Wednesday, August 12, 2015

SEC Justified in Refusal to Accept Fund’s Alternative Accounting Method

By Amy Leisinger, J.D.

A D.C. Circuit panel declined to overturn the SEC’s denial of an exemption for a mutual fund from rules governing the calculation and reporting of deferred tax liability. According to the court, the fund’s arguments questioning the SEC’s reasoning in denying the exemption failed to meet the high standard necessary to overcome deference afforded to the Commission’s decision (Copley Fund, Inc. v. SEC, August 11, 2015, Srinivasan, S.).

Background. In September 2013, Copley Fund, Inc. requested a Commission exemption from Investment Company Act Rule 22c-1 and Rule 4-01(a)(1) of Regulation S-X to permit it to alter the manner in which it accounts for tax liability. Copley proposed to account for its deferred tax liability on 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 method.

The SEC denied Copley's application for exemptive relief, noting that, 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 to record. 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 and cause non-redeeming shareholders to receive a lower price for their pro rata share. The disparity 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 the SEC’s decision to the D.C. Circuit, arguing that the denial of its request was arbitrary, capricious, and an abuse of discretion.

Review denied. Rejecting Copley’s argument that the SEC’s decision was “based solely” on “hypothetical speculation,” the panel agreed with the Commission’s determination that the fund cannot necessarily anticipate potential redemptions and that a high level of redemptions could result in disparate treatment of redeeming and non-redeeming shareholders. The Commission did not abuse its discretion in using an example (as opposed to hard data) to illustrate the potential problem, the panel noted. Further, according to the panel, the SEC did not err in rejecting Copley’s offer to disclose its alternative calculation methods or its additional arguments against full recognition of deferred tax liability. Noting the deference to be afforded to agency decisions, the paneled denied Copley’s petition for review of the denial of the requested SEC exemption.

The case is No. 14-1142.

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