Securities lending is a well-established practice by institutional investors such as U.S. open-end and closed-end investment companies (“funds”), insurance companies, pension plans, and college endowments. A fund whose investment objectives, policies, and restrictions permit it to engage in securities lending may lend out a portion of its portfolio securities to generate additional income.

Funds that engage in securities lending typically lend their portfolio securities to broker-dealers which, in turn, generally relend the securities to hedge funds and other market participants looking to implement various investment strategies. The securities loan is evidenced by a written agreement between the fund and the borrower, terminable by either party at will. To protect the fund from the risk of borrower default, the borrower posts collateral with the fund — typically cash, but U.S. Government securities and letters of credit are also possible — in an amount at least equal to the value of the borrowed securities, marked to market daily. When a fund lends its portfolio securities, the voting rights and the right to dividends and other distributions on the loaned securities transfer to the borrower until the loan is terminated and the securities are returned to the fund. While the loan is open, however, the borrower will remit back to the fund payments equal to such distributions. In addition, if fund management has knowledge of a material vote with respect to the loaned securities, fund directors should recall the loan in time to vote the proxies. When a loan is terminated, the fund must return the collateral to the borrower and the borrower must return the borrowed securities to the fund. The fund’s income from securities lending may come from fees paid to the fund by the borrowers and/or from the reinvestment of the cash collateral. Generally speaking, cash collateral reinvestment is limited to short-term, highly liquid instruments.

A fund that lends its securities typically employs a securities lending agent, which may be the fund’s custodian bank, to administer the lending program. The lending agent’s services, and the compensation that the fund pays to the lending agent, are subject to oversight by the fund’s investment adviser and directors. Funds typically compensate their lending agents with a share of the revenue generated by the lending program, and may pay lending agents an additional fee for managing the cash collateral reinvestment. Lending agents often indemnify funds against the risk that the borrower will fail to return the borrowed securities (to the extent that the value of the collateral is insufficient to replace the unreturned securities). Lending agents, however, typically do not indemnify funds for losses incurred in connection with cash collateral reinvestment.

Securities lending by funds implicates a number of provisions of the Investment Company Act of 1940 (the "1940 Act"). For example, the transfer of a fund’s portfolio securities to a borrower implicates section 17(f) of the 1940 Act, which generally requires that a fund’s portfolio securities be held by an eligible custodian. A fund’s obligation to return collateral at the termination of a loan implicates section 18 of the 1940 Act, which governs the extent to which a fund may incur indebtedness.

Notwithstanding these (and other) 1940 Act provisions, funds engage in securities lending, in large part in reliance on the following staff no-action letters,¹ addressing the following areas:

¹ To the extent that a fund seeks to lend its portfolio securities to affiliated borrowers, or to compensate an affiliated lending agent with a share of the lending program's revenues, exemptive relief from the Commission may be required. Also, certain cash reinvestment arrangements may need to comply with rule 12d1-1 under the Act.

This document has been prepared by the staff of the Division of Investment Management, and has not been subject to Commission review or approval. Funds should consult the actual authority set out herein, as well as any other applicable legal authority not included herein (both under the 1940 Act and under other laws).