Temporary Exemption for Certain Investment Advisers

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release Nos. IC-23325, IA-1736; File No. S7-22-98]

RIN 3235-AH02

Temporary Exemption for Certain Investment Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing for public comment amendments to

the rule under the Investment Company Act of 1940 that permits an

investment adviser, in certain circumstances, to advise an investment

company temporarily under a contract that the investment company's

shareholders have not approved. The proposed amendments would expand

the exemption provided by the rule to include new advisory contracts

entered into as a result of a merger or similar business combination

involving the fund's adviser or a controlling person of the adviser,

and would lengthen the period during which the adviser may serve under

a contract without shareholder approval. The proposed amendments are

intended to enable more investment advisers to rely on the rule rather

than seek individual exemptions from the Commission, subject to

conditions designed to protect the interests of investors pending the

shareholder vote.

DATES: Comments must be received on or before September 30, 1998.

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

Katz, Secretary, Mail Stop 6-9, Securities and Exchange Commission, 450

5th Street, NW., Washington, DC 20549. Comments also may be submitted

electronically at the following E-mail address: [email protected].

All comment letters should refer to File No. S7-22-98; this file number

should be included on the subject line if E-mail is used. Comment

letters will be available for public inspection and copying in the

Commission's Public Reference Room, 450 5th Street, NW., Washington, DC

20549. Electronically submitted comment letters also will be posted on

the Commission's Internet web site (http://www.sec.gov).

FOR FURTHER INFORMATION CONTACT: Marilyn Mann, Senior Counsel, or

Penelope W. Saltzman, Assistant Chief, (202) 942-0690, Office of

Regulatory Policy, Division of Investment Management, Mail Stop 5-6,

Securities and Exchange Commission, 450 5th Street, NW., Washington, DC

20549.

SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the

``Commission'') today is requesting public comment on amendments to

rule 15a-4 (17 CFR 270.15a-4) under the Investment Company Act of 1940

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

Table of Contents

I. Executive Summary

II. Background

III. Proposed Amendments to Rule 15a-4

A. Board Approval

B. Adviser Mergers

1. Terms and Conditions

2. Placement of Advisory Fees in Escrow

3. Costs of Shareholder Solicitation

C. Length of Exemptive Period

D. Availability of Exemption After Shareholder Vote

E. General Request for Comment

IV. Cost-Benefit Analysis

V. Summary of Initial Regulatory Flexibility Analysis

VI. Statutory Authority

Text of Proposed Rule

I. Executive Summary

The Commission is proposing for public comment amendments to rule

15a-4 under the Investment Company Act. Rule 15a-4 permits an

investment adviser to an investment company (``fund'') to serve

temporarily under a contract that has not been approved by the fund's

shareholders. The proposed amendments would extend the rule to new

advisory contracts entered into as a result of a merger or similar

business combination involving the fund's adviser or a controlling

person of the adviser, in connection with which the adviser or a

controlling person of the adviser receives a benefit (collectively,

``adviser mergers''). The amendments also would increase the maximum

number of days the investment adviser could serve under the rule and

clarify the timing of board approval of the fund's advisory contract.

The proposed amendments would enable more investment advisers to rely

on the rule rather than seek an individual exemption from the

Commission, subject to conditions designed to protect the interests of

investors pending the shareholder vote.

II. Background

Section 15(a) of the Investment Company Act prohibits a person from

serving as an investment adviser to a fund except under a written

advisory contract that the fund's shareholders have approved. \1\

Section 15(a) also requires that an advisory contract must provide for

its automatic termination upon its assignment.\2\ An advisory contract

that continues in effect for more than two years must be approved

annually by either the fund's board of directors or its shareholders.

\3\

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\1\ 15 U.S.C. 80a-15(a). Section 15(a) requires that a majority

of the fund's outstanding voting securities approve the contract.

Section 2(a)(42) of the Act (15 U.S.C. 80a-2(a)(42)) defines a vote

of a majority of the outstanding voting securities of a fund to mean

the vote of shareholders representing (a) 67 percent or more of the

voting securities present at the meeting, if the holders of more

than 50 percent of the fund's outstanding voting securities are

present or represented by proxy, or (b) more than 50 percent of the

outstanding voting securities of the fund, whichever is less.

\2\ 15 U.S.C. 80a-15(a)(4). An ``assignment'' of an investment

advisory contract includes a transfer of the contract to another

investment adviser as well as a transfer of a controlling block of

the investment adviser's voting securities. 15 U.S.C. 80a-2(a)(4).

\3\ 15 U.S.C. 80a-15(a)(2).

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Section 15(a) is designed to give shareholders a voice in a fund's

investment advisory contract and to prevent trafficking in fund

advisory contracts.\4\ One of section 15(a)'s unintended effects,

however, is to leave a fund without an investment adviser if the fund's

contract with the adviser is terminated before the fund's shareholders

can vote on a new contract.\5\ A fund could face this

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situation, for example, if a controlling shareholder of the fund's

adviser suddenly dies and control of the adviser passes to an heir.\6\

To prevent funds from being harmed as a result of the loss of advisory

services for a period of time, the Commission adopted in 1980 rule 15a-

4, which provides a temporary exemption from the requirement that a

fund's shareholders approve its advisory contract.\7\ The rule permits

a fund to be advised under a short-term contract while shareholder

approval is obtained for a new advisory contract.

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\4\ Hearings on S. 3580 Before the Subcomm. of the Senate Comm.

on Banking and Currency, 76th Cong., 3d Sess. 253 (1940) (statement

of David Schenker).

\5\ If an investment advisory contract is terminated by a

foreseeable assignment, an investment adviser may be required, under

its fiduciary duty, to continue providing advisory services to the

fund until the shareholders approve a new contract. See Exemptions

for Certain Investment Advisers and Principal Underwriters of

Investment Companies, Investment Company Act Release No. 10809 (Aug.

6, 1979) (44 FR 47100, 47102 (Aug. 10, 1979)) (''1979 Proposing

Release'').

\6\ See, e.g., American-South African Investment Company

Limited, Investment Company Act Release Nos. 6398 (Mar. 22, 1971)

(36 FR 5819 (1971)) (notice) and 6456 (Apr. 14, 1971) (order)

(investment adviser received exemption from section 15(a) for period

between death of indirect owner of 50 percent of outstanding shares

of investment adviser and annual meeting of shareholders).

\7\ 17 CFR 270.15a-4. See also 1979 Proposing Release, supra

note , at 47101.

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Under rule 15a-4, a person may serve as an adviser to a fund for up

to 120 days under a contract that the fund's shareholders have not

approved (``interim contract'') \8\ when (i) the previous advisory

contract has not been renewed, (ii) the fund's directors or

shareholders terminate the advisory contract, or (iii) the contract is

assigned (and therefore terminates) under circumstances in which the

investment adviser, or a controlling person of the adviser, does not

receive any money or other benefit. The rule requires the fund's board

of directors, including a majority of the directors who are not

interested persons of the fund (``independent directors''), to approve

the interim contract, \9\ and limits the compensation under the interim

contract to the amount the adviser could have received under the most

recent advisory contract approved by shareholders (``previous

contract'').\10\

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\8\ The interim contract may terminate at the earlier of the

expiration of the 120-day period or the date on which shareholders

approve a new contract with the adviser. Alternatively, the fund may

enter into a new contract with the adviser which, if approved by

shareholders, continues past the 120-day period. In the latter case,

the term ``interim contract'' refers to the contract during the time

the exemption is in effect.

\9\ Rule 15a-4(a) (17 CFR 270.15a-4(a)). Under section 15(c) of

the Act, a fund's independent directors must approve the terms of an

investment advisory contract before it can go into effect. 15 U.S.C.

80a-15(c). A fund's directors have a duty to request, and the

adviser has a duty to furnish, all information reasonably needed to

evaluate the terms of the proposed advisory contract. Id. In

reviewing the advisory contract, the independent directors' role is

to represent the interests of shareholders by acting as

``independent watchdogs'' and furnishing an independent check on the

fund's management. See Burks v. Lasker, 441 U.S. 471, 484-85 (1979);

see also Division of Investment Management, SEC, Protecting

Investors: A Half Century of Investment Company Regulation 255-57

(1992) (``Protecting Investors Report'').

\10\ Rule 15a-4(b) (17 CFR 270.15a-4(b)).

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Based on its experience with the rule since 1980, and in light of

developments in the financial services industry, the Commission is

proposing three amendments to rule 15a-4. These amendments would (i)

clarify the timing of board approval of an interim contract, (ii)

expand the rule to permit the fund to operate under an interim contract

entered into as a result of an adviser merger, and (iii) lengthen the

amount of time a fund can operate under an interim contract from 120 to

150 days. As discussed in more detail below, the amendments would

largely codify prior Commission exemptive orders, which effectively

permitted advisers or their affiliates to consummate a merger before

the fund's shareholders voted on a new advisory contract rather than

delay the merger in order to obtain shareholder approval.

Proposed Amendments to Rule 15a-4

A. Board Approval

Under section 15 of the Act and rule 15a-4, the board of directors

of a fund must approve an interim contract at or before the time the

fund enters into the interim contract. If an assignment results from an

unforeseeable event, board approval of the interim contract before the

assignment may be impracticable. In addition, with no prior notice of

the assignment, members of the board may not be immediately available

to meet to approve the interim advisory contract.11

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\11\ Section 15(c) of the Act requires the board to vote ``in

person'' to approve an investment advisory contract. 15 U.S.C. 80a-

15(c). Historically, the Commission has taken the view that the ``in

person'' requirement must be satisfied by a meeting at which the

directors are physically present. See Provisions of Investment

Company Amendments Act of 1970 (Pub.L. 91-547) Concerning Approval

of Investment Advisory Contracts and Other Matters Which Should Be

Considered by Registrants in Connection With Their 1971 Annual

Meetings, Investment Company Act Release No. 6336 (Feb. 2, 1971) (36

FR 2867, 2867 & n.3 (Feb. 11, 1971)). Section 15(c) does not by its

terms specify that the in person requirement means that board

members must be physically present. Under the laws of some states, a

similar requirement can be met by a meeting at which directors are

present through the means of a conference call or audiovisual

conference. See, e.g., Del. Code Ann. tit. 8, Sec. 141(i) (1991);

Md. Code Ann., Corps. & Ass'ns Sec. 2-409(d) (1993). The

Commission's historic view is based on the legislative history of

section 15(c), which indicates that the provision meant directors

were required to be ``personally present'' to vote at meetings. H.R.

Rep. No. 1382, 91st Cong., 2d Sess. 25-26 (1970); S. Rep. No. 184,

91st Cong., 1st Sess. 39 (1969).

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The Commission has granted an exemption from the board approval

requirement of section 15(c) when death of a controlling shareholder of

a fund's investment adviser has resulted in an assignment of the fund's

advisory contract.12 The proposed amendments would provide

similar exemptive relief in this type of situation by allowing the

board seven calendar days to approve an interim contract in

circumstances in which the current rule would permit an investment

adviser to serve a fund temporarily under a contract without

shareholder approval. The proposed amendments also would facilitate a

special meeting to approve an interim contract, by permitting the

fund's board of directors to participate by telephone or similar means

of communication that allows all participants to hear each other at the

same time.13

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\12\ See, e.g., American-South African Investment Company

Limited, supra note (permitting board approval one week after

termination of advisory contract caused by death of controlling

shareholder of the investment adviser).

\13\ Proposed rule 15a-4(b)(1)(ii).

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The Commission requests comment regarding this proposed amendment.

The Commission's rules previously have not provided this grace period

for board approval. Have boards been able to meet the requirements of

section 15(c) without a grace period when an advisory contract is

terminated as a result of an unforeseeable assignment? Does seven days

give the board sufficient time to review the interim contract and vote?

Should the rule provide a longer period for approval but not provide an

exemption from the requirement to vote in person?

B. Adviser Mergers

Since 1980, a growing number of mergers in the financial services

industry 14 has led to a growing number of requests for

exemptive relief from

[[Page 40233]]

section 15(a) of the Act.15 Adviser merger transactions can

result in the assignment (and thus the automatic termination) of

advisory contracts, 16 but are not covered by rule 15a-4

because the adviser will have received money or other benefits as a

result of the transaction.17

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\14\ See Financial Services Consolidation Hits Mutual Fund

Industry in '97, USA Today, Dec. 18, 1997, at 14E (noting the many

mergers in the mutual fund industry in 1997, and predicting that the

trend would continue in 1998); Investment Counseling, Inc., Re-

Thinking Strategic Activity 1 (1997) (showing the increase in

mergers and acquisitions in the money management industry in 1995

and 1996 over 1992-1994); Tim Quinson, Banks Add More Investment

Services With Focus On Fund Firms, The Dallas Morning News, Dec. 28,

1997, at 9H (many large U.S. banks recently purchased managers of

mutual funds); Barry P. Barbash, Mutual Fund Consolidation and

Globalization: Challenges for the Future, Remarks to the Mutual Fund

and Investment Management Conference 1-2 (Mar. 23, 1998) (during the

past year, the Commission's Division of Investment Management

received from funds and advisory firms an average of one merger-

related exemptive application each week) (available on the Internet

at http://www.sec.gov/news/speeches/spch208.htm>).

\15\ Since rule 15a-4 was adopted in 1980, the Commission has

issued over 50 orders temporarily exempting funds and their

investment advisers from the shareholder approval requirement in

connection with assignments resulting from a merger or acquisition

involving the fund's investment adviser. Over half of these orders

have been issued since the beginning of 1996.

\16\ See supra note .

\17\ When the Commission adopted rule 15a-4 in 1980, it decided

not to extend the rule to cover adviser mergers because they were

``foreseeable.'' See Exemptions for Certain Investment Advisers and

Principal Underwriters of Investment Companies, Investment Company

Act Release No. 11005 (Jan. 2, 1980) (45 FR 1860, 1861 n.2 (Jan. 9,

1980)) (''1980 Adopting Release'').

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In response to these requests for relief, the Commission has

granted exemptions from section 15(a) in a variety of circumstances in

which applicants stated it was necessary to conclude a transaction

before a shareholder vote could be held, or when the meeting to hold a

shareholder vote on the advisory contract could be combined with

another previously scheduled shareholder meeting to occur after the

adviser merger.18 Applicants have represented that it is

often impracticable to obtain shareholder approval of an advisory

contract prior to an adviser merger without causing a substantial delay

in closing the transaction. These delays can result in significant

adverse effects, such as the loss of key personnel of the investment

adviser, that could be detrimental to fund shareholders.19

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\18\ See, e.g., Cash Reserve Management, Inc., Investment

Company Act Release Nos. 16172 (Dec. 11, 1987) [52 FR 47985 (Dec.

17, 1987)] (notice) and 16202 (Jan. 5, 1988) [39 SEC Docket 1602

(Jan. 19, 1988)] (order) (acquisition of investment adviser through

tender offer); Mutual Fund Group, Investment Company Act Release

Nos. 21629 (Dec. 28, 1995) [61 FR 365 (Jan. 4, 1996)] (notice) and

21696 (Jan. 23, 1996) [61 SEC Docket 555 (Feb. 20, 1996)] (order)

(meetings to be held after the assignment to vote on fund mergers);

see also Kenneth S. Gerstein, Acquisitions of Mutual Fund Advisors:

Some Practical Issues Under the Investment Company Act, Investment

Law., Apr. 1994, at 12, 13.

\19\ See, e.g., General Securities, Inc., Investment Company Act

Release Nos. 18884 (Aug. 7, 1992) [57 FR 37020 (Aug. 17, 1992)]

(notice) and 18927 (Sept. 3, 1992) (52 SEC Docket 1776 (Sept. 22,

1992)) (order) (delaying the closing of the merger could cause

defections of investment adviser's registered representatives,

possibly threatening adviser's viability and diminishing the

services provided to the fund); Kidder, Peabody Investment Trust,

Investment Company Act Release Nos. 20818 (Jan. 4, 1995) [60 FR 2803

(Jan. 11, 1995)] (notice) and 20865 (Jan. 27, 1995) [58 SEC Docket

2092 (Feb. 28, 1995)] (order) (delaying the closing of the

transaction until shareholders could vote on new advisory contracts

would result in substantial defections by portfolio managers,

advisory employees, and supervisory personnel).

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Rule 15a-4 is designed to deal with unforeseeable assignments of

advisory contracts by permitting the board to act on an emergency basis

to prevent the fund from being harmed by the absence of advisory

services.20 By contrast, adviser mergers are often

foreseeable, will benefit the adviser, and typically occur as a result

of a transaction in which the fund is not a participant and in which

its interests are not represented.21 In these cases, fund

boards have more opportunity to protect the interests of the fund by,

among other things, more closely evaluating the services it will

receive under an interim contract (i.e., after the merger or

acquisition of the fund's investment adviser or a controlling person of

the investment adviser). Therefore, the Commission has granted

exemptive relief from section 15(a) in connection with adviser mergers

only upon certain additional conditions designed to protect the fund's

interests until shareholders have had an opportunity to approve a new

advisory contract. The Commission is proposing to codify the relief

provided in these orders based on similar conditions, as described

below.

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\20\ See 1980 Adopting Release, supra note 17, at n.2; see also

1979 Proposing Release, supra note , at 47102. The 1979 Proposing

Release stated that the Commission intended the rule to cover

assignments of advisory contracts that were not reasonably

foreseeable, such as assignments resulting from the death of a

controlling shareholder of the adviser. Id. at 47101-02. When an

investment adviser assigns a contract under reasonably foreseeable

circumstances, such as pursuant to a merger, ``the investor

protection concerns expressed by Congress with respect to section

15(a) are better fulfilled when investment company shareholders are

provided the opportunity to approve any successor investment

advisory contract prior to the successor adviser's serving the

company.'' Id. at 47102. The 1979 Proposing Release also noted that

the rule would not extend the period during which an investment

company must comply with section 15(a) requirements regarding annual

continuance of investment advisory contracts. Id. at n.8.

\21\ See Stephanie A. Djinis, Acquisition of a Mutual Fund

Adviser: The Role of Fund Directors, 29 Sec. & Commodities Reg. 135,

135-36 (June 19, 1996) (adviser may inform fund's board about merger

plans after negotiating the transaction, and the board is not in a

position to reject the merger); Gerstein, supra note 18, at 12

(neither a fund, nor its shareholders, are parties to the

acquisition of the fund's adviser).

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1. Terms and Conditions

In considering requests for exemptive relief in connection with

adviser mergers, the Commission has required certain actions by the

fund's board of directors and certain provisions in the interim

contract, which are designed to preserve the quality of advisory and

other services that the fund received before the merger until the

shareholders vote on a new contract. The Commission is proposing to

incorporate these conditions in rule 15a-4. In the case of an adviser

merger, the proposed amendments would require that: (i) The interim

contract generally contain the same terms and conditions as the

previous contract; 22 (ii) the interim contract be approved

by the fund's board of directors, including a majority of the

independent directors, before the interim contract begins;

23 and (iii) the board, including a majority of independent

directors, find that the scope and quality of the advisory services to

be provided under the interim contract will be at least equivalent to

the scope and quality of the services provided under the previous

contract.24 The Commission requests comment whether the rule

should require the board to make specific findings regarding the

interim contract. If so, should the rule require any additional

findings by the fund's board regarding the interests of investors?

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\22\ Proposed rule 15a-4(b)(2)(v). The requirement concerning

the terms and conditions of the interim contract is designed to

ensure that the contract does not vary from the previous contract

with respect to important matters such as indemnification, the

adviser's standard of care, and the allocation of expenses between

the adviser and the fund. The interim contract would, however, have

effective and termination dates that are different from the dates of

the previous contract and could contain other differences that the

fund's board of directors determines are immaterial.

\23\ Proposed rule 15a-4(b)(2)(ii).

\24\ Proposed rule 15a-4(b)(2)(iii). Thus, the interim contract

could provide for lower advisory fees, but not a lower level of

service. The Commission anticipates that the information needed to

make this additional finding generally would be similar to the

information the independent directors examine in fulfilling their

responsibilities under section 15(c) and could include information

on the services to be provided under the interim contract, such as

the quality of the investment adviser's personnel (especially in

light of any personnel changes) and the investment adviser's past

performance and compliance records.

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If the quality of the advisory services provided to the fund

diminishes during the performance of the interim contract, the board

may need to consider whether to terminate the contract and seek to

employ another adviser. In order to allow the board to act quickly, the

proposed rule would require that the interim contract permit the board

to terminate the contract on no more than 10 calendar days' written

notice to the adviser.25

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\25\ Proposed rule 15a-4(b)(2)(iv).

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The Commission requests comment whether the rule should specify

actions the directors should take to monitor the adviser's performance

during the exemptive period. Should the rule require the adviser to

report to the directors regarding changes in personnel

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or other matters? 26 The Commission also requests comment on

the maximum 10-day notice the interim contract may require before

termination of the interim contract. Is this type of provision

necessary? If it is, should the rule provide a shorter or longer

maximum notice period (e.g., 5 or 20 days)? Commenters who believe that

a shorter or longer notice period is needed should explain why, and

specify the number of days they believe would be appropriate.

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\26\ Prior exemptive orders have required that the investment

adviser report to the fund's board during the exemptive period any

material changes in the adviser's personnel, in order to permit the

directors to monitor the scope and quality of services provided to

the fund. See, e.g., Nations Fund Portfolios, Inc., Investment

Company Act Release Nos. 21801 (Mar. 4, 1996) [61 FR 9511 (Mar. 8,

1996)] (notice) and 21854 (Mar. 25, 1996) (61 SEC Docket 1821 (Apr.

23, 1996)) (order).

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2. Placement of Advisory Fees in Escrow

Orders for exemptive relief from section 15(a) have been

conditioned on placing advisory fees earned during the interim period

in an escrow account payable to the adviser only when and if the fund's

shareholders approve a new contract with the adviser. The escrow

requirement was designed to allow shareholders, in effect, to

subsequently ratify the investment adviser's compensation under the

interim contract.

The proposed amendments would include a modified escrow

requirement. The provision would require that advisory fees earned

under the interim contract be held in an interest-bearing escrow

account with a bank or the fund's custodian.27 If the

shareholders approve the new advisory contract, the escrowed fees would

be paid to the investment adviser in accordance with the interim

contract.28 If the shareholders do not approve the new

contract, however, the adviser would be compensated out of the escrowed

fees for the actual costs of performing the interim contract, so long

as the costs do not exceed the total compensation the adviser would

have received under the interim contract.29 Any remaining

escrowed fees would be returned to the fund.

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\27\ Proposed rule 15a-4(b)(2)(vi)(A).

\28\ Proposed rule 15a-4(b)(2)(vi)(B).

\29\ Proposed rule 15a-4(b)(2)(vi)(C). This procedure is similar

to that permitted by rule 18f-2(c)(2) (17 CFR 270.18f-2(c)(2)),

which allows an investment adviser to continue to advise a series

fund without approval from the series shareholders pending approval

of a new contract as long as the adviser's compensation is limited

to the lesser of actual costs or the amount it would have received

under the advisory contract.

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Most of the prior exemptive orders required all the escrowed fees

to be returned to the fund if shareholders did not approve a new

contract with the investment adviser. The proposed change from the

condition in prior exemptive orders is intended to allow shareholders

to withhold an adviser's profits if the shareholders do not approve a

new contract with that adviser, while providing for compensation for

services rendered by the adviser.30

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\30\ Placing the fees in escrow until the shareholders vote on

the new contract also may encourage the investment adviser to obtain

the shareholder vote as soon as possible.

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The Commission requests comment on the proposed escrow requirement.

Do the escrow arrangements encourage investment advisers to obtain

shareholder approval prior to the adviser merger? Does this approach

create economic burdens for investment advisers, especially smaller or

less capitalized advisers?

3. Costs of Shareholder Solicitation

In most investment adviser business combinations, the advisers bear

the expenses of the transaction.31 Applicants have stated in

requests for exemptive relief that funds would not pay any of the costs

of soliciting shareholder approval of the new advisory contract after

an adviser merger, and the orders have included this representation as

a condition for relief.32 The Commission is not proposing to

include this condition in the rule because it does not appear to be

relevant to the question of whether relief should be granted from the

shareholder approval requirement of section 15(a). If an advisory

contract is terminated as a result of an adviser's action (such as an

adviser merger) that benefits the adviser, however, issues may arise

under other sections of the Investment Company Act if the fund pays the

costs of soliciting shareholder approval of a new

contract.33 The Commission requests comment whether, in

light of these issues, rule 15a-4 should require that the parties to an

adviser merger, rather than the fund, pay the costs associated with the

transaction.

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\31\ See 1 Thomas P. Lemke et al., Regulation of Investment

Companies Sec. 24.02[1][c] (1997).

\32\ See, e.g., Merrill Lynch & Co., Inc., Investment Company

Act Release Nos. 22947 (Dec. 19, 1997) (62 FR 67420 (Dec. 24, 1997))

(notice) and 22997 (Jan. 12, 1998) (66 SEC Docket 981 (Feb. 10,

1998)) (order); USLIFE Income Fund, Inc., Investment Company Act

Release Nos. 22664 (May 16, 1997) (62 FR 28079 (May 22, 1997))

(notice) and 22701 (June 11, 1997) (64 SEC Docket 2011 (July 8,

1997)) (order).

\33\ See 1979 Proposing Release, supra note 5, at n.13 (if a

fund were to bear any of the costs caused by an adviser merger,

including costs associated with conducting a special shareholders'

meeting, payment of those costs might constitute compensation to the

investment adviser and might raise questions regarding the

availability of section 15(f) (15 U.S.C. 80a-15(f)) (creating safe

harbor under which investment advisers may receive a benefit in

connection with a sale of securities of, or a sale of any other

interest in, an investment adviser that results in an assignment of

an investment advisory contract, if certain conditions are met),

section 15(a)(1) (15 U.S.C. 80a-15(a)(1)) (advisory contract must

precisely describe all compensation to be paid under the contract)

and section 36(b) (15 U.S.C. 80a-35(b)) (investment adviser's

fiduciary duty with respect to the receipt of compensation for

services, or of payments of a material nature, paid by the fund or

its shareholders)). But see Travelers Group Inc., et al., Investment

Company Act Release Nos. 22873 (Nov. 3, 1997) (62 FR 60540 (Nov. 10,

1997)) (notice) and 22911 (Nov. 26, 1997) (65 SEC Docket 2962 (Dec.

23, 1997)) (order) (adviser to pay costs of soliciting shareholder

approval of new advisory contract, except that if solicitation is in

conjunction with fund's annual meeting at which other matters are to

be discussed, fund may pay portion of costs).

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The Commission also requests comment generally on the proposed

amendment to rule 15a-4 to exempt advisory contracts temporarily from

the shareholder approval requirement in the context of adviser mergers.

Do the proposed conditions adequately protect fund shareholders against

overreaching by the investment adviser?

C. Length of Exemptive Period

Rule 15a-4 currently exempts an investment adviser from the

shareholder approval requirement for 120 days. This time period was

adopted to provide a fund adequate time to solicit proxies and obtain a

quorum of voting shareholders.34 Today, however, the 120-day

period in many cases may be insufficient time for obtaining shareholder

approval of the new advisory contract.35 Funds have found it

difficult to obtain a quorum of shareholders necessary to vote on an

advisory contract.36 In addition, funds that hold annual

shareholders' meetings often must call a special meeting to approve the

advisory contract within

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the 120-day period, which results in additional costs for the fund.

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\34\ See 1980 Adopting Release, supra note 17.

\35\ The Commission has issued several orders temporarily

exempting fund advisers from the shareholder approval requirement of

section 15(a) when the fund was unable to obtain a quorum within the

time period allowed by rule 15a-4, or when the fund wished to

postpone the shareholder vote until its next annual or special

meeting. See, e.g., The Emerging Germany Fund Inc., Investment

Company Act Release Nos. 18323 (Sept. 18, 1991) (56 FR 48265 (Sept.

24, 1991)) (notice) and 18492 (Oct. 16, 1991) (50 SEC Docket 1432

(Feb. 4, 1992)) (order). The Commission staff also has taken the

position in a number of no-action letters that an adviser may

temporarily (pending shareholder approval of the advisory contract)

provide services to the fund at the lower of the cost to the adviser

of providing the services or the compensation the adviser would have

received under the previous contract. See, e.g., NPG Growth Fund,

Inc., SEC No-Action Letter (July 6, 1975).

\36\ See Protecting Investors Report, supra note 9, at 272 n.82;

Lori Pizzani, Avoiding Proxy Voting Bumps, Mutual Fund Market News,

Apr. 28, 1997, at 1.

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The Commission proposes to increase the period permitted by the

rule to 150 days, to allow funds more time to seek shareholder approval

of the new advisory contract.37 Commenters who believe that

a longer period is needed should explain why, and specify the number of

days they believe would be appropriate. Should the rule allow funds

that hold annual shareholder meetings to postpone the shareholder vote

on the advisory contract until the next annual meeting?38

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\37\ Proposed rule 15a-4(a)(2).

\38\ A provision related to annual shareholder meetings would,

as a practical matter, principally affect closed-end funds. The Act

does not require that shareholders annually elect directors.

Investment Company Act section 16(a) (15 U.S.C. 80a-16(a)); John

Nuveen & Co. Inc., SEC No-Action Letter (Nov. 18, 1986). Most open-

end funds are organized in states that do not require annual

shareholders' meetings. See, e.g., Del. Code Ann. tit. 12,

Sec. 3806(b)(5) (1995); Md. Code Ann., Corps. & Ass'ns Sec. 2-501(b)

(1993). See generally Protecting Investors Report, supra note 9, at

275. Most closed-end funds, however, list their shares on stock

exchanges and are required to hold annual meetings under stock

exchange rules. See, e.g., New York Stock Exchange Listed Company

Manual para. 302.00 (1995).

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D. Availability of Exemption After Shareholder Vote

The Commission's proposal to extend the exemptive period is

intended to provide sufficient time to obtain shareholder approval of a

new advisory contract. Consistent with current rule 15a-4, if the

shareholders do not approve the new contract before the exemptive

period expires, the rule would not be available for an additional

period of time. Thus, for example, if a contract terminates and

shareholders subsequently vote to terminate the interim contract, the

adviser will not be able to serve the fund under another interim

contract under rule 15a-4.39

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\39\ See 1979 Proposing Release, supra note 5, at n.12.

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E. General Request for Comment

The Commission requests comment on the proposed rule amendments

that are the subject of this release, suggestions for additional

provisions or changes to the rule, and comments on other matters that

might have an effect on the proposals contained in this release. The

Commission requests comment whether the proposals, if adopted, would

promote efficiency, competition, and capital formation. Comments will

be considered by the Commission in satisfying its responsibilities

under section 2(c) of the Investment Company Act.40 The

Commission encourages commenters to provide data to support their

views.

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\40\ Section 2(c) requires the Commission, when it engages in

rulemaking and is required to consider whether an action is

consistent with the public interest, to consider, in addition to the

protection of investors, whether the action will promote efficiency,

competition, and capital formation. 15 U.S.C. 80a-2(c).

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IV. Cost-Benefit Analysis

The Commission is sensitive to the costs and benefits imposed by

its rules. The proposed amendments are likely to result in cost savings

for investment advisers 41 by removing the need to seek

exemptive relief in the case of adviser mergers. Based on orders issued

in 1997, the Commission estimates that the total annual cost savings

for investment advisers resulting from the proposed amendments would be

approximately $260,000, and possibly more. In 1997, the Commission

issued 13 orders granting exemptive relief in connection with adviser

mergers at an estimated cost to the applicants of $20,000 for each

application. The Commission expects that cost savings could be greater

in the future because the steady increase in orders issued in

connection with adviser mergers over the past three years appears

likely to continue in 1998.42 The requirements of the rule

with respect to director findings should not be burdensome in view of

the fact that section 15(c) already requires the fund's independent

directors to review and approve the new advisory contract. In addition,

cost savings could be realized by funds and advisers not governed by

paragraph (b)(2) of the rule in that directors may participate in the

meeting to approve the advisory contract ``by any means of

communication that allows all directors participating to hear each

other simultaneously during the meeting.'' This provision could result

in savings in time and travel costs.

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\41\ One of the standard conditions to the adviser merger orders

is that the costs of the exemptive application will be paid by the

adviser or advisers.

\42\ The Commission issued 6, 11, and 13 orders granting

exemptive relief in connection with adviser mergers in 1995, 1996,

and 1997, respectively. The Commission already has received five

applications in the first quarter of 1998.

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Unlike most prior exemptive orders, the proposed amendments would

not prohibit funds from paying costs associated with soliciting

shareholder approval of a new advisory contract after an adviser

merger. Thus, the proposed amendments could result in increased costs

if funds bear those expenses in the future. In most investment adviser

business combinations, however, the advisers bear the costs of the

transaction.43 In addition, applicants have represented that

advisers will bear the costs of soliciting shareholder approval of a

new advisory contract after an adviser merger. While the Commission

cannot predict what will happen if the proposed amendments are adopted,

we believe that advisers are likely to continue to pay these costs and,

therefore, the proposed amendments are not likely to result in

increased shareholder solicitation costs for funds.

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\43\ See 1 Lemke, supra note 31, at Sec. 24.02(1)(c).

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The Commission requests comment on the potential costs and benefits

of the rule and of the proposed amendments or any suggested

alternatives to the proposed amendments. Data is requested concerning

these costs and benefits.

For purposes of the Small Business Regulatory Enforcement Fairness

Act of 1996,44 the Commission also requests information

regarding the potential impact of the proposed rule on the economy on

an annual basis. Commenters are requested again to provide data to

support their views.

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\44\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996).

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V. Summary of Initial Regulatory Flexibility Analysis

The Commission has prepared an Initial Regulatory Flexibility

Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding the

proposed amendments to rule 15a-4. The following summarizes the IRFA.

Existing rule 15a-4 provides a temporary exemption in certain

circumstances from the requirement that shareholders approve an

investment advisory contract. The rule does not, however, cover interim

contracts entered into as a result of adviser mergers. Due to the

growing number of acquisitions and mergers in the financial services

industry, the Commission has received a growing number of applications

for exemption from the shareholder approval requirement in connection

with adviser mergers. In addition, funds have advised the Commission

that the 120-day exemptive period in rule 15a-4 is too short to obtain

shareholder approval of an advisory contract.

The proposed amendments would extend rule 15a-4 to adviser mergers,

extend the length of the exemptive period to 150 days, and clarify the

timing of board approval of the fund's advisory contract. The proposed

amendments would significantly reduce the need to file exemptive

applications, resulting in cost and time savings for funds and

investment advisers.

The Commission is proposing to amend rule 15a-4 pursuant to the

authority set forth in sections 6(c) and

[[Page 40236]]

38(a) of the Act. Rule 15a-4 applies to funds (including business

development companies (``BDCs'')) and their investment advisers.

45 The rule does not affect funds that do not have an

external investment adviser 46 (i.e., unit investment trusts

or other funds that are internally managed).

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\45\ Section 59 of the Act (15 U.S.C. 80a-58) provides, among

other things, that sections 15(a) and 15(c) of the Act apply to a

BDC to the same extent as if it were a registered closed-end

investment company.

\46\ The vast majority of open-end and closed-end funds are

externally managed. All face-amount certificate companies currently

in existence are externally managed. The Commission does not keep

statistics on how many BDCs are externally managed.

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An investment adviser is a small entity if it (1) manages less than

$25 million in assets, (2) has total assets of less than $5 million on

the last day of its most recent fiscal year, and (3) does not control,

is not controlled by, and is not under common control with another

investment adviser that manages $25 million or more in assets, or any

person (other than a natural person) that had total assets of $5

million or more on the last day of the most recent fiscal year.

47 The Commission estimates that there are approximately 820

investment advisers that advise funds, approximately 180 of which are

small entities. A fund is a small entity if it, together with other

funds in the same group of related funds, has net assets of $50 million

or less as of the end of its most recent fiscal year. 48

There are approximately 2,600 active open-end funds, approximately 210

of which are small entities. There are approximately 545 active closed-

end funds, approximately 42 of which are small entities. There are

approximately 63 BDCs, approximately 33 of which are small entities.

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\47\ Definitions of ``Small Business'' or ``Small Organization''

Under the Investment Company Act of 1940, the Investment Advisers

Act of 1940, the Securities Exchange Act of 1934, and the Securities

Act of 1933, Securities Act Release No. 7548 (June 24, 1998) (63 FR

35508 (June 30, 1998)) (``Small Entity Release'').

\48\ Id.

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The Commission believes that the proposed amendments would decrease

the burdens on small funds and small investment advisers by making it

unnecessary for them to seek an exemptive order from the Commission in

order to delay the shareholder vote required by section 15(a). The

requirements of the rule, as explained above in section III, are

designed to protect the interests of investment companies, including

small funds and their shareholders, and therefore an exemption from any

of those requirements for small entities would not be consistent with

the protection of investors. The Commission believes that the burden

these requirements place on small advisers is minimal because the

requirements generally are intended to maintain the status quo until

the shareholder vote can be held.

The Commission is proposing escrow arrangements under the proposed

rule amendments that differ from the escrow arrangements required under

most exemptive orders issued to date to funds seeking relief similar to

that provided by the proposed amendments. The proposed amendments would

require the advisory fee to be paid under the interim contract to be

placed in escrow, but would allow an investment adviser to recover its

costs of performing the interim contract if a fund's shareholders do

not approve a new advisory contract. Most of the prior exemptive orders

required that all the escrowed fees be returned to the fund if

shareholders did not approve a new contract with the investment

adviser. The proposed changes from conditions imposed under prior

exemptive orders are designed to allow shareholders to withhold profits

under an interim contract when the shareholders reject a new contract

with that adviser, while providing for compensation for services

provided by the adviser. This provision may be of particular benefit to

small advisers.

The Commission has not identified any overlapping or conflicting

federal rules. The Commission has considered alternatives to the

proposed rule amendment that would accomplish the objective of the rule

and minimize the impact on small entities. These alternatives include:

(i) Establishing different compliance requirements that take into

account the resources available to small entities; (ii) clarifying,

consolidating, or simplifying compliance requirements under the rule

for small entities; (iii) using performance rather than design

standards; and (iv) exempting small entities from coverage of the rule,

or any part of the rule.

The Commission believes that further clarification, consolidation,

or simplification of the compliance requirements is not necessary.

Standards contained in the proposed amendment are performance, rather

than design, standards. 49 An exemption from coverage of the

rule for small advisers or small funds would prevent those entities

from benefiting from rule 15a-4 and would not be consistent with the

protection of investors.

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\49\ Proposed rule 15a-4(b)(2)(iii), (v).

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The Commission encourages the submission of comments on matters

discussed in the IRFA. Comment specifically is requested on the number

of small entities that would be affected by the proposed rule

amendments. Comment also is requested on the effect of the rule

amendments on investment advisers and funds that are small entities.

Commenters are asked to describe the nature of any effect and provide

empirical data supporting the extent of the effect. These comments will

be placed in the same public file as comments on the proposed rule

amendments.

A copy of the IRFA may be obtained by contacting Marilyn Mann, Mail

Stop 5-6, Securities and Exchange Commission, 450 5th Street, N.W.,

Washington, D.C. 20549.

VI. Statutory Authority

The Commission is proposing to amend rule 15a-4 pursuant to the

authority set forth in sections 6(c) and 38(a) (15 U.S.C. 80a-6(c) and

80a-37(a)) of the Investment Company Act.

List of Subjects in 17 CFR Part 270

Investment companies, Securities.

Text of Proposed Rule

For the reasons set out in the preamble, Title 17, Chapter II of

the Code of Federal Regulations is proposed to be amended as follows:

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

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

as follows:

Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39

unless otherwise noted;

* * * * *

2. Section 270.15a-4 is revised to read as follows:

Sec. 270.15a-4 Temporary exemption for certain investment advisers.

(a) Definitions. For purposes of this section:

(1) Fund means an investment company;

(2) Interim contract means a written contract for a period no

greater than 150 days that has not been approved by a majority of the

fund's outstanding voting securities; and

(3) Previous contract means an investment advisory contract that

has been approved by a majority of the fund's outstanding voting

securities and has been terminated.

(b) Notwithstanding section 15(a) of the Act (15 U.S.C. 80a-15(a)),

a person may act as investment adviser for a fund under an interim

contract after the termination of a previous contract as

[[Page 40237]]

provided in paragraphs (b)(1) and (b)(2) of this section:

(1) In the case of a previous contract terminated by an event

described in section 15(a)(3) of the Act (15 U.S.C. 80a-15(a)(3)), by

the failure to renew the previous contract, or by an assignment (other

than an assignment by an investment adviser or a controlling person of

the investment adviser in connection with which assignment the

investment adviser or a controlling person directly or indirectly

receives money or other benefit):

(i) The compensation to be received under the interim contract is

no greater than the compensation the adviser would have received under

the previous contract; and

(ii) The fund's board of directors, including a majority of the

directors who are not interested persons of the fund, has approved the

interim contract within seven calendar days after the termination, at a

meeting in which directors may participate by any means of

communication that allows all directors participating to hear each

other simultaneously during the meeting.

(2) In the case of a previous contract terminated by an assignment

by an investment adviser or a controlling person of the investment

adviser in connection with which assignment the investment adviser or a

controlling person directly or indirectly receives money or other

benefit:

(i) The compensation to be received under the interim contract is

no greater than the compensation the adviser would have received under

the previous contract;

(ii) The board of directors, including a majority of the directors

who are not interested persons of the fund, has voted in person to

approve the interim contract before the previous contract is

terminated;

(iii) The board of directors, including a majority of the directors

who are not interested persons of the fund, determines that the scope

and quality of services to be provided to the fund under the interim

contract will be at least equivalent to the scope and quality of

services provided under the previous contract;

(iv) The interim contract provides that the fund's board of

directors or a majority of the fund's outstanding voting securities may

terminate the contract at any time, without the payment of any penalty,

on not more than 10 calendar days' written notice to the investment

adviser;

(v) The interim contract contains the same terms and conditions as

the previous contract, with the exception of its effective and

termination dates, provisions governed by paragraphs (b)(2)(i),

(b)(2)(iv), and (b)(2)(vi) of this section, and any other differences

in terms and conditions that the board of directors, including a

majority of the directors who are not interested persons of the fund,

finds to be immaterial; and

(vi) The interim contract contains the following provisions:

(A) The compensation earned under the contract will be held in an

interest-bearing escrow account with the fund's custodian or a bank.

(B) If a majority of the fund's outstanding voting securities

approve a contract with the investment adviser by the end of the 150-

day period, the amount in the escrow account (including interest

earned) will be paid to the investment adviser.

(C) If a majority of the fund's outstanding voting securities do

not approve a contract with the investment adviser, the investment

adviser will be paid, out of the escrow account, the lesser of:

(1) Any costs incurred in performing the interim contract (plus

interest earned on that amount while in escrow); or

(2) The total amount in the escrow account (plus interest earned).

Dated: July 22, 1998.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98-20088 Filed 7-27-98; 8:45 am]

BILLING CODE 8010-01-U