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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.
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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 . . .
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(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.
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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.
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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.
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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.
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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.
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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...)
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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...)
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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...)
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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.
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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
have been marketed to money funds have generally
involved: (i) the trust, which issues the ABSs;
(ii) the sponsor, which contributes the assets to
the trust; (iii) the servicer, which is
responsible for administering the assets in the
pool; (iv) the trustee, which monitors the
activities of the servicer, and (v) the bank,
which provides some form of liquidity and/or
credit enhancement to assure that the trust will
have sufficient funds to meet interest and
amortization payments in the event that cash flow
from the underlying assets is insufficient to meet
the payment schedule of the ABSs.
-[131]- See, e.g., Peter Heap, "Inside Derivatives Price
and Demand Are Guide in Building Secondary Market
Derivatives," Bond Buyer, Mar. 14, 1995 at 4;
"Portfolio Manager Paints Derivatives with a Broad
Brush," The Guarantor, Oct. 10, 1994 at 3.
==========================================START OF PAGE 47======
rule. Questions were raised, however, concerning the
applicability of the rule to ABSs both prior to and after the
publication of the Proposing Release,-[132]- and
commenters presented widely divergent and, sometimes, conflicting
views on how ABSs should be treated. The Commission therefore
has concluded that amendments are necessary to reduce uncertainty
concerning the application of the rule to these securities.
2. Definitions
The Commission is adopting, substantially as proposed,
certain definitions used in the rule. The term "asset backed
security" is defined as a fixed-income security issued by a
"special purpose entity," substantially all the assets of which
consist of "qualifying assets."-[133]- The term "special
purpose entity" is defined as a trust, corporation, partnership
or other entity organized for the sole purpose of issuing fixed-
income securities, which securities entitle their holders to
receive payments that depend primarily on the cash flow from
qualifying assets.-[134]- Finally, the term "qualifying
assets" is defined as financial assets, either fixed or
revolving, that by their terms convert to cash within a finite
time period, plus any rights or other assets designed to assure
the servicing or timely distribution of proceeds to security
holders.-[135]-
---------FOOTNOTES----------
-[132]- See, e.g., Donaldson, Lufkin & Jenrette Securities
Corporation (pub. avail. Sept. 23, 1994); Orrick,
Herrington & Sutcliffe (pub. avail. July 27,
1994).
-[133]- Paragraph (a)(2) of rule 2a-7, as amended.
-[134]- This term excludes investment companies. Id.
-[135]- Id. The Division of Investment Management has
received requests for interpretive guidance under
rules 2a-7 and 3a-7 under the 1940 Act regarding
trusts that hold assets that may not be redeemed
or mature within a "finite time period." See,
e.g., Donaldson, Lufkin & Jenrette Securities
Corp. (pub. avail. Sept. 23, 1994) (auction rate
preferred stock issued by closed-end fund that
remains outstanding after sale at auction); Brown
& Wood (pub. avail. Feb. 24, 1994) (cumulative
preferred stock with no determinable liquidation
date). The Commission welcomes requests for
interpretive guidance or exemptive relief
concerning such instruments. Rule 2a-7, as
amended, should not be interpreted to permit
investments in ABSs that hold assets that are not
"qualifying assets" if the rule's conditions
(continued...)
==========================================START OF PAGE 48======
3. Diversification Standards
a. Diversification: General
The proposed diversification standards would have
distinguished between qualifying assets that consist of the
securities of ten or fewer issuers, and qualifying assets that
consist of the securities of more than ten issuers. In the case
of qualifying assets that consist of securities issued by ten or
fewer issuers (e.g., most tax exempt tender option bond
structures),-[136]- the issuer of each core security would
have been treated as the issuer for issuer diversification
purposes. The sponsor of the ABS would have been treated as the
issuer when the ten issuer limit was exceeded.
(1) Special Purpose Entity as Issuer
In proposing to treat the sponsor of the special purpose
entity as the issuer of the ABS, the Commission assumed that the
credit quality of the ABS reflects the asset origination
practices of the sponsor.-[137]- While some commenters
agreed with the Commission's analysis, most commenters addressing
the subject strongly opposed treating the sponsor of the ABS as
the issuer for diversification purposes. They argued that the
special purpose entity is protected in the event of the sponsor's
bankruptcy so that an investment in an ABS does not reflect the
credit risks associated with an investment in the sponsor. The
commenters pointed out that the NRSRO ratings assigned to ABSs
are premised on the integrity of the structure of the special
purpose entity. These commenters urged that the rule treat the
special purpose entity as the issuer of the ABS. Commenters also
pointed out that the proposed treatment of the sponsor as the
issuer of the ABS was inconsistent with the approach of the
Commission elsewhere in the securities laws.-[138]-
The Commission has decided to modify the proposal to conform
with its treatment of the special purpose entity as the sponsor
---------FOOTNOTES----------
-[135]-(...continued)
applicable to investment in ABSs (e.g., the rating
requirement) are not complied with.
-[136]- See Proposing Release, supra note 20, at Section
II.C.4.d.
-[137]- Id.
-[138]- One commenter stated that a test different from
the one proposed--that is, one based on asset
concentration, would be consistent with certain
positions taken by the Division of Corporation
Finance. An asset concentration in excess of ten
percent may elicit staff comments requesting
disclosure of financial information regarding the
obligor of the assets. See Staff Accounting
Bulletins 71 and 71A ("SAB 71/71A").
==========================================START OF PAGE 49======
of the ABS in other contexts. The diversification standards
adopted treat the special purpose entity as the issuer of the
ABS, subject to the exception described below.-[139]-
(2) Looking through the Special Purpose
Entity
Several commenters agreed that in some circumstances it
would be appropriate to "look through" the special purpose entity
and treat the obligor of the qualifying assets as the issuer of a
portion of the ABS. These commenters asserted that whether to
look through the special purpose entity should not turn on the
number of qualifying assets, as the Commission proposed, but the
extent to which the special purpose entity is concentrated in the
assets of a single obligor.
The Commission believes that the approach recommended by the
commenters has advantages over that included in the proposal.
The proposed approach was designed primarily to require a fund to
look through the special purpose entity in the case of a tender
option bond or other synthetic security that tends to have few
underlying securities. These structures may have more underlying
securities, but it would be appropriate to continue to look to
the ultimate obligor of the underlying security if the security
constitutes a sufficiently large portion of the obligations
underlying the ABS. Moreover, it would be appropriate to treat
an obligor in a more traditional ABS as the issuer of a
proportionate portion of the ABS when the security represents a
sufficiently large portion of the ABS.
Based on these considerations, the Commission has revised
the rule to provide that the special purpose entity generally is
treated as the issuer of the ABS; however, any entity whose
obligations constitute ten percent or more of the principal
amount of the qualifying assets backing the ABS is deemed to be
the issuer of that portion of the ABS equal to the percentage of
the qualifying assets represented by all of the obligations of
the entity included in the pool.-[140]- As amended, the
rule provides that a special purpose entity whose qualifying
assets are themselves ABSs ("secondary ABSs") will be treated as
---------FOOTNOTES----------
-[139]- Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as
amended.
-[140]- Id. A diversification test of this type is
consistent with a no-action position taken by
the Division of Investment Management under section 5(b)(1)
of the 1940 Act (Hyperion Capital Management, Inc. (pub.
avail. Aug. 1, 1994)) and accounting positions taken by the
Division of Corporation Finance (SAB 71/71A, supra note
136). See also Securities Exchange Act Release No. 34961
(Nov. 10, 1994) [59 FR 59590 (Nov. 17, 1994)] at n.80 and
accompanying text.
==========================================START OF PAGE 50======
the issuer of the secondary ABSs.-[141]- A fund holding
ABSs is required to make the calculations necessary to determine
the issuer of the ABSs for diversification purposes on a periodic
basis.-[142]-
b. Diversification: First Loss Guarantees
The Proposing Release noted that some ABSs are issued with
guarantees as to first losses, in which an institution guarantees
all losses up to a specified percentage (e.g., ten percent of the
assets of the pool).-[143]- Because the loss coverage is
usually a multiple of the likely losses to be experienced, the
possibility of the losses exceeding the coverage generally is
considered to be remote. Because a first loss guarantee exposes
the guarantor to essentially the same risk as a guarantor of the
entire value of the security, the Commission proposed that a
first loss guarantor be treated as guarantor of the entire
principal amount of the security for purposes of the put
diversification standards.
Only one commenter supported this aspect of the Commission's
proposal. The remaining commenters opposed the proposed
amendment, and generally argued that the proposed treatment of
first loss guarantors was inconsistent with the proposed
treatment of put providers whose obligations are limited by
contract.-[144]- One commenter objected because the
amendment appeared to be addressing the guarantor's exposure to
losses, rather than the fund's. Another commenter noted that,
because of the contractual limit on the first loss guarantor's
obligations, that guarantor is only required to make payment for
losses experienced by the pool to the extent of its guarantee,
---------FOOTNOTES----------
-[141]- Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as
amended.
-[142]- Paragraphs (c)(8)(iv) and (c)(9)(v) of rule 2a-7,
as amended. The calculations are required to be
made periodically because of the revolving nature
of many ABSs' assets.
-[143]- Proposing Release, supra note 20, at Section
II.C.4.e.
-[144]- Under proposed amendments to the rule's put
diversification provisions, the issuer of a
fractional put would have been treated as
guaranteeing only that portion of the value of the
security which it contractually agreed to provide.
See Proposing Release, supra note 20, at Section
II.C.2.c. The Commission is adopting these
amendments as proposed. See supra Section
II.C.1.d. of this Release and paragraph
(c)(4)(vi)(B)(2) of rule 2a-7, as amended.
==========================================START OF PAGE 51======
and additional losses would have to be borne by the holder of the
ABS.
Rule 2a-7 diversification requirements are designed to limit
the exposure of the fund to any single issuer or credit
enhancer.-[145]- Because the exposure of a first loss
guarantor to losses the pool may incur is substantially greater
than the exposure of a fractional guarantor, the exposure of the
fund to the first loss guarantor is also substantially
greater.-[146]- Therefore, the Commission believes that
it is appropriate to treat first loss guarantees differently from
fractional guarantees. Because first loss guarantees typically
are designed to cover likely losses to be experienced, a
statement made in the Proposing Release no commenter
contradicted, it seems appropriate to treat the first loss
guarantor as guaranteeing the entire value of the security. The
Commission is adopting this amendment as proposed.-[147]-
4. Quality Standards
---------FOOTNOTES----------
-[145]- See Proposing Release, supra note 20, at Section
II.A.
-[146]- For example, if a fractional put provider
guarantees ten percent of the losses experienced
by a $1 million pool, and the pool has losses of
seven percent, the put provider's exposure is
$7,000. By contrast, if a first loss guarantor
guarantees the first ten percent of losses
experienced by a $1 million pool, and the pool has
losses of seven percent, the guarantor's exposure
is $70,000 -- an amount ten times greater than the
fractional put provider's exposure.
-[147]- Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as
amended. The Commission also notes that the
proposed treatment of first loss guarantees under
rule 2a-7 is consistent with a notice of proposed
rulemaking issued by the Department of the
Treasury, the Federal Reserve System, and the
Federal Deposit Insurance Corporation."Risk-Based
Capital Requirements -- Recourse and Direct Credit
Substitutes; Proposed Rule," 59 FR 27115 (May 25,
1994). As described in that release, the Office
of the Comptroller of the Currency, Department of
the Treasury, The Board of Governors of the
Federal Reserve System, the Federal Deposit
Insurance Corporation and the Office of Thrift
Supervision, Department of the Treasury proposed
revisions to their risk-based capital standards
that would treat certain first loss guarantees as
a guarantee of the entire principal amount of the
assets enhanced.
==========================================START OF PAGE 52======
The proposed amendments to rule 2a-7 would have limited
funds to investing only in an ABS that has a short-term rating
from a NRSRO and, when the final maturity of the ABS exceeds 397
days, a long-term debt rating from a NRSRO. Many commenters
opposed this proposed requirement, arguing that it would be
redundant because the rule currently requires fund managers to
perform a thorough legal, structural and credit analysis with
respect to all securities. The Commission notes that the legal,
structural and credit analysis required by rule 2a-7 is to be
conducted independently of any determination of a security's
credit quality made by a NRSRO.-[148]- In addition, the
Commission continues to believe that, in view of the role NRSROs
have played in the development of the structured finance markets,
a rating requirement should not be burdensome.-[149]-
Because both short- and long-term debt ratings from NRSROs
reflect the NRSROs' legal, structural, and credit analyses, the
rule requires that an ABS be rated in order to be eligible for
fund investment, but does not specify whether the rating received
must be short- or long-term.-[150]-
5. Maturity Standards
The proposed maturity standards for ABSs would have taken
into account the difference between "pay-through" ABSs and "pass-
through" ABSs. A pay-through ABS has a maturity and payment
schedule different from that of its underlying assets. A pass-
through ABS is one in which the cash generated by the underlying
assets passes through directly to the ABS holders. Pass-through
ABSs held by funds generally are not scheduled to return a
holder's principal for three to five years. They typically
provide for periodic interest rate resets and for principal to be
returned after some period (not exceeding thirteen months) after
a demand for payment has been made.
The proposed amendments would have provided that the final
maturity of an ABS is the date on which principal is scheduled to
be returned to the holder, regardless of whether demand has been
made. The proposed amendments also would have permitted a fund
to measure the maturity of an ABS with an adjustable rate of
---------FOOTNOTES----------
-[148]- Paragraph (c)(3)(i) of rule 2a-7, as amended;
Release 18005, supra note 11, at Section II.A.
(adopting amendments to paragraph (c)(2) of rule
2a-7); Letter to Registrants (pub. avail. May 8,
1990). For a discussion of the limitations of
NRSRO ratings for evaluating certain aspects of
ABSs, see Investment Company Act Rel. No. 20509 at
I.B.1 (Aug. 31, 1994) [59 FR 46304 (Sept. 7,
1994)].
-[149]- Proposing Release, supra note 20, at Section
II.C.4.b.
-[150]- Paragraph (a)(9)(iii)(C) of rule 2a-7, as amended.
==========================================START OF PAGE 53======
interest subject to a demand feature by reference to the time
principal is scheduled to be repaid once demand is made, but only
if the holder is entitled to receive principal and interest
within thirteen months of making demand.
Several commenters expressed concern regarding the treatment
of a pass-through ABS with a "scheduled" maturity. The
commenters noted that the effect of the proposed
amendments would be to allow funds to determine the maturity of
an ABS by relying on the date on which principal is scheduled,
but not necessarily required, to be repaid. These commenters
concluded that the proposed amendments' reference to a scheduled
principal repayment is troublesome because on that date there is
no binding obligation under which the fund would receive payment.
In light of the comments, the Commission has decided to modify
the ABS maturity determination by amending the definition of
"demand feature" to include a feature of an ABS permitting the
fund unconditionally to receive principal and interest within
thirteen months of making demand.-[151]- The maturity of
---------FOOTNOTES----------
-[151]- Paragraph (a)(7)(ii) of rule 2a-7, as amended.
For example, prior to the fund's election to
receive principal payments, the maturity of an
adjustable rate ABS with a five year final
maturity and a demand feature permitting the fund
to obtain principal and interest within thirteen
months would be considered a thirteen month
instrument at all times (i.e., on a rolling
basis). After the election is made, a fund could
treat such an instrument as having a maturity
equal to the date when principal will be returned
(i.e., each day that the fund holds the instrument
after election, the fund could reduce the
security's maturity by one day).
This amendment supersedes an interpretive position taken by
the Division of Investment Management in Merrill, Lynch,
Pierce, Fenner & Smith (pub. avail. Apr. 6, 1987). In
Merrill, Lynch, the Division addressed the maturity
determination for a type of variable rate coupon note. A
holder of the notes was required to satisfy certain
conditions in order to receive principal on "the date noted
on the face of the instrument" (quoting paragraph (d)(1) of
rule 2a-7, prior to amendment), and, so long as the notes
continued to be held, their maturity was automatically
extended at the end of each interest rate reset period by
one additional such period. The Division concluded that,
subject to certain conditions, a money fund could treat such
a security as having a maturity equal to the date specified
on the face of the instrument, as automatically extended by
an additional interest payment period. The Merrill, Lynch
(continued...)
==========================================START OF PAGE 54======
an ABS with a final maturity in excess of 397 days may be
determined by reference to a demand feature only if the ABS also
meets the definition of a floating or variable rate
security.-[152]-
F. Variable and Floating Rate Securities
Rule 2a-7 generally prohibits a money fund from acquiring a
security with a remaining maturity of more than 397 calendar
days. The purpose of this requirement and the other maturity
provisions of the rule is to limit a fund's exposure to interest
rate risk.-[153]- The rule generally requires a fund to
measure the maturity of a portfolio security by reference to the
security's final maturity date. A fund, however, may measure the
maturity of a "variable rate security" or a "floating rate
security" (collectively, "adjustable rate securities") by
reference to a date that is earlier than the final maturity date.
Rule 2a-7 defines a "variable rate security" as an
instrument the terms of which provide for the adjustment of the
interest rate on specified dates and that, upon adjustment, can
reasonably be expected to have a market value that approximates
par value. A "floating rate" security is defined as an
instrument the terms of which provide for the adjustment of its
interest rate whenever a specified benchmark changes and that, at
any time, can reasonably be expected to have a market value that
approximates par value. Rule 2a-7 allows certain adjustable rate
securities to be treated as having maturities shorter than their
final maturities; however, the manner in which an adjustable rate
instrument is treated depends upon whether it has a demand
---------FOOTNOTES----------
-[151]-(...continued)
position is inconsistent with paragraph (d) of rule 2a-7, as
amended, which provides that an instrument's maturity is the
date on which "the principal amount must unconditionally be
paid" and with the maturity determination requirements for
ABS discussed in the text of this release. Money funds may,
however, continue to treat a "mandatory tender" feature as
an unconditional right to receive principal, provided that
the issuer's obligation to pay is not dependent on the fund
taking any action (such as giving notice to the issuer of
the intent to redeem), other than physically delivering the
notes or bonds for redemption.
-[152]- Paragraphs (d)(3) and (d)(5) of rule 2a-7, as
amended. The maturity of a floating or variable
rate ABS may also be determined by reference to a
demand feature meeting the requirements of
paragraph (a)(7)(i) of the amended rule.
-[153]- See Release 13380, supra note 7, at n.14 and
accompanying text; State of Wisconsin (pub. avail.
Mar. 3, 1983).
==========================================START OF PAGE 55======
feature, the final maturity of the instrument and whether the
instrument is a Government security.
1. Maturity Determinations: Floating Rate Securities
Under the current rule, the maturity of a floating rate
security subject to a demand feature is the period remaining
until principal can be recovered through demand. The same test
is generally applicable in determining the maturity of a variable
rate security subject to a demand feature, the principal amount
of which is scheduled on the instrument's face to be paid in more
than 397 days. In contrast, a variable rate security (without a
demand feature) scheduled to be paid in 397 days or less may be
treated as having a maturity equal to the period remaining until
the next readjustment of the interest rate. There is no parallel
provision for floating rate securities with final maturities of
397 days or less.
Because variable and floating rate securities expose funds
to similar types of interest rate risk, the Commission proposed
to amend the rule to permit funds to determine the maturity of
floating rate securities with final maturities of 397 days or
less by referring to the interest rate reset. Commenters
supported the proposed amendment, which the Commission is
adopting substantially as proposed.-[154]- The interest
rate of a floating rate security moves in tandem with changes in
the interest rate to which it is linked, and the amendments will
permit funds to treat these instruments as having one-day
maturities.
2. Maturity Determinations: Variable Rate Securities
Under the current rule, when the period remaining until the
final maturity of a variable rate demand instrument (i.e., its
maturity without reference to the demand feature) is less than
397 days, its maturity under rule 2a-7 is the longer of the
period remaining until the next interest rate readjustment or the
date on which principal can be recovered on demand. A variable
rate security with the same final maturity that does not have a
demand feature is treated as having a remaining maturity equal to
the period remaining until the next readjustment in the interest
rate. The effect of these provisions is that a variable rate
security with a final maturity of less than 397 days will have a
longer maturity when a demand feature is added to it.
To correct this anomaly, the Commission proposed that only a
variable rate demand security with a final maturity in excess of
397 days would have its maturity measured by the longer of the
period remaining until its next interest rate adjustment or the
date on which principal can be recovered on demand; the
---------FOOTNOTES----------
-[154]- Floating rate securities with final maturities of
more than 397 days that are subject to demand
features are deemed to having maturities equal to
the period remaining until principal can be
recovered through demand. Paragraph (d)(5) of
rule 2a-7, as amended.
==========================================START OF PAGE 56======
maturities of securities with final maturities of 397 days or
less would be measured by reference to the earlier of the date on
which the interest rate next readjusts or the date on which
principal can be recovered on demand. Commenters supported the
proposed amendment, which the Commission is adopting as
proposed.-[155]-
3. Adjustable Rate Government Securities
Rule 2a-7 provides that "an instrument that is issued or
guaranteed by the United States government or any agency thereof
which has a variable rate of interest adjusted no less frequently
than every 762 days" is deemed to have a maturity equal to the
period remaining until the next readjustment of the interest
rate.-[156]- The Commission is adopting two amendments to
clarify the scope of this provision.
First, the amendments clarify that the maturity of the
security may only be determined by reference to the interest
readjustment date if, upon readjustment, the security can
reasonably be expected to have a market value that approximates
par value.-[157]- This change makes explicit that
Government securities are treated the same way as other
adjustable rate securities under the rule.-[158]-
Second, the reference to Government securities in paragraph
(d)(1) of rule 2a-7 is being conformed to other provisions of the
rule relating to Government securities. As amended, the
provision applies to all Government securities, including
securities issued by persons controlled or supervised by and
acting as instrumentalities of the U.S. Government.-[159]-
---------FOOTNOTES----------
-[155]- Paragraph (d)(2) of rule 2a-7, as amended.
-[156]- Paragraph (d)(1) of rule 2a-7, as amended.
Generally, the readjustment must occur every 397
days to reflect the rule's maturity requirements.
For certain funds that mark-to-market, however,
readjustment may occur every 762 days. Paragraph
(c)(2)(ii) of rule 2a-7, as amended.
-[157]- This codifies the interpretation of the current
rule. See Investment Company Institute (pub.
avail. June 16, 1993); Morgan Keegan & Company,
Inc. (pub. avail. July 24, 1992) at n.7.
-[158]- The amendments also make clear that this provision
applies to floating rate Government securities.
Paragraph (d)(1) of rule 2a-7, as amended.
-[159]- The amendment reflects a no-action position taken
by the Division of Investment Management with
respect to securities issued by instrumentalities
of the U.S. government. See Student Loan
Marketing Association (pub. avail. Jan. 18, 1989).
==========================================START OF PAGE 57======
4. Other Issues Concerning Adjustable Rate Securities
a. Background
Rule 2a-7 allows the maturity of adjustable rate securities
to be determined by reference to interest rate adjustment dates
if the security "can reasonably be expected to have a market
value that approximates its par value" upon adjustment of the
interest rate.-[160]- The Commission proposed to clarify
that the board of directors or its delegate must have a
reasonable expectation that, upon each adjustment of the interest
rate until the final maturity of the security or until the
principal amount can be recovered through demand, the security
will have a market value approximating its amortized
cost.-[161]-
Several commenters discussed the proposed amendments to the
maturity determination provisions of the rule as they relate to
adjustable rate Government securities. Commenters opposing this
aspect of the proposed amendments emphasized that the amendments
should exclude adjustable rate Government securities "based on
the lack of credit risk" inherent in these instruments. The
maturity determination provisions of the rule, however, are
designed to limit a fund's exposure to interest rate, rather than
credit, risk and recent history demonstrates that an investment
in a Government security can expose the fund to substantial
---------FOOTNOTES----------
-[160]- Paragraphs (a)(7) and (a)(21) of rule 2a-7 [17 CFR
270.2a-7(a)(7) and (a)(21)], prior to amendment.
Adjustable rate securities may be priced at a
premium to par value when the security pays
interest above market rates. A fund may treat the
security as an adjustable rate security for
purposes of rule 2a-7's maturity provisions if the
fund reasonably expects that upon readjustment of
the interest rate, the market value of the
security will approximate its amortized cost. The
premium generally would be amortized over the life
of the security. It is critical that the fund
carefully consider all factors involved in the
valuation of the security, particularly the
likelihood of prepayment before the premium is
fully amortized. An accelerated return of
principal will require the fund to write off the
premium before it is amortized, and could result
in a significant deviation between the amortized
cost and market value of the security.
-[161]- Paragraphs (a)(12) and (a)(30) of rule 2a-7, as
amended.
==========================================START OF PAGE 58======
interest rate risk.-[162]- The Commission is, therefore,
---------FOOTNOTES----------
-[162]- In the Proposing Release, the Commission noted
that a number of adjustable rate securities
developed specifically for money market funds had
interest rate readjustment formulas that could not
be expected to reflect short-term interest rates
under certain conditions. At that time, the
Commission expressed the concern that changes in
interest rates or other conditions that could
reasonably be foreseen to occur during the life of
the securities could result in their market values
not returning to par at the time of an interest
rate readjustment. The Commission identified
securities that displayed this characteristic, and
concluded that such securities presented risks
that were not appropriate for money market funds
to assume. See Proposing Release, supra note 20,
at nn.161-164 and accompanying text.
In June 1994, the Division of Investment Management provided
money market funds and their advisers with additional
guidance concerning investments in adjustable rate
securities. The Division reminded fund managers of their
general obligations under rule 2a-7 to ensure that money
market funds invest only in securities that are consistent
with maintaining stable net asset values, and directed money
market funds that held these securities to work with their
advisers in developing plans for their orderly disposition.
See Letter from Barry P. Barbash, Director, Division of
Investment Management, to Paul Schott Stevens, General
Counsel, Investment Company Institute (June 30, 1994).
Money market funds holding adjustable rate securities of the
type described in the Proposing Release experienced problems
when short-term interest rates increased last year. To
maintain their funds' stable net asset values, a number of
fund advisers took actions which included purchasing certain
adjustable rate securities from their money market funds at
their amortized cost value (plus accrued interest), or
contributing capital to the funds. One fund holding notes
of this type, the US Government Money Market Fund, a series
of Community Bankers Mutual Fund, Inc., announced in
September 1994 that it would liquidate and distribute less
than $1.00 per share to its shareholders. Press reports
generally treated this liquidation as the first instance in
which a money market fund had "broken a dollar." See Brett
D. Fromson, "Losses on Derivatives Lead Money Fund to
Liquidate," Washington Post, Sept. 28, 1994 at F1; Leslie
Wayne, "For Money Market Fund Investors, New Cautions," N.Y.
Times, Sept. 29, 1994 at D1, D8.
(continued...)
==========================================START OF PAGE 59======
adopting the amendment as proposed.
The effect of the new provision is to prohibit funds from
purchasing an adjustable rate Government security with a
remaining maturity of more than 397 days unless the interest rate
readjustment mechanism can reasonably be expected to return the
instrument to par upon all interest rate adjustment dates during
the life of the instrument. A fund could purchase an adjustable
rate Government security with a remaining maturity of 397 days or
less, the value of which the fund does not expect to return to
par on all interest rate adjustment dates, but would have to
treat the security as a fixed rate security and measure its
maturity by reference to its final maturity. Adjustable rate
securities with demand features generally would not be affected
by the proposed changes because if a discount develops or is
likely to develop a fund could exercise the demand feature and
receive the amortized cost value of the instrument.
b. Recordkeeping Requirement
The Commission proposed to require a money market fund to
maintain a written record of its determination that an adjustable
rate security, the maturity of which is determined by reference
to its interest rate readjustment date, will either maintain a
value of par or return to par on each interest rate readjustment
date through the life of the security. A number of commenters
who opposed this requirement stated that further guidance
regarding the definition of the term "approximates par" was
necessary or that the rule should specifically state the amount
of deviation that would be permissible. The Commission believes
that this approach would be rigid and unnecessary, absent an
indication that decisions reached in this area by funds are
inconsistent with the purposes of the rule.
Other commenters asserted that the paperwork burden this
requirement could entail might outweigh benefits to shareholders,
and might have the effect of forcing funds to purchase higher
proportions of fixed rate securities that may have a higher
degree of price volatility than adjustable rate securities. The
Commission is not persuaded by this argument. One of these
commenters suggested that if the determination regarding the
return to par would be common to a group of securities, a single
documentation of the analysis should be sufficient. The
Commission agrees. The amendments do not require a fund's board
of directors to maintain a written determination for each
individual adjustable rate security in the fund's portfolio -- it
is sufficient for the fund to maintain the required record for
each type of security (e.g., one record could be maintained for
several different adjustable rate securities of similar credit
quality whose interest rate readjustment mechanisms are tied to
LIBOR plus or minus a number of basis points that make the
---------FOOTNOTES----------
-[162]-(...continued)
==========================================START OF PAGE 60======
securities similarly sensitive to interest rate changes). The
Commission has decided to adopt the amendments as
proposed.-[163]-
G. Other Amendments to Rule 2a-7
1. U.S. Dollar Denominated Instruments
To avoid exposure to foreign currency risk, rule 2a-7 limits
fund investment to "United States dollar-denominated
securities."-[164]- The proposed amendments would have
defined the term "United States dollar-denominated" to clarify
that it means: (a) the payment of interest and principal must be
made in U.S. dollars at all times; and (b) an eligible security's
interest rate may not vary or float with a rate tied to foreign
currencies, foreign interest rates, or any index expressed in a
currency other than U.S. dollars.
Several commenters were critical of the proposed definition
and recommended that the rule permit fund investment in
securities on which the amount of interest payable is based on
changes in the value of a foreign currency as long as principal
and interest are payable in full in U.S. dollars. The Commission
believes that amending the rule in this manner would have the
effect of exposing the fund to currency fluctuations. The
Commission has decided to adopt the definition of "United States
dollar-denominated" as proposed.-[165]-
2. Investment in Other Money Funds
The Commission is adopting, as proposed, amendments to rule
2a-7 to clarify that shares in other money funds that comply with
the rule: (a) are first tier securities;-[166]- and (b)
should be treated as having a rolling maturity equal to the
period of time within which the acquired fund is required to make
payment upon redemption under applicable law.-[167]- A
shorter maturity may be used if the fund making the investment
has a contractual arrangement with the other money fund for more
rapid receipt of redemption proceeds.-[168]-
For diversification purposes, an investment in another money
fund generally may be treated as an investment in any other
issuer (and therefore generally cannot exceed five percent of a
---------FOOTNOTES----------
-[163]- Paragraphs (c)(8)(iii) and (c)(9)(iv) of rule 2a-
7, as amended.
-[164]- Paragraph (c)(3)(i) of rule 2a-7, as amended.
-[165]- Paragraph (a)(28) of rule 2a-7, as amended.
-[166]- Paragraph (a)(11)(iv) of rule 2a-7, as amended.
-[167]- Paragraph (d)(8) of rule 2a-7, as amended. See
also Proposing Release, supra note 20, at n.182
and accompanying text; T+3 Letter, supra note 65.
-[168]- Id.
==========================================START OF PAGE 61======
fund's assets).-[169]- An exception to this treatment is
made for funds that invest substantially all of their assets in
shares of another money fund (the "underlying fund") in which
case the fund is permitted to "look through" the shares to the
assets of the underlying fund.-[170]- These include funds
in "master-feeder" arrangements and certain separate accounts
offering variable insurance products. Such a fund will be deemed
to be in compliance with rule 2a-7 for diversification and other
purposes if the board of directors reasonably believes that the
underlying money fund is in compliance with the
rule.-[171]- The board of directors of the fund is not
required to monitor every investment decision made by the
underlying fund. Rather, the board could review the underlying
fund's procedures and obtain regular reports concerning the
underlying fund's compliance with the rule.-[172]-
3. Board Approval and Reassessment of Certain
Securities
Rule 2a-7 currently requires the board of directors of a
taxable fund to approve or ratify purchases of unrated securities
and securities that are rated by only one NRSRO. The amendments
eliminate this requirement.-[173]-
---------FOOTNOTES----------
-[169]- Investment by one fund in another is limited by
section 12(d)(1)(A) of the 1940 Act [15 U.S.C.
80a-12(d)(1)(A)]. Section 12(d)(1)(A) provides
that a fund may not invest more than ten percent
of its assets in securities issued by other
investment companies, invest more than five
percent of its assets in any single investment
company, or acquire more than three percent of the
voting securities of another investment company.
-[170]- Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as
amended. The restrictions of section 12(d)(1)(A)
do not apply if the fund making the investment
invests all of its assets in shares of another
fund, subject to certain conditions. Section
12(d)(1)(E) [15 U.S.C. 80a-12(d)(1)(E)].
-[171]- Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as
amended. The responsibility for making this
determination may be delegated by the board to the
fund's adviser. Paragraph (e) of rule 2a-7, as
amended.
-[172]- In addition, the investment objectives and
policies of the two funds should not be
inconsistent. See Guide 34 to Form N-1A and Guide
38 to Form N-3.
-[173]- Paragraph (c)(3) of rule 2a-7, as amended.
==========================================START OF PAGE 62======
Rule 2a-7 also requires funds to limit portfolio investments
to securities determined to present minimal credit risks. In
compliance with this requirement, the fund's board of directors
must reassess promptly whether a security presents minimal credit
risks when the fund's investment adviser becomes aware that an
unrated security or a second tier security has been given a
rating by any NRSRO below the NRSRO's second highest rating
category. The Proposing Release requested comment on whether to
permit delegation of the reassessment requirement.-[174]-
All the commenters who responded to this request suggested that
the rule should permit delegation of the reassessment requirement
to the fund's investment adviser. These commenters stated that
the investment adviser is in a better position to make credit
determinations given its staff and analytical and information
resources. The Commission agrees, and is amending the rule as
suggested.-[175]-
4. Recordkeeping
Amendments to rule 2a-7 require a fund to maintain a written
record of the determination that a portfolio security presents
minimal credit risks and to maintain a record of NRSRO ratings
(if any) used to determine the status of a security under the
rule.-[176]- The Commission is also adopting, as
proposed, amendments to rule 31a-1 under the 1940 Act that
require money funds to maintain in their portfolio investment
records information identifying: (a) each security by its legal
name; (b) any liquidity or credit enhancements associated with
each security; and (c) any coupons, accruals, maturities, puts,
calls or any other information necessary to identify, value and
account for each security.
5. Defaulted Securities
Rule 2a-7 imposes certain obligations regarding defaulted
securities.-[177]- The Commission proposed amending the
rule to include "events of insolvency" as events that would
trigger these obligations, and is adopting those amendments
substantially as they were proposed.-[178]- The
Commission is adopting as proposed an amendment to the rule that
would require a fund to notify the Commission of the default of a
---------FOOTNOTES----------
-[174]- Proposing Release, supra note 20, at Section
II.D.6.
-[175]- Paragraphs (c)(5)(i)(A) and (e) of rule 2a-7, as
amended.
-[176]- Paragraph (c)(9)(iii) of rule 2a-7, as amended.
-[177]- See Proposing Release, supra note 20, at Section
II.D.8.
-[178]- Paragraphs (a)(10) and (c)(5)(ii) of rule 2a-7, as
amended.
==========================================START OF PAGE 63======
security subject to a credit enhancement or demand feature only
in the event that the provider of the enhancement or demand
feature failed to fulfill its obligations to the
fund.-[179]-
6. Technical Amendments
The Commission is adopting technical amendments to rule 2a-7
to clarify its terminology. References to "instruments" are
being changed to "securities." In addition, references to the
requirement that the market value of an adjustable rate security
must reasonably approximate its par value are being changed to
clarify that the security's market value must reasonably
approximate its amortized cost.-[180]- The definition of
"unrated security" also is being revised to clarify that if an
unrated security becomes rated while held by the fund, the fund
may continue to treat it as an unrated security, in the same
manner as a fund may continue to determine whether a security
rated by a single NRSRO is first or second tier if a second NRSRO
rates the security after it is acquired by the
fund.-[181]- The definition of "first tier security" is
also being amended to include government
securities.-[182]-
---------FOOTNOTES----------
-[179]- Paragraph (c)(5)(iv) of rule 2a-7, as amended.
-[180]- Paragraphs (a)(12), (a)(30), and (c)(8)(iii) of
rule 2a-7, as amended. See supra Section
II.F.4.a. (discussion of determination that par
will be approximated).
-[181]- Paragraph (a)(29) of rule 2a-7, as amended.
-[182]- Paragraphs (a)(11)(v) and (a)(13) of rule 2a-7, as
amended. Prior to the adoption of today's
amendments, a fund purchasing a government
security would have been required to treat the
security as an unrated first tier security
(paragraph (a)(11)(iii) of rule 2a-7, as amended),
because NRSROs do not rate government securities.
As a result, the fund would have been required to
perform a comparability analysis. Under the
amended definition of "first tier security," a
fund may treat a government security as first tier
without conducting a comparability analysis, even
though the security has not received a rating from
an NRSRO.
==========================================START OF PAGE 64======
III. AMENDMENTS TO DISCLOSURE RULES
The Commission is adopting amendments to the forms and
advertising rules used by tax exempt funds and is publishing a
Staff Guide designed to elicit disclosures concerning the
specific risks of investing in tax exempt funds.
A. Single State Funds
To alert investors to the greater risks of investing in
single state funds, proposed amendments to Form N-1A would have a
required a single state fund to disclose in its prospectus that:
(1) its investments are concentrated geographically; (2) for a
single state fund that does not meet the Five Percent
Diversification Test, that the fund may invest a significant
percentage of its assets in the securities of a single issuer;
and (3) that an investment in the fund therefore may be riskier
than an investment in other types of money funds.
Several commenters, while generally supporting additional
disclosure, expressed concern that the proposed disclosure for
single state funds might exaggerate the risk of investing in
these funds, leading to investor confusion. These commenters
urged the Commission not to require a single state fund to
disclose that an investment in it may be riskier than an
investment in another type of money fund. The amendments to rule
2a-7 require single state funds to be diversified at the five
percent level as to seventy-five percent of their assets, but
these funds are less diversified than other types of money market
funds and are still dependent on the financial health of a
particular state.-[183]- Because of the importance of
diversification in protecting a fund from exposure to a
particular issuer, the Commission has decided to require a single
state fund that is not diversified as to 100% of assets to
disclose on the cover page of the prospectus that it may invest a
significant percentage of its assets in the securities of a
single issuer, and that an investment in the fund may therefore
be riskier than investment in other types of money funds. The
Commission has also decided to adopt the disclosure requirement
regarding geographic concentration, which may be placed in the
text of the prospectus, substantially as proposed.-[184]-
B. Disclosure Concerning Exposure to Put Providers
The Commission is publishing an amendment to Staff Guide 21
to Form N-1A. The amendment interprets the form as requiring a
money fund having more than forty percent of its portfolio
subject to third party credit enhancements to disclose that the
safety of its portfolio (and the ability of the fund to maintain
a stable share price) is largely dependent upon guarantees from
foreign and domestic banks and that these arrangements are not
subject to federal deposit insurance. The wording of the guide
---------FOOTNOTES----------
-[183]- See supra Section II.B.1.a. of this Release and
paragraph (c)(4)(ii) of rule 2a-7, as amended.
-[184]- Item 4(c) of Form N-1A, as amended.
==========================================START OF PAGE 65======
has been changed somewhat from the draft published in the
Proposing Release-[185]- to reflect the approach taken by
the Commission in proposing to simplify money market fund
prospectuses.-[186]-
Under the proposed amendments, money fund portfolio
schedules would have been required to include information
regarding put providers.-[187]- Those amendments are not
being adopted at this time. The Commission is currently
examining portfolio schedule requirements for investment
companies generally and will continue to consider the proposed
amendments in connection with that project.
C. Risk Disclosure in Certain Communications
Money funds are required to include in certain
advertisements and sales literature a statement that an
investment in a money fund is not insured or guaranteed by the
U.S. Government and there can be no assurance that the fund will
maintain a stable net asset value.-[188]- The amendments
extend this requirement to "tombstone" advertisements under rule
134 of the 1933 Act.-[189]-
IV. EXEMPTIVE RULE GOVERNING PURCHASES OF CERTAIN PORTFOLIO
SECURITIES BY AFFILIATED PERSONS
The Proposing Release noted that when money funds have held
a security that is no longer eligible for fund investment, fund
advisers or related persons frequently have repurchased the
security from the fund at the security's amortized cost value to
avoid any fund shareholder loss.-[190]- These
transactions came within section 17(a)(2) of the 1940 Act
[15 U.S.C. 80a-17(a)(2)], which prohibits an affiliated person of
a fund, or an affiliated person of such a person, from knowingly
purchasing a security from the fund in the absence of a
Commission exemption. Nevertheless, the transactions appeared to
be reasonable, fair, in the best interests of fund shareholders,
---------FOOTNOTES----------
-[185]- Guide 21 to Form N-1A, as amended.
-[186]- Investment Company Act Rel. No. 21216 (July 19,
1995) [60 FR 38454 (July 26, 1995)].
-[187]- Proposing Release, supra note 20, at Section
III.C.
-[188]- See paragraph (a)(7) of rule 482 [17 CFR
230.482(a)(7)] and introductory paragraph of rule
34b-1 [17 CFR 270.34b-1].
-[189]- Paragraph (e) or rule 134, as amended [17 CFR
230.134(e)].
-[190]- Proposing Release, supra note 20, at nn.12 and 28
and accompanying text.
==========================================START OF PAGE 66======
and consistent with the actions that a fund should take in the
event of a default of a portfolio security.-[191]- Thus,
the staff of the Division of Investment Management advised
parties to these transactions that the staff would not recommend
enforcement action to the Commission if these transactions were
consummated.
Based upon the Commission's experience with actions taken by
funds and their affiliates to dispose of portfolio securities
that were no longer eligible under rule 2a-7,-[192]- the
Commission proposed new rule 17a-9 to exempt from section 17(a)
of the 1940 Act the purchase of a security that is no longer an
eligible security. Several commenters, including the ICI,
opposed the adoption of rule 17a-9, asserting that its mere
existence would cause investors to expect a fund's adviser to
purchase ineligible securities from the fund, and guarantee that
the fund will maintain a stable net asset value.
The Commission believes that existing rules applicable to
money funds already address this concern by requiring money fund
prospectuses and sales literature to disclose prominently that
there is no assurance or guarantee that a fund will be able to
maintain a stable net asset value of $1.00 per
share.-[193]- Moreover, the Commission believes it
unlikely that the existence of an exemptive rule alone will
create any investor expectations.
The Commission has decided to adopt the rule as proposed.
In doing so, the Commission is not suggesting that affiliated
persons of funds have any legal obligation to enter into
---------FOOTNOTES----------
-[191]- Paragraph (c)(5)(ii) of rule 2a-7, as amended,
requires a fund holding a defaulted security to
dispose of the security as soon as practicable
consistent with achieving an orderly disposition
of the security, unless the fund's board of
directors concludes that disposal would not be in
the best interests of the fund.
-[192]- See 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).
-[193]- See Release 18005, supra note 11, at Section II.H.
(adopting amendments to Item 1(a)(ix) of Form N-
1A).
==========================================START OF PAGE 67======
transactions covered by the new rule. The exemption applies to
transactions where: (a) the purchase price is paid in cash; and
(b) the purchase price is equal to the greater of the amortized
cost of the security or its market price (in each case, including
accrued interest).-[194]- The rule, as adopted, is
available for transactions involving securities that are no
longer eligible securities because they no longer satisfy either
the credit quality or maturity limiting provisions of the rule
(e.g., the securities are long-term adjustable rate securities
whose market values no longer approximate their par values on the
interest rate readjustment dates).
V. COMPLIANCE DATES
A. General Compliance Date
Money funds may comply with any of the amendments or rules
adopted today upon publication of this release in the Federal
Register. Beginning October 3, 1996, money funds must comply
with all amendments and rules adopted today not specifically
addressed below in paragraphs B. and C.-[195]- The
Commission is delegating to the Division Director the authority
to address issues regarding compliance dates that are not
addressed in this section, unless the Director believes that it
is necessary in the public interest or in the interest of
investors that the Commission consider the issue.
Rule 2a-7 requires funds to meet the rule's diversification
requirements with respect to a particular issuer on the date the
fund acquires a security of that issuer.-[196]-
Therefore, phase-in rules for the new diversification
requirements for tax exempt funds are unnecessary. A tax exempt
fund holding a greater percentage of its total assets in the
securities of an issuer than the applicable diversification
requirement permits as of October 3, 1996 may not purchase
additional securities or "roll over" current holdings until such
---------FOOTNOTES----------
-[194]- See rule 17a-9, as adopted. A fund must notify
the Commission in the event of default with
respect to portfolio securities that account for
one half of one percent or more of a fund's assets
immediately before the occurrence of default. See
paragraph (c)(5)(iii) of rule 2a-7, as amended.
-[195]- To the extent these amendments involve
clarification of Commission or staff
interpretations of the current provisions of rule
2a-7, these compliance dates are not intended to
suggest that non-compliance prior thereto does not
involve a violation of rule 2a-7.
-[196]- Paragraphs (c)(4)(i) and (ii) (with respect to
diversification generally) and (c)(4)(v) (with
respect to diversification of puts) of rule 2a-7,
as amended.
==========================================START OF PAGE 68======
securities purchased or rolled over will not cause the fund to
exceed the applicable diversification requirements immediately
after the purchase or rollover. Funds are not required to
exercise puts or otherwise dispose of portfolio holdings to meet
the new diversification requirements.
B. Grandfathered Securities
To minimize disruption to funds and markets as a result of
adoption of these amendments, the Commission is "grandfathering"
certain securities first issued on or before June 3, 1996 that
do not meet the following requirements of the amended rule:
(1) requirement that demand features be
rated;-[197]-
(2) requirement that, in order for a security subject to a
demand feature to be an eligible security, the fund must
receive notice from the demand feature's issuer or another
institution if there is a substitution of the provider of
the demand feature;-[198]-
(3) new requirements for ABSs regarding maturity
determinations and ratings;-[199]-
(4) revised definition of "put" to include ability to
recover principal and any accrued interest;-[200]-
and
(5) requirement that security subject to conditional demand
feature is an eligible security only if board of directors
or its delegate makes certain determinations regarding the
demand feature's exercisability.-[201]-
A money fund may continue to hold these "grandfathered"
securities or acquire such securities provided that they satisfy
the other provisions of the rule, as amended, and are issued on
or before June 3, 1996.
---------FOOTNOTES----------
-[197]- Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as
amended.
-[198]- Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as
amended.
-[199]- Paragraphs (a)(7)(ii) (definition of demand
feature for ABS) and (a)(9)(iii)(C) (rating
requirements) of rule 2a-7, as amended. Note,
however, that funds are required to apply the
diversification requirements for ABS in accordance
with Section V.A., supra, of this Release. See
also paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as
amended (diversification calculation for ABSs).
-[200]- Paragraph (a)(16) of rule 2a-7, as amended.
-[201]- Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
==========================================START OF PAGE 69======
C. Disclosure and Reporting
The following amendments pertaining to disclosure and
advertising will become effective as follows:
(1) amendments to Form N-1A will be effective: (1) for
investment companies whose registration statements become
effective on or after June 3, 1996 upon use of any
prospectus on or after June 3, 1996; and (2) for all other
investment companies, upon use of any prospectus contained
in any post-effective amendment filed on or after June 3,
1996;
(2) amendments to Form N-SAR will be effective for any
report required by rules 30a-1 and 30b1-1 [17 CFR 270.30a-1
and 270.30b1-1] filed on or after July 3, 1996; and
(3) the amendment to rule 134 under the Securities Act of
1933 will be effective for "tombstone" advertisements used
after June 3, 1996.
VI. REGULATORY FLEXIBILITY ANALYSIS
A summary of the Initial Regulatory Flexibility Analysis
regarding the proposed rule and form amendments was published in
the Proposing Release. No comments were received. The
Commission has prepared a Final Regulatory Flexibility Analysis
in accordance with 5 U.S.C. 604, a copy of which may be obtained
by contacting Martha H. Platt, Senior Attorney, Mail Stop 10-6,
Securities and Exchange Commission, 450 Fifth Street, N.W.,
Washington, D.C. 20549.
VII. STATUTORY AUTHORITY
The Commission is amending rule 2a-7 under the exemptive and
rulemaking authority set forth in sections 6(c) [15 U.S.C. 80a-
6(c)], 8(b) [15 U.S.C. 80a-8(b)], 22(c) [15 U.S.C. 80a-22(c)],
34(b) [15 U.S.C. 80a-34(b)], and 38(a) [15 U.S.C. 80a-37(a)] of
the Investment Company Act of 1940. The Commission is adopting
rule 17a-9 under the exemptive and rulemaking authority set forth
in sections 6(c) [15 U.S.C. 80a-6(c)] and 38(a) [15 U.S.C. 80a-
37(a)] of the Investment Company Act of 1940. The authority
citations for the amendments to the rules and forms precede the
text of the amendments.
VIII. TEXT OF RULE AND FORM AMENDMENTS
List of Subjects in 17 CFR Parts 230, 239, 270 and 274
Investment companies, Reporting and recordkeeping
requirements, Securities.
For the reasons set out in the preamble, the Commission is
amending chapter II, title 17 of the Code of Federal Regulations
as follows:
PART 230 - GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933
1. The authority citation for Part 230 continues to read
in part as follows:
==========================================START OF PAGE 70======
Authority: 15 U.S.C. 77b, 77f, 77g, 77h, 77j, 77s, 77sss,
78c, 78d, 78l, 78m, 78n, 78o, 78w, 79ll(d), 79t, 80a-8, 80a-29,
80a-30, and 80a-37, unless otherwise noted.
* * * * *
2. Section 230.134 is amended by adding paragraph (e) to
read as follows:
230.134 Communications not deemed a prospectus.
* * * * *
(e) In the case of an investment company registered under
the Investment Company Act of 1940 that holds itself out as a
"money market fund," a communication used under this section
shall contain the disclosure required by 230.482(a)(7).
Part 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
3. The authority citation for Part 270 is amended by
removing the third paragraph in the sub-authority to read as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless
otherwise noted;
* * * * *
4. Section 270.2a-7 is revised to read as follows:
270.2a-7 Money market funds.
(a) Definitions.
(1) Amortized Cost Method of valuation shall mean the
method of calculating an investment company's net asset value
whereby portfolio securities are valued at the fund's acquisition
cost as adjusted for amortization of premium or accretion of
discount rather than at their value based on current market
factors.
(2) Asset Backed Security shall mean a fixed income
security (other than a Government security) issued by a Special
Purpose Entity (as hereinafter defined), substantially all of the
assets of which consist of Qualifying Assets (as hereinafter
defined). Special Purpose Entity shall mean a trust,
corporation, partnership or other entity organized for the sole
purpose of issuing fixed income securities which entitle their
holders to receive payments that depend primarily on the cash
flow from Qualifying Assets, but does not include a registered
investment company. Qualifying Assets shall mean financial
assets, either fixed or revolving, that by their terms convert
into cash within a finite time period, plus any rights or other
assets designed to assure the servicing or timely distribution of
proceeds to security holders.
(3) Business Day shall mean any day, other than
Saturday, Sunday, or any customary business holiday.
(4) Collateralized Fully in the case of a repurchase
agreement shall mean that:
(i) The value of the securities collateralizing
the repurchase agreement (reduced by the transaction costs
(including loss of interest) that the money market fund
reasonably could expect to incur if the seller defaults) is, and
==========================================START OF PAGE 71======
during the entire term of the repurchase agreement remains, at
least equal to the Resale Price (as defined hereinafter) provided
in the agreement; and
(ii) The money market fund or its custodian either
has actual physical possession of the collateral or, in the case
of a security registered on a book entry system, the book entry
is maintained in the name of the money market fund or its
custodian; and
(iii) The money market fund retains an
unqualified right to possess and sell the collateral in the event
of a default by the seller; and
(iv) The collateral consists entirely of
securities that are direct obligations of, or that are fully
guaranteed as to principal and interest by, the United States or
any agency thereof, and/or certificates of deposit, bankers'
acceptances which are eligible for acceptance by a Federal
Reserve Bank, and, if the seller is a depositary institution as
defined in 12 U.S.C. 1813(c), mortgage related securities (as
such term is defined in section 3(a)(41) of the Securities
Exchange Act of 1934 [15 U.S.C. 78c(a)(41)]) that, at the time
the repurchase agreement is entered into, are rated in the
highest rating category by the Requisite NRSROs.
(v) Resale Price shall mean the purchase price
paid to the seller of the securities plus the accrued resale
premium on such purchase price. The accrued resale premium shall
be the amount specified in the repurchase agreement or the daily
amortization of the difference between the purchase price and the
resale price specified in the repurchase agreement.
(5) Conditional Demand Feature shall mean a Demand
Feature that is not an Unconditional Demand Feature.
(6) Conduit Security shall mean a security issued by a
Municipal Issuer (as hereinafter defined) involving an
arrangement or agreement entered into, directly or indirectly,
with a person other than a Municipal Issuer, which arrangement or
agreement provides for or secures repayment of the security.
Municipal Issuer shall mean a state or territory of the United
States (including the District of Columbia), or any political
subdivision or public instrumentality of a state or territory of
the United States. A Conduit Security does not include a
security that is:
(i) Fully and unconditionally guaranteed by a
Municipal Issuer; or
(ii) Payable from the general revenues of the
Municipal Issuer or other Municipal Issuers (other than those
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 issued by the Municipal Issuer); or
(iii) Related to a project owned and operated
by a Municipal Issuer; or
(iv) Related to a facility leased to and under the
control of an industrial or commercial enterprise that is part of
==========================================START OF PAGE 72======
a public project which, as a whole, is owned and under the
control of a Municipal Issuer.
(7) Demand Feature shall mean:
(i) A Put that may be exercised either:
(A) At any time on no more than 30 days'
notice; or
(B) At specified intervals not exceeding 397
calendar days and upon no more than 30 days' notice; or
(ii) A feature permitting the holder of an Asset
Backed Security unconditionally to receive principal and interest
within thirteen months of making demand.
(8) Demand Feature Issued By A Non-Controlled Person
shall 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 [15 U.S.C. 80a-2(a)(9)].
(9) Eligible Security shall mean:
(i) A security with a remaining maturity of 397
calendar days or less that has received a short-term rating (or
that has been issued by an issuer that has received a short-term
rating with respect to a class of debt obligations, or any debt
obligation within that class, that is comparable in priority and
security with the security) by the Requisite NRSROs in one of the
two highest short-term rating categories (within which there may
be sub-categories or gradations indicating relative standing); or
(ii) A security:
(A) That at the time of issuance had a
remaining maturity of more than 397 calendar days but that has a
remaining maturity of 397 calendar days or less; and
(B) Whose issuer has received from the
Requisite NRSROs a rating with respect to a class of debt
obligations (or any debt obligation within that class) that is
now comparable in priority and security with the security, in one
of the two highest short-term rating categories (within which
there may be sub-categories or gradations indicating relative
standing); or
(iii) An Unrated Security that is of
comparable quality to a security meeting the requirements of
paragraphs (a)(9)(i) or (ii) of this section, as determined by
the money market fund's board of directors; Provided, however,
that:
(A) The board of directors may base its
determination that a Standby Commitment that is not a Demand
Feature is an Eligible Security upon a finding that the issuer of
the commitment presents a minimal risk of default;
(B) A security that at the time of issuance
had a remaining maturity of more than 397 calendar days but that
has a remaining maturity of 397 or less and that is an Unrated
Security is not an Eligible Security if the security has received
a long-term rating from any NRSRO that is not within the NRSRO's
three highest long-term ratings categories (within which there
==========================================START OF PAGE 73======
may be sub-categories or gradations indicating relative
standing);
(C) An Asset Backed Security shall not be an
Eligible Security unless it has a debt rating from an NRSRO; and
(D) A security that is subject to a Demand
Feature shall not be an Eligible Security unless:
(1) The Demand Feature has received a
short-term rating from an NRSRO (or the issuer of the Demand
Feature has received from an NRSRO a short-term rating with
respect to a class of debt obligations or any debt obligation
within that class that is comparable in priority and security to
the Demand Feature); and
(2) The issuer of the Demand Feature,
or another institution, undertakes to notify promptly the holder
of the security in the event that the Demand Feature is
substituted with a Demand Feature provided by another issuer.
(10) Event of Insolvency shall mean, with respect to an
issuer or guarantor: x An admission of
insolvency, the application by the issuer or guarantor for the
appointment of a trustee, receiver, rehabilitator, or similar
officer for all or substantially all of its assets, a general
assignment for the benefit of creditors, the filing by the issuer
of a voluntary petition in bankruptcy or application for
reorganization or an arrangement with creditors; or
(i) The institution of similar proceedings by
another person which proceedings are not contested by the issuer
or guarantor; or
(ii) The institution of similar proceedings
by a government agency responsible for regulating the activities
of the issuer or guarantor, whether or not contested by the
issuer or guarantor.
(11) First Tier Security shall mean any Eligible
Security that:
(i) Has received a short-term rating (or that has
been issued by an issuer that has received a short-term rating
with respect to a class of debt obligations, or any debt
obligation within that class, that is comparable in priority and
security with the security) by the Requisite NRSROs in the
highest short-term rating category for debt obligations (within
which there may be sub-categories or gradations indicating
relative standing); or
(ii) Is a security described in paragraph
(a)(9)(ii) of this section whose issuer has received from the
Requisite NRSROs a short-term rating with respect to a class of
debt obligations (or any debt obligation within that class) that
now is comparable in priority and security with the security, in
the highest short-term rating category for debt obligations
(within which there may be sub-categories or gradations
indicating relative standing); or
(iii) Is an Unrated Security that is of
comparable quality to a security meeting the requirements of
==========================================START OF PAGE 74======
paragraphs (a)(11)(i) and (ii) of this section, as determined by
the fund's board of directors; or
(iv) Is a security issued by a registered
investment company that is a money market fund; or
(v) Is a Government Security.
(12) Floating Rate Security shall mean a security the
terms of which provide for the adjustment of its interest rate
whenever a specified interest rate changes and which, at any time
until the final maturity of the instrument or the period
remaining until the principal amount can be recovered through
demand, can reasonably be expected to have a market value that
approximates its amortized cost.
(13) Government Security shall mean any Government
security as defined in section 2(a)(16) of the Act [15 U.S.C.
80a-2(a)(16)].
(14) NRSRO shall mean any nationally recognized
statistical rating organization, as that term is used in
paragraphs (c)(2)(vi)(E), (F) and (H) of 240.15c3-1 of this
Chapter that is not an affiliated person, as defined in section
2(a)(3)(C) of the Act [15 U.S.C. 80a-2(a)(3)(C)], of the issuer
of, or any insurer, guarantor or provider of credit support for,
the security.
(15) Penny-Rounding Method of pricing shall mean the
method of computing an investment company's price per share for
purposes of distribution, redemption and repurchase whereby the
current net asset value per share is rounded to the nearest one
percent.
(16) Put shall mean a right to sell a specified
underlying security or securities within a specified period of
time and at an exercise price equal to the amortized cost of the
underlying security or securities plus accrued interest, if any,
at the time of exercise, that may be sold, transferred or
assigned only with the underlying security or securities. A Put
will be considered to be from the party to whom the money market
fund will look for payment of the exercise price.
(17) Put Issued By A Non-Controlled Person shall mean a
Put 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 Put. Control shall
mean "control" as defined in section 2(a)(9) of the Act [15 U.S.C
80a-2(a)(9)].
(18) Refunded Security shall mean a debt security the
principal and interest payments of which are to be paid by
Government Securities ("deposited securities") that have been
irrevocably placed in an escrow account pursuant to agreement
between the issuer of the debt security and an escrow agent that
is not an affiliated person, as defined in section 2(a)(3)(C) of
the Act [15 U.S.C. 80a-2(a)(3)(C)], of the issuer of the debt
security, and, in accordance with such escrow agreement, are
pledged only to the payment of the debt security and, to the
extent that excess proceeds are available after all payments of
principal, interest, and applicable premiums on the Refunded
==========================================START OF PAGE 75======
Securities, the expenses of the escrow agent and, thereafter, to
the issuer or another party; provided that:
(i) The deposited securities shall not be
redeemable prior to their final maturity;
(ii) At the time the deposited securities are
placed in the escrow account, an independent certified public
accountant shall have certified to the escrow agent that the
deposited securities will satisfy all scheduled payments of
principal, interest and applicable premiums on the Refunded
Securities; and
(iii) The escrow agreement shall prohibit the
substitution of the deposited securities unless the substituted
securities are Government Securities and, at the time of such
substitution, the escrow agent shall have received a
certification from an independent certified public accountant
substantially the same as that required by paragraph (a)(18)(ii)
of this section which certification shall give effect to the
substitution.
(19) Requisite NRSROs shall mean:
(i) Any two NRSROs that have issued a rating with
respect to a security or class of debt obligations of an issuer;
or
(ii) If only one NRSRO has issued a rating with
respect to such security or class of debt obligations of an
issuer at the time the fund purchases or rolls over the security,
that NRSRO.
(20) Second Tier Security shall mean any Eligible
Security that is not a First Tier Security. Second Tier Conduit
Security shall mean any Conduit Security that is an Eligible
Security that is not a First Tier Security.
(21) Single State Fund shall mean a Tax Exempt Fund
that holds itself out as primarily distributing income exempt
from the income taxes of a specified state or locality.
(22) Standby Commitment shall mean a Put that entitles
the holder to achieve same day settlement.
(23) Tax Exempt Fund shall mean any money market fund
that holds itself out as distributing income exempt from regular
federal income tax.
(24) Total Assets shall mean, with respect to a money
market fund using the Amortized Cost Method, the total amortized
cost of its assets and, with respect to any other money market
fund, the total market-based value of its assets.
(25) Unconditional Demand Feature shall mean an
Unconditional Put that is also a Demand Feature.
(26) Unconditional Demand Feature Issued By A Non-
Controlled Person shall mean an Unconditional Put that is also a
Demand Feature Issued By A Non-Controlled Person.
(27) Unconditional Put shall mean a Put (including any
guarantee, financial guarantee (bond) insurance, letter of credit
or similar unconditional credit enhancement) that by its terms
would be readily exercisable in the event of a default in payment
==========================================START OF PAGE 76======
of principal or interest on the underlying security or
securities.
(28) United States Dollar-Denominated shall mean, with
reference to a security, that all principal and interest payments
on such security are payable to security holders in United States
dollars under all circumstances and that the interest rate of,
the principal amount to be repaid, and the timing of payments
related to such security do not vary or float with the value of a
foreign currency, the rate of interest payable on foreign
currency borrowings, or with any other interest rate or index
expressed in a currency other than United States dollars.
(29) Unrated Security shall mean:
(i) A security with a remaining maturity of 397
calendar days or less issued by an issuer that did not, at the
time the security was acquired or rolled over by the fund, have a
current short-term rating assigned by any NRSRO:
(A) To the security; or
(B) To the issuer of the security with
respect to a class of debt obligations
(or any debt obligation within that class) that is comparable in
priority and security with the security, or a Demand Feature with
respect to the security; and
(ii) A security:
(A) That at the time of issuance had a
remaining maturity of more than 397 calendar days but that has a
remaining maturity of 397 calendar days or less; and
(B) Whose issuer had not at the time it was
acquired or rolled over by the fund received from any NRSRO a
short-term rating with respect to a class of debt obligations (or
any debt obligation within that class) that now is comparable in
priority and security with the security; and
(iii) A security that is a rated security and
is the subject of an external credit support agreement (including
an arrangement by which the security has become a Refunded
Security) that was not in effect when the security (or the
issuer) was assigned its rating unless the security has a rating
from an NRSRO reflecting the existence of the credit support
agreement.
(iv) A security is not an Unrated Security if any
debt obligation (reference security) that is issued by the same
issuer and is comparable in priority and security with that
security has a short-term rating by an NRSRO. The status of such
security as an Eligible Security or First Tier Security shall be
the same as that of the reference security.
(30) Variable Rate Security shall mean a security the
==========================================START OF PAGE 77======
terms of which provide for the adjustment of its interest rate on
set dates (such as the last day of a month or calendar quarter)
and which, upon each adjustment until the final maturity of the
instrument or the period remaining until the principal amount can
be recovered through demand, can reasonably be expected to have a
market value that approximates its amortized cost.
(b) Holding Out. It shall be an untrue statement of
material fact within the meaning of section 34(b) of the Act [15
U.S.C. 80a-33(b)] for a registered investment company, in any
registration statement, application, report, account, record, or
other document filed or transmitted pursuant to the Act,
including any advertisement, pamphlet, circular, form letter, or
other sales literature addressed to or intended for distribution
to prospective investors that is required to be filed with the
Commission by section 24(b) of the Act [15 U.S.C. 80a-24(b)] to:
(1) Adopt the term "money market" as part of its name
or title or the name or title of any redeemable securities of
which it is the issuer; or
(2) Hold itself out to investors as, or adopt a name
which suggests that it is, a money market fund or the equivalent
of a money market fund, unless such registered investment company
meets the conditions of paragraphs (c)(2), (c)(3), and (c)(4) of
this section. For purposes of this paragraph, a name which
suggests that a registered investment company is a money market
fund or the equivalent thereof shall include one which uses such
terms as "cash," "liquid," "money," "ready assets" or similar
terms.
(c) Share Price Calculations. The current price per share,
for purposes of distribution, redemption and repurchase, of any
redeemable security issued by any registered investment company
("money market fund"), notwithstanding the requirements of
section 2(a)(41) of the Act [15 U.S.C. 80a-2(a)(41)] and of
270.2a-4 and 270.22c-1 thereunder, may be computed by use of
the Amortized Cost Method or the Penny-Rounding Method; Provided,
however, That:
(1) Board Findings. The board of directors of the
money market fund shall determine, in good faith, that it is in
the best interests of the fund and its shareholders to maintain a
stable net asset value per share or stable price per share, by
virtue of either the Amortized Cost Method or the Penny-Rounding
Method, and that the money market fund will continue to use such
method only so long as the board of directors believes that it
fairly reflects the market-based net asset value per share.
(2) Portfolio Maturity. The money market fund shall
maintain a dollar-weighted average portfolio maturity appropriate
to its objective of maintaining a stable net asset value per
share or price per share; Provided, however, That the money
market fund will not:
(i) Except as provided in paragraph (c)(2)(ii) of
this section, purchase any instrument with a remaining maturity
of greater than 397 calendar days; or
==========================================START OF PAGE 78======
(ii) In the case of a money market fund not using
the Amortized Cost Method, purchase a Government Security with a
remaining maturity of greater than 762 calendar days; or
(iii) Maintain a dollar-weighted average
portfolio maturity that exceeds ninety days.
(3) Portfolio Quality.
(i) General. The money market fund shall limit
its portfolio investments, including Puts and repurchase
agreements, to those United States Dollar-Denominated securities
that the fund's board of directors determines present minimal
credit risks (which determination must be based on factors
pertaining to credit quality in addition to any rating assigned
to such securities by an NRSRO) and which are at the time of
acquisition Eligible Securities.
(ii) Securities Subject to Unconditional Demand
Features. A security that is subject to an Unconditional Demand
Feature may be determined to be an Eligible Security or a First
Tier Security based solely on whether the Unconditional Demand
Feature is an Eligible Security or First Tier Security, as the
case may be.
(iii) Securities Subject to Conditional Demand
Features. A security that is subject to a Conditional Demand
Feature ("Underlying Security") may be determined to be an
Eligible Security or a First Tier Security only if:
(A) The Conditional Demand Feature is an
Eligible Security or First Tier Security, as the case may be; and
(B) At the time of the purchase of the
Underlying Security, the money market fund's board of directors
has determined that there is minimal risk that the circumstances
that would result in the Conditional Demand Feature not being
exercisable will occur; and
(1) The conditions limiting exercise
either 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 of the Conditional Demand
Feature require that the fund will receive notice of the
occurrence of the condition and the opportunity to exercise the
Demand Feature in accordance with its terms; and
(C)(1) If the Underlying Security has a
remaining maturity of 397 days or less, the Underlying Security
(or the debt securities of issuer of the Underlying Security) has
received a short-term rating by the Requisite NRSROs within the
NRSROs' two highest short-term ratings categories (within which
there may be sub-categories or gradations indicating relative
standing) or, if unrated, is determined to be of comparable
quality by the money market fund's board of directors; or
(2) If the Underlying Security has a
remaining maturity of more than 397 calendar days, the Underlying
Security (or the debt securities of the issuer of the Underlying
Security) has received a long-term rating by the Requisite NRSROs
==========================================START OF PAGE 79======
within the NRSROs' two highest long-term rating categories
(within which there may be sub-categories or gradations
indicating relative standing) or, if unrated, is determined to be
of comparable quality by the money market fund's board of
directors.
(4) Portfolio Diversification.
(i) Taxable and National Funds. Immediately
after the acquisition of any security (other than a Government
Security or a security subject to an Unconditional Demand Feature
Issued By A Non-Controlled Person), a money market fund other
than a Single State Fund shall not have invested more than five
percent of its Total Assets in securities issued by the issuer of
the security.
(ii) Single State Funds. With respect to 75
percent of its Total Assets, immediately after the acquisition of
any security (other than a Government Security or a security
subject to an Unconditional Demand Feature Issued By A Non-
Controlled Person), a Single State Fund shall not have invested
more than five percent of its Total Assets in securities issued
by the issuer of the security; Provided, however, That a Single
State Fund shall not invest more than five percent of its Total
Assets in securities issued by the issuer of the security unless
the securities are First Tier Securities.
(iii) Safe Harbor. Notwithstanding paragraph
(c)(4)(i) of this section, a money market fund other than a
Single State Fund may invest up to twenty-five percent of its
Total Assets in the First Tier Securities of a single issuer for
a period of up to three Business days after the purchase thereof.
(iv) Second Tier Securities.
(A) Taxable Funds. Immediately after the
acquisition of any Second Tier Security, a money market fund that
is not a Tax Exempt Fund shall not have invested more than:
(1) The greater of one percent of its
Total Assets or one million dollars in securities issued by that
issuer which, when acquired by the money market fund (either
initially or upon any subsequent roll over) were Second Tier
Securities; and
(2) Five percent of its Total Assets in
securities which, when acquired by the money market fund (either
initially or upon any subsequent roll over) were Second Tier
Securities.
(B) Tax Exempt Funds. Immediately after the
acquisition of any Second Tier Conduit Security that is not
subject to an Unconditional Demand Feature Issued By A Non-
Controlled Person, a money market fund that is a Tax Exempt Fund
shall not have invested more than:
(1) The greater of one percent of its
Total Assets or one million dollars in securities issued by that
issuer which, when acquired by the money market fund (either
initially or upon any subsequent roll over) were Second Tier
Conduit Securities not subject to an Unconditional Demand Feature
Issued By A Non-Controlled Person; and
==========================================START OF PAGE 80======
(2) Five percent of its Total Assets in
Conduit Securities which, when acquired by the money market fund
(either initially or upon any subsequent roll over) were Second
Tier Conduit Securities not subject to an Unconditional Demand
Feature Issued By A Non-Controlled Person.
(v) Puts.
(A) General. Immediately after the
acquisition of any Put or security subject to a Put, with respect
to seventy-five percent of the assets of a money market fund, no
more than ten percent of the fund's Total Assets may be invested
in securities issued by or subject to Puts from the institution
that issued the Put, subject to sections (c)(4)(v)(B) and (C) of
this section.
(B) Second Tier Puts. Immediately after the
acquisition of any Put (or a security after giving effect to the
Put) that is a Second Tier Security, a money market fund shall
not have invested more than five percent of its Total Assets in
securities issued by or subject to Puts from the institution that
issued the Put.
(C) Puts Issued by Non-Controlled Persons.
Immediately after the acquisition of any security subject to a
Put, a money market fund shall not have invested more than ten
percent of its Total Assets in securities issued by, or subject
to Puts from the institution that issued the Put, unless, with
respect to any security subject to Puts from that institution,
the Put is a Put Issued By A Non-Controlled Person.
(vi) Diversification Calculations.
(A) General. For purposes of making
calculations under paragraphs (c)(4)(i) through (iv) of this
section:
(1) Repurchase Agreements. The
acquisition of a repurchase agreement may be deemed to be an
acquisition of the underlying securities, provided that the
obligation of the seller to repurchase the securities from the
money market fund is Collateralized Fully.
(2) Refunded Securities. The
acquisition of a Refunded Security shall be deemed to be an
acquisition of a Government Security.
(3) Conduit Securities. A Conduit
Security shall be deemed to be issued by the issuer (other than
the Municipal Issuer) ultimately responsible for payments of
interest and principal on the security.
(4) Asset Backed Securities. An Asset
Backed Security shall be deemed to be issued by the Special
Purpose Entity that issued the Asset Backed Security, Provided,
however, any person whose obligations constitute ten percent or
more of the principal amount of the Qualifying Assets shall be
deemed to be an issuer of the portion of the Asset Backed
Security such obligations represent. For purposes of the
foregoing, if the Qualifying Assets held by the Special Purpose
Entity are themselves Asset Backed Securities ("Secondary Asset
Backed Securities"), then the Special Purpose Entity shall be
==========================================START OF PAGE 81======
treated as holding directly the Secondary Asset Backed
Securities.
(5) Shares in Master Funds. A money
market fund substantially all of the assets of which consist of
shares of another money market fund acquired in reliance on
section 12(d)(1)(E) of the Act [15 U.S.C. 80a-12(d)(1)(E)] shall
be deemed to be in compliance with this section if the board of
directors reasonably believes that the money market fund in which
it has invested is in compliance with this section.
(B) Put Diversification Calculations. In
making calculations under the Put diversification requirements of
paragraph (c)(4)(v) of this section, the following rules apply:
(1) Issuer-Provided Puts. In the case
of a security subject to a Put from the same institution that
issued the underlying security, the value of the securities
subject to the Put may be excluded from the Put diversification
requirements of paragraph (c)(4)(v) of this section.
(2) Fractional Puts. In the case of a
security subject to a Put from an institution by which the
institution guarantees a specified portion of the value of the
security, the institution shall be deemed to guarantee the
specified portion thereof, Provided, however, if the security is
an Asset Backed Security and the Put is a guarantee of all or a
portion of the first losses with respect to the security, the
institution providing the Put shall be deemed to have guaranteed
the entire principal amount of the security.
(3) Layered Puts. In the case of a
security subject to Puts from multiple institutions that have not
limited the extent of their obligations as described in paragraph
(c)(4)(vi)(B)(2) of this section, each institution shall be
deemed to have guaranteed the entire principal amount of the
security, Provided, however, in the case of a security subject to
an Unconditional Demand Feature and a Put (or Puts) that is not a
Demand Feature, the Put diversification requirements of paragraph
(c)(4)(v) of this section need only be satisfied as to the
institution issuing the Unconditional Demand Feature.
(4) Puts Not Relied Upon. If the
fund's board of directors determines that the fund is not relying
on a Put to determine the quality (pursuant to paragraphs
(c)(3)(ii) or (c)(3)(iii) of this section), or maturity (pursuant
to paragraph (d) of this section), or liquidity of the portfolio
security and maintains a record of this determination (pursuant
to paragraphs (c)(8)(ii) and (c)(9)(vi) of this section), the Put
diversification requirements of paragraph (c)(4)(v) of this
section need not be satisfied as with respect to such put.
(vii) Diversification Safe Harbor. A money
market fund that satisfies the applicable diversification
requirements of paragraph (c)(4) of this section shall be deemed
to have satisfied the diversification requirements of section
5(b)(1) of the Act [15 U.S.C. 80a-5(b)(1)] and the rules adopted
thereunder.
(5) Downgrades, Defaults and Other Events.
==========================================START OF PAGE 82======
(i) Downgrades.
(A) General. Upon the occurrence of either
of the events specified in paragraphs (c)(5)(i)(A)(1) and (2) of
this section with respect to a portfolio security, the board of
directors of the money market fund shall reassess promptly
whether such security continues to present minimal credit risks
and shall cause the fund to take such action as the board of
directors determines is in the best interests of the money market
fund and its shareholders:
(1) A portfolio security of a money
market fund ceases to be a First Tier Security (either because it
no longer has the highest rating from the Requisite NRSROs or, in
the case of an Unrated Security, the board of directors of the
money market fund determines that it is no longer of comparable
quality to a First Tier Security); and
(2) The money market fund's investment
adviser (or any person to whom the fund's board of directors has
delegated portfolio management responsibilities) becomes aware
that any Unrated Security or Second Tier Security held by the
money market fund has, since the security was acquired by the
fund, been given a rating by any NRSRO below the NRSRO's second
highest rating category.
(B) Securities to Be Disposed Of. The
reassessments required by paragraph (c)(5)(i)(A) of this section
shall not be required if, in accordance with the procedures
adopted by the board of directors, the security is disposed of
(or matures) within five Business days of the specified event
and, in the case of events specified in paragraph (c)(5)(i)(A)(2)
of this section, the board is subsequently notified of the
adviser's actions.
(C) Special Rule for Certain Securities
Subject to Demand Features. In the event that after giving
effect to a rating downgrade, more than five percent of the
fund's Total Assets are invested in securities issued by or
subject to Demand Features from a single institution that are
Second Tier Securities, the board of directors (or its delegate)
shall cause the fund to reduce its investment in securities
issued by or subject to Demand Features from that institution to
no more than five percent of its Total Assets by exercising the
Demand Features at the next succeeding exercise date(s), absent a
finding by the board of directors that disposal of the portfolio
security would not be in the best interests of the money market
fund.
(ii) Defaults and Other Events. Upon the
occurrence of any of the events specified in paragraphs
(c)(5)(ii)(A) through (D) of this section with respect to a
portfolio security, the money market fund shall dispose of such
security as soon as practicable consistent with achieving an
orderly disposition of the security, by sale, exercise of any
Demand Feature or otherwise, absent a finding by the board of
directors that disposal of the portfolio security would not be in
the best interests of the money market fund (which determination
==========================================START OF PAGE 83======
may take into account, among other factors, market conditions
that could affect the orderly disposition of the portfolio
security):
(A) The default with respect to a portfolio
security (other than an immaterial default unrelated to the
financial condition of the issuer);
(B) A portfolio security ceases to be an
Eligible Security;
(C) A portfolio security has been determined
to no longer present minimal credit risks; or
(D) An Event of Insolvency occurs with
respect to the issuer of or the provider of any Put with respect
to a portfolio security other than a Put with respect to which a
non-reliance determination has been made pursuant to paragraph
(c)(4)(vi)(B)(4) of this section.
(iii) Notice to the Commission. In the event
of a default with respect to one or more portfolio securities
(other than an immaterial default unrelated to the financial
condition of the issuer) or an Event of Insolvency with respect
to the issuer of the security or any Put to which it is subject,
where immediately before default the securities (or the
securities subject to the Put) accounted for 1/2 of 1 percent or
more of a money market fund's Total Assets, the money market fund
shall promptly notify the Commission of such fact and the actions
the money market fund intends to take in response to such
situation. Notification under this paragraph shall be made
telephonically or by means of a facsimile transmission, followed
by letter sent by first class mail, directed to the attention of
the Director of the Division of Investment Management.
(iv) Defaults for Purposes of Paragraphs
(c)(5)(ii) and (iii). For purposes of paragraphs (c)(5)(ii) and
(iii) of this section, an instrument subject to a Demand Feature
or unconditional credit enhancement shall not be deemed to be in
default (and an Event of Insolvency with respect to the security
shall not be deemed to have occurred) if:
(A) In the case of an instrument subject to
a Demand Feature, the Demand Feature has been exercised and the
fund has recovered either the principal amount or the amortized
cost of the instrument, plus accrued interest; or
(B) The provider of the credit enhancement
is continuing, without protest, to make payments as due on the
instrument.
(6) Required Procedures: Amortized Cost Method. In
the case of a money market fund using the Amortized Cost Method:
(i) General. In supervising the money market
fund's operations and delegating special responsibilities
involving portfolio management to the money market fund's
investment adviser, the money market fund's board of directors,
as a particular responsibility within the overall duty of care
owed to its shareholders, shall establish written procedures
reasonably designed, taking into account current market
conditions and the money market fund's investment objectives, to
==========================================START OF PAGE 84======
stabilize the money market fund's net asset value per share, as
computed for the purpose of distribution, redemption and
repurchase, at a single value.
(ii) Specific Procedures. Included within the
procedures adopted by the board of directors shall be the
following:
(A) Shadow Pricing. Written procedures
shall provide:
(1) That the extent of deviation, if
any, of the current net asset value per share calculated using
available market quotations (or an appropriate substitute which
reflects current market conditions) from the money market fund's
amortized cost price per share, shall be calculated at such
intervals as the board of directors determines appropriate and
reasonable in light of current market conditions;
(2) For the periodic review by the
board of directors of the amount of the deviation as well as the
methods used to calculate the deviation; and
(3) For the maintenance of records of
the determination of deviation and the board's review thereof.
(B) Prompt Consideration of Deviation. In
the event such deviation from the money market fund's amortized
cost price per share exceeds 1/2 of 1 percent, the board of
directors shall promptly consider what action, if any, should be
initiated by the board of directors.
(C) Material Dilution or Unfair Results.
Where the board of directors believes the extent of any deviation
from the money market fund's amortized cost price per share may
result in material dilution or other unfair results to investors
or existing shareholders, it shall cause the fund to take such
action as it deems appropriate to eliminate or reduce to the
extent reasonably practicable such dilution or unfair results.
(7) Required Procedures: Penny-Rounding Method. In
the case of a money market fund using the Penny-Rounding Method,
in supervising the money market fund's operations and delegating
special responsibilities involving portfolio management to the
money market fund's investment adviser, the money market fund's
board of directors undertakes, as a particular responsibility
within the overall duty of care owed to its shareholders, to
assure to the extent reasonably practicable, taking into account
current market conditions affecting the money market fund's
investment objectives, that the money market fund's price per
share as computed for the purpose of distribution, redemption and
repurchase, rounded to the nearest one percent, will not deviate
from the single price established by the board of directors.
(8) Specific Procedures: Amortized Cost and Penny-
Rounding Methods. Included within the procedures adopted by the
board of directors for money market funds using either the
amortized cost or penny-rounding methods shall be the following:
==========================================START OF PAGE 85======
(i) Securities for Which Maturity is Determined
by Reference to Demand Features. In the case of a security for
which maturity is determined by reference to a Demand Feature,
written procedures shall require ongoing review of the security's
continued minimal credit risks, which review must be based on,
among other things, financial data for the most recent fiscal
year of the issuer of the Demand Feature and, in the case of a
security subject to a Conditional Demand Feature, the issuer of
the security, whether such data is publicly available or provided
under the terms of the security's governing documentation.
(ii) Securities Subject to Puts. In the case of a
security subject to one or more Puts, written procedures shall
require periodic evaluation of the determination described in
paragraph (c)(4)(vi)(B)(4)(puts not relied upon) of this section.
(iii) Adjustable Rate Securities Without
Demand Features. In the case of a Variable Rate or Floating Rate
Security that does not have a Demand Feature and for which
maturity is determined pursuant to paragraphs (d)(1), (d)(2) or
(d)(4) of this section, written procedures shall require periodic
review of whether the security, upon readjustment of its interest
rate, can reasonably be expected to have a market value that
approximates its amortized cost.
(iv) Asset Backed Securities. In the case of an
Asset Backed Security, written procedures shall require the fund
to periodically determine whether a person other than the Special
Purpose Entity is the issuer of all or a portion of the Asset
Backed Security for purposes of paragraph (c)(4)(vi)(A)(4) of
this section.
(9) Record Keeping and Reporting.
(i) Written Procedures. For a period of not less
than six years following the replacement of such procedures with
new procedures (the first two years in an easily accessible
place), a written copy of the procedures (and any modifications
thereto) described in paragraphs (c)(5) through (c)(8) and (e) of
this section shall be maintained and preserved.
(ii) Board Considerations and Actions. For a
period of not less than six years (the first two years in an
easily accessible place) a written record shall be maintained and
preserved of the board of directors' considerations and actions
taken in connection with the discharge of its responsibilities,
as set forth in this section, to be included in the minutes of
the board of directors' meetings.
(iii) Credit Risk Analysis. For a period of
not less than three years from the date that the credit risks of
a portfolio security were most recently reviewed in accordance
with paragraph (c)(8)(i) of this section, a written record of the
determination that a portfolio security presents minimal credit
risks and the NRSRO ratings (if any) used to determine the status
of the security as an Eligible Security, First Tier Security or
Second Tier Security shall be maintained and preserved in an
easily accessible place.
==========================================START OF PAGE 86======
(iv) Determinations With Respect to Adjustable
Rate Securities. For a period of not less than three years from
the date when the determination was most recently made, a written
record shall be preserved and maintained, in an easily accessible
place, of the determination required by paragraph (c)(8)(iii) of
this section (that a Variable Rate or Floating Rate Security that
does not have a Demand Feature and for which maturity is
determined pursuant to paragraphs (d)(1), (d)(2) or (d)(4) of
this section can reasonably be expected, upon readjustment of its
interest rate at all times during the life of the instrument, to
have a market value that approximates its amortized cost).
(v) Determinations with Respect to Asset Backed
Securities. For a period of not less than three years from the
date when the determination was most recently made, a written
record shall be preserved and maintained, in an easily accessible
place, of the determination required by paragraph (c)(8)(iv) of
this section (whether a person other than the Special Purpose
Entity is the issuer of all or a portion of an Asset Backed
Security pursuant to paragraph (c)(vi)(4) of this section). The
written record shall include the identities of the issuers of the
Qualifying Assets whose obligations constitute ten percent or
more of the principal value of the Qualifying Assets, the
percentage of the Qualifying Assets constituted by the securities
of each such issuer and the percentage of the fund's Total Assets
that are invested in securities of each such issuer.
(vi) Evaluations with Respect to Securities
Subject to Puts. For a period of not less than three years from
the date when the evaluation was most recently made, a written
record shall be preserved and maintained, in an easily accessible
place, of the evaluation required by paragraph (c)(8)(ii)
(regarding securities subject to one or more Puts) of this
section.
(vii) Inspection of Records. The documents
preserved pursuant to this paragraph (c)(9) shall be subject to
inspection by the Commission in accordance with section 31(b) of
the Act [15 U.S.C. 80a-30(b)] as if such documents were records
required to be maintained pursuant to rules adopted under section
31(a) of the Act [15 U.S.C. 80a-30(a)]. If any action was taken
under paragraphs (c)(5)(ii) (with respect to defaulted securities
and events of insolvency) or (c)(6)(ii) (with respect to a
deviation from the fund's share price of more than 1/2 of 1
percent) of this section, the money market fund will file an
exhibit to the Form N-SAR [17 CFR 274.101] filed for the period
in which the action was taken describing with specificity the
nature and circumstances of such action. The money market fund
will report in an exhibit to such Form any securities it holds on
the final day of the reporting period that are not Eligible
Securities.
(d) Maturity of Portfolio Securities. For purposes of this
section, the maturity of a portfolio security shall be deemed to
be the period remaining (calculated from the trade date or such
other date on which the fund's interest in the security is
==========================================START OF PAGE 87======
subject to market action) until the date on which, in accordance
with the terms of the security, the principal amount must
unconditionally be paid, or in the case of a security called for
redemption, the date on which the redemption payment must be
made, except as provided in paragraphs (d)(1) through (8) of this
section:
(1) Adjustable Rate Government Securities. A
Government Security which is a Variable Rate Security where the
variable rate of interest is readjusted no less frequently than
every 762 days shall be deemed to have a maturity equal to the
period remaining until the next readjustment of the interest
rate. A Government Security which is a Floating Rate Security
shall be deemed to have a remaining maturity of one day.
(2) Short-Term Variable Rate Securities. A Variable
Rate Security, the principal amount of which, in accordance with
the terms of the security, must unconditionally be paid in 397
calendar days or less shall be deemed to have a maturity equal to
the earlier of the period remaining until the next readjustment
of the interest rate or the period remaining until the principal
amount can be recovered through demand.
(3) Long-Term Variable Rate Securities. A Variable
Rate Security, the principal amount of which is scheduled to be
paid in more than 397 days, that is subject to a Demand Feature
shall be deemed to have a maturity equal to the longer of the
period remaining until the next readjustment of the interest rate
or the period remaining until the principal amount can be
recovered through demand.
(4) Short-Term Floating Rate Securities. A Floating
Rate Security, the principal amount of which, in accordance with
the terms of the security, must unconditionally be paid in 397
calendar days or less shall be deemed to have a maturity of one
day.
(5) Long-Term Floating Rate Securities. A Floating
Rate Security, the principal amount of which is scheduled to be
paid in more than 397 days, that is subject to a Demand Feature,
shall be deemed to have a maturity equal to the period remaining
until the principal amount can be recovered through demand.
(6) Repurchase Agreements. A repurchase agreement
shall be deemed to have a maturity equal to the period remaining
until the date on which the repurchase of the underlying
securities is scheduled to occur, or, where the agreement is
subject to demand, the notice period applicable to a demand for
the repurchase of the securities.
(7) Portfolio Lending Agreements. A portfolio lending
agreement shall be treated as having a maturity equal to the
period remaining until the date on which the loaned securities
are scheduled to be returned, or where the agreement is subject
to demand, the notice period applicable to a demand for the
return of the loaned securities.
(8) Money Market Fund Securities. An investment in a
money market fund shall be treated as having a maturity equal to
the period of time within which the acquired money market fund is
==========================================START OF PAGE 88======
required to make payment upon redemption, unless the acquired
money market fund has agreed in writing to provide redemption
proceeds to the investing money market fund within a shorter time
period, in which case the maturity of such investment shall be
deemed to be the shorter period.
(e) Delegation. The money market fund's board of directors
may delegate to the fund's investment adviser or officers the
responsibility to make any determination required to be made by
the board of directors under this section (other than the
determinations required by paragraphs (c)(1), (c)(5)(i)(C),
(c)(5)(ii), (c)(6)(i), (c)(6)(ii)(A), (B), and (C), and (c)(7) of
this section) provided:
(1) Written Guidelines. The Board shall establish and
periodically review written guidelines (including guidelines for
determining whether securities present minimal credit risks as
required in paragraph (c)(3) of this section) and procedures
under which the delegate makes such determinations:
(2) Oversight. The Board shall exercise adequate
oversight (through periodic reviews of fund investments and the
delegate's procedures in connection with investment decisions and
prompt review of the adviser's actions in the event of the
default of a security or Event of Insolvency with respect to the
issuer of the security or any Put to which it is subject that
requires notification of the Commission under paragraph
(c)(5)(iii) of this section) to assure that the guidelines and
procedures are being followed.
5. Section 270.2a41-1 is amended by revising paragraph (a)
to read as follows:
270.2a41-1 Valuation of standby commitments by registered
investment companies.
(a) A standby commitment as defined in
270.2a-7(a)(22) may be assigned a fair value of zero, Provided,
That:
* * * * *
6. Section 270.12d3-1 is amended by revising paragraph
(d)(7)(v) to read as follows:
270.12d3-1 Exemption of acquisitions of securities issued by
persons engaged in securities related businesses.
* * * * *
(d) * * *
(7) * * *
(v) Acquisition of Puts, as defined in 270.2a-7(a)(16),
provided that, immediately after the acquisition of any Put, the
company will not, with respect to 75 percent of the total value
of its assets, have invested more than ten percent of the total
value of its assets in securities underlying Puts from the same
institution. For the purposes of this section, a Put will be
considered to be from the party to whom the company will look for
payment of the exercise price.
* * * * *
==========================================START OF PAGE 89======
7. Section 270.17a-9 is added to read as follows:
270.17a-9 Purchase of certain securities from a money market
fund by an affiliate, or an affiliate of an affiliate.
The purchase of a security that is no longer an Eligible
Security (as defined in paragraph (a)(9) of 270.2a-7) from an
open-end investment company holding itself out as a "money
market" fund shall be exempt from section 17(a) of the Act [15
U.S.C. 80a-17(a)], provided that:
(a) The purchase price is paid in cash; and
(b) The purchase price is equal to the greater of the
amortized cost of the security or its market price (in each case,
including accrued interest).
8. Section 270.31a-1 is amended by adding a sentence to the
end of paragraph (b)(1) to read as follows:
270.31a-1 Records to be maintained by registered investment
companies, certain majority-owned subsidiaries thereof, and other
persons having transactions with registered investment
companies.
* * * * *
(b) * * *
(1) * * * In the case of a money market
fund, also identify the provider of any put (as defined in
270.2a-7(a)(16)) or guarantee with respect to a portfolio
security and give a brief description of the nature of the put
(e.g., unconditional demand feature, conditional demand feature,
guarantee, letter of credit, or bond insurance) and, in a
subsidiary portfolio investment record, provide the complete
legal name and accounting and other information (including
sufficient information to calculate coupons, accruals,
maturities, puts, and calls) necessary to identify, value, and
account for each investment.
* * * * *
PART 239 - FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933
PART 274 - FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF
1940
9. The authority citation for part 239 continues to read,
in part, as follows:
==========================================START OF PAGE 90======
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77sss, 78c,
78l, 78m, 78n, 78o(d), 78w(a), 78ll(d), 79e, 79f, 79g, 79j, 79l,
79m, 79n, 79q, 79t, 80a-8, 80a-29, 80a-30 and 80a-37, unless
otherwise noted.
* * * * *
10. The authority citation for Part 274 continues to read
as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l,
78m, 78n, 78o(d),
80a-8, 80a-24, and 80a-29, unless otherwise noted.
NOTE: Form N-1A does not and the amendments will not
appear in the Code of Federal Regulations.
11. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is
amended by redesignating paragraph (a)(vii) as paragraph
(a)(viii) and by adding paragraph (a)(vii) and an instruction to
the end of paragraph (a)(vii) of Part A, Item 1 to read as
follows:
FORM N-1A
* * * * *
PART A INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 1. Cover Page
* * * * *
(vii) In the case of a Registrant that holds itself out
as a money market fund primarily distributing income exempt from
the income taxes of a specified state or locality ("single state
fund"), a prominent statement that the registrant may invest a
significant percentage of its assets in a single issuer, and that
therefore investment in the Registrant may be riskier than an
investment in other types of money market funds.
Instruction: The disclosure required for money market funds by
Item 1(a)(vii) may be omitted if the registrant limits investment
in a single issuer to five percent of fund assets as to 100
percent of assets.
* * * * *
12. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is
amended by adding a sentence and an Instruction to the end of
paragraph (c) of Part A, Item 4 to read as follows:
FORM N-1A
* * * * *
==========================================START OF PAGE 91======
PART A INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 4. General Description of Registrant
* * * * *
(c) * * * In the case of a Registrant that
holds itself out as a money market fund primarily distributing
income exempt from the income taxes of a specified state or
locality ("single state fund"), a prominent statement that the
registrant is concentrated in securities issued by the state or
entities within the state and that therefore investment in the
Registrant may be riskier than an investment in other types of
money market funds.
* * * * *
NOTE: Form N-3 does not and the amendments will not
appear in the Code of Federal Regulations.
13. Form N-3 (referenced in 17 CFR 239.17a and 274.11b) is
amended by adding
Instruction 11.e. to Part A, paragraph (a) of Item 4 to read as
follows:
FORM N-3
* * * * *
PART A INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 4. Condensed Financial Information
(a) * * *
Instructions
11. The portfolio turnover rate to be shown at caption 10
shall be calculated as follows:
* * * * *
e. A registrant that holds itself out as a money
market fund is not required to provide a portfolio turnover rate
in response to this Item.
* * * * *
NOTE: Form N-SAR does not and the amendments will not
appear in the Code of Federal Regulations.
14. Form N-SAR (referenced in 17 CFR 274.101) is
amended by revising the definition of "Money Market Fund" in
General Instruction G to read as follows:
FORM N-SAR
* * * * *
GENERAL INSTRUCTIONS
* * * * *
G. Definitions
* * * * *
Money Market Fund: The term "money market fund" shall mean
any open-end fund that meets the maturity, quality and
==========================================START OF PAGE 92======
diversification conditions of paragraphs (c)(2), (c)(3), and
(c)(4) of rule 2a-7 [17 CFR 270.2a-7].
* * * * *
15. Form N-SAR (referenced in 17 CFR 274.101) is amended by
revising the last sentence of the Instruction to Item 63 to read
as follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 63: Dollar weighted average maturity
* * * A money market fund shall determine the
weighted average portfolio maturity in the same manner as it
would in monitoring compliance with the average portfolio
maturity provisions of rule 2a-7.
16. Form N-SAR (referenced in 17 CFR 274.101) is amended by
adding a sentence at the end of the first paragraph of the
Instruction to Item 71 to read as follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 71: Portfolio turnover rate
* * * A money market fund should enter a portfolio
turnover rate of "0" even if it owns securities that have
maturities in excess of one year.
* * * * *
17. Guide 21 (Disclosure of Risk Factors) to Form N-1A
(referenced in 17 CFR 239.15A and 274.11A) is amended by adding a
paragraph to the end of the Guide to read as follows:
Guide 21. Disclosure of Risk Factors
* * * * *
In many cases, a substantial portion of the portfolio
securities held by tax exempt money market funds is supported by
credit and liquidity enhancements from third parties, generally
letters of credit from foreign or domestic banks. These
securities include variable rate demand notes, tender or "put"
bonds and similar securities. Where more than forty percent of a
money market fund registrant's portfolio consists, or is likely
to consist, of securities subject to these features, the
registrant should, in response to Item 4, state that, because the
fund invests in securities backed by banks and other financial
institutions, changes in the credit quality of these institutions
could cause losses to the fund and effect its share price.
18. Guide 35 is added to Form N-1A (referenced in 17 CFR
239.15A and 274.11A] to read as follows:
==========================================START OF PAGE 93======
Guide 35. Money Market Fund Investments in Other Money Market
Funds.
Money market funds are permitted to invest in the securities
of other money market funds in accordance with the provisions of
rule 2a-7 and section 12(d)(1) of the 1940 Act. Except when a
fund has invested substantially all of its assets in the other
money market fund, the investing fund does not need to "look
through" the shares of the fund(s) in which it is investing in
order to determine compliance with the diversification or Second
Tier Security limitations of rule 2a-7.-[45]- However, the
investment objectives and policies of the money market fund
making the investment and the money market fund(s) in which it is
investing should not be inconsistent. Paragraph (c)(4)(iv)(A)(5)
of rule 2a-7 describes the obligations of a fund that invests
substantially all of its asset in another money market fund.
19. Guide 38 is added to Form N-3 (referenced in 17 CFR
239.17a and 274.11b) to read as follows:
Guide 38. Money Market Fund Investments in Other Money Market
Funds
Money market funds are permitted to invest in the securities
of other money market funds in accordance with the provisions of
rule 2a-7 and section 12(d)(1) of the 1940 Act. Except when a
fund has invested substantially all of its assets in the other
money market fund, the investing fund does not need to "look
through" the shares of the fund(s) in which it is investing in
order to determine compliance with the diversification or Second
Tier Security limitations of rule 2a-7.-[45]- However, the
investment objectives and policies of the money market fund
making the investment and the money market fund(s) in which it is
investing should not be inconsistent. Paragraph (c)(4)(v)(A)(5)
of rule 2a-7 describes the obligations of a fund that invests
substantially all of its assets in another money market fund.
By the Commission.
Jonathan G. Katz
Secretary
March 21, 1996
---------FOOTNOTES----------
-[45]- See Investment Company Act Rel. No. 21837 (March
21, 1996) at Section II.G.2.
-[45]- See Investment Company Act Rel. No. 21837 (March
21, 1996) at Section II.G.2.