An Auditor’s Perspective for Boards of Directors/Trustees
In April, the SEC released proposed Rule 2a-5 under the Investment Company Act of 1940, which addresses valuation practices and the relative role of the Board for registered investment companies and business development companies. The proposal looks to be another “catch-up” by the SEC to account for the growing complexity of valuations and the evolution of developments that have taken place with respect to accounting and auditing regulations.
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Given the current COVID-19 crisis and its economic impact, it’s possible that some Regulated Investment Companies (“RICs”) could be exploring ways to retain their cash. The shareholder distribution requirements of IRC Section 851, however, remain, and it is highly unlikely Treasury or the IRS would ever grant relief in this area.
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Many advisers of registered products, including mutual funds and closed-end interval funds, invest in private alternative investments as part of their portfolio strategy. And generally, they are permitted by the Investment Advisers Act of 1940 to do so. While mutual funds are restricted to investing up to 15% of net assets in illiquid securities, there are no such restrictions for interval funds.
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In recognition of the operational challenges caused by COVID-19 for funds and their Trustees/Directors, the Securities and Exchange Commission (“SEC”) and the Internal Revenue Service (“IRS”) have both issued exemptions relating to filing due dates and other requirements.
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One of the many appealing aspects of the ETF vehicle is that it is generally designed to be tax efficient. The primary mechanism for achieving tax efficiency is the ability to redeem appreciated securities in-kind. Any gains realized on securities redeemed in-kind are not taxable and therefore do not need to be distributed to underlying shareholders. The ability to utilize custom baskets further enhances an ETF’s tax efficiency by redeeming a sampling of appreciated securities in redemption transactions, while selling depreciated securities to harvest losses. A seasoned ETF is unlikely to ever have to pay a capital gain distribution.
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As many portfolio managers look to launch alternative investment strategies, we have seen a growing interest in the interval fund structure. An interval fund is a hybrid of an open-end mutual fund and a closed-end mutual fund. Similar to an open-end fund, an interval fund accepts subscription dollars and issues shares at net asset value on a regular basis, often daily. However, they generally only offer to repurchase shares at net asset value quarterly. These infrequent repurchases allow interval funds to hold less liquid assets compared to traditional open-end mutual funds.
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Fulcrum fee arrangements have been used by certain actively traded registered funds for years but are of late garnering increased attention as active managers attempt to stave off passive investing and the lower fee structure often associated with it. The concept aligns the interest of the advisor with that of the investor by rewarding the advisor when it outperforms its benchmark and reducing the fees of the advisor (to that of an index fund-like fee or even zero) when it underperforms its benchmark.
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The Coronavirus pandemic (“COVID-19”) is causing significant financial and operating hardships across all industries. Any companies that are currently preparing GAAP financial statements, including investment companies, should consider whether or not the impact of COVID-19 represents a significant event as defined in FASB Accounting Standards Codification (“FASB ASC”) 855, Subsequent Events.
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On December 30, 2019, the SEC proposed amendments to certain independence requirements with the goal of further aligning the auditor’s independence analysis with Rule 2-01’s “reasonable investor” concept. The concept asks us to consider whether a reasonable investor with knowledge of all the relevant facts and circumstances would conclude that the auditor is capable of exercising objective and impartial judgment?
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