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Transaction Rules for Affiliates Are Clarified


A no-action letter issued by the Securities and Exchange Commission last month gives some evidence of how the SEC views affiliated transactions with regard to fund companies, according to Alan Rosenblat, a lawyer with Dechert of Philadelphia. The issue of affiliated transactions is one the Investment Company Institute of Washington D.C. has sought guidance on from the SEC for some time, according to Rosenblat.

An affiliate is a company which has five percent or more of its stock owned by one person (or fund), according to the Investment Company Act of 1940. If a mutual fund owns five percent of a company's stock, that company is an affiliate of the fund. Section 17(a) of the 1940 Act imposes restrictions on sales between companies and affiliates. In the case prompting the recent no-action letter, two funds of Southeastern Asset Management of Memphis, Tenn. each owned more than five percent of two companies, respectively, according to a letter from Rosenblat, whose firm represents Southeastern, the investment adviser to the Longleaf Partner Funds. The Longleaf Partners Small-Cap Fund owned 12.3 percent of Bay View Capital Corporation of San Mateo, Calif. and the Longleaf Partners Realty Fund owned 8.6 percent of Franchise Mortgage Acceptance Company of Dallas, according to the letter. When Bay View announced that it was going to purchase FMAC, Southeastern was concerned that it might be violating section 17(a) of the 1940 Act because Bay View was purchasing stock that the Reality fund owned in FMAC, according to Rosenblat.

There is a provision in the rule, which exempts investment companies from the restriction in certain cases, according to Rosenblat. This situation was not covered by the exemption, however, and the investment company sought the no-action letter.

"The fund wasn't able to rely on the rule that would have otherwise governed the transaction," said Douglas Scheidt, chief counsel of the division of investment management at the SEC. "We saw nothing abusive about the transaction, especially given the funds' adviser's lack of involvement in it. It was just two companies that the funds had a significant stake in. We saw no reason to require the funds to opt out of the transaction or to lose the benefits of the transaction. There were no abuses that we thought we had to be concerned about."

The SEC has not been made aware of many of similar cases, however a resolution on the issue of what the exemption covers is something the ICI has asked for, and it is being looked at by the commission, according to Scheidt.

The timing of the no-action letter is noteworthy, said Rosenblat. The merger in question occurred in September 1999, and Southeastern requested an SEC response prior to that, according to a letter from the company to the SEC. The SEC gave the company a verbal no-action release before the merger and said it would follow with a letter to confirm that, according to Rosenblat. That letter was not issued until last month.

"That's unusual," said Rosenblat. "They're generally pretty strict about not giving people oral no action positions. I think this [no-action letter] took [the SEC] so long because they would like to change the rule, but that can take a while. The amendment has to be put out for comment and then you have to take it to the five commissioners to get it changed. So I think what they did was, they really agreed that, at least in this respect, the rule should be changed, and they took this way of telling people, if you're close to this - if your facts are on accord with this in terms of relationships - then you can probably go ahead."

The original request for a no-action letter was too close to the merger date to issue one, and so the SEC gave verbal consent, according to Scheidt. Following that agreement, it took some time to get information from the law firm and the SEC saw no reason to rush to issue the letter, said Scheidt.

Either way, the letter will serve as an indication that the commission is not going to strictly enforce regulations with regard to affiliated transactions of this nature, and other firms will be able to use the no-action letter as a guideline, according to Rosenblat.

"The general approach by lawyers in this area is that, if you think you have facts that are substantially identical to something where someone else got a no-action letter, you go ahead and you advise your client that it's probably safe to do so because even getting a plain vanilla no-action response can take several months," he said.