August 19, 2002
Mr. Jonathan G. Katz
U.S. Securities and Exchange Commission
450 Fifth Street, NW
Washington, DC 20549-0609
Re:Request for Comments on Proposed Rules Concerning the Certification of Disclosure in Companies' Quarterly and Annual Reports -- File No. S7-21-02
Dear Mr. Katz:
The Financial Services Practice Group of Dechert is pleased to have this opportunity to comment on the application of the certification requirements of Section 302 of the Sarbanes-Oxley Act of 2002 (the "Act") to investment companies registered under the Investment Company Act of 1940 (the "1940 Act"), in response to the Commission's request for comment as set forth in Release No. 34-46300, dated August 2, 2002.
Dechert is an international law firm with a wide-ranging investment management practice that serves clients in the United States and worldwide. Among these are many U.S.-registered open-end funds, closed-end funds, and UITs. We are submitting these views in behalf of clients engaged in the management of registered investment companies.
Dechert strongly supports the Commission in its ongoing efforts to implement the provisions of the Act and to accomplish the important reforms in corporate governance, disclosure, accountability and accounting practices that are mandated by the Act.
For the reasons discussed below, we believe that Section 302 of the Act should not be applied to registered investment companies without the Commission's consideration of the special circumstances of investment company governance, regulation, and operations. We believe, therefore, that the Commission should exercise its authority to defer application of Section 302 to registered investment companies pending a comprehensive review of reports filed by such companies to determine (i) whether certification of such reports would enhance the protection of shareholders; and (ii) if so, how such reports should be modified to make certification of the reports meaningful.
Section 302 of the Act requires the Commission to adopt rules for companies filing periodic reports under Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the "1934 Act"), requiring the company's principal executive officer(s) and principal financial officer(s) to certify as to certain matters related to the company's annual and quarterly reports filed under those 1934 Act provisions. The deadline for adopting these rules is August 29, 2002.
Among other matters, these certifications shall include statements that:
(1) based on the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading; and
(2) based on the officer's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition and results of operations of the issuer as of, and for, the periods presented in the report.
The signing officers must also make a number of certifications concerning the company's internal controls, including that the signing officers have presented in the report their conclusions about the effectiveness of their internal controls.
The Commission's Request for Comment
The Act was signed into law on July 30, 2002. On June 14, 2002, the Commission, on its own initiative, had already proposed certification requirements for companies filing quarterly and annual reports with the Commission (the "June 14 Proposal"). The rules required by Section 302 and the Commission's June 14 Proposal differ in a number of respects. On August 2, 2002, the Commission published supplemental information on the June 14 Proposal in light of the specific requirements of Section 302 (the "Supplemental Release"). In the Supplemental Release, the Commission stated that it would issue and make effective final certification rules on or about August 29, 2002, which would require the certifications set forth in the Act.
Specifically, the Commission asked for comments on the manner in which the certification requirement should address registered investment companies, including (1) the appropriate location for the certification, (2) the appropriate individuals to provide the certification, (3) how the rule should apply to different types of investment companies, and (4) any other matters that are specific to registered investment companies.
Application of Section 302 to Registered Investment Companies
Congress clearly intended Section 302 of the Act to require the certification of the periodic reports of "public companies." It is unclear, however, whether Congress considered how Section 302 would apply to reports of registered investment companies. The sparse legislative history of the Section 302, the ambiguous language of the provision, and the practical difficulties of applying Section 302 as it is written to investment companies strongly suggest that such application was not specifically considered.1
Neither the Act Nor the June 14 Proposal Focuses on Registered Investment Companies. While registered investment companies may be caught up in the broad definition of "issuers" used in the Act, it is clear that registered investment companies were not the focus of the Commission's or Congress's concerns in the process that led to the June 14 Proposal or the enactment of the Act. Public operating companies, and not registered investment companies, were the source of the misconduct involving financial statements and the series of corporate and accounting scandals that led to these regulatory and legislative actions.2 Senate Report 107-205 discusses the Act's origin in response to "the accounting and investor protection issues raised by the financial revelations involving Enron and other public companies."3 It is clear that Congress enacted the certification provisions of the Act because of concerns about the quality and integrity of financial reporting by public operating companies.
Significantly, the Commission itself, the agency charged with protection of the public interest in the securities markets and the repository of the greatest expertise in these matters, chose, in its June 14 Proposal, to exclude registered investment companies from the certification requirement. While that proposal, like Section 302, described its universe as all quarterly and annual reports filed under Section 15(d) of the 1934 Act, the Commission proposed the certification requirements only for forms 10-Q, 10-QSB, 10-K and 10-KSB.
Ambiguous Statutory Language. The language of Section 302 also suggests that registered investment companies were not the focus of the section. In Section 302, Congress directs the Commission to adopt rules imposing a certification requirement on the principal executive officer and principal financial officer of "each company filing periodic reports under section 13(a) or 15(d) of the Securities Exchange Act of 1934."
Form N-SAR is the only periodic report filed by registered investment companies that may arguably fall under Section 15(d) of the 1934 Act, and thus the only report potentially covered by Section 302.4 The Form N-SAR, however, is not the type of report that Section 302 seems to contemplate. Most notably, Form N-SAR does not include financial statements and does not purport to "present in all material respects the financial condition and results of operations of the registered investment company for the periods presented." An officer should not be asked, therefore, to certify that it does.
It is also unreasonable to ask that officers of a registered investment company certify that the Form N-SAR includes no material omissions. Unlike the Forms 10-Q and 10-K filed by publicly traded companies, Form N-SAR does not purport to give a full picture, through a combination of full financial statements and plain English narrative, of the issuer's financial condition during the period covered by the report. The Form N-SAR is a "fill in the blank" form calling for specific items of information, mostly in short answer or check the box format. The form has very little flexibility to receive information not specifically called for by the individual questions.5
Finally, Form N-SAR is simply not designed to be a readable document. It is a data collection vehicle, rather than a report providing useful information to shareholders.6 As such it contains much that would be irrelevant to the Section 302 certifications, and not enough to support them. In sum, the Form N-SAR would require substantial redesign before an agency could reasonably ask an officer to make the certifications specified in Section 302.
The Commission Should Defer Application of Section 302 to Registered Investment Companies Pending a Comprehensive Review of Reports Filed by Such Companies
As discussed above, the legislative history of Section 302, the ambiguous language of the provision, and the practical difficulties of applying Section 302 as it is written to investment companies strongly suggest that Congress did not specifically address the certification requirement in the context of registered investment companies. Rather, it appears that registered investment companies were caught up in Congress' desire to address the misconduct by public operating companies that was the driving force behind the enactment of the Act. Indeed, the Commission's June 14 Proposal would not have subjected registered investment companies to the certification requirements at all.
Moreover, registered investment companies are fundamentally different from the public operating companies that are the focus of the Act's requirements. The corporate governance structure of registered investment companies has recently been the subject of extensive rulemaking by the Commission, which implemented many of the reforms that the Act imposes on public companies.7 Pursuant to the 1940 Act and the rules adopted thereunder, registered investment companies:
We also note that registered open-end investment companies continuously offer shares registered under the Securities Act of 1933 (the "1933 Act") on the basis of an effective registration statement, which is amended at least annually. Because virtually all open-end investment companies are engaged in continuous offerings, officers and directors who sign such registration statements are continuously subject to civil liability under Section 11 of the 1933 Act for material misstatements or omissions in those registration statements, which include financial statements. In addition, Section 17 of the 1933 Act similarly imposes criminal liability on any person who fraudulently offers or sells a mutual fund security. The 1940 Act also imposes criminal liability for certain activities. Section 48 proscribes doing indirectly that which is prohibited by any provision of the 1940 Act, and Section 49 imposes criminal penalties for violations of the 1940 Act and material misstatements or omissions in any report filed under the 1940 Act.
In contrast, executives and directors of public operating companies subject to the reporting requirements of Section 13(a) or 15(d) of the 1934 Act currently are subject to 1933 Act liability only during those periods in which such companies are engaged in a public offering.8 Section 302 of the Act closes this gap in the federal securities laws by establishing a framework for imposing liability on chief executive officers and chief financial officers of such companies.
In light of (i) the fact that registered investment companies were not the focus of Congress' concern in enacting the Act, (ii) the regulatory regime and standards of liability to which registered investment companies and their officers are already subject, and (iii) the practical difficulties of trying to apply Section 302 to Form N-SAR, there is in our view no need to rush to impose a certification requirement on periodic reports of registered investment companies without thoughtful consideration. For this reason, and given the truncated schedule under which initial Section 302 rules must be adopted, we believe that the Commission should defer the application of Section 302 to registered investment companies pending a comprehensive review of the reports filed by such companies. The Commission would then have an opportunity to consider the special circumstances of investment company governance, regulation, and operations, and could determine (i) whether certification of such reports would enhance shareholder protections, and (ii) if so, how such reports could be modified to make certification of the reports meaningful. After completing this review, the Commission could adopt rules for the certification of the appropriate reports under Sections 6(c) and/or 30(d) of the 1940 Act, which provide the Commission with broad rulemaking authority.9
The following examples illustrate some of the issues that should be considered by the Commission with respect to certifications of reports of registered investment companies.
The Supplemental Release requests comment on the appropriate individuals to provide the Section 302 certification. Section 302(a) requires certifications to be provided by "the principal executive officer or officers and the principal financial officer or officers, or persons performing similar functions." Because of the variety and complexity of investment company structures, we believe that the certifying officers should be required to be persons of appropriate experience and authority, but that the selection of the particular individual should be determined by each registered investment company's board of directors.10
The relationship of an investment company with its investment adviser, administrator, and other service providers varies widely. An investment company's service providers may be affiliated with each other or independent. An investment company may have officers that are employees of the investment company; employees of an investment adviser; employees of an administrator or other service provider; or some combination of the above. Even within a fund complex, the officer best equipped to certify one investment company's (e.g., an equity fund's) periodic reports may not be the proper person to certify another's (e.g., a fixed income fund's) reports. In our view, it would not be possible to draft a rule that would reliably identify the officers of investment companies (or investment company service providers) who have the expertise necessary to make the Section 302 certifications regarding each investment company's financial statements and internal controls. Such a determination could best be made on a fund-by-fund basis by each investment company's board of directors.
We note that any rule that imposed a certification requirement on the principal executive officer or principal financial officer of a registered investment company would raise logistical difficulties for officers of large investment company complexes. In many large investment company complexes, the same two individuals serve as principal executive officer and principal financial officer, respectively, for all of the investment companies in the complex. Unlike officers of public operating companies, who will have a quarterly obligation to certify one set of consolidated financial information, officers of large investment company complexes could have several hundred individual sets of financial information to certify over the course of a given year. If new regulations were to impose a certification requirement on an investment company's principal executive officer or principal financial officer, we question whether a single person would have the ability to give each of hundreds of filings the same level of scrutiny that the chief executive officer or chief financial officer of a public operating company can be expected to give to four filings per year. We believe, therefore, that any rulemaking in this area should take into consideration the number of certifications that would be required in the case of a large investment company complex, and should permit the determination of the certifying officer to be made on a fund-by-fund basis by each investment company's board of directors.
Sections 302(a)(4) through (6) of the Act require the signing officers to certify several matters related to internal controls. For example, Section 302(a)(4) requires the signing officers to certify that they are responsible for establishing and maintaining internal controls, and that they have designed internal controls to ensure that material information relating to the issuer is made known to the officers by others within the issuer.
To the extent that the Commission determines to apply Section 302 to registered investment companies, we believe that the Commission should limit the certification requirement for registered investment companies to the company's own internal controls, and not the controls of service providers. This approach would be consistent with the regulatory scheme governing investment companies, which contemplates the delegation of certain functions to service providers. These service providers are, in many cases, entities that themselves are subject to regulation under the federal securities or banking laws (banks, broker-dealers, transfer agents, and custodians). For example, the foreign custody rule (Rule 17f-5 under the 1940 Act) permits an investment company's board of directors to delegate certain custodial responsibilities to a third party. Under this system, a signing officer might not be able to certify, as Section 302(a) requires, that he or she has "establish[ed] and maintain[ed]" and "designed" the controls employed by unaffiliated service providers.
The system of regulated service providers distinguishes investment companies from operating companies and, in our view, an internal controls certification requirement for registered investment companies should reflect this distinction.
* * *
We appreciate the opportunity to comment on the Section 302 certification requirements. If we can be of any further assistance in this regard, please do not hesitate to contact Joseph R. Fleming at (617) 728-7161, John V. O'Hanlon at (617) 728-7111, Paul Schott Stevens at (202) 261-3348, or Ruth S. Epstein at (202) 261-3322.
|1||We acknowledge that Section 405 of Title IV of the Act exempts registered investment companies from Sections 401, 402, and 404 of the Act, arguably suggesting by implication that Congress intended that registered investment companies fall within the scope of Section 302. Even assuming that this is the case, however, it does not suggest that Congress specifically considered how Section 302 would apply to reports filed by registered investment companies.|
|2||See, e.g., Paul Beckett, Executives Face Harsh Sanctions in Corporate-Governance Law, Wall St. J., July 31, 2002, at C7 ("The push for having CEOs and finance chiefs attest personally to the accuracy of their results has stemmed directly from the crisis of confidence in corporate responsibility amid scandals from Enron Corp. to WorldCom Inc.").|
|3||S. Rep. No. 107-205, at 2 (2002) (submitted by Sen. Sarbanes).|
|4||Registered investment companies are required by Section 15(d) of the 1934 Act to file periodic reports with the Commission. Sections 30(a) and (b) of the 1940 Act also impose a reporting requirement on registered investment companies. Section 30(d) of the 1940 Act, however, directs the Commission to issue rules regarding the filing with the Commission of periodic reports pursuant to Sections 30(a) and (b) of the 1940 Act, "in lieu of any reports and documents required of such company under Section 13 or 15(d) of the [1934 Act]" (emphasis added). Pursuant to this directive, the Commission adopted rules requiring the filing of Form N-SAR, and deeming the form to satisfy the requirement to file reports under Section 15(d). See Rules 30b1-1 and 30a-1. Thus, as a technical matter, Form N-SAR is arguably a form filed under the 1940 Act, and not a report under Section 13(a) or 15(d) of the 1934 Act.|
|5||Compare the instructions to Form 10-K (General Instruction C(1): "This Form is not to be used as a blank form to be filled in, but only as a guide in the preparation of the report on paper meeting the requirements of Rule 12b-12 [under the 1934 Act]") with the instructions to Form N-SAR (General Instruction E(1): "Form N-SAR is to be used as a blank form to be filled in by the registrant"). In addition, no exhibits to Form N-SAR are permitted, except for those specifically prescribed by Items 77 and 102 of the form.|
|6||See Exchange Act Rel. No. 21208 (Aug. 14, 1984) (Form N-SAR proposing release); Exchange Act Rel. No. 21633 (Jan. 11, 1985) (adopting release).|
|7||See Investment Company Act Rel. No. 24816 (Jan. 2, 2001).|
|8||Under certain circumstances, executives and directors of public companies may face 1933 Act liability as a result of post-effective amendments to a registration statement filed during a continuous offering pursuant to Rule 415 under the 1933 Act. See Item 512(a)(2) of Regulation S-K (undertaking required of Rule 415 registrants).|
|9||We note that the Commission has included amendments to Form N-SAR on the Commission's Regulatory Flexibility Agenda. See Investment Company Act Rel. No. 25494 (Mar. 22, 2002).|
|10||As a result of recent amendments to a number of exemptive rules under the 1940 Act, the vast majority of investment companies now are required to have boards of directors with a majority of independent members. See Investment Company Act Rel. No. 24816 (Jan. 2, 2001).|