File No. S7-17-02From: Butowsky, David M. [DButowsky@mayerbrownrowe.com] Sent: Monday, July 29, 2002 2:33 PM To: rule-comments@sec.gov Subject: File No. S7-17-02 July 29, 2002 Jonathan G. Katz Secretary Securities and Exchange Commission 450 Fifth Street, NW Washington, DC 20549-0609 Re: File No. S7-17-02 Proposed Amendments To Investment Company Advertising Rules Dear Mr. Katz: Mayer, Brown, Rowe & Maw, on behalf of its clients, respectfully submits this comment letter regarding the Commission’s proposed amendments to the investment company advertising rules in Release No. 33-8101 (May 17, 2002) (the “Release”). We wish to address two aspects of the Release. First, we urge the Commission to rethink its proposed elimination of Securities Act Rule 134 (“Rule 134”) with respect to investment companies. Second, we request that the Commission clarify that -- in reinforcing the applicability of Securities Act Section 12(a)(2) (“Section 12(a)(2)”) liability notwithstanding compliance with Securities Act Rule 482 (“Rule 482”) -- the Commission does not intend such liability to extend to independent directors of investment companies, but only to those who “offer or sell” mutual fund shares (i.e., the fund, underwriter, or dealer). 1. Rule 134 Should Be Retained For Investment Companies The Release provides two rationales for eliminating Rule 134 for investment companies. First, the Release argues that with the advent of the liberalized Rule 482 (through the elimination of the “substance of which” requirement), funds will have sufficient flexibility to discuss numerous topics without the need to rely on Rule 134. 67 Fed. Reg. 36712, 36717 (May 24, 2002). Second, the Release contends that investor protection will be increased if funds are forced to employ Rule 482 (which carries with it the prospect of Section 12(a)(2) liability), instead of Rule 134 (which does not). Ibid. Neither of these rationales has merit. The first fails to recognize the value to funds of Rule 134 as a means of advertising (albeit content-limited) without the prospect of Section 12(a)(2) liability. Whatever flexibility the proposed Rule 482 offers in comparison to current Rule 482, that added flexibility does not include protection from Section 12(a)(2) liability. Thus, the Release’s proposals will have the effect of taking away an important advertising option, and not simply adding an option of which the fund may, in its discretion, choose to avail itself. It cannot be said, as it was in the Commission’s 1979 release adopting the predecessor to Rule 482, that “since the rule is permissive, obviously investment companies need not make use of the rule if they do not choose to do so. In this regard, in order to make clear that the rule does not, to any extent, supplant Rule 134, the rule explicitly provides that it does not apply to advertisements which are excepted from the definition of prospectus by section 2(10) of the Act and Rule 134 thereunder.” 44 Fed. Reg. 52816, 52816-17 (Sept. 10, 1979). Put another way, if the proposed changes to Rule 134 are adopted, funds’ choice of Rule 482 for their advertisements will not be a “permissive” one, but a mandatory one since Rule 134 will no longer be available. The Release’s second rationale -- that investors will be better protected if funds are forced to use Rule 482 rather than Rule 134 for their advertisements -- is equally unsupportable. There is no evidence that Rule 134 advertisements have misled investors; rather, the misleading advertisements have been exclusively of the Rule 482 variety. Indeed, every example of a misleading advertisement discussed in the Release involved prior performance data, which may only be included in an advertisement under Rule 482, not Rule 134. See, e.g., 67 Fed. Reg. at 36715 (“In each of two enforcement actions, an investment adviser had marketed a relatively small fund’s unusually high return without disclosing that a significant percentage of the fund’s return was attributable to its investments in securities issued in initial public offerings.”); ibid. (discussing an enforcement action involving a fund whose “advertisements publicized extraordinary first-year returns at a time when the fund’s more current returns had become negative”). The paucity of misleading Rule 134 advertisements is to be expected, since the tight constraints imposed by that rule on the content of advertisements minimizes the opportunity for a fund to make intentionally or inadvertently misleading statements. And to the extent a risk of misleading statements in Rule 134 advertisements does exist, it is evidently adequately addressed by Exchange Act Rule 10b-5 liability. In short, current Rule 134 provides a valuable advertising tool to mutual funds with little danger of misleading the investing public. We respectfully submit that it should be retained. 2. The Proposed Cautionary Notes To Rule 482 Should Be Clarified To Indicate That Independent Directors Are Not Ordinarily Subject To Section 12(a)(2) Liability. The Release proposes adding a note to Rule 482 “that would state that an advertisement that complies with rule 482 does not relieve the fund, underwriter, or dealer of the obligation to ensure that the advertisement is not false or misleading.” 67 Fed. Reg. at 36717 (emphasis added). (The Release proposes adding a similar note to Investment Company Act Rule 34b-1 with respect to supplemental sales literature. 67 Fed. Reg. at 36717.) We observe that the word “director” is not included in this list, which suggests that the Commission does not intend to include independent directors within the scope of Section 12(a)(2) liability in connection with the fund’s Rule 482 advertisements. Nonetheless, since this interpretation of the note is not entirely free from doubt, we respectfully request that the Commission clarify the note to make clear that independent directors are not ordinarily subject to Section 12(a)(2) liability. This interpretation of the note would, first of all, be in accord with the language of Section 12(a)(2), which states that only a person who “offers or sells” a security may be a defendant under that section. Several courts have held that a director’s usual duties as director do not involve the offering or selling of securities, and therefore directors may not be defendants under Section 12(a)(2). See, e.g., In re Cendant Corp. Sec. Litig., 190 F.R.D. 331, 340 (D.N.J. 1999) (“A director’s act in authorizing the sale of a company’s securities is not sufficient to constitute him a seller of those securities under § 12(2) [the predecessor to current § 12(a)(2)]. On the contrary: such individuals are quintessentially collateral participants; and Pinter [v. Dahl, 486 U.S. 622 (1988)] teaches that this will not do.”) (quoting Mabon, Nugent & Co. v. Borey, 127 B.R. 727 (S.D.N.Y. 1991)). Policy considerations provide equally strong support for clarifying the proposed note expressly to exclude independent directors from the scope of Section 12(a)(2) liability. Under current law, independent directors face Section 11 liability in connection with the Registration Statement (of which the Section 10 prospectus is a part), and therefore will exert due diligence to ensure that the Section 10 prospectus is not materially false or misleading. Since a single registration can cover an offering that extends over time, this due diligence burden is a manageable one for independent directors, whose time is inevitably in high demand from non-fund-related pursuits. Under current Rule 482, and even assuming arguendo that Section 12(a)(2) liability does extend to independent directors in the usual case, there is not a substantial addition to an independent director’s liability since the “substance” of the information in the Rule 482 advertisement must appear in the Section 10 prospectus, and that Section 10 prospectus will have been reviewed by the independent director in connection with his clear duty to inspect the registration statement for materially false or misleading statements. The Release’s proposed amendments to Rule 482, however, will dramatically and unreasonably increase the independent director’s burden -- again, assuming arguendo that Section 12(a)(2) liability extends to independent directors. By removing the “substance of which” requirement from Rule 482, the proposed amendments effectively un-tether a fund’s Rule 482 advertisements from the Section 10 prospectus. It no longer would suffice for an independent director to examine the Section 10 prospectus for materially false or misleading statements; the independent director would further have to engage in some due diligence with respect to the Rule 482 advertisements themselves. This enormous burden (in time and liability exposure) would certainly deter many qualified persons from serving as independent directors, to the detriment of the investing public. And it would undoubtedly undermine the Release’s assertion in the cost-benefit analysis that the costs involved in the transition to the proposed Rule 482 “should be minimal and non-recurring.” 67 Fed. Reg. at 36726. There is an obvious way to avoid these unintended consequences, which is to clarify the proposed cautionary notes to state that independent directors involved in their usual activities as independent directors do not “offer or sell” securities and hence are not eligible defendants under Section 12(a)(2). * * * In conclusion, we respectfully request that the Commission retain Rule 134 for investment companies and clarify the proposed cautionary note to Rule 482 to indicate that independent directors are not in the ordinary course subject to Section 12(a)(2). We thank the Commission in advance for its consideration of the foregoing comments. Sincerely, MAYER, BROWN, ROWE & MAW By: David M. Butowsky 1675 Broadway New York, New York 10019 (212) 506-2500