Letter On Corporate LetterheadFrom: Keen, Steve [skeen@federatedinv.com] Sent: Friday, July 19, 2002 3:57 PM To: 'rule-comments@sec.gov' Cc: Neuman, Jay Subject: File No. S7-13-02 July 19, 2002 Mr. Jonathan G. Katz, Secretary U.S. Securities and Exchange Commission 450 Fifth Street, NW Washington, D.C. 20549-0609 Re: Transactions of Investment Companies With Portfolio and Subadvisory Affiliates File No. S7-13-02 Dear Mr. Katz: This letter presents the comments of Federated Investors, Inc. (“Federated”)[1] regarding the proposal (the “Proposal”) of the Securities and Exchange Commission (“Commission” or “SEC”) to adopt a new rule and several rule amendments under the Investment Company Act of 1940 (the “1940 Act”), to permit funds to engage in certain transactions with subadvisers of affiliated funds.[2] While we support the stated goal of the Proposal “… to permit funds to engage in transactions and arrangements with affiliated persons that are not likely to raise the concerns that the [1940] Act was intended to address,”[3] we are concerned that the Proposal reflects an overly-expansive interpretation of the 1940 Act’s prohibitions and, having done so, fails to provide relief for categories of transactions where relief would be consistent with the stated goal. Our concerns center on new Rule 17a-10, which is intended to provide relief for certain transactions between a subadviser and other funds in the same complex as the subadvised fund. As noted in the comment letter being submitted by the Investment Company Institute (“ICI”), if a subadviser is considered to “control” a fund that it subadvises, Rule 17a-10 should be expanded to cover transactions between the adviser of the subadvised fund and funds in the subadviser’s own complex (for which it serves as adviser). Federated strongly supports the ICI’s discussion of this subject. In particular, Federated joins the ICI in urging the SEC to clarify “that a subadviser would not be consid­ered to control a fund that it subadvises.” The need for this clarification stems entirely from the SEC’s con­tinued reliance on In re Steadman Security Corp.[4] to support a presumption that funds with a common investment adviser are commonly controlled.[5] This presumption makes all funds advised or subadvised by the subadviser direct affiliated persons of one another under § 2(a)(3)(C) of the 1940 Act. Like the ICI, we are not addressing the question of whether funds having a common set of directors and officers, and a common adviser are commonly controlled, although we agree with the ICI that this should be a question of fact rather than a presumption. However, in Steadman the SEC took the position that a common investment adviser alone was sufficient to establish common control among funds. Moreover, the SEC applied this position to circumstances in which Steadman acted as a subadviser to the putatively controlled funds. This letter sets forth Federated’s arguments as to why the SEC’s historic position on this point should be revised generally with respect to all investment advisers, and particularly with respect to subadvisers that are not otherwise affiliated with the primary adviser. In that regard, a brief review of Steadman will help focus the discussion. Facts in Steadman Security Corp. Steadman Securities Corp. involved several egregious violations of the 1940 Act by Steadman Security Corporation (“SSC”) and its principal. However, the issue of “control” related solely to securities transactions among Steadman American Fund, a foreign, unregistered investment company (“Ameri-Fund”) and registered investment companies managed by SSC. Steadman International Capital Corporation (“Intercap”), which was owned half by SSC and half by a consortium of foreign banks, managed Ameri-Fund. “More important,” according to the SEC, “Intercap delegated the management of Ameri-Fund’s portfolio to SSC. The governing documents gave SSC sole investment discretion.” Steadman at 88,339-17 n.78. In other words, SSC acted as the subadviser of Ameri-Fund. The SEC found that the transactions violated § 17(a) of the 1940 Act, which prohibits an affiliated person of a registered investment company (and any affiliated person of such person) from, among other things, pur­chasing securities from or selling securities to the registered investment company. The SEC concluded that Ameri-Fund was an affiliated person of an affiliated person of the registered investment companies under “Section 2(a)(3)(C) of the [1940] Act[, which] defines an ‘affiliated person’ of another person to include ‘any person directly or indirectly controlling, controlled by, or under common control with, such other person.’” Steadman at 88,339-17. The SEC based this conclusion entirely upon SSC’s control of Ameri-Fund’s invest­ments. According to the decision: “To control that portfolio (and SSC had sole investment discretion with respect to it) was to control Ameri-Fund. Hence SSC controlled Ameri-Fund.” Id. at 88,339-18 [footnote omitted].[6] Given that § 2(a)(3)(E) of the 1940 Act makes a subadviser (such as SSC) of a registered invest­ment company an “affiliated person” of the investment company, this “made Ameri-Fund an affiliated person of an affiliated person of the registered companies. It follows that Section 17(a) prohibited the swapping of securities between Ameri-Fund and the registered domestic companies.” Id. [footnote omitted].[7] SSC proffered two arguments in its defense. First, SSC contended that the foreign banks that owned all of Ameri-Fund’s stock controlled Ameri-Fund. The SEC granted “[t]hat [the banks] were in ultimate control is plain. When dissatisfied with Steadman, they ousted him.” Id. at 88, 339 n. 81. However, the SEC found that, until the banks exercised their control, SSC controlled Ameri-Fund. Second, SSC contended that any control it exercised over Ameri-Fund resulted from its “official position” as a subadviser. Section 2(a)(9) of the 1940 Act defines “control” as “the power to exercise a controlling influ­ence over the management or policies of a company, unless such power is solely the result of an official posi­tion with such company.” [Emphasis added]. However, the SEC held that: “This does not aid them. That exclusion applies to officers and directors because officerships and directorships are official positions. An investment adviser, on the other hand, holds no ‘official position’ by virtue of his advisership. He is an independ­ent contractor.” Steadman at 88,339-18 n. 81. The SEC cited nothing to support this narrow interpretation of “official position.” Thus arose the SEC’s often-stated premise that “an investment adviser almost always controls the fund.” Id. In our view, this premise is unwarranted because it is at odds with both the definition of “affiliated person” and the concept of “official position” as set out in the 1940 Act. We discuss each of these points below. Steadman Conflicts With the Definition of “Affiliated Persons” The key problem with the conclusion that “an investment adviser almost always controls the fund” is that it completely undermines the statutory definition of “affiliated person” in § 2(a)(3) of the 1940 Act. As previ­ously noted, clause (E) of the definition makes an investment adviser of an investment company an affiliated person of the investment company. Notably, this is a “one way” or “unilateral” affiliation; under clause (E), the adviser is an affiliated person of the fund, but the fund is not an affiliated person of the adviser. In contrast, clauses (A) and (B) of the definition of “affiliated person” establish a “bilateral” affiliation. Clause (A) makes the owner of more than five percent of a company an affiliated person of the company; Clause (B) makes any company of whose voting securities a person owns five percent or more an affiliated person of the owner. In other words, owning five percent or more of a company’s voting securities creates an affiliation between both the owner of the voting securities and the company that issued them. There is no reason to suppose that Congress’s failure to create a bilateral affiliation between an invest­ment adviser and the investment companies it advises (let alone among investment companies that share noth­ing more than a common adviser) was unintentional. First, as clauses (A) and (B) of the definition of “affiliated person” illustrate, Congress was aware of the distinction at the time it adopted the 1940 Act and could have drafted the definition to have this effect. Second, investment advisers are not unique in having unilat­eral affiliations. Clause (D) of the definition makes “any officer, director, partner, copartner, or employee” an affiliated person of the company they serve. However, the definition does not make a company an affiliated person of its officers, directors, partners and employees. The affiliation is unilateral, running solely from the officer, director, partner or employee to the company. Thus, the SEC’s position in Steadman subverts the definition of “affiliated person” in two ways. First, it makes clause (E) of the definition unnecessary. Given that clause (C) already makes a “controlling” person an affiliated person, if an “investment adviser almost always controls the fund,” then an investment adviser would always be an affiliated person of the fund even if Congress had not included clause (E). This contra­dicts the maxim that statutes should be interpreted so as “not to render one part inoperative.”[8] Second, it creates a bilateral affiliation where Congress imposed only a unilateral affiliation. Congress eas­ily could have added another clause to the definition of “affiliated person” if it intended to make invest­ment companies affiliated persons of their investment advisers.[9] Congress chose not to do so, just as they chose not to make a company an “affiliated person” of its officers, directors, partners and employees. More­over, the Steadman decision effectively creates an affiliation among all investment companies that share an investment adviser. Nothing in the 1940 Act even suggests that Congress intended this result. An Investment Adviser Is an “Official Position” The conflict between Steadman and the definition of “affiliated person” results from the SEC’s narrow inter­pretation of an “official position” as used in the definition of “control.” In Federated’s view, the plain meaning of this provision is that anyone who would not influence the management and policies of a company but for his position in the company cannot be a controlling person. The exclusion of “official positions” from the definition of “control” acknowledges that a company acts solely through its agents, and that the mere employment of an agent, even in a position of influence over the company’s management and policies, should not automatically make the company an affiliated person of the agent. Otherwise, the web of first and second tier affiliated persons spun by § 17 of the 1940 Act becomes unwieldy, ensnaring companies that would have no reason to suspect that their dealings with an investment company would be prohibited. As noted above, the investment adviser’s status as an “independent contractor” was the only reason given in Steadman for finding that the adviser could not occupy an official position. No authority was cited in sup­port of this position. Federated does not see any basis to distinguish between “independent contractors” and other agents for purposes of defining control. Indeed, we would argue that Congress’s decision to treat advis­ers identically to officers and directors in § 2(a)(3) of the 1940 Act (i.e., by establishing in each case only a unilateral affiliation with the fund) strongly suggests that they should also be treated identically for purposes of holding “official positions” for purposes of § 2(a)(9) of the 1940 Act. Moreover, following the reasoning in Steadman, if a registered investment company granted a fund officer “sole investment discretion” over its portfo­lio, the officer would not “control” the investment company, provided that his power results solely from his position as investment manager. Federated does not understand why this conclusion should change if the investment company elects to retain a company, rather than an individual, as its investment manager. Federated believes that this analysis is also consistent with the SEC’s decision in In re Transit Investment Corporation[10] (“TIC”), the earliest of its few published interpretations of “official position.” The case involved transactions between TIC and Broad Street Trust Company (“Broad Street”). TIC and Broad Street shared a director, Horan, who was also president of Broad Street. The SEC noted that Horan was an “affiliated person” of both TIC and Broad Street, but that Broad Street was not an affiliated person of TIC. (Note the unilat­eral affiliation of Horan to TIC and Broad Street.) Therefore, § 17(a) would only apply to the transac­ tions “if Broad Street is directly or indirectly controlled by Horan.” Horan contended that any control he had over Broad Street resulted solely from his position as president. However, the SEC concluded: that the historical association of Horan with the Salus family [which founded Broad Street] and the sup­port and confidence which he enjoys from the largest stockholder groups result in his having the power to exercise a controlling influence over the management and policies of Broad Street …. We find that his being president of Broad Street is a result of his power rather than the source of his power …. When assessing whether an investment adviser “controls” an investment company, Federated urges the SEC to follow the approach suggested by TIC, rather than Steadman. Instead of presuming that investment discretion over an investment company’s portfolio establishes “control” over the company, the SEC should determine whether the investment discretion is “a result” of the investment adviser’s power, or merely “the source” of its power. Note that this approach would not have changed the result in Steadman, because Steadman (as a fifty percent owner of Intercap) presumptively controlled Ameri-Fund’s investment adviser, and the SEC could have concluded that SSC became Ameri-Fund’s subadviser as a result of this control. Subadvisers Generally Do Not Exercise Controlling Influence Over the Management or Policies of an Investment Company Finally, even if the SEC does not agree with our analysis of Steadman and TIC, it should at least clarify that its presumption of control extends only to direct investment advisers, and not subadvisers, of registered investment companies.[11] Typically, an investment company retains a subadviser after the investment company has been established. The subadvisory agreement normally limits the subadviser’s authority to managing the investment company’s portfolio in accordance with its investment objectives, policies and limitations, under the direction of the investment company’s board of directors and investment adviser. The board and invest­ ment adviser also determine what investment strategies the investment company will disclose and what proce­dures the subadviser must follow in managing the portfolio. Under these circumstances, the subadviser has little if any influence over the investment policies or strategies of the investment company. These circumstances render it virtually impossible that a subadviser could effectively exercise “a control­ling influence over the management or policies” of the investment company. In reality, the grant of “sole invest­ment discretion” to a subadviser merely gives the subadviser the power to select individual securities and (in most cases) the broker or dealer used to execute the trade. This contrasts sharply with the larger role generally played by the principal investment adviser, which is involved in every detail regarding the organiza­tion, governance, distribution, management and operation of the investment company. Moreover, even allowing for presumption of control in some cases, we submit that, as between the princi­pal adviser and its subadviser, only one of those entities could rationally be presumed to “control” the invest­ment company. While it may be argued that § 2(a)(9) of 1940 Act does not make it impossible for two separate parties to simultaneously stand in a control relationship to an investment company, this cannot be the case when only one party can exercise its influence. If the subadviser has “sole investment discretion” over an investment company, then it follows that the investment adviser does not. If, as stated in Steadman, to control a portfolio is to control a fund, then an investment adviser relinquishes control when it retains a subadviser.[12] This is contrary to the position taken by the SEC in the Release, and we believe contrary to the normal relation­ship of the parties. While we would not concede that control should ever be presumed (except as explic­itly provided in § 2(a)(9)), if the SEC is going to establish a presumption of control based the power to manage the portfolio, we believe that the presumption should apply to the investment adviser, not an independ­ent subadviser. Conclusion For all of these reasons, Federated strongly urges the SEC to clarify that, notwithstanding the Steadman case, the SEC does not presume that a subadviser controls a subadvised investment company, at least if the subadviser is not an affiliated person of a person who controls a registered investment company. This would avoid the need to expand the scope of Rule 17a-10 to cover transactions between an investment adviser that retains a subadviser and other investment companies managed by the subadviser. It would also avoid other anomalous results that may occur if the SEC continues to treat investment companies from completely separate fund complexes as commonly controlled because they have a common subadviser. While we believe that this position is fully justified based on the plain meaning of “official position” in the definition of “control,” the SEC need not endorse our interpretation to reach this conclusion. Instead, the SEC could effectively limit Steadman to its facts, by noting that, although technically a subadviser, SSC also controlled the investment adviser of Ameri-Fund and had otherwise demonstrated that it exercised a controlling influence over the fund. To be clear, Federated does not dispute the SEC’s finding that the transactions in Steadman were subject to § 17(a) of the 1940 Act. We only object to appearing to base this finding entirely upon the power to exercise investment discretion, rather than on the totality of the facts in the case. * * * * * Federated very much appreciates having the opportunity to comment on this Proposal. If you would like to discuss these comments or any other aspects of the Proposal with us, please contact the undersigned. Thank you very much. Cordially, Stephen A. Keen General Counsel Phone: (412) 288-1567 Telecopier: (412) 288-8141 cc: John W. McGonigle, Federated Investors, Inc. Matthew G. Maloney, Dickstein Shapiro Morin & Oshinsky Ari Burstein, Investment Company Institute -------------------------------------------------------------------------------- [1] Federated is one of the largest asset management and mutual fund firms in the United States. Through its subsidiaries, Federated manages total assets of more than $180 billion and serves as adviser, subadviser, distributor, and/or administrator for over 135 mutual funds, as of June 30, 2002. [2] The Proposal is set forth in Investment Company Act Release No. 25557 (April 20, 2002), 67 Fed. Reg. 31081 (May 8, 2002) (the “Release”). [3] Id. at text accompanying n. 19. [4] [1977-1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,243 (June 29, 1977), aff'd in part and vacated and remanded on other grounds sub nom. Steadman v. SEC, 603 F.2d 1126 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981). [5] See, e.g., Investment Company Mergers, Investment Company Act Release No. 25259, [Current Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶86,605, at 85, 062 n. 11 (Nov. 8, 2001). [6] This takes an overly constrained view the nature of an investment company. In addition to making portfolio investments, investment companies also engage in a number of other significant activities, such as purchasing and redeeming their shares, issuing statements and financial reports to shareholders, making filings with the SEC and other regulators, and conducting board and shareholder meetings. Subadvisers rarely exercise any influence over these other activities. Thus, contrary to the assertion in Steadman, investment discretion does not, by itself, give a anyone complete control over an investment company. [7] It is interesting that the SEC treated Ameri-Fund as a “second-tier” affiliated person. Section 2(a)(3)(C) makes all commonly controlled persons “first tier” affiliated persons of one another. Therefore, if the SEC had also found that SSC controlled the registered investment companies, the SEC would not have had to rely on the § 2(a)(3)(E) to apply § 17(a) to the transactions. For whatever reason, the SEC chose not to make the additional finding. [8] Colautti v. Franklin, 439 U.S. 379, 392 (1979). [9] “[Where] Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress act[ed] intentionally and purposely in the disparate inclusion or exclusion.” Russello v. United States, 464 U.S. 16, 23 (1983). [10] [1948-1952 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 75,934 (May 6, 1948). [11] We are, of course, only addressing situations where the subadviser is not an affiliated person of the fund’s principal adviser. [12] Taken to its logical conclusion, this line of analysis would obviate the need for Rule 17a-10 altogether. If the investment adviser does not control a subadvised fund, then the fund is not an affiliated person of the other funds in the investment adviser’s complex (because it is not commonly controlled). If the subadvised fund is not a first tier affiliated person of these funds, then the subadviser would not be a second tier affiliated person of the funds, in which case, transactions between the subadviser and the other funds in the investment adviser’s complex would not be subject to § 17(a) of the 1940 Act.