds with respect to the mergers.

Applicability. In granting the no-action relief the Staff indicated that its position also applies to mergers involving Non-Specified Entities other than church plans. The Staff did note, however, that its position is limited to mergers of a Non-Specified Entity and a newly created registered fund that has no shareholders other than the fund’s adviser or the adviser’s affiliates.

The staff of the SEC’s Division of Investment Management granted no-action relief to permit certain mutual funds used as investment vehicles for insurance company separate accounts that function as funds of funds (the "Funds of Funds") to make in-kind purchases in connection with in-kind transfers of their assets from certain affiliated mutual funds offered generally to the public (the "Publicly Offered Funds") to other affiliated mutual funds (the "Variable Products Portfolios") offered only to insurance company separate accounts. All three sets of mutual funds are managed by the same adviser or one of its affiliates (collectively, the "Adviser"). Each Variable Products Portfolio has the same investment objectives and policies, and is managed in the same manner, as its corresponding Publicly Offered Fund. By investing in the Variable Products Portfolios rather than the Publicly Offered Funds, each Fund of Funds would be able to more easily satisfy Internal Revenue Code diversification requirements, which allow it to "look through" issuers whose shares are held exclusively by insurance company separate accounts. In the redemption leg of the proposed in-kind transfers, a Fund of Funds would receive its pro rata share of every security position in a Publicly Offered Fund the Fund of Funds held, which it would then tender in full to purchase shares of the corresponding Variable Products Portfolio. The use of in-kind transfers to move each Fund of Funds’ assets from the Publicly Offered Funds to their corresponding Variable Products Portfolios would seek to avoid the transaction costs ordinarily associated with transfers that involve conversion of the amounts transferred to cash as part of the process.

The request for relief was prompted by concerns that each in-kind exchange would run afoul of Section 17(a)(1) of the Investment Company Act of 1940, as amended (the "1940 Act"). Section 17(a)(1) generally prohibits the sale of securities to a registered investment company ("fund") where certain affiliations exist between the fund and the seller, such as those arising because of (a) the Adviser’s deemed control over the Funds of Funds, the Publicly Offered Funds and the Variable Products Portfolios or (b) a Funds of Fund’s ownership of 5% or more of a Variable Products Portfolio’s outstanding voting securities. The letter requesting relief notes that the terms under which the Funds of Funds propose to effect their in-kind purchases of Variable Products Portfolio shares track the procedures set forth in GE Institutional Funds, SEC No-Action Letter (pub. avail. Dec 21, 2005). In GE Institutional Funds, the SEC staff granted no-action relief with respect to Section 17(a)(1) of the 1940 Act in connection with in-kind purchases of mutual funds by retirement plans sponsored by the mutual fund’s adviser and its affiliates, but specifically noted that the relief did not extend to in-kind purchase transactions between affiliated funds. See the January 10, 2006 Alert for a more detailed discussion of GE Institutional Funds. (The request for relief noted that the Funds of Funds would rely on Signature Financial Group, Inc., SEC No-Action Letter (pub. avail. Dec. 28, 1999) to address any issues under Section 17(a)(2) of the 1940 Act with respect to the redemption leg of each in-kind exchange. Section 17(a)(2) prohibits the purchase of securities from a fund (other than the fund’s own securities) where certain affiliations exist between the fund and the buyer.)

Conditions. Under the relief, the Funds of Funds and Variable Products Portfolios (collectively, the "Participating Funds") must effect in-kind purchases pursuant to procedures adopted by their respective Boards of Trustees, including a majority of those Trustees who are not "interested persons" within the meaning of the 1940 Act ("Independent Trustees"). These procedures must be reasonably designed to ensure that (a) an in-kind purchase will not dilute the interests of either Participating Fund’s shareholders; (b) the in-kind consideration accepted by a Variable Products Portfolio is appropriate in type and amount in light of the Variable Products Portfolio’s investment objectives and policies and its current holdings; (c) a Fund of Fund’s in-kind consideration consists only of the entire proceeds from redeeming its holdings of the corresponding Publicly Offered Fund; (d) a Variable Products Portfolio and its corresponding Publicly Offered Fund have the same procedures for determining net asset value such that each ascribes the same value to the in-kind consideration; and (e) each purchase in-kind is effected simultaneously with its corresponding redemption in-kind. Within the seven days following the 30-day period immediately after completion of the in-kind purchases, each Participating Fund’s Board, including a majority of its Independent Trustees, must determine that all of the in-kind purchases (i) were effected in accordance with these procedures; (ii) did not favor a Fund of Funds to the detriment of any other Variable Products Portfolio shareholder, or favor the Variable Products Portfolio to the detriment of the Fund of Funds, and (iii) were in each Participating Fund’s best interests. The Fund of Funds must maintain certain records related to in-kind purchases conducted in reliance on the no-action relief. Finally, the Adviser must, consistent with its fiduciary duties, disclose to the Independent Trustees the existence of, and all material facts relating to, any conflicts of interest between the Adviser and the Fund of Funds or the Variable Products Portfolios in a proposed in-kind purchase.

The OCC issued an interpretive letter ("Letter 1075") in which it concluded that a national bank may retain shares of MasterCard, Inc. ("MasterCard") that the bank received in an IPO, provided that the bank’s OCC examiner determines that the retention of the shares raises no safety and soundness concerns. In its legal analysis of the issue, the OCC confirmed its long-held position that while a national bank may not purchase stock for investment purposes, it may make equity investments that are not for speculative or investment purposes, but rather are "intended to facilitate a bank’s participation in an otherwise permissible activity, or to enable the bank to receive needed services." The OCC stated that the bank that is the subject of Letter 1075 acquired the pre-IPO MasterCard stock for non-speculative purposes, i.e., because the bank needed to own them to issue MasterCard payment cards and to receive related MasterCard services. Moreover, the bank did not purchase the MasterCard shares issued in the IPO but, rather, automatically received them in the IPO as a byproduct of owning the pre-IPO MasterCard shares. Accordingly, the OCC concluded that the bank may retain the shares received in the IPO so long as such ownership raises no safety and soundness concerns.

The OCC cautions that in concluding that the bank may retain the MasterCard IPO shares, the OCC has not addressed the issues of whether a national bank may acquire additional MasterCard IPO shares or whether MasterCard IPO shares may be acquired by national banks that become members of MasterCard in the future.

The OCC, FRB, FDIC and OTS (the "Agencies") jointly issued an interim rule (the "Interim Rule") to amend their rules regarding management interlocks to implement Section 610 ("Section 610") of the Financial Services Regulatory Relief Act of 2006. The Interim Rule implements Section 610 by permitting a management official of a depository organization to serve as a management official of an unaffiliated depository organization that has an office in the same relevant metropolitan statistical area if each of the depository organizations has total assets of $50 million or less. Prior to the enactment of Section 610, the exemption was only available to depository organizations with total assets of $20 million or less. The Interim Rule became effective on January 11, 2007, and comments must be received by the Agencies by February 12, 2007.

Goodwin Procter issued a Client Alert regarding the enactment of the US Safe Web Act (the "Act"). The Act is designed to enable the FTC to protect consumers more effectively from spam, spyware and Internet fraud. The Act empowers the FTC to share confidential information and investigational assistance with counterpart agencies in foreign countries. The Client Alert is available here.

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