==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 230, 239, 270, and 274 Release Nos. 33-7275; IC-21837; S7-34-93 RIN 3235-AE17 Revisions to Rules Regulating Money Market Funds AGENCY: Securities and Exchange Commission ACTION: Final Rules SUMMARY: The Commission is adopting amendments to rules and forms under the Securities Act of 1933 and the Investment Company Act of 1940 that govern money market funds. The amendments tighten the risk-limiting conditions imposed on tax exempt money market funds by rule 2a-7 under the Investment Company Act of 1940; impose additional disclosure requirements on tax exempt funds; and make certain other changes applicable to all money market funds. The amendments are designed to reduce the likelihood that a tax exempt fund will not be able to maintain a stable net asset value. EFFECTIVE DATE: June 3, 1996. Several different compliance dates apply to the amendments. For specific compliance dates for particular amendments, see Section V. of this Release. FOR FURTHER INFORMATION CONTACT: Martha H. Platt, Senior Attorney, (202) 942-0725, or Kenneth J. Berman, Assistant Director, Office of Regulatory Policy, (202) 942-0690, Division of Investment Management, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. Requests for formal interpretive advice should be directed to the Office of Chief Counsel (202) 942-0659, Division of Investment Management, 450 Fifth Street, N.W., Washington, D.C. 20549. SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission ("Commission") is adopting amendments to rule 2a-7 [17 CFR 270.2a-7] ("rule 2a-7" or the "rule") under the Investment Company Act of 1940 [15 U.S.C. 80a-1 et seq.] ("1940 Act"), the rule governing the operations of money market funds ("money funds" or "funds").-[1]- The Commission is also adopting a new rule, rule 17a-9 under the 1940 Act [17 CFR 270. 17a-9], and amendments to the following rules and forms: rule 134 under the Securities Act of 1933 [17 CFR 230.134]; rules 2a41-1, 12d-3 and 31a-1 under the 1940 Act [17 CFR 270.2a-41-1, 270.12d3- 1, and 270.31a-1]; Form N-1A [17 CFR 239.15A and 274.11A]; Form N-3 [17 CFR 239.17a and 274.11b]; and Form N-SAR [17 CFR 274.101]. The Commission is also publishing three new or revised staff guides to Forms N-1A and N-3 that do not appear in the Code of Federal Regulations. Table of Contents Page ---------FOOTNOTES---------- -[1]- Unless otherwise noted, all references to rule 2a- 7, as amended, or any paragraph of the rule, will be to 17 CFR 270.2a-7 as amended by this Release. ==========================================START OF PAGE 2====== EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . I. BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . II. AMENDMENTS TO RULE 2a-7 . . . . . . . . . . . . . . . . . A. Preliminary Matters . . . . . . . . . . . . . . . . . B. Portfolio Quality and Diversification . . . . . . . . 1. Five Percent Diversification Test . . . . . . . a. Application to Tax Exempt Funds . . . . . . b. Scope of the Diversification Standards . . 2. Quality Limitations on Portfolio Securities . . a. Proposed Limitations for Single State Funds . . . . . . . . . . . . . . . . . . . b. Application of the Second Tier Securities Tests to Conduit Securities . . c. Definition of the Term "Conduit Security" . . . . . . . . . . . . . . . . . C. Diversification and Quality Standards for Put Providers . . . . . . . . . . . . . . . . . . . . . . 1. Put Diversification Standards . . . . . . . . . a. Uniform Diversification Standards for Conditional and Unconditional Puts . . . . b. The Twenty-Five Percent Put Basket . . . . c. Issuer-Provided Demand Features . . . . . . d. Multiple Puts and Guarantees . . . . . . . 2. Quality Standards . . . . . . . . . . . . . . . a. Rating Requirement for Demand Features . . b. Providers of Puts in Excess of Five Percent of Fund Assets . . . . . . . . . . c. Certain Unrated Securities . . . . . . . . 3. Conditional Demand Features . . . . . . . . . . . . . . . . . . . . . . . 4. Other Issues Applicable to Put Providers . . . . a. Accrued Interest . . . . . . . . . . . . . b. Notice of Substitution of Put Provider . . c. Liquidity Requirements for Money Funds and the Three Business Day Settlement Cycle . . . . . . . . . . . . . . . . . . . 5. Short-Term Ratings . . . . . . . . . . . . . . . D. Other Diversification and Quality Standards . . . . . 1. Repurchase Agreements . . . . . . . . . . . . . 2. Pre-Refunded Bonds . . . . . . . . . . . . . . . 3. Diversification Safe Harbor . . . . . . . . . . 4. Three-Day Safe Harbor . . . . . . . . . . . . . E. Asset Backed Securities and Synthetic Securities . . 1. Background . . . . . . . . . . . . . . . . . . . 2. Definitions . . . . . . . . . . . . . . . . . . 3. Diversification Standards . . . . . . . . . . . a. Diversification: General . . . . . . . . . (1) Special Purpose Entity as Issuer . . . ==========================================START OF PAGE 3====== (2) Looking through the Special Purpose Entity . . . . . . . . . . . . . . . . b. Diversification: First Loss Guarantees . . 4. Quality Standards . . . . . . . . . . . . . . . 5. Maturity Standards . . . . . . . . . . . . . . . F. Variable and Floating Rate Securities . . . . . . . . 1. Maturity Determinations: Floating Rate Securities . . . . . . . . . . . . . . . . . . . 2. Maturity Determinations: Variable Rate Securities . . . . . . . . . . . . . . . . . . . 3. Adjustable Rate Government Securities . . . . . 4. Other Issues Concerning Adjustable Rate Securities . . . . . . . . . . . . . . . . . . . a. Background . . . . . . . . . . . . . . . . b. Recordkeeping Requirement . . . . . . . . . G. Other Amendments to Rule 2a-7 . . . . . . . . . . . . 1. U.S. Dollar Denominated Instruments . . . . . . 2. Investment in Other Money Funds . . . . . . . . 3. Board Approval and Reassessment of Certain Securities . . . . . . . . . . . . . . . . . . . 4. Recordkeeping . . . . . . . . . . . . . . . . . 5. Defaulted Securities . . . . . . . . . . . . . . 6. Technical Amendments . . . . . . . . . . . . . . III. AMENDMENTS TO DISCLOSURE RULES . . . . . . . . . . . . . . A. Single State Funds . . . . . . . . . . . . . . . . . B. Disclosure Concerning Exposure to Put Providers . . . C. Risk Disclosure in Certain Communications . . . . . . IV. EXEMPTIVE RULE GOVERNING PURCHASES OF CERTAIN PORTFOLIO SECURITIES BY AFFILIATED PERSONS . . . . . . . . . . . . . V. COMPLIANCE DATES . . . . . . . . . . . . . . . . . . . . . A. General Compliance Date . . . . . . . . . . . . . . . B. Grandfathered Securities . . . . . . . . . . . . . . C. Disclosure and Reporting . . . . . . . . . . . . . . VI. REGULATORY FLEXIBILITY ANALYSIS . . . . . . . . . . . . . VII. STATUTORY AUTHORITY . . . . . . . . . . . . . . . . . . . VIII. TEXT OF RULE AND FORM AMENDMENTS . . . . . . . . . . EXECUTIVE SUMMARY The Commission is adopting amendments to rule 2a-7 under the 1940 Act, the rule that governs the operations of money funds. The primary purpose of the amendments is to tighten the risk- limiting conditions of the rule applicable to tax exempt money funds and thereby reduce the likelihood that a tax exempt fund will not be able to maintain a stable net asset value. The amendments also affect taxable money funds in certain respects. ==========================================START OF PAGE 4====== In addition, the Commission is adopting revisions to the prospectus disclosure requirements for tax exempt money funds and a new rule exempting certain transactions from the 1940 Act's limitations on affiliated transactions. In considering these amendments, the Commission has made changes from the proposal designed to simplify compliance with the rule while retaining the degree of flexibility necessary for money funds to operate in accordance with their investment objectives. A brief summary of the rule amendments is provided below. Issuer Diversification and Quality Standards The amendments extend the rule's diversification requirements to tax exempt funds. A "national" tax exempt fund is limited to investing no more than five percent of its assets in securities of a single issuer (other than Government securities) (the "Five Percent Diversification Test"). A "single state" tax exempt fund is subject to the same limitation but only with respect to seventy-five percent of its assets; the remaining twenty-five percent of a single state fund's assets ("twenty-five percent basket") may be invested in securities of one or more issuers, provided that they are "first tier securities," as the term is defined in the rule. A tax exempt fund is limited to investing five percent of its assets in "second tier securities" that are "conduit securities," as these terms are defined in the rule, with investment in the conduit securities of any one issuer limited to one percent of fund assets. To provide an additional element of flexibility, a security subject to an "unconditional demand feature issued by a non-controlled person," as defined in the rule, will be subject only to the rule's put diversification requirements. Diversification and Quality Standards Applicable to Providers of Puts and Demand Features The amendments provide that a fund cannot, with respect to seventy-five percent of its assets, invest more than ten percent of its assets in securities subject to puts from, or directly issued by, the same institution. The remaining twenty-five percent of a fund's assets ("twenty-five percent put basket") may be subject to puts from, or directly issued by, one or more institutions, provided that the puts are first tier securities. A fund may not invest more than five percent of its assets in securities subject to puts that are second tier securities. As proposed, a demand feature is an "eligible security" (as defined in the rule) only if the demand feature (or its issuer) has received a short-term rating from a nationally recognized statistical rating organization ("NRSRO"). A conditional demand feature is an eligible security if the limitations on its exercise can be readily monitored by the fund's board of directors (or its delegate). The amendments as adopted, however, do not specify the conditions that may be included in a conditional demand feature. ==========================================START OF PAGE 5====== Asset Backed Securities and "Synthetic" Securities The amendments clarify the credit quality, diversification and maturity determination standards applicable to synthetic and asset backed securities ("ABSs"). Among other things, an ABS must have a rating from a NRSRO to be eligible for fund investment. ==========================================START OF PAGE 6====== Interest Rate Risk Analysis The amendments also clarify that floating rate and variable rate securities ("adjustable rate securities") must reasonably be expected to have market values that approximate their amortized cost values on each interest rate adjustment date through their final maturity dates. The amendments require funds to review periodically whether such securities can reasonably be expected to have market values that approximate their amortized cost values upon readjustment of their interest rates. Exemptive Rule The Commission is adopting rule 17a-9 under the 1940 Act to permit (but not require) an affiliate of a fund to purchase from the fund securities that are no longer eligible securities at the higher of their amortized cost values (including accrued interest) or market values, without having to obtain a Commission order. I. BACKGROUND Money funds are open-end management investment companies registered under the 1940 Act that have as their investment objective generation of income and preservation of capital and liquidity through investment in short-term, high quality securities. More than $775 billion in assets is currently invested in approximately 25 million money fund shareholder accounts.-[2]- Approximately sixteen percent of money fund assets ($127 billion) are held by funds that have as their principal objective distribution of income exempt from federal income taxes ("tax exempt funds").-[3]- Approximately one third of the assets held by tax exempt funds ($43 billion) are held by funds that seek to distribute income that is also exempt from the income taxes of a specific state or locality ("single state funds").-[4]- The balance is held by funds that do ---------FOOTNOTES---------- -[2]- IBC's Money Fund Report at 2, Dec. 29, 1995 ("Money Fund Report"); Investment Company Institute Mutual Fund Fact Book at 58-59 (35th ed. 1995). For a summary of the development of money funds, which were first introduced in the early 1970s, see Investment Company Act Rel. No. 17589 (July 17, 1990) [55 FR 30239 (July 25, 1990)] ("Release 17589") at nn.3-7 and 15-18 and accompanying text. -[3]- Money Fund Report, supra note 2, at 2. -[4]- Single state funds are currently available for sixteen states: Alabama, Arizona, California, Connecticut, Florida, Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Texas and Virginia. Id. ==========================================START OF PAGE 7====== not limit their investments to securities exempt from the income taxes of a specific state ("national funds"). Unlike other investment companies, money funds seek to maintain a stable share price, typically $1.00 per share. This stable share price of $1.00 has encouraged investors to view investments in money funds as an alternative to either bank deposits or checking accounts, even though money funds lack federal deposit insurance, and there is no guarantee that money funds will maintain a stable share price.-[5]- To maintain a stable share price, most money funds use the amortized cost method of valuation ("amortized cost method")-[6]- or the penny-rounding method of pricing ("penny-rounding method")-[7]- permitted by rule 2a-7. The 1940 Act and applicable rules generally require investment companies to calculate current net asset value per share by valuing portfolio instruments at market value or, if market quotations are not readily available, at fair value as determined in good faith by, or under the direction of, the board of ---------FOOTNOTES---------- -[5]- A money fund is required to disclose prominently on the cover page of its prospectus that: (1) the shares of the fund are neither insured nor guaranteed by the U.S. Government; and (2) there can be no assurance that the fund will be able to maintain a stable net asset value of $1.00 per share. See, e.g., Item 1(vi) of Form N-1A. The prescribed legend must appear in money fund sales literature and advertisements as well. See paragraph (a) of rule 34b-1 under the 1940 Act, and paragraph (a)(7) of rule 482 under the Securities Act of 1933 ("1933 Act"). -[6]- Under the amortized cost method, portfolio securities are valued by reference to their acquisition cost as adjusted for amortization of premium or accretion of discount. Paragraph (a)(1) of rule 2a-7, as amended. -[7]- Share price is determined under the penny-rounding method by valuing securities at market value, fair value or amortized cost and rounding the per share net asset value to the nearest cent on a share value of a dollar, as opposed to the nearest one tenth of one cent. Paragraph (a)(15) of rule 2a- 7, as amended. See also Investment Company Act Rel. No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)] ("Release 13380") (adopting rule 2a-7) at n.6, and Investment Company Act Rel. No. 12206 (Feb. 1, 1982) [47 FR 5428 (Feb. 5, 1982)] ("Release 12206") (proposing rule 2a-7) at n.5. ==========================================START OF PAGE 8====== directors.-[8]- Rule 2a-7 exempts money funds from these provisions, but contains conditions designed to minimize the deviation between a fund's stabilized share price and the market value of its portfolio.-[9]- If the deviation does become significant, the fund may be required to take certain steps to address the deviation, including selling and redeeming its shares at less than $1.00 ("breaking a dollar").-[10]- In February 1991, the Commission amended rule 2a-7 (the "1991 Amendments")-[11]- to respond to developments in the commercial paper market since the rule was adopted in 1983.-[12]- Among other things, the 1991 Amendments permit ---------FOOTNOTES---------- -[8]- See section 2(a)(41) of the 1940 Act [15 U.S.C. 80a-2(a)(41)], together with rules 2a-4 and 22c-1 [17 CFR 270.2a-4 and 270-22c-1]. See also Accounting Series Release No. 118 (Dec. 23, 1970 [35 FR 19986 (Dec. 31, 1970)] (board may appoint persons to assist in determination of securities' values). -[9]- If shares are sold or redeemed based on a net asset value which has been either understated or overstated in comparison to the amount at which portfolio instruments could have been sold, the interests of either existing shareholders or new investors will be diluted. See Investment Trusts and Investment Companies: Hearings on S. 3580 Before a Subcomm. of the Sen. Comm. on Banking and Commerce, 76th Cong., 3d Sess. 136-138, 288 (1940), Report of the Staff of the Division of Investment Management of the Securities and Exchange Commission on the Regulation of Money Market Funds Before the Subcommittee on Financial Institutions of the Senate Committee on Banking, Housing, and Urban Affairs at 9 (Jan. 24, 1980), and Release 17589, supra note 2, at n.7. -[10]- Paragraphs (c)(6) and (c)(7) of rule 2a-7, as amended. -[11]- Investment Company Act Rel. No. 18005 (Feb. 20, 1991) [56 FR 8113 (Feb. 27, 1991)] ("Release 18005"). The 1991 Amendments were proposed in Release 17589, supra note 2, and became effective on June 1, 1991. -[12]- Before the 1991 Amendments, rule 2a-7 permitted funds to invest in "high quality" securities, that is, securities that had received at least the second highest rating from one NRSRO. See Release (continued...) ==========================================START OF PAGE 9====== funds to invest only in "eligible securities," defined generally as securities that are rated in one of the highest two short-term rating categories by the "requisite NRSROs,"-[13]- or ---------FOOTNOTES---------- -[12]-(...continued) 13380, supra note 7, at n.34. In the summer of 1989 and the spring of 1990, several taxable funds held approximately $125 million in defaulted commercial paper issued by Mortgage and Realty Trust or Integrated Resources Inc.; in the fall of 1990 several funds held commercial paper issued by MNC Financial Corp. that was downgraded to below high quality, resulting in a significant decline in its market price. In all three cases, the commercial paper had the second highest rating from one NRSRO when purchased by the funds and thus was eligible for fund investment under rule 2a-7 as then in effect. Shareholders of funds that held these commercial paper issues were not adversely affected, however, because each fund's investment adviser purchased the paper from the funds at amortized cost or principal amount or otherwise agreed to indemnify the fund. See Release 17589, supra note 2, at n.18 and accompanying text. -[13]- "Requisite NRSROs" are defined as: (1) any two NRSROs that have issued a rating with respect to an instrument or class of debt obligations of an issuer, or (2) if only one NRSRO has issued a rating with respect to such instrument or issuer at the time the fund purchases or rolls over the security, that NRSRO. Paragraph (a)(19) of rule 2a-7, as amended. The term "NRSRO" is defined in paragraph (a)(14) of rule 2a- 7 to have the same meaning as in the Commission's uniform net capital rule [17 CFR 240.15c3-1(c)(2)(vi)(E), (F) and (H)]. The Commission's Division of Market Regulation responds to requests for NRSRO designation through no-action letters. Currently, the Division of Market Regulation has designated six NRSROs: Duff and Phelps, Inc., Fitch Investors Services, Inc., Moody's Investors Service Inc., Standard & Poor's Corp., and two specialized NRSRO's: IBCA Limited and its subsidiary, IBCA Inc., which is recognized as a NRSRO only with respect to its ratings of debt issued by banks, bank holding companies, United Kingdom building societies, broker-dealers and broker-dealers' parent companies, and bank-supported debt, and Thomson BankWatch, Inc., which is recognized as a NRSRO only with respect to (continued...) ==========================================START OF PAGE 10====== comparable unrated securities. Taxable funds must further limit their investments in the securities of any one issuer (other than Government securities-[14]-) to five percent of fund assets ("Five Percent Diversification Test"),-[15]- and limit fund investment in second tier securities-[16]- to no more than five percent of fund assets, with investment in the second tier securities of any one issuer being limited to the greater of one percent of fund assets or one million dollars ("Second Tier Securities Tests").-[17]- ---------FOOTNOTES---------- -[13]-(...continued) ratings for debt issued by banks, bank holding companies, non-bank banks, thrifts, broker-dealers, and broker-dealers' parent companies. In recognition of the expanded use of credit ratings in Commission rules, the Commission solicited comment on the process employed to designate rating agencies as NRSROs and the nature of the Commission's oversight role with respect to NRSROs in a concept release issued in 1994. Exchange Act Rel. No. 34616 (Aug. 31, 1994) [59 FR 46314 (Sept. 7, 1994)]. -[14]- Under paragraph (a)(13) of rule 2a-7, as amended, the term "Government Security" means those securities issued or guaranteed by the United States or its instrumentalities -- the definition of that term given in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-2(a)(16)]. It does not include securities issued or guaranteed by the state governments or instrumentalities. For a discussion of securities issued by government- sponsored enterprises ("GSEs"), see Joint Report on the Government Securities Market (Jan. 1992) at p. D-1. -[15]- Paragraph (c)(4)(i) of rule 2a-7, as amended. A limited exception is provided for certain securities held for not more than three business days. See infra Section II.D.4. of this Release. -[16]- A "second tier security" is an eligible security that is not a "first tier security." Paragraph (a)(20) of rule 2a-7, as amended. A first tier security is generally a security that is rated by the requisite NRSROs in the highest rating category for short-term debt obligations, and comparable unrated securities. Paragraph (a)(11) of rule 2a-7, as amended. -[17]- Paragraph (c)(4)(iv)(A) of rule 2a-7, as amended. The 1991 Amendments also shortened the maximum (continued...) ==========================================START OF PAGE 11====== The 1991 Amendments did not apply the Five Percent Diversification Test and the Second Tier Securities Tests to tax exempt funds.-[18]- At that time, the Commission concluded that most tax exempt funds could not satisfy these tests without substantially restructuring their portfolios and, perhaps, losing some of their tax advantages.-[19]- Single state funds were thought to present particular problems because they concentrate their investments in debt securities issued by a single state (or issuers located within that state), making diversification more difficult to achieve. After the adoption of the 1991 Amendments, the Commission closely examined the characteristics of short-term tax exempt securities, the markets in which they trade, and tax exempt fund portfolios to determine what, if any, revisions to rule 2a-7 should be proposed to provide tax exempt fund investors with protections similar to those afforded taxable fund investors by the 1991 Amendments. The results of the Commission's examination of the tax exempt markets were reflected in amendments to rule 2a-7 that were proposed for comment on December 17, 1993 ("Proposing Release").-[20]- A primary objective of the proposed amendments was to tighten the diversification and portfolio ---------FOOTNOTES---------- -[17]-(...continued) dollar-weighted portfolio maturity that a fund may maintain from 120 to ninety days, and codified the actions that a fund must take when certain events occur, including defaults and rating downgrades. See paragraphs (c)(2) and (c)(5) of rule 2a-7, as amended. The 1991 Amendments also require that the cover page of fund prospectuses and certain fund advertisements and sales literature state prominently that investment in a fund is not guaranteed or insured by the U.S. Government and that there can be no assurance that a fund can maintain a stable net asset value per share. See Form N-1A, item 1(a)(vi); Form N-3, item 1(a)(ix); rule 482(a)(7) under the 1933 Act [17 CFR 230.482(a)(7)]; and rule 34b-1 under the 1940 Act [17 CFR 270.34b-1]. -[18]- Tax exempt funds continue to be subject to a diversification test with respect to puts, as they had been prior to the adoption of the 1991 Amendments. Paragraphs (c)(4)(v) and (c)(4)(vi)(B) of rule 2a-7, as amended. -[19]- Release 17589, supra note 2, at Section II.6. -[20]- Investment Company Act Rel. No. 19959 (Dec. 17, 1993) [58 FR 68585 (Dec. 28, 1993)] at Section I.A. ==========================================START OF PAGE 12====== quality standards applicable to tax exempt funds to make them more similar to the standards applicable to taxable funds. The proposed diversification and quality standards for tax exempt funds took into account the different investment objectives and portfolio compositions of national funds and single state funds, and would have established different requirements for each type of tax exempt fund. The Commission received comments on the proposed amendments from seventy-one commenters, including twelve municipal issuers, twenty-two mutual fund complexes, and nine professional and trade associations.-[21]- The comment letters reflect a wide variety of views on almost every topic discussed in the Proposing Release. A number of commenters, expressing a general concern over the complexity of the rule, urged that the rule's diversification and quality standards for taxable and tax exempt funds be as consistent with each other as practicable so that the rule would not become too complicated. As part of its evaluation of the proposal, the Commission considered recent events in the markets for municipal securities that had a significant effect on money funds. One such event was the bankruptcy of Orange County, California, a large municipal issuer of short-term taxable and tax exempt notes.-[22]- At the time of Orange County's bankruptcy, a number of taxable and tax exempt funds held notes issued by either Orange County or municipalities that invested in investment pools managed by the Orange County treasurer ("Orange County notes"). While no fund holding Orange County notes has broken a dollar to date (in large part because of actions taken by their advisers to support the ---------FOOTNOTES---------- -[21]- The comment period for the Proposing Release was extended from April 6, 1994 to May 6, 1994. See Investment Company Act Rel. No. 20184 (Mar. 31, 1994) [59 FR 16576 (Apr. 7, 1994)]. The comment letters and a summary of the comments prepared by the Commission staff are included in File No. S7- 34-93. -[22]- On December 6, 1994, Orange County and investment pools managed by the Orange County treasurer ("Orange County Pools") filed for protection under chapter 9 of the Federal Bankruptcy Code [11 U.S.C. 901 et seq.]. The U.S. Bankruptcy Court for the Central District of California subsequently determined that the Orange County Investment Pools were not eligible to seek protection under chapter 9. See "Orange County, Mired in Investment Mess, Files for Bankruptcy," Wall St. J., Dec. 7, 1994 at A1, A6; Michael Utley, "Judge Rules Pool's Bankruptcy Filing Invalid, But Impact is Mostly Academic," Bond Buyer, May 26, 1995 at 1, 36. ==========================================START OF PAGE 13====== funds' share prices) the Orange County bankruptcy reinforced the need to amend rule 2a-7 to address issues unique to tax exempt funds.-[23]- II. AMENDMENTS TO RULE 2a-7 A. Preliminary Matters The Commission is today adopting the second of two sets of amendments to rule 2a-7 under the 1940 Act designed to tighten the risk-limiting conditions of the rule. These amendments primarily deal with tax exempt funds; they are intended to provide investors in tax exempt money market funds with protections similar to those provided to investors in taxable funds by the 1991 Amendments. The Commission believes that these amendments are necessary to provide greater assurance that tax exempt money market funds meet investors' expectations for safety and convenience by reducing the likelihood that these funds will not be able to maintain a stable net asset value using pricing procedures permitted by rule 2a-7. The amendments to rule 2a-7 adopted in 1991, while not insulating funds from all events that could threaten their net asset values, appear to have reduced the riskiness of money market funds at a modest cost to money fund investors in terms of reduced yield.-[24]- The Commission acknowledges that none of its rules can eliminate completely the risk that a money market fund will break a dollar as a result of a decrease in ---------FOOTNOTES---------- -[23]- The Division of Investment Management addressed analogous issues raised by the Orange County bankruptcy in July 1991, when New Jersey regulators seized Mutual Benefit Life Insurance Company ("MBLI"). A number of securities held by tax exempt funds were subject to demand features provided by MBLI. After its seizure by the New Jersey insurance regulators, MBLI could not longer honor its obligations under the terms of the demand features it provided. Advisers to funds holding MBLI-backed securities took various actions to prevent shareholder losses that would have occurred had the funds been required to break a dollar. The advisers either repurchased the MBLI-backed instruments from the funds at their amortized cost or obtained a replacement guarantor. -[24]- See "Has the SEC Reduced the Riskiness of Money Market Funds? An Assessment of the Recent Changes to Rule 2a-7," S. Collins and P. Mack (Nov. 1993)(study by economists for the Board of Governors of the Federal Reserve System of money fund data indicated decrease in risk and 20 basis point reduction in yields due to 1991 Amendments). ==========================================START OF PAGE 14====== value of one or more of its portfolio securities. Thus, in adopting these amendments, the Commission is prescribing minimum standards designed not to ensure that a fund will not break a dollar, but rather to require the management of funds in a manner consistent with the investment objective of maintaining a stable net asset value. A money fund's board of directors has oversight responsibility for the sound management of the fund.-[25]- The fund's adviser is typically delegated responsibility for selecting appropriate investments for the fund. Rule 2a-7 requires that fund investments should be made in accordance with procedures "reasonably designed" to maintain a stable net asset value or share price.-[26]- In addition, investments made in accordance with such procedures should be consistent with maintaining a stable net asset value or share price. Rule 2a-7 provides an analytical framework for fund advisers to follow when making such investment decisions, including decisions regarding new types of securities not specifically addressed by the rule, Commission releases, or staff interpretive letters. As the Commission stated in 1991, that a particular security is technically eligible for fund investment under rule 2a-7 is not itself an adequate basis for an investment in the security.-[27]- For example, a number of money funds recently invested in certain structured notes that were Government securities on the asserted belief that the provisions of rule 2a-7 dealing with adjustable rate Government securities would permit such an investment. When short-term interest rates increased in early 1994, the values of these securities decreased and many became illiquid.-[28]- These and other types of losses are more likely to be avoided if a fund has in place, and operates in accordance with, procedures designed to determine whether investment in the security is consistent not only with the technical requirements of rule 2a-7, but with the rule's analytical framework and with the fund's investment objective of maintaining a stable net asset value. In preparing these rules for adoption, the Commission has weighed carefully the need to provide a similar level of safety for investors in tax exempt and taxable money funds and the need, frequently expressed by fund commenters, to allow tax exempt funds sufficient flexibility to cope with a limited supply of high quality municipal securities. For example, while the ---------FOOTNOTES---------- -[25]- See Investment Company Act Rel. No. 13380, supra note 7, at nn. 40-42 and accompanying text. -[26]- Paragraphs (c)(6)(i) and (c)(7) of rule 2a-7, as amended. -[27]- Release 18005, supra note 11, at Section II.A. -[28]- See infra Section II.F.4.a. of this Release. ==========================================START OF PAGE 15====== amendments adopted today limit all funds to investing not more than five percent of assets in the securities of any one issuer, the amendments limit the application of this standard to only seventy-five percent of single state fund assets and exclude from the diversification requirements for all funds securities subject to certain types of demand features, refunding agreements, and issuer-provided puts.-[29]- In response to comment letters, the Commission has simplified the operation of the rule in several respects. Where possible, the same provisions are applied to all types of funds, separate diversification tests for issuers of conditional and unconditional puts have been eliminated, and fund board involvement is no longer required regarding matters with which directors can be expected to have little expertise. Wherever possible, headings and cross-references have been added to the rule to assist a reader in understanding how its provisions interrelate. B. Portfolio Quality and Diversification 1. Five Percent Diversification Test a. Application to Tax Exempt Funds As discussed above, taxable funds are subject to the Five Percent Diversification Test, that is, no more than five percent of the total assets of a taxable money fund may be invested in securities of a single issuer. In proposing to extend diversification standards to tax exempt funds, the Commission took into account the differences between national and single state funds. Most national funds elect to meet the diversification requirements of section 5(b)(1) of the 1940 Act,-[30]- and choose not to use the "twenty-five percent ---------FOOTNOTES---------- -[29]- See infra Sections II.B.1.b., II.C.1.c. and II.D.2. of this Release, and paragraphs (c)(4)(i) and (ii), (c)(4)(vi)(A)(2) and (c)(4)(vi)(B)(1) of rule 2a-7, as amended. -[30]- Section 5(b)(1) provides that a diversified investment company may not, with respect to seventy-five percent of its assets, invest more than five percent of its assets in instruments of any one issuer, other than cash, cash items, Government securities (as defined in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-2(a)(16)]) and securities of other investment companies. The remaining twenty-five percent of its assets (the "twenty-five percent basket") may be invested in any manner. If an investment company invests more than five percent of its assets in a single issuer, the entire investment is placed in the twenty-five percent basket, and then aggregated with other investments that are greater than five (continued...) ==========================================START OF PAGE 16====== basket" (the portion of a diversified fund's assets that is not required to be diversified) to invest more than five percent of their assets in a single issuer. Most commenters, including most mutual fund commenters, supported the extension of the Five Percent Diversification Test to national funds, which the Commission is adopting as proposed.-[31]- Unlike national funds, many single state funds are not diversified under section 5(b)(1), and could not satisfy the Five Percent Diversification Test because their investment objectives provide them with a much narrower range of high quality investment alternatives.-[32]- Although the Commission expressed concern about the risks involved in a non-diversified portfolio of a money fund, it was unclear to the Commission that it would be possible for single state funds to satisfy the Five Percent Diversification Test. Accordingly, the proposed amendments would not have required single state funds to comply with any issuer diversification test under the rule. To reduce the risks associated with a non-diversified portfolio, the Commission proposed to limit single state funds to investing in first tier securities, and proposed additional disclosure requirements to inform investors of the risks of an undiversified single state fund.-[33]- The Commission also asked commenters to consider whether single state funds should be ---------FOOTNOTES---------- -[30]-(...continued) percent to determine whether the fund is in compliance with section 5(b)(1). The investment company may not invest more than twenty-five percent of its assets in a single issuer by splitting its investment into two lots between the twenty-five percent basket and the diversified portion of its portfolio. See Lybrand, Ross Bros. & Montgomery (Oct. 24, 1941) (pub. avail. Nov. 22, 1991). Section 5(b)(1) also prohibits a diversified fund, with respect to seventy-five percent of its assets, from investing in securities that comprise more than ten percent of the outstanding voting securities of an issuer. -[31]- Paragraph (c)(4)(i) of rule 2a-7, as amended. -[32]- Proposing Release, supra note 20, at Sections II.A. and II.A.2. -[33]- Proposed amendments to Form N-1A would have required a single state fund to disclose in its prospectus risks related to lack of diversification. Proposing Release, supra note 20, at Section III.A. ==========================================START OF PAGE 17====== required to satisfy a diversification standard under the rule.-[34]- Most commenters supported the exception from the Five Percent Diversification Test for single state funds. Many of these commenters, however, opposed the proposed first tier securities restriction, and asserted that this requirement would exacerbate the supply problem without making funds more safe by forcing single state funds to be less diversified. Other commenters maintained that the rule should mandate some diversification with respect to single state funds, which they asserted present greater risks than other types of money funds. One commenter suggested that single state funds offering securities from "large" states should be subject to the same diversification standards as national funds. Another commenter went even further, stating that the rule should impose the diversification standards applicable to national funds to all single state funds. The views of these commenters, as well as the Commission's experience in administering rule 2a-7 since the amendments were proposed, have led the Commission to reconsider its proposal to exempt single state funds entirely from a diversification test. In proposing the 1991 Amendments, the Commission noted that a fund's ability to maintain a stable net asset value under the rule may be impaired to the extent it invests heavily in one or more issuers that subsequently experience credit problems or default on their securities.-[35]- The validity of that observation has been proven by many of the incidents of the past two years in which advisers to funds have taken steps to prevent the fund from breaking a dollar as a result of holding a distressed security.-[36]- In each case, the smaller the ---------FOOTNOTES---------- -[34]- Proposing Release, supra note 20, at Section II.A.2. -[35]- Release 17589, supra note 2, at Section II.1. -[36]- Transactions of this type occurred within the last two years because funds held either long-term adjustable rate securities whose market values declined when short-term interest rates were increased, or notes issued by Orange County. Twenty-five advisers or related persons purchased adjustable rate securities from their funds at the securities' amortized cost values to avoid any fund shareholder losses. Thirty-eight advisers or related persons either purchased Orange County notes from, or entered into credit support arrangements with their affiliated funds in order to maintain the funds' stable share price of $1.00. These transactions are prohibited by (continued...) ==========================================START OF PAGE 18====== position, the less of an effect the distressed security had on the fund. In the case of the bankruptcy of Orange County, most of the funds holding the notes held a fairly small portion of their assets in Orange County notes.-[37]- As a result, in some cases, the fund could maintain its share price without any assistance from the fund's adviser; in other cases, the adviser was in a position to take steps to prevent the fund from breaking a dollar only because the fund's Orange County Note position was relatively small. While, as the Commission has stated several times, no adviser is required to guarantee its fund against the possibility of breaking a dollar,-[38]- experience has demonstrated that diversification may not only limit investment risk, but also may place the fund in a better position to address (or avoid) significant deviation between a fund's market-based and amortized cost values. ---------FOOTNOTES---------- -[36]-(...continued) section 17 of the 1940 Act [15 U.S.C. 80a-17] in the absence of a Commission exemption. See infra Section IV. of this Release. -[37]- The thirty-eight funds that sought and were granted "no-action" relief from the Division of Investment Management either to sell the Orange County notes to affiliated persons, or to arrange for affiliated persons to provide some type of credit support for the benefit of the funds, are illustrative. Most of these funds had no more than five percent of their assets invested in notes issued by Orange County, or one of the participants in the Orange County Investment Pools. Within this group, the fund (a single state fund) that had the greatest concentration of its assets in securities issued by a single issuer had 8.7 percent of its assets invested in that issuer. -[38]- See, e.g., Release 18005, supra note 11, at Section II.H.; Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Issues Affecting the Mutual Fund Industry Before the Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, U.S. House of Representatives, 23-25 (Sept. 27, 1994); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning Municipal Bond and Government Securities Markets Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 10-11 (Jan. 5, 1995). ==========================================START OF PAGE 19====== The Commission recognizes that single state funds face a limited choice of very high quality issuers in which to invest, and that the number of first tier issuers in several states is especially limited. Application of the Five Percent Diversification Test to one hundred percent of the assets of these funds could force some funds to invest in lower quality issuers than those in which they would otherwise invest. While greater diversification provides an additional measure of safety for investors where there are many issuers to choose from, the Commission is concerned that too stringent a diversification standard could result in a net reduction in safety for certain single state funds. As a result, the Commission has decided to require single state funds to be diversified at the five percent level only as to seventy-five percent of their assets; the remaining twenty-five percent basket may be invested only in the first tier securities of one or more issuers. The availability of the twenty-five percent basket will provide single state funds with the flexibility to retain several positions of over five percent in very high quality investments.-[39]- The Commission has decided to exclude from the application of the diversification requirement securities that are subject to an unconditional demand feature from a non-controlled person, as defined in the rule.-[40]- This approach will be applicable to all money funds, not only single state funds. The Commission believes that this approach, described in more detail below, will provide the advantages of diversification while permitting funds sufficient flexibility to respond to the available supply of eligible securities. b. Scope of the Diversification Standards A large percentage (sixty to seventy percent) of the securities currently held in tax exempt fund portfolios consist of long-term adjustable rate securities that are subject to unconditional demand features.-[41]- The provider of an unconditional demand feature assumes the credit risks presented by a particular issuer by agreeing to provide principal and interest payments in the event the issuer of the underlying security is unable to do so. Funds generally rely on the credit quality of the issuer of an unconditional demand feature to ---------FOOTNOTES---------- -[39]- Application of the non-diversified basket will track the comparable provision of section 5(b)(1) of the 1940 Act [15 U.S.C. 80a-5(b)(1)]. See supra note 30. -[40]- Paragraphs (c)(4)(i) and (ii) of rule 2a-7, as amended. -[41]- Proposing Release, supra note 20, at Section I.B. ==========================================START OF PAGE 20====== satisfy the rule's quality standards.-[42]- In light of this reliance, two commenters questioned the necessity of requiring a fund to satisfy the rule's issuer diversification and quality standards with respect to the issuer of the underlying security.-[43]- If a security subject to an unconditional demand feature was in default or otherwise became distressed, a money fund normally would be expected to exercise the demand feature and receive the entire principal amount of the security and any interest payments due or accrued.-[44]- Thus, lack of diversification in the underlying security may be less important to a money fund's ability to maintain a stable net asset value than the ability to exercise the demand feature. Demand features are subject to a separate diversification requirement under the rule and, thus, excessive reliance on the credit of a single issuer is already addressed by the rule.-[45]- Based on these considerations, and in light of the greater flexibility that would be afforded to single state funds, the Commission has decided to amend the rule so that the issuer diversification requirement -- for all money funds -- excludes securities subject to an "unconditional demand feature issued by a non-controlled person," as defined in the rule.-[46]- ---------FOOTNOTES---------- -[42]- Paragraph (c)(3)(ii) of rule 2a-7, as amended, permits a fund to rely on the credit quality of the unconditional demand feature in determining whether the underlying security is an eligible security or a first tier security. -[43]- The commenters discussed this issue within the context of the rule's put diversification standards. See infra Section II.C.2. of this Release. -[44]- Paragraph (c)(5)(ii) of rule 2a-7, as amended, requires a money fund to dispose of a defaulted or distressed security (e.g., one that no longer presents minimal credit risks) "as soon as practicable," absent a finding by the board of directors that disposal would not be in the best interests of the fund. -[45]- Demand features and other types of puts that enhance underlying securities continue to be subject to the rule's put diversification requirements. See infra Section II.C.1. of this Release. -[46]- An "unconditional demand feature issued by a non- controlled person" is defined in the rule to mean (continued...) ==========================================START OF PAGE 21====== The Commission is limiting this exclusion to securities whose unconditional demand features are issued by non-controlled persons to reduce a fund's exposure to the credit risks presented by a single economic enterprise.-[47]- Securities subject to other types of puts, including conditional demand features, would continue to be subject to the rule's issuer diversification standard. 2. Quality Limitations on Portfolio Securities Rule 2a-7 limits both taxable and tax exempt funds to investing only in eligible securities -- securities receiving at least the second highest rating from the requisite NRSROs (as defined in the rule) or comparable unrated securities.-[48]- Taxable funds must comply with the Second Tier Securities Tests -- investment in second tier securities is limited to five percent of fund assets, and investment in the second tier securities of any one issuer is limited to the greater of one percent of fund assets or one million dollars. The proposed amendments to the rule would have established different quality standards for national and single state funds. a. Proposed Limitations for Single State Funds The proposed amendments would have limited single state fund investment to first tier securities. The Commission stated in the Proposing Release that the first tier securities restriction was designed to reduce the additional risks that may accompany lower levels of diversification as a result of the Commission's proposal not to extend the Five Percent Diversification Test to single state funds. As noted above, most fund commenters objected to this limitation. In light of the requirement that ---------FOOTNOTES---------- -[46]-(...continued) an "unconditional put" that is also a "demand feature issued by a non-controlled person." Paragraph (a)(26) of rule 2a-7, as amended. A "demand feature issued by a non-controlled person" is defined to mean "a demand feature issued by a person that, directly or indirectly, does not control, and is not controlled by or under common control with the issuer of the security subject to the Demand Feature. Control shall mean `control' as defined in section 2(a)(9) of the Act." Paragraph (a)(8) of rule 2a-7, as amended. -[47]- Similarly, the twenty-five percent put basket will not be available for puts that do not meet the definition of a put issued by a non-controlled person. See infra Section II.C.1.b. of this Release. -[48]- See supra nn. 12 and 13 and accompanying text and paragraph (a)(19) of rule 2a-7, as amended. ==========================================START OF PAGE 22====== single state funds be diversified as to seventy-five percent of their assets,-[49]- the Commission has decided not to adopt the proposed first tier securities restriction. b. Application of the Second Tier Securities Tests to Conduit Securities The proposed amendments to the rule would have extended the Second Tier Securities Tests only to national fund investment in "conduit securities." The Proposing Release explained that, in contrast to traditional state and municipal securities, conduit securities are issued to finance non-governmental private projects, such as retirement homes, private hospitals, local housing projects, and industrial development projects, with respect to which the ultimate obligor is not a governmental entity. Conduit securities are not backed by a revenue source from any essential public facility or by the taxing authority of any state or municipality. As a result, the risk of default for conduit securities is significantly higher than it is for traditional state or municipal securities.-[50]- Therefore, the Commission proposed to treat a national fund's investment in conduit securities no differently than a taxable fund's investment in securities typically issued by a private concern. Most commenters supported the application of the Second Tier Securities Tests to national fund investment in conduit securities. These commenters generally agreed that this limited application of the Second Tier Securities Tests would allow national funds maximum flexibility to invest in the type of tax exempt securities that present the least risk of default. A smaller group of commenters, however, asserted that the proposed limitation would further limit the supply of eligible securities.-[51]- Many conduit securities in which money funds invest are subject to unconditional demand features. Because the Second Tier Securities Tests will not be applied to conduit securities with unconditional demand features issued by non-controlled persons, the application of the Second Tier ---------FOOTNOTES---------- -[49]- See supra Section II.B.1.a. of this Release and paragraph (c)(4)(iii) of rule 2a-7, as amended. -[50]- See Municipal Bond Defaults - The 1980's: A Decade in Review (J.J. Kenny & Co., Inc. 1993). Bankruptcies and defaults by major municipal issuers, such as Orange County, California, are rare events. Of the approximately 120 municipal bankruptcies since 1979, most have involved small, local governments or special tax districts. See "Banging a Tin Cup With a Silver Spoon," N.Y. Times, June 4, 1995 at F1. -[51]- See supra note 29 and accompanying text. ==========================================START OF PAGE 23====== Securities Tests to these securities should have a limited effect on the supply of tax exempt securities.-[52]- The Commission has decided to extend the Second Tier Securities Tests to national and single state fund investment in conduit securities. Under amendments to the rule being adopted, the non-governmental entity ultimately responsible for the payment of principal and interest is treated as the issuer of the conduit security for purposes of the rule's issuer diversification requirements.-[53]- Credit quality determinations for a conduit security must be made by reference to the underlying corporate or project issuer, unless the conduit security is subject to an unconditional demand feature, in which case the conduit security will not be subject to the Second Tier Securities Tests.-[54]- Credit quality determinations for conduit securities subject to conditional demand features must be made by reference to the provider of the demand feature and the long-term rating of the underlying corporate or project issuer.-[55]- In addition, for purposes of calculating compliance with the one percent limit on second tier securities of a single issuer, the issuer of the conduit is the corporation or project.-[56]- c. Definition of the Term "Conduit Security" The proposed amendments would have defined the term "conduit security" to mean a security issued through a state or territory of the United States, or any political subdivision or instrumentality thereof, which is not: (1) payable from the revenues of such governmental unit ("Revenue Clause"); (2) unconditionally guaranteed by such governmental unit; (3) related ---------FOOTNOTES---------- -[52]- As adopted, the rule exempts from the Second Tier Securities Tests any conduit security subject to an unconditional demand feature issued by a non- controlled person, whether the demand feature is first or second tier. Paragraph (c)(4)(iv)(B) of rule 2a-7, as amended. -[53]- Paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended. -[54]- Paragraph (c)(4)(iv)(B) of rule 2a-7, as amended. -[55]- See infra Section II.B.2.b. of this Release and paragraph (c)(3)(iii) of rule 2a-7, as amended. -[56]- See paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended. For example, a municipal security issued to finance a private hospital that meets the definition of a conduit security would be considered -- for diversification purposes -- to have been issued by the hospital, not the municipality. ==========================================START OF PAGE 24====== to a project or facility owned and operated by such governmental unit; or (4) related to a facility leased to and under the control of an industrial or commercial enterprise that is part of a public project owned and under the control of such governmental unit. The definition was intended to exclude securities for which the ultimate obligor is a governmental unit. Several commenters advised the Commission that portfolio managers would be able to identify conduit securities more readily and without obtaining legal and other expert opinions if the rule affirmatively stated what a conduit security is, instead of what it is not. Several commenters also urged that the Revenue Clause be deleted because it might result in excluding from the Second Tier Securities Tests a security for which the ultimate obligor is a private entity.-[57]- The Commission has modified the definition of the term "conduit security" to reflect some of these concerns.-[58]- The term "conduit security" is defined as a security issued by a municipal issuer involving an arrangement or agreement ---------FOOTNOTES---------- -[57]- For example, a governmental unit could issue bonds on behalf of a private firm for the purpose of raising funds to construct facilities for a company, such as a plant or a residential real estate project. The payment of principal or interest on the bonds would be secured through a lease arrangement under which the private firm makes periodic payments to the governmental unit. If these payments were characterized as "revenue," then the bonds issued by the governmental unit would not be treated as conduit securities under the proposed definition. -[58]- In the Proposing Release, the Commission asked commenters whether the rule's definition of a conduit security should reference the provisions of the Internal Revenue Code ("IRC") governing the treatment of private activity bonds, IRC sections 141-174 [26 U.S.C. 141-147]. Most commenters discussing the definition of a conduit security strongly opposed this approach, generally observing that it would have the effect of treating certain general obligation bonds, and bonds issued to finance property owned by a governmental unit, as conduit securities that are subject to the Second Tier Securities Tests, which would be inconsistent with the Commission's objective of subjecting only obligations of non- governmental issuers to the Second Tier Securities Tests. The Commission has decided not to reference the IRC's private activity bond rules in defining the term "conduit security." ==========================================START OF PAGE 25====== entered into, directly or indirectly, with an issuer other than a municipal issuer, which arrangement or agreement provides for or secures repayment of the security.-[59]- The term "conduit security" does not include a security that is: (1) unconditionally guaranteed by a municipal issuer; (2) payable from the general revenues of the municipal issuer (other than revenues derived from an agreement or arrangement with a person who is not a municipal issuer that provides for or secures repayment of the security); (3) related to a project owned and operated by a municipal issuer; or (4) related to a facility leased to and under the control of an industrial or commercial enterprise that is part of a public project which, as a whole, is owned and under the control of a municipal issuer.-[60]- C. Diversification and Quality Standards for Put Providers A substantial portion of securities held by tax exempt funds are subject to puts and demand features.-[61]- A "put" is the right to sell a specified underlying security within a specified period of time and at a specified exercise price that may be sold, transferred, or assigned only with the underlying security.-[62]- A demand feature is a put that may be exercised at specified intervals not exceeding 397 calendar days and upon no more than thirty days' notice.-[63]- Demand features can serve three different purposes: (1) to shorten the maturity of a variable or floating rate security;-[64]- (2) ---------FOOTNOTES---------- -[59]- Paragraph (a)(6) of rule 2a-7, as amended. The rule amendments, as adopted, define the term "municipal issuer" to mean a state or territory of the United States, or any political subdivision or instrumentality thereof. The term "state" is defined in the 1940 Act to mean any state, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States [15 U.S.C. 80a-2(a)(39)]. -[60]- Paragraph (a)(6) of rule 2a-7, as amended. -[61]- Proposing Release, supra note 20, at Section I.B. -[62]- Paragraph (a)(16) of rule 2a-7, as amended. -[63]- Paragraph (a)(7) of rule 2a-7, as amended. -[64]- Paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended. Initially, rule 2a-7 provided that only demand features that ran to the issuer of the security could be used to shorten maturities. See Release 13380, supra note 7, at n.9. This was changed by the amendments to rule 2a-7 adopted in 1986. Investment Company Act Rel. No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] ("Release 14983"). ==========================================START OF PAGE 26====== to enhance the security's credit quality; and (3) to provide liquidity support for the security. If the demand feature can be exercised on seven days' notice, then the security will be treated as a liquid security under the appropriate guidelines.-[65]- Demand features may be conditional or unconditional.-[66]- Under rule 2a-7, a demand feature used as a substitute for the credit quality of the underlying security must be an "unconditional put," defined to include any guarantee, letter of credit ("LOC") or similar unconditional credit enhancement that by its terms would be readily exercisable in the event of a default in payment of principal or interest on the underlying security.-[67]- A demand feature that is not an "unconditional put" may serve as the basis for determining whether a security is an eligible security and categorizing it as a first or second tier security; however, the long-term credit quality of the security subject to a conditional demand feature must also be analyzed.-[68]- The Commission is adopting several amendments to the provisions of the rule relating to puts and demand features. ---------FOOTNOTES---------- -[65]- A money fund is limited to investing no more than ten percent of its assets in illiquid securities. See Release 13380, supra note 7, at nn.37-38 and accompanying text. See also Investment Company Institute (pub. avail. Dec. 9, 1992). The Division of Investment Management has provided guidance concerning the implementation of three business days as the standard settlement period for trades effected by brokers and dealers, and a fund's determination of whether securities it holds should be deemed liquid for purposes of complying with the ten percent restriction. Letter from Jack W. Murphy, Associate Director and Chief Counsel, Division of Investment Management, to Paul Schott Stevens, General Counsel, Investment Company Institute (May 26, 1995) ("T+3 Letter"). -[66]- Both conditional and unconditional puts may operate as demand features to shorten the maturities of adjustable rate securities. As discussed in Section II.C.3. of this Release, infra, amendments to rule 2a-7 limit the types of conditions to which exercise of a demand feature can be subject. Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended. -[67]- Paragraph (a)(27) of rule 2a-7, as amended. -[68]- Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended. ==========================================START OF PAGE 27====== 1. Put Diversification Standards Under rule 2a-7, a taxable money fund may not invest more than five percent of its assets in securities subject to conditional puts from, or securities directly issued by, the same institution. The percentage limitation applicable to unconditional puts is ten percent. A tax exempt fund is required to comply with these two requirements with respect to seventy- five percent of its assets; there is no diversification requirement with respect to the remaining twenty-five percent ("twenty-five percent put basket"). The Commission proposed to apply a uniform ten percent limitation on all puts issued by the same institution and to eliminate the twenty-five percent put basket for tax exempt funds.-[69]- a. Uniform Diversification Standards for Conditional and Unconditional Puts Under the proposed amendments, a fund could not have invested more than ten percent of its assets in securities subject to conditional and unconditional puts, and securities directly issued by, the same issuer. A fund would have been required to aggregate conditional and unconditional puts issued by the same issuer in applying the ten percent restriction. Most of the commenters who addressed these aspects of the proposal supported the aggregation of conditional and unconditional puts in applying a uniform percentage restriction. Other commenters disagreed, either urging that the ten percent limit be raised or that the rule's put diversification standards continue to distinguish between puts that provide liquidity support (conditional puts) and puts that provide credit support (unconditional puts). The Commission has decided to adopt the uniform ten percent limitation as proposed, and eliminate the current distinction between conditional and unconditional puts under the rule's put diversification standards.-[70]- Although there are differences between the risks incurred by the put provider and the nature of the reliance by the investor in each case, the Commission does not believe that these differences are significant enough to warrant continued disparate treatment under the rule. Moreover, aggregating conditional and unconditional puts and applying a single put diversification standard to the aggregate number should simplify compliance with the rule. ---------FOOTNOTES---------- -[69]- See Proposing Release, supra note 20, at Section II.C.2. -[70]- Paragraph (c)(4)(v)(B) of rule 2a-7, as amended. ==========================================START OF PAGE 28====== b. The Twenty-Five Percent Put Basket The proposed amendments to the rule would have eliminated the twenty-five percent put basket so that a tax exempt fund would have been required to meet the rule's put diversification standards with respect to one hundred percent of its assets. The Commission explained that extensive reliance on a single put provider or a few providers could present considerable risks, particularly for a single state fund which, under the amendments as proposed, would not have been required to be diversified with respect to underlying securities.-[71]- Most commenters urged the Commission to retain the twenty- five percent put basket in some form. Many concluded that eliminating the twenty-five percent put basket would increase reliance by funds on less creditworthy put providers and decrease the flexibility currently afforded funds in enhancing the credit quality and liquidity of securities. The commenters disagreed with the Commission's assumption that one probable effect of the elimination of the twenty-five percent put basket would be new entrants to the market as put providers. A number of commenters suggested that, in light of the Commission's proposal to require that when a fund invests more than five percent of its assets in securities subject to puts from a single put provider, the puts be first tier securities,-[72]- it would be appropriate to retain the twenty-five percent put basket. The Commission has decided to incorporate this approach in amendments to the rule's put diversification standards. The amendments provide that the twenty-five percent put basket is available to all money funds for first tier puts, but only if the put is a "put issued by a non-controlled person" -- a put issued by a person that does not directly or indirectly control, and is not controlled by or under common control with the issuer of the security subject to the put.-[73]- The ---------FOOTNOTES---------- -[71]- Proposing Release, supra note 20, at Section II.C.2.b. -[72]- See infra Section II.C.2.b. of this Release. -[73]- Paragraphs (a)(17) (definition of "put issued by a non-controlled person") and (c)(4)(v) of rule 2a- 7, as amended. The Commission is adopting amendments that limit fund investment in puts that are second tier securities to five percent of fund assets. See infra Section II.C.2.b. of this Release and paragraph (c)(4)(v)(B) of rule 2a-7, as amended. Further, a fund that has invested more than ten percent of its assets in securities subject to puts and in securities directly issued by a single issuer must count the total amount (continued...) ==========================================START OF PAGE 29====== Commission is restricting fund use of the twenty-five percent put basket to non-controlled persons to minimize a fund's concentration of assets in a single economic enterprise. c. Issuer-Provided Demand Features The put diversification standards under rule 2a-7 apply to "securities issued by or subject to Puts from the institution that issued the Put."-[74]- In the Proposing Release, the Commission requested comment on the treatment of puts by the issuer of the underlying securities ("issuer-provided demand features").-[75]- Some commenters asserted that funds should be permitted to exclude issuer-provided demand features from the put diversification requirements because issuer-provided demand features can be viewed as the functional equivalent of short-term securities that are "rolled over" periodically. The commenters also suggested that including issuer-provided demand features as puts in determining compliance with the rule's put diversification standards amounts to "double counting." The Commission agrees and has added language to the rule to clarify that a fund is not required to aggregate an issuer-provided put with the security subject to the put for purpose of determining compliance with the put diversification requirement of the rule.-[76]- ---------FOOTNOTES---------- -[73]-(...continued) invested towards the twenty-five percent undiversified put basket. In other words, a fund may not use all or a portion of its twenty-five percent put basket and an additional amount of its diversified assets to invest more than twenty-five percent of its assets in a single issuer. See supra, note 30. -[74]- Paragraph (c)(4)(v)(A) of rule 2a-7, as amended. -[75]- See Proposing Release, supra note 20, at Section II.C.2.d.(3). The Commission noted that rule 2a- 7, as originally adopted, provided that only issuer-provided demand features could be used to shorten the maturity of a security. See Release 13380, supra note 7, at n.10 and accompanying text. -[76]- Paragraph (c)(4)(vi)(B)(1) of rule 2a-7, as amended. Under this paragraph, a put issued by the same institution that issued the underlying security would not be subject to the rule's put diversification requirements, and would be subject only to the rule's issuer diversification requirements. For example, a security representing four percent of a fund's total assets (continued...) ==========================================START OF PAGE 30====== d. Multiple Puts and Guarantees The proposed amendments would have amended rule 2a-7's put diversification standards to address how put diversification calculations should be made when a security is subject to several puts ("multiple puts"). Under the proposed amendments, different calculation methods would have been applied when: (i) each multiple put provider had contractually agreed to guarantee only a portion of the total principal value of the underlying security ("fractional puts"), and (ii) each multiple put provider had an obligation that was not limited contractually ("layered puts"). The proposed amendments would have clarified that an institution that provides a fractional put would be treated as guaranteeing only that portion of the principal value of the security that it contractually agreed to provide.-[77]- An institution providing a layered put would have been deemed to cover the entire principal amount of the security, notwithstanding that the security is subject to puts from other institutions. Most commenters who discussed these issues supported the proposed treatment of fractional puts. These commenters stated that it was appropriate to allocate exposure among put providers for diversification purposes in accordance with the put providers' contractual obligations. The Commission has decided to adopt these amendments to the rule as proposed.-[78]- Most commenters opposed treating each put provider in a layered put structure as the guarantor of the entire amount guaranteed because, they argued, the approach ignored the fact that the fund may be relying only on the guarantee of one of the put providers. The Commission has decided to adopt amendments to the rule that reflect these comments. For a security subject to layered puts, the rule permits a fund that is not relying on a ---------FOOTNOTES---------- -[76]-(...continued) that had an issuer-provided demand feature would be treated as a four percent position in "securities issued by or subject to Puts from the institution that issued the Put," not eight percent [quoting paragraph (c)(4)(iv)(A) of rule 2a-7, as amended]. -[77]- For example, if two banks issued puts on the same VRDN and each agreed to absorb fifty percent of the losses, then each would be deemed to guarantee no more than fifty percent of the VRDN under the rule's put diversification standards. -[78]- Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as amended. ==========================================START OF PAGE 31====== particular put for satisfaction of the rule's credit quality-[79]- or maturity standards,-[80]- or for liquidity, to exclude that put when determining its compliance with the rule's put diversification standards.-[81]- The fund must document this determination in its records.-[82]- In the context of describing the proposed amendments regarding treatment of multiple puts under the rule's diversification standards, the Commission indicated that bond insurance was a type of put under rule 2a-7.-[83]- A number of commenters disagreed with this analysis of bond insurance, arguing that bond insurance does not provide liquidity and is not viewed by the market as a substitute for the credit of ---------FOOTNOTES---------- -[79]- Under the rule, a fund holding a security that is subject to an unconditional demand feature may satisfy the rule's credit quality standards with respect to the underlying security based solely on the short-term rating of the demand feature provider. Paragraph (c)(3)(ii) of rule 2a-7, as amended. -[80]- Rule 2a-7 generally permits a fund to measure the maturity of an adjustable rate security subject to a demand feature by reference to the date on which principal can be recovered through demand. See infra Sections II.F.1. and II.F.2. of this Release and paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended. -[81]- Paragraph (c)(4)(vi)(B)(4) of rule 2a-7, as amended. This paragraph of the rule also permits a fund holding a security subject to a single put that it is not relying on to satisfy the rule's credit quality or maturity standards, or for liquidity, to disregard that put in determining its compliance with the rule's put diversification standards. If a fund is relying on separate puts for each of these purposes (e.g., a conditional demand feature for purposes of liquidity and maturity, and an unconditional put for purposes of credit quality), then each put would have to satisfy the rule's put diversification standards. -[82]- Paragraphs (c)(8)(ii) and (c)(9)(vi) of rule 2a-7, as amended. A fund would document this determination when it acquires the security. The fund may subsequently determine that it is or is not relying on a particular put, but must reflect the change in its written records. -[83]- Proposing Release, supra note 20, at note 81. ==========================================START OF PAGE 32====== the underlying issuer. Because bond insurance guarantees the timely payment of principal and interest by the insured issuer,-[84]- it meets the rule's definition of an unconditional put, permitting credit substitution in the eligibility determination. The Commission has amended the rule to clarify this matter.-[85]- The Commission recognizes, however, that bond insurance may not be relied upon by a fund when determining a security's eligibility under the rule. One commenter argued that, in the case of a security subject to a guarantee, such as bond insurance, and a demand feature, the fund is very likely to look only to the issuer of the demand feature if it needs to sell the security and thus, as a practical matter, to the issuer of the demand feature for credit support. Therefore, this commenter concluded, the guarantee should not be counted for purposes of rule 2a-7's diversification requirements. The Commission agrees, and has amended the rule to permit a fund holding a security subject to a put (including bond insurance) and an unconditional demand feature to count only the demand feature for purposes of the put diversification calculation.-[86]- A fund relying on this provision of the rule is not required to maintain contemporaneous records of its determination that the fund is not relying on the guarantee to determine credit quality. 2. Quality Standards a. Rating Requirement for Demand Features The proposed amendments to the rule would have limited funds to investing in demand features (other than standby commitments) that are rated, or provided by institutions that are rated, by NRSROs. Most commenters discussing this issue opposed the proposed rating requirement for demand features and suggested that the rule should permit a fund to purchase a security subject to an unrated demand feature if it can make a comparability ---------FOOTNOTES---------- -[84]- Eli Nathans, Municipal Bond Insurance -- The Economics of the Market, 13 Mun. Fin. J., No.2 (Summer 1992) 1, 2. -[85]- Paragraph (a)(27) of rule 2a-7, as amended. A bond insurance policy that permits the holder of the security to receive all principal and interest payments at the time of the default of the insured obligation would also be an unconditional demand feature. By contrast, a policy under which the fund would only receive periodic payments of principal and interest as those payments came due under the terms of the insured obligation would be an unconditional put, but not an unconditional demand feature. -[86]- Paragraph (c)(4)(vi)(B)(3) of rule 2a-7, as amended. ==========================================START OF PAGE 33====== determination similar to the determination permitted under the rule in connection with the purchase of unrated securities.-[87]- Other commenters asserted that the fund manager's obligation under the rule to determine that all portfolio securities present minimal credit risk obviated the need for the proposed rating requirement.-[88]- The Commission explained in the Proposing Release that NRSRO ratings assigned to demand features or the issuer of demand features may provide additional protection by ensuring input into the minimal credit risk determination by an outside source. This extra source of protection may be particularly important in light of the Commission's decision to preserve the twenty-five percent diversification basket for put providers, and to eliminate the applicability of rule 2a-7's diversification requirements to securities subject to certain unconditional demand features.-[89]- In addition, funds may have limited ability to monitor the credit quality of some demand feature providers, such as foreign banks.-[90]- The Commission is adopting the rating requirement for demand features as proposed.-[91]- b. Providers of Puts in Excess of Five Percent of Fund Assets The proposed amendments would have prohibited a money fund from investing more than five percent of its assets in securities ---------FOOTNOTES---------- -[87]- Paragraph (a)(9)(iii) of rule 2a-7, as amended, permits a fund to treat an unrated security as an eligible security if the fund's board of directors determines that the unrated security is of comparable quality to a rated security. -[88]- Paragraph (c)(3) of rule 2a-7, as amended, limits fund investment to securities that its "board of directors determines present minimal credit risks." This determination must be based on factors pertaining to credit quality "in addition to any rating assigned to such securities by an NRSRO" (emphasis added). -[89]- See supra Section II.B.1.b. of this Release. -[90]- Proposing Release, supra note 20, at Section II.C.2.d.(2). -[91]- Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as amended. The amendments remove from the definition of eligible security unrated securities that are subject to demand features. Thus, in order for a security subject to a demand feature to be eligible for fund investment, the demand feature must be rated. ==========================================START OF PAGE 34====== subject to a put from a single put provider that is not a first tier put. Compliance with this provision would be measured at the time the put was acquired by the fund. All the commenters discussing this aspect of the proposal agreed that it is appropriate to limit fund investment in puts that are not first tier securities ("second tier puts"), and the Commission is adopting the limit as proposed.-[92]- If more than five percent of a fund's assets were subject to a demand feature from a single institution that was no longer a first tier put, the proposed amendments also would have required the fund to reduce the amount of the securities subject to the demand feature to not more than five percent of the fund's assets by exercising the demand feature at the next succeeding exercise date. Most commenters were critical of this proposed requirement and suggested that it might be in the best interests of fund shareholders for the fund either to retain the securities subject to the demand features or dispose of the securities in an orderly manner. Because there may be some circumstances during which it may be in the best interest of the fund to continue to hold the securities subject to the put, the Commission is adopting the amendment with the express provision that a fund's board of directors may determine that disposal of the securities is not in the best interest of the fund, and determine to permit the fund to continue to hold the securities.-[93]- c. Certain Unrated Securities Rule 2a-7 currently provides that an unrated security that, when issued, was a long-term security but when purchased by the fund has a remaining maturity of less than 397 calendar days may be considered to be an eligible security based on whether the security is comparable in quality to a rated security, unless the security has received a long-term rating from any NRSRO that is not within the two highest categories of long-term ratings. Under this provision, a long-term rating from an NRSRO below the top two rating categories results in the security becoming ---------FOOTNOTES---------- -[92]- Paragraph (c)(4)(v)(B) of rule 2a-7, as amended. -[93]- Paragraph (c)(5)(i)(C) of rule 2a-7, as amended. This determination may not be delegated. Paragraph (e) of rule 2a-7, as amended. If the demand feature is no longer an eligible security, paragraph (c)(5)(ii) of rule 2a-7 requires the fund to obtain a new demand feature or dispose of the underlying security (unless the board of directors finds that it would be in the best interest of the fund not to dispose of the security). See Release 18005, supra note 11 at Section II.E.1. for a discussion of securities held by a money fund that are in default, are no longer eligible securities, or no longer present minimal credit risks. ==========================================START OF PAGE 35====== ineligible for investment by a money market fund. One commenter stated that, because many issuers with long-term ratings in the third highest ratings categories have first tier short-term ratings, the rule was unnecessarily restrictive. The Commission agrees, and has expanded this provision to accommodate long-term ratings within the top three ratings categories.-[94]- Funds will continue to be required to determine that such a security is of "comparable quality" to rated eligible securities.-[95]- 3. Conditional Demand Features Rule 2a-7 does not currently restrict the types of conditions to which a demand feature may be subject. The inability of a fund to exercise a demand feature because of the occurrence of a condition precluding exercise would likely result in violations of the maturity limitations of rule 2a-7, the liquidity requirements of the 1940 Act,-[96]- and a loss of value of the underlying security, when, for example, a short-term security paying interest at short-term rates is transformed into a long-term security. Therefore, the proposed amendments would have limited the permissible conditions with respect to conditional puts to the following: (1) default in the payment of principal or interest on the underlying security; (2) the bankruptcy, insolvency, or receivership of the issuer or a guarantor of the underlying security; (3) the downgrading of either the underlying security or a guarantor by more than two full rating categories; and (4) in the case of a tax exempt security, a determination by the Internal Revenue Service of taxability with respect to the interest on the security.-[97]- These conditions were designed to permit ---------FOOTNOTES---------- -[94]- Paragraph (a)(9)(iii)(B) of rule 2a-7, as amended. -[95]- Paragraph (a)(9)(iii) of rule 2a-7, as amended. -[96]- The money fund could lose liquidity at a time when it is most necessary. A money fund is limited to investing no more than ten percent of its assets in illiquid securities. See supra note 65 and accompanying text and infra Section II.C.4.c. of this Release. -[97]- The proposed amendments to the rule incorporated recommendations of Fidelity Management & Research Company ("Fidelity") and the Investment Company Institute ("ICI"). See Letter from Matthew Fink, Senior Vice President and General Counsel, ICI, to Marianne Smythe, Director, Division of Investment Management (Mar. 25, 1991); Letter from Thomas D. Maher, Associate General Counsel, Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities and (continued...) ==========================================START OF PAGE 36====== the fund to monitor the continued availability of a demand feature and to take steps to sell the security or replace the demand feature if it appears that conditions are likely to occur that would limit the ability of the fund to exercise the demand feature.-[98]- Many commenters objected to the proposed definition of the term "conditional put." These commenters stated that the current market has few, if any, variable rate demand notes ("VRDNs") with conditional puts that would satisfy the proposed definition. Even the commenters who recommended the proposed conditions conceded that although most put providers have conditions similar to those included in the proposed amendments, every provider uses somewhat different, often broader, language.-[99]- As a result, modifying the scope of one or more of the four conditions would not address this concern. The Commission has decided to adopt an alternative approach suggested by several commenters by revising the rule to provide general guidance concerning the types of conditions that are appropriate for money fund investment. Rule 2a-7, as amended, provides that a security subject to a conditional demand feature is an eligible security only if the fund's board of directors (or its delegate) determines that there is "minimal risk" of occurrence of the conditions that would result in the demand feature not being exercisable.-[100]- The fund's board of directors (or its delegate) also must determine that: (1) the conditions limiting exercise can be monitored readily by the fund, or relate to the taxability, under federal, state or local law, of the interest payments on the security; or (2) the terms ---------FOOTNOTES---------- -[97]-(...continued) Exchange Commission (Sept. 24, 1990), in File No. S7-13-90. -[98]- Proposing Release, supra note 20, at Section II.C.3. -[99]- See Letter from Thomas D. Maher, Associate General Counsel, Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission (May 5, 1994); Letter from Thomas D. Maher, Associate General Counsel, Fidelity, to Kenneth J. Berman, Deputy Office Chief, Office of Disclosure and Investment Adviser Regulation, Division of Investment Management, U.S. Securities and Exchange Commission (June 17, 1994); Letter from Paul Schott Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission (May 5, 1994), in File No. S7- 34-93. -[100]- Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended. ==========================================START OF PAGE 37====== of the demand feature require that the fund receive notice of the occurrence of the condition and the opportunity to exercise the demand feature.-[101]- Rule 2a-7 currently provides that a security subject to a conditional demand feature ("underlying security") is an eligible security only if the demand feature is an eligible security and the underlying security has received a long-term rating from the Requisite NRSROs in one of the two highest long-term ratings categories or, if unrated, is determined to be of comparable quality. The rule thus assumes securities subject to conditional demand features are always long-term securities. The Commission is amending rule 2a-7 to provide that, in the case of an underlying security that has a remaining maturity of 397 days or less, the underlying security is an eligible security only if the demand feature is an eligible security and the underlying security has received a short-term rating from the requisite NRSROs in one of the two highest short-term ratings categories or, if unrated, is determined to be of comparable quality.-[102]- 4. Other Issues Applicable to Put Providers a. Accrued Interest The Commission proposed amendments to the definition of the term "put" and also requested comment whether additional amendments to the rule were necessary to restrict fund investment to certain types of credit and liquidity enhancements. The proposed amendments would have amended the definition of a "put" to specify that the put must enable the holder to receive not only the amortized cost of the securities, but also accrued interest. The Commission is adopting these amendments as proposed.-[103]- b. Notice of Substitution of Put Provider The Commission stated in the Proposing Release that it is aware of several instances in which a money fund had invested in a security backed by a LOC or other credit or liquidity enhancement that was replaced during the life of the underlying security without notice to the fund.-[104]- A fund must know the identity of the put provider for a number of reasons, which include a determination of whether the fund is in compliance with the rule's put diversification and credit quality provisions. The Proposing Release asked commenters to consider whether the rule should be amended to limit fund investment in ---------FOOTNOTES---------- -[101]- Id. -[102]- Paragraph (c)(3)(iii)(C)(1) of rule 2a-7, as amended. -[103]- Paragraph (a)(16) of rule 2a-7, as amended. -[104]- Proposing Release, supra note 20, at Section II.D.1.c. ==========================================START OF PAGE 38====== puts that obligate the issuer of the underlying security (or the trustee under any applicable indenture) to inform investors of the substitution of the put provider. All the commenters responding to this question agreed with the Commission that it is essential for the control of credit risk and for compliance with the rule that funds be aware of the identity of their put providers at all times, and that rule amendments would be appropriate.-[105]- The Commission is adopting amendments to address these concerns. Under the amendments, a security subject to a demand feature is not eligible for fund investment unless arrangements are in place to notify the fund holding the security in the event that there is a change in the identity of the issuer of a demand feature.-[106]- c. Liquidity Requirements for Money Funds and the Three Business Day Settlement Cycle Section 22(e) of the 1940 Act provides, with certain exceptions, that no registered investment company may postpone the date of payment upon redemption of a redeemable security for more than seven days after the security is tendered for redemption. The Commission has stated that all mutual funds should limit their holdings of illiquid securities to ensure that they can satisfy all redemption requests within the seven day period. The Commission considers a security to be illiquid if it cannot be disposed of within seven days in the ordinary course of business at approximately the price at which the fund has valued ---------FOOTNOTES---------- -[105]- A number of these commenters discussed the problems a fund may encounter in obtaining notice of the substitution of a put provider when the securities are held by an intermediary, such as a securities depository. The Commission was advised that intermediaries employ methods to transmit notice of this type to their participants. -[106]- Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as amended. The obligation to provide notice may be the obligation of the issuer of the underlying security, the issuer of the demand feature, or a third party, such as the dealer from which the fund wishes to purchase the security. ==========================================START OF PAGE 39====== it.-[107]- The limit on money fund holdings of illiquid securities is ten percent of fund assets.-[108]- Rule 15c6-1 under the Securities Exchange Act of 1934, which recently became effective, established three business days ("T+3") as the standard settlement period for securities trades effected by a broker or dealer.-[109]- The Division of Investment Management provided advice regarding the implications of the T+3 standard in determining whether a security held by a fund should be deemed liquid for purposes of the restrictions described above.-[110]- This issue is significant for money funds, because a large percentage of money fund assets consist of securities with a seven day demand feature.-[111]- The Division noted that, because rule 15c6-1 applies to brokers and dealers and does not apply directly to funds, its implementation does not change the standard for determining liquidity, which is based on the requirements of section 22(e) of the 1940 Act. As a practical matter, however, many funds (including money funds) will have to meet redemption requests within three days because a broker or dealer will be involved in the redemption process. Many of these funds hold portfolio securities that do not settle within three days. In light of the T+3 standard, the Division recommended that funds should assess ---------FOOTNOTES---------- -[107]- Release 14983, supra note 64; Securities Act Rel. No. 6862 (Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)] (adopting Rule 144A under the Securities Act of 1933 (discussing the definition of "liquid" and citing Release 14983). -[108]- Release 14983, supra note 64 at Section A.4.; Investment Company Institute (pub. avail. Dec. 9, 1992). -[109]- Rule 15c6-1 [17 CFR 240.15c6-1] generally provides that "a broker or dealer shall not effect or enter into a contract for the purchase or sale of a security (other than an exempted security, government security, municipal security, commercial paper, bankers' acceptances, or commercial bills) that provides for payment of funds and delivery of securities later than the third business day after the date of the contract unless otherwise expressly agreed to by the parties at the time of the transaction." Securities Exchange Act Rel. No. 33023 (Oct. 6, 1993) [58 FR 52891 (Oct. 13, 1993)]. -[110]- See T+3 Letter, supra note 65. -[111]- Id. ==========================================START OF PAGE 40====== the mix of their portfolio holdings to determine whether, under normal circumstances, they will be able to facilitate compliance with the T+3 standard by brokers or dealers. Factors the funds should consider include the percentage of the portfolio that would settle in three days or less, the level of cash reserves, and the availability of lines of credit or interfund lending facilities. The Commission shares the Division's concerns and urges money funds to monitor carefully their liquidity needs in light of the shorter settlement period. 5. Short-Term Ratings Rule 2a-7 currently distinguishes between short-term and long-term securities based on whether the security has a remaining maturity of 366 days--primarily for the purpose of distinguishing between securities that have short-term and long- term ratings. NRSROs do not always draw such a line when assigning ratings.-[112]- Therefore, the Commission has revised the rule to replace references to "short-term securities" and "long-term securities" in various sections of the rule with references to securities that have received short-term and long- term ratings from a NRSRO.-[113]- Whether a security has received a long- or a short-term rating from a NRSRO will depend upon how the NRSRO has characterized its rating. D. Other Diversification and Quality Standards 1. Repurchase Agreements Rule 2a-7 allows a fund to "look through" a repurchase agreement ("repo") to the underlying collateral for diversification purposes when the obligation of the counterparty is "collateralized fully."-[114]- Under the current rule, ---------FOOTNOTES---------- -[112]- See, e.g., Fitch Ratings Book (May 1995) (short- term ratings apply to debt payable on demand or to securities with original maturities of up to three years), and Orrick, Herrington & Sutcliffe (pub. avail. July 20, 1994) (synthetic warrants maturing in twenty-two months given short-term ratings by NRSROs). -[113]- Paragraphs (a)(9) (definition of "eligible security"), (a)(11) (definition of "first tier security"), (a)(29) (definition of "unrated security"), and (c)(3)(iii)(C) (requirements for security subject to conditional demand feature) of rule 2a-7, as amended. In addition, the Commission has eliminated the definitions of "short-term" and "long-term" from the rule. -[114]- Paragraph (c)(4)(vi)(A)(1) of rule 2a-7, as amended. A money fund investing in a repurchase agreement that does not meet the requirements of this paragraph may not "look through" and must (continued...) ==========================================START OF PAGE 41====== a repo is collateralized fully if, among other things, the collateral consists entirely of Government securities or securities that, at the time the repo is entered into, are rated in the highest rating category by the requisite NRSROs.-[115]- The Commission is adopting, as proposed, amendments to permit a fund to treat the repo as collateralized fully only if it is collateralized by securities that would qualify the repo for preferential treatment under the Federal Deposit Insurance Act-[116]- or the Federal Bankruptcy ---------FOOTNOTES---------- -[114]-(...continued) instead treat the counterparty to the agreement as the issuer. -[115]- See Proposing Release, supra note 20, at Section II.D.3. -[116]- See also 12 U.S.C. 1821(e)(8)(A) and (C) (affording preferential treatment to "qualified financial contracts"), 12 U.S.C. 1821(e)(8)(D)(i) (defining qualified financial contract to include repurchase agreements) and 12 U.S.C. 1821(e)(8)(D)(v) (defining repurchase agreement). Not all collateral that would qualify a repo for preferential treatment under the Federal Deposit Insurance Act would be permitted. Of the mortgage-related securities referred to in 12 U.S.C. 1821(e)(8)(D)(c), only "mortgage related securit[ies]" as defined in Section 3(a)(41) of the 1934 Act [15 U.S.C. 78c(a)(41)] would be permitted. See sections 101(47) of the Federal Bankruptcy Code ("Bankruptcy Code") (defining "repurchase agreement"), and 559 (protecting repo participants from the Bankruptcy Code's automatic stay provisions) [11 U.S.C. 101(47), 559]. The Bankruptcy Code defines a repurchase agreement as follows: an agreement, including related terms which provides for the transfer of certificates of deposit, eligible bankers' acceptances, or securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States against the transfer of funds by the transferee of such certificates of deposit, eligible bankers' acceptances, or securities with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers' acceptances, or securities as described above, at a date certain no later than one year after such transfer or on demand, against the transfer of funds. ==========================================START OF PAGE 42====== Code.-[117]- The Proposing Release noted that if the collateral does not qualify for special treatment under either of these statutes, a fund could encounter significant liquidity problems if a large percentage of its assets were invested in a repo with a bankrupt counterparty.-[118]- Although some commenters argued that the rule should encompass types of collateral that fall outside the repo specific provisions of the Bankruptcy Code, the Commission believes that the "look through" provisions of the rule would be inappropriate in these circumstances because the credit and liquidity risks assumed by the fund would be tied directly to the counterparty rather than the issuers of the underlying collateral.-[119]- 2. Pre-Refunded Bonds The Proposing Release noted that a significant portion of tax exempt fund assets consist of pre-refunded bonds -- bonds the payment of which are funded by and secured by escrowed Government securities.-[120]- The proposed amendments to the rule would have allowed funds to "look through" the pre-refunded bonds to the escrowed securities for diversification purposes if the underlying securities are Government securities and the escrow arrangement satisfies certain conditions designed to assure that the bankruptcy of the issuer of the pre-refunded bonds would not affect payments on the bonds from the escrow account. The proposed amendments would have limited fund investment in pre- refunded bonds issued by the same issuer to twenty-five percent of its assets. Because these securities would, in effect, be treated as Government securities, they would not be subject to a diversification limitation. Most commenters supported the proposed treatment of pre- refunded bonds. A few of these commenters suggested that the twenty-five percent limitation per issuer was not necessary since ---------FOOTNOTES---------- -[117]- Paragraph (a)(4) of rule 2a-7, as amended. Depository institutions are not eligible for protection under the Bankruptcy Code. Section 109 of the Bankruptcy Code [11 U.S.C. 109]. Instead, the bank regulatory laws provide for the establishment of conservatorship and receiverships of depository institutions in default. See, e.g., section 11 of the Federal Deposit Insurance Act [12 U.S.C. 1821]. -[118]- Proposing Release, supra note 20, at n.172. -[119]- Id. -[120]- Id. ==========================================START OF PAGE 43====== the issuer's credit typically does not secure such bonds.-[121]- The Commission agrees, and has eliminated this limitation.-[122]- The Commission has decided to make additional technical modifications to the conditions applicable to the escrow arrangements that were suggested by the commenters.-[123]- The Commission is also amending the rule to include within the definition of an "unrated security" a rated security that subsequently was made subject to a refunding agreement.-[124]- This amendment clarifies that a fund ---------FOOTNOTES---------- -[121]- The twenty-five percent limitation was a condition specified in a "no-action" position taken by the Division of Investment Management in T. Rowe Price Tax-Free Funds (pub. avail. June 24, 1993) regarding the treatment of these securities for purposes of section 5(b)(1) of the 1940 Act. See Proposing Release, supra note 20, at n.38 and accompanying text. -[122]- The Commission is also eliminating the limitation for funds other than money funds that otherwise rely on the staff no-action position set forth in T. Rowe Price Tax-Free Funds. -[123]- Paragraphs (a)(18) and (c)(4)(vi)(A)(2) of rule 2a-7, as amended. The proposed amendments would have permitted a fund to "look through" the pre- refunded bonds to the escrowed securities for diversification purposes if: (1) the escrowed securities were Government securities; (2) the escrowed securities were pledged only with respect to the payment of principal, interest and premiums on the pre-refunded bonds; and (3) either an independent certified public accountant or a NRSRO certified that the escrowed securities would satisfy all scheduled payments of principal, interest and premiums on the pre-refunded bonds. Commenters urged the Commission to clarify condition (2) by stating that excess proceeds could be remitted to the issuer or a third party. Commenters also noted that NRSROs rarely provide the certification described in condition (3), and requested that the reference to a NRSRO be deleted from the text. The rule reflects these comments; only independent certified public accountants may provide the certification. -[124]- Paragraph (a)(29)(iii) of rule 2a-7, as amended. If the security has a NRSRO rating that does reflect the existence of the refunding agreement, (continued...) ==========================================START OF PAGE 44====== must disregard ratings given to a security before the security became a "refunded security" (as that term is defined in the rule) in determining whether the security is an eligible security (as that term is also defined in the rule). 3. Diversification Safe Harbor A money fund that elects to be diversified must comply with the requirements of section 5(b)(1) of the 1940 Act and the rules under that section.-[125]- These requirements are applicable to most taxable and many tax exempt money funds, since most elect to be diversified. Although rule 2a-7's diversification requirements are more strict, under certain circumstances a money fund may be in compliance with rule 2a-7, but not in compliance with section 5(b)(1).-[126]- The proposed amendments would have provided that money funds complying with rule 2a-7's diversification requirements are deemed to be diversified under section 5(b)(1) ("diversification safe harbor"). Commenters discussing this aspect of the proposal supported the diversification safe harbor, and the Commission is adopting the amendments as proposed.-[127]- 4. Three-Day Safe Harbor Rule 2a-7 currently permits a fund to invest more than five percent of its assets in the first tier securities of a single issuer for up to three business days (the "three-day safe harbor") and does not contain any limitation on the percentage of fund assets that can be invested in accordance with this provision. Since the provision is primarily applicable to taxable funds, which typically are diversified companies within the meaning of section 5(b)(1), funds could not use this provision to invest more than twenty-five percent of their assets ---------FOOTNOTES---------- -[124]-(...continued) then the security would not be considered unrated. Id. -[125]- See supra note 30; Proposing Release, supra note 20, at n. 29 and accompanying text. -[126]- One difference that may cause this to occur is the timing of the measurement of diversification. Compliance with section 5(b)(1) of the 1940 Act is measured at the time of a purchase based on the value of the fund's total assets as of the end of the preceding fiscal quarter. See rule 5b-1 [17 CFR 270.5b-1]). For purposes of rule 2a-7, both the fund's total assets (as defined in the rule) and compliance with the rule's diversification requirements are measured at the time a purchase is made. See paragraph (c)(4)(i) of rule 2a-7, as amended. -[127]- Paragraph (c)(4)(vii) of rule 2a-7, as amended. ==========================================START OF PAGE 45====== in the securities of a single issuer. The Commission proposed to extend the availability of the three-day safe harbor to national funds. To assure that the three-day safe harbor could not have the effect of allowing funds that are not diversified to invest an inordinate portion of their assets in a single issuer at any time, the proposed amendments would have limited to twenty-five percent the percentage of fund assets that may be invested under the safe harbor at any one time. The Commission is adopting this amendment substantially as proposed.-[128]- E. Asset Backed Securities and Synthetic Securities 1. Background The proposed amendments would have amended rule 2a-7 to clarify the application of the rule to "synthetic" tax exempt securities and ABSs. Both types of securities rely on demand features and complex liquidity arrangements that are designed to meet the risk-limiting conditions of the rule. An ABS represents an interest in a pool of financial assets, such as credit card or automobile loan receivables. Typically, an ABS is sponsored by a bank or other financial institution to pool financial assets and convert them into capital market instruments, thereby enabling the sponsor to transform illiquid assets into cash and increase balance sheet liquidity.-[129]- The ABS is structured to assure that the issuer of the ABS will not be affected by the bankruptcy of the sponsor. In addition, the structure of the ABS affects the nature and amount of the credit enhancement. While structural issues affect the risks associated with many types of securities, ---------FOOTNOTES---------- -[128]- Paragraph (c)(4)(iii) of rule 2a-7, as amended. Because single state funds are required to be diversified only as to seventy-five percent of their assets, they have available a twenty-five percent basket to accommodate purchases in excess of five percent. Paragraph (c)(4)(i) of rule 2a- 7, as amended. As a result, the three-day safe harbor of paragraph (c)(4)(ii) of the amended rule is not extended to them. -[129]- For a detailed discussion of ABSs, see U.S. Securities and Exchange Commission Division of Investment Management, Protecting Investors: A Half Century of Investment Company Regulation, May 1992, at 1-103 and Investment Company Act Rel. No. 18736 (May 29, 1992) [57 FR 23980 (June 5, 1992)] and Investment Company Act Rel. No. 19105 (Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] respectively proposing and adopting rule 3a-7 under the 1940 Act [17 CFR 270.3a-7], the rule excluding the issuers of certain ABSs from the definition of investment company. ==========================================START OF PAGE 46====== they are particularly important in evaluating ABSs.-[130]- Synthetic securities are another form of ABSs that have been developed to address the shortage in the supply of short-term tax exempt securities.-[131]- While a variety of synthetic structures exist, all involve trusts and partnerships that, in effect, convert long-term fixed-rate bonds into variable or floating rate demand securities. Typically, one or two long- term, high quality, fixed-rate bonds of a single state or municipal issuer (the "core securities") are deposited in a trust by the sponsor. Interests in the trust may be distributed through an offering of securities to the public registered under the 1933 Act, or through an offering exempt from the Act's registration requirements, such as a "private placement." Holders of interests in the trust receive interest at the current short-term market rate and the sponsor receives the difference (after administrative expenses) between the current market interest rate and the long-term rate paid by the core securities. An affiliate of the sponsor or a third party (usually a bank) issues a conditional demand feature permitting holders to recover principal at par within a specified period. The demand features are conditional to address tax-related concerns. The proposed amendments to the rule would have established specific criteria for fund investment in ABSs, and would have addressed issues concerning the diversification, maturity and quality standards applicable to these types of securities. Most commenters argued that it was not necessary to amend the rule in order to provide for the treatment of ABSs because the diversification, quality, and maturity standards applicable to ABSs could be addressed within the existing framework of the ---------FOOTNOTES---------- -[130]- While the structure of ABSs vary, the ABSs that