1 In its 1992 report on investment company regulation, the
staff of the Division of Investment Management recommended
adoption of Commission's proposed Rule 6c-10, "with certain
modifications" relating to the mechanics of the rule.
April 27, 1994
TO: ACCOUNTING/TREASURERS COMMITTEE NO. 19-94
OPERATIONS COMMITTEE NO. 9-94
TAX COMMITTEE NO. 16-94
RE: FORMATION OF SUBCOMMITTEE TO ADDRESS ISSUES RAISED BY SEC
PROPOSED RULE 6c-10
__________________________________________________________
Introduction
In 1988, the Securities and Exchange Commission proposed
Rule 6c-10 under the Investment Company Act of 1940, to permit
mutual funds to impose contingent and non-contingent deferred
sales loads without first obtaining exemptive relief from the
Commission. In response to this proposal, the Institute filed a
comment letter generally supporting the provisions relating to
contingent deferred sales loads but opposing the non-contingent
deferred load portion of the proposal. To this date, there has
been no further Commission action on the proposed rule. 1
Currently, however, the Commission is considering another
rule proposal (Rule 18f-3) that would permit mutual funds to
issue multiple classes of shares without having to seek an
exemptive order. Insofar as most funds with multiple classes
impose a contingent deferred sales load on at least one class of
shares, and at present must obtain exemptive relief to do so, we
understand that it is likely that the Commission will adopt
proposed Rule 6c-10 in some form at the time it adopts the
multiple class proposal.
Therefore, the Institute is forming a subcommittee to
discuss whether any significant concerns remain in connection
with the possible adoption of Rule 6c-10. A meeting of the
subcommittee has been scheduled for Thursday, May 12, at 10:00 am
in the Institute's David Silver Conference Room on the 12th floor
at 1401 H Street, N.W., Washington, D.C. Please indicate on the
attached form if you plan to attend.
As background for the discussion at the meeting, this
memorandum summarizes some of the issues the Institute identified
in its 1989 comment letter on proposed Rule 6c-10, and certain
developments in the area of mutual fund distribution since Rule
6c-10 originally was proposed. A copy of the Institute's comment
letter is attached.
Institute Comment Letter
As noted above, the Institute's comment letter on proposed
Rule 6c-10 generally supported the codification of exemptive
relief for the imposition of contingent deferred sales loads. We
suggested, however, that the NASD regulate these charges; that
fund complexes be permitted to continue to rely on previously
issued exemptive orders as to existing funds as well as funds
created in the future; and that the proposed definition of
contingent deferred sales load be modified slightly.
With respect to non-contingent deferred loads (in
particular, installment loads), the Institute's letter
characterized the Commission's proposal as "uneconomic and
unworkable." The letter criticized the proposal on the basis
that it dealt with an area in which the staff had no experience
and the industry had no interest. The Institute also strongly
objected to the suggestion that non-contingent deferred loads
could act as a substitute for spread-load 12b-1 plans.
The Institute's letter described numerous specific problems
under the proposal, some of which are discussed further below.
Additional potential tax issues are also described.
A. Tax Issues
The proposed non-contingent deferred load provisions
raise numerous tax concerns, some of which were identified in the
Institute's comment letter. Additional issues were addressed in a
recent comment letter submitted by counse to a bank, a copy of
which is attached, that supported adoption of the non-contingent
deferred sales load rules.
It is likely that non-contingent deferred loads would
be treated as non-recourse loans to shareholders secured by the
shareholder's interest in the fund. If, the installment load is
structured in such a way that no interest charge on the deferred
load is specified, payments would be treated as having interest
and principal components determined under the original issue
discount ("OID") rules. The principal portion of each payment
would be added to the basis of the shares while the interest
portion generally would be deductible as investment interest. If
an investor regularly purchased shares, the deferred load on each
purchase would be subject to its own OID calculations,
potentially at different interest rates for each purchase. (The
OID calculation uses an interest factor that is adjusted
periodically.) If the rule retains the requirement that the
deferred load be calculated on the lower of the net asset value
at time of purchase or time of redemption, deferred loads could
be treated as contingent payments under the OID rules.
If deferred loads are collected from dividends,
shareholders will owe tax on dividend income they do not receive.
In addition, dividend income may not be sufficient to cover the
amount of the deferred load obligation. If shares are
automatically redeemed to pay deferred loads, the shareholder may
realize taxable gains or losses. The gains would generate a tax
liability but no cash, while losses might be disallowed under the
wash sale rules if the shareholder purchases new shares shortly
before or after the redemption. Furthermore, redemptions might be
treated as essentially equivalent to a dividend and therefore
give rise to ordinary income instead of capital gain or loss.
B. Payment Problems
The Institute's letter noted certain problems with the
payment of installment loads. For example, although deducting
them from dividends might be the preferred method, this might not
be feasible in the case of shareholders who have their dividends
reinvested, since the proposed rule would prohibit the imposition
of any deferred load on shares purchased through the reinvestment
of dividends.
C. Accounting and Record-keeping Burdens
The letter noted that non-contingent deferred load
arrangements may pose difficult accounting and record-keeping
problems for fund distributors, particularly in complying with
Rule 17a-3 under the Securities Exchange Act of 1934. For
example, the load due from each shareholder would have to be
reflected as a receivable, but it could be difficult, if not
impossible, to determine the exact amount of the receivable if it
must be calculated on the basis of the lesser of net asset value
at purchase or redemption.
The letter also stated that the proposed rule's
conditions would necessitate computer redesign and capacity
augmentation to make possible individual shareholder accounting
and monitoring. Broker-dealers would be burdened by the necessity
to maintain detailed records and perform essentially transfer
agency functions in the case of shares held in street name.
D. Unworkable Conditions
The Institute's letter stated that specific conditions
under the rule raised ambiguities and anomalies demonstrating
that the rule, as proposed, was unworkable. For example,
according to the letter, the prohibition on imposing any deferred
load on amounts representing capital appreciation, combined with
the requirement to assess a deferred load at the lower of
purchase or redemption price, would result in the underwriter
receiving a load based on a lower net asset value than at the
time of purchase, whether the net asset value had appreciated or
depreciated.
Other Developments
The NASD's Rules of Fair Practice were amended, effective
July 7, 1993, so that all mutual fund sales charges -- front-end,
deferred and asset-based -- are subject to maximum limits under
those rules. Under the NASD's rules, which were approved by the
Commission, the limits on total sales charges for funds with an
asset-based sales charge specifically contemplate an interest
component. By approving the NASD's amended maximum sales charge
rules, the Commission implicitly has accepted the premise that a
fund underwriter that advances commissions to brokers and is paid
back over time should be compensated (through interest payments)
for the cost of the amounts advanced. It is our understanding
that the staff is aware of the apparent inconsistency between the
prohibition on interest in proposed Rule 6c-10 and the specific
provision for interest in the NASD rules.
In preparation for the discussion at the subcommittee
meeting, please consider: (1) which issues still would affect
the feasibility of utilizing installment loads, (2) specific
recommendations for addressing these issues, and (3) if the
remaining unresolved issues are numerous and significant, whether
the Institute should urge the Commission to re-propose the
portion of its proposal relating to non-contingent deferred
loads, or to withdraw the proposal entirely. If you have
comments on this matter but will not be able to attend the
meeting, please contact the undersigned at (202) 326-5837, or Don
Boteler at (202) 326-5845.
Please indicate on the attached form if you plan to attend.
Peter Cinquegrani
Assistant Counsel-Tax
Attachments