Vol. 1 No. 45
Goodwin, Procter & Hoar LLP, a firm of over 350 lawyers, has one of the largest financial services practices in the United States. We have created the Financial Services Alert as a service to advise our clients and other financial services institutions to news of importance to the industry in a timely manner. Some issues of the Alert, such as this one, will principally summarize significant recent developments in financial services law and regulation. Other issues will provide more indepth analysis about specific areas of financial services law. We hope that you will find the Financial Services Alert to be helpful. We welcome your suggestions for future topics of interest.
Developments of Note
U.S. Tax Court Rules Adviser May Not Deduct Mutual Fund Startup Costs
The U.S. Tax Court ruled that the startup costs incurred by an investment adviser in connection with the establishment of a mutual fund (i.e., development of the idea for the new fund, development of the marketing plan, drafting of the management contract, formation of the fund, obtaining board approval of the contract, and registering the fund with the SEC and state securities regulators) were not currently deductible and could not be amortized. Unlike the Tax Court decision with respect to the origination of bank loans, discussed in the June 23, 1998 issue of the Alert, the Tax Court did not base its determination in this case on the fact that "separate and distinct assets" were created. Rather, the Tax Court focused on the U.S. Supreme Court's decision in INDOPCO and based its determination on the fact that the adviser was realizing a significant future (beyond the current taxable year) benefit in connection with the fund establishment. In support of this determination, the Tax Court noted that the adviser could reasonably expect to be awarded not only the initial investment contract with respect to a new fund, but also annual renewals, and the adviser and the mutual fund could realistically expect the relationship to continue indefinitely. As to amortization, the Tax Court noted that amortization is potentially available to intangibles, but for such amortization the taxpayer must demonstrate that the asset has a value that wastes over an ascertainable period of time. The adviser argued that the relevant period of time was 2.2 years, which is the average life of initial investments in a new mutual fund. However, the Tax Court disagreed, ruling that there was no reason to limit the analysis of the new mutual fund's useful life to the duration of its initial investments, as the benefits of the fund to the adviser continue beyond such investments. FMR Corp. v. Comm'r of Internal Revenue.
SEC and FDIC Continue to Address Year 2000 Issues
Continuing their focus on Year 2000 ("Y2K") issues, the SEC issued a proposed rule regarding investment adviser Y2K reports, and the FDIC discussed upcoming Y2K assessments and recent FFIEC examination guidance.
SEC. The SEC proposed a new rule (204-5) and Form under the Investment Advisers Act of 1940 requiring most investment advisers registered with the SEC (i.e., advisers that have assets under management of not less than $25 million or are advisers to registered mutual funds) to submit a report regarding their Y2K preparations. The proposed rule would require affected advisers to submit a new Form ADV-Y2K no later than 30 days after the rule becomes effective, with an updated Form to be filed no later than 8 months thereafter. Part I of the ADV-Y2K, to be completed by all respondents, would contain general questions about preparations for Y2K problems. Part II of the Form would consist of questions analogous to those in Part I and be completed by advisers to registered funds. Generally, the Form requires each adviser to provide the SEC with information concerning: (1) the scope of the Y2K plan; (2) the commitment of resources and personnel; (3) systems that may be affected; (4) progress on preparation for Y2K problems, including assessment, implementation, internal testing, and testing of products and service providers; (5) contingency plans; and (6) readiness of third parties upon whom the adviser relies. While the report would have to be signed by a senior person of the adviser, it would not have to be attested to by an independent public accountant. Comments on the proposal are due by August 10, 1998.
FDIC. The FDIC stated that it has completed its first round of on-site Y2K assessments, and will begin the examination process for a second round of Y2K reviews. These assessments may be conducted as part of regularly scheduled Safety and Soundness or Information Systems examinations, or as a separate visitation. Institutions will be rated as satisfactory, needs improvement, or unsatisfactory, and those rated less than satisfactory generally will be subject to supervisory action. The FDIC also discussed recent FFIEC examiner guidance concerning Phase II of the Y2K review (the "Year 2000 Workprogram"), which extensively details the issues that examiners will review in connection with the next series of examinations.
FFIEC Proposes Revisions to Rating System for Information Systems
The FFIEC proposed changes to its Uniform Interagency Ratings System for Data Processing Operations. The proposed revisions conform the numerical ratings of the system to the Uniform Financial Institution Rating System (i.e., a rating of 1 is best and a rating of 5 is the worst). The revised rating system provides a rating for each of four subcategories, the last two of which are new: audit (the quality of independent assessments of exposure to risk and internal controls); management (the ability of the board and management as they apply to all aspects of information technology development and operations); development and acquisition (the ability to identify, acquire, install, and maintain appropriate information technology solutions); and support and delivery (the ability to provide technology services in a secure environment). The entity also would receive a composite rating based on the four subcategories. Comments on the proposal are due by August 10, 1998.
SEC Approves NASD Free-Riding Amendments; Proposes Option Disclosure Rule
The SEC approved amendments to the NASD's Free-Riding and Withholding Interpretation, and proposed a new rule excluding option disclosure documents ("ODDs") from prospectus civil liability.
Free-Riding. The SEC approved the proposal by the NASD to amend its Interpretive Material (IM-2110-1) and Rule 2720 to revise certain aspects of its Free-Riding and Withholding Interpretation (the "Interpretation"), the purpose of which is to ensure that members make a bona fide public distribution of "hot issue" securities rather than withhold such securities for their own benefit. Unlike the previous Interpretation, the revised Interpretation authorizes NASD staff to provide an exemption either unconditionally or on specified terms from any or all of its provisions. Moreover, a new section was added to the Interpretation to exempt certain passive investors (whether natural or non-natural persons)in broker-dealers, namely (1) any person who is a passive investor, owns less than 10% of the equity capital of a member, and does not purchase hot issues from the member; and (2) any person who is a passive investor and owns less than 10% of a member whose shares are traded on an exchange or Nasdaq. The rule also exempts sales of hot issues to any account established for the benefit of bona fide public customers of a restricted person, including insurance company general or separate accounts. The rule further exempts from the definition of public offering, and thus from the Interpretation's coverage, debt securities (other than debt convertible into stock), financing instrument-backed securities that are rated, and secondary offerings by an issuer whose securities are actively traded (i.e., a worldwide average daily trading volume of at least $1 million and are issued by an entity whose common equity securities have a public float value of at least $150 million). Purchases of shares of foreign mutual funds also may be exempted subject to certain verification procedures. Finally, the SEC-approved rule generally excludes qualified ERISA plans from its treatment of restricted accounts.
ODD. The SEC also issued a proposed rule to codify an SEC interpretation and provide that an ODD prepared in accordance with Rule 9b-1 under the Securities Exchange Act of 1934 is not a prospectus and, accordingly, is not subject to civil liability under Section 12(a)(2) of the Securities Act. Unlike the options registration document, which is a registration statement under Form S-20 of the Securities Act, the ODD merely provides a general description of standardized options (generally, options contracts which relate to options classes the terms of which are limited to specific expiration dates and exercise prices) and the rules of options trading. The ODD must be delivered to customers before a broker-dealer approves the customer's account for options trading. Comments on the proposal are due by July 31, 1998.
OTS Provides Guidance on Special Purpose Credit Programs
The OTS issued guidance, in Q&A format, relating to "special purpose credit programs" under the Equal Credit Opportunity Act (the "ECOA"). These programs, which are intended to meet special social needs, are exempt from ECOA's general prohibition on credit discrimination. Among other matters, the OTS guidance details: requirements for a special purpose credit program ((1) a written description of the program and the persons it is designed to benefit, and (2) actually administering the program to provide credit to persons who would ordinarily not receive such credit); that no regulatory filing or approval is necessary to initiate a program; and the type of data that may be collected under such a program.
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