SEC Modifies Conditions Relating to Section 19(b) Exemptive Order Applications

Transcription

1 May 2007 SEC Modifies Conditions Relating to Section 19(b) Exemptive Order Applications From the Investment Management Practice Group I. INTRODUCTION In October 2006 the Division of Investment Management (the Staff ) of the Securities and Exchange Commission (the Commission ) announced that the Commission would once again begin accepting applications from closed end investment companies for orders under section 19(b) ( 19(b) Orders ) of the Investment Company Act of 1940, as amended (the Act ), after an approximately two year hiatus. In doing so, the Staff set forth a number of conditions and representations (the Conditions ) that applicants were required to satisfy and make in connection with these 19(b) Orders. 1 The Commission also announced that it would entertain comments and suggestions relating to the Conditions. In December 2006, the Commission announced that it had modified certain of the Conditions (the Amended Conditions ) in connection with these 19(b) Orders. Generally, section 19(b) of the Act and rule 19b 1 2 thereunder, permit a registered investment company to make only one distribution of long term capital gains in any one taxable year. 3 Closed end funds that have implemented managed distribution plans ( Plans ) pay periodic (typically, quarterly) fixed distributions, the source of which may come from net investment income, capital gains or paid in capital. Because long term capital gains may be a source of such periodic distributions, such funds must obtain an exemption from the limitations of section 19(b) and rule 19b 1 in order to operate their managed distribution policy in the manner intended. II. SUMMARY OF CERTAIN MODIFICATIONS TO OCTOBER 2006 CONDITIONS In issuing the Amended Conditions, the Staff indicated that it did not expect to make any further global changes to the Amended Conditions and that it would not expect to entertain no action requests relating to these conditions. 4 Although the applications relating to these 19(b) Orders (the Applications ) have not been made public, in a communication to the Investment Company Institute 5 the Staff provided a copy of its notice of these Amended Conditions (the 19(b) Letters ), along with a brief explanation of the modifications to the Conditions, which are highlighted below. Sections III and IV of this Alert provide a summary of the Amended Conditions as restated in the 19(b) Letters. The most significant modifications to the representations contained in the Conditions are as follows: Deletion of Preferred Stock from Plan. The reference to preferred stock in the terms of a Plan was deleted as unnecessary and potentially confusing. Should a particular applicant seek relief in connection with preferred stock, that particular applicant is advised to add appropriate language to its Application. Conflicts of Interest. In response to requests for further clarification regarding the types of conflicts a fund s board should consider in approving the Plan, the Staff provided examples of the potential conflicts that might arise if a Plan mandates a distribution rate significantly greater than a fund s probable long term total return. In this case, the Staff noted that a conflict might arise between a fund affiliate, such as the adviser or a large shareholder, that stands to benefit in the short term from adoption of such a Plan, and the long term interests of other fund shareholders. Material Effects of Plan on Fund s Long Term Total Return. The Staff noted that it had received objections to the requirement in the Conditions that a fund s board consider, when approving a Plan, the 18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP

2 reasonably foreseeable effects of the Plan on the fund s long term total return and the expected relationship between the rate of distribution under the Plan and the fund s total return. The Staff noted that these objections argued that it would be impossible for a fund board to reasonably predict these matters. In response, the Staff stated its expectation that fund boards make informed judgments about probable material consequences of the Plan on the fund s future performance, and revised the relevant representation in the Conditions accordingly. The most significant modifications to the actual conditions contained in the Conditions are as follows: Fund Chief Compliance Officer Review and Reporting. The Staff revised the requirement of the Conditions which had obligated the board to review notices required to be sent to fund shareholders pursuant to section 19(a) of the Act and rule 19a 1 thereunder ( 19(a) Notices ) and compliance with conditions of the 19(b) Order. The Amended Conditions now require such review to be performed by the fund s chief compliance officer, who must report quarterly to the fund s board on these matters. Placement of Plan Description on Inside Front Cover of Shareholder Reports. The Conditions had required that the fund describe the Plan in a letter affixed to the shareholder report. In recognition of additional costs that would be incurred by the creation of a separate cover letter, the Amended Conditions require that the disclosure be placed on the inside front cover of each shareholder report. Communications to Third Party Information Providers. The Conditions had required a fund to provide the information in 19(a) Notices in communications with third parties who the fund has reason to believe may disseminate information about the Plan. In order to limit the burden that such a requirement might place on funds, the Amended Conditions require that such information be provided in any communication regarding distributions under the Plan by the fund or its authorized agents, to any fund shareholder, to any prospective shareholder and to any third party information provider (such as Bloomberg, Thompson, Morningstar, Lipper or Delivery of 19(A) Notices to Beneficial Owners of Fund Shares. The Amended Conditions include a new condition which requires a fund to instruct financial intermediaries who hold fund shares in street name on behalf of beneficial owners of fund shares to cause delivery of the 19(a) Notices and other required disclosures to the beneficial owners. New Conditions to Certain Public Offerings. Because of the impracticality of timely obtaining the Staff s written assurances before a fund could make a public offering of its common shares as the Staff originally required under the Conditions, the Amended Conditions now permit a fund to conduct a public offering of its common stock if it satisfies certain requirements, including a requirement that a fund s average annual rate of distribution not exceed the fund s average annual total return by more than one percentage point. III. SUMMARY OF AMENDED REPRESENTATIONS The 19(b) Letters indicate that prior to obtaining a 19(b) Order, a fund would be required to represent in its Application that it is a registered closed end management investment company and that it has adopted a Plan to make periodic, level distributions with respect to outstanding shares of common stock, based on a fixed amount per share, a fixed percentage of market price, or a fixed percentage of the fund s net asset value ( NAV ) per share. The fund would also be required to state the purpose of the Plan. The fund would further need to represent that its board of directors, including a majority of the directors who are not interested persons of the fund, as defined in section 2(a)(19) of the Act, has: approved the adoption of the Plan; requested and evaluated (and the fund s investment adviser has furnished) such information as may be necessary to an informed determination of whether the Plan should be adopted and implemented; determined that adoption and implementation of the Plan are consistent with the fund s investment objectives and policies and that the Plan is in the best interests of the fund and its shareholders, after considering the information provided by the adviser regarding (i) the purpose of the Plan, (ii) any potential or actual conflicts of interest that the adviser or its affiliates or any other fund affiliate may have relating to the adoption or implementation of the Plan, (iii) whether the rate of distribution under the Plan will exceed the fund s 2

3 expected total return (based on NAV, not on market price), and (iv) the reasonably foreseeable material effect of the Plan on the fund s long term total return (based on market price and NAV); and adopted compliance policies and procedures in accordance with rule 38a 1 of the Act reasonably designed to ensure that all 19(a) Notices, and all other communications by the fund or its agents to any fund shareholder, prospective shareholder, or third party information provider regarding distributions under the Plan (other than a communication on Form 1099) include all required disclosures under Rule 19a 1 and under the Amended Conditions. These compliance policies and procedures ( Section 19 Compliance Policies ) must also require the fund to keep records to demonstrate its compliance with all conditions of the 19(b) Order and to demonstrate the calculation of amounts disclosed in 19(a) Notices. Finally, the fund would be required to represent that its board of directors has recorded the information considered by it and the basis for its approval of the Plan in its meeting minutes, which must be preserved for a period of not less than six years from the date of the meeting, the first two years in an easily accessible place. IV. SUMMARY OF AMENDED CONDITIONS The 19(b) Letters indicate that in addition to the initial representations that must be made in the Application, each fund that receives a 19(b) Order would be subject to a number of conditions, as described below. A. Chief Compliance Officer Compliance Review and Quarterly Reports to the Fund Board The chief compliance officer of the fund ( CCO ) would be required to review the adequacy of the Section 19 Compliance Policies, and determine whether the fund and the fund s investment adviser have complied with the conditions of the 19(b) Order and whether a material compliance matter (as defined in rule 38a 1 of the Act) has occurred with respect to compliance with these conditions. The CCO would also be required to report the results of such review to the fund s board of directors no less frequently than once every three months or at the next regularly scheduled quarterly board meeting. B. Disclosures to Shareholders 1. 19(a) Notices Each 19(a) Notice would need to provide, in addition to the information required by section 19(a) and rule 19a 1, the following information in a tabular or graphical format: the disclosure required by rule 19a 1 6 on a per share basis, together with the amounts of the distribution from estimated (A) net investment income, (B) net realized short term capital gains, (C) net realized long term capital gains, and (D) return of capital 7 or other capital source, all expressed as a percentage of the total distribution amount; the fiscal year to date cumulative amount of distributions on a per share basis, together with the amounts, on a per share basis and as a percentage of such cumulative amount of distributions derived from estimated (A) net investment income, (B) net realized short term capital gains, (C) net realized long term capital gains and (D) return of capital or other capital source; the fund s (i) average annual total return for the fiveyear period ending on the last day of the month prior to the most recent distribution declaration date based on changes in NAV, compared to (ii) the current fiscal period s annualized distribution rate expressed as a percentage of NAV as of the last day of the month prior to the most recent distribution declaration date; and the fund s (i) cumulative total return based on the change in NAV from the last completed fiscal year to the last day of the month prior to the most recent distribution declaration date, compared to (ii) the fiscal year to date cumulative distribution rate expressed as a percentage of NAV as of the last day of the month prior to the most recent distribution declaration date. The total return and distribution rate here must be expressed as a percentage of NAV on a cumulative basis for the current fiscal year to the last day of the month prior to the most recent distribution declaration date and not annualized. Each 19(a) Notice would need to make specific additional disclosures. The first disclosure would instruct investors not to draw any conclusions about the fund s investment performance from the amount of the distribution or from the terms of the Plan. The second disclosure would only apply when the 19(a) Notice 3

4 included a return of capital as a component of the distribution and would require the fund to explain that (i) the fund estimates that it has distributed more than its income and net realized capital gains; therefore a portion of the investor s distribution may be a return of capital; (ii) a return of capital may occur, for example, when some or all of the money that an investor invested in the fund is paid back to the investor; and (iii) a return of capital does not necessarily reflect the fund s investment performance and should not be confused with yield or income (the Return of Capital Disclosure ). The third disclosure would relate to tax reporting and, among other things, inform investors that the actual amounts and sources of distributions reported in the Notice are only estimates and are not provided for tax reporting purposes (together with the first disclosure in this paragraph, the General Disclosures ). 2. Shareholder Reports and Prospectuses The 19(b) Letters further state that, on the inside front cover of each annual and semi annual report to shareholders, the fund would be required to (i) describe the terms of the Plan (including the fixed amount or fixed percentage of distributions and frequency of distributions); (ii) provide the General Disclosures and, if applicable, the Return of Capital Disclosure; (iii) state, if applicable, that the Plan provides that the board of directors may amend or terminate the Plan at any time without prior notice to shareholders; and (iv) describe any reasonably foreseeable circumstances that might cause the fund to terminate the Plan and any reasonably foreseeable consequences of such termination. In addition, in each annual and semi annual report to shareholders and in every prospectus on Form N 2, the fund would be required to provide the fund s total return based on changes in NAV in the financial highlights table and in any discussion about the fund s total return. 3. Additional Disclosures to Fund Shareholders, Prospective Fund Shareholders and Third- Party Information Providers The 19(b) Letters state that the fund would need to include all information contained in each 19(a) Notice, including the additional information required by the Amended Conditions, in any communication by the fund or its agents to shareholders, prospective shareholders, or any third party information providers (e.g., Bloomberg, Thompson, Morningstar, Lipper or regarding distributions under the Plan (other than a communication on Form 1099). In addition, contemporaneously with the issuance of any 19(a) Notice, the fund would be required to file a press release containing the information contained in the 19(a) Notice and must also post such information prominently on its website (or, alternatively, if the fund does not maintain a website, on the website of a fund affiliate 8 ), in each case including the additional information required by the Amended Conditions. The fund is also required to file the information contained in the 19(a) Notice and the additional information required by the Amended Conditions as an exhibit to its next filed Form N CSR. The information contained in each 19(a) Notice must remain posted on the website for no less than 24 months. C. Delivery of 19(a) Notices to Beneficial Owners The 19(b) Letters state that if a financial intermediary such as a broker, dealer, bank or other person holds shares of the fund s common stock in nominee name, or otherwise, on behalf of a beneficial owner, the fund would be required to take the following actions to effect delivery of each 19(a) Notice to beneficial owners of the fund s shares: request the financial intermediary or its agent to forward the 19(a) Notice to all beneficial owners of the fund s shares; timely provide to the financial intermediary or its agent sufficient copies of the 19(a) Notice in the form and at the location that the financial intermediary or its agent reasonably requests to facilitate the sending of the 19(a) Notices to beneficial owners of the fund s shares; and pay, upon request of the financial intermediary or its agent, the reasonable expenses of sending the 19(a) Notices to beneficial owners. D. Public Offerings of Common Stock The 19(b) Letters state that the fund would not be permitted, except under limited circumstances described below, to make a public offering of shares of its common stock. A fund would be allowed to make public offerings of its common shares involving a rights offering that meets specified conditions or an offering in connection with a dividend reinvestment plan, merger, consolidation, acquisition, spinoff or other reorganization of the fund. In addition, a fund would also be permitted to make a public offering of its common shares that satisfies each of the following conditions: 4

5 the fund s average annual distribution rate for the two years ending on the last day of the month ended immediately preceding the most recent distribution declaration date, expressed as a percentage of NAV per share as of such date, is no more than one percentage point greater than the fund s average annual return for the five year period ending on such date; the transmittal letter accompanying any registration statement filed in connection with the offering discloses that the fund has received a 19(b) Order; the common shares are issued only within the 15 day period immediately following the record date of a monthly distribution, or within the six week period following the record date of a quarterly distribution; and the prospectus for the offering clearly discloses that purchasers of the offered shares will not be entitled to receive such distribution with respect to shares issued pursuant to the offering. E. Additional Board Determinations for Funds Whose Shares Trade at a Premium In addition to the above stated conditions, the 19(b) Letters state that, in specified circumstances where the fund s common shares were trading at a premium to its NAV, 9 the Board would be required to determine whether the Plan should be continued or continued after amendment after performing an informed review and evaluation of, among other things, the accomplishment of the Plan s purpose(s), the reasonably foreseeable material effect of the Plan on the fund s long term total return (based on market price and NAV), and the fund s annualized distribution rate as a percentage of the fund s NAV over a rolling 12 week period as compared to the fund s average annual return for the 2 year period ending on the last day of such 12 week rolling period. The SEC continues to accept applications for 19(b) Orders pursuant to the Amended Conditions. We will keep you apprised of any new developments in the event that the SEC further modifies the Amended Conditions. The Staff has stated that it will seek the Commission s approval before any new 19(b) Orders will be issued and has further indicated that any 19(b) Order would expire on the effective date of any amendments to rule 19b 1 addressing multiple or periodic distributions of longterm capital gains by closed end investment companies. If you have any questions regarding the Amended Conditions or need assistance in preparing a new or amended application for exemptive relief under section 19(b) and rule 19b-1 under the Act, please do not hesitate to contact any member of our Investment Management Practice Group. Our Senior Management Team: Chair Investment Management Practice Group Michael R. Rosella mikerosella@paulhastings.com Vice Chair Investment Management Practice Group David A. Hearth davidhearth@paulhastings.com Julie Allecta julieallecta@paulhastings.com Wendell M. Faria wendellfaria@paulhastings.com Michael Glazer michaelglazer@paulhastings.com Jacqueline A. May jacquelinemay@paulhastings.com Mitchell E. Nichter mitchellnichter@paulhastings.com Domenick Pugliese domenickpugliese@paulhastings.com Gary D. Rawitz garyrawitz@paulhastings.com Arthur L. Zwickel arthurzwickel@paulhastings.com 18 Offices Worldwide Paul, Hastings, Janofsky & Walker LLP StayCurrent is published solely for the interests of friends and clients of Paul, Hastings, Janofsky & Walker LLP and should in no way be relied upon or construed as legal advice. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. These materials may be considered ATTORNEY ADVERTISING in some states. Paul Hastings is a limited liability partnership. Copyright 2007 Paul, Hastings, Janofsky & Walker LLP. IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations governing tax practice, you are hereby advised that any written tax advice contained herein or attached was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code. 5

6 1 19(b) Orders permit closed-end funds to make multiple distributions per year of long-term capital gains under a managed distribution plan. See our Client Alert dated December 2006 for further information ( PDF?wt.mc_ID=39957.pdf). As described in our Client Alert, the Commission had temporarily discontinued issuing 19(b) Orders in 2004 as it undertook a review of the continued appropriateness and effectiveness of the conditions under which such orders had been issued. 2 Rule 19b-1 was adopted November 23, See SEC Investment Company Act Release No. 6834, at 1971 SEC LEXIS Notwithstanding this general limitation, rule 19b-1 permits a registered investment company that is a regulated investment company under section 851 of the Internal Revenue Code of 1986, as amended (the Code ), to make, in addition to its one annual distribution of long-term capital gains (i) a supplemental distribution pursuant to section 855 of the Code with respect to the same taxable year and which does not exceed 10% of the aggregate amount distributed for such taxable year, and (ii) one additional distribution of long-term capital gains for the purpose of not incurring any tax under section 4982 of the Code. 4 At the same time, the Staff indicated that it might be receptive to modifying the conditions on a case-by-case basis if warranted by individual circumstances. 5 See Memorandum to Closed-End Investment Company Members No , Managed Distribution Exemptive Orders Under Section 19(b) of the Investment Company Act, April 26, 2007, Investment Company Institute. 6 Rule 19a-1 requires that each written statement accompanying a distribution to shareholders clearly indicate what portion of the payment per share is made from (i) net income for the current or preceding fiscal year, or accumulated undistributed net income, or both, not including in either case profits or losses from the sale of securities or other properties; (ii) accumulated undistributed net profits from the sale of securities or other properties; and (iii) paid-in surplus or other capital source. 7 The 19(b) Letters indicated that a fund that believes the term return of capital is not appropriate for the fund s method of accounting for 19(a) Notices can use an alternative term in its Application, provided that the fund explains, in an accompanying letter to the Application, the method of accounting and why the alternative term is appropriate and not misleading or confusing to fund shareholders. 8 For funds seeking to rely on this alternative, the third party on whose website the required information is proposed to be posted in satisfaction of this condition would be required to be included as a named applicant for the 19(b) Order. 9 The additional board determinations required by this condition are triggered only if both prongs of the following test have been met: (i) the fund s common shares trade at a premium to NAV, as averaged over a rolling 12-week period, of 10% or more; and (ii) the fund s annualized distribution rate (in relation to NAV on the last day of the rolling 12-week period) is greater than the fund s average annual total return in relation to the change in NAV over the 2-year period ending on the last day of such 12-week rolling period. The Staff notes that the purpose of this is to alert the board that the rate of distribution may not be sustainable and that amendment or termination of the Plan should be considered. 6