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Release No. 34-47262 Release No. IC-25914 68 Fed. Reg. 5347 - Feb. 3, 2003
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 Table of Contents
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I. Introduction and Background
On July 30, 2002, the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was enacted.1 Section 302 of the Sarbanes-Oxley Act, entitled "Corporate Responsibility for Financial Reports," required the Commission to adopt final rules to be effective by August 29, 2002, 30 days after the date of enactment, under which the principal executive officer or officers and the principal financial officer or officers, or persons performing similar functions, of an issuer each must certify the information contained in the issuer's quarterly and annual reports filed or submitted under Section 13(a) or 15(d) of the Exchange Act.2 Form N-SAR currently is the form designated for registered investment companies to comply with their reporting requirements under Sections 13(a) and 15(d) of the Exchange Act, as well as periodic reporting requirements under Sections 30(a) and 30(b)(1) of the Investment Company Act.3
On August 28, 2002, the Commission implemented the certification requirement of Section 302 of the Sarbanes-Oxley Act with respect to registered investment companies by adopting new rule 30a-2 under the Investment Company Act and the Sarbanes-Oxley Act.4 Rule 30a-2 requires a registered investment company that files periodic reports under Section 13(a) or 15(d) of the Exchange Act, i.e., Form N-SAR, to include the certification specified by Section 302 in those periodic reports.
In a companion release, we also proposed to require registered management investment companies to file certified shareholder reports with the Commission on new Form N-CSR and to designate these certified shareholder reports as reports that are required under Sections 13(a) and 15(d) of the Exchange Act and Section 30 of the Investment Company Act.5 As we noted in that release, we believe that the certification requirement of Section 302 of the Sarbanes-Oxley Act was intended to improve the quality of the disclosure that a company provides regarding its financial condition in its reports to investors.6 For registered management investment companies, the required reports to shareholders, rather than reports on Form N-SAR, are the primary vehicle for providing financial information to investors. We believe that the information in these reports to shareholders should be certified, and today we are adopting amendments to our forms and rules to require this certification.
In October 2002, we proposed amendments to proposed Form N-CSR and Form N-SAR to implement Sections 406 and 407 of the Sarbanes-Oxley Act with respect to registered investment companies, similar to disclosure requirements that we proposed at the same time with respect to operating companies.7 Section 406 directs the Commission to adopt rules requiring an issuer to disclose whether or not it has adopted a code of ethics for the issuer's senior financial officers, as well as any change to, or waiver of, that code of ethics. Section 407 directs the Commission to adopt rules: (1) requiring an issuer to disclose whether or not its audit committee includes at least one member who is a financial expert; and (2) defining the term "financial expert." Earlier this month, we adopted disclosure requirements to implement these provisions with respect to operating companies.8 Today, we adopt similar disclosure requirements for registered management investment companies.
In the same release in which we proposed to implement Sections 406 and 407, we also proposed amendments to implement Section 404 of the Sarbanes-Oxley Act, relating to internal control reports, with respect to operating companies, as well as certain technical amendments to our rules and forms implementing Section 302 of the Sarbanes-Oxley Act for registered investment companies.9 We have deferred adoption of the final rules to implement Section 404 to a separate release to be issued at a later date,10 and we will also consider the technical amendments to our rules and forms implementing Section 302 for registered investment companies at that time.
II. Discussion
The Commission today is adopting new rules, rule and form amendments, and new Form N-CSR under the Investment Company Act to better implement the certification requirement of Section 302 of the Sarbanes-Oxley Act for registered management investment companies, with modifications to address commenters' concerns.11 Our amendments will require a registered management investment company to file semi-annual reports on Form N-CSR, and will require the certification specified by Section 302 of the Sarbanes-Oxley Act in these semi-annual reports. Further, our amendments will remove the certification requirement from Form N-SAR, with respect to all registered investment companies.12 In addition, we are adopting rules to require registered management investment companies to maintain, and regularly evaluate the effectiveness of, controls and procedures designed to ensure that the information required in reports on Form N-CSR is recorded, processed, summarized, and reported on a timely basis. Finally, we are adopting amendments to Form N-CSR and Form N-SAR to implement Sections 406 and 407 of the Sarbanes-Oxley Act with respect to registered management investment companies, similar to amendments that we adopted earlier this month to implement these provisions with respect to operating companies.
A. Section 302 of the Sarbanes-Oxley Act -- Certification Requirements
1. Certified Shareholder Reports
We are adopting, as proposed, an amendment to rule 30b2-1 under the Investment Company Act, which currently requires registered investment companies to file copies of reports transmitted to shareholders with the Commission within 10 days of their transmission to shareholders. The amendment will require a registered management investment company to file a report with the Commission on new Form N-CSR ("certified shareholder report") containing (i) a copy of any required shareholder report, (ii) additional information regarding disclosure controls and procedures, and (iii) the certification required by the Sarbanes-Oxley Act.13 As adopted, new Form N-CSR requires certified shareholder reports to contain the exact form of the certification prescribed by the form. The certification is required of each principal executive officer and financial officer, and the form of this certification parallels the form of the certification we have prescribed for other Exchange Act reporting forms, such as Forms 10-K and 10-Q. The certification must be filed as an exhibit to a report on Form N-CSR.14 In addition to the signature required on the certification, the report must be signed by the registrant, and on behalf of the registrant by its principal executive officer or officers and its principal financial officer or officers.15 The certification requirement will also apply to amendments of certified shareholder reports on Form N-CSR.16 In addition, we are adopting new rule 30d-1 under the Investment Company Act, designating reports on Form N-CSR as periodic reports filed with the Commission under Section 13(a) or 15(d) of the Exchange Act.17
The requirement to file certified shareholder reports will apply to registered management investment companies, regardless of whether they are subject to Section 13(a) or 15(d) of the Exchange Act.18 By its terms, Section 302 of the Sarbanes-Oxley Act directs the Commission to adopt rules that will apply to companies filing periodic reports under Section 13(a) or 15(d) of the Exchange Act.19 We believe, however, that it is important for the certification requirement, like our other reporting rules, to apply consistently to all registered investment companies, regardless of whether they fall within the periodic reporting requirements of the Exchange Act.20
In light of the adoption of Form N-CSR as an Exchange Act reporting form, we are amending our rules and forms to provide that, for registered management investment companies, Form N-SAR will be filed under the Investment Company Act only and not the Exchange Act.21 We were persuaded by commenters who argued that certification of both Form N-SAR and shareholder reports would impose an unjustified burden on management investment companies. These commenters noted that Form N-SAR does not contain financial statements; that although Form N-SAR is publicly available, it was developed primarily to elicit information for use by the Commission in its compliance and inspections program; and that the information in Form N-SAR is not generally relied upon by investors.22 In light of the fact that registered management investment companies will be filing Form N-CSR under the Exchange Act, we do not believe that it is necessary for these companies to continue to file Form N-SAR under the Exchange Act or to certify Form N-SAR under the Sarbanes-Oxley Act.23 We believe that this is appropriate because, for registered management investment companies, the required reports to shareholders contained in Form N-CSR, rather than Form N-SAR, are the primary vehicle for providing financial statements and other information to investors.24 The certification requirement was intended to improve the quality of the disclosure that a company provides about its financial condition in its periodic reports to investors.25
2. Scope of Certification Requirement
We are adopting, as proposed, the requirement that all of the information filed on Form N-CSR, including all of the information in a shareholder report filed as part of Form N-CSR, be certified. This would include information that is included voluntarily, as well as that required by Form N-CSR. In addition to financial statements, annual reports to shareholders of open-end management investment companies, or mutual funds, typically contain Management's Discussion of Fund Performance ("MDFP"), although, at present, they are not required to do so.26 MDFP includes narrative disclosure of the factors that materially affected a fund's performance during the reporting period, a line graph comparing the fund's performance to that of an appropriate broad-based market index, and a table of average annual total returns for the fund. In addition, the annual report to shareholders of a management investment company must contain other information, including certain basic information about the investment company's directors.27
Many commenters objected to our proposal to require certification of all of the information contained in shareholder reports, and instead suggested that the certification should apply only to the financial statements and other financial information in shareholder reports. Commenters argued that the narrative disclosure commonly found in shareholder reports, including the narrative section of MDFP as well as a fund president's letter to shareholders, interviews with portfolio managers, and other similar information that is intended to assist investors in understanding fund performance and portfolio composition, is not analogous to Management's Discussion & Analysis (MD&A) in Form 10-K, and is not the type of objective financial information that the certification requirement of Section 302 was intended to cover.28 The MD&A, commenters noted, is intended to provide a narrative explanation of an operating company's financial statements and to provide the context within which the financial statements should be analyzed, while the MDFP is simply a narrative explanation of an investment company's performance comparative to the market. These commenters argued that the narrative disclosure in the shareholder reports, including that in the MDFP, does not lend itself to meaningful personal certification by an investment company's principal executive and financial officers, and that requiring certification of the entire shareholder report could have the unintended consequence of encouraging investment companies to reduce the scope of the narrative discussion provided voluntarily in shareholder reports, or even ceasing to provide it altogether.
We are not persuaded by these comments. Section 302 of the Sarbanes-Oxley Act does not limit the scope of the certification to financial information filed by a registrant. The MDFP and other narrative disclosure is relied upon by investors to explain the investment operations and performance of a mutual fund, which is as significant for investors in the fund as management's discussion and analysis of financial condition and results of operations is for investors in an operating company. In its integrated reviews of mutual fund prospectuses and shareholder reports, the staff has identified instances where MDFP has provided insufficient substantive discussion of the factors that affected the fund's performance during the most recent fiscal year.29The Commission has asked the staff, in its review of a mutual fund's disclosure documents, to continue to focus on areas where funds' MDFP disclosure has been deficient.30 We believe that a requirement that MDFP, if included in shareholder reports, must be certified by the mutual fund's principal executive and financial officers, would encourage funds to include a more complete and accurate discussion of the factors that affected fund performance in their MDFP. Further, we note that in the operating company context, reports on Form 10-K contain certain required non-financial information that must be certified.31
We also note that the only statement made in the certification with respect to this narrative information is that, based on the certifying officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the report.32 This certification is consistent with the current obligation of registrants under the Exchange Act not to file reports that are materially misleading.33 Therefore, we believe that it is appropriate for the certifying officers to provide assurances to investors that the reports a fund files under the Exchange Act meet this standard.
3. Application of Certification Requirements to Unit Investment Trusts and Small Business Investment Companies
To address commenters' concerns, we are amending Form N-SAR to eliminate the requirement that unit investment trusts ("UITs") and small business investment companies ("SBICs") certify their reports on Form N-SAR.34 Commenters noted that Form N-SAR, which does not contain financial statements, contains little, if any, information regarding a UIT that is of relevance or interest to investors. We agree. Form N-SAR requires both UITs and SBICs to include only limited financial and other information.35 Because Form N-SAR contains very limited information for UITs and SBICs and is not required to be sent to investors, certification of this information would not promote the intent of Section 302 of the Sarbanes-Oxley Act, which is to improve the quality of the disclosure that a company provides about its financial condition in its periodic reports to investors. We have therefore concluded that requiring UITs and SBICs to certify their reports on Form N-SAR does not produce any meaningful benefit to investors.
While certification of Form N-SAR will no longer be required, UITs and SBICs will continue to file Form N-SAR under both the Exchange Act and the Investment Company Act.36 UITs and SBICs generally are not required to transmit reports to shareholders containing their financial statements, and UITs and SBICs will not be required to file certified shareholder reports under the Exchange Act.37 We do not believe that it would be appropriate to remove UITs and SBICs from Exchange Act reporting status by making Form N-SAR an Investment Company Act-only form.
4. Disclosure Controls and Procedures
We are adopting, with modifications to address commenters' concerns, new rule 30a-3, which requires registered management investment companies to maintain, and regularly evaluate the effectiveness of, controls and procedures designed to ensure that the information required in filings on Form N-CSR is recorded, processed, summarized, and reported on a timely basis.38 Investment companies filing reports under Section 13(a) or 15(d) of the Exchange Act are currently required to maintain disclosure controls and procedures with respect to Exchange Act reports.39 Rule 30a-3 applies this requirement uniformly to all registered management investment companies, regardless of whether they are subject to Section 13(a) or 15(d) of the Exchange Act.40 We believe that registered management investment companies filing Form N-CSR should maintain effective disclosure controls and procedures, regardless of whether they fall within the periodic reporting requirements of the Exchange Act. We are also amending the definition of "disclosure controls and procedures" in rule 30a-2(c) to make clear that such controls and procedures apply to registered management investment companies regardless of whether they are subject to Section 13(a) or 15(d) of the Exchange Act, and that they do not apply to SBICs and UITs filing Exchange Act reports on Form N-SAR that are not required to be certified.41
We are also adopting, as proposed, the requirement of rule 30a-3(b) that a registered management investment company, under the supervision and with the participation of the principal executive and financial officers, conduct an evaluation of its disclosure controls and procedures within the 90-day period prior to the filing date of each Form N-CSR requiring certification under Investment Company Act rule 30a-2.42 We expect that this evaluation will be carried out in a manner that will form the basis for the certification required by Section 302 of the Sarbanes-Oxley Act regarding disclosure controls and procedures required by Investment Company Act rule 30a-2(b)(4).43
As proposed, rule 30a-3 would have extended the requirement to maintain and evaluate disclosure controls and procedures to filings under the Securities Act of 1933 ("Securities Act") and the Investment Company Act.44 Commenters argued that this extension would impose a larger burden on investment companies than on operating companies, which are only required to maintain disclosure controls and procedures with respect to their Exchange Act reports. Commenters pointed out that under the rule, as proposed, investment companies would have to establish and maintain, and conduct evaluations of the effectiveness of, disclosure controls and procedures on at least a semi-annual basis, with respect to all of the updates of their registration statements, as well as with respect to other filings required under the Securities Act and the Investment Company Act, including advertisements and sales literature.45 According to commenters, these periodic evaluations would add substantially to the workload of fund officers, but would not result in a discernible benefit to fund shareholders or further the intent of the Sarbanes-Oxley Act.
Section 302 of the Sarbanes-Oxley Act does not require evaluations of disclosure controls and procedures with respect to non-Exchange Act filings, and we have determined that it would not be appropriate to extend this requirement to Securities Act and Investment Company Act filings at this time. We are concerned that the evaluation process could be unduly burdensome, relative to its benefits, when applied to these other filings. Therefore, we are limiting the requirement to maintain and evaluate disclosure controls and procedures to Form N-CSR, the Exchange Act document that will be subject to the Sarbanes-Oxley Act certification requirements.
We wish to emphasize that effective disclosure controls and procedures are essential for an investment company to meet its disclosure obligations under all of the securities laws, including the Securities Act and the Investment Company Act. Our limitation of the definition of disclosure controls and procedures to Form N-CSR in the rules we adopt today in no way diminishes the importance of disclosure controls and procedures designed to ensure that the information required in other filings made by an investment company, including prospectuses and prospectus amendments, advertisements and sales literature, and Form N-SAR, is recorded, processed, summarized, and reported on a timely basis. Our determination to limit the scope of disclosure controls and procedures in these rules rests on our concern that the burdens of the specific evaluation process mandated by the rules may outweigh its benefits when extended to these other filings.
5. Extension of Time for Filing Form N-CSR
We are also adopting amendments to require an investment company to file a Form 12b-25 if it will not be able to file a report on Form N-CSR in a timely manner.46 Filing of a Form 12b-25 would provide the investment company with an automatic extension of time to file Form N-CSR of up to 15 calendar days following the prescribed due date. Form 12b-25 currently may be used for reports on Form N-SAR, and we note that the form will continue to be available to all filers on Form N-SAR, including registered management investment companies filing exclusively under the Investment Company Act.
B. Section 406 of the Sarbanes-Oxley Act --Code of Ethics
We are adopting, with modifications to address commenters' concerns, our proposed amendments that implement Section 406 of the Sarbanes-Oxley Act with respect to registered management investment companies. These requirements are similar to those we recently adopted for operating companies, and we direct investment companies to that release for information concerning these requirements.47 The amendments we are adopting will require a registered management investment company to:
Disclose annually whether the investment company has adopted a code of ethics that applies to the investment company's principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the investment company or a third party;48
If the investment company has not adopted a code of ethics, explain why it has not done so;49
Describe briefly the nature of any amendment to, or waiver from a provision of, the investment company's code of ethics in its report on Form N-CSR or Form N-SAR, as applicable. In the alternative, the investment company may disclose this information on its Internet website within five business days following the date of the amendment or waiver, if the investment company has disclosed in its most recently filed report on Form N-CSR or Form N-SAR its intention to provide disclosure in this manner and its Internet address, it makes the information available on its website for a 12-month period, and it retains the information for a period of not less than six years following the end of the fiscal year in which the amendment or waiver occurred.50
The rules, as adopted, reflect modifications that are similar to those we recently made to the proposed code of ethics disclosure requirements for operating companies, for the reasons described in the release adopting these disclosure requirements for operating companies. These modifications include:
Elimination of the component of the definition of a code of ethics requiring the code to promote the avoidance of conflicts of interest, including disclosure to an appropriate person or persons identified in the code of any material transaction or relationship that reasonably could be expected to give rise to such a conflict;51
Addition of an instruction to indicate that a company may have separate codes of ethics for different types of officers and that the provisions of the company's code of ethics that address the elements listed in the definition and apply to those officers may be part of a broader code that addresses additional issues and applies to additional persons;52
Allowing a company to choose among three alternative methods of making their ethics codes publicly available, including:
(i)
filing a copy of the code as an exhibit to its annual report on Form N-CSR or Form N-SAR;
(ii)
posting the text of the code on the company's Internet website and disclosing, in its most recent report on Form N-CSR or Form N-SAR, its Internet address and the fact that it has posted the code of ethics on its Internet website; or
(iii)
providing an undertaking in the company's most recent report on Form N-CSR or Form N-SAR to provide a copy of the code to any person without charge upon request, and explaining the manner in which such a request may be made;53
Extension of the deadline for disclosing any amendments to, or waivers from, the company's code of ethics on its Internet website from two business days to five business days after the amendment or waiver;54
Clarification that only amendments to, and waivers from, a company's code relating to specified elements of the code and specified officers must be disclosed;55
Addition of a definition of the terms "waiver" and "implicit waiver";56 and
Clarification that a company does not need to disclose technical, administrative, or other non-substantive amendments to its code of ethics.57
These disclosure requirements will apply to all registered management investment companies, regardless of whether they are required to file reports pursuant to Section 13(a) or 15(d) of the Exchange Act. Management investment companies other than SBICs will provide the required disclosure in Item 2 of Form N-CSR, and SBICs will provide the required disclosure as an exhibit to Form N-SAR.58
Several commenters suggested that the code of ethics requirements should not apply to any registered investment companies. These commenters argued that the proposed amendments were unnecessary and potentially duplicative, noting that investment companies are already required to disclose whether they have a code of ethics pursuant to rule 17j-1 under the Investment Company Act, and that in any event, investment companies are highly regulated under the Investment Company Act, which addresses the underlying ethical concerns substantively rather than simply through disclosure.59
We continue to believe, however, that the rule should apply with equal force to investment companies and operating companies, and we note that the Sarbanes-Oxley Act does not distinguish between them with respect to the code of ethics requirements. We recognize that rule 17j-1 currently requires investment companies, and their investment advisers and principal underwriters, to adopt codes of ethics designed to prevent fraud resulting from personal trading in securities by portfolio managers and other employees. The amendments we are adopting today, however, will address a broader range of conduct, including disclosure provided in filings with the Commission; compliance with governmental laws, rules, and regulations; and ethical conduct generally, including the ethical handling of actual or apparent conflicts of interest.60
The rules we are adopting will require disclosure of an investment company's code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions, regardless of whether these individuals are employed by the investment company or a third party.61 Our proposed rules would also have required disclosure of certain codes of ethics of an investment company's investment adviser and principal underwriter that apply to the adviser's and underwriter's principal executive officer and senior financial officers.62
We are persuaded by commenters that including codes of ethics of the investment adviser and principal underwriter goes beyond the intended scope of Section 406. In large financial services organizations, the principal executive officer and senior financial officers may have little to do with the operations or financial reporting of the investment company, but are instead responsible principally for the adviser's or underwriter's own operations and financial reporting.
In addition, we have determined to exclude UITs from the code of ethics disclosure requirements. Because UITs are unmanaged, passive investment companies, they typically do not have principal executive officers, principal financial officers, principal accounting officers or controllers, or persons performing similar functions. In light of the fact that we have limited the rules we are adopting to these persons, we believe that it is appropriate to exclude UITs from the disclosure requirements. We note that we have provided a similar exclusion to issuers of asset-backed securities.63
C. Section 407 of the Sarbanes-Oxley Act -- Audit Committee Financial Experts
We are adopting, with modifications to address commenters' concerns, our proposals that implement Section 407 of the Sarbanes-Oxley Act with respect to registered management investment companies. These requirements are similar to those that we recently adopted for operating companies, and we direct investment companies to that release for guidance concerning these requirements.64 Under the provisions that we are adopting, a registered management investment company must disclose annually that its board of directors has determined that the company either: (i) has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is "independent"; or (ii) does not have an audit committee financial expert serving on its audit committee. An investment company disclosing that it does not have an audit committee financial expert must explain why it does not have such an expert.65
The rules, as adopted, reflect modifications that are similar to those that we recently made to the proposed financial expert disclosure requirements for operating companies, for the reasons described in the release adopting these disclosure requirements for operating companies. These modifications include:
Use of the term "audit committee financial expert" rather than "financial expert;"66
Modification of the proposals that would have required disclosure of the number and names of audit committee financial experts serving on a company's audit committee to more closely track the language used in Section 407 of the Sarbanes-Oxley Act, and to require a company to disclose that its board of directors has determined that the company either has at least one audit committee financial expert serving on its audit committee or does not have an audit committee financial expert serving on its audit committee;67
Modification of the proposals to permit, but not require, an investment company to disclose that it has more than one audit committee financial expert on its audit committee. Therefore, once an investment company's board determines that a particular audit committee member qualifies as an audit committee financial expert, it may, but is not required to, determine whether additional audit committee members also qualify as experts. Every investment company subject to the audit committee disclosure requirements would, however, have to determine whether or not it has at least one audit committee financial expert; a company will not satisfy the new disclosure requirements by stating that it has decided not to make a determination or by simply disclosing the qualifications of all of its audit committee members. Furthermore, if the company's board determines that at least one of the audit committee members qualifies as an expert, the company must accurately disclose this fact. It will not be appropriate for a company to disclose that it does not have an audit committee financial expert if its board has determined that such an expert serves on the audit committee;68
Reorganization of the components of the definition of audit committee financial expert to make it easier to read and to emphasize, by including them in the first part of the definition, the attributes that an audit committee financial expert must possess;69
Revision of the second attribute to state that the audit committee financial expert must have the ability to assess the general application of generally accepted accounting principles in connection with the accounting for estimates, accruals, and reserves, rather than stating that the expert must have experience applying these principles;70
Broadening of the third attribute by requiring an audit committee financial expert to have experience "preparing, auditing, analyzing, or evaluating" financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant's financial statements, or experience actively supervising a person who prepares, audits, analyzes or evaluates financial statements;71
Modification of the fourth attribute to require understanding of, rather than experience with, internal controls and procedures for financial reporting;72
-
Modification of the definition to state that a person must have acquired the five necessary attributes through any one or more of the following:
(i) education and experience as a principal financial officer, principal accounting officer, controller, public accountant, or auditor or experience in one or more positions that involve the performance of similar functions;
(ii) experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor, or person performing similar functions;
(iii) experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing, or evaluation of financial statements; or
(iv) other relevant experience.73
Elimination of the requirement that an audit committee financial expert must have gained the relevant expertise with a company that was required to file reports pursuant to Section 13(a) or 15(d) of the Exchange Act;74
Addition of a requirement that if a person qualifies as an audit committee financial expert by virtue of possessing "other relevant experience," the company's disclosure briefly list that person's experience;75
Elimination of the list of factors that a company's board of directors should consider in evaluating the education and experience of an audit committee financial expert candidate;76 and
Addition of a safe harbor in the audit committee disclosure requirements.77
We wish to emphasize that, as with an operating company, the board of an investment company must ensure that it names an audit committee financial expert who embodies the highest standards of personal and professional integrity. In this regard, a board should consider any disciplinary actions to which a potential expert is, or has been, subject in determining whether that person would be a suitable audit committee financial expert.78
The disclosure requirements that we are adopting will apply to all registered management investment companies, regardless of whether they are required to file reports under Section 13(a) or 15(d) of the Exchange Act. Several commenters objected to our proposal to require a registered management investment company to provide disclosure about audit committee financial experts serving on its audit committee. They argued that investment companies should be excluded entirely from any disclosure requirement relating to audit committee financial experts, because the nature of investment company accounting is such that investment company audit committees rarely are required to apply complex accounting principles. These commenters stated that the preparation of investment company financial statements is straightforward and does not present the types of circumstances that require the exercise of judgment, such as selection of accounting policies, that preparation of the financial statements of operating companies would.
We continue to believe, however, that the rule should apply with equal force to investment companies and operating companies, and we note that the Sarbanes-Oxley Act does not distinguish between them with respect to the financial expert disclosure requirements. In addition, while investment company financial statements may, in many cases, be simpler than those of some operating companies, the underlying financial systems, reporting mechanisms, and internal controls are sufficiently complex that an investment company's audit committee would benefit from having one or more members who meet the definition of audit committee financial expert. Finally, we note that the modifications that we have made to the definition of an audit committee financial expert should address the concerns of commenters that the definition was too narrowly drawn to apply in the context of investment companies. The commenters argued, in particular, that the second, third, and fourth required attributes were too restrictive, and that experience as a public accountant or auditor, or principal financial officer, controller, or public accounting officer of a company should not be the exclusive means for acquiring the attributes. As described above, we have made changes that are responsive to these concerns.
We are adopting, substantially as proposed, a test for whether an audit committee financial expert may be considered to be "independent" that differs from the test we have adopted for operating companies. The definition of "independence" adopted for operating companies refers to the definition of "independent" used in Item 7(d)(3)(iv) of Schedule 14A, which generally is not applicable to investment companies.79 Under the rules we are adopting, in order to be considered "independent," a member of an audit committee of a registered management investment company may not, other than in his or her capacity as a member of the audit committee, the board of directors, or any other board committee: (i) accept directly or indirectly any consulting, advisory, or other compensatory fee from the issuer; or (ii) be an "interested person" of the investment company, as defined in Section 2(a)(19) of the Investment Company Act.80
III. Transition Provisions and Compliance Dates
Except as provided in the following sentence, the effective date of the rules, rule and form amendments, and Form N-CSR is March 1, 2003. The effective date of the removal of the certification requirement from Form N-SAR for registered management investment companies other than SBICs is May 1, 2003.
A registered management investment company other than an SBIC that has a fiscal annual or semi-annual period ending on or before March 31, 2003, may choose either to file Form N-CSR or to continue to comply with the certification requirements of Form N-SAR. A registered management investment company that elects to file Form N-CSR for a fiscal annual or semi-annual period ending on or before March 31, 2003, is not required to comply with paragraphs (b)(4), (5), and (6) of Investment Company Act Rule 30a-2, Item 9(a) of Form N-CSR, or paragraph (b) of Exchange Act Rules 13a-15 and 15d-15 and Investment Company Act Rule 30a-3 with respect to that Form N-CSR. A registered management investment company that elects to certify Form N-SAR for a fiscal annual or semi-annual period ending on or before March 31, 2003, must file its report to shareholders for that period as currently required. This transition is designed so that each such registered management investment company other than an SBIC will be required to provide a certification of its financial statements and financial information, while providing the flexibility to each company to determine whether to certify Form N-SAR or Form N-CSR during the transition period and sufficient time to establish and evaluate disclosure controls and procedures for Form N-CSR. A registered management investment company other than an SBIC that has a fiscal annual or semi-annual period ending on or after April 1, 2003, is required to file Form N-CSR for that period. Beginning immediately, a unit investment trust or an SBIC may omit the certification from Form N-SAR.
Registered management investment companies must comply with the code of ethics disclosure requirements promulgated under Section 406 of the Sarbanes-Oxley Act in their annual reports on Form N-CSR or N-SAR for fiscal years ending on or after July 15, 2003. They also must comply with the requirements regarding disclosure of amendments to, and waivers from, their ethics codes on or after the date on which they file their first annual report on Form N-CSR or N-SAR in which disclosure of their code of ethics is required. Registered management investment companies similarly must comply with the audit committee financial expert disclosure requirements promulgated under Section 407 of the Sarbanes-Oxley Act in their annual reports on Form N-CSR or N-SAR for fiscal years ending on or after July 15, 2003.
IV. Paperwork Reduction Act
The new rules and rule and form amendments contain "collection of information" requirements within the meaning of the Paperwork Reduction Act of 1995 ("PRA").81 We published notice requesting comment on the collection of information requirements in the release proposing Form N-CSR,82 submitted these requirements to the Office of Management and Budget ("OMB") for review in accordance with the PRA,83 and received approval by OMB for this collection of information. In addition, we published notice requesting comment on the collection of information requirements in the proposing release implementing Sections 406 and 407 of the Sarbanes-Oxley Act84 and submitted these requirements to OMB for review. This request is pending before OMB.
The titles for the collection of information are "Form N-CSR under the Investment Company Act of 1940 and Securities Exchange Act of 1934, Certified Shareholder Report;" "Form N-SAR under the Investment Company Act of 1940, Semi-Annual Report for Registered Investment Companies;" and "Form 12b-25 under the Securities Exchange Act of 1934, Notification of Late Filing."
Form N-SAR (OMB Control No. 3235-0330) under the Exchange Act and the Investment Company Act [17 CFR 249.330; 17 CFR 274.101] is used by registered investment companies to file periodic reports with the Commission. Form N-CSR (OMB Control No. 3235-0570) under the Exchange Act and the Investment Company Act [17 CFR 249.331; 17 CFR 274.128] will be used by registered management investment companies to file certified shareholder reports. Form 12b-25 (OMB Control No. 3235-0058) under the Exchange Act [17 CFR 249.322] provides notice to the Commission and the marketplace that a company will be unable to file a required report in a timely manner.
Compliance with the new rules and rule and form amendments is mandatory and the information provided will not be kept confidential. Under our rules for retention of manual signatures, registered investment companies have to maintain the certifications for five years.85 An agency may not conduct or sponsor, and a person is not required to respond to, an information collection unless it displays a currently valid OMB control number.
A. Summary of New Rules
On August 28, 2002, the Commission implemented the certification requirement of Section 302 of the Sarbanes-Oxley Act with respect to registered investment companies by adopting new rule 30a-2 under the Investment Company Act and the Sarbanes-Oxley Act.86 Rule 30a-2 requires a registered investment company that files periodic reports under Section 13(a) or 15(d) of the Exchange Act, i.e., Form N-SAR, to include the certification specified by Section 302 in those periodic reports.
In a companion release, we also proposed to require registered management investment companies to file certified shareholder reports with the Commission on new Form N-CSR and to designate these certified shareholder reports as reports that are required under Sections 13(a) and 15(d) of the Exchange Act and Section 30 of the Investment Company Act.87 As we noted in that release, we believe that the certification requirement of Section 302 of the Sarbanes-Oxley Act was intended to improve the quality of the disclosure that a company provides regarding its financial condition in its reports to investors.88 For registered management investment companies, the required reports to shareholders, rather than reports on Form N-SAR, are the primary vehicle for providing financial information to investors. We believe that the information in these reports to shareholders should be certified, and we are adopting amendments to our forms and rules to require this certification.
We are adopting an amendment to rule 30b2-1 under the Investment Company Act, which will require a registered management investment company to file a report with the Commission on new Form N-CSR containing (i) a copy of any required shareholder report, (ii) additional information regarding disclosure controls and procedures, and (iii) the certification required by the Sarbanes-Oxley Act.89 New rule 30d-1 designates certified shareholder reports on Form N-CSR as periodic reports under Section 13(a) or 15(d) of the Exchange Act.90 New rule 30a-3 requires all registered management investment companies to maintain, and regularly evaluate the effectiveness of, disclosure controls and procedures designed to ensure that the information required in filings under the Exchange Act is recorded, processed, summarized, and reported on a timely basis. We are also amending the definition of "disclosure controls and procedures" in rule 30a-2(c) to make clear that such controls and procedures apply to all registered management investment companies regardless of whether they are required to file reports on Form N-CSR under the Exchange Act, and that they do not apply to SBICs and UITs filing Exchange Act reports on Form N-SAR.91 Amendments to Exchange Act rules 13a-15 and 15d-15 will exclude SBICs and UITs from the requirements to maintain disclosure controls and procedures for purposes of the evaluation conducted as part of the required certification.92 We are also removing the requirement that Form N-SAR be certified by a registered investment company's principal executive and financial officers. This shifts the information collection burden relating to the certification specified by Section 302 of the Sarbanes-Oxley Act, for registered management investment companies, from Form N-SAR to Form N-CSR.
Finally, we are requiring registered management investment companies to include new disclosures on Form N-CSR or Form N-SAR, as appropriate, in order to implement the requirements of Sections 406 and 407 of the Sarbanes-Oxley Act of 2002. First, the rules require a management investment company to disclose whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. A management investment company that does not have an audit committee financial expert must disclose this fact and explain why it has no such expert. Second, the rules require a management investment company to disclose whether it has adopted a code of ethics that applies to the company's principal executive officer and senior financial officers, or persons performing similar functions, regardless of whether they are employed by the management investment company or a third party. A management investment company disclosing that it has not adopted such a code must disclose this fact and explain why it has not done so. A management investment company also will be required to disclose amendments to, and waivers from, the code of ethics relating to any of those officers.
All of these new rules and rule amendments are part of the collection of information of new Form N-CSR or Form N-SAR (in the case of SBICs) because Form N-CSR contains the requirement that each registered management investment company filing reports on this form has to certify the contents of the report, and Form N-CSR and Form N-SAR contain the requirement that management investment companies must provide the appropriate audit committee financial expert and code of ethics disclosures.
We are amending our rules and forms to provide that, for registered management investment companies other than small business investment companies, Form N-SAR will be filed under the Investment Company Act only and not the Exchange Act.93 Also, we have amended Form N-SAR to eliminate the requirement that UITs and SBICs certify their reports on Form N-SAR.94 We are also adopting amendments to require an investment company to file a Form 12b-25 if it will not be able to file a report on Form N-CSR in a timely manner.95
B. Reporting and Cost Burden Estimates
Certification of Form N-CSR
The reporting burden associated with the certification requirement requires the principal executive and financial officer to review and analyze each periodic report to be filed by an investment company in order to make the required certification. In the release proposing Form N-CSR, we estimated a total of five burden hours per respondent for the certification and asked for comment on this estimate.96 We received three comment letters specifically discussing our estimate of the burden for filing and certifying Form N-CSR. Two commenters claimed that our estimate was too low, because it did not reflect the fact that investment companies often have multiple portfolios. We note that our estimate already takes into account that many registered management investment companies have multiple portfolios. Our estimate of the hour burden required for operating companies to certify their reporting forms, such as Form 10-K, is similar to our estimate of the burden for investment companies.97 While reports on Form N-CSR will contain financial statements for multiple portfolios, investment company financial statements are generally much simpler than operating company financial statements, and operating company reporting forms, such as Form 10-K, contain much information (i.e., Management's Discussion and Analysis) that Form N-CSR will not contain. Based on the comments, however, we have revised our estimate, to estimate that the certification requirement required by Section 302 of the Sarbanes-Oxley Act will result in an increase of five burden hours per registrant per filing and an additional 0.5 hours per additional portfolio in connection with the certification of annual and semi-annual reports on Form N-CSR.98
Audit committee financial expert
The amendments will increase the burden of completing Form N-CSR and Form N-SAR by requiring a management investment company to disclose whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. A management investment company that does not have an audit committee financial expert must disclose this fact and explain why it has no such expert. In the release proposing these amendments, we estimated that the disclosure regarding audit committee financial experts would increase the annual burden of completing Form N-CSR or Form N-SAR by 0.5 hours per registered management investment company. We received no comments on this estimate. We believe the additional burden of these amendments would be limited, because they will not require any investment company to add an "audit committee financial expert" to its board. We estimate that the disclosure requirements regarding audit committee financial experts will result in an incremental increase of 0.5 burden hours per registrant per year in connection with preparing each annual report on Form N-CSR or Form N-SAR.99 Management investment companies (other than SBICs) will have to provide this disclosure on Form N-CSR; SBICs will have to provide this disclosure on Form N-SAR.
Codes of Ethics
The amendments will require a registered management investment company to disclose whether it has adopted a written code of ethics for its principal executive officer, principal financial officer, principal accounting officer or controller, or persons serving similar functions, and file the code as an exhibit to Form N-CSR or Form N-SAR. An investment company disclosing that it has not adopted such a code must disclose this fact and explain why it has not done so. In the release proposing these amendments, we estimated that the disclosure regarding code of ethics would increase the annual burden by 0.5 hours per registered management investment company. We believe that the additional burden of these amendments would be limited, because they will not require any company to adopt such a code of ethics. Management should be readily able to determine whether or not its company has adopted a code of ethics. In certain cases, the required disclosure would require minimal analysis regarding why the company does not have a code. In addition, in the first year, registrants must file a copy of the code with the Commission. We estimate that the disclosure requirements regarding codes of ethics will also result in an incremental increase of 0.5 burden hours per registrant in connection with each annual report on Form N-CSR or Form N-SAR.100 Management investment companies (other than SBICs) will have to make this disclosure on Form N-CSR; SBICs will have to make this disclosure on Form N-SAR.
Form N-SAR
The amendments remove the certification requirement from Form N-SAR and shift the burden of this requirement, for PRA purposes, to Form N-CSR. We estimate that about 4,500 registrants, including 3,702 management investment companies (including 2 SBICs), and 798 UITs, currently file reports on Form N-SAR. Based on an increase of 2 burden hours relating to audit committee financial experts and codes of ethics disclosure101 and a decrease of 41,010 burden hours relating to the removal of the certification of Form N-SAR,102 we estimate that, in the aggregate, all respondents will have an incremental decrease of 41,008 burden hours associated with Form N-SAR to comply with the new rules and rule and form amendments.
Form N-CSR
We estimate that about 3,700 registrants will file Form N-CSR. Based on Commission experience with reporting forms in general and other related rules, we estimate that approximately 75% of the added burden hours will be expended by internal staff for internal review and the remaining 25% will be for outside legal costs associated with reviewing the new disclosures at a cost of $300 per hour.103 Based on the burden hour estimate for the certification of Form N-CSR, the disclosure related to an audit committee financial expert, and the disclosure related to the code of ethics, we estimate that, in the aggregate, all respondents will incur an incremental increase of 35,139 burden hours104 and $3,513,900 in outside legal costs105 to comply with the new rules and rule and form amendments.
Form 12b-25
Form 12b-25 provides notice to the Commission and the marketplace that registrants will be unable to file a required report in a timely manner. If certain conditions are met, the registrant will be granted an automatic filing extension. The proposed amendments would permit investment companies to use Form 12b-25 for the purpose of obtaining extensions with respect to filing Form N-CSR. We estimate that an average of 168 investment companies per year use Form 12b-25 to obtain extensions of time for filing Form N-SAR spending, on average, approximately 2.5 hours completing the form. We estimate that the same number of investment companies, though not necessarily the same specific investment companies, will also use Form 12b-25 to obtain extensions of filing Form N-CSR annually, resulting in an incremental increase of 420 burden hours106 to comply with the new rules and form and form and rule amendments.
V. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits imposed by its rules. Our rules and rule and form amendments more fully implement Section 302 of the Sarbanes-Oxley Act by requiring a registered management investment company, other than a small business investment company ("SBIC"), to file certified shareholder reports with the Commission on Form N-CSR containing (i) a copy of any required report to shareholders, (ii) additional information regarding disclosure controls and procedures, and (iii) the certification required by Section 302 of the Sarbanes-Oxley Act. These amendments also will designate certified shareholder reports on Form N-CSR, filed by management investment companies, as periodic reports filed with the Commission under the Exchange Act. Therefore, these amendments will require the certification of each management investment company's principal executive and financial officer to be included in its certified shareholder reports on Form N-CSR. We also are amending the instructions to Form N-SAR, the semi-annual reporting form for registered investment companies, to remove the certification requirement from the form and designate it as an Investment Company Act only filing for registered management investment companies other than SBICs. Further, we are amending Form 12b-25 to permit investment companies to use Form 12b-25 for the purpose of obtaining extensions with respect to filing Form N-CSR. In addition, the rules will require all registered management investment companies, other than SBICs, to maintain, and regularly evaluate the effectiveness of, disclosure controls and procedures designed to ensure that the information required in their filings on Form N-CSR is recorded, processed, summarized, and reported on a timely basis.
Finally, we are requiring registered management investment companies to include new disclosures on Form N-CSR or Form N-SAR, as appropriate, in order to implement the requirements of Sections 406 and 407 of the Sarbanes-Oxley Act of 2002. First, the rules require a management investment company to disclose whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. A management investment company that does not have an audit committee financial expert must disclose this fact and explain why it has no such expert. Second, the rules require a management investment company to disclose whether it has adopted a code of ethics that applies to the company's principal executive officer and senior financial officers, or persons performing similar functions, regardless of whether they are employed by the management investment company or any third party. A management investment company disclosing that it has not adopted such a code must disclose this fact and explain why it has not done so. A management investment company also will be required to disclose amendments to, and waivers from, the code of ethics relating to any of those officers.
We received one comment letter specifically addressing this Section. The commenter urged the Commission to review its cost-benefit analysis with a view not only to the new rules but to the increased costs, such as legal and accounting fees, imposed on smaller investment companies associated with other recently adopted rules, such as anti-money laundering procedures. The purpose of this cost-benefit analysis is to focus on the costs associated only with the adoption of the rules requiring the filing of Form N-CSR. The costs associated with other recently adopted rules imposed on smaller investment companies should be discussed in the cost-benefit sections of those specific rulemakings.
A. Benefits
Certification of Form N-CSR
In adopting these new rules and rule and form amendments, we intend to more fully implement the intent of Section 302 of the Sarbanes-Oxley Act, by improving the quality of the disclosure that an investment company provides about its financial condition in its periodic reports to investors. Section 302 of the Sarbanes-Oxley Act requires the principal executive and financial officers of an issuer to certify the information contained in the issuer's quarterly or annual reports filed under Section 13(a) or 15(d) of the Exchange Act. Currently, Form N-SAR is the reporting form for registered investment companies that satisfies the filing requirement under Section 13(a) or 15(d) of the Exchange Act. Form N-SAR does not contain financial statements and is a regulatory compliance form that is not delivered to investors. Thus, the amendments will remove the certification requirement from Form N-SAR, a form that does not contain financial statements, and will impose the certification requirement on Form N-CSR, a form that contains financial statements. Requiring a registered investment company's principal executive and financial officers to file certified shareholder reports on Form N-CSR will require these officers to certify, in part, that the financial statements and other financial information contained in the report fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registered investment company.
The rules should help to ensure that registered investment companies maintain sufficient disclosure controls and procedures to provide reasonable assurance to investors that registered investment companies can record, process, summarize, and report on a timely basis information that is required on Form N-CSR, including information contained in reports to shareholders.107 To the extent that registered investment companies do not maintain adequate procedures, the rules should lead to the development, or enhancement and modernization, of these procedures. Further, the certification requirement in our rules will require an investment company under the supervision of its management to conduct an evaluation of these disclosure controls and procedures within the 90-day period prior to the filing date of each report requiring certification. This will help to ensure that registered investment companies devote adequate resources and attention to the maintenance of their reporting systems. Additionally, the required evaluation will help to ensure the continuous, orderly, and timely flow of information within the registered investment company and, ultimately, to investors.
By emphasizing the importance of the role of senior officers in the reporting process, the new rules and rule and form amendments will help to enhance investor confidence in the quality of the disclosure in registered investment companies' reports to shareholders. This, in turn, will help to encourage investor confidence in these investment companies. Even though the certification is consistent with the current obligation of officers and directors of a mutual fund not to make statements that are materially misleading, we believe that investors may benefit from the certification because the certifying officers provide additional assurance to investors that the reports that they file under the Exchange Act meet this standard. We requested comment on these benefits, but received none.
Audit committee financial expert
A management investment company must disclose whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. A management investment company that does not have an audit committee financial expert must disclose this fact and explain why it has no such expert. We believe that investors will benefit from this disclosure by being able to consider it when reviewing the disclosure currently required about the background and affiliations of the directors of the investment company. Investors will also benefit to the extent that having an audit committee financial expert on an audit committee of a company increases their confidence in the company. The modifications we are making to our proposal will not reduce the level of required expertise and thus will not mitigate the benefits to investor confidence of requiring this disclosure. We requested comment on these benefits, but received none.
Codes of Ethics
The requirement that investment companies file copies of their codes of ethics will allow investors to better understand the ethical principles that guide executives of companies in which they invest. Investors will also benefit to the extent that having disclosure of a code of ethics of a company increases their confidence in the company. We requested comment on these benefits, but received none.
B. Costs
While the new rules and rule and form amendments may lead to some additional costs for registered investment companies, we believe that these costs should be limited.
Certification of Form N-CSR
These amendments will require each registered management investment company's principal executive and financial officer to certify the information contained in its certified shareholder reports on Form N-CSR. In order to provide the required certification, each principal executive and financial officer will need to review these reports. We believe that these officers already review these reports, so there should be no additional burden imposed on these companies. To the extent that these officers would need to spend additional time critically reviewing the overall context of the disclosure provided in these reports, the company would incur costs which are difficult for us to quantify.
We believe that most registered management investment companies already maintain some form of disclosure controls and procedures for identifying and processing the information needed to satisfy their disclosure obligations to their shareholders. The amendments do not dictate that registered investment companies follow any particular procedure. Alternatively, we could have required specific controls and procedures for all investment companies. By allowing management investment companies to determine what procedures are necessary to meet the obligations of the new rules, the Commission is mitigating the costs associated with compliance. Some registered management investment companies may need to institute appropriate procedures while others may need to enhance existing informal or ad hoc procedures. These incremental costs are difficult to quantify. We do not have data to quantify the cost of implementing, or upgrading and strengthening existing, internal reporting procedures.
The requirement in the certification that disclosure controls and procedures be evaluated within 90 days of the filing of a report may result in costs for registered management investment companies. Many registered management investment companies may already regularly monitor and evaluate their procedures. However, the size and scope of these internal systems are likely to vary among registered management investment companies, and it is difficult to provide an accurate cost estimate.
Audit committee financial experts
The added burden associated with the requirements to name the audit committee financial expert and disclose whether the audit committee financial expert is independent should be minimal. We have added a safe harbor provision to clarify that we do not intend to increase or decrease the current level of liability of audit committee members, or the audit committee member determined to be the expert, by requiring the disclosure as to whether an audit committee financial expert serves on the audit committee. We do not think that the requirement to name the audit committee financial expert should affect the expert's potential liability as an audit committee member. We requested comment on these costs, but received none.
Codes of Ethics
We also note that we are adopting rules that require a registered management investment company to provide disclosure of any codes of ethics applicable to its principal executive officer and senior financial officers, regardless of whether they are employees of the registrant or a third party and provide this disclosure on Form N-CSR or Form N-SAR (in the case of SBICs). This additional disclosure may impose certain costs such as retrieval, printing and copying costs. However, this information should be readily available to the board of directors and management of the investment company. Therefore, we estimate the additional costs to investment companies in complying with these provisions will be limited. We requested comment on these costs, but received none.
We note that we have modified our proposed rules to provide two alternatives to the code of ethics filing requirement. An investment company may either post its code of ethics on its website if it discloses that it intends to do so in its report on Form N-CSR or N-SAR, or undertake in its report on Form N-CSR or N-SAR to provide investors with a copy of its code of ethics upon request. These alternatives should allow registrants to choose the most cost-efficient method to meet the new requirements.
We believe that the additional audit committee financial expert and code of ethics requirements are necessary to implement the purposes of the Sarbanes-Oxley Act and will impose minimal additional burden on companies. For example, we expect that investment companies will incur added costs to disclose the name of the audit committee financial expert, to disclose whether that person is independent and to file or otherwise make available copies of their codes of ethics to investors. Investment companies electing to disclose their codes of ethics, and changes in and waivers from their codes of ethics, via their websites in lieu of publicly filing such disclosure on Form N-CSR or N-SAR must disclose this election in their reports on Form N-CSR or N-SAR. Such costs do not include the costs imposed on investment companies by the Sarbanes-Oxley Act itself. Rather, they reflect the costs of our requirements beyond the requirements of the Sarbanes-Oxley Act.
Total Cost Calculations
For purposes of the PRA,108 with respect to Form N-SAR, we further estimate that the removal of the certification requirement will remove an incremental 41,010 hours from the current total burden hours or $6,151,500109 and the disclosure of the code of ethics and audit committee financial experts will add an incremental 2 burden hours to the current total burden hours or $259.110 With respect to Form N-CSR, all respondents will incur an incremental increase of 35,139 burden hours111 or $5,152,782112 and $3,513,900 in outside legal costs113 to comply with the amendments. The current total burden hours of Form 12b-25 will incrementally increase by 420 hours or $15,468114 to comply with the amendments.
VI. Consideration of Burden on Competition; Promotion of Efficiency, Competition, and Capital Formation
Section 23(a)(2) of the Exchange Act requires us, when adopting rules under the Exchange Act, to consider the impact that any new rule would have on competition. Section 23(a)(2) also prohibits us from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act.115 In addition, Section 2(c) of the Investment Company Act,116 Section 2(b) of the Securities Act117 and Section 3(f) of the Exchange Act118 require the Commission, when engaging in rulemaking that requires it to consider or determine whether an action is necessary or appropriate in the public interest, to consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. We received no comments relating to this specific section.
The new rules and rule and form amendments are intended to more fully implement the intent of Section 302 of the Sarbanes-Oxley Act that we adopt rules requiring the principal executive and financial officers of investment companies to certify the accuracy of their periodic reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act. Also, the amendments are intended, in part, to increase transparency regarding the competence of the audit committee and the application of codes of ethics to a company's principal executive officer and senior financial officers. We believe that the amendments will benefit investors by providing them with greater confidence in the accuracy and completeness of the disclosure contained in the annual and semi-annual reports that they receive from management investment companies, including the financial statements. However, the magnitude of the effect of the amendments on efficiency, competition, and capital formation is difficult to quantify, particularly given that most management investment companies currently are required to comply with the certification requirements in recently adopted amendments to Form N-SAR, which we are removing as part of the amendments we are adopting today.
VII. Final Regulatory Flexibility Analysis
This Final Regulatory Flexibility Analysis ("Analysis") has been prepared in accordance with 5 U.S.C. 604, and relates to the Commission's rules and rule and form amendments under the Exchange Act and the Investment Company Act that will require registered management investment companies to file certified shareholder reports on Form N-CSR with the Commission, will designate these certified reports as reports that are required under Sections 13(a) and 15(d) of the Exchange Act, and will implement Sections 406 and 407 of the Sarbanes-Oxley Act. Initial Regulatory Flexibility Analyses ("IRFAs"), which were prepared in accordance with 5 U.S.C. 603, were published in the release proposing Form N-CSR and in the release proposing rules to implement Sections 406 and 407 of the Sarbanes-Oxley Act.
The rule amendments require each registered management investment company's principal executive and financial officers to certify the information contained in these reports in the manner specified by Section 302 of the Sarbanes-Oxley Act of 2002. In addition, we are providing that, for registered management investment companies other than small business investment companies, Form N-SAR will be filed under the Investment Company Act of 1940 only and not the Securities Exchange Act of 1934. We are also removing the requirement that Form N-SAR be certified by a registered investment company's principal executive and financial officers. Furthermore, we are adopting a new rule to require every registered management investment company, other than small business investment companies, to maintain disclosure controls and procedures designed to ensure that the information required in reports on Form N-CSR is recorded, processed, summarized, and reported on a timely basis. Finally, we are requiring registered management investment companies to include new disclosures on Form N-CSR or Form N-SAR, as appropriate, in order to implement the requirements of Sections 406 and 407 of the Sarbanes-Oxley Act of 2002. First, the rules require a management investment company to disclose whether it has at least one "audit committee financial expert" serving on its audit committee, and if so, the name of the expert and whether the expert is independent of management. A management investment company that does not have an audit committee financial expert must disclose this fact and explain why it has no such expert. Second, the rules require a management investment company to disclose whether it has adopted a code of ethics that applies to the company's principal executive officer and senior financial officers, or persons performing similar functions, regardless of whether they are employed by the management investment company or a third party. A management investment company disclosing that it has not adopted such a code must disclose this fact and explain why it has not done so. A management investment company also will be required to disclose amendments to, and waivers from, the code of ethics relating to any of those officers.
A. Need for, and Objectives of, Amendments
The purpose of the new rules and rule and form amendments is to more fully implement the intent of Section 302 of the Sarbanes-Oxley Act that we adopt rules requiring the officers of investment companies to certify the accuracy of their periodic reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act.
The amendments will require registered management investment companies to file with the Commission certified shareholder reports on Form N-CSR, and will designate these reports as filings which satisfy the reporting requirements of Sections 13(a) and 15(d) of the Exchange Act for management investment companies. We believe that by requiring the certification required by Section 302 of the Sarbanes-Oxley Act to be included in a management investment company's certified shareholder report on Form N-CSR, which contains financial statements, we are more fully implementing the intent of Section 302, which is to improve the quality of the disclosure that companies provide about their financial condition in their shareholder reports. In addition, we are adopting new disclosure requirements required to comply with Sections 406 and 407 of the Sarbanes-Oxley Act.
B. Significant Issues Raised by Public Comment
In both the IRFA for the release proposing Form N-CSR and the IRFA for the release proposing to implement Sections 406 and 407 of the Sarbanes-Oxley Act, we requested comment on any aspect of the IRFAs, including the number of small entities that would be affected by the proposal, the nature of the impact, how to quantify the numbers of small entities that would be affected, and how to quantify the impact of the proposals. We received one comment letter concerning the IRFA for the release proposing Form N-CSR. The commenter raised a concern that more flexible alternatives should have been considered for small investment companies (such as not mandating Form N-CSR or new reporting requirements at all) because a small amount of fraud is committed by such investment companies. We note that Congress' mandate for the Commission to require the certification specified by Section 302 of the Sarbanes-Oxley Act does not distinguish between small and large investment companies. Further, our disclosure rules generally do not distinguish between small and large investment companies. While we have the discretion to require that only larger investment companies file new Form N-CSR, it would not be appropriate to provide investors in larger investment companies with greater confidence in the accuracy and completeness of the disclosure contained in the annual and semi-annual reports that they receive from their investment companies, but not investors in small investment companies.
C. Small Entities Subject to the Rule
The new rules and rule and form amendments will affect registered investment companies that are small entities. For purposes of the Regulatory Flexibility Act ("RFA"), an investment company is a small entity if it, together with other investment companies in the same group of related investment companies, has net assets of $50 million or less as of the end of its most recent fiscal year.119 We estimate that there are approximately 205 investment companies together with other investment companies in the same group of related investment companies that have net assets of $50 million or less as of the end of its most recent fiscal year.120
D. Reporting, Recordkeeping, and Other Compliance Requirements
The new rules and rule and form amendments will require management investment companies to file certified shareholder reports on Form N-CSR, containing (i) a copy of any required shareholder report, (ii) additional information regarding disclosure controls and procedures, and (iii) the certification required by Section 302 of the Sarbanes-Oxley Act. The form of the certification will parallel the form of the certification we adopted on Form N-SAR, and on Forms 10-K and 10-Q. The certification will require the management investment company's principal executive and financial officers to state, in part, that, based on their knowledge, the information in the certified shareholder report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made not misleading with respect to the period covered by the report, and that the financial statements, and other financial information included in the report, fairly present the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant. The certification also will require the signing officers to certify that they have established and maintained disclosure controls and procedures to ensure that material information relating to the registrant is made known to senior management, and also to certify that they have evaluated these procedures within 90 days of the filing date of the report. The amendments may increase the costs associated with compliance with investment companies' reporting obligations. However, this cost increase is expected to be limited, because most management investment companies are currently required to provide a similar certification with respect to their reports on Form N-SAR.
In addition, the amendments will require registered management investment companies to disclose information regarding whether an audit committee financial expert serves on the investment company's audit committee and whether the investment company has adopted a code of ethics that applies to the investment company's principal executive officer and senior financial officers. All registered management investment companies, including those that are not required to file reports pursuant to Section 13(a) or 15(d) of the Exchange Act, will be subject to these amendments. Because the disclosure requirements of these amendments will be new, management investment companies may need to hire outside counsel or other third parties to prepare the new disclosure. We expect that reporting information in response to these new disclosure items will increase costs incurred by small entities because the new disclosure items will require these entities to compile and report more information. For purposes of the PRA and our cost-benefit analysis,121 with respect to Form N-SAR, we further estimate that the removal of the certification requirement will remove an incremental 41,010 hours from the current total burden hours, equivalent to a cost of $6,151,500122 and the disclosure of the code of ethics and audit committee financial experts will add an incremental 2 burden hours to the current total burden hours, equivalent to a cost of $259.123 With respect to Form N-CSR, all respondents will incur an incremental increase of 35,139 burden hours,124 equivalent to internal costs of $5,152,782125 and $3,513,900 in outside legal costs126 to comply with the amendments. The current total burden hours of Form 12b-25 will incrementally increase by 420 hours or $15,468127 as a result of the amendments.
E. Agency Action to Minimize Effect on Small Entities
As required by Section 603 of the RFA, and with respect to Sections 302, 406, and 407 of the Sarbanes-Oxley Act, the Commission has considered the following alternatives to minimize the economic impact of the proposed rules and rule amendments on small entities: (i) the establishment of differing compliance or reporting requirements that take into account the resources available to small entities; (ii) the clarification, consolidation, or simplification of compliance and reporting requirements under the proposed amendments for small entities; and (iii) an exemption from coverage of the proposed amendments, or any part thereof, for small entities.
The rules we are adopting are intended to more fully implement the intent of Section 302 of the Sarbanes-Oxley Act, and should help ensure that information about an investment company's business and financial condition, specifically its financial statements, is adequately reviewed by an investment company's senior executives, thereby enhancing investor confidence in the quality of its disclosure. In addition, the rules we are adopting implement Sections 406 and 407 of the Sarbanes-Oxley Act by requiring disclosure with respect to codes of ethics and audit committee financial experts to provide investors better understanding of the ethical principles and background and affiliations of the executives and directors of the investment company.
The Commission believes at the present time that special compliance or reporting requirements for small entities, or an exemption from coverage for small entities, would not be appropriate or consistent with investor protection. The designation of certified shareholder reports on Form N-CSR as reporting forms that must contain the certification required by Section 302 of the Sarbanes-Oxley Act is intended to improve investor confidence in the quality of an investment company's disclosure to investors in its shareholder reports, particularly the financial statements contained in these reports. We believe it is important that the benefits resulting from the certification of shareholder reports as required by the new rules be provided to investors in all management investment companies, not just investors in management investment companies that are not considered small entities. The Commission also notes that Section 302 of the Sarbanes-Oxley Act does not distinguish between small entities and other investment companies. Similarly, Sections 406 and 407 of the Sarbanes-Oxley Act do not distinguish between small entities and other investment companies.
We believe that different compliance or reporting requirements or timetables for small entities would interfere with achieving the primary goal of increasing transparency of corporate activities and internal procedures. We generally believe that an exemption for small entities from coverage of the new rules is not appropriate and is inconsistent with the policies underlying the Sarbanes-Oxley Act. We also think that the disclosure requirements relating to the audit committee financial experts and codes of ethics are clear and straightforward. In addition, we are not aware of any way to clarify or simplify compliance for small entities.
VIII. Statutory Authority
The rules and rule and form amendments contained in this release are being adopted pursuant to Sections 10(b), 13, 15(d), 23(a), and 36 of the Exchange Act [15 U.S.C. 78j(b), 78m, 78o(d), 78w(a), and 78mm], Sections 6(c), 8, 24(a), 30, and 38 of the Investment Company Act [15 U.S.C. 80a-6(c), 80a-8, 80a-24(a), 80a-29, and 80a-37], and Sections 3(a), 302, 406, and 407 of the Sarbanes-Oxley Act of 2002 [Pub. L. No. 107-204, 116 Stat. 745].
List of Subjects
17 CFR Parts 240 and 249
Reporting and recordkeeping requirements, Securities.
17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements, Securities.
TEXT OF AMENDMENTS
In accordance with the foregoing, Title 17, Chapter II, of the Code of Federal Regulations is amended as follows:
PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934
1. The authority citation for Part 240 is amended by adding the specific authority for "Section 240.12b-25" in numerical order to read as follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4 and 80b-11, unless otherwise noted.
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Section 240.12b-25 is also issued under 15 U.S.C. 80a-8, 80a-24(a), 80a-29, and 80a-37.
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2. Section 240.12b-25 is amended by revising the section heading and paragraphs (a) and (b)(2)(ii) to read as follows:
§240.12b-25 Notification of inability to timely file all or any required portion of a Form 10-K, 10-KSB, 20-F, 11-K, N-SAR, N-CSR, 10-Q or 10-QSB.
(a) If all or any required portion of an annual or transition report on Form 10-K, 10-KSB, 20-F or 11-K (17 CFR 249.310, 249.310b, 249.220f or 249.311), or a quarterly or transition report on Form 10-Q or 10-QSB (17 CFR 249.308a or 249.308b) required to be filed pursuant to sections 13 or 15(d) of the Act (15 U.S.C. 78m or 78o(d)) and rules thereunder, or if all or any required portion of a semi-annual, annual or transition report on Form N-CSR (17 CFR 249.331; 17 CFR 274.128) or Form N-SAR (17 CFR 249.330; 17 CFR 274.101) required to be filed pursuant to sections 13 or 15(d) of the Act or section 30 of the Investment Company Act of 1940 (15 U.S.C. 80a-29) and the rules thereunder, is not filed within the time period prescribed for such report, the registrant, no later than one business day after the due date for such report, shall file a Form 12b-25 (17 CFR 249.322) with the Commission which shall contain disclosure of its inability to file the report timely and the reasons therefor in reasonable detail.
(b) * * *
(2) * * *
(ii) The subject annual report, semi-annual report or transition report on Form 10-K, 10-KSB, 20-F, 11-K, N-SAR, or N-CSR, or portion thereof, will be filed no later than the fifteenth calendar day following the prescribed due date; or the subject quarterly report or transition report on Form 10-Q or 10-QSB, or portion thereof, will be filed no later than the fifth calendar day following the prescribed due date; and
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3. Section 240.13a-15 is amended by revising paragraph (a) to read as follows:
§240.13a-15 Issuer's disclosure controls and procedures related to preparation of required reports.
(a) Every issuer that has a class of securities registered pursuant to section 12 of the Act (15 U.S.C. 78l), other than an Asset-Backed Issuer (as defined in §240.13a-14(g) of this chapter), a small business investment company registered on Form N-5 (§§ 239.24 and 274.5 of this chapter), or a unit investment trust as defined by Section 4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), must maintain disclosure controls and procedures (as defined in §240.13a-14(c) of this chapter).
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4. Section 240.15d-15 is amended by revising paragraph (a) to read as follows:
§240.15d-15 Issuer's disclosure controls and procedures related to preparation of required reports.
(a) Every issuer that files reports under section 15(d) of the Act (15 U.S.C. 78o(d)), other than an Asset-Backed Issuer (as defined in §240.13a-14(g) of this chapter), a small business investment company registered on Form N-5 (§§ 239.24 and 274.5 of this chapter), or a unit investment trust as defined by Section 4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), must maintain disclosure controls and procedures (as defined in §240.15d-14(c) of this chapter).
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PART 249 - FORMS, SECURITIES EXCHANGE ACT OF 1934
5. The authority citation for Part 249 is amended by adding the following citations in numerical order to read as follows:
Authority: 15 U.S.C. 78a, et seq., unless otherwise noted.
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Section 249.330 is also issued under secs. 3(a), 406, and 407, Pub. L. No. 107-204, 116 Stat. 745.
Section 249.331 is also issued under secs. 3(a), 302, 406, and 407, Pub. L. No. 107-204, 116 Stat. 745.
6. Section 249.322 is amended by revising paragraph (a) to read as follows:
§249.322 Form 12b-25 - Notification of late filing.
(a) This form shall be filed pursuant to §240.12b-25 of this chapter by issuers who are unable to file timely all or any required portion of an annual or transition report on Form 10-K and Form 10-KSB, 20-F, or 11-K (§§249.310, 249.310b, 249.220f or 249.311) or a quarterly or transition report on Form 10-Q and Form 10-QSB (§§249.308a and 249.308b) pursuant to section 13 or 15(d) of the Act (15 U.S.C. 78m or 78o(d)) or a semi-annual, annual, or transition report on Form N-SAR (§§249.330; 274.101) or Form N-CSR (§§249.331; 274.128) pursuant to section 13 or 15(d) of the Act or section 30 of the Investment Company Act of 1940 (15 U.S.C. 80a-29). The filing shall consist of a signed original and three conformed copies, and shall be filed with the Commission at Washington, DC 20549, no later than one business day after the due date for the periodic report in question. Copies of this form may be obtained from "Publications," Securities and Exchange Commission, 450 5th Street, NW, Washington, DC 20549 and at our website at http://www.sec.gov.
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7. Form 12b-25 (referenced in §249.322) is amended by:
a. Revising the preamble;
b. Revising paragraph (b) of Part II; and
c. Revising Part III to read as follows:
Note: The text of Form 12b-25 does not, and this amendment will not, appear in the Code of Federal Regulations.
Form 12b-25
NOTIFICATION OF LATE FILING
(Check One): ___ Form 10-K ___ Form 20-F ___ Form 11-K ___ Form 10-Q
___ Form N-SAR ___ Form N-CSR
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PART II - RULES 12b-25(b) and (c)
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(b) The subject annual report, semi-annual report, transition report on Form 10-K, Form 20-F, Form 11-K, Form N-SAR or Form N-CSR, or portion thereof, will be filed on or before the fifteenth calendar day following the prescribed due date; or the subject quarterly report or transition report on Form 10-Q, or portion thereof, will be filed on or before the fifth calendar day following the prescribed due date; and
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PART III - NARRATIVE
State below in reasonable detail why Forms 10-K, 20-F, 11-K, 10-Q, N-SAR, N-CSR, or the transition report or portion thereof, could not be filed within the prescribed time period.
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8. Section 249.330 is revised to read as follows:
§249.330 Form N-SAR, annual and semi-annual report of certain registered investment companies.
This form shall be used by registered unit investment trusts and small business investment companies for semi-annual or annual reports to be filed pursuant to §270.30a-1 or §270.30b1-1 of this chapter in satisfaction of the requirement of section 30(a) of the Investment Company Act of 1940 that every registered investment company must file annually with the Commission such information, documents, and reports as investment companies having securities registered on a national securities exchange are required to file annually pursuant to section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m) and the rules and regulations thereunder.
9. Section 249.331 is added to read as follows:
§249.331 Form N-CSR, certified shareholder report.
This form shall be used by registered management investment companies to file reports pursuant to §270.30b2-1(a) of this chapter not later than 10 days after the transmission to stockholders of any report that is required to be transmitted to stockholders under §270.30e-1 of this chapter.
PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
10. The authority citation for Part 270 is amended by revising the general authority citation and the specific authority for "Section 270.30a-2" and adding the following citations in numerical order to read as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-39, unless otherwise noted;
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Section 270.30a-1 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29.
Section 270.30a-2 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29, and secs. 3(a) and 302, Pub. L. No. 107-204, 116 Stat. 745.
Section 270.30a-3 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29, and secs. 3(a) and 302, Pub. L. No. 107-204, 116 Stat. 745.
Section 270.30b1-1 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29.
Section 270.30b2-1 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29, and secs. 3(a) and 302, Pub. L. No. 107-204, 116 Stat. 745.
Section 270.30d-1 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, and 80a-29, and secs. 3(a) and 302, Pub. L. No. 107-204, 116 Stat. 745.
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11. Section 270.8b-15 is amended by adding a sentence at the end of the section to