SECURITIES AND EXCHANGE COMMISSION-EXPLANATION OF AMENDMENTS TO INVESTMENT COMPANY ACT OF 1940

GENERAL OBJECTIVE OF STATUTE

The general objective of the Investment Company Act is to protect the public and investors against malpractices in the control, management, and operation of publicly owned investment companies. The statute seeks in general to secure honest and unbiased management of investors' funds; to give security holders a substantial voice in the company and in the selection of management; to insure sound and feasible capital structures; to assure fairness in all transactions between affiliated persons and the company; and to see that shareholders are provided with informative, periodic financial reports. The statute contains provisions for enforcement by the Commission through administrative and injunctive action and for the referral of information concerning violations to the Department of Justice for criminal prosecution.

WHAT THE BILL WILL DO

The amendments embodied in the bill are recommended by the Securities and Exchange Commission as desirable to further the basic intent and objectives of the statute.

These recommendations for changes in the Investment Company Act of 1940 are, for the most part, limited to the clarification of certain provisions, the elimination of inconsistencies, changes to achieve the obvious intent and purpose of a particular provision and conformance of references to other statutes. In several instances, however, substantive amendments are recommended which are considered highly desirable in order to effectuate the purposes and policy of the statute. The Commission has not, nevertheless, made any broad or sweeping recommendations which might involve an extension of the Commission's present supervision over investment companies and their affiliates or which would involve substantially greater limitations upon the management of investment companies.

Briefly, the more significant of the proposed amendments would (1) require the statement of policy of a registered investment company, which cannot be changed without the consent or approval of the holders of a majority of the voting securities, to include its fundamental investment objectives and investment characteristics; (2) strengthen the statutory provisions requiring that at least 40 percent of the members of the board of directors be persons who have no pecuniary interest in the operations and management of the investment company and who are not part of its operating staff; (3) require that if an investment company chooses to keep its securities and investments in the "custody of a bank" such custodianship shall include the cash assets of the investment company; (4) impose limitations upon the proportion of common or preferred stock that may be acquired by face-amount certificate companies issuing fixed obligations (face-amount certificates) to prevent such obligations from becoming unduly speculative; (5) clarify and make more meaningful the definition of an "advisory board" of an investment company and the substantive provisions requiring such a board to have a certain number of independent members; (6) clarify certain exceptions to the definition of an investment company required to register under the act; (7) eliminate the exception from the definition of an investment company for a company subject to regulation under the Interstate Commerce Act when this Commission finds and by order declares that such company is primarily engaged in the business of investing, reinvesting, owning, holding, or trading in securities; and (8) clarify the terms "depositor" and "share of stock" used in the statute by adding specific definitions of these terms. Section 1. Modification of the status of an "advisory board" of an investment company

Present law.-"Advisory board" of an investment company is defined in section 2(a)(1) of the Investment Company Act as a board (1) which is distinct from the board of directors or board of trustees; (2) which has advisory functions but no power to determine that any security or other investment shall be purchased or sold; and (3) which is composed solely of persons who do not serve such company in any other capacity.

Problem.-The latter qualifying provision has created a problem because it appears to be in the nature of a regulatory provision rather than a descriptive provision.

Section 10(g) provides that the same limitations of section 10 applicable to the composition of the board of directors of a registered investment company shall apply to an advisory board. For example, not more than 60 percent of the members of an advisory board may be affiliated persons of the investment adviser under section 10(a) as made applicable by section 10(g).

Through the use of an investment advisory “committee" or an advisory “group of consultants" rather than a "board" and through the appointment on such committee or group of an officer or employee who does "serve such company in any other capacity," it has been contended that the resulting committee or group is not an "advisory board" within the terms of section 2(a)(1) and, consequently, that the limitations of section 10(g) do not apply. If this were true it would be simple for an investment company to avoid having its advisory committee deemed an "advisory board" within the meaning of the act. Thus, persons in an advisory position with the investment company and who should be considered "affiliated persons" of the investment company would not be so considered and would not be subject to such important provisions of the act as those contained in section 10(f) and section 17 relating generally to prohibitions with respect to transactions by an investment company involving an affiliated perso. Whether or not an "advisory board" exists would in this manner rest entirely within the discretion of the investment company.

Although the Commission has handled this problem administratively by insisting that a company may not represent in its prospectus that it has an “advisory board," or its equivalent, unless the board actually meets the definition of section 2(a) (1), the statute should be amended to make it more workable and meaningful.

It is also to be noted that because the present definition of advisory board in the statute refers to a board "which is composed solely of persons who do not serve such company in any other capacity," the membership of such a board is in effect subject to greater statutory restrictions than the membership of the board of directors.

Remedy in the bill.-This change would bring all investment advisory boards, committees, and groups within the definition of "advisory board." Under section 10(g), the same limitations applicable to the board of directors of the investment company would be applicable to the members of such advisory boards. There appears to be no sound reason for an advisory board, which has only advisory functions, to have any greater quantum of independent directors than the board of directors itself which has the actual power to make decisions and take action.

On the other hand there would be a specific exclusion for committees composed solely of directors, officers, or employees of an investment company or of its investment adviser. There is no intention that such management or executive committees be affected by the provisions applicable to advisory boards. Section 2. Definition of "depositor" of an unincorporated investment company Present law. The term "depositor" is not defined in the statute. Problem.-The term "depositor" is used in various sections of the act, including sections 2(a) (3), 7(b), 9(a), 10(b), 26, and 27. Although the meaning of "depositor" is ascertainable from the context in which it is used and may also be derived from the legislative history of the act, it would seem advisable to have an express definition of the term. The words was most frequently used. prior to the enactment of the statute, to describe the person or company causing the formation of a fixed trust or semifixed trust during the period when these types of investment trusts were popular. It is used in the statute to describe the person or company promoting, sponsoring, or administering any unincorporated fund or trust constituting an investment company, or who as sponsor or manager of such fund or trust deposits portfolio assets with the trustee or custodian of the fund or trust or who may direct the deposit of additional or substituted securities and the elimination of deposited securities.

Remedy in the bill.-The term would be defined as indicated above. Since a trustee or custodian designated in accordance with the provisions of section 26 of the act may, in some cases, be responsible for one or more of such functions, the definition would specifically exclude them.

Section 3. Definition of term "share of stock"

Present law. The term "share of stock" is not defined in the statute. Problem.-Reference is made in several provisions of the act to shares of stock. stockholders, and to stock. Sections 12(d), 18(i), 23(b), and 30(d) contain

such terms. While it is apparent that the statutory purpose cannot be avoided by designating a security by some other name, the question has arisen in a sufficient number of cases to suggest the advisability of making it expressly clear that the term "shares of stock" means any security similar in nature to an equity security. The term "security" as now defined includes certificates of beneficial interest, shares in a fund or trust, participation in profit-sharing arrangements, and investment contracts.

The terms "stockholder" and "stock" would in effect be covered by the same proposed definition.

Remedy in the bill.-The term would be defined as meaning any security similar in nature to an equity security.

Section 4. Elimination of reference to the Philippine Islands and Alaska in the definition of "State"

Present law.-Section 2(a) (37) of the act defines the term "State" to include any State of the United States and, in addition, among others, the Philippine Islands and Alaska.

Problem.-The Philippine Islands are no longer a possession and Alaska is now

a State.

Remedy in the bill.-The amendment would delete these references.

Section 5. Modification of exception from the act for company engaged in banking, insurance, small loans, factoring, discount, or real, estate business Present law.-Section 3 (c) (7) of the act provides an exception for"(7) Any company primarily engaged, directly or through majority-owned subsidiaries in one or more of the businesses described in pargraphs (3), (5), and (6), or in one or more of such businesses (from which not less than 25 per centum of such company's gross income during its last fiscal year was derived) together with an additional business or businesses other than investing, reinvesting, owning, holding or trading in securities."

Problem. If taken literally, this section would provide an exception for a company primarily engaged, directly or through majority-owned subsidiaries, in one of the following:

(a) The banking or insurance company business.
(b) The small loan business. Section 3 (c) (5) ; or

Section 3(c) (3); or

(c) The commercial discount, factoring, or real estate business. Section 3(c) (6). Yet each of these provisions, that is, section 3(c)(3), (5), and (6), has a test which is greater than the test of "primarily engaged." Section 3(c)(3), for example, refers to an insurance company, which in section 2(a) (17) is defined as a company, organized as an insurance company, whose "primary and predominant" business activity is writing insurance or reinsuring risks and which is supervised by a State official or agency. Section 3(c) (5) refers to a company "substantially all of whose business" is the small loan business. Section 3 (c) (6) has the primary engagement test but excludes face-amount companies and periodic payment plans.

The specific exceptions with their stricter tests are obviously the ones intended rather than the more generalized and indirect exception of section 3(c) (7). This has been the Commission's interpretation following ordinary rules of statutory construction. The section, however, should be revised to make this clear and yet carry out the intention to exempt a company which does business, directly or through majority-owned subsidiaries, in the financial fields of banking, insurance, small loans, factoring, and mortgages, but which may fall within the definition of investment company under section 3(a) (3) because it deals in "securities," and "securities" constitute its major assets. On the other hand, where a company engages in a number of such activities and also engages in the business of investing, reinvesting, owning, holding, or trading in securities to a significant extent, it should not be entitled to the exception of section 3(c) (7). This follows the approach taken in section 3(c) (5), the exception for small loan companies.

Remedy in the bill.-Section 3(c) (7) would be amended to limit the exception to a company substantially all of whose business consists of one or more of the businesses described in section 3(c) (3), (5), and (6) and to add a proviso to exclude face-amount companies and periodic payment plans in the case of section 3(c) (6) businesses.