October 16, 2002
Mr. Jonathan G. Katz
Re: Certification of Management Investment Company Shareholder Reports (File No. S7-33-02)
Dear Mr. Katz:
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission's rulemaking proposal to further implement the certification requirements of Section 302 of the Sarbanes-Oxley Act of 2002 with respect to investment companies.2 The Commission's proposal would require registered management investment companies to file certified shareholder reports with the Commission on new Form N-CSR, and would designate these reports as reports that are required under Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The Commission's proposal would also require all registered investment companies to maintain and regularly evaluate the effectiveness of disclosure controls and procedures with respect to filings under the Securities Act of 1933, the Exchange Act, and the Investment Company Act of 1940.
The Commission's proposal is intended to better implement the intent of the certification requirement of Section 302 of the Sarbanes-Oxley Act as applied to investment companies.3 The Institute supports that goal and, insofar as the proposal would require certification of the financial statements and other financial information in shareholder reports, we support the proposal.
Unfortunately, however, the proposal also goes beyond the intent of the Act in several significant respects and inexplicably places a significantly heavier burden on investment companies than Congress has placed on other public companies required to file periodic reports under the Exchange Act. First, the proposal would require investment company officers to certify both shareholder reports and Form N-SAR. Second, the proposal would require certification of non-financial information contained in fund shareholder reports. Third, the proposal would extend the requirements relating to the establishment and maintenance of "disclosure controls and procedures" to filings made under the Securities Act and the Investment Company Act. These aspects of the Commission's proposal would involve substantial costs, which ultimately would be borne by investment company shareholders.
In a previous comment letter to the Commission on the application of Section 302 to investment companies, the Institute recommended that the certification requirement should apply exclusively to the financial statements and other financial information included in investment company reports to shareholders.4 We continue to believe that the application of the requirement in this manner would be consistent with Congressional intent and would avoid imposing unnecessary costs and burdens on registered investment companies.
Our specific comments on the proposal are summarized as follows:
Each of these comments is discussed more fully below.
A. Scope of Certification
According to the Proposing Release, the Commission believes that certification of Form N-SAR alone is not sufficient to fully implement the intent of the certification requirement in Section 302 of the Sarbanes-Oxley Act, which is to improve the integrity of the information that a company provides about its financial condition to investors. The Commission's proposal thus would amend Rule 30b2-1 under the Investment Company Act to require registered management investment companies also to certify their required reports to shareholders which, unlike Form N-SAR, contain financial statements. The Commission notes in the Proposing Release that these reports, rather than Form N-SAR, "are the primary vehicle for providing financial statements to investors."5 The Commission has requested comment, however, on whether it should require certification of both shareholder reports and Form N-SAR.
As discussed below, the Institute supports applying the certification requirements of Section 302 to the financial statements and other financial information included in reports to investment company shareholders. At the same time, we believe that if this part of the Commission's proposal is adopted, the requirement to certify the Form N-SAR would become completely unnecessary and therefore should be eliminated.
1. Certification of Financial Information in Shareholder Reports Would Satisfy the Intent of the Sarbanes-Oxley Act
The Commission's proposal would, in part, require the certification of financial statements and other financial information contained in investment company annual and semi-annual shareholder reports. The Institute supports this part of the Commission's proposal. Shareholders who wish to evaluate an investment company's results of operations and financial position, as contemplated by Section 302 of the Sarbanes-Oxley Act, would rely upon the financial information in these shareholder reports.6 This information is the closest analogue to the financial information included in the periodic reports that operating companies file with the Commission under the Exchange Act, which are required to be certified under Section 302. As such, a requirement for investment company officers to certify this information best accomplishes the goal of Section 302.
2. The Requirement to Certify Form N-SAR Should Be Eliminated
If the Commission adopts its proposal to require investment companies to certify the financial information in shareholder reports and to designate those reports as reports required under Section 13(a) or 15(d) of the Exchange Act, it will no longer be necessary to require certification of Form N-SAR to implement Section 302 of the Sarbanes-Oxley Act. Form N-SAR is ill-suited for this purpose in that it does not contain the type of information that Congress intended to be certified. It is a data collection form designed to elicit information from investment companies for use by the Commission's staff to, among other things, develop its compliance and inspection programs.
Form N-SAR does not contain financial statements; it contains only limited financial information derived from the investment company's financial statements, along with a significant amount of information that is not financial in nature.7 Thus, the information in Form N-SAR does not "fairly present in all material respects the financial condition and results of operations of the issuer."8 Moreover, Form N-SAR is not delivered to shareholders, nor is it relied upon by investors in evaluating an investment company's results or financial position. It became the vehicle through which the Commission implemented Section 302 with respect to investment companies solely because it is currently the only form such companies file under Section 13(a) or 15(d) of the Exchange Act.9 By designating shareholder reports as reports filed under Section 13(a) or 15(d) of the Exchange Act, the Commission will be in a position to apply the certification requirement to a fund's financial statements, consistent with the intent of the Sarbanes-Oxley Act.10
The Institute strongly believes that investment company officers should not be required to certify both the shareholder report and Form N-SAR. Such a dual certification requirement would impose an unjustified and unreasonable burden on investment companies, especially given that certification of Form N-SAR would add no value due to the nature and content of the form, for the reasons described above. Unlike an operating company, which will file a single certified report four times per year, an investment company complex would be required to file two reports on Form N-SAR and two reports on Form N-CSR each year for each investment company within its complex, many of which may have different fiscal years. The Institute is concerned that the process involved in preparing, reviewing and certifying this information would be disproportionately burdensome for investment companies, particularly those complexes with numerous funds and/or series.
The Commission does not seem to fully appreciate the significant compliance burden that would be imposed on an investment company complex as a result of a dual certification requirement. The Commission's cost/benefit analysis in the Proposing Release concludes that it would take a single investment company five hours to comply with the proposed certification requirement for shareholder reports.11 This seems significantly lower than the time that likely will be required to comply with the proposed requirement.12 More importantly, the Commission's analysis does not reflect the additional time that it would take for an investment company also to comply with the Form N-SAR certification requirement.13 In fact, based on Institute members' early experiences, the process involved in complying with the current Form N-SAR certification requirement took considerably longer than the 5 hours per report suggested by the Commission.14
It is important to note that, in addition to the tangible costs and burdens of a dual certification requirement, requiring certification of a wide range of information, including information that is immaterial to shareholders, also involves certain intangible costs. Namely, it presents a serious risk of diluting the certification requirement prescribed by Congress. Not only are there practical limits on the amount of information on which investment company principal executive and financial officers can focus, but also the certification of immaterial information risks the perception that the entire process is a meaningless ritual.
For these reasons, the Institute strongly recommends that the Commission eliminate the Form N-SAR certification requirement.
3. The Certification Requirement Should Not Apply to Non-Financial Information in Shareholder Reports
The Commission's proposal would require certification of the entire shareholder report. The Institute believes that it is inappropriate and beyond the intent of the Sarbanes-Oxley Act to require investment companies to certify non-financial information contained in those reports. Therefore, consistent with the recommendations in our earlier letter, we recommend that the Commission's proposal be revised to require certification of only the financial information (i.e., the financial statements and condensed financial information) included in shareholder reports.15
Investment company shareholder reports typically include additional, voluntary non-financial information, such as "President's letters," interviews with portfolio managers, and the like.16 The purpose of this information is to assist investors in understanding fund performance and portfolio composition. This information is subjective in nature and often expresses views on, among other things, the overall economic outlook for the market in which the fund invests.17 It is not the type of objective financial information that the Section 302 certification requirement was intended to cover and, thus, does not lend itself to meaningful personal certification by an investment company's principal executive and financial officers. Moreover, imposing a certification requirement on this type of information could have unintended consequences. In particular, investment companies might reduce its scope or even cease providing it, which would be a disservice to investors.
The Institute also believes that the Commission should not require certification of the "Management's Discussion of Fund Performance" (or "MDFP"). Many open-end investment company shareholder reports include the information otherwise required in mutual fund prospectuses under Item 5 of Form N-1A.18 The MDFP is designed to provide investors with disclosures regarding a fund's past performance and describes the factors that materially affected that performance, including a discussion of relevant market conditions and the investment strategies and techniques used by the fund's investment adviser. Like the voluntary, non-financial information described above, the discussion in the MDFP typically provides the portfolio manager's well-informed, but subjective, opinions (e.g., about why the fund performed as it did during the period covered), and thus is not readily certifiable.19 Requiring the MDFP to be certified almost certainly would result in a scaled back, less robust discussion of information that investors find useful.
We further note that the MDFP stands on its own, and does not analyze or provide context for the fund's financial statements. This is in contrast to an operating company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" (or "MD&A"),20 which is required to be included in such company's periodic reports filed under Section 13(a) or 15(d) of the Exchange Act, and which is required to be certified under Section 302. The MD&A is intended to provide a narrative explanation of an operating company's financial statements and to provide the context within which the financial statements should be analyzed. Accordingly, the MD&A (unlike a fund's MDFP) is an integral part of the financial information included in quarterly or annual reports of operating companies. Any resemblance of the MDFP to the MD&A is superficial. Accordingly, we do not believe that the fact that officers of operating companies are required to certify the MD&A provides any rationale for including the MDFP within the scope of the certification requirement for investment companies.
For all of the above reasons, the Institute strongly recommends that any certification requirement extend only to the financial statements and other financial information contained in investment company shareholder reports.21
4. Unit Investment Trusts Should Be Excluded from the Certification Requirement
The Commission's Form N-CSR proposal would apply to management investment companies and, therefore, would not apply to unit investment trusts. The Commission requested comment, however, on whether, if it removed the certification requirement from Form N-SAR, it would be appropriate to effectively eliminate the certification requirement for UITs. We believe that it would.
In our previous comment letter, we recommended excluding UITs from the requirements of Section 302 because of their unique structure and operations. In particular, we pointed out that UITs are fixed investment pools with no management and that after an investor receives a prospectus containing financial information about the trust, there is little additional material information contained in subsequent financial disclosures. Moreover, we explained that UITs are not required to send periodic reports to unitholders or to file such reports with the Commission, and any such reports that are sent to unitholders are provided to them voluntarily by the trustee and generally prepared on a cash basis and are unaudited. We do not believe this is the type of disclosure at which Section 302 is aimed. We continue to believe that the foregoing reasons justify exempting UITs from the requirements of Section 302 and we again urge the Commission to do so.
B. Disclosure Controls and Procedures for Securities Act and Investment Company Act Filings
As the Proposing Release points out, investment companies filing reports under Section 13(a) or 15(d) of the Exchange Act will be required to maintain disclosure controls and procedures under new Exchange Act Rules 13a-15 and 15d-15 with respect to Exchange Act reports. The Commission has proposed new Rule 30a-3 under the Investment Company Act, which would require all registered investment companies: (1) to maintain disclosure controls and procedures with respect to all reports, registration forms, and other filings under the Exchange Act, the Securities Act and the Investment Company Act; and (2) under the supervision and with the participation of the principal executive and financial officers, to conduct an evaluation of such controls and procedures within the 90-day period before the filing date of each report requiring certification under Rule 30a-2 under the Investment Company Act.22
The Institute does not believe that it is necessary or appropriate to expand the disclosure controls and procedures requirement for investment companies to cover filings made under the Securities Act and the Investment Company Act. The Commission's proposal goes beyond the scope of Section 302 of the Sarbanes-Oxley Act and singles out investment companies for disparate treatment, for no apparent reason. 23 There has been no demonstrated abuse or shortcoming in this area sufficient to justify extending this requirement to all filings made by investment companies under the Securities Act and the Investment Company Act,24 and the
Commission has not provided any other compelling basis for this proposal.25
Moreover, while investment companies already have controls and processes in place that "operate so that important information flows to the appropriate collection and disclosure points in a timely manner,"26 extending the disclosure controls and procedures requirement to Securities Act and Investment Company Act disclosure documents likely would require investment companies not only to revise their existing processes to fit a new mold27 but also to formalize and document those processes.28 It is not clear what benefits this formalization would provide, but it is clear that it will entail additional costs and burdens - which could be substantial - in terms of time and resources.29 In fact, it is highly plausible that the effort that would need to be devoted to creating what may amount to no more than additional bureaucracy could divert resources from more important functions.
For all of these reasons, we oppose extending the disclosure controls and procedures requirement to filings made under the Securities Act and the Investment Company Act.
C. Compliance Date
If adopted, the Commission's proposal would require compliance with the proposed amendments, including the requirement to file certified reports on Form N-CSR and the requirements with respect to disclosure controls and procedures, thirty days after the final rules are published in the Federal Register. We believe that a longer compliance period of 90 days after publication is necessary to allow investment companies adequate time to develop and implement appropriate compliance procedures. An even longer period will be necessary if the Commission extends the disclosure and controls procedures requirement to Securities Act and Investment Company Act filings.
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We appreciate the Commission's consideration of our comments. If you have any questions, or would like additional information, please contact me at (202) 326-5815, Amy Lancellotta at (202) 326-5824, or Barry Simmons at (202) 326-5923.
cc: The Honorable Harvey L. Pitt