[Federal Register Volume 61, Number 61 (Thursday, March 28, 1996)]
[Rules and Regulations]
[Pages 13956-13984]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-7334]
[[Page 13955]]
_______________________________________________________________________
Part IV
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Part 230, et al.
Revisions to Rules Regulating Money Market Funds; Final Rule
Federal Register / Vol. 61, No. 61 / Thursday, March 28, 1996 / Rules
and Regulations
[[Page 13956]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 230, 239, 270, and 274
[Release Nos. 33-7275; IC-21837; S7-34-93]
RIN 3235-AE17
Revisions to Rules Regulating Money Market Funds
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
-----------------------------------------------------------------------
SUMMARY: The Commission is adopting amendments to rules and forms under
the Securities Act of 1933 and the Investment Company Act of 1940 that
govern money market funds. The amendments tighten the risk-limiting
conditions imposed on tax exempt money market funds by rule 2a-7 under
the Investment Company Act of 1940; impose additional disclosure
requirements on tax exempt funds; and make certain other changes
applicable to all money market funds. The amendments are designed to
reduce the likelihood that a tax exempt fund will not be able to
maintain a stable net asset value.
EFFECTIVE DATE: June 3, 1996. Several different compliance dates apply
to the amendments. For specific compliance dates for particular
amendments, see Section V. of this Release.
FOR FURTHER INFORMATION CONTACT: Martha H. Platt, Senior Attorney,
(202) 942-0725, or Kenneth J. Berman, Assistant Director, Office of
Regulatory Policy, (202) 942-0690, Division of Investment Management,
Securities and Exchange Commission, 450 Fifth Street, N.W., Washington,
D.C. 20549. Requests for formal interpretive advice should be directed
to the Office of Chief Counsel (202) 942-0659, Division of Investment
Management, 450 Fifth Street, N.W., Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission
(``Commission'') is adopting amendments to rule 2a-7 [17 CFR 270.2a-7]
(``rule 2a-7'' or the ``rule'') under the Investment Company Act of
1940 [15 U.S.C. 80a-1 et seq.] (``1940 Act''), the rule governing the
operations of money market funds (``money funds'' or ``funds'').1
The Commission is also adopting a new rule, rule 17a-9 under the 1940
Act [17 CFR 270.17a-9], and amendments to the following rules and
forms: rule 134 under the Securities Act of 1933 [17 CFR 230.134];
rules 2a41-1, 12d-3 and 31a-1 under the 1940 Act [17 CFR 270.2a-41-1,
270.12d3-1, and 270.31a-1]; Form N-1A [17 CFR 239.15A and 274.11A];
Form N-3 [17 CFR 239.17a and 274.11b]; and Form N-SAR [17 CFR 274.101].
The Commission is also publishing three new or revised staff guides to
Forms N-1A and N-3 that do not appear in the Code of Federal
Regulations.
\1\ Unless otherwise noted, all references to rule 2a-7, as
amended, or any paragraph of the rule, will be to 17 CFR 270.2a-7 as
amended by this Release.
---------------------------------------------------------------------------
Table of Contents
Executive Summary
I. Background
II. Amendments to Rule 2a-7
A. Preliminary Matters
B. Portfolio Quality and Diversification
1. Five Percent Diversification Test
a. Application to Tax Exempt Funds
b. Scope of the Diversification Standards
2. Quality Limitations on Portfolio Securities
a. Proposed Limitations for Single State Funds
b. Application of the Second Tier Securities Tests to Conduit
Securities
c. Definition of the Term ``Conduit Security''
C. Diversification and Quality Standards for Put Providers
1. Put Diversification Standards
a. Uniform Diversification Standards for Conditional and
Unconditional Puts
b. The Twenty-Five Percent Put Basket
c. Issuer-Provided Demand Features
d. Multiple Puts and Guarantees
2. Quality Standards
a. Rating Requirement for Demand Features
b. Providers of Puts in Excess of Five Percent of Fund Assets
c. Certain Unrated Securities
3. Conditional Demand Features
4. Other Issues Applicable to Put Providers
a. Accrued Interest
b. Notice of Substitution of Put Provider
c. Liquidity Requirements for Money Funds and the Three Business
Day Settlement Cycle
5. Short-Term Ratings
D. Other Diversification and Quality Standards
1. Repurchase Agreements
2. Pre-Refunded Bonds
3. Diversification Safe Harbor
4. Three-Day Safe Harbor
E. Asset Backed Securities and Synthetic Securities
1. Background
2. Definitions
3. Diversification Standards
a. Diversification: General
(1) Special Purpose Entity as Issuer
(2) Looking through the Special Purpose Entity
b. Diversification: First Loss Guarantees
4. Quality Standards
5. Maturity Standards
F. Variable and Floating Rate Securities
1. Maturity Determinations: Floating Rate Securities
2. Maturity Determinations: Variable Rate Securities
3. Adjustable Rate Government Securities
4. Other Issues Concerning Adjustable Rate Securities
a. Background
b. Recordkeeping Requirement
G. Other Amendments to Rule 2a-7
1. U.S. Dollar Denominated Instruments
2. Investment in Other Money Funds
3. Board Approval and Reassessment of Certain Securities
4. Recordkeeping
5. Defaulted Securities
6. Technical Amendments
III. Amendments to Disclosure Rules
A. Single State Funds
B. Disclosure Concerning Exposure to Put Providers
C. Risk Disclosure in Certain Communications
IV. Exemptive Rule Governing Purchases of Certain Portfolio
Securities By Affiliated Persons
V. Compliance Dates
A. General Compliance Date
B. Grandfathered Securities
C. Disclosure and Reporting
VI. Regulatory Flexibility Analysis
VII. Statutory Authority
VIII. Text of Rule and Form Amendments
Executive Summary
The Commission is adopting amendments to rule 2a-7 under the 1940
Act, the rule that governs the operations of money funds. The primary
purpose of the amendments is to tighten the risk-limiting conditions of
the rule applicable to tax exempt money funds and thereby reduce the
likelihood that a tax exempt fund will not be able to maintain a stable
net asset value. The amendments also affect taxable money funds in
certain respects. In addition, the Commission is adopting revisions to
the prospectus disclosure requirements for tax exempt money funds and a
new rule exempting certain transactions from the 1940 Act's limitations
on affiliated transactions.
In considering these amendments, the Commission has made changes
from the proposal designed to simplify compliance with the rule while
retaining the degree of flexibility necessary for money funds to
operate in accordance with their investment objectives. A brief summary
of the rule amendments is provided below.
Issuer Diversification and Quality Standards
The amendments extend the rule's diversification requirements to
tax exempt funds. A ``national'' tax exempt fund is limited to
investing no more than five percent of its assets in securities of a
single issuer (other than Government securities) (the ``Five Percent
Diversification Test''). A ``single state'' tax exempt fund is subject
to the same limitation but only with respect to seventy-five percent of
its assets; the remaining twenty-five percent of a
[[Page 13957]]
single state fund's assets (``twenty-five percent basket'') may be
invested in securities of one or more issuers, provided that they are
``first tier securities,'' as the term is defined in the rule. A tax
exempt fund is limited to investing five percent of its assets in
``second tier securities'' that are ``conduit securities,'' as these
terms are defined in the rule, with investment in the conduit
securities of any one issuer limited to one percent of fund assets. To
provide an additional element of flexibility, a security subject to an
``unconditional demand feature issued by a non-controlled person,'' as
defined in the rule, will be subject only to the rule's put
diversification requirements.
Diversification and Quality Standards Applicable to Providers of Puts
and Demand Features
The amendments provide that a fund cannot, with respect to seventy-
five percent of its assets, invest more than ten percent of its assets
in securities subject to puts from, or directly issued by, the same
institution. The remaining twenty-five percent of a fund's assets
(``twenty-five percent put basket'') may be subject to puts from, or
directly issued by, one or more institutions, provided that the puts
are first tier securities. A fund may not invest more than five percent
of its assets in securities subject to puts that are second tier
securities.
As proposed, a demand feature is an ``eligible security'' (as
defined in the rule) only if the demand feature (or its issuer) has
received a short-term rating from a nationally recognized statistical
rating organization (``NRSRO''). A conditional demand feature is an
eligible security if the limitations on its exercise can be readily
monitored by the fund's board of directors (or its delegate). The
amendments as adopted, however, do not specify the conditions that may
be included in a conditional demand feature.
Asset Backed Securities and ``Synthetic'' Securities
The amendments clarify the credit quality, diversification and
maturity determination standards applicable to synthetic and asset
backed securities (``ABSs''). Among other things, an ABS must have a
rating from a NRSRO to be eligible for fund investment.
Interest Rate Risk Analysis
The amendments also clarify that floating rate and variable rate
securities (``adjustable rate securities'') must reasonably be expected
to have market values that approximate their amortized cost values on
each interest rate adjustment date through their final maturity dates.
The amendments require funds to review periodically whether such
securities can reasonably be expected to have market values that
approximate their amortized cost values upon readjustment of their
interest rates.
Exemptive Rule
The Commission is adopting rule 17a-9 under the 1940 Act to permit
(but not require) an affiliate of a fund to purchase from the fund
securities that are no longer eligible securities at the higher of
their amortized cost values (including accrued interest) or market
values, without having to obtain a Commission order.
I. Background
Money funds are open-end management investment companies registered
under the 1940 Act that have as their investment objective generation
of income and preservation of capital and liquidity through investment
in short-term, high quality securities. More than $775 billion in
assets is currently invested in approximately 25 million money fund
shareholder accounts.2 Approximately sixteen percent of money fund
assets ($127 billion) are held by funds that have as their principal
objective distribution of income exempt from federal income taxes
(``tax exempt funds'').3 Approximately one third of the assets
held by tax exempt funds ($43 billion) are held by funds that seek to
distribute income that is also exempt from the income taxes of a
specific state or locality (``single state funds'').4 The balance
is held by funds that do not limit their investments to securities
exempt from the income taxes of a specific state (``national funds'').
\2\ IBC's Money Fund Report at 2, Dec. 29, 1995 (``Money Fund
Report''); Investment Company Institute Mutual Fund Fact Book at 58-
59 (35th ed. 1995). For a summary of the development of money funds,
which were first introduced in the early 1970s, see Investment
Company Act Rel. No. 17589 (July 17, 1990) [55 FR 30239 (July 25,
1990)] (``Release 17589'') at nn.3-7 and 15-18 and accompanying
text.
\3\ Money Fund Report, supra note 2, at 2.
\4\ Single state funds are currently available for sixteen
states: Alabama, Arizona, California, Connecticut, Florida,
Massachusetts, Michigan, Minnesota, Missouri, New Jersey, New York,
North Carolina, Ohio, Pennsylvania, Texas and Virginia. Id.
---------------------------------------------------------------------------
Unlike other investment companies, money funds seek to maintain a
stable share price, typically $1.00 per share. This stable share price
of $1.00 has encouraged investors to view investments in money funds as
an alternative to either bank deposits or checking accounts, even
though money funds lack federal deposit insurance, and there is no
guarantee that money funds will maintain a stable share price.5
\5\ A money fund is required to disclose prominently on the
cover page of its prospectus that: (1) the shares of the fund are
neither insured nor guaranteed by the U.S. Government; and (2) there
can be no assurance that the fund will be able to maintain a stable
net asset value of $1.00 per share. See, e.g., Item 1(vi) of Form N-
1A. The prescribed legend must appear in money fund sales literature
and advertisements as well. See paragraph (a) of rule 34b-1 under
the 1940 Act, and paragraph (a)(7) of rule 482 under the Securities
Act of 1933 (``1933 Act'').
---------------------------------------------------------------------------
To maintain a stable share price, most money funds use the
amortized cost method of valuation (``amortized cost method'') 6
or the penny-rounding method of pricing (``penny-rounding method'')
7 permitted by rule 2a-7. The 1940 Act and applicable rules
generally require investment companies to calculate current net asset
value per share by valuing portfolio instruments at market value or, if
market quotations are not readily available, at fair value as
determined in good faith by, or under the direction of, the board of
directors.8 Rule 2a-7 exempts money funds from these provisions,
but contains conditions designed to minimize the deviation between a
fund's stabilized share price and the market value of its
portfolio.9 If the deviation does become significant, the fund may
be required to take certain steps to address the
[[Page 13958]]
deviation, including selling and redeeming its shares at less than
$1.00 (``breaking a dollar'').10
\6\ Under the amortized cost method, portfolio securities are
valued by reference to their acquisition cost as adjusted for
amortization of premium or accretion of discount. Paragraph (a)(1)
of rule 2a-7, as amended.
\7\ Share price is determined under the penny-rounding method by
valuing securities at market value, fair value or amortized cost and
rounding the per share net asset value to the nearest cent on a
share value of a dollar, as opposed to the nearest one tenth of one
cent. Paragraph (a)(15) of rule 2a-7, as amended. See also
Investment Company Act Rel. No. 13380 (July 11, 1983) [48 FR 32555
(July 18, 1983)] (``Release 13380'') (adopting rule 2a-7) at n.6,
and Investment Company Act Rel. No. 12206 (Feb. 1, 1982) [47 FR 5428
(Feb. 5, 1982)] (``Release 12206'') (proposing rule 2a-7) at n.5.
\8\ See section 2(a)(41) of the 1940 Act [15 U.S.C. 80a-
2(a)(41)], together with rules 2a-4 and 22c-1 [17 CFR 270.2a-4 and
270-22c-1]. See also Accounting Series Release No. 118 (Dec. 23,
1970 [35 FR 19986 (Dec. 31, 1970)] (board may appoint persons to
assist in determination of securities' values).
\9\ If shares are sold or redeemed based on a net asset value
which has been either understated or overstated in comparison to the
amount at which portfolio instruments could have been sold, the
interests of either existing shareholders or new investors will be
diluted. See Investment Trusts and Investment Companies: Hearings on
S. 3580 Before a Subcomm. of the Sen. Comm. on Banking and Commerce,
76th Cong., 3d Sess. 136-138, 288 (1940), Report of the Staff of the
Division of Investment Management of the Securities and Exchange
Commission on the Regulation of Money Market Funds Before the
Subcommittee on Financial Institutions of the Senate Committee on
Banking, Housing, and Urban Affairs at 9 (Jan. 24, 1980), and
Release 17589, supra note 2, at n.7.
\10\ Paragraphs (c)(6) and (c)(7) of rule 2a-7, as amended.
---------------------------------------------------------------------------
In February 1991, the Commission amended rule 2a-7 (the ``1991
Amendments'') 11 to respond to developments in the commercial
paper market since the rule was adopted in 1983.12 Among other
things, the 1991 Amendments permit funds to invest only in ``eligible
securities,'' defined generally as securities that are rated in one of
the highest two short-term rating categories by the ``requisite
NRSROs,'' 13 or comparable unrated securities. Taxable funds must
further limit their investments in the securities of any one issuer
(other than Government securities) 14 to five percent of fund
assets (``Five Percent Diversification Test''),15 and limit fund
investment in second tier securities 16 to no more than five
percent of fund assets, with investment in the second tier securities
of any one issuer being limited to the greater of one percent of fund
assets or one million dollars (``Second Tier Securities
Tests'').17
\11\ Investment Company Act Rel. No. 18005 (Feb. 20, 1991) [56
FR 8113 (Feb. 27, 1991)] (``Release 18005''). The 1991 Amendments
were proposed in Release 17589, supra note 2, and became effective
on June 1, 1991.
\12\ Before the 1991 Amendments, rule 2a-7 permitted funds to
invest in ``high quality'' securities, that is, securities that had
received at least the second highest rating from one NRSRO. See
Release 13380, supra note 7, at n.34. In the summer of 1989 and the
spring of 1990, several taxable funds held approximately $125
million in defaulted commercial paper issued by Mortgage and Realty
Trust or Integrated Resources Inc.; in the fall of 1990 several
funds held commercial paper issued by MNC Financial Corp. that was
downgraded to below high quality, resulting in a significant decline
in its market price. In all three cases, the commercial paper had
the second highest rating from one NRSRO when purchased by the funds
and thus was eligible for fund investment under rule 2a-7 as then in
effect. Shareholders of funds that held these commercial paper
issues were not adversely affected, however, because each fund's
investment adviser purchased the paper from the funds at amortized
cost or principal amount or otherwise agreed to indemnify the fund.
See Release 17589, supra note 2, at n.18 and accompanying text.
\13\ ''Requisite NRSROs'' are defined as: (1) any two NRSROs
that have issued a rating with respect to an instrument or class of
debt obligations of an issuer, or (2) if only one NRSRO has issued a
rating with respect to such instrument or issuer at the time the
fund purchases or rolls over the security, that NRSRO. Paragraph
(a)(19) of rule 2a-7, as amended.
The term ``NRSRO'' is defined in paragraph (a)(14) of rule 2a-7
to have the same meaning as in the Commission's uniform net capital
rule [17 CFR 240.15c3-1(c)(2)(vi)(E), (F) and (H)]. The Commission's
Division of Market Regulation responds to requests for NRSRO
designation through no-action letters. Currently, the Division of
Market Regulation has designated six NRSROs: Duff and Phelps, Inc.,
Fitch Investors Services, Inc., Moody's Investors Service Inc.,
Standard & Poor's Corp., and two specialized NRSRO's: IBCA Limited
and its subsidiary, IBCA Inc., which is recognized as a NRSRO only
with respect to its ratings of debt issued by banks, bank holding
companies, United Kingdom building societies, broker-dealers and
broker-dealers' parent companies, and bank-supported debt, and
Thomson BankWatch, Inc., which is recognized as a NRSRO only with
respect to ratings for debt issued by banks, bank holding companies,
non-bank banks, thrifts, broker-dealers, and broker-dealers' parent
companies. In recognition of the expanded use of credit ratings in
Commission rules, the Commission solicited comment on the process
employed to designate rating agencies as NRSROs and the nature of
the Commission's oversight role with respect to NRSROs in a concept
release issued in 1994. Exchange Act Rel. No. 34616 (Aug. 31, 1994)
[59 FR 46314 (Sept. 7, 1994)].
\14\ Under paragraph (a)(13) of rule 2a-7, as amended, the term
``Government Security'' means those securities issued or guaranteed
by the United States or its instrumentalities--the definition of
that term given in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-
2(a)(16)]. It does not include securities issued or guaranteed by
the state governments or instrumentalities. For a discussion of
securities issued by government-sponsored enterprises (``GSEs''),
see Joint Report on the Government Securities Market (Jan. 1992) at
p. D-1.
\15\ Paragraph (c)(4)(i) of rule 2a-7, as amended. A limited
exception is provided for certain securities held for not more than
three business days. See infra Section II.D.4. of this Release.
\16\ A ``second tier security'' is an eligible security that is
not a ``first tier security.'' Paragraph (a)(20) of rule 2a-7, as
amended. A first tier security is generally a security that is rated
by the requisite NRSROs in the highest rating category for short-
term debt obligations, and comparable unrated securities. Paragraph
(a)(11) of rule 2a-7, as amended.
\17\ Paragraph (c)(4)(iv)(A) of rule 2a-7, as amended. The 1991
Amendments also shortened the maximum dollar-weighted portfolio
maturity that a fund may maintain from 120 to ninety days, and
codified the actions that a fund must take when certain events
occur, including defaults and rating downgrades. See paragraphs
(c)(2) and (c)(5) of rule 2a-7, as amended. The 1991 Amendments also
require that the cover page of fund prospectuses and certain fund
advertisements and sales literature state prominently that
investment in a fund is not guaranteed or insured by the U.S.
Government and that there can be no assurance that a fund can
maintain a stable net asset value per share. See Form N-1A, item
1(a)(vi); Form N-3, item 1(a)(ix); rule 482(a)(7) under the 1933 Act
[17 CFR 230.482(a)(7)]; and rule 34b-1 under the 1940 Act [17 CFR
270.34b-1].
---------------------------------------------------------------------------
The 1991 Amendments did not apply the Five Percent Diversification
Test and the Second Tier Securities Tests to tax exempt funds.18
At that time, the Commission concluded that most tax exempt funds could
not satisfy these tests without substantially restructuring their
portfolios and, perhaps, losing some of their tax advantages.19
Single state funds were thought to present particular problems because
they concentrate their investments in debt securities issued by a
single state (or issuers located within that state), making
diversification more difficult to achieve. After the adoption of the
1991 Amendments, the Commission closely examined the characteristics of
short-term tax exempt securities, the markets in which they trade, and
tax exempt fund portfolios to determine what, if any, revisions to rule
2a-7 should be proposed to provide tax exempt fund investors with
protections similar to those afforded taxable fund investors by the
1991 Amendments.
\18\ Tax exempt funds continue to be subject to a
diversification test with respect to puts, as they had been prior to
the adoption of the 1991 Amendments. Paragraphs (c)(4)(v) and
(c)(4)(vi)(B) of rule 2a-7, as amended.
\19\ Release 17589, supra note 2, at Section II.6.
---------------------------------------------------------------------------
The results of the Commission's examination of the tax exempt
markets were reflected in amendments to rule 2a-7 that were proposed
for comment on December 17, 1993 (``Proposing Release'').20 A
primary objective of the proposed amendments was to tighten the
diversification and portfolio quality standards applicable to tax
exempt funds to make them more similar to the standards applicable to
taxable funds. The proposed diversification and quality standards for
tax exempt funds took into account the different investment objectives
and portfolio compositions of national funds and single state funds,
and would have established different requirements for each type of tax
exempt fund.
\20\ Investment Company Act Rel. No. 19959 (Dec. 17, 1993) [58
FR 68585 (Dec. 28, 1993)] at Section I.A.
---------------------------------------------------------------------------
The Commission received comments on the proposed amendments from
seventy-one commenters, including twelve municipal issuers, twenty-two
mutual fund complexes, and nine professional and trade
associations.21 The comment letters reflect a wide variety of
views on almost every topic discussed in the Proposing Release. A
number of commenters, expressing a general concern over the complexity
of the rule, urged that the rule's diversification and quality
standards for taxable and tax exempt funds be as consistent with each
other as practicable so that the rule would not become too complicated.
\21\ The comment period for the Proposing Release was extended
from April 6, 1994 to May 6, 1994. See Investment Company Act Rel.
No. 20184 (Mar. 31, 1994) [59 FR 16576 (Apr. 7, 1994)]. The comment
letters and a summary of the comments prepared by the Commission
staff are included in File No. S7-34-93.
---------------------------------------------------------------------------
As part of its evaluation of the proposal, the Commission
considered recent events in the markets for municipal securities that
had a significant effect on money funds. One such event was the
bankruptcy of Orange County, California, a large municipal issuer of
short-term taxable and tax exempt notes.22 At the time of
[[Page 13959]]
Orange County's bankruptcy, a number of taxable and tax exempt funds
held notes issued by either Orange County or municipalities that
invested in investment pools managed by the Orange County treasurer
(``Orange County notes''). While no fund holding Orange County notes
has broken a dollar to date (in large part because of actions taken by
their advisers to support the funds' share prices) the Orange County
bankruptcy reinforced the need to amend rule 2a-7 to address issues
unique to tax exempt funds.23
\22\ On December 6, 1994, Orange County and investment pools
managed by the Orange County treasurer (``Orange County Pools'')
filed for protection under chapter 9 of the Federal Bankruptcy Code
[11 U.S.C. 901 et seq.]. The U.S. Bankruptcy Court for the Central
District of California subsequently determined that the Orange
County Investment Pools were not eligible to seek protection under
chapter 9. See ``Orange County, Mired in Investment Mess, Files for
Bankruptcy,'' Wall St. J., Dec. 7, 1994 at A1, A6; Michael Utley,
``Judge Rules Pool's Bankruptcy Filing Invalid, But Impact is Mostly
Academic,'' Bond Buyer, May 26, 1995 at 1, 36.
\23\ The Division of Investment Management addressed analogous
issues raised by the Orange County bankruptcy in July 1991, when New
Jersey regulators seized Mutual Benefit Life Insurance Company
(``MBLI''). A number of securities held by tax exempt funds were
subject to demand features provided by MBLI. After its seizure by
the New Jersey insurance regulators, MBLI could no longer honor its
obligations under the terms of the demand features it provided.
Advisers to funds holding MBLI-backed securities took various
actions to prevent shareholder losses that would have occurred had
the funds been required to break a dollar. The advisers either
repurchased the MBLI-backed instruments from the funds at their
amortized cost or obtained a replacement guarantor.
---------------------------------------------------------------------------
II. Amendments to Rule 2a-7
A. Preliminary Matters
The Commission is today adopting the second of two sets of
amendments to rule 2a-7 under the 1940 Act designed to tighten the
risk-limiting conditions of the rule. These amendments primarily deal
with tax exempt funds; they are intended to provide investors in tax
exempt money market funds with protections similar to those provided to
investors in taxable funds by the 1991 Amendments. The Commission
believes that these amendments are necessary to provide greater
assurance that tax exempt money market funds meet investors'
expectations for safety and convenience by reducing the likelihood that
these funds will not be able to maintain a stable net asset value using
pricing procedures permitted by rule 2a-7.
The amendments to rule 2a-7 adopted in 1991, while not insulating
funds from all events that could threaten their net asset values,
appear to have reduced the riskiness of money market funds at a modest
cost to money fund investors in terms of reduced yield.24 The
Commission acknowledges that none of its rules can eliminate completely
the risk that a money market fund will break a dollar as a result of a
decrease in value of one or more of its portfolio securities. Thus, in
adopting these amendments, the Commission is prescribing minimum
standards designed not to ensure that a fund will not break a dollar,
but rather to require the management of funds in a manner consistent
with the investment objective of maintaining a stable net asset value.
\24\ See ``Has the SEC Reduced the Riskiness of Money Market
Funds? An Assessment of the Recent Changes to Rule 2a-7,'' S.
Collins and P. Mack (Nov. 1993)(study by economists for the Board of
Governors of the Federal Reserve System of money fund data indicated
decrease in risk and 20 basis point reduction in yields due to 1991
Amendments).
---------------------------------------------------------------------------
A money fund's board of directors has oversight responsibility for
the sound management of the fund.25 The fund's adviser is
typically delegated responsibility for selecting appropriate
investments for the fund. Rule 2a-7 requires that fund investments
should be made in accordance with procedures ``reasonably designed'' to
maintain a stable net asset value or share price.26 In addition,
investments made in accordance with such procedures should be
consistent with maintaining a stable net asset value or share price.
Rule 2a-7 provides an analytical framework for fund advisers to follow
when making such investment decisions, including decisions regarding
new types of securities not specifically addressed by the rule,
Commission releases, or staff interpretive letters. As the Commission
stated in 1991, that a particular security is technically eligible for
fund investment under rule 2a-7 is not itself an adequate basis for an
investment in the security.27 For example, a number of money funds
recently invested in certain structured notes that were Government
securities on the asserted belief that the provisions of rule 2a-7
dealing with adjustable rate Government securities would permit such an
investment. When short-term interest rates increased in early 1994, the
values of these securities decreased and many became illiquid.28
These and other types of losses are more likely to be avoided if a fund
has in place, and operates in accordance with, procedures designed to
determine whether investment in the security is consistent not only
with the technical requirements of rule 2a-7, but with the rule's
analytical framework and with the fund's investment objective of
maintaining a stable net asset value.
\25\ See Investment Company Act Rel. No. 13380, supra note 7, at
nn. 40-42 and accompanying text.
\26\ Paragraphs (c)(6)(i) and (c)(7) of rule 2a-7, as amended.
\27\ Release 18005, supra note 11, at Section II.A.
\28\ See infra Section II.F.4.a. of this Release.
---------------------------------------------------------------------------
In preparing these rules for adoption, the Commission has weighed
carefully the need to provide a similar level of safety for investors
in tax exempt and taxable money funds and the need, frequently
expressed by fund commenters, to allow tax exempt funds sufficient
flexibility to cope with a limited supply of high quality municipal
securities. For example, while the amendments adopted today limit all
funds to investing not more than five percent of assets in the
securities of any one issuer, the amendments limit the application of
this standard to only seventy-five percent of single state fund assets
and exclude from the diversification requirements for all funds
securities subject to certain types of demand features, refunding
agreements, and issuer-provided puts.29
\29\ See infra Sections II.B.1.b., II.C.1.c. and II.D.2. of this
Release, and paragraphs (c)(4) (i) and (ii), (c)(4)(vi)(A)(2) and
(c)(4)(vi)(B)(1) of rule 2a-7, as amended.
---------------------------------------------------------------------------
In response to comment letters, the Commission has simplified the
operation of the rule in several respects. Where possible, the same
provisions are applied to all types of funds, separate diversification
tests for issuers of conditional and unconditional puts have been
eliminated, and fund board involvement is no longer required regarding
matters with which directors can be expected to have little expertise.
Wherever possible, headings and cross-references have been added to the
rule to assist a reader in understanding how its provisions
interrelate.
B. Portfolio Quality and Diversification
1. Five Percent Diversification Test
a. Application to Tax Exempt Funds. As discussed above, taxable
funds are subject to the Five Percent Diversification Test, that is, no
more than five percent of the total assets of a taxable money fund may
be invested in securities of a single issuer. In proposing to extend
diversification standards to tax exempt funds, the Commission took into
account the differences between national and single state funds. Most
national funds elect to meet the diversification requirements of
section 5(b)(1) of the 1940 Act,30 and
[[Page 13960]]
choose not to use the ``twenty-five percent basket'' (the portion of a
diversified fund's assets that is not required to be diversified) to
invest more than five percent of their assets in a single issuer. Most
commenters, including most mutual fund commenters, supported the
extension of the Five Percent Diversification Test to national funds,
which the Commission is adopting as proposed.31
\30\ Section 5(b)(1) provides that a diversified investment
company may not, with respect to seventy-five percent of its assets,
invest more than five percent of its assets in instruments of any
one issuer, other than cash, cash items, Government securities (as
defined in section 2(a)(16) of the 1940 Act [15 U.S.C. 80a-
2(a)(16)]) and securities of other investment companies. The
remaining twenty-five percent of its assets (the ``twenty-five
percent basket'') may be invested in any manner. If an investment
company invests more than five percent of its assets in a single
issuer, the entire investment is placed in the twenty-five percent
basket, and then aggregated with other investments that are greater
than five percent to determine whether the fund is in compliance
with section 5(b)(1). The investment company may not invest more
than twenty-five percent of its assets in a single issuer by
splitting its investment into two lots between the twenty-five
percent basket and the diversified portion of its portfolio. See
Lybrand, Ross Bros. & Montgomery (Oct. 24, 1941) (pub. avail. Nov.
22, 1991). Section 5(b)(1) also prohibits a diversified fund, with
respect to seventy-five percent of its assets, from investing in
securities that comprise more than ten percent of the outstanding
voting securities of an issuer.
\31\ Paragraph (c)(4)(i) of rule 2a-7, as amended.
---------------------------------------------------------------------------
Unlike national funds, many single state funds are not diversified
under section 5(b)(1), and could not satisfy the Five Percent
Diversification Test because their investment objectives provide them
with a much narrower range of high quality investment
alternatives.32 Although the Commission expressed concern about
the risks involved in a non-diversified portfolio of a money fund, it
was unclear to the Commission that it would be possible for single
state funds to satisfy the Five Percent Diversification Test.
Accordingly, the proposed amendments would not have required single
state funds to comply with any issuer diversification test under the
rule. To reduce the risks associated with a non-diversified portfolio,
the Commission proposed to limit single state funds to investing in
first tier securities, and proposed additional disclosure requirements
to inform investors of the risks of an undiversified single state
fund.33 The Commission also asked commenters to consider whether
single state funds should be required to satisfy a diversification
standard under the rule.34
\32\ Proposing Release, supra note 20, at Sections II.A. and
II.A.2.
\33\ Proposed amendments to Form N-1A would have required a
single state fund to disclose in its prospectus risks related to
lack of diversification. Proposing Release, supra note 20, at
Section III.A.
\34\ Proposing Release, supra note 20, at Section II.A.2.
---------------------------------------------------------------------------
Most commenters supported the exception from the Five Percent
Diversification Test for single state funds. Many of these commenters,
however, opposed the proposed first tier securities restriction, and
asserted that this requirement would exacerbate the supply problem
without making funds more safe by forcing single state funds to be less
diversified. Other commenters maintained that the rule should mandate
some diversification with respect to single state funds, which they
asserted present greater risks than other types of money funds. One
commenter suggested that single state funds offering securities from
``large'' states should be subject to the same diversification
standards as national funds. Another commenter went even further,
stating that the rule should impose the diversification standards
applicable to national funds to all single state funds. The views of
these commenters, as well as the Commission's experience in
administering rule 2a-7 since the amendments were proposed, have led
the Commission to reconsider its proposal to exempt single state funds
entirely from a diversification test.
In proposing the 1991 Amendments, the Commission noted that a
fund's ability to maintain a stable net asset value under the rule may
be impaired to the extent it invests heavily in one or more issuers
that subsequently experience credit problems or default on their
securities.35 The validity of that observation has been proven by
many of the incidents of the past two years in which advisers to funds
have taken steps to prevent the fund from breaking a dollar as a result
of holding a distressed security.36 In each case, the smaller the
position, the less of an effect the distressed security had on the
fund.
\35\ Release 17589, supra note 2, at Section II.1.
\36\ Transactions of this type occurred within the last two
years because funds held either long-term adjustable rate securities
whose market values declined when short-term interest rates were
increased, or notes issued by Orange County. Twenty-five advisers or
related persons purchased adjustable rate securities from their
funds at the securities' amortized cost values to avoid any fund
shareholder losses. Thirty-eight advisers or related persons either
purchased Orange County notes from, or entered into credit support
arrangements with their affiliated funds in order to maintain the
funds' stable share price of $1.00. These transactions are
prohibited by section 17 of the 1940 Act [15 U.S.C. 80a-17] in the
absence of a Commission exemption. See infra Section IV. of this
Release.
---------------------------------------------------------------------------
In the case of the bankruptcy of Orange County, most of the funds
holding the notes held a fairly small portion of their assets in Orange
County notes.37 As a result, in some cases, the fund could
maintain its share price without any assistance from the fund's
adviser; in other cases, the adviser was in a position to take steps to
prevent the fund from breaking a dollar only because the fund's Orange
County Note position was relatively small. While, as the Commission has
stated several times, no adviser is required to guarantee its fund
against the possibility of breaking a dollar,38 experience has
demonstrated that diversification may not only limit investment risk,
but also may place the fund in a better position to address (or avoid)
significant deviation between a fund's market-based and amortized cost
values.
\37\ The thirty-eight funds that sought and were granted ``no-
action'' relief from the Division of Investment Management either to
sell the Orange County notes to affiliated persons, or to arrange
for affiliated persons to provide some type of credit support for
the benefit of the funds, are illustrative. Most of these funds had
no more than five percent of their assets invested in notes issued
by Orange County, or one of the participants in the Orange County
Investment Pools. Within this group, the fund (a single state fund)
that had the greatest concentration of its assets in securities
issued by a single issuer had 8.7 percent of its assets invested in
that issuer.
\38\ See, e.g., Release 18005, supra note 11, at Section II.H.;
Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange
Commission, Concerning Issues Affecting the Mutual Fund Industry
Before the Subcommittee on Telecommunications and Finance, Committee
on Energy and Commerce, U.S. House of Representatives, 23-25 (Sept.
27, 1994); Testimony of Arthur Levitt, Chairman, U.S. Securities and
Exchange Commission, Concerning Municipal Bond and Government
Securities Markets Before the Committee on Banking, Housing and
Urban Affairs, U.S. Senate, 10-11 (Jan. 5, 1995).
---------------------------------------------------------------------------
The Commission recognizes that single state funds face a limited
choice of very high quality issuers in which to invest, and that the
number of first tier issuers in several states is especially limited.
Application of the Five Percent Diversification Test to one hundred
percent of the assets of these funds could force some funds to invest
in lower quality issuers than those in which they would otherwise
invest. While greater diversification provides an additional measure of
safety for investors where there are many issuers to choose from, the
Commission is concerned that too stringent a diversification standard
could result in a net reduction in safety for certain single state
funds. As a result, the Commission has decided to require single state
funds to be diversified at the five percent level only as to seventy-
five percent of their assets; the remaining twenty-five percent basket
may be invested only in the first tier securities of one or more
issuers. The availability of the twenty-five percent basket will
provide single state funds with the flexibility to retain several
positions of over five percent in very high quality investments.39
\39\ Application of the non-diversified basket will track the
comparable provision of section 5(b)(1) of the 1940 Act [15 U.S.C.
80a-5(b)(1)]. See supra note 30.
---------------------------------------------------------------------------
The Commission has decided to exclude from the application of the
[[Page 13961]]
diversification requirement securities that are subject to an
unconditional demand feature from a non-controlled person, as defined
in the rule.40 This approach will be applicable to all money
funds, not only single state funds. The Commission believes that this
approach, described in more detail below, will provide the advantages
of diversification while permitting funds sufficient flexibility to
respond to the available supply of eligible securities.
\40\ Paragraphs (c)(4)(i) and (ii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
b. Scope of the Diversification Standards. A large percentage
(sixty to seventy percent) of the securities currently held in tax
exempt fund portfolios consist of long-term adjustable rate securities
that are subject to unconditional demand features.41 The provider
of an unconditional demand feature assumes the credit risks presented
by a particular issuer by agreeing to provide principal and interest
payments in the event the issuer of the underlying security is unable
to do so. Funds generally rely on the credit quality of the issuer of
an unconditional demand feature to satisfy the rule's quality
standards.42 In light of this reliance, two commenters questioned
the necessity of requiring a fund to satisfy the rule's issuer
diversification and quality standards with respect to the issuer of the
underlying security.43
\41\ Proposing Release, supra note 20, at Section I.B.
\42\ Paragraph (c)(3)(ii) of rule 2a-7, as amended, permits a
fund to rely on the credit quality of the unconditional demand
feature in determining whether the underlying security is an
eligible security or a first tier security.
\43\ The commenters discussed this issue within the context of
the rule's put diversification standards. See infra Section II.C.2.
of this Release.
---------------------------------------------------------------------------
If a security subject to an unconditional demand feature was in
default or otherwise became distressed, a money fund normally would be
expected to exercise the demand feature and receive the entire
principal amount of the security and any interest payments due or
accrued.44 Thus, lack of diversification in the underlying
security may be less important to a money fund's ability to maintain a
stable net asset value than the ability to exercise the demand feature.
Demand features are subject to a separate diversification requirement
under the rule and, thus, excessive reliance on the credit of a single
issuer is already addressed by the rule.45
\44\ Paragraph (c)(5)(ii) of rule 2a-7, as amended, requires a
money fund to dispose of a defaulted or distressed security (e.g.,
one that no longer presents minimal credit risks) ``as soon as
practicable,'' absent a finding by the board of directors that
disposal would not be in the best interests of the fund.
\45\ Demand features and other types of puts that enhance
underlying securities continue to be subject to the rule's put
diversification requirements. See infra Section II.C.1. of this
Release.
---------------------------------------------------------------------------
Based on these considerations, and in light of the greater
flexibility that would be afforded to single state funds, the
Commission has decided to amend the rule so that the issuer
diversification requirement--for all money funds--excludes securities
subject to an ``unconditional demand feature issued by a non-controlled
person,'' as defined in the rule.46 The Commission is limiting
this exclusion to securities whose unconditional demand features are
issued by non-controlled persons to reduce a fund's exposure to the
credit risks presented by a single economic enterprise.47
Securities subject to other types of puts, including conditional demand
features, would continue to be subject to the rule's issuer
diversification standard.
\46\ An ``unconditional demand feature issued by a non-
controlled person'' is defined in the rule to mean an
``unconditional put'' that is also a ``demand feature issued by a
non-controlled person.'' Paragraph (a)(26) of rule 2a-7, as amended.
A ``demand feature issued by a non-controlled person'' is defined to
mean ``a demand feature issued by a person that, directly or
indirectly, does not control, and is not controlled by or under
common control with the issuer of the security subject to the Demand
Feature. Control shall mean `control' as defined in section 2(a)(9)
of the Act.'' Paragraph (a)(8) of rule 2a-7, as amended.
\47\ Similarly, the twenty-five percent put basket will not be
available for puts that do not meet the definition of a put issued
by a non-controlled person. See infra Section II.C.1.b. of this
Release.
---------------------------------------------------------------------------
2. Quality Limitations on Portfolio Securities
Rule 2a-7 limits both taxable and tax exempt funds to investing
only in eligible securities--securities receiving at least the second
highest rating from the requisite NRSROs (as defined in the rule) or
comparable unrated securities.48 Taxable funds must comply with
the Second Tier Securities Tests--investment in second tier securities
is limited to five percent of fund assets, and investment in the second
tier securities of any one issuer is limited to the greater of one
percent of fund assets or one million dollars. The proposed amendments
to the rule would have established different quality standards for
national and single state funds.
\48\ See supra nn. 12 and 13 and accompanying text and paragraph
(a)(19) of rule 2a-7, as amended.
---------------------------------------------------------------------------
a. Proposed Limitations for Single State Funds. The proposed
amendments would have limited single state fund investment to first
tier securities. The Commission stated in the Proposing Release that
the first tier securities restriction was designed to reduce the
additional risks that may accompany lower levels of diversification as
a result of the Commission's proposal not to extend the Five Percent
Diversification Test to single state funds. As noted above, most fund
commenters objected to this limitation. In light of the requirement
that single state funds be diversified as to seventy-five percent of
their assets,49 the Commission has decided not to adopt the
proposed first tier securities restriction.
\49\ See supra Section II.B.1.a. of this Release and paragraph
(c)(4)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
b. Application of the Second Tier Securities Tests to Conduit
Securities. The proposed amendments to the rule would have extended the
Second Tier Securities Tests only to national fund investment in
``conduit securities.'' The Proposing Release explained that, in
contrast to traditional state and municipal securities, conduit
securities are issued to finance non-governmental private projects,
such as retirement homes, private hospitals, local housing projects,
and industrial development projects, with respect to which the ultimate
obligor is not a governmental entity. Conduit securities are not backed
by a revenue source from any essential public facility or by the taxing
authority of any state or municipality. As a result, the risk of
default for conduit securities is significantly higher than it is for
traditional state or municipal securities.50 Therefore, the
Commission proposed to treat a national fund's investment in conduit
securities no differently than a taxable fund's investment in
securities typically issued by a private concern.
\50\ See Municipal Bond Defaults--The 1980's: A Decade in Review
(J.J. Kenny & Co., Inc. 1993). Bankruptcies and defaults by major
municipal issuers, such as Orange County, California, are rare
events. Of the approximately 120 municipal bankruptcies since 1979,
most have involved small, local governments or special tax
districts. See ``Banging a Tin Cup With a Silver Spoon,'' N.Y.
Times, June 4, 1995 at F1.
---------------------------------------------------------------------------
Most commenters supported the application of the Second Tier
Securities Tests to national fund investment in conduit securities.
These commenters generally agreed that this limited application of the
Second Tier Securities Tests would allow national funds maximum
flexibility to invest in the type of tax exempt securities that present
the least risk of default. A smaller group of commenters, however,
asserted that the proposed limitation would further limit the supply of
eligible securities.51 Many conduit securities in which money
funds invest are subject to unconditional demand features. Because the
Second Tier
[[Page 13962]]
Securities Tests will not be applied to conduit securities with
unconditional demand features issued by non-controlled persons, the
application of the Second Tier Securities Tests to these securities
should have a limited effect on the supply of tax exempt
securities.52
\51\ See supra note 29 and accompanying text.
\52\ As adopted, the rule exempts from the Second Tier
Securities Tests any conduit security subject to an unconditional
demand feature issued by a non-controlled person, whether the demand
feature is first or second tier. Paragraph (c)(4)(iv)(B) of rule 2a-
7, as amended.
---------------------------------------------------------------------------
The Commission has decided to extend the Second Tier Securities
Tests to national and single state fund investment in conduit
securities. Under amendments to the rule being adopted, the non-
governmental entity ultimately responsible for the payment of principal
and interest is treated as the issuer of the conduit security for
purposes of the rule's issuer diversification requirements.53
Credit quality determinations for a conduit security must be made by
reference to the underlying corporate or project issuer, unless the
conduit security is subject to an unconditional demand feature, in
which case the conduit security will not be subject to the Second Tier
Securities Tests.54 Credit quality determinations for conduit
securities subject to conditional demand features must be made by
reference to the provider of the demand feature and the long-term
rating of the underlying corporate or project issuer.55 In
addition, for purposes of calculating compliance with the one percent
limit on second tier securities of a single issuer, the issuer of the
conduit is the corporation or project.56
\53\ Paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended.
\54\ Paragraph (c)(4)(iv)(B) of rule 2a-7, as amended.
\55\ See infra Section II.B.2.b. of this Release and paragraph
(c)(3)(iii) of rule 2a-7, as amended.
\56\ See paragraph (c)(4)(vi)(A)(3) of rule 2a-7, as amended.
For example, a municipal security issued to finance a private
hospital that meets the definition of a conduit security would be
considered--for diversification purposes--to have been issued by the
hospital, not the municipality.
---------------------------------------------------------------------------
c. Definition of the Term ``Conduit Security''. The proposed
amendments would have defined the term ``conduit security'' to mean a
security issued through a state or territory of the United States, or
any political subdivision or instrumentality thereof, which is not: (1)
payable from the revenues of such governmental unit (``Revenue
Clause''); (2) unconditionally guaranteed by such governmental unit;
(3) related to a project or facility owned and operated by such
governmental unit; or (4) related to a facility leased to and under the
control of an industrial or commercial enterprise that is part of a
public project owned and under the control of such governmental unit.
The definition was intended to exclude securities for which the
ultimate obligor is a governmental unit.
Several commenters advised the Commission that portfolio managers
would be able to identify conduit securities more readily and without
obtaining legal and other expert opinions if the rule affirmatively
stated what a conduit security is, instead of what it is not. Several
commenters also urged that the Revenue Clause be deleted because it
might result in excluding from the Second Tier Securities Tests a
security for which the ultimate obligor is a private entity.57 The
Commission has modified the definition of the term ``conduit security''
to reflect some of these concerns.58
\57\ For example, a governmental unit could issue bonds on
behalf of a private firm for the purpose of raising funds to
construct facilities for a company, such as a plant or a residential
real estate project. The payment of principal or interest on the
bonds would be secured through a lease arrangement under which the
private firm makes periodic payments to the governmental unit. If
these payments were characterized as ``revenue,'' then the bonds
issued by the governmental unit would not be treated as conduit
securities under the proposed definition.
\58\ In the Proposing Release, the Commission asked commenters
whether the rule's definition of a conduit security should reference
the provisions of the Internal Revenue Code (``IRC'') governing the
treatment of private activity bonds, IRC sections 141-174 [26 U.S.C.
141-147]. Most commenters discussing the definition of a conduit
security strongly opposed this approach, generally observing that it
would have the effect of treating certain general obligation bonds,
and bonds issued to finance property owned by a governmental unit,
as conduit securities that are subject to the Second Tier Securities
Tests, which would be inconsistent with the Commission's objective
of subjecting only obligations of non-governmental issuers to the
Second Tier Securities Tests. The Commission has decided not to
reference the IRC's private activity bond rules in defining the term
``conduit security.''
---------------------------------------------------------------------------
The term ``conduit security'' is defined as a security issued by a
municipal issuer involving an arrangement or agreement entered into,
directly or indirectly, with an issuer other than a municipal issuer,
which arrangement or agreement provides for or secures repayment of the
security.59 The term ``conduit security'' does not include a
security that is: (1) unconditionally guaranteed by a municipal issuer;
(2) payable from the general revenues of the municipal issuer (other
than revenues derived from an agreement or arrangement with a person
who is not a municipal issuer that provides for or secures repayment of
the security); (3) related to a project owned and operated by a
municipal issuer; or (4) related to a facility leased to and under the
control of an industrial or commercial enterprise that is part of a
public project which, as a whole, is owned and under the control of a
municipal issuer.60
\59\ Paragraph (a)(6) of rule 2a-7, as amended. The rule
amendments, as adopted, define the term ``municipal issuer'' to mean
a state or territory of the United States, or any political
subdivision or instrumentality thereof. The term ``state'' is
defined in the 1940 Act to mean any state, the District of Columbia,
Puerto Rico, the Virgin Islands, or any other possession of the
United States [15 U.S.C. 80a-2(a)(39)].
\60\ Paragraph (a)(6) of rule 2a-7, as amended.
---------------------------------------------------------------------------
C. Diversification and Quality Standards for Put Providers
A substantial portion of securities held by tax exempt funds are
subject to puts and demand features.61 A ``put'' is the right to
sell a specified underlying security within a specified period of time
and at a specified exercise price that may be sold, transferred, or
assigned only with the underlying security.62 A demand feature is
a put that may be exercised at specified intervals not exceeding 397
calendar days and upon no more than thirty days' notice.63 Demand
features can serve three different purposes: (1) to shorten the
maturity of a variable or floating rate security; 64 (2) to
enhance the security's credit quality; and (3) to provide liquidity
support for the security. If the demand feature can be exercised on
seven days' notice, then the security will be treated as a liquid
security under the appropriate guidelines.65
\61\ Proposing Release, supra note 20, at Section I.B.
\62\ Paragraph (a)(16) of rule 2a-7, as amended.
\63\ Paragraph (a)(7) of rule 2a-7, as amended.
\64\ Paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended.
Initially, rule 2a-7 provided that only demand features that ran to
the issuer of the security could be used to shorten maturities. See
Release 13380, supra note 7, at n.9. This was changed by the
amendments to rule 2a-7 adopted in 1986. Investment Company Act Rel.
No. 14983 (Mar. 12, 1986) [51 FR 9773 (Mar. 21, 1986)] (``Release
14983'').
\65\ A money fund is limited to investing no more than ten
percent of its assets in illiquid securities. See Release 13380,
supra note 7, at nn.37-38 and accompanying text. See also Investment
Company Institute (pub. avail. Dec. 9, 1992). The Division of
Investment Management has provided guidance concerning the
implementation of three business days as the standard settlement
period for trades effected by brokers and dealers, and a fund's
determination of whether securities it holds should be deemed liquid
for purposes of complying with the ten percent restriction. Letter
from Jack W. Murphy, Associate Director and Chief Counsel, Division
of Investment Management, to Paul Schott Stevens, General Counsel,
Investment Company Institute (May 26, 1995) (``T+3 Letter'').
---------------------------------------------------------------------------
Demand features may be conditional or unconditional.66 Under
rule 2a-7, a demand feature used as a substitute for
[[Page 13963]]
the credit quality of the underlying security must be an
``unconditional put,'' defined to include any guarantee, letter of
credit (``LOC'') or similar unconditional credit enhancement that by
its terms would be readily exercisable in the event of a default in
payment of principal or interest on the underlying security.67 A
demand feature that is not an ``unconditional put'' may serve as the
basis for determining whether a security is an eligible security and
categorizing it as a first or second tier security; however, the long-
term credit quality of the security subject to a conditional demand
feature must also be analyzed.68
\66\ Both conditional and unconditional puts may operate as
demand features to shorten the maturities of adjustable rate
securities. As discussed in Section II.C.3. of this Release, infra,
amendments to rule 2a-7 limit the types of conditions to which
exercise of a demand feature can be subject. Paragraph
(c)(3)(iii)(B) of rule 2a-7, as amended.
\67\ Paragraph (a)(27) of rule 2a-7, as amended.
\68\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------
The Commission is adopting several amendments to the provisions of
the rule relating to puts and demand features.
1. Put Diversification Standards
Under rule 2a-7, a taxable money fund may not invest more than five
percent of its assets in securities subject to conditional puts from,
or securities directly issued by, the same institution. The percentage
limitation applicable to unconditional puts is ten percent. A tax
exempt fund is required to comply with these two requirements with
respect to seventy-five percent of its assets; there is no
diversification requirement with respect to the remaining twenty-five
percent (``twenty-five percent put basket''). The Commission proposed
to apply a uniform ten percent limitation on all puts issued by the
same institution and to eliminate the twenty-five percent put basket
for tax exempt funds.69
\69\ See Proposing Release, supra note 20, at Section II.C.2.
---------------------------------------------------------------------------
a. Uniform Diversification Standards for Conditional and
Unconditional Puts. Under the proposed amendments, a fund could not
have invested more than ten percent of its assets in securities subject
to conditional and unconditional puts, and securities directly issued
by, the same issuer. A fund would have been required to aggregate
conditional and unconditional puts issued by the same issuer in
applying the ten percent restriction. Most of the commenters who
addressed these aspects of the proposal supported the aggregation of
conditional and unconditional puts in applying a uniform percentage
restriction. Other commenters disagreed, either urging that the ten
percent limit be raised or that the rule's put diversification
standards continue to distinguish between puts that provide liquidity
support (conditional puts) and puts that provide credit support
(unconditional puts).
The Commission has decided to adopt the uniform ten percent
limitation as proposed, and eliminate the current distinction between
conditional and unconditional puts under the rule's put diversification
standards.70 Although there are differences between the risks
incurred by the put provider and the nature of the reliance by the
investor in each case, the Commission does not believe that these
differences are significant enough to warrant continued disparate
treatment under the rule. Moreover, aggregating conditional and
unconditional puts and applying a single put diversification standard
to the aggregate number should simplify compliance with the rule.
\70\ Paragraph (c)(4)(v)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------
b. The Twenty-Five Percent Put Basket. The proposed amendments to
the rule would have eliminated the twenty-five percent put basket so
that a tax exempt fund would have been required to meet the rule's put
diversification standards with respect to one hundred percent of its
assets. The Commission explained that extensive reliance on a single
put provider or a few providers could present considerable risks,
particularly for a single state fund which, under the amendments as
proposed, would not have been required to be diversified with respect
to underlying securities.71
\71\ Proposing Release, supra note 20, at Section II.C.2.b.
---------------------------------------------------------------------------
Most commenters urged the Commission to retain the twenty-five
percent put basket in some form. Many concluded that eliminating the
twenty-five percent put basket would increase reliance by funds on less
creditworthy put providers and decrease the flexibility currently
afforded funds in enhancing the credit quality and liquidity of
securities. The commenters disagreed with the Commission's assumption
that one probable effect of the elimination of the twenty-five percent
put basket would be new entrants to the market as put providers.
A number of commenters suggested that, in light of the Commission's
proposal to require that when a fund invests more than five percent of
its assets in securities subject to puts from a single put provider,
the puts be first tier securities,72 it would be appropriate to
retain the twenty-five percent put basket. The Commission has decided
to incorporate this approach in amendments to the rule's put
diversification standards.
\72\ See infra Section II.C.2.b. of this Release.
---------------------------------------------------------------------------
The amendments provide that the twenty-five percent put basket is
available to all money funds for first tier puts, but only if the put
is a ``put issued by a non-controlled person''--a put issued by a
person that does not directly or indirectly control, and is not
controlled by or under common control with the issuer of the security
subject to the put.73 The Commission is restricting fund use of
the twenty-five percent put basket to non-controlled persons to
minimize a fund's concentration of assets in a single economic
enterprise.
\73\ Paragraphs (a)(17) (definition of ``put issued by a non-
controlled person'') and (c)(4)(v) of rule 2a-7, as amended. The
Commission is adopting amendments that limit fund investment in puts
that are second tier securities to five percent of fund assets. See
infra Section II.C.2.b. of this Release and paragraph (c)(4)(v)(B)
of rule 2a-7, as amended. Further, a fund that has invested more
than ten percent of its assets in securities subject to puts and in
securities directly issued by a single issuer must count the total
amount invested towards the twenty-five percent undiversified put
basket. In other words, a fund may not use all or a portion of its
twenty-five percent put basket and an additional amount of its
diversified assets to invest more than twenty-five percent of its
assets in a single issuer. See supra, note 30.
---------------------------------------------------------------------------
c. Issuer-Provided Demand Features. The put diversification
standards under rule 2a-7 apply to ``securities issued by or subject to
Puts from the institution that issued the Put.'' 74 In the
Proposing Release, the Commission requested comment on the treatment of
puts by the issuer of the underlying securities (``issuer-provided
demand features'').75 Some commenters asserted that funds should
be permitted to exclude issuer-provided demand features from the put
diversification requirements because issuer-provided demand features
can be viewed as the functional equivalent of short-term securities
that are ``rolled over'' periodically. The commenters also suggested
that including issuer-provided demand features as puts in determining
compliance with the rule's put diversification standards amounts to
``double counting.'' The Commission agrees and has added language to
the rule to clarify that a fund is not required to aggregate an issuer-
provided put with the security subject to the put for purpose of
determining compliance with the put diversification requirement of the
rule.76
\74\ Paragraph (c)(4)(v)(A) of rule 2a-7, as amended.
\75\ See Proposing Release, supra note 20, at Section
II.C.2.d.(3). The Commission noted that rule 2a-7, as originally
adopted, provided that only issuer-provided demand features could be
used to shorten the maturity of a security. See Release 13380, supra
note 7, at n.10 and accompanying text.
\76\ Paragraph (c)(4)(vi)(B)(1) of rule 2a-7, as amended. Under
this paragraph, a put issued by the same institution that issued the
underlying security would not be subject to the rule's put
diversification requirements, and would be subject only to the
rule's issuer diversification requirements. For example, a security
representing four percent of a fund's total assets that had an
issuer-provided demand feature would be treated as a four percent
position in ``securities issued by or subject to Puts from the
institution that issued the Put,'' not eight percent [quoting
paragraph (c)(4)(iv)(A) of rule 2a-7, as amended].
[[Page 13964]]
---------------------------------------------------------------------------
d. Multiple Puts and Guarantees. The proposed amendments would have
amended rule 2a-7's put diversification standards to address how put
diversification calculations should be made when a security is subject
to several puts (``multiple puts''). Under the proposed amendments,
different calculation methods would have been applied when: (i) each
multiple put provider had contractually agreed to guarantee only a
portion of the total principal value of the underlying security
(``fractional puts''), and (ii) each multiple put provider had an
obligation that was not limited contractually (``layered puts''). The
proposed amendments would have clarified that an institution that
provides a fractional put would be treated as guaranteeing only that
portion of the principal value of the security that it contractually
agreed to provide.77 An institution providing a layered put would
have been deemed to cover the entire principal amount of the security,
notwithstanding that the security is subject to puts from other
institutions.
\77\ For example, if two banks issued puts on the same VRDN and
each agreed to absorb fifty percent of the losses, then each would
be deemed to guarantee no more than fifty percent of the VRDN under
the rule's put diversification standards.
---------------------------------------------------------------------------
Most commenters who discussed these issues supported the proposed
treatment of fractional puts. These commenters stated that it was
appropriate to allocate exposure among put providers for
diversification purposes in accordance with the put providers'
contractual obligations. The Commission has decided to adopt these
amendments to the rule as proposed.78
\78\ Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as amended.
---------------------------------------------------------------------------
Most commenters opposed treating each put provider in a layered put
structure as the guarantor of the entire amount guaranteed because,
they argued, the approach ignored the fact that the fund may be relying
only on the guarantee of one of the put providers. The Commission has
decided to adopt amendments to the rule that reflect these comments.
For a security subject to layered puts, the rule permits a fund that is
not relying on a particular put for satisfaction of the rule's credit
quality 79 or maturity standards,80 or for liquidity, to
exclude that put when determining its compliance with the rule's put
diversification standards.81 The fund must document this
determination in its records.82
\79\ Under the rule, a fund holding a security that is subject
to an unconditional demand feature may satisfy the rule's credit
quality standards with respect to the underlying security based
solely on the short-term rating of the demand feature provider.
Paragraph (c)(3)(ii) of rule 2a-7, as amended.
\80\ Rule 2a-7 generally permits a fund to measure the maturity
of an adjustable rate security subject to a demand feature by
reference to the date on which principal can be recovered through
demand. See infra Sections II.F.1. and II.F.2. of this Release and
paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended.
\81\ Paragraph (c)(4)(vi)(B)(4) of rule 2a-7, as amended. This
paragraph of the rule also permits a fund holding a security subject
to a single put that it is not relying on to satisfy the rule's
credit quality or maturity standards, or for liquidity, to disregard
that put in determining its compliance with the rule's put
diversification standards. If a fund is relying on separate puts for
each of these purposes (e.g., a conditional demand feature for
purposes of liquidity and maturity, and an unconditional put for
purposes of credit quality), then each put would have to satisfy the
rule's put diversification standards.
\82\ Paragraphs (c)(8)(ii) and (c)(9)(vi) of rule 2a-7, as
amended. A fund would document this determination when it acquires
the security. The fund may subsequently determine that it is or is
not relying on a particular put, but must reflect the change in its
written records.
---------------------------------------------------------------------------
In the context of describing the proposed amendments regarding
treatment of multiple puts under the rule's diversification standards,
the Commission indicated that bond insurance was a type of put under
rule 2a-7.83 A number of commenters disagreed with this analysis
of bond insurance, arguing that bond insurance does not provide
liquidity and is not viewed by the market as a substitute for the
credit of the underlying issuer. Because bond insurance guarantees the
timely payment of principal and interest by the insured issuer,84
it meets the rule's definition of an unconditional put, permitting
credit substitution in the eligibility determination. The Commission
has amended the rule to clarify this matter.85
\83\ Proposing Release, supra note 20, at note 81.
\84\ Eli Nathans, Municipal Bond Insurance--The Economics of the
Market, 13 Mun. Fin. J., No.2 (Summer 1992) 1, 2.
\85\ Paragraph (a)(27) of rule 2a-7, as amended. A bond
insurance policy that permits the holder of the security to receive
all principal and interest payments at the time of the default of
the insured obligation would also be an unconditional demand
feature. By contrast, a policy under which the fund would only
receive periodic payments of principal and interest as those
payments came due under the terms of the insured obligation would be
an unconditional put, but not an unconditional demand feature.
---------------------------------------------------------------------------
The Commission recognizes, however, that bond insurance may not be
relied upon by a fund when determining a security's eligibility under
the rule. One commenter argued that, in the case of a security subject
to a guarantee, such as bond insurance, and a demand feature, the fund
is very likely to look only to the issuer of the demand feature if it
needs to sell the security and thus, as a practical matter, to the
issuer of the demand feature for credit support. Therefore, this
commenter concluded, the guarantee should not be counted for purposes
of rule 2a-7's diversification requirements. The Commission agrees, and
has amended the rule to permit a fund holding a security subject to a
put (including bond insurance) and an unconditional demand feature to
count only the demand feature for purposes of the put diversification
calculation.86 A fund relying on this provision of the rule is not
required to maintain contemporaneous records of its determination that
the fund is not relying on the guarantee to determine credit quality.
\86\ Paragraph (c)(4)(vi)(B)(3) of rule 2a-7, as amended.
---------------------------------------------------------------------------
2. Quality Standards
a. Rating Requirement for Demand Features. The proposed amendments
to the rule would have limited funds to investing in demand features
(other than standby commitments) that are rated, or provided by
institutions that are rated, by NRSROs. Most commenters discussing this
issue opposed the proposed rating requirement for demand features and
suggested that the rule should permit a fund to purchase a security
subject to an unrated demand feature if it can make a comparability
determination similar to the determination permitted under the rule in
connection with the purchase of unrated securities.87 Other
commenters asserted that the fund manager's obligation under the rule
to determine that all portfolio securities present minimal credit risk
obviated the need for the proposed rating requirement.88
\87\ Paragraph (a)(9)(iii) of rule 2a-7, as amended, permits a
fund to treat an unrated security as an eligible security if the
fund's board of directors determines that the unrated security is of
comparable quality to a rated security.
\88\ Paragraph (c)(3) of rule 2a-7, as amended, limits fund
investment to securities that its ``board of directors determines
present minimal credit risks.'' This determination must be based on
factors pertaining to credit quality ``in addition to any rating
assigned to such securities by an NRSRO'' (emphasis added).
---------------------------------------------------------------------------
The Commission explained in the Proposing Release that NRSRO
ratings assigned to demand features or the issuer of demand features
may provide additional protection by ensuring input into the minimal
credit risk determination by an outside source. This extra source of
protection may be particularly important in light of the
[[Page 13965]]
Commission's decision to preserve the twenty-five percent
diversification basket for put providers, and to eliminate the
applicability of rule 2a-7's diversification requirements to securities
subject to certain unconditional demand features.89 In addition,
funds may have limited ability to monitor the credit quality of some
demand feature providers, such as foreign banks.90 The Commission
is adopting the rating requirement for demand features as
proposed.91
\89\ See supra Section II.B.1.b. of this Release.
\90\ Proposing Release, supra note 20, at Section II.C.2.d.(2).
\91\ Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as amended. The
amendments remove from the definition of eligible security unrated
securities that are subject to demand features. Thus, in order for a
security subject to a demand feature to be eligible for fund
investment, the demand feature must be rated.
---------------------------------------------------------------------------
b. Providers of Puts in Excess of Five Percent of Fund Assets. The
proposed amendments would have prohibited a money fund from investing
more than five percent of its assets in securities subject to a put
from a single put provider that is not a first tier put. Compliance
with this provision would be measured at the time the put was acquired
by the fund. All the commenters discussing this aspect of the proposal
agreed that it is appropriate to limit fund investment in puts that are
not first tier securities (``second tier puts''), and the Commission is
adopting the limit as proposed.92
\92\ Paragraph (c)(4)(v)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------
If more than five percent of a fund's assets were subject to a
demand feature from a single institution that was no longer a first
tier put, the proposed amendments also would have required the fund to
reduce the amount of the securities subject to the demand feature to
not more than five percent of the fund's assets by exercising the
demand feature at the next succeeding exercise date. Most commenters
were critical of this proposed requirement and suggested that it might
be in the best interests of fund shareholders for the fund either to
retain the securities subject to the demand features or dispose of the
securities in an orderly manner. Because there may be some
circumstances during which it may be in the best interest of the fund
to continue to hold the securities subject to the put, the Commission
is adopting the amendment with the express provision that a fund's
board of directors may determine that disposal of the securities is not
in the best interest of the fund, and determine to permit the fund to
continue to hold the securities.93
\93\ Paragraph (c)(5)(i)(C) of rule 2a-7, as amended. This
determination may not be delegated. Paragraph (e) of rule 2a-7, as
amended. If the demand feature is no longer an eligible security,
paragraph (c)(5)(ii) of rule 2a-7 requires the fund to obtain a new
demand feature or dispose of the underlying security (unless the
board of directors finds that it would be in the best interest of
the fund not to dispose of the security). See Release 18005, supra
note 11 at Section II.E.1. for a discussion of securities held by a
money fund that are in default, are no longer eligible securities,
or no longer present minimal credit risks.
---------------------------------------------------------------------------
c. Certain Unrated Securities. Rule 2a-7 currently provides that an
unrated security that, when issued, was a long-term security but when
purchased by the fund has a remaining maturity of less than 397
calendar days may be considered to be an eligible security based on
whether the security is comparable in quality to a rated security,
unless the security has received a long-term rating from any NRSRO that
is not within the two highest categories of long-term ratings. Under
this provision, a long-term rating from an NRSRO below the top two
rating categories results in the security becoming ineligible for
investment by a money market fund. One commenter stated that, because
many issuers with long-term ratings in the third highest ratings
categories have first tier short-term ratings, the rule was
unnecessarily restrictive. The Commission agrees, and has expanded this
provision to accommodate long-term ratings within the top three ratings
categories.94 Funds will continue to be required to determine that
such a security is of ``comparable quality'' to rated eligible
securities.95
\94\ Paragraph (a)(9)(iii)(B) of rule 2a-7, as amended.
\95\ Paragraph (a)(9)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
3. Conditional Demand Features
Rule 2a-7 does not currently restrict the types of conditions to
which a demand feature may be subject. The inability of a fund to
exercise a demand feature because of the occurrence of a condition
precluding exercise would likely result in violations of the maturity
limitations of rule 2a-7, the liquidity requirements of the 1940
Act,96 and a loss of value of the underlying security, when, for
example, a short-term security paying interest at short-term rates is
transformed into a long-term security. Therefore, the proposed
amendments would have limited the permissible conditions with respect
to conditional puts to the following: (1) default in the payment of
principal or interest on the underlying security; (2) the bankruptcy,
insolvency, or receivership of the issuer or a guarantor of the
underlying security; (3) the downgrading of either the underlying
security or a guarantor by more than two full rating categories; and
(4) in the case of a tax exempt security, a determination by the
Internal Revenue Service of taxability with respect to the interest on
the security.97 These conditions were designed to permit the fund
to monitor the continued availability of a demand feature and to take
steps to sell the security or replace the demand feature if it appears
that conditions are likely to occur that would limit the ability of the
fund to exercise the demand feature.98
\96\ The money fund could lose liquidity at a time when it is
most necessary. A money fund is limited to investing no more than
ten percent of its assets in illiquid securities. See supra note 65
and accompanying text and infra Section II.C.4.c. of this Release.
\97\ The proposed amendments to the rule incorporated
recommendations of Fidelity Management & Research Company
(``Fidelity'') and the Investment Company Institute (``ICI''). See
Letter from Matthew Fink, Senior Vice President and General Counsel,
ICI, to Marianne Smythe, Director, Division of Investment Management
(Mar. 25, 1991); Letter from Thomas D. Maher, Associate General
Counsel, Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities
and Exchange Commission (Sept. 24, 1990), in File No. S7-13-90.
\98\ Proposing Release, supra note 20, at Section II.C.3.
---------------------------------------------------------------------------
Many commenters objected to the proposed definition of the term
``conditional put.'' These commenters stated that the current market
has few, if any, variable rate demand notes (``VRDNs'') with
conditional puts that would satisfy the proposed definition. Even the
commenters who recommended the proposed conditions conceded that
although most put providers have conditions similar to those included
in the proposed amendments, every provider uses somewhat different,
often broader, language.99 As a result, modifying the scope of one
or more of the four conditions would not address this concern.
\99\ See Letter from Thomas D. Maher, Associate General Counsel,
Fidelity, to Jonathan G. Katz, Secretary, U.S. Securities and
Exchange Commission (May 5, 1994); Letter from Thomas D. Maher,
Associate General Counsel, Fidelity, to Kenneth J. Berman, Deputy
Office Chief, Office of Disclosure and Investment Adviser
Regulation, Division of Investment Management, U.S. Securities and
Exchange Commission (June 17, 1994); Letter from Paul Schott
Stevens, General Counsel, ICI, to Jonathan G. Katz, Secretary, U.S.
Securities and Exchange Commission (May 5, 1994), in File No. S7-34-
93.
---------------------------------------------------------------------------
The Commission has decided to adopt an alternative approach
suggested by several commenters by revising the rule to provide general
guidance concerning the types of conditions that are appropriate for
money fund investment. Rule 2a-7, as amended, provides that a security
subject to a conditional demand feature is an eligible security only if
the fund's board of directors (or its delegate) determines that there
is ``minimal risk'' of occurrence of the conditions that
[[Page 13966]]
would result in the demand feature not being exercisable.100 The
fund's board of directors (or its delegate) also must determine that:
(1) the conditions limiting exercise can be monitored readily by the
fund, or relate to the taxability, under federal, state or local law,
of the interest payments on the security; or (2) the terms of the
demand feature require that the fund receive notice of the occurrence
of the condition and the opportunity to exercise the demand
feature.101
\100\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
\101\ Id.
---------------------------------------------------------------------------
Rule 2a-7 currently provides that a security subject to a
conditional demand feature (``underlying security'') is an eligible
security only if the demand feature is an eligible security and the
underlying security has received a long-term rating from the Requisite
NRSROs in one of the two highest long-term ratings categories or, if
unrated, is determined to be of comparable quality. The rule thus
assumes securities subject to conditional demand features are always
long-term securities. The Commission is amending rule 2a-7 to provide
that, in the case of an underlying security that has a remaining
maturity of 397 days or less, the underlying security is an eligible
security only if the demand feature is an eligible security and the
underlying security has received a short-term rating from the requisite
NRSROs in one of the two highest short-term ratings categories or, if
unrated, is determined to be of comparable quality.102
\102\ Paragraph (c)(3)(iii)(C)(1) of rule 2a-7, as amended.
---------------------------------------------------------------------------
4. Other Issues Applicable to Put Providers
a. Accrued Interest. The Commission proposed amendments to the
definition of the term ``put'' and also requested comment whether
additional amendments to the rule were necessary to restrict fund
investment to certain types of credit and liquidity enhancements. The
proposed amendments would have amended the definition of a ``put'' to
specify that the put must enable the holder to receive not only the
amortized cost of the securities, but also accrued interest. The
Commission is adopting these amendments as proposed.103
\103\ Paragraph (a)(16) of rule 2a-7, as amended.
---------------------------------------------------------------------------
b. Notice of Substitution of Put Provider. The Commission stated in
the Proposing Release that it is aware of several instances in which a
money fund had invested in a security backed by a LOC or other credit
or liquidity enhancement that was replaced during the life of the
underlying security without notice to the fund.104 A fund must
know the identity of the put provider for a number of reasons, which
include a determination of whether the fund is in compliance with the
rule's put diversification and credit quality provisions. The Proposing
Release asked commenters to consider whether the rule should be amended
to limit fund investment in puts that obligate the issuer of the
underlying security (or the trustee under any applicable indenture) to
inform investors of the substitution of the put provider. All the
commenters responding to this question agreed with the Commission that
it is essential for the control of credit risk and for compliance with
the rule that funds be aware of the identity of their put providers at
all times, and that rule amendments would be appropriate.105
\104\ Proposing Release, supra note 20, at Section II.D.1.c.
\105\ A number of these commenters discussed the problems a fund
may encounter in obtaining notice of the substitution of a put
provider when the securities are held by an intermediary, such as a
securities depository. The Commission was advised that
intermediaries employ methods to transmit notice of this type to
their participants.
---------------------------------------------------------------------------
The Commission is adopting amendments to address these concerns.
Under the amendments, a security subject to a demand feature is not
eligible for fund investment unless arrangements are in place to notify
the fund holding the security in the event that there is a change in
the identity of the issuer of a demand feature.106
\106\ Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as amended. The
obligation to provide notice may be the obligation of the issuer of
the underlying security, the issuer of the demand feature, or a
third party, such as the dealer from which the fund wishes to
purchase the security.
---------------------------------------------------------------------------
c. Liquidity Requirements for Money Funds and the Three Business
Day Settlement Cycle. Section 22(e) of the 1940 Act provides, with
certain exceptions, that no registered investment company may postpone
the date of payment upon redemption of a redeemable security for more
than seven days after the security is tendered for redemption. The
Commission has stated that all mutual funds should limit their holdings
of illiquid securities to ensure that they can satisfy all redemption
requests within the seven day period. The Commission considers a
security to be illiquid if it cannot be disposed of within seven days
in the ordinary course of business at approximately the price at which
the fund has valued it.107 The limit on money fund holdings of
illiquid securities is ten percent of fund assets.108
\107\ Release 14983, supra note 64; Securities Act Rel. No. 6862
(Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)] (adopting Rule 144A
under the Securities Act of 1933 (discussing the definition of
``liquid'' and citing Release 14983).
\108\ Release 14983, supra note 64 at Section A.4.; Investment
Company Institute (pub. avail. Dec. 9, 1992).
---------------------------------------------------------------------------
Rule 15c6-1 under the Securities Exchange Act of 1934, which
recently became effective, established three business days (``T+3'') as
the standard settlement period for securities trades effected by a
broker or dealer.109 The Division of Investment Management
provided advice regarding the implications of the T+3 standard in
determining whether a security held by a fund should be deemed liquid
for purposes of the restrictions described above.110 This issue is
significant for money funds, because a large percentage of money fund
assets consist of securities with a seven day demand feature.111
\109\ Rule 15c6-1 [17 CFR 240.15c6-1] generally provides that
``a broker or dealer shall not effect or enter into a contract for
the purchase or sale of a security (other than an exempted security,
government security, municipal security, commercial paper, bankers'
acceptances, or commercial bills) that provides for payment of funds
and delivery of securities later than the third business day after
the date of the contract unless otherwise expressly agreed to by the
parties at the time of the transaction.'' Securities Exchange Act
Rel. No. 33023 (Oct. 6, 1993) [58 FR 52891 (Oct. 13, 1993)].
\110\ See T+3 Letter, supra note 65.
\111\ Id.
---------------------------------------------------------------------------
The Division noted that, because rule 15c6-1 applies to brokers and
dealers and does not apply directly to funds, its implementation does
not change the standard for determining liquidity, which is based on
the requirements of section 22(e) of the 1940 Act. As a practical
matter, however, many funds (including money funds) will have to meet
redemption requests within three days because a broker or dealer will
be involved in the redemption process. Many of these funds hold
portfolio securities that do not settle within three days. In light of
the T+3 standard, the Division recommended that funds should assess the
mix of their portfolio holdings to determine whether, under normal
circumstances, they will be able to facilitate compliance with the T+3
standard by brokers or dealers. Factors the funds should consider
include the percentage of the portfolio that would settle in three days
or less, the level of cash reserves, and the availability of lines of
credit or interfund lending facilities. The Commission shares the
Division's concerns and urges money funds to monitor carefully their
liquidity needs in light of the shorter settlement period.
5. Short-Term Ratings
Rule 2a-7 currently distinguishes between short-term and long-term
[[Page 13967]]
securities based on whether the security has a remaining maturity of
366 days--primarily for the purpose of distinguishing between
securities that have short-term and long-term ratings. NRSROs do not
always draw such a line when assigning ratings.112 Therefore, the
Commission has revised the rule to replace references to ``short-term
securities'' and ``long-term securities'' in various sections of the
rule with references to securities that have received short-term and
long-term ratings from a NRSRO.113 Whether a security has received
a long- or a short-term rating from a NRSRO will depend upon how the
NRSRO has characterized its rating.
\112\ See, e.g., Fitch Ratings Book (May 1995) (short-term
ratings apply to debt payable on demand or to securities with
original maturities of up to three years), and Orrick, Herrington &
Sutcliffe (pub. avail. July 20, 1994) (synthetic warrants maturing
in twenty-two months given short-term ratings by NRSROs).
\113\ Paragraphs (a)(9) (definition of ``eligible security''),
(a)(11) (definition of ``first tier security''), (a)(29) (definition
of ``unrated security''), and (c)(3)(iii)(C) (requirements for
security subject to conditional demand feature) of rule 2a-7, as
amended. In addition, the Commission has eliminated the definitions
of ``short-term'' and ``long-term'' from the rule.
---------------------------------------------------------------------------
D. Other Diversification and Quality Standards
1. Repurchase Agreements
Rule 2a-7 allows a fund to ``look through'' a repurchase agreement
(``repo'') to the underlying collateral for diversification purposes
when the obligation of the counterparty is ``collateralized fully.''
114 Under the current rule, a repo is collateralized fully if,
among other things, the collateral consists entirely of Government
securities or securities that, at the time the repo is entered into,
are rated in the highest rating category by the requisite
NRSROs.115 The Commission is adopting, as proposed, amendments to
permit a fund to treat the repo as collateralized fully only if it is
collateralized by securities that would qualify the repo for
preferential treatment under the Federal Deposit Insurance Act 116
or the Federal Bankruptcy Code.117 The Proposing Release noted
that if the collateral does not qualify for special treatment under
either of these statutes, a fund could encounter significant liquidity
problems if a large percentage of its assets were invested in a repo
with a bankrupt counterparty.118 Although some commenters argued
that the rule should encompass types of collateral that fall outside
the repo specific provisions of the Bankruptcy Code, the Commission
believes that the ``look through'' provisions of the rule would be
inappropriate in these circumstances because the credit and liquidity
risks assumed by the fund would be tied directly to the counterparty
rather than the issuers of the underlying collateral.119
\114\ Paragraph (c)(4)(vi)(A)(1) of rule 2a-7, as amended. A
money fund investing in a repurchase agreement that does not meet
the requirements of this paragraph may not ``look through'' and must
instead treat the counterparty to the agreement as the issuer.
\115\ See Proposing Release, supra note 20, at Section II.D.3.
\116\ See also 12 U.S.C. 1821(e)(8) (A) and (C) (affording
preferential treatment to ``qualified financial contracts''), 12
U.S.C. 1821(e)(8)(D)(i) (defining qualified financial contract to
include repurchase agreements) and 12 U.S.C. 1821(e)(8)(D)(v)
(defining repurchase agreement).
Not all collateral that would qualify a repo for preferential
treatment under the Federal Deposit Insurance Act would be
permitted. Of the mortgage-related securities referred to in 12
U.S.C. 1821(e)(8)(D)(c), only ``mortgage related securit[ies]'' as
defined in Section 3(a)(41) of the 1934 Act [15 U.S.C. 78c(a)(41)]
would be permitted.
See sections 101(47) of the Federal Bankruptcy Code
(``Bankruptcy Code'') (defining ``repurchase agreement''), and 559
(protecting repo participants from the Bankruptcy Code's automatic
stay provisions) [11 U.S.C. 101(47), 559]. The Bankruptcy Code
defines a repurchase agreement as follows:
An agreement, including related terms which provides for the
transfer of certificates of deposit, eligible bankers' acceptances,
or securities that are direct obligations of, or that are fully
guaranteed as to principal and interest by, the United States or any
agency of the United States against the transfer of funds by the
transferee of such certificates of deposit, eligible bankers'
acceptances, or securities with a simultaneous agreement by such
transferee to transfer to the transferor thereof certificates of
deposit, eligible bankers' acceptances, or securities as described
above, at a date certain no later than one year after such transfer
or on demand, against the transfer of funds.
\117\ Paragraph (a)(4) of rule 2a-7, as amended. Depository
institutions are not eligible for protection under the Bankruptcy
Code. Section 109 of the Bankruptcy Code [11 U.S.C. 109]. Instead,
the bank regulatory laws provide for the establishment of
conservatorship and receiverships of depository institutions in
default. See, e.g., section 11 of the Federal Deposit Insurance Act
[12 U.S.C. 1821].
\118\ Proposing Release, supra note 20, at n. 172.
\119\ Id.
---------------------------------------------------------------------------
2. Pre-Refunded Bonds
The Proposing Release noted that a significant portion of tax
exempt fund assets consist of pre-refunded bonds--bonds the payment of
which are funded by and secured by escrowed Government
securities.120 The proposed amendments to the rule would have
allowed funds to ``look through'' the pre-refunded bonds to the
escrowed securities for diversification purposes if the underlying
securities are Government securities and the escrow arrangement
satisfies certain conditions designed to assure that the bankruptcy of
the issuer of the pre-refunded bonds would not affect payments on the
bonds from the escrow account. The proposed amendments would have
limited fund investment in pre-refunded bonds issued by the same issuer
to twenty-five percent of its assets. Because these securities would,
in effect, be treated as Government securities, they would not be
subject to a diversification limitation.
\120\ Id.
---------------------------------------------------------------------------
Most commenters supported the proposed treatment of pre-refunded
bonds. A few of these commenters suggested that the twenty-five percent
limitation per issuer was not necessary since the issuer's credit
typically does not secure such bonds.121 The Commission agrees,
and has eliminated this limitation.122 The Commission has decided
to make additional technical modifications to the conditions applicable
to the escrow arrangements that were suggested by the
commenters.123 The Commission is also amending the rule to include
within the definition of an ``unrated security'' a rated security that
subsequently was made subject to a refunding agreement.124 This
amendment clarifies that a fund must disregard ratings given to a
security before the security became a ``refunded security'' (as that
term is defined in the rule) in determining whether the security is an
eligible security (as that term is also defined in the rule).
\121\ The twenty-five percent limitation was a condition
specified in a ``no-action'' position taken by the Division of
Investment Management in T. Rowe Price Tax-Free Funds (pub. avail.
June 24, 1993) regarding the treatment of these securities for
purposes of section 5(b)(1) of the 1940 Act. See Proposing Release,
supra note 20, at n. 38 and accompanying text.
\122\ The Commission is also eliminating the limitation for
funds other than money funds that otherwise rely on the staff no-
action position set forth in T. Rowe Price Tax-Free Funds.
\123\ Paragraphs (a)(18) and (c)(4)(vi)(A)(2) of rule 2a-7, as
amended. The proposed amendments would have permitted a fund to
``look through'' the pre-refunded bonds to the escrowed securities
for diversification purposes if: (1) the escrowed securities were
Government securities; (2) the escrowed securities were pledged only
with respect to the payment of principal, interest and premiums on
the pre-refunded bonds; and (3) either an independent certified
public accountant or a NRSRO certified that the escrowed securities
would satisfy all scheduled payments of principal, interest and
premiums on the pre-refunded bonds. Commenters urged the Commission
to clarify condition (2) by stating that excess proceeds could be
remitted to the issuer or a third party. Commenters also noted that
NRSROs rarely provide the certification described in condition (3),
and requested that the reference to a NRSRO be deleted from the
text. The rule reflects these comments; only independent certified
public accountants may provide the certification.
\124\ Paragraph (a)(29)(iii) of rule 2a-7, as amended. If the
security has a NRSRO rating that does reflect the existence of the
refunding agreement, then the security would not be considered
unrated. Id.
[[Page 13968]]
---------------------------------------------------------------------------
3. Diversification Safe Harbor
A money fund that elects to be diversified must comply with the
requirements of section 5(b)(1) of the 1940 Act and the rules under
that section.125 These requirements are applicable to most taxable
and many tax exempt money funds, since most elect to be diversified.
Although rule 2a-7's diversification requirements are more strict,
under certain circumstances a money fund may be in compliance with rule
2a-7, but not in compliance with section 5(b)(1).126 The proposed
amendments would have provided that money funds complying with rule 2a-
7's diversification requirements are deemed to be diversified under
section 5(b)(1) (``diversification safe harbor''). Commenters
discussing this aspect of the proposal supported the diversification
safe harbor, and the Commission is adopting the amendments as
proposed.127
\125\ See supra note 30; Proposing Release, supra note 20, at n.
29 and accompanying text.
\126\ One difference that may cause this to occur is the timing
of the measurement of diversification. Compliance with section
5(b)(1) of the 1940 Act is measured at the time of a purchase based
on the value of the fund's total assets as of the end of the
preceding fiscal quarter. See rule 5b-1 [17 CFR 270.5b-1]). For
purposes of rule 2a-7, both the fund's total assets (as defined in
the rule) and compliance with the rule's diversification
requirements are measured at the time a purchase is made. See
paragraph (c)(4)(i) of rule 2a-7, as amended.
\127\ Paragraph (c)(4)(vii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
4. Three-Day Safe Harbor
Rule 2a-7 currently permits a fund to invest more than five percent
of its assets in the first tier securities of a single issuer for up to
three business days (the ``three-day safe harbor'') and does not
contain any limitation on the percentage of fund assets that can be
invested in accordance with this provision. Since the provision is
primarily applicable to taxable funds, which typically are diversified
companies within the meaning of section 5(b)(1), funds could not use
this provision to invest more than twenty-five percent of their assets
in the securities of a single issuer. The Commission proposed to extend
the availability of the three-day safe harbor to national funds. To
assure that the three-day safe harbor could not have the effect of
allowing funds that are not diversified to invest an inordinate portion
of their assets in a single issuer at any time, the proposed amendments
would have limited to twenty-five percent the percentage of fund assets
that may be invested under the safe harbor at any one time. The
Commission is adopting this amendment substantially as
proposed.128
\128\ Paragraph (c)(4)(iii) of rule 2a-7, as amended. Because
single state funds are required to be diversified only as to
seventy-five percent of their assets, they have available a twenty-
five percent basket to accommodate purchases in excess of five
percent. Paragraph (c)(4)(i) of rule 2a-7, as amended. As a result,
the three-day safe harbor of paragraph (c)(4)(ii) of the amended
rule is not extended to them.
---------------------------------------------------------------------------
E. Asset Backed Securities and Synthetic Securities
1. Background
The proposed amendments would have amended rule 2a-7 to clarify the
application of the rule to ``synthetic'' tax exempt securities and
ABSs. Both types of securities rely on demand features and complex
liquidity arrangements that are designed to meet the risk-limiting
conditions of the rule.
An ABS represents an interest in a pool of financial assets, such
as credit card or automobile loan receivables. Typically, an ABS is
sponsored by a bank or other financial institution to pool financial
assets and convert them into capital market instruments, thereby
enabling the sponsor to transform illiquid assets into cash and
increase balance sheet liquidity.129 The ABS is structured to
assure that the issuer of the ABS will not be affected by the
bankruptcy of the sponsor. In addition, the structure of the ABS
affects the nature and amount of the credit enhancement. While
structural issues affect the risks associated with many types of
securities, they are particularly important in evaluating ABSs.130
\129\ For a detailed discussion of ABSs, see U.S. Securities and
Exchange Commission Division of Investment Management, Protecting
Investors: A Half Century of Investment Company Regulation, May
1992, at 1-103 and Investment Company Act Rel. No. 18736 (May 29,
1992) [57 FR 23980 (June 5, 1992)] and Investment Company Act Rel.
No. 19105 (Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] respectively
proposing and adopting rule 3a-7 under the 1940 Act [17 CFR 270.3a-
7], the rule excluding the issuers of certain ABSs from the
definition of investment company.
\130\ While the structure of ABSs vary, the ABSs that have been
marketed to money funds have generally involved: (i) the trust,
which issues the ABSs; (ii) the sponsor, which contributes the
assets to the trust; (iii) the servicer, which is responsible for
administering the assets in the pool; (iv) the trustee, which
monitors the activities of the servicer, and (v) the bank, which
provides some form of liquidity and/or credit enhancement to assure
that the trust will have sufficient funds to meet interest and
amortization payments in the event that cash flow from the
underlying assets is insufficient to meet the payment schedule of
the ABSs.
---------------------------------------------------------------------------
Synthetic securities are another form of ABSs that have been
developed to address the shortage in the supply of short-term tax
exempt securities.131 While a variety of synthetic structures
exist, all involve trusts and partnerships that, in effect, convert
long-term fixed-rate bonds into variable or floating rate demand
securities. Typically, one or two long-term, high quality, fixed-rate
bonds of a single state or municipal issuer (the ``core securities'')
are deposited in a trust by the sponsor. Interests in the trust may be
distributed through an offering of securities to the public registered
under the 1933 Act, or through an offering exempt from the Act's
registration requirements, such as a ``private placement.'' Holders of
interests in the trust receive interest at the current short-term
market rate and the sponsor receives the difference (after
administrative expenses) between the current market interest rate and
the long-term rate paid by the core securities. An affiliate of the
sponsor or a third party (usually a bank) issues a conditional demand
feature permitting holders to recover principal at par within a
specified period. The demand features are conditional to address tax-
related concerns.
\131\ See, e.g., Peter Heap, ``Inside Derivatives Price and
Demand Are Guide in Building Secondary Market Derivatives,'' Bond
Buyer, Mar. 14, 1995 at 4; ``Portfolio Manager Paints Derivatives
with a Broad Brush,'' The Guarantor, Oct. 10, 1994 at 3.
---------------------------------------------------------------------------
The proposed amendments to the rule would have established specific
criteria for fund investment in ABSs, and would have addressed issues
concerning the diversification, maturity and quality standards
applicable to these types of securities. Most commenters argued that it
was not necessary to amend the rule in order to provide for the
treatment of ABSs because the diversification, quality, and maturity
standards applicable to ABSs could be addressed within the existing
framework of the rule. Questions were raised, however, concerning the
applicability of the rule to ABSs both prior to and after the
publication of the Proposing Release,132 and commenters presented
widely divergent and, sometimes, conflicting views on how ABSs should
be treated. The Commission therefore has concluded that amendments are
necessary to reduce uncertainty concerning the application of the rule
to these securities.
\132\ See, e.g., Donaldson, Lufkin & Jenrette Securities
Corporation (pub. avail. Sept. 23, 1994); Orrick, Herrington &
Sutcliffe (pub. avail. July 27, 1994).
---------------------------------------------------------------------------
2. Definitions
The Commission is adopting, substantially as proposed, certain
definitions used in the rule. The term ``asset backed security'' is
defined as a fixed-income security issued by a ``special purpose
entity,'' substantially all the assets of which consist of
[[Page 13969]]
``qualifying assets.'' 133 The term ``special purpose entity'' is
defined as a trust, corporation, partnership or other entity organized
for the sole purpose of issuing fixed-income securities, which
securities entitle their holders to receive payments that depend
primarily on the cash flow from qualifying assets.134 Finally, the
term ``qualifying assets'' is defined as financial assets, either fixed
or revolving, that by their terms convert to cash within a finite time
period, plus any rights or other assets designed to assure the
servicing or timely distribution of proceeds to security
holders.135
\133\ Paragraph (a)(2) of rule 2a-7, as amended.
\134\ This term excludes investment companies. Id.
\135\ Id. The Division of Investment Management has received
requests for interpretive guidance under rules 2a-7 and 3a-7 under
the 1940 Act regarding trusts that hold assets that may not be
redeemed or mature within a ``finite time period.'' See, e.g.,
Donaldson, Lufkin & Jenrette Securities Corp. (pub. avail. Sept. 23,
1994) (auction rate preferred stock issued by closed-end fund that
remains outstanding after sale at auction); Brown & Wood (pub.
avail. Feb. 24, 1994) (cumulative preferred stock with no
determinable liquidation date). The Commission welcomes requests for
interpretive guidance or exemptive relief concerning such
instruments. Rule 2a-7, as amended, should not be interpreted to
permit investments in ABSs that hold assets that are not
``qualifying assets'' if the rule's conditions applicable to
investment in ABSs (e.g., the rating requirement) are not complied
with.
---------------------------------------------------------------------------
3. Diversification Standards
a. Diversification: General. The proposed diversification standards
would have distinguished between qualifying assets that consist of the
securities of ten or fewer issuers, and qualifying assets that consist
of the securities of more than ten issuers. In the case of qualifying
assets that consist of securities issued by ten or fewer issuers (e.g.,
most tax exempt tender option bond structures),136 the issuer of
each core security would have been treated as the issuer for issuer
diversification purposes. The sponsor of the ABS would have been
treated as the issuer when the ten issuer limit was exceeded.
\136\ See Proposing Release, supra note 20, at Section II.C.4.d.
---------------------------------------------------------------------------
(1) Special Purpose Entity as Issuer. In proposing to treat the
sponsor of the special purpose entity as the issuer of the ABS, the
Commission assumed that the credit quality of the ABS reflects the
asset origination practices of the sponsor.137 While some
commenters agreed with the Commission's analysis, most commenters
addressing the subject strongly opposed treating the sponsor of the ABS
as the issuer for diversification purposes. They argued that the
special purpose entity is protected in the event of the sponsor's
bankruptcy so that an investment in an ABS does not reflect the credit
risks associated with an investment in the sponsor. The commenters
pointed out that the NRSRO ratings assigned to ABSs are premised on the
integrity of the structure of the special purpose entity. These
commenters urged that the rule treat the special purpose entity as the
issuer of the ABS. Commenters also pointed out that the proposed
treatment of the sponsor as the issuer of the ABS was inconsistent with
the approach of the Commission elsewhere in the securities
laws.138
\137\ Id.
\138\ One commenter stated that a test different from the one
proposed--that is, one based on asset concentration, would be
consistent with certain positions taken by the Division of
Corporation Finance. An asset concentration in excess of ten percent
may elicit staff comments requesting disclosure of financial
information regarding the obligor of the assets. See Staff
Accounting Bulletins 71 and 71A (``SAB 71/71A'').
---------------------------------------------------------------------------
The Commission has decided to modify the proposal to conform with
its treatment of the special purpose entity as the sponsor of the ABS
in other contexts. The diversification standards adopted treat the
special purpose entity as the issuer of the ABS, subject to the
exception described below.139
\139\ Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as amended.
---------------------------------------------------------------------------
(2) Looking through the Special Purpose Entity. Several commenters
agreed that in some circumstances it would be appropriate to ``look
through'' the special purpose entity and treat the obligor of the
qualifying assets as the issuer of a portion of the ABS. These
commenters asserted that whether to look through the special purpose
entity should not turn on the number of qualifying assets, as the
Commission proposed, but the extent to which the special purpose entity
is concentrated in the assets of a single obligor.
The Commission believes that the approach recommended by the
commenters has advantages over that included in the proposal. The
proposed approach was designed primarily to require a fund to look
through the special purpose entity in the case of a tender option bond
or other synthetic security that tends to have few underlying
securities. These structures may have more underlying securities, but
it would be appropriate to continue to look to the ultimate obligor of
the underlying security if the security constitutes a sufficiently
large portion of the obligations underlying the ABS. Moreover, it would
be appropriate to treat an obligor in a more traditional ABS as the
issuer of a proportionate portion of the ABS when the security
represents a sufficiently large portion of the ABS.
Based on these considerations, the Commission has revised the rule
to provide that the special purpose entity generally is treated as the
issuer of the ABS; however, any entity whose obligations constitute ten
percent or more of the principal amount of the qualifying assets
backing the ABS is deemed to be the issuer of that portion of the ABS
equal to the percentage of the qualifying assets represented by all of
the obligations of the entity included in the pool.140 As amended,
the rule provides that a special purpose entity whose qualifying assets
are themselves ABSs (``secondary ABSs'') will be treated as the issuer
of the secondary ABSs.141 A fund holding ABSs is required to make
the calculations necessary to determine the issuer of the ABSs for
diversification purposes on a periodic basis.142
\140\ Id. A diversification test of this type is consistent with
a no-action position taken by the Division of Investment Management
under section 5(b)(1) of the 1940 Act (Hyperion Capital Management,
Inc. (pub. avail. Aug. 1, 1994)) and accounting positions taken by
the Division of Corporation Finance (SAB 71/71A, supra note 136).
See also Securities Exchange Act Release No. 34961 (Nov. 10, 1994)
[59 FR 59590 (Nov. 17, 1994)] at n.80 and accompanying text.
\141\ Paragraph (c)(4)(vi)(A)(4) of rule 2a-7, as amended.
\142\ Paragraphs (c)(8)(iv) and (c)(9)(v) of rule 2a-7, as
amended. The calculations are required to be made periodically
because of the revolving nature of many ABSs' assets.
---------------------------------------------------------------------------
b. Diversification: First Loss Guarantees. The Proposing Release
noted that some ABSs are issued with guarantees as to first losses, in
which an institution guarantees all losses up to a specified percentage
(e.g., ten percent of the assets of the pool).143 Because the loss
coverage is usually a multiple of the likely losses to be experienced,
the possibility of the losses exceeding the coverage generally is
considered to be remote. Because a first loss guarantee exposes the
guarantor to essentially the same risk as a guarantor of the entire
value of the security, the Commission proposed that a first loss
guarantor be treated as guarantor of the entire principal amount of the
security for purposes of the put diversification standards.
\143\ Proposing Release, supra note 20, at Section II.C.4.e.
---------------------------------------------------------------------------
Only one commenter supported this aspect of the Commission's
proposal. The remaining commenters opposed the proposed amendment, and
generally argued that the proposed treatment of first loss guarantors
was inconsistent with the proposed treatment of put providers whose
obligations are limited
[[Page 13970]]
by contract.144 One commenter objected because the amendment
appeared to be addressing the guarantor's exposure to losses, rather
than the fund's. Another commenter noted that, because of the
contractual limit on the first loss guarantor's obligations, that
guarantor is only required to make payment for losses experienced by
the pool to the extent of its guarantee, and additional losses would
have to be borne by the holder of the ABS.
\144\ Under proposed amendments to the rule's put
diversification provisions, the issuer of a fractional put would
have been treated as guaranteeing only that portion of the value of
the security which it contractually agreed to provide. See Proposing
Release, supra note 20, at Section II.C.2.c. The Commission is
adopting these amendments as proposed. See supra Section II.C.1.d.
of this Release and paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as
amended.
---------------------------------------------------------------------------
Rule 2a-7 diversification requirements are designed to limit the
exposure of the fund to any single issuer or credit enhancer.145
Because the exposure of a first loss guarantor to losses the pool may
incur is substantially greater than the exposure of a fractional
guarantor, the exposure of the fund to the first loss guarantor is also
substantially greater.146 Therefore, the Commission believes that
it is appropriate to treat first loss guarantees differently from
fractional guarantees. Because first loss guarantees typically are
designed to cover likely losses to be experienced, a statement made in
the Proposing Release no commenter contradicted, it seems appropriate
to treat the first loss guarantor as guaranteeing the entire value of
the security. The Commission is adopting this amendment as
proposed.147
\145\ See Proposing Release, supra note 20, at Section II.A.
\146\ For example, if a fractional put provider guarantees ten
percent of the losses experienced by a $1 million pool, and the pool
has losses of seven percent, the put provider's exposure is $7,000.
By contrast, if a first loss guarantor guarantees the first ten
percent of losses experienced by a $1 million pool, and the pool has
losses of seven percent, the guarantor's exposure is $70,000--an
amount ten times greater than the fractional put provider's
exposure.
\147\ Paragraph (c)(4)(vi)(B)(2) of rule 2a-7, as amended. The
Commission also notes that the proposed treatment of first loss
guarantees under rule 2a-7 is consistent with a notice of proposed
rulemaking issued by the Department of the Treasury, the Federal
Reserve System, and the Federal Deposit Insurance Corporation.
``Risk-Based Capital Requirements--Recourse and Direct Credit
Substitutes; Proposed Rule,'' 59 FR 27115 (May 25, 1994). As
described in that release, the Office of the Comptroller of the
Currency, Department of the Treasury, The Board of Governors of the
Federal Reserve System, the Federal Deposit Insurance Corporation
and the Office of Thrift Supervision, Department of the Treasury
proposed revisions to their risk-based capital standards that would
treat certain first loss guarantees as a guarantee of the entire
principal amount of the assets enhanced.
---------------------------------------------------------------------------
4. Quality Standards
The proposed amendments to rule 2a-7 would have limited funds to
investing only in an ABS that has a short-term rating from a NRSRO and,
when the final maturity of the ABS exceeds 397 days, a long-term debt
rating from a NRSRO. Many commenters opposed this proposed requirement,
arguing that it would be redundant because the rule currently requires
fund managers to perform a thorough legal, structural and credit
analysis with respect to all securities. The Commission notes that the
legal, structural and credit analysis required by rule 2a-7 is to be
conducted independently of any determination of a security's credit
quality made by a NRSRO.148 In addition, the Commission continues
to believe that, in view of the role NRSROs have played in the
development of the structured finance markets, a rating requirement
should not be burdensome.149 Because both short- and long-term
debt ratings from NRSROs reflect the NRSROs' legal, structural, and
credit analyses, the rule requires that an ABS be rated in order to be
eligible for fund investment, but does not specify whether the rating
received must be short- or long-term.150
\148\ Paragraph (c)(3)(i) of rule 2a-7, as amended; Release
18005, supra note 11, at Section II.A. (adopting amendments to
paragraph (c)(2) of rule 2a-7); Letter to Registrants (pub. avail.
May 8, 1990). For a discussion of the limitations of NRSRO ratings
for evaluating certain aspects of ABSs, see Investment Company Act
Rel. No. 20509 at Sec. I.B.1 (Aug. 31, 1994) [59 FR 46304 (Sept. 7,
1994)].
\149\ Proposing Release, supra note 20, at Section II.C.4.b.
\150\ Paragraph (a)(9)(iii)(C) of rule 2a-7, as amended.
---------------------------------------------------------------------------
5. Maturity Standards
The proposed maturity standards for ABSs would have taken into
account the difference between ``pay-through'' ABSs and ``pass-
through'' ABSs. A pay-through ABS has a maturity and payment schedule
different from that of its underlying assets. A pass-through ABS is one
in which the cash generated by the underlying assets passes through
directly to the ABS holders. Pass-through ABSs held by funds generally
are not scheduled to return a holder's principal for three to five
years. They typically provide for periodic interest rate resets and for
principal to be returned after some period (not exceeding thirteen
months) after a demand for payment has been made.
The proposed amendments would have provided that the final maturity
of an ABS is the date on which principal is scheduled to be returned to
the holder, regardless of whether demand has been made. The proposed
amendments also would have permitted a fund to measure the maturity of
an ABS with an adjustable rate of interest subject to a demand feature
by reference to the time principal is scheduled to be repaid once
demand is made, but only if the holder is entitled to receive principal
and interest within thirteen months of making demand.
Several commenters expressed concern regarding the treatment of a
pass-through ABS with a ``scheduled'' maturity. The commenters noted
that the effect of the proposed amendments would be to allow funds to
determine the maturity of an ABS by relying on the date on which
principal is scheduled, but not necessarily required, to be repaid.
These commenters concluded that the proposed amendments' reference to a
scheduled principal repayment is troublesome because on that date there
is no binding obligation under which the fund would receive payment. In
light of the comments, the Commission has decided to modify the ABS
maturity determination by amending the definition of ``demand feature''
to include a feature of an ABS permitting the fund unconditionally to
receive principal and interest within thirteen months of making
demand.151
[[Page 13971]]
The maturity of an ABS with a final maturity in excess of 397 days may
be determined by reference to a demand feature only if the ABS also
meets the definition of a floating or variable rate security.152
\151\ Paragraph (a)(7)(ii) of rule 2a-7, as amended. For
example, prior to the fund's election to receive principal payments,
the maturity of an adjustable rate ABS with a five year final
maturity and a demand feature permitting the fund to obtain
principal and interest within thirteen months would be considered a
thirteen month instrument at all times (i.e., on a rolling basis).
After the election is made, a fund could treat such an instrument as
having a maturity equal to the date when principal will be returned
(i.e., each day that the fund holds the instrument after election,
the fund could reduce the security's maturity by one day).
This amendment supersedes an interpretive position taken by the
Division of Investment Management in Merrill, Lynch, Pierce, Fenner
& Smith (pub. avail. Apr. 6, 1987). In Merrill, Lynch, the Division
addressed the maturity determination for a type of variable rate
coupon note. A holder of the notes was required to satisfy certain
conditions in order to receive principal on ``the date noted on the
face of the instrument'' (quoting paragraph (d)(1) of rule 2a-7,
prior to amendment), and, so long as the notes continued to be held,
their maturity was automatically extended at the end of each
interest rate reset period by one additional such period. The
Division concluded that, subject to certain conditions, a money fund
could treat such a security as having a maturity equal to the date
specified on the face of the instrument, as automatically extended
by an additional interest payment period. The Merrill, Lynch
position is inconsistent with paragraph (d) of rule 2a-7, as
amended, which provides that an instrument's maturity is the date on
which ``the principal amount must unconditionally be paid'' and with
the maturity determination requirements for ABS discussed in the
text of this release. Money funds may, however, continue to treat a
``mandatory tender'' feature as an unconditional right to receive
principal, provided that the issuer's obligation to pay is not
dependent on the fund taking any action (such as giving notice to
the issuer of the intent to redeem), other than physically
delivering the notes or bonds for redemption.
\152\ Paragraphs (d)(3) and (d)(5) of rule 2a-7, as amended. The
maturity of a floating or variable rate ABS may also be determined
by reference to a demand feature meeting the requirements of
paragraph (a)(7)(i) of the amended rule.
---------------------------------------------------------------------------
F. Variable and Floating Rate Securities
Rule 2a-7 generally prohibits a money fund from acquiring a
security with a remaining maturity of more than 397 calendar days. The
purpose of this requirement and the other maturity provisions of the
rule is to limit a fund's exposure to interest rate risk.153 The
rule generally requires a fund to measure the maturity of a portfolio
security by reference to the security's final maturity date. A fund,
however, may measure the maturity of a ``variable rate security'' or a
``floating rate security'' (collectively, ``adjustable rate
securities'') by reference to a date that is earlier than the final
maturity date.
\153\ See Release 13380, supra note 7, at n.14 and accompanying
text; State of Wisconsin (pub. avail. Mar. 3, 1983).
---------------------------------------------------------------------------
Rule 2a-7 defines a ``variable rate security'' as an instrument the
terms of which provide for the adjustment of the interest rate on
specified dates and that, upon adjustment, can reasonably be expected
to have a market value that approximates par value. A ``floating rate''
security is defined as an instrument the terms of which provide for the
adjustment of its interest rate whenever a specified benchmark changes
and that, at any time, can reasonably be expected to have a market
value that approximates par value. Rule 2a-7 allows certain adjustable
rate securities to be treated as having maturities shorter than their
final maturities; however, the manner in which an adjustable rate
instrument is treated depends upon whether it has a demand feature, the
final maturity of the instrument and whether the instrument is a
Government security.
1. Maturity Determinations: Floating Rate Securities
Under the current rule, the maturity of a floating rate security
subject to a demand feature is the period remaining until principal can
be recovered through demand. The same test is generally applicable in
determining the maturity of a variable rate security subject to a
demand feature, the principal amount of which is scheduled on the
instrument's face to be paid in more than 397 days. In contrast, a
variable rate security (without a demand feature) scheduled to be paid
in 397 days or less may be treated as having a maturity equal to the
period remaining until the next readjustment of the interest rate.
There is no parallel provision for floating rate securities with final
maturities of 397 days or less.
Because variable and floating rate securities expose funds to
similar types of interest rate risk, the Commission proposed to amend
the rule to permit funds to determine the maturity of floating rate
securities with final maturities of 397 days or less by referring to
the interest rate reset. Commenters supported the proposed amendment,
which the Commission is adopting substantially as proposed.154 The
interest rate of a floating rate security moves in tandem with changes
in the interest rate to which it is linked, and the amendments will
permit funds to treat these instruments as having one-day maturities.
\154\ Floating rate securities with final maturities of more
than 397 days that are subject to demand features are deemed to
having maturities equal to the period remaining until principal can
be recovered through demand. Paragraph (d)(5) of rule 2a-7, as
amended.
---------------------------------------------------------------------------
2. Maturity Determinations: Variable Rate Securities
Under the current rule, when the period remaining until the final
maturity of a variable rate demand instrument (i.e., its maturity
without reference to the demand feature) is less than 397 days, its
maturity under rule 2a-7 is the longer of the period remaining until
the next interest rate readjustment or the date on which principal can
be recovered on demand. A variable rate security with the same final
maturity that does not have a demand feature is treated as having a
remaining maturity equal to the period remaining until the next
readjustment in the interest rate. The effect of these provisions is
that a variable rate security with a final maturity of less than 397
days will have a longer maturity when a demand feature is added to it.
To correct this anomaly, the Commission proposed that only a
variable rate demand security with a final maturity in excess of 397
days would have its maturity measured by the longer of the period
remaining until its next interest rate adjustment or the date on which
principal can be recovered on demand; the maturities of securities with
final maturities of 397 days or less would be measured by reference to
the earlier of the date on which the interest rate next readjusts or
the date on which principal can be recovered on demand. Commenters
supported the proposed amendment, which the Commission is adopting as
proposed.155
\155\ Paragraph (d)(2) of rule 2a-7, as amended.
---------------------------------------------------------------------------
3. Adjustable Rate Government Securities
Rule 2a-7 provides that ``an instrument that is issued or
guaranteed by the United States government or any agency thereof which
has a variable rate of interest adjusted no less frequently than every
762 days'' is deemed to have a maturity equal to the period remaining
until the next readjustment of the interest rate.156 The
Commission is adopting two amendments to clarify the scope of this
provision.
\156\ Paragraph (d)(1) of rule 2a-7, as amended. Generally, the
readjustment must occur every 397 days to reflect the rule's
maturity requirements. For certain funds that mark-to-market,
however, readjustment may occur every 762 days. Paragraph (c)(2)(ii)
of rule 2a-7, as amended.
---------------------------------------------------------------------------
First, the amendments clarify that the maturity of the security may
only be determined by reference to the interest readjustment date if,
upon readjustment, the security can reasonably be expected to have a
market value that approximates par value.157 This change makes
explicit that Government securities are treated the same way as other
adjustable rate securities under the rule.158
\157\ This codifies the interpretation of the current rule. See
Investment Company Institute (pub. avail. June 16, 1993); Morgan
Keegan & Company, Inc. (pub. avail. July 24, 1992) at n.7.
\158\ The amendments also make clear that this provision applies
to floating rate Government securities. Paragraph (d)(1) of rule 2a-
7, as amended.
---------------------------------------------------------------------------
Second, the reference to Government securities in paragraph (d)(1)
of rule 2a-7 is being conformed to other provisions of the rule
relating to Government securities. As amended, the provision applies to
all Government securities, including securities issued by persons
controlled or supervised by and acting as instrumentalities of the U.S.
Government.159
\159\ The amendment reflects a no-action position taken by the
Division of Investment Management with respect to securities issued
by instrumentalities of the U.S. government. See Student Loan
Marketing Association (pub. avail. Jan. 18, 1989).
---------------------------------------------------------------------------
4. Other Issues Concerning Adjustable Rate Securities
a. Background. Rule 2a-7 allows the maturity of adjustable rate
securities to be determined by reference to interest rate adjustment
dates if the security ``can reasonably be expected to have a market
value that approximates its par value'' upon adjustment of the interest
[[Page 13972]]
rate.160 The Commission proposed to clarify that the board of
directors or its delegate must have a reasonable expectation that, upon
each adjustment of the interest rate until the final maturity of the
security or until the principal amount can be recovered through demand,
the security will have a market value approximating its amortized
cost.161
\160\ Paragraphs (a)(7) and (a)(21) of rule 2a-7 [17 CFR 270.2a-
7(a)(7) and (a)(21)], prior to amendment. Adjustable rate securities
may be priced at a premium to par value when the security pays
interest above market rates. A fund may treat the security as an
adjustable rate security for purposes of rule 2a-7's maturity
provisions if the fund reasonably expects that upon readjustment of
the interest rate, the market value of the security will approximate
its amortized cost. The premium generally would be amortized over
the life of the security. It is critical that the fund carefully
consider all factors involved in the valuation of the security,
particularly the likelihood of prepayment before the premium is
fully amortized. An accelerated return of principal will require the
fund to write off the premium before it is amortized, and could
result in a significant deviation between the amortized cost and
market value of the security.
\161\ Paragraphs (a)(12) and (a)(30) of rule 2a-7, as amended.
---------------------------------------------------------------------------
Several commenters discussed the proposed amendments to the
maturity determination provisions of the rule as they relate to
adjustable rate Government securities. Commenters opposing this aspect
of the proposed amendments emphasized that the amendments should
exclude adjustable rate Government securities ``based on the lack of
credit risk'' inherent in these instruments. The maturity determination
provisions of the rule, however, are designed to limit a fund's
exposure to interest rate, rather than credit, risk and recent history
demonstrates that an investment in a Government security can expose the
fund to substantial interest rate risk.162 The Commission is,
therefore, adopting the amendment as proposed.
\162\ In the Proposing Release, the Commission noted that a
number of adjustable rate securities developed specifically for
money market funds had interest rate readjustment formulas that
could not be expected to reflect short-term interest rates under
certain conditions. At that time, the Commission expressed the
concern that changes in interest rates or other conditions that
could reasonably be foreseen to occur during the life of the
securities could result in their market values not returning to par
at the time of an interest rate readjustment. The Commission
identified securities that displayed this characteristic, and
concluded that such securities presented risks that were not
appropriate for money market funds to assume. See Proposing Release,
supra note 20, at nn.161-164 and accompanying text.
In June 1994, the Division of Investment Management provided
money market funds and their advisers with additional guidance
concerning investments in adjustable rate securities. The Division
reminded fund managers of their general obligations under rule 2a-7
to ensure that money market funds invest only in securities that are
consistent with maintaining stable net asset values, and directed
money market funds that held these securities to work with their
advisers in developing plans for their orderly disposition. See
Letter from Barry P. Barbash, Director, Division of Investment
Management, to Paul Schott Stevens, General Counsel, Investment
Company Institute (June 30, 1994). Money market funds holding
adjustable rate securities of the type described in the Proposing
Release experienced problems when short-term interest rates
increased last year. To maintain their funds' stable net asset
values, a number of fund advisers took actions which included
purchasing certain adjustable rate securities from their money
market funds at their amortized cost value (plus accrued interest),
or contributing capital to the funds. One fund holding notes of this
type, the U.S. Government Money Market Fund, a series of Community
Bankers Mutual Fund, Inc., announced in September 1994 that it would
liquidate and distribute less than $1.00 per share to its
shareholders. Press reports generally treated this liquidation as
the first instance in which a money market fund had ``broken a
dollar.'' See Brett D. Fromson, ``Losses on Derivatives Lead Money
Fund to Liquidate,'' Washington Post, Sept. 28, 1994 at F1; Leslie
Wayne, ``For Money Market Fund Investors, New Cautions,'' N.Y.
Times, Sept. 29, 1994 at D1, D8.
---------------------------------------------------------------------------
The effect of the new provision is to prohibit funds from
purchasing an adjustable rate Government security with a remaining
maturity of more than 397 days unless the interest rate readjustment
mechanism can reasonably be expected to return the instrument to par
upon all interest rate adjustment dates during the life of the
instrument. A fund could purchase an adjustable rate Government
security with a remaining maturity of 397 days or less, the value of
which the fund does not expect to return to par on all interest rate
adjustment dates, but would have to treat the security as a fixed rate
security and measure its maturity by reference to its final maturity.
Adjustable rate securities with demand features generally would not be
affected by the proposed changes because if a discount develops or is
likely to develop a fund could exercise the demand feature and receive
the amortized cost value of the instrument.
b. Recordkeeping Requirement. The Commission proposed to require a
money market fund to maintain a written record of its determination
that an adjustable rate security, the maturity of which is determined
by reference to its interest rate readjustment date, will either
maintain a value of par or return to par on each interest rate
readjustment date through the life of the security. A number of
commenters who opposed this requirement stated that further guidance
regarding the definition of the term ``approximates par'' was necessary
or that the rule should specifically state the amount of deviation that
would be permissible. The Commission believes that this approach would
be rigid and unnecessary, absent an indication that decisions reached
in this area by funds are inconsistent with the purposes of the rule.
Other commenters asserted that the paperwork burden this
requirement could entail might outweigh benefits to shareholders, and
might have the effect of forcing funds to purchase higher proportions
of fixed rate securities that may have a higher degree of price
volatility than adjustable rate securities. The Commission is not
persuaded by this argument. One of these commenters suggested that if
the determination regarding the return to par would be common to a
group of securities, a single documentation of the analysis should be
sufficient. The Commission agrees. The amendments do not require a
fund's board of directors to maintain a written determination for each
individual adjustable rate security in the fund's portfolio--it is
sufficient for the fund to maintain the required record for each type
of security (e.g., one record could be maintained for several different
adjustable rate securities of similar credit quality whose interest
rate readjustment mechanisms are tied to LIBOR plus or minus a number
of basis points that make the securities similarly sensitive to
interest rate changes). The Commission has decided to adopt the
amendments as proposed.163
\163\ Paragraphs (c)(8)(iii) and (c)(9)(iv) of rule 2a-7, as
amended.
---------------------------------------------------------------------------
G. Other Amendments to Rule 2a-7
1. U.S. Dollar Denominated Instruments
To avoid exposure to foreign currency risk, rule 2a-7 limits fund
investment to ``United States dollar-denominated securities.'' 164
The proposed amendments would have defined the term ``United States
dollar-denominated'' to clarify that it means: (a) the payment of
interest and principal must be made in U.S. dollars at all times; and
(b) an eligible security's interest rate may not vary or float with a
rate tied to foreign currencies, foreign interest rates, or any index
expressed in a currency other than U.S. dollars.
\164\ Paragraph (c)(3)(i) of rule 2a-7, as amended.
---------------------------------------------------------------------------
Several commenters were critical of the proposed definition and
recommended that the rule permit fund investment in securities on which
the amount of interest payable is based on changes in the value of a
foreign currency as long as principal and interest are payable in full
in U.S. dollars. The Commission believes that amending the rule in this
manner would have the effect of exposing the fund to currency
fluctuations. The Commission has decided to adopt the definition of
[[Page 13973]]
``United States dollar-denominated'' as proposed.165
\165\ Paragraph (a)(28) of rule 2a-7, as amended.
---------------------------------------------------------------------------
2. Investment in Other Money Funds
The Commission is adopting, as proposed, amendments to rule 2a-7 to
clarify that shares in other money funds that comply with the rule: (a)
are first tier securities;166 and (b) should be treated as having
a rolling maturity equal to the period of time within which the
acquired fund is required to make payment upon redemption under
applicable law.167 A shorter maturity may be used if the fund
making the investment has a contractual arrangement with the other
money fund for more rapid receipt of redemption proceeds.168
\166\ Paragraph (a)(11)(iv) of rule 2a-7, as amended.
\167\ Paragraph (d)(8) of rule 2a-7, as amended. See also
Proposing Release, supra note 20, at n.182 and accompanying text;
T+3 Letter, supra note 65.
\168\ Id.
---------------------------------------------------------------------------
For diversification purposes, an investment in another money fund
generally may be treated as an investment in any other issuer (and
therefore generally cannot exceed five percent of a fund's
assets).169 An exception to this treatment is made for funds that
invest substantially all of their assets in shares of another money
fund (the ``underlying fund'') in which case the fund is permitted to
``look through'' the shares to the assets of the underlying
fund.170 These include funds in ``master-feeder'' arrangements and
certain separate accounts offering variable insurance products. Such a
fund will be deemed to be in compliance with rule 2a-7 for
diversification and other purposes if the board of directors reasonably
believes that the underlying money fund is in compliance with the
rule.171 The board of directors of the fund is not required to
monitor every investment decision made by the underlying fund. Rather,
the board could review the underlying fund's procedures and obtain
regular reports concerning the underlying fund's compliance with the
rule.172
\169\ Investment by one fund in another is limited by section
12(d)(1)(A) of the 1940 Act [15 U.S.C. 80a-12(d)(1)(A)]. Section
12(d)(1)(A) provides that a fund may not invest more than ten
percent of its assets in securities issued by other investment
companies, invest more than five percent of its assets in any single
investment company, or acquire more than three percent of the voting
securities of another investment company.
\170\ Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as amended. The
restrictions of section 12(d)(1)(A) do not apply if the fund making
the investment invests all of its assets in shares of another fund,
subject to certain conditions. Section 12(d)(1)(E) [15 U.S.C. 80a-
12(d)(1)(E)].
\171\ Paragraph (c)(4)(vi)(A)(5) of rule 2a-7, as amended. The
responsibility for making this determination may be delegated by the
board to the fund's adviser. Paragraph (e) of rule 2a-7, as amended.
\172\ In addition, the investment objectives and policies of the
two funds should not be inconsistent. See Guide 34 to Form N-1A and
Guide 38 to Form N-3.
---------------------------------------------------------------------------
3. Board Approval and Reassessment of Certain Securities
Rule 2a-7 currently requires the board of directors of a taxable
fund to approve or ratify purchases of unrated securities and
securities that are rated by only one NRSRO. The amendments eliminate
this requirement.173
\173\ Paragraph (c)(3) of rule 2a-7, as amended.
---------------------------------------------------------------------------
Rule 2a-7 also requires funds to limit portfolio investments to
securities determined to present minimal credit risks. In compliance
with this requirement, the fund's board of directors must reassess
promptly whether a security presents minimal credit risks when the
fund's investment adviser becomes aware that an unrated security or a
second tier security has been given a rating by any NRSRO below the
NRSRO's second highest rating category. The Proposing Release requested
comment on whether to permit delegation of the reassessment
requirement.174 All the commenters who responded to this request
suggested that the rule should permit delegation of the reassessment
requirement to the fund's investment adviser. These commenters stated
that the investment adviser is in a better position to make credit
determinations given its staff and analytical and information
resources. The Commission agrees, and is amending the rule as
suggested.175
\174\ Proposing Release, supra note 20, at Section II.D.6.
\175\ Paragraphs (c)(5)(i)(A) and (e) of rule 2a-7, as amended.
---------------------------------------------------------------------------
4. Recordkeeping
Amendments to rule 2a-7 require a fund to maintain a written record
of the determination that a portfolio security presents minimal credit
risks and to maintain a record of NRSRO ratings (if any) used to
determine the status of a security under the rule.176 The
Commission is also adopting, as proposed, amendments to rule 31a-1
under the 1940 Act that require money funds to maintain in their
portfolio investment records information identifying: (a) each security
by its legal name; (b) any liquidity or credit enhancements associated
with each security; and (c) any coupons, accruals, maturities, puts,
calls or any other information necessary to identify, value and account
for each security.
\176\ Paragraph (c)(9)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
5. Defaulted Securities
Rule 2a-7 imposes certain obligations regarding defaulted
securities.177 The Commission proposed amending the rule to
include ``events of insolvency'' as events that would trigger these
obligations, and is adopting those amendments substantially as they
were proposed.178 The Commission is adopting as proposed an
amendment to the rule that would require a fund to notify the
Commission of the default of a security subject to a credit enhancement
or demand feature only in the event that the provider of the
enhancement or demand feature failed to fulfill its obligations to the
fund.179
\177\ See Proposing Release, supra note 20, at Section II.D.8.
\178\ Paragraphs (a)(10) and (c)(5)(ii) of rule 2a-7, as
amended.
\179\ Paragraph (c)(5)(iv) of rule 2a-7, as amended.
---------------------------------------------------------------------------
6. Technical Amendments
The Commission is adopting technical amendments to rule 2a-7 to
clarify its terminology. References to ``instruments'' are being
changed to ``securities.'' In addition, references to the requirement
that the market value of an adjustable rate security must reasonably
approximate its par value are being changed to clarify that the
security's market value must reasonably approximate its amortized
cost.180 The definition of ``unrated security'' also is being
revised to clarify that if an unrated security becomes rated while held
by the fund, the fund may continue to treat it as an unrated security,
in the same manner as a fund may continue to determine whether a
security rated by a single NRSRO is first or second tier if a second
NRSRO rates the security after it is acquired by the fund.181 The
definition of ``first tier security'' is also being amended to include
government securities.182
\180\ Paragraphs (a)(12), (a)(30), and (c)(8)(iii) of rule 2a-7,
as amended. See supra Section II.F.4.a. (discussion of determination
that par will be approximated).
\181\ Paragraph (a)(29) of rule 2a-7, as amended.
\182\ Paragraphs (a)(11)(v) and (a)(13) of rule 2a-7, as
amended. Prior to the adoption of today's amendments, a fund
purchasing a government security would have been required to treat
the security as an unrated first tier security (paragraph
(a)(11)(iii) of rule 2a-7, as amended), because NRSROs do not rate
government securities. As a result, the fund would have been
required to perform a comparability analysis. Under the amended
definition of ``first tier security,'' a fund may treat a government
security as first tier without conducting a comparability analysis,
even though the security has not received a rating from an NRSRO.
---------------------------------------------------------------------------
III. Amendments to Disclosure Rules
The Commission is adopting amendments to the forms and advertising
rules used by tax exempt
[[Page 13974]]
funds and is publishing a Staff Guide designed to elicit disclosures
concerning the specific risks of investing in tax exempt funds.
A. Single State Funds
To alert investors to the greater risks of investing in single
state funds, proposed amendments to Form N-1A would have a required a
single state fund to disclose in its prospectus that: (1) its
investments are concentrated geographically; (2) for a single state
fund that does not meet the Five Percent Diversification Test, that the
fund may invest a significant percentage of its assets in the
securities of a single issuer; and (3) that an investment in the fund
therefore may be riskier than an investment in other types of money
funds.
Several commenters, while generally supporting additional
disclosure, expressed concern that the proposed disclosure for single
state funds might exaggerate the risk of investing in these funds,
leading to investor confusion. These commenters urged the Commission
not to require a single state fund to disclose that an investment in it
may be riskier than an investment in another type of money fund. The
amendments to rule 2a-7 require single state funds to be diversified at
the five percent level as to seventy-five percent of their assets, but
these funds are less diversified than other types of money market funds
and are still dependent on the financial health of a particular
state.183 Because of the importance of diversification in
protecting a fund from exposure to a particular issuer, the Commission
has decided to require a single state fund that is not diversified as
to 100% of assets to disclose on the cover page of the prospectus that
it may invest a significant percentage of its assets in the securities
of a single issuer, and that an investment in the fund may therefore be
riskier than investment in other types of money funds. The Commission
has also decided to adopt the disclosure requirement regarding
geographic concentration, which may be placed in the text of the
prospectus, substantially as proposed.184
\183\ See supra Section II.B.1.a. of this Release and paragraph
(c)(4)(ii) of rule 2a-7, as amended.
\184\ Item 4(c) of Form N-1A, as amended.
---------------------------------------------------------------------------
B. Disclosure Concerning Exposure to Put Providers
The Commission is publishing an amendment to Staff Guide 21 to Form
N-1A. The amendment interprets the form as requiring a money fund
having more than forty percent of its portfolio subject to third party
credit enhancements to disclose that the safety of its portfolio (and
the ability of the fund to maintain a stable share price) is largely
dependent upon guarantees from foreign and domestic banks and that
these arrangements are not subject to federal deposit insurance. The
wording of the guide has been changed somewhat from the draft published
in the Proposing Release 185 to reflect the approach taken by the
Commission in proposing to simplify money market fund
prospectuses.186
\185\ Guide 21 to Form N-1A, as amended.
\186\ Investment Company Act Rel. No. 21216 (July 19, 1995) [60
FR 38454 (July 26, 1995)].
---------------------------------------------------------------------------
Under the proposed amendments, money fund portfolio schedules would
have been required to include information regarding put
providers.187 Those amendments are not being adopted at this time.
The Commission is currently examining portfolio schedule requirements
for investment companies generally and will continue to consider the
proposed amendments in connection with that project.
\187\ Proposing Release, supra note 20, at Section III.C.
---------------------------------------------------------------------------
C. Risk Disclosure in Certain Communications
Money funds are required to include in certain advertisements and
sales literature a statement that an investment in a money fund is not
insured or guaranteed by the U.S. Government and there can be no
assurance that the fund will maintain a stable net asset value.188
The amendments extend this requirement to ``tombstone'' advertisements
under rule 134 of the 1933 Act.189
\188\ See paragraph (a)(7) of rule 482 [17 CFR 230.482(a)(7)]
and introductory paragraph of rule 34b-1 [17 CFR 270.34b-1].
\189\ Paragraph (e) or rule 134, as amended [17 CFR 230.134(e)].
---------------------------------------------------------------------------
IV. Exemptive Rule Governing Purchases of Certain Portfolio Securities
by Affiliated Persons
The Proposing Release noted that when money funds have held a
security that is no longer eligible for fund investment, fund advisers
or related persons frequently have repurchased the security from the
fund at the security's amortized cost value to avoid any fund
shareholder loss.190 These transactions came within section
17(a)(2) of the 1940 Act [15 U.S.C. 80a-17(a)(2)], which prohibits an
affiliated person of a fund, or an affiliated person of such a person,
from knowingly purchasing a security from the fund in the absence of a
Commission exemption. Nevertheless, the transactions appeared to be
reasonable, fair, in the best interests of fund shareholders, and
consistent with the actions that a fund should take in the event of a
default of a portfolio security.191 Thus, the staff of the
Division of Investment Management advised parties to these transactions
that the staff would not recommend enforcement action to the Commission
if these transactions were consummated.
\190\ Proposing Release, supra note 20, at nn.12 and 28 and
accompanying text.
\191\ Paragraph (c)(5)(ii) of rule 2a-7, as amended, requires a
fund holding a defaulted security to dispose of the security as soon
as practicable consistent with achieving an orderly disposition of
the security, unless the fund's board of directors concludes that
disposal would not be in the best interests of the fund.
---------------------------------------------------------------------------
Based upon the Commission's experience with actions taken by funds
and their affiliates to dispose of portfolio securities that were no
longer eligible under rule 2a-7,192 the Commission proposed new
rule 17a-9 to exempt from section 17(a) of the 1940 Act the purchase of
a security that is no longer an eligible security. Several commenters,
including the ICI, opposed the adoption of rule 17a-9, asserting that
its mere existence would cause investors to expect a fund's adviser to
purchase ineligible securities from the fund, and guarantee that the
fund will maintain a stable net asset value.
\192\ See Testimony of Arthur Levitt, Chairman, U.S. Securities
and Exchange Commission, Concerning Issues Affecting the Mutual Fund
Industry Before the Subcommittee on Telecommunications and Finance,
Committee on Energy and Commerce, U.S. House of Representatives, 23-
25 (Sept. 27, 1994); Testimony of Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, Concerning Municipal Bond and
Government Securities Markets Before the Committee on Banking,
Housing and Urban Affairs, U.S. Senate, 10-11 (Jan. 5, 1995).
---------------------------------------------------------------------------
The Commission believes that existing rules applicable to money
funds already address this concern by requiring money fund prospectuses
and sales literature to disclose prominently that there is no assurance
or guarantee that a fund will be able to maintain a stable net asset
value of $1.00 per share.193 Moreover, the Commission believes it
unlikely that the existence of an exemptive rule alone will create any
investor expectations.
\193\ See Release 18005, supra note 11, at Section II.H.
(adopting amendments to Item 1(a)(ix) of Form N-1A).
---------------------------------------------------------------------------
The Commission has decided to adopt the rule as proposed. In doing
so, the Commission is not suggesting that affiliated persons of funds
have any legal obligation to enter into transactions covered by the new
rule. The exemption applies to transactions where: (a) the purchase
price is paid in cash; and (b) the purchase price is equal to the
greater of the amortized cost of the security or its market price (in
each
[[Page 13975]]
case, including accrued interest).194 The rule, as adopted, is
available for transactions involving securities that are no longer
eligible securities because they no longer satisfy either the credit
quality or maturity limiting provisions of the rule (e.g., the
securities are long-term adjustable rate securities whose market values
no longer approximate their par values on the interest rate
readjustment dates).
\194\ See rule 17a-9, as adopted. A fund must notify the
Commission in the event of default with respect to portfolio
securities that account for one half of one percent or more of a
fund's assets immediately before the occurrence of default. See
paragraph (c)(5)(iii) of rule 2a-7, as amended.
---------------------------------------------------------------------------
V. Compliance Dates
A. General Compliance Date
Money funds may comply with any of the amendments or rules adopted
today upon publication of this release in the Federal Register.
Beginning October 3, 1996, money funds must comply with all amendments
and rules adopted today not specifically addressed below in paragraphs
B. and C.195 The Commission is delegating to the Division Director
the authority to address issues regarding compliance dates that are not
addressed in this section, unless the Director believes that it is
necessary in the public interest or in the interest of investors that
the Commission consider the issue.
\195\ To the extent these amendments involve clarification of
Commission or staff interpretations of the current provisions of
rule 2a-7, these compliance dates are not intended to suggest that
non-compliance prior thereto does not involve a violation of rule
2a-7.
---------------------------------------------------------------------------
Rule 2a-7 requires funds to meet the rule's diversification
requirements with respect to a particular issuer on the date the fund
acquires a security of that issuer.196 Therefore, phase-in rules
for the new diversification requirements for tax exempt funds are
unnecessary. A tax exempt fund holding a greater percentage of its
total assets in the securities of an issuer than the applicable
diversification requirement permits as of October 3, 1996 may not
purchase additional securities or ``roll over'' current holdings until
such securities purchased or rolled over will not cause the fund to
exceed the applicable diversification requirements immediately after
the purchase or rollover. Funds are not required to exercise puts or
otherwise dispose of portfolio holdings to meet the new diversification
requirements.
\196\ Paragraphs (c)(4) (i) and (ii) (with respect to
diversification generally) and (c)(4)(v) (with respect to
diversification of puts) of rule 2a-7, as amended.
---------------------------------------------------------------------------
B. Grandfathered Securities
To minimize disruption to funds and markets as a result of adoption
of these amendments, the Commission is ``grandfathering'' certain
securities first issued on or before June 3, 1996 that do not meet the
following requirements of the amended rule:
(1) requirement that demand features be rated; 197
\197\ Paragraph (a)(9)(iii)(D)(1) of rule 2a-7, as amended.
---------------------------------------------------------------------------
(2) requirement that, in order for a security subject to a demand
feature to be an eligible security, the fund must receive notice from
the demand feature's issuer or another institution if there is a
substitution of the provider of the demand feature; 198
\198\ Paragraph (a)(9)(iii)(D)(2) of rule 2a-7, as amended.
---------------------------------------------------------------------------
(3) new requirements for ABSs regarding maturity determinations and
ratings; 199
\199\ Paragraphs (a)(7)(ii) (definition of demand feature for
ABS) and (a)(9)(iii)(C) (rating requirements) of rule 2a-7, as
amended. Note, however, that funds are required to apply the
diversification requirements for ABS in accordance with Section
V.A., supra, of this Release. See also paragraph (c)(4)(vi)(A)(4) of
rule 2a-7, as amended (diversification calculation for ABSs).
---------------------------------------------------------------------------
(4) revised definition of ``put'' to include ability to recover
principal and any accrued interest; 200 and
\200\ Paragraph (a)(16) of rule 2a-7, as amended.
---------------------------------------------------------------------------
(5) requirement that security subject to conditional demand feature
is an eligible security only if board of directors or its delegate
makes certain determinations regarding the demand feature's
exercisability.201
\201\ Paragraph (c)(3)(iii)(B) of rule 2a-7, as amended.
---------------------------------------------------------------------------
A money fund may continue to hold these ``grandfathered''
securities or acquire such securities provided that they satisfy the
other provisions of the rule, as amended, and are issued on or before
June 3, 1996.
C. Disclosure and Reporting
The following amendments pertaining to disclosure and advertising
will become effective as follows:
(1) amendments to Form N-1A will be effective: (1) for investment
companies whose registration statements become effective on or after
June 3, 1996 upon use of any prospectus on or after June 3, 1996; and
(2) for all other investment companies, upon use of any prospectus
contained in any post-effective amendment filed on or after June 3,
1996;
(2) amendments to Form N-SAR will be effective for any report
required by rules 30a-1 and 30b1-1 [17 CFR 270.30a-1 and 270.30b1-1]
filed on or after July 3, 1996; and
(3) the amendment to rule 134 under the Securities Act of 1933 will
be effective for ``tombstone'' advertisements used after June 3, 1996.
VI. Regulatory Flexibility Analysis
A summary of the Initial Regulatory Flexibility Analysis regarding
the proposed rule and form amendments was published in the Proposing
Release. No comments were received. The Commission has prepared a Final
Regulatory Flexibility Analysis in accordance with 5 U.S.C. 604, a copy
of which may be obtained by contacting Martha H. Platt, Senior
Attorney, Mail Stop 10-6, Securities and Exchange Commission, 450 Fifth
Street, N.W., Washington, D.C. 20549.
VII. Statutory Authority
The Commission is amending rule 2a-7 under the exemptive and
rulemaking authority set forth in sections 6(c) [15 U.S.C. 80a-6(c)],
8(b) [15 U.S.C. 80a-8(b)], 22(c) [15 U.S.C. 80a-22(c)], 34(b) [15
U.S.C. 80a-34(b)], and 38(a) [15 U.S.C. 80a-37(a)] of the Investment
Company Act of 1940. The Commission is adopting rule 17a-9 under the
exemptive and rulemaking authority set forth in sections 6(c) [15
U.S.C. 80a-6(c)] and 38(a) [15 U.S.C. 80a-37(a)] of the Investment
Company Act of 1940. The authority citations for the amendments to the
rules and forms precede the text of the amendments.
VIII. Text of Rule and Form Amendments
List of Subjects in 17 CFR Parts 230, 239, 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
For the reasons set out in the preamble, the Commission is amending
chapter II, title 17 of the Code of Federal Regulations as follows:
PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933
1. The authority citation for Part 230 continues to read in part as
follows:
Authority: 15 U.S.C. 77b, 77f, 77g, 77h, 77j, 77s, 77sss, 78c,
78d, 78l, 78m, 78n, 78o, 78w, 79ll(d), 79t, 80a-8, 80a-29, 80a-30,
and 80a-37, unless otherwise noted.
* * * * *
2. Section 230.134 is amended by adding paragraph (e) to read as
follows:
Sec. 230.134 Communications not deemed a prospectus.
* * * * *
(e) In the case of an investment company registered under the
Investment Company Act of 1940 that holds itself out as a ``money
market fund,'' a communication used under
[[Page 13976]]
this section shall contain the disclosure required by
Sec. 230.482(a)(7).
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
3. The authority citation for Part 270 is amended by removing the
third paragraph in the sub-authority to read as follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless
otherwise noted;
* * * * *
4. Section 270.2a-7 is revised to read as follows:
Sec. 270.2a-7 Money market funds.
(a) Definitions.
(1) Amortized Cost Method of valuation shall mean the method of
calculating an investment company's net asset value whereby portfolio
securities are valued at the fund's acquisition cost as adjusted for
amortization of premium or accretion of discount rather than at their
value based on current market factors.
(2) Asset Backed Security shall mean a fixed income security (other
than a Government security) issued by a Special Purpose Entity (as
hereinafter defined), substantially all of the assets of which consist
of Qualifying Assets (as hereinafter defined). Special Purpose Entity
shall mean a trust, corporation, partnership or other entity organized
for the sole purpose of issuing fixed income securities which entitle
their holders to receive payments that depend primarily on the cash
flow from Qualifying Assets, but does not include a registered
investment company. Qualifying Assets shall mean financial assets,
either fixed or revolving, that by their terms convert into cash within
a finite time period, plus any rights or other assets designed to
assure the servicing or timely distribution of proceeds to security
holders.
(3) Business Day shall mean any day, other than Saturday, Sunday,
or any customary business holiday.
(4) Collateralized Fully in the case of a repurchase agreement
shall mean that:
(i) The value of the securities collateralizing the repurchase
agreement (reduced by the transaction costs (including loss of
interest) that the money market fund reasonably could expect to incur
if the seller defaults) is, and during the entire term of the
repurchase agreement remains, at least equal to the Resale Price (as
defined hereinafter) provided in the agreement; and
(ii) The money market fund or its custodian either has actual
physical possession of the collateral or, in the case of a security
registered on a book entry system, the book entry is maintained in the
name of the money market fund or its custodian; and
(iii) The money market fund retains an unqualified right to possess
and sell the collateral in the event of a default by the seller; and
(iv) The collateral consists entirely of securities that are direct
obligations of, or that are fully guaranteed as to principal and
interest by, the United States or any agency thereof, and/or
certificates of deposit, bankers' acceptances which are eligible for
acceptance by a Federal Reserve Bank, and, if the seller is a
depositary institution as defined in 12 U.S.C. 1813(c), mortgage
related securities (as such term is defined in section 3(a)(41) of the
Securities Exchange Act of 1934 [15 U.S.C. 78c(a)(41)]) that, at the
time the repurchase agreement is entered into, are rated in the highest
rating category by the Requisite NRSROs.
(v) Resale Price shall mean the purchase price paid to the seller
of the securities plus the accrued resale premium on such purchase
price. The accrued resale premium shall be the amount specified in the
repurchase agreement or the daily amortization of the difference
between the purchase price and the resale price specified in the
repurchase agreement.
(5) Conditional Demand Feature shall mean a Demand Feature that is
not an Unconditional Demand Feature.
(6) Conduit Security shall mean a security issued by a Municipal
Issuer (as hereinafter defined) involving an arrangement or agreement
entered into, directly or indirectly, with a person other than a
Municipal Issuer, which arrangement or agreement provides for or
secures repayment of the security. Municipal Issuer shall mean a state
or territory of the United States (including the District of Columbia),
or any political subdivision or public instrumentality of a state or
territory of the United States. A Conduit Security does not include a
security that is:
(i) Fully and unconditionally guaranteed by a Municipal Issuer; or
(ii) Payable from the general revenues of the Municipal Issuer or
other Municipal Issuers (other than those revenues derived from an
agreement or arrangement with a person who is not a Municipal Issuer
that provides for or secures repayment of the security issued by the
Municipal Issuer); or
(iii) Related to a project owned and operated by a Municipal
Issuer; or
(iv) Related to a facility leased to and under the control of an
industrial or commercial enterprise that is part of a public project
which, as a whole, is owned and under the control of a Municipal
Issuer.
(7) Demand Feature shall mean:
(i) A Put that may be exercised either:
(A) At any time on no more than 30 days' notice; or
(B) At specified intervals not exceeding 397 calendar days and upon
no more than 30 days' notice; or
(ii) A feature permitting the holder of an Asset Backed Security
unconditionally to receive principal and interest within thirteen
months of making demand.
(8) Demand Feature Issued By A Non-Controlled Person shall mean a
Demand Feature issued by a person that, directly or indirectly, does
not control, and is not controlled by or under common control with the
issuer of the security subject to the Demand Feature. Control shall
mean ``control'' as defined in section 2(a)(9) of the Act [15 U.S.C.
80a-2(a)(9)].
(9) Eligible Security shall mean:
(i) A security with a remaining maturity of 397 calendar days or
less that has received a short-term rating (or that has been issued by
an issuer that has received a short-term rating with respect to a class
of debt obligations, or any debt obligation within that class, that is
comparable in priority and security with the security) by the Requisite
NRSROs in one of the two highest short-term rating categories (within
which there may be sub-categories or gradations indicating relative
standing); or
(ii) A security:
(A) That at the time of issuance had a remaining maturity of more
than 397 calendar days but that has a remaining maturity of 397
calendar days or less; and
(B) Whose issuer has received from the Requisite NRSROs a rating
with respect to a class of debt obligations (or any debt obligation
within that class) that is now comparable in priority and security with
the security, in one of the two highest short-term rating categories
(within which there may be sub-categories or gradations indicating
relative standing); or
(iii) An Unrated Security that is of comparable quality to a
security meeting the requirements of paragraphs (a)(9)(i) or (ii) of
this section, as determined by the money market fund's board of
directors; Provided, however, that:
(A) The board of directors may base its determination that a
Standby Commitment that is not a Demand Feature is an Eligible Security
upon a finding that the issuer of the commitment presents a minimal
risk of default;
[[Page 13977]]
(B) A security that at the time of issuance had a remaining
maturity of more than 397 calendar days but that has a remaining
maturity of 397 or less and that is an Unrated Security is not an
Eligible Security if the security has received a long-term rating from
any NRSRO that is not within the NRSRO's three highest long-term
ratings categories (within which there may be sub-categories or
gradations indicating relative standing);
(C) An Asset Backed Security shall not be an Eligible Security
unless it has a debt rating from an NRSRO; and
(D) A security that is subject to a Demand Feature shall not be an
Eligible Security unless:
(1) The Demand Feature has received a short-term rating from an
NRSRO (or the issuer of the Demand Feature has received from an NRSRO a
short-term rating with respect to a class of debt obligations or any
debt obligation within that class that is comparable in priority and
security to the Demand Feature); and
(2) The issuer of the Demand Feature, or another institution,
undertakes to notify promptly the holder of the security in the event
that the Demand Feature is substituted with a Demand Feature provided
by another issuer.
(10) Event of Insolvency shall mean, with respect to an issuer or
guarantor:
(i) An admission of insolvency, the application by the issuer or
guarantor for the appointment of a trustee, receiver, rehabilitator, or
similar officer for all or substantially all of its assets, a general
assignment for the benefit of creditors, the filing by the issuer of a
voluntary petition in bankruptcy or application for reorganization or
an arrangement with creditors; or
(ii) The institution of similar proceedings by another person which
proceedings are not contested by the issuer or guarantor; or
(iii) The institution of similar proceedings by a government agency
responsible for regulating the activities of the issuer or guarantor,
whether or not contested by the issuer or guarantor.
(11) First Tier Security shall mean any Eligible Security that:
(i) Has received a short-term rating (or that has been issued by an
issuer that has received a short-term rating with respect to a class of
debt obligations, or any debt obligation within that class, that is
comparable in priority and security with the security) by the Requisite
NRSROs in the highest short-term rating category for debt obligations
(within which there may be sub-categories or gradations indicating
relative standing); or
(ii) Is a security described in paragraph (a)(9)(ii) of this
section whose issuer has received from the Requisite NRSROs a short-
term rating with respect to a class of debt obligations (or any debt
obligation within that class) that now is comparable in priority and
security with the security, in the highest short-term rating category
for debt obligations (within which there may be sub-categories or
gradations indicating relative standing); or
(iii) Is an Unrated Security that is of comparable quality to a
security meeting the requirements of paragraphs (a)(11)(i) and (ii) of
this section, as determined by the fund's board of directors; or
(iv) Is a security issued by a registered investment company that
is a money market fund; or
(v) Is a Government Security.
(12) Floating Rate Security shall mean a security the terms of
which provide for the adjustment of its interest rate whenever a
specified interest rate changes and which, at any time until the final
maturity of the instrument or the period remaining until the principal
amount can be recovered through demand, can reasonably be expected to
have a market value that approximates its amortized cost.
(13) Government Security shall mean any Government Security as
defined in section 2(a)(16) of the Act [15 U.S.C. 80a-2(a)(16)].
(14) NRSRO shall mean any nationally recognized statistical rating
organization, as that term is used in paragraphs (c)(2)(vi)(E), (F) and
(H) of Sec. 240.15c3-1 of this Chapter that is not an affiliated
person, as defined in section 2(a)(3)(C) of the Act [15 U.S.C. 80a-
2(a)(3)(C)], of the issuer of, or any insurer, guarantor or provider of
credit support for, the security.
(15) Penny-Rounding Method of pricing shall mean the method of
computing an investment company's price per share for purposes of
distribution, redemption and repurchase whereby the current net asset
value per share is rounded to the nearest one percent.
(16) Put shall mean a right to sell a specified underlying security
or securities within a specified period of time and at an exercise
price equal to the amortized cost of the underlying security or
securities plus accrued interest, if any, at the time of exercise, that
may be sold, transferred or assigned only with the underlying security
or securities. A Put will be considered to be from the party to whom
the money market fund will look for payment of the exercise price.
(17) Put Issued by a Non-Controlled Person shall mean a Put issued
by a person that, directly or indirectly, does not control, and is not
controlled by or under common control with the issuer of the security
subject to the Put. Control shall mean ``control'' as defined in
section 2(a)(9) of the Act [15 U.S.C 80a-2(a)(9)].
(18) Refunded Security shall mean a debt security the principal and
interest payments of which are to be paid by Government Securities
(``deposited securities'') that have been irrevocably placed in an
escrow account pursuant to agreement between the issuer of the debt
security and an escrow agent that is not an affiliated person, as
defined in section 2(a)(3)(C) of the Act [15 U.S.C. 80a-2(a)(3)(C)], of
the issuer of the debt security, and, in accordance with such escrow
agreement, are pledged only to the payment of the debt security and, to
the extent that excess proceeds are available after all payments of
principal, interest, and applicable premiums on the Refunded
Securities, the expenses of the escrow agent and, thereafter, to the
issuer or another party; provided that:
(i) The deposited securities shall not be redeemable prior to their
final maturity;
(ii) At the time the deposited securities are placed in the escrow
account, an independent certified public accountant shall have
certified to the escrow agent that the deposited securities will
satisfy all scheduled payments of principal, interest and applicable
premiums on the Refunded Securities; and
(iii) The escrow agreement shall prohibit the substitution of the
deposited securities unless the substituted securities are Government
Securities and, at the time of such substitution, the escrow agent
shall have received a certification from an independent certified
public accountant substantially the same as that required by paragraph
(a)(18)(ii) of this section which certification shall give effect to
the substitution.
(19) Requisite NRSROs shall mean:
(i) Any two NRSROs that have issued a rating with respect to a
security or class of debt obligations of an issuer; or
(ii) If only one NRSRO has issued a rating with respect to such
security or class of debt obligations of an issuer at the time the fund
purchases or rolls over the security, that NRSRO.
(20) Second Tier Security shall mean any Eligible Security that is
not a First Tier Security. Second Tier Conduit Security shall mean any
Conduit Security that is an Eligible Security that is not a First Tier
Security.
(21) Single State Fund shall mean a Tax Exempt Fund that holds
itself out as primarily distributing income exempt
[[Page 13978]]
from the income taxes of a specified state or locality.
(22) Standby Commitment shall mean a Put that entitles the holder
to achieve same day settlement.
(23) Tax Exempt Fund shall mean any money market fund that holds
itself out as distributing income exempt from regular federal income
tax.
(24) Total Assets shall mean, with respect to a money market fund
using the Amortized Cost Method, the total amortized cost of its assets
and, with respect to any other money market fund, the total market-
based value of its assets.
(25) Unconditional Demand Feature shall mean an Unconditional Put
that is also a Demand Feature.
(26) Unconditional Demand Feature Issued By A Non-Controlled Person
shall mean an Unconditional Put that is also a Demand Feature Issued By
A Non-Controlled Person.
(27) Unconditional Put shall mean a Put (including any guarantee,
financial guarantee (bond) insurance, letter of credit or similar
unconditional credit enhancement) that by its terms would be readily
exercisable in the event of a default in payment of principal or
interest on the underlying security or securities.
(28) United States Dollar-Denominated shall mean, with reference to
a security, that all principal and interest payments on such security
are payable to security holders in United States dollars under all
circumstances and that the interest rate of, the principal amount to be
repaid, and the timing of payments related to such security do not vary
or float with the value of a foreign currency, the rate of interest
payable on foreign currency borrowings, or with any other interest rate
or index expressed in a currency other than United States dollars.
(29) Unrated Security shall mean:
(i) A security with a remaining maturity of 397 calendar days or
less issued by an issuer that did not, at the time the security was
acquired or rolled over by the fund, have a current short-term rating
assigned by any NRSRO:
(A) To the security; or
(B) To the issuer of the security with respect to a class of debt
obligations
(or any debt obligation within that class) that is comparable in
priority and security with the security, or a Demand Feature with
respect to the security; and
(ii) A security:
(A) That at the time of issuance had a remaining maturity of more
than 397 calendar days but that has a remaining maturity of 397
calendar days or less; and
(B) Whose issuer had not at the time it was acquired or rolled over
by the fund received from any NRSRO a short-term rating with respect to
a class of debt obligations (or any debt obligation within that class)
that now is comparable in priority and security with the security; and
(iii) A security that is a rated security and is the subject of an
external credit support agreement (including an arrangement by which
the security has become a Refunded Security) that was not in effect
when the security (or the issuer) was assigned its rating unless the
security has a rating from an NRSRO reflecting the existence of the
credit support agreement.
(iv) A security is not an Unrated Security if any debt obligation
(reference security) that is issued by the same issuer and is
comparable in priority and security with that security has a short-term
rating by an NRSRO. The status of such security as an Eligible Security
or First Tier Security shall be the same as that of the reference
security.
(30) Variable Rate Security shall mean a security the terms of
which provide for the adjustment of its interest rate on set dates
(such as the last day of a month or calendar quarter) and which, upon
each adjustment until the final maturity of the instrument or the
period remaining until the principal amount can be recovered through
demand, can reasonably be expected to have a market value that
approximates its amortized cost.
(b) Holding Out. It shall be an untrue statement of material fact
within the meaning of section 34(b) of the Act [15 U.S.C. 80a-33(b)]
for a registered investment company, in any registration statement,
application, report, account, record, or other document filed or
transmitted pursuant to the Act, including any advertisement, pamphlet,
circular, form letter, or other sales literature addressed to or
intended for distribution to prospective investors that is required to
be filed with the Commission by section 24(b) of the Act [15 U.S.C.
80a-24(b)] to:
(1) Adopt the term ``money market'' as part of its name or title or
the name or title of any redeemable securities of which it is the
issuer; or
(2) Hold itself out to investors as, or adopt a name which suggests
that it is, a money market fund or the equivalent of a money market
fund, unless such registered investment company meets the conditions of
paragraphs (c)(2), (c)(3), and (c)(4) of this section. For purposes of
this paragraph, a name which suggests that a registered investment
company is a money market fund or the equivalent thereof shall include
one which uses such terms as ``cash,'' ``liquid,'' ``money,'' ``ready
assets'' or similar terms.
(c) Share Price Calculations. The current price per share, for
purposes of distribution, redemption and repurchase, of any redeemable
security issued by any registered investment company (``money market
fund''), notwithstanding the requirements of section 2(a)(41) of the
Act [15 U.S.C. 80a-2(a)(41)] and of Secs. 270.2a-4 and 270.22c-1
thereunder, may be computed by use of the Amortized Cost Method or the
Penny-Rounding Method; Provided, however, That:
(1) Board Findings. The board of directors of the money market fund
shall determine, in good faith, that it is in the best interests of the
fund and its shareholders to maintain a stable net asset value per
share or stable price per share, by virtue of either the Amortized Cost
Method or the Penny-Rounding Method, and that the money market fund
will continue to use such method only so long as the board of directors
believes that it fairly reflects the market-based net asset value per
share.
(2) Portfolio Maturity. The money market fund shall maintain a
dollar-weighted average portfolio maturity appropriate to its objective
of maintaining a stable net asset value per share or price per share;
Provided, however, That the money market fund will not:
(i) Except as provided in paragraph (c)(2)(ii) of this section,
purchase any instrument with a remaining maturity of greater than 397
calendar days; or
(ii) In the case of a money market fund not using the Amortized
Cost Method, purchase a Government Security with a remaining maturity
of greater than 762 calendar days; or
(iii) Maintain a dollar-weighted average portfolio maturity that
exceeds ninety days.
(3) Portfolio Quality.
(i) General. The money market fund shall limit its portfolio
investments, including Puts and repurchase agreements, to those United
States Dollar-Denominated securities that the fund's board of directors
determines present minimal credit risks (which determination must be
based on factors pertaining to credit quality in addition to any rating
assigned to such securities by an NRSRO) and which are at the time of
acquisition Eligible Securities.
(ii) Securities Subject to Unconditional Demand Features. A
security that is subject to an Unconditional Demand Feature may be
determined to be an Eligible Security or a First Tier Security based
solely on
[[Page 13979]]
whether the Unconditional Demand Feature is an Eligible Security or
First Tier Security, as the case may be.
(iii) Securities Subject to Conditional Demand Features. A security
that is subject to a Conditional Demand Feature (``Underlying
Security'') may be determined to be an Eligible Security or a First
Tier Security only if:
(A) The Conditional Demand Feature is an Eligible Security or First
Tier Security, as the case may be; and
(B) At the time of the purchase of the Underlying Security, the
money market fund's board of directors has determined that there is
minimal risk that the circumstances that would result in the
Conditional Demand Feature not being exercisable will occur; and
(1) The conditions limiting exercise either can be monitored
readily by the fund, or relate to the taxability, under federal, state
or local law, of the interest payments on the security; or
(2) The terms of the Conditional Demand Feature require that the
fund will receive notice of the occurrence of the condition and the
opportunity to exercise the Demand Feature in accordance with its
terms; and
(C) (1) If the Underlying Security has a remaining maturity of 397
days or less, the Underlying Security (or the debt securities of issuer
of the Underlying Security) has received a short-term rating by the
Requisite NRSROs within the NRSROs' two highest short-term ratings
categories (within which there may be sub-categories or gradations
indicating relative standing) or, if unrated, is determined to be of
comparable quality by the money market fund's board of directors; or
(2) If the Underlying Security has a remaining maturity of more
than 397 calendar days, the Underlying Security (or the debt securities
of the issuer of the Underlying Security) has received a long-term
rating by the Requisite NRSROs within the NRSROs' two highest long-term
rating categories (within which there may be sub-categories or
gradations indicating relative standing) or, if unrated, is determined
to be of comparable quality by the money market fund's board of
directors.
(4) Portfolio Diversification.
(i) Taxable and National Funds. Immediately after the acquisition
of any security (other than a Government Security or a security subject
to an Unconditional Demand Feature Issued By a Non-Controlled Person),
a money market fund other than a Single State Fund shall not have
invested more than five percent of its Total Assets in securities
issued by the issuer of the security.
(ii) Single State Funds. With respect to 75 percent of its Total
Assets, immediately after the acquisition of any security (other than a
Government Security or a security subject to an Unconditional Demand
Feature Issued By a Non-Controlled Person), a Single State Fund shall
not have invested more than five percent of its Total Assets in
securities issued by the issuer of the security; Provided, however,
That a Single State Fund shall not invest more than five percent of its
Total Assets in securities issued by the issuer of the security unless
the securities are First Tier Securities.
(iii) Safe Harbor. Notwithstanding paragraph (c)(4)(i) of this
section, a money market fund other than a Single State Fund may invest
up to twenty-five percent of its Total Assets in the First Tier
Securities of a single issuer for a period of up to three Business days
after the purchase thereof.
(iv) Second Tier Securities.
(A) Taxable Funds. Immediately after the acquisition of any Second
Tier Security, a money market fund that is not a Tax Exempt Fund shall
not have invested more than:
(1) The greater of one percent of its Total Assets or one million
dollars in securities issued by that issuer which, when acquired by the
money market fund (either initially or upon any subsequent roll over)
were Second Tier Securities; and
(2) Five percent of its Total Assets in securities which, when
acquired by the money market fund (either initially or upon any
subsequent roll over) were Second Tier Securities.
(B) Tax Exempt Funds. Immediately after the acquisition of any
Second Tier Conduit Security that is not subject to an Unconditional
Demand Feature Issued By a Non-Controlled Person, a money market fund
that is a Tax Exempt Fund shall not have invested more than:
(1) The greater of one percent of its Total Assets or one million
dollars in securities issued by that issuer which, when acquired by the
money market fund (either initially or upon any subsequent roll over)
were Second Tier Conduit Securities not subject to an Unconditional
Demand Feature Issued By a Non-Controlled Person; and
(2) Five percent of its Total Assets in Conduit Securities which,
when acquired by the money market fund (either initially or upon any
subsequent roll over) were Second Tier Conduit Securities not subject
to an Unconditional Demand Feature Issued By a Non-Controlled Person.
(v) Puts.
(A) General. Immediately after the acquisition of any Put or
security subject to a Put, with respect to seventy-five percent of the
assets of a money market fund, no more than ten percent of the fund's
Total Assets may be invested in securities issued by or subject to Puts
from the institution that issued the Put, subject to sections
(c)(4)(v)(B) and (C) of this section.
(B) Second Tier Puts. Immediately after the acquisition of any Put
(or a security after giving effect to the Put) that is a Second Tier
Security, a money market fund shall not have invested more than five
percent of its Total Assets in securities issued by or subject to Puts
from the institution that issued the Put.
(C) Puts Issued by Non-Controlled Persons. Immediately after the
acquisition of any security subject to a Put, a money market fund shall
not have invested more than ten percent of its Total Assets in
securities issued by, or subject to Puts from the institution that
issued the Put, unless, with respect to any security subject to Puts
from that institution, the Put is a Put Issued By a Non-Controlled
Person.
(iv) Diversification Calculations.
(A) General. For purposes of making calculations under paragraphs
(c)(4)(i) through (iv) of this section:
(1) Repurchase Agreements. The acquisition of a repurchase
agreement may be deemed to be an acquisition of the underlying
securities, provided that the obligation of the seller to repurchase
the securities from the money market fund is Collateralized Fully.
(2) Refunded Securities. The acquisition of a Refunded Security
shall be deemed to be an acquisition of a Government Security.
(3) Conduit Securities. A Conduit Security shall be deemed to be
issued by the issuer (other than the Municipal Issuer) ultimately
responsible for payments of interest and principal on the security.
(4) Asset Backed Securities. An Asset Backed Security shall be
deemed to be issued by the Special Purpose Entity that issued the Asset
Backed Security, Provided, however, any person whose obligations
constitute ten percent or more of the principal amount of the
Qualifying Assets shall be deemed to be an issuer of the portion of the
Asset Backed Security such obligations represent. For purposes of the
foregoing, if the Qualifying Assets held by the Special Purpose Entity
are themselves Asset Backed Securities (``Secondary Asset Backed
Securities''), then the Special Purpose Entity shall be treated as
holding directly the Secondary Asset Backed Securities.
(5) Shares in Master Funds. A money market fund substantially all
of the
[[Page 13980]]
assets of which consist of shares of another money market fund acquired
in reliance on section 12(d)(1)(E) of the Act [15 U.S.C. 80a-
12(d)(1)(E)] shall be deemed to be in compliance with this section if
the board of directors reasonably believes that the money market fund
in which it has invested is in compliance with this section.
(B) Put Diversification Calculations. In making calculations under
the Put diversification requirements of paragraph (c)(4)(v) of this
section, the following rules apply:
(1) Issuer-Provided Puts. In the case of a security subject to a
Put from the same institution that issued the underlying security, the
value of the securities subject to the Put may be excluded from the Put
diversification requirements of paragraph (c)(4)(v) of this section.
(2) Fractional Puts. In the case of a security subject to a Put
from an institution by which the institution guarantees a specified
portion of the value of the security, the institution shall be deemed
to guarantee the specified portion thereof, Provided, however, if the
security is an Asset Backed Security and the Put is a guarantee of all
or a portion of the first losses with respect to the security, the
institution providing the Put shall be deemed to have guaranteed the
entire principal amount of the security.
(3) Layered Puts. In the case of a security subject to Puts from
multiple institutions that have not limited the extent of their
obligations as described in paragraph (c)(4)(vi)(B)(2) of this section,
each institution shall be deemed to have guaranteed the entire
principal amount of the security, Provided, however, in the case of a
security subject to an Unconditional Demand Feature and a Put (or Puts)
that is not a Demand Feature, the Put diversification requirements of
paragraph (c)(4)(v) of this section need only be satisfied as to the
institution issuing the Unconditional Demand Feature.
(4) Puts Not Relied Upon. If the fund's board of directors
determines that the fund is not relying on a Put to determine the
quality (pursuant to paragraphs (c)(3)(ii) or (c)(3)(iii) of this
section), or maturity (pursuant to paragraph (d) of this section), or
liquidity of the portfolio security and maintains a record of this
determination (pursuant to paragraphs (c)(8)(ii) and (c)(9)(vi) of this
section), the Put diversification requirements of paragraph (c)(4)(v)
of this section need not be satisfied as with respect to such put.
(vii) Diversification Safe Harbor. A money market fund that
satisfies the applicable diversification requirements of paragraph
(c)(4) of this section shall be deemed to have satisfied the
diversification requirements of section 5(b)(1) of the Act [15 U.S.C.
80a-5(b)(1)] and the rules adopted thereunder.
(5) Downgrades, Defaults and Other Events.
(i) Downgrades.
(A) General. Upon the occurrence of either of the events specified
in paragraphs (c)(5)(i)(A)(1) and (2) of this section with respect to a
portfolio security, the board of directors of the money market fund
shall reassess promptly whether such security continues to present
minimal credit risks and shall cause the fund to take such action as
the board of directors determines is in the best interests of the money
market fund and its shareholders:
(1) A portfolio security of a money market fund ceases to be a
First Tier Security (either because it no longer has the highest rating
from the Requisite NRSROs or, in the case of an Unrated Security, the
board of directors of the money market fund determines that it is no
longer of comparable quality to a First Tier Security); and
(2) The money market fund's investment adviser (or any person to
whom the fund's board of directors has delegated portfolio management
responsibilities) becomes aware that any Unrated Security or Second
Tier Security held by the money market fund has, since the security was
acquired by the fund, been given a rating by any NRSRO below the
NRSRO's second highest rating category.
(B) Securities To Be Disposed Of. The reassessments required by
paragraph (c)(5)(i)(A) of this section shall not be required if, in
accordance with the procedures adopted by the board of directors, the
security is disposed of (or matures) within five Business days of the
specified event and, in the case of events specified in paragraph
(c)(5)(i)(A)(2) of this section, the board is subsequently notified of
the adviser's actions.
(C) Special Rule for Certain Securities Subject to Demand Features.
In the event that after giving effect to a rating downgrade, more than
five percent of the fund's Total Assets are invested in securities
issued by or subject to Demand Features from a single institution that
are Second Tier Securities, the board of directors (or its delegate)
shall cause the fund to reduce its investment in securities issued by
or subject to Demand Features from that institution to no more than
five percent of its Total Assets by exercising the Demand Features at
the next succeeding exercise date(s), absent a finding by the board of
directors that disposal of the portfolio security would not be in the
best interests of the money market fund.
(ii) Defaults and Other Events. Upon the occurrence of any of the
events specified in paragraphs (c)(5)(ii)(A) through (D) of this
section with respect to a portfolio security, the money market fund
shall dispose of such security as soon as practicable consistent with
achieving an orderly disposition of the security, by sale, exercise of
any Demand Feature or otherwise, absent a finding by the board of
directors that disposal of the portfolio security would not be in the
best interests of the money market fund (which determination may take
into account, among other factors, market conditions that could affect
the orderly disposition of the portfolio security):
(A) The default with respect to a portfolio security (other than an
immaterial default unrelated to the financial condition of the issuer);
(B) A portfolio security ceases to be an Eligible Security;
(C) A portfolio security has been determined to no longer present
minimal credit risks; or
(D) An Event of Insolvency occurs with respect to the issuer of or
the provider of any Put with respect to a portfolio security other than
a Put with respect to which a non-reliance determination has been made
pursuant to paragraph (c)(4)(vi)(B)(4) of this section.
(iii) Notice to the Commission. In the event of a default with
respect to one or more portfolio securities (other than an immaterial
default unrelated to the financial condition of the issuer) or an Event
of Insolvency with respect to the issuer of the security or any Put to
which it is subject, where immediately before default the securities
(or the securities subject to the Put) accounted for \1/2\ of 1 percent
or more of a money market fund's Total Assets, the money market fund
shall promptly notify the Commission of such fact and the actions the
money market fund intends to take in response to such situation.
Notification under this paragraph shall be made telephonically or by
means of a facsimile transmission, followed by letter sent by first
class mail, directed to the attention of the Director of the Division
of Investment Management.
(iv) Defaults for Purposes of Paragraphs (c)(5)(ii) and (iii). For
purposes of paragraphs (c)(5)(ii) and (iii) of this section, an
instrument subject to a Demand Feature or unconditional credit
enhancement shall not be deemed to be in default (and an Event of
Insolvency with respect to the security
[[Page 13981]]
shall not be deemed to have occurred) if:
(A) In the case of an instrument subject to a Demand Feature, the
Demand Feature has been exercised and the fund has recovered either the
principal amount or the amortized cost of the instrument, plus accrued
interest; or
(B) The provider of the credit enhancement is continuing, without
protest, to make payments as due on the instrument.
(6) Required Procedures: Amortized Cost Method. In the case of a
money market fund using the Amortized Cost Method:
(i) General. In supervising the money market fund's operations and
delegating special responsibilities involving portfolio management to
the money market fund's investment adviser, the money market fund's
board of directors, as a particular responsibility within the overall
duty of care owed to its shareholders, shall establish written
procedures reasonably designed, taking into account current market
conditions and the money market fund's investment objectives, to
stabilize the money market fund's net asset value per share, as
computed for the purpose of distribution, redemption and repurchase, at
a single value.
(ii) Specific Procedures. Included within the procedures adopted by
the board of directors shall be the following:
(A) Shadow Pricing. Written procedures shall provide:
(1) That the extent of deviation, if any, of the current net asset
value per share calculated using available market quotations (or an
appropriate substitute which reflects current market conditions) from
the money market fund's amortized cost price per share, shall be
calculated at such intervals as the board of directors determines
appropriate and reasonable in light of current market conditions;
(2) For the periodic review by the board of directors of the amount
of the deviation as well as the methods used to calculate the
deviation; and
(3) For the maintenance of records of the determination of
deviation and the board's review thereof.
(B) Prompt Consideration of Deviation. In the event such deviation
from the money market fund's amortized cost price per share exceeds \1/
2\ of 1 percent, the board of directors shall promptly consider what
action, if any, should be initiated by the board of directors.
(C) Material Dilution or Unfair Results. Where the board of
directors believes the extent of any deviation from the money market
fund's amortized cost price per share may result in material dilution
or other unfair results to investors or existing shareholders, it shall
cause the fund to take such action as it deems appropriate to eliminate
or reduce to the extent reasonably practicable such dilution or unfair
results.
(7) Required Procedures: Penny-Rounding Method. In the case of a
money market fund using the Penny-Rounding Method, in supervising the
money market fund's operations and delegating special responsibilities
involving portfolio management to the money market fund's investment
adviser, the money market fund's board of directors undertakes, as a
particular responsibility within the overall duty of care owed to its
shareholders, to assure to the extent reasonably practicable, taking
into account current market conditions affecting the money market
fund's investment objectives, that the money market fund's price per
share as computed for the purpose of distribution, redemption and
repurchase, rounded to the nearest one percent, will not deviate from
the single price established by the board of directors.
(8) Specific Procedures: Amortized Cost and Penny-Rounding Methods.
Included within the procedures adopted by the board of directors for
money market funds using either the amortized cost or penny-rounding
methods shall be the following:
(i) Securities for Which Maturity is Determined by Reference to
Demand Features. In the case of a security for which maturity is
determined by reference to a Demand Feature, written procedures shall
require ongoing review of the security's continued minimal credit
risks, which review must be based on, among other things, financial
data for the most recent fiscal year of the issuer of the Demand
Feature and, in the case of a security subject to a Conditional Demand
Feature, the issuer of the security, whether such data is publicly
available or provided under the terms of the security's governing
documentation.
(ii) Securities Subject to Puts. In the case of a security subject
to one or more Puts, written procedures shall require periodic
evaluation of the determination described in paragraph
(c)(4)(vi)(B)(4)(puts not relied upon) of this section.
(iii) Adjustable Rate Securities Without Demand Features. In the
case of a Variable Rate or Floating Rate Security that does not have a
Demand Feature and for which maturity is determined pursuant to
paragraphs (d)(1), (d)(2) or (d)(4) of this section, written procedures
shall require periodic review of whether the security, upon
readjustment of its interest rate, can reasonably be expected to have a
market value that approximates its amortized cost.
(iv) Asset Backed Securities. In the case of an Asset Backed
Security, written procedures shall require the fund to periodically
determine whether a person other than the Special Purpose Entity is the
issuer of all or a portion of the Asset Backed Security for purposes of
paragraph (c)(4)(vi)(A)(4) of this section.
(9) Record Keeping and Reporting.
(i) Written Procedures. For a period of not less than six years
following the replacement of such procedures with new procedures (the
first two years in an easily accessible place), a written copy of the
procedures (and any modifications thereto) described in paragraphs
(c)(5) through (c)(8) and (e) of this section shall be maintained and
preserved.
(ii) Board Considerations and Actions. For a period of not less
than six years (the first two years in an easily accessible place) a
written record shall be maintained and preserved of the board of
directors' considerations and actions taken in connection with the
discharge of its responsibilities, as set forth in this section, to be
included in the minutes of the board of directors' meetings.
(iii) Credit Risk Analysis. For a period of not less than three
years from the date that the credit risks of a portfolio security were
most recently reviewed in accordance with paragraph (c)(8)(i) of this
section, a written record of the determination that a portfolio
security presents minimal credit risks and the NRSRO ratings (if any)
used to determine the status of the security as an Eligible Security,
First Tier Security or Second Tier Security shall be maintained and
preserved in an easily accessible place.
(iv) Determinations With Respect to Adjustable Rate Securities. For
a period of not less than three years from the date when the
determination was most recently made, a written record shall be
preserved and maintained, in an easily accessible place, of the
determination required by paragraph (c)(8)(iii) of this section (that a
Variable Rate or Floating Rate Security that does not have a Demand
Feature and for which maturity is determined pursuant to paragraphs
(d)(1), (d)(2) or (d)(4) of this section can reasonably be expected,
upon readjustment of its interest rate at all times during the life of
the instrument, to have a market value that approximates its amortized
cost).
[[Page 13982]]
(v) Determinations with Respect to Asset Backed Securities. For a
period of not less than three years from the date when the
determination was most recently made, a written record shall be
preserved and maintained, in an easily accessible place, of the
determination required by paragraph (c)(8)(iv) of this section (whether
a person other than the Special Purpose Entity is the issuer of all or
a portion of an Asset Backed Security pursuant to paragraph (c)(vi)(4)
of this section). The written record shall include the identities of
the issuers of the Qualifying Assets whose obligations constitute ten
percent or more of the principal value of the Qualifying Assets, the
percentage of the Qualifying Assets constituted by the securities of
each such issuer and the percentage of the fund's Total Assets that are
invested in securities of each such issuer.
(vi) Evaluations with Respect to Securities Subject to Puts. For a
period of not less than three years from the date when the evaluation
was most recently made, a written record shall be preserved and
maintained, in an easily accessible place, of the evaluation required
by paragraph (c)(8)(ii) (regarding securities subject to one or more
Puts) of this section.
(vii) Inspection of Records. The documents preserved pursuant to
this paragraph (c)(9) shall be subject to inspection by the Commission
in accordance with section 31(b) of the Act [15 U.S.C. 80a-30(b)] as if
such documents were records required to be maintained pursuant to rules
adopted under section 31(a) of the Act [15 U.S.C. 80a-30(a)]. If any
action was taken under paragraphs (c)(5)(ii) (with respect to defaulted
securities and events of insolvency) or (c)(6)(ii) (with respect to a
deviation from the fund's share price of more than \1/2\ of 1 percent)
of this section, the money market fund will file an exhibit to the Form
N-SAR [17 CFR 274.101] filed for the period in which the action was
taken describing with specificity the nature and circumstances of such
action. The money market fund will report in an exhibit to such Form
any securities it holds on the final day of the reporting period that
are not Eligible Securities.
(d) Maturity of Portfolio Securities. For purposes of this section,
the maturity of a portfolio security shall be deemed to be the period
remaining (calculated from the trade date or such other date on which
the fund's interest in the security is subject to market action) until
the date on which, in accordance with the terms of the security, the
principal amount must unconditionally be paid, or in the case of a
security called for redemption, the date on which the redemption
payment must be made, except as provided in paragraphs (d)(1) through
(8) of this section:
(1) Adjustable Rate Government Securities. A Government Security
which is a Variable Rate Security where the variable rate of interest
is readjusted no less frequently than every 762 days shall be deemed to
have a maturity equal to the period remaining until the next
readjustment of the interest rate. A Government Security which is a
Floating Rate Security shall be deemed to have a remaining maturity of
one day.
(2) Short-Term Variable Rate Securities. A Variable Rate Security,
the principal amount of which, in accordance with the terms of the
security, must unconditionally be paid in 397 calendar days or less
shall be deemed to have a maturity equal to the earlier of the period
remaining until the next readjustment of the interest rate or the
period remaining until the principal amount can be recovered through
demand.
(3) Long-Term Variable Rate Securities. A Variable Rate Security,
the principal amount of which is scheduled to be paid in more than 397
days, that is subject to a Demand Feature shall be deemed to have a
maturity equal to the longer of the period remaining until the next
readjustment of the interest rate or the period remaining until the
principal amount can be recovered through demand.
(4) Short-Term Floating Rate Securities. A Floating Rate Security,
the principal amount of which, in accordance with the terms of the
security, must unconditionally be paid in 397 calendar days or less
shall be deemed to have a maturity of one day.
(5) Long-Term Floating Rate Securities. A Floating Rate Security,
the principal amount of which is scheduled to be paid in more than 397
days, that is subject to a Demand Feature, shall be deemed to have a
maturity equal to the period remaining until the principal amount can
be recovered through demand.
(6) Repurchase Agreements. A repurchase agreement shall be deemed
to have a maturity equal to the period remaining until the date on
which the repurchase of the underlying securities is scheduled to
occur, or, where the agreement is subject to demand, the notice period
applicable to a demand for the repurchase of the securities.
(7) Portfolio Lending Agreements. A portfolio lending agreement
shall be treated as having a maturity equal to the period remaining
until the date on which the loaned securities are scheduled to be
returned, or where the agreement is subject to demand, the notice
period applicable to a demand for the return of the loaned securities.
(8) Money Market Fund Securities. An investment in a money market
fund shall be treated as having a maturity equal to the period of time
within which the acquired money market fund is required to make payment
upon redemption, unless the acquired money market fund has agreed in
writing to provide redemption proceeds to the investing money market
fund within a shorter time period, in which case the maturity of such
investment shall be deemed to be the shorter period.
(e) Delegation. The money market fund's board of directors may
delegate to the fund's investment adviser or officers the
responsibility to make any determination required to be made by the
board of directors under this section (other than the determinations
required by paragraphs (c)(1), (c)(5)(i)(C), (c)(5)(ii), (c)(6)(i),
(c)(6)(ii)(A), (B), and (C), and (c)(7) of this section) provided:
(1) Written Guidelines. The Board shall establish and periodically
review written guidelines (including guidelines for determining whether
securities present minimal credit risks as required in paragraph (c)(3)
of this section) and procedures under which the delegate makes such
determinations:
(2) Oversight. The Board shall exercise adequate oversight (through
periodic reviews of fund investments and the delegate's procedures in
connection with investment decisions and prompt review of the adviser's
actions in the event of the default of a security or Event of
Insolvency with respect to the issuer of the security or any Put to
which it is subject that requires notification of the Commission under
paragraph (c)(5)(iii) of this section) to assure that the guidelines
and procedures are being followed.
5. Section 270.2a41-1 is amended by revising paragraph (a)
introductory text to read as follows:
Sec. 270.2a41-1 Valuation of standby commitments by registered
investment companies.
(a) A standby commitment as defined in Sec. 270.2a-7(a)(22) may be
assigned a fair value of zero, Provided, That:
* * * * *
6. Section 270.12d3-1 is amended by revising paragraph (d)(7)(v) to
read as follows:
Sec. 270.12d3-1 Exemption of acquisitions of securities issued by
persons engaged in securities related businesses.
* * * * *
(d) * * *
(7) * * *
[[Page 13983]]
(v) Acquisition of Puts, as defined in Sec. 270.2a-7(a)(16),
provided that, immediately after the acquisition of any Put, the
company will not, with respect to 75 percent of the total value of its
assets, have invested more than ten percent of the total value of its
assets in securities underlying Puts from the same institution. For the
purposes of this section, a Put will be considered to be from the party
to whom the company will look for payment of the exercise price.
* * * * *
7. Section 270.17a-9 is added to read as follows:
Sec. 270.17a-9 Purchase of certain securities from a money market fund
by an affiliate, or an affiliate of an affiliate.
The purchase of a security that is no longer an Eligible Security
(as defined in paragraph (a)(9) of Sec. 270.2a-7) from an open-end
investment company holding itself out as a ``money market'' fund shall
be exempt from section 17(a) of the Act [15 U.S.C. 80a-17(a)], provided
that:
(a) The purchase price is paid in cash; and
(b) The purchase price is equal to the greater of the amortized
cost of the security or its market price (in each case, including
accrued interest).
8. Section 270.31a-1 is amended by adding a sentence to the end of
paragraph (b)(1) to read as follows:
Sec. 270.31a-1 Records to be maintained by registered investment
companies, certain majority-owned subsidiaries thereof, and other
persons having transactions with registered investment companies.
* * * * *
(b) * * *
(1) * * * In the case of a money market fund, also identify the
provider of any put (as defined in Sec. 270.2a-7(a)(16)) or guarantee
with respect to a portfolio security and give a brief description of
the nature of the put (e.g., unconditional demand feature, conditional
demand feature, guarantee, letter of credit, or bond insurance) and, in
a subsidiary portfolio investment record, provide the complete legal
name and accounting and other information (including sufficient
information to calculate coupons, accruals, maturities, puts, and
calls) necessary to identify, value, and account for each investment.
* * * * *
PART 239--FORMS PRESCRIBED UNDER THE SECURITIES ACT OF 1933
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
9. The authority citation for part 239 continues to read, in part,
as follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77sss, 78c, 78l,
78m, 78n, 78o(d), 78w(a), 78ll(d), 79e, 79f, 79g, 79j, 79l, 79m,
79n, 79q, 79t, 80a-8, 80a-29, 80a-30 and 80a-37, unless otherwise
noted.
* * * * *
10. The authority citation for Part 274 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, and 80a-29, unless otherwise noted.
Note: Form N-1A does not and the amendments will not appear in
the Code of Federal Regulations.
Secs. 239.15A and 274.11A [Amended]
11. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is amended
by redesignating paragraph (a)(vii) as paragraph (a)(viii) and by
adding paragraph (a)(vii) and an instruction to the end of paragraph
(a)(vii) of Part A, Item 1 to read as follows:
FORM N-1A
* * * * *
PART A--INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 1. Cover Page
* * * * *
(vii) In the case of a Registrant that holds itself out as a money
market fund primarily distributing income exempt from the income taxes
of a specified state or locality (``single state fund''), a prominent
statement that the registrant may invest a significant percentage of
its assets in a single issuer, and that therefore investment in the
Registrant may be riskier than an investment in other types of money
market funds.
Instruction: The disclosure required for money market funds by Item
1(a)(vii) may be omitted if the registrant limits investment in a
single issuer to five percent of fund assets as to 100 percent of
assets.
* * * * *
Secs. 239.15A and 274.11A [Amended]
12. Form N-1A (referenced in 17 CFR 239.15A and 274.11A) is amended
by adding a sentence and an Instruction to the end of paragraph (c) of
Part A, Item 4 to read as follows:
FORM N-1A
* * * * *
PART A--INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 4. General Description of Registrant
* * * * *
(c) * * * In the case of a Registrant that holds itself out as a
money market fund primarily distributing income exempt from the income
taxes of a specified state or locality (``single state fund''), a
prominent statement that the registrant is concentrated in securities
issued by the state or entities within the state and that therefore
investment in the Registrant may be riskier than an investment in other
types of money market funds.
* * * * *
Note: Form N-3 does not and the amendments will not appear in
the Code of Federal Regulations.
Secs. 239.17a and 274.11b [Amended]
13. Form N-3 (referenced in 17 CFR 239.17a and 274.11b) is amended
by adding Instruction 11.e. to Part A, paragraph (a) of Item 4 to read
as follows:
FORM N-3
* * * * *
PART A--INFORMATION REQUIRED IN A PROSPECTUS
* * * * *
Item 4. Condensed Financial Information
(a) * * *
Instructions
11. The portfolio turnover rate to be shown at caption 10 shall be
calculated as follows:
* * * * *
e. A registrant that holds itself out as a money market fund is not
required to provide a portfolio turnover rate in response to this Item.
* * * * *
Note: Form N-SAR does not and the amendments will not appear in
the Code of Federal Regulations.
Sec. 274.101 [Amended]
14. Form N-SAR (referenced in 17 CFR 274.101) is amended by
revising the definition of ``Money Market Fund'' in General Instruction
G to read as follows:
FORM N-SAR
* * * * *
[[Page 13984]]
GENERAL INSTRUCTIONS
* * * * *
G. Definitions
* * * * *
Money Market Fund: The term ``money market fund'' shall mean any
open-end fund that meets the maturity, quality and diversification
conditions of paragraphs (c)(2), (c)(3), and (c)(4) of rule 2a-7 [17
CFR 270.2a-7].
* * * * *
15. Form N-SAR (referenced in 17 CFR 274.101) is amended by
revising the last sentence of the Instruction to Item 63 to read as
follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 63: Dollar weighted average maturity
* * * A money market fund shall determine the weighted average
portfolio maturity in the same manner as it would in monitoring
compliance with the average portfolio maturity provisions of rule 2a-7.
16. Form N-SAR (referenced in 17 CFR 274.101) is amended by adding
a sentence at the end of the first paragraph of the Instruction to Item
71 to read as follows:
FORM N-SAR
* * * * *
Instructions to Specific Items
* * * * *
ITEM 71: Portfolio turnover rate
* * * A money market fund should enter a portfolio turnover rate of
``0'' even if it owns securities that have maturities in excess of one
year.
* * * * *
17. Guide 21 (Disclosure of Risk Factors) to Form N-1A (referenced
in 17 CFR 239.15A and 274.11A) is amended by adding a paragraph to the
end of the Guide to read as follows:
Guide 21. Disclosure of Risk Factors
* * * * *
In many cases, a substantial portion of the portfolio securities
held by tax exempt money market funds is supported by credit and
liquidity enhancements from third parties, generally letters of credit
from foreign or domestic banks. These securities include variable rate
demand notes, tender or ``put'' bonds and similar securities. Where
more than forty percent of a money market fund registrant's portfolio
consists, or is likely to consist, of securities subject to these
features, the registrant should, in response to Item 4, state that,
because the fund invests in securities backed by banks and other
financial institutions, changes in the credit quality of these
institutions could cause losses to the fund and effect its share price.
Secs. 239.15A and 274.11A [Amended]
18. Guide 35 is added to Form N-1A (referenced in 17 CFR 239.15A
and 274.11A] to read as follows:
Guide 35. Money Market Fund Investments in Other Money Market Funds.
Money market funds are permitted to invest in the securities of
other money market funds in accordance with the provisions of rule 2a-7
and section 12(d)(1) of the 1940 Act. Except when a fund has invested
substantially all of its assets in the other money market fund, the
investing fund does not need to ``look through'' the shares of the
fund(s) in which it is investing in order to determine compliance with
the diversification or Second Tier Security limitations of rule 2a-
7.45 However, the investment objectives and policies of the money
market fund making the investment and the money market fund(s) in which
it is investing should not be inconsistent. Paragraph (c)(4)(iv)(A)(5)
of rule 2a-7 describes the obligations of a fund that invests
substantially all of its asset in another money market fund.
\45\ See Investment Company Act Rel. No. 21837 (March 21, 1996)
at Section II.G.2.
---------------------------------------------------------------------------
Secs. 239.17a and 274.11b [Amended]
19. Guide 38 is added to Form N-3 (referenced in 17 CFR 239.17a and
274.11b) to read as follows:
Guide 38. Money Market Fund Investments in Other Money Market Funds
Money market funds are permitted to invest in the securities of
other money market funds in accordance with the provisions of rule 2a-7
and section 12(d)(1) of the 1940 Act. Except when a fund has invested
substantially all of its assets in the other money market fund, the
investing fund does not need to ``look through'' the shares of the
fund(s) in which it is investing in order to determine compliance with
the diversification or Second Tier Security limitations of rule 2a-
7.45 However, the investment objectives and policies of the money
market fund making the investment and the money market fund(s) in which
it is investing should not be inconsistent. Paragraph (c)(4)(v)(A)(5)
of rule 2a-7 describes the obligations of a fund that invests
substantially all of its assets in another money market fund.
\45\ See Investment Company Act Rel. No. 21837 (March 21, 1996)
at Section II.G.2.
---------------------------------------------------------------------------
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Dated: March 21, 1996.
[FR Doc. 96-7334 Filed 3-27-96; 8:45 am]
BILLING CODE 8010-01-P
