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Registered Investment Company Use of Senior Securities — Select Bibliography

Section 18 of the Investment Company Act of 1940 circumscribes the ability of registered closed-end investment companies and registered open-end investment companies to issue or sell "senior securities," which the Act defines in section 18(g). Section 18(a)(1), for example, prohibits a closed-end investment company from issuing any class of senior security or selling any senior security of which it is the issuer, that represents indebtedness, unless immediately after such issuance or sale the investment company will have asset coverage of at least 300%. Section 18(f)(1) prohibits an open-end investment company from issuing any class of senior security, or selling any class of senior security of which it is the issuer, except that the investment company may borrow from a bank provided that immediately after any such borrowing there is asset coverage of at least 300% for all of its borrowings. "Asset coverage" is defined in section 18(h). The Commission and its staff have taken the position that reverse repurchase agreements, firm commitment agreements, standby commitment agreements, short sales, written options, forwards, futures, and certain other derivatives transactions may involve the issuance of a senior security subject to the prohibitions and asset coverage requirements of sections 18(a)(1) and 18(f)(1). The Commission and the staff have indicated, however, that they will not object to investment companies' engaging in such transactions without complying with the asset coverage and other requirements of sections 18(a)(1) and 18(f)(1), provided that the investment companies segregate assets, or otherwise “cover” their obligations under the instruments, consistent with Commission and staff guidance. As an aid to registered investment companies and their counsel, the staff is publishing the following bibliography of relevant authority and precedent relating to registered investment company use of senior securities.1

Investment Company Act of 1940 Provisions Details
Section 18(a)(1) Asset coverage, and other restrictions, applicable to the issuance or sale of senior securities representing indebtedness by closed-end investment companies.
Section 18(a)(2) Asset coverage, and other restrictions, applicable to the issuance or sale of senior securities representing stock by closed-end investment companies.
Section 18(b) Asset coverage determination for closed-end investment companies (in addition to section 18(h)).
Section 18(c) Additional restrictions applicable to (1) a closed-end investment company's issuance or sale of any senior security representing indebtedness if immediately thereafter the investment company would have outstanding more than one class of senior security representing indebtedness, or (2) a closed-end investment company's issuance or sale of any senior security that is stock if immediately thereafter the investment company would have outstanding more than one class of senior security that is stock.
Sections 18(f)(1) and 18(f)(2) Asset coverage and other restrictions applicable to the issuance or sale of senior securities by open-end investment companies.
Section 18(g) Definition of "senior security."
Section 18(h) Definition and calculation of "asset coverage."
Section 1(b)(3) Investment Company Act "Findings and Declaration of Policy;" stating that the national public interest and the interest of investors are adversely affected when investment companies issue securities containing inequitable or discriminatory provisions, or fail to protect the preferences and privileges of the holders of their outstanding securities.
Section 1(b)(7) Investment Company Act "Findings and Declaration of Policy;" stating that the national public interest and the interest of investors are adversely affected when investment companies, by excessive borrowing and the issuance of excessive amounts of senior securities, increase unduly the speculative character of their junior securities.
Section 1(b)(8) Investment Company Act "Findings and Declaration of Policy;" stating that the national public interest and the interest of investors are adversely affected when investment companies operate without adequate assets or reserves.
Commission and Staff Authority Details
Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (Apr. 18, 1979) (Commission release) Reverse repurchase agreement, firm commitment agreement, and standby commitment agreement may involve the issuance by the investment company of a senior security subject to the prohibitions and asset coverage requirements of section 18. If an investment company were to issue a security which affected its capital structure in a manner analogous to these agreements, and barring other material differences, the Commission believes it would view that transaction from a similar analytical posture. In circumstances involving similar economic effects, such as short sales of securities by funds, the Division of Investment Management has determined that the issue of compliance with section 18 will not be raised with the Commission if the investment company "covers" the senior security by establishing and maintaining certain "segregated accounts." The Commission agrees that segregated accounts, if properly created and maintained, would limit the investment company's risk of loss. The segregated account should not be maintained with a broker. Release 10666 also discusses the specific attributes of segregated accounts, board obligations, and other matters.
Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (Aug. 31, 2011) (Commission Release) 2011 Commission Concept Release requesting comment on fund use of derivatives, and the application of the Investment Company Act's provisions regarding leverage, diversification, concentration, exposure to certain securities-related issuers, valuation, and related matters.
Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. avail. June 22, 1987) (staff no-action letter response) Staff agreed not to recommend enforcement action to the Commission under section 18(f) when funds sell securities short, purchase and sell futures contracts, purchase and sell options on specific securities, stock indexes, or interest rate futures contracts, and purchase and sell forward contracts on currencies, without limiting the transactions to the 300 percent asset coverage requirement of section 18(f), provided that the funds comply with the staff's segregated account or other "cover" positions, as described in the staff's response. Segregated accounts may not be established with a futures commission merchant or broker.
Merrill Lynch Asset Management, L.P. (pub. avail. July 2, 1996) (staff no-action letter response) Staff agreed not to recommend enforcement action under section 18 if a fund covers its obligations, that may otherwise be deemed to be senior securities, by maintaining a segregated account on the books of its custodian, and including in that segregated account cash or liquid securities (regardless of type) having an aggregate value, measured on a daily basis, at least equal to the amount of the covered obligations.
Robertson Stephens Investment Trust (pub. avail. Aug. 24, 1995) (staff no-action letter response) Staff agreed not to recommend enforcement action under section 18(f) if a fund that engages in short selling maintains in a segregated account on the books of its custodian an amount that, when combined with the amount of collateral (not including short sale proceeds) deposited with the broker in connection with the short sale, equals the current market value of the security sold short. Note: The letter eliminated a prior position that the value of the segregated account plus the amount deposited with the broker as collateral (not including the short sale proceeds) could not be less than the market value of the securities at the time they were sold short.
Mutual Funds Use of Derivative Instruments (pub. avail. Sept. 26, 1994) (Division of Investment Management memorandum to Chairman Levitt and transmitted to U.S. Representatives Markey and Fields) Staff memorandum responding to a letter from U.S. Representatives Markey and Fields requesting that the Commission undertake a study of the use of derivatives by mutual funds and the adequacy of laws and regulations governing their disclosure and use.
Implications of the Growth of Hedge Funds (pub. avail. Sept. 2003) (staff report to the Commission) A report reflecting a staff study of hedge funds. The report includes discussion of the restrictions on leverage and short selling to which registered investment companies are subject.
"Dear Chief Financial Officer" Letter, from Lawrence A. Friend, Chief Accountant, Division of Investment Management (pub. avail. Nov. 7, 1997) (staff letter to fund CFOs) The staff would not object if assets segregated for section 18 purposes are designated solely on the fund’s records and not designated on the fund’s custodian’s records. To the extent that a fund designates segregated assets solely on its records, the fund may need to implement additional procedures and controls to ensure that segregation is undertaken in accordance with the interpretation outlined in Release 10666.
Claremont Capital Corp (pub. avail. Sept. 16, 1979) (staff no-action letter response) Staff would not recommend enforcement action under section 17(f) if all securities, commodities, and other property of Claremont Capital Corporation in a margin account with a broker are held, in negotiable form, in the possession of the custodian of Claremont's other assets, but in a separate account in the name of the broker who has agreed that (1) the securities, commodities, and other property in the account will at all times be maintained with the custodian unless released back to Claremont or sold or disposed of as permitted under Claremont's agreement with the broker, and (2) in directing any disposition of the securities, commodities, or property in the account, the broker must state that all conditions precedent to its right to direct disposition have been satisfied.
Emerald Mgt. Co (pub. avail. Jan. 21, 1978) (staff no-action letter response) A purchase on margin is limited by section 18(f) of the Investment Company Act which prohibits borrowing by an open-end company unless such borrowing is from a bank. Short sales are limited by section 18 of the Act which prohibits the issuance of senior securities by registered investment companies. For a short sale by an investment company not to involve the creation of a senior security, the selling company must segregate assets. The writing of put and call options is also subject to certain restrictions in order that it not result in the issuance of a senior security in violation of section 18 of the Act.
Sanford C. Bernstein (pub. avail. June 25, 1990) (staff no-action letter response) Straddles on securities and on financial futures.
Hutton Options Trading LP (pub. avail. Feb. 2, 1989) (staff no-action letter response) Purchase and sale of put and call options on stocks, stock indexes, and foreign currencies.
No-action letters and releases from 1982 - 1985 regarding covering futures and options2

1 This bibliography focuses on Commission and staff guidance analyzing the application of section 18 to senior securities such as reverse repos, firm commitments, standby commitments, short sales, written options, forwards, futures, and certain other derivatives transactions that may involve the issuance of a senior security. This bibliography does not include relevant Commission and staff guidance concerning the application of section 18 to preferred stock and bank borrowings.

2 It is the staff's understanding that most funds no longer rely on these letters, but instead rely on the no-action letters and other authority cited above, particularly Release 10666, the Dreyfus no-action letter, the Merrill Lynch Asset Management no-action letter, and the Robertson Stephens Investment Trust no-action letter.

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).

 

http://www.sec.gov/divisions/investment/seniorsecurities-bibliography.htm


Modified: 02/12/2013