-------------------- BEGINNING OF PAGE #1 ------------------- TESTIMONY OF BARRY P. BARBASH, DIRECTOR DIVISION OF INVESTMENT MANAGEMENT UNITED STATES SECURITIES AND EXCHANGE COMMISSION CONCERNING H.R. 2519 THE PHILANTHROPY PROTECTION ACT OF 1995 BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE COMMITTEE ON COMMERCE UNITED STATES HOUSE OF REPRESENTATIVES October 31, 1995 Chairman Fields and Members of the Subcommittee: I am pleased to testify this afternoon on behalf of the Securities and Exchange Commission about the Philanthropy Protection Act of 1995. The Act is designed to clarify and expand the exemptions in the federal securities laws for charitable organizations. This legislation was introduced in response to a class action lawsuit that alleges, among other things, that certain common fundraising and investment management activities of charitable organizations subject those organizations to the full panoply of federal securities regulation. The Act would confirm that charitable organizations may engage in these activities without triggering the registration provisions of the federal securities laws. Background: Existing Provisions of the Securities Laws Section 3(c)(10) of the Investment Company Act of 1940 ("Investment Company Act"),-[1]- as currently written, excludes from the definition of investment company any company organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes (collectively, "charitable organizations"), so long as no part of the company's net earnings inures to the benefit of any private shareholder or individual. Language substantially identical to that in section 3(c)(10) of the Investment Company Act appears in section 3(a)(4) of the Securities Act of 1933 ("Securities Act")-[2]- and section 12(g)(2)(D) of the Securities Exchange Act of 1934 ("Exchange Act"),-[3]- and exempts from registration under those statutes the securities issued by charitable organizations. Legislative --------- FOOTNOTES --------- -[1]- 15 U.S.C. Section 80a-3(c)(10). -[2]- 15 U.S.C. Section 77c(a)(4). Securities Act section 3(a)(4) exempts "any security issued by a person organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes and not for pecuniary profit, and no part of the net earnings of which inures to the benefit of any person, private stockholder, or individual." -[3]- 15 U.S.C. Section 78l(2)(D). Exchange Act section 12(g)(2)(D) exempts "any security of an issuer organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes and not for pecuniary profit, and no part of the net earnings of which inures to the benefit of any private shareholder or individual." -------------------- BEGINNING OF PAGE #2 ------------------- history regarding the charitable organization exemptions is sparse; it would appear that the exemptions are premised on the social benefits provided by charitable organizations and Congress' belief that the operations of non-profit charitable organizations are unlikely to raise investor protection concerns of the sort addressed by the federal securities laws.-[4]- Staff Treatment of Charitable Income Funds Charities in the United States depend heavily for funds on gifts from private citizens. Many individuals donate to the charities of their choice through the use of charitable gift annuities, charitable remainder trusts, and other means that allow an individual to make a current donation to charity and receive a lifetime income interest in the property donated or an annuity interest that may be fixed or variable.-[5]- To invest and manage these donations more efficiently, charitable organizations may commingle them with other managed assets, including the organization's endowment money. A pooled account maintained by a charitable organization that contains property donated in exchange for an income or annuity interest ("charitable income fund") raises an interpretive issue under section 3(c)(10) of the Investment Company Act, because a portion of the fund's net earnings may be viewed as earmarked for the benefit of a particular donor or donors. For a similar reason, the exempted status of securities issued by charitable income funds is subject to question under section 3(a)(4) of the Securities Act and section 12(g)(2)(D) of the Exchange Act. The Commission's staff has addressed the issues raised by charitable income funds under the Investment Company Act, Securities Act, and Exchange Act on a number of occasions over the past twenty-three years. In particular, the staff has provided no-action assurance under certain circumstances when charitable income funds have operated: without registering themselves under the Investment Company Act; without registering interests in the funds under the Securities Act or the Exchange Act; and without registering themselves, or persons soliciting gifts on their behalf, as broker-dealers under the Exchange Act.-[6]- The circumstances under which registration has not been required are: (i) the charitable income fund holds no assets contributed through a revocable donation;-[7]- (ii) the fund qualifies as a recipient of tax-deductible contributions under the Internal Revenue Code of 1986 ("Internal Revenue Code"); (iii) each prospective donor receives written disclosures fully and fairly describing the fund's operations; and (iv) any --------- FOOTNOTES --------- -[4]- See 1 T. Frankel, The Regulation of Money Managers 459 (1978). -[5]- See generally Leonard G. Clough, Why Planned Giving? 12 Nonprofit World 8 (Mar./Apr. 1994). -[6]- See, e.g., Investment Company Act Release No. 11016 (Jan. 10, 1980); National Foundation for Philanthropy (pub. avail. Mar. 21, 1985); Princeton University (pub. avail. Aug. 26, 1982). -[7]- See Society for the Propagation of the Faith (pub. avail. Aug. 23, 1984) (where charitable organization pooled together assets donated by irrevocable and revocable trusts, the pool would have to register as an investment company; staff was unconvinced that the donors of the revocable trusts "evidence a true charitable donative intent and not the intention of an investor.") -------------------- BEGINNING OF PAGE #3 ------------------- person soliciting contributions to the fund is either a volunteer or is employed in the charity's overall fund-raising activities and is not compensated on the basis of the amount of gifts transferred to the fund.-[8]- Notwithstanding the staff's view that certain charitable income funds can operate without registering under the federal securities laws, the staff consistently has taken the position that the anti-fraud provisions of the federal securities laws apply to the activities of those funds and their associated persons.-[9]- Underlying the staff's position with respect to charitable income funds is the view that the primary purpose of persons who transfer property to these funds is to make a charitable donation, and not to make an investment. The staff has concluded that this donative intent -- combined with, among other things, the protections afforded by full disclosure to donors and the applicability of the anti-fraud provisions of the securities laws to the operations of charitable income funds -- makes registration under the federal securities laws unnecessary. A favorable no-action letter from the Commission's staff regarding a particular transaction does not insulate the recipient (or others similarly situated) from liability to a private litigant who alleges that the same transaction violates the federal securities laws.-[10]- Recently, a plaintiff filed a class action in federal district court in Texas alleging, among other things, that charitable income funds are investment companies required to register under the Investment Company Act.-[11]- This lawsuit has created uncertainty among charitable organizations nationwide as to the applicability of the federal securities laws to charitable income funds.-[12]- Among other --------- FOOTNOTES --------- -[8]- Generally, persons who work for a charitable organization appear not to have the incentive to engage in high pressure sales tactics and other abusive practices that broker-dealer regulation was designed to address. Because the Commission historically has viewed the receipt of transaction-based compensation as potentially providing such an incentive, see Securities Exchange Act Release No. 22172 (June 27, 1985) (adopting Exchange Act rule 3a4-1), the staff has conditioned its position that associated persons of charitable organizations need not register as broker- dealers on the absence of this type of compensation. See the authorities cited above in footnote 6. -[9]- E.g., Investment Company Act Release No. 11016 (Jan. 10, 1980); American Council on Education (pub. avail. Dec. 15, 1972). -[10]- Securities Exchange Act Release No. 13017 (Nov. 29, 1976). Courts may look to no-action letters, however, as indications of the staff's view of the law, and frequently place great weight on the staff's views on matters within its expertise. Beaumont v. American Can Co., 621 F. Supp. 484, 500 (S.D.N.Y. 1985), aff'd, 797 F.2d 79 (2d Cir. 1986). -[11]- Civil Action No. 7-94CV-128-X (N.D. Tex.). -[12]- See 141 Cong. Rec. E2006 (daily ed. Oct. 24, 1995) (remarks of Rep. Fields) ("Some organizations have already stopped accepting gifts through their charitable donation pools for fear a class action will send that money right back out the door -- into the pockets of plaintiffs and their lawyers); See also 141 Cong. Rec. S9306 (daily ed. June 28, 1995) (remarks of Sen. Hutchison) (an award in favor of the class action plaintiffs "could financially disable thousands of charities, including (continued...) -------------------- BEGINNING OF PAGE #4 ------------------- things, a charitable income fund that is an unregistered investment company could have all of its transactions invalidated, and might be required to return all donations.- [13]- The Provisions of the Philanthropy Protection Act The Philanthropy Protection Act (the "Act") is designed to clarify the uncertainty created by the Texas litigation by codifying the approach taken in the staff's no-action letters. The Act would permit charitable income funds to operate without registration under the Investment Company Act,-[14]- Securities Act,-[15]- and Exchange Act.-[16]- In addition, the Act would exempt charitable organizations that sponsor charitable income funds, and certain persons associated with those organizations, from registration under the Investment Advisers Act of 1940 --------- FOOTNOTES --------- -[12]-(...continued) hospitals, relief organizations, arts groups, museums, universities, and every religious denomination"). -[13]- Contracts entered into by unregistered investment companies may fall under section 47(b) of the Investment Company Act, 15 U.S.C. Section 46(b), which provides that a contract made or performed in violation of the Act is unenforceable by either party unless a court finds that, in a particular case, enforcement would produce a more equitable result and would not be inconsistent with the purposes of the Act. The plaintiff in the Texas lawsuit, among other things, is seeking rescission under section 47(b) of certain charitable donations made to certain of the defendants. -[14]- Section 2 of the Act would amend section 3(c)(10) of the Investment Company Act to exclude from the definition of investment company collective investment vehicles maintained by a charitable organization exclusively for the investment of certain defined assets. Those assets include assets of a charitable remainder trust and assets contributed in exchange for a charitable gift annuity, as those terms are defined in the Internal Revenue Code. -[15]- Section 3 of the Act would amend section 3(a)(4) of the Securities Act to exempt from the Securities Act's registration provisions any security issued by a fund that is excluded from the definition of investment company by virtue of the amendment to section 3(c)(10) of the Investment Company Act. See supra footnote 14. -[16]- Section 4(a) of the Act would amend the definition of exempted securities under section 3(a)(12)(A) of the Exchange Act to include any security issued by a fund that is excluded from the definition of investment company by virtue of the amendment to section 3(c)(10) of the Investment Company Act. See supra footnote 14. Section 4(b) of the Act would add new section 3(e) to the Exchange Act to provide specifically that a charitable organization, and certain persons associated with the organization, will not be deemed to be a broker, dealer, municipal securities broker, municipal securities dealer, government securities broker, or government securities dealer if the organization or person complies with the standards set forth in new Exchange Act section 3(e). -------------------- BEGINNING OF PAGE #5 ------------------- ("Advisers Act").-[17]- The Act would retain certain safeguards contained in the no-action letters, in particular the requirement that fund donors receive appropriate written disclosure and the limitation on how the funds may compensate persons soliciting donations on their behalf.-[18]- Notably, the Act would not affect the reach or scope of the anti-fraud provisions of the federal securities laws, which would continue to prohibit "Ponzi" schemes and other frauds perpetrated under the guise of charitable activity. If the Act is passed, misrepresentations by a charitable income fund to donors and other fraudulent activity would continue to be actionable under the various federal securities laws. As in the past, the Commission will aggressively pursue any such fraudulent activity.-[19]- If enacted, the Act would confirm what the Commission believes was Congress' intention all along -- that the federal securities laws should apply to investments in our capital markets, not to gift giving.-[20]- The Act would expressly permit charitable organizations and their agents to solicit donations and make income or annuity payments to donors without being subject to the full array of regulations contained in the federal securities laws. In recognition of the social desirability of charitable organizations and the important functions they provide, the Act would establish a streamlined regulatory structure for those organizations. The Commission believes that this approach strikes an appropriate balance between protecting investors and facilitating a charitable organization's ability to manage its donations. Conclusion For the reasons noted above, the Commission believes that the Philanthropy Protection Act provides an appropriate level of investor protection while not encumbering charitable organizations with the burdens of full compliance with the securities laws. The Commission thus supports the goals of this legislation. --------- FOOTNOTES --------- -[17]- Section 5 of the Act would add a new subsection (4) to section 203(b) of the Advisers Act. The new subsection would exempt from registration as investment advisers certain persons associated with a charitable organization (and the organization itself) if such persons comply with the standards set forth therein. -[18]- Section 4(c) of the Act directs the Commission to prescribe rules to implement these safeguards. -[19]- See, e.g., SEC Litigation Release No. 14503 (May 18, 1995) (announcing that the Commission had commenced civil proceedings in federal district court against the Foundation For New Era Philanthropy and its founder and president, John G. Bennett, Jr.). -[20]- 141 Cong. Rec. E2006 (daily ed. Oct. 24, 1995) (remarks of Rep. Jack Fields).