SEC Division of Investment Management staff letter: Brown & Wood

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RESPONSE OF THE OFFICE OF CHIEF COUNSEL Brown & Wood

DIVISION OF INVESTMNT MAAGEMENT File No. 132-3

Your letter of August 17, 1993, requests our concurrence

wi th your views on several interpretive issues concerning Rule

3a- 7 under the Investment Company Act of 1940 (" 1940 Act"). 1./ Specifically, you request our concurrence with the following:

(1) cumulative preferred stock that has no dete~inable liquidation date is an "eligible asset" within the meaning of

Rule 3a-7 (b) (1); (2) when a structured financing program issues two or more types of securities that are not redeemable alone,

but which give investors direct withdrawal rights if combined, the program does not issue redeemable securities wi thin the meaning of Section 2(a) (32) of the 1940 Act; and (3) the term

"trustee" in Rule 3a-7(a) (4) includes a custodian.

1. Is cumulative preferred stock that has no predetermined

liquidation date an "eligible asset? "

Rule 3a- 7 (at requires an issuer relying on the rule to be

engaged in the business of purchasing, or otherwise acquiring, and holding "eligible assets." Rule 3a- 7 (b) (1) defines "eligible assets" as "financial assets, either fixed or revolving, that by

their termsconvert-'iñtb cash within a finite time period plus

any rights or 'other assets designed to assure the servicing or timely.-disltributionof. proceeds to security 'holders." You state that cumulative preferred stock should be considered an eligible

asset even though the stock' spar, stated, or liquidation value

may have no predetermined payment date, and therefore the stock does not, by its terms, convert into cash withiri a finite period of time. ~/ You believe that, notwithstanding the absence of a

self-liquidating feature, cumulative preferred stock should be

considered an eligible asset because it was included in a non￾exclusive list of eligible assets that appeared in subparagraph

(b) (1) of proposed Rule 3a-7. 'J/ In the release adopting Rule 3a- 7, the Commission stated

that eligible assets must be self - liquidating, and chose not to

include a list of eligible assets in the final rule. ~/ The

1./ Rule 3a- 7 excludes from the definition of "investment

company" any issuer that pools certain financial assets and

issues securities backed by those 'assets.

~/ You contrast the preferred stock with its dividends, which,

you state, do convert into cash within a finite time period.

'J/ Investment Company Act ReI. No. 18736 (May 29, 1992).

~/ Investment Company Act ReI. No. 19105 (Nov. 19, 1992).

Commission clearly indicated that the characteristics of a

security, and not its label, are determinative. ~/ Therefore, if

cumulative preferred stock has no predetermined liquidation date,

it would not be an eligible asset within the meaning of .'

Rule 3a-7 (b) (1). Q/
2. Does a structured financing program that issues two or

more types of securities that are not redeemable alone.

but which give investors direct withdrawal rights if

combined. issue redeemable securities within the

meaning of Section 2 (a) (32) of the 1940 Act?
Rule 3a- 7 (a) excepts a structured financing program from the definition of investment company if, among other things, the issuer does not issue redeemable securities. 2/ Section 2 (a) (32) defines a redeemable security as "any security, . . . under the

terms of which the holder, upon presentation to the issuer or a

person the issuer designates, is entitled (absolutely or only out

of surplus) to receive approximately its proportionate share of

the issuer's current net assets or the cash equivalent. "

You state that certain structured financing programs issue two classes of securities and that the holders of one class of. securities ("Class B") may have the absolute or conditional right

to withdraw portfolio securities from the program, upon

acquisition and presentation of an appropriate amount of the

other class of securities ("Class A"). Class B holders may

acquire Class A securities directly (by purchasing the Class A

securities) or through, payment of a stipulated amount to the sponsor. ~/ You bel ieve that, notwithstanding these direct ~/ Id. at nn.13-21 and accompanying text.

, Q/ This position is consistent with that of the Division of Corporation Finance. See Securities Act ReI. No. 6964 (Oct. 29, 1992) (adopting revisions to Form S -3).

2/ Rule 3a- 7 requires structured financing programs to issue

only non- redeemable securities in order to "preclud (e)

(those) issuers from acting in a manner similar to mutual

funds," which might lead to investor confusion between

unregistered structured financings and registered investment

companies. See Investment Company Act ReI.: Nos. 19105

(adopting Rule 3a-7) at n.24 and accompanying text and 18736

(proposing Rule 3a-7) at n.61 and accompanying text.

~/ The staff understands that some issuers may conduct periodic

auctions of Class A securities to enable Class B holders to

acquire sufficient Class A securities to effect a

withdrawal. Moreover, in some programs, Class A securities

(continued. . . )

withdrawal rights, the structured financing program does not

issue "redeemable securities." ~/

Whether a structured financing program issues redeemable

securities in the circumstances you describe will depend on

whether there are substantial enough restrictio~s on an

investor's ability to withdraw portfolio securities. The

Division considers the following factors to be important to this

determination: (1) whether an investor's withdrawal right is

conditional or absolute, 10/ (2) whether the issuer offers the

matching securities for sale to investors at the 'same time or

only at different times, (3) whether and how often the issuer

sponsors activities (such as auctions and mandatory tender

features) designed to facilitate an investor's ability to acquire

the matching security or securities and present them for

withdrawal, (4) whether the amount of portfolio securities that

an investor can withdraw from the program at anyone time is

limited or unlimited, 11/ (5) how often an investor can withdraw

~/ ( . . . continued) are subj ect to a mandatory tender; that is, if a Class B

holder's auction bid is unsuccessful, it can require that

the issuer call an appropriate amount of Class A securities.

The Class B holder, upon payment of the face amount of the

called Class A securities, then may present both securities

to the issuer-t'o'-effect the withdrawal.

also 'stateth~t the structured':finanCi~ilg program does

not issue redeemable securities even if the Class A and ~/ You

Class B securities, once combined, are viewed as redeemable.

Because the decision to combine is the investor's and is not

dictated by the terms of the offering, you do not believe

that the program is the "issuer" of the combined security.

We disagree. Although the decision to combine is the '

investor's, the structured financing program will define all

of the rights attributable to the Class A and Class B

securities, and will register the securities under the

Secùrities Act of 1933. Further, the' program, not the

investor, is the obligor of the recombined security. See

The SuperTrust Trust for Capital Market Fund, Inc. Shares,

Investment Company Act ReI. No. 17613 (Jul. 25, 1990) (unit

investment trust was issuer of redeemable security as well

as its non-redeemable components) .

10/ See United States Property Investments, N.V. (pub. avail.

May 1, 1989) (no obligation on part of issuer to redeem any

or all of the securities tendered).

11/ In an effort to distinguish closed- end interval funds from issuers of redeemable securities, the Commi.:ision limits the (continued. . . )

portfolio securities from the program, 12/ (6) whether or not

there is a holding period requirement ,13 / (7) the denomination

of'the securities and the minimum amount needed to withdraw

portfolio securities, 14/and (8) how the withdrawal right

feature is presented to investors.

Your letter does not contain sufficiently specific facts about the structured financing programs and the withdrawal rights to enable the staff to determine whether or not the programs should be deemed to be issuing redeemable securities. Therefore, we cannot concur in your opinion that these arrangements would not cause Rule 3a- 7 to be unavailable.
3. Does the term "trustee" in Rule 3a-7(a) (4) include a
custodian?
Rule 3a- 7 (a) (4) requires an issuer relying on the rule to

appoint a trustee that meets the requirements of Section 26 (a) (1) of the 1940 Act. Section 26 (a) (1) requires the trustee or

custodian of a unit investment trust to be a bank with aggregate

capital, surplus, and undivided profits of at least $500,000.

11/ ( . . . continued) size 'of repurchase offers by closed-end management

investment companies to not more than 25% of the company's outstanding cOrróñ'st()ck.BeeRule 23c-3 (a) (3) and Investment CompanY;dActRel . Nos .'18869 (Jul. 28, 1992)

(proposing' Rule':23'ç¥'3):and19399.(Apr.7, 1993) (adopting Rule 23c-3). Seeå.lso California Dentists' Guild Real

Estate Mortgage Funa II (pub. avail. Jan. 4, 1990)

(withdrawals limited to the lesser of $100,000 or 25% of the

investor's account per quarter); Redwood Mortgage Investors

VII (pub. avail. Jan. 5, 1990) (total withdrawals limited to

20% 'of outstanding accounts per year) .

12/ See, e. g., California Dentists' Guild Real Estate Mortgage

Fund II (quarterly withdrawals with 90 days' notice

required); Redwood Mortgage Investors VII (quarterly

withdrawals with three months' notice required); United

States Property Investments, N. V. (annual withdrawals with four months' notice required) . 13/ See, e.g., California bentists' Guild Real Estate Mortgage

Fund II (one year holding period); Redwood Mortgage

Investors VII (one year holding period); United States

Property Investments, N. V. (two year holding period) . 14/ See SPDR Trust, Series 1, Investment Company Act ReI. No.

18959 (Sept. 17, 1992) (substantial dollar amount required

to aggregate non-redeemable securities into redeemable

uni t) .

You state that Section 26 (a) (1) expressly contemplates the

use of a custodian bank, and that many structured financing

programs use custodians rather than trustees. You also state

that the Commission, in proposing and adopting the rule, never

expressly precluded the use of a custodian bank. Finally, you

state that a custodian bank is able to perform the same functions

and comply with the same requirements required of a trustee bank.

Rule 3a- 7 (a) (4) specifically requires an issuer to appoint a

trustee. Therefore, we cannot concur in your opinion that the

term "trustee" in Rule 3a-7(a) (4) includes a custodian. ~t- 6 Monica L. Parry Senior Counsel

,.~
555 CAI.IFORNI~ ,STREET'
BROWN & WOO.O
815 CONNECTICUT AVENUE. N.W.
SAN FRANCISCO,CA,SJ4104:1 7 15 WA5HINGTON, D.C. 20006-4004

TEI.EPH°toE:;4,15~39å"3909 TEI.EPHONE: 202-973-0600

FACS.lMII.È: 415-.397-4621 ONE WORLD TRADE CENTER FACSIMII.E: 202-223-0485 : .~;;~-!:-. - ~ ¡," NEW YORK. N.Y.lp04S-0557 '" 0900'-W~ ~SH iRE, Bh~LEV~~.D" 172 WEST STATE STREET I'Ò5 ANGEI.ES,' 'CA.' Í;OÒ2~-3959 TEI.EPHONE: 212-839-5300 TRENTON. N.J. 08608-1104 TEI.EPHONE: 310-443-0200 FACSI M II.E: 212-839-5599 TEI.EPHONE: 609-393-0303 FAC5IMII.E: 310-208-5740 FAC5IMII.E: 609-393-1990 SHIROYAMAJT MORI BUILDING, 15TH FLOOR RECD S.E.C, BI.ACKWEI.1. HOU5E 3-1, TORANOMON 4-CHOME, MlNATO.KU GUII.DHAI'1. YARD TOKYO 105, ,JAPAN 1.0NDON EC2V 5AB TEI.EPHONE: 03-5472-5360 TEI.EPHONE: 071-606-1888 AUG 1 8 \993 FACSIMII.E: 03-5472-5058 FACSIMII.E: 071-796-1807 '012 ACT ICiYLJ c.1\
SECTION Investment Company Act of 1940

Rule 3a-7
RULE So. -7
PUBLIC .. l~ i I I 0. II ,:, AVAILABILIT~ August 17, 1993

Division of Investment Management

Securities and Exchange Commission

Washington, D.C. 20549

Attention: Officeof__Chief Counsel ... ,. "",~,,,..-, ,;tadies, and . Gentlemen :
Reference is made to Investment Company Act Release No. IC￾19105, dated November 19, 1992 (the "Release"), relating to the

adoption of Rule 3a-7 (the "Rule") under the Investment Company

Act of 1940 (the "Act"). The Rule, which provides that

structured financing arrangements meeting certain requirements

are not subject to registration under the Act, is designed to

remove "an unnecessary and unintended barrier to the use of

structured financings." We believe that this goal has been substantially achieved; howeve~, as wi th any important initiative, certain technical issues are presented by the

language of the Rule in its final form. We have been requested

to give advice respecting the application of the Rule to certain

structu~ed financing arrangements which appear to fall within the

intent of the Rule but are not clearly reconcilable to its actual

text. Based upon informal conversations with certain staff

members, we understand thát resolution of these issues should be

pursued through the no-action letter process. Accordingly, the

purpose of this letter is to request that the staff recommend

that the Commission take no enforcement action if transactions

are effected based on our view as to the proper resolution of the

following issues. Terms used but not defined in this letter have

the meanings assigned to them in the Release.

1. Is cumulative preferred stock an "eligible' asset"? The
   form of proposed
   Rule 3a-7 as set forth in -InvestmèntCompany Act

29, 1992 (the "Proposing Release"),

contained a non-exclusive list of eligible assets (defined in the

proposed rule to mean "obligations that require scheduled cash

payments") which included "cumulative preferred stock." The

Rule, however, requires that eligible assets "by their terms

convert into cash within a finite time period". This definition

clearly encompasses the dividends payable on cumulative preferred

stock, which can be valued, statistically analyzed and

securitized. However, the par, stated or liquidation value of a

share of cumulative preferred stock may have no determinable

payment date and it would not, therefore, appear to be a "self￾liquidating" asset. Because the Release states that the

definition of eligible assets "is intended to include all of the

assets provided as examples in the proposed paragraph" and does

not otherwise indicate an intent to exclude cumulative preferred

stock, we believe that the term "eligible assets" should be

Release No. 18736,' dated May understood to include cumulative preferred stock.
2. Do certain types of withdrawal rights create redeemable

securities? A number of structured financings involve the

deposit of securities with a non-affiliated bank, acting as

depositary or custodian,! and the issuance by the bank of

in the eligible assets so

'deposited. For example, if fixed rate securities are deposited,

receipts evidencing ,interests oneclass.of receipt ("Class ,A.,Receipts") 'may entitle the holder tòdistribütions at a floating or 'adjustable rate, with the

residual class of receipt ("Class B Receipts" ) receiving any

remaining cash flow. In many cases, however, a holder of the

Class B Receipts may have the absolute or con~itional right to

withdraw deposited securities, upon acquisition and presentation

of an appropriate amount pf the Class A Receipts (which

acquisition may be effected directly or through payment of a

stipulated amount which is then distributed to effect retirement

of the related Class A Receipts) .. We believe that these direct

withdrawal rights do not constitute the issuance of "redeemable

securities" as prohibited by Rule 3a-7.

the Proposing Release that Rule

3a-7 would be unavailable to structured financings issuing

redeemable securities in order to preclude such "issuers from

acting in a manner similar to registered investment companies."

The Rule's prohibition on the issuance of redeemable securities

is based on the same concern that led Congress in 1970 to

incorporate a virtually identical prohibition for entities

seeking to rely on the exception from the Act set forth in

The Commission stated in

See question 3 below.

. '

.",-' , ,
. ,,- .. ;., -. - - -'--,-,' ',' séCtiÓIli3 (C), ( 51:"theJ:eo:f..see~Reportof,the ,',securities and, 'ExChangè'còníission . önthe'Public' Policy Implications of

Investment company'Growth, H.R.Rep. No. 2337, 89th Cong., 2d

Sess. 328-9 (1966). See also S. Rep. No. 184, 91st Cong., 1st Sess. 37 (1969);' H.R. Rep. No. 1382, 91st Cong., 2d Sess. 17 (1970) ~ Accordingly, the Release instructs counsel to look to

Commission staff no-action letters under Section 3 (c) (5) for

guidance on whether particular types of securities may be

considered redeemable.

We do not believe the withdrawal rights discussed above are

redeemable securities either under the literal wording of the

Act's definition of a "redeemable security" or under staff no-

action letters. Under section 2 (a) (32) of the Act, a redeemable secur i ty is def ined as:
any security, other than short term paper, under the terms

of which the holder, upon its presentation to the issuer or

to a person designated by the issuer, is entitled (whether

absolutely or only out of surplus) to receive approximately

his proportionate share of the issuer's current net assets,

or the cash equivalent thereof.

_ ,We ,rec:ognizethat Section.
2 (a) (32) encompasses redemptions in ,kind '(i~e~i'J:ëaellpti-ons:for secur ities',hela.:by .,'" the issuer) as wel las"r,:#~inpti9ns ".r or:..gash "anci ,."t,p.at-',t,he to "tight, VI ithdraVl.' ,,_ , ,'depQs1 fed 'd's'ë'Òù.'rltìés tmay'.?at'.,'"f irst..t'â'pÍ)eå.f-šïm-iiârtÓ~'a~:~rêaémption :.... '".:....',;., :.,'..-. ',., :.,~,'.... ; _ "::..'.. ," .... '. ,'...... ",I.. '''''' .... ,:, -'. ,......:,' ,: ',,~ .... " .. .',,' ."C , ..: .. ';'. : :".." ' "C, ....' .-~.", ,:. .. '," ".,.' .. .~. : ~"""'.-~""'.":"~-: "".. -.. '.;,~: .. ,'~ .. '., ... ,_ .-,,_ ':
however /1 t' is apparëntthat

those withdrawal rights fall outside the section. Neither the

Class A Receipt holders nor the Class B Receipt holders have the

right to require withdrawal upon mere presentation of a Receipt

-to the issuer. A Class A Receipt holder has no withdrawal right

at all. Moreover, a Class B Receipt holder may exercise its

inkirid. upoh'6loserdex~ñiinatioii, :

withdrawal right only . if such holder first acquires Class A Receipts (ei therdirectly or by making payment of an amount

sufficient to. retire a stipulated principal amount of Class A

unencumbered right tò redeem withïn

the meaning of the section.

Receipts). Thus, there is no

In addition, the amount of securities withdrawn do not

correspond to a "proportionate share .ofthe issuer's current net

assets" under the section. That is, the withdrawal rights

attached to Clas~ B Receipts require the presentation or

retirement of a stipulated amount of Class A Receipts; the Class

B Receipt holder does not, in effect, realize fully the value of

the withdrawn securities.

The actions required of a Class B Receipt holder in order to

withdraw deposited securities also constitute "substantial

restrictions" on the right to redeem in accordance with prior

l :

-.
, ,
,Çollie;sion staff no-action letters under Section 3 (c) (5). As

recogrlized irìthe Release, where such restrictions exist with

respect to a security, the security should not be considered

redeemable so as to render the issuer ineligible to rely on the

Rule.
We are unaware of any no-action letters precisely on point.

However, certain principles evidenced in the letters support the

conclusion that the conditions to withdrawal of deposited

securities constitute "substantial restrictions. II The staff has

found substantial restrictions to exist where there are

restrictions on either the amount or frequency of redemptions, or

both. See,~, California Dentists' Guild Real Estate Mortqaqe

Fund II (pub. avail. January 4, 1990) (security redeemable only

at quarterly intervals commencing one year after purchase, then

up to a maximum of $100,000 or 25% of the investor's account);

Redwood Mortgaqe Investors VII (pub. avail. January 5, 1990) (one

year holding period and quarterly redemptions of limited amount);

United States Property Investment. NV (pub. avail. May 1, 1989)

(ini tial two year holding period requirement). The withdrawal

rights at issue here impose similar types of restrictions on the

withdrawal of deposited securities. A Class B Receipt holder

cannot simply present such Receipt for withdrawal; a Class B

Receipt holder must expend funds to realize the value of such

securities. ,Specif,icaiiy, such Class B Receipt holder must

Edth~r - undertake the expense of acquiring the necessary amount of

-'Cla;;s.d.A'Reaeipts in th~ secondary. market or pay the stipulated the deposited

securities. We believe these restrictions are substantial and

readily distinguish these withdrawal rights from the types of

,freely redeemable securities issued by registered open-end

investment, companies. 2

-amount befòre being permitted to withdraw

Finally, we believe that even if the Class A Receipts and

Class B Receipts, once recombined by the Class B Receiptholder,

may be viewed as redeemable, the arrangement still would not

violate Rule 3a-7. The Rule is available to a structured

that the financing does not issue redeemable

securities. In accordance with that requirement, the structured

financings involved in our request never issue any security that

by itself is redeemable; a purchaser of Class B Receipts may also

choose initially to purchase Class A Receipts, but that is a

financing provided

2 It is true that registered open-end investment companies may

charge redemption fees of up to two percent of the amount

redeemed to cover certain costs. Such charges, obviously,

are at a lower level and for very different purposes than

the types of expenses which must be incurred in connection

with the withdrawal rights.

tiie,buY;Ea,r~ "") not dictated ," by,thet~rIls()f the. _:/d; :;~__:';:-::'~,...,,:
-:',.'...- ....
3. will a "custodian" bank satisfY oaraqraph (a) (4)? We

note that the Rule requires the use of a trustee bank meeting the

requirements of section 26 (a) (1) of the Act. That section

expressly contemplates the use of a "custodian" bank. For

reasons of precedent and custom, many structured financings

involving the deposit of securities use arrangements and

terminology customary for custody rather than trustee

relationships. Assuming the other requirements of Section 26 (a) (1) are met, we believe that the term trustee in paragraph (a) (4) of the Rule should include a custodian and we request your

concurrence in this view. In support of our request we note that

neither the Proposing Release nor the Release reflect any

to preclude the use of a

custodian, rather than a technical trustee. To the contrary,

intention on the part of the Commission

footnote 93 of the Proposing Release recognizes that ,a similar incorporation by reference of Section 26 (a) (1) of the Act exists in Section 17(f) of the Act, which governs the qualifications of

banks that may serve as custodians for ragistered investment companies.3 In addition, as noted above, Section 2 6 itself accommodates both ~rust and custodianship arrangements.

similarly, Section 4 (2) of the Act defines a unit investment

trustasaniinve.s;t.:nient'"c;oinpany . which, amon,g othe.r~th.lng~,U (A) is organizedunder:~LtrustindentÜre" contract of custodianship or agen9Y /orsimilardinstrument.. '"'' (emphasis "addèa)Kh~;':'"F'AIla.iiý;,' thereisnoregùlatory'purpose to be served byrequiring:'å' '," trustee rather than a, custodian. An independent custodian' can

perform the same functions and meet the same requirements

required of a trustee by paragraph (a) (4) of the Rule. It is

those requirements that are important, not the particular form of

arrangement used. ,
In accordance with your request, this letter is intended to

restate our prior letter to the Division of Investment Management

dated March 9, 1993.

Section 17 (f) provides that "( e J very management investment

company shall place and maintain its securities and similar

investments in the custody of (1) a bank or banks having the

qualifications prescribed in (Section 26(a)(1)) for the

trustees of unit investment trusts."

l
,
..
:.~. ~"'~' ,::-.---'¡: .:.~-:-~- ?:.:~--¿-;),~~fj.:.l.~~~:':::;'.' .:?'::;'~',:. ".:;':;2:;,;'-S_tl'g~ldjyourequire any clarification or further information 'cori6èrñlng~these issues, please do not hesitate to call the undersigned (212-839-5354) or Brian M. Kaplowitz (212-839-5370) of this office. Very truly yours,

I7'iC
Kenneth T. Cote

cc: Thomas S. Harman

Monica L. Parry