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News September 4, 2006 Issue

SEC Brings Managed Distribution Policy Enforcement Case

The logjam that has held up the 19(b) exemptive relief necessary for funds to implement managed distribution policies may have finally cleared.

First, a bit of background: A managed distribution policy is a neat little feature that allows registered funds — even equity funds — to provide regular and periodic distribution payments to shareholders. The source of the payment depends on what is going on with the fund: It could represent net income, capital gains, and/or even a return of the shareholder’s own capital. To ensure that shareholders don’t mistakenly think that the return of their capital is actually a "yield," however, ICA Section 19(a) requires funds that pay distributions from sources other than certain types of net income to provide separate disclosure explaining how the payments are funded.

To implement managed distribution policies, registered funds have routinely sought and obtained exemptive relief from ICA Section 19(b), which generally prohibits funds from distributing long-term capital gains more than once every twelve months.

Last week, the SEC announced that it had settled an enforcement proceeding against fund administrator Delaware Service Company for allegedly making a false representation in a Section 19(b) exemptive application it had submitted on behalf of two affiliated funds. In its application, DSC represented that a Section 19(a) disclosure notice accompanied each of the funds’ distributions, as required by law. "That assertion," said the SEC, "was untrue because . . . DSC was not providing the required 19(a) notices for the two funds at the time the application was made."

In an unusual footnote, the SEC noted DSC’s "justification" for not sending out the 19(a) notices: At the time the distributions were made, DSC projected that there was a "reasonable likelihood" that the funds would receive enough investment income over the remainder of the fiscal year to cover the distributions. However, the SEC noted, the rule governing the content of 19(a) notices requires funds to make reasonable estimates at the time of the distribution payment. Moreover, the rule requires that funds correct inaccurate estimates.

To settle charges that it violated ICA Section 34, which prohibits false statements in SEC filings under the ICA, DSC was ordered to cease and desist and agreed to pay a civil penalty of $425,000.

So how is this going to clear up the 19(b) logjam?

In April of 2004, the SEC staff alerted DSC to the fact that it should have been providing 19(a) notices. Around the same time, the Division of Investment Management’s exemptive applications office imposed a moratorium on new 19(b) orders, which up until then had been routine.

Some fund groups were less than pleased.

Soon after new Division director Buddy Donohue took office, the Boulder Funds wrote in to complain that the staff’s moratorium on 19(b) orders was putting them (as well as other closed-end funds that had filed applications for 19(b) orders), at a competitive disadvantage to funds that had obtained 19(b) orders before the moratorium.

In an August 4 response, IM chief counsel Douglas Scheidt told the fund group that the staff has been "carefully evaluating the continuing appropriateness and effectiveness of the conditions" of past 19(b) orders in light of the policies and purposes of the law, as well as in light of "the manner in which some funds have implemented their managed distribution plans."

Scheidt indicated that the staff is close to wrapping up: "We are nearing completion of our evaluation, and believe that we will soon be in a position to resume processing applications for 19(b) Orders, as informed by our evaluation." Scheidt thanked the fund group for its patience, and also for working with the Division’s disclosure staff to develop enhanced disclosures about the possible consequences of its managed distribution plan.

For a look at these disclosures, check out a managed distribution policy Q&A recently posted on the Boulder Fund’s website. "It is expected that distributions under the [policy] will consist mostly of a return-of-capital," reads the disclosure. "[A] return-of-capital is just what the term implies, a return of stockholders’ capital investment in the Fund." The fund group explained that such payment is not considered yield, income, or capital gains. "When stockholders receive a return of capital, they are getting back part of their investment," explained the fund group.