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40 Act Exemptive Applications
Audit Report No. 230
March 29, 1996
The Investment Company Act and Investment Advisers Act authorize the Commission to exempt any person, security, or transaction from one or more provisions of the Acts or Commission rules. Applicants seeking exemptive relief must file an application with the Commission presenting a basis for the relief requested, and identifying any benefits expected for investors and any conditions imposed to protect investors. Most applications are reviewed by the Office of Investment Company Regulation (OICR), in the Division of Investment Management.
The primary objective of our audit was to evaluate the efficiency and effectiveness of the exemptive application process. The audit was conducted between May and November 1995. Particular attention was paid to whether the process responds with enough promptness to ensure flexibility in the administration of the Investment Company Act of 1940.
We found that the exemption process is essentially sound and that internal controls surrounding the process are generally adequate. But many of the outside attorneys we spoke to are dissatisfied with how long it takes to obtain an exemptive order, especially when novel issues are involved. It is not unusual for it to take up to 1 year or longer to obtain a complex exemptive order. Unable to wait, some attorneys say that firms either abandon the plans that cause them to seek relief, or alter them to adopt a less innovative or efficient approach that does not require filing for an exemption.
Our recommendations to improve the effectiveness and efficiency of the process include: giving the applicant the right to request a hearing after a certain period of time has passed; reducing the number of deregistrations reviewed by staff attorneys; establishing time frames for the completion of significant milestones in the review of novel applications; reaffirming a division policy of consolidating comments; and offering a generic comment letter to applicants.
We are also recommending: removing the expedited review rule from the Regulatory Flexibility Act Agenda; redirecting training resources; improving the applications database program; reducing the amount of time between the filing of applications with the Commission and their assignment for review; and requiring staff attorneys to account more closely for their time.
The Division of Investment Management generally concurred with the recommendations presented in the report. Their comments appear in the appendix.
OBJECTIVES AND SCOPE
The primary objective of the audit was to evaluate the efficiency and effectiveness of the exemptive application process related to the Investment Company Act of 1940, administered by the Office of Investment Company Regulation (OICR), in the Division of Investment Management. The scope of the audit excluded consideration of variable insurance products which are reviewed by another part of the Division. Particular attention was paid to whether the process responds with enough promptness to ensure flexibility in the administration of the Investment Company Act of 1940.
During the audit, we interviewed staff from the Division of Investment Management and reviewed application files, management reports, and other types of documentation. We also interviewed or received completed questionnaires from 15 private attorneys, including representatives of the American Bar Association, the Investment Company Institute and many former Commission staff with experience on both sides of the exemption process.
The audit was conducted between May 1995 and November 1995, in accordance with generally accepted government auditing standards.
The Investment Company Act and Investment Advisers Act authorize the Commission to exempt, conditionally or unconditionally, any person, security, or transaction from one or more provisions of the Acts or Commission rules. According to a principal author of the Investment Company Act, exemptive powers prevent the Act from being "unduly restrictive". To grant an exemption the Commission must find that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policies and provisions of the Acts.
This exemptive power has enabled the Commission to make changes in the regulation of investment companies in response to developments in the industry. As a result, the investment company industry has been able to grow and adapt during the more than 50 years since the enactment of the Investment Company Act without substantial amendments to the Act. For example, Commission exemptive orders fostered the creation of money market funds, by enabling them to use specialized pricing methods not sanctioned in the original Act. In a recent speech, Chairman Levitt noted the important role that the exemptive process has played in the growth of the fund industry, and said that he would like the Commission to make even greater use of the process in the future.
The key discretionary provision of the Investment Company Act that authorizes the Commission to order relief is section 6(c). Applicants seeking exemptive relief under section 6(c) must file an application with the Commission presenting a basis for the relief requested, and identifying any benefits expected for investors and any conditions imposed to protect investors. Applications that do not involve insurance products are reviewed by the Office of Investment Company Regulation (OICR), in the Division of Investment Management.
During the review process, the staff may send comment letters to the applicant requesting clarifications or modifications to the application to assure that the requested relief is consistent with statutory standards. If the staff determines that the relief requested is not justified, it may recommend that the application be withdrawn. If the application is not withdrawn, the Division submits the application to the Commission with a recommendation that it be set down for a hearing. While the Division has delegated authority to issue notices and orders in many circumstances, it does not have authority to order hearings or deny applications.
Once review of an application is completed, a notice outlining the requested relief is published in the Federal Register to give interested persons an opportunity to request that the matter be set down for a hearing. After a notice period of approximately twenty-five days, and unless a hearing is requested by an interested party or by the Commission on its own motion, an order is issued granting the requested relief. The time required to obtain an exemptive order averaged 5.5 months during 1994 but varies depending on the novelty and complexity of the requested relief and the staff's workload.
In 1992, the Division of Investment Management issued a report entitled Protecting Investors: A Half Century of Investment Company Regulation. The study sought to determine whether existing regulation imposed unnecessary constraints on investment companies. In response to the Commission's release soliciting opinions on the subject, many commenters complained that the exemption process takes too long. Responding to these comments, the report recommended that the Commission: (1) adopt a rule providing for expedited treatment of routine applications and; (2) expand their delegation of authority to the Division Director to reduce the number of applications that need to be presented to the Commission. While the latter recommendation has been adopted, the proposed rule amendments to establish expedited review procedures is on hold.
We found that the exemption process is essentially sound. Internal controls surrounding the process are also generally adequate. Exemptive applications are subject to several levels of review to ensure that the public interest is adequately protected in all situations. The status of each application is monitored on a personal computer based system to reduce the risk that an application will get lost or overlooked.
Average Time to Obtain Order Reduced
In addition, the Division of Investment Management has effectively shortened the process for many applicants since the publication of the report Protecting Investors: A Half Century of Investment Company Regulation. In 1990, it took an average of 98 days to issue first comments and 205 days to issue an exemptive order. By 1994, the timeline had decreased to 39 days for first comments and 167 days for orders. Similarly, the backlog of pending applications has been reduced from 174 in 1990, to 121 in September 1995. Other positive developments include the adoption of rules 18f-3, 6c-10, and amendments to rule 12d-3, which have eliminated the need to file many types of routine applications.
Many of the private attorneys interviewed during our review commended the Division's efforts. They indicated that the handling of routine applications has improved since 1992 when the Division of Investment Management issued the report Protecting Investors. For the most part, they also believe that the process offers a "fair hearing" of the views expressed in their applications.
But despite these improvements, our audit identified several areas in which further progress could be made.
Novel Applications Still Take a Long Time
Many of the outside attorneys we spoke to are still dissatisfied with how long it takes to obtain an exemptive order, especially when novel issues are involved. It is not unusual for it to take up to 1 year or longer to obtain a complex exemptive order. The length of time required for staff review may be extended due to the complexity of the issues, the lack of delegated authority, or workload pressures.
Unable to wait, firms either abandon the plans that cause them to seek relief, or alter them to adopt a less innovative or efficient approach that does not require filing for an exemption, according to some attorneys. For example, one attorney said that companies frequently opt to structure a transaction "under a particular safe harbor or other provision of the securities laws rather than experience the added expense and delay of an exemptive application".
How often this happens is not known. But it is worth noting that over the past 5 years, the number of exemptive applications filed has remained level while the number of mutual funds has grown by 84% and fund assets have more than doubled. In the past, Commission staff have noted a correlation between the need for exemptive relief, and the growth and evolution of the investment company industry.
Applicants Should Have Option to Request a Hearing
Among the comments solicited by the Commission before publication of the report Protecting Investors, were several that proposed a time limit for staff review. These proposals were of two types. Some suggested that an exemption become automatically effective after a certain period absent any action by the Commission. Others, including the American Bar Association, proposed that the applicant have the right to request that the Commission order a hearing if staff deliberation takes too long.
In Protecting Investors, Commission staff argued against automatic effectiveness saying that setting a time limit without regard to the complexity of an application or the workload of the division is unrealistic and unworkable. But the report did not address the proposal to give applicants the ability to request that the Commission order a hearing. We believe this recommendation merits serious consideration.
When Commission staff and an applicant reach an impasse, and the applicant does not wish to withdraw the application, its only alternative is for the staff to recommend to the Commission that the matter be set down for a hearing before an administrative law judge. However the staff is not obligated to make such a recommendation, and may hold an application indefinitely. Since the Division does not have the authority to deny applications, we believe that the unlimited ability to hold an application constitutes a significant internal control weakness.
As one commenter noted, this is not merely a theoretical possibility. At various times, applications have become stuck in this "procedural crack". Although in recent years the staff has generally agreed to requests to recommend a hearing, many of those we interviewed want assurance that management will continue to be receptive to these requests.
Unlike automatic effectiveness, the proposal would not compromise the fundamental protections that are part of the exemption process. It would still be necessary for Commission staff to arrive at a finding. Most private attorneys we interviewed believe that although few applicants are likely to utilize this option, its availability alone would impose some discipline in the procedural process.
Should the Division choose not to give the applicant the right to a hearing, it should consider other controls to ensure that the Division's unlimited ability to review an application is not misused. One possible solution would be for management to review and monitor the status of any application for which staff has not provided a timely response.
The Division of Investment Management should consider giving an applicant the right to a hearing after a specified period of time has elapsed. Alternatively, the Division should establish an internal control that requires management to review any active application for which the staff has taken no action over a specified period of time, after filing or after receiving an applicant's response to comments, to determine what action is appropriate.
Reduce Number of Deregistrations Reviewed by Staff Attorneys
To deregister an investment company, applicants file Form N-8F with the Division of Investment Management. During 1993 and 1994 deregistrations comprised about 36% of all exemptive applications. Most deregistrations are processed quickly with 65% ordered within 3 months versus 28% for all other types of exemptions. Depending on their complexity, they are assigned to either paralegals or staff attorneys to review.
Some Commission staff maintain that few deregistrations need to be reviewed by an attorney. Most are simple to review, not time-critical, and pose little risk to the public. However the review process is sometimes complicated because applicants find Form N-8F confusing and respond with inaccurate or incomplete information. The Division of Investment Management is in the process of revising Form N-8F to make it easier to understand and respond to. Commission staff believe that this will also simplify the review process.
We believe that changing Form N-8F presents IM with an opportunity to consider alternative methods of handling the review of deregistrations. For example, the Division of Market Regulation has successfully assigned the processing of broker dealer withdrawals (Form BDW) to the Office of Filings and Information Services (OFIS). Complicated BDW filings are returned to the division to review. If more deregistrations could be reviewed by OFIS or paralegals, then staff attorneys would have additional time to concentrate on applications that are more complex and pressing.
Before revising Form N-8F, the Division of Investment Management should consult with OFIS to determine if they can assist in reviewing deregistrations and consider other methods of minimizing the review of Form N-8F by staff attorneys.
Establish Time Frames for Completion of Application Review
Division guidelines pertaining to the review of exemptive applications should be expanded to include time frames for achieving certain milestones in the review of novel or complex applications, such as first comments and memos to the Commission.
While current guidelines require Commission staff to provide initial comments for exemptive applications within 45 days, a longer unspecified review period is allowed for novel or complex applications. There is no suggested time frame for developing memos to the Commission. We believe that more specific guidelines for the review of novel or complex applications would help promote a more efficient and focused review process.
There is some evidence to suggest that the absence of a timeline for novel and complex applications may result in a disproportionate amount of staff time being spent on routine applications. At any given time, a staff attorney is responsible for reviewing as many as 13 applications. Although guidelines require staff to review applications in the order received, in practice the easier applications are usually done first. Staff says that this happens because: (1) each branch is evaluated in part based on its production and; (2) supervisors strive to meet the 45 day time frame established for routine exemptive applications. Establishing a time frame for the review of novel applications would help staff to better balance their priorities.
Management has expressed concern about imposing a rigid deadline on staff review of complex applications. They maintain that frequently there are issues associated with complex applications that warrant the additional time taken for review. We believe that since guidelines can operate more as a goal than a firm deadline, they would not necessarily limit staff review. However as an alternative to expanding division guidelines, the division might consider setting appropriate "due dates" for achieving milestones in the review of novel applications based on the complexity of the individual application. The due dates would be monitored by management through the applications database system.
The Division of Investment Management should establish a timeline for completing important milestones in the review of complex applications by either: (a) providing for their inclusion in division guidelines or; (b) setting appropriate due dates for individual applications.
Division Should Reaffirm its Policy of Consolidating Comments
Several private attorneys we interviewed complained that sometimes Commission staff issue subsequent comments, that should have been part of the initial review. This practice prolongs the process by requiring the applicant to file new amendments that could have been requested at an earlier time. Subsequent rounds of comments usually address amendments to an application as opposed to "old" unamended language. Division guidelines require that "initial comments are to be made at one time".
Commission staff explain that sometimes changes in an application necessitate additional comments about old language. They also acknowledge that occasionally problems with old language are overlooked and corrected later, but that this occurs infrequently. Old language is only questioned if substantive problems could result from allowing it to stand.
We believe that while staff needs to retain the flexibility to comment on an application without restrictions, the Division should seek to minimize these occurrences by reaffirming its existing policy to Commission staff. When issuing comments after the initial review, staff should continue to weigh the significance of any comments that could have been made at an earlier time.
The Division of Investment Management should reaffirm to IM staff its policy of issuing initial comments at one time.
Offer a Generic Comment Letter to Applicants
The views of Commission staff toward certain types of applications sometimes shift in response to changing market conditions or new information. However, applicants may not be aware of these changes since details are contained in individual comment letters not available to the public. They learn of the change when they are asked to amend their application to conform with a new policy.
A generic comment letter similar to the one issued by the Office of Disclosure and Review, would inform prospective applicants of changes in the positions of Commission staff. The letter would provide guidelines for the scope and content of routine applications, just as the Office of Disclosure does periodically for the preparation of registration statements. By eliminating the need for individual comments to advise the applicant of a change in policy, the generic comment letter would make the process more efficient.
Management agrees that occasionally a generic comment letter would be useful, but says that the need occurs on an irregular basis. It is willing to issue a generic comment letter as the need arises.
The Division of Investment Management should issue a generic comment letter when appropriate, to provide guidelines for the scope and content of routine applications.
Remove Expedited Review Rule from Agenda
Following a key recommendation from Protecting Investors, proposed amendments to rule 0-5 under the Investment Company Act of 1940 would establish an expedited review procedure for exemptive applications that follow precedent. Qualifying applicants would be able to receive exemptive orders within 90 days of filing an application.
Many of the attorneys we spoke to qualified their support for the proposal. Critics of the proposed rule amendments are concerned that expedited review for routine applications has the potential to divert resources from complex applications, or result in less rulemaking. Some also complain that the 90 day period is too long. Others object to the requirement for a representation by counsel that the application meets the requirements for expedited review. When the Division encouraged applicants to use the procedures on a trial basis, few took advantage.
Commission staff agree that the proposed amendments may increase pressure to review routine applications at the expense of novel applications. They are also concerned about the administrative burden that the rule may impose. They note that the recent adoption of rules 18f-3 and 6c-10, and amendments to rule 12d-3, have eliminated the need to file most of the routine applications that might have been dealt with under the proposed expedited procedures. Therefore, they believe that there is no urgent need for the expedited review rule.
We agree that presently there is no compelling need to adopt the expedited review rule. If the Division continues to aggressively develop exemptive rules based on well-established precedent such as 18f-3 and 6c-10, the expedited review rule would probably never be needed and should be removed from the Regulatory Flexibility Agenda.
The Division of Investment Management should remove proposed amendments to rule 0-5 from the Regulatory Flexibility Act Agenda.
Redirect Resources for Professional Training
Until recently, new staff joining the Office of Investment Company Regulation, like most staff within the Division of Investment Management, received only on-the-job training from their supervisors and associates. Some of them were hired from law school with little knowledge of securities law and the investment company industry. Yet, many of the transactions OICR evaluates are very complex and involve issues on the forefront of securities law. People we interviewed agree that as reviewers become more familiar with the industry and the law, the quality and efficiency of their review improves.
In January, 1995, the Director of the Division of Investment Management created a standing committee composed of IM staff to develop and recommend a Division-wide policy on training. The Professional Staff Committee responded with a number of recommendations for enhancing the professional development of IM staff including a guest speaker program, assisting with fund inspections, and other opportunities to attend meetings and events related to the regulation of investment companies and advisors.
The Director has endorsed the recommendations and the Committee has taken the initiative to plan several training events. While many of the Committee's recommendations can be enacted at no cost, others require a modest amount of financial and administrative resources to implement. The Division receives an allocation of funds each year that are reserved for training. The funds which amounted to $17,500 in FY 1995 (2% of the SEC's training budget), are distributed on a first come basis. We believe that the Division should support the efforts of the Professional Staff Committee by giving activities that they sponsor priority in the allocation of their annual training budget in order to leverage the benefits of each training dollar spent.
The Division of Investment Management should give activities sponsored by the Professional Staff Committee priority in the allocation of their annual training budget.
Applications Database Program Should Be Improved
The applications database program used by the Office of Investment Company Regulation to monitor exemptive applications and generate reports should be modified to improve its flexibility and usefulness. Currently, information can only be obtained in one of several broad report formats. If more detailed information is required, the user must ask a programmer to perform a special search of the records or else do his/her own search manually. For example, a manager who recently wanted to know how many Section 17 applications were filed during a particular year had to request all Section 17 applications and then manually sort them in date order.
During our audit, the staff suggested improvements in the program to improve its usefulness. These include: the addition of a brief, narrative description of the application for each system record; the ability to print a detailed report listing all applications on file for over 45 calendar days with no action recorded; a method of distinguishing between delays due to staff review from those caused by the applicant; and putting the database on the LAN to make it more accessible to users.
The Office of Investment Company Regulation should meet with OICR staff to discuss their suggestions for improving the applications database program and its administration. After meeting with staff, OICR should undertake to make appropriate changes.
Reduce Time Between Filing and Staff Assignment
On average, 9 calendar days elapse between the time an application is filed and the time it is assigned to a staff attorney for review, according to records in the applications database kept by the Office of Investment Company Regulation.
Normally, an application is first delivered to Document Control (part of the Office of Filings and Information Services), where several administrative checks are performed and a record of the application is created in the Entity Filing and Fees System (EFFS) and Workload systems. On average, four and a half days later it is delivered to OICR. But OICR managers say that it is not unusual for applications to take longer or even get lost. In 45% of the cases we reviewed, it took 6 days or longer for the application to be delivered to OICR.
Once applications reach OICR, it can take as long as 7 days for staff to finally begin its review because staff assignments are normally made just once per week. Management says that occasionally applications are assigned more frequently if an attorney is underutilized.
Management should consult with the mailroom and Document Control to determine if the delivery of exemptive applications can be accelerated.
Staff Attorneys Should Account for Hours Spent on Individual Applications
At present, staff attorneys in the Office of Investment Company Regulation are not asked to provide a detailed accounting for the time they spend on individual applications. Staff time is charged either to the general category of investment company or investment advisor applications on STATS reports. If staff were required to charge their hours to individual applications it would improve accountability, promote time consciousness, and provide an additional source of management information for the purposes of resource planning and performance evaluation.
The staff of the Office of Investment Company Regulation should account for hours spent on individual exemptive applications on their STATS reports.