Alert April 29, 2008

SEC Staff Provides No Action Relief to Permit Insurance Companies to Forego an SEC Substitution Order in the Case of Certain Mergers of Underlying Fund Investment Options

The staff of the SEC’s Office of Insurance Products of the Division of Investment Management took a no‑action position permitting the insurance companies investing in an underlying fund not to seek a substitution order under Section 26(c) of the Investment Company Act of 1940, as amended (the “1940 Act”), when the underlying fund merged into another fund without any need for shareholder approval.  Section 26(c) requires an insurance company issuing a variable annuity contract or a variable life insurance contract through a registered separate account to obtain an SEC order before it may substitute one underlying fund investment option for another underlying fund investment option.  In a series of no‑action letters in the 1980s and 1990s, the staff took the position that substitution orders were not required for fund mergers which, at the time, generally required shareholder approval.  Since that time, state law changes have expanded the types of fund mergers that may be implemented without shareholder approval, and in 2002 the SEC adopted amendments to Rule 17a‑8 under the 1940 Act to permit certain fund mergers without shareholder approval.  For example, Rule 17a‑8 does not require shareholder approval for a merger of two portfolios of the same series fund, where there are no material differences in fundamental investment policies, advisory contracts, or Rule 12b‑1 fees. 

The current relief was sought because fund reorganizations, even those that do not require shareholder approval, could be viewed as effecting a substitution requiring an order pursuant to Section 26(c).  The no‑action position taken by the SEC staff relieves insurance companies of any obligation to obtain a Section 26(c) order when a mutual fund they use as an investment option for their variable products merges into another mutual fund, provided certain conditions are met, including: (1) the merger meets all the conditions of Rule 17a‑8; (2) the reorganization does not alter the contract owner’s rights, or the insurance company’s obligations, under the contracts; (3) the reorganization does not result in any tax liabilities to the contract owners; and (4) certain notifications are provided to the contract owners.  Goodwin Procter represented the fund seeking the no‑action relief.