[Federal Register Volume 60, Number 148 (Wednesday, August 2, 1995)]
[Proposed Rules]
[Pages 39592-39606]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-18890]




[[Page 39591]]

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Part V





Securities and Exchange Commission





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17 CFR Part 270



Custody of Investment Company Assets Outside the United States; 
Proposed Rule

  Federal Register / Vol. 60, No. 148 / Wednesday, August 2, 1995 / 
Proposed Rules  

[[Page 39592]]


SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release Nos. IC-21259; International Series Release No. 831; File No. 
S7-23-95]
RIN 3235-AE98


Custody of Investment Company Assets Outside the United States

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule amendments and request for comment.

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SUMMARY: The Commission is proposing amendments to the rule under the 
Investment Company Act of 1940 that governs the custody of investment 
company assets outside the United States. The amendments would revise 
the findings that currently must be made in establishing foreign 
custody arrangements to focus exclusively on the safekeeping of 
investment company assets. In addition, the amendments would provide 
investment companies with greater flexibility to address foreign 
custody arrangements by permitting a company's board of directors to 
delegate its responsibilities under the rule to evaluate these 
arrangements. The amendments also would expand the class of foreign 
banks and securities depositories that could serve as investment 
company custodians. The proposed amendments are intended to facilitate 
the use of foreign custody arrangements, consistent with the 
safekeeping of investment company assets.

DATES: Comments must be received on or before October 6, 1995.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Stop 6-9, Washington, D.C. 20549. All comment letters should 
refer to File No. S7-23-95. All comments received will be available for 
public inspection and copying in the Commission's Public Reference 
Room, 450 Fifth Street, NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: Elizabeth R. Krentzman, Assistant 
Chief, or Kenneth J. Berman, Assistant Director, (202) 942-0690, Office 
of Regulatory Policy, Division of Investment Management, 450 Fifth 
Street, NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission today is requesting public 
comment on proposed amendments to rule 17f-5 (17 CFR 270.17f-5) under 
the Investment Company Act of 1940 (15 U.S.C. 80a) (the ``Act'').

Table of Contents

I. Executive Summary
II. Background
III. Discussion
    A. Standard for Evaluating Foreign Custody Arrangements
    B. Delegation of Board Responsibilities
    1. Appropriate Delegate for Foreign Custody Decisions
    2. Custody in Foreign Countries
    a. Prevailing Custodial Risks
    b. Compulsory Depositories
    3. Selecting Foreign Custodians
    4. Foreign Custody Contracts
    a. Proposed Approach
    b. Request for Comment on Specific Contract Provisions
    5. Monitoring Custody Arrangements and Withdrawing Assets from 
Custodians
    C. Eligible Foreign Custodians
    1. Banks and Trust Companies
    a. Proposed Approach
    b. Other Alternatives Considered
    2. Non-Compulsory Depositories and Transnational Systems
    D. Assets Maintained in Foreign Custody
    E. Canadian and Other Foreign Funds
    F. Disclosure of Custody Risks
    G. Unit Investment Trusts
IV. Cost/Benefit Analysis
V. Summary of Initial Regulatory Flexibility Analysis
VI. Statutory Authority
Text of Proposed Rule Amendments
I. Executive Summary

    The Commission is proposing amendments to rule 17f-5 to facilitate 
the use of foreign custody arrangements by registered management 
investment companies (``funds''). Among other things, the amendments 
would revise the findings that must be made in establishing foreign 
custody arrangements. Under the current rule, a fund's board of 
directors must find that the fund's arrangements are consistent with 
the best interests of the fund and its shareholders. This standard may 
be overbroad since it suggests, for example, that, in considering 
foreign custody arrangements, a fund's board needs to assess factors 
other than custodial risks. The amended rule would require findings 
that the fund's foreign custody arrangements will provide reasonable 
protection for fund assets. The proposed ``reasonable protection'' 
standard should facilitate evaluations of foreign custody arrangements 
by focusing exclusively on safekeeping considerations.
    The amendments also would allow fund directors to play a more 
traditional oversight role with respect to foreign custody arrangements 
than that required under the current rule. Under the amendments, the 
board would be permitted to delegate its responsibility under the rule 
to evaluate foreign custody arrangements to the fund's investment 
adviser or officers or a U.S. or foreign bank. The amended rule would 
provide the board with the flexibility to assign different delegates 
responsibility for addressing different aspects of the fund's 
arrangements. The amended rule also would provide for general board 
oversight of a delegate's actions by requiring the delegate to provide 
the board with periodic reports concerning the fund's arrangements. The 
board would no longer be required to approve foreign custody 
arrangements annually.
    In addition to updating and refining certain other provisions of 
rule 17f-5, the amendments would expand the class of foreign banks and 
depositories that could serve as fund custodians. Foreign banks would 
no longer have to meet specific capital requirements and foreign 
depositories would no longer have to operate the only system for the 
handling of securities in a country. The amended rule would require 
foreign custodians to be subject to foreign regulation. In addition, in 
connection with a custodian's selection, the amended rule would require 
a finding that the custodian will provide reasonable protection for the 
fund's assets based on all relevant factors, including the custodian's 
financial strength. This approach seeks to address safekeeping 
considerations without imposing capital and other requirements that may 
unnecessarily limit fund use of appropriate foreign custodians.
II. Background

    Over the last ten years, the fund industry has become increasingly 
international in its investment perspective. At the end of 1984, 
shortly after rule 17f-5 was adopted, only 35 funds invested 
significant amounts of their assets in foreign securities.1 By the 
end of 1994, the number of funds participating in foreign markets had 
increased almost twentyfold, with over 650 funds investing significant 
amounts of their assets outside the United States.2

    \1\ Investment Company Institute, The Growth Continues 1993 
Perspective on Mutual Fund Activity 7 (Summer 1993); Lipper 
Analytical Services, Inc. (``Lipper''), Year Over Year Comparison of 
Growth by Objective of Closed-End Funds (1980-1990) (prepared for 
the Commission).
    \2\ Investment Company Institute, Trends in Mutual Fund Activity 
(Dec. 1994) (ICI News No. ICI-95-05); Lipper, Closed-End Fund 
Performance Analysis Service (Jan. 31, 1995) (as supplemented by the 
Commission staff to reflect closed-end funds that liquidated or 
converted to open-end status during the ten-year period ending 
December 31, 1994). Based on Commission filings, the Division of 
Investment Managements estimates that over 2,200 fund portfolios 
maintained some of their assets in foreign custody arrangements 
during the past year. 

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    The availability of custodial arrangements in foreign markets where 
a fund invests is important. Maintaining securities outside of their 
primary market can add significant costs to investing in that market 
and may preclude foreign investment.3

    \3\ Moving securities away from their primary market may entail 
additional costs in connection with hiring a servicing agent in the 
primary locality to collect and disseminate information with respect 
to the securities, transferring the securities to an eligible 
custodian and procuring insurance for possible loss in transit, and 
exchanging coupons for interest or dividends or for new shares in 
connection with a rights offering. Exemption for Custody of 
Securities by Foreign Banks and Foreign Securities Depositories, 
Investment Company Act Release No. 12354 (Apr. 5, 1982), 47 FR 
16341, 16342 (hereinafter 1982 Proposing Release). Funds also may be 
prevented from, or delayed in, selling the securities if they are 
unable to make timely delivery to prospective purchasers in the 
primary market. Id. In addition, the best price for a foreign 
security typically may be obtained in its primary market. Id.
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    Section 17(f) of the Act and the rules thereunder govern the 
safekeeping of fund assets.4 The legislative history and 
requirements of section 17(f) indicate that Congress intended fund 
assets to be kept by financially secure entities that have sufficient 
safeguards against misappropriation.5 Under section 17(f), only 
U.S. banks and their foreign branches, members of a U.S. securities 
exchange, funds themselves, and U.S. securities depositories may serve 
as fund custodians.6 Before rule 17f-5 was adopted, therefore, 
funds seeking to maintain their assets outside the United States could 
use only foreign branches of U.S. banks as foreign custodians.7

    \4\ 15 U.S.C. 80a-17(f).
    \5\ Investment Trusts and Investment Companies: Hearings on S. 
3580 Before a Subcomm. of the Senate Comm. on Banking and Currency, 
76th Cong., 3d Sess. 264 (1940). Cf. 10 SEC Ann. Rep. 169 (1944) 
(discussing section 17(f) and its protections against theft and 
embezzlement by affiliated persons).
    \6\ Bank custodians must be subject to federal or state 
regulation and have at least $500,000 in aggregate capital, surplus, 
and undivided profits. Investment Company Act sections 2(a)(5), 15 
U.S.C. 80a-2(a)(5) (defining bank), and 26(a)(1), 15 U.S.C. 80a-
26(a)(1) (containing the $500,000 capital requirement). See also 
rule 17f-1, 17 CFR 270.17f-1 (custody by members of a U.S. 
securities exchange), rule 17f-2, 17 CFR 270.17f-2 (custody by funds 
themselves), and rule 17f-4, 17 CFR 270.17f-4 (custody by U.S. 
securities depositories). See generally Custody of Investment 
Company Assets with Futures Commission Merchants and Commodity 
Clearing Organizations, Investment Company Act Release No. 20313 
(May 24, 1994), 59 FR 28286 (proposing rule 17f-6, which would 
permit custody of fund assets by futures commission merchants and 
commodity clearing organizations).
    \7\ 1982 Proposing Release, supra note 3, at 16342 n.11. Before 
rule 17f-5 was adopted, several Commission orders under section 
17(f) permitted funds to place their assets with certain foreign 
banks if the fund's U.S. custodian assumed responsibility for the 
arrangement. See Chase Manhattan Bank, Investment Company Act 
Release Nos. 12002 (Oct. 23, 1981), 46 FR 53567 (Notice of 
Application) and 12053 (Nov. 20, 1981), 24 SEC Docket 109 (Order).
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    Rule 17f-5 expanded the foreign custody arrangements available to 
funds.\8\ Under the rule, the fund's board of directors must approve 
each country where the fund's assets will be maintained, each foreign 
bank or depository that will hold the assets, and the contract 
governing the arrangement.\9\ The rule requires foreign custody 
contracts to contain certain provisions, and Notes to the rule 
enumerate factors that the board should consider in placing fund assets 
in foreign countries and with foreign custodians.\10\ In addition, the 
rule requires the fund's board to monitor foreign custody arrangements 
and to approve the arrangements at least annually.\11\

    \8\ Exemption for Custody of Investment Company Assets Outside 
the United States, Investment Company Act Release No. 14132 (Sept. 
7, 1984), 49 FR 36080 (hereinafter 1984 Adopting Release). Rule 17f-
5 was proposed in 1982 and reproposed in 1984. See 1982 Proposing 
Release, supra note 3; Exemption for Custody of Investment Company 
Assets Outside the United States, Investment Company Act Release No. 
13724 (Jan. 17, 1984), 49 FR 2904 (hereinafter 1984 Reproposing 
Release). In addition, certain technical amendments were made to the 
rule after its adoption. Custody of Investment Company Assets 
Outside of the United States, Investment Company Act Release Nos. 
14548 (May 31, 1985), 50 FR 24540 (hereinafter 1985 Release 
Proposing Amendments), and 14711 (Sept. 11, 1985), 50 FR 37654 
(hereinafter 1985 Release Adopting Amendments])
    \9\ Rule 17f-5(a)(1)(i)-(iii). See also ``Discussion--Assets 
Maintained in Foreign Custody'' below.
    \10\ Rule 17f-5(a)(1)(iii), Rule 17f-5, Notes 1 and 2.
    \11\ Rule 17f-5(a)(2) and (3).
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    Rule 17f-5 limits ``eligible foreign custodians'' to foreign banks 
and trust companies that either have more than $200 million in 
shareholders' equity or are majority-owned subsidiaries of U.S. banks 
or bank holding companies with more than $100 million in shareholders' 
equity.\12\ Foreign depositories that hold fund assets must operate 
either the only system for a country's handling of securities or a 
transnational system for the central handling of securities.\13\

    \12\ Rule 17f-5(c)(2)(i) and (ii). Non-subsidiary foreign bank 
and trust companies also must be subject to foreign regulation.
    \13\ Rule 17f-5(c)(2)(iii) and (iv).
    The Commission's Division of Investment Management (``Division'') 
has received extensive submissions urging amendment of rule 17f-5 from 
the Investment Company Institute (``ICI'') and a group of custodians 
that provide global custody services to funds (the ``Custodian 
Group'').14 These commenters, as well as others, have indicated 
that rule 17f-5 places inappropriate burdens on fund directors.15 
Commenters have observed that the rule requires directors to ``micro-
manage'' foreign custody arrangements, which is inconsistent with the 
oversight role directors generally perform.16 Commenters also have 
indicated that directors usually lack the expertise to make foreign 
custody determinations, and that, in discharging their responsibilities 
under the rule, directors rely almost exclusively on the analysis and 
recommendations of third parties such as the fund's adviser and primary 
custodian.17

    \14\ Letter from Matthew P. Fink, President, ICI, to Marianne K. 
Smythe, Division Director, SEC (Jan. 18, 1993) (hereinafter ICI 
Letter I); Letter from Catherine L. Heron, Vice President (Tax and 
Pension), ICI, to Barry P. Barbash, Division Director, SEC (Oct. 13, 
1993) (hereinafter ICI Letter II); Letter from Stephen K. West, 
Sullivan & Cromwell, to Barry P. Barbash, Division Director, SEC 
(Sept. 29, 1994) (hereinafter ICI Letter III); Letter from Daniel L. 
Goelzer, Baker & Mackenzie (on behalf of Bankers Trust Company, 
Boston Safe Deposit and Trust Company, Brown Brothers Harriman & 
Co., Chase Manhattan Bank, Morgan Guaranty Trust Company of New 
York, Morgan Stanley Trust Company, and State Street Bank and Trust 
Company), to Barry P. Barbash, Division Director, SEC (Feb. 9, 1994) 
(hereinafter Custodian Letter I); Letter from Daniel L. Goelzer, 
Baker & Mackenzie, to Elizabeth R. Krentzman, Special Counsel, SEC 
(Oct. 20, 1994) (hereinafter Custodian Letter II); Letter from 
Daniel L. Goelzer, Baker & Mackenzie, to Barry P. Barbash, Division 
Director, SEC (Nov. 3, 1994) (hereinafter Custodian Letter III). 
These letters are located in the Commission's Public Reference Room 
under File No. S7-23-95.
    \15\ See Division of Investment Management, SEC, Protecting 
Investors: A Half Century of Investment Company Regulation 270 n.78 
(1992) (hereinafter Protecting Investors report).
    \16\ Id.
    \17\ Id.
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    Commenters, including the ICI and the Custodian Group, also have 
indicated that the rule's definition of an eligible foreign custodian 
is too restrictive.18 Since rule 17f-5 was adopted, foreign 
custodial arrangements have evolved significantly. Today, the 
safekeeping of foreign investments typically is effected through the 
fund's primary custodian, which uses a global custody network 
consisting of various foreign custodians with which the primary 
custodian has established relationships.19 In addition, many 
countries have securities depositories, which offer ``paperless'' book-
entry systems for the custody of fund assets.20

    \18\ See, e.g., ICI Letter II, supra note 14; Custodian Letter 
I, supra note 14.
    \19\ See John Paul Lee & Richard Schwartz, Global Custody: A 
Guide for the Nineties (1990). Funds also use different custodian 
networks for different geographical regions. See Andrew Sollinger, 
Breaking Away, Institutional Investor 171 (Sept. 1991).
    \20\ See Group of Thirty, Clearance and Settlement Systems in 
the World's Securities Markets 7, 51-64 (Mar. 1989) (hereinafter 
Group of Thirty Report).
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    A number of exemptive orders and no-action letters have addressed 
the 

[[Page 39594]]
eligibility of certain foreign banks and depositories to serve as fund 
custodians.21 Obtaining administrative relief with respect to a 
particular custodian, however, may involve significant amounts of time 
and expense, and may delay or impede investment in some foreign 
jurisdictions. Exemptive orders and no-action letters also may have the 
unintended effect of suggesting Commission approval with respect to 
safekeeping abilities of some custodians, particularly in the case of 
foreign depositories.

    \21\ See ``Discussion--Eligible Foreign Custodians'' below.
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    Based on the evolution of foreign markets and related custodial 
systems, the concerns raised by industry commenters, and the 
Commission's administrative experience, the Commission is proposing 
amendments to rule 17f-5. The amendments seek to facilitate the use of 
foreign custody arrangements, consistent with the safekeeping of fund 
assets.

III. Discussion

A. Standard for Evaluating Foreign Custody Arrangements

    Rule 17f-5 currently requires fund boards of directors to find that 
the fund's foreign custody arrangements are consistent with the best 
interests of the fund and its shareholders. This finding must be made 
with respect to the custody of the fund's assets in a particular 
country, each foreign custodian that holds the assets, and the foreign 
custody contract.22 The Commission believes that the ``best 
interest'' standard may be overly broad and difficult for directors to 
apply. The standard and certain Notes to the current rule, for example, 
suggest that, in considering foreign custody arrangements, a fund's 
board needs to assess factors other than custodial risks, such as the 
risk of expropriation.23

    \22\ See rule 17f-5(a)(1)-(3).
    \23\ See 1984 Reproposing Release, supra note 8, at 59608 (in 
making the required best interest finding, the board should weigh 
the risks of maintaining the securities in or near a country against 
the benefits of the arrangement).
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    The Commission believes that the amended rule should require 
foreign custody arrangements to be evaluated based on the level of 
safekeeping they will afford fund assets. Thus, the amended rule would 
require findings that the fund's foreign custody arrangements will 
provide reasonable protection for fund assets. The proposed 
``reasonable protection'' standard is intended to facilitate 
evaluations of foreign custody arrangements by focusing exclusively on 
the safekeeping of fund assets.

B. Delegation of Board Responsibilities

1. Appropriate Delegate for Foreign Custody Decisions
    The amended rule would permit fund boards to play a role more 
consistent with their traditional oversight role in connection with a 
fund's foreign custody arrangements, by allowing the board to delegate 
its responsibilities under the rule to the fund's investment adviser or 
officers or a U.S. or foreign bank.24 The fund's investment 
adviser or custodian are likely to be in a better position than the 
fund's board to evaluate the sorts of factors that would be involved in 
assessing whether a custodial arrangement will afford reasonable 
protection for fund assets. Under the amended rule, the board could use 
different delegates for different foreign custody 
responsibilities.25 This approach seeks to provide the board with 
the flexibility to delegate components of foreign custody decisions to 
the entity it determines is in the best position to evaluate those 
aspects of the fund's arrangements.26

    \24\ The Commission previously considered permitting U.S. 
custodians to select particular foreign custodians. 1982 Proposing 
Release, supra note 3, at 16345-46; 1984 Reproposing Release, supra 
note 8, at 2910. See also Protecting Investors report, supra note 
15, at 270-71 (recommending that the Commission consider revising 
rule 17f-5 to make the fund's adviser or primary domestic custodian 
responsible for foreign custody matters, subject to the board's 
general oversight; also recommending that the Commission consider 
requiring indemnification protections from the fund's domestic 
custodian).
    \25\ The adviser, for example, could evaluate the risks 
associated with the custody of the fund's assets in a particular 
jurisdiction and a U.S. custodian could evaluate the risks of using 
specific foreign custodians.
    \26\ Proposed rule 17f-5(b). U.S. bank delegates would have to 
be subject to federal or state regulation by virtue of the 
definition of bank in section 2(a)(5) of the Act. Through the 
definition of ``qualified foreign bank,'' proposed rule 17f-5(d)(6) 
would require foreign delegates to be regulated as either a foreign 
banking institution or trust company by the government of the 
country under whose laws it is organized or any agency thereof.
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    In selecting particular delegates for foreign custody decisions, 
the board, under the amended rule, would need to find that it is 
reasonable to rely on the delegate to perform the delegated 
responsibilities.27 Factors typically involved in making this 
determination would include the expertise of the delegate and, if 
applicable, the delegate's intended use of third party experts in 
performing its responsibilities.28 Other relevant factors may 
include, in the case of foreign delegates, the board's ability to 
monitor the delegate's performance and the fund's ability to obtain 
U.S. jurisdiction over the delegate if problems arise in the delegate's 
performance.

    \27\ Proposed rule 17f-5(b)(1).
    \28\ See generally Custodian Letter II, supra note 14, at 2 
(indicating that U.S. custodians can provide information regarding 
the nature and operation of a foreign country's custody facilities); 
Gordon Altman Butowsky Weitzen Shalov & Wein, A Practical Guide to 
the Investment Company Act 30 (1993) (indicating that, under the 
current rule, the fund's custodian typically provides the board with 
information concerning foreign legal restrictions and the 
qualifications of the foreign custodians used by the fund); 
Glorianne Stromberg, Regulatory Strategies for the Mid-'90s; 
Recommendations for Regulating Investment Funds in Canada (prepared 
for the Canadian Securities Administrators) 242 (Jan. 1995) 
(suggesting it is unlikely that an individual investment company or 
its adviser will have the expertise or bargaining power to deal with 
numerous and varied foreign custodians throughout the world).
    The amended rule would not require the board to approve the fund's 
foreign custodians or other foreign custody matters on an initial or 
annual basis.29 The board also would not be required to pre-
approve or ratify actions taken by the delegate, such as the selection 
of particular foreign custodians or changes in those 
arrangements.30 Instead, the amended rule would require the 
delegate to provide the board with written reports notifying the board 
of the placement of the fund's assets in a particular country and with 
a particular custodian.31 The delegate also would have to provide 
written reports of any material changes in the fund's 
arrangements.32 These reports, which are intended to facilitate 
the board's oversight of the delegate's performance, would be provided 
to the board no later than the next regularly scheduled board 

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meeting following the delegate's actions.33

    \29\ See rule 17f-5(a)(3) (requiring the board to annually 
approve foreign custody arrangements). See also Revision of Certain 
Annual Review Requirements of Investment Company Boards of 
Directors, Investment Company Act Release No. 19719 (Sept. 17, 
1993), 58 FR 49919 (rule amendments eliminating certain annual 
approval requirements).
    \30\ The amended rule, however, would not preclude a board and 
its delegate from agreeing that the board's guidance would be sought 
on a particular matter, such as changing custodians. See Custodian 
Letter II, supra note 14, at 16-17 (expressing concerns that, 
without the board's involvement, responsibility for changing 
custodians could increase a delegate's liability if, for example, 
the delegate does not make a custodian change and fund assets are 
lost as a result of the custodian's insolvency).
    \31\ Proposed rule 17f-5(b)(2).
    \32\ Id. A material change in the fund's arrangements could 
include a delegate's decision to remove the fund's assets from a 
particular jurisdiction or custodian. A material change also could 
include circumstances that may adversely affect a foreign 
custodian's financial or operational strength, such as a change in 
control resulting from the custodian's sale. If appropriate, the 
delegate's report could discuss the reasons for continuing to 
maintain the fund's assets in the country or with a particular 
custodian.
    \33\ Proposed rule 17f-5(b)(2). See ICI Letter I, supra note 14, 
at 6-7; Custodian Letter I, supra note 14, at 18 (recommending that 
delegates provide written year-end reports).
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    The Commission requests comment on the proposed approach and 
possible alternatives. The Commission requests specific comment on the 
proposed entities to which foreign custody responsibilities could be 
delegated. In particular, the Commission requests comment whether U.S. 
and foreign bank delegates should be required to meet specific capital 
standards. The Commission also requests comment whether custodian 
delegates should be limited to U.S. banks.34 Alternatively, should 
the rule permit the board to use any party that, in the board's 
judgment, would be qualified to make foreign custody decisions?

    \34\ Several exemptive orders relating to rule 17f-5 involve 
foreign banks and their foreign subsidiaries. See, e.g., Barclays 
Bank PLC, Investment Company Act Release Nos. 20128 (Mar. 10, 1994), 
59 FR 12390 (Notice of Application) and 20192 (Apr. 5, 1994), 56 SEC 
Docket 1117 (Order).
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    The Commission also requests comment whether the amended rule 
should require the same delegate to evaluate all aspects of the fund's 
arrangements or tie certain responsibilities to particular 
delegates.35 The ICI and the Custodian Group, for example, 
indicated that the fund's adviser should be the exclusive delegate for 
considering a county's custodial risks because of the relationship 
between decisions to invest in the country and maintain the fund's 
assets in that country.36 They also suggested that U.S. bank 
custodians should be the only eligible delegates for selecting the 
fund's foreign custodians.37 The ICI suggested that evaluating 
foreign custodian arrangements is within the expertise of the fund's 
U.S. custodian and not the fund's adviser.38 The Custodian Group 
expressed concerns about advisers being in a position to make a U.S. 
custodian use a foreign custodian with which the U.S. custodian does 
not have a pre-existing relationship and whose practices and procedures 
do not meet the U.S. custodian's standards.39

    \35\ Requiring the same delegate to evaluate all aspects of 
foreign custody arrangements could effectively eliminate the 
potential for U.S. custodians to serve as delegates, since the 
Custodian Group has suggested that U.S. custodians may be unwilling 
to evaluate the prevailing custodial risks of a particular country. 
See infra note 36 and accompanying text.
    \36\ ICI Letter I, supra note 14, at 4, n.5; ICI Letter III, 
supra note 14, at 1-3; Custodian Letter I, supra note 14, at 6-7; 
Custodian Letter II, supra note 14, at 2. See also Custodian Letter 
III, supra note 14, at 2. The Custodian Group indicated that, 
because decisions relating to a country's prevailing custodial risks 
may depend on the fund's investment strategies and willingness to 
accept certain risks, custodians are not in a position to make these 
assessments. Custodian Letter I, supra note 14, at 6-7; Custodian 
Letter II, supra note 14, at 2; Custodian Letter III, supra note 14, 
at 2. The Custodian Group also asserted that requiring U.S. 
custodians to evaluate prevailing custodial risks would transfer new 
liabilities to U.S. banks, which could raise bank regulatory 
concerns. Id. at 5-6.
    As discussed infra notes 62-68 and accompanying text, the ICI 
and the Custodian Group viewed differently the responsibilities 
involved in determining whether to maintain custody of fund assets 
in a particular country.
    \37\ ICI Letter III, supra note 14, at 3 and at 1, 6 (Exhibit 
A); Custodian Letter I, supra note 14, at 8-9 and at 3-4, 7-8 
(Exhibit A) (also recommending that boards be permitted to delegate 
to U.S. custodians the authority to negotiate and approve foreign 
custody contracts and to monitor the fund's arrangements).
    \38\ ICI Letter III, supra note 14, at 3.
    \39\ Custodian Letter I, supra note 14, at 8.
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    Although these approaches may limit flexibility, they could 
eliminate potential questions between different delegates concerning 
their respective roles in foreign custody matters. They also could 
eliminate the need to attribute various foreign custody risks to the 
practices of a particular country or foreign custodian.40

    \40\ Under the current rule, for example, the board is 
responsible for both the decision to place fund assets in a 
particular country and with a particular custodian. If a country's 
prevailing custodial risks are not evaluated by the board in 
deciding to maintain assets in a particular jurisdiction, these 
risks would be considered in selecting particular custodians in that 
jurisdiction. See also infra notes 49 and 71 and accompanying text.
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    The Commission also requests comment on the proposed requirements 
relating to the board's delegation. The Commission requests specific 
comment on requiring the board to determine that it is reasonable to 
rely on the delegate to perform the delegated responsibilities and 
whether another standard would be more appropriate. The Commission also 
requests comment on requiring delegates to provide the board with 
periodic reports concerning the fund's arrangements. In particular, 
does the proposed approach appropriately address the role of the board 
in foreign custody matters? Should, for example, the rule require the 
board to establish guidelines and procedures governing a delegate's 
responsibilities? 41 Should the rule specify particular 
representations that delegates must make in performing their 
responsibilities? 42 Should the rule mandate the standard of care 
to be used by delegates in making custodial decisions? 43

    \41\ See ICI Letter III, supra note 14, at 1-3 (Exhibit A); 
Custodian Letter I, supra note 14, at 3-5 (Exhibit A) (recommending 
board-approved guidelines and procedures that include factors 
governing a delegate's selection of foreign custodians). See also 
rules 10f-3, 17a-7, and 17e-1 under the Act, 17 CFR 270.10f-3, -17a-
7, -17e-1 (consistent with this approach).
    \42\ See ICI Letter III, supra note 14, at 5 (Exhibit A); 
Custodian Letter I, supra note 14, at 7 (Exhibit A) (recommending 
that delegates make certain representations to the board prior to 
using a foreign custodian).
    \43\ See ICI Letter III, supra note 14, at 3 and at 1, 6 
(Exhibit A); Custodian Letter I, supra note 14, at 8-9 and at 3-4, 
7-8 (Exhibit A) (recommending that, in selecting foreign custodians, 
U.S. bank delegates be required to act with the degree of care, 
prudence, and diligence of a reasonable professional custodian under 
applicable state law).
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    Finally, the Commission requests comment generally on the 
relationship between the level of the delegate's role in selecting 
foreign custodians and the flexibility that a fund should have in using 
particular custodians. For example, current rule 17f-5 both limits the 
class of foreign banks that are eligible to hold fund assets (based on, 
among other things, their shareholder's equity) and requires the fund's 
board to select an appropriate custodian from that class based on 
several qualitative factors (such as the bank's reputation). As 
discussed below, the amended rule would not require foreign custodians 
to satisfy an objective financial standard.44 The amended rule 
instead would require the board's delegate to select foreign custodians 
based on the qualitative determination that the custodian will provide 
reasonable protection for the fund's assets.45

    \44\ See ``Eligible Foreign Custodians'' below.
    \45\ See ``Selecting Foreign Custodians'' below.
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    The Commission requests comment on an alternative approach that 
would rely exclusively on objective standards to determine those 
custodians that would be eligible to hold fund assets. Under this 
approach, having determined that a potential custodian meets the rule's 
objective standards, a delegate would not be required to evaluate the 
appropriateness of the foreign custodian based on any qualitative 
determination. Nor would the delegate be required by the rule to 
provide the fund's board with specific reports concerning the fund's 
arrangements.46 Commenters favoring this approach should recommend 
specific objective standards that would not unduly limit or preclude 
the use of qualified foreign custodians.47 Commenters also should 
consider whether objective standards, by themselves, would protect fund 
assets or whether, consistent with the current rule, delegates should 
be required to consider additional qualitative factors.

    \46\ This approach would be consistent with the provisions of 
section 17(f) governing the custody of fund assets with a domestic 
bank. See supra note 6.
    \47\ See ``Eligible Foreign Custodians'' below. 

[[Page 39596]]

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2. Custody in Foreign Countries
a. Prevailing Custodial Risks
    Rule 17f-5 requires a fund's board to approve each country where 
the fund's assets will be maintained.48 Because placing fund 
assets in a particular country may affect the safekeeping of those 
assets, the amended rule would continue to address the risks associated 
with custody of a fund's assets in a foreign country.49

    \48\ See rule 17f-5(a)(1)(i).
    \49\ See Custodian Letter I, supra note 14, at 6-7 (indicating 
that deciding to place assets in a particular country may mean 
accepting certain risks if custodial protections comparable to those 
of the United States are not available in the foreign jurisdiction).
    The proposed approach also seeks to address circumstances where 
different delegates assess the custodial risks of a particular 
country and the risks of using a particular foreign custodian. If, 
for example, a country's prevailing custodial risks are not 
evaluated by a delegate in deciding to maintain assets in the 
country, a different delegate selecting the fund's foreign 
custodians could determine that the custody of the fund's assets in 
that country presents unacceptable risks, without regard to the 
protections provided by any specific custodian. Delegates making the 
respective country-wide and custodian risk assessments could, in 
effect, disagree over the appropriateness of maintaining fund assets 
in the country. Such disputes may have to be resolved by the board, 
which could undermine the purposes of delegation by re-involving the 
board in foreign custody decisions.
    The amended rule would require a finding that custody of the fund's 
assets in a particular country can be maintained in a manner that will 
provide reasonable protection for those assets.50 Making the 
proposed determination would not require a finding that fund assets 
could never be lost in a foreign country.51 Rather, the proposed 
determination would require the delegate to consider whether the fund's 
assets will be maintained in a manner that will provide reasonable 
protection based on all relevant factors and, in particular, the 
factors specified in the amended rule.52

    \50\ Proposed rule 17f-5(a)(1). Consistent with the current 
rule, this finding would have to be made prior to placing the fund's 
assets in the country. The amended rule would not address the 
investment risks associated with investing in foreign securities, 
since these risks fall outside the scope of rule 17f-5.
    \51\ This approach would be consistent with the current rule.
    \52\ Throughout this release, references are made to a 
delegate's responsibilities, since the amendments contemplate that 
the board will use one or more delegates to establish and oversee 
the fund's foreign custody arrangements. If, however, the board 
decides to retain decision-making authority for foreign custody 
matters, these responsibilities would remain with the board. The 
amended rule uses the term foreign custody manager to recognize that 
a delegate or the board may assume responsibility for the fund's 
arrangements. See proposed rule 17-f(d)(1).
---------------------------------------------------------------------------

    The amended rule would require the delegate to evaluate, among 
other factors, the prevailing practices in a country for the 
safekeeping of the fund's assets.53 Evaluating a country's 
custodial practices typically would involve, among other things, 
considering the manner in which securities are maintained (e.g., 
whether securities are held in physical or uncertificated form), the 
physical protections available for certificated securities (e.g., the 
use of vaults or other facilities), the method of keeping custodial 
records (e.g., the use of computers, microfilm or paper records), 
custodial communication systems (e.g., the use of electronic media, 
telex, or telephone), security and data protection practices (e.g., 
alarm systems and the use of pass codes and back-up procedures for 
electronically stored information), and the protections provided by 
governmental or other regulatory oversight.54 These considerations 
seek to address the systemic custodial risks of a particular country. 
Although evaluating a country's custodial practices would require 
knowledge of foreign custody arrangements, it would not require a 
finding concerning the protections provided by any specific foreign 
custodian.55

    \53\ Proposed rule 17f-5(a)(1)(i).
    \54\ The importance of each of these factors would depend on the 
particular jurisdiction and related securities market. For example, 
vault facilities and alarm systems may be less important in markets 
where securities are primarily held in book-entry form. Similarly, 
the need for electronic information systems may be more important in 
markets with a high volume of securities transactions than in 
markets where trading is less frequent. See Custodian Letter II, 
supra note 14, at 4-5.
    \55\ See ``Selecting Foreign Custodians'' below.
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    In evaluating the custodial risks of a particular country, the 
delegate would be required to assess any adverse effects foreign law 
may have on the safekeeping of fund assets.56 The delegate 
specifically would have to consider whether foreign law would restrict 
(A) the access of the fund's accountants to the custodian's books and 
records and (B) the fund's ability to recover its assets in the event 
of a custodian's bankruptcy or a loss of assets in the custodian's 
control. These factors are derived from the Notes to the current 
rule.57 The amended rule would broaden the current rule, however, 
by requiring consideration of all relevant foreign legal constraints, 
in addition to those governing the custodian's books, bankruptcy, and 
loss of assets.58

    \56\ Proposed rule 17f-5(a)(1)(ii).
    \57\ See rule 17f-5, Notes 1(a)-(c).
    \58\ In evaluating any adverse effects foreign law may have on 
the safekeeping of fund assets, consideration of U.S. legal 
standards may be relevant. In determining whether custody of fund 
assets in a particular country will provide reasonable protection 
for those assets, however, delegates would not be required to find 
that the protections provided by foreign law are equivalent to U.S. 
standards.
---------------------------------------------------------------------------

    In addition, the amended rule would permit the delegate to consider 
any special arrangements that mitigate prevailing custodial 
risks.59 Such arrangements would include, for example, insurance 
or guarantee agreements covering the loss of fund assets. Such 
arrangements also may include instituting special procedures that 
depart from prevailing practices and are designed to reduce custodial 
risks. A recent Division no-action position, for example, was based, in 
part, on the existence of certain contractual protections that would 
not otherwise have been given in the course of the country's prevailing 
custody practices.60

    \59\ Proposed rule 17f-5(a)(1)(iii).
    \60\ Templeton Russia Fund, Inc. (pub. avail. Apr. 18, 1995) 
(contracts between the fund's foreign custodian and certain 
registries).
---------------------------------------------------------------------------

    The Notes to the current rule instruct the fund's board to consider 
the likelihood of various adverse political events (e.g., the 
expropriation or freezing of assets) and potential difficulties in 
converting the fund's cash and cash equivalents to U.S. dollars.61 
The amended rule would not address these risks. Although these risks 
may affect the safety and liquidity of fund assets, they appear to 
relate more to the investment risks of a particular country than the 
custodial risks of that country. Adverse political events and foreign 
exchange problems, for example, may threaten fund assets regardless of 
where the assets are held. The Commission believes that these risks 
should be considered in connection with the determination that a fund 
should invest in a particular country.

    \61\ Rule 17f-5, Notes 1(d)-(e).
---------------------------------------------------------------------------

    The ICI and the Custodian Group recommended different approaches to 
evaluating a country's prevailing custodial risks. The ICI recommended 
eliminating country-related risk determinations from the rule.62 
The ICI indicated that, for the most part, the risks of maintaining 
assets in a particular jurisdiction (e.g., expropriation risks) are 
independent of the risks associated with using a specific 

[[Page 39597]]
foreign custodian.63 The ICI indicated that, as a consequence, 
assessments of country-related risks are not appropriate considerations 
for a foreign custody rule.64 The ICI also expressed concerns that 
requiring evaluations of a country's prevailing custodial risks would 
transfer to the country selection process the responsibility to 
determine whether one or more custodians in a country could provide 
reasonable protections for the fund's assets.65

    \62\ ICI Letter III, supra note 14, at 3-7. The ICI's proposal 
would require the decision to place assets in a particular 
jurisdiction to have been made by the board or adviser as a 
condition precedent to selecting specific foreign custodians. Id. at 
6-7. The ICI indicated that the board or adviser would consider the 
custodial risks of a particular jurisdiction in deciding whether to 
invest in the country. ICI Letter I, supra note 14, at 4, n.5; ICI 
Letter III, supra note 14, at 6-9.
    \63\ ICI Letter III, supra note 14, at 3-7, 10. As discussed in 
the text above, the amended rule would not address political and 
foreign exchange considerations.
    \64\ ICI Letter III, supra note 14, at 6-7, 10.
    \65\ Id. at 3-8 (commenting on the Custodian Group's 
recommendations). See supra 49 and 55 notes and accompanying text 
(regarding the approach of the amended rule).
---------------------------------------------------------------------------

    The Custodian Group recommended that the rule require an evaluation 
of a country's prevailing custodial risks prior to placing assets in 
that jurisdiction.66 As to the factors governing these 
assessments, the Custodian Group recommended that the Commission 
consider adding two new factors to the Notes to the current 
rule.67 The Custodian Group's new factors would require the 
board's delegate to evaluate each securities depository in the country 
and to consider whether the financial systems in the country, including 
the methods for securities settlement and custody, are sufficient to 
provide reasonable protection for the fund's assets.68

    \66\ Custodian Letter I, supra note 14, at 3-7.
    \67\ Id. at 7.
    \68\ Id.
---------------------------------------------------------------------------

    The Commission requests comment on these two approaches. The 
Commission also requests comment on an alternative approach that would 
make evaluations of a country's prevailing custodial risks part of the 
custodian selection process. Such an approach would simplify the rule 
and should not raise any safekeeping concerns since the factors that 
relate to a country's prevailing custodial risks would be evaluated in 
connection with a custodian's selection.69

    \69\ This approach, however, may have potential drawbacks in 
connection with boards selecting different delegates to evaluate 
different aspects of the fund's arrangements. See supra note 35 and 
infra note 70 and accompanying text.
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b. Compulsory Depositories
    Certain countries have depositories the use of which is unavoidable 
for the custody of foreign securities purchased by a fund (a 
``compulsory depository''). Because the custody of fund assets in a 
foreign country may necessitate using any compulsory depository in the 
country, the amended rule would make the selection of compulsory 
depositories part of the assessment of a country's prevailing custodial 
risks.70 The amended rule would require a finding that using a 
compulsory depository will provide reasonable protection for the fund's 
assets based on factors specified in the amended rule governing the 
selection of foreign custodians.71

    \70\ See Custodian Letter I, supra note 14, at 4-5, 6-7 and 
Custodian Letter II, supra note 14, at 11-12 (indicating that, once 
a fund invests in a country with a compulsory depository, the fund's 
custodian (or any foreign bank custodian in that country) has no 
choice but to use the compulsory depository). The current rule does 
not distinguish between compulsory depositories and other foreign 
custodians or associate the use of any specific foreign custodian 
with the decision to maintain assets in a particular country.
    \71\ Proposed rule 17f-5(a)(1) and (a)(1)(iv). See also proposed 
rule 17f-5(a)(2)(i)-(iii), discussed infra notes 80-91 and 
accompanying text. The Commission recognizes that, conceptually, the 
decision to use a compulsory depository appears to fall within the 
scope of the rule's provisions governing the selection of foreign 
custodians (discussed in the text below). The Commission also 
recognizes that a significant number of foreign depositories may be 
considered compulsory depositories. Consequently, requiring 
compulsory depositories to be evaluated in connection with a 
country's prevailing custodial risks could mean that the majority of 
depository decisions will not be made by the delegate selecting the 
fund's other foreign custodians.
---------------------------------------------------------------------------

    The amended rule would define a compulsory depository as a 
depository the use of which is mandatory (i) by law or regulation, (ii) 
because securities cannot be withdrawn from the depository, or (iii) 
because maintaining securities outside the depository is not consistent 
with prevailing custodial practices.72 Part (iii) of the proposed 
definition is intended to recognize cases when a depository's use is 
effectively compulsory as a result of prevailing practices even though 
securities may be held outside of the depository.73 Determining 
whether a depository's use is compulsory would depend on the facts and 
circumstances presented.74 Factors relevant to making this 
determination may include whether virtually all securities are 
maintained in the depository, whether the depository's involvement is 
required to transfer securities ownership, and whether significant time 
and expense are associated with keeping securities outside the 
depository.75

    \72\ Proposed rule 17f-5(d)(4). See also proposed rule 17f-
2(d)(3)(iv) (defining an eligible foreign custodian to include a 
compulsory depository). The proposed definition should be construed 
narrowly. If maintaining assets in a depository or with a foreign 
bank custodian are feasible alternatives, the Commission believes 
the decision to use a depository should be made in connection with 
the custodian selection process. See ``Selecting Foreign 
Custodians'' below.
    \73\ See ICI Letter III, supra note 14, at 10 (Exhibit A); 
Custodian Letter I, supra note 14, at 13 (Exhibit A) (suggesting 
that a depository should be considered to be compulsory if 
securities held outside the depository cannot be traded or 
transferred in accordance with routine clearance and settlement 
practices).
    \74\ When different delegates evaluate country-wide and foreign 
custodian risks and disagree on whether using a depository is 
compulsory, the depository's status may have to be determined by the 
board.
    \75\ See Custodian Letter II, supra note 14, at 14-15 
(discussing these considerations).
---------------------------------------------------------------------------

    The Commission requests comment on requiring compulsory 
depositories to be evaluated in connection with assessments of a 
country's prevailing custodial risks.76 The Commission also 
requests comment on the proposed definition of compulsory depository.

    \76\ See ICI Letter III, supra note 14, at 10 (recommending that 
evaluations of compulsory depositories be part of the custodian 
selection process); Custodian Letter I, supra note 14, at 4-5, 6-7 
(consistent with proposed approach).
3. Selecting Foreign Custodians 77

    \77\ Any custodian selected by the delegate would have to be an 
``eligible foreign custodian'' as defined in proposed rule 17f-
5(d)(3). See ``Eligible Foreign Custodians'' below.
---------------------------------------------------------------------------

    The amended rule would require a finding that using a particular 
custodian will provide reasonable protection for the fund's 
assets.78 Selecting foreign custodians would not involve 
reassessments of a country's prevailing custodial risks and the use of 
any compulsory depositories. Under the amended rule, these matters 
would be evaluated in determining whether the custody of the fund's 
assets in the country will provide reasonable protection for those 
assets.79

    \78\ Proposed rule 17f-5(a)(2). See also ICI Letter III, supra 
note 14, at 5 (Exhibit A); Custodian Letter I, supra note 14, at 7 
(Exhibit A) (recommending that U.S. bank delegates be required to 
represent to the board that a foreign custodian's internal controls 
or established procedures are adequate to provide reasonable 
protection for fund assets).
    The proposed approach would be consistent with that governing 
country-wide custodial risks evaluations. Like the current rule, the 
proposed finding of reasonable protection would have to be made 
prior to placing the fund's assets with the foreign custodian.
    \79\ Proposed rule 17f-5(a)(2). See ``Custody in Foreign 
Countries'' above.
---------------------------------------------------------------------------

    In selecting foreign custodians, the delegate would not be required 
to find that assets could never be lost while in the foreign 
custodian's possession. Instead, the amended rule would focus on the 
reasonableness of a custodian's protections based on all relevant 
factors and, in particular, those factors specified in the amended 
rule.80 The proposed factors that would govern the selection of 
foreign custodians are 

[[Page 39598]]
derived from the Notes to the current rule.81

    \80\ Proposed rule 17f-5(a)(2) (i) through (iii). As indicated 
in the text accompanying note 71 supra, proposed rule 17f-5(a)(1) 
would require delegates that evaluate the protection afforded fund 
assets held by a compulsory depository to consider the factors set 
forth in rule 17f-5(a)(2) (i) through (iii) governing the selection 
of foreign custodians.
    \81\ See rule 17f-5, Notes 2(a)-(d).
---------------------------------------------------------------------------

    The Notes to rule 17f-5 address a foreign custodian's financial 
strength, its general reputation and standing in the country, and its 
ability to provide efficiently the custodial services required and the 
relative costs of those services.\82\

    \82\ Rule 17f-5, Note 2(a).
---------------------------------------------------------------------------

    In addition to a custodian's financial strength,\83\ the amended 
rule would address a custodian's reputation and standing generally, 
rather than in the country where the custodian is located.\84\ A 
custodian's reputation and standing outside of its own country may be 
relevant, especially in the case of multi-national banks. By no longer 
tying consideration of a custodian's reputation and standing to the 
country where the custodian is located, the amended rule seeks to 
provide delegates with greater flexibility to evaluate a custodian's 
reputation based on the facts and circumstances relevant to the 
particular custodian. The amended provision also would require, in the 
case of a securities depository, consideration of the depository's 
operating history and number of participants.\85\

    \83\ In evaluating a custodian's financial strength, the 
delegate, for example, may consider capitalization, financial 
history, and any other lines of business undertaken by the custodian 
and the potential effects of such businesses on the custodian's 
financial condition and operations.
    \84\ Proposed rule 17f-5(a)(2)(i).
    \85\ These matters currently are addressed as a separate Note 
under rule 17f-5. Rule 17f-5, Note 2(d). Although certain matters 
(i.e., operating history and number of participants) would 
specifically apply to depositories, all of the factors set forth in 
proposed rule 17f-5(a)(2) (i) through (iii) would have to be 
considered when selecting foreign depositories.
    The Custodian Group indicated that information concerning 
certain depositories may be difficult or impossible to obtain. The 
ICI and the Custodian Group recommended that the rule address this 
problem by requiring consideration of a depository's operating 
history if such information is ``reasonably obtainable.'' ICI Letter 
III, supra note 14, at 2-3 (Exhibit A); Custodian Letter I, supra 
note 14, at 14-16 and at 4 (Exhibit A).
    The extent (or absence) of information about a foreign 
depository may be relevant in determining whether the depository 
will provide reasonable protection for fund assets. For example, the 
lack of available information about a depository's operating history 
may militate against the depository's use. Consequently, the amended 
rule would not make an exception when information about a depository 
is not available.
---------------------------------------------------------------------------

    In addition, the amended provision would no longer address a 
custodian's efficiency and relative costs. Weighing a custodian's 
efficiency against the costs of its services does not appear to be 
particularly germane to the safety of fund assets in the hands of that 
custodian. Although these matters would not be addressed under the 
amended rule, the delegate may appropriately consider custodial 
efficiency and costs in selecting a foreign custodian.
    The Notes to rule 17f-5 also state that the fund's board should 
consider whether a foreign custodian will provide a level of safeguards 
not materially different from those of the fund's U.S. 
custodian.86 The Commission believes that foreign custodian 
arrangements, although different from U.S. arrangements, nonetheless 
may provide reasonable and effective safeguards for fund assets.87 
Accordingly, the amended rule would focus on whether a foreign 
custodian would provide reasonable protection for fund assets, and 
would specifically require the delegate to consider the custodian's 
practices, procedures, and internal controls in making this 
determination.88

    \86\ Rule 17f-5, Note 2(b).
    \87\ See Custodian Letter II, supra note 14, at 3-6.
    \88\ Proposed rule 17f-5(a)(2)(ii). See ICI Letter III, supra 
note 14, at 2 (Exhibit A); Custodian Letter I, supra note 14, at 9-
11 and at 4 (Exhibit A) (recommending that the rule focus on the 
protections provided by foreign custodians rather than the 
equivalency of those protections to U.S. standards).
    When different delegates evaluate country-wide and foreign 
custodian risks, the delegates may come to different determinations, 
which are attributable to the different assessments involved. See 
text accompanying note 55 supra (regarding evaluations of a 
country's prevailing custodial risks).
---------------------------------------------------------------------------

    The protections provided by custodians within a foreign country may 
vary widely. Thus, one custodian's practices and internal controls may 
provide reasonable protections, while those of other custodians may 
not. In addition, although the rule would not require parity between 
foreign and U.S. custodian arrangements, reference to U.S. standards 
may be relevant in determining whether a foreign custodian's practices 
and internal controls will reasonably protect fund assets.
    Finally, the amended rule would require the delegate to assess the 
likelihood of U.S. jurisdiction over and enforcement of judgments 
against a foreign custodian.89 The proposed requirement would 
broaden the Notes to the current rule, which address whether a foreign 
custodian has any branch offices in the United States.90 Under the 
proposed approach, in addition to considering domestic branches, the 
delegate could take into account other jurisdictional and enforcement 
means, such as whether a foreign custodian has appointed an agent for 
service of process in the United States or consented to U.S. 
jurisdiction.91

    \89\ Proposed rule 17f-5(a)(2)(iii).
    \90\ See rule 17f-5, Note 2(c).
    \91\ The Commission recognizes that U.S. jurisdiction may not be 
obtainable over certain foreign depositories. As with the other 
factors under the amended rule, an affirmative finding of U.S. 
jurisdiction would not be required. Rather, the absence of U.S. 
jurisdiction would have to be considered in making the overall 
determination that using the custodian will provide reasonable 
protection for fund assets.
---------------------------------------------------------------------------

    The Commission requests comment on the proposed approach and the 
factors that delegates would be required to consider in selecting 
foreign custodians.
4. Foreign Custody Contracts
a. Proposed Approach
    Rule 17f-5 currently requires the fund's foreign custody 
arrangements to be governed by a written contract that has been 
approved by the board.92 The current rule also enumerates specific 
provisions that must be included in the contract. The contract 
generally must provide that: (A) The fund will be indemnified and its 
assets insured in the event of loss; (B) the fund's assets will not be 
subject to liens or other claims in favor of the foreign custodian or 
its creditors; (C) the fund's assets will be freely transferable 
without the payment of money; (D) records will be kept identifying the 
fund's assets as belonging to the fund; (E) the fund's independent 
public accountants will be given access to those records or 
confirmation of the contents of those records; and (F) the fund will 
receive periodic reports, including notification of any transfers to or 
from the fund's account.93

    \92\ Rule 17f-5(a)(1)(iii).
    \93\ Rule 17f-5(a)(1)(iii)(A)-(F).
---------------------------------------------------------------------------

    The amended rule would retain the requirement of a written foreign 
custody contract, but would not enumerate specific provisions that must 
be included in the contract.94 In proposing this approach, the 
Commission does not intend to imply that the contract provisions 
required under the current rule are not important. Rather, the 
Commission believes that funds should be able to establish contractual 
arrangements that reflect the particular circumstances presented. 
Contract provisions other than those currently required may be 
important in any given foreign market or for a specific foreign 
custodian. In addition, certain practical problems and interpretive 
questions have arisen regarding the current contract 
requirements.95 As custody practices change, similar issues may 

[[Page 39599]]
arise in the future that could delay or preclude certain arrangements.

    \94\ Proposed rule 17f-5(a)(3).
    \95\ See ``Request for Comment on Specific Contract Provisions'' 
below.
---------------------------------------------------------------------------

    The amended rule would require a finding that the foreign custody 
contract will provide reasonable protection for the fund's assets based 
on all factors relevant to the safekeeping of such assets. Determining 
whether a contract provides such protection typically would involve 
consideration of the contract provisions required under the current 
rule as well as those customarily provided by U.S. custodians and other 
foreign custodians operating in the country.96

    \96\ The proposed approach would not require a finding that the 
foreign custody contract provides protections equivalent to U.S. 
safeguards or that the contract addresses every possible contingency 
for loss of the fund's assets. Rather, the amended rule would focus 
on whether the contract would provide reasonable protection for the 
fund's assets.
---------------------------------------------------------------------------

    In addition, the Commission understands that funds often contract 
with their primary custodians for foreign custody services; the primary 
custodian, in turn, enters into separate contracts with the fund's 
foreign bank custodians. When the fund's contractual relationship with 
a foreign custodian is indirect, the delegate should consider the 
fund's rights vis-a-vis both the contracting intermediary custodian and 
the foreign custodian that holds the fund's assets. The delegate, for 
example, should consider whether the intermediary custodian has agreed 
in its contract with the fund to obtain indemnification or other 
contractual protections from the foreign custodian. The delegate also 
should consider, among other things, whether the fund would be able to 
assert claims directly against the foreign custodian in the event of 
loss.97

    \97\ See, e.g., Citibank, N.A., Investment Company Act Release 
Nos. 18710 (May 15, 1992), 57 FR 21835 (Notice of Application) and 
18782 (June 12, 1992), 51 SEC Docket 1533 (Order) (contract between 
the intermediary U.S. custodian and the foreign custodian gives the 
fund the right to enforce the agreement directly against the foreign 
custodian).
---------------------------------------------------------------------------

    The Commission also understands that depository arrangements 
typically are not governed by contract.98 In addition, a foreign 
depository's services often are not provided directly to the fund or 
its primary custodian.99 Depository services typically are 
provided through foreign banks that have an established relationship 
with the depository.100 The amended rule, like the current rule, 
would not require foreign depositories to be parties to the fund's 
foreign custody contract.101 Instead, the delegate should consider 
the responsibilities of the bank custodian interacting with the 
depository, along with the rights of the fund in relation to both the 
intermediary custodian and depository.

    \98\ See Custodian Letter II, supra note 14, at 6-8. The ICI and 
the Custodian Group recommended that any required contract 
provisions should not apply to depositories. ICI Letter III, supra 
note 14, at 3-5 (Exhibit A); Custodian Letter I, supra note 14, at 
11-12. The ICI and the Custodian Group recommended requiring the 
rules or established practices of a depository to provide specific 
safeguards relating to the free transferability of the fund's 
assets, the keeping of adequate records, and periodic reporting and 
notification of asset transfers. ICI Letter III, supra note 14, at 
3-5 (Exhibit A); Custodian Letter I, supra note 14, at 12.
    \99\ See Custodian Letter I, supra note 14, at 11-12.
    \100\ Id. (indicating that, from the fund's perspective, a 
depository typically will be a custodian for a foreign bank 
custodian, which is itself a subcustodian of the fund's U.S. 
custodian). See also Custodian Letter II, supra note 14, at 6-8.
    \101\ See Investment Company Institute 2-3 (pub. avail. Nov. 4, 
1987) (hereinafter 1987 Division Letter).
---------------------------------------------------------------------------

    The Commission requests comment on the proposed approach. The 
Commission requests specific comment whether the amended rule should 
require specific contract provisions. In particular, would the proposed 
approach facilitate the use of foreign custody arrangements or create 
difficulties in obtaining important contractual protections from 
foreign custodians? For example, codifying specific contract 
requirements may offer certain advantages to fund shareholders by 
removing these protections from the items that could be subject to 
negotiation. The Commission also requests comment whether the amended 
rule should include specific factors (such as those discussed above) 
that delegates would have to consider in evaluating the protections 
provided by a contract.102

    \102\ Including specific factors does not appear to be necessary 
since the Commission understands that foreign custody contracts 
incorporating important contractual protections are a matter of 
standard industry practice. See, e.g., Custodian Letter I, discussed 
infra note 103.
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b. Request for Comment on Specific Contract Provisions
    The ICI and the Custodian Group recommended retaining the rule's 
current contract requirements, with certain modifications.103 The 
Commission requests comment on the current provisions and the related 
recommendations of the ICI and the Custodian Group. In addition, the 
Custodian Group indicated that the rule's current contract requirements 
have become industry standards for custodial arrangements involving 
foreign banks.104 The Commission requests specific comment whether 
this is the case.

    \103\ ICI Letter I, supra note 14, at 5 (indicating that it is 
appropriate for the rule to require certain essential contract 
provisions); Custodian Letter I, supra note 14, at 11. The ICI and 
the Custodian Group recommended that the contract requirements apply 
only to foreign bank custodians. See supra note (regarding the ICI 
and the Custodian Group's recommendations for depository 
arrangements).
    \104\ See Custodian Letter I, supra note 14, at 11
    The ICI and the Custodian Group recommended modifying the current 
requirement prohibiting liens on the fund's assets.105 The ICI and 
the Custodian Group indicated that this requirement should not apply to 
cash, since, in most jurisdictions, cash may become subject to 
creditors' claims if a custodian becomes bankrupt.106

    \105\ ICI Letter III, supra note 14, at 12; Custodian Letter I, 
supra note 14, at 21-22. See rule 17f-5(a)(1)(iii)(B).
    \106\ ICI Letter III, supra note 14, at 12; Custodian Letter I, 
supra note 14, at 21-22.
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    The ICI and the Custodian Group also recommended modifying the 
current recordkeeping requirement to specifically recognize the 
permissibility of ``omnibus accounts.'' 107 These accounts contain 
the assets of more than one custodial customer, and are established by 
intermediary custodians with foreign banks and securities 
depositories.108 In an omnibus account structure, the 
intermediary, which is reflected on the foreign custodian's books as 
the record owner of the assets, is responsible for maintaining records 
that identify each of its customer's assets.109

    \107\ ICI Letter III, supra note 14, at 3-4 (Exhibit A); 
Custodian Letter I, supra note 14, at 22-23. See rule 17f-
5(a)(1)(iii)(D).
    \108\ Custodian Letter I, supra note 14, at 22-23. The ICI and 
the Custodian Group also recommended specifically recognizing the 
role of U.S. intermediary custodians in connection with the current 
provisions relating to indemnification and insurance, access to the 
foreign custodian's books, and periodic reporting. ICI Letter III, 
supra note , at 3-4 (Exhibit A); Custodian Letter III, supra note 
14, at 5-6 (Exhibit A). This approach may help clarify the rule's 
requirements, although it does not appear to be necessary.
    \109\ Although the recommended change may help clarify the 
rule's requirements, it is not necessary. The current rule does not 
prescribe a specific manner for keeping custody records. See also 
State Street Bank and Trust Company (pub. avail. Feb. 28, 1995) 
(regarding the permissibility of omnibus accounts).
---------------------------------------------------------------------------

    The ICI and the Custodian Group disagreed on how the rule should 
address indemnification and insurance.110 The ICI recommended 

[[Page 39600]]
that, instead of requiring indemnification or insurance as a contract 
provision, the rule require the fund's U.S. custodian (acting as the 
delegate responsible for the foreign custody contract) to represent 
that the fund's overall contractual arrangements provide 
indemnification or insurance protections.111 The ICI indicated 
that, under its approach, indemnification or insurance protections 
could appear either in the fund's contract with its U.S. custodian or 
in the contract between the U.S. custodian and the foreign 
custodian.112 The Custodian Group objected to the ICI's approach, 
arguing that it would make custodian delegates responsible for 
indemnifying or insuring depository arrangements.113

    \110\ By its terms, rule 17f-5 requires foreign custody 
contracts to provide that the fund will be indemnified and its 
assets insured in the event of loss. Rule 17f-5(a)(1)(iii)(A). 
Consistent with a prior Division no-action position, the ICI and the 
Custodian Group recommended requiring either indemnification or 
insurance. ICI Letter III, supra note 14, at 5 (Exhibit A); 
Custodian Letter III, supra note 14, at 4 (Exhibit B). See also 1987 
Division Letter, supra note 101, at 2-3. The ICI and the Custodian 
Group also recommended requiring fund assets to be protected for 
losses resulting from a foreign custodian's failure to use 
reasonable care. ICI Letter III, supra note 14, at 5 (Exhibit A); 
Custodian Letter III, supra note 14, at 4 (Exhibit B). See 1987 
Division Letter, supra note 14, at 2-3 (indicating that the rule 
requires indemnification or insurance to cover foreseeable risks of 
loss).
    \111\ ICI Letter I, supra note 14, at 5 (noting that 
indemnification provisions often are included in the fund's contract 
with its U.S. custodian); ICI Letter III, supra note 14, at 12 and 
at 4 (Exhibit A).
    \112\ ICI Letter III, supra note 14, at 12. This approach 
currently is permitted under rule 17f-5, which does not specify the 
party that must provide indemnification and insurance protections. 
See rule 17f-5(a)(1)(iii)(A).
    \113\ Custodian Letter III, supra note 14, at 4. The Custodian 
Group would not require indemnification or insurance with respect to 
depository arrangements. Id. See also Custodian Letter II, supra 
note 14, at 6-7 (indicating that depositories often establish 
compensation funds for losses attributable to the depository).
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5. Monitoring Custody Arrangements and Withdrawing Assets From 
Custodians
    The amended rule would require the delegate to monitor the 
continuing appropriateness of the custody of the fund's assets in a 
country, with a particular custodian, and under the foreign custody 
contract.114 This requirement seeks to address the possibility 
that the fund's arrangements, although consistent with the amended 
rule's requirements when initially entered into, may later fail to 
provide reasonable protection for fund assets.115 The proposed 
monitoring requirement would involve establishing a means of receiving 
sufficient and timely information to respond to material 
changes.116 Determining appropriate monitoring procedures would 
depend on the facts and circumstances involved. For example, custodial 
practices in certain countries or used by certain custodians may 
require frequent monitoring, while other arrangements require 
significantly less oversight.117

    \114\ Proposed rule 17f-5(a)(4). See rule 17f-5(a)(2) (requiring 
a system to monitor the fund's arrangements to ensure compliance 
with the conditions of the rule).
    \115\ The amended rule seeks to clarify the scope of the 
monitoring requirement by tying monitoring obligations to the 
reasonable protection findings required to be made in establishing 
foreign custody arrangements. See ICI Letter III, supra note 14, at 
6 (Exhibit A); Custodian Letter I, supra note 14, at 17 
(recommending that monitoring responsibilities relate to specific 
representations that would have to be made when custody arrangements 
are entered into).
    \116\ See 1984 Reproposing Release, supra note 8, at 2910 
(consistent with the proposed approach). See also 1987 Division 
Letter, supra note 101, at 4 n.5 (indicating that, under the current 
rule, the board generally may rely on the fund's U.S. custodian or 
another third-party expert to oversee the fund's arrangements so 
long as the expert agrees to notify the board of any material 
changes, and that the board is not required to review periodic 
reports in the absence of a material change).
    \117\ The ICI and the Custodian Group recommended allowing 
delegates to satisfy their monitoring obligations by periodically, 
but no less frequently than annually, reviewing a foreign 
custodian's financial position and internal controls. ICI Letter 
III, supra note 14, at 6 (Exhibit A); Custodian Letter I, supra note 
14, at 17 (also indicating that, in a formal sense, the board or a 
custodian delegate could not be expected to monitor continuously a 
foreign custodian's financial position and internal controls).
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    If an arrangement no longer meets the requirements of the amended 
rule, the fund would have to withdraw its assets from the country or 
custodian as soon as reasonably practicable. The current rule requires 
a fund in these circumstances to withdraw its assets from a foreign 
custodian as soon as reasonably practical, but specifies that, in any 
event, assets withdrawals must be made within 180 days.118 The 
amended rule would eliminate the 180 day provision and focus instead on 
the importance of taking prompt action based on the circumstances 
presented. For example, a fund that invests its assets primarily in a 
single country may require more time to withdraw those assets than a 
fund that has placed only a small percentage of its assets with a 
particular custodian or in a particular country.

    \118\ Rule 17f-5(a)(4). See generally 1985 Release Proposing 
Amendments, supra note 8, at 24541 (proposing a 90-day grace 
period); 1985 Release Adopting Amendments, supra note 8, at 37655 
(adopting a 180-day grace period to provide sufficient time for 
funds to negotiate alternative arrangements).
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    The Commission requests comment on the proposed monitoring 
requirement. The Commission requests specific comment whether the 
amended rule should require asset withdrawals to be effected within a 
specific time period.119 Commenters favoring this approach should 
indicate what the time period should be and whether a period of less 
than 180 days (e.g., 90 days) would be appropriate. The Commission also 
requests comment whether, as an alternative or in addition to providing 
a specific grace period, the rule should require the use of interim 
arrangements, such as insurance or third-party indemnification 
agreements, to protect against possible loss of fund assets until 
alternative arrangements can be made.

    \119\ See ICI Letter III, supra note 14, at 6 (Exhibit A); 
Custodian Letter I, supra note 14, at 8 (Exhibit A) (incorporating 
the 180-day grace period of the current rule).
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C. Eligible Foreign Custodians

1. Banks and Trust Companies
a. Proposed Approach
    The amended rule would define an ``eligible foreign custodian'' as 
foreign banks and trust companies that are subject to foreign bank or 
trust company regulation.120 An eligible foreign custodian also 
would include majority-owned foreign subsidiaries of a qualified U.S. 
bank or a U.S. bank holding company.121 The amended rule would not 
subject foreign bank and trust custodians to specific capital 
requirements.122 The amended rule, however, would prohibit foreign 
bank and trust custodians from being affiliated persons of the fund or 
affiliated persons of such persons.123

    \120\ Proposed rule 17f-5(d)(3)(i).
    \121\ A ``qualified U.S. bank'' would be defined in proposed 
rule 17f-5(d)(5). Under current rule 17f-5, the definition of a 
qualified U.S. bank mirrors the definition of ``bank'' in section 
2(a)(5), except that it requires certain banks and trust companies 
that receive deposits or exercise fiduciary powers and that are 
subject to state or federal regulation to be organized under state 
or federal law. See 15 U.S.C. 2(a)(5)(C) and rule 17f-5(c)(3)(iii). 
Proposed rule 17f-5(d)(5) would not change this definition.
    \122\ The Commission previously considered using this approach. 
See 1982 Proposing Release, supra note 3, at 16347.
    \123\ See section 2(a)(3), 15 U.S.C. 80a-2(a)(3) (defining 
affiliated person).
---------------------------------------------------------------------------

    Rule 17f-5 currently limits the class of eligible fund custodians 
to foreign banks and trust companies that have more than $200 million 
in shareholders' equity and majority-owned foreign subsidiaries of 
qualified U.S. banks or bank-holding companies that have more than $100 
million in shareholders' equity.124 Although this approach seeks 
to protect against the risk of loss from a custodian's 
insolvency,125 the shareholders' equity requirement has become an 
inflexible standard that does not address matters, such as credit and 
market risks, that may affect an institution's financial 
health.126 

[[Page 39601]]
Shareholders' equity also does not provide a uniform assessment of 
financial strength, since it may be calculated differently depending 
both on the country where the institution is organized and the 
institution's accounting practices.127

    \124\ Rule 17f-5(c)(2) (i) and (ii).
    \125\ See John Downes & Jordan Elliot Goodman, Dictionary of 
Finance and Investment Terms 377 (2d ed. 1987) (defining 
shareholders' equity as total assets minus total liabilities of a 
corporation). Cf. 1984 Reproposing Release, supra note 8, at 2907 
(indicating that the rule's capital requirements seek to address 
disparities in the protections provided by various foreign 
regulatory systems).
    \126\ The shareholders' equity requirement has been the subject 
of several no-action letters and a number of exemptive orders. See 
infra notes 128, 142, and 144 and accompanying text.
    \127\ The Commission previously sought to address this problem 
by proposing that shareholders' equity be calculated according to 
generally accepted accounting principles. 1985 Release Proposing 
Amendments, supra note 8. The Commission decided to postpone final 
action on this proposal due to concerns that compliance costs would 
be excessive. 1985 Release Adopting Amendments, supra note 8.
    In addition, the shareholders' equity requirement may limit 
unnecessarily the class of eligible foreign custodians. Certain highly 
capitalized custodians, such as national banks that maintain 
substantial government-funded reserves to satisfy their liabilities, do 
not have shareholders' equity.128 In addition, in certain emerging 
and smaller markets, very few or no foreign custodians have sufficient 
shareholders' equity to meet the $100 million and $200 million 
standards.129

    \128\ See 1984 Adopting Release, supra note 8, at 36082. 
Custodians organized as private banks also may not have 
shareholders' equity. No-action letters, however, have found the 
capital of certain private banks to be the equivalent of 
shareholders' equity. See Pictet & Cie (pub. avail. Sept. 8, 1993) 
(private bank with partners' equity); Union Bank of Norway (pub. 
avail. Nov. 30, 1992) (private bank found to have the equivalent of 
paid-in capital and retained earnings).
    \129\ See Custodian Letter I, supra note 14, at 18-19.
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    In proposing to eliminate specific capital requirements, the 
Commission does not intend to imply that a custodian's financial 
strength is not important to the custodian's ability to serve a 
fund.130 The amended rule would require the board's delegate to 
determine that foreign custodians will provide reasonable protection 
for the fund's assets based on, among other things, a custodian's 
financial strength.131 This approach should sufficiently address 
the adequacy of a custodian's capital, without imposing specific 
capital requirements.

    \130\ See generally Sub-custodian Services Survey,  Euromoney 
116 (Jan. 1994) (indicating that U.S. custodians view capitalization 
and credit rating as the most significant considerations in 
selecting foreign custodians).
    \131\ See ``Delegation of Board Responsibilities--Selecting 
Foreign Custodians'' above.
---------------------------------------------------------------------------

    The Commission requests comment on the proposed approach. The 
Commission requests specific comment whether the current shareholders' 
equity requirement should be retained, with higher or lower 
standards.132 For example, the ICI and the Custodian Group 
recommended lowering the current $100 million and $200 million 
standards to expand the class of eligible foreign custodians in 
emerging and smaller markets.133 In particular, they recommended 
that a custodian with more than $25 million in shareholders' equity 
should be eligible to hold fund assets, if it is one of the five 
largest banks in the country.134 The Custodian Group indicated 
that this approach should not present significant risks, given the 
limited amount of assets likely to be maintained in smaller markets and 
the other protections of the rule.135

    \132\ See ICI Letter II, supra note 14, at 3 (suggesting that 
the Commission consider whether the current standards are 
unnecessarily high); Custodian Letter I, supra note 14, at 18 
(indicating that the shareholders' equity requirement ``has served 
the Custodian community well in major, established markets'').
    \133\ ICI Letter III, supra note 14, at 7 (Exhibit A); Custodian 
Letter I, supra note 14, at 18-19. See also ``Other Alternatives 
Considered'' below (regarding the ICI's and the Custodian Group's 
other recommendations).
    \134\ ICI Letter III, supra note 14, at 7 (Exhibit A); Custodian 
Letter I, supra note 14, at 18-19. See also 1984 Adopting Release, 
supra note 8, at 36082 (rejecting the use of foreign bank custodians 
that constitute one of the five largest banks in a country when no 
bank in that country meets the shareholders' equity requirement).
    \135\ Custodian Letter I, supra note 14, at n.12. The Custodian 
Group also noted that smaller banks would not become eligible 
custodians in larger markets, since they would not be one of the 
five largest banks in the country. Id. at 19.
---------------------------------------------------------------------------

    The Commission also requests comment whether any additional 
entities, such as foreign broker-dealers, should be permitted to serve 
as custodians.136 Commenters addressing this issue should consider 
the circumstances under which additional types of entities should be 
permitted to hold fund assets. For example, should these entities be 
subject to capital or other special requirements? 137

    \136\ When a foreign entity acts as both a bank and broker-
dealer, it would meet the definition of an eligible foreign 
custodian if the division or part of the entity that has custody of 
fund assets is regulated under foreign law as a banking institution. 
See generally 1984 Reproposing Release, supra note 8, at 2907-08 
(not allowing foreign broker-dealers to serve as custodians since 
funds had not expressed an interest in these arrangements). See also 
Canada Trustco Mortgage Company (pub. avail. Dec. 29, 1989) (loan 
company with wholly-owned trust subsidiary deemed to be an eligible 
foreign custodian).
    \137\ Broker-dealers, for example, could be required to be 
subject to foreign regulatory requirements relating to their 
financial responsibility and the segregation and handling of 
customer securities. See, e.g., rule 206(4)-2(b) under the 
Investment Advisers Act of 1940, 17 CFR 275.206(4)-2(b). See also 
rule 17f-1 under the Act.
---------------------------------------------------------------------------

    Finally, the Commission requests comment on prohibiting affiliated 
foreign custody arrangements. Custody by fund affiliates raises special 
investor protection concerns. To guard against potential abuses 
resulting from control over fund assets by related persons, rule 17f-2 
under the Act, the Commission rule applicable to funds that retain 
custody of their own assets, has been applied to affiliated custody 
arrangements.138

    \138\ See, e.g., Pegasus Income and Capital Fund, Inc. (pub. 
avail. Dec. 1, 1977) (custody by U.S. adviser-bank). Rule 17f-2 
appears to be unworkable in the foreign custody context because the 
rule requires, among other things, fund assets to be maintained in a 
bank that is subject to state or federal regulation; the fund's 
assets also must be subject to Commission inspection and verified by 
an independent public accountant. Rule 17f-2(b), (d), and (e). See 
1984 Reproposing Release, supra note 8, at 2907-08.
    The Division currently is reviewing rule 17f-2, and may 
recommend in the future that the Commission propose certain changes 
in the rule's requirements.
---------------------------------------------------------------------------

    The Commission is aware of only one existing affiliated foreign 
custody arrangement, and believes that other such arrangements may be 
best addressed on a case-by-case basis.139 The Commission 
recognizes, however, that affiliated arrangements may become more 
prevalent as global investing and custodian networks continue to grow 
and as the fund industry continues to consolidate.140 The 
Commission, therefore, requests comment whether the proposed 
prohibition would be unduly restrictive and whether the prohibition 
should apply only to certain affiliated arrangements, such as when 
there is a control relationship between the fund's adviser and a 
foreign custodian.141 The Commission also requests comment whether 
there are alternative safeguards that would address the investor 
protection concerns raised by these arrangements. For example, should 
fund boards establish and oversee affiliated arrangements without the 
discretion to delegate this responsibility?

    \139\ Dean Witter World Wide Investment Trust (pub. avail. Mar. 
14, 1988) (affiliation between the fund's sub-adviser and primary 
custodian deemed sufficiently remote so as not to require the 
protections of rule 17f-2).
    \140\ See John Waggoner, Urge to Merge Hits Mutual Funds, USA 
Today, Feb. 8, 1995, at 1B. See also Timothy L. O'Brien and Steven 
Lipin, In the Latest Round of Banking Mergers, Even Big Institutions 
Become Targets, Wall St. J., July 14, 1995, at A3.
    \141\ See section 2(a)(3)(C) of the Act.
---------------------------------------------------------------------------

b. Other Alternatives Considered
    The Commission considered several other approaches to defining an 
eligible foreign custodian. These alternatives could be used in lieu of 
the current shareholders' equity requirement or in conjunction with 
reduced capital standards. The Commission requests comment on each 
approach.
    The Commission considered using an approach that would focus on a 
bank or trust company's safekeeping abilities.142 

[[Page 39602]]
Under this approach, a bank or trust company would be an eligible 
foreign custodian if it had maintained custody of a substantial amount 
of assets (e.g., $500 million) over a specified period of time (e.g., 
the past five years) and had not incurred any material loss of 
custodial assets during that period. Commenters addressing this 
alternative should discuss the criteria that should be used to 
establish a custodian's safekeeping abilities and the feasibility of 
monitoring compliance with such criteria.143

    \142\ See Permanent Trustee Company Limited, Investment Company 
Act Release Nos. 17833 (Oct. 31, 1990), 55 FR 46749 (Notice of 
Application) and 17888 (Nov. 30, 1990), 47 SEC Docket 1627 (Order) 
(granting exemptive relief from the shareholders' equity requirement 
based on the applicant's established record as a custodian and 
certain other factors).
    \143\ In some foreign countries, for example, the amount of 
assets in a custodian's safekeeping may be considered proprietary 
information that would not be available to delegates.
---------------------------------------------------------------------------

    The ICI and the Custodian Group recommended using an approach based 
on prior exemptive orders.144 Under this alternative, a foreign 
bank or trust company would not have to satisfy a shareholders' equity 
requirement if (i) the bank or trust company is a subsidiary of the 
fund's primary custodian; (ii) the primary custodian meets certain 
capital requirements; and (iii) the primary custodian assumes financial 
responsibility for the bank or trust custodian's use.145 The 
Commission requests commenters addressing this alternative to consider 
the appropriateness of allowing U.S. and foreign banks to serve as both 
assurance-providers and delegates for foreign custodian 
selection.146 The Commission also requests commenters to consider 
whether assurance arrangements should be limited to parent custodians 
and their foreign subsidiaries.147

    \144\ See, e.g., Chase Manhattan Bank, Investment Company Act 
Release Nos. 18025 (Mar. 4, 1991), 56 FR 10451 (Notice of 
Application) and 18077 (Apr. 2, 1991), 48 SEC Docket 864 (Order).
    \145\ ICI Letter III, supra note 14, at 8-10 (Exhibit A); 
Custodian Letter I, supra note 14, at 20 and at 10-12 (Exhibit A) 
(the primary custodian would have to be either a U.S. bank with more 
than $100 million in shareholders' equity or a foreign bank or trust 
company with more than $200 million in shareholder's equity; in 
addition, the primary custodian would have to assume responsibility 
for any loss arising from the arrangement (including losses 
attributable to the foreign custodian's bankruptcy or insolvency) to 
the same extent as if the primary custodian had itself performed the 
custody services). See also supra note 24.
    \146\ For example, banks serving as both assurance-provider and 
the board's delegate may be inclined to disregard custodial problems 
in hopes of delaying or avoiding their indemnification 
responsibilities. On the other hand, banks serving in both 
capacities may be more vigilant in establishing and overseeing 
foreign custody arrangements, since they would be liable for losses 
associated with the foreign custodian's use.
    \147\ See State Street Bank and Trust Company, Investment 
Company Act Release Nos. 20519 (Aug. 31, 1994), 59 FR 46463 (Notice 
of Application) and 20583 (Sept. 27, 1994), 57 SEC Docket 2091 
(Order) (custodian providing assurances was not the foreign 
custodian's parent). See also Bank van Haften Labouchere N.V., 
Investment Company Act Release Nos. 19073 (Nov. 2, 1992), 57 FR 
53531 (Notice of Application) and 19135 (Dec. 1, 1992), 52 SEC 
Docket 2892 (Order) (assurances provided by a foreign company that 
was not an eligible foreign custodian since it was primarily engaged 
in the insurance business).
---------------------------------------------------------------------------

    In addition, the ICI recommended that the Commission consider using 
an investment grade rating from a nationally recognized statistical 
rating agency as a means of determining a foreign bank's eligibility to 
serve as a fund custodian.148 The ICI also recommended that the 
Commission consider using international capital standards, such as 
those approved by the Basle Committee on Banking Regulations and 
Supervisory Practices (the ``Basle Accord'').149

    \148\ ICI Letter II, supra 14, at 3. See also Nationally 
Recognized Statistical Rating Organizations, Securities Act Release 
No. 7085 (Aug. 31, 1994), 59 FR 46314 (requesting comment on the 
role of ratings generally in the federal securities laws).
    \149\ ICI Letter II, supra 14, at 3. In general, the Basle 
Accord seeks to establish minimum standards of capital adequacy for 
internationally active banks through a ratio that measures an 
institution's capital in relation to credit risk. See Basle 
Committee on Banking Regulations and Supervisory Practices, 
International Convergence of Capital Measurement and Capital 
Standards, Fed. Banking L. Rep. (CCH) para. 5403 at 3309 (amended 
Nov. 6, 1991).
2. Non-Compulsory Depositories and Transnational Systems \150\

    \150\ See also ``Custody in Foreign Countries--Compulsory 
Depositories'' above.
---------------------------------------------------------------------------

    Under the amended rule, an eligible foreign custodian would include 
a securities depository or clearing agency that operates a system for 
the central handling of securities or equivalent book-entries that is 
regulated by a ``foreign financial regulatory authority,'' which would 
include a foreign government, an agency thereof, or a foreign self-
regulatory organization.151 An eligible foreign custodian also 
would include a depository or clearing agency that operates a 
transnational system for the central handling of securities or 
equivalent book-entries.152

    \151\ Proposed rule 17f-5(d)(3)(ii) (using the definition of 
foreign financial regulatory authority in section 3(a)(52) of the 
Securities Act of 1934 [15 U.S.C. 78c(a)(52)). See 1984 Reproposing 
Release, supra note 8, at 2908 n.31 (noting that securities 
depositories may be denominated clearing agencies in some 
countries).
    \152\ Proposed rule 17f-5(d)(3)(iii). See rule 17f-5(c)(iv) 
(consistent with the proposed approach).
---------------------------------------------------------------------------

    Rule 17f-5 currently requires depositories and clearing agencies 
that are not transnational systems to operate the only system for the 
handling of securities in a country.153 This requirement seeks to 
ensure a country's interest in establishing and maintaining a 
depository's integrity.154 The Commission believes, however, that 
the current provision, which has been the subject of a number of no-
action positions, is overly restrictive.155 With the increased 
immobilization and dematerialization of securities, the Commission 
believes that rule 17f-5 should not constrain the use of depository 
arrangements.156

    \153\ Rule 17f-5(c)(2)(iii).
    \154\ See 1984 Reproposing Release, supra note 8, at 2908.
    \155\ See, e.g., 1987 Division Letter, supra note 101, at 3 
(taking a no-action position with respect to certain groups of 
depositories that are integrated and effectively function as one 
system within a country); Custody of B Shares Trading on the 
Shenzhen and Shanghai Securities Exchanges (pub. avail. Apr. 26, 
1993) (no-action position with respect to depositories that operate 
the central system for a particular issue and class of securities). 
See generally Templeton Russia Fund, supra note 60 (addressing the 
unique custodial and settlement arrangements in Russia). See also 
ICI Letter III, supra note 14, at 10 (Exhibit A); Custodian Letter 
I, supra note 14, at 21 and at 12-13 (Exhibit A) (recommending 
expanding the class of eligible foreign depositories by codifying 
prior no-action positions).
    \156\ Securities are immobilized by storing stock certificates 
or other indicia of securities ownership with the depository. 
Securities are dematerialized by dispensing with physical evidence 
of securities ownership. Group of Thirty Report, supra note 20, at 
55-56. See also Custodian Letter I, supra note 14, at 14 (indicating 
that depositories generally are subject to strict government 
regulation and provide a high level of safety for fund assets).
---------------------------------------------------------------------------

    The amended rule would address a country's interest in a depository 
by requiring the depository to be subject to foreign regulation by the 
government, an agency thereof, or a self-regulatory organization. The 
amended rule also would require, among other things, consideration of 
the depository's operating history and number of participants and 
whether the depository will provide reasonable protection for the 
fund's assets.157 This approach should sufficiently address a 
depository's custodial integrity, while giving funds the flexibility to 
use a depository that may not operate an exclusive book-entry system.

    \157\ See ``Delegation of Board Responsibilities--Selecting 
Foreign Custodians'' above.
---------------------------------------------------------------------------

    The Commission requests comment on the proposed approach. The 
Commission requests specific comment on requiring regulatory oversight 
of depository arrangements and on permitting such oversight to be 
conducted by self-regulatory organizations.158 The Commission also 


[[Page 39603]]
requests comment whether transnational depositories should be required 
to be subject to similar or other requirements.159

    \158\ See 1984 Reproposing Release, supra note 8, at 2908 (not 
requiring depositories to be regulated by foreign governments or 
agencies thereof since several principal depositories would not meet 
the requirement).
    \159\ The Commission understands that there are very few 
transnational systems, and is not aware of any problems associated 
with the current transnational provision.
---------------------------------------------------------------------------

D. Assets Maintained in Foreign Custody

    Rule 17f-5 permits funds to use foreign custody arrangements for 
their foreign securities, cash, and cash equivalents.160 Rule 17f-
5 defines foreign securities to include those that are issued and sold 
primarily outside the United States by foreign and U.S. 
issuers.161 By restricting the types of securities that may be 
maintained outside the United States, the rule seeks to establish a 
nexus between its scope and its purpose, i.e., to give funds the 
flexibility to keep abroad assets that are purchased or intended to be 
sold abroad.162 In addition, rule 17f-5 limits the cash and cash 
equivalents that funds may maintain outside the United States to 
amounts that are reasonably necessary to effect the fund's foreign 
securities transactions.163

    \160\ Rule 17f-5(a).
    \161\ Rule 17f-5(c)(1).
    \162\ See 1984 Reproposing Release, supra note 8, at 2907.
    \163\ Rule 17f-5(a).
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    The amended rule would not change these restrictions, although it 
would simplify the definition of foreign securities by eliminating 
references to specific types of issuers.164 The Commission 
requests comment whether any other changes should be made. In 
particular, should the amended rule continue to restrict the types of 
securities and amounts of cash and cash equivalents that may be 
maintained outside the United States?

    \164\ Proposed rule 17f-5(a) and (d)(2).
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E. Canadian and Other Foreign Funds

    Rule 17f-5 contains special provisions governing the foreign 
custody arrangements of registered Canadian funds.165 To address 
jurisdictional concerns, these provisions are more restrictive than 
those applied to U.S. funds.166 Rule 17f-5 allows Canadian funds 
to maintain their assets only in overseas branches of qualified U.S. 
banks.167 The rule also places responsibility for the fund's 
foreign custody arrangements on the fund's board of directors.168

    \165\ See rule 17f-5(b). Section 7(d) of the Act prohibits 
foreign investment companies from publicly offering their securities 
in the United States unless the Commission issues an order 
permitting registration under the Act. 15 U.S.C. 80a-7(d). Rule 7d-1 
sets forth conditions governing applications by Canadian funds that 
seek Commission orders pursuant to section 7(d). 17 CFR 270.7d-1. 
Among other conditions, rule 7d-1 provides that the assets of 
Canadian funds are to be held in the United States by a U.S. bank, 
except as provided under rule 17f-5. Rule 7d-1(b)(8)(v). Although 
rule 7d-1 by its terms only applies to Canadian funds, funds 
organized in other jurisdictions generally have agreed to comply 
with its conditions as a prerequisite to receiving a section 7(d) 
order. Protecting Investors report, supra note 15, at 193 n.23.
    \166\ See 1984 Reproposing Release, supra note 8, at 2906-07; 
1984 Adopting Release, supra note 8, at 36082.
    \167\ See 1984 Adopting Release, supra note 8, at 36082 
(indicating that, by restricting custody to overseas branches of 
U.S. banks, Canadian funds may not maintain their assets with 
Canadian branches of U.S. banks).
    \168\ See rule 17f-5(b)(1)-(3).
---------------------------------------------------------------------------

    Canadian investment companies have not sought to register under the 
Act for some time, and very few Canadian funds currently offer their 
shares in the United States.169 Accordingly, the amended rule 
would make limited changes in the foreign custody requirements 
applicable to Canadian funds. The amended rule would revise the current 
``best interest'' standard for placing fund assets in a particular 
country and require instead a finding that such custody will provide 
reasonable protection for the fund's assets.170 In addition, the 
amended rule would eliminate the current requirement that the board of 
a Canadian fund review and approve foreign custody arrangements at 
least annually. Under the amended rule, the board instead would be 
required to monitor the continuing appropriateness of the fund's 
arrangements.171 If an arrangement no longer meets the rule's 
requirements, the fund would be required to withdraw its assets from 
the country or custodian as soon as reasonably practicable.172

    \169\ Protecting Investors report, supra note 15, 193 n.23 
(noting that, in 1992, only three Canadian funds were active).
    \170\ See ``Standard for Evaluating Foreign Custody 
Arrangements'' above.
    \171\ Proposed rule 17f-5(c)(2).
    \172\ Proposed rule 17f-5(c)(3). See ``Delegation of Board 
Responsibilities--Monitoring Custody Arrangements and Withdrawing 
Assets from Custodians'' above.
    The Commission requests comment on the proposed approach. The 
Commission requests specific comment whether the special provisions 
applicable to Canadian funds should be eliminated. Under this approach, 
a Canadian fund's foreign custody arrangements could be considered in 
connection with the fund's registration under the Act. In evaluating 
proposed arrangements, the Commission would be able to consider any 
jurisdictional concerns and the requirements of rule 17f-5 applicable 
to U.S. funds in effect at that time.
    Alternatively, should the amended rule allow Canadian funds to use 
foreign custody arrangements on the same basis as their U.S. 
counterparts? 173 Commenters favoring this alternative should 
consider whether any special requirements should be imposed to address 
jurisdictional concerns. For example, should Canadian funds be required 
to consent to U.S. jurisdiction or should limits be placed on the 
amount of a Canadian fund's assets that could be maintained outside the 
United States? 174

    \173\ The ICI and the Custodian Group recommended this approach. 
ICI Letter I, supra note 14, at 4 (also recommending that the 
foreign custody arrangements of any non-Canadian foreign funds 
continue to be evaluated on a case-by-case basis); Custodian Letter 
I, supra note 14, at 1 (Exhibit A).
    \174\ In 1991, a South African fund was allowed to rely on rule 
17f-5 as if it were a U.S. fund. ASA Limited, Investment Company 
Release Nos. 17904 (Dec. 17, 1990) 55 FR 52925 (Notice of 
Application), and 17945 (Jan. 15, 1991), 47 SEC Docket 1535 (Order). 
Although the fund's custody arrangements were not restricted to 
foreign branches of U.S. banks, limits were placed on the amount of 
the fund's assets that could be held overseas. Id.
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F. Disclosure of Custody Risks

    The Notes to rule 17f-5 currently instruct the fund's board to 
consider disclosing in the fund's prospectus material risks, if any, 
associated with the fund's foreign custody arrangements.175 The 
amended rule would not address disclosure issues. The Commission 
believes that these issues are more appropriately addressed by 
individual funds in considering their disclosure obligations under the 
Securities Act of 1933.176

    \175\ Rule 17f-5, Note 3.
    \176\ See, e.g., Forms N-1A, 17 CFR 239.15A (the registration 
form for open-end funds) and N-2, 17 CFR 274.11a-1 (the registration 
form for closed-end funds). Item 4(c) of Form N-1A and item 8.3.a of 
Form N-2 require disclosure in the prospectus of the principal risk 
factors associated with investing in the fund. Item 13(c) of Form N-
1A and item 17.3 of Form N-2 require disclosure in the Statement of 
Additional Information (``SAI'') of the risks inherent in certain 
significant investment policies, such as investing in foreign 
securities. Guide 9 to Form N-2 instructs funds with more than 10% 
of their assets in foreign securities to discuss in the SAI the 
fund's foreign custody arrangements. See generally Templeton Russia 
Fund, supra note 60 (apprising fund investors of certain custodial 
risks in Russia).
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G. Unit Investment Trusts

    Under the Act, unit investment trusts (``UITs'') are required to 
maintain their assets in the custody of U.S. banks or their foreign 
branches.177 UITs generally are not permitted to use the foreign 

[[Page 39604]]
custodians available to funds under rule 17f-5.178 The foreign 
custody arrangements of UITs may raise special concerns, since UITs do 
not have boards of directors to oversee the arrangements.179

    \177\ A UIT is a type of fund that issues redeemable securities 
representing an undivided interest in a portfolio of specified 
securities. 15 U.S.C. 80a-4(2). See Investment Company Act 
Secs. 2(a)(5) (defining bank) and 26(a)(1) (requiring UIT custodians 
to have at least $500,000 in capital, surplus and undivided 
profits).
    \178\ Several exemptive orders permit UITs to maintain their 
assets in certain foreign transnational securities depositories. 
See, e.g., Merrill Lynch, Pierce, Fenner & Smith, Investment Company 
Act Release Nos. 15739 (May 14, 1987), 52 FR 19006 (Notice), and 
15813 (June 16, 1987), 38 SEC Docket 891 (Order).
    \179\ UITs do not have corporate-type management structures. 
Typically, UITs are created by a sponsor or ``depositor'' that 
accumulates a portfolio of securities and deposits them with a U.S. 
bank or ``trustee'' under the terms of a trust indenture. A UIT's 
portfolio generally is unmanaged; thus, UITs do not have investment 
advisers. A UIT's operations are subject to the terms of the trust 
indenture, which specifies the ongoing responsibilities of the 
trustee, the depositor and other third-party service providers. See 
generally Form N-7 for Registration of UITs Under the Securities Act 
of 1933 and Investment Company Act of 1940, Securities Act Release 
No. 33-6580 (May 14, 1985), 50 FR 21282.
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    The Commission requests comment on the appropriateness of a rule 
that would expand the foreign custody arrangements available to 
UITs.180 The Commission requests specific comment on allowing UIT 
sponsors, custodian banks or other parties to establish and monitor 
foreign custody arrangements, without independent oversight. The 
Commission also requests comment whether special protections should 
attend UIT foreign custody arrangements by, for example, requiring the 
sponsor, custodian bank, or other party to assume financial 
responsibility for a foreign custodian's use.181 Finally, the 
Commission requests comment whether foreign custody arrangements and 
the procedures for changing those arrangements should be required to be 
set forth in UIT trust indentures.

    \180\ See Letter of Pierre de Saint Phalle, Davis Polk & 
Wardwell, to Diane C. Blizzard, Assistant Director, SEC (Mar. 14, 
1995) (recommending a rule for UIT foreign custody arrangements) 
(File No. S7-23-95). In addition, certain UITs have sought exemptive 
relief to use foreign custody arrangements available to management 
funds. See United States Trust Company of New York (filed July 28, 
1992); Merrill Lynch, Pierce, Fenner & Smith, Inc. (filed Oct. 27, 
1993) (both seeking exemptive relief from section 26(a)(2)(D) of the 
Act).
    \181\ Such financial assurances, for example, could cover the 
loss of UIT assets attributable to the foreign custodian's failure 
to exercise reasonable care or bankruptcy or insolvency.
---------------------------------------------------------------------------

IV. Cost/Benefit Analysis

    The amendments would substantially reduce burdens on fund directors 
and provide funds with greater flexibility to establish and use foreign 
custody arrangements, consistent with the protection of fund assets. To 
facilitate evaluations of foreign custody arrangements, the amendments 
would revise the findings that currently must be made in establishing 
these arrangements. The amended rule would require findings that 
foreign custody arrangements will provide reasonable protection for 
fund assets.
    In addition, the amendments would allow fund boards to play a role 
more consistent with their traditional oversight role in connection 
with foreign custody arrangements, by permitting boards to delegate 
their responsibility under the rule to evaluate foreign custody 
matters. The amendments also would eliminate the current requirement 
that boards annually approve foreign custody arrangements.
    The proposed delegation provisions may impose certain additional 
costs since delegates would be required to provide fund boards with 
written reports regarding certain aspects of the arrangements. These 
costs, however, are not expected to be significant, and are likely to 
be much less than the costs associated with providing fund boards with 
information pertaining to their annual review of foreign custody 
arrangements. In addition, because the reports would facilitate a 
board's oversight of the delegate's performance, any additional costs 
associated with the reports would be outweighed by the benefits 
provided to funds and their shareholders.
    The amendments also would expand the class of foreign banks and 
securities depositories that could serve as fund custodians. Under the 
amendments, foreign custodians would no longer have to satisfy specific 
capital standards or other objective requirements. The amended rule 
instead would require delegates to select foreign custodians based on 
the custodian's ability to provide reasonable protection for fund 
assets. While addressing safekeeping considerations, this approach 
avoids imposing inflexible standards that may unnecessarily limit the 
use of foreign custodians. In addition, instead of requiring foreign 
custody contracts to contain specific provisions (as under the current 
rule), the amendments would require these contracts to reasonably 
protect fund assets.

V. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis in accordance with 5 U.S.C. 603 regarding amendments to rule 
17f-5. The analysis notes that the amendments are designed to provide 
funds with greater flexibility in establishing and using foreign 
custody arrangements, consistent with the protection of their assets. 
Cost-benefit information reflected in the ``Cost/Benefit Analysis'' 
section of this Release also is reflected in the analysis. A copy of 
the Initial Regulatory Flexibility Analysis may be obtained by 
contacting Elizabeth R. Krentzman, Securities and Exchange Commission, 
450 Fifth Street, NW., Mail Stop 10-6, Washington, DC 20549.
VI. Statutory Authority

    The Commission is proposing to amend rule 17f-5 pursuant to the 
authority set forth in sections 6(c) and 38(a) of the Investment 
Company Act of 1940 [15 U.S.C. 6(c), 37(a)].

Text of Proposed Rule Amendments

List of subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

    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-37, 80a-39 unless 
otherwise noted;
* * * * *
    2. By revising Sec. 270.17f-5 to read as follows:


Sec. 270.17f-5  Custody of investment company assets outside the United 
States.

    (a) A registered management investment company, incorporated or 
organized under the laws of the United States or of a state, may place 
and maintain in the care of an Eligible Foreign Custodian the company's 
Foreign Securities, cash and cash equivalents in amounts reasonably 
necessary to effect the company's Foreign Securities transactions, 
provided that:
    (1) The Foreign Custody Manager shall have determined that custody 
of the company's assets in a particular country can be maintained in a 
manner that will provide reasonable protection for the company's assets 
and that custody of the company's assets with any Compulsory Depository 
in that country will provide reasonable protection for the company's 
assets, after considering, in each case, all factors relevant to the 
safekeeping of such assets, including:
    (i) The prevailing practices in the country for the custody of the 
company's assets;
    (ii) Whether the country's laws will affect adversely the 
safekeeping of the company's assets, such as by restricting: 

[[Page 39605]]

    (A) The access of the company's independent public accountants to a 
custodian's books and records; and
    (B) The company's ability to recover its assets in the event of a 
custodian's bankruptcy or the loss of assets in a custodian's control;
    (iii) Whether special arrangements that mitigate the risks of 
maintaining the company's assets in the country would be used; and
    (iv) With respect to any Compulsory Depository, the factors 
specified in paragraph (a)(2) of this section.
    (2) Subject to the decision to place assets in the country and to 
use any Compulsory Depository in that country under paragraph (a)(1) of 
this section, the Foreign Custody Manager shall have determined that 
the foreign custodian will provide reasonable protection for the 
company's assets, after considering all factors relevant to the 
safekeeping of such assets, including:
    (i) The custodian's financial strength, its general reputation and 
standing and, additionally, in the case of a securities depository, the 
depository's operating history and number of participants;
    (ii) The custodian's practices, procedures, and internal controls; 
and
    (iii) Whether the company will have jurisdiction over and be able 
to enforce judgments against the custodian, such as by virtue of the 
existence of any offices of the custodian in the United States or the 
custodian's consent to service of process in the United States.
    (3) The company's foreign custody arrangements shall be governed by 
a written contract that the Foreign Custody Manager has determined will 
provide reasonable protection for the fund's assets, after considering 
all factors relevant to the safekeeping of such assets.
    (4) The Foreign Custody Manager shall have established a system to 
monitor the appropriateness of maintaining the company's assets in a 
particular country and using any Compulsory Depository in that country 
under paragraph (a)(1) of this section, maintaining the company's 
assets with a particular custodian under paragraph (a)(2) of this 
section, and the contract governing the company's arrangements under 
paragraph (a)(3) of this section. If an arrangement no longer meets the 
requirements of this section, the company shall withdraw its assets 
from the country or foreign custodian, as the case may be, as soon as 
reasonably practicable.
    (b) The company's board of directors may delegate to the company's 
investment adviser or officers or to a U.S. bank or to a Qualified 
Foreign Bank the responsibilities set forth in paragraphs (a)(1), 
(a)(2), (a)(3), or (a)(4) of this section, provided that:
    (1) The board shall have determined that it is reasonable to rely 
on the delegate to perform the delegated responsibilities;
    (2) The board shall require the delegate to provide written reports 
notifying the board of the placement of the company's assets in a 
country and with a particular custodian (including any Compulsory 
Depository) and of any material change in the company's arrangements, 
with such reports to be provided to the board no later than the next 
regularly scheduled board meeting following such event.
    (c) Any management investment company, incorporated or organized 
under the laws of Canada and registered under the Act pursuant to the 
conditions of Sec. 270.7d-1, may place and maintain its Foreign 
Securities, cash and cash equivalents in the care of an overseas branch 
of a Qualified U.S. Bank, provided that:
    (1) Prior to placing any assets with such overseas branch, the 
company's board of directors shall have determined that custody of the 
assets in the particular country will provide reasonable protection for 
those assets;
    (2) The company's board of directors shall have established a 
system to monitor such foreign custody arrangements for their 
continuing appropriateness under this section and to ensure that the 
amount of cash and cash equivalents maintained in the care of such 
overseas branch is limited to an amount reasonably necessary to effect 
the company's Foreign Securities transactions; and
    (3) If an arrangement no longer meets the requirements of this 
section, the company shall withdraw its assets from the country or such 
overseas branch, as the case may be, as soon as reasonably practicable.
    (d) For purposes of this section:
    (1) Foreign Custody Manager means the company's board of directors 
or any person serving as the board's delegate under paragraph (b) of 
this section.
    (2) Foreign Securities mean securities issued and sold primarily 
outside the United States.
    (3) Eligible Foreign Custodian means an entity that is incorporated 
or organized under the laws of a country other than the United States 
and that is:
    (i) A banking institution or trust company that is regulated as 
such by the country's government or an agency thereof or a majority-
owned direct or indirect subsidiary of a Qualified U.S. Bank or bank-
holding company, provided that such foreign custodian is not an 
affiliated person of the company or an affiliated person of such 
person;
    (ii) A securities depository or clearing agency that operates a 
system for the central handling of securities or equivalent book-
entries in the country that is regulated by a foreign financial 
regulatory authority as defined under section 3(a)(52) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(52));
    (iii) A securities depository or clearing agency that operates a 
transnational system for the central handling of securities or 
equivalent book-entries in the country; or
    (iv) A Compulsory Depository.
    (4) Compulsory Depository means an eligible foreign custodian under 
paragraph (d)(2)(ii) of this section, the use of which is mandatory:
    (i) By law or regulation;
    (ii) Because securities cannot be withdrawn from the depository; or
    (iii) Because maintaining securities outside the depository is not 
consistent with prevailing custodial practices.
    (5) Qualified U.S. Bank means an entity that has an aggregate of 
capital, surplus, and undivided profits of a specified minimum amount, 
which shall not be less than $500,000, and that is:
    (i) A banking institution organized under the laws of the United 
States;
    (ii) A member bank of the Federal Reserve System;
    (iii) Any other banking institution or trust company organized 
under the laws of any state or of the United States, whether 
incorporated or not, doing business under the laws of any state or of 
the United States, a substantial portion of the business of which 
consists of receiving deposits or exercising fiduciary powers similar 
to those permitted to national banks under the authority of the 
Comptroller of the Currency and which is supervised and examined by 
State or Federal authority having supervision over banks, and which is 
not operated for the purpose of evading the provisions of this section: 
or
    (iv) a receiver, conservator, or other liquidating agent of any 
institution or firm included in paragraphs (d)(5) (i), (ii), or (iii) 
of this section.
    (6) Qualified Foreign Bank means a banking institution or trust 
company, incorporated or organized under the laws of a country other 
than the United States, that is regulated as such by the country's 
government or an agency thereof.

    Dated: July 27, 1995.


[[Page 39606]]

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 95-18890 Filed 8-1-95; 8:45 am]
BILLING CODE 8010-01-P