Mutual Fund Distribution
Robert J. Zutz
DC 1477730 v8
Mutual Fund Distribution –
Today’s Agenda
 Multiple Distribution Channels
 Methods of Compensating for Distribution
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Sales Loads
Rule 12b-1 Fees/Service Fees
Revenue Sharing
Sub-transfer Agent Payments
 Omnibus Accounts – Noteworthy Recent Developments
 Share Classes
 ETF Differences
1
Multiple Distribution Channels
 Distribution channels:
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Direct (No-Load) Channel
Broker-Dealer Channel
RIA Channel
“Supermarket” Channel
Retirement Plan Channel
Institutional Channel
Insurance Company Channel
Each Distribution Channel
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Level and types of intermediary services vary
Distribution costs and payment structures vary
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Sales Loads
Rule 12b-1 fees current)
Service Fees
Revenue Sharing Payments
Sub-transfer agent-type fees from Funds
Multiple share classes
2
Multiple Shares Classes
 Rule 18f-3
 Permits mutual funds to issue multiple classes of
voting stock representing interests in the same
portfolio
 Classes must differ in how they distribute their
securities, in the services they provide to
shareholders, or both
 Allocation of income and expenses among classes
 Master-Feeder Structure – An alternative to multiple
share classes permitted by SEC interpretations
3
Share Classes
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Class A
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Class B
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Level 12b-1 fees (asset-based sales charge and service fee ~ 100 basis points)
CDSL of 1% in the first year
Institutional
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CDSL decreases each year (such as to 5%, 4%, 3%, 2%, 1%, 0)
12b-1 fee (asset-based sales charge and service fee ~ 100 basis points)
Converts to Class A share after 6-8 years, thus lowering 12b-1 fee
Class C
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Front-end sales load
12b-1 fee (service fee ~ 25 basis points)
Breakpoints may be available
No-load and no or low 12b-1 fee
Retirement/RIA
Retirement
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Different levels of fees (Class R Shares)
4
Sales Loads
 Front-end Sales Load
 Upfront fee that decreases amount of investment
 Section 22(d) – fixes sales load and prevents variations
 Rule 22d-1 permits disclosed variations in sales loads on class level
(e.g., breakpoints)
 Deferred Sales Load (“CDSL” or “back-end”)
 Investor pays load, if any, at redemption pursuant to Rule 6c-10
 Load based on lesser of offering price at purchase or specified % of
NAV
 No Load
 Adviser pays for distribution from its profits
 Fund can be “no load,” even if charges up to a 25 basis points fee from
fund assets
 Amount of loads limited by FINRA Conduct Rule 2830
5
Suitability of Share Class –
FINRA Conduct Rule 2310
 Considerations for share class suitability include:
 Investment amount (are load reductions available?)
 Expected term of the investment
 Sales loads, fees, and expenses
 These factors affect the total return on the
investment
 An intermediary duty; not a mutual fund duty
6
Rule 12b-1 Fees
 Rule 12b-1 (adopted in 1980) permits funds to use fund
assets to directly pay for distribution expenses:
 Written plan
 Initially approved by directors (including majority of independent directors)
 Initially approved by shareholders (unless adopted prior to public sales of
fund shares)
 Annual approval of directors (including majority of independent directors)
 Board approval
 Finding that there is “reasonable likelihood that plan will benefit fund and
shareholders”
 Board quarterly review of written report of amounts spent and
reasons for expenditures
7
Rule 12b-1 Fees (continued)
 Distribution expenses:
 Compensate intermediaries for ongoing advice
and/or services to current investors
 Compensate intermediaries for administrative
services to current investors (e.g., recordkeeping,
account statements to investors)
 Advertising, printing and mailing prospectuses and
sales materials to prospective investors
8
Rule 12b-1 Fees (continued)
 Maximum fee limited under FINRA Conduct
Rule 2830
 100 basis points maximum
 75 basis points maximum for asset-based sales charge
 25 basis points maximum for service charge
 NASD Notice to Member 93-12 defines “service fees”
 Rule 2830 limits aggregate amount of sales load
and/or 12b-1 fee
 Used as alternative or in addition to a sales load
 Issues: transparency and complexity
9
Rule 12b-1 Fees (continued)
 Some 12b-1 plans are structured as socalled “reimbursement’ plans
 Some 12b-1 plans are structured as socalled “compensation” plans
10
Revenue Sharing
 Fund adviser or affiliate pays for fund distribution
 Adviser can pay from “legitimate” profits that are
not “excessive” per SEC interpretation (although
the U.S. Supreme Court suggests otherwise)
 Disclosure of revenue sharing arrangements
 Fund disclosure
 Possible point of sale disclosure
11
Omnibus Accounts
 The Growth in Use of Such Accounts
 Recent SEC Responses to this Growth
 Increased Fees/Source of Payments
 SEC Guidance Regarding Payments
 Required Findings by Mutual Fund Boards
 Developing Due Diligence Activities
 SEC Sweep Examinations
12
ETFs
 ETFs only sell and redeem their shares at NAV
directly to unaffiliated broker-dealers with whom the
ETF has entered into an agreement (“Authorized
Participants”)
 Exemption to Section 22(d): permits price
competition by permitting selling brokers to set sales
commission for share classes offered at NAV without
ongoing sales charge
 All “primary market“ transactions by ETFs occur in
large blocks of (at least 25,000) shares called
“Creation Units”
13
ETFs
 Authorized Participants purchase and redeem
Creation Units in kind in exchange for the “Creation
Basket”
 Pro rata slice requirement
 Exceptions to pro rata slice requirement
 Custom baskets
 Authorized Participants who purchase Creation Units
sell individual fund shares on the stock exchange
 No sales loads (or CDSCs) or Rule 12b-1 fees on
ETFs
14
Questions?
Contact information:
Robert J. Zutz
Phone: 202.778.9059
Email: robert.zutz@klgates.com
15
Compliance and Examinations
Andras P. Teleki
DC 9568152 v2
Discussion Overview
I.
Duty to Establish a Compliance Program
II.
Chief Compliance Officer
III. Written Policies and Procedures
IV. Annual Review Process
V. SEC Examinations
1
Duty to Establish a
Compliance Program
Rule 38a-1 Requirements
 Adopt and implement written policies and
procedures
 Designate a Chief Compliance Officer (“CCO”)
 Review the compliance program
 Report to the Board
 Maintain records
3
Board Approval
 Compliance program of the Fund
 Compliance program of the Fund’s service
providers
 Reliance on summaries and third-party reports
 Amendments and annual re-approval not
required
4
Chief Compliance Officer
CCO Requirements
 Board must designate a CCO
 Competent and knowledgeable
 Empowered with full responsibility and authority
 Position of seniority and authority
 Duty to administer the compliance program
6
CCO Duties
 Ensuring compliance program is comprehensive
and current
 Conducting annual compliance review
 Reporting to the Board
 Implementing any material recommendations
 Advising senior management on compliance
matters
 Being the “go to person” on compliance issues
7
Independence of the CCO
 Board hires and fires
 Board sets compensation
 Direct reporting line to the Board
 Annual executive session meetings with the Board
8
Written Policies and Procedures
Compliance Program
Requirements
 Coverage of policies and procedures
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Culture of compliance
Delegation of responsibility
Training
Monitoring and auditing
Response, prevention and evaluation
 One size does not fit all
 Risk assessments
 Must be dynamic
10
Annual Review Process
Annual Review
 Compliance rule requirements
 Testing schedule
 Remediation schedule
 Leverage work being done by others
 Maintain documentation
12
Annual Report
 Written report to the board must discuss:
 Operation of the program
 Material changes to the program
 Material compliance matters
 Annual report considerations
13
Material Compliance Matter
 Compliance rule definition
 any compliance matter about which the board would
reasonably need to know to oversee fund
compliance
 violations of federal securities laws
 violations of policies and procedures
 weakness in design or implementation of policies and
procedures
14
SEC Examinations
Regulatory Environment
 Ponzi schemes – Madoff
 Pressure for OCIE to perform
 Enforcement Division – Asset Management Unit
 Increasingly complex regulatory environment
 Additional voices beyond the SEC
16
Exam results
 Enforcement actions originate from exams
 Enforcement action consequences
 Face-to-face interactions with SEC staff
 Deficiency letters
17
Exam preparation
 Contact person
 Notify management and personnel
 Prior exam records
 Examiner work area/resources
 Opening presentation
 Office tour
 Business cards
 Exit interview
18
Questions?
Portfolio Brokerage Practices
K. Susan Grafton
DC 1477775 v7
Discussion Overview
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Market Structure Developments
Best Execution
Soft Dollars
Rule 105 of Regulation M
1
MARKET STRUCTURE
DEVELOPMENTS
Tick Size Pilot Program
 One year pilot program to be developed and filed jointly by FINRA and the
exchanges
 Filed with the SEC: August 25, 2014
 Pilot Securities
 NMS common stocks with (a) a market capitalization of $5 billion or less; (b) an
average daily trading volume of one million shares or less; and (c) a share price
of $2 per share or more
 No recent IPO stocks
 Pilot Design: each group has 300 securities
 Control Group: Current quote and trading increments
 Test Group One: Minimum quote increment of $0.05 minimum
 Test Group Two: Minimum quote and trade increments of $0.05. Exceptions for:
(1) trades at the mid-point, (2) trades that provide price improvement and
(3) negotiated trades with performance targets (e.g., VWAP)
 Test Group Three: Minimum quote and trade increments of $0.05, plus a “tradeat” requirement to prevent price matching by a trading center not displaying the
NBBO
3
Pending Developments
 Regulation of high frequency traders
 Guidance on “traders exception” from the definition of
“dealer” in Section 3(a)(5) of the Securities Exchange Act
of 1934
 Elimination of exception from FINRA membership
 Increased Disclosure
 Institutional investor order routing information
 Order types
 Payment for order flow and rebates
 Alternative trading systems
4
Disruptive Trading Practices
 In re Athena Capital Research, LLC,
Release No. 73369 (Oct. 16, 2014)
 First high speed trading manipulation case
 “Marking the Close”
 Development of anti-disruptive trading rule
 Risk management of algorithmic trading
5
BEST EXECUTION
Duty of Best Execution
 Generally, best execution is the duty to obtain the best
price given the portfolio manager’s objective
 Derives from common law and the anti-fraud provisions
of the federal securities laws, particularly Section 206 of
the Investment Advisers Act of 1940
 SEC v. Capital Gains Research Bureau, 375 U.S. 180
(1963):
 Section 206 imposes a fiduciary duty on investment advisers
 Duty of loyalty and duty of care
7
Factors in Evaluating Execution
Quality; Not Just Price
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Price and price improvement
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Access to market centers and
other market participants
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Speed
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Certainty of execution
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Low trading errors and willingness
to correct mistakes
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Responsiveness
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Commission and commission
equivalent rates
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Value of research
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Confidentiality
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Order handling capabilities, such
as block and complex trades
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Reputation
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Capital adequacy
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Expertise with relevant markets or
securities
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Back office capabilities, including
automation and trade reporting
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Assistance in finding liquidity and
willingness to commit capital
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Past experience
8
Establishing a Compliance Program
 Implement and update written compliance policies and procedures
addressing best execution:
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Broker selection
Methods and measures for evaluating execution quality
Allocation of desk or trader responsibility for particular funds, investing style,
and geographic and industry sectors
 Establish a best execution committee with appropriate procedures
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Committee meetings should be periodic and systematic
Minutes should be made and maintained under direction of legal
 Implement and test systems for monitoring executions
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Determine tools that will be used
 Broker-dealers’ “dash reports” (Exchange Act Rules 605 and 606)
 Other vendors (e.g., TAG)
 Provide periodic training to relevant personnel
9
Trading Desk Compliance
 Focus should be on obtaining the best price given the portfolio
manager’s objective
 Trading desks should have the necessary tools, including an:
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Effective execution management system
Timely and accurate market data as needed to determine the best price of a
security
Protocols and mechanisms for handling trade aggregation, trade allocation, and
trade sequencing
Procedures for complying with regulatory requirements relating to cross and
agency-cross trades and principal transactions
Client account instructions, including account objections, use of soft dollars, and
disallowed brokers
 Guidance should be provided regarding the number of dealers that
should be contacted to obtain a price, particularly for illiquid and
thinly-traded securities
10
Post-Trade Review and Analysis
 Periodic and systematic meetings of the best execution committee
to review execution quality
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Analyze execution quality based on statistical information
Review executing brokers, including with respect to the reasonableness of
commissions and commission equivalents, soft dollar arrangements, potential
conflicts of interest, any credit or other financial issues regarding the broker,
news relating to litigation, regulatory investigations, and other qualitative factors
Desk errors or mistakes
Systems issues
Available third-party data
 Determine and assign responsibility for pre-meeting preparation
 Assign responsibility for implementing any needed changes based
on review
 Make and keep relevant records
11
SOFT DOLLARS &
DIRECTED BROKERAGE
Overview of Soft Dollar
Arrangements
 Practice by which investment advisers use client
commissions, rather than out-of-pocket funds, to
pay for brokerage and research services provided
by broker-dealers
 Reflects the perceived value of research and
brokerage services in managing client accounts,
notwithstanding fiduciary principles requiring
investment advisers to seek the best execution of
client trades and to refrain from using client assets
for their own benefit
13
Section 28(e) Safe Harbor
 In 1975, Congress enacted Section 28(e) of the
Exchange Act to provide investment advisers with a
safe harbor from liability for a breach of fiduciary
duty solely because the adviser paid more than the
lowest commission rate in order to receive
“brokerage and research services” provided by a
broker-dealer
 The adviser must determine, in good faith, that the
amount of the commission is reasonable in relation
to the value of the brokerage and research services
received
14
Elements of the Section 28(e)
Safe Harbor
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The investment adviser must exercise investment discretion for the
account;
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The adviser must determine in good faith that the amount of commissions
is reasonable in relation to the value of products or services received;

May be for a particular transaction or with respect to overall responsibilities
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Only agency or eligible riskless principal transactions satisfy Section 28(e);
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The services received must be eligible brokerage or research services that
provide “lawful and appropriate assistance” to the money manager in the
performance of its investment decision-making responsibilities; and
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Commissions must be paid to a broker-dealer that “effects” the trades
and/or “provides” the eligible product or service
15
Section 28(e) Eligible Research

Advice as to the value of securities; the advisability of investing in,
purchasing, or selling securities; and the availability of securities or
purchasers or sellers of securities
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Analyses and reports concerning issuers, industries, securities, economic
factors and trends, portfolio strategy, and the performance of accounts

Form is irrelevant – includes paper, electronic, and oral discussions

Must be the “expression of reasoning or knowledge”

Potentially eligible research includes research reports, market color,
investment seminars, meetings and discussions with research analysts and
company executives, trade analytics, proxy services that are reports on
issuers and securities, certain software, and market and economic data
services

Ineligible research includes mass-market publications (WSJ), operational
overhead (salaries, rent, equipment, telephone lines), proxy services relating
to the mechanical aspects of proxies, computer hardware, and travel
16
Section 28(e) Eligible
Brokerage Services
 Executing securities transactions
 Performing functions that are incidental thereto
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Clearance, settlement, and short-term custody related to particular trades
Post-trade matching of information
Electronic communications related to trades, allocations, and settlement
 Temporal standard for determining if services relate to the execution
of trades
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Begins when the adviser communicates with the broker-dealer for the purpose of
transmitting an order for execution, and
Ends at the conclusion of a trade’s clearance and settlement (i.e., when
securities or funds are delivered or credited to the advised account)
 Ineligible brokerage services include equipment, portfolio
management software, compliance testing, trade financing, long-term
custody, and prime brokerage services, including stock loan
17
Mixed Use Research and
Brokerage Services
 “Mixed use” means that eligible products or services
have eligible and non-eligible uses
 An inherent conflict exists because the non-eligible
use benefits the adviser
 The conflict is managed by the adviser making a
reasonable allocation of the value of the mixed use
service between eligible and non-eligible uses
 Adequate books and records are needed to support
allocations
18
“Effecting” Trades
 A broker-dealer effects a trade if it:
 Executes, clears, or settles the trade; or
 Performs one of four specified functions and
allocates the other functions to another broker-dealer
 Takes financial responsibility for trades until settlement
 Maintains records
 Monitors and responds to customer comments concerning
the trading process
 Monitors trades and settlements
19
“Providing” research or
brokerage services
 Broker-dealers provide research or brokerage
services if they:
 Prepare the research;
 Are financially obligated to pay for the research; or
 Are not financially obligated to pay for the research,
but take reasonable steps to assure themselves that
client commissions are used only for eligible research
and brokerage (i.e., no red flags)
20
Client Commission
Arrangements
 SEC guidance has facilitated the use of soft dollar aggregators
and service providers that are not registered broker-dealers
 See Goldman, Sachs & Co., SEC No-Action Letter (Jan. 2007)
 Conditions of the no-action relief:
 The adviser must independently value the services;
 The executing broker may not participate in valuing the services;
 Payments to the service provider must be from a commission pool that
the executing broker and adviser have agreed to set aside for obtaining
services;
 Payments may not be conditioned on the execution of transactions in
securities that are described in the research; and
 Service providers cannot perform other functions typically characteristic
of acting as a broker-dealer
21
Directed Brokerage
 Directed brokerage involves an advisory client directing transactions
to a particular broker and receiving products or services directly from
the broker
 Full and fair disclosure must be provided to advisory clients of:
 The existence and terms of practice regarding brokerage transactions, and the
effect of such practices on commissions
 The effect of client directed brokerage on the adviser’s ability to obtain volume
discounts, negotiate commissions, or achieve best execution for some
transactions
 The potential for disparities in commission charges
 The potential conflicts of interest
 Disclosures should be included in Form ADV, fund prospectuses, and
the investment management contract and updated as appropriate
 Compliance procedures should address the use of directed brokerage
 See In re Mark Bailey & Co., Advisers Act Release No. 1105 (Feb. 24,
1988)
22
Compliance Considerations
 Written policies and procedures, including recordkeeping
 Approval and compliance procedures, including:
Confirming the eligibility of products and services
Reviewing the eligibility of executions (i.e., agency or eligible riskless principal)
Evaluating broker-dealers
Analyzing brokers’ soft dollar reports with internal records
Reviewing allocations of mixed use products and services
Evaluating appropriate use of commissions (e.g., use of commissions paid by
indexed funds)
 Confirming consistency with disclosures and procedures
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 Oversight and periodic review of soft dollar and directed brokerage
arrangements for compliance
 Employee training
23
RULE 105 OF REGULATION M
Rule 105 in a Nutshell
 Rule 105 prohibits short sales of equity securities that
are the subject of a firm commitment cash offering
pursuant to a registration statement by any person who
purchases the offered securities from an underwriter or
broker-dealer participating in the offering.
 Restricted Period: Short sales are prohibited during the
shorter of the period beginning (a) five business days
before the pricing of the offering and ending with the
pricing, or (b) with the initial filing of the registration
statement or notification and ending with the pricing.
25
Key points about Rule 105
 “Per se” violation; no intent requirement
 “Short sale” has the same meaning as in Regulation
SHO
 Rule 200(a) of Regulation SHO defines a “short sale”
as “any security which the seller does not own or any
sale which is consummated by the delivery of a
security borrowed by, or for the account of, the seller.”
 Only applies to equity securities
 Does not apply to reference securities or to best
efforts offerings
26
Excepted Activity –
Bona Fide Purchases
 Purchases in an offering are permitted notwithstanding a short
sale during the restricted period if:
 The number of shares purchased must at least equal the entire amount
of the shares sold short during the restricted period;
 The purchase must be bona fide (i.e., even if the purchaser is in
technical compliance with this exception, the purchaser must be subject
to the economic risks associated with a purchase for value);
 The purchase(s) must be reported transactions and effected during
regular trading hours by or before the end of the regular trading session
on the business day prior to the day of pricing;
 The purchases must occur after the last short sale; and
 The short seller cannot effect reported short sales during the last 30
minutes of regular trading on the business day before pricing.
27
Excepted Activity –
Separate Accounts
 Short sales in separate accounts may be disregarded
for purposes of determining eligibility to purchase
securities in an offering.
 “Account” can include “portions of a particular fund,”
a “unit,” a “department” or an “identifiable division.”
 Decisions regarding securities transactions for each
“account” must be made separately and without any
coordination of trading or cooperation among or
between accounts.
28
SEC Guidance on
Separate Accounts

Separate and distinct investment and trading strategies and objectives

Separately assigned personnel with no coordinated trading

Information barriers
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
No sharing of information about securities positions and investment decisions
Separate profit and loss statements
No allocation of securities between or among accounts

No authority of senior supervisory or managerial personnel to execute or
preapprove trades in individual securities for the different accounts

Account owners of multiple accounts cannot execute or have the authority
to execute trades in individual securities in the accounts, or pre-approve or
have the authority to pre-approve trading decisions for the accounts.
29
Excepted Activity –
Investment Companies
 A registered investment company may purchase
securities in an offering without regard to short sales by
an affiliated investment company or series of such a
company, or a separate series of the investment
company.
 This exception is based on the prohibition under 1940
Act Section 17(d) and Rule 17d-1, which generally
prohibit any arrangement or concerted action between
affiliated persons of registered investment companies.
30
QUESTIONS?
Exchange-Traded Funds (ETFs)
Stacy L. Fuller
DC 9870843 v1
What are ETFs?
 Registered investment company with
hybrid structure – characteristics of openend (mutual) and closed-end funds
 Classified under the 1940 Act as open-end
funds, but trade intra-day on stock exchanges
like closed-end funds
 Retail investors buy and sell on a stock
exchange, rather than in transactions directly
with the fund
1
Why are ETFs sometimes
referred to as ETPs?
Distinguishing ETPs and ETVs
 ETPs: Commodity funds, currency funds
 ETVs: Generic
Not ETNs
 Unsecured, debt securities
 Unlike ETFs and ETPs, ETNs are not equity
securities
2
How do ETFs work?
 ETFs sell and redeem their shares at NAV
directly to unaffiliated broker-dealers with
whom the ETF has entered into an
agreement (“Authorized Participants”)
 These “primary market” transactions occur
in large blocks of (at least 25,000) shares
called “Creation Units”
3
How do ETFs work?
 Authorized Participants purchase and
redeem Creation Units in kind in exchange
for the “Creation Basket”
 Pro rata slice requirement
 Exceptions to pro rata slice requirement
 “Custom” baskets
 Authorized Participants (who purchase
Creation Units) sell individual fund shares
on the stock exchange
4
How do ETFs work?
Secondary Market
Hedging –Futures/
ETFs
Primary Market
Subscription in kind –
The AP delivers a basket of
securities and the ETF issues
shares
Buy / Sell
Order
Stock Exchange
Bid/offer
Price
Brokers
Authorized Participants
Private
Investors
Securities
ETF
Redemption in kind –
The ETF delivers the
securities and the shares are
redeemed
Secondary Market
Primary Market
5
How do retail investors
buy ETFs?
6
Business considerations
7
Why have ETFs become
more popular?
Changes in Distribution Models
Demand (by RIAs) due to
 Lower Expenses
 Enhanced returns
 Transparency
 Tax Efficiency
 Investor Protections
 Intra-day liquidity
 Market timing
8
Is anyone doing
non-transparent active ETFs?

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


Vanguard – 2007
Guggenheim – 2008
Blackrock – 2011
Precidian – 2013
SSgA – 2013
T. Rowe Price – 2013
Capital Group – 2014
Cohen & Steers – 2014
Fidelity – 2014
9
How would non-transparent
active ETFs work?
 Tracking Portfolio
 Guggenheim
 Partial Transparency
 Vanguard
 T. Rowe Price
 Fidelity
 Blind Trust

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Blackrock
Precidian
SSgA
Capital Group
 All of the Above
 Cohen & Steers
 Other
 Eaton Vance
10
Are any of the non-transparent
ETF structures patented?
 TRACKING PORTFOLIO – “Black Box”
 Guggenheim (only known licensee)
 BLIND TRUST – Precidian
 Sliding Scale License Fee
 Blackrock (first licensee), SSgA (second licensee)
 NAV-BASED TRADING – Eaton Vance
 “Low Single Digits” License Fee
 No known licensees
11
Who should we call with
questions?
Stacy L. Fuller
202.778.9475
stacy.fuller@klgates.com
12
Federal Tax Aspects Affecting
Mutual Funds
Theodore L. Press
DC 1251690 v8
Regulated Investment
Companies (“RICs”)
 Open-end funds (“mutual funds”)
 Closed-end funds
 Most exchange-traded funds (“ETFs”)
Receive “pass-through” treatment under
Subchapter M
1
Requirements for RIC Treatment
 Domestic corporation (or entity classified as such)
 Registered under 1940 Act (or BDC election)
 Election to be a RIC – Form 1120-RIC
 Gross Income Requirement – 90% of gross income
 Passive income
 Net income derived from an interest in a “qualified publicly traded
partnership”
 Income from commodities
 Revenue rulings; exceptions
 Private letter rulings (suspended)
 RIC Modernization Act
2
Requirements for RIC Treatment
(continued)
 Diversification Requirements – close of
each taxable year quarter (different from
1940 Act requirement)
 50% of assets
 5% of assets in a single issuer
 10% of a single issuer’s voting securities
 Specific instruments (including repos and
government securities)
 25% of assets
3
Requirements for RIC Treatment
(continued)
 Diversification Requirements (continued)
 No disqualification for certain failures to
comply
 Exception for market fluctuations and distributions
 30-day cure period
 RIC Modernization Act – “inadvertent” failure (i.e.,
failure “due to reasonable cause and not due to
willful neglect”) and de minimis failure
4
Requirements for RIC Treatment
(continued)
 Distribution Requirement
 90% of investment company taxable income
 Includes net short-term capital gain
 Includes net foreign currency gains and losses
 90% of net tax-exempt income
 Net capital gain
 “Year-end Dividend Rule”
5
Tax Treatment of Shareholders
 Income Dividends
 Qualified dividend income (individuals) –
15% and 20% maximum tax rates
 Dividends-received deduction (corporations)
 Capital Gain Dividends
 Former designation requirement (within 60 days after
taxable year-end) replaced, by RIC Modernization Act,
with reporting requirement
 15% and 20% maximum tax rates for individuals
 Undistributed Net Capital Gain
6
Tax Treatment of Shareholders
(continued)
 Exempt-Interest Dividends
 50% diversification requirement
 Interest-Related Dividends (“qualified net
interest income”) and Short-Term Capital Gain
Dividends
 Foreign shareholders
 Applicable only for taxable years beginning before
January 1, 2014; possibly extended
 Pass-through of Foreign Taxes Paid
7
Tax Treatment of Shareholders
(continued)
 Disposition of Shares
 Taxable gain or loss – redemption, sale, or exchange
 15% and 20% maximum tax rates for individuals
 Disposition of shares within 90 days
 Limited to acquisitions by following January 31, by RIC
Modernization Act
 “Wash” sales
 Sales after short holding period
 Basis election/reporting
 3.8% tax on “net investment income”
8
Tax Treatment of Shareholders
(continued)
 Disposition of Money Market Fund (“MMF”) Shares
 Stable NAV – no taxable gain or loss
 New SEC rules – institutional non-government MMFs
must price shares using market values – “floating NAV”

Dispositions could result in taxable gain or loss
 Prompt Treasury/IRS response



New revenue procedure - “wash” sales rules will not apply
Proposed regulations – “NAV method” permits aggregating
gain/loss during a “computation period” (taxable year or shorter
period)
Proposed regulations - Form 1099 information reporting not
required for disposed shares
9
Income Tax Treatment of a RIC
 Investment Company Taxable Income –
taxable income with adjustments
 Net capital gain excluded
 No net operating loss or certain other
deductions
 Dividends-paid deduction
 Dividends paid during the taxable year
 Year-end Dividend Rule
 “Spillover dividends”
10
Excise Tax on Undistributed
Income and Gains
 4% Tax
 Measured by calendar year, not taxable year
 98% of ordinary income
 98.2% of capital gain net income
 98% before RIC Modernization Act
 100% of “prior year shortfall”
 Include dividends deemed paid under Yearend Dividend Rule but not spillover dividends
11
Master-Feeder Structure
 RICs and other “institutional investors”
invest (as “feeder funds”) in a “master
fund”
 Non-corporate registered management
company
 Partnership classification – “check-the-box”
 Publicly traded partnership
 Not registered under Securities Act of 1933, as
amended
 Private placement safe harbor
12
Multiple Class Arrangements
 Preferential Dividend Rule
 Within class or between classes
 RIC Modernization Act – inapplicable to “publicly offered RICs”
 Private Letter Rulings
 12b-1 fees are shareholder expenses!
 Revenue Procedure 96-47
 Safe harbor
 Language similar to Rule 18f-3 under 1940 Act
 Revenue Procedure 99-40
 Waivers and reimbursements
13
Fund of Funds
 Reimbursement of Upper-Tier Fund of Funds’
Expenses
 General principle – corporation’s payment of
shareholder’s expense is constructive dividend
 Private letter rulings – not a preferential dividend
 Before RIC Modernization Act, couldn’t use for
RICs that wanted to pay exempt-interest
dividends or to pass through foreign taxes; now
“qualified funds of funds” may do so
14
Erisa For Investment Advisers
William A. Schmidt
With appreciation to Bill Wade,
Partner, Los Angeles
DC 9567585 v1
Overview
 The Basics
 Fund Perspectives
 New Disclosure Obligations
1
ERISA: THE BASICS
What is “ERISA”?
 Employee Retirement Income Security Act
 Federal law regulating benefit plans
 State laws preempted
 Other Federal laws (Advisers Act) apply
3
What Plans are Covered
by ERISA?
 Corporate retirement plans
 Corporate “welfare” plans
 Union retirement/welfare plans
 “Taft-Hartley” plans
4
What Plans are Not Covered
by ERISA?
 Self-employed (“Keogh”) plans
 Individual retirement accounts
But, . . .
Internal Revenue Code Section 4975
5
What Plans are Not Covered by
ERISA? (continued)
 Government plans
 Church plans
 Foreign plans
6
“Fiduciary” Status
The key ERISA concept
 Fiduciary status is “functional”
 Basic fiduciary functions include (but are
not limited to):
 Investment discretion
 Investment advice
7
Fiduciary Duties – General
 “Solely in the interest”; “exclusive purpose”
 Prudence; diversification
 Comply with plan documents
 Duty of disclosure – an evolving concept
 Avoid prohibited transactions
 Employer securities rules
8
Consequences of Breach
of Fiduciary Duty
 Restore “losses”
 Disgorge “profits”
 “Equitable relief”
 Excise tax under Code Section 4975
 “Correction” of prohibited transaction
9
Fiduciary Duties – Prohibited
Transactions
Two categories of prohibited transactions:
 “Fiduciary” prohibited transactions –
transactions involving self dealing or
conflicts of interest by plan fiduciaries
 “Party in interest” transactions –
transactions between a plan and a “party
in interest” of the plan
10
“Fiduciary” Prohibited
Transactions
 Statutory prohibition against fiduciary self
dealing and conflicts of interest
 General principles in DOL regulation
 Examples:
 Compensation arrangements
 Cross trades
 “Kickbacks”
11
“Party in Interest” Prohibited
Transactions
 Plan fiduciary may not cause plan to engage in
any of following transactions if fiduciary knows or
should know the transaction is with a “party in
interest”:




Sale, exchange, lease
Loan, extension of credit
“Use” of plan assets for benefit of party in interest
Services
12
“Party in Interest” Prohibited
Transactions
 Who is a “party in interest”?
Plan Sponsor:
Employer,
Union
Plan
Fiduciaries
(e.g., Investment
Managers)
Other
Service
Providers
(e.g., brokers,
custodians
PLAN
And, certain affiliates and parties related
to the persons described above
13
ERISA AND INVESTMENT FUNDS
Fund Perspective
 Mutual Funds
 Bank Collective Trusts
 Insurance Company Separate Accounts
 Private Investment (Hedge) Funds
15
Does ERISA Apply?
(Are Fund Assets “Plan Assets”?)
If fund assets are “plan assets” –
 Fund manager is an ERISA “fiduciary”
 Plans have “undivided interests” in all fund
assets
 Fund transactions subject to ERISA restrictions,
including prohibited transactions
 Exculpation, indemnity of fund manager limited
16
“Plan Assets”?
 Registered investment company – mutual fund
or closed-end fund?
NO
 Bank collective trust fund
YES
 Insurance company pooled separate account
YES
17
What about Private
(Hedge) Funds?
The “25% Test” –
Assets of a private investment fund are treated
as “plan assets” if benefit plan investors hold
25% or more of any class of equity interests in
the fund – not counting any interests held by the
fund manager or its affiliates for their own
account.
18
The Numerator:
“Benefit Plan Investors”
Defined in ERISA § 3(42):
 Plans subject to ERISA
 Plans subject to Code Section 4975
 “Plan asset” funds
19
25% Test – The Formula
Numerator:
ERISA plans
plus Code 4975 plans
plus “Plan-asset” funds (ERISA “portion”)
Denominator:
Investments by all investors
less investments by fund manager and
“affiliates”
= 25%
(or
more)
per
class?
20
NEW DISCLOSURE OBLIGATIONS
Overview
 Schedule C of Form 5500
 “Service Provider Information”
 Effective for 2009 Form 5500
 Service Provider Exemption
 New Regulations under ERISA 408(b)(2)
 Effective July 1, 2012
 Participant Disclosures
 New Regulations under ERISA 404(a)
 Initial disclosures for most plans required by August 31, 2012
22
Initial Considerations
 Which plans are covered?
 Who must disclose?
 To whom must disclosure be given?
 How must disclosure be made?
 When must disclosure be given?
 What must be disclosed?
23
Which Plans are Covered?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
“Large Plan” (100 or
more participants).
Plans subject to
ERISA.
Participant-directed
plans.
Welfare plans to be
addressed later.
IRAs, Keogh plans,
“top hat” plans, single
participant corporate
plans should not be
covered.
24
Who Must Disclose?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
Plan Administrator
of plan with 100 or
more participants.
“Covered Service
Provider” who:
Plan Administrator
of participant-directed
plan.
contracts with plan,
However,
service providers
expected/required to
provide information to
plan administrator on
request.
However,
expects to receive ≥
plan administrators
$1000, and
will request info from
providers of
“designated
acts as fiduciary or
investment
RIA, or provides
certain other services. alternatives.”
25
To Whom Must Disclosure be Given?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
Plan Administrators
file Form 5500 with
DOL/IRS.
Service provider
required to disclose
information to
“Responsible Plan
Fiduciary” (i.e.,
fiduciary who causes
plan to enter into
contract with service
provider).
Plan Administrator
required to give
information to plan
participants and
beneficiaries.
(Service providers
expected/required to
provide information to
Plan Administrators.)
(Plan Administrators
will request
investment info from
service providers.)
26
How Must Disclosure be Made?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
Plan Administrator
Covered service
must report information provider must
on Form 5500.
disclose information
to Responsible Plan
Fiduciary in writing.
(Form of service
Plan Administrator
generally must
provide information in
writing.
provider disclosure to
Plan Administrator not (DOL may clarify
specified – presumably whether disclosures
in writing.)
may be provided by
ADV Part 2 or fund
documents.)
Pending further
guidance, certain
information may be
provided
electronically (see
Tech Rel. 2011-03).
27
When Must Disclosure be Given?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
Form 5500 is due July Service provider must
31 of each year
disclose information
(unless extended).
“reasonably in
advance” of date of
contract (or contract
“Covered Service
extension / renewal).
Provider” must
Disclosures required
on or before date a
participant first may
direct investments
under the plan.
provide info within 30
days of receipt of Plan Notice of changes not
Administrator’s written later than 60 days
request.
after service provider
is informed of change.
Participants to receive
annual disclosures.
Web site content to be
kept up to date.
28
What Must be Disclosed?
Schedule C
(Form 5500)
Service Provider
Exemption
Participant
Disclosures
 “Compensation”
(money or
“anything of
value”), if ≥ $5000.
 Services provided
 Plan-related
information
 Direct
compensation
 Indirect
compensation
 Status statement
 “Compensation”
(anything of
monetary value) –
direct, indirect,
termination, “offset”
compensation
 Information related
to “Designated
Investment
Alternatives”
29
CONCLUSION