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SEC No-Action Letter: Eases Transactions with Affiliates

The Division of Investment Management of the Securities and Exchange Commission issued a no-action letter Oct. 12 that may make life easier for mutual fund boards and business development companies that have reason to engage in “affiliated transactions” as defined by the 1940 Act.

In response to a request from the Independent Directors’ Council, the Investment Management Division’s senior counsel, Asen Parachkevov, has now offered an assurance that “we would not recommend enforcement action … “ against funds that engage in affiliated transactions, even in the absence of direct due diligence by the board of directors, so long as the board of the registered management investment company or business development company receives, quarterly or more often, written representations from its chief compliance officer that the transactions “effected in reliance on rule 10f-3, 17a-7, or 17e-1 under the Act … complied with the procedures adopted by the board pursuant to the relevant Exemptive Rule.”

Boards Get to Delegate

In short, boards are now allowed to delegate their responsibility to make the determinations required by the exemptive rules, a delegation that has been expressly prohibited for nearly eight years now, since a letter sent (also to the IDC as it happens) in November 2010: of which, more later.

The new no-action letter observes that boards have growing responsibilities, as the result “of market, regulatory and technological developments” and that due to its awareness of this trend, “the staff [of IM] has continued to review existing director responsibilities and to consider whether they are appropriate.”

The three exemptive rules involved are these:

Rule 10f-3 allows affiliated transactions in securities during the existence of an underwriting syndicate of which the affiliated person is a member;

Rule 17a-7 allows certain cross-trades with affiliates;

Rule 17e-1 allows an affiliate to receive certain commissions and fees in connection with the fund’s brokerage transactions. This is a safe harbor from the restriction of the statute’s section 17(e)(2)(A), which prohibits a broker from receiving remuneration beyond the “usual and customary” brokerage commission.

Each rule has its complexities as written.

Some History

Back in 2003, the SEC created Rule 38a-1, which gave official recognition to the role of the Chief Compliance Officer. This did not settle the issue, but it inspired speculation as to whether and by how much the oversight burden on the board had been lessened.

In the 2010 letter, the SEC spoke to that speculation, and said specifically that “even if boards rely on the CCO or others ...  boards still retain ultimate responsibility for making the quarterly determinations required by these three rules, and boards cannot delegate such responsibility. As a result, even if the directors rely on others to investigate the details of each transaction, they need to be appropriately vigilant to ensure that they have sufficient information to be alerted to issues raised by these conflict transactions.”

Now, though, in 2018, it is the position of the SEC staff that 38a-1 was meant to allow such delegation, thus allowing companies to avoid the duplication of “certain functions commonly performed by, or under the supervision of, the CCO.”

Directors aren’t off the hook. It remains their responsibility, the letter emphasized, to “focus on conflict-of-interest concerns raised by affiliated transactions, including whether a fund engaging in the types of affiliated transactions permitted by the Exemptive Rules is in the best interest of that fund and its shareholders.”

BDCs and the Bigger Picture

Much of the discussion of these rules and the arrangements for compliance are presumed to be for mutual funds. But the Oct. 12 letter makes it explicit that the position it is expressing also extends to BDCs, as defined under section 2(a)(48) of the Act.

This no-action letter should probably be considered in the context of the Trump administration’s general attitude toward BDCs—it has been working in other respects too, to remove what it sees as shackles to their growth. The Small Business Credit Availability Act, which became law in March of this year, increases the ability of BDCs to use leverage in their portfolios and mandates SEC regulatory changes that will give BDCs the same flexibility as public operating companies in their communications with actual and prospective investors.