October 23, 2002
Securities and Exchange Commission
Re: File S7-33-02
Ladies and Gentlemen:
This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Business Law Section (the "Committee")* in response to the request of the Securities and Exchange Commission (the "Commission") on proposed rule and form amendments under the Investment Company Act of 1940, as amended (the "1940 Act"), relating to certification of management investment company shareholder reports and related matters (the "Proposal").1 The Proposal would require each registered management investment company's principal executive and financial officers to certify the information contained in these reports in the manner required by Section 302 of the Sarbanes-Oxley Act of 2002 (the "Act").
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.
As a threshold matter, the Committee supports the Proposal and believes that the Commission should be commended for its efforts to facilitate compliance by management investment companies with the shareholder report certification requirements of Section 302 of the Act. Our comments address four aspects of the Proposal: (i) new Form N-CSR; (ii) the scope of the certification requirement; (iv) the requirement that investment companies maintain disclosure controls and procedures with respect to filings under the Securities Act of 1933, as amended (the "Securities Act"), and the 1940 Act; and (iv) the compliance date.
Current Commission rules require that most investment companies that file semi-annual reports on Form N-SAR include the certification required by the Act (the "Certification") in Form N-SAR filings.2 In the Proposing Release, however, the Commission noted that investment companies primarily disclose their financial condition in required shareholder reports, rather than Form N-SAR. Accordingly, the Commission also has proposed that investment companies be required to file a new Form N-CSR, which would include (i) copies of any required shareholder reports; (ii) additional information regarding disclosure controls and procedures; and (iii) the Certification.
The Commission also has proposed to include in the Certification requirement all information in the shareholder report that forms part of Form N-CSR, including management's discussion of fund performance ("the MDFP").
The Commission also has proposed that, in addition to maintaining disclosure controls and procedures with respect to filings required by the Securities Exchange Act of 1934 (the "Exchange Act"), investment companies maintain such controls and procedures with respect to filings required under the Securities Act and the 1940 Act.
The Commission has proposed that investment companies must comply with the final rules 30 days after their publication in the Federal Register.
While we generally support the Proposal, we believe that it should be modified to avoid subjecting investment companies to requirements that are either duplicative or beyond the specific requirements of Section 302. In some respects, the Proposal would subject investment companies to requirements that go beyond those applicable to other types of companies that are subject to Section 302. We therefore believe that the Proposal should be modified to ensure that the Certification provisions of the Act are applied to investment companies in a fair and reasonable manner, when compared to the application of these provisions to other types of companies that are subject to the Act. Specifically, we believe that the Proposal should be modified as follows (as we discuss below):
In addition, the transition period for the compliance date with respect to the evaluation (proposed Rule 30a-3 under the 1940 Act) and Certification (Rule 30a-2(b)(4), (5) and (6) under that Act) of disclosure controls and procedures should apply to reports on Form N-CSR filed for periods ending after the compliance date for filing Form N-CSR reports.
Certified Shareholder Reports
Section 302(a) of the Act requires that the Commission adopt rules requiring the principal executive and financial officers of companies that file periodic reports under Sections 13(a) or 15(d) of the Exchange Act to certify, among other things, that "the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer. . . ."
By operation of current Rule 30a-1 under the 1940 Act, an investment company's filing of semi-annual reports on Form N-SAR technically satisfies the company's Exchange Act annual report filing requirements.4 To implement the Certification requirement, the Commission adopted Rule 30a-2 under the 1940 Act, which requires most filers of Form N-SAR to include the Certification.5
In the Proposing Release, the Commission requested comment on its proposal to require certified shareholder reports to be filed on Form N-CSR and to designate these reports as reports that are required under Sections 13(a) and 15(d) of the Exchange Act. In particular, the Commission asked whether Form N-SAR should be designated as exclusively a 1940 Act filing and the Certification requirement removed from Form N-SAR.
We believe that, generally, the Commission should not require both the filing of certified shareholder reports on Form N-CSR and the certification of Form N-SAR.6 In a letter of August 15, 2002 to the Commission commenting on, among other matters, the proposed application of the Certification provisions to management investment companies, the Committee on Federal Regulation of Securities stated its view that:
In our view, Form N-SAR contains limited financial information and does not fairly present, in all material respects, the investment company's financial condition and results of operations.
Form N-SAR is not (and is not required to be) disseminated to shareholders. Form N-SAR was designed to provide the Commission with statistical information to aid obtaining necessary compliance information about fund complexes in order to determine inspection and review priorities.8 The fact that it was adopted as an Exchange Act form rather than a 1940 Act form was undoubtedly a reflection of the SEC's limited authority to require "pure" 1940 Act reports to be filed at that time, a limitation that was remedied by the 1996 amendments to Section 30 of the 1940 Act.9
We believe that requiring Form N-SAR to include a Certification is not consistent with the Act's stated purpose of protecting "investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws."10
In order to comply with the Act's mandate that periodic reports under Sections 13(a) or 15(d) of the Exchange Act be certified, we recommend that the Commission:
Scope of Certification Requirement
The Commission has proposed that investment companies certify any information included in shareholder reports, including the MDFP and certain information regarding the companies' directors. The Commission states in the Proposing Release that this "requirement is intended to fully implement the intent of Section 302, by enhancing the quality of all the information provided to investors in an investment company's reports to shareholders."
In the Proposing Release, the Commission asked whether the Certification requirement should apply to part or all of the information contained within a shareholder report, including any information included on a voluntary basis and not required by statute or rule.
The Commission's stated rationale for the breadth of the proposed certification is that it "is intended to fully implement the intent of Section 302, by enhancing the quality of all the information provided to investors in an investment company's reports to shareholders." We acknowledge that it is difficult to divine the legislative intent behind extending Section 302 to investment companies; to the extent there was any legislative intent it appeared to be focused on improving the quality of disclosure concerning an issuer's financial condition.11
We therefore believe that the Certification provisions should apply solely to an investment company's financial statements and other financial information contained in its shareholder report and not to the report's narrative sections, such as the MDFP. In our view, requiring investment company officers to certify the MDFP and other non-financial information would not "fully implement the intent of Section 302" because, as we discuss below, we believe that such information does not come within the scope of this Section.
Item 5 of Form N-1A requires open-end management investment companies ("mutual funds") to include MDFPs in their prospectuses or (as is the more common mutual fund industry practice) in their annual reports to shareholders. In the MDFP, mutual funds must discuss the factors that materially affected their performance during the most recent fiscal year, including relevant market conditions and the investment strategies employed by their advisers. By contrast, the "Management's Discussion and Analysis of Financial Condition and Result of Operations" ("MD&A") that a public operating company must file under Sections 13(a) and 15(d) of the Exchange Act is intended to enable a shareholder to understand the company's "financial condition, changes in financial condition and results of operations."12
We believe that, for purposes of Section 302 of the Act, while the information in the MD&A constitutes "other financial information" that may "fairly present in all material respects the financial condition and results of operations of the issuer," the information in the MDFP does not. The MDFP, by its nature, consists of statements that often constitute management's perception of market conditions and the reasons for the success or failure of particular investment strategies. Similarly, investment company annual reports typically include a "President's letter" that provides an overview of market conditions and investment strategies.
Typically, many statements in the MDFP and President's letter are matters of judgment rather than certifiable fact. In that sense, they are akin to non-financial discussions that are contained in annual shareholder reports of operating companies, which are not filed under Section 15(d) and are not subject to the Certification requirement. Requiring mutual fund officers to certify the information contained in the MDFP and the President's letter would have a chilling effect on management's communications to shareholders.13 Moreover, limiting the MDFP to disclosure of certifiable facts would impair the responsiveness of this disclosure to the requirements of Item 5 of Form N-1A, which requires management to use its best judgment in communicating the various factors that it believes materially affected the fund's performance.
We also believe that requiring investment company officers to certify information about the company's directors does not come within the scope of Section 302 of the Act because such information, while relevant to a shareholder's determination of each director's independence, in no way consists of financial information that may "fairly present in all material respects the financial condition and results of operations of the issuer."
In connection with the scope of the Certification requirement, the Commission also asked whether Form N-CSR should be required to contain only a portion of the investment company shareholder report, such as the financial statements, with the remainder of the shareholder report filed exclusively under the 1940 Act.
We recommend that Form N-CSR be required to contain only the financial portions of an investment company's shareholder report, with the remainder of the report filed exclusively under the 1940 Act. This approach, in our view, clearly distinguishes between an investment company's financial information, which is required to be certified, and its non-financial information, such as its MDFP and President's letter, which is not. Assuming the Commission accepts this recommendation, we request clarification that the non-financial portions of investment company shareholder reports would continue to be filed under the 1940 Act on EDGAR Form Type N-30D.
Disclosure Controls and Procedures
Noting that Section 302 of the Act mandates certification of financial information with respect to Exchange Act filings, the Commission states its belief that "it is important for the certification requirement, like our other reporting rules, to apply consistently to all registered investment companies, regardless of whether they fall within the periodic reporting requirements of the Exchange Act." Proposed Rule 30a-2(c) states that disclosure controls and procedures should be
In the Proposing Release, the Commission asked whether registered investment companies should be required to maintain disclosure controls and procedures with respect to all filings under the Securities Act, Exchange Act and 1940 Act. 15
While we would agree that investment companies should operate in such a manner that all information required to be disclosed in its filings with the Commission is accumulated and communicated to the appropriate parties on a timely basis, we believe that the proposal to extend the disclosure controls and procedures to all filings would be excessively costly and unduly burdensome for investment companies, without the commensurate benefit, particularly when compared to public operating companies that must maintain such controls and procedures only with respect to their Exchange Act filings.
For example, the requirement that investment companies maintain disclosure controls and procedures for their Securities Act filings would have a chilling effect on investment company advertisements that are considered "omitting prospectuses" under Section 10(b) of the Securities Act.16
Rule 482 under the Securities Act currently permits investment companies to advertise investment performance data, as well as other information "the substance of which" is included in their statutory prospectuses.17 Rule 497(a)(1) under the Securities Act requires investment companies to file these "Rule 482" advertisements with the Commission.18 Because Rule 482 advertisements are statutory prospectuses under Section 10(b) of the Securities Act, they are subject to Section 12(a)(2) of the Securities Act, which imposes liability for materially false or misleading statements in a prospectus or oral communication.
Similarly, Section 11(a) of the Securities Act imposes liability for material mis-statements or omissions on, among others, every person who signs a registration statement, which includes, in accordance with Section 6(a) of the Securities Act, the issuer's principal executive and financial officers.
We also note that Section 24(b) of the 1940 Act requires investment companies to file "any advertisement, pamphlet, circular, form letter, or other sales literature" with the Commission.19 In addition, Rule 156 under the Securities Act brings investment company sales literature within the anti-fraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
We believe that the effect of these provisions of the Securities Act, the Exchange Act and the 1940 Act and the relevant rules thereunder, has served, and will continue to serve, as a strong incentive for investment company management to ensure that the disclosure required in the company's Securities Act and 1940 Act filings, including their Rule 482 advertising and other sales literature, is accumulated and communicated on a timely basis. 20
We believe that, in light of these statutory provisions, it is unnecessary to extend the proposed disclosure controls and procedures requirements to investment company filings under the Securities Act and the 1940 Act. With respect to advertising and sales literature, we believe that imposing these requirements would result in an unfair burden on investment companies, because public operating companies are not required to file their advertisements or other sales literature with the Commission.
In addition, we are not aware of any basis in the language or legislative history of Section 302 for extending this requirement to an investment company's non-Exchange Act filings.21 Thus, we believe that extending this requirement exceeds the mandate of Section 302 of the Act and is, therefore, unwarranted. Moreover, exceeding the mandate of Section 302 in this manner raises concerns over whether it is appropriate for the Commission and within its authority to impose fundamental corporate governance obligations on investment companies through the certification process.
Compliance Date of the Proposal
The Commission has stated that, if the Proposal is adopted, it intends to require compliance with the proposed amendments within 30 days after their publication in the Federal Register. The Commission requested comment on the anticipated compliance date.
We believe that 60 days is a more reasonable time frame during which investment companies would have sufficient time to draft and review any required disclosure controls and procedures with respect to Exchange Act filings. We believe that, if the Commission adopts the requirement that investment companies maintain such controls and procedures with respect to Securities Act and 1940 Act filings in addition to Exchange Act filings, the compliance date should be extended to 90 days after publication in the Federal Register. We also note that investment companies may be required to negotiate amendments to agreements with their service providers to ensure compliance with the Proposal (and obtain Board approval of such amendments), which process could not reasonably be completed within 30 days.
With respect to the application of Rule 30a-2 under the 1940 Act to filings on Form N-CSR, we note that the Commission, in adopting the Rule, prescribed that paragraphs (b)(1), (2) and (3) of the Rule (relating to financial statements) would apply to Form N-SARs filed after August 29, 2002 and that paragraphs (b)(4), (5) and (6) (relating to disclosure controls and procedures) would apply to Form N-SARs filed for periods ending after August 29, 2002.22 In the Proposing Release, the Commission did not include a similar transition provision with respect to Form N-CSR filings. Consequently, it appears that both the financial statement and disclosure controls and procedures Certifications would apply to Form N-CSRs filed after the compliance date, even if the filings covered periods that preceded the compliance date.
If the Commission adopts Rule 30a-3 and the amendments to Rule 30a-2 as proposed, investment companies must develop and adopt disclosure controls and procedures for filings on Form N-CSR that may differ from the disclosure controls and procedures required for filings on Form N-SAR. In order to allow investment companies sufficient time to develop disclosure controls and procedures appropriate for filings on Form N-CSR, we recommend that the Commission adopt transition provisions for Form N-CSR that are similar to those it adopted for Form N-SAR. That is, the transition period for the compliance date with respect to the evaluation (proposed Rule 30a-3 under the 1940 Act) and Certification (Rule 30a-2(b)(4), (5) and (6) under that Act) of disclosure controls and procedures should apply to reports on Form N-CSR filed for periods ending after the compliance date for filing Form N-CSR reports.
* * *
The Committee respectfully requests that the Commission revise its Proposal in accordance with the comments set forth above. Members of the Committee's Subcommittee on Investment Companies and Investment Advisers are prepared to meet and discuss these matters with the Commission and the staff and to respond to any questions.
Diane E. Ambler
cc: The Honorable Chairman Harvey L. Pitt