[Federal Register Volume 62, Number 95 (Friday, May 16, 1997)]
[Rules and Regulations]
[Pages 26923-26933]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-12881]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release Nos. IC-22658; IS-1080; File No. S7-23-95]
RIN 3235-AE98
Custody of Investment Company Assets Outside the United States
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
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SUMMARY: The Commission is adopting 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 provide
investment companies with greater flexibility in managing their foreign
custody arrangements consistent with the safekeeping of investment
company assets. The amendments also expand the class of foreign banks
and securities depositories that may serve as investment company
custodians.
EFFECTIVE DATE: The amendments will become effective June 16, 1997.
FOR FURTHER INFORMATION CONTACT: Robin S. Gross, Staff Attorney, or
Nadya B. Roytblat, Assistant Chief, Office of Regulatory Policy, at
(202) 942-0690, Securities and Exchange Commission, Division of
Investment Management, 450 Fifth Street, N.W., Mail Stop 10-2,
Washington, D.C. 20549. Requests for formal interpretive advice should
be directed to the Office of Chief Counsel at (202) 942-0659, Division
of Investment Management, Securities and Exchange Commission, 450 Fifth
Street, N.W., Mail Stop 10-6, Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') today is adopting amendments to rule 17f-5 (17 CFR
270.17f-5) under the Investment Company Act of 1940 (15 U.S.C. 80a)
(the ``Investment Company Act'' or ``Act'').
Table of Contents
I. Executive Summary
II. Introduction and Background
III. Discussion
A. Decision to Place Fund Assets in a Country
1. Background
2. Amended Rule
B. Delegation of Board Responsibilities
1.Selecting Delegates
2. Delegate's Standard of Care
3. Board Oversight; Delegate Reporting
C. Selecting, Contracting with, and Monitoring a Foreign
Custodian
[[Page 26924]]
1. Selecting a Foreign Custodian
a. General Standard
b. Specified Factors
i. Practices, Procedures and Internal Controls
ii. Financial Strength and Reputation
iii. Jurisdiction
2. Foreign Custody Contract
a. Indemnification and Insurance
b. Liens
c. Omnibus Accounts
d. Depository Arrangements
3. Monitoring Custody Arrangements and Withdrawing Fund Assets
D. Eligible Foreign Custodians
1. Foreign Banks and Trust Companies
2. Affiliated Foreign Custodians
3. Securities Depositories
E. Assets Maintained in Foreign Custody
F. Canadian Funds
IV. Effective Date; Compliance Dates
V. Cost/Benefit Analysis and Effects on Competition, Efficiency and
Capital Formation
VI. Summary of Final Regulatory Flexibility Analysis
VII. Paperwork Reduction Act
VIII. Statutory Authority
Text of Rule
I. Executive Summary
The Commission is amending rule 17f-5 under the Investment Company
Act to provide registered management investment companies (``funds'')
greater flexibility in managing their foreign custody arrangements. The
amendments expand the class of foreign banks and securities
depositories that may serve as custodians of fund assets by eliminating
capital requirements that have precluded funds from using otherwise
suitable custodians without first obtaining administrative relief from
the Commission. The amended rule requires instead that the selection of
a foreign custodian be based on whether the fund's assets will be
subject to reasonable care if maintained by that custodian, after
considering all factors relevant to the safekeeping of fund assets,
including the custodian's financial strength, its practices and
procedures, and internal controls.
The amendments eliminate the consideration of ``prevailing country
risks,'' i.e., risks associated with investment in a particular country
rather than placing assets with a particular custodian. The Commission
has concluded that prevailing country risks are investment risks
appropriately considered by a fund's board or investment adviser when
deciding whether the fund should invest in a particular country, rather
than custodial risks to be addressed in rule 17f-5.
The amendments also permit fund directors to play a more
traditional oversight role with respect to the custody of fund assets
overseas. Directors may delegate their duties to select a foreign
custodian and monitor a fund's foreign custody arrangements to the
fund's investment adviser, officers, or a U.S. or foreign bank, and are
no longer required to approve foreign custody arrangements annually.
II. Introduction and Background
A growing number of funds invest their assets overseas.1
Investing in foreign markets may present a fund with significant
operational issues, one of which is the availability of appropriate
custodians for fund assets. Maintaining securities outside of their
primary market can add significant costs to investing in that market
and may preclude foreign investment.2 The availability of
custodial arrangements in foreign markets where a fund invests,
therefore, is very important.
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\1\ Based on available data, the Commission staff estimates that
at the end of February 1997, approximately 1,666 portfolios with
assets of nearly $411 billion have investment objectives that
contemplated significant foreign investments. See also Karen Damato,
Mutual Funds Drew $24 Billion During January, Wall St. J., Feb. 13,
1997, at C1 (discussing recent increased investor interest in funds
that invest overseas).
\2\ 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. See 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 (April 16, 1982)) (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 generally permits a fund to maintain its
assets only in the custody of a U.S. bank and its foreign branches, a
member of a U.S. securities exchange, the fund itself, or a U.S.
securities depository.3 Before rule 17f-5 was adopted, funds
seeking to maintain their assets outside the United States could use
only foreign branches of U.S. banks as their foreign
custodians.4
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\3\ 15 U.S.C. 80a-17(f). 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), rule 17f-4 (17 CFR 270.17f-4)
(custody by U.S. securities depositories), and rule 17f-6 (17 CFR
270.17f-6) (custody by futures commission merchants and commodity
clearing organizations).
\4\ See 1982 Proposing Release, supra note 2, at n.7 and
accompanying text.
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In 1984 the Commission adopted rule 17f-5, which expanded the
foreign custody arrangements available to funds.5 The rule
permits funds to maintain their assets overseas, subject to detailed
findings by the fund's board of directors with respect to the decision
to place fund assets in a particular country and with respect to each
foreign custody arrangement.6 Fund assets may be placed in
the custody of an ``eligible foreign custodian'': (i) A foreign bank or
trust company (``foreign bank'') that has more than $200 million in
shareholders' equity; (ii) a majority-owned subsidiary of a U.S. bank
or bank holding company (``U.S. bank subsidiary'') that has more than
$100 million in shareholders' equity; or (iii) a foreign securities
depository that operates either the central system for the handling of
securities in that country or a transnational system for the central
handling of securities.7 Finally, the fund's foreign custody
arrangements must be governed by a written contract that must be
approved by the fund's board of directors and contain certain specified
provisions.8
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\5\ Exemption for Custody of Investment Company Assets Outside
the United States, Investment Company Act Release No. 14132 (Sept.
7, 1984) (49 FR 36080 (Sept. 14, 1984)) (release adopting rule 17f-
5) (hereinafter 1984 Adopting Release). For an administrative
history of rule 17f-5, see Custody of Investment Company Assets
Outside the United States, Investment Company Act Release No. 21259
(July 27, 1995) (60 FR 39592 (Aug. 2, 1995)) (hereinafter Proposing
Release) at n.8.
\6\ The fund's board of directors must determine that the
custody arrangements are consistent with the best interests of the
fund and its shareholders (the ``best interests determination'').
Rule 17f-5(a)(1)(i) through (iii). Notes to the current rule
enumerate certain factors that the fund's board should consider in
making the best interests determination. The rule also requires the
board to monitor the fund's foreign custody arrangements and to
approve each arrangement at least annually. Rule 17f-5(a)(2), (3).
\7\ Rule 17f-5(c)(2) (i) through (iv).
\8\ Rule 17f-5(a)(1)(iii) (A) through (F).
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By 1995 the Commission had become concerned that the rule's
provisions unnecessarily restricted foreign custody arrangements. In
addition, the Commission became concerned that the rule placed
unnecessary burdens on fund directors that detracted from the amount of
time they could devote to the many other important duties they are
assigned under the Act.9 In July 1995, the Commission
proposed amendments to rule 17f-5 in response to these concerns. To
make the rule's requirements for board involvement in custody matters
more consistent with the board's traditional oversight role, the
proposed amendments would have permitted fund boards to delegate their
[[Page 26925]]
responsibilities to approve and monitor foreign custody arrangements.
To better reflect modern commercial custody practices, the proposed
amendments would have revised the standard to be used in evaluating a
fund's foreign custody arrangements to one that focuses on whether the
custodial arrangement afforded ``reasonable protection'' for fund
assets.10 The proposed amendments also would have expanded
the class of foreign banks, U.S. bank subsidiaries and securities
depositories that could serve as fund custodians, and eliminated the
requirement that the fund's foreign custody contract contain certain
specified provisions.
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\9\ See Proposing Release, supra note 5, at nn.15-17 and
accompanying text.
\10\ The factors that the rule specifies should be considered in
this regard would have been revised to focus on safekeeping rather
than investment risks (particularly the factors relating to the
decision to place fund assets in a country).
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The Commission received letters from 28 commenters. The commenters
generally supported the proposed amendments, particularly those
provisions that would have permitted a fund's board to delegate its
responsibilities to select and monitor foreign custodians to the fund's
investment adviser, officers, or a U.S. or foreign bank. The Commission
is adopting the proposed amendments with several modifications that
reflect, in part, the commenters' suggestions. The Commission believes
that the amendments, as adopted, will provide significant additional
flexibility for funds without reducing the level of investor protection
afforded by the current rule.
III. Discussion
A. Decision to Place Fund Assets in a Country
1. Background
Maintaining fund assets outside the United States involves risks
that relate to the particular custodian (e.g., the risk that the
custodian selected will not exercise the appropriate level of care with
regard to fund assets, or that the custodian may not have the financial
strength, practices, and procedures in place to safeguard the fund's
assets).11 In addition, maintenance of fund assets overseas
exposes the fund to systemic risks that may affect the ability of any
custodian to safeguard fund assets in that country (``prevailing
country risks''). For example, a country's inefficient settlement
practices constitute a risk of investing in that country, regardless of
the level of care that can be provided by a particular custodian. Both
of these types of risks have been addressed by rule 17f-5, and were to
be addressed by the proposed amendments.12
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\11\ These issues also may be present when a fund's assets are
maintained in the United States. Section 17(f), however, by limiting
domestic custody arrangements to U.S. banks and certain other
arrangements subject to Commission regulation, provides some
assurance that custody arrangements will have appropriate
safeguards. See supra note 3 and accompanying text.
\12\ Rule 17f-5 currently requires a fund's board of directors
to determine that maintaining the fund's assets in a particular
country is consistent with the best interests of the fund and its
shareholders. Rule 17f-5(a)(1)(i). Note 1 to the rule requires the
board, in making this determination, to consider the effects of
applicable foreign law on the safekeeping of fund assets; the
likelihood of expropriation, nationalization, freezing, or
confiscation of the fund's assets; and any reasonably foreseeable
difficulties in repatriating the fund's assets kept overseas.
The proposed amendments would have narrowed the scope of the
prevailing country risks determination to factors that have a closer
nexus to safekeeping considerations. A fund's board of directors or
its delegate would have been required to determine that custody of
the fund's assets in a particular country could be maintained in a
manner that provided reasonable protection for the fund's assets
after considering all factors relevant to the safekeeping of such
assets including: (i) The prevailing practices in the country for
the custody of the fund's assets; (ii) whether the country's laws
will affect adversely the safekeeping of the fund's assets, such as
by restricting the access of the fund's independent public
accountants to a custodian's books and records, or by affecting the
fund's ability to recover its assets in the event of a custodian's
bankruptcy or the loss of assets in a custodian's control; and (iii)
whether special arrangements that mitigate the risks of maintaining
the fund's assets in the country would be used.
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The Proposing Release requested comment whether the rule should
continue to address prevailing country risks.13 A number of
commenters suggested that it should not. These commenters asserted that
prevailing country risks are inherently investment risks because they
are an inextricable part of the fund's decision to invest in foreign
securities. These commenters therefore urged the Commission to treat
the decision to place fund assets in a country as a decision to be made
by the fund's board or its investment adviser in the context of
deciding to invest in that country, and as separate from the
establishment of particular foreign custody arrangements under rule
17f-5.
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\13\ Proposing Release, supra note 5, at nn. 62-65 and
accompanying text.
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2. The Amended Rule
These comments have caused the Commission to reconsider the
proposed approach. Once a decision has been made to invest in a
country, prevailing country risks cannot be avoided, except by
maintaining assets outside of the country--an alternative that is often
not possible or practicable. For that reason, prevailing country risks
would seem inherently a part of the investment risks associated with
the decision to invest in a particular country and should be considered
by a fund's board or investment adviser before the fund invests in a
foreign country. Inclusion of prevailing country risks in rule 17f-5,
therefore, would appear inconsistent with the nature of those risks.
The Commission also is concerned that restrictions on a fund's
approach to prevailing country risks may have the effect of denying
funds and their shareholders overseas investment opportunities,
particularly in developing markets. Such a result is inconsistent with
the overall approach of the Investment Company Act, which generally
does not limit a fund's ability to assume investment
risks.14 Moreover, such a result is not mandated by section
17(f), the legislative history of which suggests that the section was
intended primarily to prevent misappropriation of fund assets by
persons having access to assets of the fund.15
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\14\ But see, e.g., rule 2a-7 under the Investment Company Act
(17 CFR 270.2a-7) (establishing various limitations on permissible
investments for money market funds).
\15\ See Proposing Release, supra note, at n.5; Thomas Harman,
Eligible Foreign Custodians and the Investment Company Act of 1940,
46 Bus. Law 1377 (1991).
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Based upon these considerations, the Commission has decided not to
address prevailing country risks in rule 17f-5. Rather, the Commission
believes that such risks should be carefully considered by a fund's
board or its investment adviser before the fund invests in a foreign
country, and, if material, disclosed to fund investors.16
Accordingly, the amended rule focuses exclusively on the selection and
monitoring of an eligible foreign custodian.
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\16\ Funds' disclosure obligations are governed by other
provisions of the securities laws. See, e.g., Item 4(c) of Form N-1A
(17 CFR 239.15A) (the registration form for open-end funds), and
Item 8.3 of Form N-2 (17 CFR 274.11a-1) (the registration form for
closed-end funds). These Items require disclosure in the fund's
prospectus of the principal risk factors associated with investing
in the fund. See also Proposing Release, supra note, at nn.175, 176
and accompanying text.
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The amendments are not intended and should not be construed,
however, to diminish the importance of considering the financial
infrastructure of a foreign country when deciding to invest in that
country. For example, the country's settlement systems and practices
can have a significant effect on the liquidity and investment
characteristics of fund assets.17 The
[[Page 26926]]
amendments similarly are not intended to diminish the contribution that
the fund's global custodian may make in deciding to place fund assets
in a foreign country.18 Commenters representing funds and
custodians agreed that global custodians are a ``primary source of
information concerning the financial systems and practices of foreign
markets.'' 19 The Commission, therefore, expects that fund
boards and investment advisers, in making foreign investment decisions,
will continue to seek and rely on information and opinions provided by
the fund's custodian when the custodian has experience with regard to
foreign custody services.20
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\17\ A country's settlement systems, for example, may not
require that payment for securities purchased by a fund be made only
upon delivery of those securities, or that securities sold by a fund
be delivered only upon receipt of payment for the securities
(``delivery vs. payment procedures''). Delivery vs. payment
procedures can afford significant protections from losses if the
other party to a transaction defaults on its obligations. See, e.g.,
Group of Thirty, Clearance and Settlement Systems in the World's
Securities Markets 11 (Mar. 1989). The fact that a foreign market's
settlement practices do not incorporate these procedures should be
carefully considered by the fund's board or investment adviser in
deciding to invest in the country.
A country's settlement systems and practices also may present
problems in accounting for fund assets (e.g, establishing whether
the fund owns the securities or has received dividends or other
entitlements). See, e.g., Buttonwood International Group, Emerging
Markets on the Net: India-Securities Infrastructure a Big Problem
for Investors, at http://www.buttonwood.com/p-i/1996es/india.html
(discussing, among other things, difficulties resulting from the
process of registering changes in ownership of securities).
\18\ See, e.g., John Paul Lee & Richard Schwartz, Global
Custody: A Guide for the Nineties (1990) (noting that today the
safekeeping of a fund's foreign investments typically is effected
through the fund's primary or ``global'' custodian, which uses a
world-wide network of custodians with which it has established
relationships); Gordon Altman Butowsky Weitzen Shalov & Wein, a
Practical Guide to the Investment Company Act 30 (1993) (indicating
that the fund's custodian typically provides the board with
information concerning foreign legal restrictions and the
qualifications of foreign custodians).
\19\ Letter from Baker & McKenzie to Jonathan G. Katz,
Secretary, Securities and Exchange Commission (Nov. 3, 1995), File
No. S7-23-95, at 7-8; see also Letter from the Investment Company
Institute to Jonathan G. Katz, Secretary, Securities and Exchange
Commission (Oct. 5, 1995), File No. S7-23-95, at 9. Custodian
commenters suggested that their role in this regard may expand under
the amended rule and emphasized that funds and their global
custodians ``are partners, not adversaries, in seeking to ensure
that fund assets held outside the United States are properly
safeguarded.'' Letters from Baker & McKenzie to Jonathan G. Katz,
Secretary, Securities and Exchange Commission (June 7, 1996 and
Sept. 10, 1996), File No. S7-23-95, at 3 and 2, respectively.
\20\ The Commission always has recognized the extent to which
fund boards rely on third party experts in addressing prevailing
country risks. See 1984 Adopting Release, supra note 5, at n.12 and
accompanying text. The failure of a fund's board to obtain
information from reliable sources concerning the financial systems
and practices of foreign markets in which the fund makes significant
investments may in certain instances violate the directors' duty of
care under applicable corporate and fiduciary law. See, e.g., Task
Force on the Fund Director's Guidebook, Federal Regulation of
Securities Committee, Section of Business Law, American Bar
Association, ``Fund Director's Guidebook,'' 52 Bus. Law. 229, 237
(1996) (``Compliance with the duty of care under state law is based
on diligence applied to the ordinary and extraordinary needs of the
fund, including * * * obtaining and reviewing information on which
to base decisions, and making appropriate inquiries under particular
circumstances.'') The Commission does not believe that the
amendments will discourage fund boards and investment advisers from
seeking the type of information they need to fulfill their
responsibilities. Cf. Letter from State Street Bank to Jonathan G.
Katz, Secretary, Securities and Exchange Commission (Nov. 3, 1995),
File No. S7-23-95, at 11 (suggesting that ``competitive forces'' may
place incentives on custodian banks to assume greater responsibility
for decisions to place fund assets in foreign countries). The
amendments do not affect in any way the extent to which a
custodian's opinions and reports may be relied upon by the fund's
board or the investment adviser, or the custodian's legal liability
to the fund with respect to any such opinions or reports.
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B. Delegation of Board Responsibilities
The Commission proposed amending the rule to permit a fund's board
to delegate its responsibilities to select, contract with, and monitor
foreign custodians to the fund's investment adviser, officers or a U.S.
or foreign bank. This approach was intended to permit fund boards to
play a more traditional oversight role in connection with a fund's
foreign custody arrangements.21 This approach also sought to
recognize that in discharging their responsibilities under the rule,
directors rely heavily on the analysis and recommendations of the
fund's investment adviser, legal counsel and global
custodian.22 Most commenters strongly supported the proposed
amendments permitting delegation of board responsibilities and they are
adopted substantially as proposed.23
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\21\ See Proposing Release, supra note 5, at nn.24-26 and
accompanying text.
\22\ See supra notes 18-20 and accompanying text. See also,
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 fund or its investment
adviser will have the expertise or bargaining power to deal with
numerous and varied foreign custodians throughout the world).
\23\ While commenters generally supported delegation, a number
of commenters suggested that custodian banks should not serve as
delegates for the decision to place fund assets in a country. It is
not necessary to address this issue in the amended rule, however,
because the decision to place fund assets in the country is outside
the scope of the amended rule. See supra Section III.A. of this
Release.
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1. Selecting Delegates
Under the proposed amendments, the board would have been required
to find that it is reasonable to rely on the delegate to perform the
delegated responsibilities related to the fund's foreign custody
arrangements. Most commenters that addressed this aspect of the
proposal supported the proposed standard, but suggested that the
Commission discuss the factors to be considered in determining whether
reliance on a delegate is reasonable.
The Commission is adopting the proposed reasonable reliance
standard.24 As stated in the Proposing Release, factors
typically involved in making this determination include the expertise
of the delegate and, if applicable, the delegate's intended use of
third party experts in performing its responsibilities.25
Other relevant factors may include, for example, the board's ability to
monitor the delegate's performance or, in the case of a delegate that
is a foreign bank, the fund's ability to obtain jurisdiction over the
delegate in the U.S. should problems arise in the delegate's
performance of its duties.26 The delegate's financial
strength also is relevant in analyzing its ability to perform its
responsibilities and indemnify the fund if the delegate fails to adhere
to the requisite standard of care.27
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\24\ Amended rule 17f-5(b)(1) (17 CFR 270.17f-5(b)(1)).
\25\ See Proposing Release, supra note 5, at n.28 and
accompanying text.
\26\ If the delegate is a foreign bank, it must be a ``qualified
foreign bank'' (i.e., regulated as either a banking institution or
trust company by the government of the country under whose laws it
is organized or any agency thereof). See amended rule 17f-5(d)(6)
(17 CFR 270.17f-5(d)(6)). U.S. bank delegates must be subject to
federal or state regulation by virtue of the definition of bank in
section 2(a)(5) of the Act (15 USC 80a-2(a)(5)).
\27\ The amendments, as proposed, would have required a U.S.
bank delegate to have an aggregate of capital, surplus and undivided
profits (``CSP'') of $500,000--the aggregate CSP required for a U.S.
bank to serve as a custodian for fund assets. See section 17(f)(1)
of the Act (15 U.S.C. 80a-17(f)(1)) (requiring bank custodians to
meet the qualifications prescribed by section 26(a) of the Act (15
U.S.C. 80a-26(a)) for the trustees of unit investment trusts). The
Proposing Release requested comment whether foreign bank delegates
should meet specific capital standards. Commenters were divided on
this point. One commenter supported a minimum capital requirement
for foreign bank delegates to avoid the inequity of subjecting only
U.S. banks to minimum capital requirements. Other commenters
suggested that, since the financial strength of a foreign custodian
would be a factor in deciding to use it as a custodian for fund
assets, the aggregate CSP requirement, or other minimum financial
standards for delegates, were unnecessary. Consistent with the
approach of focusing on financial strength, rather than specified
minimum capital (as discussed in Section III.D.1 of this Release),
the amended rule does not require a U.S. bank delegate to have a
specified CSP.
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Certain commenters suggested that the board's responsibilities
under the rule be delegable solely to the fund's custodian bank as the
entity most qualified to provide such services. The Commission
continues to believe that the board should have the flexibility to
[[Page 26927]]
delegate foreign custody decisions to the entity it determines is in
the best position to evaluate the particular delegated aspects of the
fund's foreign custody arrangements.28 For example, under
the delegation provisions of the amended rule, one delegate may assume
responsibility for evaluating bank custodians, while another may be
responsible for evaluating depositories.
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\28\ Similarly, a fund's board could select as delegate the
entity having the greatest expertise with a geographic region. See
Andrew Sollinger, Breaking Away, Institutional Investor 171 (Sept.
1991) (noting that U.S. custodians may use different subcustodian
networks for different geographic regions).
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The Commission notes that the terms of the delegation must be
agreed upon by the board and the delegate. The potential delegate must
agree to assume the delegated responsibilities and the delegate and the
fund's board may agree to guidelines and procedures under which the
delegate will exercise its responsibilities. If a foreign country, for
example, has a depository that, as a practical matter, must be used if
the fund is going to place assets in that country (``compulsory
depository''), the fund's board may conclude that the investment
adviser would be the appropriate delegate for evaluating the compulsory
depository.29
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\29\ The amendments, as proposed, would have expressly addressed
compulsory depositories, and would have required the evaluation of a
compulsory depository to be made in the context of the decision to
place fund assets in that country. This approach was designed to
address the expectation that, because of the depository's compulsory
nature, the fund's custodian would decline to assume the
responsibility for evaluating it. The Commission recognized,
however, that conceptually the decision to use a compulsory
depository appeared to fall within the scope of the rule's
provisions governing the selection of particular custodians. The
rule, as proposed to be amended, would have required the fund's
board or its delegate to make the same findings with respect to a
compulsory depository as those required for the selection of any
other type of foreign custodian. See Proposing Release, supra note
5, at n.71. Because the amended rule does not address the decision
to place fund assets in a country, the Commission has concluded that
it is not necessary for the rule to distinguish between compulsory
depositories and other types of foreign custodians.
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2. Delegate's Standard of Care
The Proposing Release requested comment whether the rule should
provide a standard of care to be used by a delegate in making custodial
decisions. Several commenters suggested that the rule should provide
guidance in this regard. These commenters expressed the view that if
the Commission did not clarify this aspect of the amendments, the
delegation provisions would be unworkable because potential delegates
would be unwilling to risk being held liable for losses despite
exercising reasonable care.
The amended rule requires a delegate to exercise reasonable care in
performing the delegated duties.30 The rule makes clear that
reasonable care, in this context, requires the delegate to exercise the
care, prudence and diligence that a person having the responsibility
for the safekeeping of fund assets would exercise.31 This
provision is designed to ensure that delegates adhere to a threshold
standard of care. Fund boards and their delegates may agree that the
delegate should adhere to a higher standard of care.
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\30\ Amended rule 17f-5(b)(3) (17 CFR 270.17f-5(b)(3)).
\31\ A substantially similar standard of care was suggested by
fund and custodian commenters. See also infra note 36, (discussing a
custodian's standard of care under Article 8 of the Uniform
Commercial Code (``U.C.C.'')).
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3. Board Oversight; Delegate Reporting
The Commission is amending the rule, as proposed, to no longer
require the board to review or approve the fund's foreign custody
arrangements annually. The amended rule does require the delegate to
provide the board with written reports notifying it of the placement of
the fund's assets with a particular custodian.32 The
delegate also must provide written reports to the board concerning any
material change in the fund's foreign custody arrangements (``material
change reports'').33 These reports are intended to
facilitate the board's oversight of the delegate's performance.
Commenters generally agreed that delegate reporting is desirable.
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\32\ Amended rule 17f-5(b)(2) (17 CFR 270.17f-5(b)(2)).
\33\ Id. A material change in the fund's arrangements would
include, for example, a delegate's decision to remove the fund's
assets from a particular custodian. A material change also could
include events that may adversely affect a foreign custodian's
financial or operational strength, such as a change in control
resulting from a sale of the custodian's operations. If appropriate,
the material change report would discuss the reasons for continuing
to maintain the fund's assets with a particular custodian.
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The proposed amendments would have required the reports to be
provided no later than the next regularly scheduled board meeting
following the event necessitating the report. One commenter expressed
concerns about the application of this requirement to fund boards that
do not have regularly scheduled meetings. The amended rule requires
material change reports to be provided at such times as the fund's
board deems reasonable and appropriate based on the circumstances of
the fund's foreign custody arrangements.34 This provision
should provide fund boards with the flexibility to tailor the reporting
requirements to the fund's particular circumstances. Consistent with
the provision, a fund's board could, for example, require the reports
at the next regularly scheduled board meeting, as originally proposed.
The board also may require the reports more or less frequently (e.g.,
within 30, 60 or 90 days of the event or annually) as the board
determines is reasonable and appropriate.
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\34\ Amended rule 17f-5(b)(2) (17 CFR 270.17f-5(b)(2)).
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C. Selecting, Contracting With, and Monitoring a Foreign Custodian
1. Selecting a Foreign Custodian
a. General Standard
Rule 17f-5 currently requires a fund's board to find that the
fund's foreign custody arrangements are consistent with the best
interests of the fund and its shareholders.35 Consistent
with the goal of requiring foreign custody arrangements to be evaluated
based on the level of safekeeping they will afford fund assets, the
Commission proposed amending the rule to require a finding that the
fund's foreign custody arrangement will provide ``reasonable
protection'' for fund assets. The proposed reasonable protection
standard was intended to facilitate evaluation of foreign custody
arrangements by focusing exclusively on the safekeeping of fund assets.
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\35\ Rule 17f-5(a)(2).
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Several commenters viewed the proposed reasonable protection
standard as a results-oriented standard that could effectively render
the entity making the determination a guarantor against any loss of
fund assets in foreign custody. A number of commenters recommended that
the rule require instead that the selection of a fund's foreign
custodian be based on a determination that the custodian will provide
``reasonable care'' for the fund's assets in its custody (``reasonable
care standard''). The commenters suggested that this standard of care
would be more consistent with the way in which custodians traditionally
have carried out their responsibilities.36 Commenters also
noted that a reasonable protection
[[Page 26928]]
standard would suggest that the level of custodial protection that is
deemed ``reasonable'' would vary from fund to fund.
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\36\ For example, the newly revised Article 8 of the U.C.C.
(which has been adopted in 29 states, as of December 1996),
addresses the duty of care to be exercised by a custodian (or other
``securities intermediary''). Section 8-504 provides that in the
absence of an agreement, the custodian should exercise ``due care in
accordance with reasonable commercial standards.'' (Section 8-509
recognizes that regulatory law may impose a higher standard.) Note 4
to Section 8-504 observes that ``(the duty of care includes both
care in the intermediaries' own operations and care in the selection
of other intermediaries through whom the intermediary holds the
assets in question.''
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In proposing the reasonable protection standard, the Commission
emphasized that the delegate would not be required to find that fund
assets could never be lost while in the foreign custodian's possession.
Instead, the focus would have been on the reasonableness of a
custodian's protections for the fund's assets, based on all relevant
factors and, in particular, those factors that would have been
specified in the rule.37 Thus, the proposed standard was not
intended to be substantially different than the reasonable care
standard suggested by the commenters. Nonetheless, recognizing the
benefits of using terminology currently used and commonly understood by
participants in fund custodial arrangements, the Commission has decided
to adopt a ``reasonable care'' standard as suggested by commenters. The
use of this terminology also underscores the objective nature of the
standard for determining whether a fund's custodial arrangements in a
particular country satisfy a ``reasonableness'' standard.
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\37\ See Proposing Release, supra note 5, at n.80 and
accompanying text.
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The amended rule requires the fund's board or its delegate (the
``Foreign Custody Manager'') to determine that the fund's assets will
be subject to reasonable care if maintained with the foreign
custodian.38 This determination would be based on standards
applicable to custodians in the relevant market.39 In making
this determination, the Foreign Custody Manager must consider all
factors relevant to the safekeeping of fund assets, including the
custodian's practices, procedures and internal controls, its financial
strength, reputation and standing, and whether the fund will be able to
obtain jurisdiction over and enforce judgments against the
custodian.40 The Commission notes that the reasonable care
standard is merely a threshold standard, and that fund boards and their
delegates have the flexibility to agree that the delegate will select
foreign custodians that will exercise a higher degree of care with
respect to fund assets.
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\38\ Amended rule 17f-5(c)(1) (17 CFR 270 17f-5(c)(1)).
\39\ Id. As noted in the Proposing Release, supra note 5, at
nn.88-89 and accompanying text, while reference to U.S. standards
may be relevant in determining whether the fund's assets will be
maintained with reasonable care, the rule does not require parity
between foreign and U.S. custodial arrangements.
\40\ Amended rule 17f-5(c)(1) (i) through (iv) (17 CFR 270.17f-
5(c)(1) (i) through (iv)).
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b. Specified Factors
The amended rule requires the Foreign Custody Manager to consider
all factors relevant to the safekeeping of fund assets. The rule
identifies several specific factors that the Foreign Custody Manager
must consider when selecting a foreign custodian.
i. Practices, Procedures and Internal Controls
The amended rule states that the foreign custodian's practices,
procedures, and internal controls are among the factors that must be
considered in deciding whether the fund's assets will be subject to
reasonable care.41 As noted in the Proposing Release, the
protections provided by custodians within a foreign country can vary
widely.42 The amended rule specifies certain additional
factors that should be considered in assessing the custodian's internal
controls: The physical protections the custodian makes available for
certificated securities (e.g., the use of vaults or other facilities),
the custodian's method of keeping custodial records (e.g., the use of
computers, microfilm or paper records), as well as security and data
protection practices (e.g., alarm systems and the use of pass codes and
back-up procedures for electronically stored information). The proposed
amendments would have treated these factors as related to the decision
to place fund assets in a country.43 Commenters suggested,
and the Commission agrees, that these factors also should be considered
in selecting a particular foreign custodian.44
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\41\ Amended rule 17f-5(c)(1)(i) (17 CFR 270.17f-5(c)(1)(i)).
\42\ See Proposing Release, supra note 5, at nn.88-89 and
accompanying text. For example, if delivery vs. payment procedures
are not part of the settlement practices of a particular foreign
market, some custodians in that market might provide safeguards that
address the lack of such procedures, while others might not. See,
e.g., Department of the Treasury, Office of Comptroller of the
Currency, Emerging Market Country Products and Trading Activities 20
(Dec. 1995) (discussing alternatives to delivery vs. payment
procedures). Such differences among custodians should be considered
in determining whether a particular custodian will provide
reasonable care for fund assets. See supra note 17 (discussing the
delivery vs. payment procedures).
\43\ See Proposing Release, supra note 5, at n.54 and
accompanying text.
\44\ See Letter from Chase Manhattan Bank to Jonathan G. Katz,
Secretary, Securities and Exchange Commission (Oct. 6, 1995), File
No. S7-23-95, at n.4 (noting that the use of vaults and computers,
for example, is important with respect to any particular foreign
custodian).
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ii. Financial Strength and Reputation
The amended rule requires the Foreign Custody Manager to consider
whether the foreign custodian has the requisite financial strength to
provide reasonable care for fund assets.45 Particular
emphasis should be placed on evaluating the custodian's financial
strength, since the amended rule no longer requires the foreign
custodian to have a specified minimum shareholders'
equity.46 As noted in the Proposing Release, in considering
financial strength, the Foreign Custody Manager should assess the
adequacy of the custodian's capital with a view of protecting the fund
against the risk of loss from a custodian's insolvency.47
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\45\ Amended rule 17f-5(c)(1)(ii) (17 CFR 270.17f-5(c)(1)(ii)).
\46\ See infra, Section III.D.1 of this Release.
\47\ See Proposing Release, supra note , at nn.125-131 and
accompanying text.
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In addition, consideration must be given to the custodian's
reputation and standing generally. The amended rule does not limit the
Foreign Custody Manager to considering the foreign custodian's
reputation in the country where the custodian is located. This approach
seeks to provide greater flexibility to evaluate a custodian's
reputation based on the facts and circumstances relevant to the
particular custodian (such as the custodial services it provides in
other jurisdictions).48
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\48\ Amended rule 17f-5(c)(1)(iii) (17 CFR 270.17f-
5(c)(1)(iii)). The amended rule no longer addresses a custodian's
efficiency and relative costs.
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iii. Jurisdiction
The amended rule also requires the Foreign Custody Manager to
assess the likelihood of U.S. jurisdiction over and enforcement of
judgments against a foreign custodian.49 This provision is
designed to allow the Foreign Custody Manager to consider various
factors, including whether a foreign custodian has branch offices in
the United States. The Foreign Custody Manager should evaluate other
jurisdictional and enforcement means such as whether the foreign
custodian has appointed an agent for service of process in the United
States or has consented to jurisdiction in this country. The Commission
recognizes that U.S. jurisdiction may not be obtainable over certain
foreign depositories and other custodians, and an affirmative finding
of U.S. jurisdiction would not be required. Rather, the existence or
absence of U.S. jurisdiction would have to be considered in making the
overall
[[Page 26929]]
determination that the custodian will provide reasonable care for fund
assets.
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\49\ Amended rule 17f-5(c)(1)(iv) (17 CFR 270.17f-5(c)(1)((iv)).
---------------------------------------------------------------------------
2. Foreign Custody Contract
Rule 17f-5 currently requires a fund's foreign custody arrangements
to be governed by a written contract that the fund's board determines
is in the best interests of the fund and which contains specified
provisions.50 The proposed amendments would have eliminated
the requirement that specific provisions be included in the contract
but would have required the Foreign Custody Manager to determine that
the contract would provide reasonable protection for fund assets.
Although a small number of commenters supported the proposed approach,
commenters generally favored retaining the contract requirements in the
rule as benefitting funds and their shareholders. The commenters
asserted, among other things, that the rule's requirements have
resulted in international standards for foreign custody agreements that
have served to protect investors.
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\50\ Rule 17f-5(a)(1)(iii). 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. Rule 17f-5(a)(1)(iii)(A) through (F).
---------------------------------------------------------------------------
In light of these comments, the Commission has concluded that the
amended rule should continue to require foreign custody arrangements to
be governed by a written contract. Consistent with the new standard for
evaluating foreign custody arrangements, the amended rule requires that
the Foreign Custody Manager determine that the contract will provide
reasonable care for fund assets.51 The amended rule also
retains the specific contract requirements.52 In addition,
the amended rule permits the contract to contain alternative provisions
in lieu of those specified in the rule. The Foreign Custody Manager
must determine that the alternative provisions, in their entirety, will
provide the same or a greater level of care and protection for fund
assets as the specified provisions, in their entirety.53
This change should provide funds and their custodians with the
flexibility to take advantage of innovations that are consistent with
investor protection. Finally, as discussed below, the specified
contract requirements have been modified to reflect commenters'
suggestions and staff interpretive positions.
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\51\ Reasonable care, in this context, would be determined by
reference to the same standards used in selecting the foreign
custodian.
\52\ Amended rule 17f-5(c)(2)(i) (17 CFR 270.17f-5(c)(2)(i)).
\53\ Amended rule 17f-5(c)(2)(ii) (17 CFR 270.17f-5(c)(2)(ii)).
---------------------------------------------------------------------------
a. Indemnification and Insurance
Rule 17f-5 currently requires the foreign custody contract to
provide that the fund will be adequately indemnified and its assets
adequately insured in the event of loss.54 This provision
has been interpreted as permitting the contract to provide for
indemnification (but not insurance) if the indemnification arrangements
would adequately protect the fund.55 In response to the
commenters' suggestions, the Commission has clarified the provision in
rule 17f-5 to reflect this interpretation.56 The amended
rule specifies that the contract must provide for indemnification or
insurance arrangements (or any combination of the foregoing) such that
the fund will be adequately protected against the risk of loss of
assets held in accordance with the contract.57
---------------------------------------------------------------------------
\54\ Rule 17f-5(a)(1)(iii)(A).
\55\ See Investment Company Institute (Nov. 4, 1987).
\56\ Amended rule 17f-5(c)(2)(i)(A) (17 CFR 270.17f-
5(c)(2)(i)(A)).
\57\ See Investment Company Institute, supra note 55.
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b. Liens
Rule 17f-5 currently requires the foreign custody contract to
provide that the fund's assets will not be subject to any right,
charge, security interest, lien or claim of any kind in favor of the
foreign custodian or its creditors except a claim of payment for the
safe custody or administration of the fund's assets.58
Commenters suggested that in many jurisdictions, cash deposits may
become subject to creditors' claims if a custodian becomes bankrupt.
The rule as amended addresses this issue by providing that the
prohibition against liens does not apply to cash deposits that may
become subject to creditors' claims or rights arising under bankruptcy,
insolvency, or other similar laws.59 If a fund places assets
with a custodian in a jurisdiction in which the deposits can become
subject to a lien, the Foreign Custody Manager should take this factor
into account in determining whether the foreign custodian has the
requisite financial strength to provide reasonable care for fund
assets, and in establishing monitoring procedures with respect to the
custodial arrangement.60 The Foreign Custody Manager, for
example, should consider adopting procedures for assuring that the
amount maintained in deposit accounts that could be subject to liens is
kept to a minimum or explore reasonable alternatives to cash deposits.
---------------------------------------------------------------------------
\58\ Rule 17f-5(a)(1)(iii)(B).
\59\ Amended rule 17f-5(c)(2)(i)(B) (17 CFR 270.17f-
5(c)(2)(i)(B)).
\60\ See infra Section III.C.3 of this Release.
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c. Omnibus Accounts
In an ``omnibus account'' structure, the assets of more than one
custodial customer are contained in an account that has been
established, typically by and in the name of an intermediary custodian,
with a foreign bank or securities depository. Rule 17f-5 currently
requires the foreign custody contract to provide that adequate records
will be maintained identifying the assets in foreign custody as
belonging to the fund.61 Although the Commission staff has
taken the position that the current rule does not prescribe a specific
manner for keeping custodial records, and therefore does not prohibit
omnibus accounts,62 several commenters recommended amending
the rule to specifically recognize the permissibility of omnibus
accounts.
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\61\ Rule 17f-5(a)(1)(iii)(D).
\62\ See State Street Bank & Trust Company (Feb. 28, 1995).
---------------------------------------------------------------------------
The amended rule provides that the custodian's records may either
identify the assets as belonging to the fund or as being held by a
third party for the benefit of the fund.63 The amended rule
therefore recognizes that in an omnibus account structure, the
securities depository's books may show that the custodian is the owner
of the fund's assets. The amended rule makes clear, however, that the
fund's interest in the account should be reflected on the books of the
custodian.64
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\63\ Amended rule 17f-5(c)(2)(i)(D) (17 CFR 270.17f-
5(c)(2)(i)(D)).
\64\ Id. A conforming change has been made to paragraph
(c)(2)(i)(F) of the rule, which requires that the fund receive
notice of any transfers of fund assets to or from the custodian.
This notice provision requires notice of transfers to or from third
party accounts. Amended rule 17f-5(c)(2)(i)(F) (17 CFR 270.17f-
5(c)(2)(i)(F)).
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d. Depository Arrangements
The Commission understands that foreign depository arrangements
typically are governed not by contract, but pursuant to rules or
practices of the depository.65 To accommodate the use
[[Page 26930]]
of these depositories, the Commission is amending rule 17f-5 to clarify
that the provisions required to be in the custody contract may be
reflected in the rules or established practices or procedures of the
depository, or in any combination of the foregoing.66
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\65\ Typically, the contractual arrangement pursuant to which
fund assets are held in a foreign depository involves an eligible
foreign bank that is itself a subcustodian of the fund's U.S.
custodian. Rule 17f-5 currently does not require the foreign
depository to be party to the fund's foreign custody contract. See
Proposing Release, supra note 5, at nn. 98-100 and accompanying
text.
\66\ Amended rule 17f-5(c)(2) (17 CFR 270.17f-5(c)(2)).
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3. Monitoring Custody Arrangements and Withdrawing Fund Assets
Rule 17f-5 currently contains detailed provisions concerning board
oversight and monitoring of foreign custodial
arrangements.67 The amended rule replaces these provisions
with a requirement that the Foreign Custody Manager establish a system
to monitor the appropriateness of maintaining the fund's assets with a
particular custodian and the fund's foreign custody
contract.68 Commenters supported these amendments.
---------------------------------------------------------------------------
\67\ Rule 17f-5(a) (2) through (4).
\68\ Amended rule 17f-5(c)(3)(i) (17 CFR 270.17f-5(c)(3)(i)).
---------------------------------------------------------------------------
If a foreign custody arrangement no longer meets the requirements
of the amended rule, the fund must withdraw its assets from the
custodian as soon as reasonably practicable.69 Rule 17f-5's
monitoring requirement is intended to result in the Foreign Custody
Manager receiving sufficient and timely information to permit it to
respond to material changes in the fund's foreign custody arrangement.
The amended rule focuses on the importance of taking prompt action
based on the circumstances presented. For example, a fund that places
substantially all of its assets with one custodian 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 in a particular country.
---------------------------------------------------------------------------
\69\ Amended rule 17f-5(c)(3)(ii) (17 CFR 270.17f-5(c)(3)(ii)).
Current rule 17f-5(a)(4) requires fund assets to be withdrawn within
180 days under these circumstances.
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D. Eligible Foreign Custodians
1. Foreign Banks and Trust Companies
Rule 17f-5 currently limits the class of ``eligible foreign
custodians'' to foreign banks and trust companies that have more than
$200 million in shareholders' equity and U.S. bank subsidiaries that
have more than $100 million in shareholders' equity.70 The
Commission proposed eliminating these requirements in favor of a more
flexible standard that allows the Foreign Custody Manager to take into
account all factors that affect the foreign custodian's financial
strength and its ability to provide custodial services, including
credit and market risks.71 Commenters strongly supported
these amendments.
---------------------------------------------------------------------------
\70\ Rule 17f-5(c)(2)(i), (ii).
\71\ See Proposing Release, supra note 5, at nn.124-126 and
accompanying text.
---------------------------------------------------------------------------
Under the amended rule, any foreign bank or trust company that is
subject to foreign bank or trust company regulation, as well as any
U.S. bank subsidiary, may be an eligible foreign
custodian.72 As discussed above, a custodian's financial
strength is an important factor to be considered in selecting a foreign
custodian. The amended rule requires the Foreign Custody Manager to
evaluate the financial strength of a foreign custodian in determining
whether the fund's assets will be subject to reasonable care if
maintained with that custodian.73
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\72\ Amended rule 17f-5(a)(1) (17 CFR 270.17f-5(a)(1)).
\73\ See supra Section III.C.1.b.ii of this Release.
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2. Affiliated Foreign Custodians
Rule 17f-5 currently does not address affiliated foreign custody
arrangements. Under the proposed amendments, eligible foreign banks and
trust companies would have been prohibited from being affiliated
persons of the fund or affiliated persons of such persons. The
Commission proposed this approach because rule 17f-2 under the
Investment Company Act, the rule that governs funds' self-custody
arrangements and has been interpreted by the Commission staff to apply
to affiliated custody arrangements, appeared to be unworkable in the
foreign custody context.74
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\74\ See Proposing Release, supra note 5, at n.138; Pegasus
Income and Capital Fund, Inc. (Dec. 31, 1977) (to guard against
potential abuses resulting from control over fund assets by related
persons, rule 17f-2 (17 CFR 270.17f-2) has been applied to
affiliated custody arrangements). Rule 17f-2 requires, among other
things, that fund assets 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), (e) (17 CFR 270.17f-2(b), (d), (e)).
---------------------------------------------------------------------------
Commenters generally disagreed with the proposed prohibition,
arguing that it would be particularly troublesome in certain markets
where there is a limited number of eligible custodians. In response to
these comments, and upon further consideration of the issue, the
Commission is not including the proposed prohibition on foreign
affiliated custody arrangements in rule 17f-5 as amended. The
Commission will consider the issues raised by foreign affiliated
custody arrangements when it considers comprehensive amendments to rule
17f-2.
The Commission understands, however, that a number of market
participants currently use arrangements involving an unaffiliated
primary custodian of the fund and a foreign sub-custodian that is
affiliated with the fund.75 The Commission is of the view
that such an arrangement, provided it is structured with appropriate
oversight and controls by the unaffiliated intermediary (i.e., the
primary custodian), may adequately address the concerns of self-
custody. The risks of misappropriation of fund assets are mitigated
when the custody arrangement is entered into by, and operated through,
an unaffiliated intermediary custodian and is subject to adequate
independent scrutiny.
---------------------------------------------------------------------------
\75\ See supra note 18 and accompanying text (discussing primary
custodians).
---------------------------------------------------------------------------
The Commission believes that this generally would be the case when
the fund's assets are held by the foreign sub-custodian in an omnibus
account in the name of the primary custodian, so as to preclude
specific identification of fund assets by the affiliated sub-custodian.
In addition, adequate involvement by an unaffiliated custodian would
require that the sub-custodian be permitted to settle transactions
involving fund assets solely on receipt of instructions from the
primary custodian (which, in turn, receives its instructions from the
fund).76 The primary custodian also should closely monitor
the fund's account to assure that unauthorized transactions have not
occurred, and the fund's auditors should review and test the monitoring
and control safeguards for fund assets.
---------------------------------------------------------------------------
\76\ The affiliated sub-custodian should not share personnel
with other affiliates of the fund (e.g., the fund's investment
adviser) to assure the integrity of the safeguards for fund assets.
---------------------------------------------------------------------------
3. Securities Depositories
Rule 17f-5 currently includes among eligible foreign custodians a
foreign securities depository or clearing agency that operates the only
system for the central handling of securities or equivalent book-
entries in a country (the ``only system requirement'').77
The only system requirement was designed to ensure a country's interest
in establishing and maintaining a depository's integrity. Because the
requirement has been unnecessarily restrictive, the Commission proposed
to eliminate it.78 Commenters uniformly supported the
proposed change.
---------------------------------------------------------------------------
\77\ Rule 17f-5(c)(2)(iii).
\78\ See Proposing Release, supra note 5, at nn.155-156 and
accompanying text.
---------------------------------------------------------------------------
The amended rule requires a securities depository or clearing
agency that acts as a system for the central
[[Page 26931]]
handling of securities or equivalent book-entries to be regulated by a
foreign financial regulatory authority.79 The Commission
believes that foreign regulation of a depository demonstrates a
country's interest in the depository's safety, thus achieving the
Commission's objective.
---------------------------------------------------------------------------
\79\ Amended rule 17f-5(a)(1)(ii) (17 CFR 270.17f-5(a)(1)(ii)).
Rule 17f-5 currently also includes among eligible foreign custodians
a security depository or clearing agency, incorporated or organized
under the laws of a country other than the United States, that
``operates'' a transnational system for the central handling of
securities or equivalent book-entries. The amended rule refers to
securities depositories or clearing agencies that ``act as'' such
transnational systems. Amended rule 17f-5(a)(1)(iii) (17 CFR
270.17f-5(a)(1)(iii). This change is intended to recognize that in
some instances the service provider that operates or administers the
transnational system may be organized under the laws of the United
States (e.g., as a foreign branch of a U.S. bank).
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E. Assets Maintained in Foreign Custody
Rule 17f-5 currently permits a fund to use foreign custody
arrangements for its foreign securities, cash, and cash
equivalents.80 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.81 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). In addition, rule 17f-5
currently limits the cash and cash equivalents that a fund may maintain
outside the United States to amounts that are reasonably necessary to
effect the fund's foreign securities transactions.82
---------------------------------------------------------------------------
\80\ Rule 17f-5(a).
\81\ Rule 17f-5(c)(1).
\82\ Rule 17f-5(a).
---------------------------------------------------------------------------
The Proposing Release requested comment whether the rule should
continue to restrict the types of securities and amounts of cash and
cash equivalents that a fund may maintain outside the United States.
One commenter suggested that this provision may not permit a fund to
maintain investments in other assets, such as foreign currencies, for
which the primary market is outside of the United States. To better
reflect these types of investment practices, the amended rule permits a
fund to maintain in foreign custody any investment (including foreign
currencies) for which the primary market is outside the United
States.83
---------------------------------------------------------------------------
\83\ Amended rule 17f-5(c) (17 CFR 270.17f-5(c)). As a result of
this change, the rule no longer refers to ``foreign securities''
(which had been defined as securities ``issued and sold primarily
outside of the United States''). The ``primary market'' formulation
is designed to encompass foreign securities as well as other types
of investments.
---------------------------------------------------------------------------
F. Canadian Funds
Rule 17f-5 currently contains special provisions governing the
foreign custody arrangements of Canadian funds registered in the United
States.84 To address jurisdictional concerns underlying
section 7(d) of the Act, these provisions are more restrictive than
those applied to U.S. funds and allow Canadian funds to maintain their
assets only in overseas branches of U.S. banks.85 Because
Canadian funds have not sought to register under the Act for some time,
and very few Canadian funds currently offer their shares in the United
States, the proposed amendments would have made limited conforming
changes in the foreign custody requirements applicable to Canadian
funds.
---------------------------------------------------------------------------
\84\ Rule 174f-5(b)
\85\ Section 7(d) of the Investment Company Act (15 U.S.C. 80a-
7(d)) prohibits foreign investment companies from publicly offering
their securities in the United States unless the Commission issues
an order permitting registration under the Act. Rule 7d-1 under the
Investment Company Act (17 CFR 270.7d-1) sets forth conditions
governing applications by Canadian funds that seek Commission orders
pursuant to section 7(d). 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) (17 CFR 270.7d-1(b)(8)(v)).
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The Commission received one comment letter addressing Canadian
funds. The commenter suggested that Canadian funds be permitted to use
foreign custody arrangements on the same basis as their U.S.
counterparts. The amended rule generally reflects this approach. As
under the current rule, however, a Canadian fund's assets must be kept
in the custody of an overseas branch of a U.S. bank. In addition, if
the Canadian fund's board delegates its responsibilities under the
rule, the only permissible delegates are the fund's officers,
investment adviser or a U.S. bank.86
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\86\ Amended rule 17f-5(d) (1), (2) (17 CFR 270.17f-5(d) (1),
(2)).
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IV. Effective Date; Compliance Dates
The amendments to rule 17f-5 become effective thirty days after
publication in the Federal Register. Funds that wish to rely on the
amended rule prior to the effective date of the amendments may do so.
Funds that have established foreign custody arrangements in accordance
with rule 17f-5 prior to the effective date of these amendments
(``existing foreign custody arrangements'') must bring these
arrangements into compliance with the amended rule (i.e., have the
fund's board make the findings required by the amended rule or appoint
a delegate to do so) within one year of the effective date of these
amendments. The one year period is designed to give funds the
flexibility to bring an existing foreign custody arrangement into
compliance with the amended rule either when that arrangement would
have been subject to the fund board's annual review, as was required by
the rule before these amendments, or at any board meeting within the
one year period.
V. Cost/Benefit Analysis and Effects on Competition, Efficiency and
Capital Formation
The amendments to rule 17f-5 seek to give funds greater flexibility
in their foreign custody arrangements consistent with investor
protection. The amended rule permits a fund's board to delegate its
responsibilities to select and monitor a fund's foreign custody
arrangements and no longer requires the board to approve these
arrangements annually. The amended rule does require delegates to
provide fund boards with written reports regarding certain aspects of
the foreign custody arrangements. This requirement is designed to
facilitate board oversight and protect fund shareholders. The potential
costs associated with this requirement are not expected to be
significant, and are likely to be much less than the costs associated
with the current requirement of providing fund boards with information
pertaining to their annual review of foreign custody arrangements.
The amendments also expand the class of foreign banks and
securities depositories that may serve as custodians of fund assets
overseas. These amendments give funds greater flexibility in selecting
foreign custodians and eliminate the need for funds to request
administrative relief for certain foreign custody arrangements.
Section 2(c) of the Investment Company Act provides that whenever
the Commission is engaged in rulemaking and is required to consider or
determine whether an action is necessary or appropriate in the public
interest, the Commission must consider, in addition to the protection
of investors, whether the action will promote efficiency, competition,
and capital formation.87 The Commission has considered the
amendments to rule 17f-5 in light of these standards. The Commission
believes that the amendments are consistent with the public interest
and will promote efficiency and competition because the amendments (i)
permit fund directors to
[[Page 26932]]
play a more traditional oversight role with respect to the custody of
fund assets overseas, (ii) better focus the scope of the rule on
safekeeping considerations, and (iii) expand the class of eligible
foreign banks and securities depositories that may serve as custodians
of fund assets. The Commission also believes that the amendments will
have no adverse effect on capital formation.
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\87\ 15 U.S.C. 80a--2(c).
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VI. Summary of Final Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis, which was
prepared in accordance with 5 U.S.C. 603, was published in Investment
Company Act Release No. 21259. No comments were received on that
Analysis. The Commission has prepared a Final Regulatory Flexibility
Analysis (``FRFA'') in accordance with 5 U.S.C. 604. The FRFA states
that the objective of the amendments is to give funds greater
flexibility in their foreign custody arrangements by permitting fund
boards to delegate their responsibilities to select and monitor foreign
custodians, and by expanding the class of eligible foreign custodians.
The FRFA provides that approximately 194 funds and 242 investment
advisers that are small entities may be effected by the amendments. The
FRFA explains that the amendments seek to reduce burdens on all funds,
including those that are small entities, and that the amended rule's
compliance requirements are necessary for the safekeeping of fund
assets and investor protection. Finally, the FRFA states that in
adopting the amendments the Commission considered (a) the establishment
of differing compliance requirements that take into account the
resources available to small entities; (b) simplification of the rule's
requirements for small entities; (c) the use of performance rather than
design standards; and (d) an exemption from the rule for small
entities. The FRFA states that the Commission concluded that different
requirements for small entities are not necessary and would be
inconsistent with investor protection, and that the amended rule
incorporates performance standards to the extent practicable. Cost-
benefit information reflected in the ``Cost/Benefit Analysis'' section
of this Release also is reflected in the FRFA. A copy of the FRFA may
be obtained by contacting Robin S. Gross, Mail Stop 10-2, Securities
and Exchange Commission, 450 Fifth Street, NW., Washington, DC. 20549.
VII. Paperwork Reduction Act
The amendments to rule 17f-5, among other things (i) permit a
fund's board of directors to delegate its responsibilities under the
rule upon a finding that it is reasonable to rely on the delegate to
perform the delegated responsibilities, and (ii) require the delegate
to notify the board of the placement of the fund's assets with a
particular foreign custodian and of any material change in the fund's
foreign custody arrangements. These provisions constitute a
``collection of information'' requirement within the meaning of the
Paperwork Reduction Act of 1995 (44 U.S.C. 3501), because making the
finding and providing the notices are necessary to be able to rely on
the amended rule for foreign custody arrangements. An agency may not
conduct or sponsor, and a person is not required to respond to, a
collection of information unless it displays a currently valid control
number.
Accordingly, the Commission submitted the proposed amendments to
the Office of Management and Budget (``OMB'') pursuant to 44 U.S.C.
3507 and received approval of the amendments'' ``collection of
information'' requirements (OMB control number 3235-0269). As discussed
in section III.A. of this Release, the Commission has determined not to
adopt the proposed amendment requiring a fund's board to make a finding
that placing fund assets in a particular country would provide
reasonable protection for fund assets. The Commission believes that
this is not a material change for purposes of collection of information
requirements and will not have any impact on the Commission's estimate
of total burden hours. The amended rule does not require that the
collection of information be made public or kept confidential by the
parties; to the extent that the Commission obtains access to the
collection of information through its inspection program, the
information generally would not be available to third parties.
VIII. Statutory Authority
The Commission is amending 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. 80a-6(c), 80a-37(a)).
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Rule
For the reasons set out in the preamble, Title 17, Chapter II of
the Code of Federal Regulations is 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. Section 270.17f-5 is revised to read as follows:
Sec. 270.17f-5. Custody of investment company assets outside the
United States.
(a) Definitions. For purposes of this section:
(1) 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 Qualified Foreign Bank or a majority-owned direct or indirect
subsidiary of a U.S. Bank or bank-holding company;
(ii) A securities depository or clearing agency that acts as 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 2(a)(50) of the Act (15
U.S.C. 80a-2(a)(50)); or
(iii) A securities depository or clearing agency that acts as a
transnational system for the central handling of securities or
equivalent book-entries.
(2) Foreign Custody Manager means a Fund's or a Registered Canadian
Fund's board of directors or any person serving as the board's delegate
under paragraphs (b) or (d) of this section.
(3) Fund means a management investment company registered under the
Act (15 U.S.C. 80a) and incorporated or organized under the laws of the
United States or of a state.
(4) 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 of the country's government.
(5) Registered Canadian Fund means a 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.
(6) Securities Depository means a system for the central handling
of securities as defined in Sec. 270.17f-4(a).
(7) U.S. Bank means an entity that is:
(i) A banking institution organized under the laws of the United
States;
[[Page 26933]]
(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 (a)(7)(i), (ii), or (iii) of
this section.
(b) Delegation. A Fund's board of directors may delegate to the
Fund's investment adviser or officers or to a U.S. Bank or to a
Qualified Foreign Bank the responsibilities set forth in paragraphs
(c)(1), (c)(2), or (c)(3) of this section, provided that:
(1) The board determines that it is reasonable to rely on the
delegate to perform the delegated responsibilities;
(2) The board requires the delegate to provide written reports
notifying the board of the placement of the Fund's assets with a
particular custodian and of any material change in the Fund's
arrangements, with the reports to be provided to the board at such
times as the board deems reasonable and appropriate based on the
circumstances of the Fund's foreign custody arrangements; and
(3) The delegate agrees to exercise reasonable care, prudence and
diligence such as a person having responsibility for the safekeeping of
Fund assets would exercise, or to adhere to a higher standard of care,
in performing the delegated responsibilities.
(c) Selecting an Eligible Foreign Custodian. A Fund may place and
maintain in the care of an Eligible Foreign Custodian any investments
(including foreign currencies) for which the primary market is outside
the United States, and such cash and cash equivalents as are reasonably
necessary to effect the Fund's transactions in such investments,
provided that:
(1) The Foreign Custody Manager determines that the Fund's assets
will be subject to reasonable care, based on the standards applicable
to custodians in the relevant market, if maintained with the custodian,
after considering all factors relevant to the safekeeping of such
assets, including, without limitation:
(i) The custodian's practices, procedures, and internal controls,
including, but not limited to, the physical protections available for
certificated securities (if applicable), the method of keeping
custodial records, and the security and data protection practices;
(ii) Whether the custodian has the requisite financial strength to
provide reasonable care for Fund assets;
(iii) The custodian's general reputation and standing and, in the
case of a Securities Depository, the depository's operating history and
number of participants; and
(iv) Whether the Fund 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.
(2) Contract. The Fund's foreign custody arrangements must be
governed by a written contract (or, in the case of a Securities
Depository, by such a contract, by the rules or established practices
or procedures of the depository, or by any combination of the
foregoing) that the Foreign Custody Manager has determined will provide
reasonable care for Fund assets based on the standards specified in
paragraph (c)(1) of this section.
(i) Such contract shall include provisions that provide:
(A) For indemnification or insurance arrangements (or any
combination of the foregoing) such that the Fund will be adequately
protected against the risk of loss of assets held in accordance with
such contract;
(B) That the Fund's assets will not be subject to any right,
charge, security interest, lien or claim of any kind in favor of the
custodian or its creditors except a claim of payment for their safe
custody or administration or, in the case of cash deposits, liens or
rights in favor of creditors of the custodian arising under bankruptcy,
insolvency, or similar laws;
(C) That beneficial ownership for the Fund's assets will be freely
transferable without the payment of money or value other than for safe
custody or administration;
(D) That adequate records will be maintained identifying the assets
as belonging to the Fund or as being held by a third party for the
benefit of the Fund;
(E) That the Fund's independent public accountants will be given
access to those records or confirmation of the contents of those
records; and
(F) That the Fund will receive periodic reports with respect to the
safekeeping of the Fund's assets, including, but not limited to,
notification of any transfer to or from the Fund's account or a third
party account containing assets held for the benefit of the Fund.
(ii) Such contract may contain, in lieu of any or all of the
provisions specified in paragraph (c)(2)(i) of this section, such other
provisions that the Foreign Custody Manager determines will provide, in
their entirety, the same or a greater level of care and protection for
Fund assets as the specified provisions, in their entirety.
(3)(i) Monitoring the Foreign Custody Arrangements. The Foreign
Custody Manager must have established a system to monitor the
appropriateness of maintaining the Fund's assets with a particular
custodian under paragraph (c)(1) of this section, and the contract
governing the Fund's arrangements under paragraph (c)(2) of this
section.
(ii) If an arrangement no longer meets the requirements of this
section, the Fund must withdraw its assets from the custodian as soon
as reasonably practicable.
(d) Registered Canadian Funds. Any Registered Canadian Fund may
place and maintain outside the United States any investments (including
foreign currencies) for which the primary market is outside the United
States, and such cash and cash equivalents as are reasonably necessary
to effect the Fund's transactions in such investments, in accordance
with the requirements of this section, provided that:
(1) The assets are placed in the care of an overseas branch of a
U.S. Bank that has aggregate capital, surplus, and undivided profits of
a specified amount, which must not be less than $500,000; and
(2) The Foreign Custody Manager is the Fund's board of directors,
its investment adviser or officers, or a U.S. Bank.
May 12, 1997.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 97-12881 Filed 5-15-97; 8:45 am]
BILLING CODE 8010-01-P