Custody of Investment Company Assets Outside the United States

SUMMARY: The Commission is proposing amendments to the rule under the

Investment Company Act of 1940 that governs the custody of investment

company assets outside the United States. The amendments would revise

the findings that currently must be made in establishing foreign

custody arrangements to focus exclusively on the safekeeping of

investment company assets. In addition, the amendments would provide

investment companies with greater flexibility to address foreign

custody arrangements by permitting a company's board of directors to

delegate its responsibilities under the rule to evaluate these

arrangements. The amendments also would expand the class of foreign

banks and securities depositories that could serve as investment

company custodians. The proposed amendments are intended to facilitate

the use of foreign custody arrangements, consistent with the

safekeeping of investment company assets.

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

ADDRESSES: Comments should be submitted in triplicate to Jonathan G.

Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street,

N.W., Stop 6-9, Washington, D.C. 20549. All comment letters should

refer to File No. S7-23-95. All comments received will be available for

public inspection and copying in the Commission's Public Reference

Room, 450 Fifth Street, NW., Washington, DC 20549.

FOR FURTHER INFORMATION CONTACT: Elizabeth R. Krentzman, Assistant

Chief, or Kenneth J. Berman, Assistant Director, (202) 942-0690, Office

of Regulatory Policy, Division of Investment Management, 450 Fifth

Street, NW., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission today is requesting public

comment on proposed amendments to rule 17f-5 (17 CFR 270.17f-5) under

the Investment Company Act of 1940 (15 U.S.C. 80a) (the ``Act'').

Table of Contents

I. Executive Summary

II. Background

III. Discussion

A. Standard for Evaluating Foreign Custody Arrangements

B. Delegation of Board Responsibilities

1. Appropriate Delegate for Foreign Custody Decisions

2. Custody in Foreign Countries

a. Prevailing Custodial Risks

b. Compulsory Depositories

3. Selecting Foreign Custodians

4. Foreign Custody Contracts

a. Proposed Approach

b. Request for Comment on Specific Contract Provisions

5. Monitoring Custody Arrangements and Withdrawing Assets from

Custodians

C. Eligible Foreign Custodians

1. Banks and Trust Companies

a. Proposed Approach

b. Other Alternatives Considered

2. Non-Compulsory Depositories and Transnational Systems

D. Assets Maintained in Foreign Custody

E. Canadian and Other Foreign Funds

F. Disclosure of Custody Risks

G. Unit Investment Trusts

IV. Cost/Benefit Analysis

V. Summary of Initial Regulatory Flexibility Analysis

VI. Statutory Authority

Text of Proposed Rule Amendments

I. Executive Summary

The Commission is proposing amendments to rule 17f-5 to facilitate

the use of foreign custody arrangements by registered management

investment companies (``funds''). Among other things, the amendments

would revise the findings that must be made in establishing foreign

custody arrangements. Under the current rule, a fund's board of

directors must find that the fund's arrangements are consistent with

the best interests of the fund and its shareholders. This standard may

be overbroad since it suggests, for example, that, in considering

foreign custody arrangements, a fund's board needs to assess factors

other than custodial risks. The amended rule would require findings

that the fund's foreign custody arrangements will provide reasonable

protection for fund assets. The proposed ``reasonable protection''

standard should facilitate evaluations of foreign custody arrangements

by focusing exclusively on safekeeping considerations.

The amendments also would allow fund directors to play a more

traditional oversight role with respect to foreign custody arrangements

than that required under the current rule. Under the amendments, the

board would be permitted to delegate its responsibility under the rule

to evaluate foreign custody arrangements to the fund's investment

adviser or officers or a U.S. or foreign bank. The amended rule would

provide the board with the flexibility to assign different delegates

responsibility for addressing different aspects of the fund's

arrangements. The amended rule also would provide for general board

oversight of a delegate's actions by requiring the delegate to provide

the board with periodic reports concerning the fund's arrangements. The

board would no longer be required to approve foreign custody

arrangements annually.

In addition to updating and refining certain other provisions of

rule 17f-5, the amendments would expand the class of foreign banks and

depositories that could serve as fund custodians. Foreign banks would

no longer have to meet specific capital requirements and foreign

depositories would no longer have to operate the only system for the

handling of securities in a country. The amended rule would require

foreign custodians to be subject to foreign regulation. In addition, in

connection with a custodian's selection, the amended rule would require

a finding that the custodian will provide reasonable protection for the

fund's assets based on all relevant factors, including the custodian's

financial strength. This approach seeks to address safekeeping

considerations without imposing capital and other requirements that may

unnecessarily limit fund use of appropriate foreign custodians.

II. Background

Over the last ten years, the fund industry has become increasingly

international in its investment perspective. At the end of 1984,

shortly after rule 17f-5 was adopted, only 35 funds invested

significant amounts of their assets in foreign securities.1 By the

end of 1994, the number of funds participating in foreign markets had

increased almost twentyfold, with over 650 funds investing significant

amounts of their assets outside the United States.2

\1\ Investment Company Institute, The Growth Continues 1993

Perspective on Mutual Fund Activity 7 (Summer 1993); Lipper

Analytical Services, Inc. (``Lipper''), Year Over Year Comparison of

Growth by Objective of Closed-End Funds (1980-1990) (prepared for

the Commission).

\2\ Investment Company Institute, Trends in Mutual Fund Activity

(Dec. 1994) (ICI News No. ICI-95-05); Lipper, Closed-End Fund

Performance Analysis Service (Jan. 31, 1995) (as supplemented by the

Commission staff to reflect closed-end funds that liquidated or

converted to open-end status during the ten-year period ending

December 31, 1994). Based on Commission filings, the Division of

Investment Managements estimates that over 2,200 fund portfolios

maintained some of their assets in foreign custody arrangements

during the past year.

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The availability of custodial arrangements in foreign markets where

a fund invests is important. Maintaining securities outside of their

primary market can add significant costs to investing in that market

and may preclude foreign investment.3

\3\ Moving securities away from their primary market may entail

additional costs in connection with hiring a servicing agent in the

primary locality to collect and disseminate information with respect

to the securities, transferring the securities to an eligible

custodian and procuring insurance for possible loss in transit, and

exchanging coupons for interest or dividends or for new shares in

connection with a rights offering. Exemption for Custody of

Securities by Foreign Banks and Foreign Securities Depositories,

Investment Company Act Release No. 12354 (Apr. 5, 1982), 47 FR

16341, 16342 (hereinafter 1982 Proposing Release). Funds also may be

prevented from, or delayed in, selling the securities if they are

unable to make timely delivery to prospective purchasers in the

primary market. Id. In addition, the best price for a foreign

security typically may be obtained in its primary market. Id.

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Section 17(f) of the Act and the rules thereunder govern the

safekeeping of fund assets.4 The legislative history and

requirements of section 17(f) indicate that Congress intended fund

assets to be kept by financially secure entities that have sufficient

safeguards against misappropriation.5 Under section 17(f), only

U.S. banks and their foreign branches, members of a U.S. securities

exchange, funds themselves, and U.S. securities depositories may serve

as fund custodians.6 Before rule 17f-5 was adopted, therefore,

funds seeking to maintain their assets outside the United States could

use only foreign branches of U.S. banks as foreign custodians.7

\4\ 15 U.S.C. 80a-17(f).

\5\ Investment Trusts and Investment Companies: Hearings on S.

3580 Before a Subcomm. of the Senate Comm. on Banking and Currency,

76th Cong., 3d Sess. 264 (1940). Cf. 10 SEC Ann. Rep. 169 (1944)

(discussing section 17(f) and its protections against theft and

embezzlement by affiliated persons).

\6\ Bank custodians must be subject to federal or state

regulation and have at least $500,000 in aggregate capital, surplus,

and undivided profits. Investment Company Act sections 2(a)(5), 15

U.S.C. 80a-2(a)(5) (defining bank), and 26(a)(1), 15 U.S.C. 80a-

26(a)(1) (containing the $500,000 capital requirement). See also

rule 17f-1, 17 CFR 270.17f-1 (custody by members of a U.S.

securities exchange), rule 17f-2, 17 CFR 270.17f-2 (custody by funds

themselves), and rule 17f-4, 17 CFR 270.17f-4 (custody by U.S.

securities depositories). See generally Custody of Investment

Company Assets with Futures Commission Merchants and Commodity

Clearing Organizations, Investment Company Act Release No. 20313

(May 24, 1994), 59 FR 28286 (proposing rule 17f-6, which would

permit custody of fund assets by futures commission merchants and

commodity clearing organizations).

\7\ 1982 Proposing Release, supra note 3, at 16342 n.11. Before

rule 17f-5 was adopted, several Commission orders under section

17(f) permitted funds to place their assets with certain foreign

banks if the fund's U.S. custodian assumed responsibility for the

arrangement. See Chase Manhattan Bank, Investment Company Act

Release Nos. 12002 (Oct. 23, 1981), 46 FR 53567 (Notice of

Application) and 12053 (Nov. 20, 1981), 24 SEC Docket 109 (Order).

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Rule 17f-5 expanded the foreign custody arrangements available to

funds.\8\ Under the rule, the fund's board of directors must approve

each country where the fund's assets will be maintained, each foreign

bank or depository that will hold the assets, and the contract

governing the arrangement.\9\ The rule requires foreign custody

contracts to contain certain provisions, and Notes to the rule

enumerate factors that the board should consider in placing fund assets

in foreign countries and with foreign custodians.\10\ In addition, the

rule requires the fund's board to monitor foreign custody arrangements

and to approve the arrangements at least annually.\11\

\8\ Exemption for Custody of Investment Company Assets Outside

the United States, Investment Company Act Release No. 14132 (Sept.

7, 1984), 49 FR 36080 (hereinafter 1984 Adopting Release). Rule 17f-

5 was proposed in 1982 and reproposed in 1984. See 1982 Proposing

Release, supra note 3; Exemption for Custody of Investment Company

Assets Outside the United States, Investment Company Act Release No.

13724 (Jan. 17, 1984), 49 FR 2904 (hereinafter 1984 Reproposing

Release). In addition, certain technical amendments were made to the

rule after its adoption. Custody of Investment Company Assets

Outside of the United States, Investment Company Act Release Nos.

14548 (May 31, 1985), 50 FR 24540 (hereinafter 1985 Release

Proposing Amendments), and 14711 (Sept. 11, 1985), 50 FR 37654

(hereinafter 1985 Release Adopting Amendments])

\9\ Rule 17f-5(a)(1)(i)-(iii). See also ``Discussion--Assets

Maintained in Foreign Custody'' below.

\10\ Rule 17f-5(a)(1)(iii), Rule 17f-5, Notes 1 and 2.

\11\ Rule 17f-5(a)(2) and (3).

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Rule 17f-5 limits ``eligible foreign custodians'' to foreign banks

and trust companies that either have more than $200 million in

shareholders' equity or are majority-owned subsidiaries of U.S. banks

or bank holding companies with more than $100 million in shareholders'

equity.\12\ Foreign depositories that hold fund assets must operate

either the only system for a country's handling of securities or a

transnational system for the central handling of securities.\13\

\12\ Rule 17f-5(c)(2)(i) and (ii). Non-subsidiary foreign bank

and trust companies also must be subject to foreign regulation.

\13\ Rule 17f-5(c)(2)(iii) and (iv).

The Commission's Division of Investment Management (``Division'')

has received extensive submissions urging amendment of rule 17f-5 from

the Investment Company Institute (``ICI'') and a group of custodians

that provide global custody services to funds (the ``Custodian

Group'').14 These commenters, as well as others, have indicated

that rule 17f-5 places inappropriate burdens on fund directors.15

Commenters have observed that the rule requires directors to ``micro-

manage'' foreign custody arrangements, which is inconsistent with the

oversight role directors generally perform.16 Commenters also have

indicated that directors usually lack the expertise to make foreign

custody determinations, and that, in discharging their responsibilities

under the rule, directors rely almost exclusively on the analysis and

recommendations of third parties such as the fund's adviser and primary

custodian.17

\14\ Letter from Matthew P. Fink, President, ICI, to Marianne K.

Smythe, Division Director, SEC (Jan. 18, 1993) (hereinafter ICI

Letter I); Letter from Catherine L. Heron, Vice President (Tax and

Pension), ICI, to Barry P. Barbash, Division Director, SEC (Oct. 13,

1993) (hereinafter ICI Letter II); Letter from Stephen K. West,

Sullivan & Cromwell, to Barry P. Barbash, Division Director, SEC

(Sept. 29, 1994) (hereinafter ICI Letter III); Letter from Daniel L.

Goelzer, Baker & Mackenzie (on behalf of Bankers Trust Company,

Boston Safe Deposit and Trust Company, Brown Brothers Harriman &

Co., Chase Manhattan Bank, Morgan Guaranty Trust Company of New

York, Morgan Stanley Trust Company, and State Street Bank and Trust

Company), to Barry P. Barbash, Division Director, SEC (Feb. 9, 1994)

(hereinafter Custodian Letter I); Letter from Daniel L. Goelzer,

Baker & Mackenzie, to Elizabeth R. Krentzman, Special Counsel, SEC

(Oct. 20, 1994) (hereinafter Custodian Letter II); Letter from

Daniel L. Goelzer, Baker & Mackenzie, to Barry P. Barbash, Division

Director, SEC (Nov. 3, 1994) (hereinafter Custodian Letter III).

These letters are located in the Commission's Public Reference Room

under File No. S7-23-95.

\15\ See Division of Investment Management, SEC, Protecting

Investors: A Half Century of Investment Company Regulation 270 n.78

(1992) (hereinafter Protecting Investors report).

\16\ Id.

\17\ Id.

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Commenters, including the ICI and the Custodian Group, also have

indicated that the rule's definition of an eligible foreign custodian

is too restrictive.18 Since rule 17f-5 was adopted, foreign

custodial arrangements have evolved significantly. Today, the

safekeeping of foreign investments typically is effected through the

fund's primary custodian, which uses a global custody network

consisting of various foreign custodians with which the primary

custodian has established relationships.19 In addition, many

countries have securities depositories, which offer ``paperless'' book-

entry systems for the custody of fund assets.20

\18\ See, e.g., ICI Letter II, supra note 14; Custodian Letter

I, supra note 14.

\19\ See John Paul Lee & Richard Schwartz, Global Custody: A

Guide for the Nineties (1990). Funds also use different custodian

networks for different geographical regions. See Andrew Sollinger,

Breaking Away, Institutional Investor 171 (Sept. 1991).

\20\ See Group of Thirty, Clearance and Settlement Systems in

the World's Securities Markets 7, 51-64 (Mar. 1989) (hereinafter

Group of Thirty Report).

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A number of exemptive orders and no-action letters have addressed

the

[[Page 39594]]

eligibility of certain foreign banks and depositories to serve as fund

custodians.21 Obtaining administrative relief with respect to a

particular custodian, however, may involve significant amounts of time

and expense, and may delay or impede investment in some foreign

jurisdictions. Exemptive orders and no-action letters also may have the

unintended effect of suggesting Commission approval with respect to

safekeeping abilities of some custodians, particularly in the case of

foreign depositories.

\21\ See ``Discussion--Eligible Foreign Custodians'' below.

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Based on the evolution of foreign markets and related custodial

systems, the concerns raised by industry commenters, and the

Commission's administrative experience, the Commission is proposing

amendments to rule 17f-5. The amendments seek to facilitate the use of

foreign custody arrangements, consistent with the safekeeping of fund

assets.

III. Discussion

A. Standard for Evaluating Foreign Custody Arrangements

Rule 17f-5 currently requires fund boards of directors to find that

the fund's foreign custody arrangements are consistent with the best

interests of the fund and its shareholders. This finding must be made

with respect to the custody of the fund's assets in a particular

country, each foreign custodian that holds the assets, and the foreign

custody contract.22 The Commission believes that the ``best

interest'' standard may be overly broad and difficult for directors to

apply. The standard and certain Notes to the current rule, for example,

suggest that, in considering foreign custody arrangements, a fund's

board needs to assess factors other than custodial risks, such as the

risk of expropriation.23

\22\ See rule 17f-5(a)(1)-(3).

\23\ See 1984 Reproposing Release, supra note 8, at 59608 (in

making the required best interest finding, the board should weigh

the risks of maintaining the securities in or near a country against

the benefits of the arrangement).

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The Commission believes that the amended rule should require

foreign custody arrangements to be evaluated based on the level of

safekeeping they will afford fund assets. Thus, the amended rule would

require findings that the fund's foreign custody arrangements will

provide reasonable protection for fund assets. The proposed

``reasonable protection'' standard is intended to facilitate

evaluations of foreign custody arrangements by focusing exclusively on

the safekeeping of fund assets.

B. Delegation of Board Responsibilities

1. Appropriate Delegate for Foreign Custody Decisions

The amended rule would permit fund boards to play a role more

consistent with their traditional oversight role in connection with a

fund's foreign custody arrangements, by allowing the board to delegate

its responsibilities under the rule to the fund's investment adviser or

officers or a U.S. or foreign bank.24 The fund's investment

adviser or custodian are likely to be in a better position than the

fund's board to evaluate the sorts of factors that would be involved in

assessing whether a custodial arrangement will afford reasonable

protection for fund assets. Under the amended rule, the board could use

different delegates for different foreign custody

responsibilities.25 This approach seeks to provide the board with

the flexibility to delegate components of foreign custody decisions to

the entity it determines is in the best position to evaluate those

aspects of the fund's arrangements.26

\24\ The Commission previously considered permitting U.S.

custodians to select particular foreign custodians. 1982 Proposing

Release, supra note 3, at 16345-46; 1984 Reproposing Release, supra

note 8, at 2910. See also Protecting Investors report, supra note

15, at 270-71 (recommending that the Commission consider revising

rule 17f-5 to make the fund's adviser or primary domestic custodian

responsible for foreign custody matters, subject to the board's

general oversight; also recommending that the Commission consider

requiring indemnification protections from the fund's domestic

custodian).

\25\ The adviser, for example, could evaluate the risks

associated with the custody of the fund's assets in a particular

jurisdiction and a U.S. custodian could evaluate the risks of using

specific foreign custodians.

\26\ Proposed rule 17f-5(b). U.S. bank delegates would have to

be subject to federal or state regulation by virtue of the

definition of bank in section 2(a)(5) of the Act. Through the

definition of ``qualified foreign bank,'' proposed rule 17f-5(d)(6)

would require foreign delegates to be regulated as either a foreign

banking institution or trust company by the government of the

country under whose laws it is organized or any agency thereof.

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In selecting particular delegates for foreign custody decisions,

the board, under the amended rule, would need to find that it is

reasonable to rely on the delegate to perform the delegated

responsibilities.27 Factors typically involved in making this

determination would include the expertise of the delegate and, if

applicable, the delegate's intended use of third party experts in

performing its responsibilities.28 Other relevant factors may

include, in the case of foreign delegates, the board's ability to

monitor the delegate's performance and the fund's ability to obtain

U.S. jurisdiction over the delegate if problems arise in the delegate's

performance.

\27\ Proposed rule 17f-5(b)(1).

\28\ See generally Custodian Letter II, supra note 14, at 2

(indicating that U.S. custodians can provide information regarding

the nature and operation of a foreign country's custody facilities);

Gordon Altman Butowsky Weitzen Shalov & Wein, A Practical Guide to

the Investment Company Act 30 (1993) (indicating that, under the

current rule, the fund's custodian typically provides the board with

information concerning foreign legal restrictions and the

qualifications of the foreign custodians used by the fund);

Glorianne Stromberg, Regulatory Strategies for the Mid-'90s;

Recommendations for Regulating Investment Funds in Canada (prepared

for the Canadian Securities Administrators) 242 (Jan. 1995)

(suggesting it is unlikely that an individual investment company or

its adviser will have the expertise or bargaining power to deal with

numerous and varied foreign custodians throughout the world).

The amended rule would not require the board to approve the fund's

foreign custodians or other foreign custody matters on an initial or

annual basis.29 The board also would not be required to pre-

approve or ratify actions taken by the delegate, such as the selection

of particular foreign custodians or changes in those

arrangements.30 Instead, the amended rule would require the

delegate to provide the board with written reports notifying the board

of the placement of the fund's assets in a particular country and with

a particular custodian.31 The delegate also would have to provide

written reports of any material changes in the fund's

arrangements.32 These reports, which are intended to facilitate

the board's oversight of the delegate's performance, would be provided

to the board no later than the next regularly scheduled board

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meeting following the delegate's actions.33

\29\ See rule 17f-5(a)(3) (requiring the board to annually

approve foreign custody arrangements). See also Revision of Certain

Annual Review Requirements of Investment Company Boards of

Directors, Investment Company Act Release No. 19719 (Sept. 17,

1993), 58 FR 49919 (rule amendments eliminating certain annual

approval requirements).

\30\ The amended rule, however, would not preclude a board and

its delegate from agreeing that the board's guidance would be sought

on a particular matter, such as changing custodians. See Custodian

Letter II, supra note 14, at 16-17 (expressing concerns that,

without the board's involvement, responsibility for changing

custodians could increase a delegate's liability if, for example,

the delegate does not make a custodian change and fund assets are

lost as a result of the custodian's insolvency).

\31\ Proposed rule 17f-5(b)(2).

\32\ Id. A material change in the fund's arrangements could

include a delegate's decision to remove the fund's assets from a

particular jurisdiction or custodian. A material change also could

include circumstances that may adversely affect a foreign

custodian's financial or operational strength, such as a change in

control resulting from the custodian's sale. If appropriate, the

delegate's report could discuss the reasons for continuing to

maintain the fund's assets in the country or with a particular

custodian.

\33\ Proposed rule 17f-5(b)(2). See ICI Letter I, supra note 14,

at 6-7; Custodian Letter I, supra note 14, at 18 (recommending that

delegates provide written year-end reports).

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The Commission requests comment on the proposed approach and

possible alternatives. The Commission requests specific comment on the

proposed entities to which foreign custody responsibilities could be

delegated. In particular, the Commission requests comment whether U.S.

and foreign bank delegates should be required to meet specific capital

standards. The Commission also requests comment whether custodian

delegates should be limited to U.S. banks.34 Alternatively, should

the rule permit the board to use any party that, in the board's

judgment, would be qualified to make foreign custody decisions?

\34\ Several exemptive orders relating to rule 17f-5 involve

foreign banks and their foreign subsidiaries. See, e.g., Barclays

Bank PLC, Investment Company Act Release Nos. 20128 (Mar. 10, 1994),

59 FR 12390 (Notice of Application) and 20192 (Apr. 5, 1994), 56 SEC

Docket 1117 (Order).

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The Commission also requests comment whether the amended rule

should require the same delegate to evaluate all aspects of the fund's

arrangements or tie certain responsibilities to particular

delegates.35 The ICI and the Custodian Group, for example,

indicated that the fund's adviser should be the exclusive delegate for

considering a county's custodial risks because of the relationship

between decisions to invest in the country and maintain the fund's

assets in that country.36 They also suggested that U.S. bank

custodians should be the only eligible delegates for selecting the

fund's foreign custodians.37 The ICI suggested that evaluating

foreign custodian arrangements is within the expertise of the fund's

U.S. custodian and not the fund's adviser.38 The Custodian Group

expressed concerns about advisers being in a position to make a U.S.

custodian use a foreign custodian with which the U.S. custodian does

not have a pre-existing relationship and whose practices and procedures

do not meet the U.S. custodian's standards.39

\35\ Requiring the same delegate to evaluate all aspects of

foreign custody arrangements could effectively eliminate the

potential for U.S. custodians to serve as delegates, since the

Custodian Group has suggested that U.S. custodians may be unwilling

to evaluate the prevailing custodial risks of a particular country.

See infra note 36 and accompanying text.

\36\ ICI Letter I, supra note 14, at 4, n.5; ICI Letter III,

supra note 14, at 1-3; Custodian Letter I, supra note 14, at 6-7;

Custodian Letter II, supra note 14, at 2. See also Custodian Letter

III, supra note 14, at 2. The Custodian Group indicated that,

because decisions relating to a country's prevailing custodial risks

may depend on the fund's investment strategies and willingness to

accept certain risks, custodians are not in a position to make these

assessments. Custodian Letter I, supra note 14, at 6-7; Custodian

Letter II, supra note 14, at 2; Custodian Letter III, supra note 14,

at 2. The Custodian Group also asserted that requiring U.S.

custodians to evaluate prevailing custodial risks would transfer new

liabilities to U.S. banks, which could raise bank regulatory

concerns. Id. at 5-6.

As discussed infra notes 62-68 and accompanying text, the ICI

and the Custodian Group viewed differently the responsibilities

involved in determining whether to maintain custody of fund assets

in a particular country.

\37\ ICI Letter III, supra note 14, at 3 and at 1, 6 (Exhibit

A); Custodian Letter I, supra note 14, at 8-9 and at 3-4, 7-8

(Exhibit A) (also recommending that boards be permitted to delegate

to U.S. custodians the authority to negotiate and approve foreign

custody contracts and to monitor the fund's arrangements).

\38\ ICI Letter III, supra note 14, at 3.

\39\ Custodian Letter I, supra note 14, at 8.

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Although these approaches may limit flexibility, they could

eliminate potential questions between different delegates concerning

their respective roles in foreign custody matters. They also could

eliminate the need to attribute various foreign custody risks to the

practices of a particular country or foreign custodian.40

\40\ Under the current rule, for example, the board is

responsible for both the decision to place fund assets in a

particular country and with a particular custodian. If a country's

prevailing custodial risks are not evaluated by the board in

deciding to maintain assets in a particular jurisdiction, these

risks would be considered in selecting particular custodians in that

jurisdiction. See also infra notes 49 and 71 and accompanying text.

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The Commission also requests comment on the proposed requirements

relating to the board's delegation. The Commission requests specific

comment on requiring the board to determine that it is reasonable to

rely on the delegate to perform the delegated responsibilities and

whether another standard would be more appropriate. The Commission also

requests comment on requiring delegates to provide the board with

periodic reports concerning the fund's arrangements. In particular,

does the proposed approach appropriately address the role of the board

in foreign custody matters? Should, for example, the rule require the

board to establish guidelines and procedures governing a delegate's

responsibilities? 41 Should the rule specify particular

representations that delegates must make in performing their

responsibilities? 42 Should the rule mandate the standard of care

to be used by delegates in making custodial decisions? 43

\41\ See ICI Letter III, supra note 14, at 1-3 (Exhibit A);

Custodian Letter I, supra note 14, at 3-5 (Exhibit A) (recommending

board-approved guidelines and procedures that include factors

governing a delegate's selection of foreign custodians). See also

rules 10f-3, 17a-7, and 17e-1 under the Act, 17 CFR 270.10f-3, -17a-

7, -17e-1 (consistent with this approach).

\42\ See ICI Letter III, supra note 14, at 5 (Exhibit A);

Custodian Letter I, supra note 14, at 7 (Exhibit A) (recommending

that delegates make certain representations to the board prior to

using a foreign custodian).

\43\ See ICI Letter III, supra note 14, at 3 and at 1, 6

(Exhibit A); Custodian Letter I, supra note 14, at 8-9 and at 3-4,

7-8 (Exhibit A) (recommending that, in selecting foreign custodians,

U.S. bank delegates be required to act with the degree of care,

prudence, and diligence of a reasonable professional custodian under

applicable state law).

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Finally, the Commission requests comment generally on the

relationship between the level of the delegate's role in selecting

foreign custodians and the flexibility that a fund should have in using

particular custodians. For example, current rule 17f-5 both limits the

class of foreign banks that are eligible to hold fund assets (based on,

among other things, their shareholder's equity) and requires the fund's

board to select an appropriate custodian from that class based on

several qualitative factors (such as the bank's reputation). As

discussed below, the amended rule would not require foreign custodians

to satisfy an objective financial standard.44 The amended rule

instead would require the board's delegate to select foreign custodians

based on the qualitative determination that the custodian will provide

reasonable protection for the fund's assets.45

\44\ See ``Eligible Foreign Custodians'' below.

\45\ See ``Selecting Foreign Custodians'' below.

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The Commission requests comment on an alternative approach that

would rely exclusively on objective standards to determine those

custodians that would be eligible to hold fund assets. Under this

approach, having determined that a potential custodian meets the rule's

objective standards, a delegate would not be required to evaluate the

appropriateness of the foreign custodian based on any qualitative

determination. Nor would the delegate be required by the rule to

provide the fund's board with specific reports concerning the fund's

arrangements.46 Commenters favoring this approach should recommend

specific objective standards that would not unduly limit or preclude

the use of qualified foreign custodians.47 Commenters also should

consider whether objective standards, by themselves, would protect fund

assets or whether, consistent with the current rule, delegates should

be required to consider additional qualitative factors.

\46\ This approach would be consistent with the provisions of

section 17(f) governing the custody of fund assets with a domestic

bank. See supra note 6.

\47\ See ``Eligible Foreign Custodians'' below.

[[Page 39596]]

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2. Custody in Foreign Countries

a. Prevailing Custodial Risks

Rule 17f-5 requires a fund's board to approve each country where

the fund's assets will be maintained.48 Because placing fund

assets in a particular country may affect the safekeeping of those

assets, the amended rule would continue to address the risks associated

with custody of a fund's assets in a foreign country.49

\48\ See rule 17f-5(a)(1)(i).

\49\ See Custodian Letter I, supra note 14, at 6-7 (indicating

that deciding to place assets in a particular country may mean

accepting certain risks if custodial protections comparable to those

of the United States are not available in the foreign jurisdiction).

The proposed approach also seeks to address circumstances where

different delegates assess the custodial risks of a particular

country and the risks of using a particular foreign custodian. If,

for example, a country's prevailing custodial risks are not

evaluated by a delegate in deciding to maintain assets in the

country, a different delegate selecting the fund's foreign

custodians could determine that the custody of the fund's assets in

that country presents unacceptable risks, without regard to the

protections provided by any specific custodian. Delegates making the

respective country-wide and custodian risk assessments could, in

effect, disagree over the appropriateness of maintaining fund assets

in the country. Such disputes may have to be resolved by the board,

which could undermine the purposes of delegation by re-involving the

board in foreign custody decisions.

The amended rule would require a finding that custody of the fund's

assets in a particular country can be maintained in a manner that will

provide reasonable protection for those assets.50 Making the

proposed determination would not require a finding that fund assets

could never be lost in a foreign country.51 Rather, the proposed

determination would require the delegate to consider whether the fund's

assets will be maintained in a manner that will provide reasonable

protection based on all relevant factors and, in particular, the

factors specified in the amended rule.52

\50\ Proposed rule 17f-5(a)(1). Consistent with the current

rule, this finding would have to be made prior to placing the fund's

assets in the country. The amended rule would not address the

investment risks associated with investing in foreign securities,

since these risks fall outside the scope of rule 17f-5.

\51\ This approach would be consistent with the current rule.

\52\ Throughout this release, references are made to a

delegate's responsibilities, since the amendments contemplate that

the board will use one or more delegates to establish and oversee

the fund's foreign custody arrangements. If, however, the board

decides to retain decision-making authority for foreign custody

matters, these responsibilities would remain with the board. The

amended rule uses the term foreign custody manager to recognize that

a delegate or the board may assume responsibility for the fund's

arrangements. See proposed rule 17-f(d)(1).

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The amended rule would require the delegate to evaluate, among

other factors, the prevailing practices in a country for the

safekeeping of the fund's assets.53 Evaluating a country's

custodial practices typically would involve, among other things,

considering the manner in which securities are maintained (e.g.,

whether securities are held in physical or uncertificated form), the

physical protections available for certificated securities (e.g., the

use of vaults or other facilities), the method of keeping custodial

records (e.g., the use of computers, microfilm or paper records),

custodial communication systems (e.g., the use of electronic media,

telex, or telephone), security and data protection practices (e.g.,

alarm systems and the use of pass codes and back-up procedures for

electronically stored information), and the protections provided by

governmental or other regulatory oversight.54 These considerations

seek to address the systemic custodial risks of a particular country.

Although evaluating a country's custodial practices would require

knowledge of foreign custody arrangements, it would not require a

finding concerning the protections provided by any specific foreign

custodian.55

\53\ Proposed rule 17f-5(a)(1)(i).

\54\ The importance of each of these factors would depend on the

particular jurisdiction and related securities market. For example,

vault facilities and alarm systems may be less important in markets

where securities are primarily held in book-entry form. Similarly,

the need for electronic information systems may be more important in

markets with a high volume of securities transactions than in

markets where trading is less frequent. See Custodian Letter II,

supra note 14, at 4-5.

\55\ See ``Selecting Foreign Custodians'' below.

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In evaluating the custodial risks of a particular country, the

delegate would be required to assess any adverse effects foreign law

may have on the safekeeping of fund assets.56 The delegate

specifically would have to consider whether foreign law would restrict

(A) the access of the fund's accountants to the custodian's books and

records and (B) the fund's ability to recover its assets in the event

of a custodian's bankruptcy or a loss of assets in the custodian's

control. These factors are derived from the Notes to the current

rule.57 The amended rule would broaden the current rule, however,

by requiring consideration of all relevant foreign legal constraints,

in addition to those governing the custodian's books, bankruptcy, and

loss of assets.58

\56\ Proposed rule 17f-5(a)(1)(ii).

\57\ See rule 17f-5, Notes 1(a)-(c).

\58\ In evaluating any adverse effects foreign law may have on

the safekeeping of fund assets, consideration of U.S. legal

standards may be relevant. In determining whether custody of fund

assets in a particular country will provide reasonable protection

for those assets, however, delegates would not be required to find

that the protections provided by foreign law are equivalent to U.S.

standards.

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In addition, the amended rule would permit the delegate to consider

any special arrangements that mitigate prevailing custodial

risks.59 Such arrangements would include, for example, insurance

or guarantee agreements covering the loss of fund assets. Such

arrangements also may include instituting special procedures that

depart from prevailing practices and are designed to reduce custodial

risks. A recent Division no-action position, for example, was based, in

part, on the existence of certain contractual protections that would

not otherwise have been given in the course of the country's prevailing

custody practices.60

\59\ Proposed rule 17f-5(a)(1)(iii).

\60\ Templeton Russia Fund, Inc. (pub. avail. Apr. 18, 1995)

(contracts between the fund's foreign custodian and certain

registries).

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The Notes to the current rule instruct the fund's board to consider

the likelihood of various adverse political events (e.g., the

expropriation or freezing of assets) and potential difficulties in

converting the fund's cash and cash equivalents to U.S. dollars.61

The amended rule would not address these risks. Although these risks

may affect the safety and liquidity of fund assets, they appear to

relate more to the investment risks of a particular country than the

custodial risks of that country. Adverse political events and foreign

exchange problems, for example, may threaten fund assets regardless of

where the assets are held. The Commission believes that these risks

should be considered in connection with the determination that a fund

should invest in a particular country.

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

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The ICI and the Custodian Group recommended different approaches to

evaluating a country's prevailing custodial risks. The ICI recommended

eliminating country-related risk determinations from the rule.62

The ICI indicated that, for the most part, the risks of maintaining

assets in a particular jurisdiction (e.g., expropriation risks) are

independent of the risks associated with using a specific

[[Page 39597]]

foreign custodian.63 The ICI indicated that, as a consequence,

assessments of country-related risks are not appropriate considerations

for a foreign custody rule.64 The ICI also expressed concerns that

requiring evaluations of a country's prevailing custodial risks would

transfer to the country selection process the responsibility to

determine whether one or more custodians in a country could provide

reasonable protections for the fund's assets.65

\62\ ICI Letter III, supra note 14, at 3-7. The ICI's proposal

would require the decision to place assets in a particular

jurisdiction to have been made by the board or adviser as a

condition precedent to selecting specific foreign custodians. Id. at

6-7. The ICI indicated that the board or adviser would consider the

custodial risks of a particular jurisdiction in deciding whether to

invest in the country. ICI Letter I, supra note 14, at 4, n.5; ICI

Letter III, supra note 14, at 6-9.

\63\ ICI Letter III, supra note 14, at 3-7, 10. As discussed in

the text above, the amended rule would not address political and

foreign exchange considerations.

\64\ ICI Letter III, supra note 14, at 6-7, 10.

\65\ Id. at 3-8 (commenting on the Custodian Group's

recommendations). See supra 49 and 55 notes and accompanying text

(regarding the approach of the amended rule).

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The Custodian Group recommended that the rule require an evaluation

of a country's prevailing custodial risks prior to placing assets in

that jurisdiction.66 As to the factors governing these

assessments, the Custodian Group recommended that the Commission

consider adding two new factors to the Notes to the current

rule.67 The Custodian Group's new factors would require the

board's delegate to evaluate each securities depository in the country

and to consider whether the financial systems in the country, including

the methods for securities settlement and custody, are sufficient to

provide reasonable protection for the fund's assets.68

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

\67\ Id. at 7.

\68\ Id.

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The Commission requests comment on these two approaches. The

Commission also requests comment on an alternative approach that would

make evaluations of a country's prevailing custodial risks part of the

custodian selection process. Such an approach would simplify the rule

and should not raise any safekeeping concerns since the factors that

relate to a country's prevailing custodial risks would be evaluated in

connection with a custodian's selection.69

\69\ This approach, however, may have potential drawbacks in

connection with boards selecting different delegates to evaluate

different aspects of the fund's arrangements. See supra note 35 and

infra note 70 and accompanying text.

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b. Compulsory Depositories

Certain countries have depositories the use of which is unavoidable

for the custody of foreign securities purchased by a fund (a

``compulsory depository''). Because the custody of fund assets in a

foreign country may necessitate using any compulsory depository in the

country, the amended rule would make the selection of compulsory

depositories part of the assessment of a country's prevailing custodial

risks.70 The amended rule would require a finding that using a

compulsory depository will provide reasonable protection for the fund's

assets based on factors specified in the amended rule governing the

selection of foreign custodians.71

\70\ See Custodian Letter I, supra note 14, at 4-5, 6-7 and

Custodian Letter II, supra note 14, at 11-12 (indicating that, once

a fund invests in a country with a compulsory depository, the fund's

custodian (or any foreign bank custodian in that country) has no

choice but to use the compulsory depository). The current rule does

not distinguish between compulsory depositories and other foreign

custodians or associate the use of any specific foreign custodian

with the decision to maintain assets in a particular country.

\71\ Proposed rule 17f-5(a)(1) and (a)(1)(iv). See also proposed

rule 17f-5(a)(2)(i)-(iii), discussed infra notes 80-91 and

accompanying text. The Commission recognizes that, conceptually, the

decision to use a compulsory depository appears to fall within the

scope of the rule's provisions governing the selection of foreign

custodians (discussed in the text below). The Commission also

recognizes that a significant number of foreign depositories may be

considered compulsory depositories. Consequently, requiring

compulsory depositories to be evaluated in connection with a

country's prevailing custodial risks could mean that the majority of

depository decisions will not be made by the delegate selecting the

fund's other foreign custodians.

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The amended rule would define a compulsory depository as a

depository the use of which is mandatory (i) by law or regulation, (ii)

because securities cannot be withdrawn from the depository, or (iii)

because maintaining securities outside the depository is not consistent

with prevailing custodial practices.72 Part (iii) of the proposed

definition is intended to recognize cases when a depository's use is

effectively compulsory as a result of prevailing practices even though

securities may be held outside of the depository.73 Determining

whether a depository's use is compulsory would depend on the facts and

circumstances presented.74 Factors relevant to making this

determination may include whether virtually all securities are

maintained in the depository, whether the depository's involvement is

required to transfer securities ownership, and whether significant time

and expense are associated with keeping securities outside the

depository.75

\72\ Proposed rule 17f-5(d)(4). See also proposed rule 17f-

2(d)(3)(iv) (defining an eligible foreign custodian to include a

compulsory depository). The proposed definition should be construed

narrowly. If maintaining assets in a depository or with a foreign

bank custodian are feasible alternatives, the Commission believes

the decision to use a depository should be made in connection with

the custodian selection process. See ``Selecting Foreign

Custodians'' below.

\73\ See ICI Letter III, supra note 14, at 10 (Exhibit A);

Custodian Letter I, supra note 14, at 13 (Exhibit A) (suggesting

that a depository should be considered to be compulsory if

securities held outside the depository cannot be traded or

transferred in accordance with routine clearance and settlement

practices).

\74\ When different delegates evaluate country-wide and foreign

custodian risks and disagree on whether using a depository is

compulsory, the depository's status may have to be determined by the

board.

\75\ See Custodian Letter II, supra note 14, at 14-15

(discussing these considerations).

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The Commission requests comment on requiring compulsory

depositories to be evaluated in connection with assessments of a

country's prevailing custodial risks.76 The Commission also

requests comment on the proposed definition of compulsory depository.

\76\ See ICI Letter III, supra note 14, at 10 (recommending that

evaluations of compulsory depositories be part of the custodian

selection process); Custodian Letter I, supra note 14, at 4-5, 6-7

(consistent with proposed approach).

3. Selecting Foreign Custodians 77

\77\ Any custodian selected by the delegate would have to be an

``eligible foreign custodian'' as defined in proposed rule 17f-

5(d)(3). See ``Eligible Foreign Custodians'' below.

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The amended rule would require a finding that using a particular

custodian will provide reasonable protection for the fund's

assets.78 Selecting foreign custodians would not involve

reassessments of a country's prevailing custodial risks and the use of

any compulsory depositories. Under the amended rule, these matters

would be evaluated in determining whether the custody of the fund's

assets in the country will provide reasonable protection for those

assets.79

\78\ Proposed rule 17f-5(a)(2). See also ICI Letter III, supra

note 14, at 5 (Exhibit A); Custodian Letter I, supra note 14, at 7

(Exhibit A) (recommending that U.S. bank delegates be required to

represent to the board that a foreign custodian's internal controls

or established procedures are adequate to provide reasonable

protection for fund assets).

The proposed approach would be consistent with that governing

country-wide custodial risks evaluations. Like the current rule, the

proposed finding of reasonable protection would have to be made

prior to placing the fund's assets with the foreign custodian.

\79\ Proposed rule 17f-5(a)(2). See ``Custody in Foreign

Countries'' above.

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In selecting foreign custodians, the delegate would not be required

to find that assets could never be lost while in the foreign

custodian's possession. Instead, the amended rule would focus on the

reasonableness of a custodian's protections based on all relevant

factors and, in particular, those factors specified in the amended

rule.80 The proposed factors that would govern the selection of

foreign custodians are

[[Page 39598]]

derived from the Notes to the current rule.81

\80\ Proposed rule 17f-5(a)(2) (i) through (iii). As indicated

in the text accompanying note 71 supra, proposed rule 17f-5(a)(1)

would require delegates that evaluate the protection afforded fund

assets held by a compulsory depository to consider the factors set

forth in rule 17f-5(a)(2) (i) through (iii) governing the selection

of foreign custodians.

\81\ See rule 17f-5, Notes 2(a)-(d).

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The Notes to rule 17f-5 address a foreign custodian's financial

strength, its general reputation and standing in the country, and its

ability to provide efficiently the custodial services required and the

relative costs of those services.\82\

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

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In addition to a custodian's financial strength,\83\ the amended

rule would address a custodian's reputation and standing generally,

rather than in the country where the custodian is located.\84\ A

custodian's reputation and standing outside of its own country may be

relevant, especially in the case of multi-national banks. By no longer

tying consideration of a custodian's reputation and standing to the

country where the custodian is located, the amended rule seeks to

provide delegates with greater flexibility to evaluate a custodian's

reputation based on the facts and circumstances relevant to the

particular custodian. The amended provision also would require, in the

case of a securities depository, consideration of the depository's

operating history and number of participants.\85\

\83\ In evaluating a custodian's financial strength, the

delegate, for example, may consider capitalization, financial

history, and any other lines of business undertaken by the custodian

and the potential effects of such businesses on the custodian's

financial condition and operations.

\84\ Proposed rule 17f-5(a)(2)(i).

\85\ These matters currently are addressed as a separate Note

under rule 17f-5. Rule 17f-5, Note 2(d). Although certain matters

(i.e., operating history and number of participants) would

specifically apply to depositories, all of the factors set forth in

proposed rule 17f-5(a)(2) (i) through (iii) would have to be

considered when selecting foreign depositories.

The Custodian Group indicated that information concerning

certain depositories may be difficult or impossible to obtain. The

ICI and the Custodian Group recommended that the rule address this

problem by requiring consideration of a depository's operating

history if such information is ``reasonably obtainable.'' ICI Letter

III, supra note 14, at 2-3 (Exhibit A); Custodian Letter I, supra

note 14, at 14-16 and at 4 (Exhibit A).

The extent (or absence) of information about a foreign

depository may be relevant in determining whether the depository

will provide reasonable protection for fund assets. For example, the

lack of available information about a depository's operating history

may militate against the depository's use. Consequently, the amended

rule would not make an exception when information about a depository

is not available.

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In addition, the amended provision would no longer address a

custodian's efficiency and relative costs. Weighing a custodian's

efficiency against the costs of its services does not appear to be

particularly germane to the safety of fund assets in the hands of that

custodian. Although these matters would not be addressed under the

amended rule, the delegate may appropriately consider custodial

efficiency and costs in selecting a foreign custodian.

The Notes to rule 17f-5 also state that the fund's board should

consider whether a foreign custodian will provide a level of safeguards

not materially different from those of the fund's U.S.

custodian.86 The Commission believes that foreign custodian

arrangements, although different from U.S. arrangements, nonetheless

may provide reasonable and effective safeguards for fund assets.87

Accordingly, the amended rule would focus on whether a foreign

custodian would provide reasonable protection for fund assets, and

would specifically require the delegate to consider the custodian's

practices, procedures, and internal controls in making this

determination.88

\86\ Rule 17f-5, Note 2(b).

\87\ See Custodian Letter II, supra note 14, at 3-6.

\88\ Proposed rule 17f-5(a)(2)(ii). See ICI Letter III, supra

note 14, at 2 (Exhibit A); Custodian Letter I, supra note 14, at 9-

11 and at 4 (Exhibit A) (recommending that the rule focus on the

protections provided by foreign custodians rather than the

equivalency of those protections to U.S. standards).

When different delegates evaluate country-wide and foreign

custodian risks, the delegates may come to different determinations,

which are attributable to the different assessments involved. See

text accompanying note 55 supra (regarding evaluations of a

country's prevailing custodial risks).

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The protections provided by custodians within a foreign country may

vary widely. Thus, one custodian's practices and internal controls may

provide reasonable protections, while those of other custodians may

not. In addition, although the rule would not require parity between

foreign and U.S. custodian arrangements, reference to U.S. standards

may be relevant in determining whether a foreign custodian's practices

and internal controls will reasonably protect fund assets.

Finally, the amended rule would require the delegate to assess the

likelihood of U.S. jurisdiction over and enforcement of judgments

against a foreign custodian.89 The proposed requirement would

broaden the Notes to the current rule, which address whether a foreign

custodian has any branch offices in the United States.90 Under the

proposed approach, in addition to considering domestic branches, the

delegate could take into account other jurisdictional and enforcement

means, such as whether a foreign custodian has appointed an agent for

service of process in the United States or consented to U.S.

jurisdiction.91

\89\ Proposed rule 17f-5(a)(2)(iii).

\90\ See rule 17f-5, Note 2(c).

\91\ The Commission recognizes that U.S. jurisdiction may not be

obtainable over certain foreign depositories. As with the other

factors under the amended rule, an affirmative finding of U.S.

jurisdiction would not be required. Rather, the absence of U.S.

jurisdiction would have to be considered in making the overall

determination that using the custodian will provide reasonable

protection for fund assets.

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The Commission requests comment on the proposed approach and the

factors that delegates would be required to consider in selecting

foreign custodians.

4. Foreign Custody Contracts

a. Proposed Approach

Rule 17f-5 currently requires the fund's foreign custody

arrangements to be governed by a written contract that has been

approved by the board.92 The current rule also enumerates specific

provisions that must be included in the contract. The contract

generally must provide that: (A) The fund will be indemnified and its

assets insured in the event of loss; (B) the fund's assets will not be

subject to liens or other claims in favor of the foreign custodian or

its creditors; (C) the fund's assets will be freely transferable

without the payment of money; (D) records will be kept identifying the

fund's assets as belonging to the fund; (E) the fund's independent

public accountants will be given access to those records or

confirmation of the contents of those records; and (F) the fund will

receive periodic reports, including notification of any transfers to or

from the fund's account.93

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

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

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The amended rule would retain the requirement of a written foreign

custody contract, but would not enumerate specific provisions that must

be included in the contract.94 In proposing this approach, the

Commission does not intend to imply that the contract provisions

required under the current rule are not important. Rather, the

Commission believes that funds should be able to establish contractual

arrangements that reflect the particular circumstances presented.

Contract provisions other than those currently required may be

important in any given foreign market or for a specific foreign

custodian. In addition, certain practical problems and interpretive

questions have arisen regarding the current contract

requirements.95 As custody practices change, similar issues may

[[Page 39599]]

arise in the future that could delay or preclude certain arrangements.

\94\ Proposed rule 17f-5(a)(3).

\95\ See ``Request for Comment on Specific Contract Provisions''

below.

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The amended rule would require a finding that the foreign custody

contract will provide reasonable protection for the fund's assets based

on all factors relevant to the safekeeping of such assets. Determining

whether a contract provides such protection typically would involve

consideration of the contract provisions required under the current

rule as well as those customarily provided by U.S. custodians and other

foreign custodians operating in the country.96

\96\ The proposed approach would not require a finding that the

foreign custody contract provides protections equivalent to U.S.

safeguards or that the contract addresses every possible contingency

for loss of the fund's assets. Rather, the amended rule would focus

on whether the contract would provide reasonable protection for the

fund's assets.

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In addition, the Commission understands that funds often contract

with their primary custodians for foreign custody services; the primary

custodian, in turn, enters into separate contracts with the fund's

foreign bank custodians. When the fund's contractual relationship with

a foreign custodian is indirect, the delegate should consider the

fund's rights vis-a-vis both the contracting intermediary custodian and

the foreign custodian that holds the fund's assets. The delegate, for

example, should consider whether the intermediary custodian has agreed

in its contract with the fund to obtain indemnification or other

contractual protections from the foreign custodian. The delegate also

should consider, among other things, whether the fund would be able to

assert claims directly against the foreign custodian in the event of

loss.97

\97\ See, e.g., Citibank, N.A., Investment Company Act Release

Nos. 18710 (May 15, 1992), 57 FR 21835 (Notice of Application) and

18782 (June 12, 1992), 51 SEC Docket 1533 (Order) (contract between

the intermediary U.S. custodian and the foreign custodian gives the

fund the right to enforce the agreement directly against the foreign

custodian).

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The Commission also understands that depository arrangements

typically are not governed by contract.98 In addition, a foreign

depository's services often are not provided directly to the fund or

its primary custodian.99 Depository services typically are

provided through foreign banks that have an established relationship

with the depository.100 The amended rule, like the current rule,

would not require foreign depositories to be parties to the fund's

foreign custody contract.101 Instead, the delegate should consider

the responsibilities of the bank custodian interacting with the

depository, along with the rights of the fund in relation to both the

intermediary custodian and depository.

\98\ See Custodian Letter II, supra note 14, at 6-8. The ICI and

the Custodian Group recommended that any required contract

provisions should not apply to depositories. ICI Letter III, supra

note 14, at 3-5 (Exhibit A); Custodian Letter I, supra note 14, at

11-12. The ICI and the Custodian Group recommended requiring the

rules or established practices of a depository to provide specific

safeguards relating to the free transferability of the fund's

assets, the keeping of adequate records, and periodic reporting and

notification of asset transfers. ICI Letter III, supra note 14, at

3-5 (Exhibit A); Custodian Letter I, supra note 14, at 12.

\99\ See Custodian Letter I, supra note 14, at 11-12.

\100\ Id. (indicating that, from the fund's perspective, a

depository typically will be a custodian for a foreign bank

custodian, which is itself a subcustodian of the fund's U.S.

custodian). See also Custodian Letter II, supra note 14, at 6-8.

\101\ See Investment Company Institute 2-3 (pub. avail. Nov. 4,

1987) (hereinafter 1987 Division Letter).

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The Commission requests comment on the proposed approach. The

Commission requests specific comment whether the amended rule should

require specific contract provisions. In particular, would the proposed

approach facilitate the use of foreign custody arrangements or create

difficulties in obtaining important contractual protections from

foreign custodians? For example, codifying specific contract

requirements may offer certain advantages to fund shareholders by

removing these protections from the items that could be subject to

negotiation. The Commission also requests comment whether the amended

rule should include specific factors (such as those discussed above)

that delegates would have to consider in evaluating the protections

provided by a contract.102

\102\ Including specific factors does not appear to be necessary

since the Commission understands that foreign custody contracts

incorporating important contractual protections are a matter of

standard industry practice. See, e.g., Custodian Letter I, discussed

infra note 103.

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b. Request for Comment on Specific Contract Provisions

The ICI and the Custodian Group recommended retaining the rule's

current contract requirements, with certain modifications.103 The

Commission requests comment on the current provisions and the related

recommendations of the ICI and the Custodian Group. In addition, the

Custodian Group indicated that the rule's current contract requirements

have become industry standards for custodial arrangements involving

foreign banks.104 The Commission requests specific comment whether

this is the case.

\103\ ICI Letter I, supra note 14, at 5 (indicating that it is

appropriate for the rule to require certain essential contract

provisions); Custodian Letter I, supra note 14, at 11. The ICI and

the Custodian Group recommended that the contract requirements apply

only to foreign bank custodians. See supra note (regarding the ICI

and the Custodian Group's recommendations for depository

arrangements).

\104\ See Custodian Letter I, supra note 14, at 11

The ICI and the Custodian Group recommended modifying the current

requirement prohibiting liens on the fund's assets.105 The ICI and

the Custodian Group indicated that this requirement should not apply to

cash, since, in most jurisdictions, cash may become subject to

creditors' claims if a custodian becomes bankrupt.106

\105\ ICI Letter III, supra note 14, at 12; Custodian Letter I,

supra note 14, at 21-22. See rule 17f-5(a)(1)(iii)(B).

\106\ ICI Letter III, supra note 14, at 12; Custodian Letter I,

supra note 14, at 21-22.

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The ICI and the Custodian Group also recommended modifying the

current recordkeeping requirement to specifically recognize the

permissibility of ``omnibus accounts.'' 107 These accounts contain

the assets of more than one custodial customer, and are established by

intermediary custodians with foreign banks and securities

depositories.108 In an omnibus account structure, the

intermediary, which is reflected on the foreign custodian's books as

the record owner of the assets, is responsible for maintaining records

that identify each of its customer's assets.109

\107\ ICI Letter III, supra note 14, at 3-4 (Exhibit A);

Custodian Letter I, supra note 14, at 22-23. See rule 17f-

5(a)(1)(iii)(D).

\108\ Custodian Letter I, supra note 14, at 22-23. The ICI and

the Custodian Group also recommended specifically recognizing the

role of U.S. intermediary custodians in connection with the current

provisions relating to indemnification and insurance, access to the

foreign custodian's books, and periodic reporting. ICI Letter III,

supra note , at 3-4 (Exhibit A); Custodian Letter III, supra note

14, at 5-6 (Exhibit A). This approach may help clarify the rule's

requirements, although it does not appear to be necessary.

\109\ Although the recommended change may help clarify the

rule's requirements, it is not necessary. The current rule does not

prescribe a specific manner for keeping custody records. See also

State Street Bank and Trust Company (pub. avail. Feb. 28, 1995)

(regarding the permissibility of omnibus accounts).

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The ICI and the Custodian Group disagreed on how the rule should

address indemnification and insurance.110 The ICI recommended

[[Page 39600]]

that, instead of requiring indemnification or insurance as a contract

provision, the rule require the fund's U.S. custodian (acting as the

delegate responsible for the foreign custody contract) to represent

that the fund's overall contractual arrangements provide

indemnification or insurance protections.111 The ICI indicated

that, under its approach, indemnification or insurance protections

could appear either in the fund's contract with its U.S. custodian or

in the contract between the U.S. custodian and the foreign

custodian.112 The Custodian Group objected to the ICI's approach,

arguing that it would make custodian delegates responsible for

indemnifying or insuring depository arrangements.113

\110\ By its terms, rule 17f-5 requires foreign custody

contracts to provide that the fund will be indemnified and its

assets insured in the event of loss. Rule 17f-5(a)(1)(iii)(A).

Consistent with a prior Division no-action position, the ICI and the

Custodian Group recommended requiring either indemnification or

insurance. ICI Letter III, supra note 14, at 5 (Exhibit A);

Custodian Letter III, supra note 14, at 4 (Exhibit B). See also 1987

Division Letter, supra note 101, at 2-3. The ICI and the Custodian

Group also recommended requiring fund assets to be protected for

losses resulting from a foreign custodian's failure to use

reasonable care. ICI Letter III, supra note 14, at 5 (Exhibit A);

Custodian Letter III, supra note 14, at 4 (Exhibit B). See 1987

Division Letter, supra note 14, at 2-3 (indicating that the rule

requires indemnification or insurance to cover foreseeable risks of

loss).

\111\ ICI Letter I, supra note 14, at 5 (noting that

indemnification provisions often are included in the fund's contract

with its U.S. custodian); ICI Letter III, supra note 14, at 12 and

at 4 (Exhibit A).

\112\ ICI Letter III, supra note 14, at 12. This approach

currently is permitted under rule 17f-5, which does not specify the

party that must provide indemnification and insurance protections.

See rule 17f-5(a)(1)(iii)(A).

\113\ Custodian Letter III, supra note 14, at 4. The Custodian

Group would not require indemnification or insurance with respect to

depository arrangements. Id. See also Custodian Letter II, supra

note 14, at 6-7 (indicating that depositories often establish

compensation funds for losses attributable to the depository).

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5. Monitoring Custody Arrangements and Withdrawing Assets From

Custodians

The amended rule would require the delegate to monitor the

continuing appropriateness of the custody of the fund's assets in a

country, with a particular custodian, and under the foreign custody

contract.114 This requirement seeks to address the possibility

that the fund's arrangements, although consistent with the amended

rule's requirements when initially entered into, may later fail to

provide reasonable protection for fund assets.115 The proposed

monitoring requirement would involve establishing a means of receiving

sufficient and timely information to respond to material

changes.116 Determining appropriate monitoring procedures would

depend on the facts and circumstances involved. For example, custodial

practices in certain countries or used by certain custodians may

require frequent monitoring, while other arrangements require

significantly less oversight.117

\114\ Proposed rule 17f-5(a)(4). See rule 17f-5(a)(2) (requiring

a system to monitor the fund's arrangements to ensure compliance

with the conditions of the rule).

\115\ The amended rule seeks to clarify the scope of the

monitoring requirement by tying monitoring obligations to the

reasonable protection findings required to be made in establishing

foreign custody arrangements. See ICI Letter III, supra note 14, at

6 (Exhibit A); Custodian Letter I, supra note 14, at 17

(recommending that monitoring responsibilities relate to specific

representations that would have to be made when custody arrangements

are entered into).

\116\ See 1984 Reproposing Release, supra note 8, at 2910

(consistent with the proposed approach). See also 1987 Division

Letter, supra note 101, at 4 n.5 (indicating that, under the current

rule, the board generally may rely on the fund's U.S. custodian or

another third-party expert to oversee the fund's arrangements so

long as the expert agrees to notify the board of any material

changes, and that the board is not required to review periodic

reports in the absence of a material change).

\117\ The ICI and the Custodian Group recommended allowing

delegates to satisfy their monitoring obligations by periodically,

but no less frequently than annually, reviewing a foreign

custodian's financial position and internal controls. ICI Letter

III, supra note 14, at 6 (Exhibit A); Custodian Letter I, supra note

14, at 17 (also indicating that, in a formal sense, the board or a

custodian delegate could not be expected to monitor continuously a

foreign custodian's financial position and internal controls).

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If an arrangement no longer meets the requirements of the amended

rule, the fund would have to withdraw its assets from the country or

custodian as soon as reasonably practicable. The current rule requires

a fund in these circumstances to withdraw its assets from a foreign

custodian as soon as reasonably practical, but specifies that, in any

event, assets withdrawals must be made within 180 days.118 The

amended rule would eliminate the 180 day provision and focus instead on

the importance of taking prompt action based on the circumstances

presented. For example, a fund that invests its assets primarily in a

single country may require more time to withdraw those assets than a

fund that has placed only a small percentage of its assets with a

particular custodian or in a particular country.

\118\ Rule 17f-5(a)(4). See generally 1985 Release Proposing

Amendments, supra note 8, at 24541 (proposing a 90-day grace

period); 1985 Release Adopting Amendments, supra note 8, at 37655

(adopting a 180-day grace period to provide sufficient time for

funds to negotiate alternative arrangements).

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The Commission requests comment on the proposed monitoring

requirement. The Commission requests specific comment whether the

amended rule should require asset withdrawals to be effected within a

specific time period.119 Commenters favoring this approach should

indicate what the time period should be and whether a period of less

than 180 days (e.g., 90 days) would be appropriate. The Commission also

requests comment whether, as an alternative or in addition to providing

a specific grace period, the rule should require the use of interim

arrangements, such as insurance or third-party indemnification

agreements, to protect against possible loss of fund assets until

alternative arrangements can be made.

\119\ See ICI Letter III, supra note 14, at 6 (Exhibit A);

Custodian Letter I, supra note 14, at 8 (Exhibit A) (incorporating

the 180-day grace period of the current rule).

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C. Eligible Foreign Custodians

1. Banks and Trust Companies

a. Proposed Approach

The amended rule would define an ``eligible foreign custodian'' as

foreign banks and trust companies that are subject to foreign bank or

trust company regulation.120 An eligible foreign custodian also

would include majority-owned foreign subsidiaries of a qualified U.S.

bank or a U.S. bank holding company.121 The amended rule would not

subject foreign bank and trust custodians to specific capital

requirements.122 The amended rule, however, would prohibit foreign

bank and trust custodians from being affiliated persons of the fund or

affiliated persons of such persons.123

\120\ Proposed rule 17f-5(d)(3)(i).

\121\ A ``qualified U.S. bank'' would be defined in proposed

rule 17f-5(d)(5). Under current rule 17f-5, the definition of a

qualified U.S. bank mirrors the definition of ``bank'' in section

2(a)(5), except that it requires certain banks and trust companies

that receive deposits or exercise fiduciary powers and that are

subject to state or federal regulation to be organized under state

or federal law. See 15 U.S.C. 2(a)(5)(C) and rule 17f-5(c)(3)(iii).

Proposed rule 17f-5(d)(5) would not change this definition.

\122\ The Commission previously considered using this approach.

See 1982 Proposing Release, supra note 3, at 16347.

\123\ See section 2(a)(3), 15 U.S.C. 80a-2(a)(3) (defining

affiliated person).

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Rule 17f-5 currently limits the class of eligible fund custodians

to foreign banks and trust companies that have more than $200 million

in shareholders' equity and majority-owned foreign subsidiaries of

qualified U.S. banks or bank-holding companies that have more than $100

million in shareholders' equity.124 Although this approach seeks

to protect against the risk of loss from a custodian's

insolvency,125 the shareholders' equity requirement has become an

inflexible standard that does not address matters, such as credit and

market risks, that may affect an institution's financial

health.126

[[Page 39601]]

Shareholders' equity also does not provide a uniform assessment of

financial strength, since it may be calculated differently depending

both on the country where the institution is organized and the

institution's accounting practices.127

\124\ Rule 17f-5(c)(2) (i) and (ii).

\125\ See John Downes & Jordan Elliot Goodman, Dictionary of

Finance and Investment Terms 377 (2d ed. 1987) (defining

shareholders' equity as total assets minus total liabilities of a

corporation). Cf. 1984 Reproposing Release, supra note 8, at 2907

(indicating that the rule's capital requirements seek to address

disparities in the protections provided by various foreign

regulatory systems).

\126\ The shareholders' equity requirement has been the subject

of several no-action letters and a number of exemptive orders. See

infra notes 128, 142, and 144 and accompanying text.

\127\ The Commission previously sought to address this problem

by proposing that shareholders' equity be calculated according to

generally accepted accounting principles. 1985 Release Proposing

Amendments, supra note 8. The Commission decided to postpone final

action on this proposal due to concerns that compliance costs would

be excessive. 1985 Release Adopting Amendments, supra note 8.

In addition, the shareholders' equity requirement may limit

unnecessarily the class of eligible foreign custodians. Certain highly

capitalized custodians, such as national banks that maintain

substantial government-funded reserves to satisfy their liabilities, do

not have shareholders' equity.128 In addition, in certain emerging

and smaller markets, very few or no foreign custodians have sufficient

shareholders' equity to meet the $100 million and $200 million

standards.129

\128\ See 1984 Adopting Release, supra note 8, at 36082.

Custodians organized as private banks also may not have

shareholders' equity. No-action letters, however, have found the

capital of certain private banks to be the equivalent of

shareholders' equity. See Pictet & Cie (pub. avail. Sept. 8, 1993)

(private bank with partners' equity); Union Bank of Norway (pub.

avail. Nov. 30, 1992) (private bank found to have the equivalent of

paid-in capital and retained earnings).

\129\ See Custodian Letter I, supra note 14, at 18-19.

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In proposing to eliminate specific capital requirements, the

Commission does not intend to imply that a custodian's financial

strength is not important to the custodian's ability to serve a

fund.130 The amended rule would require the board's delegate to

determine that foreign custodians will provide reasonable protection

for the fund's assets based on, among other things, a custodian's

financial strength.131 This approach should sufficiently address

the adequacy of a custodian's capital, without imposing specific

capital requirements.

\130\ See generally Sub-custodian Services Survey, Euromoney

116 (Jan. 1994) (indicating that U.S. custodians view capitalization

and credit rating as the most significant considerations in

selecting foreign custodians).

\131\ See ``Delegation of Board Responsibilities--Selecting

Foreign Custodians'' above.

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The Commission requests comment on the proposed approach. The

Commission requests specific comment whether the current shareholders'

equity requirement should be retained, with higher or lower

standards.132 For example, the ICI and the Custodian Group

recommended lowering the current $100 million and $200 million

standards to expand the class of eligible foreign custodians in

emerging and smaller markets.133 In particular, they recommended

that a custodian with more than $25 million in shareholders' equity

should be eligible to hold fund assets, if it is one of the five

largest banks in the country.134 The Custodian Group indicated

that this approach should not present significant risks, given the

limited amount of assets likely to be maintained in smaller markets and

the other protections of the rule.135

\132\ See ICI Letter II, supra note 14, at 3 (suggesting that

the Commission consider whether the current standards are

unnecessarily high); Custodian Letter I, supra note 14, at 18

(indicating that the shareholders' equity requirement ``has served

the Custodian community well in major, established markets'').

\133\ ICI Letter III, supra note 14, at 7 (Exhibit A); Custodian

Letter I, supra note 14, at 18-19. See also ``Other Alternatives

Considered'' below (regarding the ICI's and the Custodian Group's

other recommendations).

\134\ ICI Letter III, supra note 14, at 7 (Exhibit A); Custodian

Letter I, supra note 14, at 18-19. See also 1984 Adopting Release,

supra note 8, at 36082 (rejecting the use of foreign bank custodians

that constitute one of the five largest banks in a country when no

bank in that country meets the shareholders' equity requirement).

\135\ Custodian Letter I, supra note 14, at n.12. The Custodian

Group also noted that smaller banks would not become eligible

custodians in larger markets, since they would not be one of the

five largest banks in the country. Id. at 19.

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The Commission also requests comment whether any additional

entities, such as foreign broker-dealers, should be permitted to serve

as custodians.136 Commenters addressing this issue should consider

the circumstances under which additional types of entities should be

permitted to hold fund assets. For example, should these entities be

subject to capital or other special requirements? 137

\136\ When a foreign entity acts as both a bank and broker-

dealer, it would meet the definition of an eligible foreign

custodian if the division or part of the entity that has custody of

fund assets is regulated under foreign law as a banking institution.

See generally 1984 Reproposing Release, supra note 8, at 2907-08

(not allowing foreign broker-dealers to serve as custodians since

funds had not expressed an interest in these arrangements). See also

Canada Trustco Mortgage Company (pub. avail. Dec. 29, 1989) (loan

company with wholly-owned trust subsidiary deemed to be an eligible

foreign custodian).

\137\ Broker-dealers, for example, could be required to be

subject to foreign regulatory requirements relating to their

financial responsibility and the segregation and handling of

customer securities. See, e.g., rule 206(4)-2(b) under the

Investment Advisers Act of 1940, 17 CFR 275.206(4)-2(b). See also

rule 17f-1 under the Act.

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Finally, the Commission requests comment on prohibiting affiliated

foreign custody arrangements. Custody by fund affiliates raises special

investor protection concerns. To guard against potential abuses

resulting from control over fund assets by related persons, rule 17f-2

under the Act, the Commission rule applicable to funds that retain

custody of their own assets, has been applied to affiliated custody

arrangements.138

\138\ See, e.g., Pegasus Income and Capital Fund, Inc. (pub.

avail. Dec. 1, 1977) (custody by U.S. adviser-bank). Rule 17f-2

appears to be unworkable in the foreign custody context because the

rule requires, among other things, fund assets to be maintained in a

bank that is subject to state or federal regulation; the fund's

assets also must be subject to Commission inspection and verified by

an independent public accountant. Rule 17f-2(b), (d), and (e). See

1984 Reproposing Release, supra note 8, at 2907-08.

The Division currently is reviewing rule 17f-2, and may

recommend in the future that the Commission propose certain changes

in the rule's requirements.

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The Commission is aware of only one existing affiliated foreign

custody arrangement, and believes that other such arrangements may be

best addressed on a case-by-case basis.139 The Commission

recognizes, however, that affiliated arrangements may become more

prevalent as global investing and custodian networks continue to grow

and as the fund industry continues to consolidate.140 The

Commission, therefore, requests comment whether the proposed

prohibition would be unduly restrictive and whether the prohibition

should apply only to certain affiliated arrangements, such as when

there is a control relationship between the fund's adviser and a

foreign custodian.141 The Commission also requests comment whether

there are alternative safeguards that would address the investor

protection concerns raised by these arrangements. For example, should

fund boards establish and oversee affiliated arrangements without the

discretion to delegate this responsibility?

\139\ Dean Witter World Wide Investment Trust (pub. avail. Mar.

14, 1988) (affiliation between the fund's sub-adviser and primary

custodian deemed sufficiently remote so as not to require the

protections of rule 17f-2).

\140\ See John Waggoner, Urge to Merge Hits Mutual Funds, USA

Today, Feb. 8, 1995, at 1B. See also Timothy L. O'Brien and Steven

Lipin, In the Latest Round of Banking Mergers, Even Big Institutions

Become Targets, Wall St. J., July 14, 1995, at A3.

\141\ See section 2(a)(3)(C) of the Act.

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b. Other Alternatives Considered

The Commission considered several other approaches to defining an

eligible foreign custodian. These alternatives could be used in lieu of

the current shareholders' equity requirement or in conjunction with

reduced capital standards. The Commission requests comment on each

approach.

The Commission considered using an approach that would focus on a

bank or trust company's safekeeping abilities.142

[[Page 39602]]

Under this approach, a bank or trust company would be an eligible

foreign custodian if it had maintained custody of a substantial amount

of assets (e.g., $500 million) over a specified period of time (e.g.,

the past five years) and had not incurred any material loss of

custodial assets during that period. Commenters addressing this

alternative should discuss the criteria that should be used to

establish a custodian's safekeeping abilities and the feasibility of

monitoring compliance with such criteria.143

\142\ See Permanent Trustee Company Limited, Investment Company

Act Release Nos. 17833 (Oct. 31, 1990), 55 FR 46749 (Notice of

Application) and 17888 (Nov. 30, 1990), 47 SEC Docket 1627 (Order)

(granting exemptive relief from the shareholders' equity requirement

based on the applicant's established record as a custodian and

certain other factors).

\143\ In some foreign countries, for example, the amount of

assets in a custodian's safekeeping may be considered proprietary

information that would not be available to delegates.

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The ICI and the Custodian Group recommended using an approach based

on prior exemptive orders.144 Under this alternative, a foreign

bank or trust company would not have to satisfy a shareholders' equity

requirement if (i) the bank or trust company is a subsidiary of the

fund's primary custodian; (ii) the primary custodian meets certain

capital requirements; and (iii) the primary custodian assumes financial

responsibility for the bank or trust custodian's use.145 The

Commission requests commenters addressing this alternative to consider

the appropriateness of allowing U.S. and foreign banks to serve as both

assurance-providers and delegates for foreign custodian

selection.146 The Commission also requests commenters to consider

whether assurance arrangements should be limited to parent custodians

and their foreign subsidiaries.147

\144\ See, e.g., Chase Manhattan Bank, Investment Company Act

Release Nos. 18025 (Mar. 4, 1991), 56 FR 10451 (Notice of

Application) and 18077 (Apr. 2, 1991), 48 SEC Docket 864 (Order).

\145\ ICI Letter III, supra note 14, at 8-10 (Exhibit A);

Custodian Letter I, supra note 14, at 20 and at 10-12 (Exhibit A)

(the primary custodian would have to be either a U.S. bank with more

than $100 million in shareholders' equity or a foreign bank or trust

company with more than $200 million in shareholder's equity; in

addition, the primary custodian would have to assume responsibility

for any loss arising from the arrangement (including losses

attributable to the foreign custodian's bankruptcy or insolvency) to

the same extent as if the primary custodian had itself performed the

custody services). See also supra note 24.

\146\ For example, banks serving as both assurance-provider and

the board's delegate may be inclined to disregard custodial problems

in hopes of delaying or avoiding their indemnification

responsibilities. On the other hand, banks serving in both

capacities may be more vigilant in establishing and overseeing

foreign custody arrangements, since they would be liable for losses

associated with the foreign custodian's use.

\147\ See State Street Bank and Trust Company, Investment

Company Act Release Nos. 20519 (Aug. 31, 1994), 59 FR 46463 (Notice

of Application) and 20583 (Sept. 27, 1994), 57 SEC Docket 2091

(Order) (custodian providing assurances was not the foreign

custodian's parent). See also Bank van Haften Labouchere N.V.,

Investment Company Act Release Nos. 19073 (Nov. 2, 1992), 57 FR

53531 (Notice of Application) and 19135 (Dec. 1, 1992), 52 SEC

Docket 2892 (Order) (assurances provided by a foreign company that

was not an eligible foreign custodian since it was primarily engaged

in the insurance business).

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In addition, the ICI recommended that the Commission consider using

an investment grade rating from a nationally recognized statistical

rating agency as a means of determining a foreign bank's eligibility to

serve as a fund custodian.148 The ICI also recommended that the

Commission consider using international capital standards, such as

those approved by the Basle Committee on Banking Regulations and

Supervisory Practices (the ``Basle Accord'').149

\148\ ICI Letter II, supra 14, at 3. See also Nationally

Recognized Statistical Rating Organizations, Securities Act Release

No. 7085 (Aug. 31, 1994), 59 FR 46314 (requesting comment on the

role of ratings generally in the federal securities laws).

\149\ ICI Letter II, supra 14, at 3. In general, the Basle

Accord seeks to establish minimum standards of capital adequacy for

internationally active banks through a ratio that measures an

institution's capital in relation to credit risk. See Basle

Committee on Banking Regulations and Supervisory Practices,

International Convergence of Capital Measurement and Capital

Standards, Fed. Banking L. Rep. (CCH) para. 5403 at 3309 (amended

Nov. 6, 1991).

2. Non-Compulsory Depositories and Transnational Systems \150\

\150\ See also ``Custody in Foreign Countries--Compulsory

Depositories'' above.

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Under the amended rule, an eligible foreign custodian would include

a securities depository or clearing agency that operates a system for

the central handling of securities or equivalent book-entries that is

regulated by a ``foreign financial regulatory authority,'' which would

include a foreign government, an agency thereof, or a foreign self-

regulatory organization.151 An eligible foreign custodian also

would include a depository or clearing agency that operates a

transnational system for the central handling of securities or

equivalent book-entries.152

\151\ Proposed rule 17f-5(d)(3)(ii) (using the definition of

foreign financial regulatory authority in section 3(a)(52) of the

Securities Act of 1934 [15 U.S.C. 78c(a)(52)). See 1984 Reproposing

Release, supra note 8, at 2908 n.31 (noting that securities

depositories may be denominated clearing agencies in some

countries).

\152\ Proposed rule 17f-5(d)(3)(iii). See rule 17f-5(c)(iv)

(consistent with the proposed approach).

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Rule 17f-5 currently requires depositories and clearing agencies

that are not transnational systems to operate the only system for the

handling of securities in a country.153 This requirement seeks to

ensure a country's interest in establishing and maintaining a

depository's integrity.154 The Commission believes, however, that

the current provision, which has been the subject of a number of no-

action positions, is overly restrictive.155 With the increased

immobilization and dematerialization of securities, the Commission

believes that rule 17f-5 should not constrain the use of depository

arrangements.156

\153\ Rule 17f-5(c)(2)(iii).

\154\ See 1984 Reproposing Release, supra note 8, at 2908.

\155\ See, e.g., 1987 Division Letter, supra note 101, at 3

(taking a no-action position with respect to certain groups of

depositories that are integrated and effectively function as one

system within a country); Custody of B Shares Trading on the

Shenzhen and Shanghai Securities Exchanges (pub. avail. Apr. 26,

1993) (no-action position with respect to depositories that operate

the central system for a particular issue and class of securities).

See generally Templeton Russia Fund, supra note 60 (addressing the

unique custodial and settlement arrangements in Russia). See also

ICI Letter III, supra note 14, at 10 (Exhibit A); Custodian Letter

I, supra note 14, at 21 and at 12-13 (Exhibit A) (recommending

expanding the class of eligible foreign depositories by codifying

prior no-action positions).

\156\ Securities are immobilized by storing stock certificates

or other indicia of securities ownership with the depository.

Securities are dematerialized by dispensing with physical evidence

of securities ownership. Group of Thirty Report, supra note 20, at

55-56. See also Custodian Letter I, supra note 14, at 14 (indicating

that depositories generally are subject to strict government

regulation and provide a high level of safety for fund assets).

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The amended rule would address a country's interest in a depository

by requiring the depository to be subject to foreign regulation by the

government, an agency thereof, or a self-regulatory organization. The

amended rule also would require, among other things, consideration of

the depository's operating history and number of participants and

whether the depository will provide reasonable protection for the

fund's assets.157 This approach should sufficiently address a

depository's custodial integrity, while giving funds the flexibility to

use a depository that may not operate an exclusive book-entry system.

\157\ See ``Delegation of Board Responsibilities--Selecting

Foreign Custodians'' above.

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The Commission requests comment on the proposed approach. The

Commission requests specific comment on requiring regulatory oversight

of depository arrangements and on permitting such oversight to be

conducted by self-regulatory organizations.158 The Commission also

[[Page 39603]]

requests comment whether transnational depositories should be required

to be subject to similar or other requirements.159

\158\ See 1984 Reproposing Release, supra note 8, at 2908 (not

requiring depositories to be regulated by foreign governments or

agencies thereof since several principal depositories would not meet

the requirement).

\159\ The Commission understands that there are very few

transnational systems, and is not aware of any problems associated

with the current transnational provision.

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D. Assets Maintained in Foreign Custody

Rule 17f-5 permits funds to use foreign custody arrangements for

their foreign securities, cash, and cash equivalents.160 Rule 17f-

5 defines foreign securities to include those that are issued and sold

primarily outside the United States by foreign and U.S.

issuers.161 By restricting the types of securities that may be

maintained outside the United States, the rule seeks to establish a

nexus between its scope and its purpose, i.e., to give funds the

flexibility to keep abroad assets that are purchased or intended to be

sold abroad.162 In addition, rule 17f-5 limits the cash and cash

equivalents that funds may maintain outside the United States to

amounts that are reasonably necessary to effect the fund's foreign

securities transactions.163

\160\ Rule 17f-5(a).

\161\ Rule 17f-5(c)(1).

\162\ See 1984 Reproposing Release, supra note 8, at 2907.

\163\ Rule 17f-5(a).

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The amended rule would not change these restrictions, although it

would simplify the definition of foreign securities by eliminating

references to specific types of issuers.164 The Commission

requests comment whether any other changes should be made. In

particular, should the amended rule continue to restrict the types of

securities and amounts of cash and cash equivalents that may be

maintained outside the United States?

\164\ Proposed rule 17f-5(a) and (d)(2).

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E. Canadian and Other Foreign Funds

Rule 17f-5 contains special provisions governing the foreign

custody arrangements of registered Canadian funds.165 To address

jurisdictional concerns, these provisions are more restrictive than

those applied to U.S. funds.166 Rule 17f-5 allows Canadian funds

to maintain their assets only in overseas branches of qualified U.S.

banks.167 The rule also places responsibility for the fund's

foreign custody arrangements on the fund's board of directors.168

\165\ See rule 17f-5(b). Section 7(d) of the Act prohibits

foreign investment companies from publicly offering their securities

in the United States unless the Commission issues an order

permitting registration under the Act. 15 U.S.C. 80a-7(d). Rule 7d-1

sets forth conditions governing applications by Canadian funds that

seek Commission orders pursuant to section 7(d). 17 CFR 270.7d-1.

Among other conditions, rule 7d-1 provides that the assets of

Canadian funds are to be held in the United States by a U.S. bank,

except as provided under rule 17f-5. Rule 7d-1(b)(8)(v). Although

rule 7d-1 by its terms only applies to Canadian funds, funds

organized in other jurisdictions generally have agreed to comply

with its conditions as a prerequisite to receiving a section 7(d)

order. Protecting Investors report, supra note 15, at 193 n.23.

\166\ See 1984 Reproposing Release, supra note 8, at 2906-07;

1984 Adopting Release, supra note 8, at 36082.

\167\ See 1984 Adopting Release, supra note 8, at 36082

(indicating that, by restricting custody to overseas branches of

U.S. banks, Canadian funds may not maintain their assets with

Canadian branches of U.S. banks).

\168\ See rule 17f-5(b)(1)-(3).

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Canadian investment companies have not sought to register under the

Act for some time, and very few Canadian funds currently offer their

shares in the United States.169 Accordingly, the amended rule

would make limited changes in the foreign custody requirements

applicable to Canadian funds. The amended rule would revise the current

``best interest'' standard for placing fund assets in a particular

country and require instead a finding that such custody will provide

reasonable protection for the fund's assets.170 In addition, the

amended rule would eliminate the current requirement that the board of

a Canadian fund review and approve foreign custody arrangements at

least annually. Under the amended rule, the board instead would be

required to monitor the continuing appropriateness of the fund's

arrangements.171 If an arrangement no longer meets the rule's

requirements, the fund would be required to withdraw its assets from

the country or custodian as soon as reasonably practicable.172

\169\ Protecting Investors report, supra note 15, 193 n.23

(noting that, in 1992, only three Canadian funds were active).

\170\ See ``Standard for Evaluating Foreign Custody

Arrangements'' above.

\171\ Proposed rule 17f-5(c)(2).

\172\ Proposed rule 17f-5(c)(3). See ``Delegation of Board

Responsibilities--Monitoring Custody Arrangements and Withdrawing

Assets from Custodians'' above.

The Commission requests comment on the proposed approach. The

Commission requests specific comment whether the special provisions

applicable to Canadian funds should be eliminated. Under this approach,

a Canadian fund's foreign custody arrangements could be considered in

connection with the fund's registration under the Act. In evaluating

proposed arrangements, the Commission would be able to consider any

jurisdictional concerns and the requirements of rule 17f-5 applicable

to U.S. funds in effect at that time.

Alternatively, should the amended rule allow Canadian funds to use

foreign custody arrangements on the same basis as their U.S.

counterparts? 173 Commenters favoring this alternative should

consider whether any special requirements should be imposed to address

jurisdictional concerns. For example, should Canadian funds be required

to consent to U.S. jurisdiction or should limits be placed on the

amount of a Canadian fund's assets that could be maintained outside the

United States? 174

\173\ The ICI and the Custodian Group recommended this approach.

ICI Letter I, supra note 14, at 4 (also recommending that the

foreign custody arrangements of any non-Canadian foreign funds

continue to be evaluated on a case-by-case basis); Custodian Letter

I, supra note 14, at 1 (Exhibit A).

\174\ In 1991, a South African fund was allowed to rely on rule

17f-5 as if it were a U.S. fund. ASA Limited, Investment Company

Release Nos. 17904 (Dec. 17, 1990) 55 FR 52925 (Notice of

Application), and 17945 (Jan. 15, 1991), 47 SEC Docket 1535 (Order).

Although the fund's custody arrangements were not restricted to

foreign branches of U.S. banks, limits were placed on the amount of

the fund's assets that could be held overseas. Id.

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F. Disclosure of Custody Risks

The Notes to rule 17f-5 currently instruct the fund's board to

consider disclosing in the fund's prospectus material risks, if any,

associated with the fund's foreign custody arrangements.175 The

amended rule would not address disclosure issues. The Commission

believes that these issues are more appropriately addressed by

individual funds in considering their disclosure obligations under the

Securities Act of 1933.176

\175\ Rule 17f-5, Note 3.

\176\ See, e.g., Forms N-1A, 17 CFR 239.15A (the registration

form for open-end funds) and N-2, 17 CFR 274.11a-1 (the registration

form for closed-end funds). Item 4(c) of Form N-1A and item 8.3.a of

Form N-2 require disclosure in the prospectus of the principal risk

factors associated with investing in the fund. Item 13(c) of Form N-

1A and item 17.3 of Form N-2 require disclosure in the Statement of

Additional Information (``SAI'') of the risks inherent in certain

significant investment policies, such as investing in foreign

securities. Guide 9 to Form N-2 instructs funds with more than 10%

of their assets in foreign securities to discuss in the SAI the

fund's foreign custody arrangements. See generally Templeton Russia

Fund, supra note 60 (apprising fund investors of certain custodial

risks in Russia).

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G. Unit Investment Trusts

Under the Act, unit investment trusts (``UITs'') are required to

maintain their assets in the custody of U.S. banks or their foreign

branches.177 UITs generally are not permitted to use the foreign

[[Page 39604]]

custodians available to funds under rule 17f-5.178 The foreign

custody arrangements of UITs may raise special concerns, since UITs do

not have boards of directors to oversee the arrangements.179

\177\ A UIT is a type of fund that issues redeemable securities

representing an undivided interest in a portfolio of specified

securities. 15 U.S.C. 80a-4(2). See Investment Company Act

Secs. 2(a)(5) (defining bank) and 26(a)(1) (requiring UIT custodians

to have at least $500,000 in capital, surplus and undivided

profits).

\178\ Several exemptive orders permit UITs to maintain their

assets in certain foreign transnational securities depositories.

See, e.g., Merrill Lynch, Pierce, Fenner & Smith, Investment Company

Act Release Nos. 15739 (May 14, 1987), 52 FR 19006 (Notice), and

15813 (June 16, 1987), 38 SEC Docket 891 (Order).

\179\ UITs do not have corporate-type management structures.

Typically, UITs are created by a sponsor or ``depositor'' that

accumulates a portfolio of securities and deposits them with a U.S.

bank or ``trustee'' under the terms of a trust indenture. A UIT's

portfolio generally is unmanaged; thus, UITs do not have investment

advisers. A UIT's operations are subject to the terms of the trust

indenture, which specifies the ongoing responsibilities of the

trustee, the depositor and other third-party service providers. See

generally Form N-7 for Registration of UITs Under the Securities Act

of 1933 and Investment Company Act of 1940, Securities Act Release

No. 33-6580 (May 14, 1985), 50 FR 21282.

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The Commission requests comment on the appropriateness of a rule

that would expand the foreign custody arrangements available to

UITs.180 The Commission requests specific comment on allowing UIT

sponsors, custodian banks or other parties to establish and monitor

foreign custody arrangements, without independent oversight. The

Commission also requests comment whether special protections should

attend UIT foreign custody arrangements by, for example, requiring the

sponsor, custodian bank, or other party to assume financial

responsibility for a foreign custodian's use.181 Finally, the

Commission requests comment whether foreign custody arrangements and

the procedures for changing those arrangements should be required to be

set forth in UIT trust indentures.

\180\ See Letter of Pierre de Saint Phalle, Davis Polk &

Wardwell, to Diane C. Blizzard, Assistant Director, SEC (Mar. 14,

1995) (recommending a rule for UIT foreign custody arrangements)

(File No. S7-23-95). In addition, certain UITs have sought exemptive

relief to use foreign custody arrangements available to management

funds. See United States Trust Company of New York (filed July 28,

1992); Merrill Lynch, Pierce, Fenner & Smith, Inc. (filed Oct. 27,

1993) (both seeking exemptive relief from section 26(a)(2)(D) of the

Act).

\181\ Such financial assurances, for example, could cover the

loss of UIT assets attributable to the foreign custodian's failure

to exercise reasonable care or bankruptcy or insolvency.

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IV. Cost/Benefit Analysis

The amendments would substantially reduce burdens on fund directors

and provide funds with greater flexibility to establish and use foreign

custody arrangements, consistent with the protection of fund assets. To

facilitate evaluations of foreign custody arrangements, the amendments

would revise the findings that currently must be made in establishing

these arrangements. The amended rule would require findings that

foreign custody arrangements will provide reasonable protection for

fund assets.

In addition, the amendments would allow fund boards to play a role

more consistent with their traditional oversight role in connection

with foreign custody arrangements, by permitting boards to delegate

their responsibility under the rule to evaluate foreign custody

matters. The amendments also would eliminate the current requirement

that boards annually approve foreign custody arrangements.

The proposed delegation provisions may impose certain additional

costs since delegates would be required to provide fund boards with

written reports regarding certain aspects of the arrangements. These

costs, however, are not expected to be significant, and are likely to

be much less than the costs associated with providing fund boards with

information pertaining to their annual review of foreign custody

arrangements. In addition, because the reports would facilitate a

board's oversight of the delegate's performance, any additional costs

associated with the reports would be outweighed by the benefits

provided to funds and their shareholders.

The amendments also would expand the class of foreign banks and

securities depositories that could serve as fund custodians. Under the

amendments, foreign custodians would no longer have to satisfy specific

capital standards or other objective requirements. The amended rule

instead would require delegates to select foreign custodians based on

the custodian's ability to provide reasonable protection for fund

assets. While addressing safekeeping considerations, this approach

avoids imposing inflexible standards that may unnecessarily limit the

use of foreign custodians. In addition, instead of requiring foreign

custody contracts to contain specific provisions (as under the current

rule), the amendments would require these contracts to reasonably

protect fund assets.

V. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis in accordance with 5 U.S.C. 603 regarding amendments to rule

17f-5. The analysis notes that the amendments are designed to provide

funds with greater flexibility in establishing and using foreign

custody arrangements, consistent with the protection of their assets.

Cost-benefit information reflected in the ``Cost/Benefit Analysis''

section of this Release also is reflected in the analysis. A copy of

the Initial Regulatory Flexibility Analysis may be obtained by

contacting Elizabeth R. Krentzman, Securities and Exchange Commission,

450 Fifth Street, NW., Mail Stop 10-6, Washington, DC 20549.

VI. Statutory Authority

The Commission is proposing to amend rule 17f-5 pursuant to the

authority set forth in sections 6(c) and 38(a) of the Investment

Company Act of 1940 [15 U.S.C. 6(c), 37(a)].

Text of Proposed Rule Amendments

List of subjects in 17 CFR Part 270

Investment companies, Reporting and recordkeeping requirements,

Securities.

For the reasons set out in the preamble, Title 17, Chapter II of

the Code of Federal Regulations is proposed to be amended as follows:

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

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

as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless

otherwise noted;

* * * * *

2. By revising Sec. 270.17f-5 to read as follows:

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

States.

(a) A registered management investment company, incorporated or

organized under the laws of the United States or of a state, may place

and maintain in the care of an Eligible Foreign Custodian the company's

Foreign Securities, cash and cash equivalents in amounts reasonably

necessary to effect the company's Foreign Securities transactions,

provided that:

(1) The Foreign Custody Manager shall have determined that custody

of the company's assets in a particular country can be maintained in a

manner that will provide reasonable protection for the company's assets

and that custody of the company's assets with any Compulsory Depository

in that country will provide reasonable protection for the company's

assets, after considering, in each case, all factors relevant to the

safekeeping of such assets, including:

(i) The prevailing practices in the country for the custody of the

company's assets;

(ii) Whether the country's laws will affect adversely the

safekeeping of the company's assets, such as by restricting:

[[Page 39605]]

(A) The access of the company's independent public accountants to a

custodian's books and records; and

(B) The company's ability to recover its assets in the event of a

custodian's bankruptcy or the loss of assets in a custodian's control;

(iii) Whether special arrangements that mitigate the risks of

maintaining the company's assets in the country would be used; and

(iv) With respect to any Compulsory Depository, the factors

specified in paragraph (a)(2) of this section.

(2) Subject to the decision to place assets in the country and to

use any Compulsory Depository in that country under paragraph (a)(1) of

this section, the Foreign Custody Manager shall have determined that

the foreign custodian will provide reasonable protection for the

company's assets, after considering all factors relevant to the

safekeeping of such assets, including:

(i) The custodian's financial strength, its general reputation and

standing and, additionally, in the case of a securities depository, the

depository's operating history and number of participants;

(ii) The custodian's practices, procedures, and internal controls;

and

(iii) Whether the company will have jurisdiction over and be able

to enforce judgments against the custodian, such as by virtue of the

existence of any offices of the custodian in the United States or the

custodian's consent to service of process in the United States.

(3) The company's foreign custody arrangements shall be governed by

a written contract that the Foreign Custody Manager has determined will

provide reasonable protection for the fund's assets, after considering

all factors relevant to the safekeeping of such assets.

(4) The Foreign Custody Manager shall have established a system to

monitor the appropriateness of maintaining the company's assets in a

particular country and using any Compulsory Depository in that country

under paragraph (a)(1) of this section, maintaining the company's

assets with a particular custodian under paragraph (a)(2) of this

section, and the contract governing the company's arrangements under

paragraph (a)(3) of this section. If an arrangement no longer meets the

requirements of this section, the company shall withdraw its assets

from the country or foreign custodian, as the case may be, as soon as

reasonably practicable.

(b) The company's board of directors may delegate to the company's

investment adviser or officers or to a U.S. bank or to a Qualified

Foreign Bank the responsibilities set forth in paragraphs (a)(1),

(a)(2), (a)(3), or (a)(4) of this section, provided that:

(1) The board shall have determined that it is reasonable to rely

on the delegate to perform the delegated responsibilities;

(2) The board shall require the delegate to provide written reports

notifying the board of the placement of the company's assets in a

country and with a particular custodian (including any Compulsory

Depository) and of any material change in the company's arrangements,

with such reports to be provided to the board no later than the next

regularly scheduled board meeting following such event.

(c) Any management investment company, incorporated or organized

under the laws of Canada and registered under the Act pursuant to the

conditions of Sec. 270.7d-1, may place and maintain its Foreign

Securities, cash and cash equivalents in the care of an overseas branch

of a Qualified U.S. Bank, provided that:

(1) Prior to placing any assets with such overseas branch, the

company's board of directors shall have determined that custody of the

assets in the particular country will provide reasonable protection for

those assets;

(2) The company's board of directors shall have established a

system to monitor such foreign custody arrangements for their

continuing appropriateness under this section and to ensure that the

amount of cash and cash equivalents maintained in the care of such

overseas branch is limited to an amount reasonably necessary to effect

the company's Foreign Securities transactions; and

(3) If an arrangement no longer meets the requirements of this

section, the company shall withdraw its assets from the country or such

overseas branch, as the case may be, as soon as reasonably practicable.

(d) For purposes of this section:

(1) Foreign Custody Manager means the company's board of directors

or any person serving as the board's delegate under paragraph (b) of

this section.

(2) Foreign Securities mean securities issued and sold primarily

outside the United States.

(3) Eligible Foreign Custodian means an entity that is incorporated

or organized under the laws of a country other than the United States

and that is:

(i) A banking institution or trust company that is regulated as

such by the country's government or an agency thereof or a majority-

owned direct or indirect subsidiary of a Qualified U.S. Bank or bank-

holding company, provided that such foreign custodian is not an

affiliated person of the company or an affiliated person of such

person;

(ii) A securities depository or clearing agency that operates a

system for the central handling of securities or equivalent book-

entries in the country that is regulated by a foreign financial

regulatory authority as defined under section 3(a)(52) of the

Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(52));

(iii) A securities depository or clearing agency that operates a

transnational system for the central handling of securities or

equivalent book-entries in the country; or

(iv) A Compulsory Depository.

(4) Compulsory Depository means an eligible foreign custodian under

paragraph (d)(2)(ii) of this section, the use of which is mandatory:

(i) By law or regulation;

(ii) Because securities cannot be withdrawn from the depository; or

(iii) Because maintaining securities outside the depository is not

consistent with prevailing custodial practices.

(5) Qualified U.S. Bank means an entity that has an aggregate of

capital, surplus, and undivided profits of a specified minimum amount,

which shall not be less than $500,000, and that is:

(i) A banking institution organized under the laws of the United

States;

(ii) A member bank of the Federal Reserve System;

(iii) Any other banking institution or trust company organized

under the laws of any state or of the United States, whether

incorporated or not, doing business under the laws of any state or of

the United States, a substantial portion of the business of which

consists of receiving deposits or exercising fiduciary powers similar

to those permitted to national banks under the authority of the

Comptroller of the Currency and which is supervised and examined by

State or Federal authority having supervision over banks, and which is

not operated for the purpose of evading the provisions of this section:

or

(iv) a receiver, conservator, or other liquidating agent of any

institution or firm included in paragraphs (d)(5) (i), (ii), or (iii)

of this section.

(6) Qualified Foreign Bank means a banking institution or trust

company, incorporated or organized under the laws of a country other

than the United States, that is regulated as such by the country's

government or an agency thereof.

Dated: July 27, 1995.

[[Page 39606]]

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 95-18890 Filed 8-1-95; 8:45 am]

BILLING CODE 8010-01-P