[Federal Register Volume 66, Number 225 (Wednesday, November 21, 2001)]
[Proposed Rules]
[Pages 58412-58422]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-29021]


 ========================================================================
 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
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 

  Federal Register / Vol. 66, No. 225 / Wednesday, November 21, 2001 / 
Proposed Rules  

[[Page 58412]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-25266; File No. S7-22-01]
RIN 3235-AG71


Custody of Investment Company Assets With a Securities Depository

AGENCY: Securities and Exchange Commission (``Commission'').

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing amendments to the rule under the 
Investment Company Act that governs investment companies' use of 
securities depositories. The amendments would expand the types of 
investment companies that can maintain assets with a depository, expand 
the types of depositories they can use, and update the conditions they 
must follow to use a depository. The amendments are designed to respond 
to developments in securities depository practices and commercial law 
since the rule was adopted.

DATES: Comments must be received on or before January 31, 2002.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 5th Street, 
NW., Washington, DC 20549-0609. Comments also may be submitted 
electronically to the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-22-01; this file number 
should be included on the subject line if E-mail is used. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 5th Street, NW., Washington, DC 
20549. Electronically submitted comment letters will be posted on the 
Commission's Internet web site (http://www.sec.gov).\1\
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    \1\ We do not edit personal, identifying information, such as 
names or E-mail addresses, from electronic submissions. Submit only 
information you wish to make publicly available.

FOR FURTHER INFORMATION CONTACT: Hugh P. Lutz, Attorney, or C. Hunter 
Jones, Assistant Director, Office of Regulatory Policy, at (202) 942-
0690, in the Division of Investment Management, Securities and Exchange 
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Commission, 450 5th Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission today is proposing for public 
comment amendments to rule 17f-4 (17 CFR 270.17f-4) under the 
Investment Company Act of 1940 (15 U.S.C. 80a) (the ``Investment 
Company Act'' or the ``Act'').\2\
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    \2\ Unless otherwise noted, all references to ``rule 17f-4'' or 
any paragraph of the rule will be to 17 CFR 270.17f-4.
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Table of Contents

Executive Summary

I. Background
II. Discussion
    a. Functions of a Securities Depository
    B. Scope of the Rule
    C. Reliance on Rule by Non-Management Companies
    D. Compliance Requirements for the Custodian or Securities 
Depository
    E. Approval of Custody Arrangements
    F. Note Clarifying Application of Rule
17f-4
III. General Request For Comment
IV. Effects on Efficiency, Competition, and Capital Formation
V. Cost-Benefit Analysis
VI. Summary of Regulatory Flexibility analysis
VII. Paperwork Reduction Act
VIII. Statutory Authority
Text Of Proposed Rule

Executive Summary

    Rule 17f-4 under the Investment Company Act permits a registered 
management investment company (``fund'') to deposit the securities it 
owns in a system for the central handling of securities (``securities 
depository''). The Commission adopted the rule in 1978. Since then, the 
custody practices and commercial law that relate to custody 
arrangements with securities depositories have changed substantially.
    Today we are proposing amendments to update and simplify rule 17f-4 
to reflect these business and legal developments. The proposed 
amendments would permit additional types of custodians to operate 
depositories and allow depositories to perform additional functions 
under the rule, and would expand the types of investment companies that 
can rely on the rule. The amendments also would eliminate certain 
custodial compliance requirements of rule 17f-4 that are no longer 
necessary. Instead, the fund's contract with its custodian would be 
required to provide that the custodian will take appropriate action to 
safeguard assets held for the fund, and furnish the fund with periodic 
reports on its internal accounting controls and financial strength. 
Finally, the amendments would eliminate requirements that fund 
directors approve the fund's own custody arrangements and that the fund 
approve its custodian's arrangements with depositories.

I. Background

    Section 17(f) of the Investment Company Act governs the custody of 
a fund's assets, including its portfolio securities.\3\ This section 
requires a fund to maintain its securities and other investments with 
certain types of custodians under conditions designed to assure the 
safety of the fund's assets. After the ``paperwork crisis'' of the late 
1960s demonstrated the inefficiency of transferring securities in paper 
certificate form,\4\ Congress amended section 17(f) to permit a fund to 
deposit its securities in a system for the central handling of 
securities (also referred to as a ``securities depository''), subject 
to rules adopted by the Commission.\5\ A securities depository handles 
the custody and transfer of securities through electronic bookkeeping 
rather than physical delivery of certificates.\6\ Today, the widespread 
use of depositories permits the efficient

[[Page 58413]]

electronic processing of high volumes of securities transactions.\7\
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    \3\ 15 U.S.C. 80a-17(f).
    \4\ See James S. Rogers, Policy Perspectives on Revised UCC 
Article 8, 43 UCLA L. Rev. 1431, 1442 (1996) [``Policy 
Perspectives''].
    \5\ See section 17(f) (authorizing use of ``system for the 
central handling of securities''); H.R. Rep. No. 1382, 91st Cong., 
2d Sess. at 27 (1970) (amendment was intended to permit the use of a 
``central certificate depository''); Policy Perspectives, supra note 
4, at 1442-45 (the primary response to problems with paper 
settlement was immobilization of securities certificates through 
depositories; some securities were also dematerialized); Group of 
Thirty, Clearance and Settlement Systems in the World's Securities 
Markets 55-56 (Mar. 1989) (securities are immobilized by storing 
certificates with a depository that can transfer them by changing 
electronic records; securities are dematerialized by dispensing with 
any physical evidence of ownership and relying entirely on 
electronic records).
    \6\ See section 17(f).
    \7\ The use of depositories also may enhance the efficiency of 
clearance and settlement by permitting the netting of offsetting 
transactions of depository participants before account balances are 
adjusted, and may eliminate some risks of holding paper 
certificates. See Policy Perspectives, supra note, at 1442; Custody 
of Investment Company Assets Outside the United States, Investment 
Company Act Release No. 23815 (Apr. 29, 1999) [64 FR 24489 (May 6, 
1999)] at n.20 and accompanying text. The immobilization of 
certificates in depositories has steadily increased since 1975 when 
Congress amended the Securities Exchange Act of 1934 (``Exchange 
Act'') to authorize the Commission to develop a national system for 
clearance and settlement. See S. Rep. No. 75, 94th Cong., 1st Sess. 
4-6, 55-56 (1975); sections 3(a)(23)(A) and 17A of the Exchange Act 
[15 U.S.C. 78c(a)(23)(A), 78q-1].
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    In 1978, the Commission adopted rule 17f-4 to establish conditions 
for use of securities depositories by funds.\8\ The conditions were 
designed to limit potential risks to funds using the new depository 
systems. The conditions were drafted to be compatible with the 1978 
revisions to Article 8 of the Uniform Commercial Code, which governs 
the ownership and transfer of investment securities under state law.\9\
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    \8\ See Deposits of Securities in Securities Depositories, 
Investment Company Act Release No. 10453 (Oct. 26, 1978) [43 FR 
50869 (Nov. 1, 1978)] [``1978 Adopting Release'']. We estimate that 
more than 97 percent of all funds now use depository custody 
arrangements. Our estimate is based on responses to Item 18 of Form 
N-SAR [17 CFR 274.101].
    \9\ See Uniform Commercial Code, 1978 Official Text with 
Comments, Article 8, Investment Securities (West 1978) (``Prior 
Article 8''); Use of Depository Systems by Registered Management 
Companies, Investment Company Act Release No. 10053 (Dec. 8, 1977) 
[42 FR 63722 (Dec. 19, 1977)] (``1977 Reproposing Release'') at nn. 
4-7, 9, 12 and accompanying text (citing provisions of Prior Article 
8); 1978 Adopting Release, supra note 8, at nn. 4 and 6.
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    Custody practices evolved after 1978, leading to significant 
revisions to Article 8 in 1994 (``Revised Article 8'').\10\ Prior 
Article 8 assumed that issuers would record investors' interests on 
their own books. Today, investors typically maintain a security through 
an account with a broker-dealer, bank or other financial institution 
(``securities intermediary''),\11\ which in turn will maintain an 
account for its customers with a securities depository.\12\ The 
depository generally does not record each investor's interest, but 
records the interest of the intermediary on behalf of all of its 
customers.\13\ Thus, the individual investor's interest (or ``security 
entitlement'') \14\ appears only on the books of the intermediary with 
which the investor maintains an account.\15\ Revised Article 8 refers 
to this type of securities ownership arrangement as an ``indirect 
holding'' arrangement,\16\ as distinguished from a ``direct holding'' 
arrangement in which the investor's ownership interest appears on the 
issuer's books.\17\ Revised Article 8 has significantly clarified the 
legal rights and duties that apply in indirect holding 
arrangements,\18\ and every state has enacted Revised Article 8 into 
law.\19\
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    \10\ See Uniform Commercial Code, Revised Article 8--Investment 
Securities (With Conforming and Miscellaneous Amendments to Articles 
1, 4, 5, 9, and 10) (1994 Official Text with Comments) (``Revised 
Article 8''), Prefatory Note at I.B., C., and D.; Warren F. Cooke, 
United States Legal Report, in Banking Yearbook 1998 157-62 (Richard 
Forster ed., Euromoney Publications 1998) (referring to Revised 
Article 8 as ``[o]ne of the most significant legal shifts in the 
U.S. legal landscape affecting banking'').
    \11\ Revised Article 8, supra note 10, Prefatory Note to Art. 8, 
Part III.A. and Sec. 8-102(a)(14) (defining a ``securities 
intermediary'').
    \12\ The Depository Trust Company (``DTC'') is a registered 
clearing agency that acts as the securities depository for most 
publicly traded equity securities and many fixed-income securities 
(other than government securities) in U.S. markets.
    \13\ Intermediaries deposit their securities with a depository, 
and the depository's records reflect the ownership interests of the 
various intermediaries in those securities. See Revised Article 8, 
supra note 10, Prefatory Note to Art. 8, Parts I.B., C., and D.
    \14\ See Revised Article 8, supra note , Sec. 8-102(a)(17) and 
cmt. 17 (``security entitlement'' means ``the rights and property 
interest of an entitlement holder with respect to a financial 
asset'' in an ``indirect holding'' arrangement).
    \15\ A security entitlement gives the investor a limited pro 
rata property interest in comparable entitlements (or other 
interests in securities) maintained by the investor's intermediary 
with a depository or other intermediary. See Revised Article 8, 
supra note 10, Secs. 8-503(b) and cmt. 1, and 8-504 and cmt. 1 (all 
customers of the securities intermediary share a pro rata property 
interest in all interests in the same financial asset held by the 
intermediary).
    \16\ An indirect holding arrangement can be compared to a chain 
of persons who hold interests in a particular security. The investor 
stands at one end of the chain and the issuer at the other end. They 
are linked by one or more securities intermediaries (such as a bank 
and a depository). The investor has certain rights against the 
intermediary linked to it, which in turn has rights against the next 
intermediary. The issuer owes certain duties to the depository, 
which owes duties to the next intermediary, which owes duties to the 
investor. See generally Revised Article 8, supra note 10, Prefatory 
Note to Art. 8, Parts I.B., C., D., and II.C., and Sec. 8-109.
    \17\ In a direct holding arrangement, the investor or its 
custodian may hold either certificates or uncertificated securities 
that have been registered in the investor's own name.
    \18\ See infra note and accompanying text.
    \19\ Revised Article 8 has been adopted by all 50 states, the 
District of Columbia, and Puerto Rico. The National Conference of 
Commissioners on Uniform State Laws, Introductions & Adoptions of 
Uniform Acts: A Few Facts About'Revised UCC Article 8 (1994) 
(visited Aug. 14, 2001) http://www.nccusl.org/nccusl/uniformact--
factsheets/uniformacts-fs-ucca8.asp>. The U.S. Department of the 
Treasury relied on Revised Article 8 in drafting its Treasury/
Reserve Automated Debt Entry System (``TRADES'') regulations for 
government securities. See Regulations Governing Book-Entry Treasury 
Bonds, Notes and Bills, Department of the Treasury Circular, Public 
Debt Series, No. 2-86 [61 FR 43626 (Aug. 23, 1996)] (``1996 Treasury 
Circular'') (adopting TRADES regulations codified at 31 CFR 357, 
Subpart B). The Commission staff has stated that it would not 
recommend enforcement action if certain funds used the federal book-
entry system under the revised regulations. Investment Company 
Institute, SEC No-Action Letter (Oct. 3, 1997).
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    Last year, we adopted a new rule concerning the use of foreign 
securities depositories that focused on the risk of these 
arrangements.\20\ In the domestic context, the important changes in 
custody practice and commercial law that have occurred since 1978 have 
reduced the risks of these arrangements, and made some requirements of 
rule 17f-4 unnecessary for the protection of fund assets. Today we are 
proposing to revise rule 17f-4 to reflect these and other developments. 
The amendments would (i) expand the types of custodial entities that 
may operate depositories under the rule and the functions they may 
perform, as well as the types of investment companies that may rely on 
the rule, (ii) update the conditions of the rule, and (c) revise 
certain fund approval requirements for custody arrangements involving 
depositories.
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    \20\ See Custody of Investment Company Assets Outside the United 
States, Investment Company Act Release No. 24424 (Apr. 27, 2000) [65 
FR 25630 (May 3, 2000)] (``Rule 17f-7 Adopting Release'').
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II. Discussion

A. Functions of a Securities Depository

    We propose to update the terms we use in the rule to reflect the 
broader range of functions today performed by securities depositories 
for funds. The rule currently permits a securities depository to hold 
fund securities that are transferred (or pledged) by bookkeeping 
entry.\21\ The proposed amendments would permit a depository to hold 
fungible assets that are transferred, pledged, or ``otherwise acquired 
or disposed of'' by bookkeeping entry.\22\ Permitting a depository to 
hold assets that may be ``acquired or disposed of'' without being 
``transferred'' would accommodate the use of depositories that hold 
open-end fund shares or ``Treasury Direct'' securities, both of which 
securities typically are conveyed through redemption by the issuer.\23\ 
Other

[[Page 58414]]

amendments to rule 17f-4 also would permit a depository to hold assets 
that are conveyed ``by physical delivery.'' \24\ This change is 
designed to facilitate the use of centralized custody arrangements for 
investments that are commonly held in certificate form.\25\
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    \21\ See rule 17f-4(a).
    \22\ Proposed rule 17f-4(b)(9). Rule 17f-4 also requires that 
the securities be fungible. Under the proposed amendments, the 
securities would be considered fungible even if a depository 
transfers some shares of the same class in different forms (e.g., it 
transfers most shares in electronic form, but periodically transfers 
some shares in certificate form).
    \23\ See Revised Article 8, supra note 10, at Sec. 8-102(a)(18) 
(``uncertificated security'' means a security that is not 
represented by a certificate); Sec. 8-103 cmt. 3 (``the typical 
transaction in shares of open-end investment companies is an 
issuance or redemption, rather than a transfer of shares''); 1996 
Treasury Circular, supra note 19, Appendix B to Part 357 at n.1 and 
accompanying text (describing ``Treasury Direct'' system through 
which investors may hold non-transferable Treasury securities issued 
directly to them).
    \24\ A centralized processing facility that transfers 
certificates by physical delivery appears to offer benefits 
comparable to those of a depository, including centralized custody, 
recordkeeping, and transfer capabilities, and reduction of the 
expenses, delays, and risks of decentralized holding of 
certificates.
    \25\ These types of investments include some equity securities, 
bankers acceptances, certificates of deposit, municipal securities, 
and non-depository eligible mortgage-backed securities.
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    The proposed amendments also would update the terminology of rule 
17f-4 that describes how funds and their custodians use depositories. 
The rule currently permits a fund or its custodian (or an agent of the 
custodian) to ``deposit * * * securities owned by'' the fund in a 
depository.\26\ The proposed amendments would permit a fund or its 
custodian to ``place and maintain assets'' in a depository,\27\ and 
permit a custodian to use an ``intermediary custodian.''\28\
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    \26\ Rule 17f-4(b).
    \27\ Proposed rule 17f-4(a). ``Place and maintain'' would be 
substituted for ``deposit'' in order to make the language of the 
rule more consistent with Revised Article 8 and with rules 17f-5 and 
17f-7. See Revised Article 8, supra note 10, Sec. 8-504 (duty of 
securities intermediary to ``maintain'' financial asset); rule 17f-5 
Note; rule 17f-7 Note. ``Assets'' would be substituted for 
``securities owned by the fund'' to clarify that assets are not 
always held in the fund's name and may not be its exclusive 
property. See supra note 15. ``Assets'' would include cash, 
securities, and similar investments owned by the fund or held by 
another person for the fund's benefit. Proposed rule 17f-4(b)(1). 
The staff has stated that it would not recommend enforcement action 
if a fund that participated directly in a depository maintained a 
cash account to facilitate settlement or to secure obligations to a 
reserve fund. Midwest Securities Trust Co., SEC No-Action Letter 
(Mar. 14, 1990).
    \28\ Proposed rule 17f-4(b)(5) (an intermediary custodian would 
mean any subcustodian through which the fund's custodian maintains 
assets with a depository, if the subcustodian is qualified to act as 
a custodian).
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B. Scope of the Rule

    Rule 17f-4 permits funds to maintain assets with a depository 
established by a registered clearing agency, such as DTC, and the book-
entry system of the Federal Reserve.\29\ We now propose to revise the 
scope of rule 17f-4 by permitting funds to maintain assets with a 
registered transfer agent for the purpose of holding shares of an open-
end registered management investment company (mutual fund).\30\ This 
amendment would acknowledge that a mutual fund's transfer agent may 
serve as the functional equivalent of a depository.\31\ This amendment 
responds to the growth in ``fund of funds,'' cash sweep and other 
arrangements in which a registered investment company invests in shares 
of a mutual fund.
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    \29\ See rule 17f-4(b)(1), (2), (c), and (d). The proposed 
amendments would update references to Treasury regulations to 
reflect revisions and to add a reference to the Treasury Direct 
regulations. See supra note 19; proposed rule 17f-4(a)(4)(i).
    \30\ Proposed rule 17f-4(a)(4)(iii). A conventional depository 
rarely holds shares issued by a fund. See Transfer Agents Operating 
Direct Registration System, Securities Exchange Act Release No. 
35038 (Dec. 1, 1994) [59 FR 63662 (Dec. 8, 1994)] at n.6 and 
accompanying text. The staff has stated that it would not recommend 
enforcement action when a fund acts as a transfer agent for its own 
shares. See Capital Supervisors Helios Fund, Inc., SEC No-Action 
Letter (June 18, 1984). See also American Pension Investors Trust, 
SEC No-Action Letter (Feb. 1, 1991) (staff stated it would not 
recommend enforcement action if the custodian for fund of funds 
maintained shares of underlying funds with its transfer agent based 
on rule 17f-4 if underlying funds did not disclaim liability for 
acting on instructions believed to be genuine); Gardner Fund, SEC 
No-Action Letter (Mar. 7, 1988) (staff stated that it would not 
recommend enforcement action if fund of funds maintained its 
investments directly with transfer agents of unaffiliated funds, 
subject to conditions based on rules 17f-2 and 17f-4).
    \31\ A registered transfer agent, like a clearing agency, is 
subject to significant regulatory oversight. A transfer agent must 
register with the Commission or a bank regulatory agency, section 
17A(c) of the Exchange Act [15 U.S.C. 78q-1(c)], and must comply 
with Commission regulations that govern its primary functions. See 
sections 17A(d)(1) and (2) of the Exchange Act [15 U.S.C. 78q-
1(d)(1)-(2)] (Commission may prescribe regulations for any 
registered transfer agent, which may be enforced by Commission or 
transfer agent's appropriate regulatory agency); rules 17Ad-1 to 
17Ad-13 [17 CFR 240.17Ad-1--240.17Ad-13] (Commission rules apply to 
all registered transfer agents, including banks, with limited 
exceptions for ``exempt transfer agents'' that handle few 
transactions under 17 CFR 240.17Ad-4(b)); Securities Exchange Act 
Release No. 35038, supra note 30 (Commission rules address matters 
including the timely issuance and cancellation of certificates, 
recordkeeping practices, and the safeguarding of securities and 
cash); sections 17A(d)(3), (d)(4), and (f) of the Exchange Act [15 
U.S.C. 78q-1(d)(3), (d)(4), and (f)] (rules adopted by other 
regulatory bodies must be consistent with Commission rules).
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    We request comment on the scope of rule 17f-4 and our proposed 
amendments. Are there other organizations that act as depositories for 
funds? Should they be included in the rule?

C. Reliance on Rule by Non-Management Companies

    Rule 17f-4 currently permits only registered management investment 
companies, i.e., open-end funds (or mutual funds) and closed-end funds, 
to rely on the rule.\32\ The proposed amendments would broaden the rule 
to permit any registered investment company, including a unit 
investment trust (``UIT'') or a face-amount certificate company, to use 
a securities depository.\33\ The staff has stated that it would not 
recommend enforcement action in similar circumstances when non-
management companies maintained assets in a depository\34\ to 
supplement custody arrangements with a trustee.\35\ Because a non-
management company has no directors, officers, or investment adviser, 
the proposed amendments would authorize a trustee to approve these 
arrangements.\36\ The trustee also would have to establish an internal 
control system reasonably designed to prevent unauthorized officer's 
instructions.\37\ The Commission requests comment on these proposals 
for the use of depositories by non-management companies. Should other 
conditions apply to these arrangements? \38\
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    \32\ Rule 17f-4(b). Section 17(f) of the Investment Company Act 
likewise applies to registered management companies.
    \33\ Proposed rule 17f-4(b)(4) (``fund'' means a registered 
investment company).
    \34\ E.g., Bradford Trust Co., SEC No-Action Letter (Nov. 29, 
1982) (staff stated it would not recommend enforcement action if 
trustee maintained UIT's holdings of corporate and municipal bonds 
with DTC); United States Trust Co. of New York, SEC No-Action Letter 
(Apr. 16, 1992) (staff stated it would not recommend enforcement 
action if trustee maintained UIT's investments in open-end funds 
with transfer agents of portfolio funds under conditions based on 
rule 17f-4, if portfolio funds did not disclaim liability for acting 
on instructions believed to be genuine). Insurance company separate 
accounts registered as UITs also may use depository-like 
arrangements. See rule 26a-2(b) under the Act [17 CFR 270.26a-2(b)] 
(separate account registered as UIT may hold securities of 
underlying portfolio funds in uncertificated form with transfer 
agent); rules 6e-2(b)(9)(iv) and 6e-3(T)(b)(9)(iv) under the Act [17 
CFR 270.6e-2(b)(9)(iv), and 270.6e-3(T)(b)(9)(iv)].
    \35\ Section 26(a)(2)(D) of the Act [15 U.S.C. 80a-26(a)(2)(D)] 
requires the assets of a UIT to be held by a trustee. Section 28(c) 
of the Act [15 U.S.C. 80a-28(c)] imposes similar requirements on a 
face-amount certificate company, but authorizes the Commission to 
adopt custody rules.
    \36\ Proposed rule 17f-4(a)(3).
    \37\ Proposed rule 17f-4(a)(2)(ii) and (b)(6). The staff has 
stated that it would not recommend enforcement action if, among 
other things, a trustee maintained a system designed to prevent 
unauthorized officer's instructions. United States Trust Co. of New 
York, supra note 34. Under the proposed amendments, the trustee as 
the fund's custodian also would have to enter into an appropriate 
custody agreement with the company's sponsor. See proposed rule 17f-
4(a)(1).
    \38\ See, e.g., United States Trust Co. of New York, supra note 
34 (staff stated that it would not recommend enforcement action if, 
among other things, the shares of a portfolio fund were registered 
with transfer agent in the name of trust company as trustee of UIT).
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D. Compliance Requirements for the Custodian or Securities Depository

    Rule 17f-4 requires that, if a fund holds securities in a 
depository through a custodian or its agents, the custodian must 
maintain the fund's securities in a depository account for the 
custodian's

[[Page 58415]]

customers that is separate (or ``segregated'') from the depository 
account for the custodian's own securities, and must identify (or 
``earmark'') on the custodian's records a portion of the total customer 
securities as belonging to the fund (the ``segregation and earmarking 
requirements''). The custodian also must send to the fund confirmations 
of transfers to or from the fund's account with the custodian (the 
``confirmation requirement'').\39\ In addition, a depository that deals 
directly with a fund must deliver the fund's securities to an 
appropriate successor if the depository no longer acts for the fund 
(the ``successor custodian requirement'').\40\ Each of these 
requirements appears unnecessary for the protection of fund assets in 
light of the revisions to commercial law adopted in Revised Article 8. 
The proposed amendments would eliminate these requirements and 
substitute requirements designed to provide reasonable protection for 
fund assets under modern commercial law.
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    \39\ See rule 17f-4(d)(2)-(3).
    \40\ See rule 17f-4(c)(2).
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    With respect to the segregation and earmarking requirements, 
Revised Article 8 provides that a fund and other customers of a 
custodian have proportionate interests in all securities of the 
custodian, even if the custodian does not segregate particular 
securities as the property of customers.\41\ In addition, the 
earmarking of some securities for the fund rather than other customers 
appears inconsistent with the guiding principle of Revised Article 8 to 
treat entitlement holders alike.\42\ The confirmation requirement of 
rule 17f-4 seems unnecessary to establish the fund's ownership of 
security entitlements under commercial law,\43\ and may in effect limit 
the methods the custodian uses to inform the fund about the status of 
its securities account.\44\ Finally, the rule's successor custodian 
requirement seems unnecessary\45\ and concerns matters that should 
reasonably be the responsibility of the fund.\46\
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    \41\ See supra note 15 and accompanying text; cf. Revised 
Article 8, supra note 10, Sec. 8-511 (entitlement holders have 
priority over creditors' claims to all assets of their securities 
intermediary, unless a creditor has perfected a security interest in 
some assets by obtaining ``control''). In direct holding 
arrangements, segregation of customer assets seems unnecessary to 
protect fund shares or securities certificates that are maintained 
in the fund's own name with a depository such as a transfer agent or 
a centralized processing facility.
    \42\ See Revised Article 8, supra note 10, Sec. 8-503 and cmts. 
1-2 (one entitlement holder generally cannot assert that its rights 
to the assets held by a securities intermediary are superior to the 
rights of another entitlement holder; a security entitlement is not 
a claim to a specific identifiable thing).
    \43\ See Revised Article 8, supra note 10, Sec. 8-501(b) and 
cmt. 2 (securities intermediary creates a security entitlement when 
it indicates by book entry that a financial asset has been credited 
to the customer's account, accepts an asset for credit to the 
account, or becomes obligated under law to credit an asset); cmt. 3 
(the existence of a security entitlement does not depend on when the 
custodian acquires financial assets to support it); cf. 1977 
Reproposing Release, supra note 9, at nn. 4-7 and accompanying text 
(confirmation may help to establish fund's ownership of securities). 
Confirmation also seems unnecessary to protect assets that are 
maintained directly with a depository in the fund's own name. See 
supra note 41.
    \44\ The custodian and fund may prefer timed updates, daily 
balance reports, or other methods of indicating that the custodian 
has credited an account. See Revised Article 8, supra note 10, 
Sec. 8-501(b) cmt. 2 (``Paragraph (1) does not attempt to specify 
exactly what accounting, record-keeping, or information transmission 
steps suffice to indicate that the intermediary has credited the 
account. That is left to agreement, trade practice, or rule in order 
to provide the flexibility necessary to accommodate varying or 
changing accounting and information processing systems.'').
    \45\ Rule 17f-4(c)(2) requires that, if a fund deals with a 
depository directly (rather than through a custodian), the 
arrangement with the depository must provide that, if the depository 
ceases to act for the fund, it will deliver the fund's assets to an 
appropriate successor custodian. The provision appears unnecessary 
because failure by a fund to maintain assets in a permissible manner 
would violate section 17(f) of the Act.
    \46\ See infra Section II.E.
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    The proposed amendments to rule 17f-4 would substitute more general 
compliance requirements for custodians and depositories in place of 
these existing requirements.\47\ First, the fund's contract with its 
custodian would be required to provide that the custodian will take all 
actions reasonably necessary or appropriate under applicable commercial 
and regulatory law to safeguard assets held by the custodian, or assets 
maintained elsewhere for the benefit of the fund.\48\ If the fund deals 
directly with a depository, the depository's contract or rules for 
participants would be required to provide that the depository will meet 
similar obligations.\49\ These undertakings would assure that the 
fund's own custodian or depository must comply with the specified 
duties of a securities intermediary or issuer under Revised Article 
8.\50\ This assurance is important because Revised Article 8 sharply 
limits the ability of a fund to seek recourse from any party other than 
its own custodian for assets mishandled by the custodian.\51\
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    \47\ Proposed rule 17f-4(a)(1) and (2)(i).
    \48\ Proposed rule 17f-4(a)(1)(i) (obligation of custodian or 
trustee of unit investment trust). The applicable commercial law 
normally would be the local law of the jurisdiction of the 
custodian, see Revised Article 8, supra note 10, Sec. 8-110, which 
would usually be Revised Article 8 or similar regulations that 
govern the federal book-entry system.
    \49\ Proposed rule 17f-4(a)(2)(i). A depository that deals only 
with the fund's custodian would not have to enter into an agreement 
with the fund.
    \50\ The securities intermediary's duties under commercial law 
include: (i) maintaining sufficient unencumbered financial assets to 
cover all security entitlements of all entitlement holders, see 
Revised Article 8, supra note 10, Sec. 8-504; (ii) obtaining for the 
entitlement holder payments made by the issuer of a financial asset, 
id., Sec. 8-505; (iii) exercising rights with respect to a financial 
asset (such as the right to vote proxy materials) as directed by the 
holder, id., Sec. 8-506; (iv) complying with orders given by the 
holder concerning financial assets (such as to dispose of 
entitlements), id., Sec. 8-507; and (v) changing the holder's 
entitlement into another available form of holding upon request 
(such as converting it into a security certificate in a direct 
holding arrangement), id., Sec. 8-508. A transfer agent may be 
subject to the duties of an issuer under commercial law. See, e.g., 
Revised Article 8, Sec. 8-207 (duties of issuer concerning 
registered owner); Sec. 8-401 (duty of issuer to register transfer).
    \51\ See Revised Article 8, supra note 10, Secs. 8-116, 8-502, 
8-503 and cmts. 2-3, 8-510 (adverse claims may not be asserted 
against a purchaser who acquires a security entitlement for value 
and without notice of the adverse claims; entitlement holders may 
assert a claim against a purchaser other than their securities 
intermediary only if their own intermediary is insolvent and lacks 
sufficient assets to satisfy their claims, and the purchaser 
knowingly colluded with the intermediary to violate duties to 
holders); Policy Perspectives, supra note 4, at 1508.
---------------------------------------------------------------------------

    Second, the custody contract (or depository rules) would have to 
state that the custodian (or depository) will promptly provide periodic 
reports on its internal accounting controls and financial strength, and 
available reports on the controls of any depository or intermediary 
custodian it uses.\52\ Rule 17f-4 currently requires a custodian to 
provide similar reports about internal controls.\53\ Periodic review of 
a custodian's controls by fund auditors is a significant safeguard for 
fund assets.\54\ The fund also should consider the financial strength 
of its own custodian or of any depository with which it deals 
directly.\55\
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    \52\ Proposed rule 17f-4(a)(1)(ii) (obligation of custodian); 
see proposed rule 17f-4(a)(2)(i) (similar obligation for depository 
that deals directly with the fund).
    \53\ See rule 17f-4(d)(4).
    \54\ Fund auditors review a custodian's internal controls when 
evaluating factors that could affect the fair presentation of 
information in financial statements. See AICPA Audit and Accounting 
Guide, Audits of Investment Companies, Paras.  2.132 to 2.136 (May 
1, 1998) (auditor reviews fund's internal control structure and 
considers custodian's controls; should test interaction of these 
controls); Sub-Item 77B of Form N-SAR [17 CFR 274.101] (auditor's 
report on internal controls must be attached to the fund's Form N-
SAR report).
    \55\ Revised Article 8 severely limits the circumstances in 
which the fund could assert a claim against anyone other than its 
own custodian. See supra note and accompanying text.
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    The Commission requests comment on the proposed contractual 
requirement to take actions necessary or appropriate under applicable 
commercial and regulatory law to safeguard assets. Should the rule 
specify duties applicable in particular

[[Page 58416]]

circumstances?\56\ Should the rule clarify that custody contracts 
should not generally waive duties under commercial law? \57\ We also 
request comment on the proposed contractual requirement to provide 
reports on the custodian's internal accounting controls and financial 
strength, and reports on the internal controls of subcustodians. Is it 
appropriate to require reports about the custodian's financial 
strength? Are reports on subcustodians' internal controls unnecessary 
because subcustodians do not deal directly with the fund? \58\ Should 
other requirements apply to a custodian or depository? Should the 
amendments include a transition provision that would apply the current 
requirements of the rule to any custody arrangement that remains 
subject to Prior Article 8?\59\
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    \56\ Special duties might be appropriate when a fund or its 
custodian maintains securities certificates with a centralized 
processing facility. If the certificates are not endorsed to the 
facility, and the facility does not act as a representative for the 
issuer, the facility may not have to comply with either the duties 
of a securities intermediary or the duties of an issuer under 
Revised Article 8.
    \57\ See Revised Article 8, supra note 10, Secs. 8-111, 8-
504(c)(1), 8-505(a)(1), 8-506(1), 8-507(a)(1), 8-508(1), 8-509(b) 
(securities intermediary must perform its duties under Revised 
Article 8 with ``due care in accordance with reasonable commercial 
standards,'' unless modified by regulatory requirements or 
contractual provisions that meet ``good faith'' standard).
    \58\ A fund could rarely assert a claim against an intermediary 
with which it does not deal directly. See supra note 51.
    \59\ A few U.S. jurisdictions may require additional time to 
enact Revised Article 8 into law. See supra note. In jurisdictions 
where Revised Article 8 is in effect, a fund would need to update 
its custody contracts to incorporate the revised protections and 
remove any inconsistent provisions. See proposed rule 17f-4(a)(3) 
(discussed below).
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E. Approval of Custody Arrangements

    We are proposing to eliminate the requirements of rule 17f-4 that 
fund directors approve (i) the fund's direct arrangements with 
depositories, and (ii) arrangements by custodians with 
depositories.\60\ Custody arrangements involving depositories have 
become routine.\61\ Although directors, in exercising their general 
responsibility to oversee fund operations, should monitor the fund's 
dealings with its own custodian, close involvement in approving 
arrangements with domestic depositories appears unnecessary. The 
amendments would permit the fund itself (through an officer) to approve 
arrangements with depositories and with custodians that use 
depositories.\62\
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    \60\ See rule 17f-4(c)(3), (d)(5); proposed rule 17f-4(a)(3).
    \61\ See Revision of Certain Annual Review Requirements of 
Investment Company Boards of Directors, Investment Company Act 
Release No. 19719 (Sept. 17, 1993) [58 FR 49919, 49920 (Sept. 24, 
1993)] (commenters suggested that depository arrangements are 
commonplace, generally do not involve conflicts of interest, and 
involve a degree of technical expertise that is more appropriately 
exercised by fund management); cf. id. at n.15 (consent requirement 
in section 17(f) may favor director approval); see SEC Division of 
Investment Management, Protecting Investors: A Half-Century of 
Investment Company Regulation at 255 (May 1992) (directors should 
primarily address conflicts of interest).
    \62\ See proposed rule 17f-4(a)(3). This approval would satisfy 
the statutory requirement that a custodian use a system for the 
central handling of securities only ``with the consent of the 
registered management company for which it acts as custodian.'' See 
section 17(f). If the fund is a unit investment trust or other non-
management company, a trustee would be required to approve those 
arrangements. See proposed rule 17f-4(a)(3).
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    The Commission requests comment on these proposals. Should the fund 
or its directors have to approve any arrangement in which the custodian 
maintains certificates in the fund's name with a centralized processing 
facility,\63\ or maintains fund shares with a transfer agent that acts 
as a depository? Should the fund board have to approve any direct 
dealings with a depository?
---------------------------------------------------------------------------

    \63\ See supra note and accompanying text.
---------------------------------------------------------------------------

F. Note Clarifying Application of Rule 17f-4

    We propose to add a note to rule 17f-4 clarifying the relationship 
between that rule and rule 17f-5 under the Act, which governs the 
maintenance of fund assets with a foreign custodian.\64\ The note would 
state that a custody arrangement in which fund assets are held with a 
U.S. depository through a foreign custodian, would be governed by rule 
17f-5 as well as by rule 17f-4.\65\
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    \64\ The note would not add any new requirements, but instead 
would clarify the operation of rules 17f-4 and 17f-5 in cases where 
fund assets are held with a U.S. depository through a foreign 
custodian.
    \65\ In some circumstances, rule 17f-2 (governing fund ``self-
custody'') may apply to a depository arrangement as well. The staff 
has taken the position that a ``self-custody'' arrangement may arise 
when the fund's investment adviser controls or is controlled by (or 
is under common control with) the fund's custodian, intermediary 
custodian, or depository, and that these arrangements may be subject 
to rule 17f-2 under the Investment Company Act (governing self-
custody arrangements), as well as rule 17f-4. See, e.g., Rodney 
Square Fund, SEC No-Action Letter (June 15, 1987) (staff refused to 
provide assurance concerning enforcement action in case where a 
fund's custodian was adviser to one fund and controlled adviser to 
other funds, and custodian/adviser retained effective control over 
assets even though it maintained assets with unaffiliated 
depository). See also Mutual Fund Group, SEC No-Action Letter (Dec. 
12, 1989) (staff refused to provide assurance concerning enforcement 
action in case where a fund's adviser also acted as subcustodian, 
despite fund's use of unaffiliated custodian); In the Matter of 
Gofen and Glossberg, Inc., Investment Advisers Act Release No. 1400 
(Jan. 11, 1994) (the Commission imposed sanctions for adviser's 
failure to protect client trust assets held by unaffiliated 
custodian but transferable by adviser's employees as trustees). The 
existence of common personnel also may raise self-custody concerns. 
See, e.g., Dean Witter World Wide Investment Trust, SEC No-Action 
Letter (Mar. 14, 1988) (staff stated that it would not recommend 
enforcement action if, among other things, foreign adviser's 
personnel did not have access to assets held by affiliated domestic 
custodian).
---------------------------------------------------------------------------

III. General Request for Comment

    The Commission requests comment on the rule amendments proposed in 
this Release, suggestions for additional changes to existing rules or 
forms, and comment on other matters that might have an effect on the 
proposals contained in this Release. For purposes of the Small Business 
Regulatory Enforcement Fairness Act of 1996,\66\ the Commission also 
requests information regarding the potential impact of the proposals on 
the U.S. economy on an annual basis. Commenters are requested to 
provide empirical data to support their views.
---------------------------------------------------------------------------

    \66\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

IV. Effects on Efficiency, Competition, and Capital Formation

    Section 2(c) of the Investment Company Act requires the Commission, 
when it engages in rulemaking and is required to determine whether an 
action is consistent with the public interest, to consider, in addition 
to the protection of investors, whether the action will promote 
efficiency, competition, and capital formation.\67\ The Commission 
therefore requests comment whether the proposals, if adopted, would 
promote efficiency, competition, and capital formation. Does rule 17f-4 
currently create inefficiencies? Would the proposed amendments reduce 
or compound those inefficiencies? Would other regulatory approaches be 
more efficient? Does rule 17f-4 currently hinder competition or capital 
formation? Would the proposed amendments, or any alternative 
amendments, result in improvements in competition or capital formation? 
Commenters are requested to provide empirical data to support their 
views.
---------------------------------------------------------------------------

    \67\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    We have received correspondence from an association of global bank 
custodians (``Bank Custodians'') that raises issues of regulatory 
fairness under the Commission's rules. The Bank Custodians recommend 
that the Commission treat domestic and transnational depositories 
similarly under the Commission's custody rules under section 17(f).\68\ 
The Bank

[[Page 58417]]

Custodians stated that the treatment of depositories under rule 17f-4, 
rule 17f-5 (governing eligibility of foreign custodians to hold fund 
assets), and rule 17f-7 (governing eligibility of foreign depositories 
to hold fund assets) is premised on two assumptions--that U.S. 
depositories will handle and hold securities that are traded in the 
United States, and that foreign banks and depositories will handle and 
hold securities that trade outside the United States, in the 
jurisdiction in which the securities' markets are located. In the Bank 
Custodians' view, these assumptions are becoming increasingly obsolete, 
because local depositories often do not serve a single market but 
instead are portals to custody in other markets. Given this 
development, the Bank Custodians suggest that rule 17f-4 should include 
requirements that are similar to those contained in rules 17f-5 \69\ 
and 17f-7 \70\ or, alternatively, that the requirements of the latter 
rules should apply if a domestic depository holds custody of its assets 
with foreign custodians or depositories.\71\
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    \68\ See Letter from Daniel L. Goelzer, Baker & McKenzie, to 
Robert E. Plaze, Associate Director, Division of Investment 
Management (Dec. 7, 2000). See also Letter from Daniel L. Goelzer, 
Baker & McKenzie, to C. Hunter Jones, Assistant Director, Division 
of Investment Management (Oct. 17, 2001). These letters are 
available in File No. S7-19-00 (comments on Commission's Regulatory 
Flexibility Agenda issued Oct. 17, 2000) and in File No. S7-22-01.
    \69\ Rule 17f-5 generally requires that a delegate of the fund's 
board of directors (i) determine that the assets will be subject to 
reasonable care, (ii) determine that the arrangement with the 
foreign custodian is governed by a written contract that meets 
specified standards, and (iii) monitor the appropriateness of 
maintaining the fund's foreign assets with the custodian. Rule 17f-4 
does not include these requirements.
    \70\ Rule 17f-7 generally requires a foreign depository to meet 
minimum requirements in order to be an ``eligible securities 
depository'' and requires that each fund's primary custodian provide 
the fund (or its adviser) with a continually updated risk analysis 
of the foreign depository. Rule 17f-4 does not include these 
requirements.
    \71\ We encountered a similar issue during the adoption of rule 
17f-7. We noted at that time that the risk analyses performed under 
that rule with respect to a transnational depository should include 
information reasonably available about the depository's global 
custodial network. See Rule 17f-7 Adopting Release, supra note , at 
n.24.
---------------------------------------------------------------------------

    We have decided not to propose the amendments to rule 17f-4 
suggested by the Bank Custodians at this time, because they may impose 
unnecessary burdens on funds using U.S. depositories. We regulate the 
U.S. depositories discussed by the Bank Custodians as clearing agencies 
under the Securities Exchange Act of 1934.\72\ As such, they are 
subject to rigorous standards for their operations, which are designed 
to safeguard the interests of investors, including investment 
companies.\73\ Before a clearing agency may establish a link with a 
foreign custodian or depository, it must obtain an order from us after 
demonstrating that its arrangement with the custodian or depository 
will adequately safeguard customer securities.\74\ We believe our 
approval and ongoing monitoring of a clearing agency's link with a 
foreign custodian or depository provide at least the same degree of 
protection of fund assets as the standards that apply to a foreign 
custodian or depository that holds assets on behalf of a fund under 
rules 17f-5 and 17f-7.\75\ Thus it initially appears unnecessary to 
require U.S. depositories that link to foreign custodians and 
depositories to also satisfy the eligibility requirements of rules 17f-
5 and 17f-7.
---------------------------------------------------------------------------

    \72\ See section 17A of the Exchange Act [15 U.S.C. 78q-1]. The 
Fedwire system and mutual fund transfer agents do not register as 
clearing agencies, but are very unlikely to hold securities through 
a foreign custodian or depository.
    \73\ In 1980 the Commission specified the standards that would 
apply to the registration and oversight of clearing agencies under 
the Exchange Act. Those standards relate to the provisions of 
section 17A that require clearing agencies to have the capacity to 
facilitate the prompt and accurate settlement of securities 
transactions, and safeguard securities and assets in their control. 
See 15 U.S.C. 78q-1(b)(3)(A), (F). The standards require the 
clearing agency, among other things, to: (i) perform periodic risk 
assessments of its operations; (ii) have a board audit committee 
composed of non-management directors who select (or participate in 
selecting) the agency's independent public accountant and review its 
work; (iii) have a competent internal audit department that reviews 
the clearing agency's system of internal accounting controls; (iv) 
annually furnish to participants audited financial statements, and 
furnish on request unaudited quarterly financial statements; (v) 
annually furnish to participants an opinion report prepared by the 
independent public accountant based on a study and evaluation of the 
clearing agency's system of internal accounting control; and (vi) 
have detailed plans to assure the physical safeguarding of 
securities and funds, the integrity of the automatic data processing 
systems, and the recovery from loss or destruction of securities, 
funds or data. See Securities Exchange Act Release No. 16900 (June 
17, 1980) [45 FR 41920 (June 23, 1980)].
    \74\ See, e.g., Self-Regulatory Organizations; The Depository 
Trust Company, Securities Exchange Act Release No. 39657 (Feb. 12, 
1998) [63 FR 8725 (Feb. 20, 1998)] (notice of proposed link between 
DTC and Canadian securities depository); Self-Regulatory 
Organizations; The Depository Trust Company, Securities Exchange Act 
Release No. 40523 (Oct. 13, 1998) [63 FR 54739 (Oct. 13, 1998)] 
(order approving proposed link).
    \75\ When approving links between a U.S. clearing agency and a 
foreign custodian or depository, the Commission applies the same 
standards for the safeguarding of securities as it does for 
securities held with a U.S. clearing agency. See supra note 73. 
Thus, a U.S. clearing agency's custodial arrangements with a foreign 
custodian or depository are held to U.S. standards. In contrast, 
rule 17f-5 permits a fund's foreign custody manager to determine 
that assets maintained on behalf of the fund are subject to 
reasonable care based on the standards applicable to custodians in 
the relevant foreign market, even if those standards are lower than 
those that would be acceptable for a U.S. custodian. 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)], at n.39 and accompanying text.
---------------------------------------------------------------------------

    While we are not proposing the amendments to rule 17f-4 recommended 
by the Bank Custodians, we are concerned about the issues of regulatory 
fairness raised in their letter. Would our failure to apply rules 17f-5 
and 17f-7 (or their requirements) to domestic depositories create an 
unfair burden on competition between domestic depositories and global 
custodians of funds? If it would, should we therefore apply those rules 
to U.S. depositories that hold fund assets through foreign linkages? 
Alternatively, should we amend rules 17f-5 and 17f-7 to provide an 
exception from some or all of their requirements if a fund maintains 
assets with a foreign custodian with which a U.S. depository has 
established a linkage? Would such a change impede the establishment of 
linkages that a U.S. depository might otherwise choose to establish?
    We specifically request analyses of the costs and benefits of any 
such regulatory approaches. Is there any difference in costs to funds 
and risks to investors, either because of differences in disclosure to 
funds or otherwise, between arrangements in which a fund uses a 
clearing agency's linkage with a foreign depository to hold custody of 
foreign assets, versus arrangements in which a fund holds assets in a 
foreign depository through a global custodian? Would any of the 
alternatives impose unnecessary regulatory burdens, or impose 
overlapping or duplicative requirements? What would be the effect of 
each alternative on efficiency, competition, and capital formation? We 
request that commenters provide us with data that we might use in 
evaluating the costs and benefits of the alternative approaches.\76\
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    \76\ The Bank Custodians have estimated, for example, that the 
average costs of complying with the risk monitoring provisions of 
rule 17f-7 for its nine member banks are $300,000 per bank. See 
Letter from Daniel L. Goelzer, Baker & McKenzie, to C. Hunter Jones, 
Assistant Director, Division of Investment Management (Oct. 17, 
2001).
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V. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits that result 
from its rules. The proposed amendments to rule 17f-4 respond to 
developments in securities custody practices and commercial law that 
have occurred since the rule was adopted. The proposed amendments would 
expand the types of funds and custodial entities that may rely on the 
rule, update the rule's compliance requirements, and reduce burdens on 
fund directors. Discussed below are certain costs and benefits that the 
Commission has identified with respect to the proposed rule amendments.
    The Commission requests comment on the costs and benefits of the

[[Page 58418]]

proposed rule amendments. We encourage commenters to identify, discuss, 
analyze, and supply relevant data regarding any additional costs and 
benefits.

A. Benefits

    The Commission staff estimates that approximately 5,255 entities 
(including 4,900 registered investment companies,\77\ 130 custodians, 
and 225 possible securities depositories \78\) would benefit from the 
proposed amendments.
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    \77\ The number of registered investment companies is based on 
approximately 4,100 management investment companies, 795 unit 
investment trusts, and 5 face amount certificate companies.
    \78\ The proposed amendments would allow more entities to 
operate as a securities depository. This number is approximated by 
adding the following entities: 12 Federal Reserve Banks; 13 clearing 
agencies; and approximately 200 registered transfer agents.
---------------------------------------------------------------------------

    Updates the rule to reflect current custody practice and commercial 
law. The proposed amendments to rule 17f-4 would benefit funds, 
advisers, and custodians because the amendments update the rule to 
conform to current custody practices and commercial law. As discussed 
above, rule 17f-4 was adopted in 1978 and was designed to operate in 
the context of commercial law applicable at that time. Custody 
practices and commercial law have changed significantly since 1978, and 
the proposed amendments would bring the rule up to date in those 
respects.
    The Commission staff has issued numerous no-action letters in an 
attempt to keep the rule current with custody practice and commercial 
law.\79\ Investment companies, custodians, subcustodians, transfer 
agents, and securities depositories would benefit from these amendments 
because the amendments would reflect changes in custody practices and 
applicable commercial law.
---------------------------------------------------------------------------

    \79\ See, e.g., supra notes 27 and 34.
---------------------------------------------------------------------------

    Removes unnecessary regulatory requirements. The proposed 
amendments to rule 17f-4 would remove three custodial compliance 
requirements \80\ that have accounted for a significant amount of 
custodians' time and resources. The Commission staff estimates that 
custodians could spend approximately 66,300 hours \81\ and $3,673,852 
\82\ annually to comply with these three requirements. The proposed 
amendments would eliminate the burden of complying with these 
requirements, which could benefit fund investors through reduced costs.
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    \80\ The three custodial compliance requirements (the 
segregation, earmarking, and confirmation requirements) are 
discussed above. See supra note and accompanying text.
    \81\ The staff estimates that, to comply with the rule, each 
custodian spends about 10 hours segregating, 250 hours earmarking, 
and 250 hours on daily confirmations to funds. (510 hours  x  130 
custodians = 66,300 total hours by all custodians).
    \82\ The following is an estimated breakdown of the annual cost 
for custodians to comply with the three compliance requirements:
    Segregation--10 total hours: 5 hours of support staff and 5 
hours by professional staff.
    Earmarking--250 hours: 125 hours of support staff and 125 hours 
of professional staff.
    Daily Confirmations--250 hours: 250 hours of support staff.
    Total: 380 hours of support staff ($30.58 per hour) and 130 
hours of professional staff ($128 per hour). (380  x  $30.58) + (130 
 x  $128) = $28,260.40x 130 custodians = $3,673,852.
---------------------------------------------------------------------------

    Provides general compliance requirements. In place of the three 
custodial compliance requirements, the proposed amendments to rule 17f-
4 would include more general compliance requirements. Most importantly, 
the proposed amendments would require that the fund's contract with its 
custodian must provide that the custodian take all actions reasonably 
necessary or appropriate under applicable commercial and regulatory law 
to safeguard assets held by the custodian. This safeguarding of assets 
requirement is more flexible and less prescriptive than the current 
requirements in rule 17f-4. This reduces costs by creating a more 
efficient safeguarding process.
    Allows more entities to operate securities depositories. Under the 
proposed amendments, more entities would be able to operate securities 
depositories. This would benefit the additional entities that are 
allowed to operate securities depositories such as registered transfer 
agents. These entities already perform depository-like functions \83\ 
and the proposed amendments would codify this practice. Current rules 
only allow registered clearing agencies, of which there are 13, and 
those using the federal book-entry system, of which there are 12, to be 
securities depositories. The effect of the proposed amendments would be 
to allow approximately 200 registered transfer agents to operate 
depositories under the rule. This would increase competition for 
services, lowering costs and bettering services to investment 
companies.
---------------------------------------------------------------------------

    \83\ See supra note and accompanying text.
---------------------------------------------------------------------------

    Expands the functions of securities depositories. The proposed 
amendments to rule 17f-4 would enlarge the functions that a securities 
depository may perform on behalf of a fund. The amendments would 
clarify that securities depositories can hold assets, such as open-end 
fund shares or ``Treasury Direct'' securities, that are typically 
conveyed only through redemption by the issuer. Securities depositories 
also would be permitted to hold assets that are conveyed by physical 
delivery. These amendments would facilitate the use of centralized 
custody arrangements for investments. Costs would be reduced in the 
clearing and settlement process, because it is easier to clear and 
settle transactions with an entity that can hold almost all the assets 
of the fund than with several entities that hold separate portions of 
fund assets. Reducing the costs and fees associated with securities 
depositories and custodians should benefit each industry.
    Makes more entities eligible to rely on rule 17f-4. The proposed 
amendments would benefit all of the approximately 800 registered non-
management companies because they could rely on rule 17f-4 and maintain 
assets in a securities depository under the clear standards of the 
rule. Investors would benefit from this amendment because the non-
management company assets would be maintained with a securities 
depository under the standards of rule 17f-4.
    Reduces burdens on fund directors. The proposed amendments to rule 
17f-4 would remove the burdens on fund directors to approve all custody 
arrangements and changes to those arrangements. Instead, a fund's 
officers would approve the fund's own arrangement with a custodian that 
uses a depository and its own arrangement directly with a 
depository.\84\ The proposed amendments should benefit fund directors 
and fund shareholders by eliminating the need for fund directors to 
approve arrangements that have become increasingly routine.
---------------------------------------------------------------------------

    \84\ As noted above, however, a fund's directors should review 
the fund's custody arrangements as an exercise of their general 
oversight responsibilities.
---------------------------------------------------------------------------

B. Costs

    The proposed amendments to rule 17f-4 would impose one-time costs 
on funds, custodians, and securities depositories. As discussed above, 
contracts between funds and custodians (or securities depositories) 
would need to be modified to include language that the custodian will 
take all actions reasonably necessary to safeguard the assets held by 
the custodian and that the custodian will provide periodic reporting on 
its internal accounting controls and financial strength to the fund. 
The modification of these contracts will impose some costs. During the 
first year, the Commission

[[Page 58419]]

staff estimates that it could take a total of approximately 10 hours 
and $1,555 \85\ per fund to comply with the proposed amendments. It is 
estimated that all the funds together would spend approximately 45,160 
hours \86\ and $7,020,483 \87\ to comply with the proposed amendments. 
This would be a one-time event, and the future contracts between funds 
and custodians (or securities depositories) would include this 
language. After the first year, the staff estimates that funds change 
custodians (or securities depositories) on average every 10 years, 
i.e., each year only 10 percent of funds change custodians (or 
securities depositories). The Commission staff estimates each fund will 
spend approximately 2 hours and $393 \88\ each year to ensure 
compliance with the contracts between funds and custodians or about 980 
hours and $192,712 annually for all funds to ensure contract compliance 
after the first year.\89\
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    \85\ This number is calculated by adding the following:
    Fund Directors--1 hour  x  $500 per hour = $500
    In House Counsel--8 hours  x  $128 per hour = $1,024
    Support Staff--1 hour x $30.58 per hour = $30.58
    Total = 10 hours and $1,554.58
    \86\ This number is calculated by:
    Renegotiation of contracts--multiply 97 percent of the 4,100 
funds that already have contracts with custodians by 10 hours (3,977 
 x  10 hours = 39,770 hours).
    New contracts--multiply 539 (490 non-management companies that 
use custodians + 49 funds that deal directly with securities 
depositories) by 10 hours (539  x  10 hours = 5,390 hours).
    Total = 39,770 hours + 5,390 hours = 45,160 hours
    \87\ This number is calculated by:
    Renegotiation of contracts--multiply 97 percent of the 4,100 
funds that already have contracts with custodians by $1,554.58 
(3,977  x  $1,554.58 = $6,182,564.70).
    New contracts--multiply 539 (490 non-management companies that 
use custodians + 49 funds that deal directly with securities 
depositories) by $1,554.58 (539  x  $1,554.58 = $837,918.62).
    Total = $6,182,564.70 + $837,918.62 = $7,020,483.32
    \88\ This number is calculated by adding the following:
    Fund Director--.5 hours  x  $500 per hour = $250
    In House Counsel--1 hour  x  $128 per hour = $128
    Support Staff--.5 hours  x  $15 per hour = $15.29
    Total = 2 hours and $393.29
    \89\ The annual hours and cost is calculated by multiplying the 
hours and cost per fund by 490 funds (10 percent of 4900 funds). 
Custodians (or securities depositories) would likely incur minimal 
costs in providing copies of existing reports on internal accounting 
controls to funds. The rule amendments would not require the 
preparation of new reports.
---------------------------------------------------------------------------

    We request comment on the costs and benefits of the proposed rule 
amendments and invite commenters to submit their own estimates of costs 
and benefits that would result from the proposal. In order to fully 
evaluate the costs and benefits associated with the proposed 
amendments, we request that commenters' estimates of the costs and 
benefits of the proposed amendments be accompanied by specific 
empirical data supporting their estimates.

VI. Summary of Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding the 
amendments to rule 17f-4 under the Investment Company Act. The 
following summarizes the IRFA.
    The IRFA summarizes the background of the proposed amendments. The 
IRFA also discusses the reasons for the proposed amendments and the 
objectives of, and legal basis for, the amendments. Those items are 
discussed above in this release.
    The IRFA discusses the effect of the proposed amendments on small 
entities. Rule 17f-4 specifies conditions under which funds maintain 
assets with securities depositories either directly, or through 
custodians that maintain assets with depositories. As a result, the 
proposed amendments to rule 17f-4 have the potential to affect (i) any 
fund that directly or indirectly uses securities depositories, (ii) its 
custodian, and (iii) any securities depository.
    Approximately 4,900 registered investment companies, including 
approximately 230 registered investment companies that are small 
entities, would be affected by amended rule 17f-4.\90\ Approximately 
130 custodians, most of which are banks or registered broker-dealers, 
would be affected by rule 17f-4. Few if any of these custodians are 
small entities.\91\ Approximately 225 entities would be permitted by 
the rule amendments to serve as fund securities depositories; few if 
any of these entities are small entities. The IRFA states that 
Commission staff expects the proposed amendments to have little impact 
on small entities. The rule amendments obligate fund custodians and 
depositories that deal directly with funds to undertake to take all 
actions reasonably necessary or appropriate to safeguard the fund's 
assets. These undertakings would not add to the existing obligations of 
funds, custodians, and depositories. Rather, they would assure that the 
fund's custodian or depository complies with the specified duties of a 
securities intermediary or issuer under Revised Article 8. In addition, 
the aggregate burden on small entities would be minimal because few of 
the affected entities (i.e., funds, custodians, and depositories) are 
small entities.
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    \90\ A fund is considered a small entity for purposes of the 
Regulatory Flexibility Act, 5 U.S.C. 601 et seq., if it, together 
with other investment companies in the same group of related 
investment companies, has net assets of $50 million or less. 17 CFR 
270.0-10. There are approximately 4,900 registered investment 
companies, including 240 small entities. Approximately 97 percent of 
registered investment companies (4,750) report that they maintain 
assets in securities depositories. Assuming that a proportionate 
number of small entities use securities depositories, then 
approximately 230 registered investment companies that are small 
entities will be affected by the rule amendments.
    \91\ 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 n.8.
---------------------------------------------------------------------------

    The IRFA explains that the proposed amendments would significantly 
ease reporting, recordkeeping, and other compliance requirements of 
rule 17f-4. The rule currently provides that, if a fund holds 
securities in a depository through a custodian or its agents, the 
custodian must maintain the fund's securities in a depository account 
for the custodian's customers that is separate from the depository 
account for the custodian's own securities, and must identify on the 
custodian's records the portion of the total customer securities that 
belong to the fund. The custodian also must send the fund confirmations 
of transfers to or from the fund's account with the custodian.\92\ In 
addition, a depository that deals directly with a fund must deliver the 
fund's securities to an appropriate successor if the depository no 
longer acts for the fund.\93\ The proposed amendments would eliminate 
these requirements and substitute more general compliance requirements 
for custodians and depositories.\94\
---------------------------------------------------------------------------

    \92\ See rule 17f-4(d)(2)-(3).
    \93\ See rule 17f-4(c)(2).
    \94\ Proposed rule 17f-4(a)(1) and (2)(i).
---------------------------------------------------------------------------

    The IRFA states that the Regulatory Flexibility Act directs the 
Commission to consider significant alternatives that would accomplish 
the stated objectives, while minimizing any significant economic impact 
on small entities. As discussed above, few of the entities that would 
be affected by the proposed amendments to rule 17f-4 would be 
considered to be small entities for purposes of the Regulatory 
Flexibility Act. Moreover, the overall impact of the amendments would 
be to decrease the burdens on all entities, including small entities, 
because the burdens under the proposed amendments should be more than 
offset by the elimination of existing requirements. Therefore, the 
potential

[[Page 58420]]

impact of the amendments on small entities should not be significant. 
For these reasons, alternatives to the proposed amendments and proposed 
new rule are unlikely to minimize any impact that the proposed 
amendments may have on small entities.\95\
---------------------------------------------------------------------------

    \95\ Alternatives in this category would include: (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.
---------------------------------------------------------------------------

    The Commission encourages the submission of comments with respect 
to any aspect of the IRFA. Comment specifically is requested on the 
number of small entities that would be affected by the proposed 
amendments, and the likely impact of the proposed amendments on small 
entities. Commenters are requested to describe the nature of any impact 
and to provide empirical data supporting the extent of the impact. 
These comments will be considered in connection with the adoption of 
the rule amendments, and will be placed in the same public file as 
comments on the proposed rules themselves. A copy of the IRFA may be 
obtained by contacting Hugh P. Lutz, Securities and Exchange 
Commission, 450 5th Street, NW, Washington, DC 20549-0506.

VII. Paperwork Reduction Act

    Certain provisions of the proposed amendments to rule 17f-4 contain 
``collection of information'' requirements within the meaning of the 
Paperwork Reduction Act of 1995 [(44 U.S.C. 3501-3520)] (``PRA''), and 
the Commission is submitting the proposed amendments to the Office of 
Management and Budget in accordance with 44 U.S.C. 3507(d). The title 
for the collection of information is ``Custody of Investment Company 
Assets with a Securities Depository.'' An agency may not conduct or 
sponsor, and a person is not required to respond to, a collection of 
information unless it displays a valid control number.
    The proposed amendments to rule 17f-4 would eliminate several 
collection of information requirements (specifically, the segregation, 
earmarking and confirmation requirements) \96\ and replace them with 
more general requirements. The proposed amendments would require a 
modification of contracts between funds and custodians (or securities 
depositories) to provide that the custodian will take all actions 
reasonably necessary or appropriate under applicable commercial and 
regulatory law to safeguard fund assets.\97\ In addition, the custody 
contract (or depository rules) would have to state that the custodian 
(or depository) will promptly provide periodic reports on its internal 
controls and financial strength, and available reports on the controls 
of any depository or intermediary custodian it uses.\98\
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    \96\ See supra note 39 and accompanying text.
    \97\ If the fund deals directly with a depository, the 
depository's contract or rules for participants would be required to 
provide that the depository would meet similar obligations.
    \98\ This provision is designed to assure that the fund (or its 
adviser) receives any reports that are already available about the 
financial soundness of the custodian and depository. The provision 
would not require the special preparation of additional reports.
---------------------------------------------------------------------------

    The Commission staff estimates that 5,255 respondents (including 
4,900 registered investment companies,\99\ 130 custodians, and 225 
possible securities depositories \100\) would be subject to the 
proposed amendments to rule 17f-4. The rule is elective, but most, if 
not all, funds use depository custody arrangements.\101\ The proposed 
amendments to the rule would increase the information collection burden 
by approximately 8,138 hours during the first year because of the 
required one-time contract modifications detailed above. After the 
first year, the information collection burden would decrease by 
approximately 36,042 hours annually. These changes are reflected in the 
summaries below:
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    \99\ The number of registered investment companies comprises 
approximately 4,100 management investment companies, 795 unit 
investment trusts, and 5 face amount certificate companies.
    \100\ The proposed amendments would increase the types of 
entities eligible to serve as depositories. The estimate of 225 
possible entities is reached by adding the following: 12 Federal 
Reserve Banks, 13 clearing agencies, and approximately 200 
registered transfer agents.
    \101\ The Commission staff estimates that more than 97 percent 
of all funds now use depository custody arrangements. This estimate 
is based on responses to Item 18 of Form N-SAR [17 CFR 274.101].

------------------------------------------------------------------------
                                                              Paperwork
                     First year burden                          burden
                                                                hours
------------------------------------------------------------------------
Current Rule 17f-4.........................................       42,600
Rule 17f-4 as proposed to be amended.......................       50,738
  Net Change...............................................        8,138
Annual Burden after First Year
Current Rule 17f-4.........................................       42,600
Rule 17f-4 as proposed to be amended.......................        6,558
                                                            ------------
  Net Change...............................................     (36,042)
------------------------------------------------------------------------

    Arrangements between funds, custodians, subcustodians, and 
securities depositories are written arrangements according to business 
practice. The Commission believes that requiring investment companies 
to modify their existing contracts with custodians and depositories to 
incorporate the new compliance requirements would create an initial 
one-time burden of 10 hours per fund, or about 45,160 burden hours for 
all funds.\102\
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    \102\ The Commission staff estimates that 97 percent of the 
4,100 registered management companies (3,977 funds) would have to 
renegotiate their custodial contracts to comply with the proposed 
amendments. In addition, the staff estimates that 490 of the 800 
non-management companies would enter into new custodial contracts 
consistent with the proposed amendments. The staff estimates that 49 
investment companies deal directly with securities depositories and 
would enter into contracts with securities depositories consistent 
with the proposed amendments. The staff estimates that it would take 
10 hours per fund to comply with the two contract provisions 
required by the proposed amendments. The total number of burden 
hours for the first year would be 45,160 hours (4,516 funds  x  10 
hours).
---------------------------------------------------------------------------

    The Commission estimates that after the first year, 490 investment 
companies \103\ would spend on average 2 hours annually complying with 
the contract requirements of the rule (i.e., signing contracts with 
additional custodians or securities depositories) for a total of 980 
burden hours.
---------------------------------------------------------------------------

    \103\ The staff estimates that approximately 10 percent of all 
funds, or 490 funds, approve new depository custody arrangements 
yearly, i.e., a fund changes custodians (or securities depositories) 
every 10 years.
---------------------------------------------------------------------------

    Currently rule 17f-4 requires custodians or their agents to send 
periodic reports to funds concerning internal accounting controls of 
the depository, the custodian, and its agents. The proposed amendments 
would require that this report include any reports on the financial 
strength of the custodian and any other available reports on the 
internal accounting controls of securities depositories or their 
operators and of any intermediary custodian. The Commission staff 
estimates that 130 custodians or their agents and 49 securities 
depositories \104\ would spend 12 hours \105\ annually in transmitting 
such reports to funds. The total annual burden hours for compliance 
with proposed rule 17f-4's reporting requirement is estimated to be 
2,148 hours annually.
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    \104\ The proposed amendment also would extend this requirement 
to securities depositories with which a fund deals directly. 
Commission staff estimates that 49 funds, or about one percent of 
funds, deal directly with securities depositories.
    \105\ Custodians or their agents usually send out periodic 
reports twice a year. Currently, it is estimated that custodians or 
their agents spend 6 burden hours per report to fulfill the 
requirement of rule 17f-4.
---------------------------------------------------------------------------

    Under rule 17f-4, funds are required to approve any new depository 
arrangements or changes to existing

[[Page 58421]]

depository arrangements. The staff estimates that 490 funds per year 
currently spend 8 hours annually reviewing these arrangements and the 
modifications to them. The proposed amendments to the rule would 
require a fund to approve only its own custody arrangements with a 
custodian or securities depository; the staff estimates that on average 
490 funds per year will spend 6 hours in approving custody 
arrangements. The total burden hours for this requirement are 2,940 
annual burden hours.
    If a fund deals directly with a securities depository, the proposed 
amendments to rule 17f-4 would require that the fund implement internal 
control systems reasonably designed to prevent unauthorized officer's 
instructions (by providing at least for the form, content, and means of 
giving, recording, and reviewing all officer's instructions). Currently 
rule 17f-4 requires funds to have internal control systems designed to 
prevent unauthorized instructions. The Commission staff estimates that 
49 funds, or one percent of all funds, will spend 10 hours annually 
implementing systems to prevent unauthorized officer's instructions, 
resulting in 490 burden hours for this requirement under the proposed 
amendments to rule 17f-4.
    We request your comments on the accuracy of our estimates. Pursuant 
to 44 U.S.C. 3506(c)(2)(b), the Commission solicits comments to: (i) 
Evaluate whether the proposed collection of information is necessary 
for the proper performance of the functions of the agency, including 
whether the information will have practical utility; (ii) evaluate the 
accuracy of the Commission's estimates of the burden of the proposed 
collection of information; (iii) determine whether there are ways to 
enhance the quality, utility and clarity of the information to be 
collected; and (iv) evaluate whether there are ways to minimize the 
burden of the collection of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    Persons desiring to submit comments on the collection of 
information requirements should direct them to the Office of Management 
and Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should also send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609 with reference to File No. S7-22-01. OMB is required to 
make a decision concerning the collection of information between 30 and 
60 days after publication, so a comment to OMB is best assured of 
having its full effect if OMB receives it within 30 days after 
publication. Requests for materials submitted to OMB by the Commission 
with regard to this collection of information should be in writing, 
refer to File No. S7-22-01, and be submitted to the Securities and 
Exchange Commission, Records Management, Office of Filings and 
Information Services, 450 5th Street, NW., Washington, DC 20549.

VIII. Statutory Authority

    The Commission is proposing to amend rule 17f-4 pursuant to the 
authority set forth in sections 6(c), 17(f), 26, 28, 30, 31, and 38(a) 
of the Investment Company Act of 1940 [15 U.S.C. 80a-6(c), 80a-17(f), 
80a-26, 80a-28, 80a-29, 80a-30, and 80a-37(a)].

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rule

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

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

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

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, 
unless otherwise noted;
    2. Section 270.17f-4 is revised to read as follows:


Sec. 270.17f-4.  Custody of investment company assets with a securities 
depository.

    (a) Custody arrangement with a securities depository. A Fund or its 
Custodian may place and maintain Assets with a Securities Depository, 
provided that:
    (1) Contract with custodian. If the Fund uses a Securities 
Depository through its Custodian (or through the Fund's trustee, if the 
Fund is a Non-Management Company), the Fund's contract with the 
Custodian (or trustee) provides that the Custodian will:
    (i) Take all actions reasonably necessary or appropriate under 
applicable commercial and regulatory law to safeguard Assets maintained 
by the Custodian with a Securities Depository or Intermediary Custodian 
for the benefit of the Fund; and
    (ii) Promptly provide periodic reports concerning the internal 
accounting controls and financial strength of the Custodian, and 
available reports concerning the internal accounting controls of any 
Securities Depository or its operator and of any Intermediary 
Custodian.
    (2) Direct dealings with securities depository or non-management 
company arrangements. If the Fund maintains Assets directly with a 
Securities Depository, or is a Non-Management Company:
    (i) The Fund's contracts with the Securities Depository or its 
operator, or the Securities Depository's written rules for its 
participants, provide that the Securities Depository will, in 
performing its duties, comply with obligations comparable to those of a 
Custodian under paragraphs (a)(1)(i) and (ii) of this section; and
    (ii) The Fund (or the Fund's trustee, if the Fund is a Non-
Management Company) has implemented internal control systems reasonably 
designed to prevent unauthorized Officer's Instructions (by providing 
at least for the form, content, and means of giving, recording, and 
reviewing all Officer's Instructions).
    (3) Fund's approval. An officer of the Fund (or a trustee of a Fund 
that is a Non-Management Company) has approved each of the Fund's own 
custody arrangements with its Custodian or with a Securities Depository 
under this paragraph (a).
    (4) Operators of a securities depository. The Securities Depository 
is operated by:
    (i) A Federal Reserve Bank or other person authorized to hold 
custody of securities in the federal book-entry system described in 
regulations of the United States Department of the Treasury codified at 
31 CFR Part 357, Subparts B and C, or comparable regulations of other 
federal agencies affecting the book-entry system;
    (ii) A clearing agency registered with the Commission under section 
17A of the Securities Exchange Act of 1934 (15 U.S.C. 78q-1); or
    (iii) A transfer agent registered with the Commission or other 
appropriate regulatory agency as provided in section 17A of the 
Securities Exchange Act of 1934 (15 U.S.C 78q-1), when acting as agent 
for an open-end registered investment company whose securities it 
holds.
    (b) Definitions. For purposes of this section:
    (1) Assets means cash and securities and similar investments that 
are owned by the Fund or held by another person for the benefit of the 
Fund.

[[Page 58422]]

    (2) Custodian means a bank or other person authorized to hold 
Assets for the Fund under section 17(f) of the Act (15 U.S.C. 80a-
17(f)) or Commission rules in this chapter, but does not include a Fund 
itself, a Safekeeping Facility, or a Foreign Custodian.
    (3) Foreign Custodian means a custodian whose use is governed by 
Sec. 270.17f-5 or Sec. 270.17f-7.
    (4) Fund means an investment company registered under the Act.
    (5) Intermediary Custodian means any subcustodian through which a 
Custodian maintains any Assets with a Securities Depository, if the 
subcustodian is qualified to act as a Custodian.
    (6) Officer's Instruction means a request or direction to a 
Securities Depository or its operator in the name of the Fund by one or 
more persons authorized by the Fund's board of directors (or by the 
Fund's trustee, if the Fund is a Non-Management Company) to give it.
    (7) Non-Management Company means a Fund that is a unit investment 
trust or a face-amount certificate company.
    (8) Safekeeping Facility means any vault, safe deposit box, or 
other repository for safekeeping maintained by a bank or other company 
whose functions and physical facilities are supervised by a federal or 
state authority, if the Fund maintains its own Assets there in 
accordance with Sec. 270.17f-2.
    (9) Securities Depository means a system for the central handling 
of Assets in which Assets are treated as fungible and are transferred, 
pledged, or otherwise acquired or disposed of by bookkeeping entry 
without physical delivery, or by physical delivery within or through 
the system.

    Note to Sec. 270.17f-4:
    If a Fund's (or its custodian's) custody arrangement with a 
Securities Depository involves one or more Eligible Foreign 
Custodians (as defined in Sec. 270.17f-5) through which assets are 
maintained with the Securities Depository, Sec. 270.17f-5 will 
govern the Fund's (or its custodian's) use of each Eligible Foreign 
Custodian.


    Dated: November 15, 2001.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 01-29021 Filed 11-20-01; 8:45 am]
BILLING CODE 8010-01-P