[Federal Register Volume 65, Number 86 (Wednesday, May 3, 2000)]
[Rules and Regulations]
[Pages 25630-25639]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-11000]



[[Page 25630]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release Nos. IC-24424, IS-1221; File No. S7-15-99]
RIN 3235-AH55


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 a new rule and rule amendments 
under the Investment Company Act to address the custody of investment 
company assets outside the United States. The rule and rule amendments 
establish new standards governing the maintenance of an investment 
company's assets with a foreign securities depository. These standards 
are designed to provide a framework under which an investment company 
can protect its assets while maintaining them with a foreign securities 
depository.

DATES: Effective Date: June 12, 2000. Compliance Date: July 2, 2001. 
Section III of this release contains more information on transition 
prior to the compliance date.

FOR FURTHER INFORMATION CONTACT: Jaea F. Hahn, Attorney, Office of 
Regulatory Policy, at (202) 942-0690, or Thomas M.J. Kerwin, Senior 
Counsel, at (202) 942-0660, in the Division of Investment Management, 
Securities and Exchange Commission, 450 5th Street NW, Washington DC 
20549-0506.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission 
(``Commission'') today is adopting new rule 17f-7 [to be codified at 17 
CFR 270.17f-7], amendments to rule 17f-5 [17 CFR 270.17f-5] and 
conforming amendments to rule 7d-1 [17 CFR 270.7d-1] and rule 17f-4 [17 
CFR 270.17f-4] under the Investment Company Act of 1940 [15 U.S.C. 80a] 
(the ``Investment Company Act'').\1\
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    \1\ Unless otherwise noted, all references to rules 17f-5, 17f-
4, and 7d-1 (or any paragraph of those rules) will be to 17 CFR 
270.17f-5, 270.17f-4, and 270.7d-1, as amended by this release.
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Table of Contents

Executive Summary

I. Background
II. Discussion
    A. Foreign Securities Depositories: Rule 17f-7
    1. Eligible Securities Depository
    2. Risk Analysis, Monitoring and Notification
    3. Exercise of Care
    B. Foreign Bank Custodians: Rule 17f-5
    C. Conforming Amendments
III. Effective Date
IV. Cost-Benefit Analysis
V. Effects on Efficiency, Competition and Capital Formation
VI. Paperwork Reduction Act
    A. New Rule 17f-7
    B. Amendments to Rule 17f-5
VII. Summary of Final Regulatory Flexibility Analysis
    A. Need for and Objectives of the Rule and Rule Amendments
    B. Significant Issues Raised by Public Comments
    C. Small Entities Subject to the Rules
    D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    E. Agency Action to Minimize Effects on Small Entities
VIII. Statutory Authority

Text of Rules

Executive Summary

    The Commission is adopting new rule 17f-7 under the Investment 
Company Act and amendments to rule 17f-5, the rule that governs the 
custody of the assets of registered management investment companies 
(``funds'') with custodians outside the United States. The new rule and 
rule amendments will permit funds to maintain their assets in foreign 
securities depositories based on conditions that reflect the operations 
and role of these depositories. Depositories are systems for the 
central handling of securities in which transactions in securities are 
processed through adjustment of electronic account records rather than 
delivery of certificates.
    The rule and amendments we are adopting today establish basic 
standards for foreign depositories that funds may use, and generally 
require that a fund's contract with its global custodian obligate the 
custodian to analyze and monitor the custody risks of using a 
depository, and provide information about the risks to the fund or its 
adviser, as well as any information regarding material changes in the 
risks. Unlike amended rule 17f-5, rule 17f-7 does not contain any 
provisions regarding the delegation of authority under the rule. 
Decisions to maintain assets with a depository would be made by the 
fund or its adviser, based upon information provided by the global 
custodian.

I. Background

    Rule 17f-5 was adopted in 1984,\2\ and extensively revised in 1997 
(``1997 Amendments'') to reflect significant developments in foreign 
investment by U.S. funds and the Commission's greater experience with 
foreign custody arrangements.\3\ The 1997 Amendments expanded the types 
of foreign banks and securities depositories that may serve as 
custodians of fund assets, and required that the selection of a foreign 
custodian be based on whether the fund's assets will be subject to 
reasonable care if maintained with that custodian.\4\ In 1998, as a 
result of difficulties experienced by funds, their advisers and bank 
custodians in applying the standards of rule 17f-5 to the use of 
foreign depositories, representatives of funds asked the Commission to 
delay the compliance date for the 1997 Amendments.\5\ The Commission 
suspended the compliance date for most of the 1997 Amendments in May 
1998.\6\ Representatives of funds and bank custodians then submitted a 
proposal to further amend rule 17f-5 to change the standards by which 
foreign depositories are evaluated.\7\
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    \2\ See 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)]. Section 17(f) of the 
Investment Company Act, which governs fund custody arrangements, 
does not address the use of a foreign custodian. The Commission 
adopted rule 17f-5 under its exemptive authority in section 6(c) of 
the Act [15 U.S.C. 80a-6(c)] and under its authority in section 
38(a) of the Act [15 U.S.C. 80a-38(a)].
    \3\ See Custody of Investment Company Assets Outside the United 
States, Investment Company Act Release No. 22658 (May 12, 1997) [62 
FR 26923 (May 16, 1997)] (the ``1997 Release'').
    \4\ See Custody of Investment Company Assets Outside the United 
States, Investment Company Act Release No. 23815 (Apr. 29, 1999) [64 
FR 24489 (May 6, 1999)] (the ``Proposing Release''), at nn.4-10 and 
accompanying text.
    \5\ The history of rule 17f-5 is discussed in greater detail in 
the introductory section of the Proposing Release. See Proposing 
Release, supra note 4, at nn.2-17 and accompanying text.
    \6\ See Custody of Investment Company Assets Outside the United 
States, Investment Company Act Release No. 23201 (May 21, 1998) [63 
FR 29345 (May 29, 1998)]. A further extension remains in effect 
today. See Custody of Investment Company Assets Outside the United 
States; Extension of Compliance Date, Investment Company Act Release 
No. 23814 (Apr. 29, 1999) [64 FR 24488 (May 6, 1999)] (extending 
compliance date until the Commission acts on 1999 proposals or May 
1, 2000). The compliance date for the amended definition of 
``eligible foreign custodian'' remained June 16, 1998. Compliance 
with the 1997 Amendments will become moot when amended rule 17f-5 
and new rule 17f-7 take effect. See infra notes 38 to 40 and 
accompanying text (discussing effective date and compliance date for 
amended rule and new rule; prior to the compliance date, a fund may 
comply with the 1997 Amendments or follow other compliance options).
    \7\ See Proposing Release, supra note 4, at nn.13 & 15 and 
accompanying text. The submitted proposal (the ``ICI/Bank 
Proposal'') would have deemed fund assets maintained with a 
depository to be subject to reasonable care if eight objective 
criteria were met. See id. at n.16. Under a revised joint proposal 
submitted in 1999, the foreign custody manager would have (i) 
considered other information known to it that established certain 
compliance problems, and (ii) monitored depository arrangements for 
material changes. See id.

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    Last year, we proposed amendments to rule 17f-5 and a new rule 17f-
7.\8\ We received letters from seven commenters on the proposals.\9\ 
Commenters generally favored the proposals, but also recommended 
changes.\10\ We are adopting new rule 17f-7 with modifications that 
respond to certain of the issues raised by commenters; we are adopting 
the amendments to rule 17f-5 substantially as proposed.\11\
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    \8\ See Proposing Release, supra note 4.
    \9\ The commenters included an individual attorney, an 
investment adviser, a bank custodian, a depository operator, two 
trade associations and a bar association. The comment letters and a 
summary of the comments prepared by the Commission staff are 
available in the Commission's Public Reference Room, 450 5th Street, 
NW, Washington, DC (File No. S7-15-99).
    \10\ Commenters representing the bank custodians and the 
Investment Company Institute expressed a preference for the ICI/Bank 
Proposal. As we noted in the Proposing Release, we did not believe 
the ICI/Bank Proposal would adequately resolve the issues raised 
because the reliance on limited objective criteria may not 
adequately identify the potential risks of depository arrangements 
in a changing global marketplace. In addition, we were concerned 
that the ICI/Bank Proposal might unduly narrow the evaluation of 
potential risks and reduce incentives to provide relevant 
information to funds. See Proposing Release, supra note 4, at n.19 
and accompanying text.
    \11\ We are also adopting conforming amendments to rules 7d-1 
and 17f-4 substantially as proposed.
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II. Discussion

A. Foreign Securities Depositories: Rule 17f-7
    New rule 17f-7 permits a fund to maintain assets with a foreign 
securities depository if certain conditions are met. First, the 
depository must be an ``eligible securities depository'' as described 
below. Second, the fund's ``primary custodian'' must provide the fund 
or its adviser with an analysis of the custodial risks of using the 
depository, monitor the depository on a continuing basis and notify the 
fund of any material changes in risks associated with using the 
depository. The rule defines a primary custodian (often referred to as 
a ``global custodian'') as a U.S. bank or qualified foreign bank (as 
defined by rule 17f-5) that contracts directly with the fund to provide 
custodial services for foreign assets.\12\
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    \12\ See rule 17f-7(b)(2). One commenter noted that some funds 
may not contract directly with the custodian that is primarily 
responsible for global custody arrangements. Instead, a fund may 
contract with a domestic custodian that subcontracts with a global 
custodian to handle the fund's foreign custody arrangements. The 
risk analysis and monitoring requirements of rule 17f-7 reflect 
these alternative arrangements by providing that the Primary 
Custodian ``or its agent'' (i.e., the global custodian) may furnish 
the information required by the rule. See rule 17f-7(a)(1)(i).
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    1. Eligible Securities Depository. Under the rule, funds and their 
custodians may maintain their assets with a foreign securities 
depository only if it is an ``Eligible Securities Depository.'' An 
eligible securities depository must act as or operate a system for the 
central handling of securities that is regulated by a foreign financial 
regulatory authority.\13\ In addition, an eligible securities 
depository must: \14\
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    \13\ See rule 17f-7(b)(1)(i) and (ii). As proposed, the 
definition of eligible securities depository would have applied only 
to the depository system itself. At one commenter's suggestion, we 
have expanded the definition of eligible securities depository to 
include the operator of a depository system.
    \14\ See rule 17f-7(b)(1)(iii) to (vi). The following 
requirements reflect five of the eight requirements suggested in the 
ICI/Bank Proposal. See supra note 7.
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     (Hold assets on behalf of the fund under safekeeping 
conditions no less favorable than those that apply to other 
participants; \15\
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    \15\ As proposed, rule 17f-7 would have required an eligible 
securities depository to treat a fund no less favorably than other 
participants with respect to all conditions generally, rather than 
``safekeeping'' conditions. Two commenters suggested that the rule 
should permit different business conditions, such as different 
credit terms or volume-adjusted fees, because they do not imply 
different levels of safekeeping protection. We agree with this point 
and have modified the rule accordingly. See rule 17f-7(b)(1)(iii).
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     (Maintain records that identify the assets of 
participants, and keep its own assets separated from the assets of 
participants;
     (Provide periodic reports to participants; and
     (Undergo periodic examination by regulatory authorities or 
independent accountants.\16\
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    \16\ As proposed, rule 17f-7 would have required an eligible 
securities depository to be subject to periodic ``review,'' rather 
than ``examination,'' by regulators or auditors. The change in the 
final rule is intended to distinguish this requirement from the 
requirement that a foreign financial regulatory authority regulate 
the depository. See rule 17f-7(b)(1)(vi).
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    The proposed rule included within the definition of eligible 
securities depository certain foreign transfer agents that perform 
custodial functions analogous to those of a depository.\17\ Commenters 
urged that the rule not address these types of arrangements, which are 
found in countries such as Russia and Ukraine.\18\ Commenters pointed 
out that while some transfer agents may be analogous to securities 
depositories, others clearly are not, and some transfer agents perform 
some but not all the functions of a depository. We have decided to 
accept the recommendations of these commenters, and will continue to 
address the use of these transfer agents on a case-by-case basis.\19\
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    \17\ See Proposing Release, supra note 4, at nn.32-34 and 
accompanying text. Interpretations by Commission staff have treated 
U.S.-based transfer agents as depositories when they maintain 
records of the ownership of uncertificated securities not held in a 
conventional depository. See, e.g., American Pension Investors 
Trust, SEC No-Action Letter (Feb. 1, 1991) (custodian for fund of 
funds could maintain fund's investments in uncertificated shares of 
underlying funds with the domestic transfer agents of those funds 
acting as deemed depositories); FundVest, SEC No-Action Letter (Nov. 
21, 1984) (similar position).
    \18\ In the case of Russia, for example, hundreds of registrars 
typically are used to record securities transfers. See Proposing 
Release, supra note 4, at n.33 and accompanying text.
    \19\ In urging the Commission to continue to address the use of 
transfer agents on a case-by-case basis, commenters suggested that 
it would be burdensome to obtain a risk analysis of the many 
transfer agents (such as the registrars in Russia) that funds might 
use, and that transfer agents may not meet all of the requirements 
of an eligible securities depository. We note, however, that the 
staff provided no-action assurance in the past to allow funds to 
hold assets with foreign transfer agents that perform some custodial 
functions, based upon representations that the transfer agents would 
be subject to similar oversight. Those no-action letters were issued 
in reliance on representations that, among other things, the 
transfer agents' activities would be monitored, independent auditors 
would verify the share registry, and the fund's board of directors 
would receive quarterly reports. See, e.g., Templeton Russia Fund, 
Inc., SEC No-Action Letter (Apr. 18, 1995) and Russia Growth Fund, 
Inc., SEC No-Action Letter (May 20, 1997). Because rule 17f-7 does 
not address the use of foreign transfer agents, funds should 
continue to follow the applicable no-action letters or exemptive 
relief on which they rely to hold assets with those transfer agents.
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    2. Risk Analysis, Monitoring and Notification. The definitional 
requirements for an eligible securities depository described above are 
minimum requirements that all foreign securities depositories must meet 
before a fund may rely on the rule to place fund assets with them. We 
also are adopting, as a condition for use of the rule, a requirement 
that the custody risks of using the eligible securities depository be 
analyzed and monitored by the primary custodian or its agent.
    Rule 17f-7 requires that a fund's primary custodian \20\ furnish 
the fund or its investment adviser an analysis of the custody risks of 
using an eligible securities depository before the fund places its 
assets with the depository.\21\ The fund's contract with its primary 
custodian also must require the custodian to monitor these risks on a

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continuing basis,\22\ and promptly notify the fund or its adviser of 
any material change.\23\
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    \20\ See rule 17f-7(a)(1)(i)(A). A local subcustodian or other 
agent may prepare the initial risk analysis on behalf of the primary 
custodian.
    \21\ See id. We recognize that in certain emergency 
circumstances a fund may need to move its assets to a depository in 
order to protect its assets before a risk analysis of the new 
depository can be prepared. In those circumstances, we would expect 
the initial risk analysis of the new depository to be provided as 
soon as possible after the fund places its assets with that 
depository. See infra ``Part III. Effective Date,'' for a discussion 
of the treatment of fund assets in the custody of a foreign 
securities depository before the fund's depository arrangements are 
subject to the requirements of rule 17f-7.
    \22\ See rule 17f-7(a)(1)(i)(B). The proposed rule would have 
required the primary custodian to ``continuously'' monitor the 
custody risks of using a foreign depository. One commenter argued 
that the term ``continuously'' could imply that the primary 
custodian must learn of material changes affecting a depository more 
quickly than it learns of developments affecting other subcustodians 
such as a foreign bank. As adopted, rule 17f-7 mirrors a requirement 
imposed in the United Kingdom that custodians be subject to a 
``continuing risk assessment.'' See United Kingdom Securities and 
Futures Authority, Board Notice 433, New Safekeeping Rules, Custody 
Rule 4-107(1), Assessment of Custodian (July 21, 1997) (after a firm 
makes an appropriate risk assessment of an eligible custodian, it 
must undertake a ``continuing risk assessment''). The requirement 
that monitoring of custody risk occur on a ``continuing basis'' 
better reflects the Commission's view, expressed in the Proposing 
Release, that there should be an ongoing assessment of the custody 
risks associated with a depository, and that the level of this 
monitoring should be based on the specific facts and circumstances 
related to the foreign depository and the country in which the 
depository operates. See Proposing Release, supra note 4, at nn.38-
43 and accompanying text. As with the preparation of the initial 
risk analysis, a local subcustodian or other agent may monitor 
custody risks on behalf of the primary custodian.
    \23\ A commenter suggested that a primary custodian should be 
permitted to suspend its monitoring and notification activities if 
political developments or other circumstances interfere with these 
obligations. The Commission anticipates that exceptional 
developments will be addressed in a report to the fund and that the 
primary custodian, in performing its duties under the contract, will 
make a reasonable effort to continue to monitor further developments 
or to resume monitoring as soon as practicable in these 
circumstances.
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    We have written the risk analysis requirements of the rule broadly 
to provide custodians with flexibility to tailor the risk analysis to 
the specific risks involved in the use of each particular 
depository.\24\ The rule does not prescribe specific factors or types 
of risk to be considered in a risk analysis. As a general matter we 
expect that an analysis will cover a depository's expertise and market 
reputation, the quality of its services, its financial strength,\25\ 
any insurance or indemnification arrangements, the extent and quality 
of regulation and independent examination of the depository,\26\ its 
standing in published ratings, its internal controls and other 
procedures for safeguarding investments, and any related legal 
protections.
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    \24\ One commenter pointed out that certain transnational 
depositories may perform depository and global custodial functions. 
Under the rule, the risk analysis of a transnational depository that 
also performs custodial functions should take into consideration any 
information reasonably available to the primary custodian from the 
depository regarding its custodial network (e.g., the local bank 
subcustodian's internal controls, financial strength, and 
information regarding enforceability of judgments).
    \25\ Relevant measures of financial strength might include the 
level of settlement guarantee funds, collateral requirements, lines 
of credit, or insurance as compared with participants' daily 
settlement obligations.
    \26\ This factor relates to requirements under the definition of 
an eligible securities depository.
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    Rule 17f-7 does not assign a role to the investment adviser or fund 
board, but is designed to assure that sufficient material information 
about depositories is provided to the fund or adviser in a timely 
manner. The decision whether to place fund assets with a depository 
should be made by the adviser (subject to oversight of the fund's 
board) or the fund, after consideration of the information provided by 
the primary custodian or its agent,\27\ and based on standards of care 
that are generally applicable to fund advisers and directors.\28\ The 
decision to place fund assets with a depository does not have to be 
made separately, but may be made in the overall context of the decision 
to invest in a particular country.
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    \27\ We recognize that fund boards do not typically have the 
expertise to make day-to-day decisions regarding foreign depository 
arrangements, and we assume that a fund board will delegate these 
responsibilities to the fund's adviser, subject to the board's 
general oversight, even though the rule does not require delegation. 
As we stated in the Proposing Release, when custodial risks are a 
material factor in the decision to enter or exit a market, we would 
expect the adviser to inform the board of the risks based on the 
risk analysis and other information provided by the primary 
custodian or its agent. See Proposing Release, supra note 4, at 
nn.51-53 and accompanying text.
    \28\ These standards generally require the exercise of care, but 
do not set limits on the risks that a fund or its adviser may find 
acceptable for the fund's depository arrangements.
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    As proposed, rule 17f-7 would have permitted a fund to rely on 
indemnification or insurance that adequately protects the fund from all 
custody risks of using the depository, as an alternative to the risk 
analysis and monitoring requirement.\29\ Several commenters urged that 
we not adopt this alternative, and pointed out that, if we did, they 
would need guidance on the scope and amount of indemnification adequate 
to meet the requirements of the rule.\30\ In light of the issues raised 
by commenters and the likelihood that this alternative would not be 
used by funds, we have decided not to adopt it. Instead, as noted 
above, we suggest that insurance and indemnification arrangements are 
factors that a risk analysis would cover.\31\
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    \29\ See Proposing Release, supra note 4, at text accompanying 
nn.35-37.
    \30\ Some commenters said that guidance would be needed on 
whether the rule would allow for common insurance exclusions (such 
as insurrection, natural disasters, or governmental action). Some 
commenters also suggested that coverage against negligence by a 
depository (as distinguished from larceny or embezzlement) might be 
unavailable or prohibitively expensive, and that reasonable coverage 
limits and deductible amounts would need to be defined.
    \31\ For example, the primary custodian could determine that 
certain risks are mitigated by indemnification or insurance.
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    3. Exercise of Care. Rule 17f-7 requires the fund's contract with 
its primary custodian to provide that the primary custodian will agree 
to exercise reasonable care, prudence and diligence in performing its 
duties under the rule, or adhere to a higher standard of care.\32\ This 
standard of care is the same required of foreign custody managers under 
rule 17f-5,\33\ and is similar to standards for U.S. custodians under 
commercial law. \34\
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    \32\ See rule 17f-7(a)(1)(ii). As proposed, rule 17f-7 also 
would have required the custodian or subcustodian to agree to 
exercise reasonable care in ``all other conduct relating to custody 
arrangements.'' The rule as adopted does not include this latter 
provision because, as one commenter pointed out, it would broadly 
apply to some custody activities that may be unrelated to the use of 
a depository (e.g., activities not related to analysis of the 
depository and monitoring of risks).
    \33\ See rule 17f-5(b)(3).
    \34\ See Uniform Commercial Code, Sec. 8-504 and cmt. 3, and 
Sec. 8-509 (1994) (securities intermediary must perform its duties 
under the Code, including duties to follow certain procedures in 
maintaining financial assets and to exercise care in selecting 
subcustodians, with ``due care in accordance with reasonable 
commercial standards,'' unless modified by regulatory requirements 
or contractual provisions that meet a ``good faith'' standard).
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B. Foreign Bank Custodians: 
Rule 17f-5
    Amended rule 17f-5 will continue to govern a fund's use of a 
foreign bank custodian. As amended, the rule excludes arrangements with 
foreign securities depositories from its scope because they are 
addressed by rule 17f-7. The amended rule also reflects other 
clarifying changes from the previous version of the rule.\35\ A note to 
amended rule 17f-5 (and a similar note to rule 17f-7) explains that 
when a depository arrangement involves one or more foreign bank 
custodians through which assets are maintained with the depository, 
rule 17f-5 applies to the fund's or its custodian's use of each foreign 
bank subcustodian, while rule

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17f-7 applies to the subcustodian's use of the depository itself.\36\
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    \35\ Amended rule 17f-5 uses the term ``foreign assets'' in 
place of ``fund assets'' to clarify that assets maintained with a 
foreign custodian may not be the exclusive property of the fund. See 
U.C.C. Sec. 8-503(b) and cmt. 1 (1994) (entitlement holder's 
property interest in securities held by its securities intermediary 
is a pro rata interest shared with other customers of the 
intermediary). The amended rule also refers to ``maintaining assets 
with'' an eligible foreign custodian rather than ``selecting'' a 
custodian, and uses the term ``eligible foreign custodian'' 
throughout the rule. In addition, the amended rule provides that the 
fund's foreign custody manager, as well as the fund itself, may 
place and maintain fund assets with an eligible foreign custodian. 
See amended rule 17f-5.
    \36\ See Note to amended rule 17f-5; Note to rule 17f-7.
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C. Conforming Amendments
    Conforming amendments to rules 17f-4 and 7d-1 clarify references to 
rule 17f-5 by adding a reference to rule 17f-7. One commenter 
recommended that the word ``foreign'' be deleted from the reference to 
a ``foreign eligible securities depository'' in the proposed amendment 
to rule 17f-4 because it is too restrictive. As adopted, the amendment 
to rule 17f-4 does not include the word ``foreign,'' and refers instead 
to an ``eligible securities depository'' as defined in new rule 17f-
7.\37\
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    \37\ This change clarifies that an eligible securities 
depository may include, for example, a branch of a U.S. bank that 
meets the other requirements of the definition of an eligible 
securities depository.
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III. Effective Date

    New rule 17f-7 and the amendments to rule 17f-5 will be effective 
June 12, 2000. Compliance with the new rule and rule amendments will 
not be required until July 2, 2001.\38\ In the interim, a fund may 
operate its foreign custody arrangements in accordance with the new 
rule and amendments or with the 1997 Amendments to rule 17f-5,\39\ or 
it may comply with ``old'' rule 17f-5 as it existed prior to the 1997 
Amendments (but subject to the definition of an eligible foreign 
custodian under the 1997 Amendments).\40\
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    \38\ A fund may undertake to comply with new rule 17f-7 and 
amended rule 17f-5 before the compliance date. With respect to fund 
assets in the custody of a foreign securities depository before it 
has begun to comply with rule 17f-7, we expect the fund or its 
adviser to determine whether the depository is an eligible 
securities depository as defined by the rule, and to obtain an 
initial risk analysis of the depository by the compliance date.
    \39\ Compliance with the 1997 Amendments will become moot when 
amended rule 17f-5 and new rule 17f-7 take effect. See supra note 6 
(clarifying the status of the compliance date for the 1997 
Amendments). Therefore, the Commission is extending the compliance 
date of the 1997 Amendments to the effective date of the rule and 
amendments we are adopting today.
    \40\ See Custody of Investment Company Assets Outside the United 
States, Investment Company Act Release No. 23201 (May 21, 1998) [63 
FR 29345 (May 29, 1998)] at nn.7 & 9 and accompanying text. The fund 
may apply any of these alternative frameworks separately to each 
foreign custodian or subcustodian it uses. The fund's arrangement 
with a particular foreign custodian, subcustodian, or depository 
should comply in its entirety with amended rule 17f-5 and new rule 
17f-7, or with rule 17f-5 as amended by the 1997 Amendments, or with 
old rule 17f-5 as it existed prior to the 1997 Amendments (but 
subject to the amended definition of an eligible foreign custodian).
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IV. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits of its rules. 
In the Proposing Release, we requested comments and specific data 
regarding the costs and benefits of the proposed rule and rule 
amendments, but commenters did not address any specific costs or 
quantify any benefits.
    New rule 17f-7 and the amendments to rule 17f-5 respond to concerns 
expressed by global custodians and fund managers that rule 17f-5, as 
amended in 1997, is not workable. The new rule and rule amendments also 
address our concerns that, as a result of global custodians' 
unwillingness to assume delegated responsibilities under rule 17f-5, 
obligations to evaluate depositories' custodial capabilities may fall 
to fund boards, which lack the relevant knowledge and expertise to make 
these evaluations.
    We believe that new rule 17f-7 will benefit investors by 
establishing a workable framework under which assets may be maintained 
in foreign depositories consistent with the investor protection goals 
of the Investment Company Act. In adopting this rule, we recognize that 
investment in many foreign countries presents custodial risks that 
cannot be avoided, including the use of local securities depositories. 
The rule seeks to reduce the risks by requiring that fund advisers (or 
funds) be fully apprised of these risks when they make the decision to 
invest in the country on an ongoing basis. The rule will also benefit 
funds and their shareholders by freeing fund boards of the 
responsibility to make findings concerning foreign depositories that 
often remained with them after the 1997 Amendments because of global 
custodians' refusals to accept delegated responsibility. As a result, 
fund boards should have more time to address other issues that are 
important to investors.
    New rule 17f-7 and the amendments to rule 17f-5 may impose costs. 
Although the new rule sets minimum requirements for depositories, it 
does not dictate a standard for custody risks. A depository may fail, 
causing losses to investors, despite the diligence of global 
custodians, funds and advisers.
    Global custodians should not incur materially greater costs under 
new rule 17f-7, which generally requires them to perform duties they 
may perform already under custodial contracts.\41\ Rule 17f-7 may have 
the effect of requiring global custodians to exercise a greater degree 
of vigilance in monitoring depositories (or to refrain in the future 
from reducing their diligence) because it requires them to monitor a 
depository ``on a continuing basis,'' and in this respect may impose 
some costs. It is unlikely, however, that these costs will be material, 
since many custodians already monitor their foreign subcustodians, the 
countries in which these subcustodians are located, and foreign 
securities depositories. Existing custodial agreements with funds may 
need to be amended because of rule 17f-7 and the amendments to rule 
17f-5. We expect that global custodians may pass on additional costs to 
mutual funds, but that the costs are unlikely to materially affect 
overall fund expense ratios, in part because custodial fees are not 
calculated on an hourly basis.
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    \41\ Rule 17f-7 should not materially increase a custodian's 
risk of liability because most custodial contracts will probably 
continue to limit the custodian's liability, particularly with 
respect to information it may receive from third parties.
---------------------------------------------------------------------------

    The Commission staff estimates that approximately 3,690 fund 
portfolios will be affected by rule 17f-7 and the amendments to rule 
17f-5.\42\ The staff estimates that during the first year after rule 
17f-7 goes into effect, approximately 15 global custodians (or their 
agents) \43\ will make an average of 80 responses per custodian, and 
that each response will require approximately 10 hours, for a total 
annual burden for global custodians of 12,000 hours.\44\ The staff 
estimates that during the first year after the amendments to rule 17f-5 
go into effect, approximately 15 global custodians will be required to 
make an average of 80 responses per custodian concerning the use of 
foreign custodians other than depositories, requiring 10 hours per 
response.\45\ In addition, during that first year, the staff estimates 
that each custodian will require approximately 96 hours for an 
additional ``response'' under rule 17f-5, which involves renegotiating 
the custodial contract with the fund and establishing a system to 
monitor custody arrangements for the fund. The total annual burden 
associated with the amendments to rule

[[Page 25634]]

17f-5 for global custodians during the first year will be approximately 
13,440 hours (15 global custodians  x  896 hours per global custodian).
---------------------------------------------------------------------------

    \42\ This information is based on data reported by funds on Form 
N-SAR [17 CFR 274.101].
    \43\ This estimate is based on staff review of custody contracts 
and other research.
    \44\ These estimates assume that each of the 15 custodians 
services an average of 250 client portfolios within 40 fund 
complexes, that a single response by each custodian can 
simultaneously address approximately 6 client portfolios in a fund 
complex. A ``response'' may involve the preparation of risk analyses 
of depository arrangements, the monitoring of depositories for 
material changes in risks and the preparation of notices for funds 
of material changes in risks related to these depositories.
    \45\ These estimates assume that each of the 15 custodians 
services an average of 250 client portfolios within 40 fund 
complexes, that a single response by each custodian can 
simultaneously address approximately 6 client portfolios in a fund 
complex. A ``response'' may involve establishing bank custody 
arrangements for approximately 40 fund complexes, preparing reports 
to fund boards and monitoring custody functions.
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    Under rule 17f-7, funds or their advisers will bear the cost of 
evaluating the information provided by global custodians and making 
decisions regarding the continued use of a depository (and in this 
respect, continued investment in the country where the depository is 
located). We believe that in the context of foreign depository 
arrangements, this allocation of costs is appropriate in light of (i) 
the unwillingness of global custodians to assume responsibilities that 
may overlap with investment decisions and (ii) the extent to which the 
decision to use a foreign depository may affect an investment strategy 
that contemplates investment in a particular foreign market. An 
adviser's costs (and the related fund's costs) should not materially 
increase because of the rule, since decisions concerning use of a 
depository likely are part of the overall decision to invest in a 
country, and are decisions that funds and their advisers made prior to 
adoption of rule 17f-7. Savings under rule 17f-5 may offset increased 
costs to funds and their advisers with respect to new rule 17f-7, since 
fund directors will no longer have to make time-consuming ``reasonable 
care'' determinations regarding foreign depositories.
    The staff estimates that during at least the first year after rule 
17f-7 goes into effect, approximately 650 investment advisers \46\ may 
make an average of 3 responses per adviser under the new rule, 
requiring a total of approximately 25 hours for each adviser.\47\ The 
total annual burden for funds and their advisers under rule 17f-7 will 
be approximately 16,250 hours. The staff further estimates that during 
the first year after the amendments to rule 17f-5 go into effect, the 
total annual burden associated with the rule's requirements will be 
approximately 7,380 hours (3,690 portfolios  x  2 hours per 
portfolio).\48\ The removal of custody arrangements involving 
securities depositories from amended rule 17f-5 may eliminate as many 
as 28,600 burden hours from the current total burden hours for funds 
and their advisers.\49\
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    \46\ Commission staff estimates that there are 3,690 portfolios 
with securities held by a foreign custodian or foreign securities 
depository, and that these portfolios are divided among 
approximately 1,327 registered funds with approximately 650 fund 
complexes that may share the same investment adviser, board of 
directors, U.S. bank custodian or all of these entities. Each board 
of directors and its delegates for a fund complex could therefore 
meet rule 17f-7's requirements by simultaneously approving similar 
arrangements for some 6 portfolios in the same complex. The 
estimated hour burdens are based on discussions with representatives 
of funds about the burdens of analogous requirements in another 
custody rule.
    \47\ These estimates assume that one adviser manages 6 
portfolios, and that each adviser would make 3 responses annually 
requiring a total of 25 hours for each adviser. A ``response'' may 
involve addressing depository compliance with minimum requirements, 
and reviews of risk analyses and notifications for the fund complex. 
The staff also assumes that fund boards will delegate most of the 
responsibility for reviewing risk analyses and notifications to a 
fund's adviser. To the extent fund boards do not delegate these 
responsibilities, funds will bear the costs of reviewing risk 
analyses and notifications.
    \48\ The staff estimates that 2 hours of board or adviser time 
will be required annually to make the necessary findings concerning 
foreign custody managers required by amended rule 17f-5.
    \49\ This estimate assumes that without the amendments, under 
rule 17f-5, approximately 650 investment advisers would have to make 
an average of 3 responses per adviser annually (requiring a total of 
approximately 44 hours for each adviser) to address depository 
arrangements. The 44 hours include: 10 hours establishing custody 
arrangements with depositories and making ``reasonable care'' 
determinations, 24 hours monitoring depository arrangements, and 10 
hours reporting to fund boards.
---------------------------------------------------------------------------

    It is unclear whether the new rule and rule amendments will 
increase or decrease investments in funds holding foreign securities. 
Custody risks are only one factor investors may consider before 
deciding to invest in a particular fund. Fund managers may have more 
information regarding custodial risks because of the new rule and 
amendments, and this may affect their decisions regarding where to 
invest a fund's assets, or in some cases, when to remove a fund's 
assets from a country. The new rule and rule amendments may affect 
competition among custodians, but are unlikely to significantly change 
the tasks that custodians currently perform. The rules allow third 
parties to prepare risk analyses and monitor depositories for changes 
in risks for custodians. It is unclear whether custodians will pass the 
costs of utilizing these third party service providers to funds or 
investors. Many custodians already may be using the services of these 
providers.

V. Effects on Efficiency, Competition and Capital Formation

    Section 2(c) of the Investment Company Act requires the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is consistent with the public interest, to consider 
whether the action will promote efficiency, competition and capital 
formation.\50\ The Commission has considered these factors.
---------------------------------------------------------------------------

    \50\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    As discussed above, the Commission anticipates that new rule 17f-7 
and the amendments to rule 17f-5 will provide a workable framework 
under which a fund can protect its assets while maintaining them with a 
foreign securities depository. These rule changes may marginally 
promote efficiency in custody arrangements involving foreign assets by 
better delineating the responsibilities of fund boards, fund advisers 
and custodians with respect to custody of investment company assets 
outside the United States, whether an eligible foreign custodian or an 
eligible securities depository holds them. It is unlikely that the rule 
changes will have any material effect on competition among custodians, 
because the rules do not substantially change the duties of custodians, 
or increase the potential universe of custodians or depositories. The 
rule changes should also have little effect on domestic capital 
formation because the rules relate only to foreign custody of fund 
assets. There are relatively few funds affected by the new rule and 
amendments, compared to the total number of funds. Similarly, the total 
dollar amount invested in funds affected by the rule and amendments is 
also relatively small, compared to the total amount invested in all 
funds.

VI. Paperwork Reduction Act

    Certain provisions of new rule 17f-7 and the amendments to rule 
17f-5 contain ``collection of information'' requirements within the 
meaning of the Paperwork Reduction Act of 1995.\51\ The Commission 
submitted the collection of information requirements contained in the 
rule and rule amendments to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11.\52\ An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless the agency 
displays a valid OMB control number.\53\
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    \51\ 44 U.S.C. 3501-3520.
    \52\ The titles of the collections of information are ``Custody 
of Investment Company Assets Outside the United States'' and 
``Custody of Investment Company Assets with a Foreign Securities 
Depository.'' The OMB control numbers for the rules are as follows: 
rule 17f-7 (3235-0529, expires Aug. 31, 2002); rule 17f-5 (3235-
0269, expires Aug. 31, 2002).
    \53\ 44 U.S.C. 3506(c)(1)(B)(v).
---------------------------------------------------------------------------

A. New Rule 17f-7
    New rule 17f-7 contains some collection of information 
requirements. Under the rule, an eligible securities depository must 
meet certain minimum standards. The fund or its investment

[[Page 25635]]

adviser will generally determine whether the depository complies with 
those requirements based on information provided by the fund's primary 
custodian. The depository custody arrangement also must meet certain 
conditions. The fund or its adviser must receive from the primary 
custodian (or its agent) an initial risk analysis of the depository 
arrangements, and the fund's contract with its primary custodian must 
state that the custodian will monitor risks and promptly notify the 
fund or its adviser of material changes in risks. The primary custodian 
and other custodians also must agree to exercise reasonable care.
    The staff estimates that during the first year after rule 17f-7 
goes into effect, approximately 650 investment advisers will review an 
average of 3 risk analyses per adviser under the rule, requiring a 
total of approximately 25 hours for each adviser. Each of these 
``responses'' by an adviser may address depository compliance with the 
minimum requirements of the rule, and require the adviser to review 
risk analyses or notifications of material changes in risks related to 
a depository.\54\ The total annual burden associated with these 
requirements of the rule during the first year is estimated to be 
approximately 16,250 hours (650 advisers  x  25 hours per adviser). The 
staff further estimates that during the first year after the proposed 
rule goes into effect, approximately 15 global custodians will make an 
average of 80 responses per custodian under the rule that will require 
approximately 10 hours per response.\55\ A ``response'' by a global 
custodian may involve the preparation of the risk analysis, the 
monitoring of depository risks or the preparation of subsequent 
notifications of material changes in depository risks. The total annual 
burden associated with these requirements of the new rule is estimated 
to be approximately 12,000 hours (15 custodians  x  800 hours). 
Therefore, the total annual burden associated with all collection of 
information requirements of new rule 17f-7 during the first year after 
its adoption is estimated to be 28,250 hours (16,250 + 12,000).
---------------------------------------------------------------------------

    \54\ These estimates assume that one adviser manages 6 
portfolios, and that each adviser will make 3 responses annually 
requiring a total of 25 hours for each adviser to address depository 
compliance with minimum requirements, and reviews of risk analyses 
or notifications for the adviser's fund complex. The 25 hours would 
include 5 hours spent to verify depository compliance with minimum 
requirements, and 20 hours spent to review risk analyses or 
notifications for the fund complex.
    \55\ These estimates assume that each of 15 custodians services 
an average of 250 client portfolios within 40 fund complexes, that a 
single response by each custodian can simultaneously address 
approximately 6 client portfolios in a fund complex, and that each 
custodian makes approximately 80 annual responses requiring 10 hours 
per response to prepare risk analyses of depository arrangements and 
monitor risks, and to provide notices of material changes in risks 
to its clients.
---------------------------------------------------------------------------

B. Amendments to Rule 17f-5
    The amendments to rule 17f-5 do not substantively change the rule's 
collection of information requirements, which will continue to apply 
when a fund (i.e., a registered management investment company) 
maintains its assets with a foreign bank custodian. The amendments 
remove custody arrangements with foreign securities depositories from 
the rule, however, so that the rule's requirements no longer apply to 
these custody arrangements. In general, therefore, the amendments 
reduce the information collection burdens of rule 17f-5.
    The requirements of amended rule 17f-5 that may call for the 
collection of information are substantially the same as under the 
current rule. The fund's board of directors must find that it is 
reasonable to rely on each delegate it selects to act as the fund's 
foreign custody manager. The delegate must agree to provide written 
reports that notify the board when the fund's assets are placed with a 
foreign custodian and when any material change occurs in the fund's 
custody arrangements. The delegate must agree to exercise reasonable 
care, prudence, and diligence, or to adhere to a higher standard of 
care. When the foreign custody manager selects an eligible foreign 
custodian, it must determine that the fund's assets will be subject to 
reasonable care if maintained with that custodian, and that the written 
contract that governs each custody arrangement will provide reasonable 
care for fund assets. The contract must contain certain specified 
provisions or others that provide at least equivalent care. The foreign 
custody manager must establish a system to monitor the contract and the 
appropriateness of continuing to maintain assets with the eligible 
foreign custodian.
    The Commission's staff estimates that during the first year after 
the amendments go into effect, approximately 3,690 fund portfolios \56\ 
will be required to make an average of one response per portfolio under 
amended rule 17f-5, requiring approximately 2 hours of director time 
per response, to make the necessary findings concerning foreign custody 
managers.\57\ A ``response'' by a fund portfolio may involve the 
directors making certain findings concerning foreign custody managers, 
and the review and ratification of custodial contracts. The total 
annual burden associated with these requirements of the amended rule 
during the first year is estimated to be approximately 7,380 hours 
(3,690 portfolios  x  2 hours per portfolio). The staff further 
estimates that during the first year after the amended rule goes into 
effect, approximately 15 global custodians \58\ will be required to 
make an average of 80 responses per custodian concerning the use of 
foreign custodians other than depositories, requiring approximately 10 
hours per response, plus one additional response per custodian that 
requires approximately 96 hours per response.\59\ A ``response'' by a 
custodian under the amended rule may involve negotiating new custodial 
contracts with funds, establishing bank custody arrangements for fund 
complexes, preparing reports for funds and establishing a system to 
monitor custody arrangements. The total annual burden associated with 
these requirements of the rule during the first year is estimated to be 
approximately 13,440 hours (15 global custodians  x  896 hours per 
global custodian). Therefore, the total burden of all collection of 
information requirements of rule 17f-5 during the first year after its 
amendment is estimated to be approximately 20,820 hours (7,380 + 
13,440).\60\
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    \56\ This information is based on data reported by funds on Form 
N-SAR [17 CFR 274.101].
    \57\ The staff estimates that these 3,690 portfolios are divided 
among approximately 1,327 registered funds within approximately 650 
fund complexes that may share the same investment adviser, board of 
directors, U.S. bank custodian, or all of these entities. Each board 
of directors and its delegates for a fund complex could therefore 
meet rule 17f-5's requirements by simultaneously approving similar 
arrangements for some 6 portfolios in the same complex. The 
estimated hour amounts are based on discussions with representatives 
of funds about the burdens of analogous requirements in another 
custody rule.
    \58\ This estimate is based on staff review of custody contracts 
and other research.
    \59\ These estimates assume that each of 15 custodians services 
an average of 250 client portfolios within 40 fund complexes, that a 
single response by each custodian can simultaneously address 
approximately 6 client portfolios in a fund complex, and that each 
custodian makes approximately 80 responses annually requiring 10 
hours per response to establish bank custody arrangements for 
approximately 40 fund complexes and report to their fund boards, and 
one response annually requiring 96 hours per response to establish a 
system to monitor custody arrangements for these clients.
    \60\ The number of responses may decline substantially after the 
first year because some responses made during that year (e.g., 
negotiating a custodial contract with a fund or establishing a 
system to monitor custody arrangements) will suffice for some time 
thereafter.

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[[Page 25636]]

    The staff estimates that the amendments' removal of custody 
arrangements involving securities depositories from rule 17f-5 will 
eliminate as much as 28,600 additional burden hours currently imposed 
by the rule's collection of information requirements. This estimate 
assumes that without the amendments, approximately 650 investment 
advisers \61\ would have to make an average of 3 responses per adviser 
annually (i.e., making reasonable care determinations), requiring a 
total of approximately 44 hours for each adviser, to address depository 
arrangements.\62\
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    \61\ See supra note 57.
    \62\ These estimates assume that one adviser manages 6 
portfolios, and that each adviser would make 3 responses annually 
requiring a total of 44 hours to approve depository custody 
arrangements for each fund complex, report to fund boards, and 
establish a system to monitor depository arrangements for the fund 
complex. The 44 hours would include 10 hours spent to establish 
custody arrangements with depositories and make ``reasonable care'' 
determinations, 24 hours spent to monitor depository arrangements, 
and 10 hours spent to report to fund boards.
---------------------------------------------------------------------------

    As reflected in the following summary of the burden hours 
associated with the collection of information requirements in old rule 
17f-5, rule 17f-5 as amended, and new rule 17f-7, the staff estimates 
that the net effect of the new rule and rule amendments will be to 
reduce the total annual paperwork burden by 350 hours:

------------------------------------------------------------------------
                  Rule                        Paperwork burden hours
------------------------------------------------------------------------
Old rule 17f-5..........................  49,420 hours.
Rule 17f-5 as amended...................  20,820 hours.
New rule 17f-7..........................  28,250 hours.
Net reduction...........................  350 hours.
------------------------------------------------------------------------

    The information collection requirements imposed by the new rule and 
rule amendments are required for those funds that decide to rely on the 
rules to obtain the benefit of maintaining assets in foreign custody 
arrangements. Funds that do not maintain assets in foreign custody 
arrangements are not required to rely on the rules. Responses to the 
collections of information will not be kept confidential.

VII. Summary of Final Regulatory Flexibility Analysis

    The Commission has prepared a Final Regulatory Flexibility Analysis 
(``FRFA'') in accordance with 5 U.S.C. 604 relating to new rule 17f-7, 
the amendments to rule 17f-5, and the conforming amendments to rules 
7d-1 and 17f-4. A summary of the Initial Regulatory Flexibility 
Analysis (``IRFA''), which was prepared in accordance with 5 U.S.C. 
603, was published in the Proposing Release. The following is a summary 
of the FRFA.
A. Need for and Objectives of the Rule and Rule Amendments
    Rule 17f-5 governs the custody of the assets of registered 
management investment companies (``funds'') with custodians outside the 
United States. The Commission amended the rule in 1997 to modernize its 
conditions. In 1998, representatives of funds and bank custodians 
informed the Commission that some conditions of the rule presented 
problems regarding the use of foreign securities depositories.
    The Commission is adopting new rule 17f-7 and amendments to rule 
17f-5, pursuant to the authority set forth in sections 6(c), 7(d), 
17(f), and 38(a) of the Investment Company Act [15 U.S.C. 80a-6(c), -
7(d), -17(f), and -37(a)], to permit funds to maintain their assets in 
foreign securities depositories based on conditions that reflect the 
operations and role of these depositories. New rule 17f-7 establishes 
new provisions for the use of depositories. The rule requires every 
foreign securities depository that holds fund assets to meet specified 
minimum standards. The rule also requires a custody arrangement with a 
depository to meet certain risk-limiting conditions. The fund or its 
adviser must receive an initial risk analysis of the depository 
arrangement from the primary custodian (or its agent), and the fund's 
contract with its primary custodian must state that the custodian will 
monitor those risks and notify the fund or its adviser of material 
changes in the risks. The primary custodian and other custodians 
involved in the depository arrangement also must agree to exercise 
reasonable care.
    The amendments to rule 17f-5 remove custody arrangements with 
foreign securities depositories from the rule. This eliminates the 
applicability to depository arrangements of requirements that certain 
findings be made by the fund board, its investment adviser or global 
custodian, and that certain specified terms or equivalent protections 
appear in the rules of the depository. The conforming amendments to 
rules 7d-1 and 17f-4 clarify references to rule 17f-5 by adding a 
reference to rule 17f-7 as well.
B. Significant Issues Raised by Public Comments
    The Commission received no public comments on the IRFA.
C. Small Entities Subject to the Rules
    The new rule and rule amendments affect, among other persons, the 
approximately 15 global custodians that act as foreign custody managers 
for funds under rule 17f-5 and as primary custodians under rule 17f-7. 
None of these global custodians likely qualifies as a small entity, 
because each custodian is a major bank with a global branch network or 
global ties to other banks.\63\ The new rule and rule amendments also 
affect the funds that invest in foreign markets and their investment 
advisers. Few if any of the affected funds and advisers are small 
entities.\64\
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    \63\ A bank is considered by the Small Business Administration 
to be a small entity if it has less than $100 million in assets. See 
13 CFR 121.201 (1999). See also 5 USC 601(3). A bank's assets are 
determined by averaging its total assets reported for each of the 
last four quarters. See 13 CFR 121.201 at n.7.
    \64\ A fund is considered a small entity if it, together with 
other investment companies in the same group of related investment 
companies, has net assets of $50 million or less. See 17 CFR 270.0-
10. An adviser is considered a small entity if it has assets under 
management of less than $25 million, has total assets of less than 
$5 million, and is not in a control relationship with other advisers 
or persons that are not small entities. See 17 CFR 275.0-7. Most 
funds that invest in foreign securities are part of a fund complex 
that holds net assets of more than $50 million, and are advised by 
advisers with assets under management of $25 million or more.
---------------------------------------------------------------------------

    On balance, the impact of the new rule and rule amendments on 
global custodians, funds, and advisers is not expected to be great, 
because the burdens of the new rule's requirements will be offset in 
part by the elimination of burdens by amended rule 17f-5. For this 
reason, and because few if any of the affected entities would qualify 
as small entities, the new rule and rule amendments are unlikely to 
have a significant impact on a substantial number of small entities.
D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements
    New rule 17f-7 establishes new requirements for arrangements with 
depositories. As described above, the new rule requires each foreign 
securities depository that holds fund assets to meet specified minimum 
requirements. Depository arrangements also must meet other risk-
limiting conditions. The fund or its adviser must receive an initial 
risk analysis of the depository arrangement from the primary custodian 
(or its agent), and the fund's contract with its primary custodian must 
state that the custodian will monitor the risks and promptly notify the 
fund of any material changes in risks. The primary custodian and other 
custodians also must agree to exercise reasonable care.

[[Page 25637]]

    The amendments to rule 17f-5 retain existing reporting, 
recordkeeping, and other compliance requirements of the rule without 
substantive changes, insofar as they apply to custody arrangements with 
a foreign bank custodian. The amendments would remove a custody 
arrangement with a foreign depository from the rule, eliminating the 
necessity for compliance with the rule's requirements in these 
arrangements.
E. Agency Action To Minimize Effects on Small Entities
    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant economic impact on small entities. In 
considering adoption of the new rule and amendments, the Commission 
considered: (i) establishing different compliance or reporting 
standards that take into account the resources available to small 
entities; (ii) clarifying, consolidating or simplifying the compliance 
requirements for small entities; (iii) using performance rather than 
design standards; and (iv) exempting small entities from coverage of 
all or part of the rule.
    We believe that further clarification, consolidation, or 
simplification of the compliance requirements is not necessary. In 
addition, performance standards are impracticable with respect to the 
amendments and new rule. The Commission believes that different 
requirements for small entities would also be inconsistent with the 
protection of investors, particularly in light of the fact that rule 
17f-7 establishes only minimum requirements for foreign securities 
depositories.
    As discussed above, none of the global custodians affected by new 
rule 17f-7 or the amendments to rule 17f-5 and few, if any, of the 
affected funds and advisers are likely to be considered small entities 
for purposes of the Regulatory Flexibility Act. As further discussed 
above, the impact of the amendments is likely to be limited, because 
burdens under the new rule will be offset in part by reduced burdens by 
amended rule 17f-5. Therefore, the potential impact of the new rule and 
rule amendments on small entities will not be significant.
    The FRFA is available for public inspection in File No. S7-15-99, 
and a copy may be obtained by contacting Jaea F. Hahn, Attorney, at 
(202) 942-0690, Office of Regulatory Policy, Division of Investment 
Management, Securities and Exchange Commission, 450 5th Street, NW, 
Washington, DC 20549-0506.

VIII. Statutory Authority

    The Commission is adopting new rule 17f-7, amending rule 17f-5, and 
adopting conforming amendments to rules 7d-1 and 17f-4 pursuant to 
authority set forth in sections 6(c), 7(d), 17(f), and 38(a) of the 
Investment Company Act [15 U.S.C. 80a-6(c), 80a-7(d), 80a-17(f) and 
80a-37(a)].

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Rules

    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-34(d), 80a-37, 80a-39 
unless otherwise noted:
* * * * *

    2. Section 270.7d-1 is amended by revising the introductory text of 
paragraph (b)(8)(v) to read as follows:


Sec. 270.7d-1  Specification of conditions and arrangements for 
Canadian management investment companies requesting order permitting 
registration.

* * * * *
    (b) * * *
    (8) * * *
    (v) Except as provided in Sec. 270.17f-5 and Sec. 270.17f-7, 
applicant will appoint, by contract, a bank, as defined in section 
2(a)(5) of the Act (15 U.S.C. 80a-2(a)(5)) and having the qualification 
described in section 26(a)(1) of the Act (15 U.S.C. 80a-26(a)(1)), to 
act as trustee of, and maintain in its sole custody in the United 
States, all of applicant's securities and cash, other than cash 
necessary to meet applicant's current administrative expenses. The 
contract will provide, inter alia, that the custodian will:
* * * * *

    3. Section 270.17f-4 is amended by revising the introductory text 
of paragraph (b) to read as follows:


Sec. 270.17f-4  Deposits of securities in securities depositories.

* * * * *
    (b) A registered management investment company (investment company) 
or any qualified custodian may deposit all or any part of the 
securities owned by the investment company in an Eligible Securities 
Depository as defined in Sec. 270.17f-7 in accordance with the 
provisions of Sec. 270.17f-7 and applicable provisions of Sec. 270.17f-
5, or in:
* * * * *

    4. 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 a Qualified Foreign Bank or a majority-owned direct or 
indirect subsidiary of a U.S. Bank or bank-holding company.
    (2) Foreign Assets means any investments (including foreign 
currencies) for which the primary market is outside the United States, 
and any cash and cash equivalents that are reasonably necessary to 
effect the Fund's transactions in those investments.
    (3) 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.
    (4) 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.
    (5) 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.
    (6) 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.
    (7) U.S. Bank means an entity 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

[[Page 25638]]

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) Reasonable Reliance. The board determines that it is reasonable 
to rely on the delegate to perform the delegated responsibilities;
    (2) Reporting. The board requires the delegate to provide written 
reports notifying the board of the placement of Foreign Assets with a 
particular custodian and of any material change in the Fund's foreign 
custody 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 arrangements; and
    (3) Exercise of Care. The delegate agrees to exercise reasonable 
care, prudence and diligence such as a person having responsibility for 
the safekeeping of the Fund's Foreign Assets would exercise, or to 
adhere to a higher standard of care, in performing the delegated 
responsibilities.
    (c) Maintaining Assets with an Eligible Foreign Custodian. A Fund 
or its Foreign Custody Manager may place and maintain the Fund's 
Foreign Assets in the care of an Eligible Foreign Custodian, provided 
that:
    (1) General Standard. The Foreign Custody Manager determines that 
the Foreign Assets will be subject to reasonable care, based on the 
standards applicable to custodians in the relevant market, if 
maintained with the Eligible Foreign Custodian, after considering all 
factors relevant to the safekeeping of the Foreign Assets, including, 
without limitation:
    (i) The Eligible Foreign 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 Eligible Foreign Custodian has the requisite 
financial strength to provide reasonable care for Foreign Assets;
    (iii) The Eligible Foreign Custodian's general reputation and 
standing; and
    (iv) Whether the Fund will have jurisdiction over and be able to 
enforce judgments against the Eligible Foreign Custodian, such as by 
virtue of the existence of offices in the United States or consent to 
service of process in the United States.
    (2) Contract. The arrangement with the Eligible Foreign Custodian 
is governed by a written contract that the Foreign Custody Manager has 
determined will provide reasonable care for Foreign Assets based on the 
standards specified in paragraph (c)(1) of this section.
    (i) The contract must provide:
    (A) For indemnification or insurance arrangements (or any 
combination) that will adequately protect the Fund against the risk of 
loss of Foreign Assets held in accordance with the contract;
    (B) That the Foreign Assets will not be subject to any right, 
charge, security interest, lien or claim of any kind in favor of the 
Eligible Foreign 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 of the Foreign 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 
Foreign 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 Foreign 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) The contract may contain, in lieu of any or all of the 
provisions specified in paragraph (c)(2)(i) of this section, other 
provisions that the Foreign Custody Manager determines will provide, in 
their entirety, the same or a greater level of care and protection for 
the Foreign Assets as the specified provisions, in their entirety.
    (3)(i) Monitoring the Foreign Custody Arrangements. The Foreign 
Custody Manager has established a system to monitor the appropriateness 
of maintaining the Foreign Assets with a particular custodian under 
paragraph (c)(1) of this section, and to monitor performance of the 
contract under paragraph (c)(2) of this section.
    (ii) If an arrangement with an Eligible Foreign Custodian no longer 
meets the requirements of this section, the Fund must withdraw the 
Foreign Assets from the Eligible Foreign Custodian as soon as 
reasonably practicable.
    (d) Registered Canadian Funds. Any Registered Canadian Fund may 
place and maintain its Foreign Assets outside the United States in 
accordance with the requirements of this section, provided that:
    (1) The Foreign 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.

    Note to Sec. 270.17f-5: When a Fund's (or its custodian's) 
custody arrangement with an Eligible Securities Depository (as 
defined in Sec. 270.17f-7) involves one or more Eligible Foreign 
Custodians through which assets are maintained with the Eligible 
Securities Depository, Sec. 270.17f-5 will govern the Fund's (or its 
custodian's) use of each Eligible Foreign Custodian, while 
Sec. 270.17f-7 will govern an Eligible Foreign Custodian's use of 
the Eligible Securities Depository.


    5. Section 270.17f-7 is added to read as follows:


Sec. 270.17f-7  Custody of investment company assets with a foreign 
securities depository.

    (a) Custody arrangement with an eligible securities depository. A 
Fund, including a Registered Canadian Fund, may place and maintain its 
Foreign Assets with an Eligible Securities Depository, provided that:
    (1) Risk-limiting safeguards. The custody arrangement provides 
reasonable safeguards against the custody risks associated with 
maintaining assets with the Eligible Securities Depository, including:
    (i) Risk analysis and monitoring. (A) The fund or its investment 
adviser has received from the Primary Custodian (or its agent) an 
analysis of the custody risks associated with maintaining assets with 
the Eligible Securities Depository; and
    (B) The contract between the Fund and the Primary Custodian 
requires the Primary Custodian (or its agent) to monitor the custody 
risks associated with maintaining assets with the Eligible Securities 
Depository on a continuing basis, and promptly notify the Fund or its 
investment adviser of any material change in these risks.
    (ii) Exercise of care. The contract between the Fund and the 
Primary

[[Page 25639]]

Custodian states that the Primary Custodian will agree to exercise 
reasonable care, prudence, and diligence in performing the requirements 
of paragraphs (a)(1)(i)(A) and (B) of this section, or adhere to a 
higher standard of care.
    (2) Withdrawal of assets from eligible securities depository. If a 
custody arrangement with an Eligible Securities Depository no longer 
meets the requirements of this section, the Fund's Foreign Assets must 
be withdrawn from the depository as soon as reasonably practicable.
    (b) Definitions. The terms Foreign Assets, Fund, Qualified Foreign 
Bank, Registered Canadian Fund, and U.S. Bank have the same meanings as 
in Sec. 270.17f-5. In addition:
    (1) Eligible Securities Depository means a system for the central 
handling of securities as defined in Sec. 270.17f-4 that:
    (i) Acts as or operates a system for the central handling of 
securities or equivalent book-entries in the country where it is 
incorporated, or a transnational system for the central handling of 
securities or equivalent book-entries;
    (ii) 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));
    (iii) Holds assets for the custodian that participates in the 
system on behalf of the Fund under safekeeping conditions no less 
favorable than the conditions that apply to other participants;
    (iv) Maintains records that identify the assets of each participant 
and segregate the system's own assets from the assets of participants;
    (v) Provides periodic reports to its participants with respect to 
its safekeeping of assets, including notices of transfers to or from 
any participant's account; and
    (vi) Is subject to periodic examination by regulatory authorities 
or independent accountants.
    (2) Primary Custodian means a U.S. Bank or Qualified Foreign Bank 
that contracts directly with a Fund to provide custodial services 
related to maintaining the Fund's assets outside the United States.

    Note to Sec. 270.17f-7: When a Fund's (or its custodian's) 
custody arrangement with an Eligible Securities Depository involves 
one or more Eligible Foreign Custodians (as defined in Sec. 270.17f-
5) through which assets are maintained with the Eligible Securities 
Depository, Sec. 270.17f-5 will govern the Fund's (or its 
custodian's) use of each Eligible Foreign Custodian, while 
Sec. 270.17f-7 will govern an Eligible Foreign Custodian's use of 
the Eligible Securities Depository.


    Dated: April 27, 2000.
By the Commission.

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-11000 Filed 5-2-00; 8:45 am]
BILLING CODE 8010-01-P