the lines mentioned above (Hearings on H.R. 10065 before subcommittee of House Interstate and Foreign Commerce Committee, 76th Cong., 3d sess. 63). After 5 weeks of steady work, the conferees came up with a memorandum of agreement in principle (May 13, 1940). Then a bill was prepared on the basis of the agreement, substantially a redraft of the original bill, and substantially in the form now embodied in the statute.

The memorandum of May 13, 1940, was circulated among the investment companies who had appeared at the hearings and among other companies. Arthur Bunker stated (House hearings 71): "This agreement received unanimous endorsement of the industry."

Regarding affiliations of directors, the memorandum of agreement in principle stated (House hearings 97):

"9. Affiliations of directors (sec. 10, present bill).—As a complete substitution for the provisions of section 10 of the bill as introduced, the following is to be substituted:

"(1) In the event that the board of directors of any investment company shall have a majority of directors who are independent of principal underwriters, regular brokers, investment bankers, all restrictions of the present section 10 are eliminated except "No registered investment company *** (Here follow provisions substantially similar to present sec. 10 (f)." * * *

"'(2) In respect of investment companies where no officer or director acts either as the principal underwriter, regular broker, investment banker, or manager, the directors, independent of managers or officers need number only 40 percent."

It will be seen that (1) above is the predecessor provision of present section 10(b) and (2) above is the predecessor of section 10(a). Obviously a compromise had been reached between the SEC which was arguing for a majority of independent directors and the industry which wanted no more than a minority. The SEC obtained majority independence as indicated by (1) above and as reflected in section 10(b), and the industry got its way as indicated by (2) above and as should have been reflected in section 10(a). For it is to be noted that (2) above was premised on the assumption that no director would be a principal underwriter, regular broker, or investment banker. There is no question, therefore, that under the agreement in principle between the SEC and industry the two parts of the compromise measure were to be keyed together. This was entirely reasonable and logical in the light of the legislative history preceding the compromise and the absurd result flowing from a failure to interrelate both subsections.

We do not know of any reason why this agreement was not carried out in drafting section 10(a) and 10(b). It may well be attributed to "inadvertence" due to the extreme pressure on the draftsman of rewriting an entire comprehensive regulatory statute in a very short time.

The NAIC in its memorandum to the Senate subcommittee has referred to David Schenker's testimony as support for its statement that there was no intention on the part of Congress to interrelate sections 10 (a) and 10(b). But this testimony, and the Senate report also referred to, are simply descriptive of sections 10(a) and 10(b) and upon close analysis entirely consistent with a belief that the two subsections would be read together. Mr. Schenker's view that as a result of subsection (b) a broker, investment banker, or principal distributor could no longer "dominate the board" must have been based upon the opinion that such a broker, investment banker, or principal distributor could not organize an investment company and fill the minority positions on the board with its own directors and the majority positions with officers of the company.

STAFF MEMORANDUM ON AMENDMENTS TO S. 1181, THE INVESTMENT COMPANY ACT OF 1940

The Investment Company Act of 1940 is a regulatory statute, dealing with the structure and corporate activities of investment companies. In this respect it differs from the Securities Act of 1933, which is primarily a disclosure act, with punitive sanctions for failure to disclose or for false disclosures.

The 1940 act set forth certain requirements with respect to the capital structure of companies; it regulates dealings between investment companies and persons affiliated with them; it prohibits self dealing on the part of officers, directors, and affiliates of investment companies; it prohibits activities gener

ally which might be in the interests of other than the shareholders of the companies; and it provides for ultimate shareholder control with respect to important investment company relationships such as its contracts with investment advisers and underwriters.

Information to be made public must be filed with the SEC in a registration statement. The act provides that companies shall not change their investment policy, as indicated in the registration statement, unless authorized to do so by a majority vote.

Further, to limit the transfer of control of investment companies from one group to another, section 16 provides that no person may serve as a director of an investment company unless elected to that position by the holders of the voting securities.

Many provisions of the act are attempts to insure that the companies shall be honestly run in the interests of all classes of stockholders. For example, persons convicted of a crime arising out of the securities business may not serve as officers.

To minimize the danger of abuse of power by insiders, the act provides that there shall be sufficient independent directors to make it difficult for brokers, underwriters and bankers to take undue advantage of their position, though it does not directly prohibit bankers or brokers from serving as officers and directors of investment companies.

Further limitations on insiders are contained elsewhere, prohibiting officers, directors, and principal underwriters from selling securities to the company, or buying them from the company, or borrowing money or property from the company. Excessive commissions for insiders who act as brokers for an investment company are likewise outlawed.

The issuance of nonvoting stock is prohibited; moreover, each share of voting stock must have a vote equal to every other voting share. Voting trusts may not be used for investment company securities.

Certain other provisions, together with the requirement that all preferred dividends shall be cumulative, serve to protect bondholders and preferred stockholders in the event that the company proves unprofitable.

Controls on pyramiding prevent an increase of that abuse, but do nothing to change the existing situation.

Other provisions of the act prohibit the issuance of excessive amounts of bonds and preferred stock, restrict the payment of dividends, provide for regulation of the solicitation of proxies, and lay down rules concerning plans for reorganization. The Commission is given broad powers to require reports from the companies, their officers and directors, to prescribe forms and methods of keeping accounts and records, and so on.

AMENDMENTS TO THE INVESTMENT COMPANY ACT OF 1940, S. 1181

Amendments in S. 1181 are recommended by the SEC to clarify certain provisions and to effectuate the purposes of the act. This memorandum discusses the principal substantive amendments; technical provisions have been omitted. The most significant of the proposed amendments would (1) increase the recital of investment policy required in the registration statement; (2) increase the recital required for special classes of stock; (3) increase the number of independent directors on the board; (4) redefine the meaning of "advisory board"; (5) define strictly the exception for transactions of an underwriter subsidiary of an investment company; and (6) require that bank custodianship must include holding cash assets of the investment company. Section 7 of S. 1181, redefining an exception from the act for a company regulated by the ICC, is not discussed in this memorandum.

Section 12. Increased recital of investment policy

The principal functions of investment companies, and of their directors. officers, and advisers, is the management of their investment portfolios. Everything else is incidental to the performance of this function. Neither the Investment Company Act of 1940 nor any other law imposes many restraints on this function, or gives the SEC any broad authority to regulate it.

Section 8(b) (1) requires every registered investment company to file a registration statement including a recital of the policy of the company regarding various important subjects. These involve such matters as diversification, redeemability of its securities, borrowing money, concentration of investments in any particular industry, and making loans. Under section 13 (a) these policies

may not be changed unless authorized by a majority vote of the company's stockholders.

The basic investment objectives and characteristics of the investment company are omitted from the list of subjects as to which policies are to be declared by the investment company, despite the fact that for the SEC this is one of the most significant factors for the public investor to consider.

Whether an investment company is a balanced fund, a bond fund or a common stock fund is so important that financial publications and financial services analyzing or describing investment companies treat such companies in separate categories, or a representation that its investment objective is primarily capital appreciation or income.

Nevertheless, if a company does not choose to treat these objectives or characteristics as fundamental under section 8(b) (2), it may change its policy as to them without obtaining the consent or approval of its stockholders.

Despite the foregoing, it should be added that the Commission has power to control certain of this information in another manner. Since investment companies also are obliged to register their new offerings of shares under the Securities Act of 1933, some aspects of the company must be disclosed in the registration statement and presumably in the prospectus. For open-end companies, a new registration may be filed every 16 months. If a company stated therein that it would invest in bonds, commenced selling the issue, and then began investing in common stock, the SEC would consider that a misstatement of a material fact. It would then by stop-order proceeding prohibit the sale of the remainder of the stock.

The objectives described above, that of a balanced fund or income appreciation, are of at least equal importance with the matters required to be stated under section 8(b) (1) and, the SEC feels, should be required to be set forth as a statement of fundamental policy which could not be changed without the consent of the stockholders. Therefore, SEC proposes to amend section 8(b) (2) to require a recital of policy in respect of (1) the types of securities in which the company intends to invest; (2) the investment objectives, as to income or capital appreciation, if it intends to emphasize such objectives; (3) geographical areas of investment, if any; and (4) investment for control or management. Appropriate reservation of freedom to invest in so-called defensive securities may be made under the amendment.

Strong industry opposition to the proposed section 12, has been voiced by the National Association of Investment Companies. It believes that this is a further encroachment on management of investment portfolios, the one thing that the act was not designed to curtail. If an open-end company stated that it would be a balanced fund, there might be occasion to shift the proportion between bonds to income securities when a change in the market justified a defensive move. Such a change might not be considered by the management to be a change in investment policy and thus one requiring approval of a majority of stockholders. If the shift lost money, would the SEC then punish the company for failing to get the approval or stop the sale of the remainder of the issue? To the industry there is a real possibility that in this way the Commission might "second-guess" management decisions.

The reply of the SEC is that the worry is not justified: a sudden switch from bonds to income stocks, for instance, is already subject to the powers of the SEC under the 1933 act, as described.

Moreover, the Commission says it has no intention of restricting management beyond requiring approval for significant changes in policy. For the wording of the new section says that the investment policy of the company may make "appropriate reservations of freedom of action for the protection of investors," before requiring the new areas to be specified.

Under this clause the company may claim it reserves the freedom to move from one type of investment to another for the purpose of defensive switches. It is the company which advertises and attracts buyers on the representation that it is only one type of fund which should be prohibited from quick transferral, urges the SEC. That company has not made the reservation and so should be required to get permission from its shareholders.

The reply of the industry is that though the defensive clause for freedom of action is necessary, it will encourage vague hedging reservations by all companies, similar to those which appear in corporation franchises. Moreover, industry anticipates the SEC will consider itself the final arbiter of the width of the "freedom." To the former, even intelligent minds may differ as to whether a particular investment is appropriate to the objective stated.

The attitude of the SEC is that since the NAIC has not opposed in principle the necessity of such a vote, the industry should not fear the actions of the Commission any more than the approval of their own shareholders.

The remaining fear of the investment companies is that under the new recitals of policy, stockholders will be encouraged to sue for a misrepresentation of a material fact when a shift without approval has turned out unsuccessfully.

To the regulated companies, detailed information may more accurately be sought by the investor in periodic reports and prospectuses.

In addition, they argue that investors in these companies really invest in management, not necessarily in the type of fund advertised. Moreover, if the investor is not satisfied, an open-end company (one which redeems its shares) values shares twice a day and will buy them back. The SEC responds that repurchase would not return the enormous overhead for the initial price.

Specifically, industry opposes 8(b) (2) (A), the statement of “extent" of "general" intention to invest in bonds or common stocks. It foresees the Commission reducing these ideas to a formula which will impede management. It also opposes the proposed paragraph (B), calling for specification of objectives as to income, or capital appreciation, as too vague and applicable to all investments. Paragraphs (C), on geographical concentration, and (D), on investment for control or mangement are not so objectionable to the NAIC, since they are special situations and the former is more properly subject to uniform interpretation.

If the amendment proposed in section 12 is adopted, an accompanying amendment to section 13(a) (3) is proposed in section 16 of S. 1181, to prohibit any change or deviation from the statement of policy in this regard without a majority vote of stockholders.

Section 21. Investment policy recital required for issuing special series or classes of stock

Section 18(f) (2) of the act permits an open-end company to have classes or series of stock, each of which has an interest in specific assets allocated to such class or series. There is no specific requirement in section 8(b) for a recital of policy in respect of each class or series of stock and it is not clear whether a change in policy as to any particular class must be approved by the stockholders of that class or by all stockholders of the company.

In effect this type of corporation comprises a number of individual funds, with each share issued by the company having an interest in only one of such funds. Each fund has its own investment objectives and characteristics and is, in effect, for investment purposes, a separate entity. Moreover, it is anomalous to consider such a company as diversified unless the assets allocated to each series are diversified.

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Therefore, section 21 of S. 1181 would add a new paragraph to section 18(f) (2) of the act, requiring a separate recital of policy according to section 8(b) whether the fund is a face-amount certificate company, a unit investment trust, or a management company. If the latter, then a specification must be made as to whether open- or closed-end, diversified or not; also as to borrowing money, issuing senior securities, underwriting, making loans, etc. Moreover. the detail as to each fund's recital may be considerably increased if section 12 of S. 1181, above, is passed, necessitating further description.

Under section 13, the policies stated for each series or class of stock could be changed by a majority vote of those stockholders affected by the change. Section 10. "Diversified investment company" defined strictly

Section 5(b) classifies management investment companies as diversified or nondiversified companies. This is necessary because certain substantive requirements apply to diversified companies. For example, such companies may not change their policy and become nondiversified without a majority vote of stockholders (section 13 (a) (1)).

In order to qualify as a diversified company, at least 75 percent of the value of the total assets of a company must be represented by

(a) Cash and cash items;

(b) Government securities;

(c) Securities of other investment companies; and

(d) Other securities limited in respect of any one issuer to not more than 5 percent of the value of the total assets of the investment company and 10 percent of the voting securities of such issuer.

A company may have its entire portfolio or a major portion of its portfolio in the securities of other investment companies. The extent of diversification of

of the portfolio investment company in this case is significant. If the portfolio company is nondiversified, the investing company is also essentially nondiversified, although it would be technically classified as diversified. This result was not intended, says the SEC.

Section 5(b) (1) would be amended to provide that the securities of other investment companies which can be included within the 75 percent of assets required to be diversified must be securities of diversified investment companies. As a practical matter, the Commission adds that there is only one investment company which has become thus nondiversified.

Section 13. Increase of independent directors

Some investment company critics have insisted that investment companies must be segregated from any investment banker, security dealer, broker, or similar person, and from any person acting as its investment adviser or distributor of its securities-that is to say, that all such persons should be excluded from acting as officers or directors of investment companies.

Specifically, there have been instances of investment houses selling securities to affiliated investment companies under circumstances which constituted a conscious unloading of securities on the investment company. Charges were made that frequent switches were made in investments with one eye on brokerage commissions to be derived, and distributors of investment company securities who controlled investment companies were said to place undue emphasis on selling to the detriment of management.

The conclusion finally reached by the Commission in 1940, after 3 years of investigation, was not to recommend extreme segregation, although proposing safeguards in the way of prohibitions considerably beyond those in the act as finally enacted.

The stringent features of the original bill, S. 3580, were so strongly opposed by industry that Senator Wagner, chairman of the Senate Banking and Currency Committee, suggested that the two points of view be compromised. The industry representatives then wrote the framework of their own proposed legislation. When the present Investment Company Act of 1940 emerged, however, both the SEC and industry had triumphed in separate sections. The act, states the report (No. 1775 on S. 4108, 76th Cong., 3d sess., p. 2), had the "virtually unanimous support" of both factions.

The theory of section 10, the main section on affiliations of directors, along with sections 15 and 17, is (1) that it is desirable that all investment company transactions be subject to the scrutiny of at least a minority of directors independent of the management and (2) that in cases where affiliations of directors might involve conflict of interest, stockholders are entitled to the protection afforded by the existence of a majority of disinterested directors. This latter protection, coupled with the specific prohibitions on certain transactions of directors and affiliated persons and other safeguards of the act, was deemed sufficient. (Jaretzki, the Investment Company Act, 26 Wash. U.L.Q., 303, 320 (1941)).

Section 10 (a), (b), and (c) have the general purpose of assuring that an investment company will have a certain number of independent directors on the board of directors. Section 10(a) is designed to assure that at least 40 percent of the members of the board will be persons who have no pecuniary interest in the management of the investment company and who are not part of its operating staff. Thus, this provides that no more than 60 percent of the directors will be officers, employees, or investment advisers of the investment company, or affiliated persons of an investment adviser of the investment company. It was in this part that the industry's point of view prevailed, that the officers of the company should not lose a vote to outsiders on the board.

Section 10(b) goes further in providing that a majority of the board may not be directors who are regular brokers or principal underwriters of the investment company or who are investment bankers. These provisions also cover affiliated persons of these persons. Section 10(c) provides that a majority of the board may not be officers or directors of any one bank. In this provision the point of view of the Commission prevailed, that keeping such persons to a minority of the board would reduce the potential conflict of interests.

The SEC argues, however, that because of the limited scope of section 10(a) and the fact that sections 10(a) and 10(b) are not keyed together, it is possible to have a board composed of no "independent" directors. For example, a board of five members could consist of three officers and two regular brokers for the company, or three officers and two principal underwriters for the company, or