SEC Division of Investment Management staff letter: Chief Financial Officer

M: ICA of iqi¡o --.
SECTION $, I '6. 30
RUL
UNITED STATES PULIC SECURITIES AND EXCHANGE COMMISSION AVAILAILIT il-7 - C) 1 WASHINGTON. D.C. 20549 DIVISION OF

INVESTMENT MANAGEMENT
November 7, 1997
Dear Chief Financial OiTcer:
The accounting staff of the Division of Investment Management (the "Division") has prepared this letter to assist investment company registrants and their independent public accountants in dealing with certain accounting-related matters. These comments represent the views of the staff of the Division and are not necessarily those of the

Securities and Exchange Commission
(the "Commission"). The comments described below apply to fiings, including reports to shareholders, made by registered investment

companies. This letter should be read together with earlier letters issued by the Division's Chief Accountant and letters issued by the Division's Office of Insurance Products and Offce of Disclosure and Review.

Foreign Pricing Considerations

In its letter dated November 1, 19961, the staff discussed certain accounting-

related matters involving a fùnds ability to obtain and verify foreign corporate actions. In particular, the staff focused on the situation in wltich management of a fund uses reasonable diligence to attempt to obtain timely notification and verification of the eflective date of foreign corporate actions but delayed the recording of the foreign corporate actions until third pai1y confirmation. . Such a procedure is commonly referred to as reflecting a "reasonable diligence standard." Since the letter' s issuance, registrants have asked whether a reasonable diligence standard could extend to the pricing of foreign securities. Although the staff recognizes that accounting for both corporate actions and pricing of securities is often intertwined, we do not believe the same standard applies. As noted in a previoiis letter2, the Commission's Accounting Series Releases 113 and 118 are the accounting standards that govern the valuation and accounting for investments.3

See Letter 10 Chiel Fiiiancial Oflcers lrom Lcnvreiice A. Friend. dalcd November 1. I tJtJÚ. "Accounting ror Foreigii Corporaie Actions." See Letter to Chief Fiiiancial Offcers rrom Lawrence A. Frieiid. dated November i. i tJtJ4. "Valuation or Certain Portfolio I nvestinents." Accounting Series Release ILL. (October 2 L I t)tJ): Accouniing Series Release I I X. (December 23, ItJ70). These releases have been codified in Sections 404.04 and 404.(13. respectively. in the Codification or Financial Reporting Policies.

"
"
Fund (~tFunds Considerations
In recent years, the number of fund of funds arrangements,4 in which one fund ("top tier fùnd") invests its assets in shares of another fund ("underlying fund") rather than directly in securities, has increased. In some of these arrangements, the top tier fund has invested a significant amount of its investments in an underlying fund. The degree of investment raises financial reporting concerns for these top tier funds. Top tier funds, like all other funds, report each investment separately on their financial statements.5 When a top tier fund has a significant amount of its portfolio invested in a single underlying fund or owns a controlling interest in an underlying fund, registrants should consider providing additional financial information to shareholders. its portfolio invested in an underlying fund, the top tier fund should consider accompanying its financial statements For example, if the top tier fund has a significant portion of

with those of the underlying fund. Additionally, if a top tier fund owns a controlling interest in an underlying fund, current accounting literature may require consolidating the financial statements 'of an underlying fund and the top tier fund6 Designation of Segregated A.'sets Certain trading practices undertaken by registrants may involve the issuance of senior securities subject to the prohibitions and asset coverage requirements of Section 18 of the Investment Company Act of 1940.7 In 1979, the Commission issued a General Statement of PoÜc/ indicating the staffs view that certain instruments held by a fund would not be deemed subject to Section 18 if the fund's obligation, with respect to any such instrument, was "covered" by assets established and maintained by the fund in a segregated account. Release 10666 further stated that the board of directors of a fund that is engaged in the specified trading practices should review the fùnd' s portfolio and custodial accounts to determine if the fund has created or should create any segregated accounts with the companv's custodian. Although Release i 0666 includes a section on valuation and accQunting, it does not discuss internal accounting control and reporting issues related to the segregated accounts. . .1 Fund of funds arrangements are sulJject to the provisions of Section 12 of the Investment Company Act of I tJ40. See Regulation S-X. Ai1icles (i-04. 6-10 and 12-12. 117 CFR 210.6-04.6-10. and 12-12). " Statement or Financial Accounting Standards No. 94. "Consolidation of All Majorí~y-Owl1ed

.';iihsidiaries. .. financial Accouuting Standards Board. (October. 1987) ("SF AS 94"). SF AS 94 requires consolidation of all majority-owned subsidiaries unless control is temporary or does not rest with the lIajorily owner. Control is defined as ownership of over 50% of the outstanding voting shares of company. While a rund of funds arrangement differs from an operating company envisioned by the current accounting literature. SF AS tJ.l suggests that consolidation may be appropriate. another 15 U.S.C XOa-18

,/

~ hivestmen! Company Act Release No. 10666. April 18. 1979 ("Release 10666").

Typically, investment companies have designated securities to be segregated on the records of their custodians. The staff has been asked by registrants whether it would be consistent to segregate accounts on the fund's records. The staff has indicated that it would not object if assets segregated under Section 18 were designated solely on the t-iind's records and not designated on the fund's custodian's records.9 Accountingfor Securities ¡,em/ing Transactions In a typical fund securities lending transaction, the fund lends its securities to a borrower which pledges cash or securities as collateral for the securities on loan. Generally Accepted Accounting Principles ("GAAP") for securities lending transactions are governed by Statement of Financial Accounting Standards No. 125 ("SF AS i 25"). II SFAS 12) focuses on "effective control" 11 as a key component for determining the accounting treatment for securities on loan and the corresponding collateral exchanged

between the lending fund and borrower.
When a lending fund receives securities as collateral and does not have effective control over the securities, it should not record the securities as its asset. Conversely,

when a fùnd receives securities as collateral and has effective control over the securities, it should record the securities as its asset with a corresponding liability for repayment. When a t-iind receives cash as collateraL, it is deemed to have effective control of the collateral and should record the cash as its asset with a corresponding liability for 1" repayment. ~

., To ihç e-,tenl that a lìiid designates segregated assels solely on its records. the fund may need to in accordance implement addiiional procedures and controls to ensure thai segregation is undertaken

\ith the interprelaiion outlined in Release WCi66.

i" ".lcWIiIi/llig .Ii!/ lraiis!á." (I/U/ ,"'/'/Ticing ol Fiii(liicial .
Isseis and E-rtinguishiients oj' Liahilities, ,.
Financial Acconniing Siandards Board. (June. 19%) CSFAS 125"). SPAS 125 was amendcd by Stalemeiit on Financial Accouniing Siandards No. 127. ''le!áral (/l ihe qli'ctive Dale ol ('crlain 1'l'wisloll 0(1-: i...¡. ,\101('11/(111 ."iiiih(' 1';5. .. Financial Accounting Siandards Board. (December. 19(6) ("SFAS 127") by delcrring the c1Tecti'e date or certain rcle'ant portions or SFAS 125. inclnding the paragraphs dealing \'ih securities lending. to Deceiiber ~ I. 1997. For the purpose or this letter. the rererclIce \0 SFAS 125 encompasses SF AS 125. as amended by SF AS 127. ¡¡See SF AS 125. Par. 9 (dcIines the three conditions under which the .transretor has surrcndcrcd control O'er lransrelTed assets. an ol \diich must be met: (i) the transferred asscthas becn put presumptively or the transreror and its crcditors. e'cn in bankniptcy, (2) caeh transfcree may use the transrerred assets. and (~) the transreror does not i(i.c an agrcement that maintains effective control beyoltd the reach

O'er the Iransrerred asset.) the roiio",ing rcatures:
See SPAS 125. Par. 27 (defines em:cti'e control as an agreement that has all of

--(a) the assets \0 berepurcliased or redeemed are ihe same or subslantially the same as those transrerred: (b) the transreror is able to repurchase or redeem them on substantially the agrced terms. en:n in the e'ent or dclÜult by the transferee: (c) the agreement is to repurchase or redecm them berore maiuriiy. al a lI-,ed or deteniiinable price: and (d) the agreemeiit is entered concurrently with thc I ranslcr.") 12 See SFAS i 25. Par. i (i i. ..... all cash collaieral should be recorded as an asset by the secured party. logcth..1 \ iih a liahility lor ihe obli~;itioiiio returi it 10 ihe Iraiislcror. \'hose assel is a rccei'able."

F11i1her. the Ii~!lding lìlld remaiiis Iiahle ror retiiriing ihe amouiil or cash collateraL. and incurs ihe risk

or loss from aiiy securiiics purchascd \"th ihe cash collateraL. .

We have noted inconsistent accounting by some funds that automatically reinvest cash collateral in securities. These funds are "looking through" to the securities purchased with the cash collateral and treating the securities received as collateral without effective control. Therefore, the funds do not record them as assets. The staff believes, consistent with SF As 125, that a fund has effective control over cash collateral and also has effective control over any. securities purchased with the cash collateraL. As a result, a fund should record these securities as its asset and a corresponding liability for repayment, in the 13 amount of the cash collateral received, in its financial statements.

Closed-End Fund Expense Ratios
In, reviewing the financial statements of closed-end funds, we have noted inconsistencies in how they have calculated their expense ratiosl4 when they incurred interest expense on debt securities or paid dividends on preferred shares. interest Expense Item 4 of Form N-2, flnancial HiKhlighis, requires expense ratios to include all expenses of the fund. The instructions to Form N-2 make no exception for any expense item; all expenses, including interest expense, should be included in the fund's calculation of its expense ratio. 15 We have been asked by registrants and their independent accountants whether more than one expense ratio may be shown as a part of the financial highlights table. For example, some funds believe a more meaningful ratio would be based on expenses that do not include interest ("net expenses"). The staff has not objected to a second ratio that 16 In all cases, the expense ratio that includes excludes interest in certain circumstances.

interest expense ("gross expenses") should be shown in the body of the financial highlights. The staff would not object if both the net and gross expense ratios are shown in the body of the financial highlights table or if the expense ratio, without the interest expense, is reflected in a footnote to the financial highlights table. Both ratios should be clearly identified with appropriate disclosure about the differences. 13 The Staff noted in Norwest Bank Minnesota N.A.. SEC No-Action Letter (pub. avaiL. May 15. 1995) that cash collateral should be invested in accordance with the funds investment policies. Because the fund invests the cash collateral in securities consistent with its policies,. the fund exercises control over the cash collateral and the securities purchased with that cash. As fund assets, the securities purchased with the cash collateral are subject to the funds usual valuation procedures. 14 See Form N-2,ltem 4. L line i. ì:; In proposing Form N-2. ihe Commission stated that 'interest payments on long-term debt, which may be part of the capitalization of a closed-end fund, would be ineluded among the annual shareholder expenses." (Release No. LC- i 709 1. July 2X, i 9X9, footnote 18). 16 This position reflects an application of a general principle stated in the instructions to Form N-2, General Instnictions (2) to the form states: "The prospectus or the SAI may contain more inrormation than called for by this form, provided the information is not incomplete. inaccurate, or misleading and does not, because of its nature, quantity. or manner of presentation. obscure or impede understanding of required information."

Dividend Payments
GAA defines preferred stock to be a component of equity and not debt, even though it has characteristics of both.17 Accordingly, dividend payments to preferred stockholders are not considered to be an expense of the fund and, in the staffs view, should not be included as expenses in the financial statements.IS Instruction i 5 to Item 4 of Form N-2 require~ a fund to "indicate in a note that the expense ratio and net investment income ratio do not reflect the effect of dividend payments to preferred shareholders." Also, Instruction 9 to Item 3, fee Table and Synopsis, states that other expenses includes all expenses that will be reflected as expenses in the registrant's statement of operations. Because GAA does not permit dividends to be included as expenses in a statement of operations, the staffs position is that dividends would not be included as an expense in yither Item 3 or 4 of Form N-2. In view of the reporting differences, the staff takes the position that it would not object to additional ratios reflecting the treatment of the preferred shares; In the staffs view, the additional ratios should not be included on the face of the financial highlights
table; rather, they should be included in the footnotes to that table.
Other Disclosures

Instruction 6 to Item 3 of Form N-2 prescribes "other expenses (to) be stated as a percentage of net asset value attributable to common shares." Although this instruction is to Item 3 and is not repeated as an instruction to Item 4, the staff believes the concept

should be consistently applied in both tables. Expense ratios should be presented as a percentage of the net asset value attributable to common shares only.19 The staff would not object to the inclusion, in the footnotes to the financial highlights table, of additional ratios that are clearly identifìed and explained. The Division acknowledges that its positions stated above with respect to c1osed￾end fùnds may result in some funds changing their financial statements. To enable those funds suffcient time to complete these changes, the staff would not object if registrants implement these interpretations for all ratios contained in financial statements for fiscal years that begin after November i 5, 1997. I' See Accounting Principles Board Opinion Number io - Omnibus Opinion. American Institute or Certified Publ ic Accountants_ (Deccmber. 19(6). i~ Disiributions 10 prererred and common stockholders are required to be shown broad in Form N-2. ¡ Item 4.1. ,J I') Similarly. the ratio or net income 10 ¿lVerage net assets (Form N-2. Itcll;.l,1 line j.) should also be

presented as a perceiltage or the net asset value attributable to common shares si.'JJ~';'

Organization CO.lt.'ì COn.lÍlerlition.'ì
The stafl continues to address questions from registrants and their independent

accountants regarding the accounting treatment for organization costs20 that arise in connection with a merger, liquidation, or dissolution of a fund.21 The staff has indicated that the remaining amount of organization costs, in such a transaction, are the responsibility of the holder of the original shares and should be netted against redemption proceeds of the original shares.22 The staff has indicated that it is not appropriate to accelerate the write-off of the remaining organization costs to the date of the merger, liquidation, or dissolution, or to immediately charge to fund expenses the remaining amount of organization costs.

This letter c~ntains information of importance to the company's independent public accountants;' therefore, we encourage you to discuss these items with them. Address any questions about the contents of this letter or related matters to John S. Capone or Paul T. Kraft, Assistant Chief Accountants, or me, at (202) 942-0590. Very truly yours, ~)/i~~~ !2. l~.,l Lawrence A. Friend Chief Accountant ~(l This ilem docs not addrcss any possible changes to the accounting ror and the reporting on organization costs as coniemplated in proposed Statemenl or Position (SOP) "Reporting on Costs or Start-Up Acii'iiies:' daled April 22. 1997. issued by ihc American Institulc or Certified Public Accountants. The starr would not object if. in the case or a merger. the organizcÙion costs or thc acquiring. Icgal suniHlr rund are capitalized and amortized. Howeyer. rcmaining organization costs of the target ) rUiidshouldbe nCllcd against thc redemption proceeds of the original shares. Sec Lettcr to ¡Ü:gisir,.iiis ¡ruii' c'arolyn B. Lewis. dated January 3. I 9tJ 1. Item II. E. "Organization Expcnses."

6'