MUTUAL FUND INVESTMENT ADVISERS, AFFILIATED DISTRIBUTOR SETTLE SEC AND STATE ENFORCEMENT ACTIONS RELATING TO MARKET TIMING

[18095] October 25, 2004 TO: BOARD OF GOVERNORS No. 67-04 CHIEF COMPLIANCE OFFICER COMMITTEE No. 16-04 COMPLIANCE ADVISORY COMMITTEE No. 101-04 PRIMARY CONTACTS - MEMBER COMPLEX No. 96-04 SEC RULES MEMBERS No. 154-04 SMALL FUNDS MEMBERS No. 115-04 RE: MUTUAL FUND INVESTMENT ADVISERS, AFFILIATED DISTRIBUTOR SETTLE SEC AND STATE ENFORCEMENT ACTIONS RELATING TO MARKET TIMING The Securities and Exchange Commission has issued an order making findings and imposing disgorgement, penalties, and compliance and mutual fund governance reforms to resolve enforcement proceedings against two affiliated registered investment advisers (“Adviser One” and “Adviser Two”) to two groups of mutual funds and an affiliated distributor (collectively, “Respondents”).1 The Respondents consented to the entry of the SEC Order without admitting or denying the SEC’s findings. In addition, the Respondents settled related charges with the Attorney General of New York.2 Adviser One also settled related charges with the Attorney General of Colorado3 and the Colorado Division of Securities.4 All of 1 See In the Matter of Invesco Funds Group, Inc., AIM Advisors, Inc., and AIM Distributors, Inc., SEC Release Nos. 34- 50506, IA-2311 and IC-26629, Admin. Proc. File No. 3-11701 (Oct. 8, 2004) (“SEC Order”). The SEC Order also censures the Respondents and imposes a cease and desist order. According to the SEC Order, in 2003 and 2004, the Invesco (Adviser One) and AIM (Adviser Two) fund complexes became fully integrated and are now overseen by a single board of directors. AIM Advisors began assuming responsibility for serving as investment adviser to the Invesco Funds in 2003. Invesco Funds Group intends to voluntarily withdraw its registration with the SEC as an investment adviser as soon as it is practicable. Copies of the SEC Order and accompanying press release are available at http://www.sec.gov/litigation/admin/34-50506.htm and http://www.sec.gov/news/press/2004- 143.htm, respectively. 2 See Invesco and AIM Settle Mutual Fund Timing Cases (press release issued by Office of NY State Attorney General Eliot Spitzer, Sept. 7, 2004), available at http://www.oag.state.ny.us/press/2004/sep/sep7c_04.html. Copies of the settlement documents for Invesco and AIM (each entitled an Assurance of Discontinuance) are available at http://www.oag.state.ny.us/press/2004/sep/sep7c_04_attach1.pdf and http://www.oag.state.ny.us/press/2004/sep/sep7c_04_attach2.pdf, respectively. 3 See Salazar Announces Final Market-Timing Settlement with Invesco Funds Group Inc. (press release issued by Colorado Attorney General, Department of Law, Oct. 8, 2004), available at http://www.ago.state.co.us/PRESREL/presrl2004/presrl76.htm. A copy of the settlement document (entitled an Assurance of Discontinuance) is available at http://www.ago.state.co.us/consalert/IFGAODFINAL.pdf. 2 these enforcement actions involved allegations that the Respondents facilitated widespread market timing trading in mutual funds with which each entity was affiliated. The settlements are summarized below. I. SEC Order A. Findings5 Adviser One The SEC Order finds that from at least 2001 through July 2003, Adviser One entered into, but did not disclose, market-timing agreements with over 40 investors that allowed them to market time certain of Adviser One’s mutual funds. Under the agreements, according to the SEC Order, Adviser One permitted select investors to make excessive exchanges and redemptions totaling approximately $58 billion in select mutual funds. The SEC Order finds that under some of the market timing agreements, Adviser One required that the market timers invest “sticky” assets in other mutual funds (i.e., long-term money that would remain in a particular fund without being actively traded). During the same time period, according to the SEC Order, the mutual funds’ prospectuses stated that shareholders were limited to four exchanges out of each fund per twelve-month period and also reserved the right to modify the exchange policy if such a modification was determined to be in the “best interests” of the fund. The SEC Order states that Adviser One’s market-timing agreements were inconsistent with the funds’ prospectus disclosure because the agreements provided for more than the disclosed number of exchanges and Adviser One did not make a “best interests” determination before entering into the timing agreements. The SEC Order further states that Adviser One knew that its agreements with market timers were inconsistent with earlier representations Adviser One had made to the mutual funds’ board of directors about how Adviser One would discourage market timing activities within its mutual funds. Adviser Two and Affiliated Distributor The SEC Order finds that between January 2001 and September 2003, Adviser Two entered into, but did not disclose, market timing agreements with investors, valued collectively at tens of millions of dollars, that allowed them to market time Adviser Two’s mutual funds. The SEC Order further finds that one of the timing agreements was entered into with the understanding that the market timer would invest so-called “sticky assets,” in certain of the funds. During the same time period, according to the SEC Order, the funds’ prospectuses stated that shareholders were limited to ten exchanges per calendar year. The SEC Order states that the prospectus disclosure also implied that Adviser Two would not allow trading it had identified as market timing, unless Adviser Two had concluded, after sufficient analysis that the proposed market timing would not harm the performance of the funds. The SEC Order further 4 See Invesco Funds Group Agrees to Settle Colorado Division of Securities Fraud Charges for $325 Million for Undisclosed Market Timing (press release issued by Colorado Division of Securities, Sept. 7, 2004), available at http://www.dora.state.co.us/securities/press.htm#invesco. A copy of the settlement document (entitled a Stipulation for Consent Order) is attached. 5 The factual allegations described in the settlements with state regulators generally mirror those in the SEC Order and, accordingly, will not be discussed separately in this Memorandum. 3 states that such an analysis had not been conducted. According to the SEC Order, Adviser Two’s market timing agreements were inconsistent with the language in the funds’ prospectus because the agreements provided for more than the stated permissible number of exchanges. The SEC Order finds that executives from Adviser Two and the affiliated distributor jointly or individually approved the market timing agreements and that the executive from the distributor approved the sticky asset agreement. The SEC Order further finds that during the relevant period, the funds’ trustees were lead to believe by Adviser Two and the distributor, that Adviser Two was diligently, and for the most part successfully, enforcing the per-year ten- exchange limit, and preventing market timing within Adviser Two’s funds. Violations As a result of the conduct generally described above, the SEC Order finds that the Respondents willfully violated, or willfully aided and abetted and caused violations of: • the antifraud provisions of Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 by entering into arrangements with market timers that were inconsistent with the funds’ prospectus and not disclosed to the funds’ board of directors or shareholders and • Section 17(d) of the Investment Company Act of 1940 and Rule 17d-1 under that Act for effecting transactions in connection with joint arrangements in which their respective funds were participants without filing an application with SEC and obtaining an SEC order approving the transactions. The SEC Order also finds that Adviser One and Adviser Two willfully violated Section 34(b) of the Investment Company Act, by making material misstatements and omissions in their respective funds’ prospectuses. B. Voluntary Undertakings In determining to accept the settlement offer, the SEC considered the following: • Fund Governance – Adviser Two agreed to use its best efforts to cause the Adviser Two funds, including funds previously advised by Adviser One, (“Funds”) to operate in accordance with the following governance policies and practices, which the Funds have represented are currently, or will shortly be in effect: o At least 75% of the members of the board of directors of the Funds will be independent. o The chairman of the board of directors of the Funds will be independent. o Any counsel to the independent directors of the Funds will be an “independent legal counsel,” as defined under the Investment Company Act. 4 • Board Actions – No action by the Funds’ board of directors will be taken without the approval of a majority of the independent directors, and any action approved by a majority of the independent directors but not by the full board will be disclosed in Fund shareholder reports. • Election of Trustees – Commencing in 2008, the Funds will hold a shareholder meeting to elect its board of directors at least once every five years. C. Required Undertakings In determining to accept the settlement offer, the SEC required the following: • Cooperation – The Respondents will cooperate fully with the SEC in any investigations, litigation or other proceedings relating to or arising from matters described in the SEC Order. • Internal Controls Committee – Adviser Two will establish an Internal Controls Committee that will include, among others, Adviser Two’s chief compliance officer (“CCO”). The committee will meet at least quarterly and the chief compliance officer appointed by the Funds (if different from the CCO) will be invited to participate in all meetings of the committee. The committee will consider and review compliance issues and related policy with respect to the Funds. Quarterly reports on the activities of the committee, including violations and other compliance matters considered, recommendations made, and actions taken, will be provided to the Funds’ board of directors. • Funds’ CCO -- Adviser Two’s CCO will provide to the Funds’ chief compliance officer (if different from the CCO) compliance information in connection with the latter’s role in monitoring Adviser Two’s compliance with relevant rules, regulations, and procedures applicable to Adviser Two’s performance of its investment advisory responsibilities to the Funds, including its code of ethics. • Quarterly Compliance Reporting –Adviser Two’s CCO will report to the independent directors of the Funds at least quarterly any breach of fiduciary duty or the federal securities laws of which the CCO becomes aware. Any material breach will be reported promptly. • Ombudsman – Adviser Two will establish an ombudsman to whom its employees may convey concerns about ethics matters or questionable practices. Adviser Two must review any matters brought to the ombudsman’s attention, along with any resolution of such matters, with the independent directors of the Funds with such frequency as the independent directors may instruct. • Independent Compliance Consultant – Within 60 days of the SEC Order, Adviser Two will retain an Independent Compliance Consultant acceptable to the SEC staff and to the majority of the independent directors to conduct a comprehensive review of its supervisory, compliance, and other policies and procedures designed to prevent and detect breaches of fiduciary duty, breaches of the code of ethics, and federal securities law violations by Adviser Two and its employees. The review will include, but not be 5 limited to: (1) Adviser Two’s market timing controls across all areas of its business; (2) pricing practices that may make the Funds vulnerable to market timing; (3) use by the Funds of short-term trading fees and other controls for deterring excessive short term trading; and (4) Adviser Two’s policies and procedures concerning conflicts of interest, including conflicts arising from advisory services to multiple clients. Adviser Two will require that the Independent Compliance Consultant complete its review and provide its recommendations in a report to Adviser Two, the board of directors, and the SEC staff no more than 180 days after the entry of the SEC Order. • Periodic Compliance Review – At least once every other year, commencing in 2007, Adviser Two will undergo a compliance review by a third party that is not an interested person of Adviser Two. The third party will issue a report of its findings and recommendations to the Internal Controls Committee and the independent directors of the Funds’ board of directors. • Independent Distribution Consultant – Within 90 days of the SEC Order, Adviser Two will retain an Independent Distribution Consultant acceptable to the SEC staff and to the majority of the independent directors. The consultant will develop a plan to distribute the total disgorgement and penalties ordered to compensate the Funds’ shareholders for losses attributable to market timing during the relevant period. Adviser Two will require that the Independent Distribution Consultant submit the distribution plan to Adviser Two and the SEC staff within 160 days of the SEC Order. Following the issuance of an SEC Order approving a final plan of disgorgement, the Independent Distribution Consultant and Adviser Two will take all necessary and appropriate steps to administer the final plan. • Excess Recovery – Adviser Two will undertake to disgorge and pay to the SEC all amounts in excess of $235 million that the Respondents obtain through settlement, final judgment or otherwise from individuals or entities based on allegations of substantially the same facts as alleged in the SEC Order. Such amounts will be distributed pursuant to the distribution plan described above. • Certification – No later than 24 months after the entry of the SEC Order, the Chief Executive Officer(s) of Adviser One and Adviser Two will certify to the SEC in writing that Adviser One and Adviser Two have fully adopted and complied in all material respects with the undertakings and the recommendations of the Independent Compliance Consultant, or will describe any material non-adoption or non-compliance. • Recordkeeping – Any record of Adviser One’s or Adviser Two’s compliance with the undertakings will be preserved for at least six years from the end of the fiscal year last used, the first two years in an easily accessible place. 6 D. Disgorgement and Civil Penalties6 • Adviser One will pay $215 million in disgorgement and a civil money penalty of $110 million. Adviser Two, as the successor adviser to Adviser One, will pay these penalty and disgorgement amounts ordered against Adviser One. • Adviser Two and the distributor will pay, jointly and severally, $20 million in disgorgement. • Adviser Two will pay a civil money penalty of $25 million and the distributor will pay a civil money penalty of $5 million. II. Settlement of New York Attorney General’s Charges Adviser One The New York Attorney General’s settlement document finds that certain practices of Adviser One violated New York’s Martin Act and other statutes. Adviser One, without admitting or denying the allegations in the document, agreed to the entry of an Assurance of Discontinuance to resolve the action against it. The Assurance of Discontinuance imposes a cease and desist order on Adviser One and generally requires Adviser One to cooperate fully and promptly with the New York Attorney General in any pending or subsequent initiated investigation, litigation or other proceeding relating to market timing or late trading. Among other things, such cooperation will include making outside counsel reasonably available to provide comprehensive presentations concerning any internal investigation relating to all matters in the Assurance of Discontinuance and to answer questions, except to the extent such presentation or questions call for the disclosure of confidential or privileged information. Adviser Two The New York Attorney General’s settlement document finds that certain practices of Adviser Two violated New York’s Martin Act and other statutes. Adviser Two, without admitting or denying the allegations in the document, agreed to the entry of an Assurance of Discontinuance to resolve the investigation against it. The Assurance of Discontinuance imposes a cease and desist order on Adviser Two and generally requires the following: • Reduction in Advisory Fees – Adviser Two will reduce the advisory fees payable by certain identified Funds for a period of five years. The projected reduction, based upon the assets under management in those Funds as of July 1, 2004, would total $75 million for the period. • Restrictions on the Adviser’s Management of the Funds – On or after January 1, 2005, Adviser Two generally may manage a Fund only if, among other things: 6 Each of the settlements with state regulators requires the Respondents, as applicable, to pay disgorgement and penalties in the amounts and manner set forth in the SEC Order. 7 o The Fund’s board has at least 75% independent trustees and an independent chair. The person selected as chair also must have had no prior relationship with Adviser Two or its affiliates (other than service as a member of the Funds’ Board). o The Fund’s board hires and retains a full-time senior officer, reporting exclusively to the board, to monitor compliance. The senior officer may also function as the Fund’s CCO, provided that he or she is not otherwise an employee of Adviser Two. o The Fund’s board assigns to the senior officer responsibility for managing the process by which the proposed management fees to be charged to the Fund are reasonable, negotiated at arm’s length, and consistent with the Assurance of Discontinuance. o The reasonableness of fees is determined by the Fund’s board through either competitive bidding (which must include at least three sealed bids) or an annual independent evaluation that considers factors including: (1) the level of fees charged to institutional and other clients for like services; (2) the level of fees charged by other mutual funds for like services; (3) the costs of providing services; (4) the profit margins of Adviser Two and its affiliates; (5) possible economies of scale as the Fund grows larger; and (6) the nature and quality of Adviser Two’s services, including the Fund’s performance. o Adviser Two publicly discloses a summary of any independent fee evaluation no later than 15 days after the Fund’s Board has approved a new advisory agreement or the continuation of a presently existing advisory agreement. The summary must contain data regarding the factors considered in the evaluation and sufficient specifics so that an investor can evaluate the reasonableness of the fees, but the summary does not have to include confidential, competitively sensitive data. Public disclosure must include at least: (1) continuous, prominent posting on the Fund’s website of the two most recent summaries; (2) inclusion of the most recent summary in shareholder reports; and (3) prominent notice in account statements furnished to direct investors of the summary’s availability. • Actual Cost Disclosures – For each Fund, in an easy-to-understand format, Adviser Two must disclose: o In periodic account statements, beginning with the statement for the period ending March 31, 2005, the fees and costs in actual dollar amounts charged to each investor based upon (1) the investor’s most recent quarterly closing balance and (2) a hypothetical $10,000 investment held for 10 years, assuming an annual return of 5% and application of the reduced management fee rates for five years as required by the Assurance of Discontinuance, and showing the impact of such fees and costs on fund returns for each year and cumulatively. 8 o In the Fund’s prospectus (subject to SEC approval) and on Adviser Two’s website, the fees and costs associated with the hypothetical example described above. o On Adviser Two’s website, a calculator that will enable an investor to calculate the fees and costs, in actual dollars and on a Fund by Fund basis, charged to the investor based on the investor’s most recent quarterly closing balance. • Cooperation -- Adviser Two will cooperate fully and promptly with the New York Attorney General in any pending or subsequent initiated investigation, litigation or other proceeding relating to market timing or late trading. Among other things, such cooperation will include making outside counsel reasonably available to provide comprehensive presentations concerning any internal investigation relating to all matters in the Assurance of Discontinuance and to answer questions, except to the extent such presentation or questions call for the disclosure of confidential or privileged information. III. Settlement with Attorney General of Colorado The Attorney General of Colorado filed a lawsuit against Adviser One under the Colorado Consumer Protection Act. Adviser One, without admitting or denying the allegations against it, agreed to the entry of an Assurance of Discontinuance to settle the lawsuit. It requires Adviser One to pay $1.5 million to the Attorney General for costs associated with this matter and for investor education and related enforcement efforts. The Assurance of Discontinuance also generally requires that Adviser Two comply with the undertakings described below for a period of ten years.7 A. Voluntary Undertakings In determining to accept the settlement offer with Adviser One, the Attorney General considered certain efforts voluntarily undertaken by Adviser Two. These undertakings include those outlined in the SEC Order relating to fund governance, board actions, and the election of directors. The remaining voluntary undertakings, which Adviser Two will use its best efforts to ensure, are as follows: • Board Committees – The Funds’ board will maintain one or more committees primarily dedicated to oversight of the Funds’ investment operations. Each committee will have a majority of independent trustees and an independent chair. • Evaluation of Management Fees – In approving the Funds’ advisory agreements, the independent trustees of the Funds will consider factors that are consistent with their fiduciary duties and are in the best interests of shareholders, including those factors identified in the New York Attorney General settlement. The Funds will disclose a fee summary similar to that required by the New York Attorney General settlement. 7 Adviser Two agrees that the undertakings described above will apply solely to Adviser Two, provided, however, that the undertakings will apply equally to Adviser One in the event that it reenters the business of advising retail mutual funds. 9 • Compliance Monitoring – The Funds’ board will designate an independent individual or firm to assist the board in monitoring compliance. (Similar undertakings are included in the SEC Order and New York Attorney General settlement). B. Required Undertakings The settlement requires Adviser Two to adhere to several undertakings that are the same as, or similar to, those in the SEC Order relating to: the maintenance of an Internal Compliance Controls Committee; hiring of a senior officer; quarterly compliance reporting; establishment of an ombudsman; retention of an Independent Compliance Consultant; periodic compliance reviews; certification; recordkeeping; and ongoing cooperation. The additional required undertakings include the following: • Market Timing or Excessive Trading – Adviser Two will include reasonable policies concerning market timing and excessive trading in its compliance policies and procedures and implement procedures that are designed to (i) detect market timing and excessive trading in the Funds and (ii) enforce policies and procedures regarding market timing or excessive trading in the Funds in accordance with the terms of the Funds’ prospectuses. It will also include its policies concerning market timing or excessive trading in its code of ethics. • Redemption Fee Waivers – Adviser Two will require that any waiver of a redemption fee, a change to the existing exemptions to a redemption fee, or the addition of any new exemption be approved by the Internal Compliance Controls Committee or the Funds’ board of trustees. • Sticky Assets – Adviser Two will not solicit or accept any assets of any investor in a Fund if the solicitation or acceptance of such assets is in any way tied to, contingent upon, or given in exchange for, trading privileges by the investor in excess of, or otherwise in contravention of, the market timing or excessive trading policies of the Funds’ prospectuses. • Omnibus Accounts – Adviser Two will implement policies and procedures that are reasonably designed to detect and prevent late trading and market timing of Fund shares through intermediaries or omnibus accounts. 10 IV. Settlement with Colorado Division of Securities The Colorado Division of Securities conducted an investigation into possible violations of Colorado law by Adviser One. Adviser One, without admitting or denying the allegations against it, agreed to the entry of a Consent Order to resolve this matter. The Consent Order imposes a cease and desist order and contains undertakings that generally mirror: (1) those in the SEC Order relating to the retention of an Independent Compliance Consultant, periodic compliance reviews, certification, recordkeeping, and ongoing cooperation; (2) those in the New York Attorney General settlement relating to disclosure of actual fund costs, including the web- based fee calculator; and (3) those in the settlement with the Colorado Attorney General relating to market timing or excessive trading policies and omnibus accounts. Jane G. Heinrichs Assistant Counsel