The Securities and Exchange Commission (the “SEC”) staff recently provided clarification with respect to an investment adviser’s fiduciary duties in connection with Rule 17a-7 (the “Rule” or “Rule 17a-7”) transactions. The clarification was provided in the form of a no-action letter (Federated Municipal Funds, (November 20, 2006)).
Rule 17a-7 is an exemptive rule under the Investment Company Act of 1940, as amended (the “1940 Act”), that permits purchase and sale transactions among affiliated investment companies, or between an investment company and a person that is affiliated solely by reason of having a common (or affiliated) investment adviser, common directors, and/or common officers. The Rule contains a number of requirements but is silent with regard to an investment adviser’s fiduciary duties in connection with a Rule 17a-7 transaction.
In the no-action letter, the SEC staff clarified that before entering into a Rule 17a-7 transaction, the adviser has a duty to, among other things, “carefully consider” its duties of best execution and loyalty to each fund. With regard to best execution, the SEC stated that an adviser should ensure that:
- the selling fund’s total proceeds are the most favorable under the circumstances; and
- the buying fund’s total cost is the most favorable under the circumstances.
In that regard, the adviser should consider whether the selling fund can obtain an increase in proceeds by selling the security in the market, and, conversely, whether the buying fund can obtain a better price for the security by purchasing it in the market. This aspect of the guidance should not create difficulties as there are numerous pricing and fee safeguards incorporated into Rule 17a-7 that usually result in these types of transactions being cost effective.
However, the SEC staff’s advice with regard to an adviser’s duty of loyalty may prove more problematic. The SEC staff indicated that an adviser must determine that the Rule 17a-7 transaction is in the best interests of both the selling and buying funds. According to the SEC staff, that means that one or other of the funds cannot participate in the transaction if the transaction only benefits the other fund. The SEC staff is concerned that if the buying fund participates in such a transaction, it may be forgoing an opportunity to make a better investment in a different security in the marketplace. The new guidance could be interpreted to mean that if the transaction is in the best interest of one fund but is otherwise neutral to the other fund, the fund for which the transaction is neutral cannot participate in the transaction. The SEC staff’s advice regarding the adviser’s duty of loyalty may therefore make it more difficult for advisers to enter into Rule 17a-7 transactions.
In light of the SEC staff’s guidance, we recommend that advisers review their internal procedures with regard to Rule 17a-7 transactions to incorporate the SEC staff’s latest guidance as part of their reviews.