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Staff Says Closed-End Funds Do Not Have to Review Underwriters' Compliance Procedures

The staff of the Division of Investment Management has advised the Investment Co. Institute ("ICI") that closed-end funds do not have to comply with Investment Company Act rule 38a-1 with respect to principal underwriters that do not provide ongoing services to the funds. Rule 38a-1 requires the board of directors of a registered investment company to review and approve the compliance policies and procedures of each service provider, including each principal underwriter of the fund.

Most closed-end funds offer shares to the public through an underwriting syndicate that enters into an underwriting agreement with the fund immediately prior to the effective date of the fund's registration statement, at which point the syndicate members become the fund's principal underwriters. The underwriting syndicate dissolves after the fund shares are sold to the public and the fund commences operations, which is typically three days after the effective date of the registration statement.

ICI suggested that applying rule 38a-1 to a principal underwriter of a closed-end fund is unnecessary because a principal underwriter and a closed-end fund do not have an ongoing relationship. In addition, it would be burdensome for a closed-end fund to comply with the board approval requirements of rule 38a-1 due to the large number of principal underwriters in a typical syndicate, which ranges from 10 to 50 firms, according to ICI.

ICI also was concerned that requiring closed-end funds to comply with rule 38a-1 with respect to their syndicate members would have an unintended chilling effect on the willingness of prospective underwriters to participate in closed-end fund underwritings.

The staff believes that rule 38a-1 was intended to require investment companies to adopt and implement written policies designed to prevent violation of the federal securities laws by service providers, including principal underwriters, who provide ongoing services to investment companies.

In this regard, the staff noted that the NASD is about to implement rule 3013, which will require NASD members, including those who are principal underwriters, to appoint a chief compliance officer and to certify annually that they have processes in place to establish, maintain, review, test and modify written supervisory procedures reasonably designed to achieve compliance with applicable NASD rules, Municipal Securities Rulemaking Board rules and federal securities laws and regulations.

In all instances, other than the one raised by ICI, the staff believes that rule 38a-1 requires an investment company to oversee the compliance of service providers that provide ongoing services to the investment company. Advisers, administrators, transfer agents, and with respect to an open-end fund the principal underwriter, all provide ongoing services to investment companies.

The staff stated that the definition of investment adviser in Investment Company Act section 2(a)(20) and incorporated into the rule is limited to those investment advisers that "regularly furnish investment advice" to the investment company. As a result, rule 38a-1 does not require an investment company's compliance policies and procedures to cover an investment adviser that, for example, provides an isolated research report to the investment company or its adviser, according to the staff.

The staff said that an annual review of the adequacies of that adviser's policies and procedures would not be very useful, and an annual review of the many advisers that may provide the investment company with similar limited services would be very burdensome.

Accordingly, the staff ruled that a closed-end fund does not have to comply with the provisions of rule 38a-1 concerning principal underwriters with respect to any principal underwriter of the fund that does not undertake regularly to serve or act as a principal underwriter for the fund.