Protecting Investors: A Half Century of

Investment Company Regulation 

Division of Investment Management 

United States Securities and Exchange Commission 

May 1992 

This is a report of the Division of Investment Management. The Commission has 

expressed no view regarding the analysis, findings, or conclusions herein. 
Division of Investment Management 

United States Securities and Exchange Commission 

450 Fifth St. N.W., Washington, D.C. 20549 
UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON. D.C. 20549 

THE CHAIRMAN 

May 1,1992 

When the Investment Company Act came into effect just over a half century ago, only 

436 entities holding slightly more than $2 billion in assets were covered by the new law. At 

the outset, there were fewer than 300,000 accounts in the newly registered "investment 

companies". 

During the intervening years, investment companies have grown enormously in 

number, size and variety. Today, more than 3300 investment companies in the United States 

hold over $1.5 trillion in assets on behalf of over 68 million accounts. To put that in 

perspective, the assets of these investment companies are approximately 50% greater than the 

total value of all the stocks traded in London, one of the world's largest capital markets. 

Without government subsidies or taxpayer credit, investment companies have 

operated with remarkable safety and provided capital to meet the needs of a growing 

economy. The most common type of investment company, the open end "mutual fund,'' has 

become the vehicle for professional management of the current investments and retirement 

savings of millions of Americans. 

The Investment Company Act provides investors with specific protections against selfdealing, conflicts of interest, misappropriation of funds, and overreaching with respect to 

fees, expenses and undisclosed risks of many types. The SEC has the important job of 

policing these and other requirements of the law. 

While regulation to protect investors is vital to public confidence, overly broad 

regulation can limit the choices of investors, and unnecessary regulatory costs are ultimately 

passed through to investors. Therefore, two years ago I asked the Division of Investment 

Management to conduct a thorough study of our system. In particular, I asked them to look 

at areas where the law should be more flexible, or where regulatory costs could be reduced, 

without sacrificing the quality of investor protection. After a half century of market change, 

it is appropriate to consider where we can update and improve the overall system. 

The resulting report recommends a number of proposals for constructive evolution in 

this vital law. My fellow Commissioners and I look forward to reviewing these 

recommendations carefully. It is my hope that they will enhance innovation and efficiency in 

the capital markets while maintaining the highest quality of investor protection and market 

integrity. 

Richard C. Breeden 
DIVISION OF 

INVESTMENT MANAGEMENT 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON. D.C. 20549 

May 1,1992 

Dear Mr. Chairman: 

I am pleased to submit the Division of Investment Management’s report on 

investment company regulation. Two years ago, with the approach of the fiftieth anniversary 

of the Investment Company Act of 1940, you asked the Division to take a fresh look at the 

regulation of investment companies to determine whether existing regulation imposed 

unnecessary constraints on investment companies or the provision of other 

and whether there were gaps in investor protection. 

The Division has devoted considerable effort to the report. In addition to a full-time 

staff of ten, virtually everyone in the Division has contributed. I especially would like to 

note the indispensable contribution of Matthew A. Chambers, whose leadership has guided 

the review from its inception. Special commendation also should go to Nancy Moms, who 

served as the deputy director of the project until late last year, and to Karen Skidmore and 

received substantial assistance from other Commission divisions and offices and from Mary 

Ann Gadziala, Counsel to the Chairman. 

~ Diane Blizzard, whose office largely has been responsible for completing the work. We 

Without preconceived notions, we have sought the opinions of investor groups, 

academic researchers, the private bar, and the investment company, investment advisory, 

banking, pension, insurance, and brokerage industries. We have consulted with other 

government offices. We received and analyzed over two hundred comments and 

investigated the operations and dimensions of the financial markets. Research info the Act’s 

history complemented our fact-finding efforts. 

We have concluded that the regulatory system crafted half a century ago has worn 

well, providing the framework for the development of a dynamic industry. In some respects, 

however, regulation has not kept pace with the changes in financial markets and may 

prevent investment companies from offering flexible, efficient, and competitive vehicles for 

investing in the financial markets. It also may distort the activities of companies that should 

not fall within the Act. 

We do not recommend changes to the fundamental protections that have worked so 

well since 1940. At the same time, we do recommend changes that we believe will promote 

investor protection, encourage innovation and flexibility, and facilitate competition and 

capital formation by removing unnecessary regulation. We believe that these changes should 

allow the financial markets to continue to provide United States investors with a broad range 

of sound and flexible investment options. 

Sincerely, 

7 HL&fl/Cc 17% 

Marianne K. Smythe 

Director 
ACKNOWLEDGMENTS 

In the preparation of this report, the Division had the able assistance of 

many members of the Commission staff. The Division Director at the inception 

of the study was Kathryn B. McGrath. The Division’s original study team 

consisted of Matthew A. Chambers, Associate Director, Nancy Morris, Deputy 

Chief Counsel, Karen L. Skidmore, Assistant Director, Paul Goldman, Chief 

Financial Analyst, Diane C. Blizzard, Deputy Chief of Office, Wendell Faria, 

Deputy Chief of Office, Regina Hamilton, Branch Chief, Ann Glickman, Special 

Counsel, Rochelle Kauffman, Senior Counsel, Stuart Horwich, Attorney, Maura 

Murphy, Attorney, and Muriel Edwards, Secretary. 

Many other members of the Division contributed to the drafting or editing 

of various sections, including Thomas S. Harman, Associate Director (Chief 

Counsel), Clifford Kirsch, Assistant Director, Robert Plaze, Assistant Director, 

Heidi Stam, Associate Chief Counsel, Kenneth J. Berman, Deputy Chief of Office, 

Angela Goelzer, Special Counsel to the Director, L. Bryce Stovell, Senior Special 

Counsel, Robert G. Bagnall, Special Counsel, Thomas Sheehan, Special Counsel, 

Lawrence Stoller, Special Counsel, Eva Carney, Senior Counsel, Roseanne 

Harford, Attorney, Richard Jackson, Attorney, Elizabeth Krentzman, Attorney, L. 

Hope Lewis, Attorney, Edward Rubenstein, Attorney, Gregory Jaffray, 

Compliance Examiner, Evelyn Malone, Legal Technician, and Michele Bartley, 

Secretary . 

Many members of the Division also made significant contributions in 

reviewing and commenting on the report, including Gene A. Gohlke, Associate 

Director, Mary S. Podesta, Associate Director, Carolyn Lewis, Assistant Director, 

R. Michael Parker, Assistant Director, Jeremy N. Rubenstein, Assistant Director, 

Douglas Scheidt, Assistant Director, Sid Cimmet, Senior Special Counsel, 

Lawrence A. Friend, Chief Accountant, Stanley B. Judd, Senior Special Counsel, 

Michael Wible, Special Counsel, Yvonne Hunold, Senior Counsel, Thomas E. 

Bisset, Attorney, Marc Duffy, Attorney, Wendy Friedlander, Attorney, Patrice 

Pitts, Attorney, Nicholas Thomas, Attorney, Courtney Thornton, Attorney, Julia 

Ulstrup, Attorney, and Barbara Whisler, Attorney. 
TABLE OF CONTENTS 

PROTECTING INVESTORS: A HALF CENTURY 

OF INVESTMENT COMPANY REGULATION 

EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii 

PART I. THE SCOPE OF THE INVESTMENT COMPANY ACT 

Chapter 1. The Treatment of Structured Finance 

under the Investment Company Act . . . . . . . . . . . . . . . 1 

Chapter 2. 

Chapter 3. 

Private Investment Company Exceptions . . . . . . . . . . . 103 

Pooled Investment Vehicles for 

Employee Benefit Plan Assets . . . . . . . . . . . . . . . . . . . 119 

PART 11. REMOVING BARRIERS TO CROSS-BORDER SALES 

OF INVESTMENT MANAGEMENT SERVICES 

Chapter 4. Internationalization and Investment Companies . . . . 185 

Chapter 5. The Reach of the Investment Advisers Act of 1940 . . . 221 

Chapter 6. Performance Based Advisory Compensation . . . . . . . . 237 

PART 111. REGULATION OF INVESTMENT COMPANIES 

Chapter 7. Investment Company Governance . . . . . . . . . . . . . . . . 251 

Chapter 8. The Sale of Open-End Investment Company Shares . . 291 

Chapter 9. Investment Company Advertising . . . . . . . . . . . . . . . . 347 

Chapter 10. Variable Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373 

Chapter 11. Repurchases and Redemptions of 

Investment Company Shares . . . . . . . . . . . . . . . . . . . . 421 

Chapter 12. Affiliated Transactions . . . . . . . . . . . . . . . . . . . . . . . . . 473 

Chapter 13. Procedures for Exemptive Orders . . . . . . . . . . . . . . . . 503 

vii 
CHAPTER 1 

I . 

I1 . 

I11 . 

IV . 

V . 

VI . 

I . 

I1 . 

III . 

IV . 

THE TREATMENT OF STRUCTURED FINANCE UNDER 

THE INVESTMENT COMPANY ACT 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ................................ 1 

OVERVIEW OF STRUCTURED FINANCE ................. 5 

A . The Structured Finance Market ........................ 5 

B . Sponsors of Structured Financings ..................... 15 

C . Purchasers of Structured Financings .................... 20 

D . Expectations for the Future .......................... 24 

THE SECURITIZATION PROCESS ....................... 25 

A . The Components of a Structured Financing .............. 26 

B . The Role of the Rating Agencies ...................... 49 

C . Unrated Transactions ............................... 63 

THE INVESTMENT COMPANY ACT AND STRUCTURED 

FINANCE .......................................... 66 

A . Applicability of 66 the Act ............................. B . Effects of the Regulatory Structure ..................... 76 

THE REFORM OF THE TREATMENT OF STRUCTURED 

FINANCE .......................................... 76 

A . The Potential for Abuse in Structured Financings .......... 77 

83 

95 

B . The Lack of Abuse in Structured Financings ............. 81 

C . Recommendation .. An Exemptive Rule ................. D . Other Options Considered ........................... E . Section 3(c)(5) ..................................... 98 

CONCLUSION ..................................... 101 

CHAPTER 2 

PRIVATE INVESTMENT COMPANY EXCEPTIONS 

INTRODUCTION AND SUMMARY ..................... 103 

THE PRIVATE INVESTMENT COMPANY EXCEPTION ...... 105 

A QUALIFIED PURCHASER EXCEPTION ................ 110 

OTHER OPTIONS CONSIDERED ....................... 114 

viii 
V . CONCLUSION ..................................... 116 

Appendix2-A ...................................... 117 

CHAPTER 3 

POOLED INVESTMENT VEHICLES FOR 

EMPLOYEE BENEFIT PLAN ASSETS 

I . INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 119 

I1 . TREATMENT OF POOLED INVESTMENT VEHICLES UNDER 

THE FEDERAL SECURITIES LAWS ..................... 123 

A . Historical Treatment of Bank Collective Trust Funds ...... 123 

B . Historical Treatment of Insurance Company Separate 

Accounts ....................................... 128 

C . Current Securities Laws Exemptions for Pooled Investment 

Vehicles ........................................ 131 

RECENT DEVELOPMENTS IN THE EMPLOYEE BENEFIT 

PLAN INDUSTRY ................................... 136 

A . Increase in Number of Defined Contribution Plans ....... 136 

B . Growth of 401(k) Plans ............................. 139 

C . Growth in Defined Contribution Plan Assets ............ 140 

D . Competition Among Mutual Funds. Banks. and Insurance 

Companies ...................................... 143 

IV . INFORMATION PROVIDED TO INVESTORS .............. 144 

A . Comparison of Disclosure and Reporting Requirements .... 145 

B . Recommendations for Reform ....................... 151 

V . SUBSTANTIVE REGULATION OF POOLED INVESTMENT 

VEHICLES ......................................... 153 

A . Fiduciary Standards ............................... 153 

B . Prohibitions Against Self-Dealing: Investment 

Company Act. ERISA. and Regulation 9 ................ 157 

C . Fund Management ................................ 173 

D . Valuation and Redemption .......................... 175 

E . Advertising ..................................... 176 

F . Diversification ................................... 177 

G . Liquidity ....................................... 178 

VI . CONCLUSION ..................................... 178 

Appendix3-A ...................................... 182 

ix 
. 

CHAPTER 4 

INTERNATIONALIZATION AND INVESTMENT COMPANIES 

I . 

I1 . 

I11 . 

IV . 

V . 

I . 

I1 . 

I11 . 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 185 

BACKGROUND .. COMMISSION EXPERIENCE WITH 

SECTION 7(d) ...................................... 191 

A . Early Canadian Applications and Rule 7d-1 ............. 192 

B . Foreign Portfolio Sales Corporation Act of 1973 .......... 193 

C . The 1975 Guidelines ............................... 194 

D . The Union-Investment Application .................... 195 

E . The "Mirror Funds" Release ......................... 196 

F . The Foreign Investment Company Amendments Act of 1984 198 

G . Section 7(d) and Private Offerings .................... 200 

DISCUSSION .. REMOVING UNNECESSARY BARRIERS TO 

CROSS-BORDER SALES .............................. 202 

A . Harmonization ................................... 202 

C Recommendation .. Amendment of Section 7(d) ......... 205 

B . Treaties ........................................ 204 

OTHER IMPEDIMENTS TO CROSS-BORDER SALES ........ 214 

A . United States Tax Law ............................. 215 

B . State "Blue Sky" Laws ............................. 216 

CONCLUSION ..................................... 217 

Appendix4-A ...................................... 218 

CHAPTER 5 

THE REACH OF THE INVESTMENT ADVISERS ACT OF 1940 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 221 

THE REACH OF THE INVESTMENT ADVISERS ACT .. THE 

CURRENT APPROACH ............................... 223 

A CONDUCT AND EFFECTS APPLICATION OF THE 

INVESTMENT ADVISERS ACT ......................... 227 

A . The Statute's Jurisdictional Reach ..................... B . Policy Considerations Favoring a New Approach ........ 228 

C . Access to Books and Records and Personnel ............ 230 

227 

X 
D . Implications of a New Approach ..................... 230 

E . Other Alternatives ................................ 234 

IV . CONCLUSION ..................................... 236 

CHAPTER 6 

PERFORMANCE BASED ADVISORY COMPENSATION 

I . INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 237 

I1 . AN OVERVIEW OF THE PERFORMANCE FEE 

PROHIBITION ...................................... 241 

I11 . DISCUSSION ....................................... 245 

A . Financially Sophisticated Clients ..................... 246 

B . Foreign Clients ................................... 246 

IV . RECOMMENDATIONS ............................... 247 

Appendix6-A ...................................... 250 

CHAPTER 7 

INVESTMENT COMPANY GOVERNANCE 

I . INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 251 

I1 . CONFLICTS OF INTEREST AND INVESTMENT COMPANY 

GOVERNANCE UNDER THE ACT ...................... 255 

A . The Role of the Board of Directors .................... 255 

B . The Role of Shareholders ........................... 260 

I11 . THE DEBATE OVER THE CURRENT GOVERNANCE SYSTEM 

AND RECOMMENDATIONS FOR REFORM .............. 263 

A . The Debate over the Appropriate Role for Directors ...... 264 

B . Recommended Reforms of the Role of Directors ......... 266 

C . The Debate over Investment Company Shareholder Voting . 272 

D . Recommended Reforms of Investment Company Shareholder 

Voting ......................................... 274 

IV . ALTERNATIVE GOVERNANCE ARRANGEMENTS ......... 282 

A . The Original Unitary Investment Fund Proposal ......... 283 

B . Investor Protection Issues ........................... 284 

xi 
V . 

C . Cost Considerations ............................... 286 

D . The Impact of the UIF on Internationalization ........... 287 

E . Recommendations Concerning the UIF ................. 288 

CONCLUSION ..................................... 289 

CHAPTER 8 

THE SALE OF OPEN-END INVESTMENT COMPANY SHARES 

I . INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 291 

I1 . SALES LOADS AND RETAIL PRICE MAINTENANCE ....... 298 

A . The Purposes of Section 22(d) ....................... 299 

B . Commission Action under Section 22(d) ................ 303 

C . Amendment of Section 22(d) to End Mandatory Retail Price 

Maintenance ..................................... 307 

D . Other Options Considered ......................... 314 

I11 . SPONSORS OPTIONS FOR DISTRIBUTION FINANCING .... 315 

A. The Treatment of Fees and Distribution Charges 

under the Act .................................... 315 

B . Administrative Action Since 1940 ..................... 320 

C . Proposed NASD Regulation of Rule 12b-1 Fees .......... 325 

D . Limited Amendments to Rule 12b-1 ................... 326 

E . Adoption of Rule 6c-10 ............................ 328 

F . Multiple Class Exemptive Rule ...................... 330 

IV . THE UNIFIED FEE INVESTMENT COMPANY AN 

ALTERNATIVE ..................................... 332 

A . Rationale for the Unified Fee Investment Company ....... 334 

B . Operation of a Unified Fee Investment Company ......... 338 

C . Investor Protection Issues ........................... 344 

V . CONCLUSION ..................................... 345 

Appendix8-A ...................................... 346 

CHAPTER 9 

INVESTMENT COMPANY ADVERTISING 

I . INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 347 

xii 
I1 . 

111 . 

IV . 

V . 

I . 

I1 . 

I11 . 

IV . 

BACKGROUND ..................................... 352 

A . Application of the Securities Act and Rules to 

Investment Company Advertising .................... 352 

B . The Interplay of Rules 482 and 134 ................... 360 

RECOMMENDATIONS ............................... 361 

361 

B . "Off-the-Page" Advertisements ....................... 363 

A . "Investment Company Advertising Prospectuses" ......... 

OTHER OPTIONS CONSIDERED ....................... 369 

369 

B . Eliminating Liability under Section 12(2) ............... 369 

A . Requiring Prior Delivery of Mutual Fund Prospectuses .... 

CONCLUSION ..................................... 370 

Appendix 9-A ...................................... 371 

CHAPTER 10 

VARIABLE INSURANCE 

INTRODUCTION AND SUMMARY ..................... 373 

VARIABLE INSURANCE PRODUCTS UNDER THE FEDERAL 

SECURITIES LAWS .................................. 378 

A . 

B . 

C . 

D . 

E . 

Variable Annuities ................................ 378 

Variable Life Insurance ............................ 379 

The Introduction of Variable Products ................. 380 

Periodic Payment Plans ............................ 382 

Application of Sections 26 and 27 to Variable Insurance 

Products ........................................ 384 

PROBLEMS WITH THE CURRENT REGULATORY 

FRAMEWORK ...................................... 390 

390 

B . 394 

C . Problems With Variable Life Insurance .. Industry Concerns 395 

D . Problems with Variable Annuities - How Much Is the 

"Insurance" Worth? ............................... 400 

A . The Nature of the Products and Sponsors .............. The Investment Charge . Insurance Charge Dilemma ...... 

RECOMMENDATION ................................ 402 

A . Statutory Amendments ............................ 403 

B . Disclosure Proposals .............................. 408 

C . Effects ......................................... 410 

xiii 
__ 

V . 

I . 

I1 . 

I11 . 

IV . 

I . 

I1 . 

111, 

CONCLUSION ..................................... 417 

Appendix 10-A ..................................... 418 

CHAPTER 11 

REPURCHASES AND REDEMPTIONS OF 

INVESTMENT COMPANY SHARES 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 421 

BACKGROUND ..................................... 425 

A . The Treatment of Open-End and Closed-End Investment 

Companies Under the Act: The Historical Context ....... 425 

B . The Re-Emergence of Closed-End Companies and the Problem 

of Discounts ..................................... 432 

C . Methods For Reducing Discounts ..................... 436 

D . Closed-End Tender Offers .......................... 439 

RECOMMENDATIONS ............................... 442 

A . Repurchase Offers by Closed-End Companies ........... B . Limited Redemption Investment Companies ............ 456 

C . Portfolio Liquidity ................................ D . Definition of Redeemable Security .................... 

442 

463 

466 

CONCLUSION ..................................... 470 

Appendix 11-A ..................................... 471 

CHAPTER 12 

AFFILIATED TRANSACTIONS 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 473 

CURRENT REGULATION OF AFFILIATED TRANSACTIONS 

UNDER THE INVESTMENT COMPANY ACT ............. 474 

A . Investment Companies ............................. B . Business Development Companies .................... 481 

A . Section 17(a) and Riskless Principal Transactions ......... B . Section 17(d) .................................... 488 

475 

OPTIONS FOR REFORM AND RECOMMENDATIONS ...... 482 

485 

xiv 
IV . 

I . 

I1 . 

I11 . 

IV . 

V . 

C . Section 1O(f) and Rule 1Of-3 ......................... 499 

CONCLUSION ..................................... 500 

CHAPTER 13 

PROCEDURES FOR EXEMPTIVE ORDERS 

INTRODUCTION AND SUMMARY OF 

RECOMMENDATIONS ............................... 503 

BACKGROUND ..................................... 506 

A . The Historical Use of Section 6(c) ..................... 506 

B . Current Procedures for Obtaining Exemptive Relief under 

Section 6(c) ...................................... 508 

RECOMMENDATIONS TO EXPEDITE REVIEW OF 

EXEMPTIVE APPLICATIONS .......................... 509 

A . Expedited Procedures for Applications Based on Precedent . 510 

B . Amendments to the Division’s Delegated Authority ....... 514 

OTHER OPTIONS CONSIDERED ....................... 515 

A . Automatic Effectiveness for All Applications Absent 

Commission Action ............................... 515 

B . Dispensing with Prior Notice for Routine Applications .... 518 

C . Substantive Changes to Section 6(c) ................... 518 

D . Increased Use of Rulemaking Authority ................ 521 

CONCLUSION ..................................... 522 

Appendix 13-A ..................................... 523 

xv 
FIGURES AND TABLES 

Figure ES-1 

Figure 1-1 

Figure 1-2 

Figure 1-3 

Figure 1-4 

Figure 1-5 

Figure 1-6 

Figure 1-7 

Figure 3-1 

Figure 3-2 

Figure 3-3 

Figure 3-4 

Figure 3-5 

Table 3-1 

Table 3-2 

Figure 10-1 

Figure 11-1 

Figure 12-1 

Growth of Management Investment Company Assets 1940-1990 

............................................... xix 

Comparative Data Reflecting Growth of Structured Finance in the 

United States 1986-1991 ............................... 3 

Mortgage-Backed Securities Issued in the United States 1986-1991 

................................................. 6 

Non-Mortgage Asset-Backed Securities Issued in the 

United States 1986-1991 .............................. 12 

Total Issuance of Non-Mortgage Asset-Backed Securities by 

Collateral Type .................................... 14 

Structured Financing Components ...................... 26 

Financing Backed by Credit Card Accounts Receivable ...... 42 

A Master Trust Structure ............................. 47 

Total Number of Pension Plans in 1988 ................. 137 

Growing of Defined Contribution Plans ................ 138 

Pension Plan Assets by Type of Plan 1975-88 ............ 141 

Comparison of Pension Plan Assets 1981 vs . 1988 ......... 142 

1988 Pension Plan Assets -- Small Plans ................ 143 

Total Pensions Plan Assets (billions) in Pooled Vehicles, 1990 

............................................... 144 

Summary of Status Quo and Recommendations .......... 180 

Estimate of Annualized New Premium Market Share by Product 

............................................... 376 

Premiums and Discounts from NAV for IPOs of 

Closed-End Funds ................................. 435 

Upstream Affiliations .............................. 476 

xvi 
EXECUTIVE SUMMARY 

In the half century since the enactment of the Investment Company Act of 

1940, tremendous growth and structural change have taken place in the financial 

markets, including the investment company industry. In light of this growth and 

change, the Chairman of the Securities and Exchange Commission established a 

task force composed of members of the Division of Investment Management to 

reexamine the manner in which investment companies and other pooled securities 

vehicles are regulated. 

The modern investment company industry had its genesis in the 1920's 

when legal impediments 'to one corporation holding the stock of another had 

fallen. As businesses prospered and common stocks reached record highs, 

investors of modest means sought to participate in the stock market. Established 

brokers, investment bankers, and other members of the financial community 

began actively to promote the investment company concept and to distribute 

investment company securities. 

While the concept itself -- the pooling of funds to provide for 

diversification, economies of scale, and professional management -- had and still 

has obvious merit, the early rapid growth of the industry came, in large measure, 

at the expense of the investing public. Frequently, investment company assets 

were used by unscrupulous sponsors to further their own business interests. 

Failures to observe principles of fiduciary duty were widespread, and, as a 

consequence, holders of investment company securities, including the small, 

unsophisticated investors for whom the investment company product was so 

attractive, lost large sums of money. 

By the mid-l930's, the problems of the unregulated investment company 

industry were such that Congress recognized the need to take action. In 1935, 

Congress directed the Commission to study the fledgling investment company 

industry and report its findings. Between 1938 and 1940, the Commission 

transmitted to Congress an exhaustive report on the investment company 

industry. The report, commonly known as the "Investment Trust Study," laid the 

foundation for the Investment Company Act. Following several preliminary bills, 

the legislation that was finally enacted in 1940 was the product of cooperative 

negotiations between representatives of the Commission and of the investment 

company industry. 

The Investment Company Act reflects a congressional recognition that 

substantive protections beyond the disclosure requirements of the Securities Act 

of 1933 and the Securities Exchange Act of 1934 were needed because of the 

unique character of investment companies and their role in channeling savings 

into the national economy. As Congress observed in section 1 of the Investment 

Company Act, "[investment] companies are media for the investment in the 

xvii 
national economy of a substantial part of the national savings and may have a 

vital effect upon the flow of such savings into the capital markets . . . .I1 

The Investment Company Act establishes a comprehensive federal 

regulatory framework for investment companies. Regulation of investment 

companies is designed to: 

-- prevent insiders from managing the companies to their benefit and 

to the detriment of public investors; 

-- prevent the issuance of securities having inequitable or 

discriminatory provisions; 

-- prevent the management of investment companies by irresponsible 

persons; 

-- prevent the use of unsound or misleading methods of computing 

earnings and asset value; 

-- prevent changes in the character of investment companies without 

the consent of investors; 

-- prevent investment companies from engaging in excessive 

leveraging; and, finally, 

-- ensure the disclosure of full and accurate information about the 

companies and their sponsors. 

To accomplish these ends, the Investment Company Act requires the safekeeping 

and proper valuation of fund assets, restricts greatly transactions with affiliates, 

limits leveraging, and imposes governance requirements as a check on fund 

management. 

Since 1940 and particularly in the last decade, the investment company 

industry has grown rapidly. In 1940, the industry held only about two billion 

dollars in assets, including 105 registered management investment companies 

holding slightly more than one billion dollars in assets. Today, the industry 

serves as one of the nation’s largest financial intermediaries, with more than 3,500 

investment companies, and holding over $1.3 trillion in assets as of the end of 

1991. Approximately twenty-five percent of American households invest in 

investment companies -- either directly, or indirectly through pension funds and 

similar vehicles. 

xviii 
FIGURE ES-1 

Growth of Management Investment Company Assets 1940 - 1990 

55 

30 

2s 1al 15 

10 

5 

n 

As the industry has grown, its composition also has changed greatly. In 

1940, the dominant form of management investment company was the closed-end 

company. Open-end companies had only recently been popularized and had 

assets whose value was approximately only two-thirds of the value of closed-end 

companies. Unit investment trusts also were very popular. 

In contrast, by 1966, the open-end segment had grown dramatically and 

accounted for eighty-two percent of industry assets. Today the investment 

company industry continues to be dominated by the open-end companies, or 

mutual funds, as they are more commonly known. Such funds currently account 

for ninety-five percent of industry assets. A particular form of open-end 

company, the money market fund, which did not exist until the late 1970's, now 

accounts for forty-one percent of the industry's assets. 

Increasingly, mutual funds are organized in investment company 

"complexes," i.e., large groups of mutual funds associated with common advisers 

or underwriters, typically with liberal exchange privileges among the funds. The 

one hundred largest mutual fund complexes account for eighty-five percent of 

total investment company assets. 

Executive Summary xix 
In spite of this dramatic growth and the concomitant changes in the 

character of the industry, the Investment Company Act has been amended 

significantly only once, in 1970. That legislation followed two studies of 

investment company operations: the Wharton School of Finance's "A Study of 

Mutual Funds," published in 1962, and the Commission's "Report on the Public 

Policy Implications of Investment Company Growth," published in 1966. The 

1970 amendments added a number of new provisions to provide additional 

safeguards and protections for public investors. Most significantly, the 

amendments enhanced the effectiveness of boards of directors as checks on 

management by strengthening the independence of boards and increasing their 

role. In addition, the amendments added new provisions restricting sales charges 

and fund expenses. 

In recent years, continued industry growth has been fueled in large part 

by dramatic changes in the financial marketplace. Institutional demand for 

collective investment products accounts for a significant portion of that growth. 

When the Investment Company Act was passed, few, if any, institutional 

investors invested in investment companies. Institutional assets, which accounted 

for only eleven percent of investment company assets in 1970, now account for 

over twenty-five percent of total investment company assets. 

In addition, in recent years, an international market for professional asset 

management has emerged. Investment companies have proved to be attractive 

vehicles for investors who wish to invest in diversified portfolios of foreign 

securities. Internationalization of the securities markets also has sparked interest 

in eliminating barriers to cross-border sales of investment company services. 

Marketplace innovations also have led to a host of new pooled securities 

products that either were not anticipated or whose significance was not fully 

appreciated when the Investment Company Act was passed or in 1970. Many of 

these products are constrained by the framework of a statute that originally was 

designed to deal with only those limited forms of pooled investment vehicles that 

existed in the marketplace in the 1930's. 

For example, a relatively new financial technique called structured finance 

or securitization is revolutionizing corporate finance, enabling companies to 

borrow at low cost while providing investors with high quality debt insulated 

from the credit risk of the company. This technique has gained widespread 

acceptance. In fact, structured finance volume now constitutes more than half of 

all United States corporate bond new issue volume. This technique was not 

anticipated when the Investment Company Act was enacted. Thus, some but not 

all structured financings fall within the Act's definition of investment company 

but, as a practical matter, those offerings that fall within the definition of 

investment company cannot operate as registered investment companies within 

the regulatory framework of the Act as currently written. 
Another example of an unanticipated development is the emergence of 

defined contribution retirement plans. These plans give individuals a far greater 

say and responsibility in the investment of their retirement savings than do 

defined benefit plans and are changing the way in which millions of Americans 

provide for post-retirement benefits. Increasingly, retirement plans are funded 

with employees’ own contributions and employees choose among a number of 

funding vehicles, including registered investment companies, bank collective 

funds, and insurance separate accounts. The employees, of course, bear the risk 

of their choices. Today, almost forty percent of all private pension plan assets are 

held in defined contribution plans, and present trends suggest that this number 

will increase substantially by the end of the century. 

To compete more effectively with other financial intermediaries, insurance 

companies have developed variable insurance contracts. These contracts, hybrids 

of insurance and investment, were not contemplated by the original drafters of 

the Investment Company Act, nor were they in widespread use in 1970. 

Consequently, treatment of variable insurance contracts under the Investment 

Company Act presents a number of regulatory and practical problems. 

To evaluate the need for modernization of the regulation of pooled 

investment vehicles, the Division identified a number of significant issues that 

appeared to merit reexamination. The Commission published a concept release, 

Investment Company Act Release No. 17534 @ne 15, 1990), to seek public 

comment on these issues and any other issues commenters believed significant. 

In response, the Commission received over 200 comment letters, many of which 

provided detailed analyses of significant regulatory issues and suggested specific 

regulatory or legislative solutions. In addition, the Division met with 

representatives of numerous groups, including investor groups, mutual fund 

sponsors, mutual fund directors, securities dealers, banks, insurance companies, 

rating agencies, trade associations, and state, federal, and foreign regulators. 

Finally, the Division reexamined the historical basis for the current regulatory 

approach, including legislative and administrative history and prior Commission 

studies. 

The many technological and innovative changes in financial markets since 

1940 and even since 1970 have compelled this review of the Investment Company 

Act and are reflected in the conclusions and recommendations of this report. The 

recommendations are aimed at achieving three critical objectives: 

-- maintaining and improving the current level of investor protection; 

-- facilitating competition and capital formation by removing barriers; 

and 

Executive Summary xxi 
-- encouraging innovation. 

Our recommendations leave unchanged the fundamental principles 

underlying the Investment Company Act. Their soundness is demonstrated by 

the successful and safe operation of investment companies. Indeed, those 

principles are partially responsible for the remarkable success of the industry. Of 

course, no amount of regulation can prevent unsuccessful management of 

investment companies or losses on investments. It can, however, limit selfdealing, undue risks, and imprudent practices, as well as promote informed 

investor choice. 

The Division's reexamination of the Investment Company Act in light of 

the financial markets of the 1990's addressed a number of specific topics, which 

fall into three broad categories: 

-- The appropriate scope of the Act; that is, its applicability to various 

pooled investment vehicles that may fall within the definition of 

investment company or may resemble traditional investment 

companies. 

-- How best to remove unnecessary barriers to cross-border sales of 

investment management services. 

-- The regulation of investment company operations under the Act 

and the other federal securities laws. 

Our key recommendations are discussed below. 

The Scope of the Investment Company Act 

The Treatment of Structured Finance under the Investment Company 

- Act. In the last decade, the structured finance industry has become a 

major facet of American financial markets. Since its origination in the 

1970's with the securitization of residential mortgages, modern structured 

finance has evolved to include securities backed by credit card receivables, 

automobile loans, corporate bonds, and other financial assets. 

Under current law, structured financings literally fall within the 

Investment Company Act's definition of investment company because they 

both hold and issue securities. As a practical matter, structured financings 

cannot register as investment companies because they cannot operate 

under the Act's provisions. Some structured financings have not been 

regulated under the Act based on statutory exceptions that were intended 

for very different businesses. Other financings, primarily involving 

mortgage products, have received exemptions by Commission order. 

Financing that are unable to rely on an exception or obtain an exemptive 

xxii 
order are sold offshore or in private placements to not more than one 

hundred investors. Thus, today the Act distorts the operation and growth 

of the structured finance market by enforcing distinctions that do not 

reflect economic reality. 

In light of these distinctions between structured financings and traditional 

invesment companies and the virtually abuse-free record of structured 

financings, the Division recommends that: 

The Commission should adopt a rule exempting structured 

financings from the Investment Company Act, subject to 

requirements that would address the potential investor protection 

concerns presented by structured financings. The requirements y- 

- essentially those imposed today by the marketplace -- should 

restrict the degree of "management" of exempt financings, 

prohibit the issuance of redeemable securities, require ratings in 

the top two investment grades for all publicly-issued securities, 

and mandate independent trustees. 

The adoption of the rule is intended to remove the artificial constraints that 

the Act now imposes on the market, while addressing investor protection 

concerns that may be raised by structured finance offerings. 

Private Investment Companv Exceptions. The Investment Company Act 

excepts from the definition of "investment company" any issuer whose 

securities are owned by not more than 100 persons and that is not making 

and does not presently propose to make a public offering. This "private 

investment company" exception is used by a wide variety of issuers, 

including small groups of ordinary investors such as investment clubs and 

pools of Sophisticated institutional investors. For investment companies 

whose shares are held by less sophisticated investors, the 100 investor limit 

reasonably reflects the point at which federal regulatory concerns are 

raised. For funds that sell exclusively to sophisticated investors, however, 

the 100 investor limit is an unnecessary constraint not supported by 

sufficient public policy concerns. In light of these factors, the Division 

recommends that: 

The Investment Company Act should be amended to add a new 

exception for investment companies whose securities are owned 

exclusively by such "qualified purchasers" as designated in 

Commission rulemaking. 

Executive Summary xxiii 
Section 3(c)(l) should be amended to simplify the existing 

shareholder attribution provision to facilitate investments in the 

excepted issuers. 

The Act should be amended to make both private investment 

companies and the new qualified purchaser pools subject to the 

restrictions in section 12(d)(l) governing purchases of securities 

of registered investment companies. 

The pyramiding restrictions in section 12(d)(l) thus would apply to all 

issuers relying on the new "qualified purchaser" exception and all issuers 

relying on section 3(c)(l), but only with respect to investments in 

registered investment companies. Investments in the proposed qualified 

purchaser pools and section 3(c)(l) companies by registered investment 

companies would not be limited under section 12(d)(l). While protecting 

the public shareholders of registered investment companies, the 

amendment would facilitate registered investment company participation 

-in venture capital funds. In addition, the Division has concluded that the 

existing shareholder attribution provision in section 3(c)(l) is overly broad. 

By simplifying the provision, the amendment would ease compliance 

problems without lessening investor protection. 

Pooled Investment Vehicles for Employee Benefit Plan Assets. Bank 

collective funds and insurance company separate accounts that hold assets 

of employee benefit plans are exempt from the registration requirements 

of the federal securities laws. Thus, these vehicles are not regulated as 

investment companies, even though they are similar functionally and 

structurally to investment companies; and they do not provide plan 

participants with disclosure comparable to that required under the 

securities laws. Historically, these exemptions were premised upon the 

following assumptions: 

-- that interests in these vehicles were offered not to the public, 

but to employers that are sophisticated investors and that 

can fend for themselves by obtaining adequate information 

and by negotiating with the vehicles' sponsors; and 

-- that retirement plans were predominantly defined benefit 

plans, under which the employer made the investment 

decisions and bore the financial risk of ensuring the fund 

had sufficient assets to meet pension obligations. 

When the exemptions were enacted, those assumptions were essentially 

correct, but in the past twenty years retirement plans have changed 

materially. A substantial and fast-growing portion of retirement plans now 

consists of defined contribution plans. Under these plans, the employee 

xxiv 
often makes an investment decision about the vehicle in which the 

contributions allocated to the employee’s account will be invested, and the 

employee bears the investment risk of the performance of the plan 

vehicles. 

From a functional regulation perspective, it can be argued that mutual 

funds, bank collective funds, and insurance separate accounts sold to plan 

participants should be regulated under a common and uniform set of 

principles, and hence that bank collective funds and separate accounts 

should be regulated as management investment companies. Nevertheless, 

the costs of a major regulatory overhaul that would apply the Investment 

Company Act to these vehicles do not appear justified at this time. The 

Employee Retirement Income Security Act of 1974 imposes a number of 

obligations on those vehicles and generally provides investor protection in 

the same areas as the Investment Company Act, and we are unaware of 

any widespread abuses under the existing system that would be eliminated 

by applying the Act to these vehicles. Accordingly, the Division does not 

recommend that bank collective trust funds or insurance company separate 

accounts containing retirement plan assets be required to register under the 

Investment Company Act. 

By contrast, these vehicles are not required to make significant disclosure 

to plan participants, yet participants who direct their own investments in 

defined contribution plans are in essentially the same position as any 

investor. For many Americans these pooled retirement vehicles are the 

most important investment in their lives. Those plan participants’ 

investment decisions should have the benefits of the same disclosure 

obligations under the securities laws as other investment decisions. 

Accordingly, to ensure that plan participants receive full and fair 

disclosure, the Division recommends that: 

The Commission should propose amending the Securities Act of 

1933 to remove the exemption from registration for interests in 

pooled funding vehicles for participant-directed defined 

contribution plans. The Commission also should propose 

amending the federal securities laws to require the delivery of 

prospectuses to plan participants who direct their investments. 

The Commission should further propose amending the Securities 

Exchange Act of 1934 to require the delivery of semiannual and 

annual shareholder reports for the underlying investment vehicles 

(other than registered investment companies) to these plan 

participants. 

Executive Summary xxv 
The Commission should amend the rules under the Investment 

Company Act to require the delivery of semiannual and annual 

reports of underlying registered investment companies to these 

plan participants. 

Such disclosure should help plan participants make more informed 

decisions about their retirement assets and promote greater competition 

among investment vehicles offered under defined contribution plans. 

Removing Barriers to Cross-Border Sales of Investment 

Management Services 

Internationalization and Investment Companies. As a result of 

technological advances and the removal of many legal impediments to 

foreign participation, the world securities markets have become 

internationalized to an unprecedented degree in the last decade. Although 

investors worldwide appear more eager than ever to diversify their 

investments with managed portfolios of foreign securities, access by United 

States investors to foreign investment companies and by foreign investors 

to United States investment companies generally remains limited, in large 

part because of legal barriers to cross-border sales of investment company 

shares. In view of the opportunities for both United States investors and 

investment companies if hurdles to cross-border sales are lowered, the 

Division recommends that the Commission adopt a multifaceted approach 

to remove such barriers. 

Section 7(d) of the Investment Company Act is a major hurdle. This 

section prevents a foreign investment company from making a public 

offering in the United States unless the Commission finds that it can 

enforce the company’s compliance with all provisions of the Act. The 

enforceability standard in effect prohibits foreign investment companies 

from publicly offering their securities in the United States since it requires 

them virtually to transform themselves into United States investment 

companies. Because of these burdens, no foreign investment companies 

have registered since 1973. Accordingly, the Division recommends that: 

The Commission should propose amending section 7(d) of the 

Investment Company Act to permit foreign investment companies 

to sell shares in the United States if they can demonstrate that 

they are subject to regulation in their home country that provides 

substantially equivalent investor protection and that permitting 

their entrance into the United States markets would be in the 

public interest. To facilitate this process, the Commission should 

be authorized to enter into bilateral regulatory memoranda of 

xxvi 
understanding with the securities authorities in countries with 

regulatory regimes providing the same type and quality of 

investor protections as provided by the Investment Company Act. 

The Commission generally should support tax law changes to 

enable United States investment companies securing access to 

foreign markets to compete effectively with foreign investment 

companies, and the Commission should continue to work with 

state regulators to eliminate duplicative substantive regulation of 

investment companies. 

Implementing these recommendations should create a framework for 

regulatory cooperation and mutual recognition of investment company 

regulation, thus providing complementary access to investment company 

markets without sacrificing investor protection. 

The Reach of the Investment Advisers Act of 1940. The scope of the 

Investment Advisers Act is critically important for the internationalization 

of investment management services. When an investment adviser, foreign 

or domestic, registers under the Advisers Act, the Division has taken the 

position that all of the adviser's advisory activities everywhere are subject 

to the Advisers Act. Many of the Advisers Act's requirements, however, 

are different from or exceed those that apply to foreign advisers in their 

home country and may be contrary to accepted business practices there. 

Consequently, a foreign adviser that registers under the Advisers Act 

because it does business in the United States, as well as in its home 

country, may find itself unable to engage in legal and acceptable business 

conduct in its home country because the Advisers Act prohibits it. To 

avoid the consequences of this position, some foreign advisers establish 

"independent" subsidiaries, registered in the United States, to advise their 

clients here. Those subsidiaries, however, are subject to strict requirements 

that may restrict their ability to function effectively and also may reduce 

the quality of investment advice they are able to provide to United States 

investors. 

To alleviate these problems, the Division recommends that: 

1 

The Division should issue no-action letters narrowing the 

application of the Advisers Act to the activities of registered 

advisers with their foreign clients, in accordance with a "conductf' 

and "effects" approach. Under that approach, the Commission 

generally would not regulate a registered foreign adviser's 

dealings with clients outside the United States, but would 

regulate a registered domestic adviser's dealings with foreign 

Executive Sununary xxvii 
clients where a sizable amount of advisory conduct occurs in the 

United States. To ensure the Commission’s ability to police 

overseas conduct that affects United States clients, registered 

advisers would still be required to maintain records regarding 

their own overseas trading and that of their clients and provide 

the Commission with access to their overseas personnel. 

This approach would be consistent with the Commission’s other 

international initiatives under the other federal securities laws. The 

approach also would permit greater flexibility for foreign advisory 

businesses to form and register separate subsidiaries or affiliates here. 

Performance Based Advisorv Compensation. The Advisers Act generally 

prohibits a registered investment adviser from receiving compensation on 

the basis of a share of capital gains in, or capital appreciation of, a client‘s 

account. Subject to specific requirements, limited exemptions from that 

prohibition are available for advisory contracts with registered investment 

companies, business development companies, and certain clients with 

significant assets. By contrast, many foreign countries do not impose any 

restrictions on performance-based fees, and such fees are a customary way 

of doing business in those countries. United States registered advisers, 

however, are subject to the Advisers Act’s limits on such fees, even when 

dealing with non-United States clients. Moreover, none of the current 

exemptions is sufficiently flexible to permit sophisticated clients not 

needing the protections of the prohibition to structure advisory fees on 

terms they determine are appropriate. 

To provide more flexibility in the use of performance fees, the Division 

recommends that: 

The Commission should propose amending the Advisers Act’s 

limits on performance-based advisory fees to grant the 

Commission rule-making authority to exempt two types of 

advisory relationships from the restrictions on performance fees. 

First, United States registered advisers should be permitted to 

enter into performance fee contracts with non-United States 

clients to the extent that these compensation arrangements are 

lawful in the clients’ home jurisdiction. Second, the performance 

fee restrictions should be amended to provide an exception for 

contracts with clients who the Commission determines by 

regulation, do not need the protections of the prohibition, based 

on factors such a$ wealth and financial sophistication. 

xxviii 
The first change would reduce the competitive burden on domestic 

advisers seeking to compete in overseas markets. The second change 

would give United States registered advisers and sophisticated institutional 

investors greater flexibility to structure appropriate compensation 

arrangements. 

Regulation of Investment Companies 

Investment Companv Governance. The Investment Company AcYs 

requirements concerning the organizational structure of open-end 

investment companies, which interpose independent directors as a check 

on investment company sponsors, are fundamentally sound. They provide 

significant protections against the inherent conflicts between the interests 

of public investors and the interests of fund sponsors. At present, the 

Investment Company Act requires that a majority of the board be 

independent only in limited circumstances. To strengthen the 

independence of boards, the Division recommends that: 

The Commission should propose amending the Investment 

Company Act to require that the minimum proportion of 

independent directors on investment company boards be 

increased from forty percent to a majority, and that independent 

director vacancies be filled by the remaining independent 

directors. Independent directors should be given the authority to 

terminate advisory contracts. 

At the same time, a small number of provisions would be amended to 

eliminate requirements that independent directors make detailed, 

formalistic findings in areas that generally do not present the potential for 

conflict between the interests of a fund and its adviser. Specifically, the 

Division recommends that: 

The Commission should amend rules under the Investment 

Company Act to streamline requirements for board review and 

approval of foreign custody arrangements, domestic securities 

depositories, and the time of day for determining net asset value. 

These changes should increase directors’ effectiveness by allowing them to 

focus on what they do best -- exercising business judgment in their review 

of interested party transactions and in their oversight of operational 

matters where the interests of a fund and its adviser may diverge. 

While shareholder voting continues to be important as an effective means 

of communication, deterrence, and holding the board accountable, some 

Executive Summary xxix 
of the voting requirements under the Investment Company Act do not 

comport with the realities of modern securities markets and do not really 

protect investors. Accordingly, the Division recommends that: 

The Commission should propose amending the Investment 

Company Act to eliminate requirements that shareholders ratify 

the initial advisory contract, concur in the board’s selection of 

fund auditors, or approve changes in relatively routine investment 

policies. 

The Commission also should recommend amending the 

Investment Company Act to require that shareholders approve 

any change in a fund’s investment objective in order to clarify 

that the investment objective is a critical determinant of the 

potential risk and reward inherent in the shareholder’s 

investment. 

The Commission should eliminate the requirement that 

shareholders ratify the initial rule 12b-I plan (if any) of a newly 

organized fund, but should not recommend changes to voting 

requirements relating to amendments to rule 12b-1 plans that 

materially increase the amount spent on distribution. 

The Investment Company Act relies on boards of directors to monitor 

investment company operations and resolve conflicts of interest; available 

data suggest that board operations impose minimal costs upon investment 

companies. Accordingly, the Division does not recommend changes that 

would permit the introduction of a unitary investment fund or other 

contractual structure that would eliminate shareholder and director voting. 

In view of the importance of director and shareholder voting requirements 

under the Investmen’t Company Act, it would be fundamentally 

incompatible with the Act‘s regulatory philosophy to introduce such 

alternative structures, which would have little or no apparent benefits for 

investors. 

The Sale of Open-End Investment Companv Shares. Over the past fifty 

years, tremendous changes have taken place in how mutual funds sell their 

securities (known as “distribution”) and in how the sales are regulated. 

Today, the major distribution issue facing the Commission continues to be 

the degree and effect of competition in the mutual fund industry. We 

conclude that fund pricing is not as market-driven as it could be. 

Accordingly, the Division’s recommendations focus on eliminating 

regulatory impediments to vigorous price competition, increasing investor 

understanding of total investment costs, promoting cost comparability 

among funds, and easing restrictions so that funds may experiment with 

distribution arrangements that make costs more explicit. We believe these 

xxx 
changes would promote price competition and more economical and 

efficient distribution methods. 

a. Retail Price Maintenance. Section 22(d) of the Investment Company 

Act requires that investment company sponsors fix the prices at which 

redeemable shares are sold to the public and that retail dealers adhere to 

those prices. Together with section 22(f), which permits mutual funds to 

impose restrictions on transferability of shares, this provision inhibits price 

competition in the distribution of mutual fund shares, harming investors 

by causing higher prices than might otherwise be available in a 

competitive marketplace. Accordingly, in order to promote greater 

competition in the distribution of mutual funds, the Division recommends 

that: 

The Commission should propose amending section 22(d) of the 

Investment Company Act to repeal the retail price maintenance 

requirement and to provide the Commission with explicit 

authority to issue orders or rules to deal with any issues of 

investor protection or the operation of the secondary market that 

may arise. 

This proposal would promote retail competition among dealers and permit 

the market to develop more efficient methods of mutual fund distribution. 

In addition, this proposal could facilitate the creation of new and 

innovative products that depend on free secondary markets in their 

securities. 

b. investor^ Choice. Since 1980, Commission rules and exemptive orders 

have permitted the development of a variety of distribution financing 

methods in addition to the traditional front-end loads. These innovations 

have included asset-based sales charges, contingent deferred sales loads, 

and the offering of multiple classes in the same portfolio. In response to 

a number of issues arising out of the use of these methods, the Division 

recommends that a variety of distribution options currently permitted 

under individual exemptive orders also be -codified and that certain 

outstanding rule proposals be adopted with appropriate modifications. 

The Commission should adopt its outstanding rule proposal to 

permit deferred loads, including installment loads assessed 

directly on a shareholder's account. While tax consequences 

apparently would inhibit widespread use of installment loads, 

there is no reason to require individual exemptive orders for their 

use. 

Executive Summary xxxi 
The Commission should adopt only limited amendments to the 

rule governing asset-based sales loads, or rule 12b-1 fees, 

consistent with the continued use of spread loads and the 

proposal by the National Association of Securities Dealers, Inc. to 

regulate these loads under its maximum sales load rule. 

The Commission should adopt a new exemptive rule to permit 

multiple class arrangements which can increase investor choice, 

result in economies of scale and certain efficiencies in the 

distribution of fund shares, and allow fund sponsors to tailor 

products more closely to the needs of investors. 

In combination, these changes will allow funds to offer investors a variety 

of methods of financing distribution costs while enhancing investors' 

comprehension of their choices. 

c. Unified Fee Investment Companies. The array of fees and loads 

available to investors does increase investor choice but also may impede 

price competition. The Division believes that price competition might be 

improved if, ironically, still another form of investment company were 

permitted -- one with a simplified fee structure and low barriers to exit by 

dissatisfied shareholders. Accordingly, the Division recommends that: 

The Commission should propose amending the Investment 

Company Act to permit the introduction of a new investment 

vehicle -- a unified fee investment company ("UFIC"). The UFIC 

would have a single, fixed fee, set by the vehicle's "investment 

manager" and no sales charges or redemption fees. All UFIC 

expenses, except brokerage commissions on the fund's own 

portfolio transactions and extraordinary costs, would be paid from 

the fee or from the manager's own resources. Rule 12b-1 would 

not apply. The level of the fee would be prominently displayed 

on the cover page of the prospectus and in all sales literature and 

advertising. To protect investors should competition not restrain 

fee levels for the UF'IC, the Act would prohibit "unconscionable 

or grossly excessive" unified fees. The fee would not require 

shareholder or director approval nor would it be subject to private 

litigation. 

Because such funds would not impose either front-end or deferred sales 

loads, dissatisfied investors could "vote with their feet." A unified fee 

structure would substitute market competition for the oversight role of 

boards of directors and courts, who today review the fee levels of 

investment companies to prevent excessive charges to investors. The UFIC 

would have a board of directors to police operational conflicts and approve 

a variety of activities, just as do other funds. The board would oversee the 

xxxii 
level of services provided to the UFIC through review of all material 

contracts. 

Investment Comuanv Advertising. Under the Securities Act, investment 

companies historically have experienced unique problems communicating 

with the public. First, unlike traditional issuers which generally only offer 

their shares periodically, mutual funds and unit investment trusts 

continuously offer and sell their shares and units to the public, and, 

therefore, are continuously subject to the Securities Act's advertising 

requirements. In addition, because the Securities Act broadly defines the 

term "offer," and because the "products" of an investment company are its 

securities, virtually every written attempt by an investment company to 

promote and make the public aware of its products is potentially an offer 

to sell its securities that must conform to the Securities Act's advertising 

requirements. Traditional issuers, in contrast, whose products are not 

securities, do not have this problem and may advertise their products more 

freely. Finally, the advertising restrictions of the Securities Act restrict 

direct-marketed funds more than funds sold through brokers. Directmarketed funds use print, radio, and television almost exclusively to sell 

fund shares, while broker-sold funds employ sales personnel who sell fund 

shares orally. Since the advertising restrictions of the Securities Act 

generally apply to written communications but not to oral 

communications, broker-sold funds have an advantage over directmarketed funds. To promote more effective written communications with 

investors, the Division recommends that: 

The Commission should propose amending the Securities Act to 

delete the requirement that all of the information in an 

investment company's "omitting prospectus" must be derived 

from the statutory prospectus and to add a provision for a new 

"advertising prospectus" for investment companies. The contents 

of the advertising prospectus would not be restricted to 

information "the substance of which" is contained in the statutory 

prospectus. In addition, the Commission should rescind the 

special provisions in the tombstone rule for investment 

companies. 

The Commission should also adopt amendments to the Securities 

Act rules to permit mutual funds to sell "off-the-page" directly 

from advertisements, as is the practice in several European 

countries, without requiring that investors first receive a statutory 

prospectus. Off-the-page advertisements would be required to 

contain such information as the Commission may prescribe, such 

as fees and expenses, performance data, investment objectives, 

Executive Summary xxxiii 
and risks. The advertisements would also be required to inform 

investors about the availability of a statutory prospectus, and the 

mutual fund would still be required to deliver a statutory 

prospectus to investors prior to, or with, the earlier of the 

confirmation of the sale or the delivery of the security. In 

, addition, off-the-page advertisements would be section 10 

prospectuses, and hence subject to section 12(2) prospectus 

liability. 

These proposals should make it easier for investment companies to market 

their funds and for investors to receive useful information. In addition, the 

proposals would subject all investment company advertising to prospectus 

liability which, in turn, will maintain the high level of investor protection 

that exists today. 

Variable Insurance. Variable annuities and variable life insurance 

contracts are regulated both as insurance products under state law, and as 

securities under the periodic payment plan model under sections 26 and 

27 of the Investment Company Act, which imposes considerable limits on 

individual charges such as distribution costs and administrative fees. With 

variable insurance products, the policyholder's premium payments are 

allocated to a segregated or "separate" account investing in a portfolio of 

securities, not to the company's general account (which receives premiums 

for most life insurance and annuity policies). Under variable contracts, 

certain benefits (such as cash surrender values, annuity payments, and 

death benefits) reflect the investment performance of the portfolio of the 

applicable separate account. While variable insurance contracts are 

regulated as periodic payment plan certificates, they are not comparable 

investment products. The variable life contracts, in particular, have huge 

start-up and issuance costs, and multiple insurance and administrative 

costs that are not provided for adequately under current Investment 

Company Act regulation. In addition, because the contracts are hybrids 

of insurance and investment, with state insurance law applying to the 

insurance elements of the contracts and federal securities laws to the 

investment elements, difficult jurisdictional and practical problems arise, 

particularly over the regulation of contract charges. Accordingly, in order 

to recognize the unique nature of variable insurance contracts the Division 

recommends the following: 

The Commission should recommend amending sections 26 and 27 

of the Investment Company Act to exempt variable insurance 

contracts from certain charge limitations under those provisions 

and to improve flexibility of pricing by requiring aggregate 

contract charges simply to be reasonable in relation to the services 

rendered under the contracts, the expenses expected to be 

incurred, and the risks assumed by the insurance company. The 

xxxiv 
amendment also should provide the Commission with rulemaking 

authority to establish standards of reasonableness if the market 

should fail to provide competitive prices or if abusive industry 

practices should develop. 

Under the amendment, the Commission's role in regulating contract 

charges would be made more consistent with the unique features of 

variable insurance and the Commission's approach to regulating charges 

in the mutual fund industry. 

Repurchases and Redemptions of Investment Company Shares. 

Traditionally, investment company regulation has maintained a relatively 

rigid separation between open-end and closed-end investment companies. 

Open-end companies must price their shares daily and pay redemption 

proceeds to investors within seven days of receipt of a redemption request. 

With limited exceptions, closed-end companies may not repurchase their 

shares directly from shareholders, except through cumbersome and 

expensive tender offers. Some investment companies today elect closedend status because they invest in markets that, for various reasons, make 

it impractical to pay redemption proceeds within seven days. Many 

closed-end companies, however, tend to trade at a discount from their net 

asset value and thus are unattractive to many investors. Accordingly, to 

permit a greater range of options and innovation, the Division 

recommends that: 

The Commission should adopt a new rule under section 23 of the 

Investment Company Act defining circumstances under which 

closed-end companies may conduct regular repurchases of their 

shares directly from shareholders at prices based on net asset 

value. 

The Commission also should adopt a new exemptive rule under 

section 22 of the Investment Company Act permitting new 

variations on the open-end form, to be called "limited 

redemption" investment companies, offering alternative 

redemption and offering procedures to investors. Such companies 

would be either extended payment companies, which would 

redeem shares continuously but take longer to make payments 

than the seven days currently mandated for open-end companies, 

or interval companies, whose shareholders could redeem at fixed 

regular intervals, such as monthly. To prevent investor confusion, 

the new rule should require prominent, clear disclosure of a 

fund's limits on redeemability and prohibit the use of the term 

"mutual fund" and similar expressions in connection with these 

Executive Summary xxxv 
new companies. In other respects, the new kinds of funds should 

be regulated in the same manner as traditional open-end 

investment companies. 

These new procedures would give shareholders the ability to invest in 

managed portfolios with less liquidity than mutual funds, while retaining 

the ability to exit the fund at a price based on net asset value. 

Finally, because of the importance of portfolio liquidity to an investment 

company’s ability to redeem or repurchase its shares, the Division 

recommends that: 

The Commission should propose amending the Investment 

Company Act to make express a portfolio liquidity requirement 

for all companies that redeem or regularly repurchase their shares 

and to give the Commission authority to prescribe appropriate 

liquidity standards. 

Liquidity requirements would help protect investors’ reasonable 

expectations regarding their ability to exit a particular fund at net asset 

value. 

Affiliated Transactions. The Investment Company Act has as one of its 

cornerstones strict prohibitions on transactions involving investment 

companies and their affiliates. These prohibitions go beyond those 

imposed by common law, by federal and state law on other types of 

pooled investment vehicles, such as bank common trust funds and 

commodities pools, or by foreign laws regarding investment companies. 

Because there is significant potential for abuse in many affiliated 

transactions, it would be unwise to make sweeping changes to the 

provisions of the Act concerning transactions involving investment 

companies and their affiliates, such as authorizing fund boards of directors 

to approve all such transactions. At the same time, however, some limited 

relief is appropriate to permit limited classes of transactions with affiliates 

that do not present significant conflicts, subject to review by boards of 

directors. Accordingly, the Division recommends that: 

The Commission should amend the limitations on joint 

transactions under rule 17d-1 to broaden the class of transactions 

currently permitted by allowing directors of investment 

companies to authorize joint transactions with remote affiliates, 

and by exempting joint transactions where an investment 

company and its affiliates participate on the same terms, except 

to the extent of their participation. 

xxxvi 
The Commission should adopt amendments to rule 1Of-3, which 

allows limited purchases by investment companies from 

underwriting syndicates that contain affiliates, to permit 

purchases in overseas markets. 

Procedures for Exemptive Orders. The authority to issue 

granting exemptions from the Act is vital to the Commission’s 

ability to administer the Act flexibly and promptly in response to 

new developments in the financial markets. The large number of 

applications reviewed by the staff illustrates the extent to which the 

Commission and the industry depend on the process. In order to 

strengthen the ability of the staff and the Commission to respond 

promptly, the Division recommends that: 

The Commission should adopt a rule providing for expedited 

treatment of routine applications for which there is recent, fully 

applicable precedent. Applicants employing this procedure 

generally would receive relief no later than 120 days after filing 

an application. 

The Commission should expand the delegation of authority to the 

Division Director under existing regulations to expedite review of 

applications. 

The Division believes that more radical revisions to the existing exemptive 

authority would be both unwise and unnecessary. 

Executive Summary xxxvii 
Chapter 1 

The Treatment of Structured Finance 

under the Investment Company Act 

I. Introduction and Summary of Recommendations 

Structured finance is a financing technique in which financial assets, in 

many cases illiquid, are pooled and converted into capital market instruments.' 

In a typical structured financing, a sponsor transfers a pool of assets to a limited 

purpose entity, which in turn issues non-redeemable debt obligations or equity 

securities with debt-like characteristics ("fixed income securities"). Payment on 

the securities depends primarily on the cash flows generated by the assets in the 

underlying pool. Typically, the securities are rated in one of the two highest 

categories by at least one nationally recognized statistical rating organization 

("rating agency"). Issuers that have more assets or that expect to receive more 

income than needed to make full payment on the fixed income securities also may 

sell interests in the residual cash flow. 

Structured finance differs from conventional financing techniques in that 

it involves the pooling of financial assets, which are then removed from the 

sponsor's balance sheet. The risks inherent in holding the financial assets are 

shifted away from the sponsor to investors that believe they are in a better 

position to accept these risks? As a result, the sponsor may be able to manage 

its balance sheet better, while gaining access to alternative funding sources. 

'Although "structured finance" is the term most commonly used to describe this financing 

technique, the terms "structured securitized credit," "asset-backed arrangement," "asset-backed 

financing," and "asset securitization" also are used. We use these terms interchangeably 

throughout this chapter. 

2See JAMES A. ROSENTHAL & JUAN M. OCAMPO, SECURITIZATION OF CREDIT: INSIDE THE NEW 

TECHNOLOGY OF FINANCE 5, 9-11 (sponsored and produced by McKinsey & Company 

Securitization Project; 1988). The sponsor may still bear some risk, depending on whether it 

provides recourse or owns some of the securities issued in the financing. Id. 

1 
Since its inception in the 1970'~~ the structured finance market in the 

United States has grown rapidly? One observer has estimated that $292.8 billion 

of structured financing securities were issued in the United States in 1991, 

compared with $174.0 billion in 1990.4 The significance of the structured finance 

market is particularly apparent when its market share is compared to the market 

share of other types of offerings. In 1991, structured financings accounted for 

approximately fifty percent of total public securities issuances (debt and equity) 

in the United States, and approximately fifty-seven percent of total public debt 

securities issuances? 

%tructured finance is a form of "securitization." Although observers define "Securitization" 

in somewhat differing ways, generally it is the process by which funding that traditionally was 

obtained from commercial lenders, such as banks and finance companies, is obtained instead 

through the use of securities. See, e.g., id. at 3; LOWELL L. BRYAN, BREAKING UP THE BANK: 

RETHINKING AN INDUSTRY UNDER SIEGE 66-70 (1988). In addition to structured finance, other forms 

of securitization include commercial paper, loan participations and high yield bonds. See, e.g., 

BRYAN, supra, at 66, 69; TAMAR FRANKEL, SECURITIZATION: STRUCTURED FINANCING, FINANCIAL 

ASSETS POOLS, AND ASSET-BACKED SECURITIES, 5 1.2, at 6 (1991). 

41n 1991, approximately $246.21 billion of mortgage-backed securities and $46.60 billion of nonmortgage asset-backed securities were issued compared with reported issuance in 1990 of $133.94 

billion of mortgage-backed securities and $40.10 billion of non-mortgage asset-backed securities. 

Michael Liebowitz, Reversing Four-year Trend and Swooning Economy, Wall Street Explodes in 1991 , INV. DEALERS' DIG., Jan. 6, 1992, at 26-27 [hereinafter IDD 1991 Figures]. 

51n 1991, an estimated $585.97 billion of total United States debt and equity securities were 

issued of which $510.96 billion were debt securities. Id. at 24, 27, 30-31. In comparison, in 1990, 

an estimated $312.11 billion of total United States debt and equity securities were issued of which 

$288.36 billion were debt securities. As the foregoing figures indicate, although total 

structured finance issuances grew 68% from 1990 to 1991 (mostly as a result of an 84% increase 

in the issuance of mortgage-backed securities), both total securities issuances and total debt 

securities issuances grew even faster between 1990 and 1991 (88% and 77% respectively). Thus, 

from 1990 to 1991, structured finance issuances declined six percent as a portion of total securities 

issued and three percent as a portion of total debt securities issued. 

Id. 

2 CHAPTER 1 
FIGURE 1-1 

Comparative Data Reflecting Growth of Structured Finance in the 

United States 1986-1991 

1986 1987 1988 l9BB 1990 1991 

a Structured flnanw Debt 

scute: I-osskn'Digsa 

Despite this robust growth, the Investment Company Act6 has constricted 

the development and evolution of the structured finance market. Structured 

financings fall within the definition of investment company but cannot operate 

under the Act's req~irements.~ Many financings have avoided regulation under 

the Act by re1 in on the exception to the definition of investment company in 

section 3(c)(5), which Congress included in 1940 for the commercial finance and 

mortgage banking industries? The Commission has granted exemptions with 

61nvestment Company Act of 1940'15 U.S.C. Q 8Oa. 

'see generally infiu Section IV. 

'15 U.S.C. § 80a-3(~)(5). 

'Certain federally sponsored structured financings, such as those sponsored by the Federal 

National Mortgage Association ("FNMA"), also are exempted from the Act's provisions under 

section 2b), which exempts, among other things, activities of United States Government 

instrumentalities or wholly-owned corporations of such instrumentalities. 15 U.S.C. Q 80a-2(b). 

The Division did not re-examine the treatment of federally sponsored structured financings under 

the Act. 

The Treatment of Structured Finance under the Investment Company Act 3 
respect to other finanangs, primarily those involving mortgage-related assets." 

Financings that are unable to rely on a statutory exception or obtain an exemptive 

order must sell their securities either privately to no more than 100 investors in 

reliance on the Act's private investment company exception, or outside the United 

States?' Thus, the Investment Company Act distorts the structured finance 

market, even driving some offerings offshore. The Act also causes much 

unproductive discussion over whether particular offerings may rely on section 

3(c)(5). 

In light of these problems, the Division has re-examined the Investment 

Company Act's treatment of private sector structured financings.12 .We 

recommend that the Commission adopt a rule exempting structured financings 

from all provisions of the Investment Company Act, subject to conditions that 

would address the investor protection concerns presented by structured 

finan~ings:~ The conditions generally would restrict "management" of exempt 

financings; prohibit the issuance of redeemable securities; limit public securities 

issuances to debt or debt-like securities that are rated in the top two investment 

~ 

"See infra Section N.A.2. 

"Investment Company Act Q 3(c)(l), 15 U.S.C. Q 3(c)(l). 

I2In the course of this examination, the Division met with representatives of entities associated 

with the structured finance industry to discuss, among other things, how structured financings 

work, the roles of the various participants, the status of the structured finance market, likely 

developments, and investor protection concerns. In addition, the Division published a request for 

comments on reform of the regulation of investment companies which included a request for 

comments on the regulation of structured financing under the Act. Request for Comments on the 

Reform of the Regulation of Investment Companies, Investment Company Act Release No. 17534, 

Q 1II.C. (June 15, 19901, 55 FR 25322 [hereinafter Study Release]. The Division received many 

responses to the Study Release addressing structured finance issues including letters from The 

American Bankers Association; The 1940 Act Structured Finance Task Force of the American Bar 

Association; Banca DItalia; Bankers Trust Company; Chase Manhattan Bank; Chemical Bank; 

Citicorp; Cleary, Gottlieb, Steen & Hamilton; Davis Polk & Wardwell; Dean Witter Reynolds Inc.; 

The Equitable Life Assurance Society of the United States; Federated Investors; Financial Security 

Assurance; Foley & Lardner on behalf of Smith Barney Asset Capital Corp.; Tamar Frankel; 

Investment Company Institute; Mayer Brown & Platt; Mayer Brown & Platt on behalf of 

Continental Bank N.A.; Merrill Lynch & Co., Inc.; New York Clearing House; Sears, Roebuck and 

Co.; and Shearson Lehman Brothers. 

I3Of course, structured financings are also subject to various regulatory requirements under 

the Securities Act of 1933 (15 U.S.C. QQ 77a-77aa), the Securities Exchange Act of 1934 (15 U.S.C. 

§§ 78a-7812), and the Trust Indenture Act of 1939 (15 U.S.C. Q§ 77aaa-77bbbb), as well as other 

federal laws and state laws. The Division examined only the Investment Company Act issues. 

4 CHAPTER 1 
grades, the payment of which depend on the cash flows from the underlying 

assets; and require independent trustees. 

Section 11 of this chapter provides an overview of structured finance, 

discussing the present status of the market and how it began, which institutions 

are securitizing their assets and why, who purchases these securities, and 

expectations for the future. Section I11 discusses the basic mechanics of structured 

financings, including the responsibilities of the various entities involved. Section 

IV describes the application of the Investment Company Act to structured 

financings and its effects. Section V discusses whether structured financings 

should be subject to the Act, examining whether structured financings present the 

potential for the type of abuses the Investment Company Act is designed to 

remedy and, if so, how structured financings could be regulated under the Act. 

Section V also analyzes possible reforms, including several of those suggested by 

commenters in response to the Division's request for comments on reform of the 

regulation of investment companies (the "Study Relea~e"),'~ and discusses the 

Division's proposed rule. 

XI. Overview of Structured Finance 

A. The Structured Finance Market 

1. The Mortgage Market 

The modern structured finance market originated in the 1970's with the 

securitization of residential mortgages.15 Since then, securities backed by 

residential mortgages have dominated the structured finance market. As of 

September 30,1991, the aggregate amount of securities backed by one- to fourfamily mortgages was reported to be $1.2 trillion, representing forty-two percent 

of all mortgage debt?' Total value of mortgage-backed securities issued in 1991 

%tudy Release, sup note 12. 

15Mortgages were "securitized," in crude fashion, in the 1920's and 1930's. Typically, banks 

or mortgage insurers guaranteed the mortgages. Many of the mortgage pools experienced 

defaults and many of the guarantors failed, as a result of inadequate capital. Edward L. Pittman, 

Economic and Regulatory Developments Affecting Mortgage Related Securities, 64 NOTRE DAME L. REV. 

497,500 (1989). 

I6Federal Home Loan Mortgage Corp., Dufabase, Securitized Mmtguge Debt Outstanding, in THE 

SECONDARY MORTGAGE MARKETS Table 5 (Winter 1991 /1992) [hereinafter Database.] In contrast, 

as of the same date, only 10% of all outstanding multi-family mortgage debt had been securitized. 

Id. 

The Treatment of Structured Finance under the Investment Company Act 5 
was estimated to be $246.2 billion, an eighty-four percent increase from the 1990 

level of $133.9 bil1i0n.l~ Figure 1-2 illustrates the growth of the mortgage market. 

FIGURE 1-2 

Mortgage-Backed Securities Issued in the United States 1986-1991' 

The securitization of residential mortgages is a direct outgrowth of federal 

promotion of the secondary market in residential mortgages.18 The Government 

National Mortgage Association ("GNMAI'), the Federal National Mortgage 

Assgciation ("FNMA"), and the Federal Home Loan Mortgage Corporation 

("FHLMC") were formed to provide greater access to capital for residential 

171DD 1991 Figures, supra note 4, at 21. It is likely that only a small dollar amount of 

securitized commercial mortgages is included in this figure. For a discussion of securitization of 

commercial mortgages, see note 36 and accompanying text below. 

%ee, e.g., BRYAN, supra note 3, at 71. 

6 CHAPTER 1 
mortgage financing through development of a secondary market for residential 

mortgages.*' FNMA and FHLMC promote the secondary mortgage market in 

part by purchasing mortgages and either holding the mortgages or selling them, 

in the latter case primarily by repackaging the mortgages into securities. GNMA 

primarily guarantees payment on the securities issued by mortgage pools that are 

created by financial institutions. 

In 1970, GNMA created the first publicly traded mortgage-backed 

security?' The security, known as a mortgage pass-through certificate, 

represented beneficial ownership of a fractional undivided interest in a fixed pool 

of residential mortgage loans. GNMA guaranteed timely payment of principal 

and interest on the certificates. Both FNMA and FHLMC subsequently issued 

mortgage-backed securities; and, like GNMA, embarked on mortgage-backed 

securities programs ("agency programs"). The FNMA and FHLMC programs 

differ from the GNMA program in two significant ways. First, both FNMA and 

FHLMC themselves issue securities, while GNMA guarantees securities issued by 

I%NMA was created by Congress in 1938 as a wholly-owned government corporation for the 

purpose of providing a secondary mortgage market for Federal Housing Administration ("FHA") 

and later Veterans Administration C'VA'') mortgage loans. In 1968, pursuant to Title VI11 of the 

Housing and Urban Development Act of 1968 (Pub. L. No. 90-448, Title VIII, § 801, Aug. 1, 1968, 

82 Stat. 536) (codified at 12 U.S.C. § 1716b1, FNMA was divided into two separate entities. One 

continued to be called FNMA, but became a privately owned entity, subject to the regulatory 

authority of the Department of Housing and Urban Development ("HUD). 12 U.S.C. § 1723(b). 

FNMA continues to provide a secondary market for FHA and VA mortgage loans, and, in 1970, 

was authorized to do the same for certain other mortgage loans. 12 U.S.C. 5 1718. The other 

entity became GNMA, an instrumentality within HUD that generally services the portfolio of 

mortgages owned by the federal government. GNMA also guarantees securities issued by HUDapproved mortgagees that represent interests in pools of mortgages comprised solely of FHA, VA, 

and certain Farm Housing Administration loans. FHLMC was created in 1970, pursuant to Title 

I11 of the Emergency Home Finance Act of 1970 (12 U.S.C. 55 1451-14591, to develop and maintain 

a nationwide secondary market for conventional residential mortgages issued by savings and 

loans, mortgage bankers, banks, and HUD-approved mortgagees. Under the Financial Institutions 

Reform, Recovery and Enforcement Act of 1989 ("FTRREA"), FHLMC became privately owned, 

subject to the regulatory authority of HUD. Pub. L. No. 101-73, Title Vm73l(b)-(e), 103 Stat. 183, 

429-435 (Aug. 9,1989) (codified as amended at 12 U.S.C. 55 1451-1459). 

20See KENNETH G. LORE, MORTGAGE-BACKED SECURITIES DEVELOPMENTS AND TRENDS IN THE 

SECONDARY MORTGAGE MARKET 2-4 (1991-92 ed.). Mortgage-backed securities differ from 

mortgage-backed bonds, which were offered to the public as early as 1880. Mortgage-backed 

bonds are general obligations of an issuer that are secured by a pool of mortgage loans or 

mortgage securities. Payment of these bonds does not necessarily depend on the underlying cash 

stream from the mortgage pool; it may come from the issuer's general funds. See Pittman, supra 

note 15, at 500. 

The Treatment of Structured Finance under the Investment Company Act 7 
others. Second, unlike the GNMA program, securities issued by FNMA and 

FHLMC are not backed by the full faith and credit of the United States. Because 

of FNMA and FHLMC's close association with the federal government, however, 

securities issued by them are perceived by many to be virtually as safe as GNMA 

securities.2l 

The design of the agency programs, as well as the characteristics of the 

residential mortgages in each program's portfolio, greatly simplify the 

securitization of mortgages. The agencies generally purchase only a relatively 

homogenous class of these mortgages; accordingly, these mortgages meet similar 

credit criteria and have similar maturities. The large volume of loan originations 

and the relatively small principal amounts of the loans simplify securitization by 

facilitating credit and cash flow analysis, among other things. Finally, the 

perception of a federal guaranty backing the instruments, whether explicit or 

implicit, promotes investor acceptance. 

The development by FHLMC, GNMA, and FNMA of mortgage-backed 

securities ("agency securities" or "agency certificates") promoted residential 

mortgage financing. By increasing the liquidity of the secondary residential 

mortgage market, the agency programs have reduced the cost of borrowing by 

lowering interest rates and origination fees?2 The agency programs also 

contributed to the innovation of new mortgage forms by creating a variety of new 

mortgage securities pr0ducts.2~ For example, in 1983, FHLMC created the 

collateralized mortgage obligation (TMO"). A CMO is a debt obligation whose 

structure allows the cash flows on the underlying mortgage pools to be carved up 

into separate classes of securities, called "tranches," each with a specified coupon 

21See, eg., LORE, supra note 20, at 1-8; Pittman, supra note 15, at 500. See also Peter V. Darrow, 

et al., Rating Agency Requirements, in 1 SECURITIZATION OF FINANCIAL ASSETS 5 7.02[G], at 7-44 to 

7-45 (Jason H.P. Kravitt ed. 1991). 

22Rosenthal and Ocampo reported (in 1989) that "[hlome buyers are now paying approximately 

100 basis points less in interest (versus U.S. Treasury yields) on fixed-rate mortgages than they 

were a decade ago when mortgage securitization was much less pervasive." ROSENTHAL & 

OCAMPO, supra note 2, at 12. See also LORE supra note 20, at 1-12 (FHLMC's annual report 

indicated that interest rates on mortgages that qualify for sale to FHLMC are about one-half of 

a percentage point lower than nonconforming mortgages). But see Pittman, supra note 15, at 542- 

543 (as of 1986, the Federal Reserve Board did not credit SMMEA with any decrease in interest 

rates available to homeowners nor did it anticipate that SMMEA would effect any significant 

reduction in the future); BRYAN, supra note 3, at 86 (in 1988, a reduction in mortgage rates had not 

yet occurred although the author viewed that result as inevitable, eventually). 

23W~~~~ W. BARTLETT, MORTGAGE-BACKED SECURITIES 12 (1989). 

8 CHAPTER 1 
and stated maturity. Scheduled payments and prepayments from the mortgage 

pool are allocated to retire the classes in the order of stated mat~rities.2~ 

The three agency programs dominate the secondary residential mortgage 

markeG5 but the private sector has also participated in issuing mortgage-backed 

securities. Mortgage-backed securities issued by the private sector have typically 

been backed by agency certificates and conventional mortgages that the sponsor 

either originates itself or purchases in the secondary market. Many of the 

conventional mortgages have balances exceeding the maximum loan limits 

permitted to be purchased by the agencies ("nonconforming loans")F6 These 

securities also lack the guaranty of the agency securities, a significant handicap 

to the private sector in the secondary residential mortgage ma1-ket.2~ 

In an effort to expand the participation of the private sector in the 

secondary market, Congress enacted the Secondary Mortgage Market 

Enhancement Act of 1984 ("SMMEA")?8 Congress was concerned that the 

agencies would not be able to meet future demands for mortgage credit. SMMEA 

removed obstacles for privately sponsored mortgage-backed securities by, among 

29he CMO structure followed a prior unsuccessful attempt to devise a multiclass mortgage 

security. In 1983, Sears Mortgage Securities Corporation introduced a multiple class pass-through 

security, which was unsuccessful because it received unfavorable tax treatment by the Internal 

Revenue Service ("IRS'). Pittman, supra note 15, at 505-506. In 1986, Congress effectively 

overruled the IRS in this matter by enacting the Real Estate Mortgage Investment Conduit 

("REMIC") provisions in the Tax Reform Act of 1986. (Pub. L. No. 99-514, 671-675, 100 Stat. 

2085,2309-2320 (19861, codified at 26 U.S.C. §§ 860A-860G. See Pittman, supra note 15, at 505,508. 

For more discussion of CMOs and REMICs, see infra notes 146-151 and accompanying text. 

25For example, in 1990, FHLMA, GNMA and FNMA together issued $235 billion in passthrough securities out of a total pass-through issuance of $249 billion, thus giving the agencies 

94.2% of total pass-through issuances in 1990. Database, supra note 16, at Table 2, Part A. In 

addition, in 1990, FHLMA and FNMA combined issued $97.5 billion in multiclass mortgage 

securities (CMOs and REMICs) out of a total multiclass issuance of $118.6 billion, thus giving the 

agencies 82.2% of total multiclass issuances in 1990. Id. at Table 3. In the first three quarters of 

1991, FNMA and FHLMC increased their market domination, issuing 94.2% of all multiclass 

mortgage-backed securities offered. Id. 

26LORE, supra note 20, at 1-14. 

27David Abelman, The Secondary Mortgage Market Enhancement Act, 14 REAL ESTATE L. J. 136, 

145-147 (1985). 

*Qhe Secondary Mortgage Market Enhancement Act of 1984, Pub. L. No. 98-440,98 Stat. 1689 

(1984) (codified at scattered sections of 12 and 15 U.S.C.). 

The Treatment of Structured Finance under the Investment Company Act 9 
other things, pre-empting certain state investment laws so that state regulated 

institutions might purchase privately sponsored mortgage-backed securities to the 

same extent as agency securities, granting authority for certain depository 

institutions to invest in these securities, and requiring states to exempt privately 

sponsored mortgage-backed securities from state registration to the same extent 

as agency securities, unless the state specifically deemed otherwise?' 

Despite SMMEA, the private sector has not made significant inroads in the 

secondary residential mortgage market. Indeed, in 1989, the dominance of the 

agencies grew even greater as private issuance slowed in response to problems 

in the financial market, the loss in 1986 of tax incentives, and the savings and loan 

crisis?' Issuance of privately sponsored pass-through certificates dropped by 

more than forty percent between 1988 and 1989 causing a 6.4% decline in market 

share?' More dramatically, the market share of publicly offered multiclass 

securities (e.g., CMOS) issued by the private sector dropped almost fifty percent 

between 1988 and 1989?2 In 1990, the market share of privately sponsored passthrough certificates held steady?3 while the market share of privately sponsored 

multiclass securities recovered slightly only to dip again in the first three quarters 

of 1991?4 

~ 

2%or more information on SMMEA, see Pittman, supra note 15; Abelman, supra note 27. 

3k0RE, supra note 20, at 2-39. 

311n 1988, non-agency sponsors issued approximately $20.7 billion of pass-through securities 

representing 12.1% of total issuance ($170.6 billion). Database, supra note 16, at Table 2, Part A. 

In 1989, non-agency sponsors issued only $12.2 billion of pass-throughs representing 5.7% of total 

issuance ($212.6 billion). Id. Although the volume of non-agency sponsored pass-through 

securities in'creased to approximately $14.3 billion in 1990, total issuance also increased to $249.3 

billion leaving the non-agency sponsors' market share the same as 1989. Id. 

321n 1988, non-agency sponsors issued $51.0 billion of multiclass securities out of a total 

volume of $76.8 billion for 66.4% of the multiclass mortgage market. Id. at Table 3. In 1989, nonagency sponsors experienced a precipitous 49.8% drop in multiclass market share (and a 67.3% 

drop in volume) issuing $16.7 billion of multiclass securities out of a total volume of $100.5 billion 

or 16.6% of the multiclass mortgage market. Id. 

33See supra note 31. 

341n 1990, non-agency sponsors issued $21 .I billion of multiclass securities out of a total 

volume of $118.6 billion for a slight market share increase to 17.8% of the multiclass mortgage 

market. Database, supra note 16, at Table 3. In the first three quarters of 1991, however, nonagency sponsors issued only $10.5 billion of multiclass securities out of a total volume of $137.6 

billion for a mere 7.6% of the multiclass market, of which $2.5 billion or 1.8% consisted of 

(continued. ..) 

10 CHAPTER 1 
The private sector has begun to securitize commercial mortgages and 

mortgage products. Sponsors have publicly offered securities backed by small 

commercial loans, large single mortgages on office buildings, and commercial 

mortgage loans in the form of tax-exempt industrial development b0nds.3~ The 

development of these securities has been slowed, in part, by the lack of 

standardization in loan structure and documentation and soft real estate 

markets?6 

In addition to the public mortgage market, there have been a number of 

private placements of mortgage products. Private placement of securities backed 

by residential mortgages apparently is unusual. The opposite is true for 

commercial mortgages, with many, if not most, commercial mortgage-backed 

securities sold in private placements, perhaps because of the lack of 

s tandardiza ti0n.3~ 

2. The Non-Mortgage Market 

Since the mid-1980'~~ the techniques pioneered in the secondary residential 

mortgage market have been used by the private sector to securitize other assets. 

As of year-end 1991, approximately $158.34 billion of non-mortgage asset-backed 

34(...continued) 

securities issued under the securitization program of the Resolution Trust Corporation (the "RTC"). 

Id. For further information about the RTC's securitization program, see irzfra notes 96 & 97 below 

and accompanying text. 

3"AVEL, supra note 43, at 77-78. 

36See LORE, supra note 20, at 1-3, 14,241. See also Suzanne Wittebort, Asset-Buck& Come of 

Age, INSTITUTIONAL INVESTOR, Dec. 1991, at 80 ("[Mlortgages on commercial property tend to be 

more individualized and cash flows on a package of them can be lumpy."'). 

37Wittebort, supra note 36, at 80 (reporting that most of the anticipated commercial mortgagebacked structured financings in 1991 would be issued in private placements). Standard & Poor's 

("S&P') has estimated that 75% of the commercial mortgage-backed securities it has rated have 

been privately placed. See Commercial Mortgage Securitization -- It's Time Has Come, STANDARD & 

POOR'S CREDITREVIEW COMMERCIAL MORTGAGE SECURITIES, Apr. 8,1991, at 3. But see LORE, supra 

note 20, at 1-3, 2-42 (the earliest commercial mortgage-backed securities issuances took place in 

the private market but subsequently the market saw a series of public transactions involving pools 

of smaller commercial mortgages). 

The Treatment of Structured Finance under the Investment Company Act 11 
securities had been publicly issued?8 One observer has estimated that the 

volume of non-mortgage asset-backed public issuances in 1991 totalled 

approximately $50.8 billion, up from a $10 billion total in 1986.3' 

FIGURE 1-3 

Non-Mortgage Asset-Backed Securities issued in the 

United States 1986-1 991 

50 

40 

- f - 

B 

10 

50.8 I 

3 

45 =I 

1 

25.5 I 

1986 1987 1988 1989 1990 1991 

sarce: DeaWimrReynolds.Ine 

ABsecBadred S6uniUw Relerenca Glide 

Year Ended 1991 

38DEAN WI'ITER REYNOLDS, INC., ASSET-BACKED SECURITIES REFERENCE GUIDE A-22 (Year Ended 

1991) [hereinafter DEAN WITTERI. This figure is still dwarfed by the aggregate amount of 

mortgages securitized, which was estimated as of September 30,1991 to have amounted to $1.2 

trillion. See supra note 16 and accompanying text. 

391d. at A-10. But see IDD 1992 Figures, supra note 4, at 22 (reporting $46.6 billion of assetbacked securities issued in 1991). 

12 CHAPTER 1 
Securities backed by automobile loans and credit card receivables represent 

approximately eighty percent of the public non-mortgage asset-backed market and 

also constitute by far the two largest segments of that market?' In 1991, 

securities backed by credit card accounts receivable represented approximate1 

Other assets presently being securitized publicly include home equity 

boat loans, computer leases, airplane leases, mobile home and recreational vehicle 

loans, vacation timeshares, hospital accounts receivable, Small Business 

Administration and industrial development bonds backed by different 

types of assets, including equipment lea~es.4~ 

forty-three percent of the non-mortgage asset-backed securities issuances. x 

40As of year-end 1991, securities backed by credit card receivables and automobile loans 

together amounted to $129.4 billion out of $158.3 billion total asset-backed securities original 

issuance. DEAN WI?TER, supra note 38, at A-16. Financings backed by automobile loans were 

among the first non-mortgage structured financings publicly offered, and, until recently, 

represented the largest segment of the public market. Id. at A-17. By year-end 1991, financings 

backed by credit card receivables had surpassed automobile loan transactions in market share of 

outstanding securities. Id. at A-16. 

411d. at A-16. In 1991, credit card receivables backed the issuance of $21.6 billion out of a total 

issuance of $50.8 billion in non-mortgage asset-backed securities. Id. at A-1. 

42Technically, home equity loans are mortgage products. Nevertheless, because home equity 

loans have many of the same characteristics as credit card receivables, structured financings 

backed by these loans are considered by many to be part of the non-mortgage asset-backed 

market. 

43The Small Business Secondary Market Improvements Act of 1984 (Pub. L. No. 98-352,98 Stat. 

329 (1984) (codified at 15 U.S.C. 633-634,639)), authorized the Small Business Administration 

C'SBA") to establish a program for securitizing SBA loans. SBA also acts as a guarantor of such 

securities packaged by the private sector. For a more detailed discussion of such securities, see 

CHRISTINE A. PAVEL, SECURITIZATION 152-155 (1989). 

44See DM WITTER, supra note 38, passim. 

The Treatment of Structured Finance under the Investment Company Act 13 
FIGURE 14 

Total Issuance of Non-Mortgage Asset-Backed Securities by Collateral Type 

Credit Card Receivables 

$68.04 

Automobile Loans 

39% 

Other Loans 

$5.05 

Mfd. Housing Loans 

$5.37 

Home Equity Loans 

Total: $158.34 Billlon 

Sourn: Dean Wltsf Reynolds, Inc. 

Asset-Bded Securities Reference Guide 

Year Ended 1991 

Most of the assets that have been securitized have homogeneous 

characteristics, including similar terms, structures, and credit characteristics.@' 

The assets tend to have payment streams with proven histories of performance, 

which in turn make future payments reasonably predictable. These characteristics 

facilitate analysis of the credit risks. 

Other types of assets lack the homogeneity necessary for easy credit risk 

analysis and therefore are just beginning to be securitized. For example, nonperforming loans, middle market loans, and other types of commercial loans are 

in the beginning stages of securitization!6 The obstacles associated with 

45PAVEL, supra note 43, at 17-20. 

461d. See also Christopher L. Snyder, Jr., Securitizing Middle Market Loans in THE ASSET 

SECURITIZATION HANDBOOK 440-476 (Phillip Zweig ed., 1989) [hereinafter THE ASSET 

SECURITIZATION HANDBOOK]. But see Jean-Louis LeLogeais and Don Kerr, Applying the Strategic 

View to Asset Seairitization Decisions, AM. BANKER (Special Adv. Supp.), May 30,1989, at 4A to 5A. 

(Securitization is prohibitively expensive for banks whose asset mix is concentrated in the middle 

market with its relatively higher spreads and returns; this is true because of the nonuniform 

nature of business risks and the inherent inability to pool loans effectively.) 

14 CHAPTER 1 
securitizing these assets include the lack of reliable data on losses, uniform 

underwriting and collection standards, standardized documentation, and similar 

loan balances. In addition, the transaction must be structured so that credit risk 

analysis can be accomplished without loan-by-loan re~iew.4~ 

A number of non-mortgage, asset-backed securities have been private1 placed. Although some of these securities are similar to those sold publicly, & 

many private placements involve types of structured financings that have never 

been publicly offered in the United States, in part because of the Investment 

Company Act. For example, financings backed by high yield bonds 

("collateralized bond obligations" or "CBOs"), installment loans, future royalties, 

and Medicare and Medicaid receivables have all been issued in private 

placements, but have never been sold publicly in the United States. 

B. Sponsors of Structured Financings 

With the exception of the federal government and federally sponsored 

entities, the most active sponsors of structured financings are commercial banks 

and savings and loans. In 1988, the last year the private sector was relatively 

active in the residential mortgage-backed securities market, the major issuers were 

savings and loans, responsible for half of private sector mortgage-backed 

issuances, and commercial banks, responsible for fourteen percent of such 

issuances in 1988.49 Other active sponsors of residential mortgage-backed 

securities in 1988 included investment banks (twenty-four percent), insurance 

47See Peter Haidorfer, Assessing Consumer Debt Risk is Vital for Credit Enhancers, AM. BANKER 

48%me of the first sales of assets now commonly securitized and sold publicly were initially 

sold in private placements. For example, the first structured financing backed by credit card 

receivables was placed privately in March 1986, with the first public transaction occurring in 1987. 

See PAVEL, supra note 43, at 109. 

(Special Adv. Supp.), May 30, 1989, at 10A to 11A. 

4%~~~, supra note 20, at 2-38 to 2-39. 

The Treatment of Structured Finance under the Investment Company Act 15 
companies (eight percent), and conduits5’ (four percent)?l Although these 

types of entities continue to sponsor mortgage-backed securities, since 1989 their 

volume and market share have dropped considerably with the increase in the 

strength of the agency programs?2 

In the non-mortgage market, as of year-end 1991, commercial banks had 

originated approximately 45.6% of total issuance^?^ Other sponsors included 

auto manufacturers (28.0%), retailers (7.1 %), and savings and loans (5.5%).54 

From a sponsor’s perspective, there are sound reasons to securitize 

a~sets.5~ The sponsor may be better able to manage its loan portfolio, and, in 

turn, its balance sheet: asset securitization permits a sponsor to convert financial 

assets into cash, which can be used to retire debt or acquire new receivables. 

Asset securitization can increase the liquidity of a loan portfolio, permitting a 

sponsor to select the financial assets it wishes to keep, and to sell the assets it 

does not want. Asset securitization also permits a sponsor to reduce its interest 

rate risk resulting from its funding fixed-rate, long-term assets with floating rate 

and/or short-term liabilities, a particularly attractive option in times of volatile 

interest Alternatively, by selling portions of portfolios concentrated in 

50A mortgage conduit is an organization that purchases mortgages, packages the mortgages 

into pools, and sells the mortgages through the capital markets. For information on the evolution 

of conduits, see BARTLETT, supra note 23, at 9-11. 

51LoRE, supra note 20, at 2-38 to 2-39. 

52See supra notes 30-36 and accompanying text. See also LORE, supra note 20, at 2-38. 

53DEAN WITTER, supra note 38, at A-26. 

550riginators that sell assets to a financial intermediary, such as a conduit, that in turn 

sponsors a structured financing backed by the assets, receive many of the same benefits as 

originators that sponsor a financing. Originators may choose to sell to these intermediaries if they 

do not hold enough assets to make sponsorship economical. 

56See, e.g., Thomas R. Boemio & Gerald A. Edwards, Jr., Asset Securitization: A Supemking 

Perspective, 75 FED. RES. BULL. 659,663 (1989); BRYAN, supra note 3, at 85; ROSENTHAL, supra note 

2, at 10-13. Savings and loans, for example, securitized portions of their mortgage portfolios in 

part to address risks of rising interest rates. Mortgage loans traditionally had maturities of 30 

years and had fixed interest rates. By contrast, 65% of a typical savings and loan’s liabilities are 

time and savings deposits that mature in less than one year. See Pittman, supra note 15, at 501. 

In response to increasing competition from national residential mortgage originators, savings and 

(continued. ..) 

16 CHAPTER 1 
a single industry or geographic area, for example, a sponsor may use structured 

financings to diversify its credit ri~k.5~ 

By being better able to manage its loan portfolio, a sponsor also can 

strengthen its financial condition. Removing certain assets from the balance sheet 

can boost the return on assets and on equity. If the transaction is considered to 

be a sale of assets, income recognition may be accelerated by permitting the 

sponsor to realize a gain (or loss) upon sale?’ Income may also be recognized 

from previously deferred loan fees. 

Structured financings also allow sponsors to gain access to alternative 

funding s0urces.5~ Some sponsors, particularly those that enter the capital 

markets frequently, find it useful to be able to offer new instruments. In addition, 

structured financings allow sponsors to broaden their investor base.60 

Structured financings also provide sponsors with access to funding sources 

that, depending on the sponsor’s credit rating, may be less expensive and more 

feasible than traditional sourcesP1 Because securitized assets usually are no 

longer assets of the sponsor, the structured financing may be rated independently 

of the sponsor’s rating. Sponsors find structured financings particularly beneficial 

during economic downturns when there frequently is widespread downgrading 

of corporate credit, making the issuance of corporate debt or equity through the 

markets less 

56(...continued) 

loans also have used structured financing to lower their costs of funding and to sell off assets with 

inadequate spreads. Innovations in Thrift Financing: Opportunity and Risk, MOODY’S STRUCTURED 

FINANCE RFSEARCH & COMMENTARY, Aug. 1987, at 3. 

57See, eg., BRYAN, supra note 3, at 82-83; Boemio & Edwards, supra note 56, at 663; ROSENTHAL, 

supra note 2, at 9-10; Wittebort, supra note 36, at 78. 

58Boemio and Edwards, supra note 56, at 663. 

59See, e.g., BRYAN, supra note 3, at 84. 

60See, e.g., Wittebort, supra note 36, at 78. 

61See, e.g., BRYAN, supra note 3, at 81-82, 124. 

62See Richard Benson, Recession and Credit Crunch Will Spur Asset Securitization, MORTGAGEBACKED SEC. LETTER, Nov. 12,1990, at 8. 

The Treatment of Structured Finance under the Investment Company Act 17 
Banks have been particularly active in using structured finan~ings.6~ This 

activity can be traced in part to the severe financial pressures in the United States 

banking industry. Bank credit quality steadily declined throughout the 1980'~~ 

with a considerable acceleration of this decrease occurring within the last few 

years as a result of deterioration of real estate assets and loans to highly leveraged 

b0rrowers.6~ The deteriorating quality of bank assets has resulted in a 

significant number of downgrades of the credit ratings of United States 

In some cases, structured financings may provide regulatory benefits for 

banks, savings and loans, and other regulated entities, by enabling them to meet 

their reserve and capital requirements. For example, banking and thrift 

regulatory a encies have adopted "risk-based" capital requirements for depository 

institutions4 The risk-based capital requirements for banks assign assets and 

credit equivalent amounts of off-balance sheet items to risk categories, depending 

on each asset's level of credit risk.67 The level of capital that a bank must 

maintain depends on the level of risk -- or "risk weight" -- assigned to that bank's 

assets. Many banks have had to increase their capital ratios to meet these 

requirements, but, because of market concerns about their creditworthiness, have 

@See, e.g., Boemio & Edwards, supra note 56, at 662. 

64Andrew Freeman, Credit Downgrades on US Banks Predominate amid Asset Worries, FIN. TIMES, 

Aug. 16, 1990, at 19. See also Bank Profitability in the 2990'~~ FITCH RESEARCH FINANCIAL 

INSTITUTIONS (Special Report), Dec. 20, 1991, at 2. 

65See Pressures on US. Bank Ratings, Presentation by Christopher T. Mahoney, Vice 

President/Associate Director, Financial Institutions Group, Moody's Investor's Service, to the 

American Bankers Association CFO Forum, New York, September 11, 1990 in MOODY'S 

STRUCTURED FINANCE RESEARCH AND COMMENTARY, Oct. 1990, at 9. See also U.S. Money Center 

Banks, MOODY'S INDUSTRY OUTLOOK, Aug. 1990, at 4. 

66Risk-based capital requirements are set forth at 12 C.F.R. pt. 3, App. A (for national banks); 

12 C.F.R. pt. 208, App. A (for state member banks insured by the Federal Deposit Insurance 

Corporation ("FDIC")); 12 C.F.R. pt. 225, App. A (for bank holding companies); 12 C.F.R. pt. 325, 

App. A (for FDIC-insured state non-member banks); and 12 C.F.R. pt. 567 (for savings 

associations). For a general discussion of risk-based capital requirements, see, e.g., Michael G. 

Capatides, et al., Bank and Savings and Loan Association Regulatory Considerations, in 2 

SECURITIZATION OF FINANCIAL ASSETS, supra note 21,s 12.03 at 12-19 to 12-38; FRANKEL, supra note 

3, Q 7.14, at 224-234. 

67For example, most securities issued or unconditionally guaranteed by United States 

government agencies are assigned a zero percent risk weight. 12 C.F.R. pt. 3, App. A, 3(a)(l)(iii) 

& (iv). An example of a high risk (100% risk weight) asset is stripped mortgage-backed securities 

(12 C.F.R. pt. 3, App. A, 3(a)). 

18 CHAPTER 1 
had difficulties raising the necessary capital!' To meet their capital needs, 

many banks have sponsored structured financings, either by securitizing assets, 

such as credit-card receivables, or, less frequently, by setting up "bad banks" 

whereby non-performing loans are sold to newly created entities chartered as 

banks, whose primary function is to liquidate these assets. Structured financings 

have enabled banks to meet risk-based capital requirements by securitizing 

"higher risk-weighted assets" and either taking the sale proceeds and purchasing 

"lower risk-weighted risk assets" (which require less capital), or keeping the 

proceeds in cash or other liquid assets. 

Even without higher capital requirements, structured financings may be 

very attractive for banks.6' In addition to obtaining capital by selling their 

assets through structured financings, banks may also obtain funding by retaining 

the servicing rights to those assets and retaining a possibly economically valuable 

residual interest?' Also, structured financings can benefit banks by increasing 

the liquidity of their loan portfolio^.^^ 

68For a discussion of the use of securitization by banks and bank 

manage their risk-based capital and capital adequacy requirements, see 

supra note 56, at 664-669. 

holding companies to 

Boemio and Edwards, 

@It has been argued that even a bank with a AAA rating would benefit in terms of capital cost 

savings by securitizing those high-quality assets for which regulatory capital requirements 

overestimate actual expected credit losses. See BRYAN, supra note 3, at 83. 

7%or a discussion of residual interests, see infra notes 143-145 and accompanying text. By 

retaining the servicing rights to the assets, banks may continue existing lending relationships with 

their customers even though the original loans are no longer on their balance sheets. 

71The advantages of increased liquidity are discussed supra notes 55-56. Some observers 

believe that structured financings could lead to a more stable and less costly financial system. See 

ROSENTHAL & OCMPO, supra note 2, at 13-17, 21. See also PAVEL, supra note 43, at 227-229 

(suggesting a variety of scenarios in which securitization would help to make the banking system 

more efficient). Others have suggested that the technology of structured financing could be used 

to help restructure the banking industry. One observer has written that the technology of 

structured financing would enable the banking industry to separate the depositing and lending 

functions of a bank and permit banks to establish separate businesses around the functions that 

it is the most capable of delivering at the best price. This would address what the observer 

believes is one of the fundamental flaws of the present banking system, the cross-subsidy of. 

deposits and loans, and promote a competitive banking environment, with only the depository 

institutions being protected by a federal guarantee. BRYAN, supra note 3, at vii-x, 92-98, and 

passim. 

The Treatment of Structured Finance under the Investment Company Act 19 
C. Purchasers of Structured Financings 

1. Institutional Investors 

Institutional investors, including banks, savings and loans, pension funds, 

insurance companies, and mone managers have been the predominant 

purchasers of asset-backed issues?' These investors find asset-backed securities 

attractive for several reasons. First, institutional investors generally consider most 

asset-backed securities to be relatively safe investments because such securities 

generally are highly rated by one or more rating agencies.73 Also, in many 

instances, institutional investors conduct their own due diligence review prior to 

investing.74 Second, the securities typically offer returns that are hi her than 

those of United States Treasury securities with comparable maturitie~?~ Third, 

some asset-backed securities, such as certain mortgage-backed securities, are 

relatively liquid, enabling the investors to resell the securities to meet changed 

portfolio objectives or new liquidity needs. Fourth, most agency securities and 

nR~~~ & OCAMPO, supra note 2, at 13; LORE, supra note 20, at 2-48. See also Boemio and 

Edwards, supra note 56, at 663. Until recently, savings and loans were the largest holders of 

mortgage-backed securities. Their share of this market has shrunk, in part, because 

undercapitalized savings and loans must sell substantial amounts of assets. KENNETH G. LORE, 

MORTGAGE-BACKED SECURITIES: DEVELOPMmTS AND TRENDS IN THE SECONDARY MARKET 2-53 

(1990-91 ed.). See also LORE, supra note 20, at 2-38. Banks and insurance companies have taken 

up some of the slack; one observer has reported that insurance companies presently hold 

approximately one-third of the mortgage-backed securities market. IDD 1991 Figures, supra note 

4, at 22. See also Phil Roosevelt, Banks Halt Their Binge in Mortgage Securities, AM. BANKER, May 

8,1990, at 1; Bank Profitability in the 199O's, supra note 64, at 2/12. Banks and insurance companies 

also have been active in purchasing non-mortgage asset-backed securities. Although at first blush 

it may Seem ironic that the sponsors of structured financings are among the most active 

purchasers, asset securitization may allow institutions to diversify their assets. Boemio and 

Edwards, supra note 56, at 663. For example, a Californian bank may find it desirable to securitize 

mortgages on properties on the West Coast and use the proceeds to buy CMOS backed by 

mortgages on East Coast properties. 

73Boemio and Edwards, supra note 56, at 663; ROSENTHAL AND O~AMPO, supra note 2, at 13. 

741n some cases, particularly for private placements, institutional investors are involved in 

structuring the financing. 

7%ittebort, supra note 36, at 79 (according to Sears, "spreads over five-year Treasuries for 

credit card issues now run roughly 30 basis points below an index of single- and double-A 

corporate debt issues, versus about 40 basis points above the index in 1988. . .'I). See also Boemio 

6 Edwards, supra note 56, at 663. 

20 CHAPTER 1 
CMOs backed by agency securities have low risk weighting under depository 

institution capital 

In addition to the highly rated fixed income securities that are the 

predominant type of securities offered, many structured financings include other 

securities that are riskier such as stripped securities and residual interests. Some 

institutional investors find these securities attractive because they often have 

higher yields than the highly rated fixed income securities. In addition, 

institutional investors find that certain of these securities may be useful for 

hedging?7 

2. The Retail Market 

Although institutional investors are the predominant purchasers of 

structured financings, there is also a retail market in these securities. Some 

residential mortgage market products have been specifically targeted to retail 

investors. For example, since 1985, many CMOs and other multiclass mortgagebacked securities have been structured to include classes that are designed for the 

retail investor, with minimum denominations as low as $1000?8 

There are fewer retail transactions in the non-mortgage asset-backed 

market. In 1990, approximately $1 billion of these securities were sold to 

individual investors, a seventy-six percent increase from 1989?9 All were 

backed by credit card receivables originated by Sears Credit Account Trust or 

Standard Credit Card Trust.so Securities targeted for the retail market typically 

76See supra note 67. 

771n 1990, banks and savings and loans became less active in purchasing some of these 

securities, possibly in anticipation of regulatory changes. See Banks Halt Their Binge in Mortgage 

Securities, supra note 72; IDD 1991 Figures, supu note 4, at 22. For further discussion of these 

securities and the proposed regulatory changes, see infru notes 132-138 and accompanying text. 

780ne observer has estimated that thus far, individual investors have accounted for 

approximately five percent of all REMIC sales. Richard Chang, Promising Year for Mortgage 

Backeds, AM. BANKER, Jan. 6, 1992, at 20. 

7%EAN WITTER REYNOLDS, INC., ASSET-BACKED SECURITIES REFERENCE GUIDE A-1, (Jan. 1991) 

'Osee DEAN WI'ITER, supra note 38, at A-18. 

[hereinafter DEAN WITTER]. 

The Treatment of Structured Finance under the Investment Company Act 21 
have been rated AAA and sold in denominations as low as $1000.81 In 1991, no 

non-mortgage offerings were specifically targeted for retail investors.82 

Retail investors find structured financing securities attractive because of 

their high ratings and because their yields are higher than those of comparable 

Treasuriesm (although their yields usually are not as high as the yields on 

comparable structured financings sold on the institutional market)P4 Sponsors 

sell to retail investors to diversify and expand their investor base, as well as to 

ensure a liquid secondary market for their securities. Selling to the retail market 

is very labor intensive, however, and thus underwriting fees for structured 

financings directed to the retail market may be more expensive than for 

structured financings targeted for institutions. 

3. The International Market 

A significant number of structured financings sponsored by United States 

institutions are sold abroad. International issues have been structured both as 

unregistered Eurobonds in bearer form and as registered securities in the country 

or countries where the offering is sold. In addition, they have been sold overseas 

to both institutional and retail investors. 

United States sponsors of structured financings have targeted the 

international market for a variety of reasons. Some have sold their issues 

overseas because their large portfolios need broad distribution. Others have gone 

overseas to avoid compliance with the Investment Company Act. 

"For example, "through its Dean Witter Reynolds subsidiary, [Sears] has sold $1 billion in 

asset-backed securities to the retail market in denominations as low as $1,000.'' Wittebort, supra 

note 36, at 79. 

s2D~~ WITTER, supra note 38, at A-18. 

@In addition, one investment columnist has suggested that investors who desire more yield 

than that available from the average money market fund or certificate of deposit should 

investigate asset-backed securities. See James E. Lebherz, Asset-Backed Securities Can Be Higher-Yield 

Investment, WASH. POST, June 30,1991, at H9. 

@DEAN WITTER, supra note 38, at A-18. For example, spreads on credit card asset-backed 

securities issued on the institutional market from January 1,1989 to December 30,1991, averaged 

approximately 83 basis points, while the spreads on similar asset-backed securities sold to retail 

investors averaged 46 basis points. Id. 

22 CHAPTER 1 
Although many offerings have been structured and sold directly in the 

international market, several sponsors have recently conducted "global" offerings, 

in which offerings are conducted simultaneously in the United States and 

abroad.@ Global offerings provide a larger market for distribution and promote 

liquidity for sales on the secondary 

International investors find asset-backed securities attractive investments 

for many of the same reasons that domestic investors find them attractive. 

International investors, like domestic investors, are attracted to these securities, 

typically high ratings and view them as an alternative to corporate debt securities, 

which, in uncertain economic times, are less desirable in~estments.8~ Many 

international investors consider asset-backed securities "chea investments" 

because they have higher yields than other, similarly rated debt. !8 

Notwithstanding the fact that a significant number of United States 

sponsors are selling structured finance offerings abroad, international offerings 

have not been entirely successful. For many global offerings, a majority of the 

securities are ultimately placed in the United State~8~ Because structured 

financings are still in their infancy abroad, international investors must be 

educated as to the merits of these securities, particularly in light of their 

unfamiliar structure. This is particularly true for global offerings which must be 

85For example, 17 issues of non-mortgage asset-backed securities were sold in global offerings 

in 1991, more than double the number offered in all of 1990. DEAN WI"TER, supra note 38, at A-1; 

DEAN WITTER, supra note 79, at A-1. 

'%n 1990, two Eurobond settlement agencies, Cede1 S.A. and Euroclear System, began handling 

Citicorp-sponsored credit card structured financings, thereby linking international clearinghouse 

systems and permitting local clearance. See Michael R. Sesit, Citicorp Forges "Global Bonds" with 

Credit-Card Link, WALL ST. J., Aug. 30, 1990, at C1, C8. 

s7See Tracy Corrigan, Asset-Backed Securities Make Their Mark on Europe, F". TIMES, June 25, 

1990, at 124, 

"See Sesit, supra note 86, at C8. 

89See, e.g., Tracy Corrigan, Europe Grows Cautious of Credit Card-Backed Issues, FIN. TIMES, June 

21,1990, at 22 (dealers report stronger demand in United States than in international markets for 

latest issues of bonds backed by credit-card receivables); Corrigan, supra note 87 (''asset-backed 

securities market remains substantially US-based, in terms of both issuers and investors"); Citicorp 

Deal Well Received but Retail Holders Want Out, THOMSON'S GLOBAL ASSET BACKED MONITOR, Aug. 

31,1990, at 1,2. Foreign investors bought 48% and 45% respectively of Citicorp's first two global 

credit card offerings. See Sesit, supra note 86, at C8. 

The Treatment of Structured Finance under the Investment Company Act 23 
structured to be attractive to both United States and foreign investors. For 

example, the limited European participation in one global offering was attributed 

in part to the fact that the payment schedule for the arrangement which, while 

typical for securities issued in the United States, was unfamiliar to European 

investors?' 

D. Expectations for the Future 

The future of structured financings is subject to some debate. Proponents 

have argued that this type of financing will become and remain in the long term 

as prevalent a financing technique as equity, conventional debt, or bank loans?* 

but others disagree?2 

Most commenters, however, believe that, at least in the short term, 

structured financings will continue to have a large presence in the United States 

capital markets. One observer has predicted that 1992 will be a record-setting 

'?he arrangement required coupons to be paid monthly, and the redemption of the principal 

to be spread out over the last year of the issue's life. See Tracy Corrigan, MBNA America Bank in 

Asset-Backed Loan Debut, FIN. TIMES, Nov. 2,1990, at 130. 

The difficulty in selling structured financings abroad is illustrated by the recent problems 

in the credit card backed securities market. Overseas issuances of financings backed by United 

States generated credit card receivables were virtually nonexistent in late 1990 and early 1991. 

This was due, in part to the rise in default rates on credit card receivables increasing the 

possibility of accelerated payments to investors, which caused anxiety among foreign investors 

that were unfamiliar with the concept of prepayment risk. As a result of this concern, sponsors 

have structured recent transactions to reduce the chance of prepayment. See Sears Taps 

In ternatimal Bond Markets with $750M of Card-Backed Securities, THOMSON'S GLOBAL ASSET BACKED 

MONITOR, Apr. 12,1991, at 3; Patrick Harverson, Back to Normal After Scares ouer Prepyment Risk, 

FIN. TIMES; Jun. 19, 1991, at 5 111, p. 111. 

"See ROSENTHAL & OCAMPO, supra note 2, at 221-22; John B. Caovette, As the Capital Markets 

Unbundle What Wilf the Future Bring?, THOMSON'S GLOBAL ASSET BACKED MONITOR, Aug. 17,1990, 

at 6; Wittebort, supra note 36, at 80. One observer has predicted that within the next 10 to 15 years, 

60% to 80%, or more, of all new loans may be securitized. BRYAN, supa note 3, at 81. 

'*See, e.g., LeLogeais & Kerr, supra note 46. These observers argue that the need to securitize 

may not necessarily be as important in the future as it is today. They also assert that not all assets 

can be securitized because of their lack of uniformity, an assertion echoed by Rosenthal and 

Ocampo. Rosenthal and Ocampo acknowledge that some commenters believe that the recent 

growth of structured financings is only a "temporary exploitation of certain regulatory loopholes," 

although they conclude that securitization is not simply regulatory arbitrage. ROSENTHAL & 

OCAMPO, supra note 2, at 5. 

24 CHAPTER 1 
year for mortgage-backed securities, as low-interes t rates prompt large increases 

in refinancings and initial loan 0riginations.9~ The non-mortgage market also 

should remain strong to the extent that structured financings remain the best 

funding techniques for car companies and banks?4 

In addition, some observers believe that more sponsors -- both financial 

and non-financial institutions -- will become interested in asset securitization. 

Such sponsors could seek to issue securities backed by assets that are not 

presently among those commonly being ~ecuritized.9~ 

Finally, two federally sponsored entities have recently begun securitization 

programs. The Resolution Trust Company has begun to securitize more than 

seventy percent of the assets amassed from failed savings and loans?6 Of the 

approximately $67 billion in financial assets that will be used, $57 billion are 

mortga e loans, $3.2 billion are high yield bonds, and $6.9 billion are consumer 

loans. 97g 

In addition, in mid-1991, the Federal Agricultural Mortgage Corporation 

("Farmer Mac"), which administers the secondary market activities for agricultural 

real estate loans, began issuing securities backed by pools of loans guaranteed by 

the Farmers Home Administration. In the near future, Farmer Mac intends to 

offer guarantees for securities backed by agricultural mortgages that are issued 

by conventional lenders. 

111. The Securitization Process 

All structured financings share the same basic structure. We outline below 

the basic components of a typical structured financing and discuss how the 

93Chang, supra note 78. 

941DD 1991 Figures, supra note 4, at 23. 

95For example, one observer predicted that financings backed by computer and other 

9%usan Schmidt, Cleanup Agency to Back Bonds With Thrift Assets, WASH. Po=, Oct. 25,1990, 

equipment leases would soon flourish. Wittebort, supra note 36, at 80. 

at El. 

971d. For additional discussion of the RTC securitization program, see Paulette Thomas, S&L 

Liquidators Get $294.5 Million in Junk Bond Sale, WALL ST. J., Oct. 2,1991, at B12; Paulette Thomas, 

Mmtguge-Backed 'Ritzy Mues' Stroll Down the Street with RTC, WALL ST. J., Jul. 12, 1991, at C1. 

The Treatment of Structured Finance under the Investment Company Act 25 
financing works. We also discuss investor protection issues, the role of the rating 

agencies, and the use of credit enhancement. Finally, we consider the differences 

between unrated and rated structured financings. Our discussion is necessarily 

general; there is a wide range of permutations used in practice. 

and 

inteerest senricer 

Sponsor 

A. The Components of a Structured Financing 

sells or ISSUeS 

pledgssassets seeudi 

b issuer Investors I 

I 1-11, 

1. The Participants 

A typical structured financing has four primary participants: the sponsor, 

who often is the initial owner of the assets; the issuer, who obtains the assets and 

issues the securities; the servicer, who takes ultimate responsibility for servicing 

the assets in the pool; and the trustee, who is assigned and holds the assets 

through the life of the issue and monitors the activities of the ~ervicer.’~ The 

basic components of a structured financing are shown in Figure 1-5 below. 

FIGURE 1-5 

Structured Financing Components 

Transfers payments 

minus fees Transmits payments due 

1111111. 

I 

I 

I 

Rmil I Transbassets 

u Proceeds 

from sale 

of securiiies 

Proceeds 

from sale 

of securities 

Legend 

Structure --.) CashFlows 

%Credit enhancers and the rating agencies may also participate in structuring the transaction. 

Because not all structured financings are rated or contain external credit enhancement, the roles 

and responsibilities of these parties are discussed separately. For a discussion of credit 

enhancement see Section III.B.2 infix. For a discussion of rating agencies, see Section 1II.B infua. 

Of course, as in most securities issuances, underwriters and independent auditors are also 

participants. 

26 CHAPTER 1 
A structured financing begins with a pooling and servicing agreement 

(T&S agreement") among the sponsor, the trustee, and the servicer. The P&S 

agreement establishes the issuer and governs the transfer of the assets from the 

sponsor to the issuer (and ultimately to the trustee). It also sets forth the rights 

and responsibilities of the participants and typically contains a number of 

representations, warranties, and covenants about the characteristics of the assets. 

Finally, the agreement may require that periodic reports be sent to investors, the 

trustee, and other parties. 

Typically, under the P&S agreement, the sponsor transfers a fixed pool of 

homogeneous assets, which it owns, to the issuer (either directly or through a 

subsidiary of the sponsor) in return for the proceeds from the sale of securities 

backed by these assets. In order for the sponsor to remove the assets from its 

balance sheet and therefore to obtain many of the benefits of asset securitization, 

the transfer must be a sale for accounting purposes?' Whether the transaction 

9%nder generally accepted accounting principles ("GAAP), a sale occurs when both the risks 

and rewards of ownership have been transferred to the purchaser. Under GAAP, a sponsor may 

remove assets from its balance sheet if the sponsor sells the assets without recourse. For many 

sponsors, a transfer with recourse may still be a sale, provided that the transfer meets the 

conditions set forth in Statement of Financial Accounting Standards No. 77 ("FAS 77"). FAS 77 

generally provides that a transfer of receivables with recourse shall be recognized as a sale if (i) 

the transferor surrenders control of future economic benefits of the sold receivables, (ii) the 

transferor cannot be required by the transferee or any other entity to repurchase the receivables 

except in accordance with the recourse provisions, and (iii) the transferor's recourse obligation can 

be reasonably estimated. FAS 77 is currently under review as part of a re-examination of financial 

instruments and off-balance sheet accounting. 

Historically, banks and savings and loans have generally been subject to regulatory 

accounting principles ("RAP'). RAP, like GAAP, has allowed a sponsor to remove assets from its 

balance sheet if the sponsor sells the assets without recourse. Unlike GAAP, however, RAP 

generally has required an asset sale with recourse to be treated as a borrowing. The seller must 

continue to hold the full amount of regulatory capital reserves against the proceeds from the 

transfer of the assets. There are two relevant exceptions. First, in regard to sales of participations 

in pools of residential mortgages, the bank may treat the transfer as a sale as long as the bank 

does not retain any "significant risk of loss," which generally has been viewed as being more than 

10% recourse. The other exception pertains to the use of "spread accounts," which are also a type 

of credit enhancement, discussed infra note 232 and accompanying text. For more information 

about the accounting aspects of securitization, see Ernest L. Puschaver, Accounting Issues, in 2 

SECURITIZATION OF FJNANCIAL ASSETS, supra note 21, at §§ 18.81-18.04; ROSENTHAL & OcAMPo, 

supra note 2, at 65-73; PAVEL, supra note 43, at 163-181 (Chapter 7, "Accounting for Securitization: 

GAAP versus RAP'). 

Recently, section 121 of the Federal Deposit Insurance Corporation Improvement Act of 1991 

(continued.. .) 

The Treatment of Structured Finance under the Investment Company Act 27 
between the sponsor and the issuer constitutes a sale also is relevant to 

determining whether the assets transferred and the cash flow therefrom could be 

used to pay the sponsor's creditors should the sponsor become insolvent. (What 

constitutes a sale for bankruptcy purposes may differ from what constitutes a sale 

for accounting purposes.) 

The issuer is typically a special purpose entity whose only business activity 

is to acquire and hold the assets, and issue securities backed by the assets. 

Because the issuer has no significant facilities or employees, its duties are 

contracted out to other parties, primarily the servicer.lOO 

The form of organization of the issuer generally depends on tax 

considerations and the desired payment structure of the financing."' There are 

two basic types of payment structures that are used: pass-through and paythrou&.'02 In a pass-through structure, the issuer typically is a grantor 

trust. A grantor trust essentially is a trust that acts as a conduit for the 

''(...continued) 

(Pub. L. 102-242, 105 Stat. 2236, 2250-51 (Dec. 19, 1990, codified at 12 U.S.C. § 183111) amended 

the Federal Deposit Insurance Act to require that financial statements submitted to federal banking 

agencies be prepared in accordance with GAAP, unless an agency determines that a particular 

GAAP principle is inconsistent with certain stated objectives, in which case the agency may 

prescribe an accounting principle no less stringent than GAAP. 

'O02 FRANKEL, supra note 3,s 14.1, at 80-81; The Importance of the Role of the Servicer in Securitized 

Transactions, MOODY'S STRUCTURED FINANCE RESEARCH & COMMENTARY, Apr. 1990, at 12 

[hereinafter The Servicer in Securitized Transactions]. 

'"The form of organization of an issuer holding mortgagerelated assets need not affect the 

payment structure of the financing if the issuer elects REMIC status. See infra note 149 and 

accompanying text. 

. 

'OZFor a general discussion of these structures and the attendant tax issues, see, eg., William 

A. Schmalzl et al., Tax Issues, in 1 SECURITIZATION OF FINANCIAL ASSETS, supra note 21,§§ 9.01-9.06; 

Charles M. Adelman & Roger D. Lorence, Tax Considerations, THE ASSET SECURITIZATION 

HANDBOOK, supra note 46, at 298-334; ROSENTHAL & OCAMPO, supra note 2, at 48-63. 

103R~~~~~ & OCAMPO, supra note 2, at 49. Although securitizations of credit card 

receivables use trusts that issue certificates and often are characterized as pass-through (see DEAN 

WIT'ER, supra note 38, at B-37 to B-43 (characterizing Sears Credit Card Account Trusts as passthrough)), the structure of this type of financing generally prevents the issuer from qualifymg as 

a grantor trust for tax purposes. See Jason H.P. Kravitt, A Brief Summary of Structures Utilized in 

the Securitization of Financial Assets, in 1 SECURITIZATION OF FINANCIAL ASSETS, supra note 21, § 

4.03[CI, at 4-39. 

28 CHAPTER 1 
outright sale of assets to the investors. Investors purchase certificates 

representing a fractional undivided interest in the trust and are entitled to a pro 

rata share of the cash flows from the assets.lo4 To be considered a grantor trust 

for tax purposes, the trust must be passive. Thus, this structure generally 

requires that the pool remain fixed, except for limited substitutions to replace 

"defective" assets, and does not allow for management of cash flowsJo5 

In a pay-through structure, the issuer typically is a special purpose 

corporation or an owner trustJo6 Most of the securities issued are structured 

as debt, permitting deduction of interest payments which offsets the income 

received on the assets. Issuers structured in this manner need not be subject to 

the constraints imposed by the grantor trust tax classification. Thus, payments 

to investors need not be tied to the incoming cash flows from the underlying 

assets, but rather may be structured to permit the creation of classes of securities 

with different payment schedules that are tailored to investor demand.lo7 

The servicer is the primary administrator of the financing. Often the 

sponsor or an affiliate of the sponsor is the servicer."' In other financings, the 

104The certificates are considered to be equity (3 FRANKEL, supru note 3,s 8.2, at 2891, although 

in many respects they have debt-like characteristics. One drawback of these securities, from a 

marketing standpoint, is that investors are subject to greater prepayment risk. ROSENTHAL & 

OCAMPO, supru note 2, at 53. For a discussion of the characteristics of these securities, see infra 

note 128 and accompanying text. 

lasThe trust must be passive to avoid being classified as an association, which would be 

taxable as a corporation. Such a characterization could have adverse tax consequences because 

the interest income to the trust from the assets would be taxable while the payments from the 

trust to the investors would be nondeductible distributions. Consequently, the trust would have 

a substantial tax liability, and investors would receive yields substantially less than anticipated. 

ROSENTHAL & OCAMPo, supru note 2, at 51. 

'&Id. at 54. 

lwza. at 55. 

'''See Credit Curd Deals Aren't Equal, FITCH STRUCTURED FINANCE (Special Report), Apr. 10, 

1990, at 5. If the sponsor is the servicer, the sponsor typically agrees that, in servicing the 

accounts, it will impose the same terms as those it imposes with respect to its own portfolio of 

accounts. In some mortgage transactions, where the sponsor is a conduit, each originator of the 

mortgages in the pool may act as a "subservicer," and perform many of the functions that the 

servicer would perform, but only for the mortgages it originates. A "master servicer" is 

responsible for overseeing the subservicers and tracking the funds from subservicers to investors. 

See STANDARD &POOR'S CORPORATION, SWS STRUCTURED FINANCE CRITERIA 98 (1988) [hereinafter 

s&P'S STRUCTURED FINANCE CRITERIA]. 

The Treatment of Structured Finance under the Investment Company Act 29 
servicing function is carried out by a third party that may not necessarily be in 

the business of generating the type of assets that it is servicing. 

The servicer collects payments on the underlying assets when due and 

ensures that funds are available so that investors are paid in a timely 

manner.lo9 The servicer's specific obligations depend on the transaction and 

the assets involved. Generally, the servicer is responsible for collecting on 

delinquent accounts.'" The servicer may commingle collections on the assets 

with its own funds until payment to investors, may remit the collections to the 

trustee, or maintain the funds in custodial accounts:" The servicer may also 

reinvest idle cash in short-term investments when there is a timing mismatch 

between the collections and distributions to investors.'l2 

In addition, the servicer oversees the substitution of assets as permitted by 

the P&S agreement. For example, the agreement may permit the substitution of 

assets that are determined not to meet specified eligibility criteria. A servicer also 

may monitor tax and insurance payments, maintain escrow accounts, advance 

funds to provide liquidity to cover loans in arrears, maintain all relevant 

documentation, and administer other day-to-day operations of the issuer.ll3 

The trustee is appointed to monitor the issuer's obligation to investors. 

Generally, publicly issued structured financings that issue debt are subject to the 

Trust Indenture Act!14 The Trust Indenture Act sets forth requirements 

'@See 2 FRANKEL, supra note 3, 5 14.8, at 91. 

'"If the credit quality of the servicer is low, some risk is created by the servicer commingling 

collections. The funds may become subject to claims of the servicer's creditors if the servicer 

becomes insolvent. See Darrow, et al., supra note 21, 5 7.02[D1[21, at 7-14. 

1121d. at 7-13. 

'I3See S&P's STRUCTURED FINANCE CRITERIA, supra note 108, at 24. 

114Congress amended the Trust Indenture Act in 1990. See Trust Indenture Reform Act of 

1990, Pub. L. 101-550, 104 Stat. 2721 (1990), codified at 15 U.S.C. 77ccc-77eee1 77iii-77rrr1 and 

77vvv (effective November 15, 1990). The 1990 legislation, among other things, removed the 

prohibition against an otherwise qualified trustee that has one of the statutorily specified 

relationships with the obligor on the indentured securities (formerly "conflicts of interest") from 

serving as trustee provided that there is no default. The legislation also expressly incorporated 

provisions previously required to be specifically placed in the trust indenture, and gave the 

Commission exemptive authority. 

30 CHAPTER 1 
regarding, among other things, the eligibility and qualifications of trustees;l5 

the preferential collection of claims against the issuer, and reporting obligations. 

The Trust Indenture Act also addresses the duties of trustees when an issuer 

defaults. 

The Trust Indenture Act applies only to financings that issue debt. Because 

pass-through certificates are regarded as equity, transactions issuing such 

securities are not subject to that Act. As a practical matter, however, the 

structures of many such transactions are similar to transactions that are subject 

to the Trust Indenture Act?16 , Similarly, although private placements are 

exempt from the Trust Indenture Act, some of these transactions also are 

structured in a way that is consistent with that Act's requirements. 

In a publicly offered structured financing, the trustee typically is a bank 

that is not affiliated with the sponsor or any other parties to the transaction.l17 

only a few entities currently are in the business of acting as trustees in structured 

financings. 

1'5Generally, the Trust Indenture Act requires the appointment of one or more trustees, at least 

one of which is a corporation organized under the laws of the United States or a state (or 

organized under the laws of a foreign government as permitted by the Commission), with a 

minimum combined capital and surplus of $150,000. 15 U.S.C. 5 77jjj (a) (1) & (2). The Trust 

Indenture Act prohibits an obligor or its affiliate from serving as trustee for indentured securities 

offered by the obligor. 15 U.S.C. 5 77jjj(a)(5). Also, if a trustee has or becomes subject to a 

conflicting interest, the trustee must resign or remove the conflict. 15 U.S.C. 5 77jjj(b). A 

conflicting interest generally arises if the indentured securities are in default and the trustee has 

one of the relationships with the obligor set forth in section 310(b) of the Trust Indenture Act. 

15 U.S.C. 5 77jjj(b). 

'"See LORE, supra note 20, at 4-49. 

l17Because the Trust Indenture Act prohibits the obligor or its affiliates from serving as trustee, 

neither a sponsor of a structured financing that falls within that Act, its affiliates, nor a credit 

enhancer (which meets the definition of obligor under Section 303(12) of that Act) may act as 

trustee. The Trust Indenture Reform Act of 1990, sup note 114, amended the Trust Indenture 

Act to provide that an underwriter may act as trustee so long as there is no default. See 15 U.S.C. 

§ 77jjj(b)(2). 

The Treatment of Structured Finance under the Investment Company Act 31 
Generally, the trustee is assigned and holds the underlying assets (or 

documentation of interest in the assets) in accounts designated for each structured 

financing for the benefit of investors. The trustee also receives payments from the 

servicer and any credit enhancers, and remits them to investors>18 The trustee 

also may reinvest the funds on a short-term basis prior to payment."' In 

addition, the trustee reviews the activities of the servicer, in part by receiving 

periodic reports from the servicer on payments and future projections. The 

trustee may be expected to calculate the payments and future cash flow 

projections if the servicer fails to perform this duty>20 Similarly, if the servicer 

becomes insolvent or withdraws, the trustee may act as interim servicer until 

another servicer has been appointed. Final1 , the trustee may act to represent the 

interests of investors if there is a default. 127 

2. The Securities Issued 

Almost all issuers, whether using a pass-through or pay-through structure, 

offer fixed-income securities &e., securities that are either debt obligations or that 

have debt-like characteristics)>22 The securities typically entitle the holder or 

owner to a specified principal amount at maturity and bear interest based on the 

principal amount at a fixed rate, a floating rate determined periodically by 

reference to an index, or a rate determined through periodic auctions among 

investors or rospective investors, or through the periodic remarketing of the 

instrument.lg The interest rate also may be determined by reference to 

'18Asset Finance Group, The First Boston Corp., Overview of Assets and Structures, in THE ASSET 

SECURITIZATION HANDBOOK, supra note 46, at 35-36. 

'19E. Kay Liederman, TheRuZe ofthe Trustee in Securitization, AM. BANKER (Special Adv. Supp.), 

Dec. 17,1991, at 13A. 

12'See S&P's STRUCTURED FINANCE CRITERIA, supra note 108, at 24. 

12'For a more detailed discussion of the role of the trustee, see Liederman, supra note 119. 

lzThe traditional distinction between debt and equity is somewhat blurred in the context of 

structured finance. For further discussion, see 1 FRANKEL, supra note 3, § 8.9 at 301. 

few issuers, mainly finance subsidiaries of thrift institutions and corporations, have 

offered asset-backed auction rate preferred stock. See S&P'S STRUCTURED FINANCE CRITERIA, supra 

note 108, at 51. See aIsu 1 FRANKEL, supra note 3, § 8.6. 

32 CHAPTER 1 
specified portions of the interest received on the underlying assets. The average 

life of most non-mortgage structured financings ranges from one to five years; 

mortgage-backed securities usually have a longer duration?24 The securities 

are not redeemable at the option of the holder. 

The payment of the security derives directly from the cash flow generated 

by the portfolio of assets?25 The yields paid to investors obviously must be 

lower than the effective yield on the underlying assets. For example, securities 

backed by credit card receivables may yield on1 nine percent, even though the 

receivables themselves yield eighteen percent.'' Investors, in effect, give up 

a substantial portion of the yield spread because the transformation of these assets 

into securities enables investors to receive what they consider to be safer and 

more liquid investments than if they had purchased the assets without the 

financing being structured?27 

The structure of the security depends in part on whether the payment 

structure is pass-through or pay-through. In the case of a pass-through structure, 

with two exceptions discussed below, the issuer must issue a single class of 

securities. Each security represents a fractional interest in the trust. Investors are 

entitled .to a pro rata share of the cash flows, net of fees. This structure requires 

that all payments, including prepayments, be passed through to investors almost 

immediately after receipt. Accordingly, the timing of payments and maturity of 

'"The average life of a debt security is the expected average time it will take to repay each 

dollar of principal. Most securities backed by automobile loans, for example, run from one to two 

years, while credit card-backed securities typically have a maturity of two to six years. DEAN 

WITTER, supra note 38, at A-28. 

lxThere are two other payment structures used in structured finance for which payment does 

not depend directly on the cash flow on the assets. "Market value transactions" are financings in 

which payment on the securities sold depends on the market value of the underlying assets. This 

structure has been used primarily in securitizing high yield bonds. See infra note 162. "Third 

party credit-supported debt" involves the issuance of securities the payment on which is derived 

primarily from third-party credit support. Darrow et al., supra note 21,s 7.02[Bl, at 7-9. Because 

the overwhelming majority of structured financings are cash flow transactions, these other 

payment structures generally are not discussed in this chapter. 

'2&rhe differential usually is used to pay fees for servicing and credit enhancement and to 

cover losses on the underlying assets. Any remaining spread may be allocated to the holder of 

the residual interest. See infra notes 143-145 and accompanying text. 

lnSee BRYAN, supra note 3, at 81-82. 

The Treatment of Structured Finance under the Investment Company Act 33 
a pass-through security is uncertain, and investors may receive pa ment of 

principal when reinvestment opportunities are relatively unattractive. 1YS 

In contrast, the pay-through structure allows allocation of cash flow to 

permit the issuance of securities with maturities and payment schedules different 

from those of the underlying assets. Although structured financings using the 

pay-through structure may issue only one class of securities, many issue several 

classes. One common form of this structure, often called the "sequential-pay 

structure," permits the issuance of several classes of securities with differing 

maturities. Typically, interest is paid concurrently on most or all of the classes, 

but principal is allocated to one class until that class is retired. The other classes 

are retired sequentially in order of maturity date?29 Yields and ratings may 

vary among the classes. In addition, the pay-through structure permits the use 

of different payment schedules. Thus, the pay-through structure permits 

securities to be structured with maturities and payment schedules that meet the 

needs of particular 

Both structures permit the issuance of stripped securities. Stripped 

securities are created by splitting the cash flow from an asset pool into separate 

components of interest and principal, so that investors of different classes receive 

unequal proportions of principal and interest. There are an infinite number of 

possible principal and interest combinations. In simplest form, strips are issued 

in interest only (TO") and principal only ("PO") classes. IO certificates entitle the 

holder to a pro rata share of interest paid on the assets, without any preference 

or priority in the class. PO certificates entitle the holder to a pro rata share of 

principal payments made on the assets. Stripped securities were developed for 

and are used primarily in the mortgage market.131 

'?5ee, e.g., ROSENTHAL & OCAMPO, supra note 2, at 52-54; CRAIG J. GOLDBERG, MERRILL LYNCH 

MORTGAGE CAPITAL Wc., INVESTING IN ASSET-BACKED SECURITIES 9-10 (1988). 

129A multiclass structure may contain classes that issue more complicated types of securities, 

such as zero coupon and floating rate bonds and stripped securities. See, e.g., Pittman, supra note 

15, at 506-507; Rating Whole-Loan Backed Multiclass Securities, MOODY'S STRUCTURED FINANCE 

RESEARCH & COMENTARY, Aug. 1989, at 12. 

l3OSee GOLDBERG, supra note 128, at 9-10. See also supra text accompanying note 107. 

131See, e.g., Pittman, supra note 15, at 511. When we refer to "stripped securities," we are 

excluding stripped Treasury Securities where principal and interest components of Treasury notes 

and bonds are separated. 

34 CHAPTER 1 
IO and PO certificates are volatile securities. The investor in an IO or PO 

certificate is paying for an interest in a payment stream that is priced based upon 

an assumed prepayment pattern. Accordingly, changes in interest rates or other 

factors that alter prepayments on the assets greatly affect the timin and amount 

of payment on the securities and thus the value of the securities. 18 

Despite this volatility, or because of it, many institutional investors have 

purchased stripped securities either as stand alone securities or for use as hedging 

Because of the risks inherent in investing in stripped securities and 

similar instruments, the Federal Financial Institutions Examination Council 

the selection of securities dealers by, and certain securities activities of, depository 

ins tit~ti0ns.l~~ 

("FFIEC 11 ) 134 has issued for comment a Supervisory Policy Statement concerning 

13*Id. at 511-512. If the assets are prepaid faster than expected (e.g., when interest rates 

decline), IO investors may suffer large losses. In the case of a sudden drop in interest rates, IO 

investors may lose most of their investment. PO investors would experience a gain in this 

situation since PO certificates are sold at discount and investors would recover their investment 

sooner than anticipated. Conversely, if the assets are prepaid more slowly than expected (e.g., 

when interests rates are rising), IO investors benefit because maturities lengthen and more interest 

is collected. PO investors effectively would experience a loss because the yield to maturity on the 

certificates would be lower since the term to maturity of the assets is extended. Id. 

'%The credit quality of stripped securities may be rated. The ratings, however, do not address 

prepayment risk. See Stripped Mmtguge Securities, STANDARD & POOR'S CREDITREVIEW: 

COLLATERALIZED MORTGAGE OBLIGATIONS, Aug. 29, 1988, at 5. 

'34The FFIEC consists of the Board of Governors of the Federal Reserve System, the FDIC, the 

Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National 

Credit Union Administration. 

1351n January 1991, the FFIEC published for comment Supervisory Policy Statement 

Concerning Selection of Securities Dealers, Securities Portfolio Policies and Strategies and 

Unsuitable Investment Practices, and Stripped Mortgage-Backed Securities, Certain CMO 

Tranches, Residuals, and Zero-Coupon Bonds, 56 FR 263 (Jan. 3,1991). In response to comments, 

in August, 1991, the FFIEC published for comment a revised portion of the Supervisory Policy 

Statement that pertained to the acquisition of stripped mortgage-backed securities, certain CMO 

tranches, residual interests, and zero coupon bonds. Supervisory Policy Statement on Securities 

Activities, 56 FR 37095 (Aug. 2, 1991) [hereinafter Supervisory Policy Statement]. 

The Treatment of Structured Finance under the Investment Company Act 35 
Under the proposal, stripped securities and certain other securities that the 

FFIEC considers to be "high-risk mortgage ~ecurities"~~' are deemed to be 

"[un]suitable investments for depository institutions" because of their volatility. 

Accordingly, the proposal would prohibit most depository institutions from 

investing in such securities unless they are urchased for the purpose of reducing 

the institution's overall interest rate risk." Depository institutions wanting to 

purchase these securities must have the internal ability to determine both prior 

and subsequent to purchase that the securities would actually reduce interest rate 

risk. Depository institutions would be required to dispose of high-risk mortgage 

securities that do not reduce interest rate risk in an orderly fa~hi0n.l~' 

In addition, both pass-through and pay-through structures permit the 

issuance of classes of senior and subordinate securities. The senior/subordinate 

structure splits the cash flow into at least two classes. The senior class has first 

claim on the cash flow from the pool; the subordinate class absorbs credit losses 

before the senior class.139 

The senior class usually is offered publicly and is considered to be 

insulated from credit risk in part because of the presence of the subordinated 

class. Performance of the classes depends on the specific senior/subordinate 

structure adopted and on the actual level of defaults on the assets. The 

'%In general, the FFIEC considers any mortgage derivative product that possesses average 

price volatility or average life greater than a standard, fixed-rate 30-year mortgage-backed passthrough security to be "high risk." Thus, the policy also applies to certain CMOS, certain REMICs, 

and CMO and REMIC residuals. Supervisory Policy Statement, supra note 135, at 37096-98. In 

addition, the policy applies to residuals issued in non-mortgage structured financings. Id. at 

37097. For a discussion of residuals, see infru notes 143-145 and accompanying text. The National 

Association of Insurance Commissioners is drafting a proposal limiting insurance company 

purchases of these securities. See IDD 1991 Figures, supra note 4, at 22. 

137Depository institutions with "strong capital and earnings and adequate liquidity" and with 

"closely supervised trading department[s]" would be permitted to purchase high-risk mortgage 

securities for trading purposes. See Supervisory Policy Statement, supra note 135, at 37096 n.1. 

1381d. at 37098. The proposal would also require that the depository institutions develop 

written portfolio policies, approved by their boards, regarding the purchase of these types of 

securities. Id. 

139Some senior/subordinate structures split the cash flows into several senior sequential-pay 

classes. Similarly, some structured financings have more than one subordinated class. See Rating 

Whole-Loan Bucked Multicluss Securities, supra note 129, at 11-12. 

36 CHAPTER 1 
subordinate class may be privately placed, publicly offered:40 with yields 

higher than those of the senior class certificate^:^' or held by the 

Finally, most structured financings include residual interests, which are 

equity interests backed by cash flow not needed to pay the holders of the fixedincome securities or to pay administrative expenses. This cash flow may be 

derived from income generated by the reinvestment of collections on the assets 

prior to disbursement to investors, by overcollateralization, or by the spread 

between the interest rate on the assets and the interest rate on the fixed-income 

securities.14 

Residuals may have a high return, but they are volatile, unpredictable 

securities. Predicting the ultimate return on residual interests is highly 

complicated, and requires a high degree of sophistication, given the variety of 

sources of cash flows and the effects of changes in prepayments and interest rates 

on the cash flow. The risks vary from transaction to transaction, depending on 

the transaction's structure and assets. The interdependency of these factors "leads 

to myriad analyses and predictions for residual interest investor^.''*^^ 

14'The market for subordinate securities has grown tremendously in the last two years, with 

estimated issuance for 1991 totaling over $2 billion. Wesley W. Sparks, The Consumer Asset-Backed 

Market: A Trader's Perspective, AM. BANKER (Special Adv. Supp), Dec. 17, 1991, at lA, 6A. 

14'The subordinate class may or may not be rated. GOLDBERG, supra note 128, at 12. If the 

subordinate class is rated, it usually has a rating lower than the senior piece. In many cases, the 

subordinate class has an external credit enhancement and is thereby protected to some degree 

against default losses. The amount of credit enhancement needed to achieve an investment grade 

rating is relatively high due to the greater risk of default. See Credit Card Deals Aren't Equal, supa 

note 108, at 13. 

'@The sponsor's retention of the subordinated class is considered by some to be a form of 

recourse, and therefore the transfer of the receivables to the pool may not be considered a true 

sale for bankruptcy concerns. For example, following a downgrade of the rating of Sears' senior 

debt, Fitch downgraded from AAA to AA certain structured financings where Sears retained the 

subordinate class. See Sears' Debt, Asset-Backed Ratings Cut, FITCH INSIGHTS, Apr. 16, 1990, at 4. 

"%eel e.& Pittman, supra note 15, at 509-510; Boemio & Edwards, Jr., supra note 56, at 662. 

'%MO Residuals, STANDARD & POOR'S CREDITREVIEW: COLLATERALIZED MORTGAGE 

OBLIGATIONS, Aug. 29, 1988, at 4. Residuals structured as equity are not rated. Some residuals 

are structured as debt, having stated principal amounts (which often are extremely small) and 

bearing interest at a minimum stated rate. These securities can be rated. As with other debt-like 

obligations, the rating does not address prepayment and interest rate risk, which can be extreme 

for residuals. 

The Treatment of Structured Finance under the Investment Company Act 37 
Initially, residual interests usually were retained by the sponsor. In the last 

several years, residual interests increasingly have been sold to institutional 

investors, which usually purchase them for hedging purposes.145 , 

3. Types of Structured Financings 

Many structured financings, regardless of their underlying assets, are 

structured and operate generally in the manner set forth in the previous two 

subsections. Some structured financings, however, possess different attributes 

than other types of structured financings, in part because of the nature of their 

assets. This- section briefly describes some of these differences. 

a. CMOs and REMICS 

CMOs are multiclass, sequential pay, debt obligations backed by various 

types of mortgage loans or by mortgage-backed ~ecurities.'~~ Most CMOs issue 

at least four tranches, with each tranche typically having a different maturity, 

interest rate, and prepayment risk. Like most sequential pay securities, the first 

tranche on which principal is paid typically is the class with the shortest maturity. 

That class generally bears the highest prepayment risk, while classes with 

longer maturities bear less of a prepayment risk. To reduce prepayment risk, 

CMOs may contain tranches that issue "planned amortization class" bonds 

("PACs"). Investors in PACs receive principal and interest payments that are 

made in accordance with a fixed amortization schedule that does not depend on 

the rate of prepayments of the underlying mortgages, thereby providing a high 

degree of predictability regarding final maturity and expected average life. 

Prepayment risk is shifted to other tranches in the CMO, which consist of 

"companion" bonds that are subordinate to PACs and which have more volatile 

prices and expected average lives. Some CMOs also include tranches that issue 

stripped securities, zero coupon bonds, floating rate bonds, and debt-like residual 

securities. 

'45See 1 FRANKEL, supra note 3, § 8.3.2. 

'%Of the approximately $118.6 billion in CMOs and other multiclass mortgage securities 

offered in 1990, approximately $112.8 billion or ninety-five percent held pass-through securities 

as collateral. Database, supra note 16, at Table 3. Of the approximately $138.0 billion in CMOs and 

other multiclass mortgage-backed securities offered in the first three quarters of 1991, 

approximately $134.8 billion or 97.7%, held pass-through securities as collateral. Id. 

38 CHAPTER 1 
Many issuers elect to be treated as "real estate mortgage investment 

conduits" ("REMICs"), which were created by the Tax Reform Act of 1986?47 

The election of REMIC status permits the issuance of multiple classes of securities 

without tax constraint^.'^^ REMIC status affects only the taxation of the issuer 

and the investors -- the securities law and accounting requirements remain the 

same. 

Under the REMIC provisions, the issuer's form of organization does not 

affect the payment structure. The issuer may be a grantor trust, corporation, 

partnership, or even a designated pool of mortgages that is not a separate legal 

entity. The securities issued may be pass-through securities, debt, stock, or 

partnership interests. Only issuers of securitized mortgage products can elect 

REMIC status.'49 

In practice, REMICs are very similar to CMOs (and are considered by some 

to be a subset of CMOs), with the exception of their tax treatment. A REMIC 

must issue at least two types of securities: regular interests and residual interests. 

A REMIC may have multiple classes of regular interests, each with varying 

maturities, but only one class of residual interests.15* Although REMIC status 

is elective, as of January 1, 1992, it is generally the only means for issuing 

IgTax Reform Act of 1986, Pub. L. No. 99-514,100 Stat. 2309, Title VI, 5 671(a)(Oct. 22,19861, 

codified and amended as 26 U.S.C. §§ 860A-860G. 

14For example, non-REMIC multiclass securities generally must be issued as debt obligations 

to avoid dual taxation. See supu notes 106-107 and accompanying text. 

149See Kravitt, supu note 103,s 4.02[cI, at 4-16. Substantially all of the assets of a REMIC must 

consist of "qualified mortgages" or "permitted investments." I.R.C. § 860D(a)(4). The term 

"qualified mortgage" includes "any obligation (including any participation or certificate of 

beneficial ownership therein) which is principally secured by an interest in real property," among 

other things (I.R.C. 5 860G(a)(3)), such as residential and commercial mortgages and mortgagebacked securities. The term "permitted investment" includes any cash flow investment, qualified 

reserve asset, or foreclosure property. I.R.C. 5 860G(a)(5). 

lwFor tax purposes, regular interests are considered debt, notwithstanding the actual form of 

ownership interest, while residual interest holders are treated much like partners in a partnership. 

Residual interest holders do not, however, have the disadvantages associated with owning a 

partnership interest, i.e., the limited ability to transfer the interest, and personal liability. See 

ROSENTHAL & OCAMPO, supra note 2, at 60-62; Pittman, supra note 15, at 508-09. 

The Treatment of Structured Finance under the Investment Company Act 39 
multiclass mortgage-backed securities without certain adverse tax 

consequences.15' 

b. Revolving Accounts Receivable 

Many of the assets being securitized are fixed payment obligations; that is, 

they are loans for a fixed amount of credit, amortized according to a fixed 

schedule of payments. Such assets include fixed rate residential mortgages, 

consumer automobile loans, boat loans, and manufactured housing loans. 

Revolving accounts receivable also are being securitized, however. A 

revolving account generally allows a borrower to draw on a line of credit up to 

a certain limit and repay only a minimum amount on a monthly basis. A 

borrower may pay more than the minimum monthly amount or repay the entire 

outstanding balance when billed. Thus, unlike a fixed payment obligation, the 

outstanding balance in a revolving account is unpredictable and may vary 

significantly every month. The type of revolving account most commonly 

securitized is the credit card account re~eivab1e.l~~ 

The structure of a financing backed by credit card accounts receivable 

reflects the characteristics of the asset. Typically, the sponsor pools and transfers 

to a trust current and future receivables generated by specified credit card 

accounts. The accounts themselves do not become the property of the trust. 

Although the portfolio of the accounts from which the receivables are generated 

is fixed at the time the securities are issued, the balance of the pooled assets will 

fluctuate as new receivables are generated and existing amounts are paid or 

charged off as a default. Although credit card balances fluctuate, the balance of 

a large pool of credit card receivables is generally predictable over time, which 

permits credit card receivables to be ~ecuritized.'~~ In the event that the 

I5'See Kravitt, supra note 103, 4.02[C], at 4-16, and Robert E. Gordon, et al., RmZ Estate, in 2 

SECURITIZATION OF FINANCIAL ASSETS, supra note 21,s 15.02[E1[21, at 15-39 to 15-40. 

152Revolving home equity lines of credit and revolving wholesale automobile loans also are 

beginning to be securitized. For a discussion of the securitization of home equity loans, see 

Securitizing a Nau Industry, STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED SECURITIZATION, 

Mar. 27,1989, at 49-54. 

'%See Credit Card Deals Aren't Equal, supra note 108, at 7. 

40 CHAPTER 1 
accounts do not generate enough receivables to support the securities, the sponsor 

may be required to assign receivables from other accounts to the 

In most cases, to accommodate the fluctuating balances, at least two classes 

of certificates are issued: the investor certificates and the seller (sponsor) 

certificates. The interests of these securities typically are equal in priority (i.e., 

"pari passu"). The outstanding principal amount of the seller's certificate, however, 

will fluctuate to absorb variations in the balance of the pool, thereby enabling the 

principal balance of the investors' certificates to be maintained at a fixed level for 

a stated term.155 The investor certificates, which represent most of the interests 

in a pool (typically eighty percent or more), are usually sold in a public offering. 

The remaining interest is allocated to the seller's certificate, and is retained by the 

seller. 

A credit card portfolio typically liquidates at a rapid rate (eight percent to 

twenty percent per month). Thus, the expected life of a credit card portfolio is 

less than one year, assuming a constant portfolio size.156 To extend the life of 

the securities, investors are paid only interest during the transaction's initial 

stages, typically eighteen to thirty-six months. During this period, principal 

payments are allocated to the sponsor and used to purchase additional receivables 

arising from the pooled accounts. The "interest-only" period (also called the "nonamortization" or "revolving period') is followed by an "amortization" period in 

which investors receive distributions of principal in accordance with a specified 

payment ~chedu1e.l~~ The basic components of a financing backed by credit 

card accounts receivable are illustrated in Figure 1-6 below. 

'%Id. at 15. 

155See id. at 7; Credit Card-Bucked Securities' Innovations, STANDARD & POOR'S CREDITREVIEW: 

ASSET-BACKED SECURITIZA~ON, Sept. 12, 1988, at 34. 

'%See Credit Card-Bucked Securities Innovations, supra note 155, at 34. 

'%everal amortization methods have been used to make the schedule of principal 

distributions more predictable. For more information on these methods, see Credit-Curd-Bucked 

Securities: Understanding fhe Risks, MOODY'S STRUCTURED FINANCE RESEARCH & COMMENTARY 

(Special Report), Jan. 1991, at 18-19; Credit Curd Deals Aren't Equal, supra note 108, at 8-12. 

The Treatment of Structured Finance under the Investment Company Act 41 
RGURE 1-6 

Financing Backed by Credit Card Accounts Receivable 

Remil 

principal 

and 

interest I Cardholders C 

I 

I 

I 

interest in assets I during 

'interest only' I 

Sewicer period 

I Accounts I I 

receivables from I 

I 

I 

.. *Tdn Issuer I 

Sponsor designated I 

Seller * 1 

111 

Certificate Proceeds .) 1111 from sale 

Proceeds of securities L 

1 

Transfers interest and 

principal payments (after 

'interest only' period) 

cm=mmm 

Transmits payments due 

c - - - - 1- 1111111 Trustee 

Retained by sponsor 

Legend 

Structure + Cash Flow . 

Unlike most other assets used in structured financings, pooled credit card 

accounts receivable return to the balance sheet when the securities are retired. To 

continue to keep these assets off the sponsor's balance sheet new financings must 

be offered.15* 

Credit card transactions also differ from other structured financings in that 

the sponsor has a continuing relationship with the borrowers. The sponsor may 

be in a business that depends on continuing sales to the card holders whose 

obligations are transferred to the issuer. In addition, the sponsor continues to 

own the accounts throughout the term of the financing, even though the 

receivables generated may be owned by the issuer. Accordingly, the sponsor 

'%See Credit Card Deals Aren't Equal, supra note 108, at 12. For example, one observer has 

estimated that, between January 1991 and December 1992, banks will be returning to their balance 

sheets more than $6 billion of previously securitized credit card accounts receivable, representing 

approximately 14% of all credit card offerings by banks. See Kelley Holland, Card-Backed Issuers 

Bracing for Repeat Securitizatims, AM. BANKER, Sept. 4, 1991, at 1. 

_" . 

42 CHAPTER 1 
typically will make representations that it will not amend the terrns of its credit 

card program so as to affect adversely the structured financing. 

c. Poorly Performing Assets 

Interest in securitizing low quality and poorly performing assets has 

increased recently. Many of these assets are difficult to securitize because the 

Almost all financings backed by these assets have been either privately placed in 

the United States or sold overseas, in part because of the application of the 

Investment Company Act. 

lack the homogeneous characteristics necessary to assess credit risks easily. 1.J 

The poorly performing assets most often securitized have been high yield 

or "junk' bonds. Finance companies, savings and loans, and insurance companies 

(directly or through affiliates), among others, have sponsored structured 

financings backed by high yield bonds to reduce their portfolio of these 

instruments. Savings and loans also are sponsoring structured financings to 

liquidate their high yield bond portfolios by 1994, as required by the Financial 

Institutions Reform, Recovery and Enforcement Act of 1989 (TIRREA").160 

Other sponsors have acquired high yield bonds on the secondary market solely 

to repackage them to take advantage of the interest rate arbitrage.16' 

The structure used most frequently to securitize high yield bonds is the 

CBO. The payment of CBOs, like most types of structured financings, is derived 

from the cash flow from a relatively fixed pool of high yield bonds.162 With 

'%See supra text accompanying notes 45-47. 

'(%ub. L. No. 101-73, Title VI 5 222, 103 Stat. 183, 270 (codified as amended at 12 U.S.C. Q 

1831e(d)). See also Securitized Corporate Debt, STANDARD & POOR'S CREDITREVIEW: STRUCTURED 

FINANCE, Feb. 26 1990, at 3-4. 

I6lSee Donald J. Korn, Split-Level Junking, FINANCIAL PLANNING, Apr. 1990, at 79/81; Constance 

Mitchell, One Man's Junk Becomes Another's CBO, WALL ST. J., Dec. 14, 1989, at C1. 

16*The other structure used in securitizing high yield bonds is the market value structure. 

Securities issued using this structure differ from CBOs in that the payment on the securities is 

derived from the aggregate market value of the pooled bonds, rather than from the cash flow on 

the assets. The pooled assets are marked to market on a regular basis. If the market value 

declines beyond certain limits, then new collateral must be obtained. If the issuer is unable to 

raise the market value of the pool to the required limit, the pool is liquidated, with the proceeds 

used to retire the securities. All market value transactions are significantly overcollateralized, 

sometimes as much as 220%. See Rating Cash Flow Transactions Backed by Corpurafe Debt, MOODY'S 

(continued. ..I 

The Treatment of Structured Finance under the Investment Company Act 43 
a typical CBO, however, bonds can be sold to prevent the deterioration of the 

pool or to capture appreciation of portfolio assets, with reinvestment of the 

proceeds in other high yield bonds meeting certain criteria.163 CBOs can be 

issued as pass-through certificates or as multiclass sequential pay-through 

securities. Residual interests also may be sold.164 For most CBOs, the senior 

class is rated by at least one rating agency.165 

Another type of asset that has been securitized is the non-performing bank 

loan. A number of banks have considered disposing of their non-performing 

assets by establishing a spin-off entity, called a "bad bank," whose primary 

function is to liquidate those loans. Although there have been relatively few 

transactions to date, and each has been structured differently, the leading model 

is the Grant Street National Bank ("Grant Street") transaction, which occurred in 

October 1988. In this transaction, Mellon Bank Corp. ("Mellon") sold to Grant 

Street, a newly chartered bank established solely for the non162(...continued) 

STRUCTURED FINANCE RESEARCH & CO~~MENTARY, Sept. 1989, at 6-8; Junk Bond Securitization 

Initiated, STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED SECURITIZATION, Sept. 12,1988, at 39. 

IaThe rating agencies impose reinvestment criteria to ensure that the terms of the replacement 

securities reasonably match the terms of the bonds that were sold. See High Yield Cash Flow 

Criteria, STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED SECURITIES, Mar. 27, 1989, at 88-89. 

'@Savings and loans previously were active in purchasing the residuals. In 1990, most of 

these securities were placed with international investors, particularly with Japanese accounts. See 

FSA Reports No Claims As CBO Deal Is Scuttled, GLOBAL GUARANTY, Sept. 10, 1990, at 1, 6. 

'65Theodore V. Buerger, et al., An Overview of Securitization Risks, in THE ASSET SECURITIZATION 

HANDBOOK, supra note 46, at 515. Some rating agencies may not monitor a CBOs portfolio for 

credit quality maintenance after issuance, unless new bonds are added or the CBO contains 

covenants requiring the manager to maintain a certain credit quality in the portfolio. See Anne 

Schwimmer, Moody's May Downgrade First Boston CBO, INv. DEALERS' DIG., July 1, 1991, at 17. 

Most CBOs appear to have weathered the recent downturn in the high yield bond market (see, e.g., 

Junk Bond Structures Withstand Stress, STANDARD & POOR'S CREDITREVIEW: STRUCTURED FINANCE, 

June 11, 1990, at 17-18), although at least one financing has been downgraded. See Schwimmer, 

supra. One CBO was liquidated when the holders of the equity interest decided to exercise a right 

to withdraw from the transaction. All senior debt holders were repaid at par. See FSA Reports 

No Claims As CBO Deal is Scuttled, supra note 164. 

'&As a bank, Grant Street was excepted from the Investment Company Act by section 3(c)(3). 

44 CHAPTER 1 

I 
performing loans, foreclosed real estate, and other repossessed assets>67 Grant 

Street purchased these assets with the proceeds of a public offering of two classes 

of rated debt obligations, with maturities of three and five years, 

respectivelyJ6* In addition, Mellon received Grant Street senior and junior 

preferred stock, and Grant Street common stock. Mellon distributed the common 

stock to Mellon's shareholders, and distributed the junior preferred to Grant 

Street directors. 

Unlike most structured financings, the Grant Street assets were actively 

managed. Employees of Mellon were transferred to a subsidiary of Mellon that 

was dedicated solely to the servicing of the assets. The servicer had substantial 

discretion in the strategy employed for liquidating the assets. Mellon and the 

servicer received fees based on the amount of recoveries. 

Grant Street retired the three-year term notes in six months due to the 

servicer shifting its strategy to accelerate collection more rapidly than initially 

planned, in part because of the deteriorating real estate market. The acceleration 

of the liquidation plan also resulted in almost half of the five-year notes being 

redeemed within one year of their issuance.169 

Finally, highly leveraged transaction ("HLT") loans, primarily resulting 

from leveraged buyouts and other acquisition activity, have been securitized. As 

of June 1990, approximately $2.5 billion of HLT loans had been securitized; 

another $50 billion of HLT loans remained in the portfolios of large United States 

banks.17' 

167The assets were sold at approximately 50% of their face value. See Securitizing Problem 

Loans, STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED SECURITIZATION, Mar. 1989, at 82-83. 

'%tandard & Poor's rated the shorter-term class BBB-, while the other class was rated B-. Id. 

To our knowledge, bad banks are the only structured financings backed by poorly performing 

assets that have been publicly offered. 

169Grant Street National Bunk (in liquidation), STANDARD & POOR'S CREDITREVIEW: STRUCTURED 

FINANCE, Feb. 26,1990, at 63. 

l7'See Sheila M. Cahill & Susan R. Chalfin, HLTs Still Hampered by a 50-Year-0111 Law, AM. BANKER, June 3,1991, at 26. 

The Treatment of Structured Finance under the Investment Company Act 45 
d. Master Trusts 

One variant of the traditional structured financing structure is the "master 

trust." Master trusts have been used predominately in financings backed by 

credit card accounts receivable, but the structure may also be used to securitize 

other types of assets.171 

As with traditional structured financings, the sponsor of a master trust 

transfers assets to a special purpose entity that issues securities backed by the 

assets. The master trust structure allows sponsors to transfer large amounts of 

assets at one time, h0~ever.l~~ In addition, under certain conditions, assets 

may be added173 or removed throughout the life of the 

The master trust structure also permits the issuance of multiple series of 

securities over a period of time, with varying terms.175 Each asset-backed 

'"For example, Chrysler Financial Corp. recently sponsored a financing backed by "wholesale 

floorplan loans" that used the master trust format. Chrysler used this format to facilitate future 

securitizations. See Kathleen Devlin, Chrysler Financial Returns for Dealer-Back-ed Notes, INV. 

DEALERS' DIG., May 27,1991, at 14. 

InFor example, the aggregate amount of assets initially included in the master trust sponsored 

by Citibank totalled $6.4 billion; the Chase Manhattan Credit Card Master Trust was established 

with $4.7 billion of assets. See Standard Credit Card Master Trust I, RTCH RESEARCH STRUCTURED 

FINANCE, Aug. 12, 1991, at 2; Chase Manhattan Credit Card Master Trust Series 1991-2, RTCH 

RESEARCH STRUCTURED FINANCE, Sept. 23,1991, at 1-2. 

lmFor example, under Citibank's master trust structure, receivables from new credit card 

accounts may be sold to the trust on a daily basis. Other receivables that may be added on a 

periodic basis include those arising from accounts acquired from other credit card issuers, 

accounts of a type that have not been previously securitized by Citibank, and accounts from 

maturing stand-alone trusts. Participations representing undivided interests in a pool of assets 

primarily consisting of credit card accounts receivable and their collections also may be added 

periodically. See Letter from Edward J. OConnell, Vice President, Citibank, to Matthew A. 

Chambers, Assistant Director, Division of Investment Management, SEC 2 (Jan. 16,19911, File No. 

57-11-90. 

'74Typically, such transactions may be effected only if at least one rating agency concludes that 

the addition or removal of assets will not result in the downgrading of any outstanding securities. 

'75For example, the first series of securities issued by the CARCO Auto Loan Master Trust 

paid a floating rate of interest; the second and third series were structured with fixed interest 

rates. See CARCO Auto Loan Master Trust, FITCH RESEARCH STRUCTURED FINANCE, Aug. 26,1991, 

at 2, 4, 6. 

46 CHAPTER 1 
security, regardless of the series to which it belongs, represents an undivided 

interest in the trust. The formula for allocating collections and administrative 

costs amon the different series has varied among the master trusts thus far 

est ablis hed. 66 

FIGURE 1-7 

A Master Trust Structure 

Sponsor 

Transfers assets initially 

and throughout life of 

trust 

Assets Removed from 

Trust 

Issues 

Securities I MasterTrust 

The master trust structure offers several advantages over traditional 

structured financings. It permits a sponsor to securitize assets without the cost 

of establishing a new structured financing for each offering. Also, the size and 

diversity of the asset pool reduces the trust's volatility in performance, lessening 

credit and prepayment risk. These advantages make it possible that more 

sponsors will use this structure in the future. 

e. Asset-Backed Commercial Paper Programs 

Asset-backed commercial paper programs also are becoming increasingly 

popular. At year-end 1990, outstanding asset-backed commercial paper totaled 

176See Kravitt, supra note 103, 5 4.03IDl. 

The Treatment of Structured Finance under the Investment Company Act 47 
$50 billion, up from the previous year's total of $42 bi11i0n.l~~ Banks have 

sponsored most asset-backed commercial paper programs.178 As with other 

structured financings, in an asset-backed commercial paper program assets are 

transferred to a special-purpose entity that issues securities backed by the assets. 

Asset-backed commercial paper programs differ from traditional structured 

financings in several significant ways, however. 

First, most of these programs issue only commercial paper, on a continuing 

basis. The paper issued typically has a minimum denomination of $100,000 and 

is highly rated.179 

Second, commercial paper programs are backed by a diversified pool of 

assets that often are acquired from a number of different originators. Most pools 

contain a variety of relatively short-term assets, such as credit card receivables, 

auto lease receivables, trade receivables, equipment lease receivables, and shortterm money market instruments.18' 

Third, the pool is not fixed, with additional assets being purchased 

throughout the life of the program, and, although the cash flow on the assets may 

be applied to repayment of maturing commercial paper, repayment of maturing 

paper is frequently funded with the proceeds from new issuances.18' Thus, an 

asset-backed commercial paper program will not necessarily terminate when the 

lnKelley Holland, Regulators Examine Risk of Asset-Backed Paper, AM. BANKER, Mar. 12, 1991, 

at 16. 

178As of year-end 1990, asset-backed commercial paper programs sponsored by banks had 

issued almost 90% of the asset-backed commercial paper outstanding. Id. 

179At least one issuer has offered medium-term notes. See, e.g., Kravitt, supra note 103, 

§4.03[D], at 4-40. By offering medium-term notes the sponsor can minimize reliance on the 

commercial paper market. 

lqn some asset-backed commercial paper programs, the issuer may use the proceeds from 

the commercial paper to purchase higher coupon, longer-term assets in the secondary market. 

These assets include agency securities, mortgage loans, commercial loans, corporate bonds, and 

sovereign debt. See Third-Party and Asset-Supported Commercial Paper, MOODY'S STRUCTURED 

FINANCE RESEARCH & COMMENTARY, Nov. 1989, at 22-23. 

18'Liquidity usually is provided by a bank line of credit to support payment to commercial 

paper holders if the issuer is unable to roll over the commercial paper due to market conditions. 

See ROSENTHAL & OCAMPO, supra note 2, at 200; Pooled Receivables' Robust Growth, STANDARD & 

POOR'S CREDITREVIEW: ASSET-BACKED SECURITIZATION, Mar. 27,1989, at 89-90. 

48 CHAPTFiR 1 
assets are paid off or deemed to be in default or when the Commercial paper 

initially issued matures. 

These programs are attractive to originators for several reasons. First, 

unlike a traditional structured financing, which generally is not economically 

feasible with less than $100 million in assets,lg2 an asset-backed commercial 

paper program can be initiated with smaller pools?83 The structure also 

permits securitization of diversified pools of assets. In addition, because assetbacked commercial paper programs, like master trusts, provide a continuing 

vehicle for securitizing assets, originators can securitize assets more readily once 

the program begins, without the cost of a new structure. Finally, originators may 

find asset-backed commercial paper programs attractive because commercial 

paper generally is exempt from registration under section 3(a)(3) of the Securities 

and issuers of commercial paper may be excepted from the definition of 

investment company under section 3(c)(l) of the Investment Company Act. 

B. The Role of the Rating Agencies 

The rating agencies play an integral role in most structured financings. 

There are six well-known rating agencies that provide credit ratings on debt 

securities, with four, Standard & Poor's Corporation ("S&Pt'), Moody's Investors 

Service, Inc. ("Moody's"), Fitch Investors Service, Inc. ("Fitch"), and Duff & Phelps, 

Inc., being particularly active in rating domestic structured financings?" 

As with a traditional corporate bond, a rating of an asset-backed security 

assesses only credit risk, Le., the likelihood that the investor will receive full and 

timely payments. The rating generally does not address market risks to investors 

182Michael BeVier and Tom Kaplan, Asset-Bucked Commercial Paper: Structure With Cure, AM. 

BANKER (Special Adv. Supp.), May 30, 1989, at 5A. 

lmId. 

lM15 U.S.C. § 77c(a)(3). 

'=The other most widely followed rating agencies are IBCA (which includes IBCA Limited 

and its subsidiary IBCA Inc.), a London based rating agency, and Thomson Bankwatch. The 

Division met with S&P, Moody's, and Fitch in the course of its review. Generally, the rating 

categories used by the various rating agencies are similar for investment grade securities. In 

addition, their general methodologies for rating structured financings appear to be similar, 

although the criteria for a given rating vary among the agencies. 

The Treatment of Structured Finance under the Investment Company Act 49 
that may result from changes in interest rates or from prepayments on the 

underlying asset p001.l~~ 

Almost all structured finance fixed-income securities offered publicly are 

rated by at least one rating with most containing at least one class 

of securities that is rated in one of the top two categories.lm The larger, 

privately placed financings are often rated, with the range of ratings being much 

broader. The fact that structured financings are subject to the scrutiny of the 

rating agencies and are typically rated in one of the top two rating categories 

makes them attractive to some investor^.'^' 

We discuss below the role of the rating agencies in structured financings. 

We first review the process of obtaining a rating and the factors used to 

determine a rating. We then focus on the use of credit enhancements. Finally, 

we describe what happens after the rating is given. 

'%Of course, the ratings are based primarily on the information supplied to the rating 

agencies. Thus, ratings do not address fully the possibility of inaccurate information or fraud, 

although the agencies often insist on verification of information by independent auditors and 

others. 

IS7With the exception of securities backed by residential mortgages, most publicly offered 

structured financings are rated by two rating agencies. 

ISsSee, e.g., DEAN WITTER, supra note 38, at A-28. In 1991, a large majority of structured 

financings involving automobile loans, credit card receivables, and home equity loans were rated 

AAA, although some lower-rated transactions were issued. Id. at A-29. Other types of nonmortgage financings do have AA, or lower, ratings. See id. Mortgage-backed securities offered 

by the federal agency programs have an implicit AAA rating and are not subject to rating agency 

scrutiny. To be a "mortgage-related security" under the Exchange Act, a security must be rated 

AAA or AA. Exchange Act 5 3(a)(41), 15 U.S.C. § 78c(a)(41). Finally, some multiclass transactions 

(mortgage and non-mortgage) contain classes that, if rated, are rated lower than AA. See, e.g., 

DEAN WITTER, supra note 38, at A-29. 

189Because of the complexity of structured financings, it appears that many investors rely 

heavily upon the rating of these securities in making their investment decisions. Of course, many 

other investors also conduct their own due diligence review. See supra text accompanying note 

74. 

50 CHAPTER 1 

I 
1. Rating the Deal 

a. The Process 

The process for rating a structured financing is generally the same 

regardless of the underlying assets. The sponsor and/or its underwriter meets 

with a rating agency to discuss the proposed structure and provide an overview 

of the sponsor's business. A rating agency may not agree to rate the transaction 

if it believes that the assets being used do not have sufficient credit history to 

enable the rating agency to predict the pool's future performance. A rating 

agency also may decline to rate the transaction if the company originating the 

assets is a new company.lgO If rating the proposed transaction appears viable, 

the sponsor and/or underwriter officially requests that the ratin agency rate the 

transaction, and agrees to provide all relevant information?" The sponsor 

and/or underwriter also agrees to pay the rating agency for its rating 

services.lg2 

In determining the rating, the rating agency reviews the relevant 

documentation regarding the transaction, including the P&S agreement, the 

prospectus or private placement memorandum, and any indenture. The rating 

agency also may conduct an on-site due diligence inspection of the sponsor and 

the servicer. Typically, the agency reviews the underwriting and servicing 

operations, particularly the credit and collection processes. This may entail 

tracking an application through the credit review and approval process and 

tracking collection on a delinquent receivable. The historical, current, and 

expected performance of the sponsor's portfolio (from which the pool will be 

taken) also may be discussed. In addition, the rating agency may review whether 

"See, e.g., Start-up Companies Pose Risk, STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED 

SECURITIZATION, Mar. 1989, at 5. For example, as of March 1989, S&P had never rated assetbacked securities supported by assets from a start-up company, because of the material risks these 

companies face. Id. As of that date, S&P insisted on a minimum of one to two years' operating 

history and receivables performance, unless the assets were originated by a new business unit of 

an established operating company. 

IglFitch and S&P rate transactions only upon request. Moody's rates every publicly offered 

transaction regardless of whether it is asked and compensated. According to Moody's, sponsors 

provide them with information necessary to rate the deal because it is in a sponsor's best interest 

to do so. 

192S&P's fees, for example, range from $8,000 to $75,000 with additional "surveillance" fees of 

$500 to $2,500, although S&P may charge special fees for new vehicles. 

The Treatment of Structured Finance under the Investment Company Act 51 
the sponsor has the capability to track the assets that will be pooled separately 

from the overall p~rtfolio.'~~ Finally, an agency will review its own internal 

resources to obtain information about the sponsor, historical performance data on 

the type of assets being securitized, and other relevant information. 

After completing its review, the agency's rating committee decides on a 

rating. The decision is then communicated to the underwriter. Typically, the 

rating process may take several weeks, although more complicated transactions 

have taken over a year, depending in part on whether the financing involves a 

type of asset previously securitized. 

b. Determining the Rating 

A structured financing is rated so that the credit risk is equivalent to the 

credit risk of a corporate bond, or other security, rated in the same category. 

Similarly, regardless of the nature of the underlying assets, a structured financing 

is rated so that all financings that are rated in a particular category are deemed 

to have equivalent credit risk?94 

Rating agencies apply the same basic criteria to almost all structured 

financings that issue securities with maturities exceeding one year.lg5 They 

analyze the structure of the transaction, including the quality of the assets, and 

'?l%ese on-site meetings do not necessarily duplicate the due diligence performed by many 

underwriters. Rather, the rating agency may review the underwriter's due diligence process, 

work and results. See, eg., Competition Threatens "Due Diligence" Standards, MOODY'S STRUCTURED 

RNANCE REsEARCH & COMMENTARY, Dec. 1988, at 3. According to Moody's, increase in the 

number of intermediaries entering the field, and the "commoditization of the business created by 

an increase in volume and augmented by the negotiating power of large, repeat issuers have 

resulted in competitive pressures on underwriters to lower their underwriting fees and cut back 

on the expensive due diligence process. Id. If Moody's finds that the due diligence conducted by 

the underwriter is less than satisfactory, it requires a higher level of credit support to achieve a 

given rating. Id. See Structured Finance Annual Report: 1989 Review and 1990 Outlook, MOODY'S 

STRUCrURED FINANCE RESEARCH & COMMENTARY, Jan. 1990, at 5-6. 

194According to Moody's "[rlatings for structured finance classes are intended to be consistent 

with ratings assigned to corporate, municipal, and other structured finance securities . . . . the 

expected reduction in annual yield from credit losses should be approximately the same for two 

equally rated securities." See Rating Whole-bun Bucked Multiclass Securities, supra note 129, at 11. 

'95Asset-backed commercial paper programs are subject to somewhat different rating criteria, 

in part because of their need to have the liquidity to pay off commercial paper when due. See 

supra note 181 and accompanying text. 

52 CHAPTER 1 
then determine the amount of credit enhancement that is needed for the 

transaction to obtain the rating category desired by the sponsor. In reviewing the 

structure, a rating agency generally looks at three areas: legal issues, credit 

quality, and cash flow. 

(1) Legal Issues 

One legal question inherent in structured finance is whether the issuer's 

assets and the cash flow on those assets will be available to pay investors in a 

timely manner notwithstanding the insolvency or bankruptcy of the sponsor. 

Rating agencies have developed criteria to address this question. If these criteria 

are not met, the rating on the securities generally will not be higher than the 

sponsor's 

The criteria depend on whether the sponsor is subject to the Bankruptcy 

Code. Section 362 of the Bankruptcy Code provides that the filing of a 

bankruptcy petition automatically stays all creditors from exercising their rights 

with respect to the sponsor's assets?97 Unless a financing is structured 

properly, a stay could prevent investors from receiving full and timely payment. 

Although bankruptcy courts may lift stays under certain circumstances, even if 

a stay is lifted, timely payment to investors could be jeopardized. Furthermore, 

under some circumstances other provisions of the Bankruptcy Code could be 

interpreted as ermitting the assets and the cash flow on them to be returned to 

the sponsor.lg E? *.) 

If a sponsor is subject to the Bankruptcy Code, the agencies typically 

review two related items. First, the rating agencies examine whether the assets 

and liabilities of the issuer are likely to be consolidated with those of the sponsor 

"See, e.g., S&P'S STRUCTURED FINANCE CRITERIA, supra note 108, at 33. Rating agencies may 

conclude, on a case-by-case basis, that the likelihood of a sponsor becoming insolvent during the 

term of the structured financing is sufficiently remote to overcome noncompliance with some of 

these criteria. Id. at 34. 

19711 U.S.C. 5 362. 

Ig8For a more detailed discussion of structured financings and the Bankruptcy Code, see 

generally Thomas S. Kiriakos, et al., Bankruptcy, in 1 SECURITIZATION OF FINANCIAL ASSETS, supra 

note 21, at 5.01-5.06; Thomas W. Albrecht, Securitising Receivables: Protecting Against Bankruptcy, 

9 INT'L. FIN. L. REV. 33-37 (Sept. 1990); Steven L. Schwarcz, Structured Finance: The New Way to 

Securitize Assets, 11 CARDOZO L. REV. 607,611-627 (Feb. 1990); Neil Baron, Asset-Backed Securities 

and US. Bankruptcy Laws, 6 INT'L. FIN. L. REV. 19-23 (Dec. 1987). 

The Treatment of Structured Finance under the Investment Company Act 53 
in a bankruptcy proceeding. To address this concern, the rating agencies examine 

whether the issuer is separate from the sponsor. Factors demonstrating this 

separation include whether the issuer maintains separate books and records and 

office space from the sponsor, maintains separate accounts from the sponsor, and, 

in the case of a corporation, observes appropriate corporate formalitie~?~~ In 

addition, the agencies may require an opinion from counsel that the assets and 

liabilities of the issuer would not be consolidated with the sponsor in the event 

of the sponsor's bankruptcy?" 

The rating agencies also examine whether the transfer of the assets from 

the sponsor to the issuer is a true sale and not a secured loan. If the transaction 

is characterized as a secured loan, the pooled assets may be deemed to be assets 

of the sponsor. The rating agencies look for indicia of a sale, which may include 

that the transfer is treated as a sale for accounting and tax purposes, that the level 

of recourse to the sponsor is less than a reasonably anticipated default rate (based 

primarily on historical default data):o1 that the sponsor does not retain the 

benefits of ownership of the transferred assets (ie., that the sponsor may not 

receive any of the assets' appreciation or their cash flow), and that neither the 

assets nor their cash flow is commingled with the property of the sponsor?o2 

The rating agencies also may require an opinion from counsel that the transfer of 

the assets from the sponsor to the issuer would be characterized by a court as a 

sale ("true sale opinion")?03 In transactions where a true sale opinion is given 

but not all indicia of a sale are met, the rating agencies may consider the financial 

strength of the sponsor in determining the rating?04 

'%See Darrow, et al., supra note 21, 7.03[CI; see generally Kiriakos et al., supra note 198, fj 

5.05(G). 

2ooSee Darrow et al., supra note 21,s 7.03[C]; S&P'S STRUCTURED FINANCE CRITERIA, supra note 

108, at 34, 69. 

20'Recourse may take several forms, such as the retention of a subordinate class or the 

obligation to repurchase defaulted assets, the substitution of good assets for defaulted assets, or 

the reimbursement of a third party credit enhancer. See Legal Issues in Transferring Assets, 

STANDARD & POOR'S CREDITREVIEW: ASSET-BACKED SECURITIZATION, Ma. 1989, at 7. 

202See id. at 7. See also Darrow et al., supra note 21, Q 7.03[Bl. 

*03See Legal Issues in Transferring Assets, supru note 201, at 7-8. 

2041d. 

54 CHAPTER 1 

w 
The insulation of the structured financing from sponsor insolvency is less 

difficult for sponsors that are not subject to the Bankruptcy Code, such as banks 

and savings and loans. Generally the rating agencies have concluded that such 

sponsors may pledge, instead of sell, the assets to the issuer (or, in some cases, 

to the investors), if the issuer (or investors) have at least a first perfected security 

interest in the a~sets.2'~ In addition, the rating agencies require an opinion of 

counsel that the investors' rights with respect to the assets of and the cash 

generated by the financing would be enforceable in the event of the insolvency 

or receivership of the seller or pledgor of the assetsFo6 

The rating agencies also evaluate whether the issuer itself could become 

the subject of bankruptcy proceedings. To minimize this risk, the rating agencies 

may require, among other things, that the issuer restrict its business to the 

purchase of the assets and the issuance of securities, incur additional debt only 

in limited circumstances, be capable of paying for expenses out of its capital and 

revenues, and be able to institute bankruptcy proceedings only in limited 

cir~umstances.~'~ 

(2) Credit Quality 

The most important and time consuming role of the rating agencies is 

analyzing the credit risk of the financing. The principal credit risk in a structured 

financing is the potential impairment of cash flows resulting from shortfalls due 

to borrower delinquencies or losses due to defaultsFo8 

205See Darrow, et al., supra note 21,s 7.03[B]; S&P'S STRUCTURED FINANCE CRITERIA, supra note 

108, at 70. 

206See S&P's STRUCTURED FINANCE CRITERIA, supra note 108, at 70. As of October 1, 1990, 

savings and loans had been quite successful in insulating their structured financings from their 

own insolvency. As of that date, no structured financing sponsored by a failed savings and loan 

had defaulted as a result of a sponsor's insolvency, although several issues had been redeemed 

or accelerated. See Bright Spot in S&L Crisis, RTCH INSIGHTS, Oct. 1, 1990, at 7. 

'07S&P'S STRUCTURED FINANCE CRITERIA, supra note 108, at 29-30,70; Darrow et al., supra note 

21, § 7.03[D]. 

208Credit and legal analysis are closely related. A high credit quality may mitigate rating 

agency concerns relating to legal risks. Darrow et al., supra note 21,s 7.02[CI. Also, with enough 

credit enhancement, a structured financing with a perceived "risky" sponsor may nevertheless 

receive a high rating. 

The Treatment of Structured Finance under the Investment Company Act 55 
The rating agencies typically evaluate a sponsor's historical and expected 

financial performance, organizational strengths and weaknesses, and competitive 

position in the industry from which the assets are being sold. The rating agencies 

also examine the characteristics of the sponsor's portfolio from which the pool 

will be drawn, including any relevant customer concentration^^^^ historic 

origination and repayment statistics, and delinquency and loss statistics?*' 

The process of selecting a pool from the portfolio is critical. The agencies 

generally prefer that a pool be representative of the portfolio. The selection is 

usually done randomly, although, in some cases, the assets for the pool are 

"cherry picked." If the latter method is used, however, the pool may not consist 

of predominately lesser quality assets. Typically, an independent auditor 

confirms that the pool is representative of the sponsor's portfolio?11 

The rating agencies forecast pool performance by examining the credit 

characteristics of the assets. While the factors used and their weightings differ 

depending on the type of assets, they invariably include the historical 

performance of the assets.212 The methodology used also varies according to 

the type of assets. Typically, rating agencies use an actuarial or statistical 

approach to make generalized assumptions regarding future Performance when 

a pool contains a large number of assets with homogenous characteristics, such 

as credit card receivables, auto loans, or home equity loans. Where a pool 

contains a small number of assets, typically with limited standardization, such as 

high yield bonds, probable future performance is assessed by examining each 

asset. 

The rating agencies attempt to predict whether the financing will pay full 

and timely interest and principal in a "worst case" scenario. The transaction must 

2090ne important factor is the diversification by borrower and geographic area of the assets. 

"qn selecting the pool, however, the sponsor may improve the credit quality by excluding 

from the portfolio delinquent and unseasoned accounts and reducing geographic concentrations. 

211An unrepresentative sample may add expense to the sponsor, resulting from either the need 

for additional credit enhancement or a lower rating. To market a security with a lower rating, 

a higher yield is needed, reducing the proceeds received by the sponsor. 

"'For example, to obtain performance criteria for automobile loan and credit card-backed 

transactions, S&P reviewed more than 10 years of history, over a number of economic cycles. 

56 CHAPTER 1 
be structured to be able to survive this scenario to obtain the desired rating?I3 

In theory, the rating will not change even if this scenario does occur. Thus, in a 

highly rated financing, the transaction is structured so that the assets’ 

performance would have to deteriorate greatly before investors in the fixedincome securities would not be fully paid. 

As part of the review of the credit quality of the transaction, rating 

agencies evaluate the ~ervicer?*~ The quality of servicing may be important 

to the rating, depending on the importance of the servicer’s resp~nsibilities?~~ 

The rating agencies evaluate the servicer in terms of its responsibilities to manage 

and maintain the payment stream on the underlying assets. The rating agencies 

generally insist that a servicer that is not rated as high as the fixed-income 

securities not commingle its own funds with the cash flow from the transaction, 

but remit the cash flow to the trustee within forty-eight hours?I6 The rating 

agencies also will take into consideration the servicer’s rating if the servicer is 

responsible for making advances on delinquent assets or repurchasing assets that 

have defaulted.217 

In addition, the rating agencies have developed criteria for permitting 

reinvestment of cash flows in short-term investments?” such as commercial 

213F0r example, Fitch uses the mortgage default patterns in Texas during the 1980‘s as 

benchmarks for assessing the credit loss levels of mortgage-backed securities. See Mortgage Criteria 

Update, FITCH RESEARCH STRUCTURED FINANCE (Special Report), July 8, 1991. 

*14The rating agencies also may evaluate the trustee. Because generally only a few entities act 

as trustees for structured financings, the rating agency generally will not perform any due 

diligence if one of these entities is trustee. For a discussion of the rating agencies’ concerns with 

respect to the trustee, see Darrow et al., supra note 21,s 7.02[D][31. 

215F0r example, Moody’s has stated that extremely weak servicing could result in an otherwise 

AAA transaction being given an A or AA rating. The Servicer in Securitized Transactions, supra note 

100, at 12. 

216See, eg., SWS STRUCTURED FINANCE CRITERIA, supra note 108, at 67. A rating agency’s 

concern also may be alleviated if the servicer obtains a letter of credit or some other form of credit 

enhancement. 

217See Darrow et al., supra note 21, 5 7.02[D1[21. 

218See, e.g., Eligible Investment Guidelines in Structured Securities, MOODY’S STRUCTURED FINANCE 

RESEARCH & COMMENTARY, Feb/Mar. 1990, reported in Moody’s Approach to Rating Residential 

Mortgage Pass-Throughs, MOODY’S STRUCTURED FINANCE RESEARCH & COMMENTARY (Special 

Report), Apr. 1990, at 45. 

The Treatment of Structured Finance under the Investment Company Act 57 
paper, which may include paper issued by the sponsor. Finally, the rating 

agencies evaluate the amount and method of payment of the servicing fee and the 

difficulty of obtaining an alternative servicer, if nece~sary.”~ 

(3) Cash Flow Analysis 

Cash flow analysis examines the risks related to the cash flow funding the 

securities. Rating agencies examine the cash flow generated by the underlying 

assets. Such an examination may include, among other things, a review of the 

assets’ ayment speeds, delinquency and loss rates, and interest rates and basis 

risks.229 The agencies also analyze the allocation of the cash flow, including the 

financing’s payment structure. For example, with respect to a financing using a 

pay-through structure, the rating agencies may examine how the financing 

addresses concerns relating to the reinvestment of cash flows prior to payment, 

the calculation of stated maturities, and the trustee’s powers with respect to the 

assets in the event of a default?21 

2. Credit Enhancement 

Once the structure is analyzed, the agencies determine the amount of credit 

enhancement needed to obtain the desired rating. Credit enhancement is 

intended to protect investors from the continuing effects of shortfalls due to 

borrower delinquencies or losses due to defaults, or other adverse events. 

Most structured financings include some credit enhancement. The amount 

of enhancement needed for a given rating depends on the historical performance 

of the assets222 and the structure of the transaction. Consequently, the actual 

219The rating agencies may insist that the fee be a percentage of the outstanding principal 

balance and be subordinated to payments of principal and interest to investors. S&P’s 

STRUC~URED FINANCE CRITERIA, supra note 108, at 68. 

220See Asset Securitization and Secondury Markets: Hearings Before the SubComm. on Policy Research 

and Insurance of the House Comm. on Banking, Finance and Urban Affairs, 102nd Cong., 1st Sess. 4-5 

(July 31, 1991) (statement of Clifford Griep, Executive Managing Director, Structured Finance 

Rating Department, S&P’s Rating Group). 

“See S&P’S STRUCTURED FINANCE CRITERIA, supra note 108, at 66-67; Darrow et al., supra note 

21, 5 7.02IEl. 

222Thus, the amount of credit enhancement depends on the assets. For example, without credit 

enhancement, most credit card transactions would be rated BB or BBB. Credit enhancement is 

necessary for an AAA rating. See Credit-Card Deals Aren’t Equal, supra note 108, at 12. Because 

(continued ... ) 

58 CHAPTER 1 
- 

amount of credit enhancement in a structured financing largely depends on what 

rating the sponsor believes is needed to sell the securities and what a rating 

agency requires for the transaction to obtain that rating. 

Credit enhancements can be divided into two types: external and internal. 

External credit enhancements are provided by the sponsor or highly rated third 

parties; internal credit enhancements are those structural protections inherent in 

the design of the financing. 

The most common external credit enhancements are irrevocable standby 

letters of credit ("LOCs"), sponsor guaranties or "recourse," and financial guaranty 

insurance. External credit enhancements are more common than internal 

enhancements, but their use has declined somewhat because the rating of a 

structured financing depends on that of the provider of the credit enhancement. 

If the provider subsequently is downgraded below the rating of the structured 

financing, the structured financing likewise may be downgraded. 

Historically, LOCs have been the most common external credit 

enhan~ements.2~~ Typically, an LOC provides a limited guaranty against 

defaults and payment delinquencies up to either a fixed dollar amount or a 

percentage of the outstanding principal balance of the financing. The amount of 

the LOC depends on the particular transaction and the underlying a~sets.2~~ 

Draws against the LOC provider limit the coverage amount available. The LOC 

provider may be reimbursed by the sponsor, from a reserve account that is 

funded by the sponsor, or by excess cash flow on the a~sets.2~~ 

m(...continued) 

the historical loss experience of a pool of credit card receivables is typically lower and less 

variable than a pool of high yield bonds, the amount of credit enhancement needed to obtain an 

AAA rating on a credit card pool is much lower than that needed for a CBO. In fact, most CBOs 

are not rated AAA in part because of the expense of the requisite credit enhancement. 

223Approximately 26.2% of all non-mortgage structured financings issued as of year-end 1991 

used an LOC as the sole means of credit enhancement. DEAN WIITER, supra note 38, at A-23. An 

additional 17.3% used an LOC in conjunction with some other credit enhancement. Id. 

224For example, LOC coverage on credit card transactions existing as of April, 1990 ranged 

from 5%-30% or a stated dollar amount. See Credit-Card Deals Aren't Equal, supra note 108, at 13. 

225LOCs reimbursed by a reserve fund are used in almost all transactions in which the sponsor 

is a bank because reserve accounts are not considered recourse for purposes of regulatory 

requirements. See supra note 99. 

The Treatment of Structured Finance under the Investment Company Act 59 
Most LOCs have been provided by foreign commercial banks, primarily 

because of the limited number of AAA-rated United States banks.226 Recently, 

however, many foreign commercial banks have experienced rating downgrades, 

resulting in the downgrading of structured financings supported by LOCs from 

these banks?27 Accordingly, many sponsors have turned to other credit 

enhancements.228 

Sponsor guaranties or recourse require the sponsor to cover any losses up 

to either a fixed dollar amount or a fixed percentage of the declining principal 

balance of the financing. It may be used alone or, more typically, in conjunction 

with some other form of credit enhancement. Because the rating of the structured 

financing will not be higher than that of the sponsor, this form of credit 

enhancement is used only by highly rated sponsors. It also generally is not used 

in savings and loan or bank-sponsored structured financings because of 

regulatory requirementsz9 

Financial guaranty insurance policies typically guarantee the timely 

payment of principal and interest in accordance with the insurer's original 

payment schedule during the tern of the structured financing. According to 

insurers, in deciding whether to issue a financial guaranty, they underwrite to a 

zero-loss standard, rather than using actuarial assumptions about future 

2260f the 13 largest LOC providers for non-mortgage structured financings as of year-end 1991, 

only two (Morgan Guaranty Trust Co. of N.Y. and State Street Bank and Trust Company) were 

United States banks, each having provided LOCs for three issues. DEAN WITTER, supra note 38, 

at A-33. The leading LOC provider as of that date was Union Bank of Switzerland (61 issues), 

followed by Credit Suisse (38 issues). Id. 

mSee, eg., Downgrade: To Ad Credit Ratings on Letter-Of-Credit-Supported And Guaranteed Issues 

of Dai-Ichi Kangyo Bank, MOODY'S STRUCTURED FINANCE RESEARCH AND COMMENTARY, Aug. 1990, 

at 49; Downgrude From Aaa to Aal: Credit Ratings on Letter-@-Credit- Supported and Guaranteed Issues 

of Fuji Bank, Ltd., MOODY'S STRUCTURED FINANCE RESEARCH & COMMENTARY, Aug. 1990, at 48. 

=One relatively new form of credit enhancement is the "cash collateral account." In a cash 

collateral account, a third party deposits cash in a trust prior to the offering. The cash may be 

drawn upon during the life of the issue if needed and is typically invested in highly rated shortterm securities with the income allocated to the depositor. See Cash Collateral Support for ABS Hot 

New Financial Product in NY, THOMSON'S GLOBAL ASSET BACKED MONITOR, Apr. 12,1991, at 1-2. 

229~ee supra note 99. 

60 CHAPTER 1 
claims?30 Guarantors often require that other types of credit enhancement also 

be obtained. 

Financial guaranties typically are obtained from insurers who are rated 

AAA by at least one rating agency. Because these guaranties are expensive, they 

usually are used only in types of structured financings that are new or perceived 

as being more speculative (such as CBOs)F3* 

Internal credit enhancements have become more common. The most 

common types are overcollateralization, spread accounts, senior /subordinated 

structures, and payout or amortization events. 

Overcollateralization means that the amount of the assets in the pool 

exceeds that needed to make full payment on the securities and to pay expenses. 

The cash flow from the excess collateral offsets any defaults or delinquencies on 

the assets. Many financings use overcollateralization, usually in conjunction with 

some other credit enhancement. 

Spread accounts are escrow accounts whose funds are derived from the 

spread between the interest earned on the assets in the underlying pool and the 

amount needed to pay servicing fees and interest on the ~ecurities.2~~ 

Typically, the differential in interest (less fees) is placed in the account as the 

payments are made on the underlying pool until the account reaches a stated 

level. Any additional spread is returned to the sponsor or to residual interest 

holders, while the funds in the spread account provide credit support. When the 

fixed-income securities are completely paid off, the remaining funds in the spread 

account either return to the sponsor or residual holders. 

The senior/subordinate structure uses two different classes of securities, 

with the senior class having the first claim on the cash flow. Thus, the 

='See, eg., FINANCIAL SECURITY ASSURANCE, 1989 ANNUAL REVIEW 6 (1990). 

231For more information on the financial guaranty industry, see Bund Insurers' Turbulent Future, 

232For example, for a transaction in which the pool of assets has a yield of 20%, the investor 

coupon of the asset-backed security has a yield of lo%, and the servicing fee is 2.5%, the spread 

would be 7.5%, assuming no defaults and no other expenses. 

FITCH FINANCIAL INSTITUTIONS (Special Report), June 4,1990. 

The Treatment of Structured Finance under the Investment Company Act 61 
subordinate class absorbs credit losses before any are charged to the senior class. 

The amount of coverage by the subordinate class varies by transactio11.2~~ 

Payout or amortization events are events specified in the P&S agreement 

that trigger early retirement of the securities and are intended to ensure that 

investors in the fixed- income securities receive all principal and accrued interest. 

Payout events have included charge-offs on assets rising above a certain level for 

specified periods or the net yield on the assets falling below certain levels for 

specified periods. This form of credit enhancement has been used primarily in 

financings backed by revolving accounts receivable, where all principal payments 

on receivables may be used to amortize the remaining balances, rather than 

reinvest in new re~eivables.2~~ 

At least one financing has accelerated payment as a result of the occurrence 

of a payout event?35 Investors received all principal and interest due. Of 

course, acceleration causes investors to lose interest payments they would have 

received had the financing continued. In addition, if prevailing interest rates have 

declined, investors must reinvest in lower yielding instruments. 

Most structured financings allow for asset substitution to protect the credit 

quality of the pool, although this is not considered to be a credit enhancement. 

Assets often are substituted for similar assets that are deemed defective, or, after 

pooling, are determined not to meet the requirements of the P&S agreement. In 

addition, some structured financings include a "defeasance mechanism." This 

mechanism permits the trustee to sell assets in the pool and to use the proceeds 

to purchase Treasury bills that will, in turn, provide sufficient cash flow so that 

investors will receive full and timely principal and interest payments. 

3. Monitoring a Financing 

Once a financing is rated, the rating agencies typically monitor its 

performance monthly or quarterly. The agencies review factors such as asset 

233For example, the typical subordinate loss coverage of structured financings backed by credit 

card receivables ranges from 7% to 15% of the original outstanding principal amount. See CreditCard DeaZs Aren't Equal, supra note 108, at 13. If the loss ratio is lo%, a $100 million pool may be 

divided into $90 million senior securities and $10 million subordinate securities, with investors 

holding the senior securities being protected for up to $10 million in losses. 

234See supra note 157 and accompanying text. 

235See Credit Card Prepayment Risk, STANDARD & POOR'S CREDIT WEEK, July 1, 1991, at 45. 

62 CHAPTER 1 
performance, including default and delinquency rates, and the credit 

enhancement, including whether there has been any change in the 

creditworthiness of a credit enhancement provider. Historically, downgrades 

have been infrequent, although they have increased in recent years?36 

Most downgrades have occurred as a result of downgrades in the rating 

of the providers of external credit enhancements. Downgrades due to poor pool 

performance have been rare, perhaps because the rating agencies, in determining 

the amount of credit enhancement needed for a high rating, incorporate 

delinquency and loss levels of three to five times historical performance. Very 

few of the down rades have resulted in the securities being rated below 

investment grade. 2h 

On occasion, a financing may be restructured to preserve a rating. 

Typically, a financing is restructured to provide added credit enhancement to 

support the pool. The sponsor generally has an additional incentive to add such 

support, so that it may sponsor additional finan~ings.2~’ 

C. Unrated Transactions 

Not all structured financings are rated. Most unrated structured financings 

are privately placed. These transactions are relatively small, and because of their 

size, sponsors may find it uneconomical to obtain a rating. 

The structure of unrated private placements varies. Some transactions look 

very similar to those that are rated and sold publicly, but many do not. For 

example, the issuer may not be bankruptcy-remote or an unrated servicer may 

commingle the cash flow with its own funds. The assets may not consist of a 

representative sampling of the portfolio; in fact, in some transactions the sponsor’s 

entire portfolio may be securitized. Finally, these transactions may not have any 

%See Annual Report: 1990 Review b 1991 Outlook, MOODY‘S STRUCTURED FINANCE RESEARCH 

& COMMENTARY (Special Report;), 3991, at 3. 

237The Division knows of only two financings that have been downgraded below investment 

grade. According to S&P, it is highly unlikely that an AAA rated asset-backed issue suddenly 

could be downgraded below investment grade as a result of some unforeseen event, given the 

structure of such highly rated transactions. See Asset-Backed Event Risk and the Seller’s Rating, 

STANDARD & POOR’S CREDITREVIEW, June 1990, at 15. 

238See, e.& Steven Lipin, Citicmp Acts to Prop Rating of its Securities, WALL ST. J., Oct. 24,1991, 

at C1. 

The Treatment of Structured Finance under the Investment Company Act 63 
credit enhancement. Investors may not be concerned about the lack of these 

attributes because they are involved in structuring the transaction, and are 

familiar with the sponsor and the a~sets.2~' 

Some unrated financings have been sold publicly. Many of these 

financings were mortgage-backed securities that were sold prior to the enactment 

of SMMEA?40 Today, almost all publicly offered financings issue at least one 

highly rated class of securities. 

Unlike rated structured financings, there have been instances where 

unrated structured financings have defaulted. The largest and most notable of 

these defaults occurred in 1985, when Equity Programs Investment Corporation 

("EPIC"), and certain of its affiliates, defaulted on approximately $1.4 billion in 

mortgages and privately placed mortgage-backed securities.241 

Beginning in 1975, EPIC organized, syndicated, operated, and served as 

general partner of real estate limited partnerships with interests in model homes 

that were purchased from home b~ilders.2~~ Subsequently organized 

partnerships invested in unsold homes also purchased from home builders. Much 

of the partnership property was located in the southwest section of the United 

States. Mortgages on the properties were obtained from an EPIC affiliate, 

typically at ninety-five percent of the properties' appraised value. EPIC 

represented that, during the period of the partnership, the residential units were 

to be leased back to the builders or leased for tenant occupancy, with an EPIC 

239For example, banks often invest in structured financings sponsored by their customers. 

*%ee Sears Mortgage Securities Corp. (pub. avail. May 21,1985) (stating that traditional shelf 

registered "mortgage related securities" were direct pass-through securities that differed from the 

definition of the term "mortgage related security" in section 3(a)(41) of the Exchange Act (15 U.S.C. 

3 78c(a)(41)) "primarily because they had not received a rating from a nationally recognized 

statistical rating organization"). 

241The first two EPIC-sponsored financings were rated by S&P and investors did not 

experience any loss. Those offerings were structured differently from the unrated financings that 

were subsequently issued (and that defaulted) in terms of, for example, their underlying collateral 

and loss coverage. See infra notes 248-249 and accompanying text. 

242The facts summarized below are derived in part from the opinion issued in re EPIC 

Mortgage Ins. Litig., 701 F. Supp. 1192 (E.D. Va. 1988), uff'd in part, redd in part, sub nom. Foremost 

Guaranty Corp. v. Meritor Sav. Bank, 910 F.2d 118 (4th Cir. 1990). The EPIC default resulted in 

extensive litigation initiated by two insurance companies that had insured some of the mortgages 

backing the defaulted securities. See infru note 247 and accompanying text. 

64 CHAPTER 1 
affiliate managing the property. The mortgage obligations were to be paid 

through the rental income, builders' rebates to EPIC (called "rental deficit 

contributions"), the limited partner's capital contributions, and if necessary, 

advances from EPIC. EPIC represented that funds obtained through these sources 

would be used for the sole benefit of each individual partnership. Under the 

contemplated arrangement, the properties would be sold, typically after four 

years, and the partnership liquidated, with the profits distributed to the 

~artners.2~~ By mid-1985, EPIC managed over 18,000 partnership homes owned 

by more than 350 limited partnerships. 

From January 1980 through July 1985, EPIC privately placed approximately 

$935 million in pass-through securities backed by pools of mortgages on 

partnership properties. Credit enhancement consisted of private mortgage 

insurance that covered up to a certain percentage of any An EPIC 

affiliate was the servicer, with the underlying mortgages assigned to an 

independent trustee. 

The actual operation of the EPIC enterprise differed significantly from that 

which was represented. First, EPIC partnerships did not operate as separate 

entities. Rather, EPIC commingled the funds of each partnership with its general 

funds, and then advanced such funds to the various partnerships based solely 

upon the partnership's needs. In addition, the EPIC companies were unable to 

sell the partnership properties and, beginning in 1984, new partnership interests, 

both of which resulted in shortfalls of funds. EPIC subsequently became 

dependent on the acquisition of new properties and the formation of new types 

of partnerships to generate the funds to pay obligations of older partnerships, and 

in turn, the outstanding mortgage-backed ~ecurities.2~~ In 1982, EPIC acquired 

Community Savings and Loan, Inc., to eliminate EPIC's cash concerns; as of May 

1985, the savings and loan had advanced over $26 million to the EPIC limited 

partnerships, primarily in the form of unsecured second trust mortgages on the 

*@In the earlier years of EPIC, when the interests primarily consisted of model homes that 

were leased back to the builder, positive cash flow was generated, and those partnerships were 

syndicated as "income" partnerships. In the later years of operation, the Partnerships were 

syndicated as tax shelters. 

244For example, on some of the pass-through securities sold immediately prior to EPIC's 

default, the first 25% of the risk was to be borne by a primary insurer, with a reinsurer bearing 

up to 33.3% of the excess loss. 

245EPIC created "pac-man" partnerships to purchase unsold units and to subsequently 

syndicate them. These partnerships only delayed the problem since these too had to be sold. 

The Treatment of Structured Finance under the Investment Company Act 65 
properties. When, in mid-August 1985, the savings and loan was eliminated as 

a funding SOU~C~,~~~ EPIC defaulted on its loans, with the partnerships being 

placed in bankruptcy shortly thereafter. The default resulted in extensive 

litigation brought by several of the mortgage insurers who unsuccessfully sought 

to rescind mortgage insurance coverage, claiming that the insurance was procured 

by and the subsequent liquidation of the insurer that had insured the 

largest amount of EPIC mortgages. 

The characteristics of the defaulted EPIC financings differed in significant 

respects from rated financings.248 For example, the assets used to back the 

securities -- particularly the mortgages on unsold units in developments -- were 

very risky, and to be rated would have required a loss coverage (ie., credit 

enhancement) far in excess of what was actually incorporated. This risk was 

exacerbated because appraisals of the units were often inflated, thereby 

understating the loan to value ratios of the mortgages. Also, the mort ages were 

concentrated heavily in a region that was not economically diverse. 28 

In addition, according to one rating agency, if the later financings had 

been rated, their structure would have been subject to much more scrutiny, 

including EPIC‘S role as servicer. In this regard, EPIC likely would not have been 

permitted to commingle the partnerships’ funds with its own. 

IV. The Investment Company Act and Structured Finance 

A. Applicability of the Act 

Most, if not all, structured financings meet the definition of investment 

company under section 3(a) of the Investment Company Act, because they both 

issue securities and are primarily engaged in investing in, owning, or holding 

2461n September 1985, the Maryland Deposit Insurance Fund placed the savings and loan into 

conservatorship, after determining that its fiscal mismanagement contributed to Maryland’s 1985 

savings and loan crisis. 

247See Foremost Guaranty Corp. v. Meritor Sav. Bank, 910 F.2d 118 (4th Cir. 1990). 

2480f course, ratings are not complete protection against fraud, such as was prevalent in the 

operation of the EPIC enterprise. 

249See EPIC Revisited, MOODY’S STRUCTURED FINANCE RESEARCH & COMMENTARY, Mar. 1988, 

at 3. 

66 CHAPTER 1 
securities?50 Structured financings use special purpose entities that issue debt 

or equity interests. In the context of the Investment Company Act, the financial 

instruments held by the issuers in structured financings generally have been 

considered to be securities?51 

Because the structured finance market did not exist in 1940, the Act was 

not drafted to regulate or exclude structured financings. The drafters of the Act 

simply were attempting to devise a regulator framework for the types of 

investment companies that existed at that time. 2& 

Not surprisingly, structured financings cannot operate under the Act's 

requirements. For example, section 17(a) prohibits certain affiliates of registered 

investment companies from selling securities and other property to the investment 

250Section 3(a)(l) defines an investment company as any issuer of securities which "is or holds 

itself out as being engaged primarily, or proposes to engage primarily, in the business of 

investing, reinvesting, or trading in securities. 15 U.S.C. 5 80a-3(a)(l). Section 3(a)(3) defines an 

investment company as any issuer of securities which "is engaged or proposes to engage in the 

business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes 

to acquire investment securities [as that term is defined in the Act] having a value exceeding 40 

per centum of the value of such issuer's assets (exclusive of Government securities and cash items) 

on an unconsolidated basis." Almost all structured finanangs meet one, if not both, of these 

definitions. See C. Thomas Kunz, Securities Law Considerations, in THE ASSET SECLJRITIZATION 

HANDBOOK 347, 374 (Phillip L. Zweig ed., 1989) ("because the issuer in an asset securitization 

transaction (whether a grantor trust, a finance subsidiary, or an asset-backed securities issuer) 

issues a 'security' and holds 'receivables' of some kind, which are both 'securities' and 'investment 

securities' within the Investment Company Act, an exemption from compliance therewith or a 

,safe-harbor' thereunder must be sought."). 

251See, eg., SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY 

GROWTH, H.R. REP. No. 2337,89th Cong., 2d Sess. 328 (1966) [hereinafter PPI REPORT] (stating that 

notes representing the sales price of merchandise, loans to manufacturers, wholesalers, retailers 

and purchasers of merchandise or insurance, and mortgages and other interest in real estate are 

investment securities for purposes of the Act). See also inpa notes 333-339 and accompanying text. 

252See, e.g., Investment Trusfs and Investment Companies: Hearings on S.3580 Before a Subcomm. of 

the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 43 (1940) [hereinafter 2940 Senate 

Hearings] (statement of Robert E. Healy, Commissioner, SEC) ("[Tlhe bill does not attempt to set 

up an ideal form of investment company and then compel all companies to conform to the ideal. 

Its provisions have been scrupulously adapted to the existing diversities of investment company 

organizations and functions."). Although interests in pools of mortgages were sold to the public 

in the 1930's and in fact raised a number of investor protection concerns (see supra note 151, there 

is no indication that Congress or the Commission intended them to be covered by the Act. 

Section 3(c)(5)(C), discussed infva notes 263-269 and accompanying text, excepts many, if not most, 

of these issuers. See 15 U.S.C. 5 80a-3(c)(5)(C). 

The Treatment of Structured Finance under the Investment Company Act 67 
~ompany.2~~ Ina structured financing, this section would prohibit the 

sponsor's sale of assets to the issuer, or any substitution of assets by the sponsor. 

In addition, section 18 limits management investment companies from issuing 

senior securities, which includes debt. These restrictions are fundamentally 

inconsistent with the operations of virtually all securitized credit offerings. 

Thus, sponsors must find a way to avoid application of the Act. They 

must either structure their transactions to come within one of the statutory 

exceptions to the definition of investment company or seek exemptive relief from 

the Commission. 

1. Statutory Exceptions 

Although section 3(c) of the Act excepts from the definition of investment 

company a number of issuers, only two exceptions are particularly relevant to 

private sector structured financings: sections 3(c)(5) and 3(~)(1)?~~ 

a. Section 3(c)(5) 

Many structured financings have relied on section 3(c)(5), which, as 

enacted in 1940 and amended in 1970, was intended to except issuers engaged 

primarily in the factoring, discounting, or real estate busines~es.~~ Such 

activities were "generally understood not to be within the concept of a 

*For a more detailed discussion of section 17(a), see Chapter 12. 

exceptions may be available for a limited number of private sector structured 

financings. For example, some structured financings may be able to avoid application of the Act 

by relying on section 3(c)(4), which excepts issuers whose businesses are substantially confined 

to making small loans, industrial banking, or similar businesses. In addition, some financings 

may be able to rely on section 3(c)(6), which pertains to holding companies of entities in the 

businesses described in sections 3(c)(3), 3(c)(4), and 3(c)(5). The "bad bank finanangs have 

received bank charters and relied on section 3(c)(3). Some financings sponsored by the federal 

government are excepted from the Act by section 203). See, e.g., Cleary, Gottlieb, Steen & 

Hamilton (pub. avail. Jul. 18, 1991) (no-action position regarding proposed CBOs sponsored by 

issuers created and controlled by the RTC). 

255S. REP. NO. 1775, 76th Cong., 3d Sess. 13 (1940); H.R. REP. NO. 2639,76th Cong., 3d Sess. 

12 (1940); S. REP. NO. 184,91st Cong., 1st Sess. 37 (1969); H.R. Rep. No. 1382,91st Cong., 2d Sess. 

17 (1970). See also 1940 Senate Hearings, supra note 252, at 181-182 (testimony of David Schenker, 

Chief Counsel, SEC Investment Trust Study). 

68 CHAPTER 1 
conventional investment company which invests in stocks and bonds of corporate 

issuers. 11256 

Section 3(c)(5) was added at the request of sales finance companies. By its 

terms, the section excepts: 

[alny person who is not engaged in the business of issuing 

redeemable securities, face-amount certificates of the installment 

type or periodic payment plan certificates, and who is primarily 

engaged in one or more of the following businesses: (A) purchasing 

or otherwise acquiring notes, drafts; acceptances, open accounts 

receivable, and other obligations representing part or all of the sales 

price of merchandise, insurance, and services; (B) making loans to 

manufacturers, wholesalers, and retailers of, and to prospective 

purchasers of, specified merchandise, insurance, and services; and 

(C) purchasing or otherwise acquiring mortgages and other liens on 

and interests in real estate. 

Thus, to be within section 3(c)(5), an issuer may not issue certain types of 

securities and also must be primarily engaged in one or more of the businesses 

enumerated in the section. 

Many sponsors of structured financings have relied on section 3(c)(5) to 

avoid regulation under the Act. Virtually no structured financings issue 

redeemable securities, face-amount certificates, or periodic payment plan 

 certificate^?^^ (Certain other issuers are required to register under the Act 

256PPI REPORT, supra note 251, at 328. In 1940, the exclusion was limited to factoring, 

discounting and real estate businesses that did not engage in issuing face-amount certificates of 

the installment type or periodic payment plan certificates. This limitation was in response to the 

abuse found prior to 1940 in the sale of these types of securities, usually to relatively 

unsophisticated investors, by companies, including those of the type that would have been 

excluded by this provision but for the limitation. See 1940 Senate Hearings, supra note 252, at 182 

(statement of David Schenker). In 1970, Congress amended section 3(c)(5) to prohibit the issuance 

of redeemable securities. The purpose of the amendment was to prevent excepted companies 

from capitalizing on the popularity of open-end investment companies by selling shares of 

redeemable securities. Investment Company Amendments Act of 1970, Pub. L. No. 91-547,s 2(a), 

3(b), 84 Stat. 1413 (1970) (codified us amended at 15 U.S.C. §§ 80a-2(a)(32), 3(c)(5)). 

257Section 2(a)(32) (15 U.S.C. 5 80a-2(a)(32)), defines "redeemable security" to be "any security, 

other than short-term paper, under the terms of which the holder, upon its presentation to the 

issuer or to a person designated by the issuer, is entitled . . . to receive approximately his 

proportionate share of the issuer's current net assets, or the cash equivalent thereof." Numerous 

(continued ... ) 

The Treatment of Structured Finance under the Investment Company Act 69 
because they issue redeemable securities, even though they invest in section 

3(c)(5) assets. For example, so-called GNMA funds, i.e., issuers that invest in 

GNMA certificates, register as open-end investment companies or unit investment 

trusts because they issue redeemable securities.)258 

To rely on section 3(c)(5), a structured financing must be "primarily 

engaged" in one or more of the types of businesses described in subparagraphs 

(A), (B), and (C). The issues relevant to whether a structured financing comes 

within subparagraphs (A) or (B) differ somewhat from those relevant to whether 

a structured financing comes within subparagraph (C). Accordingly, we discuss 

subparagraphs (A) and (B) separately from subparagraph (C). 

(1) Subparagraphs (A) & (B) 

Subparagraph (A) refers to the purchase or other acquisition of notes and 

other evidences of indebtedness representing the sales price of merchandise, 

insurance, and services. Subparagraph (B) refers to the making of loans to 

manufacturers, wholesalers, retailers, and prospective purchasers of specified 

merchandise, insurance, and services. A number of no-action letters have been 

issued to entities holding a wide variety of receivables, loans to refinance 

receivables, open accounts receivable, and loans to manufacturers of specified 

merchandise and ~ervices.2~~ When the assets the entity acquires are not 

257(...continued) 

no-action positions have been issued with respect to the definition of redeemable security in the 

context of section 3(c)(5). For example, a debt security may be a redeemable security. See 

G.A.B.E. Inc. (pub. avail. Feb. 15,1974). No-action positions also have treated a security that may 

be presented to the issuer by the holder as not being a redeemable security if substantial 

restrictions are placed on the right of redemption. See, e.g., California Dentists' Guild Real Estate 

Mortgage Fund I1 (pub. avail. Jan. 4, 1990) (restrictions included prohibiting investors from 

withdrawing funds during the first 12 months after purchase, after which withdrawal could occur 

only on a quarterly basis and with 90 days prior notice; limiting the amount an investor could 

withdraw; and limiting the amount available to fund withdrawals). 

258Some GNMA certificates are considered to be section 3(c)(5)(C) assets. See infra note 267 

and accompanying text. 

259See, e.g., Ambassador Capital Corporation (pub. avail. Oct. 6,1986) (no-action position taken 

with respect to entity holding airline credit card accounts receivable); Days Inn of America, Inc. 

(pub. avail. Dec. 30, 1988) (no-action position taken with respect to entity holding franchise fee 

receivables). 

Whether an issuer is "primarily engaged" in one or more of these activities for purposes of 

subsections (A) and (B) generally has not been an issue. But see Econo Lodges of America, Inc. 

(pub. avail. Dec. 22, 1989) (no-action position taken where franchise royalty fee receivables 

(continued ... ) 

70 CHAPTER 1 
related to the purchase or sale of specific merchandise, insurance, or services, the 

no-action request has been refused?60 

Many non-mortgage structured financings, including financings backed by 

automobile loans, boat loans, credit card receivables, and equipment leases, 

among others, rely on subparagraphs (A) or (B)F61 All of these financings are 

backed by assets that relate to the purchase or sale of specified goods or services. 

Other financings, such as those using commercial loans, student loans, and CBOs, 

typically are unable to rely on these subparagraphs because their assets do not 

meet the criteria of subparagraphs (A) and (B). 

Not all financings backed by revolving credit card accounts receivable are 

able to rely on subparagraph (A). Although most financings using these assets 

259( ... continued) 

obtained from entity's parent represented at least 55% of the entity's assets, and at least 85% of 

the net proceeds from the sale of notes backed by the receivables were subsequently loaned to 

parent). This issue, however, has been the subject of a substantial number of no-action letters in 

the context of section 3(c)(5)(C). See, eg., no-action letters cited infra notes 263-269 and 

accompanying text. 

260See, e.g., World Evangelical Development Ltd. (pub. avail. Apr. 5,1979) (no-action position 

declined where entity would issue general purpose commercial loans); Educational Loan 

Marketing Associations, Inc. (pub. avail. Feb. 4, 1986) (no-action position declined where entity 

would issue debt secured by the repayment of student loans financed by proceeds from the debt 

offering). 

261See Letter from Thomas R. Smith, Jr., Brown & Wood, on behalf of Merrill Lynch Capital 

Markets et al., to Kathryn B. McGrath, Director, Division of Investment Management, SEC 7-14 

(Feb. 27,1990), File No. S7-11-90 (arguing that credit card receivable financings are excepted from 

the Investment Company Act). The Investment Company Institute ("ICI") has argued that 

financings backed by credit card receivables are investment companies and should be regulated 

under the Act. The IC1 has argued that section 3(c)(5) does not exempt these financings because 

they have little in common with traditional commercial finance companies. The IC1 has also 

argued, among other things, that the relationships among the participants of credit card-backed 

financings give rise to the types of potential Self-dealing and conflicts of interest concerns that the 

Investment Company Act is intended to address. See Letter from the IC1 to Richard C. Breeden, 

Chairman, SEC 2 (Feb. 2,1990), File No. S7-11-90. The IC1 had previously sent a similar letter to 

the Division. See also Letter from Tamar Frankel, Professor of Law, Boston University, to Kathryn 

B. McGrath, Director, Division of Investment Management, SEC 1,6 (Jan. 26,1990), File No. S7-11- 

90 (suggesting the Commission design a regulatory system under the Act for financings backed 

by credit card receivables). 

The Treatment of Structured Finance under the Investment Company Act 71 
have not registered as investment companies in reliance on this section, they 

generally have limited the percentage of their assets that consist of obligations 

resulting from cash advances out of concern that, since such advances are general 

purpose consumer loans, a significant amount of these assets could cause a 

financing to be outside section 3(~)(5).2~~ 

(2) Subparagraph (C) 

Many issuers of mortgage-backed securities and similar products have 

relied on subparagraph (C). An issuer seeking to rely on this exception must 

invest at least fifty-five percent of its assets in mortgages and other liens on and 

interests in real estate ("qualifying interests"). An additional twenty-five percent 

of the issuer's assets must be in real estate related assets, although this percentage 

may be reduced to the extent that more than fifty-five percent of the issuer's 

assets are invested in qualifying interests.263 

A number of no-action letters have been issued explicating what are 

qualifyin interests for purposes of subparagraph (C). These interests include fee interest^!^ leaseholds:65 and interests fully secured by a mortgage solely 

on real estate (''whole mortgages")266. Qualifying interests also include agency 

"whole pool certificate^."^^^ The rationale is that the holder of these certificates 

generally has the same economic experience as the investor who purchases the 

underlying mortgages directly, including the receipt of both principal and interest 

payments and the risk of prepayment on the underlying mortgage loans, 

notwithstanding the guarantees provided by the agencies. 

262See Letter from Cleary, Gottlieb, Steen & Hamilton to Jonathan G. Katz, Secretary, SEC 62 

(Oct. 12, 1990), File No. S7-11-90 [hereinafter Cleary, Gottlieb Study Comment]. 

263See, e.g., Greenwich Capital Acceptance, Inc. (pub. avail. Aug. 8,1991); United Bankers, Inc. 

(pub. avail. Mar. 23,1988). Generally, there are no restrictions on the investment of the remaining 

20% of the issuer's assets. See, e.& NAB Asset Corp. (pub. avail. June 20,1991). 

264United Bankers, Inc., supra note 263. 

265See Health Facility Credit Corp. (pub. avail Feb. 6,1985). 

266See Medidentic Mortgage Investors (pub. avail. May 23, 1984). 

267See, e.g., American Home Finance Corp. (pub. avail. Apr. 9,1981) (GNMA certificates). The 

term "whole pool certificate" means a certificate that represents the entire ownership interest in 

a particular pool of mortgage loans. A "partial pool certificate" is a certificate that represents less 

than the entire ownership interest in a particular pool of mortgage loans. 

72 CHAPTER 1 
Agency partial pool certificates that represent less than the entire 

ownership interest in a pool of mortgages ("partial pool certificates") have not 

been considered to be qualifying interestsF6' The rationale is that an investor 

in partial pool certificates obtains greater diversification and is subject to a 

different prepayment risk than an investor who purchases the underlying 

mortgages directly. An investment in partial pool certificates is viewed as being 

more like an investment in the securities of the issuer, rather than an investment 

in the underlying mortgages. Partial pool certificates are considered to be a real 

estate related asset for purposes of meeting the twenty-five percent portion of the 

"primarily engaged in" test, however. Similarly, residual interests are not 

qualifying interests for purposes of subparagraph (C),269 although they may be 

considered to be real estate related assets. 

b. Section 3(c)(l) 

Many financings rely on section 3(c)(l). This section, known as the "private 

investment company" exception, excepts any issuer whose outstanding securities 

(other than short term paper) are beneficially owned by not more than 100 

persons. In addition, the issuer may not make, or propose to make, a public 

offering.270 Thus, sponsors that wish to offer publicly securitized credit in the 

United States cannot rely on this exception. 

2. Exemptive Relief 

Some structured financings have obtained exemptive relief from the 

Commission under section 6(c), the general exemptive provision of the 

Most of the exemptive orders concern CMOS and REMICs whose assets consist 

268See Nottingham Realty Securities, Inc. (pub. avail. Apr. 19, 1984). 

269See, e.g, M.D.C. Holdings (pub. avail. May 5, 1987). While agency whole pool certificates 

are deemed to be qualifymg interests, it is the position of the Division that whole pool (or partial 

pool) certificates issued by private issuers are not qualifymg interests under section 3(c)(5)(C). 

A no-action position has not been requested regarding private residential mortgage loans held by 

the issuer under funding agreements (Le., promissory notes secured by mortgage loans or 

mortgage Certificates). Nevertheless, these assets are not generally considered to be qualifying 

interests for purposes of section 3(c)(5)(C). Some issuers investing primarily in partial pool 

certificates and other real estate related assets have received exemptive relief. See infig note 272 

and accompanying text. 

270For a more detailed discussion of section 3(c)(l), see Chapter 2. 

27*15 U.S.C. 9 80a-6(c). 

The Treatment of Structured Finance under the Investment Company Act 73 
primarily of partial pool certificates and other mortgage-related assets that are not 

qualifying interests under section 3(~)(5)(C)?~~ In this regard, the legislative 

history of SMMEA indicates that Congress expected the Commission to provide 

appropriate administrative relief if the Investment Compan Act unnecessarily 

hindered development of the secondary mortgage market?' The Commission 

has issued approximately 125 orders under section 6(c) exempting structured 

financings backed by mortgage-related a~sets.2~~ 

In general, the orders have required, among other things, that (i) the 

securities be rated in the top two categories by at least one rating agency; (ii) 

substitution of the assets be limited quantitatively and qualitatively; (iii) the assets 

be held by an independent trustee, qualified under the Trust Indenture Act, who 

has a first priority perfected security or lien interest in the collateral; (iv) the 

servicer not be affiliated with the trustee; and (v) the issuer be audited annually 

to determine that the cash flow is sufficient for payments of principal and interest. 

These conditions have been imposed to ensure the safety and adequacy of the 

assets, to guard against self-dealing by sponsors, and to address concerns about 

capital structure. Many of the conditions parallel requirements imposed by the 

rating agencies as a condition of receiving a rating in the top two categories. The 

exemptive orders also have imposed conditions limiting the sale of residual 

interests. 

Another type of structured financing that has received exemptive relief is 

the sale of federal government loans. Pursuant to the Omnibus Reconciliation 

2nIn addition to CMOS and REMICs, exemptive orders have been issued to special purpose 

corporations organized by home builders that wish to issue, among other things, bonds secured 

by pledges of mortgage loans on single family residences constructed by the builders, called 

"builder bonds." See, eg., American Southwest Financial Corp., et al., Investment Company Act 

Release No. 12771 (Oct. 29,1982),47 FR 50594 (Notice of Application) and 12844 (Nov. 23,1982), 

26 SEC Docket 1251 (Order). 

273See S. REP. NO. 293, 98th Cong., 2d Sess. 9 (1983). The Senate Committee on Banking, 

Finance and Urban Affairs considered whether the Investment Company Act should be amended 

to except issuers investing in certain mortgage-backed securities from the definition of investment 

company, but reported legislation without such an exception in light of the Commission's 

administrative flexibility. Id. 

274See, e.g., Mortgage Bankers Financial Corp. I et al., Investment Company Act Release Nos. 

16458 (June 28, 1988), 53 FR 25226 (Notice of Application) and 16497 (July 25, 1988), 41 SEC 

Docket 814 (Order); Shearson Lehman CMO, Inc., Investment Company Act Release Nos. 15796 

(June 11,1987), 52 FR 23246 (Notice of Application) and 15852 (July 2,1987), 38 SEC Docket 1403 

(Order). 

74 CHAPTER 1 
Acts of 1986275 and 1987,276 the federal government sold portions of the loan 

portfolios of certain government agencies. Most of these sales could not be 

completed without exemptive relief from the Investment Company Act, although 

some were excepted under section 3(c)(5). A total of seven financings either 

received exemptions under sections 6(c) and 6(e) from most provisions of the Act, 

including the registration or registered as closed-end 

mana ement investment companies and received exemptions from much of the 

Act?' The conditions imposed were similar to those for mortgage-related 

financings, requiring, among other things, that (i) the debt obligations be rated in 

at least one of the two highest rating categories; (ii) the residual interests be 

privately placed with a maximum of 100 sophisticated and experienced investors; 

and (iii) the pool of assets be fixed, except for limited substitution^?^^ 

2750mnibus Budget Reconciliation Act of 1986, Pub. L. No. 99-509,100 Stat. 1874 (1986). 

2760mnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203,101 Stat. 1330 (1987). The 

objectives of the loan asset sales program were to reduce the government's cost of administering 

credit programs by transferring administrative responsibility to the private sector; improve loan 

origination and documentation; determine the actual subsidy of a federal credit program; and 

reduce the budget deficit in the year of sale. See OMB Guidelines on Loan Asset Sales, reprinted 

in GENERAL ACCOUNTING OFFICE, LOAN ASSET SALES: OMB POLICIES WILL RESULT IN PROGRAM 

OBJECTIVES NOT BEING FLJLLY ACHIEVED, App. I1 (Sept. 1986). 

2nGenerally, the issuer agreed to be subject to section 26 (15 U.S.C. 5 8Oa-26) (with certain 

exceptions), which applies to unit investment trusts; section 36 (15 U.S.C. § 80a-35), which subjects 

certain affiliated persons of an investment company, including a depositor of a unit investment 

trust, to liability for breaches of fiduciary duty involving personal misconduct; section 37 (15 

U.S.C. 8Oa-361, which makes it a crime for any person to steal or embezzle any funds or assets 

of a registered investment company; and sections 38 through 53 (15 U.S.C. 55 80a-37 to -52) (often 

referred to as the "jurisdictional" sections of the Act) to the extent necessary to enforce compliance 

with sections 26, 36, and 37. 

278Some issuers registered as investment companies because of tax advantages. See, eg., 

College and University Facility Loan Trust, Investment Company Act Release Nos. 15903 (July 31, 

1987),52 FR 28890 (Notice of Application) and 15990 (Sept. 18,1987), 39 SEC Docket 348 (Order). 

279The only other exemptive order issued by the Commission with respect to structured 

finanangs involved trusts established by the Government of Israel to facilitate the financing of 

its housing program for Soviet refugees. Each trust was to issue non-redeemable pass-through 

certificates backed by a single promissory note, the payment of which would be guaranteed by 

the full faith and credit of the United States. See Government of Israel, Investment Company Act 

Release Nos. 18047 (Mar. 18,1991), 56 FR 11806 (Notice of Application) and 18069 (Mar. 28,1991), 

48 SEC Docket 943 (Order). 

The Treatment of Structured Finance under the Investment Company Act 75 
B. Effects of the Regulatory Structure 

As a practical matter, the Act today treats similar types of structured 

financings very differently. Some structured financings are subject to prohibitive 

conditions imposed by the Act, while others are exempted from the Act entirely. 

Structured financings that are excepted by section 3(c)(5) or that have 

obtained exemptions may be sold publicly or privately in the United States, 

overseas, or both. Financings that do not fit within section 3(c)(5) or that are 

unable to obtain an exemption either must be privately placed in the United 

States or sold overseas. Each may be problematic for the sponsor. For example, 

private placements prevent sponsors from diversifying and expanding their 

investor bases and ensuring a liquid secondary market for the securities. The 

success of international offerings has been mixed. 

The differing regulatory treatment affects the development of the 

structured finance market. The most widely accepted types of structured 

financings are those that are sold on the domestic public market, while those 

structured financings whose distribution is limited to private placements or 

overseas offerings have lagged in development. Many United States investors 

that may wish to purchase these securities are prohibited from doing so, even 

though the securities may be highly rated by a rating agency, because the 

securities are not offered publicly. Thus, today the Act distorts the market by 

enforcing a distinction that does not reflect the economic reality that any asset 

with a relatively predictable cash flow, whether it may be classified as a 

"commercial" instrument or a "financial" instrument, may be securitized. 

The attempt by market participants to fit financings into section 3(c)(5) is 

understandable, but unproductive, consuming much time of sponsors, 

underwriters, and their counsel, as well as the time of the Commission and its 

staff. A preferable alternative is to develop a coherent approach to the treatment 

of structured financings under the Investment Company Act. Such an approach 

must take into account the unique operation of the industry and also address any 

investor protection concerns resulting from the pooling of securities. 

V. The Reform of the Treatment of Structured Finance 

In determining how the Investment Company Act should treat private 

sector structured finance, it is important to recognize that the purpose of 

structured finance is quite different from that of most investment companies. 

Structured finance primarily is a financing technique that integrates the capital 

76 CHAPTER 1 
markets with borrowers seeking access to those markets; the sponsors of asset 

securitizations are seeking a source of financing. In contrast, investment 

companies are intended to provide the advantages of professional management, 

diversification, and economies of scale to investors. 

Nevertheless, the fundamental issue is whether structured financings in 

fact present opportunities for abuse similar to those presented by registered 

investment companies. We conclude that all structured financings, regardless of 

the nature of their underlying assets, theoretically present the opportunities for 

abuses similar to those that led to the enactment of the Investment Company Act. 

The industry, however, has been remarkably free of abusive practices, due 

primarily to the requirements thus far imposed by the market itself. 

Based on this record, we recommend that the Commission adopt an 

exemptive rule to permit all structured financings to offer their securities publicly 

in the United States without registering under the Investment Company Act, 

provided that the financings meet certain conditions that would codify present 

industry practice. The conditions would limit the scope of the rule to issuers that 

invest in assets that have scheduled cash flows; primarily hold the assets to 

maturity (i.e., have limited portfolio management); issue nonredeemable securities; 

issue publicly only debt or debt-like securities rated in the top two investment 

grades, the payment of which depends on the cash flows of the underlying assets; 

and whose assets are held by a qualified trustee. In addition, we recommend that 

the Commission seek public comment on whether section 3(c)(5) should be 

amended so that all structured financings are subject to the same requirements 

for exemption. 

In this section, we analyze the potential for abuse in structured financings 

in light of the structural and operational differences between investment 

companies and structured financings, the actual experience over the last two 

decades, options for rationalizing the treatment of structured finance under the 

Act, and the outlines of the exemptive rule we recommend. We also discuss 

whether section 3(c)(5) should be amended. 

A. The Potential for Abuse in Structured Financings 

Because structured financings have some of the principal features of 

registered investment companies -- that is, they are issuers of securities and hold 

pooled financial assets -- the key question is whether those financings share with 

traditional investment companies the potential for the types of abuses that led to 

the enactment of the Investment Company Act. These abuses include 

The Treatment of Structured Finance under the Investment Company Act 77 
opportunities for self-dealing and overreaching by insiders, inaccurate valuation 

of assets, excessive leverage, and inadequate protection of assets. 

1. Overreaching and Self-Dealing by Insiders 

One of the most significant concerns addressed by the Investment 

Company Act is overreaching and self-dealing by investment company insiders. 

The Commission's 1940 Investment Trust Study documented numerous instances 

in which investment companies were managed for the benefit of their sponsors 

and affiliates to the detriment of investors. For example, the "dumping" by 

sponsors of worthless or unmarketable securities into investment companies was 

prevalent. Accordingly, the Act and the rules, thereunder prohibit or restrict most 

transactions with insiders?" 

Structured financings present a number of opportunities for analogous 

forms of self-dealing and overreaching. For example, a sponsor could engage in 

a form of dumping by selling to a special purpose issuer assets of insufficient 

credit quality and amount to produce adequate cash flows to make full and 

timely payment on the fixed income securities sold to the public?81 

Self-dealing and overreaching by insiders after the initial deposit of assets 

also could harm investors. For example, a sponsor could substitute inferior assets 

for the assets originally placed in the pool, thereby jeopardizing payments to 

investors. In the case of structured financings backed by revolving credit card 

receivables and asset-backed commercial paper programs, similar abuses could 

arise, because a sponsor may sell additional assets to the issuer after the financing 

first offers securities to the public. 

In addition, the servicer often reinvests idle cash in short-term investments 

when there is a timing mismatch between the collections from the underlying 

assets, and distributions to investors?s2 Absent appropriate restrictions, a 

servicer, particularly if it is the sponsor or an affiliate, might reinvest the cash in 

280See Chapter 12. 

2810f course, section 17(a) (15 U.S.C. 5 80a-l7(a)), the Investment Company Act's prohibition 

on principal transactions with insiders, does not apply to the initial deposit of securities into a 

UIT, a transaction which is analogous to the transfer of assets to a special purpose issuer in a 

structured financing. 

282See supra note 112 and accompanying text. 

78 CHAPTER 1 
the sponsor's own risky securities, thereby benefitting the sponsor at the expense 

of investors, should the sponsor default. 

Finally, the potential for other types of self-dealing exist where the sponsor 

or its affiliate acts as servicer. Perhaps the most serious type is where the 

sponsor/servicer has other dealings with the obligors on the assets in the pools, 

which decrease its incentive to service the debt pr0perly.2~~ For example, in 

a structured financing backed by credit card accounts receivable, the sponsor 

owns the accounts from which the receivables are generated and typically 

continues to service them through and beyond the course of the financing. If the 

sponsor is also a retailer, it may alter the accounts' terms (e.g., interest rate 

charged, credit limit, minimum payment schedule), in order to generate additional 

receivables from the accounts, or to preserve its relationship with its customers. 

Because the receivables generated from the accounts are continually sold to the 

issuer during the "interest only" period of the transaction:84 the amended terms 

could prevent timely payment to investors. Also, in acting as servicer, the 

sponsor may commingle collections on the assets with its own funds, thereby 

subjecting investors to the risk of the sponsor's insolvency. 

On the other hand, the nature of the securities issued in most structured 

financings alters and to some extent reduces the concerns about self-dealing. 

Losses on the assets in the pool are borne first by parties other than fixed-income 

investors, such as the holder of the residual interest and the servicer?@ Thus, 

self-dealing affects fixed-income investors only to the extent it completely erodes 

the cash flow cushion provided by those with more junior interests in the pool. 

2. Inaccurate Valuation of Assets 

Before 1940, investment companies often valued their portfolios 

inaccurately, resulting in unfair and discriminatory practices in the pricing of their 

securities. The Act now generally requires that investment companies value their 

assets at market value. 

2830f course, for many financings, the fact that the sponsor services the assets is desirable 

because the sponsor is familiar not only with the type of business from which the underlying 

assets were generated, but also with many of the characteristics of the specific assets. 

284See supra note 157 and accompanying text. 

285Because the holders of residual interests are almost invariably sophisticated institutional 

investors, they presumably are able to evaluate the risk of self-dealing, inaccurate valuation of 

assets, excessive leverage, and inadequate protection of assets. 

The Treatment of Structured Finance under the Investment Company Act 79 
In a structured financing, the valuation of the assets (albeit on a cash flow 

basis) is critical because payments on the fixed-income securities sold to public 

investors depend primarily or entirely on those assets. Because structured 

financings primarily issue unredeemable fixed-income securities whose payment 

is derived solely or primarily from the cash flow on the underlying assets, and 

are evaluated by investors and others on that basis, continuous valuation of assets 

on a market value basis is not as critical. Arguably, however, the sponsor may 

misvalue assets used in structured financings, resulting in a structured finance 

issuer holding assets whose cash flow has little relationship to the securities 

issued in the financing. 

3. Excessive Leverage 

Prior to 1940, some investment companies were highly leveraged, issuing 

large amounts of "senior securities," in the form of debt or preferred stock. This 

often resulted in the companies being unable to meet their obligations to the 

holders of these securities. This risk was exacerbated when equity holders 

redeemed their shares. Excessive issuance of senior securities also greatly 

increased the speculative nature of the common stock of the companies. In 

response, the Act limits the issuance of senior securities by management 

investment 

In theory, leverage concerns are somewhat applicable to structured 

financings, given the degree of leverage used in virtually all structured financings. 

Financings could be established with assets that would not produce the cash 

flows needed to meet the obligations to the investors of the fixed-income 

securities. The effect of leverage on residual interest holders in structured 

financings is not truly an Investment Company Act concern, however, since those 

investors invariably are extremely so histicated investors, not the type of investor 

the Act was intended to protectF8' Moreover, because structured financings 

do not issue redeemable securities, there is no threat of redemption or 

repurchases of equity that could endanger senior security holders. 

4. Protection of Assets 

In numerous instances prior to 1940, the assets of investment companies 

were not adequately protected. In many cases, controlling persons of investment 

286See Investment Company Act § 18/15 U.S.C. 5 8Oa-18. For a general discussion of the Act's 

limits on leverage, see Chapter 11. 

287There is no requirement that residual investors be sophisticated, however. 

80 CHAPTESR 1 
companies commingled the investment company's assets with the investment 

adviser's, and then proceeded to take the assets on loan?88 Accordingly, the 

Act requires that investment company assets be held by qualified cu~todians.2~~ 

The assets of a structured financing also may be subject to risk, absent the 

imposition of adequate safeguards. For example, the servicer could commingle 

collections with its own funds and then use them in such a manner as to 

jeopardize their availability to pay investors. The insolvency of the servicer also 

could affect payment to investors. 

B. The Lack of Abuse in Structured Financings 

Although structured financings present opportunities for abuses analogous 

to those that led to the enactment of the Investment Company Act, the Division 

is aware of only one case of abuse, despite the large volume of securitized 

transactions in the last de~ade.2~' The relative lack of abuse appears to result 

from the interplay of three factors. 

The first factor is that most issues have been sold to institutional investors 

with a high degree of financial sophistication. Such investors often conduct their 

own due diligence reviews prior to investing and are involved in the structuring 

of the finan~ing.2~~ 

The second factor is that most structured financings, and virtually all that 

have been offered publicly, have contained at least one class of highly rated 

~ecurities.2~~ In order for a financing to obtain a high rating, the rating 

agencies have required that it be structured to minimize the chance that investors 

in the rated securities will receive less than full and timely payment. Although 

the rating agencies' requirements are intended to reduce the credit risk of a 

structured financing, many of them have the added effect of protecting investors 

from the types of abuses discussed above. 

288See, e.g., 2940 Senate Heun'ngs, supra note 252, at 89 (statement of Carl S. Stern, Attorney, 

SEC). 

289See Investment Company Act § 17(f) (15 U.S.C. 5 8Oa-l7(f)), and rules 17f-lr17f-2, 17f-3,17f4, and 17f-5 (17 C.F.R. §§ 270.17f-1, .17f-2, .17f-3, .17f-4, and .17f-5). 

'290See supra notes 241-249 and accompanying text for a discussion of the EPIC defaults. 

291See supra note 74 and accompanying text. 

*=See supra note 188 and accompanying text. 

The Treatment of Structured Finance under the Investment Company Act 81 
For example, the rating agencies require that the sponsor of a financing sell 

to the issuer assets of sufficient amount and credit quality to produce adequate 

cash flows to pay principal and interest on the fixed-income securities being rated. 

Thus, they either review the specific assets to be deposited, or the method by 

which they will be selected, and typically require safeguards such as independent 

auditor confirmation that the selection is random. In addition, the rating agencies 

impose limitations on the substitution of assets in the pool, the reinvestment of 

cash flows, and servicing decisions. These requirements protect investors from 

self-dealing and overreaching by sponsors. 

The rating agencies also address concerns related to the valuation of assets. 

In order to determine whether the pooled assets will produce the necessary cash 

flows, the rating agencies, among other things, use an actuarial or statistical 

analysis to make generalized assumptions about the pool’s performance, as it 

relates to the scheduled rincipal and interest payment on the rated securities and 

any other debt issued?’ This analysis is fundamentally an assessment of the 

degree of leverage of the issuer. 

Finally, the rating agencies impose requirements that are intended to 

ensure the safety of a financing’s assets. They have developed criteria to address 

concerns that the assets would be jeopardized in the event of the sponsor’s 

ins~lvency?’~ In addition, the rating agencies generally prohibit the servicer 

from commingling the underlying cash flows with its own funds unless the 

servicer is rated as high as the fixed-income securities. They also may require 

that a trustee hold the assets in an account in trust for the benefit of the investors 

in the tran~action.2~~ 

The third factor that appears to have prevented abuses is that most 

sponsors of structured financings have been large, well-known companies. These 

entities have an interest in ensuring that their financings are structured and 

operated properly, in part because any problems associated with an offering will 

affect their ability to offer other financings in the future. For the sponsors, the 

financings are a critical means to address their capital needs. In addition, 

sponsoring a financing that defaults could adversely affect a sponsor’s public 

293See supra notes 212,220-221 and accompanying text. 

294See supra notes 196-206 and accompanying text. 

295~ee S&P’S STRUCTURED FINANCE CRITERIA, supra note 108, at 23-24. The involvement of the 

rating agencies also alleviates to a large extent any concerns regarding the complex capital 

structures of structured financings. Investor confusion resulting from complex capital structures 

was one of the concerns that led to the enactment of section 18 of the Act. 

82 CHAPTER 1 
image?96 We note, however, that this third factor appears to be much less 

important than the other two, since many structured financings have been 

sponsored by depository institutions that subse uently were declared insolvent. 

None of these financings has suffered a default. 997 

C. Recommendation -- An Exemptive Rule 

Reforming the treatment of structured finance under the Investment 

Company Act initially presents two choices. Structured financings could be 

considered investment companies and required to register and comply with a set 

of provisions specially tailored for the structured finance industry. Alternatively, 

structured financings could be exempted under conditions that serve both to draw 

lines of demarcation between traditional investment companies and structured 

financings and to ensure that structured financings continue to be free of abuse. 

Because the structured finance industry has been virtually free of abuse, 

we recommend against attempting to bring all structured financings under the 

Investment Company Act. It is difficult and probably futile to attempt to address 

any investor protection concerns that have not yet arisen. The drafters of the 

Investment Company Act had as their inspiration the problems that plagued the 

investment company industry in the 1920's and 1930's. Fortunately, the 

structured finance industry has not presented such problems. 

Just as important, any attempt to apply even a limited array of the Act's 

provisions is likely to disrupt an increasingly important form of finance, 

depriving investors of attractive, low risk investments and foreclosing low cost 

borrowing for businesses. For example, the Investment Company Institute ("ICI") 

has submitted a proposal to regulate structured financings as essentially unit 

investment trusts that issue only unredeemable securities (including debt)F9' 

While the proposal addresses some of the problems structured financings would 

face in attempting to comply with the Act, such as the Act's limits on leverage, 

*%Sponsors also often retain some form of economic interest in the financing after issuance, 

either by providing recourse, acting as servicer (whose fee is typically a percentage of cash flow), 

or retaining the residual interest or subordinate securities. Thus, any losses from overreaching 

or other abuses typically will affect the sponsors, providers of external credit enhancements, or 

sophisticated investors first. 

2"See supra note 206 and accompanying text. 

298See Memorandum from the Investment Company Institute on the Regulation of AssetBacked Arrangements under the Investment Company Act (undated), File S7-11-90 [hereinafter 

IC1 Memorandum]. 

The Treatment of Structured Finance under the Investment Company Act 83 
it nevertheless would prohibit a number of practices that have not, to date, 

harmed investors. 

For example, the proposal would limit reinvestment of cash proceeds to 

short-term government securities and cash items. While this would prevent 

possible abuses, it would also reduce returns to investors by prohibiting shortterm reinvestment in highly rated commercial paper and similar, relatively low 

risk investments. 

The proposal also would subject structured financings to the Act's 

restrictions on joint transactions with affiliates. Some of the mechanisms that 

have been created to strengthen structured financings likely would be prohibited 

by those restrictions. For example, spread accounts in which excess cash flow is 

used as a credit support might be prohibited, since both the issuer and the 

sponsor have an interest in the cash flow from that account?99 

In addition, the proposal would subject structured financings to the Act's 

restrictions on distributions of long-term capital gains.300 While these 

restrictions are appropriate for registered investment companies, since they reduce 

the possibility that equity investors may be led to believe that capital gain income 

will be regular, they are not needed to protect investors in fixed-income securities 

and actually could prevent timely payment of principal and interest. 

Finally, the proposal would require that a pool be entirely fixed at 

inception, with only limited exceptions. Thus, it would prohibit some of the 

newer generation of structured financings, such as credit card master trusts and 

asset-backed commercial paper programs which, although they are not truly 

"managed" in the sense that management investment companies are, undergo 

some degree of change in the composition of their assets. It would also prohibit 

CBOs, since most of these structures provide for limited discretionary 

management of the pool?o1 While we agree that structured financings should 

not engage in asset management to the same degree as a typical open-end or 

*%The proposal also would subject structured financings to section 17(a) of the Act, which 

prohibits principal transactions with affiliates, except for the initial deposit of assets and limited 

substitutions. Id. Thus, it would prohibit short-term reinvestment in a sponsor's commercial 

paper or in reverse repurchase agreements with the sponsor. Rating agencies have not objected 

to such transactions, if sufficient safeguards are present (e&, commercial paper investments are 

permitted where the sponsor is rated as highly as the financing). 

3001nvestment Company Act 5 19(b), 15 U.S.C. § 80a-l9(b). 

301See supra note 163 and accompanying text. 

84 CHAPTER 1 
closed-end investment company, we do not believe that the strict limits of the IC1 

proposal are necessary. 

Moreover, regulation under the Investment Company Act is likely to stifle 

innovation in structured finance. In just the last few years, the market has gone 

through a number of evolutionary changes that have benefited investors. 

Originally, most financings used a simple pass-through payment structure, but 

investors expressed concern over uncertain maturities and prepayment risk. 

Sponsors, underwriters, and rating agencies have designed a number of 

mechanisms to respond to these concerns, including multi-class structures, 

retention by the sponsor of an interest that absorbs the prepayment risk, shortterm reinvestment of proceeds, the addition of new assets during the life of a 

financing, and master trusts. Designing a regulatory approach that does not 

inadvertently prevent or interfere with future development of the market would 

be extremely difficult. 

For these reasons, we believe that the Commission should exempt all 

structured financings from the definition of investment company, subject to a 

number of conditions that would properly delineate the operational distinctions 

between investment companies and structured financings, address the investor 

protection concerns that could arise in this market, and accommodate future 

innovation. The Division recommends that the Commission promulgate a rule 

under the Investment Company Act to exempt all structured financings that meet 

the following conditions: 

(1) the issuer holds only "eligible assets," which would be defined to 

include assets that require regularly scheduled cash payments, such as 

notes, bonds, debentures, evidences of indebtedness, certificates of deposit, 

leases, installment contracts, interest rate swaps, repurchase agreements, 

guaranteed investment agreements, accounts receivable, chattel paper, 

cumulative preferred stock, guarantees, annuities, and participations or 

beneficial ownership interests in any of the foregoing; 

(2) the issuer primarily holds the assets to maturity or for the life of the 

issuer and does not acquire assets for the purpose of generating income 

from the trading or resale thereof or from the appreciation in value thereof; 

(3) the issuer does not issue any redeemable securities; 

(4) all securities offered and sold to the issuer to persons other than 

affiliates of the issuer or qualified institutional buyers, as defined in rule 

The Treatment of Structured Finance under the Investment Company Act 85 
144A under the Securities Act:302 

(a) entitle the holder to receive: 

30217 C.F.R. 5 230.144A. 

(i) a stated principal amount and either (A) interest based on 

such principal amount calculated by reference to a fixed rate, 

a floating rate determined periodically by reference to an 

index that is generally recognized in financial markets as a 

reference rate of interest, or a rate or rates determined 

through periodic auctions among holders and prospective 

holders or through periodic remarketing of the security, or 

(B) an amount equal to specified portions of the interest 

received on the assets held by the issuer; 

(ii) a stated principal amount at maturity and no interest 

payments; or 

(iii) interest payments only, based on a notional or stated 

principal amount and determined in the manner described 

in clauses (i)(A) or (B); 

(b) at the time of issuance are rated in one of the two highest grade 

debt rating categories by at least one nationally recognized 

statistical rating organization that is not affiliated with the issuer; 

and 

(c) entitle the holder to receive payments that depend on the cash 

flow from the assets in paragraph (I) and that do not depend on the 

market value of those assets; and 

(5) the issuer’s assets are held by a trustee that meets the requirements of 

section 26(a)(l) of the Act, that is not affiliated with the issuer, and that 

executes an agreement concerning the securities described in paragraph (4) 

containing provisions to the effect set forth in sections 26(a)(3) and 26(a)(4) 

of the Act. 

We believe that the conditions of the proposed rule would draw a clear 

dividing line between structured financings and investment companies that are 

required to register under the Act. At the same time, by codifying existing 

practices, the proposed rule would minimize the potential for the types of abuses 

86 CHAPTER 1 
addressed by the Investment Company Act, without limiting existing practices 

that have not harmed investors. It also should permit the continued evolution of 

structured financings. For example, it would permit the establishment of 

continuous structures and structures with differing underlying assets. All 

structured financings, regardless of their assets, should be able to rely on this 

exemp tion?03 

We now discuss each of the major requirements of the proposed rule. 

Many of the details of the rule would be refined in the notice and comment 

process. 

1. Eligible Assets 

The definition of eligible assets is intended to encompass all financial assets 

that produce regular cash flow and thus could be used in a structured financing. 

In other words, the only limitation is that the assets have a regularly scheduled 

cash flow of the type that may be statistically analyzed by rating agencies and 

investors. Common stock and similar equity instruments would not be eligible 

assets. 

Obviously, this would be a substantial departure from the current practice 

under the Investment Company Act. Today, the Act exempts structured 

financings based on the type of assets held and not on their structure. The rule 

would recognize that the ability to use an asset successfully in a structured 

financing turns on whether it has a relatively predictable cash flow. 

2. Holding Assets to Maturity 

This condition is intended to limit the amount of "management" permitted 

in a structured financing, while allowing enough flexibility to accommodate some 

of the recent innovations in the market. We have considered a number of 

different ways to articulate the limits on the adjustment of a financing's portfolio. 

For example, one commenter responding to the Study Release304 

suggested requiring that an exempt financing have a fixed portfolio, with assets 

being removed and new assets being added only where assets are in default or 

in imminent danger of default, where assets do not conform to the representations 

3mMost commenters advocated an exemptive rule similar to the one we recommend. See, eg., 

304Study Release, sup note 12. 

Cleary, Gottlieb Study Comment, supra note 262, at App. A. 

The Treatment of Structured Finance under the Investment Company Act 87 " ., 
and warranties made in good faith by the sponsor, or where necessary to wind 

up the affairs of the issuer?05 Another commenter suggested simply limiting 

substitutions of assets by requiring that the substituted assets be of the same 

general type as the original assets and not aggregate more than forty percent of 

the amount of assets deposited?06 A third suggested allowing a greater degree 

of substitution, limiting it only by the requirement that the issuer not acquire 

assets for the purpose of generatin profits from the trading or resale thereof or 

appreciation in the value there~f?'~ All of these alternatives attempt to draw 

a line between structured financings and typical management investment 

companies with regard to the degree of "management" of assets. 

Drawing this line is complicated somewhat by the increase in the number 

of financings that do not have a fixed pool. Today, most structured financings, 

regardless of the nature of their assets, have some limited degree of 

"management" with respect to substitution of assets, reinvestment of proceeds, 

and, of course, servicing, but the amount of discretion in the servicer or manager 

varies greatly among financings depending on the terms of the transaction and 

on the assets being securitized?08 It is apparent that the structured finance 

market is developing structures that have ever more flexibility in the selection of 

assets, such as the master trust format for credit card receivables and asset-backed 

commercial paper programs. Both involve issuers that continuously purchase 

assets and issue securities. These structures have advantages over more 

traditional structured financings in that, among other things, they permit sponsors 

'05See id. Merrill Lynch suggested that if new assets are substituted for assets originally held 

by the issuer, the new assets must be of the same type as the assets originally held, including the 

same maturity and coupon, of at least the same quality as such original assets held, and insured 

or guaranteed to the same extent as the original assets. Letter from Merrill Lynch & Co., Inc. to 

Jonathan G. Katz, Secretary, SEC IX-16 (Oct. 18,1990), File No. S7-11-90 [hereinafter Merrill Lynch 

Study Comment]. 

306See Letter from the American Bar Association, Section of Business Law, 1940 Act Structured 

Finance Task Force to Jonathan G. Katz, Secretary, SEC 14-15 (Oct. 16, 1990), File No. S7-11-90 

[hereinafter Structured Finance Task Force Study Comment]. 

'07See Letter from Citicorp to Jonathan G. Katz, Secretary, SEC 11 (Oct. 10,1990), File No. S7- 

11-90 [hereinafter Citicorp Study Comment]. 

'@For example, because the balance of pooled credit card receivables will fluctuate over time, 

financings backed by these assets often are structured to permit the sponsor to assign receivables 

from other accounts to the pool if the originally designated accounts do not generate enough 

receivables to support the securities. Similarly, because of the volatility and low credit quality 

of high yield bonds, financings using these assets are structured so that the bonds may be traded 

to prevent the deterioration of the pool, although typically the anticipated degree of management 

and trading is much less than that of a high yield bond fund. 

88 CHAPTER 1 
to securitize assets without the cost of establishing new structures for each 

offering. They also reduce prepayment risk?09 Accordingly, it is foreseeable 

that more of these types of financings will be used in the future. 

Nevertheless, structured financings do not involve management to the 

same degree or for the same purpose as do management investment companies. 

Even in a CBO offering, where the manager may have some discretion to sell 

bonds of issuers that may soon default or bonds that have appreciated greatly 

and buy new bonds, investors choose to invest based primarily on the expected 

cash flows from the assets initially deposited, not on the trading expertise of the 

manager?" 

We believe that the increase in financings involving changing pools of 

assets necessitates imposing a condition that permits additions to the assets in the 

pool, but ensures that an exempt financing is not in fact managed in the same 

manner as a typical investment company. Preliminarily, we recommend requiring 

that the issuer primarily hold its assets until their maturity or for the life of the 

issuer and not acquire them for the purpose of trading them for profit. This will 

provide a standard that accommodates a limited degree of discretion as is 

common presently in structured financings, but ensures that exempted issuers are 

not in fact truly management investment companies?11 Given the importance 

of this condition and wide range of suggestions made by commenters responding 

to the Study however, we recommend that the Commission 

specifically request comment on this point. 

309See supra text following note 176. 

310See Letter from Edward F. Greene to Thomas S. Harman, SEC 14 (Dec. 16, 19911, Equitable 

Capital Management Corp. (pub. avail. Jan 6, 1992) ("Who the collateral manager is does not 

influence investors' perceptions of the riskheturn characteristics of an investment in a particular 

CBO nearly to as great an extent as with actively managed pooled investment vehicles, because 

investors are not relying predominantly on the investment adviser's ability and expertise to trade 

the securities in the portfolio."). 

311A~ discussed in Section V.C.4. below, we also recommend including a condition to the 

exemption requiring that the securities sold to the general public be rated in at least one of the 

top two investment grades. We expect that rating agencies will evaluate closely the degree of 

discretion given to the manager or servicer of the issuer's assets. 

312Study Release, supra note 12. 

The Treatment of Structured Finance under the Investment Company Act 89 
3. Prohibition on the Issuance of Redeemable Securities 

Like most of the other conditions, this condition would codify industry 

practice. In addition, it would ensure that no exempted issuer behaves like an 

open-end investment company, which could lead to investor confusion. It would 

also prevent junior security holders from redeeming their interests, thereby 

endangering payment to public investors. 

4. The Securities Issued to the Public 

The fourth condition relates to the nature of the securities issued in the 

financings. It has three related requirements: all of the issuer's securities sold to 

public investors must be fixed-income securities; all of these securities must be 

rated in one of the two highest investment grade categories; and payment on the 

securities must be derived from the cash flow on the assets in the pool. 

The first requirement would codify present practice by recognizing that 

structured financings almost invariably issue debt or debt-like securities. Such 

securities are very different from the equity interests sold by most registered 

investment ~ompanies.3'~ The rule is intended to give issuers a great deal of 

flexibility in choosing the type of fixed-income security to be issued. For 

example, it would allow the issuance of principal-only or interest-only securities. 

We recommend that the Commission specifically request comment on 

whether the rule should permit the ublic sale of IO and PO certificates, because 

of their volatility and complexity?" While we do not wish to impose, in effect, 

investor suitability requirements, one of the Act's concerns is complex ca ita1 

structures. At least arguably, IO and PO certificates raise similar concerns. 85 

-~ 

313UITs may not issue debt or senior equity securities. See 15 U.S.C. Q 4(2). Open-end 

management investment companies may not issue senior securities, except that they may borrow 

from banks as long as they have 300% asset coverage. Investment Company Act Q 18(f)(1), 15 

U.S.C. Q 80a-l8(f)(l). Closed-end management investment companies may issue debt and senior 

equity, but must have 300% asset coverage for debt and 200% asset coverage for senior equity. 

Investment Company Act Q 18(a), 15 U.S.C. Q 80a-l8(a). While face-amount certificate companies 

primarily issue debt securities, there are only two such issuers registered with the Commission. 

314Tw0 commenters suggested that sales of IO certificates should be restricted because of their 

extreme volatility. See Cleary, Gottlieb Study Comment, supra note 262, at 73; Merrill Lynch Study 

Comment, supra note 305, at 9-13. PO certificates also are volatile. 

315We note that the ICI's proposal would not restrict the capital structure of structured 

financings, since it would permit a registered financing to offer any combination of debt and 

equity securities. IC1 Memorandum, supra note 298, at 2. 

90 CHAPTER 1 
The second requirement, that all publicly offered fixed-income securities 

be rated in one of the two highest investment grades by a rating agency, also 

generally codifies present practice?16 Virtually all structured financings have 

sold only rated securities publicly; most publicly offered securities have been 

rated in one of the top two categories. Securities that are not so rated or are 

unrated at all (e.g., residual interests) could be sold only to qualified institutional 

buyers, as defined in rule 144A, or affiliates of the issuer. We believe it would 

be appropriate to request comment on whether the rule should require restrictions 

on resale of residual interests and similar securities. 

This requirement would ensure that every structured financing sold to the 

public is subject to the scrutiny of at least one rating agency. It would rely on the 

agencies to continue to impose requirements that prevent self-dealing and 

overreaching, misvaluation of assets, and inadequate asset coverage. We believe 

it is appropriate to rely on the rating agencies in light of the outstanding record 

of rated financings. We appreciate the concerns expressed by the IC1 that relying 

on rating agencies is inappropriate because they are private organizations whose 

sole function is to give opinions as to the credit quality of certain securities;17 

but believe that the benefits, particularly in light of the agencies' past performance 

in rating structured financings, are obvious, while the concerns are theoretical at 

best. 

For example, today virtually all publicly-offered financings are rated in one 

of the top two investment grade ratings. Thus, the rule simply would take 

advantage of the role played today by the agencies and is not likely to distort the 

agencies' decision-making processes. 

We believe also that the process of analyzing the sufficiency of the cash 

flow from particular assets is uniquely suited for the statistical methodology used 

by rating agencies to evaluate structured financings. We do not suggest that the 

agencies are infallible and that in the future every highly rated financing will be 

completely free of abuse. Nevertheless, to the Division's knowledge, no rated 

structured financing has defaulted on payments and relatively few have been 

downgraded?" We conclude that relying on the agencies will provide a very 

316We recommend using the term "nationally recognized statistical rating organization," which 

317See ICI Memorandum, supra note 298, at 2 ("The Institute does not believe that it is the 

function of the federal securities laws to regulate the public distribution of securities based on 

'quality standards', whether determined by the SEC or private rating agencies."). 

is used in a number of other instances in the federal securities laws. See infva note 319. 

31sSee supra notes 236-237 and accompanying text. 

The Treatment of Structured Finance under the Investment Company Act 91 
high degree of protection against abuses. Of course, even if the Commission were 

to attempt to regulate structured financings under the Investment Company Act, 

not all abuses would be prevented. 

Further, reliance on the rating agencies as an element of the regulation of 

the securities markets is far from novel. Ratings first were used in 1975 in rule 

15~3-1 under the Exchange Act. Today, ratings play a role in at least eleven 

separate provisions in the federal securities laws and rules?19 In addition, 

ratings are used in a number of instances in federal banking law and in the 

securities laws of other nations?20 In fact, France requires ratings for all 

structured financings?21 Moreover, the Commission has already issued more 

than 100 orders exempting mortgage-related asset-backed securities financings 

and government loan sales from the Act, conditioned on, among other things, 

ratings in one of the top two investment grades?22 We are not aware of any 

abuses in those financings or any indication that the orders somehow have 

interfered with the rating process. 

Finally, while adoption of another rule relying on rating agencies may 

heighten concern over their unregulated status, we do not believe it should delay 

adoption of an exemptive rule for structured financings. 

Although under this second requirement publicly offered securities would 

need to be rated in one of the top two investment grades, the Commission 

ultimately may decide to require only investment grade ratings. Many 

commenters suggested that the securities receive a rating in one of the top two 

319Section 3(a)(41) of the Exchange Act, 15 U.S.C. 5 78c(a)(41); Securities Act rules 415,436,17 

C.F.R. !j§ 230.415,436; General Instructions to Forms S-3, F-2, and F-3/17 C.F.R. 59 239.13,31, and 

32; Exchange Act rules lob-6 and 15c3-1,17 C.F.R. 5s 240.1Ob-6 and 15c3-1; Investment Company 

Act rules 2a-7, 1Of-3, and 12d3-1; 17 C.F.R. 270.2a-7,10f-3, and 12d3-1. 

320See Neil D. Baron, Statutory and Regulatory Uses of Ratings in the United States and other 

Jurisdictions (Jan. 30,1989). 

321~ee French Asset-Backed Criteria, STANDARD & POOR'S CREDITREVIEW: STRUCTURED FINANCE, 

June 1990, at 26. 

3"See supra notes 275 & 279 and accompanying text. 

92 CHAPTER 1 
categories, thereby in effect codifying the present market req~irement.3~~ Some 

commenters, however, favored requiring only investment grade ratings?24 

The third requirement of this condition would limit the availability' of the 

exemption to those financings that issue securities whose payment depends on 

the cash flows generated by the income-producing assets in the underlying pool. 

This criteria is intended to limit the scope of the rule to the predominate types of 

structured financings that are currently being offered, rather than the few "market 

value" financings that have been offered. Thus, financings using a market value 

structure, where payment of the securities is derived from the aggregate market 

value, would not be exempted from the rule. Such transactions raise issues that 

differ from those financings utilizing the cash flow structure. Although this 

structure has been used in the past, primarily to securitize high yield bonds, its 

popularity has diminished significantly, and accordingly, we do not believe this 

limitation will significantly affect the structured finance market. Of course, 

financings wishing to use the market value structure could still be sold in private 

placements or overseas, or seek exemptive relief. 

5. Independent Trustee 

The rule would require, in part, that all of the issuer's assets not needed 

for servicing be held in a segregated account by a qualified trustee or custodian 

for the benefit of the investors. Accordingly, all property of the pool at the time 

of issuance would be deposited with the trustee. This provision is intended to 

mitigate the concerns relating to the protection of assets. It also would require 

that the trustee execute an agreement providing that it shall not resign until the 

financing has been completely liquidated or until a successor trustee has been 

designated, and providing that records be kept of the security holders of the 

issuers. These requirements generally would codify industry practice. 

This condition would not specify the other duties of the trustee. Thus, it 

would not address the other aspect of the role of the trustee in a structured 

financing: monitoring the issuer's obligation to investors and acting to protect the 

323See, eg., Letter from Financial Security Assurance Inc. to Jonathan G. Katz, Secretary, SEC 

4 (Oct. 9, 1990), File No. S7-11-90; Merrill Lynch Study Comment, supra note 305, at IX-13. 

324See Cleary, Gottlieb Study Comment, supra note 262, at 50; Structured Finance Task Force 

Study Comment, supra note 306, at 20-21. The rating agencies have told the Division that a 

financing whose securities are rated investment grade is structured in such a way as to address 

Investment Company Act concerns. A related issue is whether requiring a rating from more than 

one agency would be appropriate. While we believe that the vast majority of financings are rated 

by at least two agencies, we do not wish to impose unnecessary costs. 

The Treatment of Structured Finance under the Investment Company Act 93 
interests of investors if the financing defa~lts.3~~ The specific obligations of the 

trustee invariably are set forth in the P&S agreement, indentures, or similar 

documents. Of course, financings that publicly offer debt obligations are subject 

to the Trust Indenture Act;26 and, accordingly, the trustees of these financings 

would generally be subject to those duties and responsibilities required by that 

Act. Similarly, this condition would not prevent issuers from continuing the 

industry practice of contractually agreeing to comply with the requirements of the 

Trust Indenture Act, even if they are exempt from that Act. We believe, however, 

that the Commission should request comment on whether other duties should be 

~pecified.3~~ 

The proposed rule would require that the trustee be a bank that is 

qualified to serve as a trustee of a UIT. Accordingly, the trustee of a securitized 

asset pool would be required to be a bank whose aggregate capital, surplus, and 

undivided profits is not less than $500,000?28 The definition of qualified 

trustee would be consistent with industry practice. 

The trustee also could not be affiliated with the issuer. Accordingly, a 

sponsor, servicer, or credit enhancer of a structured financing could not act as 

tru~tee.3~~ This limitation is necessary because the sponsor, which also may act 

as servicer, often is a bank that would otherwise be a qualified trustee. Absent 

this prohibition, the sponsor could act in all capacities of the pool, without any 

independent party monitoring the issuer's obligations to investors. The trustee 

in a publicly offered structured financing usually is a commercial bank that is not 

affiliated with any parties to the transaction. In addition, the requirement that the 

trustee not be affiliated with the issuer is similar to a requirement in the Trust 

Indenture 

**** 

325See supra notes 114-121 and accompanying text. 

326See supra notes 114-117 and accompanying text. 

327We considered but rejected proposing that the requirement found in section 26(a)(2) also 

should apply, because that provision's limits on fees are not compatible with the fee structure 

typically. used in structured financings. 

328See Investment Company Act 5 26(a)(l); 15 U.S.C. § 26(a)(l). 

3%s requirement would not preclude the trustee from owning securities issued by the 

structured financing. 

330See supra note 117. 

94 CHAPTER 1 
We believe that these conditions effectively will codify the protections 

imposed by the marketplace, thus addressing Investment Company Act investor 

protection concerns. At the same time, we believe that the rule is sufficiently 

flexible to allow for continued innovation in the structured finance market. 

We also believe that the rule would meet the standards of section 6(c). 

That is, it would be appropriate in the public interest and consistent with the 

protection of investors and the purposes intended by the policy and provisions 

of the Act. The rule would be in the public interest since it would facilitate the 

continued development of the structured finance market, a vitally important 

financing technique. More importantly, we believe that the track record of 

structured finance and the conditions of the proposed rule clearly would enable 

the Commission to find that the rule would be consistent with the protection of 

investors and the purposes fairly intended by the provisions of the Investment 

Company Act. 

The legislative history of the Act indicates that, at a minimum, section 6(c) 

enables the Commission to address situations that Congress either could not have 

considered because they did not exist in 1940, or had not considered because they 

were 0verlooked.3~' Congress did not consider structured finance in 1940 or 

1970. Moreover, to the extent that Congress later considered the development of 

the structured finance industry and the Commission's exemptive authority, it 

indicated that the Commission should use its exemptive authority flexibly to 

accommodate the industry's development, where consistent with investor 

pr0tection.3~~ 

D. Other Options Considered 

As an alternative, the Division considered, but rejected, recommending that 

structured financings be conditionally exempted from the Act through a statutory 

amendment, rather than by rule. We believe that rulemaking is preferable, since 

it gives the Commission the opportunity to craft the specific terms through the 

notice and comment process. It also is likely the quickest means to address the 

331See, e.g., 1940 Senate Hearings, supra note 252, at 872 (Commissioner Healy stated that "it 

seemed possible and even quite probable that there might be companies - which none of us have 

been able to think of - that ought to be exempted.") See also In re J.D. Gillespie, 13 S.E.C. 470,477 

(1943) ("Section 6(c) was included in the Act to give us authority to deal with the situations that 

could not be foreseen at the time of its passage, to exempt persons, securities or transactions 

falling within the literal language of the Act but not fairly intended to be governed by its policy 

or provisions."). 

%*See supra note 273. 

The Treatment of Structured Finance under the Investment Company Act 95 
problems caused by the Act today. Rulemaking also gives the Commission the 

flexibility to amend the requirements for exemption, if later market developments 

indicate that the rule is impeding the market or that additional safeguards are 

needed. 

We also rejected another option for the reform of the treatment of 

structured finance under the Investment Company Act. A few commenters 

argued that the definition of "security" under the Investment Company Act, like 

the definition of security under the Securities Act and the Exchange Act, should 

be interpreted to exclude "commercial" instr~ments.3~~ Under this approach, 

structured financings backed by these instruments, as well as other types of 

pooled vehicles that invest in these assets, would not be considered investment 

companies. This proposal is based on the fact that many investment companies 

primarily invest in liquid, readily marketable instruments, while structured 

financings generally are used to convert illiquid debt instruments into liquid 

capital market instruments. In our view, this approach neither reflects the true 

nature of the structured finance market nor addresses potential investor protection 

concerns. 

Many of the illiquid debt instruments are assets that are generated in a 

commercial context, such as mortgages and consumer receivables. Such 

instruments generally are not securities for purposes of the Securities Act and the 

Exchange Act, under the Supreme Court's analysis in Reves v. Ernst b Y0ung.3~~ 

In Reves, the Court stated that every note is presumed to be a security, but that 

the presumption can be rebutted by a showing that the note bears a strong 

resemblance to any of the notes on a judicially crafted list of notes that are not 

deemed to be securities, or if it is determined, looking to four factors identified 

in Reves, that the note should be on the list?35 Included on this list are notes 

%See, e.g., Memorandum from Sidley & Austin to the Division of Investment Management, 

on behalf of the National Commercial Finance Association, on the Application of the Investment 

Company Act of 1940 to the Asset-Backed Commercial Finance Services Industry, SEC 1-2,20,26- 

27 (Oct. 23,1987) [hereinafter Sidley & Austin Memorandum], accompanying Letter from Sidley 

& Austin, on behalf of the National Commercial Finance Association, to Jonathan G. Katz, 

Secretary, SEC (Oct. 9, 19901, File No. S7-11-90 [hereinafter Sidley & Austin Study Comment]. 

334110 S.Ct. 945, 951 (1990) (but holding demand notes in question to be securities). 

Commercial loans such as bank loans are securities for purposes of the Public Utility Holding 

Company Act of 1935,15 U.S.C. 55 79a to 792-6. 

335110 S.Ct. at 952. 

96 CHAPTER 1 
delivered in consumer financings and notes secured by residential 

m0rtgages.3~~ 

This approach would be problematic in several respects. Although there 

are some differences in the types of assets typically held by registered investment 

companies and those held by structured financings, there is a significant degree 

of overlap. Many registered investment companies invest in instruments that 

generally have been held not to be securities under the Securities Act or the 

Exchange Act. For example, man money market funds invest heavily in 

instruments such as time dep0sits.3~' Also, a number of closed-end investment 

companies have as their primary investments bank loan participations, which 

generally have not been deemed to be securities under the Securities Act and the 

Exchange Such issuers should remain subject to the Commission's 

jurisdiction under the Investment Company Many structured financings 

3361d. at 951. 

337See, e.g., Marine Bank v. Weaver, 455 U.S. 551 (1982) (holding that a bank certificate of 

deposit was not a security under the Securities Act and the Securities Exchange Act). 

=See, e.g., McVay v. Western Plains Corp., 823 F.2d 1395, 1399 n.4 (10th Cir. 1987); Union 

Planters Nat'l Bank v. Commercial Credit Business Loans, 651 F.2d 1174, 1185 (6th Cir.), cot. 

denied, 451 U.S. 91 (1981). At note 5 of its brief, as amicus curiae, in the case of Banco Espunol De 

Credit0 TI. Security Pacific National Bunk (Nos. 91-7563, 91-7571 (2d Cir. 1992))) the Commission 

argued that certain short-term loan notes, bearing a "superficial resemblance to traditional loan 

participations" (id. at 21, were securities because, among other things, they were purchased for an 

investment purpose rather than as part of a commercial lending business or to facilitate an 

independent business relationship with the borrower. Id. at 4. The Commission distinguished 

the notes in question from traditional loan participations, and distinguished this case from those 

cases holding that traditional loan participations are not securities. Id. at 14-15. See Chapter 11 

for a discussion of investment companies that invest in loan participations. 

3391n other words, while excluding commercial instruments from the disclosure requirements 

of the Securities Act and the Exchange Act is consistent with the purposes of those Acts, issuers 

that pool these instruments nevertheless may be functionally equivalent to, and present the same 

investor protection concerns as, investment companies that invest in securities that are registered 

under those Acts. See Brief for the United States as Amicus Curiae at 22-23, Marine Bank v. 

Weaver, 455 U.S. 551 (1982) ("While the language in the Investment Company Act's definition of 

the term 'security' is identical to that in the Securities Act, the regulatory context under the 

Investment Company Act differs fundamentally from that under the Securities Act and the 

Securities Exchange Act. The Investment Company Act broadly regulates the operation and 

management of investment companies. Because the relationship between a money market fund 

and its shareholders is identical to the relationship between any other investment company and 

its shareholders, and because the assets of both investment media are highly liquid and are subject 

to external management, investor protection requires that money market funds continue to be 

regulated under the Act."). 

The Treatment of Structured Finance under the Investment Company Act 97 
have as their primary assets instruments that are quintessentially securities, such 

as high yield bonds, industrial development bonds, and agency pass-through 

certificates. In addition, most structured financings provide for short-term 

reinvestment of proceeds collected on their assets; that reinvestment typically is 

in liquid instruments such as Treasury bills and commercial paper. 

Moreover, a Reves approach would treat structured financings 

inconsistently: structured financings backed by commercial assets would be 

unconditionally exempt, while financings using financial assets would be required 

to register and comply with the full complement of the Act's requirements. Thus, 

for example, financings backed by agency securities or high yield bonds could not 

be publicly offered in the United States, even if their structural protections were 

similar to, or better than, exempt financings. The practical effect of this approach 

would be to continue to distort the market for structured financings. 

E. Section 3(c)(5) 

Finally, we address whether section 3(c)(5) should be amended to remove 

structured financings from the exception. Absent an amendment, structured 

financings that come within the exception would not be required to meet the 

conditions of our proposed rule for exemption. Thus, structured financings 

would continue to be treated inconsistently, depending solely on the type of 

assets being securitized?40 

Amending section 3(c)(5) is not a simple matter. Of course, any 

amendment to exclude structured financings would need to be crafted so that 

finance companies or real estate businesses do not become subject to the Act. 

Some types of structured financings, however, possess attributes similar to those 

of commercial finance and mortgage banking companies. Moreover, the 

3mThere are other issues with respect to section 3(c)(5) that could be addressed through a 

statutory amendment. For example, one commenter asserted that current interpretations of 

sections 3(c)(5)(A) and 3(c)(5)(B) are unduly narrow, so that finance companies that provide loans 

secured by a pledge of the borrower's inventory and receivables cannot rely on the exception. 

See Sidley & Austin Study Comment, supu note 333, at 2. See also Sidley & Austin Memorandum, 

supra note 333, at 15-17, 25-27, 31-43. Such issues are outside the scope of our review of the 

treatment of structured financings, and the Division has not developed specific recommendations 

with regard to these matters. 

98 CHAPTER 1 
commercial finance and mortgage banking industries have evolved considerably 

since 1940 and it is difficult to make generalizations about them?41 

While structured financings appear at first blush to have some operational 

distinctions from finance companies, upon closer examination the dividing lines 

are far from clear. Thus, it is difficult to amend section 3(c)(5) in a way that 

would prevent structured financings from relying on the 3(c)(5) exception without 

also inadvertently preventing some finance companies from relying on the 

exception. 

The Division considered the suggestion made by the IC1 that section 3(c)(5) 

be amended to exclude issuers from the exception, and thus, bring within the Act, 

that do not have an "active Because there are structured finance 

issuers whose life extends beyond a single deposit of assets and issuance of 

securities, and whose acquisition of additional assets is made pursuant to 

carefully prescribed conditionsPG we are not certain that this distinction is 

feasible. 

The Division also considered whether section 3(c)(5) should be amended 

to exempt only those finance companies that are primarily engaged in the 

business of making, purchasing, or otherwise acquiring commercial assets (e.g., 

ies, drafts, open accounts receivable) from unaffiliated parties. Some major 

finance companies acquire assets from affiliates, however, or originate or acquire 

their assets to facilitate an affiliate's operating business. For example, a number 

of large finance companies originate loans to support sales by affiliates (eg., the 

finance companies owned by automobile manufacturers). Moreover, some 

341Non-mortgage structured financings have relied primarily on subparagraphs (A) and (B) 

of section 3(c)(5) to avoid regulation under the Act. See supra notes 259-262 and accompanying 

text. Apparently, the traditional distinctions between companies engaged in factoring, sales 

financings, and other types of commercial financing activities have been substantially reduced 

since 1940. Today, a finance company may be engaged in several kinds of financing activities or 

variations thereof. See Sidley & Austin Memorandum, supra note 333, at 5-6. Some finance 

companies originate loans, while others purchase loans or receivables, often from unaffiliated 

companies, which they typically hold to maturity. 

3421CI Memorandum, supra note 298, at page 2 of attachment thereto (suggesting adding the 

following sentence at the end of section 3(c)(5): "This exemption shall be applicable only to 

persons engaged in an active business, and not to limited purpose entities engaged in no other 

business other than investing in or owning securities and receivables which are organized after 

[date of enactment]"). 

343For examples, see supra discussions of master trusts (Section III.A.3.d.) and asset-backed 

commercial paper programs (Section III.A.3.e.). 

The Treatment of Structured Finance under the Investment Company Act 99 
structured financings, such as asset-backed commercial paper programs, obtain 

their assets through unaffiliated transactions, and accordingly could continue to 

rely on the exclusion. 

Finally, the Division considered recommending that the section be 

amended to provide that excluded companies must have internal management, 

in the form of their own officers and directors. At least preliminarily, we do not 

believe that this approach would provide meaningful distinctions. For example, 

while master trusts and asset-backed commercial paper programs do not have 

independent officers making credit determinations, they do have processes by 

which their assets are screened, pursuant to the terms of their organizational 

documents. If the exclusion were amended to require internal management, the 

sponsors of these issuers simply could add internal management to their 

structures, which would raise expenses, but would not increase investor 

protection. Also, many finance companies are wholly-owned subsidiaries of 

operating companies and the finance companies' managements are selected by the 

parent companies and cannot truly be said to be independent of the affiliates?44 

We also considered whether the range of assets section 3(c)(5)(C) issuers 

may hold should be narrowed. Although the section was intended to except 

mortgage bankers that originated, serviced, and sold mortgages, other types of 

issuers have relied on it. Based on the broad language of clause (C), the Division 

has taken the position that issuers primarily engaged in investing in loans secured 

by real estate may rely on the exception as long as the principal amounts of the 

loans are fully secured by real estate at origination and the market value of the 

loans are fully secured by real estate at the time the issuers receive the loans?45 

The Division also has issued favorable no-action positions with respect to certain 

instruments that represent an interest (in the nature of a security) in an entity 

engaged in real estate activities. Most significantly, the Division has said that 

"whole pool" agency certificates may be considered interests in real estate?46 

The Division has considered whether it should reconsider these positions. 

In particular, we believe that the whole pool interpretation may be unrealistic, 

since agency certificates clearly are in fact liquid securities and not interests in 

real estate. Moreover, whole pool holders in fact have a different economic 

3%Jntil recently, another distinction between structured financings and finance companies was 

that structured financings were not continuous operations. This distinction ended with the 

development of asset-backed commercial paper programs and master trusts. 

345See NAB Asset Corp., supra note 263. See also Citytrust (pub. avail. Dec. 19, 1990). 

346See supra note 267 and accompanying text. 

100 CHAPTER 1 
experience than mortgage holders, largely because of the agency guarantees and 

the resulting increased liquidity of their interests. 

. Because of the complexity of these issues, the Division believes that the 

Commission may wish to request public comment on the possible amendment of 

section 3(c)(5), including reversal of the whole pool interpretation, in the release 

accompanying the proposed exemptive rule for structured finanangs. 

VI. Conclusion 

The Division recommends that the Commission propose a rule exempting 

structured financings from the definition of investment company, subject to 

conditions that recognize and build upon the operational and structural 

distinctions between structured financings and investment companies. The 

Commission also may wish to request public comment on the scope of section 

3(c)(5) 

a 

The Treatment of Structured Finance under the Investment Company Act 101 
~ 

Chapter 2 

Private Investment Company 

Exceptions 

I. Introduction and Summary 

The Investment Company Act: under section 3(c)(l)p excepts from the 

definition of investment company "[alny issuer whose outstanding securities 

(other than short-term paper) are beneficially owned by not more than one 

hundred persons and which is not making and does not presently propose to 

make a public offering of its securities." The exception, often referred to as the 

"private investment company" exception, is used by a wide variety of issuers that 

provide important sources of capital to small businesses and others. At one end 

of the financial spectrum, small groups of investors known as investment clubs 

rely on it because registering and complying with the Act would be too costly. 

At the other end, well-capitalized investment pools with sophisticated investors 

rely on the exception to avoid substantive regulation under the Act. These pools 

include venture capital funds, acquisition vehicles, subsidiaries of large 

corporations formed to manage excess cash, leveraged buyout funds, hedge funds, 

and certain structured financings. 

To rely on section 3(c)(l), an issuer must meet both elements of the 

exception. It may not have more than 100 holders of its debt and equity 

securities, other than purchasers of its commercial paper, and it may not be 

making or presently proposing to make a public offering. While the public 

offering prohibition is relatively straightforward: the 100 investor limit is 

complicated by a two-part attribution provision intended to prevent 

circumvention of the limit through layers of intermediaries. Section 3(c)(l)'s 

'On March 11,1992, the Commission approved the Division's recommendations discussed in 

this chapter to amend section 3(c)(l) of the Investment Company Act and to create a new 

exception from the Act for issuers whose securities are held exclusively by qualified purchasers. 

These proposals were introduced in Congress as part of the Small Business Incentive Act of 1992. 

S. 2518, 102d Cong., 2d Sess. (Apr. 2, 1992); H.R. 4938, 102d Cong., 2d Sess. (Apr. 9, 1992). See 

Hearings on the Small Business Incentive Act of 1992, 102d Cong., 2d Sess. (Mar. 26, 1992). 

*Investment Company Act of 1940, 15 U.S.C. 5 8Oa. 

315 U.S.C. Q 80a-3(c)(l). 

4An offering that qualifies as a non-public offering under section 4(2) of the Securities Act of 

1933 (15 U.S.C. 5 77d(2)) and rule 506 of Regulation D (17 C.F.R. Q 230.506) also generally qualifies 

as non-public for purposes of section 3(c)(l). Santa Barbara Securities (pub. avail. April 8, 1983). 

103 
attribution provision also determines which section 3(c)(l) issuers are deemed to 

be investment companies for purposes of the "fund of funds" investment 

restrictions of section 12(d)(l) of the Act? 

Companies relying on section 3(c)(l) also must take care to avoid 

"integration" with related issuers: If other issuers are integrated with the private 

investment company, their security holders will be aggregated with the security 

holders of the private investment company for purposes of determining 

compliance with the 100 investor limit? 

The private investment company exception has fostered the development 

of investment vehicles well-suited for sophisticated investors8 Often, however, 

large-scale capital participation by sophisticated investors in private investment 

companies is frustrated by the requirements of section 3(c)(l). For issuers whose 

securities are owned exclusively by sophisticated investors, the public offering 

prohibition and 100 investor limit are unnecessary constraints not supported by 

sufficient public policy concerns. Therefore, the Division recommends an 

amendment to the Investment Company Act to create a new exception for funds 

whose securities are held exclusively by "qualified purchasers" as defined by rule. 

The new exception would be premised on the theory that "qualified purchasers" 

do not need the Act's protections because they are able to monitor such matters 

515 U.S.C. 5 80a-l2(d)(l). The attribution provision of section 3(c)(l) and its role in 

determining which issuers are subject to the restrictions of section 12(d)(l) are described infru 

notes 13-16 and accompanying text. 

6The integration concept allows the Commission to look behind ostensibly separate issues, 

issuers, or transactions to determine if, in economic reality, they are actually a single issue, issuer, 

or transaction. See generally Interpretive Release Relating to the Securities Act and General Rules 

and Regulations Thereunder, Securities Act Release No. 4552, 1 Fed. Sec. L. Rep. (CCH) q[ 2770 

at 2918 (Nov. 6, 1962) (articulating five factors relevant to the question of integration under the 

Securities Act). 

7See, e.g., Meadow Lane Associates, L.P. (pub. avail. May 24, 1989); Frontier Capital 

Management Company, Inc. (pub. avail. July 13,1988); PBT Covered Option Fund (pub. avail. Feb. 

17, 1979). For a discussion of the integration issue and other questions that arise under section 

3(c)(l), see Thomas P. Lemke & Gerald T. Lins, Private Investment Companies Under Section 3(c)(l) 

of the Investment Company Act of 1940,44 BUS. LAW. 401,424-28 (1989). 

%his appears to be a relatively recent development. In 1940, institutional participation in 

pooled investment vehicles was relatively minor. Since that time, institutional investors have 

become active participants. At the end of 1990, they accounted for approximately 34% of total 

mutual fund assets. INVESTMENT COMPANY INSTTITUTE, 1991 MUTUAL FUND FACT BOOK: INDUSTRY 

"RENDS AND STATISTICS FOR 1990, at 53 (1991). 

104 CHAPTER 2 
as management fees, transactions with affiliates, corporate governance, and 

leverage. 

The Division also recommends legislation to amend section 3(c)(l). The 

current structure of section 3(c)(l) is overly complicated and unnecessarily 

restricts investments by both corporate investors and registered investment 

companies. Reform of section 3(c)(l) would encourage participation in private 

investment companies without lessening investor protection? 

Finally, the Division believes that the inter-fund, or "fund of funds," 

investment restrictions of section 12(d)(l) as applied to private issuers should be 

revised. Specifically, section 3(c)(l) should be amended to eliminate section 

12(d)(l)'s limits on investments by registered investment companies in private 

investment companies. In order to protect the public shareholders of registered 

investment companies, however, the restrictions of section 12(d)(l) should apply 

to all investments by private issuers in registered investment companies. This 

approach also should be incorporated in the proposed "qualified purchaser" 

exception. 

Section 11 of this chapter discusses the private investment company 

exception in section 3(c)(l) and our recommendations to modify the attribution 

provision and the "fund of funds" restrictions in that exception. Section 111 

discusses our recommendation to create a new exception under the Investment 

Company Act for funds whose securities are held exclusively by "qualified 

purchasers." Section IV briefly describes other options that we considered. 

11. The Private Investment Company Exception 

Section 3(c)(l) reflects Congress's belief that federal regulation of private 

investment companies is not warranted. The 100 investor limit and public 

offering rohibition are both designed to ensure the private nature of exempted 

issuers>' When there is no public offering, the 100 investor limit, while 

91n connection with this change, the Division recommends a related amendment to section 

3(a)(3) to prevent companies from avoiding regulation under the Act through investment in 

subsidiaries that qualify as section 3(c)(l) issuers. See infva note 18 and accompanying text. The 

Division recommends that the amendment to section 3(a)(3) also cover issuers relying on the new 

"qualified purchaser" exception. 

"See WALL BUSINESS INVESTMENT INCENTIVE ACT OF 1980, H.R. REP. NO. 1341,96th Cong., 2d 

Sess. 34-35 (1980) [hereinafter 1980 HOUSE REPORT]. See also SEC, REPORT ON THE PUBLIC POLICY 

IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. REP. NO. 2337,89th Cong., 2d Sess. 34-35 

(1966) [hereinafter PPI REPORT] ("[tlhe Act is also limited to companies in which there is a 

significant public interest, since it excludes from its coverage a company that has no more than 

100 security holders and is neither making nor presently proposing to make a public offering of 

its securities") (footnotes omitted). 

Private Investment Company Exceptions 105 
somewhat arbitrary, reasonably reflects the point at which an issuer should not 

be regarded as a public investment company." As David Schenker, the Chief 

Counsel to the Commission's Investment Trust Study, explained 

You have the situation where there are personal holding companies. 

A family may have a substantial estate and has invested its money 

in marketable securities. In essence that is a private investment 

company, is it not? We do not want any part of it; and so we have 

said that even though you engage in the same type of activity as an 

investment company, which is within the purview of this section, 

if you have less than 100 security holders you are not a public 

investment company and not within the purview of this 

legislation.12 

The legislative history of section 3(c)(l) indicates that the 100 investor limit 

represents an outer limit of an investor base likely to be composed of people with 

personal, familial, or similar ties. In some circumstances, investor protection 

concerns may be raised by small investment pools whose securities are held by 

investors of modest means, even if the pools have fewer than 100 investors. But 

the concept that the investors in these smaller pools are bound by personal or 

familial ties retains some validity, and, in any case, federal oversight of these 

pools under the Investment Company Act would be impractical. 

To prevent circumvention of the 100 investor limit, section 3(c)(l) currently 

includes a two-part attribution provision that, in some instances, requires an 

entity seeking to rely on the exception to "look through* its security holders to 

their underlying investors. The attribution provision is most easily explained by 

a sample fact situation. Assume Company B is seeking to rely on section 3(c)(l). 

If one of Company Bs security holders, Company A, beneficially owns ten 

percent or more of the voting securities of Company B, then the security holders 

"In a 1941 opinion, the Commission observed that the 100 investor limit "obviously is an 

arbitrary figure." In re Mzaitime Corp., 9 S.E.C. 906, 909 n.2 (1941). 

'2Znveshnent Trusts and Investment Companies: Hearings on S. 3580 Bgwe a Subcomm. of the Senate 

Comm. on Banking and Currency, 76th Cong., 3d Sess. 179 (1940). 

106 CHAPTER 2 

15 s 
of Company A are counted as security holders of Company B (part I of the 

attribution provision), unless Company A has no more than ten percent of its assets 

in securities of section 3(c)(l) issuers (part 

This two-part attribution provision is also pivotal in determining which 

section 3(c)(l) issuers are deemed to be investment companies for purposes of 

section 12(d)(l). Section 12(d)(l) is intended to restrict the pyramiding of funds 

by limiting the purchase of registered investment company securities by any 

investment company (whether or not registered), and the purchase of securities 

of any investment company (whether or not registered) by registered investment 

companies.14 Unlimited pyramiding raises public policy concerns because a 

fund acquiring another fund's securities could exercise undue influence over that 

fund or disrupt its orderly management through the threat of redemption. 

Pyramiding also may result in a layering of costs to investors through duplicate 

administrative expenses, sales charges, and advisory fees without providing any 

significant benefit.15 

Under current section 3(c)(l), only those issuers that would be investment 

companies but for the second part of that section's attribution provision (ie., they 

have large security holders, but those holders do not have more than ten percent 

of their assets in securities of section 3(c)(l) issuers) are deemed to be investment 

companies for the limited purposes of the anti-pyramiding restrictions in section 

12(d)(1).I6 All other section 3(c)(l) issuers are not investment companies for the 

purposes of the anti-pyramiding restrictions of section 12(d)(l). 

13Prior to 1980, the attribution provision was more restrictive in that the 10% restriction was 

applied across the board. That is, beneficial ownership of 10% or more of Company B's 

outstanding voting securities was deemed to be beneficial ownership by all of the security holders 

of Company A, without exception. 

14Section 12(d)(l) prohibits such purchases if, after the purchase, the acquiring company and 

any company or companies controlled by it own (i) more than three percent of the total 

outstanding voting stock of the acquired company; (ii) securities issued by the acquired company 

having an aggregate value of more than five percent of the total assets of the acquiring company; 

or (iii) securities issued by the acquired company and all other investment companies having an 

aggregate value of more than ten percent of the total assets of the acquiring company. 

15PPI REPORT, supra note 10, at 311-24. The PPI Report noted the benefit of the fund holding 

company structure as a vehicle to achieve diversification was largely "illusory." Id. See infra note 

22. 

'*he anti-pyramiding restriction in section 3(c)(l) was added in 1980, when the attribution 

provision was narrowed. SMALL BUSINESS SECURITIES ACE AMENDMENTS OF 1980, S. REP. NO. 958, 

96th Cong., 2d Sess. 20 (1980); 1980 HOUSE REPORT, supra note 10. 

Private Investment Company Exceptions 107 
The two-part attribution provision in section 3(c)(l) is both overly broad 

and extremely confusing. In many instances, the current test exaggerates public 

interest by counting the security holders of corporate investors when these 

security holders do not have a significant economic interest in a section 3(c)(l) 

issuer's performance. Moreover, investments in section 3(c)(l) issuers by 

companies which are not themselves investment companies (whether or not 

registered) generally do not, standing alone, implicate the concerns respecting the 

layering of intermediaries that the attribution test is intended to address. Put 

another way, if an intermediate investing entity is not itself a registered 

investment company or a private investment company, attribution is unnecessary. 

Thus, we recommend an amendment to narrow the attribution provision. 

Under our proposal, if Company A, the intermediate investing entity, is itself not 

an investment company as defined in section 3 of the Investment Company Act, 

or is not relying on the section 3(c)(l) private investment company exception or 

the new "qualified purchaser'' exception we propose below, Company A's security 

holders would not be counted for purposes of the 100 investor limit.17 

In connection with this change/ we recommend a related amendment to 

section 3(a)(3) of the Act to provide that the securities of a majority-owned 

subsidiary relying on section 3(c)(l) would not be excluded from the definition 

of "investment securities" under section 3(a)(3). This amendment would preclude 

a company that would itself fall within the definition of an investment company 

under section 3(a)(3) from avoiding regulation under the Act through investment 

in a section 3(c)(l) subsidiary.18 

In addition, the Division believes that investments by registered investment 

companies in section 3(c)(l) issuers should not be constrained by section 12(d)(l). 

Any anti-pyramiding concerns raised in this context are minimized by the other 

provisions of the Act regulating the conduct of registered funds. Investments by 

I7More specifically, the Division recommends legislation to narrow the attribution provision 

to provide that if an issuer seeking to rely on section 3(c)(l) has a 10% holder of the issuer's 

voting securities that: (i) is a registered investment company pursuant to section 3, or (ii) is itself 

an excepted section 3(c)(l) private investment company, or (iii) is a proposed section 3(c)(7) 

investment company whose securities exclusively are held by sophisticated investors, the issuer 

must count the security holders of the 10% holder of the issuer's voting securities as its own. 

"Section 3(a)(3) generally provides that an investment company includes any company with 

more than 40% of its assets in investment securities. The definition of investment securities under 

section 3(a)(3) excludes, among other things, securities issued by majority-owned subsidiaries that 

are not investment companies; because of the section 3(c)(l) exclusion, the securities of a majorityowned section 3(c)(l) issuer are not investment securities. In light of the proposed change in the 

attribution provision and in the absence of the recommended amendment to section 3(a)(3), 

companies could avoid regulation under the Act by "downstreaming" their investment activities 

through a section 3(c)(l) subsidiary. 

108 CHAPTER 2 
registered investment companies in section 3(c)(l) issuers, for example, are 

governed by the conflict-of-interest provisions of section 17 of the Act” as well 

as those concerning breaches of fiduciary duty by the registered company’s 

investment adviser under section 36.2’ The latter could come into play where 

investments in section 3(c)(l) issuers result in unnecessary duplication of fees or 

expenses. Moreover, as a result of the recommended change in section 3(c)(l)’s 

attribution provision, a registered fund’s investment would be limited to ten 

percent of any one section 3(c)(l) issuer?* Removing section 12(d)(l)’s 

restrictions in connection with investments by registered investment companies 

in section 3(c)(l) issuers would eliminate unnecessary constraints without 

compromising important investor 

The Division believes, on the other hand, that limitations on the ability of 

a22 section 3(c)(l) issuers to invest in registered investment companies are 

necessary to protect the public shareholders of registered investment companies. 

Private issuers, excepted from regulation under the Act, could acquire controlling 

interests and exert undue influence over registered funds, disrupting their 

portfolio management through the threat of redempti0n.2~ 

Accordingly, the Division recommends amendment of section 3(c)(l) to 

eliminate application of section 12(d)(l) in connection with investments by 

registered investment companies, but to require that all section 3(c)(l) issuers be 

subject to section 12(d)(l)’s restrictions governing the purchase of registered 

investment company ~ecurities.2~ 

’’15 U.S.C. 5 80a-17. 

*‘15 U.S.C. 5 80a-35 

”The amended attribution provision would count toward the 100 investor limit, without 

exception, the shareholders of an investment company owning 10% or more of a section 3(c)(l) 

issuer; as a result, the issuer would not be eligible for the private investment company exception. 

22The diversification benefits derived from inter-fund investments depend largely on the 

investment objective and policies of the issuer in which the investment is made. Because private 

investment companies often offer specialized investment services, investment in these vehicles 

may enable the shareholders of registered funds to benefit from such services. 

23While similar concerns are manifested whenever large institutional security holders threaten 

to redeem, the threat is compounded when the redeeming security holder is an investment 

company that must in turn meet its own redemption requests. PPI REPORT, supra note 10. 

*?o cover the other side of transactions involving open-end funds, section 12(d)(l) also would 

apply to a registered open-end investment company’s sale of its securities to a section 3(c)(l) 

issuer. The application of section 12(d)(l) to all section 3(c)(l) issuers under the proposal would 

not affect existing holdings in registered investment companies, since section 12(d)(l) prohibits 

(continued ... ) 

Private Investment Company Exceptions 109 
The proposed amendments to section 3(c)(l) would facilitate participation 

in private issuers. As a result of the revised attribution provision, section 3(c)(l) 

would not limit investments by corporate, non-investment company investors. 

In the case of registered investment companies, the combined effect of the 

proposed changes to the attribution provision and the application of section 

12(d)(l) would be to raise the limit on registered investment company purchases 

of private issuers from three percent to ten percent of any one such issuer.25 

111. A Qualified Purchaser Exception 

In contrast to the existing private investment company exception, an 

exception for funds owned by sophisticated investors would be premised on the 

theory that such investors can adequately safeguard their interests in a pooled 

investment vehicle without extensive federal regulationF6 As an alternative to 

the more narrow section 3(c)(l), such an exception could be relied upon by 

venture capital funds and other vehicles to increase funding available for small 

businesses as well as larger concerns. 

Accordingly, the Division recommends amendment of the Investment 

Company Act to add a new section -- section 3(c)(7) -- to except from the Act any 

24(...continued) 

only purchases or other acquisitions that cause holdings to exceed the numerical limits in the 

section. 

25As indicated supra notes 14-16 and accompanying text, section 12(d)(l) currently limits 

investments by a registered fund to no more than three percent of any one private issuer that has 

a security holder owning ten percent or more of the issuer's voting securities. 

26The Commission's release soliciting comments on the reform of investment companies 

specifically requested comment on whether the private investment company exception should be 

expanded to include entities that sell their securities to an unlimited number of institutional 

security holders. Request for Comments on Reform of the Regulation of Investment Companies, 

Investment Company Act Release No. 17534 Uune 15, 19901, 55 FR 25322 [hereinafter Study 

Release]. Commenters addressing this issue generally supported an expansion, although they 

differed on how best to implement the change. The commenters included Aetna Life Insurance 

Company; the American Council of Life Insurance; Bankers Trust Company; The Chase Manhattan 

Bank, N.A.; Chemical Bank; Citicorp; Cleary, Gottlieb, Steen & Hamilton; Davis Polk & Wardwell; 

Dechert Price & Rhoads; The Equitable Life Assurance Society of the United States; Fidelity 

Management & Research Company; IDS Financial Services, Inc.; the Investment Company 

Institute; Levitt Greenberg Kaufman & Goldstein, P.C.; certain members of The Federal Regulation 

of Securities Committee of the Los Angels County Bar Association; Merrill Lynch & Co., Inc.; The 

New York Clearing House Association; PaineWebber Development Corporation; Paloma Partners 

Management Company Inc.; Ropes & Gray; S.G. Warburg & Co., Inc.; Shearson Lehman Brothers 

Inc.; Skadden, Arps, Slate, Meagher & nom; State Street Bank and Trust Company; Stradley, 

Ronon, Stevens & Young (on behalf of DFA Investment Dimensions Group Inc. and Dimensional 

Fund Advisors Inc.); The Vanguard Group, Inc.; and Weil, Gotshal & Manges. 

110 CHAPTER 2 
issuer whose securities are beneficially owned exclusively b one or more persons 

who, at the time of acquisition, are "qualified purchasers."' There would be no 

limit on the number of investors or a prohibition on public offerings, provided the 

issuer's securities were sold to "qualified purchasers." To protect the public 

shareholders of registered investment companies, we recommend that the 

restrictions of section 12(d)(l) apply to investments by proposed section 3(c)(7) 

issuers in registered investment companies for the same reasons as issuers relying 

on section 3(~)(1)?~ As in the case of the section 3(c)(l) exception, we also 

recommend amendment of section 3(a)(3) of the Act to prevent companies from 

avoiding Investment Company Act re dation through investments in subsidiaries 

that qualify as section 3(c)(7) issuers 8 . 

To implement the new exception, we also propose the adoption of a new 

section 2(a)(51) to define qualified purchaser to be any person so defined by rule, 

based on such factors as financial sophistication, net worth, knowledge and 

experience in financial matters, amount of assets owned or under management, 

relationship with the issuer, or such other factors as the Commission determines 

to be within the intent of the section?' This approach would enable the 

Commission to respond to changing financial conditions and to benefit from the 

public comment process. 

While the class of investors for a sophisticated investor exception would 

have to be defined adequately to ensure that investors are capable of safeguarding 

their interests, the idea that some investors do not need the protections of the 

federal securities laws is certainly not novel. A number of exemptive or safe 

harbor provisions under the federal securities laws are based, in part, on the 

degree of sophistication of investors. The three most noteworthy are section 4(6) 

27Evaluating a security holder's status at the time of acquisition would ensure that subsequent 

changes in the holder's net worth or other attributes would not result in the issuer inadvertently 

becoming an investment company. 

28See supra notes 14-15 & 23 and accompanying text. 

29See supra note 18 and accompanying text. 

30An attribution provision designed to preclude circumvention of the qualified purchaser 

standard is unnecessary, since any concerns about evasion of the requirements of the exception 

could be addressed adequately in rulemaking. In defining eligible investors, the Commission alsb 

could decide to provide reasonable care defenses similar to those in Regulation D and rule 144A. 

Private Investment Company Exceptions 111 
of the Securities Act:* rule 144A under that Act:2 and rule 205-333 under the 

Advisers 

For example, section 4(6) of the Securities Act exempts from the 

registration requirements of that Act transactions involving offers or sales by an 

issuer solely to one or more "accredited investors," if the aggregate offering price 

of the issue does not exceed $5 million, there is no advertising or public 

solicitation in connection with the transaction, and the issuer files a prescribed 

notice with the Commission. For purposes of section 4(6), an "accredited 

investor,'' as defined in section 2(15) of the Securities Act,% includes all banks 

(whether acting in an individual or fiduciary capacity), insurance companies, 

registered investment companies, business development companies, and small 

business investment companies. The term also includes any employee benefit 

plan, including an individual retirement account, subject to the provisions of the 

Employee Retirement Income Security Act of 1974 ("ERISA')36 if the investment 

decision is made by a plan fiduciary that is either a bank, insurance company, or 

registered investment adviser. 

The Commission also may designate other persons as accredited investors 

on the basis of such factors as financial sophistication, net worth, knowledge and 

experience in financial matters, or amount of assets under management?7 In 

Regulation D, an "accredited investor" also is defined to include, among other 

things, any state or local government employee benefit plan with total assets in 

excess of $5 million, any ERISA plan if the investment decision is made by a plan 

fiduciary that is either a bank, a savings and loan association, insurance company, 

or registered investment adviser, or if the plan has total assets in excess of $5 

million, corporations, business trusts, partnerships, or charitable organizations 

with total assets in excess of $5 million, executive officers and directors of the 

issuer, private business development companies, natural persons with a net worth 

(or joint net worth with a spouse) of $1 million, and natural persons with 

individual income of $200,000 in each of the last two years or joint income with 

3115 U.S.C. 5 77d(6). 

3217 C.F.R. Q 230.144A. 

%7 C.F.R. § 275.205-3. 

341nvestment Advisers Act of 1940,15 U.S.C. Q 80b. 

3515 U.S.C. Q 77b(15). 

36Employee Retirement Income Security Act of 1974,29 U.S.C. 5 1001. 

37Securities Act Q 2(35)(ii), 15 U.S.C. Q 77b(15)(ii). 

112 CHAPTER 2 
a spouse in excess of $300,000 and a reasonable expectation of reaching that 

income level in the current 

Rule 144A under the Securities Act provides a non-exclusive safe harbor 

for resales of restricted securities to "qualified institutional buyers." Qualified 

institutional buyers include (1) certain types of institutional purchasers that own 

and invest on a discretionary basis at least $100 million in securities, including 

any insurance company, investment company, business development company, 

small business investment company, state plan, employee benefit plan, charitable 

organization, corporation, partnership, business trust, or investment adviser; (2) 

any registered dealer that owns and invests on a discretionary basis at least $10 

million in securities; any registered investment company that is part of a family 

of investment companies with at least $100 million in securities; and (3) any bank 

or savings and loan that owns and invests at least $100 million and has an 

audited net worth of at least $25 million. In addition, Rule 205-3 exempts from 

the restrictions on performance-based advisory fees in section 205 of the Advisers 

certain contracts with sophisticated clients, including advisory clients with 

at least $500,000 under management with the adviser and clients with a net worth 

of at least $1,000,000. 

Given the many risks to investors of committing assets to managed pools, 

the Division believes the ability to evaluate unregulated investment companies 

requires a high degree of sophistication. Consequently, we believe that an 

accredited investor standard would be too low,4o and that, at least initially, the 

definition of qualified institutional buyer in rule 144A would represent an 

appropriate level of sophistication for institutions. We also believe that a 

standard could be developed to permit certain natural persons to invest in 

proposed section 3(c)(7) issuers; where such persons possess a high degree of 

3817 C.F.R. 5 230.501(a). 

3915 U.S.C. 5 80b-5. 

4~n response to the Study Release (supra note 26), most proponents of a new exception 

favored an accredited investor standard. See, e.g., Letter of the American Council of Life Insurance 

to Jonathan G. Katz, Secretary, SEC 75-78 (at. 10, 19901, File No. S7-11-90; Letter from Merrill 

Lynch & Co., Inc. to Jonathan G. Katz, Secretary, SEC VII-1 to 8 (Oct. 18, 19901, File No. S7-11-90 

("Merrill Lynch Study Comment"); Letter of Weil, Gotshal & Manges to Jonathan G. Katz, 

Secretary, SEC (at. 9, 19901, File No. S7-11-90. Others commenters favored a qualified 

institutional buyer standard. See Letter of Cleary, Gottlieb, Steen & Hamilton to Jonathan G. Katz, 

Secretary, SEC 14-17 (at. 12,1990), File No. 57-11-90; Memorandum of the Investment Company 

Institute, Amendment of Section 3(c)(l) of the Investment Company Act of 1940 9-11 (undated), 

File No. S7-11-90; Letter of Ropes & Gray to Jonathan G. Katz, Secretary, SEC 4 (Oct. 9,1990), File 

NO. S7-11-90. 

Private Investment Company Exceptions 113 
financial sophistication, they would be fully capable of evaluating and assuming 

the risks associated with the new section 3(c)(7) pools. 

Of course, many investors who would be able to invest in the new section 

3(c)(7) issuers nevertheless may choose to invest instead in registered investment 

companies, relying on the protections afforded by the existing regulatory 

structure. Some institutional investors are limited by law as to the types of 

investments that they may make, and may be required to invest only in registered 

investment companies. Moreover, fiduciaries may be reluctant to take the risks 

associated with investments in unregistered investment companies and may 

choose instead to invest only in registered companies. Our recommendation, if 

implemented, would not limit the access of large investors to registered 

investment companies. 

IV. Other Options Considered 

In response to the Commission’s solicitation of comments on reform of the 

regulation of investment companies:l commenters favoring a sophisticated 

investor exception generally asserted that funds sold exclusively or primarily to 

sophisticated investors should be excepted from all provisions of the Act. A few, 

however, argued that such companies should be registered and remain subject to 

some of the Act‘s requirements if they have more than 100 security holders.42 

The Division believes no sufficiently useful governmental purpose is served by 

~~ ~ 

41St~dy Release, supra note 26. 

4%ne commenter recommended the elimination or modification of a number of the regulatory 

requirements of the Act for funds offered only to sophisticated investors, including the corporate 

governance provisions of section 16 (15 U.S.C. § 80a-16), the capital structure limitations of section 

18 (15 U.S.C. 5 80a-18) , the restrictions on the timing of redemptions in section 22(e) (15 U.S.C. 

Ej 80a-22(e)), and the restrictions on affiliated transactions in section 17. Letter from Paul A. 

Hilstad, Vice President and Deputy General Counsel, IDS Financial Services, Inc., to Jonathan G. 

Katz, Secretary, SEC 25 (Oct. 2, 1990), File No. 57-11-90. Another commenter stated that 

“registration of institutional funds under the 1940 Act must continue,” so that such funds will get 

pass-through tax treatment under Subchapter M of the Internal Revenue Code, but recommended 

the funds be exempt from certain portions of section 5 (15 U.S.C. § 80a-5) (definition of diversified 

company), section 12 (margin purchases and fund holding companies), section 13 (15 U.S.C. 5 8Oa13) (certain shareholder approval requirements), section 18 (redemptions in kind), section 22 (daily 

calculation of net asset value), and section 30 (15 U.S.C. 80a-29) (listing of portfolio holdings). 

Letter from Stephen W. Kline, Stradley, Ronon, Stevens & Young, on behalf of DFA Investment 

Dimensions Group, Inc. and Dimensional Fund Advisors, Inc., to Jonathan G. Katz, Secretary, SEC 

(Oct. 12, 19901, File No. S7-11-90. We believe that private investment companies would use an 

expanded exception, even if Subchapter M is not available to them. A number of issuers now 

avail themselves of section 3(c)(l), apparently finding a way to obtain acceptable tax treatment, 

either by organizing as limited partnerships or some other means. 

114 CHAPTER 2 
continuing to regulate funds owned exclusively by sophisticated in~estors.4~ 

Moreover, even limited Commission jurisdiction could lead to unrealistic 

assumptions on the part of investors concerning the ability of the Commission to 

police private investment companies.@ 

Proponents of a sophisticated investor exception also suggested two other 

approaches to accommodating increased participation by sophisticated investors. 

After consideration, we believe that these proposals are less desirable than the 

approach we recommend. 

One approach would be to amend section 3(c)(l) to resemble section 4(2) 

of the Securities Act, which exempts from the registration requirements of that 

Act transactions by an issuer not involving a public offering.@ Under this 

approach, the 100 investor limit in section 3(c)(l) would be deleted, thus making 

the exception available to any fund not making or presently proposing to make 

a public offering.& 

The second approach would be to exclude sophisticated investors from 

counting towards the 100 investor limit in section 3(c)(l). Under this approach, 

a fund could have an unlimited number of sophisticated investors and rely on 

section 3(c)(l) so long as it had no more than 100 other participants. 

We believe the 100 investor limit in the current private investment 

company exception reasonably reflects the point at which federal regulatory 

concerns are raised if any unsophisticated investors are involved. The 100 

investor limit is an effective proxy for requiring that the investors have some 

relationship outside the pool, such as familial or social ties. To simply focus on 

@The Commission would continue to have the ability to monitor the securities trades of large 

private investment companies under sections 13(f) and 13W of the Securities Exchange Act of 

1934 (15 U.S.C. $5 78m(f) and 78m(h)). 

440f course, even if funds owned by more than 100 sophisticated investors were excepted from 

all of the Act, the Commission would retain the jurisdiction and responsibility under the Securities 

Act, the Exchange Act, and the Advisers Act to police securities fraud perpetrated by private 

investment companies and their sponsors. 

45See, e.g., Letter from Davis Polk & Wardwell to Jonathan G. Katz, Secretary, SEC 36-40 (Oct. 

10, 19901, File No. S7-11-90. One commenter suggested that an exception for issuers that sell 

exclusively to sophisticated investors should not turn on whether the issuer conducted a public 

offering, but only on whether the offering was a "directed public offering" to unsophisticated 

investors. Merrill Lynch Study Comment, supra note 40, at Ex. VII-6. The definition of "directed 

public offering" was derived from Regulation S (17 C.F.R. 5 230.901) under the Securities Act, 

which defines "directed selling efforts" and "overseas directed offering." 17 C.F.R. €j 230.902. 

460f course, there would also have to be a prohibition on ever having made a public offering. 

Otherwise, an issuer could deregister whenever it completed its initial public offering. 

Private Investment Company Exceptions 115 
whether or not an issuer had ever conducted a public offering would ignore that 

repeated private offerings or secondary market transactions could result in a 

supposedly private issuer being owned by significant numbers of unsophisticated 

investors. And to suggest that unsophisticated investors would rely, when 

participating in these unregulated pools, upon the expertise and bargaining power 

of participating sophisticated investors, rather than their own resources, merely 

identifies additional risks that implicate the public interest. Thus, given the risks 

for the financially unsophisticated, we believe such pools should be registered 

under the Act. In comparison, pools owned exclusively by sophisticated investors 

do not present these concerns, regardless of the number of investors. 

V. Conclusion 

The Division recommends amendment of the Investment Company Act to 

create a new exception for funds whose securities are owned exclusively by 

qualified purchasers, as defined by rule. The Division also recommends that the 

current attribution provision in section 3(c)(l) be narrowed, and that section 

3(a)(3) be amended to prevent a circumvention of the Act through investments 

in issuers relying on section 3(c)(l) or section 3(c)(7). Finally, the Division 

believes that the anti-pyramiding restrictions of section 3(c)(l) should be revised 

to govern all private issuers seeking to invest in the securities of registered 

investment companies. 

\ 

116 CHAPTER 2 
APPENDIX 2-A 

Red-Lined Version of Proposed Amendments to the 

Investment Company Act of 1940 

. . . . . . . . . . . 

I J) 

Section 2(a) [15 U.S.C. 5 80a-2(a)]. When used in this title, unless the context 

otherwise requires - 

*** 

Section 3(a) [15 U.S.C. 5 80a-3(a)]. When used in this title, ”investment company’’ 

means any issuer which-- 

(3) is engaged or proposes to engage in the business of investing, reinvesting, 

owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding40 per centum of the value of such issuer’s 

total assets (exclusive of Government securities and cash items) on an unconsolidated basis. 

As used in this section, “investment securities” includes all securities except 

(A) Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which 

Section 3(c) [15 U.S.C. § 80a3(c)l. Notwithstanding subsection (a), none of the 

following persons is an investment company within the meaning of this title: 

(1) Any issuer whose outstanding securities (other than short-term paper) 

are beneficially owned by not more than one hundred persons and which is not 

Private Investment Company Exceptions 117 
(A) Beneficial ownership by a company shall be deemed to be 

beneficial ownership by one person, except that,if such company owns ..... (............. . 10 . . . . . . per . . . ........... 

centurn or more of the outstanding voting; securities of the issuer, &j@gj 

the holders of such company’s outstanding securities (other than short-term 

paper). 9 . .. 

(B) Beneficial ownership by any person who acquires securities or 

interests in securities of an issuer described in the first sentence of this 

paragraph shall be deemed to be beneficial ownership by the person from 

whomsuch transfer was made, pursuant to such rules and regulations as the 

Commission shall prescribe as necessary or appropriate in the public interest 

and consistent with the protection of investors and the purposes fairly 

intended by the policy and provisions of this title, where the transfer was 

caused by legal separation, divorce, death, or other involuntary event. 

*** 

118 CHAPTER 2 
Chapter 3 

Pooled Investment Vehicles for 

Employee Benefit Plan Assets 

I. Introduction and Summary of Recommendations 

Over 50 million Americans have more than two trillion dollars invested in 

and through their employers' employee benefit plans. The assets of employee 

benefit plans are frequently invested in bank collective trust funds and insurance 

company separate accounts in which a bank or insurance company pools the 

assets of two or more plans to manage the assets more efficiently and to diversify 

the plans' investments more effectively. Although those pooled investment 

vehicles are functionally similar to registered investment companies, they are 

generally exempted from most provisions of the federal securities laws: The 

Division has examined these exemptions in light of numerous business and legal 

changes that have occurred in the pension industry in recent years and has 

concluded that certain of the exemptions are no longer desirable as a policy 

matter . 

When the securities laws exceptions for pooled investment vehicles were 

enacted, pension plans were predominantly "defined benefit plans" offered by 

large and generally sophisticated employers. Employers offering defined benefit 

plans promise the employees a specific benefit payable upon retirement, choose 

the plans' investments, and bear any investment risk associated with the plans. 

Further, the Pension Benefit Guaranty Corporation insures defined benefit plans2 

The Employee Retirement Income Security Act of 1974 ("ERISA")3 is the primary 

law governing the activities of all retirement plans and their sponsors. ERISA 

'Section 3(a)(2) of the Securities Act of 1933 ("Securities Act") generally excepts from 

registration the securities issued by collective trust funds and separate accounts. Securities Act 

of 1933,15 U.S.C. 5 77c(a)(2). Section 3(a)(12) of the Securities Exchange Act of 1934 ("Exchange 

Act") exempts the securities issued by these vehicles from the registration requirements of that 

Act. Securities Exchange Act of 1934, 15 U.S.C. 5 78c(a)(12). Section 3(c)(ll) of the Investment 

Company Act of 1940 (''Investment Company Act") excludes these pooled investment vehicles 

from regulation under the Investment Company Act. Investment Company Act of 1940,15 U.S.C. 

5 80a-3(c)(ll). 

*The PBGC safety net, alone, may not provide sufficient protection to defined benefit plan 

participants. See SLJBCOMM. ON OVERSIGHT OF HOUSE COMM. ON WAYS AND MEANS, 102d Cong., 

1st Sess., PENSION BENEFIT GUARANTY CORPORATION'S PROGRAM TO IDENTIFY, COLLECT, AND 

ACCOUNT FOR PREMIUM PAYMENTS 2-6 (Comm. Print 1991); Albert B. Crenshaw, Pension Agency's 

Books in D~saway, Study Finds, WASH. POST, Nov. 8, 1991, at G1. 

3Employee Retirement Income Security Act of 1974,29 U.S.C. § 1001. 

119 
subjects plan sponsors to a range of fiduciary duties regarding the choice of plan 

investments depending on the type of pension plan. With respect to defined 

benefit plans, the plan fiduciaries have duties to choose prudently and monitor 

the plans' investments. 

During the last two decades, many employers, particularly small and 

medium-sized employers, have offered their employees "defined contribution 

plans." In recent years the creation of these plans has far outpaced the creation 

of defined benefit plans! Defined contribution plans differ from defined benefit 

plans in several respects. In a defined contribution plan, an employer promises 

that it will set aside a specific contribution in an individual account for each 

employee's benefit and that each employee will receive a benefit equal to the 

amounts contributed to his or her account plus or minus the account's investment 

gains or losses. Many of these plans place the responsibility on employeeparticipants to direct the investment of their individual accounts? By doing so, 

the investment risk associated with the investment of a pension plan falls on the 

employee. Fiduciaries of a participant-directed defined contribution plan have a 

duty to choose prudently and monitor the investment options available to 

participants, but the plan fiduciaries have no obligation to assure that participants 

choose suitable investments from the available options. Finally, the employee in 

a participant-directed defined contribution plan has no PBGC safety-net 

undergirding his or her choices. 

While ERISA governs the activities of retirement plans, its disclosure 

regulations focus on disclosure about the plan itself and not on the investments 

that underlie the plans. The limited disclosure provided to plan participants 

about the underlying investments may have been appropriate when the employer 

made the investment decision and bore the investment risk. With the growth of 

participant-directed defined contribution plans, however, where the investment 

risk falls on the employee, plan participants need the same information as any 

other individual who invests in securities, and the focus of the securities laws 

needs to shift from the sponsor/employer to the participant/employee. This is 

4See EMPLOYEE BENEFITS RESEARCH INSTITUTE, EBRI ISSUE BRIEF 8, Table 3 (Oct. 1991) 

[hereinafter EBRI]; Phyllis Feinberg, Changing Times for Pension Funds in the 299Os, BARRON'S, Nov. 

18,1991, at 34. 

5Craig S. Smith, Investor Control of Retirement Funds is Rising, Wall St. J., Jan. 31, 1992, at B4c. 

120 CHAPTER 3 
particularly so where the plan fiduciaries do not have a fiduciary obligation with 

respect to a participant's investment choices! 

The Division has reconsidered the securities laws exemptions from two 

perspectives: whether employees should receive better disclosure regarding their 

investments, and whether the pooled investment vehicles themselves should be 

registered under the Investment Company Act. The Division recommends that 

the Commission send to Congress legislation that would remove the current 

exemption from registration in section 3(a)(2) of the Securities Act of 1933 

("Securities Act") for interests in pooled investment vehicles for participant-directed 

defined contribution plans. Further, the legislation would amend the federal 

securities laws to require the delivery of prospectuses for the underlying 

investment vehicles to plan participants who direct their investments. We also 

recommend legislation that would amend the Securities Exchange Act of 1934 

("Exchange Act") to require the delivery of semiannual and annual shareholder 

reports for the underlying investment vehicles (other than registered investment 

companies) to these plan participants. Finally, we recommend that the rules 

under the Investment Company Act be amended to require the delivery of 

semiannual and annual reports of underlying registered investment companies to 

these plan participants. Without these changes, plan participants will increasingly 

be forced to fend for themselves and make uninformed investment decisions, with 

the result that they may invest imprudently or too conservatively, fail to diversify 

their investments, and retire with inadequate assets. 

The Division recommends retaining the current Securities Act exemption 

for interests in pooled investment vehicles for defined benefit plans and defined 

contribution plans that do not provide for participant direction. Since the fiduciaries 

of a defined benefit plan are subject to all of the fiduciary duties and liabilities 

under ERISA and the plans are PBGC insured, we do not believe that the 

additional protections of the securities laws are necessary. 

Despite the general appeal of functional regulation, we do not recommend 

that bank collective trust funds or insurance company separate accounts 

containing retirement plan assets be required to register under the Investment 

%ee 29 U.S.C. 5 1104(c); Participant Directed Individual Account Plans, 56 F'R 10724 (1991) 

(reproposing 29 C.F.R. 5 2550.404~-1). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 121 
Company Act of 1940 ("Investment Company Act")? Participants in plans that 

invest in bank collective trust funds or insurance company separate accounts are 

protected by other regulatory schemes, such as ERISA, banking regulations 

(regulation 9, the regulation of the Comptroller of the Currency governing the 

fiduciary powers of national banks), and state insurance laws; diminishing the 

need for regulation under the Investment Company Act. Although these 

regulatory schemes differ, the differences do not justify altering the sfafus quo and 

the additional costs that would result from applying the Investment Company Act 

to these investment vehicles. 

This chapter reviews the historical justifications for the exemption of 

pooled investment vehicles from the securities laws and discusses recent changes 

in the nature of employee benefit plans (see Chronology, Appendix A). It then 

compares the disclosure and other requirements of the three federal regulatory 

schemes under which registered investment companies, bank collective trust 

funds, and pooled insurance company separate accounts currently operate and 

discusses the reasons for the Division's recommendations. 

71n connection with its proposal to modernize the financial system, the Department of the 

Treasury has recommended regulating banks' pooled investment activities in a manner more 

similar to investment companies. see U.S. DEP'T OF THE TREASURY, MODERNIZING THE FINANCIAL 

SYSTEM 59 (1991). We believe that we can accomplish the goals of functional regulation at the 

lowest cost by requiring interests in collective trust funds and separate accounts containing assets 

of participant-directed defined contribution plans to be registered under the Securities Act and 

by requiring these collective trust funds and separate accounts to provide prospectuses and 

shareholder reports to plan participants. 

81nsurance company separate accounts are established under state law. Unless excepted by 

the pension plan provisions of the securities laws, separate accounts that fund variable annuities 

or variable life insurance are subject to the federal securities laws and thus are regulated by the 

Commission. While this chapter does not attempt to survey state insurance law, states provide 

an additional layer of protection to plan participants. For example, most states require insurance 

companies to insulate separate account assets from liabilities arising out of other business the 

company may conduct. State laws also may prescribe diversification requirements and sometimes 

prohibit transactions between the separate account and the insurance company. See generully 

Stephen E. Roth, Susan S. Krawczyk, & David S. Goldstein, Reorganizing Insurance Company 

Separate Accounts under Federal Securities Laws, 46 Bus. LAW. 537, 542-45 (1991). 

122 CHAPTER 3 
11. Treatment of Pooled Investment Vehicles Under the Federal 

Securities Laws 

A. Historical Treatment of Bank Collective Trust Funds 

As enacted, the Investment Company Act provided that any employees' 

pension, stock bonus, or profit-sharing trust which met the conditions of section 

165 (now section 401) of the Internal Revenue Code ("Code") was not an 

"investment ~ompany."~ There is no legislative history for this exclusion 

(originally section 3(c)(13)). The Code required, and requires now, that a pension 

trust be administered for the exclusive benefit of the participants, and generally 

that the plan assets not revert to the employer. The Code also prohibits 

transactions between the employer and the trust. Given these protections, the 

employer's incentive would be to maximize the benefits to employees and, 

especially in the case of defined benefit plans, minimize administrative costs. 

Thus, Investment Company Act protection was apparently considered 

unnecessary?' The Investment Company Act did not provide an exception for 

pooled investment vehicles in which pension plans were invested. 

qnvestment Company Act of 1940, ch. 686,s 3(c)(13), 54 Stat. 789,799 (1940). The provision 

was redesignated as section 3(c)(ll) in 1970. Investment Company Amendments Act of 1970, Pub. 

L. No. 91-547, 84 Stat. 1413 (1970) [hereinafter 1970 Amendments] (codified as amended at 15 

U.S.C. 5 80a-3(c)(ll)). 

Section 165 of the Code exempted from federal income tax a trust forming part of a stock 

bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of some or all of 

its employees if contributions were made to the trust by such employer, or employees or both, 

for the purpose of distributing to such employees the earnings and principal of the fund 

accumulated by the trust in accordance with such plan,'and if under the trust instrument it was 

impossible, at any time prior to the satisfaction of all liabilities with respect to employees under 

the trust, for any part of the corpus or income to be used for, or diverted to, purposes other than 

for the exclusive benefit of his employees. Revenue Act of 1938, ch. 289,s 165,52 Stat. 447,518 

(1938) (codified as amended at 26 U.S.C. § 401). 

Section 401 replaced section 165 when the Internal Revenue Code of 1954 was enacted. 

Internal Revenue Code of 1954, ch. 736,s 401,68A Stat. 3,134 (1954) (codified as amended at 26 

U.S.C. § 401). Section 401 sets forth tax qualification requirements similar to those described 

above, and includes certain non-discrimination provisions as well as other restrictions. 

*'See Robert H. Mundheim & Gordon D. Henderson, Applicability of the Federal Securities Laws 

to Pensiun and Profit-sharing Plans, 29 L. & CONTEMP. PROBS. 795,815 (1964) [hereinafter Mundheim 

& Henderson]. Corporate plans that did not meet the conditions for qualification under section 

165 could apply for an order exempting them from the Investment Company Act under section 

6(b) of the Investment Company Act, a provision allowing the Commission to exempt employees' 

securities companies. 15 U.S.C. 5 80a-6(b). See Mundheim & Henderson, supra, at 815-16. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 123 
The Securities Act had no parallel exemption for interests in employee 

benefit plans or pooled investment vehicles. The Commission's staff early on 

expressed the view that employee interests in pension and profit-sharing plans 

generally are securities, but did not require the interests in the plans to be 

registered under the Securities Act unless the plan provided for the purchase of 

the employer's stock?' The staff's early view was premised on several theories: 

(1) if there are no employee contributions, an interest in an employee benefit plan 

is the equivalent of a gift and therefore does not involve a (2) if 

employee contributions are involuntary, there is no sale because there is no 

investment decision;13 and (3) voluntary contributions are permissible so long 

as the contributions are not used to purchase the employer's stock (ie., the 

corporation does not use an employee benefit plan as an outlet for its own 

stock).14 

%ee Ops. SEC Ass't Gen. Couns., [1941-1944 Transfer Binder] Fed. Sec. L. Rep. (CCH), 

75,195 [hereinafter 1941 Opinion1 (discussing the Assistant General Counsel's opinions with 

respect to the presence of a "security" and a "sale" in connection with an interest in certain 

employee benefit plans). The Assistant General Counsel also noted that exemptions from 

registration were available to plans that invested in employer stock under sections 3(a)(l), 3(a)(8), 

3(a)(ll), 3(b), and 40) of the Securities Act. Id. 

Commissioner Purcell testified that the Commission had always considered pension plans 

that involved the sale of a security to be subject to the Securities Act. Commissioner Purcell noted 

that noncontributory and involuntary plans would not be subject to the Securities Act. See 

Proposed Amendments to Securities Act of 1933 and the Securities Exchange Act of 1934: Hearings Before 

the Comm. on Interstate and Foreign Commerce, House of Representatives, 77th Cong., 1st Sess. 892-97 

(1941). 

I2For a discussion of the "no sale" theory and the view that there is a "sale" for value %because 

the employee can be. deemed to have received constructively the appropriate amount of wages 

and tendered them back," see Martin E. Lybecker, Bank-Sponsored Investment Management Services: 

A Legal History and Statutory Interpretive Analysis - Part 2, 5 SEC. REG. L. J. 195, 227-8 (1977) 

[hereinafter Lybecker]. See also Mundheim & Henderson, supra note 10, at 807 n.39. 

l3Mundheim & Henderson note that the Commission's "no-sale'' theory here was "not 

premised on the theory that the interest in the pension plan was disposed of without value or 

consideration in the common law sense. . . . Rather, the Commission's view is premised on the 

ground that there is no offer or sale in the securities laws sense because 'there is no element of 

volition on the part of the employees whether or not to participate and make contributions."' 

Mundheim & Henderson, supra note 10, at 807 (quoting 1941 Opinion, supra note 11). 

%ne basis for the staff's view was a concern that the burden of preparing a registration 

statement in connection with the operation of a pension plan might result in many employers not 

allowing employees to make contributions toward their retirement. However, requiring 

registration where employer stock is purchased is justified because the employer would have a 

direct financial interest in the solicitation of the employees' contributions. Where employer stock 

is among the investment options, "it is not unfair to make [the employer] assume the same 

burdens which corporations typically assume when they go to the public for financing." Id. at 

(continued. ..) 

124 CHAPTER 3 
Before World War 11, most retirement plans were defined benefit plans15 

sponsored by large corporate employers. Banks did not need to pool the assets 

of these large plans for efficient management.16 Banking regulations governing 

collective investment funds, then administered by the Federal Reserve Board, 

permitted the use of common trust funds toepool moneys received solely for bona 

fide fiduciary purposes, but did not separately authorize collective trust funds for 

employee benefit ~1ans.l~ 

The number of corporate employee benefit plans increased rapidly after 

World War 11,18 and some banks pooled the assets of small employee benefit 

plans with their common trust funds. Apparently in response, the Federal 

Reserve Board amended its regulations to permit banks to invest the assets of 

pension, profit-sharing, and stock bonus plans collectively, provided that each 

f4(...continued) 

809-10. Cf. SEC v. Ralston Purina Co., 346 U.S. 119 (1953) (interpreting the nonpublic offering 

exemption under the Securities Act in the context of an offer of the employer’s stock to a large 

number of employees through an employees’ stock investment plan); and Form S-8, Securities Act 

Release No. 6867 (June 6, 1990), 55 FR 23925 (registration statement for employee benefit plans 

under which employees are permitted to invest their own contributions in employer stock). 

IkOBERT L. CLARK & A” A. MCDERMED, THE CHOICE OF PENSION PLANS IN A CHANGING 

REGULATORY ENVIRONMENT 64/65/72 (1990) [hereinafter CLARK & MCDERMED]. 

“See Mundheim & Henderson, supra note 10, at 821. 

I7See Trust Powers of National Banks, 2 FR 2976 (1937) (adoption of amendments to regulation 

F by Federal Reserve Board); see also 24 Fed. Reserve Bull. 4-5 (1938) (common trust funds to be 

operated strictly for fiduciary purposes). Common trust funds allow banks to conveniently 

administer assets held by the bank for true fiduciary purposes and are excepted from the 

definition of investment company by section 3(c)(3) of the Investment Company Act. 15 U.S.C. 

5 80a-3(~)(3). 

18A Senate subcommittee report, summarizing hearings and studies conducted by the 

subcommittee and its staff, attributes postwar growth in employee benefit plans to: 

(1) High corporate taxes during and since World War 11, coupled with the 

allowance of tax deductions for contributions to these programs, thus permitting 

their establishment at a low net cost; (2) Wage stabilization programs during and 

since World War I1 and the Korean conflict, which froze wage rates but permitted 

increased employee compensation in the form of these ’fringe’ benefits; (3) Court 

decisions in the years 1948-50 which made welfare and pension matters a 

bargainable issue; and (4) Since 1948, the drive of labor unions to obtain welfare 

and pension programs. Labor spokesmen state that another reason for the 

development of these programs has been the inadequacy of benefits under the 

governmental programs. 

SENATE COMM. ON LABOR AND PUBLIC WELFARE, SUBCOMM. ON WELFARE AND PENSION FUNDS, 

WELFARE AND PENSION PLANS INVESTIGATION, S. REP. NO. 1734, 84th Cong., 2d Sess. 12 (1956). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 125 
such plan was exempt from federal income taxes and the collective investment 

was s ecifically authorized by the trust instrument underlying the plan or court 

order g Also apparently in response, and recognizing that many employee 

benefit plans were too small to permit satisfactory diversification of their 

investments, the IRS ruled that a qualified plan may pool its funds with the funds 

of other qualified plans in a group trust without losing its "qualifiedf status under 

section 401 of the Code?' Under those circumstances, the group trust itself 

would be a qualified trust under section 401F1 

The Commission's view at this time regarding the status of collective trust 

funds under the securities laws was unclear. By the early 1960's, the Commission 

interpreted the exclusion provided by section 3(c)(13) of the Investment Company 

Act to apply to collective trust funds.= Later in the decade, however, the staff, 

by "no-action" letter, took the position that interests in a collective trust fund 

would have to be registered under the Securities Act if the participating plans 

were voluntary and c~ntributory?~ 

In 1962, to provide tax incentives and benefits similar to those available to 

corporate plans, Congress amended section 401 of the Internal Revenue Code to 

establish H.R. 10 ("Keogh') plans for self-employed persons and their 

- ~ 

IgSee Collective Investment Trust Funds, 20 FR 3305 (1955). The Federal Reserve Board did 

not extend to collective investment funds the restrictions in regulation F that were "designed to 

prevent the use of common trust funds primarily as investment vehicles." Id.; William P. Wade, 

Bank-Sponsored Collective Investment Funds: An Analysis of Applicable Federal Banking and Securities 

Laws, 35 Bus. LAW. 361,365-366 (1980). Regulation F required common trust funds to be operated 

only for 'true fiduciary purposes," not advertised to the public as investment vehicles. Id. at 366 

n.30; 42 Fed. Reserve Bull. 228 (1956). See also Lybecker, supra note 12, at 246. 

2kev. Rul. 56-267,1956-1 C.B. 206, restated in Rev. Rul. 81-100,1981-1 C.B. 326. 

=See Common Trust Funds - Overlapping Responsibility and Conflict in Regulation: Hearings Before 

a Submmm. of the House Comm. on Gozwnment Operations, 88th Cong., 1st Sess. 7 (1963) [hereinafter 

Fascell Hearings] (statement of William L. Cary, Chairman, SEC). Wade asserts that "the 

justification underlying this interpretation apparently emanated from policy considerations 

relating to encouragement of pension plan growth, reliance on the ability of corporate plan 

sponsors to fend for themselves in the market place, and avoidance of overlapping jurisdiction 

between bank regulators and the SEC." Wade, supra note 19, at 377. 

=See Central Bank of Montana (pub. avail. pending) (response dated Apr. 26, 1968); Safe 

Deposit Bank and Trust Company (pub. avail. pending) (response dated Mar. 5, 1968); 

Birmingham Trust National Bank Self-Employed Retirement Trust (pub. avail. pending) (response 

dated Mar. 4, 1968). 

126 CHAPTER 3 
employees?* Keogh plans are generally so small that pooling is necessary for 

their efficient management. 

The Commission construed section 3(c)(13) to include Keogh plans and 

collective trust funds containing Keogh plan assets.= However, the Commission 

took a different view on registration of the interests in pooled investment vehicles 

that included Keogh plan assets under the Securities Act, because these interests 

would be offered to relatively unsophisticated investors who would be unable to 

rely on the individualized, personal contact generally viewed as an integral part 

of traditional fiduciary services?6 The Comptroller of the Currency27 opposed 

registration of interests in bank-sponsored pooled investment funds for Keogh 

plans, asserting that the exemption in section 3(a)(2) of the Securities Act for 

securities issued by banks applied to such interests28 and that the advertising 

2%elf Employed Individuals Tax Retirement Act of 1962, Pub. L. No. 87-792,76 Stat. 809 (1962) 

(codified as amended at 26 U.S.C. 9 40Uc)). 

%e status of Keogh plans under the Investment Company Act was ambiguous, turning on 

a convoluted and technical analysis. It was not clear whether the exclusion of section 3(c)(13) 

applied to them. Section 3(c)(13) referred to plans qualified under section 165 of the Internal 

Revenue Code of 1939 "as amended," not section 401 of the Internal Revenue Code of 1954 "as 

amended." Since section 401 covered the same types of corporate plans covered by section 165 of 

the 1939 Code, it seemed appropriate to treat section 3(c)(13) as though it referred to corporate 

plans described in section 401. Because section 165 did not provide for a Keogh-type plan, the 

question arose whether to read section 3(c)(13) to apply to Keogh plans authorized under 

amended section 401. 

Then-SEC Chairman William L. Cary testified that while "we have construed the employees' 

pension trust exemption of section 3(c)(13) of [the Investment Company Act] to be available" to 

bank collective investment funds for Keogh plans, "[tlhis construction was not free from doubt, 

for it was not certain that Congress intended to exempt anything of this nature as an employees' 

pension trust." Fuscell Hearings, supra note 22, at 7 (statement of William L. Cary). The 

Commission could have distinguished between H.R. 10 commingled funds and collective trust 

funds for other section 401 plans on the basis that employer-participants in H.R. 10 commingled 

funds were not able to fend for kh selves. See Mundheim & Henderson, supra note 10, at 834-36. 

*%ee Wade, supra note 19, at 396; see also G.T. Lumpkin, Jr., Vice President, Wachovia Bank 

& Trust Co., Address Before the 44th Mid-Winter Trust Conference of the Am. Bankers Ass'n (Feb. 

5, 1963), reprinted in Fuscell Hearings, supra note 22, at 114-20 (H.R. 10 impact on trust business); 

Mundheim & Henderson, supra note 10, at 822-23. 

27The power to regulate bank trust activities was transferred from the Federal Reserve Board 

to the Comptroller of the Currency in 1962. Act of September 28,1962, Pub. L. No. 87-722'76 Stat. 

668 (codified as amended at 12 U.S.C. 5 92a). See also Wade, supra note 19, at 366. 

28FusceZZ Hearings, supra note 22, at 38 (statement of James J. Saxon, Comptroller of the 

Currency). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 127 
restrictions in regulation 929 would address the Commission's concern that 

interests in the collective trust funds would be "publicly offered" for Securities Act 

purposes?' 

Chairman Cary, in testimony concerning commingled managed agency 

accounts, concluded that an "investor in bank sponsored mutual funds is entitled 

to the same protection as the investor in non-bank sponsored mutual funds."31 

More specifically, in reply to the Comptroller's argument that bank regulation 

made unnecessary the investor protections of the federal securities laws, 

Chairman Cary stated that banking regulation was concerned primarily with 

controlling the flow of credit, maintaining an effective banking structure, and 

protecting de ositors?2 Banking regulation does not ad ess investors' need for 

information?' As will be discussed below:4 Congress finally resolved in favor 

of the Commission the issue of whether bank collective trust funds for Keogh 

plans should be registered under the Investment Company Act, and whether 

interests in those funds should be registered under the Securities Act, when it 

enacted the 1970 amendments to the Investment Company Act. 

B. Historical Treatment of Insurance Company Separate Accounts 

In the late 1950's and early 1960'~~ large employers increasingly were 

willing to risk investing in equity securities to obtain a higher return and lessen 

the amount of cash required to fund their pension obligation^?^ The return on 

2?he Comptroller adopted regulation 9 in 1963. Fiduciary Powers of National Banks and 

Collective Investment Funds, 28 FR 3309 (1963) (codified as amended at 12 C.F.R. 5 9). As 

adopted, paragraph (b)(5)(iv) of regulation 9.18 restricted national banks from advertising and 

publicizing their collective investment funds that consisted solely of retirement, pension, profitsharing stock bonus, or other trusts exempt from federal income tax. This restriction was 

eliminated in 1972. Fiduciary Powers of National Banks and Collective Inveament Funds, 37 FR 

24161 (1972). 

3oFasceZZ Hearings, supra note 22, at 48-50 (statement of James J. Saxon, Comptroller of the 

Currency). 

311d. at 8-9 (statement of William L. Cary). 

32SEC Legislation, 1963: Hearings on S.1642 Before a Subcommittee of the Senate Committee on 

Banking and Currency, 88th Cong., 1st Sess. at 54-55 (1963) (statement of William L. Cary, 

Chairman, SEC). 

%See id. at 55. 

34See infva note 48 and accompanying text. 

3%tephen B. Middlebrook & George N. Gingold, Mass Merchandising of Equity Products by 

Insurance Companies, 3 CONN. L. REV. 44/47 (1970). 

128 CHAPTER 3 
these investments, often managed by banks, was higher than that available from 

traditional insurance products?6 To compete with the banks, insurance 

companies obtained state legislation allowing them to segregate premiums paid 

by employers from the insurance company's general reserves and invest the 

segregated funds in a broader and less conservative mix of securities than that 

normally permitted for insurance companies, with the entire investment risk of 

the segregated account placed on the insurance cu~tomer?~ 

The development of insurance company separate accounts raised the 

concern that insurance companies were engaging in the offer and sale of securities 

to the public and operating as investment companies. Ultimately, the courts held 

that separate accounts are subject to the requirements of the securities laws?8 

To address the insurance industry's concern that it be allowed to compete 

with banks and other financial institutions providing investment management 

services on an equal footing, the Commission, in the early 1960's, adopted rules 

to provide exemptions for variable annuities and insurance company separate 

accounts that were similar to those afforded to bank products under section 

3(c)(13). Rule 3c-3 under the Investment Company Act exempted from 

Investment Company Act regulation certain group annuity contracts held by an 

insurance company in a separate account?' The exemption was available only 

if the pension plan in connection with the group contract met the qualifications 

of sections 401 or 404(a)(2) of the Code. In addition, the Commission required 

that the group contract provide that regardless of the earnings of the separate 

36ra. 

371d. at 47-48. 

38See Prudential Ins. Co. of America v. SEC, 326 F.2d 383 (3rd Cir. 19641, cert. denied, 377 U.S. 

953 (1964) (insurance company separate account could be required to register under the 

Investment Company Act). 

3%xemp tion of Certain Transactions of Insurance Companies, Investment Company Act 

Release No. 3605 (Jan. 7, 19631, 28 FR 401 (adopting rule 3c-3). In adopting rule 3c-3, the 

Commission noted its intention to provide relief similar to that already available to pooled 

investment vehicles for employee benefits maintained by banks: 

Although the insurance companies may not be acting as trustees, the 

arrangements for utilization by employers of such special accounts maintained 

by insurance companies would be similar to arrangements excepted from the 

definition of investment company pursuant to Section 3(c)(13) of the Act, and 

maintained by bank trustees for the investment of funds which the employers 

have set aside to meet their obligations under qualified pension plans. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 129 
account, the retirement benefits to employees be payable in fixed dollar 

cover at least 25 employees at the time it was executed; and prohibit 

employee contributions to the separate account. The Commission's position 

seems to have been predicated on the theory that Investment Company Act 

protection was not necessary where a plan was large and where the risk to pay 

defined benefits fell on the employer. 

The Commission also adopted rule 156 under the Securities Act to bring 

transactions exempted from Investment Company Act regulation by rule 3c-3 

conditionally within the nonpublic offering exemption in the Securities 

Rule 156 exempted these transactions from the registration requirements, but not 

from the antifraud provisions, of the Securities Act. The Commission conditioned 

the exemption, among other things, on there being no advertising in connection 

with the transaction. In adopting rule 156 the Commission noted that "[ilt has 

been represented to the Commission that because of the variety and complexity 

of such contracts, they must be separately negotiated with employers who retain 

expert advisers, are fully informed in the matter and are in a position to fend for 

them~elves."~~ 

In the late 1960's, the Commission adopted rule 6e-I. While rule 3c-3 

exempted a narrow class of separate accounts entirely from Investment Company 

Act regulation, rule 6e-1 exempted a broader class of tax-qualified insurance 

company separate accounts from some parts of the Investment Company A~t.4~ 

A separate account exempt under rule 6e-1 was allowed to contain employee 

contributions. In addition, the rule required that, if the retirement plan provided 

for benefits which varied to reflect the investment results of the separate account, 

the insurance company (1) make available to participating employers sufficient 

copies of a written disclosure statement for all covered employees, (2) recommend 

to the employer that it distribute the disclosure statement to each covered 

employee, and (3) file the statement with the Commission. The Commission 

required that the disclosure statement explain that the benefits to be received by 

employees would vary to reflect the investment experience of the separate 

4orhe Commission later amended rule 3c-3 to allow group contracts to provide that retirement 

benefits payable to employees may vary depending on the extent of the employer's contributions. 

Exemption From Certain Contracts, Investment Company Act Release No. 4007 (July 2,1964)' 29 

FR 9433. 

4*See Certain Group Annuity Contracts; Exemptions, Securities Act Release No. 4627 (Aug. 1, 

1963)' 28 FR 8208 (adopting rule 156 under the Securities Act). 

421d. 

&See Certain Separate Accounts of Insurance Companies, Investment Company Act Release 

No. 5741 (July 15,1969), 34 FR 13019 (adopting rule 6e-1 under the Investment Company Act and 

conforming amendments to rule 156 under the Securities Act). 

130 CHAPTER 3 
account, and that the assets held in the account would include common stocks 

and other equity investments. 

C. Current Securities Laws Exemptions for Pooled Investment Vehicles 

Congress's amendments to the Investment Company Act in 1970 included 

the current exemptions from the securities laws for bank collective trust funds 

and insurance company separate accounts holding retirement plan a~sets.4~ The 

amendments to section 3(c)(13) (which was renumbered section 3(c)(ll)) 

essentially codified existing Commission positions with respect to collective trust 

funds45 and provided a "level playing field" between banks and insurance 

companies that managed employee benefit plans assets through pooled 

investment vehicles:6 I At the same time, Congress amended section 3(a)(2) of 

the Securities Act to exempt certain interests in collective trust funds and 

insurance company separate accounts for tax-qualified plans from registration 

under the Securities Interests issued by these pooled investment vehicles 

remain subject to the antifraud provisions of the Securities Act. The amendments 

to section 3(a)(2) also codified the Commission's position requiring registration 

of interests in Keogh plans, pooled investment vehicles for Keogh and 

plans under which employee contributions are permitted to be invested in 

securities issued by the employer. 

441970 Amendments, supra note 9 (codified as amended at 15 U.S.C. ,§ 80a-3(c)(ll)). 

45See supra Section ILA. Many banks had relied on no-action relief under section 3(c)(13) of 

the Investment Company Act and the intrastate exemption in section 3(a)(ll) of the Securities Act. 

Lybecker, supra note 12, at 235, n.107; Mundheim & Henderson, supra note 10, at 830, n.114. 

46HOUSE COMM. ON INTERSTATE AND FOREIGN COMMERCE, INVESTMENT COMPANY AMENDMENTS 

ACT OF 1970, H.R. REP. NO. 1382,91st Cong., 2d Sess. 10,18 (1970) [hereinafter REPORT NO. 13821. 

In connection with these amendments, the Commission rescinded rules 3c-3 and 6e-1 under the 

Investment Company Act and rule 156 under the Securities Act. See Registration and Regulation 

of Insurance Company Separate Accounts, Investment Company Act Release No. 6430 (April 2, 

1971), 36 FR 7897. 

471970 Amendments, supra note 9 (codified as amended at 15 U.S.C. § 77c(a)(2)). 

48Although Keogh plans are qualified under section 401 of the Internal Revenue Code, 

Congress did not exempt interests in collective trust funds for Keogh plans from Securities Act 

registration, in part because of the likelihood that these securities would be sold to 

unsophisticated employers. REPORT NO. 1382, supra note 46, at 44. Instead, Congress gave the 

Commission rulemaking authority in section 3(a)(2) to exempt interests in these pooled investment 

vehicles under certain circumstances. See infra note 68 and accompanying text (Commission 

adopted rule 180 exempting from registration certain Keogh plans and their pooled investment 

vehicles). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 131 
Congress intended these amendments to respond to concerns expressed by 

both the banking and insurance industries that the lack of a clear exemption 

under the Securities Act for interests in pooled investment vehicles might expose 

banks and insurance companies to civil liability under the Securities Act?' 

Congress exempted these vehicles, in part, because they were subject to regulation 

under other provisions of law?' Congress assumed, however, that the person 

making the investment decisions for a plan, whether it was the sponsoring 

employer or a professional investment manager, was a sophisticated investor able 

to fend for itself and the plan participants with the application of only the 

Securities Act's antifraud provisions?1 

The Commission generally supported the 1970 legislation extending the 

existing exemptions for qualified employee benefit plans to bank collective trust 

funds consisting solely of the assets of those plans?2 In this connection, the 

Commission sought and retained the authority under section 3(a)(2) of the 

Securities Act to require registration of interests in single and collective trust 

funds for Keogh plans and interests in plans that invest employee contributions 

in employer securities. At the same time, the Commission opposed the legislation 

giving similar exemptions for insurance company separate accounts and interests 

therein. The Commission recognized that amending the Securities Act and 

Investment Company Act to exempt only the collective trust funds might give the 

banks an advantage over the insurance companies in competing to manage 

pension assets, but justified its position on the grounds that banks were already 

subject to more extensive regulation, by federal and state banking regulators, than 

were the insurance companie~?~ The Commission would have preferred to 

49See Employee Benefit Plans; Interpretation of Statutes, Securities Act Release No. 6188 (Feb. 

1, 1980), 45 FR 8960 (interpretive release on the treatment of employee benefit plans under the 

securities laws); Mundheim & Henderson, supra note 10, at 822. 

"See REPORT NO. 1382, supra note 46, at 10. 

51~ee id. at 43-44. 

52See Mutual Funds Legislation of 1967: Hearing on Amendment No. 438 to S. 1659 Bejbre the Senate 

Committee on Banking and Currency, 90th Cong., 1st Sess. 1326-27 (1967) [hereinafter 1967 Senate 

Hearings] (statement of Manuel F. Cohen, Chairman, SEC); cf. Investment Company Act Amendments 

of 1967 -- Bank and Insurance Company Collective Investment Funds and Accounts: Hearings on H.R. 

14742 B#ore the Subcommittee on Commerce and Finance of the House Committee on Interstate and 

Foreign Commerce, 90th Cong., 2d Sess. 115, 117-18, 133 (1968) [hereinafter 1968 House Hearings] 

(statement of Manuel F. Cohen, Chairman, SEC) (supporting extension of Investment Company 

Act exception to collective trust funds but opposing blanket exemption from Securities Act). 

%See Letter from Hamer H. Budge, Chairman, SEC to Senator John J. Sparkman (Apr. 29,1969) 

reprinted in Investment Company Amendments Act of 1969: Hearings on S. 34 and S. 296 Before the 

Senate Committee on Banking and Currency, 91st Cong., 1st Sess. 31-33 (1969) [hereinafter Budge 

(continued ... ) 

132 CHAPTER 3 
retain jurisdiction over insurance company separate accounts for employee benefit 

plan assets and to use its rulemaking authority to exempt separate accounts from 

some provisions of the Investment Company A~t.5~ 

Four years after the 1970 amendments, Congress enacted ERISA to provide 

comprehensive minimum standards for the administration of private employee 

benefit plans?5 While ERISA was a response to the growth in size, scope, and 

number of corporate employee benefit plans, and their increasing importance to 

employees and to the economy as a whole, ERISA also authorized the 

establishment of Individual Retirement Accounts ('TRAs")?~ The new provisions 

permitted individuals not covered by an employer or government plan to 

establish, and make deductible contributions to, their own IRA. IRAs do not meet 

the requirements for qualification under section 401 of the Code and accordingly, 

virtually from the time of their creation, the staff has taken the position that the 

exception in section 3(c)(lI) is not available to bank collective funds that pool IRA 

assets or commingle the assets of IRAs with corporate plans qualified under 

section 401 of the C0de.5~ The staff did not believe that the historical 

justifications for the exemptions for pooled investment vehicles for employee 

benefit plans could support exempting pooled vehicles for IRAs, since the 

participants generally would be less able to fend for themselves than even the 

self-employed participants in Keogh plans. 

%(...continued) 

Letter]; 1968 House Hearings, supra note 52, 137 (statement of Manuel F. Cohen); 1967 Senate 

Hearings, supra note 52, at 1334-35 (statement of Manuel F. Cohen). 

54Budge Letter, supra note 53; 1967 Senate Hearings, supra note 52, at 133435 (statement of 

Manuel F. Cohen). 

55Employee Retirement Income Security Act of 1974, Pub. L. No. 93-406, 88 Stat. 829 (1974) 

(codified as amended at 29 U.S.C. §1001). 

561d. at § 2002(b), 88 Stat. at 959 (1974) (codified as amended at 26 U.S.C. § 408). 

57See, e.g., Santa Barbara Bank and Trust (pub. avail. Nov. 1, 1991); United Missouri Bank of 

Kansas City, N.A. (pub. avail. Dec. 31, 1981); Continental Illinois National Bank & Trust Co. of 

Chicago (pub. avail. April 28,1975). 

The staff believes that pooled funds for IRAs require the protection of both the Securities and 

Investment Company Acts in part because interests in them would be offered to the general public 

as investments, not simply because IRAs are authorized under section 408 instead of section 401. 

Cf. Continental Illinois National Bank & Trust Co. of Chicago, supra. 

The fact that a collective trust fund for IRAs is not excepted from the provisions of the 

securities laws has been explicitly recognized by Congress. See SUBCOMM. ON SECURITIES OF THE 

SENATE COW. ON BANKING, HOUSING AND URBAN AFFAIRS, STUDY OUTLINE: THE SECURITIES 

ACTIVITIES OF COMMERCIAL BANKS, 94th Cong., 1st Sess. 13 (1975). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 133 
Congress created the 401(k) plan, now the most popular type of defined 

contribution plan, by amending section 401 of the Code in 1978?8 This 

amendment exempted from taxation certain profit-sharing and stock bonus plans 

that allowed employees to elect to receive, as part of their taxable income, the 

employer's contribution or, instead, defer receipt of, and taxation on, the 

contribution. If the employee elected to defer receipt of the contribution, it would 

be invested in a trust where the contributions and the earnings thereon would 

accumulate tax-free until disbursed. 

The Supreme Court, in 1979, held that participant interests in involuntary, 

noncontributor ension plans are not securities under the Securities Act and the 

Exchange Act? 'Subsequently, the Commission issued two major interpretive 

releases clarifying the treatment under the Securities Act of employee benefit 

plans not covered by the Supreme Court's decision?' These releases repeated 

the longstanding position that an employee's interest in a corporate pension or 

profit-sharing plan falls within the Securities Act's definition of "security" if the 

plan is both voluntary and contributory, but that registration is required only if 

the plan permits employee contributions to be invested in employer securities!' 

The Commission did not require interests in other plans to be registered for two 

reasons: (1) participants generally do not make investment decisions for an 

involuntary plan, and (2) the Commission did not wish to impose on an employer 

the cost of registering the interests in a plan except where the employer had a 

direct financial interest in soliciting voluntary employee contributions, such as 

where employee contributions are used to purchase the employer's securities?2 

At this time, 401(k) plans were funded entirely by employer contributions. 

Accordingly, the staff took the position that 401(k) plans were noncontributory 

and that, therefore, interests in 401(k) plans were not subject to the Securities 

A~t.6~ 

58Revenue Act of 1978, Pub. L. No. 95-600, § 135, 92 Stat. 2763, 2785-87 (1978) (codified as 

amended at 26 U.S.C. 5 401(k)). 

5?lnternational Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979). 

%mployee Benefit Plans, Securities Act Release No. 6281 (Jan. 15, 19811, 46 FR 8446 

(supplemental release on application of Securities Act to employee benefit plans); Sec. Act Rel. 

6188, supra note 49 (stating staff's position on application of Securities Act to employee benefit 

plans). 

%3ec. Act Rel. 6188, supra note 49. 

621d. See Lybecker, supra note 12, at 230. Interests in plans that are required to be registered 

generally are registered on Form S-8, a simplified registration form that now allows a registrant 

to incorporate certain ERISA disclosure documents by reference. The form is available to 

reporting companies. See Sec. Act Rel. 6867, supra note 14. 

%ec. Act Rel. 6281, supra note 60. 

134 CHAPTER 3 
Congress revisited the securities law exclusions for bank and insurance 

company pooled investment vehicles in 1980 in relation to governmental plans. 

It amended the securities laws to exclude interests in single and pooled 

governmental plans from registration under both the Securities Act and the 

Exchange Act, and governmental plans and their ooled investment vehicles from 

regulation under the Investment Company Act. 8 

In 1981, the Internal Revenue Service issued rules under section 401(k) of 

the Code, allowing plans to provide for pre-tax "out-of-pocket" employee 

contributions through salary reduction.& The Commission staff subsequently 

stated that interests in 401(k) plans that permit employees to contribute 

voluntarily a portion of their compensation would be Although a 

salary reduction 401(k) plan would involve the issuance of a security, registration 

of the interests in a 401(k) plan generally would not be required unless employee 

contributions are permitted to be invested in employer st0ck.6~ 

The last major action affecting the employee benefit exceptions occurred 

in 1981 when the Commission adopted rule 180.6* The rule conditionally 

exempts an interest in a Keogh plan, and the plan's interest in a pooled 

investment vehicle, from Securities Act registration on the basis of the financial 

sophistication of the sponsoring employer or on the employer's use of an 

independent professional manager. 

%mall Business Investment Incentive Act of 1980, Pub. L. No. 96-477, $$$701-03,94 Stat. 2275, 

2294-96 (1980) (codified at 15 U.S.C. 5s 77c(a)(2)(C) (Securities Act Q 3(a)(2)(C)), 78c(a)(12)(C) 

(Exchange Act 5 3(a)(12)(C)), 80a-3(c)(ll) (Investment Company Act 3(c)(ll))). 

65See Certain Cash or Deferred Arrangements Under Employee Plans, 46 FR 55544 (1981) 

(notice of proposed rulemaking); Income Tax; Taxable Years Beginning After December 31,1953 

and OMB Control Numbers Under the Paperwork Reduction Act; Certain Cash or Deferred 

Arrangements Under Employee Benefit Plans, 53 FR 29658 (1988) (final regulations, codified as 

amended at 26 C.F.R. 5 1.401k-1. See generally Curtis Vosti, Creator Faced Long Struggle, PENSIONS 

& INVESTMENTS, Od. 28,1991, at 17 (establishment of 401(k) plans that allow employees to make 

pre-tax contributions). 

&See 1 Pens. Plan Guide (CCH) q[ 1112 (Dec. 7, 1990); Diasonics, Inc. (pub. avail. Nov. 29, 

1982). 

67Diasonics, Inc., supra note 66. 

68Exemption From Registration of Interests and Participations Issued in Connection With 

Certain H.R. 10 Plans, Securities Act Release No. 6363 (Nov. 24, 1981),46 FR 58287 (codified at 

17 C.F.R Q 230.180). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 135 
111. Recent Developments in the Employee Benefit Plan Industry 

The 1980's witnessed a marked shift toward the establishment of defined 

contribution plans among employers, although defined benefit plans still contain 

the majority of retirement plan a~sets.6~ As noted above?' under a defined 

benefit plan, the employer is obliged to pay retirement benefits of specified 

amounts to employees meeting the plan's eligibility and vesting requirements. 

Defined contribution plans only obligate an employer to make contributions to the 

participant's account in the plan. The retirement benefits the employee receives 

will depend on the amount of assets in his or her account at retirement.71 In a 

defined benefit plan, the employer bears the investment risk of ensuring that there 

are sufficient assets to meet the plan's obligation^;^^ in a defined contribution 

plan, the investment risk falls upon the plan participants. 

A. Increase in Number of Defined Contribution Plans 

Defined benefit plans continue to be the primary type of private pension 

plan, covering more workers and containing more assets than defined 

contribution plans. During the past decade, however, the number of defined 

contribution plans has grown dramatically and the number of defined benefit 

plans has decreased correspondingly, especially among mid-sized employer^?^ 

Defined contribution plans constitute 81% of all pension plans (see Figure 

69See PENSION BENEFIT GUARANTY CORPORATION, PENSION PLAN CHOICE, 1979-1987: 

CLARIFICATIONS AND EXTENSIONS (1990) [hereinafter PBGC STUDY]; CLARK & MCDERMED, supra 

note 15. 

70~ee supra pp. 1-2. 

"See 29 U.S.C. 5 1002(34) (definition of defined contribution plan). 

29 U.S.C. § 1002(35) (definition of defined benefit plan). 

73Approximately 51 million workers, 55% of the full-time labor force, will be covered by a 

private retirement plan (either defined benefit or defined contribution) at the end of 1991. The 

coverage rate for employees in smaller firms is lower. Less than 25% of small employers provide 

retirement benefits. Frank Swoboda, White House Proposes Nm Pension Laws, WASH. POST, May 

1, 1991, at F1. 

74EBRI, supra note 4, at 8, Table 3. Defined contribution plans constitute 83% of pension plans 

covering fewer than 100 participants. See id. 

136 CHAPTER 3 
FIGURE 3-1 

Total Number of Pension Plans in 1988 

(thousands) 

Ddi ned Contribi 

594.8 

Total Number of Plans: 737.3 

Iefned Benefit 

142.5 

Saurca: Employes Benefits Research lme 

Among retired workers currently receiving pensions, 96% were participants in 

defined benefit plans, while only 4% were participants in defined contribution 

~lans.7~ Moreover, while 88% of all workers covered by a retirement plan in 

1979 were covered by a defined benefit plan, by 1987 only 75% of those covered 

were under a defined benefit plan (see Figure 3-2)?6 

75u.s. GENERAL ACCOUNTING OFFICE, PRIVATE PENSIONS MILLIONS OF WORKERS LOSE FEDERAL 

BENEFIT PROTECTION AT RETIREMENT 4-5 (1991). 

76PBGC STUDY, supra note 69, at 2. By contrast, the study notes that the portion of workers 

covered primarily by a defined benefit plan was relatively stable during the period from 1960 to 

1980. Id. See generally CLARK & MCDERMED, supra note 15, at 81-90 (data from 1977-85 show 

increasing use of defined contribution plans as primary pension plan among employers of all 

sizes, especially smaller employers). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 137 
FIGURE 3-2 

Growing Role of Defined Contribution Plans 

Today's Retirees 1979 Worktorce 1987 Worktorce 

Defined Benefit Defined Contribution 

Sauw US. heal Acmuming Mfiae 

Persian Benefit Guaranty corp 

Analysts attribute the change to a variety of factors, including: changes in 

employment patterns, which have resulted in greater numbers of workers 

employed by smaller firms;77 the authorization of the 401(k) plan in 1978; the 

increased administrative costs associated with operating a defined benefit plan, 

particularly for smaller plans:8 and the importance to employers of being able 

RSee James B. Lockhart, PBGC Advocates Defined-Benefit Plan Growth, PENSION WORLD, Feb. 

1990, at 38/40 (noting that "more people are working for smaller and/or service sector employers, 

who are inclined to establish defined-contribution plans"). However, changing employment 

patterns appear to account for only 20% of the shift in plan choice. See PBGC STUDY, supra note 

69, at 1,5. The PBGC STUDY also notes that 70% of the switch to 401(k) plans is "attributable to 

firms that otherwise would have been more likely to have chosen defined-benefit plans." Id. at 

19. See also CLARK & MCDERMED, supra note 15, at 91. 

'*See PBGC STUDY, supra note 69, at 1. See also Peter F. Drucker, Reckoning with the Pension 

Fund Revolution, HARV. Bus. REV., Mar.-Apr. 1991, at 106,112 (poor investment performance and 

new accounting standards for underfunding mean that employers will move away from defined 

benefit plans). But see Barry B. Burr, Reckoning with Notions of Drucker, PENSIONS & INVESTMENTS, 

May 13, 1991, at 12 (disputing Drucker's assertions about investment performance of defined 

benefit plans). An employer must report unfunded defined benefit plan obligations as a liability 

(continued ... ) 

138 CHAPTER 3 
to predict and control liabilities more accurately with defined contribution 

plans.79 

B. Growth of 401(k) Plans 

The popularity of one particular type of defined contribution plan -- the 

401(k) plan - is a major cause of the growth of defined contribution plans relative 

to defined benefit plans.80 Many employers, large and small, are establishing 

these plans8l There are many reasons why 401(k) plans are the fastest growing 

form of defined contribution plan. Employers like 401(k) plans because the 

employees contribute through salary reduction, which lowers the employers' cost 

of providing retirement benefits. In addition, employers believe that a 401(k) plan 

helps to attract and retain employeesg2 Like other defined contribution plans, 

the employer's 401(k) cost of complying with ERISA is lower, the employees bear 

the investment risk, and the employer can more easily predict its future 

liability?3 Employees like 401(k) plans because they can make voluntary pre-tax 

contributions to a plan, taxes are deferred on employees' earnings under a plan, 

and their employers usually match a percentage of their contributions, thereby 

instantly increasing the employees' retirement savings. Employees further like 

that they are able to exert some control over how their 401(k) plan contributions 

are inve~ted.8~ These plans are also attractive to employees because the assets 

78(...continued) 

on its balance sheet. 

Accounting Standards No. 87,s 36 (Fin. Accounting Standards Bd. 1985). 

See EMPLOYERS' ACCOUNTING FOR PENSIONS, Statement of Financial 

79hW!.STMENT COMPANY INSTITUTE, PERSPECTIVE ON MUTUAL FUND ACTIVITY: HOLDING THE 

COURSE (Fall 1991) at 17-18. See also Daniel H. Jackson & William J. McDonnell, What's Behind fhe 

Swifch to Defined Confribufion Plans?, PENSION WORLD, Aug. 1990, at 40,41 [hereinafter Jackson & 

McDonnell] . 

"See PBGC STUDY, supra note 69, at 13-22; Feinberg, supra note 4, at 34; Curtis Vosti, 401(k) 

'Clarification' a Crossroads, PENSIONS & INVESTMENTS, Oct. 28, 1991, at 17 [hereinafter 4OZ(k) 

Clarificafionl. 

"See Feinberg, supra note 4, at 36; Henry von Wodtke and Nancy Sabatiel, 40Z(k) Keeps Sfahrs 

as America's Favorife Employee Benefif, PENSION WORLD, Nov. 1991, at 14 [hereinafter Wodtke & 

Sabatiell; 402(k) Clarificafion, supra note 80. 

'2See PBGC STUDY, supra note 69, at 14/16; Wodtke & Sabatiel, supra note 81, at 14; Peter Starr, 

Competitive 401(k) Plans, PENSION WORLD, Apr. 1991, at 48. 

@See generally Richard N. Pallan, Defined Responsibility Should Follow Popularity of Refiremenf 

84See Wodtke & Sabatiel, supra note 81, at 15; 402(k) Clarification, supra note 80, at 17; Starr, 

Plans, PENSION WORLD, Dec. 1991, at 34; Feinberg, supra note 4, at 34, 36. 

supra note 82. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 139 
in the plan are "portable," the participant can more easily ascertain his or her 

account balance, and many plans allow a participant to borrow from the 

account.85 

According to estimates, 401(k) plans now have nearly $300 billion in assets 

and continue to grow rapidlys6 A recent survey found that 82% of participants 

in 401(k) plans decide how their own contributions are to be invested and 54% 

of participants decide how their employers' contributions are to be inve~ted.8~ 

C. Growth in Defined Contribution Plan Assets 

Available statistics show that defined contribution plans represent a 

growing portion of the nation's retirement plan assets. The proportion of assets 

invested in defined contribution plans has grown steadily since the mid-1970s. 

Defined contribution plan assets grew from 28% of total private pension assets in 

1975 to 39% in 1988 (see Figure 3-3).@ 

85See Feinberg, supra note 4, at 34/38; Jackson & McDonnell, supra note 79, at 41; Starr, supra 

note 82. See also Sheldon R. Barker, In Pursuit of 401W Dollars: A Billion Here; A Billion There; 

Pretty Soon You are Talking Real Money, FUNDS AGENTS CUSTODIANS SUPPLIERS, Summer 1991, at 

7-8. 

Defined contribution plans increasingly are used by participants as a means of general 

purpose investment. Most employees who obtain lump sum payments of their 401(k) plan 

accounts when they change jobs spend the money rather than place it in another retirement 

account. See Department of Labor Press Release No. 91-200 (Apr. 30,1991); Swoboda, supra note 

73, at F2. Many participants view their 401(k) plan as a means of saving for needs other than 

retirement, even though the 401(k) plan may be the only employer-sponsored source of retirement 

income for increasing numbers of employees. See Jackson & McDonnell, supra note 79, at 41. In 

this respect, defined contribution plan investment vehicles compete with investments that are 

available to investors outside of their retirement plans. 

"See Barker, supra note 85, at 7; Bill Montague, 402M Offer Options Gain Appeal, USA TODAY, 

May 20, 1991, at 3B; Joel Chernoff, Nm Rule Increases Flexibility, PENSIONS & INVESTMENTS, Dec. 

24,1990, at 30. 

"PROFIT SHARING COUNCIL OF AMERICA, 34TH ANNUAL SURVEY OF PROFIT SHARING AND 401(K) 

PLANS 15 (1991). The survey also found that 74% of plan participants who make after-tax 

contributions direct the investment of their contributions. Id. 

88pENSION AND WELFARE BENEFITS ADMIN., U.S. DEP'T OF LABOR, TRENDS IN PENSIONS 1991 

(John A. Turner & Daniel J. Beller, eds., forthcoming 1992) [hereinafter PWBA] (manuscript at 

Table 16.11, on file with Division). 

140 CHAPTER 3 
FIGURE 3-3 

Pension Plan Assets By Type of Plan 1975-88 

I 

75 76 77 78 79 80 81 82 83 84 85 66 67 68 

Defined Contribution Defined Benefit 

Source: Pension B Welfare Benefits Admin. 

Most of this growth has occurred since 1981,g9 the first year the IRS allowed 

pre-tax contributions by employees through salary-reduction (see Figure 3-4)?' 

"See supra note 65 and accompanying text. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 141 
FIGURE 3-4 

Comparison of Pension Plan Assets 1981 vs. 1988 

Defined Benefit 

Defined Contribution 

$184.5 Defined Contribution 

1981 

Assets: $628.9 Billion 

$591.6 

1988 

Assets: $1,503.6 Billion 

The vast majority of all private pension plans existing in 1988 covered a 

single employer with fewer than 100 participating employees?' Defined 

contribution plans are overwhelmingly the pension plan of choice for smaller 

employers as evidenced by 77% of their assets being invested in defined 

contribution plans (see Figure 3-5)?2 

91EBlU, supra note 4, at 7. 

92PWBA, supra note 88. 

142 CHAPTER 3 
FIGURE 3-5 

1988 Pension Pian Assets 

Small Plans 

I Benefii 

4.6 

Defined Contributi 

$186.2 

Total Assets: $240.8 Billion 

Source: Pension 8 Welfare Benefits Acknin. 

D. Competition Among Mutual Funds, Banks, and Insurance Companies 

The trend toward greater participant direction of defined contribution plan 

accounts has intensified competition among mutual funds, banks, and insurance 

companies for the management of retirement plans, especially 401(k) plan assets 

(see Table 

93Banks, insurance companies, and mutual funds compete for market share by emphasizing, 

where relevant, differences in investment performance and expertise in management, the security 

of assets underlying the investments offered, recordkeeping services, "one-stop shopping" for 

combined services, or participant services such as daily valuation and telephone switching. See 

Diane Levick, Insurance Companies, Banks, Mutual Funds Vie, HARTFORD COURANT, Oct. 8,1990; see 

also Curtis Vosti, Adapting to Change, PENSIONS & INVESTMENE, Sept. 30, 1991, at 1 (banks and 

mutual funds offer innovative services and new investment strategies to attract 401(k) plan 

investments). Some fund management groups have set up registered investment companies 

specifically for the assets of qualified plans. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 143 
Table 3-1 

Total Pension Plan Assets (billions) in Pooled Vehicles, 1990 

bank collective trust funds $267 

insurance company separate accounts $135 

mutual funds $ 36 

Sources: Employee Benefit Research Institute, American Council of Life Insurance, Investment Company Institute 

As evidence of the increased competition for defined contribution plan 

assets, a recent survey of the 100 largest U.S. bank and trust corporations found 

that many banks and trusts offer services to 401(k) plan clients comparable to 

those provided by mutual funds, including daily valuation and a variety of 

investment products.94 Eighty-five percent of the banks and trust companies 

responding to the survey offer collective investment funds and "slightly more 

than half" offer mutual funds. Of those that offer mutual funds, sixty-eight 

percent offer proprietary funds (ie., funds available only to the banks' customers). 

The consultant that conducted the survey expressed the view that "the trend 

toward proprietary mutual funds is due to client [i.e., the plan sponsor or 

administrator] demand for daily ~aluation."~~ Thesurvey also noted that banks 

and trust companies increasingly are offering computerized "on-line" services to 

their 401(k) plan clients?6 

IV. Information Provided to Investors 

As discussed above?7 employees increasingly participate in defined 

contribution plans, and increasingly make their own investment decisions 

regarding the assets in these plans. These changes eviscerate the original 

rationale for the exemptions from securities disclosure requirements for pooled 

~~ 

9%PTIMA GROUP, INC., NATIONAL 401(K) MARKETING TRENDS 9 (1990). 

96~d. at IO. 

97~ee supra Section III. 

CHAPTER 3 144 
investment vehicles -- that large employers, making the investment decisions and 

bearing the investment risks, could obtain needed information without disclosure 

requirements. 

Another possible rationale for these exemptions is that they are 

unnecessary in light of the other federal regulations now applicable to pension 

plans and their pooled investment vehicles. As this section shows, however, these 

regulations do not ensure that participants in defined contribution plans receive 

the information they would receive under the federal securities laws, or the 

information they need to make informed investment decisions. 

A. Comparison of Disclosure and Reporting Requirements 

Investment companies, bank collective trust funds, and insurance company 

separate accounts are each subject to distinct disclosure and reporting 

requirements. These schemes of regulation are described below. 

1. Prospectuses; Written Plans 

An investment company must register itself under the Investment 

Company Act and the securities it issues under the Securities Act. The 

disclosures required under the securities laws as a result of registration include 

a prospectus which contains information about the fund's fundamental 

investment objectives and policies; performance information covering ten years; 

information about the investment manager's background and compensation; how 

to purchase and redeem shares; and a table summarizing the fund's fees and 

expenses and their effect on a shareholder's investment. Section 5 of the 

Securities Act requires that a copy of the prospectus precede or accompany any 

security sold. 

Under the Securities Act, an investment company sponsor offering shares 

in an investment company can be sued for damages if the registration statement 

is materially misleading or defective?8 if the sponsor fails to deliver a 

prospectus in connection with the sale of a security?' or if the sponsor or its 

employees offer or sell any security by means of a prospectus or oral 

communication that includes a material misstatement or omission."' The 

investment company's underwriter and board of directors are also liable under 

section 11 of the Securities Act for a materially misleading or defective 

registration statement. In addition, a shareholder can bring an action for fraud 

'%ecurities Act § 11, 15 U.S.C. 5 77k. 

99Securities Act 5 12(1), 15 U.S.C. 5 77l(l). 

'mSecurities Act 5 12(2), 15 U.S.C. 5 77N2). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 145 
under rule 10b-5 of the Exchange Act in connection with the purchase or sale of 

an investment company's securities. 

ERISA disclosure requirements focus primarily on information about the 

plan itself, rather than on detailed information about the vehicles that fund the 

plan. Under ERISA, participants must receive a Summary Plan Description that 

must be updated periodically if material changes occur in the plan?" The 

Summary Plan Description summarizes the participants' rights and obligations 

under a plan, including the plan's eligibility and vesting provisions, procedures 

for presenting benefits claims, and the method by which contributions to the plan 

are determined. With respect to the plan's investments, the Summary Plan 

Description is required to include only the identity of any investment vehicles in 

which the plan invests.*'' Thus, ERISA does not require a plan's investment 

vehicles to provide disclosure to the plan fiduciaries or participants nearly 

comparable to that provided to investors by investment companies or other 

issuers under the federal securities laws. With respect to participant-directed 

plans, while employers currently make available information about investment 

vehicles to participants in a number of ways, the participant must take the 

initiative to obtain the information; ERISA does not require the plan fiduciaries 

or the em lo er to furnish participants with information about their 

investments. PO3 

Recently proposed regulations of the Department of Labor, if adopted, 

would shift even greater responsibility for investment decisions from the plan 

fiduciaries to the employees and heighten participants' need for information>04 

lo129 U.S.C. 1022(a)(l), 1024(b). 

'?See 29 U.S.C. 5 1022; 29. C.F.R. § 2520.102-3. Indeed, some commentators advocate providing 

plan participants with the least information possible. One writer has suggested that, with respect 

to underperforming 401(k) plans, "it makes sense not to name the mutual fund, or investment 

advisor used for the investment choices. Use generic terms: equity fund, fixed fund, balanced 

fund. That way, changes can be made behind the scenes without upsetting the employees." 

Renee Brody Levow, How to Get Your Employees to Love You and Their 401(k), PENSION WORLD, 

Aug. 1990, at 39. This abbreviated disclosure apparently would not satisfy ERISA's requirement 

that the Summary Plan Description identify the plan's investment vehicles. 

103Employers may make available information to employees by providing a prospectus, if one 

is available and if requested by a participant; through "on-line" computerized information services; 

through other written materials; by use of a bulletin board; or by referring participants to other 

sources of information. See generally Julie Rohrer, The Communications Cloud Over 401(k)s, 

INSTITUTIONAL INVESTOR, Sept. 1991, at 189 (increasing need for information about investment 

options). 

'04The Department of Labor first proposed rule 404c-1 in 1987. Proposed Regulation 

Regarding Participant Directed Individual Account Plans (ERTSA Section 404k) Plans), 52 FR 

(continued ...I 

146 CHAPTER 3 
Plan fiduciaries would be relieved of their fiduciary obligations for choosing plan 

investments where participants are provided with an opportunity to exercise 

control over the assets in their individual accounts and given an opportunity to 

choose from a broad range of investments, including at least three diversified 

categories of investments. While the proposed regulations would require that 

sufficient information be available from public sources for the three investment 

options, they would not require the plan fiduciary actually to furnish adequate 

written information about designated alternatives to those participants who 

request Further, the sufficient information requirement would not apply 

to any investment options over and above the required three. 

Under ERISA, a participant, fiduciary, or the Secretary of Labor may bring 

a civil action to enforce any rovision of ERISA, including the right to receive a 

Summary Plan Description.'g6 Participants and fiduciaries may also bring civil 

actions for violations of the terms of the plan. Further, the Secretary of Labor 

may levy fines against a plan administrator who fails to comply with a 

participant's request for information required under ERISA's reporting and 

disclosure requirements in a timely manner, where ERISA requires that such 

information be provided to the participant upon request. 

The Comptroller's rules for bank collective funds require banks to make 

available upon request a written plan, approved by the bank's board of directors, 

that generally describes the policies of the bank with respect to the fund, the 

allocation of income, profits and losses, and the terms for admission and 

~ithdrawa1.l'~ The bank must make available upon request an audited annual 

financial report that includes a list of the fund's investments, income and 

disbursements, and fees charged by the bank to the fund. That financial report 

may, but need not, include a description of the fund's value on previous dates, 

as well as its income and disbursements during previous periods."' The 

'%..continued) 

33508 (1987) (proposing 29 C.F.R. § 2550.404~-1). The 1987 proposal elicited a number of 

comments and a public hearing was held to address certain controversial aspects of the rule. 

After considering the comments and testimony, the Department of Labor substantially revised the 

1987 proposal and reproposed rule 404c-1 in 1991. Participant Directed Individual Account Plans, 

56 FR 10724 (reproposing 29 C.F.R. 5 2550.404~-1). 

'''If the investment options are limited to investments designated by the plan, the plan must 

make available an identified plan fiduciary to direct employees to sources of information. Id. at 

10728, 10737 (proposed 29 C.F.R. 5 2550.404c-l(b)(3)(iii)). 

'0629 U.S.C. 5 1132(a)(3), (5). 

"12 C.F.R. 5 9.18(b)(l). 

"'12 C.F.R. 5 9.18(b)(5). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 147 
Comptroller of the Currency has general authority to fine any national bank or 

affiliated party for violations of any provision of the laws or regulations 

governing national banks, including failure to provide these materials, but 

investors have no private right of action?" 

2. Shareholder and Periodic Reports 

a. Shareholder Reports 

An investment company must provide reports to shareholders of record 

at least semi-annually.''' The semi-annual report must contain the fund's 

balance sheet; an income statement; a portfolio schedule that shows the amount 

and value of each security owned by the fund on that date; a statement of 

operations (net changes); and condensed financial information (the per share 

table)?" The annual report must include audited financial statements 

accompanied by a certificate of an independent public accountant.ll2 

The Exchange Act also requires investment companies to provide reports 

to shareholders. Any proxy solicitation with respect to an annual meeting for the 

election of directors must be preceded or accompanied by an annual report to 

shareh01ders.l'~ A bank or other fiduciary who holds securities in nominee 

name is generally required to pass through all proxy materials, including 

shareholder reports, to the beneficial owners on whose behalf it holds the 

securities.l14 

*OgSee 12 U.S.C. Q 93(b). The statute provides a formula for determining the amount of any 

fine. Id. 

'"15 U.S.C. § 29(d); 17 C.F.R. Q 270.3Od-1. 

"'The per share table in an annual report must contain financial information for five years. 

The per share table in a semi-annual report must contain financial information for the period 

covered by the report and the preceding fiscal year. Item 23, Instruction 5(ii) to Form N-lA, 

Investment Company Act Release No. 13436 (Aug. 12,1983), 48 FR 37928. 

11*15 U.S.C. Q 80a-29(d), (e); 17 C.F.R. 5 270.3Od-1. 

'1317 C.F.R. Q 240.14a-3b). 

'1417 C.F.R. Q 240.14b-2. Participants in an employee benefit plan are considered to be the 

beneficial owners entitled to receive proxy materials if they have the right under the plan or 

otherwise to vote the securities held on their behalf. See Shareholder Communications Facilitation, 

Securities Exchange Act Release No. 23847 (Nov. 25,1986), 51 FR 44267. Employee benefit plans 

sponsored by the issuer or an affiliate of the issuer must comply with different procedures 

regarding the delivery of shareholder reports and proxy materials. See Facilitation of Shareholder 

Communications, Securities Exchange Act Release No. 25631 (Apr. 27, 19881, 53 FR 16399 

(continu ed... ) 

148 CHAPTER 3 
ERISA requires that participants receive a Summary Annual Report that 

discloses the net change in the value of the plan's assets, net unrealized 

appreciation of plan assets, total expenses, and total incorne>l5 The Summary 

Annual Report is not required to include information about a plan's 

investments.'16 The Summary Annual Report is a condensed version of the 

detailed annual report that must be filed on Form 5500 with the IRS, which must 

include, among other things, audited financial statements and information about 

the plan's in~estrnents."~ ERISA does not require the participant to be given 

the plan's Form 5500. Consequently, a participant will have to request a copy of 

Form 5500 from the lan administrator if it wants financial information about the 

plan's investmentsJ8 If a plan invests in a bank collective trust fund or an 

insurance company separate account, plan participants who request a copy of the 

plan's Form 5500 will also receive a copy of the annual statement of assets and 

liabilities of the collective trust fund or separate account.'*g ERISA regulations 

do not require independently-audited financial statements as to plan assets held 

in a collective trust fund or a separate account if the statements are prepared by 

a bank or insurance company regulated, supervised, and subject to examination 

by a state or federal agency and such statements are certified by the bank or 

insurance company and made part of the annual report>20 

In addition to its filing obligations under ERISA, a national bank that 

administers a collective trust fund is required by the Comptroller's rules to 

'14(...continued) 

(adopting rules excluding some employee benefit plan participants from proxy processing and 

direct communications provisions). 

'1529 U.S.C. Q 1024(b)(3); 29 C.F.R. Q 2520.104b-10. 

"'Form for Summary Annual Report Relating to Pension Plans, 29 C.F.R. Q 2520.104b-lO(d)(3). 

*I7, plan does not file its Form 5500 annual report directly with the Department of Labor. 

Plans sponsored by smaller employers may file a simplified annual report on Form 5500-C or 

Form 5500-R with the IRS, without audited financial statements. 

"*See 29 C.F.R. Q 2520.104b-lO(d)(3). 

'"ERISA requires banks and insurance companies to provide sufficient information to plan 

sponsors to allow them to complete Form 5500, including a copy of the statement of assets and 

liabilities of any collective trust fund or separate account in which the plan invests. 29 U.S.C. 9 

1023(a)(l)(B)(2). ERISA also requires plans to file with its Form 5500 an annual statement of assets 

and liabilities for any collective trust fund or separate account in which it invests. 29 U.S.C. .§ 

1023@)(3)(G). Alternatively, the bank or insurance company may file the statement directly with 

the Department of Labor and provide a copy to the plan administrator, in which case the plan's 

Form 5500 incorporates the statement by reference. 29 U.S.C. 5 1023(b)(4); 29 C.F.R. § 2520.103-9. 

12*29 U.S.C. Q 1023(a)(3)(C); 29 C.F.R. 5 2520.103-8. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 149 
prepare an audited financial report of the fund at least once a year>21 The 

financial report must include a list of the fund's investments, income and 

disbursements, and fees charged by the bank to the fund. Unlike an investment 

company's obligation to deliver financial information to shareholders and similar 

to ERISA's requirement that financial information about the plan be made available 

upon request to plan participants, banking regulations only require a national bank 

to provide notice of the avaizability of the annual financial report to any plan invested 

in its collective trust fund.122 While a bank must furnish a plan with a copy 

of the financial report upon request, there is no specific requirement under the 

banking regulations that the bank furnish annual financial reports to plan 

participants. 

b. Periodic Reports 

Investment companies must annually and semi-annually report to the 

Commission on Form N-SAR.123 The annual report must include financial 

information and an annual report by the independent accountant on the material 

weaknesses in internal accounting controls noted during its audit.124 

Employee benefit plans are required to file an annual report with the IRS 

on Form 5500, including audited financial statements, as described above>25 

Bank collective trust funds are not required to file periodic reports with the 

Comptroller,'26 The auditor of a collective fund's annual financial report, 

described above, is not required to file any report pointing out weaknesses in a 

fund's internal accounting controls found during its audit. 

12'12 C.F.R. § 9.18(5)(ii). 

1212 C.F.R. 5 9.18(b)(5)(iv). 

'%5 U.S.C. § 80a-29(a); 17 C.F.R. 

124See Item 77B and accompanying instructions to Form N-SAR, Investment Company Act 

Release No. 14299 (Jan. 4,1985), 50 FR 1442; AUDIT AND ACCOUNTING GUIDE, Aadits of Investment 

Companies 164 (Am. Inst. of Certified Pub. Accountants 1987). 

270.3Oa-1, 270.3Obl-1. 

lzSee supra notes 117,118,119,120 and accompanying text. 

I2%ee 12 C.F.R. 5 9.18(b)(5). 

150 CHAPTER 3 
B. Recommendations for Reform 

Today, plan participants receive far less information about the investment 

objectives and policies, performance, investment managers, fees, and expenses of 

their investment options than do investors who directly purchase securities issued 

by investment companies or other issuers. The Division believes that disclosure 

to plan participants who direct and bear the risk of their investments should be 

improved. Therefore, we recommend that the Commission send to Congress 

legislation that would remove the current exemption from Securities Act 

registration in section 3(a)(2) for interests in pooled investment vehicles consisting 

of assets of participant-directed defined contribution plans. Further, we 

recommend that the legislation amend the federal securities laws to require the 

delivery of prospectuses for the underlying investment vehicles to plan 

participants who direct their investments. We also recommend legislation that 

would amend the Exchange Act to require the delivery of semiannual and annual 

shareholder reports for the underlying investment vehicles (0 ther than registered 

investment companies) to these plan participants. Finally, we recommend that 

the rules under the Investment Company Act be amended to require the delivery 

of semiannual and annual reports of underlying registered investment companies 

to these plan participants. 

Two factors prompted us to reconsider the Securities Act exemption for 

interests in pooled investment vehicles for participant-directed defined 

contribution plans. The historical reasons justifying the securities law exemptions 

of pooled vehicles for employee benefit plan assets -- that "sales" are made to 

sophisticated employers and that the employers bear the risk of loss -- are both 

inapposite in the case of participant-directed defined contribution plans. Second, 

the current ERISA requirements and banking regulations do not provide investors 

with information comparable to that provided under the securities laws. 

Although plan fiduciaries are held to a "prudent person" standard under ERISA 

with respect to. the initial and continued suitability of the investment alternatives 

designated by the plan sponsor in a participant-directed plan, participants 

nonetheless must make the final investment decision in such plans?27 

Participants in these plans are in a position similar to that of an ordinary investor, 

but without the benefits of the disclosure provided under the federal securities 

laws. 

Accordingly, we recommend that the Commission seek legislation to 

amend section 3(a)(2) of the Securities Act to remove the exemption from 

registration for interests issued by those collective trust funds and separate 

accounts in which participant-directed defined contribution plan assets are 

lwSee infru notes 133-137 and accompanying text (ERISA prudence requirements). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 151 
invested.128 We only recommend removal of the exemption from registration 

for interests in pooled investment vehicles, not the exemption for the participant's 

interest in the plan itself. We further recommend that the securities laws be 

amended to require the delivery of prospectuses of underlying collective trust 

funds, separate accounts, and registered investment companies to the participants 

in these participant-directed plans. These recommendations would provide plan 

participants who make their own investment decisions with the benefit of the 

disclosures required under the federal securities laws. As we have discussed 

above, these disclosures are far more timely and comprehensive than those 

currently required under ERISA or the banking regulations. Moreover, those 

making these disclosures would be subject, for the first time, to civil liability for 

material misstatements and omissions under sections 11 and 12(2) of the Securities 

These pooled investment vehicles, however, otherwise would remain 

subject to ERISA, the Internal Revenue Code, and, with respect to bank collective 

trust funds, the Comptroller's regulations. 

Subsequent to their initial decision to invest in securities, participants have 

a continuing need for information to evaluate their investments and decide 

whether to maintain or reallocate them. Essential information for this ongoing 

investment review is contained in the issuers' current prospectuses and 

shareholder reports. For this reason, the Division believes that the federal 

securities laws should be amended to require delivery of prospectuses of 

underlying collective trust funds, separate accounts, and registered investment 

companies to plan participants when they reallocate their investments. In 

addition, to ensure that participants receive important financial information in 

connection with monitoring their investments, the Division recommends that the 

periodic reporting exemption in the Exchange Act for collective trust funds and 

separate accounts be deleted and that those pooled investment vehicles be 

required to transmit to participants the same information required of investment 

companies under the shareholder reporting provision of the Investment Company 

~ 

128We conclude that it is appropriate to continue the securities law exemptions for pooled 

investment vehicles, and interests therein, that consist exclusively of assets of defined benefit plans 

and defined contribution plans that do not provide for participant direction. ERISA imposes 

duties and liabilities on sponsors and managers of these plans that relieve the individual 

participant of much of the responsibility for the management of his or her assets under the plan. 

With respect to defined benefit plans in particular, the employers bear the investment risks, and 

the plans are subject to certain ERISA funding and liability requirements that are not applicable 

to defined contribution plans. Unlike defined contribution plans, defined benefit plans generally 

are insured by the PBGC. 

'*%e believe that both a plan, and its participants on a derivative basis, should have a cause 

of action against issuers who violate these sections - in the same way as any other issuer is liable. 

The plan sponsor or fiduciaries should be liable for an issuer's material misstatement or omission 

only if it reasonably should have known about it. 

152 CHAPTER 3 
Finally, the rules under the Investment Company should be amended 

to ensure that all beneficial owners in registered investment companies receive 

semiannual and annual reports. 

V. Substantive Regulation of Pooled Investment Vehicles 

We also considered whether section 3(c)(ll) of the Investment Company 

Act should be amended to require collective funds and separate accounts to 

register as investment companies. To analyze this issue, we compared the three 

regulatory frameworks. This section compares certain key areas of substantive 

regulation under the Investment Company Act, ERISA, and the Comptroller’s 

regulation 9. We conclude that while the protections provided by the Investment 

Company Act probably are somewhat greater, ERISA adequately protects 

participants in both defined benefit and defined contribution plans, including 

participant-directed defined contribution plans. Requiring these pooled 

investment vehicles to register under the Investment Company Act would be 

costly and disruptive. Accordingly, we do not recommend that these collective 

trust funds and separate accounts be required to register under the Investment 

Company Act. 

The three regulatory frameworks impose differing sets of requirements and 

apply to groups of persons with differing relationships to employee benefit plan 

assets. Despite those differences, in many key areas of investor protection 

investment companies, bank collective funds, and insurance company separate 

accounts holding plan assets are subject to comparable (though not identical) 

regulation. 

A. Fiduciary Standards 

The Investment Company Act imposes several somewhat general fiduciary 

duties on certain persons in connection with their investment company activities. 

An investment company’s investment adviser has a fiduciary duty with respect 

to any compensation, including its management fee, it receives from an 

investment company or its shareholders, Section 36(b) allows the Commission or 

any shareholder to bring an action for breach of this fiduciary duty.131 Section 

36(a) authorizes the Commission to bring an action for injunctive or other judicial 

relief against any officer, director, investment adviser, or principal underwriter 

of an investment company for breach of fiduciary duty involving personal 

13’As further discussed supra at notes 110-112 and accompanying text, the Investment 

Company Act shareholder reporting provisions, section 30(d) and rule 3Od-1 thereunder, require 

a registered investment company to provide semi-annual and annual reports containing basic 

financial information about the fund. See 15 U.S.C. § 80a-29(d); 17 C.F.R. 5 270.3Od-1. 

13’15 U.S.C. Q 80a-35(b). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 153 
misconduct.132 Further, the antifraud provision of the Investment Advisers Act 

of 1940 also protects investment companies and their shareholders a ainst 

fraudulent, deceptive, and manipulative conduct by investment advisers. 183 

ERISA contains an explicit fiduciary requirement that obligates an ERISA 

plan fiduciary to act "with the care, skill, prudence, and diligence under the 

circumstances then prevailing that a prudent man [sic] acting in a like capacity 

and familiar with such matters would use in the conduct of an enterprise of a like 

character and with like aims."134 The plan fiduciary must ensure that the plan's 

investments are diversified to minimize the risk of large losses, unless it is clearly 

prudent not to do and generally act in accordance with the plan 

documents:36 A plan fiduciary must monitor the performance and suitability 

of plan A plan fiduciary also may be liable for another 

fiduciary's breach of fiduciary duty under certain circumstance^.^^^ 

ERISA preempts state civil law with respect to employee benefit plans.139 

Participants, therefore, cannot bring a common law action for breach of fiduciary 

duty against a plan fiduciary. Participants, beneficiaries, fiduciaries, and the 

Secretary of Labor may bring civil actions under ERISA for any breach of 

fiduciary duty, including breaches of the prohibited transactions provisions.140 

13215 U.S.C. Q 80a-35(a). 

'%15 U.S.C. Q 80b-6. 

13429 U.S.C. Q 1104(a)(l)(B). 

lS29 U.S.C. § 1104(a)(l)(C). 

13Generally, a fiduciary must consider certain factors in the prudent performance of its 

investment duties, including the diversification of the plan's assets, liquidity and current return, 

and projected return. 29 C.F.R. Q 2550.404a-1. 

"'ERISA does not set forth specific requirements with respect to the type of information that 

pooled investment vehicles must provide to the plan sponsors. 

13'29 U.S.C. Q 1105(a). 

13'29 U.S.C. Q 1144(a). 

lm29 U.S.C. §§ 1132(a)(2)-1132(a)(3). See generally Daniel Candee Knickerbocker, Trust Law with 

u Difference: An Overview of ERISA Fiduciary Responsibility, 23 REAL PROP. PROB. & TR. J. 633 (1988) 

(comparing fiduciary duties and liabilities under ERISA and traditional trust law). Recently, the 

Department of Labor filed suits against employers and other fiduciaries, charging them with 

violating their fiduciary responsibility in purchasing retirement annuities for their employees from 

a subsidiary of bankrupt First Executive Corp. See U.S. is Suing AFG on Buying Annuities From 

Executive Life, WALL ST. J., July 12,1991, at C8; Robert Rosenblatt, U.S. Challenges Pension Switching, 

(continued. ..) 

154 CHAPTER 3 
The Secretary is required to assess a civil penalty against a fiduciary for breaching 

a fiduciary duty or engaging in a prohibited transaction and may also assess a 

civil penalt against a party in interest for violations of the prohibited transactions 

provisions . '" The Internal Revenue Code also imposes excise taxes on 

"disqualified persons" who engage in prohibited transactions with a plan>42 

ERISA imposes strict responsibilities and limitations on banks and 

insurance companies as fiduciaries with respect to plans whose assets are invested 

in collective funds or separate accounts. ERISA defines as a plan fiduciary any 

person who exercises discretion with respect to the management of a plan or its 

assets, renders investment advice to a plan for a fee (direct or indirect), or has 

discretion with respect to the administration of a plan.*43 This generally 

includes the plan sponsor, its directors, and certain of its officers and employees. 

A fiduciary must act with respect to the plan solely in the interest of the plan 

participants and for the exclusive purpose of (i) providing benefits to the 

participants and (ii) defraying reasonable expenses of administering the plan.144 

ERISA limits a plan fiduciary's fiduciary responsibility to the specific plan 

assets over which it exercises discretion or has the responsibility that makes it a 

fiduciary>& When a plan invests in an entity/ the "plan assets" of the plan 

generally include its investment but not, solely by reason of that investment, any 

140(...continued) 

L.A. TIMES, June 13,1991, at Al; Frank Swoboda, US. Tests Rules on Annuities Purchased by Pension 

Funds, WASH. POST, June 13,1991, at B11; see also Ann Hagedorn & Suein L. Hwang, Unisys Sued 

for Investing in Executive Life, WALL ST. J., June 17, 1991, at B3 (suit brought by plan participants 

alleging imprudent investments). 

14'29 U.S.C. @, 1132(i), 11320). 

Internal Revenue Code contains a similar set of prohibited transactions provisions and 

statutory exemptions with respect to plans qualified under section 401. Most of the transactions 

prohibited under ERISA give rise to excise taxes under the Code. However, the Code imposes 

the excise taxes on a smaller class of persons. Compare 26 U.S.C. 3 4975(c) (prohibited 

transactions) with 29 U.S.C. 5 1106 (prohibited transactions). 

'@29 U.S.C. 5 1002(21)(A). See also 29 C.F.R. § 2510.3-21(~)(1) (definition of "investment 

advice"). 

1429 U.S.C. 5 1104(a). 

145Exemptions From Prohibitions Respecting Certain Classes of Transactions Involving 

Employee Benefit Plans and Certain Broker-Dealers, Reporting Dealers, and Banks, Prohibited 

Transaction Exemption 75-1, 40 FR 50845, 50846 (1975) [hereinafter PTE 75-11. See 29 C.F.R. § 

2510.3-21 (definition of "fiduciary"). A person is a fiduciary only with respect to those plan assets 

over which that person exercises any fiduciary responsibility. That person, however, is a party 

in interest with respect to all plan assets. PTE 75-1, supra, at 50846. For a discussion of "party in 

interest," see infra note 155 and accompanying text. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 155 
of the underlying assets of that entity>& When a plan invests in an equity 

interest of a company that is not an operating company and the security is neither 

a publicly-offered security nor a security issued by a registered investment 

company, however, the plan’s assets include both the equity interest and an 

undivided interest in the underlying assets of the entity that issued the equity 

ERISA makes any person exercising authority or control over the 

management or disposition of the underlying assets of that entity, and any person 

who provides investment advice with respect to those assets for a fee (direct or 

indirect), a fiduciary of the investing lan, subject to all of the duties and 

liabilities imposed upon plan fiduciariesFa When a plan invests in a collective 

trust fund or a pooled separate account, plan assets include both the interest 

issued by the entity and an undivided interest in each of the underlying assets of 

the entity.’49 Consequently, any person who exercises authority or control 

respecting the management or disposition of the underlying assets of the 

collective trust fund or separate account, and anyone providing investment advice 

with respect to such assets for a fee (direct or indirect), is a fiduciary of the plan. 

These persons could include a bank’s or insurance company’s board of directors 

or investment committee, or a bank’s trust department. 

Regulation 9 describes national banks as fiduciaries with respect to the 

employee benefit plan assets they invest in their collective trust funds but, unlike 

the Investment Company Act and ERISA, does not enumerate specific fiduciary 

duties. Regulation 9 does not provide specific remedies for breach of fiduciary 

duty with respect to investments in collective trust funds. Nonetheless, the 

Comptroller of the Currency may fine a national bank or an affiliated party for 

‘&29 C.F.R. § 2510.3-101(a)(2). 

If equity participation in the entity by benefit plan investors is not significant, plan 

assets include only the equity interest in the entity. Id. 

‘%i. 

‘@29 C.F.R. 2510.3-101(h)(l). The underlying assets of separate accounts maintained solely 

in connection with guaranteed investment contracts under which amounts payable to the plan are 

not affected in any manner by the investment performance of the separate account are not plan 

assets. 

By contrast, when a plan invests in securities issued by an investment company, those 

securities -- but not any assets of the investment company - become plan assets. 29 U.S.C. Q 

llOl(b)(l). Accordingly, neither the investment company nor its investment adviser or principal 

underwriter is treated as a fiduciary of such plan under ERISA. 29 U.S.C. 5 1002(21)(B). This 

special treatment of investment companies reflects Congress’ perception that the Investment 

Company Act already subjects investment companies to extensive fiduciary regulation. See 

William M. Tartikoff, Treatment @Mutual Funds Undm ERISA, 1979 DUKE L.J. 577, 581 (citing 

pertinent legislative history). 

156 CHAPTER 3 
violating the banking laws or regulations constituting a breach of fiduciary 

, duty?50 

B. Prohibitions Against Self-Dealing: Investment Company Act, ERISA, 

and Regulation 9 

The Investment Company Act extensively restricts self-dealing between 

investment companies and their affiliates. As discussed in detail in Chapter 12, 

section 17 restricts three broad categories of affiliated transactions to protect 

investors from a variety of conflicts of interest that may arise when a passive pool 

of assets is within the reach of interested parties. The Investment Company Act 

prohibits or restricts transactions in which an affiliate (or an affiliate of an 

affiliate): (1) purchases securities from or sells securities to, or borrows money 

or property from, the investment company ("principal transactions"); (2) jointly 

participates in a transaction with the re istered investment company ("joint 

transactions"); and (3) acts as broker or agent for the investment company 

("agency transa~tions")?~~ Further, to prevent an affiliate from unloading or 

"dumping" unwanted securities into an investment company, section lO(f) of the 

Investment Company Act generally prohibits an investment company from 

purchasing securities in an underwritin in which any affiliated person 

participates as a principal underwriter. lE2 Under rule 1Of-3, investment 

companies may purchase securities from a syndicate containing an affiliate if 

certain safeguards are met.153 

To protect a plan's assets against abusive practices by persons in a position 

to control those assets, ERISA prohibits plans from engaging in transactions with 

two types of persons: "parties in interest" and "fiduciaries." "Party in interest" is 

defined broadly to include many persons who, by virtue of a financial interest in 

a plan's operations, or some relationship to a plan or another party in interest, 

might be in a position to exert im roper influence over the plan to the detriment 

of the plan and its participant^?'^ Plan investment managers, administrators, 

and other fiduciaries are parties in interest and thus subject to the prohibitions 

lm12 U.S.C. Q 93(b). 

15'15 U.S.C. Q 8Oa-17. 

15215 U.S.C. Q SOa-lO(f). 

'%17 C.F.R. Q 270.1Of-3. 

'%See 29 U.S.C. Q 1002(14)(A) (definition of "party in interest"). Parties in interest with respect 

to a particular plan include the sponsors, fiduciaries, and service providers of the plan and all 

officers, directors, employees, and ten percent shareholders of the plan sponsor and the plan. 29 

U.S.C. Q 1002(14)(A)-(I). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 157 
applicable to all parties in interest as well as certain prohibitions specifically 

governing only fiduciaries. 

The coverage of ERISA's self-dealing and conflict of interest prohibitions 

is similar but not identical to those of the Investment Company Act. These 

differences exist partly because the Investment Company Act self-dealing 

prohibitions affect transactions between the investment company and any 

"affiliated person," a defined term broader in some respects and narrower in 

others than "party in interest."*55 For example, the owner of five percent of the 

outstanding voting shares of an investment adviser must comply with the 

Investment Company Act self-dealing restrictions, whereas only a ten percent or 

larger shareholder of a plan sponsor would be subject to ERISA's per se prohibited 

transactions provisions. On the other hand, any custodian of a plan and any 

person who provides services to a plan, such as a broker, is a party in interest 

with respect to that plan, while a person who provides custodial or brokerage 

services to an investment company is not, for that reason alone, an affiliated 

person of the investment company. Differences in coverage also exist because the 

Investment Company Act does not distinguish between fiduciaries and other 

affiliated persons with respect to its self-dealing prohibitions, while some of 

ERISA's prohibitions apply only to "fiduciaries," a defined term covering plan 

trustees, investment advisers, and administrator^:^^ 

ERISA's core prohibitions, contained in section 406, are generally 

comparable to many of those in the Investment Company Act. Under section 

406(a), a plan may not engage in a transaction with a party in interest that would 

directly or indirectly constitute: a sale, exchange, or lease of any property; a loan 

of money or other extension of credit; furnishing goods, services, or facilities; a 

transfer to or use by or for the benefit of a party in interest of any assets of the 

plan; or an acquisition on behalf of the plan of employer securities or employer 

real property in excess of prescribed limits which, for defined benefit plans, 

would be 10% of plan As with the Investment Company Act, ERISA 

permits affiliates to provide certain services to the fiduciary client. Section 406(b) 

prohibits a plan fiduciary from dealing with plan assets for its own interest or 

account, acting on behalf of any party whose interests are adverse to the plan's 

or participants' interests in a transaction involving the plan, or receiving any 

consideration (Le., kickbacks) from any party dealing with the plan in connection 

with a transaction involving assets of the plan. 

~~~ ~ 

f55Compure 15 U.S.C. Q 80a-2(a)(3) with 29 U.S.C. Q 1002(14) (definitions of "affiliated person" 

and "party in interest"). 

'%See 29 U.S.C. 1002(21)(A), 1106(b). 

157See 29 U.S.C. Q 1106(a)(l). 

158 CHAPTER 3 
Regulation 9 subjects bank collective funds to some self-dealing restrictions. 

A national bank maintaining a collective trust fund may not sell to or purchase 

from the collective trust fund securities or other property, although affiliates of 

the bank are not prohibited from making such purchases or sales?58 Banks 

may purchase securities on behalf of their collective trust funds in an 

underwriting in which an affiliate participates, if a majority of the bank's outside 

directors approves the transa~tion.'~' Even if a bank fails to obtain approval 

of the outside directors, it may "cure" a self-dealing underwriting transaction 

through disclosure.16' 

1. Principal Transactions: Prohibitions and Exceptions 

Section 17(a) of the Investment Company Act prohibits an affiliate of an 

investment company, acting as principal, from knowingly purchasing or selling 

securities ok property from or to the investment company. It also prohibits 

affiliates from borrowing from the investment company. The Commission has 

adopted rules providing certain exceptions from these prohibitions.l6' In 

addition, under section 17(b), the Commission may exempt a proposed transaction 

if its terms are fair and reasonable, involve no overreaching by any person, and 

are consistent with the general purposes of the Investment Company Act. 

Notwithstanding the prohibitions of section 17(a), section 17(c) permits an 

affiliated person, in the ordinary course of business, to purchase from or sell to 

an investment company merchandise, enter into lessor-lessee relationships with 

the investment company, and furnish services incident thereto. Nevertheless, the 

Investment Company Act and the rules thereunder protect against affiliated 

persons engaging in self-dealing with respect to service contracts with investment 

companies. As earlier noted, an investment adviser and its affiliated persons have 

a fiduciary duty with respect to any compensation, including any fees for services 

it receives from an investment company or its shareholders. Under section 36(b) 

of the Investment Company Act, both the Commission and shareholder may sue 

'%12 C.F.R. Q 9.18(b)(8)(i). 

159The Competitive Equality Banking Act of 1987, Pub. L. No. 100-86, Q 102(a), 101 Stat. 552, 

564 (1987) (codified at 12 U.S.C. Q 371c-11, added Section 23B to the Federal Reserve Act, which 

prohibits the purchase of securities by a member bank or its subsidiary, either as principal or 

fiduciary, from any underwriting in which an affiliate is a "principal underwriter" of those 

securities, unless a majority of the outside directors of the bank approves the purchase. 

1600FFICE OF THE COMPTROLLER OF THE CURRENCY, Trust Banking Circular No. 19 (Sept. 25, 

1981), 5 Fed. Banking L. Rep. (CCH) 9[ 59,309. 

I6'See Chapter 12. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 159 
the adviser for breach of this fiduciary duty>62 Shareholders know exactly 

what they pay to affiliates for services, because all expenses incurred by an 

investment company, including those paid to affiliates for services, must be 

reflected on the fee table in the fund's Finally, an affiliated 

person may perform services for an investment company without violating section 

17(d)164 only if adequate safeguards exist, including approval by the investment 

company's directors, to prevent 0~erreaching.l~~ 

Because of the large number of persons subject to ERISA's self-dealing 

prohibitions, ERISA contains several exemptions from the prohibited transactions 

provisions of section 406(a).166 Further, the Department of Labor has issued a 

number of class exemptions to permit potentially beneficial principal transactions 

where it perceives self-dealing opportunities as minimal>67 For example, a 

separate account or a bank collective trust fund may engage in otherwise 

prohibited transactions with a party in interest, or acquire or hold employer 

securities or real property, provided the assets of the plan invested in that 

separate account or collective trust fund do not exceed ten percent of the total 

assets of the separate account or collective trust fund>68 

la15 U.S.C. 80a-35(b). 

'@Item 2 of Form N-lA, Investment Company Act Release No. 16244 (Feb. 1, 1988),53 FR 

3192. 

'64Discussed infra at notes 199-201 and accompanying text. 

'&See, e.g, Merrill Lynch Capital Fund, Inc. (pub. avail. Dec. 21, 1990); Washington Square 

Cash Fund (pub. avail. July 9,1990); Unified Management Corporation (pub. avail. June 28,1990); 

The Flex-fund (pub. avail. Nov. 22,1985); Federated Securities Corp. (pub. avail. Oct. 21,1983). 

'&See 29 U.S.C. 5 1108. These statutory exemptions do not relieve fiduciaries from the general 

standards of prudence and loyalty that govern a fiduciarfs obligations with respect to a plan. 

'67Class exemptions may provide relief from some or all of the section 406(a) prohibited 

transactions provisions, or some or all of the section 406(b) fiduciary self-dealing restrictions, or 

both. 

'@Amendment to Prohibited Transaction Exemption (PTE) 80-51 Involving Bank Collective 

Investment Funds, Prohibited Transaction Exemption 91-38,56 FR 31966,31969 (1991) [hereinafter 

PTE 91-38]; Amendment to Prohibited Transaction Exemption (PTE) 78-19 Involving Insurance 

Company Pooled Separate Accounts, Prohibited Transactions Exemption 90-1/55 FR 2891 (1990) 

[hereinafter PTE 90-11. These exemptions do not relieve a fiduciary from liability for self-dealing 

under section 406(b). Indirect holdings in qualifying employer securities and qualifymg employer 

real property are not counted for purposes of this 10% limitation. PE 91-38, supra, at 31969; PTE 

90-1, supra, at 2893. Further, the party in interest engaging in the transaction may not be the 

insurance company or bank, any separate account of that insurance company or collective 

investment fund of that bank, or any affiliate of either. 

160 CHAPTER 3 
All transactions between a separate account or collective trust fund and a 

person who is a party in interest solely by reason of providing services to the 

plan (including a plan fiduciary), or having a particular relationship to a service 

provider, are also Another exemption conditionally permits any 

purchase or sale of a security between a plan and a registered broker-dealer, a 

primary dealer in U.S. government securities, a bank, or any affiliate of such 

persons, that is not a fiduciar and is a party in interest soIeZy by virtue of 

providing services to the plan. 170 

A party in interest of a plan may engage in otherwise prohibited 

transactions involving plan assets (including a collective trust fund or separate 

account in which the plan invests) if the assets are managed by a "qualified 

professional asset manager'' (,'QPAM'').l7* A QPAM must be a bank, savings 

and loan, insurance company, or registered investment adviser and must meet 

certain equity capital or net worth standards. To qualify as a QPAM with respect 

to a transaction, the plan's assets, together with the assets of any other plan 

maintained by the same employer, or an affiliate thereof, or employee 

organization must not constitute more than twenty percent of the total client 

assets managed by that QPAM at the time of the transaction. The QPAM also 

must be independent of the parties in interest involved in any transaction covered 

by this class exernption.l7* 

A plan's sale or purchase of an interest in a collective trust fund or a 

separate account of an insurance company is also exempt from the prohibited 

16'PTE 91-38, supra note 168, at 31968; PTE 90-1, supra note 168, at 2893. Unlike the previous 

exemption, a fiduciary would not be liable for self-dealing under this exemption. See supra note 

169 and accompanying text. However, the party in interest must not be affiliated with the 

insurance company or bank and must not have any discretion with respect to the plan's 

investment in the separate account or collective investment fund or the management or disposition 

of the assets of the separate account or collective investment fund. 

'?P"E 75-1, supra note 145, at 50847. 

'"Class Exemption for Plan Asset Transaction Determined by Independent Qualified 

Professional Asset Managers, Prohibited Transaction Exemption 84-14/49 FR 9494 (19841, amended 

50 FR 41430 (1985). A QPAM must have investment discretion over the plan assets, but need not 

have custody. Id. at 9506. Transactions involving fiduciary self-dealing or the acquisition of 

employer securities or real property are not covered by this exemption. 

lTLA transaction will not be exempt under this class exemption if the party in interest, or an 

affiliate thereof, has the power, or within the preceding 12 months has exercised the power, to 

appoint or remove the QPAM or to negotiate the terms of the management agreement with the 

QPAM. Id. at 9504. Further, the party in interest dealing with the investment fund must not be 

the QPAM or any person that owns a 5% interest in, or is 5% owned by, the QPAM. Id. at 9504, 

9506. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 161 
transactions provisions under certain condition^.'^^ The plan must pay no 

more than reasonable compensation in connection with the transaction. The 

purchase or sale must be expressly permitted by the instrument governing the 

plan or by a fiduciary (other than the bank, trust company, insurance company, 

or an affiliate thereof) that has authority to manage and control the assets of the 

plan. The exemption relieves parties in interest from the prohibited transactions 

provisions of section 406(a) of ERISA. The Department of Labor has not stated 

whether the exemption also relieves fiduciaries from the self-dealing or conflicts 

of interest prohibitions of Section 406(b), although the Department has stated that 

a bank that is a fiduciary of a plan would not violate Section 406(b) if the bank 

invested the assets of the plan in its "common trust fund" where the bank had no 

discretion with respect to that investment.17* It is not clear whether this 

exemption might allow a plan to invest in a collective trust fund or separate 

account with the expectation that the bank or insurance company will then extend 

a loan to, or engage in other transactions for the benefit of, a party in 

The Department of Labor has said, however, that a plan's purchase 

of an insurance policy pursuant to an arrangement under which the insurance 

company will then lend money to a party in interest would be a prohibited 

trans action: 76 

The Department of Labor also has exempted the purchase or sale of a 

security between a plan and a fiduciary that is a market-maker for that security, 

subject to certain conditions, as long as there is at least one other market-maker 

for the security, and the net price for the transaction is more favorable to the plan 

than that which the fiduciary, acting in good faith, reasonably believes to be 

~ 

In29 U.S.C. Q 1108(b)(8). 

1740pinion 88-11A, 1988 ERISA LEXIS 11 (Aug. 17,1988). See also Proposed Class Exemption 

for Certain Transactions Involving Bank Collective Investment Funds, 44 FR 44290, 44291 n.3 

(1979) (proposing PTE 80-51, predecessor to current PTE 91-38, supvu note 168). 

lEIf the loan to a non-fiduciary party in interest is from the collective trust fund or separate 

account (ie., the loan is from plan assets), the transaction, while prohibited, would fall within two 

class exemptions which exempt transactions between a pooled investment vehicle and a party in 

interest of a plan where the plan's assets constitute no more than 10% of the assets of the 

collective trust fund or separate account. See PTE 91-38, supra note 168, at 31966; PTE 90-1, supa 

note 168, at 2891. However, if the bank loans funds that are not plan assets to a non-fiduciary 

party in interest, it might not be a prohibited transaction, even if the plan has a substantial 

investment in the bank's collective trust fund. A loan to a fiduciary under these circumstances 

might be self-dealing under section 406(b). 

1761nterpretive Bulletin Relating to Prohibited Transactions, 29 C.F.R. 5 2509.75-2. 

162 CHAPTER 3 
available at the time from all other market-maker^?^^ However, the 

Department stated that such a transaction might be deemed a prohibited 

transaction if its purpose was to benefit the fiduciary or an affiliate of such 

Plan assets may be invested in short term debt instruments issued 

by a party in interest such as bankers' acceptances, commercial paper, repurchase 

agreements, and certificates of deposit issued by parties in interest.17' A 

registered broker-dealer that executes securities transactions for a plan and hence 

is a party in interest, but is not a fiduciary, may extend credit to a plan in 

connection with the purchase or sale of securities.18' Conversely, a plan may 

lend its securities to certain parties in interest, provided neither the borrower, nor 

any affiliate of the borrower, has discretionary authority or control with respect 

to the investment of plan assets or provides investment advice with respect to 

those assets."' 

Just as section 17(c) of the Investment Company Act permits an affiliate to 

sell merchandise or lease real property to an investment company in the ordinary 

course of business, two ERISA class exemptions conditionally permit a party in 

interest, including any fiduciary, to furnish certain goods to a separate account 

or collective trust fund, and a separate account or collective trust fund to lease 

real property to a party in interest.ls2 The party in interest must not be the 

insurance company or bank, another separate account or collective trust fund of 

that company or bank, or an affiliate of the company or bank. 

Again similar to section 17(c), ERISA permits a bank or similar financial 

institution that is a plan fiduciary to provide an "ancillary service" for reasonable 

lnPTE 75-1, supa note 145, at 50849-50. This class exemption provides relief from both the 

prohibited transactions provisions of section 406(a) and the fiduciary self-dealing provisions of 

section 40613). 

179Class Exemption Covering Certain Short-Term Investments, Prohibited Transaction 

'%E 75-1, supu note 145, at 50850. A registered broker-dealer that is a fiduciary may extend 

credit to a plan in connection with the purchase or sale of securities under this exemption 

provided that neither the fiduciary, nor any affiliate of the fiduciary, receives any interest or other 

consideration in return. Id. 

Exemption 81-8/46 FR 7511 (1981), amended 50 FR 14043 (1985). 

'"Class Exemption to Permit Certain Loans of Securities by Employee Benefit Plans, 

Prohibited Transaction Exemption 81-6/46 FR 7527 (1981), amended 52 Fl7 18754 (1987). A plan 

may lend securities to a party in interest only if the party in interest is a registered broker-dealer, 

a person exempt from registration as a dealer in exempted government securities, or a bank. Id. 

182PTE 91-38, supra note 168, at 31968; PTE 90-1, supra note 168, at 2893. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 163 
compensati~n.~~~ The bank must adopt safeguards to ensure that the service 

is provided consistent with sound banking and financial practices and the best 

interests of participants and beneficiaries of the plan, and not in an excessive or 

unreasonable manner.lM 

ERISA also contains an exemption known as the "multiple services 

exemption." A person that is a party in interest by virtue of providing certain 

services to the plan may also provide office space, legal, accounting, and other 

services necessary for the establishment or o eration of the plan, if the plan pays 

no more than reasonable compensation. " A broker-dealer that executes 

transactions on behalf of a plan (making it a party in may, for 

example, provide recordkeeping or other necessary services to that plan for 

reasonable compensati~n.'~~ 

2. Purchasing an Affiliate's Assets 

The Investment Company Act generally prohibits registered investment 

companies from acquiring securities issued by or any other interest in the 

business of a broker, dealer, underwriter, or investment adviser.'@ Rule 12d3-1 

provides limited exemptions from this requirement but, recognizing the inherent 

conflict of interest, generally prohibits a registered investment company from 

acquiring any security issued by its investment adviser, promoter, or principal 

'@29 U.S.C. 5 1108(b)(6). 

"Id. Plan assets held by a bank that is a plan fiduciary which are reasonably expected to be 

needed to satisfy current plan expenses may be placed by the bank in a non-interest-bearing 

checking account in the bank if the conditions of regulation 408b-6 are met, notwithstanding the 

requirement of the statutory exemption for investments in bank deposits that the account bear a 

reasonable rate of interest. 29 C.F.R. § 2550.408b-6(a). See also 29 U.S.C. 5 1108(b)(4) (statutory 

exemption for bank deposits). 

ls29 U.S.C. § 1108(b)(2). Arrangements for office space or services must be reasonable. The 

arrangements are exempt only from the prohibited transactions provisions of section 406(a) of 

ERISA. No relief is provided from the prohibitions on conflicts of interest and self-dealing by 

fiduciaries under section 406(b) of ERISA. See 29 C.F.R. § 2550.408b-2(a). 

'%See ERISA and the Investment Management and Brokerage Industries: Five Years kter, 35 BUS. 

L. 189,268 Nov. 1979) [hereinafter ERISA Five Years Later]. 

ImSee Howard Pianko & Stephen J. Nelson, Special Issues Involving Broker-Dealers and Their 

Employee Benefit Plan Clients, 23 REAL PROP. PROB. & TR. J. 749, 757 (1988) [hereinafter Pianko & 

Nelson]. 

'%ee 15 U.S.C. 5 80a-l2(d)(3). This section provides an exception for corporate issuers all of 

whose outstanding securities are owned by registered investment companies. 

164 CHAPTER 3 
underwriter, or any affiliated person of such investment adviser, promoter, or 

principal underwriter that is a "securities related 

ERISA general1 rohibits the acquisition of employer securities and real 

property by a plan." 'Section 407 does permit a plan to acquire employer 

securities or real property if, after the acquisition, the aggregate fair market value 

of the employer securities and employer real pro erty does not exceed ten percent 

of the fair market value of the plan's assets?" Further, in enacting ERISA, 

Congress noted that certain kinds of defined contribution plans commonl 

Congress therefore included an exception in section 407 to allow the practice to 

continue with respect to certain kinds of defined contribution plans that explicitly 

provide for investment of more than ten percent of their assets in employer 

securities and real property.193 Many defined contribution plans, including 

401(k) plans, may thus acquire employer securities and real property in an 

amount exceeding ten percent of the plan's assets. ERISA further accommodates 

the use of defined contribution plans for the acquisition of employer securities 

and real property by excepting these acquisitions from a fiduciary's duty under 

section 404(a) to diversify a plan's in~estments?~~ 

provide for substantial investments in employer securities and real property. ld: 

ERISA permits a plan to invest its assets in deposits in a bank or similar 

financial institution that is a plan fiduciary if the deposits bear a reasonable rate 

of interest and the investment is expressly authorized by a provision of the plan 

'8917 C.F.R. 5 270.12d3-l(c). 

lW29 U.S.C. 5 1106(a)(2). 

'"Further, under section 407, the plan may only acquire "qualifying employer securities" and 

'=U.S. CONGRESS CONFERENCE COMMITTEE,MPLOYEE RETIREMENT SECURITY ACT OF 1974, H.R. 

193Jd. A defined contribution plan relying on this exception must be an "eligible individual 

account plan" and may acquire only "qualifying employer securities" and "qualifying employer 

real property." Id. 

'%he Department of Labor has also exempted acquisitions of employer securities and 

employer real property by a collective trust fund or separate account in which a plan is invested, 

provided the plan's assets constitute no more than 10% of the assets of the collective trust fund 

or separate account. PTE 91-38, supra note 168, at 31966; PTE 90-1, supra note 168, at 2891. A 

collective trust fund or separate account more than 10% of the assets of which are assets of a 

401(k) plan or certain other types of defined contribution plan may acquire employer securities 

or employer real property if certain conditions are met. PTE 91-38, supra note 168, at 31968; PTE 

90-1, supra note 168, at 2893. 

"qualifying employer real property." 29 U.S.C. § 1107(a)(l). 

CONF. REI?. NO. 1280,93d Cong., 2d Sess. 317 (1974) [hereinafter ERISA CONFERENCE REPORT]. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 165 
or by a fiduciary other than the bank.lg5 A plan may also enter into insurance 

and annuity contracts with an insurer which is either the employer maintaining 

the plan or a party in interest which is wholly-owned by the employer 

maintaining the plan, or by another party in interest with respect to the plan, if 

the plan pays no more than adequate consideration.lg6 

Regulation 9 permits national banks to deposit collective trust fund assets 

awaiting investment or distribution in their time or savings deposits or those of 

their affiliates , * 97 

3. Joint Transactions 

Section 17(d) of the Investment Company Act, and rule 17d-1 thereunder, 

make it unlawful for any affiliated person of or principal underwriter for a 

registered investment company, or any affiliated person of such a person or 

principal underwriter, to engage in any transaction in which the registered 

investment company, or a company controlled by the registered investment 

company, jointly partici ates without obtaining prior Commission approval by 

exemptive application?' The rule also provides certain exceptions for which 

applications are not required?" Because of the Commission's broad exercise 

of its rulemaking authority, many transactions come within rule 17d-1's ambit; 

these transactions generally require individual approval under a standard that 

requires the investment company to participate on a basis no less advantageous 

than that of the other joint participants?" 

I9%e approving fiduciary must be expressly authorized by the plan to instruct the trustee 

with respect to the investment. 29 U.S.C. Q 1108(b)(4); 29 C.F.R. Q 2550.408b-4. 

'%29 U.S.C. Q 1108(b)(5). 

'"12 C.F.R. Q 9.18@)(8)(i). 

'%5 U.S.C. 5 80a-l7(d); 17 C.F.R. § 270.17d-l(a). 

'99These exceptions include the following: a profit-sharing, stock option, and stock purchase 

plan covering affiliates or employees of a company controlled by the registered investment 

company; a qualified employee benefit plan provided by a registered investment company for its 

employees; certain joint transactions in which a registered investment company and a company 

that is a "downstream" affiliated person, participate, provided that no "upstream" affiliated 

persons participate; the receipt of cash or securities by an investment company and its affiliated 

persons pursuant to the reorganization of a portfolio company; and any arrangement regarding 

liability insurance policies (other than a fidelity bond required by rule 17g-1). 17 C.F.R. Q 270.176- 

Ud). 

2ooThe Commission will also consider whether the registered investment company's 

participation in the joint transaction is consistent with the Investment Company Act. 17 C.F.R. 

9 270.17d-l(b). 

166 CHAPTER 3 
Unlike the Investment Company Act, ERISA does not expressly prohibit 

joint transactions between a plan and a party in interest or fiduciary. The general 

fiduciary responsibilities imposed by ERISA and the prohibited transactions 

provisions may nonetheless protect plans from some joint transactions. For 

example, if a fiduciary participates in a transaction with the plan on its own 

behalf, it might violate its duty under section 404(a) to act solely in the interests 

of the participants. 

Federal banking law and regulation 9 do not expressly prohibit banks and 

their affiliates from engaging in joint transactions with their collective trust funds. 

4. Underwriting Involving Fiduciaries and Their Affiliates 

To prevent dumping of unwanted securities into investment companies' 

portfolios, section 1O(f) of the Investment Company Act prohibits a registered 

investment company from acquiring any security during the existence of an 

underwriting or selling syndicate for that security containing an affiliated person 

(or any person of whom that person is an affiliated person)Fol This prohibition 

applies only where the affiliate is a "principal underwriter."202 Where the 

prohibition applies, the investment company may not purchase the securities from 

any member of the syndicate. Rule 1Of-3 allows a registered investment company 

to purchase securities in a transaction that would otherwise violate section lO(f) 

if certain safeguards are metJo3 

ERISA prohibits a plan, during the existence of an underwriting or selling 

syndicate for a security of which a fiduciary is a member, from purchasing the 

security from the fiduciary or an affiliate of the fiduciaryFo4 Where a fiduciary 

is a member of the underwriting syndicate for a security, a plan's purchase of 

those securities during the underwriting from a member of the syndicate other 

'OISee Chapter 12. 

2mId. See 15 U.S.C. § 80a-2(a)(29) (definition of "principal underwriter"). 

2mAn investment company that engages in transactions in reliance upon rule 1Of-3 must report 

these transactions on its semi-annual report (Form N-SAR) filed with the Commission. 17 C.F.R. 

Q 270.10f-3(g). The investment company's board of directors, including a majority of the 

disinterested directors, must adopt and periodically review procedures designed to ensure 

compliance with rule 1Of-3 and must determine, at least quarterly, that all transactions during the 

period were effected in compliance with the rule. 17 C.F.R. Q 270.10f-3(h). Rule 1Of-3 also 

prohibits the investment company from acquiring more than the greater of 4% or $500,000 (but 

in no case more than 10%) of the principal amount of the offering and from paying an amount 

greater than 3% of its assets for the acquisition. 17 C.F.R. 5 270.1@-3(d)-lOf(3)(e). 

204PTE 75-1, supra note 146, at 50848 (the Department of Labor did not specify which 

prohibited transactions provision(s) would be violated by such purchase). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 167 
than the fiduciary or its affiliate might also be a prohibited transaction in that it 

could constitute a use of plan assets for the benefit of a party in intere~t.2'~ 

The Department of Labor has issued a class exemption, Prohibited 

Transaction Exemption (TTE") 75-1, that permits a plan to acquire securities, 

during the existence of an underwriting or selling syndicate, from any person 

other than the plan's fiduciary (or its affiliate) of the plan that is also a member 

of such syndicateFo6 No fiduciary involved in causing the plan to purchase 

securities in a transaction that is exempt under this class exemption may be a 

"manager" of the underwriting or selling syndicate. The transaction must also 

meet certain requirements relating to the security, its price, the nature of the 

underwriting and the extent of a plan's in~estment.2'~ It might be a prohibited 

transaction for a bank participating in an underwriting to have its collective trust 

fund holding plan assets purchase the securities from another member of the 

syndica te?08 

The prohibition under the Investment Company Act seems somewhat 

broader, affecting more parties and transactions than the ERISA prohibition. 

Where section 1O(f) applies, the investment company may not purchase the 

securities from any member of the syndicate?" PTE 75-1 exempts transactions 

206PTE 75-1, supra note 145, at 50848. If the purchase is from a non-fiduciary party in interest, 

the transaction does not have to comply with this class exemption. However, the transaction 

would be a principal transaction, prohibited by section 406(a) of ERISA unless exempt under a 

separate class exemption for principal transactions. See supra note 170 and accompanying text 

(class exemption for principal transactions with non-fiduciary parties in interest). 

The Department of Labor has stated that the purchase of securities during the existence of 

an underwriting or selling syndicate for that security, of which a fiduciary or an affiliate thereof 

is a member, from a member that is not that fiduciary or an affiliate thereof will not be deemed 

a prohibited transaction where that fiduciary is not involved in any way in causing the plan to 

make the purchase, e.g., the fiduciary does not recommend the purchase to the plan or participate 

in the plan's decision to make the purchase. PTE 75-1, supra note 145, at 50848. See also 29 U.S.C. 

§ 1106(b)(l) (use of plan assets for benefit of fiduciary); ERISA Five Years Later, supra note 186, at 

272-73 (purchase from a syndicate member other than the fiduciary might benefit the fiduciary 

because each member may have an interest in the success of the entire offering). 

207The plan may not acquire more than 3% of the offering or pay an amount greater than 3% 

of the market value of the plan's assets (or 1% of plan assets if the amount exceeds $1 million) 

for the acquisition. PTE 75-1, supra note 145, at 50849. 

20sSee id. at 50848. 

209Rule 1Of-3 provides a safe harbor that conditionally allows an investment company to 

purchase from members of the syndicate other than the prohibited parties. See 17 C.F.R. 9 270.10f3(f). 

168 CHAPTER 3 
between a plan and any syndicate member that is not a plan fiduciary so long as 

the fiduciary causing the plan to make the purchase (or affiliate) does not serve 

as manager of the syndicate?1° Further, the ERISA prohibition only reaches 

fiduciaries and their affiliates that act as managers -- not other parties in interest. 

As previously discussed, the Investment Company Act definition of "affiliated 

person" is substantially broader than the ERISA definitions of "fiduciary" and 

"affiliate."211 The Investment Company Act prohibitions thus reach more 

persons with potential conflicts of interest. 

Another significant difference between the Investment Company Act and 

ERISA anti-dumping provisions is that the ERISA class exemption permits the 

purchase of any security issued by a bank, whether or not registered and 

regardless of quality, and certain other types of unregistered securities?12 Rule 

IOf-3 exempts only purchases of securities registered under the Securities Act and 

municipal securities and then only if the securities have at least an investment 

grade rating (for municipal securities)213 or the issuers are "seasoned' (for 

registered securities). Securities acquired under the class exemption must also be 

seasoned @e., the issuer must have been in continuous operation for at least three 

years), but securities "fully guaranteed'' by a bank or certain others are excepted 

from the seasoning requirement. By more closely restricting the availability of its 

anti-dumping safe harbor to securities that are rated or that have been registered 

under a statute with civil liabilities for material misstatements and omissions, the 

Investment Company Act more successfully removes the opportunity for the 

dumping of securities by affiliated underwriters. 

*'It may still be a prohibited transaction for a plan to purchase securities offered in an 

underwriting from a member of the syndicate other than the fiduciary or its affiliate if the 

fiduciary profits from the transaction. See Pianko & Nelson, supra note 187, at 763. 

211See supra notes 155, 156 and accompanying text. 

212PTE 75-1, supra note 145, at 50848. Securities issued or guaranteed by a bank are generally 

not subject to the registration requirements of the 1933 Act. See Securities Act tj 3(a)(2), 15 U.S.C. 

5 77c(a)(2). Further, the class exemption allows the purchase of securities (1) issued by a common 

or contract carrier under the Interstate Commerce Act, (2) exempt from registration by a federal 

statute other than the Securities Act, or (3) the subject of a distribution and of a class required to 

be registered under section 12 of the Exchange Act and the issuer of which has been subject to 

the reporting requirements of section 13 of the Exchange Act for at least 90 days and has filed all 

required reports with the Commission during the preceding year. PTE 75-1, supra note 145, at 

50848. 

213See 17 C.F.R. 5 270.10f-3(c). If the municipal issuer has been in continuous operation for less 

than three years, the issue must receive one of the three highest ratings. Id. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 169 
5. Use of Offering Proceeds to Retire Debts to Affiliates 

The Commission has supported legislation that would specifically prohibit 

an investment company from acquiring, during the existence of an underwriting 

or selling syndicate, securities of an issuer that will use the proceeds of the 

offering to defray indebtedness owed to an entity that is an affiliated person of 

the investment company?14 The Investment Company Act currently does not 

explicitly proscribe such activity. This legislation is needed to prevent banks and 

others from using affiliated investment companies as a source of capital to bail 

out themselves or their financially troubled debtors or to otherwise further its 

own interest as creditor of such i~suers.2'~ 

ERISA generally prohibits the use of offering proceeds to retire debts to 

affiliates, but the Department of Labor has issued a class exemption permitting 

a plan to purchase securities in two situations where the offering proceeds would 

be so used. First, the class exemption conditionally allows a fiduciary that is a 

bank or an affiliate thereof to purchase securities on behalf of a plan in a public 

offering where the proceeds muy be used by the issuer to retire or reduce 

indebtedness owed to that fiduciary or its affiliate?16 If the fiduciary "knows" 

that the proceeds of the issue will be used by the issuer to reduce or retire 

indebtedness owed to that fiduciary or its affiliate, the transaction must comply 

with several additional conditions relating to the timing and terms of the 

purchase, the nature of the offering, and the extent of the plan's participation. 

Second, the class exemption conditionally allows a plan fiduciary to purchase 

securities on behalf of a plan in a public offering where the issuer may use the 

proceeds of the offering to retire or reduce indebtedness owed to a party in 

interest other than the fid~ciary.2'~ The class exemption does not apply if the 

securities to be purchased are issued by the employer or any affiliate of the 

employer. 

214See, eg., The Securities Regulatory Equality Act of 1991: Hearings on H.R. 797 Before the 

Subcomm. on Telecommunications and Finance of the Hduse Comm. on Energy and Commerce, 102d 

Cong., 1st Sess. (1991) (statement of Richard C. Breeden, Chairman, SEC) [hereinafter H.R. 797 

Testimony]; Hearings on S. 543 and S. 713 Before the Senate Comm. on Banking, Housing, and Urban 

Affairs, 102d Cong., 1st Sess. (1991) (statement of Richard C. Breeden, Chairman, SEC); see also S. 

543, 102d Cong., 1st Sess. 5 742(a) (1991); H.R. 6, 102d Cong., 1st Sess. 5 462(b) (1991). 

2151n connection with any such legislation, the Commission has stated that it should be given 

the authority to exempt proposed transactions from such a prohibition in the interest of 

investment company shareholders. See H.R. 797 Testimony, supra note 214, at 21. 

216See Class Exemption for Certain Transactions Involving Purchase of Securities Where Issuer 

May Use Proceeds to Reduce or Retire Indebtedness to Parties in Interest, Prohibited Transaction 

Exemption 80-83/45 FX 73189 (1980). 

170 CHAPTER 3 
Regulation 9 does not specifically prohibit a collective trust fund from 

investing in securities where the offering proceeds will be used by the issuer to 

reduce or retire indebtedness owed to the bank or an affiliate of the bank.218 

6. Agency Transactions by Affiliates 

The Investment Company Act does not prohibit all affiliated agency 

transactions. Instead, section 17(e) establishes limits within which an affiliate, 

acting as agent, may receive compensation in connection with the purchase or sale 

of any property from or to the investment company. The transaction must be in 

the course of the affiliate's business as an underwriter or broker. Any 

commissions received by an affiliated person acting as broker must meet the 

limitations of section 17(e)(2)F1' Further, an investment adviser has a duty to 

obtain best execution for transactions in which it has brokerage discretion. 

Section 406 of ERISA generally prohibits a party in interest from acting as 

agent for a plan. Because service providers are, by definition, parties in interest, 

ERISA section 408 exempts certain essential services from section 406.220 In 

addition, the Department of Labor has issued class exemptions to enable plans to 

obtain certain services from fiduciaries and other parties in interest. One class 

exemption conditionally permits a plan fiduciary to execute securities transactions 

for a plan for a fee, if the transactions are not "excessive, under the circumstances, 

in either amount or frequency."221 Further, a plan fiduciary may generally act 

as the agent in an agency cross transaction involving the plan and receive 

reasonable compensation from the plan and the other parties to the 

218The Glass-Steagall Act prohibition of stock underwriting by commercial banks and their 

affiliates has significantly eroded. Recently, J.P. Morgan Securities, an affiliate of Morgan 

Guaranty, helped underwrite a public offering of common stock. The issuer planned to use about 

18% of the proceeds of the offering to pay off part of its indebtedness to Morgan Guaranty, the 

lead commercial bank for its line of credit. See David B. Hilder, Stuck Offering Shows HurdZes Faced 

by Bunks, WALL ST. J., Feb. 25,1991, at A5. 

219Section 17(e)(2)(A) limits an affiliated broker's commission on transactions effected on an 

exchange to the "usual and customary broker's commission;" rule 17e-1, a safe harbor under 

section 17(e)(2)(A), permits commissions that are reasonable and fair compared to commissions 

pzid to other brokers involving similar transactions. 17 C.F.R. Q 270.17e-1. 

220See supru notes 183, 185 and accompanying text. 

22'Class Exemption for Securities Transactions Involving Employee Benefit Plans and BrokerDealers, Prohibited Transaction Exemption 86-128,51 FR 41686, § II(a) (1986) [hereinafter PTE 86- 

1281. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 171 
transaction?22 A plan fiduciary that is a discretionary trustee or administrator 

of the plan, or an employer whose employees are covered by the plan, may 

engage in agency or agency cross transactions with the plan on1 if it returns or credits to the plan all "profits"223 it earns in those transactions. 2J4 

An independent fiduciary of a plan must give written authorization in 

advance for any agency or agency cross transaction executed by a fiduciary and 

the executing fiduciary must furnish the authorizing fiduciary with certain 

disclosures. A fiduciary engaging in agency cross transactions with a plan must 

provide additional disclosures beyond those required when the fiduciary executes 

transactions on behalf of the plan. The fiduciary executing an agency cross 

transaction may have investment discretion and/or render investment advice only 

with respect to either buyers or sellers in the transaction, but not both?25 

While a service provider is not always a plan fiduciary, it is always a party 

in interest and therefore subject to the prohibited transactions provisions under 

ERISA section 406(a). A party in interest, or an affiliate of a party in interest, may 

provide, by class exemption, the following services to the plan: effecting 

securities transactions on behalf of the plan, acting as agent for the plan, 

performing clearance, settlement, and custodial functions incidental to effecting 

transactions, and providing investment advice and analyses to the plan under 

circumstances which do not make the party in interest a fiduciary of the 

~~ 

mid. at 41695. This class exemption only exempts transactions from the fiduciary self-dealing 

and conflicts provisions of section 406(b) of ERISA, not from the prohibited transactions provisions 

of section 406(a). If a plan fiduciary purchases securities for the plan from a person the fiduciary 

knows is a party in interest in an agency cross transaction and the fiduciary receives a commission 

from the party in interest for effecting a transaction, the fiduciary will not be deemed to have 

received a kickback in violation of section 406(b)(3). Id. at 41690. However, the purchase of the 

securities on behalf of the plan from the party in interest would still be a prohibited transaction 

under section 406(a)(l). Id. 

""Profit" is defined to allow a discretionary trustee, plan administrator, or employer to 

recoup its expenses, both direct and indirect, including overhead. Id. at 41694. 

224See id. at 41696. A bank that maintains a collective trust fund would be a discretionary 

trustee and thus a plan fiduciary of a plan that invests in the fund. That bank cannot execute 

securities transactions on behalf of the plan as agent for the plan or engage in agency cross 

transactions involving the plan unless the bank returns or credits to the plan all "profits" it earns 

in connection with those transactions. Id. 

%e conditions for engaging in agency cross transactiqns do not apply in every case. A 

fiduciary may engage in agency cross transactions with the plan if it, in effect, is not acting as a 

fiduciary with respect to the plan assets used for the transaction. Id. at 41696. 

172 CHAPTER 3 
plan,226 A fiduciary of a plan cannot rely upon this class e~emption.2~~ Each 

exempted transaction must be effected on behalf of the plan, and any advice or 

analysis must be provided to the plan, on terms that are at least as favorable to 

the plan as would be obtained in an arm's length transaction with an unrelated 

party. 

While regulation 9 is largely silent on affiliates acting as agent to a 

collective trust fund, the Comptroller has construed regulation 9 to prohibit 

national banks from engaging in securities transactions for trust accounts they 

administer through an affiliated discount broker exce t where neither the bank 

nor the affiliated broker profits from the transactionj' However, a bank may 

execute transactions through an affiliated broker if authorized by the trust 

instrument, local law, or the trust benefi~iaries.2~' 

C. Fund Management 

The Investment Company Act subjects the management of a registered 

investment company to extensive regulation."' A majority of shareholders 

must approve any change in its fundamental policies and certain changes in its 

investment policie~?~' A registered investment company must obtain 

shareholder approval to vary the fund's policies described in the registration 

statement regarding borrowing money, issuing senior securities, underwriting 

other issuers' securities, purchasing or selling real estate or commodities, or 

making loans to other persons?32 Shareholders elect the investment company's 

226See PTE 75-1, supra note 145, at 50846. 

227Fiduciaries may execute transactions for a plan as previously discussed. See ME 86-128, 

2280FFICE OF THE COMPTROLLER OF THE CURRENCY, Trust Banking Circular No. 23 (Oct. 4,1983), 

5 Fed. Banking L. Rep. (CCH) q[ 60,575. A bank or its affiliate may impose a fee to cover the cost 

of the transaction. Id. 

supra note 221 and accompanying text (execution of transactions by a fiduciary). 

2291d. 

230See Chapter 7. 

231See 15 U.S.C. Q 80a-l3(a)(3). 

23215 U.S.C. 5 80a-l3(a)(2). 

Pooled Investment Vehicles for Employee Benefit Plan Assets 173 
board of directors?33 Shareholders must also approve any amendments to the 

investment advisory ~ontract.2~~ 

ERISA requires that every covered employee benefit plan be established 

under a written instrument which provides for one or more "named fiduciaries" 

to manage and control the operation and administration of the ~lan.~' All 

assets of the plan must be held in trust by one or more trustees: except for 

plan assets held by an insurance company?37 The plan may provide that a 

named fiduciary with responsibility for managin the lan assets may appoint an 

investment manager to manage those assets?gs The appointed investment 

manager must be a bank, insurance company or registered investment adviser 

and must acknowledge, in writing, that it is a fiduciary of the plan?39 Under 

ERISA, participants in employee benefit plans are generally not entitled to vote 

on any matter affecting the management of the plan. Rather, ERISA regulates the 

management of plan assets by establishing certain basic duties of plan fiduciaries 

under section 4O4(a)F4' 

A bank collective trust fund must be established pursuant to a written 

plan.241 Participants in bank collective trust funds are not entitled to vote on 

any matters with respect to the funds. A collective trust fund's fundamental 

policies may be changed without the approval of representatives of participating 

plans?42 Regulation 9 requires that the bank have the exclusive management 

23315 U.S.C. 3 8Oa-16. 

23415 U.S.C. 9 80a-l5(a). In connection with shareholder votes, an investment company must 

file proxies containing the disclosures specified under the proxy rules of the Exchange Act, 

including certain additional information where a proxy relates to the election of directors or 

approval of the investment advisory contract. 17 C.F.R. 99 270.2Oa-1 , 270.20a-2,270.20a-3. 

23529 U.S.C. 1102(a). 

%29 U.S.C. § 1103(a). 

23729 U.S.C. 5 1103(b). 

*29 U.S.C. $j 1102(c)(3). 

23g29 U.S.C. 5 1002(38). 

240See supra notes 133-137 and accompanying text. 

24112 C.F.R. § 9.18(b)(l). A collective trust fund's written plan must be approved by the bank's 

board of directors and filed with the Comptroller. Id. 

242Apparently the plan may be amended by the bank's board of directors. See Martin E. 

Lybecker, Bank-Sponsored Investment Management Services: Consideration of the Regulatory Problems, 

(continued ...I 

1 74 CHAPTER 3 
of a collective investment Regulation 9 also requires that a periodic 

audit be made by auditors responsible only to the bank's board of dire~tors.2~~ 

D. Valuation and Redemption 

Open-end investment companies generally must value their portfolios on 

a "mark-to-market" basis daily. This requirement assures that fund assets are 

valued accurately and that sales and repurchases of fund shares occur at prices 

that prevent the interests of new, existing, or ing shareholders from being 

diluted. Investment company securities may e sold or redeemed except at 

a price based on their current net asset value next computed after receipt 

of a redemption or purchase order. Rule erally requires a registered 

open-end investment company to calculate its current net asset value per share 

at least daily. Under section 22(e) of the Investment Company Act, an investor 

tendering shares for redemption generally must be paid within seven days of 

tender. 

The regulations adopted under the Internal Revenue Code provide that a 

qualified ension plan is a plan established primarily to provide retirment 

benefits. 24p Accordingly, defined contribution plan participants generally 

cannot redeem their investments before they retire or cease working for their 

employer, in which case they are entitled to receive the vested portion of their 

individual accounts. Some defined contribution plans allow participants to 

withdraw their own account contributions?46 A qualified pension plan may 

not, however, permit participants to withdraw the employer's contributions prior 

to retirement, termination of employment, or termination of the plan.247 

Participants in participant-directed defined contribution plans are allowed to 

transfer funds among the investment options available under the plan, in 

accordance with the terms of the plan. Defined contribution plans must value 

~~ ~~~~~ 

242(...continued) 

and Suggested Legislative and Stahrtmy Interpretive Respunses, 1977 DUKE L.J. 983, 1032 (regulation 

9 does not contain any restriction on changing a collective trust fund's investment policy once the 

fund is established). 

24312 C.F.R. § 9.18(b)(12). 

24412 C.F.R. 5 9.18(b)(5)(i). 

245See 26 C.F.R. $j 1.4Ol(b)(l)(i). 

246See Rev. Rul. 69-277, 1969-1 C.B. 116. 

247See Rev. Rul. 74-417, 1974-2 C.B. 131; Rev. Rul. 74-254,1974-1 C.B. 91. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 175 
each individual account at least annually, on a specified date?@ The plan must 

use the fair market value of the plan assets as of the valuation date in 

determining the value of the individual accounts?49 

Bank collective trust funds are required to describe in their written plans 

the basis and method used to value the fund assets, and generally to value their 

assets at market value?50 Plans invest in and withdraw from bank collective 

trust funds on the basis of this valuation, which must be made at least 

quar ter~y?~~ 

E. Advertising 

Investment companies must file copies of the full text of their sales 

literature with the Commission, or the NASD, not later than ten days after they 

are transmitted or distributed to prospective investors?52 If a registered 

investment company chooses to advertise its performance, it must do so in 

accordance with rules that standardize and prescribe certain performance 

indicators. Generally, a registered investment company is required to portray 

total return data for one, five, and ten year periods. If an investment company 

advertises its yield, it must use a standardized thirty day yield. Investment 

companies, bank collective trust funds, and insurance company separate accounts 

are subject to the antifraud provisions of section 10(b) of the Exchange Act, rule 

lob-5 thereunder, and section 17(a) of the Securities Act. 

ERISA does not specifically address the promotion or advertisement of 

pooled investment vehicles. 

The Comptroller generally permits unrestricted advertising of collective 

trust funds, except that advertisement of future performance or comparative 

performance with funds other than those offered by the bank is not permitted. 

National banks are not required to file copies of collective trust fund sales 

literature with the Comptroller, although the Comptroller does monitor such 

248Rev. Rul. 80-155,1980-1 C.B. 84, 85. 

2%-l. 

25012 C.F.R. $9 9.18@)(1), 9.18@)(15). 

=I12 C.F.R. Q 9.18(b)(4). 

25215 U.S.C. $ 80a-24@); 17 C.F.R. 270.24b-3. 

176 CHAPTER 3 
advertisements for compliance with the antifraud provisions of the securities 

lawsE3 

F. Diversification 

To qualify for pass-through tax treatment, an investment company must 

meet the Internal Revenue Code’s two-part diversification standard. First, with 

respect to fifty percent of an investment company’s assets, no more than five 

percent may be invested in the securities of any one issuer and the investment 

company may not own more than ten percent of the outstanding voting securities 

of any one issuer. Second, as to 100% of the investment company’s assets, no 

more than twenty-five percent may be invested in the securities of any one 

issuer. 254 

Under ERISA, plan fiduciaries are required to ensure that the plan’s 

investments are diversified to minimize the risk of lar e losses, unless under the 

circumstances it is clearly prudent not to do ~0%~ Failure of a plan’s 

investment manager to investigate the plan’s cash flow requirements and to 

adequately diversify the plan’s investments to meet its liquidity needs is a breach 

of fiduciary duty for which the manager may be liable.256 The Conference 

Committee’s report on the adoption of ERISA states that, with respect to the 

requirement of diversification, the fiduciary should consider factors such as (1) 

the purposes of the plan; (2) the amount of the plan assets; (3) financial and 

industrial conditions; (4) the type of investment; (5) distribution as to geogra hical 

location; (6) distribution as to industries; and (7) the dates of maturityJ7 In 

determining whether plan assets are sufficiently diversified, the fiduciary should 

look to the plan’s underlying assets held in a mutual fund, bank collective fund, 

or insurance company separate account.258 

253cOMPTROLLER OF THE CURRENCY, COMPTROLLER’S HANDBOOK FOR FIDUCIARY ACTIVITIES 243 

(Sept. 1990). 

25426 U.S.C. 5 851. 

25529 U.S.C. § 1104(a)(l)(C). 

256See GIW Industries, Inc. v. Trevor, Stewart, Burton & Jacobsen, Inc., 895 F.2d 729 (11th Cir. 

1990). 

257Similarly, diversification could be achieved through the use of several different investment 

managers, each of whom concentrated in specific forms of investment, so long as the portfolio of 

the plan as a whole was diversified. See ERISA CONFERENCE REPORT, supra note 193, at 304. 

2581d. Investments of a separate account underlying a variable annuity, endowment, or life 

insurance contract are adequately diversified if (1) no more than 55% of the value of its assets is 

represented by any one investment; (2) no more than 70% is represented by any two investments; 

(continued ...I 

Pooled Investment Vehicles for Employee Benefit Plan Assets 177 
Regulation 9 does not specifically require that collective trust funds 

diversify their investments, except that the fund must be maintained as set forth 

in the written plan?59 

G. Liquidity 

All three regulatory frameworks impose requirements that an investment 

vehicle maintain a sufficient portion of its assets in liquid investments. Open-end 

investment companies generally ma not invest more than fifteen percent of their 

net assets in illiquid investments?' ERISA's prudence standard includes a 

requirement to consider liquidity needs in the management of lan assets?61 

Collective trust funds, other than short-term investment fundsF2 may invest 

any percentage of their assets in illiquid investments consistent with anticipated 

redemption needs. 

VI. Conclusion 

As the foregoing somewhat lengthy analysis shows, ERISA and, to a lesser 

extent, the Comptroller's rules provide important safeguards to ensure that plan 

participants will receive the benefits at retirement that they both expect and need. 

Nonetheless, participants increasingly are expected to rely on the investment 

performance of their individual accounts to provide their retirement benefits. 

258(...continued) 

(3) no more than 80% is represented by any three investments; and (4) no more than 90% is 

represented by any four investments. 26 C.F.R. § 1.817-5; see also Announcement 8848,1988-16 

I.R.B. 36 (diversification requirements for variable annuity, endowment and life insurance 

contracts). 

259By contrast, a bank's common trust fund may not invest more than 10% of its assets in 

securities of any one issuer. See 12 C.F.R. 5 9.18(b)(9)(ii). 

260See Guide 4 to Form N-lA, Investment Company Act Release No. 18612 (March 12,19921, 

57 FR 9828; Restricted Securities, Investment Company Act Release No. 5847 (Oct. 21,1969), 35 

FR 19989. The Commission has stated that an "illiquid security" generally is any security that 

cannot be disposed of within seven days in the ordinary course of business at approximately the 

amount at which the investment company has valued the instrument. See Resale of Restricted 

Securities, Securities Act Release No. 6862 (April 23,1990), 55 FR 17933 (adopting rule 144A under 

the Securities Act); Acquisition and Valuation of Certain Portfolio Instruments by Registered 

Investment Companies, Investment Company Act Release No. 14983 (Mar. 12,1986), 51 FR 9773 

(adopting amendments to rule 2a-7). 

26129 C.F.R. 5 2550.404a-l(b)(2)(ii)(B). 

262See 12 C.F.R. 5 9.18&)(15)(i), 9.18(b)(15)(iv) (liquidity requirements for short-term investment 

funds). 

178 CHAPTER 3 
Further, a growing number of plans are requiring that the participants, 

themselves, decide how to invest their individual accounts. 

For many pension plan participants, choosing where to invest their 

retirement plan assets will be the most important investment decision they will 

ever make. Participants need to be furnished complete information about their 

investment options, both concerning initial investment decisions (i.e., 

prospectuses) and reallocations (Le., prospectuses and shareholder reports). To 

provide employees with adequate information about their investment decisions, 

legislation is needed to (1) amend section 3(a)(2) of the Securities Act to remove 

the exception for interests in collective trust funds and separate accounts in which 

participant-directed defined contribution plans invest, and (2) amend the federal 

securities laws to require delivery of prospectuses for the underlying investment 

vehicles, including investment companies, to plan participants who direct their 

investments (see Table 3-2 for a summary of our proposed legislative changes). 

Further, to provide employees with adequate information to enable them to 

monitor their investments’ performance, the Exchange Act and the rules under the 

Investment Company Act should be amended to ensure that all plan participants 

receive semiannual and annual shareholder reports issued by the pooled 

investment vehicles in which they invest. 

We do not recommend that Investment Company Act regulation (other 

than the shareholder reporting provisions) be imposed on collective trust funds 

and separate accounts in which employee benefit plans invest. The participants 

in these plans are sufficiently protected by other regulatory schemes, and the 

additional benefits to be derived by imposing Investment Company Act 

regulation are outweighed by the costs. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 1 79 
Table 3-2 

Summary of Status Quo and Recommendations 

Current Federal Securities Law 

Defined Benefit Plans (and Nonparticipant - -Directed Defined 

Contribution Plans) 

1. Interests in defined benefit plans 

excepted from Securities Act and 

Exchange Act registration and plans 

excepted from Investment Company 

Act regulation. 

2. Interests in collective trust funds 

and separate accounts consisting 

solely of assets of defined benefit 

plans excepted from Securities Act 

and Exchange Act registration and 

the funds and separate accounts 

excepted from Investment Company 

Act regulation. 

3. Neither prospectuses nor 

semiannual reports for underlying 

investment vehicles of defined benefit 

plans required to be delivered to 

plan participants under federal 

securities laws. 

Participant-Directed Defined 

Contribution Plans 

1. Interests in participant-directed 

defined contribution plans excepted 

from Securities Act registration 

(except plans that invest employee 

contributions in employer stock) and 

Exchange Act registration, and plans 

excepted from Investment Company 

Act regulation. 

2. Interests in collective trust funds 

and separate accounts containing 

assets of participant-directed defined 

contribution plans excepted from 

Securities Act and Exchange Act 

registration and the funds and 

separate accounts excepted from 

Investment Company Act regulation. 

3. Neither prospectuses nor 

semiannual reports for underlying 

investment vehicles of participantdirected defined contribution plans 

required to be delivered to plan 

participants under federal securities 

laws. 

180 CHAPTER 3 
Recommendations 

1. Interests in defined benefit plans 1. Interests in participant-directed 

excepted from Securities Act and defined contribution plans excepted 

Exchange Act registration and plans from Securities Act registration, 

excepted from Investment Company except plans that invest employee 

Act regulation. contributions in employer stock and 

Exchange Act registration, and plans 

excepted from Investment Company 

Act regulation. 

2. Interests in collective trust funds 

and separate accounts consisting 

solely of assets of defined benefit 

plans excepted from Securities Act 

and Exchange Act registration and 

the funds and separate accounts 

excepted from Investment Company 

Act regulation. 

2. Interests in collective trust funds 

and separate accounts containing 

assets of participant-directed defined 

contribution plans required to be 

registered under the Securities Act, 

but the funds and separate accounts 

excepted from Investment Company 

Act regulation. 

3. Neither prospectuses nor 3. Federal securities laws amended 

semiannual reports for underlying to require that participants in 

investment vehicles of defined benefit participant-directed defined 

plans required to be delivered to contribution plans receive 

plan participants under federal prospectuses and shareholder reports 

securities laws. for the underlying investment 

vehicles in which the plan invests. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 181 
APPENDIX 3-A 

Chronology 

1938: Section 165 of Internal Revenue Code enacted. 

1940: Investment Company Act enacted. Section 3(c)(13) excepts employee 

benefit plans qualified under section 165 of Internal Revenue Code. 

Late 1940's: Rapid growth of corporate pension plans begins. 

1955: Federal Reserve Board amends regulation F, permitting collective 

investment of pension assets. 

1956: Internal Revenue Service rules that collective trust funds, and pension 

plans whose assets are invested collectively, qualify under section 401 

(successor to section 165). 

Late 1950's: State legislation permits insurance companies to establish separate 

accounts to fund pension plans. 

1962: Section 401 amended to create H.R. 10 ('Keogh') plans. 

1962-63: Comptroller of the Currency assumes authority over collective trust 

funds of national banks, adopts regulation 9. 

1963-69: Commission adopts rules exempting separate accounts from various 

provisions of Investment Company Act. 

1963: 

1968: 

1970: 

Commission construes section 3(c)(13) of Investment Company Act to 

apply to Keogh plans and collective trust funds containing Keogh plan 

assets. 

Commission staff takes position that interests in collective trust funds must 

be registered under Securities Act if the participating plans were voluntary 

and contributory. 

Section 3(c)(13) amended, changed to section 3(c)(ll). Collective trust 

funds and separate accounts containing solely assets of section 401 pension 

plans excepted from Investment Company Act regulation. Section 3(a)(2) 

of Securities Act amended to except interests in collective trust funds and 

separate accounts, except interests sold to Keogh plans. Interests in a plan 

under which employee contributions are invested in employer stock also 

required to register under Securities Act. 

182 CHAPTER 3 
1974: ERISA enacted. 

1978: 401(k) plans created by amendment to section 401 of Internal Revenue 

Code. 

1979: Supreme Court' holds that interests in involuntary, noncontributory 

pension plans are not securities. 

1980: Securities Act and Investment Company Act amended to except 

governmental plans, collective trust funds and separate accounts 

containing governmental plan assets, and interests therein. 

1980-81: Commission issues interpretive releases clarifying staff's treatment 

of pension plans under Securities Act. 

1981: Commission adopts rule 180 conditionally excepting collective trust funds 

and separate accounts in which certain Keogh plans invest. 

1981: IRS permits employees to make pre-tax contributions to 401(k) plans 

through salary reduction. 

Pooled Investment Vehicles for Employee Benefit Plan Assets 183 
Chapter 4 

Internationalization and Investment 

Companies 

I. Introduction and Summary of Recommendations 

Internationalization is perhaps the most significant development in the 

United States and world securities markets in recent years. Accelerated by 

technological advances and the removal of many legal impediments to foreign 

participation, world markets have become internationalized to an unprecedented 

degree? 

The increased levels of cross-border sales of securities have been fostered 

in part by and have encouraged regulatory reform. As reported by the 

Organisation for Economic Co-operation and Development, "[tlhere is no other 

sector within the broad area of the financial services markets in which such a 

large number of organizational and regulatory changes has taken place as has 

been the case in the field of securities-related activities."2 In the United States, 

Congress and the Commission have demonstrated a firm commitment to 

regulatory reform that facilitates internationalization and also maintains investor 

protection. 

As trade, communication, and technological developments have fueled 

internationalization of the markets generally, they have stimulated interest in 

investment companies that offer diversified portfolios of foreign securities. Recent 

global stock market volatility also has heightened interest in these fundse3 

'According to figures compiled by the Commission's Office of Economic Analysis, in 1990, 

foreign purchases and sales of United States securities were over 20 times higher than they were 

in 1980, rising from $198.1 billion to $4.2 trillion. That same year, United States purchases and 

sales of foreign securities grew to a level approximately 16 times higher than that in 1980, from 

$53.1 billion to $902.9 billion. 

%RGANIZATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT, FINANCIAL MARKET TRENDS 

18 (May 1990). 

3See Jim Freer, Irztemational Investors Seek Added Diversity, INT'L BUS. CHRON., Oct. 29 - Nov. 

11,1990, at 16; see also Terry M. Chuppe, Hugh R. Haworth, & Marvin G. Watkins, The Securities 

Markets in the 1980s: A Global Perspective 84-88 (Jan. 26,1989) (unpublished manuscript, on file 

with the Securities and Exchange Commission) (citing factors precipitating recent surge in global 

portfolio investments). 

185 
Although investors worldwide appear more eager than ever to diversify 

their investments with managed portfolios of foreign securities, access by United 

States investors to foreign investment companies and by foreign investors to 

United States investment companies generally remains limited. Despite some 

evidence that cross-border sales of investment company securities are on the 

rise: the Division believes cross-border sales do not constitute a significant 

percentage of total fund sales? 

United States investors seeking managed portfolios of foreign investments 

generally invest in United States-registered funds that concentrate investments in 

foreign issuers. A growing number of United States-registered investment 

companies hold foreign securities in their portfolios. For example, the number of 

United States-registered open-end international equity funds rose from 

approximately 25 in 1985 to 145 as of December 31, 1991.6 The number of 

United States-registered closed-end “country” funds grew from 3 in 1985 to 33 as 

of December 31,19917 

4Foreign investors are purchasing more shares of investment companies generally. Reports 

published by the United States Department of the Treasury on foreign investment in selected 

United States mutual funds show a nearly 92% increase in the total dollar amount invested by 

foreign investors from 1978 to 1984 (from $1,134,000,000 to $2,173,000,000). DEPT OF THE 

TREASURY, REPORT ON FOREIGN PORTFOLIO INVESTMENT IN THE UNITED STATES AS OF DEC. 31,1984, 

at Table A.8 (1989); DFPT OF THE TREASURY, REPORT ON FOREIGN PORTFOLIO INVESTMENT IN THE 

UNITED STATES AS OF DEC. 31,1978, at Table A.3 (1980). 

bata on the extent of cross-border sales by foreign investment companies to United States 

investors or by United States investment companies to foreign investors are limited. The 

Commission is not able to monitor the nature and extent of foreign investment in United States 

funds or track United States investment in foreign funds. While the Departments of the Treasury 

and Commerce and the Board of Governors of the Federal Reserve System collect extensive data 

concerning cross-border investment, none has comparative data for investment companies. The 

Department of the Treasury does monitor foreign investment in United States mutual funds, but 

it provides data on only certain United States investment companies. Although the largest United 

States investment company industry association, the Investment Company Institute, collects 

extensive data on the domestic activities of its members, it does not track their overseas activities. 

6These 145 international equity funds (excluding global funds) held total assets of 

approximately $18.5 billion as of December 31,1991. International equity funds invest their assets 

mostly in securities whose primary trading markets are outside the United States. LIPPER 

ANALYTICAL SERVICES, NC., DIRECTORS’ ANALYTICAL DATA (1st ed. 1992) [hereinafter DIRECTORS’ 

ANALYTICAL DATA]. 

’These 33 single country funds held total assets of approximately $4.2 billion as of December 

31,1991. UPPER ANALYTICAL SERVICES, INC., CLOSED-END PERFORMANCE ANALYSIS SERVICE 44 (Jan. 

31, 1992). Country funds invest their assets primarily in the securities of issuers domiciled in a 

particular country or region. In addition, the number of United States global funds (which invest 

at least 25% of their assets in securities traded outside the United States) rose from 16 as of 

(continued. ..I 

186 CHAPTER 4 
There has been a great deal of debate on how best to increase cross-border 

sales of investment company sharesg In the European Community, this debate 

resulted in the European Council Directive of 20th December 1985 on the 

Coordination of Laws, Regulations and Administrative Provisions Relating to 

Undertakin s for Collective Investment in Transferable Securities ("UCITS 

Directive").$ The UCITS Directive prescribes a common denominator approach 

to protecting investors in certain open-end investment companies qualifying as 

UCITS. A UCITS from one European Community Member State 

7(...continued) 

December 31, 1985, with total assets of $6.57 billion, to 71 as of December 31, 1991, with total 

assets of $18.8 billion. The number of world income funds (which invest in both United States 

dollar and non-United States dollar debt instruments) grew from 1 as of December 31,1985, with 

total assets of $61.2 million, to 88 as of December 31, 1991, with total assets of $29.4 billion. 

DIRECTORS' ANALYTICAL DATA, supra note 6. 

'In response to the Commission's request for public comment on cross-border sales, SEC 

Request for Comments on Reform of the Regulation of Investment Companies, Investment 

Company Act Release No. 17534 (June 15, 1990), 55 FR 25322 [hereinafter Study Release], the 

Commission received comments from the American Bar Association (Section of Business Law); 

American Council of Life Insurance; Amsterdam Stock Exchange; Banca d'Italia (Italy); Bankers 

Trust Company; Benham Management Group; Bundesaufsichtsamt fur das Kreditwesen 

(Germany); Calvert Group, Ltd.; Central Bank of Ireland; The Chase Manhattan Bank, N.A.; 

Citicorp; Cleary, Gottlieb, Steen & Hamilton; Rkpublique Franqaise, Commission des Operations 

de Bourse (France); Commission des valeurs mobili5res du Qukbec; DFA Investment Dimensions 

Group, Inc. and Dimensional Fund Advisors, Inc.; the Danish Supervisory Authority 

(Finanstilsynet); Davis Polk & Wardwell; Dechert Price & Rhoads; The Equitable Life Assurance 

Society of the United States; Federated Investors; the Independent Trustees of the Fidelity Funds; 

Fidelity Management & Research Company; French Bankers' Association (Association FranCaise 

des Banques); Timothy J. Gallagher; IDS Financial Services, Inc.; Leslie L. Ogg, Vice President, 

General Counsel and Treasurer, IDS Mutual Fund Group; Investment Company Institute; the 

Japanese Government, Ministry of Finance; Howard Kaikow; Linklaters & Paines; Los Angeles 

County Bar Association, Business and Corporations Law Section (certain committee members); 

Merrill Lynch & Co., Inc.; Robert G. Miller; Office of the Secretary of State of Missouri; The New 

York Clearing House Association; North American Securities Administrators Association, Inc.; 

Prudential Mutual Fund Management, Inc.; The Putnam Companies; Ropes & Gray; Scudder, 

Stevens & Clark, Inc.; Securities and Investments Board (United Kingdom); Shearson Lehman 

Brothers Inc.; State Street Bank and Trust Company; Jan Stenbeck, Shareholder and Director of 

Industriforvaltnings AB Kinnevik; Swedish Bank Inspection Board (Bankinspektionen); Kathleen 

A. Veach, Mutual Fund Examiner, Ohio Department of Commerce, Division of Securities; Warburg 

Investment Management International Ltd.; S.G. Warburg & Co., Inc.; Wayne Hummer Growth 

Fund Trust and Wayne Hummer Money Fund Trust; Westpac Banking Corporation; and the State 

of Wisconsin (Office of the Commissioner of Securities). 

'Council Directive 85/611, 1985 O.J. (L 375) 3. 

Internationalization and Investment Companies 187 
may sell its shares in any other Member State, subject only to the host country's 

marketing, advertising, and tax laws." 

In the United States, many in the investment company industry believe that 

changes in domestic policy are necessary for more receptive treatment of United 

States funds in foreign countries. The Investment Company Institute ("ICI") has 

met regularly in recent years with its European counterpart, the European 

Federation of Investment Companies and Funds. These representatives are 

working to develop terms for a United States-European Community treaty to 

facilitate cross-border sales, which the industries propose to present to their 

respective governments. The topic of cross-border sales of investment company 

shares also is frequently raised in meetings between the Commission and foreign 

officials. 

There are a number of barriers to cross-border sales of United States 

investment company shares. For example, to capitalize on the significant 

investment required in order to reach a large market abroad, United States funds 

must be able to comply simultaneously with different rules in several countries. 

In some foreign jurisdictions, United States funds may be subject to more 

restrictive conditions than are funds organized in those jurisdictions:' Perhaps 

most importantly, United States funds may find it difficult to break into wellestablished affiliated distribution networks.12 

Obviously, only foreign jurisdictions can remove these barriers, but many 

argue that at least one principal problem for United States funds marketing 

abroad could be resolved unilaterally by the United States. United States tax law 

%ach Member State must adopt domestic legislation to implement the UCITS Directive, but 

each is free to choose a form and method of implementation consistent with its legal system. The 

UCITS Directive generally permits a Member State to impose more stringent requirements on its 

own UCITS than on other Member States' UCITS sold within its borders. 

'IFor example, in Japan, a foreign investment trust fund may not denominate its securities in 

yen. See infra note 68 and accompanying text. In Germany, foreign funds are subject to higher 

fees and more complex notification procedures than domestic funds or UCITS. Roland W. Baum 

and Olivia P. Adler, Public Distribution of Foreign Mutual Fund Shares in Germany, 23 REV. SEC. & 

COMMODITIES REG. 223, 225 (1990). 

'kenerally, large investment company complexes with the ability to absorb temporary losses 

sustained while developing a foreign distribution network cite time, money, and unfavorable 

United States tax treatment as the primary obstacles, not foreign law. These complexes tend to 

be less eager than others about changes in regulation to facilitate cross-border sales. Investment 

company complexes, typically smaller, that do not now operate overseas generally express more 

enthusiasm about regulatory reform, believing that amending our laws to provide foreign 

investment companies greater access in the United States will facilitate improved market access 

for them in other countries. 

188 CHAPTER 4 
deters foreign investors from purchasing securities issued by United States 

investment companies.13 Unlike the United States, many foreign countries do 

not impose distribution and withholding requirements on investment company 

income.14 These 

distinctions encourage foreign investors to purchase securities from non-United 

States investment companies. 

They also tend to impose little if any capital gains tax. 

From the perspective of a foreign fund seekin to market its securities in 

the United States, the Investment Company presents a formidable 

challenge. Section 7(d)l6 prohibits a foreign investment company from making 

a public offering of its shares in the United States through United States 

jurisdictional means unless the Commission issues an order permitting it to 

register under the Investment Company Act. Under that section, the Commission 

must find that "by reason of special circumstances or arrangements, it is both 

legally and practically feasible effectively to enforce the provisions of [the Act] 

against such company and that the issuance of such order is otherwise consistent 

with the public interest and the protection of investors." 

Congress enacted section 7(d) to enable the Commission to enforce the 

investor protections of the Investment Company Act against foreign funds 

operating in the United States.17 Section 7(d) was intended to ensure the 

integrity of the United States investment company industry, and effectively 

provides national treatment for foreign funds registering in the United States. 

Unfortunately, because foreign regulatory systems for investment companies 

differ greatly from the Investment Company Act, section 7(d) has operated to 

limit the entry of foreign funds into the United States market. Because the 

standard effectively requires a foreign investment company organized in a 

country with substantially different investment company regulation to structure 

itself and operate as a United States company, it has proved impossible for most 

foreign investment companies to meet. In fact, only nineteen foreign funds, most 

13See, e.g., Letter from The Equitable Life Assurance Society of the United States to Jonathan 

G. Katz, Secretary, SEC 31 (Oct. 5, 1990), File No. S7-11-90; Letter from Federated Investors to 

Jonathan G. Katz, Secretary, SEC (Oct. 10, 1990), File No. S7-11-90; and Letter from IDS Financial 

Services, Inc. to Jonathan G. Katz, Secretary, SEC 28 (Oct. 2, 1990), File No. S7-11-90. 

14See infva Section W.A. 

151nvestment Company Act of 1940,15 U.S.C. § 80a. 

1615 U.S.C. § 80a-7(d). 

I7See Commission Policy and Guidelines for Filing of Application for Order Permitting 

Registration under the Act and Sale of Shares in the United States of Foreign Investment 

Companies, Investment Company Act Release No. 8959 (Sept. 26, 1975), 40 FR 45424, discussed 

inpu notes 26-31 and accompanying text. 

Internationalization and Investment Companies 189 
from Canada, have ever received orders under section 7(d). The last such order 

was issued in 1973.l' 

Faced with this standard, a foreign investment company may decide to 

avoid section 7(d) registration requirements by making only a limited United 

States offering. The Commission has stated that section 7(d) permits a foreign 

investment company to make a private offering of its securities in the United 

States without registering, provided that the company has no more than 100 

beneficial owners who are United States residents:' Because a foreign 

investment company may fear the consequences of inadvertently failing to stay 

within the numerical limit, it might not consider this approach to be a realistic 

a1 terna tive. 

A foreign investment company that receives a Commission order under 

section 7(d) must satisfy another layer of securities regulation in the United States, 

the "blue sky" laws of those states in which it seeks to offer its securities. Some 

critics question the merits of state blue sky substantive investment company 

regulation, considering that the company already would be subject to the 

extensive investor protections of the Investment Company Act, as well as to its 

home country investment company regulation. 

In view of the opportunities for both United States investors and 

investment companies if hurdles to cross-border sales are lowered, the Division 

recommends that the Commission adopt a multi-faceted approach to remove 

unnecessary barriers to cross-border sales of investment company securities. To 

promote greater access to foreign markets by United States funds, we recommend 

that the Commission expand current consultations with foreign fund regulators 

to increase mutual understanding of investment company regulatory systems. To 

facilitate access to United States markets by foreign funds and to foreign markets 

by United States funds, we recommend that section 7(d) of the Investment 

Company Act be amended to authorize the Commission to enter into bilateral 

regulatory memoranda of understanding that would create a framework for 

regulatory cooperation and mutual recognition of investment company regulation. 

We propose that section 7(d) further be amended to give the Commission greater 

flexibility to permit foreign funds to register in the United States and to clarify, 

in the absence of a public offering, when section 7(d) requires foreign funds to 

register. 

"See Pan Australian Fund Limited, Investment Company Act Release Nos. 7795 (Apr. 30, 

1973),38 FR 11141 (Notice of Application) and 8028 (Oct. 10,1973),2 SEC Docket 585 (Order). 

"See Resale of Restricted Securities; Changes to Method of Determining Holding Period of 

Restricted Securities under Rules 144 and 145, Securities Act Release No. 6862, at 1I.F (Apr. 23, 

1990), 55 F'R 17933, 17940-41. 

190 CHAPTER 4 
The Division also recommends that the Commission continue to work with 

state securities regulators to coordinate and consolidate substantive regulation 

while preserving states' significant enforcement responsibilities. Finally, the 

Division recommends that the competitive disadvantages for United States funds 

created by the Internal Revenue Code be addressed, although we express no view 

on specific terms of any amendments to the Code. 

This chapter begins with an historical overview of commission attempts 

to provide a workable standard under section 7(d) for public and private offerings 

by foreign investment companies. Then follows an explanation of the Division's 

recommendation to amend section 7(d) to facilitate cross-border sales of 

investment company securities, maintain investor protection standards, and 

encourage foreign regulators to provide and facilitate meaningful market access 

by United States investment companies. The chapter ends with a 

recommendation that the Commission support generally tax proposals that would 

enable United States investment companies securing access to foreign markets to 

compete effectively with foreign funds, and that the Commission continue to 

work with state securities administrators to eliminate duplicative substantive 

regulation of investment companies. 

11. Background -- Commission Experience with Section 7(d) 

The initial Senate version of what became the Investment Company Act 

absolutely prohibited foreign investment companies from publicly offering their 

securities in the United States?' Ultimately, Congress determined that it would 

be inappropriate to exclude a foreign investment company from United States 

markets if the Investment Company Act could be enforced against the company 

and registration would not adversely affect the public interest or investor 

protection. It enacted a redrafted version of the section, incorporating strict 

enforceability and public interest provisions?* 

201nvestment Trusts and Investment Companies: Hearings on S. 3580 B@re a Subcomm. of the Senate 

Comm. on Bunking and Currency, 76th Cong., 3d Sess. 6 (1940) [hereinafter 1940 Senate Hearings]. 

"Section 7(d) provides: 

No investment company, unless organized or otherwise created under the laws 

of the United States or of a State, and no depositor or trustee of or underwriter 

for such a company not so organized or created, shall make use of the mails or 

any means or instrumentality of interstate commerce, directly or indirectly, to 

offer for sale, sell, or deliver after sale, in connection with a public offering, any 

security of which such company is the issuer. Notwithstanding the provisions 

of this subsection and of Section 8(a), the Commission is authorized, upon 

application by an investment company organized or otherwise created under the 

laws of a foreign country, to issue a conditional or unconditional order permitting 

(continued. ..) 

Internationalization and Investment Companies 191 
For the past fifty years, the enforceability standard of section 7(d) has 

precluded all but a few foreign investment companies from making public 

offerings in the United States. Section 7(d) theoretically permits foreign funds to 

register, but practically prevents them from doing so. The Commission has made 

several unsuccessful attempts to resolve this dilemma. 

A. Early Canadian Applications and Rule 7d-1 

In the early 1950'~~ four Canadian investment companies applied to the 

Commission for section 7(d) orders. In reviewing these applications, the 

Commission considered the circumstances under which the Investment Company 

Act would apply to the persons or transactions involved and the ability of the 

Commission and investors effectively to enforce the Act. 

In 1954, the Commission adopted rule 7d-1, setting forth the conditions 

with which Canadian a plicants must comply to satisfy the enforceability 

standard of section 7(d)?' Among other criteria, the rule requires that:.. 

(1) the fund's charter and bylaws contain the substantive provisions of the 

Investment Company Act, and an interpretation of the charter or bylaws 

conform with United States law; 

(2) each officer, director, adviser, custodian, and underwriter for the 

investment company enter into an agreement, filed with the Commission, 

that provides that each will comply with the Investment Company Act, 

and that the shareholders of the investment company may sue in the 

United States for any violation of the Investment Company Act; 

(3) at least a majority of the directors and officers be United States citizens, 

a majority of whom will be United States residents; 

*'(...continued) 

such company to register under this title and to make a public offering of its 

securities by use of the mails and means or instrumentalities of interstate 

commerce, if the Commission finds that, by reason of special circumstances or 

arrangements, it is both legally and practically feasible effectively to enforce the 

provisions of this title against such company and that the issuance of such order 

is otherwise consistent with the public interest and the protection of investors. 

=17 C.F.R. 5 270.7d-1; Notice of Proposed Rule N-7D-1 Relating to Registration of 

Management Investment Companies Organized under Canadian Law, Investment Company Act 

Release No. 1945 (Jan. 28, 19541, 19 FR 754 (proposing rule 7d-1); and Adoption of Rule N-7D-1 

Relating to Registration of Management Investment Companies Organized under Canadian Law, 

Investment Company Act Release No. 1973 (Apr. 27, 1954), 19 FR 2584 (adopting rule 7d-1). 

192 CHAPTER 4 
(4) all of the investment company’s assets be maintained in the United 

States with a United States bank; 

(5) the original or a duplicate copy of the investment company’s books and 

records be kept in the’United States; 

(6) the investment company’s principal underwriter be a United States 

entity; and 

(7) the investment company use a United States auditor. 

Although the rule by its terms applies only to Canadian companies, the 

Commission also requires non-Canadian foreign investment companies seeking 

registration orders to comply with the rule’s ~onditions.2~ Because the 

conditions dictate that a company relying on the rule be structured and operated 

in large part like a United States investment company, they are impractical for 

most foreign investment companies. 

B. Foreign Portfolio Sales Corporation Act of 1973 

In 1973, the Commission proposed amendments to the Investment 

Company Act to provide special provisions for the registration and regulation of 

domestic investment companies organized to sell their securities exclusively to 

foreigners, and to give the Commission greater flexibility to permit foreign 

investment companies to register under the While the proposal would 

23Between 1954 and 1973, the Commission issued section 7(d) orders to investment companies 

from Canada, Australia, Bermuda, South Africa, and the United Kingdom. Of these, only three 

Canadian funds and the one South African fund remain active. Each of the applicants agreed to 

comply with the conditions in rule 7d-1 as a prerequisite to receiving its section 7(d) order. 

In some instances, the Commission has granted limited exemptive relief from rule 7d-1. For 

example, in 1979, the Commission permitted a Canadian investment company to maintain its 

Japanese portfolio securities in the custody of a Japanese branch of a United States bank, which 

otherwise violated rule 7d-l(b)(8)(v) (providing, among other things, that the company’s trustee 

must maintain sole custody of all of the company’s securities and cash in the United States.) See 

Templeton Growth Fund, Ltd., Investment Company Act Release Nos. 10628 (Mar. 13,1979),44 

FR 17247 (Notice of Application) and 10657 (Apr. 11,1979), 17 SEC Docket 280 (Order). 

24H.R. 8256, 93d Cong., 1st Sess. (1973). The proposal would have provided for the 

registration of a new type of investment company that would sell its securities exclusively to 

foreign investors. The Commission anticipated that the legislation would be accompanied by 

changes in United States tax law to provide a United States fund that sold exclusively to foreign 

investors with tax treatment comparable to that available to offshore funds investing in United 

States securities. This tax treatment would have encouraged offshore funds investing in securities 

of United States issuers to consider domiciling in the United States. See also Offshore Fund 

(continued ...) 

Internationalization and Investment Companies 193 
have continued to require a Commission determination that it was "both legally 

and practically feasible effectively to enforce" the provisions of the Investment 

Company Act against a foreign fund, it also would have authorized the 

Commission to "take into account the differing laws, regulations, customs, and 

business conditions of particular countries in which such com anies are organized 

and the adequacy of existing regulation in such countries." 2 

The proposal was introduced in the House of Representatives, but no 

further action was taken. In retrospect, it seems probable that even had the 

amendment become law, it would not have improved the prospects for a foreign 

fund seeking a section 7(d) order, since it would have retained the strict 

enforceability language of section 7(d). More likely, the statute would have 

generated lengthy hearings comparing foreign law and United States law, and 

invited litigation on the enforceability of the Investment Company Act against a 

foreign fund. 

C. The 1975 Guidelines 

In 1975, the Commission issued guidelines for foreign investment 

companies seeking to register in the United States?6 The 1975 guidelines 

temper the requirements of rule 7d-1 by providing that foreign investment 

companies may satisfy the standards of section 7(d) through other means. Since 

"differences in foreign law applicable to a foreign investment company . . . might 

prevent compliance with all of the requirements of the [Investment Company] 

the guidelines state that it may be appropriate for the Commission to 

grant relief under sections 7(d), 6(c),2' or other sections of the Act. In reviewing 

registration applications by foreign investment companies, the Commission might 

"take into account the differing laws, regulations, customs and business conditions 

of particular countries in which such com anies are organized and the adequacy 

of existing regulation in such countries." The protections accorded investors 

by the regulatory' system governing a foreign investment company, however, 

!? 

"(...continued) 

Legislation Proposed by the Securities and Exchange Commission, Investment Company Act 

Release No. 7751 (Apr. 3, 1973), [1973 Transfer Binder] Fed. Sec. L. Rep. (CCH) 4[ 79,306 

(announcing the submission of the legislative proposal to Congress). 

25H.R. 8256, supra note 24. 

261nv. Co. Act Rel. 8959, supra note 17. 

27~d. at I. 

%15 U.S.C. Q 80a-6(c). 

"Inv. Co. Act Rel. 8959, supra note 17, at 2. 

194 CHAPTER 4 
"should be substantially equivalent to those provisions of the [Investment 

Company] Act which the Commission determines should be applicable to the 

foreign investment company.1130 

The 1975 guidelines, in theory, afford the Commission greater flexibility in 

interpreting the enforceability standard of section 7(d)?l The guidelines, 

however, have never resulted in a section 7(d) order. 

D. The Union-Investment Application 

The 1975 guidelines appear in practice to be flawed for much the same 

reason that the 1973 proposed legislation may have been flawed. Like the 

legislative proposal, they require the Commission to make detailed findings about 

the adequacy of foreign law in the narrow context of a specific application, rather 

than encouraging the Commission to consult directly with foreign regulators in 

the broader context of determinations on a country-by-country basis. 

The Commission's protracted consideration during the 1970's and early 

1980's of an application by Union-Investment Gesellschaft m.b.H. ("UnionInvestment"), a West German investment management company, on behalf of 

Unifonds, a West German mutual fund, illustrates this point. The UnionInvestment application requested a Commission order under section 6(c) granting 

exemptions from many provisions of the Investment Company Act, and under 

section 7(d) permitting registration of Union-Investment, so that it could sell 

Unifonds shares in the United States. 

The Union-Investment application raised a number of novel and difficult 

issues. For example, Unifonds did not have the legal stature of an entity capable 

of applying to register under the Investment Company Act. Union-Investment 

applied on its behalf. In addition, German law prevented Unifonds from agreeing 

to basic jurisdictional requirements, including consent to jurisdiction of United 

States courts or appointment of an agent for service of process in the United 

31The guidelines require that a foreign investment company applicant: (1) be a bona fide and 

established company; (2) be subject to actual regulation by an appropriate foreign governmental 

authority; (3) not be dependent solely on sales in the United States; (4) be a vehicle for investment 

primarily in foreign securities; (5) subject itself and its management to service of process; and 

(6) provide adequate disclosure to investors in the United States. A foreign investment company 

generally would satisfy these requirements by complying with standards outlined in the release, 

including that the investment company have minimum net assets of $50 million, a minimum of 

500 shareholders resident in the country in which it is organized, no more than 50% of its shares 

sold to United States investors, and a minimum of either 60% of the value of its portfolio invested 

in issuers in the country in which it is organized or 75% in non-United States issuers. Id. at 2. 

Internationalization and Investment Companies 195 
States?2 Furthermore, Union-Investment was unable or unwilling to comply 

with the Investment Company Act in a number of significant respects (e.g,, 

affiliated transactions, disinterested directors, and voting shareholders). 

Nonetheless, the Commission published a notice of the application in 

1982?3 In 1983, after the IC1 requested a hearing on the appli~ation:~ UnionInvestment announced that it could no longer bear the time and expense involved 

in continuing to pursue its registration and exemptive requests, and withdrew its 

application. 

E. The "Mirror Funds" Release 

The Union-Investment application demonstrated that, notwithstanding the 

1975 guidelines, a foreign investment company still may have difficulty meeting 

section 7(d)'s enforceability standards. In December 1983, following UnionInvestment's withdrawal, the Commission issued a release advising any 

prospective foreign investment company applicant subject to laws conflicting 

irreconcilably with the Investment Company Act to consider forming a "mirror" 

fund to offer its securities in the United state^?^ By organizing a United States 

32See, e.g., 17 C.F.R. § 270.7d-l(b)(l), (b)(2), (b)(2), (b)(6), (b)(8). Union-Investment had 

consented to United States jurisdiction and to the appointment of an agent for service of process 

in the United States. It also undertook to secure an irrevocable letter of credit, initially in the 

amount of $1 million, to be increased to an amount equaling five percent of Unifonds shares 

actually sold in the United States, to be available to pay damages to any person obtaining a 

United States judgment against Union-Investment for violating United States securities laws. 

These conditions, however, could not ensure the Commission's ability to investigate possible 

cases of United States securities law violations or to bring a criminal action or enforce an 

injunction against Unifonds, its distributor, custodian, or accountant, or against the officers of 

Union-Investment. Union-Investment represented that it would have been inconsistent with West 

German business practices for these parties to have agreed to comply with the terms of the 

Investment Company Act, waive their immunity from personal liability to United States 

shareholders, consent to jurisdiction of United States courts, and appoint an agent for service of 

process in the United States. Moreover, neither Unifonds nor Union-Investment would have 

maintained duplicate books or records in the United States, and German law prohibited UnionInvestment from permitting Commission staff to inspect books and records in Germany. 

33Union-Investment-Gesellschaft m.b.H., Investment Company Act Release No. 12863 (Dec. 1, 

1982), 47 FR 57179 (Notice of Application). 

34Union-Investment-Gesellschaft m.b.H.; Hearing on Application for an Order Permitting 

Registration of an Investment Company Organized in West Germany and Granting Exemptions, 

Investment Company Act Release No. 13234A (May 17,1983), 48 FR 23342. 

35Applications of Foreign Investment Companies Filed Pursuant to Section 7(d) of the 

Investment Company Act of 1940, Investment Company Act Release No. 13691 (Dec. 23,1983),49 

FR 55. 

196 CHAPTER 4 

r 
investment company investing primarily in the securities of foreign issuers, a 

foreign money manager would be able to offer its services to United States 

investors without needing to register the foreign investment company under 

section 7(d)?6 The newly-created United States fund could "mirror" the 

investments of any of the foreign money manager's foreign funds. The 

Commission emphasized that this approach was not based on the merits of 

foreign regulatory systems as compared to the United States system, but rather 

on the reality that, unless section 7(d) was amended, a mirror fund was a more 

feasible and less costly alternative to regi~tration.3~ 

The mirror fund alternative has the advantage of avoiding section 7(d) 

determinations about the adequacy of foreign law and investor protection under 

that law. Judging from the registration of foreign-based advisers and subadvisers, 

mirror funds may comprise a significant portion of the growing number of United 

States companies investing in foreign securities?' 

The mirror fund approach, however, is of limited practicality in an 

increasingly international securities market. It is a burdensome and expensive 

option for foreign investment companies. As a separate company, a mirror fund 

loses the ability to promote its securities in the United States based on any 

previous successful history of the overseas investment and cannot 

realize certain economies of scale. The investing public ultimately bears the 

additional costs. The mirror fund solution does little to improve United States 

investment company access abroad. 

360f course, the "mirror" fund would need to register under section 8 of the Investment 

Company Act (15 U.S.C. 5 80a-8). 

371nv. Co. Act. Rel. 13691, supra note 35. 

38As of September 1988, 165 foreign investment advisers representing 27 countries had 

registered in the United States; by March 1992,269 foreign advisers representing 36 countries had 

registered. A significant number of the United States registered investment companies advised 

by these foreign advisers may be mirror funds. See, eg., The Japan OTC Equity Fund, Inc. 

(Registration No. 81 1-59921, advised by Nomura Investment Management; The Germany Fund 

(Registration No. 81 1-4632), advised by DB Capital Management International (Deutsche Bank); 

and The First Australia Fund (Registration No. 811-4438), advised by EquitiLink Australia Ltd. 

39See 17 C.F.R. 5 230.482(e); Advertising by Investment Companies, Investment Company Act 

Release No. 16245 at n.31 (Feb. 2,1988), 53 FR 3868 (adopting advertising rules). 

Internationalization and Investment Companies 197 
F. The Foreign Investment Company Amendments Act of 1984 

One month after issuing the mirror funds release, the Commission 

proposed the Foreign Investment Company Act Amendments of 1984.4' The 

Commission observed that section 7(d) had operated to prevent foreign 

investment companies from registering under the Investment Company Act and 

offering shares in the United States, which, in turn, led to "needless costs and 

insurmountable barriers to foreign companies seeking access to United States 

markets, lost competitive opportunities, and a denial of investment opportunities 

for United States investor^."^^ The proposed legislation would have given the 

Commission greater flexibility to recognize differences among regulatory sys tems 

and "to fashion workable regulatory approaches for companies doing business 

internationally without sacrificing investor protection.tt42 

The proposal would have retained the present language of section 7(d), but 

also would have authorized the Commission to exempt an operating foreign 

investment company from any provision of the Investment Company Act, 

provided that: (I) compliance with the provision would be unduly burdensome 

because the company was organized or otherwise created under foreign law and 

invested primarily in foreign securities; (2) either the laws under which the 

company operated provided protections for investors that served the same 

purposes as the protections provided by the provisions of the Investment 

Company Act from which exemption was requested, or specific conditions agreed 

to by the company provided such protections; (3) an exemption was consistent 

with the protection of investors and the purposes fairly intended by the policies 

of the Investment Company Act; and (4) the company was not operated for the 

purpose of evading the provisions of the Investment Company Act. By 

broadening the Commission's authority to grant exemptions, the proposal would 

have relaxed significantly the enforceability standard of section 7(d). 

The proposal included a number of important safeguards. It would have 

applied only to operating foreign investment companies. An operating foreign 

investment company was defined as a company, organized or created under the 

laws of a foreign country, that had been in operation with a minimum of 500 nonUnited States shareholders and $100 million in net assets for at least three years, 

4%etter from John S.R. Shad, Chairman, United States Securities and Exchange Commission, 

to Thomas P. ONeill, Jr., Speaker of the United States House of Representatives (Jan. 31, 1984) 

(transmitting proposal to amend section 7(d)). 

41Memorandum of the Securities and Exchange Commission in Support of the Foreign 

Investment Company Amendments Act of 1984, at 1 (Jan. 31, 1984) (accompanying proposal to 

amend section 7(d)). 

@Id. at 3. 

198 CHAPTER 4 
and that was primarily engaged in investing in the securities of non-United States 

i~suers.4~ This requirement was intended to deter United States investment 

company sponsors from moving offshore to a jurisdiction with differing 

regulation and seeking a section 7(d) 0rder.4~ 

The Commission’s proposal never was introduced in Congress. Critics 

argue that it would have offered foreign investment companies a competitive 

advantage in the United States. They maintain that for many foreign investment 

companies, the costs of complying with the laws of their home countries are 

lower than those incurred by United States investment companies complying with 

United States securities laws.45 They also charge that the proposal did not 

address the barriers that United States investment companies face when offering 

their shares abroad. Arguing that foreign laws imposing stricter licensing and 

other requirements on non-domestic investment companies have greatly limited 

the marketing of United States investment company shares overseas, industry 

representatives generally favor amendments that would permit the Commission 

to consider reciprocity as a factor in determining whether to issue an order 

permitting registration of a foreign fund?6 

Furthermore, the 1984 proposal again would have required the 

Commission to make difficult determinations about the adequacy of foreign law 

compared with United States law in the context of a specific application. In 

addition to the problems identified in the course of the Union-Investment 

application, gaps between foreign law as written and as practiced would make 

it difficult for the Commission to make these findings. Moreover, making these 

determinations in the context of individual applications could result in 

inappropriate precedent. Given variations in size, reputation, practice, and 

success among foreign investment companies from the same country, the process 

~~ 

at 5. Foreign funds that did not meet the definition would have remained subject to the 

original section 7(d) standards. 

4’?he proposal also provided that any section 7(d1 order could be revoked or modified if the 

circumstances upon which the order were based had changed. This could occur, for example, if 

the applicable provisions of the Investment Company Act could no longer be enforced against the 

company, the regulatory system upon which the Commission’s determination was based no longer 

provided sufficient investor protections, or if the foreign company no longer was engaged 

primarily in investing in securities of non-United States issuers. Id. 

45See Letter from Davis, Polk & Wardwell to Jonathan G. Katz, Secretary, SEC 20 (Oct. 10, 

19901, File No. S7-11-90 (summarizing critics’ objections) [hereinafter Davis Polk Study Comment]. 

46See id.; Letter from Investment Company Institute to Jonathan G. Katz, Secretary, SEC 65-66 

(Oct. 5, 1390), File No. S7-11-90; and Letter from Prudential Mutual Fund Management, Inc. to 

Jonathan G. Katz, Secretary, SEC 8 (Oct. 9, 19901, File No. S7-11-90. 

Internationalization and Investment Companies 199 
could have resulted in the development of application standards that would have 

been unsuitable for other investment companies from even the same country. 

G. Section 7(d) and Private Offerings 

Section 7(d) is the only section of the Act directed specifically to foreign 

investment companies. While section 7(d) prohibits a foreign fund from making 

a public offering of its securities in the United States without obtaining a 

Commission order permitting it to register under the Investment Company Act, 

it does not expressly prohibit private offerings or limit the number of 

shareholders that a foreign fund may ha~e.4~ 

Section 3(c)(l) of the Investment Company Act addresses offerings by 

private investment companies:' It excepts from the definition of investment 

company an entity that has no more than 100 beneficial owners of its securities 

and that does not presently propose to make a public offering of its securities. 

As discussed in Chapter 2, Congress determined that the point at which an 

investment company has more than 100 owners reasonably reflects when public 

interest concerns arise. 

If an entity does not qualify for the section 3(c)(I) exception and is 

otherwise an investment company as defined in the Act, it must look to section 

7 for its registration obligation. Section 7(a) prohibits a domestic fund from 

making any offering of its securities without Investment Company Act 

registration. In contrast, by its terms, section 7(d) only prohibits an unregistered 

foreign fund from making a public offering in the United States. 

The Commission, through interpretation of the statute, has married section 

7(d) to secfion 3(c)(l). In 1984, the Division stated that an unregistered foreign 

fund could make.a private offering in the United States concurrently with a 

public offering abroad and not violate section 7(d), provided the fund had no 

47Congress, in the legislative history of section 7(d), did not distinguish between public and 

private offerings by foreign investment companies. See 1940 Senate Hearings, supra note 20, at 196- 

97 (statement of David Schenker, Counsel for the Investment Trust Study, Securities and Exchange 

Commission); S. REP. No. 1775, 76th Cong., 3d Sess. 13 (1940). 

4815 U.S.C. § 80a-3(c)(l). 

200 CHAPTER 4 
more than 100 beneficial owners resident in the United States.49 In 1990, the 

Commission endorsed that position in its r.elease adopting rule 144A.5’ 

Critics of the Commission’s position charge that it lacks a statutory basis. 

They argue that Congress intended section 7(d) to restrict only public offerings by 

foreign investment companies, and stress that section 7(d) does not contain any 

shareholder limit comparable to that found in section 3(c)(l). They also point out 

that the Commission’s position creates competitive problems for foreign funds?l 

For example, certain foreign central depositary systems like Euro-Clear and 

CEDEL (Central de Livraison Valeurs Mobili2res) do not provide for constant 

monitoring of the nationalities of purchasers. Consequently, the Commission’s 

position compels foreign funds considering United States offerings to include 

charter provisions permitting forced transfers, purchases, or denials of ownership 

registration whenever the number of United States residential owners exceeds 100. 

These procedures are quite costly and burdensome?2 Further, because it is 

difficult to track ownership of United States residents, foreign funds may 

inadvertently exceed the 100 United States resident limit. Fear of inadvertent 

4?ouche Remnant (pub. avail. Aug. 27,1984). The position that the private offering need not 

be integrated with the public offering is consistent with Regulation D under the Securities Act of 

1933 (17 C.F.R. 55 230.501 - .508 (1991)). Preliminary Note 7 to Regulation D states that an issuer 

may make a private placement in the United States in accordance with Regulation D concurrently 

with an offering abroad in accordance with Regulation S under the Securities Act (17 C.F.R. 

230.901 - .904) without integrating the two offerings. 

50The release stated: 

The Commission believes that resales of privately placed investment company 

securities pursuant to the safe harbor provisions of Rule 144A would not cause 

the issuing investment company to lose the exemption provided by section 3(c)(l) 

or cause a violation of section 7(d) of the Investment Company Act as long as 

after the resale the securities are held, for purposes of section 3(c)(l), by no more 

than 100 beneficial owners or, for purposes of section 7(d), by no more than 100 

beneficial owners who are U.S. residents . . . . Rule 144A will not obviate the 

obligation of . . . a foreign investment company [ 1 to apply for an exemptive 

order permitting it to register [ ] under the Investment Company Act if . . . there 

will be more than 100 U.S. residents who are beneficial owners of its securities. 

Sec. Act Rel. 6862, supra note 19, at 1I.F. 

51See, e.g., Letter from Cleary, Gottlieb, Steen & Hamilton to Jonathan G. Katz, Secretary, SEC 

30 (Oct. 12, 1990), File No. S7-11-90. 

52See, eg., Davis Polk Study Comment, supra note 45, at 16-17. 

Internationalization and Investment Companies 201 
violations may cause foreign funds to forego completely offering their securities 

in the United States. 

Section 7(d) is intended to protect United States investors by subjecting 

foreign and domestic investment companies to similar standards. The 

Commission's position does prevent foreign funds from circumventing the point 

at which a valid United States regulatory interest arises and from enjoying an 

unfair advantage over domestic funds. Therefore, the effects of the position plus 

the absence of language in section 7(d) specifically addressing non-public 

offerings by foreign investment companies warrant statutory clarification. 

111. Discussion -- Removing Unnecessary Barriers to Cross-Border 

Sales 

The Division analyzed a number of approaches to overcoming the barriers 

created by section 7(d), including: more expansive use of the Commission's 

exemptive and rulemaking authority; harmonization of United States and foreign 

law; pursuit of treaties that would override section 7(d); and amending section 

7(d) to give the Commission more flexibility in permitting foreign funds to 

register under the Investment Company Act. 

The Commission has tried repeatedly to use its authority within the 

strictures of section 7(d). Further expanding the Commission's use of existing 

authority would disregard the strict limitations that section 7(d) places on the 

Commission's flexibility, as demonstrated by the history of the Union-Investment 

application, and, as such, is unworkable. Accordingly, we do not recommend it. 

Harmonization and treaty negotiations have merit, but, as discussed below, both 

approaches have significant drawbacks and are not substitutes for an amendment 

of section 7(d). Only the third approach, statutory amendment, promises both to 

offer greater access by United States funds to foreign markets and to maintain an 

effective and efficient means of regulation. Under our proposal, section 7(d) 

would be amended to provide the flexibility needed to permit foreign funds to 

register under the Investment Company Act and encourage foreign regulators to 

ease regulatory restrictions on United States funds abroad. 

A. Harmonization 

Harmonizing the provisions of the Investment Company Act with 

standards provided under foreign lag3 would assure equality of investor 

53"Harmonization" refers to the achievement of substantially identical regulatory regimes or 

common regulatory requirements. It should be distinguished from "mutual recognition," which 

means two or more jurisdictions have regulation following the same basic principles and each 

generally accepts compliance with the others' rules within its own jurisdiction. 

202 CHAPTER 4 
protection and the elimination of competitive disadvantages, provided each 

jurisdiction interpreted and enforced its laws similarly. The differences between 

the regulatory systems of foreign countries and the United States are so vast, 

however, that harmonization is unlikely in the foreseeable future. 

Many foreign investment company regulatory systems are driven by 

fundamentally different philosophical underpinnings from those underlying the 

United States system. For example, Japan and many of the Member States in the 

European Community rely on licensing or authorization procedures to restrict 

market entrance to only "fit and proper" applicants. In contrast, in the United 

States, any person may sponsor an investment company provided it has the 

necessary seed money of $100,000 and is not subject to a statutory disqualification. 

While some may view the vetting system as unduly paternalistic and subject to 

abuse and favoritism, foreign regulators may view the more open system of the 

United States as inordinately risky. 

Further, many of the regulatory provisions that Congress and the 

Commission have deemed essential to investor protection simply do not exist 

abroad. For example, the European Community's UCITS Directive does not 

prohibit backward pricing of fund shares; United States regulation under the 

Investment Company Act requires forward pricing to avoid manipulative 

pra~tices.5~ Similarly, most European Community Member States do not 

prohibit transactions between a fund and an affiliate; in the United States, the 

prohibition against affiliated transactions is a cornerstone of the Investment 

Company A~t.5~ Such widespread differences among countries suggest that 

harmonization is unlikely in the foreseeable future. 

Because complete harmonization is unlikely, some industry representatives 

have suggested a more limited approach. They propose an amendment of the 

Investment Company Act to authorize an alternate collective investment vehicle, 

the unitary investment fund (YJF"). They argue that the UIF would be a new 

type of United States investment company that would resemble more closely the 

structure of investment companies in the European Community and Japan. 

As discussed in Chapter 7, the Division has analyzed the UIF. We 

conclude that, while the governance requirements of the Investment Company Act 

may be improved, they are generally efficient and should not be replaced. In 

addition, the Division does not believe that the UIF would resolve section 7(d) 

54See Chapter 8. 

55Many Member States apparently rely on an investment company's depositary to prevent 

abuses that may arise from affiliated transactions, even though the depositary is itself an affiliate 

of the investment company. 

Internationalization and Investment Companies 203 
issues. Despite the UIFs structural similarity to investment vehicles in other 

countries, it would not address the significant differences in regulatory 

approaches to other investor protection issues, such as the treatment of affiliated 

transactions and pricing methods. 

B. Treaties 

Mutual recognition through treaties is another possible route for achieving 

cross-border sales of investment management services. The pursuit of treaties 

with other countries is the most obvious and often recommended mutual 

recognition approach. A treaty would supersede the current enforceability 

standard of section 7(d). 

A treaty between two countries, such as the United States and Canada, for 

example, might provide that shares of investment companies from either country 

could be traded freely in the other country, subject to some general guidelines. 

For instance, the treaty might provide that the country of domicile would regulate 

the fund’s structure and operations, while each country would regulate marketing 

within its borders (an approach taken by the UCITS Directive). Presumably, 

either country could include in the treaty any additional conditions it believed 

necessary in order to permit entry by a foreign fund. 

In light of the UCITS Directive, many have suggested that the European 

Community should be the United States’ first treaty partner. The UCITS Directive 

allows cross-border sales within the European Community of UCITS, which 

resemble United States open-end funds. The development of a European 

Community-wide market for UCITS has raised hopes for a United StatesEuropean Community treaty that would allow any UCITS qualified in a Member 

State to register in the United States, and would allow United States investment 

companies to register in one and market in all twelve of the Member States. 

The United States and European investment company industries already 

have attempted to lay the groundwork for this type of treaty. In recent years, the 

Invesfment Company Institute has met with its European counterpart to discuss 

the possibility of a reciprocal agreement along these lines. Representatives of 

both groups have met with Division staff to discuss the possibility of an 

agreement. 

The Division believes that treaty negotiations are a useful alternative and 

should not be discounted. One major advantage of the treaty approach is that it 

allows the United States to determine, based on investor protection standards, 

which country or group of countries would be appropriate treaty partners; only 

funds from those countries would be affected. 

204 CHAPTER 4 
The treaty alternative may not be the most effective approach, however, 

because it may not give the Commission as much flexibility as would a legislative 

amendment of section 7(d). Should the foreign operation or regulation of a 

foreign fund registered in the United States materially change, amending a treaty 

likely would be much more difficult than amending a Commission rule or order 

under a revised section 7(d). 

C. Recommendation - Amendment of Section 7(d) 

The third approach, and the one the Division recommends, is a modified 

version of the Commission's 1984 legislative proposal. That proposal would have 

authorized the Commission to grant, by rule or order, permission to an "operating 

foreign investment company" to register under the Investment Company Act and 

to exempt it from one or more of the provisions of the Act if the Commission 

found that: compliance with the Act would be unduly burdensome, given the 

nature of the company; either the laws under which the company operates 

provide protections to investors that serve the same purposes as the provisions 

of the Act from which exemption is requested, or that specific conditions agreed 

to by the company provide these protections; an exemption is consistent with 

investor protection and the policies of the Act; and the company is not operated 

for the purpose of evading the provisions of the Act?6 

Our proposal introduces five changes to the 1984 ~tandards.5~ Our 

proposal also would address activities of investment companies that have not 

made a public offering in the United States, but have taken active steps to 

promote the sale of their securities to United States residents. The proposed 

amendment to section 7(d) would require a foreign investment company to 

register if it uses United States jurisdictional means in connection with any United 

States offering of its securities and has more than 100 shareholders of record who 

are United States residents. Similarly, a foreign investment company would be 

subject to section 7(d) if it has taken steps to facilitate secondary market trading 

in its securities by, among other things, listing its shares on a securities exchange 

or having its shares quoted in an over-the-counter market in the United States, 

and has more than 100 shareholders of record who are United States residents. 

56~ee supra Section II.F. 

57The full text of our proposal is set forth in Appendix 4-A which appears at the end of this 

chapter. 

Internationalization and Investment Companies 205 
1. Necessary or Appropriate 

The Division's proposal would substitute a "necessary or appropriate in the 

public interest" standard for the 1984 proposal's "unduly burdensome" 

determination. This change would make the proposed language consistent with 

the standard of section 6(~),5~ Arguably, an "unduly burdensome" standard is 

a lower standard than domestic investment companies must meet in order to 

receive an exemption from a provision of the Investment Company Act. 

Domestic funds must demonstrate a requested exemption is necessary and 

appropriate in the public interest; the 1984 proposal would have required foreign 

funds to demonstrate that compliance would be merely too onerous. 

2. Adequacy of Foreign Law -- Mutual Recognition 

Like the 1984 proposal, the Division's proposal would require the 

Commission to find that the foreign law under which a fund operates or specific 

conditions agreed to by the applicant provide protections for investors that serve 

the same purposes as the protections under provisions of the Investment 

Company Act from which the fund requests exemption. Of course, the 

protections provided by the foreign regulatory system need not be identical to the 

Investment Company Act provisions from which exemption is requested. Rather, 

the Commission need find that the foreign law adequately addresses the same 

regulatory concerns and serves essentially the same purposes, and that the 

exemption is consistent with the protection of investors and the purposes fairly 

intended by the Investment Company Act. In making that finding, the 

Commission could consider the different regulatory requirements, customs, 

investment company business practices, and overall investment company 

regulatory framework in the jurisdiction in which the fund is 0rganized.5~ 

58Under section 6(c), the Commission must find that a proposed exemption is "necessary or 

appropriate in the public interest and consistent with the protection of investors and the purposes 

fairly intended by the policy and provisions of this title." 

59For example, some foreign regulatory systems permit backward pricing and affiliated 

transactions. Although prohibitions against 

backward pricing and certain affiliated transactions are cornerstones of the Investment Company 

Act, the Commission might determine that other protections afforded by those systems 

appropriately could substitute for the Act's prohibitions. Although we would not expect that the 

Commission would deny a request for a section 7(d) order merely because a regulatory system 

permitted affiliated transactions, it would be critical for the Commission to determine that the 

system protected fund investors against harm from such transactions. For instance, in the case 

of foreign funds operating under the UCITS Directive, the Commission might look at whether 

customary business practices in the European Community and monitoring by the depositary could 

serve the same purposes as provisions under section 17. 

See supra notes 54-55 and accompanying text. 

206 CHAPTER 4 
~ ~~ 

The Division anticipates that it will be difficult to make detailed findings 

about the adequacy of foreign law, particularly if there exists a gap between the 

law as written and as actually practiced. To address this concern, the Division's 

proposal would require the Commission, prior to acting on applications for 

section 7(d) orders, to enter into bilateral regulatory memoranda of understanding 

with the securities authorities in countries with regulatory regimes providing the 

same type and quality of investor protection as provided by the Investment 

Company Act. The memorandum would set forth representations about the 

nature and extent of foreign regulation. Negotiating special memoranda of 

understanding with the appropriate foreign regulators would give the 

Commission the advantage of learning from the foreign regulators, rather than the 

applicants, the manner in which foreign law is interpreted and enforced, and 

would eliminate the need for extensive discussions with the applicants about how 

they are regulated!' 

In addition, the memoranda would create a framework for regulatory 

cooperation and mutual recognition of investment company regulatory practices. 

They would establish the basis not only for exempting a foreign investment 

company from regulation under the Investment Company Act, but also for 

allowing United States funds to satisfy foreign regulatory requirements to the 

degree necessary to provide them complementary access into foreign countries!' 

One of the principal criticisms of the 1984 proposal is that it failed to 

address barriers that United States companies face when offering shares abroad. 

Although investment company laws in some of the largest investment company 

markets outside the United States -- the United Kingdom, Germany, and Japan 

-- currently permit foreign investment companies to make public offerings of 

securities within their borders, differing legal standards and onerous regulatory 

requirements continue to make foreign registration problematic, if not impossible, 

for many United States investment companies. 

For example, in the United Kingdom, United States investment companies 

face problems not unlike those created by section 7(d) for foreign funds. Section 

87 of the Financial Services Act provides for registration of foreign investment 

companies from a country whose laws will protect investors in the United 

?Memoranda of understanding also would assist the Commission in reviewing the operations 

of United States investment companies registered and operating abroad. Agreements could help 

the Commission better understand foreign regulation of United States funds. 

61Cf. H.R. 1347,102d Cong., 1st Sess. (1991); S. 347,102d Cong., 1st Sess. (1991) (as passed by 

the Senate) (a recent legislative initiative that would authorize the Commission to deny brokerdealer and investment adviser registration to a foreign company if the company's home country 

denies United States broker-dealers and investment advisers national treatment). The Commission 

took no position on this initiative. 

Internationalization and Investment Companies 207 
Kingdom at least to the extent to which investors are protected in authorized 

United Kingdom trusts.62 The Isle of Man, Jersey, Guernsey, and Bermuda have 

been able to meet the standards in section 87; however, each jurisdiction changed 

its laws to make them nearly identical to those of the United Kingdom. 

Investment companies from the United States likely would have difficulty 

qualifying under section 87.63 

United States investment companies more readily qualify to register under 

the statutes and regulations of countries such as Germany and Japan. In these 

countries, however, marketing and procedural hurdles restrict access by United 

States funds to foreign investors. 

German law generally accommodates foreign investment companies not 

comporting with typical German investment company structures or 

relati0nships.6~ A United States investment company still may have difficulty 

breaking into the German investment company distribution network, however, 

because German banking and insurance companies marketing their own 

investment company securities dominate the market.65 

Application of Japanese regulations appears to reduce the competitive 

ability of United States investment companies in other ways. United States and 

other foreign open-end investment trust funds may offer shares publicly if they 

meet the requirements of the "Standard Rules for the Selection of Foreign 

Investment Trust Funds to be Sold in Japan" of the Japan Securities Dealers 

62Financial Services Act, 1986, Ch. 8, 5 87 (Eng.). 

&Section 88, the other applicable provision in the Financial Services Act, is also problematic 

since that provision requires, among other things, that persons connected with the control and 

operation of the investment company be "fit and proper." Id. at Ch. 8, 5 88. The Investment 

Company Act does not have a similar standard. 

@For example, custodians of foreign investment companies need not perform exactly as 

custodians for German funds if investors are assured of security comparable to that provided 

under German domestic investment company law. Baum and Adler, supra note 11, at 227. 

651d. at 228. A few United States investment company complexes, including Pioneer and 

Templeton, have succeeded in developing distribution networks in Germany. As of July 1990, 

Pioneer had annual sales of $150 million of its United States funds in West Germany. Pioneer to 

Skip UCIT Route and Sell Own Funds in Europe, FUND ACTION, July 9, 1990, at 7. Apparently, the 

United States tax treaty with Germany (reducing the withholding tax rate from 30% to 15%) and 

the credit Germany allows for payment of the United States withholding tax sufficiently reduce 

the United States tax burden for German investors. 

208 CHAPTER 4 
While these rules may seem relatively easy for United States and 

other foreign investment companies to satisfy, United States industry 

representatives state that other Ja anese regulations severely impede United 

States market access and success.6' For example, they prohibit United States 

and other foreign investment companies from denominating their securities in 

yen, and Japanese investors are generally reluctant to invest in foreign currencydenominated They also prohibit direct marketing of foreign fund 

shares, making it difficult for foreign government securities funds to develop a 

sales network for their products. 

These types of market constraints led the opponents of the 1984 proposal 

to argue that foreign funds should not be allowed to register in the United States 

unless United States funds receive reciprocal treatment abroad. The Division 

believes that the memorandum of understanding approach to mutual recognition 

meets these concerns because, by resolving prudential and jurisdictional issues, 

the memoranda themselves would provide a mandate for bilateral access to each 

country's market. 

In addition, a memorandum of understanding procedure would be a 

practical means of addressing compliance and enforcement issues. Under the 

Division's proposal, exemptions from the Investment Company Act for foreign 

funds will be based on a determination that the applicable foreign law is an 

adequate substitute. Accordingly, the appropriate foreign regulator in each case 

would be in the best position to assess compliance concerns under its own law. 

Following a memorandum of understanding procedure, the Commission would 

6qHE INVESTMENT TRUSS ASSOCIATION, INVESTMENT TRUSTS IN JAPAN 52 (1990). The 

Investment Trusts Association is the only authorized self-regulatory body of investment trust 

funds in Japan. 

67Foreign investment managers have found it very difficult to secure licenses to manage 

investment trust funds in Japan. Until December 1989, Japanese law absolutely prohibited foreign 

firms from engaging in investment trust management in Japan. Today, although it may receive 

a license, a foreign management company must satisfy burdensome standards regarding capital, 

distribution, and administration. For example, Fidelity Investments, the only United States 

company that has received a license to manage a yen-denominated fund for Japanese investors, 

has not yet begun operations. Fidelity cites several reasons for the delay, including a capital 

requirement of $7 to $8 million to manage the fund, the need for an additional license to 

distribute fund shares (entailing another large capital contribution), and a requirement that foreign 

fund managers utilize 30 Japanese employees to support back office operations. Letter from 

Robert C. Pozen, General Counsel, Fidelity Investments, to Marianne Smythe, Director, Division 

of Investment Management, SEC (June 7, 1991) (expressing concerns about improving access by 

foreign investment companies to United States markets without simultaneously securing greater 

access for United States investment companies abroad). 

@Managing Money: A Legal Guide to the World's I?zvestrnent Fund Markets, INYL FIN. L. REV. 109 

(Special Supp. Apr. 1990). 

Internationalization and Investment Companies 209 
agree with foreign regulators as to how to enforce investor protection^?^ In an 

extreme case where foreign or United States methods of enforcement would prove 

inadequate, the Commission would have authority to revoke the registration 

order of the foreign fund. To the extent foreign regulators are unable to address 

a violation in the first instance, memoranda of understanding would provide 

mutually acceptable standards for cooperative enforcement efforts.70 

The Division's proposal would increase the Commission's flexibility by 

expressly authorizing it to issue rules as well as orders in connection with 

registering operating foreign investment companies. In contrast to registration 

and exemptive orders, rulemaking would permit the Commission to take 

advantage of a country-by-country approach. Once the Commission negotiates 

a regulatory memorandum recognizing that a particular jurisdiction's regulatory 

system sufficiently protects fund investors and creating a framework for 

regulatory cooperation and mutual recognition of investment company regulation, 

a Commission rule would enable any investment company regulated under that 

system and complying with the terms of the rule to register under section 7(d). 

3. Operating Foreign Investment Company 

The amendment, like the 1984 proposal, also would allow the Commission 

to deny a request for an order by an investment company seeking to circumvent 

the Investment Company Act. Obviously, an amended section 7(d) should not 

provide a means of access to United States investors by newly created foreign 

shell investment companies, or an incentive for United States funds to reorganize 

in a jurisdiction with more permissive regulation and receive section 7(d) orders 

permitting public offerings in the United States. By limiting section 7(d) orders 

to funds qualifying as "operating foreign investment companies," and requiring 

that an applicant not be operated for the purposes of evading the provisions of 

the Investment Company Act, the Commission in the 1984 proposal intended that 

only a bona fide foreign investment company with an established operating history 

could avail itself of the more flexible section 7(d) provisions. The 1984 proposal 

69Relying on memoranda of understanding is conceptually consistent with the Division's 

premise for amending section 7(d); namely, that the Commission may rely upon foreign regulation 

to provide protections serving the same purposes as those afforded under the Investment 

Company Act. If the Commission determines it may rely on foreign law in place of Investment 

Company Act requirements, it must also determine that the foreign law and regulators provide 

means for United States investors and the Commission to enforce foreign law. Memoranda of 

understanding could permit the Commission to determine whether United States investors in 

practice would have meaningful access to remedies under foreign law and the extent to which the 

Commission appropriately should require consent to United States jurisdiction and to the 

appointment of an agent for service of process. 

79n no case should the proposed memoranda of understanding process affect the 

Commission's ability to enforce the fraud-related provisions of United States securities laws. 

210 CHAPTER 4 
would have defined an operating foreign investment company as a company that: 

(1) was organized or created under the laws of a foreign country; (2) had been in 

operation, with a minimum of 500 non-United States shareholders and $100 

million in net assets, for a period of three years or more; and (3) was primarily 

engaged in investing in the securities of non-United States issuers. 

The Division recommends retaining the 1984 definition, with one important 

modification. To give the Commission necessary flexibility, the legislation should 

authorize the Commission to establish, by rule or order, the minimum assets 

under management, number of non-United States shareholders, and years in 

~peration.~~ 

4. Commission Authority to Rescind Section 7(d) Orders 

The 1984 proposal would have authorized the Commission to rescind a 

section 7(d) order under circumstances suggesting that the order was not serving 

its intended purpose?2 The Division's proposal deletes this authorization 

71The Division considered whether it might be more appropriate to use the analogous 

definitions of "foreign issuer" or "foreign private issuer" in rules and regulations under the 

Securities Act (15 U.S.C. 55 77a-77aa) and the Securities Exchange Act (15 U.S.C. $5 78a-78lI). 

Under the Exchange Act, "[tlhe term 'foreign issuer' means any issuer which is a foreign 

government, a national of any foreign country or a corporation or other organization incorporated 

or organized under the laws of any foreign country." 17 C.F.R. 5 240.3b-4(b); see also 17 C.F.R. 

5 230.902(f) (definition of "foreign issuer" under Regulation S of the Securities Act). "Foreign 

private issuer" under both acts 

means any foreign issuer other than a foreign government except an issuer 

meeting the following conditions: (1) more than 50 percent of the outstanding 

voting securities of such issuer are held of record either directly or through 

voting trust certificates or depositary receipts by residents of the United States; 

and (2) any of the following: (i) the majority of the executive officers or directors 

are United States citizens or residents; (ii) more than 50 percent of the assets of 

the issuer are located in the United States; or (iii) the business of the issuer is 

administered principally in the United States. 

17 C.F.R. 55 230.405 and 240.3b-4(c). These definitions are intended to prevent foreign issuers 

generally owned and managed by United States persons from taking advantage of exemptions or 

forms available to other issuers organized under foreign law. 

None of these definitions includes tests for minimum asset levels, number of non-United 

States shareholders, or operating history. As such, they do not address a primary concern under 

section 7(d) -- avoiding the United States sale of shares of foreign investment companies that are 

shells. 

72The proposal would have authorized the Commission to revoke or modify any order issued 

under section 7(d) if it found: (1) that it was not legally or practically feasible effectively to 

(continued ... ) 

Internationalization and Investment Companies 21 1 
because section 38(a) specifically grants the Commission the authority to rescind 

or amend orders.73 The Division sees no reason to include special standards for 

rescission within section 7(d). 

5. Non-Public Offerings 

The proposed amendment would include language to address when the 

Investment Company Act requires registration by foreign funds actively 

promoting the sale of their securities to United States residents in other than 

public offerings. Because it is difficult overseas to track United States resident 

ownership, a foreign fund should not be required to make determinations as to 

whether there are more than 100 United States residents who beneficially own its 

~ecurities.7~ Because a continuous monitoring requirement is appropriate, 

however, a foreign fund should be required to monitor its shareholders of record. 

Accordingly, the proposal would require a foreign fund not otherwise 

excepted from the definition of an investment company to register if it makes 

a public offer using United States jurisdictional means; it has used United States 

jurisdictional means in connection with any United States offering of its securities 

and has more than 100 shareholders of record who are United States residents; 

or it has taken steps to facilitate secondary market trading in its securities in the 

United States either by listing its shares on a securities exchange or having its 

shares quoted by any securities processor registered under the Exchange Act or 

by other means, and has more than 100 shareholders of record who are United 

States residents. The first of these circumstances reflects a foreign fund’s 

registration obligation as currently provided under section 7(d); the second 

clarifies the language of the statute to reflect expressly the Commission’s position 

in the release adopting rule 144A; and the third sets forth the remaining 

circumstances under which a foreign investment company may incur a 

registration obligation under the Investment Company Act. 

?...continued) 

enforce the provisions of the Investment Company Act to which the fund was subject; (2) that the 

fund was not primarily investing in the securities of non-United States issuers; or (3) that the laws 

under which the foreign fund operates did not provide investor protections that serve the same 

purpose as the provisions of the Investment Company Act from which exemptions were provided. 

7315 U.S.C. 5 80a-37(a). 

74See supra Section 1I.G. 

212 CHAPTER 4 
This approach will not result in exact parity of treatment for foreign and 

domestic funds with respect to the 100 shareholder limitati~n?~ but will 

eliminate most disparity without penalizing foreign funds that have never used 

United States jurisdictional means in any significant manner. The proposed 

amendment would not compel registration by a foreign fund that has never taken 

any steps either to offer its shares or to facilitate secondary market trading in the 

United States, even if it inadvertently has more than 100 shareholders who are 

United States residents.76 

A "shareholder of record" standard would substitute for the "beneficial 

owner" standard currently used in calculating and tracing United States 

ownership for section 7(d) purposes. The shareholder of record concept would 

alleviate some of the problems foreign funds have in identifying and monitoring 

ownership by United States residents. In defining and interpreting the concept, 

the Division expects to look, in part, to analo ous definitions set forth in rules 12g5-1 and 12g3-2(a) under the Exchange Act. % 

Rule 12g5-1 provides that securities are deemed to be "held of record" by 

each person who is identified as the owner of the securities on the records of 

security holders maintained by or on behalf of the issuer, subject to certain 

qualifications. These qualifications pertain to specific circumstances under which 

questions could arise regarding the method of calculation. They also seek to 

prevent the use of artificial calculations as a means of circumventing the 

statute.78 For example, the Division might look to rule 12g3-2 in interpreting 

who the holders of record would be in cases where foreign fund securities are 

held in street name for United States resident^.^' Similarly, one of the 

75United States investment companies must include both United States and foreign resident 

beneficial owners in their calculations for purposes of section 3(c)(l). 

7&rhe legislative history of the Investment Company Act indicates that, despite section 7(d), 

Congress expected some leakage of foreign fund shares into the United States. 1940 Senate 

Hearings, supra note 20, at 199. 

"17 C.F.R. §§ 240.12g5-1, .12g3-2(a) 

78For example, subsection (b)(3) of rule 12g5-1 provides that if an issuer has reason to know 

that the form of holding securities of record is used primarily to circumvent the provisions of the 

Exchange Act, the beneficial owners of such securities shall be deemed to be the record owners 

of the securities. 

79Rule 12g3-2 provides in pertinent part: 

securities held of record by persons resident in the United States shall be 

determined as provided in Rule 12g5-1 . . . except that securities held of record 

by a broker, dealer, bank or nominee for any of them for the accounts of 

(continued ... ) 

Internationalization and Investment Companies 213 
refinements provided by rule 12g5-1 that the Division might consider in the 

foreign investment corn any context is the manner in which holders of bearer 

securities are counted.8' The Division expects that similar refinements of the 

"shareholder of recordt concept in section 7(d) will assist foreign funds in 

calculating and tracing United States resident shareholders. 

Using a shareholder of record standard, a foreign fund should be able to 

determine whether it is in danger of overstepping the 100 United States 

shareholder limit. Therefore, the 100 shareholder limitation should be ongoing, 

and not be restricted to a "snapshot" count taken immediately after the completion 

of a private offering, or one taken within a certain time period after the listing of 

a fund's securities on a securities exchange in the United States. 

The Division believes that it would be inappropriate to place a registration 

obligation on a foreign fund that has never taken any steps either to offer its 

shares in the United States or to facilitate secondary market trading in the United 

States, but whose shares have inadvertently leaked into the United States.8l 

Therefore, under the Division's proposal, such a fund would not be required to 

register, even if it has more than 100 shareholders of record that are United States 

residents. 

IV. Other Impediments to Cross-Border Sales 

In addition to section 7(d) and restrictive securities laws and practices in 

other countries, at least two other factors significantly impede cross-border sales 

of investment company securities: United States tax law and state "blue sky" 

laws. 

79(...continued) 

customers resident in the United States shall be counted as held in the United 

States by the number of separate accounts for which the securities are held. The 

issuer may rely in good faith on information as to the number of such separate 

accounts supplied by all owners of the class of its securities which are brokers, 

dealers, or banks or a nominee for any of them. 

"Rule 12g5-1(a)(5), 17 C.F.R. § 240.12g5-l(a)(5). 

"In defining and interpreting which steps would trigger a registration obligation, the Division 

expects to consider both analogous concepts set forth under other federal securities laws, e&, 

"directed selling efforts" under Regulation S (17 C.F.R. § 230.902(b)), and the unique investor 

protection concerns of the Investment Company Act. 

214 CHAPTER 4 
A. United States Tax Law 

Without amendments to United States tax laws, securing greater access for 

United States funds overseas most probably will not meaningfully increase sales 

to foreign investors. The Division recommends that the Commission support 

proposals to eliminate the competitive tax disadvantages for United States 

investment companies marketing overseas. 

United States distribution requirements and withholding standards provide 

a strong incentive for foreign investors to invest in foreign funds rather than in 

United States investment companies. Under subchapter M of the Internal 

Revenue Code, in order to avoid taxation at the investment company level, a 

United States registered fund must distribute at least ninety percent of its taxable 

income to its shareholders each year and is subject to tax on its undistributed 

taxable income.82 Further, Internal Revenue Code section 4982 imposes an 

additional excise tax on a fund if it does not distribute ninety-seven percent of its 

ordinary income and ninety-eight percent of its capital gain net income to its 

~hareholders.8~ Ifa fund operates within these limits, domestic shareholders 

receive the same tax treatment as if they owned their proportionate share of the 

fund's portfolio of securities directly. 

Foreign investors, however, may not receive the same tax treatment under 

United States tax law. Foreign investors, upon receipt of fund distributions 

effectively mandated by subchapter M, have fifteen to thirty percent of the 

ordinary income and short-term capital gains distributions withheld from the 

distributions that they receive. Under some circumstances, if the foreign investor 

owned the fund's portfolio securities directly, the same income would not be 

subject to this withholding tax.84 The net result is that foreign investors may 

incur a smaller United States tax liability by investing in securities directly rather 

than investing in a United States investment company. 

Moreover, many foreign jurisdictions do not require an investment 

company to distribute income and realized capital gain in order to avoid tax at 

the fund level; in fact, many foreign countries do not impose any tax at the fund 

'226 U.S.C. Q 852. 

=26 U.S.C. 5 4982. 

84While dividends to foreign investors on United States publicly traded stocks normally are 

subject to withholding tax, most interest payments on short- and long-term capital gains realized 

by foreign investors from United States securities are generally exempt from withholding. Even 

though ordinary distributions by United States mutual funds are composed in large part of 

interest income and short-term capital gains, withholding tax still applies because mutual fund 

distributions are technically dividends on fund shares and are treated as such. 

Internationalization and Investment Companies 215 
level. The absence of a distribution requirement permits a shareholder in a 

foreign fund to enjoy tax-free buildup of earnings and to avoid paying any tax 

until the fund shares are redeemed. Further, since several foreign countries 

impose little or no capital gains tax, foreign fund shareholders pay little tax upon 

redemp ti0n.8~ 

The difference in tax treatment for foreign investors in United States funds 

strongly suggests that any amendment to section 7(d) should be accompanied by 

an amendment to the Internal Revenue Code to reduce the disparity. It would 

make little sense to enact securities legislation that will encourage the sale of 

foreign investment company securities in the United States without at the same 

time eliminating a critical barrier to the sale of United States fund shares overseas. 

Of course, amending United States tax law in this area raises policy and revenue 

concerns, and any amendment to the Internal Revenue Code should take those 

concerns into account. 

B. State "Blue Sky" Laws 

In addition to satisfying registration requirements of section 7(d), a foreign 

investment company also must satisfy the applicable "blue sky" laws of each state 

in which it seeks to sell its securities. Because blue sky requirements vary among 

states, a foreign investment company selling throughout the United States would 

have to comply with numerous differing state blue sky requirements. This 

second layer of registration is arguably more burdensome for a foreign investment 

company than a United States investment company, since the former must also 

satisfy applicable regulatory requirements in its home country. 

In light of the substantive federal regulation of investment companies and 

their investment advisers under the Investment Company Act, the Securities Act, 

and the Investment Advisers Act:6 the merits of additional state substantive 

s5For instance, in Germany, since capital gains retained by funds that are foreign EC registered 

UCITS are not taxable for private investors, investors can avoid taxation if the fund retains the 

capital gains. The investors might realize capital gains upon the sale of fund shares, but only if 

they had held the shares for fewer than six months. INTL FIN. L. REV., supra note 68, at 103. 

''Investment Advisers Act of 1940, 15 U.S.C. 5 Sob. 

216 CHAPTER 4 
review are debatable.'7 

substantive review outweigh the benefits?' 

Critics argue that the costs to investors for state 

The diversity of each state's substantive and procedural blue sky 

requirements make compliance difficult. Critics point out that few of the various 

substantive requirements apply in more than a few states. For example, 

California is the only state that still prescribes an expense limitation. For an 

investment company seeking to sell in California as well as in other states, that 

expense limitation, in effect, establishes a nationwide standard. Critics also 

charge that, because of this diversity, investors who are citizens of states with 

rational regulatory fees and policies in effect subsidize those states with inefficient 

or expensive fees and policies. 

The Division recommends that the Commission continue to work with state 

securities administrators to develop a means of coordinating and consolidating 

federal and state substantive regulation of investment companies. Any solution 

should preserve states' significant enforcement responsibility and provide that 

states continue to require, for notice purposes, filings of any documents filed with 

the Commission, consent to service of process, and requisite fees. These 

requirements are justifiably within the scope of states' legitimate interest in 

protecting their residents. 

V. Conclusion 

The Division recommends amendments to section 7(d) of the Investment 

Company Act to give the Commission greater flexibility in permitting a foreign 

fund to register in the United States, and to clarify, in the absence of a public 

offering, when section 7(d) requires a foreign fund to register. The Division also 

recommends that the Commission work with state securities administrators to 

eliminate duplicative securities regulation. These efforts may encourage foreign 

jurisdictions to ease some of their legal and practical restrictions on United States 

investment companies seeking to market abroad. Finally, the competitive 

disadvantages for United States funds created by the Internal Revenue Code 

should be addressed, although we express no view on specific terms of any 

amendments to the Code. 

87For example, critics charge blue sky review is less than comprehensive. They suggest that 

state regulators "rarely if ever examine the merits of investment company offerings." See, eg., 

Davis Polk Study Comment, supra note 45, at 71. 

"Costs include actual filing fees and the expenses of fulfilling state filing requirements. Word 

processing expenses, collect telephone calls from state regulators, express mail charges, and legal, 

professional, and other personnel fees make filing expensive. Even blue chip exemptions, 

intended to reduce costs for investment grade securities, may be uneconomic for investment 

companies, since many expire after one year, at which time an additional fee is required. 

Internationalization and Investment Companies 217 
APPENDIX 4-A 

Red-Lined Version of Proposed Amendment 

to the Investment Company Act of 1940 

Section 7 [15 U.S.C. 5 80a-71. 

**Y 

............ 

No investment company, unless organized or otherwise created 

f the United States or of a State, and no depositor or trustee of or 

underwriter for such a company not so organized or created, shall make use of the 

mails or any means or instrumentality of interstate commerce, directly or indirectly, 

to offer for sale, sell, or deliver after sale, in connecti 

............ 

......... 

CHAPTER 4 21 8 
:.:.:.:.:.>:+:.:.: 

..... !@A$ ;:.:.::s;.:.:.: the Commission finds that, by reason of special circumstances 

or arrangements,it is both legally and practically feasible effectively to enforce the 

provisiok of this title against& company and 

that the issuance of such order is otherwise consistent with the public interest and 

the protection of investors; and 

*** 

Internationalization and Investment Companies 219 
Chapter 5 

The Reach of the Investment Advisers 

Act of 1940 

I. Introduction and Summary of Recommendations 

One area of great importance for the internationalization of investment 

management services is the reach of the Investment Advisers Act.' Under 

existing interpretations, the Advisers Act is applied on an "entity" basis. That is, 

when an investment adviser, whether foreign or domestic, registers under the 

Advisers Act, all of the adviser's activities everywhere are subject to the Act? 

Many of the Advisers Act's provisions differ from or exceed those that apply to 

foreign advisers under the laws of their home country and also may be contrary 

to accepted business practices there. Consequently, a foreign adviser that 

registers under the Advisers Act because it does business with clients in the 

United States, as well as in its home country, may find itself unable to engage in 

conduct that is legal and acceptable business conduct in its home country because 

the Act prohibits it. To avoid this result, some foreign advisers establish 

"independent" subsidiaries, registered under the Advisers Act, to advise their 

clients here. Those subsidiaries, however, are subject to strict conditions that may 

reduce the amount and quality of investment advice available to investors in the 

United States? 

The Division has reexamined the current interpretations on the reach of the 

Advisers Act and concluded that they should be changed! We recommend 

'Investment Advisers Act of 1940,15 U.S.C. § 80b. 

2See in@ note 7 and accompanying text. We use "domestic adviser" to refer to an adviser 

whose offices and personnel are located in the United States and "foreign adviser" to refer to an 

adviser whose offices and personnel are located outside the United States. 

3See infra notes 9-15 and accompanying text. 

*he Commission received eight comments on this topic in response to SEC Request for 

Comments on Reform of the Regulation of Investment Companies, Investment Company Act 

Release No. 17534 (June 15, 1990), 55 FR 25322, all critical of the current positions. The 

commenters were certain members of a subcommittee of the American Bar Association; Citicorp; 

Cleary, Gottlieb, Steen & Hamilton; Davis Polk & Wardwell; Debevoise & Plimpton, on behalf of 

Westpac Banking Corporation; Dechert Price & Rhoads; Ropes & Gray; and Kathleen A. Veach. 

In addition, Debevoise & Plimpton, with the assistance of several other law firms, provided the 

Division with a memorandum entitled International Survey of Investment Adviser Regulation (Aug., 

(continued. ..) 

221 
applying the Advisers Act on a more narrow basis tied to "territorial" concepts 

focusing on conduct and the effect of conduct. Under such an approach, the 

Advisers Act would apply to activities where a sizable amount of advisory 

services takes place in the United States or where the advisory services have effects 

in the United States. Thus, where a registered foreign adviser or a registered 

domestic adviser deals with clients resident in the United States, it can be 

assumed that a sizable amount of advisory services will take place in the United 

States and that there will be effects in the United States and the Advisers Act will 

apply. Where, however, a registered foreign adviser deals with a client residing 

outside the United States, the Advisers Act generally will not apply. A more 

difficult question arises where a registered domestic adviser deals with a client 

residing outside the United States. In such a case, a sizable amount of advisory 

services is likely to take place in the United States and the Advisers Act ordinarily 

will apply. Another difficult question arises where either a foreign or a domestic 

adviser is multinational, that is, has offices outside its foreign or domestic base. 

Here again, application of the Advisers Act will depend on whether a sizable 

amount of advisory services takes place in the United States. Thus, for instance, 

if a domestic adviser has a branch office in a foreign country, and has a corporate 

policy requiring that all portfolio decisions regarding clients residing in that 

country come from that foreign office, then the Advisers Act generally would not 

apply. If, on the other hand, the client wishes to invest in United States markets 

and the firm's personnel located in the United States are involved in formulating 

or providing advice, the Advisers Act generally would apply! Because of the 

fact-specific nature of these issues, close cases would be addressed on a case-bycase approach through interpretive and no-action letters. 

Although the approach we recommend would lessen the need to create 

separate subsidiaries, some investment advisers still may wish to form separate 

entities. We recommend revision of the criteria for the formation and registration 

of separate subsidiaries. 

This chapter begins with a discussion of the existing positions on the reach 

of the Advisers Act and some of the interpretive and practical difficulties they 

present. It then discusses a new approach to application of the Advisers Act, 

based upon conduct and effect of conduct, and the policy considerations that 

4(...continued) 

1990) [hereinafter IntemationaI Survey] with analyses of the investment advisory laws of Australia, 

Brazil, France, Germany, Japan, Switzerland, and the United Kingdom. 

51n Chapter 6, however, we recommend legislation that would authorize the Commission to 

exempt from the Advisers Act's prohibition on performance-based advisory fees with persons not 

residing in the United States to the extent that such fees are lawful in the client's country of 

residence. 

222 CHAPTER 5 
support that approach. This chapter also describes the alternatives that the 

Division considered but does not recommend. 

11. The Reach of the Investment Advisers Act -- The Current 

Approach 

Section 203 of the Advisers Act requires the registration of any investment 

adviser, whether domestic or foreign, that uses the United States mails or any 

other means or instrumentality of interstate commerce in connection with its 

business as an investment adviser, unless the adviser is exempted from 

registration? The Division has stated that, once registered, domestic and foreign 

advisers are subject to all the substantive provisions of the Advisers Act with 

respect to both their United States and non-United States clients? 

6Section 202(a)(10) defines "interstate commerce" to include "trade, commerce, transportation, 

or communication . . . between any foreign country and any State. . . ." 15 U.S.C. .§ 80b-(a)(10). 

Section 202(a)(11) defines an "investment adviser" to mean, with certain exceptions, "any person 

who, for compensation, engages in the business of advising others, either directly or through 

publications or writings, as to the value of securities or as to the advisability of investing in, 

purchasing, or selling securities, or who, for compensation and as part of a regular business, 

issues or promulgates analyses or reports concerning securities . . . ." A foreign adviser to clients 

residing outside the United States may use limited United States jurisdictional means without 

triggering the registration requirements of the Advisers Act; that is, it may acquire information 

about securities of United States issuers and effect transactions in securities through United States 

broker-dealers. Gim-Seong Seow (pub. avail. Nov. 30, 1987). In contrast, a domestic adviser 

dealing exclusively with foreign clients must register if it uses any jurisdictional means in 

connection with its advisory business. Id. 

The Advisers Act exempts from registration any adviser that has fewer than 15 clients and 

that neither holds itself out as an adviser nor acts as an adviser to any registered investment 

company. Investment Advisers Act .§ 203(b)(3), 15 U.S.C. § 80b-3@)(3). Domestic advisers and 

foreign advisers have been treated differently in determining whether foreign clients should be 

counted. Domestic advisers are required to count foreign clients; foreign advisers are not. See, 

e.g., Murray Johnstone Ltd. (pub avail. Apr. 17,1987); Alexander, Holburn, Beaudin & Lang (pub. 

avail. Aug. 13,1984); S&R Management Co. (pub. avail. May 8,1975). But see Walter L. Stephens 

(pub. avail. Nov. 18, 1985) (indicating no distinction). 

Section 203(b) also exempts from registration certain "intrastate" advisers and advisers to 

insurance companies. The Advisers Act's antifraud provision, section 206 (15 U.S.C. § 80b-6), by 

its terms applies to any adviser, whether or not required to register, that is using the jurisdictional 

means. 

7Reavis & McGrath (pub. avail. Oct. 29, 1986). On one occasion, a registered foreign adviser 

received a no-action response where it proposed not to comply with the performance fee limits, 

among other things, with respect to its home country clients. Nikko Sec. Inv. Trust & 

Management Co., Ltd. (pub. avail. May 17,1985). Since the response concerned only performance 

fees and one other aspect of adviser regulation, the adviser presumably was required to comply 

(continued ...) 

The Reach of the Investment Advisers Act of 1940 223 
This poses a number of problems for foreign advisers. For example, a 

registered foreign adviser that provides advice both to United States clients and 

to clients in its own country may find that it is unable to engage in legal and 

acceptable business conduct in its home country because the Advisers Act 

prohibits the conduct. The most striking example of this is the use of 

performance-based advisory fees. While advisory fees based on investment 

performance are legal and in fact accepted business practice in many countries, 

the Advisers Act restricts their use? Thus, a foreign adviser that registers in the 

United States to advise United States clients finds that it is prohibited from 

entering into fee arrangements with clients in its home country that are otherwise 

lawful in that country. 

To avoid this broad reach of the Advisers Act, a foreign adviser may form 

a separate and independent subsidiary to provide advice to United States clients. 

Under current positions, however, such a subsidiary will only be "regarded as 

having a separate, independent existence and to be functioning independently of 

its parent,'' thereby permitting the foreign parent to remain unregistered, if the 

subsidiary satisfies the following five conditions (known as the "Ellis conditions," 

after the no-action letter in which they were set forth)? The subsidiary must: (1) 

be adequately capitalized; (2) have a "buffer" between the subsidiary's personnel 

'(...continued) 

with the other provisions of the Advisers Act, including the recordkeeping and antifraud 

provisions, with respect to all of its clients. This was an "enforcement only" response, however, 

not an interpretive one, and the Division subsequently indicated that all provisions of the 

Advisers Act apply to a registered adviser's dealings with foreign clients. Reavis & McGrath, 

supra. 

The Commission has taken a similar position with regard to broker-dealers registered under 

the Securities Exchange Act of 1934 (15 U.S.C. §§ 78a-7811). Once a broker-dealer is registered, it 

is subject to the full panoply of United States broker-dealer regulations. See Registration 

Requirements for Requirements for Broker-Dealers, Exchange Act Release No. 27017, at IILA, 

III.B.l (July 11, 1989), 54 FR 30013 (''if a foreign brokerdealer . . . becomes subject to U. S. 

registration requirements, . . . the regulatory system governing U.S. broker-dealers would apply 

to the entire brokerdealer entity"). 

'Advisers Act 5 205(a)(l), 15 U.S.C. Q 80b-5(a)(l). See Chapter 6 for the Division's 

recommendations concerning performance fees. 

%chard Ellis (pub. avail. Sept. 17, 1981). The status of separate affiliates under common 

control has not been definitively resolved. Compare H.P. Hambrick Co., Inc. and Pajolo A.G. (pub. 

avail. Oct. 14,1988) (indicating that questions could arise where a United States resident adviser 

provides advisory services to foreign clients through an unregistered wholly owned foreign 

corporation, particularly where the individual also provides advice to United States clients 

through another wholly owned corporation registered as an adviser with the Commission) with 

TAC America, Ltd. (pub. avail. July 25,1984) and Double D Management Ltd. (pub. avail. Jan. 31, 

1983) (performance fee provisions of the Advisers Act not applicable to unregistered foreign 

affiliates of registered advisers, even where the affiliates have common personnel). 

224 CHAPTER 5 
and the parent, such as a board of directors a majority of whose members are 

independent of the parent; (3) have employees, officers, and directors, who, if 

engaged in providing advice in the day-to-day business of the subsidiary entity, 

are not otherwise engaged in an investment advisory business of the parent; (4) 

itself make the decisions as to what investment advice is to be communicated to, 

or is to be used on behalf of, its clients, and has and uses sources of information 

not limited to its parent; and (5) keep its investment advice confidential until 

communicated to its clients." All five criteria were believed to be necessary to 

establish that the parent company was not doing indirectly under the Advisers 

Act what it could not do directly, in violation of section 208(d).11 

While the Ellis conditions were designed to ameliorate the problems 

created by the Division's interpretations of the reach of the Advisers Act, they 

*?he Ellis conditions were derived from a 1972 Commission release proposing a rule that 

would have set forth virtually identical conditions under which an affiliate formed to provide 

advisory services would be deemed an autonomous entity. The Commission noted, however, that 

"[wlhether a registered investment adviser is merely a conduit for advisory services provided by 

its controlling person or an affiliate of such controlling person, depends in each case upon the 

substance of the arrangement." Notice of Proposals under the Investment Advisers Act to (1) 

Adopt New Rule 202-1 under the Investment Advisers Act of 1940, as amended ("Advisers Act"), 

with respect to Exemption from the Definition of "Investment Adviser," and (2) Amend Rule 204- 

2(a) under the Advisers Act by Amending Paragraph (12) and Adopting New Paragraphs (13) and 

(14) thereunder with respect to Record-Keeping Requirements for Certain Investment Advisers 

under the Advisers Act, Investment Advisers Act Release No. 353 at n.2 and accompanying text 

(Dec. 18, 1972), 38 FR 1649. The proposed rule (redesignated Advisers Act proposed rule 202-2 

in Investment Advisers Act Release No. 369 (Feb. 21,1973), 36 FR 5912) would have provided an 

exemption from registration for the company controlling the registered adviser and affiliates of 

the controlling company if the enumerated conditions were satisfied. Id. at 1650. The 

Commission withdrew the proposed rule in 1976 without explanation. Notice of Withdrawal of 

Proposed Rule 202-2 under the Investment Advisers Act of 1940, Investment Advisers Act Release 

No. 497 (Feb. 19, 1976), 41 FR 8498. 

"15 U.S.C. 5 80b-Hd). Section 208(d), which was added in 1960 (Pub. L. No. 86-750,s ll(b), 

74 Stat. 885,887), provides: 'lilt shall be unlawful for any person indirectly, or through or by any 

other person, to do any act or thing which it would be unlawful for such person to do directly 

under the provisions of this title or any rule or regulation thereunder." The legislative history of 

the section indicates that it is based on section 20(b) of the Exchange Act (15 U.S.C. 5 78t(b)). See 

S. REP. NO. 1760, 86th Cong., 2d Sess. 8 (1960). The Exchange Act, however, has not been 

interpreted to require compliance with conditions similar to those in Ellis in establishing a 

separate broker-dealer affiliate. In determining whether a foreign broker-dealer must register, the 

Commission has indicated that sharing personnel with a registered entity is permissible, as long 

as the registered entity maintains appropriate supervision and control of shared personnel, and 

certain other conditions are met. Exch. Act Rel. 27017, supra note 7, 54 FR at 30017 ("the 

Commission believes that it is consistent with these principles for a registered representative 

stationed outside the United States with a foreign broker-dealer to contact personnel in the United 

States from within or without this country on behalf of the registered broker-dealer"). The foreign 

broker-dealer may not control the registered broker-dealer's day-to-day market making activities, 

however. See id. at n.205 and accompanying text. 

The Reach of the Investment Advisers Act of 1940 225 
pose great difficulties in practice?' The separate personnel requirement, in 

particular, has harsh effects. A foreign parent adviser may be unable to employ 

its most talented portfolio managers on United States accounts, since such 

portfolio managers may be required to bring their specialized expertise to bear 

on a larger proportion of business represented by non-United States accounts 

served by the parent. It is probably unrealistic to expect that a foreign adviser 

would make a valuable portfolio manager unavailable to its non-United States 

clients by transferring the manager to a subsidiary registered under the Advisers 

Act. Finding another portfolio manager with equivalent expertise to work in the 

registered subsidiary is inefficient and may be impossible. Thus, as a practical 

matter, because of the Ellis conditions, United States clients may have limited 

access to advisory personnel with expertise in particular specialized markets.13 

The Ellis conditions concerning the flow of information also may have 

deleterious consequences. While portfolio managers working in a registered 

subsidiary have the benefit of research materials generated by the parent, and 

may participate in some circumstances in discussions with personnel of the parent 

concerning current trends and allocation of portfolios between industries and 

national markets, the conditions may prohibit day-to-day exchanges of ideas and 

discussions between portfolio managers of the parent and subsidiary. As a result, 

a foreign adviser's ability to provide the best available service to United States 

clients likely is impeded. 

In addition, while Ellis requires the registered subsidiary of a foreign 

adviser to be adequately capitalized, Ellis does not provide any guidance as to 

what constitutes adequate ~apitalization?~ Investment advisers do not have to 

meet capital requirements under the Advisers Act.15 Finally, assuming that an 

12The Ellis conditions have been characterized as "unworkable." Greene, Dupler, and Cohen, 

Jurisdictional Reach of the Investment Advisers Act of 1940, INSIGHTS, OCr. 1990, at 21/27 (1990). 

13See Letter from Davis Polk & Wardwell to Jonathan G. Katz, Secretary, SEC 27-29 (Oct. 10, 

1990), File No. S7-11-90. 

141nv. Adv. Act Rel. 353, supra note 10, when proposing the rule originally proposed as 

Advisers Act rule 202-1, appeared to suggest that all that was required was sufficient capital to 

avoid the affiliate being a shell. Inv. Adv. Act Rel. 353, supra note 10. If this is the capital level 

to which Elk refers, it would not appear burdensome, being essentially consistent with state 

corporate law concepts of separateness. 

15Many states impose a net capital or minimum net worth requirement. E.g., N.C. GEN. STAT. 

Q 78C-17. Other states apparently have the authority to do so, but have not exercised that 

authority. E.g., S. D. CODIFIED LAWS ANN. 5 47-31A-202 (119). At least one state, Arkansas, 

exempts investment advisers registered under the Advisers Act from that state's capital 

requirements. ARK. STAT. ANN. 5 23-42-303(b). 

226 CHAPTER 5 
adequate level of capital could be determined, this condition nonetheless requires 

a foreign adviser to divide its capital for seemingly artificial purposes. 

111. A Conduct and Effects Application of the Investment Advisers 

Act 

A. The Statute's Jurisdictional Reach 

The language of the Advisers Act does not contain explicit territorial 

restrictions, except that a number of provisions require the use of jurisdictional 

means to establish a violation:' Other parts of the federal securities laws also 

lack explicit territorial limits. The Commission, through rulemaking and 

interpretation, has sought to balance the literal reach of those provisions with the 

legislative purpose underlying the particular statute, principles of international 

law as recognized in the United States, and the realities of global markets.I7 This 

has resulted in an emphasis on territorial limits in applying the regulatory 

requirements of the federal securities laws, with the precise limits being 

determined by reference to the language, legislative history, and purposes of the 

specific provision at issue. 

Generally, statutes are applied to regulate activity taking place outside the 

United States where that activity produces substantial and foreseeable effects in 

the United States or involves conduct occurring in the United States, even if the 

conduct has no effect on United States persons or markets. These principles of 

jurisdiction -- known as the "conduct" and "effects" tests -- are well-established in 

other areas of the law and have been applied frequently in determining the 

application of the federal securities laws to foreign persons and conduct.18 

The conduct and effects tests have been most often used as bases for 

asserting jurisdiction under the federal securities laws' antifraud provisions. 

I6Despite this absence of restrictions, the Advisers Act's substantive regulations have not been 

applied with respect to foreign advisers with de minimis connection to or activity in the United 

States. See supra note 6. 

I7One example is the Commission's approach under the Securities Act of 1933 (15 U.S.C. §§ 

77a-77aa), which is codified in Regulation S (17 C.F.R. §§ 230.901-.904). See Offshore Offers and 

Sales, Securities Act Release No. 6863 (Apr. 24,1990),55 FR 18306. In regulating broker-dealers, 

the Commission uses a territorial approach in applying the registration requirements, but 

regulates registered broker-dealers under an entity approach. See Exch. Act. Rel. 27017, supra note 

7, at III.B.l. 

?See infra notes 19-22. See also RESTATEMENT (THIRD) OF THE FOREIGN RELATIONS LAW OF THE 

UNITED STATES 9 402 (1987) [hereinafter RESTATEMENT (THIRD)]; RESTATEMENT (SECOND) OF ' 

FOREIGN RELATIONS LAW OF THE UNITED STATES 17/18 (1965). 

The Reach of the Investment Advisers Act of 1940 227 
Under the conduct test, acts that are committed in the United States in 

furtherance of a fraudulent scheme and are more than merely preparatory are 

sufficient to justify application of the federal securities laws to the unlawful 

conduct.lg Courts have concluded that Congress did not intend for this country 

to be used as "a base for manufacturing fraudulent security devices for 

export,'I2' or to become "a 'Barbary Coast! . . . harboring international securities 

'pirates'" whose victims are foreign?' Under the "effects" test, the federal 

securities laws may be applied to conduct overseas that injures or defrauds 

United States investors or adversely affects a United States listed securityF2 

The antifraud provisions of the securities laws have typically been given 

broader effect than purely regulatory provi~ions2~ Nevertheless, if the effect in 

the United States is sufficiently significant, or the conduct sufficiently important, 

the assertion of regulatory jurisdiction is appr0priate.2~ 

B. Policy Considerations Favoring a New Approach 

The Division believes that a conduct and effects approach to the Advisers 

Act is consistent with important policy considerations and that the Act should be 

IgSee, e.g., Leasco Data Processing Equip. Corp. v. Maxwell, 468 F.2d 1326 (2d Cir. 1972) and 

Continental Grain (Australia) Pty. Ltd v. Pacific Oilseeds, Inc., 592 F.2d 409, 421 (8th Cir. 1979) 

(misrepresentations made in the United States for securities transactions consummated abroad); 

cf. Psimenos v. E.F. Hutton & Co., 722 F.2d 1041, 1045 (2d Cir. 1983) (fraudulent practices with 

respect to foreign client prohibited by United States law where practices concerned trades 

executed for client on United States commodity exchange). 

?IIT v. Vencap, Ltd., 519 F.2d 1001,1017 (2d Cir. 1975). 

%EC v. Kasser, 548 F.2d 109, 116 (3d Cir. 1977), cert. denied, 431 U.S. 938 (1977). 

"See, e.g., Consolidated Gold Fields, PLC v. Minorco, S.A., 871 F.2d 252 (2d Cir. 1989); Bersch 

v. Drexel Firestone, 519 F.2d 974,993 (2d Cir. 19751, cut. denied, 423 U.S. 1018 (1975); Schoenbaum 

v. Firstbrook, 405 F.2d 200 (2d Cir. 1968)) redd on other grounds, 405 F.2d 215 (2d Cir. 1968) (en 

banc), cert. denied, 395 U.S. 906 (1969). 

23See Plessey Co., PLC v. General Electric Co., 628 F. Supp. 477 (D. Del. 1986); see also 

Consolidated Gold Fields, 871 F.2d at 262-63 (distinguishing between the enforcement of United 

States regulatory and antifraud jurisdiction). 

241ndeed, the RESTATEMENT (THIRD) recognizes the regulation of investment advice rendered 

in the United States as a reasonable assertion of regulatory jurisdiction. RESTATEMENT (THIRD), 

supra note 18, Q 416. 

228 CHAPTER 5 
applied more narrowly, in keeping with that appr0ach.2~ Under general 

principles of comity, nations recognize legislative and judicial acts of other 

nations, having due regard for the rights of their own citizens. Comity suggests 

that the Advisers Act should not apply to a foreign registered adviser's 

relationship with its non-United States clients outside the United States, just as the 

Commission would not expect the laws and regulations of a foreign count 

apply to a United States adviser's relationship with its United States clients. 72" 

A strong argument also can be made that foreign clients of foreign advisers 

do not expect, and may not desire, a foreign adviser to be subject to the Advisers 

Act. Assuming a foreign adviser does not hold itself out as being registered 

under the Advisers Act, there would be no apparent reason for a foreign investor 

to expect to be protected by United States law. 

In addition, a conduct and effects approach is consistent with Commission 

efforts to remove unnecessary barriers to international securities markets. Today, 

foreign investment advisers may be reluctant to register under the Advisers Act 

so that they may advise United States clients because to do so subjects all their 

non-United States advisory operations to United States law. Their avoidance has 

the unfortunate effect of limiting United States investors' access to foreign 

advisory expertise. 

Just as important, under a conduct and effects approach, the Commission 

still would be able to reach conduct that affects United States markets and United 

States clients. For example, where a foreign adviser's dealings with non-United 

States clients operate to defraud its United States clients, such as where the 

adviser was "front-running" trades of United States clients, the Advisers Act 

would apply since the acts would affect a United States client. Given these 

protections, little purpose is served by requiring foreign advisers to comply with 

all of the United States requirements regarding their non-United States clients. 

2?3everal commenters recommended a similar approach on policy grounds, as have other 

observers. See, e.g., Letter from Dechert Price & Rhoads to Jonathan G. Katz, Secretary, SEC 26 

(Oct. 10,1990), File No. S7-11-90 [hereinafter Dechert Price Study Comment]; Greene, Dupler, and 

Cohen, supra note 12. 

26We understand the laws of other countries generally reflect these principles. For example, 

the United Kingdom does not apply certain of its investment advisory laws to the foreign 

activities of foreign investment advisers registered there. See Rule 28.01 of the Rules of the 

Investment Management Regulatory Organization Limited (1988) [hereinafter IMRO Rules]. 

Brazil's regulations do not apply to activities of registered investment managers outside Brazil. 

International Survey, supra note 4, at 111-13. Japanese law does not apply to the dealings between 

registered foreign-based advisers and their clients located outside Japan. Id. at VI-40. France 

applies its laws extraterritorially, id. at xviii-xix, but the activities of affiliates apparently are not 

subject to review to ensure separateness from the entity seeking to register. Id. at IV-2. 

The Reach of the Investment Advisers Act of 1940 229 
We recognize that the approach we recommend may appear to differ from 

that taken by the Commission with respect to broker-dealer regulation. A closer 

look, however, reveals that the underlying rationale is entirely consistent. It is 

appropriate to use an entity analysis to apply the broker-dealer provisions of the 

Exchange Act to the foreign activities of a registered broker-dealer, for example, 

because of the consequences of such activities for the broker-dealer’s net capital 

position. The Advisers Act, however, emphasizes disclosure and fiduciary 

obligations and does not regulate financial safety and soundness.27 Accordingly, 

conduct by a registered foreign adviser outside the United States, with nonUnited States clients, is much less likely to implicate United States regulatory 

concerns. 

C. Access to Books and Records and Personnel 

Although the activities of a registered foreign adviser with its foreign 

clients should not generally be subject to the Advisers Act, the Commission 

should require United States registered foreign advisers to keep certain records 

with respect to their offshore activitiesJ8 Because the offshore activities of a 

registered foreign adviser may have a significant effect on United States clients, 

these records will enable the Commission to carry out an effective examination 

program. In addition, the Commission will need access to foreign personnel of 

the adviser, even where those personnel do not deal with United States clients. 

The Commission’s interest in the offshore activities of a registered foreign adviser, 

however, will generally be limited to obtaining access to information concerning 

trades by the adviser and its affiliates and foreign clients in order to monitor and 

enforce compliance with the adviser‘s obligations to its United States clients. 

D. Implications of a New Approach 

The implications of the approach we recommend, for both foreign and 

domestic advisers, are discussed below. Of course, in some cases, determination 

of whether the Advisers Act applies will be fact-specific. 

27From time to time, various persons, including the Commission, have suggested amending 

the Advisers Act to impose capital requirements on investment advisers. If the Advisers Act were 

amended to address financial safety and soundness concerns, we would expect to revisit this 

topic. 

28Rule 204-2 under the Advisers Act (17 C.F.R. § 275.204-2) already requires, among other 

things, that registered advisers maintain records of not only their trades, but also of trades by any 

controlling persons or affiliates thereof who obtain information about investment advice before 

it is effectively disseminated. 

230 CHAPTER 5 
1. Foreign Advisers and United States Clients 

The conduct and effects approach generally would not affect the regulation 

of the relationships between registered foreign advisers and United States clients. 

If a foreign adviser has fifteen or more United States clients, it must register 

under the Advisers Act. Once registered or required to be registered, all of the 

foreign adviser's advisory activities with United States clients would be subject 

to the full panoply of the Advisers Act's requirements. This can be justified on 

either a conduct or effects basis -- sizable activity will take place in the United 

States or there will be an effect in the United States. 

One issue that would arise more frequently under this approach is who is 

a "United States client" protected by the Advisers For example, while 

undoubtedly all persons resident in the United States are protected, the status of 

United States citizens abroad as clients protected by the Advisers Act has not 

been addressed. If the Commission takes a conduct and effects approach to the 

reach of the Advisers Act, we would expect to address these questions on a caseby-case basis through no-action letters, using criteria similar to those in 

Regulation S and rule 15a-6.3' 

2. Foreign Advisers and Clients Outside the United States 

Under a conduct and effects approach, the Advisers Act generally would 

not govern the relationship between a registered foreign adviser and its clients 

residing outside the United States. In this situation, the United States would not 

have a significant regulatory interest because the relationship would involve 

neither clients, nor advisory services rendered, within the United States. Also, if 

a nonresident adviser does not hold itself out to foreign persons as being 

registered under the Advisers Act, an expectation of protection under the 

Advisers Act is unlikely?1 Finally, a foreign regulator would have a much 

*%rider the existing positions, the question arises only in connection in with determining 

whether a foreign adviser may rely on the exemption in section 203(b)(3) for advisers with fewer 

than 15 clients. See supra note 6. 

3%egulation S generally deems United States citizens residing abroad as outside the 

protections of the registration requirements of the Securities Act. Rule 902(0) thereof defines 

"United States person" to include, among others, any natural person resident in the United States, 

but does not include United States citizens resident abroad. Rule 15a-6 under the Exchange Act 

(17 C.F.R. 5 240.15a-61, adopts an approach similar to that of Regulation S. See Exch. Act. Rel. 

27017, supra note 7, at III.B.2. 

311n adopting a conduct and effects approach, the Commission could prevent registered 

foreign advisers that do not want their activities outside the United States to be governed by the 

Advisers Act from holding themselves out to foreign clients as being subject to Commission 

(continued ...) 

The Reach of the Investment Advisers Act of 1940 231 
greater interest than the United States in regulating investment advice given 

within its territory to persons located there. 

At the same time, the offshore activities of a registered foreign adviser may 

have a significant effect on United States clients. Abusive practices such as front 

running and unauthorized principal and agency cross transactions involving the 

accounts of foreign clients or foreign affiliates could harm United States investors. 

For example, an adviser might sell a security from a foreign client's account to the 

account of a United States client without receiving written authorization from the 

United States client in contravention of section 206(3) of the Advisers Act, which 

addresses such agency cross-transactions, or place foreign client transactions 

ahead of a large transaction by a United States client. In our view, the Advisers 

Act should be applied to such activities because they involve United States clients. 

3. Domestic Advisers and Foreign Clients 

When a domestic adviser is advising foreign clients, it is likely that a 

sizable amount of the advisory activity will occur in the United States. Where the 

investment advice is being provided by a domestic adviser and where its 

employees providing the advice are based in the United States, the United States 

has a significant regulatory interest in the activity and application of the Advisers 

Act is appropriate. 

A foreign client doing business with an adviser located in the United States 

would be justified in expecting the protections afforded by United States law. 

When a client chooses to deal with advisory personnel located in the United 

States, the client chooses to have the relationship governed by United States 

law. 32 

We note that this approach means that a person in a foreign country who 

seeks the advice of an investment adviser located in the United States would find 

that the advisory relationship is subject to all the provisions of the Advisers Act. 

Thus, were a foreign pension fund to hire a domestic investment adviser to 

manage a portion of its portfolio, all provisions of the Advisers Act would apply 

3*(...continued) 

regulation. Cf. IMRO Rule 16.11 (that advertisements of IMRO membership by investment 

managers for use outside the United Kingdom also must state that the rules and regulations under 

the United Kingdom's Financial Services Act pertaining to investor protection do not apply to 

those foreign investment managers). 

32When a foreign client deals with advisory personnel located abroad, however, it may be 

appropriate that the relationship be governed by foreign laws, even if the adviser's main offices 

are in the United States. 

232 CHAPTER 5 
to that relationship, including the restrictions on performance fees and principal 

transactions with ~lients.3~ 

4. Multinational Advisers and Foreign Clients 

The most difficult questions under the conduct and effects approach would 

arise with multinational firms, i.e., firms with offices in the United States and at 

least one other country. A multinational advisory firm may deal with a foreign 

client with personnel from offices in numerous countries. In the case of such a 

firm, it will be necessary to determine whether a sizable amount of advisory 

services takes place in the United States, such that United States regulatory 

interest is justified. At one extreme, if a foreign client deals exclusively with the 

foreign office of a multinational firm that has a corporate policy requiring that all 

portfolio decisions made by that office be formulated by that office, the Advisers 

Act generally would not apply. At the other extreme, if the client wished to 

invest in United States markets and dealt exclusively with United States 

personnel, the Advisers Act would apply. Cases between these extremes may 

present difficult questions. 

Until we have the opportunity to address the difficult questions, we are 

reluctant to draw definitive lines. The Division expects to provide guidance on 

a case-by-case basis, where appropriate, through letters. After we have had the 

opportunity to explore the various questions that necessarily will arise, we will 

recommend that the Commission codify that approach. 

5. Establishing Separate Entities 

Adoption of a conducts and effects approach would lessen the need for 

foreign advisers to organize and register separate entities. Nevertheless, there 

may be some foreign advisers who, for a variety of reasons, may wish to use a 

separate registered entity either in the United States or abroad. We believe that 

it would be consistent with a conduct and effects approach to modify the Ellis 

conditions for the registration of a separate affiliate. 

We believe the Commission shodd recognize separateness if the affiliated 

companies are separately organized (e.g., two distinct entities), and if the 

registered entity is staffed with personnel (whether physically located in the 

33Section 205(a)(l)’s restrictions on performance fees go beyond those in some other countries, 

although the section has a limited exception for contracts with investment companies and clients 

with accounts of $1 million or more, and the Commission has adopted an exemptive rule for 

certain other contracts with sophisticated clients. Advisers Act rule 205-3, 17 C.F.R. 5 275.205-3. 

In Chapter 6, the Division recommends amending section 205 to permit registered investment 

advisers to enter into performance fee arrangements with clients not residing in the United States 

under certain conditions. 

The Reach of the Investment Advisers Act of 1940 233 
United States or abroad) who are capable of providing investment advice. Of 

course, there would still be a need to evaluate the separate identity of affiliates 

to ensure that all personnel involved in providing advice to United States persons 

and all supervisory personnel are subject to Commission jurisdiction. We see no 

reason to require separate boards, however, nor would we object to the sharing 

of personnel or communications. To ensure compliance with the Advisers Act, 

the Commission should require that all personnel involved in United States 

advisory activities be "associated persons" of the registrant and subject to the 

supervision of the regi~trant.~~ In addition, the Commission should have access 

to trading and other records of the affiliate, and to its personnel, to the extent 

necessary to monitor and police conduct that may harm United States 

 investor^?^ Thus, we would recommend requirements generally analogous to 

those in rule 15a-6 under the Exchange Act?6 

E. Other Alternatives 

The Division considered three alternatives to the conduct and effects 

approach: "nationality," "local law for local clients," and applying the Advisers 

Act's antifraud provisions, but not its regulatory provisions (such as its 

recordkeeping requirements), to dealings with foreign clients. 

The first alternative, the "nationality" doctrine, postulates that a nation has 

an interest in applying its law to its citizens, wherever they are located and 

regardless of where conduct or effects occur. This approach is generally 

disfavored and has not been extensively applied by the c0urts.3~ Accordingly, 

we do not recommend it. 

34Under section 202(a)(17) of the Advisers Act, persons associated with an investment adviser 

include "any partner, officer, or director of such investment adviser (or any person performing 

similar functions), or any person directly or indirectly controlling or controlled by such investment 

adviser, including any employee of such investment adviser, . . . [but not] persons . . . whose 

functions are clerical or ministerial. . . .I' 

35See supra text following note 31. 

36Rule 15a-6 requires, among other things, that an unregistered broker-dealer relying on the 

rule effect transactions through a registered broker-dealer and that the registered brokerdealer 

obtain from the foreign broker-dealer certain information required by the broker-dealer 

recordkeeping rules and a consent to service of process for any civil action brought by or 

proceeding before the Commission or a self-regulatory organization. 

37See Laker Airways Ltd. v. Sabena Belgian World Airlines, 731 F.2d 909, 934-37 (D.C. Cir. 

1984) (rejecting assertion of nationality as the "paramount" basis of jurisdiction); Bersch v. Drexel 

Firestone, Inc., 519 F.2d at 992 (concluding the antifraud provisions would not be applied solely 

on basis of nationality to United States nationals residing abroad). 

234 CHAPTER 5 
The second alternative, the so-called "local law for local clients" approach, 

was advocated by a few commenters?8 Under their approach, the Advisers Act 

would not apply to a United States adviser's dealings with clients residing outside 

the United States, even where the advice is formulated and provided by persons 

residing in the United States. 

The arguments in favor of a local law for local clients approach are largely 

competitive. Supporters say that United States advisers are at a competitive 

disadvantage because the Advisers Act in some ways is more restrictive than the 

systems of regulation imposed by many foreign laws, so that, in addition to 

complying with the laws and regulations of the country in which the client is 

located, United States advisers have the added burden of complying with the 

Advisers Act -- a burden not shared by foreign advisers. Thus, for example, 

United States advisers of foreign clients would not be able to enter into the same 

types of fee arrangements as foreign advi~ers.3~ 

Although we are sympathetic to the competitive concerns, we believe the 

local law for local clients approach is inconsistent with the purposes of the 

Advisers Act, general principles of jurisdiction, and the expectations of investors. 

In our view, the better approach is to apply the Advisers Act where a domestic 

adviser's dealings with foreign clients involve a sizable amount of activity in the 

United States. 

As the courts have recognized, the United States and the Commission have 

a strong interest in preventing this country from being used as a base for 

fraudulent or abusive practices by investment advisers. It is not realistic to expect 

other countries to police the activities of United States advisers, particularly where 

those advisers may be conducting only limited solicitation and other marketing 

activities abroad. 

The third alternative, applying only the antifraud provisions of the 

Advisers Act to dealings with foreign clients and not the regulatory provisions, 

has some basis under the securities laws. As noted above, in interpreting the 

scope of the securities laws, courts have indicated that the antifraud provisions 

38See, e.g., Letter from Cleary, Gottlieb, Steen & Hamilton to Jonathan G. Katz, Secretary, SEC 

391n theory, one effect of the competitive disadvantage might be that investment advisers 

would be less likely to base their operations in the United States because, while they can serve 

United States clients by simply registering in this country, they can avoid regulation under the 

Advisers Act with respect to foreign clients by locating outside the United States. We do not 

believe this is particularly likely because, among other things, advisers that desire to develop 

United States market expertise and to deal with United States clients will undoubtedly find it 

helpful or necessary to have personnel located here. 

76 (Oct. 12, 19901, File No. S7-11-90; Dechert Price Study Comment, supra note 25, at 27. 

The Reach of the Investment Advisers Act of 1940 235 
have wider scope than do other regulatory provisions!' Similarly, in adopting 

Regulation S the Commission determined that the registration provisions of 

section 5 of the Securities Act generally should not apply to issuers' sales of 

securities outside the United States, but did not limit the reach of the antifraud 

provisions. 41 

On balance, however, we generally believe that the Commission should 

apply all of the Advisers Act to the dealings of United States advisers with 

foreign clients where a sizable amount of the advisory activity occurs in the 

United States. Most of the substantive provisions of the Advisers Act are 

intended as prophylactic means to prevent fraud. In fact, a number of the more 

important rules under the Advisers Act, including advertising restrictions, 

custody requirements, and certain disclosure obligations, have been adopted using 

the authority of section 206(4), which prohibits fraud and gives the Commission 

the authority to make rules defining fraud and prescribing means reasonably 

designed to prevent fraud. Determining which of these provisions should have 

greater or lesser reach would be a difficult and probably fruitless task. We 

believe that once an investor chooses to deal with a domestic adviser, it would 

be anomalous to apply only the Advisers Act's antifraud provisions. As 

discussed in Chapter 6, however, we believe that an exception should be made 

for section 205's limits on performance fees. 

IV. Conclusion 

The Division believes the Advisers Act should be applied more narrowly, 

based on a conduct and effects analysis. Accordingly, the Division intends to 

provide no-action advice to investment advisers using this approach. After the 

Division has had the opportunity to explore the various questions that necessarily 

will arise, the Division will recommend that the Commission codify that 

approach. 

40See supra note 23 and accompanying text. See also Registration Requirements for Foreign 

Broker-Dealers, Exchange Act Release No. 25801 at nn.42-44 and accompanying text (June 14, 

1988),53 FX 23645. 

4'See Sec. Act Rel. 6863, supra note 17, at I. 

236 CHAPTER 5 
Chapter 6 

Performance Based Advisory 

Corn pensat ion 

I. Introduction and Summary of Recommendations 

Section 205(a)(l) of the Investment Advisers Act* generally prohibits a 

registered investment adviser from receiving compensation on the basis of a share 

of capital gains in or capital appreciation of a client‘s account, or any portion 

thereof? Commonly referred to as a “performance fee,’I3 this type of 

compensation arrangement can take various forms. For example, fees equaling 

ten percent of the gains in an account or of the gains exceeding the performance 

of a designated securities index or other benchmark are performance fees. 

Another example of a performance fee is waiver by an adviser of its customary 

fee unless there is a gain in an account. 

The performance fee prohibition was included in the Advisers Act because 

of Congressional concern that performance fees created incentives for advisers to 

take inappropriate risks in managing a client‘s account in order to increase 

advisory fees4 Performance fees in use at the time typically rewarded an 

adviser, above and beyond its customary fee, for good performance, without 

penalizing it for poor performance. Congress concluded that performance fees 

‘Investment Advisers Act of 1940, 15 U.S.C. § Sob. 

215 U.S.C. 5 80b-5(a)(l). Section 205(a)(l) provides in relevant part: 

No investment adviser, unless exempt from registration pursuant to section 

203(b), shall make use of the mails or any means or instrumentality of interstate 

commerce, directly or indirectly, to enter into, extend, or renew an investment 

advisory contract, or in any way to perform any investment advisory contract 

entered into, extended, or renewed on or after the effective date of this title, if 

such contract -- 

(1) provides for compensation to the investment adviser on the 

basis of a share of capital gains upon or capital appreciation of 

the funds or any portion of the funds of the client. 

3We use the term “performance fee“ to refer to those types of compensation arrangements 

based on capital gains or capital appreciation that are prohibited by section 205(a)(l). 

Compensation arrangements based on other measures of performance, such as net income, are not 

prohibited by the Advisers Act. 

4H.R. REP. No. 2639, 76th Cong., 2d Sess. 29 (1940). 

237 
encouraged advisers to speculate unduly because they had everything to gain and 

little to lose. 

As originally enacted, section 205(a)(l) did not cover contracts between 

registered investment advisers and investment companies registered under the 

Investment Company Act? In 1970, however, Congress extended the 

performance fee prohibition to advisory contracts with registered investment 

companies based, in part, on information that revealed many registered 

investment companies had performance based fee arrangements that allowed their 

advisers to earn a bonus for good performance without imposing a comparable 

penalty for poor performance. 

At the same time, Congress acknowledged that not all performance fees are 

inherently undesirable and exem ted from the performance fee prohibition a type 

of fee known as a "fulcrum fee.'"With a fulcrum fee, an adviser's compensation 

increases or decreases depending on how an account performs relative to an 

appropriate index or other measure of performance over a specified peri~d.~ 

Under the statute, fulcrum fee arrangements may be made only with registered 

investment companies or persons with whom the adviser has contracted to 

manage at least $1 million in assets. 

Congress in 1970 also gave the Commission broad authority to exempt, 

among other things, performance fee arrangements. The Commission exercised 

its authority in 1985, adopting a rule providing for a second limited exemption 

from the performance fee prohibition for advisory contracts with wealthy clients 

having at least $500,000 under the management of the investment adviser or a net 

worth exceeding $1 million, if certain conditions and restrictions contained in the 

rule are met? 

51nvestment Company Act of 1940,15 U.S.C. 5 80a. 

'Advisers Act 5 205(b)(2), 15 U.S.C. 5 80b-5(b)(2). 

7Advisers Act rules 205-1 and 205-2 (17 C.F.R. 55 275.205-1, .205-2) contain requirements 

regarding how the investment performance of an account and the investment record of an index 

may be measured and compared. 

'Investment Advisers Act Release No. 996 (Nov. 14,1985), 50 FR 48556 (adopting rule 205-3). 

238 CHAPTER 6 
Section 205(a)(l) always has been controversial? Supporters of the 

prohibition on performance fees point to the potential for excessive risk taking." 

They believe performance fees may have anti-competitive effects, favoring wellcapitalized advisers." They also challenge whether there is any basis, 

theoretical or actual, for believing that performance fees will improve 

performance.12 In addition, some have expressed concern that performance fees 

would act to the detriment of clients that do not pay performance fees because 

advisers would devote more of their tirne and resources to the clients that doJ3 

Critics of the prohibition argue that performance fees are a rational means 

of compensating advisers because they create a coincidence of advisory and client 

goals by linking advisory compensation to ~erf0rmance.l~ They assert that 

performance fees encourage the establishment of new advisory firms and provide 

an incentive for advisers to service smaller accounts that otherwise would be 

deprived of advisory services.15 They also argue that performance fees reduce 

'See, eg., Julie Roher, The Great Debate Over Performance Fees, 17 INSTITUTIONAL WESTOR 123 

(Nov. 1983); Richard Grinold and Andrew Rudd, Incentive Fees: Who Wins? Who Loses?, 43 FIN. ANALYSTS J. 27 (Jan.-Feb. 1987); Lawrence K. Davanzo and Stephen L. Nesbitt, Performance Fees For 

Investment Management, 43 FBI. ANALYSTS J. 14 (Jan.-Feb. 1987); Mark P. Kritzman, Incentive Fees: 

Some Problems and Some Solutions, 43 FIN. ANALYSTS J. 21 (Jan.-Feb. 1987); Eugene E. Record, Jr. and 

Mary Ann Tynan, Incentive Fees: The Basic Issues, 43 FIN. ANALYSTS J. 39 (Jan.-Feb. 1987); Laura T. 

Starks, Performance Incentive Fees: An Agency Theoretic Approach, 22 J. FIN. AND QUANTITATIVE 

ANALYSIS 17 (Mar. 1987); Linda Parham, Plan Sponsors Cautiously Approach Performance-Based Fees, 

25 PENSION WORLD 24 (June 1989); Charles W. Gregor, What Are Investment Managers Saying About 

Performance Based Fees?, 22 PENSION WORLD 20 (Dec. 1986); HARVEY E. BINES, THE LAW OF 

INVESTMENT MANAGEMENT ¶ 5.03[21[a] (1978 & Supp. 1986). 

'boher, supra note 9, at 127. 

"Grinold & Rudd, supra note 9, at 37. 

'*See, e.g., Roher, supra note 9, at 128 (noting that incentives for good performance already exist 

since advisers are compensated on the basis of account size and must perform well in order to 

retain their clients). See also BINES, supra note 9, at 5-36 (indicating that there is no demonstrable 

connection between performance fees and superior performance). 

13Letter from the Honorable John D. Dingell, Chairman, House Committee on Energy and 

'krinold & Rudd, supra note 9, at 37. See also BINES, supra note 9, qI5.03[2l[b], at 5-43 

(observing that the principal justification for performance fees is that they permit the uncertainty 

in the quality of the product - the management of the portfolio -- to be shared between the 

adviser and the client). 

Commerce, to John S.R. Shad, Chairman, SEC (Mar. 23, 1983). 

15Roher, supa note 9, at 124. Critics also argue that performance fees permit advisers to stay 

smaller than they otherwise would under traditional compensation arrangements because, 

(continued.. .) 

Performance Based Advisory Compensation 239 
advisory costs, encourage better performance, and reward good performance.16 

On a practical level, critics charge that clients not needing the protections of the 

prohibition should be able to structure advisory fees on whatever terms they 

consider appropriate. 

Finally, critics say the prohibition harms domestic advisers17 when they 

compete for foreign clients because in many countries performance fee 

arrangements are not only legal, they are acceptable and customary.18 Some 

have suggested that registered advisers be permitted to enter into performance 

fee contracts with foreign clients to the extent that the laws of a foreign client's 

home country do not prohibit these fee arrangement^.'^ 

The Division believes that some of the criticisms of the performance fee 

prohibition are valid and that modification of the prohibition is warranted. 

Specifically, we recommend that the Commission transmit to Congress legislation 

clarifying the Commission's authority under the Advisers Act to exempt from the 

performance fee prohibition investment advisory contracts with (1) persons whom 

the Commission determines do not need the protections of the prohibition, based 

on factors such as wealth and financial sophistication, or (2) persons not residing 

in the United States, to the extent that performance fees are lawful in the person's 

country of residence. Although the Commission could expand the existing 

performance fee exemptive rule to permit certain sophisticated clients of 

investment advisers to enter into performance fee arrangements, the Division 

15(...continued) 

assuming an adviser can successfully manage its clients' portfolios, it can generate sufficient 

income without having to attract a large asset base. Id. 

16B~~, supra note 9, at 5-36 to 5-37. Properly drafted performance fees can reduce total 

management fees during periods of market decline when investors are less willing to pay sizable 

advisory fees and increase fees during periods of rising returns when investor attitudes are quite 

different. Id. 

"We use "domestic adviser" to refer to an adviser whose offices and personnel are located in 

the United States and "foreign adviser" to refer to an adviser whose offices and personnel are 

located outside the United States. 

'*Cornenters responding to the Commission's release regarding the reform of investment 

company regulation (SEC Request for Comments on Reform of the Regulation of Investment 

Companies, Investment Company Act Release No. 17534 (June 15, 1990), 55 FR 25322) were 

particularly concerned about the anti-competitive effects of the prohibition. See, e.& Letter from 

Davis Polk & Wardwell to Jonathan G. Katz, Secretary, SEC 40-44 (Oct. 10,1990), File No. S7-11- 

90. See also Edward F. Greene, MitcheIl S. Dupler, and Alan B. Cohen, Jurisdictional Reach uf the 

Investment Advisers Act of 2940,4 INSIGHTS 21,24-25/28 (Oct. 1990). 

"See, eg., Stanley B. Judd, Internafional Investment Advisers, 19 REV. OF SEC. & COMM. REG. 1, 

7 (1986). 

240 CHAPTER 6 
believes it is preferable to obtain from Congress explicit authority to adopt rules 

effecting the proposed changes?' 

This chapter begins with an historical overview of the performance fee 

prohibition. It then analyzes why broad exemptions from the performance fee 

prohibition are appropriate for advisory contracts with financially sophisticated 

clients and foreign clients. Finally, the chapter discusses the recommended 

legislation. 

11. An Overview of the Performance Fee Prohibition 

As originally enacted, the Advisers Act prohibited registered investment 

advisers from charging performance fees. The prohibition was prompted more 

by concerns about the inherent nature of performance fees, rather than by 

evidence of any actual abuse. Congress believed that performance fees 

encouraged a degree of risk taking by advisers seeking to increase advisory 

fees.21 Also, studies indicated that performance fees could induce an investment 

adviser to advise some clients to buy and others to sell the same securities?' 

In addition, the Code of Professional Practice of the Investment Counsel 

Association of America expressly prohibited performance feesF3 

The performance fee prohibition was not absolute. Contracts between 

investment advisers and investment companies were excluded from the 

'-he Division believes that, absent statutory amendments, the Commission could not exempt 

performance fee arrangements with less sophisticated foreign clients. 

21H.R. REP. NO. 2639, supra note 4, at 29; S. REP. NO. 1775,76th Cong., 3d Sess. 22 (1940). See 

also SEC, INVESTMENT TRUSTS AND INVESTMENT COMPANIES, H.R. Doc. No. 477,3d Sess. 30 (1939) 

[hereinafter INVESTMENT TRUST STUDY] (stating that performance fees encourage advisers to 

recommend a degree of risk that investors themselves would not knowingly undertake, as 

advisers have everything to gain and nothing to lose). The INVESTMENT TRUST STUDY found that 

a number of investment companies paid performance fees, typically 25% of profits, to their 

investment advisers. INVESTMENT TRUST STUDY, supra, at 17. see also TWENTIETH CENTURY FUND, 

INc., THE SECURITY MARKETS 646 (1935) (citing with disapproval investment advisers who "conduct 

speculative operations with other people's money for a percentage of the profits without liability 

for losses"). 

221nvestment Trusts and Investment Companies: Hearings on S. 3580 befme u Subcomm. of the Senate 

Comm. on Banking and Currency, 76th Cong., 3d Sess., pt. 2,1004-17 (1940) [hereinafter 1940 Senute 

Hearings] (referring to findings of the Research Department of the Illinois Legislative Council). 

In the normal course of the market, some of the accounts receiving advice would profit. Thus, 

an adviser receiving a performance fee for conflicting advice about the same security would be 

reasonably assured of profiting from its advice. Id. at 1012. 

=Id. at 726 (statement of Dwight C. Rose, President, Investment Counsel Ass'n). 

Performance Based Advisory Compensation 241 
pr~hibition?~ The investment company industry had argued successfully that 

performance fees closely linked the interests of investors and management 

throughout the life of the investment and that the basis of compensation should 

not be specified by statute as long as the chosen basis was disclosed adequately 

to share holders .25 

The industry's position on performance fees was challenged in 1966, when 

the Commission issued a report that, among other things, recommended that the 

performance fee prohibition be extended to investment company contractsF6 

Although the report contained no specific examples of abuse, the Commission 

subsequently furnished Congress with information that, out of 137 registered 

investment companies with performance fee arrangements, 48 allowed the adviser 

to earn a bonus for good performance without imposing a penalty for poor 

perf~rmance.~~ An additional 45 investment companies had performance fee 

arrangements in which the potential rewards were substantially greater than the 

penaltiesF8 Based in part on the Commission's recommendation, bills were 

introduced in Congress to extend the performance fee prohibition to contracts 

with investment companies. 

Ultimately, in 1970, Congress enacted amendments to the Advisers Act 

that, among other things, extended the erformance fee prohibition to contracts 

with registered investment companies?' At the same time, however, Congress 

exempted contracts with registered investment companies and certain advisory 

24S. 3580, the bill that ultimately became the Investment Company and Advisers Acts, at first 

included in its declaration of policy a statement that "the national public interest and the interests 

of investors are adversely affected when advisory compensation is based on profit sharing 

contracts and other contingent arrangements conducive to excessive speculation and trading." 

This statement was deleted from the bill as enacted and contracts with investment companies 

were excluded from the performance fee prohibition. 

251940 Senate Hearings, supra note 22, at 664,1055. 

26sEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. 

REP. NO. 2337, 89th Cong., 2d Sess. 345 (1966). 

27Mutual Fund Amendments: Hearings before the Subcommittee on Commerce and Finance of the 

House Committee on Interstate and Foreign Commerce on H.R. 11995, S. 2224, HR. 13754 and H.R. 

14737, 91st Cong., 1st Sess. 207 (1969). 

281d. 

291nvestment Company Act Amendments of 1970, Pub. L. No. 91547,s 25,84 Stat. 1413 (1970) 

(codified at 15 U.S.C. § 80b-5(b)(l)). 

242 CHAPTER 6 
accounts in excess of $1 million that used fulcrum fees?' Congress believed that 

limiting investment company performance fees to those of the fulcrum variety 

"would insulate investment company shareholders from arrangements that give 

investment managers a direct pecuniary interest in pursuing high risk investment 

Congress also added section 206A to the Advisers Act, giving the 

Commission general exemptive authority?2 In enacting section 206A, Congress 

expressly contemplated Commission action in appropriate cases "to exempt 

persons . . . from the ban on performance-based advisory compensation in . . . section [205(a)(l)] of the Advisers Act. . . . $53 

Thereafter, the Commission issued several orders exempting performance 

fee arrangements. Generally, the orders applied to contracts with wealthy and 

financially sophisticated investors, where the advisers made their own substantial 

investments in the accounts, thus reducing their incentive to take undue risks.34 

301d. (codified at 15 U.S.C. 5 80b-5(b)(2)). This exemption does not apply to accounts organized 

as trusts, governmental plans, collective trust funds, or separate accounts (essentially, most 

employee benefit plans). 

31H.R. REP. NO. 1382,91st Cong., 2d Sess. 41 (1970); S. REP. NO. 184, 91st Cong., 1st Sess. 45 

(1969). 

32P~b. L. No. 91-547, supra note 29, at 5 26 (codified at 15 U.S.C. § 80b-6a). Section 206A is 

substantially similar to section 6(c) of the Investment Company Act (15 U.S.C. Q 80a-6(c)). 

Congress intended this section to give the Commission greater flexibility in administering the 

Advisers Act. Section 206A provides: 

The Commission, by rules and regulations, upon its own motion, or by order 

upon application, may conditionally or unconditionally exempt any person or 

transaction or any class or classes or persons, or transactions, from any provision 

or provisions of this title or of any rule or regulation thereunder, if and to the 

extent that such exemption is necessary or appropriate in the public interest and 

consistent with the protection of investors and the purposes fairly intended by 

the policy and provisions of this title. 

33See, e.g., S. REP. NO. 184, supra note 31, at 46. 

34See, eg., Foster Management Company, Investment Advisers Act Release Nos. 646 (Nov. 1, 

1978), 43 FR 52313 (Notice of Application) and 651 (Nov. 28,1978), 16 SEC Docket 316 (Order); 

Weiss, Peck & Greer, Investment Advisers Act Release Nos. 623 (Mar. 28, 19781, 43 FR 14193 

(Notice of Application) and 625 (Apr. 25,1978), 14 SEC Docket 946 (Order); Connecticut Mutual 

Life Ins. Co., Investment Advisers Act Release Nos. 459 (May 7, 1975),40 FR 20992 (Notice of 

Application) and 461 (June 5,19751, 16 SEC Docket 316 (Order). 

Performance Based Advisory Compensation 243 
The Commission also issued a number of orders exempting advisers to business 

development companies ("BDCS")?~ 

In 1985, the Commission adopted rule 205-3, establishin a limited 

performance fee exemption for advisers to certain wealthy clients!6 The rule 

sets forth alternative objective tests -- $500,000 under the adviser's management 

or a $1 million net worth - for measuring a client's eligibility to enter into a 

performance fee contract. The rule also sets forth two different methods for 

calculating the compensation paid to an adviser for a given period depending 

35BDCs generally invest in small, growing companies whose financing needs cannot be met 

by the traditional public and institutional financial capital markets. BDC officers and directors 

usually provide managerial assistance to issuers whose securities are held by the BDC. The 

developing companies in which the BDC invests typically do not have the funds to compensate 

the BDC for the efforts of its officers and directors. Therefore, the developing company usually 

provides compensation in the form of common stock, which, it is hoped, will appreciate in value. 

Such a compensation arrangement would fall within section 205(a)(l). See generally Reginald L. 

Thomas & Paul F. Roye, Regulation of Business Development Companies under the Investment Company 

Act, 55 S. CAL. L. REV. 895 (1982). Until 1978, when an adverse court decision (Abrahamson v. 

Fletcher, 568 F.2d 862 (2d Cir. 1977), cert. denied, 436 U.S. 913 (1978)) changed matters, these 

advisers had relied on an exemption from the registration requirements of the Advisers Act and 

thus were not subject to the performance fee prohibition. Congress ultimately prescribed special 

provisions for BDCs. See The Small Business Incentive Investment Act of 1980, Pub. L. No. 96-477, 

Q 203,94 Stat. 2275 (1980). The legislation, among other things, created a limited exemption from 

section 205(a)(l) to permit a registered investment adviser to a BDC to receive performance based 

compensation limited to not more than 20% of the BDC's net realized capital gains. See Advisers 

Act 5 205(b)(3), 15 U.S.C. Q 80b-5(b)(3). In the interim, the Commission proposed a rule, rule 

205-3, which would have permitted BDC advisers to receive performance fees under certain 

circumstances. See Investment Advisers Act Release No. 680 (June 19, 1979), 44 FR 37470. The 

proposed rule would have permitted certain BDC advisers to receive performance fees, provided 

the BDC's investors were sophisticated and able to bear the economic risk of their investment. 

Commenters on the proposed rule supported the Commission's efforts to facilitate the flow of 

capital to small and developing businesses but criticized the rule's restrictive nature. The 

Commission subsequently withdrew the proposal. Investment Advisers Act Release No. 750 (Feb. 

20,1981), 46 FR 14353. 

3&mv. Adv. Act Rel. 996, supra note ?. The Commission previously had proposed a different 

version of rule 205-3. That version would have provided general exemptive relief from section 

205(a)(l), if the clients were wealthy and knowledgeable and did not need the protections that the 

prohibition was intended to provide. Investment Advisers Act Release No. 865 (June 10, 1983)) 

48 FR 2771. The proposal would have required the adviser to find that the client or his 

representative was sufficiently sophisticated in financial and business matters to understand the 

merits and risks of the performance fee contract. It also would have required the contract to relate 

to a minimum of $150,000 in assets, The Commission later withdrew the proposal. Investment 

Advisers Act Release No. 911 (May 2,1984),49 FR 19524. 

244 CHAPTER 6 
upon the nature of the securities being managed?7 In addition, the rule requires 

that any performance fee be based on the gains less the losses in the client's 

account for a period of not less than one year.38 

Rule 205-3 also requires an adviser to disclose any potential conflicts of 

interest that the arrangement may create, the periods which will be used to 

measure investment performance, the nature and significance of any index that 

will be used as a comparative measure of investment performance, and the reason 

the adviser believes the index is appropriate. Where the adviser's compensation 

is based in part on the unrealized appreciation of securities for which market 

quotations are not readily available, the adviser is also required to disclose how 

the securities will be valued and the extent to which the valuation will be 

independently determined. In essence, the rule places on the adviser the burden 

of demonstrating that the fee is fair. 

111. Discussion 

In enacting the statutory exemptions to the performance fee prohibition, 

Congress has acknowledged that performance fees are appropriate in certain 

circumstances. Existing exemptions, however, preclude the use of performance 

fees in advisory contracts in a number of situations, even where the clients are 

institutions or are otherwise sophisticated. The Division believes that, where a 

client appreciates the risk of performance fees and is in a position to protect itself 

from overreaching by the adviser, the determination of whether such fees provide 

value is best left to the client. The Division also is concerned that the inability of 

United States investment advisers to enter into performance fee contracts with 

their foreign clients, even where these arrangements are legal and customary in 

a client's country of residence, may prevent United States advisers from 

competing with non-United States advisers in attracting foreign clients. 

Accordingly, the Division believes that additional exemptions from the 

performance fee prohibition are warranted. 

37For securities for which market quotations are readily available, the formula must include 

realized capital losses and unrealized capital depreciation of the securities over the period. For 

securities for which market quotations are not readily available, the formula still must include 

realized capital losses, but need not include unrealized capital depreciation unless it also includes 

unrealized capital appreciation. 17 C.F.R. 5 205-3(c). 

38Advisers may use any method for receiving payment of the performance fee, but it must be 

consistently applied and fully disclosed to clients. For example, the fee could be paid annually 

after each year's performance or the fee could be paid on a rolling basis beginning at the end of 

a year's performance. Regardless of the method chosen, no part of a performance fee may be paid 

for any period of less than one year. See Inv. Adv. Act Rel. 996, supra note ?, at n.14. 

Performance Based Advisory Compensation 245 
A. Financially Sophisticated Clients 

Neither of the two limited performance fee exemptions available for 

advisory contracts with financially sophisticated clients is sufficiently flexible to 

permit advisers to enter into unconditional performance fee arrangements with 

those clients. Advisers relying on the fulcrum fee exemption must structure their 

performance fee arrangements to increase and decrease proportionately. Many 

institutional investors, however, prefer to structure performance fee arrangements 

with a low base fee, with satisfactory performance resulting in additional 

compensation. Such a fee does not qualify as a fulcrum fee. 

Rule 205-3 provides an alternative for sophisticated investors that do not 

wish to use a fulcrum fee arrangement. Rule 205-3 contains a number of 

conditions that, while they are intended to protect investors and might well be 

insisted upon by a sophisticated client, preclude the use of certain types of 

performance fee arrangements. For example, some clients may wish to employ 

performance fees in short-term investment situations (e.g., less than one year). Or, 

in cases where market quotations are not readily available, clients may wish to 

exclude realized capital losses or unrealized capital depreciation (even if 

unrealized capital appreciation is included) from performance fee calculations. 

Rule 205-3 prohibits either of these situations no matter how sophisticated the 

client. 

Advisory clients that are financially sophisticated, or have the resources to 

obtain sophisticated financial advice, and that can negotiate fee arrangements on 

an arm's length basis should be permitted to employ performance fees on terms 

they consider appropriate. In these instances, we believe that such clients can 

take steps to protect themselves against overreaching by an adviser?' 

B. Foreign Clients 

Historically, the Division has taken the position that the Advisers Act 

applies to all activities of foreign advisers registered under the Act. One 

consequence of this position is that, unless a foreign adviser establishes an 

"independent" affiliate registered under the Advisers Act in accordance with 

conditions set forth by the Division, the adviser is subject to the performance fee 

prohibition with respect to its foreign clients as well as its United States clients. 

As discussed in Chapter 5, the Division now believes that the Commission should 

employ a "conduct" and "effects" approach to the application of the Advisers Act. 

Under that approach, the Advisers Act's provisions, including the performance 

390f course, advisers entering into performance fee arrangements with sophisticated clients 

wouId continue to be subject to the antifraud prohibitions of Advisers Act section 206 (15 U.S.C. 

5 Bob-6). 

246 CHAPTER 6 
fee prohibition, generally would not apply to a foreign adviser’s dealings with 

non-United States clients. The dealings of domestic advisers with foreign clients, 

however, would remain subject to the Advisers Act. Thus, without further 

modifications, domes tic advisers still would be restricted in charging performance 

fees to foreign clients, even where performance fees are legal and customary in 

the client‘s country of residence. 

Many foreign countries do not restrict the use of performance fees by 

advisers?’ In countries where performance fees are an accepted practice, 

foreign advisory clients may be discouraged from employing domestic advisers 

because those advisers only may enter into performance fee arrangements that 

meet the requirements of one of the two available exemptions. These limitations 

likely reduce the ability of domestic advisers to compete effectively with foreign 

advisers in foreign markets. 

The Division has concluded that domestic advisers should be permitted to 

enter into performance fee contracts with foreign clients on terms that are lawful 

in a given client‘s country of residence. While the Commission has a strong 

interest in regulating the conduct of investment advisers resident in the United 

States to ensure that our shores do not become a base for the export of fraud, the 

Commission’s interest in restricting the use by domestic advisers of performance 

fee contracts with their foreign clients is less compelling given the limited 

purposes of section 205(a)(l). Indeed, Congress has acknowledged that 

performance fees are not inherently fraudulent. 

Of course, a foreign client may choose a domestic adviser precisely because 

the adviser is subject to United States regulatory requirements, including the 

performance fee prohibition. In that case, the foreign client would be free to 

refuse to contract for advisory services on a performance fee basis. If a domestic 

adviser were to impose a performance fee contract on a foreign client in a 

misleading manner (e.g., either the client was unaware he was entering into a 

performance fee contract, or was misled as to the nature of the fee arrangement), 

the adviser’s conduct would continue to be subject to the antifraud prohibitions 

of Advisers Act section 206. 

IV. Recommendations 

We recommend legislation authorizing the Commission generally to 

provide exemptions from the performance fee prohibition for advisory contracts 

40See, eg., Rule 5 of the Rules of the Investment Management Regulatory Organization 

Limited. See also Debevoise & Plimpton, International Sumey of Investment Adviser Regulation (Aug. 

1990) (providing analyses of the investment advisory laws of Australia, Brazil, France, Germany, 

Japan, Switzerland, and the United Kingdom). 

Performance Based Advisory Compensation 247 
with (1) any person whom the Commission determines does not need the 

protections of the prohibition and (2) foreign clients, to the extent that 

performance fees are lawful in the client’s country of residence?’ Although the 

Commission probably could use its section 206A authority to provide further 

exemptions from the performance fee prohibition for advisory contracts with 

sophisticated investors, absent specific legislative authority the Commission could 

not provide performance fee exemptions for advisory contracts with less 

sophisticated foreign clients. Therefore, because the Commission will need 

Congressional authority to institute a foreign client exemption, we suggest that 

Congress, at the same time, clarlfy through legislation the Commission’s ability 

to provide unconditional exemptions for advisory contracts with sophisticated 

investors . 

Under the proposed legislation, the Commission could adopt a rule 

permitting United States advisers to enter into performance fee arrangements with 

their foreign clients to the extent those arrangements were lawful in the client‘s 

country of residence.42 The Division would expect to recommend a rule under 

this authority that would place on the adviser the burden of determining whether 

and to what extent the law of a foreign country ennits the use of performance 

fees by advisers resident within that jurisdiction! The rule would provide that 

violations of a foreign country’s law by an adviser with respect to performance 

fees would result in the adviser’s loss of the exemption and, absent the 

availability of another exemption, a violation of section 205(a)(l). We also would 

expect to recommend that United States advisers be required to keep records 

regarding their performance fee contracts with foreign clients to enable the 

Commission to monitor these activities through its inspection program. 

The legislation would not establish specific eligibility requirements for 

persons with whom an adviser may contract for performance fees; instead the 

Commission would set those requirements by rule. This approach will provide 

more flexibility in administering the exemptions. Writing directly into the statute 

an unconditional sophisticated client exemption based solely on a financial means 

test would require the Commission to seek statutory amendments if the monetary 

level chosen became anachronistic. Similarly, writing a foreign client exemption 

directly into the statute would, absent statutory amendments, preclude 

Commission revision or rescission of the exemption if problems arose. In 

addition, the specific criteria for identifying sophisticated advisory clients not 

41The recommended statutory language appears in Appendix 6-A at the end of this chapter. 

42As discussed previously, these advisers’ activities would continue to be subject to the 

antifraud provisions of Advisers Act section 206. 

&Placing this burden on advisers would mean that the Commission would not have to commit 

substantial resources to make these determinations on a case-by-case basis. 

248 CHAPTER 6 
requiring the protections of a prohibition on performance fees may be subject to 

debate, as may be the exact terms of an exemption for foreign clients. 

Performance Based Advisory Compensation 249 
APPENDIX 6-A 

Red-Lined Version of Proposed Amendment to the 

Investment Advisers Act of 1940 

Section 205 [¶5 U.S.C. 5 80b-51. 

*** 

CHAPTER 6 250 
Chapter 7 

Investment Company Governance 

I. Introduction and Summary of Recommendations 

The age-old question, "who will watch the watchmen?," is of particular 

relevance to the present-day investment company industry. Twenty-five percent 

of American households entrust their accumulated savings and investment funds 

to investment company sponsors and managers.' Total investment in 

management investment companies exceeded $1.34 trillion as of December 31, 

1991.2 As evidenced by the recent episodes of mismanagement and abuse that 

have beset other financial intermediaries, the need for effective oversight of these 

entities is crucial. 

The task of providing such protection is a difficult one. Investment 

companies are unique in that they are organized and operated b people whose 

primary loyalty and pecuniary interest lie outside the enterprise!Consequently, 

conflicts of interest inhere in the structure of companies, creating great potential 

for abuse. 

Congress recognized this when it enacted the Investment Company Act: 

a statute whose purpose was to eliminate the pervasive abuses that occurred in 

the investment company industry prior to 1940. To correct these abuses, and 

police the conflicts of interest that engendered them, the Act 

'INVESTMENT COMPANY INSTITUTE, 1990 MUTUAL FUND FACT BOOK 66 (30th ed. 1990). The 

Institute estimates that there are over 62 million shareholder accounts in mutual funds. 

INVESTMENT COMPANY INSTITUTE, 1991 MUTUAL FUND FACT BOOK 75 (31st ed. 1991). 

21nvestment Company Institute News Release, ICI-92-03 (Jan. 29, 1992); Lipper Analytical 

Services Closed End Fund Performance Analysis Service 44 (Jan. 31, 1992). This figure does not 

include monies invested in unit investment trusts and variable insurance products. 

3The typical investment company is organized by an outside "sponsor." The sponsor may be 

a broker-dealer, investment advisory firm, insurance company, or bank. All services necessary 

to market and operate the company, including investment advisory, administration, and 

distribution services, are provided by the sponsor, its affiliates, or outside contractors. Although 

investment companies have officers, they usually are employed and compensated by the sponsor. 

Thus, an investment company has no employees that are truly its own. 

41nvestment Company Act of 1940,15 U.S.C. 5 80a. 

251 
establishes a comprehensive regulatory framework predicated upon principles of 

corporate democracy. 

Although the Act does not explicitly require that investment companies be 

organized in corporate form; it imposes requirements that assume the standard 

equipment of a corporate democracy: a board of directors (forty percent of whom 

must be independent): whose function is to oversee the operations of the 

investment company and police conflicts of interest; and shareholder voting to, 

among other things, elect board members, approve or disapprove fee 

arrangements, and accept or reject changes in a company's investment policies. 

These requirements apply even to investment companies that are not corporations 

but are organized in some other form such as a business trust or limited 

partnership. 

Over the years, commentators have expressed skepticism about the 

effectiveness of boards of directors and the value of shareholder voting for 

investment companies. Some have argued that boards of directors are not 

effective monitors of the sponsor. Others have observed that boards of directors 

increasingly are called upon to micro-manage the day-to-day affairs of the 

investment company to the detriment of the board's traditional oversight function. 

A third group has asserted that investment company shareholder voting is 

perfunctory and that costs incurred in complying with shareholder voting 

requirements outweigh any benefits to shareholders. While some commentators 

have called for improvements to current governance arrangements, others have 

advocated alternative governance arrangements embodied in proposals such as 

%deed, the definition of an "investment company" includes entities organized in any form 

whatsoever. See sections 3(a), 2(a)(22), and 2(a)(8), 15 U.S.C. 93 80a-3(a), -2(a)(22), and -2(a)(8) 

(definitions of "investment company," "issuer," and "company," respectively). 

bSection 10(a), 15 U.S.C. 5 80a-l0(a), requires that at least 40% of the board of directors of a 

registered investment company consist of individuals who are not "interested persons," as defined 

in section 2(a)(19), 15 U.S.C. 9 80a-2(a)(19). We refer to such individuals as "independent 

directors." 

252 CHAPTER 7 

I 
the unitary investment fund ("UIF")7 as a way of streamlining investment 

company governance requirements and reducing operating costs8 

The Division has reexamined the adequacy of the governance structure for 

investment companies. Our purpose was to analyze whether changes could be 

made to the existing structure that would increase the effectiveness of boards of 

directors in monitoring conflicts of interest, provide shareholders with more 

meaningful voting opportunities, and reduce investment company expenses, 

without sacrificing investor protections. The Division has also considered the 

feasibility and desirability of permitting alternative organizational forms like the 

UIF as a means to streamline governance requirements and reduce expenses. 

The Division has concluded that the governance model embodied in the 

Act is sound and should be retained, with limited modifications. The oversight 

function performed by investment company boards of directors, especially the 

"watchdog" function performed by the independent directors, has served investors 

well, at minimal cost. In our view, however, the increasingly significant 

responsibilities placed on independent directors warrant a few changes to further 

strengthen their independence. Accordingly, the Division recommends that the 

Commission recommend legislation that would increase the minimum proportion 

of independent directors on investment company boards from forty percent to 

more than fifty percent. In addition, the Division recommends that independent 

7The UIF, originally proposed over 10 years ago, would be an alternative form of investment 

company similar to a trust. The UIF would have no board of directors and no shareholder voting. 

A contract between the investment manager and the fund would set forth investment objectives, 

fees, and charges to shareholder accounts. A single management fee would cover all expenses, 

except for extraordinary expenses and shareholder account services. The contract could be 

amended after a period of time, but only with notice to investors. Section IV, infra, discusses the 

UIF concept in greater detail. 

'In the SEC's Request for Comments on Reform of the Regulation of Investment Companies, 

Investment Company Act Release No. 17534 (June 15, 19901, 55 FR 25322 [hereinafter Study 

Release], the Commission specifically requested comment on whether management open-end 

investment companies should be allowed to operate as UIFs. A number of commenters addressed 

the UIF proposal, including Benham Capital Management Group; Francis X. Cain; Calvert Group, 

Ltd.; Debevoise & Plimpton (on behalf of the independent directors of the Fidelity Investment 

Company complex); Dechert Price & Rhoads; Federated Investors; Fidelity Management & 

Research Co.; Tamar Frankel; Michael I. Freedman; S. Green Research Associates, Inc.; K. C. 

Gupta; Hale and Dorr; IDS Mutual Fund Group; Institutional Shareholder Services, Inc.; The 

Investment Company Institute; Lipper Analytical Services, Inc.; members of the Business and 

Corporations Law section of the Los Angeles County Bar Association; R. Bruce Oliver; Prudential 

Mutual Fund Management, Inc.; Putnam Management Company, Inc.; Ropes and Gray; Scudder, 

Stevens and Clark, Inc. ("Scudder"); the independent trustees of investment companies managed 

by Scudder; The Vanguard Group, Inc.; Kathleen A. Veach; and Warburg Investment Management 

International Ltd. Other commenters addressed issues relating to governance requirements but 

did not mention the UIF. 

Investment Company Governance 253 
director vacancies be filled by persons chosen by remaining independent 

directors. Finally, the Division proposes that independent directors be given the 

express authority to terminate advisory contracts. 

At the same time, however, the Division recommends eliminating 

provisions in certain rules under the Act that make independent directors 

responsible for detailed findings of fact or for reviews and findings that involve 

more ritual than substance. Elimination of such formalistic requirements will 

increase the effectiveness of boards of directors by allowing them to focus to a 

greater extent on what they do best -- exercising business judgment in their 

review of interested party transactions and in their oversight of operational 

matters where the interests of an investment company and its adviser may 

diverge. 

The Division also has concluded that while shareholder voting continues 

to have a valuable communicative and deterrent function in investment company 

regulation -- particularly where redemption is not cost free -- several voting 

requirements under the Act do not comport with the realities of modern securities 

markets and can no longer be justified on an investor protection basis. The 

Division consequently recommends the elimination or modification of a number 

of these requirements. In particular, the Division recommends that investment 

company shareholders no longer be required to ratify the initial advisory contract 

and rule 12b-1 plan (if any) of a newly organized company, concur in the board’s 

selection of auditors, or approve changes in relatively routine investment policies. 

Conversely, the Division recommends that other voting requirements 

relating to proposals that could significantly alter the nature of an investor’s 

investment (e.g., changes in investment advisory contracts and amendments to 

rule 12b-1 plans that materially increase the amount spent on distribution) be 

retained. In addition, because we believe that an investment company’s 

investment objective is a critical determinant of the potential risk and reward 

inherent in the shareholder’s investment, we recommend that the Act be amended 

to add an explicit requirement that shareholders approve any change in 

investment objective. 

Finally, the Division has concluded that a contractual or UIF structure is 

fundamentally incompatible with the regulatory philosophy of the Act, which 

relies on boards of directors to monitor investment company operations and 

resolve conflicts of interest. In our view, implementation of the UIF concept 

254 CHAPTER 7 
would require a wholesale restructuring of existing regulatory arrangements, with 

little or no apparent benefit for investors? 

This chapter begins with a description of the Act's governance 

requirements, and how they address the conflicts of interest inherent in 

investment companies. We then discuss the most significant issues raised by both 

critics and proponents of the current governance system and set forth 

recommendations for reform that we believe will improve investment company 

governance without sacrificing investor protection. Finally, we analyze the 

feasibility and desirability of the UIF as an alternative investment vehicle. 

11. Conflicts of Interest and Investment Company Governance 

under the Act 

Unlike the typical corporation, virtually all registered investment 

companies are organized and operated by an "outsider," usually a separate 

corporate entity with its own public shareholders. In such an arrangement, there 

is obvious potential for conflict between the interests of investment company 

sponsors and managers and the interests of investment company shareholders. 

To address those situations in which interests conflict, the Act establishes 

a comprehensive regulatory framework premised on the checks and balances of 

governance. The Act imposes watchdog and other responsibilities on boards of 

directors, grants shareholders voting rights with respect to particular matters, and 

authorizes shareholders to seek judicial review of certain fee arrangements. 

A. The Role of the Board of Directors 

The role of directors in policing conflicts of interest is central to the Act:' 

The independent directors, in particular, are expected to look after the interests 

9As described in Chapter 8, however, we recommend, as an alternative to the UIF, the unified 

fee investment company ("UFIC"). The UFIC, which would be an optional form of investment 

company, would have a streamlined fee structure similar to that of the UIF, but would retain 

directors to monitor operational conflicts of interest. Shareholder voting would be reduced. 

'%e duties imposed on directors by the Act are in addition to those imposed by state law. 

Under state law, for example, the role of the board of directors of a public corporation is to 

provide management direction to the corporation, to approve major transactions, and to exercise 

particular oversight as to matters involving conflicts of interest of management. Directors are 

typically bound, under statutes and case law, by duties of loyalty and care. The duty of loyalty 

prohibits a director from taking advantage of a corporation and its shareholders. The duty of care 

requires that a director exercise the degree of skill, diligence, and care that a reasonably prudent 

person would exercise in the same circumstances or in the management of his own affairs. 

Investment Company Governance 255 
of shareholders by "furnishing an independent check upon management,"" 

especially with respect to fees paid to the investment company's sponsor. 

As we discuss in greater detail below, a number of provisions of the Act 

and rules thereunder rely on boards of directors to protect investment company 

shareholders in conflict of interest situations. The board has primary 

responsibility under the Act for evaluating the reasonableness of a number of 

different, and in some cases overlapping, fees and charges for investment advice, 

distribution, administration, and shareholder services. The Act and its rules also 

make the board responsible for policing various operational conflicts, and give the 

board the authority to permit various types of transactions to go forward without 

prior Commission review of individual exemptive applications. 

1. Board Evaluation of Fees Paid to Sponsors and their Affiliates 

Fees paid from an investment company's assets to sponsors and their 

affiliates -- whether advisers' fees, principal underwriting fees, distribution fees, 

or fees for other services -- directly affect shareholders' investment return. The 

higher the fee, the lower the return. The conflict of interest is inherent12 

To ensure the reasonableness of fees paid to investment company sponsors 

and others for services provided to a company, the Act imposes varying 

requirements, depending on the type of fee involved. In certain cases, the Act 

requires the board of directors to evaluate the reasonableness of a particular fee. 

In other cases, the Act requires a multilayered review process that includes not 

only evaluation by the board but also shareholder approval and the opportunity 

for judicial review. The Act does not require the board to review all fees, 

however. 

For advisory fees, sections 15(a) and 15(c)13 charge the board of directors 

with the responsibility for evaluating the adviser's contract with the investment 

"Burks v. Lasker, 441 U.S. 471,484 (1979). 

I2Related conflicts may arise in connection with dividing the benefits of any economies of scale 

that may be generated as the assets of the company increase. Advisory fees typically are 

calculated as a percentage of assets under management, although the cost of providing investment 

advisory services -- consisting largely of salaries and overhead -- is relatively fixed (i.e., a portfolio 

manager can manage $500 million nearly as easily as $100 million). An advisory fee that does not 

scale down as company assets increase consequently may yield enormous profits to the adviser, 

to the detriment of shareholders. 

1315 U.S.C. 55 80a-l5(a), -15(c). 

256 CHAPTER 7 
company and the compensation paid under the contract.14 The independent 

directors must separately evaluate and approve the advisory contract and any 

renewals of such contracts. Advisory contracts continuing in effect for a period 

of more than two years must be approved annual1 by either the full board or a 

majority of the company's outstanding shares? The full board has the 

authority to terminate the advisory contract at any time, but such authority is not 

expressly given to the independent directors.16 

Principal underwriting contracts are subject to similar board scrutiny. Such 

contracts and any renewals must be evaluated and approved by the independent 

dire~t0rs.l~ Multiyear contracts also must be approved annually by the board 

or by a majority shareholder voteJ8 

I4When section 15 was enacted in 1940, Congress and the Commission were not concerned 

with the magnitude of advisory fees. David Schenker, after discussing certain state laws that 

limited management and operating expenses to a percentage of assets, testified that: 

There is not a single provision in section 15 which even remotely assumes to fix 

what [advisers] should be paid in compensation . . . . We feel that is a question 

for the stockholders to decide. If they want to pay a man a million dollars to 

manage the fund and if they know they are paying him a million dollars and if 

they have the right to approve the payment of a million dollars, the bill says that 

is perfectly all right. 

Investment Trusts and Investment Companies: Hearings on S. 3580 before a Subcomm. of the Senate 

Comm. on Banking and Currency, 76th Cong., 3d Sess. 252 (1940) (statement of David Schenker, 

Chief Counsel, SEC Investment Trust Study). In the 1960's, the Commission began to examine 

the level of advisory fees. See SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF LNVEsTMENT 

COMPANY GROWTH, H.R. Rep. No. 2337, 89th Cong., 2d. Sess. 10-12, 69, 102-21, 126-27 (1966) 

[hereinafter PPI REPORT]. See also WHARTON SCHOOL OF FINANCE AND COMMERCE, A STUDY OF 

MUTLJAL FUNDS, H.R. Rep. No. 2274, 87th Cong., 2d Sess. 491-95 (1962) [hereinafter WHARTON 

REPORT]. The Commission concluded that the unique nature of the mutual fund industry made 

arms length bargaining impossible, that the marketplace consequently could not be relied upon 

to curb excessive fees, and that existing law did not adequately protect investors with respect to 

such fees. PPI REPORT at 12-13. The Commission thereafter recommended that the Act be 

amended to include a "reasonableness" standard for fees. This standard, however, was never 

adopted. In 1970, Congress enacted section 36(b) (15 U.S.C. 5 80a-35(b)), which imposes a 

fiduciary duty on advisers with respect to the amount of compensation received. See infra notes 

55-58 and accompanying text. Congress also enacted current section 15(c), which strengthened 

the ability of directors to carry out their responsibility for scrutinizing advisory contracts. 

Investment Company Act Amendments of 1970, Pub. L. No. 91-547, 84 Stat. 1413 (1970). 

15Section 15(a)(2), 15 U.S.C. 5 80a-l5(a)(2). 

'%ection 15(a)(3), 15 U.S.C. § 80a-l5(a)(3). 

17Section 15(c), 15 U.S.C. 5 8Oa-15k). 

"Section 15(b)(l), 15 U.S.C. 5 80a-l5(b)(l). 

Investment Company Governance 257 
The board also is required to review and evaluate asset-based distribution 

fees. Rule l2b-1'' permits open-end companies to use fund assets to pay for 

distribution expenses under a plan ("rule 12b-1 plan") approved and monitored 

by the directors. Rule 12b-1 plans, and any material amendments to the plan, 

must by approved by both the full board and the independent directors?' The 

independent directors also are empowered by rule 12b-1 to terminate the plan 

and any agreement related to the plan at any time?' 

Contracts covering ancillary services such as transfer agency, shareholder 

accounting, and custodial arrangements are not subject to express director or 

shareholder approval requirements under the Act.22 Because service contracts 

with affiliates of the adviser are within the plain language of section ?16(b):~ an 

investment company's board of directors likely would review any service contract 

between the company and the adviser's affiliate^.^^ 

-~ ~~ 

1917 C.F.R. 5 270.12b-1. 

2!Rule 12b-l(b)(2), -(b)(4), 17 C.F.R. 270.12b-l(b)(2), .12b-l(b)(4). 

21Rule 12b-l(b)(3)(iii), -(b)(3)(iv)(A), 17 C.F.R. §§ 270.12b-l(b)(3)(iii), .12b-l(b)(3)(iv)(A). 

the 1970's, the Commission considered whether some service contracts involving affiliates 

were joint transactions under section 17(d) and rule 17d-1. Notice of Proposal to Amend Rule 

17d-1 under the Investment Company Act of 1940 to Provide an Exemption from the Rule for 

Affiliated Persons with Respect to Certain Service Agreements with Investment Companies, 

Investment Company Act Release No. 8245 (Feb. 25, 1974), 39 FR 8935 (proposing conditional 

exemption from rule 17d-1). The Commission proposed that independent directors review 

administrative contracts in the same manner required for advisory contracts under section 15(c). 

The issue was never definitively resolved. See Investment Company Contracts for Services with 

Affiliated Persons; Withdrawal of Proposed Rule Amendment, Investment Company Act Release 

No. 10822 (Aug. 8,1979), 44 FR 47546 (withdrawing proposal). The Division has issued a number 

of no-action letters under sections 17(a) and 17(d) and rule 17d-1 on service contracts involving 

affiliates. See, e.g., Merrill Lynch Capital Fund, Inc. (pub. avail. Dec. 21, 1990). 

23See infra notes 55-58 and accompanying text. 

241ncreasingly, large investment company complexes are contracting with investment adviser 

affiliates for ancillary services. The need for board scrutiny and approval of such contracts is 

plain, especially when one considers that service fees may greatly exceed advisory fees. For 

example, during its 1991 fiscal year, the Prime Portfolio of Vanguard Money Market Reserves paid 

$837,000 for investment advisory services, $10.86 million for administration and operations, and 

$21.93 million for shareholder account maintenance. Vanguard Money Market Reserves, 1991 

Annual Report. 

258 CHAPTER 7 
2. Board Responsibilities Related to Operational Conflicts 

In addition to policing conflicts over fees paid to affiliates, investment 

company boards of directors also police a number of operational activities, some 

of which involve potentially serious conflicts. 

The Act and the Commission's rules give independent directors several 

specific responsibilities in this regard. For example, the independent directors 

select the company's independent public ac~ountants:~ oversee securities 

transactions involving affiliates to the extent such transactions are permitted by 

various determine annually whether participation in joint liability 

insurance policies is in the best interests of the companyF7 and review and 

approve fidelity bondsF8 They are also required to select and nominate 

individuals to fill independent director vacancies for a period of three years 

following the sale of an investment advisory c0ntract.2~ 

In other cases, the full board must approve operational a~tivities.~' For 

example, the full board values certain types of portfolio securities31 and sets the 

time of day at which net asset value is determined?2 With respect to a 

rmposed merger of two or more investment companies in the same complex, the 

board must determine that participation is in the best interest of the company and 

that the interests of shareholders will not be dil~ted.3~ The board annually 

2%ection 32(a)(l), 15 U.S.C § 80a-31(a)(l). 

26See, e.g., sections lO(f), 17(a), 17(e), 15 U.S.C 8Oa-lO(D, -17(a), -17(e), and rules lOf-3,17a-7, 

17e-1, 17 C.F.R. 270.1Of-3, .17a-7, .17e-1. 

27Rule 17d-l(d)(7), 17 C.F.R. § 270.17d-l(d)(7). 

28Rule 17g-1, 17 C.F.R. § 270.17g-1. 

29Section 16(b), 15 U.S.C § 80a-l6(b). 

3% addition to the operational responsibilities described in the text, the full board has 

concurrent responsibility with the independent directors with respect to the required oversight 

of affiliated transactions under rules 1Of-3, 17a-7, and 17e-1, and in making determinations 

concerning joint liability insurance under rule 17d-l(d)(7). 

31Under section 2(a)(41) (15 U.S.C. 80a-2(a)(41)), and rule 2a-4 (17 C.F.R. 5 270.2a-4), the 

directors are responsible for valuing portfolio securities and other assets for which market 

quotations are not readily available. Rule 2a-7 (17 C.F.R. 5 270.2a-7) requires money market fund 

directors to monitor both the valuation process and the credit quality of portfolio securities. 

32Rule 22c-l(b), 17 C.F.R. § 270.22c-l(b). 

33Rule 17a-8, 17 C.F.R. § 270.17~1-8. 

Investment Company Governance 259 
approves custody contracts with members of national securities exchanges, 

clearing agencies or book-entry systems, and foreign c~stodians.3~ It also makes 

determinations of credit quality with respect to investments in debt securities of 

issuers deriving more than fifteen percent of their revenues from securities-related 

a~tivities.3~ Finally, the board approves an investment company's code of ethics, 

which must be designed to prevent fraudulent, deceptive, or manipulative 

company insiders in connection with personal securities 

B. The Role of Shareholders 

As an additional safeguard against self-dealing by the investment adviser 

and underwriter, the Act accords voting powers to investment compan 

requires that, with limited exceptions, every share of investment company stock 

must "be votin stock and have equal voting rights with every other outstanding 

voting stock."3' As we discuss below, the Act and the rules thereunder also 

provide shareholders with specific voting rights and impose shareholder approval 

requirements in three general areas: imposition of fees, selection of shareholder 

representatives, and changes in an investment company's investment policies. 

Shareholder voting generally is not used to police operational conflicts. 

shareholders beyond those required by state corporate law. Section 18 8 

1. Shareholder Voting on Fees 

Advisory contracts and rule 12b-1 distribution plans must be approved 

initially by a majority of the investment company's voting ~hares.3~ Subsequent 

changes to the advisory contract, and amendments to the rule 12b-1 plan that 

34Rules 17f-1, 17f-4, and 17f-5, 17 C.F.R. 55 270.17f-1, J7f-4, .17f-5. 

35Rule 12d3-l(b)(5), 17 C.F.R. 5 270.12d3-1@)(5). 

36Rule 17j-1, 17 C.F.R. $? 270.17j-1. 

3715 U.S.C $? 80a-18. 

38Section 18(i), 15 U.S.C. 5 SOa-lS(i). The primary exception is for investment companies 

organized in series, with each series representing interests in a single portfolio of securities. 

Section 18(f)(2), 15 U.S.C. 5 80a-l8(f)(2). 

39Section 15(a), 15 U.S.C. 5 80a-l5(a), and rule 12bl(b)(l), 17 C.F.R. 5 270.12bl(b)(l). 

Shareholders are also required, under section 15(a)(3) and 15(a)(4) respectively, to approve a new 

advisory contract following the board's termination of an advisory contract and to approve any 

assignment of the advisory contract. Under rule 15a-4, this vote must occur within 120 days after 

the board termination or the assignment. 17 C.F.R. § 270.15a-4. Shareholders, by a majority vote, 

also may terminate the advisory contract on their own accord. Section 15(a)(3). 

260 CHAPTER 7 
would materially increase the amount spent for distribution, also must be 

approved by shareholders!' 

2. Shareholder Voting on the Election of Shareholder 

Representatives 

The Act requires that shareholders elect a board of directors. Section 16(a) 

generally prohibits any person from serving as a director of a registered 

investment company unless elected by a majority of the investment company's 

voting shares. An exception to this requirement, however, permits vacancies in 

the board to be filled in "any otherwise legal manner" if, after the vacancy is 

filled, at least two-thirds of the directors are shareholder-elected?l In addition, 

under section 16(b), shareholders are required, with certain exceptions, to elect 

independent directors for a period of three years following the assignment of an 

investment advisory contract, if the vacancy occurs in connection with the 

adviser's reliance on the safe harbor provided by section 15(f)(1)(A)?2 

Shareholders also are required to ratify the selection of public accountants 

previously made by the independent directors, but only if an annual meeting of 

shareholders is held!3 If no annual meeting is held, the selection of auditors 

is left to the discretion of the independent directors. 

3. Shareholder Voting on Changes in Investment Company 

Investment Policies 

Taken together, sections S(b)44 and 13(a)45 effectively require an 

investment company to adopt fundamental policies with respect to certain key 

40Section 15(a), 15 U.S.C. 5 80a-l5(a), and rule 12b-l(b)(4), 17 C.F.R. 5 270.12b-l(b)(4). In 

addition, either shareholders or the board must annually approve multiyear advisory and 

principal underwriting contracts. Sections 15(a), (b). Typically, the board approves such contracts, 

rather than shareholders. 

41Section 16(a), 15 U.S.C. 5 80a-l6(a). 

%ection 15(f)(l)(A) permits an investment adviser to receive compensation for the assignment 

of an investment company's advisory contract if, among other things, 75% of the board is 

comprised of independent directors for three years following the assignment of an investment 

advisory contract. 15 U.S.C. 5 80a-l5(f)(l)(a). 

'@Section 32(a)(2), 15 U.S.C 5 80a-31(a)(2). 

4415 U.S.C § 80a-8Cb). 

4515 U.S.C 9 80a-l3(a). 

Investment Company Governance 261 
investment activities, which policies are changeable only by shareholder vote.& 

Section 8(b) requires an investment company to file a registration statement with 

the Commission reciting, among other things, its policies as to classification and 

subclassification under the Act, borrowing money, issuance of senior securities, 

engaging in the business of underwriting, concentration, purchase and sale of real 

estate and commodities, making loans to other persons, and portfolio turn0ver.4~ 

The company also must recite all investment policies that are changeable only by 

shareholder vote48 and all policies the company deems f~mdamental.4~ 

Section 13 complements section 8(b) by prohibiting an investment company 

from changing investment and other policies absent a shareholder vote. It 

requires shareholder approval where a company: (1) changes its subclassification 

as an open-end or closed-end company or changes from a diversified to a nondiversified company:' (2) borrows money, issues senior securities, underwrites 

securities issued by others, purchases or sells real estate or commodities, or makes 

loans to other persons, except as stated in the recital of policy set forth in the 

company's registration ~tatement;~' (3) deviates from the concentration policy 

set forth in its registration statement;52 (4) deviates from any investment policy 

that is changeable only by shareholder vote or that is a fundamental policy under 

section 8(b)(3);53 or (5) changes the nature of its business so as to cease being an 

investment c0mpany.5~ 

461n general, the activities that must be governed by a fundamental investment policy deal 

with those elements of capital structure, permissible investments, and investment strategies that 

significantly affect the investment characteristics and the risk-reward profile of the securities 

issued by an investment company. The fundamental policy requirements of the Act have 

remained unchanged for 50 years, although there has been a steady accretion of Commission and 

Division interpretations of their applicability to new investment instruments and techniques. 

47Section 8(b)(l). Each recital of policy must contain a statement as to whether the registrant 

reserves freedom of action to engage in such activities, and, if so, the intended extent of that 

engagement. Id. 

48Section 8(b)(2), 15 U.S.C. 5 80a-8(b)(2). 

49Section 8(b)(3), 15 U.S.C. 5 80a-8(b)(3). 

50Section 13(a)(l), 15 U.S.C. 5 80a-l3(a)(l). 

51Section 13(a)(2), 15 U.S.C. 5 80a-l3(a)(2). 

5%ection 13(a)(3), 15 U.S.C. 5 80a-l3(a)(3). 

%Id. 

5%ection 13(a)(4), 15 U.S.C. 5 80a-l3(a)(4). 

262 CHAPTER 7 
4. Shareholder and Commission Actions under Section 36(b)55 

As a final measure of protection for investment company shareholders 

against fee-related conflicts of interest, section 36(b)56 imposes, as a matter of 

federal law, a fiduciary duty on the investment adviser to a registered investment 

company with respect to the amount of compensation the adviser and its affiliates 

receive from the company and its ~hareholders.5~ The provision, enacted in 

1970, is designed to provide an effective means for either the Commission or 

private shareholders to challenge excessive fees in a judicial forum. Both the 

Commission and any shareholder are authorized to bring an action for breach of 

this duty against the adviser, affiliated person of the adviser, or any other person 

listed in section 36(a) who has a fiduciary duty with respect to such 

111. The Debate over the Current Governance System and 

Recommendations for Reform 

There has been long-running and multifaceted debate over the efficacy of 

the system of investment company governance mandated by the Act. The debate 

has included such issues as whether the current system achieves the goal of 

effectively policing conflicts of interest; whether it costs too much for the results 

it achieves; whether the required structure has impeded the internationalization 

of the investment company industry and impeded the competitiveness of United 

States investment companies in the global market; and whether alternative 

regulatory structures could streamline governance requirements and fee structures 

without sacrificing investor protection. In this section, we discuss the most 

significant issues raised by both critics and proponents of the current investment 

%ection 36(b), 15 U.S.C. § 80a-35(b). 

56Because section 36 is somewhat peripheral to governance issues, we only summarize its 

requirements here. Chapter 8 discusses section 36 more extensively. 

57The fiduciary duty imposed by section 36b) is unique in that it relates to the compensation 

received for performing fiduciary functions, and not the performance of those functions. The 

provision encompasses compensation for services or payments of a material nature paid by the 

investment company or its shareholders. This includes not only advisory fees, but any material 

fees the adviser or its affiliates receive for non-advisory services. Rule 12b-1 fees and service fees 

paid to affiliates of the adviser consequently are subject to section 36(b). Sales loads are excluded, 

however. Section 36(b)(4). 

%Persons listed in section 36(a) include officers, directors, members of an advisory board, 

investment advisers, depositors, and principal underwriters. Such persons may be defendants in 

an action under section 36(b) only if they received compensation from the investment company. 

Damages are limited to actual damages and cannot exceed the amount of compensation received. 

Section 36(b)(3). 

Investment Company Governance 263 
company governance system and set forth our recommendations for reform, first 

with respect to the role of directors and then with respect to shareholder voting. 

A. The Debate over the Appropriate Role for Directors 

Critics of the role assigned by the Act to investment company directors, 

and particularly the independent directors, believe that because an investment 

company is a creature of its sponsor/adviser, it is difficult for directors to provide 

effective 0versight.5~ Because an investment company usually is managed by 

its sponsor or an affiliate, they argue, the independent directors are not truly 

independent, and have little choice but to approve the fee levels that the adviser 

deems necessary to operate the company and market its shares?’ They cite 

court cases and Commission decisions where independent directors have not 

successfully challenged or even attempted to challenge certain management 

actions that allegedly violated the Act‘s self-dealing prohibitions?* These critics 

also point out that independent directors almost never fire the adviser, and while 

they sometimes negotiate a fee rate below that proposed by the adviser, the 

amount of the reduction is usually 

59S~~h criticisms are not new. For example, the WHARTON REPORT observed that: 

[Wlith the selection of directors in the hands of a control group affiliated with the 

investment adviser, and where the board is typically outside the sphere of active 

management of the investment company, there is some question about the extent 

to which reliance can be placed on the independent directors to safeguard 

adequately the rights of shareholders in negotiations between the investment 

company and the investment adviser. 

WHARTON REPORT, supra note 14, at 8. 

6-here is some contention that the increased responsibilities assigned to independent directors 

by Congress and the Commission may have caused those directors to become even more 

susceptible to control by the adviser. The theory is that as directors’ salaries increase to reflect 

their increased responsibilities, their capacity for independence may diminish. This impairment 

may occur even if the directors are paid by the investment company, rather than (as was 

historically the case) by the adviser, particularly if the directors depend on compensation from 

the company. In such circumstances, the adviser’s control of the proxy machinery, which in turn 

affects the directors’ reelection, may hinder the ability of the independent directors to perform 

their duties with appropriate detachment. See Tamar Frankel, Money Market Funds, 14 REV. SEC. 

REG. 913,915 n.18 (May 20,1981). 

%ctor Brudney, The Independent Director -Heavenly City or Potemkin Village?, 95 HARV. L. REV. 

597 (1982). 

62See, e.g., Werner Renberg, Sixth Men or Fifth Wheels: Do Fund Directors Earn Their Paychecks?, 

BARRON’S, Aug. 12, 1991, at M14. 

(continued. ..I 

264 CHAPTER 7 
Supporters of the current role of investment company boards disagree. In 

their view, the conflicts presented by an externally managed entity make it 

uniquely appropriate that independent directors of investment companies take an 

active role in their governance. They assert that investment company 

shareholders need the protections provided by a third party monitor and that 

neither the Commission staff nor the market is capable of replacing the board in 

that r0le.6~ These observers generally approve of the long-term trend toward 

a stronger role for the independent directors, believing that many independent 

directors have developed a high level of expertise and have proved effective as 

monitors for shareholders. They point out that the investment companies have 

prospered under the current regulatory system, and have not experienced the 

abuses and mismanagement that recently have plagued other financial 

institutions. With respect to oversight of fees, they cite the success of defendants 

in section 36@) fee litigation as evidence that the independent directors generally 

perform well in their review of advisory contracts and rule 12b-1 distribution 

plans. 

Some industry observers agree that the independent directors are generally 

effective in their role as watchdogs for shareholders, but caution that 

improvements are needed to ensure their continued effectiveness. They believe 

that independent directors are unnecessarily burdened by requirements to make 

determinations that call for a high level of involvement in day-to-day activities 

requiring directors to "micro-manage" operational matters or to make detailed 

findings of fact. They also express concern about requirements that independent 

directors conduct reviews and make findings with respect to matters that have 

become routine or that involve virtually no discretion. In their view, these 

formalistic requirements unnecessarily clutter board meetings, making it difficult 

for directors to devote their time and attention to areas where they can exercise 

their business judgment most fruitfully. 

62(...continued) 

In a recent section 36(b) lawsuit over the fees charged a fund, the trial judge noted that the 

independent directors had persuaded the adviser to accept a $250,000 cut in $56 million of fees 

and commented that they "had performed their responsibilities in a conscientious and careful 

manner." Kalish v. Franklin Advisers, Inc., 742 F, %pp. 1222,1249 (S.D.N.Y. 19901, affd, 928 F.2d 

590 (2d Cir.), cert. denied, 112 S. Ct. 75 (1991). 

%'roponents of the current system also point out that current governance arrangements 

require the adviser to go through an extensive and ongoing process of preparing information for 

directors to keep them informed. They argue that this process is beneficial because it compels the 

adviser to address and resolve issues that might otherwise not even be raised and increases the 

likelihood that operational problems will be identified at an early stage, when they can be most 

easily resolved. Perhaps more important, when mistakes or violations of law do occur, the 

independent directors are able to exert pressure on the adviser to act in the best interest of 

shareholders, whether that entails prompt and full disclosure of the problem, reimbursement of 

the investment company so that shareholders are "made whole," or other remedial action. 

Investment Company Governance 265 
B. Recommended Reforms of the Role of Directors 

After examining the current governance requirements of the Act as they 

relate to the role of directors, the various criticisms of those requirements, and 

proposals for reform, we have concluded that the corporate regulatory structure 

embodied in the Act is fundamentally sound. It nonetheless can be streamlined 

and improved by changes to both the structure and the responsibilities of 

investment company boards of directors. 

Our recommendations concerning the role of directors are premised on two 

beliefs. First, we believe that the investment company governance system works 

best when the functions required of independent directors are performed by 

individuals who are truly independent. Measures that enhance the independence 

of independent directors, if they can be undertaken without undue expense, are 

consequently desirable. 

Second, we believe that independent directors perform best when required 

to exercise their judgment in conflict of interest situations -- for example, when 

they review advisory contracts under sections 15(c) and 36(b) or review the use 

of affiliated brokers under rule 17e-1. We believe that independent directors are 

unnecessarily burdened, however, when required to make determinations that call 

for a high level of involvement in day-to-day activities. Rules that impose specific 

duties and responsibilities on the independent directors should not require them 

to "micro-manage" operational matters. To the extent possible, operational 

matters that do not present a conflict between the interests of advisers and the 

investment companies they advise should be handled primarily or exclusively by 

the investment adviser. Similarly, information gathering should be left to the 

adviser, the investment company's auditor, counsel, or outside consultants, as 

appropriate under the circumstances. Finally, in order to allow directors to 

devote their time and attention to truly important matters, we believe that 

provisions that require directors to conduct reviews and detailed make findings 

that involve more ritual than substance should be eliminated. 

1. Structural Changes to Enhance Board Independence 

Section 10(a) provides that at least forty percent of the board of directors 

of a registered investment company must consist of independent directors. We 

recommend that this section be amended to require that more than fifty percent 

266 CHAPTER 7 
of the directors be independent6* and, as is now required for funds that have 

rule 12b-1 plans, that they be self-nominating. 

The primary reason for this recommendation is the trend in investment 

company regulation toward an increase in the oversight and policy 

responsibilities of independent investment company directors. Over the past two 

decades, the Commission, in a series of exemptive rules, has placed increasing 

reliance on boards of directors to monitor investment company operations. Our 

recommendation in Chapter 12 that rule 17d-1 be amended to allow investment 

company directors to approve certain types of joint transactions with remote 

affiliates would mark another step in this direction. We believe that an increased 

measure of independence is necessary65 to allow independent directors to 

perform these responsibilities 

Our recommendation to require that a majority of investment company 

directors be disinterested is also consistent with a trend in large industrial or 

@The original Senate bill that culminated in the Act would have required that a majority of 

investment company directors be independent. See S. 3580, 76th Cong., 3d Sess. ,§ 10(a) (1940). 

That provision was changed in the House bill to a 40% requirement out of fear that a board with 

an independent majority would repudiate the recommendations of the adviser, depriving 

investment company shareholders of the benefits of those recommendations. Obviously, 

experience has proven this fear to be unfounded. 

650~r concern is that in some situations disinterested directors may not be able to act with 

genuine independence in addressing conflict of interest situations because of direct or indirect 

influence by the adviser. The requirements that boards have a majority of independent directors 

and that independent directors be self-nominating are intended, in an environment where the role 

of independent directors has expanded significantly, to increase the likelihood that an investment 

company's directors would be able to act independently of management. 

The requirement of an independent majority might make a voting difference, for example, 

in the statutory procedures for terminating an advisory contract. While the advisory contract and 

any annual continuances must be approved by the independent directors, it may be terminated 

only by the board as a whole or by a majority vote of shareholders. Section 15(a)(3). We also 

believe that having an independent majority may improve the dynamics of the decision-making 

process. 

661mplementation of independence-enhancing measures might also benefit directors in 

litigation alleging breaches of fiduciary duty under section 36. In considering whether 

independent directors have carried out their responsibilities, courts have focused on the degree 

of independence of the directors, as well as whether their decisions were made in a reasonable 

and informed manner. See, e.g., Tannenbaum v. Zeller, 552 F.2d 402,418-19 (2d Cir.), cerf. denied, 

434 U.S. 934 (1977) (decision by board of directors not deemed a violation of their fiduciary 

obligations where independent directors "(1) were not dominated or unduly influenced by the 

investment adviser; (2) were fully informed by the adviser and interested directors of [possible 

alternative courses of action]; and (3) [were]. fully aware of this information, [and] reached a 

reasonable business decision . . . after a thorough review of all relevant factors"). 

Investment Company Governance 267 
commercial companies, which do not have the unique structural conflicts faced 

by investment companies. Many of these companies (and their institutional 

shareholders) have recognized that having at least a majority of outside directors 

greatly improves the governance process, and consequently have found it 

appropriate to increase the number of outside directors on their b0ards.6~ It 

would be anomalous if investment companies had boards with proportionately 

fewer independent directors than most large industrial companies. 

Finally, we believe that the change to require that a majority of investment 

company boards be composed of independent directors could be accomplished 

at a relatively small cost. Indeed, many, if not most, major investment company 

complexes already have boards with independent majorities!' 

We also considered, but do not recommend, requiring investment 

companies to provide independent directors with their own staff or c0unsel.6~ 

While we recognize that a separate staff and counsel may be beneficial to 

independent directors and benefit investment company Shareholders, and that, in 

some circumstances, separate staff and/or counsel may be necessary for the board 

properly to perform its responsibilities under the Act, we also believe that 

independent directors are capable in many situations of making appropriate 

determinations without such assistance. We consequently conclude that the cost 

of requiring separate staff or counsel in all cases is not justified. 

2. Addition of Authority for Independent Directors to Terminate 

Advisory Contracts 

Although independent directors are required to approve advisory 

contracts7' and rule 12b-1 plans:* and have authority to terminate rule 

67According to an annual index of 100 large corporations compiled by SpencerStuart Executive 

Search Consultants, the number of boards with a 4-to-1 or greater ratio of outside to inside 

directors has doubled to 40; and the number of inside directorships has fallen 30%. Only 5 of the 

100 companies in the survey still have a majority of inside directors, down from 19 companies a 

decade ago. Timothy D. Schellhardt, More Directors me Recruited From Outside, WALL ST. J., Mar. 

20, 1991, at B-1. 

68See Lipper Director's Analytical Data Vol. 1, Sec. V, 321-424 (4th ed. 1991). 

69See Letter from Francis X. Cain to Jonathan G. Katz, Secretary, SEC (Sept. 17,1990), File No. 

S7-11-90. 

70Section 15(c), 15 U.S.C. 5 80a-l5(c). 

71Rule 12b-l(b)(2), 17 C.F.R. 5 270.12b-l(b)(2), 

268 CHAPTER 7 
12b-1 

contracts. Only the full board or the shareholders can take such an action.73 

they have no explicit autonomous authority to terminate advisory 

Because we see no principled basis for this distinction, and because we 

believe that it is important for independent board members to have separate 

authority to protect shareholder interests by terminating an advisory contract, the 

Division recommends that section 15(a)(3) be amended to so provide. 

3. Board Review and Approval of Service Contracts with 

Affiliates of the Adviser 

We also have considered the advisability of adding an explicit statutory 

requirement that independent board members review and approve, and have the 

power to terminate, service contracts with affiliates of the adviser. While we 

believe that scrutiny of service contracts with affiliates is an essential board 

function, we have concluded that it is not necessary to amend the Act to explicitly 

so require. In our view, the potential for section 36(b) liability by itself provides 

adequate incentive for board scrutiny in this area. While the parameters of what 

constitutes a breach of the fiduciary duty imposed by section 36(b) might be 

ambiguous in other contexts, we believe that liability with respect to service 

contracts with adviser affiliates may be established more easily. Proof that the 

investment company paid affiliates higher fees than outside contractors for the 

same services would go a long way toward establishing such liability, although 

comparing the quality of services provided may not always be straightforward. 

4. Elimination of Formalistic Requirements under Existing Rules 

As discussed above, the Division recommends elimination of a number of 

rule provisions that make independent directors responsible for detailed findings 

of fact or for reviews and findings that involve more ritual than substance. 

a. Rule 12d3-1 

Rule 12d3-174 requires directors to determine that any debt security of an 

issuer that in its most recent fiscal year derived more that fifteen percent of its 

gross revenues from securities-related activity be "investment grade" to be eligible 

for investment by the company. We believe that determination of credit quality 

in this particular context does not present a conflict between the interests of the 

72Rule 12b-l(b)(3)(iii), 17 C.F.R. 5 270.12b-l(b)(3)(iii). 

"Section 15(a)(3), 15 U.S.C. § 80a-l5(a)(3). 

7417 C.F.R. 5 270.12d3-1. 

Investment Company Governance 269 
investment company and its adviser, and thus is better left to a company's 

adviser.75 The Division consequently recommends that the requirement for a 

board determination of credit quality be eliminated. 

b. Rules 10f-3,17a-7, and 17e-1 

Rules 1Of-3, 17a-7, and 17e-1 require both the full board and the 

independent directors to oversee securities transactions with affiliates, to the 

extent that such transactions are permitted. Each of these rules allows affiliated 

transactions that otherwise would be prohibited under the Act to go forward, 

subject to the conditions or standards specified in the rule. Under each rule, the 

full board and a majority of the independent directors each must initially adopt 

procedures designed to assure that all relevant conditions and standards have 

been satisfied, review the procedures at least annually for "continuing 

appropriateness," and determine at least quarterly that all relevant transactions 

have complied with the established proced~res.~~ 

We believe that fixed annual review of operating procedures is unnecessary 

and recommend these rules be amended to delete this requirement. Each rule, 

however, should make clear that the full board and the independent directors 

continue to be concurrently responsible to review and update procedures 

whenever necessary. All other responsibilities imposed on the directors by these 

rules should be retained. 

c. Rule 17f-5 

Rule 17f-577 requires directors annually to approve foreign custody 

arrangements after considering numerous legal matters, country risk factors, and 

factors relating to the particular foreign custodian. Because we believe that the 

selection and monitoring of foreign custodians does not present major conflicts 

between the investment company and the adviser, we recommend that rule 17f-5 

be revised to limit the role of directors to one of general oversight of business 

decisions made by the adviser and the primary c~stodian.~' 

75-rhis rule does not allow for the purchase of a security issued by the adviser or one of its 

affiliates. 

76Rules 10f-3(h), 17a-7(e), 17e-l(b), 17 C.F.R. §§ 270.10f-3(h), .17a-7(e), .17e-l(b). 

n17 C.F.R. § 270.17f-5. 

7%everal commenters cited rule 17f-5 as a major source of frustration for directors. According 

to them, the rule is unduly burdensome and difficult to administer, and embroils directors in 

matters involving an inappropriate level of detail. They contend that independent directors have 

(continued.. .) 

270 CHAPTER 7 
We see two possible approaches that should be explored in rulemaking 

proceedings. One approach would be to revise the rule to make the adviser or 

the primary domestic custodian responsible for selecting and supervising foreign 

sub-custodians, under the general oversight of the board of directors. Also, or 

alternatively, the rule could be amended to require that the primary custodian 

provide appropriate indemnification protections for the investment company, 

d. Rule 17f-4 

Rule 17f-479 requires that directors initially approve and annually review 

arrangements involving the use of domestic securities depositories. We believe 

that annual review of such arrangements has become unnecessary. The use of 

domestic securities depositories has become an integral part of securities 

investing, and the dependability of depositories (for example, the 

Treasury/Federal Reserve Book Entry System and the Depository Trust Company) 

and of the depository concept in general has become well established. Thus, the 

Division recommends that rule 17f-4 be modified to require that directors approve 

securities depository arrangements initially, as well as any changes in such 

arrangements, while eliminating the annual review requirement. 

e. Rule 22e-1 

Finally, the Division recommends changes to rule 22c-1,8' which now 

requires the directors to approve at least annually the time of day for determining 

net asset value. In our view, annual approval is unnecessary. We recommend 

that the rule be revised to require that directors initially approve the time of day 

for determining net asset value and approve any change proposed by the adviser. 

The rule should clarify that directors continue to be responsible for reviewing the 

pricing time whenever necessary and for changing it in response to new 

developments (eg., evolution of twenty-four hour trading, or changes in the 

nature of the investment company's investments). 

78(...continued) 

a limited factual basis to make the legal, operational, political, and economic judgments required 

of them by the rule, particularly when numerous foreign banks and clearing agencies may be 

involved. Moreover, they argue, it is inappropriate to expect directors to review the enormous 

volume of material that is developed annually to demonstrate compliance with the rule. 

According to some commenters, in practice directors rely almost exclusively on analysis and 

recommendations from the adviser, counsel, or the investment company's primary custodian. 

7917 C.F.R. 5 270.17f-4. 

"17 C.F.R. 5 270.22~-1. 

Investment Company Governance 271 
C. The Debate over Investment Company Shareholder Voting 

Critics of the Act's shareholder voting requirements view voting as a 

superfluous exercise. According to this view, investment company shareholders 

need not vote on changes in investment policies, given that they are motivated 

to "hire" the investment company's investment manager precisely because they 

wish to delegate their investment decisions to the manager. They need not vote 

on investment advisory and distribution fees because if such fees are too high, 

they can "vote with their dollars" and not buy the product. Similarly, if a 

moderate fee rate is subsequently raised, or if investors otherwise become 

unhapp with an adviser's performance, they can "vote with their feet" and 

redeem. XI 

In addition, voting rights critics contend, and offer strong proof, that 

investment company shareholders are essentially passive82 In their view, the 

81Many critics of the Act's shareholder voting requirements -- including those who advocate 

implementation of the UIF -- contend that such requirements misconstrue the fundamental nature 

of the relationship between the sponsor and investors, which they believe is contractual. They 

argue that in such a relationship, investors should not be treated as owners. The argument that 

shareholder voting requirements should be eliminated, however, is not endorsed exclusively by 

those who would do so only in the context of the UIF or similar alternatives; some critics of 

voting rights have argued for the elimination of voting rights for all investment companies. See 

Richard M. Phillips, Deregulation under the Investment Company Act - A Reevaluation of the Corporate 

Paraphernalia of Shareholder Voting and Boards of Directors, 37 Bus. LAW. 903,908-910 (1982). Indeed, 

in 1982, when the Commission first requested public comment on the UIF concept, it also 

requested comment on the advisability of modifying the Act to enable all or certain types of openend investment companies to be organized and operated without shareholder voting. Advance 

Notice and Request for Comment on Mutual Fund Governance, Investment Company Act Release 

No. 12888 (Dec. 10, 1982), 47 FR 56509. While the UIF proposal received a lukewarm response 

from commenters, the proposal to eliminate shareholder voting received considerable support. 

The Commission did not take further action. 

**For example, critics point to the findings of the WHARTON REPORT, supra note 14, and the 

Commission's endorsement of those findings in the PPI REPORT, supra note 14. The WHARTON 

REPORT concluded that the Act's shareholder voting provisions appeared to be of "limited value" 

in governing the relationships between funds and their investment advisers and principal 

underwriters, and that "the very concept of shareholder control through the exercise of voting 

rights may be contrary to the realities of the mutual fund business." WHARTON REPORT at 7-8. 

The report attributed ineffectiveness of shareholder voting to "the wide diffusion of ownership 

. . . [coupled with] the redemption feature of mutual fund shares which facilitates exit from the 

fund as the normal outlet for dissatisfaction with management performance." Id. at 64. 

It is difficult to dispute the contention that investment company shareholders are passive. 

While in theory proxy voting should be an important mechanism through which shareholders 

express opinions and attempt to influence management, short of the more final step of 

redemption, in practice, investment company shareholders do not appear to use their vote to great 

(continued ... ) 

272 CHAPTER 7 

- 
typical investment company shareholder has neither the desire nor the ability to 

be an active owner and to digest the large amount of material that must 

necessarily be considered in order to make decisions on fee levels and investment 

policies. 

Advocates of voting rights for investment company shareholders argue that 

such rights are beneficial even assuming shareholders are passive. They contend 

voting is a fundamental characteristic of share ownership and provides a needed 

restraint on investment company management. While acknowledging both that 

investment company shareholders rarely disapprove management proposals, even 

those that would raise fees, and that proxy contests are practically non-existent 

for open-end companies,s3 they nevertheless maintain that voting rights play a 

useful role in opening channels of communication between investors and 

management and deterring management abuse. They also point out that 

shareholder voting gives the board additional leverage in negotiating with the 

adviser concerning matters that are of importance to shareholders. Finally, they 

point out that there are still disincentives to redemption -- including front end 

and deferred sales loads, redemption fees, and adverse tax consequences -- which 

may impose a significant cost penalty and may deter shareholders from 

redeeming. In their view, such disincentives make shareholder voting far from 

superfluous. 

Some voting rights proponents also argue that the costs of the shareholder 

voting process are de minimis. These commenters contend that the industry has 

responded rapidly to moves by certain states to adopt more liberal corporation 

laws and, as a result, the vast majority of investment companies are now 

domiciled in states that do not require them to hold an annual shareholders' 

meeting. They assert that most shareholders' meetings consequently are held to 

consider important matters such as an increase in the advisory fee rate, imposition 

82(...continued) 

effect. Many industry participants and observers have told the staff that investment companies 

often find it difficult to obtain a quorum, meeting attendance is usually sparse, and a vote 

outcome is almost never contrary to the wishes of management. 

s30ccasionally, however, investment company shareholders do vote against the 

recommendation of management. Recently, T. Rowe Price ("Price") recommended that six 

companies in its complex which invest abroad or in small company issues adopt a one percent 

redemption fee. Under the proposal contained in fund proxy statements, shareholddrs who 

redeem shares shortly after they are purchased (within either 6 or 12 months) would be assessed 

a fee in order to compensate the funds for extra transactions costs created by short-term trading. 

Fee proceeds would be kept by the fund. According to newspaper accounts, the proposals 

prompted an outpouring of letters to Price. When the votes were counted, shareholders approved 

the fees for four funds and rejected them for two others. Price decided not to ask the board of 

directors of any of the funds to implement the fees. Carole Gould, Mixed Reviews on Redemption 

Fees, N.Y. TIMES, May 12, 1991, sec. 3, at 14. 

Investment Company Governance 273 
of a rule 12b-1 plan or an increase in its fee rate, or revision of a fundamental 

investment policy; and that relatively few meetings are held solely to vote on 

routine matters such as election of directors or ratification of auditors.84 

D. Recommended Reforms of Investment Company Shareholder Voting 

Our analysis and recommendations concerning the appropriate role of 

shareholder voting in the regulation of investment companies are premised on a 

simple, but not easily applied, test. Do the benefits of statutorily required 

shareholder voting, both in the global sense and with respect to particular sections 

of the Act, outweigh its costs? Based on this analysis, we propose to eliminate 

several obsolete shareholder voting requirements, modify others to comport with 

the realities of modern day securities markets, and add an express voting 

requirement for changes in investment objective. 

1. The Costs and Benefits of Investment Company Shareholder 

voting 

There obviously are costs associated with the shareholder voting 

requirements imposed by the Act. These costs include the costs of proxy 

solicitation (such as legal and accounting fees incurred in connection with 

preparing proxy material and printing and mailing costs incurred in the 

distribution of such material), the cost of resolicitation if necessary in order to 

achieve a quorum, and the costs of holding annual or special meetings of 

shareholders . 

It is difficult to estimate the magnitude of these costs with any degree of 

accuracy, or even to extrapolate how those costs have changed over time.85 

~~ ~ 

84For example, the IDS Mutual Fund Group did not hold a regular meeting of shareholders 

for any of its funds over a three year period between 1988 and 1991. Letter from IDS Mutual 

Fund Group to Jonathan G. Katz, Secretary, SEC (Sept. 26,1990>, File No. S7-11-90 [hereinafter IDS 

Study Comment]; and telephone conference with Leslie Ogg, IDS General Counsel, updating 

information set forth in IDS Study Comment. 

851n comments responding to the Study Release, Lipper Analytical Services, Inc. provided the 

most detailed anaIysis of the costs of investment company governance, using data from 2,524 

investment companies for which current fiscal year data are available. Letter from Lipper 

Analytical Services, Inc. to Jonathan G. Katz, Secretary, SEC (Oct. 9, 1990>, File No. S7-11-90 

[hereinafter Lipper Study Comment]. These data, however, related primarily to the costs 

associated with independent directors. See infva notes 116-118 and accompanying text. With 

respect to shareholder voting, Lipper stated that "[wle do not have a way to identify the costs of 

proxy solicitation, but we can say with certainty that these costs have been reduced materially in 

recent years." Observing that changes in state law have enabled investment companies to reduce 

greatly the frequency of shareholder meetings, Lipper maintained that "the proxy solicitation of 

(continued ... ) 

274 CHAPTER 7 
Generally, however, the cost of shareholder voting undoubtedly has decreased 

significantly on a per-fund basis as a result of a 1986 Division interpretive 

position that the Act does not require annual meetings to elect directorss6 and 

related changes in state law following that pronouncement. Most significantly, 

at least five states (Delaware, Maryland, Minnesota, California, and 

Massachusetts) have business trust or special corporate law structures that have 

the effect of not requiring shareholder meetings other than those required by the 

A~t.8~ As of March 1991, over eighty-four percent of open-end investment 

companies were organized as Maryland corporations or Massachusetts business 

trusts.@ Thus, to a large extent, the costs of shareholder voting have been 

minimized by changes in state law?' 

Finally, we note that potential cost savings resulting from the elimination 

of shareholder voting would be significantly diminished by the continuing need 

to provide notice to shareholders of changes that are currently described in the 

proxy statement. In fact, it appears that proxy statement preparation, printing 

and mailing costs represent the bulk of the costs of shareholder voting. Because 

most shareholder voting requirements arise from significant changes in 

investment company operations, and because the Commission would 

undoubtedly require that shareholders be notified of such significant changes 

even if voting were eliminated, we do not believe that cost savings associated 

with eliminating shareholder voting would be appreciable. 

85(...continued) 

old which did no more than ask for a vote on directors and an approval of auditors is becoming 

an anachronism." 

86John Nuveen & Co. Inc. (pub. avail. Nov. 18, 1986). This no-action letter pointed out that 

section 16(a) expressly requires a meeting to elect directors only (1) for the initial board and (2) 

to fill vacancies if less than a majority of the board is elected by shareholders. The letter took the 

position that the necessity for annual meetings was generally a question of state law. 

87DEL. CODE ANN. tit. 12, § 3806 (Supp. 1990); MD. CORPS. & ASNS CODE ANN. § 2-501(b) 

(Supp. 1991); MI". STAT. 5 302A.431 (1991); CAL. COW. CODE § 60003) (West 1990); MASS. ANN. 

LAWS. Ch. 182 (Law. Co-op 1987). 

88Lipper Analytical Services, The'"Fom" Used by Mutual Funds to Organize State by State 

''Costs associated with shareholder voting requirements have also been lowered by the 

Commission's revision of proxy rule 14a-6(a), 17 C.F.R. § 240.14a-6(a), to eliminate the requirement 

that investment companies file preliminary proxy material with the Commission with respect to 

meetings at which only routine proposals will be considered. Proxy Rules; Amendments to 

Eliminate Filing Requirements for Certain Preliminary Proxy Material; Amendments With Regard 

to Rule 14a-8, Shareholder Proposals, Securities Exchange Act Release No. 25217 (Dec. 21,1987), 

52 FR 48977. 

(Mar. 1991) (survey prepared for the Investment Company Institute). 

Investment Company Governance 275 
Our views on the benefits of investment company shareholder voting 

straddle the middle ground between those who advocate voting rights and those 

who propose their elimination.” On the one hand, we believe that, at the very 

least, voting rights serve an important communicative and deterrent function, 

particularly in circumstances where there are impediments to redemption. 

Accordingly, we do not favor large-scale elimination of voting rights on issues 

that may have a major effect on investment company operations. We also agree, 

however, with those who advocate the elimination of shareholder voting rights 

that under the current structure voting is often a “ritualistic anachroni~rn.”’~ 

This is particularly true when the required voting relates to matters that have 

little relationship to investor protection concerns. 

2. Conclusions and Recommendations on Shareholder Voting 

Against this background, we have developed the recommendations 

described below. These recommendations are premised on the underlying belief 

that investors should continue to have the opportunity to vote on proposals that 

significantly alter the nature of the investment, and, in effect, require another 

investment decision on their part. We are also guided by the principle that voting 

requirements imposed by the Act should relate to matters that are of particular 

concern to investment company shareholders from an investor protection 

perspective, and should reflect the realities of modern securities markets. We 

consequently recommend that voting requirements that have become outdated 

and have no current bearing on investor protection concerns be eliminated or 

modified?’ Finally, in circumstances where there are no significant obstacles 

to redemption, we believe that shareholder voting requirements should be 

streamlined to the greatest extent possible.93 

9%Ve do not believe that the 

propose their elimination can be, 

argument between advocates of voting rights and those who 

or need be, finally settled. In our opinion, proponents of each -- 

position plausibly describe some, but not all, aspects of the operation of investment companies, 

and offer compelling arguments in support of their views. 

g’Phillips, supa note 81, at 910. 

921n each instance where we recommend that an existing voting right be eliminated, we expect 

to develop rules to require that shareholders receive equivalent information to that which they 

now receive in proxy statements. We believe that disclosure should be made at least after the fact 

with respect to all matters for which a vote is currently required. For certain matters, however, 

advance notice may be appropriate. 

93This premise is one of the bases for our recommendation concerning shareholder voting 

requirements in the context of the unified fee investment company (“UFIC”). See Chapter 8. 

While we believe that voting requirements should be streamlined for the UFIC, we are simply not 

convinced that it makes sense to eliminate all voting rights for that or any other type of 

(continued. ..) 

276 CHAPTER 7 
a. Voting Requirements That Should Be Eliminated 

i. Ratification of Investment Company Auditors 

The Division recommends repeal of the section 32(a) requirement that 

shareholders ratify the selection of investment company auditors if a 

shareholders’ meeting is held. While this is not a particularly costly requirement, 

in that it is imposed only in situations where a shareholders’ meeting is already 

being held, we believe that review of the adviser’s selection of the auditors is a 

task appropriately left to the board of directors in all cases, unless they seek 

shareholder ratification. 

ii. Initial Approval of Advisory Contracts and Rule 

12b-1 Plans 

The Division recommends that section 15(a) be revised to eliminate the 

need for a vote on the investment advisory contract by the initial shareholders. 

Currently, after the board of directors has approved the advisory contract, a 

management investment company that is still in its organizational stage holds a 

shareholders’ meeting so that those persons that have supplied the $100,000 seed 

capital required by section 14(a)94 can vote on the contract. In almost all cases 

this entails a meeting at which the sponsor, as initial shareholder, votes to 

approve an advisory contract it has negotiated with itself, or with its advisory 

affiliate. The purpose of such a “vote” is nonexistent and the outcome of such a 

“vote” is automatic. Occasionally, however, the initial capital is supplied by 

persons other than the sponsor. We believe that because these persons have 

voted with their dollars to accept investment advisory arrangements that have 

93(...continued) 

investment company. In our view, voting rights do serve a communicative and deterrent 

function. A decision to eliminate such rights might be justified only if it were demonstrated that 

significant cost savings would be achieved and that shareholders, having been informed of 

significant management decisions before they occur, would have an unrestricted ability to redeem 

and invest elsewhere if they object to those decisions, (i.e., there are no disincentives to 

redemption). There has been no showing that the elimination of shareholder voting would result 

in significant cost savings. Indeed, given the changes in state law over the last decade, we think 

it unlikely that any such a demonstration could be made. In addition, while we acknowledge that 

for certain types of funds redemption is a cost free alternative to voting for many investors, we 

also believe that -- even for no-load funds -- there are disincentives to redemption (including tax 

consequences) for some investors. 

9415 U.S.C. § 80a-14(a). 

Investment Company Governance 277 
been disclosed to them, a separate vote on the advisory contract is largely 

red~ndant?~ 

The Division also recommends revising its interpretation requiring new 

mutual funds or new series of existing funds to hold a shareholders’ meeting 

during the first sixteen months of operations to allow the public shareholders to 

vote on the investment advisory contract and vote on any rule 12b-1 plan?‘ We 

agree with those who argue that this shareholder vote is unnecessary because 

investors in a newly organized fund or series have already voted with their 

dollars to accept these arrangements. We believe that a separate proxy vote is not 

necessary until management proposes that these arrangements be ~hanged.9~ 

b. Voting Requirements That Should Be Retained or Added 

As previously noted, we believe that shareholders of current investment 

companies should have the opportunity to vote on proposals that significantly 

alter the nature of their investment and proposals that are of particular concern 

from an investor protection perspective. Applying this standard, we first, and 

most importantly, recommend that sections 8(b) and 13(a) of the Act be amended 

to classify as fundamental a company’s investment objective. An investment 

company’s investment objective is one of its most defining attributes. A change 

in objective, for example, from income to capital appreciation (or vice versa) 

dramatically alters the nature of the shareholders’ investment, requiring in effect, 

a new investment decision. We believe that a change of this magnitude should 

be permitted only if it is authorized by shareholder vote. 

In addition, we recommend that there be no change in: (a) the current 

section 16(a) requirement that at least two-thirds of the membership of the board 

95Requiring shareholder approval of an advisory contract when a sponsor adds an additional 

series to an existing investment company is an equally meaningless ritual. In such situations, 

there is no initial capital requirement, and the new series usually issues a special “share” to the 

sponsor to enable it to approve the advisory contract for that series. 

96See Letter from Carolyn B. Lewis, Assistant Director, Division of Investment Management, 

SEC, to Registrants at 2 (Jan. 3, 1991). 

971n addition to the voting requirements discussed above, the Division also recommends that 

shareholders no longer be required to vote on a change in an open-end company’s fundamental 

investment policy regarding investments in real estate and underwriting securities issued by other 

persons, as is currently required by sections 8(b)(l) and 13(a)(2). The reason, however, is not that 

we view these rights as unimportant. Indeed, changes in these policies may significantly affect 

a fund’s liquidity and level of risk. Rather, we are recommending elimination of this requirement 

because in Chapter 11, we recommend the addition of an explicit statutory liquidity requirement, 

which would obviate the need for a shareholder vote on these issues. If this liquidity requirement 

is not implemented, the voting requirements should be retained. 

278 CHAPTER 7 
of directors consist of directors who have been elected by shareholder^;'^ (b) the 

requirement that increases in investment advisory fees and rule 12b-1 fees be 

subject to shareholder approval;99 (c) the requirement that shareholders vote on 

assignments of advisory contracts and on new advisory contracts following 

termination of an advisory contract by the board; (d) the current section 13(a)(4) 

requirement for shareholder approval of a change in the nature of business "so 

as to cease to be an investment company"; (e) the section 13(a)(l) requirement of 

shareholder approval for a change in an investment company's subclassification 

from "issuer-diversified" to "issuer non-diversified,"lo0 or a change in either 

direction from open-end to closed-end company; and (f) the section 13(a)(2) 

requirement of shareholder approval of changes in an investment compan 's 

fundamental investment policies for borrowing and issuing senior securities. yo1 

c. Voting Requirements That Should Be Modified 

The Division believes that several fundamental investment policy 

requirements imposed by sections 8(b) and 13(a) should be revised to comport 

more closely with the realities of today's financial markets. 

i. Lending 

Sections 8(b) and 13(a)(2) require that a registered investment company 

recite in its registration statement its policy with respect to "mak[ing] loans to 

other persons." This recitation of olicy currently must encompass the company's 

use of repurchase agreements,l' the lending of portfolio securities, and the 

purchase of privately-offered debt securities (collectively "security-based loans"). 

'&rhis requirement enhances the legitimacy of directors as shareholder representatives, and, 

because shareholder meetings are rarely commenced solely for the purpose of electing a director, 

is practically cost-free. 

99As discussed previously, however, we recommend eliminating these voting requirements 

lo0These terms would be substituted for the terms "diversified" and "non-diversified" that are 

for newly organized companies. 

now contained in sections 5(b)(l), 5(b)(2), and 13(a)(l). 

'"Section 18 limits the extent and the means by which investment companies may borrow or 

issue senior securities for the purpose of employing investment leverage. Within the limits set 

by section 18, these fundamental policies control the degree of investment leverage an investment 

company may undertake. A change in either policy may significantly change the risk-reward 

characteristics of the shareholders' investment. 

lmSee section 2(a)(23), 15 U.S.C. 5 80a-2(a)(23) ("'lend' includes a purchase coupled with an 

agreement by the vendor to repurchase; 'borrow' includes a sale coupled with a similar 

agreement"). 

Investment Company Governance 279 
The Division recommends that sections 8(b) and 13(a) be amended to narrow the 

scope of transactions included under this fundamental policy -- in particular by 

excluding "security-based loans." 

In our view, the inclusion of security-based loans in a policy designed to 

regulate loans to other persons ignores the realities of modern securities markets. 

In such markets, repurchase agreements are a standard short-term cash 

management technique; securities are commonly loaned on a short-term basis to 

earn extra income on portfolio assets; and institutional investors such as 

investment companies routinely purchase debt instruments that are not publicly 

offered. These transactions generally have no more than a modest effect on an 

investment company's overall risk or return. Consequently, while we believe that 

security-based loans should continue to be subject to substantive regulation to 

ensure that they are conducted in a prudent and responsible manner, we also 

believe that a continued requirement for shareholder approval of any change with 

respect to these activities serves no useful purpose. 

ii. Concentration 

The Division recommends several changes to the shareholder voting 

requirements for investment "concentration" in a particular industry or group of 

industries. As explained below, the net effect of our recommendations would be 

to treat "concentration" in the same way that the Act currently treats investment 

diversification among issuers, Le. to require a shareholder vote only when an 

investment company moves from being diversified to being non-diversified, but 

not the reverse. 

Under current law, a shareholder vote is required for an investment 

company to move into or out of "concentration" in a particular industry or group 

of industries. The Division currently interprets "concentration" as an investment 

of twenty-five percent or more of company assets in a single industry or group 

of industries. An investment company may not reserve freedom of action to 

move into and out of concentration in an industry. Thus, a company that 

specifies in its registration statement an intention to concentrate must invest at 

least twenty-five percent of its assets in the identified industry, unless it adopts 

a temporary defensive position in anticipation of a market decline. If the 

registration statement specifies no intention to concentrate, the company may not 

invest more than twenty-five percent of its assets in one industry. 

We believe that the current treatment of "concentration" as a fundamental 

investment policy is flawed in two major respects. First, it may prevent an 

investment company's adviser from reallocating portfolio assets among industries 

in a way that best reflects its analysis of current market conditions, even if such 

action would pose little or no risk to shareholders. In particular, we think that 

280 CHAPTER 7 
the current policy is flawed in requiring shareholder approval before the adviser 

can move the company from a more risky non-diversified position to a relatively 

less risky diversified position. Second, there is an issue of terminology or, 

perhaps, semantics. We are unaware of the term "concentration" being used 

anywhere outside the Act to describe the extent to which an investment portfolio 

is divided among issuers from different industries. Instead, portfolio managers 

and investors commonly refer to this portfolio attribute as "industry 

diversifi~ation."~~~ 

To cure these defects, the Division first recommends that section 8(b)(l) 

be amended to remove "concentrating investments in a particular industry or 

group of industries" from the list of fundamental investment policies and that 

section 13(a)(3) be amended corre~pondingly.~~~ Theeffect of this change 

would be to eliminate the requirement that shareholders approve a change in 

either direction in a company's "concentration" policy. Second, because we 

believe that the extent to which an investment portfolio spreads its investments 

among different industries is an important determinant of its level of risk, and 

that investors should be able to determine whether or not an investment company 

portfolio must be industry diversified, we recommend that (irrespective of 

difficulties in defining an industry) investment companies be required to label 

themselves with respect to portfolio diversification among industries in the same 

manner that they must currently label themselves with respect to portfolio 

diversification among issuers, i.e., as "industry diversified" or "industry nondiversified" investment companies.1°5 Finally, the Division recommends that 

lmIn addition to the defects described above, the current treatment of "concentration" suffers 

from problems of industry definition. There is no clear standard to determine what constitutes 

an "industry," much less "a group of industries." Indeed, as the boundaries between different 

industries erode and the trend toward corporate diversification and conglomeration continues, it 

is often difficult to fit companies into distinct industry categories (e.g., in which industry is 

General Electric?). Moreover, in many cases, an imaginative counsel can structure a concentration 

policy to provide the adviser with considerable freedom of action by defining particular industry 

groupings broadly or narrowly, as desired. We recognize that our recommendation does nothing 

to cure these problems. Under our proposal, however, industry definition would become less 

important because the adviser would have greater discretion to move from non-diversified to 

diversified status. 

'@?See Guide 19 to Form N-1 A, Registration Form Used by Open-End Management Investment 

105Currently, sections 5(b)(l) and (2) require an investment company to identify itself as 

"diversified" or "non-diversified" based upon whether it must invest in at least a minimum 

number of issuers. 15 U.S.C. 55 80aS(b)(l), -5(b)(2). We recommend adding new subsections (3) 

and (4) to section 5(b) that would, in a similar manner, require investment companies to label 

themselves as "industry diversified" or "industry non-diversified' investment companies. To avoid 

confusion, we also recommend revising the terminology used in sections 5(b)(l), 5(b)(2), and 

(continued. ..) 

Companies, Investment Company Act Release No. 13436 (Aug. 12,1983), 48 FR 37928,37962. 

Investment Company Governance 281 
section 13(a)(l) be amended to require shareholder approval for an investment 

company to change its classification from "industry diversified" to "industry nondiversified" status. This change would ensure that shareholders are given the 

opportunity to vote on a change in the composition of the investment company's 

assets that may significantly increase their level of risk.lo6 

IV. Alternative Governance Arrangements 

Disenchantment with the present investment company governance 

structure has led some to endorse radically simplified governance arrangements 

such as the unitary investment fund (ttUIFt)).107 Originally proposed in 

1980:08 the UIF is an alternative form of open-end management investment 

company whose structure is predicated on the belief that an investment company 

is a proprietary product, more suited to a contractual arrangement than to 

corporate democracy. Its advocates claim that the UIF's simplified governance 

and fee arrangements would be more flexible for the manager and more 

comprehensible to investors. 

To determine whether the UIF is a desirable or acceptable alternative to the 

traditional governance structure currently required by the Act, we examined a 

number of aspects of the UIF proposal and how they would affect the regulation 

105(...continued) 

13(a)(2) to refer to "issuer diversified" and "issuer non-diversified" investment companies. See supra 

note 100 and accompanying text. 

The 25% asset composition test that currently defines the "concentration" border under Guide 

19 to Form N-1A would continue to be used as the dividing line between "industry diversified" 

and "industry non-diversified" investment companies. 

IffiUnder our recommendation, the adviser of a company that elects industry non-diversified 

status thus would be free to move the company into and out of industry non-diversified status 

at any time while the adviser of a company that elects industry diversified status would be 

required at all times to invest less than 25% of portfolio assets in any single industry. Of course, 

the prospectus of an industry non-diversified investment company would have to identify the 

company's non-diversified status and describe the risk factors that accompany this status. 

Io7The Commission first requested public comment on the UIF in 1982. Inv. Co. Act Rel. 

12888, supra note 81. Most commenters opposed the UIF, based largely on concerns about the 

adequacy of investor protections for UIF investors and unresolved questions about how the 

concept would work in practice. In the Study Release, the Commission asked commenters to 

assess the TJIF in light of the numerous changes that have occurred in the investment company 

industry since 1982, including, most notably, the increasingly global nature of securities markets, 

and the increased complexity of fee structures and methods of paying for distribution. 

ImStephen K. West, Address at the General Meeting of the Investment Company Institute 

(May 1, 1980). 

282 CHAPTER 7 
? 

of investment companies. In particular, we analyzed whether the single fee 

structure would eliminate the need for the layers of fee review that exist today, 

whether the traditional governance structure is needed for other investor 

protection purposes, whether the UIF would result in any significant cost savings, 

and what impact the UIF would have on internationalization. 

We conclude that, although the UIPs approach to fees generally is sound 

and should be implemented with minor modification^^^^ there is no practical 

substitute for the oversight of boards of directors regarding investment company 

operations. Moreover, the cost savings of the UIF appear to be minimal, and we 

do not believe the UIF would facilitate internationalization significantly. 

A. The Original Unitary Investment Fund Proposal 

As proposed in 1980, the UIF would have the following key features: 

The UIF would be an optional form of investment company, similar 

in form to a trust, with a corporate trustee (the sponsor/manager), 

a trust indenture (which would spell out fundamental investment 

policies and the management fee), and investors holding interests 

in the trust. 

A single management fee would cover all expenses, except for 

extraordinary expenses and shareholder account services. The fee 

would be subject to a statutory maximum, which the Commission 

could increase by rulemaking. No limit would be placed on the 

percentage of the fee that could be used for distribution expenses. 

The UIF would have no board of directors or shareholder voting, 

nor would section 36(b) apply. 

During an initial period (perhaps five years) the indenture could not 

be amended without an exemptive order from the Commission. 

Thereafter, the sponsor could amend the indentwe at any time 

upon adequate notice to investors. Shareholders objecting to a 

change could redeem. 

The UIF would either be no-load or would refund the sales charge 

upon redemption in most situations. 

All section 17 prohibitions concerning transactions with affiliates 

would apply. Because there would be no board of directors to 

'@See Chapter 8. 

Investment Company Governance 283 
prevent the sponsor's brokerage affiliate from charging excessive 

commissions to a UIF, agency transactions with affiliates currently 

allowed under section 17(e) would be prohibited. 

(7) The UIF could not engage in activities that rely on rules or 

exemptive orders conditioned on director oversight unless 

mechanical rules or individual exemptive orders were substituted 

for such oversight.'" 

B. Investor Protection Issues 

Assuming that the single fee approach would be an adequate substitute for 

the current system of director, shareholder, and judicial review of fees, the 

question remains whether the corporate model is necessary for other investor 

protection purposes. We conclude that it is. In short, investment company 

shareholders should have certain protections provided by an independent third 

party monitor and, to a lesser degree, by shareholder voting. 

As previously discussed, under the Act and the rules thereunder, directors 

oversee investment company operations in many areas that do not involve 

fees?" While rejecting the notion that a board of directors is essential, UIF 

proponents offer no practical alternative for the board's oversight in these 

nor are we able to advance one. 

'"Since the time of the original proposal, a number of variations have been suggested. For 

example, some advocates of the UIF now take the position that even UIF shareholders should 

have voting rights. These commenters believe that a UIF sponsor should be able to recover 

distribution costs through front-end and contingent-deferred sales charges as well as through the 

asset-based fee paid by the UIF. Since a UIF would have no board of directors to review 

proposed fee increases and investment policy changes on behalf of shareholders, these 

commenters would require the sponsor to obtain shareholder approval of any such changes. 

Others, citing investor protection concerns, have recommended that any UIF structure retain 

independent directors to exercise oversight over the affairs of the company. Finally, although the 

original proposal included a statutory maximum fee that the Commission could increase through 

rulemaking, no pro-UIF commenters would retain this provision. Some UIF proponents, however, 

would continue to require that fee increases be subject to shareholder approval. 

ll'See supra notes 25-36 and accompanying text (describing board responsibilities). 

'12For example, some commenters suggested that, in most cases, matters currently reviewed 

by independent directors could be detailed in the trust indenture (e&, a money market fund's 

indenture could spell out the criteria that must be followed by the investment manager in order 

to comply with rule 2a-7 in the absence of board review), but no commenter provided any 

analysis of how the various rules that look to directors could be modified to operate without 

directors. See, eg., Letter from the Investment Company Institute to Jonathan G. Katz, Secretary, 

SEC at 31 (Oct. 5, 19901, File No. S7-11-90. 

284 CHAPTER 7 
The most obvious means of replacing the independent directors would be 

to substitute the trustee or custodian, in much the same way that a "depositary" 

is used in the European Council Directive of 20th December, 1985 on the 

Coordination of Laws, Regulations and Administrative Provisions Relating to 

Undertakin s for Collective Investment in Transferable Securities (the "UCITS 

Directive")j3 Under the UCITS Directive, a fund's depositary is supposed to 

act in a general oversight capacity for all fund operations. Such a change would 

not appear to create significant cost savings, however, since presumably a 

depositary would insist on some level of compensation, and as discussed below, 

the costs of the present structure are minimal. In the absence of demonstrable 

savings, we see no reason to substitute depositaries for independent directors, 

given the generally successful functioning of investment company boards. 

Another alternative, mentioned in the original UIF proposal, would be to 

substitute greater oversight and examination by the Commission. We believe, 

however, that this suggestion is unrealistic given fiscal constraints, and also is 

unlikely to result in any net cost savings. 

We are also concerned that the UIF would create unchecked incentives for 

advisers to cut corners on basic services to meet competitive pressures -- for 

example, by hiring the proverbial "shoebox" custodian. Even in the absence of 

competitive pressures, an unscrupulous adviser might be tempted to cut back or 

eliminate basic services to bolster its own profitability. This obviously is of great 

concern from an investor protection perspective. Without a third party monitor 

to oversee the level of services, investors would be virtually left to their own 

devices, but typically without the expertise, incentive or power to assess the 

quality of these services. 

Finally, we believe that, even in the context of a single fee arrangement, 

shareholder voting plays an important investor protection role in connection with 

a limited range of investment company operational activities such as investment 

company mergers, a change from closed-end to open-end, or a change in an 

investment company's investment objective. We consequently disagree with the 

contention that shareholder voting should be eliminated entirely in a UIF 

context?14 

113Counal Directive 85/611, 1985 O.J. (L375) 3. 

*I4F0r this reason, we recommend in Chapter 8 that certain shareholder voting rights be 

retained for the UFIC. 

Investment Company Governance 285 
C. Cost Considerations 

Proponents of the UIF argue that significant cost savings would result from 

its implementation as a consequence of a reduction in governance. After 

examining the issue and reviewing various estimates of cost savings submitted 

by commenters, however, we conclude that elimination of the corporate structure 

as adapted to investment companies would result in only minimal cost savings. 

As we have previously discussed, many of the cost savings that the UIF was 

designed to achieve have already been realized by changes in state laws since the 

UIF was first proposed.'l5 In our view, the principal savings from 

implementation of the UIF would result not from the elimination of the corporate 

structure per se, but from the elimination of the multilayered review and approval 

of various fees now required by the Act. 

Lipper Analytical Services, Inc. provided the most detailed analysis of the 

costs of investment company governance>16 Lipper concluded that, based on 

available data, the potential cost savings from eliminating the governance 

structure are de minimis. According to Lipper, the industry-wide dollar weighted 

average cost to shareholders of independent directors is 0.005%, or one-half of one 

basis point. In dollar amounts, the median director expense for an individual 

fund is $8,261; the mean expense $14,646; and the dollar weighted average 

$50,484. In percentage terms, the median director expense is 1 basis point, the 

mean 3.5 basis points, and the dollar weighted average 0.5 basis ~0ints.l'~ 

With respect to the legal expense of the independent director system, the median 

expense incurred for "professional fees" -- which often includes audit expenses in 

addition to legal fees paid by the fund -- is $30,000, according to Lipper. Dollar 

weighted "professional fee" expense as a percentage of net assets is 0.014%, or 

slightly less than 1.5 basis points. 

Thus, allowing for overstatement of legal expenses resulting from use of 

the "professional fee" data, Lipper estimates that total governance costs, including 

'15See supru notes 85-89 and accompanying text. 

'%ee Lipper Study Comment, supru note 85, at 1. Lipper identified the costs of current 

governance arrangements as including the fees and expenses of independent directors, the cost 

of proxy solicitation, the costs of counsel for the independent directors, and the costs incurred in 

preparing materials and reports for directors. As previously discussed, Lipper was unable to 

quantify the costs of proxy solicitation, but believed that such costs have been reduced materially 

in recent years as a result of changes in state laws. It did provide cost savings estimates with 

respect to all other cost components. 

'I7Cost calculations performed on the basis of median or average (mean) costs give more 

weight to the costs incurred by small companies than do calculations of dollar weighted average 

cost. Dollar weighted average cost, by giving more weight to large companies, better reflects the 

costs that most shareholders actually pay. 

286 CHAPTER 7 
the occasional mailing of proxy material, do not exceed two basis points for the 

typical investor. Compared with an average total expense ratio of 1.118% 

(approximately 112 basis points) for 2,731 funds (and median and dollar weighted 

average expense ratios of 0.950% and 0.767%, respectively), such costs are 

insignificant.l18 

D. The Impact of the UIF on Internationalization 

We also considered whether the UIF would facilitate efforts to provide a 

common legal framework for cross-border sales of investment company shares. 

We conclude that it would not significantly facilitate those efforts. 

In some ways, the UIF resembles the structure predominantly used in 

Europe, commonly known as the UCITS>19 Such similarity, however, does not 

necessarily lead to the conclusion that the governance structure established by the 

Act should be vitiated in an effort to promote internationalization. As one 

commenter models of investment company regulation outside the 

United States "were developed under different conditions and in different 

environments. Accordingly, they ma not be suitable for the domestic United 

States investment company industry. llY21 

'l8Two other commenters provided estimates of the costs of governance under current law. 

IDS Mutual Fund Group, put the costs of directors as a percentage of fund net assets at under 

three-tenths of a basis point (0.0028%) and estimated total governance costs of under one basis 

point. Total management and operating expenses for IDS funds in the last fiscal year were 74 

basis points (0.7400%). See IDS Study Comment, supra note 84, at 2. (The IDS investment 

companies are incorporated under Minnesota law, which does not require an annual meeting of 

shareholders, and did not hold shareholders' meetings for a three year period.) 

The independent trustees of the Scudder Funds stated that their annual compensation and 

other related expenses typically represent between one and two percent of a fund's total expenses. 

Letter from Non-Interested Trustees of Scudder Funds to Jonathan G. Katz, Secretary, SEC at 4 

(Oct. 9,19901, File No. S7-11-90. For a fund with annual expenses of two percent of assets8 or two 

hundred basis points, this means that the trustees cost between two and four basis points as a 

percentage of fund net assets. 

"'See supra note 113 and accompanying text regarding the UCITS. Both the UCITS model and 

the UIF contemplate a pool organized under a governing document setting forth the material 

aspects of the pool, including the rates of fee. In both instances, assets would be kept under the 

custody of an established financial institution. Under the UCITS model, however, the custodian 

could be affiliated with the pool sponsor. 

I2'Letter from Debevoise & Plimpton to Jonathan G. Katz, Secretary, SEC at 3 (Oct. 10,1990), 

File No. 57-11-90. 

'*'In England, for example, individuals are required to go through an extensive vetting process 

before being permitted to act as advisers. Once qualified, however, such advisers are subjected 

(continued. ..) 

Investment Company Governance 287 
Moreover, even if governance structures were more uniform, formidable 

barriers to internationalization would remain in the areas of taxation, distribution, 

marketing, and regulatory compliance. As discussed in Chapter 4, we believe that 

such barriers are best dealt with through amendments to section 7(d) of the 

Act122 and the Internal Revenue Code. 

E. Recommendations Concerning the UIF 

The TJIF has two predominant features: a single fee to cover all 

management expenses and the elimination of the governance structure required 

by the Act. Commenters generally have assumed that they are inextricably 

linked. We believe, however, that the link can and should be severed. As we 

discuss in Chapter 8, while competitive forces and ease of shareholder redemption 

may provide adequate discipline with respect to the single fee aspect of the UIF, 

they are clearly insufficient to police operational conflicts of interest. We 

therefore conclude that while the UIF as proposed should not be permitted, the 

single fee aspect of the UIF proposal has merit and should be implemented. 

However, governance protections, including board review of operational conflicts, 

should be retained for matters other than fees. 

121(...continued) 

to relatively minimal regulation. In contrast, in the United States, there is no such vetting process, 

but advisers are required to comply with the relatively extensive requirements imposed by the 

Act. 

lZ15 U.S.C. 5 80a-7(d). Section 7(d) prohibits a foreign investment company from using 

interstate commerce to offer its shares publicly, absent an order from the Commission. Under 

current law, such an order can be granted only if "by reason of special circumstances or 

arrangements, it is both legally and practically feasible effectively to enforce the provisions of [the 

Act] against such company and that the issuance of such order is otherwise consistent with the 

public interest and the protection of investors." In Chapter 4, we recommend that section 7(d) be 

amended to authorize the Commission to enter into bilateral regulatory memoranda of 

understanding that would create a framework for regulatory cooperation and mutual recognition 

of investment company regulation. We propose that section 7(d) further be amended to give the 

Commission greater flexibility to permit foreign funds to register in the United States and to 

clarify, in the absence of a public offering, when section 7(d) requires foreign funds to register. 

Under this recommendation, a UCITS might well qualify for registration and sale in the 

United States. We see no anomaly, however, in permitting such a vehicle to be sold in the United 

States while simultaneously refusing to implement the UIF. The harmonizing element of these 

two positions concerns both the protection and the expectations of investors. When investors 

purchase a domestic open-end fund, they expect and are afforded the protections of the 

governance system required by the Act. When investors buy a UCITS or other foreign fund that 

may qualify for sale under amended section 7(d), they will expect and will be afforded the 

protections provided by the laws under which such company operates - which must serve the 

same purposes as the protections provided by the Act -- or by specific conditions agreed to by the 

foreign company. The UIF provides neither the protections of the Act's governance requirements 

nor the similar protections of a foreign regulatory system. 

288 CHAPTER 7 
V. Conclusion 

The governance model embodied in the Act is sound and should be 

retained, with three limited modifications. First, the Division recommends certain 

changes that it believes will enhance the independence of investment company 

boards of directors without undue expense. In particular, we recommend that the 

minimum proportion of independent directors on investment company boards be 

increased from forty percent to a majority, that independent directors be given the 

authority to terminate advisory contracts, and that independent director vacancies 

be filled by remaining independent directors. 

Second, to focus the responsibilities of board members into areas where 

they perform best -- namely exercising business judgment in conflict of interest 

situations -- the Division recommends eliminating provisions in certain rules 

under the Act that make independent directors responsible for detailed findings 

of fact or for reviews and findings that involve more ritual than substance. 

Specifically, we recommend modification or elimination of the board’s functions 

in connection with rules 1Of-3, 12d3-1, 17a-7, 17e-1, 17f-4, and 22c-1. 

Third, to further streamline investment company governance, the Division 

recommends the elimination or modification of a number of voting requirements 

that we believe do not comport with the realities of modern securities markets 

and can no longer be justified on an investor protection basis. In particular, we 

recommend that investment company shareholders no longer be required to ratify 

the initial advisory contract and rule 12b-1 plan (if any) of a newly organized 

company, concur in the board’s selection of auditors, or approve changes in 

relatively routine investment policies. Conversely, however, because we believe 

that an investment company’s investment objective is a critical determinant of the 

potential risk and reward inherent in the shareholder’s investment, we 

recommend that a requirement be added to the Act that shareholders approve 

any change in investment objective. 

Finally, the Division recommends against implementation of the UIF 

because the Division believes that the UIF raises significant investor protection 

concerns, would not reduce costs substantially, and would not significantly 

promote internationalization. 

Investment Company Governance 289 
Chapter 8 

The Sale of Open-End Investment 

Company Shares 

I. Introduction and Summary of Recommendations 

Over the past fifty years, tremendous changes have taken place in how 

open-end investment companies, known as "mutual funds," sell their securities 

and in how the sales are regulated under the Investment Company Act'. The 

evolution of the current sales or "distribution" system reflects an ongoing search 

for the proper balance between competition and regulation. As distribution 

methods have changed, Congress and the Commission have had to examine the 

effectiveness of competition in a number of contexts. While Congress historically 

has preferred to rely on competition to check the level of investment company 

fees and expenses, Congress has substituted regulation where it determined 

effective competition was lacking. 

Today, as in 1940, the sale of fund shares is almost always contracted out, 

on an exclusive basis, to a "principal underwriter," which in most cases is the 

adviser itself or a close affiliate. Principal underwriters typically confine 

themselves to wholesale transactions and leave the public selling to independent 

retail dealers, under sales agreements. Some principal underwriters, eg., 

insurance companies that own advisers, have their own retail sales organizations 

sometimes referred to as "captive sales forces." Captive sales forces sell primarily 

funds the underwriter represents or other securities issued by the underwriter 

and its affiliates? Most retail dealers have contracts with numerous principal 

underwriters and sell the shares of many different funds simultaneously. 

In 1940, most investors paid a "sales load1I3 when they purchased shares, 

which was retained by the principal underwriter and the selling broker-dealer and 

no part of which was paid to the fund. The load was used to finance the 

underwriter's profit, the broker's commission, and other sales and promotional 

expenses. 

'Investment Company Act of 1940,15 U.S.C. 5 80a. 

*See, e.g., INVESTMENT COMPANY IN!TITUTE ("ICI"), 1991 MUTUAL FLJND FACT BOOK: INDUSTRY 

TRENDS AND STATISTICS FOR 1990, at 34-36 (1991) [hereinafter 1991 IC1 FACT BOOK]. 

3Sales load is defined as the difference between the public offering price paid by investors and 

the current net asset value per share received by the fund, less any portion of such difference 

deducted for administrative expenses not properly chargeable to sales or promotional activities. 

See Investment Company Act Q 2(a)(35), 15 U.S.C. Q 80a-2(a)(35). 

291 
This "front-end sales load" was and is expressed as a percentage of the total 

purchase or offering price.4 For example, if the current net asset value of a 

fund5 is $9.15 per share and the front-end sales load is 8.5%, the public offering 

price will be $10 per share. The $0.85 sales load per share is a markup of 9.3% 

on the $9.15 per share actually invested in the fund. 

In 1940, a small number of funds, called "no-load" funds, marketed their 

shares directly to the public, primarily through advertising, and did not charge 

sales loads. Their more limited sales expenses were paid by the funds' 

investment advisers or principal underwriters out of their own profits, 

As enacted in 1940, the Investment Company Act6 had few limits on the 

levels of sales loads or other fees. The Act included a general prohibition on 

unconscionable or grossly excessive sales loads, to be defined by a registered 

securities association, such as the National Association of Securities Dealers, Inc. 

("NASD")? The Act also required that advisory services and fees be stipulated 

in a written contract approved initially by a fund's shareholders and directors.8 

To prevent abusive trading practices that resulted from the "backward 

pricing" method used by funds before 1940: the Act required that all sales of 

registered investment company shares be made at a fixed offering price specified 

in the prospectus. The base price of a mutual fund is always derived from net 

asset value, so this requirement fixed the sales load component of the public 

offering price. Although this provision, section 22(d),1° minimized the identified 

41n contrast, sales commissions or markups in most securities transactions are expressed as a 

percentage of the net amount actually invested. 

?he offering pece of a mutual fund's shares is based on the fund's current net asset value, 

which is a term designating the excess of the value of portfolio securities owned, cash, receivables, 

and other assets of the fund over the liabilities of the fund. AMERICAN INSTITUTE OF CERTIFIED 

PUBLIC ACCOUNTANTS, AUDIT AND ACCOUNTING GUIDE: AUDITS OF INVESTMENT COMPANIES 209 

(3d ed., revised 1987). Funds must redeem their shares at net asset value, calculated daily. Rule 

22~-1, 17 C.F.R. fj 270.22~1. 

61nvestment Company Act of 1940, Pub. L. No. 76-768,54 Stat. 789 (1940). 

71a. Q 22(b), 54 Stat. 789,823 (codified as amended at 15 U.S.C. Q 80a-22(b)). The NASD is the 

only securities association registered under section 15A of the Securities Exchange Act of 1934, 

15 U.S.C. Q 780-3. 

'Investment Company Act of 1940, Pub. L. No. 76-768, Q 15/54 Stat. 789, 812 (codified at 15 

U.S.C. Q 80a-15). 

'See infra notes 39-43 and accompanying text. 

"15 U.S.C. fj 22(d). 

292 CHAPTER 8 
trading abuses, it also made lawful a system of retail price maintenance, 

eliminated all secondary market trading, and impeded price competition. Thus, 

the Act provided that the sale of mutual fund shares is exempt from normal 

antitrust law principles of free competition. 

In the 1960'~~ theCommission recommended greater regulation of sales 

loads and advisory fees because competition had not been an effective check on 

their levels.'' The Commission found that retail price maintenance, the external 

management structure of mutual funds, and a lack of investor sophistication and 

influence had all interfered with competition. In effect, mutual fund fees and 

charges had become insulated from both competition and regulation. 

In response, Congress imposed on advisers a fiduciary duty with respect 

to the receipt of compensation for services and also imposed on advisers a duty 

to furnish, and on directors a duty to evaluate, all information relevant to the 

review of advisory contracts.12 Congress considered repealing the retail price 

maintenance provision, section 22(d), but deferred action pending a formal 

Commission study. As an interim measure, Congress gave a registered national 

securities association rulemaking authority to prevent "excessive sales loads." 

Under this authority, the NASD has imposed an 8.5% cap on front-end sales 

10ads.l~ 

After study, the Commission did not recommend an immediate repeal of 

section 22(d), but instead recommended an administrative program to allow the 

retail price maintenance system to be replaced over time by competition. The 

administrative program sought to promote efficiencies in mutual fund distribution 

through a gradual introduction of limited forms of retail price competition, i.e., 

by relaxing rigid advertising rules and permitting more sales load ~ariati0ns.l~ 

"SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, H.R. 

REP. No. 2337,89th Cong., 2d Sess. 126-27,143-47,221-23 (1966) [hereinafter PPI REPORT]. The PPI 

REPORT drew upon a report by the Wharton School of Finance and Commerce on mutual funds 

requested by the Commission (WHARTON SCHOOL OF FINANCE AND COMMERCE, A STUDY OF 

MUTUAL FUNDS, H.R. REP. No. 2274,87th Cong., 2d Sess. (1962) [hereinafter WHARTON REPORT]), 

and a Commission staff report that examined, among other things, the way in which mutual funds 

were bought and sold (SEC, SPECIAL STUDY OF SECURITIES h.IARKETS, H.R. Doc. No. 95,88th Cong., 

1st Sess., pt. 4 (1963) [hereinafter 1963 SPECIAL STUDY]). 

l2Investment Company Act 55 15(c), 36031, 15 U.S.C. §§ 80a-l5(c), -3503). 

13See infru notes 109-110 and accompanying text. 

14SEC DIVISION OF INVESTMENT MANAGEMENT REGULATION, MUTUAL FUND DISTRIBUTION AND 

SECTION 22(d) OF THE INVESTMENT COMPANY ACT OF 1940 at 10-16 (1974) [hereinafter 1974 

DISTRIBUTION REPORT]. 

The Sale of Open-End Investment Company Shares 293 
In 1980, after much debate, the Commission adopted rule 12b-1, which 

permits funds conditionally to use their assets to make continuing payments to 

distributors and other sellers of fund sharesJ5 Funds that adopt rule 12b-1 

plans under the rule as a substitute for front-end sales loads typically assess 

charges that range today from 0.50% to 1.25% of average daily net assets to ay for sales commissions, "trail" commissions, and other distribution expenses. IF 

Shortly thereafter, the Commission issued the first of many exemptive 

orders allowing the deduction of contingent deferred sales loads ("CDSLs") upon 

emption of fund sharesJ7 CDSLs are "contingent" since they are paid only 

demptions that occur within a specified period after purchase and may be 

expressed as a percentage of either the original purchase price, or more typically, 

the redemption proceeds. Almost since rule 12b-1's inception, CDSLs have been 

used in combination with plans of distribution under the rule (a "spread load") 

as an alternative to high front-end sales loads. For example, instead of a fund 

charging a 6% front-end load, it could recoup roughly the same amount through 

a combination of an annual 1% rule 12b-1 fee and a CDSL of 6% that declined 1% 

per year until it reached zero at the end of the sixth year. CDSLs protect 

underwriters from early redemptions as the high initial outlays in commissions 

to a sales force are recouped over time through the rule 12b-1 fees. To some 

degree, spread loads have replaced high front-end loads, but they have also been 

criticized as "hidden loads" because they ermit funds to impose high sales costs 

without the visibility of front-end Idads. w 

1517 C.F.R. 5 270.12b-1. Rule 12b-1 was adopted in Bearing of Distribution Expenses by 

Mutual Funds, Investment Company Act Release No. 11414 (Oct. 28,1980), 45 FR 73898. 

"See Letter of the IC1 to Jonathan G. Katz, Secretary, SEC 21 (Sept. 19,1988)' File No. S7-10-88 

(responding to Payment of Asset-Based Sales Loads by Registered Open-End Management 

Investment Companies, Investment Company Act Release No. 16431 (June 13,1988), 53 FIX 23258) 

[hereinafter IC1 Rule 12b-1 Comment]. See also Lipper Directors' Analytical Data, Vol. I, Sec. 111, 

Table VI1 Study on 12b-1 Plans (1st ed. 1992). In addition to transaction-based sales commission 

payments, smaller "trail commissions" are often used to compensate broker-dealers and other 

sellers for ongoing sales and shareholder servicing efforts. They are generally assessed either 

separately as service fees or are part of rule 12b-1 fees. Under the NASD proposal to regulate 

asset-based sales loads, service fees would be limited to 0.25% of a fund's average daily net assets. 

See infra notes 145-148 and accompanying text. 

17E.F. Hutton Investment Series, Inc., Investment Company Act Release Nos. 12079 (Dec. 4, 

1981), 46 FR 60703 (Notice of Application) and 12135 (Jan. 4, 1982),24 SEC Docket 647 (Order). 

I'See, e.g., Albert B. Crenshaw, New Rules Drafted for Mutual Funds, Wash. Post, Tun. 19, 1988, 

at H3 and Letter from Charles Trzcinka to Jonathan G. Katz, Secretary, SEC 1 (May 23,1990, File 

No. SR-NASD-90-69 (responding to Notice of Proposed Rule Change by National Association of 

Securities Dealers, Inc. Relating to the Limitation of Asset-Based Sales Charges as Imposed by 

Investment Companies, Exchange Act Release No. 29070 (Apr. 12,1991), 56 FR 16137). 

294 CHAPTER 8 
In 1988, because of concern about the open-ended nature of rule 12b-1 fees 

as well as their "opaqueness," the Commission proposed amendments to rule 

12b-1 that, in effect, would have precluded spread loadslg. Shortly thereafter, 

the Commission proposed rule 6c-10 to permit not on1 CDSLs but also deferred 

loads generally as an alternative to spread loads? In response to those 

initiatives, the NASD proposed amendments to regulate rule 12b-1 fees and 

CDSLs under its maximum sales load rule?' The three proposals are still 

outstanding. 

Two other regulatory developments deserve brief mention. In 1985, the 

Commission by rule permitted funds to schedule variations in, or eliminate, frontend sales loadsz More recently, the Commission has issued a number of 

exemptive orders permitting funds to issue multiple classes of securities, each 

subject to a different distribution arrangement, but representing interests in the 

same portfolio of in~estments.2~ 

The fund industry's explosive growth and diversity in the 1980's is 

partially attributable to the changes in the regulation of the marketing of funds, 

especially the relaxation of restrictions on investment company advertising. Of 

course, favorable market conditions and changes in the financial services industry 

are other important factors in the decade's record level of salesF4 

As the fund industry has grown and diversified, the channels of mutual 

fund distribution have expanded. Generally, the distribution of funds in the 

individual investor market still may be divided into two main channels: shares 

sold by direct marketing and shares sold by commissioned sales forces. Direct 

marketers offer shares to investors through the mail, or by telephone, or at fund 

offices. Commissioned sales forces are used by securities firms and, in addition, 

I9Inv. Co. Act Rel. 16431, supra note 16. 

2%xemptions for Certain Registered Open-End Management Investment Companies to Impose 

Deferred Sales Loads, Investment Company Act Release No. 16619 (Nov. 2, 1988), 53 FR 45275. 

2'See infra notes 149-150 and accompanying text. 

221nvestment Company Act rule 22d-1, 17 C.F.R. 5 270.22d-1. Rule 22d-1 was adopted in 

Exemption from Section 22(d) to Permit the Sale of Redeemable Securities at Prices That Reflect 

Different Sales Loads, Investment Company Act Release No. 14390 (Feb. 22,1985), 50 FR 7909. 

=See infra notes 171-174. 

24See ICI, A DECADE OF GROWTH, PERSPECTIVE ON MUTUAL FVND ACTIVITY 20-27 (Spring 1990) 

[hereinafter DECADE OF GROWTH]. Changes in pricing structures, restructuring of distribution 

channels, increased emphasis on promotion and public relations, and heightened awareness of 

investor needs also have contributed to this growth. Id. 

The Sale of Open-End Investment Company Shares 295 
financial planners, life insurers, and depositary institutions. In the past two 

decades, direct-marketed funds have come to represent a significant part of 

mutual fund distribution. In 1990, direct-marketed funds had sales of $51.8 

billion, or thirty-five percent of stock, bond, and income fund sales, while funds 

sold through sales forces accounted for $90.2 billion, or sixty percent of stock, 

bond, and income fund salesF5 

Investors today may select among a variety of methods to finance the 

purchase of shares. While the number of funds using high front-end sales loads 

certainly has decreased?' and funds have moved to rule 12b-1 fees, it is not 

clear whether investors' costs have in fact been lowered as a result of these 

~hanges.2~ Many of the factors recognized as impeding competition in the 

1960's, such as retail price maintenance, still exist. Additionally, the increasing 

complexity and variety of sales and other charges may interfere with competitive 

pressures on fee levels. Thus, the major distribution issue facing the Commission 

continues to be the degree and effect of competition in the mutual fund industry. 

Three factors are critical to the dynamics of distribution and the interplay 

of regulation and competition on distribution pricingF8 First, the open-end 

nature of mutual funds gives rise to the tremendous and continuous pressures to 

=Other sales result from reinvested dividends in funds no longer offering shares and from 

261n response to the Commission's request for comments on investment company regulation 

(Request for Comments on Reform of the Regulation of Investment Companies, Investment 

Company Act Release No. 17534 @ne 15,1990), 55 FR 25322 [hereinafter Study Release]), the IC1 

indicated that "the number of funds with a maximum sales load of 8.5 percent has decreased 

dramatically (from 341 funds with 80 percent of assets in 1972 to 159 funds with 60 percent of 

assets in 1983, and to 60 funds with 18 percent of assets in 1990)." Letter from the IC1 to Jonathan 

G. Katz, Secretary, SEC 50 n.40 (Oct. 5,19901, File No. S7-11-90 [hereinafter IC1 Study Comment]. 

Of course, the nature of funds sold has changed markedly. For example, money market funds 

(including tax-exempt money-market funds), which typically charge little or no loads and did not 

exist until the early 1970'~~ accounted for 744 funds with 47% of mutual fund assets in 1990. 1991 

IC1 FACT BOOK, supra note 2, at 45, 74. 

variable annuities. 1991 IC1 FACT BOOK, supra note 2, at 37. 

27A result of this repositioning, however, is that average fund expense ratios in certain 

segments of the industry, eg., equity and taxable fixed income funds, have risen over the past 

decade. This is largely because rule 12b-1 fees are an annual fund expense that are included in 

the ratio while front-end sales loads are not. 

*he Commission requested comment on the broad questions of whether the present 

regulatory approach should be changed and whether retail price competition would reduce the 

need for regulatory limitations, and encouraged commenters to consider any alternative 

approaches used by other pooled investment vehicles. See Study Release, supra note 26, at § 1II.D. 

The Commission received over 90 comment letters on these topics, including almost 60 from 

individual investors. For the most part, industry related commenters favored the status quo, 

while individual investors believed that fees should be made simpler and more comparable. 

296 CHAPTER 8 
sell new shares in order to offset redemptions (otherwise, funds are said to be in 

a state of "net redemption"). Second, the external management structure of 

investment companies brings with it certain built-in conflicts of interest in the 

pricing of advisory and other services provided to funds and in the decision to 

spend fund assets to promote distribution. Third, because funds may finance 

distribution costs through various methods, including sales loads, rule 12b-1 fees, 

advisory fees, and underwriting regulation of one method inevitably 

affects the others. 

The Division has considered various ways to modify the present regulatory 

approach in light of these factors. Our recommendations focus on eliminating 

impediments to vigorous price competition, increasing investor understanding of 

total investment costs, promoting cost comparability among funds, and easing 

restrictions so that funds may experiment with distribution arrangements that 

make costs more explicit. We believe these changes would promote price 

competition and result in more economical and efficient distribution methods. 

First, the Division recommends that the Commission seek legislation to 

amend section 22(d) to unfix front-end sales loads. This action would introduce 

price competition among dealers. In addition, repeal of the price maintenance 

provision could facilitate the creation of new and innovative securities products 

that depend on free secondary markets. 

Second, the Division recommends several rule changes to address the 

variety of alternative distribution arrangements that have developed in the past 

decade. We generally endorse the concept of extending the NASDs maximum 

sales charge rule to rule 12b-1 fees and CDSLs on the same basis as front-end 

sales loads. NASD regulation of these charges is consistent with our view that 

regulation should be substituted where competition is ineffective; price 

competition cannot be relied upon to check the size of spread loads since those 

fees often are confusing and opaque to investors. We recommend that the 

Commission adopt a limited portion of the amendments to rule 12b-1 proposed 

in 1988. The amendments should clarify certain requirements for funds financing 

distribution through fund assets, including use of a spread load. In addition, we 

recommend that the Commission adopt the rule proposed in 1988 to permit 

deferred sales loads, including instal ent loads, with slight modifications. 

Finally, we recommend proposing a new rule that would codify existing 

exemptive orders permitting funds to offer shares in multiclass structures. This 

action would expand investor choice in the methods of financing distribution and 

eliminate the costs funds now bear of seeking individual exemptive orders. 

2%efore 1975 and the repeal of fixed commissions, fund brokerage commissions (in reciprocal 

and "customer-directed give-up" practices) were another important source of additional 

compensation for retailers selling mutual funds. PPI REPORT, supra note 11, at 162-72. 

The Sale of Open-End Investment Company Shares 297 
Third, the Division recommends that the Commission propose legislation 

to permit the introduction of an optional form of mutual fund with a simplified 

method of distribution financing: a unified fee investment company ("TJFIC"). 

This type of fund would have a single fee, prominently disclosed, out of which 

the sponsor would pay all fund expenses other than extraordinary expenses and 

brokerage. No separate sales loads or distribution charges would be imposed. 

UFIC fee levels would be market-based and not subject to regulatory limits, other 

than a general prohibition on unconscionable or grossly excessive fees. 

Section I1 of this chapter discusses the relationship between sales load 

levels and retail price maintenance and our recommendation to amend section 

22(d) of the Act. Section I11 details the various methods currently available for 

distribution financing and our recommendations for change. Section IV discusses 

our recommendations for the UFIC. 

11. Sales Loads and Retail Price Maintenance 

Section 22(d) of the Act prohibits registered investment companies, their 

principal underwriters, and dealers in their redeemable securities from selling 

such securities except at a current public offering price described in their 

prospectus?' Thus, section 22(d) effectively prohibits price competition in sales 

loads on mutual fund shares at the retail level. Together with section 22(f), which 

permits mutual funds to impose restrictions on the transferability or negotiability 

of their shares, section 22(d) confers federal antitrust immunity for retail price 

maintenance and mutual fund distribution restrictions?' 

Over the years, section 22(d) has been the subject of considerable analysis 

and debate. Many have argued that it effectively has raised investors' costs 

without compensating benefits?2 Others have maintained that retail price 

maintenance is so fundamental to the distribution of the shares of open-end 

~~ ~ ~ 

3%vestment Company Act section 2(a)(29) (15 U.S.C. Q 80a-2(a)(29)) defines a principal 

underwriter for an open-end investment company to be any underwriter who as principal 

purchases from such company securities for distribution, or as agent for such company sells such 

securities to a dealer or the public or both. Section 2(a)(40) defines an underwriter to be any 

person who purchases from an issuer with a view to distribution. Section 2(a)(ll) defines a dealer 

to be any person engaged in buying and selling securities for his own account as part of a regular 

business. 

31United States v. National Ass'n of See. Dealers, Inc., 422 U.S. 694 (1975). 

32See, e.g., PPI REPORT, supra note 11, at 221; Hearings on S. 1659, Bejore the Senate Cmm. on 

Banking and Currency, 90th Cong., 1st Sess. 665 (1967) [hereinafter 1967 Senate Hearings] (statement 

of Professor Irwin Friend, one of the principal authors of the Wharton Report). 

298 CHAPTER 8 
~ 

companies that its elimination would have a profoundly harmful impact on the 

industry and in~estors.3~ 

Today, there no longer seems to be any basis for restricting retail price 

competition in mutual fund distribution. Developments in the last fifty years, 

most notably the introduction of mandatory forward pricing, have eliminated the 

original rationales for retail price maintenance. Moreover, the strength and 

creativity of the investment company industry make it unlikely that further 

competition would harm investors. Indeed, there is reason to believe that price 

competition would benefit investors, as it benefits consumers of other goods and 

services. Accordingly, the Division recommends amending section 22(d) to end 

retail price maintenance. 

A. The Purposes of Section 22(d) 

Section 22(d) departs from the usual congressional policy, expressed in the 

antitrust laws, against price fi~ing.3~ The le 'slation proposed by the 

Commission in 1940 contained no such provision? it was first suggested by 

industry representatives and set forth in a memorandum of agreement between 

those representatives and the Commission that was drafted after the Senate 

hearings on the initial Although the legislative history contains little 

explanation of the purpose of section 22(d), retail price maintenance does not 

%See, e.g., 1967 Senate Hearings, supra note 32, at 665 (statement of the ICI); 1974 DISTRIBUTION 

34Sherman Antitrust Act (15 U.S.C. 5 1) and Federal Trade Commission Act (15 U.S.C. 5 41). 

Although there is some difference in the standard, horizontal and vertical agreements to restrict 

resale prices are considered illegal per se and generally prosecuted as felonies under Sherman Act 

section 1. See, e.g., Business Elect. Corp. v. Sharp Elect. Corp., 485 U.S. 717 (1988); Monsanto Co. 

v. Spray-Rite Sew. Corp., 465 U.S. 752 (1984); United States v. U.S. Gypsum Co., 438 U.S. 422 

(1978). 

REPORT, supra note 14, at 51-53 (written comment of the ICI). 

35Section 22 of the proposed legislation contained two subsections addressing dilution. 

Subsection (a) would have permitted the Commission to prescribe pricing rules for the purpose 

of eliminating or reducing dilution. Subsection (b) would have provided that no underwriter or 

dealer, in a primary distribution, could purchase securities from a registered investment company 

or underwriter except at the price at which it sold such securities, less a commission or spread 

allowed by the seller. S. 3580,76th Cong., 3d Sess., § 22, at 48-50 (Mar. 14,1940). See Investment 

Trusts and Investment Companies: Hearings on S. 3580, Before a Subcomm. of the Senate Comm. on 

Banking and Currency, 76th Cong., 3d Sess. 15 (1940) [hereinafter 2940 Senate Hearings]. 

361d. at 1057. 

The Sale of Open-End Investment Company Shares 299 
itself appear to have been the purpose of the secti0n.3~ Rather, the legislative 

history suggests that Congress intended retail price maintenance simply as a 

means of preventing certain activities that existed in the distribution of mutual 

fund shares before 1940: riskless trading by insiders and resulting dilution, 

disruption of distribution systems, and unjust discrimination?8 

1. Riskless Trading by Insiders 

The first activity to which we believe section 22(d) was primarily addressed 

was riskless trading by insiders and the resulting dilution of fund assets?’ 

Under the system of backward pricing generally used before the Act‘s passage 

and for many years thereafter, the price of a mutual fund share was based upon 

the fund’s net asset value per share determined at the close of the market on the 

previous day. If the market rose, an investor could purchase fund shares near the 

end of the day at the price based upon the previous day’s valuation, knowing that 

the actual net asset value of the shares was greater than the price he or she was 

paying!’ The transaction could be made riskless by redeeming the shares the 

following day, before a new and possibly lower price reflecting that day’s market 

activity was established!l 

For most investors, payment of a sales load made riskless trading 

unprofitable, since a load generally would more than offset any profit that could 

result from one day‘s increase in the value of a fund’s shares. Insiders and 

favored customers, however, often could purchase fund shares without paying 

371f section 22(d) was intended as a retail price maintenance provision, it seems reasonable to 

expect some discussion on that point. Yet, for example, there was no mention of retail price 

maintenance in a Commission representative’s analysis of the final bill. Hearings on H.R. 20065 

B#ore the House Comm. on Interstate and Foreign Commerce, 76th Cong., 3d Sess. 124 (1940) 

[hereinafter 2940 House Hearings] (testimony of David Schenker, Chief Counsel, Investment Trust 

Study). 

38A complete legislative and administrative history of section 22(d) was prepared as an 

appendix to the release proposing rule 22d-6 which was later adopted as rule 22d-1. See 

Exemption From Section 22(d) To Permit the Sale of Redeemable Securities at Prices That Reflect 

Different Sales Loads, Investment Company Act Release No. 13183 (Apr. 22,1983),44 FR 19887, 

27 SEC Docket 1353 (May 10,1983) (Appendix). 

39Some commentators have suggested that the only abuse that Congress addressed in section 

22(d) was dilution. See James V. Heffernan & James F. Jorden, Section 22(d of the Investment 

Company Act of 2940 - Its Original Purpose and Present Function, 1973 DUKE L.J. 975,984-93. 

402940 Senate Hearings, supra note 35, at 138-141 (statement of Baldwin Bane, Director, SEC 

Registration Division). 

411d. at 289 (statement of David Schenker). 

300 CHAPTER 8 
sales loadsF2 Since the overwhelming majority of open-end funds in 1940 Act 

were front-end load funds, the enactment of section 22(d) reduced the degree of 

dilution occurring from such riskless trading practices by requiring all investors 

to pay the same sales load.& 

2. Disruption of Orderly Trading 

The second activity was the creation of unauthorized secondary markets 

which was said to cause the disruption in the orderly distribution of mutual fund 

shares.44 Before 1940, authorized dealers that distributed a fund's shares 

generally were bound by contract with the principal underwriter to charge the 

single price described in the prospectus and were not given the discretion to 

lower prices to meet competition from non-contract dealers. Non-contract dealers 

were able to purchase shares for slightly more than the published redemption 

price and to offer the shares for slightly less than the published sales price. 

Because authorized dealers could not compete with non-contract dealers, an active 

secondary market developed, the so-called "bootleg market."45 This bootleg 

market resulted in the cancellation of many selling agreements between 

42See SEC, INVESTMENT TRUSTS AND INVESTMENT COMPANIES, H.R. Doc. No. 279, 76th Cong., 

1st Sess., pt. 3,862 (1940) [hereinafter INVESTMENT TRUST STUDY]. See 1940 Senate Hearings, supra 

note 35, at 289. 

-he Commission would have cured riskless trading by requiring forward pricing. The 

industry, however, vigorously resisted, and section 22(d) as enacted was the compromise modeled 

on an Ohio securities provision that was designed to address insider riskless trading. See 1940 

Senate Hearings, supra note 35, at 523, 526-27, 859. 

44See INVESTMENT TRUST STUDY, pt. 3, supra note 42, at 865. See also United States v. National 

Ass'n of Sec. Dealers, Inc., 422 U.S. 694, at 714-15 (1975); PPI REPORT, supra note 11, at 219; Survey, 

The Mutual Fund Industry: A Legal Survey, 44 NOTRE DAME LAW. Rev. 732, 850 (1969); and 

Lawrence M. Greene, The Unifmm Ofering Price of Mutual Fund Shares Under the Investment 

Company Act of l940,37 U. DET. L.J. 369,371-72 (1960). But see Heffernan & Jorden, supra note 39, 

at 990, 996-97 (suggesting that this was a post facto argument with no basis in the legislative 

history). 

451NVESTMENT TRUST STUDY, pt. 3, supra note 42, at 809, 856-57, and 865 ("Such operations 

actually had the effect of initiating a small scale price war between retailers and tended generally 

to disrupt the established offering price"). See Greene, supra note 44; 4 TAMAR FRANKEL, THE 

REGULATION OF MONEY MANAGERS 10, 42, 90 (1978 & Supp. 1990). See also INVESTMENT TRUST 

STUDY, pt. 3,809,857 (noting the existence of a secondary market maintained by contract dealers, 

which apparently was stronger and more active, and contending the principal abuse within that 

market was not disruption of the offering price but rather the riskless profit obtained by contract 

dealers as a result of the backward pricing system). 

The Sale of Open-End Investment Company Shares 301 
contractual dealers and underwriters and threatened the contractual distribution 

system.& 

Members of the industry have over the years, argued that an "orderly" 

distribution system under the control of fund underwriters facilitates the ability 

of mutual funds to offer constant redemption of their ~hares.4~ They have long 

urged that mutual fund distribution has a unique status because fund shares are 

redeemable at any time at the option of holders, making funds naturally shrinking 

entities. They have argued that net redemption status makes portfolio 

management difficult and can be prevented only by active sales of new shares; 

thus, secure dealer compensation is perceived as critical to the vitality of the fund 

industry. They also have argued that firms might suffer if non-contract dealers 

accumulated lar e blocks of shares and then, because of market fluctuations, 

redeemed them. & 

A related argument for preserving retail price maintenance is that without 

section 22(d) non-contract dealers would bypass the primary distribution system, 

thereby avoiding paying their "fair share" of the romotional costs of the underwriter, giving the dealers an unfair advantage. 48 

461n 1975, the Commission argued that preservation of orderly distribution by eliminating 

secondary market competition from non-contract dealers was a probable aim of section 22(d). 

Amicus Brief for the SEC at 43-44, United States v. National Ass'n of Sec. Dealers, Inc., 422 U.S. 

694 (1975). The Commission pointed to the fact that, before the passage of the final bill, secondary 

market dealers apparently alerted the Commission and the Senate to the consequences of section 

22(d) to their business in an unsuccessful attempt to have that section amended. The non-contract 

dealers complained in a memorandum that the section was designed to "effectively hamper 

[non-contract] . . . dealers in dealing in trust shares, concentrate such transactions in the hands 

of authorized dealers and principal underwriters, and thus create a virtual monopoly." Id. at n.95. 

47SeeJ e.g., Statement of the IC1 on the Potential Impact of the Repeal of Section 22(d) of the 

Investment Company Act of 1940 and on Other Matters Dealing with Distribution of Mutual Fund 

Shares 31-34 (Feb. 2,1973, File No. 4-164 (Hearings on Mutual Fund Distribution and §22(d) of 

the Investment Company Act of 1940); 1974 DISTRIBUTION REPORT, supra note 14, at 52 (written 

comment of the ICI) ("ability of fund sales to keep pace with redemptions would be endangered" 

by the lowering of sales incentives to salesmen resulting from secondary market influences). But 

see Comments of the U.S. Dep't of Justice 35 (Feb. 2,19731, File No. 4-164 [hereinafter 1973 Justice 

Department Comment] (contending this rationale is "sheer gloss on the legislative history" with 

the "patina of age upon the continued urging of the ICI"). 

48See 1974 DISTRIBUTION REPORT, supra note 14, at 53 (testimony of Carl Frischling, Channing 

Management Corporation). 

4%is line of argument is sometimes raised in antitrust cases dealing with distribution 

restraints, but courts have rejected such "unfair cost burden" arguments in favor of a rule which 

holds that such restraints are per se violations of the law. See, e.g., 1973 Justice Department 

Comment, supra note 47, at 38 ("The per se rule is based on a recognition that the potential benefits 

(continued ... ) 

302 CHAPTER 8 
3. Unjust Discrimination 

The third phenomenon arguably addressed by section 22(d) was 

discrimination among investors resulting from a fund charging different prices to 

different investors. While commentators have differed on whether the purpose 

of section 22(d) was to address such price discrimination, the Commission has 

cited it as such?' At the same time, however, the section has never been 

considered to require the same percentage load on every purchase, so long as 

variations (e.!., quantity discounts) available to one purchaser also are available 

to the next. Indeed, in 1966, the Commission expressed concern that retail 

price maintenance is unfair if investors requiring different levels of sales efforts 

must be charged the same sales load?2 Today, any scheduled variation in frontend loads to particular classes of investors is permitted, if it is di~closed?~ 

Alternatively, some have argued that the "investor discrimination" aimed at was 

not price discrimination, but discrimination that allowed favored "insider" 

purchasers to exploit backward pri~ing.5~ 

B. Commission Action under Section 22(d) 

Since 1940, the Commission has addressed the effect of section 22(d) on the 

pricing and distribution of mutual fund shares both in numerous reports and in 

rulemaking. The prevailing theme has been that retail price maintenance, as well 

49(...continued) 

of a market system where all dealers are free to buy from and sell to whomever they chose, at any 

price agreed upon, are more readily apparent than speculative disadvantages to the primary 

distributors and dealers forced to compete with the discounters.). See also VAN CISE AND UFLAND, 

UNDERSTANDING THE ANTITRUST LAWS 120-123,126-27 (1980). 

5oCompare Greene, supra note 44, at 371 (citing, among other factors, prevention of 

discrimination as a purpose "well known in the industry and to the Commission"), with Heffernan 

& Jorden, supra note 39, at 990 (arguing that legislative history does not support prevention of 

discrimination as a rationale). Unjust discrimination appears first to have been cited in a 1941 

opinion of the Commission's General Counsel rather than in the legislative history (Investors 

Diversified Servs., Investment Company Act Release No. 89 (Mar. 13,1941)). But see Heffernan 

& Jorden, at 994 (also suggesting that the discrimination referred to in the 1941 opinion involved 

the potential for insiders to obtain riskless profits, i.e., the insider riskless trading abuse). 

5'The language of section 22(d) suggests that Congress contemplated that more than one 

offering price could be charged different investors since the section requires sales at "a current 

public offering price described in the prospectus" rather than "the price." 

52~~~ REPORT, supra note 11, at 221. 

531nvesbnent Company Act rule 22d-I. 

54Heffernan & Jorden, supra note 39, at 993. 

The Sale of Open-End Investment Company Shares 303 
as inefficient distribution methods, have led to high sales costs for investors. 

While the Commission generally has viewed competition as the antidote to high 

costs and has questioned the need for section 22(d), it has not to date pursued 

outright repeal of the section. 

The issue of retail price maintenance was highlighted in the Commission's 

1966 report, entitled "The Public Policy Implications of Investment Company 

Growth" ("PPI Report"), on the adequacy of investor protections under the Act. 

The Commission concluded that, because section 22(d) prohibits competition 

among retail dealers, competition among distributors (principal underwriters) had 

the effect of raising rather than lowering mutual fund share prices to investors. 

Underwriters, instead of competing for sales through lower sales loads to 

investors, competed for the favor of the retailers who sold the shares by 

increasing the sales loads and thus the retailers' compen~ation?~ The PPI 

Report stated that: 

[tlhis reflects the industry view that mutual fund shares are sold, 

not bought. Retail dealers in and salesmen of fund shares are 

viewed as the key figures in the distribution process . . . . 

In a freely competitive market the load-raising effects of the 

vigorous competition among principal underwriters for the favor of 

dealers and salesmen could be restrained by countervailing 

downward pressures stemming from price competition among 

retailers for investor patronage. By precluding price competition at 

the retail level, section 22(d) suppresses the downward pressures 

that normal market forces might otherwise exert?6 

While citing advantages to the repeal of section 22(d), the Commission ultimately 

recommended a fixed maximum sales load, principally to avoid any "unsettling 

and unforeseeable effects" repeal might have in the broker-dealer community 

while still reducing investors' sales costs?7 

In 1970, Congress considered repealing section 22(d), but decided that it 

lacked sufficient information concerning the economic impact of repeal. The 

5?PPI REPORT, supra note 11, at 208-09, 221. 

561d. at 221. 

571d. at 222-23. The Commission noted that the industry had accommodated itself to a system 

of retail price maintenance and that immediate repeal might disrupt distribution networks, 

harming investors' access to funds; the report instead recommended a maximum sales load of five 

per cent. 

304 CHAPTER 8 
Commission was directed to study the matter and report back?8 As a more 

immediate solution, Congress amended section 22(b) to give rulemaking authority 

to a registered securities association, i.e., the NASD, to prevent excessive sales 

loads, subject to Commission 0versight.5~ 

In 1972, the Commission submitted to Congress a report concerning the 

economic impact of repeal of section 22(d). The report was an analytical study 

that made no recommendations for legislative or administrative action. It 

disputed, however, the "disruption of distribution systems" argument; and the 

transmittal letter by Chairman Casey stated that the findings "certainly suggest 

there is no compelling public interest in continued retail price maintenance in this 

field and that the repeal of section 22(d) would on balance be desirable."60 

Subsequent public hearings provided an opportunity for an in-depth 

exploration of mutual fund distribution and its regulation!l A very different 

picture of the mutual fund industry emerged from the 1973 hearings from that 

described in the Commission's 1966 PPI Report. Net redemptions had replaced 

the record sales the industry had enjoyed earlier!* Funds had lost ground with 

their traditional best customers, the small investors. In addition, the industry 

faced a number of disruptions to its marketing system. Competing products, such 

as variable annuities, real estate investment trusts, and oil and gas drilling funds, 

had made substantial inroads because they were often easier to sell and 

compensation to the broker-dealers was as high or higher than for mutual funds. 

Within the industry itself, "load" funds were losing sales to "no-load" funds. Fund 

%S. REP. NO. 184,91st Cong., 1st Sess. 7-8 (May 21,1969). 

5%e NASD enacted a maximum sales load rule that generally limits loads to 8%% of the 

offering price. See infva text accompanying note 110. 

'!REPORT OF THE SEC STAFF ON THE POTENTIAL ECONOMIC IMPACT OF A REPEAL OF SECTION 

22(d) OF THE INVESTMENT COMPANY ACT OF 1940, at iii-vi (1972). Among other conclusions, the 

report found that: repeal would result in lower acquisition costs for many fund investors, 

although it was unlikely the very small investor (accounts of less than $1,000) would see any 

immediate benefit; reductions in fund sales charges would have an extremely modest impact on 

the securities industry and on most retail sellers of fund shares, except for the 13% of the brokerdealer community that obtained most of their gross revenue from sales of funds; repeal was 

unlikely to lead to protracted net redemptions on an industry-wide basis because any lessening 

of sellers' incentives would be offset to some extent by the diminished sales resistance normally 

associated with lower prices (citing the recent growth of the no-load sector); and concern over 

adverse consequences (end-running existing distribution procedures) that might result from the 

development of a secondary market seemed exaggerated. 

"Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release No. 

9470 (Oct. 4, 19761, 41 FR 44770 (announcing public hearings). 

621974 DISTRIBUTION REPORT, supra note 14, at 19. 

The Sale of Open-End Investment Company Shares 305 
distribution, seldom profitable, had become even less profitable, requiring greater 

subsidization of distribution from advisory pr0fits.6~ 

In this environment, the Commission did not recommend immediate repeal 

of retail price maintenance in its report to Congress!4 The report concluded 

that, due to a lack of investor sophistication and price sensitivity, the industry 

would need to cultivate public demand and diminish its historic reliance on 

intensive personal selling efforts in order to avoid widespread disruption in the 

fund distribution system that might otherwise occur with an immediate repeal of 

section 22(d). The Commission decided to lay the groundwork for a gradual and 

orderly introduction of price competition through administrative action that 

would permit funds to adopt voluntarily pricing programs designed to foster 

retail competition. The report also recommended that Congress amend section 

22(d) to expand the Commission's authority to take further steps toward "the 

ultimate goal of retail price competition.tt65 

Since announcing that program, the Commission has taken a number of 

steps toward modifying regulation of sales loads and mutual fund distribution 

generally, including easing restrictions on mutual fund permitting 

funds to finance distribution expenses out of their assetsP7 and adopting rules 

and issuing orders exempting some practices from section 22(d).68 In 1983, the 

@Id. at 17-43. In addition, the poor performance of the equity markets (in contrast to the "gogo" boom of the late 1960's) coupled with rising interest rates likely turned many investors to 

more secure products. Id. at 28/39. 

641974 DISTRIBUTION REPORT, supra note 14, at 76-83. 

%i. at 11. 

(j6See Chapter 9. 

67By adopting rule 12b-1, supra note 15. 

68Rules 22d-1 through 22d-5 were adopted pursuant to this program. See Variations in Sales 

Load Permitted for Certain Sales of Redeemable Securities, Investment Company Act Release No. 

2798 (Dec. 2,1958), 23 FR 9603 (adoption of rule 22d-1); Sales of Redeemable Securities Without 

a Sales Load Following Redemption, Investment Company Act Release NO. 8235 (Feb. 20,19741, 

39 FR 8321 (adoption of rule 22d-2); Variable Annuities, Adoption of Exemptive Rules, Investment 

Company Act Release No. 8878 (Aug. 7, 1975), 40 FR 33970 (adoption of rule 2211-3); Mergers 

and Consolidations Involving Registered Investment Companies, Investment Company Act 

Release No. 11053 (Feb. 19, 1980), 45 FR 12408 (adoption of rules 22d-4 and 22d-5). With the 

exception of rule 22d-3 (re-numbered rule 22d-2 (17 C.F.R. 5 270,2211-2) and applicable to 

insurance products), they were subsequently rescinded with the adoption of rule 22d-1 (originally 

proposed as rule 22d-6). From 1974 through 1983, the year rule 22d-1 was adopted, the 

Commission received approximately 20 applications annually requesting exemptive relief from 

section 22(d) and the rules thereunder. 

f 

306 CHAPTER 8 
Commission proposed rule 22d-6, to permit all funds broad latitude to vary sales 

10ads.6~ Under the rule as proposed, funds could establish a single public 

offering price; a schedule of fixed but different prices applicable in different 

transactions; or a system of unfixed prices arrived at by negotiation with 

purchasers. The majority of commenters (mostly industry members) expressed 

opposition to the negotiation aspect, positing potential market injury 

(concentration and disruption of distribution systems arguments), attacking the 

Commission’s statutory authority to permit negotiated loads, and suggesting that 

permitting negotiation would eliminate antitrust immunity for fixed pricing of 

fund shares. 

In 1985, the Commission adopted a revised rule permitting scheduled 

variations of prices, but dropping the provision allowing negotiation of prices7’ 

The rule opened the way for all funds to sell their shares at prices that reflected 

different front-end sales loads, subject to the requirements that any variation be 

uniformly applied to all offerees in the class specified, that variations be described 

in the prospectus, and that current shareholders be advised within one year of 

any new sales load variations. While the Commission did not explain why it 

dropped the negotiation provision, concern over the Commission’s authority was 

a primary factor, rather than a change in point of view about the policy. 

C. Amendment of Section 22(d) to End Mandatory Retail Price 

d 

Maintenance 

The Division recommends amendment of section 22(d) to end retail price 

maintenance. This change would permit the development of retail price 

competition among dealers and the development of secondary markets in mutual 

fund shares. 0 

Our recommendation is based on the general principle that the public 

benefits from free and vigorous price competition. Accordingly, an 

anticompetitive provision such as section 22(d) should be retained only if there 

is a convincing public policy rationale. As discussed below, since 1940 and even 

since the 1970’~~ changing circumstances, reflecting both regulatory and 

marketplace developments, have eliminated the rationales that apparently 

prompted enactment and retention of section 22(d). If the industry did need a 

transition period before section 22(d) could be amended or repealed, the past 

@Inv. Co. Act Rel. 13183, supra note 38. 

701nv. Co. Act Rel. 14390, supra note 22. 

The Sale of Open-End Investment Company Shares 307 
decade and a half has served that purpose.71 

compelling reasons to retain retail price maintenance. 

There no longer are any 

1. Disappearance of Original Rationales for Retail Price 

Maintenance 

The first, and we believe the primary, purpose of section 22(d) has been 

rendered moot. Riskless trading by fund insiders to the dilution of other 

shareholders has not been possible since 1968, when the Commission adopted rule 

22c-1, requiring "forward" pricing of fund shares.72 

Nor is it likely that the introduction of retail competition would disrupt 

orderly distribution of mutual fund shares, another rationale for section 22(d). 

The "orderly distribution" point rests on two interrelated arguments: that orderly 

distribution gives "secure compensation" to the sellers of mutual fund 

and that an active secondary market would threaten that 

c~mpensation?~ These arguments assume that only with the assurance of a 

fixed commission will a securities sales representative make the effort necessary 

to persuade an ordinary investor to buy shares. This ignores the vast changes in 

71For example, since adoption of rule 22d-1, funds have established a variety of scheduled 

variations in sales loads. By the ICI's assessment, the industry seems to be in a position to meet 

the demands of a competitive marketplace. DECADE OF GROWTH, supra note 24, at 8. ("Despite 

rising competition from other financial institutions, mutual funds entered the decade of the 1990's 

in excellent shape. The very size of assets now under management, in the vicinity of $1 trillion, 

virtually assures substantial additions to the asset base from reinvested dividends. . . . The most 

important secular economic and demographic trends, as they appear at the beginning of the 

decade, look quite favorable for investment in general, and mutual fund investing in particular."). 

721nvestment Company Act rule 22c-1. Under forward pricing, redemptions are effected at 

a price based on the net asset value next computed after receipt of an order, typically at the close 

of the United States securities markets. See Pricing of Redeemable Securities for Distribution, 

Redemption and Repurchase and Time-Stamping of Orders by Dealers, Investment Company Act 

Release No. 5519 (at. 16, 1968),33 FR 16331. 

731n responding to the Study Release, the IC1 concluded, as it had in earlier submissions 

spanning two decades, that the purpose of section 22(d) was to assure a stable, systematic, and 

ongoing sales effort at the retail level. IC1 Study Comment, supra note 26, at 49-51. 

7%ome members of the industry have conceded that, under the right set of circumstances, 

section 22(d) could be repealed. See, eg., 1974 DISTRIBUTION REPORT, supra note 14, at 60 

(statement of Robert Loeffler, Senior Vice President, Investors Diversified Services) (opining that 

as the public became more familiar with funds, salesmen would produce higher sales volumes 

for the same amount of time, thus permitting a reduction of commission rates so that such rates 

ultimately might be "competitive with what the spread might be on just a shelf product, which 

it would be in the secondary market, at which point you could repeal 22(d) and it probably 

wouldn't make any difference because your levels would be the same"). 

308 CHAPTER 8 
public awareness and acceptance of mutual funds in the last twenty years?' 

The size and visibility of the fund industry and the increasing market share 

captured by direct-marketed funds today belie the assumption that "funds are 

sold not bought." 

In addition, we agree with the prediction made by the Department of 

Justice almost twenty years ago that lower sales loads would increase, rather than 

decrease, sales.76 In the 1973 hearings, the Justice Department argued that "[tlhe 

Supreme Court has noted that ruinous competition, financial disaster, evils of 

price cutting and the like appear throughout ow history as ostensible, albeit 

unpersuasive, justifications for price-fi~ing."~~ 

The related concern that non-contract dealers might "free ride" by not 

paying their fair share of promotional costs carries far less weight today than it 

might have in 19407' A secondary market probably would not eliminate the 

benefit to a principal underwriter of promoting the fund where there is affiliation 

between the underwriter and the investment adviser, as is true of many funds 

today. Underwriting of mutual funds has not been profitable historically, and 

75The IC1 has said that "[ilncreased demand for mutual funds has resulted not only from these 

market changes but also from the public's increased awareness of funds. Industry research shows 

that the awareness of mutual funds among all U.S. households has expanded significantly since 

1980, resulting in funds becoming a household word . . . ." See 1990 MUTUAL FLJND FACT BOOK: 

INDUSTRY TRENDS AND STATISTICS FOR 1989, at 64 (1990). 

761973 Justice Department Comment, supra note 47, at 12-15. In addition, the Justice 

Department noted that Professor Paul Samuelson had testified that elimination of section 22(d) 

would result in a substantial decrease in sales loads and that these judgments were confirmed by 

the pre-1940 experience in the mutual fund industry which showed that retail price competition 

reduced costs to the investor. Id. A 1988 ICI-commissioned study suggested that there is a 

corresponding (and offsetting) increase in market share for a full service channel relative to the 

direct market channel as the former decreases its commission or fee charges. See ICI, THE 

DISTRIBUTION CONNECTION: A SUMMARY REPORT OF MAJOR RESEARCH FINDINGS 19 (1990). 

n1973 Justice Department Comment, supra note 47, at 20-23; see also Hearings Before the Sen. 

Comm. on Banking and Currency, 91st Cong., 1st Sess. 65 (1969) (testimony of Professor Paul 

Samuelson); Donald Baker & W. Todd Miller, Vertical Pricing, Territorial and Customer Restraints: 

The Search for Clarity, or At Least Sanity, 30TH ANNUAL ADVANCED ANTITRUST SEMINAR, PLI Course 

Handbook Series No. 720, at 9/55 (1991) (citing SCHERER, INDUSTRIAL MARKET STRUCTURE AND 

ECONOMIC PERFORMANCE 593 (2d ed. 1980)). 

'?he "free rider" argument resurfaced in the comments to the Study Release, supvu note 26, 

with regard to unit investment trusts ("UITs"). See Letter from Davis Polk & Wardwell to 

Jonathan G. Katz, Secretary, SEC 83 (Oct. 10,19901, File No. S7-11-90 [hereinafter Davis Polk Study 

Comment], Letter from Shearson Lehman Brothers to Jonathan G. Katz, Secretary, SEC 21 (Oct. 

10, 19901, File No. S7-11-90. 

The Sale of Open-End Investment Company Shares 309 
underwriting expenses often have been subsidized by the investment advi~er.~' 

Thus, the real benefit of promoting a fund often lies in increasing the asset base 

of the fund on which the adviser's compensation is determined. The elimination 

of retail price maintenance would not impair that benefit. Finally, the 

underwriter's exclusive access to new shares from the fund is a substantial 

advantage over non-contract dealers, which have the expenses and uncertainties 

associated with maintaining inventory?' 

Finally, section 22(d) is not needed to prevent "price discrimination." 

Competitive markets generally tend to eliminate discriminatory price differences, 

i.e., differences unrelated to costs. In addition, competition generally should 

reduce prices for investors at all levels, even though reductions are likely to be 

most dramatic for the largest investors. The results of the unfixing of brokerage 

commission rates in 1975 bear these suppositions out; commission rates have 

declined sharply and fallen into rational patterns that reflect the sales costs and 

the services provided8l Moreover, if, as some have argued, the "investor 

discrimination" aimed at was not price discrimination, but the discrimination that 

allowed the favored "insider" purchaser to exploit backward pricing,s2 it became 

irrelevant in 1968 with the adoption of forward pricing. 

2. Consequences of Retail Price Competition 

In addition to considering whether the original bases for section 22(d) 

remain valid, we considered other concerns that could arise from retail price 

competition. In theory, repeal could lead to increased concentration and investor 

confusion, but we conclude that the benefits would more than offset any 

disadvantages. Residual rulemaking authority could give the Commission the 

ability to address any concerns. 

79See, eg., PPI REPORT, supra note 11, at 209. Of course, advisory fees and other compensation 

paid by a fund to its adviser must meet the requirements of section 36(b). See infra Section III.A.2. 

"See 1973 Justice Department Comment, supra note 47, at 38-39. See also Davis Polk Study 

Comment, supra note 78, at 81. Non-contract dealers also would reduce the distribution system 

costs by taking on some of the promotional expenses that encourage investing in the fund as well 

as taking some of the redemption pressure, and attendant costs, off the underwriter and fund. 

"See DIRECTORATE OF ECONOMIC POLICY AND ANALYSIS, REPORT ON THE SECURITIES INDUSTRY 

IN 1980 81-85 (Sept., 1981) [hereinafter 1980 INDUSTRY REPORT]. 

82See Heffernan & Jorden, supra note 39, at 994. While this latter view has some support, there 

are numerous Commission interpretations to the contrary, including some issued after backward 

pricing was abolished. See, e.g., Sale of Redeemable Securities Without a Sales Load Following 

Redemption, Investment Company Act Release No. 8235 (Feb. 20, 19741, 39 FR 8321; Variable 

Annuities, Adoption of Exemptive Rule, Investment Company Act Release No. 8878 (Aug. 7, 

19751, 40 FR 33970. 

31 0 CHAPTER 8 
We do not believe that retail price competition would lead to concentration 

in the mutual fund and broker-dealer industries, as some have argued. There is 

no reason to believe that repeal of section 22(d) would cause undue concentration 

any more than the 1975 unfixing of brokerage commission rates caused undue 

concentration among broker-dealers.B To the extent that some firms might not 

survive, as a former Commission Chairman stated, "it is hardly necessary or even 

desirable for the Government to maintain a price structure under which 

investors -- particularly small investors -- subsidize an inefficient, oversized 

distribution system . . . . 

1184 

Nor does it seem likely that the range of commission charges would 

confuse investors. Negotiation of sales loads theoretically could result in infinite 

permutations but, as a practical matter, broker-dealers are likely to establish 

schedules of a limited range of possible loads, just as they currently do for 

negotiable commission rates on securities purchases for different customers. In 

essential respects, negotiated sales loads would expand the concept of scheduled 

variations in rule 22d-1, which is accepted and understood by both the industry 

and the public.85 

The current widespread use of rule 12b-1 fees and contingent deferred 

sales loads% will complicate the elimination of retail price maintenance. Unlike 

front-end sales loads, rule 12b-1 fees do not easily lend themselves to negotiation 

and secondary markets in fund shares. For example, in the same fund customers 

mAlthough concentration increased in the securities industry between 1971 and 1980, the 

Directorate of Economic Policy and Analysis concluded that the trend toward concentration began 

well before the introduction of negotiated rates in 1975, for various reasons, and that despite 

consolidations, the industry appeared to remain competitive in terms of structure, as well as 

conduct and performance. See 1980 INDUSTRY REPORT, supra note 81, at 79-80. The staff also noted 

that the number of discount brokers continued to grow in the period following the full advent of 

negotiated rates and that their profitability was the highest among the industry segments. See, 

eg., id. at vi, 85-87. 

842967 Senate Hearings, supra note 32/ at 30 (statement of Chairman Cohen). Immediately 

following the elimination of fixed rates in 1975, commission rates for both individual and 

institutional clients declined sharply. 1980 INDUSTRY REPORT, supra note 81, at 82. 

"For example, proposed rule 22d-6 permitting negotiated sales loads had several disclosure 

conditions designed to assist the investor in evaluating investment costs. The conditions included 

prospectus disclosure of the maximum load that could be charged, accompanied by a discussion 

of the circumstances under which a negotiated load was available. See Inv. Co. Act Rel. 13183, 

supra note 38. Similarly, the prospectus fee table used today also includes only the maximum 

sales load that can be charged and leaves scheduled variations of sales load to be discussed in the 

narrative. See Consolidated Disclosure of Mutual Fund Expenses, Investment Company Act 

Release No. 16244 (Feb. 1,1988), 53 FR 3192. 

'%ee supra notes 15-18 and accompanying text. 

The Sale of Open-End Invesfment Company Shares 311 
of non-contract dealers and customers of the principal underwriter and contract 

dealers would be bearing the same amount of rule 12b-1 fees, despite differences 

in sales costs. 

Second, contingent deferred sales loads, while susceptible to negotiation, 

would present difficult tracking and inventory questions that are likely to limit 

the formation of secondary markets. To give an example, assume shareholder A 

wishes to sell, after two years, shares originally subject to a CDSL of five percent 

that declined one percent annually until year five when it disappeared. 

Shareholder A might offer the shares, with a current net asset value of $10,000, 

to a dealer, at a price of net asset value minus the CDSL of three percent (or what 

the fund would redeem them for), e.g., $10,000 - $300 = $9,700, plus whatever 

premium the dealer was paying to attract redeeming shareholders, e.g., $10087 

The dealer, having paid $9,800 for shares with a value of $10,000 minus a 

declining CDSL of three percent, would hope to sell those same shares to 

shareholder B, at a discount from what the fund would offer shareholder B 

(shares at $10,000 with a contingent liability of five percent or $500), eg., $9,900 

or maybe even $10,200. The spread between the price paid to the selling 

shareholder and the price paid by the buying shareholder would be the dealer's 

profit, e.g., $100 or $400 in this example. 

The market value of the shares depends on how long they have been 

outstanding (that is, what level the CDSL has reached) and the holding 

expectations of the buying shareholder. In the example above, the shares would 

still bear a load of three percent, if redeemed before the end of the third year of 

the original selling shareholder's purchase. If shareholder B planned to sell the 

shares quickly, he or she would have an incentive to pay a higher premium to the 

dealer than a shareholder who planned to hold the shares for two or three years. 

A shareholder planning to hold shares for the full five years would not pay more 

than the price at which the fund was offering shares. Dealers, therefore, would 

have to be able to identify the "aging" of each share in inventory and know their 

customer. 

3. Development of Secondary Markets 

To the extent that funds seek to restrict secondary market transactions, the 

Commission could use its existing rulemaking authority under section 22(f). 

Section 22(f) prohibits funds from restricting the transferability of their shares in 

87Securities firms today may act as statutory "brokers," Le., as agents in a sale of already issued 

shares between two investors. See, eg., United States v. National Ass'n of Sec. Dealers, Inc., 422 

U.S. 694 (1975). This practice is not common today. 

312 CHAPTER 8 
contravention of any Commission rules.88 To date, the Commission has not 

adopted any rules under section 22(f). The Commission's Investment Trust Study 

detailed a number of problems related to the secondary dealer (or "bootleg") 

market under the backward pricing system prevalent at the time and listed a 

variety of means used by funds to deal with those problems, including restricting 

the negotiability of shares so that they could only be tendered for redemption to 

the fund and rohibiting the underwriter from taking any trading position in the 

fund's shares!' Commission staff indicated that the provision was designed to 

provide regulatory "oversight" over these types of ractices because of a concern 

that these practices might also penalize investors. w 

Leaving section 22(f) intact would reserve authority with the Commission, 

consistent with the protection of the fund's shareholders, either to preclude 

certain restrictive practices or to protect contract dealers and underwriters from 

any unfair advanta e on the part of secondary market dealers, should events 

prove it necessary. 98 

Finally, it may be necessary to amend rule 22c-1 to permit secondary 

market transactions by dealers at negotiated prices. The rule now requires all 

dealers to effect transactions at prices based upon the next computation of net 

88As the Supreme Court stated in 1975: "[slection 22(f) complements [section 22(d)] by 

authorizing the funds and the SEC to deal more flexibly with other detrimental trading practices 

by imposing SEC-approved restrictions on transferability and negotiability." Id. at 724-25. 

s91nrVESTMENT TRUST STUDY, pt. 3, supra note 42, at 849,856-57,861,865,867-74. In addition, 

some funds required their underwriters to impose restrictions on the dealers or entered into 

restrictive agreements with the dealers directly. Id. at 868-71. 

%avid Schenker testified that 

some companies . . . have a provision in their certificates to the effect that you 

cannot sell that certificate to anybody else, and the only way you can sell it is to 

sell it back to the company. That is a technical problem. It presents a whole 

problem which they call the bootleg market. What happens is that dealers keep 

switching people from one company to another. 

1940 Senate Hearings, supra note 35, at 292-93. Mr. Schenker went on to state that while the 

bootleg market was a problem, these restrictions "are taking away a big portion of the owner's 

right of initiative." His recommendation was that, rather than have an explicit prohibition, the 

subject "ought to be a matter of rules." Id. 

"For example, a rule under section 22(f) might permit a fund to impose a reasonable fee when 

ownership of its shares is transferred from a non-contract dealer to a customer to compensate a 

fund for any administrative costs it incurs. 

The Sale of Open-End Investment Company Shares 313 
asset value?2 Rule 22c-1 prevents dilution of the shareholders' equity that 

results from backward pricing. Amending the rule to permit dealers to make 

secondary markets in fund shares at fully negotiable prices would not be 

inconsistent with the rule's purpose. The issuance and redemption of shares by 

funds and their principal underwriters would continue to be based on forward 

pricing; therefore, secondary market transactions would not lead to dilution or 

opportunity for riskless trading. 

D. Other Options Considered 

1. "Voluntary" Retail Price Competition 

We considered recommending that the Commission seek expanded 

authority to permit, but not require, retail price competition. This would permit 

the Commission to adopt a rule permitting the negotiation of sales loads, similar 

to proposed rule 22d-6, and also give the Commission flexibility to deal with any 

new products or any new questions involving secondary market trading of fund 

shares. 

A permissive approach has some appeal. Permitting the voluntary 

negotiation of sales loads would allow funds to elect price competition to meet 

market needs, but not force all funds to face those particular competitive 

pressures immediately. A voluntary approach would allow funds to control the 

circumstances of their experiments with price competition and might yield some 

of the benefits of full retail price competition. Under a permissive rule, those 

funds that believe that retail price maintenance is desirable could continue it. 

The obvious flaw with a permissive rule is that only a few funds, if any, 

likely would "elect" price competition. Historically, dealer pressure on 

underwriters has increased, not decreased, sales loads. We see no reason to 

believe that the same pressures would not continue under a voluntary system. 

Accordingly, we do not recommend this approach. 

2. The Status Quo 

We also considered maintaining the status quo. Opponents of repeal have 

argued that retail price maintenance has in fact permitted price competition and 

"worked well" over the last half century, as evidenced by the great variety of sales 

charges, the increases in the number of no-load funds and low-load funds, and 

92The rule has a limited exemption for "backward pricing" by sponsors of unit investment 

trusts, allowing them conditionally to purchase or sell units in the secondary market at a price 

based on the offering side, determined weekly. 

314 CHAPTER 8 
the apparent decline of the effective sales charges since 1960?3 Thus, they 

conclude that section 22(d) need not be amended. 

The Division disagrees. While there is a great degree of interbrand 

competition in the industry, nonetheless, the statute today precludes intrabrand 

competition. The original rationales for section 22(d) no longer exist and investors 

are harmed by higher prices than might otherwise be available in a competitive 

marketplace. 

111. Sponsors’ Options for Distribution Financing 

Section 22(d) most directly affects funds with front-end sales loads, for a 

long time the only form of distribution charge paid by invest0rs.9~ Alternative 

forms of distribution charges, such as rule 12b-1 fees and contingent deferred 

sales loads, have become increasingly prevalent and have resulted in complex 

distribution arrangements . 

Because these distribution financing techniques are linked, regulation or 

competition affecting one leads to changes in use of another. Our general 

recommendation is to continue permitting a variety of distribution charges and 

regulating all distribution charges in as equivalent a manner as is feasible, and 

placing renewed emphasis on full and clear disclosure of those charges. 

Accordingly, the Division generally endorses the NASDs proposed extension of 

its maximum sales charge rule to asset-based sales charges and CDSLs. The 

Division also recommends minor amendments to rule 12b-1 to clarify its 

applicability to spread loads, adoption of proposed rule 6c-10 permitting CDSLs, 

and adoption of a rule permitting the issuance of multiple classes of shares in the 

same portfolio. 

A. The Treatment of Fees and Distribution Charges under the Act 

Several sections of the Investment Company Act address the use or level 

of various types of distribution charges. Under section 22(b), the NASD is 

authorized to prohibit “excessive” sales loads. Section 36(b) imposes a fiduciary 

duty on investment advisers with respect to fees, including distribution fees, paid 

93See, e.g., IC1 Study Comment, supra note 26, at 50-51. It is difficult, however, to assess 

whether those rates actually have declined, however, in part because the introduction of rule 12b-1 

fees makes comparison difficult, and because the types of funds sold have changed. 

94Advisers to no-load funds in theory cover any limited distribution expenses out of their own 

resources. 

The Sale of Open-End Investment Company Shares 315 
by funds to advisers and their affiliate^?^ Section 12(b) authorizes the 

Commission to make rules governing funds' distribution of their own shares.96 

1. Section 22(b) 

In the 1930'~~ investment company underwriters maintained continuous 

sales pro rams to offset redemptions with new sales, with high costs to 

investors8 The costs were due in part to the dependence of underwriters on 

dealers for sales?8 This dependence prevented reductions in sales charges99 

and fostered a number of questionable sales practices.'" In addition, a number 

of questionable computational techniques resulted in the actual distribution 

profits being larger than the load itself would have generated."* 

The Commission addressed these problems in the legislation that it 

recommended to Congress in 194O.lo2 The Commission recommended leaving 

the level of sales loads to competition among distributors, and retaining 

jurisdiction to act only where an "unconscionable or grossly excessive sales load" 

was charged (even if that load were di~closed).'~~ Members of the industry 

expressed a preference for self-policing under the auspices of the NASD>04 As 

enacted by Congress in 1940, section 22(b) included a general prohibition on 

9515 U.S.C. fi 35(b). 

9615 U.S.C. Q 12(b). 

971NVFSTMJ3JT TRUST STUDY, pt. 3, supra note 42, at 807,809-13,817'856. 

981n a highly competitive field, where most dealers had competing fund shares to sell, 

"maintenance of dealer good will" was "of paramount importance . . . . [Iln short, any device or 

practice which would facilitate the task of the dealer might be adopted or encouraged by openend investment companies in order to assure the continued sale of their securities." Id. at 826-27. 

991a. at 826. 

loOIa. at 829-47. 

''The Commission in the Investment Trust Study observed that "[tlhe open-end distribution 

system permits the inclusion of certain multiple and hidden profits . . . . Thus the various 

additions and adjustments made in the computation of the selling commission serve to enlarge 

the distribution profits beyond the apparent implications of the published load." Id. at 813. 

'@S. 3580, supa note 35, Q 22(c). 

1032940 Senate Hearings, supra note 35, at 290 (testimony of David Schenker). 

lo4See, eg., id. at 1057 (testimony of Arthur Bunker, Executive Vice President, Lehman Corp.). 

316 CHAPTER 8 
"unconscionable or grossly excessive sales load[s]," and authorized the NASD to 

define these terms through rulemaking, subject to Commission review.lo5 

By the mid 1960's, the PPI Report documented that the 8.5% front-end sales 

load then typical for mutual funds reflected large increases in sales charges since 

the early 1950's, with the increases going to higher dealer concessions.lo6 The 

report observed that profits from advisory fees, and brokerage commissions, as 

well as a fund's own resources, often subsidized sales efforts.lo7 

Although the Commission ultimately recommended a statutor cap of five 

percent on sales loads in lieu of ending resale price maintenance)" Congress 

decided to rely on the NASD to protect investors against unreasonable sales 

charges. As part of the 1970 amendments to the Act, section 22(b) was revised 

to provide for NASD-prescribed sales loads subject to Commission oversight 

under the Exchange Act>og In 1975, the NASD adopted an 8.5% maximum 

sales load limit, with lower ceilings if certain features were not offered.'" 

2. Section 36(b) 

Section 36(b) imposes a fiduciary duty on the investrnent adviser of a 

registered investment company with respect to fund fees. The duty covers "the 

receipt of compensation for services, or of payments of a material nature, paid by 

such registered investment company, or by the security holders thereof, to such 

investment adviser or any affiliated person thereof." Thus, the adviser's duty 

'@Investment Company Act of 1940, Pub. L. No. 76-768,s 22(b), 54 Stat. 789, 823 (1940). 

f06PPI REPORT, supra note 11, at 204,207-09. In addition, the report noted that the typical fund 

sales load was between two and a half and five times the "round trip" exchange commission 

charged for a trade in a listed security, and that loads were charged on reinvested dividends 

when they were not related to or justified by any special selling effort apart from the initial sale. 

Id. at 209-11,215-16. 

ICnAll or part of the cost of preparing prospectuses and sales-oriented shareholder reports were 

included in fund operating expenses and fund brokerage supplied added cash compensation to 

dealers selling fund shares. Id. at 201. 

'081a. 

lmSecurities Exchange Act of 1934, 15 U.S.C. $5 78a-7811. Investment Company Act 

Amendments of 1970, Pub. L. No. 91-547,s 12(a), 84 Stat. 1413,1422 (1970) (codified as amended 

at 15 U.S.C. Q 80a-22(b)). 

''!Proposed Rule Change By the NASD, Investment Company Act Release Nos. 8893 (Aug. 

14,1975),40 FR 36813 (Notice of Filing and Request for Comment), and 8980 (Oct. 10,1975), 8 SEC 

Docket 66 (Order Approving Rule Change). 

The Sale of Open-End Investment Company Shares 317 
under section 36b) applies not only to advisory fees, but also to distribution 

charges such as rule 12b-1 payments."' 

Congress adopted section 36(b) in 1970 in response to concerns articulated 

in the PPI Report that advisory fees were not subject to usual competitive 

pressures because of the external management of mutual funds?l2 The PPI 

Report concluded that the competitive forces that normally restrain prices did not 

operate efficiently in checking the costs of fund management. The primary reason 

was that, unlike typical corporations, funds were usually managed and operated 

by separate entities that provided investment advice and managerial services 

under contracts with funds. These separate entities usually had their own 

shareholders and were profit centers in their own right, creating a conflict of 

interest unique to mutual funds. The virtually complete merger of the funds' 

management with the advisory organizations meant that funds were not able to 

"bargain" for advice and the directors' ability to negotiate effectively on behalf of 

the funds was hampered by their inability, as a practical matter, to fire 

management in a dispute over fees.113 In addition, investors did not 

understand or were not sensitive to the level of advisory fees or to fees generally 

and, in an case, were not influential because share ownership was so 

dispersed. 11z 

The PPI Report concluded that "mutual fund shareholders need protection 

against incurring excessive costs in the acquisition and management of their 

investments and that, given the structure and incentives prevailing in the 

industry, neither competition nor the few elementary safeguards against conflict 

of interest deemed sufficient in 1940 . . . presently provide this protection in 

adequate measure."l15 Accordingly, the report recommended that the Act be 

amended to require that the compensation received by affiliated persons of 

investment companies for services furnished to an investment company be 

reasonable and that this standard be enforceable in the courts?16 

'"See, e.g., Krinsk v. Fund Asset Management, 715 F. Supp. 472 (S.D.N.Y. 1988), uff'd, 875 F.2d 

404 (2d Cir.), cut. denied, 110 S. Ct. 281 (1989). 

ll*See, eg., H.R. REP. NO. 1631, 91st Cong., 2d Sess. (1970) (conference report); H.R. REP. NO. 

1382, 91st Cong., 2d Sess. 7-8 (1970); id. at 86-88 (Memorandum of the SEC on H.R. 27333 to the 

Comm. on Interstate and Foreign Commerce). 

113PPI REPORT, supru note 11, at 10-12, 126-27, 130-32. 

Ii4Id. at 126, 129-30. 

'I51d. at viii. 

'"Id. at viii, 143-147. 

318 CHAPTER 8 
Rather than imposing a reasonableness standard, Congress imposed a 

fiduciary duty on investment advisers with respect to the receipt of compensation 

for services and instructed a court in any action brought under the provision to 

give only "appropriate" consideration to any prior approvals of the compensation 

by shareholders or directors. Congress also amended section 15(c) of the 

Act117 to impose on directors a duty to evaluate, and on an adviser a duty to 

furnish, all relevant information needed to review the terms of advisory contracts. 

This amendment was designed to strengthen the ability of directors, particularly 

the independent directors, to carry out their responsibilities with respect to 

approval of these contracts.l18 

Since the enactment of section 36(b), the relatively few decided cases 

addressing the issue of management com ensation under the Act all have 

resulted in decisions for fund management!' The first of these cases remains 

the leading authority for evaluating an adviser's breach of fiduciar duty with 

regard to compensation.'20 One factor identified by that the role 

and decision-making process of fund directors in approving compensation 

arrangements, has been uniformly considered by following courts as the most 

important factor in determining section 36b) 

11'15 U.S.C. Q 8Oa-l5(c). 

ll'See S. REP. No. 184, 91st Cong., 1st Sess. 15 (1969). 

Il'See Gartenberg v. Merrill Lynch Asset Management, Inc., 528 F. Supp. 1038 (S.D.N.Y. 19811, 

urd, 694 F.2d 923 (2d Cir. 1982) ("Gartenberg I"); Gartenberg v. Merrill Lynch Asset Management, 

Inc., 573 F. Supp. 1293 (S.D.N.Y. 1983), uffd, 740 F.2d 190 (2d Cir. 1984); Schuyt v. Rowe Price 

Prime Reserve Fund, Inc., 663 F. Supp. 962 (S.D.N.Y.), urd, 835 F.2d 45 (2d Cir. 1987), cert. denied, 

485 U.S. 1034 (1988); Krinsk v. Fund Asset Management, 715 F. Supp. 472 (S.D.N.Y. 1988), urd, 

875 F.2d 404 (2d Cir.), cert. denied, 110 S. Ct. 281 (1989); Meyer v. Oppenheimer Management 

Corp., 609 F. Supp. 380 (S.D.N.Y. 19841, rev'd, 764 F.2d 76 (2d Cir. 19851, on remand, 707 F. Supp. 

1394 (S.D.N.Y. 1988) (corrected version; originally published at 691 F. Supp. 669) (section 36(b) 

issue reserved but discussed in dicta), 715 F. Supp. 574 (S.D.N.Y. 1989) (addressing section 36b) 

claim), urd, 895 F.2d 861 (2d Cir. 1990); and Kalish v. Franklin Advisers, Inc., 742 F. Supp. 1222 

(S.D.N.Y. 1990), ufd, 928 F.2d 590 (2d Cir.), cert. denied, 112 S. Ct. 75 (1991). 

IzoGartenberg I, 528 F. Supp. 1038. 

121The court primarily examined six factors in determining whether a breach of fiduciary duty 

had occurred. These factors are the nature and quality of the services rendered to the fund; the 

profitability in providing those services; the economies of scale that may result from fund asset 

growth and the effect such economies have on the adviser's Compensation; potential fall-out 

benefits arising from the investment company relationship; fees and expense ratios of other similar 

funds; and the role and decision-making process of fund directors in approving compensation 

arrangements. Id. 

'=See, e.g., Kalish, 742 F. Supp. at 1241-49; Schuyt, 663 F. Supp. at 980-88. 

The Sale of Open-End Investment Company Shares 319 
3. Section 12(b) 

Section 12(b) generally provides that a registered open-end investment 

company may not act as a distributor of its securities, except through an 

underwriter, in contravention of any rules prescribed by the Commission. The 

Commission testified in 1940 that this provision was intended to protect investors 

in open-end companies "against excessive sales, promo tion expenses, and so 

forth."123 Another explanation of its purpose comes from a commentator 

writing shortly after the Act's adoption: "[alpparently the Commission was 

particularly fearful of the possibility that open-end investment companies in their 

formative stages might be made to shoulder the unprofitable burden of selling 

and distributing their shares during this period of heavy expense and small 

return, building up the investment company for the benefit of some controlling 

person."124 Thus, section 12(b) was intended to prevent abuses through the 

grant to the Commission of authority to regulate the use of fund assets to pay for 

distribution. 25 

B. Administrative Action Since 1940 

1. The Use of Fund Assets to Pay for Distribution 

The Commission did not exercise its authority under section 12(b) to 

prescribe a rule governing the use of fund assets for distribution until 1980, when 

it adopted rule 12b-1.126 Since the adoption sf the rule, more than half of all 

mutual funds have enacted rule 12b-1 plans, using these char es, alone or with 

sales loads, as the primary means of financing di~tribution!~~ Other funds, 

typically funds with no front-end loads, have added a relatively modest rule 

12b-1 fee to pay for some sales commissions, printing prospectuses and sales 

literature, advertising, and similar expenses. 

When the Act was adopted, most funds charged a front-end sales load. By 

the mid-l970's, the no-load segment of the industry had increased 

1231940 House Hearings, supra note 37, at 112 (statement of David Schenker). 

'24Alfred Jaretzki, Jr., TheInvestmmt Company Act of1940.26 WASH. U. L. Q. 303,324-25 (1941). 

'=See also Inv. Co. Act Rel. 11414, supra note 15, at n.49 and accompanying text (adopting rule 

12b-1). 

126The legislative and administrative history leading up to the adoption of rule 12b-1 is 

lengthy. It is recounted in detail in Inv. Co. Act Rel. 16431, supra note 16. 

lnSee Lipper Directors' Analytical Data Vol. I, Sec. 111, at 3, Vol. 11, Sec. 11, at 157 (1st ed. 1992). 

320 CHAPTER 8 
The distribution expenses of these no-load funds were borne 

by their investment advisers. As the popularity and number of no-load funds 

increased, several of these funds requested that the staff take a no-action position 

allowing them to use fund assets to pay for distribution. These requests were 

generally denied in accordance with the traditional position of the Commission 

that the use of fund assets to pay the costs of distributing fund shares was 

improper .129 

The industry nonetheless continued to press its view, pointing to the 

increase in net redemptions in some segments of the fund industry, the growing 

resistance to high front-end sales loads, and the rising popularity of no-load 

It argued that the rigidity of the regulatory approach for fund 

distribution put mutual funds at a disadvantage to competing investment 

products that could be offered to investors without such sales 10ads.l~~ The 

industry also argued that use of fund assets for distribution expenditures would 

result in a net flow of cash into funds, and in turn, economies of scale and more 

effective portfolio 

'%See 1974 DISTRIBUTION REPORT, supra note 14, at 19,20-22. 

129See, eg., Axe-Houghton Funds (pub. avail. Nov. 15, 1973). See also Inv. Co. Act Rel. 9470, 

supra note 61, at n.1 and accompanying text. Despite the traditional position, investment 

companies were allowed on a number of occasions to bear distribution expenses under 

circumstances which served to lessen the potential for overreaching. First, certain funds that had 

internalized management functions were allowed to pay distribution expenses out of fund assets. 

See, eg., Broad Street Investing Corp., Investment Company Act Release Nos. 7071 and 7072 (Mar. 

16, 1972), 37 FR 5846 (Notices of Applications) and 7114 and 7117 (Apr. 14, 1972)(0rders); see 

generally PPI REPORT, supra note 11, at 49. Nor did the Commission object generally to the 

payment of fund distribution expenses by the fund's investment adviser; where, however, the 

advisory fee was increased in contemplation of payments for distribution by the adviser, the staff 

took the position that the advisory fee might result in a violation of section 36(b). See Inv. Co. Act 

Rel. 16431, supra note 16, at nn.11-13 and accompanying text. Historically, the Commission's 

opposition was based on the potential conflict inherent in the fact that, given the external 

management of mutual funds, most decisions relating to the use of fund assets are made by a 

fund's adviser, which directly benefits from increased sales of fund shares because its 

compensation is based on a percentage of fund assets. The Commission also was concerned 

whether using fund assets for distribution would in fact benefit existing shareholders. See Inv. 

Co. Act Rel. 9470, supra. 

'%Hearings on the Bearing of Distribution Expenses by Mutual Funds, File No. 4-186, Tr. at 

13'See Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release 

No. 10252, text accompanying nn. 2-3 (May 23, 1978), 43 FR 23589 (advance notice of proposed 

rulemaking). 

23, 248-49, 307-08. Inv. Co. Act Rel. 16431, supra note 16, at text following n.13. 

132See id. 

The Sale of Open-End Investment Company Shares 321 
In 1979, after extensive con~ideration?~~ the Commission proposed rule 

12b-1, stating that funds should be permitted to bear distribution expenses if they 

were disclosed and reg~1ated.l~~ The Commission adopted rule 12b-1 in 

October 1980.135 

2. Contingent Deferred Sales Loads 

The use of CDSLs developed contemporaneously with the use of rule 12b-1 

plans and indeed worked in tandem with them since the load is imposed to 

assure recoupment to the distributor of the costs of distribution. Where a fund 

might once have charged a six percent front-end load, it might now roughly 

recoup the same six percent through a combination of rule 12b-1 fees and 

contingent deferred 10ads.l~~ This "spread load" arrangement grew in 

popularity during the 1980's as many retail broker-dealers advanced to their 

salespersons large amounts of commissions for mutual fund sales, expecting 

reimbursement from future rule 12b-1 fees and CDSLS.~~~ 

'%In late 1976, the Commission held public hearings on the appropriateness of open-end 

companies bearing expenses related to the distribution of their shares. In 1977, the Commission 

considered that proposal but later issued a release stating it was still considering the question. 

Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release No. 9915 

(Aug. 31, 19771, 42 FR 44810. In 1978, the Commission issued an advance notice of proposed 

rulemaking stating that the Commission had not decided whether funds could benefit from 

paying distribution expenses. Inv. Co. Act Rel. 10252, supra note 131, at text accompanying n.4 

and text following n.9. 

I3*See Bearing of Distribution Expenses by Mutual Funds, Investment Company Act Release 

No. 10862 (Sept. 7,1979),44 FR 54014 (proposing rule 12b-1). 

'351n~. Co. Act Rel. 11414, supra note 15. 

13%ee, e.g., Drexel Burnham Fund and DBL Tax-Free Fund, Inc., Investment Company Act 

Release Nos. 16201 (Jan. 22,1988), 53 FR 2664 (Notice of Application), and 16284 (Feb. 24,1988), 

40 SEC Docket 548 (Order). The Commission's 1988 release proposing rule 6c-10, an exemptive 

rule permitting funds to impose deferred sales loads (including contingent loads), discusses the 

legislative and administrative history of these arrangements in detail. Inv. Co Act. Rel. 16619, 

supru note 20. 

13'For example, one fund that pioneered the use of a spread load grew from about $109 

thousand to almost $4 billion in assets in a single year. During that year, the distributor spent 

roughly $205 million on behalf of the fund and received only $23 million in rule 12b-1 fees and 

$3 million in CDSLs, resulting in unreimbursed distribution fees of over $179 million. Assuming 

constant asset size and no redemptions, it would have taken five years to recover this "carryover" 

amount. Although the distributor treated the carryover as an asset - a receivable to be collected 

in future years - the fund did not consider the carryover to be a liability. Rather, the fund 

recognized only a current expense in an amount equal to the amount of rule 12b-1 fees paid that 

year ($23 million) because it was not contractually obligated to pay any additional amounts if the 

(continued ...I 

322 CHAPTER 8 
The spread load is essentially a financing of a front-end sales load. 

Unfortunately, neither component of the spread load is as obvious to investors as 

is a front-end sales load. The rule 12b-1 charge is deducted as an expense at the 

fund level, while the CDSL is deducted out of an individual shareholder's 

redemption proceeds. 

3. The Commission's 1988 Proposals to Limit Spread Loads and 

Permit Installment Loads 

In 1988, the Commission proposed broad amendments to rule 12b-l.138 

The proposal reflected concern with the open-ended nature of distribution 

payments and their criticism by some as "hidden loads." The proposal would 

have effectively prohibited the use of spread loads as alternatives to front-end 

loads. 

Shortly thereafter, the Commission proposed rule 6c-10, in part to codify 

exemptive orders issued to applicants permitting CDSLsJ3' Proposed rule 6c10 went beyond these orders to allow non-contingent deferred sales loads, 

including installment loads.'@ Proposed rule 6c-10 was intended to provide 

eater flexibility to mutual funds in their distribution arrangements, especially 

13'(. . .continued) 

rule 12b-1 plan was cancelled or allowed to lapse by the board of directors. Of the $205 million 

spent by the distributor, 45% represented commission credits to brokers and 52% represented an 

allocation of branch office overhead, sales seminar costs, travel expenses of mutual fund sales 

coordinators, and other incidental expenses related to branch sales promotion. Prudential-Bache 

Government Plus Fund, Inc., Prospectus 11-13 (May 1, 1986) and Statement of Additional 

Information B-15 to B-17, B-25 to E28 (May 1,1986), SEC File No. 2-82976. 

I3'See Inv. Co. Act Rel. 16431, supra note 16. 

1391nv. Co. Act Rel. 16619, supra note 20. 

140Commission rules relating to certain variable life insurance contracts permit sales loads to 

be deducted over time, as well as upon redemption. See rule 6e-3(T) under the Investment 

Company Act, 17 C.F.R. 5 270.6e-3(T). See also Separate Accounts Funding Scheduled Premium 

Variable Life Insurance Contracts, Investment Company Act Release No. 14421 (Mar. 15, 1985), 

50 FR 11709 (proposing amendments to Rule 6e-2 that would, among other things, permit 

installment loads and loads on redemption for scheduled contracts). In addition, the Commission 

has issued exemptive orders to permit sales loads to be deducted from variable annuity contract 

owner accounts over time. See, eg., MB Variable Life Ins. Co., et. al., Investment Company Act 

Release Nos. 18434 (Dec. 10,1991), 56 FX 65528 (Notice of Application), and 18476 (Jan. 8,19921, 

50 SEC Docket 1145 (Order). 

The Sale of Open-End Investment Company Shares 323 
arrangements designed to offer shareholders deferred payments for sales charges 

without use of rule 12b-1 ~1ans.l~~ 

Both proposals were met by a storm of criticism from the industry, which 

regarded them as dooming spread loads without a satisfactory replacement, 

forcing most spread load funds to revert to front-end 10ads.l~~ They rejected 

installment loads as a feasible alternative to spread 10ads.l~~ They predicted 

that investors would reject funds in favor of other investments that permitted 

deferred charges, eg., variable annuities>44 Critics also argued that the 

proposals would jeopardize maintenance of viable distribution systems. Such 

systems, they argued, stimulate growth and benefit funds and shareholders by 

enabling advisers to build stronger advisory organizations, with greater 

economies of scale and more sophisticated communication and data processing 

facilities for shareholder servicing.lG Many of these commenters contended 

that funds would not be interested in using non-contingent deferred sales loads 

because of high administrative costs and operational diffic~1ties.l~~ 

14'Inv. Co. Act Rel. 16431, supra note 16, at n.84; Inv. Co. Act Rel. 16619, supra note 20, at text 

following n.33. 

142See, e.g., Letter from Keystone Group, Inc. to Jonathan G. Katz, Secretary, SEC 1 (Jan. 6, 

1989), File No. S7-24-88 (responding to Inv. Co. Act Rel. 16619, supra note 20); IC1 Rule 12b-1 

Comment, supra note 16, at 4. They noted that spread load plans had been adopted by more than 

300 funds with over seven million shareholder accounts and assets exceeding $70 billion. With 

respect to the rule 12b-1 amendments, the Commission received 91 letters from the industry, 1,650 

letters from individual investors, and over 70 congressional inquiries regarding the proposing 

release. Generally, individual investors supported the amendments. 

Ig3See, e.g., Letter from the IC1 to Jonathan G. Katz, Secretary, SEC 13-16 (Jan. 9,1989), File No. 

57-24-88 (responding to Inv. Co. Act Rel. 16619, supra note 20) [hereinafter IC1 Rule 6c-10 

Comment]; Letter from the Subcomm. on Investment Companies and Investment Advisers of the 

Comm. on Federal Regulation of Securities, Section of Corporation, Banking and Business Law, 

American Bar Association, to Jonathan G. Katz, Secretary, SEC 3 (Jan. 31,1989), File No. S7-24-88 

(responding to Inv. Co. Act Rel. 16619, supra note 20). 

I4ICI Rule 12b-1 Comment, supra note 16, at 11. 

'&For example, the IC1 also contended that the practical effect would be to prevent new and 

smaller funds from adopting or continuing spread loads while permitting large, established funds 

with a large asset base to finance new shares on the proposed current or one year basis. In 

addition, the IC3 argued that the amendments would frustrate the legitimate expectations of 

underwriters and investors. IC1 Rule 6c-10 Comment, supra note 143, at 15; IC1 Rule 12b-1 

Comment, supra note 16, at 5-6. 

*&See, e.g., IC1 Rule 6c-10 Comment, supra note 143, at 2-3. Cf. Letter from IDS Financial Corp. 

to Jonathan G. Katz, Secretary, SEC 1 (Jan. 3,1989), File No. 57-24-88 (responding to Inv. Co. Act 

Rel. 16619, supra note 20). 

324 CHAPTER 8 
Some critics also argued that the proposed prohibition on the use of the 

no-load label by all funds with rule 12b-1 plans did not distinguish between 

funds that are essentially no-load but assess a small charge to pay for 

supplemental distribution expenses and those that use rule 12b-1 plans as the 

functional equivalent of front-end sales 10ads.l~~ 

C. Proposed NASD Regulation of Rule 12b-1 Fees 

In response to the 1988 proposal, the NASD sought to address the concern 

that rule 12b-1 fees were being used to circumvent the NASD imposed limitations 

on excessive sales loads148 Subsequently, it proposed amendments to its 

maximum sales load The amendments would limit all sales charges, 

including front-end loads, rule 12b-1 payments, and CDSLs.15' 

The NASDs espoused objective was to assure in the simplest and most 

expedient way that shareholders paying for distribution indirectly through rule 

e.g., IC1 Rule 12b-1 Comment, supra note 16, at 71-72; Letter from ICI to Jonathan G. 

Katz, Secretary, SEC 3-4 (May 10, 19911, File No. SR-NASD-90-69 (responding to Exch. Act Rel. 

29070, supra note 18) [hereinafter IC1 NASD Rule Comment]. 

148Form 19b-4, Proposed Rule Change by NASD 10-11 (Dec. 28,19901, File No. SR-NASD-90-69 

[hereinafter NASD Proposal]. 

149The NASD extensively regulates sales compensation paid in connection with sales of 

securities by its members under Article 111, Section 1 of the Rules of Fair Practice. NASD Manual 

(CCH) 4[ 2151. See also NASD Proposal, supra note 148, Exhibit 5. See NASD Notice to Members 

No. 90-26 (Apr. 1990) and NASD Notice to Members No. 90-56 (Sept. 1990). In response to the 

Study Release (supra note 261, several commenters supported NASD regulation as a more 

acceptable alternative than the 1988 Commission proposal. See, eg., IC1 Study Comment, supra 

note 26, at 52-53. 

lWIn brief, the NASD proposal would create a rolling cap of 6.25% of new gross sales, plus 

annual interest equal to the prime rate plus one percent on the total sales charges -- front-end, 

asset-based, and deferred -- for funds that pay "service fees" and a rolling cap of 7.25% for funds 

that do not pay service fees. The reduction from 8.5%, the maximum permitted sales charge 

under the present rule governing front-end loads occurs because asset-based sales charges do not 

provide quantity discounts or rights of accumulation. New gross sales are defined to exclude the 

reinvestment of distributions and complex-wide exchanges of shares. Service fees are defined 

under the proposal as payments by a fund for personal service and/or shareholder account 

maintenance. The rule also imposes an annual cap on the amount of asset-based sales charges 

that may be collected in any one year of .75% of average annual net assets. In addition, a 

maximum .25 of 1% of its average annual net assets may be paid by a fund for personal service 

and/or account maintenance of shareholder accounts as a "service" fee, which is not counted in 

the .75% cap. If the maximum aggregate cap is reduced to zero, no more rule 12b-1 fees may be 

collected until there are new sales; if the fund continues to receive deferred charges on 

redemption, those monies may not be used to pay for sales-related expenses. See NASD Proposal, 

supra note 148, at 2-9. 

The Sale of Open-End Investment Company Shares 325 
12b-1 fees would pay no more than those paying at the front-end151. The 

present state of technology forced it to reject tagging rule 12b-1 fees to individual 

accounts. It opted, therefore, for fund-level accounting, which could be 

implemented rapidly and would not preclude the industry from eventually 

implementing individual shareholder a~c0unting.l~~ Accordingly, the NASD 

proposal requires fund-level accounting as the minimum standard. It preserves 

the use of spread loads>53 

D. Limited Amendments to Rule 12b-1 

In light of the NASD's proposal to limit asset-based sales charges, we 

end that the Commission adopt only limited changes to rule 12b-1, not 

der amendments proposed in 1988. The Division's recommendation 

would permit the continued use of spread loads. 

Those opposing the 1988 rule proposal generally have argued that the 

present variety of fees and charges provides fund sponsors with needed ricing 

flexibility and gives investors a wide range of payment option^.'^' For 

example, the IC1 believes that improved required disclosures, such as the 

prospectus fee table155 and disclosure of the existence of CDSLs on the front of 

tonfirmation~,l~~ willreduce investor confusion about the multiplicity of sales 

load ~tructures.l~~ The IC1 also argues that the Commission's concerns about 

the level of rule 12b-1 fees are most effectively addressed by direct NASD 

regula ti~n.'~~ 

15'Id. at 10-11 and 17-19. 

152See Exch. Act Rel. 29070, supra note 18 at 1I.C. Fund-level accounting requires that all sales 

charges end when a percentage of gross sales is reached while individual shareholder accounting 

requires separate tabulation of all charges paid by each shareholder. Id. 

lSIn addition to addressing rule 12b-1 fees, the current rule would be modified to include 

explicitly deferred sales charges. 

'%See IC1 Study Comment, supra note 26, at 51-53. 

155See infra notes 181 and 200 and accompanying text. 

lM0rder Granting Approval to Proposed Rule Change Relating to Disclosure of Deferred Sales 

Charges, Exchange Act Release No. 29069 (Apr. 11, 1991), 56 FR 15654. 

lrnSee IC1 Study Comment, supra note 26, at 53; IC1 Rule 12b-1 Comment, supra note 16, at 17- 

18. 

lsSee IC1 NASD Rule Comment, supra note 147, at 1-2. 

326 CHAPTER 8 
While the NASD proposal would not entirely resolve the problems that 

gave rise to the 1988 proposals, it is a step in the direction of limiting fee levels. 

In addition, while reverting to the status quo ante may have some appeal to those 

who yearn for a simpler time, the fact is that many investors may wish to finance 

their sales loads through a spread load arrangement and would not appreciate 

elimination of that option. 

We remain concerned, however, that the inherent lack of transparency of 

spread loads compromises competitive pressures on fee levels. Although the 

methods for calculating shareholder transaction expenses and fund operating 

expenses are disclosed in the prospectus, comprehensible disclosure of spread 

loads, and what amount an individual ultimately will pay, is inherently difficult. 

The rule 12b-1 fee component of this type of sales load is deducted at the fund 

level as an expense of the fund, before the calculation of net asset value and 

investment return, and not as a dollar amount periodically deducted from a 

shareholder's account as an installment load would be. In the prospectus, it is 

listed with the other fund operating expenses, such as management and other 

fees, and not with the shareholder transaction expenses which include the other 

types of sales loads. The CDSL component of the spread load is even less visible 

or convertible to a "sum certain" at the time the investment is made.159 

To address the disclosure problem, we considered recommending that all 

funds be required to pay for transaction-based distribution charges (largely sales 

commissions) out of individual shareholder sales loads, which could be either the 

front-end or the installment type, rather than out of fund assets. All other types 

of distribution expenses could be paid for by the adviser, out of its management 

fee. 

While this approach has considerable appeal, we concluded that tax law 

cornplicationsl6' would make the method essentially impossible. Unless and 

until the tax laws change, we think spread loads generally should be permitted. 

Thus, at least at present, the Division recommends that the Commission adopt 

only the portions of the proposed amendments to rule 12b-1 that are consistent 

with the use of spread loads. 

The Division, however, remains concerned with investor understanding of 

rule 12b-1 fees and will continue to focus on improving disclosure of these 

159The accounting treatment of spread loads exacerbates the confusion. When a principal 

underwriter advances commissions to salespersons, it records as an asset on its books a receivable 

from the fund, but the fund does not report a matching liability on its books. In economic reality, 

however, the fund probably will be paying for much of the sales commission over the next several 

years. 

'?See infva text accompanying notes 165-68. 

The Sale of Open-End Investment Company Shares 327 
arrangements. The recent NASD rule amendment to require disclosure of the 

existence of contingent deferred sales loads on confirmations is a positive step. 

In addition, we believe investor demand may cause more funds to adopt methods 

of financing distribution other than spread loads, such as multiple class 

arrangements with a "conversion" feature,16' and low front-end sales loads>62 

We believe, too, that the unified fee investment company proposal that we discuss 

below also will be used by funds to meet investor demand for simple and more 

easily understandable fee arrangements. 

E. Adoption of Rule 6c-10 

The Division recommends that the Commission adopt rule 6c-10 largely as 

proposed to provide for both CDSLs and non-contingent deferred loads such as 

installment loads. Commenters supported adoption of proposed rule 6c-10 to the 

extent it would have codified exemptive orders for CDSLS.~~~ By and large, 

they roundly criticized the proposal for non-contingent loads, however, as 

operationally infeasible because of high administrative costs and operational 

difficulties associated with the implementation of such charges, adverse tax 

consequences for shareholders, and aspects that would make the loads 

economically undesirable for underwriter^.'^^ 

The Division disagrees with that criticism. The funds that currently impose 

a contingent load or offer class conversions may well possess the type of 

operational systems and procedures necessary to offer the non-contingent 

deferred loads that would be permitted under the rule. In addition, whether the 

implementation of a deferred load would result in substantial costs or difficulties 

will depend on many factors, including the complexity of the load. In any case, 

~ 

16'See, e.g., infia note 174 and accompanying text. 

162For example, the Lexington family of funds recently changed from front-end loads to a noload structure. See Lexington Goes No-had, DONOGHUE'S MONEEETTER 7 (Oct. 1990). 

'@Thirtyeight commenters responded; seven commented only on the life insurance separate 

account rules. Almost all supported codification of CDSL exemptive orders. See, eg., ICI Rule 

6c-10 Comment, supra note 143, at 2-3. 

IaEight commenters opposed non-contingent deferred sales loads. See Letter from the 

American Bar Association, Section of Business Law, to Jonathan G. Katz, Secretary, SEC 4 (Jan. 

31, 1989), File No. S7-24-88; Letter from the IC1 to Jonathan G. Katz, Secretary, SEC 2-3, 6, 8-11 

(Jan. 9,1989), File No. S7-24-88; Letter from IDS Financial Co., to Jonathan G. Katz, Secretary, SEC 

1-2 (Jan. 3, 19891, File No. S7-24-88; Letter from Keystone Group to Jonathan G. Katz, Secretary 

SEC 1 (Jan. 6,1989), File No. S7-24-88; Letter from the NASD to Jonathan G. Katz, Secretary, SEC 

1 (Mar. 14,1989), File No. S7-24-88; Letter from NYLIFE Securities to Jonathan G. Katz, Secretary, 

SEC 2-4 (Dec. 30, 1988), File No. S7-11-88; and two individual investors. Sixteen commenters 

supported non-contingent deferred sales loads; of those, fifteen were individual investors. 

328 CHAPTER 8 
technology is evolving rapidly and it is reasonable to anticipate that cost-effective 

systems for implementing even the most complex types of loads will be available 

soon, if they are not already. 

We also note that the rule offers a voluntary option. A fund not able to 

take advantage of its provisions would not be required to do so. 

We recognize that the tax laws are a significant impediment to 

implementing non-contingent deferred loads and installment loads. The tax laws 

may prohibit payments of installment loads in certain tax-privile ed situations, 

such as Individual Retirement Accounts or pension accountsJ6' In addition, 

the collection of installment loads is likely to occur through redemptions of fund 

shares:66 which is a taxable event. Investors either would incur tax liabilities 

for gains when not actually receiving any distributions or would realize 

10sses.l~~ Investors also would bear added recordkeeping burdens, because 

each installment of a deferred load would be treated as an increase in the 

shareholder's basis.168 

On balance, we conclude the benefits of proposed rule 6c-10, a permissive 

rule, outweigh the problems raised by commenters. In addition to codifying 

orders permitting CDSLs, the proposed rule would allow noncontingent deferred 

loads, which some funds may choose to implement. Indeed, the Division 

proposed the rule only after receiving informal inquiries whether such loads 

could be imposed on fund shares. Accordingly, the Division recommends that 

rule 6c-10 be adopted, largely as proposed, but with certain modifications 

suggested by commenters to improve the mechanics of the rule. We recognize, 

however, that installment loads likely will not be used without tax reform. 

'65Payments from pension plans and individual retirement accounts and annuities that are not 

considered rollovers would likely be taxed to the investor as a distribution. See Internal Revenue 

Code of 1986,26 U.S.C. 55 402(a)(5) and 408(d)(3). For an IRA, the entire account may lose its 

exempt status and the investor would recognize the amount of that distribution in taxable income 

for that tax year. See Internal Revenue Code of 1986, 26 U.S.C. $j§ 4975(e)(2)(A), (B), 408(e)(2), 

402(a)(l) and 408(d)(l). 

166Alternatively, the installment load could be billed directly to the customer (with no adverse 

tax consequences in most cases) or deducted from the shareholder's dividends; or the customer's 

shares, if any, in a related money market fund could be redeemed to cover the charges. The tax 

consequences for shareholders of an annual installment payment would be similar to those of an 

annual redemption elected by a shareholder for trading or other purposes. 

1671n addition to shareholder recognition problems, tax-related issues involve imputed interest 

(and investment interest expense) and withholding; other difficult issues raised by deferred loads 

would include access to margin securities and receivables at the distributor level. 

'&Bills introduced in the 102nd Congress would require funds to provide shareholders and 

the Internal Revenue Service with cost basis information for all fund shares redeemed, taking into 

account all adjustments to basis, e.g., returns of capital, wash sales. See, e.g., H.R. 2735 and S. 530, 

102nd Cong., 1st Sess. (1991). 

329 
F. Multiple Class Exemptive Rule 

Since 1985, a number of funds have obtained exemptive orders permitting 

them to issue multiple classes of securities, with each class subject to a different 

distribution arrangement, but representing interests in the same portfolio of 

investment~?~' Typically, the classes are identical in all respects except for the 

allocation of distribution, administrative, or support service expenses, and related 

incremental expenses (Le., transfer agency fees), differences in voting rights, and 

dividend payment differences. The funds fall into three basic types, which 

roughly may be characterized as "multiclass" funds, "dual distribution" funds, and 

"conversion" funds, although more recent orders have mixed some of the features 

of these ty~es.1~' 

"Multiclass" funds were the first type used. They were created to compete 

for the short-term investments of certain institutional investors. The investors 

wanted services adapted to their particular needs. Typically, multiclass funds 

enter into arrangements whereby particular classes of fund shares are sold to 

specific institutional investors, such as banks acting in a fiduciary, advisory, 

agency, custodial, or similar capacity on behalf of customer accounts, insurance 

companies, investment counselors, brokers, or other financial institution^?^^ 

In some cases, one or more of the classes are sold directly to indi~idua1s.l~~ 

The fund usually makes payments to the institution for providing administrative 

or shareholder services and, sometimes, for distribution services as well. This 

arrangement allows the "unbundling" of services typically provided by the fund 

and permits institutional investors to select the services they wish to provide to 

their shareholders. 

169The applicants received exemptive orders under section 6(c) (15 U.S.C. § 80a-6(c)) from 

section 18 (15 U.S.C. 5 8Oa-18) to the extent that the arrangements might be deemed to result in 

the issuance of a "senior security" and to be inconsistent with the requirement that every share 

have equal voting rights. See releases cited infva notes 171-74. 

17'A recent related development is the "hub and spoke" fund structure, under which funds 

with different costs share a single investment portfolio. It is similar to a multiclass structure, but 

uses separate funds instead of classes. Typically, the spoke funds invest solely in the hub fund, 

which holds the investment portfolio and bears advisory fees. 

'"See, e.g., The Hex-Funds, Investment Company Act Release Nos. 18110 (Apr. 23, 1991),56 

FR 19888 (Notice of Application) and 18162 (May 21,1991), 48 SEC Docket 1685 (Order); Federated 

Securities Corp., Investment Company Act Release Nos. 17645 (Aug. 2,1990), 55 FR 32531 (Notice 

of Application), and 17715 (Aug. 30, 1990),46 SEC Docket 1993 (Order) (permitting unlimited 

number of future classes and allocation of a broad array of expenses by class). 

lnSee, eg., Mutual Fund Group, Investment Company Act Release Nos. 17539 (June 19,1990), 

55 FR 26045 (Notice of Application), and 17590 (July 17,19901, 46 SEC Docket 1366 (Order). 

330 CHAPTER 8 
"Dual distribution" funds typically have two classes that bear different 

distribution charges, e.g., a front-end load and a spread load. They have a 

somewhat different purpose -- to allow investors to select the method of financing 

distribution best suited to their investment horizon and the size of their 

investment. For example, investors who would qualify for a significant reduction 

in the front-end load or investors who will be holding their shares for a long time 

may decide that a front-end sales load is preferable to an ongoing distribution fee 

under a spread load>73 

The "conversion" funds are a variant of the dual distribution funds. 

Typically, investors may still choose between two classes, one with a front-end 

load and no or a relatively low rule 12b-1 fee, and the other with a spread load, 

but with a relatively large rule 12b-1 fee. Shares of the spread load class convert 

to shares of the other class, without payment of any fee or load, after a specified 

period (e.g., four to eight years) desi ned to permit the principal underwriter to 

recover its distribution expense^.'^' The conversion feature limits the rule 

12b-1 plan payments borne by each shareholder to an amount approximately 

equal to the distribution expenses incurred on the shareholder's behalf in the 

primary distribution while also placing a ceiling on the compensation received by 

the distributor for these initial distribution expenses. 

The conditions to exemptive orders have addressed three areas of concern. 

The first is possible conflicts of interest among the classes of shareholders, 

especially as to the allocation of expenses. To address this concern, the applicants 

have agreed that the funds' directors will monitor for material conflicts and take 

action necessary to remedy such conflicts. In addition, the funds' methodology 

for allocating direct and indirect distribution expenses among the classes is 

reviewed by an outside expert and approved by the independent directors. 

The second area addressed is the funds' calculation of different net asset 

values. The net asset values of the classes in some types of funds usually will 

vary. For example, a front-end load class having lower expenses than a spread 

load class, which bears the rule 12b-1 plan expenses and the related higher 

transfer agency costs, will be entitled to receive more of the fund's current net 

*%%e, e.g., Merrill Lynch California Municipal Series Trust, Investment Company Act Release 

Nos. 16503 @dy,28,1988), 53 FR 29294 (Notice of Application), and 16535 (Aug. 23,1988),41 SEC 

Docket 1165 (Order) (first dual distribution order) [hereinafter Merrill Order], amended in Merrill 

Lynch Short-Term Global Income Fund, Inc., Investment Company Act Release Nos. 18015 (Feb. 

22, 1991), 56 FR 8814 (Notice of Application), and 18059 (Mar. 22, 19911, 48 SEC Docket 838 

(Order). 

174See, e.g., Alliance Short-Term Multi-Market Trust, Inc., Investment Company Act Release 

Nos. 17295 (Jan. 8, 1990), 54 FR 1300 (Notice of Application), and 17330 (Feb. 2, 19901, 45 SEC 

Docket 1024 (Order). 

The Sale of Open-End Investment Company Shares 331 
assets on a per share basis. Applicants have retained an outside expert to assure 

that the funds have systems to compute net asset values accurately. 

The third area addressed is whether investors receive information enabling 

them to understand a multiple class arrangement and make informed investment 

decisions. Certain disclosures have been required, e.g., that salespersons' 

compensation depends upon which class is sold and differences in the yields and 

total returns for the respective classes. 

The Division recommends that the Commission adopt a rule permitting 

funds to issue multiple classes of shares in a single underlying portfolio. We 

intend to re-examine the conditions imposed on applicants, with a view towards 

streamlining them. A more general rule would simplify the procedure for 

creating multiple classes, saving time and reducing expenses. Multiple class 

funds are a useful structure that can increase investor choice, result in economies 

of scale and certain efficiencies in the distribution of fund shares, and allow fund 

sponsors to tailor products more closely to the needs of investors. 

IV. The Unified Fee Investment Company: An Alternative 

As the foregoing discussion suggests, mutual fund fee structures have 

grown increasingly complicated in the last two decades. The array of fees and 

loads now available to investors does increase investor choice, but may also 

impede price competition. The Division believes that price competition might be 

improved if, ironically, still another form of investment company were permitted -- 

one with a simplified fee structure and low barriers to exit by dissatisfied 

shareholders. 

Accordingly, the Division recommends that the Commission propose 

legislation to permit the introduction of a new investment vehicle, which we term 

a unified fee investment company ("URC"). The UFIC would have a single, fixed 

fee set by the vehicle's "investment manager" and no separate sales charges or 

redemption fees. All UFIC expenses, except brokerage commissions on the fund's 

own portfolio transactions and extraordinary costs, would be paid from the single 

fee or from the manager's own resources. Rule 12b-1 would not apply. The level 

of the fee would be prominently displayed on the cover page of the prospectus 

and in all sales literature and advertising. To protect investors should 

competition not restrain fee levels for the UFIC, the Act would prohibit 

"unconscionable or grossly excessive" unified fees. 

The UFIC would have a board of directors to police operational conflicts 

and approve a variety of operational activities, just as do other funds. The UFIC's 

board also would be charged with approving the investment manager's contract 

with the fund, and ensuring that the level of the single fee is not unconscionable 

332 CHAPTER 8 
or grossly excessive. Short of protecting shareholders against such fees, however, 

the board would not be responsible for negotiating the level of the fee, nor would 

the board be required to scrutinize the fee provisions of the fund’s investment 

advisory contracts. The board also would oversee the level of services provided 

to the UFIC through review of all material service contracts. Shareholders would 

elect directors in accord with section 16(a) of the Act. Two-thirds of the directors 

would be independent; and, once initially selected by the UFIC sponsor, the 

independent directors would be self-nominating. 

The UFIC’s shareholders would not vote on issues related to fees or 

contracts. Thus, they would not vote to approve or terminate the management 

contract, any investment advisory contract, or any other contracts for fund 

services. Their authorization would not be needed to increase the rate of the 

unified fee. Rather, after reviewing advance notice of a fee increase or contractual 

change, shareholders would have the opportunity to accept or reject the increase 

or change by remaining in the fund or redeeming their shares. The shareholders 

would have all other voting rights mandated for shareholders of open-end 

companies. 

The UFIC’s single fee would be reflected in the vehicle’s performance 

figures and could be readily compared with the fees charged by other UFICs. 

Without sales loads as barriers to exit, dissatisfied UFIC investors could redeem 

freely. This ready ability to exit should focus managers on keeping expense levels 

low and investors satisfied. 

Regulatory provisions imposed by the 1970 amendments to the Investment 

Company Act to counteract the ineffectiveness of competitive forces on fee levels 

would not apply to the UHC. Thus, section 36(b) would not apply to the fee paid 

to the UFIC‘s investment manager. In addition, section 22(b) would not apply to 

the fee or any portion thereof. 

It appears likely that no-load funds would use the UFIC first. Many longterm bond or stock funds that distribute their shares through commissioned sales 

forces likely would have to restructure their sales compensation arrangements in 

order to operate as UFICs. A few broker-dealers have already reformulated sales 

compensation from large up-front payments to streams of payments, which would 

be more compatible with the UFIC structure. Given the flexibility of the UFIC, 

if investor demand for a simplified fee product is strong, we expect that the 

industry would use its creativity to devise distribution methods acceptable to 

commissioned sales forces that would allow long-term bond and stock funds to 

use the UFIC. 

The Sale of Open-End Investment Company Shares 333 
A. Rationale for the Unified Fee Investment Company 

Investors today appear to have a heightened awareness of fund expenses 

and their effect on investment return, but at present bond and equity funds do 

not appear to compete on the basis of expenses, perhaps because of several factors 

that inhibit market pressure. This increased investor awareness is likely due 

partly to Commission actions in the past twenty years to relax restrictions on 

advertising generally by investment companies and to develop standards for 

disclosing and advertising fund performance>75 These actions permitted the 

evolution of an information industry that tracks funds. Specialized newsletters 

are published by a host of organizations, and many financial and general interest 

publications provide extensive coverage and analysis of mutual funds, including 

periodic rankings of performance and fund expense ratios. 

As a result of these changes, funds that have low expenses have enjoyed 

substantial and market forces appear to be a more effective restraint 

on expenses today than they were in the 1960's. The degree of restraint, however, 

varies among the three major fund types: money market funds, bond funds, and 

stock funds. Two factors appear to explain the variations. First, where the costs 

of owning mutual fund shares are clear-cut and there are few barriers to exit, 

investors have greater incentive to leave, and, consequently, fund sponsors must 

be vigilant about paring expense levels. Second, where expenses directly and 

substantially affect short-term performance, investors focus on expense levels; the 

less ex enses affect short-term performance, the less investor scrutiny they receive. Y77 

"3ee Chapter 9. 

176For example, assets under the management of the Vanguard Group, the lowest-cost 

producer in the mutual fund industry, grew twentyfold during the 1980'~~ from $2.4 billion to 

over $50 billion, twice the rate of the industry as a whole. SANFORD C. BERNSTEIN AND Co., THE 

FUTURE OF THE MONEY MANAGEMENT INDUSTRY 60 (1990) [hereinafter BERNSTEIN REPORT]. 

lnThe level of expenses, of course, varies widely among fund types. According to one fund 

group: 

[Costs] tend, for example, to be higher in equity-oriented funds (where they are 

easy to overlook on any short-term basis), and lower in money market funds 

(where they account for substantially all of the difference in yield). The costs of 

taxable and tax-exempt bond funds fall between this range. 

Vanguard Money Market Reserves, 1990 ANNUAL REPORT ii (1990). One writer contrasts the 

expenses of bond funds with those of stock funds by noting that "[blond funds usually have lower 

expense ratios than stock funds because they are not managed as aggressively." Carole Gould, 

High Expenses: Sign of Weakness, N.Y. TUIFS, Mar. 4,1990, at F-28. 

334 CHAPTER 8 
These factors converge for money market funds and consequently market 

forces appear to exert great downward pressure on money market fund expenses. 

Investors accurately perceive that the money market fund is a relatively 

homogenous product for which yield is a major purchase criterion. The typical 

money market fund has no sales loads, either front-end or contingent deferred, 

and either no or low rule 12b-1 fees and thus simple, intelligible expenses and no 

barriers to a dissatisfied shareholder‘s exit from the fund. To attract and retain 

investors, money market fund sponsors actively compete on yield. Expense 

differentials may account for as much as three quarters of the variation in money 

market fund yield and almost one half of the difference between the highest- and 

lowest-yielding money market funds>78 Investor focus on money market fund 

expense levels is sharpened by advertising and media coverage, which provide 

significant information to facilitate yield comparisons, and emphasize that the 

level of fund expenses is a major determinant of yield. Substantial fee waivers 

by money market fund sponsors have been common in recent years, and further 

emphasize the relationship between expenses and yield.179 In fact, the fee 

waivers are usually styled as the manager absorbing all fund expenses beyond a 

certain level (e.g., twenty-five basis points), resulting in a fixed, single fee. 

There is less market pressure on the levels of fees with bond and stock 

funds than with money market funds. The variety of charges and operating and 

Insee IBC/DONOGHLJE~S MONEY FUND REPORT 1 (Aug. 10,1990); BERNSTEIN REPORT, supra note 

176, at 12. The effect of expenses on yield is likely to be further enhanced, as the recent 

amendments to rule 2a-7 (17 C.F.R. 5 270.2~1-7) have tightened the conditions of the rule relating 

to portfolio quality, maturity, and diversification, so that money market funds’ portfolios (and 

rates of return) are likely to become increasingly fungible. See Revisions to Rules Regulating 

Money Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 1991),56 FX 8113. 

17’Carole Gould, One Way Funds Can Inflate Yields, N.Y. TIMES, June 23, 1991, at 111-10 (“More 

and more funds are absorbing some expenses as part of marketing strategies intended to attract 

investors by inflating yields -- the amount that funds earn in interest after the expense charges 

are subtracted. As of April 30, [1991,1 7 of the 10 top-yielding money funds were subsidizing at 

least part of their expenses by charging investors less than the total amount spent to run the 

funds. And, on average, 7 of the 10 top money funds have done so for the last year . . . .‘I), 

The Sale of Open-End Investment Company Shares 335 
distribution expenses of bond and stock funds are difficult to aggregate, cannot 

be readily compared among funds:" and cause investor confusion?" 

Today, bond and stock funds typically operate under an unbundled fee structure: 

they pay multiple fees for separate services provided under separate contracts. 

Of further confusion to investors, fees with the same label pay for different 

services. For example, some advisory contracts provide for portfolio management 

only. Other advisory contracts also provide for administrative, shareholder 

accounting, and transfer agency services. Compounding the labeling problem, 

particular fees are obscured by their placement in either the fund or the 

shareholder account, or by shifting their timing among point of purchase, 

investment period, and point of exit. Moreover, the sales loads (contingent or 

otherwise) and redemption fees charged by many bond and stock funds are 

perceived by investors as a penalty for taking one's money elsewhere and, as 

barriers to shareholders' exit, discourage competition for investors' dollars. 

Consequently, the competitive pressures on these funds appear to be less than on 

money market funds. 

In addition, the relative investment performance of stock funds and, to a 

lesser degree, bond funds is not as significantly affected by expenses, at least in 

the short run, as is the performance of money market funds?82 As a 

'%ontributing to this difficulty, rule 12b-1 distribution fees currently are treated as an annual 

fund expense that is automatically included in annual return computations, while front-end loads 

and contingent deferred sales charges are sometimes included in calculations of total return and 

at other times are not included. For example, rule 482 (17 C.F.R. § 230.482) permits mutual funds 

to advertise performance data that do not reflect sales loads or other nonrecurring fees, provided 

that the funds disclose that the performance data do not reflect their deduction, and that, if 

reflected, the loads or fees would reduce the performance quoted. Rankings of fund performance 

issued by various publications often do not reflect such charges. 

I8'With the 1988 amendments to Form N-1A (see Inv. Co. Act Rel. 16244, supra note 85), the 

Commission required mutual funds to consolidate expense data in a fee table located near the 

front of each prospectus and to include additional disclosure regarding rule 12b-1 plans. These 

disclosures improve investor understanding of fund expenses and sales charges, but the different 

kinds of costs still frustrate direct comparisons. 

182Bond funds' expense differentials account for a lesser, although still significant, proportion 

of the overall yield and total return variation than do those of money market funds. Bond fund 

yields are subject to greater variation than yields of money market funds because bond fund 

portfolio managers are not bound by the limits on portfolio quality and maturity mandated by 

rule 2a-7 and accordingly, their portfolios are not as homogenous. The expenses of bond funds, 

however, have different effects on yield than on total return. A bond fund's total return usually 

differs from its yield because the value of its portfolio varies with changes in the general level of 

interest rates and changes in the credit quality of the issuers whose securities it owns; the impact 

of interest rate and credit quality changes on portfolio value and on total return are greatest for 

bond funds with portfolios of long-term or low-quality bonds. Correspondingly, expenses have 

less effect on the total return of these funds, at least in the short run. 

(continued ... ) 

336 CHAPTER 8 
consequence, investors appear to focus less on the expense levels of these funds 

than they do for money market funds!% 

For these reasons, the Division has concluded that a new type of open-end 

investment company that has readily determinable and comparable expenses and 

minimal barriers to exit, like money market funds, would appeal to investors 

because of the simplicity of its fee and would foster competitive pricing among 

bond and stock funds. Accordingly, the Division recommends that the 

Commission propose amendments to the Act to permit the UFIC, an alternative 

type of mutual fund with a single fee. The UFIC would be subject to a lesser 

degree of fee regulation, and its simple fee structure would benefit both investors 

and sponsors. Fee disclosures for UFICs would be easy to prepare and 

'@-(...continued) 

For stock funds, the impact on fund performance of expense differentials may be 

insignificant compared to the impact of portfolio gains and losses. See, e.g., Jonathan Clements, 

Dues Your Stuck Fund Pass These Three Tests, WALL ST. J., July 22,1991, at C-1 ("With money funds 

and most bond funds, analysts say, the most important criteria are each fund's annual expenses 

. . . . But when it comes to hunting down a well-managed stock fund, analysts put a bit of 

emphasis on past performance, especially a fund's results over larger time periods such as five 

and ten years."); Letter from John C. Bogle, Chairman, The Vanguard Group of Investment 

Companies, to George A. Fitzsimmons, Secretary, SEC 11 (Mar. 9, 1983), File No. S7-955 

(commenting on Investment Company Act Release No. 12888 which requested public comment 

on mutual fund governance) (,'In stock funds, where annual performance differs by large 

magnitudes from one fund to another, total performance, not the expense ratio and its relatively 

modest impact on performance, is the focus of investor attention"). 

'%onetheless, bond funds today compete in part on expense levels. The Bernstein Report 

gives this example: 

Franklin [Resources, Inc.'s] municipal yields are among the best in the industry 

owing to fund expense levels of about 50 basis points versus an industry average 

of 80 basis points. . . . Virtually all of this pricing advantage relates to nonadvisory expenses (transfer agent, custody, professional fees) which are spread 

over three funds with combined assets of $16.5 billion. Franklin provides these 

services to the funds, and at cost. 

BERNSTEIN REPORT, supra note 176, at 77. This report also states that "direct price competition 

increasingly makes sense for the largest firms, who enjoy scale advantages in name awareness, 

servicing costs and actual money management. We believe pricing will be a more important 

factor and therefore expect both sales loads and management fees on fixed income products to 

be under pressure." Id. at 12. 

In addition, bond and equity index funds appear to compete on expense levels. The chief 

difference in yield or total return among such funds will be any difference in expenses. 

The Sale of Open-End Investment Company Shares 337 
understand, and readily compared with those of other funds of the same 

type.'84 Additionally, the true cost of investing in the vehicle would be 

apparent, since distribution-related and other charges would be included in all 

published figures for fund yield and total return. From the perspective of 

sponsors and directors, bundling all costs of operation and distribution into a 

single fee also should reduce the time and expense of detailed accounting reports, 

legal analyses, and deliberations surrounding expenditures from fund assets that 

must be allocated for advisory, distribution, and other services. 

B. Operation of a Unified Fee Investment Company 

The UFIC would be organized and operated as described be10w.l'~ 

1. Role of the "Investment Manager" and Parameters of the 

"Unified Fee" 

A UFIC would be organized and operated by an "investment manager." 

The UFIC would be defined as a type of open-end investment company organized 

under the laws of any state or states, that is operated by an investment manager 

pursuant to a written contract in return for a unified fee. The term 'Fnvestment 

manager" would be defined to distinguish the sponsor and manager of a UFIC 

from the investment advisers of other management investment companies. The 

term "investment manager" would be added, where appropriate, to provisions of 

the Act and rules that refer to a fund's "investment adviser."186 

~~ ~ 

'%The benefits of a single fee fund and of off-the-page advertising (discussed in Chapter 9) 

would be mutually reinforcing. A unified fee vehicle would lend itself to off-the-page 

advertisements by simplifying the task of providing the relevant expense and historical 

performance information. The ability to advertise off-the-page would facilitate the use of single 

fee funds by providing an efficient means of informing investors of this alternative vehicle and 

promote price competition. 

'%As discussed in Chapter 7, some industry observers have previously advanced an 

alternative type of open-end investment company termed a unitary investment fund ("UIF'). The 

UIF would feature a fixed expense ratio or manager's fee, subject to a statutory cap, that would 

finance all fund expenses except for extraordinary expenses and transfer agency costs. The latter 

expense would be charged directly to each shareholder's account and not to the fund. 

Accordingly, the cost of investment in the UIF would be readily apparent to investors. Because 

the UIF would not have the protections provided by boards of directors and shareholder voting, 

would not diminish costs substantially, and would not significantly facilitate internationalization, 

we do not recommend it. As is evident from our present proposal, however, we believe that the 

single fee aspect of the UIF has merit, if accompanied by appropriate protections. 

'%For example, section 36(a) would be amended to include the investment manager among 

those persons whom the Commission may sue for breach of fiduciary duty involving personal 

misconduct. 

338 CHAPTER 8 

~ 
A written "management contract" between the investment manager and the 

UFIC would specify a single, unified fee payable to the manager in exchange for 

all services necessary for the UFIc's operation and bind the manager to provide 

or contract with third parties for these services. This fee would be subject to 

market pressure and the continuous "vote" of investors in the form of investor 

decisions to purchase or redeem shares. The fee would be computed as a 

percentage of fund assets and deducted from assets on a daily basis. 

From an investor's perspective, the UFIC would be a "pay-as-you-go" 

vehicle. All costs of operating the fund and distributin its shares -- other than 

portfolio transaction costs and extraordinary expense$87-- would be financed 

by the investment manager out of the unified fee or its own resources?88 Thus, 

UFIC investors could not be assessed sales charges of any type or redemption 

fees:89 and the portion, if any, of the fee that could be spent on distribution 

would be within the discretion of the manager. The manager could not use fund 

brokerage to pay for services such as custody, or free credit balances to pay for 

transfer agency services. To facilitate election of UFIC status and because a 

unified fee structure obviates the need to unbundle costs, the UFK would be 

exempt from section 12(b) and rule 12b-1. 

ls7Treating brokerage costs as a general fund expense would be contrary to the current 

approach of applying these costs to the cost basis of each individual security. It also would 

require an investment manager to set its fee rate at a level that would include compensation for 

executing the fund's securities transactions or contracting with others to perform this function. 

This exercise would entail a certain amount of guesswork, and once undertaken, it could lead to 

"reverse churning," as the manager's interest in actively managing the portfolio might wane, given 

that all transactions would reduce the manager's profitability. 

To ensure clarity and comparability among UFICs, "extraordinary" expenses would be 

lssAllowing shareholders to be directly assessed any operating costs would impair investors' 

ability to compare expenses -- the heart of any market-oriented reform of mutual fund fee 

arrangements. Thus, the fact that certain operating costs are variable, i.e., they are affected by the 

number and level of activity of fund shareholders, does not justify their exclusion from the single 

fee. 

defined under Commission rules implementing the UFIC. 

The UFIC's fee structure bears some resemblance to a proposal put forth by John Markese 

of the American Association of Individual Investors in response to the Study Release. Citing 

investor confusion and comparability problems, Mr. Markese advocated limiting funds to a single 

asset-based distribution charge, capped at 0.50% annually of the investor's holdings, and an 

investment management fee out of which fund advisers could pay for additional distribution costs 

to the extent of their profits. See John Markese, A Simplified Fee Proposal, AAII J., Aug. 1990, at 17. 

A large number of individual investors endorsed Mr. Markese's article in their comments on the 

Study Release. 

18'Of course, as with other mutual funds, redemption from UFICs may not be entirely cost free 

since UFIC shareholders may realize capital gains upon redemption. 

The Sale of Open-End Investment Company Shares 339 
The terms of the management contract between a UFIC and its investment 

manager would be governed by new section 15(g). Section 15(g) would make it 

unlawful for any person to serve or act as a UFIC's investment manager except 

pursuant to a written contract which precisely describes all compensation to be 

paid under the contract, and would specify that such compensation shall be 

limited to a unified fee payable to the investment manager, "extraordinary 

expenses," as defined by Commission rule, and interest, taxes and portfolio 

transaction costs (Le,, brokerage fees). The investment manager would have the 

discretion to change the fee on ninety days' advance notice to shareholders of any 

increase. A fee could not be changed until it had been in effect for a full year. 

The section would incorporate the requirements of sections 15(a) and 15(c) 

regarding director approval of the initial contract and any renewals, but would 

provide that, in approving the rate of the unified fee, the directors need only 

ensure it is not "unconscionable or grossly excessive." The section would also 

require that the contract provide, in substance, that it may be terminated at any 

time by the full board or by the independent directors, voting separately. 

2. Limits on the Unified Fee , 

Because the unified fee would be subject to competitive pressures, it need 

not be limited by statute or rule, except that no fee should be so grossly excessive 

as to constitute a waste of corporate assets as that standard is understood under 

state corporate 1aw.l'' Accordingly, section 36(b) would be amended to exempt 

UF'ICs, their sponsors, investment advisers, affiliated entities, and other persons 

identified in the section, and to prohibit only unconscionable or grossly excessive 

UFIC fees. Section 22(b) would also be amended to exclude UFICs from the 

NASD's "excessive sales load" rules. 

We do not believe that the UFIC's investors need the protections of the 

defensive procedures generally followed by investment company boards to ensure 

compliance with section 36(b). The UFIC would have few barriers to competitive 

pricing, so that competition could be substituted for regulation. Its key features -- 

a readily determinable single fee and minimal exit barriers -- would permit the 

UFIC to be freed from the regulatory restraint of section 36(b), imposed to 

compensate for the limited competition that was ineffectual in restraining fee 

levels. Similarly, the unified fee would not be subject to section 22(b). 

'%e Commission would enforce the prohibition to protect investors where market pressure 

proves an illusory check on a greedy investment manager. The limit would provide a uniform 

standard for all UFICs by essentially codifying state corporate law standards concerning "waste 

of corporate assets," which governed excessive advisory fee litigation before the enactment of 

section 36b) in 1970. See generally 2 FRANKEL, supra note 45, at 252-262. See also infra note 194. 

340 CHAPTER 8 
3. Composition and Role of the Board of Directors 

Except as to fee issues, a UFIC generally would have the same types of 

operational conflicts and potential for overreaching by mana ement that inhere 

in the structure of open-end investment companies. '" Thus, UFIC 

shareholders, like shareholders in other management companies, would need the 

protection afforded by board oversight of management. Moreover, the UFIC 

structure would perhaps create or exacerbate some risks that are not present, or 

not to the same degree, in the standard mutual fund structure. This suggests that 

UFIC investors would have a somewhat greater need than other investors for a 

third party monitor to oversee management's activities, and would require 

particularly effective, independent, and investor-minded monitors to protect their 

interests. 

The first potential risk is that the investment manager, which would have 

discretion to allocate the unified fee as it deems appropriate and need not disclose 

the method of allocation, might be tempted to skimp on the basic level of services 

needed to operate the UFIC to bolster its own profitability. Market pressures 

might not check the temptation because investors, who typically lack the expertise 

or incentive to assess the quality and level of fund services, could not police the 

manager's choices. 

A similar risk is that if market pressures on fee rates were extreme, the 

investment manager might be tempted to cut back or eliminate basic services to 

keep the fund in business. These temptations could create serious investor 

protection problems, if, for example, the manager hired an incompetent custodian. 

To protect investors against these various conflicts and the possibility of 

management overreaching, the UFIC, like other open-end companies, would have 

a board of directors, which would be elected by shareholders in accord with 

section 16(a).192 To foster the requisite qualities of effectiveness, independence, 

and investor-mindedness, section 10 would be amended to require that two-thirds 

of the UFIC's directors be inde~endent.'~~ The UFIC sponsor would nominate 

'"See Chapter 7. 

'%ection 16(a) requires that at least two-thirds of the membership of the board of directors 

consist of directors who have been elected by shareholders. 15 U.S.C. 5 80a-l6(a). 

lsWe use the term "independent directors" to refer to individuals on the board of directors 

of a registered investment company who are not "interested persons," as defined in section 

2(a)(19). In Chapter 7, we recommend that the proportion of independent directors that must be 

independent for management investment companies generally be increased to a majority from the 

40% level section 10(a) today requires. 15 U.S.C. § $Oa-lO(a). 

The Sale of Open-End Investment Company Shares 341 
the initial independent directors, but the TJF'IC's independent directors would be 

self-nominating as to any vacancies occurring once the UFIC was organized. 

The duties of the board would include evaluating and approving the 

management contract. The board would be required to review the fee only to 

ensure that the fee was not "unconscionable or grossly excessive;"194 the board 

would not be required to engage in more extensive eva1~ation.l~~ The board 

also would approve any management contract continuing in effect for a period 

of more than two years. The UFIC's independent directors would separately 

evaluate and approve the initial contract, and any renewal of the contract, and 

either the full board or the independent directors, voting separately, would be 

authorized to terminate the management contract at any time on sixty days' 

written notice. Given the proposed exemption of the UFIC from section 12(b) and 

rule 12b-1, the UFIC's board of directors would not be required to authorize, 

review, or evaluate the component of the unified fee representing asset-based 

distribution fees. 

The Division also recommends that new section 15(g) specify that the 

board, including the independent directors voting separately, must approve and 

periodically review all material contracts the investment manager has executed 

with others furnishing services to the fund, to ensure provision of adequate 

services to the fund. It also would provide that either the full board or its 

independent directors may terminate a material contract at any time, on 

appropriate notice. Section 15(a) and 15(c) would be amended to state that the 

directors shall not review the fee provisions of any investment advisory contract. 

This material contract review would ensure that the UFIC is provided the level 

of services needed for its safe operation. To buttress this oversight authority, 

either the full board or its independent directors, voting separately, would be 

authorized to terminate each material contract at any time on sixty days' written 

notice. 

In addition to their ongoing scrutiny of the management contract and of 

material contracts for fund services, the UFIC's directors would police actions of 

the investment manager (or of parties with which the manager has contracted for 

~- ~ 

19*We intend "unconscionable or grossly excessive" to be consistent with a corporate waste 

standard. See, e.g., Saxe v. Brady, 184 A.2d 602, 610 (Del. Ch. 1962) (the essence of a claim of 

corporate waste of assets is that the consideration received by the corporation is "so inadequate 

in value that no person of ordinary, sound business judgment would deem it worth what the 

corporation has paid' or that the fee is "unconscionable" or "shocking"). Accord, Acampora v. 

Birkland, 220 F. Supp. 527,548-49 (D. Colo. 1963); Grobow v. Perot, 539 A.2d 180,189 (Del. Sup. 

1988). 

"%he degree of board review of the unified fee would thus be significantly less than that 

undertaken currently by the boards. 

342 CHAPTER 8 
fund services) that involve potentially serious conflicts that are not readily 

monitored by shareholders: the investment manager's method of portfolio 

valuation, permissible principal and agency transactions with affiliates, and a host 

of other operational matters. For example, investors in money market funds 

organized as UFICs would have the benefit of board oversight of the valuation 

process under rule 2a-7>96 In this respect, their responsibilities would be 

identical to those of other mutual fund directors. 

4. Shareholder Voting Rights 

The UFIC's shareholders would be accorded all voting rights accorded 

shareholders in other registered open-end investment companies, except those 

regarding fee-related issues,lg7 as to which UFIC shareholders would be 

entitled to notice sent not less than ninety days in advance of a proposal's 

implernentati~n?~~ In addition, a fee could not be changed until it had been 

in effect for one year. Providing such notice would give investors the opportunity 

to approve or reject a fee-related proposal by remaining in the fund or redeeming 

their shares>99 Streamlining these rights, with respect to fees, is consistent with 

protecting shareholders' interests through price competition and the ready 

redeemability of UFIC shares. Thus, it would not be necessary for the UFIC's 

shareholders to vote formally their approval, or termination, of the management 

contract, advisory or sub-advisory contracts, any new contracts resulting from 

assignment of prior management, advisory, or sub-advisory contracts, principal 

underwriting contracts or contracts with others for fund services. Nor would it 

be necessary that shareholders formally approve an increase in the unified fee. 

In each instance, shareholders would receive advance notice of a proposed fee 

increase or contractual change. Finally, given the UFIC's exemption from rule 

12b-1, its shareholders would not be consulted as to whether the fee would be 

used for distribution-related purposes. 

'%17 C.F.R. Q 270.2a-7. 

'wThus, our recommended changes to existing shareholder voting requirements for registered 

investment companies, generally, discussed in Chapter 7, would apply to the UFIC where they 

do not conflict with the more particularized requirements discussed here. 

'-he notice would be deemed a solicitation of a proxy, consent, or authorization for purposes 

of section 20(a) of the Investment Company Act (15 U.S.C. 5 80a-20(a)), and would include all 

information now required to be included in a proxy statement. 

'*The Division considered substituting a notice requirement for the requirement of 

shareholder approval of matters that are not fee-related. We rejected this approach because exit 

from the UFIC is not entirely cost-free (see supra note 189) and because the manager, in complying 

with a notice requirement, would incur costs similar to those incurred in soliciting shareholder 

approval. 

The Sale of Open-End Investment Company Shares 343 
Accordingly, the definition of "voting security" would be amended to 

include any security issued by a UFIC. Also, section 15(a) would be amended to 

state that an investment advisory contract or other contracts with a unified fee 

company for fund services need not be approved (initially or annually) by the 

UFIC's shareholders and that its shareholders are not authorized to terminate 

such contracts. 

C. Investor Protection Issues 

We have considered four concerns that may be raised by the UFIC. As set 

forth below, we believe the concerns would be addressed by the recommended 

statutory amendments. 

First, some may object that "bundling" the fee would leave investors 

without specific information as to the costs of particular aspects of a hd's 

operations. We do not see the harm, as we believe that relatively few investors 

can analyze the specific expense items in fund financial statements in a 

meaningful way. Indeed, the fee table in Form N-1A requires only that fund 

expenses be separated into three categories: "management" fees, rule 12b-1 fees, 

and other expenses?" In contrast, the benefits of introducing UFICs seem 

clear: increased investor and media focus on bottom-line fund expenses, in 

general, and their importance to investment performance, in particular. 

Second, because the UFK would not be mandated, but would be an 

optional form of organization for open-end companies, arguably it would 

introduce to an already complex market a vehicle that departs in significant 

respects from the current mutual fund model. To ameliorate concerns about 

introducing a new vehicle, the Division would monitor the operations of the first 

UFICs and report its findings to the Commission after three years. For 

monitoring purposes, we considered limiting eligibility for UFIC status to money 

market funds and relatively short-term bond funds, the types of funds whose fee 

rates are most subject to market forces and whose current structure most easily 

lends itself to conversion to the UFIC structure. On balance, we concluded that 

limiting the types of open-end companies that may organize as UFICs is 

unnecessary and would delay the introduction of competitive pressures on longterm bond funds and stock funds, the funds whose investors would most benefit 

from more competitive pricing?'' 

200See Inv. Co. Act Rel. 16244, supvu note 85. 

2010f course, the differences in degree to which expenses affect the short-term performance 

of money market, bond, and stock funds suggest that eliminating sales charge and expense 

comparability problems among bond and stock funds, as well as significant barriers to their 

shareholders' exit, will promote the type of price competition among these funds that money 

market funds now exhibit, but not necessarily the same level of competition. 

344 CHAPTER 8 
Third, one could argue that permitting a "bundledt fee would afford 

investment managers the opportunity to build an excessive profit into the single 

fee, particularly for fund types whose investors de-emphasize fund expenses in 

their quest for the services of an investment manager with perceived stock- or 

bond-picking ability, if the market does not function efficiently to check the level 

of the fee. We believe that the market will work to keep fees at reasonable levels, 

given the single fee and minimal exit barriers, and that the statutory prohibition 

on an "unconscionable or grossly excessive" unified fee will protect investors 

should the market prove inefficient. We expect that a vigorous, competitive 

market would keep fees fluctuating within a range that is not excessive. As an 

alternative, we considered imposing a statutory maximum fee level, as was 

posited for the unitary investment fund, but concluded that a fee cap is 

unnecessary. Moreover, because expense levels vary greatly across different types 

of portfolios, a single cap would not be appropriate. 

Fourth, some may argue that, because the investment manager would be 

responsible for paying for all services provided to the UFK, it would have a 

strong incentive to contract with low-cost service providers. Investor protection 

risks would be created if these providers are not competent. As discussed above, 

we believe that interposing board review of all material contracts will address this 

concern. 

V. Conclusion 

The Division recommends that the Commission pursue several legislative 

and rulemaking proposals designed to enhance competition and improve investor 

understanding of investment costs. We recommend legislation to end retail price 

maintenance and to permit a single fee investment company. We recommend 

rule changes to permit multiple class arrangements. Finally, we recommend that 

the Commission generally support the NASDs initiative to provide comparable 

regulation for all types of sales charges. 

The Sale of Open-End Investment Company Shares 345 
APPENDIX 8-A 

Proposed Amendment to Section 22(d) of the Investment Company Act 

Section 22 [I5 U.S.C § 80a-221. 

(i) pursuant to an offer of exchange permitted by section 11 including any offer made 

pursuant to section ll(b); (ii) pursuant to an offer madesolely to all registered holders 

of the securities, or of a particular class or series of securities issued by the company 

proportionate to their holdings or proportionate to any cash distribution made to 

them by the company (subject to appropriate qualifications designed solely to avoid 

issuance of fractional securities); or (iii) in accordance with rules and regulations of 

the Commission made pursuant to subsection (b) of section 12. 

346 CHAPTER 8 
Chapter 9 

Investment Company Advertising 

I. Introduction and Summary of Recommendations 

Investors today have a complex range of financial products and services 

from which to select, and competition is fierce among the many providers of 

financial services for investors' dollars. To compete effectively in this market, 

financial service providers, including investment companies and their sponsors, 

use advertising to inform the public about their products and services. 

Like most issuers of securities, when a mutual fund or other investment 

company offers its shares to the public, its promotional efforts become subject to 

the advertising restrictions of the Securities Act of 1933: Congress imposed 

these restrictions so that investors would base their investment decisions on the 

full disclosures contained in the "statutory prospectus,''2 which Congress 

intended to be the primary selling document. Originally, the reach of the 

advertising restrictions was formidable. The Securities Act essentially prohibited 

all advertising other than the statutory prospectus and limited announcements 

called "tombstones," which only identified the existence of offerings and provided 

information on how to obtain a prospectus. Under current law, investment 

companies may advertise using certain types of information if the advertisements 

comply with certain "safe harbor" rules. 

The advertising restrictions of the Securities Act cause special problems for 

many investment companies. Mutual funds continuously offer and sell their 

shares to provide an ongoing flow of capital into their portfolios and to enable 

them to meet redemption requests from outgoing shareholders. Unit investment 

trusts ("UITs") have active secondary markets in which the trusts' sponsors are 

continuously redeeming and selling the trusts' units? These ongoing distribution 

practices contrast sharply with the more traditional underwritings in which set 

amounts of capital are raised through periodic offerings of limited duration. In 

'Securities Act of 1933,15 U.S.C. §§ 77a-77aa. See Section 1I.A. of this chapter for a discussion 

2As used in this chapter, "statutory prospectus" means the full prospectus required by section 

10(a) of the Securities Act. 15 U.S.C. 9 77j(a). 'Section 10 prospectus" refers to any prospectus 

permitted under any subsection of section 10, and is not limited to a section lO(a) prospectus. 

of the pertinent Securities Act provisions. 

3See infra text accompanying note 29. 

347 
the case of the latter, the advertising restrictions end with the offering. In the 

case of mutual funds and UITs, the advertising restrictions never end because the 

offering process, in effect, never ends. 

In addition, because of the nature of their business, the effect of the 

advertising restrictions is more severe for investment companies than for other 

types of companies. Other companies, even when engaged in a public offering, 

are able to advertise their products, and thus gain name recognition with 

potential investors, because advertising that does not attempt to sell securities is 

not subject to the Securities Act. Investment companies, in contrast, do not sell 

products in the usual commercial sense. In fact, the very nature of an investment 

company is so inextricably tied to the securities it offers that almost any 

advertisement about the company is potentially an offer to sell its securities that 

must conform to the Securities Act's requirements. 

The advertising restrictions of the Securities Act also affect direct-marketed 

funds more than funds sold through broker networks. Direct-marketed funds use 

print, radio, and television advertising almost exclusively to sell fund shares to 

investors, while broker-sold funds employ sales personnel who sell fund shares 

orally. The advertising restrictions of the Securities Act have a much greater 

impact on direct-marketed funds than on broker-sold funds because the Securities 

Act does not hold the oral representations of sales personnel to the same 

prospectus requirements4 as it does written communications? 

In recognition of these problems, and to better enable investment 

companies to market themselves, the Commission has adopted advertising safe 

harbor rules. The most important of these is rule 482, which permits investment 

companies to advertise investment performance data! Rule 482 advertisements, 

however, are "prospectuses" under section 10(b) of the Securities Act (so-called 

"omitting prospectuses")? which means that they may only contain information 

4As discussed infra at text accompanying note 52, however, oral representations are subject to 

the liability provisions of section 12(2) of the Securities Act. 

5See infra text accompanying notes 20, 28, and note 70. In this chapter, "written" 

communications, advertisements, sales material, and offers include those made by means of print, 

radio, television, and any other means contemplated by section 200) of the Securities Act. 15 

U.S.C. Q 77b(10). 

617 C.F.R. § 230.482. 

715 U.S.C. 5 77j(b). 

348 CHAPTER 9 
"the substance of whicht is included in the statutory prospectus: and that they 

are subject to section 12(2) of the Securities Act? which imposes liability for false 

or misleading statements of material fact ("prospectus liability"). Rule 134, the socalled "tombstone rule,"*' stands in contrast. Over the years the Commission 

has expanded this safe harbor to the point where today inveshnent company 

tombstones may contain almost any type of information other than performance 

data. The expansion of rule 134 raises investor protection concerns. Unlike rule 

482 advertisements, there is no requirement that the substance of tombstone 

advertisements be contained in the statutory prospectus. In addition, because 

tombstone advertisements are not prospectuses, they are not subject to section 

12(2). 

In view of the impact that the Securities Act's advertising requirements 

have on investment companies, and in view of the anomalous and not wholly 

satisfactory evolution of the advertising safe harbor rules, the Division has 

considered whether the Securities Act's advertising requirements should be 

modified as they apply to investment companies. After reviewing the public 

comments and considering a number of alternatives, the Division recommends 

replacing the rule 482, omitting prospectus with a new section 10 "advertising 

prospectus" for investment companies:' This investment company advertising 

prospectus, like the current rule 482 prospectus, would be perrnitted to advertise 

performance data. Unlike the rule 482 prospectus, however, the investment 

company advertising prospectus would not be limited to information "the 

substance of which" is contained in the statutory prospectus. Eliminating this 

requirement would permit investment companies to advertise more freely and 

creatively, and would result in the dissemination of more information to the 

investing public. 

*- , 

%ee 17 C.F.R. 9 230.482(a)(2). This requirement stems directly from the status of rule 482 

advertisements as "omitting prospectuses" under section 10(b). See infva note 54 and 

accompanying text. 

'15 U.S.C. § 771(2). 

"17 C.F.R. 9 230.134. 

'IThe Commission would accomplish this either by amending rule 482 or by rescinding rule 

482 and adopting a new rule. Because section 1O(b) of the Securities Act only permits a 

prospectus "which omits in part or summarizes information in the [statutory] prospectus," and 

because the proposed investment company "advertising prospectus" arguably will not comply 

with this requirement, the Division recommends amending section 10 to give the Commission the 

express authority to adopt this new advertising prospectus. 

Investment Company Advertising 349 
The Commission would maintain or increase the current level of investor 

protection by developing standards governing the content and other aspects of 

investment company advertising prospectuses. With respect to the advertisement 

of performance information in particular, the Commission will determine whether 

the standards in rule 482 are sufficient, or whether, given the elimination of the 

"substance of" requirement and the broader advertising that will ensue, additional 

standards are needed. In addition, because the investment company advertising 

prospectus will be a "prospectus" as defined in section 2(10) of the Securities Act, 

the information contained therein will continue to be subject to the liability 

provisions of section 12(2) of the Securities Act. Finally, investment companies 

will still be required to deliver the statutory prospectus to investors prior to, or 

with, the earlier of the confirmation of the sale or the delivery of the security.12 

In connection with the proposal for an investment company advertising 

prospectus, the Division also proposes rescinding those provisions of rule 134 

that are applicable to investment companies only. The Division believes that 

much of the information currently advertised by investment companies in rule 

134 tombstones would be more appropriately advertised in the new investment 

company advertising prospectuses, which would be subject to section 12(2). 

The Division considered, but does not recommend, permitting investment 

companies to advertise subject only to the antifraud provisions of the Securities 

Act and the Securities Exchange Act of 1934.13 The Division believes that 

investors should continue to have an express private right of action, subject to a 

reasonable care defense, as provided by section 12(2) of the Securities Act.14 

Eliminating this private right of action would, in effect, require investors that are 

harmed by misleading advertisements to sue under rule lob-5, which requires 

investors to prove "scienter" or an intent to deceive.15 This would reduce the 

ability of investors to recover on the basis of misleading advertisements, and thus 

significantly weaken investor protection. 

The Division also recommends that the Commission permit mutual funds 

to sell their shares "off-the-page," which would be similar to a practice currently 

permitted in the United Kingdom and certain other European countries. The 

advertising restrictions of the Securities Act unintentionally have had disparate 

effects on direct-marketed funds in relation to broker-sold funds, and, as a result, 

'*See infru note 24 and accompanying text. 

13Securities Exchange Act of 1934,15 U.S.C. §§ 78a-78I1. 

I4See infru note 50 and accompanying text. 

1517 C.F.R. 5 240.1Ob-5. See also infya note 53 and accompanying text. 

350 CHAPTER 9 
have put direct-marketed funds at a competitive disadvantage. "Off-the-page" 

advertisements would help address this problem. 

Off-the-page advertisements (which, under the legislation we recommend, 

would be a form of "advertising prospectus") would allow investors the option 

of purchasing mutual fund shares directly from an advertisement by completing 

an application form included with the advertisement. Investors that choose to 

review the statutory prospectus before investing would complete a request form 

that also would be included with the advertisement. The advertisement would 

continue to be subject to liability under section 12(2) of the Securities Act and 

would be required to contain core information about the investment company, as 

the Commission prescribes by rule, such as historical performance data, levels of 

fees and expenses, and investment objectives. The investment company would 

still be required to deliver the statutory prospectus to investors prior to, or with, 

the earlier of the confirmation of the sale or the delivery of the security. 

The Division believes that an off-the-page rule would produce better and 

more informative advertisements. Because core information about the funds 

would be standardized in advertisements for the first time, investors would have 

access to a new, widely circulated source of important information that could be 

used to make comparative judgments about their investment alte 

Investors that wish to study the statutory prospectus before making an 

investment decision would receive it before investing, but investors that choose 

to purchase off-the-page would receive the statutory prospectus along with 

written confirmation of the sale. This practice would parallel the current 

requirements that apply to brokers who may sell securities by means of oral, 

rather than written, communications. 

As an alternative, the Division considered whether the statutory prospectus 

should be required to be delivered prior to all mutual fund sales, including sales 

made on the basis of oral communications. The Division does not recommend 

this because the statutory prospectus is easily available to investors upon request 

and because the requirement would disrupt longstanding practice. In the absence 

of evidence that investors are dissatisfied with, or are being harmed by, the 

current system, an inflexible advance prospectus delivery requirement does not 

seem warranted. 

This chapter begins by analyzing the current application of the Securities 

Act and the rules thereunder to investment company advertising. Next, it 

considers whether certain restrictive conditions in rule 482 should be eliminated 

and whether investment companies should be permitted to sell off-the-page. The 

chapter concludes with a brief discussion of other proposals the Division 

considered. 

Investment Company Advertising 351 
11. Background 

A. Application of the Securities Act and Rules to Investment Company 

Advertising 

1. General Considerations 

When Congress enacted the Investment Company Act of 1940>6 the 

Securities Act already regulated the offer and sale of investment company 

securities. While the Investment Company Act contained provisions that either 

supplemented the Securities Act or harmonized the scheme of regulation under 

the two statutes, it did not make any fundamental changes in the way investment 

companies could distribute their shares to the public. As a result, even though 

investment companies, particularly mutual funds, almost certainly were not the 

type of issuer Congress had foremost in mind when drafting the Securities Act, 

investment companies continued to be subject to its provisions.17 

The central provision of the Securities Act, section 5>* contains 

prohibitions regarding the use of interstate commerce to offer and sell securities 

to the public. Absent an exemption, under section 5(c) it is illegal for an issuer 

or underwriter to offer a security for sale to the public using jurisdictional means 

until a registration statement is filed with the Commission. 

Section 5 also contains prohibitions regarding the dissemination of written 

selling material to investors during the offering period. Section 5(b)(l) makes it 

unlawful to use interstate commerce to transmit any prospectus relating to a 

security with respect to which a registration statement has been filed unless the 

prospectus meets the requirements of section 10 of the Securities Act." 

"Prospectus" is broadly defined in section 200) to include any advertisement or 

other communication, "written or by radio or television, which offers any security 

"Investment Company Act of 1940,15 U.S.C. $j 8Oa. 

"One possible explanation is that the predominant form of investment company in existence 

in 1940 was closed-end. See Chapter 11. Unlike open-end companies, closed-end companies 

usually engage in traditional underwritten offerings of a fixed number of shares, and in most 

cases do not offer their shares to the public on a continuous basis. 

'*15 U.S.C. § 77e. 

"Section 10 and Schedule A of the Securities Act set forth specific information required in 

section 10 prospectuses, as modified by the rules and regulations of the Commission adopted 

pursuant to its powers under section 10. 

352 CHAPTER 9 

a 
for sale or confirms the sale of any security."20 Thus, advertisements are 

considered prospectuses under the Securities Act if they offer a security for sale. 

Because the term "offer" is defined and interpreted broadly to encompass any 

attempt to procure orders for a security:* written advertisements relating to a 

security or aiding in the selling effort with respect to a security generally must be 

in the form of a section 10 prospectus. 

Investment companies primarily use two types of section 10 prospectuses: 

the statutory prospectus specified in section 10(a); and a prospectus permitted 

under section lO(b) that "omits in part or summarizes" information in the section 

10(a) prospectusF2 A securig cannot actually be sold until the registration 

statement becomes effective, and the section 10(a) prospectus must be 

delivered no later than the delivery of the security or the confirmation of the sale, 

whichever occurs fir~t.2~ 

There is a limited exception to the general requirement that written offers 

after the filing of a registration statement must be in the form of a section 10 

prospectus. So-called "supplemental sales literature" may be used after the 

effective date of a re istration statement if accompanied or preceded by the 

statutory prospectus?' Thus, advertisements not meeting the requirements of 

section 10 may be used after the effective date if the statutory prospectus is 

printed in the advertisement (or was sent previously to each person receiving the 

advertisement). In addition, the use of specific types of advertisements such as 

"tombstone" advertisements are permitted under very limited circumstances, 

2015 U.S.C. 5 77b(10). 

21Section 2(3) defines the term "offer" to include "every attempt or offer to dispose of, or 

solicitation of an offer to buy, a security or interest in a security, for value." 15 U.S.C. 5 77b(3). 

See, also, e.g., In the Matter of Carl M. Loeb, Rhodes & Co., 38 S.E.C. 843,848 (1950) (holding that 

the statutory definitions of "offer" and "prospectus" are intentionally broad so as to include any 

document designed to procure orders for a security). 

22For a discussion of summary and preliminary prospectuses, see discussion infra at notes 43- 

44 and accompanying text, and note 70. See also infra note 58 for a discussion of generic 

advertisements and newsletters. 

23Securities Act 3 5(a), 15 U.S.C. 5 77e(a). 

24See Securities Act $5 2(10), 5(b)(1)-(2), 15 U.S.C. 55 77b(10), 77e(b)(l)-(2). 

=Under section 2(10)(a), supplemental sales literature is not considered to be a prospectus, and 

thus is not subject to section 5(b)(l) of the Securities Act. Many investment companies use 

supplemental sales literature extensively, often as an insert in the prospectus. 

Investment Company Advertising 353 
without prior delivery of the statutory prospectus. 

The advertising restrictions and the prospectus delivery requirements are 

intended to foster an environment for making rational decisions based on the full 

disclosures contained in the filed registration statementF6 The requirements 

also are intended to limit the potential for high pressure salesmanship, undue 

expectations, and appeals to emotion in the sale of ~ecurities.2~ It is possible, 

however, under the Securities Act to sell a security orally and to send the 

statutory prospectus later, either with the security or the confirmation of the sale 

(whichever is earlier), because section 5(b)(l) limits only the use of a prospectus, 

and "prospectus" is defined to include written -- but not oral -- communications. 

Thus, investors do not necessarily receive full, written disclosure before they 

decide to purchase a securityF8 

As discussed above, many investment companies are continuously subject 

to the advertising restrictions of the Securities Act. Mutual funds engage in 

continuous offerings. UITs are continuously subject to the Securities Act because 

the trusts' sponsors typically operate secondary markets in which sponsors offer 

to buy back trust units from existing unit holders and sell them to new unit 

holders. Because the sponsor, as the trust's depositor, is an "issuer" under section 

2(4) of the Securities all offers and sales by the sponsor in the secondary 

market, unless otherwise exempt, are subject to the Securities Act. 

The greater impact of the Securities Act on these investment companies 

compared to other issuers cannot be traced to any particular congressional 

concern. Instead, it is simply a product of a statute that treats issuers that 

distribute their shares continuously the same as issuers that distribute their shares 

periodically. 

2. The Advertising Rules Before 1954 

When Congress passed the Securities Act, securities professionals were 

reluctant to disseminate any written material about an offering for fear it would 

26See FEDERAL SUPERVISION OF TRAFFIC IN INVESTMENT SECURITIES IN INTERSTATE COMMERCE, 

H.R. REP. No. 85,73d Cong., 1st Sess. 8 (1933) [hereinafter 1933 HOUSE REPORT]. 

"See id. at 2. 

'?he Commission has imposed requirements to encourage the pre-sale distribution of 

preliminary prospectuses, but the requirements do not affect the vast majority of mutual fund 

sales. See infra note 70 . 

2915 U.S.C. 5 77bW 

354 CWTER 9 
constitute an illegal offer?' Practitioners found it difficult to distinguish 

between disseminating information, which was permitted and encouraged, and 

solicitation, which was prohibited. 

Within months of the Securities Act's passage, and continuing for years 

afterward, regulators provided guidance on the dissemination-solicitation 

distinction in the form of public releases. An early release originated the "red 

herring" theory, under which circulars, describing the security in the manner 

required for prospectuses but marked to show that they were informative only 

and did not offer any securit for sale, could be used prior to the effective date 

of the registration statement!' Later, the red herring theory was extended to 

permit the dissemination of certain summaries, such as the "blue card" summaries 

prepared by statistical organizations?2 Eventually, the Commission adopted a 

rule specifically providing for the use of red herring prospectuses on the theory 

that they did not offer a security for sale within the meaning of section 2(3) of the 

Securities 

In addition to red herrings, certain advertisements could be circulated 

under a narrow exception contained in section 2(10)(b) of the Securities Act. That 

eption provided for a tombstone advertisement which stated from whom a 

section 10 prospectus could be obtained and, in addition, did no more than 

identify the security, state the price thereof, and state by whom orders would be 

e~ecuted.3~ The tombstone was regarded as a "mere announcement" that did 

not interfere with the intent of Congress that investors have a complete 

understanding of the transactions in which they were invited to parti~ipate?~ 

300riginally the Securities Act prohibited all offers until the registration statement became 

effective. 

310ffers of Sale Prior to Effective Date of Registration Statement, Securities Act Release No. 

70,l Fed. Sec. L. Rep. (CCH) 9[ 3150 (Nov. 6, 1933). 

32Distribution by Statistical Services of Bulletins Describing Securities, Securities Act Release 

No. 464, 1 Fed. Sec. L. Rep. (CCH) 4[ 3165 (Aug. 19, 1935); Circulation of Information in 

Registration Statements Prior to their Effective Date, Securities Act Release No. 802, 1 Fed. Sec. 

L. Rep. (CCH) q[ 3175 (May 23,1936). 

33Adoption of Rule 131, Securities Act Release No. 3177, [1945-1947 Transfer Binder] Fed. Sec. 

L. Rep. (CCH) 9[ 75,720 (Dec. 5, 1946). 

3"Tombstones are not prospectuses under section 200) and thus are not subject to section 

35See 1933 HOUSE REPORT, supra note 26, at 8. 

5(b)(l). See supra text accompanying note 20. 

Investment Company Advertising 355 
In the early 1950's, the Commission used its rulemaking powers to permit 

issuers to advertise in a context other than the limited statutory tombstone. The 

Commission adopted a rule providing for an "identifying statement," which 

resembled an expanded tombstone?6 An identifying statement could contain 

up to sixteen categories of information (as opposed to three or four for 

tombstones), but was only required to contain a red herring-type legend and a 

tear-off form for requesting the statutory prospectus. According to Professor 

Louis Loss, issuers did not use identifying statements, particularly complete 

identifying statements, very often in newspaper advertisements, except for mutual 

funds which adapted the tear-off form to their traditional tombstone 

ad~ertisements.3~ 

The Commission at that time also adopted a more expansive rule roviding 

for a "newspaper prospectus" to be used by foreign governments?' Unlike 

identifying statements, newspaper prospectuses could contain any information 

"the substance of which" was included in the registration statement. Eventually 

the Commission adopted procedures permitting certain qualified domestic issuers 

(but not investment companies) to use newspaper prospectuses. In many ways 

the newspaper prospectuses (which are still available today to foreign 

 government^)^^ were very similar to modern day "summary prospect use^."^^ 

3. Post-1954 Development of Special Rules for Investment 

Companies 

Uncertainty among securities professionals regarding the use of written 

communications in connection with public offerings continued until 1954 when 

36Securities Act Release No. 3453 (Oct. 1,1952), 17 FR 8898 (adopting rule 132). The theory 

underlying rule 132 was the same as the theory underlying the red herring, ie., that the 

advertisement was not an offer under section 2(3). 

371 LOUIS LOSS & JOEL SELIGMAN, SECURITIEs REGULATION 402, n.47 (3rd ed. 1989). This 

adaptation was possible because of the overlap in the information permitted by the rule and the 

statutory tombstone exception. An advantage of the identifying statement was that it could be 

used before and after the effective date of the registration statement, whereas, at the time, 

tombstones were limited to the post-effective period. The distinction, however, held little 

significance for mutual funds because they did -- and still do -- most of their selling in the posteffective period. 

38Newspaper Prospectuses for Foreign Governments, Securities Act Release No. 3425 (Aug. 

27,1951), 16 FR 8820. Newspaper prospectuses differed from identifymg statements in that they 

could be used only in newspapers or periodicals after the effective date of the registration 

statement and were required to contain specific types of information. 

39See 17 C.F.R. § 230.494. 

4oSee infra notes 43-44 and accompanying text. 

356 CHAPTER 9 
~ 

Congress significantly amended the Securities Act!1 Congress amended section 

5 to permit offers during the so-called "waiting period," i.e., the period after a 

registration statement is filed but before it becomes effective. This largely solved 

the dissemination-solicitation problem!2 In addition, Congress added 

rulemaking authority to section 2(10)(b), permitting the Commission to adopt 

rules specifying additional types of information that could be included in 

tombstone advertisements, and amended section 10(b), directing the Commission 

to adopt rules providing for a prospectus that "omits in part or summarizes" 

information in the statutory prospectus. These changes codified the prior 

administrative actions taken by the Commission and set the stage for further 

rulemaking. 

Shortly thereafter, the Commission used its new rulemakin authority in 

section lo&) to adopt rules providing for summary prospectusesB Investment 

companies, however, were not permitted to use summary prospectuses until 1972 

when the form for registering mutual funds was amended to provide for their 

use. Even then, the summary prospectuses were required to contain a substantial 

amount of information that made their use impractical for advertising in mass 

media!4 

41Ch. 667,68 Stat. 683 (1954). 

*The dissemination-solicitation debate centered mostly on whether a communication 

constituted "jumping the gun," i.e., making an offer before the offer legally could be made. Even 

after Congress legalized offers in the waiting period, a problem continued to exist in terms of 

discerning whether a communication was an offer, because, if a communication was an offer, it 

had to be in a permissible form. 

43Adoption of Rule 434, Securities Act Release No. 3592,[1952-1956 Transfer Binder] Fed. Sec. 

L. Rep. (CCH) 76,371 (Nov. 10,1955) (permitting blue card summaries); Adoption of Summary 

Prospectus Rule 434A and Amendments to Forms S-1 and $9, Securities Act Release No. 3722, 

11952-1956 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 76,415 (Nov. 26,1956) (merging the concept 

of summary prospectus with the old concept of newspaper prospectus). In 1982, a new summary 

prospectus rule, rule 431, replaced the earlier rules. Adoption of Integrated Disclosure System, 

Securities Act Release No. 6383 (Mar. 3, 1982),47 FX 11380. 17 C.F.R. 5 230.431. 

441nvestment Company Advertising and Summary Prospectus for Investment Companies, 

Securities Act Release No. 5248 (May 9, 1972), 37 FR 10071. For current summary prospectus 

requirements for mutual funds, see Instructions as to Summary Prospectuses contained in Form 

N-lA, Fed. Sec. L. Rep. (CCH) q[ 51,207. 

Investment Company Advertising 357 
The Commission also exercised its rulemaking authority under section 

2(10)(b) to adopt rule 134, the tombstone rule.& The legislative history of the 

1954 amendments to section 2(10)(b) demonstrates that Congress believed that the 

rulemaking power was needed to permit "appropriate variation" in the contents 

of tombstone advertisements with safeguards.& The legislative history 

indicates, however, that Congress still intended tombstone advertisements to be 

a simple means for soliciting inquiries for the statutory prospectus. Accordingly, 

when the Commission adopted rule 134, the newly expanded tombstone 

advertisements still were quite limited in scope. They could not contain financial 

information, general descriptions of the issuer, or other information that might 

reflect the desirability of buying the security. 

Because of these limitations, rule 134 was not very useful to investment 

nies until the Commission amended it, first in and again in 

These amendments permitted tombstone advertisements to contain a 

cription of a mutual fund's particular attributes and method of operation, as 

well as limited financial information such as net asset value as of the most recent 

practicable date. In 1975, the Commission again amended the rule to allow 

discussions of general economic conditions (eg., inflation) as well as references 

to retirement plans or other specific investment goals that could be achieved 

through an investment in the f~nd.4~ 

Today investment companies can include a broad range of information in 

rule 134 advertisements. Essentially the only information that investment 

companies may not include under rule 134 is performance information. 

The almost annual amending of rule 134 in the early to mid-1970's reflected 

the tension between the desire of investment companies to advertise more and 

broader topics of information and the theory that the tombstone was a simple 

device for screening out investors interested in obtaining a prospectus. This 

tension intensified in the late 1970's, and the Commission came under increasing 

&Adoption of Rules 134 and 135, Securities Act Release No. 3568, [1952-1956 Transfer Binder] 

Fed. Sec. L. Rep. (CCH) 4[ 76,359 (Aug. 29, 1955). At the same time, the Commission rescinded 

the identifymg statement rule, because rule 134 made that rule unnecessary. 

"H.R. REP. No. 1542, 83d Cong., 2d Sess. 22 (1954); S. REP. NO. 1036, 83d Cong., 2d Sess. 6 

(1954). 

47Sec. Act Rel. 5248, supra note 44. 

481nvestment Company Advertising and Statement Required in Prospectus, Securities Act 

Release No. 5536 (Nov. 4,1974), 39 FR 39868. 

*?nvestment Company Advertising, Securities Act Release No. 5591 (June 16, 19751, 40 FR 

27442. 

358 CHAPTER 9 
pressure to permit the inclusion of performance information in tombstone , 

advertisements. 

The Commission was reluctant, however, to expand the tombstone rule 

further without imposing prospectus liability under section 12(2) of the Securities 

Act for false or misleading statements of material fact?' Because tombstones 

are excepted from the definition of prospectus, they do not appear to create 

liability under the two express private causes of action in the Securities Act for 

material misstatements and omissions. Section 11 applies onl to effective 

registration statements (which include the statutory prospectus)?'section 12(2) 

by its terms applies only to prospectuses (both statutory and otherwise) and oral 

communications?2 Thus, sponsors, issuers, and underwriters using misleading 

tombstones probably are subject to private liability only if they act fraudulently 

or rec~essly.5~ 

The resolution of these tensions came in 1979 with the adoption of the socalled "omitting prospectus1' rule, now rule 482, under the rulemaking power in 

%ection 12(2) imposes liability on persons who offer or sell a security in interstate commerce 

by means of a prospectus or oral communication which includes an untrue statement of material 

fact, or omits to state a material fact that is necessary under the circumstances in order to make 

the statements made not misleading, subject to a defense that the offeror/seller did not know and, 

in the exercise of reasonable care, could not have known, of the untruth or omission. 

51Section 11 imposes liability not on sellers of securities but on issuers of securities, as well 

as a broad range of other persons including directors, underwriters, and consenting experts, such 

as accountants, for information contained in the effective registration statement. 15 U.S.C. 5 77k. 

There are certain other differences between section 11 and section 12. For example, under section 

11 issuers do not have the "reasonable care" defense that they have under section 12(2). For an 

indepth discussion and comparison of liability under sections 11 and 12(2), see LOUIS Loss, 

FUNDAMENTALS OF SECURITIES REGULATION 887-906 (2d ed. 1988). 

52But see LOSS, supra note 51, at 892 n.19. Professor Loss raises the problem of a seller who 

uses the statutory prospectus, which tells the whole truth, but sends along supplementary selling 

literature (which, Eke tombstones, are not prospectuses) containing "a pack of lies." He finds it 

hard to believe a court would exalt a "drafting bug" over clear legislative intent and deny recovery 

under section 12(2). 

90 prevail in a lawsuit under rule lob-5 under the Exchange Act (which applies to 

tombstones), a plaintiff must prove that the defendant acted with scienter. Ernst & Ernst v. 

Hochfelder, 425 U.S. 185, 193 (1976). Although section 17(a) of the Securities Act (15 U.S.C. 

5 77q(a)) essentially prohibits negligent misstatements or omissions in tombstones, most courts 

and commentators believe that an implied private right of action does not exist under section 

17(a). See generally Loss, supra note 51, at 975-981. 

Investment Company Advertising 359 
section 10(b) of the Securities A~t.5~ Rule 482 permits investment companies to 

advertise any information "the substance of which'' is included in the statutory 

prospectus. The "substance of" requirement relates directly to the word "omits" 

in section 10(b) of the Securities Act, upon which authority for the rule rests. The 

theory behind the "substance of' requirement is that an advertisement cannot be 

one that "omits" information from the statutory prospectus unless all of the 

information in the advertisement is derived from (Le., is the "substance of") 

information in the statutory prospectus. 

The most significant effect of adopting the rule under section 10(b) of the 

Securities Act, rather than section 2(10)(b), was to attach private liability under 

section 12(2) for false or misleading statements in rule 482 ad~ertisements.5~ 

Because advertisements under rule 482 are prospectuses, they carry liability under 

section 12(2), subject only to a reasonable care defense. 

B. The Interplay of Rules 482 and 134 

In the fifty-two years since the enacbnent of the Investment Company Act, 

Congress and the Commission have attempted to accommodate the unusual 

requirements of investment companies within the federal securities laws. The 

result now is a somewhat anomalous situation in which one kind of 

advertisement, the rule 134 tombstone, may be used to promote investment 

company shares creatively, perhaps even irresponsibly, subject only to the 

antifraud provisions and to the prohibition against the inclusion ,of any 

performance information. While the rule 482 omitting prospectus advertisement 

may use performance information, the substance of the information also must be 

in the statutory prospectus, and is subject to the stricter liabilities of section 12(2) 

of the Securities Act. 

Moreaver, although rule 482 permits mutual funds to advertise 

performance information, they may do so only because of an attenuated link to 

the "substance of'' requirement. To make the rule workable, investment 

companies have not been required to put actual performance figures in the 

statutory prospectuses, which would have resulted in investment companies 

constantly having to "sticker" their section 1O(a) prospectuses. Rather, 

advertisements are deemed to meet the "substance of' standard of rule 482 as 

54Advertising by Investment Companies, Securities Act Release No. 6116 (Aug. 31,1979),44 

FR 52816. 

5%ection 10(b) of the Securities Act by its terms provides that section 10(b) prospectuses, even 

if filed with the registration statement, do not create liability under section 11 of the Securities Act. 

Section 11 imposes a tougher standard of liability on issuers of securities than section 12 imposes 

on sellers because, under section 11, issuers have strict liability. See supu notes 50-51. 

360 CHAPTER 9 
long as the section 10(a) ros ectus describes the methodology used to calculate 

the performance figures. lip 

The interplay between rule 134 and rule 482 has some ironic and 

unintended consequences. When reviewing advertisements, employees of the 

National Association of Securities Dealers, Inc. must try to discern which rule the 

sponsor is or should be relying upon to publish the ad~ertisement.5~ As a 

practical matter, the only distinguishing feature is the inclusion or absence of 

performance information. If an advertisement contains such information, it must 

conform to rule 482's requirements, including the "substance of" requirement. If 

an advertisement does not contain performance data, it may be subject only to 

rule 134.5' 

111. Recommendations 

A. "Investment Company Advertising Prospectuses" 

The Division recommends replacing the rule 482 omitting prospectus with 

a new section 10 advertising prospectus, to be called an "investment company 

advertising prospectus" or "advertising prospectus." The salient feature of this 

new advertising prospectus is that, unlike a rule 482 omitting prospectus, the 

information contained therein would not be limited to information the "substance 

of which" is contained in the statutory prospectus. Eliminating this requirement 

will remove a substantial regulatory burden, and should permit investment 

companies to advertise more freely and to disseminate valuable information to 

investors. 

56See Dechert Price & Rhoads (pub. avail. Nov. 20,1979). 

57For the rules governing the filing of advertisements with the NASD, see Securities Act rule 

497(i)(17 C.F.R. 5 230.497(i)) and Article 111, section 35 of the NASD Rules of Fair Practice, Nat'l 

Ass% Sec. Dealers, Sec. Dealers Manual (CCW I 2195. 

58Tw0 other communication formats utilized by investment companies deserve mention. 

"Generic" advertisements, which do not name any particular fund, have been permitted since 1972 

as a way to promote the investment company i ustry generally. Sec. Act Rel. 5248 (adopting 

rule 135a under the Securities Act), supra note 44. 17 C.F.R. 5 230.135a. In addition, funds 

distribute newsletters that often combine articles of general interest (non-offering material or "free 

writing") with separately designated rule 134 and rule 482 material. The Division has issued 

guidelines for the preparation of newsletters. See Letter from Kathryn B. McGrath, Director, 

Division of Investment Management, Securities and Exchange Commission, to Matthew P. Fink, 

Senior Vice President and General Counsel, Investment Company Institute (Jan. 29, 1990). 

Investment Company Advertising 361 
In order to accomplish this, the Division recommends adding a new 

subsection (g) to section 10 of the Securities Act, expressly authorizing the 

Commission to permit investment companies to advertise using this new 

advertising prospect~s?~ The Division believes legislation is desirable because 

section 10, as currently written, does not expressly authorize a prospectus the 

substance of which is not contained in the statutory prospectus. As already 

discussed, section 1O(b) requires that the information in a section 10(b) prospectus 

"omi[t] in part or summariz[e] information in the [statutory] prospectus." Thus, 

section lO(b) clearly authorizes rule 482 "omitting prospectuses'' and rule 431 

"summary prospectuses." Dropping rule 482's requirement that the prospectus 

contain only information the substance of which is contained in the statutory 

prospectus arguably is not authorized by section 10(b). Assuming section 10 is 

amended, the Commission would then adopt the investment company advertising 

prospectus by amending rule 482 or by adopting a new rule and rescinding rule 

482. 

Eliminating the "substance of" requirement will not diminish investor 

protection. As a general matter, the "substance of" requirement does not, in itself, 

prevent misleading statements. The release proposing rule 482 states that 

advertisements can convey the same "idea" as the section 10(a) prospectus without 

using the same words, and that advertising "techniques" can be used even though 

the techniques are not themselves included in the section 10(a) prospectus.60 

These practices leave a great deal of room for underwriters and broker-dealers to 

rephrase information in ways that undermine the utility of the "substance of" 

requirement.6l 

59A draft of proposed subsection (g) appears in Appendix 9-A at the end of this chapter. 

Congress also would need to make a technical, or conforming, amendment to section 2(10)(a) to 

add the words "or subsection (g)" after the words "subsection (b)." This would make clear that 

communications made under new subsection (g), like communications under subsection (b), 

would not be excepted from the definition of "prospectus" in section 2(10)(a). 

"Advertising By Investment Companies, Securities Act Release No. 5833 (June 8,1977), 42 FR 

"Some would argue that the requirement is useful in that, in the course of its review of 

registration statements, the Commission may uncover certain information, such as an adviser's 

past performance record, that is included in a registration statement to meet the "substance of" 

requirement. The Division could then advise the registrant that such information would, in the 

Division's view, be misleading if used in advertisements to sell the fund. We believe that the 

"substance of" requirement is not necessary for this purpose. Rule 482 (or any successor rule 

contemplated herein) provides the opportunity for the Commission to address the misleading 

character of particular types of information without the "substance of" requirement. In addition, 

rule 156 provides guidance on certain types of representations made in sales literature (including 

all advertisements) that are most likely to be misleading for purposes of an investment company's 

compliance with the general antifraud provisions. 17 C.F.R. Q 230.156. 

30379. Rule 482 was at that time designated as rule 434(d). 

362 CHAPTER 9 
In addition, issuers may clutter statutory prospectuses with unnecessary 

information so that their omitting prospectuses satisfy the "substance of" 

requirement. Thus, the requirement actually may operate to obfuscate other, 

more important information in the statutory prospectus and to dissuade investors 

from reading it. 

Because the proposed investment company advertising prospectus would 

still be a "prospectus," issuers and sponsors would remain liable for false or 

misleading statements of material fact under section 12(2) of the Securities Act. 

Also, the new subsection (g) would provide for the same summary suspension 

procedure as in section 1O(b) of the Securities Act, permitting the Commission to 

take prompt action to prevent the use or distribution of unlawful or deficient 

advertisements. In addition, investment companies would still be required to 

deliver a copy of the statutory prospectus prior to, or with, the earlier of the 

confirmation of the sale or the delivery of the security. 

Finally, the Commission would retain its ability to regulate any aspect of 

advertising in the advertising prospectus, such as performance claims, which are 

susceptible to being misused. In rule 482, the Commission has standardized the 

manner in which fund performance may be advertised. The Commission may 

retain those standards, which have worked well, without change, or may 

strengthen them in view of the expanded advertising that the proposed 

advertising prospectus would permit. 

The Division also recommends that when the Commission adopts the new 

investment company advertising prospectus rule, it rescind the provisions of rule 

134 (the tombstone rule) that apply only to investment companies. The new 

investment company advertising prospectus would provide sufficient flexibility 

so that investment companies could discuss topics, such as economic conditions, 

that currently are discussed in tombstones, but generally not in statutory 

prospectuses. The information would then be subject to prospectus liability, 

instead of only antifraud liability, which would increase investor protection. 

B. "Of f-the-Page" Advertisements 

The Division has concluded that the Securities Act and rule 482 currently 

create an unwarranted competitive disadvantage for direct-marketed funds. 

Direct-marketed funds must attract investor interest by complying with the 

requirements of a safe harbor rule such as rule 482. Investors who clip a rule 482 

advertisement must complete a form requesting the statutory prospectus62 

62See infra note 68 and accompanying text. 

Investment Company Advertising 363 
which is received days, or perhaps even weeks (depending on when the investor 

has time to complete the form), after the investor first becomes interested. 

Finally, either the customer or the fund must initiate further contact to close the 

sale. This process is expensive and time-consuming. 

In contrast, investors that desire to purchase investment company shares 

from brokers based on oral communications need not request, or wait for, a 

statutory prospectus before buying; they only need to receive the statutory 

prospectus prior to, or with, the earlier of the confirmation of the sale or the 

delivery of the securities, both of which occur after the investor has made an 

investment decisi0n.6~ Thus, Investor A may discuss various investment options 

at his broker's office or over the telephone and may actually purchase securities 

based on those discussions without receiving a prospectus until the confirmation 

of the sale. Investor B, who also may know what she wants to buy based on her 

own reading and research, but whose interest runs to a fund that is not sold by 

commissioned sales personnel, cannot make her purchase until she requests and 

receives the pro~pectus.6~ Investor B is unable to invest her money as quickly 

as Investor A. 

The Division recommends amending rule 482, or adopting a new rule, to 

give investors the option of purchasing mutual fund shares directly from 

advertisements ("off-the Off-the-page advertisements would be 

required to contain standardized, core information about the fund. Under an offthe-page system, an investor would be able to purchase securities by completing 

an application form included with the advertisement, and sending a check with 

the completed form. The statutory prospectus would be delivered with the 

confirmation of the sale, paralleling the current requirements that apply to sales 

entered into on the basis of oral, rather than written, communications. Of course, 

investors also would have the option of requesting the statutory prospectus before 

investing; every off-the-page advertisement would be required to contain a 

prospectus request box, just as the rule 482 advertisements do today. 

Selling off-the-page would provide significant savings for direct-marketed 

funds, would increase competition, and would provide investors with a new 

source of important information about their investment alternatives. The Division 

believes an amendment to rule 482 (or adopting a new rule) providing specific 

~~ ~ 

@See supra text accompanying note 28. 

64See infra note 68 and accompanying text. 

6%'he Division does not anticipate recommending that closed-end funds be permitted to use 

the off-the-page option because they typically use a more traditional type of underwriting. See 

sup note 17. The Division recommends that the Commission request comment on whether other 

types of investment companies, such as UITs, should be able to sell off-the-page. 

364 CHAPTER 9 
requirements for selling off-the-page could be accomplished without statutory 

amendment. 

Under the Securities Act as originally passed, the statutory prospectus 

occupied an elevated status as the only sanctioned selling document. Not only 

was there an affirmative obligation to deliver the prospectus to investors, there 

was a prohibition on using most other forms of written communications. As 

discussed above, in 1954, the strictness ,of the Securities Act regarding 

prospectuses was relaxed somewhat by amendments to section lO(b), which 

authorized the Commission to adopt rules providing for a prospectus that omits 

in part or summarizes information in the statutory prospectus. The statutory 

prospectus no longer was the only document that could be used to make offers. 

The legislative history of the 1954 amendments to the Securities Act 

indicates that Congress, in authorizing section 10(b) prospectuses, was primarily 

concerned with legalizing offers during the waiting (or "pre-effective") period, 

when offers cannot be accepted. The legislative history does not discuss the role 

of section lo@) prospectuses during the post-eff ective period, the period during 

which investment companies most extensively offer their shares, probably because 

traditional corporate underwritings sell out rapidly after the registration statement 

becomes effective, based on indications of interest received during the waiting 

period. There is nothing in the legislative history, however, that would indicate 

that section 1O(b) prospectuses cannot form the basis for sales after the registration 

statement has been declared effective, as long as the liability provisions of sections 

12(2) and 17 attach and the statutory prospectus is sent to the investor prior to, 

or with, the earlier of the confirmation of the sale or the delivery of the 

In adopting rules under section 1O(b), such as the summary prospectus rule 

and rule 482, the Commission has stated its intent to provide additional means 

for disseminating information, but not to supplant the statutory prospectus as the 

primary selling d0cument6~ In effect, in the case of rule 482, this means that 

although offers based on rule 482 advertisements are legal, sales based on rule 482 

advertisements cannot proceed directly. The rule contains several requirements 

preventing investment companies from using rule 482 advertisements to close a 

66See S. REP. NO. 1036, supra note 46, at 12; see also Hearings on S. 2846 Before u Subcomm. of the 

Senate Cmm. on Banking and Currency, 83d Cong., 2d Sess. 31-32 (1954) (statement of Ralph H. 

Demmler, Chairman, SEC, regarding summary prospectuses). 

67Sec. Act Rel. 3722, supra note 43 (adopting summary prospectus rule); Sec. Act Rel. 6116, 

supra note 54, (adopting rule 434(d), later renumbered rule 482). 

Investment Company Advertising 365 
sale, the most important of which prohibits an application form from 

accompanying the 

The Division recognizes the Commission's historical concern that the 

statutory prospectus be the primary selling document for securities transactions. 

Nonetheless, we believe that permitting off-the-page sales would promote 

increased dissemination of information, which would benefit the investing public. 

Off-the-page advertisements would be required to contain the most critical 

information in the statutory prospectus (although, as discussed below, the 

Division does not recommend restricting these advertisements to information 

contained in the statutory prospectus). These shortened versions of the statutory 

prospectus probably would be widely circulated and could be used by investors 

for comparative purposes. Moreover, as long as off-the-page advertisements are 

considered section 10 prospectuses €or purposes of liability under section 12(2), 

and rule 482 (or a successor rule) adequately addresses the presentation of 

performance and other information in the advertisements, issuers would not be 

tempted to use this medium for misleading ~tatements.6~ 

In addition, there are convincing policy reasons favoring an off-the-page 

system for investment companies. Funds sold primarily by broker networks 

make full use of the treatment accorded oral communications under the Securities 

Direct-marketed funds, on the other hand, have access to potential 

6qhe application form, which contains shareholder account information, cannot be sent alone 

because it would be an illegal "prospectus" unless preceded or accompanied by the statutory 

prospectus. Rule 482 also contains requirements for a legend encouraging the investor to request 

and read the statutory prospectus before investing, as well as information on how to obtain a 

statutory prospectus. 

Division also recommends that the Commission explore in rulemaking proceedings 

whether off-the-page advertisements should be subject to pre-filing and clearance requirements. 

Such requirements could lessen the possibility of misleading advertisements and would allow the 

Commission to monitor the use of off-the-page advertisements. 

We also believe that use of off-the-page advertisements should be limited to mass media 

advertisements and not extended to mailings and similar solicitations. Where a fund sponsor 

chooses to mail prospective investors written materials, we believe it should be required to 

include a statutory prospectus. 

'%rakers who offer orally, either in person or over the telephone, are permitted to deliver the 

section 10 prospectus after the investor has made an investment decision. This situation was 

addressed when the Commission began requiring the broad distribution by underwriters and 

brokers of preliminary prospectuses to investors. See rule 460 under the Securities Act (which 

does not apply to sales of certain investment company securities) and rule 15C2-8 under the 

Exchange Act. 17 C.F.R. Q 230.460; 17 C.F.R. § 240.15~2-8. Preliminary prospectuses are not, 

however, widely used for sales of mutual fund securities because mutual funds generally do not 

(con tinued.. .) 

366 CHAPTER 9 

L- 
investors only through the print and broadcast media. Because sales through 

those media cannot be accomplished directly, these funds are at a disadvantage 

in reaching potential customers. 

For an off-the-page system to work, the advertisements must be short 

enough to be economically feasible and yet convey enough information for 

investors to evaluate the investment. The success of the British off-the-page 

system suggests this can be done. Rule 7.25 of the British Conduct of Business 

Rules requires that off-the-page advertisements contain u to eighteen items of 

information, along with certain statements, if applicable?' These items include 

information regarding the minimum amounts that can be invested, sales charges, 

reinvestment options, redemption procedures, investment objectives, expenses, 

fees, and performance. Although these requirements are quite extensive, and the 

advertisements can take up half of a page or more of advertising space, the size 

of the advertisements has not prevented their use in the British press. 

The Division believes that it would be appropriate to develop an off-thepage rule along the lines of the British rule. There is a limited universe of facts 

that are central to an investment in a mutual fund, particularly given the degree 

of standardization of the industry imposed by the Investment Company Act. The 

Division would anticipate working with the industry and investors through the 

rulemaking process to develop the presentation of core information in off-thepage advertisements. A similar exercise resulted in the development of a "fee 

table" for mutual fund prospectuses, which has proven extremely useful to 

investors. Much about the options for presenting information would be learned 

through the rulemaking process. 

Investor protection issues arising from the ability to sell off-the-page also 

could be addressed through the rulemaking process. For example, the 

Commission may wish to consider imposing a "seasoning" requirement so that 

only funds that have been registered for a certain period of time, e.g., two or more 

years, could sell off-the-page. The Division also recommends that the rule 

continue to require the advertisements to carry legends regarding the availability 

of the prospectus, so that investors would be able to request the prospectus by 

clipping the advertisement or calling the fund, just as they do today. This 

"(...continued) 

begin marketing until after the registration statement becomes effective, and, in any case, the vast 

majority of offers as well as sales occur in the post-effective period when preliminary prospectuses 

are not used (because statutory prospectuses are available). 

"See Securities and Investments Board (United Kingdom), the Financial Services (Conduct of 

Business) Rules 1987, rule 7.25. 

Investment Company Advertising 367 
requirement gives investors the option to study the statutory prospectus before 

investing. 

Another issue that would be appropriate to consider during the rulemaking 

process is whether, if off-the-page sales are permitted, investors should be 

allowed to rescind purchases within a specified period of time (eg., mailing time 

plus five days) in order to allow for an appropriate review of the statutory 

prospectus. Purchase monies could be required to be held in escrow and not 

invested until the close of the waiting period. Alternatively, a system could be 

developed by which the investor would assume the risk of any fluctuation in 

share prices during the waiting eriod, but any sales charge would be returned 

if the investor chose to rescind. 7!? 

A further question for review is whether an off-the-page rule should 

permit information other than the required information and, if so, under what 

standards. If the rule permits other information, the Commission must determine 

whether that information should be limited to information included in the 

statutory prospectus. The Division would not now recommend that off-the-page 

advertising be so limited. We think the reasons for abandoning the "substance 

of" requirement for rule 482 (or any successor) advertising also apply to off-thepage advertising. Furthermore, the current multiplicity of rules governing 

investment company advertising creates unnecessary confusion and resulting 

costs?3 If the "substance of" requirement were to apply to off-the-page 

advertisements, but not to investment company advertising prospectuses, the 

situation would become further confused. 

Thus, the Division recommends that off-the-page selling be an option 

under rule 482 (or its successor) which, as expanded, would not be limited to 

information in the statutory prospectus. Alternatively, off-the-page could be 

limited initially to information that is required by rule to appear. 

72British rules do not require that an investor be able to rescind his purchase as long as that 

fact is disclosed, although British investment schemes may voluntarily provide for that privilege. 

The Division recommends a similar approach, but anticipates further study and comment. 

73The concern centers mainly on the current rules as they apply to newsletters. A single 

newsletter may contain so-called "free writing" articles, separately designated rule 134 material, 

and separately designated rule 482 material. The existing multiplicity problem would be partially 

solved by deleting the investment company provisions of rule 134 and returning investment 

company "tombstones" to a more traditional format. See supra Section 1II.A. 

368 CHAPTER 9 
IV. Other Options Considered 

A. Requiring Prior Delivery of Mutual Fund Prospectuses 

The Division also considered whether statutory prospectuses for mutual 

funds should be required to be delivered to investors prior to sale. After 

considering the issue, the Division does not recommend an advance prospectus 

delivery requirement for mutual funds. 

We recognize there are legitimate arguments in favor of such a 

requirement. Statutory prospectuses for mutual funds are uniquely available 

because mutual fund securities are virtually always for sale. The timetable of the 

offering and the method of distribution for mutual funds are completely different 

than those for traditional issuers. In the case of mutual funds, there is not the 

same urgency or need to minimize risks; underwriters and brokers are not "on the 

hook" for large blocks of securities that must be quickly distributed at the retail 

level because mutual fund securities are sold on a "best efforts" basis. The timing 

of the offering does not depend on "indications of interest" solicited during the 

waiting period. Finally, there is no reason to resort to the alternative disclosure 

tool of the preliminary prospectus because the great majority of offers, and all 

sales, occur after the effective date of the registration statement. 

On the other hand, the prospectus is easily obtained by anyone requesting 

it. Indeed, investors who know what they want to buy may not appreciate 

having to wait until their brokers send them a statutory prospectus. With the 

thousands of funds currently available, brokers may not be able to keep adequate 

stocks of prospectuses on hand. If the broker had to take the extra step of 

obtaining the prospectus from the fund, the process of actually getting the 

investor's money invested could be slowed unnecessarily. In the absence of 

evidence that investors are dissatisfied with the current system, or are not 

adequately informed today, we believe the possible benefits to be derived from 

an advance prospectus delivery requirement do not justify the time delays, 

additional costs, and administrative burdens that would be imposed.74 

B. Eliminating Liability under Section 12(2) 

Some have argued that investment company advertisements should not be 

subject to prospectus liability under section 12(2) of the Securities Act, and that 

74A prospectus delivery requirement prior to sale would increase costs to some degree because 

brokers would have to adopt new sales systems to keep track of when prospectuses are sent and 

when sales are made. 

Investment Company Advertising 369 
investment companies should be able to advertise any information that is truthful 

and not misleading, subject only to the general antifraud provisions of the 

securities laws?5 Proponents of this view suggest it would level the playing 

field between direct-marketed, whose written communications are subject to 

section 5(b)(l), and broker-sold funds, whose brokers' oral representations are not. 

This suggestion would do more than level the playing field, however, because 

oral representations are subject to section 12(2) liability for false statements. If the 

suggestion were implemented, that liability would no longer attach to written 

advertisements. 

Proponents of this suggestion also argue that the antifraud provisions of 

the Securities Act and the Exchange Act are enough to protect investors. The 

Division strongly disagrees. Besides leaving investors without an express private 

right of action under the Securities ActT6 the Commission would be left without 

a means to halt misleading advertisements under the summary suspension 

procedures authorized in section 10(b). The Division therefore recommends that 

the Commission not support legislation at this time that would expand 

investment company advertising in a way that would remove the protections of 

section 12(2). 

V. Conclusion 

The Division recommends amending the Securities Act so that investment 

companies may advertise a wide range of information in the form of a section 10 

"investment company advertising prospectus," including information that is not 

included in the statutory prospectus required by section 10(a). If the Securities 

Act is amended to permit broader advertising subject to prospectus liability, we 

believe investment company tombstones should return to a traditional format 

similar to that of other issuers. We also recommend that mutual funds be 

permitted to sell "off-the-page" directly from an advertisement. 

75See, eg., Letter from Dechert Price & Rhoads to Jonathan G. Katz, Secretary, SEC 54-56 (Oct. 

10, 1990), File No. S7-11-90. 

'%ee supra notes 14-15 and 50-53, and accompanying text. 

370 CHAPTER 9 
APPENDIX 9-A 

Red-Lined Version of Proposed Amendment to the Securities Act of 1933 

Section 10 [15 U.S.C. § 77jI. 

*** 

Investment Company Advertising 371 
Chapter 10 

Variable Insurance 

I. Introduction and Summary 

The regulation of variable annuities and variable life insurance under the 

Investment Company Act' presents questions of application and interpretation 

that defy easy analysis? In many ways, the regulation of these products under 

the Act is a historical anomaly. The Investment Company Act naturally presents 

a statutory framework for the products and services that existed in 1940. Variable 

insurance products did not exist then in any form, and Congress did not 

anticipate their creation. Though Investment Company Act regulation of these 

products is appropriate, the differences these products present from more 

traditional investment company products are significant enough that the Act is 

the proverbial "round hole" into which the "square peg" of insurance products is 

forced. 

The products themselves are extremely complex. Although explained in 

greater detail in Part XI below, a brief description at the outset may be useful. 

Both variable life insurance and variable annuity premium payments are allocated 

to investment portfolios maintained by an insurance company in a segregated or 

"separate acco~nt."~ A variable life insurance policy is similar to a whole life 

policy, except that the cash value and/or death benefit vary depending upon the 

investment experience of the separate account! An annuity is a contract under 

which an insurer, in return for a lump sum payment or a series of payments 

during the "accumulation" or "pay-in" period, agrees to make a series of payments 

to the contract owner for life or for a specified period, the "annuity" or "pay-out" 

phase of the contract. Under a variable annuity contract, the value of what the 

contract owner may receive during the pay-in and sometimes the pay-out period 

'Investment Company Act of 1940,15 U.S.C. 5 80a. 

*We use the term "variable insurance" to include both variable life insurance and variable 

annuities. 

3The separate account is distinct from the insurance company's general account, which funds 

all of the company's fixed insurance obligations. For a definition of the term "separate account," 

see Investment Company Act § 2(a)(37) (15 U.S.C. § 80a-2(a)(37)); see also rules 0-l(e), 6e-2(a), and 

6e-3(T)(a) (17 C.F.R. 9 270.0-l(e), .6e-2(a), and .6e-3(T)(a)). 

4Unlike term insurance, which provides only a guaranteed death benefit payment, a whole life 

policy has both a cash value and a guaranteed death benefit. Generally, the cash value builds up 

to the policy face amount by age 100. 

373 
depends upon the investment performance of the separate account into which his 

or her payments have been invested? 

Because contract owners assume certain investment risks under variable 

contracts, the contracts are securities under the Securities Act: and the separate 

accounts funding the contracts are investment companies under the Investment 

Company Act? In addition, a distributor of the contracts is a broker-dealer 

under the Securities Exchange Act! and a person rendering investment advice 

to the separate account, if organized as a management company, is an investment 

adviser under the Investment Advisers Act? The contracts are also insurance 

contracts regulated under state law.'' 

Confronted with a product that did not fit neatly within the Investment 

Company Act, the Commission, in early administrative decisions, concluded that 

variable insurance contracts should be regulated as periodic payment plans.** 

5For descriptions of the variable annuity, see generally In re Variable Annuity Life Ins. Co. of 

Am., 39 S.E.C. 680,683-685 (1960); PAUL A. CAMPBELL, THE VARIABLE ANNUITY; ITS DEVELOPMENT, 

ITS ENVIRONMENT & ITS FUTURE (1969); and George E. Johnson, The Variable Annuity -- Insurance, 

Investment, or Both?, 48 GEO. L. J. 641 (1960). 

For descriptions of the variable life insurance contract, see generally Tamar Frankel, 

Regulation of Variable Life Insurance, 48 NOTRE DAME LAW REV. 1017 (1973); DIVISION OF 

INVESTMENT MANAGEMENT REGULATION, SEC, VARIABLE LIFE bJSURANCE AND THE PETITION FOR 

THE ISSUANCE AND AMENDMENT OF EXEMPTIVE RULES (1973) [hereinafter 1973 REPORT]; and SEC 

Request for Comments on Issues Arising Under the Investment Company Act of 1940 Relating 

to Flexible Premium Variable Life Insurance, Investment Company Act Release No. 13632 (Nov. 

23,1983),48 FR 54043. 

bSecurities Act of 1933, 15 U.S.C. 55 77a-77aa. 

7See infra notes 29-32 and accompanying text. An insurance company separate account may 

be organized and registered under the Investment Company Act as an open-end management 

company or as a unit investment trust ("UIT"). Currently, the UIT is the more popular 

organizational structure. 

%ecurities Exchange Act of 1934,15 U.S.C. 55 78a-7811. 

%nvestment Advisers Act of 1940,15 U.S.C. 5 80b. 

"See, e.g., N.Y. INS. LAW § 4240 (McKinney 1985 & Supp. 1992); CAL. INS. CODE §§ 10506, 

10506.3 (West 1972 & Supp. 1992); ILL. ANN. STAT. CH. 73 5 857.24 (Smith-Hurd Supp. 1991). 

llwith respect to variable annuities, see In re Prudential Ins. Co. of Am. (41 S.E.C. 335, 348 

(1963), afd sub nom. Prudential Ins. Co. v. SEC, 326 F.2d 383 (3rd Cir. 1964), ceut. denied, 377 U.S. 

953 (1964)), and In re Variable Annuity Life (39 S.E.C. at 700-03)), in which the Commission 

considered requests for exemptions from the periodic payment plan provisions of the Investment 

Company Act. Similarly, since the introduction of variable life insurance contracts, the 

(continued. ..) 

374 CHAPTER 10 
Periodic payment plans are, essentially, a means of purchasing investment 

company securities by installment and are subject to heightened Investment 

Company Act regulation. This enhanced regulation, which focuses on the types 

of sales and related charges allowed and the manner in which they may be 

deducted and, at times, refunded, goes beyond that imposed on ordinary mutual 

funds?2 

Although variable insurance products fit within the literal definition of 

periodic payment plan certificates,13 they are significantly different investment 

products. The net result is that the regulations applicable to periodic payment 

plans are in many ways ill suited for variable insurance. While the Commission 

has issued or adopted numerous exemptive orders and rules to address some of 

the inconsistencies, the basic problem, namely that these provisions were not 

drafted with variable insurance products in mind, persists. 

I 

Some of the resulting difficulties are primarily business concerns for the 

industry, and do not directly implicate the Commission's mandate to protect 

investors, but may harm investors mainly by reducing the choices available to 

them. For example, the industry argues that, because of current pricing and 

distribution requirements of Investment Company Act regulation, an insurer finds 

it difficult to price its variable life insurance contracts in a way that adequately 

reflects the heavy capital expenditure needed to establish and maintain a variable 

''(...continued) 

Commission has regulated them as periodic payment plans. See Separate Accounts of Life 

Insurance Companies Funding Certain Variable Life Insurance Contracts, Investment Company 

Act Release No. 9104 (Dec. 30,1975), 41 fX 2556 (proposing rule 6e-2 that would require variable 

life separate accounts to be treated as issuers of periodic payment plan certificates). 

As used in this chapter, the term "periodic payment plan" refers only to the contractual plan, 

one of two forms of installment investing used by investment companies. The other type, the 

voluntary plan, was not subject to the many abuses that resulted in the enactment of sections 26 

and 27 of the Investment Company Act (15 U.S.C. $35 80a-26, -27) and is not discussed herein. For 

an explanation of the differences between contractual and voluntary plans, see SEC, PUBLIC POLICY 

IMPLICATIONS OF INVESTM~VT COMPANY GROWTH, H.R. REP. NO. 2337,89th Cong., 2d Sess. 231-32 

(1966) [hereinafter PPI REPORT]; SEC, REPORT OF SPECIAL STUDY OF SECURITIES MARKETS OF THE 

SECURITIES AND EXCHANGE COMMISSION, H.R. DOC. NO. 95, Pt. 4, 88th Cong., 1st Sess. 174-79 

(1963). 

''Periodic payment plans, although rare today, were the source of serious abuses prior to 1940. 

Under these plans, investors periodically contribute a preestablished amount to a UIT that invests 

in an underlying mutual fund. In the 1930'~~ periodic payment plans were offered primarily to 

low income investors who could not meet the minimum investment required by a mutual fund. 

See infra notes 37-46 and accompanying text. 

I3Both types of securities fall within the definition of periodic payment plan certificates in 

Investment Company Act section 2(a)(27). 

Variable Insurance 375 
- 

life operation; nor may the insurer distribute its contracts on an equal basis with 

fixed-dollar life insurance. To be competitive, a variable life issuer must bear an 

extra burden on its capital and surplus. As a result, relatively few variable life 

contracts are offered to the public, and few insurers have entered the variable life 

insurance business.14 

The following table15 illustrates the estimated annual market share for 

new sales of scheduled premium variable life insurance and flexible premium 

variable life insurance" from 1976 to 1991. 

TABLE 10-1 

Estimate of Annualized New Premium1 Market Share by Product 

- 1976 - 1977 -- 1978 1979 - 1980 - 1981 - 1982 - 1983 - 1984 - 1985 - 1986 - 1987 - 1988 - 1989 - 1990 - 1991 

Universal 

me2 -- -- - -- -- 2% 9% 18% 30% 38% 35% 27% 26% 27% 26% 26% 

Variable 

me3 -- - -- - 1% 2% 2% 3% 3% 3% 3% 1% 1% 1% 1% 

universal4 - _- __ -- - __ Variable 

-- -- - 1% 3% 7% 7% 6% 6% 5% 

Term 12% 14% 15% 16% 18% 19% 18% 15% 12% 11% 12% 12% 13% 13% 13% 13% 

WholeLife gs% 86% 85% 84% 82% 78% 71% 65% 55% 47% 47% 51% 53% 53% 54% 55% 

100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 

'Includes 10% of Single Premiums, excludes universal life excess (dumpin premiums). 

2"Universal life," "term," and" whole life" are forms of life insurance that are not registered with the Commission. 

%e first variable life (referred to in this Chapter as "scheduled premium variable life") insurance contract was sold in 1976. 

%e first variable universal life (referred to in this Chapter as "flexible premium variable life") insurance contract was sold 

around 1985. 

Source: Life Insurance Marketing Research Association 

14Approximately 36 of the more than 2,000 life insurance companies in the United States 

currently offer variable life products, for an estimated total net asset value at December 31,1991, 

of $6.2 billion. Letter from Lipper Analytical Services, Inc. to Clifford E. Kirsch, Assistant 

Director, and Wendell Faria, Deputy Chief, Office of Insurance Products, Division of Investment 

Management, SEC (Mar. 30, 1992). Approximately 76 life insurance companies currently offer 

variable annuities, for an estimated total net asset value at December 31, 1991, of $101.1 billion. 

Id. 

'?able based on data compiled from Life Insurance Marketing and Research Association 

(''LIMFL4"), Monthly Sumey of Life Imurance Sales in the United States and facsimile from LIMRA 

to Thomas Bisset, Attorney, Office of Insurance Products, Division of Investment Management, 

SEC (Mar. 26, 1992). 

16For an explanation of the distinction between scheduled premium variable life insurance and 

flexible premium variable life insurance, see infra note 56. 

376 CHAPTER 10 
Other problems with variable insurance regulation directly affect the 

Commission's responsibilities under the Act. A major concern for the 

Commission is the continuing need to separate "insurance-related" charges from 

"securities-related' charges and subject only the latter to comprehensive periodic 

payment plan regulation. With the enactment of the McCarran-Ferguson Act in 

1945, Congress determined that re ulation of the insurance industry was the 

exclusive prerogative of the states.lF Primarily for this reason, the Commission 

seeks to focus its regulatory efforts exclusively on the securities elements of 

variable insurance products and to avoid regulation of the insurance elements. 

Securities-related charges and insurance-related charges, however, cannot be 

neatly divided for regulatory purposes. Some charges that the industry 

characterizes as insurance charges appear to have components that should be 

subject to Investment Company Act regulation. Further, so long as the 

Commission regulates only "investment-related" charges, insurance companies 

may evade charge limits by adjusting "insurance-related" or unregulated charges 

to the extent permitted by state law. These problems are compounded by 

significant differences in the degree of insurance protection provided by variable 

life insurance and variable annuities?* 

For these and other reasons discussed below, the Division recommends a 

fundamental change in the regulation of variable insurance. The Division 

concludes that the regulation of specific charges under sections 26 and 27 of the 

Investment Company Act" is inappropriate for variable insurance, and 

recommends a more flexible approach in which the Commission would have 

jurisdiction over all contract charges in the aggregate. The Commission generally 

would no longer engage in an examination of individual contract charges and the 

manner in which they are deducted or refunded, but would have the authority 

to adopt whatever rules, governing the overall level of charges, become necessary. 

Specifically, the Division recommends that the Commission propose legislation 

that would grant the Cpmmission jurisdiction over all contract charges, including 

discretionary rulemaking authority to establish standards for determining the 

reasonableness of aggregate contract charges and the manner in which they are 

deducted; amend sections 26 and 27 to exempt variable insurance contracts from 

17McCarran-Ferguson Act, 15 U.S.C. @ 1011-1015. 

I8During the pay-in or accumulation phase, a variable annuity has a minimal insurance 

element and closely resembles a mutual fund. See infra Section 111. D. Variable life contracts, by 

contrast, afford significant death benefit protection to insureds, particularly in light of recent tax 

law changes that eliminated important tax benefits for contracts without a significant insurance 

element. See Internal Revenue Code §§ 7702 (definition of life insurance contract), 7702A 

(definition of modified endowment contract), I.R.C. §§ 7702,7702A. 

1915 U.S.C. §§ Boa-26, -27. 

Variable Insurance 377 
the specific charge limits of those sections; and require aggregate charges under 

the contracts to be reasonable and the insurer to so represent in its registration 

statement. The proposal would recognize that variable insurance contracts and 

periodic payment plan certificates are different products that should not be 

treated identically under the Investment Company Act. Rather, variable insurance 

separate accounts should be treated more like mutual funds, which are subject to 

more general prohibitions against excessive fees?' The Division's 

recommendation would not affect any other provision of the federal securities 

laws; investors would remain protected by the substantive and procedural 

protections of these laws. 

This chapter begins with an overview of the regulation of variable 

insurance under the Securities Act and the Investment C 

chapter then reviews the differences between periodic payme 

insurance. The chapter next examines regulatory and pr 

have developed as a result of the decision to regulate variable insurance as 

periodic payment plans and concludes that those problems warrant a different 

legislative approach for variable insurance. Finally, the chapter discusses the 

Division's proposal to regulate variable insurance charges on a basis more 

comparable to the regulation of mutual fund expenses. 

11. Variable Insurance Products under the Federal Securities Laws 

A. Variable Annuities 

An annuity may be described simply as a contract under which an insurer 

agrees to make a series of payments for a specified period, either a fixed period 

or for the life of a designated individual. Under "immediate" annuities, payments 

begin shortly after the initial cash contribution. Under the more common 

"deferred" annuities, payments do not begin until some future date selected by 

the owner or set by the contract. Contract owners purchase these contracts by 

paying either single or periodic premiums. 

The benefits under an annuity may be funded in one of two fundamental 

ways: fixed or variable. Under a fixed or "fixed-dollar" contract, the insurance 

company guarantees that a minimum rate of interest will be credited to the 

owner's account during the accumulation or pay-in period, and also guarantees 

that once the pay-out period begins, payments will be a certain guaranteed 

amount per dollar accumulated. Payments during the accumulation period of a 

*Osee, e.g., Investment Company Act §§ 22(b), 36(b), 15 U.S.C. §§ 80a-22(b), -35(b); rule 12b-1, 

17 C.F.R. Q 270.12b-1. 

378 CHAPTER 10 
fixed annuity are allocated to the insurer’s general account, which is invested in 

accordance with state law. A variable annuity contract, by contrast, provides for 

values that vary directly with the investment performance of the contract owner’s 

payments. Variable annuity premiums are invested in an insurer’s separate 

account, which offers the contract owner a number of investment options. 

Payments to the contract owner during the pay-out period may be variable or 

fixed, depending on the annuity option selected. 

B. Variable Life Insurance 

Variable life insurance is similar to whole life insurance, except that the 

cash value and/or death benefit vary depending on the investment performance 

of the separate account in which the premium payments are invested. Under a 

whole life policy, premium payments are allocated to an insurer’s general account 

and invested conservatively (as required by state law) to ensure that the company 

is able to meet its death benefit and cash value guarantees. The investment 

return on assets in the general account has little or no direct effect on the cash 

value and on the death benefit received. 

Premium payments under a variable life policy, in contrast, are invested 

in an insurance company separate account, which is not subject to state 

requirements that the assets be invested conservatively. A variable life 

policyholder typically is offered a variety of investment options to choose from 

(e.g., money market, equity, and bond funds). Death benefits and cash values are 

directly related to performance of the separate account, although typically there 

is a minimum below which the death benefit is guaranteed not to fall. Variable 

life policies have either scheduled or flexible premiums, although the flexible 

premium policy is more common today. Under a scheduled premium contract, 

premiums are fixed as to both timing and amount. Under a flexible premium 

policy, also called a variable universal life policy, the policyholder may vary the 

amount and the frequency of policy premiums as well as the level of death 

benefit protection. 

Variable Insurance 379 
C. The Introduction of Variable Products 

Until variable insurance was developed, there was little controversy over 

ation under the federal 

"fixed' insurance contracts from registration if they are issued by a corporation 

subject to state insurance reg~lation.2~ Similarly, section 3(c)(3) of the 

Investment Company AcG4 excepts from the definition of investment company 

any company organized as an insurance company that has as its primary and 

predominant business activity the writing of insurance and is subject to 

supervision by an appropriate state a~thority?~ 

whether insurance contracts were securities subject to 

securities laws?' Section 3(a)(8) of the Securities traditional or 

When variable annuities were introduced in the 1950'~~ the Commission 

took the position that these products were securities. The industry disagreed. 

The issue was decided by the Supreme Court, which held that variable annuities 

are securities under the Securities Act, not exempted insurance contracts?6 The 

Court determined that insurance required "some investment risk-taking on the 

part of the [insurance] company. . . [and] a guarantee that at least some fraction 

21Historically, insurance has been the exclusive preserve of state regulation. In Paul v. 

Virginia (75 U.S. (8 Wall.) 168, 183 (1868)), the Supreme Court determined that issuing a policy 

of insurance is not a transaction of commerce. The Court's decision laid the groundwork for the 

development of state regulation of insurance over the next several decades on the basis that 

Congress had no authority under the commerce clause to regulate the business of insurance. 

When Paul v. Virginia was subsequently overruled in United States v. Southeastern Underwriters 

Ass'n (322 U.S. 533 (1944)), Congress promptly enacted the McCarran-Ferguson Act to preserve 

state regulation of insurance. 

2215 U.S.C. § 77~-3(a)(8). 

23The Commission has taken the view that an insurance contract falling within section 3(a)(8) 

is excluded from all provisions of the Securities Act, even though the section by its terms is an 

exemption from only the registration provisions of the Act. See, e.g., Definition of "Annuity 

Contract or Optional Annuity Contract," Securities Act Release No. 6558 (Nov. 21, 19841, 49 FR 

46750 (proposing rule 151). The legislative history of the Securities Act supports this view (see 

HOUSE COMM. ON INTERSTATE AND FOREIGN COMMERCE, FEDERAL SUPERVISION OF TRAFFIC IN 

INVETMENT SECURITIES IN INTERSTATE COMMERCE, H.R. Rep. No. 85, 73rd Cong., 1st Sess. 15 

(1933)), as well as the Supreme Court in dicta (see Tcherepnin v. Knight, 389 U.S. 332, 342 n.30 

(1967)), and at least one commentator (see LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION 

204-05 (2d ed. 1988)). 

2415 U.S.C. 5 80a-3(~)(3). 

2?he term'linsurance company" is defined in section 2(a)(17) of the Investment Company Act. 

26SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65/71-73 (1959) [hereinafter "VALIC"]. 

380 CHAPTER 10 
of the benefits will be payable in fixed amounts."27 Because the variable annuity 

contracts at issue placed the entire investment risk on the contract owner rather 

than the insurance company, the Court concluded that the contracts were 

securities?8 The Court also determined that the insurance company, which sold 

only variable annuities, was an investment company under the Investment 

Company Act?' 

A few years later, the Commission considered whether an insurance 

company that sold both variable annuities funded by a separate account and 

traditional insurance products funded by the general account was an investment 

company under the Investment Company The Commission concluded 

that the separate account funding the variable annuities was an investment 

company, but that the insurance company itself could continue to rely on the 

exception in section 3(~>(3).3~ On appeal, a federal court affirmed the 

Commission's decision?2 

In the early 1970'~~ the insurance industry introduced variable life 

insurance. After extensive public hearings, the Commission concluded that 

~ 

271d. at 71. Similarly, in SEC v. United Benefit Life Ins. Co. (387 US. 202, 211-12 (1967)), the 

Court held that a deferred annuity that offers an insubstantial guarantee in the accumulation 

phase is subject to the Securities Act. 

28VALIC, 359 U.S. at 71-73. In a concurring opinion, Justice Brennan concluded that state 

insurance laws, which focus on such matters as solvency, reserves, and contract terms, are 

inadequate substitutes for the disclosure requirements and other protections of the federal 

securities laws. Id. at 78, 85. 

291d. at 67-68, 71-73. 

3% re Prudential, 41 S.E.C. 335. It was unnecessary to reach the section 3(c)(3) issue in 

VALIC because the company in VALIC issued only variable annuities and had no basis for relying 

on the exemption. 

3iId. at 339-41. 

32See Prudential Ins. Co. v. SEC, 326 F.2d at 383. The Commission's reasoning in that case is 

sometimes called the "ectoplasmic theory." See LOSS, supra note 23, at 208-09; Thomas J. Finnegan 

& Joseph P. Garner, The Separate Account us an Investment Company: Structural Problems of the "Ectoplasmic Theory," 3 CONN. L. REV. 106 (1970). Under the ectoplasmic theory, the issuer of a 

variable annuity is the separate account and the insurance company is deemed to be the writer 

of the contract (In re Prudential, 41 SEC at 345), and the creator of the fund (id. at 340-41). Under 

section 2(4) of the Securities Act (15 U.S.C. Q 77(b)(4)), the depositor of a UIT is considered to be 

the issuer of its securities. Accordingly, a separate account organized as a UIT and the insurance 

company /depositor are considered co-issuers of a variable insurance contract or the units of 

participation in the separate account. 

Variable Insurance 381 
variable life insurance contracts are securities required to be registered under the 

Securities A~t.3~ In light of the variable death benefit and cash value features 

of the contracts, the Commission concluded that variable life insurance contract 

owners assume a substantial investment ri~k.3~ 

An early Commission decision noted that variable annuities, when 

purchased on an installment basis, provided for "periodic payments, redemption 

and undivided interests in a unit or fund of securities," characteristics common 

to periodic payment plan ~ertificates.3~ The Commission made similar 

comparisons when variable life insurance was introduced?6 In light of these 

comparisons, the Commission regulates variable insurance products as periodic 

payment plans under sections 26 and 27 of the Investment Company Act. 

D. Periodic Payment Plans 

Sections 26 and 27 address the abuses that were endemic in the periodic 

payment plan industry prior to 1940. The plans are contracts for investing in the 

shares of open-end investment companies on an installment ba~is.3~ Before 

enactment of the Investment Company Act, the most serious abuses associated 

with the plans resulted from the manner in which the sales load was deducted. 

An investor purchasing shares in a mutual fund directly would typically incur a 

sales load deducted as a simple percentage of his or her current investment. An 

investor buying through a periodic payment plan, in contrast, had his or her total 

sales load calculated as a percentage of the total amount to be invested over the 

33Exemption of Certain Variable Life Insurance Contracts and Their Issuers from Federal 

Securities Laws, Investment Company Act Release No. 7644 (Jan. 31,1973),38 FR 4315. 

341d. 

351n re Prudential, 41 S.E.C. at 348. See also In re Variable Annuity Life, 39 S.E.C. at 683,700- 

03. Cf. PPI REPORT, supra note 11, at 226-27. The Supreme Court had previously noted the 

resemblance of variable annuities to periodic payment plan certificates. VALIC, 359 U.S. at 85, 

96 (Brennan, J., concurring, and Harlan, J., dissenting). 

36The Division's 1973 Report on variable life insurance concluded that "the separate account 

formed to fund variable life insurance contracts would be an open-end management investment 

company issuing a periodic payment plan certificate." 1973 REPORT, supra note 5, at 128 (footnote 

omitted). 

37The security directly purchased by an investor is the periodic payment plan certificate, which 

represents an undivided interest in, rather than direct ownership of, shares of an open-end 

investment company. See Investment Company Act 5 2(a)(27). Plans typically have a two-tier 

structure under which payments are invested in a UIT, which invests in an underlying mutual 

fund. PPI REPORT, supra note 11, at 226. 

382 CHAPTER 10 
life of the plan (often ten or more years), rather than as a percentage of each 

individual payment. The plans deducted a proportionately higher amount from 

early payments, in order to encourage marketing efforts by salesmen. The net 

result was that little of the early payments under the plans was left for actual 

investment. Frequently, plans either were terminated or lapsed long before 

completion of planned payments. Since there was no requirement to refund 

excess sales loads, investors paid effective loads substantially in excess of the 

loads contemplated for completed plans. In other words, an investor who 

stopped making payments under a lan ended up paying a sales load on a larger 

investment than he actually made. & 

The structure of the plans caused other abuses as well. Plan investors paid 

double sales loads: a primary sales load when they purchased interests in the 

unit investment trust ("UIT") and a second load when the trust purchased shares 

of the underlying mutual fund?' These double loads also were paid on 

dividend reinvestments?' In addition, the sponsor often deducted a fee for 

"managing" the UIT assets even though these were non-discretionary accounts 

and management fees were paid to the adviser of the underlying fund!1 Plan 

investors paid other miscellaneous fees, such as withdrawal fees and a trustee's 

charge?2 

Although section 27 permits the higher initial sales loads needed to market 

periodic payment plans, it addresses abuses common to the plans by establishing 

a maximum sales load, the manner of deducting sales charges, and refund 

requirements that return a portion of the load paid by planholders that terminate 

early.43 It also subjects a periodic payment plan certificate issued by a 

3$EC, INVESTMENT TRUSTS AND INVESTMENT COMPANIES, COMPANIFS SPONSORING INSTALLMENT 

INVESTMENT PLANS, H.R DOC. NO. 482,76th Cong., 2d Sess. 33-34 (1940) [hereinafter INSTALLMENT 

INVESTMENT PLAN STUDY]. 

391d. at 40. If the underlying fund was not affiliated with the plan's sponsor, the plan sponsor 

typically kept the commission or discount included in the underlying fund's offering price rather 

than passing the discount on to plan investors. If the plan sponsor also managed the underlying 

fund, the sponsor typically assessed a full load when the trust purchased the fund's shares. 

40Zd. at 45. 

411d. at 38. 

@Investment Company Act 55 27(a), 27(d), 15 U.S.C. 5 80a-27(a), -27(d). In addition, section 

2(a)(35) of the Act prevents duplicative sales loads by requiring sales loads at the underlying fund 

level and the trust level to be combined for the purpose of meeting statutory limits. 

Variable Insurance 383 
management company to the charge limitations established for UITs under section 

26.44 Section 26 prohibits the payment of any amount from trust assets to the 

depositor or principal underwriter for the trust unless the payment qualifies as 

reasonable compensation for performing certain bookkeeping or other 

administrative servicesG Section 26 also limits the trustee's or custodian's fees 

to those fees and expenses set forth in the trust instrument and actually 

incurredF6 No other charges are allowed. 

E. Application of Sections 26 and 27 to Variable Insurance Products 

1. Variable Annuities 

A typical variable annuity contract assesses four types of charges: (1) 

front-end, deferred, and/or contingent deferred sales loads; (2) administrative 

expense charges; (3) mortality and expense risk charges; and (4) investment 

related charges, such as investment advisory fees. Advisory fees are subject to 

the fiduciary obligations imposed under section 36(b) of the Investment Company 

Act, which applies generally to all investment ~ompanies.4~ Sales loads, 

administrative charges, and mortality and expense risk charges, however, are 

regulated primarily under sections 26 and 27 of the Investment Company Act. 

a. Sales Loads 

The sales load limitations for periodic payment plans, and therefore 

variable annuities, are complex. Section 27(a)(l) limits issuers to a load not to 

exceed nine percent of total premium payments.@ Section 27(a)(2) permits an 

issuer to deduct more than nine percent from a particular premium (as much as 

fifty percent of the first twelve monthly premiums) but only if (1) no subsequent 

sales load deduction exceeds a prior one;49 (2) the contract contains a provision 

%nvestment Company Act Q 27(c)(2), 15 U.S.C. Q 80a-27(~)(2). 

4hvestment Company Act Q 26(a)(2), 15 U.S.C. Q 80a-26(a)(2). 

47Section 36(b) is described in greater detail in Chapters 7 and 8. 

48B~t see NATIONAL ASSOCIATION OF SECLJRITIES DEALERS MANUAL - RULES OF FAIR PRACTICE, 

Art. 111, Q 29(c) (1984) (limiting the maximum sales charge for variable annuities to 8.5% of total 

payments) [hereinafter NASD RULES]. 

4~nvestment Company Act § 27(a)(3), 15 U.S.C. Q 80a-27(a)(3). This is known as the "stair step 

provision." 

384 CHAPTER 10 
that permits the owner to surrender the contract within the first eighteen months 

and obtain a refund of some portion of the excess sales load assessed:' and (3) 

the period over which the life of the contract is measured for compliance with the 

nine percent limitation does not exceed twelve years?' An issuer may elect to 

use a "spread load" design, in accordance with the requirements of sections 27(g) 

and (h), and thus avoid the refund requirements of section 27(d)?2 

b. Administrative Expenses 

Administrative expenses under a variable annuity are regulated closely. 

Under section 26(a)(2)(C), administrative fees must be reasonable, as determined 

by the Commission. Rule 26a-1 defines reasonable administrative expenses for 

a separate account funding variable annuities, in essence providing that sponsors 

may not make a profit on administrative expenses. The rule limits administrative 

fees to the cost of services to be provided for one year in cases where the separate 

account reserves the right to increase the fee, or to the average expected cost for 

a specified period where the fee is guaranteed not to increase for that time. 

c. Mortality and Expense Risk Charges 

Variable annuity issuers deduct a mortality and expense risk charge from 

the assets of a separate account to compensate the insurer for the "mortality" risks 

and "expense" risks it assumes under the contracts. The insurer assumes a 

mortality risk when it guarantees annuity rates to contract owners. These annuity 

rates are based on mortality projections for future annuitants. In the event that 

actual mortality rates differ from projections (i.e., annuitants live longer than 

expected), the insurer remains obligated to pay annuity benefits as guaranteed in 

the contract. Some insurers also assume a mortality risk by agreeing to pay a 

50Section 27(d) requires the insurer to refund any sales load exceeding 15% of gross premiums 

paid by a contract owner. To assure payment of refunds, rule 27d-1 requires the insurer to keep 

certain reserves in a segregated account. 17 C.F.R. Q 270.27d-1. Alternatively, under rule 276-2 

the insurer may undertake to refund excess sales load if it meets certain capital and reporting 

requirements. 

51This third restriction is imposed by rule 27a-1. 17 C.F.R. Q 270.27a-1. Certain notice 

requirements regarding surrender and withdrawal rights also must be observed. See Investment 

Company Act 55 27(e), 27(f), 15 U.S.C. QQ 80a-27(e), -27(f). 

52Under a "spread load' design, an issuer may deduct a maximum of 20% of any payment, 

or an average of 16% of the first 48 monthly payments, provided that the overall load does not 

exceed nine percent of total payments and certain other conditions are met. The periodic payment 

spread load should not be confused with the spread load used by some mutual funds, which 

consists of a rule 12b-1 fee and a contingent deferred sales load. See Chapter 8. 

Variable Insurance 385 
death benefit if the annuitant dies before a specified time. The insurer assumes 

an expense risk when an annuity contract guarantees that administrative charges 

under the contract will not increase even if actual administrative costs increase 

during the life of the contract. 

Risk charges are not compensation for performing bookkeeping or other 

administrative services under section 26(a) and therefore are prohibited. Attempts 

to adopt a rule to permit the deduction of these charges have been unsuccessful; 

consequently, a variable annuity issuer must obtain an exemptive order to deduct 

risk ~harges.5~ 

2. Variable Life Insurance 

When variable life insurance was first introduced in the early 1970's, the 

Commission decided to exempt the product from regulation under the Investment 

Company Act on the assumption that state insurance law would be adapted to 

provide protections comparable to those afforded under the A~t.5~ Shortly 

thereafter, because of dissatisfaction with the state regulatory effort, the 

Commission adopted rule 6e-2 for certain scheduled premium variable life 

insurance c0ntracts.5~ Rule 6e-2 seeks to accommodate the insurance elements 

of variable life contracts without sacrificing Investment Company Act regulation. 

It exempts a qualifying separate account, principal underwriter, and depositor 

from many sections of the Act that are inconsistent with the operation of variable 

life insurance. 

Rule 6e-2 does not deal with the particular problems presented by flexible 

premium variable life insurance, a product developed in the early 1980's. In 1983, 

the Commission proposed rule 6e-3, which was designed to accommodate the 

=See infva notes 87-90 and accompanying text. Applicants for exemptive relief from sections 

26(a)(2) and 27(c)(2) to deduct risk charges must represent, among other things, that the charge 

is within the range of industry practice for comparable contracts or reasonable in relation to the 

risks assumed. If an applicant anticipates that sales loads under the contract will not cover sales 

expenses, and consequently that proceqds of risk charges may be used to pay for distribution 

costs, the insurance company also must represent that there is a reasonable likelihood the 

distribution financing arrangement under the contract will benefit contract owners and the 

separate account. 

541nv. Co. Act Rel. 7644, supra note 33. The Commission was concerned particularly with 

uniform valuation of portfolio securities, annual reporting requirements, unauthorized changes 

in investment policies, excessive fees, and affiliated transactions. Id. 

"Separate Accounts of Life Insurance Companies Funding Certain Variable Life Insurance 

Contracts, Investment Company Act Release No. 9482 (Oct. 18,1976), 41 FR 47023 (adopting rule 

6e-2). See also Inv. Co. Act Rel. 9104, supra note 11 (proposing release). 

386 CHAPTER 10 
unique features of flexible premium variable life insurance contracts?6 In 1984, 

the Commission adopted rule 6e-3(T) on a temporary basis in order to gain some 

experience with flexible premium variable life in~urance.5~ The variable life 

insurance rules offer insurers needed relief from those provisions of the 

Investment Company Act that are incompatible with the operation of insurance 

contracts. 

The main charges deducted under a typical variable life insurance contract 

are: (1) front-end, deferred, and/or contingent deferred sales loads; (2) 

administrative expense charges; (3) cost of insurance charges (the cost of death 

benefit protection); (4) mortality and expense risk charges; and (5) investment 

related charges, such as investment advisory fees. Regulation of cost of insurance 

is left to state law because of the insurance nature of the charges. Sales loads, 

administrative charges, and mortality and expense risk charges are regulated 

under sections 26 and 27 of the Investment Company Act. Advisory fees are 

subject to section 36(b) of the Act. 

a. Sales Loads 

The sales load assessed under a variable life contract is regulated by 

section 27 and rules 6e-2 or 6e-3(T). Each rule provides that the sales load may 

not exceed nine percent of total premiums paid or expected to be paid over the 

lesser of twenty years or the life expectancy of the insured. An insurer may 

comply with this provision in one of two ways. It may choose a "level" load and 

deduct no more than nine percent from each premium or it may use 

an "excess" load and deduct a percentage that exceeds nine percent of payments 

561nv. Co. Act Rel. 13632, supra note 5. Flexible premium contracts permit a contract owner 

to vary the timing and/or mount of premium payments and to adjust the level of death benefit 

protection. Rule 6e-3(T)(c)(lIr 6e-3(T)(d)(2It 17 C.F.R. 5 270.6e-3(T)(c)(l), .6e-3(T)(d)(2). Scheduled 

contracts generally require a contract owner to adhere to a premium payment plan and do not 

permit adjustments in the level of death benefit protection (except to the extent it varies with the 

investment experience of the separate account). Rule 6e-2(c)(l), 17 C.F.R. § 270.6e-2(c)(l). 

57Separate Accounts Funding Flexible Premium Variable Life Insurance Contracts, Investment 

Company Act Release No. 14234 (Nov. 14, 1984),49 FR 47208. Rule 6e-3(T) has been mended 

twice since 1984. Separate Accounts Funding Flexible Premium Variable Life Insurance Contracts, 

Investment Company Act Release Nos. 14625 (July 10, 19851, 50 FR 28930 and 15651 (Mar. 30, 

1987), 52 FR 11187. 

%Rule &3(T)(b)(13)(i)(B), 17 C.F.R. §§ 270.6e-3(T)(b)(13)(i)(B). While there is no corresponding 

provision in rule 6e-2, an insurer under a scheduled premium contract may choose a level sales 

load in compliance with Investment Company Act sections 27(a)(l) and 27(h)(l). 

Variable Insurance 387 
made in the early contract ears but decreases in later contract years to remain 

within the aggregate limit. J 

An excess load structure for a variable life insurance contract with 

scheduled premiums is easy to monitor. Premiums under a scheduled contract 

are paid in a predictable pattern, usually in level amounts. Because it is known 

what payments are expected to be made over the life of the contract, it can readily 

be determined whether the loads assessed will exceed nine percent of total 

premium payments. 

An excess load structure for a flexible premium contract, on the other 

hand, is more difficult to monitor because the contract gives the owner the right 

to vary the timing and amount of premium payments. It is not possible to 

predict accurately the total amount of premium payments that will be made 

under the contract. To assure compliance with the nine percent limit, Rule 6e-3(T) 

uses the concept of a "guideline annual premium," which simulates a attern of 

fixed payments over a specified period based on certain assumptions. Ho 

Whether premiums are scheduled or flexible, considerable limits are 

imposed on the use of excess loads. For example, sales loads deducted during the 

first twelve contract months may never exceed fifty percent of any one payment 

or, for flexible contracts, one guideline annual premium. In addition, under "stair 

step" provisions, the proportionate amount of any sales load deducted from any 

payment generally may not exceed the proportionate amount deducted from any 

prior payment?' Finally, to the extent a variable life insurance contract has an 

excess load, an issuer must allow the contract owner to surrender the contract 

durin the first twenty-four months and receive a refund of "excess" loads 

paid! The contract owner must get back the amount of any load in excess of 

thirty percent of first year payments (or of the guideline annual premium for 

59Rules 6e-2(b)(13)(i), 6e-3(T)(b)(13)(i)(A), 17 C.F.R. $5 270.6e-2@)(13)(i), .Se-3(T)(b)(13)(i)(A). 

Variable life insurers frequently use excess load designs. The use of a 20 year term enables the 

Commission to assure compliance with the nine percent limit for variable life contracts having an 

excess load design. Without the use of an artificial maximum term, the nine percent limit could 

be easily circumvented by an insurer through the use of an unreasonably long period over which 

to "average" sales load deductions. 

6'kule 6e-3(T)(c)(8), 17 C.F.R. 5 270.6e-3(T)(c)(8). 

611nvestment Company Act 55 27(a)(3), 27(h)(3), 15 U.S.C. 55 80a-27(a)(3), -27(h)(3); rules 6e2@)(13)(ii), 6*3(T)@)(13)(ii), 17 C.F.R. 270.6e-2(b)(13)(ii), .6e3(T)(b)(13)(ii). 

621nvestment Company Act section 27(d), 15 U.S.C. 5 80a-27(6); rules 6e-2(b)(13)(vl1 6e3(T)(b)(13)(v), 17 C.F.R. 55 270.6e-2(b)(13)(v), .6e-3(T)(b)(13)(v). 

388 CHAPTER 10 
flexible contracts), ten percent of second year payments (or guideline annual 

premium), and nine percent of any additional payments made during the twentyfour month period. 

b. Administrative Expenses 

Rules 6e-2 and 6e-3(T) provide relief from sections 26(a)(l), 26(a)(2), and 

27(c)(2) to permit the deduction of certain charges from separate account assets 

and to permit various custodial activities regarding those assets. Unlike variable 

annuities, the administrative expenses under scheduled premium variable life 

contracts are not limited to cost, but must be reasonable in relation to the services 

rendered and expenses in~urred.6~ The fees for administrative services 

performed under a flexible premium contract, on the other hand, must be limited 

to the cost of the services pr0vided.6~ 

c. Mortality and Expense Risk Charges 

Mortality and expense risk charges under variable life insurance contracts 

compensate the insurer for the risk that actual mortality rates will differ from 

actuarial projections or that actual expenses will exceed guaranteed rates. In 

contrast to variable annuities, the insurer's mortality risk is the risk that the 

insured will die sooner than projected and thus before the expected amount of 

&Rule 6e-2(b)(13)(iii)(C), 17 C.F.R. § 270.6e-2(b)(13)(iii)(C). Despite the language of that 

section, the industry apparently views it as requiring that administrative expenses under a 

scheduled premium contract be limited to cost, similar to the requirement in rules 26a-1 and 6e3(T) for variable annuities and flexible premium contracts, respectively. See, e.g., Letter on behalf 

of Prudential Ins. Co. of Am. to Jonathan G. Katz, Secretary, SEC 70,77-78 (Oct. 2,19901, File No. 

S7-11-90 [hereinafter Prudential Study Comment]. (Documents referred to in this chapter as 

"Study Comments" were submitted to the Commission in response to its request for comments 

on reform of the regulation of investment companies. Investment Company Act Release No. 

17534 (June 15,19901, 55 FR 25322.) 

64Rule &3(T)(b)(l3)(iii)(A), 17 C.F.R. § 270.6e-3(T)(b)(l3)(iii)(A). Rule 6e-2 was adopted before 

the Commission established the "at cost" standard in rule 26a-1 for variable annuities. When rule 

6e-3(T) was later adopted, the requirements of rule 26a-1 were incorporated into that rule. The 

industry apparently views both forms of variable life contracts as subject to the "at cost" standard. 

See, e.g., Prudential Study Comment, supra note 63, at 70, 77-78. 

Variable Insurance 389 
premium payments has been ~aid.6~ Variable life issuers deduct mortality and 

expense risk charges from separate account assets pursuant to exemptive 

111. Problems with the Current Regulatory Framework 

A. The Nature of the Products and Sponsors 

Variable insurance contracts fall within the definition of periodic payment 

plans because they are contracts "providing for a series of periodic payments by 

the holder, and representing an undivided interest in certain specified securities 

or in a unit or fund of securities purchased wholly or partly with the proceeds of 

such payments . . . Despite this superficial resemblance, variable contracts 

differ fundamentally from the periodic payment plan contemplated by Congress: 

erms of the benefits contract owners receive; the services the sponsors provide; 

capital structure of the sponsor companies; and the extent of state regulation. 

se differences highlight the inappropriateness of the current statutory 

framework as applied to variable insurance and provide a basis for understanding 

the difficulties such issuers face. 

First, in terms of the benefits contract owners receive, the differences are 

significant enough to justify different pricing and distribution requirements.@' 

As discussed above:' periodic payment plans are no more than a means of 

purchasing securities by installment. In the early stages of plan participation, an 

6qn the case of the variable annuity, the insurer's mortality risk, in part, is the risk that the 

insured (annuitant) will live longer than projected. See supra Section 11.E.1.3. 

66Rules 6e2(c)(l)(iii), .6e-3(T)(b)(l3)(iii)(F), 17 C.F.R. 55 270.6e-2(c)(l)(iii), .&-3(T)(b)(l3)(iii)(F). 

Because of the chronological development of the regulation of risk charges, the standards for 

deducting those charges are different under scheduled premium contracts and flexible premium 

contracts. Risk charges for scheduled premium contracts relying on rule 6e-2 must be disclosed 

in the prospectus and be at least equal to 50% of the maximum deductions stated in the 

prospectus and in the contract. Rule 6e-3(T) for flexible premium contracts contains this standard 

but also includes conditions similar to those required of variable annuity issuers in applications 

for exemptive orders under section 6(c) of the Act. See supfa notes 53,56 & 57 and accompanying 

text, and infra notes 85-90 and accompanying text. The Division anticipates that, even if the 

Investment Company Act is not amended, eventually all variable insurance produds will be 

subject to the same standard for the deduction of risk charges. 

671nvestment Company Act 5 2(a)(27), 15 U.S.C. 5 80a-2(a)(27). 

68For a discussion of pricing and distribution problems faced by variable life issuers, see infra 

Section 1II.C. 

69See supra notes 37-42 and accompanying text. 

390 CHAPTER 10 
investor receives little more than the opportunity to pay excessive sales loads on 

initial pa ments. Because a relatively small portion of early payments is actually 

invested!' there is the certainty of severe economic harm if payments are not 

continued. Variable insurance, on the other hand, offers a combination of 

insurance and investment in one product for which there is no obvious substitute. 

Variable life contracts provide immediate benefits to a contract owner in the form 

of full insurance protection after the first premium payment. Although a 

relatively high percentage of initial payments is subject to charge deductions, 

unlike the periodic payment plan investor, the variable life contract owner 

receives a real economic benefit?* Variable annuities also typically offer benefits 

in the form of death benefit protection during the contracfs pay-in phase and 

rights to select annuity pay-out options at rates established when the contract is 

purchased?2 

Second, there are significant differences in the administrative services 

provided to contract owners that may warrant a more flexible approach for 

regulating variable contract charges. The periodic payment plan, because it is 

nothing more than a means of purchasing securities by installment, requires a 

plan trustee or sponsor to perform relatively simple administrative tasks. 

Therefore, the often illusory services for which such sponsors were paid out of 

trust assets before 1940 necessitated the restrictions of section 26(a>(2>(C)73 and 

the at cost limits of rule 26~1-1.~~ A variable insurance sponsor, on the other 

hand, provides a wider array of services in administering a variable contract. An 

insurer must make a significant commitment of capital to develop and maintain 

very elaborate systems that can handle a variety of contract features and monitor 

the panoply of insurance, tax, and securities law requirements that apply to the 

70See PPI REPORT, supra note 11, at 245 (observing that a periodic payment plan investor after 

making all scheduled first-year payments has only five to six percent of this amount invested on 

his or her behalf). 

711n the PPI REPORT, the Commission emphasized the different benefits provided under the 

contracts in recommending that the front-end sales load under a periodic payment plan be 

abolished. Id. at 246-47. The Commission noted that the insured under a life insurance policy 

immediately receives the full measure of the contemplated death protection when the contract is 

purchased, "not 5 percent of it." Id. at 246. 

72See supra Section I1.E.l.c. 

73Under this section, the trust may pay its sponsor only reasonable compensation for 

performing bookkeeping and other administrative services of a character normally performed by 

the trustee or custodian. 

74For an explanation of the "at cost" limits of rule 26a-1, see supra Section I1.E.l.b. 

Variable Insurance 391 
 contract^?^ These services have real market value. According to one 

commenter, these services, even without a corresponding assumption of contract 

risks, are sold to other insurers in the group and pension markets?6 

A third important distinction between the periodic payment plan and 

variable insurance relates to the capital structure of the sponsor companies. 

Periodic payment plan sponsors historically were thinly capitalized entities; plan 

sponsors made minimal capital investments, believing that very little capital was 

needed to enter the b~siness.7~ Therefore, when trusts were "orphaned" and 

liquidated, a not infrequent occurrence in the pre-Investment Company Act 

eraT8 some investors did not receive the services for which they had already 

paid. Moreover, despite successful judgments, these investors could not recover 

damages from the thinly capitalized spon~ors?~ The Commission sought to 

remedy the problem of "orphaning" and the shortage of assets available for 

paying judgments by recommending to Congress the imposition of minimum 

capital requirements for plan sponsors?' Congress decided, however, to enact 

the more restrictive framework of sections 26 and 27. Because the avera e 

insurance company has a stronger capital base than the typical plan sponsor, 

and because a separate account is an integral part of an insurance company with 

%I 

75See Letter from American Council of Life Insurance to Jonathan G. Katz, Secretary, SEC 16-29 

(Oct. 10, 1990), File No. S7-11-90 [hereinafter ACLI Study Comment]. See also discussion of 

administrative expenses, infra notes 97-101 and accompanying text. 

76Letter from Metropolitan Life Insurance Company to Jonathan G. Katz, Secretary, SEC 9 (Oct. 

9, 19901, File No. S7-11-90 [hereinafter Metropolitan Study Comment]. 

n~STALLM~T INVESTMENT PLAN STUDY, supra note 38, at 110-11 (noting that in 1935, the 

average outstanding capital stock of 22 major sponsor companies was valued at less than $50,000). 

78Trusts were "orphaned when their sponsor companies dissolved or became bankrupt, 

forcing the trusts to liquidate. Id. at 117. 

791d. at 117-18. Losses sometimes resulted from the sale of underlying securities in an 

unfavorable market when trust assets were liquidated, and were particularly heavy for those 

certificate holders who had only made a few payments from which sales load was taken. 

mSee In re Variable Annuity Life, 39 S.E.C. at 702 (citing INSTALLMENT INVESTMENT PLAN 

STUDY, supra note 38, at 119). 

"At December 31,1989, the aggregate capital and surplus (or net worth) of all 2,350 United 

States life insurance companies was $80.6 billion, yielding a simple average capital and surplus 

size per company of $34.3 million. see AMERICAN COUNCIL OF LIFE INSURANCE, 1990 LIFE 

INSURANCE FACT BOOK, at 79,81,105 (1990). 

392 CHAPTER 10 
little chance of being "orphaned,'Is2 a less paternalistic structure for variable 

insurance regulation may be more suitable. The greater likelihood that a variable 

insurance contract owner would recover against an insurance company sponsor 

suggests that greater regulatory flexibility should be accorded such issuers. 

Finally, the presence of state insurance law as an additional layer of 

regulation for the insurance industry distinguishes variable insurance from 

periodic payment plans and argues in favor of a more flexible approach for 

regulating variable contract charges. Before 1940, periodic payment plans were 

largely unregulated; therefore, the restrictive framework of sections 26 and 27 of 

the Act was justified, particularly in light of the abuses then existing in that 

industry.83 Variable insurance, on the other hand, is subject to state solvency 

law, including the maintenance of minimum capital, statutory reserves, and 

investment re~trictions.8~ Together these requirements have made the average 

insurance company a stronger financial entity than the typical plan sponsor. In 

addition, state law provides valuable protection to contract owners in the form 

of nonforfeiture benefits and, through the mandatory approval of contract forms 

before they are sold to the public, state officials ensure that every contract 

contains other important protections. While the Division does not recommend a 

full exemption from Investment Company Act regulation for variable insurance 

issuers, the presence of state insurance law suggests that a more flexible approach 

to charge regulation would be appropriate. 

'*It is unlikely for a separate account to be "orphaned" because: (1) state approval is necessary 

before contractual obligations may be assigned in the ordinary course of business bee, eg., N.Y. 

INS. LAW § 1308(f)(2) (McKinney 1985 & Supp. 19901, ILL. ANN. STAT. CH. 73, 786 (Smith-Hurd 

1965 & Supp. 1990) (consent of state commissioner required for reinsurance of separate account 

obligations)); and (2) the states generally intervene to protect the contract owners of a troubled 

insurer, for example, through the use of state guaranty funds (see, e.g., N.Y. INS. LAW 55 7701-7718 

(McKinney Supp. 1991); CAL. INS. CODE 5 1067 (West Supp. 1991); ILL. ANN. STAT. CH. 73 § 

1065.80-1 (Smith-Hurd Supp. 1991)) or through rehabilitation proceedings (see, e.g., Susan Pulliam, 

New Iersey Takes Over Mutual Benefit In Largest Seizure Ever of an Insurer, WALL ST. J., July 16,1991, 

at A4, col.1). 

%ee supra notes 3742 and accompanying text. 

841n declaring that state insurance law did not provide adequate protection to an investor in 

a mutual fund, Justice Brennan in his concurring opinion in VALIC appeared to focus on the 

absence of disclosure requirements in state law. VALIC, 359 U.S. at 78, 85-86 (Brennan, J., 

concurring). The Division believes that state law affords protections similar to those currently 

provided by sections 26 and 27 of the Investment Company Act. See infra notes 138,140-143 and 

accompanying text. 

Variable Insurance 393 
B. The Investment Charge - Insurance Charge Dilemma 

Regulation of variable products under the system established for periodic 

payment plans presents a formidable challenge: the Commission must enforce 

the rigid controls placed on charges levied by the plans, and, at the same time,. 

attempt to separate the insurance features of variable contracts from their 

investment features and regulate only the latter. Efforts to regulate some charges, 

but not others, may be ineffectual because issuers may compensate for restrictions 

on regulated charges by increasing unregulated charges and using the proceeds 

for regulated purposes. These problems argue in favor of a regulatory approach 

that explicitly grants the Commission jurisdiction over all contract charges. 

The Commission’s experience with mortality and expense risk charges is 

illustrative. The insurance industry contends that mortality and expense risk 

charges are insurance chargs properly subject to state regulation and outside the 

Commission’s jurisdiction. The Commission, on the other hand, is concerned 

that an insurer may use the proceeds of mortality and expense risk charges to pay 

for distribution, an activity that is properly within the Commission’s domain. In 

fact, mortality and expense risk charges may be used to cover insurance-related 

expenses or may be profit, depending upon the ultimate wisdom of the actuarial 

projections that shape the contract. If the actual mortality and expense experience 

under a contract is consistent with or better than the original projections of the 

pricing actuary, the insurer makes a profit on the charge. If actual experience 

differs and mortality or expense losses exceed original projections, the risk charge 

is needed to pay “insurance” costs. Many insurers anticipate, however, that the 

entire risk charge deduction will not be needed to pay contingent mortality costs 

or administrative expenses under the contracts.86 

85T’he industry always has asserted that the Commission’s jurisdiction over variable insurance 

contracts extends only to their investment element, with the states retaining exclusive authority 

to regulate the insurance aspect of the contracts. See, eg., Letter from American Council of Life 

Insurance to Jonathan G. Katz, Secretary, SEC 12-13 (June 5, 1987), File No. S7-6-87 [hereinafter 

ACLI Reproposal Comment] (discussing reproposed rule 26a-3). See also infra note 88 and 

accompanying text. 

%See, e.g., IDS Life Ins. Co., Investment Company Act Release Nos. 18221 (July 3,1991), 56 FR 

31452 (Notice of Application) and 18252 (July 31,19911, 49 SEC Docket 0761 (Order); Allstate Life 

Ins. Co. of New York, Investment Company Act Release Nos. 17640 (Aug. 1,1990), 55 FR 32524 

(Notice of Application) and 17709 (Aug. 29,1990)’ 46 SEC Docket 1985 (Order); NN Investors Life 

Ins. Co., Investment Company Act Release Nos. 17364 (Mar. 5, 1990), 55 FR 9239 (Notice of 

Application) and 17405 (Apr. 3, 1990), 45 SEC Docket 1787 (Order) (all stating that the insurer 

expects to profit from the mortality and expense risk charge). 

394 CHAPTER 10 
Beginning in 1980, the Commission interpreted the Investment Company 

Act to require insurers to obtain exemptions from sections 26(a)(2) and 27(c)(2) 

to deduct the so-called risk charges from the assets of the separate acc0unt.8~ 

The volume of these applications led to proposed rule 26a-3, proposed in 1984 

and reproposed in 1987 but never adopted.@ The arguments over the rule 

consistently have been drawn along jurisdictional lines: the industry claims the 

Commission does not adequately acknowledge the insurance nature of the 

charges, and the Commission seeks to limit risk charges so that the charges 

cannot be used as a hidden funding vehicle for distribution e~penses.8~ In the 

mid-l980's, the Division took the position that it would not su port exemptions 

from the Act for risk charges that exceeded specified levels5 The Division's 

search for an appropriate standard for mortality and expense risk charges was 

suspended when the Investment Company Act Study began. 

C. Problems With Variable Life Insurance -- Industry Concerns 

The insurance industry claims that the application of sections 26 and 27 of 

the Investment Company Act to variable life insurance has created enormous 

pricing and distribution problems for insurers. Under current regulation, an 

insurer may not price its contracts in a way that adequately reflects the heavy 

capital expenditure needed to establish and maintain a variable insurance 

operation. In addition, an insurer may not distribute its variable life contracts on 

87See, eg., Beneficial Nat'l Life Ins. Co., Investment Company Act Release Nos. 11101 (Mar. 25, 

1980), 45 FX 21417 (Notice of Application) and 11173 (May 19,1980),20 SEC Docket 77 (Order). 

Management separate accounts also obtained exemptions from Investment Company Act section 

12(b) (15 U.S.C. § 80a-l2(b)), if the accounts expected to pay part of their distribution expenses 

with the proceeds of risk charges. See, e.g., Travelers Ins. Co., Investment Company Act Release 

Nos. 13130 (Mar. 31,1983), 48 FR 15059 (Notice of Application) and 13241 (May 13,1983), 27 SEC 

Docket 1668 (Order). 

@Exemptive Relief for Variable Annuity Separate Accounts Relating to Deduction of Certain 

Charges from Account Assets, Investment Company Act Release Nos. 14190 (Oct. 11,1984), 49 FR 

40879 (proposal) and 15586 (Feb. 26,1987), 52 FR 7166 (reproposal). When comments received in 

response to the reproposal suggested that few registrants would be able to meet the proposed 

standards, the Division began to consider a third version. 

'?For a general discussion of the history of risk charges, see ACLI Reproposal Comment, supra 

note 85. 

'OAfter an informal survey of industry practice, the Division decided that applications for the 

deduction of risk charges would not be processed under delegated authority if they exceeded 

1.25% for a variable annuity contract, 0.50% for a scheduled premium variable life contract, and 

0.90% for a flexible premium variable life contract. The Division has advised insurance companies 

that it would recommend that such applications be set down for a Commission hearing. 

Variable Insurance 395 
an equal basis with fixed-dollar contracts unless it undertakes an extra burden on 

its capital and surplus. Accordingly, variable life insurance has had modest 

growth, both in terms of product development and in terms of the number of 

insurers offering the product. 

Many commenters asserted that the current statutory emphasis on 

regulation of individual charges is inappropriate for variable insurance because 

it inhibits product development.” While the structure may work for periodic 

payment plans, the economics of life insurance demands greater fle~ibility.~~ 

In designing a new contract, an actuary must make important assumptions 

regarding a number of pricing variable^.'^ In seeking to establish an 

appropriate contract price, the actuary strives for the optimum combination of 

assumptions that, consistent with company objectives, would enable the company 

to recover its expenses on a block of policies within a given number of years and 

then become pr~fitable.~~ State law gives an insurer the flexibility it needs to 

adjust the pricing elements in designing new contracts. Investment Company Act 

’*See, e.g., Prudential Study Comment, supra note 63, at 80 (the regulatory focus on each 

separate charge is unworkable and interferes with the design and proper pricing of variable life 

contracts); Letter from Equitable Life Assurance Company of the United States to Jonathan G. 

Katz, Secretary, SEC 6 (Oct. 5, 19901, File No. S7-11-90 (stating that regulation under sections 26 

and 27 has constrained product design and innovation); Metropolitan Study Comment, supra note 

76, at 8 (stating that the periodic payment plan constraints, as applied to variable insurance, have 

restricted the depth of innovation). 

=The business of life insurance requires an insurer to finance the heavy costs of issuing a 

policy. These costs include sales commissions, advertising costs, underwriting expenses, and firstyear administrative expenses, and may constitute as much as 110% of first-year premium 

payments. DM M. MCGILL, LIFE INSURANCE, 253-54 (rev. ed. 1967). To be affordable, life 

insurance usually is paid for over many years. The first-year premium is usually insufficient to 

pay for issuance expenses, death claims occurring during the year (cost of insurance charges) and 

to meet statutory reserve requirements. Therefore, a company relies on its capital and surplus to 

finance these obligations, hoping to recover these amounts from continuing contract payments 

remitted over the years. For a discussion of the economics of life insurance, see generally 

KENNETH BLACK, JR. & HAROLD SKIPPER, JR., LIFE INSURANCE 23,350-351 (11th ed. 1987). 

%In pricing a life insurance policy, an actuary must make critical judgments concerning six 

basic elements for a block of policies: (1) the probable rate of death and, therefore, payment of 

claims; (2) expected earnings on investment of premium payments; (3) long-term expenses of 

administering the policy; (4) the rate of persistency (i.e., the probability that the contract would 

not lapse or be terminated before the company has recovered the expenses incurred in issuing the 

policy); (5) an expected profit margin that accords with company objectives; and (6) contingencies 

(a factor to allow for unexpected events). See BLACK & SKIPPER, supra note 92, at 16, 367. 

94Depending on a company’s philosophy or the extent of new business it has issued, a 

company expects to recover its expenses over a period of years that generally may range from five 

to twelve years. Id. at 369. 

396 CHAPTER 10 

,--.IE 
regulation, by contrast, limits almost all pricing elements and thus inhibits the 

actuarial process. 

By restricting individual contract charges, current Investment Company Act 

regulation forces the creation of inappropriately priced contracts. An insurer may 

not arrive at the combination of assumptions that best suits its objectives and that 

may produce the best value for contract owne~s?~ Inaddition, the industry has 

indicated that it is difficult for companies to adapt existing fixed-dollar contract 

desi ns to a variable contract form because of the restrictions of sections 26 and 

27.9' These sections, which are more restrictive than state law, cause an insurer 

to make costly changes to its administrative systems in reproducing fixed-dollar 

designs. 

The lack of pricing flexibility in variable life insurance is exacerbated by 

the stringent limits placed on specific charges. In particular, most commenters 

were critical of the requirement that an insurer must perform the administrative 

services under a variable life contract at cost?7 Unlike periodic payment plans 

where sponsors incur very little capital ex enses?' the operation of variable life 

insurance requires a heavy capital outlay5 An insurer must develop elaborate 

95The benefit of greater pricing flexibility to contract owners was well illustrated by one 

commenter who demonstrated that, with greater pricing flexibility, it could design a variable life 

contract that produces higher cash surrender values for contract owners. Prudential Study 

Comment, supra note 63, at 89-99. 

96See ACLI Study Comment, supra note 75, at 8 (charge structures typical of more traditional, 

fixed-dollar insurance products are difficult to replicate for variable contracts). 

97See, eg., Prudential Study Comment, supra note 63, at 102-03 (because of extensive 

administrative services, "compensation" should include a fair, reasonable profit); Metropolitan 

Study Comment, supra note 76, at 9 (insurance company should be able to make a profit on its 

charges for the significant administrative services it provides); Letter from Los Angeles County 

Bar Association, Business & Corporations Law Section, to Jonathan G. Katz, Secretary, SEC 5 (Oct. 

9, 1989) [sic], File No. S7-11-90 [hereinafter LA Bar Study Comment] (administrative charges 

should not be limited to "cost," but should be left to free market competition). 

98See supra notes 73-77 and accompanying text. 

99See, e.g., ACLI Study Comment, supra note 75, at 16-29. The Equitable Variable Life 

Insurance Company spent approximately Seven and one-half million dollars before selling its first 

policy in the late 1970s, and North American Reassurance Company is estimated to have spent 

eight to nine million dollars developing a variable life service-reinsurance package. RICHARD 

JOHNS, VARIABLE LIFE INSURANCE - AN OLJT'SIDE VIEW, 25-26 (1977). 

Variable Insurance 397 
administrative systems to handle the far more complex variable life contract?" 

In addition, such systems must be capable of monitorin compliance with a 

variety of securities, insurance, and tax law provisions.''F An insurer would 

not be willing to invest heavily in variable life insurance if it perceived any 

competitive disadvantage in doing so. The more liberal state law pricing 

provisions that apply to fixed-dollar life insurance create such a disadvantage. 

Therefore, unless Investment Company Act regulation provides comparable 

flexibility to issuers of variable life insurance, many insurers would continue to 

emphasize fixed-dollar products. 

Another major concern expressed by commenters was the belief that the 

refund requirements of section 27(d) and rules 6e-2 and 6e-3(T) create a marketing 

bias against the sale of variable life insurance.lo2 Under these provisions, an 

insurer is required to return (or may not deduct more than) certain prescribed 

sales load amounts if an excess-loaded contract is surrendered during the first 

twenty-four contract months.lo3 Some commenters asserted that, compared 

with fixed life insurance, these requirements are too onerous because they force 

companies that must pay competitive commissions for selling variable life 

insurance to bear an additional strain on the companies' capital and surplu~.''~ 

Many insurers appear unwilling to commit significant amounts of capital to 

'%e typical variable life contract contains a variety of features such as different premium 

payment options, varying methods of expense deductions, cash surrender values that may change 

daily, different investment options (e.g., money market, aggressive growth, bond subaccounts), 

different death benefit options, exchange privileges among investment options, withdrawal rights, 

tax-deferred benefits, and varying riders providing for optional benefits. See generally ACLI Study 

Comment, supra note 75, at 19-20. 

lo11d. at 21-29. 

'@See, e.g., id. at 14-16; Metropolitan Study Comment, supra note 76, at 8-9. 

lmRules 6e2(b)(13)(v), &-3(T)(b)(13)(v), 17 C.F.R. $5 270.6e-2@)(13)(~), .6e-3(T)(b)(13)(v). For 

further discussion of these provisions, see text accompanying note 62 supra. Insurance companies 

traditionally have paid high front-end commissions for selling life insurance and have financed 

these amounts from capital and surplus because of the insufficiency of first-year premiums. 

BLACK & SKIPPER, supra note 92, at 527,350-51. The Commission has acknowledged the need for 

paying high commissions in early contract years. PPI REPORT, supra note 11, at 246. A company 

expects to recover these expenses when premiums are paid in subsequent years. If a contract is 

terminated before the expected recovery period, the insurance company incurs a loss unless the 

proceeds of surrender are sufficient to cover unamortized expenses and to the extent state or 

federal law permits the insurer to deduct these expenses. 

'040ne company indicated that the refund provisions of rules 6e-2 and 6e-3(T) can delay 

recovery of its issuance costs for up to six years compared to fixed products. Metropolitan Study 

Comment, supra note 76, at 8. 

398 CHAPTER 10 
establish and maintain a variable life operation if they cannot sell such contracts 

on an equal basis with fixed-dollar products. 

The effect of the re€und requirements on a variable life issuer's capital and 

surplus may be best illustrated by example. Assume that an insurer pays an 

agent that sells a scheduled premium variable life contract a commission equal 

to fifty-five percent of the first year annual premium, the same rate it pays for 

selling a comparable fixed-dollar life contract. Consistent with industry practice, 

the insurer finances a portion of this commission, together with other issuance 

expenses, from its capital and surplus. If the contract is surrendered after six 

months, the insurer may assess a sales load of only thirty percent of the first year 

annual premium.lo5 The company, therefore, will incur a loss of twenty-five 

percent on the contract, unless it can recapture commissions from the selling 

agent, a difficult task to accomplish. Under a fixed-dollar contract, by contrast, 

an insurer may recover a higher portion of its unamortized issuance expenses 

because of the more liberal state refund (nonforfeiture) requirements. To 

minimize its loss, the variable life issuer can pursue one of two basic courses. 

First, it can establish a higher annual premium and, by applying a lower 

commission rate, effectively pay the agent the same amount that is paid for 

selling the fixed-dollar contract; alternatively, it can pay the agent a commission 

equal to the effective current maximum limit of thirty percent. Under either 

option, however, the variable life issuer would be at a competitive disadvantage. 

Because the fixed-dollar contract is a close substitute for the variable life contract, 

the two contracts must have reasonably competitive prices. In addition, an agent 

would not have an incentive to sell a variable life contract paying a commission 

of thirty percent when that agent can earn a higher commission for selling a 

comparable fixed-dollar contract. 

The net effect of current pricing and distribution problems has been to 

make the offering of variable life insurance riskier than the sale of fixed-dollar 

contracts?" Not many insurers appear willing to undertake additional risk of 

offering variable life insurance, particularly when they can sell certain interest- 

'"See rule 6e-2(b)(13)(v), 17 C.F.R. § 270.6e-2(b)(13)(v). Instead of deducting a 30% sales load 

upon surrender, an insurer may deduct a 50% load when the premium is paid and return 20% 

to the contract owner at the time of surrender. See Investment Company Act 5 27(a)(2), 15 U.S.C. 

§ 80a-27(a)(2) (issuer may deduct up to 50% of any of the first 12 monthly payments). The 

effective load in either case is 30% for surrenders made during the first contract year. 

106Metropolitan Study Comment, supa note 76, at 8 (current refund restriction can have a 

significant impact on the profitability of a variable product and increase the risk to the insurance 

company). 

Variable Insurance 399 
sensitive, fixed-dollar life contractszo7 that are relatively close substitutes for 

variable life insurance and avoid regulation under the federal securities laws. As 

a result, variable life insurance has not realized its growth potential, The few 

insurers that have entered the marketplace are the larger companies that have a 

strong capital base capable of withstanding the additional strain on their capital 

and surplus, and smaller insurers that are committed to the product. 

D. Problems with Variable Annuities -- How Much Is the "Insurance" 

Worth? 

Related to the problem of the uses to which the proceeds of risk charges 

may be applied"' is the question of the extent to which there exists a justifiable 

basis for deducting mortality and expense risk charges during a variable annuity's 

pay-in phase. Insurers assert that it is appropriate to deduct risk charges because 

the variable annuity offers important insurance benefits: annuity options at preestablished rates, death benefit protection during the pay-in phase, and expense 

guarantees. In support of this assertion, insurers make representations regarding 

the reasonableness of risk charges.log However, the Division has had a difficult 

time in determining whether and to what extent these insurance benefits contain 

value. 

While variable life insurance must contain a significant insurance 

element,l" there is no comparable requirement for variable annuities. Unlike 

variable life insurance, a purchaser of a variable annuity need not provide 

evidence of insurability before his or her application for a contract is 

approved."' There is no evidence that the annuity purchase rates guaranteed 

when the contract is purchased are significantly more advantageous than rates a 

~ 

lwInterest sensitive fixed-dollar life contracts refer to insurance policies developed within the 

last 15 years that permit an owner to share more meaningfully in the investment returns (and 

other operating efficiencies) of the insurance company. They may be distinguished from the 

traditional whole life insurance contract, under which insurers historically have credited a 

conservative interest rate (usually from two and one-half to four percent) on cash vaIue 

accumulation and have not adjusted other pricing assumptions to reflect favorable operating 

experience. See BLACK & SKIPPER, supra note 92, at 28, 71. 

'"See discussion in Section IILB., supra. 

'@See supra note 53 and accompanying text. 

'''See stipru note 18. 

"'Before deciding whether to issue a variable life insurance contract, an insurer, in a process 

called medical underwriting, usually assesses the insured's risk based on factors such as age, sex, 

and health. 

400 CHAPTER 10 
mutual fund investor could find if he or she decided to purchase an annuity with 

his or her accumulated investment in a regular mutual fund.l12 It is also 

questionable whether expertly priced expense guarantees expose an insurer to any 

meaningful risk. Finally, the minimum death benefit which typically guarantees 

the return of premium payments, arguably protects against a relatively small risk. 

For these reasons, the Division has considered whether variable annuity 

issuers should have as much pricing flexibility as issuers of variable life contracts 

to deduct "insurance-related" charges. The inquiry is particularly relevant since 

the expenses of issuing a contract a ear to be lower than the expenses incurred 

in selling a variable life contractJ'and because the marketing strategies of 

most variable annuity issuers appear to focus on the contract's tax-deferral and 

investment features rather than insurance benefits.'l4 In many respects, the 

variable annuity separate account operates much like a mutual fund during the 

contract's pay-in phase. As a result, the Division and other commenters have 

questioned whether variable annuity issuers should be permitted to deduct assetbased charges (like risk charges) on a basis that is different from that required of 

mutual funds.115 

Notwithstanding the questionable worth of a variable annuity's insurance 

benefits, the Division believes that the contract does offer some insurance 

protection, and that an issuer should be permitted to assess a reasonable fee for 

'*If information about the number of contract owners that annuitize were available, perhaps 

it would be easier to determine the meaningfulness of annuity purchase rate guarantees and to 

gauge the reasonableness of mortality and expense risk charges. However, variable annuity 

issuers claim that statistics on the percentage of contract owners that annuitize are not available, 

and, in any event, would not be very useful at this time because the industry may not have been 

in existence long enough to produce meaningful trends. 

'I3The Division is aware of only one issuer that offers an excess-loaded variable annuity 

contract. All other issuers assess sales loads that are comparable with those paid under mutual 

funds. 

lI4If enacted, a recent Treasury Department proposal would eliminate the tax-deferred feature 

of variable annuities unless the contract contains a life contingency. Pension annuities and 

annuities that are part of structured settlements are excluded from the proposal. See Ellen E. 

Schultz, Insurers Attack Bush Proposal on Annuities, WALL ST. J., Jan. 31,1992, at C1, co1.3; Ellen E. 

Schultz, Annuities: Treasury's Switch May Spur Buying, WALL ST. J., Feb. 3, 1992, at C1, col. 3. 

'I5See Executive Summary, Letter of Investment Company Institute to Jonathan G. Katz, 

Secretary, SEC 10-11 (Sept. 19, 1988), File No. S7-10-88 (responding to Payment of Asset-Based 

Sales Loads by Registered Open-End Management Investment Companies, Investment Company 

Act Release No. 16431 (June 8, 1988),53 FR 23258) (claiming competitive disadvantage to mutual 

funds in relation to variable insurance products because of different treatment of rule 12b-1 fees 

and risk charges). 

Variable Insurance 401 
underwriting these risks. Accordingly, the Division does not recommend 

prohibiting such charges. At the same time, the Division does not believe the 

Commission should continue to expend resources in trying to affix a reasonable 

value to mortality and expense risk charges individually; rather, any attempt to 

assess the reasonableness of risk charges should be part of a larger effort to 

determine the overall reasonableness of aggregate interest charges. The history 

of the rulemaking effort for rule 26a-3116 illustrates the futility of retaining an 

individualized approach to charge regulation, under which limits are established 

for investment-related charges but not for insurance-related charges. The 

aggregate approach to charge regulation the Division is recommending would 

improve the Commission's role in regulating variable contracts and avoid most 

of the regulatory problems we have identified. 

IV. Recommendation 

The Division believes that variable insurance issuers should have the. same 

ability as mutual funds to set roduct charges as long as the charges are plainly 

disclosed and not excessive?" Accordingly, the Division recommends that the 

Commission propose amendments to the Investment Company Act to exempt 

variable insurance contracts from the charge restrictions in sections 26 and 27, and 

instead require aggregate charges under variable contracts to be reasonable.'" 

Under the Division's proposal, the Commission would be given explicit authority 

to adopt rules establishing guidelines for this standard. 

The Division's proposal would eliminate most of the current charge limits 

for variable contract issuers: 

~~ 

116SeFsupva notes 88-89 and accompanying text. 

117Mutual funds are not subject to any numerical limits on charges under the Act, except in 

a few minor instances. See, e.g./ Investment Company Act §§ 10(d)(4), 10(d)(6), 15 U.S.C. §§ 80a10(d)(4), -10(d)(6) (setting forth limits on certain charges for certain investment companies). The 

focus of regulation is the prevention of excessive charges while giving fund management 

appropriate busine9 flexibility. Thus, for example, section 2203) prohibits excessive sales loads 

and section 36(b) prohibits excessive charges by imposing a fiduciary duty on certain recipients 

of payments for investment advisory services. 

ll'The Division does not recommend that the Commission use its rulemaking authority to 

resolve thesexeplatory problems. While the Commission could adopt rules to provide for the 

deduction of risk charges, relax the refund requirements, or repeal the "at cost" standard for 

administrative expenses, the Division believes that these actions would provide unsatisfactory 

remedies. Adopting rules under current statutory provisions would perpetuate the basic 

regulatory and jurisdictional problems the Commission has experienced over the years. 

402 CHAPTER 10 
0 There would be no direct limit on the amount of administrative 

charges under a variable insurance contract. Rather, administrative 

charges would be regulated as a component of aggregate charges. 

o Insurance-related charges, such as mortality and expense risk 

charges and cost of insurance, would be subject to the 

federalsecurities laws as components of aggregate charges. Risk 

charges would no longer be subject to de facto limits.119 

o The limits of section 27 would not apply to sales charges, but sales 

charges would be subject to the reasonableness requirement for 

aggregate charges and any guidelines established by Commission 

rules. There would be no refund, conversion, or free-look 

requirements under the Investment Company Act, although state 

law typically provides similar provisions. There would be no "stair 

step" requirements. 

o Variable annuity sales charges would still be subject to section 22(b) 

and NASD Although there are no current NASD limits 

pertaining to variable life insurance sales charges, the Commission 

and NASD would retain authority under section 22(b) to 

promulgate standards for sales loads under those contracts. 

In conjunction with the proposed increased flexibility in pricing, the 

Division expects to give priority to the development of a registration form for 

variable life insurance and standardized illustrations of benefits and expenses for 

variable insurance contracts to be used in prospectuses and supplemental sales 

literature. Improved disclosure would foster competition, particularly in variable 

life insurance, because it would assist contract owners in comparing the relative 

costs and benefits of competitive contracts. 

A. Statutory Amendments 

As described more fully below, under the Division's proposal, section 26 

would be amended in three ways?21 New paragraph (a)(5) would exempt a 

'"See supra note 90. 

I2'See, e.g., NASD RULES, supa note 48, at Art. 111, 5 29(c) (limits the front-end sales load on 

variable annuities to eight and onehalf percent of total payments, determined over a maximum 

period of 12 years). 

'"The proposed text of the amendments appears at the end of this chapter in Appendix 10-A. 

Variable Insurance 403 
registered separate account, its sponsor, and its principal underwriter from the 

requirements of section 26(a). New subsection (e)(l) would establish a 

reasonableness standard for evaluating total contract charges, require insurers to 

represent that such charges are reasonable, and also explicitly would authorize 

the Commission to adopt rules for determining when contract charges may be 

reasonable. Subsection (e)(2) would codify the existing custodial and capital 

requirements set forth in the variable insurance rules. 

Section 27 would be amended in two ways. A new subsection (i) would 

exempt a registered separate account, its sponsor, and its principal underwriter 

from the requirements of section 27, except for new subsection 27(j). Subsection 

27(j) would require registered separate accounts organized as management 

companies to comply with all the provisions of proposed section 26(e). 

1. The Reasonableness Standard -- Section 26(e)(l) 

Proposed section 26(e)(l) would require the total charges under a variable 

insurance contract to meet a reasonableness standard: an issuer would be 

required to establish aggregate charges that are reasonable in relation to the 

services rendered under the contract, the expenses expected to be incurred, and 

the risks assumed by the insurance Under this standard, an 

insurer could consider all relevant factors in assessing the reasonableness of 

contract charges. For example, an insurance company could take into account the 

nature and extent of services performed under a variable insurance contract, the 

benefits conferred on the contract owner, and the nature and extent of the risks 

assumed by the insurer. The standard also contemplates that a reasonable profit 

could be built into the price of a variable insurance contract. 

The Division believes that the reasonableness standard, together with 

Commission rulemaking authority, would improve regulation of variable 

insurance under the Investment Company Act. The proposal provides a fair 

measure for contract charges. At the same time, the reasonableness standard 

gives the insurance industry the business flexibility it needs to develop and 

market the products effectively. 

'=The ACLI recommended a similar approach to the regulation of variable insurance charges. 

Under the ACLI's proposal, an insurer would include in its registration statement one of two 

representations regarding the reasonableness of aggregate contract charges as a condition for 

exemption from sections 26 and 27 of the Investment Company Act. ACLI Study Comment, supra 

note 75, at 10-12. The ACLI would not require explicitly that charges be reasonable, however. 

The ACLI proposal also differs from the Division's in that the ACLI would not give the 

Commission rulemaking authority. 

404 CHAPTER 10 
A reasonableness standard to regulate contract charges is currently used 

under the Investment Company Act and is, therefore, not novel under the 

Division's recommendation. For example, to secure an exemption from sections 

26 and 27 to deduct mortality and expense risk charges, insurers represent either 

that the charges are reasonable in relation to the risks assumed under the 

contracts or that the charges are reasonable because they are within the range of 

industry practice for comparable contracts.*23 Although the language of section 

26(a) has been construed narrowly by the Commission, that section merely 

provides that payments to the trustee or custodian of a UIT be reasonable as 

determined by the Commission. Also, under sections 27(a)(5) and 27(a)(6), the 

Commission may determine the reasonableness of certain charges under periodic 

payment plans. 

Proposed section 26(e)(l) would place the burden of assessing the 

reasonableness of charges on variable insurance issuers rather than the 

Commission. The standard contemplates a facts and circumstances analysis of 

each case and may require difficult determinations. As discussed below, 

however, the Division believes that the use of standardized hypothetical 

illustrations would help in evaluating the reasonableness of variable contract 

charges?24 

The reasonableness standard the Division proposes should approximate the 

standard for regulation of mutual fund sales charges contained in section 

22(b).lE In amending section 22(b) in 1970, Congress indicated that the NASD, 

pursuant to its authority under this section, should give fair consideration to the 

interests of both sellers and investors in promulgating rules to prevent excessive 

sales loads>26 Congress further advised the NASD to consider the nature and 

quality of services necessary to ensure proper distribution of fund shares to the 

lzSee supra note 53. Under the Division's proposal, the "within the range of industry practice" 

representation would not provide a separate basis for assessing the reasonableness of variable 

contract charges. It would merely be one factor to be considered in determining whether the 

standard has been met in a particular case. 

124A discussion of hypothetical illustrations appears infra at notes 134-137 and accompanying 

text. 

1251nvestment Company Act 5 22(b), 15 U.S.C. § 80a-22(b). This section generally authorizes 

the NASD or other registered securities association to adopt rules that prohibit its members from 

assessing excessive sales loads in connection with the distribution of redeemable securities. 

126Congress advised the NASD to allow for "reasonable compensation for sales personnel; for 

reasonable opportunity for profit for broker-dealers, and underwriters; and for reasonable sales 

loads to investors." HOUSE COMM. ON INTERSTATE AND FOREIGN COMMERCE, INVESTMENT 

COMPANY AMENDMENTS ACT OF 1970, H.R. REP. NO. 1382,91st Cong., 2d Sess. 29 (1970). 

Variable Insurance 405 
public, and specifically acknowledged that the rules adopted pursuant to section 

22(b) might include provisions for higher sales loads in situations where relatively 

more selling effort is Similarly, the Division’s proposal would 

require an issuer to evaluate the reasonableness of aggregate charges b 

considering, among other things, the nature and quality of services provided. 

The reasonableness standard is also flexible enough to allow higher charges to be 

deducted in cases where an insurance company takes on greater risks. 

I& 

2. Commission Rulemaking Authority - Section 26(e)(l) 

Proposed section 26(e)(l) also would grant the Commission the authority 

to adopt rules and regulations that provide guidelines for determining the 

reasonableness of variable contract charges. The scope of the Commission’s 

rulemaking authority would be comparable to the scope of rulemaking authority 

granted to the Commission under other provisions of the Investment Company 

Act .l 29 

The rulemaking authority proposed by the Commission in section 26(e)(l) 

would balance the pricing flexibility granted to insurers by the exemptions from 

sections 26 and 27 of the Investment Company Act. The existence of this 

authority should tend to discourage excessive pricing in the variable insurance 

industry. While the Division does not expect that the Commission necessarily 

will need to use its rulemaking authority, it would be shortsighted not to 

acknowledge the possibility that industry practices could be subject to abuse. In 

the event widespread, undesirable pricing practices develop, the Commission’s 

ability to address them should not be limited to enforcement actions for specific 

abuses. Rather, the Commission should have the discretion to develop 

appropriate regulations to the extent needed to curb industry-wide problems. 

There are many factors relating to the reasonableness of contract charges 

that the Commission may want to consider if it became necessary to exercise its 

rulemaking authority under the proposal. Among these would be general 

economic factors and industry trends, including product development, marketing 

practices, and contract design. Sources of information necessary to evaluate these 

lPId. at 29-30. Similarly, section 27(b) permits the Commission to relax sales load limits for 

smaller companies that incur relatively higher operating costs in issuing periodic payment plans. 

‘%There is a major distinction between section 22(b) and proposed section 26(e)(l) in that 

section 26(e)(l) would require the issuer, rather than the NASD, to make the reasonableness 

determination. Nevertheless, the Division believes that the comparison between the two sections 

is valid because of the similarity in the reasonableness standard under both sections. 

‘29See, e.g., Investment Company Act 55 22(c), 27(d), 15 U.S.C. 95 80a-22(c), -27(d). 

406 CHAPTER 10 
factors might include the model rules and regulations of the National Association 

of Insurance Commissioners. It may be appropriate to conduct an industry-wide 

survey of industry practice, or commission a study similar to that done for the 

NASD rior to its rulemaking effort relating to sales load limits under section 

2Z(b).13' Such a study may be conducted, for example, to determine the 

percentage of contract owners that actually purchases annuities under guaranteed 

rates, a statistic that may be important in determining the reasonableness of 

charges for variable annuities. Under certain circumstances, it may be 

appropriate for the Commission to employ actuarial resources in developing rules 

under this provision. 

3. Custodial Provision -- Section 26(e)(2) 

Proposed section 26(e)(2) would codify those parts of rules 26a-2,6e-2, and 

6e-3(T) that permit an insurance company to maintain custody of separate account 

assets:31 and therefore would nat change current regulation of insurance 

companies or their separate account operations. The codification is necessary to 

preserve the current custodial provisions in conjunction with the exemption 

provided by proposed section 26(a)(5)>32 

As is the case now, an insurer will be required to file with its domiciliary 

state an annual statement of financial condition that shows it has a combined 

capital and surplus (if a stock company) or an unassigned surplus (if a mutual 

company) of not less than $1,000,000. The company would have to be examined 

periodically by state officials as to its financial condition and other affairs. In 

IMSee 3 BOOZ, ALLEN & HAMILTON, INC., ECONOMIC STUDY OF THE DISTRIBUTION OF MUTUAL 

FUNDS AND VARIABLE ANNUITIES MV-11 (May 1972) [hereinafter BWZ, ALLEN & HAMILTON, INC.] 

(prepared for the purpose of developing guidelines to assist the NASD in formulating sales load 

rules for investment companies in accordance with the requirements of section 22(b)). 

I3'The Commission adopted rules to enable insurance companies to hold separate account 

assets without a trust indenture for two primary reasons. First, section 26(a), which requires bank 

custody, conflicts with state laws that prohibit an insurer from holding separate account assets 

in trust. Second, state insurance laws governing the safekeeping of insurance company assets 

generally are adequate to ensure the preservation of these assets. See Exemptive Relief for 

Separate Accounts Relating to Custodianship of and Deduction of Certain Fees and Charges from 

the Account's Assets, Investment Company Act Release No. 13706 (Jan. 6, 1984), 49 FR 1737 

(proposing rule 26a-2); rules 6e-Z(b)(9)(ii), 6e-3(T)(b)(9)(ii). 

'32Witho~t proposed section 26(e)(2), there would be no custodial requirements under the 

Division's proposal for separate accounts organized as UITs. Because of the importance of 

custody in Investment Company Act regulation, the Division found it necessary to maintain 

current requirements. The provisions of sections 26(e)(2) would apply to managed separate 

accounts through the requirements of proposed section 27(j). 

Variable Insurance 407 
addition, the company’s separate account operations would have to be supervised 

and inspected by the state. 

4. Exemption from Sales Load Restrictions -- Sections 27(i) and 

(j> 

A broad exemption from the charge restrictions of section 27 is set forth in 

new subsection 27(i). In conjunction with this exemption, new subsection (j) 

requires separate accounts organized as management companies to comply with 

the provisions of amended section 26. Currently, section 27(c)(2) links the 

regulation of periodic payment plans to procedures established in section 26 for 

UITs even if the issuer is organized as a management investment company. 

Proposed section 27(j), in effect, preserves that cross-reference to ensure that the 

charges under variable contracts funded by trust or managed separate accounts 

would be treated alike. 

B. Disclosure Proposals 

If the Division’s legislative proposal is enacted, the Division will give high 

priority to two specific disclosure projects: the design of a registration form for 

variable life insurance and the development of standardized hypothetical 

illustrations for use in both variable insurance prospectuses and supplemental 

sales literature. Improved disclosure is necessary to complement the added 

flexibility variable insurance issuers would have in pricing and distributing their 

contracts . 

While variable annuity issuers register their contracts and separate 

accounts simultaneously in one registration statement, variable life issuers register 

their contracts on Form S-6 under the Securities Act and their separate accounts 

on Form N-8B-2 under the Investment Company Form S-6 is intended 

for the general use of all UITs registered on Form N-8B-2 and therefore does not 

contain requirements that are uniquely tailored to variable life insurance. 

Variable life insurance should have its own registration form, especially if the 

regulation of contract charges is changed as proposed. 

The development of standardized hypothetical illustrations for variable life 

insurance is important in the context of the proposed amendments because the 

use of illustrations would improve an owner’s understanding of contract charges 

and enable better cost comparison among competing contracts. As a result, there 

133Currently, no variable life insurance separate accounts are organized as management 

companies. A variable life separate account organized as a management company would register 

on Form N-1. 

408 CHAPTER 10 
should be greater price competition among issuers of variable life contracts.134 

The Division also expects the use of illustrations to help in evaluating whether a 

particular combination of contract charges is unreasonable. 

Illustrations are an essential part of a variable life insurance prospectus. 

Although variable contract charges are disclosed in the prospectus, complicated 

contract designs make it dif€icult to understand the product and the effect of the 

charges without illustrations. Effective illustrations "interpret" charges by 

showing their impact on contract benefits. For example, variable life insurance 

illustrations show tabular presentations of cash values, cash surrender values, and 

death benefits over a twenty to thirty year period based on certain assumptions 

such as age, sex, health, and interest rates. Disclosure of fees and charges without 

accompanying illustrations means little to most in~est0rs.l~~ 

Illustrations currently are included in all variable life prospectuses and 

usually are adapted in supplemental sales literature to suit the specific 

characteristics of a contract owner. Because the illustrations are not based on 

standardized assumptions, however, they do not improve the comparability of 

contracts. In addition, issuers are uncertain about what assumptions are 

permissible in illustrations. 

The need for standardized illustrations depicting charges during the pay-in 

phase of a variable annuity is less acute because of the mandatory use of fee 

tables.136 The fee table is intended to improve an owner's understanding of the 

contract by requiring all charges to be presented as prescribed in an early part of 

the prospectus. Nevertheless, standardized illustrations with respect to a 

contract's pay-out phase would be beneficial. Illustrations are not generally used 

for variable annuities at the present time. Since 1979, when the Commission 

stated it would reconsider the appropriateness of mandatory hypothetical 

illustrations for variable annuities, registrants have not included illustrations in 

~ 

134See 1 Booz, ALLEN & HAMILTON, INC, supra note 130, at 111-113 to 111-115. 

l3?his view was echoed by at least two commenters calling for relief from the provisions of 

sections 26 and 27. See Prudential Study Comment, supra note 63, at 116-118; LA Bar Study 

Comment, supra note 97, at 5-6; see also 1 BWZ, ALLEN & HAMILTON, INC., supra note 130, at III113-15 (concluding that it is very difficult for investors to compare the costs of alternative annuity 

contracts without the benefit of hypothetical illustrations). 

13%ee Item 3 of Forms N-3 and N-4. There is no fee table requirement for variable life 

insurance, in large part because of the difficulty of presenting in a prospectus the cost of insurance 

charge, which differs for each individual. 

Variable Insurance 409 
variable annuity prospectuses>37 As more contract owners approach 

annuitization under these contracts, however, the Division has begun to receive 

requests to permit the use of illustrations during the pay-out phase. 

C. Effects 

1. Investor Protection 

Although the proposed amendments to sections 26 and 27 would change 

significantly the current charge restrictions for variable insurance products, the 

changes would not sacrifice investor protection. The Commission would have 

express authority to develop rules for determining the reasonableness of all 

variable insurance contract charges should they become necessary for the 

protection of investors. Of course, the wide array of state and deral regulations 

that currently applies to variable insurance operations will continue to applyT3' 

Furthermore, the Division anticipates that the proposed amendments to sections 

26 and 27, coupled with improved disclosure, will encourage market entry and 

improve price competition in the variable insurance industry to the ultimate 

benefit of investors. 

1371n 1975, the Commission proposed to require the use of standardized hypothetical 

illustrations in variable annuity prospectuses. See Prospectuses of Variable Annuity Separate 

Accounts, Investment Company Act Release No. 8784 (May 9,19751, 40 FR 23770. The industry 

objected to the form of the proposed illustrations. In 1979, when the Commission withdrew both 

its Statement of Policy, Advertising and Supplemental Sales Literature Used in Sale of Investment 

Company Shares, Investment Company Act Release No. 3385 (Aug. 14,1950), 15 FR 5468, that sets 

forth the respects in which the Commission considers investment company sales literature to be 

misleading, and its proposal to require standardized illustrations, it indicated it would reconsider 

mandatory use of illustrations for variable annuities. Investment Company Sales Literature 

Interpretive Rule, Investment Company Act Release No. 10621 (Mar. 8, 19791, 44 FR 16935; 

Prospectuses for Variable Annuities; Withdrawal of Proposed Amendments to Forms S-5 and S-6, 

Investment Company Act Release No. 10789 (July 20, 1979), 44 FR 44552. Since then, despite 

adopting Forms N-3 and N-4 in 1985 and later amending them, the Commission has not taken any 

further action on variable annuity illustrations. See Registration Form for Insurance Company 

Separate Accounts that Offer Variable Annuity Contracts, Investment Company Act Release No. 

14575 (June 14,1985), 50 FR 26145 (adoption of Forms N-3 and N-4); Advertising by Investment 

Companies, Investment Company Act Release No. 16245 (Feb. 2,1988),53 FR 3868 (amendments 

to Form N-3 and N-4); Consolidated Disclosure of Variable Annuity Separate Account Expenses, 

Investment Company Act Release No. 16766 (Jan. 23,1989),54 FR 4772. 

*%Because of recent insurance company failures, Congress is considering whether the 

insurance industry as a whole should be subject to uniform federal solvency standards. See S. 

1644, 102nd Cong., 1st Sess. (1991); see also Susan Pulliam, Dingell Developing Insurance Industry 

Regulafion Plan, Wall St. J., Jan. 10, 1991, at A16, col. 4; Paulette Thomas, Insurance Firms To Be the 

Focus of Senate Probe, Wall St. J., Dec. 7, 1990, at A3, col. 1. The Division believes that the results 

of those deliberations should not affect its proposal. 

410 CHAPTER 10 
Adoption of the proposed amendments to sections 26 and 27 would change 

only the treatment of variable insurance as periodic payment plans, but would not 

otherwise affect federal securities regulation of variable insurance. Issuers would 

remain subject to the Securities Act and all other provisions of the Investment 

Company Act. Although a variable contract would no longer be subject to the 

sales load provisions of section 27, the Commission would retain the authority 

under the more flexible provisions of sections 22(b) and 22(c) to regulate variable 

contract sales charges. Section 36(b) would apply to investment advisory fees and 

other payments made to the investment adviser or its affiliates. 

The disclosure obligations of the Securities Act will continue to be an 

essential feature of investor protection. Over the last two decades, the 

Commission has developed disclosure requirements to suit the unique nature of 

variable insurance so that consumers can make better investment decisions.*39 

The Division will continue to focus on improving disclosure under variable 

contracts, particularly in conjunction with the proposed amendments. Improving 

a contract owner's ability to compare charges, especially through the use of 

standardized hypothetical illustrations, should foster competition among variable 

insurance issuers. Staff resources saved as a result of the proposed amendments 

could be allocated to this important project. 

In addition, contract owners and purchasers of variable contracts will 

continue to benefit from important state law protections. State insurance law, 

particularly its nonforfeiture provisions, is designed to achieve objectives that are 

similar to the restrictions of sections 26 and 27. Like section 27(d) of the 

Investment Company Act, nonforfeiture law protects contract owners from paying 

excessive charges by limiting an insurer's deduction when an owner voluntarily 

surrenders his or her contract. In deciding what is appropriate for an insurer to 

retain, state officials, through the nonforfeiture requirements, attempt to balance 

the extent to which an insurer has not recovered the expenses incurred in issuing 

the contract and the extent to which the surrenderin contract owner has prepaid 

for services for which he or she will never receivefm Because selling costs are 

139For example, in 1985 the Commission adopted Forms N-3 (for separate account management 

companies) and N-4 (for separate account UITs) to be used by issuers of variable annuity 

contracts. Inv. Co. Act Rel. 14575, supra note 137. In 1989, the Commission adopted amendments 

to these forms to require the inclusion of fee tables in variable annuity prospectuses. Inv. Co. Act 

Rel. 16766, supra note 137. 

l4OSee generally BLACK & SKIPPER, supra note 92, at 22, 355-64 (describing the principles 

underlying industry practices for determining the proper value to be granted to discontinuing 

contract owners). 

Variable Insurance 41 1 
usually a key component of unamortized expenses,14' nonforfeiture law, like 

section 27(d), helps to limit the amount of these expenses an insurer may keep. 

Less directly, state reserve requirements, like sections 26 and 27 of the 

Investment Company Act, also protect a contract owner from paying excessive 

charges for contract services. The reserve requirements achieve this aim in two 

important respects: (1) by requiring that mortality costs be determined in 

accordance with prescribed mortality tables; and (2) by requiring that prepaid 

premiums or cash value be credited with a minimum rate of interest. While 

reserve requirements do not affect directly the amount of expenses that may be 

deducted under a contract, they generally assure the maintenance of minimum 

values so that guaranteed benefits can be provided. 

Finally, state law provides an important protection that would be lost 

under the Division's proposal: the free-look right. Under the free-look provisions 

of section 27(f) and as modified in rules 6e-2 and 6e-3(T),142 a contract owner 

has a certain time within which to return an excess loaded variable insurance 

contract and obtain a certain refund of remium payments. State law will 

continue to provide this important benefit. P43 

2. Regulatory Problems 

Regulating variable contract charges as proposed would settle the 

Commission's longstanding dispute with the insurance industry over insurancerelated charges, simplify substantive regulatory controls, streamline administrative 

procedures, and both conserve and better channel Commission resources. 

The regulatory status of mortality and expense risk charges would be 

clarified because the Commission would have jurisdiction over all fees and 

charges assessed under a variable insurance contract. With clear jurisdiction over 

aggregate charges, including previously unregulated charges such as cost of 

insurance, the Commission would be in a better position to perform its regulatory 

function. The Commission would no longer have to separate the investment and 

insurance elements of a variable contract or determine whether each charge 

I4'A major portion of issuance expenses relates to selling costs. See McGill, supra note 92, at 

253-54. 

*@Rules 6e-2(b)(l3)(viii)(A), 6e-3(T)(b)(l3)(viii)(A), 17 C.F.R. §§ 270.6e-2(b)(13)(viii)(A), .6e3(T)(b)(l3)(viii)(A). 

'@See, e.g., N.Y INS. LAW § 3203(a)(11) (McKinney 1985 & Supp. 1992); CAL. INS. CODE Q 

10127.9 (West Supp. 1992); ILL. ANN. STAT. CH. 73 § 836(n) (Smith-Hurd Supp. 1991). 

412 CHAPTER 10 
satisfies regulatory limits. Insurers could not raise unregulated fees to avoid 

statutory or regulatory limits on regulated charges. 

In addition to settling jurisdictional questions, the proposed legislation 

would improve the regulation of variable insurance simply because it would, for 

the first time, establish a regulatory framework specifically intended for variable 

insurance. The Commission would have a clear statutory mandate with respect 

to variable insurance regulation. As a result, it should be easier for the 

Commission to implement appropriate rules and policies with respect to variable 

insurance. 

The simplification of the substantive regulation of sales loads would be a 

substantial benefit of the proposal. The Division currently expends considerable 

resources in monitoring compliance with the complex sales load requirements of 

section 27 and rules 6e-2 and 6e-3(T) under the Investment Company 

The proposed exemption from section 27 would make possible a simpler 

regulatory framework, but one that the Division believes would not sacrifice 

investor protection. In addition, adoption of the proposal would eliminate a 

substantial number of exemptive applications and protracted rulemaking projects. 

3. Pricing and Distribution Problems of Variable Life Insurance 

The proposed amendments would address pricing and distribution 

problems currently experienced by variable life issuers. Under the proposal, 

issuers would obtain the needed flexibility to establish an appropriate price for 

a variable life insurance contract, a price that would reflect sufficiently a 

company's desire to recover and profit from its heavy capital investment in 

variable life insurance and to be competitive with fixed-dollar life contracts. This 

enhanced flexibility should foster the development of innovative variable life 

contracts and faeilitate the reproduction of fixed-dollar contract designs. 

Consequently, the Division believes more insurers would be willing to offer 

variable life insurance. 

The proposed amendments also would eliminate the refund requirements 

that currently make it difficult for an insurer to pay competitive commissions for 

selling variable and fixed life insurance contracts without a consequent strain on 

its capital and surplus. The expected parity in sales commissions that would 

result from the proposed amendments would end the current marketing bias 

against variable life insurance contracts. The Division expects that more insurance 

'%%e supra Section II.E.2.a. 

Variable Insurance 413 
companies will expend the large sums needed to establish and maintain a variable 

life insurance operation knowing that they can pay the commissions necessary to 

ensure a vigorous sales effort from agents. 

By eliminating the refund requirements of section 27 and the variable life 

rules, the proposed amendments would alter the method of calculating and the 

value of the refund a contract owner would receive upon surrender of a contract. 

Currently, surrender values are based on the amount of sales load paid by the 

contract 0~rter.l~~ Absent the refund requirements of section 27, surrender 

values would be determined by state nonforfeiture law which is based on cash 

value.'& State nonforfeiture law generally provides for lower surrender values 

in the first twenty-four contract months than the values currently provided under 

rules 6e-2 and 6e-3(T).147 

In the overall context of its proposal, however, the Division believes that 

state nonforfeiture law would provide a better accommodation between an 

insurer's desire to recover its unamortized ex enses and the surrendering contract 

owner's desire to recover prepaid expenses!48 The lower refund values, while 

placing variable life issuers on an equal basis with issuers of fixed-dollar 

contracts, would be balanced by Commission rulemaking authority in proposed 

section 26(e)(l). Moreover, state law will continue to provide important rights in 

early contract months to contract owners. Importantly, under state free-look 

provisions, a contract owner will be permitted to return his or her contract within 

a certain time of purchase and recover some or all of the premium payments. 

Like so many of the policies established for variable insurance, decisions 

regarding surrender values were made at a time when variable insurance was an 

infant industry and the Commission had limited experience with insurance 

 product^.'^' The Division now believes that section 27 should not apply to 

145See supra note 62 and accompanying text. 

'&The Commission has considered using a cash value approach to the refund requirement in 

the past, but has not elaborated on its decision to reject that approach. See Inv. Co. Act Rel. 9482, 

sup note 55. 

BLACK & SKIPPER, supra note 92, at 362 (using tables to illustrate the effects of different 

assumptions on nonforfeiture values). 

l'%ee supra note 140 and accompanying text. 

149The refund formula of current regulation appears to have been based primarily on the 

design of the first scheduled premium life insurance contract to register with the Commission. 

(continued ... ) 

414 CHAPTER 10 
variable life insurance contracts. As stated elsewhere, variable life insurance 

contracts are very different from the periodic payment plans that generated the 

refund provisions of section 27 and should be regulated differently. 

4. A Practical Approach to Variable Annuities 

Under the proposal, there would be no specific limit on mortality and 

expense risk charges except as part of the issuer's determination that aggregate 

contract charges are reasonable. In theory, the proposal could therefore 

exacerbate current problems by effectively permitting variable life and variable 

annuity issuers to increase the amount of mortality and expense risk charges and 

therefore the percentage of those charges that could be used to pay for 

distribution or other expenses. 

The Division acknowledges that there is some possibility for abuse, 

particularly in the case of variable annuities. While greater charge flexibility is 

supported for variable life insurance contracts because of the traditional and 

significant insurance elements of those contracts, the industry does not make that 

argument for variable annuities. We agree that variable annuities, during the 

pay-in phase, are more likely than life insurance to be offered in competition with 

mutual funds. We also acknowledge that variable annuity issuers offer 

purchasers something more than a traditional mutual fund for which a fee is 

appropriate, but it is difficult to determine the value of those services. The 

Division's proposal reflects these considerations and the conclusion that full 

disclosure of charges is a more practical solution. If specific abuses develop in 

the future, the proposal would allow the Commission to address them through 

rules and regulations providing standards for defining the reasonableness of fees 

and charges. 

Further, the Division believes that the proposed legislative amendments 

and subsequent disclosure changes will improve the comparability of variable 

annuity contracts generally and also with respect to mutual fund investments. 

The enhanced comparability will lead to even greater price competition in the 

variable annuity market. 

~ ~ ~~ ~ ~ 

149(...continued) 

According to at least one commenter, that contract was inappropriately priced in an effort to 

address Commission concern over sales loads and congressional action amending section 27(d) 

in 1970. Prudential Study Comment, supra note 63, at 57-61,89-99. 

Variable Insurance 415 
5. Increased Competition 

Many United States life insurers do not offer variable products, in part, 

according to some commenters, because of restrictive regulation under sections 

26 and 27 of the Investment Company The Division believes that the 

proposed changes to variable insurance regulation would ease barriers to market 

entry and enhance competition in the industry. Improved competition should 

benefit investors by lowering contract prices and stimulating product 

development. 

There is evidence that competition in the insurance industry already 

operates to keep charges at a reasonable level. Apparently, most insurers 

currently provide nonforfeiture values in excess of statutory minimum 

req~irements?~~ In addition, despite having the ability to deduct excess loads 

under variable annuities, practically all insurers use a level load design.152 

Even with the small number of companies offering variable insurance, 

competition appears to have been the key factor in steering prices below statutory 

limits. The Division believes that the proposal would foster even more 

competition to the benefit of contract owners. 

The ACLI has noted that products structurally similar to variable insurance 

contracts have been offered in other countries and that such products are more 

attractive than United States variable insurance contracts.153 According to the 

ACLI, part of that success may be due to less stringent re ulation in those 

countries and the relatively lower cost of foreign products.le4 In any event, 

successful foreign sales of variable insurance support the Division's belief that 

these contracts are desirable products for many consumers. By adopting a more 

flexible approach to variable insurance regulation, the Division believes that 

eventually these contracts will be more widely available in the United States. 

The Division also expects that the proposal would encourage United States 

issuers to sell their variable insurance products abroad. According to the ACLI, 

'?See, e.g., ACLI Study Comment, supra note 75, at 41-43; Prudential Study Comment, supra 

note 63, at 104-05. 

15'See BLACK & SKIPPER, supra note 92, at 356-57. 

152The Division is aware of only one company that currently offers an excess-loaded variable 

annuity contract. 

'%See ACLI Study Comment, supra note 75, at 43-45. 

'%d. at 44. 

416 CHAPTER 10 
because United States insurance companies are restricted by sections 26 and 27 

of the Investment Company Act, they are unable to design products that would 

compete effectively in foreign markets. The ACLI asserts that insurance products 

in many foreign countries are simpler than variable products sold in the United 

States because they are not subject to as many regulatory c~nstraints.l~~ 

V. Conclusion 

The Division recommends that the Commission propose legislation to 

amend sections 26 and 27 to exempt variable insurance contracts from the specific 

charge limitations under those provisions, and instead create restrictions against 

unreasonable aggregate fees. In connection with this proposal, the Division will 

give priority to the development of a registration form for variable life insurance 

and standardized illustrations for variable insurance contracts. The Division 

believes that the proposed amendments to sections 26 and 27, together with 

improved disclosure, will resolve significant problems associated with the 

regulation of variable insurance charges under the Investment Company Act and 

continue to provide important investor protections under the federal securities 

laws. 

'=Id. 

Variable Insurance .417 
APPENDIX 10-A 

Red-Lined Version of Proposed Amendments to the 

Investment Company Act of 1940 

.... 

Section 26 [15 U.S.C. 5 80a-261. 

... 

(a) 

. I 

No 

1) 

principal underwriter for or depositor of a 

registered unit investment trust shall sell, except by surrender to the trustee for 

redemption, any security of which such trust is the issuer (other than short-term 

paper), unless the trust indenture, agreement of custodianship, or other instrument 

pursuant to which such security is issued -- 

%** 

*** 

418 CHAPTER 10 
Section 27 [15 U.S.C. § 80a-271. 

*** 

Variable Insurance 419 
Chapter 11 

Repurchases and Redemptions of 

Investment Company Shares 

I. Introduction and Summary of Recommendations 

The earliest United States management investment companies were closedend, and closed-end companies far outnumbered their open-end counterparts at 

the time of the enactment of the Investment Company Act: since then, however, 

open-end companies have been considerably more popular with investors. A 

major reason for that popularity is that the redemption rights of open-end shares 

assure shareholders of being able to exchange their shares for net asset value, 

whereas closed-end securities have no such rights and often trade in the market 

at a discount to net asset value after the initial public offering is completed. 

At the same time, the closed-end form has attracted renewed interest. For 

example, the increasingly global marketplace has caused sponsors to reconsider 

closed-end companies as investment vehicles. Open-end companies operate 

subject to a liquidity standard that restricts their ability to invest in less liquid 

securities, such as some foreign securities? Because closed-end companies do 

not issue redeemable securities, they are not subject to a liquidity standard. Thus, 

sponsors wishing to offer investment companies with portfolios consisting of less 

liquid securities must choose the closed-end form. 

The Investment Company Act contains a rigid classification system from 

which many important regulatory consequences flow. Investment companies are 

divided into "face-amount certificate companies," "unit investment trusts," and 

"management companies." Management companies in turn are divided into 

"open-endt and "closed-end." These terms are defined comprehensively so that 

every investment company fits within a particular classification and 

subclassification? The classification system is crucial to an investment 

'Investment Company Act of 1940,15 U.S.C. § 8Oa. 

*An open-end company's aggregate holdings of illiquid securities may not exceed 15% of the 

3Section 4 of the Act contains fairly specific definitions for face-amount companies and unit 

investment trusts, while management companies are defined simply to mean any investment 

company other than a face amount company or a unit investment trust. 15 U.S.C. ,§ 80a-4. 

Similarly, section 5 of the Act defines what is meant by open-end company, and then defines 

(continued. ..) 

company's net assets. See infra note 34 and accompanying text. 

421 
company's structure and operation because specific statutory requirements will 

apply or not apply depending on the classification of the particular company. 

Section 5(a) defines an open-end company as a management company that 

issues or has outstanding any "redeemable ~ecurity."~ All other management 

companies are closed-end. A redeemable security entitles the holder to receive, 

upon presentation to the issuer, the holder's approximate proportionate share of 

the issuer's current net assets, or the cash such share represents? 

Open-end and closed-end companies are subject to many of the same key 

provisions of the Act, including prohibitions on affiliated transactions in section 

17, requirements for a written advisory contract approved by shareholders in 

section 15, requirements attending the composition and operations of the board 

of directors in sections 10 and 16, and the anti-pyramiding and investment 

restrictions in section 12(d).6 Nevertheless, the fact that open-end shareholders 

have redemption rights and closed-end shareholders do not leads to many 

~~~~~nces in the regulatory treatment of open-end and closed-end companies 

the Act. 

For example, section 18 restricts the use of leverage by both open-end and 

closed-end companies but treats the two types of companies quite differently? 

While closed-end companies may issue "senior securities" such as debt and 

preferred stock under certain circumstances, open-end companies may not.' This 

marked difference in how open-end and closed-end companies may organize their 

capital structures is due, in part, to the nature of redeemable securities. Nothing 

would prevent the holders of the junior securities (the common stock) in an openend company from redeeming the equity that normally acts as a "cushion" 

3(...continued) 

closed-end company as any management company other than an open-end company. 15 U.S.C. 

80a-5. The presence of these "catch-all" categories ensures that the classification system 

encompasses the entire universe of investment companies. 

415 U.S.C. 80a-5W. 

51nvestment Company Act $i 2(a)(32), 15 U.S.C. $i 80a-2(a)(32). 

U.S.C. §§ 80a-37, -15, -10, -16, -12(d). 

'15 U.S.C. 8Oa-18. 

%ection 18 does, however, permit open-end companies to borrow from-banks under certain 

conditions. 

422 CHAPTER 11 
supporting the payment obligations on senior securities; such senior securities 

thus would be fundamentally unsound investments. 

Section 22 of the Act imposes s ecific requirements governing the pricing 

and redemption of open-end shares? Different requirements apply to nonredeemable shares of closed-end companies under section 23;' which permits 

closed-end companies to repurchase their shares from investors on the open 

market (after notice to shareholders), pursuant to tender offers, or in compliance 

with Commission rules or orders>* 

Because of the special nature of redeemable securities, open-end and 

closed-end companies distribute their shares quite differently. Open-end 

companies are subject to constant liquidation pressures from shareholders, who 

may decide to redeem their shares at any time. To replenish the monies 

withdrawn, open-end companies generally offer and sell new shares to the public 

on a continuous basis. Closed-end companies, on the other hand, generally 

engage in traditional underwritten offerings of a fixed number of shares (either 

through an initial public offering or a series of discrete offerings) and in most 

cases do not offer their shares to the public on a continuous basis. 

Another major difference between open-end and closed-end companies is 

that closed-end shares usually are traded in secondary markets, either on 

exchanges or over the counter, whereas open-end shares are not. This difference 

stems from section 22(d) of the Act, which in effect fixes the prices at which openend shares are sold. The result is a system of retail price maintenance that 

precludes dealers from making a secondary market in open-end shares.12 

As a result of market fluctuations, closed-end shareholders selling in the 

secondary market may receive more or less than the net asset value of the 

shares>3 Closed-end securities often trade at a discount to net asset value in the 

915 U.S.C. $j 8Oa-22. 

"15 U.S.C. $j 8Oa-23. 

"As discussed infra notes 19-26 and accompanying text, repurchase procedures are controlled 

strictly due to the numerous abuses that existed prior to the Act's passage. Repurchases are 

different from redemptions by open-end companies because the closed-end company may decide 

whether, when, and how much of its securities to repurchase, and because the repurchases 

generally do not occur often or regularly. 

12For a detailed discussion of the effects of this system of retail price maintenance on mutual 

131n contrast, open-end shareholders tendering their shares are assured of receiving net asset 

fund distribution, see Chapter 8. 

value, less any deferred sales load or redemption fee. 

Repurchases and Redemptions of Investment Company Shares 423 
secondary market, a situation that has adverse consequences for both investors 

and sponsors. Some investors lose money when discounts develop; others may 

profit as discounts diminish. Persistent discounts in the marketplace also make 

it more difficult for sponsors to launch new closed-end companies. In addition, 

discounts prevent existing companies from raising capital because the Act 

generally prohibits closed-end companies from selling new shares at less than net 

asset value.14 While some closed-end companies have sought to minimize 

market discounts by repurchasing their shares, they have been unable to commit 

to repurchases in advance due to concerns that such an advance commitment ma 

be inconsistent with the fiduciary obligations of closed-end company directors. K 

Despite significant problems with the closed-end form, recently some 

sponsors have used it to offer interests in portfolios consisting of foreign securities 

and new types of less liquid securities such as participation interests in corporate 

loans. Use of the closed-end form to offer these types of portfolios raises 

questions about the restrictiveness of the Act’s classification system, which 

currently forces companies to be either open-end (and highly liquid) or closedend. Under the existing system of regulation, neither form appears to provide the 

best vehicle for offering portfolios that have substantial but not complete 

liquidity. 

Given the changes that have occurred in the securities markets since 1940, 

it is appropriate to re-examine the classification system and its current regulatory 

requirements. Sponsors organizing an investment company in 1940 did not have 

available the vast array of semi-liquid portfolio securities that exists today. 

Today, however, the rigidity of the Act’s classification system has become a 

limitation on sponsors’ ability to offer innovative products. The Division has 

concluded it would be appropriate to provide the opportunity for investment 

companies to chart new territory between the two extremes of the open-end and 

closed-end forms, consistent with investor protection. 

The Division has examined several alternatives. We considered amending 

the statutory definition of the closed-end and open-end forms to provide 

additional flexibility. We also considered recommending either legislation or 

Commission rulemaking that would permit development of a third, entirely new 

form of investment company that would combine characteristics from each of the 

other two. These alternatives did not seem to respond to the problems that 

141nvestment Company Act 5 23(b). It is also likely that investors would not buy shares priced 

at net asset value if they could obtain them for less in the secondary market. 

15See infra notes 86/88 and accompanying text. 

424 CHAPTER 11 
prompted our examination or to provide for the range of investment choices we 

believe is necessary for effective reform. 

The Division recommends giving the industry the ability to employ new 

redemption and repurchasing procedures, subject to Commission rulemaking and 

oversight. First, the Division recommends that the Commission adopt a new rule 

under section 23 of the Act that would permit closed-end companies to conduct 

periodic repurchases of their shares at net asset value under specified 

circumstances. The Division also recommends that the Commission adopt a new 

rule under section 22 of the Act permitting a new variation within the open-end 

form (to be called a "limited redemption" investment company) to offer alternative 

redemption and offering procedures to investors. Finally, the Division 

recommends that the Act be amended to impose an express portfolio liquidity 

requirement on all management investment companies that redeem or regularly 

repurchase their shares. Liquidity requirements would help protect investors' 

reasonable expectations regarding their ability to exit a particular company at net 

asset value. 

This chapter begins by exploring further the dichotomy between open-end 

and closed-end investment companies under the Act. It then discusses our 

recommendation to facilitate periodic repurchases of closed-end securities, 

followed by our recommendation for developing new limited redemption 

investment companies. The chapter continues with our proposal for amending 

the Act to provide the Commission with express authority to impose liquidity 

requirements on all investment companies that redeem or periodically repurchase 

their shares. It closes with an analysis of the consistency of our recommendations 

with prior interpretations of the definition of "redeemable security" in section 

2(a)(32) of the 

11. Background 

A. The Treatment of Open-End and Closed-End Investment Companies 

Under the Act: The Historical Context 

The Act's delineation of the closed-end and open-end categories responded 

to the characteristics of the investment company industry in the decades 

preceding the Act and sought to correct certain abuses and problems. Closed-end 

companies became prominent during the 1920'~~ when new issues quickly sold 

%5 U.S.C. 5 80a-2(a)(32). 

Repurchases and Redemptions of Investment Company Shares 425 
out at large premiums over net asset value.17 The stock market crash of 1929 

virtually eliminated the market for new public offerings of closed-end securities, 

however, and closed-end shares began trading in the secondary market at prices 

below net asset value. Open-end companies, relatively unknown before the crash, 

quickly became popular because they offered protection from discounts by 

committing to redeem investors' shares at net asset value. 

Although the open-end company was a fairly new form of investment 

vehicle in 1940, the Commission's Study on Investment Trusts and Investment 

Companies (the "Investment Trust Study") documented extensive abuses in the 

operations of both open-end and closed-end investment companies>' Not 

surprisingly, abuses were often related to practices that gave preferential 

treatment to investment company insiders and affiliates. Three areas in particular 

provided substantial opportunity for abuse. Closed-end companies had 

aggressively repurchased their shares in response to discounts, often manipulating 

the market for shares in ways that benefitted management and insiders to the 

detriment of selling shareholders. Similarly, open-end companies had engaged 

in questionable pricing and distribution practices in connection with their ongoing 

sales and redemptions procedures. Finally, complex capital structures, 

particularly in closed-end companies, had resulted in dangerous leveraging effects 

that threatened the viability of many investment companies. These abuses, and 

the provisions of the Investment Company Act and rules that address them, are 

discussed more fully below. 

1. Repurchases of Closed-End Shares 

The condition of the market during the 1920's and 1930's provided 

powerful incentives for closed-end companies to engage in extensive repurchase 

 operation^.'^ While repurchasing of shares is not, in itself, an abusive practice, 

certain strategies used by closed-end companies during the period of 1927-1935 

resulted in market manipulation and harm to public shareholders. 

Before the crash, it was not unusual for sponsors of closed-end companies 

to instigate repurchases for the purpose of influencing the market to aid in the 

17Alfred Jaretzki, Jr., The Investment Company Act of 1940,26 WASH. U. L. Q. 303,306 (1941). 

The tremendous growth of closed-end companies during the 1920's apparently was closely tied 

to public confidence in the investment houses sponsoring them. Id. 

%EC, INVESTMENT TRUSTS AND INVESTMENT COMPANIES, pt. 3, H.R. Doc. No. 279,76th Cong., 

1st Sess. (1939) [hereinafter INVESTMENT TRUST STUDY, pt. 31. 

''Id. at 954. From 1927 through 1935, closed-end companies and their affiliated holding 

companies repurchased a net amount of $472 million of their securities, or about 12% of the 

securities issued and sold by closed-end companies during that period. Id. at 935-54. 

426 CHAPTER 11 
distribution of new shares?’ Repurchases could support or increase the market 

price, creating an appearance that the value of the shares was steady or rising, 

and enhancing the value of the sponsors’ own holdings?’ 

After the crash, repurchases often were made for different reasons. As the 

price of closed-end shares fell to a discount, repurchases at discount prices 

became a source of book profits for closed-end companies. Many times, however, 

the profits were made at the expense of selling shareholders who had no way of 

knowing the extent of the discount and, therefore, the extent to which they were 

liquidating their shares at prices that did not reflect their true valueF2 This was 

possible because closed-end companies did not disclose the net asset value of 

their shares. In addition, because some companies made purchases on the open 

market without informing investors, investors could not determine the extent to 

which the market was being driven by the company’s rnanagementF3 

Other abuses occurred. Some closed-end companies would repurchase 

securities from insiders in private purchases, sometimes at a premium or in blocks 

that could not have been sold at the prevailing market price because of the size 

of the purcha~e?~ Some companies would repurchase from certain shareholders 

to establish control or remove opposition to management.E Finally, repurchases 

were used in various ways in connection with mergers, consolidations, and 

acquisitions. Some companies, for example, made repurchases to manipulate the 

market values of securities involved in exchangesF6 

In response to these abuses, Congress enacted section 23 of the Investment 

Company Act. Section 23(c) restricts repurchases of closed-end company shares, 

limiting them to purchases (1) on a national securities exchange or other market 

designated by the Commission (after adequate notice to all shareholders); (2) 

pursuant to tenders open to all security holders; or (3) in such other 

circumstances as the Commission permits by rule or order. Section 23 also 

regulates additional sales of common stock by closed-end companies after the 

2oId. at 95457. 

211d. at 960-61. 

=Id. at 966-67. 

231d. 

241d. at 977-78. Repurchases at a premium to market price were particularly troublesome 

because they diluted the company’s assets for the benefit of the insider seller. 

25~a. at 997. 

261d. at 1009. 

Repurchases and Redemptions of Investment Company Shares 427 
initial offering is completed. Section 23(b) generally prohibits such sales at prices 

below net asset value, except (1) in connection with an offering to holders of one 

or more classes of capital stock; (2) with the consent of a majority of the holders 

of common stock; (3) upon conversion of a convertible security in accordance with 

its terms; (4) upon the exercise of any warrant issued in accordance with the 

provisions of section 18(d); or (5) under such other circumstances as the 

Commission may permit by rule or order. These provisions are aimed at 

protecting existing shareholders from the effects of sales of new shares that would 

unfairly dilute their holdings. 

2. Pricing and Redemption of Open-End Shares 

Abusive practices also occurred with early open-end companies that 

claimed that their securities were redeemable, but then instituted barriers to 

redemption. Redemptions typically were suspended because a company was 

redeeming more shares than it was selling and wanted to stop net redemptions 

from further diminishing assets and decreasing management fees; some 

companies apparently suspended redemptions to prevent shareholders from 

switching into other funds?7 Companies often suspended redemptions based 

on provisions contained in charter documents that shareholders never saw?' 

Even if there could be no suspension without a shareholder vote, management 

could persuade shareholders to vote for sus ension by offering a plausible explanation of why suspension was necessary. 8 

There also were abuses associated with the pricing of redeemable 

securities. Most significantly, open-end companies engaged in "backward 

pricing," under which investors were priced into the fund based on the net asset 

value of the fund on the previous day. In a rising market, insiders and favored 

customers, who did not pay a sales load, could purchase shares based upon the 

previous day's lower price, turn around and redeem their shares the next day, 

and be assured of riskless profits, which resulted in dilution of the remaining 

shareholders' holdings. 

Section 22 of the Investment Company Act regulates the pricing, 

distribution, and redemption of open-end company securities. Paragraph (c) of 

section 22 gives the Commission broad power to regulate the pricing of 

redeemable securities, including the power to prescribe by rule methods for 

27See Investment Trusts and Investment Companies: Hearings on S. 3580 B4or-e a Subcmm. of the 

Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 291-92 (1940) [hereinafter 1940 Senate 

Hearings] (statement of David Schenker, Chief Counsel, SEC Investment Trust Study). 

28See id. at 291. 

29See id. at 292. 

428 CHAPTER I1 
computing the price a shareholder will receive upon redemption?' Rule 22c-1 

makes backward pricing illegal for open-end companies and, instead, institutes 

a requirement of "forward pricing" based on a daily computation of net asset 

value?l These provisions are intended to prevent dilution and assure that 

prices bear an appropriate relation to the current net asset value of the shares?2 

Paragraph (d) of section 22 requires that open-end securities be sold only 

at the current offering price described in the prospectus. This subsection, 

designed at least in part to prevent insider riskless trading and the resulting 

dilution, has resulted in a system of retail price maintenance that fixes open-end 

share prices and prevents dealers from making a secondary market?3 

Paragraph (e) of section 22 provides that registered open-end companies may not 

suspend the right of redemption, and must pay redemption proceeds within 

seven days. That subsection recognizes that open-end companies might need to 

suspend redemptions in certain emergencies, however, or for such periods as the 

Commission may by order permit. 

Because open-end companies must redeem their shares at any time and 

pay redemption proceeds within seven days, their portfolios must contain enough 

readily marketable securities to enable them to raise sufficient cash to meet 

redemptions in a timely manner. To ensure that open-end companies will be able 

to meet their redemption obligations, the Commission has indicated that they 

should maintain at least eighty-five percent of their assets in "liquid" securities for 

which there are readily available market prices.34 

3%ection 22(c) gives the Commission powers similar to those given to registered securities 

associations under sections 22(a) and (b) in connection with the promulgation of rules governing 

member activities with respect to the pricing and distribution of redeemable securities. Section 

22(c) specifically provides that Commission rules preempt any conflicting rules adopted by 

securities associations. 

3117 C.F.R. 5 270.22~-1. Specifically, rule 22c-1 provides that open-end securities may not be 

sold, redeemed, or repurchased "except at a price based on the current net asset value of such 

securities which is next computed after receipt of a tender of such security for redemption or of an 

order to purchase or sell such security" (emphasis added). 

32See Adoption of Rule 22c-1 under the Investment Company Act of 1940 and Amendment of 

Rule 17a3(a)(7) under the Securities Exchange Act of 1934, Investment Company Act Release No. 

5519 (Oct. 16,1968), 33 FX 16331. 

33See Chapter 8. 

34See Guide 4 to Form N-lA, Revision of Guidelines to Form N-lA, Investment Company Act 

Release No. 18612 (March 12,1992), 57 FR 9828. See also Interpretative Releases Relating to the 

Investment Company Act of 1940 and Rules and Regulations Thereunder: Restricted Securities, 

Investment Company Act Release No. 5847 (Oct. 21, 19691, 35 FR 19989 (interpretive release 

(continued. ..) 

Repurchases and Redemptions of Investment Company Shares 429 
If a certain level of liquidity were not required, an open-end company 

could maintain a portfolio that would make it difficult to meet the seven day 

deadline in section 22(e). The company might be forced to sell illiquid assets for 

less than the best price, diluting the company’s net asset value for the nonredeeming shareholders. Alternatively, if the level of liquidity were simply 

inadequate, the investment manager may have to sell more liquid assets that 

otherwise would have been kept on the basis of comparative investment merit. 

These transactions could affect performance, thus harming shareholders who did 

not redeem?5 

3. Use of Leverage 

Leverage, applied to investment company assets through excessive 

borrowing and the issuance of excessive amounts of senior securities, was a 

primary concern that led to the Act‘s passage?6 Leverage introduces an element 

of speculation to both the junior and senior shares. Nevertheless, many public 

investors did not understand how leverage affected their investment or even how 

their holdings fit within the investment company’s overall capital struct~re?~ 

Typically, sponsors and others in the securities business held most of an 

investment company’s equity securities (i.e./ common stock) and authorized 

successive issues of debt and preferred stock to be sold to the public?8 

, 

34(...continued) 

regarding investment by investment companies in restricted securities); Resale of Restricted 

Securities; Changes to Methods of Determining Holding Period of Restricted Securities under 

Rules 144 and 145, Securities Act Release No. 6862 (Apr. 23, 19901, 55 FR 17933 (adopting rule 

144A). 

35Closed-end companies are not subject to a liquidity requirement because they do not redeem 

shares on a daily basis. Of course, closed-end companies may need a certain degree of liquidity 

in order to generate cash to pay expenses and to pay cash dividends and distributions if any. 

Some amount of liquidity also may be desirable to the extent necessary to pay holders of senior 

debt securities such as preferred stock or, as recommended later in this chapter, in the event the 

company repurchases its shares. 

36See Investment Company Act 5 l(b)(7), 15 U.S.C. 5 80a-l(b)(7). Almost 400 pages of the 

INVESTMENT TRUST STUDY are devoted to problems in connection with capital structure. 

INVESTMENT TRUST STUDY, pt. 3, Supra note 18, at 1563-936. 

37~~~nu~ TRUST STUDY, pt. 3, supra note 18, at 1674-75. 

38Complex capital structures were common. About 75% of closed-end companies used some 

form of leverage. SEC, INVESTMENT TRUSTS AND INVESTMENT COMPANIES, pt. 1, H.R. Doc. NO. 707, 

75th Cong., 3d Sess. at 29 (1938); INVESTMENT TRUST STUDY, pt. 3, supra note 18, at 1582. Use of 

leverage by open-end companies apparently was rare. Id. at 838 (describing one case of a 

leveraged open-end company). 

430 CHAPTER 11 
Purchasers of senior securities, many of whom were individual investors, bought 

the securities in the belief that they were "safe" in~estments.3~ These investors 

often had no voting rights!' As a result, the equity holders were able to gain 

control over substantially more capital than they themselves invested?l In 

addition, the equity holders could induce the company to repurchase their shares, 

thereby reducing the capital available to generate income to pay the senior 

holders.42 

Leverage not only presents dangers to the senior holders, it increases 

dramatically the speculative nature of the equity securities. Because the equity 

securities receive the benefits of all capital appreciation, and absorb all capital 

losses or asset depreciation, the value of the equity shares rises or falls faster than 

changes in the market value of the underlying assets of the leveraged investment 

~ompany!~ The effects of leverage are accentuated if equity shares may be 

repurchased or redeemed, exposing the remaining equity holders to higher risks 

as well as higher returns. 

Section 18 of the Act limits the use of leverage by both closed-end and 

open-end investment companies, but treats the two types of companies very 

differently. Closed-end companies may borrow from banks and private sources 

and may issue one class of senior debt, subject to a 300% asset coverage 

requirement, and also may issue one class of preferred stock, subject to 200% 

asset coverage requirement?* Among other restrictions, a leveraged closed-end 

company may not pay dividends or other distributions, or purchase any of its 

capital stock, unless the prescribed asset coverage will be in place after the 

transaction. Provision also must be made to give senior security holders certain 

3%ESlX4ENT TRUST STUDY, pt. 3, supra note 18, at 1594. 

401d. at 1597. 

41~a. at 1594-95. 

"%ee id. at 1001. 

@Id. at 1000-01. In contrast, senior securities represent a fixed charge on the assets of the 

company and do not share in these gains or losses. 

44Paragraph (h) of the section defines asset coverage. For example, a closed-end company 

with $100 million in assets and no other outstanding indebtedness may issue senior debt of up 

to $50 million. The ratio of the total assets after the borrowings ($150 million) to the amount of 

debt outstanding ($50 million) would be 300%. The same company also may issue preferred stock 

having a liquidation preference of $50 million. The ratio of the total assets of the company after 

the issuance ($200 million) to the aggregate of borrowings and preferred stock ($100 million) 

would be 200%. 

Repurchases and Redemptions of Investment Company Shares 431 
rights if the asset coverage falls below the prescribed arno~nts!~ Open-end 

companies, because they issue redeemable securities, are permitted much less 

freedom to use leverage. They may borrow on1 from banks and must maintain 

300% asset coverage for all amounts borrowed. & 

B. The Re-Emergence of Closed-End Companies and the Problem of 

Discounts 

In 1940, open-end companies had assets only two-thirds as great as those 

of closed-end ~ompanies.4~ By 1950, open-end company assets had grown to 

nearly three times those of closed-end companies!' This trend continued until 

the latter half of the 1980'~~ when closed-end companies experienced a resurgence. 

In 1986, there were 69 closed-end companies with $12 billion in a~sets.4~ By the 

end of 1991, there were 290 closed-end companies with almost $73 billion in 

assets?' Although this increase is impressive, the total assets of closed-end 

companies still are small in comparison to those of open-end companies which, 

as of the end of 1991, amounted to approximately $1.3 trillion?l 

Despite their relative lack of popularity, there are a number of reasons why 

sponsors choose the closed-end form. Because closed-end companies do not sell 

or redeem their shares continuously, and thus need not take cash inflows and 

outflows into account in managing their portfolios, closed-end companies 

arguably have an advantage over open-end companies in efficiency of portfolio 

management. While open-end companies must maintain a certain amount of cash 

or highly liquid investments to meet daily redemptions, closed-end companies 

451nvestment Company Act § 18(a). 

461nvestment Company Act 5 18(f)(l). 

471940 Senate Hearings, supra note 27, at 43. 

481nformation compiled by the Division from data prepared by Lipper Analytical Services, Inc., 

the Investment Company Institute (the "ICY), Arthur Wiesenberger, and Wiesenberger Financial 

Services. 

491a. 

5kipper Analytical Services, Inc., Lipper Closed-End Fund Performance Analysis Service 44 

(Jan. 31, 1992). 

511nvestment Company Institute News Release, ICI-92-03 (Jan. 29,1992). This figure does not 

include monies invested in unit investment trusts and variable insurance products. 

432 CHAPTER 11 
may keep their assets fully invested according to their investment objectives."2 

More importantly, the closed-end form enables sponsors to offer companies with 

investment portfolios that could not meet the liquidity requirements imposed on 

open-end companies. Because closed-end companies do not issue redeemable 

securities, the Act permits them greater use of leverage than open-end companies, 

providing investors with the opportunity for greater returns (as well as greater 

risks) ."3 

Internationalization of the securities markets and optimism about emerging 

markets overseas have created significant opportunities for new offerings of 

closed-end companies in recent years. So-called "country funds" have provided 

an important medium for United States investors to invest 0verseas.5~ Country 

fund portfolios often contain a large percentage of securities that are thinly traded 

or are considered to be illiquid for other reasons. For example, the size of the 

fund may be relatively large in relation to the overall capitalization of an 

emerging market and enormous in proportion to the daily trading volume. In 

addition, securities transactions in foreign countries may be subject to slower 

settlement procedures than those in the United States, or currency restrictions 

may limit a fund's ability to convert cash into United States dollars. These 

portfolios also may be difficult to value, due to limited data on market prices. 

Beginning in late 1989, there was a surge of investor interest in single 

country closed-end companies. During this period, the shares of many country 

funds were trading at significant premiums to their net asset values. Market 

prices shortl lummeted, however, with share prices dropping on average 31% 

during 1990!5PWhile the drop may have resulted from the large number of new 

'*See, e.g., Request for Comments on Reform of the Regulation of Investment Companies, 

Investment Company Act Release No. 17534 (June 15, 1990), !55 FR 25322 [hereinafter Study 

Release]. See also Letter from General American Investors Company, Inc. to Jonathan G. Katz, 

Secretary, SEC 4 (Oct. 3,19901, File No. S7-11-90 [hereinafter General American Study Comment]; 

and Letter from Baker, Fentress & Company to Jonathan G. Katz, Secretary, SEC 2 (Oct. 9,1990), 

File No. S7-11-90 [hereinafter Baker, Fentress Study Comment]. 

53Many, if not most, closed-end companies do not issue significant amounts of senior 

securities, however. Currently, the issuance of senior securities is most common among closedend bond funds, particularly municipal bond funds. Edward A. Wyatt, On Borrowed Time? 

Leveraged Funds' Promise -- and Perils, BARRON'S, Nov. 11,1991, at M16. Some investors may view 

these senior securities as a higher income alternative to investing in a tax-exempt money market 

fund. See James E. Lebherz, Mutual Funds' Prefewed Shares Ojfer an Alternative to Investors, WASH. 

POST, Aug. 25,1991, at H10. 

'%ome of these companies invest in a number of countries; others invest only in a particular 

55See Jonathan Clements, Country Fund Fever Leaves Investors Feeling Queasy, WALL ST. J., Jan. 

geographical region or in a single country. 

22, 1991, at C1. 

Repurchases and Redemptions of Investment Company Shares 433 
companies launched or fading enthusiasm about markets such as eastern 

Europe:6 many single country funds declined along with the general downward 

trend in the market?7 

A key factor that may influence investor interest in new or existing closedend companies is the recurring tendency of their shares to trade at a discount to 

net asset value. In general, discounts appear shortly after initial public offerings 

and affect all types of publicly traded closed-end companies, although to varying 

degrees. A 1989 study by the Commission's Office of Economic Analysis of the 

post-offering price performance of closed-end companies found that, on average, 

closed-end companies lost significant value during the first 120 trading days 

following their initial public offerings. After twenty-four weeks, the average 

discount for closed-end United States equity funds was 10.019%. For closed-end 

foreign stock funds, the discount was 11.424%. The average discount for closedend bond funds was much lower, only 0.012%.58 

56See John Waggoner, Closed-End Funds Wither in Europe, USA TODAY, Feb. 13, 1991, at 3B. 

57See Roger Lowenstein, Mexico Funds' Deep Discount May Be Bargain, WALL ST. J., Oct. 18,1990, 

at C1 (discussing the general decline in prices of country fund shares). In the market generally, 

for the year ended January 2,1991, Standard & Poor's 500 Composite Stock Price Index declined 

by 9.0%, the Dow Jones Industrial Average by 7.1%, and the Russell 2000 index of small 

companies by 22.9%. Investment Figures of the Week, BUS. WK., Jan. 14,1991, at 143. 

The dramatic slump in share prices forced managers to try various methods to reverse this 

trend. See Carole Gould, Hunting the Closed-End Conversiun, N.Y. TIMES, Aug. 26, 1990, at 18F; 

Deborah Hargreaves, Euro-Spain Fund May Buy Back Its Shares, FIN. TIMES, Sep. 27, 1990, at 23; 

Jonathan Clements, Public Funds Are Facing Some 'Raiders' They Might Like: Their Own Managers, 

WALL ST. J., Dee. 11,1990, at C1. The methods currently being used by closed-end companies to 

reduce discounts are discussed in the text below. 

58See Office of Economic Analysis, SEC, THE POST-OFFERING PRICE PERFORh4ANCE OF 

CLOSED-END FUNDS 4 (July 21, 1989) [hereinafter THE POST-OFFERING PRICE PERFORMANCE OF 

CLOSED-END FUNDS]. 

434 CHAPTER 11 
FIGURE 11-1 

Premiums and Discounts from NAV for lPOs of Closed-End Funds 

a All Funds a Bond Funds U.S. stodc Funds Foreign stock Funds 

scuta ~C~oI~~ 

A popular theory advanced to explain the discount is that market interest 

in closed-end companies falls significantly after the initial public offering, mainly 

because brokers are paid low commissions for secondary trades59 and because, 

until recently, few market analysts have followed closed-end companies on a 

regular basis!' Brokerage houses have begun hiring closed-end company 

analysts, however, and there is evidence that brokers are recommending 

purchases of closed-end company shares (at least in the secondary market) to 

5$URTON G. MAMEL, A RANDOM WALK DOWN WALL STREEX at 261-62 (Rev. ed., 1975); 

BENJAMIN GRAHAM, THE INTELLIGENT INVESTOR at 126 (4th rev. ed., 1973). 

@Another analysis argues that "the closed-end fund discount, the rate at which initial public 

offerings are made, and the relative valuation of small stocks [are all] driven by changes in the 

sentiment of the small investors." Under this view, "[tlhe closed-end discount thus serves as a 

thermometer of small-investor sentiment -- of their overoptimism or overpessimism." J. Bradford 

De Long & Andrei Shleifer, Closed-End Fund Discounts: A Yardstick of Small-Investor Sentiment, 18 

J. PORTFOLIO MANAGEMENT, No. 2,& (Winter 1992). 

Repurchases and Redemptions of Investment Company Shares 435 
retail investors?' 

narrowed during 1991. 

Perhaps as a result of this increased interest, discounts 

Whatever the cause of discounts, the initial investors in closed-end 

companies may be affected more than the initial participants of other securities 

products. In part, selling fees may be higher with closed-end offerings than with 

other initial public offerings.62 Often investors in closed-end offerings do not 

realize that part of their investment will go to finance the offering, so that their 

shares will automatically have a lower net asset value than the amount of their 

initial inve~tment.6~ Ifthose investors have no choice but to sell their shares in 

the secondary market at a discount, they consequently suffer a loss of capital. For 

this reason, seasoned investors avoid purchasing during initial offerings and wait 

for discounts to appear in the secondary market before buying ~hares.6~ 

C. Methods For Reducing Discounts 

Market discounts are a frequent source of concern for many closed-end 

company managers and sponsors. As a result, sponsors have considered and 

used a variety of techniques for responding to discounts or attempting to forestall 

them. 

Approaches to curing market discounts have met with varying degrees of 

success. For example, some companies use leverage to borrow cash equal to the 

underwriting discount paid to brokers, and invest that amount in the company. 

The theory behind this practice is that discounts result from the company being 

worth less than the investors' initial in~estment.6~ Of course, the benefit of 

added earnings potential from increasing the assets invested in the company is 

countered by the increased risk of leverage. 

61See Jonathan Clements, Slim Pickings Among Closed-End Funds, WALL ST. J., Mar. 8, 1991, at 

c1. 

62~~~ POST-OFFERING PRICE PERFORMANCE OF CLOSED-END FUNDS, supra note 58, at 23. 

63Proposed revisions to Form N-2, the registration form used by closed-end companies, would 

re-label underwriting discount as "sales load" in the per share table to increase investors' 

understanding of this charge. Registration Form for Closed-end Management Investment 

Companies, Investment Company Act Release No. 17091, section 1II.B. (July 28,1989), 54 FR 32993 

(proposed amendments to Form N-2 and guidelines). 

64See, e.g. Marsha Meyer, The Savvy Way to Buy Closed-End Funds, MONEY, Sept. 1987, at 153, 

154; Jonathan Clements, In Aftermath of Stocks' Sell-Of, Some Advocate Closed-End Funds, WALL ST. 

J., Aug. 22,1990, at C1; Richard Phalon, Duck Shoot, FORBES, Sept. 3,1990, at 165. 

65See supra note 63 and accompanying text. 

436 CHAPTER 11 
Some companies offer dividend reinvestment plans, under which the 

company reinvests shareholder dividends and distributions in additional shares 

that are issued by the company at the lower of market value or net asset value. 

Similarly, some companies engage in rights offerings, which are strictly limited 

by the While these practices appear to counteract the tendency toward 

discounts, dilution occurs when shareholders exercise rights or purchase new 

shares at prices less than net asset value. This eventually may cause a 

corresponding downward adjustment in the market price. 

Finally, some companies offer a variation on the dividend reinvestment 

plan that includes a "cash purchase'' feature through which shareholders may 

authorize an independent agent to purchase shares in the market whenever the 

market price is less than net asset value. While these purchases are made by 

existing shareholders, and not the company, they act in the same way as 

repurchases by the company on the open market in reducing discounts. 

One method of ending discounts is to convert from closed-end to open-end 

status, but this approach has significant drawbacks. Conversion radically changes 

how a closed-end company may operate. The company's investment strategy 

may have to be re-evaluated; there are expenses and potential losses associated 

with restructuring a portfolio to increase its liquidity to match that of open-end 

companies; and leverage and capital structure may have to be adjusted. In 

addition, and perhaps most importantly, the former closed-end company has to 

develop a relationship with a distributor and comply with the more rigorous 

pricing, distribution, and redemption requirements that apply to open-end 

companies. Thus, for many closed-end companies, conversion from closed-end 

to open-end status has significant drawbacks. 

Even the potential for elimination of discounts upon conversion can affect 

a closed-end company. Discounts attract arbitrageurs who gamble on swings in 

the discount and "raiders" or others who attempt to take over the company, 

sometimes forcing proxy contests to cause a company to convert from closed-end 

to open-end status.67 As a result, potential targets have adopted supermajority 

(%rider section 23, closed-end companies may issue warrants or rights exercisable at less than 

net asset value as provided by section 18(d). Section 18(d) requires warrants and rights to be 

issued exclusively to existing shareholders and to expire within 120 days of their issuance. 

67Upon conversion to open-end status, all shareholders may redeem shares at net asset value. 

Thus, raiders would instantly realize any profit on the difference between the discount prices they 

paid for the closed-end shares and the net asset value they are entitled to receive for the open-end 

shares. See, eg., Gould, Hunting the Closed-End Conversion, supra note 57, and Phalon, Duck Shoot, 

supra note 64. 

Repurchases and Redemptions of Investment Company Shares 437 
voting provisions that make it nearly impossible for conversions to 

In addition, to pre-empt the threat of forced takeovers, sponsors have organized 

closed-end companies that automatically will seek to convert to open-end status 

under certain circumstances, or after a fixed period of While these 

provisions are intended primarily as anti-takeover tactics, they may actually 

minimize discounts, particularly as a shareholder vote appro ache^.^' 

For many closed-end companies, a more reasonable alternative for reducing 

discounts may be to repurchase shares under the limited circumstances rovided 

by section 23(c) of the Act and rules 23c-1 and 23c-2 thereunder?‘ Under 

section 23(c)(I), closed-end companies may purchase shares on a securities 

exchange and such other open market as the Commission by rule designates, 

provided that the company has notified stockholders of its intention within the 

preceding six months (if such securities are stock). Rule 23c-1 permits purchases 

on other open markets subject to a number of additional provisions designed to 

protect shareholder^.^^ Rule 23c-2 permits closed-end companies to call or 

redeem securities according to their terms, under certain condition^.^^ Such 

@Section 13(a)(l) of the Act requires a majority of a company’s outstanding voting securities 

to authorize a change in subclassification from closed-end to open-end. 15 U.S.C. § 80a-l3(a)(l). 

A typical supennajority voting provision requires at least a two-thirds (but usually not over threefourths) vote in favor of conversion. See Mary Joan Hoene, Closed End Funds - Discount and 

Takeuuer Issues, 1990 MUTUAL FUNDS AND INVESTMENT MANAGEMENT CONFERENCE at IX-95. 

@‘The conversion is contingent, of course, on obtaining the necessary shareholder approval 

required by section 13(a) of the Act. The shareholder vote usually may take place only several 

years after the fund’s inception, and may hinge on a specific level of discount appearing or 

continuing for a specified period of time. See, eg., id. at IX-98. 

70See Greggory A. Brauer, ’Open-Ending’ Closed-End Funds, 13 J. FIN. ECON., 491,506-07 (1984) 

(examining the effect on secondary market prices of closed-end companies’ announcements of 

proposed conversions to open-end status). But see THE POST-OFFERING PRICE PERFORMANCE OF 

CLOSED-END FUNDS, supra note 58, at 18-19, 36 (an examination of a sample of 64 closed-end 

companies 24 weeks after their initial public offering showed that there was a statistically 

insignificant difference in the discount or premium between companies with anti-takeover 

provisions and those without, and that the results did not change when the sample was broken 

down by type of fund). 

”17 C.F.R. 59 270.23~-1, .23~-2. 

72Among other things, the rule generally requires that purchases of junior shares not disturb 

the asset coverage requirements of section 18, that purchases not be from affiliated persons of the 

issuer, and that purchases be made at a price not exceeding the lower of the market value, if any, 

or the net asset value of the security at the time of purchase. 

73Rule 23c-2(a) generally permits a registered closed-end company to call or redeem its shares 

in accordance with the terms of such securities or the company’s charter; this rule has been 

(continued.. .) 

438 CHAPTER 11 
repurchases can create some market activity that may reduce the discount, but 

those rules do not facilitate transactions such as periodic direct repurchase offers 

by closed-end companies. 

Under section 23(c)(2), closed-end companies may repurchase shares 

directly from shareholders by conducting issuer tender offers, after reasonable 

opportunity to submit tenders is given to all holders of securities of the class to 

be purchased, In addition, section 23(c)(3) provides the Commission with 

rulemaking authority to provide other means for closed-end companies to 

repurchase their shares in a manner that does not unfairly discriminate against 

any holders of the securities being repurchased. 

D. Closed-End Tender Offers 

Certain closed-end companies have avoided discounts entirely while still 

remaining closed-end by making periodic tender offers at net asset value under 

section 23(c)(2). With one exception, these companies' shares have not been 

traded in the and the companies have provided shareholder liquidity 

solely through quarterly tender offers. 

The first closed-end companies to use this procedure were loan 

participation or "prime rate" funds. These companies, first introduced in 1988, 

invest primarily in illiquid assets consisting of interests in senior, secured 

73(...continued) 

interpreted as permitting calls and redemptions solely at the issuer's option and without any 

choice on the part of the shareholder. Dimensional Fund Advisors, Inc. (pub. avail. Nov. 21, 

1988). 

74As a condition to exemptive relief from rule lOb-6 under the Exchange Act (17 C.F.R. 

5 240.10b-6), closed-end companies that intend to make such repurchases may not list their shares 

on a securities exchange or have their shares quoted on the National Association of Securities 

Dealers Automated Quotation system. Moreover, due to the similarities between open-end 

companies and closed-end companies making continuous offerings and periodic repurchases, 

United States securities exchanges might not permit the shares of such funds to be listed. 

Securities exchanges in the United States generally do not list redeemable securities. For example, 

staff of the New York Stock Exchange have advised us in discussions that the exchange's policy 

is to begin de-listing proceedings if a listed closed-end company converts to open-end status. 

Recently, however, the American Stock Exchange ("AMEX') has participated in the development 

of at least one complex synthetic securities product that includes redeemable securities intended 

to trade on AMEX. See SuperTmst Trust for Capital Market Fund, Inc. Shares, Investment 

Company Act Release Nos. 17613 (Jul. 25,1990), 55 FR 31281 (Notice of Application) and 17809 

(Oct. 19,1990),47 SEC Docket 1098 (Order). 

Repurchases and Redemptions of Investment Company Shares 439 
corporate loans that have floating interest rates.75 Although loan participation 

funds register as closed-end companies, they operate much like open-end 

companies, offering shares continuously and providing the sole source of liquidity 

for their shareholders. While only five loan participation funds have re istered 

with the Commission, they have been successful in attracting investors! As of 

December 31, 1991, the loan participation funds had total assets of almost $6 

billion and accounted for approximately eight percent of the total assets held by 

closed-end companies.77 

By the end of 1991, two other closed-end companies had followed the lead 

of the loan participation funds and indicated that they would periodically 

consider making tender offers to their shareholders?8 In early 1992, by contrast, 

one loan participation fund appeared to abandon the procedures. Pilgrim Prime 

Rate Trust announced that it would not make a repurchase tender offer and listed 

its shares on the New York Stock Exchange on March 9, 1992?9 None of the 

other closed-end companies followed suit, and Pilgrim’s shares kaded on the 

exchange at a significant discount. Within two weeks after the beginning of 

exchan e trading, Pilgrim announced a tender offer for nearly nine percent of its 

shares. & 

Closed-end company repurchase offers are subject to a number of 

significant restrictions, however. Issuer tender offers must comply with the 

7?he interest rates float or reset at a margin above a generally recognized base lending rate 

such as the prime rate quoted by a designated United States bank, the London InterBank Offered 

Rate, the average secondary market rate for large certificates of deposit, or other base lending 

rates used by commercial lenders. 

79he five registrants are Allstate Prime Income Trust, Eaton Vance Prime Rate Reserves, 

Merrill Lynch Prime Fund, Pilgrim Prime Rate Trust, and Van Kampen Merritt Prime Rate Income 

Trust. 

nLipper Analytical Securities Corp., Lipper Closed-End Performance Analysis Service, Jan. 31, 

1992, at 44 (assets of $5.80 billion out of total closed-end fund assets of $72.76 billion). But see 

Randall W. Forsyth, Nut Necessarily Prime Time, BARRON’S, Oct. 21, 1991, at 47 (indicating that 

investors tendered their shares at significant levels beginning in mid-1991 as interest rates 

dropped). 

78Merrill Lynch High Income Municipal Bond Fund, Inc., and Emerging Markets Growth 

Fund, Inc. The latter, however, has not made any tender offer since January, 1991. 

7Tonathan Clements, Pilgrim Takes Fund Industry by Surprise, WALL ST. J., Feb. 21,1992, at C1 

(quoting letter to shareholders from Palomba Weingarten, Chairman, Pilgrim Group). 

*‘Jonathan Clements, Pilgrim Prime Xate Plans Tender Ofer for 9% of Shares, WALL ST. J., Mar. 

26, 1992, at B6. 

440 CHAPTER 11 
requirements of rules 13e-4'l and 14e-lS2 under the Securities Exchange 

Moreover, they must obtain exemptive relief from the provisions of rule 

lob-6 under the Exchange Act, which generally prohibits participants in a 

distribution from contemporaneously buying securities of the same class bein 

distributed. They must conduct their offerings in compliance with rule 415 

under the Securities Act,g5 which governs "shelf" registrations. As a result, 

tender offers generally are a relatively cumbersome and limited way for closedend companies to provide for shareholder liquidity. They involve costs such as 

producing offering materials, notifying shareholders, and paying registration and 

filing fees. Open-end companies are not subject to similar requirements when 

redeeming their shares. 

A 

Tender offers also are subject to a number of qualifications that do not 

apply to redemptions of open-end shares. For example, tender offers generally 

are made for limited amounts of shares and, if more shares are tendered than the 

company is prepared to buy, the company is only required to accept them on a 

pro rata basis. A company also is not obligated to make a tender offer. Finally, 

these companies have not been able to provide investors with assurance the 

tender offers will take place. The Division has stated that committing in advance 

to make periodic tender offers might result in directors breaching their fiduciary 

duties to shareholders, since investors could not be certain when or if their shares 

would actually be repurchased by the Accordingly, these 

companies' prospectuses represent that each quarter the board of directors will 

consider whether to make a tender offer for outstanding shares, but caution that 

tender offers may not take place every quarter. 

The closed-end company repurchase offers illustrate clearly the difficulty 

experienced by sponsors wishing to offer an alternative procedure for 

shareholders to resell their shares. This chapter has described other examples of 

funds that do not fit comfortably within the strict open-end/closed-end system. 

"17 C.F.R. Q 240.13e-4. 

8217 C.F.R. Q 240.14e-1. 

%ecurities Exchange Act of 1934,15 U.S.C. Q§ 78a-7811. These requirements are discussed in 

Section III.A.1, infra. 

s417 C.F.R. Q 230.415. 

85Securities Act of 1933,15 U.S.C. QQ 77a-77aa. Closed-end companies may continuously offer 

new shares in reliance on paragraph (a)(l)(ix) of rule 415, but paragraph (h) of the rule limits 

them to registering only the number of shares that they reasonably expect will be offered or sold 

within two years from the effective date of the registration statement. 

86See Guide 2 to proposed amendments to Form N-2, Inv. Co. Act Rel. 17091, supra note 63. 

Repurchases and Redemptions of Investment Company Shares 441 
For example, some country funds appear capable of operating much like openend companies but cannot because of the seven-day requirement for meeting 

redemptions. Certain closed-end funds appear interested in providing 

opportunities for shareholders to exchange their shares for net asset value, but 

have not been able to do so with any certainty and remain within the closed-end 

classification. 

111. Recommendations 

The Division believes it is appropriate to modernize the existing regulatory 

structure to permit the development of new investment companies that, while 

having characteristics of the current open-end and closed-end forms, would offer 

a degree of redeemability or "repurchase-ability" between the two traditional 

extremes. Accordingly, the Division recommends adoption of a rule under 

section 23(c) of the Act to facilitate periodic repurchases of closed-end shares. In 

addition, the Division recommends that the Commission propose a new 

exemptive rule under section 22 of the Act to establish requirements for a new 

type of open-end investment company (a "limited redemption investment 

company") that would invest in less liquid securities and provide shareholders 

with a limited right to redeem shares at net asset value. Finally, given the 

importance of portfolio liquidity to any investment company that redeems or 

repurchases its shares, the Division recommends the introduction of legislation 

enabling the Commission to specify liquidity standards appropriate to each form 

of investment company. 

A. Repurchase Offers by Closed-End Companies 

In light of the problems raised by market discounts and the closed-end 

companies periodic tender offers responding to the discounts, the Division 

considered whether to recommend to the Commission that it facilitate direct share 

repurchases by closed-end companies. As discussed above, the only effective 

mechanism that has emerged for addressing the discounts is the direct repurchase 

approach that a small number of closed-end companies have made to their 

shareholders pursuant to section 23(c)(2) of the Investment Company Act and 

Exchange Act rules governing issuer tender offers. 

In view of those companies' experience and the comments received in 

response to Commission's release soliciting comments on the regulation of 

investment ~ompanies,8~ the Division believes that it would be appropriate to 

87Study Release, supra note 52. Several commenters favored a mechanism for such 

repurchases. See, e.g., Letter from American Bar Association, Section of Business Law, Committee 

on Federal Regulation of Securities, 1940 Act Structured Finance Task Force, to Jonathan G. Katz, 

(continued ... ) 

442 CHAPTER 11 
provide a more defined, efficient mechanism for direct repurchase offers by 

closed-end companies. The Division therefore recommends that the Commission 

adopt rules under section 23(c) to permit closed-end companies to repurchase 

their shares at fixed intervals in accordance with appropriate safeguards for the 

protection of investors.% 

While many companies and shareholders are interested in repurchases at 

net asset value, repurchase offers would not be appropriate or desirable for all 

closed-end companies. Some types of companies tend not to have discounts. 

Other companies invest in securities that are not liquid or easily marketable; the 

valuation of the assets of these companies may be so imprecise that it is difficult 

to ensure that repurchase prices would be fair to both tendering and remaining 

shareholders. In many cases, the portfolio management demands created by 

repurchases and new sales may be incompatible with a corn any’s (and its 

shareholders’) objective of remaining fully invested in securitie~!~ Accordingly, 

we do not propose that any repurchase rule be mandatory for all closed-end 

”(...continued) 

Secretary, SEC (Oct. 16,1990), File No. S7-11-90 [hereinafter ABA Comment]; Letter from Davis, 

Polk &E Wardwell, to Jonathan G. Katz, Secretary, SEC (Oct. 10, 1990), File No. S7-11-90 

[hereinafter Davis Polk Study Comment]; and Letter from Merrill Lynch & Co., Inc. to Jonathan 

G. Katz, Secretary, SEC (Oct. 18, 1990), File No. S7-11-90 [hereinafter Merrill Lynch Study 

Comment]. 

-his recommendation represents a change from the prior position that an advance 

commitment to repurchase may be inconsistent with the fiduciary duties of the company’s board 

of directors to consider the merits of the proposed repurchase based on the circumstances at the 

time the repurchase is made. Inv. Co. Act Rel. 17091, supru note 63. While the Division continues 

to believe that the directors of a closed-end company have a fiduciary duty to consider the 

appropriateness of share repurchases, this fiduciary duty should not preclude a closed-end 

company from making an advance commitment to periodic repurchases. This duty would include 

reviewing a company’s portfolio management and borrowing procedures to ensure that the 

company can meet its repurchase commitments. 

The proposed repurchase procedures would address many of the underlying concerns of the 

Division’s prior position, as would the proposed requirement that closed-end companies making 

repurchases disclose possible limitations on repurchases and possible effects on portfolio 

management of the need to plan for repurchases. Moreover, the adoption of an express liquidity 

standard and of limitations on the use of leverage by closed-end companies making repurchases 

should address concerns about a company’s ability to manage its portfolio so as to meet its 

repurchase commitments. 

”See, eg., General American Study Comment, supru note 52, at 2-6; Baker, Fentress Study 

Comment, supra note 52, at 2-5 (both of which opposed any procedure for such repurchases). 

Repurchases and Redemptions of Investment Company Shares 443 
companies. Rather, any rule should provide a safe harbor within which each 

company could elect to offer the repurchase feature?' 

It is unclear whether there would be a demand for such closed-end 

repurchase procedures if the Commission also adopts rules permitting limited 

redemptions by open-end companies; many investment companies that would 

wish to provide shareholder liquidity might prefer to operate as limited 

redemption open-end companies rather than as closed-end companies making 

periodic repurchase offers. Ultimately, if both options are available, sponsors and 

investors will determine which options works best for a particular fund. 

1. Operational Procedures for Repurchases 

Periodic repurchases raise a number of operational issues. To address 

those issues, the discussion below recommends including specific operational 

requirements in rules authorizing periodic repurchases. The Division has 

examined the experience of certain companies (mainly the loan participation 

funds) that currently make periodic tender offers to repurchase their shares. 

Following that model, the basic steps of the process are the following: (i) a fund 

makes a repurchase offer to shareholders; (ii) during the tender offer period that 

follows, shareholders may tender their shares and withdraw their tenders until 

the termination of that period (the "cut-off date"); (iii) by the cut-off date the fund 

determines whether to accept or reject tenders; and (iv) the fund makes payment 

promptly thereafter. The experience of the closed-end companies that have made 

periodic repurchase offers raises a number of questions, which we explore below, 

and suggests that it would be appropriate to modify the procedures used by those 

companies. 

a. Relationship to Tender Offer Rules 

Currently, closed-end companies that make periodic repurchases do so via 

tender offers. In man respects, the tender offer rules under sections 13 and 14 

of the Exchange Act" address important investor protection concerns relating 

to repurchases by closed-end companies. In other respects, however, the 

experiences of closed-end companies that have conducted repurchases in 

accordance with the tender offer rules suggest that some provisions of those rules 

were intended to apply to different transactions and do not achieve their 

?hch a rule could be promulgated under section 23(c)(3), which expressly authorizes the 

Commission to issue rules, regulations and orders defining other circumstances in which 

repurchases may be made. Alternately (or in addition), the rule could be promulgated under 

section 23(c)(2) as a safe harbor within which an offer would be deemed to provide "reasonable 

opportunity to submit tenders given to all holders of securities of the class to be purchased." 

9115 U.S.C. §§ 78m, 7811. 

444 CHAPTER 11 
objectives when applied to closed-end companies conducting repurchases at a 

price based on net asset value. Accordingly, the Division recommends that rule 

13e-4 be amended to exempt closed-end company periodic repurchases complying 

with a new rule under section 23(c) of the Act, and that the new rule under 

section 23(c) incorporate certain pertinent requirements of rule 13e-4 as adapted 

to address the unique investor protection concerns that are raised by closed-end 

company repurchase offers. The Division also recommends taking an analogous 

approach with respect to rule 14e-1, which prohibits certain tender offer practices. 

The following discussion examines some of the areas where specific adaptations 

for repurchasing closed-end companies may be appropriate. 

b. Formulation of Repurchase Offers 

A key issue to be addressed by the proposed rules would be the procedure 

to be used by a company in determining the timing and extent of repurchase 

offers. Because this issue is of critical importance both in shareholders’ 

investment decisions and in a company’s ability to manage its portfolio, the 

Division recommends that the rule require repurchase offers to take place 

according to a fundamental policy that defines both the timing of repurchases and 

the minimum and maximum amount of shares to be repurchased under any offer. 

This approach would contrast with the current practice in closed-end company 

repurchase offers, where the amount to be repurchased is determined by the 

company with respect to each repurchase. At the same time, we recognize that, 

because of market conditions and considerations of portfolio management, it 

might be appropriate for a company to repurchase a greater or lesser amount in 

a given offer. For that reason, the Division also recommends that a company 

have authority to determine, pursuant to guidelines established by the company’s 

board of directors, the amount of each repurchase offer within minimum and 

maximum limits set by fundamental policy. 

(1) Fundamental Policy. The procedures governing closed-end 

redemption offers should be matters of fundamental policy, because shareholders 

should have maximum certainty about the timing and extent of purchase^.'^ An 

irregular or sporadic repurchase program would cause confusion and might also 

provide opportunities for insider abuse and manip~lation?~ 

92Because the procedures would be fundamental, they could not be changed unless authorized 

by a majority vote of the shareholders. See Investment Company Act 55 8(b)(3), 13(a)(3), 15 U.S.C. 

§§ 80a-8(b)(3), -13(a)(3). 

’%he rulemaking proceeding also could examine whether alternative requirements would 

provide sufficient investor protection. One alternative, which we do not favor, but which would 

continue the current practice of closed-end companies that have made periodic offers, would be 

to leave the full determination of the timing and amount of the offer to the board of directors, 

(con tinued ...I 

Repurchases and Redemptions of Investment Company Shares 445 
93(...continued) 

subject to a requirement of full disclosure and notice. Cf. rule lla-3, 17 C.F.R. Q 270.11a-3 (60 

days’ advance notice required before any change in the terms of a mutual fund’s exchange offer). 

94Rule 13e-40. Rule 14e-l(b) has a comparable provision. 

9%7e recognize that allowing such discretion would necessarily reduce the amount of certainty 

associated with repurchases. In theory, a company could have a minimum schedule providing 

for small repurchase amounts, yet regularly accept more shares, possibly lulling investors into 

believing that the company will always buy back a significant number of shares. We believe, 

however, that clear disclosure of the minimum and maximum amounts of shares the company 

commits to repurchase would minimize the possibility for confusion and misleading practices. 

(2) Intervals between Repurchase Offers. The Division believes that any 

rule should require a schedule for periodic repurchases at regular, fixed intervals. 

The interval should be regular and easily ascertained; for example, the rule could 

specify that permissible intervals are three months, six months, or a year. Such 

intervals reduce the potential for investor confusion and allow investors some 

ability to plan. From the range of permissible intervals specified in the rule, each 

company could select the frequency at which it would make repurchase offers as 

a matter of fundamental policy consistent with the company’s investment 

objectives. 

(3) Minimum and Maximum Amounts of Repurchase Offers. The 

Division believes that a company seeking to periodically repurchase its shares 

should be required to determine at the outset the minimum and maximum amount 

of shares that will be repurchased, either in absolute terms or as a percentage of 

shares outstanding. For example, a closed-end company could adopt a policy that 

provided for quarterly repurchases of between five and ten percent of the shares 

of common stock outstanding. Establishing a maximum repurchase amount 

would assist managers in judging the company’s liquidity needs, while a 

minimum would assure shareholders that the company will in fact make 

repurchase offers at a sufficient level to accommodate shareholder liquidity needs. 

(4) Levels of Individual Repurchase Offers. The Division recognizes that 

a company should have some flexibility to determine at the time of each 

repurchase offer the maximum amount of that offer. Currently, under rule 13e-4, 

an issuer may purchase “an additional amount of securities not to exceed two 

percent of the class of securities that is the subject of the tender offer;” be ond 

that point, the issuer must extend the tender offer for a specified periodPk It 

would be appropriate for a closed-end company to have similar limited discretion 

to increase the amount if it determines that repurchasing a larger number of 

shares is appr~priate?~ The investment adviser would make these 

determinations pursuant to guidelines established by the company’s board of 

directors. This discretion would allow the company to respond to portfolio 

446 CHAPTER 11 
management concerns and any expectations of the level of shareholder 

tenders?6 Of course, the amount of the repurchase offer could not be increased 

beyond the maximum limit set by fundamental policy. 

(5) Exceptions. Finally, the Division also recognizes that it would be 

appropriate to allow closed-end companies to suspend scheduled repurchases in 

limited circumstances when repurchases would have severe consequences for 

shareholders. For example, in unusual circumstances, repurchases could affect 

a company’s tax status as a regulated investment company under Subchapter M 

of the Internal Revenue C0de.9~ In those circumstances, a company’s board 

should be allowed to suspend or limit repurchases. Such circumstances currently 

are disclosed in prospectuses where tender offers are contemplated and in issuer 

tender offer documents?8 Closed-end companies seeking to rely on the new 

rule similarly should be required to disclose these limitations i 

prospectuses. 

c. Preparation of Disclosure Materials 

Rule 13e-4 under the Exchange Act requires an issuer to provide a 

statement containing extensive disclosure. Among other items, the statement 

must disclose the source and amount of the consideration to be paid, the purpose 

of the tender offer, transactions in the issuer‘s securities by certain related 

persons, and any arrangements relating to the tender offer. These requirements 

can impose significant costs and delays on closed-end companies and their 

shareholders in the preparation, printing, and distribution of the statements. 

Much of the current tender offer disclosure requirements would not be 

relevant to periodic repurchase offers by closed-end companies under the 

proposed rule. Since the essential purpose would be simply to remind 

shareholders of the previously disclosed opportunity to have shares repurchased 

at net asset value, lengthy, detailed disclosure would not be necessary. Investors 

in such closed-end companies would already know the general terms and 

96Pursuant to their fiduciary obligations to shareholders, the directors would monitor the 

repurchase process and serve as a check on proposals by the investment adviser that repurchase 

offers consistently be made in the minimum amount, since such proposals might serve primarily 

the adviser’s interest by maximizing the level of assets under management on which advisory fees 

would be paid. On this and other points, the Division expects that the consideration of any 

proposed rule will examine what role, if any, the independent directors should have. 

9726 U.S.C. 5s 851-860. 

”See, eg., Pilgrim Prime Rate Trust, Offer to Purchase at 5-6 (Aug. 2,1991), reprinted in Pilgrim 

Prime Rate Trust, Schedule 13E-4, Exhibit (a)(l)(ii) (Aug. 2,1991); Merrill Lynch Prime Fund, Inc., 

Offer to Purchase at 5-6 (Aug. 19,1991), reprinted in Merrill Lynch Prime Fund, Inc., Schedule 13E4, Exhibit (a)(l)(ii) (Aug. 19, 1991). 

Repurchases and Redemptions of Investment Company Shares 447 
purposes of such offers from prospectus disclosure -- indeed, this procedure 

might be a material factor in most investors' decisions to purchase shares of such 

closed-end companies. Thus, at the time of each repurchase offer, investors 

would need to receive only basic disclosure concerning the procedures for 

tendering their shares for repurchase. For example, first, they would need some 

reminder of the existence and timing of the repurchase offer. Second, they would 

need to know the amount to be repurchased in a given offering; if the company 

has discretion to set the amount of the offering, the statement should disclose any 

material factors pertinent to the determination of the amount. Third, basic 

information about net asset value also would be appropriate, including the net 

asset value as of the date of the repurchase offer and information about means 

for shareholders to learn net asset value at subsequent points (such as references 

to newspaper publication or any telephone information ~ystems)?~ Accordingly, 

the Division recommends that a repurchase offer rule require closed-end 

companies making periodic repurchases to provide shareholder notification 

containing the basic information outlined above. 

d. Timing of Repurchase Offer Events 

The determination of the relative timing of key events in the repurchase 

process raises several questions. First, how far in advance should the company 

provide notice to shareholders of each repurchase offer? For issuer tender offers, 

rule 13e-4(f) requires that a tender offer remain open for "(i) at least twenty 

business days hom its commencement; and (ii) at least ten business days from the 

date" of notice of certain changes in the offer.*" Less advance notice may be 

necessary with periodic repurchase offers than with most issuer tender offers, 

since under most circumstances shareholders would not need to consider any 

pertinent extraordinary corporate events or the relation of the offer price to a 

market price. Instead, the chief concern would be to ensure that shareholders 

receive enough advance notice to decide whether they want to tender their shares 

and can return their tender forms to the company by the date of the termination 

of the repurchase offer. It may be appropriate for the length of the notice period 

to vary depending on the frequency of repurchase offers: investors may need 

more advance notice if a company makes repurchase offers annually rather than 

quarterly. 

Second, should there be a mandated minimum or maximum interval 

between the date by which shareholders must tender shares (the cut-off date) and 

the date by which the company makes payment, and, if so, how long should the 

interval be? Certainly some advance notice would be necessary to provide 

"Cf. Guide 2 to proposed revisions to Form N-2, Inv. Co. Act Rel. 17091, supra note 63. 

lWSee also rule 14e-l(a), (b). 

448 CHAPTER 11 

, 
enough time for the portfolio manager to adjust the portfolio without depressing 

the value of portfolio securities, but the length of time may vary depending on 

the liquidity of a given company's portfolio. Commenters have suggested a range 

of intervals, generally between thirty and sixty days:" that range suggests that 

it may be appropriate to leave companies some flexibility to set the terms of 

repurchase offers. Currently, repurchases made as issuer tender offers are subject 

to a requirement of "prompt" payment; the rules do not expressly mandate a 

period for payment but the Commission generally has interpreted the term 

"prompt" as requiring payment within five business days.'O2 

Third, when should the repurchase price be calculated? Currently, closedend companies making tender offers repurchase their shares at the net asset value 

calculated as of the close of business on the date on which the offer expires, but 

certain factors raise questions whether that is the most appropriate date for 

determining net asset value. Pricing shares at or near tender would allow 

shareholders who tender their shares to "lock in" their prices. Thus, they would 

not participate either in future losses experienced by other shareholders, or in any 

potential gains. If, however, exiting shareholders receive repurchase proceeds 

based on asset valuations calculated before the actual sales take place, remaining 

"'See, eg., ABA Comment, supra note 87, at 22 (30 to 60 days); Davis Polk Study Comment, 

supra note 87 (30 days); Merrill Lynch Study Comment, supra note 87 (not more than 60 days). 

See also Letter from Ronald L. Gallatin, Managing Director, Shearson Lehman Hutton, to Richard 

Ketchum, Director, Division of Market Regulation, SEC (Oct. 18, 1989) (suggesting that 21 days 

would be sufficient, including 14 days between the cut-off date and the valuation date, and seven 

days between valuation and payment). Mr. Gallatin provided the following diagram illustrating 

his proposed schedule for repurchases: 

Regular Way Sale of 

Notice Period Securities by Fund Valuation Date Payment Date 

I I I I 

Day -14 Day 0 Day 14 Day 21 

ImThe Commission has stated that there is not a single standard for what constitutes prompt 

payment under rules 14e-1 and 13e-4: 

The Commission recognizes that the operation of this standard will be affected 

by the practices of the financial community and the following factors: current 

settlement, handling and delivery procedures relating to tenders made by 

guaranteed deliveries by appropriate institutions; procedures to cure technical 

defects in tenders; and the application of the Hart-Scott-Rodino Antitrust 

Improvement Act of 1976 and the rules promulgated thereunder. 

Tender Offers, Exchange Act Release No. 16384, at text accompanying nn 34-35 (Nov. 29, 19791, 

44 FR 70326, 70337 (adoption of amendments to tender offer rules). For the interpretation that 

"prompt" payment generally requires payment within five business days, see id. at n.36. 

Repurchases and Redemptions of Investment Company Shares 449 
shareholders' holdings may be diluted if it turns out that the assets sold did not 

garner the proceeds predicted for them at the time of pricing. 

Alternatively, if shares are priced closer to the date of payment, there is a 

more accurate match between the price paid for repurchased shares and amounts 

realized upon disposition of portfolio securities sold to pay repurchase proceeds. 

In addition, shares that are tendered participate proportionally in the company's 

gains and losses during the payout period. On the other hand, shareholders who 

tender their shares for repurchase would assume the risk of market changes for 

extended periods after they have tendered their shares.lo3 

Certain of those factors may assume greater weight to the extent that 

closed-end portfolios include securities that are less liquid or have less reliable 

valuations. To that extent, there is a greater risk that the amount realized upon 

disposition to meet redemptions might differ significantly from the amount 

estimated in calculating net asset value at the time of tender by shareholders. On 

the other hand, this risk may be reduced by requiring that a company already 

have sufficient liquid assets to meet its repurchase commitment by the time a 

repurchase offer is made. 

e. Repurchase and Offering Price 

The Division recommends that any rule for closed-end repurchase offers 

should require the repurchase price to be based on net asset value. This 

requirement would be consistent with the current practice of closed-end company 

periodic tender offers, which offer to repurchase shares at a price based on net 

asset value.lo4 Moreover, the basic rationale for the Commission's allowance 

of closed-end company share repurchases is to provide a mechanism for 

shareholder liquidity at net asset value. 

The requirement to base the repurchase price on net asset value need not 

preclude the imposition of certain charges on redemption. First, the rulemaking 

should address whether closed-end companies making repurchase offers may 

1 ImThe rule would require forward pricing, that is, pricing after shareholders have tendered 

their shares. 

'O4See, e.g., Pilgrim Prime Rate Trust, Offer to Purchase, supra note 98, at 1. The use of net 

asset value has departed from traditional practice in other issuer tender offers. First, tender offers 

generally must state a fixed dollar amount for the price offered because schedule 13E-4 in Item 

l(b) requires the issuer to state "the exact amount of such securities being sought and the 

consideration being offered therefor." For most portfolios, stating a dollar amount would not be 

possible if the offer is to be made at net asset value. But see, eg., Baldwin Securities Corporation 

(pub. avail. Dee. 24, 1986) (exemption granted for tender offer by closed-end company where 

consideration would be adjusted net asset value). 

450 CHAPTER 11 
impose distribution charges comparable to contingent deferred sales loads:05 

currently, some closed-end companies making repurchase tender offers impose 

comparable early withdrawal charges. The rulemaking also should consider the 

appropriate treatment of exchanges into or from affiliated investment companies. 

Similarly, a net asset value requirement need not preclude companies from 

charging any scheduled fee reasonably necessary to compensate the investment 

company for the costs incurred in disposing of portfolio securities to generate 

cash to pay for repurchases.lo6 

Likewise, the price of shares sold by closed-end companies making 

periodic repurchases should be based on net asset value. Such a requirement is 

necessary to comply with section 23(b), which generally prohibits closed-end 

companies from offering shares at prices below net asset value. Section 23(b) 

safeguards shareholders against dilution that would occur if subsequent 

purchasers were to buy shares at prices lower than the asset value of shares held 

by existing shareholders. This requirement coupled with those relating to the 

determination of the repurchase price, should preclude manipulation of the price 

of the company's shares and avoid a number of the abuses noted in the 

Investment Trust Study?07 

If closed-end companies are to base their repurchase and offering prices on 

net asset value, they should calculate net asset value on a regular basis, perhaps 

linked to the periodicity of the repurchase offers. While rule 22c-1 requires openend funds to determine net asset value every business day, closed-end companies 

are not required to price their shares more often than quarterly (for reporting 

purposes). Many closed-end corn anies, however, do voluntarily calculate and publish net asset values weekly. lOl: 

Io5A related issue would be whether to permit closed-end companies to vary scheduled 

deferred charges for certain classes of shareholders as open-end companies may do with front-end 

loads under rule 22d-1, 17 C.F.R. 5 270.22d-1. For closed-end companies making issuer tender 

offers, rule 13e-4 originally was interpreted as prohibiting variation in early withdrawal charges 

(comparable to contingent deferred sales loads). See Michael Berenson, The Experience of Loan 

Participation Funds -- Insights fur the 2990s, 1990 MUTUAL FUNDS AND INVESTMENT MANAGEMENT 

CONFERENCE, at IX-12 to IX-13. The %est price" rule (rule 13&(f)(8)) requires that "the 

consideration paid to any security holder pursuant to the tender offer is the highest consideration 

paid to any security holder during such tender offer." 

laopen-end companies may impose similar redemption fees. See Offers of Exchange 

Involving Registered Open-End Companies, Investment Company Act Release No. 17097, at n.37 

(Aug. 3,1989), 54 FR 35177 (adopting rule lla-3). 

'@See supra Section ILA.l. 

Io8Net asset values compiled by Lipper Analytical Services and the IC1 appear each week in 

Bawon's. Weekly listings also appear in the Wall Street Journal every Monday. 

Repurchases and Redemptions of Investment Company Shares 451 
2. Repurchase Offer Filing Costs 

Under rule 13e-4, in preparing and filing tender offer materials with the 

Commission, closed-end issuers incur costs that open-end companies do not bear. 

For loan participation funds that make tender offers every quarter, filing fees can 

become a significant expense.log To minimize the filing fee, closed-end issuers 

file tender offers for less than the total of their outstanding shares, then stand 

prepared to extend the tender offer if shareholders tender more shares than the 

registered amount. The practical effect of the fee requirement is that closed-end 

companies must pay one fee to register shares and a second to repurchase them. 

While the same requirement applies to non-investment company issuers, tender 

offers typically are extraordinary events for those issuers. By contrast, under the 

proposed repurchase procedures, closed-end companies would be unique because 

they alone would make periodic repurchase offers as a means of providing 

shareholder liquidity. 

Closed-end company periodic repurchases would not be subject to those 

filing requirements, if the Commission exempts closed-end companies making 

periodic repurchases from rule 13e-4, as recommended above. 

3. Offerings by Closed-End Companies 

Closed-end companies conducting periodic repurchases may need to raise 

additional equity. Otherwise, as their equity shrinks, their expense ratios will 

rise, harming their investtnent return. Moreover, an inflow of new capital can 

give a company greater flexibility in managing its portfolio by reducing the 

pressure to sell portfolio securities to meet repurchases. As discussed above, 

several closed-end companies that make periodic repurchases also conduct 

continuous offerings of their shares. These companies register their shares under 

rule 415(a)(l)(ix) under the Securities Act, which permits a continuous offering 

provided that the offering begins promptly and lasts more than thirty days. 

Although this rule allows continuous offerings to take place, it is an imperfect 

mechanism. The rule does not contemplate periodic offerings, although at least 

one closed-end company has agreed to abstain from offering or selling its shares 

during certain brief periods as a condition of exemption from rule lob-6 

(discussed below).'" A closed-end company registered under this section also 

may have to halt continuous offerings temporarily, if, for example, material 

lOgFiling fees for tender offers under rule 134 are calculated at a rate equal to 1/50th of one 

percent of the amount to be purchased. 

"%errill Lynch High Income Municipal Bond Fund, Inc. (Oct. 26,1990). 

452 CHAPTER 11 
changes occur that require it to file an amendment to the registration 

statement?" 

Closed-end companies cannot qualify for rule 415(a)(l)(x), which allows 

continuous or delayed offerings by registrants that register on Form S-3 or Form F-3 

(the so-called "short form registrations") because closed-end companies are not 

eligible to use those registration forms. But for this problem, rule 415(a)(l)(x) 

would provide a convenient method for closed-end companies to plan to make 

intermittent, rather than continuous, offerings. Such an ability would allow 

closed-end companies to coordinate the timing and amount of repurchases and 

sales, thus facilitating greater control over portfolio management. 

Accordingly, the Division recommends that the Commission amend rule 

415 to provide express au oriza tion for closed-end companies making periodic 

repurchase offers to make delayed or continuous offerings>l2 As an 

alternative, it might be appropriate to impose on closed-end companies 

registration requirements comparable to those applicable to open-end funds, 

separate accounts, or unit investment trusts under rules 485,486, and 487 of the 

Securities Such a procedure would expedite the filing by closed-end 

companies of amendments for the purpose of updating financial statements. 

4. Rule lob-6 

If a closed-end company offers shares continuously, it currently cannot 

conduct tender offers without exemptive relief from rule lob-6 under the 

Exchange Act. Rule lob-6 generally prohibits persons involved in a securities 

offering from purchasing shares until after their participation in the offering is 

c0mp1ete.l'~ The rule's purpose is to prevent persons interested in the 

"'This is the practice of a limited number of venture capital business development companies 

structured as closed-end limited partnerships that hold multiple closings, typically when the 

companies are making a significant investment, such as in connection with "mezzanine financing" 

of friendly leveraged acquisitions and similar transactions. Each time these issuers make a 

material investment, they halt sales until they file a post-effective amendment to their registration 

statement and updated disclosure becomes available. 

'I2See Merrill Lynch Study Comment, supra note 87, at 111-9. 

'1317 C.F.R. §§ 230.485, ,486, .487. 

'I4The provisions of rule lob-6 do not apply to redeemable securities issued by an open-end 

investment company. See rule lOb-6(d). 

Repurchases and Redemptions of Investment Company Shares 453 
distribution from "artificially conditioning the market for the securities in order 

to facilitate the distribution."l15 

In light of rule lob-6, closed-end companies seeking to periodically 

repurchase their shares are faced with the choice of either seeking exemptive 

relief or interrupting their continuous offerings so that the rule does not apply. 

Neither alternative is entirely satisfactory. Obtaining exemptive relief from rule 

lob-6 imposes additional costs and delays. Interrupting an offering also is 

problematic, since rule 415 does not permit closed-end companies to conduct 

periodic offerings. Each closed-end company that makes periodic repurchases has 

obtained an exemption from the prohibitions of rule lob-6. These exemptions are 

subject to requirements designed to prevent manipulation, 

requirement that there be no secondary market for the company's shares." includinE a 

The Division recommends that the Commission exempt closed-end 

companies making repurchase offers from rule lob-6, thus building upon the 

exemptions previously granted.'I7 These repurchases would not involve any 

djal for "artificially conditioning the market for the securities" -- the primary 

that rule lob-6 was intended to prevent;l8 The Commission has stated 

at rule lob-6 was "designed to protect the integrity of the securities trading 

For investment 

companies, however, net asset value provides an independent pricing mechanism 

rket as an independent pricing mechanism. . . . 11119 

"%'rohibition Against Trading by Persons Interested in a Distribution, Exchange Act Release 

116Pilgrim Prime Rate Trust (Aug. 23,1988), Eaton Vance Prime Rate Reserves (July 14,1989), 

Van Kampen Merritt Prime Rate Income Trust (Sept. 27, 19891, Merrill Lynch Prime Fund (Oct. 

24, 1989), and Allstate Prime Income Trust (Nov. 21, 1989). See also Emerging Markets Growth 

Fund, Inc. (Aug. 13,1991), and Merrill Lynch High Income Municipal Bond Fund, Inc., supra note 

110. The two latter exemptions involved additional requirements. First, neither the company, its 

principal underwriter, or any other broker-dealer may conduct any offers or sales of the 

company's shares during the last five business days of any tender offer. Second, the Merrill 

Lynch exemption provides that the company may not purchase any municipal bonds that are 

unrated, or are not considered investment grade, during the last five business days of any tender 

offer, except for bonds that are part of a new issue. We understand that this second requirement 

responds to concerns of the Division of Market Regulation that purchases of relatively illiquid 

portfolio securities might present the potential for manipulation of the price of securities held in 

the fund's portfolio and hence of net asset value. 

No. 24003, section I Uan. 16, 1987),52 FR 2994 (adopting amendments to rule lob-6). 

Il7The rulemaking proceeding also should address the question of to what extent it would be 

appropriate to permit secondary market activity in the shares of closed-end companies making 

periodic repurchase offers. 

"'Exch. Act Rel. 24003, supra note 115. 

1191d., 52 FR at 2994. 

454 CHAPTER 11 
that distinguishes investment companies from all other issuers. This mechanism 

is based upon the values of the underlying portfolio assets and is not affected by 

the terms of a repurchase offer or of a distribution by an investment company. 

Accordingly, sales and repurchases at net asset value, properly computed, do not 

necessarily implicate the concerns of rule lob-6, as evidenced by the rule’s express 

exemption for redeemable securities issued by open-end companies. The policies 

that underlie the exemption of open-end shares also support the exemption of 

shares of closed-end companies that make periodic repurchases at a price based 

on net asset value. 

5. Leverage 

The issuance of senior securities by a closed-end company that periodically 

repurchases its shares presents two concerns. First, unless new equity is raised, 

repurchases will shrink the company’s asset base, effectively increasing leverage 

and the riskiness of senior securities. Second, section 18(a) of the Act requires 

that the terms of senior securities prohibit repurchases of common stock if the 

repurchases would reduce the asset coverage below the required level. This 

prohibition creates potential uncertainty regarding scheduled repurchases of 

common stock. It was intended to respond to closed-end company practices in 

the 1920’s and 1930’s, when companies sometimes issued senior securities to the 

public, then repurchased common shares, leaving the senior securities holders 

with speculative instruments. If a scheduled repurchase would reduce the 

company’s asset coverage below that required, the repurchase cannot occur unless 

the company takes other steps, such as retiring senior securities or selling 

additional common stock. There might be investor confusion if closed-end 

companies were to schedule repurchases only subject to the proviso that 

repurchases would not occur if they would reduce asset coverage below that 

required by section 18. 

Accordingly, a repurchase rule for closed-end companies must ensure both 

that repurchases do not impair necessary asset coverage and that companies’ 

levels of senior securities do not inhibit the companies’ ability to meet their 

repurchase commitments. Accordingly, the Division recommends that closed-end 

companies making periodic repurchases should be limited to bank borrowing12’ 

‘20Some of the closed-end companies that make periodic repurchase offers have bank lines of 

credit to provide financing for their tender offers. Even if these companies do not use these 

sources of financing, the commitment fees can add to shareholder expenses. In rulemaking it may 

be appropriate to consider whether any limitation beyond the provisions of section 18 should be 

imposed on the use of borrowing to fund the repurchase of shares or on the allocation of 

borrowing expenses between shares that are tendered for repurchase and those that remain. 

Repurchases and Redemptions of Investment Company Shares 455 
under the same standards that apply to open-end funds?21 This requirement 

would ensure that a company could make the maximum permitted repurchase 

offer without running afoul of the requirements of section 18. 

B. Limited Redemption Investment Companies 

The Division also recommends that the Commission adopt rules providing 

carefully circumscribed exemptions from the requirement in section 22(e) that 

open-end companies pay redemption proceeds within seven days. To satisfy this 

requirement, open-end companies generally must maintain a relatively high 

degree of portfolio liquidity in order to pay redemption proceeds within seven 

days?= Thus, investment companies purchasing less liquid securities, notably 

companies investing in foreign securities, generally register as closed-end 

companies despite the perceived disadvantages of the closed-end form. Pursuant 

to the Commission's exemptive authority under section 6(c) of the the 

recommended rule would enable companies issuing redeemable securities and 

investing in securities with limited liquidity to operate within the open-end form 

with more limited redemption requirements than those traditionally applicable to 

mutual funds. Hence, we would use the term "limited redemption investment 

company" to refer to open-end companies that would operate under the rules that 

we recommend. 

We have identified two major forms that a limited redemption investment 

company could take. The first form, referred to as the "extended payment" 

'*lSuch an approach would follow the provisions of the exemptive order in Wisconsin 

Investment Company, 10 S.E.C. 555 (1941), in which the Commission permitted a closed-end 

company, which continuously offered its shares, to make periodic repurchases without complying 

with the predecessor of rule 23c-1, provided the company complied with provisions of the Act 

that are applicable only to open-end companies. 

'=The Commission has stated that open-end investment companies may hold no more than 

15% of their assets in illiquid assets. See Guide 4 to Form N-lA, supra note 34. 

IB15 U.S.C. 5 80a-6(c). The Commission has previously granted exemptions from section 22(e) 

to permit issuers investing in less liquid securities to pay redemption proceeds on an intermittent 

basis or in longer than seven days. See, e.g., American Federation of Labor and Congress of 

Industrial Organizations Mortgage Investment Trust, Investment Company Act Release Nos. 10650 

(Mar. 30, 1979) (Notice of Application), 44 FR 21094, and 10674 (Apr. 26, 1979) (Order) 

(redemptions only during period preceding quarterly valuation dates of commingled trust fund 

investing in loans to union built housing); Mutual Investment Fund of Connecticut, Inc., 

Investment Company Act Release Nos. 2457 (Dec. 12,1956) (Notice of Application), and 2465 (Dec. 

31,1956) (Order) (investment fund for Connecticut savings banks might limit redemptions on any 

one day, and by-laws provided for seven business days to pay redemptions); Savings Bank 

Investment Fund, 24 S.E.C. 531 (1946) (Order) (mutual investment fund for Massachusetts savings 

banks invested in mortgages and other assets and might take ten days to pay redemption 

requests). 

456 CHAPTER 11 
company, would offer to redeem its shares every day subject to a rolling payout 

period of, for example, thirty days that would begin to run for each shareholder 

on the day the shareholder presents shares for payment. Otherwise, the extended 

payment company would operate like a traditional open-end company. Extended 

payment companies would accept shares for redemption daily, would be subject 

to daily pricing requirements, and most likely would offer and sell securities 

continuously, just like open-end companies. 

The second form of limited redemption company, referred to as the 

"interval" company, would redeem shares periodically at set intervals, such as 

monthly or quarterly. In order for interval companies to be able to manage their 

portfolios and have cash available to meet redemptions, the Division recommends 

that they be permitted to require shareholders to give a reasonable amount of 

advance notice before redeeming. Interval companies have the potential 'to be 

more complex. Because they would redeem only periodically, some interval 

companies may wish to adopt procedures for selling new shares other than daily. 

Beyond those general points, the Division has not set forth in detail all of 

the requirements of a rule permitting limited redemptions. There are no 

operating models upon which to base assumptions as to what kinds of portfolios 

sponsors would wish to offer and what kinds of modified redemption features 

investors would want or accept. Accordingly, many of the specifics must be 

worked out through the rulemaking process. The following discussion addresses 

several of the chief considerations regarding the operation of both types of limited 

redemption companies to be addressed during the rulemaking process. 

1. Pricing of Shares for Redemption 

For both extended payment and interval companies, the time between the 

date of tender and the date of payment would extend beyond the seven day 

maximum for traditional mutual funds. This extended period raises several 

concerns in determining the appropriate time to calculate redemption prices for 

these companies. Even with mutual funds, the value of a fund's assets can 

fluctuate between the time a shareholder places a redemption order and the time 

net asset value is determined, as well as over the seven days between the day the 

order is given and the date by which the fund must make payment. Thus, 

shareholders may be priced out of the fund based on asset values that decline 

significantly before redemption proceeds are actually paid or before portfolio 

securities are actually sold. Excluding periods of market volatility, however, the 

amount of fluctuation generally is small so that market changes cause minimal 

change in either the net asset value paid for redeeming shares, or the net asset 

value of remaining shares. With a longer period of, for example, fourteen or 

thirty days, the range of possible fluctuation is much greater. 

Repurchases and Redemptions of Investment Company Shares 457 
Like closed-end company repurchase offers, limited redemptions raise 

several concerns in deciding whether pricing should be calculated closer to the 

date of tender or to the date of payment. The most equitable method of pricing 

may depend, in part, upon the liquidity and composition of the portfolio. For 

example, thirty day "rolling" redemptions (of the extended payment type) would 

be most feasible in cases where the company's portfolio contains securities that 

are traded in formal marketplaces, such as overseas exchanges. While such a 

company would need a longer payout period to accommodate overseas settlement 

and currency exchange procedures, the company would be reasonably assured of 

obtaining accurate prices daily. Thus, an extended ayment company might be 

able to price redemptions near the time of tender. 129 

Redemptions at periodic intervals, however, may be preferred where the 

company's portfolio securities are thinly traded and valuations based on actual 

market transactions are not available. Limiting redemptions to set periods, with 

advance notice of redemptions from shareholders, may be needed for the 

manager to plan for redemptions and, at the same time, manage the portfolio 

with the least disruption. Because portfolio transactions would be more 

concentrated around specific redemption periods, and because pricing would be 

less reliable, it may be more e uitable for the company to price redemptions close 

to the payment of proceeds. 125 

Thus, different portfolios may be able to price redemptions fairly and 

accurately according to different procedures. In the rulemaking process, the 

proposing release should seek information regarding the portfolio management 

practices of companies that invest in less liquid securities. The Division also 

recommends that the Commission request comment regarding the level of 

liquidity necessary to deal effectively with limited redemption procedures. 

Finally, the Commission should request comment regarding the most equitable 

way to price redemptions. 

I2?o the extent, however, that a company with substantial foreign investments relied upon 

receipt of proceeds from selling securities abroad, the precise amount of those proceeds may vary 

with currency exchange rate fluctuations. In such circumstances, pricing near the time of tender 

might not provide the most equitable treatment. 

lxCf. Memorandum accompanying Letter from the Investment Company Institute to Jonathan 

G. Katz, Secretary, SEC 3-4 (Aug. 8,19911, File No. S7-11-90 [hereinafter IC1 Aug. 8,1991 Study 

Comment] (discussing different options for periodic redemption procedures). The IC1 argued that 

the timing of pricing should be left to the business judgment of fund management. At least 

initially, we question whether this deference would provide adequate investor protection. 

458 CHAPTER 11 
2. Interval Company Notice of Redemption 

As noted above, an interval company would redeem shares periodically on 

set dates, such as monthly or quarterly. While the length of the interval would 

be determined by the company, the Division believes that it should be an easily 

recognizable period and, at least at the outset, one of a limited choice of intervals 

(eg., biweekly, monthly, or quarterly, not every twenty-three days). The Division 

recommends that interval companies be permitted to require redeeming 

shareholders to provide notice in advance of the specified redemption date. 

Advance notice would enable managers to adjust their portfolios to accommodate 

redemptions. 

We expect that the period between shareholder notice and redemption 

payment might vary depending on the length of the interval. Companies with 

different portfolio composition may require different notice periods. For example, 

the less liquid the company’s portfolio, the more notice the manager likely would 

need. We anticipate that at most thirty days’ notice would be sufficient for most 

interval companies. Longer periods in all likelihood would be undesirable from 

the investor’s standpoint. The longer payout period allowed for interval 

companies would be in lieu of, and not tacked onto, the seven-day period 

required by section 22(e). 

This requirement would depart significantly from the current practice of 

open-end companies. Because shareholders would have to be aware of the 

company’s redemption dates and notice procedures, the rule should require the 

company to establish and disclose the notice period and the terms and conditions 

surrounding notice as matters of fundamental 

3. Pricing Procedures for Issuing Shares 

The Division anticipates that limited redemption companies generally 

would offer new shares continuously, much like traditional open-end companies, 

and recommends that such companies should be required to price their shares 

daily under rule 22c-1 to the extent fea~ib1e.l~~ The task of pricing less liquid 

portfolio securities, however, may be so time-consuming and expensive that daily 

pricing may not be feasible for some companies wishing to use the interval form. 

Industry representatives have advised us that some companies may prefer to 

I2%ee supra note 92 (regarding treatment of closed-end procedures as matters of fundamental 

policy). 

lWThe Act itself does not require daily pricing. The Commission instituted the daily pricing 

requirement pursuant to its authority in section 22(c) to make rules concerning the pricing of 

redeemable securities. Closed-end companies are required only to compute prices quarterly for 

reporting purposes, although many voluntarily price weekly for publication in the trade press. 

Repurchases and Redemptions of Investment Company Shares 459 
forego offering new shares continuously to avoid the burden of daily pricing.12* 

Thus, some limited redemption companies, especially interval companies, may 

prefer to determine the prices of shares, and issue new shares, less frequently 

than daily. Accordingly, the Commission may need to modify rule 22c-1 or adopt 

new procedures specifically governing the pricing of sales of shares of limited 

redemption companies. 

Some interval companies might wish to limit their sales to specific days or 

~eri0ds.l~~ For example, some companies might wish to offer continuously, but 

to issue new shares at set "closings" that are scheduled weekly, monthly, or 

according to some recognizable interval. This option would be similar to a 

practice engaged in by certain closed-end companies.130 Other companies 

might prefer to offer and sell new shares only during certain periods. This option 

would allow interval companies to coordinate redemption and offering periods, 

and thus to offset shrinking assets with cash from sales of new shares. For 

example, an interval company might offer new shares only during the period 

from the deadline for redemption requests until the date redemption proceeds are 

paid. Still other companies might prefer to arrange their offering periods to 

coincide with times when the companies expect that attractive investment 

opportunities might be available. 

Such limitations raise significant questions about the extent to which 

Commission rules governing limited redemption pricing should prescribe clear 

limitations or grant issuers operational flexibility. The first question is the 

minimum frequency of pricing. To ensure fairness to shareholders and to provide 

'%See IC1 Aug. 8, 1991 Study Comment, supra note 125. Rule 22c-l(b) requires issuers of 

redeemable securities to calculate net asset value daily (excluding weekends and holidays) except 

on (i) days on which changes in the value of the investment company's portfolio securities will 

not materially affect the current net asset value of the investment company's redeemable 

securities; or (ii) days during which no security is tendered for redemption and no order to 

purchase or sell such security is received by the investment company. Interval companies may 

be able to use the second exception. 

12%othing in the Investment Company Act would require an interval company, as an issuer 

of redeemable securities, to engage in continuous offerings. Open-end companies have stopped 

offering new shares in certain circumstances, such as when their assets are so large that it is 

difficult to maintain investment returns or find investments that are consistent with investment 

objectives. 

130Certain registered closed-end limited partnerships have combined continuous offerings and 

multiple closings to offer participations in portfolios composed of securities issued in conjunction 

with the so-called "mezzanine financing" of leveraged acquisitions and similar transactions. These 

offerings were registered on Form N-2, in compliance with rule 415 under the Securities Act. 

Because interval companies would be regulated as open-end companies, and since rule 415 does 

not apply to open-end funds, compliance with rule 415 would not be necessary. 

460 CHAPTER 11 
reliable information in connection with any secondary market that may 

develop>31 however, the Division recommends that companies be required to 

calculate the price of their shares according to some minimum schedule -- if not 

daily, then perhaps at least weekly -- whether or not they are currently selling 

new shares. The reasonableness of such requirements would be explored during 

the rulemaking process. In addition, interval companies whose shares are traded 

in secondary markets may be required to recalculate the price of their shares if 

there is reason to believe that net asset value has changed materially. 

Another question is when new shares would be priced vis-84s 

redemptions. With open-end companies, both redemptions and sales are priced 

daily and, thus, incoming and outgoing shareholders receive the same price. In 

a "multiple closing" situation, however, a company may wish, for example, to 

price sales every Friday and redemptions on the last day of each quarter (a 

redemption date) whether or not it falls on a Friday. In the case of a company 

selling new shares only during redemption payout periods, depending on when 

the company prices redemptions, investors coming into the com an ma or may 

not receive the same price as investors exiting the company32 'In Le latter 

case, at least, it may be fair to require that the same price apply to both incoming 

and outgoing investors, and hence that purchases of shares and redemptions take 

place only on the designated redemption date. In addition, the Division believes 

that, to avoid serious investor confusion, selling and redemption periods should 

be arranged according to easily recognizable schedules. 

Finally, another question is whether the Commission should require 

companies to establish an appropriate mechanism for handling orders for new 

shares between sale dates. Escrow accounts or temporary investment in affiliated 

money market funds may provide such a mechanism. The rulemaking process 

should provide a clearer picture of how these mechanisms might work and of 

whether such mechanisms would increase administrative costs, and hence 

shareholder expenses. In addition, escrow accounts or temporary investments 

may also raise questions about investor's legal relationship with the company and 

rights in the company's securities. 

8, we recommend the repeal of the retail price maintenance provision of section 

22(d) of the Act, 15 U.S.C. 5 80a-22(d); that repeal would permit the development of secondary 

markets in open-end company shares. Pending legislative action, however, the Division 

recommends that the rule proposal for limited redemption companies address whether to exempt 

some or all limited redemption companies from section 22(d). 

132The Investment Company Institute suggested that companies that do not price on a daily 

basis should effect purchases only upon the designated redemption dates in order to give the 

same price for both purchases and redemptions; the IC1 stated its impression that this is the 

practice of many illiquid private funds and bank collective funds. IC1 Aug. 8, 1991 Study 

Comment, supra note 125, at 4. 

Repurchases and Redemptions of Investment Company Shares 461 
4. Regulation As Open-End Companies 

Both extended payment and interval companies would be regulated as 

open-end companies. As such, these companies would be subject to the open-end 

leverage restrictions of section 18. They would be permitted to impose assetbased distribution fees as provided under rule 12b-1 under the In 

addition, we anticipate that all limited redemption companies would register their 

shares on Form N1-A and, in doing so, would be able to use the provisions of 

sections 24(e) and 240 of the Act and the rules there~nder.'~~ 

To prevent investor confusion between such limited redemption companies 

and traditional open-end companies, limited redem tion companies should be 

investors would not mistake the new companies for traditional mutual funds, the 

redemption and offering features of each company should be prominently 

disclosed. Extended payment companies pose the greatest risk that investors 

would confuse them with traditional open-end companies; the major difference 

between them would be the time in which the company is required to pay 

redemption proceeds. It is critical that investors understand this difference before 

they invest. The Division believes, however, that investors are capable of 

understanding the consequences of investing in an extended payment company 

and that, with appropriate disclosure requirements, investors quickly would learn 

to consider the length of a company's redemption period in deciding whether to 

invest. Interval company prospectuses should disclose the redemption procedures 

prominently because they too would be a significant departure from the practices 

of open-end funds. 

prohibited from calling themselves "mutual funds." P 35 To further ensure that 

5. Market Disruption 

Interval companies could affect the markets adversely for certain portfolio 

securities by clustering portfolio transactions around specific redemption dates. 

For example, the market prices of portfolio securities could become artificially 

depressed in anticipation of heavy sales by the interval company, or the sales 

themselves could depress market prices, so that net asset value would be reduced, 

'%7 C.F.R. § 270.12b-1. 

13415 U.S.C. § 80a-24(e), (0. 

13%e term "mutual fund' historically has applied only to open-end management investment 

companies. See SEC, REPORT ON THE PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY 

GROWTH, H.R. Rep. No. 2337,89th Cong., 2d. Sess. 43 n.69 (1966). We believe that the investing 

public generally is unfamiliar with the term "open-end company" but has come to use the term 

"mutual fund to refer to open-end companies as those companies have operated traditionally. 

Our proposal would preserve that usage. 

462 CHAPTER 11 
and other investors in the same securities also would experience depressed asset 

values. Establishing appropriate liquidity standards may assist in preventing 

these market disruptions. In addition, it is possible to reduce the potential for 

clustering of portfolio transactions if the rule does not mandate that all companies 

redeeming at given intervals select the same payment dates; for example, if some 

companies that redeem monthly may do so on the first, while others may redeem 

on the fifteenth, transactions are more likely to be dispersed. 

C. Portfolio Liquidity 

The Division's recommendations raise a number of questions about the 

appropriate degrees of liquidity for different categories of investment companies. 

The importance of portfolio liquidity cannot be overstated for any investment 

company that redeems or periodically repurchases its shares. Recent experiences 

with open-end real estate unit trusts in Australia reaffirm the tremendous risks 

inherent with open-end issuers that do not hold sufficient liquid assets; several 

of those trusts collapsed following massive shareholder redemptions that 

exhausted any buffer of liquid investments that the trusts had maintained>36 

1. Current Liquidity Requirements 

Currently, the Commission's only liquidity standard is that an open-end 

company's aggregate holdings of illiquid assets must be limited to fifteen percent 

of the value of the fund's net assets?37 The Commission has stated and 

reiterated that an "illiquid security" generally is any security that cannot be 

disposed of within seven days in the ordinary course of business at approximately 

1361n the mid-1980'~~ Australian open-end investment trusts investing in real estate related 

assets attracted significant investment. Following an economic slowdown in 1989, problems 

developed in the Australian real estate markets, including bankruptcies of developers, and 

declines in property values and rental income. The Estate Mortgage group of real estate trusts 

faced significant redemptions during this period; because the bulk of the trusts' investments were 

in real estate development and construction lending, the trusts did not have sufficient liquidity 

to meet the run of redemption demands. In April, 1990, regulators permitted the trusts to 

suspend redemptions. Subsequently, the Australian National Companies and Securities 

Commission (now the Australian Securities Commission) promulgated guidelines imposing 

liquidity standards on open-end trusts. Alan Cameron & Jennifer Puhach, Unlisted Property Trusts 

Down Under, INT'L FUND FORUM (Jan. 1991) (enclosure in letter from Allan S. Mostoff to Matthew 

A. Chambers, Assistant Director, Division of Investment Management, SEC (Feb. 20, 1991), File 

NO. S7-11-90). 

137See Guide 4 to Form N-lA, supra note 34. 

Repurchases and Redemptions of Investment Company Shares 463 
the amount at which the company has valued the instrument (the "seven day 

~tandard").'~~ 

No comparable liquidity standard has developed for closed-end companies. 

Because they do not issue redeemable shares, they have not needed the same 

capacity to raise cash promptly. Moreover, many closed-end companies serve as 

a vehicle for investing in less than fully liquid securities. At the same time, 

however, managers of other closed-end companies have kept their portfolios 

highly liquid in order to be able to take advantage of investment opportunities 

that may arise. 

2. Proposed Statutory Liquidity Requirement 

The purpose of the liquidity standard for open-end funds has been to 

ensure that such funds have capacity to meet redemptions pursuant to the 

requirement in section 22 that repurchase payment be made to shareholders 

within seven days following tender for redemptionJ3' The Division believes 

that, as a general matter, any investment company that holds itself out as ready 

to redeem or repurchase its shares on a periodic basis should be required to have 

sufficient liquidity to meet those demands without causing material deviations 

from the valuation of its portfolio assets:40 Accordingly, the Division 

recommends that express liquidity standards be established for all management 

investment companies that redeem or periodically repurchase their shares. 

Specifically, the Division recommends that the Commission seek legislation to 

amend section 12 of the Investment Company Act to impose an express liquidity 

requirement on open-end companies and on those closed-end companies that 

138Acquisition and Valuation of Certain Portfolio Instruments by Registered Investment 

Companies, Investment Company Act Release No. 14983, section II.A.4 (Mar. 12,1986), 51 FR 9773 

(adopting amendments to rule 2a-7); Sec. Act Rel. 6862, supra note 34, at II.F, 55 FR at 17940. See 

also guides 12 and 13 of the guidelines to Form N-1A stating the view that "real estate for which 

there is no established market" and "debt securities for which there is not established market" 

should be included in the limit on illiquid assets; and Guidelines for the Preparation of Form 

N-8B-1, Investment Company Act Release No. 7221 (June 9,1972),37 FR 12790 (guidelines for the 

preparation of Form N-8B-1, a predecessor to Form N-1 A), counting restricted securities, interests 

in real estate, and commodities futures contracts toward the limit on illiquid investments. 

1391nv. Co. Act Rel. 5847, supra note 34. 

'+bus, appropriate liquidity standards should address the same concerns as the portfolio 

liquidity requirements in the rule lob-6 exemption for Merrill Lynch High Income Municipal Bond 

Fund, Inc., sup notes 110 and 116. 

464 CHAPTER 11 
periodically repurchase their shares.'41 The appendix to this chapter contains 

the Division's proposed new paragraph to be added to section 12 of the Act. 

As the proposed new paragraph indicates, however, the Division believes 

that the Act should not set specific requirements for each category of investment 

company. Specific requirements would run the risk of quickly becoming obsolete 

because of market changes. Rather, the Division believes that the statute should 

contain a general, self-effecting requirement that investment company portfolios 

have sufficient liquidity to meet any redemption or repurchase obligations. In 

addition, it should give the Commission authority to set specific liquidity 

requirements for different types of investment companies, including traditional 

open-end funds, limited redemption companies, and closed-end companies 

making periodic repurchases. While the final details of those requirements would 

emerge in the rulemaking process, the Division anticipates that the following 

issues would need to be addressed. 

a. Definition of Liquidity 

The current definition of portfolio liquidity applicable to open-end 

investment companies is a simple standard: a security either is liquid or is not, 

depending on whether it can be sold within seven days. The proposals outlined 

above, however, envision other categories of investment companies that would 

respond to shareholder tenders of shares on a less prompt and continuous basis 

than do mutual funds. Those other investment companies might need to satisfy 

different standards depending upon the degree of redeemability or 

repurchasability. For example, a different degree of liquidity may be necessary 

for a compan that redeems in seven days than for a company that redeems in 

thirty days. 14Y 

Rulemaking also might consider what weight to give to factors that 

traditionally have been viewed as indicating illiquidity. For example, restricted 

securities have generally been viewed as illiquid regardless of convertibility or 

14'Such requirements arguably could be promulgated by rule through amendments to rule 

22c-1, through any rulemaking defining the circumstances in which closed-end companies may 

make periodic repurchases, and through any rulemaking permitting limited redemptions. 

Nevertheless, we recommend that the Commission propose a statutory liquidity requirement in 

order to make clear the fundamental importance of the appropriate degree of liquidity in 

investment company portfolios. Pending the adoption of a statutory provision, however, it might 

be appropriate to include liquidity provisions in the recommended rules for limited redemptions 

and periodic closed-end repurchases. 

IQThis would be analogous to the approach recently taken by the Australian National 

Companies and Securities Commission, which promulgated special guidelines for unit trusts in 

August, 1990; under those guidelines, the required level of liquidity decreased as the redemption 

period increased. See Cameron & Puhach, supra note 136. 

Repurchases and Redemptions of Investment Company Shares 465 
fungibility with other securities. Such securities in fact may have varying degrees 

of liquidity, although they are not as liquid as, for example, New York Stock 

Exchange listed stocks. Conversely, even within the current category of liquid 

securities, some securities are more liquid than others. For example, securities of 

issuers with very large market capitalizations and securities that are designated 

components of an index such as the S&P 500 can be traded in very large blocks 

with minimal price effect; cash and cash equivalents have the highest liquidity of 

any assets. 

b. Valuation 

Another issue to be explored is whether the definitions of liquidity should 

also incorporate some degree of reliability of valuation. The current seven day 

standard implicitly requires reliable valuation since it requires that a security be 

sellable within seven days at approximately the amount at which a company has 

valued the security. It is not clear whether some liquidity standards should 

permit an intermediate degree of reliability, as would occur if a security's 

valuation were susceptible upon disposition to some deviation from the value 

currently assigned by the company to the security. It might be difficult to 

construct a definition of such permissible deviation since it could be expected to 

fluctuate depending on market 

D. Definition of Redeemable Security 

The proposed new redemption and repurchase procedures raise 

interpretive questions concerning the definition of "redeemable security" in section 

2(a)(32) of the Act. The definition is key to the distinction between open-end and 

closed-end companies because, under section 5, any management company that 

issues redeemable securities is an open-end company; conversely, a closed-end 

company may not issue redeemable securities. The first question is whether 

limited redemption rights, and in particular periodic redemptions, would be 

inconsistent with that definition. The second question is whether closed-end 

companies would issue redeemable securities if they offer to repurchase shares 

from investors at net asset value according to a set schedule; if so, then the 

company could not be a closed-end company. Although the recommended 

repurchase and redemption procedures depart from practices that traditionally 

have characterized the two categories of management companies, the Division 

believes that, under the procedures outlined above, the shares of limited 

'@Indeed, in some cases, the extent to which investment companies participate in certain 

markets can have a significant impact on the liquidity and pricing of the markets. This appears 

to have been the case in the last few years in the market for junk bonds, where recent new 

issuances and price increases have been attributed by some analysts to extensive purchases by 

mutual funds. See also George Anders, Junk Bond Issuance Soar to Hottest Pace Since '88, WALL ST. 

J., Dec. 2, 1991, at C1. 

466 CHAPTER 11 
redemption companies would be redeemable securities, while the shares of 

closed-end companies making periodic repurchase offers would not. 

1. Limited Redemption Rights 

Section 2(a)(32) defines a redeemable security as 

any security, other than short-term paper, under the terms of 

which the holder, upon its presentation to the issuer or to a 

person designated by the issuer, is entitled (whether 

absolutely or only out of surplus) to receive approximately 

his proportionate share of the issuer’s current net assets, or 

the cash equivalent thereof. 

Interpretive questions about what is a redeemable security have arisen 

primarily in the context of section 3(c)(5) of the which excepts certain 

companies from the definition of investment company provided, in part, that they 

do not issue redeemable securities. The chief characteristic that distinguishes a 

redeemable security is whether the security is redeemable at the option of the 

holder, rather than of the issuer. This is the direct implication of the statutory 

wording: the holder of a redeemable security is entitled to receive redemption 

proceeds upon presentation to the issuer. This distinction is also clear from the 

legislative history of section 3(c)(5), which was amended in 1970 to include the 

prohibition on issuing redeemable securities: 

. 

Thus, the proposed amendment would in no way affect companies 

which issue securities redeemable at the option of the issuer -- the 

conventional form of redeemable security commonly used in 

corporate financing. The amendment applies only to those 

companies which purport to model themselves after open end 

companies by issuing a security redeemable at the option of the 

holder. 145 

No-action letters have been issued to companies that voluntarily make a practice 

of redeeming securities, but do not give the holder an unqualified right to compel 

the company to redeem, on the basis that the companies had not issued 

~ 

1415 U.S.C. 5 80a-3(~)(5). Issuers relying on section 3(c)(5) also cannot issue face-amount 

certificates or periodic payment plan certificates and must be primarily engaged in certain 

specified types of businesses. 

1451NVEsTMENT COMPANY AMENDMENTS ACT OF 1969, S. REP. NO. 184,91st Cong., 1st Sess. 37 

(1969); INVESTMENT COMPANY AMENDMENTS ACT OF 1970, H.R. REP. NO. 1382,91st Cong., 2d Sess. 

17 (1970). 

Repurchases and Redemptions of Investment Company Shares 467 
redeemable securities and, thus, were eligible for the section 3(c)(5) 

exception.16 No-action relief has been declined for a section 3(c)(5) company 

that proposed to give investors the right to have their shares redeemed ninety 

days after presentment on the theory that a security which is redeemable in 

accordance with its terms is a redeemable security even though it is only 

redeemable four times per year.147 

The only question that arguably may remain is whether the definition 

requires a redeemable security to be redeemable at any time, i.e., essentially upon 

demand. Such an interpretation would be inconsistent with redemptions at 

intervals. The language of section 2(a)(32) does not expressly require constant 

redeemability, but it might be possible to infer such a requirement if the phrase 

"upon its presentation to the issuer" were interpreted to mean "at any time that 

a holder tenders securities to the issuer." This reading arguably finds support in 

the testimony of former Commissioner Healy in describing to Con ress in 1940 

the differences between open-end and closed-end companies. '48 Section 

2(a)(32), however, does not expressly require redemption requests to be honored 

at any time. Instead, any obligation to redeem on demand appears to arise under 

section 22(e) (concerning payment of redemption proceeds within seven 

not under section 2(a)(32). To the extent that redemption at intervals 

~~ 

'%eel eg., United Bankers, Inc. (pub. avail. Mar. 23, 1988); MBCH, Inc. (pub. avail. Dec. 16, 

1981); Salomon Brothers, Inc. (pub. avail. June 17,1985); Arthur D. Little, Inc. (pub. avail. Dec. 16, 

1971). 

147Huntoon, Paige & Co., Inc. (pub. avail. Nov. 28,1974). In addition, no-action letters under 

section 3(c)(5) have considered a number of other restrictions relating to the redeemability of 

securities; the specific details of the no-action requests have varied considerably. 

I4Healy remarked 

The peculiarity of open-end companies is that they issue so-called redeemable 

securities - that is, [a] security which provides that the holder may tender it to 

the company at any fime and receive a sum of money roughly proportionate to 

the current market value of his share of the company assets. 

1940 Senate Hearings, supra note 27, at 43 (emphasis supplied). Commissioner Healy's use of the 

phrase at any time arguably could imply that the holder of a redeemable security is entitled to 

receive redemption proceeds whenever the holder wishes, and that the company is not able to 

limit in any way that right. Nevertheless, Commissioner Healy's statements during the Senate 

hearings describing prior practices clearly do not constitute a definitive gloss on the subsequently 

enacted definition; for example, his description contemplates redemption only in cash, whereas 

section 2(a)(32) permits redemption either in cash or in kind, through the distribution of portfolio 

securities. 

149Section 22(e) provides that "[nlo registered investment company shall suspend the right of 

redemption, or postpone the date of payment or satisfaction upon redemption of any redeemable 

(continued. ..) 

468 CHAPTER 11 
might be considered a departure from the redemption rights that shareholders 

traditionall have had in open-end companies to redeem shares promptly on 

demand,15d;he Commission could always use its authority to promulgate rules 

clarifying the status under section 2(a)(32) of limited redemption companies, as 

well as the status of closed-end companies making periodic repurchase offers. 

The Division recognizes that it would be untenable to suggest that a 

security which is redeemable at the option of the holder in accordance with its 

terms is a redeemable security no matter what those terms are; such a position 

would give open-end companies carte blanche to impose all kinds of restrictions 

on redemption rights. For example, at some point, the interval between 

redemptions could become so long that the company should not be regarded as 

an issuer of redeemable securities. We have concluded, however, that redemption 

rights that are limited solely with respect to the times during which presentation 

will be accepted by the company, or the length of the delay before proceeds are 

received, do not offend the statutory scheme as long as the parameters of such 

rights are tightly controlled by rule to prevent possible harm to investors and to 

assure some degree of real redeemability. For this reason, the rule should require 

that an interval company redeem shares at one of several intervals specified by 

the rule, but no less frequently than quarterly. Companies wishing to provide 

liquidity to shareholders at longer intervals should not be able to operate as 

limited redemption companies but might be organized as closed-end companies 

using the repurchase rule. 

2. Periodic Repurchases of Closed-End Shares 

Conversely, the Division believes that repurchases of securities by closedend companies under the circumstances proposed would not render the securities 

redeemable within the meaning of section 2(a)(32). There is a critical difference 

between companies offering limited redemptions and companies committing to 

repurchase their shares. The former company's securities are redeemable because 

the redemptions are at the option of the security holder. The latter does not issue 

redeemable securities because the holder is not entitled upon presentation to the 

company to receive approximately his or her proportionate share of the 

company's net assets as required by section 2(a)(32). Rather, significant 

restrictions on the repurchases would apply, and control over most aspects of the 

149(...continued) 

security in accordance with its terms for more than seven days" except under specified 

circumstances. 

laSee United States v. National Ass'n of Sec. Dealers, 422 U.S. 694,698 (1975) (under sections 

2(a)(32) and 22(e), open-end companies are required to redeem securities on demand); United 

States v. Cartwright, 411 U.S. 546, 547 (1973) (section 22(e) requires open-end companies to be 

prepared to redeem their outstanding shares at any time). 

Repurchases and Redemptions of Investment Company Shares 469 
repurchase process would remain with the ~ompany?~' While the repurchases 

would be conducted at net asset value pursuant to modified tender offer 

procedures, and the company would be subject to liquidity standards, there also 

is a real possibility that the company may not purchase all of the shares tendered 

at any particular time. In particular, the rule would require a company to 

establish a fundamental policy specifying the maximum amount that the company 

could repurchase in any repurchase offer; and at the time of each offer, the 

company could establish a lower maximum for that offer. If more shares were 

tendered than the company had offered to repurchase, the company would have 

only limited capacity to increase the offer. Moreover, the rule should restrict the 

permissible levels of repurchase offers so that a company could not guarantee to 

repurchase all shares tendered; for example, a company could not set a policy of 

offering to repurchase all of its outstanding shares. As a result, the primary 

characteristic of a redeemable security -- the entitlement it provides the holder -- 

would not be present. This conclusion is consistent with previous interpretations 

of the Act stating that a closed-end company does not issue a redeemable security 

if the company decides whether or not to accept the shares tendered.'52 This 

conclusion is also consistent with the no-action positions holding that companies 

do not issue redeemable securities if they do not give holders an unqualified right 

to compel redem~ti0n.l~~ 

IV. Conclusion 

The Division recommends that the Commission adopt an exemptive rule 

under section 23 of the Investment Company Act defining the circumstances 

under which closed-end companies may make periodic repurchase offers, and a 

rule under section 22(e) permitting open-end companies to make redemptions on 

a periodic basis or with an extended period of payment. In conjunction with 

those proposals, the Division also recommends the amendment of the Act to add 

an express requirement of portfolio liquidity for all open-end companies and all 

closed-end companies making periodic repurchases. 

15'Cf. Dimensional Fund Advisors, Inc., sup note 73 (rejecting the argument that nominal 

limitations on redeemability made securities non-redeemable). 

152See id. Conversely, securities are redeemable if the issuer or its board has limited ability 

to defer redemption payments under unusual circumstances, such as the exceptions specified in 

section 22(e). See also Savings Bank Investment Fund, 24 S.E.C. at 539-40 (securities were 

redeemable securities under the Act even though executive committee was authorized to defer 

payment of redemptions under extraordinary circumstances). 

'%See supra note 146. 

470 CHAPTER 11 
APPENDIX 11-A 

Red-Lined Version of Proposed Amendment to the 

Investment Company Act of 1940 

) . . . .. 

Section 12 115 U.S.C. 5 80a-121. 

*** 

Repurchases and Redemptions of Investment Company Shares 471 
Chapter 12 

Aff i I iated Transact ions 

I. Introduction and Summary of Recommendations 

Several provisions of the Investment Company Act' restrict transactions 

involving investment companies and their affiliates. Most notably, section 172 

prohibits or restricts a wide range of affiliated transactions, and section 10(f)3 

limits an investment company's acquisition of securities from an underwriting 

syndicate containing certain affiliates. The restrictions on affiliated transactions 

were enacted in 1940 in response to a wide array of abuses that occurred in the 

1920's and 1930's. The Division has concluded that these restrictions remain 

sound and should be preserved in all critical respects. For more than fifty years 

they have played a vital role in protecting the interests of shareholders and in 

preserving the industry's reputation for integrity; they continue to be among the 

most important of the Act's many protections. 

The breadth of some of these provisions, however, prohibits some 

transactions that do not involve the concerns the provisions are intended to 

address, and the process of applying for exemptive relief can impose delays and 

costs upon investment companies and may deter them from pursuing beneficial 

investments. Accordingly, the Division recommends rulemaking proceedings to 

narrow the prohibitions on affiliated transactions in certain limited areas where 

current prohibitions can be relaxed without reducing the protection of investment 

companies and their shareholders. 

In particular, the restrictions in section 17(d) and rule 17d-14 on a 

particular form of affiliated transaction, the "joint" transaction, unduly inhibit 

some types of transactions that pose little risk of conflict of interest. The Division 

therefore recommends that the Commission broaden the classes of transactions 

currently permitted in two areas. First, the Division recommends allowing 

directors of investment companies to authorize joint transactions with remote 

affiliates, rather than requiring that such transactions be reviewed by the 

Commission. The Division does not, however, recommend allowing directors to 

'Investment Company Act of 1940,15 U.S.C. Q 80a. 

215 U.S.C. Q 8Oa-17. 

315 U.S.C. 5 8Oa-lO(f). 

417 C.F.R. Q 270.17d-1. 

473 
approve other affiliated transactions such as principal transactions or transactions 

with closer affiliates, because such other transactions present greater risks of 

I conflicts of interest. Second, the Division recommends exempting joint 

transactions where an investment company and its affiliates participate on the 

same terms, except to the extent of their participation. 

In addition, the Division recommends that the Commission revise rule 1Of3 to permit investment companies to purchase securities in foreign markets in 

underwritings involving affiliates. That rule currently exempts certain 

transactions from the Act's prohibition on investment company purchases from 

an underwriting syndicate that includes an affiliate, but in practice the exemption 

does not reach transactions involving foreign offerings. 

This chapter begins by describing the current regulatory framework 

governing affiliated transactions. It then discusses briefly how that framework 

has been altered for business development companies. Finally, it analyzes the 

various options for reform considered by the Division and sets forth the 

Division's recommendations. 

11. Current Regulation of Affiliated Transactions Under the 

Investment Company Act 

The Investment Company Act's provisions concerning affiliated 

transactions were enacted in response to the Commission's exhaustive report on 

the investment company industry. The Investment Trust Study described in great 

detail numerous instances of overreaching and self-dealing by investment 

company insiders. The Commission found that: 

[slponsors, in their capacity as sellers of securities to and purchasers of 

securities from investment companies, perpetrated many abuses. They not 

only sold securities to investment companies to realize profits as 

principal[s] or commissions as brokers, but also sold securities to these 

companies for a variety of other reasons. For example, "dumping" (selling 

to a controlled investment company securities which are otherwise 

unmarketable at the sale price) was very common. Also, the sponsors 

frequently sold securities to their investment companies in order to secure, 

facilitate, or maintain control of the portfolio companies, or to aid in 

474 CHAPTER 12 
mergers, consolidations, or other objectives of [the] sponsors. Sales were 

also made to investment companies by sponsors to secure various indirect 

benefits? 

The resulting regulatory framework included restrictions on transactions 

involving investment companies and their affiliates. These are summarized 

below. 

A. Investment Companies 

1. Affiliation under the Act 

The Act's restrictions apply to transactions with persons having various 

degrees of affiliation with an investment company. For example, the affiliates 

subject to section 17(a) include any affiliated person6 or promoter of or principal 

underwriter for a registered investment company (a "first tier" affiliate), or any 

affiliated person of such a person, promoter, or underwriter (a "second tier" 

affiliate)7. Other provisions of the Act apply to transactions with slightly 

different combinations of affiliates. 

%EC, INVESTMENT TRUSTS AND INVETMENT COMPANIES, PT. 3, H.R. Doc. No. 136,77th Cong., 

1st Sess., at 2581 (1939) [hereinafter INVESTMENT TRUST STUDY]. The Commission devoted over 

200 pages of the Investment Trust Study to the discussion of specific instances of overreaching 

by affiliates in connehion with the purchase and sale of portfolio securities, loans by investment 

companies, and investments in related investment companies. Id. at 2581-2793. 

6Secticn 2(a)(3) defines an "affiliated person" of an investment company to include any person 

owning five percent or more of the investment company's voting securities; any person in which 

the investment company owns five percent of more of the voting securities; any person directly 

or indirectly controlling, controlled by, or under common control with, the investment company; 

any of the company's officers, directors, partners, or employees; the investment adviser and any 

members of an advisory board; and, in the case of a unit investment trust, the depositor. 15 U.S.C. 

5 80a-2(a)(3). For the sake of brevity, this chapter uses the term "affiliate" when referring to 

persons subject to sections lO(f), 17(a), and 17(d) of the Act and rule 17d-1 thereunder. 

7These sets of affiliated relationships are referred to as "tiers" for convenience. In fact, each 

of these tiers often consists of intricate, multi-leveled sets of entities that are directly or indirectly 

under common control. 

Affiliated Transactions 475 
Figure 12-1, below, depicts certain registered investment company 

upstream affiliated relationships. 

FIGURE 12-1 

Upstream Affiliations 

I control I 

The depictions in Figure 12-1 include one entity that is “unaffiliated” with 

the investment company (see Legend); transactions between this entity and the 

investment company are outside of section 17’s scope. Six of the depicted entities, 

on the other hand, are close affiliates of the investment company; transactions 

between these entities and the investment company generally must be approved 

by the Commission. Four of the depicted entities are remote affiliates of the 

investment company. Under the terms of the Division’s proposed amendments 

to rule 17d-1, discussed below, the investment company could engage in certain 

joint transactions with these remote affiliates if approved by the company’s board 

of directors, rather than the Commission. 

476 CHAPTER 12 
2. Section 17(a) 

Section 17(a) makes it unlawful for any first or second tier affiliate of a 

registered investment company (1) knowingly to sell securities or property to the 

company; (2) knowingly to purchase securities or property from the company; or 

(3) to borrow money or property from the company. Thus, section 17(a) prohibits 

transactions with first or second tier affiliates and applies only where the affiliate 

is acting as principal8 (Section 17(e), discussed below, applies to agency 

transactions.) Under section 17(b), the Commission, upon application, shall 

exempt a proposed transaction from section 17(a) if it finds that the proposed 

transaction is reasonable and fair and does not involve overreaching, is consistent 

with the policy of the company, and is consistent with the general purposes of the 

Act? 

Under section 6(c))O the Commission has adopted eight rules exempting 

from section 17(a) certain classes of affiliated transactions that otherwise would 

require Commission exemptive orders. For example, rule 17a-7 permits funds 

that are affiliated persons solely by virtue of having common or related advisers, 

common directors, and/or common officers, to sell securities at market prices to 

each other, subject to certain conditions, one of which requires a form of director 

review. A fund's board, including a majority of the "independent" directors:* 

must adopt procedures that are reasonably designed to provide for compliance 

with the other conditions in the rule, annually review the procedures, and 

quarterly review all sales for compliance. Similarly, rule 17a-8 permits funds that 

are affiliated persons solely by virtue of having common or related advisers, 

common directors, and/or common officers to merge with one another if the 

funds' boards, including a majority of each board's independent directors, find 

$ection 17(c) exempts certain sales of merchandise and leases from the section 17(a) 

prohibition. 

qf a registered company and a person covered by section 17(a) seek to engage in a series of 

transactions, the Commission may not exempt them under section 17(b). It may, however, use 

its authority in section 6(c) (15 U.S.C. 5 80a-6(c)) to exempt the series of transactions with reference 

to the standards set forth In section 17(b). Keystone Custodian Funds, Inc., 21 S.E.C. 295, 299 

(1945). 

"15 U.S.C. § 80a-6(c). 

"Section 10(a> generally provides that an investment company may not have a board more 

than 60% of the members of which are interested persons. "Interested person" is defined in 

section 2(a)(19) to include persons with certain relationships to the investment company or to the 

securities industry generally as well as persons with certain relationships with such persons. We 

use the term "independent directors" to refer to those directors who are not interested persons. 

Affiliated Transactions 477 
that the transaction is in the best interests of the investment companies and that 

the interests of shareholders will not be diluted.12 

3. Section 17(d) and Rule 17d-1 

Section 17(d) makes it unlawful for an affiliated person of or principal 

underwriter for a registered investment company, or any affiliated person of such 

a person or principal Underwriter, acting as principal, to effect any transaction in 

which the registered company is a 'oint or a joint and several participant, in 

contravention of Commission rules.'' In contrast to section 17(a), section 17(d) 

does not directly prohibit any specific conduct. Rather, it allows the Commission 

to adopt rules that set standards for transactions in which investment companies 

are joint participants. 

The Commission has adopted three rules under section 17(d), the most 

significant of which is rule 17d-1.14 Rule 17d-1 prohibits an affiliated person of 

or principal underwriter for any registered investment company, or any affiliated 

person of such person or underwriter, acting as principal, from participating in 

or effecting any transaction in connection with a joint enterprise or other joint 

arrangement in which the investment company is a participant, without prior 

12Rule 17a-1 exempts certain purchases by an investment company acting as an underwriter; 

rule 17a-2 exempts certain commercial transactions; rule 17a-3 exempts transactions with fully 

owned subsidiaries; rule 17a-4 exempts sales pursuant to certain contracts executed prior to the 

existence of any affiliation; rule 17a-5 exempts pro rata distributions to stockholders; and rule 17a6 exempts certain transactions with "downstream" affiliates. 

l?he term "joint" has not been interpreted as requiring a strict common law meaning. Rather, 

only "some element of 'combination' is required." SEC v. Talley Indus., Inc., 399 F.2d 396,402-03 

(2d Cir. 1968), cut. denied, 393 U.S. 1015 (1969). 

14For the first 17 years after the AcYs passage, the Commission prohibited very few joint 

transactions. The Commission first adopted a rule under section 17(d) in 1946. That rule 

concerned only bonus, profit-sharing, and pension plans and arrangements "provided by" 

investment companies "for directors, officers and other affiliated persons." Adoption of Rule 

Governing Applications Regarding Bonus, Profit-sharing and Pension Plans and Arrangements, 

Investment Company Act Release No. 858 (Feb. 6, 1946), 11 FR 1461. Thus, as originally 

promulgated, rule 17d-1 prohibited only a limited class of transactions with first tier affiliates. 

This version of the rule was later amended in Applications and Exemption of Transactions 

Between Registered Companies and Fully Owned Subsidiaries, Investment Company Act Release 

No. 1060 (June 23, 1947), 12 FR 3441, and Applications Regarding Bonus, Profit-sharing and 

Pension Plans, Investment Company Act Release No. 1598 (Mar. 20,1951),16 FR 2680. Rule 17d-1 

in substantially its present form, prohibiting a broad range of joint transactions, was adopted in 

1957. Applications Regarding Joint Enterprises and Certain Profit-sharing Plans, Investment 

Company Act Release No. 2472 van. 10,1957), 22 FR 426. 

478 CHAPTER 12 
Commission approval.'' Thus, the rule effectively prohibits joint transactions 

or arrangements involving either first tier or second tier affiliates, absent 

Commission approval. 

The rule has limited exceptions for certain employee compensation plans, 

certain tax-deferred employee benefit plans, certain transactions involving small 

business investment companies, transactions with "downstream" affiliates (where 

the affiliation arises solely because of the investment company's portfolio 

holdings), the receipt of securities or cash by certain affiliates pursuant to a plan 

of reorganization, and arrangements regarding liability insurance policies. 

The Commission has acknowledged that there is considerable uncertainty 

about the scope of the section and the rule>6 In 1967, the Commission proposed 

amending the rule in an attempt to delineate its scope more precisely. In its 

release, the Commission observed that: 

[ulnder the present Rule, it is in some circumstances unclear 

whether an application should or should not be filed, and a 

considerable amount of the staff's time is absorbed in assisting 

registered companies and their affiliates to determine the 

applicability of the filing requirement, apart from any determination 

of approval or disapproval on the merits?7 

Among other things, the amendment would have reduced the number of 

affiliates subject to the rule by excluding five percent shareholders of five percent 

shareholders. It also would have excluded investment companies that are 

affiliated solely because they had the same adviser and would have attempted to 

15Talfey held that the Commission did not exceed its authority when it adopted rule 17d-1, a 

I6In Steadman Security Corporation, Investment Company Act Release No. 9830 (June 29, 

1977), 46 S.E.C. 896,911, the Commission stated that "[tlhe generality of [the] language [of section 

17(d),l together with the paucity of judicial decisions construing it, has led to considerable 

uncertainty as to its exact scope." 

17Notice of Proposal to Adopt a Revision of Rule 17d-1 Requiring Applications For 

Transactions in Which Investment Companies Participate with Affiliated Persons, Investment 

Company Act Release No. 5128, 11966-67 Transfer Binder] Fed. See. L. Rep. (CCH) q[ 77,477, at 

82,949 (at. 13,1967). 

procedural rule requiring prior approval, rather than a substantive rule. 399 F.2d at 404-05. 

Affiliated Transactions 479 
limit the class of transactions subject to the rule. The amendment was 

withdrawn, apparently in response to the criticism of commenters who believed 

the proposal would expand rather than clarify the rule:' 

4. Section lO(0 and Rule 1Of-3 

Section 1O(f) generally prohibits a registered investment company from 

purchasing securities during the existence of an underwriting syndicate if a 

member of the syndicate is affiliated with the investment company in certain 

ways. Section 1O(f) prevents an affiliated underwriter from lacing or "dumping" 

unmarketable securities with an investment company." Section 1O(f) also 

expressly provides the Commission with authority to exempt transactions by rule 

or by order. 

Under its exemptive authorityf the Commission has adopted rule IOf-3, 

which exempts purchases from an underwriting syndicate that includes an 

affiliate, subject to several conditions relating to the nature of the offering and the 

terms of an investment company's participation. In particular, the securities must 

either be registered under the Securities Aci?' or be municipal securities. 

'$EC Rule Proposals Withdrawn, Investment Company Act Release No. 5874, I1969-70 

Transfer Binder] Fed. Sec. L. Rep. (CCH) %[ 77,758 (Nov. 7,1969). For example, the Investment 

Company Institute ('"3'') argued that the rule would have required applications for many 

coincidental purchases of securities where there was no joint participation. See Letter of Robert 

L. Augenblick, President, ICI, to the Commission (Jan. 17, 1968). Other attempts to reform the 

regulatory treatment of joint transactions have not been successful. According to the American 

Law Institute, for example: 

the uncertainty as to the range of transactions covered by [section 17(d)l, prompted an 

attempt at an entirely new approach to the section designed to clarify its coverage and 

relax its strictness to the extent of interposing the unrelated directors to blunt the 

intrusion of court or Commission in reviewing a challenged transaction. But 

disagreement among the Consultants and Advisers with respect to an acceptable (let alone 

a desirable) solution of the problems - together with the rejection of proposed changes 

by spokesmen for the industry -- led to a decision, particularly in the light of the Code's 

limited approach to substantive revision of the Investment Company Act, to leave [section 

17(d)] substantially as it is today. 

2 A.L.I. FED. SEC. CODE, § 1412 cmt. 3 (1980). 

I90ne of the major abuses noted in the period preceding the Act was the use of investment 

companies as a '.'dumping ground' for otherwise unmarketable securities. See Investment Trusts 

and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Senate Comm. on Banking and 

Currency, 76th Cong., 3d Sess. 35 (1940) (statement of Commissioner Healy). 

20Securities Act of 1933,15 U.S.C. 55 77a-77aa. 

480 CHAPTER 12 
B. Business Development Companies 

In 1980, Congress amended the Investment Company Act to allow for a 

less regulated type of mana ement investment company, the business 

development company ("BDC")!' Congress determined that the regulatory 

structure applicable to investment companies needed to be modified to facilitate 

venture capital formation. 

The result is that although BDCs are subject to section 1O(f) to the same 

extent as are registered investment companies, the treatment of other affiliated 

transactions involving BDCs is somewhat different. They are regulated under 

section 5722 (rather than section 17) in one of two ways, depending on the 

closeness of the affiliation between the BDC and the affiliates involved in the 

tran~action.2~ Transactions involving closer affiliates require prior Commission 

approval, as do transactions under section 17?4 Transactions involving persons 

less closely affiliated with a BDC25 may be approved by majority vote of the 

BDC's board, including a majority of the BDC's independent directors. The 

findings the directors must make are essentially the same as those required for 

Commission orders under section 17(b). 

Thus, a BDC may engage in either principal or joint transactions with 

remote affiliates without seeking Commission approval if the directors of the BDC 

approve the transactionF6 The 1980 amendments preserve the need for 

21Pub. L. No. 96-477,94 Stat. 2275 (1980) (codified as amended at 15 U.S.C. 55 8Oa-53 to 80a64). 

2215 U.S.C. 5 8Oa-56. 

23Section 57 also differs from subsections (a) and (d) of section 17 in that it expressly prohibits 

24Like section 17(d), section 57(a)(4) prohibits only those joint transactions with affiliated 

persons that are in contravention of Commission rules. Section57(i), however, provides that, until 

the Commission adopts rules under subsection (a) and (d), the rules under subsections (a) and 

(d) of section 17 shall apply. Because the Commission has not adopted rules under section 57(d), 

rule 17d-1 requires prior Commission approval of those joint transactions involving BDCs that 

cannot be approved by BDC boards. 

only Icnowingly borrowing from, or engaging in joint transactions with, BDCs. 

9hese more remote affiliates are those specified in section 57(e). See infra note 45 and 

261n addition, rule 57b-107 C.F.R. 5 270.57b-1) exempts transactions with certain "downstream 

affiliates" (affiliates that are directly or indirectly controlled by a BDC, and any persons 

controlling, controlled by, or under common control with, those controlled affiliates). Section 57 

(continued ...) 

accompanying text. 

Affiliated Tr ansactions 481 
Commission approval where an "upstream affiliate," such as an officer, director, 

investment adviser, principal underwriter, or controlling person of the BDC, is a 

participant. Thus, those transactions that present a greater risk of self-dealing 

remain subject to prior Commission re~iew.2~ 

Because the provisions of the Act concerning transactions involving BDCs 

and their affiliates are less restrictive than for other investment companies, the 

Act imposes additional governance requirements on BDCs to limit possible 

overreaching. Section 56(a)28 requires that the majority of a BDC's board consist 

of persons who are not interested persons of the BDC, rather than the forty 

percent required of boards of registered investment companies under section 

lO(a). Section 57(h) requires that the directors adopt and periodically review and 

update procedures designed to monitor the possible involvement of those persons 

who are subject to the restrictions of section 57 in transactions with the BDC. 

Finally, section 57(f)(3) requires BDC directors to record in the minutes of their 

meetings detailed information about their decisions to approve transactions with 

affiliates. 

111. Options for Reform and Recommendations 

As the Commission noted in the release seeking comments on the 

regulation of investment companie~?~ the prohibitions of section 17(a) and rule 

17d-1 and the procedures for approval thereunder have been criticized as unduly 

26(...continued) 

does not cover transactions with some affiliates that are covered by section 17(a). Specifically, 

section 57(f) does not limit transactions with persons a BDC controls or with which it is affiliated 

because it holds at least five percent of their outstanding securities, and affiliated persons of those 

persons. The Commission has adopted an exemptive rule, rule 17a-6, that provides essentially 

the same relief for investment companies. 

27See SMALL BUSINESS SECURITIES ACE AMENDMENTS OF 1980, S. REP. NO. 958,96th Cong., 1st 

Sess. 7-8 (1980) [hereinafter 1980 SENATE REPORT]. 

*%5 U.S.C. Q 80a-55(a). 

*%equest for Comments on Reform of the Regulation of Investment Companies, Investment 

Company Act Release No. 17534 (June 15, 1990), 55 FR 25322, at § III.J.4. [hereinafter Study 

Release]. Unless otherwise indicated, all references in this chapter to commenters and comment 

letters are to those responding to the Study Release. 

482 CHAPTER 12 
cumbersome; and some commentators have criticized rule 17d-1 as overbroad, 

unclear, or inconsistent with the purpose of section 17(d)?' 

From the standpoint of cost and efficiency, it is desirable to limit the 

number of prohibited affiliated transactions requiring Commission approval and 

to clarify what transactions are prohibited. Moreover, because of the time and 

cost attendant to filing an application, it is probable that many transactions that 

do not involve overreaching are simply foregone; thus, the restrictions also may 

impose opportunity costs on investment companies. 

From the standpoint of investor protection, however, the Investment 

Company Act's provisions concerning affiliated transactions are at its heart and 

continue to serve as a fundamental protection. The provisions were intended to 

go beyond those provided under common law, which allows fiduciaries to deal 

with their beneficiaries if adequate disclosure is made?l They are also greater 

than the protections provided to investors in other domestic pooled investment 

vehicles, such as common trust funds and real estate investment trusts, and in 

foreign investment companies?2 

3oSee, e.g., Joseph W. Bartlett & Stephen P. Dowd, Section 17 of the Investment Company Act -- An Example of Regulation by Exemption, 8 DEL. J. CORP. L. 449 (1983). In response to the Study 

Release, several commenters addressed affiliated transactions, including: certain members of a 

subcommittee of the American Bar Association; the American Council of Life Insurance; Citicorp; 

Debevoise & Plimpton, on behalf of the independent trustees of the Fidelity Funds; Dechert Price 

& Rhoads; The Equitable Life Assurance Society of the United States; Fidelity Management & 

Research Company; R. James Gormley; IDS Financial Services, Inc.; the ICI; Merrill Lynch & Co., 

Inc.; a committee of the Association of the Bar of the City of New York; Prudential Mutual Fund 

Management; Ropes & Gray; Shearson Lehman Brothers, Inc.; and Warburg Investment 

Management International, Ltd. 

31See Thomas P. Lemke, The Investment Company Act of 1940, in 4 SECURITIES LAW TECHNIQUES 

TRANSACTIONS LITIGATION (A.A. Sommer, ed.) 5 83-07, at 83-135 (Aug. 1991). 

32For example, under the regulations of the Comptroller of the Currency, a common trust fund 

may engage in principal transactions with affiliates if authorized by the governing trust 

instrument, a court order, or the law of the jurisdiction under which the trust is administered. 

12 C.F.R. § 9.12. Some affiliated transactions may be approved by a majority of the bank's outside 

directors or "cured' through disclosure. Id. A real estate investment trust, under the statement 

of policy of the North American Securities Administrators Association, which (as of March, 1991) 

had been adopted in 20 states, may engage in certain transactions with affiliates if a majority of 

its trustees (or directors), including a majority of its independent trustees (or directors), approve 

the transaction. NASAA Reports (CCH) 4[¶263, 3404 (1991). The European Community's 

Directive on Undertakings For Collective Investment in Transferable Securities, discussed in 

Chapter 4, has no prohibition on transactions with affiliates. European Council Directive of 20th 

December 1985 on the Coordination of Laws, Regulations and Administrative Provisions Relating 

to Undertakings for Collective Investment in Transferable Securities, Council Directive 85/611, 

(continued ... ) 

Affiliated Transactions 483 
The need for the protections provided by the affiliated transaction 

provisions of the Investment Company Act has not diminished with the passage 

of time and is amply demonstrated by a recent enforcement action, SEC v. 

Gr~shans.~ In that case, the Commission obtained a permanent injunction 

against the chairman and president of a mutual fund, and the appointment of a 

trustee, based primarily on an affiliated transaction. The chairman sold all of the 

stock of a company in which he owned a ninety-six percent interest to the fund 

for shares of the fund. He then assigned an artificial value of $1.05 per share to 

the stock and artificially raised the price of the stock each day thereafter causing 

the net asset value of the fund to be overstated. He eventually redeemed his 

fund shares for over $2 rnilli0n.3~ 

Other sectors of the financial services industry demonstrate the 

consequences of similar kinds of transactions. Some of the most publicized 

abusive transactions in recent years have occurred in the savings and loan 

industry. In addition, some sources have estimated that various forms of "insider 

abuse" have played a significant role in bank fail~res.3~ 

32( ... continued) 

1985 O.J. (L 375) 3. The current trend in the United States, however, may be in favor of tighter 

controls, particularly with respect to principal transactions. For example, the Commodity Futures 

Trading Commission has proposed a rule that would prohibit a commodities pool operator 

("CPO') from using funds or property of a commodities pool that it operates to lend money or 

property to or purchase assets of or securities issued by such CPO or any affiliated person of such 

CPO; "affiliated person of a CPO is defined as any entity in which the CPO has an "interest." 

Proposed Regulation Prohibiting Certain Transactions Between Commodity Pool Operators and 

Affiliated Persons, 56 FR 50067 (at. 3,1991), corrected at 56 FR 55527 (at. 28, 1991). 

33Civ. Act. No. 90-6703 (E.D. Pa.) [cited in Litigation Release No. 12677 (Oct. 19, 199011. 

34~. 

35See Note, Insider Abuse and Criminal Misconduct in Financial Institufions: A Crisis?, 64 NOTRE 

DAME L. REV. 222,226-229 (1989) (discussing an Office of the Comptroller of the Currency study 

of bank failures, a General Accounting Office study of bank and thrift failures, and a Federal 

Deposit Insurance Corporation study of bank failures); compare with LAWRENCE J. WHITE, THE 

SAVINGS AND LOAN DEBACLE: PUBLIC POLICY LESSONS FOR BANK AND THRIFT REGULATION 126-128 

(1991) (attributing the largest set of failures to poor business judgments exacerbated by economic 

conditions, rather than to abuse). In addition, for an example of abusive transactions involving 

a savings and loan, see Lincoln Savings and Loan Assoc. v. Wall, 743 F. Supp. 901 (D.D.C. 1990) 

(describing, among other things, a series of transactions involving a savings and loan and its 

affiliates that resulted in the looting of the thrift). See also Catherine Yang with Dean Foust, 

Disaster on a Watchdog's Doorstep, Bus. WK., June 3, 1991, 114 (describing loans to insiders at 

Madison National Bank). 

484 CHAPTER 12 
Thus, there is a need to maintain investor protection for transactions where 

abuses are likely to occur while eliminating review by the Commission for 

transactions that do not pose the same potential for abuse. Accordingly, the 

Division recommends some additional exclusions under section 17(d) but does not 

recommend any wholesale changes to the current regulatory system and 

specifically does not recommend any changes to section 17(a). We propose that 

rule 17d-1 be amended to permit the following joint transactions: (i) transactions 

with certain remote affiliates when certain conditions are satisfied, including 

approval of the directors; and (ii) transactions in which the investment company 

and any affiliate participate on identical terms except for the amount of their 

participation. We also propose that rule 1Of-3 be amended to permit investment 

companies to participate in foreign offerings if certain conditions are satisfied that 

provide protections comparable to those provided by the current requirements. 

A. Section 17(a) and Riskless Principal Transactions 

The Division does not recommend changes to section 17(a). We considered 

whether to recommend that the Commission exempt "riskless principal" 

transactions from section 17(a), and instead treat them like agency transactions 

under section 17(e). Under section 17(e) brokerage transactions with affiliates are 

permitted, subject to limits on the amount of compensation an affiliate may 

receive, depending on the market where the transaction is effected. For 

transactions effected on an exchange, the commission must not exceed the usual 

and customary broker's commission?6 For transactions effected in connection 

with a secondary distribution, the commission may not exceed two percent of the 

sales price. For other transactions, such as over-the-counter trades and private 

placements, the commission may not exceed one percent of the sales pri~e.3~ 

36Under rule 17e-1, which is a non-exclusive safe harbor for brokerage transactions with 

affiliates on an exchange, a commission will "be deemed as not exceeding the usual and 

customary broker's commission" if it is reasonable and fair compared to the fees received by other 

brokers, the board of the investment company has adopted procedures to monitor compliance 

with this standard and quarterly reviews compliance, and the investment company maintains 

records of its procedures and its transactions with affiliates. Disclosure of commissions paid to 

affiliated brokers is required by Item 17 of Form N-lA, Registration Form Used by Open-End 

Management Investment Companies; Guidelines, Investment Company Act Release No. 13436 

(Aug. 12,1983),48 FR 37928 (requiring this disclosure in the Statement of Additional Information) 

and by Item 9 of Form N-2/47 FR 39986,40047. 

37Compliance with section 17(e) does not obviate the affiliate's duty to provide best execution. 

In proposing rule 17e-1, the Commission noted that "any transaction executed by an affiliated 

broker must satisfy also the investment company's obligation to obtain best price and execution 

in each securities transaction." Agency Transactions by Affiliated Persons on a Securities 

Exchange, Investment Company Act Release No. 10605, n.9 (Feb. 27,1979),44 FR 12202. See also 

(continued ...) 

Affiliated Transactions 485 
We do not recommend adopting a rule exempting riskless principal 

transactions because of the substantive differences between agency and riskless 

principal transactions. Even under a rule modeled on the safe harbor for 

affiliated broker's commissions under rule 17e-1, some conflicts of interest would 

remain. Moreover, it is difficult to monitor the execution provided by an affiliate 

in a riskless principal transaction and hence to determine whether the price and 

transaction costs meet standards comparable to those under section 17(e). 

Riskless principal transactions typically are performed by dealers other 

arket makers in a security. They are unlike most principal transactions in 

that the dealer does not execute a customer's purchase or sale order from the 

dealer's existing inventory. Rather, the dealer executes the order by engaging in 

simultaneous transactions after locating a counterparty in the open market: the 

dealer purchases or sells the security from the customer for its own account and 

offsets that transaction with a simultaneous sale to, or purchase from, the 

counterparty?8 Instead of a commission, the dealer typically receives a markup 

on the transaction. Riskless principal transactions are commonplace in some 

markets, particularly for transactions in debt securities. 

Investment companies may not engage in riskless principal transactions 

their affiliates, because such transactions involve the purchase or sale of 

urities by an affiliate acting as principal and are prohibited under section 17(a). 

in many respects, riskless principal transactions are functionally equivalent 

to brokerage transactions and may present less risk of overreaching than do 

typical principal transaction^?^ Most principal transactions present at least the 

possibility that the affiliated dealer may be "dumping" a security into an 

investment company to remove it from its inventory. In a true riskless principal 

37(...continued) 

Delaware Management Co., Inc., 43 S.E.C. 392, 400 (1967) ("Persons engaged in the securities 

business cannot be unaware of their obligation to serve the best interests of customers, and that 

interpositioning is bound to result in increased prices or costs.") (citation omitted). Cf. Edgemont 

Asset Management Corp. and Bowling Green Securities, Inc., Investment Advisers Act Release No. 

1280 (June 18,1991), 49 SEC Docket 224 (settling administrative proceedings against an investment 

adviser and a broker regarding interpositioning in trades of fund's portfolio securities). 

3%s definition is drawn from rule lob-10 (17 C.F.R. Q 240.1Ob-10) under the Exchange Act, 

which requires broker-dealers to provide confirmations. Rule 15~3-1 under the Exchange Act also 

describes riskless principal transactions. 17 C.F.R. 5 240.15~3-1(a)(2)(vi). 

39Several commenters made this point in response to the Study Release. Letter from Fidelity 

Management & Research Company to Jonathan G. Katz, Secretary, SEC 8-9 (Oct. 11, 19901, File 

No. S7-11-90; Letter from the IC1 to Jonathan G. Katz, Secretary, SEC 72-73 (Oct. 5,19901, File No. 

S7-11-90; Letter from Prudential Mutual Fund Management to Jonathan G. Katz, Secretary, SEC 

10-11 (Oct. 9, 19901, File No. S7-11-90. 

486 CHAPTER 12 
transaction, the dealer is not selling from inventory, but is acting essentially as 

an agent. 

Riskless principal transactions do differ in some critical respects from 

agency transactions, however. A key difference is that in a riskless principal 

transaction the affiliated dealer deals directly with both the purchaser and seller, 

whereas in most agency transactions the broker does not have relationships with 

both parties. Thus, it is possible that a transaction might be initiated by an 

affiliate in order to dump overpriced securities as a favor to another customer. 

Most significantly, it appears that monitoring price and execution for many 

riskless principal transactions is much more difficult than for agency transactions, 

in large part because of the lesser amount of information about the prices of fixed 

income securities. In contrast to the equity exchange markets, fixed income 

markets have few quotes and no trade information available to customers, so it 

is difficult to assess whether best execution occurred. In the government 

securities markets, the most reliable sources of information about current market 

prices are the interdealer brokers' screens, which only are available to primary 

and aspiring primary dealers. Other recently developed sources of quotes such 

as GOVPX are a promising beginning in improving the availability of price and 

quotation information on government securities but generally are not 

comprehensive:' Similarly, in the municipal securities markets, broker's 

brokers' quotes, such as those provided by Kenney S&P, are generally only 

available to bond dealers, and not to institutions. Finally, only some dealer 

quotes on corporate bonds and very limited price information concerning private 

mortgage-backed securities are available to investors on Telerate. 

In addition, the legally mandated disclosure of markups or markdowns is 

limited, making it even more difficult to monitor the compensation paid in 

riskless principal transactions. Rule 10b-104' under the Exchange Act does not 

require disclosure of markups or markdowns by dealers in debt securities, nor 

does it require such disclosures for market makers in non-reported equity 

securities; instead, rule lob-10 requires disclosure of markups or markdowns only 

4%EPARTMENT OF THE TREASURY, SEC, AND BOARD OF GOVERNORS OF THE FEDERAL RESERVE 

SYSTEM, JOINT REPORT ON THE GOVERNMENT SECURITIES MARKET B-87 to E90 (1992). 

*l17 C.F.R. 5 240.1Ob-10. 

Affiliated Transactions 487 
for transactions by non-market makers in e uity securities and transactions by any dealer in non-reported equity securities. 12 

For these reasons, enactment of a rule exempting riskless principal 

transactions from section 17(a) would not be feasible at present. There currently 

is not sufficient information available about prices and markups in riskless 

principal transactions that investment companies and their directors could comply 

with restrictions comparable to those in section 17(e) and the rule 17e-1 safe 

harbor for affiliated brokers’ commissions~3 Although a rule exempting all 

riskless principal transactions would not be appropriate at this time, the 

Commission might issue individual exemptive orders involving fund trades in 

high quality, liquid debt securities provided that applicants demonstrated that 

adequate information and safeguards existed. 

B. Section 17(d) 

1. Approval by Directors of Joint Transactions with Remote 

Affiliates 

The Division recommends permitting investment companies to engage in 

some affiliated transactions currently subject to section 17(d) with the approval 

of their directors, including their independent directors. The directors could 

approve specific affiliated transactions if they determined that each transaction 

met the relevant standards that must now be met for exemptive relief from the 

Commission. The elimination of the requirement of Commission approval would 

reduce the burden on investment companies and the Commission staff and the 

resulting expense and delay. Granting to directors the authority to approve some 

affiliated transactions makes sense if the group of transactions within their 

authority is sufficiently circumscribed that the risk of abuse is limited and the 

board can perform a meaningful review of each transaction. We propose 

%f. In 1978, the Commission proposed amendments to rule lob-10 that would have required 

disclosures of markups or markdowns received by dealers in debt securities, including municipal 

securities. Securities Confirmations, Securities Exchange Act Release No. 15220 (Oct. 6,1978),43 

FR 47538. The Commission withdrew this proposal in 1982. Securities Confirmations, Securities 

Exchange Act Release No. 18987 (Aug. 20,1982), 47 FR 37919. Those who opposed amending rule 

lob-10 argued that discIosure of markups and markdowns was not material, since debt securities 

are usually priced by yield. 

43For example, it would not be possible to determine whether a markup was reasonable and 

fair compared to those charged in other riskless principal transactions or to adopt and administer 

procedures designed to ensure compliance with such a standard. 

488 CHAPTER 12 
amending rule 17d-1 to permit directors to approve joint transactions with certain 

remote affiliates on a transaction-by-transaction basis.44 

The restriction of director approval to transactions involving remote 

affiliates follows the line drawn in section 57(f), which permits directors of BDCs 

to approve transactions with those affiliates described in section 57(e).45 This 

would allow directors to review joint transactions that Congress has determined 

create "generally less potential for actual overreaching and . . . generally less 

conflict between these persons and the directors who would be responsible for 

reviewing the proposed tran~action."~~ 

Consistent with the treatment of affiliated transactions in section 57(h), this 

authority should be accompanied by conditions designed to strengthen the 

independence and the fact gathering capabilities of the independent directors. 

Such conditions could include requirements that at least a majority of the fund's 

directors be inde~endent;~ fund directors adopt and periodically review and 

update procedures reasonably designed to prevent overreaching in transactions 

with affiliates, and detailed minutes be kept of meetings in which the 

independent directors consider transactions with affiliates. The exemption also 

44As discussed in the following section, the Division also recommends rulemaking to allow 

joint transactions where the fund and its affiliated persons do not participate on different terms, 

subject to periodic board review rather than transaction-by-transaction approval. 

45The affiliates subject to this more streamlined procedure include: (1) any person who is an 

affiliated person by virtue of owning between five percent and 25% of the shares of a BDC, or of 

being between five percent and 25% owned by a BDC; (2) any officer or director of, or general 

partner in, any person specified in (1); (3) any person who directly or indirectly controls, is 

controlled by, or is under common control with any person specified in (1); and (4) with certain 

specified exceptions, any affiliated person of a director, officer, employee, investment adviser, 

member of an advisory board or promoter of, principal underwriter for, general partner in, or any 

affiliated person of any person directly or indirectly controlling or under common control with, 

a BDC. 

461980 SENATE REPORT, supra note 27, at 30. The Division recognizes that section 57(f) also 

permits independent directors of BDCs to approve purchases and sales of property to or from 

such remote affiliates acting as principal, but, as stated above, such relief would be inappropriate 

for investment companies. 

471n Chapter 7, the Division recommends amending the Act to require all investment company 

boards of directors to have a majority of independent directors. 

Affiliated Transactions 489 
might require that any fund seeking to rely on the exemption have selfnominating independent directors, as is now required for funds that have plans 

of distribution under rule 12b-1.@ 

The amendment should make clear that directors may engage outside 

experts to assist them in evaluating such transactions. While the use of 

independent experts would not be required, it is critical that the directors 

understand they have the authority to hire such experts as they deem necessary 

to judge the fairness of transactions and that, in some instances, such hiring may 

be necessary for the directors to meet their fiduciary obligations. Fund directors 

do not have the time or, in many cases, the capability to perform independent fact 

gathering. Thus, in reviewing affiliated transactions, they may be forced to rely 

on facts presented by the adviser unless they are able to hire personnel to gather 

facts for them. 

The directors would have authority to approve only joint transactions, and 

not principal transactions under section 17(a), because there are significant 

differences between joint and principal transactions. All principal transactions 

squarely present potential conflicts of interest since the affiliate and the 

investment company are on opposite sides of the transaction. Joint transactions, 

by contrast, present less risk that securities are being "dumped" on an investment 

company by an affiliate. Joint transactions also appear better suited to review by 

the board because they would occur substantially less frequently than would 

principal transactions and in many cases would be easier to evaluate than 

principal transactions. Indeed, some commenters recommended that joint 

transactions under section 17(d) be permitted if approved by the independent 

directors of the investment company, but did not suggest this approach for 

principal transacti0ns.4~ 

@17 C.F.R. § 270.12b-1. In Chapter 7, the Division also recommends amending section 10 of 

the Ad to require that all investment company boards of directors have self-nominating 

independent directors. Commenters that recommended board approval of joint transactions also 

suggested that such authority be subject to similar conditions. Letter from Ropes & Gray to 

Jonathan G. Katz, Secretary, SEC 11 (Oct. 9, 1990), File No. S7-11-90 [hereinafter Ropes & Gray 

Study Comment] (also suggesting that section 36(b), 15 U.S.C. § 80a-35(b), should apply to any 

participation in a joint transaction involving an adviser or principal underwriter or any of their 

affiliates); Letter from Debevoise & Plimpton, on behalf of the independent trustees of the Fidelity 

Funds, to Jonathan G. Katz, Secretary, SEC 6-7,9 (Oct. 10,1990), File No. S7-11-90 (also suggesting 

that independent directors have direct access to the fund's independent auditors; be represented 

by independent counsel; have periodic executive sessions; document proceedings in which they 

are involved; and, where appropriate, rely on information and advice furnished by independent 

auditors, counsel, or other appropriate consultants). 

49See, e.g., Ropes & Gray Study Comment, supra note 48, at 11 . 

490 CHAPTER 12 

I 
In addition, principal transactions require particular caution because they 

almost invariably carry the risk of overreaching. For example, if an investment 

company purchased a debt security from an affiliated market maker and, later, 

the issuer of the security defaulted, the affiliate could argue that the transaction 

was fair if it was done at fair market value, as determined by contemporaneous 

transactions with unrelated third parties. Nevertheless, it always remains open 

to question whether the investment company would have purchased the security 

at all if it were not for the affiliation. That is, transactions with affiliates at a "fair 

market price" may still compromise the unbiased nature of the portfolio 

management of the investment company. 

a. Director Approval of All Affiliated Transactions 

under Section 17 

The Division does not recommend that directors should have the authority 

to approve all affiliated transactions under section 17, including principal 

transactions and transactions with closer affiliates. Principal transactions in 

particular raise serious concerns, which we have discussed in the previous 

section. Moreover, we do not believe that general corporate law standards 

governing directors' conduct provide investor protection comparable to the 

current requirement of Commission approval. Some commenters had argued that 

the Commission should adopt exemptive rules permitting independent directors, 

at their option, to determine whether a particular transaction under section 17(a) 

or rule 17d-1 meets the relevant standards for exemption under the Investment 

Company Act?' In their view, since the enadment of the Act, state corporate 

law has become better developed as to the role of independent directors in 

policing possible self-dealing and overreaching by insiders. 

While state laws dealing with corporate transactions in which a director or 

other affiliate has an interest have evolved considerably since 1940, the law has 

evolved in the context of operating companies, which typically have a very 

different management structure. The management of an operating company 

rarely is involved in running another business; accordingly, affiliated transactions 

50See, e.g., Letter from Dechert Price & Rhoads to Jonathan G. Katz, Secretary, SEC 7, 30-33 

(Oct. 10, 1990, revised Oct. 15, 1990), File No. 57-11-90; see also Letter from Citicorp to Jonathan 

G. Katz, Secretary, SEC 25 (Oct. 10,1990), File No. S7-11-90. This approach was suggested in 1976 

by two Commission staff members. Alan Rosenblat & Martin E. Lybecker, Some Thoughts on the 

Federal Securities Laws Regulating External Investment Management Arrangements and the ALJ Federal 

Securities Code Pruject, 124 U. PA. L. REV. 587, 634-51 (1976) (also suggesting subjecting service 

contracts (such as transfer agency, custodial, and accounting support contracts) to section 17(a), 

but exempting such contracts where a majority of the independent directors approve the 

contracts). 

Affiliated Transactions 491 
tend to arise on a more limited basis and often only in the context of unusual 

corporate events, such as contests for corporate control. 

By contrast, the management of an investment company usually is 

performed by another business enterprise that has its own pecuniary interest and 

also has other significant ongoing business operations that create numerous 

opportunities for transactions between affiliates and the investment company. For 

example, many investment companies are affiliated with broker-dealers or with 

other diversified financial services concerns having a wide range of investments 

and operations. In those interactions, the interests of the investment company 

and the affiliate often diverge. Accordingly, state law governing the decisions of 

corporate directors may not provide sufficiently specific standards for the 

directors’ approval of numerous portfolio and other transactions on an ongoing 

basis?* 

Moreover, because of the limitations on the information and time available, 

directors, and in particular the independent directors, could be overwhelmed if 

they were required to evaluate and approve a large number or wide range of 

affiliated transactions, particularly principal transactions. A typical investment 

company that is affiliated with a large broker-dealer might effect numerous 

principal transactions with the affiliated dealer, on a daily basis, absent the 

prohibitions of section 17. Asking fund directors to review numerous transactions 

is not only unrealistic, but might also interfere with the critical role independent 

directors play in overseeing the operations of the company by distracting their 

attention from broader issues. Indeed, the larger the number of transactions that 

the directors must review, the harder it would be for directors to scrutinize the 

merits of each transaction. 

51A related question in delegating such authority is whether section 36@) should apply to 

director-approved affiliated transactions. Section 36(b) imposes a fiduciary duty on an investment 

company’s investment adviser with respect to the amount of compensation received from the 

company by the adviser or an affiliate of the adviser; it currently does not apply to transactions 

subject to section 17, however. Subjecting director-approved affiliated transactions to section 36(b) 

would not provide sufficient additional protection to obviate the need for prior Commission 

review. To police overreaching effectively, the Commission’s ability to bring actions under section 

36(b) would have to be supplemented by private actions. It is unclear, however, how private 

parties would ever be able to monitor abusive transactions involving an investment company and 

its affiliates.. 

492 CHAPTER 12 
2. Permitting Joint Transactions on an Equal Basis 

The Division also recommends amendments to rule 17d-1 to permit certain 

types of joint transactions by an investment company and its affiliates where the 

investment company partici ates on terms not different from those applicable to 

any affiliated participant?' Over the years, the Commission has issued a 

number of exemptive orders allowing investment companies and BDCs and 

certain affiliates to invest jointly in securities, if a number of conditions are met 

to ensure that the company's participation is on a basis not less favorable than 

any affiliate?3 Those orders require, among other things, that the investment 

company and its affiliate purchase the same class of security at the same time and 

at the same price. They also have conditions concerning the timing of disposition 

of the security and typically require the independent directors of the investment 

company to review or approve such purchases. 

Similarly, in the 1970~~ the Commission proposed an amendment to rule 

17d-1 to permit a practice known as "bunching," in which an investment company 

and its affiliates combine contemporaneous purchases or sales of securities of their 

various investment portfolio^?^ Commenters generally supported the proposal, 

but the Commission withdrew it in 1976, citing several concern^?^ The 

Commission questioned whether the elimination of fixed commissions had 

eliminated the economic considerations supporting the exemption. The 

Commission also indicated that three questions raised by the rule would be better 

resolved on a case-by-case basis, through the consideration of exemptive 

applications: (I) whether bunching would be consistent with the fiduciary duties 

of affiliates; (2) whether affiliates could reap a disproportionate benefit; and 

(3) how to combine non-concurrent orders such as limit orders or partially 

executed orders. We have reevaluated those concerns and believe they can be 

52Cf. Letter from R. James Gormley to Jonathan G. Katz, Secretary, SEC, attached 

memorandum at 14 (Oct. 24, 19901, File No. S7-11-90. 

530ne commenter suggested codifying these orders. Letter from The Equitable Life Assurance 

Society of the United States to Jonathan G. Katz, Secretary, SEC 25-27 (Oct. 5,1990), File No. S7- 

11-90. 

54Joint Enterprises or Arrangements and Certain Profit-sharing Plans, Investment Company 

55Bunching Rule, Withdrawal of Proposal, Investment Company Act Release No. 9170 (Feb. 

Act Release No. 7035 (March 9,1972),37 FR 5831. 

19,1976),41 FX 8799. 

Affiliated Transactions 493 
addressed in an exem tive rule, rather than by requiring individual applications 

for such transactions. 8 

In addition, some transactions exempted during the last few years share 

some of the characteristics of the bunching proposal and exemptive orders 

discussed above. The Division believes those transactions would similarly be 

amenable to regulation under an exemptive rule. For example, the Commission 

has exempted joint repurchase agreements, where two or more investment 

companies in the same complex jointly invest their excess cash in one or more 

repurchase agreements, resulting in cost savings and higher interest earned for 

each of the participating f~nds.5~ The Commission also has exempted the 

affiliates of several investment companies from rule 17d-1 to permit them to join 

in a lawsuit against the issuer of securities each of them held and share all legal 

fees and expenses in proportion to their respective securities holdings?8 

These transactions do not present the risks that section 17(d) was designed 

to prevent: the participation by an investment company "on a basis different from 

or less advantageous than that of [any] other parti~ipant."~~ Rather, in each 

case, the investment company and its affiliates participate on the same terms, 

except as to the amount of their participation. Accordingly, the Division 

recommends an amendment to rule 17d-1 to permit any joint transaction where 

560ne commenter suggested an amendment to rule 17d-1 to permit bunching of trades with 

affiliates, subject to five conditions: (1) the transaction involves only a cash payment against 

prompt delivery of a security; (2) the net price for the securities purchased or sold is the same to 

each participant; (3) the allocation of actual trades is substantially in proportion to the participants' 

orders; (4) the transaction is consistent with the investment company's policy; and (5) the 

investment company's board, including its independent directors, determines that transactions will 

be of benefit to the investment company. Letter from the American Council of Life Insurance to 

Jonathan G. Katz, Secretary, SEC 123-24 (Oct. 10, 1990), File No. S7-11-90. Similarly, another 

commenter recommended that the rule be amended to exempt "concurrent purchases or sales of 

portfolio securities by funds in the same complex." Letter from the Subcommittee on Investment 

Companies and Investment Advisers of the Committee on Federal Regulation of Securities, Section 

of Business Law, American Bar Association, to Jonathan G. Katz, Secretary, SEC 29 (Oct. 18,1990), 

File No. 57-11-90 [hereinafter ABA Study Comment]. 

57See, e.g., ABT Growth and Income Trust, Investment Company Act Release Nos. 17626 (July 

30, 1990), 55 FR 31933 (Notice of Application) and 17712 (Aug. 29, 19901, 46 SEC Docket 1990 

(Order). 

%See The Prudential Insurance Co. of America, Investment Company Act Release Nos. 17568 

(July 3,1990), 55 FR 28499 (Notice of Application) and 17644 (Aug. 2,1990),46 SEC Docket 1609 

(Order). 

5%ule 17d-l(b) (describing standard for Commission consideration of applications seeking 

approval of joint transactions). 

494 CHAPTER 12 
an investment company and its affiliates participate on equal terms, except for the 

amount of the participation. The exemption would require the board of the 

company, including a majority of the independent directors, to establish 

procedures to ensure that the transactions are within the exemption, and to 

determine periodically that the participation of the fund in the joint transactions 

continues to be in its best interest. 

The Division believes that the amendment also should make clear that an 

exemption from section 17(d) and rule 17d-1 does not by itself address all 

questions under the Investment Company Act, other federal securities laws, or 

state laws. For example, it would not address whether an adviser to an 

investment company, as a fiduciar is obligated to put the fund's trade ahead 

its own or those of other clients.6'Such concerns are not within the gambit of 

section 17(d), which allows the Commission to adopt rules to prevent 

participation by an investment company on a basis different from or less 

advantageous than that of other participants. Thus, if a transaction is on equal 

terms among the company and its affiliates, it is inconsistent with the purposes 

of the section to prohibit the transaction absent a Commission order, whether or 

not some other provision of law may prohibit joint participation. Therefore, the 

amendment would clarify, for example, that practices such as "bunching" are not 

prohibited under rule 17d-1, but may be subject to limitations under other legal 

standards. 

3. Narrowing the Scope of Section 17(d) and Rule 17d-1 

The Division also considered three other ways to reduce the scope and 

attendant costs of the prohibition on joint transactions. One way would be to 

limit the prohibition to transactions where a fund and its affiliate are on the same 

side of the transaction, thereby excluding from the rule more complex 

arrangements. A second would be to reduce the number of affiliates subject to 

the prohibition.^ A third would be to replace rule 17d-1's application requirement 

with a rule that simply prohibits overreaching. As discussed below, we conclude 

that none of these proposals would provide adequate investor protection. 

6"hat question is not addressed by rule 17d-1 today. We note that section 17(j) and rule 15-1 

require funds and their advisers and principal underwriters to adopt codes of ethics governing 

securities trading by personnel with access to information about fund trading activities. Some 

codes of ethics require that such "access persons" effect all their trades in securities after fund 

trades. See, e.g., Mary Ann Tynan, Drafting Guide for Codes of Ethics under Rule 17j-I, IC1 MUTUAL 

FUND TRAINING CONFERENCE, at IV-22 to IV-23 (1987). 

Affiliated Transactions 495 
a. Prohibiting Only Participation on the Same Side 

of Transactions 

One way to clarify the scope of rule 17d-1 would be to limit its coverage 

to transactions where the investment company and an affiliate are on the same 

side. Two commenters recommended clarifying section 17(d) and rule 17d-1 in 

this manner?' One quoted a Commission brief that stated that section 17(d) 

applies to "a transaction in which the investment company and its affiliated 

person participate on the same side."62 The other recommended amending rule 

176-1 to define a joint transaction as a transaction in which an affiliate "knowingly 

acts in combination with such registered investment company or a controlled 

company thereof in a manner that results in a potential sharing of the assets, 

liabilities, profits or losses of such enterprise or ~ndertaking."~~ Thecommenter 

argued that "where parties are on opposite sides of the transaction it appears to 

'negate the existence or possibility of "some element of combination" that the 

Second Circuit, in [Talley], said "is required" for purposes of Section 17(d) and rule 

17d-1 .'lr6* 

- 

Such a restricted definition of joint transactions would unduly narrow rule 

17d-1. While it is true that section 17(d) often is described as applying to 

transactions where an investment company and its affiliate are "on the same side 

of the table transacting business with a third party,'165 courts, the Commission, 

and the Commission's staff consistently have interpreted rule 17d-1 to apply 

where the affiliate and the fund are not on the same side of the table, but 

nevertheless have a joint interest in the transaction?6 For example, in Sfeadrnan 

61ABA Study Comment, supra note 56, at 29; letter from Merrill Lynch & Co., Inc. to Jonathan 

G. Katz, Secretary, SEC 11-33 (Oct. 18, 1990), File No. S7-11-90 [hereinafter Merrill Lynch Study 

Comment]. 

62ABA Study Comment, supra note 56, at 29, quoting the Commission's brief in SEC v. Talley 

Industries, Inc., supra note 13. 

63Merrill Lynch Study Comment, supra note 61, at 11-32, -33, -38. 

641d. at 11-33, quoting Morgan Capital Corp. (pub. avail. Oct. 17, 1986). The commenter also 

suggested that inserting a "knowingly" requirement in the rule would help to clarify that actions 

such as simultaneous but independent investments are not prohibited. Id. We agree that this 

would not be a change from current law. (As noted earlier, section 57(a)(4) of the Act, concerning 

joint transactions by BDCs, has an express "knowingly" requirement.) 

%ee, e.g., LEMKE, supra note 31, at 83-136. 

&See SEC v. Commonwealth Sec. Investors, Inc., 11970-71 Transfer Binder] Fed. Sec. L. Rep. 

(CCH) 3 92,859 (E.D. Ky. Oct. 21, 1970) (enjoining investment company insiders from future 

(continued.. J 

496 CHAPTER 12 
Security C0rp.,6~ the Commission, in determining that the controlling person of 

an adviser did not violate rule 17d-1 by having the fund maintain deposits at 

banks where he obtained personal loans, rejected the argument that section 17(d) 

applied only to joint ventures and observed that "three party transactions, such 

as those present here, would seem within section 17(d)'s scope were there a 

causal connection between the funds' deposits and [the controlling person's] 

loans." 

The reasons for the Commission's position are obvious. As one writer put 

it: 

Section 17(d) . . . was designed to deal with transactions of the 

investment company . . . in which affiliates have a conflict of 

interest. Congress was concerned with overreaching and unfair 

advantages to insiders. Conflict of interest and overreaching may 

exist whether or not the affiliates' participation is of the same 

economic nature. . . . [Tlhere are many examples in the Act's 

legislative history of investment companies that were induced to 

participate not only on different terms but in different economic 

arrangements. Investment companies' assets were used to finance 

companies and acquire control of enterprises in which affiliates had 

personal interests. Investment companies were operated as 

discretionary brokerage accounts to produce commissions for 

affiliates. They were used to manufacture securities for promoters 

in the securities distribution business.@ 

The concerns of the 1940 Congress about overreaching and unfair 

advantage to insiders are equally relevant today. Indeed, those joint transactions 

reviewed by the Commission in which the fund and an affiliate do not participate 

on the same side of the table often involve complex business arrangements. Our 

experience in reviewing such arrangements suggests that close examination 

continues to be necessary, especially for those transactions where an investment 

company and an affiliate will experience different economic consequences. 

66(...continued) 

violations of rule 17d-1 based on their obtaining loans, securities, and fees from a company with 

which the investment company was negotiating a merger); South Bay Corp. (pub. avail. Dec. 4, 

1974) (declining to provide no-action assurance regarding settlement of lawsuit by registered 

investment company against officers and directors of 45% shareholder of investment company). 

67Sup.a note 16. 

682 TAMAR FRANKEL, THE REGULATION OF MONEY MANAGERS, ch. XIII, 5 24.3, at 531-32 (1980 

& Supp. 1991) (citations omitted). 

Affiliated Transactions 497 
b. Narrowing the Group of Affiliates Subject to the Rule 

Another way to reduce the uncertainty about the scope of rule 176-1 would 

be to reduce the number of affiliates brought within its prohibitions. One 

commenter recommended amending rule 17d-1 to apply only to transactions 

where the affiliate is an investment adviser, principal underwriter, or controlling 

person with respect to the c0mpany.6~ Thus, joint transactions with relatively 

close affiliates such as controlling persons of fund advisers and principal 

underwriters and with fund officers and directors would be lawful, without any 

restriction even though such affiliates may still be in a position to exercise 

significant influence over an investment company. By contrast, in enacting 

section 57, which permits independent directors of BDCs to approve transactions 

with remote affiliates, Congress did not accept that such relatively close affiliates 

presented a reduced risk of overreaching or conflict of interest. 

Transactions with many of these relatively close affiliates are as susceptible 

to overreaching and abuse as are transactions directly with fund advisers and 

underwriters. Indeed, some of the leading precedents under section 17(d) involve 

the affiliates that would be excluded under this proposal. For example, in SEC 

v. Midwest Technical Development a mutual fund made heavy 

investments in certain portfolio companies sorely in need of financing. The court 

found that the investments had been induced by the fund's directors, who had 

assisted in the organization of the companies. After the strengthening of the 

financial structure of the portfolio companies by the fund's investments, the 

directors made their own investments. 

In light of those risks, we do not recommend so great a narrowing of the 

scope of rule 17d-1. We recommend instead, as discussed above, amending rule 

17d-1 to make it parallel to the requirements of section 57. Thus, fund directors 

would have the authority to approve only joint transactions with those more 

remote affiliates that Congress has determined present little risk of abuse. 

c. Prohibiting Only Overreaching 

The Division also considered whether to alter the regulation of joint 

transactions radically by amending rule 17d-1 to prohibit only those joint 

transactions that involve overreaching. This idea was proposed in 1971 by two 

69Letter from the Committee on Securities Regulation of the Association of the Bar of the City 

of New York to Jonathan G. Katz, Secretary, SEC 2-3 (Oct. 4, 19901, FiIe No. S7-11-90. 

70[1961-64 Transfer Binder] Fed. Sec. L. Rep. (CCH) 4[ 91,252 (D. Minn. July 5,1963). 

498 CHAPTER 12 
trade associations representing insurers?* They suggested that, instead of 

requiring prior Commission approval, the Commission rely on enforcement 

actions under an amended rule 17d-1 and section 36(a). The Commission did not 

pursue this suggestion then, and we do not recommend that it do so now. 

Relying on after-the-fact enforcement action to address overreaching would 

give investment companies and their affiliates the opportunity to do improper 

transactions subject only to the risk of subsequent and probably incomplete 

enforcement. It is doubtful that any enforcement could provide a full remedy, 

because it would be difficult and time-consuming to undo improper affiliated 

transactions. Even if a transaction could be undone and a fund could be 

compensated, such actions would not compensate shareholders harmed by the 

improper transaction who may have redeemed in the interim. For such a rule to 

be effective, the Division would have to monitor carefully all joint transactions 

through its examination process -- an impossibility and an extremely intrusive 

prospect. 

C. Section lO(f) and Rule 1Of-3 

The Division also recommends that rule 1Of-3 be expanded to permit 

investment company purchases of foreign securities that are not currently exempt 

under the rule from the section 1O(f) prohibition on purchases from syndicates 

containing affiliates?* Funds that invest overseas generally are unable to rely 

on rule IOf-3 because it requires that the securities being purchased either be 

registered under the Securities Act or be municipal securities. Obviously, in most 

cases, neither alternative can be satisfied in an overseas offering. The 

Commission has met that problem by exempting investment companies where the 

71Memorandum of American Life Convention and Life Insurance Association to the Division 

of Corporate Regulation, SEC (Feb. 11,1971). One author also discussed this approach in 1972: 

Under [section] 17(d) we might consider a self-operating lob-5 type rule, making 

overreaching in joint transactions unlawful, rather than the cumbersome 

application procedure. A blanket exemptive rule could be adopted covering 

situations where there is an absence of overreaching. This would replace the 

existing application procedure with a self-operating approach such as that 

reflected by rule lob-5 under the [Exchange] Act. 

Milton P. Kroll, The ’Portfolio Affiliate’ Problem, in THIRD ANNUAL INST. ON SEC. REGULATION, 261, 

290-91 (PLI Sec. Reg. Transcript Series No. 3,1972). 

7%oments on rule 10f-3 mostly focused on the inability of funds that invest overseas to rely 

on the rule. See, e.g., Letter of Davis Polk & Wardwell to Jonathan G. Katz, Secretary, SEC 33-34 

(Oct. l0,1990), File No. 57-11-90; Letter of S.G. Warburg & Co. Inc. to Jonathan G. Katz, Secretary, 

SEC 6-8 (at. 12, 1990), File No. S7-11-90. 

Affiliated Transactions 499 
company represented that the securities regulation of the country in which the 

company was to purchase securities was "substantially equivalent for purposes 

of rule 10f-3."73 This substantial equivalence standard, however, is not 

attainable in emerging markets that are subject to less regulation than the home 

market. 

Since neither the registration requirement of rule 1Of-3 nor the "substantial 

equivalence'' standard of exemptive orders provides relief in markets that cannot 

meet those requirements, we recommend that rule 1Of-3 be amended specifically 

to permit investment companies to purchase foreign securities in compliance with 

restrictions that would provide protections comparable to those provided by the 

current requirement^.^^ These might include requirements that the offering be 

a public offering75 conducted in accordance with applicable law and that the 

offering be conducted by means of a firm commitment underwriting?6 The 

conditions would also require that audited financial statements of the issuer for 

the most recent three years be available to prospective purchasers, to ensure that 

adequate public information is available to the investment company and its 

adviser and directors to facilitate their review of the investment merit of such 

securities. These requirements would retain safeguards against "dumping," while 

removing an unnecessary barrier to portfolio transactions in foreign securities. 

IV. Conclusion 

The Act's restrictions on transactions with affiliates are among its core 

provisions. Recent experience has reaffirmed the wisdom of the Act's drafters in 

imposing those restrictions. Accordingly, we recommend only limited changes 

in this area. We recommend that the Commission begin rulemaking proceedings 

to amend rule 17d-1 to permit the directors, including the independent directors, 

to review and approve all joint transactions with remote affiliates and also to 

73See, e.g., The Japan Fund, Inc., Investment Company Act Release Nos. 9789 (June 6,1977), 

42 FR 29351 (Notice of Application) and 9832 (June 24, 1977), 12 SEC Docket 1087 (Order). 

741t appears that the Commission imposed the registration requirement in rule 1Of-3 to ensure 

that the investment company purchased marketable securities, at the public offering price, which 

ordinarily would not exist absent registration. Registration also tends to ensure that the securities 

offering is in the ordinary course of business. 

7%7e understand, however, that in certain foreign markets public offerings are not conducted 

at a uniform offering price. A public offering requirement would need to address the issues 

raised by non-uniform pricing, and especially by the existence of distinct prices for affiliates. 

76We note that in Japan initial public offerings are bifurcated into two portions, only one of 

which is on a firm commitment basis. The other portion includes an auction procedure. 

500 CHAPTER 12 
~ 

permit all joint transactions where the investment company and its affiliates 

participate on the same terms, except for the amount of the participation; and 

amend rule 1Of-3 to provide relief for purchases overseas similar to that extended 

to purchases in domestic markets. 

Affiliated Transactions 501 
Chapter 13 

Procedures for Exemptive Orders 

I. Introduction and Summary of Recommendations 

The Commission is accorded significant discretion to administer the 

provisions of the Investment Company Act: In at least thirty-three separate 

instances, the Act authorizes the Commission to issue orders for different types 

of relief from specific statutory requirements? The quintessential discretionary 

provision is section 6(c>,3 which authorizes the Commission to: 

conditionally or unconditionally exempt any person, security, or 

transaction, or any class or classes of persons, securities, or transactions, 

from any provisions of [the Act] or of any rule or regulation thereunder, 

if and to the extent that such exemption is necessary or appropriate in the 

public interest and consistent with the protection of investors and the 

purposes fairly intended by the policy and provisions of [the Act]? 

Congress, in its foresight, added this section to provide the Commission with 

administrative flexibility? 

lInvestment Company Act of 1940,15 U.S.C. § 8Oa. 

*Investment Company Act §§ 2(a)(9), 3(b)(2), S(f),9(c), 10(e)(3), 1O(f), IUa), 12(g), 15(0(3),16(a), 

17(b), 17(e)(2), 18(i), Nj), 19(b), 22(b)(l), 22(e)(3), 23(b), 23(c)(1), 23(c)(3), 26(b), 27(b), 28(b), 28(d), 

31(d), 34(a), 38(a), 56(b), 57(c), 57(j)(NE)(ii), 57(k), 57(n)(l)(A)(ii), 61(a)(3)(B)(i), 15 U.S.C. §§ 8Oa2(a)(9), -3(b)(2), -S(0, -9(c), -10(e)(3), -1O(f), -lW, -12(g), -15(0(3), -16(a), -17(b), -17(e)(2), -18(i), - 

lS(j), -19(b), -22(b)(l), -22(e)(3), -23(b), -23(c)(l), -23(c)(3), -26(b), -27(b), -28(b), -28(d), -30(d), -33(a), 

-37(a), -55(b), -56(c), -56(j)(2)(E)(ii), -56(k), -56(n)(l)(A)(ii), -6O(a)(3)(B)(i). In addition, the 

Commission also issues exemptive orders under rule 17d-1 to permit the consummation of joint 

transactions involving affiliates otherwise prohibited by section 17(d) and rule 17d-1 thereunder. 

17 C.F.R. 5 270.17d-1. See Chapter 12. 

315 U.S.C. 9 80a-6(c). 

41n addition, section 6(b) authorizes the Commission to exempt employees’ securities 

companies from one or more of the Act‘s provisions, section 6(d) authorizes the Commission to 

exempt certain small, closed-end, intrastate investment companies from any or all of the Act’s 

provisions, and section 6(e) authorizes the Commission, in exempting any investment company 

from the registration provisions of section 7 (15 U.S.C. 5 8Oa-7), to impose conditions of 

compliance with any of the Act‘s provisions. 

51n his remarks to Congress recommending the bill that later became the Investment Company 

Act, David Schenker, Chief Counsel of the Commission’s Investment Trust Study and a principal 

(continued. ..) 

503 
Despite the flexibility of section 6(c), however, responses to the 

Commission's release soliciting comments on the reform of investment companies 

(the "Study Release"),6 criticized section 6(c) and particularly the Commission's 

and the Division's administration of the pro~ision.~ While many commenters 

declared that the flexibility provided by section 6(c) is indispensable to the success 

of the Act: many of the same commenters also complained that the process of 

obtaining an exemptive order simply takes too long? Commenters also criticized 

5(...continued) 

author of the Act, stated that "the difficulty of making provision for regulating an industry which 

has so many variants and so many different types of activities . . . is precisely [the reason that 

section 6(c)l is inserted." Investment Trusts and Investment Companies: Hearings on S. 3580 Before u 

Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 197 (1940) [hereinafter 

1940 Senate Hearings]. 

6Request for Comments on Reform of the Regulation of Investment Companies, Investment 

Company Act Release No. 17534 (June 15,1990), 55 FR 25322. 

7See, eg., Letter from the Subcommittee on Investment Companies and Investment Advisers 

of the Committee on Federal Regulation of Securities, Section of Business Law, American Bar 

Association ("ABA Subcommittee"), to Jonathan G. Katz, Secretary, SEC 5-9 (Oct. 18, 19901, File 

No. S7-11-90 [hereinafter ABA Study comment]; Letter from Davis Polk & Wardwell to Jonathan 

G. Katz, Secretary, SEC 40-44 (at. 10, 1990), File No. S7-11-90 [hereinafter Davis Polk Study 

Comment]; Letter from Dechert Price & Rhoads to Jonathan G. Katz, Secretary, SEC 5,ll-17 (Oct. 

10, 1990), File No. S7-11-90 [hereinafter Dechert Price Study Comment]; Letter from Federated 

Investors to Jonathan G. Katz, Secretary, SEC 26 (Oct. 10, 1990), File No. S7-11-90 [hereinafter 

Federated Study Comment]; Letter from Fidelity Management & Research Co., Inc. to Jonathan 

G. Katz, Secretary, SEC 9-10 (Oct. 11, 1990), File No. S7-11-90 [hereinafter Fidelity Study 

Comment]; Letter from IDS Financial Corporation to Jonathan G. Katz, Secretary, SEC 25-27 (Oct. 

2,1990), File No. S7-11-90 [hereinafter IDS Study Comment]; Letter from the Investment Company 

Institute (TX") to Jonathan G. Katz, Secretary, SEC 44-46 (Oct. 5, 19901, File No. S7-11-90 

[hereinafter IC1 Study Comment]; Letter from Merrill Lynch & Co., Inc. to Jonathan G. Katz, 

Secretary, SEC 1-4, Ex. I (Oct. 18, 1990), File No. S7-11-90 [hereinafter Merrill Lynch Study 

Comment]; Letter from PaineWebber Development Corporation to Jonathan G. Katz, Secretary, 

SEC 4 (Oct. 10, 1990), File No. S7-11-90 [hereinafter PaineWebber Study comment]; Letter from 

Prudential Mutual Fund Management, Inc. to Jonathan G. Katz, Secretary, SEC 8-9 (Oct. 9,1990), 

File No. S7-11-90 [hereinafter Prudential Study Comment]. 

'According to Alfred Jaretzki, Jr., one of the principal authors of the Act, "Without these 

exemptive powers and without a wise exercise of discretion thereunder, the Act would be 

unworkable, unduly restrictive and would cause unnecessary hardships." Alfred Jaretzki, Jr., The 

Investment Company Act of 1940,26 WASH. U. L.Q. 303,344 (1941). Several responses to the Study 

Release shared Mr. Jaretzki's view. See, e.g., ABA Study Comment, supra note 7, at 6; Davis Polk 

Study Comment, supra note 7, at 40-41 n. 57; IC1 Study Comment, supra note 7, at 44-45; 

PaineWebber Study Comment, supra note 7, at 3 n.*. 

'See, e.g., ABA Study Comment, supra note 7, at 7 (recounting the experience of one of its 

members, stating that "whereas [the member] once advised clients to expect that an order could 

be issued in four to six months he now advises one to two years."). Critics have focused on 

(continued ... ) 

CHAPTER 13 504 
the Division for a perceived reluctance to exercise its delegated authority" in 

granting exemptive orders)' and a perceived narrow interpretation of section 

6(c).12 

Because of the importance of the application procedure to the 

administration of the Act, the Division examined a number of options for reform, 

either through changes to the substantive standards in the statute or through 

procedural changes. We considered a number of alternatives, including the 

suggestions made by commenters. We conclude that while existing standards and 

procedures are fundamentally sound, they may be improved. 

Our first recommendation for procedural reform is of our own creation, 

although it draws on certain of the recommendations made by commenters. The 

procedure we propose would permit expedited treatment of applications for 

which there is precedent. Applicants employing this procedure generally would 

receive relief no later than 120 days after filing an application. (Currently, on 

average, applicants receive orders approximately 190 days after filing.) Our 

second recommendation is an amendment to the Division's delegated authority 

that we believe would expedite review of applications. We discuss these 

recommendations, as well as the approaches we considered and rejected, below. 

'(...continued) 

perceived unnecessary delays in the review of relatively routine applications (see, eg., IDS Study 

Comment, supra note 7, at 26) as well as those presenting novel and complex issues (see, e.g., ABA 

Study Comment, supra note 7, at 7-9; Davis Polk Study Comment, supra note 7, at 41-42; Fidelity 

Study Comment, supra note 7, at 9; IDS Study Comment, supra note 7, at 26), and have argued that 

these delays make it difficult to obtain exemptive orders within the time frame required to 

accommodate a specific transaction, which may prevent worthwhile financial products from 

entering the marketplace, to the detriment of investors. 

"See infra notes 36 & 46 and accompanying text. 

"See, e.g., ABA Study Comment, supra note 7, at 7-9; Merrill Lynch Study Comment, supra 

note 7, at 2-3. 

**See, e.g., Davis Polk Study Comment, supra note 7, at 41-42; Dechert Price Study Comment, 

supra note 7, at 11-16; IDS Study Comment, supra note 7, at 26; Merrill Lynch Study Comment, 

supra note 7, at 2; PaineWebber Study Comment, supra note 7, at 3-4. 

Procedures for Exemptive Orders 505 
11. Background 

A. The Historical Use of Section 6(c) 

Early opinions of the Commission emphasized that use of its exemptive 

authority was to be somewhat limited.13 As the financial markets have evolved, 

however, the need for exemptive relief has grown, not only to respond to new 

innovations but also to keep pace with the general evolution of the investment 

company industry.14 The orders issued by the Commission have addressed 

matters ranging from relatively minor investment company operational matters 

to complex trading vehicles that do not necessarily fit within the regulatory 

confines of the Act. 

Perhaps the most powerful example of the flexibility and scope of the 

Commission's authority under section 6(c) is the introduction and growth of 

money market funds. Under section 2(a)(41), registered in tment companies 

must value their securities based on market values, if available., or, if not, values 

determined in good faith by the board of directors. In a series of exemptive 

orders beginning in the 1970'~~ theCommission permitted money market funds 

to use two alternative valuation methods, amortized cost or penny rounding.15 

Those orders were later codified in rule 2a-7.16 The orders and the rule were 

critical to the evolution and success of money market funds, which, as of year-end 

1991, represented a roximately $450 billion in assets and about 33% of all 

mutual fund assets. RP 

~- ~ 

131n a 1941 opinion, the Commission stated that "[tlhe very breadth of a power to exempt any 

person, security, or transaction from any provision of the Act places upon us a grave 

responsibility that such power be exercised with the greatest circumspection." In re American 

Participations, Inc., 10 S.E.C. 430,437 n.8 (1941). See also In re Atlantic Coast Line Company, 11 

S.E.C. 661,667 (1942) (construing section 6(c) as authorizing relief only in those "special situations 

that might have been overlooked or that could not be foreseen at the time the legislation was 

drafted"). 

'%e extent to which the Commission and the financial services industry now depend on the 

exemptive process is demonstrated by the number of applications reviewed by the Division. In 

recent years, the number received has fluctuated somewhat, but is always substantial, ranging 

from 415 in fiscal year 1989 to 347 in fiscal year 1990 to 310 in fiscal year 1991. 

15See genwdly Valuation of Debt Instruments and Computation of Current Price Per Share By 

Certain Open-End Investment Companies (Money Market Funds), Investment Company Act 

Release Nos. 12206 (Feb. 1,1982), 47 FR 5428 (request for comments on proposed rule 2a-7) and 

13380 (July 11, 1983), 48 FR 32555 (notice of final rule 2a-7). 

1617 C.F.R. § 270.2a-7. 

17See IC1 News Release, IC1 92-03 (Jan. 29,1992). 

CHAPTER 13 506 
In the last several years alone, the Commission's exemptive orders have 

covered a wide variety of Investment Company Act issues. For example, many 

relate to new sales and distribution practices in the mutual fund industry, such 

as offers of exchange among investment portfolios in the same family of funds:' 

imposition of contingent deferred sales loads,lg and more complicated matters 

such as funds offering multiple classes of shares with different sales charges and 

expenses ?O 

Recent Commission orders also have involved somewhat narrow but 

complicated factual circumstances. For example, in 1989, as part of its settlement 

with Drexel Burnham Lambert Inc. ("Drexel"), the Commission issued an order 

under section 9(c) of the Act temporarily allowing Drexel to remain as an adviser 

and principal underwriter to a number of registered investment companies, 

notwithstanding the automatic disqualification in section 9(a>. The order 

contained a number of conditions, including a requirement that Drexel hire an 

independent examiner to conduct an extensive review of its investment company 

operations.2l 

Another exemptive order involving a complex factual situation is the 1990 

Commission order permitting a unit investment trust to issue redeemable equity 

interests that are divided into two unredeemable components?2 The order 

exempted the trust, its sponsor, and dealers from section 22(d) of the Act, thereby 

permitting the trust's securities to be traded freely on secondary rnarketsF3 

"See, eg., PNCG Money Market Fund, Inc., Investment Company Act Release Nos. 16971 (May 

19, 19891, 54 FR 23000 (Notice of Application) and 17007 (June 14, 19891, 43 SEC Docket 2059 

(Order). Orders of this type now have been codified in rule 11a-3. 17 C.F.R. 5 270.11a-3. 

19See, eg., Freedom Investment Trust, Investment Company Act Release Nos. 16487 (July 20, 

1988), 56 FR 56260 (Notice of Application) and 16526 (Aug. 16,1988), 41 SEC Docket 904 (Order). 

20See, e.g., Goldman Sachs--Institutional Liquid Assets, Investment Company Act Release Nos. 

17420 (Apr. 11,1990), 55 FR 14541 (Notice of Application) and 17479 (May 8,1990), 46 SEC Docket 

350 (Order). 

21Drexel Burnham Lambert Inc., Investment Company Act Release No. 17133 (Sept. 11,1989), 

44 SEC Docket 1104. 

22The SuperTrust Trust for Capital Market Fund, Inc. Shares, Investment Company Act Release 

Nos. 17613 (July 25,19901, 55 FR 31281 (Notice of Application) and 17809 (Oct. 19,1990), 47 SEC 

Docket 1098 (Order). 

In addition, as discussed in Chapter 1, the Commission has issued a number of orders 

in recent years exempting certain types of structured financings from the provisions of the Act. 

Procedures for Exemptive Orders 507 
B. Current Procedures for Obtaining Exemptive Relief under 

Section 6(c) 

Applicants seeking exemptive relief under section 6(c) must file an 

application with the Commission setting forth a basis for the relief requested 

(including a detailed justification for removal of any statutory protections), and 

identifying any benefits expected for investors and any conditions imposed to 

protect in~estors.2~ Applications are reviewed in the order received, unless the 

applicant makes a compelling demonstration that the application could not have 

been filed in time to allow it to be addressed and acted upon in due course?5 

The total time period for consideration of an exemptive application by the staff 

and (in some instances) the Commission, responses by the applicant, and the 

notice period typically ranges from six to eight months, depending on the novelty 

and complexity of the requested relief and the staff's workload. During the 

review process, the staff may send comment letters to the applicant requesting 

clarifications or modifications to the application to assure that the requested relief 

is consistent with statutory standardsF6 Once review of an application is 

completed, a notice outlining the requested relief is published in the Federal 

Register to give interested persons an opportunity to request that the matter be set 

down for a hearingF7 After a notice period of approximately twenty-five 

2%Zommission guidelines require prospective applicants to review all relevant provisions of 

the Act and rules thereunder, and all pertinent Commission releases, before filing an application. 

Applicants are also required, to the extent possible, to bring their proposal within applicable 

precedent, and to cite and discuss such precedent in the application. Commission Policy and 

Guidelines for Filing of Applications for Exemption, Investment Company Act Release No. 14992 

(Apr. 30, 1985), 50 FR 19339 (setting forth procedures and guidelines for applicants to follow in 

connection with filing exemptive applications, and representing the Commission's efforts to 

streamline the exemptive applications process in response to increases in the early 1980's in both 

the number and complexity of exemptive applications filed under section 6(c)). 

251d. 5 6/50 FR at 19340. 

26Division guidelines require the staff to give initial comments on an exemptive application 

within 45 days of receipt of the application (id. at n.1, 50 FR at 19339 n.1) and the applicant to 

file any amendments to its application within 60 days of receipt of staff comments (id. 3 8/50 ER 

at 19340). At the staff's discretion, an applicant who does not file an amendment within 60 days 

may be placed on inactive status. Id. An applicant may reactivate an inactive application at any 

time by filing an appropriate request with the Division or by filing the required amendment. Id. 

Action on reactivated applications commences from the date of the Division's receipt of such an 

such request or amendment, and does not date back to the filing of the original application. Id. 

27Under section 40(a) of the Act, orders of the Commission may be issued only after 

appropriate notice and opportunity for hearing. 15 U.S.C. ,§ 80a-39(a). Division guidelines require 

that notices of routine applications which require no amendment be published within 60 days of 

receipt of the application. Inv. Co. Act Rel. 14492, supra note 24, at n.l,50 FR at 19339 n.1. 

CHAPTER 13 508 

116 
daysF8 and unless a hearing is requested by an interested party or is ordered 

by the Commission on its own motion, an order is issued granting the requested 

relief?’ If the staff determines that it cannot support an application because the 

relief requested is not justified, it may recommend that the application be 

withdrawn?’ If the Division is unwilling to support an application, and it is not 

withdrawn, the Division submits the application to the Commission with a 

recommendation that it be set down for a hearing?’ The Division does not have 

delegated authority to order hearings or deny applications?2 

111. Recommendations to Expedite Review 

of Exemptive Applications 

Because of the importance of the exemptive process and the significant 

Commission resources involved, the Division has re-examined both the statutory 

basis for exemptive orders and the Commission’s own procedures to determine 

if either could be impr0ved.3~ Among other things, the Division hoped to 

identify a means to shorten the time period for the issuance of orders or 

withdrawal of applications, because of om concern that, at times, the process is 

unnecessarily lengthy. At the same time, we sought to avoid imposing on the 

Commission unnecessarily short time frames for resolving all requests for 

exemptive relief, given the complexity and significance of many application^?^ 

28The Act does not specify the duration of the notice period. However, under the Federal 

Register Act, the notice period generally must last for at least 15 days after publication. 44 U.S.C. 

§ 1508. Because of this 15 day requirement and because of the fact that notices generally are not 

published in the Federal Register for at least six days after the notice is issued, the Commission 

typically provides that the opportunity to request a hearing extends for between 25 and 28 days 

from the date of issuance. 

291nternal Division g didelines also require that orders granted under delegated authority be 

issued within two business days after the expiration of the notice period. Inv. Co. Act. Rel. 14492, 

supra note 24, at n.l,50 FR at 19339 n.1. 

301d. 5 3,50 FR at 19340. 

311d. at n.3, 50 FR at 19340 n.3. 

32This authority is not granted to the Division Director under the rules governing delegated 

authority. 17 C.F.R. 5 200.30-5(a)(l), (2). 

33See supra notes 6 & 7 and accompanying text. 

34A number of the other recommendations in the Division’s study should reduce the need to 

rely on the Commission’s exemptive authority. See, e.g., Chapter 1 (exemptive rule for structured 

financings); Chapter 12 (amendments to rules 1Of-3 and 17d-1 to reduce the scope of the 

prohibitions imposed by these rules) (17 C.F.R. §§ 270.1Of-3, .17d-l); and Chapter 2 (new exception 

(continued. ..) 

Procedures for Exemptive Orders 509 
A. Expedited Procedures for Applications Based on Precedent 

Our primary recommendation incorporates certain of the commenters' 

suggestions. It would establish a procedure that would decrease the amount of 

time required for consideration of applications that are controlled by precedent, 

while also incorporating appropriate ~afeguards.3~ Essentially, it would provide 

for expedited review of applications that are based on recent precedent, if the 

applicant complied with certain procedural requirements. The procedure we 

propose would be available only with respect to applications seeking relief from 

those provisions of the Act for which the Division has been granted delegated 

authority to issue notices and orders$6 and only for those applicants who 

specifically request it. In addition, because our proposal would continue to 

require publication of a notice of application and would afford opportunity for 

a hearing, it would comply with section 40(a) of the Act. Consequently, the 

proposal could be implemented by a change in the Commission's procedures and 

would not require a statutory amendment. 

34(...continued) 

€or issuers whose securities are owned exclusively by qualified purchasers). We nevertheless 

believe that some changes to the applications procedures also are warranted. 

351n response to the Study Release (supra note 6), several commenters recommended 

procedures providing for expedited treatment of applications for which there is precedent. Some 

commenters recommended that all applications seeking relief similar to that which the 

Commission has granted previously, and containing the same conditions as the precedential 

application, be deemed granted after 30 days if the Commission does not take affirmative action 

to prevent the exemption. See Fidelity Study Comment, supra note 7, at 9; IC1 Study Comment, 

supra note 7, at 45-46; Prudential Study Comment, supra note 7, at 9. These proposals could only 

be implemented through legislation. One commenter recommended, for applications "where there 

is precedent for the issues involved, and where applicants represent that there are no material 

differences of fact [from the precedential application], that exemptions be automatically granted 

after 60 days unless the staff indicates that it has concerns." IDS Study Comment, supra note 7, 

at 26. Another commenter suggested a slightly different approach, recommending that the 

Commission adopt a procedure for expedited treatment of exemptive requests where the 

application is accompanied by a certificate of independent fund counsel to the effect that the 

application is clearly supported by precedent and does not raise any material issues not addressed 

in a previous Commission order, including orders granted by delegated authority. Dechert Price 

Study Comment, supra note 7, at 16-17. 

3617 C.F.R. 5 200.30-5(a)(l), (2). For a discussion of the Division Director's delegated authority, 

see infra note 46. As discussed below in Section III.B., we recommend that the Division's 

delegated authority be expanded to include all exemptive provisions of the Act. If this proposal 

were implemented, there would be no limitation concerning the provisions of the Act to which 

the expedited procedures described above would apply. 

510 CHAPTER 13 
Our proposal is comprised of the following elements: 

a. Counsel Certification: Investment company counsel would be required 

to certify that the application is consistent with the two most recent 

applications relied on as precedent, the most recent of which was issued 

within the last two years, and that such application contains all of the 

same conditions and material representations as the most recent 

precedential application. In addition, the applicant would be required to 

provide, as exhibits to its application, a copy of the application marked to 

show changes from the most recent precedential application and a draft 

notice marked to show changes from the Commission notice issued in 

connection with that ap licati0n.3~ Counsel also would certify the 

accuracy of these exhibits. )38 

b. Notice Within Ninety Days of Filing: A notice of application would 

issue no later than ninety days of the filing of the application, unless the 

Division informed the applicant prior to that time that the application 

would not be handled under expedited procedures, but instead would be 

considered under regular review procedures. The Division would have 

complete discretionary authority to make this determination, which would 

not be subject to re~iew.3~ The notice, which would be published in the 

Federal Register, would inform the public that, unless an interested party 

requests a hearing within the notice period (twenty-five to twenty-eight 

days), or the Commission orders a hearing on its own motion, an order 

will be issued. 

c. Order Within 120 Days of Filing: An application satisfymg the criteria 

of paragraph (a) above that is handled in accordance with the time periods 

set forth in paragraph (b) would be granted no later than 120 days after 

filing (or thirty days after issuance of the notice), unless a request for a 

hearing were filed in response to the notice of application published in the 

Federal Register, or the Commission ordered a hearing on its own motion. 

While an expedited procedure runs the risk of overwhelming the Division’s 

resources, we believe that there are sufficient safeguards built into the proposal 

to diminish that risk significantly. 

37A number of law firms already provide copies of applications and draft notices marked to 

38Compare the proposed procedures with the approach suggested by Dechert Price & Rhoads, 

39The circumstances under which an application would be reviewed under regular procedures 

show changes from prior precedent. 

discussed supra note 35. 

are discussed infra note 41 and accompanying text. 

Procedures for Exemptive Orders 511 
First, we envision that the proposed procedure would be used only for 

applications that are clearly governed by precedent. While Division staff assigned 

to applications for which expedited treatment is requested would still have to find 

that the particular application did or did not conform with precedent, the 

required certifications by fund counsel and marked copy of the application and 

notice would provide some assurance that such is indeed the case. 

Moreover, the Division would have a full ninety days to review the 

application and decide whether it is and should be controlled by the precedent 

cited.40 If the Division believed that the application did not conform to, or was 

not controlled by, the precedent cited, or determined that the precedent relied on 

should not have precedential value or should be modified in future orders, it 

would inform the applicant that the application would be decided under regular 

application procedures!l 

In addition, the requirement that the precedential order have been issued 

within the last two years would ensure that no "stale" precedent was relied on 

and that the Division would have some familiarity with the relief sought. More 

significantly, the Division's position on issues often evolves based on new 

information about the operation of particular types of exemptions. Because of the 

limited staff available to review applications, however, the Division rarely 

recommends that the Commission institute proceedings to revoke orders. 

Without the requirement that the precedent relied on be recent, and the staff's 

discretion to remove an application from expedited consideration, the expedited 

procedure could result in the granting of exemptive applications that merit fresh 

con~ideration.~~ 

4"The proposed procedures also may have to take into account the impact of staff comment 

letters on the time limits prescribed in our recommendation. While we envision that comment 

letters will be infrequent, the Division may on occasion have questions or comments in connection 

with applications that appropriately qualify for expedited treatment under our proposal. One 

option would be to provide that comment letters toll the 90 day period. Additionally, or 

alternatively, the procedure could require an applicant to respond within a reasonable amount of 

time (e.g., 30 days) or the 90 day period would begin anew. 

41While, as noted in the text above, the Division's determination would not be reviewable, it 

is contemplated that these would be the only circumstances under which a particular application 

otherwise eligible for expedited treatment would be reviewed under regular procedures. The 

Division, however, would have the authority to suspend the availability of the expedited 

procedure in response to resource needs, although we expect this would happen rarely, if at all. 

%ne alternative to the "recent precedent" approach would be for the Division to publish a 

list of applications that could not be relied on for expedited treatment. Given present staffing 

constraints, however, such an approach is unrealistic. 

512 CHAPTER 13 
Finally, while we recognize that there is potential for abuse in the 

expedited procedure we propose, we believe we have diminished that potential 

through the required certifications of counsel and the requirement that the 

applicant provide as exhibits copies of the application and draft notice reflecting 

any changes from the precedent relied on. In connection with the required 

certifications, section 34(b) of the Act, which prohibits the making of misleading 

statements in filings under the Act, including applications, will apply. In 

addition, if counsel were to certify in a misleading manner, it might be grounds 

for a Commission disciplinary proceeding under rule 2(e) of the Commission's 

Rules of Pra~tice.4~ Informulating the expedited treatment procedures, we also 

intend to consider whether additional, less drastic disciplinary procedures might 

be appr~priate.~~ 

We believe that our proposal would achieve the desired goal of enabling 

applicants seeking non-controversial relief based on established precedent to 

receive an exemption on a predictable and expedited bad5 Our proposal also 

provides the Division with the flexibility to require that an application be 

reviewed under regular procedures to avoid the possibility that an order would 

be issued based on mistaken precedent as well as to allow the Division's analysis 

with respect to the conditions and representations necessary for a particular type 

of exemptive relief to evolve. For these reasons, we recommend its 

implementation. Because staff resources are limited, however, the Commission 

should recognize, that the need to meet the time periods imposed by the 

recommended procedure could divert resources from novel and complex 

applications. 

@17 C.F.R. 5 201.2(e). 

44By way of analogy, under rule 487, which provides for expedited effectiveness of registration 

statements for certain series of unit investment trusts, the Commission may suspend indefinitely 

a registrant's eligibility for expedited treatment. 17 C.F.R. 5 230.487. The Commission has 

delegated that authority to the Division Director. 17 C.F.R. 5 200.30-5(b-3). 

4%7e contemplated other approaches that utilized prior exemptive applications as precedent. 

For example, we considered implementing a procedure whereby applicants seeking expedited 

review of precedented applications would receive a "temporary" or time limited order within 60 

days of filing (unless the staff determined that application would not be handled under expedited 

procedures) and a permanent order within 180 days of filing. During the temporary relief period, 

the staff could require amendments incorporating additional and/or modified conditions and 

representations. We envisioned that this approach would permit applicants to obtain relief 

quickly (even more quickly than under our recommended approach), but would also afford the 

staff the opportunity to "fine tune" applications before a permanent order was entered. We 

decided against recommending this approach, however, because of a concern that applicants 

would not find temporary relief helpful in most cases. An applicant proceeding with a proposed 

transaction, for example, would remain vulnerable to possible modification of its operations to 

satisfy conditions arising under the permanent order. In addition, we sought a relatively simple 

procedure. 

Procedures for Exemptive Orders 513 
B. Amendments to the Division's Delegated Authority 

We believe that delay on some applications may be caused by an 

unnecessarily narrow delegation of authority from the Commission to the 

Division Director?6 Currently, the delegation of authority requires the Division 

Director to present to the Commission all applications involving any matter that 

has not been previously settled by the Commission, even if the matter does not 

raise investor protection or public interest c0ncerns.4~ Because we believe that 

this standard is unnecessarily restrictive, we recommend that Commission rules 

governing the delegation of authority be amended to incorporate a concept of 

materiality in connection with the determination of whether a particular matter 

appears to present issues not previously settled by the Commission.48 

Moreover, there are several exemptive provisions of the Act for which the 

Division Director has not been granted delegated authority to issue notices or 

0rders.4~ Because we can discern no principled basis for distinguishing these 

49he Division Director has delegated authority to issue notices where, "upon examination, 

the matter does not appear to [herl to present issues not previously settled by the Commission 

or to raise questions of fact or policy indicating that the public interest or the interest of investors 

requires that a hearing be held." 17 C.F.R. 9 200.30-5(a)(l). The Division Director is similarly 

permitted to "authorize the issuance of orders where a notice . . . has been issued and no 

[timely] request for a hearing has been filed by an interested person . . . and the matter involved 

presents no issue that [slhe believes has not previously been settled by the Commission and it 

does not appear to [her] to be necessary in the public interest or the interest of investors that a 

hearing be held." 17 C.F.R. 9 200.30-5(a)(2) (emphasis added). 

471d. 

481n response to the Study Release (supra note 6), the ABA Subcommittee and Merrill Lynch 

&z Co., Inc. both maintained that the Division has been unduly narrow in exercising its existing 

delegated authority, although neither cited a specific example. ABA Study Comment, supra note 

7, at 7-9; Merrill Lynch Study Comment, supra note 7, at 1-11 to 1-14. For applications not decided 

under delegated authority, the ABA Subcommittee also charged that the Commission review 

procedure, including specifically the preparation and use of internal memoranda regarding 

particular applications and the Division's recommendation with respect thereto, is unduly time 

consuming and formalistic. ABA Study Comment, supra note 7, at 9. We simply disagree. We 

believe that the Division has exercised its authority appropriately and that the Commission review 

procedure works well. 

4%s category includes section 2(a)(9) (Commission may determine that applicant has 

rebutted presumption of control); section 15(f)(3) (Commission shall consider asset size in 

determining whether to exempt transaction from the certain provisions of section 15(f)(l)); section 

18(i) (Commission may permit issuance of stock by registered investment company that is not 

voting stock with rights set forth in that section); section 19(b) (Commission may permit 

distribution of long-term capital gains more often than once every twelve months); section 22(b)(l) 

(Commission may "make due allowance'' and grant "appropriate qualified exemptions" from 

(continued.. .) 

514 CHAPTER 13 
exemptive provisions from others for which delegated authority has been granted, 

we recommend that they be added to list of provisions included in the delegation. 

Under our proposal, the delegation would be amended to read as set forth in 

Appendix 13-A at the end of this chapter. 

IV. Other Options Considered 

A. Automatic Effectiveness for All Applications Absent Commission 

Action 

We considered a more radical change to the Commission's exemptive 

procedures: amending the Act to provide that all exemptive applications become 

automatically effective within a fixed period of time unless the Commission takes 

action to stop effectiveness?' As noted by commenters supporting an automatic 

effectiveness rule?' such a change would make the Investment Company Act's 

exemptive procedures resemble provisions of the Securities Act governing the 

effectiveness of registration statements;2 and provisions under the Exchange Act 

49(...continued) 

provisions of section 22 when it appears that small companies are subject to relatively higher 

operating costs); section 27b) (Commission may relax sales load requirements on registered 

investment companies that issue periodic payment plan certificates); section 28(b) (Commission 

may authorize as "qualified investments" for face amount certificate companies investments other 

than those defined in section 28(b)); section 28(d) (for face amount certificate companies, 

Commission may permit deferment of payment to a certificate holder other than deferment of the 

type and for the period specified in the subsection); section 34(a) (Commission may permit 

destruction or alteration of documents otherwise required to be preserved); section 38(a) 

(Commission may make, issue, amend, or rescind orders necessary or appropriate to the exercise 

of its powers, including rules and regulations defining accounting, technical, and trade terms, and 

prescribing the form in which information required for registration statements, applications, and 

reports to the Commission shall be set forth); section 56(b) (Commission may exempt business 

development companies ("BDCs") from requirements relating to director qualifications); and 

section 57(j)(2)(E)(ii) (Commission may approve loans by BDCs to certain directors or partners 

otherwise prohibited by sections 57(a) and (d)). 

5%ederated Investors, the ICI, and Prudential Mutual Fund Management all recommended 

that applications under section 6(c) be automatically granted 90 days after filing unless the 

Division or Commission takes some action to stop effectiveness. Federated Study Comment, supra 

note 7, at 1-2; IC1 Study Comment, supra note 7, at 45-46; Prudential Study Comment, supra note 

7, at 9. 

51See IDS Study Comment, supra note 7, at 26 (regarding the procedures attending the review 

of proxy statements and post-effective amendments under the federal securities laws); IC1 Study 

Comment, supra note 7, at 46 n.38 (regarding the processing of applications under section 4(c)(8) 

of the Bank Holding Company Act of 1956). 

52These provisions are discussed infra note 55. 

Procedures for Exemptive Orders 515 
regarding the use of proxy material^?^ We believe that such an approach 

would be seriously flawed, for several reasons. 

We believe that a procedure that sets an inflexible time period for 

responding to all types of exemptive applications without regard to their novelty 

or complexity, or to the volume of applications and the Commission's staffing 

levels, would be unrealistic. These factors are largely outside the Commission's 

control. Moreover, trends in federal spending indicate that it is very uncertain 

whether the Commission would be able to devote sufficient resources so that all 

applications would be reviewed adequately within ninety days. 

Moreover, if this approach were im~lemented?~ it is likely that the 

practice would evolve into a procedure much like the one that now exists 

regarding the effectiveness of registration statements under the Securities Act. 

Although the Securities Act provides that registration statements become effective 

in twenty days unless the Commission issues a stop order?5 in practice a lar e 

percentage contain the "delaying amendment" language prescribed in rule 473 %6 

%Rule 14a-6,17 C.F.R. 5 240.14a-6. The procedures for review of proxy materials generally 

permit an issuer whose preliminary proxy statement has been on file for 10 days to mail such 

materials to shareholders without first receiving notice or comments from the Division. If the 

Division has or will have comments on a preliminary proxy statement, it must advise the issuer 

promptly, and in no event later than the tenth day. Proxy statements become "automatically 

effective" when the solicitation concerns only those matters specified in rule 14a-6(a) under the 

Securities Exchange Act of 1934. Id. 

54Unlike our recommended procedure, this approach would require a statutory amendment. 

5%ection 8(a) of the Securities Act provides that registration statements become effective in 

20 days unless the Commission issues an order under either section 8(b) or 8(d). Securities Act 

of 1933, 15 U.S.C. § 77h(a), (b), (d). Procedures governing the review of post-effective 

amendments to registration statements filed by investment companies are set forth in rule 485 of 

Regulation C. 17 C.F.R. 5 230.485. Under rule 485(a), post-effective amendments usually become 

effective on the 60th day after filing, although the Commission (and the Division Director, by 

delegation) has the authority to declare an earlier effective date. Under paragraph (b) of rule 485, 

post-effective amendments filed for certain limited purposes (e.g., to increase the number or 

amount of securities proposed to be offered under section 24(e)(l) of the Investment Company Act 

(15 U.S.C. 5 80a-24(e)(l)) may become effective on the date on which the amendment is filed, if 

certain conditions are satisfied. The Commission (and the Division Director, by delegated 

authority) may suspend a post-effective amendment prior to its effective date if it appears that 

the amendment may be incomplete or inaccurate in any material respect. 17 C.F.R. 5 230.485(c). 

Following such action, the registrant may petition the Commission for review of the suspension. 

Id, The Commission will order a hearing on the matter if such a request is included in the 

petition. Id. 

56Rule 473 of Regulation C, 17 C.F.R. 5 230.473. 

516 CHAPTER 13 
and do not become effective until the staff has completed its re~iew.5~ Absent 

the equivalent of a delaying amendment, we believe that the system proposed 

would not be workable. With the equivalent of a delaying amendment, we do 

not believe that the proposal would be effective in expediting the review of 

exemptive applications. 

In evaluating the propriety of any automatic effectiveness procedure, it is 

also important to recognize that section 6(c) of the Investment Company Act 

requires the Commission to determine whether and the extent to which a 

requested exemption is necessary and appropriate in the "public interest" -- a term 

that is not defined under the Act -- and is consistent with the "protection of 

investors" -- also undefined -- and the "policies and provisions" of the Act. Each 

determination requires the Commission not only to apply two flexible standards, 

but also may require a determination of consistency with the purposes of any one 

or more of the AcVs sixty-five sections, and with the policies underlying the 

statute. 

In this regard, we note that there is a critical distinction between allowing 

Securities Act registration statements and their amendments to become effective 

by the simple passage of time, and deeming exemptive applications to be granted 

on the same basis. In the first situation, a statutory obligation is imposed on the 

issuer to provide appropriate disclosure of material information?8 Such 

obligation continues even after the registration statement has become effective and 

any staff review has been ~ompleted.5~ In contrast, approval of an exemptive 

application, which consists of both fact and legal argument, requires the 

Commission to apply the relevant statutory standards and make the required 

determination. Once granted, the "exempted" transaction or product may proceed 

with no ensuing liability for the applicant.60 

In sum, given the broad authority in section 6(c) to exempt any person 

from any provision of the Act, the flexible standards governing such 

determinations, and the consequences of the granting of exemptive relief, we 

57For a description of this practice and its evolution, see LOUIS LOss, FUNDAMENTALS OF 

SECURITIES REGULATION 122-25 (1988 & Supp. 1 

5$ecurities Act 55 ll(a), 12, 17(a), 15 U.S.C. 95 77k(a), 771, 77q(a). 

59See gnmu2ly LOUIS Loss AND JOEL SELIGMAN, SECURITIES REGULATION 3519-3525 (3d ed. 1991) 

(discussion of the duty to update and the duty to correct statements made in Commission filings 

and otherwise in connection with the sale of securities). 

6%nder section 38(c), no liability under the Act attaches "to any act done or omitted in good 

faith in conformity with any rule, regulation, or order of the Commission, notwithstanding that 

such rule, regulation, or order may, after such act or omission, be amended or rescinded or be 

determined by judicial or other authority to be invalid for any reason." 15 U.S.C. 5 80a-37(c). 

Procedures for Exemptive Orders 517 
believe it would be inappropriate for all types of applications presumptively to 

be granted unless the Commission takes affirmative action to stop the application. 

B. Dispensing with Prior Notice for Routine Applications 

In the Study Release, the Commission specifically noted the 1984 

recommendation of the Task Group on Regulation of Financial Services ("Task 

Group") that "the process of granting exemptions under the Investment Company 

Act should be streamlined to remove the requirement for public notice and 

comment in every case."61 As indicated above, we support the essence of the 

Task Group's recommendation, which is to shorten the review process. We 

believe that this objective would be achieved by the expedited procedures we 

recommend. In addition, our proposal does not require a statutory amendment. 

We note that notices of applications form a body of law and administrative 

practice that is very valuable to investment company sponsors and their counsel, 

as well as to the Division. If the Act were amended to remove the prior notice 

requirement, we believe that it still would be necessary to draft and issue orders 

that summarized the substance of an application, so that the public would know 

of Commission regulatory decisions. 

Finally, removing the notice requirement would have its costs. From time 

to time, the Commission receives hearing requests, which may result in the 

applicant amending its application or in a hearing. If prior notices were not 

given, interested persons, uninformed of Commission action, would be forced to 

seek any redress in court; such an outcome likely would result in less efficient 

resolution of their concerns. 

C. Substantive Changes to Section 6(c) 

Cornmenters also suggested substantive changes to the Commission's 

exemptive One recommended that section 6(c) be amended to 

include expressly the ability to balance perceived costs of regulation to investors 

against any benefits accruing from an exempti0n.6~ That commenter cited two 

"Study Release, supra note 6, at 8 n.8. This recommendation was endorsed in the Dechert 

Price Study Comment, supra note 7, at 16, and the IDS Study Comment, supra note 7, at 27. 

62Dechert Price Study Comment, supra note 7, at 11-16; Federated Study Comment, supra note 

7, at 1; Merrill Lynch Study Comment, supra note 7, at Ex. I.A. 

@Dechert Price Study Comment, supra note 7, at 15-16. To achieve this result, the commenter 

recommended adding the following sentence at the end of section 6(c): "In interpreting its 

authority under this subsection with respect to any section or rule, the Commission may take into 

(continued. ..) 

518 CHAPTER 13 

-. 
recent orders of the Commission as evidence that the Commission has already 

used section 6(c) in such a manner, but the commenter expressed concern that the 

legislative history of the provision and the Commission's own early 

interpretations cast some doubt on this approach!* The recommended 

amendment purportedly would protect against challenges to the Commission's 

authority. 

We do not recommend this amendment to section 6(c) because we believe 

that it is unnecessary. As the commenter noted, the Commission has treated 

investment flexibility, diversification, and cost to investors as appropriate 

elements for consideration under section 6(c)F5 We believe that the broad 

statutory authority granted to the Commission by section 6(c) permits the 

Commission to consider these factors. 

Another commenter argued that: 

During the last few years, . . . it has become evident that the 

Commission staff is developing a new and severely restrictive view 

of Section 6(c). Under that approach, the exemptive authority of the 

Section does not reach certain provisions of the 1940 Act so that 

applications for exemption from those provisions do not warrant 

substantive considerationF6 

To remedy this perceived problem, the commenter suggested adding the 

following sentence at the end of the section 6(c): "No provision of this title shall 

be construed as limiting the Commission's authority to grant exemptions under 

this 

We agree that section 6(c) empowers the Commission to exempt persons 

from every section of the Act, limited only by the requirement that the exemption 

63(...continued) 

account the estimated costs to investors of regulation under such section or rule as compared with 

the benefits to investors reasonably contemplated from granting an exemption." Id. at 16. 

@Id. at 12-14. 

651d. at 14-15. 

66Merrill Lynch Study Comment, supra note 7, at 1-1. Another commenter apparently shares 

this view, stating that it "particularly takes issue with the proposition that certain provisions of 

the 1940 Act are automatically precluded from the possibility of exemptive relief due to the 

manner in which the statutory language is constructed." ABA Study Comment, supra note 7, at 

5. 

67Merrill Lynch Study Comment, supra note 7, at 1-2. 

Procedures for Exemptive Orders 519 
be in the public interest and consistent with the protection of investors and the 

purposes of the Act. While we believe that any consideration of an application 

under section 6(c) necessarily must be informed by a careful examination of the 

purpose(s) of the particular provision from which the applicant seeks relief, we 

do not believe that there are sections of the Act from which the Commission may 

not grant exemptions. Accordingly, we do not believe the suggested amendment 

is 

Finally, two commenters, while not suggesting substantive statutory 

amendments to section 6(c), recommended that the Commission issue a release 

clarifying its interpretation of the section's statutory standards!' We do not 

agree with this proposal for a number of reasons. 

Determinations under section 6(c) are made on a fact-specific basis. In our 

view, any attempt to define section 6(c) standards outside a specific factual 

context would not be fruitful and might unnecessarily limit the Commission's 

flexibility in the future. 

Moreover, to the extent that it is possible to make statements of general 

applicability concerning section 6(c)'s standards, we believe that the Commission 

has already done so. In the Study Release, for example, the Commission 

indicated: 

Congress bestowed upon the Commission a broad power to exempt 

persons, securities, and transactions from any provision or 

provisions of the Investment Company Act "if and to the extent that 

such exemption is necessary or appropriate in the public interest 

and consistent with the protection of investors and the purposes 

fairly intended by the policy and provisions of [the Act]." That 

exemptive power has been historically exercised by the Commission 

"with circumspection and with full regard to the public interest and 

the purposes of the Act . . . .'I Over the decades, the Commission 

has granted exemptions in situations where the Investment 

Company Act by its terms clearly applied, and has rejected the 

argument that simply because a provision prohibited certain 

conduct any exemption from that provision was contrary to the 

intent of the Act. . . .'I The Commission believes that the tripartite 

test set forth in section 6(c) provides the Commission with 

681n the Study Release (supra note 6), the Commission rejected the idea that its power under 

section 6(c) was limited because a particular provision prohibited certain conduct. See text 

accompanying note 70 below. 

@Davis Polk Study Comment, supra note 7, at 42-44; PaineWebber Study Comment, supra note 

7, at 4. 

520 CHAPTER 13 
standards that, applied with circumspection, allow it to exempt 

particular vehicles and particular interests from those provisions of 

the Investment Company Act that inhibit competitive development 

of new products and new markets offered and sold in or from the 

United States?' 

Lastly, we believe that an interpretive release is unnecessary. In our view, 

the Commission's interpretation of its authority under section 6(c) is discernible 

from its prior exemptive orders. 

D. Increased Use of Rulemaking Authority 

While we believe that the proposed procedural changes and the suggested 

amendment to the Division's delegated authority would expedite the review of 

exemptive applications, we also believe that the greatest improvement to 

exemptive procedures would be for the Division to develop, and the Commission 

to adopt, exemptive rules more quickly -- in short, for the development and 

adoption of rules based on well-established precedent to become a more routine 

part of the Division's and Commission's work. Consequently, we recommend an 

increased allocation of Division personnel to rulemaking activities?' 

'%tudy Release, supu note 6, § IV (footnotes omitted). 

"Somewhat analogously, some commenters suggested that the Commission make increased 

use of its authority under section 6(c) to exempt "classes of persons, securities, or transactions" and 

to grant '%road, class-based exemptions" in situations where it appears likely that a particular 

exemption would benefit persons in addition to the applicant. Davis Polk Study Comment, supa 

note 7, at 41-42; Letter from Davis Polk & Wardwell to Jonathan G. Katz, Secretary, SEC (June 

14, 19901, File No. S7-11-90 (supplementing Oct. 10, 1990 Davis Polk Letter re class exemptions); 

PaineWebber Study Comment, supra note 7, at 3-4. The ICI recommended that, failing adoption 

by the Commission of its suggestions concerning substantive modifications to the Act, the 

Commission should %e provided the authority to grant class exemptions with respect to each of 

[its] specific proposals." ICI Study Comment, supra note 7, at 45 n.37. We believe that a classexemption order is unwise as a matter of policy. Procedures required in connection with the 

issuance of orders are not well-suited to crafting industry-wide standards. Notices of applications 

are designed to present the terms of the exemption solely for a particular applicant. Only "interested persons" (as that term is defined in the Act) may present their views (17 C.F.R. § 270.0- 

5(a)) and only by requesting a hearing (id.). In our view, rulemaking procedures are much better 

suited to address matters of general applicability. Notices of proposed rulemaking are designed 

to inform a wide range of persons on the broad policy issues presented. Any person may 

comment simply by writing a letter. 5 U.S.C. § 553(c). Finally, unlike an exemptive order, an 

exemptive rule is codified in the Code of Federal Regulations and other compilations of agency 

rules (5 U.S.C. 5 553(d)), giving affected persons much clearer notice of the agency's 

determinations. While we believe that the Commission could modify its procedures for exemptive 

orders so that the procedures would be better suited to eliciting helpful public comment, such 

changes would simply have the effect of turning case-bycase adjudications into rulemaking 

proceedings. We see no discernible benefit from such a result. 

Procedures for Exemptive Orders 521 
The Commission should be aware, however, that because rulemaking takes 

time, any such shift in personnel may not result in an immediate improvement 

in the number of pending applications or in a reduction in the average amount 

of time required for an application to be noticed and ordered. Over time, 

however, we believe that the increased focus on rulemaking would lead to a 

significant decrease in the number of applications filed, with a resulting 

improvement in both backlog and the time period required for applications 

review. 

V. Conclusion 

In our view, major changes to either the Commission’s substantive 

authority or its procedures are unnecessary. While we support a procedural 

modification, as well as some modifications to the Division Director’s delegated 

authority, we believe that the most significant way to reduce the backlog of 

applications is to amend the Act to remove unnecessary provisions and to adopt 

exemptive rules more quickly. 

522 CHAPTER 13 
APPENDIX 13-A 

Red-Lined Version of Proposed Amendments to 

Rule 30-5 of the Rules Delegating Functions to Division Directors, 

Regional Administrators and the Secretary of the Commission 

Rule30-5. Pursuant to the provisions of PublicLawNo. 87-592,76Stat. 394 [15U.S.C. 

78d-I, 78d-21, the Securities and Exchange Commission hereby delegates, until the 

Commission orders otherwise, the following functions to the Director of the 

Division of Investment Management, to be performed by him or under his direction 

by such person or persons as may be designated from time to time by the Chairman 

of the Commission: 

(a) With respect to the Investment Company Act of 1940 [15 U.S.C. 80a-1, et 

seq.]: 

(I) To issue notices, pursuant to Rule 0-5(a), with fespect to applications for 

orders under the Act and the rules and regulations 

promulgated thereunder and, with respect to Section 8(f) of the Act, in cases where 

no application has been filed, where, upon examination, the matter does not appear 

to him to present~~~~~~~~~issues not previously settled by the Commission or to raise ............... ................... 

questions of fact or policy indicating that the public interest or the interest of 

investors 

A\ TTTTPP o u/, id W.J.L. u 

/I3 1rlTCP , Id U.d.L. 

Procedures for Exemptive Orders 523 
h 

n I~TTCP , Id U.J.L. 

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\ ICfJCP 

I . J .L. 

iv/-a\ ICTTCP on I/ \u/l Id U.J.L. vu 

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17/:\ I~TTCP o +/ (11, Id U.J.L. v 

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- r T T c P a/, IJ u .. J L . 

CTTPP 0 

q\ ITTTCP LJ/, IJ u .. LJL . 

524 CHAPTER 13 
(2) To authorize the issuance of orders where a notice, pursuant to Rule 0-5(a), 

has been issued and no request for a hearing has been received from any interested 

person within the period specified in the notice and it appears to him that the matter 

involved presents no~~~~~~a~issue that he believes has not previously been settled 

by the Commission and it does not appear to him to be necessary in the public interest 

or the interest of investors that 

Procedures for Exemptive Orders 

Sr U.S. GOVERNMENT PRINTING OFFICE1992-312-618165104 

525