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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release Nos. IC-22658; IS-1080; File No. S7-23-95]
RIN 3235-AE98
Custody of Investment Company Assets Outside the United States
AGENCY: Securities and Exchange Commission
ACTION: Final Rule
SUMMARY: The Commission is adopting amendments to the rule
under the Investment Company Act of 1940 that governs the
custody of investment company assets outside the United
States. The amendments provide investment companies with
greater flexibility in managing their foreign custody
arrangements consistent with the safekeeping of investment
company assets. The amendments also expand the class of
foreign banks and securities depositories that may serve as
investment company custodians.
EFFECTIVE DATE: The amendments will become effective [insert
date thirty days after publication in the Federal Register].
FOR FURTHER INFORMATION CONTACT: Robin S. Gross, Staff
Attorney, or Nadya B. Roytblat, Assistant Chief, Office of
Regulatory Policy, at (202) 942-0690, Securities and Exchange
Commission, Division of Investment Management, 450 Fifth
Street, N.W., Mail Stop 10-2, Washington, D.C. 20549.
Requests for formal interpretive advice should be directed to
the Office of Chief Counsel at (202) 942-0659, Division of
Investment Management, Securities and Exchange Commission, 450
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Fifth Street, N.W., Mail Stop 10-6, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange
Commission ("Commission") today is adopting amendments to rule
17f-5 [17 CFR 270.17f-5] under the Investment Company Act of
1940 [15 U.S.C. 80a] (the "Investment Company Act" or "Act").
TABLE OF CONTENTS:
I. EXECUTIVE SUMMARY
II. INTRODUCTION AND BACKGROUND
III. DISCUSSION
A. Decision to Place Fund Assets in a Country
1. Background
2. Amended Rule
B. Delegation of Board Responsibilities
1.Selecting Delegates
2. Delegate's Standard of Care
3. Board Oversight; Delegate Reporting
C. Selecting, Contracting with, and Monitoring a
Foreign Custodian
1. Selecting a Foreign Custodian
a. General Standard
b. Specified Factors
i. Practices, Procedures and Internal
Controls
ii. Financial Strength and Reputation
iii. Jurisdiction
2. Foreign Custody Contract
a. Indemnification and Insurance
b. Liens
c. Omnibus Accounts
d. Depository Arrangements
3. Monitoring Custody Arrangements and
Withdrawing Fund Assets
D. Eligible Foreign Custodians
1. Foreign Banks and Trust Companies
2. Affiliated Foreign Custodians
3. Securities Depositories
E. Assets Maintained in Foreign Custody
F. Canadian Funds
IV. EFFECTIVE DATE; COMPLIANCE DATES
V. COST/BENEFIT ANALYSIS AND EFFECTS ON COMPETITION,
EFFICIENCY AND CAPITAL FORMATION
VI. SUMMARY OF FINAL REGULATORY FLEXIBILITY ANALYSIS
VII. PAPERWORK REDUCTION ACT
VIII. STATUTORY AUTHORITY
TEXT OF RULE
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I. EXECUTIVE SUMMARY
The Commission is amending rule 17f-5 under the
Investment Company Act to provide registered management
investment companies ("funds") greater flexibility in managing
their foreign custody arrangements. The amendments expand the
class of foreign banks and securities depositories that may
serve as custodians of fund assets by eliminating capital
requirements that have precluded funds from using otherwise
suitable custodians without first obtaining administrative
relief from the Commission. The amended rule requires instead
that the selection of a foreign custodian be based on whether
the fund's assets will be subject to reasonable care if
maintained by that custodian, after considering all factors
relevant to the safekeeping of fund assets, including the
custodian's financial strength, its practices and procedures,
and internal controls.
The amendments eliminate the consideration of "prevailing
country risks," i.e., risks associated with investment in a
particular country rather than placing assets with a
particular custodian. The Commission has concluded that
prevailing country risks are investment risks appropriately
considered by a fund's board or investment adviser when
deciding whether the fund should invest in a particular
country, rather than custodial risks to be addressed in rule
17f-5.
The amendments also permit fund directors to play a more
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traditional oversight role with respect to the custody of fund
assets overseas. Directors may delegate their duties to
select a foreign custodian and monitor a fund's foreign
custody arrangements to the fund's investment adviser,
officers, or a U.S. or foreign bank, and are no longer
required to approve foreign custody arrangements annually.
II. INTRODUCTION AND BACKGROUND
A growing number of funds invest their assets
overseas.-[1]- Investing in foreign markets may present
a fund with significant operational issues, one of which is
the availability of appropriate custodians for fund assets.
Maintaining securities outside of their primary market can add
significant costs to investing in that market and may preclude
foreign investment.-[2]- The availability of custodial
-[1]- Based on available data, the Commission staff
estimates that at the end of February 1997, approximately
1,666 portfolios with assets of nearly $411 billion have
investment objectives that contemplated significant foreign
investments. See also Karen Damato, Mutual Funds Drew $24
Billion During January, WALL ST. J., Feb. 13, 1997, at C1
(discussing recent increased investor interest in funds that
invest overseas).
-[2]- Moving securities away from their primary market
may entail additional costs in connection with hiring a
servicing agent in the primary locality to collect and
disseminate information with respect to the securities,
transferring the securities to an eligible custodian and
procuring insurance for possible loss in transit, and
exchanging coupons for interest or dividends or for new shares
in connection with a rights offering. See Exemption for
Custody of Securities by Foreign Banks and Foreign Securities
Depositories, Investment Company Act Release No. 12354 (Apr.
5, 1982) [47 FR 16341, 16342 (April 16, 1982)] [hereinafter
1982 Proposing Release]. Funds also may be prevented from, or
delayed in, selling the securities if they are unable to make
(continued...)
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arrangements in foreign markets where a fund invests,
therefore, is very important.
Section 17(f) of the Act generally permits a fund to
maintain its assets only in the custody of a U.S. bank and its
foreign branches, a member of a U.S. securities exchange, the
fund itself, or a U.S. securities depository.-[3]-
Before rule 17f-5 was adopted, funds seeking to maintain their
assets outside the United States could use only foreign
branches of U.S. banks as their foreign custodians.-[4]-
In 1984 the Commission adopted rule 17f-5, which expanded
the foreign custody arrangements available to funds.-[5]-
-[2]-(...continued)
timely delivery to prospective purchasers in the primary
market. Id. In addition, the best price for a foreign
security typically may be obtained in its primary market. Id.
-[3]- 15 U.S.C. 80a-17(f). Bank custodians must be
subject to federal or state regulation and have at least
$500,000 in aggregate capital, surplus, and undivided profits.
Investment Company Act sections 2(a)(5) [15 U.S.C. 80a-
2(a)(5)] (defining bank), and 26(a)(1) [15 U.S.C.
80a-26(a)(1)] (containing the $500,000 capital requirement).
See also rule 17f-1 [17 CFR 270.17f-1] (custody by members of
a U.S. securities exchange), rule 17f-2 [17 CFR 270.17f-2]
(custody by funds themselves), rule 17f-4 [17 CFR 270.17f-4]
(custody by U.S. securities depositories), and rule 17f-6 [17
CFR 270.17f-6] (custody by futures commission merchants and
commodity clearing organizations).
-[4]- See 1982 Proposing Release, supra note 2, at n.7
and accompanying text.
-[5]- Exemption for Custody of Investment Company Assets
Outside the United States, Investment Company Act Release No.
14132 (Sept. 7, 1984) [49 FR 36080 (Sept. 14, 1984)] (release
adopting rule 17f-5) [hereinafter 1984 Adopting Release]. For
an administrative history of rule 17f-5, see Custody of
Investment Company Assets Outside the United States,
Investment Company Act Release No. 21259 (July 27, 1995)
(continued...)
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The rule permits funds to maintain their assets overseas,
subject to detailed findings by the fund's board of directors
with respect to the decision to place fund assets in a
particular country and with respect to each foreign custody
arrangement.-[6]- Fund assets may be placed in the
custody of an "eligible foreign custodian": (i) a foreign
bank or trust company ("foreign bank") that has more than $200
million in shareholders' equity; (ii) a majority-owned
subsidiary of a U.S. bank or bank holding company ("U.S. bank
subsidiary") that has more than $100 million in shareholders'
equity; or (iii) a foreign securities depository that operates
either the central system for the handling of securities in
that country or a transnational system for the central
handling of securities.-[7]- Finally, the fund's foreign
custody arrangements must be governed by a written contract
that must be approved by the fund's board of directors and
contain certain specified provisions.-[8]-
-[5]-(...continued)
[60 FR 39592 (Aug. 2, 1995)] [hereinafter Proposing Release]
at n.8.
-[6]- The fund's board of directors must determine that
the custody arrangements are consistent with the best
interests of the fund and its shareholders (the "best
interests determination"). Rule 17f-5(a)(1)(i) through (iii).
Notes to the current rule enumerate certain factors that the
fund's board should consider in making the best interests
determination. The rule also requires the board to monitor
the fund's foreign custody arrangements and to approve each
arrangement at least annually. Rule 17f-5(a)(2), (3).
-[7]- Rule 17f-5(c)(2)(i) through (iv).
-[8]- Rule 17f-5(a)(1)(iii)(A) through (F).
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By 1995 the Commission had become concerned that the
rule's provisions unnecessarily restricted foreign custody
arrangements. In addition, the Commission became concerned
that the rule placed unnecessary burdens on fund directors
that detracted from the amount of time they could devote to
the many other important duties they are assigned under the
Act.-[9]- In July 1995, the Commission proposed
amendments to rule 17f-5 in response to these concerns. To
make the rule's requirements for board involvement in custody
matters more consistent with the board's traditional oversight
role, the proposed amendments would have permitted fund boards
to delegate their responsibilities to approve and monitor
foreign custody arrangements. To better reflect modern
commercial custody practices, the proposed amendments would
have revised the standard to be used in evaluating a fund's
foreign custody arrangements to one that focuses on whether
the custodial arrangement afforded "reasonable protection" for
fund assets.-[10]- The proposed amendments also would
have expanded the class of foreign banks, U.S. bank
subsidiaries and securities depositories that could serve as
fund custodians, and eliminated the requirement that the
-[9]- See Proposing Release, supra note 5, at nn.15-17
and accompanying text.
-[10]- The factors that the rule specifies should be
considered in this regard would have been revised to focus on
safekeeping rather than investment risks (particularly the
factors relating to the decision to place fund assets in a
country).
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fund's foreign custody contract contain certain specified
provisions.
The Commission received letters from 28 commenters. The
commenters generally supported the proposed amendments,
particularly those provisions that would have permitted a
fund's board to delegate its responsibilities to select and
monitor foreign custodians to the fund's investment adviser,
officers, or a U.S. or foreign bank. The Commission is
adopting the proposed amendments with several modifications
that reflect, in part, the commenters' suggestions. The
Commission believes that the amendments, as adopted, will
provide significant additional flexibility for funds without
reducing the level of investor protection afforded by the
current rule.
III. DISCUSSION
A. Decision to Place Fund Assets in a Country
1. Background
Maintaining fund assets outside the United States
involves risks that relate to the particular custodian (e.g.,
the risk that the custodian selected will not exercise the
appropriate level of care with regard to fund assets, or that
the custodian may not have the financial strength, practices,
and procedures in place to safeguard the fund's
assets).-[11]- In addition, maintenance of fund assets
-[11]- These issues also may be present when a fund's
assets are maintained in the United States. Section 17(f),
(continued...)
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overseas exposes the fund to systemic risks that may affect
the ability of any custodian to safeguard fund assets in that
country ("prevailing country risks"). For example, a
country's inefficient settlement practices constitute a risk
of investing in that country, regardless of the level of care
that can be provided by a particular custodian. Both of these
types of risks have been addressed by rule 17f-5, and were to
be addressed by the proposed amendments.-[12]-
-[11]-(...continued)
however, by limiting domestic custody arrangements to U.S.
banks and certain other arrangements subject to Commission
regulation, provides some assurance that custody arrangements
will have appropriate safeguards. See supra note 3 and
accompanying text.
-[12]- Rule 17f-5 currently requires a fund's board of
directors to determine that maintaining the fund's assets in a
particular country is consistent with the best interests of
the fund and its shareholders. Rule 17f-5(a)(1)(i). Note 1
to the rule requires the board, in making this determination,
to consider the effects of applicable foreign law on the
safekeeping of fund assets; the likelihood of expropriation,
nationalization, freezing, or confiscation of the fund's
assets; and any reasonably foreseeable difficulties in
repatriating the fund's assets kept overseas.
The proposed amendments would have narrowed the scope of the
prevailing country risks determination to factors that have a
closer nexus to safekeeping considerations. A fund's board of
directors or its delegate would have been required to
determine that custody of the fund's assets in a particular
country could be maintained in a manner that provided
reasonable protection for the fund's assets after considering
all factors relevant to the safekeeping of such assets
including: (i) the prevailing practices in the country for
the custody of the fund's assets; (ii) whether the country's
laws will affect adversely the safekeeping of the fund's
assets, such as by restricting the access of the fund's
independent public accountants to a custodian's books and
records, or by affecting the fund's ability to recover its
assets in the event of a custodian's bankruptcy or the loss of
assets in a custodian's control; and (iii) whether special
(continued...)
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The Proposing Release requested comment whether the rule
should continue to address prevailing country
risks.-[13]- A number of commenters suggested that it
should not. These commenters asserted that prevailing country
risks are inherently investment risks because they are an
inextricable part of the fund's decision to invest in foreign
securities. These commenters therefore urged the Commission
to treat the decision to place fund assets in a country as a
decision to be made by the fund's board or its investment
adviser in the context of deciding to invest in that country,
and as separate from the establishment of particular foreign
custody arrangements under rule 17f-5.
2. The Amended Rule
These comments have caused the Commission to reconsider
the proposed approach. Once a decision has been made to
invest in a country, prevailing country risks cannot be
avoided, except by maintaining assets outside of the country -
- an alternative that is often not possible or practicable.
For that reason, prevailing country risks would seem
inherently a part of the investment risks associated with the
decision to invest in a particular country and should be
considered by a fund's board or investment adviser before the
-[12]-(...continued)
arrangements that mitigate the risks of maintaining the fund's
assets in the country would be used.
-[13]- Proposing Release, supra note 5, at nn.62-65 and
accompanying text.
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fund invests in a foreign country. Inclusion of prevailing
country risks in rule 17f-5, therefore, would appear
inconsistent with the nature of those risks.
The Commission also is concerned that restrictions on a
fund's approach to prevailing country risks may have the
effect of denying funds and their shareholders overseas
investment opportunities, particularly in developing markets.
Such a result is inconsistent with the overall approach of the
Investment Company Act, which generally does not limit a
fund's ability to assume investment risks.-[14]-
Moreover, such a result is not mandated by section 17(f), the
legislative history of which suggests that the section was
intended primarily to prevent misappropriation of fund assets
by persons having access to assets of the fund.-[15]-
Based upon these considerations, the Commission has decided
not to address prevailing country risks in rule 17f-5.
Rather, the Commission believes that such risks should be
carefully considered by a fund's board or its investment
adviser before the fund invests in a foreign country, and, if
-[14]- But see, e.g., rule 2a-7 under the Investment
Company Act [17 CFR 270.2a-7] (establishing various
limitations on permissible investments for money market
funds).
-[15]- See Proposing Release, supra note 5, at n.5;
Thomas Harman, Eligible Foreign Custodians and the Investment
Company Act of 1940, 46 Bus. Law 1377 (1991).
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material, disclosed to fund investors.-[16]-
Accordingly, the amended rule focuses exclusively on the
selection and monitoring of an eligible foreign custodian.
The amendments are not intended and should not be
construed, however, to diminish the importance of considering
the financial infrastructure of a foreign country when
deciding to invest in that country. For example, the
country's settlement systems and practices can have a
significant effect on the liquidity and investment
characteristics of fund assets.-[17]- The amendments
-[16]- Funds' disclosure obligations are governed by
other provisions of the securities laws. See, e.g., Item 4(c)
of Form N-1A [17 CFR 239.15A] (the registration form for open-
end funds), and Item 8.3 of Form N-2 [17 CFR 274.11a-1] (the
registration form for closed-end funds). These Items require
disclosure in the fund's prospectus of the principal risk
factors associated with investing in the fund. See also
Proposing Release, supra note 5, at nn.175, 176 and
accompanying text.
-[17]- A country's settlement systems, for example, may
not require that payment for securities purchased by a fund be
made only upon delivery of those securities, or that
securities sold by a fund be delivered only upon receipt of
payment for the securities ("delivery vs. payment
procedures"). Delivery vs. payment procedures can afford
significant protections from losses if the other party to a
transaction defaults on its obligations. See, e.g., GROUP OF
THIRTY, CLEARANCE AND SETTLEMENT SYSTEMS IN THE WORLD'S
SECURITIES MARKETS 11 (Mar. 1989). The fact that a foreign
market's settlement practices do not incorporate these
procedures should be carefully considered by the fund's board
or investment adviser in deciding to invest in the country.
A country's settlement systems and practices also may present
problems in accounting for fund assets (e.g, establishing
whether the fund owns the securities or has received dividends
or other entitlements). See, e.g., Buttonwood International
Group, Emerging Markets on the Net: India -Securities
Infrastructure a Big Problem for Investors, at
(continued...)
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similarly are not intended to diminish the contribution that
the fund's global custodian may make in deciding to place fund
assets in a foreign country.-[18]- Commenters
representing funds and custodians agreed that global
custodians are a "primary source of information concerning the
financial systems and practices of foreign
markets."-[19]- The Commission, therefore, expects that
fund boards and investment advisers, in making foreign
investment decisions, will continue to seek and rely on
information and opinions provided by the fund's custodian when
-[17]-(...continued)
http://www.buttonwood.com/p-i/1996es/india.html (discussing,
among other things, difficulties resulting from the process of
registering changes in ownership of securities).
-[18]- See, e.g., John Paul Lee & Richard Schwartz,
GLOBAL CUSTODY: A GUIDE FOR THE NINETIES (1990) (noting that
today the safekeeping of a fund's foreign investments
typically is effected through the fund's primary or "global"
custodian, which uses a world-wide network of custodians with
which it has established relationships); GORDON ALTMAN
BUTOWSKY WEITZEN SHALOV & WEIN, A PRACTICAL GUIDE TO THE
INVESTMENT COMPANY ACT 30 (1993) (indicating that the fund's
custodian typically provides the board with information
concerning foreign legal restrictions and the qualifications
of foreign custodians).
-[19]- Letter from Baker & McKenzie to Jonathan G. Katz,
Secretary, Securities and Exchange Commission (Nov. 3, 1995),
File No. S7-23-95, at 7-8; see also Letter from the Investment
Company Institute to Jonathan G. Katz, Secretary, Securities
and Exchange Commission (Oct. 5, 1995), File No. S7-23-95, at
9. Custodian commenters suggested that their role in this
regard may expand under the amended rule and emphasized that
funds and their global custodians "are partners, not
adversaries, in seeking to ensure that fund assets held
outside the United States are properly safeguarded." Letters
from Baker & McKenzie to Jonathan G. Katz, Secretary,
Securities and Exchange Commission (June 7, 1996 and Sept. 10,
1996), File No. S7-23-95, at 3 and 2, respectively.
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the custodian has experience with regard to foreign custody
services.-[20]-
B. Delegation of Board Responsibilities
The Commission proposed amending the rule to permit a
fund's board to delegate its responsibilities to select,
contract with, and monitor foreign custodians to the fund's
investment adviser, officers or a U.S. or foreign bank. This
approach was intended to permit fund boards to play a more
traditional oversight role in connection with a fund's foreign
-[20]-The Commission always has recognized the extent to
which fund boards rely on third party experts in addressing
prevailing country risks. See 1984 Adopting Release, supra
note 5, at n.12 and accompanying text. The failure of a
fund's board to obtain information from reliable sources
concerning the financial systems and practices of foreign
markets in which the fund makes significant investments may in
certain instances violate the directors' duty of care under
applicable corporate and fiduciary law. See, e.g., Task Force
on the Fund Director's Guidebook, Federal Regulation of
Securities Committee, Section of Business Law, American Bar
Association, "Fund Director's Guidebook," 52 Bus. Law. 229,
237 (1996) ("Compliance with the duty of care under state law
is based on diligence applied to the ordinary and
extraordinary needs of the fund, including . . . obtaining and
reviewing information on which to base decisions, and making
appropriate inquiries under particular circumstances.") The
Commission does not believe that the amendments will
discourage fund boards and investment advisers from seeking
the type of information they need to fulfill their
responsibilities. Cf. Letter from State Street Bank to
Jonathan G. Katz, Secretary, Securities and Exchange
Commission (Nov. 3, 1995), File No. S7-23-95, at 11
(suggesting that "competitive forces" may place incentives on
custodian banks to assume greater responsibility for decisions
to place fund assets in foreign countries). The amendments do
not affect in any way the extent to which a custodian's
opinions and reports may be relied upon by the fund's board or
the investment adviser, or the custodian's legal liability to
the fund with respect to any such opinions or reports.
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custody arrangements.-[21]- This approach also sought
to recognize that in discharging their responsibilities under
the rule, directors rely heavily on the analysis and
recommendations of the fund's investment adviser, legal
counsel and global custodian.-[22]- Most commenters
strongly supported the proposed amendments permitting
delegation of board responsibilities and they are adopted
substantially as proposed.-[23]-
1. Selecting Delegates
Under the proposed amendments, the board would have been
required to find that it is reasonable to rely on the delegate
to perform the delegated responsibilities related to the
fund's foreign custody arrangements. Most commenters that
addressed this aspect of the proposal supported the proposed
standard, but suggested that the Commission discuss the
factors to be considered in determining whether reliance on a
-[21]- See Proposing Release, supra note 5, at nn.24-26
and accompanying text.
-[22]- See supra notes 18-20 and accompanying text. See
also, GLORIANNE STROMBERG, REGULATORY STRATEGIES FOR THE MID-
'90S; RECOMMENDATIONS FOR REGULATING INVESTMENT FUNDS IN
CANADA (prepared for the Canadian Securities Administrators)
242 (Jan. 1995) (suggesting it is unlikely that an individual
fund or its investment adviser will have the expertise or
bargaining power to deal with numerous and varied foreign
custodians throughout the world).
-[23]- While commenters generally supported delegation, a
number of commenters suggested that custodian banks should not
serve as delegates for the decision to place fund assets in a
country. It is not necessary to address this issue in the
amended rule, however, because the decision to place fund
assets in the country is outside the scope of the amended
rule. See supra Section III.A. of this Release.
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delegate is reasonable.
The Commission is adopting the proposed reasonable
reliance standard.-[24]- As stated in the Proposing
Release, factors typically involved in making this
determination include the expertise of the delegate and, if
applicable, the delegate's intended use of third party experts
in performing its responsibilities.-[25]- Other
relevant factors may include, for example, the board's ability
to monitor the delegate's performance or, in the case of a
delegate that is a foreign bank, the fund's ability to obtain
jurisdiction over the delegate in the U.S. should problems
arise in the delegate's performance of its duties.-[26]-
The delegate's financial strength also is relevant in
analyzing its ability to perform its responsibilities and
indemnify the fund if the delegate fails to adhere to the
requisite standard of care.-[27]-
-[24]- Amended rule 17f-5(b)(1) [17 CFR 270.17f-5(b)(1)].
-[25]- See Proposing Release, supra note 5, at n.28 and
accompanying text.
-[26]- If the delegate is a foreign bank, it must be a
"qualified foreign bank" (i.e., regulated as either a banking
institution or trust company by the government of the country
under whose laws it is organized or any agency thereof). See
amended rule 17f-5(d)(6) [17 CFR 270.17f-5(d)(6)]. U.S. bank
delegates must be subject to federal or state regulation by
virtue of the definition of bank in section 2(a)(5) of the Act
[15 USC 80a-2(a)(5)].
-[27]- The amendments, as proposed, would have required a
U.S. bank delegate to have an aggregate of capital, surplus
and undivided profits ("CSP") of $500,000 -- the aggregate CSP
required for a U.S. bank to serve as a custodian for fund
(continued...)
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Certain commenters suggested that the board's
responsibilities under the rule be delegable solely to the
fund's custodian bank as the entity most qualified to provide
such services. The Commission continues to believe that the
board should have the flexibility to delegate foreign custody
decisions to the entity it determines is in the best position
to evaluate the particular delegated aspects of the fund's
foreign custody arrangements.-[28]- For example,
under the delegation provisions of the amended rule, one
delegate may assume responsibility for evaluating bank
custodians, while another may be responsible for evaluating
depositories.
-[27]-(...continued)
assets. See section 17(f)(1) of the Act [15 U.S.C. 80a-
17(f)(1)] (requiring bank custodians to meet the
qualifications prescribed by section 26(a) of the Act [15
U.S.C. 80a-26(a)] for the trustees of unit investment trusts).
The Proposing Release requested comment whether foreign bank
delegates should meet specific capital standards. Commenters
were divided on this point. One commenter supported a minimum
capital requirement for foreign bank delegates to avoid the
inequity of subjecting only U.S. banks to minimum capital
requirements. Other commenters suggested that, since the
financial strength of a foreign custodian would be a factor in
deciding to use it as a custodian for fund assets, the
aggregate CSP requirement, or other minimum financial
standards for delegates, were unnecessary. Consistent with
the approach of focusing on financial strength, rather than
specified minimum capital (as discussed in Section III.D.1 of
this Release), the amended rule does not require a U.S. bank
delegate to have a specified CSP.
-[28]- Similarly, a fund's board could select as delegate
the entity having the greatest expertise with a geographic
region. See Andrew Sollinger, Breaking Away, INSTITUTIONAL
INVESTOR 171 (Sept. 1991) (noting that U.S. custodians may use
different subcustodian networks for different geographic
regions).
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The Commission notes that the terms of the delegation
must be agreed upon by the board and the delegate. The
potential delegate must agree to assume the delegated
responsibilities and the delegate and the fund's board may
agree to guidelines and procedures under which the delegate
will exercise its responsibilities. If a foreign country, for
example, has a depository that, as a practical matter, must be
used if the fund is going to place assets in that country
("compulsory depository"), the fund's board may conclude that
the investment adviser would be the appropriate delegate for
evaluating the compulsory depository.-[29]-
2. Delegate's Standard of Care
The Proposing Release requested comment whether the rule
should provide a standard of care to be used by a delegate in
making custodial decisions. Several commenters suggested that
-[29]- The amendments, as proposed, would have expressly
addressed compulsory depositories, and would have required
the evaluation of a compulsory depository to be made in the
context of the decision to place fund assets in that country.
This approach was designed to address the expectation that,
because of the depository's compulsory nature, the fund's
custodian would decline to assume the responsibility for
evaluating it. The Commission recognized, however, that
conceptually the decision to use a compulsory depository
appeared to fall within the scope of the rule's provisions
governing the selection of particular custodians. The rule,
as proposed to be amended, would have required the fund's
board or its delegate to make the same findings with respect
to a compulsory depository as those required for the selection
of any other type of foreign custodian. See Proposing
Release, supra note 5, at n.71. Because the amended rule does
not address the decision to place fund assets in a country,
the Commission has concluded that it is not necessary for the
rule to distinguish between compulsory depositories and other
types of foreign custodians.
==========================================START OF PAGE 19======
the rule should provide guidance in this regard. These
commenters expressed the view that if the Commission did not
clarify this aspect of the amendments, the delegation
provisions would be unworkable because potential delegates
would be unwilling to risk being held liable for losses
despite exercising reasonable care.
The amended rule requires a delegate to exercise
reasonable care in performing the delegated
duties.-[30]- The rule makes clear that reasonable
care, in this context, requires the delegate to exercise the
care, prudence and diligence that a person having the
responsibility for the safekeeping of fund assets would
exercise.-[31]- This provision is designed to ensure
that delegates adhere to a threshold standard of care. Fund
boards and their delegates may agree that the delegate should
adhere to a higher standard of care.
3. Board Oversight; Delegate Reporting
The Commission is amending the rule, as proposed, to no
longer require the board to review or approve the fund's
foreign custody arrangements annually. The amended rule does
require the delegate to provide the board with written reports
notifying it of the placement of the fund's assets with a
-[30]- Amended rule 17f-5(b)(3) [17 CFR 270.17f-5(b)(3)].
-[31]- A substantially similar standard of care was
suggested by fund and custodian commenters. See also infra
note 36, (discussing a custodian's standard of care under
Article 8 of the Uniform Commercial Code ("U.C.C.")).
==========================================START OF PAGE 20======
particular custodian.-[32]- The delegate also must
provide written reports to the board concerning any material
change in the fund's foreign custody arrangements ("material
change reports").-[33]- These reports are intended to
facilitate the board's oversight of the delegate's
performance. Commenters generally agreed that delegate
reporting is desirable.
The proposed amendments would have required the reports
to be provided no later than the next regularly scheduled
board meeting following the event necessitating the report.
One commenter expressed concerns about the application of this
requirement to fund boards that do not have regularly
scheduled meetings. The amended rule requires material change
reports to be provided at such times as the fund's board deems
reasonable and appropriate based on the circumstances of the
fund's foreign custody arrangements.-[34]- This
provision should provide fund boards with the flexibility to
tailor the reporting requirements to the fund's particular
circumstances. Consistent with the provision, a fund's board
-[32]- Amended rule 17f-5(b)(2) [17 CFR 270.17f-5(b)(2)].
-[33]- Id. A material change in the fund's arrangements
would include, for example, a delegate's decision to remove
the fund's assets from a particular custodian. A material
change also could include events that may adversely affect a
foreign custodian's financial or operational strength, such as
a change in control resulting from a sale of the custodian's
operations. If appropriate, the material change report would
discuss the reasons for continuing to maintain the fund's
assets with a particular custodian.
-[34]- Amended rule 17f-5(b)(2) [17 CFR 270.17f-5(b)(2)].
==========================================START OF PAGE 21======
could, for example, require the reports at the next regularly
scheduled board meeting, as originally proposed. The board
also may require the reports more or less frequently (e.g.,
within 30, 60 or 90 days of the event or annually) as the
board determines is reasonable and appropriate.
C. Selecting, Contracting with, and Monitoring a
Foreign Custodian
1. Selecting a Foreign Custodian
a. General Standard
Rule 17f-5 currently requires a fund's board to find that
the fund's foreign custody arrangements are consistent with
the best interests of the fund and its
shareholders.-[35]- Consistent with the goal of
requiring foreign custody arrangements to be evaluated based
on the level of safekeeping they will afford fund assets, the
Commission proposed amending the rule to require a finding
that the fund's foreign custody arrangement will provide
"reasonable protection" for fund assets. The proposed
reasonable protection standard was intended to facilitate
evaluation of foreign custody arrangements by focusing
exclusively on the safekeeping of fund assets.
Several commenters viewed the proposed reasonable
protection standard as a results-oriented standard that could
effectively render the entity making the determination a
guarantor against any loss of fund assets in foreign custody.
-[35]- Rule 17f-5(a)(2).
==========================================START OF PAGE 22======
A number of commenters recommended that the rule require
instead that the selection of a fund's foreign custodian be
based on a determination that the custodian will provide
"reasonable care" for the fund's assets in its custody
("reasonable care standard"). The commenters suggested that
this standard of care would be more consistent with the way in
which custodians traditionally have carried out their
responsibilities.-[36]- Commenters also noted that a
reasonable protection standard would suggest that the level of
custodial protection that is deemed "reasonable" would vary
from fund to fund.
In proposing the reasonable protection standard, the
Commission emphasized that the delegate would not be required
to find that fund assets could never be lost while in the
foreign custodian's possession. Instead, the focus would have
been on the reasonableness of a custodian's protections for
the fund's assets, based on all relevant factors and, in
particular, those factors that would have been specified in
-[36]- For example, the newly revised Article 8 of the
U.C.C. (which has been adopted in 29 states, as of December
1996), addresses the duty of care to be exercised by a
custodian (or other "securities intermediary"). Section 8-504
provides that in the absence of an agreement, the custodian
should exercise "due care in accordance with reasonable
commercial standards." (Section 8-509 recognizes that
regulatory law may impose a higher standard.) Note 4 to
Section 8-504 observes that "[t]he duty of care includes both
care in the intermediaries' own operations and care in the
selection of other intermediaries through whom the
intermediary holds the assets in question."
=========================================START OF PAGE 23======
the rule.-[37]- Thus, the proposed standard was not
intended to be substantially different than the reasonable
care standard suggested by the commenters. Nonetheless,
recognizing the benefits of using terminology currently used
and commonly understood by participants in fund custodial
arrangements, the Commission has decided to adopt a
"reasonable care" standard as suggested by commenters. The
use of this terminology also underscores the objective nature
of the standard for determining whether a fund's custodial
arrangements in a particular country satisfy a
"reasonableness" standard.
The amended rule requires the fund's board or its
delegate (the "Foreign Custody Manager") to determine that the
fund's assets will be subject to reasonable care if maintained
with the foreign custodian.-[38]- This determination
would be based on standards applicable to custodians in the
relevant market.-[39]- In making this determination,
the Foreign Custody Manager must consider all factors relevant
to the safekeeping of fund assets, including the custodian's
practices, procedures and internal controls, its financial
-[37]- See Proposing Release, supra note 5, at n.80 and
accompanying text.
-[38]- Amended rule 17f-5(c)(1) [17 CFR 270 17f-5(c)(1)].
-[39]- Id. As noted in the Proposing Release, supra note
5, at nn.88-89 and accompanying text, while reference to U.S.
standards may be relevant in determining whether the fund's
assets will be maintained with reasonable care, the rule does
not require parity between foreign and U.S. custodial
arrangements.
==========================================START OF PAGE 24======
strength, reputation and standing, and whether the fund will
be able to obtain jurisdiction over and enforce judgments
against the custodian.-[40]- The Commission notes that
the reasonable care standard is merely a threshold standard,
and that fund boards and their delegates have the flexibility
to agree that the delegate will select foreign custodians that
will exercise a higher degree of care with respect to fund
assets.
b. Specified Factors
The amended rule requires the Foreign Custody Manager to
consider all factors relevant to the safekeeping of fund
assets. The rule identifies several specific factors that the
Foreign Custody Manager must consider when selecting a foreign
custodian.
i. Practices, Procedures and Internal
Controls
The amended rule states that the foreign custodian's
practices, procedures, and internal controls are among the
factors that must be considered in deciding whether the
fund's assets will be subject to reasonable care.-[41]-
As noted in the Proposing Release, the protections provided by
-[40]- Amended rule 17f-5(c)(1)(i) through (iv) [17 CFR
270.17f-5(c)(1)(i) through (iv)].
-[41]- Amended rule 17f-5(c)(1)(i) [17 CFR 270.17f-
5(c)(1)(i)].
=========================================START OF PAGE 25======
custodians within a foreign country can vary
widely.-[42]- The amended rule specifies certain
additional factors that should be considered in assessing the
custodian's internal controls: the physical protections the
custodian makes available for certificated securities (e.g.,
the use of vaults or other facilities), the custodian's method
of keeping custodial records (e.g., the use of computers,
microfilm or paper records), as well as security and data
protection practices (e.g., alarm systems and the use of pass
codes and back-up procedures for electronically stored
information). The proposed amendments would have treated
these factors as related to the decision to place fund assets
in a country.-[43]- Commenters suggested, and the
Commission agrees, that these factors also should be
considered in selecting a particular foreign
-[42]-See Proposing Release, supra note 5, at nn.88-89
and accompanying text. For example, if delivery vs. payment
procedures are not part of the settlement practices of a
particular foreign market, some custodians in that market
might provide safeguards that address the lack of such
procedures, while others might not. See, e.g., Department of
the Treasury, Office of Comptroller of the Currency, Emerging
Market Country Products and Trading Activities 20 (Dec. 1995)
(discussing alternatives to delivery vs. payment procedures).
Such differences among custodians should be considered in
determining whether a particular custodian will provide
reasonable care for fund assets. See supra note 17
(discussing the delivery vs. payment procedures).
-[43]- See Proposing Release, supra note 5, at n.54 and
accompanying text.
==========================================START OF PAGE 26======
custodian.-[44]-
ii. Financial Strength and Reputation
The amended rule requires the Foreign Custody Manager to
consider whether the foreign custodian has the requisite
financial strength to provide reasonable care for fund
assets.-[45]- Particular emphasis should be placed on
evaluating the custodian's financial strength, since the
amended rule no longer requires the foreign custodian to have
a specified minimum shareholders' equity.-[46]- As
noted in the Proposing Release, in considering financial
strength, the Foreign Custody Manager should assess the
adequacy of the custodian's capital with a view of protecting
the fund against the risk of loss from a custodian's
insolvency.-[47]-
In addition, consideration must be given to the
custodian's reputation and standing generally. The amended
rule does not limit the Foreign Custody Manager to considering
the foreign custodian's reputation in the country where the
custodian is located. This approach seeks to provide greater
-[44]- See Letter from Chase Manhattan Bank to Jonathan
G. Katz, Secretary, Securities and Exchange Commission (Oct.
6, 1995), File No. S7-23-95, at n.4 (noting that the use of
vaults and computers, for example, is important with respect
to any particular foreign custodian).
-[45]- Amended rule 17f-5(c)(1)(ii) [17 CFR 270.17f-
5(c)(1)(ii)].
-[46]- See infra, Section III.D.1 of this Release.
-[47]-See Proposing Release, supra note 5, at nn.125-131
and accompanying text.
==========================================START OF PAGE 27======
flexibility to evaluate a custodian's reputation based on the
facts and circumstances relevant to the particular custodian
(such as the custodial services it provides in other
jurisdictions).-[48]-
iii. Jurisdiction
The amended rule also requires the Foreign Custody
Manager to assess the likelihood of U.S. jurisdiction over and
enforcement of judgments against a foreign
custodian.-[49]- This provision is designed to allow
the Foreign Custody Manager to consider various factors,
including whether a foreign custodian has branch offices in
the United States. The Foreign Custody Manager should
evaluate other jurisdictional and enforcement means such as
whether the foreign custodian has appointed an agent for
service of process in the United States or has consented to
jurisdiction in this country. The Commission recognizes that
U.S. jurisdiction may not be obtainable over certain foreign
depositories and other custodians, and an affirmative finding
of U.S. jurisdiction would not be required. Rather, the
existence or absence of U.S. jurisdiction would have to be
considered in making the overall determination that the
custodian will provide reasonable care for fund assets.
-[48]- Amended rule 17f-5(c)(1)(iii) [17 CFR 270.17f-
5(c)(1)(iii)]. The amended rule no longer addresses a
custodian's efficiency and relative costs.
-[49]- Amended rule 17f-5(c)(1)(iv) [17 CFR 270.17f-
5(c)(1)((iv)].
==========================================START OF PAGE 28======
2. Foreign Custody Contract
Rule 17f-5 currently requires a fund's foreign custody
arrangements to be governed by a written contract that the
fund's board determines is in the best interests of the fund
and which contains specified provisions.-[50]- The
proposed amendments would have eliminated the requirement that
specific provisions be included in the contract but would have
required the Foreign Custody Manager to determine that the
contract would provide reasonable protection for fund assets.
Although a small number of commenters supported the proposed
approach, commenters generally favored retaining the contract
requirements in the rule as benefitting funds and their
shareholders. The commenters asserted, among other things,
that the rule's requirements have resulted in international
standards for foreign custody agreements that have served to
protect investors.
In light of these comments, the Commission has concluded
that the amended rule should continue to require foreign
custody arrangements to be governed by a written contract.
-[50]- Rule 17f-5(a)(1)(iii). The contract generally
must provide that: (A) the fund will be indemnified and its
assets insured in the event of loss; (B) the fund's assets
will not be subject to liens or other claims in favor of the
foreign custodian or its creditors; (C) the fund's assets will
be freely transferable without the payment of money; (D)
records will be kept identifying the fund's assets as
belonging to the fund; (E) the fund's independent public
accountants will be given access to those records or
confirmation of the contents of those records; and (F) the
fund will receive periodic reports, including notification of
any transfers to or from the fund's account. Rule 17f-
5(a)(1)(iii)(A) through (F).
==========================================START OF PAGE 29======
Consistent with the new standard for evaluating foreign
custody arrangements, the amended rule requires that the
Foreign Custody Manager determine that the contract will
provide reasonable care for fund assets.-[51]- The
amended rule also retains the specific contract
requirements.-[52]- In addition, the amended rule
permits the contract to contain alternative provisions in lieu
of those specified in the rule. The Foreign Custody Manager
must determine that the alternative provisions, in their
entirety, will provide the same or a greater level of care and
protection for fund assets as the specified provisions, in
their entirety.-[53]- This change should provide funds
and their custodians with the flexibility to take advantage of
innovations that are consistent with investor protection.
Finally, as discussed below, the specified contract
requirements have been modified to reflect commenters'
suggestions and staff interpretive positions.
a. Indemnification and Insurance
Rule 17f-5 currently requires the foreign custody
contract to provide that the fund will be adequately
indemnified and its assets adequately insured in the event of
-[51]- Reasonable care, in this context, would be
determined by reference to the same standards used in
selecting the foreign custodian.
-[52]- Amended rule 17f-5(c)(2)(i) [17 CFR 270.17f-
5(c)(2)(i)].
-[53]- Amended rule 17f-5(c)(2)(ii) [17 CFR 270.17f-
5(c)(2)(ii)].
==========================================START OF PAGE 30======
loss.-[54]- This provision has been interpreted as
permitting the contract to provide for indemnification (but
not insurance) if the indemnification arrangements would
adequately protect the fund.-[55]- In response to the
commenters' suggestions, the Commission has clarified the
provision in rule 17f-5 to reflect this
interpretation.-[56]- The amended rule specifies that
the contract must provide for indemnification or insurance
arrangements (or any combination of the foregoing) such that
the fund will be adequately protected against the risk of loss
of assets held in accordance with the contract.-[57]-
b. Liens
Rule 17f-5 currently requires the foreign custody
contract to provide that the fund's assets will not be subject
to any right, charge, security interest, lien or claim of any
kind in favor of the foreign custodian or its creditors except
a claim of payment for the safe custody or administration of
the fund's assets.-[58]- Commenters suggested that in
many jurisdictions, cash deposits may become subject to
creditors' claims if a custodian becomes bankrupt. The rule
-[54]- Rule 17f-5(a)(1)(iii)(A).
-[55]- See Investment Company Institute (Nov. 4, 1987).
-[56]- Amended rule 17f-5(c)(2)(i)(A) [17 CFR 270.17f-
5(c)(2)(i)(A)].
-[57]- See Investment Company Institute, supra note 55.
-[58]- Rule 17f-5(a)(1)(iii)(B).
==========================================START OF PAGE 31======
as amended addresses this issue by providing that the
prohibition against liens does not apply to cash deposits that
may become subject to creditors' claims or rights arising
under bankruptcy, insolvency, or other similar
laws.-[59]- If a fund places assets with a custodian in
a jurisdiction in which the deposits can become subject to a
lien, the Foreign Custody Manager should take this factor into
account in determining whether the foreign custodian has the
requisite financial strength to provide reasonable care for
fund assets, and in establishing monitoring procedures with
respect to the custodial arrangement.-[60]- The Foreign
Custody Manager, for example, should consider adopting
procedures for assuring that the amount maintained in deposit
accounts that could be subject to liens is kept to a minimum
or explore reasonable alternatives to cash deposits.
c. Omnibus Accounts
In an "omnibus account" structure, the assets of more
than one custodial customer are contained in an account that
has been established, typically by and in the name of an
intermediary custodian, with a foreign bank or securities
depository. Rule 17f-5 currently requires the foreign custody
contract to provide that adequate records will be maintained
identifying the assets in foreign custody as belonging to the
-[59]- Amended rule 17f-5(c)(2)(i)(B) [17 CFR 270.17f-
5(c)(2)(i)(B)].
-[60]- See infra Section III.C.3 of this Release.
==========================================START OF PAGE 32======
fund.-[61]- Although the Commission staff has taken the
position that the current rule does not prescribe a specific
manner for keeping custodial records, and therefore does not
prohibit omnibus accounts,-[62]- several commenters
recommended amending the rule to specifically recognize the
permissibility of omnibus accounts.
The amended rule provides that the custodian's records
may either identify the assets as belonging to the fund or as
being held by a third party for the benefit of the
fund.-[63]- The amended rule therefore recognizes that
in an omnibus account structure, the securities depository's
books may show that the custodian is the owner of the fund's
assets. The amended rule makes clear, however, that the
fund's interest in the account should be reflected on the
books of the custodian.-[64]-
d. Depository Arrangements
The Commission understands that foreign depository
arrangements typically are governed not by contract, but
-[61]- Rule 17f-5(a)(1)(iii)(D).
-[62]- See State Street Bank & Trust Company (Feb. 28,
1995).
-[63]- Amended rule 17f-5(c)(2)(i)(D) [17 CFR 270.17f-
5(c)(2)(i)(D)].
-[64]- Id. A conforming change has been made to
paragraph (c)(2)(i)(F) of the rule, which requires that the
fund receive notice of any transfers of fund assets to or from
the custodian. This notice provision requires notice of
transfers to or from third party accounts. Amended rule 17f-
5(c)(2)(i)(F) [17 CFR 270.17f-5(c)(2)(i)(F)].
==========================================START OF PAGE 33======
pursuant to rules or practices of the depository.-[65]-
To accommodate the use of these depositories, the Commission
is amending rule 17f-5 to clarify that the provisions required
to be in the custody contract may be reflected in the rules or
established practices or procedures of the depository, or in
any combination of the foregoing.-[66]-
3. Monitoring Custody Arrangements and Withdrawing
Fund Assets
Rule 17f-5 currently contains detailed provisions
concerning board oversight and monitoring of foreign custodial
arrangements.-[67]- The amended rule replaces these
provisions with a requirement that the Foreign Custody Manager
establish a system to monitor the appropriateness of
maintaining the fund's assets with a particular custodian and
the fund's foreign custody contract.-[68]- Commenters
supported these amendments.
If a foreign custody arrangement no longer meets the
requirements of the amended rule, the fund must withdraw its
-[65]- Typically, the contractual arrangement pursuant to
which fund assets are held in a foreign depository involves an
eligible foreign bank that is itself a subcustodian of the
fund's U.S. custodian. Rule 17f-5 currently does not require
the foreign depository to be party to the fund's foreign
custody contract. See Proposing Release, supra note 5, at nn.
98-100 and accompanying text.
-[66]- Amended rule 17f-5(c)(2) [17 CFR 270.17f-5(c)(2)].
-[67]- Rule 17f-5(a)(2) through (4).
-[68]- Amended rule 17f-5(c)(3)(i) [17 CFR 270.17f-
5(c)(3)(i)].
==========================================START OF PAGE 34======
assets from the custodian as soon as reasonably
practicable.-[69]- Rule 17f-5's monitoring requirement
is intended to result in the Foreign Custody Manager receiving
sufficient and timely information to permit it to respond to
material changes in the fund's foreign custody arrangement.
The amended rule focuses on the importance of taking prompt
action based on the circumstances presented. For example, a
fund that places substantially all of its assets with one
custodian in a single country may require more time to
withdraw those assets than a fund that has placed only a small
percentage of its assets with a particular custodian in a
particular country.
D. Eligible Foreign Custodians
1. Foreign Banks and Trust Companies
Rule 17f-5 currently limits the class of "eligible
foreign custodians" to foreign banks and trust companies that
have more than $200 million in shareholders' equity and U.S.
bank subsidiaries that have more than $100 million in
shareholders' equity.-[70]- The Commission proposed
eliminating these requirements in favor of a more flexible
standard that allows the Foreign Custody Manager to take into
account all factors that affect the foreign custodian's
financial strength and its ability to provide custodial
-[69]- Amended rule 17f-5(c)(3)(ii) [17 CFR 270.17f-
5(c)(3)(ii)]. Current rule 17f-5(a)(4) requires fund assets
to be withdrawn within 180 days under these circumstances.
-[70]- Rule 17f-5(c)(2)(i), (ii).
=========================================START OF PAGE 35======
services, including credit and market risks.-[71]-
Commenters strongly supported these amendments.
Under the amended rule, any foreign bank or trust company
that is subject to foreign bank or trust company regulation,
as well as any U.S. bank subsidiary, may be an eligible
foreign custodian.-[72]- As discussed above, a
custodian's financial strength is an important factor to be
considered in selecting a foreign custodian. The amended rule
requires the Foreign Custody Manager to evaluate the financial
strength of a foreign custodian in determining whether the
fund's assets will be subject to reasonable care if maintained
with that custodian.-[73]-
2. Affiliated Foreign Custodians
Rule 17f-5 currently does not address affiliated foreign
custody arrangements. Under the proposed amendments, eligible
foreign banks and trust companies would have been prohibited
from being affiliated persons of the fund or affiliated
persons of such persons. The Commission proposed this
approach because rule 17f-2 under the Investment Company Act,
the rule that governs funds' self-custody arrangements and has
been interpreted by the Commission staff to apply to
affiliated custody arrangements, appeared to be unworkable in
-[71]- See Proposing Release, supra note 5, at nn.124-126
and accompanying text.
-[72]- Amended rule 17f-5(a)(1) [17 CFR 270.17f-5(a)(1)].
-[73]- See supra Section III.C.1.b.ii of this Release.
==========================================START OF PAGE 36======
the foreign custody context.-[74]-
Commenters generally disagreed with the proposed
prohibition, arguing that it would be particularly troublesome
in certain markets where there is a limited number of eligible
custodians. In response to these comments, and upon further
consideration of the issue, the Commission is not including
the proposed prohibition on foreign affiliated custody
arrangements in rule 17f-5 as amended. The Commission will
consider the issues raised by foreign affiliated custody
arrangements when it considers comprehensive amendments to
rule 17f-2.
The Commission understands, however, that a number of
market participants currently use arrangements involving an
unaffiliated primary custodian of the fund and a foreign
sub-custodian that is affiliated with the fund.-[75]-
The Commission is of the view that such an arrangement,
provided it is structured with appropriate oversight and
controls by the unaffiliated intermediary (i.e., the primary
-[74]- See Proposing Release, supra note 5, at n.138;
Pegasus Income and Capital Fund, Inc. (Dec. 31, 1977) (to
guard against potential abuses resulting from control over
fund assets by related persons, rule 17f-2 [17 CFR 270.17f-2]
has been applied to affiliated custody arrangements). Rule
17f-2 requires, among other things, that fund assets be
maintained in a bank that is subject to state or federal
regulation; the fund's assets also must be subject to
Commission inspection and verified by an independent public
accountant. Rule 17f-2(b),(d), (e) [17 CFR 270.17f-2(b),(d),
(e)].
-[75]- See supra note 18 and accompanying text
(discussing primary custodians).
==========================================START OF PAGE 37======
custodian), may adequately address the concerns of
self-custody. The risks of misappropriation of fund assets
are mitigated when the custody arrangement is entered into by,
and operated through, an unaffiliated intermediary custodian
and is subject to adequate independent scrutiny.
The Commission believes that this generally would be the
case when the fund's assets are held by the foreign sub-
custodian in an omnibus account in the name of the primary
custodian, so as to preclude specific identification of fund
assets by the affiliated sub-custodian. In addition, adequate
involvement by an unaffiliated custodian would require that
the sub-custodian be permitted to settle transactions
involving fund assets solely on receipt of instructions from
the primary custodian (which, in turn, receives its
instructions from the fund).-[76]- The primary
custodian also should closely monitor the fund's account to
assure that unauthorized transactions have not occurred, and
the fund's auditors should review and test the monitoring and
control safeguards for fund assets.
3. Securities Depositories
Rule 17f-5 currently includes among eligible foreign
custodians a foreign securities depository or clearing agency
that operates the only system for the central handling of
-[76]- The affiliated sub-custodian should not share
personnel with other affiliates of the fund (e.g., the fund's
investment adviser) to assure the integrity of the safeguards
for fund assets.
==========================================START OF PAGE 38======
securities or equivalent book-entries in a country (the "only
system requirement").-[77]- The only system requirement
was designed to ensure a country's interest in establishing
and maintaining a depository's integrity. Because the
requirement has been unnecessarily restrictive, the Commission
proposed to eliminate it.-[78]- Commenters uniformly
supported the proposed change.
The amended rule requires a securities depository or
clearing agency that acts as a system for the central handling
of securities or equivalent book-entries to be regulated by a
foreign financial regulatory authority.-[79]- The
Commission believes that foreign regulation of a depository
demonstrates a country's interest in the depository's safety,
thus achieving the Commission's objective.
E. Assets Maintained in Foreign Custody
Rule 17f-5 currently permits a fund to use foreign
-[77]- Rule 17f-5(c)(2)(iii).
-[78]- See Proposing Release, supra note 5, at nn.155-156
and accompanying text.
-[79]- Amended rule 17f-5(a)(1)(ii) [17 CFR 270.17f-
5(a)(1)(ii)]. Rule 17f-5 currently also includes among
eligible foreign custodians a security depository or clearing
agency, incorporated or organized under the laws of a country
other than the United States, that "operates" a transnational
system for the central handling of securities or equivalent
book-entries. The amended rule refers to securities
depositories or clearing agencies that "act as" such
transnational systems. Amended rule 17f-5(a)(1)(iii) [17 CFR
270.17f-5(a)(1)(iii). This change is intended to recognize
that in some instances the service provider that operates or
administers the transnational system may be organized under
the laws of the United States (e.g., as a foreign branch of a
U.S. bank).
==========================================START OF PAGE 39======
custody arrangements for its foreign securities, cash, and
cash equivalents.-[80]- Rule 17f-5 defines foreign
securities to include those that are issued and sold primarily
outside the United States by foreign and U.S.
issuers.-[81]- By restricting the types of securities
that may be maintained outside the United States, the rule
seeks to establish a nexus between its scope and its purpose
(i.e., to give funds the flexibility to keep abroad assets
that are purchased or intended to be sold abroad). In
addition, rule 17f-5 currently limits the cash and cash
equivalents that a fund may maintain outside the United States
to amounts that are reasonably necessary to effect the fund's
foreign securities transactions.-[82]-
The Proposing Release requested comment whether the rule
should continue to restrict the types of securities and
amounts of cash and cash equivalents that a fund may maintain
outside the United States. One commenter suggested that this
provision may not permit a fund to maintain investments in
other assets, such as foreign currencies, for which the
primary market is outside of the United States. To better
reflect these types of investment practices, the amended rule
permits a fund to maintain in foreign custody any investment
(including foreign currencies) for which the primary market is
-[80]- Rule 17f-5(a).
-[81]- Rule 17f-5(c)(1).
-[82]- Rule 17f-5(a).
==========================================START OF PAGE 40======
outside the United States.-[83]-
F. Canadian Funds
Rule 17f-5 currently contains special provisions
governing the foreign custody arrangements of Canadian funds
registered in the United States.-[84]- To address
jurisdictional concerns underlying section 7(d) of the Act,
these provisions are more restrictive than those applied to
U.S. funds and allow Canadian funds to maintain their assets
only in overseas branches of U.S. banks.-[85]- Because
Canadian funds have not sought to register under the Act for
some time, and very few Canadian funds currently offer their
shares in the United States, the proposed amendments would
have made limited conforming changes in the foreign custody
requirements applicable to Canadian funds.
The Commission received one comment letter addressing
-[83]- Amended rule 17f-5(c) [17 CFR 270.17f-5(c)]. As a
result of this change, the rule no longer refers to "foreign
securities" (which had been defined as securities "issued and
sold primarily outside of the United States"). The "primary
market" formulation is designed to encompass foreign
securities as well as other types of investments.
-[84]- Rule 17f-5(b).
-[85]- Section 7(d) of the Investment Company Act [15
U.S.C. 80a-7(d)] prohibits foreign investment companies from
publicly offering their securities in the United States unless
the Commission issues an order permitting registration under
the Act. Rule 7d-1 under the Investment Company Act [17 CFR
270.7d-1] sets forth conditions governing applications by
Canadian funds that seek Commission orders pursuant to section
7(d). Among other conditions, rule 7d-1 provides that the
assets of Canadian funds are to be held in the United States
by a U.S. bank, except as provided under rule 17f-5. Rule 7d-
1(b)(8)(v) [17 CFR 270.7d-1(b)(8)(v)].
==========================================START OF PAGE 41======
Canadian funds. The commenter suggested that Canadian funds
be permitted to use foreign custody arrangements on the same
basis as their U.S. counterparts. The amended rule generally
reflects this approach. As under the current rule, however, a
Canadian fund's assets must be kept in the custody of an
overseas branch of a U.S. bank. In addition, if the Canadian
fund's board delegates its responsibilities under the rule,
the only permissible delegates are the fund's officers,
investment adviser or a U.S. bank.-[86]-
IV. EFFECTIVE DATE; COMPLIANCE DATES
The amendments to rule 17f-5 become effective thirty days
after publication in the Federal Register. Funds that wish to
rely on the amended rule prior to the effective date of the
amendments may do so. Funds that have established foreign
custody arrangements in accordance with rule 17f-5 prior to
the effective date of these amendments ("existing foreign
custody arrangements") must bring these arrangements into
compliance with the amended rule (i.e., have the fund's board
make the findings required by the amended rule or appoint a
delegate to do so) within one year of the effective date of
these amendments. The one year period is designed to give
funds the flexibility to bring an existing foreign custody
arrangement into compliance with the amended rule either when
that arrangement would have been subject to the fund board's
-[86]- Amended rule 17f-5(d)(1), (2) [17 CFR 270.17f-
5(d)(1), (2)].
==========================================START OF PAGE 42======
annual review, as was required by the rule before these
amendments, or at any board meeting within the one year
period.
V. COST/BENEFIT ANALYSIS AND EFFECTS ON COMPETITION,
EFFICIENCY AND CAPITAL FORMATION
The amendments to rule 17f-5 seek to give funds greater
flexibility in their foreign custody arrangements consistent
with investor protection. The amended rule permits a fund's
board to delegate its responsibilities to select and monitor a
fund's foreign custody arrangements and no longer requires the
board to approve these arrangements annually. The amended
rule does require delegates to provide fund boards with
written reports regarding certain aspects of the foreign
custody arrangements. This requirement is designed to
facilitate board oversight and protect fund shareholders. The
potential costs associated with this requirement are not
expected to be significant, and are likely to be much less
than the costs associated with the current requirement of
providing fund boards with information pertaining to their
annual review of foreign custody arrangements.
The amendments also expand the class of foreign banks and
securities depositories that may serve as custodians of fund
assets overseas. These amendments give funds greater
flexibility in selecting foreign custodians and eliminate the
need for funds to request administrative relief for certain
foreign custody arrangements.
Section 2(c) of the Investment Company Act provides that
==========================================START OF PAGE 43======
whenever the Commission is engaged in rulemaking and is
required to consider or determine whether an action is
necessary or appropriate in the public interest, the
Commission must consider, in addition to the protection of
investors, whether the action will promote efficiency,
competition, and capital formation.-[87]- The
Commission has considered the amendments to rule 17f-5 in
light of these standards. The Commission believes that the
amendments are consistent with the public interest and will
promote efficiency and competition because the amendments (i)
permit fund directors to play a more traditional oversight
role with respect to the custody of fund assets overseas, (ii)
better focus the scope of the rule on safekeeping
considerations, and (iii) expand the class of eligible foreign
banks and securities depositories that may serve as custodians
of fund assets. The Commission also believes that the
amendments will have no adverse effect on capital formation.
VI. SUMMARY OF FINAL REGULATORY FLEXIBILITY ANALYSIS
A summary of the Initial Regulatory Flexibility Analysis,
which was prepared in accordance with 5 U.S.C. 603, was
published in Investment Company Act Release No. 21259. No
comments were received on that Analysis. The Commission has
prepared a Final Regulatory Flexibility Analysis ("FRFA") in
accordance with 5 U.S.C. 604. The FRFA states that the
objective of the amendments is to give funds greater
-[87]- 15 USC 80a-2(c).
==========================================START OF PAGE 44======
flexibility in their foreign custody arrangements by
permitting fund boards to delegate their responsibilities to
select and monitor foreign custodians, and by expanding the
class of eligible foreign custodians. The FRFA provides that
approximately 194 funds and 242 investment advisers that are
small entities may be effected by the amendments. The FRFA
explains that the amendments seek to reduce burdens on all
funds, including those that are small entities, and that the
amended rule's compliance requirements are necessary for the
safekeeping of fund assets and investor protection. Finally,
the FRFA states that in adopting the amendments the Commission
considered (a) the establishment of differing compliance
requirements that take into account the resources available to
small entities; (b) simplification of the rule's requirements
for small entities; (c) the use of performance rather than
design standards; and (d) an exemption from the rule for small
entities. The FRFA states that the Commission concluded that
different requirements for small entities are not necessary
and would be inconsistent with investor protection, and that
the amended rule incorporates performance standards to the
extent practicable. Cost-benefit information reflected in the
"Cost/Benefit Analysis" section of this Release also is
reflected in the FRFA. A copy of the FRFA may be obtained by
contacting Robin S. Gross, Mail Stop 10-2, Securities and
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C.
20549.
==========================================START OF PAGE 45======
VII. PAPERWORK REDUCTION ACT
The amendments to rule 17f-5, among other things (i)
permit a fund's board of directors to delegate its
responsibilities under the rule upon a finding that it is
reasonable to rely on the delegate to perform the delegated
responsibilities, and (ii) require the delegate to notify the
board of the placement of the fund's assets with a particular
foreign custodian and of any material change in the fund's
foreign custody arrangements. These provisions constitute a
"collection of information" requirement within the meaning of
the Paperwork Reduction Act of 1995 [44 USC 3501], because
making the finding and providing the notices are necessary to
be able to rely on the amended rule for foreign custody
arrangements. An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of
information unless it displays a currently valid control
number.
Accordingly, the Commission submitted the proposed
amendments to the Office of Management and Budget ("OMB")
pursuant to 44 USC 3507 and received approval of the
amendments' "collection of information" requirements (OMB
control number 3235-0269). As discussed in section III.A. of
this Release, the Commission has determined not to adopt the
proposed amendment requiring a fund's board to make a finding
that placing fund assets in a particular country would provide
reasonable protection for fund assets. The Commission
==========================================START OF PAGE 46======
believes that this is not a material change for purposes of
collection of information requirements and will not have any
impact on the Commission's estimate of total burden hours.
The amended rule does not require that the collection of
information be made public or kept confidential by the
parties; to the extent that the Commission obtains access to
the collection of information through its inspection program,
the information generally would not be available to third
parties.
VIII. STATUTORY AUTHORITY
The Commission is amending rule 17f-5 pursuant to the
authority set forth in sections 6(c) and 38(a) of the
Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-
37(a)].
List of Subjects in 17 CFR Part 270.
Investment companies, Reporting and recordkeeping
requirements, Securities.
TEXT OF RULE
For the reasons set out in the preamble, Title 17,
Chapter II of the Code of Federal Regulations is amended as
follows:
PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF
1940
1. The authority citation for Part 270 continues to
read, in part, as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39
==========================================START OF PAGE 47======
unless otherwise noted;
* * * * *
2. Section 270.17f-5 is revised to read as follows:
270.17f-5. Custody of investment company assets outside the
United States.
(a) Definitions. For purposes of this section:
(1) Eligible Foreign Custodian means an entity that is
incorporated or organized under the laws of a country other
than the United States and that is:
(i) A Qualified Foreign Bank or a majority-owned direct
or indirect subsidiary of a U.S. Bank or bank-holding company;
(ii) A securities depository or clearing agency that acts
as a system for the central handling of securities or
equivalent book-entries in the country that is regulated by a
foreign financial regulatory authority as defined under
section 2(a)(50) of the Act [15 U.S.C. 80a-2(a)(50)]; or
(iii) A securities depository or clearing agency that
acts as a transnational system for the central handling of
securities or equivalent book-entries.
(2) Foreign Custody Manager means a Fund's or a
Registered Canadian Fund's board of directors or any person
serving as the board's delegate under paragraphs (b) or (d) of
this section.
(3) Fund means a management investment company
registered under the Act [15 U.S.C. 80a] and incorporated or
organized under the laws of the United States or of a state.
==========================================START OF PAGE 48======
(4) Qualified Foreign Bank means a banking institution
or trust company, incorporated or organized under the laws of
a country other than the United States, that is regulated as
such by the country's government or an agency of the country's
government.
(5) Registered Canadian Fund means a management
investment company incorporated or organized under the laws of
Canada and registered under the Act pursuant to the conditions
of 270.7d-1.
(6) Securities Depository means a system for the central
handling of securities as defined in 270.17f-4(a).
(7) U.S. Bank means an entity that is:
(i) A banking institution organized under the laws of
the United States;
(ii) A member bank of the Federal Reserve System;
(iii) Any other banking institution or trust company
organized under the laws of any state or of the United States,
whether incorporated or not, doing business under the laws of
any state or of the United States, a substantial portion of
the business of which consists of receiving deposits or
exercising fiduciary powers similar to those permitted to
national banks under the authority of the Comptroller of the
Currency and which is supervised and examined by State or
Federal authority having supervision over banks, and which is
not operated for the purpose of evading the provisions of this
section, or
==========================================START OF PAGE 49======
(iv) A receiver, conservator, or other liquidating agent
of any institution or firm included in paragraphs (a)(7)(i),
(ii), or (iii) of this section.
(b) Delegation. A Fund's board of directors may
delegate to the Fund's investment adviser or officers or to a
U.S. Bank or to a Qualified Foreign Bank the responsibilities
set forth in paragraphs (c)(1), (c)(2), or (c)(3) of this
section, provided that:
(1) The board determines that it is reasonable to rely
on the delegate to perform the delegated responsibilities;
(2) The board requires the delegate to provide written
reports notifying the board of the placement of the Fund's
assets with a particular custodian and of any material change
in the Fund's arrangements, with the reports to be provided to
the board at such times as the board deems reasonable and
appropriate based on the circumstances of the Fund's foreign
custody arrangements; and
(3) The delegate agrees to exercise reasonable care,
prudence and diligence such as a person having responsibility
for the safekeeping of Fund assets would exercise, or to
adhere to a higher standard of care, in performing the
delegated responsibilities.
(c) Selecting an Eligible Foreign Custodian. A Fund may
place and maintain in the care of an Eligible Foreign
Custodian any investments (including foreign currencies) for
which the primary market is outside the United States, and
==========================================START OF PAGE 50======
such cash and cash equivalents as are reasonably necessary to
effect the Fund's transactions in such investments, provided
that:
(1) The Foreign Custody Manager determines that the
Fund's assets will be subject to reasonable care, based on the
standards applicable to custodians in the relevant market, if
maintained with the custodian, after considering all factors
relevant to the safekeeping of such assets, including, without
limitation:
(i) The custodian's practices, procedures, and internal
controls, including, but not limited to, the physical
protections available for certificated securities (if
applicable), the method of keeping custodial records, and the
security and data protection practices;
(ii) Whether the custodian has the requisite financial
strength to provide reasonable care for Fund assets;
(iii) The custodian's general reputation and standing
and, in the case of a Securities Depository, the depository's
operating history and number of participants; and
(iv) Whether the Fund will have jurisdiction over and be
able to enforce judgments against the custodian, such as by
virtue of the existence of any offices of the custodian in the
United States or the custodian's consent to service of process
in the United States.
(2) Contract. The Fund's foreign custody arrangements
must be governed by a written contract (or, in the case of a
==========================================START OF PAGE 51======
Securities Depository, by such a contract, by the rules or
established practices or procedures of the depository, or by
any combination of the foregoing) that the Foreign Custody
Manager has determined will provide reasonable care for Fund
assets based on the standards specified in paragraph (c)(1) of
this section.
(i) Such contract shall include provisions that provide:
(A) For indemnification or insurance arrangements (or
any combination of the foregoing) such that the Fund will be
adequately protected against the risk of loss of assets held
in accordance with such contract;
(B) That the Fund's assets will not be subject to any
right, charge, security interest, lien or claim of any kind in
favor of the custodian or its creditors except a claim of
payment for their safe custody or administration or, in the
case of cash deposits, liens or rights in favor of creditors
of the custodian arising under bankruptcy, insolvency, or
similar laws;
(C) That beneficial ownership for the Fund's assets will
be freely transferable without the payment of money or value
other than for safe custody or administration;
(D) That adequate records will be maintained identifying
the assets as belonging to the Fund or as being held by a
third party for the benefit of the Fund;
(E) That the Fund's independent public accountants will
==========================================START OF PAGE 52======
be given access to those records or confirmation of the
contents of those records; and
(F) That the Fund will receive periodic reports with
respect to the safekeeping of the Fund's assets, including,
but not limited to, notification of any transfer to or from
the Fund's account or a third party account containing assets
held for the benefit of the Fund.
(ii) Such contract may contain, in lieu of any or all of
the provisions specified in paragraph (i), such other
provisions that the Foreign Custody Manager determines will
provide, in their entirety, the same or a greater level of
care and protection for Fund assets as the specified
provisions, in their entirety.
(3)(i) Monitoring the Foreign Custody Arrangements.
The Foreign Custody Manager must have established a system to
monitor the appropriateness of maintaining the Fund's assets
with a particular custodian under paragraph (c)(1) of this
section, and the contract governing the Fund's arrangements
under paragraph (c)(2) of this section.
(ii) If an arrangement no longer meets the requirements
of this section, the Fund must withdraw its assets from the
custodian as soon as reasonably practicable.
(d) Registered Canadian Funds. Any Registered Canadian
Fund may place and maintain outside the United States any
investments (including foreign currencies) for which the
primary market is outside the United States, and such cash and
==========================================START OF PAGE 53======
cash equivalents as are reasonably necessary to effect the
Fund's transactions in such investments, in accordance with
the requirements of this section, provided that:
(1) The assets are placed in the care of an overseas
branch of a U.S. Bank that has aggregate capital, surplus, and
undivided profits of a specified amount, which must not be
less than $500,000; and
(2) The Foreign Custody Manager is the Fund's board of
directors, its investment adviser or officers, or a U.S. Bank.
By the Commission.
Jonathan G. Katz
Secretary
May 12, 1997