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Decemer 23, 1998
 

Our Ref. No. 98-694-CC
 RESPONSE OF TH OFFZCE OF CHZEF COUNSEL
 Defined Asset Fuds DZVZSZON OF ZNVSTM MAGEM Pile No. 811-1777
 

Your letter of November 30, 1998 requests our agreement with
 

your view that Section 26 (a) (2) (C) of the Investment Company Act
 

of 1940 (the "Act") does not prohibit the Defined Asset Funds
 

(the "Trustsll), a family of unit investment trusts (nUITs"), from
 

paying the costs of updating their registration statements as
 described in your letter. .
 

Facts 

The Trusts are organized as UITs and jointly sponsored by
 

Merrill Lynch, Pierce, Fenner & Smith, Inc., Salomon Smith Barney
 

Inc., Dean Witter Reynolds, Inc., and PaineWebber Inc. (the
 

"Sponsors"). The Trusts currently pay the costs of preparing and
 

filing their initial registration statements. The Sponsors
 

currently pay the costs of updating the Trusts' registration
 

statements. The Sponsors also currently maintain, and pay the
 

costs associated with maintaining, a secondary market for units
 

of the Trusts.
 

You propose that in the future, the Trusts, rather than the
 

Sponsors, would pay the expenses incurred in connection with
 

updating the Trusts' registration statements. These expenses
 

consist of legal fees, typesetting fees, 
 electronic filing
 expenses and regulatory filing 
 fees . Under your proposal, the
 Sponsors would continue to pay all direct distribution expenses
 

of the Trusts (including the costs of maintaining the secondary
 

market for the Trusts), such as printing and distributing
 

prospectuses, and preparing, printing and distributing any
 

advertisements or sales literature. The trust indentures for the
 

Trusts would provide that expenses for updating the Trusts'
 

registration statements will be paid by the Trusts. The Trusts'
 

prospectuses and annual reports would disclose that the expenses
 

of updating the Trusts' registration statements will be paid by
 

the Trusts and, for at least one year from the date that the
 

Trusts' prospectuses first disclose that the Trusts will pay the
 

expenses, also disclose that these expenses historically have
 

been paid by UITs' sponsors. Any payments made to reimburse the
 

Sponsors for updating registration statements would not exceed
 

the costs incurred by the Sponsors for that purpose.
 

Analvsis 

i.. Requirement to Deliver a Current Prospectus
 

Section 4 (2) of the Act, in relevant part, defines a UIT as
 

an investment company that is organized under a trust indenture
 
... 

o~ similar instrument, does not have a board of directors, and
 

is~ues, only. redeemable securities, each of which represents an
 

undivided interest in a unit of specified securities. UITs
 

typically are created by a sponsor that accumulates a fixed
 

portfolio of securities and deposits the securities with a
 

trUstee under the terms of a trust indenture. The UIT then
 

issues units of participation in the portfolio and offers these
 

units to the public at an offering price that is based u~on the
 

value of the underlying securities, plus a sales charge.
 

After completing its iyitial offering, a UIT no longer
 

offers units to the public. In almost all cases, however, the
 

sponsor establishes and maintains a secondary market in units
 

issued by the UIT. In the secondary market, the sponsor
 

purchases units tendered for redemption by UIT unitholders and
 

resells the units to new investors at an offering price that is
 

based4 upon the value of the underlying securities, plus a sales


load. 

The Securities Act of 1933 (nSecurities Act n) requires that securities publicly offered by an issuer be accom~anied or
 preceded by the delivery of a current prospectus. The 

i The same entity usually is the sponsor and the depositor of
 

a UIT. See definition of "depositor" in the General Instructions
 

to Form N-8B-2, the registration statement under the Act for


UITs . 

2 For background on the nature and structure of UITs, see Form 

N-7 for Registration of Unit Investment Trusts Under the 

Securities Act of 1933 and the Investment Company Act of 19401 

Investment Company Act Release Nos. 14513 at nn. 8-14 and 

accompanying text (May 14, 1985) ("Release 1451311) and 15612 

(Mar. 9, 1987) (IlRelease 1561211) (releases proposing and
 

reproposing a unified form to register UITs under both the Act
 

and the Securities Act of 1933).
 

3 See generally Rule Proposal for Unit Investment Trust StartUp Exemptions and Proposed Revision of. Rule Regarding Pricing of 

Investment Company Shares Generally, Investment Company Act 

Release No. 10545 (Jan. 8, 1979) (describing UITs and'the 

operation of secondary markets by UIT sponsors) . 

4 The existence of a secondary market enhances the liquidi ty of a UIT. In the absence ofa secondary market, a UIT might have
 

to sell portfolio securities to meet redemption requests. If
 

redemptions were significantly high, the terms of a UIT' s trust
 

indenture may require the trustee to terminate the UIT.
 

5 Section 5 of the Securities Act prohibits the use of the
 

U. S. mails or interstate commerce to sell a security unless
 

accompanied or preceded by a prospectus that meets the
 

requirements of Section 10 (a) of the Securities Act. Section
 

2
 
prospectus delivery requirement applies both to initial sales of
 

UIT units and to fesales of UIT units by a sponsor in the


secondary market. Thus, the continued operation of a UIT 

depends, in part, on maintaining a current registration statement
 

because the UIT' s units cannot be offered for sale unless the
 

underwriter or sponsor can deliver a current prospectus to
 

offerees or purchasers.
 

2 . UIT Expenses
 

Section 26 (a) (2) of the Act indirectly limits the expenses that may be paid out of a UITI s assets by prohibiting a depositor
 

or principal underwriter from selling interests in a UIT unless
 

the UIT's trust indenture, or similar instrument, specifically
 

includes the payment limitations in Section 26 (a) (2). Paragraph


(C) of Section 26 (a) (2) provides: 

that no payment to the depositor of or a principal
 

underwriter for (a UIT), or to any affiliated person or
 

agent of such depositor or underwriter, shall be allowed the.
 

trustee or custodian as an expense (except that provision
 

may be made for the payment to any such person of a fee, not
 

exceeding such reasonable amount as the Commission may
 

prescribe as compensation for bookkeeping and other
 

administrative services, of a character normally performed
 by the trustee or custodian itself) . 

Paragraph (D) requires a UIT i S trustee or custodian to hold all
 

assets of the UIT in trust, subject only to the charges allowed
 

by Section 26 (a) (2~, until the assets are distributed to the
 UIT's unitholders. Rule 26a-1 under the Act, in relevant part, 

10 (a) (3) of the Securities Act requires that information contained in a prospectus be current. 

6 Secondary market transactions in most securities are not subj ect to the prospectus delivery requirements. UIT depositors, however, are considered "issuers" under Section 2 (4) of the 

Securities Act, and are therefore subject to the prospectus
 

delivery requirement. See Release 15612 supra note 2, at n.2 and
 

accompanying text; Release 14513, supra note 2 at n.14 
 and accompanying text. See also M. L. Stern & Co. Inc. (pub. avail.
 

Nov. 18, 1988) (explaining when the prospectus delivery
 

requirements of the Securities Act apply to resales of UIT units
 

in a secondary market) .
 

7 Paragraph (A) of Section 26 (a) (2) limits payments to a UIT IS
 

trustee or custodian to fees for services, or reimbursements for
 expenses, as are set forth in the UIT i S trust indenture or 

similar instrument. Paragraph (B) limits payments under
 

paragraph (A) to payments for services previously performed or to
 

reimbursement for expenses previously incurred.
 

3 
provides that any payments made under Section 26 (a) (2) (C) may not 

exceed the cost of the services rendered.
 

You represent that your proposal is consistent with
 

paragraph (C) of Section 26 (a) (2). You acknowledge that the
 

staff, in E. F. Hutton Tax Exempt Fund (pub. avail. Apr. 11,
 1979) (IIHutton"), previously took the position that Section 26(a) (2) prohibits the payment by a UIT's trustee from the UIT's 

assets to its sponsor of any expenses related to the maintenance
 

of a secondary market for units of a UIT. In Hutton, the staff
 

stated that secondary market expenses include the costs of
 

keeping a UIT i S registration statement current. The staff also
 

stated in Hutton that an alternate proposal to have the UIT
 

itself bear the expenses of maintaining a secondary market would


seem to be an attempt to circumvent Section 26 (a) (2) (C) ofa the 

Act, and would therefore violate Section 48 (a) of the Act. In
 

your view, however, your proposal is consistent with more recent
 

staff interpretations of Section 26 (a) (2) (C). You state that the
 

positions taken by the staff in Kemper Sales Company (pub. avail.
 

Jan. 3, 1985) ("Kemper") and Unit Investment Trust Organizational
 

Expenses (pub. avail. May 9, 1995) ("Organizational Expenses
 Letterll) provide support for your position. 

In Kemper, the staff agreed not to recommend enforcement
 action to the Commission under Section 26 (a) (2) (C) of the Act if 

UITs were to bear the expenses of preparing audited financial
 

statements for the purpose of maintaining current registration
 statements for the UITs. The staff i s position was limited to two 

circumstances: (1) the audi t was required by the terms of a UIT i S
 

trust indenture; or (2) the UIT' s trustee determined that an
 

audit would be in the best interests of the UIT' s unitholders.
 

In the Organizational Expenses Letter, the staff stated that
 Section 26 (a) (2) does not prohibit a UIT from bearing its own 

organizational and initial registration expenses even though
 

those expenses historically had been paid by a UIT i S sponsor.
 

The staff reasoned that: (1) 
 the express language of Section
 26 (a) (2) did not prohibit the practice; and (2) the proposed 

expense allocation would not lead to the abu~es that Section
 26 (a) (2) of the Act was intended to prevent, particularly the 

a Section 48 (a) makes it "unlawful for any personß'directly or
 

indirectly, to cause to be done any act or thing through or by
 

means of any other person which it would be unlawful for such
 person to do under the provisions of (the Act) or any rule, 

regulation, or order thereunder. II
 

9 The legislative history of the Act demonstrates that the
 

restrictions and limitations contained in Section 26 (a) (2) were
 

intended by Congress 
 to prevent or mitigate abuses in the
 investment company industry that were identified by the
 

Commission in a series of reports. S. Rep. No. 1775, 76th Cong.,
 

3d Sess. 8, 18 (1940); H.R. Rep. No. 2639, 76th Cong., 3d'Sess.
 

22 (1940). Some of the abuses described in the Commission's
 ., 

4 
assessment of II hidden charges II against UITs by their sponsors,

provided that the allocation was adequately disclosed to

investors. The staff concluded that a UIT's payment of its own

organizational and initial registration expenses is consistent with paragraph (C) of Section 26 (a) (2) because the expenses are

legitimate business expenses paid to parties unaffiliated with

the UIT i S sponsor for services that are necessary to the

operatio£ of the UIT and that do not directly benefit the

sponsor. 0 As a result, the sponsor would not receive any hidden

fees, even when directly reimbursed for organizational expenses,

because (1) the sponsor would be reimbursed only for its costs

and (2) the UIT's payment of its organizational expenses would be

prominently disclosed to investors.

We believe that Section 26 (a) (2) (C) does not prohibit a UIT from paying the expenses of updating its registration statement,

including payments to reimburse the UIT' ¥i sponsor for its costs

incurred in providing updating services. The Commission has

stated that Section 26 (a) (2) (C) was designed "to preserve trust

assets and prevent securityholders from being subjected to

purported i administrative i fees which, instead of compensating

the depositor for administrative services actually rendffed, in fact provide additional remuneration to the depositor." The

Commission also has stated that II (t) he purpose of (Section 26 (a) (2)) is to prohibit the depositor from 'realjng hidden

profits' through purported administrative fees."

A UIT's payment of the expenses of updating its registration

statement, similar to its payment of its own organizational and

reports included examples of UIT sponsors reaping hidden profits

through practices such as: buying securities for the UIT at the

(lower) bid price and selling them to the UIT at the (higher)

asking price; charging the UIT odd-lot brokerage commissions even

when the sponsor purchased the portfolio securities in round

lots; adding brokerage commissions to the base price of units and

calculating the sales load on the increased amount; adjusting the

offering price to the next highest eighth of a dollar; and

retaining the interest earned on the UIT' s cash. Securities and

Exchange Commission, Investment Trusts and Investment Companies,

Fixed and Semifixed Investment Trusts, Ch. 10 (1940) " reprinted as H.R. Doc. No. 567, 76th Cong., 3d Sess. (1940). _..

io Organizational Expenses Letter at n. 6.

To the extent that this position is inconsistent with

Hutton, Hutton is superseded.

ii

i2 Payment of Administrative Fees to the Depositor or Principal

Underwriter of a Unit Investment Trust, Investment Company Act

Release No. 13705 at n.5 (Jan. 9, 1984) (proposing Rule 26a-1) .

i3 I d . at text accompanying n. 3 .

5
auditing expenses, would not provide the kind of direct


remuneration to the sponsor that Section 26 (a) (2) (C) was intended 

to prevent. Updating expenses, like organizational and auditing
 

expenses, are legitimate business expenses that are necessary to
 

the operation of the Trusts and do not directly benefit the
 

Sponsors. While the payments of updating expenses by the Trusts
 

indirectly benefit the Sponsors because the Sponsors otherwise
 

would bear the expenses, we believe that these expenses are not
 

the type of charges that directly benefit UIT sponsors in the 14


manner deemed abusive by Congress in enacting Section 26 (a) (2) . 

We believe that the Trusts i payment of updating expenses, as
 

described in your letter, would not constitute hidden profits to
 

the Sponsors. The Trusts will fully disclose the expenses in
 

their prospectuses and annual reports and, for at least one year
 

from the date that the Trusts i prospectuses first disclose the
 

expenses, the prospectuses also will disclose that these expenses
 

historically have been paid by UITs' sponsors. Nor are updating
 

expenses tl~ kind of "hidden chargesn about which Congress was
 concerned. To the extent that updating expenses are paid 

directly to the Sponsors, the payments will be limited to the
 

Sponsors' costs, as required by Rule 26a-l.
 

This position is based on the facts and circumstances set
 

forth in your letter. Any different facts or circumstances may
 require a different conclusion. ' 

tJ-iLJQ/~ 

Wendy Finck Friedlander
 

Senior Counsel
 

14 See supra note 9. 

15 Id. 

6 
r DAVIS POLK & WARDWELL 

1300 I STREET, N.W.
 

WASHINGTON, D.C. 20005
 450 LEXINGTON AVENUE
 

17'22, AKASAKA 2'CHOME
 NEW YORK, N.Y. 100 17 MINATO-KU, TOKYO 107 

i 5, AVENUE MATIGNON 2 i 2'''50'''000 

75008 PARIS
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 ME5SETURM 

60308 FRANKFURT AM MAIN
 

I FREDERICK'S PLACE
 WRITER'S DIRECT
 LONDON EC2R 8AB
 

3.0 CHATER ROAD 

(212) 450-4525 HONG KONG 

Investm~i:t Company Act 

Section 26(a)(2)(C) 

November 30, 1998 

Securities and Exchange Commission 

450 Fifth Street, N. W. 

Washington, D.C. 20549 

Attention: Douglas Scheidt, Esq.
 

Chief Counsel 

Division of Investment Management 

Re: Allocation of Expenses Incured to 

Update UIT Re¡istrtion Statements
 

Dear Mr. Scheidt: 

By letter dated May 9, 1995, the Sta of 


the Securties and Exchange Commission (the "Sta') advised us that it would not recommend enforcement action if a 

unit investment trst bear its own organzational expenses. Unit Trust Organizational 

Expenses (available 5/9/95). On behalf of 


Merrll Lynch, Pierc, Fenner & Smith
 Incorprated, Agent for the Sponsorsl (the "Sponsors'') of 


the Defined Asset Funds family of 
 unt investment trts ("UITs''), we hereby request similar confirmatian from
 

the Staff with respect to the permissibilty of individua UITs to bear expenses related to 

IThe other sponsors are curently Salomon Smith Barey Inc., Dean Witter Reynolds, 

Inc. and Paine Webber Incorprated. 
,. 

Douglas Scheidt, Esq. 2 November 30, 1998 

updating trt registration statements pursuat to the Securties Act of 1933 (the "1933
 

Act"). 

1. The Proposal 

Historically, the Sponsors have paid all the costs of maitaning a secondar 

market in tr unts and reoffering units acquired in the secondar market, including the
 

costs of anualy updating a trt's i 933 Act registrtion statement. 2 The Sponsors
 

propose that, in the futue, certin expenses related to the prepartion and fiing of 

post-effective amendments would be borne by the trts themselves. These expenses 

consist of the anua legal expenses for the prepartion of 
 post -effective amendments to 

the trts' registrtion statements, the associated typesetting, electronic filing and related
 

charges of a financial printer and regulatory filing fees, if any. The Sponsors wil 

continue to bear all costs of printing and distrbuting prospectues and of preparng, 

printing and. distrbuting any advertising and promotional material. The updating 

expenses to be borne by a trst under the proposal would be immaterial on a pei: unt
 

basis. The legal fees and printing expenses associated with the anua amendment to 

trt registrtion statements tota $3,700 per trt, per year. The weighted average cost is
 

estimated to be $0.21 per year on a unit of about $ 1000. Ths level of expense would. 

have only a minal impact of approximately 0.024% on an investor's retu.
 

We submit tht ths proposa is consistent with the way 
 mutu fuds that have not 

adopted distrbution plans pursuat to Rule 12b- 1 allocate expenses of anua prospectus 

updates and with the provisions of 
 the Investment Company Act of 1940 (the "1940 

Act"), as discussed belöw. Furhermore, except in limited circumstaces when the 

Sponsors prepay thd par expenses (in which case the charge will not exceed the 

amount of ihe payments made), the expenses borne by the trts will involve payments by
 

the trtee to thd paries, in paricular regulators, lawyers and priters -- not to the
 

Sponsors. 

2Since 1978, the cost of 


an anual audit ofa trt's fmancial statements has, as
 

provided in the indentue, been borne by the trt. Ths practice was approved in Kemper
 

Sales Company, avail 1/3/85. 
Douglas Scheidt, Esq. 3 November 30, 1998 

II. Le~al Analysis 

Section 26 of the 1940 Act requires inclusion of certn provisions in the
 

indentue establishing a trust. The purose of Section 26(a)(2) is to preserve the assets of 

registered investment companies and to prevent untholders from bearng 

"admnistrative" fees which, instead of compensating the custodian for its services, 

actuly provide additional profit to the sponsors. ~,~, Unit Investment Trust 

Organizational Expenses. . 

We believe that this proposal is not inconsistent with Section 26(a)(2)(C). Section 

26(a)(2)(C) was designed to ensure that sponsors and depositors could not receive hidden 

protits by charging excessive fees to the truts. Municipal Invesiment Trust Fund (avaiL. 

6/14/82). While E.F Hutton Tax Exempt Fund (avaiL. 4/11/79), an early Staff 

pronouncement. cited Section 26(a)(2)(C) as authority for the proposition that trusts 

could not bear the "expenses of maintaining a secondar market," more recent no-action 

letters express a less restrictive view by the Staff. Kemper Sales Company (avaiL. 1/3/85), 

for example, found that trsts could bear the costs of obtaning anual audited finacial 

statements despite the us of these statements by the sponsors in updating the trsts'
 

registrtion statements, which would in tu allow the sponsors to maintan a secondar 

market in unts. Similarly, the Stas response in Unit Investment Trust Organizational
 

Expenses, citing the practice of mutul fuds generally to bear their own organzational 

expenses, agreed that a unit trst also could bear these expenses, including legal fees and
 

"the cost of preparng and printing its registration statement." 

Rule 12b-l(a)(2), applicable only to mutul fuds, defines distrbution as .'any 

activity which is primarly intended to result in the sale of shares." Although Rule 12b- 1 

is not applicable to unt trsts, our proposal is consistent with the interpretation of 

distrbution-related expenses prescribed by Rule 12b-1. We propose that the trst would 

pay only for expenses to prepare and fie anua amendments to its registrtion statement 

which, like an anua audit, is not an "activity priarly intended to result in the sale of 

shares." Under ths proposal, the sponsors of a trt will continue to bear all expenses
 

related to maintag a secondar market in unts and all marketing and distrbution 

expenses. 

Furermore, virtly all other issuers which compete with unit investment trts
 

pay their own updte expenses. The principal other tys of fuds regulated by the 1940
 
Douglas Scheidt, Esq. 4 November 30, i 998 

Act -- mutu fuds and closed-end fuds -- routinely bear the anual 
 legal fees for the preparation of post-effective amendments to their registrtion statements, the associated 

typesetting, electronic fiing and related expenses of a financial printer and anual 

regulatory filing fees if any.J Therefore. issuers of securties that compete with unit 

investment truts an ar subject to periodic fiing requirements -- packaged products
 

such as mutual fuds and closed-end fuds -- pay their own updte expenses. 

Consequently, our proposal to charge legal and printing expenses associated with 

updating trst registrtion statements is designed to level the playing field on which UITs 

compete with mutul funds and closed-end fuds.
 

Since the anua expense to update a trut's registration statement is de minimus 

on a. per unit basis, we believe that existing trsts which have not previously disclosed 

this expense may amend their .prospectuses and henceforth bear the update expense, as 

was permitted with respect to.audit fees in Kémper Sales Company, We specifically 

agree. that for at least a year following implementation of these ~hanges, the fee table 

section of the' prospectu wil 
 include disclosure that historically these updting expenses 

have been borne by the Sponsors. 

In sum, our proposal is reasonable, fair and consistent with both the specific 

mandate and 
 overall purose of Section 26(a)(2)(C) and the protection of investors. It 

has been pointed outrepeatealy in no-action letters and exemptive orders that the purse 

of Section 26( a)(2)(C) is to preserve tle assets of registered inyestment companes and to 

prevent unitholders from bearng fees which actually provide additional profit to the 

sponsors. Our proposal involves no payments to the Sponsors (except to reimburse them 

for prepayments of permissible third pary expenses). Payments to thrd paries for actul
 

expenses incured in updating a trt's registration statement, as contemplated by this
 

proposal, hardly constitute profit to the sponsors. This proposa merely equaizes the 

treatment of UITs and competing investment products. 

3Neither Section 12(b) (applicable to open-end management companies) nor Secion 23 of 


the Act 

(applicable to closed-end companies) prohibits mutual fuds and closed-end fuds from bearg the tye of
 

update expenses proposed here. 
Douglas Scheidt, Esq. 5 November 30, 1998 

Please call me at (212) 450-4525 (or Gar Granik at (212) 450-4721 or Ken Chase 

at (212) 450-4731 in my absence) with any questions or comments you may have. 

Very trly your,
 ~AJ~~

Pierre de Saint Phalle 

cc: Mercer Bullard, Esq.
 

Wendy Friedlander, Esq. ­