SEC Division of Investment Management staff letter: Unit Investment Trust Organizational Expenses

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON. D.C. 20549
DIVISION OF

INVESTMENT MANAGEMENT May 9, 1995
ACl 'ICA .1.0

:i'(A )(:2) Pierre de St. Phalle, Esquire SEON

Davis Polk & Wardwell
RULE
450 Lexigton Avenue

New York, NY 10017 PUBLIC
AVAILABIL oslo, "5'
Re: Unit Investment Trust Organational Expenses Dear Mr. de St. Phale:
Per your request on behal of the Defined Asset Funds,I we have considered the issue

of whether the Investment Company Act of 1940 alows a unit investment trst ("UIT" or "Trust") to bear its own organational expenses. Although you acknowledge that, historically, UIT sponsors have borne their Trusts' organational expenses, you contend that nothing in the Investment Company Act prohibits the Trusts themselves from bearg those expenses. You propose that a Trust be permitted to bear the cost of preparg and priting its

registration statement, trust indenture, and other documents; registerig its securities with the Commission and the states; and the intial audit of the Trust. The sponsor would bear the Trust's other expenses, including al distribution costs such as advertising and priting and distributing prospectuses and sales material to prospective investors. The trust indenture would specify how organational and other expenses wil be alocated. The Trust's

prospectus would prominently disclose that investors wil bear org~ational expenses.

Under your proposal, the trustee of the Trust would be responsible for paying the. Trust's organational expenses, although on rare occasion the sponsor may do so. In either case, the payor would be entitled to receive reimbursement from the Trust equal to actual out-of-pocket expenses. For the reasons set forth below, we agree that the Investment Company Act does not prohibit a UIT from bearig its own organational expenses. First, the express language. of
section 26(a)(2) of the Investment Company Act appeas to permit this practice. Second, the
proposed expense allocation would not lead to any of the abuses that the Investment Company Act was designed to prevent, provided the alocation is adequately disclosed to trust investors. Finaly, open-end and closed-end management investment companes currently bear their own organational expenses, and we see no reason to impose a different standard on UITs. i The Defined Asset Funds are a famly of unit investment trusts jointly sponsored by Merrll Lynch, Pierce, Fenner & Smith Inc., Smith Barey Inc., PaineWebber Inc., Prudential Securities Inc., and Dea Witter Reynolds Inc. 2 In particular, the Trust's fee table would conta a separate line item for organzational expenses, and the Trust's prospectus would inform investors that although historically the Trust's sponsors have paid all the costs of establishig UITs, this Trust wil bear some or all of its organzational expenses. 2

Pierre de St. Phalle, Esq.

May 9, 1995

Section 26 of the Investment Company Act regulates cert key aspects of a UIT's

operation. Section 26(a)(2) was designed to preserve a UIT's assets by requirg that a

UIT's trust indenture or custodian agreement limit the expenses that can be paid out of those 3 Paragraph (A) of section 26(a)(2) liits payments to the UIT's trustee and custodian assets. to compensation for services and reimbursement for expenses that are specifed in the trust payments to the UIT's trustee and custodian to payments for services actualy pedormed and to reimbursement for expenses actually incurred. Paragraph (C) prohibits, with one exception not relevant here, indenture or custodian agreement. Pargraph (B) further liits payments to the UIT's depositor4 or pricipal underwriter. Finaly, pargraph (D) of section

26(a)(2) requires that the trustee or custodian maintain possession of al UIT assets and hold them in trust, subject only to the charges and collections alowed under paragraphs (A), (B), and (C). The proposed expense allocation is consistent with pargraph (A) of section 26(a)(2). The trust indenture would specifcally authorie the trustee to pay organational expenses and to reimburse itself out of Trust assets. Just as audit fees, anual report priting costs, and other charges are appropriate expenses of a UIT if the indenture so provides, we believe that the ordinar and necessar expenses of organiing and registerig a UIT are similarly 3 Section 26(a)(2) provides as follows:

(a) No principal underwriter for or depositor of a registered unit investment trust shall sell, except by surrender to the trustee for redemption, any security of which such trust is the issuer (other than short-term paper), unless the trust indenture, agreement of custodianship, or other instrument pursuant to which such security is issued- (1) * * * (2) provides, in substace,

(A) that durig the life of the trust the trustee or custodian, if not otherwise remunerated, may

charge against and collect from the income of the trust, and from the corpus thereof if no income is available, such fees for its services and such reimbursement for its expenses as are provided for in such instrument; (B) that no such charge or collection shall be made except for services theretofore performed or

expenses theretofore incurred;
(C) that no payment to the depositor of or a principal underwriter for such trust, or to any affiiated person or agent of such depositor or underwriter, shall be allowed the trustee or

custodian as an expense (except that provision may be made for the payment to any such person of a fee, not exceeing such reasonable amount as the Commssion may prescribe as compensation for performg bookkeeping and other admistrative services, of a character normally performed by the trustee or custodian itselt); and (D) that the trustee or custodian shall have possession of all securities and other propert in which the funds of the trust are invested, all funds held for such investment, all equalization, redemption, and other special funds of the trust, and all income upon, accretions to, and proceeds of such propert and funds, and shall segregate and hold the same in trust (subject only to the charges and collections allowed under clauses (A), (B), and (C)) until distribution thereof to the security holders of the trust. 4 The depositor of a UIT includes the sponsor. See General Instructions to Form N-8B-2 (defintion of

" deposi tor").

Pierre de St. Phalle, Esq.

May 9, 1995

appropriate for a UIT to bear, provided those expenses are authoried in the indenture. The

proposed expense allocation also is consistent with paragraph (B) of section 26(a)(2) because reimbursement would be liited to actual out-of-pocket expenses incurred by the trustee. The proposed expense alocation is consistent with pargraph (C) of section 26(a)(2). By its terms, paragraph (C) prohibits payments to a UIT's sponsor (or to an afilate or agent of the sponsor), but the staf has interpreted pargraph (C) also to prohibit payments to thid parties if such payments directly benefit the sponsor.s Under your proposal, a Trust in most cases would pay paries other than its sponsor for their services in organing the Trust. These payments to thid parties would not directly benefit the sponsor.6 On rae occasion, a sponsor may advance funds to pay an organational expense to an unaffilated

third party and receive reimbursement directly from the Trust. In light of the purposes

underlying section 26(a)(2) and the legislative history of that section, discussed below, we do not believe that paragraph (C)' s prohibition on payments to a UIT's sponsor applies to a Trust's at-cost reimbursement of its sponsor. 7 Finally, paragraph (D) of section 26(a)(2) provides, in effect, that the trustee or custodian of a UIT may use trust assets to pay only those expenses authoried by pargraph (A) of the section and not otherwise prohibited by pargraphs (B) and (C). Because we believe, for the reasons set forth above, that the Trust may reimburse the trustee for its payment of organiational expenses under paragraphs (A), (B), and (C), the proposed expense allocation is consistent with pargraph (0). We believe that our statutory interpretation is consistent with the policies and purposes of section 26(a)(2), as expressed by Congress and the Commission. In the legislative history of section 26, Congress noted that, "(e)xcept under special circumstances, the ( sponsor) or underwriter must be prohibited from deriving any fees from the trust other than the original sales load for distributing the shares. ,,8 Here, the Sponsors would not receive any "fees" by virue of the proposed expense alocation. Although the Sponsors may occasionally receive reimbursement at cost for their payment of a bona fide organational 5 In assessing whether a payment benefits the sponsor, the staff has considered whether the payment is for a service typically provided by a UIT sponsor. The staff has refused, for example, to allow UIT sponsors to shift the expense of maintaing a seconda maket in a UIT's securities to the UIT itself. Kemper Sales Co. 11, 1979). (pub. avaiL. Jan. 3, 1985); E.F. Hutton Tax Exempt Fund (pub. avaiL. April

6 Under your proposal, a Trust would pay the legal, accounting, registration, and other fees necessary to organize and establish the Trust, but would not pay any expenses that directly benefit the sponsor, such as those related to distributing, or maintainng a secondar market for, the Trust's securities. Of course, a UIT's sponsor benefits indirectly any time the trust bears an expense that the sponsor otherwise would have to bear. However, we do not interpret section 26(a)(2)(C) to prohibit the trust from paying any expense that might indirectly benefit the sponsor. Under that stadad, UIT sponsors would be responsible for paying trustee and custodian fees, even though section 26(a)(2)(A) expressly authorizes the trust to mae those payments. In our view, organzational expenses owed to third parties are analogous to trustee and custodian fees because they are legitimate business expenses paid to parties unaffiliated with the trust's sponsor for services that are necessary to the operation of the trust and that do not directly benefit the sponsor.

7 See note 9 infra and accompanying text.
8 S. Rep. No. 1775, 76th Cong., 3d Sess. (1940), at 18; H.R. Rep. No. 2639, 76th Cong., 3d Sess., at 22 (1940) (emphasis added).

Pierre de St. Phale, Esq.
May 9, 1995

expense, we do not believe that such reimbursement constitutes payment of a "fee" in contravention of section 26(a)(2).9 Moreover, there is no evidence in the legislative history that Congress intended to prohibit a UIT from bearg its own organiational expenses. The restrictions and liitations contaed in section 26(a)(2) were designed to prevent or mitigate

certn abuses identifed by the Commission in a 1940 report on UITs,lO paricularly the none of the hidden charges cited in the report related in any way to a UIT's organational expenses. "hidden charges" assessed agaist UITs by their sponsors.11 Signicantly,

Based on the legislative history of section 26(a)(2), the Commission has stated that
section 26(a)(2) was designed "to preserve trust assets and prevent securityholders from
being subjected to purported 'adminstrative' fees which, instead of compensating the depositor for adminstrative services actualy rendered, in fact provide additional remuneration to the depositor. . .. The purpose of (section 26(a)(2)) is to prohibit the depositor from 'reaping hidden profits' through purported adminstrative fees. ,,12 Under your proposal, a Trust's payment of organational expenses would not be hidden, but would 13 On those rae occasions (if ever) when the be prominently disclosed in its prospectus.

proposed expense alocation results in a payment from a Trust to its sponsor, payment would be limited to reimbursement for out-of-pocket expenses. Thus, the sponsor would not receive any "additional remuneration" or "profit" as a result of the proposed expense alocation. Finally, we note that open-end and closed-end management companies routinely pay their own organiational expenses. We have not identifed any policy reason for alowing the sponsors of management companes to alocate organational expenses to their funds, while prohibiting UIT sponsors from alocating the same expenses to their trusts. For the reasons set forth above, we believe that your proposal that a UIT bear its own organizational expenses, either directly or through reimbursement of its sponsor, is 9 The Commssion recognzed the distinction between at-cost reimbursement and payment of a "fee" when it promulgated rule 26a-l under the Investment Company Act. Rule 26a-l permts a UIT to pay its sponsor for bookkeeping and other admistrative services if payment is in an amount not greater than the actu cost of the services provided. The Commssion considered the "at cost" stadad of rule 26a-l to be consistent with the policies underlying section 26(a)(2). See Investment Company Act Release Nos. 13705 (Jan. 9, 1984)

(proposing rule 26a-l) and 14066 (July 27, 1984) (adopting rule 26a-l).

10 Securities and Exchange Commssion, Investment Trusts and Investment Companes: Fixed and

Semi fixed Investment Trusts, H. Doc. No. 567, 76th Cong., 3d Sess. (1940). Ths report was one of a series of Commssion reports about the investment management industry thåt led to the enactment of the Investment Company Act of 1940. 11 These charges included, among other thigs: buying securities for a Trust at the (lower) bid price and even when the sponsor purchased the portfolio securities in round lots; including brokerage commssions on portfolio securities in the figure on which the load was calculated; adjusting the offerig price of the Trust's securities to selling them to the Trust at the (hgher) askig price; charging the Trust odd-lot brokerage commssions

the next highest eighth of a dollar; and retaining the interest earned on the Trust's cash. Fixed and Semifixed Investment Trusts, supra note 10, at 165-189 (Chapter X, "Costs to Investors and Profits to Sponsors"). 12 Investment Company Act Release No. 13705, supra note 9. 13 See supra note 2.

Pierre de St. Phalle, Esq.

May 9, 1995

consistent with the Erovisions of the Investment Company Act and the policies and purposes underlying the Act. 4

Sincerely,
~ A- 1o,JpÇ&L

Ba.. Mendelson

Senior Counsel
14 The position we anounce today appears to conflct with an exemptive order issued by the Commssion in 1979. In Third Generation Tax-Exempt Bond Trust. Series 1, Investment Company Act Release Nos. 10819 (Aug. 7, 1979) (notice) and 10857 (Sept. 5, 1979) (order), the Commssion granted an exemption from section (a) (2) to permt a UIT to bear its own organzational expenses, implying that this practice would be prohibited without exemptive relief. The staff no longer believes that a UIT requires an exemptive order to bear its own organizational expenses, and has apprised the Commssion of its position on this issue. 26