Tripping over Federal securities regulations can bring a mutual fund advisor to its knees. But running afoul of state securities divisions can also be painful.
American Century Investments of Kansas City, Mo., recently found itself mired in the regulatory web of the California Secretary of State. Five of its mutual funds, all registered as a series of quantitative equity portfolios, are domiciled in the state of California, and, accordingly, each has its articles of incorporation registered under California securities laws.
Early in 2004, when American Century personnel routinely filed the annual reports on its five funds with California regulators, it was discovered that the registration of additional shares classes on each fund had been done incorrectly seven years earlier, explained Deborah Weinstein, a spokeswoman in the Mountain View, Calif., office of American Century.
Although the board of directors had properly authorized the creation of additional share classes several years ago, California regulators questioned whether these new share classes provided fund investors with the same rights and limitations as owners of the original share class sold for each fund.
"These [new share classes] were legally registered, and all shareholders were treated equally," said Chris Doyle, a spokesman in the firm's headquarters. American Century is working with California regulators to resolve the deficiencies and does not anticipate the resolution will have any impact on the funds. The funds include an equity growth fund, an income and growth fund, a small company fund, a utilities fund and a global gold fund. Together, this series of funds has total assets of $7.9 billion. These are the only funds in the American Century lineup of 62 funds that are domiciled in California.
The funds in question were the original equity funds managed by The Benham Group, a California-based, predominantly fixed-income fund manager, which American Century, then known as Twentieth Century Cos., acquired in 1995. Records from the California Secretary of State show that the quantitative equity funds have been registered as a California corporation since 1987.
But doing business in California can be tricky, largely because California doesn't have special laws designed for mutual funds, nor the vast investment company case law that states such as Delaware, Maryland and Massachusetts can boast. Few, if any, other mutual funds have their funds domiciled in California. Even those funds who call the Golden State home, including the American Funds managed by Capital Research & Management, and Wells Fargo Funds, have other funds domiciled in the trio of East Coast fund-friendly states. Because of the attractive legal and tax incentives they offer funds, Maryland, Delaware and Massachusetts are equipped with voluminous case laws and decades of court precedence to fall back on.
Being domiciled in California can lead to unexpected challenges, said American Century officials. For example, in 2002 when American Century executives decided to liquidate a sixth fund, a global natural resources index fund, they found that California law held no clear guidelines on conducting a proxy vote, Doyle said.
Moreover, under California law all of the funds need to be treated as a group. That meant that if the firm desired a change to one of the funds, it was required to communicate with the shareholders of all of the funds, Weinstein explained. In contrast, Maryland law only requires the shareholders of the one fund being changed to be proxied, which is less expensive for shareholders, she added.
To make life a bit easier, last week American Century sent a proxy statement to investors of these five funds, asking for approval to move the funds' state of incorporation from California to Maryland.
The Blue Sky Blues
Even those mutual fund companies that are domiciled in fund-friendly states can sometimes run afoul of state securities regulations. Individual states' Blue Sky laws, which govern the registration and distribution of shares of mutual funds, as well as reporting requirements, can sometimes trip up well-meaning fund advisors.
States first began passing Blue Sky laws in 1911 as a way to prevent the fraudulent sale of securities. According to industry lore, the term "Blue Sky" was first used in 1917 by Supreme Court Justice Joseph McKenna to denote bogus investments and "speculative schemes which have no more basis than so many feet of blue sky."
Each state has its own set of Blue Sky laws. And although The National Securities Markets Improvement Act of 1996 largely transferred regulatory oversight of those who manage more than $25 million to the Securities and Exchange Commission, it preserved the rights of state securities regulators to bring actions against violators.
The exercising of those state regulators' rights became all too clear this past September when New York Attorney General Eliot Spitzer used his authority under New York State's little-enforced Martin Act, a Blue Sky law, to charge several fund companies with securities fraud in relation to late trading and market timing of mutual funds.
Beyond those more egregious activities, it can be common for funds to occasionally miss a state-mandated filing deadline, or misinterpret a state's laws, said industry Blue Sky experts.
State Regs, Still a Crazy Quilt
Because the laws and filing fees vary widely from state to state, it's important for fund advisors, or their third-party service providers, to be sure they understand the letter of each state's laws, experts say. It's also important to bone up on required fees because some states base fees on fund assets, while others calculate fees upon actual sales, and some exempt certain types of sales.
Fund advisors sometimes believe that a state securities filing is required only after the sale of a mutual fund is made, but that isn't true, counseled Liz Nystedt, president and CEO of Automated Business Development Corp., whose ClearSky unit handles Blue Sky compliance for 150 clients. The firm is a division of PFPC Worldwide. Shares must be registered in advance of a sale, often entailing sales predictions. Also, some states require each fund to be registered, while others expect each portfolio or class of a fund's shares to be separately registered. It's also important to know which states require the tracking and reporting of in-state sales, she added.
And missing deadlines can bring about regulatory ire in the form of fines, or worse. If there's a pattern of missing deadlines, state regulators can require a fund advisor to rescind an offering, and force it to refund the original investment to all investors with interest, Nystedt noted. "But, if states understand that you're trying, they may give you a reprieve," she added.
Some states require specific amounts of shares to be registered for sale, while others allow for the filing of an unlimited number, said Rick Cortese, vice president of National Regulatory Services in Lakeville, Conn., a subsidiary of Thomson Media, publisher of Money Management Executive.
Texas, long known as being a stickler for details, also charges the highest filing fees. And in Texas, if you file to sell a certain amount, but end up overselling, the state regulator asks for a retroactive fee at three times the original rate, Nystedt said.
Timing is also quite important, said Alaina Metz, VP, regulatory services at BISYS, which processes about 27,000 annual Blue Sky filings for clients. "There are filing deadlines throughout the year," she cautioned. And states have varied rules about filing at a fund's fiscal year-end, at the calendar year-end or based upon when the fund last registered, she said.
State regulators have come to view Blue Sky filings as a lucrative revenue stream. As such, the trend is definitely toward higher fees. Many states, facing budgetary shortfalls, have raised their filing fees over the last several months.
As for hopes that one day, a single set of Blue Sky filing standards will be adopted across all 50 states, don't hold your breath, said Chuck Booth, chief compliance officer at BISYS. "They all have their own securities divisions that deal with more than just mutual funds," he said.
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