SEC Division of Investment Management staff letter: Merrill Lynch Capital Fund, Inc.

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SATTERLEE 8 STEPHENS
.' ., HENRY.J. FOi1MO~;, Jll
JOH N 9. HORTO~J r.:OBERT C. HUBBARD
FRANCiS D. KALOSKY
MARY M. LURIA
DENIS R. PINKE"NELL
PAUL J. POWERS, JR.
ROGE:R E:VAN SHE:R WASHINGTON O..ICE: GEOR'::iE C.SHIVELY .....__......_-:---""'J' O' DONALDW.SMITH Dec.ember, 22 1977 17 I PENNSYLVANIA ENUE,N.W. ~:D E:~GT~p:;:Rrz Act . be ct-. *0-.. wASFlr~::, ~~ .)20006 BRYAN WE:BB Section .__1./ ( ~J~________TELEPHONE (202) 98-6358 Secur i ties and Exchange Commission ~.. 500 North Capi tol Stree l~~~ Washington, D. C. 20549 Publie Avai.lnbHi ty Att: Alan Rosenblat, Cñìef Counse! ~ Division of Investment Management 277 PARK AVENUE NEW YORK,N.Y. 10017 COU/,IC,EL TELEPHONE; (212) 826-6200 TELEX NO. 223437 CABLE "SATER.IELD" NEW YORY. JAI'-1ES F. DWYEr~ HAROLD H. MEYERS BARBARA L. ZINS5ER PAUL J. POW2:RS ....--.~-..--- ~iljl-zg~~~-, Re: Merrill Lynch Capital Fund, Inc.: . Request for Interpretive Ruling under
Section 17 (f) of the 1940 Acf
Dear Sir:
We are counsel to .Merr ill ,£ynch Capi tal Fund, Inc.
("Capfund"), and as such are wr i ting to you on behalf of Capfund to seek further clarification of the guidelines un~~r the Investment Company Act of 1940 for the lending of portfolio secur i ties by registered investment companies. These guidel:Lnes were first enunciated in an interpretive response on Dece~ber 27, 1971, to State Street Bank and Trust Co. and have been elaborated on' in a series of subsequ,ent responses, the latest being the response of the Staff of May 4, 1974, to Salomon Brothers. I have spoken to Mr. craig Sparks of your office r~garding 'this' matter and he suggested that we write this letter. The guidelines permit either cash or marketable securities issued or guaranteed by the united States Government or its agencies to be used as collateral in con￾nection with loans of portfolio securities. When the borrower .deposits with the lend~r marketable securities as collateral, the borrower pays the lender a loan premium computed as a percentage 6f the daily market valu~ of the loaned secur ities. Any yield on the deposited secûrities is for the account of the borrower. When cash is deposi ted viith the lender as collateral, the lender invests the cash in "high yielding short-term investments which give maximum liquidity to pay back the borrower when the securities are returned." In this type of arrangement, the lender .must look to the investment return on the cash collateral as its compensation for loaning its par tfolio secur i ties.

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¡SATTERLEE 8 STEPHENS
, PAGE L
It has been the exper ience of Capfund that borrowers of sec~r ities may prefer to use the arrangement whereby cash is delivered to the lender as collateral for the borrowed securities. Guideline 4 provides that the lender of portfolio secur i ties must receive reasonable interest on loans of its portfolio securities and imposes upon the directors of such fund the duty of making the determination that the overall compensation received by the fund in consideration for lending its portfolio securities is reasonable and desirable in view ~f the risks involved in making such determination taking into account prevailing interest rates and other factors effecting the overall return to the fund.. If a fund is reqUired to segregate. the. cash col￾lateral received in ~onnecti6n with a securities loan, it is conceivable that the fund might realize capital losses on the sale of the marketable secur i ties in order to pay back the bor ro-'ier when the secur i ties are returned. Tnese capital losses, which would reduce the overall rate of return to the fund on any loan of its portfolio securities, would be attri￾butable pr imar ily to the effect of fluctuating interest rates on the face am6unt of such marketable securities at the time the loan is called. The return to the fund would be even further reduced by the fact that all borrowers involved in loans of portfolio .secur i ties who use the cash collateral arrangement insist on receiving some return on the collatetal posted for the stock loan, generally a fraction of the return being earned on the collateral. by ..the lender, e.g. 1/2 the- rate of return received by the lender as interest on. the collateral. In any event, such segregation would reduce the flexibility of man~gement and wóuld likély reduce the return to the fund. The uncertainty wi th respect to the rate of return on a portfolio secur i ties loan created by fluctuating interest rates coupled with the possible necessi ty of having to sell marketable securities prior to their maturity date on account of the loan being called makes it difficult for a fund and its directors to comply wi th the requirements of Guideline 4, particularly with respect to the determination that the fund receive reasonable compensation in consideration of loaning its portfolio secur i ties in view of the. risk involved. The possibility that the fund may realize capital losses on the sales of marketable secur ities held as collateral for port￾folio loans obviously increases the risk to the fund in making such loans and may preclude the fund from making such loans.

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I~/SATTERLEE 8. STEPHENS PAGE 3 l
Management of Capfund bel ieves that these potential problems could be el imina ted if such colla ter al were permi t ted to be commingled \vi th the general cash and other liquid assets of the fund. Under this proposal, the fund would commingle the collateral received by it for portfolio securities loans wi th the general liquid assets in its portfolio. The fund's investment advisor, under the supervision of the Board of Directors of the fund, would invest such cash in such short￾term investments as it deemed appropr iate to properly balance this portion of the fund's portfolio in order to accomodate . the cash needs of the fund, including. cash required for redemptions and to repay collater~lon portfolio loans. .. The need to liquidate investments at an inopportune time for the purpose of paying back the borrower ~hen the loan is termina ted would be minimi zed, if not entirely eliminated, since the fund presumably would have sufficient cash on hand or, if cash were not readily available, marketable securities having a matur i ty date closer to the time of termination of the loan which could be liquidated to raise the necessary cash.
Section 17 (f) of the Investment Company Act of 1940
requires every registered management investment company to maintain its portfolio secur i ties and other investments in the custody of a qualified custodian arid author izes the Commission to adopt rules and regulations wi th respect to the segregation of such secur i ties and investments. The rules adopted by the C.ormniss ion under such author i ty embody the philosophy thatthe secur i ties and investments heid in custody are to. be segre￾gated from secur i ties and investments of any other person and marked to identify them as the property of such investment company. Although collateral delivered. to Capfund for .the purpose .of securing loans of. its portfolio securities presently is segregated by its custodian from Capfund IS general assets, the philosophy expressed in the rules promulgated under Section 17 (f) would not appear to be violated if collateral were commingled with the fund i s assets. Capfund i s assets held by the custodian would not be subjected . to any greaterr isk by having the custodian also hold such' collateral with the fund's other assets. No provision of law of which we are aware, including
Section 17 (f), expressly prohibits such commingling pf collater al wi th fund' assets. In the Staff's response dated
May 22, 1972, to the State Street Bank and Trust Co.' s letter of inquiry the Staff indicated that it would not require that collateral compr ised of short-term secur i ties held by an investment company in connection with loans of its portfolio securities be separately segregated from the other short-term

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'I' secur i ties of the fund. The present proposal is merely an extension of this principle to permit commingling of cash collate i al r ece i ved to secur e loans of poi tfol io secur i ties wi th the cash and marketable secur i ties of the fund. The borrower's interest in the collateral would continue to be protected if the cash collateral were commingled wi th cash or marketable secur i ties of the fund, subj ect to the lender's duty to use reasonable care in the custody and care of the collateral in its possession. Since the Uniform Commercial Code contemplates that fungible collateral may be commingled, th.e borrower's rights in the, collateral. would not be adversely affected by commingling the collateral with other cash assets of thelendcir.. This proposal would permi t' Capfund greater flexibili ty in selecting among the var ious brokers who borrow portfol io secur i ties, and would afford the fund more opportuni ty to maximize the investment return on cash collateral. The higher yield resulting from the return on such collateral would accrue directly to the benefit of Capfund's shareholders. Capfund' s investment advisor also would be provided wi th addi tional cash flmv which would be useful in managing the cash and marketable secur i ty needs of . the fund. . .' On the basis of the foregoing, it is our opinion that the commingling of cash collateral received in connection with loans of portfolio securities with the cash and ~arketable securifies of ~he fund, undeicircumstances ~here the guidelines established by the Staff of the Commission with respect to loans of por tfolio secur i ties are otherwise complied wi th, would not result in the violation of any provisions of the' Investment Company Act of 1940, as amended,' or any of the rules and regulations promulgated thereunder. . We would appreciate your advice as to whether you concur in our opinion based on the facts set forth in this letter. If you have any questions. concerning this matter, please communicate wi th the undersigned or, in his absence, Denis R. Pinkernell of this firm. Very' truly yours,
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/ c~r.:..-.-e. -ç,. ~. rom Robert L. Losey
RESPONSE OF rlHE OFFICE OF CHIEF COUNSEL
DIVISION OF INVESTt1ENT ~aNAGEMENT
Our Ref. No. 77-1274CC
Satterlee & Stephens
File No. 132-3
February 7, 1978
Based on the facts and representations above, we would not recoITùl1end any action under Section 17 (f) of tho: Investment Company Act of 1940

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  .. ~::;-i-:,.-.' if cash collateral received by Merrill Lynch Capital Fund, Inc.
  (;iCapfund") in connection with loans of its portfolio securities is commingled by Capfund' s custodian with Capfund' s cash and marketable securities so long as (1) the loan agreement allows such commingling and (2) the guidelines established by the staff with respect to loans of portfolio securities are complied with.' .'- - , ',' Division of Investment Management E'IT:hbg '------- t.'. :,.~.. " ,:..:.,. .~ .~...... ---:,...-.............~~~