On January 8, 2003, the SEC adopted a new rule and amended several existing rules under the Investment Company Act of 1940 (the "1940 Act"). These rule changes give registered investment companies new authority to engage in affiliated transactions with portfolio affiliates and sub-advisers.

Background

The 1940 Act contains provisions that prevent persons who may be in a position to take advantage of a fund from entering into certain transactions or arrangements with the fund. These include prohibitions on principal transactions and joint transactions with "affiliated persons."[fn1] Many of the restrictions on transactions and arrangements with fund affiliates apply not only to affiliated persons of the fund (first-tier affiliates), but also to affiliated persons of those persons (second-tier affiliates).

The 1940 Act authorizes the SEC to issue orders and adopt rules permitting these transactions when the SEC determines that an exemption is "necessary or appropriate in the public interest and consistent with the protection of investors." In adopting these rule changes, the SEC has codified a number of orders that have been issued to funds permitting principal and joint transactions with two types of affiliates (portfolio affiliates and sub-adviser affiliates), the highlights of which are summarized below. The rule changes will eliminate the need for funds to obtain individual exemptive orders in circumstances that, in the SEC's view, are not likely to raise the concerns that the 1940 Act was intended to address.

Transactions with Portfolio Affiliates

The SEC amended rules 17a-6 and 17d-1(d)(5), which permit a fund to enter into principal and joint transactions with companies 5% or more of whose voting securities are owned by the fund. The policy underlying these rules is that this type of affiliated person is unlikely to be in a position to take advantage of the fund. The amendments broaden these exemptions to permit funds to enter into transactions and arrangements with companies 5% or more of whose securities are owned by other funds in the fund complex.[fn2]

Transactions with Sub-Adviser Affiliates

The SEC also adopted new rule 17a-10 and amendments to rules 10f-3, 12d3-1, and 17e-1, which now permit funds to enter into a variety of transactions and arrangements with certain sub-adviser affiliates.[fn3] Ordinarily, a sub-adviser has little power to overreach those funds, or portions of a fund, with which it is affiliated but which it does not advise. The SEC has therefore issued a number of orders exempting sub-advisers from 1940 Act prohibitions in order to permit sub-advisers to engage in transactions with affiliated funds when the sub-adviser is not in a position to influence the fund's decision to participate in the transaction. The new rule exemptions, which codify these orders, are only available to sub-advisers (and their affiliated persons) that are neither responsible for, nor affiliated persons of the persons responsible for, providing advice to the fund or portion of the fund that participates in the transaction. The new rule exemptions are also subject to two conditions that were designed to enhance fund protection against any remaining possibility of sub-adviser influence:

• The sub-adviser must not be an affiliated person of the primary adviser (in most cases, at least to the extent the primary adviser is "responsible for providing advice") or of the principal underwriter or a director of the Fund; and
• The sub-advisory contracts with both the participating sub-adviser (including any sub-adviser whose affiliated person is a transaction participant) and any sub-adviser of the participating fund or portion thereof must prohibit them from consulting with one another concerning securities transactions of the participating fund or portion thereof.[fn4]

Summarized below are highlights of the new rule and rule amendments with respect to transactions with sub-adviser affiliates:

• New Rule 17a-10 (principal transactions): Permits a fund to participate in principal transactions with (1) sub-advisers that do not advise the participating fund; and (2) sub-advisers of the same fund, but with respect to discrete portions of the fund which the sub-adviser does not advise. The sub-advisory relationship must be the only reason the 1940 Act otherwise prohibits the transaction. This new rule would allow, for example, a sub-adviser of Fund X in a complex to purchase a security from Fund Y if a different sub-adviser managed Fund Y and the other conditions of the new rule were satisfied.
• Amended rule 10f-3 (affiliated underwriting): Deems each of the series of a series company and the "managed portions" of a fund to be separate registered investment companies for purposes of section 10(f) and rule 10f-3. This amendment will exempt a fund's purchase of securities from the prohibition in section 10(f), if the purchase would not be prohibited if each series or portion of the fund were separately registered. Thus, a fund that wishes to purchase a security from an underwriting syndicate that includes a sub-adviser's affiliate would have to meet the conditions of rule 10f-3 only if the purchasing series' or managed portion's own sub-adviser is involved in the underwriting. The SEC also revised the way that funds relying on rule 10f-3 must aggregate purchases under the rule's percentage limits.[fn5] Previously, rule 10f-3 required aggregation of purchases by all funds that have a common investment adviser, regardless of whether the common adviser or its affiliate is the participant in the underwriting syndicate. Under amended rule 10f-3, only purchases by funds that are advised, and accounts that are controlled, by an investment adviser that is involved in the underwriting or selling syndicate need be aggregated.
• Amended Rule 12d3-1 (ownership of securities): Allows a fund to invest in securities of a sub-adviser that does not actually advise the fund or discrete portion of the fund purchasing the securities. Thus, Fund X could purchase shares of Fund Y's sub-adviser's parent's stock if Fund X and Fund Y are managed by different sub-advisers and the other conditions of the rule were satisfied.
• Amended rule 17e-1 (brokerage transactions): Relieves a fund from certain recordkeeping and review requirements when that fund uses an affiliated sub-adviser for portfolio brokerage services, so long as that sub-adviser does not provide advisory services to that fund.

The SEC approved these rule changes based on its belief that they will benefit funds, their shareholders and their affiliated persons by eliminating the need to seek exemptive relief before entering into these types of transactions. However, Funds that anticipate entering into these types of sub-advisory transactions will need to amend their sub-advisory contracts in accordance with the second condition described above. The SEC specifically stated that this type of amendment would not have to be submitted to shareholders for their approval.
Footnotes

1: "Affiliated persons" of a fund include, among others, its investment adviser and any sub-advisers, and portfolio companies 5% (or more) of whose securities are held by the fund.

2: These principal and joint transactions are permitted as long as certain other affiliated persons of the fund are not parties to the transaction and do not have a "financial interest" in a party to the transaction. The Commission also expanded the interests deemed not to be "financial interests" by including any interest that the fund's board of directors, including a majority of the directors who are not interested persons of the fund, finds to be not material.

3: A sub-adviser affiliate is a person that is an affiliated person of a fund because the person is a sub-adviser to the fund, an affiliated person of the fund's sub-adviser, or a sub-adviser of another fund under common control with the fund.

4: The rule does not contain a condition prohibiting sub-advisers and principal advisers from consulting with each other, however the principal adviser remains a fiduciary of the fund and may not collaborate with fund sub-advisers for purposes of overreaching the fund.

5: One of the key conditions of rule 10f-3 is that a fund relying on the rule, together with any other fund advised by the fund's adviser, purchase no more than 25 percent of the offering ("percentage limit"). The purpose of the percentage limit is to ensure that a significant portion of the offering is being purchased by persons acting independently of the adviser. The existence of these purchasers suggests that the price of the securities is based on market forces and demonstrates that the securities are not being "dumped."