June 11, 1992
TO: INTERNATIONAL MEMBERS NO. 13-92
RE: SEC STAFF REPORT - RECOMMENDATIONS AFFECTING INTERNATIONAL
FUNDS AND ADVISERS
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The recently-released report prepared by the SEC’s Division
of Investment Management, Protecting Investors: A Half Century of
Investment Company Regulation, contains recommendations with
broad implications for U.S. and foreign investment companies and
investment advisers that seek to do business abroad. These
recommendations are set forth in Chapter 4, Internationalization
and Investment Companies; Chapter 5, The Reach of the Investment
Advisers Act of 1940; and Chapter 6, Performance Based Advisory
Compensation. Each of these chapters is described below.
Internationalization and Investment Companies
A. The Prohibitions of Section 7(d)
Section 7(d) provides that no foreign fund may publicly
offer securities of which it is the issuer in the U.S. unless the
Commission by order finds that it is "both legally and
practically feasible effectively to enforce" all of the
provisions of the 1940 Act against the company. For a variety of
reasons relating to foreign legal requirements and business
practice, this is a nearly impossible standard for most foreign
funds. In Touche Remnant (pub. avail. Aug. 27, 1984), Commission
staff stated that a foreign fund could make a private placement
of its securities in the U.S. concurrently with a public offering
abroad so long as it had no more than 100 shareholders resident
in the U.S. The staff position in Touche was affirmed by the
Commission in the release adopting Rule 144A under the Securities
Act. Securities Act Rel. No. 6862 (April 23, 1990).
B. Staff Recommendations
The staff’s proposal is a modified version of the
Commission’s 1984 proposal to amend Section 7(d). That proposal
would have authorized the Commission by rule or order to allow an
"operating foreign investment company" to register under the Act
with an exemption from one or more provisions of the Act if the
Commission made certain findings.
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The 1984 proposal would have required the Commission to
find that compliance with a provision of the 1940 Act would be
"unduly burdensome" in order to grant a foreign fund exemptive
relief. The new proposal substitutes a "necessary or appropriate
interest" determination, on the grounds that an "unduly
burdensome" standard is a lower standard than what domestic funds
must meet in order to receive exemptive relief under Section
6(c).
Like the 1984 proposal, the new recommendation conditions
exemptive relief upon a finding of the adequacy of foreign law or
special conditions agreed to by the fund. The Report states that
the protections provided by foreign regulatory system need not be
identical to the provisions of the 1940 Act from which relief is
requested, but must address the same regulatory concerns and
serve the same purposes. To facilitate findings as to the
adequacy of foreign law, the staff proposes that Section 7(d)
require the Commission to enter into a memorandum of
understanding with a foreign country prior to entertaining
applications from funds from that country. The MOU would set
forth representations as to the nature and extent of foreign
regulation, and create a framework for regulatory cooperation in
enforcement and inspection matters. The staff anticipates that
the process of negotiating MOUs will also facilitate access to
foreign markets by U.S. funds.
The Report recommends that Section 7(d) be amended to
specify the circumstances under which a foreign fund is required
to register under the 1940 Act. As is the case under Section
7(d) currently, a foreign fund will be required to register if it
uses U.S. jurisdictional means in connection with a public
offering. Further, if a foreign fund has used U.S.
jurisdictional means in connection with a non-public offering and
has more than 100 shareholders of record that are U.S. residents,
it will be required to register. Finally, if a foreign fund has
taken steps to facilitate secondary market trading in its
securities in the U.S., such as by listing its shares on a
securities exchange, and has more than 100 shareholders of record
that are U.S. persons, registration will be required. The
proposal would require a foreign fund to continuously monitor
whether it has more than 100 shareholders of record that are U.S.
residents.
Finally, the Report states that the Commission should
support U.S. tax law changes to enable U.S. funds to compete with
foreign funds in overseas markets, and that the Commission should
continue to work with state regulators to eliminate duplicative
substantive regulation of investment companies.
The Reach of the Investment Advisers Act of 1940
Current staff interpretations of the extraterritorial
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reach of the Investment Advisers Act of 1940 inhibit cross-border
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investment advisory activities. Historically, the staff has
taken the position that once registered under the Advisers Act,
both U.S. and foreign-based advisers are subject to all of the
Act’s provisions with respect to all of their activities
worldwide. See, e.g., Gim-Seong Seow (pub. avail. Nov. 30,
1987). To avoid Advisers Act regulation with respect to their
foreign activities, many foreign advisers create a separate U.S.
registered subsidiary to service their U.S. clients. However,
unless the U.S. registrant meets certain tests as to
independence, the staff generally takes the view that the foreign
parent or affiliate is also subject to Advisers Act regulation.
See Richard Ellis (pub. avail. Sept. 17, 1981).
The Report states that the broad extraterritorial
application of the Advisers Act and the Ellis standards have
proven unworkable and should be changed. The changes recommended
by the Report would be done at the staff level primarily through
the no-action process and would not involve legislation or
rulemaking.
The Report recommends that the Advisers Act be applied in
accordance with territorial concepts that focus on conduct and
the effects of conduct. Under this approach, the Advisers Act
would apply to activities where a sizable amount of the services
take place in the U.S. or where the services have effects in the
U.S. In the case of a registrant, foreign or domestic, dealing
with clients resident in the U.S., the staff states that it can
be assumed that a sizable amount of advisory services will take
place in the U.S., that there will be effects in the U.S., and
that therefore the Advisers Act would apply to these activities.
Where a foreign adviser deals with a client resident outside the
United States, the Advisers Act generally would not apply because
it is unlikely that there would be any conduct or effects within
the U.S. When a domestic adviser renders advice to foreign
clients, the Report concludes that a sizable amount of advisory
services is likely to take place within the United States and the
Advisers Act ordinarily would apply.
The Report recommends changing the Ellis standards. The
staff believes that although the adoption of a conduct and
effects test will lessen the need for foreign advisers to create
and register separate entities, there may be some that wish to
use a separate registered entity either in the U.S. or abroad.
The standards would be modified such that the Commission would
recognize entities as distinct so long as they are separately
organized and the U.S. registrant is adequately staffed with
personnel capable of providing investment advice. However, the
staff believes the Commission must have access to the trading and
other records of any unregistered affiliate of the U.S.
registrant, and to its personnel, in order to monitor conduct
that could harm U.S. investors.
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Performance Based Advisory Compensation
Section 205(a)(1) of the Advisers Act generally prohibits a
registered investment adviser from receiving compensation based
on a share of the capital gains in or capital appreciation of a
client’s account. As a result of these prohibitions, and the
current extraterritorial application of the Advisers Act, a U.S.
registered adviser may not charge any client, foreign or
domestic, a performance based fee, except a fulcrum fee under
Section 205(b)(2) or a performance fee allowed under Rule 205-3,
even though such fees are customary in a number of foreign
countries.
The Report recommends that the statute be amended to
authorize the Commission to relax the performance fee
prohibitions in two ways. First, the Commission could by rule or
order permit performance fees in the case of any client who, for
reasons such as net worth or financial sophistication, does not
need the protections of the Act in this regard. Second, the
Report states that the amendment should authorize the Commission
to permit performance fees in the case of a client that is not a
U.S. resident, but resides in a country where such fees are
lawful. A U.S. adviser would be required to maintain records
regarding its performance fee contracts with foreign clients to
enable the Commission to monitor the activities by inspection.
We will keep you informed of developments with respect to
these staff recommendations.
Catherine L. Heron
Vice President - Tax & Pension