The affiliated transaction provisions of the Investment Company Act of

Vol. 16, No. 2 February 2009 Classifying Affiliates under the Investment Company Act by David M. Geffen The affiliated transaction provisions of the Investment Company Act of 1940 (ICA) are the ICA s third rail. These strict liability provisions regulate transactions between an investment company (fund) and its first-tier or second-tier affiliates. Violations carry severe consequences. 1 Identifying a fund s first-tier affiliates is relatively easy under the ICA. However, interpretive difficulties arise in distinguishing a fund s second-tier affiliates (that is, an affiliate of an affiliate) from more-distantly affiliated entities (for example, a third-tier affiliate), which are not subject to the ICA s affiliated transaction provisions. The resulting uncertainty means that funds and their affiliates risk violating these provisions. This article addresses this interpretive difficulty to assist funds and their affiliates in avoiding violations of the ICA s affiliated transaction provisions. David M. Geffen is Counsel at Dechert LLP. He holds an SB from the Massachusetts Institute of Technology, and a JD from Harvard Law School. Mr. Geffen s practice focuses on registered investment companies and their advisers, and he has extensive experience in all sectors of the US investment management industry. 2008. Most recently, Mr. Geffen is the author of: A Shaky Future for Securities Act Claims Against Mutual Funds, 37 Sec. Reg. L.J. (Spring 2009) (forthcoming). Applicable Law The ICA s affiliated transaction provisions protect investors from the fund s insiders using the fund to benefit themselves at the expense of the fund. The provisions have been described as being at the heart of the ICA. 2 The ICA defines the term affiliated person (affiliate) and, therefore, it normally is easy to identify a fund s first-tier affiliates by reading the definition carefully. Under Section 2(a)(3) of the ICA affiliated person (affiliate) of another person includes: (A) any person directly or indirectly owning, controlling, or holding with power to vote, 5 per centum or more of the outstanding voting securities of such other person; (B) any person 5 per centum or more of whose outstanding voting securities are directly or indirectly owned, controlled, or held with power to vote, by such other person; (C) any person directly or indirectly controlling, controlled by, or under common

control with, such other person; (D) any officer, director, partner, copartner, or employee of such other person; (E) if such other person is an investment company, any investment adviser thereof or any member of an advisory board thereof.... Under Section 2(a)(9) of the ICA, a control relationship is presumed when a person owns beneficially, either directly or through one or more controlled companies, more than 25 percent of the voting securities of a company. Thus, a parent company is deemed to control each of its subsidiaries. The ICA s affiliated transaction provisions are contained within Sections 17(a), 17(d), and 17(e) and 10(f). For example, with limited exemptions, Section 17(a) prohibits any first-tier or secondtier affiliate of a fund, acting as principal, from knowingly selling any security or other property to the fund, and from knowingly purchasing any security or other property from the fund. For brevity, the discussion below is limited to fact patterns that could fall within Section 17(a). 3 However, the method presented to distinguish second-tier affiliates from more-distantly affiliated entities applies to any transaction that approaches any of the ICA s affiliated transaction provisions. The 1970s Approach The language in Section 2(a)(3) of the ICA is clear about who is an affiliate, and the language of Section 17(a) is clear that its affiliated transaction provisions apply to first-tier and second-tier affiliates of a fund, but not to more-distantly affiliated entities. Nevertheless, in a 1971 no-action letter, without analysis, the Securities and Exchange Commission (Commission) Staff effectively disregarded the clear language in both sections by collapsing a fund adviser s parent company and the adviser, making a director of the parent company a second-tier affiliate of the fund. 4 In a 1973 noaction letter, 5 the Staff similarly collapsed a bank and its affiliate adviser, making a natural person, who had acted as counsel to the bank, an interested person of the fund within the meaning of Section 2(a)(19). 6 In effect, in both no-action letters, the Staff treated a parent and its wholly owned subsidiaries as one collapsed entity. Separately, in a 1977 administrative proceeding, the Commission suggested that investment advisers may control the funds they advise. 7 If followed, that suggestion would make funds sharing a common adviser first-tier affiliates of each other because, under Section 2(a)(3)(C), persons under common control are affiliates of each other. If these 1970s precedents control, then the Commission Staff could take the position that a fund adviser s parent should be collapsed with the adviser, making the parent company a firsttier affiliate of each of the funds advised by the adviser. The Staff also could take the position that funds with a common adviser are first-tier affiliates of one another and, therefore, a first-tier affiliate of one fund is a second-tier affiliate of the other funds. Consider Exhibit 1. Simply following the language in Section 2(a)(3) of the ICA, the Adviser is a first-tier affiliate of the Funds, as specified in Section 2(a)(3)(E). Intermediate Co. and the Adviser, as wholly owned subsidiaries of Parent, are deemed to be controlled by Parent, making Exhibit 1 Parent Adviser Intermediate Co. 12% ABC Co. Funds THE INVESTMENT LAWYER 2

Intermediate Co. a first-tier affiliate of the Adviser (under Section 2(a)(3)(C), persons under common control are affiliates of each other) and a second-tier affiliate of each Fund. Finally, because Intermediate Co. owns 12 percent of the voting securities of ABC Co., ABC Co. is a first-tier affiliate of Intermediate Co., a second-tier affiliate of the Adviser, and a third-tier affiliate of each Fund. As a third-tier affiliate of the Funds, the ICA s affiliated transaction provisions should not extend to any proposed transaction between ABC Co. and a Fund. For example, ABC Co. could issue its stock to each Fund without violating Section 17(a). However, if the 1970s precedents control, the Adviser would be collapsed with Parent. This would make ABC Co. a first-tier or second-tier affiliate 8 of each Fund, regardless of whether ABC Co. has an incentive or the ability to influence the actions of any Fund. 9 Thus, under the 1970s precedents, ABC Co. would violate the affiliated transaction provisions of Section 17(a), if ABC Co. were to issue its stock to a Fund. In retrospect, the 1970s automatic-collapse precedents employed a blunt instrument. They probably deterred a good number of transactions with entities that, at least under the plain language of the ICA, were more-distantly affiliated with a fund than second-tier affiliates. From the perspective of investor protection, some of the deterred transactions probably involved overreaching of a fund and, therefore, the transactions were justifiably deterred. However, other deterred transactions probably were arm s-length transactions lacking any overreaching, resulting in funds incurring opportunity costs. 10 More-Recent Precedents Fortunately, beginning with the 1995 Salomon Brothers no-action letter, 11 the Staff moved away from the automatic-collapse method of analysis. In the Salomon Brothers letter, Salomon advisers acted as sub-advisers to registered funds that were series of the same trust. The Staff indicated that it would take no action under Sections 17(a) and 17(e) of the ICA if a Salomon broker-dealer affiliate of the Salomon advisers effected principal and agency transactions for other portfolios that were not sub-advised by the Salomon advisers. 12 The Staff observed the inherently factual nature of the inquiry, and took no position on whether the Salomon advisers controlled the sub-advised portfolios. For purposes of its conclusion, the Staff instead expressly relied on representations by the Salomon applicants that, as sub-advisers, the Salomon advisers did not control the sub-advised portfolios. The Staff then acknowledged that, in the past, it had treated a parent and its wholly owned subsidiaries as one collapsed entity, but noted that Section 2(a)(3) of the ICA specifically provides that companies under common control, such as the Salomon broker-dealer and the Salomon advisers, are first-tier affiliates of each other. The Staff went on to conclude that, under the circumstances, there were no policy reasons to view the affiliated Salomon entities as a single entity. There was scant discussion of policy reasons, generally, although the Staff noted that Section 17 is intended to preclude insiders from benefiting themselves to the detriment of funds and their shareholders. In 1996, in the GT Global letter,13 the Staff agreed to take no action under Section 2(a)(19) where a fund trustee was a partner in a law firm that did work for a bank that was an affiliate of a fund s adviser. The Staff acknowledged that its position was a departure from a 1973 letter 14 under Section 2(a)(19), in which the Staff indicated that a person (or the partner of a person) who had acted as counsel to a bank that was under common control with a fund s adviser would be considered an interested person of the fund within the meaning of Section 2(a)(19). As part of this acknowledgement, the Staff in GT Global contrasted the collapse of the two affiliated entities in its 1973 letter and cited the Salomon Brothers letter for the proposition that, absent substantial policy reasons, we generally will not consider affiliated companies to be a single entity. Finally, in 1997, in the First Financial letter,15 the Staff rejected its own past collapses of two affiliated entities under Section 2(a)(19). In First Financial, the Staff wrote: The [S]taff in the past has collapsed secondtier affiliations into first-tier affiliations for purposes of determining an individual s status as an interested person under Section 2(a)(19) [citations]. More recently, however, the [S]taff has taken the position that it would not, absent substantial policy reasons, collapse affiliated entities for purposes of determining a person s status as an interested or affiliated person. See GT Global Growth Series (pub. avail. Feb. 2, 1996); Salomon Brothers, Inc. (pub. avail. May 26, 1995). 3 Vol. 16, No. 2 February 2009

The Salomon Brothers letter and its progeny lack any gloss on the Staff s new, general approach that, absent substantial policy reasons, the Staff no longer will collapse affiliates automatically. 16 It follows that an affiliated transaction analysis that relies on the plain language of the statutes should be accepted by the Staff as an enforcement policy matter, unless the Commission Staff believes that the results would be at odds with the policies underlying the affiliated transaction provisions of the ICA, or that a transaction is structured for the primary or sole purpose of avoiding the restrictions of those provisions. 17 The New Method Are There Substantial Policy Reasons? From Salomon Brothers and its progeny, we know that the likelihood of the Staff collapsing affiliated entities in a transaction with a fund depends on whether the transaction presents incentives and opportunity for the fund being overreached by an affiliate. This is the harm Section 17 and Section 10(f) is intended to prevent. 18 In practice, for any proposed transaction, to distinguish a second-tier affiliate of a fund from a more-distantly affiliated entity, this means that counsel should identify and weigh the incentives facing an affiliate, and assess the affiliate s ability to overreach the fund. Returning to the ABC Co. example above, some additional facts will underscore this approach. ABC Co. offers its stock through a public firmcommitment underwriting in which no member of the underwriting syndicate has a relationship with a Fund or any other company within the Parent complex. From the perspective of ABC Co., it lacks the ability to influence the portfolio managers of any Fund to purchase ABC Co. stock in the public offering. From the perspective of the Funds, admittedly, there is a remote incentive for the Adviser to direct the Funds to acquire ABC Co. shares to enhance the success of the offering and to support the market price of ABC Co. s shares in which Intermediate Co. has an ownership interest of 12 percent. However, there are incentives in the opposite direction that affect the Adviser and the Funds portfolio managers decisions whether to acquire ABC Co. s stock. Better performance by the Funds attracts assets, which leads to greater revenue for the Adviser. Further, the portfolio managers, who have been trained to seek better performance and to disregard any investments by sister companies, are compensated according to a scheme that rewards portfolio managers for better Fund performance. Based on these additional facts, counsel should be able to conclude reasonably that the mere existence of a potential conflict of interest (due to Intermediate Co. s 12 percent ownership of ABC Co.) does not constitute substantial policy reasons that would lead the Commission Staff to disregard the corporate structure and collapse the entities. Collectively, the facts the strong incentives to enhance Fund performance, the limited countervailing incentives to overreach a Fund and ABC Co. s inability to influence the Adviser and portfolio managers present a situation in which there are no substantial policy reasons for the Commission Staff to disregard the plain language of Section 2(a)(3) of the ICA. Accordingly, counsel should be able to conclude reasonably that the Staff would treat the Funds, the Adviser, Parent and Intermediate Co. as separate entities under Section 2(a)(3) of the ICA. ABC Co. would be a third-tier affiliate of the Funds and, therefore, any sale of ABC Co. stock to a Fund would be outside the scope of the affiliated transaction provisions of Section 17(a). To generalize from the example, in any proposed transaction, distinguishing a second-tier affiliate of a fund from a more-distantly affiliated entity involves considering the incentives affecting the affiliate and the ability of the affiliate to overreach the fund. Each fact pattern is different, which means that the fact-intensive analysis should evaluate and catalog carefully: (1) The set of incentives and their relative strengths; and (2) The set of restraints that thwart overreaching and the effectiveness of those restraints. If there are no or remote incentives for an affiliate to overreach, and effective restraints preclude an affiliate from overreaching, it should be reasonable to conclude that there are no substantial policy reasons to collapse affiliates of a fund in analyzing a transaction. If, instead, there are material incentives to overreach, then counsel may look for no or remote opportunities to overreach before concluding that the facts present no substantial policy reasons to collapse affiliates for purposes of analyzing the transaction. Conclusions Salomon Brothers and its progeny indicate that distinguishing a second-tier affiliate of a fund THE INVESTMENT LAWYER 4

from a more-distantly affiliated entity calls for an assessment of the potential for a conflict of interest to affect the fund. This assessment applies in any transaction that approaches the ICA s affiliated transaction provisions. The outcome of the assessment indicates whether there are substantial policy reasons to justify collapsing affiliates. The 1970s precedents are still read and confusion still lingers. Consequently, this author continues to encounter clients that are pleased to learn that a proposed transaction with a fund does not implicate the ICA s affiliated transaction provisions because the non-fund party to the transaction is no closer than a third-tier affiliate. NOTES 1. See, e.g., In the Matter of Imperial Financial Services, Inc., Securities Exchange Act Release No. 7684 (Aug. 26, 1965); In the Matter of Evergreen Investment Management Company, LLC, Investment Company Act Release No. 27973 (Sept. 19, 2007); U.S. v. Ostrander, 792 F. Supp. 241 (S.D.N.Y. 1992), aff d, 999 F.2d 27 (2d Cir. 1993). In addition, ICA Section 47(b) provides that any contract involving a violation of any provision of the ICA may be voidable. Therefore, a transaction that violates an affiliated transaction provision, in effect, may give a fund the equivalent of a put option to unwind the violative transaction at the affiliate s expense. 2. See Securities and Exchange Commission, Division of Investment Management, Protecting Investors: A Half- Century of Investment Company Act Regulation 483 (1992) [hereinafter Protecting Investors]. 3. The Securities and Exchange Commission has noted that Section 17(a) is intended primarily to proscribe a purchase or sale transaction when a party to the transaction has both the ability and the pecuniary incentive to influence the actions of the investment company. See Investment Company Act Release No. 10886 (Oct. 2, 1979), citing Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess., at 256 259 (1940). 4. See Viking Growth Fund, Inc., SEC No-Action Letter (pub. avail. Mar. 8, 1971). 5. Vestaur Securities, Inc., SEC No-Action Letter (pub. avail. Jan. 4, 1973). 6. Section 2(a)(19), among other things, defines who is an interested person of a fund. Whether a person is interested or non-interested with respect to a fund is important because Section 10(a) of the ICA requires that at least 40 percent of a fund s board members must be non-interested persons. Still other provisions of the ICA ( e.g., approval of advisory contracts and adoption of a Rule 12b-1 plan) require approval by a fund s board as a whole and by a majority of the non-interested members. 7. See In the Matter of Steadman Security Corp., Investment Company Act Release No. 9830 (Jun. 29, 1977), remanded on other grounds sub nom. Steadman v. SEC, 603 F.2d 1126 (5th Cir. 1979), aff d on other grounds, 450 U.S. 91 (1981). 8. ABC Co. s status as a first-tier or second-tier affiliate depends upon whether Intermediate Co., like the Adviser, is collapsed with the Parent. 9. See supra n.3. 10. See Protecting Investors, supra n.2 at 483. 11. Salomon Brothers Inc. (pub. avail. May 26, 1995). Arguably, there were earlier signals that the Commission and its Staff were backing away from the assumption that a fund always is controlled by its adviser. For example, in Investment Company Act Release No. 11136 (Apr. 21, 1980), the Commission proposed amendments to Rule 17a-7. In that release, the Commission cited the 1977 Steadman case for the proposition that, had an unregistered fund in question been registered, it could have relied on the Rule as it then was written. But, when the Commission adopted the amendments, it did not cite the Steadman case. Rather, it stated: The rule does not represent a Commission finding that investment companies having common officers, directors or investment advisers are always affiliated persons or affiliated persons of an affiliated person. They may or may not be, depending on the facts. The rule enables the parties to go forward without resolving that question if the requirements of the rule are met. Investment Company Act Release No. 11676 (Mar. 10, 1981). See also, Investment Company Act Release No. 11053 (Feb. 19, 1980) (using identical language in adopting Rule 17a-8); Fundtrust, SEC No-Action Letter (pub. avail. May 26, 1987) ( Investment companies with a common investment adviser are not necessarily under common control and, therefore, are not necessarily affiliated persons solely for this reason ). 12. Following the 1970s precedents, the Salomon broker-dealer and the Salomon advisers would have been collapsed into a single entity. That single entity would have been a first-tier affiliate of each portfolio sub-advised by a Salomon adviser, and a second-tier affiliate of each portfolio not sub-advised by a Salomon adviser. Thus, without the Staff s acquiescence, the ICA s affiliated transaction provisions would have applied to transactions between a portfolio not sub-advised by a Salomon adviser and the Salomon broker-dealer. 13. GT Global Growth Series, SEC No-Action Letter (pub. avail. Feb. 2, 1996). 14. Vestaur Securities, Inc., SEC No-Action Letter (pub. avail. Jan. 4, 1973). 15. First Financial Fund, Inc., SEC No-Action Letter (pub avail. Jun. 5, 1997). 16. The Salomon Brothers letter and its progeny do not disavow the Commission and Staff s statements that an adviser controls any fund it advises. The Staff stressed the fact in the Salomon Brothers letter that it is always a matter of factual determination as to whether a fund is controlled by its adviser. It is reasonable to assume that any such factual determination will turn on the context in which it is made. That is, the background question will be whether there are substantial policy reasons for reaching that conclusion. 17. Section 48(a) of the ICA makes it unlawful for any person, directly or indirectly, to cause to be done any act 5 Vol. 16, No. 2 February 2009

or thing through or by means of any other person which it would be unlawful for such person to do under the provisions of this [Act] or any rule, regulation, or order thereunder. See, e.g., Cornish & Carey Commercial, Inc., SEC No-Action Letter (pub. avail. Jun. 21, 1996); Willkie Farr & Gallagher, SEC No-Action Letter (pub. avail. Jun. 21, 1996). 18. See Section 17(b). Section 10(f) was designed to address a particular form of overreaching the use of funds by underwriters that controlled funds as a dumping ground for unmarketable securities. See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 35 (1940) (statement of Commissioner Healy). Reprinted from The Investment Lawyer February 2009, Volume 16, Number 2, pages 16-20, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, 1-800-638-8437, www.aspenpublishers.com THE INVESTMENT LAWYER 6