Second Letter Recommending Improvements to Industry Regulation, May 2002

I. Recommendations Concerning Affiliated Transactions
A. Permit Certain Affiliated Transactions Under Section 17
1. 1998 ICI Recommendations
One of the cornerstones of the Investment Company Act of 1940 is Section 17, which prohibits certain transactions involving investment companies and their affiliates in order to ensure that investment companies are managed in the best interests of their shareholders, rather than for the benefit of affiliated entities. Section 17 undeniably has served shareholders well and, by bolstering the investing public's confidence in the investment company industry, also has contributed to the industry's success. While its restrictions remain fundamentally sound, there is an increasing number of instances in which they impede transactions that would benefit fund shareholders and that do not raise the concerns the section was intended to address.

With this in mind, the Institute in 1998 submitted to the Division of Investment Management a series of proposed rules and rule amendments designed to provide relief from prohibitions on affiliated transactions in these circumstances, while maintaining appropriate safeguards to protect the interests of fund shareholders.¹ There has been progress on some these proposals² but, unfortunately, most of them have yet to be considered by the Commission. We continue to strongly urge the Commission to take expeditious action on our 1998 proposals that remain pending.³

2. Joint Transactions on an Equal Basis (Rule 17d-1)
In its 1992 study of investment company regulation, the Division recommended amendments to Rule 17d-1 to permit certain types of joint transactions by an investment company and its affiliates when the investment company participates on terms not different from those applicable to any affiliated participant, except for the amount of the participation.⁴ The Division expressed the view that, in many cases, these transactions do not present the risks that Section 17(d) was designed to prevent-the participation by an investment company on a basis different from or less advantageous than that of any other participant-and may provide substantial benefits to shareholders. We agree with the Division's recommendation and urge that Rule 17d-1 be amended to permit investment companies to engage in such transactions, without having to seek individual exemptive relief.⁵ The language we recommend is consistent with the Division's general recommendation in the 1992 Study,⁶ although the 1992 Study did not provide specific language. The Institute's recommended language would require the investment company board to adopt procedures reasonably designed to ensure that the transactions comply with the requirements of the rule.⁷

Proposed Amendments to Rule 17d-1 to Permit Certain Joint Transactions
[New language in bold]

"(d) Notwithstanding the requirements of paragraph (a) above, no application need be filed pursuant to this rule with respect to any of the following:

"(9) A transaction to which a registered investment company (or one or more series of a registered investment company) and an affiliated person of such company, or an affiliated person of such a person, are parties (`participants'); provided that:

"(A) The terms of the proposed transaction are reasonable and fair and do not cause any investment company (or series of an investment company) to participate on a basis that is less advantageous than that of any other participant (except with respect to the amount of participation);

"(B) The board of directors of each registered investment company, with respect to the investment company (or series of such investment company) concerned, including a majority of the directors who are not interested persons of such investment company:

"(1) determines that participating in such transactions is in the best interests of the investment company (or series) and its shareholders;
"(2) adopts procedures that are reasonably designed to ensure that the transactions meet the requirements set forth in paragraph (A) above; and
"(3) determines no less frequently than quarterly that all transactions effected during the preceding quarter pursuant to this rule complied with such procedures;

"(C) The investment company (1) shall maintain and preserve in an easily accessible place a written copy of the procedures (and any modification thereto) described in paragraph (B)(2) above, and (2) shall maintain and preserve for a period not less than six years from the end of the fiscal year in which any transactions occurred, the first two years in an easily accessible place, a written record of each such transaction setting forth its terms, the identity of the parties to the transaction, and the information or materials upon which the assurances described in paragraph (B)(3) were based; and

"(D)(1) A majority of the directors of the investment company are not interested person of the company, and those directors select and nominate any other disinterested directors of the company; and

"(2) Any person who acts as legal counsel for the disinterested directors, other than a person who provides services as a special counsel,8 is an independent legal counsel."

B. Amend the Rule on Underwritings by Affiliates (Rule 10f-3)
Section 10(f) of the Investment Company Act prohibits a fund from knowingly purchasing or otherwise acquiring, during the existence of any underwriting or selling syndicate, any security a principal underwriter of which is an investment adviser of the fund or an affiliate of that adviser. Congress adopted Section 10(f) in response to concerns about investment bankers "dumping" otherwise unmarketable securities into portfolios of investment companies, by unduly encouraging or causing the investment company to purchase unmarketable securities either from the underwriting affiliate itself, or from another member of the syndicate.

Rule 10f-3 exempts from Section 10(f) a fund's purchase of underwritten securities subject to certain limitations, including the so-called "unseasoned issuer" limitation. This limitation requires that the issuer of securities eligible for purchase under the rule (other than municipal securities) "shall have been in continuous operation for not less than three years, including the operation of any predecessors."⁹ For the reasons discussed below, the Institute recommends that the Commission amend Rule 10f-3 to eliminate the unseasoned issuer limitation.

The unseasoned issuer limitation unnecessarily constrains the professional judgment of portfolio managers of funds affiliated with underwriters. A fund that is precluded from purchasing securities of an unseasoned issuer in an initial public offering as a result of its affiliation with a principal underwriter must wait until the syndicate has closed and then purchase the securities in the aftermarket. This waiting period may result in the fund paying a significantly higher price for the securities. In addition, funds may pay additional transaction costs, such as brokerage commissions, when purchasing securities in the secondary market, costs that they do not pay when purchasing directly in an underwritten offering. While the length of time of an issuer's continuous operations may be an appropriate factor for consideration, it should not be the basis for a regulatory limitation that precludes a fund manager from exercising investment judgment.

The unseasoned issuer limitation is based on the assumption that IPOs of unseasoned issuers are so highly speculative so as to be relatively unmarketable. While this may have been true when Rule 10f-3 was adopted in 1958, the market no longer expects companies seeking to go public to have three years of operations. In recent years, IPOs by issuers with less than three years of operations not only have become commonplace, but also highly marketable. Indeed, at times the demand for such IPOs by investors, including institutional investors, has far outstripped the supply and has caused the aftermarket price for those securities to substantially exceed the IPO price. In such situations, the unseasoned issuer limitation has served not to protect fund investors but to deprive them of attractive investment opportunities.

The unseasoned issuer limitation is particularly anomalous for fund investments in certain asset-backed securities (ABSs). ABSs tend to be relatively safe investments with high ratings from ratings agencies and they typically offer returns that are higher than those of U.S. Treasury securities with comparable maturities.¹⁰ Because of these characteristics, they are attractive investments for many funds. Unfortunately, the legal structure of ABSs implicates the letter, but not the spirit, of the unseasoned issuer limitation. When assets such as debt obligations are securitized, the assets are held by a newly created special purpose entity (SPE). The SPE, not its sponsor, also issues the ABSs themselves. Investors that desire to acquire ABSs generally must purchase them in the primary offering, since there is generally not a significant secondary market for ABSs. However, because SPEs have less than three years of continuous operations at the time of the primary offering, the unseasoned issuer limitation precludes funds from purchasing in that offering when an affiliate is a principal underwriter of the offer. The unfortunate result is that these funds face severe limitations on investing in ABSs.

The adverse impact of the unseasoned issuer limitation has been aggravated by the consolidation of the financial services industry. Consolidation among financial services firms has made it more likely that a fund-affiliated underwriter will be a member of the underwriting syndicate.

Not only does the unseasoned issuer limitation inappropriately restrict fund investment choices, but also it is not needed to protect investors. The other conditions of the rule provide adequate protection against potential "dumping" abuses.¹¹ Moreover, removal of the unseasoned issuer limitation would be consistent with the Commission's longstanding recognition since the adoption of Rule 10f-3 that the rule can serve its intended purpose only if it is periodically adapted to changing conditions in the financial markets and regulatory environment.¹² Accordingly, the Institute recommends that the Commission eliminate the unseasoned issuer limitation in Rule 10f-3.¹³

II. Recommendations Concerning Shareholder Communications
A. Improve Disclosure in Mutual Fund Shareholder Reports
The Division of Investment Management has been developing a rulemaking proposal designed to improve disclosure in mutual fund shareholder reports. The Institute strongly supports the goals of making shareholder reports more comprehensible, informative and useful to the average investor. As we recommended in an earlier submission to the Division on this topic, as part of this initiative,14 the Commission should make changes to improve disclosure of mutual fund portfolio holdings in those reports. Under the current requirements, funds must disclose every investment, which can lead to a very lengthy list that generally is not helpful to most investors. For funds with a large number of holdings, such as index funds, current requirements greatly increase the length and complexity of shareholder reports (thus increasing the printing and mailing costs, which are passed on to shareholders).

We therefore suggest that the Commission eliminate the requirement to disclose all fund holdings. Instead, the Commission should require disclosure of any holding that constitutes more than one percent of a fund's net assets and, at a minimum, the fund's top 50 holdings.15 We also recommend that money market funds be exempt from the requirement to list portfolio holdings, given the strict regulation of money market funds' portfolios under Rule 2a-7 under the Investment Company Act and the short-term nature of such portfolio holdings.16 To address any concerns that the Commission or a fund's shareholders would not receive complete information regarding fund holdings, the Commission could require a complete list of holdings as of the last day of the reporting period to be filed with the Commission and provided to shareholders at no charge upon request.

The Institute also continues to support changes to require graphic presentations of portfolio information, such as pie charts showing different categories of securities held in a fund's portfolio. Many funds already provide this type of disclosure because it facilitates investor understanding of a fund's portfolio holdings. A requirement that all funds provide graphic presentations would benefit investors by making it more broadly available. We recommend that funds retain the flexibility to determine what type of chart, table, or graph would provide the most useful information to shareholders given the fund's investment objectives and limitations.

In addition, as we previously suggested, the Commission should consider requiring that the Management's Discussion of Fund Performance required by Item 5 of Form N-1A be included in a fund's annual report, whether or not it is also included in the fund's prospectus. The MDFP fits naturally with other "backward looking" information about a fund's performance, such as the fund's financial statements.

B. Streamline Disclosure Regarding Independent Directors
In January 2001, the Commission adopted a number of rule and form amendments related to investment company governance.¹⁷ The changes were designed to enhance the independence and effectiveness of fund directors and to provide investors with greater information about fund directors. Among the changes are requirements for director-related disclosure beyond that previously required in fund statements of additional information and proxy statements. All new fund registration statements, post-effective amendments that are annual updates to registration statements, proxy statements for the election of directors and shareholder reports filed with the Commission on or after January 31, 2002 must comply with the new disclosure requirements.

As fund groups have begun to implement the new disclosure requirements, it has become evident that some of the requirements create unwarranted burdens on funds and their independent directors. In particular, the requirements to disclose positions, interests, transactions and relationships of independent directors and their immediate family members with the fund and various related persons and entities are very broad in scope. The sweeping breadth of these requirements not only makes them burdensome but, more importantly, in many cases would elicit disclosure of information that is not indicative of a potential conflict of interest.

The requirements cover certain positions with: (1) the fund; (2) any investment company (including private investment companies) that has the same investment adviser or principal underwriter as the fund or that has an investment adviser or principal underwriter that directly or indirectly controls, is controlled by, or is under common control with an investment adviser or principal underwriter of the fund; (3) an investment adviser, principal underwriter, or affiliated person of the fund; or (4) a person directly or indirectly controlling, controlled by, or under common control (control person) with an investment adviser or principal underwriter of the fund.¹⁸ They also cover certain interests of independent directors or their immediate family members in transactions in which any of (1) through (4) above, or an officer of (1) through (4) above, was a party, and certain relationships with any of such persons or entities. ¹⁹ In addition, they cover certain interests in an investment adviser or principal underwriter of the fund or a control person of a fund adviser or underwriter.²⁰ Finally, they cover instances where an officer of an investment adviser or principal underwriter of the fund or of a control person of the adviser or underwriter has served during the two most recently completed calendar years on the board of directors of a company of which an independent director or his or her immediate family member is an officer. These requirements result, in some instances, in the identification of an enormous universe of persons and entities, particularly where the fund's investment adviser is part of a large conglomerate and/or the fund uses subadvisers (especially where the subadvisers are part of large conglomerates). Independent directors then must review a very lengthy list of persons and entities for purposes of determining whether disclosure is required.

In response to comments indicating that the disclosure requirements as originally proposed were overly broad, the Commission narrowed some of the requirements when it adopted the final amendments. For example, the Commission's proposal would have covered positions, interests, transactions or relationships with the fund's administrator or any entity that controls, is controlled by, or is under common control with, the administrator. The final amendments did not include administrators, except to the extent that an administrator controls, is controlled by, or is under common control with the fund's investment adviser or principal underwriter. The Institute recommends further changes to eliminate some potential disclosure of situations that likely would not raise conflict of interest concerns and to mitigate excessive burdens on independent directors and funds.²¹

First, we reiterate our previous recommendation that the scope of covered positions, interests, transactions and relationships be limited to those that involve a fund's investment adviser, principal underwriter, or their parents or subsidiaries, and thus not include all entities under common control with the adviser or principal underwriter.²² As we indicated previously, information concerning entities under common control with the adviser or underwriter would be of limited value to assessing a fund director's independence, because the attenuated nature of the relationship between a sister company of the adviser or underwriter and the fund makes any conflict of interest unlikely.

Second, we recommend that the Commission revise the disclosure requirements to exclude positions, interests, transactions or relationships with subadvisers (other than any subadviser that controls or is controlled by the fund's primary investment adviser or principal underwriter). Although an independent director's relationship with a subadviser potentially could raise conflict of interest concerns, these concerns are moderated to a significant degree by the involvement of the fund's primary adviser in negotiating subadvisory arrangements. Furthermore, the burdens of identifying all of the persons and entities that potentially could trigger a disclosure requirement, and having independent directors review an extensive list of such persons and entities, far outweigh any benefit that such disclosure might provide. Fund groups generally must rely on each subadviser to provide them with the information and to do so on a timely basis. Fund groups also have no way to verify the accuracy or completeness of the information they receive.

C. Amend After-Tax Return Disclosure Rules
In January 2001, the Commission adopted rules to require mutual funds to disclose standardized after-tax returns.²³ This disclosure is intended to enhance fund shareholders' understanding of the impact that taxes can have on fund performance and permit investors to compare the impact of taxes on the performance of different funds. The rules as adopted, however, include features that seriously undermine their ability to assist investors. The problems with the rules are as follows:

Under the rules, after-tax returns are required to be computed by applying the highest marginal income tax rate, notwithstanding the fact that this rate is applicable to no more than a de minimis portion of fund shareholders. As a result, the vast majority of fund shareholders will receive disclosure that has little relevance to them and that will greatly overstate the tax consequences of investing in mutual funds.
The rules compound the problem noted above by applying the short-term capital gains rate to the one-year total return number. While, as a technical matter, short-term rates apply for investments held exactly one year, it is highly unlikely that any shareholders would redeem on such date, when the shareholder would be eligible for long-term treatment if he or she held the shares for one additional day. Consequently, the rules further distort the tax implications of mutual fund investing.
The rules mandate that after-tax return numbers be included in the "risk/return summary" section of fund prospectuses, rather than in the section on tax disclosure. This makes it difficult for funds to place the disclosure in proper context, as well as to fully explain important aspects of it, including the fact that it employs an assumed tax rate that may differ from the shareholder's, and that it is not applicable to shares held in tax-deferred accounts.

These concerns need to be addressed; overstating the impact of the tax consequences of investing in mutual funds and limiting the ability of funds to place the disclosure in context only serves to mislead fund shareholders.

The Institute therefore recommends that the after-tax return disclosure rules be amended as follows.²⁴ First, the formula for computing after-tax returns should use marginal federal ordinary income and long-term capital gains tax rates that are more representative of the average fund investor's tax situation,²⁵ rather than the highest marginal tax rate. The former rates are far more representative of the average fund investor's tax situation than the latter rate, which significantly overstates the tax consequences of investing for most fund shareholders. Consequently, most investors are receiving tax information that is not applicable or meaningful to them.

Second, we recommend that all hypothetically-redeemed shares (including shares purchased with reinvested dividends) be treated as generating long-term capital gains or losses, rather than looking to the actual period that the shares were held to determine the tax treatment of the gains and losses. It is inappropriate to impose an ordinary income tax rate to the one-year "post liquidation" after-tax return (the gain or loss on which is treated as "short-term) when the applicable rate the very next day would drop to 20 percent (because shares held for one year and one day get long-term capital gain treatment). This treatment (particularly when using the highest tax rate) overstates the tax consequences of investing for approximately (as opposed to exactly) one year. Given that few if any investors ever redeem one day before any tax on a gain would be cut almost in half, it is unrealistic to treat one-year redemption gains as short-term. Finally, there is little if any benefit to be derived from treating any gain or loss on shares acquired by dividend reinvestment during the current calendar year as short-term.

Third, we recommend that the after-tax return disclosure be included in the tax section of a fund's prospectus, rather than the risk/return summary. Investors would benefit if all of the information about the tax consequences of investing in a fund were provided in one central location. In addition, including disclosure of after-tax numbers along with the required extensive narrative disclosure in the risk/return summary may overwhelm other important information included in the summary.

D. Permit Use of the Profile to Support Additional Investments by Existing Fund Shareholders
The Division of Investment Management has been considering possible ways to eliminate the need for funds to deliver full updated prospectuses to existing shareholders that make an investment in the same fund, including by allowing the use of fund profiles for this purpose.²⁶ As we recommended previously,²⁷ the Division should recommend that the Commission issue a proposal specifically permitting this use of profiles.

The federal securities laws do not require funds to send an updated prospectus annually to existing shareholders. Nevertheless, many funds do so to ensure that investors have the information necessary to make an informed investment decision, should they wish to make an additional investment in the fund. By routinely sending an updated prospectus to existing shareholders, funds avoid the need to continuously track which investors have received an updated prospectus. Other funds provide existing shareholders with an updated prospectus at the time of confirmation of any additional investment. Either way, fund groups, and ultimately fund shareholders, bear significant printing and mailing costs to provide existing shareholders with updated prospectuses.

The profile would provide an effective way to communicate updated information to existing shareholders. It is a concise document that summarizes the critical information needed to make an investment decision, and thus would provide existing shareholders with updated information in a format that they are likely to read. Also, it would be relatively easy for funds that have not yet created profiles to do so, since the profile incorporates many elements required in the full prospectus (e.g., the risk/return summary). Sending the profile to existing shareholders not only would provide those shareholders with the information they need in a user-friendly format but also ultimately could result in significant cost savings for funds and their shareholders. Of course, any shareholder receiving a profile would be entitled to receive a full prospectus upon request.

E. Eliminate the Form Used to Register Securities Issued in Business Combinations (Form N-14)
The Institute recommends that the Commission substitute the Schedule 14A proxy statement and fund prospectus for Form N-14 in connection with investment company reorganizations. Filings on Form N-14 are unnecessarily burdensome and expensive to funds; conventional proxy statement and prospectus disclosure would be clearer and more concise to investors.

Form N-14 is used to register securities issued by the acquiring investment company in a reorganization of two investment companies that is subject to Rule 145 under the Securities Act of 1933.²⁸ Form N-14 also may serve as the proxy statement for soliciting the approval of the reorganization by shareholders of the investment company being acquired. The Commission adopted Form N-14 in 1985 for the purpose of simplifying the registration process and improving the disclosure made to investors voting on reorganization proposals.²⁹

Form N-14, sometimes called a "merger proxy" or "proxy prospectus," is essentially a complete registration statement and proxy statement combined. The key disclosures relating to the reorganization transaction and participating companies required by Form N-14 are substantially similar to the disclosures required by Schedule 14A under the Exchange Act.³⁰ A significant portion of the disclosure required by Form N-14 is also derived from Form N-1A (or other corresponding registration form).³¹ Only a few disclosure items do not have their source in Schedule 14A or Form N-1A (or other corresponding registration form). The most important of these are pro forma financial statements and numerous additional exhibits. These additional disclosure requirements are of little or no value to investors. Primarily because of the required pro forma financial statements and exhibits, the time and expense necessary to prepare a Form N-14 is significantly greater than preparing a Schedule 14A proxy statement.

Replacing Form N-14 with a conventional proxy statement and the prospectus of the acquiring fund would provide clearer and more concise disclosure to the target fund shareholders. These two clear and understandable documents are best designed to enable investors to make an informed investment decision. One document would present the important disclosures relating to the new investment vehicle under consideration, and the other would describe the reorganization and the differences between the acquiring fund and the fund being acquired.

At the time Form N-14 was adopted, it was thought that a single disclosure document would provide simpler and more understandable disclosure for shareholders. This is no longer true. First, the conventional fund prospectus on Form N-1A (which, unlike Form N-14, has been updated and modernized) sets forth in a more meaningful and readable format the information essential for deciding whether to invest in a new fund.³² Moreover, a proxy statement prepared in accordance with Schedule 14A would provide a more streamlined format for information about the reorganization decision itself. A reorganization decision is essentially no different from other shareholder decisions, such as approving a change in a fund's investment policy or its investment adviser. Such a decision should not require the more cumbersome combination of a "proxy prospectus." Finally, the use of two separate disclosure documents would better capture the two-fold nature of the decision that the investor has to make-whether to invest in a new fund and whether to do so through a reorganization transaction.

For these reasons, rescinding Form N-14 and replacing it with a conventional proxy statement and a fund prospectus would make disclosure more understandable to the investor. Rescinding the Form also would save investment companies the considerable time and expense associated with preparing the overly detailed and unnecessary pro forma financial statements and exhibits required by Form N-14. The Commission does not require delivery of this type of information to investors in connection with a decision to invest in a fund. Rather, under Form N-1A, the Commission has determined that the prospectus contains the information investors need to make an informed investment decision; financial statements and exhibits are filed with the Commission but not delivered to investors. There is no reason to believe this type of information would be material to shareholders in considering a mutual fund reorganization proposal.

The strict liability standards of Section 11 of the Securities Act for untrue statements or omissions of material fact in a prospectus would, of course, still apply to statements made in the Form N-1A prospectus. While Section 11 liability would not attach to the proxy statement, investors would continue to receive the protections of the antifraud provisions of Rule 14a-9 under the Exchange Act. In addition, material misstatements in both documents would still be subject to Rule 10b-5 under the Exchange Act, since reorganizations involve the purchase and sale of a security. Thus, investors would have substantial and adequate legal remedies for false or misleading statements in connection with the proposed disclosure process for reorganizations.

In sum, the framework for reorganization-related disclosure resulting from rescinding Form N-14-delivery of the N-1A prospectus of the acquiring fund together with a Schedule 14A proxy statement-would provide investors with more useful disclosure documents and would be less expensive and burdensome to investment companies.

F. Amend the Requirement to Disclose the Source of Dividend Payments (Rule 19a-1)
Section 19(a) of the Investment Company Act and Rule 19a-1 thereunder require management investment companies to inform shareholders of the source of dividend payments if any portion of the payment is attributable to a source other than net investment income. In effect, the different sources of dividend payments (net investment income, capital gains, paid-in capital) must be identified. Section 19(a) is intended to ensure that shareholders are properly advised as to the source of any dividends and are not misled into believing that dividend payments from non-recurring sources are of a regular and recurring nature.

There is an inherent problem, however, with the current requirement. Namely, it is rarely possible to know with certainty, at the time of an investment company's dividend payment, the precise nature of amounts included in the distribution. The exact allocation between investment income, capital gains and return of capital cannot be definitively determined until after the investment company's fiscal year-end. Because of this uncertainty, Rule 19a-1 notices are typically qualified with language that warns shareholders that the amounts associated with the stated sources are estimates subject to change, and that final information will be provided in the shareholder's IRS Form 1099-DIV. As a result, investment companies and their shareholders currently bear considerable expense in the form of printing and mailing costs associated with providing information of limited value to investment company shareholders.

For these reasons, the Institute recommends that the Commission replace the dividend source notification currently required under Rule 19a-1 with a requirement that the source of dividend payments be identified in the investment company's annual report to shareholders.³³ (The Institute has furnished a proposed amendment to Rule 19a-1 to implement this recommendation.) This requirement would place the disclosures in the proper context of the investment company's financial statements, thereby permitting shareholders to see the character of their dividend payments along with the investment company's presentation of per share distributions in the financial highlights table.

Proposed Amendments to Rule 19a-1
[New language in bold; deleted language underlined and in brackets]

"(a) Every written statement made pursuant to Section 19 by or on behalf of a management company shall be made in the annual report provided to shareholders pursuant to Rule 30d-1 [on a separate paper] and shall clearly indicate what portion of the payment per share is made from the following sources:"

G. Improve Financial Statement Disclosure of Capital and Dividends Paid
Rule 6-04 of Regulation S-X requires investment companies to disclose the financial accounting components of capital on the balance sheet (i.e., shareholder capital, undistributed net investment income, undistributed net realized gains, and unrealized appreciation/depreciation). However, investment company shareholder distributions are based on taxable income. Generally accepted accounting principles (GAAP) for investment companies were recently changed to collapse the components of capital on the balance sheet into two categories: paid in capital and distributable earnings.³⁴ In addition, GAAP now requires funds to disclose the tax-basis components of distributable earnings (i.e., undistributed ordinary income, undistributed long-term capital gains, capital loss carryforwards, and unrealized appreciation/depreciation) in the financial statement footnotes. This change is intended to better enable investors to determine the amount of accumulated and undistributed earnings that could be paid out to investors as taxable distributions in the future.

Rule 6-09 of Regulation S-X requires investment companies to disclose in the Statement of Changes in Net Assets dividends paid from net investment income, realized gains, and other sources. Similarly, Item 9 of Form N-1A requires funds to disclose in the financial highlights dividends paid from net investment income, realized gains, and any return of capital. GAAP for investment companies was recently changed to require that dividends paid be disclosed as a single line item in the Statement of Changes in Net Assets and the Financial Highlights (except that any return of capital on a tax basis would be disclosed as a second line item). In addition, GAAP now requires funds to disclose the tax-basis components of dividends paid in the financial statement footnotes. This disclosure is consistent with the manner in which dividends are reported to shareholders at calendar year end on IRS Form 1099-DIV.

These changes simplify the presentation of capital and dividends paid in the financial statements while providing shareholders better tax-basis information on current and possible future distributions. However, funds cannot fully take advantage of these changes until the Commission amends its financial reporting rules. We recommend that the Commission amend the investment company financial reporting rules and form requirements relating to capital and dividends paid so that they conform to GAAP.

III. Recommendations to Amend Other Investment Company Act Rules
A. Amend the "Independent Legal Counsel" Provisions (Rule 0-1(a)(6))
Last year, the Commission adopted new fund governance provisions that are designed to enhance the independence and effectiveness of independent fund directors.35 The governance provisions, among other things, added new conditions to a set of ten exemptive rules under the Investment Company Act upon which funds regularly rely in their day-to-day operations.36 One such condition is that the independent directors of any fund seeking to rely on these exemptive rules must determine that any legal counsel retained to represent the independent directors is an "independent legal counsel" as defined in Rule 0-1(a)(6) under the Act.37

Since the new fund governance rules were adopted, concerns have arisen regarding the independent legal counsel provisions. One significant concern relates to the potential for retroactive loss of exemptive relief if a determination by directors that counsel is independent is overturned. Under the new rules, independent directors are permitted to conclude that counsel representing a fund's investment adviser, principal underwriter or administrator (management organizations) or their control persons may nonetheless be deemed an independent legal counsel, if any representation of these entities is "sufficiently limited." In these circumstances, the inherently subjective nature of the independent directors' determination raises the prospect that the determination could be second-guessed. If so, funds and their advisers could be faced with challenges that they were not entitled to rely on certain exemptive rules. Even if such challenges are unlikely to be successful, the potential consequences are so severe that they could act to discourage independent directors from retaining counsel in circumstances in which Rule 0-1(a)(6) was not intended to disqualify such counsel.

The potential for retroactive loss of exemptive relief also could exist if independent directors subsequently discover that counsel is not in fact "independent" within the meaning of the new rules, despite good faith reliance by the independent directors on counsel's representations. In addition, because the independent legal counsel condition added to the exemptive rules applies by its terms to any legal counsel selected and retained by independent fund directors for any purpose, there are concerns that it would restrict the independent directors' ability to retain "special counsel" in matters not involving significant conflicts of interest between funds and fund management.

The Division of Investment Management recently issued a letter to the Institute regarding these issues.³⁸ Although the staff's letter provides some comfort, it would be far preferable for the rules themselves to be clear on these points. For example, while the views articulated in the staff's letter might provide useful guidance to a court should these issues be litigated, rule changes would provide more definitive guidance. In addition, rule changes would provide greater certainty to independent directors and funds as to the funds' continuing ability to rely on key exemptive rules.

The staff's letter notes that the fund governance rules will be considered in the context of the planned comprehensive review of all Commission regulations. The Institute still questions the advisability of the independent legal counsel requirement.³⁹ If it is retained, however, we strongly recommend that the Commission revise the fund governance rules in order to codify, in essence, the positions expressed in the staff's letter concerning independent legal counsel.

Specifically, we recommend amending Rule 0-1(a)(6) to provide that a person determined to be an independent legal counsel pursuant to the rule will be deemed as such for purposes of satisfying the independent legal counsel condition of the affected exemptive rules unless and until the Commission issues an order finding that such determination was not reasonable. In addition, Rule 0-1(a)(6) should allow the independent directors to continue to deem that counsel independent for purposes of relying on the exemptive rules for up to three months from the effective date of a Commission order. The rule also should make clear that such an order would have no impact on a fund's reliance on the exemptive rules prior to the date of the order. This approach is analogous to the provisions of Section 2(a)(19) of the Investment Company Act that authorize the Commission to issue an order finding an independent director to be an "interested person" of a fund due to a "material business relationship." Such an order is prospective only.

Rule 0-1(a)(6) should be further amended to provide that a fund would not lose the ability to rely on the exemptive rules if independent directors learn that information previously provided by counsel and relied upon to make the required independence determination was materially false or incomplete, so long as within three months of learning of the incorrect information, the directors determine that counsel meets the definition of an independent legal counsel notwithstanding the new information.

Finally, the Commission should amend the independent legal counsel provision in each of the relevant exemptive rules to provide that any person who provides services as a "special counsel" to the independent directors of a fund need not be an independent legal counsel within the meaning of Rule 0-1(a)(6). In conjunction with this change, the Commission should adopt a new Rule 0-1(a)(7) that would define a "special counsel" with respect to the independent directors of a fund to be a person whose representation does not relate materially to matters affecting the directors' independent review and judgment in carrying out their responsibilities under the relevant exemptive rules.

Consistent with the staff's letter, the rule changes we propose would address the concerns raised by the independent legal counsel provisions in a narrowly targeted manner, without materially altering the intended operation of those provisions or any other aspect of the new fund governance rules.

Proposed Amendments to the Independent Legal Counsel Provisions
[New language in bold; deleted language underlined and in brackets]

(6)(i) A person is an independent legal counsel with respect to the directors who are not interested persons of an investment company (disinterested directors) if:

(A) A majority of the disinterested directors reasonably determine in the exercise of their judgment (and record the basis for that determination in the minutes of their meeting) that any representation by the person of the company's investment adviser, principal underwriter, administrator (management organizations), or any of their control persons, since the beginning of the [fund'] company's last two completed fiscal years, is or was sufficiently limited that it is unlikely to adversely affect the professional judgment of the person in providing legal representation to the disinterested directors; and

(B) The disinterested directors have obtained an undertaking from such person to provide them with information necessary to make their determination and to update promptly that information when the person begins to represent, or materially increases his representation of, a management organization or control person.

(ii) The disinterested directors are entitled to rely on the information obtained from the person, unless they know or have reason to believe that the information is materially false or incomplete. The disinterested directors must re-evaluate their determination no less frequently than annually (and record the basis accordingly), except as provided in paragraph (iii) of this section.

(iii) [After] If, after making a determination that a person is an independent legal counsel pursuant to paragraph (a)(6)(i) of this section in reliance on information obtained from the person, the disinterested directors [obtain] become aware of additional information that causes them to conclude or have reason to believe either that the information provided by the person and relied on to amek their determination was materially false or incomplete, or become aware that the person has begun to represent, or has materially increased his representation of, a management organization (or any of its control persons), the person may continue to be deemed an independent legal counsel, for purposes of paragraph (a)(6)(i) of this section, for up to [no longer than] three months from the date the disinterested directors became aware of the additional information, unless during that period the disinterested directors make a new determination under that paragraph.

(iv) If a determination that a person is an independent legal counsel is made pursuant to paragraph (a)(6)(i) of this section, and the disinterested directors have not become aware of additional information that would cause them to revise or reconsider the determination pursuant to paragraph (a)(6)(iii) of this section, the person will be deemed to be an independent legal counsel from the date of such determination, unless the Commission, by order, finds that the determination was not reasonable. In the event the Commission issues an order finding that the determination was not reasonable, the ability to rely on any rule under the Act that is conditioned on a personacting as legal counsel for the disinterested directors of an investment company being an independent legal counsel will continue for up to three months from the effective date of such order. No order issued by the Commission pursuant to this paragraph (a)(6)(iv) will affect the ability of an investment company to rely on any rule under the Act prior to the effective date of such order.

(A) The term person has the same meaning as in section 2(a)(28) of the Act (15 U.S.C. 80a-2(a)(28)) and, in addition, includes a partner, co-member, or employee of any person; and

(B) The term control person means any person (other than an investment company) directly or indirectly controlling, controlled by, or under common control with any of the investment company's management organizations.

(7)(i) A person is a special counsel with respect to the directors who are not interested persons of an investment company (disinterested directors) if the person's representation, since the beginning of the company's last two completed fiscal years, is or was limited to matters that do not involve, to a material extent, the disinterested directors' duties or responsibilities in connection with section 10(f) [15 U.S.C. 80a-10(f)] of the Act as it relates to the operation of rule 10f-3 [17 CFR 270.10f-3] thereunder; section 12(b) [15 U.S.C. 80a-12(b)] of the Act as it relates to the operation of rule 12b-1 [17 CFR 270.12b-1] thereunder; section 15(a) [15 U.S.C. 80a-15(a)] of the Act as it relates to the operation of rule 15a-4(b)(2) [17 CFR 270.15a-4(b)(2)] thereunder; section 17(a) [15 U.S.C. 80a-17(a)] of the Act as it relates to the operation of rules 17a-7 [17 CFR 270.17a-7] and 17a-8 [17 CFR 270.17a-8] thereunder; section 17(d) [15 U.S.C. 80a-17(d)] of the Act as it relates to the operation of rule 17d-1(d)(7) [17 CFR 270.17d-1(d)(7)] thereunder; section 17(e) [15 U.S.C. 80a-17(e)] of the Act as it relates to the operation of rule 17e-1 [17 CFR 270.17e-1] thereunder; section 17(g) [15 U.S.C. 80a-17(g)] of the Act as it relates to the operation of rule 17g-1(j) [17 CFR 270.17g-1(j)] thereunder; section 18(f) [15 U.S.C. 80a-18(f)] of the Act as it relates to the operation of rule 18f-3 [17 CFR 270.18f-3] thereunder; and section 23(c) [15 U.S.C. 80a-23(c)] of the Act as it relates to the operation of rule 23c-3 [17 CFR 270.23c-3] thereunder.

(ii) For purposes of paragraph (a)(7)(i) of this section, the term person has the same meaning as in section 2(a)(28) of the Act (15 U.S.C. 80a-2(a)(28)) and, in addition, includes a partner, co-member, or employee of any person.

2. Amend the independent legal counsel condition in each relevant exemptive rule⁴⁰ as follows:

Any person who acts as legal counsel for the disinterested directors, other than a person who provides services as a special counsel, is an independent legal counsel.

B. Amend the Rule Governing Exchanges (Rule 11a-3)
Section 11(a) of the Investment Company Act generally prohibits a registered open-end investment company from making an exchange offer with respect to its shares or those of another open-end investment company on any basis other than the relative net asset values of the securities to be exchanged, except with prior Commission approval or pursuant to Commission rules. Rule 11a-3 under the Investment Company Act provides an exemption that allows the imposition of a sales charge, redemption fee, administrative fee, or any combination of such fees on the security to be acquired in an exchange, but only if a detailed series of conditions is met. The Institute recommends that the Commission amend Rule 11a-3 to revise or eliminate conditions that are unduly restrictive and not necessary for the protection of investors or to achieve the purposes of Section 11.

First, we recommend that the Commission delete paragraph (b)(8) of Rule 11a-3, which generally requires 60 days' prior notice to fund shareholders before an exchange offer can be terminated or its terms materially amended. This requirement unduly constrains funds' ability to determine that, due to changing business conditions or other factors, their shareholders would be better served by a different exchange program, or perhaps even no exchange program. There is no basis for the notice requirement in the legislative history of the Investment Company Act, and it inappropriately implies that exchange privileges are something more than privileges. Section 11 is intended to restrict the terms of exchange offers in order to discourage "switching"; it does not create a vested right in existing exchange offers.

In proposing the notice requirement, the Commission indicated that it was needed for reasons of fairness to shareholders who may have purchased shares in reliance upon the existence of an exchange offer with the specific terms set forth in the prospectus.⁴¹ Any such reliance would not be reasonable, however, given that Rule 11a-3 specifically requires disclosure in prospectuses of funds that offer exchanges, if the offering company reserves the right to change the terms of or terminate an exchange offer, that the exchange offer is subject to termination and its terms are subject to change. Moreover, a notice requirement in this context is anomalous when one considers that no such requirement applies to changes to other services that funds may provide, such as redemptions by telephone.

For similar reasons, we recommend that subparagraph (b)(7)(ii) of the rule be deleted. That provision requires the same disclosure in sales literature or advertising that mentions the existence of an exchange offer as is required in fund prospectuses when a fund reserves the right to change the terms of or terminate an exchange offer. Especially given the requirement for prospectus disclosure, this disclosure is not necessary. Requiring such "boilerplate" disclosure ignores the basic principle that investors should read the prospectus before purchasing fund shares. Moreover, in the prospectus, the disclosure is presented in context. It is neither possible nor appropriate to include all relevant information in fund advertisements and sales literature. Like the notice requirement, this disclosure requirement inappropriately implies that the terms of an exchange program are among the most important characteristics of a fund.

Second, we recommend that the Commission delete paragraph (b)(3) of Rule 11a-3, which prohibits the imposition of a deferred load on an exchanged security at the time of the exchange. In addition, we recommend that the Commission delete paragraph (b)(9), which sets forth requirements concerning the calculation of sales loads with respect to exchanged shares where an investor exchanges less than all of his securities and in the case of exchanged shares acquired through reinvestment of dividends or capital gains distributions. Similar types of provisions were eliminated from Rule 6c-10 when it was amended in 1996, on the theory that appropriate disclosure and the NASD's limits on sales charges provide adequate protection. The same theory is equally applicable in the context of Rule 11a-3.

Third, we recommend changes to paragraphs (b)(4) and (b)(5) of the rule to accommodate installment loads. Paragraph (b)(4) generally provides that a sales load imposed on an acquired security may not exceed the difference between the sales load applicable to that security in the absence of an exchange and all sales loads previously paid on the exchanged security. By referring to "any sales load charged," this provision creates an ambiguity in the case of an installment load. To illustrate, if an investor purchased a fund with a 3 percent front-end load (Fund A), and subsequently exchanged into a fund that imposed an installment load of 1 percent for five years (Fund B), the rule could be read not to permit any load to be charged on the Fund B shares, because the investor already paid a 3 percent load (which is greater than 1 percent). This would produce an illogical result. The relevant comparison is between the load already paid and the aggregate amount of an installment load (i.e., 5 percent in the above example), rather than the amount of an individual installment payment. The rule should be revised accordingly.

Paragraph (b)(5) governs the determination of an investor's holding period for purposes of computing the applicable deferred sales load and requires, generally, that the time during which the investor held the exchanged security be taken into account. This requirement only makes sense, however, in the case of a contingent deferred sales load and does not work where the acquired fund imposes an installment load. Thus, using the funds described in the preceding paragraph to illustrate, if an investor purchased shares of Fund A (which has a 3 percent front-end load), held them for five years, and then exchanged into Fund B (which imposes an installment load of 1 percent for five years), paragraph (b)(5) would seem to prohibit Fund B from imposing any further load, because Fund B does not impose any load after five years. Yet it is more appropriate to treat an installment load like a front-end sales load for this purpose; the holding period is irrelevant. To the extent the load previously paid is lower than the load that normally would apply to the acquired security, the second fund should be permitted to charge a load that does not exceed the difference between these two (pursuant to paragraph (b)(4) as we suggest it should be clarified above). To accomplish this result, paragraph (b)(5) should be modified to apply only to contingent deferred sales loads.⁴²

We also recommend the deletion of paragraph (d) of Rule 11a-3, which is obsolete.

Proposed Amendments to Rule 11a-3
[New language in bold; deleted language underlined and in brackets]

(1) Acquired security means the security held by a securityholder after completing an exchange pursuant to an exchange offer;

(2) Administrative fee means any fee, other than a sales load, deferred sales load or redemption fee, that is

(i) reasonably intended to cover the costs incurred in processing exchanges of the type for which the fee is charged, Provided that: the offering company will maintain and preserve records of any determination of the costs incurred in connection with exchanges for a period of not less than six years, the first two years in an easily accessible place. The records preserved under this provision shall be subject to inspection by the Commission in accordance with section 31(b) of the Act [15 U.S.C. 80a-30(b)] as if such records were records required to be maintained under rules adopted under section 31(a) of the Act [15 U.S.C. 80a-30a)]; or

(3) Contingent deferred sales load means any amount properly chargeable to sales or promotional expenses that is paid by a shareholder upon redemption, which declines over a specified period of time after purchase until the amount reaches zero;

(4) Deferred sales load means any amount properly chargeable to sales or promotional expenses that is paid by a shareholder after purchase but before or upon redemption, and includes a contingent deferred sales load and an installment load;

(ii) any security previously exchanged for such security or for any of its predecessors;

(6) Group of investment companies means any two or more registered open-end investment companies that hold themselves out to investors as related companies for purposes of investment and investor services, and

(ii) the investment adviser or principal underwriter of one of the companies is an affiliated person as defined in section 2(a)(3) of the Act [(15 U.S.C. 80a-2(a)(3)] of the investment adviser or principal underwriter of each of the other companies;

(7) Installment sales load means any amount properly chargeable to sales or promotional expenses that is to be paid by a shareholder over a specified period of time in a series of two or more successive payments.

(8) Offering company means a registered open-end investment company (other than a registered separate account) or any principal underwriter thereof that makes an offer (an exchange offer) to the holder of a security of that company, or of another open-end investment company within the same group of investment companies as the offering company, to exchange that security for a security of the offering company;

(9) Redemption fee means any fee (other than a sales load, deferred sales load or administrative fee) that is paid to the fund and is reasonably intended to compensate the fund for expenses directly related to the redemption of fund shares; and

(b) Notwithstanding section 11(a) of the Act [15 U.S.C. 80a-11(a)], and except as provided in paragraphs (d) and (e) of this section, in connection with an exchange offer an offering company may cause a securityholder to be charged a sales load on the acquired security, a redemption fee, an administrative fee, or any combination of the foregoing, Provided that:

(1) Any administrative fee or scheduled variation thereof is applied uniformly to all securityholders of the class specified;

(2) Any redemption fee charged with respect to the exchanged security or any scheduled variation thereof

(ii) does not exceed the redemption fee applicable to a redemption of the exchanged security in the absence of an exchange.

Any scheduled variation of a redemption fee must be reasonably related to the costs to the fund of processing the type of redemptions for which the fee is charged;

[(3) No deferred sales load is imposed on the exchanged security at the time of an exchange;]

(3) [(4)]Any sales load (or, with respect to an installment sales load, the sum of the rates of all payments made under such load) charged with respect to the acquired security is a percentage that is no greater than the excess, if any, of the rate of the sales load (or, with respect to an installment sales load, the sum of the rates of all payments to be made under such load) applicable to that security in the absence of an exchange over the sum of the rates of all sales loads previously paid on the exchanged security, Provided that:

(i) the percentage rate of any sales load charged when the acquired security is redeemed, that is solely the result of a contingent deferred sales load imposed on the exchanged security, may be no greater than the excess, if any, of the applicable rate of such sales load, calculated in accordance with paragraph (b)(4) of this section, over the sum of the rates of all sales loads previously paid on the acquired security, and;

(ii) in no event may the sum of the rates of all sales loads imposed prior to and at the time the acquired security is redeemed, including any sales load paid or to be paid with respect to the exchanged security, exceed the maximum sales load rate, calculated in accordance with paragraph (b)(4) of this section, that would be applicable in the absence of an exchange to the security (exchanged or acquired) with the highest such rate;

(4) [(5)]Any contingent deferred sales load charged at the time the acquired security is redeemed is calculated as if the holder of the acquired security had held that security from the date on which he became the holder of the exchanged security, Provided that:

(i) the time period during which the acquired security is held need not be included when the amount of the contingent deferred sales load is calculated, if the contingent deferred sales load is

(A) reduced by the amount of any fees collected on the acquired security under the terms of any plan of distribution adopted in accordance with rule 12b-1 under the Act [17 CFR 270.12b-1] (a 12b-1 plan), and

(B) solely the result of a sales load imposed on the exchanged security, and no other sales loads, including contingent deferred sales loads, are imposed with respect to the acquired security,

(ii) the time period during which the exchanged security is held need not be included when the amount of the contingent deferred sales load on the acquired security is calculated, if

(A) the contingent deferred sales load is reduced by the amount of any fees previously collected on the exchanged security under the terms of any 12b-1 plan, and

(iii) the holding periods in this subsection may be computed as of the end of the calendar month in which a security was purchased or redeemed;

(i) the amount of any administrative or redemption fee imposed on an exchange transaction for its securities, as well as the amount of any administrative or redemption fee imposed on its securityholders to acquire the securities of other investment companies in an exchange transaction, and

(ii) if the offering company reserves the right to change the terms of or terminate an exchange offer, that the exchange offer is subject to termination and its terms are subject to change;

(6) [(7)] Any sales literature or advertising that mentions the existence of the exchange offer also discloses

[(i)]the existence of any administrative fee or redemption fee that would be imposed at the time of an exchange; [and]

[(ii) if the offering company reserves the right to change the terms of or terminate the exchange offer, that the exchange offer is subject to termination and its terms are subject to change;]

[(8) Whenever an exchange offer is to be terminated or its terms are to be amended materially, any holder of a security subject to that offer shall be given prominent notice of the impending termination or amendment at least 60 days prior to the date of termination or the effective date of the amendment, Provided that:]

[(i) no such notice need be given if the only material effect of an amendment is to reduce or eliminate an administrative fee, sales load or redemption fee payable at the time of an exchange, and]

[(A) there is a suspension of the redemption of the exchanged security under section 22(e) of the Act [15 U.S.C. 80a-22(e)] and the rules and regulations thereunder, or]

[(B) the offering company temporarily delays or ceases the sale of the acquired security because it is unable to invest amounts effectively in accordance with applicable investment objectives, policies and restrictions; and]

[(9) In calculating any sales load charged with respect to the acquired security:]

[(i) if a securityholder exchanges less than all of his securities, the security upon which the highest sales load rate was previously paid is deemed exchanged first; and]

[(ii) if the exchanged security was acquired through reinvestment of dividends or capital gains distributions, that security is deemed to have been sold with a sales load rate equal to the sales load rate previously paid on the security on which the dividend was paid or distribution made.]

(c) If either no sales load is imposed on the acquired security or the sales load imposed is less than the maximum allowed by paragraph (b)(3) of this section, the offering company may require the exchanging securityholder to have held the exchanged security for a minimum period of time previously established by the offering company and applied uniformly to all securityholders of the class specified.

[(d) Any offering company that has previously made an offer of exchange may continue to impose fees or sales loads permitted by an order under section 11(a) of the Act upon shares purchased before the earlier of]

[(2) when the offer has been brought into compliance with the terms of this section, and upon shares acquired through reinvestment of dividends or capital gains distributions based on such shares, until such shares are redeemed.]

(d) [(e)]Any offering company that has previously made an offer of exchange cannot rely on this section to amend such prior offer unless

(1) the offering company's prospectus disclosed, during at least the two year period prior to the amendment of the offer (or, if the fund is less than two years old, at all times the offer has been outstanding) that the terms of the offer were subject to change, or

(2) the only effect of such change is to reduce or eliminate an administrative fee, sales load or redemption fee payable at the time of an exchange.

C. Amend the Rule Concerning Investments in Securities Related Businesses (Rule 12d3-1)
Section 12(d)(3) of the Investment Company Act prohibits, with certain limited exceptions, investment companies from acquiring "any security issued by or any other interest in the business of any person who is a broker, a dealer, is engaged in the business of underwriting, or is either an investment adviser of an investment company or an investment adviser registered under [the Investment Advisers Act of 1940]." Rule 12d3-1(a) under the Act exempts from Section 12(d)(3) investments in issuers that derive 15 percent or less of their gross revenues from "securities related activities."⁴³ Rule 12d3-1(b) permits investment companies to acquire the securities of issuers that derive more than 15 percent of their gross revenues from "securities related activities," provided that: (1) immediately after the acquisition of any equity security, the company owns less than five percent of the outstanding securities of that class of the issuer's equity securities; (2) immediately after the acquisition of any debt security, the company owns less than ten percent of the outstanding principal amount of the issuer's debt securities; and (3) immediately after any such acquisition, the acquiring company has invested not more than five percent of the value of its total assets in the securities of the issuer (the five percent asset limit). Rule 12d3-1(c) provides that, notwithstanding the foregoing, the rule does not exempt the acquisition of a general partnership interest or of a security issued by the acquiring company's investment adviser, promoter, principal underwriter, or an affiliated person of such adviser, promoter, or underwriter.

Although Rule 12d3-1 provides some relief from the prohibition in Section 12(d)(3), it is more restrictive than is necessary to promote the goals of Section 12(d)(3), to the detriment of fund shareholders.⁴⁴ The Institute recommends that Rule 12d3-1 be amended to avoid unduly constraining funds from taking advantage of attractive investment opportunities, consistent with the purposes of Section 12(d)(3). In particular, as discussed below, we recommend that the Commission amend Rule 12d3-1 to (1) increase the five percent asset limit to ten percent, and (2) codify exemptive relief in which the Commission has allowed a discrete portion of a multi-managed fund to invest in securities issued by an unaffiliated investment adviser (or its affiliate) to another portion of the fund.⁴⁵

1. The Five Percent Asset Limit
The Commission has recognized that Section 12(d)(3) is intended to address two potentially abusive reciprocal practices. First, an investment company might purchase the securities of a broker-dealer to reward it for selling the investment company's shares. Second, an investment company might direct brokerage transactions to a broker-dealer in which the investment company had an investment, in order to enhance the broker-dealer's profitability.⁴⁶ The five percent asset limit is intended, along with the limits on investments in a securities related issuer's equity and debt securities (investment limits) to "minimize the potential for conflicts of interest and reciprocal practices by preventing an investment company from acquiring a significant stake in any particular broker or dealer."⁴⁷ While the asset limit is designed to address the potential abuses that the Commission had in mind in adopting Rule 12d3-1, there does not seem to be any reason that the limit should be five percent.⁴⁸ When it adopted Rule 12d3-1, the Commission stated: "In view of the broad prohibition in the [Investment Company] Act against investment company acquisitions of interests in issuers engaged in securities related activities, the Commission believes that any exemptive relief must be conditioned upon certain quantitative limitations. The proposed amendments impose reasonable limits on such acquisitions and are therefore adopted."⁴⁹ For the reasons discussed below, the five percent asset limit is no longer "reasonable."

The five percent asset limit hinders some investment companies from meeting their investment objectives, policies, and/or strategies. In an era of increasing consolidation in the financial services sector, certain securities related issuers represent more than five percent of the capitalization of the sector.⁵⁰ Funds that wish to invest in accordance with this relative weighting must invest more than five percent of their assets in the securities of certain financial services companies.⁵¹ Similarly, certain securities related issuers represent a larger percentage of the broader market than they did in the past.⁵² Some actively managed funds with an investment policy or strategy of investing primarily in the securities of large-capitalization issuers have found that it would be desirable and in accordance with their investment objectives, policies and strategies to invest more than five percent of the fund's assets in these securities related issuers.

A ten percent limit would enhance the ability of funds such as those described above to fulfill their investment objectives, policies and strategies while still providing protection against the abusive reciprocal practices that the rule was designed to address. First, the rule's investment limits would remain unchanged. Investment limits are the most significant safeguards provided by the rule: they focus squarely on reciprocal practices by directly limiting the amount of capital that a fund can place at the disposal of a broker-dealer. In addition, an increase in the asset limit from five to ten percent represents only an incremental adjustment in the rule's protections. Moreover, in recent years, the Commission has put into place additional safeguards to prevent the potential conflicts of interest presented by investments in broker-dealers: the Commission recently adopted rule amendments designed to strengthen the positions of independent directors to serve as "watchdogs" for fund shareholders.⁵³ An important responsibility of fund directors is to oversee fund brokerage allocations.

For these reasons, the Institute recommends that Rule 12d3-1 be amended to increase the asset limit from five to ten percent.

2. Codification of Relief Granted to Multi-Managed Funds
An increasing number of investment companies today employ multiple unaffiliated subadvisers to make investment decisions for a discrete portion of fund assets assigned to that subadviser. Each such subadviser has no authority regarding the remainder of the fund's portfolio. Nevertheless, because each unaffiliated subadviser is considered to be an adviser to the entire multi-managed fund, the portion of the fund assets managed by such unaffiliated subadviser would be prohibited by Rule 12d3-1(c) from investing in issuers that are subadvisers to, or affiliated with a subadviser to, a different portfolio segment.

As a result, in the past several years, a number of investment companies have requested and received exemptive relief from the Commission to permit a separately managed portion of a multi-managed fund to invest in securities issued by the subadviser (or its affiliate) to another portion of the fund, provided that the other conditions of Rule 12d3-1 are met.⁵⁴ In these cases the petitioners have argued that, where each subadviser acts independently of the other subadvisers in making investment decisions, the potential conflicts of interest that Rule 12d3-1(c) was designed to address would not likely exist. Recognizing the validity of this argument, the Commission now routinely grants such relief.

Because the exemptive application process is costly and time consuming for both the staff and petitioners, the Commission frequently codifies routinely granted exemptive relief. Accordingly, the Institute recommends that the Commission amend Rule 12d3-1 to provide relief from subparagraph (c) of the rule in the circumstances described above.

D. Amend the Self-Custody Rule (Rule 17f-2)
Section 17(f) of the Investment Company Act seeks to protect registered management investment companies and their shareholders against the risk of loss by prescribing qualifications for custodians of the fund's portfolio assets. In addition, Section 17(f) permits a registered management investment company to maintain its securities and similar assets with itself-i.e., it may "self-custody"-but only in accordance with such rules as may be prescribed by the Commission. Rule 17f-2 sets forth those rules.

Rule 17f-2 provides, in pertinent part, that self-custodied securities must be deposited "in the safekeeping of, or in a vault or other depository maintained by" a bank or other federally- or state-supervised company, that those assets must be "physically segregated at all times" and that access to those securities by fund personnel must be limited to no more than five board-designated persons, at least two of whom must act jointly to obtain access. The rule further specifies that persons depositing, withdrawing or ordering the delivery (e.g., a transfer for purposes of sale) of self-custodied securities must sign "notations" showing, among other things, the "identification" of the relevant securities "by certificate numbers or otherwise," and that notations must be transmitted to another board-designated person. Finally, the rule requires that the securities be "verified by actual examination" by the fund's independent auditors at least three times a year, at least two of which must be surprise examinations performed "without prior notice" to the fund. Pursuant to an accounting release issued promptly after the adoption of Rule 17f-2,⁵⁵ the Commission has construed this examination requirement to mean that fund auditors must "make a physical examination of the [self-custodied] securities," or in "certain" unspecified, cases "obtain confirmation," and that the auditors must "reconcile the physical count or confirmation with the book records."

The Institute recommends that Rule 17f-2 be revised to: (1) eliminate existing obstacles to the ability of investment companies to self-custody uncertificated securities (including uncertificated shares of other mutual funds); (2) make less onerous the procedures that investment companies must undertake to protect against the theft or misappropriation of self-custodied securities; and (3) provide separately for any special requirements applicable to the use of affiliated custodians, rather than continue to treat such use as self-custody.

1. Self-Custody of Uncertificated Securities
Rule 17f-2 was adopted in 1941,⁵⁶ when virtually all securities were issued in certificated form and when securities ownership normally entailed physical possession of the securities certificates. Accordingly, as reflected by the provisions described above, the rule specifically contemplates the safekeeping of physical securities in a secure environment (such as a vault), subject to controls designed to protect against the theft or misappropriation of physical certificates by dishonest fund officers, investment advisers or their employees.

Today, however, many securities are uncertificated,⁵⁷ and a substantial portion of these uncertificated securities are owned by investment companies. Uncertificated securities include the shares of most mutual funds, virtually all U.S. government debt, most mortgage- and asset-backed securities, and a growing number of money market and other debt securities. There is nothing in Section 17(f) to suggest that Congress intended for investment companies to be able to self-custody certificated securities but not uncertificated securities. Nevertheless, those provisions of Rule 17f-2 that envision the self-custody of only certificated securities constitute obstacles to the self-custody of uncertificated securities.

One area where this has been a problem is when a fund invests in another fund. Funds that hold shares of other mutual funds-whether in a fund of funds structure, pursuant to cash sweep arrangements, or by investing cash reserves in a money market fund-can realize cost savings by holding the shares of the issuing funds directly (i.e., by becoming the registered owners of the shares on the issuing funds' books) rather than indirectly through a custodian. Both the staff and the Commission have recognized the appropriateness of such direct holdings. The staff has taken no-action positions allowing a fund of funds to hold shares directly with the issuing funds' transfer agents, subject to conditions that effectively adapt the Rule 17f-2 requirements to accommodate uncertificated securities.⁵⁸ Similarly, in its recent proposal to amend Rule 17f-4, the Commission has proposed to allow funds to maintain shares of other mutual funds with the issuing funds' transfer agents by treating those transfer agents as the operators of securities depositories for purposes of Rule 17f-4.⁵⁹

As indicated in our comment letter on the Rule 17f-4 Proposal,⁶⁰ we agree that funds should be able to hold shares of other investment companies directly-i.e., to self-custody those shares without being impeded by requirements under Rule 17f-2 that were conceived in the context of maintaining physical possession of certificated securities. We also believe that funds should be able to self-custody other uncertificated securities. Accordingly, we recommend that Rule 17f-2 be revised to accommodate such direct holdings by eliminating or modifying those current requirements noted above that make self-custody of uncertificated securities impracticable (e.g., physical segregation, verification by actual examination, etc.).

2. Safeguards Against Theft or Misappropriation
Regardless of whether securities that a fund holds directly are certificated or uncertificated, many of Rule 17f-2's existing requirements impose procedural burdens on self-custodying funds that are disproportionate to the protections that they provide. These overly burdensome procedures should be streamlined, and in some cases eliminated, to make self-custody practicable in those cases where it would result in operational efficiencies.

More specifically, consistent with the spirit and purpose of the current requirements of Rule 17f-2, we recommend amending the rule to require that:

self-custodying funds deposit their directly held, certificated securities for safekeeping in a vault or other depository maintained by a bank or with another, comparably supervised organization, and that those certificated securities be segregated from other assets;
self-custodying funds implement internal control systems that are reasonably designed to prevent unauthorized instructions, withdrawals or transfers with respect to self-custodied securities, whether certificated or uncertificated; and
such control systems be reviewed by the fund's outside auditors on at least an annual basis, with appropriate reporting to the fund's board.

Conversely, however, we believe that many of the specific and detailed requirements currently imposed by Rule 17f-2 should be eliminated because they: (i) provide little or no practical benefit; and (ii) can interfere with the timely effectuation of the fund's ordinary business of buying and selling portfolio securities. These include limitations on the number of fund personnel authorized to "access" self-custodied securities, requirements that the board specifically designate those persons, detailed requirements as to the "notations" that must be made by those authorized persons whenever they take actions with respect to the self-custodied assets, and the requirements for multiple and surprise audits.

The primary purpose of these requirements seems clearly to be the prevention of theft or misappropriation of a self-custodying fund's assets by the fund's investment adviser or by dishonest personnel. Other provisions of the Investment Company Act, however, are also designed to protect against those same risks. Fund advisers and officers have fiduciary responsibilities to the fund, and Section 37 of the Act makes the theft, conversion or embezzlement of fund securities or other assets a federal crime. Moreover, while even requirements as stringent as those of current Rule 17f-2 cannot ensure that there will never be theft or fraud, Section 17(g) and Rule 17g-1 require funds to maintain adequate fidelity bond coverage with respect to any person having access to a fund's securities or other assets.

In light of these protections, we recommend that the detailed requirements of Rule 17f-2 be modified in the manner described above.

3. Treatment of Affiliated Custodians
The staff has interpreted Rule 17f-2 to apply to funds whose bank custodians are affiliated with the fund's investment adviser. The staff has indicated that this interpretation is based on a concern that the policies underlying Rule 17f-2 "would be frustrated if an investment adviser rendering custodial services were not subject to additional safeguards such as those in Rule 17f-2."⁶¹ However, the staff's interpretation has been applied broadly to cover not only situations when the adviser itself (or a separate division thereof) is the fund's custodian, but also when the adviser is a sub-custodian⁶² or when the custodian is a separate but affiliated bank.⁶³ Moreover the staff has required compliance with Rule 17f-2 even when the affiliated custodian used unaffiliated sub-custodians and when the fund had established internal controls or similar safeguards to protect against the risks envisioned by Rule 17f-2.⁶⁴

The Institute agrees that special safeguards, whether internal or regulatory, may be needed to protect against possible abuses when a fund uses an affiliated custodian. We do not believe, however, that such arrangements should be considered tantamount to self-custody or that all of the current requirements of Rule 17f-2 should be applied to affiliated custodians. Indeed, imposing those requirements on affiliated custodians creates substantial distortions. For example, as indicated above, a fund that holds securities through a "securities intermediary"-which would include an affiliated bank custodian-holds those shares "indirectly" and, thus, only in a book entry form. If use of an affiliated custodian means that these indirectly held securities are subject to the requirements of Rule 17f-2, then all of the problems described above with respect to uncertificated securities would apply equally to certificated securities "held" by the custodian. Funds are not in a position to perform physical counts or similar inspections of securities held "indirectly" through security entitlements with affiliated bank custodians or with the securities depositories that generally hold the underlying certificates. Similarly, implementation of signed notations in connection with withdrawals, deposits and transfers through banks or securities depositories may not be practicable.

We believe that the appropriate means of providing additional safeguards for the use of affiliated custodians is to establish specific requirements for such use as a separate regulation, rather than to subject such arrangements to Rule 17f-2. Indeed, such an approach seems exactly what was contemplated by Congress when, as part of the Gramm-Leach-Bliley Act,⁶⁵ it amended Section 17(f) to add a new paragraph (6). New subsection 17(f)(6) provides that:

"[t]he Commission may, after consultation with and taking into consideration the views of the Federal banking agencies ..., adopt rules and regulations [and] issue orders, consistent with the protection of investors, prescribing the conditions under which a bank, or an affiliated person of a bank, either of which is an affiliated person, promoter, organizer, or sponsor of, or principal underwriter for, a registered management company, may serve as custodian of that registered management company."

We recommend that the Commission accept the invitation of Congress in Section 17(f)(6) with respect to affiliated bank custodians. At the same time, the Commission should clarify that Rule 17f-2 will not apply to the use of any type of affiliated custodian.⁶⁶

Also, in fashioning a special rule for the use of affiliated custodians, we believe that the Commission should clarify which types of relationships between a fund and its custodian should constitute an affiliation sufficient to trigger the rule. Currently, this is not sufficiently clear. Examples of custody arrangements whose treatment is uncertain under existing staff interpretations include the use of a custodian that is affiliated with the fund's adviser through common directors, officers or employees but not through common control,⁶⁷ or the use of certain foreign custody arrangements involving remote affiliates, and the extent to which the use of affiliated sub-custodians is covered when there is an unaffiliated primary custodian.⁶⁸

E. Amend the Fidelity Bonding Rule (Rule 17g-1)
Rule 17g-1 under the Investment Company Act requires that officers and employees of investment companies with access to company assets be bonded against larceny and embezzlement by a reputable fidelity insurance company. The rule includes a schedule setting forth the minimum amount of the bond required, based on each individual investment company's gross assets. The current schedule, as applied to fund complexes that obtain joint insured bonds, results in a required amount of coverage greatly exceeding what is reasonably necessary, at a significant cost to shareholders. In 1996, the Institute submitted a letter to the SEC staff recommending that the Commission amend Rule 17g-1 to address this problem, and to improve the rule in certain other respects, as discussed below.⁶⁹ We urge the Commission to move forward on the Institute's proposal.

First, to provide for a more appropriate required amount of coverage, the rule should establish minimum coverage requirements for a fund complex, rather than for individual funds. The rule also should set a cap on the amount of required fidelity bond cov

Proposals to Improve Investment Company Regulation