By Amanda Maine, J.D.
A panel of the D.C. Circuit Court of Appeals heard arguments from the SEC and a mutual fund regarding the SEC’s decision to deny the fund’s application for an exemption for its method of accounting for potential deferred tax liability (Copley Fund, Inc. v. SEC, May 4, 2015).
Background. On September 4, 2013, Copley Fund, Inc. submitted an application with the SEC requesting an exemption from Rule 22c-1 under the Investment Company Act and Rule 4-01(a)(1) of Regulation S-X. Copley, a mutual fund, requested an exemption that would permit it to alter the manner in which it currently accounts for deferred tax liability on unrealized gains. Copley proposed to account for its deferred tax liability for unrealized gains by establishing a tax reserve based on a pre-set formula designed to present a more accurate and fairer disclosure to the investing public of its invested assets and net asset value (NAV). Copley had used this method until 2007, when the SEC informed it that this method violated GAAP and that it would recommend enforcement action if Copley did not change its accounting for deferred tax liability.
To comply with the SEC’s determination, Copley currently makes a provision for federal income taxes in the full amount of federal income tax that would be due if the full amount of Copley’s existing unrealized gains were realized. Copley argued that under its proposed exemption, its entire federal income tax liability would be due only in the “unlikely event” that its entire portfolio were liquidated. Copley's current use of the full liquidation value method “has produced a skewed and unreasonable result,” according to Copley. Copley's per share NAV does not reflect the realistic value of the Fund, but using the method proposed in its application would “fairly and accurately [reflect] a realistic tax liability,” Copley contended.
The SEC denied Copley's application for exemptive relief. According to the SEC, with respect to Copley’s calculation of NAV, if a high level of shareholder redemptions forced Copley to liquidate portfolio assets with significant unrealized gains in order to pay the redeeming shareholders, then the actual tax liability from those gains could exceed the partial deferred tax liability that Copley proposed recording. The lower recorded tax liability could yield a higher NAV per share at the time of redemptions, causing redeeming shareholders to receive more than their pro rata share of the Fund’s net assets, while the higher actual tax liability could yield a lower NAV per share following the redemptions. This would cause non-redeeming shareholders to receive a lower price for their pro rata share of the Fund’s net assets. The disparity between redeeming and non-redeeming shareholders would produce an “unfair and inequitable result” among Copley’s shareholders, the SEC said, which is contrary one of the Investment Company Act's primary purposes.
Copley appealed to the Circuit Court for the District of Columbia under the Administrative Procedure Act, arguing that the SEC's denial of its request was arbitrary, capricious, and an abuse of discretion. The SEC contended that it reasonably determined that Copley’s method could result in the disparate treatment of investors.
Oral argument. Before a panel of the D.C. Circuit, Copley counsel Paul M. Honigberg criticized the SEC’s denial of Copley’s application because it failed to address the company’s unique operating history, with low levels of redemptions and a philosophy of reinvesting dividends and accumulating capital gains. The denial was based on a “hypothetical and unprecedented” scenario involving massive redemption of shares that actually inflicts harm on present investors because the full liquidation method is misleading and also puts Copley at a disadvantage relative to other mutual funds because it artificially deflates the Fund’s NAV, making it appear to be a less attractive investment opportunity, Honigberg argued. He also found fault with the SEC’s failure to consider alternatives to Copley’s proposal; instead of evaluating alternative methods, the SEC simply said “you can’t do it,” Honigberg added.
Questioned by Judge Janice Rogers Brown on why it took Copley so long to file for an exemption, Honigberg stated that the company tried numerous times in the six years following the SEC’s original notice to get the agency’s attention, but was “stonewalled at every turn.” Judge Sri Srinivasan observed that because investors do redeem their shares sometimes, it was not unreasonable to envision scenario where there will be some level of redemption, even if is not to the extent as hypothesized by the SEC. Honigberg disagreed, maintaining that the SEC’s refusal to grant the exemption based on hypothetical future redemption requests of any degree was “a solution without a problem.”
SEC senior counsel Stephen G. Yoder explained that as a mutual fund registered under the Investment Company Act, Copley holds itself out to stand ready to honor redemption requests at any time and for any reason. The Commission used its expert judgment, Yoder said, to determine that Copley simply cannot anticipate all of its shareholder needs in the future. Judge Brown inquired why Copley’s earlier interactions with the SEC were focused on the company’s alleged GAAP violations, while its denial of the requested exemption was based on the Investment Company Act. Yoder replied that the earlier interactions were at the staff level, including discussions about a potential enforcement action and no-action letter relief, and were not binding on the agency. However, when Copley applied for the exemption, the SEC’s decision was governed by Section 16 of the Investment Company Act.
Judge Nina Pillard asked how the court can know when the SEC makes a decision based on predictive judgments or unfounded conjecture. Yoder said the distinction here is that Copley, in asking for exemptive relief, is asking to be exempted from rules that bind every other mutual fund. Judge Brown pointed out that Copley is unique among mutual funds because, unlike other most mutual funds, it is organized as a C Corporation, subjecting it to different tax treatment than a Regulated Investment Company (RIC). Yoder explained that the SEC is aware of other mutual funds that elected to operate as C Corporations, however, none of them have requested the exemptive treatment that Copley desires.
Pillard also observed that the SEC’s rationale appears to be standardization—it should require the same thing of everyone so the investing public can “compare apples to apples.” Honigberg replied that, due to Copley’s unique structure and operating history, the “apples to apples” comparison does not work in this case. No mutual fund can guarantee what the government is asking of Copley, he said. The SEC is “hiding behind extra deference” because Copley is seeking the exemption, Honigberg said. But deference must be reasoned and based on the facts in the record, and the SEC has failed to do this, Honigberg concluded.
The case is No. 14-1142.