Summary of Comments on
|I.||Introduction and Background|
|1. Scope of Exemption|
|2. Conditions of Exemptive Relief|
|3. Transactions with Subadvisers as Brokers (Rule 17e-1)|
|4. Purchases during Primary Offering Underwritten|
by Subadvisers (Rule 10f-3)
|5. Purchases of Securities Issued by Subadvisers (Rule 12d3-1)|
Investment Companies, Investment Advisers and Banks
|1. Federated Investors, Inc.||Federated|
|2. Merrill Lynch Investment Managers, L.P.||Merrill Lynch|
|3. Goldman, Sachs & Co.||Goldman Sachs|
|4. T. Rowe Price Associates, Inc.||T. Rowe Price|
|5. Fidelity Management and Research Co.||Fidelity|
Professional and Trade Associations
|6. Investment Company Institute||ICI|
|7. Investment Counsel Association of America||ICAA|
|8. Money Management Institute||MMI|
|9. Securities Industry Association||SIA|
On April 30, 2002, the Securities and Exchange Commission ("Commission") issued a release ("Proposing Release") proposing new rule 17a-10 and amendments to rules 10f-3, 12d3-1, 17a-6, 17d-1, and 17e-1 under the Investment Company Act of 1940 ("Investment Company Act" or "Act").1 The Commission proposed to amend rules 17a-6 and 17d-1 to expand the circumstances in which a fund may enter into principal transactions and joint arrangements with its "portfolio affiliates"-that are affiliated with the fund solely as a result of the fund (or another fund in the fund complex) controlling them or owning more than five percent of their voting securities.2 The Commission also proposed new rule 17a-10 and amendments to rules 10f-3, 12d3-1, and 17e-1 to permit funds to engage in transactions with subadvisers of affiliated funds (and affiliated persons of those subadvisers) that are currently prohibited by sections 10(f), 12(d), 17(a), and 17(e) of the Act.
The Commission received nine comment letters. The following discussion summarizes the commenters' general views and specific remarks on matters discussed in the Proposing Release. The Division of Investment Management prepared this summary.
The commenters supported the proposals to provide exemptions for certain affiliated transactions as outlined in the Proposing Release.3 Goldman Sachs stated that it supports:
fully the Commission's efforts to modernize the regulatory framework of the federal securities laws, in general, and the 1940 Act, in particular. We believe that investors and the investment management industry will benefit from the Commission's efforts. Many restrictions that were adopted in an earlier time have not only ceased to serve any meaningful regulatory purpose, but have become an impediment to efficient regulation as a result of industry developments and changed market conditions.
As described in more detail below, most commenters suggested that the amendments be modified in one or more respects.
Rules 17a-6 and 17d-1(d)(5) permit a fund's portfolio affiliates (and affiliated persons of the fund's portfolio affiliates) to enter into principal transactions and joint arrangements with the fund that would otherwise be prohibited by sections 17(a) and 17(d) of the Act and rule 17d-1 under the Act. This exemption is unavailable if certain other affiliated persons of the fund (e.g., the fund's adviser, officers, or directors, which we call "prohibited participants") are, or have a financial interest in, participants in the transaction.4
The Commission proposed to amend rules 17a-6 and 17d-1(d)(5) to extend the rules' exemptions to transactions and arrangements between a fund and portfolio affiliates of funds under common control with the fund - e.g., portfolio affiliates of funds in the same fund complex.5 The ICI, Fidelity, and T. Rowe Price were the only commenters that addressed this proposal. All three commenters supported the proposed amendments.
The Commission also proposed to amend both rules to exclude from the definition of "financial interest" any interest that the fund's board of directors finds to be not material.6 The effect of this proposal would be to permit a portfolio affiliate to enter into a transaction with a fund if a prohibited participant has a financial interest that the fund's board of directors determines not to be "material." The ICI supported the proposal, recommending that the rule not mandate how a board should determine whether a prohibited participant's financial interest is material.7
The Commission proposed to amend the rules to make them consistent with one another with regard to the time period for which a prohibited participant's financial interest will result in loss of the rules' exemption.8 Under the proposed amendments, the exemptions under both rules 17a-6 and 17d-1(d)(5) will be available unless a prohibited participant (i) has a financial interest in a party at the time of the fund's participation in the transaction or arrangement, (ii) had a financial interest in a party within the six months preceding the fund's participation, or (iii) will obtain a financial interest in a party pursuant to an arrangement in existence at the time of the fund's participation.9 The ICI suggested that the Commission further amend rules 17a-6 and 17d-1(d)(5) to make the exemptions available without regard to the past financial interests of prohibited participants. The ICI argued that it is improbable that a prohibited participant's past financial interest "would raise the investor protection concerns that the rules are intended to address" and that the provision imposes unnecessary compliance burdens on funds in obtaining information about the past financial interests of prohibited participants.10
Finally, the Commission proposed to amend rule 17d-1(d)(5) to eliminate the current limit on the percentage of its assets that a fund may commit to a joint enterprise with a portfolio affiliate.11 No commenters addressed this proposal.
The Commission proposed new rule 17a-10 and amendments to rules 10f-3, 12d3-1, and 17e-1, which would permit funds to enter into certain transactions and arrangements with certain subadviser affiliates.12 Ordinarily a subadviser has little power to overreach those funds, or portions of a fund, with which it is affiliated but which it does not advise, and the Commission has therefore issued a number of orders exempting subadvisers and funds from sections 17(a), 17(e), 10(f), and 12(d)(3) in order to permit subadvisers to engage in transactions with affiliated funds when the subadviser is not in a position to influence the fund's decision to participate in the transaction. The proposed amendments were designed to codify the relief in those exemptive orders. Under the proposal, exemptions would only be available to subadvisers (and their affiliated persons) that are neither responsible for, nor affiliated persons of, the persons responsible for providing advice to the fund or portion of the fund's portfolio that participates in the transaction ("participating fund"). The proposed exemptions would also be subject to two conditions that were designed to bolster fund protection against any remaining possibility of subadviser influence13 -
All eight commenters supported the Commission's proposals with respect to transactions between funds and their subadviser affiliates. They recommended several changes.
Under the Act, two funds are first-tier affiliates of each other if they are under common control. The Commission stated in In the Matter of Steadman Security Corporation that, in most cases, fund advisers control the funds they advise.14 As a result, two funds in the same fund complex are under the common control of their shared principal adviser, making them first-tier affiliates. Federated argued that while advisers may "control" the fund, the same cannot be said about subadvisers. Federated argued that the Commission wrongly decided the Steadman case, which it believes is not supported by the language of the Act. Federated and the ICI asked that the Commission clarify that subadvisers do not control the funds they advise.
The ICI and Federated requested that, in the alternative, the Commission expand the exemptions in the proposed amendments to allow a principal adviser of one fund to enter into transactions with another fund where the funds share a common subadviser.
As discussed above, two conditions designed to insulate the participating fund's investment decisions from the influence of the participating subadviser must first be met before a transaction may occur under the proposed exemptions. The ICI and T. Rowe Price were the only commenters to address the proposed conditions. Both commenters argued that it is unnecessary to prohibit subadvisers from consulting with one another concerning securities transactions of the fund because (i) subadvisers are market competitors and have no incentive to communicate with one another about investment decisions;15 (ii) the subadviser, as a fiduciary of the fund, is already prohibited from engaging in practices designed to overreach the fund;16 (iii) subadvisers may be contractually responsible for only a portion of a fund's account, making communications with other subadvisers unlikely;17 and (iv)collaboration is already prohibited by section 48(a) under the Act.18 The ICI suggested, in the alternative, that the prohibition against consulting among fund subadvisers be revised to prohibit "creating an understanding or agreement" to transact in a manner that would evade the rule's provisions.
Both commenters argued that the "non-consult" requirement should be included as an affirmative condition of the rules, rather than a required provision of the subadvisory contracts as proposed by the Commission. The commenters recommended the change so that funds could avoid the cost of amending their subadvisory contracts.
Section 17(e)(2) of the Act generally limits the remuneration that a first- or second-tier affiliate of a fund may receive for effecting purchases and sales of securities on a securities exchange on behalf of the fund, or a company the fund controls, to the "usual and customary broker's commission."19 Rule 17e-1 conditions relief on the fund's board performing certain oversight duties, the records of which must be maintained by the fund ("review and recordkeeping requirements").20 The Commission proposed to permit a fund's subadviser (or the subadviser's affiliated persons) to receive remuneration for service as a broker without complying with rule 17e-1's review and recordkeeping requirements, subject to conditions identical to those described above, under which the subadviser (or affiliated persons) could engage in a principal transaction with the fund under proposed rule 17a-10.21 The ICI, the only commenter to address the proposal, supported the proposed amendments.22
Section 10(f) of the Act prohibits a fund from purchasing any security during an underwriting or selling syndicate if the fund has certain affiliated relationships with a principal underwriter for the security.23 For example, section 10(f) would prohibit a fund from purchasing securities during an underwriting if a broker-dealer participating in the underwriting were an affiliated person of the purchasing fund's adviser. The section protects fund shareholders by preventing an affiliated underwriter from placing or "dumping" unmarketable securities with the fund. Rule 10f-3 provides an exemption from the prohibition in section 10(f) if certain conditions are satisfied.24
One of the key conditions of rule 10f-3 is that a fund relying on the rule, together with any other fund advised by the fund's adviser, purchase no more than 25 percent of the offering ("percentage limit"). The purpose of the percentage limit is to provide an indication that a significant portion of the offering is being purchased by persons acting independently of the adviser. The existence of these purchasers suggests that the price of the securities is based on market forces and demonstrates that the securities are not being "dumped."
When a fund relies on the services of more than one adviser, there is an increased potential that one of those advisers will have an affiliation with a member of an underwriting or selling syndicate.25 This can limit significantly the fund's ability to purchase securities in an offering, because a fund is subject to section 10(f) if any of its advisers (in the case of a series fund) or subadvisers (in the case of a multi-managed fund) participate in the underwriting or selling syndicate (or are affiliated persons of participants). The Commission proposed to amend rule 10f-3 to deem each of the series of a series company and the "managed portions"26 of a fund to be separate registered investment companies for purposes of section 10(f) and rule 10f-3.27 These amendments would exempt a purchase of securities by an investment company from the prohibition in section 10(f), if the purchase would not be prohibited if each series or portion of the fund were separately registered. Thus, a fund would have to rely upon rule 10f-3 only if the purchasing series' or managed portion's own subadviser had an affiliation with an underwriting. The Commission also proposed to revise the way that funds relying on rule 10f-3 must aggregate purchases under the rule's percentage limits. Currently rule 10f-3 requires aggregation of purchases by all funds that have a common investment adviser, regardless of whether the common adviser is a participant in the underwriting or selling syndicate. Under the proposal, only purchases by funds that are advised, and accounts that are controlled, by an investment adviser that is participating in the underwriting or selling syndicate need be aggregated.
Seven commenters addressed the Commission's proposal to amend rule 10f-3.28 One commenter, T. Rowe Price, offered unqualified support for the proposal.29 The commenter expressly supported requiring aggregation of purchases by non-fund accounts, as well as purchases by funds advised by the investment adviser, for purposes of compliance with rule 10f-3's percentage limits. The commenter stated that "[t]he explosive growth of the hedge fund industry warrants inclusion of an adviser's discretionary private accounts in the 25% purchase limit under [r]ule 10f-3. Otherwise, fund advisers to hedge funds could still purchase a substantial portion of an offering underwritten by an affiliate, while still complying with the limit for its fund clients."
Three commenters strongly supported limiting rule 10f-3's the aggregation requirement to purchases by funds and portions of a fund for which an investment adviser that participates in the underwriting syndicate provides investment advice.30 Those commenters, however, and two additional commenters, opposed requiring aggregation of purchases by non-fund accounts controlled by the investment adviser.31 Two commenters, Merrill Lynch and SIA, suggested that other protections in rule 10f-3 make it unlikely that securities could be "dumped" in the fund.32 Merrill Lynch and Goldman Sachs suggested that including non-fund accounts in the aggregation calculation would be beyond the scope of section 10(f).33 All five commenters stated that the amendment could result in funds purchasing fewer securities from underwritings of which a fund adviser is an affiliated person.34 Three commenters argued that the Commission underestimated the cost of complying with the proposed amendments.35
Three of the commenters that opposed the proposal to require aggregation of purchases by non-fund accounts for purposes of the percentage limit, recommended that the Commission raise the percentage limit from twenty-five percent to fifty percent if it adopts the rule amendment as proposed.36
Section 12(d)(3) of the Act generally prohibits funds, and companies controlled by funds, from purchasing securities issued by a registered investment adviser, broker, dealer, or underwriter ("securities-related businesses").37 Rule 12d3-1 permits a fund to invest up to five percent of its assets in securities of an issuer deriving more than fifteen percent of its gross revenues from securities-related businesses, but a fund may not rely on rule 12d3-1 to acquire securities of its own investment adviser or any affiliated person of its own investment adviser. The Commission proposed to amend rule 12d3-1 to permit a fund to acquire securities issued by one of its subadvisers (or an affiliated person of one of its subadvisers) subject to the same conditions under which other types of transactions with subadvisers would be permitted, namely that the rule would be available only to a subadviser that provides investment advice with respect to a discrete portion of the fund's portfolio, and that is not an affiliated person of the adviser causing the fund to purchase the securities.38 In addition, the advisory contracts of the subadviser that is the issuer (or whose affiliated person is the issuer) and any subadviser that is advising the purchasing portion of the acquiring company must prohibit the subadvisers from consulting with each other concerning securities transactions for the acquiring company, and must limit the subadvisers to providing advice to a discrete portion of the acquiring company's portfolio.39
One commenter addressed the proposed amendments to rule 12d3-1.40 The commenter supported the Commission's efforts to expand the rule's exemptive relief. The commenter also recommended that the Commission amend rule 12d3-1 to increase the percentage of a fund's assets that may be invested in a securities-related business from the current five percent to ten percent.
|1||Transactions of Investment Companies With Portfolio and Subadvisory Affiliates, Investment Company Act Release No. 25557 (April 30, 2002) [67 FR 31081 (May 8, 2002)].|
|2||Absent an exemption from the Commission, such transactions are prohibited by sections 17(a) and 17(d) of the Investment Company Act and rule 17d-1 thereunder.|
|3||SIA, ICAA, Merrill Lynch, Goldman Sachs, T. Rowe Price, Fidelity, and the ICI supported the proposals. The other two commenters, MMI and Federated, limited their discussions to specific aspects of the proposed amendments, but did not comment on the proposals as a whole.|
|4||See rules 17a-6(a) and 17d-1(d). Section 17 under the Act is primarily concerned with preventing a fund's affiliated persons from being able to misuse their authority to cause a fund to enter into transactions that may not be in the fund's best interest. Rules 17a-6 and 17d-1(d) have been structured, therefore, to prevent such affiliated persons with the capability of overreaching a fund from participating in principal and joint transactions with the fund. The proposed amendments to rules 17a-6 and 17d-1 were limited to portfolio affiliates, which present minimal risk of overreaching to the funds with which they are affiliated.|
|5||See Proposing Release, supra note 1, at nn. 21-25 and accompanying text.|
|6||Id. at nn. 27-28 and accompanying text.|
|7||The ICI was the only commenter to address this proposal.|
|8||Rule 17a-6 is not available if a prohibited participant "has, or within six months prior to the transaction had . . . or pursuant to an arrangement will acquire" a financial interest in a party to the transaction. Rule 17a-6(a)(ii). Rule 17d-1(d)(5) is not available if a prohibited participant "is, was or proposes to be" a participant in the joint enterprise through a financial interest in a person "who is, was or will be" a participant in the joint enterprise. Rule 17d-1(d)(5)(i).|
|9||Proposed rules 17a-6(b)(1)(ii) and 17d-1(d)(5)(ii)(B). Rule 17d-1(d)(6) includes references to the prohibited participants identified in current rule 17d-1(d)(5)(i) and to the definition of "financial interest" in current rule 17d-1(d)(5)(iii). We are proposing to amend rule 17d-1(d)(6) to conform these references to rule 17d-1(d)(5) as proposed to be amended.|
|10||The ICI made a technical comment pointing out that a fund would be unable to rely on the proposed rule amendments if an affiliated fund has a financial interest in, but is not an affiliated person of, the portfolio affiliate. Fidelity made a similar comment.|
|11||See Proposing Release, supra note 1, at nn. 33-34 and accompanying text.|
|12||A subadviser affiliate is a person that is an affiliated person of a fund because the person is a subadviser to the fund, an affiliated person of the fund's subadviser, or a subadviser of another fund under common control with the fund.|
|13||If adopted, the proposed amendments would codify the conditions under which the Commission has granted individual exemptive orders permitting transactions involving subadvisers and affiliated funds.|
|14||In the Matter of Steadman Security Corporation, Investment Company Act Release No. 9830 [1977 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,243, at n.81 (June 29, 1977) ("[T]he investment adviser almost always controls the fund.").|
|15||T. Rowe Price.|
|18||Section 48(a) under the Act states, in part, that "[i]t shall be unlawful for any person, directly or indirectly, to cause to be done any act or thing through or by means of any other person which it would be unlawful for such person to do under the provisions of this title. . . ." 15 U.S.C 80a-47(a).|
|19||Section 17(e)(2) limits the remuneration that any affiliated broker of a fund may receive in connection with a securities transaction to (A) the usual and customary broker's commission for transactions effected on an exchange, (B) two percent of the sales price for secondary distribution, and (C) one percent of the purchase or sale price for other purchases or sales.|
|20||In particular, the board of a fund seeking relief from section 17(e) must review transactions to determine that they comply with procedures adopted by the board to ensure that the remuneration received by the affiliated person does not exceed the usual and customary broker's commission. Rule 17e-1(a) and (b). In addition, the fund must maintain a record of the transactions. Rule 17e-1(d).|
|21||See Proposing Release, supra note 1, at section I.B.2.|
|22||The ICI also made a technical comment, requesting clarification that the exemption from the recordkeeping and review requirements in rule 17e-1 would be available to all of the affiliated persons that could rely on the exemptions in proposed rule 17a-10.|
|23||Section 10(f), in relevant part, prohibits a registered investment company from knowingly purchasing or otherwise acquiring, during the existence of any underwriting or selling syndicate, any security (except a security of which the company is the issuer) a principal underwriter of which is an officer, director, member of an advisory board, investment adviser, or employee of the company, or any person of which any of the foregoing are affiliated persons.|
|24||Rule 10f-3 permits a fund to purchase securities in a transaction that otherwise would violate section 10(f) if, among other things: (i) the securities either are registered under the Securities Act of 1933 [15 U.S.C. 77a-aa], are part of an issue of government securities, are municipal securities with certain credit ratings, or are offered in certain foreign or private institutional offerings; (ii) the offering involves a "firm commitment" underwriting; (iii) the fund (together with other funds advised by the same investment adviser) purchases no more than 25 percent of the offering; (iv) the fund purchases the securities from a member of the syndicate other than its affiliated underwriter; and (v) the fund's directors have approved procedures for purchases under the rule and regularly review the purchases to determine whether they have complied with the procedures. See rule 10f-3(b).|
|25||A fund may have multiple subadvisers because more than one subadviser has been retained to provide investment advice with respect to various portions of the fund (a "multi-managed fund"). A fund may also have multiple advisers because the fund is one of several portfolios of a series company, and different advisers provide investment advice with respect to the assets of the different portfolios.|
|26||Under the proposal a portion of a fund's portfolio would be a "managed portion" if it is a discrete portion of the portfolio for which a subadviser is responsible for providing investment advice, and the subadviser (i) does not provide investment advice with respect to any other portion of the fund's portfolio, (ii) is prohibited by its advisory contract form consulting with any other investment adviser of the investment company that is a principal underwriter or affiliated person of a principal underwriter concerning securities transactions of the fund, and (iii) is not an affiliated person of any other investment adviser, or any promoter, underwriter, officer, director, member of an advisory board, or employee of the investment company. See proposed rule 10f-3(a)(6).|
|27||See Proposing Release, supra note 1, at nn.62-65 and accompanying text.|
|28||SIA, MMI, ICAA, Merrill Lynch, Goldman Sachs, T. Rowe Price, ICI.|
|29||T. Rowe Price.|
|30||ICI, Goldman Sachs, ICAA.|
|31||SIA, MMI, Merrill Lynch, Goldman Sachs, ICI. Goldman Sachs, MMI, and ICI argued that fund shareholders have not been demonstrably harmed by the current rule.|
|32||Merrill Lynch and SIA.|
|33||Merrill Lynch and Goldman Sachs.|
|34||Merrill Lynch, Goldman Sachs, MMI, SIA, ICI.|
|35||Merrill Lynch, Goldman Sachs, ICI. Goldman Sachs queried whether the purchase limit would apply to an investment adviser's discretionary advisory account in situations where the adviser gets the client's consent to purchase from a particular offering. MMI sought clarification of the meaning of "account," "investment discretion," and otherwise exercises control."|
|36||SIA, Goldman Sachs, ICI.|
|37||With minor exceptions, section 12(d)(3) prohibits a fund from purchasing or otherwise acquiring "any security issued by or any other interest in the business of any person who is a broker, a dealer, is engaged in the business of underwriting, or is [an] investment adviser."|
|38||Proposed rule 12d3-1(c)(3)(i) and (ii). The ownership limits in rule 12d3-1(a) and (b) would continue to apply to the fund as a whole.|
|39||Proposed rule 12d3-1(c)(3)(ii).|
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