SEC Division of Investment Management staff letter: PaineWebber Managed Investments Trust

1 4 AUG 19
P BLI l
¡ Our Ref. No. 94-472-CC
PaineWebbei Managed
RESPONSE OF THE OFFICE OF CHIEF COUNSE~ Investments Trust DIVISION OF INVESTMENT MANAGEMENT File No. 811-4040

By letter dated August 3, 1994, PaineWebber Capital Inc.

("PWC") and PaineWebber Managed Investments Trust (the "Trust"),

of which PaineWebber Short-Term U. S. Government Income Fund (the

"Fund") is a series, request our assurance that we will not

recommend any enforcement action under Section 17 (a) of the

Investment Company Act of 1940 against PWC, the Trust, or the

Fund as a result of the transaction described in the letter.

On the basis of the unusual facts and circumstances

described in the letter, and the specific representations

therein, we will not recommend enforcement action under Section

17 (a). Our position applies solely to the transaction described

in the letter. We take no position with respect to any other aspect of the underlying matter, including, but not limited to, the valuation of the securities that are the subject of the

transaction. You should note that any different facts or

representations might require a different conclusion. Moreover,

this response expresses the Division's position on enforcement

action only and does not express any legal conclusions on the

~.. i su:s presented.

eidi Starn - .l~1
Assistant Chief Counsel

KIRKATRCK & LOCKHT
SOlT LOBBY. 9T FLR
180 M sn N.w
BON, MA

WASHINGrN, D.C 20036-5891 HABURG, PA

MI, FL lEHONE (22) 77s.
NE YORK NY lE 2+459

PI1URGH, PA
!i (22) 77119100
ARTIUR 1. BROWN
(202) 778-90
August 3, 1994

1940 Act Section 17 (a)
HA DELIVEED

Ac:
Heidi Stam, Esquire SECON ~0dJO
Assistant Chief Counsel
RULE Division of Investment Management Securi ties and Exchange Commission PUBLIC 450 Fifth Street, N.W. A V AI:LLBi::i'I'Y Washington, D.C. 20549 fjtflrv Re: PaineWebber Managed Investments Trust:

PaineWebber Shòrt-Term U. S. Government Income Fund

Dear Ms. Stam:

We are writing on behalf of PaineWebber càp,i tal Inc. ("PWC")

and PaineWebber Managed Investments Trust ("Trust"T, an investment

company registered under the Investment Company Act of 1940 "("1940

Act"), of which PaineWebber Short-Term u. S. Government Income Fund

("Fund") is a series, to seek your assurance that the staff of the

Division of Investment Management ("Staff") will not recommend enforcement action under Section 17 (a) of the 1940 Act against PWC, the Trust or the Fund if PWC purchases from the Fund two

"structured floater" securities, as described below. PWC, the

Trust and the Fund believe that the proposed sale of the securities

is in the best interests of the Fund and its shareholders, that the

sale would be consistent with prudent portfolio management of the

Fund under the Fund's investment objective and pOlicies, and that

under the unusual and novel circumstances presented, a no-action

posi tion is appropriate in this matter.

I. Backqround on the Parties. the Structured Floaters.

and the Pro~osed Transaction

PWC is a wholly-owned subsidiary of Paine Webber Group Inc.,

a publicly held financial services holding company. Mitchell

Hutchins Asset Management Inc. ("MH"), a broker-dealer registered

under the Securities Exchange Act of 1934 ("1934 Act") and an

DC-152m.1

'kIATRCK & LOCKHT

investment adviser registered under the Investment Advisers Act of

1940, is a wholly-owned subsidiary of PaineWebber Incorporated

("PaineWebber"), another wholly-owned subsidiary of Paine Webber

Group Inc. and a broker-dealer registered under the 1934 Act. MH

serves as investment adviser and administrator of the Fund pursuant

to a contract with the Trust. MH acts as the distributor of the

shares of the Fund under separate distribution contracts with the

Trust. Under separate exclusive dealer agreements between MH and

PaineWebber, PaineWebber and its correspondent firms sell the

Fund's shares.
The Trust was organized under Massachusetts law by a Declaration of Trust dated November 21, 1986. The Trust is a series mutual fund with six series, including the Fund. The Fund

commenced operations on May 3, 1993. The Fund's investment

objective is to achieve the highest level of income consistent with

the preservation of capital and low volatility of net asset value.

The Fund invests, under normal conditions, at least 65% of its

total assets in U. S. government securities, including mortgage-

backed securities issued or guaranteed by the U. S. government, its

agencies or instrumentalities, other obligations issued or guaran￾teed by the U.s. government, its agencies or instrumentalities and

repurchase agreements with respect to those securities. Up to 35%

of the Fund's total assets may be invested in mortgage- and asset-

backed securities that are issued by private issuers and that at

the time of purchase have been rated AA by Standard & Poor's

Ratings Group or Aaa by Moody's Investors Service, Inc., have an

equivalent rating from another nationally recognized statistical

ratings organization or, if unrated, have been determined by MH to

be of comparable quality.

Among the portfolio securities currently held by the Fund are

two mortgage-backed securities commonly referred to as "structured

floaters." The first of these structured floaters ("Security I")

was purchased by the Fund on March 23, 1994. The second of these

structured floaters ("Security II") was originally issued in July

1993, and was purchased by the Fund on March 29, 1994. Security I

was issued by the Federal National Mortgage Association, and thus is a "government security," as defined in Section 2 (a) (16) of the 1940 Act; Security II was issued by a private issuer and is rated AA by Fitch Investors Service, Inc. Over the past several months, the mortgage-backed securities markets have endured an unprecedented period of disruption. Dealers, hedge funds and other institutional investors have been

forced to liquidate large holdings in mortgage-backed securities,

resulting in severely depressed prices and, in some instances,

KIRKATRCK & LOCKHT greatly reduced liquidity.Y As a consequence of these events, by

eárly June, the Fund's Valuation Committee had determined that the

Securities were illiquid. These dramatically changing market con￾ditions also had an adverse effect on the Fund, which experienced

a decrease in its net asset value per share and a relatively rapid

rate of net redemptions. The effect of the redemption rate was

exacerbated when, starting on June 7, 1994, the Fund suspended

sales of new shares pending court approval of the proposed settle￾ment of certain class action litigation. The Fund's net assets

were reduced from approximately $1,029,000,000 on June 7 to

approximately $730,000,000 on July 27. During the month of July,

the Fund experienced redemptions at a rate of approximately $8

million per day.

As Fund redemptions have continued, the proportion of the

Fund's assets represented by the Securities has increased. As ot

July 27, the Securities amounted to approximately 24% of the Fund's

assets. As the Securities came to represent a larger and larger

percentage of the Fund's assets (and with the prospect that this trend would only continue), the Securities presented certain portfolio management issues. For example, in the current rising

interest rate environment, MH has sought to maintain a weighted

average portfolio duration for the Fund of approximately 1.5 years,

which is shorter than the duration of either of the Securities.

Maintaining this duration while the Fund is holding its current

large positions in the Securities becomes more difficult as the

Fund's asset size shrinks. Moreover, adverse publicity regarding

structured floaters in general (frequently referred to in the press

as "kitchen sink" bonds) ,Y and regarding the Fund's holdings of

these securities in particular,~ has created additional pressures

on the Fund to dispose of the Securities.

In the absence of reliable and meaningful market quotations

for the Securities, on June 27, the Fund's Valuation Committee

determined that the Fund should utilize an alternative pricing

Y See qenerally Jeffrey M. Laderman, What's a Security Worth?, BUSINESS WEEK, July 25, 1994, at p. 76 ("And now, says (Edward J.)

Kohler, mortgage-backed securities are a 'dysfunctional market''') ; Mortqaqe-backed Securities: Not for Widows. OrDhans or Hedqe Funds,

THE ECONOMIST, July 9, 1994, at p. 81 (referencing "the recent

distress in the (mortgage-backed securities) market").

y See,~, Richard Waters, No Lonqer as Safe as Houses: The

ReDercussions of Losses Made in the US Market for Securities Based

on Home Loans, FINANCIAL TIMES, July 22, 1994, at 15; John Connor,

Currency ComDtroller Warns Banks About Investinq in structured

Notes, WALL ST. J., July 22, 1994, at A4B.

~ See,~, BARON'S, July 4, 1994, at MW9.

KIRKATRCK & LOCKHT methodology to value the Securities for purposes of calculating the

Fund's net asset value.~ Using the Fund's methodology, the fair

values of Securities I and II were $104,478,814 and $75,846,663,

respectively, on July 21, 1994. On that date, recognizing the

nearly total absence of market demand at fair value for these

instruments, PWC presented to the independent Trustees of the

Trust, and the independent Trustees approved, a proposal whereby,

subject to regulatory review, PWC would purchase the Securities at

those July 21 prices. This PWC proposal was confirmed in a written

bid (again subject to regulatory review) on July 22. The bid is

revocable by PWC on 24 hours' notice, and PWC may need to exercise

its right to revoke the bid if business considerations so require.

PWC agreed as part of its proposal that if PWC sold or disposed

of the Securities by July 22, 1996 (or if one or both of the

Securities were unsold at the end of such two-year period and firm

offers to purchase were available for the unsold Securities), PWC

would pay to the Fund the amount, if any, by which such sale

proceeds and/or firm offers to purchase exceeded PWC's purchase

price plus its carrying costs for the Securities.~

The independent Trustees' approval of the proposal was

conditioned on the Fund being unable to sell the Securities in the

market at the same or a higher price than would be paid by PWC

following regulatory review. Thus, even though it was deemed

highly unlikely that the condition would occur, prior to closing

the purchase, the Fund would confirm that there was no interest in

the market to buy either Security at a price equal to or higher

~ Under this methodology, the Valuation Committee established a

fair value for the Securities based on the discount from par that,

when combined with the coupon interest on the securities, would

produce a yield equal to the estimated market spread over LIBOR

required by the market. LIBOR was utilized in this methodology

because the Securities each pay a coupon rate of interest that is

adjusted monthly based on one-month LIBOR. The estimated spread over LIBOR was initially determined by reference to the most recent

dealer quotes on other structured floaters that were available to,

and were considered reliable by, MH. The yield implicit in those

quotes was then used to calculate the spread over LIBOR required by

the market for instruments such as these. The difference between

that market spread and the spread provided by the coupon rate of

interest on each of the Securities was then used to derive a market

price for each Security that was sufficiently discounted from par

to produce a market yield. The market price so derived is then

adjusted daily based on the actual changes in the market price of

Treasury securities having approximately the same anticipated

average lives as the respective Securities.

~ The proposal was referenced in PaineWebber's press release

containing its second quarter financial results, issued on .July 22.

KIA1RICK & LOCKHT than the firm bids made by PWC. If a firm offer was made at such

a pLice, the Fund would accept it. Further, as indicated above,

the proposal by PWC was conditioned upon regulatory review by the

Staff with respect to Section 17(a) issues. It is to remove the

latter condition to the proposed transaction that PWC, the Trust

and the Fund seek this no-action letter.

II . Analysis

Section 17 (a) of the 1940 Act prohibits, among other things,

an affiliated person of a registered investment company or an

affiliated person of such person, acting as principal, from

knowingly purchasing' any security or other property from such

registered investment company. Accordingly, Section 17 (a) would

proscribe the proposed transaction -- which involves a purchase of

securities from the Fund by an affiliated person of an affiliated

person of the Fund, acting as principal. We recognize that as a

general matter, the Staff will not entertain no-action requests

under Section 17 (a).~ As the Staff has recognized, however,

no-action positions under Section 17 ~a) may be appropriate in "very unusual or novel circumstances. ,,-l Indeed, on a numer of occasions, the Staff has taken no-action positions under Section 17 (a) , albei t under circumstances different than those here presented. l/ ~ Section 17 (b) of the 1940 Act provides a statutory mechanism for exemptive relief from the proscriptions of Section 17 (a) . Under Section 17 (b) , the Commission may exempt a proposed

transaction from Section 17 (a) upon application when it finds that

(1) the terms of the proposed transaction, including the consideration to be paid or received, are reasonable and fair and

do not involve overreaching on the part of any person concerned,

(2) the proposed transaction is consistent with the policy of each registered investment company concerned, and (3) the proposed

transaction is consistent with the general purposes of the 1940

Act. y See Massachusetts Investors Trust, SEC No-Action Letter (Dec.

8, 1992).

l/ Thus, in dealing with defaulted securities held by money

market funds, the Staff has taken no-action positions wi thout requiring applicants to seek exemptive orders under Section 17 (b) , notwithstanding that the transactions clearly fall within Section 17 (a) (2) of the 1940 Act. See,~, Liquid Green Trust, SEC No￾Action Letter (Dec. 19, 1991) (Staff granted no-action request

under Sections 17 (a) and 17 (d) to permit "purchase" by an adviser of defaulted commercial paper held by fund).

(continued. . . )

KIATRCK & LOCKHT
For the reasons indicated above, a no-action position enabling PWC to purchase the Securities on the terms proposed is urgently

needed as a business matter. In the time that would be required

for PWC and the Trust to file, and for the Commission to act upon,

an exemptive application under Section 17 (b), continued redemptions in the Fund -- perhaps exacerbated by the obstacles to effecti ve management that could be presented as the Securities come to

represent a still larger percentage of the Fund's total assets __

could reach a point such that MH's efforts to achieve the Fund's

objective is severely impaired, thereby harming the Fund's

remaining shareholders. The passage of time may also make it

impracticable for PWC to purchase these securities as a business

matter. Thus, a delay could simply foreclose the proposed

transaction.21 The proposed transaction is clearly in the best

interests of the Fund and its shareholders, and the terms of the

proposed transaction, including the consideration to be paid to the

11 ( . . . continued)
Moreover, in at least one response to a no-action request, the

Staff has explicitly recognized that the "business urgency" of a

proposed transaction may .support a no-action position under Section

17. In Narragansett Capital Corporation, SEC No-Action Letter

(Dec. 15, 1974), the Staff took a no-action position under Rule

17d-1(d) (5) before that rule was effective. The Staff noted that

while it was usually unwilling to take a no-action position prior

to a rule' s effective date, especially in a situation that would

otherwise require an application for exemption, it would take a no-

action position, in part because of the "unique facts involved,

including the business urgency of the transaction ...."

The Staff has also taken no-action positions without requiring

applicants to seek exemptive orders under Section 17 (b) for de

minimis transactions. See National Aviation & Technology

Corporation, SEC No-Action Letter (May 28, 1983) (no-action relief

granted for purchase by investment adviser from affiliated fund of

$10,945 worth of office furniture and fixtures and a telephone

system); Nelson Fund, Inc., SEC NO-Action Letter (Dec. 15, 1975)

(no-action relief granted in view of imminent liquidation of fund and de minimis financial impact of prohibi ted transactions involving assignment of "key man" insurance policy and sale of

office equipment, furniture, fixtures and supplies to an affiliated

person of the fund).

~ Cf. Division of Investment Management, United States

Securities and Exchange Commission, Protectinq Investors: A Half

Century of Investment ComDanv Reaulation 483 (1992) (" (B)ecause of

the time and cost attendant to filing an application, it is

probable that many transactions that do not invol ve overreaching

are simply foregone; thus, the restrictions (of Section 17) also

may impose opportunity costs on investment companies").

.. ,KIRKATRCK & LOCKHT
Fud, are reasonable and fair and do not involve overreaching on

the part of any of the parties.

Even assuming that the Securities could be sold in the market,

the price to be paid by PWC for the Securities will necessarily

exceed what would be available elsewhere. This is because the

Fund's independent Trustees, in approving the proposal as reason￾able and fair, condi tioned their approval on the Fund's being

unable to sell the Securities in the market at the same or a higher

price than would be paid by PWC following regulatory review. PWC's

good faith with respect to the purchase price to be paid is

evidenced by its further commitment to pay to the Fund the amount,

iL any, by which the price of the Securities sold or disposed of

wi thin two y~ars of the purchase (or, if unsold at the end of the

two-year period, the price at which firm offers to purchase, if

any, are then available for the Securities) exceeds PWC's

acquisition and carrying costs for the Securities.

The benefits to the Fund and its shareholders from the

proposed transaction are clear. A delay until a normal market for

the Securities is restored -- which restoration cannot be fairly

predicted or guaranteed -- could have adverse consequences for the

Fund. Prudent portfolio management of the Fund under its invest￾ment obj ecti ve and policies would dictate reduction or elimination

of the position as soon 'as possible. The possibility of a "fire

sale" in the market, in which PWC would be disqualified from

bidding for the Securities, could have more adverse consequences

for the Fund than would simply having the Fund hold the Securities.

A sale of the Securities to PWC at the price established by the

Fund would not have these adverse consequences, and, indeed, would

have the beneficial effect of providing cash to the Fund that could

be redeployed in a manner most advantageous to shareholders.

The proposed transaction would not only enhance management of

the Fund's portfolio but also would enhance liquidity for redeeming

shareholders. Moreover, when the transaction is completed,

PaineWebber and MH expect that the rate of redemptions wiii

decline, thereby reducing the very pressures that currently are

making it difficult for the Fund to achieve its objective. If the

transaction is consumated, the Fund's investment adviser will be

in a position to maintain a level of liquidity in the portfolio

that should satisfy any level of redemption acti vi ty, and permit

better management of the asset mix. Conversely, if the transaction

is not completed promptly, the very problem now faced by the Fund

-- illiquidity in the face of increasing redemptions and undue

constraints on portfolio management -- may well be exacerbated.

In conclusion, we believe that because the proposed transac￾tion is fair and reasonable and in the best interests of the Fund

and its shareholders, and because business exigencies and the

potentially adverse effects of delay militate against undertaking

KIRKATRCK & LOCKHT a lengthy exemptive process, ~t is appropriate for the Staff to

take the nô-action posi tion requested. We understand that the

Staff is not taking any position on any other aspects of the

underlying matter.
If you have any questions regarding this letter or require

additional information, please contact the undersigned at the above

numer.
Sincerely,
Arthur J. Brown

cc: Theodore A. Levine, Esq.

Victoria E. Schonfeld, Esq.