In its June 2014 Guidance Update, the SEC’s Division of Investment Management said that series funds are individual investment companies for purposes of compliance with certain investor protections, including the 1940 Act’s restrictions on principal transactions.
Section 17(a) of the 1940 Act generally prohibits an “affiliated person” of a mutual fund, or an affiliated person of an affiliated person (a so-called “second-tier affiliate”) from selling any security or other property to the fund. This prohibition can cause compliance headaches when evaluating certain transactions such as repos and swaps.
Here’s why: an affiliated person includes any 5 percent shareholder of a fund, so that any financial institution owning 5 percent or more of the fund cannot be a repo or swap counterparty. An affiliated person of that financial institution (the second-tier affiliate) also would be prohibited from acting as a counterparty. Small funds, in particular, can violate Section 17(a) if a repo or swap counterparty, or its affiliate, owns a relatively small position in a fund. To avoid this potential foot-fault, funds must monitor ownership and affiliation relationships that may be difficult to track.
Left unsaid in this regulatory guidance is that funds cannot, when measuring 5 percent ownership, take into consideration the entire shareholder base of the corporation or trust that serves as the “umbrella” for a series fund. If a counterparty measured its ownership of a series fund’s shares against the total assets of all funds under the umbrella trust, then the counterparty is much less likely to be considered an affiliated person, because its percentage of ownership of the entire complex would be much smaller as a percentage.
We conjecture that OCIE examiners found that some funds sought to avoid Section 17(a) issues by measuring percentage ownership on a complex-wide basis, rather than on a fund-by-fund scale. In light of this guidance, any fund attempting to determine who is an affiliated person on a complex–wide scale, rather than measuring on a fund-by-fund basis, likely will see a deficiency letter, or worse, an enforcement referral.
In light of this guidance, advisers and fund directors should review their fund compliance policies and procedures to ensure they are adequate to identify first and second tier affiliated persons.