[Federal Register Volume 68, Number 34 (Thursday, February 20, 2003)]
[Rules and Regulations]
[Pages 8438-8443]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-4042]



[[Page 8437]]

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Part IV





Securities and Exchange Commission





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17 CFR Part 270



Custody of Investment Company Assets With a Securities Depository; 
Final Rule

  Federal Register / Vol. 68, No. 34 / Thursday, February 20, 2003 / 
Rules and Regulations  

[[Page 8438]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-25934; File No. S7-22-01]
RIN 3235-AG71


Custody of Investment Company Assets With a Securities Depository

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

ACTION: Final rule.

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SUMMARY: The Commission is adopting amendments to the rule under the 
Investment Company Act of 1940 that governs investment companies' use 
of securities depositories. The amendments expand the types of 
investment companies that may maintain assets with a depository, and 
update the conditions they must follow to use a depository. The 
amendments respond to developments in securities depository practices 
and commercial law since the rule was adopted.

EFFECTIVE DATES: The amendments are effective on March 28, 2003. The 
incorporation by reference of certain definitions listed in the rule is 
approved by the Director of the Federal Register as of March 28, 2003.

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 
Commission, 450 5th Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission today is adopting 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'').\1\
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    \1\ Unless otherwise noted, all references to ``rule 17f-4'' or 
any paragraph of the rule will be to 17 CFR 270.17f-4, as amended.
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Table of Contents

Executive Summary
I. Background
II. Discussion
    A. U.S. Depositories
    B. Reliance on Rule by Non-Management Companies; Approval of 
Custody Arrangements
    C. Compliance Requirements for the Custodian or Securities 
Depository
    D. Treatment of U.S. and Foreign Depositories
III. Cost-Benefit Analysis
IV. Effects on Efficiency, Competition, and Capital Formation
V. Summary of Final Regulatory Flexibility Analysis
VI. Paperwork Reduction Act
VII. Statutory Authority
Text of Rule

Executive Summary

    The Commission today is adopting amendments to rule 17f-4 under the 
Investment Company Act, the rule that 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 custody practices and commercial law that relate to 
custody arrangements have changed substantially since we adopted the 
rule in 1978, and the amendments update and simplify rule 17f-4 to 
reflect these business and legal developments. The amendments permit 
additional types of investment companies to rely on the rule, and allow 
depositories to perform additional functions under the rule. The 
amendments also eliminate a number of specific custodial compliance 
requirements of rule 17f-4, and require instead that a fund's 
custodian, when using a depository, exercise due care in accordance 
with reasonable commercial standards.

I. Background

    Section 17(f) of the Investment Company Act governs the custody of 
a fund's assets, including its portfolio securities.\2\ 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. It permits a fund to maintain its 
securities in a system for the central handling of securities (commonly 
referred to as a ``securities depository''), subject to rules adopted 
by the Commission.\3\
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    \2\ 15 U.S.C. 80a-17(f).
    \3\ In 1999, the Gramm-Leach-Bliley Act, Pub. L. 106-102, 113 
Stat. 1338 (1999), added section 17(f)(6) to the Investment Company 
Act. Section 17(f)(6) authorizes the Commission to prescribe 
conditions under which a bank-sponsored fund may maintain fund 
assets with an affiliated bank. This section is intended to allow 
the Commission to address self-custody issues such as conflicts of 
interest and misappropriation of fund assets that could arise when a 
fund holds its assets with an affiliated bank custodian. The 
amendments to rule 17f-4 affect the ability of all funds and their 
custodians to use certain depositories. The amendments do not 
address specific issues that arise when a fund maintains assets with 
an affiliated bank custodian, and we are not relying on the 
authority contained in section 17(f)(6) in adopting these 
amendments.
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    The Commission adopted rule 17f-4 in 1978 to establish conditions 
for the use of securities depositories by funds.\4\ The conditions were 
designed to limit potential risks to funds using securities 
depositories, and were drafted to be compatible with the 1978 revisions 
to Article 8 of the Uniform Commercial Code (``UCC''), which covers the 
ownership and transfer of investment securities under state law.\5\ 
Since 1978, securities custody practices have changed substantially, as 
more investors (including funds) have come to hold their securities 
with depositories such as the Depository Trust Company, either directly 
or through an intermediary. In 1994, Article 8 was substantially 
revised to clarify the legal rights of funds and other investors that 
use securities depositories.\6\ In addition, experience with 
depositories during this period has shown that the use of depositories 
raises substantially fewer risks than had been apparent in 1978.
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    \4\ 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'').
    \5\ See UCC, 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 4, at nn.4 and 6.
    \6\ 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''), which in turn 
will maintain an account for its customers with a securities 
depository. The depository generally does not record each investor's 
interest, but records the interest of the intermediary on behalf of 
all of its customers. Thus, the individual investor's interest (or 
``security entitlement'') appears only on the books of the 
intermediary with which the investor maintains an account. Revised 
Article 8 refers to this type of securities ownership arrangement as 
an ``indirect holding'' arrangement, as distinguished from a 
``direct holding'' arrangement in which the investor's ownership 
interest appears on the issuer's books. 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''). Revised 
Article 8 has been adopted by all 50 states, the District of 
Columbia, and Puerto Rico.
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    In November 2001, we proposed amendments to rule 17f-4 to reflect 
these significant developments.\7\ We received six comment letters on 
the proposal.\8\ Commenters generally favored the amendments, but also 
recommended several changes that they believed would improve the 
interaction

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of the rule with Revised Article 8. In addition, commenters disagreed 
on whether our rules governing a fund's use of foreign custodians and 
depositories should apply when a fund holds securities with a U.S. 
depository that itself holds the securities with a foreign custodian or 
depository.\9\ We are adopting new rule 17f-4 with modifications that 
respond to many of the issues raised by the commenters.
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    \7\ See Custody of Investment Company Assets With a Securities 
Depository, Investment Company Act Release No. 25266 (Nov. 15, 2001) 
[66 FR 58412 (Nov. 15, 2001)] (``Proposing Release''), at nn.4-19 
and accompanying text, for a more detailed discussion of Prior 
Article 8 and Revised Article 8.
    \8\ We received the six comment letters from three commenters. 
Each of the commenters wrote an initial letter, and an additional 
letter discussing points raised by the other commenters. The comment 
letters are available for public inspection and copying in the 
Commission's Public Reference Room, 450 5th Street, NW, Washington, 
DC (File No. S7-22-01).
    \9\ See infra Section II.D.
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II. Discussion

    Rule 17f-4 permits funds to place and maintain ``financial assets'' 
corresponding to the fund's ``securities entitlements'' \10\ with a 
securities depository subject to certain conditions, discussed 
below.\11\ As suggested by a commenter, we have drafted the rule to 
employ terms used by Revised Article 8 to assure the rule will interact 
well with that Article, which, as we noted above, is the primary law 
governing securities ownership under state law.\12\
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    \10\ The amended rule incorporates the definition of ``security 
entitlement'' contained in Revised Article 8. See rule 17f-4(c)(1). 
A security entitlement means ``the rights and property interest of 
an entitlement holder with respect to a financial asset'' in an 
indirect holding arrangement. See Revised Article 8, supra note 6, 
section 8-102(a)(17). 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 id., 
section 8-503(b) and cmt. 1, and section 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).
    \11\ In addition, the amendments permit a custodian to use an 
intermediary custodian. See rule 17f-4(a).
    \12\ The proposed amendments would have defined a securities 
depository as a ``system for the central handling of assets in which 
those 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.'' See Proposing Release, supra note 7 at n.22 and 
accompanying text. One commenter stated that we could accomplish the 
same objectives by simply amending the rule to define securities 
depository by reference to a ``clearing corporation'' under Article 
8 and a ``clearing agency'' under the Securities Exchange Act of 
1934. We agree that this change simplifies the rule text and 
embodies relevant terms defined elsewhere in the federal securities 
laws, and the amended rule therefore reflects this revision.
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A. U.S. Depositories

    Rule 17f-4 permits funds to keep and maintain securities and other 
assets in a ``securities depository'' subject to regulation in the 
United States.\13\ Under the rule, a ``securities depository'' is a 
``clearing corporation'' that is registered with the Commission as a 
clearing agency,\14\ or a federal reserve bank or other person 
authorized to operate the federal book-entry system for U.S. Treasury 
securities. At the suggestion of a commenter, we simplified the 
definition to describe what a depository is rather than what it does. 
The rule no longer restricts the functions that a depository may 
perform. As a result, a fund may use a depository that holds securities 
that are acquired or disposed of by bookkeeping entry as well as those 
that are conveyed by physical delivery.
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    \13\ The use of foreign depositories by funds is governed by 
rule 17f-7 [17 CFR 270.17f-7].
    \14\ A clearing agency is ``any person who acts as an 
intermediary in making payments or deliveries or both in connection 
with transactions in securities or who provides facilities for 
comparison of data respecting the terms of settlement of securities 
transactions, to reduce the number of settlements of securities 
transactions, or for the allocation of securities settlement 
responsibilities. Such term also means any person, such as a 
securities depository, who (i) acts as a custodian of securities in 
connection with a system for the central handling of securities 
whereby all securities of a particular class or series of any issuer 
deposited within the system are treated as fungible and may be 
transferred, loaned or pledged by bookkeeping entry without physical 
delivery of securities certificates, or (ii) otherwise permits or 
facilitates the settlement of securities transactions or the 
hypothecation or lending of securities without physical delivery of 
securities certificates.'' 15 U.S.C. 78c(23)(A).
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B. Reliance on Rule by Non-Management Companies; Approval of Custody 
Arrangements

    The amendments expand rule 17f-4 to permit any registered 
investment company, including a unit investment trust (``UIT'') or a 
face-amount certificate company, to use a securities depository.\15\ 
The amendments also eliminate from the rule the requirement that fund 
directors approve arrangements with depositories, which today largely 
are routine matters. Commenters supported these changes.\16\
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    \15\ Rule 17f-4(c)(3). In addition to expanding the types of 
funds that could rely on rule 17f-4, the Proposing Release would 
have expanded the types of organizations that could operate as 
depositories under the rule. The Proposing Release would have 
allowed a registered transfer agent to operate as a securities 
depository for purposes of holding shares of other funds. See 
Proposing Release, supra note 7, at nn.29-31 and accompanying text. 
All of the commenters raised issues concerning this proposed change. 
Two argued that a fund's use of another fund's transfer agent 
involves self-custody issues that could be addressed in conjunction 
with rule 17f-2 [17 CFR 270.17f-2], the rule governing fund self-
custody arrangements. In light of the issues raised by commenters, 
we have decided not to adopt the amendment related to mutual fund 
transfer agents, but instead intend to consider these issues in 
connection with any future revisions to rule 17f-2. Until then, 
funds should continue to rely on the staff no-action letters that 
address arrangements in which funds invest in shares of other funds. 
See, e.g., United States Trust Co. of New York, SEC Staff 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).
    \16\ At the suggestion of one commenter, we have eliminated the 
requirement we included in the proposed amendments that a fund 
officer approve a depository arrangement. The requirement is 
unnecessary because a fund officer (or a person with similar 
authority) would have to execute agreements necessary to permit the 
fund to use the depository. See section 17(f)(2) of the Investment 
Company Act [15 U.S.C. 80a-17(f)(2)] (requiring that a fund consent 
to its custodian's deposit of securities with a depository).
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C. Compliance Requirements for the Custodian or Securities Depository

    The amendments also eliminate, as proposed, the specific 
safeguarding requirements that have been in rule 17f-4, and substitute 
two more general obligations.\17\ First, a fund's custodian must be 
obligated, at a minimum, to exercise due care in accordance with 
reasonable commercial standards in discharging its duty as a 
``securities intermediary'' to obtain and thereafter maintain financial 
assets.\18\ If the fund deals directly with a depository, the 
depository's contract or rules for participants must provide that the 
depository will meet similar obligations.\19\ This condition thus 
incorporates the minimum standard of care that Revised Article 8 sets 
forth for circumstances where the parties have not agreed to a 
standard.\20\
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    \17\ These specific requirements were the earmarking, 
segregation, confirmation, and successor custodian requirements. For 
a detailed discussion of these requirements, see Proposing Release, 
supra note 7, at nn.39-46.
    \18\ Rule 17f-4(a)(1). We proposed to require a custodian using 
a depository to ``take all actions reasonably necessary or 
appropriate under applicable commercial or regulatory law'' to 
safeguard fund assets. See Proposing Release, supra note 7, at 
nn.48-51 and accompanying text. Two commenters suggested that a 
better approach to accomplish the intent of that provision would be 
to require the custodian, as a securities intermediary, to take 
reasonable steps to preserve rights of the fund as an entitlement 
holder in financial assets held by the depository. One of these 
commenters urged us to incorporate into the rule the standard of 
care provided for by section 504(c) of Article 8 when the parties 
have not agreed to a standard. Section 504(c) provides that a 
securities intermediary satisfies the duty relating to maintaining a 
financial asset in those circumstances if it ``exercises due care in 
accordance with reasonable commercial standards to obtain and 
maintain the financial asset.'' This standard is reflected in the 
rule.
    \19\ Rule 17f-4(b)(1)(i).
    \20\ One commenter questioned our authority to establish 
compliance requirements for custodians. Section 17(f)(2) of the 
Investment Company Act authorizes the Commission to adopt rules that 
establish conditions under which a ``registered management company 
or any * * * custodian'' may deposit securities with a securities 
depository.
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    Second, the custodian must provide, promptly upon request by the 
fund, such reports as are available about the internal accounting 
controls and

[[Page 8440]]

financial strength of the custodian.\21\ If the fund deals directly 
with a depository, the depository's contract or written rules for its 
participants must provide that the depository will provide similar 
financial reports.\22\
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    \21\ Rule 17f-4(a)(2). As proposed, rule 17f-4 also would have 
required custodians to provide available reports on the internal 
accounting controls of any securities depository (or its operator) 
and any intermediate custodian. In response to comments questioning 
funds' need for these financial reports, we are not adopting the 
proposed provision. Because Revised Article 8 generally limits a 
fund's recourse to its own custodian, reports on intermediaries with 
which it does not directly deal are likely to be less important to 
the fund.
    \22\ Rule 17f-4(b)(1)(ii).
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D. Treatment of U.S. and Foreign Depositories

    The Depository Trust Company (``DTC''), the predominant U.S. 
securities depository, has established linkages with several foreign 
custodians and depositories through which it holds assets with those 
foreign institutions. In the Proposing Release, we requested comment on 
whether a fund, when it holds securities with a U.S. depository that 
are ultimately custodied with a foreign custodian or depository, should 
be subject to rules 17f-5 or 17f-7,\23\ which establish conditions for 
the custody of fund assets with foreign custodians and 
depositories.\24\
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    \23\ 17 CFR 270.17f-5, 270.17f-7.
    \24\ See Proposing Release, supra note 7, at nn.67-76 and 
accompanying text.
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    Three commenters responded to our request. One commenter, an 
association of global custodian banks, argued that the failure of the 
Commission to extend the requirements of rules 17f-5 and 17f-7 would 
permit funds to circumvent these rules and would deny fund investors 
the protections of the rules. The Investment Company Institute and DTC 
opposed the application of the foreign custody rules. They pointed out 
that U.S. depositories are regulated by the Commission as registered 
clearing agencies, and that any linkages between them and foreign 
custodians and depositories are subject to our approval and monitoring. 
They argued that further regulation would increase the burden on these 
domestic depositories without enhancing the protection of fund assets.
    We have decided not to revise the rule to require the application 
of our foreign custody rules when a fund holds securities through a 
U.S. depository that has a linkage to a foreign custodian or 
depository. As we explained in the Proposing Release, U.S. depositories 
register with us as clearing agencies under the Securities Exchange Act 
of 1934,\25\ and are subject to rigorous standards for their 
operations.\26\ We approve each proposed linkage to a foreign custodian 
or depository only when the custodian or depository will provide a 
level of protection equivalent to that which a U.S. clearing agency 
must provide.\27\ This is a standard considerably higher than we 
require fund boards to apply in selecting a foreign custodian.\28\ We 
agree with the commenters who argued that the application of the 
foreign custody rules would impose regulatory burdens without 
appreciably enhancing the protection of fund assets.\29\
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    \25\ See section 17A of the Securities Exchange Act [15 U.S.C. 
78q-1].
    \26\ See Proposing Release, supra note , at n.73 and 
accompanying text.
    \27\ 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. 6, 1998) [63 FR 54739 (Oct. 13, 1998)] 
(order approving proposed link).
    \28\ Rule 17f-5 generally requires that a fund's board of 
directors or its delegate determine that (i) a fund's financial 
assets will be subject to reasonable care, based on the standards 
applicable in the relevant market, and (ii) the arrangement with the 
foreign custodian is governed by a written contract that meets 
specified standards.
    \29\ Similarly, we have not revised rule 17f-4 to except a fund 
from the foreign custody rules if the fund maintains financial 
assets with a foreign custodian or depository with which a U.S. 
depository has established a link that we have approved. One 
commenter suggested in an earlier letter that the costs of complying 
with the foreign custody rules are relatively fixed, and that the 
addition or subtraction of institutions therefore would not have a 
significant effect on those costs. See Letter from Daniel L. 
Goelzer, Baker & McKenzie, to C. Hunter Jones, SEC, at p.4 (Oct. 17, 
2001). Moreover, the analysis required by rule 17f-7 can provide 
custodians and funds with current information regarding a foreign 
depository's expertise and market reputation, the quality of its 
services, and its financial strength. This information can play an 
important role in any future custody decisions made by funds and 
their advisers.
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III. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits that result 
from its rules. As discussed above, the amendments to rule 17f-4 
respond to developments in securities custody practices and commercial 
law that have occurred since the rule was adopted. The amendments 
expand the types of funds that may rely on the rule, update the rule's 
compliance requirements, and reduce burdens on fund directors. In the 
Proposing Release, we requested comment and specific data regarding the 
costs and benefits of the proposed amendments. We received one comment 
on the costs and benefits of the amendments. The comment is discussed 
below.

A. Benefits

    The Commission staff estimates that approximately 5,155 entities 
(including 5,000 registered investment companies, 130 custodians, and 
25 possible securities depositories) would benefit from the 
amendments.\30\
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    \30\ These estimates are based on statistics compiled by 
Commission staff from January 1, 2002 through December 31, 2002.
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    Removes specific custodial compliance requirements. The amendments 
to rule 17f-4 remove three custodial compliance requirements \31\ that 
have accounted for a significant amount of custodians' time and 
resources. The Commission staff estimates that custodians currently 
spend approximately 66,300 hours \32\ and $3,694,600 \33\ annually to 
comply with these three requirements. In place of these costly 
requirements, the amendments provide that a fund's custodian, when 
using a depository, must at a minimum exercise due care in accordance 
with reasonable commercial standards and that custodians (or securities 
depositories) provide reports on internal accounting controls to funds. 
The new compliance requirements are much less prescriptive than those 
previously contained in rule 17f-4, which will allow custodians some 
flexibility in determining the most efficient method of safeguarding 
financial assets. The reduction in the compliance burdens in rule 17f-4 
may ultimately benefit fund investors through reduced costs.
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    \31\ The three custodial compliance requirements are the 
segregation, earmarking, and confirmation requirements.
    \32\ The staff estimates that, in order 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).
    \33\ 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 ($31 per hour) and 130 hours 
of professional staff ($128 per hour). (380 x $31) + (130 x $128) = 
$28,420 x 130 custodians = $3,694,600.
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    Reduces burdens on fund directors. The amendments to rule 17f-4 
eliminate the requirement that fund directors approve all custody 
arrangements and changes to those arrangements. The amendments will 
benefit fund directors and fund shareholders by eliminating the need 
for fund directors to approve arrangements that have become 
increasingly routine. The elimination of this requirement will free 
directors to

[[Page 8441]]

spend more time on other, more significant matters.
    Updates the rule to reflect current custody practices and 
commercial law. The amendments to rule 17f-4 will benefit funds, 
advisers, and custodians by updating 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 
amendments reflect these developments.
    The Commission staff has issued numerous no-action letters in an 
attempt to keep the rule current with custody practice and commercial 
law.\34\ The amendments will make the rule more transparent by 
eliminating the need for funds to rely on the staff's no-action 
letters, and will resolve current and future ambiguities that have 
arisen and are sure to arise between the application of Revised Article 
8 and rule 17f-4.
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    \34\ See Proposing Release, supra note , at nn.30-34 and 
accompanying text.
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    Expands functions of securities depositories. The amendments expand 
the functions that a securities depository may perform on behalf of a 
fund.\35\ These amendments therefore may 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, rather than with several entities that hold 
separate portions of fund assets. Reducing the costs and fees 
associated with securities depositories and custodians will benefit 
investors.
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    \35\ See supra Section II.A.
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B. Costs

    The Proposing Release identified one provision in the rule that 
would impose costs--the requirement that custody contracts be modified 
to reflect the rule's new, general compliance requirements.\36\ One 
commenter objected to the contract amendment language, and instead 
recommended that the rule allow the affected parties to determine the 
specific means of compliance. In response to this comment, we have 
modified the relevant regulatory language to state that the custodian 
must be ``at a minimum obligated'' to exercise due care in accordance 
with reasonable commercial standards in discharging its duty to obtain 
and thereafter maintain financial assets.\37\ This change provides 
custodians and funds with some flexibility in determining the specific 
means of compliance with the rule. The requirements of the rule could 
be met, for instance, by simply having the custodian send a letter to 
the fund, citing as consideration the continued ability of the 
custodian to provide custodial services for the fund. The costs 
associated with this method of compliance would be minimal.\38\
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    \36\ See Proposing Release, supra note , at nn.85-89 and 
accompanying text.
    \37\ Rule 17f-4(a)(1).
    \38\ Approximately 49 funds deal directly with securities 
depositories. In these cases, compliance with rule 17f-4 can occur 
simply by having the depository modify its written rules for its 
participants, if necessary.
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    Rule 17f-4 requires that custodians (or securities depositories) 
provide reports on internal accounting controls to funds. The costs 
associated with providing copies of existing reports to funds should be 
minimal. The amendments do not require the preparation of new reports.

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.\39\ The Commission has 
considered these factors.
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    \39\ 15 U.S.C. 80a-2(c).
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    As noted above, we received three letters on whether a fund, when 
it holds securities that are ultimately custodied with a foreign 
custodian or depository, should be subject to rules 17f-5 or 17f-7. We 
have decided not to apply the foreign custody rules in these 
circumstances in part because U.S. depositories are regulated by the 
Commission as registered clearing agencies, and it would be inefficient 
to subject these depositories to the additional requirement in rules 
17f-5 and 17f-7.\40\
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    \40\ See supra Section II.D.
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    The rule amendments should promote efficiency by eliminating the 
restrictions on the functions that a depository may perform. The 
amendments permit a fund to use a depository that holds securities that 
are acquired or disposed of by bookkeeping entry as well as those that 
are conveyed by physical delivery. The amendments therefore should 
facilitate the use of centralized custody arrangement for investors. 
This change may promote efficiency because it is easier and less costly 
to clear and settle transactions with a single entity that can hold 
almost all of the assets of a fund, rather than with several entities. 
In addition, the rule amendments will promote efficiency by eliminating 
the requirement that fund directors approve custody arrangements, which 
will allow directors to focus on other, more important matters, and by 
eliminating four custodial compliance requirements that are no longer 
necessary for the protection of fund assets.
    The rule amendments will not have a significant impact on 
competition and capital formation. The amendments may marginally 
promote competition by permitting all registered investment companies, 
including UITs and face-amount certificate companies, to rely on the 
rule. As noted above, previously only registered management investment 
companies could use a securities depository under the rule.

V. Summary of Final Regulatory Flexiblity Analysis

    We have prepared a Final Regulatory Flexibility Analysis (``FRFA'') 
in accordance with 5 U.S.C. 604, related to the amendments to rule 17f-
4 under the Investment Company Act of 1940 that we are adopting today. 
A summary of the Initial Regulatory Flexibility Analysis (``IRFA''), 
which was prepared in accordance with 5 U.S.C. 603, was published in 
the Proposing Release.\41\ Copies of the FRFA and the IRFA may be 
obtained by contacting Hugh P. Lutz, Attorney, Securities and Exchange 
Commission, 450 5th Street, NW., Washington, DC 20549-0506
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    \41\ See Proposing Release, supra note , at Section VI.
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A. Need for Rule Amendments

    The FRFA summarizes the background of the amendments. The FRFA also 
discusses the reasons for the new rule and amendments and the 
objectives of, and legal basis for, these rulemaking initiatives. Those 
items are discussed above in this Release.\42\ The FRFA discusses the 
effect of the amendments on small entities.
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    \42\ See supra Section II.
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B. Significant Issues Raised by Public Comment

    The Commission received no comments on the IRFA.

C. Small Entities Subject to the Rule Amendments

    The FRFA addresses the effect that amendments to rule 17f-4 will 
have on small entities. For purposes of the

[[Page 8442]]

Regulatory Flexibility Act,\43\ a fund is a small entity if the fund, 
together with other funds in the same group of related funds, has net 
assets of $50 million or less as of the end of its most recent fiscal 
year.\44\ Approximately 4,850 registered investment companies, 
including approximately 233 registered investment companies that are 
small entities, will be affected by amended rule 17f-4.\45\ 
Approximately 130 custodians, most of which are banks or registered 
broker-dealers, will be affected by rule 17f-4. Few if any of these 
custodians are small entities.\46\ Approximately 25 entities that could 
serve as securities depositories will be affected by the rule;\47\ few 
if any of these entities are small entities. The rule imposes 
conditions for the use of securities depositories by all funds 
regardless of the size of the fund, its custodian, or the securities 
depository. The risks attendant to funds' use of securities 
depositories do not vary based on the size of the entities involved.
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    \43\ 5 U.S.C. 601-612.
    \44\ 17 CFR 270.0-10.
    \45\ There are approximately 5,000 registered investment 
companies, including 240 small entities. Approximately 97 percent of 
registered investment companies (4,850) report that they maintain 
assets in securities depositories. Assuming that a proportionate 
number of small entities use securities depositories, then 
approximately 233 registered investment companies that are small 
entities will be affected by the rule amendments.
    \46\ A bank is considered by the Small Business Administration 
to be a small entity if it has less than $150 million in assets. See 
13 CFR 121.201 (1999). See also 5 U.S.C. 601(3).
    \47\ This includes approximately 12 Federal Reserve Banks and 13 
registered clearing agencies.
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D. Projected Reporting, Recordkeeping, and Other Compliance 
Requirements

    The amendments will significantly ease rule 17f-4's reporting, 
recordkeeping, and other compliance requirements. The amendments 
eliminate a number of specific requirements \48\ and substitute two 
general compliance requirements for custodians and depositories.\49\ 
First, the custodian must, at a minimum, exercise due care in 
accordance with reasonable commercial standards in discharging its duty 
as a securities intermediary to obtain and thereafter maintain 
financial assets.\50\ If the fund deals directly with a depository, the 
fund's contract with the securities depository (or the depository's own 
written rules for its participants) must provide that the depository 
will meet similar obligations.\51\ Second, the custodian must provide, 
promptly upon request by the fund, such reports as are available about 
the internal accounting controls and financial strength of the 
custodian.\52\ If the fund deals directly with a depository, the 
depository's contract or written rules for its participants must 
provide that the depository will provide similar financial reports.\53\
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    \48\ See supra Section II.C.
    \49\ Rule 17f-4(a) and (b)(1).
    \50\ Rule 17f-4(a)(1).
    \51\ Rule 17f-4(b)(1)(i).
    \52\ Rule 17f-4(a)(2).
    \53\ Rule 17f-4(b)(1)(ii).
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E. Duplicative, Overlapping or Conflicting Federal Rules

    The Commission believes that there are no federal rules that 
duplicate, overlap, or conflict with the rule amendments.

F. Agency Action to Minimize Effect on Small Entities

    In connection with the amendments, the Commission considered the 
following alternatives: (i) Establishing different compliance or 
reporting standards that take into account the resources available to 
small entities; (ii) clarifying, consolidating or simplifying the 
compliance requirements for small entities; (iii) using performance 
rather than design standards; and (iv) exempting small entities from 
coverage of all or part of the rule.
    We do not believe that special compliance, timetable, or reporting 
requirements or an exemption from coverage of the rule for small 
entities would be consistent with investor protection. Similarly, any 
further clarification, consolidation, or simplification of the 
reporting requirements for small entities could compromise the 
safeguards embodied in the new rule and amendments. The rule amendments 
use performance, rather than design standards, in the sense that the 
amendments require that custodians exercise due care in accordance with 
reasonable commercial standards in discharging their duty as a 
securities intermediary to obtain and thereafter maintain financial 
assets.

VI. Paperwork Reduction Act

    As explained in the Proposing Release, certain provisions of the 
amendments to rule 17f-4 contain ``collection of information'' 
requirements within the meaning of the Paperwork Reduction Act [44 
U.S.C. 3501-3520] (``PRA''). We published notice soliciting comments on 
the collection of information requirements in the Proposing Release and 
submitted these requirements to the Office of Management and Budget 
(``OMB'') for review in accordance with 44 U.S.C. 3507(d) and 5 CFR 
1320.11. 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 OMB control number for rule 17f-4 is 3235-0225.
    As discussed above, today we are adopting amendments to rule 17f-4 
that are substantially similar to the amendments that we proposed in 
November 2001. The amendments permit additional types of investment 
companies to rely on the rule, and allow depositories to perform 
additional functions under the rule. The amendments also eliminate a 
number of specific custodial compliance requirements of rule 17f-4, and 
substitute two more general compliance requirements. None of the 
commenters addressed the PRA burden associated with these amendments.

VII. Statutory Authority

    The Commission is amending 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)].

Text of Rule

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

List of Subjects in 17 CFR Part 270

    Incorporation by reference, Investment companies, Reporting and 
recordkeeping requirements, Securities.

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, and 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's 
custodian may place and maintain financial assets, corresponding to the 
fund's security entitlements, with a securities depository or 
intermediary custodian, if the custodian:

[[Page 8443]]

    (1) Is at a minimum obligated to exercise due care in accordance 
with reasonable commercial standards in discharging its duty as a 
securities intermediary to obtain and thereafter maintain such 
financial assets;
    (2) Is required to provide, promptly upon request by the fund, such 
reports as are available concerning the internal accounting controls 
and financial strength of the custodian; and
    (3) Requires any intermediary custodian at a minimum to exercise 
due care in accordance with reasonable commercial standards in 
discharging its duty as a securities intermediary to obtain and 
thereafter maintain financial assets corresponding to the security 
entitlements of its entitlement holders.
    (b) Direct dealings with securities depository. A fund may place 
and maintain financial assets, corresponding to the fund's security 
entitlements, directly with a securities depository, if:
    (1) The fund's contract with the securities depository or the 
securities depository's written rules for its participants:
    (i) Obligate the securities depository at a minimum to exercise due 
care in accordance with reasonable commercial standards in discharging 
its duty as a securities intermediary to obtain and thereafter maintain 
financial assets corresponding to the fund's security entitlements; and
    (ii) Requires the securities depository to provide, promptly upon 
request by the fund, such reports as are available concerning the 
internal accounting controls and financial strength of the securities 
depository; and
    (2) The fund 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).
    (c) Definitions. For purposes of this section the terms:
    (1) Clearing corporation, financial asset, securities intermediary, 
and security entitlement have the same meanings as is attributed to 
those terms in Sec.  8-102, Sec.  8-103, and Sec. Sec.  8-501 through 
8-511 of the Uniform Commercial Code, 2002 Official Text and Comments, 
which are incorporated by reference in this section pursuant to 5 
U.S.C. 552(a) and 1 CFR part 51. The Director of the Federal Register 
has approved this incorporation by reference in accordance with 5 
U.S.C. 552(a) and 1 CFR part 51. You may obtain a copy of the Uniform 
Commercial Code from the National Conference of Commissioners on 
Uniform State Laws, 211 East Ontario Street, Suite 1300, Chicago, Il 
60611. You may inspect a copy at the following addresses: Louis Loss 
Library, U.S. Securities and Exchange Commission, 450 5th Street, NW., 
Washington, DC 20549, and Office of the Federal Register, National 
Archives and Records Administration, 800 North Capitol Street, NW, 
Suite 700, Washington, DC.
    (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 foreign custodian whose use is governed by Sec.  270.17f-5 or 
Sec.  270.17f-7, or a 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.
    (3) Fund means an investment company registered under the Act and, 
where the context so requires with respect to a fund that is a unit 
investment trust or a face-amount certificate company, includes the 
fund's trustee.
    (4) Intermediary custodian means any subcustodian that is a 
securities intermediary and is qualified to act as a custodian.
    (5) Officer's instruction means a request or direction to a 
securities depository or its operator, or to a registered transfer 
agent, 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 
unit investment trust or a face-amount certificate company) to give the 
request or direction.
    (6) Securities depository means a clearing corporation that is:
    (i) Registered with the Commission as a clearing agency under 
section 17A of the Securities Exchange Act of 1934 (15 U.S.C. 78q-1); 
or
    (ii) A Federal Reserve Bank or other person authorized to operate 
the federal book entry system described in the regulations of the 
Department of Treasury codified at 31 CFR 357, Subpart B, or book-entry 
systems operated pursuant to comparable regulations of other federal 
agencies.

    Dated: February 13, 2003.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-4042 Filed 2-19-03; 8:45 am]
BILLING CODE 8010-01-P