United States: SEC Attempts To Resolve Tension Between Global Custodians And Investment Advisers Over Responsibilities With Respect To Foreign Securities Depositories

By Barbara A. Nugent, Esquire

On April 29, 1999, the SEC proposed amendments to Rule 17f-5 under the Investment Company Act of 1940, and the adoption of a new Rule 17f-7 under the Act.1 Rule 17f-5 under the Investment Company Act of 1940 governs custody arrangements for assets of registered investment companies that are held by custodians outside the United States. In a companion release,2 the SEC further delayed compliance with the June 1997 Amendments to Rule 17f-5 (1997 Amendments). In its continuing efforts to resolve the tension the 1997 Amendments created between global custodians and investment advisers, the SEC seeks to resolve the debate about who should bear responsibility for the risks related to custody of fund assets with foreign securities depositories (compulsory depositories). The release also provides the criteria necessary for a compulsory depository to qualify as an eligible foreign securities depository. A securities depository is an entity that acts as a clearinghouse for the settlement of transactions involving uncertificated securities.

Tension Arises

The 1997 Amendments were intended to update Rule 17f-5 to address significant developments that have taken place with respect to foreign custody of fund assets since the rule was initially adopted. Among such developments are the increase in the number of funds participating in foreign markets; the evolution of foreign custodial relationships to include, among other things, paperless book entry systems; and the perceived burden on fund directors to micromanage foreign custody arrangements. Problems with the practical application of the 1997 Amendments arose as fund boards attempted to delegate responsibility for analyzing foreign custody risk and monitoring subcustodian relationships to the fund’s global custodian as a foreign custody manager (FCM). While global custodians were generally willing to accept delegation of responsibility for the foreign bank subcustodians in their own network, they were reluctant to accept delegation of responsibility for compulsory depositories. Global custodians pointed out that, unlike their relationship with their own subcustodian banks with whom they have agreements ¾ access to information and, therefore, the ability to monitor their activities and risks ¾ they have no such relationship with compulsory depositories. Moreover, a compulsory depository may be an instrumentality of a foreign government with an exclusive license to clear transactions in a particular country. Therefore, it may be legally and practically necessary for a fund that wants to operate in foreign markets to use the depository, and a decision not to use the compulsory depository because of custody risks may, effectively, result in a decision not to invest in a particular country.

Some funds’ boards delegated the responsibility for assessing and monitoring custody risks to the fund’s investment adviser as part of its analysis of country or market risk. However, investment advisers claimed they, too, lacked the necessary information to perform initial and ongoing risk analyses. Confusion continued with respect to how to safeguard fund assets maintained with compulsory depositories, and over who is in the best position to do so.

The SEC received numerous comments and letters in response to the 1997 Amendments, most notably a joint letter sent by representatives of the mutual fund industry and the global custodian banks (Joint Letter). The Joint Letter suggested a list of eight criteria that FCMs could use to make the necessary reasonable care determination about the fitness of compulsory depositories to safeguard fund assets sufficiently. In its most recent releases, the SEC incorporates many of the criteria suggested in the Joint Letter as it attempts to strike a balance between and foster cooperation among investment advisers and global custodians on this issue.

Rule 17f-5 ¾ Amended to Govern Foreign Bank Custodians Only

The SEC proposes to eliminate compulsory depositories from coverage under Rule 17f-5 and, instead, proposes that new Rule 17f-7 govern these depositories. The SEC has further suspended compliance with the 1997 Amendments (except with the definition of eligible securities depositories) until May 1, 2000, or until the SEC adopts these additional amendments and new Rule 17f-7.

Rule 17f-7 ¾ Proposes to Govern Compulsory Depositories

The new rule, as proposed, would specifically govern compulsory depositories. A fund could place assets with a particular compulsory depository only if it meets the standards of an eligible securities depository described below.

Eligible Securities Depository

In addition to the requirement that it be regulated by a foreign financial regulatory authority, the compulsory depository would have to meet four additional criteria that incorporate many of the recommendations contained in the Joint Letter. Specifi-cally, the depository would be required to:

(1) hold a fund’s assets under conditions no less favorable than those applied to other participants;

(2) maintain records identifying each participant’s assets and keep participants’ assets separate from its own;

(3) provide periodic reports to participants; and

(4) undergo periodic reviews by regulatory authorities or independent accountants.

The Custodial Risk - Management Alternatives

Rule 17f-7 also would require funds to choose one of two methods to limit further the risks of maintaining assets with compulsory depositories. A fund could insure or be indemnified against all custody risks of maintaining assets with compulsory depositories by taking out a policy or contracting with a reliable party to compensate it for all losses arising from the use of a compulsory depository. A fund’s coverage under the revised or new rule would be for all custody risks and would not be limited to fund assets foreseeable under a particular contract, as is the case under the current Rule 17f-5. Alternatively, a fund could amend its contract with its global custodian to require the custodian to provide for an initial risk analysis of using a particular depository before assets are placed with the depository. The latter alternative also would require the global custodian to monitor risks continuously and notify the fund or its investment adviser of any material change in risks.

While the global custodian would be required to provide an initial analysis, continued monitoring, and reports of material changes in the custody risks related to maintaining fund assets with a particular compulsory depository, the SEC stopped short of specifying to whom responsibility should be delegated for determining to place or maintain assets in a particular depository. Instead, the SEC stated that responsibility for the decision to place and maintain assets with a particular depository (or to withdraw from that depository and, effectively, from that market or country) could be made by the fund’s investment adviser or by its board of directors under a standard of reasonable care. If the board delegates the decision to the fund’s investment adviser, the board also would be required to oversee the investment adviser’s decision under the reasonable care standard.

SEC Seeks Comment ¾ Key Topics

The SEC is seeking specific comments on whether the intended interaction between the amended Rule 17f-5 and proposed Rule 17f-7 is clear or whether further clarification is needed to resolve these issues.

With respect to new Rule 17f-7, the SEC requests comment on the proposed criteria for eligible securities depositories and, in particular, the effect these criteria may have on investments in developing markets. The SEC is concerned about whether the proposed criteria will hinder investments in developing markets that may not meet

the minimum criteria of eligible securities depository. Alternatively, the SEC solicits comment on whether the minimum criteria may actually encourage depositories in developing markets to meet the criteria.

While the proposed minimum criteria for an eligible securities depository address five of the eight conditions recommended in the Joint Letter, the SEC requests comment on whether it should add the remaining three criteria. The additional criteria provide that:

(1) no foreign regulators may have issued public statements indicating that the depository has not complied with financial strength requirements; or

(2) internal controls requirements, unless the problem has been cured; and

(3) the fund’s custodian must have agreed to comply with the depository’s requirements.

In addition, the SEC asks whether a more simplified general requirement of minimum reasonable commercial standards would be sufficient to safeguard fund assets held by these entities.

Finally, proposed Rule 17f-7 would include transfer agents that hold uncertificated securities for market participants within the definition of an eligible securities depos-itory. The SEC requests comment on this proposal as well. Comments are due by July 15, 1999. n

1 SEC Release No. 1C - 23815

(April 29, 1999)

2 SEC Release No. 1C - 23814 (April 29, 1999)

Information contained in this article should not be construed as legal advice or opinion, or should not be a substitute for legal counsel. This material is provided for informational and educational purposes.