Merrill Lynch Investment Managers, L.P.
800 Scudders Mill Road
Plainsboro, New Jersey 08536
609-282-1591 Fax

Philip L. Kirstein
General Counsel

July 19, 2002

Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609

Re: IC-25557: Transactions of Investment Companies with Portfolio and Subadvisory Affiliates (File No. S7-13-02)

Dear Mr. Katz:

Merrill Lynch Investment Managers, L.P. ("MLIM"), an investment adviser registered with the Securities and Exchange Commission (the "SEC" or "Commission") under the Investment Advisers Act of 1940, welcomes the opportunity to comment on SEC Release No. IC-25557: Transactions of Investment Companies with Portfolio and Subadvisory Affiliates (the "Release"). We act as investment adviser to approximately 200 investment companies that are registered with the SEC (each a "fund" or collectively, the "funds") under the Investment Company Act of 1940 (the "1940 Act"). We also advise over 30,000 non-fund accounts, including privately managed accounts for individuals, onshore and offshore funds, private funds, and other pooled investment vehicles. Our comments herein are limited to the Commission's proposal to modify the Rule 10f-3 (the Rule) 25% limit on purchases to cover not only purchases by a fund or by any other funds with the same investment adviser, but also any other non-fund account over which the fund's investment adviser has discretionary authority or exercises control.1 With respect to the other proposals set forth in the Release, we generally support the positions outlined in the Investment Company Institute's comment letter on the Release.

As discussed fully below, we are seriously concerned by and strongly oppose the proposal to modify the Rule's 25% limit to extend to purchases by any other non-fund account over which the fund's investment adviser has discretionary authority or exercises control. The proposed amendment goes well beyond the policy concerns that prompted Congress to adopt Section 10(f) of the Investment Company Act of 1940 (the "1940 Act") and that are imbedded in the Rule. Moreover, the Commission cites no factual support whatsoever that the Rule, in its current form, provides insufficient protection or has caused any harm or been abused by the underwriting or investment management communities. Moreover, we believe the amendment would have severe adverse consequences on smaller investors whose interests the Commission has historically sought to protect, would require costly and extensive changes to recordkeeping and compliance systems for funds and their advisers that are not to be supported by instances of abuse under the Rule's current requirements, would provide no additional investor protection, and will likely have unintended and undesirable results for both funds and non-fund clients.


Section 10(f) of the 1940 Act prohibits a fund from knowingly purchasing a security during an underwriting or selling syndicate if the fund is affiliated in certain ways with the principal underwriter for the security ("affiliated underwriter"). As noted in the Release, Section 10(f) was designed to protect funds and their investors from the "dumping" of unmarketable securities by an affiliated underwriter seeking to advance its interests, rather than those of the funds and their shareholders.

Congress recognized that Section 10(f)'s prohibition of all purchases by a fund with an affiliated underwriter during the existence of an underwriting or selling syndicate could be overly broad. As a result, Congress gave the Commission specific authority to exempt persons from that prohibition when an exemption would be consistent with the protection of investors. In 1958, the Commission used its exemptive authority under Section 10(f) to adopt Rule 10f-3.2 The Rule, as amended over time, currently permits a fund to purchase securities in a transaction that otherwise would violate Section 10(f) if, among other things: (1) the securities are registered under the Securities Act of 1933, are municipal securities having certain credit ratings, U.S. government agency securities, or are securities made available in certain foreign or private institutional offerings; (2) the offering involves a "firm commitment" underwriting; (3) the fund (together with other funds advised by the same investment adviser) purchases no more than 25% of the offering; (4) the fund purchases the securities from a member of the syndicate other than its affiliated underwriter; (5) if the securities are municipal securities, the purchase is not a group sale; and (6) the fund's independent directors have approved procedures for purchases under the Rule and regularly review the purchases to determine whether they have complied with the procedures.

Policy Considerations

In reproposing the modification to the 25% limit in the Rule, the Commission indicated that the commentators opposing the original proposal failed to address the underlying policy concerns behind the proposal. The Release suggests that Rule 10f-3 needs to be amended because the 25% limit may not provide "reliable evidence" of a market for the security being offered if a fund's investment adviser could circumvent the percentage limitations by placing Rule 10f-3 securities in other accounts managed by the adviser. We would agree that the 25% limit alone is not a sufficient protection to ensure that the "anti-dumping" policy behind Section 10(f) of the 1940 Act and Rule 10f-3. We would argue, however, that Rule 10f-3 has numerous other protections which provide more substantial impediments to dumping abuses by affiliated underwriters including (a) the requirement for the fund to purchase the Rule 10f-3 securities from a non-affiliated dealer and (b) the requirement that fund's independent directors have approved procedures for purchases under the Rule and regularly review the purchases to determine whether they have complied with the procedures. Moreover, in an era of increasing consolidation and affiliation of financial institutions, we would argue that the percentage limitations set forth in Rule 10f-3 have less and less reliability as a test of whether an offering is sufficiently broadly distributed among investors to prevent abuses of funds by affiliated underwriters. Neither the legislative history of Section 10(f) nor the administrative history of Rule 10f-3 indicates that the provisions were intended to cover non-fund accounts.3 Further, we submit that the adverse effect on non-fund clients (discussed fully below) far outweigh any additional protection to the funds that can be gained by aggregating fund and non-fund clients for purposes of the 25% limitation.

We believe that the proposal, if adopted, may well result in funds purchasing securities through affiliated underwritings to a lesser extent than at present. Such a result is at odds with the SEC's policy position reflected in its 1997 amendments to Rule 10f-3 that the potential benefits to funds purchasing securities during the existence of a syndicate in which an affiliated underwriter participates include better investment performance and lower costs to funds,4 and in prior Commission statements regarding the participation of funds in affiliated underwritings.5 As noted, the Release does not suggest that funds have been harmed by purchasing securities through affiliated underwritings. Our experience, and we would submit that of other large advisers with affiliated underwriters, is quite to the contrary--we believe that Rule 10f-3 has, in fact, benefited funds and their investors by allowing them to participate in primary offerings. The proposed amendments, in contrast, may well result in the investment management community, especially companies with strong international practices, moving their non-U.S. clients to accounts managed by advisers established offshore and away from the SEC's jurisdiction to escape the strictures of the 25% purchase limitation.6 We fail to see how this result in any way serves to protect either U.S. mutual funds or an affilitated adviser's other clients.

Adverse Effect on Small Investors

As proposed, the amendment would directly and adversely affect the accounts of non-fund clients by limiting the amount of securities available for purchase by these accounts in an affiliated offering. Currently, only funds are subject to the Rule's 25% limitation; non-fund clients may purchase Rule 10f-3 securities without being limited by the often large demand for these securities by funds.

We believe the Commission made significant strides in 1997 when it raised the level at which affiliated funds can participate in Rule 10f-3 transactions from 4% to 25%. As noted by the Commission in the 1997 adopting release, the amendments are "intended to respond to concerns that the dramatic growth in the fund industry, combined with increasing concentration in the underwriting industry, and increasing business affiliations between funds and underwriters, has made the percentage limit too restrictive."7 Our experience over the past five years, however, is that the 25% limitation, while a clear improvement over its predecessor, constrains our ability to invest in underwritten securities on behalf of our clients. When demand for an offering by the funds would exceed the limitation if all orders were filled in their entirety, we typically allocate purchases in the offering to our funds on a proportionate basis based on original order size. Such pro rata allocations routinely occur in our municipal and high yield funds.

The proposed amendment would require that we aggregate the purchases of all of our funds and the accounts of non-fund clients that we advise for purposes of the Rule's 25% purchase limitation. Under a proportionate allocation methodology of the sort we now use for Rule 10f-3 offerings, the smallest accounts, especially those accounts owned by individual investors, consistently would be allocated a much smaller portion of the offering, often resulting in little chance for the small investor to participate in the offering in a meaningful way. The portfolio manager of these smaller non-fund clients, for example, may find it inefficient to make an odd lot allocation, or may decide not to purchase the security at all. If these smaller non-fund clients wish to purchase more than their pro rata allotment, they would have to wait until the underwriting or selling syndicate terminates, and purchase the securities in the secondary market. This delay may cause these non-fund clients to pay a significantly higher price for the securities and incur significant additional transaction costs, including brokerage commissions, than they usually would pay when purchasing directly in an underwritten offering.

The result of reducing or eliminating the portion of an offering available to small individual accounts appears completely contrary to recent SEC initiatives to put small investors on the same footing as large institutional clients. In 2000, the Commission adopted Regulation FD,8 which sought to preclude issuers from disclosing important nonpublic information, such as advance warnings of earnings results, to securities analysts or selected institutional investors or both, before making full disclosure of the same information to the general public. The Commission stated in the adopting release that the practice of selective disclosure leads to a loss of investor confidence in the integrity of the capital markets, leaving investors to wonder whether they are on a level playing field with market insiders. The proposed amendments to Rule 10f-3 would similarly appear to disadvantage smaller investors by effectively making them competitors with large funds for a proportionate share of securities in Rule 10f-3 transactions. This likely result of the amended Rule certainly seems quite at odds with the Commission's stated objective when it adopted Regulation FD of placing the investing public on an equal footing with market insiders and large institutions.

Recordkeeping and Compliance Burdens

The Release asserts that the recordkeeping burden for funds that rely on Rule 10f-3 may minimally increase under the new proposal. The Commission cites no clear factual basis for this observation, and our experience leads us to take exception to the Commission's view. We believe that the Commission has significantly underestimated the costs, both in terms of dollars and employee time, of compliance with the proposed amendments. The proposal would require compliance and recordkeeping systems, which were only recently redesigned to address Rule 10f-3's recent amendments in 1997, to be dramatically reconfigured. MLIM, and we would strongly suspect most other firms affiliated with large underwriters, created compliance and recordkeeping systems designed to track registered fund purchases of Rule 10f-3 securities, and extensively trained personnel charged with enforcement of the Rule's requirements. If the proposed amendment is adopted, the systems would have to be substantially redesigned to ensure compliance with the new requirements, and personnel retrained, at significant expense. Imposing these additional costs a mere three years after Rule 10f-3 was last amended, and based on what appears to be conclusory observations about potential conflicts, strikes us as unjustified.


For the reasons set out above, we strongly believe that the proposal to amend Rule 10f-3 by extending the 25% limitation to purchases by non-fund clients managed by a fund's investment adviser is unnecessary, costly, provides no additional investor protection, and will likely have unintended and undesirable results for both small investors and funds. Rule 10f-3, as currently written, protects funds and their investors from an adviser's placing unmarketable securities in a fund in order to advance the interests of the fund's affiliated underwriter. The SEC has offered no factual support that Rule 10f-3 is not adequately addressing the concerns underlying Section 10(f).

We appreciate the opportunity to comment on the proposed rulemaking. Please call Philip Kirstein or Phillip Gillespie at 609-282-2021 if you have any questions regarding the letter.

Very truly yours,

Philip L. Kirstein
General Counsel

1 The SEC first proposed this change to Rule10f-3 in 2000. See Exemption for the Acquisition of Securities During the Existence of an Underwriting or Selling Syndicate, Investment Company Act Release No. 24775 (November 29, 2000).
2 Adoption of Rule N-10f-3 Permitting Acquisition of Securities of Underwriting Syndicate Pursuant to Section 10(f) of the Investment Company Act of 1940, Investment Company Act Release No. 2797 (Dec. 2, 1958) ("1958 Release"). The Rule codified orders that the Commission had granted prior to 1958 exempting certain funds from Section 10(f) to permit them to purchase specific securities. See, e.g., The Chicago Corporation, Investment Company Act Release No. 107 (Apr. 8, 1941); The Pennroad Corporation, Investment Company Act Release No. 1636 (Aug. 10, 1951) (together, "Pre-1958 Releases").
3 Subjecting investors other than funds to Rule 10f-3 limitations indirectly regulates those accounts that are otherwise exempt from regulation under the 1940 Act--a practice that appears questionable as a matter of policy and administrative law.
4 See Exemptions for the Acquisition of Securities During the Existence of an Underwriting of Selling Syndicate, Investment Company Act Release No. 22775 (July 31, 1997). ) ("1997 Rule 10f-3 Amendments").
5 See, e.g., Withdrawal of Quarterly Reporting Forms and Filing Obligation of Certain Registered Investment Companies, Securities Act Release No. 6591 (July 1, 1985); Exemption of Acquisition of Securities During the Existence of Underwriting Syndicate, Investment Company Act Release No. 10736 (June 14, 1979); 1958 Release; Pre-1958 Releases.
6 Indeed, to the extent that non-U.S. accounts are separately regulated under the laws of another jurisdiction, such as MLIM's Luxembourg UCITS fund family, the rule proposal would effectively override legal and regulatory determinations made by such jurisdictions regarding the permissibility of purchases from affiliated underwriting groups.
7 See 1997 Rule 10f-3 Amendments.
8 Selective Disclosure and Insider Trading, SEC Rel. No.34-43154 (Aug. 15, 2000).