The final objection of the investment companies is that far-reaching new restrictions will make it harder than ever to get qualified directors. This objection, earnestly made in 1940, has become more serious due to two developments: (1) The SEC has ruled that for this purpose lawyers are "employees" and thus fall under the "affiliation" restrictions; (2) in addition, the Federal Reserve Board has interpreted the Banking Act of 1933 to prohibit officers, directors, or employees of a member bank of the Federal Reserve System from acting as directors of an open-end investment company which is continuously offering its share for sale (sec. 32, Banking Act of 1933, 12 U.S.C. 78). These two interpretations drastically reduce the number of qualified people who may act as directors, according to the NAIC. For it is not industrial experience which is needed, but rather banking or trustee work. In general, then, industry feels that it is a question of balancing the benefit against the detriment of obtaining desirable directors by reason of prohibition due to remote possibility of conflict. (See Jaretzki, above, at 318, note 44.)

But the objection is not realistic to the agency, for it finds that in practice most companies already comply with the limitations the amendment would require.

Specifically, the companies do not think a one-share stockholder of the investment adviser is so prone to conflict that he should be in the 60-percent category (now only those holding 5 percent are in it), and that underwriters should not be so included. But the NAIC does not believe that if the amendment is passed regular brokers should necessarily have any lesser limitation upon them.

The SEC points out that the purpose of the phrase in brackets “(other than solely as directors)," means that a director of a controlling or controlled company should not be deemed a "management" director merely because of his directorship. For he may be, in fact, one of the "independent" directors who is also selected as one of the "independent" directors of a parent or subsidiary company. Thus the phrase will exclude him from the prohibition.

Section 1. "Advisory board" of an investment company redefined

"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.

It is important to distinguish "advisory board" from the investment "adviser." The latter is the organization of professionals which for a fee gives expert advice to the investment company, often having the power to select which stocks shall be bought. The advisory board usually is not professional, does not receive a fee, though it may give advice of the same kind. At one time Massachusetts Investment Trust had such a body, but the concept was never popular and perhaps no more than a dozen exist today.

Nevertheless, when a group of nonprofessional investors forms a company they may be unable to afford a real investment adviser; therefore, they may advertise that they have the services of an “advisory board,” with the resulting publicity. It was for such a situation that the restrictions of section 10(b) were applied to the advisory board (by 10(g)). 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).

It has been contended that an investment advisory "committee," is not an "advisory board" and that the limitations do not apply to such a group. Thus, persons who should be considered "affiliated persons" of the investment company would not be subject to such important provisions as those prohibiting the purchase by an investment company of stock underwritten by an officer or director of the company and the purchase or sale by underwriters from the company (sec. 10(f) and 17).

The amendment, section 1 of S. 1181, would bring all investment advisory boards, committees, and groups within the definition of "advisory board," and under the restrictions of section 10(g).

At the time the statute was written the intention was that the advisory board would be a completely independent group, one which could bring a fresh point of view to bear on the company's problems. For that reason the present wording forbids a member of the board to serve the company in any other capacity, making directors, etc., ineligible.

The Commission believes at the present that there is 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. That is, there may be employees and directors of the company on the advisory board under the new section, but in the same proportion as on the board of directors of the company itself.

The final provision of the amendment, put in at the request of the industry, would provide 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. They are still subject to the restrictions of section 10(b).

Sections 14, 17, 18, and 19. Exception for tranactions of underwriter subsidiary of investment company strictly defined

Among the abuses that were discovered in investment companies after the crash of 1929 were the interrelationships between the companies and underwriters, brokers, and investment advisers. Because these organizations were affiliated through management or through ownership, there was often a conflict of interest. In the 1940 hearings evidence was presented showing that brokerage firms, managing investment companies, bought up properties, hoping to realize a profit for themselves, but if they found that the market value of these properties had greatly decreased, sold them to their companions without suffering losses.

For the same reason section 12(d) prohibits an investment company from making certain acquisitions of securities of (1) any other investment company, generally aimed at the evils of pyramiding; (2) any insurance company; or (3) any broker, dealer, underwriter, or investment adviser. (It is true that a diversified company may commit itself to underwriting, but it is limited to a certain percent of its assets.)

Nevertheless, Congress thought that no conflict of interest arises where the underwriter is a subsidiary of the investment company itself. Therefore an investment company may own part of an underwriter which is (A) a corporation all of whose stock is owned by one or more investment companies, and (B) is primarily engaged in the underwriting or brokerage business (sec. 12(d) (3) (A) and (B)).

Consistent with this exception, exceptions have also been incorporated in provisions dealing with transactions of affiliated persons: Sections 10(f), 17(a). and 17 (d). Section 10 (f) prohibits an investment company from buying stocks from an underwriting synidicate, if acting as principal underwriter is a director, officer, or adviser of the company. Excepted from the category of principal underwriter is a company of the character described in section 12(d) (3) (A) and (B).

Section 17 (a) prohibits purchases and sales of securities between affiliated persons and an investment company, such as an officer of the principal underwriters, and certain borrowings. Section 17 (d) covers transactions in which affiliated persons and an investment company are joint or joint and several participants. A section 12 (d) (3) (A) and (B) company is also specifically excepted from these sections.

These exclusions appear to the SEC to extend further than intended. An underwriter subsidiary should, of course, be able to deal with its parent companies either during the course of an underwriting 10(f) or by purchase and sale of securities 19 (a), or in a joint venture 17(d). However, the exclusion of the underwriter subsidiary from these sections is expressed in absolute terms and, if literally taken, might be said to exclude from the purview of sections 19 (f), 17(a), and 17 (d) transactions between the underwriter "subsidiary" and a registered investment company which is not its parent but affiliated in some other manner.

That is, the company might be affiliated because its director may be acting as a principal underwriter (10(f)), because it may be buying from an officer of the principal underwriter (17(a)), or be engaged in a joint participation with an affiliated person (17(d)), without necessarily owning any of the stock of the underwriting "subsidiary."

In the opinion of the Commission, there is no logical reason for the exclusion to be so extended. The exclusion should only be made for an underwriting firm which is in fact a "subsidiary" of the investment company. To carry out this purpose, the exception of 12(d) (b) (3) will be allowed in the situations of 10(f), 17(a), and (d) only where the company owns voting stock of the underwriting subsidiary. (This language was put in at the suggestion of the industry,

so that to qualify, rather than exercise actual control (defined in 2(a) (9) as 25 percent stockownership), it would not be necessary to own more than a few shares.)

It may therefore be objected that such a low percentage does not make the underwriting firm a real subsidiary of the investment company. Would a 25percent ownership better carry out the avowed purpose of the exception?

Section 17(a) would be amended by deleting references therein to the underwriter subsidiary and a new paragraph would be added to section 17(c) to permit specifically the underwriter subsidiary to deal with its parent investment company. Section 17(d) would be amended in a similar manner.

In addition, the absolute terms of the exclusion also raises the question as to whether affiliated persons of the underwriter subsidiary fall within the category of affiliated persons of an affiliated person of a registered investment company and thus are subject to the prohibitions of section 17(a) and 17 (d). This would be a meaningless exclusion. No rational ground appears for distinguishing such affiliated persons from affiliated persons of other types of subsidiaries of the investment company who are admittedly covered by the language of sections 17 (a) and 17(d). The suggested amendments to sections 10 (f), 17(a), and 17 (d), it is believed, will cover them.

Section 20. “Bank custodianship" to include holding of cash assets

Under section 17(f), an investment company of the management type must place its securities and investments (1) in the custody of a bank, (2) in the custody of a stock exchange firm subject to rules prescribed by the Commission, or (3) in its own custody subject to rules or orders prescribed by the Commission. If a company chooses to turn over custody of its securities and similar investments to a bank, something more than safekeeping and access upon the mere receipt of company officials must have been intended and this has been the Commission's position. In other words, custody of a bank should mean that not only the company's portfolio securities but the proceeds of those securities are in the bank's hands. Anything less than that would mean that bank custodianship existed only at the desire of the company officials with access to the securities or with power to direct their disposition and was tantamount to a safekeeping agreement.

Nevertheless, although the SEC has so interpreted the phrase "custody of a bank," as it has no rulemaking power under 17(f) (1) it has not been able to require that income on the company's holdings as well as cash proceeds on the sale of the stock be held by the bank subject to appropriate directions as to expenditures and dispositions by proper company officials.

Most investment companies which use bank custodianship provide for the keeping of all cash receipts by the bank. This provision would apply mainly to open-end companies. Some States insist upon this complete bank custodianship as a prerequisite to the sale of securities within the State. It appears to the Commission that if an investment company desires to obtain the advantage of representing that it has bank custodianship, the protection afforded should be complete.

It is proposed to add a sentence to section 17(f) to provide that if an investment company maintains its securities with a bank, all cash assets shall likewise be kept in such custody. A proviso would permit an operating checking account, for convenience, in an amount not to exceed the fidelity bond required under section 17(g) of the act. The amendment would also state that more than one bank may act as custodian.

Although the National Association of Investment Companies does not object to this amendment, some companies do.

[S. 1182, 86th Cong., 1st sess.]

A BILL To amend certain provisions of the Investment Advisers Act of 1940, as amended

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, That paragraph (18) of section 202 (a) of the Investment Advisers Act of 1940, as amended, is amended by striking out "Alaska," and "the Philippine Islands,”.

SEC. 2. Clause (F) of paragraph (1) of section 203 (c) of the Investment Advisers Act of 1940, as amended, is amended to read as follows: "(F) whether such investment adviser; any part r, officer, director, or person performing

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similar functions, or any person directly or indirectly controlling or controlled by such investment adviser, is subject to any disqualification which would be a basis for denial, suspension, or revocation of registration of such investment adviser under the provisions of subsection (d), and".

SEC. 3. Subsection (d) of section 203 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"(d) The Commission shall, after appropriate notice and opportunity for hearing, by order deny registration or suspend for a period not exceeding twelve months or revoke the registration of an investment adviser, if it finds that such denial, suspension, or revocation is in the public interest and that (1) such investment adviser, whether prior or subsequent to becoming such, or (2) any partner, officer, or director (or any person performing similar functions), or any person directly or indirectly controlling or controlled by such investment adviser, whether prior or subsequent to becoming such (A) has willfully made or caused to be made in any application for registration or report filed with the Commission under this title, or in any proceeding before the Commission with respect to registration, any statement which was at the time and in the light of the circumstances under which it was made false or misleading with respect to any material fact, or who has omitted to state in any such application or report any material fact which is required to be stated therein; or (B) has been convicted within ten years preceding the filing of the application or at any time thereafter of any felony or misdemeanor which the Commission finds (i) involves the purchase or sale of any security, (ii) arises out of the conduct of the business of a broker, dealer, or investment adviser, (iii) involves embezzlement, fraudulent conversion, or misappropriation of funds or securities, or (iv) involves the violation of section 1341, 1342, or 1343 of title 18, United States Code, as heretofore or hereafter amended; or (C) is permanently or temporarily enjoined by order, judgment, or decree of any court of competent jurisdiction from acting as an investment adviser, underwriter, broker, or dealer, or as an affiliated person or employee of any investment company, bank, or insurance company, or from engaging in or continuing any conduct or practice in connection with any such activity, or in connection with the purchase or sale of any security; or (D) has willfully violated any provision of the Securities Act of 1933, or of the Securities Exchange Act of 1934, or of this title, as any of such statutes heretofore have been or hereafter may be amended, or of any rule or regulation under any of such statutes."

SEC. 4. Subsection (e) of section 203 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"(e) The commencement of a proceeding to deny registration under this section shall operate to postpone the effective date of registration for a period of ninety days, or until final determination whether such registration shall be denied if that determination is made within such ninety-day period; but if, after appropriate notice and opportunity for hearing, it shall appear to the Commission to be necessary or appropriate in the public interest or for the protection of investors to postpone the effective date of such registration be yond such ninety-day period and until final determination of whether such registration shall be denied, the Commission shall so order."

SEC. 5. Subsection (g) of section 203 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"(g) Any person registered under this section may, upon such terms and conditions as the Commission finds necessary in the public interest or for the protection of investors, withdraw from registration by filing a written notice of withdrawal with the Commission. An application for registration under this section may be withdrawn only with the consent of the Commission if the request to withdraw such application is received by the Commission after it has commenced a proceeding to deny reigstration. If the Commission finds that any person registered under this section, or who has pending an application for registration filed under this section, is on longer in existence or is not engaged in business as an investment adviser, the Commission shall by order cancel the registration of such person."

SEC. 6. Section 204 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"SEC. 204. Every investment adviser who makes use of the mails or of any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser (other than one specifically exempted from

registration pursuant to section 203 (b)), shall make, keep, and preserve for such periods, such accounts, correspondence, memorandums, papers, books, and other records, and make such reports, as the Commission by its rules and regulations may prescribe as necessary or appropriate in the public interest or for the protection of investors. Such accounts, correspondence, memorandums, papers, books, and other records shall be subject at any time or from time to time to such reasonable periodic, special, or other examinations by examiners or other representatives of the Commission as the Commission may deem necessary or appropriate in the public interest or for the protection of investors."

SEC. 7. The introductory paragraph of section 205 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"SEC. 205. No investment adviser, unless exempt from registration pursuant to section 203 (b), shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to enter into, extend, or renew any investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed on or after the effective date of this title if such contract-".

SEC. 8. The introductory paragraph of section 206 of the Investment Advisers Act of 1940, as amended, is amended by striking out "registered under section 203".

SEC. 9. Section 206 of the Investment Advisers Act of 1940, as amended, is amended by adding the following new clause:

"(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative."

SEC. 10. The caption of section 208 of the Investment Advisers Act of 1940, as amended, is amended by striking out "UNLAWFUL REPRESENTATIONS" and inserting in lieu thereof "GENERAL PROHIBITIONS".

SEC. 11. Section 208 of the Investment Advisers Act of 1940, as amended, is amended by adding the following new subsection :

"(d) It shall be unlawful for any person indirectly, or through or by any other person, to do any act or thing which it would be unlawful for such person to do directly under the provisions of this title or any rule or regulation thereunder. It shall be unlawful for any person to aid, abet, counsel, command, induce, or procure the violation of any provision of this title or any rule or regulation thereunder by any other person. These provisions shall not constitute a limitation with respect to the applicability to this title of section 2 of title 18, United States Code."

SEC. 12. Subsection (e) of section 209 of the Investment Advisers Act of 1940, as amended, is amended by striking out "has engaged or is about to engage" in the first and in the second sentences and inserting in lieu thereof "has engaged, is engaged or is about to engage".

SEC. 13. Subsection (b) of section 210 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"(b) Subject to the provisions of subsections (c) and (e) of section 209, the Commission, or any member, officer, or employee thereof, shall not make public the fact that any examination or investigation under this title is being conducted, or the results of or any facts ascertained during any such examination or investigation; and no member, officer, or employee of the Commission shall disclose to any person other than a member, officer, or employee of the Commission any information obtained as a result of any such examination or investigation except with the approval of the Commission. The provisions of this subsection shall not apply

"(1) in the case of any hearing which is public under the provisions of section 212; or

"(2) in the case of a resolution or request from either Houses of Congress."

SEC. 14. Subsection (a) of section 211 of the Investment Advisers Act of 1940, as amended, is amended to read as follows:

"(a) The Commission shall have authority from time to time to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this title. For the purposes of its rules or regulations the Commission may classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters."