Section 21. Clarification and extension of investment policy recital requirements relating to companies issuing special series or classes of stock Present law. Section 18 (f) (2) 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.

Problem.-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. Since each of these "funds" has its own investment policies, it would be reasonable to treat each "fund" separately under sections 8(b) and 13. Thus, the policies stated for each series or class of stock would be changed solely by a majority vote of those stockholders affected by the change.

Remedy in the bill.-Section 18(f) (2), which permits this particular type of company, would be amended to require a recital of policy in respect of each series or class of stock in accordance with section 8(b) (1) and (2), and any change in policy would have to be authorized solely by the majority vote of holders of such series or class of stock.

Section 22. Tightening provisions relating to cross ownership and circular ownership

Present law.-Section 20 (d) makes it the duty of an investment company to eliminate within 5 years after the effective date of the act, "cross ownership" or "circular ownership", existing on the effective date of the act. Thereafter, if cross ownership or circular ownership comes into existence "upon the purchase by a registered company of the securities of another company," the investment company has the duty to eliminate such cross ownership or circular ownership within 1 year after it knows of its existence.

Problem. It is not adequate to require an investment company to eliminate only those cross holdings caused by its own purchase of the securities of another company, since a company controlled through stock ownership by an investment company might contend that it can buy securities of the investment company with impunity. This would negate the objectives of this section of the act. While section 48(a), which makes it unlawful for a controlling person to cause to be done any act which would be unlawful for such person to do, might be invoked in this case, it would seem appropriate to amend section 20 (b) to prohibit expressly such action by a controlled company.

Remedy in the bill.-The bill would amend section 20 (d) to require the elimination of cross ownership or circular ownership created by a controlled company.

Section 23. Correction of provision relating to sales of stock by closed-end company below net asset value with consent of stockholders

Present law-Section 23(b) prohibits the sale of stock of a closed-end investment company at a price below the current net asset value "except (2) with the consent of a majority of its common stockholders * * *"

Problem. From the content of the statute, it is clear that the language should read "with the consent of the holders of a majority of its common stock." Remedy in the bill. The correct phrase would be substituted for the present

one.

Section 24. Providing limitations on holdings of common and preferred stock by face-amount certificate companies

Present law.-A face-amount certificate company may be briefly described as an investment company engaged in the business of selling its own unsecured debentures or debt obligations on the installment basis. The proceeds are invested and used, together with increments, to pay the obligations at maturity. Section 28(b) requires a face-amount certificate company to have cash or qualified investments equal to its capital stock requirements and certificate reserves. Qualified investments are those "of a kind" permitted under the District of Columbia Code for insurance companies and such other investments as the Commission may authorize. Since life insurance companies may purchase com

mon and preferred stocks under the District Code, if they meet certain tests, faceamount certificate companies may also purchase such securities. The act places no limitation on the proportion of common or preferred stock that face-amount certificate companies may acquire.

Problem. The face-amount certificate companies studied by the Commission prior to 1940 invested in real estate mortgages and high grade corporate bonds and preferred stock in view of the fixed obligations they undertook to pay at maturity. The failure to place a limitation on the amount of common stock or preferred stock that such companies may acquire would seem to have been an unintentional omission. The entire thrust of the provisions of section 28 is to assure that the company will be able to meet its liabilities. This is not only shown by the legislative history of the act, but is evident from the very elaborate provisions of section 28 itself requiring the maintenance of reserves and requiring their computation on the basis of a rate of accumulation limited to not more than 3%1⁄2 percent per annum. To make these requirements meaningful, a limitation on the proportion of common and preferred stock which may be maintained as part of the reserve is required. It would be contrary to the purpose of the act to permit faceamount companies to invest in the more speculative types of securities such as common stocks to any appreciable extent.

The Commission has considered the views of one of the face-amount companies registered under the act which would be seriously affected by a stringent restriction on investment in common stock. This company issues face-amount certificates of the installment type in series which provide (1) for a fixed obligation at the end of a 10-year period to pay an amount approximately equal to the amount paid to the company by the holder and (2) for a participation in the income and possible profits derived from the funds paid in. It is an integral part of the company's purpose and structure that a portion of its funds be invested in stocks to provide for income and possible capital appreciation. The recommended amendment to section 28, discussed below, would provide reasonable limitations upon stock investments by face-amount companies, but would not impair the arrangement adopted by this face-amount company.

Remedy in the bill.—Two approaches were taken to the problem. Based upon analogy to the insurance field, an overall limitation of 10 percent of the certificate reserves has been suggested as to common stock and 25 percent as to preferred stock. Some flexibility is thereby accorded to the company in its investment program but most of the speculative element is eliminated by limiting the amount of investment in equity securities. In addition, by analogy to the restrictions in section 18 of the act applicable to closed-end companies, it is believed that additional common stock investments may be warranted where there is asset coverage protection furnished by the capital, or stockholders' equity. An asset coverage equal to 200 percent was selected rather than the 300 percent figure used in section 18 (a) (1) because of the additional limitations imposed by the District of Columbia Code applicable under section 28(b). These additional limitations of the code relate to earnings and dividends tests which must be met by the common stock before it may be acquired.

Therefore, it is provided that certificate reserves may also include common stock investments in an amount equal to 100 percent of the stockholders' equity in the company represented by assets consisting of cash or qualified investments. In addition, since the same degree of protection would be afforded, it is also provided that to the extent that the stockholders' equity consists of cash or qualified investments other than common stocks or similar equity securities, the required certificate reserves may include common stock investments equal to 100 percent of such assets. Where certificate reserves and assets are separately allocated for series of certificates, the 10 percent and 25 percent overall percentage limitations would apply to each series which is in effect a separate fund. On the other hand, since the stockholders' equity is a cushion of security for each certificate issued by the company regardless of its series, more flexibility may be permitted in allocating the amount of common stock investments made pursuant to the asset coverage test. To guard against undue speculation in any series of certificates, a limitation of 30 percent applicable to each series is suggested. Sections 25 and 26

Would change the references in section 43(a) and 44 to the Judicial Code to reflect redesignation of these provisions in the United States Code.

Section 27. Effective date for proposed amendments

Since presently registered investment companies may need some time to comply with the amendments to sections 5, 8(b) (2), and 18(f) (2), it is proposed

that these sections would not become effective until 6 months after the date of enactment of the bill. In addition, it is provided that the terms of section 28(b) (2) would not apply to series of face-amount certificates outstanding prior to the enactment of this section, where the reserve requirements of such series are maintained separately. This would avoid any retroactive effect of the limitations of this section to face-amount certificate companies which have sold series of such certificates on the representation that the holders would participate in the earnings to be realized from a separate fund of investments, including, among other things, common stocks without any limit as to the amount thereof specified in the statute. In all other respects, the amendments would be effective upon enactment of the bill.

MEMORANDUM OF THE DIVISION OF CORPORATE REGULATION OF THE SECURITIES AND EXCHANGE COMMISSION ON AMENDMENTS PROPOSED IN SECTIONS 12, 13, AND 16 OF S. 1181

The National Association of Investment Companies (NAIC) has opposed two proposed changes in the Investment Company Act of 1940: (1) Amendments which would require investment policies not to be changed without approval of share holders, and (2) an amendment which would strengthen the requirement of a minimum number of independent directors on the boards of investment companies. This memorandum supplements the statements previously submitted to the committee in justification of the Commission's recommendations. 1. Recommendations relating to recitals of investment policy and adherence to such policy unless authorized by a majority vote of stockholders (a) The NAIC does not actually express disagreement with the purpose of the Commission's recommendation. Although desirous of retaining complete freedom of action, they have not said that stockholders should not have the opportunity to voice their opinion regarding a change in fundamental policy. Instead they have extolled the benefit of "flexibility," mistakenly assuming that the proposed amendment would prevent any desired flexibility which is adequately represented; and they have expressed fears as to how the provision would be administered by the SEC. In this respect, they have apparently misconceived the nature of the proposal, despite the many conferences between the staff of the SEC and industry representatives and despite the adoption of specific language in the proposed amendment by the SEC suggested by industry. Within the area of investment policy chosen by investment company management, not by the SEC, there would be complete flexibility. If the investment company desires to be completely unrestricted as to the type of securities in which it intends to invest, and so represents, it would have complete flexibility. It would never have to get a vote of stockholders unless it changes this policy. On the other hand, if it is a common stock fund and it so represents, there is no reason why it should not get the consent of shareholders if it believes that preferred stocks or bonds should be the new vehicle for investments. The terms "balanced fund," "growth fund," "income fund," and the like are words which have taken on definite meaning in the financial world. The NAIC has not made it clear why these objectives should be subject to change without a vote of the shareholders who relied upon them when purchasing their shares.

The NAIC points out that investment companies differ in their purposes and Mr. Eaton stated that the public is offered many different kinds of investment companies. There is no denial that investment companies vary widely in their investment objectives and characteristics. Some are conservative; some more speculative. These investment policies are emphasized in prospectuses, in sales literature, in advertisements. The position of the SEC is simply that the public invests on the basis of these representations and in fariness these policies ought not to be changed without shareholders getting a chance to express their approval or disapproval.

Typical investment company advertisements illustrating emphasis on various investment policies are shown in appendix A. Typical recitals of investment policy, disclosed in prospectuses, are set forth in appendix B.

1 The National Association of Investment Companies represents 180 registered investment companies holding over $15 billion of assets. There are 511 investment companies registered under the Investment Company Act. Total assets are estimated at over $18 billion.

2 Secs. 12 and 16 of S. 1181.

Sec. 13 of S. 1181.

(b) The SEC has never taken the position that investment objectives must be stated with mathematical precision (NAIC memo 9) and the proposed amendment would clearly not require such precision. The functions of the SEC. whether from the disclosure standpoint as at present or from the standpoint of regulation under the proposed amendment, would continue to be the same. As it endeavors to do now, the SEC would try to assure definitive, consistent, and meaningful statements and to avoid misleading, incomplete, or inadequate statements. It would, as it does now, attempt to eliminate "doubletalk," to use the vernacular. But it would not "interfere with" or "oversee" the discretion of management within the limits established by management.

(c) The NAIC raises the question as to the possibility of differences of opinion between the SEC and the company as to when a vote of shareholders would be required. Apparently there is no objection to the principle of the proposed amendment (none having been expressed) but there are apparently fears as to the borderline cases and as to the decision of the SEC staff members in such cases. Naturally, differences of opinion may occur but the company is fully protected against adverse views of the staff by taking the matter up with the Commission which is always available for such purposes. This com plaint comes with poor grace when considered against a background of over 18 years of administrative regulation in this area of fundamental investment policy without a single court dispute by company, Commission, or shareholder. During this period, as the NAIC notes (NAIC memo 3), public confidence has been established in the industry and the assets entrusted to it have grown from $2 to $18 billion.

(d) The proposed amendment is also criticized as "vague" and "indefinite." It is difficult to see the basis for this charge unless the industry itself contends that their representations to the public that they are selling shares in a "balanced," "common stock," "growth stock," or "income" fund are themselves so "vague" and "indefinite" that they cannot be supported by a meaningful, lucid statement of investment policy. Surely the NAIC does not intend to urge that all the sales talk is just so much "vague" and "indefinite" puffing. This is completely inconsistent with Mr. Eaton's statement regarding the industry's constructive job of merchandising and is not what investors and the SEC have been given to understand.

2. The principal NAIC objections to the recommended change in section 10(a) to assure a minimum number of independent directors are not addressed to the basic desirability of the SEC proposal

These objections rather involve collateral considerations: (1) increased diffi culty in recruiting competent directors; and (2) misconstruction by the SEC of the intent of Congress in enacting section 10. The NAIC also asserts that there has been no showing of necessity for the proposal.

(a) Regarding the alleged difficulty experienced by industry in recruiting directors, the NAIC furnishes no evidence but merely points to two restrictions which narrow the choice of prospective candidates.

One restriction involves attorneys who act as counsel for the investment com. pany. But these attorneys are not excluded from acting as directors. They are simply not considered "independent" directors under section 10(a) because they are employed by the company. The investment company in fact may have any number of lawyers on the board who are not regularly retained by the company. This source of directors is of course fairly broad.

The other restriction concerns bank officials under a Federal Reserve Board ruling as to the limitations of section 32 of the Banking Act of 1933. This limi tation applies only to open-end investment companies because they are engaged in the continuous sale of their stock to the public. It does not apply to closedend companies.

It would be unprofitable to explore whether these restrictions "greatly narrow the field from which competent directors can be chosen" or only slightly narrow the field. The argument is irrelevant. A more pertinent question is whether the proposed amendment would greatly narrow the field. The experience of over 18 years is to the contrary. Of more than 350 registered investment companies having boards of directors, only a handful would be affected by the proposed amendment. The overwhelming bulk of investment companies has complied with the spirit and intent of section 10 that there be a minimum number of truly independent directors on the board. Their ability to attract directors has apparently not been diminished by following the principles which the proposed amendment would make mandatory for all.

(b) The second major argument of the NAIC against the independent director amendment is directed to what it conceives to be a basic reason for the SEC proposal: "inadvertence on the part of Congress in 1940 in not keying together' sections 10(a) and 10(b) of the act" (NAIC Memo 13). Whether or not the omission of a "keying together" or an interrelationship was inadvertent or simply not considered at the time is beside the point. The Commission does not rely upon this contention. The issue of course is whether there is a need of amendment at the present time. In fact, the Commission's suggestions go further than the limitations that would obtain if there had been a "keying together" of the two subdivisions of section 10. The SEC proposal, for example, includes "controlling persons" and all stockholders of the investment adviser. Nevertheless, the NAIC is in error in stating that there was no intention on the part of Congress to interrelate sections 10(a) and 10(b) (NAIC Memo 15), The only support for the NAIC statement is the testimony of David Schenker, Chief Counsel of the SEC Investment Trust Study, explaining the provisions of present section 10 and the Senate report describing them. The legislative history of section 10, however, shows to the contrary that there was a distinct intention to interrelate subdivisions (a) and (b) and in fact, the complete testimony of Mr. Schenker indicates the strong probability that he believed they would be interpreted as though interrelated. Furthermore, the use of the word "moreover" in the Senate report when, after describing section 10(a), it proceeds to describe section 10(b), is consistent with the same view. Also consistent with this view is the fact that practically all companies in the industry follow the practice of designating at least 40 percent of the board who are independent of officers and investment advisers (that is, not dependent upon salaries or management fees) and who are also independent of the principal underwriter or regular broker (that is, not dependent upon underwriting or brokerage commissions).

To view the provisions as not interrelated would result in a sterile, meaningless statutory enactment. This point is well illustrated in Mr. Schenker's testimony before the House subcommittee. This testimony follows the paragraph quoted by the NAIC which begins Mr. Schenker's exposition of subsection (b). The two paragraphs are as follows:

Mr. Schenker's statement was that under subsection (b) the broker, investment banker, or principal underwriter could no longer dominate the board. This must necessarily have been based upon the opinion that the independent directors under subsection (a) would also be independent directors under subsection (b). Unless this were so, the principal underwriter or broker, in organizing an investment company, could simply designate the officers of the investment company to be directors, e.g. three of a board of five, and then designate their own directors as directors of the investment company, e.g., two of a board of five. The obvious result would be absolutely no independent directors, using the term "independent" in the sense so forcefully described by Mr. Schenker. And this result would obtain despite what Mr. Schenker said was "one of the most salutary provisions in this bill." It must also be considered that sections 10 (a) and 10(b) are alternatives to a much more restrictive pr posal recommended by the SEC in the original bill. Mr. Schenker can har

Hearings before House Subcommittee on Interstate and Foreign Commerce, 76th Cor 3d sess.. on H.R. 10065 (at 110),:

"You come to a different situation which is dealt with in subsection (b). Howe bill provides that if you have a pecuniary interest more direct than that of mer ager who gets a fee if you have a pecuniary interest in the transactions in whic vestment company effects and have the power to make these transactions, then p give up control of the board.

"What is a classic example of that? The classic example is where an invest is controlled by a brokerage firm. The firm gets the brokerage business of t trust. The firm may be motivated rapidly to turn over the portfolio of the in order to increase its brokerage commissions. Another typical case is * distributes the securities of the investment company. Still another akin to the type of abuse or deficiency prevailing in the broker relations company is controlled by an investment banker. The investment bank to have the investment company make an investment, not based upon of that investment, but because the particular investment may give ba banking business from the company whose securities the investment H I make myself clear? What does this bill here say? Hereafter the b the board. The investment banker cannot dominate the board; thr of the securities of the investment company cannot dominate th directors in each case must be independent of those individuals broker for the investment company, and have control of the pore to subject your activity to the independent scrutiny of a board wi of the independent directors."