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Advisors Fined for Improper Disclosure: Failed to Denote Distributions Came From Capital


Four fund firms that manage closed-end funds were sanctioned and fined a collective $1.7 million on Sept. 28 by the Securities and Exchange Commission for not properly disclosing the true nature of shareholder distributions made under their fund's managed distribution plans.

Without proper detail, investors could have been led to believe that the distributions were dividends. In reality, the regulator noted, some or all of those distributions were actually a return of shareholders' capital or capital gains being paid.

The firms include AllianceBernstein of New York as manager of The Spain Fund and Alliance All-Market Advantage Fund; Putnam Investment Management of Boston as manager of the Putnam Master Intermediate Income Trust, Putnam Master Income Trust, Putnam Managed High Yield Trust and the Putnam Premier Income Trust; and Salomon Brothers Asset Management and Smith Barney Fund Management both of New York and owned by Legg Mason as respective managers of the Salomon Brothers High Income Fund and High Income Fund II, and the High Income Opportunity Fund, Managed High Income Portfolio and The Zenix Income Fund.

In addition, Salomon Brothers and Smith Barney were found to have also made misleading statements in their annual reports to shareholders by providing inaccurate annual dividend figures and yield calculations on the funds.

Putnam was fined $350,000, while the other three firms were each fined $450,000. All of the firms consented to the settlements without admitting or denying the charges.

The SEC found that over several years spanning from 2000 to 2004, these closed-end funds collectively made 200 separate distributions to shareholders, none of which contained the necessary statements being issued to investors explaining the nature of the distributions. Under the Investment Company Act, Section 19(a) and related Rule 19a-1, funds are required to provide shareholders with specific information identifying the source of all distributions made where distributions are not directly from a fund's net income earnings.

The SEC found that while Alliance's closed-end fund shareholders did get notices accompanying their checks, the specific and necessary information was lacking. The SEC found that Putnam's, Salomon Brothers' and Smith Barney's closed-end investors never received any notices at all with their distributions.

Managed distribution plans may legally pay out dividends and/or capital gains earned on the fund's underlying portfolio and a return of capital, or some combination thereof. A return of capital means that closed-end fund investors actually receive back some of their own capital, rather than earnings, which can have a negative effect on a closed-end fund because the portfolio is being depleted with each distribution.

There are also tax implications. A return of capital is not taxable. But a return of capital then skews the investor's cost basis, which can lead to an accounting nightmare when the fund is sold, said Tom Roseen, senior research analyst at Lipper.

The SEC has been so concerned that investors don't understand how managed distribution plans work that the regulator has, for some time now, imposed a moratorium on approving new managed distribution plans on closed-end funds. An SEC spokesman confirmed the existence of a moratorium.

"People have been buying these funds" because of their generous distributions, Roseen added. "But if it appears to be too good to be true, it usually is."

From an investor's perspective, managed distribution plans can make closed-end funds attractive options because they pay a steady and predictable income stream throughout the year.

"Most people like the regular distribution," said Anne Kritzmire, managing director within the closed-end funds and structured products group at Nuveen Investments in Chicago. Moreover, such payout plans allow investors to invest beyond traditional fixed-income product offerings, she said. "Managed distribution plans allow investors to get a regular cash flow from a wider variety of sources." These include equity and even REIT funds. Of Nuveen's 119 closed-end fund offerings, 14 sport managed distribution plans.

From the advisor's perspective, managed distribution plans are worthwhile because they attract investors seeking a steady income. Moreover, because they are attractive to investors, these funds' share prices tend to stay at steadier, elevated rates, in some cases helping mitigate trading discounts that often plague closed-end funds.

The challenges to advisors can be numerous. Advisors must do a better job at managing the forecasts for distributions, Kritzmire said.

In addition, if the fund's periodic earnings do not meet or exceed the forecasted distributions, managers must ensure that investors fully understand what those fund distributions really represent, experts said. If fund advisors dip into capital in order to live up to their managed distribution promises to investors, that must be made crystal clear to investors.

Advisors with aggressive distribution plans paying way more than a fund's securities are earning pump up the fund's yield to more enticing levels by dipping into capital to meet their goal.

"I don't have a problem with managed distribution funds, except for those reaching too high," said Amy Charles, director and vice president of closed-end funds at Raymond James Financial of St. Petersburg, Fla. Some of the older funds with 10% distribution policies in place are being unrealistic, she said. Funds that pay out 6%, where half of that is directly from dividends are much more manageable and more reasonable, she added.

Many closed-end funds are sold on the basis of their yield, which is the percentage representing a fund's total distributions divided by its share price. Fund advisors have little control over a closed-end fund's net asset value, which fluctuates with the value of the fund's securities, nor the fund's exchange-traded price as it trades on the secondary market. Market prices are largely influenced by investor sentiment.

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