- Fund Regulation
- Retirement Security
- Trading & Markets
- Fund Governance
- ICI Comment Letters
January 31, 2002
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Custody of Investment Company Assets with a Securities Depository
(File No. S7-22-01)
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission’s proposed amendments to Rule 17f-4 under the Investment Company Act of 1940.2 According to the Proposing Release, the proposed amendments would update and simplify the rule to reflect developments in securities depository practices and commercial law that have occurred over the years. Specifically, they would update the conditions funds and their custodians must follow to use a depository, expand the types of depositories they can use, and expand the types of investment companies that can maintain assets with a depository. The amendments also would eliminate unnecessary custodial compliance requirements and revise fund approval requirements for depository arrangements.
The Institute generally supports the goal of these proposals, which is to modernize and simplify the regulatory regime relating to funds’ use of securities depositories. We also applaud efforts by the Commission to conform Rule 17f-4 to revised Article 8 of the Uniform Commercial Code.3 Accordingly, the Institute supports a number of the proposed amendments contained in the proposal. However, we question the need for or the approach suggested by certain other of the proposed amendments. In summary, our comments are as follows:
- We believe the approach taken in proposed Rule 17f-4 does not fully accomplish its goal of reflecting the nature of the indirect holding system established under Revised Article 8. For this reason, we recommend that the rule be revised further.
- More specifically, we believe that an amended Rule 17f-4 should recognize that, by reason of Revised Article 8, a custodian’s use of securities depositories or other securities intermediaries is a means by which the custodian obtains and maintains its own financial assets in order to perform its duty under the UCC to support the “security entitlements” that it establishes for its fund customers, not a means to re-deposit fund assets with a third party.
- Consequently, we believe Rule 17f-4 should be amended to establish minimum standards of performance for the discharge by custodians of the duties that are imposed on them with respect to the maintenance of their own financial assets with securities depositories and other securities intermediaries.
- We support the elimination of the requirement for board approval of arrangements with securities depositories and the elimination of obsolete requirements currently included in the rule, such as the segregation and successor custodian requirements.
- We support revisions that would clarify the ability of funds to hold shares of other mutual funds through a custodian (i.e., indirectly) or directly (i.e., to self-custody those shares), but recommend that provisions relating to funds that hold directly be included in Rule 17f-2, rather than in Rule 17f-4.
- Revised Article 8 clarifies that when funds or their custodians hold shares of other funds by becoming the registered owner on the books of the issuer or its transfer agent, they hold “directly” rather than in an indirect holding arrangement such as exists when they hold through a securities depository. We therefore oppose the proposed characterization of transfer agents as securities depositories for purposes of Rule 17f-4.
- We support the requirement that funds be entitled to obtain such periodic reports concerning the internal accounting controls and financial strength of their own custodians as they may request, as well as available reports for any securities depositories with which funds directly maintain accounts. We do not believe, however, that the rule should require funds to receive reports concerning these matters for any securities depository, or any intermediary custodian, used by a fund’s custodian.
- We support the expansion of Rule 17f-4 to permit the use of securities depositories by non-management investment companies.
- We would oppose the application of Rules 17f-5 and 17f-7 to domestic depositories as an unnecessary burden that would offer no discernible benefits to fund shareholders.
To these ends, and for the reasons explained in more detail in our comments below, we suggest that Rule 17f-4 be revised as set forth in the attachment to this letter.
1. Rule 17f-4 Should More Fully Reflect Revised UCC Article 8
While the Commission clearly recognizes that Revised Article 8 established significant changes in the commercial law relating to securities, we do not believe that the proposed amendments to Rule 17f-4 accomplish the Commission’s stated objective of aligning the rule with the UCC and modern commercial practice. The proposed amendments take the approach followed in the current rule that financial assets held by securities depositories should be viewed as the assets of the investment companies that have accounts (or, much more commonly, whose custodians have accounts) with them.4 However, commercial law no longer adheres to the premise that a fund’s assets are actually the assets held by their custodians or securities depositories or that “possession and delivery of physical certificates are the key elements” in holding and transferring securities.5
Under Revised Article 8, when a fund holds portfolio securities through an account with a securities intermediary (generally, its custodian), the fund “acquires” a security entitlement, not a certificated or uncertificated security.6 A security entitlement “is not … a specific property interest in any financial asset held by the securities intermediary or by the clearing corporation [i.e., securities depository] through which the securities intermediary holds the financial asset.”7 Its primary attribute is the package of personal rights that the entitlement holder acquires against its intermediary, not its quality as a property interest in assets held by others.8 Of special importance in the context of Rule 17f-4 is that a fund’s security entitlement with its custodian gives the fund no rights that it could enforce against a securities depository with which the fund’s custodian maintains its own account.9
We believe any amendments to Rule 17f-4 need to more fully reflect this fundamental aspect of the Revised Article 8 “indirect holding system.” Specifically, we believe the proposed provisions of Rule 17f-4 that are expressed in terms of “assets” that are defined to be “securities and similar investments that are owned by the Fund or held by another person for the benefit of the Fund,” are inapplicable in the indirect holding system. As illustrated by our proposed language, we do not believe it is necessary for the rule to define “assets” at all. To the extent the Commission determines that it is necessary to include such a definition, however, it should be revised to be the fund’s security entitlements. The financial assets maintained by a custodian or securities depository to satisfy a custodian’s obligations to all of its entitlement holders (including, but by no means limited to, the fund) should not be treated as the “assets” of the fund.
2. Rule 17f-4 Should Set Minimum, General Performance Standards
As explained above, a fund’s “assets” with a securities intermediary are security entitlements, and not the financial assets held by the fund’s securities intermediary. Consequently, there is no need for Rule 17f-4 to permit a fund’s custodian to place fund assets with a securities depository.10 Such a provision mischaracterizes what a fund’s custodian would be doing when using a securities depository.
The Institute believes it is appropriate, however, to amend Rule 17f-4 to establish certain conditions relevant to the use of securities depositories (and intermediary custodians) by fund custodians. We believe that the proposed amendments were intended to do just that, but that the language of the proposal falls short of accomplishing that objective. The Institute has set forth suggested language, which we believe will accomplish the Commission’s objectives, in the attachment to this letter.
Under UCC §8-504, a securities intermediary has a duty to maintain financial assets that are sufficient to satisfy all the security entitlements that it has established in favor of all of its entitlement holders.11 This duty is imposed by law and cannot be waived.12 However, Article 8 allows a fund and its custodian (or the fund’s securities depositories, if the fund interacts directly with them, rather than through its custodian) to establish contractual performance standards for the discharge of this or any of a securities intermediary’s other Article 8 duties. Article 8 provides only that a generalized standard of “due care in a commercially reasonable manner” will apply to the performance of those duties “in the absence of [an] agreement” of the parties specifying their own standards of performance, or unless “specific standards” are imposed by other law or regulation.13
Proposed Subsection (a)(1)(i) seems intended to impose such standards in two ways. First, it limits the types of securities intermediaries that a custodian may use.14The Institute is not opposed to such a limitation. However, as discussed in Section 5 below, we do not think that fund transfer agents should be considered “securities depositories.”
Second, Subsection (a)(1)(i) seems intended to set a substantive performance standard. It does this, however, by requiring custodians to “take all actions reasonably necessary or appropriate under applicable commercial or regulatory law” to “safeguard” what the proposal considers fund assets. For the reasons described in Section 1 above, the custodian in an indirect holding arrangement is not safeguarding fund assets when it uses a securities depository. Rather, what the custodian is doing is fulfilling its own duty under UCC §8-504 to maintain corresponding financial assets of its own.
Further, when considered in light of what UCC §8-504 requires, the subsection’s formulation of taking actions “reasonably necessary or appropriate under applicable commercial or regulatory law” appears somewhat circular. This is because “applicable commercial law”—i.e., Article 8—does not mandate any binding performance standard. Rather, it allows the parties to agree on one.
Accordingly, we recommend that the rule be revised in the manner set forth in the attachment, which would impose minimum, general standards of performance.15 Our approach would provide funds the flexibility to negotiate more specific protections to the extent they wish to do so, while ensuring that all protections contemplated by the UCC are retained.
3. Elimination of Obsolete Requirements
The Proposing Release notes that the indirect holding relationships established under Revised Article 8 have rendered certain requirements relating to custodial arrangements unnecessary for the protection of fund assets. In particular, the Proposing Release states that the segregation and successor custodian requirements in current Rule 17f-4(c)(2) are no longer needed under Revised Article 8. We agree.
The Institute also agrees that there is no continued need for fund boards to approve arrangements with securities depositories as required by current Rule 17f-4(c)(3) and (d)(5). As stated in the Proposing Release, such arrangements have become routine. The proposal would permit an officer of the fund (or a trustee of an entity that is a non-management company) to assume primary responsibility for approving the fund’s direct arrangements with depositories and with custodians that use depositories. The Institute applauds this effort to reduce the obligations of directors with respect to routine matters and with respect to matters where director involvement does not necessarily increase protections for shareholders. We concur in the determination that directors should continue to monitor the fund’s dealings with its own custodian.
We note that the proposed amendments would require that fund officers “approve” the fund’s own direct arrangements with its custodian or with a securities depository. We concur with this in principle, but we believe that such approval would be inherent in a fund’s entering into a custodial contract or any account arrangement with a securities depository. Accordingly, we do not believe that there is any need for the rule to specifically provide for this.
While the Institute agrees that the “earmarking” and confirmation requirements of current Rule 17f-4 should be eliminated, we do not believe that the practices themselves are obsolete. The current rule’s “earmarking” and confirmation requirements relate to the custodian’s own record keeping and reporting of the security entitlements that it establishes for the fund. The Institute continues to believe that it is important that custodians maintain accurate records of the assets that are supposed to be credited to fund accounts.16 Similarly, it is desirable for funds to receive current information as to the daily transactions recorded by their custodians (and any securities depositories with which the funds act directly) in the funds’ accounts.17
These provisions, however, have little, if any, specific relation to whether the custodian uses a securities depository to maintain financial assets corresponding to the security entitlements that they maintain for the fund. Accordingly, there is no need to include them in Rule 17f-4. However, we recommend that the Commission clarify in the adopting release that the deletion of these requirements should not be viewed as indicating that they are no longer relevant or important.
4. Delivery of Reports Concerning the Accounting Controls and Financial Strength of Fund Custodians and Securities Depositories
Proposed Subsection (a)(1)(ii) would require a fund that uses a securities depository through its custodian to contractually require the custodian to promptly provide the fund with periodic reports “concerning the internal accounting controls and financial strength” of the custodian18 and “available” reports concerning the same matters for any securities depository (or its operator) and any intermediary custodian used by the custodian.
The Institute supports the proposal to require the prompt delivery of requested reports that would permit a fund to periodically review the controls and monitor the financial strength of its own custodian. Indeed, the importance of this is highlighted by Revised Article 8, which makes clear that (in the absence of extraordinary circumstances, such as fraudulent collusion) a fund’s recourse with respect to its custodied assets is exclusively against the custodian.19
For essentially the same reason, however, we do not believe that it is appropriate for Rule 17f-4 to require the custodian to provide “available” periodic reports with respect to every securities depository and intermediary custodian at which the custodian itself maintains accounts. Since the fund generally cannot enforce its security interests against such “second tier” intermediaries, such information is of relatively little value to the fund.20
Under UCC §8-504, the custodian bears the burden of selecting such depositories and intermediaries with due care in accordance with reasonable commercial standards unless its agreement with a fund or other law provides otherwise. More specifically, UCC §8-509(a) provides, if “the substance of a duty imposed upon a securities intermediary by [inter alia, UCC §8-504] is the subject of [a] regulation,” compliance with that regulation “satisfies the duty.”
The inclusion of a requirement in Rule 17f-4 that custodians provide funds with financial and similar information relating to the securities depositories or other intermediaries used by the custodian—a requirement seemingly designed to enable the funds to make their own evaluation of the second-tier intermediaries—could be construed as being such a regulatory statement of “the substance” of the custodian’s UCC §8-504 duty. This, in effect, would relieve custodians of their obligation to evaluate these depositories and intermediaries and would shift the burden to the funds themselves. We would be opposed to any such result.
For the reasons set forth above, we recommend that this requirement be eliminated.
5. Expansion of Rule to Treat Fund Transfer Agents as Securities Depositories; Relation to Rule 17f-2
The proposed amendments would expand the eligible securities depositories that a fund or its custodian could use to include registered transfer agents acting for open-end registered investment companies “whose securities [the transfer agent] holds.”21 The Proposing Release explains that this expansion would acknowledge that a fund’s transfer agent “may serve as the functional equivalent of a depository” and responds to the growth of fund of funds, cash sweeps and other arrangements in which one fund invests in the shares of another fund.22We oppose the proposal to characterize transfer agents as securities depositories for purposes of Rule 17f-4.
We agree that changes are appropriate to make clear that there is no regulatory bar to the ability of funds or their custodians to hold mutual fund shares or, for that matter, other uncertificated securities, irrespective of the fact that those shares may not be held through either registered clearing agencies or the federal book-entry system. However, we do not believe that this should be accomplished by characterizing fund transfer agents as “securities depositories.” At least since the adoption of Revised Article 8, that would mischaracterize the transfer agency function, which is in no respect the same as that of a securities intermediary in the Article 8 indirect holding system. No security entitlement is created when a transfer agent records an investor’s interest on the books of the issuer.23 Rather, the registered owner (whether that be the fund or its custodian) holds “directly.”
By defining fund transfer agents as “securities depositories,” the proposed amendments effectively codify the relief granted by the Commission staff in a series of no-action letters.24 The Institute believes that the relief granted in those letters was appropriate at the time because it allayed concerns that Rules 17f-2 and 17f-4 might preclude funds from holding other funds’ uncertificated shares. However, that relief should not now be incorporated into Rule 17f-4. This is because the two concerns addressed in the letters are no longer relevant under Rule 17f-4, for the reasons discussed below.
A. Clarification that Custodians May Hold Uncertificated Shares Directly
The staff issued a no-action letter in 1991 that permitted the custodian of a fund that intended to invest in uncertificated shares of other funds to hold the fund shares directly with the issuing funds’ transfer agents, even though current Rule 17f-4 “does not expressly permit the use of [a fund transfer agent’s] systems ...”25 The issue addressed in this letter should no longer exist because of the clarification provided by the Article 8 indirect holding system. Section 17(f) of the Investment Company Act requires funds (other than those that self-custody in accordance with Rule 17f-2) to “place and maintain” their securities with specified entities, which include bank custodians and, subject to Rule 17f-4, securities depositories. However, current Rule 17f-4 addresses not only the ability of funds to place their own securities directly with securities depositories, but also the ability of custodians to essentially re-deposit fund securities with such depositories. As discussed above, Revised Article 8 makes clear that the custodian really is not “re-depositing” the fund’s securities. Nevertheless, the current rule implies that, if the custodian does not have physical possession of the fund’s securities, the party that has such possession needs to be expressly authorized to have it. It further implies that, without an express rule, there might be no authority to invest in uncertificated securities, since these obviously are not physically possessed by anyone.
Current Rule 17f-4 accommodates at least some uncertificated securities, but only those uncertificated securities that are issued and held through the federal book-entry system. Apart from the government, mutual funds are the principal issuers of uncertificated securities, but as the Proposing Release observes, “a conventional depository rarely holds” fund shares.26 Thus, there was no apparent authority for anyone to “hold” uncertificated fund shares.
Applying the traditional, chain-of-title logic reflected in Former Article 8 and current Rule 17f-4, the place that uncertificated securities could be most readily understood to be held was with the transfer agent. Accordingly, in response to a no-action request, the staff granted relief based on its determination that, among other things, a fund’s transfer agent “performs the functions” of a securities depository.27
Viewed in the context of Revised Article 8, however, there should be no need for such relief and no reason for Rule 17f-4 to address the issue. A fund that holds shares in another mutual fund through its (i.e., the investing fund’s) custodian holds them “indirectly” and has security entitlements to those shares with its custodian. Those security entitlements are unaffected by the nature of the corresponding financial assets that the custodian maintains to discharge its UCC §8-504 duties to the investing fund. Most likely, the custodian would hold those corresponding financial assets “directly,” by becoming the registered owner of the uncertificated shares on the issuer’s books as maintained by the transfer agent.28 Thus, it is not appropriate to characterize the custodian as having placed or deposited its financial assets with the issuing fund’s transfer agent. The custodian has acquired a financial asset by acquiring the uncertificated securities through the direct holding system.
B. Address Self-Custody in Rule 17f-2
The second concern addressed in the no-action letters cited in the Proposing Release is the ability of an investing fund to hold another fund’s shares directly, without the intermediation of a custodian.29 Section 17(f) and Rule 17f-2 expressly allow funds to self-custody their portfolio securities, but Rule 17f-2 presents obstacles to funds doing so with respect to securities that, like most investment company shares, are uncertificated. No-action relief has been granted in some cases where the fund followed procedures similar to the controls established by Rule 17f-4 securities depositories.30
The Institute agrees 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. Accordingly, we believe that Rule 17f-2 should be revised to accommodate such direct holdings by funds themselves of uncertificated mutual fund shares. We further agree that since, as noted in the Proposing Release, registered transfer agents, like clearing agencies, “are subject to significant regulatory oversight” by the Commission under Section 17A of the Securities Exchange Act of 1934,31 compliance with many of the existing requirements of Rule 17f-2 may not be necessary in the context of fund holdings of uncertificated shares. Indeed, since registered transfer agents are subject to the same regulatory strictures with respect to all issuers, not just mutual funds, it would be appropriate to extend this relief beyond funds’ direct holdings of shares of other funds.
We believe that these changes can and should be made without characterizing transfer agents as “securities depositories.” The proposed language that we have attached suggests a way of doing this under Rule 17f-4. We have placed that language in brackets, however, because we believe that this is a self-custody matter that would be more appropriately addressed by revising Rule 17f-2.
C. Additional Changes in Scope of Rule 17f-4
The proposed amendments also make changes to the definition of the term “securities depository” that are intended to expand depositories’ permitted functions. The reference in proposed Section (b)(9) to securities that are “otherwise acquired or disposed of” by book keeping entries, is intended to allow the use of securities depositories to maintain mutual fund shares and Treasury Direct securities. Such securities normally are only issued and redeemed, not “transferred” as the current rule provides.32 The proposed definition also allows for securities depositories that provide systems for transferring securities “by physical delivery within or through the system.” This change is intended to facilitate use of “centralized custody arrangements” for certificated securities, such as banker’s acceptances, certificates of deposit and certain municipal and “non-depository eligible” mortgage-backed securities.33
The Institute supports the substance of these expansions. However, we think that the Commission’s objectives can be achieved more effectively by simply avoiding the characterization of a security depository’s systems.34 Instead, permissible securities depositories should be defined in terms of the Article 8 definition of a “clearing corporation” and the limitations (to the extent that the Commission concludes that they remain necessary) on permissible “operators” that are contained in proposed Rule 17f-4(a)(4). This approach is illustrated in our proposed revised rule.
Moreover, we note that Treasury Direct securities are registered in investors’ names on the books of the Treasury Department,35 rather than in the name of a Federal Reserve Bank as in the case of securities that are held through TRADES. Thus, funds or their custodians would hold Treasury Direct securities “directly.” To the extent that a fund holds Treasury Direct securities in its own name, rather than having them registered in the name of its custodian, it would be appropriate to view the fund as maintaining self-custody. Thus, provisions dealing with holding Treasury Direct securities should parallel those relating to funds (or, if applicable, their custodians) holding shares of other funds directly on the books of a transfer agent. Our proposed revised rule does this by providing uniform treatment for direct holdings of all uncertificated securities.
The Proposing Release specifically requests comments as to whether funds or their boards should have to approve arrangements in which a custodian maintains certificates that are registered in a fund’s name with a centralized processing facility or when a fund holds shares directly with a transfer agent. We would oppose any such approval requirement.
As discussed above, when a fund holds other fund shares directly with a transfer agent, it is a matter of self-custody. Conversely, when a central processing facility holds a securities certificate that is registered in a fund’s name, the facility’s participant (normally, the fund’s custodian) would have a security entitlement to the security and the ordinary UCC §8-504 duties would apply as long as the certificates are duly endorsed to the custodian or the facility or in blank. Again, no special approvals would appear to be needed. If the certificates are registered in a fund’s name and have not been so endorsed, the fund would be considered to hold the securities directly.36 Such a case may present special considerations for the fund, but we believe those considerations are well within the scope of the day-to-day matters ordinarily handled by fund management. Accordingly, the rule should not mandate any special board approvals, even in these relatively uncommon situations.
6. Use of Securities Depositories by Non-Management Funds
The proposed amendments would expand Rule 17f-4 to permit unit investment trusts and face-amount certificate companies (“non-management companies”) to use securities depositories.37 As proposed, the trustees for such entities would be required to approve these arrangements because non-management companies have no directors, officers or investment adviser. For the same reason, the trustees would be required to establish internal control systems reasonably designed to prevent unauthorized officers’ instructions.
There appears to be no practical reason to preclude non-management companies from using securities depositories. Accordingly, the Institute supports the proposed expansion of the rule to include them. The same conditions that would protect shareholders of management companies are appropriate and sufficient to ensure the protection of shareholders of non-management companies.
We note, however, that proposed Section (a)(1) of the rule is phrased in terms that equate a unit investment trust or certificate company with the fund’s custodian, rather than with the fund itself. Thus, the proposed section refers to a fund using a securities depository “through its Custodian” in the case of management companies or “through the Fund’s trustee” in the case of non-management companies. The same section refers to the requirements for the fund’s contract “with the Custodian (or trustee).” This is in contrast to the provisions in proposed Rule 17f-4(a)(2)(ii) and (3), which properly refer to the fund or its trustee implementing the appropriate internal controls or approving custodial and depository arrangements.
7. Application of Rule 17f-4 to Foreign Custody Arrangements
The proposed amendments would add a note to Rule 17f-4 to clarify the rule’s relationship to Rule 17f-5, which governs the maintenance of fund assets with a foreign custodian. The note indicates that, if fund assets are held with a domestic depository through a foreign custodian, the foreign custody arrangement would be covered by both Rules 17f-4 and 17f-5. Subject to the changes discussed above that would be needed to reflect the fact that it is the foreign custodian’s financial assets that would be maintained with the domestic depository, the Institute does not oppose this clarification.38
8. Application of Rules 17f-5 and 17f-7 to Domestic Depositories
The Commission specifically requests comment on whether Rules 17f-5 and 17f-7, the rules relating to a fund’s use of a foreign custodian and a foreign securities depository, also should apply to domestic depositories in certain cases. We would oppose the application of those rules to domestic depositories.39
The Commission regulates domestic depositories as clearing agencies and, before a clearing agency can establish a link with a foreign custodian or depository, it must obtain a Commission order. In our opinion, further regulation of domestic depositories would not in any way enhance the protection of fund assets. Indeed, requiring a fund to evaluate a foreign subcustodian used by a domestic depository under Rules 17f-5 and 17f-7 generally would be impracticable. Funds generally have no direct dealings or privity of contract with domestic depositories and have no involvement in the depositories’ selection of, negotiations with, or monitoring of any foreign subcustodians that the domestic depositories might use. Funds also would generally have no right of recourse against these foreign subcustodians under Article 8 and analogous foreign laws. In light of these legal realities and the extensive regulation that already governs domestic depositories, applying Rules 17f-5 and 17f-7 to these arrangements would impose unnecessary regulatory burdens without producing any discernible benefits for fund shareholders.
* * *
The Institute appreciates the opportunity to comment on this rule proposal. If you have any questions regarding our comments, please contact the undersigned at (202) 326-5824 or Marguerite C. Bateman at (202) 326-5813.
Amy B. R. Lancellotta
cc: Paul F. Roye, Director
Robert E. Plaze, Associate Director
C. Hunter Jones, Assistant Director
Division of Investment Management
U.S. Securities and Exchange Commission
1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes9,040 open-end investment companies ("mutual funds"), 484 closed-end investment companies, and 6 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.906trillion, accounting for approximately 95% of total industry assets, and over 88.6 million individual shareholders.
2 SEC Release No. IC-25266 (Nov. 15, 2001) (“Proposing Release”).
3 As used herein, and except where the context otherwise indicates, references to “Article 8” (sometimes called “Revised Article 8” or “the Revision”) or to “UCC §8-___” are to the official version of the Uniform Commercial Code (“Uniform Commercial Code, 2001 Official Text”). Subject to minor state variations that are not relevant here, Revised Article 8 is in effect in every U.S. jurisdiction. Unless otherwise indicated, references to “Former Article 8” are to the 1978 official text of Article 8.
4 Thus, just as current Rule 17f-4 sets forth the conditions under which an investment company or its custodian “may deposit all or any part of the securities owned by the investment company” with an eligible securities depository, proposed Rule 17f-4(a) would set forth the conditions under which a fund or custodian “may place or maintain Assets” with a securities depository.
5 UCC Article 8, Prefatory Note §I.A. “The traditional Article 8 … idea that a paper certificate [or, we could add, the book entry evidencing an uncertificated security] could be regarded as a nearly complete reification of the underlying right” is a concept that “do[es] not work for the indirect holding system…. The idea that discrete objects might be traced through the hands of different persons has no place in the Revised Article 8 rules for the indirect holding system.” UCC §8-503, cmt. 2.
6 See UCC §8-501(a).
7 UCC §8-102, cmt. 17.
8 A security entitlement constitutes only a very limited and unique interest in the intermediary’s property interests “the incidents of [which] are established by the rules of Article 8, not by common law property concepts.” UCC §8-503, cmt. 2. As suggested in footnote 15 of the Proposing Release, a fund’s security entitlement represents, in part, “a limited pro rata property interest” in the financial assets maintained by its security intermediary. But that limited interest in what literally are other financial assets is not its chief attribute, which is the package of personal rights that the entitlement holder acquired against its securities intermediary.
9 UCC §8-503, cmt. 2. “The entitlement holder cannot assert rights directly against other persons, such as other intermediaries through whom [its own] intermediary holds the positions ….”
10 Section 17(f) of the Investment Company Act allows funds to maintain their assets with a qualified bank custodian. A fund holding portfolio securities indirectly is acquiring a security entitlement with such custodian. The custodian is not then moving those assets anywhere else, no matter where it maintains financial assets of its own to support the fund’s security entitlements.
11 UCC §8-504(a).
12 Such a waiver would not be consistent with the obligation of good faith performance that is imposed under the UCC. See UCC §8-504, cmt. 4.
13 UCC §§8-504 and 509.
14 Proposed Rule 17f-4(b)(5). This limitation is substantively the same as under current Rule 17f-4(d)(1). Like the current provision, the proposed definition also would limit “intermediary custodians” to entities “through which” a custodian maintains assets with a securities depository. For the reasons discussed in Section 1 above, it is not correct to say that a custodian actually maintains assets at a securities depository “through” another intermediary.
15 The suggested language provides, in effect, a default to the commercial standards in Revised Article 8, in the event parties decline to set a specific performance standard by contract.
16 In fact, the custodian’s practices in this respect presumably would be among the “internal accounting controls” on which proposed Rule 17f-4(a)(1)(ii) would require fund custodians to report to the fund. If it is important for funds to determine that custodians have systems to properly record fund transactions, it is at least as important that custodians actually do so. This remains an important control notwithstanding that under UCC §8-501(b) a fund may acquire a security entitlement even if its custodian fails to credit the fund’s account.
17 It normally should not be necessary for this information to be in the form of individual confirmations, as opposed to daily transaction statements containing appropriate detail.
18The Proposing Release states that “periodic review of a custodian’s controls by fund auditors is a significant safeguard for fund assets.” Executive Summary Section II.D., text accompanying note 54. The Institute agrees. This review could take place, for example, in the context of a review by fund auditors of a report as to the custodian’s controls under Statement of Accounting Standards (SAS) 70. However, we do not interpret Proposed Rule 17f-4(a)(1)(ii) to require that reports on custodians’ internal controls necessarily be provided in the context of an audit.
19 See UCC §8-503(c).
20 This is particularly true with respect to conventional securities depositories (i.e., excluding the transfer agents that the proposed amendments would categorize as “securities depositories”), which under Proposed Rule 17f-4(a)(4) would continue to be limited to the Federal Reserve Banks or other parties authorized to hold custody of federal book-entry securities and to clearing agencies registered with the Commission under Section 17 of the Securities Exchange Act of 1934. These entities are highly regulated, and at least in the case of the major depositories, the sufficiency of their financial resources is clear.
21 Proposed Rule 17f-4(a)(4)(iii). Subsection (a)(4)(i) also expands the coverage of this provision to include securities maintained in the “Treasury Direct” book-entry system pursuant to 31 CFR Part 357, Subpart C. Treasury Direct securities are held directly by investors. See Proposing Release, fn. 23 and Section 5.C. of the text below. Thus, the Federal Reserve Banks do not act as securities intermediaries or “securities depositories” with respect to Treasury Direct securities. When functioning with respect to these securities, they are more analogous to transfer agents and would be subject to the same considerations discussed in the text below.
22 Proposing Release, Executive Summary §II.A.
23 UCC §8-501(e).
24 See Proposing Release at n. 30.
25 See American Pension Investors Trust (1991 SEC No-Act. LEXIS 279 (Feb. 1, 1991)) at *16.
26 Proposing Release, n. 30.
27 Id., at *4.
28 Of course, the custodian could also hold the issuing fund shares indirectly through an intermediary custodian, in which case the fund’s custodian would acquire a security entitlement against that intermediary. But this just moves the analysis up (or, depending on your viewpoint, down) a level. In any case, whoever deals with the transfer agent holds “directly.”
29 It should be noted that a fund does not “hold directly” when it interacts directly with a conventional securities depository (which by definition under Revised Article 8 is itself a type of securities intermediary). Therefore, a fund’s direct interactions with a conventional securities depository is not a self-custody matter and is properly addressed under Rule 17f-4.
30 See Gardner Fund (1988 SEC No-Act. LEXIS 285 (March 7, 1988)).
31 Proposing Release, n. 31.
32 Proposing Release, Executive Summary §II.A.
34 Proposed Rule 17f-4(b)(9) incorporates, subject to the expansions noted in the text, the language of current Rule 17f-4(a), which in turn appears to have been adapted from the securities transfer provisions of Former UCC §§8-313(1)(d) and (2) and 8-320. Those provisions are no longer a part of Article 8.
35 See 31 CFR §§357.0(a), 357.20 and 357.21.
36 See UCC §8-501(d).
37 Under current Rule 17f-4, only registered management investment companies may rely on the rule. The SEC has granted exemptive relief to non-management companies seeking to maintain assets in a depository to supplement custody arrangements with a trustee.
38 We believe, however, that the likelihood of this situation arising is remote. For this reason, we question the need for the proposed note.
39 In Section 7 above, the Institute indicated it does not oppose the application of Rule 17f-4 to domestic depositories utilized by foreign custodians. In contrast, for the reasons set forth in this section, we would oppose the application of rules relating to foreign custody arrangements, Rules 17f-5 and 17f-7, to situations where a domestic depository utilizes a foreign subcustodian.