-------------------- BEGINNING OF PAGE #1 ------------------- TESTIMONY OF BARRY P. BARBASH, DIRECTOR DIVISION OF INVESTMENT MANAGEMENT UNITED STATES SECURITIES AND EXCHANGE COMMISSION OCTOBER 31, 1995 CONCERNING H.R. 1495, THE INVESTMENT COMPANY ACT AMENDMENTS OF 1995 EXECUTIVE SUMMARY The Investment Company Act Amendments of 1995 would improve, and help bring into the 21st century, many aspects of investment company operation and regulation. The Commission welcomes the opportunity to fine tune and enhance the Investment Company Act. The Commission recognizes that the bill represents a "work in progress." The Commission stands ready to work with the Subcommittee in this effort to improve and modernize investment company regulation. The goal of the Investment Company Act Amendments of 1995 - - to improve and modernize the Investment Company Act -- is one that the Commission itself has been seeking to achieve over the past several years. During 1995, the Commission undertook many actions -- particularly in the disclosure area -- with this purpose in mind. Several Commission initiatives are especially notable, such as the "profile prospectuses" currently being tested among investor groups and the proposed short-form prospectus for money market funds. The Commission also proposed rule amendments to reduce the burdens placed on fund directors in reviewing foreign custody arrangements. The Investment Company Act Amendments of 1995 would: * provide funds with significantly more flexibility in their advertising practices and give the Commission rulemaking authority to address deceptive and misleading fund names; * strengthen the role of independent directors and update shareholder voting requirements and related procedures; * lift restrictions on a mutual fund's investments in other funds; * give fund sponsors the option of offering a new type of mutual fund that has a single fee covering all fund services and most expenses; * facilitate the Commission's efforts to increase the efficiency and effectiveness of its investment company inspections program, as well as help the Commission obtain important information about funds in times of market stress; and * simplify the existing exception for "private" investment companies with no more than 100 investors and create a new exception from Investment Company Act regulation for investment pools whose only shareholders are highly sophisticated investors. The Commission generally supports the proposed legislation, although we have concerns about the potential effects of the amendment that would change the vote of fund shareholders -------------------- BEGINNING OF PAGE #2 ------------------- required to approve certain actions taken by a fund. The Commission also has several recommendations intended to refine certain proposals. ---------------------------------------------------------------- TESTIMONY OF BARRY P. BARBASH, DIRECTOR DIVISION OF INVESTMENT MANAGEMENT UNITED STATES SECURITIES AND EXCHANGE COMMISSION CONCERNING H.R. 1495, THE INVESTMENT COMPANY ACT AMENDMENTS OF 1995 BEFORE THE SUBCOMMITTEE ON TELECOMMUNICATIONS AND FINANCE COMMITTEE ON COMMERCE UNITED STATES HOUSE OF REPRESENTATIVES October 31, 1995 Chairman Fields and Members of the Subcommittee: I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission (the "Commission" or "SEC") on the proposed amendments designed to improve and modernize the Investment Company Act of 1940 (the "Investment Company Act" or the "Act"). I. INTRODUCTION The review of the Investment Company Act reflected in the Investment Company Act Amendments of the 1995 comes at an especially appropriate time. A quarter of a century has passed since the Act was last significantly revised by the Congress.-[1]- The changes in the investment company (or "fund") industry since that time have been dramatic. In 1970, investors could choose from among 361 open-end management investment companies ("mutual funds").-[2]- Today, over 5,500 mutual funds (almost twice the number of stocks trading on the New York and American Stock Exchanges)-[3]- and over 500 closed-end management investment companies ("closed-end funds") are available to investors.-[4]- Funds, which in 1970 held approximately $48 billion in assets,-[5]- now hold over $3 trillion in assets.- [6]- --------- FOOTNOTES --------- -[1]- Investment Company Amendments Act of 1970, Pub. L. No. 91-547, 84 Stat. 1413 (1970). See also Small Business Incentive Act of 1980, Pub. L. No. 96-477, 94 Stat. 2275 (1980) (amending the Investment Company Act to create business development companies). -[2]- INVESTMENT COMPANY INSTITUTE, MUTUAL FUND FACT BOOK (1990) (hereinafter ICI 1990 FACT BOOK). -[3]- Figures compiled by the Commission staff. -[4]- Figures compiled by the Commission staff. -[5]- ICI 1990 FACT BOOK, supra note 2. -[6]- Figures compiled by the Commission staff. -------------------- BEGINNING OF PAGE #3 ------------------- That nearly one third of all U.S. households own investment company shares attests to the enormous significance of the fund industry to our country's economy and its citizens. Americans have entrusted their retirement monies, savings for their children's education, and even their ready cash to investment companies. The Investment Company Act Amendments of 1995 would improve, and help bring into the 21st century, many aspects of investment company operation and regulation.-[7]- The legislation would complement the Commission's emphasis on better communications to investors by allowing the Commission to make its advertising rules more flexible and by giving the Commission rulemaking authority to address deceptive and misleading fund names. The legislation would reinforce the importance of the role of independent directors, as well as address shareholder voting requirements and related corporate governance procedures. The legislation would facilitate the development of new types of investment products by lifting restrictions on a mutual fund's investments in other funds and by giving fund sponsors the option of offering a new type of mutual fund that has a single fee covering all fund services and most expenses. The legislation also would facilitate the Commission's efforts to increase the efficiency and effectiveness of its investment company inspections program, as well as help the Commission obtain important information about funds in times of market stress. Finally, the legislation would simplify the existing exception from Investment Company Act regulation for "private" investment companies with no more than 100 investors and create a new exception for investment pools whose only shareholders are highly sophisticated investors. The Commission welcomes this opportunity to fine-tune and enhance the Act, which has been characterized by the fund industry's leading trade association as "a model of effective legislation."-[8]- The Commission recognizes, as Chairman Fields said when the legislation was introduced, that the bill represents a "work in progress."-[9]- The Commission looks forward to working with the Subcommittee and its staff in this effort to improve and modernize investment company regulation. II. RECENT COMMISSION INITIATIVES The goal of the Investment Company Act Amendments of 1995 - - to improve and modernize the Investment Company Act -- is one that the Commission itself has been seeking to achieve over the past several years. During this year, for instance, the Commission has undertaken many initiatives -- particularly in the disclosure area -- with this purpose in mind. Among the --------- FOOTNOTES --------- -[7]- Some of the amendments were recommended by the Commission's Division of Investment Management in its 1992 report on investment company regulation. Division of Investment Management, SEC, PROTECTING INVESTORS: A HALF CENTURY OF INVESTMENT COMPANY REGULATION (1992) (hereinafter PROTECTING INVESTORS REPORT). -[8]- Oversight Hearings on the Mutual Fund Industry: Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing, and Urban Affairs, 103rd Cong., 1st Sess. 94 (1993) [hereinafter 1993 Oversight Hearings] (prepared statement of Matthew P. Fink, President, Investment Company Institute). -[9]- 141 CONG. REC. E868 (daily ed. Apr. 7, 1995). -------------------- BEGINNING OF PAGE #4 ------------------- Commission's most recent significant initiatives are the following: Profile Prospectuses. The Commission has worked, and will continue to work, closely with the fund industry to promote investor protection by identifying ways to improve fund disclosure documents and eliminate unnecessary requirements. This summer, with the encouragement and strong support of Chairman Levitt, the Commission's Division of Investment Management (the "Division") cooperated with state regulators in facilitating the fund industry's development of "profile prospectuses." The key element of these prospectuses is a short summary or "profile" of 3 to 4 pages in length that accompanies a fund's prospectus and outlines the fund's key features. This approach, premised on the view that many investors will find that "less is often more" in mutual fund disclosure documents, is designed to encourage greater understanding and less confusion among mutual fund investors. Prototype profiles are now being used by six fund groups. A number of these fund groups, the Investment Company Institute, the Commission and state regulators all anticipate conducting investor research to assess the effectiveness of the profile prospectuses as disclosure documents. Upon completion of this testing, the Commission will focus on issues such as whether the profile concept should be incorporated into Commission rules and whether profiles should be used as stand-alone disclosure documents. The Commission appreciates Chairman Fields's recent praise of the profile concept and his support of this initiative.-[10]- Summary Document for Employee Benefit Plans. A number of observers have suggested that a short-form disclosure document resembling the profile would be particularly useful to participants in and beneficiaries of employee benefit plans. This past year, the Division, in a letter to the country's largest mutual fund group, facilitated the development of just such a document.-[11]- Short-Form Money Market Fund Prospectus. In another recent initiative designed to provide investors with more understandable disclosure documents, the Commission proposed a short-form prospectus for money market funds.-[12]- The proposal would tailor existing prospectus disclosure requirements to the unique characteristics of money market funds and the needs of money market fund investors. The proposal would promote the use of money market fund prospectuses that are simpler, shorter, and more informative. The Division anticipates that this will be the first proposal in a series of rulemakings designed to improve fund disclosure. Commission Review of Fund Disclosure Documents. The Commission's efforts to improve disclosure have extended beyond a review of applicable disclosure requirements to a reassessment of --------- FOOTNOTES --------- -[10]- See Letter from Jack Fields, Chairman, House Subcomm. on Telecommunications and Finance, to Arthur Levitt, Chairman, SEC (July 31, 1995). -[11]- Kirkpatrick & Lockhart (pub. avail. Apr. 5, 1995) (on behalf of Fidelity Institutional Retirement Services Co., Inc.). -[12]- Money Market Fund Prospectuses, Securities Act Release No. 7196 (July 19, 1995), 60 FR 38454. -------------------- BEGINNING OF PAGE #5 ------------------- the process by which the staff reviews disclosure documents. We recognize that funds may be in a better position to improve the quality and readability of their prospectuses if the Commission improves this process. Last year, the Commission amended the rules governing the review of fund prospectuses to make the process more efficient for the funds as well as the Commission staff.-[13]- This year, the Division, in addition to reevaluating a number of its existing disclosure interpretations, appointed a disclosure ombudsman to the fund industry who has been working closely with funds to resolve disclosure issues and improve the quality of prospectuses. Electronic Communications. In recognition of the growing use of the information superhighway by investors, the Commission recently issued interpretive guidance and proposed rules designed to assist funds and other issuers in using electronic media to provide investors with information required under the federal securities laws. The Commission hopes that this action will encourage the use of these media.-[14]- Operational Initiatives. The Commission's efforts to update its regulation of investment companies have included not only disclosure initiatives, but also measures intended to reduce operational burdens on investment companies. Early this year, the Commission adopted rules to allow a single mutual fund to offer multiple classes of shares with different sales charge arrangements and to permit mutual funds to impose certain types of deferred sales loads.-[15]- These rules give funds greater flexibility to tailor their sales load arrangements without having to apply to the Commission for exemptive relief. In August of this year, the Commission proposed amendments to the Investment Company Act rule governing the custody of fund assets outside the United States.-[16]- The amendments, if adopted, would reduce the burdens currently placed on fund directors in reviewing foreign custody arrangements and provide funds with significantly more flexibility to select foreign custodians without sacrificing investor protection. The Commission is committed to leaving no regulatory stone unturned in seeking to improve its oversight of the fund business. Thus, the Commission staff is working with the fund --------- FOOTNOTES --------- -[13]- Post-Effective Amendments to Investment Company Registration Statements, Securities Act Release No. 7083 (Aug. 17, 1994), 59 FR 43460. -[14]- Use of Electronic Media for Delivery Purposes, Securities Act Release Nos. 7233 and 7244 (Oct. 16, 1995), 60 FR 53458, 53468. -[15]- Exemption for Open-End Management Investment Companies Issuing Multiple Classes of Shares, Securities Act Release No. 7143 (Feb. 23, 1995), 60 FR 11876; Exemption for Certain Open-End Management Investment Companies to Impose Contingent Deferred Sales Loads, Investment Company Act Release No. 20916 (Feb. 23, 1995), 60 FR 11887. -[16]- Custody of Investment Company Assets Outside the United States, Investment Company Act Release No. 21259 (July 27, 1995), 60 FR 39592. -------------------- BEGINNING OF PAGE #6 ------------------- industry to review other rules that should be modernized or that impose unnecessary burdens, and the Commission expects that additional revisions to its rules will be forthcoming in the coming year. During the coming year and beyond, the Commission intends to continue to improve investment company regulation and remove unnecessary regulatory burdens. Our efforts themselves can be enhanced and improved by Congress's retooling certain provisions of the Investment Company Act. III. THE INVESTMENT COMPANY ACT AMENDMENTS OF 1995 The Investment Company Act Amendments of 1995 represent the most significant and comprehensive attempt at improving the Act undertaken in the past twenty-five years. The changes that would be effected by the proposed legislation are described in detail below. Corporate Governance Provisions. The successful and safe operation of the fund industry over the last several decades is due in large part to the system of "checks and balances" prescribed by the Investment Company Act. The heart of the Act is a series of prohibitions on dealings between funds and their sponsors designed to ensure that the conflicts of interest and other abusive conduct that characterized the U.S. fund industry in the 1920s and 1930s are not repeated. To supplement these prohibitions, the Act requires that fund boards include members who are independent of the fund's sponsor and that fund boards monitor and address certain conflicts between the interests of fund insiders and shareholders. The Act also provides shareholders with a voice concerning fundamental changes in a fund's management or operations. For some time, commentators have debated the effectiveness of the Act's corporate governance provisions.-[17]- Some have suggested that fund directors do not provide any real check on fund management and that shareholder voting is perfunctory and imposes unnecessary costs on funds. Others argue that the inherent conflicts between fund sponsors and shareholders make it uniquely appropriate for fund directors to have an active role in governance, and that directors generally have performed their responsibilities well. These commentators also assert that shareholder votes provide a valuable communicative and deterrent function. The Commission believes that the core concepts of the governance model embodied in the Act are sound and appear to have worked well.-[18]- The Commission believes, however, that certain of the Act's governance provisions could be improved. The legislation would strengthen the independence of fund boards of directors and update the Act's shareholder voting requirements and related procedures. The Commission supports --------- FOOTNOTES --------- -[17]- See PROTECTING INVESTORS REPORT, supra note 7, at 251- 82. See also notes 61 and 62 and accompanying text (discussing alternatives to the current corporate governance model embodied in the Act in connection with the proposed unified fee investment company). -[18]- Representatives of the fund industry appear to agree as to the importance of fund boards as watchdogs for shareholders' interests and as a check on fund sponsors. See 1993 Oversight Hearings, supra note 8, 83 (prepared statement of Matthew P. Fink, President, Investment Company Institute). -------------------- BEGINNING OF PAGE #7 ------------------- these amendments, although we have concerns about the potential effects of an amendment that would change the vote of fund shareholders required to approve certain actions taken by a fund. Board of Directors. The Commission, particularly over the past two years, has stressed the importance of fund boards in the success of the fund industry. Chairman Levitt has said that a fund's independent directors are "the frontlines of investor protection."-[19]- Commissioner Wallman noted recently that they "play an essential role in a remarkable industry."-[20]- Recognizing the importance of fund boards, the legislation would enhance board independence by raising the required minimum percentage of independent directors on a board from forty percent to a majority.-[21]- We understand that this reflects the composition of many fund boards today. The legislation would therefore codify what would appear to be the norm in fund governance. The legislation also would give independent directors the sole responsibility for selecting and nominating other independent directors.-[22]- The legislation would further strengthen the independent directors' ability to protect shareholder interests by giving independent directors the express authority to terminate investment advisory contracts.-[23]- At present, independent directors, along with the full board, are responsible for evaluating and approving the initial advisory contract and any subsequent renewals. While the full board and the fund's shareholders can terminate an advisory agreement at any time, the independent directors currently do not have this authority under --------- FOOTNOTES --------- -[19]- See Arthur Levitt, Chairman, SEC, Remarks at the Second Annual Symposium for Mutual Fund Trustees and Directors, Washington, D.C. (Apr. 11, 1995); Arthur Levitt, Chairman, SEC, Remarks at the Mutual Funds and Investment Management Conference, Scottsdale, AZ (Mar. 21, 1994). "Independent directors" are directors who are not "interested persons" of an investment company under section 2(a)(19) of the Act. 15 U.S.C. Section 80a-2(a)(19). -[20]- See Steven M.H. Wallman, Commissioner, SEC, Remarks before the Investment Company Institute's 1995 Investment Company Directors Conference and New Directors Workshop, Washington, D.C. (Sept. 22, 1995). -[21]- Section 2(a) of H.R. 1495 (amending section 10(a) of the Investment Company Act, 15 U.S.C. Section 80a-10(a)). -[22]- Section 2(a) of H.R. 1495 (amending section 10(a) of the Investment Company Act). See also section 16(a) of the Act, 15 U.S.C. Section 80a-16(a) (regarding shareholder approval of fund directors). -[23]- Section 2(b) of H.R. 1495 (amending section 15(a) of the Investment Company Act, 15 U.S.C. Section 80a-15(a)). A similar approach is taken by certain Commission rules that require certain determinations be made by independent directors. See, e.g., rule 12b-1 under the Investment Company Act, 17 CFR Section 270.12b-1 (requiring that payment of asset- based sales charges by mutual funds only be made in accordance with a plan approved by a majority of the fund's independent directors). -------------------- BEGINNING OF PAGE #8 ------------------- the Act. The legislation would close this gap in fund governance. Shareholder Voting. Reflected in the Act is the view that fund shareholders should have a voice on matters that fundamentally affect fund operations or the nature of their investment. A fund's investment objective is a key indicator of the potential risks and rewards inherent in investing in the fund. The objective often forms the basis for the decision to invest and remain invested in a fund. The legislation would recognize the significance of a fund's investment objective by requiring changes in the objective to be approved by the fund's shareholders.-[24]- The legislation also would update the Investment Company Act's shareholder voting provisions by eliminating two requirements that appear to provide only minimal investor protection. Under existing law, a fund's initial agreement with its investment adviser must be voted upon by the fund's shareholders. This shareholder approval is virtually automatic since persons who supply the fund with its initial capital typically become shareholders of the fund and approve the advisory agreement prior to the fund's commencing a public offering of its shares. Moreover, investors participating in the fund's initial public offering, in effect, vote with their dollars to accept the fund's initial advisory arrangement. The legislation recognizes this view and would eliminate the perfunctory initial investment advisory agreement approval requirement.-[25]- Another provision affording minimal investor protection that would be removed by the legislation is the Act's requirement that shareholders ratify the independent directors' selection of a fund's auditors.-[26]- Shareholder ratification currently is --------- FOOTNOTES --------- -[24]- Sections 2(d) and 2(e) of H.R. 1495 (amending section 8(b)(1) of the Investment Company Act, 15 U.S.C. Section 80a-8(b)(1), to require funds to adopt their investment objectives as a fundamental policy, and section 13(a)(1), 15 U.S.C. Section 80a-13(a)(1), to require shareholder approval to change the objective). -[25]- Section 2(b) of H.R. 1495 (amending section 15(a) of the Investment Company Act, 15 U.S.C. Section 80a- 15(a)). As drafted, the provision appears to eliminate the requirement for shareholders to approve advisory agreements in all cases, even when the agreement has been entered into after the commencement of a fund's public offering. See W. John McGuire, Legislation Signals Congressional Intent to Review Investment Company Regulation, 2 INVESTMENT LAW. 17, 18 (1995). We do not believe that this result was intended and suggest that this provision be clarified to eliminate any confusion. -[26]- Section 2(c) of H.R. 1495 (amending section 32(a) of the Investment Company Act, 15 U.S.C. Section 80a-31(a)). The proposed amendment also would replace the current timeframes within which directors must select the auditors by codifying the requirements of rule 32a-3 under the Investment Company Act, 17 CFR Section 270.32a-3, which governs the board's selection of auditors when annual shareholders meetings are not held. In the case of a fund that belongs to a (continued...) -------------------- BEGINNING OF PAGE #9 ------------------- required only for funds that hold annual shareholders' meetings. The legislation appropriately would leave the selection of auditors to the board in all cases. If shareholders are dissatisfied with the directors' decision, the shareholders can vote to terminate the auditors at any time.-[27]- The legislation would address shareholder voting procedures in "master-feeder" fund arrangements. In a master-feeder arrangement, one or more funds ("feeder" funds) invest solely in the shares of another fund ("master" fund).-[28]- When a matter is submitted for approval by the master fund's shareholders, the Investment Company Act requires feeder funds to seek voting instructions from their shareholders and vote accordingly ("pass- through voting").-[29]- This provision seeks to place control of matters that fundamentally affect the master fund's operations and investments in the hands of the feeder funds' shareholders.-[30]- Because the master-feeder voting provision initially was enacted to address concerns about unregistered foreign funds investing in and exercising control over U.S. funds, it applies only to unregistered feeder funds.-[31]- The legislation would recognize that feeder funds' shareholders should have a say in the fundamental decisions affecting the master fund in all cases. Thus, the legislation would extend the Act's voting provision to registered feeder funds as well.-[32]- --------- FOOTNOTES --------- -[26]-(...continued) group (or "set") of related investment companies with different fiscal years, the selection could be made within 90 days before or after the beginning of the fund's fiscal year. In all other cases, the selection could be made within 30 days before or 90 days after the beginning of a fund's fiscal year. -[27]- Section 32(a) of the Investment Company Act. -[28]- This two-tier structure is permitted by section 12(d)(1)(E) of the Investment Company Act, 15 U.S.C. Section 80a-12(d)(1)(E). -[29]- Section 12(d)(1)(E)(iii)(aa) of the Investment Company Act. This provision also allows feeder funds, as an alternative to pass-through voting, to vote their shares in the master fund in the same proportion as the votes cast by the other feeder funds ("echo voting"). -[30]- See, e.g., SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. Rep. No. 2337, 89th Cong., 2d Sess. 316-322 (1966) (discussing the dangers created when control is exercised by a fund holding company) (hereinafter PPI REPORT). -[31]- See, e.g., H.R. REP. NO. 1382, 91st Cong., 2d Sess. 23- 24 (1970). -[32]- Section 2(f) of H.R. 1495 (amending section 12(d)(1)(E) of the Investment Company Act). Because feeder funds that register with the Commission have agreed in their registration statements to provide pass-through voting for their shareholders, the legislation would not impose any additional burdens on registered feeder funds. -------------------- BEGINNING OF PAGE #10 ------------------- Definition of Majority Vote. The Investment Company Act currently requires certain important matters to be approved by the vote of a "majority of the fund's outstanding shares."-[33]- Under the Act, the vote of a majority of a fund's outstanding shares means the lesser of (a) the vote of at least 67% of shares present at a meeting, if the holders of more than 50% of the outstanding shares are present at the meeting, or (b) the vote of more than 50% of the outstanding shares.-[34]- Under this provision, any matter subject to the Act's majority vote requirement must be approved by the holders of more than 33.5% of a fund's shareholders (i.e., 67% of the shares present at a meeting when a majority (more than 50%) of the outstanding shares are present). For purposes of the provision, shares represented by proxy are considered present, regardless of whether the proxies provide voting instructions. The small amount of legislative history on the majority vote requirement suggests that the provision was intended to prevent the holders of a small block of a fund's shares from controlling the fund.-[35]- Many funds have advised us of the considerable time they expend and of the costs they incur in seeking the requisite majority votes, particularly when a large number of proxies provide no voting instructions.-[36]- The legislation seeks to address these difficulties and give shareholders who have provided voting instructions on specific matters the right to decide these matters. Thus, the legislation would amend the Act to provide that a matter subject to the Act's majority vote requirement would need to be approved by only a majority of the shares voting on the matter at a meeting.-[37]- The effect of the amendment would be to reduce significantly the number of shares required to obtain shareholder approval for important matters such as increases in advisory fees and changes --------- FOOTNOTES --------- -[33]- See, e.g., Investment Company Act Section 15(a) (requiring a majority shareholder vote to approve increases in a fund's investment advisory fees); Section 13(a), 15 U.S.C. Section 80a-13(a) (requiring a majority shareholder vote to approve certain changes in a fund's investment policy). If the proposed amendment to section 13(a) is adopted, a majority shareholder vote also would be required to approve changes in a fund's investment objective. -[34]- Investment Company Act Section 2(a)(42)(a)-(b), 15 U.S.C. Section 80a-2(a)(42)(a)-(b). -[35]- See, e.g., Jaretzki, The Investment Company Act of 1940, 26 Wash.U.L.Q. 303, 316-317 (1941). -[36]- Shareholder abstentions often take the form of so- called "broker non-votes." Broker non-votes generally are shares held in record name by a broker for which the broker does not have discretionary voting power or voting instructions from the beneficial owner. While the non-votes are effectively negative votes, they do assist the fund in obtaining a quorum. -[37]- Section 2(g) of H.R. 1495 (amending section 2(a)(42) of the Investment Company Act). The amendment would not change the existing provision in section 2(a)(42) that effectively requires a majority of the fund's outstanding shares to be present at a meeting to constitute a quorum. -------------------- BEGINNING OF PAGE #11 ------------------- in a fund's investment policies. Under the proposed amendment, for example, these matters could be approved by a small percentage of a fund's outstanding shares (e.g., 10.1%) when a relatively small percentage of the shares present at a meeting (e.g., 20%) give voting instructions. In contrast, the Act's existing majority vote provision, as noted above, requires an affirmative vote of more than 33.5% of a fund's outstanding shares. The Commission acknowledges that the proposed definition of majority vote contained in the legislation is similar to that included in certain state corporation laws.-[38]- The Commission also recognizes that the new requirement would likely result in funds' incurring lower costs in connection with proxy solicitations. The Commission is concerned, however, that the new definition could in many cases result in a dilution of shareholder voting rights, which the Act historically has deemed most important. We are not aware of any concrete data that demonstrates a systemic lack of interest among fund shareholders in exercising their right to vote on important matters. We would be in a better position to assess this provision if such data were available. Investment Company Advertising Prospectus. Advertising is particularly important to mutual funds because they continuously offer and sell their shares to the public. Like other public issuers of securities, funds are subject to the advertising requirements of the Securities Act of 1933 (the "Securities Act"). That regulatory scheme, however, has proved to be problematic when applied to fund advertising. Currently, funds may advertise performance data and other information, so long as the "substance of" that information is contained in the fund's prospectus. These advertisements are subject to liability for false or misleading statements. As a result of the "substance of" requirement, funds often cannot advertise matters of investor interest, such as policies that a fund will not use derivatives or the effect of economic conditions on the fund's investment policies, since these matters may not have been addressed in the fund's prospectus and related statement of additional information.-[39]- Funds often attempt to avoid this result by cluttering their prospectus (or the --------- FOOTNOTES --------- -[38]- See, e.g., MD. CODE ANN., CORPS. & ASS'NS Section 2- 506 (1993). -[39]- Dudley H. Ladd, Why It's Time to Change the Advertising and Newsletter Rules, in 1995 MUTUAL FUNDS AND INVESTMENT MANAGEMENT CONFERENCE IV-B-11 (Federal Bar Assoc. and CCH Inc., 1995). Form N-1A, 17 CFR Section 274.11A, the mutual fund registration form under the Investment Company Act and the Securities Act, 15 U.S.C. Section 77a et seq, incorporates a two part disclosure format consisting of (i) a simplified prospectus, that satisfies the prospectus delivery requirements of section 5(b)(2) of the Securities Act, 15 U.S.C. 77e(b)(2), and (ii) a statement of additional information, available to investors upon request. A fund's advertisement will satisfy the "substance of" requirement if information to be included in fund advertisements (but not otherwise required to be included in the prospectus) is placed in the statement of additional information and incorporated by reference into the prospectus. -------------------- BEGINNING OF PAGE #12 ------------------- related statement of additional information) with information they may later want to include in advertisements. The legislation would improve fund advertising by giving the Commission express authority to create a new investment company "advertising prospectus."-[40]- The amendment would enable funds to use such a prospectus to show performance data and other information unrestricted by the "substance of" requirement. Providing funds with greater flexibility to determine the content of their advertisements should not undermine investor protection; the advertising prospectus generally would be subject to the liability provisions of the Securities Act applicable to prospectuses.-[41]- As Chairman Fields noted in introducing the legislation, the new advertising prospectus would bring "a new era of generally improved communications to mutual fund investors."-[42]- The Commission agrees with this assessment and supports this initiative. The legislation also would further the Commission's efforts to develop shorter, more "investor-friendly" disclosure documents, since advertisements would no longer be tied to the contents of a fund's prospectus.-[43]- The proposal also may increase the amount of information about funds that reaches investors, which should, in turn, benefit investors and funds. Books, Records and Inspections. Because the success of the investment company industry depends greatly on public trust, both the fund industry and the Commission agree on the importance of the Commission's inspections program.-[44]- As the Commission and others have noted to Congress repeatedly over the recent past, the ability of the Commission to conduct fund inspections has been affected by a scarcity of resources.-[45]- As --------- FOOTNOTES --------- -[40]- Section 3 of H.R. 1495 (creating new section 24(g) of the Investment Company Act). -[41]- The advertising prospectus also would be subject to the summary suspension procedures under section 10(b) of the Securities Act, 15 U.S.C. Section 77j(b), permitting the Commission to take prompt action to prevent the use or distribution of materially false or misleading advertisements. The Commission also could require advertising prospectuses to comply with the same standards for calculating performance information included in current advertisements. See rule 482 under the Securities Act, 17 CFR Section 230.482. -[42]- 141 CONG. REC. E868 (Apr. 7, 1995). -[43]- See, e.g., Arthur Levitt, Chairman, SEC, Remarks at the National Press Club, Washington, D.C. (Oct. 13, 1994). -[44]- See, e.g., Mutual Fund Industry: Hearings Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, 103rd Cong., 2d Sess. 49 (1994) (statement of Matthew P. Fink, President, Investment Company Institute). -[45]- See, e.g., 1993 Oversight Hearings, supra note 8, 55- 57 (prepared statement of Arthur Levitt, Chairman, SEC); See also Mutual Fund Industry: Hearings Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce (prepared statement of Matthew P. Fink, President, Investment Company Institute). -------------------- BEGINNING OF PAGE #13 ------------------- investors have entrusted more and more of their savings to mutual funds, as the number and type of funds have proliferated, and as funds have invested in increasingly complex financial instruments, including derivatives, the Commission's resources to fulfill its responsibilities as a law enforcement agency have lagged far behind. The Commission has itself attempted to address this problem by utilizing its limited resources more efficiently. In its latest effort, the Commission consolidated all of its inspection programs into a new office, the Office of Compliance Inspections and Examinations. By giving our examination process a more unified perspective, we will not only better apply our limited resources, but also strengthen and improve the process. The Commission believes that more can and should be done to enhance its fund inspections program. The provisions of the legislation relating to books, records, and inspections would assist the Commission in improving and making the program more efficient. The Commission supports these amendments. The Commission inspects investment companies to evaluate compliance with statutory provisions, assess the accuracy of disclosures made to investors, and review internal control systems. Fund examinations promote regulatory compliance by deterring as well as detecting abuses. Our experience has been that most funds understand the goals and benefits of the inspections program and cooperate fully with requests for information made by the staff conducting inspections. The Investment Company Act permits the Commission to inspect records that funds are required to maintain under Commission rules.-[46]- Under the Act, however, the Commission can require a fund to maintain only those records that relate to the fund's financial statements.-[47]- Many matters that could shed light on a fund's operations and facilitate more comprehensive inspections, however, may not be reflected in records related to the fund's financial statements. The legislation would reduce the existing limitations on, and further clarify, the Commission's authority to require funds to maintain various records.-[48]- In so doing, the legislation would make the recordkeeping requirements of the Investment Company Act similar to those applicable to broker-dealers and depository institutions under the Securities Act of 1934 and --------- FOOTNOTES --------- -[46]- Investment Company Act Section 31(b), 15 U.S.C. Section 80a-30(b). -[47]- Section 31(a) of the Investment Company Act, 15 U.S.C. Section 80a-30(a); rule 31a-1 under the Act, 17 CFR Section 270.31a-1. -[48]- Section 4 of H.R. 1495 (amending section 31(a) of the Investment Company Act to require investment companies to keep such records as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors). The legislation also would amend section 31(b) of the Act to allow examiners to obtain copies of fund records without seeking a formal order. Consistent with current requirements, the amendments would apply to registered investment companies and certain fund affiliates, including investment advisers and principal underwriters. -------------------- BEGINNING OF PAGE #14 ------------------- thereby strengthen the Commission's inspections program.-[49]- The Commission could use its rulemaking authority to facilitate examinations of fund transactions that present novel investor protection issues, such as derivative investments, which often are documented in records unrelated to the financial statements. The legislation seeks to increase the efficiency of the Commission's inspections program by clarifying the Commission's authority to specify the format for maintaining and providing records to the Commission.-[50]- The Commission expects to use this authority, at least initially, not to require that funds maintain records in a particular medium (e.g., on computer disk), but simply to clarify that the Commission can request that records maintained by funds in a given medium be provided to the Commission in that medium. The Commission acknowledges that the authority provided under the legislation would enable it to require funds to maintain records in an electronic format. Such a requirement, the Commission submits, could significantly improve the efficiency of the Commission's fund inspections program. Allowing the staff to review fund information electronically prior to commencing on-site inspections, for example, could reduce dramatically the amount of staff time spent at a fund's offices, and thereby lessen regulatory burdens on funds. The Commission recognizes that the benefits of requiring fund records to be kept in a particular medium must be balanced against the burdens of such a requirement on the fund industry. Moreover, the Commission is acutely aware of the potential costs and difficulties new electronic recordkeeping requirements could create for funds. The legislation acknowledges these potential concerns by expressly requiring that the Commission, in exercising its new recordkeeping authority, seek to minimize burdens on small entities. The Commission appreciates that recordkeeping requirements present potential burdens for all funds, large and small, and would exercise this authority with a view to minimizing burdens on all funds. The fund industry in the past has acknowledged that the Commission and its staff have been successful in adapting the Act to "a fast-changing marketplace through rulemaking, exemptive orders and no-action letters."-[51]- The Commission believes that it can update the Act's recordkeeping requirements in the same spirit. Reports to the Commission and Shareholders. The significant growth of the fund industry underscores the need for the Commission to be able to monitor fund operations and investment activities. The Commission currently has the authority to require fund reports on a semi-annual or quarterly basis.-[52]- Under the existing regulatory scheme, the Commission's authority --------- FOOTNOTES --------- -[49]- See, e.g., sections 17(a) and (b) of the Securities Exchange Act of 1934 ("Securities Exchange Act"), 15 U.S.C. 78q(a)-(b). -[50]- Section 4 of H.R. 1495 (creating new section 31(c) of the Investment Company Act). -[51]- 1993 Oversight Hearings, supra note 8, 70 (testimony of James S. Riepe, Managing Director, T. Rowe Price Associates, Inc.) -[52]- Sections 30(a) and (b) of the Investment Company Act, 15 U.S.C. Section 80a-29(a), -(b). See also rule 30b1-1 under the Act, 17 CFR Section 270.30b1-1 (requiring funds to file semi-annual reports). -------------------- BEGINNING OF PAGE #15 ------------------- to require prompt reports from funds during times of market stress, for example, is limited. Typically, to obtain such information, the Commission must await the next periodic filings, initiate inspections, or rely on voluntary efforts by the industry. The legislation would allow the Commission to improve its access to information by authorizing the Commission to specify, by rule, the frequency of fund reporting.-[53]- The legislation also would make clear that the Commission has rulemaking authority to obtain information on fund portfolios and sales and redemption activity, as well as other information that may help identify particular funds or patterns of events that require closer scrutiny.-[54]- Thus, rulemaking authority would enable the Commission to adapt the content of fund reports to changing market and industry conditions. The legislation would broaden the Commission's authority to prescribe the content of annual reports to fund shareholders.-[55]- The Commission would be able to require annual reports to contain pertinent investor information, such as a fund's investment activities underlying its recent performance results.-[56]- This, in turn, may help reduce the length and complexity of fund prospectuses and better inform investors of the risks of their fund investments. As in the case of recordkeeping requirements, the Commission is sensitive to the costs and burdens that additional reporting requirements might impose on funds. The Commission would exercise its new authority under this provision cautiously. The Commission believes that the goals of more efficient oversight by --------- FOOTNOTES --------- -[53]- Section 5 of H.R. 1495 (amending section 30(b) of the Investment Company Act). The Commission has similar authority with respect to registered broker-dealers under section 17(a) of the Securities Exchange Act, 15 U.S.C. Section 78q(a) (authorizing the Commission to require broker-dealers to make and disseminate a broad range of reports). See also section 17(h)(2) of the Securities Exchange Act, 15 U.S.C. Section 78q(h)(2) (authorizing the Commission, in times of adverse market conditions, to require registered broker-dealers to file reports concerning the financial and securities activities of their associated persons) and note 49 supra. -[54]- Section 5 of H.R. 1495 (amending section 30(b) of the Investment Company Act to give the Commission rulemaking authority to request information that is necessary or appropriate in the public interest or for the protection of investors). Existing section 30(b) of the Act limits fund reporting to information that is necessary to keep a fund's registration statement current. -[55]- Section 5 of H.R. 1495 (amending section 30(d) of the Investment Company Act, 15 U.S.C. Section 80a-29(d), which currently limits the Commission's authority to prescribing the content of financial statements contained in annual reports). -[56]- Such rulemaking would be particularly beneficial for the shareholders of closed-end funds who, unlike their mutual fund counterparts, receive updates on fund activities only in the form of annual reports. -------------------- BEGINNING OF PAGE #16 ------------------- the Commission, and more informative shareholder reports, are not inconsistent with reducing regulatory burdens on the industry. The Commission supports both amendments. Unified Fee Investment Company. As the investment company industry has grown and diversified, the variety of fees for services related to fund operations also has increased. The legislation would provide sponsors with the alternative of offering a mutual fund, termed a unified fee investment company or "UFIC," that would charge a single fee.-[57]- The proposed single fee structure could facilitate cost comparisons among funds, which, in turn, could increase competition and place downward pressure on fee levels. The Commission supports the UFIC concept. The UFIC envisioned by the legislation would generally have the same corporate structure as that of a typical mutual fund, including a board of directors. With limited exceptions, all UFIC expenses would be paid from the unified fee or from the investment manager's own resources.-[58]- The fee would be set by the fund's investment manager, which could impose no additional sales charges or other fees. To make investors aware of the fee paid in connection with their UFIC investment, the legislation would require the fee to be prominently disclosed on the cover of the fund's prospectus. The fee could not be changed more frequently than annually and only upon adequate notice to shareholders. In addition, to provide a check on the amount of the unified fee and the manager's control over the UFIC's operations, the legislation would require at least two-thirds of a UFIC's board of directors to be independent. The directors would be responsible for approving the management contract and other key service arrangements.-[59]- While we cannot say whether investors and the fund industry will embrace the UFIC concept, the Commission believes that they should have the opportunity to do so.-[60]- The UFIC structure contemplated by the legislation preserves many of the Act's corporate governance concepts. Some in the fund industry have suggested an approach for UFIC-type arrangements that is premised on the belief that the respective rights and obligations of investors and fund managers should be governed by a contract rather than the corporate governance --------- FOOTNOTES --------- -[57]- Section 6 of H.R. 1495 (adding new section 66 of the Investment Company Act to give the Commission rulemaking authority to implement the UFIC proposal by exempting open-end funds from the Act's current provisions governing fund management and distribution fees). -[58]- A UFIC would pay its own taxes, interest and brokerage commissions associated with its portfolio transactions, and fees of the fund's independent directors and experts engaged on their behalf. UFICs also would pay any extraordinary expenses associated with their operations, so that the unified fee could be based on reasonable expectations of fund operating expenses. -[59]- The board would have to determine that the unified fee paid under the management contract is not unconscionable or so grossly excessive as to constitute a waste of corporate assets under state law. -[60]- At least one fund complex, Twentieth Century Investors, Inc., currently imposes a single fee. -------------------- BEGINNING OF PAGE #17 ------------------- structure currently required by the Act.-[61]- Under this approach, a UFIC-type company would not have a board of directors, its shareholders would not have voting rights, and its management would not be subject to the fiduciary duty provisions of the Act.-[62]- These issues may need to be addressed for the UFIC concept to be viable. It may be appropriate to develop practical substitutes for the oversight provided by fund boards of directors and the other investor protection features of the Act's corporate governance provisions. The Commission believes that exploring alternatives would be worthwhile, and looks forward to working with the Subcommittee if it determines to further refine this proposal. Investment Company Names. In selecting mutual funds, investors often focus on a fund's name as a way of determining its investment objective and level of risk. As some commentators have suggested, relying solely on a fund's name in making an investment may prevent investors from fully appreciating the fund's risks and objectives.-[63]- To address this issue, the Commission has undertaken a number of initiatives to educate investors about the pitfalls of relying on a fund's name in making an investment decision.-[64]- The Commission also believes that investor protection concerns may be raised by fund names that, for example, include the word "government," "guaranteed," or "insured." Such names may in some cases cause investors to conclude, incorrectly, that their investments are guaranteed by state or federal governmental authorities. Although the Investment Company Act currently prohibits funds from using misleading or deceptive names, the means provided in the Act for enforcing this provision are antiquated. The Act requires the Commission to find, and declare by order, that a fund's name is deceptive or misleading, and then bring an --------- FOOTNOTES --------- -[61]- See PROTECTING INVESTORS REPORT, supra note 7, at 282- 288; Stephen K. West, Address at the General Meeting of the Investment Company Institute (May 1, 1980) (suggesting simplified governance and fee arrangements would be more flexible for a manager and more comprehensible to investors). It has been suggested by others, however, that the UFIC corporate governance requirements included in the legislation should be strengthened. Pat Regnier, If It Ain't Broke. . ., 25 MORNINGSTAR MUTUAL FUNDS 8, Aug. 18, 1995, at S2. -[62]- Section 36(b) of the Act, 15 U.S.C. Section 80a-35(b), imposes a fiduciary duty on a fund's investment adviser with respect to the amount of compensation the adviser and its affiliates receive from the fund and its shareholders. While the legislation contemplates that a UFIC would not be subject to section 36(b), it also requires that the UFIC's board determine that the compensation paid to the UFIC manager is not unconscionable or grossly excessive. -[63]- See Carole Gould, When the Title Doesn't Tell the Story, N.Y. TIMES, Jan. 22, 1995, at 14. -[64]- Chairman Levitt has addressed fund names in a number of "town meetings" with investors. See, e.g., Arthur Levitt, Chairman, SEC, Remarks at Investors' Town Meeting at the Houstonian Hotel, Houston, TX (Apr. 12, 1995). -------------------- BEGINNING OF PAGE #18 ------------------- action in federal court to enjoin the use of the name.-[65]- This process is cumbersome and has been rarely used by the Commission. The legislation would give the Commission a more effective and efficient means of addressing deceptive or misleading fund names by authorizing the Commission to address these practices by rule.-[66]- The Commission supports this amendment. Private Investment Companies and Qualified Purchaser Pools. The Investment Company Act excepts from registration and regulation under the Act any fund that has no more than 100 investors and does not publicly offer its securities.-[67]- The 100 investor limit and the public offering prohibition both are designed to ensure the private nature of the fund so that federal regulation is not warranted. The legislation would simplify the "private" fund exception, as well as create a new exception from Investment Company Act regulation for funds whose shareholders are all highly sophisticated investors. Amendments to the Private Fund Provision. The legislation would simplify the complex test now used to calculate a private fund's 100 investor limit.-[68]- Under the current test, a private fund may have to include within the 100 investor limit the shareholders of certain corporate investors in the fund.-[69]- In practice, private funds avoid application of this "look through" provision by restricting corporate investments to less than 10% of their securities. The legislation would simplify the private fund exception by no longer requiring private funds to count the underlying shareholders of their corporate, non-investment company investors under any circumstances. Such investors are unlikely to be mere conduits intended to enable a private fund to have indirectly more than 100 investors. The legislation, however, would effectively limit participation in private funds by a registered investment company, another private pool, or a new qualified purchaser pool --------- FOOTNOTES --------- -[65]- See section 35(d) of the Investment Company Act, 15 U.S.C. Section 80a-34(d). -[66]- Section 7 of H.R. 1495 (amending section 35(d) of the Investment Company Act). The judicial enforcement provision in current section 35(d) would be eliminated since the Commission could use the cease and desist authority in section 9(f) of the Act, 15 U.S.C. Section 80a-9(f), and the general enforcement authority in section 42(d) of the Act, 15 U.S.C. Section 80a-41(d), to preclude the use of a misleading fund name. -[67]- Investment Company Act Section 3(c)(1), 15 U.S.C. Section 80a-3(c)(1). -[68]- Section 8(a) of H.R. 1495 (amending section 3(c)(1) of the Investment Company Act). -[69]- The requirement to "look through" certain corporate shareholders to their underlying investors applies when a corporate shareholder acquires 10% of a private fund's securities and also has invested 10% of its assets in one or more private funds. -------------------- BEGINNING OF PAGE #19 ------------------- (discussed below) to no more than 10% of any one private fund's voting securities.-[70]- Qualified Purchaser Pool Provision. The legislation would create a new exception from registration and regulation under the Act for investment pools whose shareholders are all highly sophisticated, "qualified purchasers."-[71]- These new pools would not be prohibited from publicly offering their securities or required to limit the number of their investors.-[72]- The qualified purchaser alternative would recognize that financially sophisticated investors are in a position to appreciate the risks associated with investment pools that do not have the Investment Company Act's protections.-[73]- These investors generally can evaluate on their own behalf matters such as the level of a fund's management fees, governance provisions, transactions with affiliates, investment risk, leverage, and redemption rights. The legislation would define a qualified purchaser as any natural person who owns at least $10 million in securities, or any person (e.g., an institutional investor) that owns and manages on a discretionary basis at least $100 million in securities.-[74]- The Commission would be able to adopt rules --------- FOOTNOTES --------- -[70]- See also infra note 71 regarding additional technical amendments. -[71]- Sections 8(a) and 8(b) of H.R. 1495 (creating new section 3(c)(7) of the Investment Company Act as the exception for qualified purchaser pools, and new section 2(a)(51) of the Act that would define the term "qualified purchaser" for purposes of the new provision). Section 8(a) of H.R. 1495 also would make technical amendments to sections 3(c)(1) and 3(a)(3) of the Investment Company Act, 15 U.S.C. Sections 80a-3(c)(1), -(3)(a)(3). These include restrictions on the acquisition of a registered fund's securities by private and qualified purchaser pools and a provision that would prevent investment companies from avoiding regulation under the Act by establishing private funds or qualified purchaser pools. -[72]- The Commission anticipates that, although they would not be prevented from conducting registered offerings under the Securities Act, these pools would be unlikely to conduct such offerings in view of the sophisticated nature of their investors. See the "private offering" exemption in section 4(2) of the Securities Act, 15 U.S.C. Section 77d(2), and the related safe harbors of Regulation D thereunder. -[73]- This approach is consistent with other federal securities law provisions that are based, in part, on the financial sophistication of investors. See section 4(6) of the Securities Act, 15 U.S.C. Section 77d (accredited investors), rule 144A under the Securities Act, 17 CFR Section 230.144A (qualified institutional buyers), and rule 205-3 under the Investment Advisers Act of 1940, 17 CFR Section 275.205-3 (sophisticated clients). -[74]- Since all pool participants would have to be highly sophisticated, any time an institutional purchaser (continued...) -------------------- BEGINNING OF PAGE #20 ------------------- governing the proposed $10 million and $100 million statutory standards.-[75]- The definition of qualified purchaser under the legislation differs from approaches previously considered by this Subcommittee. Under the proposal recommended by the Commission and introduced in both Houses of Congress in 1992, the Commission would have had sole responsibility to specify, by rule, those persons eligible to invest in qualified purchaser pools.-[76]- A similar proposal subsequently considered by the Congress contained the $10 million and $100 million standards, but would have given the Commission rulemaking authority to define additional persons as qualified purchasers.-[77]- This approach would have codified standards of financial sophistication and also would have enabled the Commission to respond to changing financial conditions or take other appropriate action based on its administrative experience with the qualified purchaser exception. In defining any new class of qualified purchasers by rule, the Commission would have been required to consider factors such as the participants' sizeable net worth, extensive knowledge and experience in financial matters, substantial amount of assets owned or under management, and relationship with the issuer. The Commission believes that the preferable approach in crafting a qualified purchaser exception from the Act would be to provide the Commission with rulemaking authority to define the class of investors eligible to participate in the new pools. The Commission understands that the qualified purchaser exception is designed only for highly sophisticated investors, and would support incorporating standards in this provision that would limit its authority to define additional classes of qualified purchasers. Nonetheless the Commission recognizes that Congress may determine that the Commission should not have this authority, --------- FOOTNOTES --------- -[74]-(...continued) (e.g., an investment adviser) invests on behalf of another person (e.g., an individual client or an investment partnership) that person would also have to meet the qualified purchaser standard. -[75]- The Commission could use its rulemaking authority, for example, to determine the types of securities eligible for consideration in satisfying the $10 million and $100 million securities tests, when securities under the discretionary management of a subsidiary could be considered those of the parent, or the circumstances under which the partners of an investment partnership would not meet the qualified purchaser standard. -[76]- See The Small Business Incentive Act of 1992, S. 2518, 102d Cong., 2d Sess. (1992); H.R. 4938, 102d Cong., 2d Sess. (1992). -[77]- See The Small Business Incentive Act of 1993, S. 479, 103d Cong., 1st Sess. (1993); The Small Business Incentive Act of 1994, H.R. 4858, 103d Cong., 2d Sess. (1994). According to the Senate report, the $10 million and $100 million eligibility standards were included in response to concerns expressed by the Investment Company Institute regarding participation in the new pools by unsophisticated investors. SENATE COMM. ON BANKING, HOUSING, AND URBAN AFFAIRS, SMALL BUSINESS INCENTIVE ACT OF 1993, S. Rep. No. 166, 103d Cong., 1st Sess. 8-9 (1993). -------------------- BEGINNING OF PAGE #21 ------------------- and supports this amendment even in the absence of such authority. Proposed Provisions and Hedge Funds. Some commentators have suggested that the principal effect of the proposed changes to the Act's private fund exception and the proposed qualified purchaser pool exception would be to provide additional relief from the Act for "hedge funds."-[78]- Many other types of pooled vehicles, however, use the existing private fund exception and could use the new exception contained in the legislation. These investment pools include venture capital funds, acquisition vehicles, and structured financing mechanisms. It is difficult for the Commission to assess the potential effects that the legislation will have on hedge funds. The term "hedge fund" has come to be used to refer to a variety of pooled investment vehicles that are not registered under the federal securities laws and are therefore not subject to the reporting obligations applicable to public corporations, investment companies, or broker-dealers.-[79]- Hedge funds typically are operated to comply with the private investment company exception so that they will be exempt from regulation under the Investment Company Act. Interests in hedge funds typically are sold privately to sophisticated, high net worth individuals in ways that do not require registration of the interests under the Securities Act.-[80]- Thus, no precise figures are available regarding the number of hedge funds that are active in U.S. --------- FOOTNOTES --------- -[78]- See Small Business Incentives: Hearings on S. 479 Before the Subcomm. on Telecommunications and Finance of the House Energy and Commerce Comm., 103rd Cong., 2nd Sess. (1994). -[79]- The term "hedge fund" is not defined or used in the federal securities laws, and has no precise legal definition. The relatively scarce information publicly available about hedge funds suggests that, like other market participants, they vary widely in size, trading strategies, degrees of leverage, and market influence. Some control relatively small amounts of capital and, like many individual investors, pursue conservative buy and hold strategies. Others are more active, using investment techniques such as arbitrage, leveraging, and hedging. These more active hedge funds also trade in a broad range of financial products, including equities, government securities, commodities, financial futures, options, foreign currencies, and derivatives. -[80]- See supra note 72. Hedge funds also claim an exclusion from registration as securities dealers under section 15(a) of the Securities Exchange Act, 15 U.S.C. Section 78o(a), based on the "trader" exception to the definition of "dealer." In general, a trader is an entity that trades securities solely for its own investment account and does not carry on a public securities business, while a dealer buys and sells securities as part of a regular business, deals directly with public investors, engages in market intermediary activities, and also may provide other services to investors. See, e.g., Davenport Management, Inc. (pub. avail. Apr. 13, 1993); Louis Dreyfus Corp. (pub. avail. July 23, 1987). -------------------- BEGINNING OF PAGE #22 ------------------- markets or the total value of assets under their management.-[81]- The Commission receives limited information regarding the activities of various large market participants, including some hedge funds, through reports filed in connection with the acquisition of certain equity securities issued by publicly traded companies, and reports filed by managers exercising investment discretion over accounts having $100,000,000 in equity securities.-[82]- This information, --------- FOOTNOTES --------- -[81]- A recent article about hedge funds stated that "[t]here are at least 1,500 U.S. hedge funds, with some estimates running as high [as] 3,000 -- about the same number of mutual funds that were in existence in 1981." Jaye Scholl, Hedge Funds Abhor a Vacuum, Barron's, July 10, 1995, at 16. Older press accounts give significantly lower estimates of the number of hedge funds. Kate Rakine & Helen Dunne, Burnt Fingers on Passing the Buck in the Hedge Fund Thicket, DAILY TELEGRAPH, Mar. 5, 1994, at C1 (reporting that there are 800 hedge funds with $75 billion in assets under management); Sara Webb & Tracy Corrigan, Hedge Funds Hog the Limelight, FIN. TIMES, Mar. 5, 1994, at 10 (reporting that there are hundreds of hedge funds, many of which have $2 million or less in assets under management); Earl Gottschalk, Look Before Taking Leap Into Hedge Funds, WALL ST. J., Jan. 7, 1994, at C1 (reporting that there are 800 to 1,000 hedge funds with $40 billion in assets under management). Several recent press reports also have indicated that certain larger hedge funds are returning assets under management to investors. Peter Truell, Hedge Fund Returns Cash to Investors, N.Y. TIMES, June 9, 1995, at D3; Laura Jereski, Kovner, Surprising Wall Street, Is Disbanding U.S. Hedge Fund, WALL ST. J., June 9, 1995, at C1. -[82]- Section 13(d) of the Securities Exchange Act, 15 U.S.C. Section 78m(d), and Rule 13d-1(a) (17 CFR Section 240.13d-1(a)) thereunder require any person, who after acquiring directly or indirectly the beneficial ownership of any security registered under section 12 of the Securities Exchange Act, is directly or indirectly the beneficial owner of more than 5% of such class, to file a Schedule 13D with the Commission within 10 days of such event. Certain persons, however, including registered broker-dealers, banks, insurance companies, registered investment companies, registered investment advisers, and employee benefit plans, that acquire such holdings in the ordinary course of business and without the purpose of changing or influencing the control of the issuer, are eligible to file a short form statement on Schedule 13G within 45 days after the end of the calendar year in which the reporting obligation arises. Rule 13d-1(b)(1) under the Securities Exchange Act, 17 CFR Section 240.13d- 1(b)(1). Section 13(f) of the Securities Exchange Act, 15 U.S.C. Section 78m(f), requires "institutional investment managers" exercising investment discretion with respect to accounts having $100,000,000 or more in equity securities on the last trading day of any month to file a Form 13F with the (continued...) -------------------- BEGINNING OF PAGE #23 ------------------- however, does not reveal much about the trading activities of hedge funds or ways in which they raise capital. Because hedge funds are, by their very nature, not highly visible participants in the capital markets, the Commission is not in a position to assess the opportunities for growth that the legislation would afford hedge funds. Along with other investment pools, a hedge fund would be able to rely on either the amended private investment company exception or the new qualified purchaser provision. A hedge fund using the new qualified purchaser exception would be limited to investors that meet the legislation's high standards of financial sophistication, and a hedge fund relying on the amended private investment company provision would remain limited to 100 investors and could not publicly offer its securities. Funds of Funds. A "fund of funds" arrangement arises when one fund (the "acquiring fund") invests substantially all of its assets in other funds (the "acquired funds"). Certain types of fund of funds have been popular with investors recently, it would appear, because they offer investors a way to diversify their fund investments through a single, professionally managed portfolio.-[83]- In order to operate, however, these funds have generally required exemptive relief from the Investment Company --------- FOOTNOTES --------- -[82]-(...continued) Commission. This information, however, only is required to be filed on a quarterly basis. "Institutional investment manager" is defined to include any person (other than a natural person) investing in or buying and selling securities for its own account, and any person exercising investment discretion with respect to the account of any other person. Reporting also is required under the Large Option Position Reporting ("LOPR") system, established in 1973 by the various options exchanges. The LOPR system requires reporting by broker-dealers to the exchanges of the establishment and net change in large option positions, and is designed to monitor compliance with exchange position limits and to detect excessive short uncovered option positions. Likewise, the Commodity Futures Trading Commission requires large position reporting identifying the positions of large traders in specific futures contracts. See section 4i of the Commodity Exchange Act, 7 U.S.C. Section 6i. -[83]- Two funds of funds that commenced operations in 1985 and 1989, respectively, for example, have aggregate assets of approximately $6.3 billion and approximately 400,000 aggregate shareholder accounts. See infra note 87. The Commission recently has received applications from several other funds requesting exemptive relief to operate as funds of funds. It appears that the popularity of these arrangements is part of a trend in which investors are increasingly interested in asset allocation products, such as wrap accounts and mutual fund wrap accounts. In a wrap fee program, the client typically is provided with portfolio management, execution of transactions, asset allocation, and administrative services for a single fee based on assets under management. Mutual fund wrap fee programs provide similar services, but the client account is invested only in mutual funds. -------------------- BEGINNING OF PAGE #24 ------------------- Act because the Act, with certain exceptions, places restrictions on a fund's investment in other funds.-[84]- Under the Act, a fund may not acquire more than 3% of another fund's voting stock, and may not invest more than 5% of its assets in any one fund. In addition, a fund's investments in all other funds may not exceed, on an aggregate basis, more than 10% of its assets. These restrictions were enacted in 1970, and were intended to protect investors from the potential harm resulting from complicated pyramid structures.-[85]- In particular, Congress and the Commission were concerned, at that time, that fund of fund arrangements could result in excessive layering of fees and present opportunities for abuse of control arising from the concentration of voting power in the acquiring fund.-[86]- The Commission has recently granted individual exemptions from the Investment Company Act's restrictions to fund of fund arrangements that operate under conditions designed to address the concerns upon which the restrictions were premised.-[87]- The legislation would incorporate certain of these conditions and would enable fund of fund arrangements that comply with those conditions to be offered without obtaining prior exemptive relief from the Commission. The legislation would exempt mutual funds from the Investment Company Act's restrictions on fund investments if they invest substantially all of their assets in other mutual funds in the same group, or "family," of funds.-[88]- The legislation would allow an acquiring fund to invest in short-term paper so that the fund has sufficient liquidity to meet redemption requests. To prevent overly complex arrangements, however, an --------- FOOTNOTES --------- -[84]- Sections 12(d)(1)(A)-(C) of the Investment Company Act, 15 U.S.C. Section 80a-12(d)(1)(A)-(C). Sections 12(d)(1)(E) and (F) provide exemptions from these restrictions for funds that invest only in one other fund (e.g., master-feeder arrangements, discussed at supra note 28 and accompanying text) and for funds that do not acquire more than 3% of the total outstanding stock of any one other fund and do not charge sales loads of more than 1 %. -[85]- See H.R. REP. NO. 1382, 91st Cong., 2nd Sess. 10-11, 23-35 (1970); PPI REPORT, supra note 30, at 322. As originally enacted in 1940, section 12(d)(1) contained certain prohibitions on fund of fund arrangements. The 1970 amendments provided for additional prohibitions. H.R. REP. NO. 1382. -[86]- See H.R. REP. NO. 1382; PPI REPORT, supra note 30, at 322. -[87]- See, e.g., T. Rowe Price Spectrum Fund, Inc., Investment Company Act Release No. 21371 (Sept. 22, 1995) (Notice), Investment Company Act Release No. 21425 (Oct. 18, 1995) (Order); Vanguard Star Fund, Investment Company Act Release No. 21372 (Sept. 22, 1995) (Notice), Investment Company Act Release No. 21426 (Oct. 18, 1995) (Order). -[88]- Section 9(2) of H.R. 1495 (adding new section 12(d)(1)(G) to the Investment Company Act). The legislation would define a "group of investment companies" as any two or more mutual funds that hold themselves out to investors as related companies for purposes of investment and investor services. -------------------- BEGINNING OF PAGE #25 ------------------- acquiring fund would not be permitted to invest in another fund of funds.-[89]- To prevent the payment of excessive sales loads and other distribution-related charges in the fund of funds context, the legislation would limit the sales charges that may be imposed (directly or indirectly) on an acquiring fund's investors. The legislation contains two alternatives that would address sales charges. The first alternative would allow either the acquiring or the acquired fund, but not both, to impose sales charges. The second alternative would allow sales charges to be imposed by both the acquiring and acquired funds so long as the charges, taken together, comply with applicable rules of the National Association of Securities Dealers, Inc. concerning sales charges.-[90]- The Commission believes that the first alternative, which would restrict sales charges to one fund (acquiring or acquired), is unnecessarily restrictive. The second alternative would address excessive sales charges while providing flexibility to the acquiring fund, the acquired fund, or both, to assess sales charges. The legislation would not address other fees that may be charged, directly or indirectly, to an acquiring fund's investors, but we do not believe that it is necessary for the legislation to do so. The Commission would be able to use its authority under the Securities Act to require full disclosure about the acquiring fund's structure. The Commission, for example, would be able to address the potential for excessive layering of advisory fees by requiring an acquiring fund to disclose in the prospectus fee table the cumulative advisory fees paid by the acquiring and acquired funds. The legislation would require an acquiring fund to comply with the pass-through and echo voting procedures that the legislation would make applicable to registered feeder funds.-[91]- In its recent exemptive orders, however, the Commission has not required an acquiring fund to use these voting methods. The Commission believes that specifying the voting method in this manner is unnecessary for investor protection and that the acquiring fund's board of directors is in the best position to select the type of voting procedure to be used by the acquiring fund.-[92]- The Commission, therefore, recommends that the provision regarding voting be deleted from the legislation. --------- FOOTNOTES --------- -[89]- New section 12(d)(1)(G)(iv) would require an acquired fund to have a fundamental policy prohibiting it from investing in the shares of other funds in reliance on paragraphs (F) or (G) of section 12(d)(1). -[90]- Section 26(d) of the NASD Rules of Fair Practice addresses investment company sales charges. NASD Manual (CCH) 2176. -[91]- See supra note 29 and accompanying text. -[92]- Mandatory pass-through voting could be potentially burdensome for an acquiring fund that invests in a large number of other funds. Additionally, an acquiring fund's board of directors may determine that echo voting procedures (that is, voting the shares of the acquired fund held by the acquiring fund in the same proportion as the votes cast by the acquired fund's other shareholders) would not give the acquiring fund's shareholders adequate participation in matters submitted for shareholder approval by an acquired fund. -------------------- BEGINNING OF PAGE #26 ------------------- Under the legislation, the Commission would have the authority to adopt rules to fill any gaps in investor protection or to address any abuses arising in connection with the new fund of funds exemption. The legislation also would give the Commission the authority to exempt by rule or order any person, security or transaction from the Investment Company Act's restrictions on fund of fund arrangements.-[93]- The Commission, for example, could use this authority to issue a rule exempting arrangements that involve funds that are not part of the same fund family or that otherwise do not fall within the new exemptive provision. The legislation would expand the scope of the Commission's existing exemptive authority under the Investment Company Act by permitting it to grant relief from the Act's restrictions on fund of fund arrangements if and to the extent the exemption is consistent with the protection of investors.-[94]- This new authority would clarify that the Commission could place greater emphasis on the costs and benefits resulting from such an exemption. The Commission supports the proposed fund of funds amendments, although the provisions addressing affiliated fund of funds may not be necessary in view of the approach taken by the Commission in its recent exemptive orders. If this provision is retained, as noted above, we recommend leaving the selection of the type of voting procedures used in these arrangements to the discretion of an acquiring fund's board of directors. The Commission supports the provision that would clarify the Commission's exemptive authority to address other fund of funds arrangements. IV. CONCLUSION The Commission appreciates this opportunity to assist the Subcommittee in reconsidering certain provisions of the Investment Company Act. The Commission strongly supports the Subcommittee's goal of improving and modernizing investment company regulation. The Investment Company Act has served investors and the fund industry well for many years, but changes can and should be made. The Investment Company Act Amendments of 1995 will improve and modernize the framework of investment company regulation. As this legislation progresses, the Commission stands ready to work with the Subcommittee and its staff to meet our shared goals of protecting investors and fostering the successful, efficient, and safe operation of the fund industry. --------- FOOTNOTES --------- -[93]- Section 9(3) of H.R. 1495 (adding paragraph 12(d)(1)(J) to the Investment Company Act). This authority would extend not only to exemptions from the Investment Company Act's restrictions on fund investments, but also to master-feeder and other fund of fund arrangements allowed under section 12(d)(1). See supra note 84. -[94]- See section 6(c) of the Investment Company Act, 15 U.S.C. Section 80a-6(c) (giving the Commission broad authority to exempt, by rule or order, any person from the provisions of the Investment Company Act, if and to the extent that the exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the Investment Company Act).