March 19, 2001
The Securities and Exchange Commission has traditionally taken a hard line against redemption fees of more than two percent, but a no-action letter it issued earlier this month may open the way for certain funds to charge as much as four percent redemption fees, according to industry analysts and executives.
The SEC issued a no-action letter March 7, allowing Fidelity Investments of Boston to charge a four percent redemption fee on its Advisor Korea Fund, a former closed-end fund that converted to an open-end fund last year. Fidelity sought the SEC's permission to charge investors seeking redemptions within 199 days of the fund's conversion to an open-end fund a four percent redemption fee.
The SEC's permission is a surprising departure from its traditional stance on redemption fees and will most likely prompt other funds to seek to impose more than two percent fees, analysts said.
"I certainly think some fund families are going to look at this and test the waters themselves," said Scott Cooley, a senior analyst with Morningstar of Chicago. "I think people are going to try to see what are the limits and does this signal a little flexibility on the SEC's part."
The fee is intended to cover increased costs incurred by arbitrage activity prompted by opening the fund, according to a Feb. 22 letter from Robert C. Hacker, a lawyer for Fidelity with Kirkpatrick & Lockhart of Washington D.C. to Douglas Scheidt, associate director and chief counsel of the division of investment management.
The SEC has taken the position that charging redemption fees higher than two percent may penalize shareholders and effectively deprive them of their right to redeem shares at net asset value, according to the no-action letter.
However, because the Korea Fund was reorganized as an open-end fund, special circumstances mitigate the SEC's stance on keeping redemption fees at two percent, according to the letter.
"Several factors in combination heightened the possibility that short-term traders could adversely affect the interests of the [fund's] long-term investors and the viability of the [fund]," the
Because closed-end funds issue a limited number of shares and are bought and sold on the open market like stocks, their price is determined by market demand, not net asset value, like open-end funds. Often, closed-end funds trade at a discount to net asset value, providing arbitrage opportunities when a closed-end fund is converted
to an open-end fund, said Thomas J. Herzfeld, whose firm, Thomas J. Herzfeld Advisors of Miami, invests in closed-end funds. When a closed-end fund converts to an open-end fund, usually a third of all of its investors redeem their shares, he said.
That puts a burden on the fund because it often has to sell a portion of its holdings in order to meet heavy redemption activity, creating capital gains that are borne by the remaining investors. Also, the fund's net asset value plummets and there is a rise in administrative costs associated with redeeming all of the shares.
"Not everybody gets out of these funds," said Brian Smith, executive director of the Closed-End Fund Association. "Many shareholders remain in the funds and these are potentially very negative impacts against those shareholders."
The SEC has held redemption fees for open-end funds at two percent, despite several attempts by fund companies to charge higher redemption fees. Most notably, last April, Fidelity dropped a three percent redemption fee that it had imposed on its Small Cap Stock Fund after the SEC made its position clear on the two percent maximum.
"While we believe that the three percent fee is fully justifiable, we decided to decrease the fee to two percent rather than engage in protracted discussions with the SEC," said Jessica Catino, a Fidelity spokesperson. (MFMN 5/08/00)
The Deutsche Preservation Plus Income Fund and the Amerindo Technology Fund, both of New York, also charged three percent redemption fees at one time. Both funds reduced their fees following SEC pronouncements on the issue.
Although the Closed-End Fund Association has not taken a position on the SEC no-action letter, it is something that has caught the attention of the industry, said Smith.
"It certainly has caught the attention of the investment company industry overall to see what might happen as a result of [the SEC's] intended actions," he said. "As the industry trade group we do not have a position on this yet. We're going to wait and see what happens. There really isn't any history with this sort of thing. Nobody has done this previously."
The four percent fee is excessive, said Phillip Goldstein, president of Opportunity Partners LP of Pleasantville, N.Y. Goldstein is a closed-end fund investor, fund director and the leader of several proxy fights to open closed-end funds.
"The SEC seems to take everything management says at its word," he said. "Nobody asks for any verification that the fees would be like this. I mean, where does the four percent come from? ... What if you come in with a five percent fee or a six percent fee? At some point, don't you have to justify it?"
The SEC's letter also sets the stage for similar closed-end funds that are converting to open-end mutual funds to seek four percent redemption fees, said George Karpus, a closed-end fund shareholder activist. Karpus is president and CEO of Karpus Investment Management of Pittsford, N.Y.
"The precedent being set is disturbing to me," he said.