Exemption for the Acquisition of Securities During the Existence of an Underwriting or Selling Syndicate

AGENCY:

Securities and Exchange Commission (“Commission”).

ACTION:

Proposed rule.

SUMMARY:

The Commission is proposing amendments to the rule under the Investment Company Act of 1940 that permits a registered investment company (“fund”) that has certain affiliations with an underwriting participant to purchase securities during an offering. The proposed amendments would expand the exemption provided by the rule to permit a fund to purchase government securities in a syndicated offering. The proposed amendments also would modify the rule's quantitative limit on purchases, to cover purchases by a fund as well as any account advised by the fund's investment adviser. These amendments are intended to respond to recent changes in the method of offering certain government securities, and to improve the effectiveness of the quantitative limit on fund purchases.

DATES:

Comments must be received on or before February 15, 2001.

ADDRESSES:

Comments should be submitted in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0609. Comments also may be submitted electronically to the following E-mail address: rule-comments@sec.gov. All comment letters should refer to File No. S7-20-00; this file number should be included on the subject line if E-mail is used. Comment letters will be available for public inspection and copying in the Commission's Public Reference Room, 450 5th Street, NW., Washington, DC 20549. Electronically submitted comment letters also will be posted on the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT:

Curtis A. Young, Senior Counsel, or C. Hunter Jones, Assistant Director, at (202) 942-0690, Office of Regulatory Policy, Division of Investment Management, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION:

The Commission today is requesting public comment on proposed amendments to rule 10f-3 [17 CFR 270.10f-3] under the Investment Company Act of 1940 [15 U.S.C. 80a] (the “Investment Company Act” or “Act”).

I. Discussion

A. Background

Section 10(f) of the Investment Company Act prohibits a fund from purchasing any security during an underwriting or selling syndicate if the fund has certain affiliated relationships with a principal underwriter for the security (“affiliated underwriter”). This provision was designed to protect funds and their investors from the “dumping” of unmarketable securities on a fund in order to benefit the fund's affiliated underwriter. Section 10(f) is a broad prohibition, and Congress included in the provision specific authority for the Commission to issue rules or orders exempting transactions from the prohibition, if consistent with the protection of investors.

Rule 10f-3, which the Commission adopted in 1958 and last amended in 1997, permits a fund to purchase securities in a transaction that section 10(f) would prohibit, if certain conditions are met. The conditions of rule 10f-3 are designed to ensure that the purchases are not likely to raise the concerns that section 10(f) was enacted to address, and are thus consistent with the protection of investors.

B. Purchase of Government Securities

When the Commission first adopted rule 10f-3 in 1958, one of the conditions of the rule was that the securities be registered under the Securities Act of 1933 (“Securities Act”) as part of a public offering. This condition served to assure that the fund did not purchase the securities through a private placement, and provided the basis for other conditions of the rule concerning the timing and conduct of the public offering. Since then, in response to changes in the methods of offering securities and other developments, we have revised the rule to permit the purchase of certain types of securities that are not registered under the Securities Act, such as municipal securities and securities offered through regulated foreign offerings or private institutional offerings. We determined that the circumstances in which these securities generally are offered, including the availability of relevant information about the issuer and the establishment of a uniform offering price, provided an effective substitute for the Securities Act registration requirement.

Government securities, including securities issued by agencies or instrumentalities of the U.S. government, are not included in the types of securities that rule 10f-3 permits affiliated funds to purchase. Until recently, there has been little need to exempt the purchase of government securities from section 10(f), because these securities generally have not been offered through “selling syndicates” or underwritings that involve affiliated underwriters to a significant degree. In 1998, however, at least two government-sponsored enterprises began to offer their securities through syndicated underwritings. Because rule 10f-3 does not provide an exemption from section 10(f) for affiliated funds to purchase government securities, affiliated funds have been unable to purchase securities in those offerings, and investors in those funds have been unable to benefit from the purchases their funds otherwise would have been able to make.

The Commission is proposing to amend rule 10f-3 to permit affiliated funds to purchase government securities during the existence of an underwriting or selling syndicate for those securities. Government securities are high-quality investments, and therefore are unlikely to be dumped into a fund. Moreover, the circumstances under which government agencies offer their securities to the public appear to be an effective substitute for Securities Act registration for purposes of rule 10f-3. Government agencies generally must obtain approval from the Department of Treasury concerning the timing, price, and terms of the securities offering. In addition, information about these securities typically is available to the public through prospectuses or similar offering documents, and these securities trade actively in the secondary market. Under the proposed amendments, the other restrictions of rule 10f-3, such as limitations on the price and quantity of securities purchased, would apply to the purchase of government securities by the fund.

The Commission requests comment on the proposed amendments related to government securities. Should the rule include limitations on the purchase of government securities that do not apply to other securities purchased under the rule? For example, should rule 10f-3 require that government securities receive a certain credit rating from a Nationally Recognized Statistical Rating Organization (“NRSRO”), as is required for municipal securities? Should any of the limitations included in rule 10f-3 not apply to purchases of government securities?

C. Purchases Covered by the Percentage Limit

One of the key conditions of rule 10f-3 is that a fund, together with any other fund advised by the fund's adviser, purchase no more than 25 percent of an offering (“percentage limit”). The purpose of the percentage limit is to provide an indication that a significant portion of an offering is being purchased by persons acting independently of the adviser. The existence of these purchasers demonstrates that the securities are not being “dumped” and suggests that the price of the securities is based on market forces.

Since amending rule 10f-3 in 1997, we have become aware of a possible “loophole” in the rule that could permit an investment adviser to circumvent the percentage limit and compromise the effectiveness of the rule. Although the percentage limit requires that an adviser aggregate the purchases of all the funds that it advises, the rule does not require that the adviser also aggregate purchases by its other (i.e., non-fund) clients. As a result, if an adviser purchases most or all of an offering for its fund clients and non-fund clients, the percentage limit may not provide a reliable indicator of market forces. The adviser could use these controlled accounts to assure the success of the affiliated underwriting, thus undermining an important protection that section 10(f) provides fund shareholders.

In order to assure the effectiveness of the percentage limit of rule 10f-3, we are proposing to amend the rule to include purchases by any other account over which the adviser has discretionary authority or exercises control. Therefore, if a fund purchases securities in reliance on rule 10f-3, the fund's purchases, aggregated with purchases by any other fund advised by the fund's adviser, and any other account over which the fund's adviser has discretionary authority or otherwise exercises control, could not exceed 25 percent of the offering.

The Commission requests comment on the proposed amendment to the percentage limit. Should we increase the percentage in light of the changes that we are now proposing?

II. General Request for Comments

Any interested persons wishing to comment on the rule changes that are the subject of this Release, to suggest additional changes, or to comment on other matters that might have an effect on the proposals contained in this Release, are requested to submit written comments. Comment is specifically requested whether the Commission should amend or eliminate conditions in rule 10f-3 other than those addressed in this Release.

The Commission also requests comment whether the proposals, if adopted, would promote efficiency, competition, and capital formation. Comments will be considered by the Commission in satisfying its responsibilities under section 2(c) of the Investment Company Act. For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996, the Commission also requests information regarding the potential impact of the proposed rule on the economy on an annual basis. Commenters are requested to provide data to support their views.

III. Cost-Benefit Analysis

A. Purchase of Government Securities

The proposed amendments to rule 10f-3 should, if adopted, increase the ability of funds to purchase securities during the existence of a syndicate in which an affiliated underwriter participates. The benefits to funds would include the ability to purchase government securities in syndicates involving an underwriter affiliated with the fund's investment adviser, without having to seek an exemptive order from the Commission. The potential benefits to fund investors would include better investment performance, and possibly lower fund expenses.

The costs to funds and investors of the proposed amendments should be small. Funds would be required to determine whether purchases of government securities comply with the conditions of the rule. The additional cost of determining compliance with the rule's conditions, as applied to purchases of government securities, should be minimal. Funds also would be required to (i) maintain a written record of each purchase of government securities made in reliance on the proposed amendments and (ii) report those transactions on Form N-SAR. Rule 10f-3 currently requires funds relying on the rule to comply with these recordkeeping and reporting requirements. The additional costs of complying with these requirements with respect to purchases of government securities made in reliance on the proposed amendments would be minimal and likely would be justified by the potential benefits to funds and investors described above.

B. Purchases Covered by the Percentage Limit

The proposed amendments would require that the total of the fund's purchases in any offering purchased by the fund in reliance on the rule, aggregated with purchases in the offering by any other fund advised by the fund's adviser, and purchases in the offering by any other account over which the fund's adviser has discretionary authority or otherwise exercises control, not exceed 25 percent of the offering. The proposed amendments will benefit funds and their investors by closing a loophole in the percentage limit. By doing so, the rule will reduce the likelihood that the fund's adviser is circumventing the percentage limit, and will thereby minimize the risk that fund investors will be harmed by the dumping of unmarketable securities into their funds. With respect to costs, the proposed amendments will require a fund or its adviser to monitor the purchases of non-fund accounts over which the fund's adviser has discretionary authority or otherwise exercises control. The cost of this monitoring is likely to be minimal, because this information should be readily available to the fund's adviser.

C. Request for Comments

The Commission requests comment on the potential costs and benefits of the proposed amendments and any suggested alternatives to the proposal. Data are requested concerning these costs and benefits.

IV. Paperwork Reduction Act

Certain provisions of the proposed amendments to rule 10f-3 contain “collection of information” requirements within the meaning of the Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) (“PRA”), and the Commission is submitting the proposed amendments to the Office of Management and Budget for review in accordance with 44 U.S.C. 3507(d). The title for the collection of information is “Exemption for the Acquisition of Securities During the Existence of an Underwriting or Selling Syndicate.” Rule 10f-3 contains currently approved collections of information under OMB control number 3235-0226. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number.

A. Purchase of Government Securities

Rule 10f-3 permits a fund to purchase securities, from an unaffiliated underwriter, in an underwriting of securities in which an affiliated underwriter is a member of the underwriting or selling syndicate. The proposed amendments to rule 10f-3 would permit a fund to purchase government securities under the conditions of the rule.

Rule 10f-3 requires the board of directors of a fund relying on the rule to approve procedures that are reasonably designed to ensure compliance with the conditions of the rule, and to approve changes to these procedures as necessary. The fund must maintain these procedures permanently in an easily accessible place. A fund that chooses to rely on the proposed amendments also may need to amend these procedures to account for purchases of government securities. The fund also must report on Form N-SAR any transactions under the rule and attach a written record of each transaction, and the board must review the transactions quarterly to determine compliance with the fund's procedures. Finally, a fund must retain written records of the rule 10f-3 transactions and of the information reviewed by the board, for at least six years from the end of the fiscal year in which the transactions occurred. A fund would need to comply with these recordkeeping requirements in order to obtain the benefit of exemption from section 10(f) of the Act for purchases of government securities under the proposed amendments.

The collections of information are necessary to provide the Commission with information regarding compliance with rule 10f-3. The Commission may review this information during periodic examinations or with respect to investigations. Except for the information required to be kept under paragraph (b)(11)(ii) of rule 10f-3, none of the information required to be collected or disclosed for PRA purposes will be kept confidential. If the records required to be kept under these rules are requested by and submitted to the Commission, they will be kept confidential to the extent permitted by relevant statutory and regulatory provisions.

The Division of Investment Management estimates that 300 funds rely upon rule 10f-3 each year, and that 70 of those funds purchase government securities (although not all 70 funds would likely need to rely upon rule 10f-3 to purchase government securities). It is estimated that the recordkeeping burden for funds that rely on the proposed amendments to purchase government securities would increase by an estimated 0.25 hours per fund per year.

B. Purchases Covered by the Percentage Limit

The recordkeeping burden for funds that rely on rule 10f-3 may minimally increase due to the condition that the total of the fund's purchases in any offering, aggregated with purchases of any other fund advised by the fund's adviser, and purchases by any other account over which the fund's adviser has discretionary authority or otherwise exercises control, not exceed 25 percent of the offering.

C. Comments

The Commission solicits comments under 44 U.S.C. 3506(c)(2)(B) concerning: whether the proposed collection of information is necessary for the proper performance of the function of the Commission, including whether the information will have practical utility; the accuracy of the staff's estimate of the burden of the proposed collection of information; the quality, utility, and clarity of the information to be collected; and whether the burden of collection of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology, may be minimized.

Persons desiring to submit comments on the collection of information requirements should direct them to the Office of Management and Budget (“OMB”), Attention: Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Washington, DC 20503, and should also send a copy of their comments to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 5th St., NW., Washington, DC 20549-0609 with reference to File No. S7-20-00. Requests for materials submitted to OMB by the Commission with regard to this collection of information should be in writing, refer to File No. S7-20-00, and be submitted to the Securities and Exchange Commission, Records Management, Office of Filings and Information Services, 450 5th Street, NW., Washington, DC 20549. OMB is required to make a decision concerning the collection of information between 30 and 60 days after publication, so a comment to the OMB is best assured of having its full effect if the OMB receives it within 30 days of publication.

V. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility Analysis (“IRFA”) in accordance with 5 U.S.C. 603 regarding amendments to rule 10f-3 under the Investment Company Act. The following summarizes the IRFA.

Section 10(f) prohibits investment companies from purchasing government securities from an affiliated underwriter during the existence of an underwriting or selling syndicate for that security, and authorizes the Commission to exempt transactions by rule or order from the prohibition. The Commission adopted rule 10f-3 to permit a fund to purchase securities from an unaffiliated member of an underwriting or selling syndicate when an affiliated underwriter is a member of the underwriting or selling syndicate. We are proposing amendments to rule 10f-3 in response to the recent syndicated underwriting of government securities issued by government-sponsored enterprises. The proposed amendments are designed to permit funds to purchase government securities in syndicated offerings, in accordance with other conditions of rule 10f-3. We are also proposing amendments in response to concerns that purchases by advisory clients other than funds may undercut the effectiveness of the percentage limit of the rule. To address this concern the Commission is proposing that the total of the fund's purchases in any offering, aggregated with purchases of any other fund advised by the fund's adviser, and purchases by any account over which the fund's adviser has discretionary authority or otherwise exercises control, not exceed 25 percent of the offering.

A small business or small organization (collectively, “small entity”) for purposes of the Investment Company Act is a fund that, together with other funds in the same group of related investment companies, has net assets of $50 million or less as of the end of its most recent fiscal year. Of approximately 3900 active funds, 339 are small entities. Any of these 339 funds would be able to rely on the proposed amendments to rule 10f-3. It appears that the proposed amendments would affect small entities in the same manner as other entities subject to section 10(f), and that the proposed amendments increase flexibility for all funds.

The IRFA states that purchases of government securities made in reliance on rule 10f-3 would be subject to the existing and amended reporting and recordkeeping requirements of the rule. There are no rules that duplicate, overlap, or conflict with the proposed amendments. The IRFA also discusses the absence of any viable alternatives considered by the Commission in connection with the proposed amendments that might minimize the effect on small entities.

The Commission encourages the submission of comments on matters discussed in the IRFA. Comment specifically is requested on the number of small entities that would be affected by the proposed rule amendments. Comment is also requested on the effect of the rule amendments on investment advisers and funds that are small entities. Commenters are asked to describe the nature of any effect and provide empirical data supporting the extent of the effect. These comments will be placed in the same public file as comments on the proposed rule amendments. A copy of the IRFA may be obtained by contacting Curtis A. Young, Securities and Exchange Commission, 450 5th Street, NW., Washington, DC 20549-0506.

VI. Statutory Authority

The Commission is proposing to amend rule 10f-3 under the authority set forth in sections 10(f), 31(a) and 38(a) of the Investment Company Act [15 U.S.C. 80a-10(f), 80a-30(a), 80a-37(a)].

List of Subjects in 17 CFR Part 270

• Investment companies
• Reporting and recordkeeping requirements
• Securities

Text of Proposed Rule Amendments

For the reasons set out in the preamble, Title 17, Chapter II of the Code of Federal Regulations is proposed to be amended as follows:

PART 270—RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

1. The authority citation for Part 270 continues to read, in part, as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39 unless otherwise noted;

2. Amend § 270.10f-3 by revising paragraphs (b)(1), (b)(4) and (b)(7).