While Sections 22 (a) and (b) of the Investment Company Act authorize the Association to adopt rules on certain specified subjects, the adoption of such rules is subject to all the conditions of Section 15A of the Securities Exchange Act. The questions before us, therefore, are not only whether there is statutory authority for the proposed amendment, but also, if such authority exists, whether the amendment is "consistent with the requirements of subsection (b)" of Section 15A. If the proposed rule lacks statutory authorization, or if it cannot be reconciled with the provisions of subsection (b) (7) of Section 15A, it is our duty under Section 15A (j) to disapprove it. In no event are we called upon to approve the rule. If we do not disapprove the rule, so far as this Commission is concerned it will become effective on April 13, 1941.5

Since criticism of the proposed rule has centered principally around paragraphs (e), (h) and (j) (2) thereof, this opinion will be primarily devoted to a discussion of those paragraphs.

Footnote 3 continued:

current net asset value of such security computed as of such time as the rules may prescribe; and

(2) a minimum period of time which must elapse after the sale or issue of such security before any resale to such company by a member or its redemption upon surrender by a member; in each case for the purpose of eliminating or reducing so far as reasonably practicable any dilution of the value of other outstanding securities of such company or any other result of such purchase, redemption, or sale which is unfair to holders of such other outstanding securities; and said rules may prohibit the members of the association from purchasing, selling, or surrendering for redemption any such redeemable securities in contravention of said rules.

(b) Such a securities association may also, by rules adopted and in effect in accordance with said Section 15A, and subject to all provisions of said section applicable to the rules of such an association, prohibit its members from purchasing, in connection with a primary distribution of redeemable securities of which any registered investment company is the issuer, any such security from the issuer or from any principal underwriter except at a price equal to the price at which such security is then offered to the public less a commission, discount, or spread which is computed in conformity with a method or methods, and within such limitations as to the relation thereof to said public offering price as such rules may prescribe. in order that the price at which such security is offered or sold to the public shall not include an unconscionable or grossly excessive sales load.

(c) After one year from the effective date of this Act, the Commission may make rules and regulations applicable to principal underwriters of, and dealers in, the redeemable securities of any registered investment company, whether or not members of any registered securities association, to the same extent, covering the same subject matter and for the accomplishment of the same ends as are prescribed in subsections (a) and (b) of this section in respect of the rules which may be made by a registered securities association governing its members; and any rules and regulations so made by the Commission, to the extent that they may be inconsistent with the rules of any such association, shall so long as they remain in force supersede the rules of the association and be binding upon its members as well as all other underwriters and dealers to. whom they may be applicable.

• Subsection (d) of Section 15A, which with subsection (b) is referred to in subsection (j), is not here involved.

The rules by their own terms and for the purposes of the Association do not become effective until June 1, 1941. This date was set by the board of governors of the Association, pursuant to Article VII, Section 1 of the Association's bylaws.

PARAGRAPHS (e) AND (h)

Paragraphs (e) and (h) of the rule are concerned with the method of pricing redeemable securities of open-end investment companies for the purpose of sale and redemption. In order to appreciate the significance of these provisions it is necessary briefly to outline the manner in which such shares are characteristically distributed and redeemed.

Because of the redeemability of their shares it is the custom of open-end investment companies, with rare exceptions, constantly to issue additional shares in order to prevent their funds from shrinking. Since the assets of these companies consist almost exclusively of securities, usually common stocks, which are subject to market fluctuations, it is necessary that the shares which the companies issue and redeem be priced in a manner to reflect these shifts in portfolio values. If a company's method of pricing does not adequately reflect changes in portfolio values inequalities will result among its shareholders. To take an example (oversimplified for the purpose of illustrating the point), if a company with net assets, at market, of $100,000 has 1,000 shares outstanding and the value of these assets doubles during market hours, the per share value will also double, increasing from $100 to $200; but if after the increase in value, 1,000 additional shares are sold not at $200 a share but on the basis of the preceding asset value of $100 per share, the 100 percent appreciation in value will be divided between the old and new shareholders with the result that the value of each old share will increase from $100 to only $150. This process, by which shareholders who remain in the company do not receive the full benefit of portfolio appreciation, is often referred to as "dilution." The same process can occur in reverse when a share is redeemed at a price above its asset value at the time of redemption. Either process is made possible by a lag between a change in portfolio values and the establishment of a sale or redemption price. To the extent that the lag is cut down the possibilities of dilution are decreased, but they can be absolutely eliminated only if the price of shares at the time of sale or redemption by the investment company exactly corresponds to the underlying asset values at the same moment.

In the past a majority of open-end investment companies have priced their shares only once a day; that is, a price based on portfolio values computed as of the close of the market on one day has remained in effect until after the close of the market on the following day. Thus two known or determinable prices have existed at the

In actual practice the selling price of redeemable shares includes additional charges, principally selling commission, and occasionally a charge is also made for redemption.

same time. This method of pricing has caused substantial dilution in periods of rapidly rising markets when shares are sold at the lower of these two prices. Even during periods when the market has been relatively quiet, so that the dilution on any particular day has been small, the cumulative effect of this method of pricing has been to dilute appreciably the interests of shareholders, since by far the greater proportion of redeemable shares, perhaps as much as 90 percent, are sold on a rising market.

Paragraph (e) of the proposed rule, simply stated, will require that hereafter shares sold through members of the Association be priced at least twice a day. Generally speaking, the rule will require that a new price be established at 4:00 p. m. every day, based upon asset values computed as of the close of the New York Stock Exchange (3:00 p. m.) on that day; this price will remain in effect until 1:00 p. m. the following day, when a new price, based upon asset values at noon, will be established to remain in effect until 4:00 p. m. A more frequent computation of asset values is expressly permitted by the rule.

It is reasonable to anticipate that under paragraph (e) of the proposed rule less dilution will occur than under the once-a-day pricing heretofore in effect. It will not absolutely eliminate dilution, but Section 22 (a) of the Investment Company Act requires only that the rule be adopted "for the purpose of eliminating or reducing so far as reasonably practicable" any dilution resulting from methods of pricing. Whether the proposed rule will in fact reduce dilution to a practical minimum is a point upon which we express no opinion at this time. Section 22 of the Investment Company Act clearly contemplates that, until the powers granted the Commission in subsection (c) thereof become effective, the Association should have an opportunity to adopt rules which, in the Association's opinion, are adequate to meet the problem of dilution.3

Criticism of paragraph (e) of the proposed rule has been of two kinds. One group wishes to retain the system of pricing once a day which has generally been prevalent in the past. What we have already said is sufficient indication that we are not disposed to endorse that point of view. The other objection to paragraph (e) is that it does not go far enough, that dilution should be absolutely eliminated by a requirement that each share sold be priced at the market at the time of sale or that orders be held and not confirmed

'See Hearings of a Subcommittee of the Senate Committee on Banking and Currency on S. 3580 (Investment Company Bill), 76th Cong., 3d Sess., pp. 138 et seq., 841 et seq.

Both the House and the Senate Committee Reports on the Investment Company Bill, after summarizing subsections (a), (b) and (c) of Section 22, make the following statement: "In other words, the industry is given a year in which to solve this problem for itself." (S. Rep. No. 1775, p. 16; H. Rep. No. 2639, p. 20; 76th Cong., 3d Sess.)

until a recomputation of portfolio values can be made. The proposed rule as it stands permits pricing on such a basis, but it is urged that it is impracticable for competitive reasons for one company to adopt such a method while other companies are employing the twice-a-day pricing permitted by paragraph (e). Representatives of the Association answer this argument by asserting that such a method of pricing would be impractical and unduly expensive.

We do not feel that it is our duty to attempt to resolve this disagreement at this time. As we have already pointed out, however, Section 22 of the Investment Company Act clearly contemplates that, until Section 22 (c) becomes effective, the Association should be given reasonable latitude in attempting to work out a practical solution to the problem of dilution. Under the circumstances, we would hardly be justified in rejecting the rule because it does not go far enough.

The objections to paragraph (h) are closely allied to the objections to paragraph (e). Paragraph (h), in effect, requires that shares be redeemed at a price based upon actual asset value at the time of redemption, or at a price based upon the asset value upon which the current offering price of shares is based, whichever is the lower. As a result, a shareholder who redeems in a rising market will not get the advantage of portfolio appreciation until the next change in the offering price of the shares. While such a situation is by no means ideal, it is merely a corollary of the pricing methods permitted by paragraph (e). Since the pricing methods permitted by that paragraph still leave open the possibility that shares will be purchased below their true asset value, it may be reasonable to require the shareholder to run a comparable risk that on redemption of his shares he will realize somewhat less than their true asset value.

Accordingly we shall not interpose any objection to the effectiveness of paragraphs (e) and (h) of the proposed rule. In reaching this conclusion, however, we wish to make it clear that we are neither approving these paragraphs nor inferring in any way that they are adequate to solve the problems to which they relate.

PARAGRAPH (j) (2)

Paragraph (j) (2) in effect prohibits any dealer who is not a party to a sales agreement with the principal underwriter, and any investor, from redeeming outstanding shares of open-end investment companies unless the dealer or investor is record owner of the shares in question. This provision has been attacked by dealers who make an over-the-counter market in the shares of open-end investment com

panies as violative of the standards of Section 15A of the Securities Exchange Act. The dealers assert that this provision is inconsistent with the protection of investors and the public interest. They also assert specifically that this provision will impede the mechanism of a free and open market and that it creates unfair discrimination between dealers who have a sales agreement with an underwriter and dealers who do not.

Some explanation of the nature of the sales agreement to which we have referred is appropriate at this point. The primary distribution of the shares of open-end investment companies is customarily made through underwriters and dealers having sales agreements with the issuer or principal underwriter. Paragraph (c) of the proposed rule in effect requires such an agreement by providing that a member of the Association who is a principal underwriter may not sell to another member at a concession from the public offering price unless a sales agreement is in effect between the parties. Such a sales agreement must contain certain provisions, among them a statement of the concession granted the purchaser. It is important to note in this connection that the proposed rule does not provide for any specific minimum (or maximum) concession, nor does it provide that a breach of the sales agreement is in itself a breach of the rule. Paragraph (c), therefore, does not establish minimum profits or commissions, nor does it expressly or inferentially authorize the enforcement by the Association of provisions in syndicate or other distribution agreements establishing any minimum profit or commission.

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It is important to note the precise effect of paragraph (j) (2), the extent to which it does not restrict a dealer's activities as well as the extent to which it does. It does not prevent a dealer buying from whomever he wishes at whatever price he wishes. It does not prevent his selling to any other dealer or to any investor at any price he may wish to charge. It does prevent his redeeming a share he has bought unless he has had himself made owner of record. On the other hand, it does not prevent his acting as agent for an investor (if the investor is the record owner) and charging the investor a brokerage commission for surrendering shares for redemption. Thus the principal effect of the paragraph so far as the dealer is concerned is to force him to run the risk of a change in the redemption price of shares during the time it takes him to become record owner.

Any restriction upon the transferability of securities, including a restriction which takes the form of requiring record ownership, is

If shares of the same class are currently the subject of a public offering he is prohibited by Section 22 (d) of the Investment Company Act from selling to investors at a price below the public offering price. This statutory provision, however, has nothing to do with the rule under discussion.