UNITED STATES
 

SECURITIES AND EXCHANGE COMMISSION
 

WASHINGTON. D.C. 20549
 

DIVISION OF
 

INVESTMENT MANAGEMENT 

January 27, 1995


ACT r CA-- t/ 

SECTION 

Catherine s. Bardsley, Esq. RULE /7 tL - 7

Kirkpatrick & Lockhart PUBLIC 1800 M street, N. W.
 AVAILABILITY II).Î/7~ Washington, D. C. 20036-5891 , ,

Re: Uni ted Municipal Bond Fund (pub. avail. 

Julv 30. 1992)
 

Dear Ms. Bardsley: 

By letter dated October 29, 1991, United Municipal Bond
 

Fund, Inc. and united High Income Fud, Inc. (the "Funds")
 

requested the staff' s assurance that it would not recommend
 

enforcement action to the Commission under section 17 (a) of the
 

Investment Company Act of 1940 ("1940 Act") if the Funds, in
 

reliance on Rule 17a-7 under the 1940 Act, bought and sold
 

between themselves municipal bonds for which market quotations
 

are not readily available. The Funds proposed to value the bonds
 

by using the price provided by the Funds' independent pricing
 

service for purposes of calculating net asset value under R~le
 

2a-4 under the 1940 Act. The staff granted the Funds no-action
 

relief in United Municipal Bond Fund (pub. avail. July 30, 1992),
 

but not on the terms requested. Instead, the staff required that
 

the Funds value the municipal bonds by averaging prices obtained
 

from at least three independent matrix pricing services, or by
 

averaging three independent bid prices, or by averaging three
 

prices obtained from some combination of pricing serv~ces and bid
 prices. 

By letter dated October 18, 1994, you requested that the 

staff reconsider its position, and permit the Funds to buy and 

sell certain municipal bonds between themselves using the price 

provided by their independent pricing service, as proposed in the Funds' ini tial no-action request. You state that taking the 

average of prices provided by pricing services, bid prices, or
 

some combination thereof results in an artificial gain or loss
 

for the purchasing or selling Fund because the average price is
 

unlikely to be the same as the price that the Fund uses to
 

compute net asset value. Moreover, completing the transaction
 using the average of two or three bid prices always \ will be 

disadvantageous to the seller of the security. .
 

You believe that the use of the Funds' pricing service to
 

price transactions between the Funds provides a reliable method
 
of determining the value of the securities, particularly in view
 

of the steps the Funds take to verify the accuracy of the prices
 

quoted. The Funds' use the prices provided by an independent


pricing service, Muller Data corporation ("Muller"), to value
 

their municipal bonds for purposes of Rule 2a-4. Muller's staff
 

determines the price of a particular security by "hand pricing,"
 

which consists of gathering market information about that
 

security (~, trade execution data and the latest bid and ask
 

quotes for the security, as well as information about offerings


of similar securities). lj The Funds' adviser, Waddell & Reed
 

(the "Adviser"), regularly tests the overall accuracy of Muller's


pricing system. Each week, the Adviser obtains prices from
 

another pricing service for those securities that represent 1% or
 

more of the net assets of each of its funds that use Muller's
 

_ _ pricing service. The Adviser compares the total of the alternate
 

prices to the total of Muller's prices. Y Further, each Fund" s
 

board annually reviews and approves the use of Muller and the
 

Adviser's testing methodology. In addition, the Funds'
 

independent auditor, Price Waterhouse, as part of its annual
 

review of the Funds' internal control structure, tests the
 

reliability of Muller's pricing system. Specifically, Price
 

Waterhouse compares the aggregate of Muller's prices with the
 

aggregate of the alternate prices from its own pricing module.
 

The Funds are not requesting relief with respect to
 

transactions invol ving municipal bonds with an embedded swap, cap
 

or floor, or other derivative structure that would impair the
 

liquidity of the bond because of the customized nature of the
 

structure, the information (or lack thereof) available about the
 bond, . or other factor(s). The Adviser will determine whether a 

lj On November 9, 1994, the Commission approved a program by


the Municipal Securities Rulemaking Board to make pricing
 

information available to investors. Securi ties Exchange Act
 

Release No. 34955 (November 9, 1994), 59 FR 59810 (order
 

approving file No. SR-MSRB-94-09). Under the first phase of
 

the program, reports of inter-dealer transactions and daily
 

high-low and average price figures for the most frequently
 

traded issues will be made public. Under phase two and
 

phase three of the program, these requirements will be
 

expanded to include institutional customer transactions and
 

retail transactions. Finally, the program will implement
 

more contemporaneous reporting of transaction information.
 

We expect that such information will be utilized by pricing
 

services and persons charged with evaluating the performance
 

of pricing services as it becomes available.
 

Y You state that the Adviser believes that its testing methodology is accurate and ,that, it would promptly consider
 

al ternati ves if, in the future , its methodology did not
 

accurately test Muller's prices.
 

- 2 ­
bond should be excluded on the basis of this description, subject
 

to the general review and oversight by each Fund's board of
 

directors. You also state that the Funds will not rely on the
 

staff's no-action position to engage in transactions in municipal
 

bonds that the Adviser knows or has reason to know are in
 

default, including those that are in technical default. 1/
 

The staff agrees to modify the pricing condition in the
 

original no-action relief granted to the Funds, and, accordingly,
 

would not recommend that the Commission take any enforcement
 

action under Section 17 (a) if the Funds buy and sell portfolio
 

securities between themselves using a price provided by the
 

pricing service that values the Funds' municipal bonds for Rule
 

2a-4 purposes, provided that the Funds comply with the conditions
 

in your October 18, 1994 letter and above. !/
 

Sincerely, 

1Q/Wc J1l. (lQ~L 

/Jana M. Cayne


Attorney' 

Office of Chief Counsel
 

1/ Confirmed in a telephone conversation between Catherine


Bardsley and Amy Doberman, November 3, 1994.
 

!/ The other conditions to no-action relief that wére included


in the original no-action letter remain unchanged.
 

- 3 ­
KIRKATRCK & LOCKHT 

scum LOBBY. 9T FLR 

180 M ST N:W,	 BON, MA
 

WASHINGrN, D,C. 20036-5891 HASBURG, PA


MI, FL
 

1EONE (2) 778­ NE YOR NY
 m. 2+19
 PITURGH, PA
 

W:IM (22) 77s.1oo CA TI S, BARLE
 

(202) 778-9289 

October 18 , 1994

VIA XESSENGER
 

Amy R. Doberman, Esq.
 

Special Counsel
 

Di vi~~on of Investment Management
 

Securities and Exchange Commission
 

450 5th Street, N.W.
 

Washington, D.C. 20549
 

Re: Your Ref. No. 91-536-CC
 

united Municipal Bond Fund, Inc.
 

United Municipal High Income Fund. Inc.
 

Dear Ms. Doberman:
 

This letter is to respond to the issues raised in the
 

telephone conference call August 12, 1994, regarding the request
 

of United Municipal Bond Fund, Inc., and United Municipal High
 

Income Fund, Inc. ("Funds") for no-action assurance as to the
 

application. of Rule 17a-7 under the Investment Company Act of
 1940 ("1940 Act") and the staff's above-referenced response. In 

that call, the staff requested that the Funds: (a) make certain
 

changes in their proposed definition of an embedded derivative
 

for puroses of determining which municipal bonds are to be
 

excluded from the relief requested; (b) address further the
 

testing of the prices from the pricing service used by the Funds;
 

and (c) provide a consolidated statement of the facts and discussions contained in the prior letters submitted on behàlf of the
 

Funds since the issuance of the staff's initial response.
 

As presented more fully below, the Funds agree to the
 

staff's requested revisions to the definition of embedded derivati ves and have provided further information as to the testing of
 

the pricing service's prices. This letter also consolidates the
 

substance of my prior letters of April 20, 1993 and January 4,
 

1994 to Thomas S. Harman and of June 22, 1994 to Jana M. Cayne


(copies of which letters are attached for your reference). As in

each of those prior letters, the Funds respectfully request that
 

the staff re-evaluate its no-action response and modify that
 

response to permit the Funds to use the price provi~ed by an
 

independent pricing service as the current market ptice for
 

puroses of compliance with Rule 17a-7.
 

DC-88. , 
KIRKATRCK & LOCKHT 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 2
 

BACKGROUN 

By letter dated October 29, 1991, the Funds requested that
 

the staff provide assurance that it would not recommend enforcement action if the Funds between themselves buy and sell municipal bonds at the prices provided by the independent pricing
 

service which is also used by each Fund to value the municipal
 

bonds in its portfolio for purposes of Rule 2a-4 under the 1940
 

Act. The staff's response, which was sent to the Funds and made
 

publicly available on JUly 30, 1992, stated that the staff would
 

not recommend enforcement action under Rule 17a-7 if, as the
 

first of five conditions set forth in the response:
 

(1) the municipal bonds are valued by averaging prices
 

obtained from at least three independent matrix pricing
 

services, or by averaging three independent bid prices, or
 

by averaging three prices obtained from some combination of
 

independent pricing services and independent bid prices;


( footnote omitted) ... 

(copies of the respective request and no-action letters are


enclosed for your reference.) Shortly thereafter, at the Funds'
 

request, I spoke with Ms. Cayne about whether in certain circumstances, the numer of prices required to be averaged could be
 

reduced from three to two.
 

This possibility was not pursued further by the Funds
 

because, after the first transaction in accordance with the no-


action letter, it became apparent that there was a more fundamental problem with the averaging approach itself. specifically,
 

in a sale made in reliance on the no-action letter and at a price
 

determined by averaging two independent bid prices and one price
 

from an independent pricing service, the selling Fund experienced
 

a loss, because each of the bid prices, and therefore the average
 

of the three prices, was lower than that provided by the pricing
 

service (whose price, had there been no sale, would have been
 

used for the Fund's valuation pursuant to Rule 2a-4) .1/ Waddell
 

& Reed Investment Management Company, the investment adviser to
 

each Fund, thereafter informed the Directors of the Funds that it
 

would investigate further the impact of the averaging approach
 

1/ The Fud did not suffer any actual loss because ah amount
 

representing the difference between the sale price and the price
 

provided QY the pricing service was promptly paid to the Fund by
 

the Fund's investment adviser.
 
KIRKATRCK & LOCKHT
 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 3
 

and that until the issue was resolved to the satisfaction of the
 

Funds, no further transactions would be made in reliance upon the
 

no-action letter.
 

SPECIFIC ISSUES
 

Artificial Gain or Loss
 

As previously expressed in telephone conversations with the
 

staff and in my letter of April 20, 1993, the Funds believe that
 

implementation of the first condition set forth in that response
 

disadvantages one, and possibly both, of the parties to the
 

transaction in that the execution price prescribed by that condition results in an artificial element of gain or loss on the
 

transaction. This gain (or loss) is artificial for two reasons.
 

One is that the prescribed execution price rarely, if ever, will
 

be the price at which the particular securities would otherwise
 

be traded with an unaffiliated counter-party. In addition, the
 

gain or loss is artificial because the execution price is
 

differently from the method used by the Funds in
 

calculating net asset value per share. As a result, the
 

purchaser (as opposed to the seller) will have an immediate and
 

unintended, unrealized gain or loss. The use of a price based on
 

the average of three prices, as required under the first condition of the no-action letter, creates an element of gain or loss
 

that is economically artificial but nonetheless has real, adverse
 

tax and accounting effects to the Funds and their respective


calculated' 

shareholders. 

Fund typi-
 For purposes of Rule 2a-4 under the 1940 Act each 


cally values the municipal bonds held in its portfolio on the
 

basis of priees provided by an independent pricing service. The
 

problem with the first condition of the no-action letter is
 

simply that, in virtually all cases, the price derived from the
 average of three numers will be different from anyone of the 

three. certainly this differential does not represent a better
 

or more accurate market-based valuation but does result in more
 

or less gain or loss on a sale transaction. The problem is
 

illustrated by the following example:
 

Fund A has a municipal bond in its portfolio that it
 

purchased at par (100.00) and is currently priced at 105.00
 

by Fund A's independent pricing service. In order to sell


the bond to Fund B under the no-action letter, FÙnd A
 

obtains two independent bids, 105.00 and 104.00, which when
 

averaged with the price from the pricing service, produce a
 

price of 104.66.
 
KIRKATRCK & LOCKHT
 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 4
 

Using a sale price of 104.66 results in a gain af 4. 66; had
 

the pricing service price been used as the sale pricé, the gain
 

to Fund A would have been 5.00. Fund A's net asset value is also
 

0.34 less using the average than it would have been using the
 

price provided by the pricing service (which would have been used
 

to value the bond had it not been.sol(i). There is a corresponding impact on Fund B. If 104.66 is the initial value of the bond
 

in Fund B's portfolio, FundB will have a built-in potential gain
 

or loss of 0.34 simply by virtue of the differential between the
 

averaged price and the pricing service valuation. Thus, when
 

Fund B next determines its net asset value and values the bond at
 

the price provided by the independent pricing service (assume
 

105.00 or higher), Fund B's net asset value will reflect an
 

increase of 0.34 which is artificial in that it derives solely
 

from the change in pricing methodology. Thus, the pricing
 

methodology prescribed in the first condition of the no-action
 

letter creates an artificial element of gain or loss to each
 

party that distorts the economic reality of the transaction.
 

In condition one of the no-action letter, the staff may have


sought to parallel the approach in section (b) (4) of the Rule 

17a-7, i.~., using the average of the highest current independent
 

bid and lowest current independent offer. Rule 17a-7 (b) (4) may
 

reflect the appropriate valuation for securities whose values
 

under Rule 2a-4 are derived according to that methodology. It is
 

not, however, an appropriate methodology for securities which
 

regularly use a different valuation method such as an independent
 pricing service. 

(4) , as To apply the general methodology of Rule 17a-7 (b) 


reflected in condition one, so as to require a Fund to' use a
 

different methodology for inter-fund transactions than the Fund
 

does for Rule 2a-4 net asset value determinations serves no
 

policy purpose and instead has unwarranted and adverse consequences to the Fund and its shareholders. Indeed, it seems contrary to the policy underlying Rule 17a-7 that two funds with the
 

same pricing policy that enter into a cross-transaction could not
 

use that pricing policy and instead must use a different pricing
 

method that will almost always result in an immediate unrealized
 

gain or loss to the purchaser together with a distortion of the
 

seller's gain or loss. Aècordingly, the Funds request that the
 

staff permit the Funds to use the price provided by an independent pricing service which the Fund otherwise uses for Rule 2a-4
 

purposes as the current market price for puroses of \compliance
 

with Rule 17a-7.
 
KIRKATRCK & LOCKHT 

Amy R. Doberman, Esq.
 

October i8, 1994
 

Page 5
 

/ Pricina service
 

Each Fuhd has, since its inception, used the prices provided


by Muller Data Corporation ("Muller") to value the municipal 

obligations in the Fund's portfolio for purposes of Rule 2a-4
 

under the 1940 Act. In our discussions with Muller personnel,
 

Muller has described its services to the Funds as "hand pricing"
 

rather than "matri~: pricing." Muller does not attempt to follow
 

a general universe of municipal securities for its mutual fund
 

clients, but rather, it has advised us, it follows only the
 

securities in those clients' portfolios. Muller has a staff of
 

evaluators to whom clients' secuities are assigned, typically
 

according to particular segments of the municipal market, such as
 

pre-~efunded bonds or general obligations. We understand that
 

evaluators operate generally as follows: in the morning, an
 

evaluator calls his or her contacts in the market (~.g., dealers
 

and portfolio managers) to gather further information about
 

recent trades, current bids, offerings of similar securities,
 

general conditions or movements in the market or in particular
 

market sectors, etc.; and in the afternoon, the evaluator makes
 

an evaluation of each security for which he or she is
 responsible. 

We have discussed with Muller personnel certain of the
 

publicized concerns relating to municipal bonds with embedded
 

derivatives and the attendant pricing issues. In this context,
 

we note that Muller regards these issues as raised primarily by
 

bonds with embedded swaps, caps or floors. This is in contrast
 

to municipal bonds with common variable or floating rate
 

features, which Muller characterizes as relatively easy to


follow. 

We understand, however, that dealers have responded to
 

concerns regarding embedded derivatives by increasing the amount
 

and frequency of information provided to services such as Muller
 

and others in the secondary market. Muller is one of the participants in the Task Force on Derivatives Information Standardization formed last fall by the Public Securities Association to
 

study the standardization and dissemination of information on
 

municipal bond derivatives.
 
KIRKATRICK & LOCT 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 6
 

Testino of Pricino Service Prices " 

Waddell & Reed Investment Management Company ("Manager"), in
 

its capacity as the investment adviser to each Fund, regularly
 

tests the overall accuracy of Muller's pricing system. Under its
 

current procedures, 'each week the Manager obtains from another
 

pricing service prices for those securities which represent 1% or
 

mòre of the ,net assets of all funds advised by the Manager that
 

use Muller's pricing service. The total of these alternate
 

prices is then compared to the total derived from Muller's prices
 

tor the same securities. Under current procedures, on an annual
 

basis each Fund's Board of Directors reviews and considers the
 

continuance of the use of the pricing service and the Manager's
 

testing methodology.
 

In addition, in connection with its annual review of the
 

internal control structure for the Fuds and the other funds for
 

which it serves as independent accountants, Price Waterhouse
 

tests the reliability of Muller's pricing. Price Waterhouse uses
 

its Automated systems and Services for Investment Securities
 

Transactions ("PW-ASSIST") pricing module to evaluate the prices
 

provided by Muller. Price Waterhouse compares the aggregate of
 

the prices provided by Muller and the aggregate of the alternate
 

PW-ASSIST prices. Where the difference is immaterial in relation
 

to a fund's net assets, Price Waterhouse is able to establish an
 

independent basis for reliance that the prices provided by Muller
 

are indicative of market value.
 

As reported in my letter of June 22, 1994, a then-recent,
 

representative application of the 1% test performed by.the
 

Manager was as follows:
 

For united Municipal Bond Fud, Inc., 30 of a total of
 

approximately 100 securities were tested, representing
 

approximately $400 million of a total $1 billion in assets.
 

For united Municipal High Income Fund, Inc., 30 of a
 

total of approximately 150 securities were tested,
 

representing approximately $90 million of a total $350
 million in assets. 

In addition, please be advised that a recent representative


application of the 1% test was follows: '
 
KIRKATRCK & LOCKHT 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 7
 

, For United Municipal Bond Fund, Inc., 31 of a total of
 

approximately 205 securities were tested, representing
 

approximately $377 million of a total $944 billion in


assets. 

For united Municipal High Income Fund, Inc.', 28 of a
 

total of approximately 191 securities were tested, representing approximatei~ $89 million of a total $328 million in


assets.
 

Fuher, the turnover rates, as stated in the annual reports
 for the respectivé Funds' fiscal years ended September 30, 1989,


though 1993, were as follows: 

For united Municipal Bond Fund, Inc., the turnover
 

rates were 226%, 181%, 144%, 125% and 94.5%, respectively.
 

For united Municipal High Income Fund, Inc., the
 

turnover rates were 38%, 27%, 60%, 54% and 26%,
 respectively. 

For the fiscal year ended September 30, 1994, the
 

portfolio turnover rates were 62. 6% (unaudited) for united
 

Municipal Bond Fund, Inc., and 26.3% (unaudited) for united


Municipal High Income Fund, Inc. 

The Manager believes that its testing methodology provides a
 

meaningful test of the overall accuracy of the prices provided by
 

the pricing service used by the Funds. If the Manager were to
 

determine this methodology did not meaningfully test that
 

service's prices, it would promptly consider the alternatives
 

available and take such actions as it deemed necessary or appropriate, including notice to the Fund's Board of Directors of the
 

actions taken and/or recommended.
 

Exclusion of MuniciÐal Bonds with Emedded Derivatives
 

In view of the concerns previously expressed by the staff
 

regarding municipal bonds with embedded derivatives, the Funds
 

had proposed limiting their original no-action request so as to
 

exclude inter-Fund sales of municipal ,bonds with embedded derivarelief requested. Based on our
 

discussions with the staff with respect to defining ~mbedded
 

derivatives for this purpose, the Funds agree that the municipal
 

bonds to be excluded from the no-action relief requested by the
 

ti ves from the scope of the 


those with an "embedded swap, cap or floor, or other
 

derivative structure that would impair the liquidity of the bond
 

Funds are . 

KIRKATRICK & LOCKHT 

Amy R. Doberman, Esq.
 

October 18, 1994
 

Page 8
 

because of the customized nature of the structure, the informa- ,/ 

tion (or lack thereof) available about the bond, or other

factor (s) . n 

Each Fund anticipates that determinations as to a bond's
 

exclusion or eligibility would be made by its investment adviser,
 

subject to the general review and oversight by the Board of
 

Directors. It is the Funds' understanding that certain types of
 

municipal bonds with' aspects which might technically be deemed
 

"derivative", such as those having a variable amount, adjustable
 

rate or put feature, nevertheless do not necessarily present
 

valuation concerns. Further, a determination that a bond had an
 

embedded structure which "would impair liquidity" would not
 

necessarily constitute a determination that the bond is illiquid
 

for purposes of a Fund's limitation on illiquid securities.
 

* * * * * * 

We hope the foregoing is responsive to your requests and
 

will enable the staff to permit the Funds, for purposes of Rule
 

17a-7, to treat the price provided by an independent pricing
 

service, and which is the price otherwise used for Rule 2a-4
 

purposes, as the current market price of a municipal bond, other
 

than a municipal bond with an embedded derivative.
 

If you have further questions or believe that there are
 

further issues which remain to be resolved, please contact either
 

the undersigned or Clifford J. Alexander at 202/778-9068.
 

Thank you for your consideration of this important matter
 

for the Funds.
 

Very truly yours,
 

~ S. ~J~
 Catherine s. Bardsley ~ 

Enclosures 

cc: Sharon K. Pappas, Esq.
 

Clifford J. Alexander, Esq.