The SEC wants to divide responsibility between mutual fund boards and custodians for oversight of the foreign companies which keep possession and records of the foreign stocks and bonds mutual funds own.

The SEC has proposed a new rule which would set minimum standards for so-called foreign sub-custodians and would give funds and custodians some flexibility as to how they oversee foreign sub-custodians. The arrangement calls for a fund's custodian to provide a fact-finding report and analysis to a fund's board of directors on the stability of foreign sub-custodians which funds use. Fund directors then must decide whether to hire the foreign sub-custodian.

The proposal is "designed to create a partnership between a fund adviser and a global custodian in which each performs responsibilities appropriate for its expertise," the SEC said in a statement filed April 30 introducing the proposal.

The public has until July 15 to comment on the proposal, which revises the language of Rule 17-5 under the Investment Company Act and proposes a new rule, 17-7. The existing rule permits fund boards to delegate much of the responsibility for overseeing sub-custodians to the custodian.

A mutual fund hires a custodian, usually the subsidiary of a large bank, to hold securities which the fund owns. For mutual funds which invest abroad, the custodians usually hire a foreign sub-custodian or "foreign securities depository," as foreign sub-custodians are known. The foreign depository holds the U.S. fund's securities invested in that country.

Regulators, mutual fund executives and fund custodians have been concerned about the risks and legal liability posed by the quality of security and record keeping among foreign depositories. The SEC rules are an attempt to outline the responsibilities of the funds and the custodians and reduce risks for investors.

Under the proposal, foreign depositories must be regulated by the foreign country and submit to periodic reviews by regulators or accountants. Foreign depositories also must take steps to keep their own assets separate from those of U.S. mutual funds.

Those requirements are new, and along with other new requirements might make it impossible for mutual funds to invest in some countries, the SEC said. It did not identify the countries which may not have depositories that would meet the SEC's proposed requirements.

The proposal also generally requires the fund custodian to provide the fund board or fund adviser with an analysis of the initial risk which the foreign depository has, monitor the risks of the depository on a continuing basis and make reports to the fund or the adviser when risks change substantially. As an alternative to reports from the custodian, funds could seek insurance to cover potential risks.

This is the second time in two years that the SEC has taken up issues surrounding custody of international holdings of mutual funds. In 1997, the SEC adopted the current rule, which funds and custodians criticized as unworkable. That rule was to take effect on May 1 of this year. But, that date has been repeatedly postponed because of objections. The rule is currently scheduled to take effect in May, 2000. The proposed new rules, if adopted, would replace the existing rules.

The Investment Company Institute is assessing the SEC proposal and will file written comments by July 15, an ICI spokesperson said. A lawyer for the Association of Global Custodians was not available for comment.

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