The SEC has made it easier for funds to redeem the holdings of affiliates and large shareholders in securities rather than cash, a move industry accountants and lawyers say should reduce fund costs and ease operational headaches.

Mutual funds can redeem the holdings of large investors in securities so long as the funds satisfy six key guidelines, the SEC said in an interpretive letter dated Dec. 28. Funds that satisfy the requirements can redeem shareholders in securities rather than cash - a move known as an in-kind redemption - without seeking special regulatory approval from the SEC, David W. Grim, SEC special counsel, said in the so-called no-action letter.

Such in-kind redemptions to fund affiliates or shareholders owning five percent or more of a fund have been illegal without a special order from the SEC. Those orders, known as exemptive orders, can take four months or longer to obtain, mutual fund lawyers said last week. Funds have only seven days to pay redemption requests under federal securities laws. Fund executives who follow the requirements outlined in Grim's letter now can process in-kind redemptions without seeking an exemptive order.

"I think this is a big benefit," said Paul Kraft, an accountant in the Boston office of Deloitte & Touche LLP of New York, of the SEC no-action letter. "It's a good option to have in your back pocket" to meet a large redemption request.

Funds facing large requests now must have a large quantity of cash on hand, sell off securities - incurring transaction costs and potential capital gains - or borrow money to make redemption payments in cash. These alternatives mean either lost investment opportunity or added costs to all shareholders rather than just the redeeming shareholder. The SEC, itself, in a 1966 report, enumerated the disadvantages for a fund and its shareholders when the fund is faced with a large redemption request.

Nevertheless, federal securities laws prohibit a mutual fund from selling securities to an affiliate or five percent shareholder. That prohibition is intended to guard against unfair transactions in which a fund redeems an affiliate or five percent shareholder using the most preferred securities - such as securities which are the most easily sold or have the most favorable cost basis. The SEC frequently has granted exemptions to the in-kind prohibition when there was no danger of unfair dealing, Grim said.

The SEC identified six requirements for a fund to redeem shareholders in kind without seeking a special exemptive order. Those requirements include that a redeeming shareholder not get the benefit of the most desirable securities and that redeeming shareholders not be unfairly burdened by the redemption in kind.

The no-action letter also requires that fund directors closely oversee and approve the procedures that funds use to make in-kind redemptions to insure that they are fair to shareholders who remain in a fund.

The SEC issued the no-action letter in response to a request from the Signature Financial Group of Boston. The firm did not immediately return a call seeking commet.

The SEC letter may prove helpful to closed-end funds that convert to open-end status, said David Sturms, a lawyer with the firm of Vedder, Price, Kaufman & Kammholz in Chicago. Closed-end funds can face a rash of redemption requests from institutional investors once the fund opens, Sturms said. Grim's letter should make it easier for those newly open-ended funds to pay redeeming investors in kind rather than with cash, Sturms said. The letter also will serve as a road map for fund companies that currently have no formalized policies on when and how they handle large redemption requests, Sturms said.

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