SEC Division of Investment Management staff letter: Morgan Guaranty Trust Company of New York

.'Î'... , ,J

DAVIS POLK & WARDWELL

"'!50 LEXINGTON "'VENUE I FREDERICK'S PLACE 2'1. M..RUNOUCHI I-CHOME NEW YORK, N. Y. 10017 CHIYOD...KU. TOKYO 100 LONDON EC2R eAB... , ".. l~I\II..¡\\i...~;,~', 1300 I STREET, N.W. TELEPHONE: 0171'418 13O:~.... J (' A ME!55ETURM W..SHINGTON, D.C. 200011 F..X:0171.4181400 ,:,..: 00308 F'RANKFURT AN MAn.. ~.'''l1'... "'. PLAE DE L'" CONCORDE W.OT'." D'.'CT Nu.i!l~ti"n ¡z(ç J 3.. CH..TER RO"'D .........",.1.. 7!5008 P..RIS l-ò..u ~u..u ; P..RTNER5 RESIDENT IN LONDON t~.~: ~l~~ CHARLE 5. WHITM..N, II (44-171) 41S-iÌii!d.1(' D..VID M. WELLS

P"'UL KUMLEeEN :::~': J. ~: t y 77o/t6 .,~n~..tI~~~...~~.~. R"'NDALL D. GUYNN Novemer 17, 1995

Re: Investment ComDanv Act of 1940 -- Section 17 efl: Rules 17f-2 and 17f-5

Division of Investment Management

Securities and Exchange Commission

450 Fifth Street, N.W.

Washington, D. C. 20549 .
Attn: Mr. Jack Murphy

Associate Director

Office of Chief Counsel

Ladies and Gentlemen:

We represent Morgan Guaranty Trust Company of New

York, a New York banking corporation ("Morgan Guaranty"),

whose Brussels office ("Morgan Guaranty Brussels") acts as

operator of the Euroclear System. We are writing on behalf

of Morgan Guaranty Brussels to request your confirmation

that the Staff will not recommend enforcement action under

Section 17 (f) of the Investment Company Act of 1940, as

amended (the "1940 Act"), or Rules 17f-2 or 17f-5

promulgated by the Securities and Exchange Commission (the

"Commission") thereunder, against a registered investment

company that lends securities through the Euoclear

Securities Lending and Borrowing Program (the "Euroclear

Program" or th "Program"), if:
.
(i) each loan is collateralized by

(A) the guaranty of Morgan Guaranty described below, or (B) a substantially identicåi guaranty of a separately incorporated and capitalized bank (as

defined by Section 2 (a) (5) of the 1940 Act) that THE PRINCIPAL PLACE 0" BUSINESS 0" THE ~""TNERSHIP IN GREAT BRITAIN IS THE ADDRESS SET FORTH ABOVE AT WHICH A LIST 0" THE PARTNERS' NAMES IS OPEN "OR INSPECTIONe

.
Division of Investment
2 November 17, 1995 Management satisfies the qualifications of ~ bank custodian

set forth in Sections 17 (f) and 26 (a) (1) of the

1940 Act or a banking institution or trust company

that qualifies as an "eligible foreign custodian"

(as defined by Rule 17f-5(c) (2)); and

(ii) the registered investment company acts

(A) as a direct Participant in the Euroclear System (a "Participant"), or

(B) though a bank or other custodian Participant that agrees to pass though to such

registered investment company the benefits of such

guaranty.
In order to facilitate the. issuance of the

requested no-action letter, Morgan Guaranty Brussels makes

the following voluntarycommi tments:

1. No registered investment company as to which

Morgan Guaranty or any of its affiliates is an

"affiliated person or promoter of or principal

underwiter" or an "affiliated person of such

person, promoter, or principal underwiter", and

no company controlled by such a registered

investment company, is or will be permitted to

lend securities belonging to it through the

Euroclear Securities Lending and Borrowing

Program, absent appropriate exemptive relief or

changes in applicable law or regulations.

2 · Morgan Guaranty Brussels will send a notice

to all Euoclear Participants advising them in

reasonable detail of the existence and conditions

of the requested no-action letter, and offering to

provide thea with a copy of it upon request.

In addition, Morgan Guaranty Brussels is not

asking for relief with respect to securities loans made on a fixed-term basis. The Euroclear System

The Euoclear System is the largest clearance and settlement system for internationally' traded debt and equity securities. It was created in 1968 by Morgan Guaranty

Brussels in response to the need of the international

Division of Investment 3 November 17, 1995 Management securities markets for a mechanism for the settlement of

transactions. In 1972, the ownership of the Euroclear

System was acquir~d by an English company now known as the

Euroclear Clearance System Public Limited Company ("ECS").

ECS is owned by 125 banks, brokers and investment

insti tutions, none of which holds more than 3.9' of its.

shares. At the time of acquisition in 1972, ECS entered

into a contract with Morgan Guaranty ~nder which Morgan

Guaranty Brussels continued to operate the Euroclear System.

In 1987, ECS licensed the Euroclear system to Euroclear

Clearance system Sociêtê Coopêrative, a Belgian cooperative corporation (the "Euroclear Cooperative" or the

"cooperative") in which all the Participants in the

Euroclear system have the opportunity of becoming membrs.

Morgan Guaranty Brussels currently operates the Euroclear

System under a contract with the Euroclear Cooperative.

The Euroclear System has more than 2,700

including most of the major banks,

broker-dealers and other institutions professionally engaqed

in cross-border securities transactions. Registered

investment companies may participate in the Euroclear system

ei ther as direct Participants or through bank or other

custodian Participants, subject to admissions criteria

approved by the Board of Directors of the Euroclear

Cooperative. Participants (and indirectly their customers)

can confirm, clear and settle trades of securities' by book-

entry in any of 33 currencies on a simultaneous delivery￾versus-payment basis. Under Section 12 (i) of the Terms and

Conditions (defined below), which is the basic aqreement

governing participation in the Euroclèar System, "Morgan

Guaranty may be a Participant and, in that capacity, will

have the same rights, duties and liabilities it would have

Participants worldwide,

if Morgan Guaranty Brussels were not the operator of the

Euroclear System." Affiliates of Morgan Guaranty are also

allowed to become Participants in the Euroclear system on

the same terms and conditions' as unaffiliated Participants.

The value of securities held on behalf of

Participants was approximately $1.8 trillion at the end of

1994. The system settled transactions valued at
      approximately $21.9 trillion in 1994, with daily instruction

volume averaging over 38,000. Average daily securities

loans outstanding were $6.7 billion in 1994. .

Division of Investment 4 Novembr 17, 1995 Management The Euroclear Securities Lendina and BorrowinQ Proaram

The Euroclear Securities Lending and Borrowing

Program was designed in 1975 to improve the efficiency of

securities settlement and increase market liquidity,

Thirty's recommendation that

securities lending and borrowing should be encouraged as a

method of reducing the numer of fails in the settlement of

securities transactions. It allows Participant. with stable

portfolios of securities to increase overall yield (without

loss of ownership benefits) by lending securities to other

participants who seek to avoid fails because of lack of

inventory. Through the Euroclear System, borrowers have

access to a substantial pool of lending resources, and

lenders have access to the demand of active borrowers in the

anticipating the Group of

international markets. .
Most debt securities accepted in the Euroclear

System are eligible for .securities lending and borrowing.

Internationally traded DaniSh, Dutch, French, German,

Italian, Japanese, Spanish, Swedish and Swiss equities are

also eligible. Lenders in the Euroclear Program are mainly

custodians, central and commercial banks and other

institutions that are not active traders. Borrowers in the

Program are usually active traders such as market-makers or dealers. The Program works on the basis of "pools" of

lendable securities, from which loans are allocated to

borrowers. Each issue of securities is lent through a separate pool, with an equal numer of securities being lent into and borrowed from each pool, but without any matching

of a specific lender to a specific borrower.

Lenders and borrowers may choose to participate in

the standard or reserved portions of the Euroclear Program.

The standard program is designed to make securities

available for borrowing as needs arise. The reserved

program i. designed to allow borrowers to reserve securities

for future borrowing. within the standard program, lenders

and borrowers can be automatic or opportunity lenders or

borrowers, depending on their needs. Within the reserved

lAutomatic lenders agree to make available for lending

all or a portion of the securities they hold in the .

Euroclear system; opportunity lenders may be called upon to

lend securities from time to time when needed to supplement

Division of Investment
5 Novemr 17, 1995
Management program, lenders may be automatic or opportunity lenders,

but all borrowers are opportunity borrowers. All loans in

the standard program are open-ended. Lenders and borrowers

in the reserved program have the option of entering into

fixed-term or open-ended loans. A fixed-term loan has a

start date and an expiry date; an open-ended loan has a

start date only. A fixed-term loan must be repaid on its

expiry date; an open-ended loan must be repaid in response

to a recall request.

Morgan Guaranty Brussels has developed data on the

volume and mix of open-ended and fixed-term loans made

through the Program. Largely because loans made through the

standard program far exceed those made through the reserved

program, the vast majority of loans are mad~ on an open-

ended basis. To date, no equity securities have been lent

on a fixed-term basis. The longest term of a fixed-term

loan to date has been 26 days.

A Participant wishing to lend or borrow securities

must acknowledge receipt of and agreement to the Terms and

Conditions Governing Use of Euroclear, revised as of

December 1, 1982 (the "Terms and Conditions") and the

Supplementary Terms and Conditions Governing the Lending and

Borrowing of Securities through Euroclear, revised as of

September 1, 1995 (the "Supplementary Terms and

Conditions"). These documents and the Operating Procedures

of the Euroclear system (revised as of May 1, 1995 and as

supplemented from time to time, the "Operating Procedures")

set forth detailed rules and procedures with respect to the

functioning of the Euroclear system in general, and, inter

Al, the Program in particular. Copies of the Operating

Procedures, the Supplementary Terms and Conditions,' the

Terms and Conditions and the form' of Participants' letter

agreement agreeing to be bound thereby (collectively, the

"operative Documents.) have been provided to you in

connection with this submission.

the supply of securities made available by automatic

lenders. Automatic borrowers authorize Morgan Guaranty

Brussels to identify their borrowing needs and to seek to

àrrange loans to fill them; opportunity borrowers identify

their own borrowing needs and submit specific borrowing

requests.

Division of Investment 6 November 17, 1995 Management The Supplementary Terms and Conditions provide

that each borrower must return borrowed securities so that

they can be credited to lenders' accounts on any repayment

date (the "Repayment Date") for the borrowed securities. A

borrower's failure to return borrowed securities on a

Repayment Date will result in a default by the borrower.

Pusuant to the Supplementary Terms and Conditions

and Section 9 of the Operating Procedures, Morgan Guaranty

acting in its capacity as a bank and not as operator of. the

Euroclear System, guarantees the return of securities lent

(or the cash equivalent) upon a default.

Lenders on both fixed-term and open-ended loans

may recall their securities at any time. Historicaiiy,

Morgan Guaranty Brussels has been able to replace lenders

seeking a recall of securities by substituting other lenders

over 99% of the time on a same-day or next-day basis. If a

substitute lender is found, the original lender is released

from its obligations.

If no substitute lender is found (historically

less than l' of the time), the result depends on whether the

loan was fixed-term or open-ended. If it was fixed-term,

the original lender will not be released from its obligation

and the loan continues until the specified Repayment Date.

If the loan was open-ended, Morgan Guaranty Brussels sends

out a mandatory recall request to designated borrowers

requiring them to return the recalled securities within a

specified recall period. .

The current recall periods for the various types

of securities eligible for lending through the Euroclear

Program are set forth in Sections 9.3(f) and 9.4(e) of the

Operating Procedures, as amended by Amendment 95-0P-002

(August 14, 1995) and the relevant country section of the

Participant User Guide -- Domestic Markets. 2 Such

securities currently include most traditional Euro and

global debt securities, equity securities of certain non-

U.S. issuers, domestic debt securities of certain non-U.S.

issuers, and debt securities of certain non-U.S.

2Amendment 95-0P-002 amended the recall periods set

forth in Sections 9.3 and 9.4 of the Operating Procedures to

reflect the recent adoption of a standard settlement period

for secondary market transactions in the U. S., Euro and

other markets of three business days after the trade date.

! .

i

Division of Investment 7 November 17, 1995 Management governments. With two exceptions, the recall periods for

each type of security set forth in the Operating Procedures

have been calculated as the shorter of (i) the shortest

customary settlement period for the securities in question

plus one business day and (ii) any shorter period determined

by Morgan Guaranty Brussels in light of the existence of an

active "repo market"3 for the securities; sUbject in either

case to a minimum recall period of three business days. 4

Thus, for example, under Rules 222 and 323 of the

International Securities Market Association ("ISMA"), the

standard settlement period for secondary market transactions

in Euro debt securities is effectively three business days

after the trade C"T+3"). Thus, the recall period for such

securities lent through the Euroclear Program is four

business days.

The time required for a registered investment

company (or its custodian) to recall securities lent though

the Euroclear Program may frequently be less, and should

rarely be longer than one business day more, than the time

required to recall securities through most U.S.-based programs. The recall period for open-ended securities loans made through most U. S. programs is typically the standard

3In some markets, borrowers can satisfy recall requ~sts

by purchasing the securities sUbject to an agreement to

resell an equivalent amount of such securities at a later

date ("raverse repurchase agreement"). The settlement

period for a reverse repurchase agreement C"repo")

transaction can be shorter than the settlement period for an

outright purchase.

4The exceptions are ECU-denominated securities and

Irish government securities, which have recall periods of 6

business days. EC-denominated securities have different

customary settlement periods depending on their country of

issuance. Irish government securities have different

customary settlement periods depending on whether they are

domestically traded or internationally traded. It is not

practical for Morgan Guaranty Brussels to distinguish among

ECU-denominated securities depending on their country of

issuance or between domestically traded and internationally

traded Irish government securities. The longest customary settlement period in each case is T+5. Therefore, the recall periods for all ECU-denominated securities and all

Irish government securities are six business days.

'))

... ,

Division of Investment 8 November 17, 1995 Management settlement period for trades in the underlying securities.

For example, section 5 of the standard form securities loan

agreement published by the Public Securities Association

( "PSA"), which was developed to standardize general industry

practices, provides that the recall period for open-ended

securities loans may not be less than the standard

settlement period for trades in the underlying securities.

It further specifies that in the absence of a contrary

agreement the recall period for u.s. government securities

will be one business day, and the recall period for other

(presumably U.S.) securities will be five business days - periods that match or exceed the current standard settlement

periods for u.s. corporate securities.s

As noted above, Morgan Guaranty Brussels has

historically been able to satisfy the recall requests of

lender Participants by replacing them with other lender

Participants over 99' of the time, significantly reducing

any delay in the recall of securities. Thus, in the vast

majority of cases, recall will be much faster in the

Euroclear Program than in a u.s. program that does not have

a'similar lender substitution procedure. Moreover, where

lender substitution is not possible, the recall periods of

the Euroclear Program are comparable to those in the typical

u. S. program, corresponding to the shortest customary

settlement period of the underlying securities, plus one

business day. 6 spresumably, the PSA standard form will be revised to

reflect the reduction in the standard settlement period for

transactions in u.s. corporate securities from T+5 to T+3,

when such reduction is fully phased in, if a similar

reduction in the recall period is feasible under most u.s.

securities lending programs.

6rus ,registered investment companies that lend voting securities through the Euroclear Program will have sUbstantially the same or better opportunities to recall their securities prior to any vote of the securities than they currently have under U.S. securities lending programs. In addition, they will have substantially the same or better opportunities to use recalled securities to satisfy their deli very requirements on a contemporaneous sale of such recalled securities (especially in the case of lender sUbstitution) . .

..- .

,I
Division of Investment
9 November 17, 1995
Management
If any outstanding securities are not returned by

the end of the last processing cycle for the return of lent

securities for a particular Repayment Date, which is

typically approximately 2: 30 a.m. (Brussels time) on the

Repayment Date,' an affected lender may instruct Morgan

Guaranty Brussels to credit it with an amount of cash equal

to the market value of the lent securities as of the

business day on which the instructions are received,

together with accrued interest and other distributions, if

any, on the securities to the date the credit is effected.'

If Morgan Guaranty Brussels receives such instructions by

10:00 a.m. (Brussels time) on the Repayment Date, or if, at

the time such instructions are received, Morgan Guaranty

Brussels has not yet begun to purchase replacement

securities as described below, Morgan Guaranty Brussels will

credit the iènder, generally within two business days, with

the cash amount described above, calculated on the basis of

'Securities transactions settled through the Euroclear

system for a particular settlement day are currently

processed in two overnight batch processing cycles, the

second of which is typically completed by approximately 2: 30

a.m. (Brussels time) on the settlement day (or in the case

of securities loans, Repayment Date). Although there is

also a daylight processing cycle for certain transactions

settled through the Euroclear System, securities lending and

borrowing transactions are not currently processed in the

daylight cycle.

~he market value of lent securities is determined

pursuant to Section 9.2 (p) of the Operating Procedures.

According to that provision, market value is determined by

Morgan Guaranty Brussels on the basis of information

obtained from independent sources, including, but not

limited to, the offered price obtained from the lead manager

of the relevant issue of securities, information obtained

from publicly available independent sources, offered prices

obtained from recOCnized market participants in the relevant

issue of securities on or immediately before the Repayment

Date and the cost of any buy-in that would be incurred by

the affected lender under the rules of any relevant . regulated securities market. If indications of value cannot

be obtained for a particular issue of lent securities,

Morgan Guaranty Brussels is required to determine the market

value in its sole discretion, giving consideration to other

outstanding issues of similar credit rating, maturity and characteristics. / \ !

. e' .
Division of Investment 10 November 17, 1995 Management the market value of the lent securities as of the business

day on which the instructions are received.

If Morgan Guaranty Brussels does not receive

instructions from a lender that it be credited with the cash

amount described above by 10:00 a.m. (Brussels time) on the

Repayment Date, Morgan Guaranty Brussels will make a

reasonable effort, for a period of two business days, to

purchase the securities. If Morgan Guaranty Brussels

purchases replacement securities during the two~day buy-in

period, the account of the lender will be credited with the

securities when they are received by Morgan Guaranty

Brussels pursuant to the settlement of the replacement

purchase. If, after two business days, no replacement

securities are purchased, Morgan Guaranty Brussels will

advise the lender that its recall of the lent securities

will remain outstanding, and thus the loan will continue in

default, until either (i) the lent securities are returned

(whether reimbursed by the borrower or pursuant to a

replacement purchase) or (ii) the lender instructs Morgan

Guaranty Brussels to credit it with the cash amount

described above. If, however, such lender continues to mae

securities of the same issue as the unreturned securities

available for lending and the amount of such issue of

securities in such lender's securities clearance account

becomes sufficient to cover the amount of the unreturned

securities, the recall of the lent securities will lapse and the loan will continue, but will no longer be in default.' In this case, the lender may at any time initiate another

recall of the lent securities.

Pursuant to Section 9.2 (r) of the Operating

Procedures, defaulting borrowers pay, and aggrieved lenders

receive, a supplementary fee based on the market value of

the lent securities to compensate len~ers for the time value

of money between the Repayment Date and the date on which

the recall of the lent securities lapses. In calculating

the supplementary fee, the market value of the lent

securities is determined for each business day during the

~n contrast, if such lender does not continue to make

such issue of securities available for lending, then even if

the amount of such issue in such lender's securities

clearance account becomes sufficient to cover the amount of

the unreturned securities, the recall of the lent securities

would not lapse and the loan would not cease to be in

default for that reason.

. . f ~

Division of Investment 11 November 17, 1995 Management period in respect of which the fee is payable. In addition,

for each recall that is not satisfied on the Repayment Date,

the aggrieved lender receives a "Failed Return

Administration Fee" of $500.

Discussion
Subsection (b) of Rule 17f-2 requires registered investment companies to deposit their securities and similar

investments in the safekeeping of, or in a vault or other

depository maintained by, a bank or other company whose

functions and physical facilities are supervised by u.s.

Federal or state authorities. Subsection (c) of Rule 17f-2

provides that the requirement of Subsection (b) of Rule 17f￾2 does not apply to "securities on loan which are

collateralized to the extent of their full market value."

In addition, a management investment company is permitted by

Rule 17f-5 to deposit foreign securities with an eligible

foreign custodian if certain determinations are made. As

operated by Morgan Guaranty Brussels,. the Euroclear System

qualifies as an eligible foreign custodian under Rule 17f￾5 (c) (2) (iv). .~ Investment Company Act Release No. 14132

(Sept. 7, 1984), 1984 Fed. Sec. L. Rep. (CCH) ! 83,655, at

pp. 87,042-87,043.

In a letter to State Street Bank and Trust Co.

Cavailabie Jan. 29, 1972 and Sept. 29, 1972) (the "State

Street Letter"), the Staff provided no-action relief under

Section 17(f) and Rule 17f-2(c) for registered investment

companies to lend their securities through a securities

lending program operated by State Street Bank and Trust Co.,

as long as the program complied with certain guidelines. As

more fully discussed below, we believe that the Euroclear

Securities Lending and Borrowing Program is consistent with

the policies behind each of the guidelines announced in the

State Street Letter, and request no-action relief to the

extent the Program addresses these policies in a way that

does not fit within the literal terms of the guidelines as previously articulated. Guideline 1. The registered investment company must receive

100 percent cash collateral from the ~orrower.

This guideline is designed to give content to the

requirement in Rule 17f-2 (c) that loans of securities be

"collateralized to the extent of their full market value."

Through a series of subsequent no-action letters, the Staff

has expanded Guideline 1 to permit collateral in the form of

/
, i

...4
Division of Investment 12 November 17, 1995 Management U.S. government securities or irrevocable standby letters of

credit issued by a bank that satisfies the qualifications of a bank custodian under sections 17(f) and 26(a) (1) .10 ~ Lionel D. Edie capital Fund, Inc. (available May 15,

1975) (U.S. government securities); Salomon Brothers

(available May 4, 1975) (same) (the "Salomon Brothers

Letter"); Standard Shares, Inc. (available Aug. 24,

1974) (same); The Adams Express Company (available October

20, 1979) (bank letter of credit) (the "Adams Express

Letter") .
It is our view that the guaranty of Morgan

Guaranty of loans of securities by Participants in the

Euroclear Program is the legal and functional equivalent as

collateral of the irrevocable standby letter of credit

permi tted by the Adams Express Letter. Morgan Guaranty (of

which Morgan Guaranty Brussels is a branch) is a membr bank

of the Federal Reserve system and, as of Decembr 31, 1994,

had aggregate capital, surplus, and undivided profits of

approximately $7.31 billion.

Under the proposed arrangement described in the

Adams Express Letter, the registered investment company

would receive an irrevocable standby letter of credit issued

by a bank with a face amount equal to 102' of the initial

market value of the securities lent and an expiration date

expected to be approximately six months after the issuance

date. The registered investment company would be authorized

lOunder sections 17 (f) and 26 (a) (1) of the 1940 Act and Rule 17f-2 thereunder, a qualified bank custodian includes:

a bank (as defined by section 2 (a) (5)) that has "at all

times an aggregate capital, surplus, and undivided

profits of . . . not . . . less. than $500,000..

Under Rule 17f-S(c), an "eligible foreign custodian"

includes the following type of foreign banking institution:

" (1) A baing institution or trust company,

incorporated or organized under the laws of a country

other than the United states, that is regulated as such

by the country's government or an agency thereof and

that has shareholders ' equity in excess of $200,000,000

. . . as of the close of its fiscal year most recently

completed . . . ."

Division of Investment 13 November 17, 1995 Management to draw down all or any portion of the face amount of the

letter of credit by presenting to the issuing bank a sight

draft, together with an affidavit certifying that (i) the

borrower had failed to return the securities when due or

otherwise was in default and (ii) the amount being drawn

down represented the current market value of the unreturned

securities or the amount required to cure any other default.

In accordance with Section 5-112 (1) of the Unifora

Commercial Code ("UCC"), the issuing bank would be required

to make payment under the letter of credit by the close of

the third banking day following receipt of the documents or

such later time as mutually agreed, but could not be

required to pay earlier. The registered investment company

could then use the cash drawn under the letter of credit to

purchase replacement securities on the open market.

The issuing bank's obligation under the letter of

credit was absolute and .unconditional in the sense that the

bank could not refuse to honor it based on defenses

available to the borrower, if the registered investment

company properly presented a demand for payment under the

letter of credit. If . the issuing bank defaulted on the

letter of credit, the registered investment company would

have a legal right under UCC S 5-115 (1) to recover the face

amount of the letter of credit plus incidental dam~ges and

interest. Once issued, the letter of credit could not be

unilaterally modified or revoked by the issuing bank until

its expiration date.

If, because of increases in the value of lent

securities, the fixed amount of any letter of credit became

insufficient to fully collateralize the borrower's

reimbursement obligation, the borrower would be permitted to

pledge cash or u.s. government securities to collateralize

the shortfall. Alternatively, the old letter of credit

could be canceled and a new one, at a sufficiently higher face amunt, could be issued. Adams Exress successfully argued that a bank

letter of credit with these characteristics was as good or

better than cash or u.s. government securities as

collateral, and in any case satisfied the policy concerns

behind Guideline 1.
The guaranty of Morgan Guaranty performs the same

economic function as a letter of credit in the typical

securities lending transaction -- it effectively substitutes

\ j
ì

Division of Investment 14 Novemer 17, 1995 Management the unconditional credit of Morgan Guaranty for that of the

borrower in the transaction. The reimbursement obligation

of the borrower to Morgan Guaranty, which matures if Morgan

Guaranty is required to honor the guaranty to the lender, is

typically secured by a pledge of cash or securities

collateral on deposit with Morgan Guaranty in the Euroclear

system. Hence, the arrangement appearø in all respects

consistent with the paradigm transaction described in the

August 1989 surey of securities lending prepared by the

Federal Reserve Bank of New York. ~ Securities Lendin9 4 10 (Federal Reserve Bank of New York, Aug. 1989).

From a legal standpoint, the rights of the.

beneficiary of this guaranty are in all material respects

the same as or superior to those of a beneficiary of the

type of standby letter of credit described in the Adams

Express Letter. The guaranty is governed by Belgian law.

We have been advised by Liedekerke Wolters Waelbroeck ,

Kirkpatrick, Belgian counsel to Morgan Guaranty Brussels,

that, under Belgian law, Morgan Guaranty would have no

defenses against the beneficiary under the facts described

herein. If there were a default on the guaranty, the

beneficiary would have a legal right under Belgian law to

compel specific performance or obtain damages. Under the

Operative Documents, the guaranty may not be modified or

revoked by Morgan Guaranty, except upon ten days' prior

written notice to Euroclear Participants.

In many respects, the guaranty of Morgan Guaranty

provided for in the Euroclear Program is superior to the

irrevocable standby letter of credit permitted in the Adams

Express Letter as far as protecting a lender of securities.

Under the guaranty, a lender need not present a sight draft

or aff idavi t to receive payment as would be required under a letter of credit. In addition, payment under the guaranty

is available, at the option of the lender, in the form of

securities, if available. A letter of

credit, on the other hand, provides for a cash payment only.

Finally, the guaranty covers all cash entitlements on a

security, aa well as non-cash distributions. Indeed, the

features of a letter of credit which would arguably

distinguish it from a gûaranty (namely, a fixed dollar

amount representing the maximum amount which could be drawn

and a fixed expiry date after which no drawings could be

made) operate only to protect the issuer of the letter of

credit, rather than the beneficiary.

cash or replacement

j
\
I

Division of Investment 15 November 17, 1995 Management The time required for a registered investment

company to receive replacement securities (or their cash

equivalent) in the event of a borrower default 'should

typically be less and should not be longer in the Euroclear

Program than in a lending transaction secured by a letter of

credit in a typical u.s. program. Upon the default of a

securities loan collateralized by a letter of credit, the

lender must present a sight draft and affidavit to the

issuing bank. Even if this can be done on the same business

day as the default (which is uncertain), UCC S 5-112 (1)

allows the issuing bank until the close of the third bankinq

day after presentment to make payment under the letter of

credit. Assuming the lender is not in a position to execute

a trade for replacement securities before collecting the

proceeds under the letter of credit, the lender may have to

wait for up to eight business days or more after default to

receive replacement securities (three business days to

receive the proceeds under the letter of credit plus five

business days to settle the trade for replacement 11 securities), even under ideal conditions.

In contrast, if a borrower fails to return

securities on the due date in the Euroclear Program and no

substitute lender is found (historically less than 1% of the

time), Morgan Guaranty has frequently been able to credit

the lender's account with the cash equivalent, or enter into

a transaction to purchase replacement securities, on the

same business day as the default and, in any case, is

required by the Operative Documents (i) to credit the

lender's account with cash within two business days of its

receipt øf the lender's instructions requesting cash

compensation by 10:00 a.m. (Brussels time) on the Repayment

Date or (ii) to enter into a transaction to purchase

replacement securities, if available, within two business

days after default. If, at the end of such two-day period,

no replacement securities are purchased and the lender does

not provide instructions requesting cash compensation,

Morgan Guaranty Brussels will, at its own discretion,

continue to attempt to purchase replacement securities.

I1Moreover, as pointed out in the request seeking _ the

Adams Exress Letter, it may take more time to liquidate

u.s. government securities collateral than to collect on a

letter of credit. Thus, the time required to obtain

replacement securities on defaulted securities loans

collateralized by u.s. government securities may take longer

than loans collateralized by letters of credit.

16 November 17, 1995
Like securities loans made by registered

investment companies, securities borrowings from customers

made by broker-dealers are restricted by Rule 15c3-3 (b)

promulgated by the commission under the Securities Exchange

Act of 1934, as amended (the "Exchange Act") and Regulation

T (12 C. F . R. S 220. 16) promulgated by the Board of Governors of'the Federal Reserve system (the "FRB") pursuant to the

Exchange Act. Both Rule 15c3-3 (b) and Regulation T impose substantially similar collateral requirements on securities

borrowings by broker-dealers from customers, including

specifically the permissive use of letters of credit as

collateral. Hence, sUbstantially the same issue discussed

above is presented under Rule 15c3-3 (b) and Regulation T. The Division of Market Regulation has granted no-action relief under Rule 15c3-3 (b) with respect to securities borrowings collateralized by the guaranty of' Morgan Guaranty described herein, and the FRB staff has concluded that such guaranty satisfies the collateral requirement under Regulation T. A copy of the no-action letter issued by the Di vision of Market Regulation and a copy of the FRB Staff opinion have been provided to the Staff in connection with

this request. We believe that their analysis and conclusion

is correct, and that the same result is indicated for

purposes of section 17(f), and Rules 17f-2 and 17f-5

thereunder.
Although registered investment companies may

become direct Participants in the Euroclear system, almost

none are direct Participants and Morgan Guaranty Brussels

anticipates that most will continue to find it more

positions through global or other

custodians. Under this arrangement, only their custodians

would have the legal right under Belgian law to enforce the

guaranty of Morgan Guaranty.

convenient to hold their

As a practical matter, custodians can be expected

to pass on the benefits of the guaranty to their registered

investment company customers in the rare event that both a

replacement lender cannot be found for recalled securities

and the relevant borrower defaults on its return obligation.

It is the nature of custody arrangements that the custodian

acts as agent for its customers, and not as principal. In

Division of Investment
17 November 17, 1995
Management addition, most bank and other custodians are highly

regulated institutions with legal duties to their customers.

Furthermore, the custody business is highly competitive.

Most registered investment companies can easily bargain for

a provision in their agreements with custodians requiring

the custodians to pass through the benefits of entitlements

such as the guaranty, and most custody agreements probably

contain a general provision to that effect already.

Nevertheless, in order to facilitate the issuance

of the requested no-action letter, Morgan Guaranty Brussels

is willinq to have the no-action letter provide that a

registered investment company may not rely upon the letter

unless (i) it is a direct Participant in the Euroclear

System or (ii) if it is not a direct Participant, a direct

Participant (or any other intermediaries) through which it

acts has a contractual or other legal obligation to enforce the guaranty pursuant to instructions' from such registered investment company and to pass through the benefits of the if the guaranty to such registered investment company as

registered investment company were a direct Participant. In

addition, if the requested no-action letter is granted,

Morgan Guaranty Brussels will send a notice to all Euroclear

Participants advising them in' reasonable detail of the

existence and conditions of the requested no-action letter,

and offering to provide them with a copy of it upon request.

As noted above, certain affiliates of Morqan

Guaranty are permitted to be Participants in the Euroclear

System and the Euroclear Securities Lending and Borrowing

Program on the same basis and subj ect to the same conditions

as other Participants. As a result, it is theoretically

possible that one of its affiliates could be one of the

borrowers with respect to an issue (pool) of lent securities

part of which could, on any particular day, be lent by a

registered investment company.

Any guaranty by Morgan Guaranty of an affiliated

Participant's obligation to return securities upon recall of

an open-ended borrowing. or, upon, expiry of a fixed-term borrowing i. subject to sections 23A and 238 of the Federal

Reserve Act. sections 23A and 238 werè designed by Congress

to regulate the safety and soundness, and control any'

conflicts of interest, associated with the issuance of

guaranties and other extensions of credit by banks on behalf

or in favor of any affiliate., section 23A requires that any

such guaranty or other "covered transaction" be "on terms

and conditions that are consistent with safe and sound

Division of Investment 18 November 17, 1995 Management banking practices." Section 23B requires that it be "on

terms and under conditions, including credit standards, that

are substantially the same . . . as those prevailing at the

time for comparable transactions with or involving other

nonaffiliated companies."

To ensure that such guaranties and other covered

transactions are provided in a safe and sound manner and

wi thout any adverse effects as a result of any possible

conflict of interest, section 23A requires that they be

fully secured by collateral. In addition, except for

guaranties and other covered transactions fully secured by

u.s. government securities or cash collateral on deposit

with the bank, section 23A also imposes ceilings on the

aggregate amount of such guaranties and other covered

transactions to any single and to all affiliates. It

restricts the aggregate amount of covered transactions

(including any guaranties) on behalf or in favor of any

single affiliate to 10% of Morgan Guaranty's capital stock

and surplus. It restricts the aggregate amount of covered

transactions on behalf or in favor of all affiliates to 20'

of Morgan Guaranty's capital stock and surplus.

As a result of Sections 23A and 23B, the guaranty

by Morgan Guaranty of any affiliated borrower's obligation

to return securities must be on substantially the same terms

and conditions as its guaranty of any unaffiliated

borrower's obligation. This requirement is satisfied since

the terms and conditions of the guaranty in section 14 of

the Supplementary Terms and Conditions and Section 9 of the

Operating Procedures are the same whether the borrower is an

affiliate or a nonaffiliate of Morgan Guaranty. In

addi tion, Morgan Guaranty Brussels has procedures in place to ensure that it complies with the other provisions of sections 23A and 23B when an affiliate is a borrower under

the Euoclear Program.

Issued in compliance with sections 23A and 23B,

the guaranty of Horgan Guaranty is just as liquid and

valuable to a registered investment company lender whether

it is issued to secure the obligations of an affiliated or

an unaffiliated Participant. It is also at least as liquid and valuable, if not more so, as a guaranty or letter. of credit issued by most unaffiliated banks. Morgan Guaranty

has long been widely recognized as one of the world'.

leading and well-capitalized banking institutions, and there

has never been a default on its ,guaranty in the twenty-year

Division of Investment 19 November 17, 1995 Management history of the Euoclear Securities Lending and Borrowing

Program.
Although we believe that the guaranty serves the

same credit function when Morgan Guaranty, in its capacity

as a Euroclear Participant, is one of the borrowers from a

pool of lent securities, in order to facilitate the issuance

of the requested no-action letter, Morgan Guaranty Brussels

will obtain one or more guaranties sUbstantially on the same

terms and conditions as its guaranty set forth in Section 14

of the Supplementary Term and Conditions and Section 9 of

the Operating Procedures from one or more of the following

types of banking institutions to secure the Obligation of

Morgan Guaranty, in its capacity as borrower in the

Euroclear Securities Lending and Borrowing Program, to

return borrowed securities when due to any registered

investment company lender:

(i) a separately incorporated and capitalized bank

(as defined by section 2 (a) (5) of the 1940 Act) that satisfies the qualifications of a bank

custodian set forth in sections 17(f) and 26(a) (1)

of the 1940 Act;12 or

(ii) a banking institution or trust company that

qualifies as an "eligible foreign custodian" (as defined by Rule 17f-5(c) (2)). Banking institutions satisfying these criteria could include

a separately incorporated and capitalized bank affiliate of

Morgan Guaranty (such as J.P. Morgan Delaware) ,13 subject to compliance with applicable u.S. ,banking laws and regulations

including Sections 23A and 23B of the Federal Reserve Act,

12Under Section 17 (f), which makes applicable to bank

custodians of registered investment companies the

qualifications for the trustees of unit investment trusts

under section 26(a) (1), a bank custodian must be a bank

which at all times has aggregate capital, surplus, and

undivided profits of not less than $500,000. uJ. P. Morgan Delaware is a separately incorporated and

capitalized Delaware-chartered bank that is a member of the

Federal Reserve System. As of December 31, 1994, it had

aggregate capital, surplus, and undivided profits of

approximately $668 million.

Division of Investment 20 November 17, 1995 Management or a leading foreign bank that would qualify as an eligible

foreign custodian under Rule 17f-5 (c) (2) and might be a participant in or depository of the Euroclear System.

Guideline 2. The borrower adds to such collateral whenever

the price of the securities rises (i.e., mark to market OD a daily basis). As more fully discussed above, the guaranty covers

the return of the lent securities or the cash equivalent of

their full mark-to-market value as of the date on which

Morgan Guaranty Brussels receives the lender's instructions

requesting cash compensation. The guaranty thus covers the full mark-to-market value of any lent securities regardless

of any fluctuations in such value between the date the loan

is made and any date on which the lent securities are

returned or, in the case of compensation, the date on which

such compensation is requested by the lender.

Guideline 3. The registered investment company may

terminate the loan at any time, and any stock loans are ..de

in accordance with the rule. of the Hew York stock Exchange

which require the borrower, after notice, to redeliver the

borrowed securities within the normal settlement time of five business days. '

As more fully discussed above, lenders on both

fixed-term and open-ended loans may recall their securities

at any time. Historically, Morgan Guaranty Brussels has

been able to replace lenders seeking recall of securities by

substituting other lenders over 99l of the time, virtually

eliminating any recall delay. The loan automatically

terminates when a substitute lender is found.

If no substitute lender is found, the timing of the right to recall securities and terminate the loan depend. on whether the loan was fixed-term or open-ended.

If it was fixed term, the original lender is not released

from it. obligation and..the loan continues until the

specified Repayment Date. If the loan was open-ended, the

length of the recall period varie. depending on the type of

securitiea involved, and, subject to the few temporary

exceptions described above, is calculated as the shorter of

(i) the shortest customary settlement period for the

securities in question plus one busin~ss day and (ii) any

shorter period determined by Morgan Guaranty Brussels in

light of the existence of an active repo market for the

securities; subject in either case to a minimum recall

Division of Investment 21 November 17, 1995 Management period of thee business days. An op~n-ended loan for which

a substitute lender could not be found terminates at the end

of the recall period.

Because of the global nature of the Euroclear

System and the fact that many participants and many of the

relevant securities markets for lent securities operate in

different time zones,w it would be impracticable to have a

recall period equal to any local settlement period in a

particular security, without an extra business day to accommodate the cross-border nature of the system.

In our view, the recall and loan termination

rights of the Euroclear Program should satisfy the pOlicies

of Guideline 3. The Euroclear situation is distinguishable

from the situation in the Salomon Brothers Letter, where the

Staff declined to provide no-action relief for a six-day

recall period in a domestic u.s. securities lending program

when the customary settlement period was five business days.

The Staff explained that a registered investment company

might be unable to settle a sale of securities executed on

the same day as a loan recall if the loan recall period were

longer than the trade settlement period.

The loan recall period in the Euroclear Program is

likely to be much shorter than the relevant trade settlement

period in over 99% of the cases since Morgan Guaranty

Brussels has historically been able to find a substitute

lender in response to over 99% of all recall requests. Even

in the remaining cases (representing less than 1% of th~

total), the recall period may be shorter than the relevant trade settlement period if there is an active repo market in the securities in question. In addition, the extra business day is a practical necessity in the Euroclear context because of the inevitable reality of different time zones and operating hours around the globe. Such a practical necessity did not exist or was not articulated in the Salomon Brothers Letter. W~ Cross-Border Clearance. Settlement. and custody:
Bevond the G30 Recommendations 17-19 (Euroclear Operations

Centre, June 1993); Release of the Board of Governors of the

Federal Reserve System Announcing Expansion of the Operating

Hours of the Fedwire On-Line Funds Transfer Service, 59 Fed.

Reg. 8981, 8985-8989 (Feb. 24, 1994).

Division of Investment 22 November 17, 1995 Management Finally, although fixed-term loans made though the Euoclear Program have typically had a short enough tera

to permit lenders ample time to recall lent securities prior

to any vote of such securities and the length of any such

term is within the power of the lender upon enterinC) into

any lending transaction, in order to facilitate the issuance

of the requested no-action letter, Morgan Guaranty Brussels

is not seeking relief with respect to. securities loans made on a fixed-term basis. Guideline 4. The registere4 investment company receive.

reasonable interest on such loan, any dividends, interest or

other distributions on the loaned securities, and any

increase in the market value of such .ecuri ties. The staff

indicated that "reasonable interest on such loan" coul4

include the registered investment company investing the cash

collateral in high yielding short-tera investments vhich

give maximum liquidity to pay back the ~orrower wheD the

securities are returned.

Lenders in the Euroclear Securities Lending and

Borrowing Program are entitled to the benefits of all

dividends, interest or other distributions on lent

securities, and any increase in the market value of such

securities. They also receive an explicit fee to compensate

them for the use of the lent securities. The fee may vary

depending on the type of securities involved. The fees

payable by or to borrowers and lenders are published in

section 13.3 of the Operating Procedures, and updated from

time to time in amendments to the Operating Procedures. All

lenders in the program receive the same fees for the same

class of securities. Lenders' fees currently range from 1

to 4.5' per annum on the daily mark-to-market value of lent

securities, plus accrued interest, if any, except in the

case of loans of domestic securities made in anticipation of

intraday receipts of such domestic securities by borrowers

where such domestic securities are actually received as

anticipated and returned to the lender, in which case the

fee may be less than l' or even zero.

Guideline 5. The registere4 investment company i. not

require4 to pay any service, placement or other fees in

connectioD vi th .uch loan, but the reqistere4 investment

company may pay reasonable custodial fees to its custo4ian

in connection vi th the len4ing of portfolio .ecuri tie.

pursuant to a contract between the registere4 investment

company an4 it. custodian, and approved by the directors of

the registered investment company.

Division of Investment 23 November 17, 1995 Management Under the Euroclear Program, lenders are not

required to pay any service, placement or other fees in

connection with any loan, but there is a spread between the

fees payable by borrowers and receivable by lenders that is

designed to compensate Morgan Guaranty for assuming the

credit risk of the borrowers on the guaranty and to

compensate the Euoclear Cooperative for making the Program

available to the Participants. To the extent any

compensation to the Euoclear Cooperative is in excess of

the costs of operating the Program, it would be available

for distribution back to the Participants as rebates on

their fees.

Guideline'. The registered investment company retains

voting rights on the loaned securitiel. The Staff indicated

that it would not object if voting rights passed with the

lending of the securities, although this would not relieve

the directors of a registered investment company of their

fiduciary obligation to vote proxies and if the manager of

the registered investment company has knowledge that a

material event will occur affecting an investment on loan,

the directors would be Obligated to call such loan in time

to vote the proxies.

Securities borrowed through the Euroclear

Securities Lending and Borrowing Program can be transferred

by the borrowers to third parties as if the securities had

been purchased. If a registered investment company wishes

to exercise its voting rights with respect to any lent

securities, it must recall the securities before any

relevant record date. As noted above, the time required to

recall securities lent through the Euroclear Program should

frequently be less, and should rarely be longer than one

business day more, than the time required to recall

securities through most U.S.-based programs. As further

noted above, in the rare instances in which the recall

period could be one business day longer than the related

trade settlement period, the extra business day is a

practical necessity in the Euroclear context given the

reality of different time zones and operating hours around

the globe. As a result, a registered investment company

should generally be able to recall securities with

sufficient time to vote proxies.

Guideline 7. If the fundamental policies of the registered

investment company, or those which may not be changed

without shareholder approval, do not permit lending of

portfolio securities, shareholder approval of the change in

Division of Investment 24 November 17, 1995 Management investment policy must be obtained prior to engaging in the practice. The Euroclear Program is in' the same position as

any of the programs addressed' in the prior no-action letters

with respect to this guideline.

ComDliance with section 17 eal e3l
Section 17 (a) (3) of the 1940 Act prohibits any
"affiliated person or promoter of or principal underwiter

for a registered investment company. . . or any affiliated

person of such person, promoter, or principal underwiter,

acting aa principal. . . to borrow money or other property

from such registered investment compa,ny or from any company

controlled by such registered investment company . . ·

except .. permitted by section 21 (b) ." Section 21 (b)

provide. an exemption for "any loan from a registered

company to a company which owns all of the outstanding

securities of such registered company, except directors'

qualifying shares." Thus, section 17 (a) (3) generally prohibits a registered investment company from lending its

securities to an affiliated person.

.' .. .

25 November 17, 1995
In order to ensure compliance with section 17 (a) , no registered investment company as to which Morgan Guaranty or any of its affiliates is an "affiliated person or promoter of or principal underwiter" or an "affiliated person of such person, promoter, or principal underwiter", and no company controlled by such a registered investment company, is or will be permitted to lend securities the Euroclear Securities Lending and

Borrowing Program, absent appropriate exemptive, no-action

or other relief other- than the relief requested hereby.

belonging to it through

Conclusion
Based upon the foregoing, it is our view that

securities lent by a registered investment company under the

Euroclear Securities Lending and Borrowing Program are

exempted from the restrictions of section 17 (f) under the

1940 Act as implemented by Rules 17f-2 (b) and 17f-5. We

would appreciate your confirming to us that the Staff will

not recommend enforcement action by the Commission against a

registered investment company which, in reliance on Rule

17f-2 (c), lends securities through the Euroclear Program.

If you have any questions or need any additional

information with respect to the matters set forth in this

letter, please contact me at the numer provided above.

Very truly yours,

~~
Randall D. Guynn

APR I 7 19
Our Ref. No. 95-513

Morgan Guaranty

Trust Company of

RESPONSE OF THE OFFICE OF CHIEF COUNSEL New York

DIVISION OF INVESTMENT MAAGEMENT File No. 132-3

Your letter dated November 17, 1995 requests assurance that

we would not recommend enforcement action to the Commission under

section 17 (f) of the Investment Company Act of 1940 (the "1940

Act") or rules 17f-2 or,lif-5 thereunder if an investment company

lends securities through the Euroclear Securities Lending and

Borrowing Program ("the Euroclear Program"), and each loan is

collateralized by the guaranty (the "Guaranty") of the Morgan

Guaranty Trust company~f ;New York ("Morgan") as described in your letter. ' -'(~
I. The Program

Morgan's Brussels office ("Morgan Brussels") operates the

Euroclear Prógram through the Euroclear System, a clearance and

settlement ,system for internationally traded debt and equity

securities.l Under the Euroclear Program, each issue of

securities is lent and borrowed through a separate pool. A

borrower is not matched with a specific lender.2 You state that

lenders in the Euroclear Program (i) receive specified fees as

compensation for the use of the lent securities, (ii) receive any

dividends, interest or other distributions paid on those

securities, and (iii) are not required to pay any service,

placement or other fees in connection with any loan.

The loans for which you request no-action relief are "open￾ended," which means they do not have a specified expiration date,

lyou state that the Euroclear System has more than 2,700

participants, including most of the major banks, broker-dealers

and other institutions engaged in cross-border securities

transactions. Morgan Brussels also operates the Euroclear System. 2Section 17 (a) (3) of the 1940 Act prohibits an affiliated

person, promoter, or principal underwiter of an investment

company, or an affiliated person of such person, from borrowing

money or other property from that investment company. You state

that Morgan and certain of its affiliates may participate as

borrowers in the Euroclear Program. You represent, therefore, that to avoid violations of Section 17 (a) (3), no investment

company as to which Morgan or any of its affiliates is an

affiliated person, or an affiliated person of an affiliated

person, will lend securities through the Euroclear Program

without first obtaining appropriate relief under the 1940 Act.

but must be repaid when recalled. 3 When a lender recalls its

lent securities, Morgan Brussels will attempt to replace the

lender with a substitut~ lender.4 If Morgan Brussels does not

find a substitute lender; it will send out a mandatory recall

request to designated borrowers requiring them to return the liS The recall securities within the applicable "recall period.

period generally is the shorter of (i) the shortest customary

settlement period for the securities on loan plus one business

day, or (ii) any shorter period determined by Morgan Brussels

given the borrower's ability to satisfy the recall request by

enter ing into reverse 'repurchase agreements, subj ect in either

case to a minimum recall period of three business days. 6 If the

3The staff takes the position that, while the voting rights

with respect to securities on loan may pass to the borrower, the

board of directors of an investment company has a fiduciary

obligation to recall a loan in time to vote proxies if it has

knowledge that a vote concerning a material event regarding the

securities will occur. state street Bank and Trust Corp. (pub.

avail. Dec. 27, 1971; May 22, 1972) (iistate street"). You state

that open-ended loans under the Euroclear Program provide lenders

with sufficient time to recall securities in order to vote

proxies. The no-action relief provided herein does not extend to

fixed-term loans (i.e., loans that must be repaid on a specific

date and that do not impose on the borrower an obligation to

return recalled securities before that date).

4you state that Morgan Brussels historically has been able

to find substitute lenders more than 99% of the time on a same-

day or next-day basis for lenders that have recalled their

securities. When Morgan Brussels finds a substitute lender, the

original lender is released from its obligations and its

securities are returned.

SThe recall period commences when Morgan Brussels sends the

mandatory recall request, which is required to occur no later

than the next business day following the lender's recall request.

Telephone conversation with Randall D. Guynn on March 5, 1996.

6The recall period is determined in this manner except in

~he case of ECU-denominated securities and Irish government

securities, which have recall periods of six business days. You

state that the customary settlement period for ECU-denominated

securities varies depending upon the country of issuance, and

that the customary settlement period for Irish government

securities depends on whether they are traded domestically or

internationally. You state that, in light of this variation, for

practical reasons Morgan Brussels uses the longest customary

settlement period plus one business day as the recall period for

all loans of ECU-denominated and Irish government securities.

securities are not returned by the end of the recall period, the

loan is considered to be in default.

II. The Guaranty

In the event of a default, the Guaranty, which will be

administered by Morgan Brussels on behalf of Morgan,7 will

operate as follows. Morgan Brussels will, at the lender's

option, either credit the lender's account with cash in the

amount of the market value of the securities or attempt to

purchase replacement securities. specifically, the lender may,

on the date that the recall period ends ("Repayment Date") ,

instruct Morgan Brussels to have its account credited with cash.

If the lender does not request cash on the Repayment Date, Morgan

Brussels will make a reasonable effort for two business days to

purchase replacement securities for the lender. Then, if Morgan

Brussels is unable to purchase replacement securities, the lender

may again request and receive cash. 8 In any case in which the

lender has requested and is entitled to receive cash, the

lender's account, within two business days of the request, will

be credited with cash in an amount equal to the market value of

the securities as of the date Morgan Brussels receives the

request plus any accrued interest and other distributions on the

securities to the date the cash is credited to the lender's

account.
You state that you have been informed by Belgian counsel

that if Morgan does not honor the Guaranty, the lender would have

the legal right under Belgian law to compel specific performance

or obtain damages from Morgan, and Morgan would have no defenses

against the lender in such an action. 9 In addition, Morgan may

7yoU note that Morgan qualifies a.s a custodian under section

i7 (f) .
8The lender also is entitled to have its account credited

with cash if it requests cash during the two-day replacement

period and Morgan Brussels has not yet begun to purchase

replacement securities.

9you state that, al though registered investment companies

may participate in the Euroclear System as direct participants,

virtually all participating investment companies do so indirectly

through banks or other custodians that are themselves direct

participants. An investment company that is not a direct

participant in the Euroclear system may participate in the

Euroclear Program in reliance on this letter only if the direct

participant acting on its behalf is contractually or otherwise

legally obligated to enforce the Guaranty on the investment

company's behalf and to pass through the benef its of the Guaranty

to the investment company as if the investment company itself

not modify or revoke the Guaranty without giving ten days prior

written notice to participants in the Euroclear Program, thereby

allowing lenders sufficient time to recall their securities.

III. Analysis

section 17 (f) of the 1940 Act and the rules thereunder set
forth requirements with respect to the custody of the portfolio

securities and similar investments of management investment

companies. Rule 17f-2 permits management investment companies to

act as custodians of their own securities if, among other

requirements, the securities are deposited with a bank or other

company supervised by Federal or state authorities. This

requirement, however, does not apply to "securities on loan which

are collateralized to the extent of their full market value."

Rule 17f-5 permits management investment companies, under certain

conditions, to place and maintain foreign securities and certain

other assets with "eligible foreign custodians" as defined in

10 that rule.

The staff previously has taken no-action positions

permitting investment companies to lend their securities in

accordance with certain specified guidelines, particularly that

loan be fully collateralized by the borrower. 11 In prior

letters, this collateral has taken the form of cash, government

the
12 The principal securities, and bank standby letters of credit.

question raised by your letter is whether the Guaranty may serve

as collateral for investment companies ' securities lending

through the Euroclear Program.

were a direct participant. In order that investment companies

lending securities through the Euroclear Program can be made

aware of this and the other conditions of this letter, you state

that Morgan Brussels will send a notice to all Euroclear

Participants advising them in reasonable detail of the letter's

existence and conditions and offering to provide a copy upon

request.
1~OU state that the Euroclear System qualifies as an

eligible foreign custodian under rule 17f-5. The Commission has

proposed amendments to rule 17f-5 that would, among other

matters, revise the definition of eligible foreign custodian.

Investment Company Act Rel. No. 21259 (July 27, 1995).

11See, e.g., State Street; SalomQn Brothers (pub. avaiL. May

23,1972).
12See, e.g., state Street (cash); Lionel D. Edie Capital Fund

(pub. avail. May 15, 1975) (U.S. government securities); The

Adams Express Company (pub. avail. Oct. 20, 1979) ("Adams

Express") (bank standby letter of credit).

You assert that the Guaranty is the legal and functional

equivalent of the irrevocable standby letter of credit that the

staff has permitted in the past and, in certain respects, with greater protection than a letter of

credit. You state that, like a letter of credit, the Guaranty

substitutes the guarantor's credit for that of the borrower, and

that Morgan would have no defenses against the borrower under the

facts you describe.13 Further, under a letter of credit, the

bank may have three business days from the time the lender

provides the required documentation to credit the lender's

account with cash,14 while the Guaranty permits a lender to

receive the cash value of the securities sooner than the third

business day after the lender's request, without any

documentation. In addition, a letter of credit provides for cash

payment only, while a participant in the Euroclear Program has

the option of receiving either cash or replacement securities.

provides the lender

While the Euroclear Program generally conforms to the other

guidelines set forth in the earlier no-action letters,lS it departs from those letters in that, in the past, the Division has

required that borrowers agree to return the borrowed securities,

upon request of the lender, within the normal settlement period

for trading the securities.16 The Euroclear Program, however,

permits a period for the return of borrowed securities that may

be two days longer than the customary settlement period. First,

Morgan Brussels' attempt to find a substitute lender often

results in a one-day delay in its issuing a recall notice to the

borrower. Second, the recall period, which commences when the

notice is sent, may set a Repayment Date of one day after the

customary settlement period ends. You maintain, however, that as

13As noted above, Morgan may participate as a borrower in the

Euroclear Program. When it does, the Guaranty may fail to serve

the intended credit enhancement function, as Morgan would be

guaranteeing its own obligations. Therefore, you state that when

Morgan borrows from a pool of lent securities, Morgan's

borrowings from that pool will be collateralized by the guaranty

of a separately incorporated and capitalized bank that qualifies

as a bank custodian under section 17 (f), or by the guaranty of a

banking institution or trust company that qualifies as an

eligible foreign custodian under rule 17f-5. This guaranty will

be substantially on the same terms and conditions as the Guaranty

provided by Morgan with respect to other securities loans under

the Euroclear Program.

14See Adams Express.

lSSee state street.

16See Salomon Brothers (pub. avail. May 4, 1975) (staff

specifically rejected a six-day recall period).

a practical matter a lender typically faces little or no delay in

the return of its securities, as Morgan Brussels historically has

found substitute lenders more than 99% of the time within one day

of a lender's request for return of the securities. You also

assert that extending the recall period by one day beyond the

settlement period is necessary because many of the Euroclear

Program's participants are located in different time zones and,

as a result, operate during widely varying hours. We agree that

permitting the additional time is justified in light of the

benef its to lenders of Morgan Brussels' finding a substitute

lender (i.e., immediate return of the securities), the

international nature of the Program, and because it would not

appear to subject fund assets to any increased risk of loss or misappropriation.

Therefore, based on the facts and representations set forth

in your letter, we would not recommend enforcement ~ction to the

Commission under section 17 (f) of the 1940 Act or the rules

thereunder if an investment company lends securities through the

Euroclear Program, and each loan is collateralized by the 18 You should note that different facts or Guaranty. circumstances might require a different conclusion.

lt~ ~ ~. (' ~i,t:1
Eric C. Freed

special Counsel

VSee Investment Company Act Rel. No. 21259, supra note 10,

at §II.
18similarly, we would not recommend enforcement action if, as

described in your letter, a loan is collateralized by the

guaranty of another bank and trust company to the extent Morgan

is a borrower from a pool of securities. See supra note 13.