Investment Companies and Investment Advisers

Spring 2007

Professor Steve Bradford

Exam Answer Outline

The following answer outlines are not intended to be model answers, nor are they intended to include every issue students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

I graded each question separately. Those grades appear on the front cover of your blue books. To determine your overall average, each question was then weighted in accordance with the time allocated to that question. The following distribution will give you some idea how you did in comparison to the rest of the class:

Question 1: Range 3-7; Average 4.71

Question 2: Range 3-9; Average 6.57

Question 3: Range 4-7; Average 6.00

Question 4: Range 4-9; Average 6.86

Question 5: Range 2-8; Average 6.71

Total (of exam, not final grades): Range 3.64-7.42; Average 6.25

Question 1

This plan does not in any way violate § 12 of the Investment Company Act because, although Infidelity is acquiring securities of a registered investment company, Infidelity is not itself an investment company. It could, however, violate §17. Infidelity, as Cortes’s investment adviser, is an affiliate of Cortes. § 2(a)(3)(E). Thus, it’s an affiliate of an investment company and subject to the restrictions in § 17. If the retirement plan is treated as a separate entity, it’s controlled by Cortes, and thus is a second-tier affiliate of the investment company. Second-tier affiliates (affiliate of such an affiliate) are also subject to the restrictions in § 17.

There is a potential problem under § 17(a)(2) because Infidelity (or the retirement plan) is knowingly purchased a security from such registered investment company. However, these are securities of which the seller is the issuer and thus excepted from (a)(2). The seller is Cortes, the issuer of its own securities. However, another problem arises when an employee retires or dies and Infidelity cashes out the employee’s interest by redeeming the fund’s securities. Section 17(a)(1) would cover this. Infidelity would then be selling securities to Cortes, but, as Cortes is the issuer of these securities, they’re excepted from the prohibition by 17(a)(1)(A).

This could also be a joint transaction in violation of § 17(d) and Rule 17d-1. Infidelity (an affiliate), Infidelity’s employees (second-tier affiliates), and Cortes are all involved. The SEC staff has taken a pretty broad view of what constitutes a joint transaction. This does not appear to be excepted by Rule 17d-1(b)(1) or (b)(2) because Infidelity is not a controlled company of Cortes. It also is not excepted by (b)(5). Infidelity is not a “portfolio affiliate” as defined in Rule 17a-6, because the problem is not that the fund controls Infidelity and Jones.

Another problem arises under § 17(e). Jones, the administrator of the retirement plan, is an employee, and thus an affiliate, of Infidelity. § 2(a)(3)(D). Thus, if Infidelity is an affiliate of Cortes, Jones is a second-tier affiliate. He is therefore prohibited from accepting any compensation while acting as agent for the purchase or sale of any property to the investment company. He does not fall within the parenthetical exception for compensation “other than a regular salary or wages from such registered company” because his wages are coming from Infidelity. He does not fall within the “underwriter or broker” exception because he is acting as neither. Thus, on its face, this appears to violate 17(e). Infidelity and Jones are not “portfolio affiliates” and thus not excepted from this prohibition.

It is hard to see any real harm in this to the investment company. Therefore, although the statute appears to prohibit it, Jones and Infidelity could probably obtain an exemption under § 6(c).

Question 2

Omega must register under § 8 of the Investment Company Act if it is an investment company as defined in § 3 and is not exempted by § 6. Omega does not fall within any of the § 6 exemptions, so the question is solely whether it is an investment company.

An investment company must first be an issuer. § 3(a)(1). Omega is an issuer, a person that issues or has outstanding any security. § 2(a)(22). Omega is a corporation, which is a “company” under § 2(a)(8) and therefore a “person” under § 2(a)(28). It has outstanding stock, which is clearly a security. See § 2(a)(36).

Omega doesn’t appear to fall within § 3(a)(1)(A). It owns securities; in fact, that is all that Omega does. But, with the possible exception of the CDs, it does not invest, reinvest, or trade securities. It merely holds the securities of other companies. It’s also not within subsection (B) because it does not issue or propose to issue face-amount certificates.

Omega does, however, appear to fall within subsection (C). It is in the business of owning and holding securities (the certificates of deposit and the securities of the other companies) and investment securities have a value of more than 40% of the value of its total assets. The securities of Trainco are not investment securities because it’s a majority-owned subsidiary. See 2(a)(24). The certificates of deposit, although considered CDs by the SEC under the Investment Company Act, are government securities, and thus excluded. See 2(a)(16). Hedgco is also a majority-owned sub, but its securities are nevertheless investment securities because, although not itself an investment company, it is relying on the 3(c)(7) exception. Thus, investment securities are roughly 51% of Hedgco’s assets. It therefore falls within the general definition.

Omega is nevertheless not an investment company if it comes within one of the exceptions in 3(b) or 3(c). Section 3(c)(1) and 3(c)(7) are not available to Omega because its stock is traded on the New York Stock Exchange. It clearly has more than 100 investors and not all of those investors would be qualified purchasers.

Section 3(b)(1) also does not help. Trainco is a wholly-owned subsidiary, (more than 95% under 2(a)(43), but it only accounts for 46% of Omega’s assets and 48% of its income—not quite enough to meet the primarily requirement. And, as stated above, the CDs are a securities-related business, so Omega’s own operations aren’t helpful.

It appears that Omega’s only option is to seek an SEC order under § 3(b)(2). Under 3(b)(2), one may consider Omega’s own operations, its majority-owned subs, and controlled companies conducting similar types of businesses. Trainco, as previously stated, is a majority-owned sub. Compco and Paperclips are both controlled companies; the presumption is that control of 25% of a company’s voting stock is sufficient for control, and that presumption is rebuttable only by SEC order. The SEC takes the position that the “similar types of business” requirement modifies only the controlled companies that are used to establish primary business. In other words, Trainco’s business doesn’t have to be similar to any other company’s. Trainco with either controlled company accounts for 49% of the assets and 51% of the income. This alone might be sufficient to establish primary business; there is no exact cutoff. Trainco and both of the controlled companies account for 52% of the assets and 54% of the income. This clearly is enough to show that the primary business is not securities-related. The question is whether Compco and Paperclips are conducting similar types of business. Both are selling office equipment in a broad sense, and some office supply stores actually sell computers and computer peripherals. If this is sufficiently similar, Omega appears to qualify for the 3(b)(2) exception and is not an investment company. If not, it’s a much closer question. In either case, Omega must obtain an SEC order; the 3(b)(2) exception is not automatic.

Question 3

One possible basis of challenge is § 36(b) of the Investment Company Act, which imposes a fiduciary duty on, among others, the investment adviser of a registered investment company. The fund is a registered investment company and Adviser is its adviser, so § 36 applies.

Some jurisdictions, as in the Gartenberg case, hold that 36(b) allows a challenge only for excessive fees. The SEC would not have a claim in such a jurisdiction because of the assumption that 3.5% would not be an excessive or unreasonable fee. The most that the Fund would ever pay under this contract is 3.5%, as the Kicker is capped at 1.5% and the Base Fee is 2.0%.

However, other jurisdictions, as in Green v. Nuveen Advisory, recognize that 35(b) might create a fiduciary claim for things other than merely excessive fees. The court in that case recognizes that a fee might violate 36(b) if it gives the adviser an incentive to engage in behavior injurious to the shareholders of the fund. That’s a possibility here, as a result of the contract’s provision that the Kicker adjustment will only apply every other year. The Adviser would have an incentive to take most of its losses in “off” years, to maximize its gains in “on” years. The result would be yo-yoing fund values. In addition, as a result of the maximum cap on the Kicker, when the fund is below the maximum loss in “on” years, the Adviser would have an incentive to take undue risks to increase the fund’s return and thus increase its fee. It would have nothing to lose because its fee could not fall more.

It’s unclear how successful these arguments will be. First, Green rejected a fiduciary duty claim like this in the absence of any proof that the fund had actually been affected by the negative incentive. We don’t know if there’s any proof here that Adviser actually did what’s outlined in the prior paragraph. Second, this contract was approved by both the shareholders and the Fund’s board and § 36(b)(2) says the court may consider that in evaluating a 36(b) claim. Third, the staff approved a capped incentive fee in the IDS no-action letter without any discussion of the cap (although that approval was under the Advisers Act, not § 36).Finally, the plaintiff, here the SEC, would have the burden of proving a breach of fiduciary duty.

There is also a possible claim under § 205 of the Investment Advisers Act. Section 205(a)(1) generally prohibits any advisory contract which provides, as here, for compensation on the basis of the Fund’s capital gains. However, there’s an exception in § 205(b)(2)(A) that could apply. The Fund falls within (b)(2)(A) because it’s a registered investment company. The contract “provides for compensation based on the asset value of the company” with an increase or decrease proportionate to the “investment performance of the . . . fund . . . in relation to the investment record of an appropriate index of securities prices.” The S&P 500 is an index of securities prices.

There are three potential problems under 205(b)(2)(A). First, it’s not clear if the S&P 500 is an appropriate index against which to measure the performance of this particular fund. The problem provides no information about what the Fund invests in. The second issue is the on-and-off nature of the Kicker. Neither the statute nor any of the relevant SEC rules specifically provide for this and, as indicated earlier, it has problematic features. The third potential problem is the cap. However, the cap does not keep the Kicker from being proportionate—the upside is identical to the downside. And the SEC staff approved a performance incentive with a maximum in IDS.

Question 4

Section 10(a) of the Investment Company Act provides that no more than 60% of the directors of a registered investment company may be “interested persons,” a term that is defined in § 2(a)(19).

Zappa clearly is an interested person of the Fund. Section 2(a)(19)(A)(iii) says an interested person of the Fund’s principal underwriter is an interested person of the Fund. Section 2(a)(19)(B)(i) says any affiliated person of the underwriter is an interested person of the underwriter, and an employee is an affiliate. § 2(a)(3)(D). Thus, Zappa is an interested person of the underwriter and thus and interested person of the Fund.

Young is also an interested person of the Fund, along essentially the same line of reasoning. A director is an affiliate, § 2(a)(3)(D), so Young is an interested person of Adviser, § 2(a)(19)(B)(i), and thus of the Fund. § 2(a)(19)(A)(iii).

Xerxes is not an interested person. Any person who knowingly has a beneficial interest in any security issued by a controlling person of a principal underwriter is an interested person of the underwriter. § 2(a)(19)(B)(iii). Parent controls Underwriter because it owns more than 25% of the voting stock of Underwriter. § 2(a)(9). This presumption of control is conclusive absent an SEC order to the contrary. Id. Arguably, through his investment in the fund, Xerxes has an indirect beneficial interest in Parent itself. If he knows about this interest, Xerxes would then be an interested person of the Underwriter, § 2(a)(19)(B)(iii), and therefore an interested person of the Fund. § 2(a)(19)(A)(iii). However, Rule 2a19-3 exempts Xerxes from the definition of “interested person.” His only relationship to Parent and Underwriter is through ownership of a “broad-based securities index; under the rule, ownership of the index fund’s shares does not make him an interested person.

That leaves Williams. If he is an interested person, the board violates § 10(a) because 75% of the directors would be interested. If he is not, the board satisfies § 10(a) because only 50% of the directors would be interested. Chief, the CEO of the Fund, clearly is an affiliate of the Fund, § 2(a)(3)(D), and thus an interested person of the Fund. § 2(a)(19)(A)(i). This does not, however, make Williams an interested person. Williams probably has a material business or professional relationship with Chief, the principal executive officer of the Fund. This would be covered by § 2(a)(19)(A)(vii), but only if the SEC by order declares Williams an interested person; the subsection does not make him one automatically. Thus, absent an SEC order, this is not a problem.