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News November 6, 2017 Issue

SEC Staff Rejects No-Action Request from Adviser Seeking Allocation Permission

Advisory firms seeking SEC staff permission to allocate certain fund operating expenses to other funds it manages – and possibly invest in the funds receiving those allocations – must first obtain a Rule 17d-1 exemptive order to overcome that potential conflict of interest. They should not seek a no-action letter, and they definitely should not begin allocating prior to receiving the exemptive order.

Maryland-based advisory firm Mutual of America Capital Management found this out after it sought a no-action letter that it hoped would state that the SEC staff would not recommend enforcement action if it engaged in such allocation. The agency staff on October 26 took the unusual step of publicly rejecting its no-action letter request. It also did not seem pleased that the adviser had previously begun the allocation in question before requesting the letter, even if the firm terminated the practice before the request was sent.

"After consultation with the Division of Enforcement, we are issuing this letter denying your request as a caution to you and others against creating an arrangement such as the one described in your letter outside of the parameters and condition of a Commission order under Rule 17d-1," the staff said in its rejection letter.

The staff’s decision to issue a public rejection letter to the no-action request is "rare," said Stradley Ronon partner Lawrence Stadulis. "In those instances where it is disinclined to grant no-action relief, the SEC staff typically communicates its decision orally to the requesting party and permits them to withdraw the incoming request. Not surprisingly, most people take them up on this offer."

So why did the staff publicly reject the no-action request? Consider the following possibilities:

  • A warning to others. The agency staff made clear in its response that the rejection was meant to be read by all. Stating that the letter denying the request was issued "as a caution to you and others" would seem to support this view. The message the agency staff sent was that it is "unwilling to consider requests for relief in connection with these types of arrangements through the no-action process, and will do so only through an application for exemptive relief," Stadulis said.
  • A response to acting without permission. Mutual of America Capital Management, according to the SEC’s letter, had already started the allocation in question, then terminated the practice, before seeking agency assurance of no enforcement action. The SEC staff may have not liked that – and the staff’s statement that it consulted with the Enforcement Division prior to sending its response was most likely not welcome news to the adviser.
  • It’s the new SEC. "It is possible that the SEC staff’s response is reflective of the new approach the SEC is taking toward enforcement under chairman Jay Clayton, which appears to use warnings and other methods short of enforcement actions," said Stadulis.

"The industry practice over the past 30 years with respect to arrangements such as the proposed expense allocation among the [funds in question] has been to seek Commission orders under Rule 17d-1 prior to implementing the arrangements," the staff said. "In reaching our conclusion, we note in particular the fact that some of the operating expenses proposed to be allocated to the underlying funds would not be incurred by, or otherwise attributable to, the underlying funds, but rather would be incurred by or solely to the [family of funds they were to be allocated from]. We believe that this fact creates the potential for conflicts of interest and for participation by a fund on a basis less advantageous than that of other participants, that is not present (or present to a much lesser degree) in the typical industry practice of allocating certain shared expenses among the relevant funds in a fund family without an order under Rule 17d-1."

In its August 14 letter requesting assurances of no action, an attorney representing Mutual of America Capital Management stated that the non-advisory operating expenses it sought to allocate included "legal and compliance service, costs of printing and distribution of fund prospectuses and shareholder reports, as well as certain licensing fees and directors, legal and auditing, and custodial fees."

The attorney, when reached, did not comment on the request or the agency staff’s response.

The issue of seeking exemptive orders under the Investment Company Act is a highly sensitive one in the asset management industry, said Mayer Brown attorney Adam Kanter. "The Investment Company Act has many more explicit requirements than the Advisers Act, which is more about fiduciary requirements."