October 17, 2002
Mr. Jonathan G. Katz
Re: Request for Comments on Proposed Rules Concerning Certification of Management Investment Company Shareholder Reports and Designation of Certified Shareholder Reports as Exchange Act Periodic Reporting Forms - File No. S7-33-02
Dear Mr. Katz:
The Financial Services Practice Group of Dechert is pleased to have this opportunity to comment on the Securities and Exchange Commission's proposal regarding the certification of management investment company shareholder reports and the designation of certified shareholder reports as Exchange Act periodic reporting forms. The proposed rules were presented in the Commission's request for comment as set forth in Release No. 34-46441, dated August 30, 2002.
Dechert is an international law firm with a wide-ranging investment management practice that serves clients in the United States and worldwide. Our clients include many U.S.-registered open-end funds, closed-end funds, and unit investment trusts. We are submitting these views in behalf of clients engaged in the management of registered investment companies.
As a preliminary matter, for the reasons discussed in our August 19, 2002 comment letter on the certification of disclosure in companies' quarterly and annual reports,1 we continue to believe that Section 302 of the Sarbanes-Oxley Act (the "Act") was not directed at registered investment companies. Nevertheless, if the Commission decides to adopt this proposal in final form, we have a number of comments, which are set forth below.
As a general matter, for the reasons described below, we do not believe that investment companies should be subject to more stringent and burdensome requirements under Section 302 than other types of companies, as reflected in the proposal. Specifically, we recommend that the Commission, in its implementation of Section 302, adopt a revised version of proposed Form N-CSR and eliminate the recently adopted certification requirement for Form N-SAR. We believe that proposed Form N-CSR should be modified to require certification only of financial information included in a shareholder report. In addition, we believe that the proposed disclosure controls and procedures for investment companies should be limited to filings made under the Securities Exchange Act of 1934 ("Exchange Act") and request that the Commission require only annual certification. Finally, we request that the Commission provide further clarification of the disclosure controls and procedures as outlined in the proposal.
I. Certified Shareholder Reports
A. Form N-CSR
Currently, certification of Form N-SAR is the only step the Commission has taken under the Act towards the goal of greater accountability and improved financial disclosure with regard to registered investment companies. The Commission has proposed new Form N-CSR in order to fully effectuate the intent of the certification requirement set out in Section 302 of the Act. Proposed Form N-CSR would consist of: (1) a copy of any required shareholder report; (2) additional information regarding disclosure controls and procedures; and (3) the certification required by Section 302 of the Act. The Commission has acted in this manner in recognition that the Act, by its terms, applies only to reports made under the Exchange Act. While registered investment companies prepare and file annual and semi-annual reports to shareholders that include financial statements, those reports are currently required under the Investment Company Act of 1940 ("Investment Company Act") and not under the Exchange Act.
B. Scope of Certification
As proposed, Form N-CSR would require a management investment company to certify its entire shareholder report. Although a public company filing under the Exchange Act is also required to certify its entire periodic report (filed on Form 10-K or Form 10-Q), the effect of the proposed certification requirements on management investment companies is markedly different because of differences between the information required by the two types of reports. The shareholder reports of management investment companies typically include a considerable amount of non-financial information. This information, which often consists of forecasting, opinions on market trends, and analysis of the effects of market events on the portfolio of the investment company, is non-factual and non-financial information and, as such, is not well-suited for certification.
In addition, a comparison of public companies' Management's Discussion and Analysis (MD&A) with the narrative portion of Management's Discussion of Fund Performance (MDFP) contained in the annual report of management investment companies demonstrates a major difference in the scope of the information contained in the two documents.2 In the MD&A, the company's chief executive officer evaluates the performance of the company and its businesses during the prior period and addresses the current outlook for the company and its operations. While the MDFP also reflects back on the past year and may offer forecasts for the future, the points of view from which the two disclosure items are made are considerably different. The officer responsible for the MD&A exercises considerable control over the public company and its operations. In evaluating the prior period, he or she has nearly complete access to the information surrounding the events, decisions, and circumstances as they existed at that time and, in forecasting the company's future he or she speaks as one who has the power to make critical decisions about future events. In contrast, the MDFP specifically calls for information outside of management's control, such as market conditions. As a result of these differing circumstances, the information contained in these two disclosure items varies considerably, with the narrative portion of the MDFP tending to focus more on subjective information and opinion and the MD&A providing more factual information about the company's past and future operations.
In recognition of the differences between the reports of public operating companies and those of management investment companies, we believe that the Commission should modify Form N-CSR to limit the portions of the shareholder reports subject to certification. By limiting certification to financial information, the Commission can ensure that the responsibilities placed on management investment companies will more closely mirror those placed on public companies. Furthermore, fund officers will naturally be reluctant to certify non-financial matters as to which they cannot develop a high degree of certainty. Requiring certification of all information included in shareholder reports therefore could discourage investment companies from fully and frankly discussing the performance of the fund or making any other voluntary disclosure, resulting in the inclusion in the report of only the minimum amount of information which companies are specifically required to present. Moreover, public companies reporting under the Exchange Act are required to file their annual and quarterly reports on Forms 10-K and 10-Q, but most companies also distribute a "glossy" annual report to shareholders. This "glossy" report contains additional information beyond what is included in the required filings, but because this report is not a required filing under Section 13(a) or 15(d) of the Exchange Act, the public company will have no obligation to certify this additional, voluntary information. The Commission should give investment companies the same degree of flexibility as is given to operating companies.
C. Certification of Form N-SAR
Form N-SAR does not include financial statements, and consequently we do not believe it lends itself easily to the certification requirement. Moreover, because it does not provide investors with a complete and accurate picture of an investment company's financial condition, we believe certification of Form N-SAR does not effectively meet the goals of Section 302 and should be eliminated. Form N-SAR is not transmitted to shareholders and was not designed as a tool to convey meaningful information to investors. As a "fill-in-the-blank" form, Form N-SAR calls for specific statistical information in a limited format.3 There is virtually no flexibility in completing the form, and filers have no opportunity to supplement the form with additional information or explanation. Furthermore, with the implementation of proposed Form N-CSR, the certification of Form N-SAR becomes not only unnecessary but also duplicative, especially in light of the fact that the certification in Form N-SAR and the proposed certification in Form N-CSR would be filed at approximately the same time with the Commission after the end of the relevant fiscal period.
In order to eliminate the certification requirement on Form N-SAR, we believe that the Commission should reclassify Form N-SAR as an Investment Company Act filing for management investment companies. A complete removal of the certification requirement from Form N-SAR would leave unit investment trusts and small business investment companies without any certification requirements. If the Commission believes that certification of filings by these entities is necessary, we suggest that unit investment trusts and small business investment companies separately be required to continue their certification of N-SAR filings. The Commission could accomplish this by amending the Form N-SAR filing instructions and/or applicable rules under Section 30 of the Investment Company Act to require certification by any companies not required to file a new Form N-CSR.
D. Section 906 Certification
Section 906 of the Act amends the United States criminal code to incorporate additional certification requirements. As noted by the Commission staff during the August 27, 2002 open meeting considering this proposal, Section 906 is not addressed by these proposals although it is currently in force. In this regard, we would urge the Commission staff to consult with officials at the Department of Justice to clarify the relationship between Sections 302 and 906, which have differing certification requirements, and thereby assist issuers with their compliance obligations.
II. Disclosure Controls and Procedures
A. Scope of Evaluation
The Commission has also proposed Rule 30a-3, which would require all registered investment companies to maintain and regularly evaluate the effectiveness of controls and procedures designed to ensure that information required in filings that it files or submits under the Securities Act of 1933 ("Securities Act"), the Investment Company Act, and the Exchange Act is recorded, processed, and summarized on a timely basis.
Under new Rules 13a-15 and 15d-15, only those companies filing under the Exchange Act are required to maintain and evaluate their disclosure controls and procedures and then only in relation to their Exchange Act filings. In proposed
Rule 30a-3, as well as in proposed amendments to Rule 30a-2, the application of this requirement would include all investment companies and would be extended to cover all filings under the Securities Act, the Exchange Act, and the Investment Company Act, including prospectuses, prospectus amendments, reports to shareholders, Form N-SAR filings, and registration statements. We do not believe that the required disclosure controls and procedures for investment companies should extend to filings under the Securities Act and the Investment Company Act, in addition to the Exchange Act.
The application of this requirement would appear to extend beyond the types of filings cited by the Commission to other types of filings by investment companies, including, among others, applications under Rule 17d-1 relating to joint enterprises, fidelity bonds under Rule 17g-1, Rule 19b-1 filings addressing the distribution of capital gains, pleadings and other related documents in connection with civil actions filed under Section 33, Form 24F-2 with respect to securities sold, Form N-18F-1 with respect to making a Rule 18f-1 election, and any applications for exemptive relief under the Investment Company Act. These filings are not of documents that are widely disseminated to investors as disclosure documents and no benefit to investors would be gained by requiring investment companies to take such action. In addition, under Section 24(b), open-end investment companies and unit investment trusts are required to file sales literature with the Commission (although the vast majority of these materials, as a practical matter, are filed with NASD Regulation, Inc. in accordance with Rule 24b-3). It is not clear whether the Commission intended the expanded scope of the proposed disclosure control requirements to cover each of these filings under the Investment Company Act, or whether those requirements were intended to be limited to disclosure documents.
Moreover, we note that the Commission has not extended the application of these disclosure control requirements and certifications beyond the Exchange Act for other types of companies. In light of the fact that investment companies clearly were not the focus of the Commission's or Congress's concerns in the process that led to the enactment of the Act, investment companies should not be subject to more stringent requirements than the public companies whose misconduct led to the enactment of the Act.4 Moreover, an investment company's board of directors and principal officers already are subject to liability under Section 11 of the Securities Act and/or Section 34(b) of the Investment Company Act for any misstatements or misrepresentations contained in registration statements and other filings made under the Securities Act and/or the Investment Company Act.5
B. Timing of Evaluation
Regarding the timing of the evaluation of disclosure controls and procedures under 30a-3, investment companies would be required to conduct such evaluation within 90 days prior to the filing of each report requiring certification. By requiring a separate evaluation for each report filed under Rule 30a-2, a tremendous burden is placed on larger fund complexes. These groups make frequent filings on behalf of funds within the fund complex, many of which have fiscal year-ends staggered throughout the year. Consequently, a large fund complex would be forced to conduct evaluations on a nearly continuous basis in order to make the proposed certification.6 We recommend that the Commission permit fund complexes that rely on one set of disclosure controls and procedures to rely on a single evaluation conducted on an annual basis. In this way, the Commission would be able to ensure that these procedures are effectively regulated and monitored, while not placing an undue burden on large fund complexes.
C. Need for Clarification
In addition, we believe the Commission should provide greater clarification regarding the intended scope of disclosure controls and procedures. The Commission notes that particular procedures and specific controls were not set out in the proposal in order to provide investment companies with greater flexibility. This flexibility is intended to enable companies to control costs by allowing them to closely tailor their program to meet their own individual needs. However, we believe further guidance from the Commission is still necessary. As acknowledged in the proposal, most investment companies already maintain some form of disclosure controls and procedures.7 Without providing greater clarification on proposed Rule 30a-3, the Commission could leave investment companies unable to determine where their regular compliance process ends and where the new required evaluation of disclosure controls should begin.
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We appreciate the opportunity to comment on this proposal regarding the certification of management investment company shareholder reports. If we can be of any further assistance in this regard, please feel free to contact Kimberly Dopkin Rasevic at (202) 261-3447 or Jack W. Murphy at (202) 261-3303.
cc: Paul F. Roye
Paul G. Cellupica