Federated Investors, Inc.
Federated Investors Tower
1001 Liberty Avenue
Pittsburgh, PA 15222-3779
Via E-mail and Federal Express
January 17, 2002
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, D.C. 20549-0609
|Re:||Proposed Amendments to Rule 17a-8|
|File No. S7-21-01|
Dear Mr. Katz:
This letter presents the comments of Federated Investors, Inc. ("Federated")1 regarding the proposal (the "Proposal") of the Securities and Exchange Commission ("Commission") to amend Rule 17a-8 of the Investment Company Act of 1940 ("Rule 17a-8" or the "Rule"), which permits certain affiliated registered investment companies to merge without first obtaining an exemptive order from the Commission. Currently, the Rule permits registered investment companies ("funds") to merge only when the funds are affiliated solely because they have a common investment adviser, common directors, and/or common officers. The Proposal would expand the availability of the Rule to permit (1) mergers of funds that are affiliated for other reasons, and (2) mergers of funds and affiliated common or collective trust funds.2 The Proposal, however, would require funds to comply with certain new conditions for relief, including (1) board consideration of certain enumerated factors, if relevant, (2) approval of the merger by shareholders of a non-surviving fund, (3) board adoption of certain pricing procedures in mergers involving a fund and a collective or common trust fund, and (4) the use of "echo voting" by certain shareholders.
At the outset, we would like to express our support for the overall objective of the Proposal, which is "to reduce burdens on investment companies by eliminating the need to obtain Commission approval [for affiliated mergers] while protecting investors in these companies."3 We especially support expansion of the Rule to permit mergers of funds and affiliated common or collective trust funds.
For over twenty years, Rule 17a-8 has, in our view, regulated certain fund mergers in a protective yet efficient manner, without placing undue burdens on affected funds or their shareholders. We have every reason to expect that extending the Rule to cover additional circumstances would be just as beneficial. However, we believe that specific aspects of the Proposal would be unworkable and/or impose unnecessary burdens on funds, without creating any significant benefits for shareholders, thereby severely impairing the overall utility of the Rule.
Specifically, we believe that:
Each of these comments is discussed in more detail below.
I. THE COMMISSION SHOULD NOT CODIFY FACTORS THAT A BOARD SHOULD CONSIDER IN CONNECTION WITH A MERGER.
Rule 17a-8 currently requires the board of a merging fund to determine that participation in the merger is in the best interests of the fund, and the interests of the fund's shareholders will not be diluted as a result of the merger. However, the Rule does not currently require the board to consider any specific factors in connection with the merger. Nevertheless, with respect to the "best interests" determination, the Commission now proposes to add to the Rule a host of factors that a board must consider. For the reasons discussed below, we oppose the addition of these factors to the Rule, and we believe that the Rule's current approach continues to be appropriate.
As the Commission stated in the Proposal, state law places "substantial duties on fund directors considering a merger to act in the best interests of the shareholders."4 The Commission further noted that in the context of mergers, directors today "must be diligent and vigilant in examining critically the proposal and alternatives, . . . [and] must act with due care in considering all material information reasonably available, including information necessary to compare an offer to alternative courses of action.'"5 Accordingly, to the extent that the factors enumerated in the Proposal are material to a proposed merger, state law already requires directors to consider them in connection with approval of the merger. Thus, we feel that the board determinations currently required by the Rule, coupled with existing state law requirements, provide strong and sufficient shareholder protections by requiring boards to consider all factors that are material to a proposed merger.
Moreover, by codifying specific factors, we believe that the Commission creates the risk that a board will focus too much attention on the enumerated factors, and potentially too little attention on relevant, but non-enumerated, factors in an effort to satisfy the perceived requirements of the Rule. In addition, factors which the Commission believes may be relevant to a board's deliberations in 2002 may become outdated, thus placing boards in awkward situations and requiring periodic revisions to the Rule to keep the factors current.6
We have particular objections to the Proposal's fourth board factor (requiring consideration of "[a]ny change in [shareholder] services"), which does not differentiate between minor services and those services that may be material to a transaction. Instead, the Proposal would require a board to consider differences in any services (whether immaterial or material) if such differences are "relevant" to the board's determination that the merger is in the best interests of the fund's shareholders. Without more specific guidance, boards could easily focus undue attention on immaterial services, and thus potentially detract from their consideration of material, non-enumerated factors. For example, under the proposed wording, we can easily envision a board concluding that it must analyze whether differences in such relatively minor matters as check writing privileges, or the hours when personnel are available to respond to telephone inquiries, or the availability of a systematic withdrawal plan are "relevant." We also note that the concept of services can be exceedingly elastic, yet the Proposal gives no guidance as to what "services" means. For example, is the quality of a website or of an account statement design a "service"?
Finally, there is no apparent need for the adoption of these types of additional conditions. The Release cites a number of newspaper articles that raise merger-related issues, but does not cite any relevant Commission enforcement actions or other evidence that would suggest that boards have been remiss in their deliberations regarding proposed fund mergers. Given that Rule 17a-8 has been in place for over twenty years, we find the lack of such precedent a compelling reason to forego additional, and potentially counter-productive, burdens to funds and their boards.
In the Proposal, the Commission asked whether, as an alternative, such factors should be discussed in the adopting release rather than the Rule. Because factors can easily become outdated, we do not believe that the Commission should discuss specific factors in the Rule or the adopting release. However, to the extent that the Commission believes it is necessary or desirable to provide guidance on such matters, we strongly urge the Commission to address these factors in the adopting release, but merely as examples of the types of matters a board might wish to focus on.
II. THE PROPOSED SHAREHOLDER APPROVAL REQUIREMENT IS UNNECESSARY ABSENT A SHOWING OF ABUSE, AND SHAREHOLDER APPROVAL REQUIREMENTS SHOULD CONTINUE TO BE GOVERNED BY STATE LAW.
Rule 17a-8 does not currently include a shareholder voting requirement. As with most matters relating to basic corporate governance of investment companies, the Rule currently defers to state law with respect to the voting rights of shareholders. The Proposal would, however, replace state law requirements with a federal requirement that shareholders of an acquired fund approve the merger.
We believe the adoption of a federal voting requirement is unnecessary and, absent a showing of abuse, unwarranted. The fact that business trusts may not be required to receive shareholder approval before being acquired by another fund is not a new development. Nevertheless, as noted, Rule 17a-8 has been in effect for over twenty years, and, to date, there has been no indication that shareholders have been inadequately protected by the Rule, even in instances where shareholder approval was not required.
Moreover, just because a shareholder vote is not required, that does not mean that one will not be sought. The Commission itself noted that it "rarely sees fund mergers in which a shareholder vote is not held. Many funds are constrained by state law [or their charter documents] to conduct a shareholder vote in the event of a merger. Even funds that are not required by state law to obtain shareholder approval may do so in order to maintain good relations with their share-holders."7 We suggest that the board of such a fund would be in the best position to assess all the relevant circumstances and make a decision on the desirability of proceeding with a shareholder meeting. Thus, it seems the Proposal is attempting to remedy a problem that does not really exist.8
Furthermore, shareholder interests are well protected by the independent director and independent legal counsel requirements of the Rule. Under both the current Rule and the Proposal, any fund participating in a merger under the Rule would be required to have a majority of independent directors on the board. Moreover, independent directors would be required to nominate any new independent directors. In addition, any legal counsel for the independent directors would be required to be independent. The independent director and independent legal counsel requirements well protect shareholder interests, especially in light of the "substantial duties" which state law imposes upon directors in connection with the approval of a merger.9
To the extent that the Commission is concerned about shareholders being informed about the merger, we recommend that the Commission adopt a requirement that the non-surviving fund provide advance notice of the merger to its shareholders if its shareholders will not be voting to approve the merger. We believe the shareholder notice requirements in Rule 35d-1(c), recently adopted by the Commission to address certain changes in a fund's investment policies that will be made without a shareholder vote, would work equally well with respect to pending mergers. Further, we would also support a disclosure requirement for funds that have the ability to be acquired by another fund without a shareholder vote. Item 4(a) of Form N-1A currently requires prospectus disclosure if a fund can change its investment objective(s) without shareholder approval. We believe that a fund's ability to be acquired without shareholder approval is best dealt with through similar disclosure (rather than a new requirement to hold a shareholder meeting).
III. THE PROPOSED USE OF SPECIAL PRICING PROCEDURES IN CONNECTION WITH MERGERS INVOLVING COMMON OR COLLECTIVE TRUST FUNDS POTENTIALLY HARMS SHAREHOLDERS.
The Proposal would require funds merging with affiliated common or collective trust funds to comply with special pricing conditions. Specifically, the board must approve special pricing procedures, which would require, among other things, the fund to retain an "Independent Evaluator" (as defined in the Proposal) to value the common or collective trust funds' assets in accordance with the procedures set forth in Rule 17a-7(b). We oppose these special pricing requirements for several reasons.
First, as the Commission acknowledges, the surviving fund will already have "well-established procedures" for pricing.10 These procedures typically involve the use of a pricing service to obtain market quotations, and the use of an established fair valuation methodology for certain securities for which market quotations are not readily available. As the Commission knows, a fund's normal pricing procedures will differ to some extent from the procedures set forth in Rule 17a-7(b). Accordingly, if a fund is required to value assets pursuant to Rule 17a-7(b) for purposes of acquiring them, and applies its normal pricing procedures after the acquisition, certain assets will be assigned values that differ from the values that would have been assigned had the fund been permitted to use its standard pricing procedures.11 As a result, the surviving fund will be paying either too much or too little for those assets (compared to what it would have paid under its normal procedures). If the former, existing (pre-merger) shareholders of the fund are diluted; if the latter, shareholders of the acquired fund are shortchanged. Either way, the result is unfair. Likewise, if it uses Rule 17a-7(b) procedures, the surviving fund will have an immediate, and unintended, unrealized gain or loss upon consummation of the merger. This unrealized gain or loss, while artificial, nonetheless may have adverse tax and accounting consequences to the fund and its shareholders (including the new shareholders from the non-surviving fund).12
In addition, the use of an Independent Evaluator is a cost that will likely be borne by the fund's shareholders. The Commission estimates that the cost of engaging an Independent Evaluator would be approximately $15,000, a cost which is not insubstantial. In addition, the Proposal would require the fund's board to approve formal procedures for the valuation of the common or collective trust fund's assets. The preparation of the procedures, presumably by independent legal counsel, would result in additional costs borne by the fund's shareholders. Moreover, approval of such procedures could, in some circumstances, require a special board meeting, which would result in still further costs borne by the fund's shareholders.
We believe that shareholders are more than amply protected if funds are permitted to use their standard pricing procedures to value the assets of collective or common trust funds. The fund's board is responsible for initially approving and periodically reviewing the fund's pricing procedures. The fund's board also has ultimate responsibility for the proper execution of the procedures. As noted above, Rule 17a-8 currently requires and would continue to require the fund to have a majority of independent directors on its board. This requirement serves as a further safeguard against mispricing.
In short, fund shareholders rely on the fund's standard pricing procedures every time they buy or redeem shares. If these procedures provide adequate protection for valuing assets the fund already owns, there is no reason to believe that they would be in any way deficient if used to value the assets of a common or collective trust fund which the fund is about to acquire.
Accordingly, we oppose the proposed use of an Independent Evaluator and Rule 17a-7 procedures to value the assets of a merging common or collective trust fund because: they are unnecessary; they create the possibility for dilution; they result in creation of artificial gains or losses; and they would inflict additional costs on shareholders, all without any increase in existing shareholder protections. We believe that the fund's use of its existing pricing procedures well protects shareholders, especially in light of the Rule's independent director requirements.
IV. THE PROPOSED ECHO VOTING REQUIREMENT IS INCONSISTENT WITH THE FIDUCIARY DUTIES OF FIDUCIARIES WHICH MAY BE "RELATED SHAREHOLDERS" UNDER THE PROPOSAL.
The Proposal would impose a new "echo voting" requirement in certain circumstances. Specifically, if an owner of more than five percent of the shares ("owner affiliate") of the fund holding the vote is another merging fund, or an investment adviser, principal underwriter, or owner affiliate of another merging fund (a "related shareholder"), then the related shareholder would have to vote its shares in the same proportion as non-related shareholders ("echo voting"). We oppose the addition of an echo voting requirement to the Rule because: (1) it would deprive related shareholders of a basic corporate right, (2) investors are well protected by the independent director requirements of the Rule, and (3) with respect to related shareholders that are fiduciaries, the echo voting requirement would likely violate their fiduciary duties.
The Proposal does not acknowledge, let alone address, the fact that "related shareholders" are still shareholders of the fund and, as envisioned in §1(b)(3) of the Act, should be protected from "discriminatory provisions" vis-à-vis their fellow shareholders. As noted above, in the vast majority of mergers, shareholders of the acquired fund will be asked to vote on the matter, yet the Commission is proposing to effectively disenfranchise related shareholders in these cases. Where state law and/or the fund's organizational documents give shareholders the right to vote on a matter, we maintain that the Commission should have to meet the highest burden of demonstrating a bona fide necessity before it deprives any segment of the shareholder base of its elemental corporate rights. As discussed below, it does not appear that the Commission has met that burden with respect to this aspect of the Proposal.
As discussed above, Rule 17a-8 currently requires and, if amended, would continue to require funds wishing to rely on the rule to have a majority of independent directors on their boards. A fund's directors are required under applicable state law to act in the best interests of shareholders. Prior to any shareholder vote, Rule 17a-8 requires a fund's board to determine that the terms of the proposed merger are in the best interests of the fund and not dilutive to its shareholders. We believe that the role of directors, especially the independent directors, in considering and approving the terms of the merger prior to a shareholder vote protects non-related shareholders from possible overreaching by the related shareholders, and thus eliminates the potential abuses that an echo voting requirement seeks to address.
In addition, we believe that an echo voting requirement would potentially violate certain state laws relating to fiduciary duties. As the Commission is aware, some related shareholders will be holding their shares in a fiduciary capacity (e.g., a bank holding shares in a trust capacity). The proposed echo voting requirement would cause related shareholders acting in a fiduciary capacity ("fiduciary shareholders") to potentially violate their fiduciary duties, because state law restricts the ability of a fiduciary to delegate discretionary powers, such as the voting of shares.13
The Restatement (Third) of Trusts, Prudent Investor Rule states that a trustee "has a duty personally to perform the responsibilities of the [fiduciary] except as a prudent person might delegate those responsibilities to others."14 The Restatement further states that "[d]ecisions of [fiduciaries] concerning delegation are matters of fiduciary judgment and discretion. Therefore these decisions may not be controlled by a court except to prevent abuse of that discretionary authority."15 A fiduciary shareholder has "discretion whether and how to vote and if he does not abuse his discretion the court will not control him in voting . . . ."16 Accordingly, we believe that the imposition of a mandatory echo voting requirement would violate the discretionary powers granted to fiduciary shareholders under state law, and force fiduciary shareholders to delegate their voting authority in situations where it is not in the best interest of their beneficiaries.
The Proposal notes that the echo voting requirement would not prevent a fiduciary from seeking voting instructions from beneficial owners.17 However, this ignores the main reasons that a fiduciary relationship is created - settlors specifically wish to entrust matters such as voting to a fiduciary because of the fiduciary's ability to stay better informed about the nature and circumstances relating to an investment, and to secure for the beneficiaries the professional judgment and expertise of the selected fiduciary.
Finally, it is worth noting that shareholders are well protected in situations where a fiduciary shareholder votes. State law obligates fiduciary shareholders to vote shares strictly in the best interests of the beneficiaries of the underlying fiduciary relationship.18 This duty is heightened when a fiduciary shareholder holds a significant stake in a fund.19 The failure of a fiduciary shareholder to vote its shares in the best interests of its beneficiaries creates liability. The Restatement (Second) of Trusts states that "[w]here a trustee of shares of stock uses his power to vote to make an improper profit, he is liable for the profit so made."20 Thus, if a fiduciary shareholder were to vote shares in such a manner as to enrich itself at the expense of shareholders, it would be liable to its fiduciary clients.
* * * * *
Federated very much appreciates having the opportunity to comment on this Proposal. If you would like to discuss these comments or any other aspects of the Proposal with us, please contact: Jay Neuman by phone at (412) 288-7496 or by e-mail at Fjneuman@federatedinv.com; or John Johnson by phone at (412) 288-6653 or by e-mail at firstname.lastname@example.org . Thank you very much.
Very truly yours,
Jay S. Neuman
John D. Johnson
Associate Corporate Counsel
|cc:||Paul F. Roye, Director |
Division of Investment Management
|1||Federated is one of the largest asset management and mutual fund firms in the United States. Through its subsidiaries, Federated manages total assets of more than $179 billion and serves as adviser, distributor, and/or administrator for over 550 classes of mutual fund shares, as of December 31, 2001.|
|2||The Proposal is set forth in Release No. IC-25259 (November 8, 2001), 66 F.R. 57602 (November 15, 2001)( "Release")|
|3||Release at p. 57602.|
|4||Release at p. 57604.|
|5||Release at p. 57604, n. 21 (quoting Diane Holt Frankle, Fiduciary Duties of Directors Considering a Business Combination, PLI/Corp. 525, 531 (June 2000)).|
|6||For example, the adopting release for Rule 12b-1 included a list of factors that a board should consider in connection with the approval or continuation of a Rule 12b-1 plan. Many of these factors are now arguably outdated, as the SEC staff recently acknowledged in its December 2000 Report on Mutual Fund Fees and Expenses
in which it stated:
In addition, many directors believe that when they consider whether to approve or continue a 12b-1 plan, they are required to evaluate the plan as if it were a temporary arrangement. The adopting release for rule 12b-1 included a list of factors that fund boards might take into account when they consider whether to approve or continue a rule 12b-1 plan. Many of the factors presupposed that funds would typically adopt rule 12b-1 plans for relatively short periods in order to solve a particular distribution problem or to respond to specific circumstances, such as net redemptions. Although the factors are suggested and not required, some industry participants indicate that the factors are given great weight by fund boards. Some argue that the recitation of the factors impedes board oversight of rule 12b-1 plans because the temptation to rely on the factors, whether they are relevant to a particular situation or not, is too great to ignore. Although the factors may have appropriately reflected industry conditions as they existed in the late 1970s, others argue that many have subsequently become obsolete because, today, many funds adopt a rule 12b-1 plan as a substitute for or supplement to sales charges or as an ongoing method of paying for marketing and distribution arrangements.
* * *
Because of these issues, the Commission should consider whether to give additional or different guidance to fund directors with respect to their review of rule 12b-1 plans, including whether the factors suggested by the 1980 adopting release are still valid.
Report on Mutual Fund Fees and Expenses, Division of Investment Management, S.E.C. (December 2000)(emphasis added).
|7||Release at p. 57608, n. 78 (emphasis added).|
|8||We note that the Release repeatedly cites to Section 1(b)(6) of the Investment Company Act of 1940 (the "Act") in support of the proposed shareholder voting requirement to demonstrate Congress' intention that the Act covers mergers and its recognition of the importance of shareholder consent. However, we find it telling that, notwithstanding these sentiments, Congress declined to legislate a shareholder voting requirement for fund mergers. We would maintain that, where Congress felt it was truly important to impose a shareholder voting requirement, it did so in the Act (e.g., §§ 13, 15, and 16).|
|9||In the Release, the Commission states that the independent trustee requirements give the Commission "greater confidence . . . that independent directors will be in a position to influence the terms of the merger and prevent abuse." Release at p. 57604.|
|10||Release at p. 67606.|
|11||This is particularly an issue with respect to Rule 17a-7(b)(4), which requires the use of the cumbersome and time-consuming process of obtaining, typically, three independent quotes in order to satisfy the "reasonable inquiry" element of that provision.|
|12||The Commission staff addressed similar issues in United Municipal Bond Fund, Inc., SEC No-Action Letter (Jan. 27, 1995) in which the staff modified the special pricing procedures of a previously issued No Action Letter to permit a fund to use its pricing procedures instead of the special pricing procedures to avoid adverse tax and accounting consequences.|
|13||For a more fulsome discussion of the conflict between echo voting and state law, please see the complete file relating to Federated Investors, No Action Letter, WSB File No. 050294006 (April 21, 1994). We have not cited specific state laws for purposes of our discussion in this comment letter but rather have cited The Restatement of Trusts, which sets forth general principles that we believe are embodied in most states' laws relating to fiduciaries.|
|14||Restatement (Third) of Trusts, Prudent Investor Rule, § 171 (1992)(emphasis added). Please note that the Restatement of Trusts was partially revised in 1992 to reflect changes to the "prudent investor rule." To the extent not revised in 1992, the Restatement (Second) of Trusts (1959) is still in effect.|
|15||Id. at § 171, cmt. a.|
|16||Restatement (Second) of Trusts at § 193, cmt. a.|
|17||Release at p. 57605, n. 44.|
|18||See, e.g., Restatement (Third) of Trusts, Prudent Investor Rule, § 170 (1992)(discussing the duty of loyalty).|
|19||See, Restatement (Second) of Trusts, at § 193, cmt. a. ("Where the trustee holds as trustee such a large proportion of the shares of a corporation that he is in control or substantially in control of the corporation, his responsibility with respect to voting of the shares is heavier than it is where he holds only a small fraction of the shares.").|
|20||Restatement (Second) of Trusts, §170, cmt. o (1959)|