January 18, 2002
Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-21-01
Ladies and Gentlemen:
We submit this letter in response to a request for comment by the Securities and Exchange Commission (the "Commission") on proposed rule amendments relating to mergers and other business combinations between certain affiliated investment companies.1 The proposal would broaden the scope of an exemptive rule (the "Exemptive Rule") under the Investment Company Act of 1940, as amended (the "1940 Act"), that provides relief from various statutory prohibitions of the 1940 Act.2
These comments have been prepared by members of the Subcommittee on Investment Companies and Investment Advisers of the Committee on Federal Regulation of Securities, Section of Business Law of the American Bar Association (the "Subcommittee"). A draft of this letter was circulated for comment among members of the Subcommittee and the Chairs and Vice-Chairs of the other subcommittees and task forces of the Committee on Federal Regulation of Securities (the "Committee"), the officers of the Committee, the members of the Committee's Advisory Committee and the officers of the Section. This letter generally represents the views of those who have reviewed it but does not represent the official position of the American Bar Association, the Section or the Committee.
The Subcommittee commends the Commission and its staff for developing this important proposal to expand the Exemptive Rule. The expanded Exemptive Rule should significantly reduce the number of exemptive orders processed by the Commission and the associated costs to the industry. It also should allow funds to complete beneficial business transactions in a more timely manner.
The Subcommittee agrees with the general philosophy that appears to underlie the Commission's proposal, namely that the board's business judgment and enhanced independence requirements offer shareholder protections sufficient to render the "affiliated solely by reason of" standard unnecessary.3 The Subcommittee's specific comments follow.
Mergers between Registered Investment Companies
The Subcommittee believes that the Commission's proposed list of factors that are generally relevant to evaluating a merger proposal is fairly complete. Accordingly, the Subcommittee has no comment on the contents of the list as written.
However, the Subcommittee does not believe that a list of specifically identified factors needs to be included in the Exemptive Rule, as contrasted with the Proposing Release or adopting release, and is concerned about the potential adverse consequences of doing so. Currently, the Exemptive Rule and many other rules under the 1940 Act4 specify particular findings that boards must make as a condition to reliance. We are aware of no other Commission rules that identify specific factors that boards must consider in support of these findings. Rather, the Commission has traditionally deferred to the expertise and business judgment of boards and their legal and other counselors in identifying factors to consider. The Commission has occasionally identified relevant factors in proposing or adopting releases. For example, in the 1979 proposing release for current Rule 17a-8, the Commission included a list of some of the factors that may be relevant in support of the required findings, and stated that the boards "should consider all information which would be material to the determination."5
We believe there are valid reasons for the Commission's historic approach. The relevant factors that may support a particular finding can and do change, depending on the particular factual circumstances and the passage of time. The factors that may be most relevant in 2002 may differ from those that are most relevant in 2022. Perhaps the best example of this phenomenon was the Commission's approach in adopting Rule 12b-1 under the 1940 Act. Many of the factors listed in the adopting release for Rule-1 have since been superseded by other relevant factors in light of industry and market changes.6 Accordingly, while there may be some utility to mentioning the types of factors that may be relevant in a proposing or adopting release, codifying them in rule form unnecessarily reduces the flexibility to respond to future changes in circumstances.
In addition to these staleness concerns, including specifically enumerated factors in the Exemptive Rule runs contrary to the goal of encouraging boards to engage in a careful deliberative process rather than a routinized process of checking items off a list. While including "if relevant" offers some protection against charges that a board failed to consider an irrelevant factor, the Subcommittee also is concerned that strict compliance with the Exemptive Rule would require a board to make a specific finding as to whether each enumerated factor is or is not relevant to a particular reorganization. This is a process that could unnecessarily complicate the board's deliberations. Moreover, the recent board governance initiatives clearly obviate the need to formally instruct board members on the factors to be considered.
In sum, we are not aware of a general failure of boards to consider all relevant factors, which is the standard that is in effect today. Since the stated intent of the proposed amendment is still to have affected boards consider all relevant factors, enumerating specific factors in the Exemptive Rule itself introduces unnecessary procedural rigidity with no real benefit.
The Subcommittee generally supports the proposal to require shareholder votes, although some Subcommittee members question the Commission's eagerness to override several states' carefully deliberated decision not to require shareholder votes on certain matters. As a general matter, a merger that substantially affects a shareholder's investment by, for example, materially changing the investment objective, principal investment strategies or principal investment risks should be treated as a change requiring a shareholder vote, despite the associated cost.
However, the Subcommittee believes that there is a category of reorganizations that may technically come within the definition of "merger" but that do not impact a shareholder's investment in a way that compels the conclusion that a shareholder vote should be solicited. In addressing somewhat analogous circumstances, the Commission and its staff have acknowledged a distinction in adopting and interpreting the exception in Rule 145(a)(2) under the Securities Act of 1933, as amended, for "re-domiciling" transactions. In the context of Rule 145(a)(2), the Commission and its staff have recognized a distinction between reorganizations that involve a new investment decision and those that involve a mere re-domiciling with other limited non-material changes.
The Subcommittee urges the Commission to require voting only in situations where the merger involves a new investment decision or otherwise materially affects shareholders.7 These situations may include, for example, situations where the surviving company's investment advisory and/or Rule 12b-1 fees are higher or its investment objectives, principal investment strategies and/or principal investment risks differ materially from those of the merging company.8 Fund boards should have the authority to decide that changes associated with a merger are non-material changes, even if they involve differences in fundamental policies, and therefore do not justify the expense of a shareholder proxy. We believe that boards, with their majority independent composition and in consultation with independent legal counsel, if they choose to do so, can adequately evaluate and should be allowed to exercise their business judgment to determine whether a particular merger affects a shareholder's investment in a material fashion.9
In addition, the Subcommittee notes that state law increasingly does not require a shareholder vote to merge or liquidate funds and that, most recently, a number of funds liquidated without a shareholder vote in the aftermath of the Internet investing bubble. The existence of a federally imposed vote requirement for a merger with an affiliate, coupled with the absence of any vote requirement for a liquidation, may tip the balance towards a liquidation and away from a merger with an affiliate, where a board could reasonably pursue either alternative. Moreover, the absence of any vote requirement for a merger with an unaffiliated fund could tip the balance towards an unaffiliated merger or at least compel a board to engage in a more extensive consideration of this alternative. It would be ironic to require a shareholder vote in all situations where the adviser is not changing but not to require a shareholder vote in situations where an unaffiliated acquiring fund has a different adviser. In the Subcommittee's view, this possible tipping further supports the Subcommittee's suggestion that not all mergers with affiliated funds should be subject to a shareholder vote requirement.
Although not all Subcommittee members support the Commission's proposal to require echo voting in order to address certain affiliate conflict situations, the Subcommittee generally acknowledges the benefits of the proposal, but believes that the proposed exceptions to the echo voting requirement should be expanded. First, in some circumstances (e.g., a plan, or a trustee for a plan, that is subject to the Employee Retirement Income Security Act of 1974, as amended) an owner affiliate, as defined in the Exemptive Rule, may be prohibited from echo voting or appointing another person to vote those shares by other governing law. The exceptions to the echo voting requirement should, therefore, be broadened to cover circumstances where other applicable laws or regulations impose obligations or restrictions that conflict with the echo voting requirement.
In addition, as proposed, the requirement would essentially dictate to an owner affiliate of both a merging company and a surviving company which is not otherwise an affiliated person of a merging company (e.g., is not the investment adviser of either company or an affiliated person of the investment adviser) how it must vote its shares. The Subcommittee does not believe the risk of harm to other shareholders justifies barring such a person from voting in its own best interest. The Subcommittee believes that the Commission can address this issue by establishing an exception for an owner affiliate which is affiliated with the merging company and the surviving company "solely by reason of" being an owner affiliate. Alternatively, echo voting could be imposed on such an independent owner affiliate only if it is a control affiliate of (i.e., an owner of a more than 25% voting interest in) the merging company. Another alternative would be for the Commission to permit such an independent owner affiliate to engage an independent fiduciary to evaluate and vote on the merger.
In addition, the echo voting requirement proposed here differs from similar 1940 Act requirements that are designed to promote fairness in voting. For example, Section 12(d)(1)(E) requires that a feeder fund in a master-feeder structure commit to vote its interests in the master fund either in accordance with instructions solicited from its own shareholders or in the same proportion as all other interestholders. Similarly, Rule 6e-3(T)(b)(15) generally requires pass-through voting to separate account contract-holders and further requires an insurance company to echo vote investment company shares not attributable to contract-holders for which no instructions are received. An owner affiliate that is merely a record owner should have a similar option if the beneficial owners are not themselves owner affiliates.
Finally, an additional technical question relates to the definition of owner affiliate. As written, the Proposing Release would deem "an owner of more than 5 percent of the shares" an owner affiliate. There is no indication, however, whether the ownership must be beneficial ownership, record ownership, any form of ownership that allows the entity to vote the shares or another form of ownership. The first exception to the echo voting requirement seems to imply that either beneficial or record ownership would trigger owner affiliate status, but the proposed definition itself is ambiguous.
In sum, with respect to the echo voting proposal, we recommend expanding the exceptions from echo voting beyond those proposed, permitting pass-through voting as an alternative to echo voting where appropriate, and clarifying the definition of owner affiliate.
Mergers of Registered Investment Companies and Certain Unregistered Entities
As a general matter, the Subcommittee supports expanding the scope of the Exemptive Rule to cover mergers involving unregistered funds reorganizing into registered funds. The proposed special valuation procedures, however, seem unduly burdensome and may lead to anomalous results. With mergers involving registered merging companies, the Agreement and Plan of Reorganization typically provides for assets of the merging company to be valued at closing based on the board-approved valuation procedures of the surviving company. This mechanism is intended to address dilution concerns and to bring those assets over at valuations that are "in synch" with the way that they will be valued going forward. Even though this process may result in a slight adjustment to the value of a merging company's shareholders' holding, it is an accepted and appropriate method to ensure that the merging company's shareholders do not overpay or underpay for their surviving company shares. The Subcommittee does not perceive any special or additional risk of overpayment or underpayment where the company that is reorganizing is not a registered investment company.
The Subcommittee does not believe that requiring funds or management to incur the cost of an independent evaluator is necessary, and is concerned also that the proposed requirements could lead to a need to reconcile valuations after a transaction. Accordingly, we recommend revising the proposed Exemptive Rule to eliminate the proposed special valuation provisions.
Prohibition for Certain Transactions
The Subcommittee does not believe there is any need for the "plan or scheme to evade" prohibition in the Exemptive Rule itself and is concerned that it may lead to inconsistency and uncertainty in application. Although we believe Section 48(a) is widely known in the industry, the Commission could call attention to Section 48(a) in the adopting release for the Exemptive Rule and, for that matter, future releases relating to other rules or amendments. Including the proposed prohibition in the Exemptive Rule itself, however, may be interpreted as requiring an additional finding by boards that a particular reorganization is not part of such a plan or scheme, which may require management to prove a negative. In addition, the terminology used in the Proposing Release -- "part of a plan or scheme to evade" -- differs from that used in Section 48(a). This difference introduces uncertainty as to whether this is a new standard that is being proposed or a new articulation of the standard that the Commission believes applies under Section 48(a). At a minimum, the Subcommittee believes the Commission should clarify whether it is a different standard or the same.
In footnote 54 of the Proposing Release, the Commission proposes to overturn existing no-action guidance under Rule 17a-7 by making Rule 17a-8 the exclusive avenue, absent an exemptive order, for mergers of funds with affiliated funds, bank common trust funds, bank collective funds, or other entities. The investor protection aspects of Rule 17a-7, which the Commission has recently enhanced, are just as appropriate for situations involving a transfer of an entire portfolio as they are for situations involving individual portfolio cross-trades. Indeed, many mergers that today qualify under Rule 17a-8 would not qualify under Rule 17a-7 due to some of its more restrictive provisions, such as its availability only for portfolio securities that have readily available market quotations. So long as the pricing and other more restrictive conditions of Rule 17a-7 (other than the cash only requirement) are met, a merger should be allowed to proceed either under Rule 17a-7 where the conditions of that rule are satisfied, or under the Exemptive Rule where its conditions are met.
The Subcommittee respectfully recommends that the Commission revise its proposal in accordance with the comments contained herein. We are prepared to meet and discuss these matters with the Commission and its staff and respond to any questions.
Chair, Committee on Federal Regulation of Securities
Diane E. Ambler
Chair, Subcommittee on Investment Companies
And Investment Advisers
Jay G. Baris
Vice-Chair, Subcommittee on Investment Companies And Investment Advisers
Marco E. Adelfio
Diane E. Ambler
Jay G. Baris
Cathy G. O'Kelly
|cc:||The Honorable Chairman Harvey L. Pitt |
Commissioner Laura S. Unger
David M. Becker, General Counsel
Meyer Eisenberg, Deputy General Counsel
Paul F. Roye, Director, Division of Investment Management
Cynthia M. Fornelli, Deputy Director of the Division of Investment Management
|1||Release No. IC-25259 (November 8, 2001) (the "Proposing Release").|
|2||The amendments apply to Rule 17a-8 under the 1940 Act.|
|3||The Subcommittee notes that Rule 17a-7 under the 1940 Act imposes a similar "affiliated solely by reason of" standard to transactions between registered investment companies and unregistered entities. The Subcommittee suggests that the board's business judgment and enhanced independence requirements also offer shareholder protections sufficient to render the "affiliated solely by reason of" standard unnecessary in this part of Rule 17a-7. The Subcommittee urges the Commission to consider amending Rule 17a-7 to eliminate this standard there as well.|
|4||The Subcommittee notes that it also has concerns about the precedential effect of including a list of specifically enumerated factors in the Exemptive Rule itself. In this regard, any future proposals to add lists of specifically enumerated factors to other rules under the 1940 Act would raise issues similar to those discussed here.|
|5||See Release No. IC-10886 (October 2, 1979) at text accompanying n. 17.|
|6||See Release No. IC-11414 (October 28, 1980).|
|7||Although we think the analogy to the exception in Ruleis appropriate, we are not suggesting that the Subcommittee's proposed exception to the shareholder vote requirement needs to be as broad as some of the existing interpretations of the Ruleexception.|
|8||We also believe that the amendment should not apply to a conversion of a stand-alone fund to a master-feeder structure, even though that transaction may technically involve a sale by the stand-alone fund and a purchase by the master portfolio of substantially all the assets of the stand-alone fund. Nor should it apply to a conversion of a master-feeder fund to a stand-alone structure. Regardless of whether the Commission adopts the Subcommittee's suggestions in this comment letter, it would be helpful for the Commission to confirm either in the adopting release or in the Exemptive Rule itself that the term "merger" does not encompass master-feeder conversions.|
|9||An advance notice or an information statement meeting the disclosure requirements of Regulation 14C under the Securities Exchange Act of 1934, as amended, could be substituted for a proxy solicitation in these circumstances.|