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For RELEASE Tuesday, October 21,1969 

SECURITIES AND EXCHANGE COMMISSION 

Washington, D. C. 20549 

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I INVESTMENT COMPANY ACT OF 1940 

·1	 Release No. 5847 

ACCOUNTING SERIES .... 1 . ',.-1.:	 Release No·. 113 

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i The Securities and Exchange Commission today made public the 

following statement. 'I 

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"Restricted Securities" 

TheCommis·sion is aware that many investment companies have been 

acquiring substantial quantities of securities that cannot be offered 

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to the public for sale without first being registered under the 

Securities Act of 1933 ("restricted securities"). For the year f968, 

annual reports filed by registered investment companies indicate that 

open-end and closed-end companies together held in excess of $4.2 

billion of restricted equity securities. Open-end companies--excluding 

exchange funds--accounted for about $3.2 billion of these restricted J. 

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securities which represented 4.4 per cent of their total net assets. 

The acquisition by investment companies of such securities raises 

certain problems under the securities laws of which shareholders, 

distributors, managements and directors of these companies should be 

aware. This statement discusses these problems. No inference should 

be drawn from publication of this statement, however, as to the desirability or merits of the acquisition of restricted securities by a 

registered investment company. 

Problems for the Seller 

::-1	 Section 4(2) of the Securities Act of 1933 exempts from the 

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registration requirements of that Act "transactions by an issuer no·t 

involving any public o£fering. 1I This is the so-called "private offering" 

provision in the Securities Act. The securities involved in transactions 

effected pu~suant to this exemption are referred to as restricted 

securities because they cannot be resold to the public without prior 

registration. They are also sometimes referred to as "investment letter 

securities" because of the practice frequently followed by the seller in 

such a transaction, in order. to substantiate the claim that the transaction does not involve a public offering, of requiring that the buyer 

"furnis"h a so-called lIinvestment letter" representing th~t the purchase 

is for investment and not for resale to the general public. . 

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IThe private offering exemption of Section 4(2) of the Securities 

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Act is available only where th~ offerees do not need the" protections 

afforded by the registration procedure. As the Court of Appeals for 

the Second Circuit recently stated in Katz v. Amos Treat & Co. eCH; 

Fed'1. Sec. Law Rep. 92,409 (1969): 

"The Supreme Court has instructed that the applicability 

of the exemption should turn on whether the particular 

class of persons affected need the protection of the Act. 

SEC v. Ralston Purina Co., 346 U.S. 119, i25.. (1953)." 

! The' test of the availability of the Section 4(2) exemption is 

whether the offerees are in such a position with respect to the issuer 

as to have access to the kind of information that_would be made available 

in a registration statement filed pursuant to the Securities Act. This 

test is no different when the offeree is an investment company. 

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Problems for the Buyer 

1. The Problems of Valuation 

It is critically -important that an investment company properly 

value its portfolio' securities. It is obvious, for example, that any 

distortion in the valuation of a restricted security held by an investment company will distort the price at which the shares of the, investment 

company are sold or redeemed. It is also clear that investment managers 

who are compensated ori the basis of net asset value or performance may be 

unduly compensated if a restricted security, purchased.at a discount from 

the market quotation for unrestricted securities of the same class, is 

overvalued. In such a case, investors may also bemisled.by the reported 

performance of the investment company. 

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i The acquisition of restricted securities by Qbth open-end and 

close~~end investment companies creates serious problems of valuation. 

Section 2(a) (39). of.the Investment Company Act 'of 1940 arid Rule 2a-4. ::.:_1
 thereunder requires that 'in determining net asset value, "securities for 

-.Which market quotations are- readily available" must be valued at current 

market value while other securities and assets must be valued at "fair 

value as determined in good faith by the board of directors." 

Readily available market quotations refers to reports of current 

public quotations for securities similar in all respects to the securities 

in question. No such current public quotations can exist in the case of 

restricted securities. For valuation purposes, therefore, restricted 

securities constitute securities for which market quotations are not 

readily available. Accordingly, their fair values must be determined in 

good faith by the board of directors and this obligation necessarily 

continues throughout the period these securities are retained in the 

compan~'s portfolio. 
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Restricted securities should be included in the. portfolio of a 

company and valued to determine current net asset value on the date 

that the investment company has an enforceable right to demand the 

securities from the seller. 

Where the investment company negotiates the acquisition of the 

restricted securitie's directly with the owner of the securities, there 

are three significant dlltes. The first occurs when the investment 

company a~d the seller oral'ly agree upon the. price' and the amount of 

the securities (the "handshake date").' At this point, there would no~

seem to be any enforceable right, of the 'investment company to demand 

the securities from the seller since, in most s.tates, particularly 

those which have adopted the Uniform Commercial Code, there is no enforceable right unless there exists Some writing 'fsufficient to indicate 

that a contract has been made for sale of a stated quantity of described 

securities at a defined or statedprice" . (Section 8-3l9(a) of the Uniform 

Commercial Code). If· the terms of the oral understanding do notcontemplate compliance with any condition by the seller, it is suggested that 

the investment company procure, from the seller, a signed memorandum 

setting forth the price and quantity of securities to be sold. Upon 

receipt of that memorandum, an enforceable.-right would be obtained. The 

securities should be valued as of that date. 

In those situations where the oral understanding contemplates the 

execution of a formal contract of purchase and sale, no enforceable right 

exists until the time the formal contract is signed (the " contract date"). 

If the formal contract does not. require compliance with any conditions 

by the seller, an enforceable right iSc then.obtained, and the securities 

should be valued as of that date.· 

Where the formal contract requires compliance with stated conditions 

which the investment company believes should not be waived, no enforceableright is obtained until the stated conditions are satisfied. In that 

situation, the valuation date should be the date upon which the c~nditions

are satisfied (the "closing date"). . 

Restricted securiti~s are often purchased at adiscount,.frequently 

substantial, from the market price of outstanding unrestricted securities 

of the same class. Tnisreflects the fact that securities which cannot 

be re,adily sold in the, public market place are less valuable than'-securities 

which can be sold, and also the fact .that, by the dirpct sale of restricted' 

securities, sellers avoid the expense, time and public disclosure which 

registration entails. 
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Asa general principle, the current fair value of restricted 

securities would appear to be the amount which the. owner might 

reasonably expect to receive for them upon their cur.rent sale.. this 

depends upon their inherent worth, without regard to the restrictive 

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 feature, adjusted for any diminution in value resulting from the restrictive 

feature. Consequently, the valuation of restricted securities 

:1 at the market quotations for unrestricted securities of the same class 

would, except for most unusual situations, be improper.!/ Further, ,the I continued valua~ion of such securities.at cost wauldbe improper if, as 

a result of the operations of the issuer, change in general market conditions orotherwise,cost has ceased to represent ·fair value. In such 

circumstances,maintaining:the value of the restricted securities at cost 

would mislead investors as to the value of the portfolio of the investment 

company which holds restricted securities. 

Instead of valuing restricted securities at cost or at the market 

value of unrestricted securities of the same class, some investment 

companies value restrfcted securities held in their portfolio by applying 

either a constant, percentage or an absolute dollar di~count to the market 

quotation for unrestricted securities of the same class. The automatic 

valuation of restricted securities by such a method, however, would also 

not appear to satisfy the requirement of the Act that each security, for 

which a market quotation is not readily available, be valued at fair 

value as determined in good faith by,the board of directors. 

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Thus, it would be improper in valuing restricted securities automatically to maintain the same. percentage discount (from the market 1 

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quotation for unrestricted securities of the same class) that was received 

when the restricted securities were purchased; without regard to other 

relevant factors such as, for example, the extent to which the inherent 

value of the securities may ,have changed. 

Furthermore, the valuation of restricted securities by reference to 

the rnarke.tprice forunrestri'cted securit;i.es of the same' class assumes 

that the market price for unrestricted securities of the same class is 

representative of the fair value of the securities. This may not be the 

case ~h~Qthe market for.the unrestricted securities is very thin, i.e., 

only a limit~d 'Volume of shares are available for trading. With a thin 

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mgrket, the news of the investment company's purchase of the restricted 

securi.ties may, by itself,have the effect of stimulating a public demand 

for the unrestricted securities, thesupply of which has,not been increased, 

and thus lead to. a spiralling increase in the valuation of both the re"' ; 

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I stricted and unrestricted securities.

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! 1/ See Proposed Guidelines For 4he Preparation Of Form N-8B-l; Investment 

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Company Act Release-No. 5633, p. 21 (March 11, 1969). 1 
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Moreover, if in valuing restricted securities, the diminution 

in value attributable to the restrictive featur~ is itself affected 

by factors subject to change, such as the length of time which must 

elapse before the investment company may require the issuer to cause 

the securities to be registered for public sale, the valuation should 

'·1 refl~ct any such changes. "·~·,·lI. 

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. ! Some companies value restricted securities, acquired at prices I

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below the market quotations for unrestricted secur1ties of the same 

I· class, by autoinatically arnort'izing the difference over some chosen 

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period on the assumption. that it will be possible to sell them at the 

market price for unrestricted securities at the expiration of the time 

period. Under prevailing ~onditions, however, it ~annot always be determined either that the securities will, in fact, be effectively 

registered at the expiration of that period or that their public sale 

will otherwise be possible. For example, the issuer may be unable or 

I· unwilling to 'register at the expiration of the estimated period, and 

public sale at the end of that period withQut· registration may not be 

lawful. Consequently, the practice of automatically amortizing the discount 

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over an arbitrarily 'chosen period creates'the appearance of an appreciation in the value of the securities which has not, in fact, occurred, 

and, accordingly, is improper. 

r An undertaking by the issuer to register the securities within a , 

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specified time period would not dictate a different result. In view of the 

many factors that may alter the date of the proposed public offering, it is 

at best speculative to use such an undertaking alone as the. basis for .~ amortizing the discount. :J 

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I Similarly, the possible adoption by the Commission·of the more 

definite holding periods contained in proposed Rules 101, 160, L61, 162, 

163, 164, and 180, Securities Act Release No. 4997, (dated September 15, 

1969) would also not alter the 'conclusion that amortization of the discount 

may be improper. The more definite holding periods there proposed are i .~

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In summary, there can be no automatic formula by which an investment 

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company can value res~~iEted securities in its portfolio to comply with . 

Section 2(a) (39) and Rule 2a-4. It is the responsibility of the board of 

directors to determine the fair value of each issue of restricted securities 

. in good faith; and the data and information considered and the analysis I

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thereof should be retained for inspection by the company's independent 

auditors. While the boart: may', consistent with this responsibility, 

determine the method of valuing each issue of restricted security in the 

! company's portfolio, it must continuously review the appropriateness of 

any method so determined. The actual calculations may be made by persons 

acting pursuant to the direction of the board. 

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2.lhe Problems of Portfolio Management 

. .. .In addition to valuation, restricted securities present special 

,p·#o.blems of portfolio management. I 

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.\.:.. The concept of the Securities Act exemption of a private placement

iif securities is premised on the belief that in stich a ·sit~ation·t:he

investor has such information concerning the issuer that·he ·is able to 

fend for himself without need for the disclosures that would be provided 

by an effective registration statement. Correlatively, where the investor 

is a registered investment company, it would seem to be the fiduciary· 

duty of the persons responsible for the investment decisigns of the investment company toobtairi, prior to purchase, the necessary information to 

make an independehtanalysis of the investment merits of the particular 

restricted securities. 2/ Also, in order toeriablethe continuing 

valuation of such securities, the investment company should require the 

seller to undertake to provide, to the .extent known to the seller, informationon a: continuing basis as to any subsequent private sales of the 

issuer'.s securities. The investment company should also assure itself , that it is. in the position to obtain the appropriate financial. information. . .j

! at appropriate times. It is assumed that any public disclosures, such as , 

that made in periodic reports filed pursuant to the Securities Exchange 

Act, are carefully considered by the investment company portfolio manager. ! 

i There is also the paradox of too much success to consider. For i 

i	 example, if restricted securities rapidly appreciate in value, perhaps 

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j company may find instead of having, for example, 5 per cent of its assets ! invested in a particular company, it has instead, 25 per cent of its assets 

in that company. The investment company to which this happens sllffers a
 

loss in diversification and may find that it has become overly sensitive
 

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to any adverse developments in the affairs of that particular portfolio
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..···1 Tbeforegoing factors in portfolio management relate to both open­

.~! end and closed-end management companies. There are additional special 

factors that relate only to op-en-end compariies. ," 

Section2(a)(31), when read together with Section 5(a), of the I	 Investment Company Act requires that the holders of redeemable shares 

issued by an open-end investment company be entitled to receive appro'Ximately their proportionate share of the issuer's current net assets, or 

the cash equivalent thereof, upon presentation of the security to the 

issuer or to a person designated by the issuer. Section 22(e) of the Act 

provides that, absent specified unusual conditions, payment of the redemptionprice must be made within seven days after the tender of a redeemable 

security to an investment company or its agent designated for that purpose. 

2/ See The Value Line Fund v. Marcus ('64-'66 Transfer Binder) 

Sec. Law Rep. 91,523 at p. 94,970 (S.D. N. Y. 1965). 

CCH Fed'l. 

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It is desirable that an ope.Ii":end company retaj.n maximum flexibi lity . 

in the c:hoice of portfolio securities which~ on the basis of.their· J 

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relative investment merits, could best'be sold where necessary to meet 

redemptions. To the extent that the portfolio consists of-restricted 

securities, this flexibility is reduced. 

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Restricted securities may not be publicly sold--nor can they be 

distributed to redeeming. shareholders as ?n in-kin~~redemption•. While 

they may be sold privately, there may not be sufficient time to o.btain 

the .best price since the date of payment or satisfaction may not be 

postponed more than seven days after the tender of the company's redeemable 

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securities for redemption. A private sale within t[J.at period may result 

in the investment company receiving less than its carrying value of the 

restricted securities. This would result in a preference in favor of the 

redeeming shareholders and a diminution of the .Iietasset value per share 

of shareholders who have not redeemed. Therefore, instead of arranging 

a private sale of restricted securities, an open-end company that is 

faced with redemptions may decide to sell unrestricted securities which 

it would otherwise have retained on the.basis ofcolliparative investment 

merit. 

Significant holdings o~ restricted securities not onty magnify the 

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,. valuation difficulties but may also present serious liquidity questions . 

Because open-end companies hold themselves out at all times as being 

prepared to meet redemptions within seven days, it is essential that such 

companies maintain a portfolio of investments that enable them to fulfill 

that obligation. This requires a high degree of liquiclityin the assets 

of open-end compan{es because the extent of redemption demands or other 

exigencies are not always predictable. It has been with this iIi mind that 

the staff of the Commission has for several years taken the' position that 

an open-end company should not acquire restricted securities when the 

securities to be acquired, together with othersilch assets already in the 

portfolio, would exceed 15 per cent of the company's net assets at the time 

of acquisition. The Commission, however, is of the view that a prudent 

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I limit on any open-end company's acqUisition of re.stricted securities, or 

other assets not having readily availabie market quotations, would be 

19 per cent. 3/ When as a result'of either the increase in the value of 

some or all of the restrieted securities held, or the clilliiilUtion in the 

value of unrestricted securities in the portfolios, the restricted securities 

come to represent a larger percentage of the value of the company's net assets, 

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3/	 The Commission is aware that certain open-end companies my have acquired 

restricted securities in excess of 10 per cent of net_assets. It is 

assumed that such companies will not undertake commitments, beyond any 

obligation existing on this date, to acquire restricted securities until, 

in the normal course of business, such holdings are not in excess of 

10 per cent of current net asset value. 
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the same valuation and liquidity questions occur. Accordingly, if the
 

fair value of restricted holdings increases beyond 10 p~r cent, it ­


wou14be desirable for the open-end co~panj to consider' appropriate
 

step~·to protect maximum flexibility. , The Commission wUl re-ex~mi~H~!
 

apprQpria~e limitations inth·is area in light of all the policy objectives
 

. o~ ·the Investment Company Act •. 

3. The Problem of Disclosure 

Section 8(b}(1}(D) of the Investment COmpany Act requires that an 

investment company incrude, in its registration stateme~t filed with the 

Commission under the Act, information as to its policy with respect to 

"engaging in the business of' underwriting securities issued by other 

persons~" Item 4(c} of'-Form N-8B-l requires that a registrant under the 

Act describe its policy or proposed policy with respect· to "the undei:-- . 

Writing of securities of other issuers." 'In response to this item, 

registrant's policy with respect to the acquisition of restricted securities 

should be disclosed. y In view of the fact that policies listed under 

Item 4 are fundamental policies whichtannot be changed without prior 

shareholder approval, the importance of adopting a clear policy with regard 

to such. investments is apParent. 

The prospectus of. a registered investment company should also 

fully disclose the company's policy with respect to restricted 

securities. 5/ It is also clear that an investment company which has 

a policy of acquiring restricted securities is responsible for full 

and adequate disclosure with respect to all matters relating to the 

valuation of such securities. Specifically, there should be included, 

in a note to the financial statements, (1) identification of any 

restricted securities and the date of acquisition, (2) disclosure of 

the methods used in valuing such securities both at the date of acquisition'and the date of the financial statements, (3) disclosure of the 

cost of such securities and the market quotation for unrestricted. 

securities of the same class both on the day the purchase price was 

agr.eed to (the so-called: "handshake date") ,and on the day the inve.st.,. 

ment company first obtained an enforceable right to acquire suchsecuri­

. "i:ies, and (4) a statement as -to whether the issuer or. the registrant
 

will bear costs, including those involved in registration under the
 

Securities Act, in connection with the disposition of such securities.
 

4/ See Proposed Guidelines For the Preparation of Form N-8B-l, 

Company Act Release No. 5633, p. 7 (March 11, 1969). 

Investment 

5/ See Proposed Guidelines For The Preparation Of Forms S-4 and S-5, 

Investment Company Act Release No. 5634, pp. 11, 13 (March 11, 1969). 
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Section lO(b) of the Securities Exchange Act of 1934 and Rule lOb-5 

thereunder makes it unlawful, among other things, for any person, in 

connection with the purchase or sale of securities, to e~pl~y any device, 

scheme, or artifice to defraud or to make any untrue statement of a 

material fact or to omit to state a material fact necessary in order 

to make the statements made not misleading, or engage in any ac~, practice, 

or course of business which operates or would operate as a fraud or deceit 

upon any persons. 

The offering price of securities issued by a management investment 

i- company is premised upon the net asset value of such shares as determined 

pursuant to Section 2(a)09) of the Act and Rule ~a-4 thereunder and is so i-I 

represented in its prospectus. The improper valuatio~ of restricted securities held by such a company would distort the net asset value of the shares 

being offered or, in the case of an open-end company, redeemed-, and would 

therefore constitute a fraud and deceit within the meaning of Section lO(b) 

and Rule lOb-5. 

An open-end company, of course, represents to investors, in its 

prospectus, that it will, as required by Section 22(e) of the Act, redeem 

! its securities at approximate net asset value within seven days after tender. 

To the extent a material percentage of the assets of an open-end company 

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consist of restricted securities which cannot publicly be sold without ..
 registration under the Securities Act, the ability of the company to comply

with the provisions of the Investment Company Act relating to redemption, 

and to fulfill the implicit representations made in its prospectus with 

respect thereto, may be adversely affected.!/ In any such situation, the 

investment company concerned and the persons responsible for the sale of its 

securities should give careful consideration to the possible application of 

the provisions of Section lO(b) of the Exchange Act and Rule lOb-5 thereunder. 

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6/ See Proposed Guidelines For The Preparation Of Form N-8B-l, 

Investment Company Act Release No. 5633, p. 7 (March 11, 1969). II 


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