[Federal Register Volume 64, Number 87 (Thursday, May 6, 1999)]
[Proposed Rules]
[Pages 24489-24499]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-11357]
Federal Register / Vol. 64, No. 87 / Thursday, May 6, 1999 / Proposed
Rules
[[Page 24489]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release Nos. IC-23815, IS-1194; File No. S7-15-99]
RIN 3235-AH55
Custody of Investment Company Assets Outside the United States
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Commission is proposing rule amendments and a new rule
under the Investment Company Act to address the custody of investment
company assets outside the United States. The amendments and new rule
would establish new standards governing the maintenance of an
investment company's assets with a foreign securities depository. The
proposals are designed to provide a workable framework under which an
investment company can protect its assets while maintaining them with a
foreign securities depository.
DATES: Comments must be received on or before July 15, 1999.
ADDRESSES: Comments should be submitted in triplicate to Jonathan G.
Katz, Secretary, Securities and Exchange Commission, 450 5th Street,
NW, Washington, DC 20549-0609. Comments also may be submitted
electronically to the following E-mail address: rule-comments@sec.gov.
All comment letters should refer to File No. S7-15-99; this file number
should be included on the subject line if E-mail is used. Comment
letters will be available for public inspection and copying in the
Commission's Public Reference Room, 450 5th Street, NW, Washington, DC
20549. Electronically submitted comment letters will be posted on the
Commission's Internet web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Thomas M.J. Kerwin, Senior Counsel, or
C. Hunter Jones, Assistant Director, Office of Regulatory Policy, at
(202) 942-0690, in the Division of Investment Management, Securities
and Exchange Commission, 450 5th Street NW, Washington DC 20549-0506.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') today is proposing for public comment amendments to
rule 17f-5 (17 CFR 270.17f-5),\1\ a new rule 17f-7, and conforming
amendments to rule 7d-1 (17 CFR 270.7d-1) and rule 17f-4 (17 CFR
270.17f-4) under the Investment Company Act of 1940 (15 U.S.C. 80a)
(the ``Investment Company Act''). In a companion release, the
Commission also is extending the compliance date for previous
amendments to rule 17f-5 (except for the amended definition of an
``eligible foreign custodian'') that were published on May 16, 1997 (62
FR 26923). The compliance date is extended from May 1, 1999 until May
1, 2000, or until a date to be announced by the Commission when it
takes further action on the amendments proposed in this Release. See
Investment Company Act Release No. 23814 (Apr. 29, 1999).
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\1\ Unless otherwise noted, all references to ``rule 17f-5'' or
any paragraph of the rule will be to 17 CFR 270.17f-5.
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I. Executive Summary
Rule 17f-5 under the Investment Company Act governs the custody of
the assets of registered management investment companies (``funds'')
with custodians outside the United States. We amended the rule in 1997
to modernize its conditions, but later suspended the compliance date
for some of the amendments after learning that they presented problems
for the use of foreign securities depositories. Depositories are
systems for the central handling of securities in which transactions in
securities are processed through adjustment of electronic account
records rather than delivery of certificates.
The Commission is proposing amendments to rule 17f-5 and a new rule
17f-7, which together would permit funds to maintain their assets in
foreign securities depositories based on conditions that reflect the
operations and role of these depositories. The amendments would
eliminate for foreign depository arrangements the requirements that
certain findings be made by the fund board, its investment adviser, or
global custodian, and that certain specified terms appear in depository
rules for participants. Instead, the proposed rule would establish
basic standards for foreign depositories eligible to be used by funds,
and generally require that a fund's contract with its global custodian
obligate the custodian to provide the fund or its adviser with an
initial risk analysis of the depository, continuously monitor risks
associated with use of the depository, and notify the fund or its
adviser of material changes in these risks. The global custodian also
generally would have to agree to exercise reasonable care with respect
to these and other duties.
Unlike rule 17f-5, proposed rule 17f-7 would not contain any
provisions regarding the delegation of authority under the rule.
Decisions to maintain assets with the depository should be made by the
adviser, subject to the oversight of the fund board, based upon
information provided by the global custodian. The adviser and board, in
making these decisions, would be subject to the standards of care that
are generally applicable to fund advisers and directors.
I. Introduction
Rule 17f-5 was initially adopted in 1984,\2\ and extensively
revised in 1997 (``1997 Amendments'') to reflect significant
developments in foreign investment by U.S. funds and the Commission's
greater experience with foreign custodial arrangements.\3\ The 1997
Amendments expanded the types of foreign banks and securities
depositories that may serve as custodians of fund assets by eliminating
capital requirements and other restrictions that in some cases had
precluded funds from using otherwise suitable custodians.\4\ Instead,
the 1997 Amendments require that the selection of a foreign custodian
be based on whether the fund's assets will be subject to reasonable
care if maintained with that custodian, after consideration of all
factors relevant to the safekeeping of fund assets.\5\
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\2\ Section 17(f) of the Investment Company Act, which governs
fund custody arrangements, does not address the use of a foreign
custodian. The Commission adopted rule 17f-5 pursuant to its
exemptive authority under section 6(c) of the Act. See Exemption for
Custody of Investment Company Assets Outside the United States,
Investment Company Act Release No. 14132 (Sept. 7, 1984) (49 FR
36080 (Sept. 14, 1984)) (the ``1984 Release'').
\3\ See Custody of Investment Company Assets Outside the United
States, Investment Company Act Release No. 22658 (May 12, 1997) (62
FR 26923 (May 16, 1997)) (the ``1997 Release'').
\4\ 1997 Release, supra note 3, at text accompanying nn.71-73
and nn.77-79.
\5\ See rule 17f-5(c)(1). These provisions replaced earlier
standards under which the fund board had determined whether
maintaining assets with a custodian would be ``consistent with the
best interests'' of the fund. See 1997 Release, supra note 3, at n.6
and accompanying text.
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The 1997 Amendments also eliminated from rule 17f-5 the
consideration of ``prevailing country risks,'' i.e., risks associated
with investing in a particular country rather than placing assets with
a particular custodian, as well as the consideration of other
investment risks.\6\ We made these changes after concluding that
prevailing country risks were akin to investment risks, and that both
should be considered by a fund's board or investment adviser when
deciding whether the fund should invest in a
[[Page 24490]]
particular country. Finally, the amendments permitted directors to play
a more traditional oversight role by allowing them to delegate their
duties under the rule to a ``foreign custody manager,'' which could
include the fund's investment adviser, officers, or a bank.\7\
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\6\ 1997 Release, supra note 3, at text accompanying nn.13-16
and at n.29.
\7\ See rule 17f-5(b); 1997 Release, supra note 3, at text
accompanying n.21.
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The 1997 Amendments altered the conditions under which funds could
maintain their assets with foreign securities depositories as well as
other types of foreign custodians. Throughout the rulemaking, the
Commission made it clear that we considered foreign depositories to be
custodians for purposes of the rule.\8\ In response to comments on the
proposals, the 1997 Amendments looked to depository rules for
participants rather than custodial contracts to satisfy certain
conditions of the rule.\9\ Having addressed what we believed to be
commenters' concerns regarding depositories, we established a one-year
transition period to allow funds and bank custodians to enter into new
custodial agreements, which would include the use of foreign
depositories.\10\
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\8\ Custody of Investment Company Assets Outside the United
States, Investment Company Act Release No. 21259 at n.71 and
accompanying text (July 27, 1995) (60 FR 39592 (Aug. 2, 1995)); 1997
Release, supra note 3, at n.29 and accompanying text.
\9\ 1997 Release, supra note 3, at nn.65-66 and accompanying
text. In response to comments, we also did not adopt proposed
amendments that would have treated the selection of some types of
depositories differently from the selection of other types of
foreign custodians. Id. at n.29.
\10\ Id. at text following n.86.
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By early 1998, it became apparent that the rule would not operate
as anticipated. Bank custodians refused to accept delegated
responsibility to make findings under the rule regarding funds' use of
most foreign securities depositories.\11\ Representatives of funds
requested that we delay the compliance date for the 1997 Amendments to
permit them to prepare a proposal to further amend the rule.\12\ They
asserted that many funds had been unable to establish foreign custody
arrangements under the amendments because of significant unforeseen
problems with the evaluation and use of most depositories. In
particular, they stated that global bank custodians were unable to
commit to making ``subjective'' determinations of whether foreign
securities depositories would exercise reasonable care with fund
assets.\13\
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\11\ See Letter to Douglas J. Scheidt, Chief Counsel, Division
of Investment Management, from Dorothy M. Donohue, Associate
Counsel, Investment Company Institute (Nov. 24, 1997) (placed in
File No. S7-15-99).
\12\ See Letter to Barry P. Barbash, Director, Division of
Investment Management, from Dorothy M. Donohue, Associate Counsel,
Investment Company Institute (Mar. 24, 1998) (placed in File No. S7-
15-99) (the ``March 1998 Letter'').
\13\ Id. In general, representatives of funds and bank
custodians have asserted that depositories provide a necessary
service for which no feasible alternative may exist, that depository
standards vary from one country to another, that information about
quasi-sovereign depositories may be more difficult to obtain than
information about other foreign custodians, and that inflexible
depository rules may not accommodate the contract terms or
equivalent protections required by the 1997 Amendments. See id.;
Letter to Barry P. Barbash, Director, Division of Investment
Management, from Amy B.R. Lancellotta, Senior Counsel, Investment
Company Institute and Daniel L. Goelzer, Baker & McKenzie (June 30,
1998) (placed in File No. S7-15-99) (the ``June 1998 Letter'').
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On May 21, 1998, we suspended the compliance date for most of the
1997 Amendments to allow time for representatives of funds and
custodians to submit suggested amendments to rule 17f-5.\14\ In June
1998, representatives of funds and representatives of bank custodians
submitted a joint proposal to further amend the rule (``ICI/Bank
Proposal'').\15\ The ICI/Bank Proposal would deem fund assets
maintained with a depository to be subject to reasonable care if eight
objective criteria were met.\16\ Depository rules would not have to
contain provisions that rule 17f-5 generally requires to be included in
custody contracts, including provisions for indemnification or
insurance.\17\
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\14\ See Custody of Investment Company Assets Outside the United
States, Investment Company Act Release No. 23201 (May 21, 1998) (63
FR 29345 (May 29, 1998)). The compliance date for the amended
definition of ``eligible foreign custodian'' remained June 16, 1998.
\15\ See June 1998 Letter, supra note 13.
\16\ The criteria would require that no foreign regulators have
issued public statements indicating that the depository has not
complied with financial strength or internal controls requirements
(unless the problem has been cured); that the depository maintain
certain safeguards such as segregating depository assets from
participant assets, identifying assets in depository records,
providing account reports to participants, and undergoing periodic
review by auditors or regulators; and that the fund's custodian
agree to comply with the depository's requirements. June 1998
Letter, supra note 13.
Representatives of funds and bank custodians submitted a revised
proposal on February 26, 1999. See Letter to Paul F. Roye, Director,
Division of Investment Management, from Amy B.R. Lancellotta, Senior
Counsel, Investment Company Institute and Daniel L. Goelzer, Baker &
McKenzie (Feb. 26, 1999) (placed in File No. S7-15-99) (the
``Revised ICI/Bank Proposal''). Under the Revised ICI/Bank Proposal,
the foreign custody manager would consider information known to it
if the information established certain compliance problems, even if
foreign regulators had not yet acted. In addition, the foreign
custody manager would have to monitor depository arrangements for
any material changes.
\17\ See rule 17f-5(c)(2)(i) and (ii) (requiring specified
terms, or other provisions that provide equivalent protection, to
appear in custody contract).
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The Commission has reviewed the ICI/Bank Proposal and related
submissions, and is persuaded that the 1997 Amendments do not work well
when applied to foreign securities depositories. Some contract
provisions generally required by the amended rule to protect fund
assets may not be feasible when applied to depository rules.\18\ We are
not persuaded, however, that the ICI/Bank Proposal provides a solution.
We are concerned that a rule that relied only on limited objective
criteria may not adequately identify the potential risks of depository
arrangements in a changing global marketplace. We are particularly
reluctant to implement a proposal that might unduly narrow the
evaluation of potential risks, and reduce incentives to provide
relevant information to funds.\19\
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\18\ See June 1998 Letter, supra note 13 (accompanying appendix
suggests that contractual provisions for indemnification or
insurance, no liens, free transferability of assets, and auditor
access might be unworkable for depository custody). It is unclear
whether other provisions might provide equivalent protection. See
rule 17f-5(c)(2)(ii).
\19\ We are also concerned that the terms of such a rule could
be used to delimit responsibility under custodial contracts.
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The Commission proposes to take a different approach in a proposed
new rule with respect to foreign securities depositories. In doing so,
we recognize that the establishment of depositories in countries around
the world is generally a favorable development for funds and their
shareholders. The use of depositories simplifies the clearance and
settlement of securities transactions, and may eliminate some risks of
loss, theft, and destruction of securities held in certificate
form.\20\ Depositories in many countries, however, are relatively new
institutions, and their financial strength and operational capabilities
vary. Only a limited group of intermediaries, including global
custodians and local banks that participate directly in depositories,
may have any contractual relationship with a depository or the ties
needed to monitor risks associated with the use of the depository.
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\20\ See Uniform Commercial Code, Revised Article 8, Prefatory
Note at I.C.; Randall D. Guynn, Modernizing Securities Ownership,
Transfer and Pledging Laws 21 (Capital Markets Forum, International
Bar Association 1996).
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Our new approach can best be explained by reference to the
regulatory discussion that preceded the 1997 Amendments. Those
amendments distinguished between the ``custody risks'' of maintaining
assets overseas, which must be addressed by a fund's foreign custody
manager, and ``prevailing country risks,'' which no longer had to be
considered under the rule because we believed they were more
appropriately considered by a
[[Page 24491]]
fund's adviser or board of directors as part of the decision to invest
in the country.\21\ A securities depository keeps asset ownership
records that might be tampered with or destroyed, and the use of a
depository thus exposes a fund to custody risks.\22\ Yet a securities
depository also may be an instrumentality of a foreign government or
market and may operate under an exclusive license, making its use
practically (and perhaps legally) necessary for a fund that wishes to
invest in a particular foreign market. As a result, a custody decision
not to use a foreign depository because of custody risks may
effectively compel an investment decision not to invest in the country.
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\21\ 1997 Release, supra note 3, at text accompanying nn.13-16
and at n.29.
\22\ Thus, securities depositories were included in the
``selection process'' of rule 17-5, as amended in 1997. See Letter
to Dorothy M. Donohue, Associate Counsel, Investment Company
Institute and Daniel L. Goelzer, Baker & McKenzie, from Robert E.
Plaze, Associate Director, Division of Investment Management (Feb.
19, 1998) (placed in File No. S7-15-99).
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While global custodians ``are in the best position to obtain
information concerning depositories and to evaluate whether that
information suggests that a change in custody conditions has occurred
at the depository,''\23\ the decision to maintain assets with the
depository remains closely linked to the decision to invest or continue
to invest in the country. Investment decisions are more appropriately
the province of the fund's investment adviser or board of directors.
Nevertheless, the adviser and the board are in a position to make these
decisions only if fully informed of the custody risks by the fund's
global custodian. Based on these conclusions, we are amending rule 17f-
5 and proposing a new rule designed to create a partnership between a
fund adviser and a global custodian in which each performs
responsibilities appropriate to its expertise for the purpose of
protecting fund assets placed with the foreign depository.
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\23\ See Revised ICI/Bank Proposal, supra note 16, Attachment 3
at 3.
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II. Discussion
A. Foreign Bank Custodians: Rule 17f-5
Under our proposal, a fund's use of a foreign bank custodian would
continue to be governed by rule 17f-5, as amended in 1997.
We propose to further amend this rule to exclude foreign securities
depositories from its coverage,\24\ and to make other minor clarifying
changes.\25\ Compliance with the 1997 Amendments to rule 17f-5 (except
for the amended definition of Eligible Foreign Custodian) will continue
to be suspended until we complete consideration of new rule 17f-7.\26\
We request comment on whether any further amendments to rule 17f-5 are
necessary.
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\24\ A proposed note to rule 17f-5 would clarify that custody
arrangements involving securities depositories would be governed by
rule 17f-7 and by relevant provisions of rule 17f-5, which would
remain applicable to foreign bank subcustodians participating in
these arrangements. Rule 17f-7 would include a similar note.
\25\ The amendments would use the term ``foreign assets'' in
place of ``fund assets'' for convenience, and to clarify that assets
maintained with a foreign custodian may not be the exclusive
property of the fund. See Uniform Commercial Code, Revised Article
8, section 8-503(b) and comment 1 (entitlement holder's property
interest in securities held by its securities intermediary is a pro
rata interest shared with other customers of the intermediary).
The amendments also would refer to ``maintaining assets with''
an eligible foreign custodian rather than ``selecting'' a custodian,
and would use the term ``eligible foreign custodian'' throughout the
rule. In addition, the amendments would note that the fund's foreign
custody manager, as well as the fund itself, may place and maintain
fund assets with an eligible foreign custodian. See proposed rule
17f-5.
\26\ See ``Supplementary Information'' section supra; Custody of
Investment Company Assets Outside the United States; Extension of
Compliance Date, Investment Company Act Release No. 23814 (Apr. 29,
1999); Custody of Investment Company Assets Outside the United
States, Investment Company Act Release No. 23670 (Jan. 28, 1999) (64
FR 5156 (Feb. 3, 1999)); see also supra note 14.
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When a depository custody arrangement involves a foreign bank
subcustodian that participates in the depository, rule 17f-5 would
continue to apply to the global custodian's use of the foreign bank
subcustodian, while proposed rule 17f-7 would apply to the foreign bank
subcustodian's use of the depository itself.\27\ Is the interaction
between rule 17f-5 and proposed rule 17f-7 in regulating these
respective custody arrangements sufficiently clear? If not, what
further clarification is needed?
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\27\ See supra note 24.
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B. Foreign Securities Depositories: Proposed Rule 17f-7
Proposed rule 17f-7 would govern custody arrangements with foreign
securities depositories. Funds usually deal with these depositories
through a ``Primary Custodian'' (also often referred to as a ``global
custodian''), which the rule would define as a U.S. Bank or Qualified
Foreign Bank (under rule 17f-5) that contracts directly with the fund
to provide custodial services for foreign assets.\28\ As discussed
below, the rule would assign particular duties to the Primary
Custodian.
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\28\ Proposed rule 17f-7(b)(2).
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1. Eligible Securities Depository
Under the proposed rule, funds or their custodians could maintain
their assets with a securities depository only if it is an ``Eligible
Securities Depository.'' An Eligible Securities Depository must
function as a system for the central handling of securities, and must
be regulated by a foreign financial regulatory authority.\29\ The
Commission also is proposing four additional minimum requirements,
which were suggested to us by representatives of funds and bank
custodians. To be an Eligible Securities Depository under rule 17f-7, a
depository must, among other requirements:
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\29\ Proposed rule 17f-7(b)(1)(i) and (ii). The definition of an
Eligible Securities Depository would combine elements of two related
definitions in current rule 17f-5. See current rule 17f-5(a)(1)(ii)
and (iii) (definitions of certain Eligible Foreign Custodians that
are securities depositories or clearing agencies) and (a)(6)
(definition of Securities Depository).
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Hold assets on behalf of the fund under conditions no less
favorable than those that apply to other participants;
Maintain records identifying the assets of each
participant and keep its own assets separated from those of the
participants;
Provide periodic reports to participants; and
Be reviewed periodically by regulatory authorities or
independent accountants.\30\
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\30\ Proposed rule 17f-7(b)(1)(iii) to (vi). The proposed
requirements address five of the requirements suggested in the ICI/
Bank Proposal. See supra note 16.
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Comment is requested on the proposed criteria. Inclusion of these
minimum requirements may have the effect of precluding funds from
investing in some developing markets in which depositories might fail
to meet the criteria. The existence of the rule provisions also may
encourage depositories in these markets to meet these requirements.
Comment is requested as to their effect on investment in developing
markets. Comment also is requested on whether these minimum standards,
together with the other protections described below, are sufficient to
protect fund assets. With respect to the periodic review requirement,
should the rule require review by regulators or auditors to focus on
the depository's custodial activities, or to include verifications of
assets held? The ICI/Bank Proposal included three other minimum
requirements that are not included in proposed rule 17f-7.\31\ Should
the rule include them? Are
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there other minimum requirements that funds or their custodians
typically insist on before placing assets with a depository? Instead of
the proposed approach, should the definition state generally that a
depository should meet minimum reasonable commercial standards, and
then specify some but not all applicable requirements?
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\31\ The ICI/Bank Proposal also required that (i) no foreign
regulators have issued public statements indicating that the
depository has not complied with financial strength requirements or
(ii) internal controls requirements, unless the problem has been
cured, and (iii) that the custodian for the fund has agreed to
comply with the depository's requirements.
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In some foreign securities markets, transfer agents or similar
entities may perform custodial functions analogous to those of a
depository. For example, an Australian central electronic subregistry
may effectively function as a central transfer agent that performs
custody functions in a manner similar to a depository.\32\ In Russia
and other countries such as the Ukraine, registrars for each issuer may
perform analogous custody functions.\33\ The proposed amendments would
define an Eligible Securities Depository to include a transfer agent
that, among other things, transfers and holds uncertificated securities
on the books of an issuer for market participants.\34\ The transfer
agent would have to be regulated by a foreign financial regulatory
authority, and meet other minimum standards for securities depositories
as discussed above.
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\32\ Thomas Murray Ltd, Central Securities Depositories Guide
1997 at 49. The Australian ``CHESS'' system supplements issuers' own
share registers. It records market transactions as transfers of
legal ownership on the issuer's records. Although local law may not
treat CHESS as a custodian, CHESS may effectively perform custodial
functions by holding definitive evidence of the ownership of
securities that do not exist in certificate form Cf. ASX Settlement
and Transfer Corporation Pty Ltd, SEC No-Action Letter (Apr. 19,
1994) (suggesting that CHESS system may not perform custodial
functions); rule 17f-4(a) under the Investment Company Act (17 CFR
270.17f-4(a)) (defining a securities depository as a system for the
central handling of securities where all securities of any
particular class or series of any issuer deposited within the system
are treated as fungible and may be transferred or pledged by
bookkeeping entry without physical delivery of the securities).
\33\ See Thomas Murray Ltd. Worldwide Securities Market Report
(19)97, at 247 (1996). In Russia, equity securities are generally
uncertificated, and entries on the registrar's books are generally
recognized as the only binding evidence of the ownership of
securities. The registrar may effectively act as a custodian by
holding definitive evidence of the ownership of securities that are
uncertificated. See Templeton Russia Fund, Inc., SEC No-Action
Letter (Apr. 18, 1995) (Suggesting that registrars may be limited
participants in the custodial process).
\34\ Proposed rule 17f-7(b)(1); cf. American Pension Investors
Trust, SEC No-Action Letter (Feb. 1, 1991) (custodian for fund of
funds could maintain fund's investment in uncertificated shares of
underlying funds with the domestic transfer agents of those funds
acting as deemed depositories); FundVest, SEC No-Action Letter (Nov.
21, 1984) (similar position).
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The Commission requests comment on the proposed expansion of the
definition of an Eligible Securities Depository. Is it appropriate to
treat transfer agents as Eligible Securities Depositories in these
circumstances? Should other requirements be added if a transfer agent
is to be treated as a depository? To avoid confusion about whether a
transfer agent performs all of the functions of a depository, should
the rule define a broader type of entity, such as an ``eligible
securities holding facility,'' and permit funds to maintain foreign
assets with either a depository or a transfer agent that qualifies as
this type of facility? In the alternative, should the rule omit any
provision for the use of foreign transfer agents, and require funds and
custodians to seek approval for their use on a case-by-case basis?
2. Risk-Limiting Conditions
Proposed rule 17f-7 would provide two alternative approaches to
managing the custody risks that funds may face when they maintain
assets with an Eligible Securities Depository.
a. Indemnification or Insurance
Under the first alternative, a fund could obtain indemnification or
insurance that adequately protects it against all custody risks of
using the depository.\35\ A fund would be ``adequately protected''
under this provision by an agreement with or policy issued by a
reliable party to compensate the fund for any custody losses arising
from use of the depository.\36\ A fund could rely on this alternative
with respect to all of its assets maintained in foreign securities
depositories or with respect to assets held by a particular
depository.\37\
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\35\ Proposed rule 17f-7(a)(1). Potential custody risks of using
a depository might include, for example, faults in recordkeeping
systems or securities handling procedures or systems for
distributing losses among participants. See infra text accompanying
notes 44 to 48 (list of factors that may be relevant to custody
risks).
\36\ Current rule 17f-5 requires a contract with a foreign
custodian to provide for indemnification or insurance (or equivalent
protections) that adequately protect the fund against the loss of
assets held under the contract. Rule 17f-5(c)(2)(i)(A) and (ii): see
also 1997 Release, supra note 3, at text accompanying n.27 (foreign
custody manager itself may have obligation to indemnify the fund in
some circumstances). The rule provision has been interpreted to bind
the primary custodian globally unless each subcustodian satisfies it
individually, and to extend to all foreseeable risks of loss.
Investment Company Institute, SEC No-Action Letter, at nn. 1-2 and
accompanying text (Nov. 4, 1987). In contrast, the first
alternative, discussed in the text above, would require coverage of
all custody losses.
\37\ Protection available from the depository itself, such as a
depository guarantee fund, normally would not protect a beneficial
owner such as the fund, and may provide only for sharing or partial
reimbursement of losses. A government guarantee of a depository may
suffice if the guarantee is complete and extends to beneficial
owners as well as depository participants.
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This alternative would recognize that a fund that is indemnified or
insured against all custodial losses of a depository arrangement is not
exposed to the risks of using the depository (which are transferred to
the indemnifying or insuring party), and therefore the risk analysis,
monitoring, and notification requirements discussed below may not be
necessary. The Commission requests comment on this approach. Should the
rule define the types of custody risks that should be covered? Should
the rule specify how the fund would determine that indemnification or
insurance is adequate to protect the fund against all losses
attributable to custody risks? Are there any reasons why
indemnification or insurance could not cover all custody risks? Should
the rule permit a determination that more limited coverage may be
adequate in some circumstances?
b. Risk Analysis, Monitoring, and Notification
Under the second alternative, the fund's contract with its Primary
Custodian must require the custodian to provide the fund or its
investment adviser an initial risk analysis of the custody risks of
using a depository before the fund places its assets with the
depository.\38\ The contract also must require the Primary Custodian to
continuously monitor these custody risks and promptly notify the fund
or its investment adviser of any material change.\39\ These provisions
are designed to allocate responsibilities for overseeing the safety of
fund assets to the parties best suited to the tasks involved.
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\38\ Proposed rule 17f-7(a)(2)(i)(A). Cf. United Kingdom
Securities and Futures Authority, Board Notice 433, New Safekeeping
Rules, Custody Rule 4-107(1), Assessment of Custodian (July 21,
1997) (``U.K. Custody Rule 4-107(1)'') (before a custodial firm or
an arranger of custodial services holds a safe custody investment
with an eligible custodian, it must undertake an appropriate risk
assessment of the custodian).
\39\ Proposed rule 17f-7(a)(2)(i)(B). Cf. U.K. Custody Rule 4-
107(1), supra note 38 (after firm makes an appropriate risk
assessment of the eligible custodian, it must undertake a continuing
risk assessment).
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In earlier commentary on rule 17f-5, representatives of funds
argued that because of global custodians' expertise and their
contractual relationships with depositories or their participants,
custodians were in a better position to make findings regarding the use
of depositories.\40\ Global custodians disagreed, arguing that the
decision to use a depository, because it is often a prerequisite for
participation in a particular foreign market, is an
[[Page 24493]]
investment decision more properly made by the fund or its investment
adviser.\41\ Each of these views has merit and contributes to our
proposed rule.
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\40\ E.g., Letter to Jonathan G. Katz, Secretary, Securities and
Exchange Commission, from Craig S. Tyle, Vice President & Senior
Counsel, Investment Company Institute at 1, 3-4 (July 26, 1996)
(place in File No. S7-15-99).
\41\ E.g., Letter to Jonathan G. Katz, Secretary, Securities and
Exchange Commission, from Daniel L. Goelzer, Baker & McKenzie at 3-5
(June 7, 1996) (place in File No. S7-15-99).
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Proposed rule 17f-7 would assign to the fund's Primary Custodian
the responsibility to analyze and monitor the risks of using the
depository, under an approach that reflects provisions that many
custodial agreements may already contain.\42\ The Primary Custodian
also would be required to agree to exercise reasonable care and
diligence in performing these and other responsibilities, as discussed
below, but would not be required to make specific findings under the
rule. Its obligations under the required contractual provisions would
be generally fulfilled by providing the adviser with an initial
analysis and an ongoing assessment of the custody risks associated with
the use of the depository. A local subcustodian or other agent could
prepare the risk analysis on behalf of the Primary Custodian.\43\
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\42\ See e.g., Amendment No. 2 to Custody Agreements between
Templeton Funds and The Chase Manhattan Bank (July 23, 1998), filed
with Templeton Funds Inc. Form N-1A, Post-Effective Amendment No. 31
(Oct. 29, 1998) (custodian would monitor compulsory depositories and
advise fund of any material negative change in the performance of,
or arrangements with, any compulsory depository that would adversely
affect the custody of assets); see also Revised ICI/Bank Proposal,
supra note 16 (suggesting that foreign custody manager monitor
whether any material change has occurred in fund custody
arrangements with depository).
\43\ Proposed rule 17f-7(a)(2)(i).
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The risk analysis requirements of the proposed rule are written
broadly to provide custodians with flexibility to tailor the risk
analysis in proportion to the risks involved in the use of each
particular depository. We would expect, for example, the Primary
Custodian to provide a more detailed analysis of a less established
depository than of a depository with an extensive operating history. To
facilitate the flexible application of the rule's requirements to
different depository arrangements, the proposed rule does not specify
particular types of risk that the custodian should analyze, monitor,
and report.
As a general matter, we would expect that a custodian's analysis
could include a discussion of the depository's expertise and market
reputation, quality of services, financial strength,\44\ insurance
arrangements, extent and quality of regulation or other independent
examination,\45\ standing in published ratings,\46\ internal controls
and other procedures for safeguarding investments,\47\ and related
legal protections. Comment is requested on whether the rule should
specifically require the analysis to cover these or other areas.\48\
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\44\ Representatives of funds and bank custodians suggest that
capital may not be a reliable gauge of financial strength because
depository capital levels vary widely. See June 1998 Letter, supra
note 13 (accompanying appendix). Other measures of depository
financial strength that may be more significant include the level of
depository settlement guarantee funds, collateral requirements,
lines of credit, or insurance, as compared with participants' daily
settlement obligations. See Gary Stephenson, Emerging Market
Depositories: What to Look For, at 6 (speech delivered in Bermuda on
May 4, 1998) (place in File Not. S7-15-99).
\45\ This factor relates to requirements in the definition of an
Eligible Securities Depository.
\46\ These ratings may include evaluations or survey information
published by sources such as Global Custodian or Thomas Murray Ltd,
or more formal ratings of depositories that may be available.
\47\ This factor related to requirements in the definition of an
Eligible Securities Depository.
\48\ See generally U.K. Custody Rule 4-107(1), supra note 38
(cites seven analogous factors to be considered in undertaking
continuing risk assessments).
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Proposed rule 17f-7 would not assign a particular role to the
investment adviser or fund board, although it assumes that the
investment adviser would generally determine whether to place fund
assets with a depository under the general oversight of the fund board.
The rule is designed to assure that sufficient material information
about depositories is provided to the adviser in a timely manner.
Decisions regarding whether to place fund assets with a depository
would be made by the adviser or board based on standards of care that
are generally applicable to fund advisers and directors.\49\ These
standards generally require the exercise of care, but do not strictly
limit the risks that may be acceptable in depository arrangements in
appropriate circumstances.\50\
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\49\ See, e.g., Transamerica Mortgage Advisors, Inc. v. Lewis,
444 U.S. 11 (1979) (section 206 of the Investment Advisers Act (15
U.S.C. 80b-6) imposes fiduciary duties on investment advisers);
Burks v. Lasker, 441 U.S. 471 (1979) (Investment Company Act
entrusts independent directors with responsibility to furnish an
independent check on management); American Law Institute, Principles
of Corporate Governance: Analysis and Recommendations Sec. 4.01
(1994) (discussing duties of directors and officers under state law,
including duties of care and inquiry).
\50\ See id. The primary custodian's analysis and continuous
monitoring of risks may help to provide an ``early warning system''
concerning a depository custody arrangement that presents more risks
than other arrangements.
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Fund boards do not typically have the expertise to make day-to-day
decisions regarding foreign depository arrangements.\51\ Therefore, we
assume (but the rule does not require) that a fund board would delegate
this responsibility to the fund's adviser, subject to the board's
general oversight. Fund boards play an important role, however, in
deciding whether to invest in or exit the markets of a particular
country.\52\ When custodial risks are a material factor in a decision
to enter or exit a market, we would expect the adviser to inform the
board of the risks based on analysis provided by the Primary
Custodian.\53\ The rule does not require, nor would we expect, fund
boards to continue to be provided with the lengthy and detailed
briefing books they often receive today.
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\51\ See SEC, Division of Investment Management, Protecting
Investors: A Half Century of Investment Company Regulation 270 n. 78
(1992).
\52\ See 1997 Release, supra note 3, at n. 20 and accompanying
text.
\53\ The Commission would expect that the primary custodian also
would continue to provide other information relating to country risk
and other investment risks. See id. at nn. 18-20 and accompanying
text.
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The Commission requests comment on the proposed provisions relating
to risk analysis, monitoring, and notification requirements. Should the
rule permit a fund to use a primary custodian that is also a securities
depository \54\ If it does, should the rule require the primary
custodian/depository to prepare the initial analysis of the custody
risks of its own custody arrangements (including arrangements with its
subcustodians) and to monitor the risks \55\ Should the rule require
another person to prepare the analysis and monitor the risks? For
example, should the rule require the fund's investment adviser to
retain an independent custody consultant to analyze and monitor the
risks of any depository arrangement in which the fund's primary
custodian is itself the depository?
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\54\ Some foreign depositories may permit funds to use their
services directly as clients or participants. See Simon Thomas and
Simon Murray, Global Securities Services: The Institutional
Investors' Guide 55, 90 (1995) (Euroclear has altered its rules to
permit fund mangers to participate); see generally rule 17f-4(c)
under the Investment Company Act (17 CFR 270.17f-4(c)) (permitting a
fund to participate directly in a domestic depository, subject to
certain conditions); Midwest Securities Trust Company, SEC No-Action
Letter (Mar. 14, 1990) (fund that participates directly in a
depository may maintain a cash account to facilitate settlement of
transactions or to secure obligations to a reserve fund to cover
participant defaults).
\55\ A foreign depository may itself maintain securities with
other depositories. See Richard Dale, Clearing and Settlement Risks
in Global Securities Markets: The Case of Euroclear, Journal of
Business Law 434, 445 (Sept. 1998).
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c. Exercise of Care
Proposed rule 17f-7 also would require under the second alternative
that the fund's contract with its Primary Custodian provide that the
Primary Custodian, and each bank subcustodian
[[Page 24494]]
in its network involved in a depository arrangement, will agree to
exercise reasonable care, prudence, and diligence in performing its
duties under the rule and in all other conduct relating to the
custodial arrangements, or to adhere to a higher standard of care.\56\
The proposed standard of care is the same required of foreign custody
managers under rule 17f-5,\57\ and similar to standards for U.S.
custodians under commercial law.\58\
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\56\ Proposed rule 17f-7(a)(2)(ii).
\57\ Rule 17f-5(b)(3); see proposed rule 17f-5(b)(3) (same
requirement); Revised ICI/Bank Proposal, supra note 16, Attachment 3
at 5 (``(c)onsistent with that (reasonable care) standard, an FCM
(foreign custody manager) could not, in our view, place assets with
a depository that it knew to be unsafe'').
\58\ See Uniform Commercial Code, Revised Article 8, sections 8-
504 and 8-509 (securities intermediary must perform its duties under
Code, including duties to follow procedures in maintaining financial
assets and to exercise care in selecting subcustodians, with ``due
care in accordance with reasonable commercial standards,'' unless
modified by regulatory requirements or contractual provisions that
meet ``good faith'' standard).
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C. Request for Comment on Other Issues
The Commission requests comment on possible additional changes to
rule 17f-5 and proposed rule 17f-7. For example, should the Commission
consider adapting the proposed requirements for the use of a depository
to apply to the use of a bank subcustodian as well, and eliminate the
separate requirements for the use of a bank subcustodian? Because the
fund's Primary Custodian would likely act as its foreign custody
manager in most cases,\59\ should the Commission simply eliminate
provisions that require the appointment of a foreign custody manager,
and allocate related responsibilities directly to the Primary
Custodian? Alternatively, should the Commission not adopt the proposed
amendments to rule 17f-5 and proposed rule 17f-7, and instead revise
the compliance date for the 1997 Amendments to allow funds to contract
with global custodians that accept the responsibilities described in
current rule 17f-5? Is there any need to address matters outside the
scope of the proposed amendments, such as the handling of cash, or the
use of affiliated custodians or subcustodians?
---------------------------------------------------------------------------
\59\ See Revised ICI/Bank Proposal, supra note 16, Attachment 3
at 3 (``global custodian banks * * * are most likely to be asked to
assume delegated Foreign Custody Manager responsibilities in most
cases'').
---------------------------------------------------------------------------
The Commission requests comment on the new rule and rule amendments
proposed in this Release, suggestions for additional provisions or
changes to existing rules or forms, and comments on other matters that
might have an effect on the proposals contained in this Release. The
Commission also requests comment whether the proposals, if adopted,
would promote efficiency, competition, and capital formation. Comments
will be considered by the Commission as it satisfies its
responsibilities under section 2(c) of the Investment Company Act.\60\
For purposes of the Small Business Regulatory Enforcement Fairness Act
of 1996,\61\ the Commission also requests information regarding the
potential impact of the proposals on the U.S. economy on an annual
basis. Commenters are requested to provide empirical data to support
their views.
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\60\ Section 2(c) of the Investment Company Act (15 U.S.C. 80a-
2(c)) requires the Commission, when it engages in rulemaking and is
required to consider whether an action is consistent with the public
interest, to consider, in addition to the protection of investors,
whether the action will promote efficiency, competition, and capital
formation.
\61\ Pub. L. No. 104-121, Title II, Stat. 857 (1996).
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III. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits that result
from its rules. The proposed amendments to rule 17f-5 and proposed new
rule 17f-7 respond to concerns expressed by global custodians and fund
managers that rule 17f-5, as amended in 1997, is not workable. The
proposals also address fund managers' concerns that, as a result of
global custodians' unwillingness to assume delegated responsibilities
under rule 17f-5, obligations to evaluate depositories' custodial
capabilities may fall to fund boards, which lack the relevant knowledge
and expertise to make these evaluations.
Proposed rule 17f-7 should benefit funds and their investors by
establishing a workable framework designed to require global
custodians, which are in the best position to monitor and evaluate
risks of foreign depositories, to assume these responsibilities. The
rule also should benefit funds and their shareholders by freeing fund
boards of the responsibility to make findings concerning foreign
depositories that often remained with them after the 1997 Amendments
because of global custodians' refusals to accept delegated
responsibility. As a result, fund boards should have more time to
address other issues that are important to investors.
The proposed rule and rule amendments may impose costs. Although
the proposed rule sets minimum requirements for depositories, its lack
of a maximum standard for custody risks could cause losses to investors
if a depository fails, despite diligent performance by global
custodians and advisers of their responsibilities. Because the rule
does not limit maximum custody risks in depository arrangements,
additional prospectus disclosure may be required where it may be
necessary for investors to evaluate the risks and rewards of investing
in the fund.\62\ The Commission requests comment on the costs and
benefits of current rule 17f-5, including its requirement that a
foreign custody manager determine that assets maintained with a
depository will be subject to reasonable care, as compared with the
costs and benefits of proposed rule 17f-7's provisions that do not set
limits on potential depository custody risks.
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\62\ See Form N-1A, Item 4(c) (requirement to disclose principal
risks of investing in fund).
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Global custodians should not incur materially greater costs under
proposed rule 17f-7, which generally would require them to perform
duties they typically perform already under custodial contracts. The
rule may have the effect of requiring global custodians to exercise a
greater degree of vigilance in monitoring depositories (or to refrain
in the future from reducing their diligence) and in this respect may
impose costs. Such costs are necessary, however, for the protection of
funds consistent with the purposes of sections 6(c) and 17(f) of the
Investment Company Act. We expect that global custodians will pass on
any additional costs to mutual funds, but that the costs are unlikely
to materially affect overall fund expense ratios.
Fund managers may bear the cost of evaluating the information
provided by global custodians and making decisions regarding the
continued use of a depository (and in this respect, continued
investment in the country). We believe that in the context of foreign
depository arrangements, this allocation of costs is appropriate in
light of (i) the unwillingness of global custodians to assume
responsibilities that may overlap with investment decisions and (ii)
the extent to which the decision to use a foreign depository may affect
an investment strategy that contemplates investment in a particular
foreign market. Advisers to funds could pass on this responsibility to
directors, but this result would not be mandated by the proposals, and
fund directors would be free to reject this responsibility.
The Commission requests comment on the potential costs and benefits
associated with the proposed amendments and proposed rule, and on any
suggested alternatives to the proposals.\63\ Specific comment is
[[Page 24495]]
requested on the potential costs or benefits of these proposals for
funds and their boards of directors, investment advisers, primary
custodians, foreign subcustodians, and depositories. Data is requested
concerning these costs and benefits and how they could be quantified
and expressed in dollar terms.
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\63\ As noted in Section IV, the Commission's staff estimates a
slight reduction in the paperwork burden. The Commission
particularly invites comment on the reasonableness to the staff's
burden estimates.
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IV. Paperwork Reduction Act
Portions of the proposed amendments to rule 17f-5 and proposed new
rule 17f-7 contain ``collection of information'' requirements within
the meaning of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501-
3520), and the Commission is submitting these proposals to the Office
of Management and Budget (``OMB'') for review in accordance with 44
U.S.C. 3507(d). The titles of the collections of information are
``Custody of Investment Company Assets Outside the United States'' and
``Custody of Investment Company Assets with a Foreign Securities
Depository.'' An agency may not sponsor, conduct, or require responses
to an information collection unless it displays a currently valid OMB
control number.
A. Proposed Amendments to Rule
17f-5
The proposed amendments to rule 17f-5 would not substantively
change the rule's collection of information requirements, which would
continue to apply when a fund (i.e., a registered management investment
company) maintains its assets with a foreign bank custodian. The
amendments would remove custody arrangements with foreign securities
depositories from the rule, however, so that the rule's requirements
would no longer apply to these custody arrangements. In general,
therefore, the proposed amendments would reduce the information
collection burdens of rule 17f-5.
The requirements of amended rule 17f-5 that may call for the
collection of information would be substantially the same as under the
current rule. The fund's board of directors must find that it is
reasonable to rely on each delegate it selects to act as the fund's
foreign custody manager. The delegate must agree to provide written
reports that notify the board when the fund's assets are placed with a
foreign custodian and when any material change occurs in the fund's
custody arrangements. The delegate must agree to exercise reasonable
care, prudence, and diligence, or to adhere to a higher standard of
care. When the foreign custody manager selects an eligible foreign
custodian, it must determine that the fund's assets will be subject to
reasonable care if maintained with that custodian, and that the written
contract that governs each custody arrangement will provide reasonable
care for fund assets. The contract must contain certain specified
provisions or others that provide at least equivalent care. The foreign
custody manager must establish a system to monitor the contract and the
appropriateness of continuing to maintain assets with the eligible
foreign custodian.
The Commission's staff estimates that during the first year after
the proposed amendments go into effect, approximately 3,690 fund
portfolios \64\ would be required to make an average of one response
per portfolio under amended rule 17f-5, requiring approximately 2 hours
of director time per response, to make the necessary findings
concerning foreign custody managers.\65\ The total annual burden
associated with these requirements of the rule during the first year
would be approximately 7,380 hours (3,690 portfolios x 2 hours per
portfolio). The staff further estimates that during the first year
after the proposed amendments go into effect, approximately 15 global
custodians \66\ would be required to make an average of 80 responses
per custodian concerning the use of foreign custodians other than
depositories, requiring approximately 10 hours per response, plus one
additional response per custodian that requires approximately 96 hours
per response.\67\ The total annual burden associated with these
requirements of the rule during the first year would be approximately
13,440 hours (15 global custodians x 896 hours per global custodian).
Therefore, the total burden of all collection of information
requirements of rule 17f-5 during the first year after its amendment is
estimated to be approximately 20,820 hours (7,380 + 13,440).\68\
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\64\ This information is based on data reported by funds on Form
N-SAR (17 CFR 274.101).
\65\ The staff estimates that these 3,690 portfolios are divided
among approximately 1,327 registered funds within approximately 650
fund complexes that may share the same investment adviser, board of
directors, U.S. bank custodian, or all of these entities. Each board
of directors and its delegates for a fund complex could therefore
meet rule 17f-5's requirements by simultaneously approving similar
arrangements for some 6 portfolios in the same complex. The
estimated hour amounts are based on discussions with representatives
of funds about the burden of analogous requirements in another
custody rule.
\66\ This estimate is based on staff review of custody contracts
and other research.
\67\ These estimates assume that each of 15 custodians services
an average of 250 client portfolios within 40 fund complexes, that a
single response by each custodian can simultaneously address
approximately 6 client portfolios in a fund complex, and that each
custodian makes approximately 80 responses annually requiring 10
hours per response to establish bank custody arrangements for
approximately 40 fund complexes and report to their fund boards, and
one response annually requiring 96 hours per response to establish a
system to monitor custody arrangements for these clients.
\68\ The number of responses may decline substantially after the
first year because some responses made during that year would
suffice for some time thereafter.
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The staff estimates that the proposed amendments' removal of
custody arrangements involving securities depositories from rule 17f-5
would eliminate as much as 28,600 additional burden hours currently
imposed by the rule's collection of information requirements. This
estimate assumes that without the amendments, approximately 650
investment advisers \69\ would have to make an average of 3 responses
per adviser annually, requiring a total of approximately 44 hours for
each adviser, to address depository arrangements.\70\
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\69\ See supra note 65.
\70\ These estimates assume that one adviser manages 6
portfolios, and that each adviser would make 3 responses annually
requiring a total of 44 hours to approve depository custody
arrangements for each fund complex, report to fund boards, and
establish a system to monitor depository arrangements for the fund
complex. The 44 hours would include 10 hours spent to establish
custody arrangements with depositories and make ``reasonable care''
determinations, 24 hours spent to monitor depository arrangements,
and 10 hours spent to report to fund boards.
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B. Proposed New Rule 17f-7
Proposed new rule 17f-7 would contain some collection of
information requirements. Under the proposed rule, an eligible
depository would have to meet minimum standards for a depository.
The fund or its investment adviser would generally determine
whether the depository complies with those requirements based on
information provided by the fund's primary custodian. The depository
custody arrangement also would have to meet certain risk limiting
requirements. The fund could obtain indemnification or insurance
arrangements that adequately protect the fund against custody risks.
The fund or its investment adviser generally would determine whether
indemnification or insurance provisions are adequate. If the fund does
not rely on indemnification or insurance, the fund's contract with its
primary custodian would be required to state
[[Page 24496]]
that the custodian will provide to the fund or its investment adviser a
custody risk analysis of each depository, monitor risks on a continuous
basis, and promptly notify the fund or its adviser of material changes
in risks. The primary custodian and other custodians also would be
required to agree to exercise reasonable care.
The staff estimates that during the first year after proposed rule
17f-7 goes into effect, approximately 650 investment advisers would
make an average of 3 responses per adviser under the proposed rule,
requiring a total of approximately 25 hours for each adviser, to
address depository compliance with minimum requirements, any
indemnification or insurance arrangements, and reviews of risk analyses
or notifications.\71\ The total annual burden associated with these
requirements of the rule during the first year would be approximately
16,250 hours (650 advisers x 25 hours per adviser). The staff further
estimates that during the first year after the proposed rule goes into
effect, approximately 15 global custodians would make an average of 80
responses per custodian under the rule that would require approximately
10 hours per response.\72\ The total annual burden associated with
these requirements of the new rule would be approximately 12,000 hours
(15 custodians x 800 hours). Therefore, the total annual burden
associated with all collection of information requirements of the
proposed new rule during the first year after its adoption is estimated
to be 28,250 hours (16,250 + 12,000).
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\71\ These estimates assume that one adviser manages 6
portfolios, and that each adviser would make 3 responses annually
requiring a total of 25 hours for each adviser to address depository
compliance with minimum requirements, any indemnification or
insurance arrangements, and reviews of risk analyses or
notifications for the adviser's fund complex. The 25 hours would
include 3 hours spent to verify depository compliance with minimum
requirements, 2 hours spent to address any indemnification or
insurance arrangements, and 20 hours spent to review risk analyses
or notification for the fund complex.
\72\ These estimates assume that each of 15 custodians services
an average of 250 client portfolios within 40 fund complexes, that a
single response by each custodian can simultaneously address
approximately 6 client portfolios in a fund complex, and that each
custodian makes approximately 80 annual responses requiring 10 hours
per response to prepare risk anslyses of depository arrangements and
monitor risks for approximately 40 fund complexes, and to provide
notices of material changes in risks to these clients.
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As reflected in the following summary of the burden hour
requirements of the collection of information requirements in current
rule 17f-5, rule 17f-5 as proposed to be amended, and proposed rule
17f-7, the staff estimates that the net effect of the proposed
amendments and new rule may be to reduce the total annual paperwork
burden by 350 hours:
------------------------------------------------------------------------
Paperwork
Rule burden
hours
------------------------------------------------------------------------
Current rule 17f-5........................................... 49,420
Rule 17f-5 as proposed to be amended......................... 20,820
Proposed rule 17f-7.......................................... 28,250
Net reduction................................................ -350
------------------------------------------------------------------------
The Commission requests comment on the reasonableness of these
estimates. Commenters who disagree are requested to provide their own
estimates with supporting rationales.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits
comments in order to: (i) evaluate whether the proposed collections of
information are necessary for the proper performance of the functions
of the Commission, including whether the information will have
practical utility; (ii) evaluate the accuracy of the staff's estimate
of the burden of the proposed collections of information; (iii) enhance
the quality, utility and clarity of the information to be collected;
and (iv) minimize the burden of the collections of information on those
who are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons wishing to submit comments on the collection of information
requirements of the proposed amendments and proposed rule should direct
them to the following persons: (i) Desk Officer for the Securities and
Exchange Commission, Office of Information and Regulatory Affairs,
Office of Management and Budget, Room 3208, New Executive Office
Building, Washington, DC 20503; and (ii) Jonathan G. Katz, Secretary,
Securities and Exchange Commission, 450 5th Street NW, Washington, DC
20549-0609, with reference to File No. S7-15-99. OMB is required to
make a decision concerning the collections of information between 30
and 60 days after publication; therefore, a comment to OMB is best
assured of having its full effect if OMB receives it within 30 days
after publication of this Release. Requests for materials submitted to
OMB by the Commission with respect to these collections of information
should be in writing, refer to File No. S7-15-99, and be submitted to
the Securities and Exchange Commission, Records Management, Office of
Filings and Information Services.
V. Summary of Initial Regulatory Flexibility Analysis
The Commission has prepared an Initial Regulatory Flexibility
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding the
proposed amendments to rule 17f-5 and proposed new rule 17f-7, and
conforming amendments to rules 7d-1 and 17f-4. The following summarizes
the IRFA.
A. Reasons for the Proposed Action
Rule 17f-5 governs the custody of the assets of registered
management investment companies (``funds'') with custodians outside the
United States. The Commission amended the rule in 1997 to modernize its
conditions. In 1998, representatives of funds and bank custodians
informed the Commission that some conditions of the rule presented
problems regarding the use of foreign securities depositories.
B. Objectives
The Commission is proposing amendments to rule 17f-5 and a new rule
17f-7, which together would permit funds to maintain their assets in
foreign securities depositories based on conditions that reflect the
operations and role of these depositories. The proposed amendments to
rule 17f-5 would remove custody arrangements with foreign securities
depositories from the rule, eliminating the applicability to depository
arrangements of requirements that certain findings be made by the fund
board, its investment adviser, or global custodian, and that certain
specified terms or equivalent protections appear in the rules of the
depository.
Proposed new rule 17f-7 would establish new provisions for the use
of depositories. The proposed rule would require every foreign
securities depository that holds fund assets to meet specified minimum
standards for depositories. The proposed rule also would require a
custody arrangement with a depository to meet either of two alternative
sets of risk-limiting conditions. Under one alternative, the fund could
obtain adequate indemnification or insurance against the custody risks
of depository arrangements. Under the other alternative, the fund's
contract with its primary custodian would have to state that the
custodian will provide the fund or its adviser an initial analysis of
the custody risks of the depository arrangement, continuously monitor
those risks, and notify the fund or its adviser of material changes in
the risks. The primary custodian and other custodians involved in the
depository
[[Page 24497]]
arrangement also would have to agree to exercise reasonable care in
performing these duties and in other conduct relating to custody
arrangements. The conforming amendments to rules 7d-1 and 17f-4 would
clarify current references to rule 17f-5 by adding a reference to rule
17f-7 as well.
C. Legal Basis
The Commission is proposing the amendments to rule 17f-5 and new
rule 17f-7 and conforming amendments to rules 7d-1 and 17f-4 pursuant
to the authority set forth in sections 6(c), 7(d), 17(f), and 38(a) of
the Investment Company Act (15 U.S.C. 80a-6(c), -7(d), -17(f), and -
37(a)).
D. Small Entities Subject to the Rules
The proposed amendments and new rule will affect, among other
persons, the approximately 15 global custodians that act as foreign
custody managers for funds under rule 17f-5 and as primary custodians
under proposed rule 17f-7. None of these global custodians would likely
qualify as a small entity, because each custodian is a major bank with
a global branch network or global ties to other banks. The proposed
amendments and new rule also will affect the funds that invest in
foreign markets and their investment advisers. Few if any of the
affected funds and advisers would be small entities.\73\
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\73\ A fund is consisered a small entity if it, together with
other investment companies in the same group of related investment
companies, has net assets of $50 million or less. 17 CFR 270.0-10.
An adviser is considered a small entity if it has assets under
management of less than $25 million, has total assets of less than
$5 million, and is not in a control relationship with other advisers
or persons that are not small entities. 17 CFR 275.0-7. Most funds
that invest in foreign securities are part of a fund complex that
holds net assets of more than $50 million, and are advised by
advisers with assets under management of $25 million or more.
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On balance, the impact of the proposed amendments and new rule on
global custodians, funds, and advisers is not expected to be great,
because the burdens of the new rule's requirements would be offset in
part by the elimination of burdens under existing rule 17f-5. For this
reason, and because few if any of the affected entities would qualify
as small entities, the proposed amendments are unlikely to have a
significant impact on a substantial number of small entities.
E. Reporting, Recordkeeping, and Other Compliance Requirements
The proposed amendments to rule 17f-5 would retain existing
reporting, recordkeeping, and other compliance requirements of the rule
without substantive changes, insofar as they apply to custody
arrangements with a foreign bank custodian. The amendments would remove
a custody arrangement with a foreign depository from the rule,
eliminating the necessity for it to comply with these requirements.
Proposed new rule 17f-7 would establish new requirements for
arrangements with depositories. As described above, the new rule would
require each foreign securities depository that holds fund assets to
meet certain specified minimum requirements. Depository arrangements
also would have to meet other risk-limiting conditions. A fund could
obtain adequate indemnification or insurance against the custody risks
of depository arrangements. In the alternative, the fund's contract
with its primary custodian would have to state that the custodian will
provide an analysis of depository custody risks, continuously monitor
the risks, and promptly notify the fund of any material changes in
risks. The primary custodian and other custodians also would have to
agree to exercise reasonable care in all conduct relating to custody
arrangements.
F. Significant Alternatives
The Regulatory Flexibility Act directs the Commission to consider
significant alternatives that would accomplish the stated objective,
while minimizing any significant economic impact on small entities. As
discussed above, none of the global custodians affected by the proposed
amendments to rule 17f-5 or proposed rule 17f-7, and few if any of the
affected funds and advisers, are likely to be considered small entities
for purposes of the Regulatory Flexibility Act. As further discussed
above, the impact of the amendments is likely to be limited, because
burdens under the proposed new rule would be offset in part by reduced
burdens under current rule 17f-5. Therefore, the potential impact of
the amendments and the proposed new rule on small entities would not be
significant.
For these reasons, alternatives to the proposed amendments and
proposed new rule are unlikely to minimize any impact that the proposed
amendments may have on small entities. Alternatives in this category
would include: (1) Establishing different compliance or reporting
standards that take into account the resources available to small
entities; (2) clarifying, consolidating or simplifying the compliance
requirements for small entities; (3) using performance rather than
design standards; and (4) exempting small entities from coverage of all
or part of the rule.
The Commission encourages the submission of comments on matters
discussed in the IRFA. Comment specifically is requested on the number
of small entities that would be affected by the proposals and the
impact of the proposals on small entities. Commenters are asked to
describe the nature of any impact and provide empirical data supporting
the extent of the impact. These comments will be placed in the same
public comment file as comments on the proposals. A copy of the IRFA
may be obtained by contacting Thomas M.J Kerwin, Securities and
Exchange Commission, 450 5th Street, NW, Washington, DC 20549-0506.
VI. Statutory Authority
The Commission is proposing amendments to rule 17f-5 and new rule
17f-7 and conforming amendments to rules 7d-1 and 17f-4 pursuant to
authority set forth in sections 6(c), 7(d), 17(f), and 38(a) of the
Investment Company Act (15 U.S.C. 80a-6(c), -7(d), -17(f) and -37(a)).
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Rule
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is proposed to be amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
1. The general authority citation for part 270 continues to read in
part as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39
unless otherwise noted:
* * * * *
2. Section 270.7d-1 is amended by revising the introductory text of
paragraph (b)(8)(v) to read as follows:
Sec. 270.7d-1 Specification of conditions and arrangements for
Canadian management investment companies requesting order permitting
registration.
* * * * *
(b) * * *
(8) * * *
(v) Except as provided in Sec. 270.17f-5 and Sec. 270.17f-7,
applicant will appoint, by contract, a bank, as defined in section
2(a)(5) of the Act (15 U.S.C. 80a-2(a)(5)) and having the qualification
described in section 26(a)(1) of the Act (15 U.S.C. 80a-26(a)(1)), to
act as trustee of, and maintain in its sole custody in the United
States, all of applicant's securities and cash, other than cash
[[Page 24498]]
necessary to meet applicant's current administrative expenses. The
contract will provide, inter alia, that the custodian will:
* * * * *
3. Section 270.17f-4 is amended by revising the introductory text
of paragraph (b) to read as follows:
Sec. 270.17f-4 Deposits of securities in securities depositories.
* * * * *
(b) A registered management investment company (investment company)
or any qualified custodian may deposit all or any part of the
securities owned by the investment company in a foreign Eligible
Securities Depository as defined in Sec. 270.17f-7 in accordance with
the provisions of Sec. 270.17f-7 and applicable provisions of
Sec. 270.17f-5, or in:
* * * * *
4. Section 270.17f-5 is revised to read as follows:
Sec. 270.17f-5 Custody of investment company assets outside the United
States.
(a) Definitions. For purposes of this section:
(1) Eligible Foreign Custodian means an entity that is incorporated
or organized under the laws of a country other than the United States
and that is a Qualified Foreign Bank or a majority-owned direct or
indirect subsidiary of a U.S. Bank or bank-holding company.
(2) Foreign Assets means any investments (including foreign
currencies) for which the primary market is outside the United States,
and any cash and cash equivalents that are reasonably necessary to
effect the Fund's transactions in those investments.
(3) Foreign Custody Manager means a Fund's or a Registered Canadian
Fund's board of directors or any person serving as the board's delegate
under paragraphs (b) or (d) of this section.
(4) Fund means a management investment company registered under the
Act (15 U.S.C. 80a) and incorporated or organized under the laws of the
United States or of a state.
(5) Qualified Foreign Bank means a banking institution or trust
company, incorporated or organized under the laws of a country other
than the United States, that is regulated as such by the country's
government or an agency of the country's government.
(6) Registered Canadian Fund means a management investment company
incorporated or organized under the laws of Canada and registered under
the Act pursuant to the conditions of Sec. 270.7d-1.
(7) U.S. Bank means an entity that is:
(i) A banking institution organized under the laws of the United
States;
(ii) A member bank of the Federal Reserve System;
(iii) Any other banking institution or trust company organized
under the laws of any state or of the United States, whether
incorporated or not, doing business under the laws of any state or of
the United States, a substantial portion of the business of which
consists of receiving deposits or exercising fiduciary powers similar
to those permitted to national banks under the authority of the
Comptroller of the Currency, and which is supervised and examined by
state or federal authority having supervision over banks, and which is
not operated for the purpose of evading the provisions of this section,
or
(iv) A receiver, conservator, or other liquidating agent of any
institution or firm included in paragraphs (a)(7)(i), (ii), or (iii) of
this section.
(b) Delegation. A Fund's board of directors may delegate to the
Fund's investment adviser or officers or to a U.S. Bank or to a
Qualified Foreign Bank the responsibilities set forth in paragraphs
(c)(1), (c)(2), or (c)(3) of this section, provided that:
(1) The board determines that it is reasonable to rely on the
delegate to perform the delegated responsibilities;
(2) The board requires the delegate to provide written reports
notifying the board of the placement of Foreign Assets with a
particular custodian and of any material change in the Fund's foreign
custody arrangements, with the reports to be provided to the board at
such times as the board deems reasonable and appropriate based on the
circumstances of the Fund's arrangements; and
(3) The delegate agrees to exercise reasonable care, prudence and
diligence such as a person having responsibility for the safekeeping of
the Fund's Foreign Assets would exercise, or to adhere to a higher
standard of care, in performing the delegated responsibilities.
(c) Maintaining Assets with an Eligible Foreign Custodian. A Fund
or its Foreign Custody Manager may place and maintain the Fund's
Foreign Assets in the care of an Eligible Foreign Custodian, provided
that:
(1) General Standard. The Foreign Custody Manager determines that
the Foreign Assets will be subject to reasonable care, based on the
standards applicable to custodians in the relevant market, if
maintained with the Eligible Foreign Custodian, after considering all
factors relevant to the safekeeping of the Foreign Assets, including,
without limitation:
(i) The Eligible Foreign Custodian's practices, procedures, and
internal controls, including, but not limited to, the physical
protections available for certificated securities (if applicable), the
method of keeping custodial records, and the security and data
protection practices;
(ii) Whether the Eligible Foreign Custodian has the requisite
financial strength to provide reasonable care for Foreign Assets;
(iii) The Eligible Foreign Custodian's general reputation and
standing; and
(iv) Whether the Fund will have jurisdiction over and be able to
enforce judgments against the Eligible Foreign Custodian, such as by
virtue of the existence of offices in the United States or consent to
service of process in the United States.
(2) Contract. The arrangement with the Eligible Foreign Custodian
is governed by a written contract that the Foreign Custody Manager has
determined will provide reasonable care for Foreign Assets based on the
standards specified in paragraph (c)(1) of this section.
(i) The contract must provide:
(A) For indemnification or insurance arrangements (or any
combination) that will adequately protect the Fund against the risk of
loss of Foreign Assets held in accordance with the contract;
(B) That the Foreign Assets will not be subject to any right,
charge, security interest, lien or claim of any kind in favor of the
Eligible Foreign Custodian or its creditors, except a claim of payment
for their safe custody or administration or, in the case of cash
deposits, liens or rights in favor of creditors of the custodian
arising under bankruptcy, insolvency, or similar laws;
(C) That beneficial ownership of the Foreign Assets will be freely
transferable without the payment of money or value other than for safe
custody or administration;
(D) That adequate records will be maintained identifying the
Foreign Assets as belonging to the Fund or as being held by a third
party for the benefit of the Fund;
(E) That the Fund's independent public accountants will be given
access to those records or confirmation of the contents of those
records; and
(F) That the Fund will receive periodic reports with respect to the
safekeeping of the Foreign Assets, including, but not limited to,
notification of any transfer to or from the Fund's account or a third
party account containing assets held for the benefit of the Fund.
(ii) The contract may contain, in lieu of any or all of the
provisions specified
[[Page 24499]]
in paragraph (c)(2)(i) of this section, other provisions that the
Foreign Custody Manager determines will provide, in their entirety, the
same or a greater level of care and protection for the Foreign Assets
as the specified provisions, in their entirety.
(3)(i) Monitoring the Foreign Custody Arrangements. The Foreign
Custody Manager has established a system to monitor the appropriateness
of maintaining the Foreign Assets with a particular custodian under
paragraph (c)(1) of this section, and to monitor performance of the
contract under paragraph (c)(2) of this section.
(ii) If an arrangement with an Eligible Foreign Custodian no longer
meets the requirements of this section, the Fund must withdraw the
Foreign Assets from the Eligible Foreign Custodian as soon as
reasonably practicable.
(d) Registered Canadian Funds. Any Registered Canadian Fund may
place and maintain its Foreign Assets outside the United States in
accordance with the requirements of this section, provided that:
(1) The Foreign Assets are placed in the care of an overseas branch
of a U.S. Bank that has aggregate capital, surplus, and undivided
profits of a specified amount, which must not be less than $500,000;
and
(2) The Foreign Custody Manager is the Fund's board of directors,
its investment adviser or officers, or a U.S. Bank.
Note to Sec. 270.17f-5: A custody arrangement that involves an
Eligible Securities Depository (as defined in Sec. 270.17f-7) would
be governed by the provisions of Sec. 270.17f-7 as well as by
provisions of Sec. 270.17f-5 that apply to any Eligible Foreign
Custodian involved in the depository custody arrangement.
5. Section 270.17f-7 is added to read as follows:
Sec. 270.17f-7 Custody of investment company assets with a foreign
securities depository.
(a) Custody arrangement with an Eligible Securities Depository. A
Fund, including a Registered Canadian Fund, may place and maintain its
Foreign Assets with an Eligible Securities Depository, provided that:
(1) Indemnification or insurance. The Fund has obtained
indemnification or insurance arrangements (or any combination) that
will adequately protect the Fund against all losses attributable to the
custody risks associated with maintaining assets with the Eligible
Securities Depository; or (2)
(2) Alternative safeguards. The custody arrangement provides other
reasonable safeguards against the custody risks associated with
maintaining assets with the Eligible Securities Depository, including:
(i) Risk analysis and monitoring. The Fund's contract with its
Primary Custodian states that the Primary Custodian (or its agent)
will:
(A) Provide the Fund or its investment adviser with an analysis of
the custody risks associated with maintaining assets with the Eligible
Securities Depository, before the Fund places its assets with the
depository; and
(B) Continuously monitor the custody risks associated with
maintaining assets with the Eligible Securities Depository and promptly
notify the Fund or its investment adviser regarding any material change
in these risks.
(ii) Exercise of care. The Fund's contract with its Primary
Custodian states that the Primary Custodian and each other custodian
that acts on behalf of the Fund in maintaining assets with the Eligible
Securities Depository will agree to exercise reasonable care, prudence,
and diligence in performing the requirements of paragraph (a)(2)(i) of
this section and in all other conduct relating to custody arrangements,
or to adhere to a higher standard of care.
(3) Withdrawal of assets from Eligible Securities Depository. If a
custody arrangement with an Eligible Securities Depository no longer
meets the requirements of this section, the Fund's Foreign Assets must
be withdrawn from the depository as soon as reasonably practicable.
(b) Definitions. The terms Foreign Assets, Fund, Qualified Foreign
Bank, Registered Canadian Fund, and U.S. Bank have the same meanings as
in Sec. 270.17f-5. In addition:
(1) Eligible Securities Depository means a system for the central
handling of securities as defined in Sec. 270.17f-4, or a transfer
agent that transfers and holds uncertificated securities on the books
of an issuer for market participants, that:
(i) Acts as a transnational system for the central handling of
securities or equivalent book-entries, or acts as a system for the
central handling of securities or equivalent book-entries in the
country where it is incorporated or organized;
(ii) Is regulated by a foreign financial regulatory authority as
defined under section 2(a)(50) of the Act (15 U.S.C. 80a-2(a)(50));
(iii) Holds assets for the custodian that participates in the
system on behalf of the Fund under conditions no less favorable than
the conditions that apply to other participants;
(iv) Maintains records that identify the assets of each participant
and segregate the system's own assets from the assets of participants;
(v) Provides periodic reports to its participants with respect to
its safekeeping of assets, including notices of transfers to or from
any participant's account; and (vi) Is subject to periodic review by
regulatory authorities or independent accountants.
(2) Primary Custodian means a U.S. Bank or Qualified Foreign Bank
that contracts directly with a Fund to provide custodial services
related to maintaining the Fund's assets outside the United States.
Note to Sec. 270.17f-7: A custody arrangement that involves an
Eligible Securities Depository would also be governed by provisions
of Sec. 270.17f-5 that apply to any Eligible Foreign Custodian (as
defined in Sec. 270.17f-5) involved in the depository custody
arrangement.
Dated: April 29, 1999.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-11357 Filed 5-5-99; 8:45 am]
BILLING CODE 8010-01-P
