SEC Amends Rule 17f-5 Under the 1940 Act

Washington, DC, May 15, 1997 - The Securities and Exchange Commission recently adopted amendments to Rule 17f-5, the rule that governs the custody of investment company assets outside the United States. The final rule is summarized below.

Delegation of Assessment of Country Risks
Unlike the proposed amendments to Rule 17f-5, the amended rule does not address a country's prevailing custodial risks. The release explains that the Commission reconsidered the proposed approach and is of the view that prevailing country risks seem inherently a part of the investment risks associated with the decision to invest in a particular country and should be considered by a fund's board or investment adviser before the fund invests in a foreign country. The Commission reasoned that once a decision has been made to invest in a country, prevailing country risks cannot be avoided, except by maintaining assets outside the country-an alternative that is often not possible or practicable. The Commission also stated its concern that restrictions on a fund's approach to prevailing country risks may have the effect of denying funds and their shareholders overseas investment opportunities, particularly in developing markets. Such a result is inconsistent with the overall approach of the Investment Company Act, which generally does not limit a fund's ability to assume investment risks.

The Commission noted that it expects fund boards and investment advisers, in making foreign investment decisions, to continue to consider the financial infrastructure, and the settlement systems and practices, of foreign countries in which a fund seeks to invest. In making those decisions, boards and advisers will be expected to seek and rely on information and opinions provided by the fund's custodian when the custodian has experience regarding foreign custody services. In addition, the Commission noted that prevailing country risks, if material, should be disclosed to fund investors.

Delegation of Selecting, Contracting With, and Monitoring Foreign Custodians
The amended rule would permit a fund's board to delegate to the fund's investment adviser, the fund's officers, a U.S. bank, or a foreign bank the selection of an eligible foreign custodian, the contract with this custodian, and the monitoring of foreign custody arrangements. The amended rule requires that it be reasonable for a board to rely on the delegate to perform the delegated responsibilities. Factors typically involved in making this determination include the expertise of the delegate, the board's ability to monitor the delegate's performance, and the delegate's financial strength.

Standard of Reasonable Care
Unlike the proposal, the amended rule does not require that a fund's foreign custody arrangements provide "reasonable protection" for a fund's assets. Rather, the amended rule requires the fund's board or its delegate to determine that the fund's assets will be subject to "reasonable care" if maintained with a foreign custodian.This determination will be based on standards applicable to custodians in the relevant market.In making this determination, the delegate must consider all factors relevant to the safekeeping of fund assets, including the custodian's practices, procedures, financial strength, reputation and standing, and whether the fund will be able to obtain jurisdiction over and enforce judgments against the custodian. The Commission notes that boards and their delegates have the flexibility to agree that the delegate will select foreign custodians that will exercise a higher degree of care with respect to fund assets.

The amended rule also requires a delegate to exercise reasonable care in performing the delegated duties. The rule makes clear that reasonable care, in this context, requires the delegate to exercise the care, prudence and diligence that a person having the responsibility for the safekeeping of fund assets would exercise. The amended rule also provides that boards and their delegates may agree to select custodians that will exercise a higher degree of care with respect to fund assets.

Delegate Reporting to the Board
The amended rule does not require a board to review and approve annually the fund's foreign custody arrangements. The amended rule does require the delegate to provide the board with written reports notifying it of the placement of fund assets with a particular custodian, and of any material changes in the fund's foreign custody arrangements. Unlike the proposal (which would have required the reports to be provided no later than the next regularly scheduled board meeting following the event necessitating the report), the amended rule requires material change reports to be provided at such times as the fund's board deems reasonable and appropriate based on the circumstances of the fund's foreign custody arrangements. The Commission explained that this provision should provide fund boards with the flexibility to tailor the reporting requirements to the fund's particular circumstances. Consistent with the provision, a funds' board could, for example, require the reports at the next regularly scheduled board meeting or more or less frequently as the board determines is reasonable and appropriate.

Selection of a Foreign Custodian
The amended rule specifies several factors that a delegate must consider when selecting a foreign custodian, including the foreign custodian's practices, procedures, and internal controls, the foreign custodian's financial strength, and the fund's ability to obtain jurisdiction over, and enforce judgments against, a foreign custodian. (The Commission notes that particular emphasis should be placed on evaluating the custodian's financial strength because the amended rule no longer requires a fund's foreign custodian to have a specified minimum shareholders' equity.)

Foreign Custody Contracts
Unlike the proposal, the amended rule retains the current requirement that funds' foreign custody arrangements be governed by a written contract containing specified provisions. Consistent with the new standard for evaluating foreign custody arrangements, the amended rule requires that the delegate determine that the contract will provide reasonable care for fund assets. The amended rule modifies several of the specific provisions required to appear in the contract. Specifically, the amended rule specifies that the contract must provide for indemnification or insurance arrangements such that the fund will be adequately protected against the risk of loss of assets held under the contract, the prohibition against liens does not extend to cash deposits that may become subject to creditors' claims or rights arising under bankruptcy, and the custodian's records may either identify the assets as belonging to the fund or as being held by a third party for the benefit of the fund.

While the amended rule retains the specific contract provisions, it also permits the contract to contain alternative provisions in lieu of those specified in the rule provided that the delegate determines that the alternative provisions, in their entirety, will provide the same or a greater level of care and protection for fund assets as the specified provisions.

Recognizing that foreign depository arrangements typically are governed by rules or practices of the depository rather than contract, the amended rule clarifies that the required contract provisions may be reflected in the rules or established practices or procedures of the depository, or in any combination of the foregoing.

Monitoring Foreign Custody Arrangements
Like the proposal, the amended rule requires that the delegate establish a system to monitor the appropriateness of maintaining the fund's assets with a particular custodian and under the foreign custody contract. Under the amended rule, if a foreign custody arrangement no longer meets the rule's requirements, the fund must withdraw its assets from the custodian as soon as reasonably practicable. The Commission explains that this requirement focuses on the importance of taking prompt action based on the circumstances presented and recognizes that some funds may require more time than others to withdraw their assets (e.g., a fund that places substantially all of its assets with one custodian in a single country may require more time to withdraw those assets than a fund that has placed a small percentage of its assets with a particular custodian in a particular country).

Eligible Foreign Custodians
Under the amended rule, any foreign bank or trust company that is subject to foreign bank or trust regulation, as well as any majority-owned direct or indirect subsidiary of a U.S. bank or bank holding company, may be an eligible foreign custodian. The amended rule does not retain the current shareholder equity requirements for foreign banks and trust companies to be eligible. In a change from the proposal, U.S. banks do not have to meet capital standards to be eligible foreign custodians. The Commission reasoned that this treatment of U.S. banks would be consistent with the amended rule's approach of focusing on a custodian's financial strength, rather than on minimum capital standards.

Affiliated Custodians
The amended rule does not contain a prohibition on a fund's use of affiliated custodians, as was proposed. Rather, the Commission will consider the issues raised by foreign affiliated custody arrangements when it considers comprehensive amendments to Rule 17f-2 (the rule that governs funds' self-custody arrangements that has been interpreted by the Commission staff to apply to affiliated custody arrangements).

Securities Depositories
The amended rule eliminates the current requirement that a foreign securities depository or clearing agency operate the only system for the central handling of securities. Rather, the amended rule requires a securities depository or clearing agency that acts as a system for the central handling of securities to be regulated by a foreign financial regulatory authority. The Commission reasoned that foreign regulation of a depository demonstrates a country's interest in the depository's safety.

Assets Maintained in Foreign Custody
As the Institute recommended, the amended rule permits a fund to maintain in foreign custody "any investment (including foreign currencies)" for which the primary market is outside the United States. This change permits funds more flexibility than the current requirement which limits funds to maintaining in foreign custody foreign securities and cash and cash equivalents that are reasonably necessary to effect the fund's foreign securities transactions.

Effective Date; Compliance Dates
The amendments to Rule 17f-5 become effective thirty days after publication in the Federal Register. The release indicates that funds that wish to rely on the amended rule prior to the effective date of the amendments may do so. Funds that have established foreign custody arrangements in accordance with Rule 17f-5 prior to the amendments' effective date must bring these arrangements into compliance with the amended rule within one year of the amendments' effective date.