Investment Company Act - Sections 2(a)(3)(A), 2(a)(3)(C), 2(a)(9), 18(a)(2)(C), 18(a)(2)(D)
RESPONSE OF THE OFFICE OF CHIEF COUNSEL
IM Ref. No. 2008811937
Your letter dated March 12, 2009 requests our assurance that we would not recommend enforcement action to the Securities and Exchange Commission ("Commission") against a liquidity provider ("Liquidity Provider"), any affiliated person of the Liquidity Provider (included in the term "Liquidity Provider"), or any registered closed-end investment company ("Fund") with respect to the Liquidity Provider, under provisions of the Investment Company Act of 1940 (the "1940 Act") and the rules thereunder applicable to affiliated persons of the Funds or affiliated persons of affiliated persons of the Funds ("Affiliate Restrictions") under the circumstances described in your letter.
You state that since mid-February 2008, the general loss of confidence in the auction rate securities markets spread to the market for the Funds' auction rate preferred shares ("ARP") and auction failure has been virtually universal since that time. Consequently, most ARP investors have been unable to sell their holdings.1
You state that it is unlikely that the existing auction markets for ARP will resume normal functioning. You state that, as a result, certain Funds and their investment advisers are developing liquidity protected preferred shares ("LPP") as a permissible investment for registered open-end investment companies that hold themselves out as money market funds in reliance on rule 2a-7 under the 1940 Act ("Money Market Funds")2. You state that, although the characteristics of LPP may vary, the central feature of all LPP is that a Liquidity Provider agrees to purchase LPP at its liquidation value preference plus accumulated but unpaid dividends in the event that sell orders exceed buy orders in a remarketing failure (the "Liquidity Feature"). You acknowledge that a Liquidity Provider may be required to purchase all or a large portion of the LPP issued by a Fund in performing its obligations under the Liquidity Feature. You also state that some or all LPP will provide the Liquidity Provider with a contractual right to sell to the Fund, or to an affiliated person of the Fund, such acquired LPP in the circumstances described in your letter (the "Fund Put").
You state that the willingness of a person to act as a Liquidity Provider depends, in large part, upon a high degree of certainty as to the legal implications that service in this capacity may entail. You acknowledge that the EV Letter provides useful guidance3. You state, however, that the EV Letter does not address the potential application of the Affiliate Restrictions to a Liquidity Provider. You state that the Affiliate Restrictions could be triggered solely by the Liquidity Provider's acquisition of all or a large portion of the LPP issued by the Fund through the operation of the Liquidity Feature or a Fund Put provided to the Liquidity Provider by the terms of the LPP4. You state that, under these facts and circumstances, the application of the Affiliate Restrictions to the Liquidity Provider would unnecessarily hamper the development of LPP as a solution to the ARP liquidity problem.
Section 2(a)(3)(A) of the 1940 Act defines an "affiliated person" of another person as "any person directly or indirectly owning, controlling, or holding with power to vote, 5 per centum or more of the outstanding voting securities of such other person." Section 2(a)(42) of the 1940 Act defines "voting security" as
any security presently entitling the owner or holder thereof to vote for the election of directors of a company. A specified percentage of the outstanding voting securities of a company means such amount of its outstanding voting securities as entitles the holder or holders thereof to cast said specified percentage of the aggregate votes which the holders of all the outstanding voting securities of such company are entitled to cast.
Section 18(i) of the 1940 Act requires all stock issued by a Fund to be voting stock and have equal voting rights with every other outstanding voting stock, except as provided in section 18(a) of the 1940 Act or as otherwise required by law. Section 18(a) of the 1940 Act, among other things, requires that preferred stock vote as a class on certain matters but does not prohibit preferred stock from voting for the election of directors. Thus, LPP are voting securities, and LPP held by a Liquidity Provider must be included in any determination of whether a Liquidity Provider is an affiliated person, as defined in section 2(a)(3)(A), of a Fund.
You assert that a Liquidity Provider holding all of the LPP issued by a Fund (and none of the common shares) will always hold less than five percent of all of the outstanding voting securities of the Fund. You support your assertion with an example. You state that Funds typically offer common stock at $25 or less per share, with one vote per share, and that ARP were, and LPP are expected to be, offered at $25,000 or more per share, also with one vote per share.5 Your example presents a Fund with 1,000,000 common shares, each with a net asset value ("NAV") of $25, that can issue a maximum of 1,000 LPP, each with a liquidation value of $25,000, consistent with the asset coverage requirement applicable to preferred stock in section 18(a)(2)(A) of the 1940 Act6. Although the common shares and LPP contribute equally to the Fund's $50,000,000 of capital, the LPP represents less than 0.1% of the total voting power of the Fund's 1,001,000 outstanding voting securities. You also state that in practice the LPP issued by a Fund would account for much less than 0.1% of the combined voting power of common shares and LPP because (i) Funds generally maintain asset coverage somewhat higher than 200% and (ii) the NAV of common shares often is less than $25 per share. You therefore conclude that a Liquidity Provider could not become an affiliated person, as defined in section 2(a)(3)(A), of a Fund solely because it acquired all of the LPP issued by that Fund through operation of the Liquidity Facility.
Section 2(a)(3)(C) of the 1940 Act defines an "affiliated person" of another person as "any person directly or indirectly controlling, controlled by, or under common control with, such other person." "Control" is defined in section 2(a)(9) of the 1940 Act, in pertinent part, as "the power to exercise a controlling influence over the management or policies of a company."7 Section 2(a)(9) further establishes a presumption of control with respect to "[a]ny person who owns beneficially … more than 25 per centum of the voting securities of a company." A presumption of non-control is provided to "[a]ny person who does not so own more than 25 per centum of the voting securities of any company." Section 2(a)(9) provides that either presumption may be rebutted by evidence, but will continue "until a determination to the contrary made by the Commission by order either on its own motion or on application by an interested person."8 Nevertheless, no person may rely on the presumption that ownership of less than 25% of a company's voting securities is not control if a control relationship exists under all the facts and circumstances.9
You state that the presumption of non-control in section 2(a)(9) of the 1940 Act would apply to a Liquidity Provider that acquired all of a Fund's LPP through operation of the Liquidity Facility because, as discussed above, the LPP's aggregate voting power would be a "tiny fraction" of the Fund's total outstanding voting securities, i.e., much less than 25%. You concede, however, that other rights accruing to the LPP or the Fund Put may preclude reliance on the presumption. You acknowledge that a Liquidity Provider holding all of a Fund's LPP may be able to: (i) elect unilaterally the two directors that section 18(a)(2)(C) of the 1940 Act10 reserves for the preferred stock; and (ii) defeat unilaterally a proposal that section 18(a)(2)(D) of the 1940 Act11 requires receive the approval of a majority of the outstanding preferred stock voting as a class. You add that if a Liquidity Provider were able to exercise a Fund Put, that ability might appear to be a means of exerting control over a Fund.
You assert that if a Liquidity Provider holding a majority or more of the LPP issued by a Fund is able to elect unilaterally two directors, that board representation would not give the Liquidity Provider the power to exercise a controlling influence over the management or policies of the Fund, absent other evidence of the power to influence management. You explain that the two directors generally would not constitute a majority of the Fund's directors or a majority of the Fund's directors who are not "interested persons," as defined in Section 2(a)(19), of the Fund (the "Independent Directors"). You state that an external investment adviser, which provides or supervises all the services necessary to operate the Fund, manages each Fund. You state that the 1940 Act requires the vote of a majority of a Fund's directors, including a majority of the Independent Directors, to take critical actions regarding the Fund's investment adviser, such as approval, annual renewal or termination of the investment adviser's contract with the Fund.12 Thus, you believe that when a Liquidity Provider merely elects two directors and those directors do not represent a majority of the directors or the Independent Directors, that board representation is insufficient to control the Fund, absent other evidence of the power to influence management. You also state that in the past the staff has appeared to recognize that representation on a company's board does not necessarily cause a person to control the company. You state that in one case, the staff recognized that the ability to appoint one of six directors of a registered investment company did not result in control of the company.13 You state that the staff also recognized that the ability to appoint two out of ten directors of a company, coupled with a significant economic interest, did not constitute control.14
You also assert that your position is consistent with the legislative history of the 1940 Act. You state that Congress provided for representation of preferred shareholders on a Fund's board as a protective measure to avoid the abuses that occurred prior to enactment of the 1940 Act rather than to give those holders control of a Fund.15 You note that section 18(a)(2)(C) of the 1940 Act provides for the preferred shareholders to elect a majority of a Fund's directors in the event that the Fund fails to pay dividends due to them for two years. You state that one of the purposes of section 18(a)(2)(D) of the 1940 Act is the protection of preferred shareholders from action taken by the common shareholders (who typically hold substantially all of a Fund's voting securities) that would adversely affect the interests of the preferred shareholders.16
You contend that the Fund Put does not provide the Liquidity Provider with any meaningful ability to influence the Fund by threatening large redemptions. You note that the Fund Put would be conditioned upon a number of specific events, notice requirements and holding periods, along the lines of those set forth in the EV Letter. You state that the terms of the Fund Put would reduce or eliminate the risk of large redemptions because the Fund will have advance notice of the possibility of a large redemption of the LPP and would have time to accommodate the redemption. You also state that other instances where the LPP might be redeemed in large amounts will be at the option of the Fund, and not the Liquidity Provider, and so do not give rise to the same concerns. For example, the Fund may wish to accelerate redemption under the voluntary redemption provisions of the LPP for economic or business reasons.
You state that a Liquidity Provider may become subject to the Affiliate Restrictions to the extent that the Liquidity Provider may be deemed to be an affiliated person, or an affiliated person of an affiliated person, of a Fund under section 2(a)(3)(A) or (C), solely as a result of the Liquidity Provider's acquisition, pursuant to the terms of a Liquidity Feature, of LPP issued by the Fund or the Fund Put. You also state that that the willingness of a person to act as a Liquidity Provider depends, in large part, upon a high degree of certainty as to the legal implications that service in this capacity may entail. You state that, under these facts and circumstances, the application of the Affiliate Restrictions to the Liquidity Provider would unnecessarily hamper the development of LPP as a solution to the ARP liquidity problem.
Based on the facts, representations and assumptions set forth in your letter, and without necessarily agreeing with your arguments or your legal analysis, we would not recommend enforcement action to the Commission against a Liquidity Provider or any Fund with respect to the Liquidity Provider, under the Affiliate Restrictions that would be triggered solely by the Liquidity Provider's acquisition, pursuant to the terms of a Liquidity Feature, of LPP issued by the Fund, or by the Fund Put. This response expresses our views on enforcement action only and does not express any legal or interpretive conclusion on the issues presented. Because our positions are based upon the facts, representations and assumptions in your letter, any different facts, representations or assumptions may require a different conclusion.
Associate Director and Chief Counsel
1 As of February, 2008, Funds had outstanding ARP with an aggregate liquidation value equal to nearly 20% of the $330 billion auction rate securities market. See Thomas J. Herzfeld Advisors, Inc., The Investor's Guide to Closed-End Funds, March 2009, at 16 (noting that there was $63.883 billion in closed-end ARP outstanding prior to February 2008, of which, as of February 25, 2009, $31.067 billion has been redeemed or is pending redemption pursuant to an announcement by the issuer).
2 You state that LPP as discussed in your letter is substantially similar to the LPP that was the subject of Eaton Vance Management, SEC Staff No-Action Letter (June 13, 2008) (the "EV Letter") available at http://www.sec.gov/divisions/investment/noaction/2008/eatonvance06132008.pdf. You state that the differences between the LPP in the EV Letter and other versions of LPP being contemplated in the market are immaterial to the issue presented in your letter.
3 The EV Letter states that: (i) we would not recommend enforcement action to the Commission against a Money Market Fund under sections 34(b) and 35(d) of the 1940 Act and rule 22c-1 thereunder if the Money Market Fund purchases LPP, provided that the Money Market Fund otherwise complies with the requirements of rule 2a 7 under the 1940 Act; (ii) we concur that LPP would not be redeemable securities, as defined in section 2(a)(32) of the 1940 Act; and (iii) the Division of Corporation Finance, subject to certain conditions, would not recommend enforcement action to the Commission against a Fund, a Liquidity Provider, or any other third party, under sections 13(e) and 14(d) of the Securities Exchange Act of 1934 and rules 13e-4 and Regulations 14D and 14E thereunder in connection with the purchase of LPP not sold in the remarketing process.
4 As described in the EV Letter, the Liquidity Provider may exercise the Eaton Vance version of the Fund Put only with respect to LPP that it has been unable to sell, after at least three months, in weekly remarketings. In addition, Eaton Vance Management represented that the holding period under the Fund Put would conform to the guidance provided by the Internal Revenue Service ("IRS") regarding the treatment of a security such as LPP as equity rather than as debt for Federal income tax purposes. That IRS guidance essentially requires that the Liquidity Provider hold LPP for six months, instead of three months, before the Fund Put is exercisable. IRS Notice 2008-55 (June 26, 2008). You state that other versions of LPP being contemplated in the market may have different holding periods.
5 You state that, in nearly every instance, ARP have one vote per share, and you expect that LPP also will have one vote per share. See Drexel Burnham Lambert Inc. (TARPS), SEC Staff No-Action Letter (June 14, 1989) (no-action position under section 18(i) of the 1940 Act concerning a Fund's issuance of preferred stock at $100,000 per share and common stock at $15 per share where each share would have one vote; except as otherwise required by the 1940 Act, the common shares and the preferred shares would vote together as a single class). You also concede that if, as a result of a different class structure, the number of votes attributable to preferred shares exceeds five percent of a Fund's total outstanding voting securities, your analysis would not be applicable to that Fund.
6 Section 18(a)(2)(A) of the 1940 Act prohibits a Fund from issuing or selling a senior security that is stock unless immediately after such issuance or sale it will have "an asset coverage of at least 200 per centum."
7The Commission has held that the term "controlling influence" means the "'act or process, or power of producing an effect which may be without apparent force or direct authority and is effective in checking or directing action, or exercising restraint or preventing free action.'" See In the Matter of Investors Mutual, Inc., et al., Investment Company Act Release No. 4595 (May 11, 1966) at text preceding n.12 (citation omitted), aff'd, Phillips v. SEC, 388 F.2d 964 (2d Cir. 1968) ("Investors Mutual"). Furthermore, a controlling influence:
need not be actually exercised; the latent power to exercise it is sufficient . . . . And those exercising a controlling influence need not necessarily be able to carry their point, since such influence may be effective without accomplishing its purpose fully. . . . In applying [these principles], however, it must be borne in mind that control determinations involve issues of fact which cannot be resolved by use of a mathematical formula. They require a careful appraisal of the over-all effect of the various relationships and other circumstances present in [each] particular case, some of which may point to one inference while others to an opposite one.
Id. at text accompanying nn.13-15 (citations omitted).
8 A presumption of control or non-control may be rebutted in a judicial proceeding, as well as by Commission order. If a presumption is successfully rebutted, the determination may be applied retroactively. See In the Matters of Fundamental Investors, Inc., et al., Investment Company Act Release No. 3596 (Dec. 27, 1962).
9 See Investors Mutual; Exemption of Transactions by Investment Companies with Certain Affiliated Persons, Investment Company Act Release No. 10698 (May 16, 1979) at n.2 ("no person may rely on the presumption that less than 25 percent ownership is not control when, in fact, a control relationship exists under all the facts and circumstances").
10 Under section 18(a)(2)(C) of the 1940 Act, the holders of any preferred stock outstanding, voting as a class, have the exclusive right to elect at least two directors at all times and to elect a majority of the Fund's directors if at any time the dividends on the preferred stock are unpaid in an amount equal to two full years' dividends.
11 Section 18(a)(2)(D) of the 1940 Act requires that a majority of the outstanding preferred stock issued by a Fund, voting as a class, approve: (i) any plan of reorganization adversely affecting the holders of such preferred stock; or (ii) "any action requiring a vote of security holders as in section 13(a) provided." Section 13(a) of the 1940 Act requires the approval of a majority of a registered investment company's outstanding voting securities to: (i) change its subclassification from a closed-end to an open-end investment management company or its subclassification from a diversified to a nondiversified company; (ii) borrow money, issue senior securities, underwrite securities issued by other persons, purchase or sell real estate or commodities or make loans to other persons, except in each case in accordance with the recitals of policy contained in its registration statement; (iii) deviate from its policy in respect of concentration of investments in any particular industry or group of industries as recited in its registration statement, deviate from any investment policy which is changeable only if authorized by shareholder vote, or deviate from any policy recited in its registration statement pursuant to section 8(b)(3) of the 1940 Act; or (iv) change the nature of its business so as to cease to be an investment company
12 See sections 15(a), 15(b) and 15(c) of the 1940 Act.
13 See National Liquid Reserves, Inc., SEC Staff No Action Letter (Mar. 29, 1980). See also Investors Mutual (presumption of non-control not rebutted where, among other factors, holder of 15% of voting stock of company elected two seats on company's ten-member board of directors but failed to reach accord with 33% shareholder; evidence did not support conclusion that such holder actually exercised a controlling influence over the company's management and policies; and other shareholders continued to exercise a dominant role and to retain a substantial pecuniary interest in the company).
14 See American Century Companies, Inc./J.P. Morgan & Co. Incorporated, SEC Staff No-Action Letter (Dec. 23, 1997).
15 See Report of the Securities and Exchange Commission on Investment Trusts and Investment Companies, Part 3, Chapter 5, H.R. Doc. No. 279, 76th Cong., 1st Sess. 1790-96 (1939).
16 See Hearings Before a Subcommittee of the Committee on Interstate and Foreign Commerce, House of Representatives, 76th Cong. 3rd Sess. 1046-47 (1940) (statement of Commissioner Robert E. Healy).
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