July 15, 1999
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W., Mail Stop 6-9
Washington, D.C. 20549-0609
RE: File No. S7-15-99 -- Custody of Investment Company Assets Outside the United States/Investment Company Act Release No. 23815 (April 29, 1999)
Dear Mr. Katz:
The Association of Global Custodians ("Association")1 is pleased to submit this letter in response to the Commission's request for comments in Investment Company Act Release No. 23815 ("Release No. 23815").2 Release No. 23815 contains certain proposals, particularly new Rule 17f-7, that address the custody of investment company assets by foreign securities depositories. Release No. 23815 states that these 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." 3 While the Association recommends that the Commission adopt proposed Rule 17f-7, there are a number of important changes and clarifications that should first be made.
1. Summary of the Association's Position
Proposed Rule 17f-7 recognizes that foreign securities depositories should not be subject to the selection and evaluation procedures that apply to other types of foreign custodians under Rule 17f-5. The Association supports this approach. We urge, however, that the rule be revised in three important respects:
In addition, we recommend that the Commission make two technical changes to proposed Rule 17f-7. These changes are necessary to avoid creating confusion or imposing needless burdens:
Finally, the release adopting Rule 17f-7 should clarify four points. While these issues do not directly affect the text of the rule, each involves an important issue concerning its operation --
The Association has been an active participant in the Commission's four-year review and revision of its rules governing the foreign custody of investment company assets.4 We have consistently urged that the Commission's rules in this area recognize that depositories are a key part of a market's financial infrastructure and that the decision to invest in a particular security is inevitably also a decision to use the depository for that security. 5 Imposing the Rule 17f-5(c) selection process on funds with assets held in foreign depositories would ignore this reality. Depositories should therefore be assessed as part of the overall investment decision and not treated as if they are subcustodians that can be selected or rejected based on the criteria in Rule 17f-5(c).
The Association believes that proposed Rule 17f-7 is consistent with these views. For that reason, we recommend the adoption of Rule 17f-7, subject to the following comments.
3. Substantive Changes to Proposed Rule 17f-7
The Association believes that three revisions to proposed Rule 17f-7 are necessary. These are described below.
1. Indemnification or Insurance
Proposed Rule 17f-7(a) would permit a U.S. or Canadian registered fund to place and maintain its foreign assets with an "Eligible Securities Depository" under either of two alternative arrangements. Under the first alternative, the fund must have "indemnification or insurance arrangements" (or any combination of indemnification or insurance) that will "adequately protect" the fund "against all losses attributable to the custody risks associated with maintaining the assets with the Eligible Securities Depository." As we have previously urged, this provision should be deleted from proposed Rule 17f-7. 6
We strongly believe that insurance is not a substitute for analyzing risk. Where insurance against some type of depository losses exists, understanding its scope, nature, and cost should be part of the fund's country-risk decision-making process. But a risk analysis would still be needed in order for the fund board or adviser to balance the costs of insurance (which are likely to be high) and the coverage exclusions (which are likely to be significant) against the potential investment risks and returns in the foreign market. Thus, insurance and risk analysis are not truly alternatives.
To evaluate whether the benefits of insurance outweigh its costs, one must understand the risks of the depository in question because it is doubtful that indemnification or insurance against "all losses" would be available to funds. 7 Advisers and custodians are not normally willing to assume unconditionally the risks associated with governmental or quasi-governmental entities, such as foreign depositories, over which they have little or no influence. To the extent commercial insurance may be available, it would likely be narrowly drawn and prohibitively expensive. 8
Moreover, the insurance provision is inconsistent with the Commission's longstanding philosophy of leaving fund investment decision-making unregulated. By seeming to characterize insurance as the regulatory default position, and custody risk assessment as an alternative, the Commission may unintentionally raise the inference that funds should, if at all possible and regardless of cost, obtain insurance against depository risk. We would respectfully suggest that Section 17(f) was not intended as the predicate for this type of regulation. How a fund chooses to deal with the risks inherent in a particular market or security should be determined by the fund's investment policies and process, not by Commission rule.
A further problem with this alternative is that the proposed standard of adequate protection against all losses attributable to depository custody risk is confusing. The phrase, "custody risks" is not defined and has no commonly understood meaning. Therefore, whether or not particular coverage exclusions were permissible would frequently be a matter of disagreement. It is unclear how these disputes could be resolved, since the phrase "adequately protect" is also undefined, and the identity of the party responsible for determining "adequacy" is unspecified. Proposed Rule 17f-7(a)(1) would likely generate numerous inquiries and no-action requests to which the staff would be compelled to devote its limited interpretive resources. 9
In short, discussion of any indemnification or insurance that may exist in a particular case should be included as part of the information concerning depository risk that the custodian supplies to the fund. Indemnification or insurance should not, however, be a substitute for an understanding of that risk.
2. Transfer Agents
Proposed Rule 17f-7(b)(1) would (subject to certain conditions) define the phrase "Eligible Securities Depository" to mean "a system for the central handling of securities [as defined in Rule 17f-4] * * *, or a transfer agent that transfers and holds uncertificated securities on the books of an issuer for market participants" (emphasis added). The treatment of some transfer agents as securities depositories raises complex issues that have not previously been addressed in this proceeding. We recommend that this clause be deleted from the proposed rule.
As a conceptual matter, it would be anomalous to regulate the use of transfer agents as part of the regulation of custody. Transfer agents do not perform traditional custody functions -- they are neither part of the chain of registered title holders nor are they in possession of any securities. Moreover, any risks associated with the activities of an issuer's transfer agent are a subset of the overall risks of investing in the securities of that issuer, not of the risks of custody. As the federal securities laws already recognize, transfer agents are selected by, and are service-providers to, the issuer. 10 Because transfer agents are agents of the issuer, they are not properly addressed under the rubric of custody regulation. The risks and rewards associated with the issuer and its agents are at the core of the decision to invest in a company's securities, not a part of decision-making concerning a fund's custody arrangements.
As a practical matter, defining certain transfer agents as depositories would result in a substantial increase in the costs and burdens of the risk analysis required under Rule 17f-7 and may prevent funds from continuing to invest in some markets in which they are already active. In many countries, some classes of securities are uncertificated and not held through depositories. These range from emerging markets, such as Russia and Ukraine, to established, First World countries, such as the United Kingdom and Australia. Merely identifying the relevant transfer agents and obtaining basic information concerning their activities would be a formidable task. 11 Further, many of these transfer agents might be unable to meet the Rule 17f-7 depository eligibility standards. 12 U.S. funds could therefore be barred from investing in securities of the issuers served by these transfer agents.
For these reasons, the reference to transfer agents should be deleted from the definition of Eligible Securities Depository in Rule 17f-7(b)(1). To the extent that particular transfer agent systems raise unique issues, the staff may wish, as in the case of Russia, to continue to address those situations on a case-by-case basis. If the Commission believes that it may be appropriate to regulate investment company consideration of the risks associated with the processes by which the issuers of the securities maintain their ownership records, we would respectfully suggest that this matter be the subject of a separate rulemaking proceeding. 13 Resolution of the issue of foreign depository evaluation should not, however, be delayed by injecting the complex subject of transfer agent risk into the current proceeding. 14
3. Exercise of Care
Rule 17f-7(a)(2) would require that the contract between a fund and its primary custodian state that the primary custodian "and each other custodian that acts on behalf of the Fund in maintaining assets with the Eligible Securities Depository" agrees to "exercise reasonable care, prudence, and diligence" in performing the requirements described above in i. [relating to the depository analysis and monitoring] and in "all other conduct relating to custody arrangements." 15 Thus, this provision would impose a standard of care applicable to all the custody activities of the primary custodian and its sub-custodians, including activities wholly unrelated to depositories.
We do not believe that a rule relating to the use of foreign depositories should serve as a vehicle for a far-reaching provision requiring that the contract between a fund and its primary custodian contain a single standard of care applicable to all custody matters. Further, as to subcustodians, the proposed requirement is inconsistent with Rule 17f-5. Rule 17f-5(c)(2) requires that an investment company's foreign custody relationships be governed by a written contract that "provides reasonable care for fund assets" based on the standards applicable in the relevant market. The relationship between this market-oriented requirement and the proposed "reasonable care, prudence, and diligence" standard in Rule 17f-7(a)(2) is unclear, and the difference in terminology is likely to engender confusion and uncertainty. 16
The fund's reliance, in some other jurisdiction, on the custody risk alternative in Rule 17f-7(a)(2) should not be a basis for imposing a new standard of care on its custody relationships. Rule 17f-5 already addresses this issue. Therefore, the words "and in all other conduct relating to custody arrangements" should be deleted from proposed Rule 17f-7(a)(2)(ii).
4. Technical Changes to Proposed Rule 17f-7
In addition to these substantive revisions, two technical changes to proposed Rule 17f-7 should be made.
1. "Continuous" Monitoring
As an alternative to insurance or indemnification, proposed Rule 17f-7(a)(2) would permit a fund to maintain assets with a foreign depository under a "custody arrangement [that] provides other reasonable safeguards against the custody risks associated with maintaining assets with the Eligible Securities Depository." These safeguards must include certain contractual undertakings by the fund's primary custodian. One of these undertakings is to "[c]ontinuously monitor the custody risks associated with maintaining assets with the Eligible Securities Depository."
The meaning of the "continuous" monitoring requirement is not clear, especially in juxtaposition to the requirement in Rule 17f-5(c)(3) that Foreign Custody Managers "establish a system to monitor the appropriateness of maintaining" assets with an Eligible Foreign Custodian. The use of the word "continuously" could create the implication that the primary custodian must somehow become aware of any material change in a depository more rapidly than a Foreign Custody Manager is expected to learn of adverse developments affecting other types of custodians. However, obtaining prompt information concerning changes in depository practice is typically harder, not easier, than monitoring bank subcustodians. Accordingly, if "continuous" monitoring under Rule 17f-7 is meant to be more rigorous than monitoring under Rule 17f-5, the proposed requirement would be highly impractical.
We recommend that the word "continuously" be deleted from Rule 17f-7(a)(2)(i)(B) and that this provision be conformed to Rule 17f-5(c)(3). As revised, Rule 17f-7(a)(2)(i)(B) would require the primary custodian to:
"Establish a system to [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" (addition underscored, deletion in brackets).
2. Equal Treatment of Investment Company Assets
Rule 17f-7(b)(1) contains six conditions that systems for the central handling of securities or equivalent book entries must satisfy in order to be deemed Eligible Securities Depositories. The third eligibility condition, which relates to parity of treatment between fund assets and those of other depository participants, provides that such systems must --
"(iii) Hold 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;"
This condition is based on one of the objective depository evaluation criteria that was jointly recommended to the Commission by the Association and the Investment Company Institute ("Institute").17 However, the Commission has made a change in the language recommended by the Association and the Institute. As proposed by the Association and the Institute, the condition would have required that the fund's custodian participate in the depository under "no less favorable safekeeping conditions" (emphasis added). By omitting the word "safekeeping," the Commission has apparently altered the scope of this condition.
The Association believes that this condition should focus on safekeeping conditions in order that differences in the business relations between a depository and its various participants will not disqualify the depository from holding investment company assets. Some participants may, for example, be subject to a fee schedule that is different from that applicable to other members. Similarly, depositories that are affiliated with a government may afford other governmental entities special rights and privileges. Even determining whether a depository affords equal economic treatment may be difficult, since, in many cases, depositories might refuse to reveal to one member the terms of the depository's economic relations with other members.
If differences in the conditions under which various participants can access a depository result in the assets of some participants enjoying a higher level of safety than those of a participant acting on behalf of a U.S. investment company, that depository should not be deemed eligible under Rule 17f-7. However, the fact that some participants may be subject to more favorable fee arrangements, or to other non-safekeeping terms and conditions that differ from those extended to an investment company's subcustodian, should not, in the Association's view, preclude an investment company from placing assets in that depository. The use of the word "safekeeping" in the proposal submitted by the Association and the Institute was intended to reflect this distinction, and we recommend that the word "safekeeping" be re-inserted in Rule 17f-7(b)(1)(iii).
With the change we propose, this provision would state:E. Points of Clarification
"(iii) Holds assets for the custodian that participates in the system on behalf of the fund under safekeeping conditions no less favorable than the conditions that apply to other participants;" (addition underscored).
Finally, the Commission should address four points in the text of the release adopting Rule 17f-7.
1. Analysis of Depository Risk
Release No. 23815 states that, "[t]o 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."18 We support this approach. However, the release also lists eight factors that "as a general matter, we would expect that a custodian's analysis could include." 19 The Commission invites comment on whether the rule should specifically require that these or other areas be discussed in the analysis.
While we do not object to the illustrative list of factors in Release No. 23815, we urge that specific areas of analysis not be incorporated into the rule. As we have demonstrated in prior submissions,20 the operating, financial, and regulatory characteristics of depositories vary widely. Forcing every depository to be analyzed under a fixed set of criteria would inevitably call for information that is irrelevant or unavailable in specific cases. The Commission should rely on industry expertise to determine what information, both positive and negative, is relevant to the evaluation of a particular depository.
2. Fund Decision-Making
As set forth at the outset of this letter, the Association believes -- and has advocated to the Commission and staff during the past two years -- that the decision to use the facilities of a particular foreign depository cannot be separated from the decision to invest in securities that trade in the market served by that depository. Correlatively, fund directors or fund advisers are the appropriate parties to address the issue of depository risk, since they have general responsibility for fund investment decisions.
Consistent with this view, we do not interpret proposed Rule 17f-7 or the commentary in Release No. 23815 as requiring that the fund or its adviser make a separate "custody decision" based on the depository analysis furnished by the primary custodian. However, we recommend that the release adopting Rule 17f-7 make clear that review of the information concerning depositories furnished by the primary custodian would be part of the fund's overall investment or "country risk" analysis -- not the predicate for a separate decision concerning the depository. The risk associated with the depository cannot be considered in isolation from the other factors relevant to whether to invest in a particular country's markets.
3. Status of Transnational Depositories
As noted earlier, proposed Rule 17f-7(b)(1) contains six conditions that a system for the central handling of securities must satisfy in order to be an Eligible Securities Depository. The first of these conditions is that the system --
"Acts as a transnational system for the central handling of securities or equivalent book-entries, or as a system for the central handling of securities or equivalent book-entries in the country where it is incorporated or organized * * *."
Transnational systems are not otherwise addressed in the proposed rule, and there is no discussion of these entities in Release No. 23815. It is, however, commonly understood that references in Rule 17f-5 to transnational systems are intended to include Euroclear and Cedelbank. The treatment of transnational systems as Eligible Securities Depositories raises important issues.
Euroclear and Cedelbank have changed significantly since Rule 17f-5 was first adopted in 1984. These entities now function in two wholly different roles --
Thus, in addition to serving as central depositories for certain types of de-materialized euro debt securities, both Euroclear and Cedelbank have also begun to offer global custody services for traditional debt and equity securities. To provide these services, each has developed a network of subcustodian banks in various jurisdictions around the world. These subcustodians are, in turn, participants in the central depository that serves their country's securities market. Through their networks, or through direct links to local market depositories, Euroclear and Cedelbank act as an alternative method for their participants to hold securities that trade in many local markets.
When a transnational system acts in the capacity of a central securities depository, it is appropriate that the system be subject to Rule 17f-7 and that its eligibility be determined under Rule 17f-7(b)(1). However, when a transnational system acts in the capacity of a global custodian, that system and its network should, like any other global custodian, be subject to Rule 17f-5. For example --
The fact that, in another facet of its business, the transnational system qualifies as an Eligible Securities Depository under Rule 17f-7, should have no impact on the application of Rule 17f-5 to the system and its network when it acts as a global custodian.
In the Association's view, this difference in the regulatory requirements that are applicable to a transnational system acting as a central depository under Rule 17f-7 and to a transnational system acting as a global custodian under Rule 17f-5 is inherent in the regulatory regime that would be created by the adoption of the proposals in Release No. 23815. Because of the confusion which could, however, result from the fact that transnational systems may operate in more than one capacity, we recommend that the Commission make clear in the text of the adopting release that, when a transnational system acts in two capacities -- as a central depository and as global custodian -- it will be treated as an Eligible Securities Depository only with respect to its depository functions. In its global custodian capacity, it and its subcustodian network must satisfy the same Rule 17f-5 requirements as any other global custodian.
4. Transition Period
While we support the basic approach of proposed Rule 17f-7, it should be recognized that compliance with its requirements will require substantial effort. We estimate that U.S. funds currently have assets in the custody of well in excess of 100 institutions (exclusive of transfer agents) that would be within the scope of the rule. For each of these entities that a particular fund is using, it will be necessary to determine eligibility by gathering information and analyzing the six factors in proposed Rule 17f-7(b)(1). It will also be necessary for the fund's primary custodian to prepare a risk analysis in accordance with proposed Rule 17f-7(a)(2) and for that analysis to be furnished to the fund. If compliance with the rule is required before the completion of this process with respect to a market, the fund would apparently be required to dis-invest from that market.
In order to permit sufficient time for these tasks to be completed, the Commission should allow a one-year transition period following the effectiveness of Rule 17f-7. During that period of time, funds should have the option of continuing existing relationships with foreign depositories under Rule 17f-5 (as in effect prior to the amendments adopted on May 16, 1997) or of relying on new Rule 17f-7. A fund should also be permitted to maintain relationships with some depositories under old Rule 17f-5 while, over time, conforming other relationships to Rule 17f-7. After the expiration of this one-year transition period, all depository relationship would, of course, be required to comply with Rule 17f-7. Conclusion
We appreciate the opportunity to comment on the proposals in Release No. 23815. If the Commission or staff have any questions concerning these comments, please contact the undersigned at 202/452-7013.
Daniel L. Goelzer
cc: Paul F. Roye
Division of Investment Management
Robert E. Plaze
Regulatory Policy and Investment
C. Hunter Jones
Office of Regulatory Policy
Thomas M.J. Kerwin
Office of Regulatory Policy
--The Association is an informal group of nine U.S. banks that are major providers of global custody services to U.S. institutional investors. The members of the Association hold the majority of the foreign assets of registered investment companies. The members of the Association are The Bank of New York, Bankers Trust Company, Boston Safe Deposit & Trust Company, Brown Brothers Harriman & Co., The Chase Manhattan Bank, Citibank, N.A., Investors Bank & Trust Company, Northern Trust Company, and State Street Bank and Trust Company. -- Investment Company Act Release No. 23815 (April 29, 1999), 64 FR 24489 (May 6, 1999). -- Release No. 23815 at 1. -- See, e.g., Letters, dated June 30, 1998, and February 26, 1999, from Amy B.R. Lancellotta, Senior Counsel, Investment Company Institute, and Daniel L. Goelzer (Counsel to the Association), to Barry Barbash, Director, Division of Investment Management (Joint Association/Investment Company Institute proposal to amend Rule 17f-5 with respect to foreign securities depositories); Letters, dated November 3, 1995, June 7, 1996, and September 10, 1996, from Daniel L. Goelzer to Jonathan G. Katz (Association comment letters on proposed amendments to Rule 17f-5; SEC File No. S7-23-95). -- Letter, dated December 11, 1997, to Douglas J. Scheidt, Chief Counsel, Office of Associate Director (Chief Counsel), Division of Investment Management, from Daniel L. Goelzer. -- See Letter, dated April 7, 1999, from Daniel L. Goelzer to Paul Roye, Director, Division of Investment Management. --The proposed alternative is not analogous to the indemnification or insurance clause in Rule 17f-5(c)(2)(i). First, that clause has been interpreted to apply only to losses stemming from the actionable misconduct of a bank subcustodian. Second, the requirement in Rule 17f-5 relates to a risk over which funds and custodians have a substantial degree of control. Through review and selection of subcustodians and adherence to internal control procedures, custodians can limit their exposure to liabilities resulting from their own activities or those of their network members. They have no such control over depositories. --Insurance against "all losses attributable to the custody risks" of a depository is unlikely to be offered at economically feasible rates. Although fidelity coverage against depository losses is available, deductible amounts are typically high, and most policies expressly exclude losses resulting from force majeure or governmental action. -- As noted above, the concepts of "all losses" and "adequately protect" will be fertile grounds for debate. Other examples of interpretive issues include: Is insurance running to the depository to reimburse it for claims paid within the rule? In judging "adequacy", should the fund assume that only its assets would be lost or that the insurer or indemnifier would simultaneously face claims from other depository participants? Are deductibles prohibited? Is there any financial strength threshold or other limit on categories of persons who can provide acceptable indemnities or insurance? Does custody risk include Y2K readiness and similar risks relating to depository computer systems? -- See Securities Exchange Act Section 3(a)(24) ("transfer agent" means "any person who engages on behalf of an issuer of securities or on behalf of itself as an issuer" in specified activities) (emphasis added). -- Transfer agents, unlike depositories, are private, commercial enterprises, not quasi-public bodies. A fund's primary custodian has no relationship, direct or indirect, with the transfer agents for securities in which its clients have invested and is not a "participant" in any transfer agent "system". Since they are selected and paid by issuers, not by trading market participants, transfer agents have no incentive to reveal their recordkeeping and operating practices to third parties. -- For example, Rule 17f-7(b)(1)(i) would require that transfer agents subject to the rule act "as a system for the central handling of securities or equivalent book-entries." However, most transfer agents are not part of any "central system." Similarly, Rule 17f-7(b)(1)(iv) would require that transfer agents subject to the rule "segregate the system's own assets from the assets of participants." Unlike depositories, transfer agents do not have "participants," and segregation is therefore not normally an attribute of their recordkeeping. -- One of the objectives of that proceeding should be to identify which, if any, transfer agent functions are part of custody. Further, the Commission could consider the differing roles and risks of transfer agents in certificated and uncertificated environments and in jurisdictions with and without depositories. It should also explore the relationship between transfer agents and share issuers, registrars, and central depositories.
A comprehensive review of the activities of foreign transfer agents would reveal many different permutations, with many different risk profiles. For example, the logic of limiting consideration to transfer agents for uncertificated securities is open to debate. If the records of the transfer agent erroneously indicate that the fund's share certificate is void, or is subject to some type of restriction or claim, the fund will, at minimum, suffer a loss of liquidity and may have to resort to litigation to establish its right to the underlying securities.
We believe that such a review would demonstrate that the costs of transfer agent risk assessment would far outweigh the benefits. --Absent appropriate criteria for their eligibility and a more precise definition of when these entities "perform custodial functions analogous to those of a depository" (Release No. 23815 at 14), further delay in the effectiveness of the Commission's foreign custody rules and further proposed amendments may be necessary in order to avoid unintended disruptions in fund foreign investment. --The contract may instead require the Primary Custodian and the other custodians to "adhere to a higher standard of care." -- The leeway that Rule 17f-5(c)(2) affords is important because of the differences in standards and local custody practices in different markets. Further, many jurisdictions in which the assets of U.S. funds are held have civil law traditions, and agreements with subcustodians may therefore employ civil law terminology, rather than common law phraseology, such as "reasonable care, prudence, and diligence." -- See Letter, dated June 30, 1998, supra, note 4. -- Release No. 23815 at 13. -- Id. These factors are: