SEC Division of Investment Management staff letter: Investment Company Institute

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

DIVISION OF

INVESTMENT MANAGEMENT
May 9, 1996

ACT ''CA
S1:(7I'ID2T
Amy B.R. Lancellotta¡ Esq.

Associate General Counsel RULE ~a-7 ~ Investment Company Institute P'l"~ 1401 H Street, N~W. A9AI s-9~ 9, " Washington, D.C. 20005-2148

Dear Ms. Lancellottà:
Since the adoption of amendments to rule 2a-7 on March 21,

1996, the staff has received a numer of inquiries regarding the

rule amendments. Enclosed are the staff's responses to the

issues raised in these inquiries. Please note that these

responses are based on the facts as presented, and that different

facts may warrant a different result. Questions concerning these

interpretations or other aspects of the rule should be addressed

to Marjorie S. Riegel or the undersigned at (202) 942-0660.

This letter will be made public- immediately.

~re~.~
Jack W. Murphy

Associate Director

(Chief Counsel)

May 9, 1996

QUESTIONS AN ANSWERS ON AMNDMENTS TO RULE 2a - 7 These questions and interpretive answers -reflect positions taken by the staff of the Division of Investment Management. They should be read in conjunction with the rule, and the rule and form amendments adopted by the Securities and Exchange Commission ("Commission") in Investment Company Act Release No. 21837 (March 21, 1996) (61 FR 13956..JMarch 28, 1996)) ("Release 21837"). ~, Puts Not Relied Upon

(1) Q. Paragraph (c) (4) (vi) (B) (~) of rule 2a-7 permits a fund to exclude from the put diversification requirements a put that is not relied on to dete~ine the quality or maturity of the underlying security or for liquidity purposes.

May the fund exceed the five percent limitation on

second tier puts with respect to such a put?

(1) A. Yes.
(2) Q. May the fund ignore the put described in Question

and Answer (1) for purposes other than appiying

the rule's put diversification standards?

(2) A. Although paragraph (c) (4) (vi) (B) (~) only applies to the put diversifioation requirements, the Division would not object if funds ignore such a put for all purposes under the rule 2a-7, including: (i) paragraph (a) (9) (iii) (D) UJ (requiring demand features to be rated (or

requiring the issuer of the demand feature to be

rated) ), and (ii) paragraph (c) (5) (i) (C) (requiring the fund's board of directors to reduce

investment in securities subject to downgraded

demand features absent finding).

(3) Q. May a fund that is treating a put that is an

unconditional demand feature that is not being

relied on for purposes of diversification under

paragraph (c) (4) (vi) (B) (~), use the demand feature to permit the fund to invest in a security subject

to the demand feature in excess of the applicable

diversification limitations pursuant to paragraph

(c) (4) (i)?

(3) A. No.

Puts and Demand Features - - Definitional Matters

(4) Q. A security with a remaining maturity of 397 days

at the time of acquisition by the fund is subject

to a letter of credit (LOC) that will pay

principal and interest upon default of the issuer

of the underlying security, and which does not

contain any particular provision permitting

demand. Could the LgC be treated as an , unconditional demand feature so that (i) the fund

may substitute the credit of the LOC provider

pursuant to paragraph (c) (3) ((ii), and (ii) the

note is not subject to issuer diversification pursuant to paragraphs (c) (4) (1) and (ii)? (4) A. Yes. The question raises the issue of whether the

LOC may be treated as a "demand feature" within

the ~eaning of paragraph (a) (7) of the rule. Paragraph (a) (7) defines a demand feature as a put

that may be exercised (i) at any time on no more

than 30 days notice, or (ii) at specified

intervals not exceeding 397 days and upon no more

than 30 days' notice. Although the LOC is only

exercisable upon default, it can be said to meet

the definition of a demand feature because the

default must, if it occurs at all, occur at the

end of an interval no greater than 397 days.

NOTES: (1) The analysis described above only

applies if the period until of the final maturity

date of the security subject to the put is 397

calendar days or less (e.g., if the put falls

within the definition of demand feature under

paragraph (a) (7) of rule 2a-7). (2) The analysis

described above also could be applied to a

security subject to bond insurance. (3) If the

fund is treating the put as an unconditional

demand feature, the demand feature (or the issuer

of the demand feature) must have received a short- term rating. See paragraph (a) (9) of rule 2a-7. Layered Puts (5) Q. A variable rate demand note (VRN) is subj ect to two demand features. One is provided by the

issuer of the VRN, the other by another

institution. Maya fund exclude the value of

securities subject to these puts pursuant to

paragraph (c) (4) (vi) (B) (~) from the put diversification requirements?

(5) A. The fund may exclude the value of the securities

subj ect to t~e issuer-provided demand feature from

the put diversification requirements, but must include the value of the securities subj ect to the demand feature provided by the other institution

in determining compliance with the put

diversification requirements. That is, the fund

is not required to "double count" assets subj ect

to layered puts wher~ one of the puts was issued

by the issuer. e

(6) Q. A fund holds a security subj ect to an unconditional demand feature and an unconditional

put (that is not a demand feature). The issuer of

the underlying security and the issuer of the put

are under common control pursuant to section

2 (a) (9) of the Investment Company Act of 1940 ( "Inyestment Company Act"). How should the fund

determine compliance with the rule's issuer and put diversification tests? (6) A. (i) Put Diversification - - Paragraph

(c) (4) (vi) (B) (~) of rule 2a-7 states that a fund holding a security subj ect to an unconditional demand feature and put (that is

not a demand feature) may disregard the put,

and consider only the unconditional demand

feature for purposes of determining

compliance with the put diversification

tests.
(ii) Issuer Diversification - - Because the underlying security is subj ect to an unconditional demand feature issued by a non-

controlled person, the fund need not include

the security's value in determining

compliance with the rule's issuer

diversification tests. See paragraphs

(c) (4) (i), (c) (4) (ii) and (c) (4) (iv) of rule 2a-7. Unconditional Demand Feature Issued by a Non-Controlled Person

(7) Q. A security is subject to an unconditional demand

feature from a non- controlled person that covers

20% of the value of the security. Is the security

subject to the rule's issuer diversification

requirements?
(7) A. Yes. Paragraph (c) (4) excludes from the issuer diversification requirements only securities the

entire value of which is subj ect to an unconditional demand feature (or features) from a non-controlled person (or persons) . Issuer-Provided Unconditional Demand Features

(8) Q. A VRN is subject to an issuer-provided unconditional demand feature. How are the VRN

, and the unconditiona! demand feature analyzed under the rule? (8) A. The unconditional demand feature is not subject to

the rule's put diversification requirements because it is an issuer-provided put. See paragraph (c) (4) (iv) (B) (~). The security subject to the unconditional demand feature (the VRDN) ,

however, is subj ect to the rule's issuer

diversification requirements. This is because an

issuer-provided demand feature is not a demand feature issued by a non-controlled person. See paragraph (a) (8) of rule 2a-7, and Release 21837

at note 76.

Securities Subiect to Second-Tier Demand Features Issued by Non-

Controlled Persons

'(9) Q. Paragraphs (c) (4) (i) and (ii) exclude from the

issuer diversification requirements securities

subject to unconditional demand features issued by

a non-controlled person, but paragraph (c) (4) (iv) , which provides the special diversification

requirements for second tier securities, does not.

Are securities subject to second tier demand

features from non- controlled persons subj ect to the rule's issuer diversification requirements?

(9) A. No. Paragraph (c) (4) (iv) is intended to be a modification to the general diversification requirements in paragraphs (c) (4) (i) and (ii), which exclude securities subject to unconditional

demand features issued by a non-controlled person.

Conditional Demand Features

(10) Q. Under paragraph (c) (3) (iii) (C), a fund is required

to consider the short-term ratings of a security

subject to a conditional demand feature if the

security has a remaining maturity of 397 days or

less, the long-term ratings of a security with a

remaining maturity of more than 397 days, and to

do a comparable quality analysis if the security

is not rated. When a security that, when

purchased, had a remaining maturity of more than

397 days, draws toward maturity so that it has a

maturity of 397 days or less, must a fund begin to

look to the short - term ratings of the security or,

in the case of a security that is not rated, do a

new comparable quali~y analysis?

(10) A. No. The paragraph should be interpreted so that the fund looks only to the long-term ratings (or, in the case of an unrated security, determine that

it is of comparable quality to long-term rated

securities) if the security had a remaining

maturity of 397 days or more at the time it was

purchased by the fund. The Division would not

obj ept, however, if the fund subsequently decides

to determine the eligibility of the security by

reference to the rating of the short - term

securities of the issuer when the security has a

remaining maturity of 397 days or less.

Rating Requirement for Demand Features

(11) Q. Paragraph (a) (9) (iii) (D) (~) requires a demand

feature to be rated in order to be an eligible

security. Does this apply to issuer-provided

demand features?

(11) A. Yes. However, a demand feature upon which the

fund is not relying is not required to be rated by

a NRSRO. In addition, securities issued on or

before June 3, 1996 are grandfathered. See

Release 21837 at Section V.B.

Repurchase Agreements ("Reposll) (12) (i) Q. A repo is partially collateralized by cash. Cash is not one of the items in the list of eligible collateral in section 101 (47) of the Federal Bankruptcy Code. Is the repo considered to be "collateralized fully" under paragraph (a) (4) of rule 2a-7? (12) (ii). Q. A repo is collateralized by obligations issued by the Student Loan Marketing Association ("Sallie Mae"). Sallie Mae obligations are "Government securities" under
section 2 (a) (16) of the Investment Company

Act; however, they are not included in the

list of eligible collateral under the

relevant provisions of the Bankruptcy Code.

Is the repo "collateralized fully" under rule

2a-7?
(12 ) A. The rule is intended to ensure that the securities collateralizing a repo can be promptly liquid~ted under applicable bankruptcy law. Therefore, the question of whether a repo is collateralized fully so that a fund can ignore the repo counterparty and look solely to the issuer of the collateral to determine compliance with the rule's issuer diversification standards is governed by the applicable bankruptcy law. Asset Backed Securities and Synthetic Securities ("ABSs") - Definitional Matters

(13) Q. Paragraph (a) (2) of rule 2a-7, in part, defines a

special purpose entity as a "trust, corporation or

partnership or other entity organized for the sole

purpose of issuing fixed income securi ties . . ."

(Emphasis added.) Maya fund purchase ABSs issued by an entity that issues both fixed income and

non- fixed income securities, if the other

provisions of the rule relating to ABSs are satisfied? (13) A. Yes. The rule was intended to permit money market

funds to purchase ABSs that are fixed income

securitiès issued by a special purpose entity,

even if the entity also issues other types of securities. ABSs - - Diversification Standards

( 14 ) Q. As a practical matter, how can a fund determine that no one obligor has obligations that constitute ten percent or more of the qualifying assets underlying the ABSs? (14) A. The fund may use any reasonable method to make

this determination. This would include reasonable

reliance on written representations made by

representatives of the sponsor or other

knowledgeable persons concerning the percentage of

an obligor's obligations.

ABSs and First Loss Guarantees

(15) Q. An ABS is supported by a cash collateral account.

The cash collateral account represents a multiple

of expected losses on an average pool of

receivables. The sponsor of the asset backed

program establishes the cash collateral account as

an escrow account wi~h a bank. The cash

, collateral account' is drawn on if the losses in

the portfolio exceed a certain percentage. Is the

cash collateral account a first loss guarantee, as

that term is used in paragraph (c) (4) (vi) (B) (~) of rule 2a-7?

(15) A. On the basis of the facts presented, the staff believes that the cash collateral account is not a put" and therefore is not a first loss guarantee under the rule. (16) Q. An ABS is subject to a first loss guarantee and

two other puts. Each provider of the two

additional puts has guaranteed only a specified

portion of the value of the security. The ABS is

designed so that a fund holding the ABS need only

rely on the first loss guarantee. Because' the

fund is required to treat the provider of the

first loss guarantee as if it has guaranteed the

entire principal amount of the ABS (paragraph

(c) (4) (vi) (B) (~) of yule 2a-7), may the fund ignore the two additional puts for purposes of

determining its compliance with the put

diversification requirements and other

requirements of the rule?

(16) A. Yes. The two other puts are layered puts under paragraph (c) (4) (vi) (B) (~) of rule 2a-7. Each institution must be deemed to guarantee the entire

principal amount of the ABS, unless the fund's

board of directors (or its delegate)

(i) determines that the fund is not relying on the

puts to determine the credit quality or maturity

of the ABS, or for liquidity purposes pursuant to

paragraph (c) (4) (vi) (B) (~) of the rule; and (ii) makes a contemporaneous record of this

determination pursuant to procedures adopted by the fund's board. See paragraphs (c) (8) (ii) (required procedures) and (c) (9) (vi) (recordkeeping and reporting) of the rule.

ABSs - - Maturity Provisions

(17) Q. Section V.B of Release 21837 states that ABSs

issued on or before June 3, 1996 are

"grandfathered" from the provisions of the rule

concerning maturity determinations. In note 151

of the Release, the Commission stated that the

maturity determinatign provisions of the rule

, applicable to ABSs ?supersede the interpretive

position taken by the Division of Investment

Management in Merrill, Lynch, Pierce, Fenner &

Smith (pub. avail. April 6, 1987) ("Merrill, Lynch"). The securities at issue in Merrill, Lynch were non-ABSs. Does the "grandfathering" provision described in Section V. B of Release

21837 also apply to non-ABSs of the type described

in M~rrill, Lynch?

(17) A. Yes.

(18) Q. A fund holds an ABS having a remaining maturity of

397 calendar days. The terms of the ABS permit

the fund to affirmatively elect to extend the

maturity of the security by an additional 397

days. How should the fund measure the maturity of

the security under the rule?

(18) A. The fund should measure the maturity of the security by reference to the date on which it must be paid. The existence of a right to extend the maturity does not affect the maturity unless and until the right is exercised. In Release 21837, the Commission stated that funds may continue to treat a "mandatory tender" feature as an uncondi tional right to receive principal, provided that the issuer's obligation to pay is no~ 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. See Release 21837 at note 151. (19) Q. A particular tranche of a CMO -has an anticipated

payment date of less than 397 days, and the

securi ties issued are not subj ect to a demand

feature. These securities do not satisfy the

maturity standards for asset backed securities

because the date on which the fund must

unconditionally receive payment exceeds 397 days.

May funds hold securities of this type if the

securities have been issued on or before June 3,

1996?
(19) A. Yes. Securities of the type described above that

are issued on or before June 3 are grandfathered.

Funds holding such securities may continue to

determine their maturities by reference to the

expected payment date.
Pre - Refunded Bonds
(20) Q. The payment of certain bonds are funded by and

secured by escrowed Government securities. The

bonds have been irrevocably funded before June 3,
1996. The certification described in paragraph

(a) (18) of rule 2a-7 (definition of refunded

security) was not obtained from a certified public

accountant at the time the Government securities were escrowed. May funds that either hold' or purchase the refunded bonds described above look

through the bonds to the escrowed securities for

diversification purposes?

(20) A. In Release 21837, the Commission gave the Director

of the Division delegated authority to address

issues regarding compliance dates not addressed in the release. Pursuant to this authority, the Division is grandfathering refunded securities

with respect to which the escrow arrangements were

finalized on or before October 3, 1996, provided

such securities comply with the Division's

interpretive position in T. Rowe Price Tax-Free

Funds (pub. avail. June 24, 1993). Please note

that funds need no longer comply with the 25%

limit in that letter. See Release 21837 at note

122 and accompanying text.

Other Amendments

(21) Q. In the 1991 release adopting amendments to rule

2a-7, the Commission stated that "(f) or purposes of the diversification and quality tests, subsidiaries of parent companies are treated as

separate issuers." Investment Company Act Release

No. 18005 (Feb. 20, 1991) (56 FR 8113 (Feb. 27,

1991)) at note 34. Did recent amendments to the

rule change this position?

(21) A. No.

(22) Q. A money market fund operates under a fundamental policy, the language of which tracks section 5 (b) (1) of the Investment Company Act (and not rule 2a-7). May the fund rely on the diversification safe harbor codified in paragraph (c) (4) (vii) of rule 2a-7, even though the safe harbor mentions section 5 (b) (1) only? (22) A. The board of directors of a fund may be able to

, interpret the fundâmental policies of the fund as

permitting compliance with the new diversification

provisions of rule 2a-7 without obtaining a

shareholder vote to amend those policies. If,

however, the board believes that the terms of the

fundamental policies do not permit such an

interpretation, the Division would not recommend

enforcement action under Section 13 of the

Investment Company Act of 1940 if the fund

operåted in compliance with the diversification

requirements of rule 2a-7 without obtaining a

shareholder vote until the next meeting of the

fund's shareholders.

(23) Q. In Release 21837, the Commission stated that

amendments to rule 2a-7 "require a fund to

maintain a written record of the determination

that a 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." (Section.II.G.4.) Paragraph

(c) (9) (iii) of the rule suggests that this recordkeeping requirement is only applicable with

respect to a security whose maturity is determined

by reference to a demand feature. What is the

correct application of the recordkeeping

requirement?
(23) A. A line of text was deleted inadvertently from the final rule amendments. Paragraph (c) (9) (iii) was intended to codify the staff's position that the

fund's board of directors (or its delegate) should

document the minimal credit risk determination

wi th respect to all securities in the fund's portfolio.